(James Saft is a Reuters columnist. The opinions expressed are his own)

Stocks and other risky assets are rallying around the world this week because the Group of 20 nations said on the weekend they would keep the economic stimulus flowing, a state of events which illustrates where we are and what a very strange place it is.

The G20, the only group of big hitters that matters because it is the only group which includes the Chinese, met in Scotland over the weekend and, as is the way of these things, did very little with immediate consequences for anybody.

In the communique they issued, the Group of 20 finance ministers, after congratulating themselves on the recovery, more or less admitted that the measures we once thought of as heroic are in the process of becoming commonplace.

"However, the recovery is uneven and remains dependent on policy support, and high unemployment is a major concern," the statement said. "To restore the global economy and financial system to health, we agreed to maintain support for the recovery until it is assured."

Let me put that in human terms for you:

"We've spent untold trillions saving the economy, but, er, we've really only saved the financial system and that only to the extent that we keep on saving it. Jobs, well, not so much. We therefore pledge to continue doing this thing that may or may not be working until we are sure that it is."

Global stock markets then went off on a stonking rally on Monday, which major media attributed to the pledge of continued stimulus. I suppose we shouldn't dismiss the possibility that the financial media was, as we often do, mistaking coincidence for causation, but professionals were citing it too.

So, what are they promising to do? Will they be able to do it? And why do the risk markets like it so much?

There are at least two aspects to the stimulus - continued easy money from central banks and actual government spending.

The easy money part - low interest rates and unconventional measures - clearly will continue. It will be politically very difficult to raise interest rates while unemployment is still so high, and given the wan nature of the recovery, unemployment will take a long time to fall.

The actual government spending part is a lot harder to bank on, as it were. One reading of the Japanese experience in the 1990s is that their stimulative measures worked but they lost heart and withdrew them for mostly political reasons, thereby bringing on a relapse from which they never really properly recovered.

The politics of another stimulative spending binge will not be easy, especially in the U.S. and especially given populist backlash. That's not to say more stimulus won't be needed, it very likely will, but you can't count on it arriving. Deleveraging takes a long time and we very likely would have been better off just writing the debt down in the first place.

MARKETS LOVE CERTAINTY

Investors have decided, and I think they are probably right, that so long as the authorities are hell bent on reflation it is foolish to get in the way.

As analyst David Merkel has pointed out, the statement of the Federal Reserve meeting, released last week, characterized financial markets as "roughly unchanged" since they last met in September, revealing that they pay far more attention to equity markets than debt markets.

Because of course equity markets were going more or less sideways in October but many of the riskier parts of the debt markets were rallying strongly. Wasn't this whole crisis, and its expensive fix, supposed to be about "unfreezing credit markets"? Not anymore, apparently.

That is because the Fed realize that they have got to keep equity markets up, indeed have got to force them to rise. It is the only way to float the equity above the debt, make the banks and the holders of debt whole, and allow the financial system to weather the crisis.

There were other options - default, temporary nationalization - but that is not the route we went down. So, within this context the rally makes great sense.

Notice how equity markets have been on a huge tear since last week, going up on news that implied that the Fed would remain on hold for a long time, going up on unemployment rising through 10 percent in the U.S. and, funnily enough, going up on faith that the G20 would stick with stimulus measures.

This brings us to the crazy part. While it may be individually rational for everyone to hitch a ride on the policy train and follow asset prices higher, I would argue that the project is collective folly.

The risks are inflation and a rapidly falling U.S. dollar which leave banks and debtors solvent in nominal terms but not better off. Those risks are best observed now through the dollar, which is falling, and gold, which is at record highs.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The discrediting of the efficient markets theory in the aftermath of the financial crisis appears to have been accompanied with growing support for the view that rather than efficient in nature, financial markets are predisposed towards the formation of bubbles.

A bubble can simply be defined as an occurrence that begins when the price of an asset has been driven significantly above it “fair” value. According to the efficient markets theory this would not happen.

If bubbles are a natural outcome of financial market activity it is relevant to ask whether the very loose fiscal and monetary policies of many central banks and governments are presently sowing the seeds of the next bubble.

Even though the real economies of the U.S., UK, Eurozone and Japan continue to be defined by expectations of rising unemployment and falling real wages, access to cheap money has already helped restore the profitability of many investment banks.

In turn, this has fed risk appetite which is evident in the rally in stocks since the spring, increased demand for “risky” currencies and a recovery in commodities prices. Brent oil has rallied by 128 percent from its 2009 low. The ability of oil to rally despite the existence of oil supplies well above the seasonal average suggests there is already speculative element in this market which could be in danger of driving prices above their fair value.

This week’s meetings of the Federal Reserve, the Bank of England and the European Central Bank have focussed attention not so much on rates, but on the extraordinary policy decisions taken by these central banks in the wake of the financial crisis and whether conditions are ripening in favour of a gradual withdrawal of some of these policies.

The Fed last week ended its $300 billion treasury bond purchasing plan, though it will carry on buying mortgage backed securities. The Bank of Japan last week announced that it will stop buying corporate bonds at year end. The Reserve Bank of India also removed emergency support measures last week.

This week there is speculation that the ECB could announce that it will hold no more 12-month cash tenders next year. By contrast the Bank of England is expected to increase quantitative easing at the November 5, Monetary Policy Committee meeting. Supporters of quantitative easing continue to stress that the lack of clear inflation pressures suggests there is room for these plans to be extended.

However, the lack of response in either money supply or inflation indices could equally be illustrating that these plans are not having a significant impact on the real economy and are therefore no longer appropriate. The paring back of these plans are likely to have an impact on the ability of some banks to turn an easy profit and thus should rein in risk appetite and limit speculative and “bubble” forming activity.

Unfortunately, a bubble can only be truly confirmed after it has burst; a characteristic with clear destabilising consequences. If bubbles are natural phenomena within financial markets, the need for tighter regulation and ongoing reviews of processes that oversee the financial system are absolutely necessary.

This conclusion, while in complete contrast to the implications of the efficient markets theory, ties in very well with the political desire to reform the banking regulatory framework in order to protect the tax payer from future hefty bank bail-out costs. The banking landscape, while already vastly different from just two years ago could continue its transformation for years.

researchEMEA@forrex.com

Having wrapped up the two-day get-together in London, G20 central bankers moved down to the Swiss city of Basel (I counted central bank governors and officials from at least 9 countries onboard the same flight) to discuss more about the global economy for a two-day meeting.

The focus here again is the global economic recovery, which seems to be gathering momentum, and the timing of exit policy -- which is essential in the future to avoid inflationary pressure.

The mood is decidedly more positive this time than the last time they met in Basel, where they warned that unprecedented attempts to stimulate economic may fail to bring a sustainable recovery.

G10 chairman and ECB President Jean-Claude Trichet will give a briefing on Monday.

Trichet has recently been sounding as if he expects a double-dip recession, as our European affairs columnist Paul Taylor suggests here.

It just won't go away, this needling worry about the U.S. dollar losing its coveted top-dog status.

No matter that there are plenty of reasonable arguments to support the dollar as the world reserve currency -- namely there's just no alternative -- for perhaps decades to come.

Yet, in a world where once-rock-solid assumptions quickly turn to dust, investors should keep an eye on the dollar since changing perceptions are chipping away at its cherished status as currency to world.

Much of the debate so far this year has centered on creating an alternative to the U.S. dollar, championed by China and Russia as a way to wean the world off its dependence on the U.S. as well as buffer individual nations against the missteps of those in developed world. Most recognize creating a new currency will take years and the chances of an existing currency, like the yuan, usurping the dollar anytime soon are remote.

But that doesn't mean big money isn't starting to prepare for world in which the buck isn't the currency of choice.

Curtis Mewbourne, a portfolio manager at PIMCO, has suggested that investors diversify away from the dollar and to move into other currencies, especially those in emerging markets.

"And while we have not yet reached the point where a new global reserve currency will arise, we are clearly seeing a loss of status for the U.S. dollar as a store of value even in the absence of a single viable alternative," he wrote in an article published on PIMCO's website.

Notwithstanding its big bounce during the financial maelstrom last year, the dollar has been on downward trajectory for most of this decade. The U.S. dollar index, which currently stands around 78, once traded well above 100. In the early days of the dollar's decline, currency traders worried about general diversification where central banks with big dollar reserves would begin to shave off a small portion of their holdings and exchange them for something else like euros.

The financial crisis, however, woke the world up to just how vulnerable those squirreling away dollars -- like China and Russia -- were to the fortunes of the United States. The bulk of the world's currency reserves are in dollars, with the euro still a distant second. Foreign central banks, however, could hardly start selling dollar-denominated assets to limit their exposure because such sales would cause prices on their remaining holdings to fall further.

So far, calls for alternative currencies have been seen as political posturing for both international and domestic audiences alike, but the United States. has a lot to lose if it ever turns into something more concrete.

That's because the loss of reserve status means, among other things, that the United States would lose a crucial crutch that has allowed it to borrow its way into prosperity as well as out of depression with relative impunity. Foreign investment in dollar assets have helped keep a cap on interest rates even though the government's borrowing binge in recent years has brought new meaning to the word stimulus.

In an op-ed published in the New York Times today, Warren Buffett railed against the flowing red ink that will push the nation's debt to roughly 56 percent of GDP from 41 percent in this fiscal year.

Presumably this is something that has also caught the eye of foreign investors.

While the greenback is likely to stay on top for some years, persistent concerns about its reserve status and moves to diversify away from it could usher in a new era for U.S. borrowers, public and private alike -- a more painful one where debt costs can no longer be offset by the kindness of foreign investment.

-Morten Hansen is head of the economics department at the Stockholm School of Economics in Riga. The opinions expressed are his own.-

Latvia, with its 18 percent year-on-year economic decline, ruthless budget cuts to meet the demands stated by the IMF-EU bailout package and recurring rumours of devaluation, may be the most written about country in the world right now, at least on a per capita basis.

Yet life goes on here and journalists I speak to seem somewhat disappointed when I cannot confirm sighting starvation or death in the streets…. Admittedly, it is very hard to be optimistic but it was clearly a positive sign when the parliament approved yet another round of budget cuts including across-the-board 20 percent wage cuts in the public sector and a 10 percent cut in pensions, which should release another tranche of much-needed money from the IMF and the EU. These cuts are tough but necessary as Latvian public finances were unsustainable – even in the years of growth rates of 9, 10, 11 percent the country still ran budget deficits.

Whatever the value of the currency, the public sector needs serious reform, which is why I am somewhat annoyed by the incessant rumours of devaluation emanating from in particular Sweden and the UK. The currency and the public sector are not linked to each other and should be treated as separate issues.

The Latvian central bank has repeatedly made it very clear that devaluation is not an option – and let me be the first to admit that such announcements have been made by numerous central banks on numerous occasions in the past, only to see devaluation nevertheless.

What foreign observers miss is the length to which the Latvian authorities will go to maintain the peg – very considerable pain in the form of high unemployment and declining GDP is acceptable here, rightly or wrongly, as the currency is viewed as an anchor of stability and euro adoption as the main monetary goal.

The spectre of an uncontrolled devaluation/currency collapse and of the collateral damage in the form of contagion effects are the main arguments against devaluation.

Competitiveness in the private sector is to be raised by “internal devaluation” in the form of declining wages – an “undoing of the past”, so to speak, where wages in some years rose as much as 35 percent year-on-year. Textbook-wise this works well, practical examples are, however, few and far between. Casual evidence does suggest, however, that this mechanism is working here (at 17 percent unemployment choosing between a wage cut and being laid off is easy and there are barely any trade unions to resist wage compression).

Will it work and will it work fast enough? This is still uncharted territory but I think it should be given a chance – but of course it is an uphill struggle and the mythical figure of Sisyphus might have found his task quite a bit easier.

-- James Saft is a Reuters columnist. The opinions expressed are his own --

The recession will soon be dead, laid to rest alongside the idea of the "Great Moderation", a set of hopeful assumptions that underpins expectations about economic growth and asset valuations.

This, when investors, bankers and executives ultimately realise it will cause them to pull in their horns, take less risks and be less willing to pay high prices for assets.

Economists, observing that since the 1980s recessions have been mild and short and expansions long and robust, developed the theory that better economic management, namely cutting rates in the aftermath of bubbles, globalisation and, get this, improvements in financial markets, had led to a sort of best-of-all-possible-worlds "Great Moderation", in which economic volatility fell and with it the risk premia required for holding financial assets.

This little theory has, needless to say, come somewhat unstuck during the current downturn which has been great but far from moderate.

This raises the uncomfortable possibility that the last 25 years of good times were just a bit of luck, or even worse, an artificially engineered consumption binge with central banks and governments playing a role similar to what Chicago tavern keepers used to do -- opening up early so last night's patrons can have a quick nip to take the edge off on the way into work.

It's a debate which is far from academic and its outcome will influence much more than the actions of central bankers and regulators.

While financial market volatility has been a feature during the past decades, the idea, or at least the feeling, of the Great Moderation has seeped into the culture, influencing the behaviour of actors across the economy.

A corporate manager is going to be more likely to leverage up and go for the big hit if he feels as if most recessions are mild and short, in the same way that a consumer will buy a boat on credit or an investment property for the same reasons. If the weather never gets that cold why waste money on insulation?

What if these people now decide that the universe is a less friendly place and that they ought to, heaven help us all, save a considerable amount against the day?

This is really about volatility, which, because it can tend to ruin you, is expensive. Most investment or economic management strategies have at their heart attempts to limit or cushion volatility. And so, if we really can expect more volatility in the economy we can expect it to find expression in a lower ceiling for economic growth, leverage and asset prices.

IT AIN'T NECESSARILY SO
Of course, the current debacle may be just one data point rather than a trend, a view financial markets seem to have adopted. That is more or less the argument of Larry Summers and the U.S. administration, who are betting that this is the kind of thing that happens only very rarely.

This is a version of the 100-year storm argument beloved of company managers trying to explain why their results are so poor; the implication is you could not have been expected to plan for a freak storm and once it is past it is back to the good times.

This thinking lies behind the strategy of making financial conditions so easy that people are tempted to borrow and invest. It just might work, and we just might have a sharp and long recovery which generates enough revenue to pay off the public debts we are now racking up.

But two other possibilities, both speculative, spring to mind.

One is that deleveraging proves to be not just an event but a state of mind. As in Japan, people may simply decide that they've had enough risk, thank you very much, leading to a weak recovery, a relapse and then a quandary about how best to pay off the bills we've recently run up.

The other is that the current mix of policy, deep cuts in interest rates, deficit spending and quantitative easing, the effects of which are little understood, ends up breeding volatility of its own, probably in inflation.

The cost of that volatility will be an unpleasant surprise to the investors now bidding up the prices of shares and managers now preparing to invest for expansion, and one that might lead them to at last act more conservatively.

Add to arguments for a new "Great Immoderation"  that emerging markets will almost certainly be more of a driver of global economic growth under most of the reasonable scenarios in the coming decade. Emerging markets historically are more volatile and if as they grow to be a bigger piece of the pie are likely to make overall growth more volatile.

None of this takes away from the essentially good news that the recession looks to be ending soon, but higher economic volatility will hang heavy over the recovery and the cycle to come.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.--

-- John Kemp is a Reuters columnist. The views expressed are his own --

The bond market's adverse reaction after the Fed announced no new asset purchase facilities or bond buyback programs highlights the fundamental difference between interest rates and quantitative easing (QE).

Rate cuts provide ongoing support for an indefinite period until the Federal Open Market Committee chooses to reverse them. In contrast, QE programs provide a one-off, time-limited boost that has to be continually reapplied to have the same effect.

With interest rates a decision to leave rates alone represents "no change" in policy; with QE, a decision to leave the scale and duration of the buyback program unchanged is a "tightening".

QE is time-limited because it drives up bond prices and cuts yields only as long as buybacks continue, or are expected to do so. Once planned buybacks have been completed, or are not expected to be extended, the market will revert to its natural clearing equilibrium. Repeated doses of QE are needed just to keep yields unchanged.

This creates something of a dilemma for policymakers in both the United States and the United Kingdom. The Bank of England's program to buy 75 billion pounds worth of government and corporate bonds will be completed in mid-June. The Fed's program to buy $300 billion of medium and long-term U.S. Treasury securities finishes in September.

Once the current round of purchases are complete, both central banks will have to decide whether to embark on another one (intensifying criticism about inflationary financing of public debt) or end it (triggering a sharp yield increase).

In fact, yields will start rising well ahead of the formal end of the programs, unless the Bank and the Fed give a clear signal they will undertake further purchases.

The dilemma is especially pressing for the Bank of England given the imminent expiry of the current round. Officials will come under pressure to clarify their intentions at next week's Monetary Policy Committee meeting. But the Fed too will face growing pressure over the summer to signal whether the existing programme will be extended beyond September.

It was the Fed's failure to announce new and larger QE programs yesterday, and the implication that current support might expire in a few months, that caused the bond sell off overnight. Yields on 10-year U.S. Treasuries jumped to 3.16 percent, the highest since Nov. 2008 on Thursday, undoing all of the gains since the Fed announced its QE programme last month.

Terminating QE programs and not replacing them would amount to a sharp tightening of policy and trigger a large, destabilising rise in yields. So the central banks might opt to scale them back instead -- continuing to buy debt, but in progressively smaller quantities -- as a smoother way to withdraw exceptional support.

The problem is that if QE programs are not withdrawn fairly soon, they risk breaking down anyway under the weight of their own internal contradictions. Because the longer programs run, the more debt central banks will monetize, and the more fears of an eventual inflationary breakout will grow.

Eventually upward pressure on yields caused by increased fears about inflation will offset the downward pressure from QE purchases, neutering the programs' effectiveness. At that point, ever larger quantities of QE will be needed to achieve the same degree of yield reduction or stabilization.

QE may have bought the central banks a little time but returns will diminish later in the year. The sooner they can articulate a managed retreat the more likely they are to retain some influence over the back end of the yield curve.

-- James Saft is a Reuters columnist. The opinions expressed are his own --

The dollar is, and will remain, the U.S.'s currency and its own and everyone else's problem.

The idea of creating a global currency, as espoused by China earlier this week, is interesting, has a certain amount of merit and is simply not going to happen any time soon.

U.S. desire for free access to the cookie jar that being the world's reserve currency represents will be too strong, especially given its need to finance huge amounts of debt reasonably cheaply. As well practicalities are fearsome, even if consensus was more or less there.

Chinese central bank head Zhou Xiaochuan on Monday called for the creation of a new "super-sovereign" global reserve currency, advocating building on an International Monetary Fund instrument called Special Drawing Rights.

Zhou echoed a call by Russia last week, when it indicated it would raise the issue at the upcoming Group of 20 meeting in London on April 2, saying the idea had support from emerging market economies including Brazil, India, South Korea and South Africa.

There is no doubt that the current system breeds instability, but it enjoys the great advantage of entrenchment and sticking with it allows the U.S., and others, to avoid making hard choices and paying true market prices for their economic decisions.

No surprise then that President Obama knocked the idea down in blunt terms. "I don't believe that there's a need for a global currency," Obama said, terming the dollar "extraordinarily strong right now."

Exactly. Too strong by some margin, especially when one considers the coming effects of both quantitative easing and a massive long-term need to fund the costs of the debt binge that exploded and the ever increasing bailout to clean up the aftermath.

In fact you could say the dollar's "extraordinary" strength can only be fully explained when you take into account the fact that foreign central banks keep piling up huge reserves of the thing and that it is the international medium of exchange for commodities and energy, well really for global trade and financial intermediation.

Treasury Secretary Timothy Geithner said on Wednesday the U.S. dollar is still the world's reserve currency and will remain so for a long time, but expressed openness to greater use of IMF SDRs.

The dollar's central role has two main implications, both rather ugly but also very seductive for those involved.

For the U.S. it's a bit of a free ride as far as debt financing goes. People buy and hold treasuries more and the U.S. gets cheaper financing that would otherwise be the case. Of course that's a bit like an alcoholic bartender getting a discount at work; a real benefit, but not a true one.

It also means that even if the U.S. has the will to take away the proverbial punchbowl or drive the dollar down, it doesn't always have control, as what it does at the short end of the interest rate curve can be confounded by foreign purchases that keep the long end and financing costs down and the dollar up.

SOVEREIGN OVER US ALL?

The U.S. reserve status also opens up the opportunity for mercantilist countries, like, say China, to keep its own currency cheap, building up huge dollar stocks and force-feeding the American milch cow with cheap credit with which to buy imported goods.

That may not work any more anyway, as all of the cow's stomachs are full and the milk's gone thin.
There is a temptation also to build up reserves as protection against bad times and bitter IMF medicine.

Many Asian leaders seem to have vowed after 1997 that they would do what was needed, which often included building up dollar reserves, to avoid having to meet an IMF director's plane at the airport and accept the accompanying prescription.

That rather indicates that the old system, with the U.S. as global reserve currency, is dying, but I doubt it will do so without a fight and with cooperation among nations willing to cede part of their sovereignty, even for a greater good.

It is amazing and encouraging that China speaks of ceding control of a portion of its foreign reserve assets to IMF management, but I have a hard time seeing it happening widely soon.

So, we will have to get through the next year or two without a super-sovereign currency and with global imbalances being worked out, or around, under the current system.

My best guess is that things actually go in the right direction, more or less. The dollar should weaken as a result of U.S. policy even without a deliberate push downhill from the Chinese. Asian exporting nations will see slowing reserve growth generally, which should translate into diminished flows into the dollar and Treasuries.

That's going to be painful all around. The Chinese and others will see their investments dwindle, even as they have to resist the impulse to sell into the fall. For the U.S. the process of implementing monetary policy and paying for fiscal policy will be made that much more difficult.

So, goodbye and perhaps good riddance to dollar hegemony, but don't expect a stable system of global cooperation to rise easily and quickly in its place.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund --

-- John Kemp is a Reuters columnist. The views expressed are his own --

It is time to add another victim to the ever-growing list of institutions (Bear Stearns, Lehman Brothers) and theories (value at risk, fair value accounting and originate to distribute) which have been tested by the financial crisis and found wanting. The central bank practice of inflation targeting -- the jewel in the crown of modern monetary economics -- has palpably failed.

Over the last two decades, inflation targeting has emerged as the most popular strategy for monetary policy among the world's major central banks, and become something of a state-of-the-art choice among theorists and central bankers.

Even the Fed, long skeptical, considered announcing a formal target for inflation last year. Senior officials considered whether it would be a useful way to counter the threat of deflation by providing an "anchor" for expectations about future prices. In the end the central bank ducked the decision and decided to press ahead with long-term inflation forecasts instead, as a form of "soft" targets.

But the experience of major central banks over the last five years -- both those pursuing formal targets and those like the Fed which have been employing "shadow" ones -- suggests inflation targeting has failed and will need to be overhauled once the immediate crisis has passed.

CENTRAL BANK PERFORMANCE

Controlling inflation has been the central objective for monetary policy for the last 30 years. But using interest rates to target the inflation rate directly emerged only in the early 1990s. In many countries, it was something of a default choice after strategies targeting intermediate variables (such as the money supply and the exchange rate) had been tried and failed.

In its own (narrow) terms, inflation targeting has been successful. In the United Kingdom, consumer prices have increased broadly in line with the Bank of England's target since the central bank was given operational independence to set interest rates in May 1997.

Evidence from the United States is more mixed. The Fed has long insisted it does not have a formal inflation target (preferring to retain flexibility for what it calls a "risk-management" approach). But senior officials have defined the "price stability" component of its dual mandate as an inflation rate of about 1.5-2.0 percent per annum.

Both the all-items consumer price index and the core index excluding food and energy have consistently risen faster than the Fed's implied target since 1997. Access PDF here.

In fact, the performance of inflation and the Fed's interest rate decisions suggest the Fed has actually been targeting a core inflation rate of about 2.25 percent per year, or an all-items rate of 2.50 percent.

While this is slightly faster than officials have been prepared to admit publicly, it is still respectable by historical standards.

The real problem is that a narrow obsession with hitting inflation targets blinded central bankers around the world to the build up of other problems, including bubbles in the bond and real-estate markets, as well as the build up of excessive levels of household and corporate debt.

Moderate growth in each month's consumer price numbers provided false comfort even as distortions built up in other parts of the financial system (overvalued asset markets) and economy (a gaping trade imbalances and surging commodity prices).

If the ultimate purpose of inflation targeting was to provide a stable economic framework for long-term decision-making by households and businesses, it has failed. Bubbles and over-indebtedness have caused far greater output losses when they collapsed than any amount of moderate consumer price inflation.

FLAWED THEORY

The excessively narrow focus of inflation targeting reflects conceptual shortcomings.

In 1952, Professor Jan Tinbergen proved that to achieve two independent policy objectives simultaneously, policymakers must employ two independent policy instruments.

Tinbergen's rule implies monetary and fiscal policy work best when coordinated to achieve the optimal joint outcome for inflation and growth, or between internal balance (inflation-growth-employment) and external balance (the trade deficit and exchange rate).

But in a curious inversion, modern economics has sought to separate them, assigning monetary policy the role of pursuing price stability, while leaving fiscal policy to worry about growth and employment.

It reflects the impact on the discipline of Milton Friedman's famous comment about inflation being "always and everywhere a monetary phenomenon," amplified by the impact of the rational expectations revolution, which seemed to indicate monetary policy could not have an enduring impact on the level of business activity and employment, only on prices.

From this stemmed the idea monetary policy should focus on choosing a desirable (low) rate of inflation, leaving other aspects of demand-management and employment policy to fiscal policy.

The discipline has gone further, and sought to implement an institutional separation between the fiscal and monetary authorities. Most theorists have supported establishment of "independent" central banks able to set monetary policy at arms length from the fiscal authorities.

This reflects a mistaken view that monetary policy is essentially a technical academic exercise that can and should be insulated from other aspects of the policymaking process.

Reflecting this technocratic approach, modern monetary economics has been dominated by a debate over rules versus discretion -- with a rule-based system generally held up as superior.

The history of the discipline since the late 1970s can be summed up as the perfect monetary "rule," specifying how much the central bank should adjust the instruments under its control (reserves and interest rates) to achieve some intermediate variable (money growth and the exchange rate) or direct target (consumer prices) and ensure the ultimate goal of price stability is met.

PRACTICAL SHORTCOMINGS

But focusing monetary policy on consumer prices encouraged central banks to ignore signs of growing instability in other parts of the financial system (such as asset prices and lending). The target was too narrow and needs to be broadened in future.

It was a mistake to separate monetary policy and fiscal policy and assume monetary policy could somehow operate in isolation from tax and spending decisions and other interventions in the economy. Macro management would be more effective if monetary policy and fiscal policy were coordinated.

Elsewhere, I have suggested the authorities might need to go further and supplement existing monetary and fiscal policies with a third, distinct policy to govern the quantity of credit and build up of debt to ensure that internal balance, external balance and financial balance can all be achieved simultaneously.

Finally, it was a mistake to pretend monetary policy is a technocratic exercise. Decisions about interest rates have distributional effects (between savers and borrowers, more and less growth, more and less employment) and are inherently political.

This is not an argument for interference. But it is an argument for greater honesty about the social trade offs involved.

It is also an argument for allowing discretion back in. Rather than mechanically applying rules targeting a single variable such as consumer prices, central banks need freedom to respond to changing circumstances. That means freedom to cut interest rates dramatically in response to a financial panic. But it also means freedom to raise them during a boom to prevent wider distortions in the financial system even when there are no obvious signs of consumer price inflation.

Inflation targeting needs to be reworked in favor of a more holistic approach that gives central bankers more discretion to pursue a complex set of goals (including financial stability. But they must also be held more accountable, and accept this not just a technical exercise but one which involves difficult choices for society as a whole.