Journal Issue


International Monetary Fund. External Relations Dept.
Published Date:
January 1992
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Currencies and Monetary Policy: Searching for an Effective Approach

Paul Volcker and Toyoo Gyohten (edited by Lawrence Malkin)

Changing Fortunes

The World’s Money and the Threat to American Leadership

Times Books, New York, NY, USA, 1992, xix + 394 pp., $25.

Changing Fortunes should be required reading for the incoming US Secretary of the Treasury and, for that matter, all finance ministers and central bank governors of major industrial countries. This is not because it is such a well-written (and edited) book or an easily accessible review of a complex aspect of recent history—which it is. Instead, it should be read because it is a look at the past that is remarkably relevant to the challenges faced today by those responsible for moving the world economy out of its sluggish state to a new path characterized by low inflation and expansion. This authoritative story of the evolution of the Bretton Woods system, from its inception through 1991, informs us of the lessons learned, and shares with us much of the wisdom gained from this period.

The authors were both centrally involved in the development and management of the par value system, as well as the turbulent transition to today’s floating rate system. For those who are mostly familiar with Volcker as the Chairman of the Federal Reserve Board from 1979 through 1987, there are fascinating accounts of his prior experience as an officer in the US Treasury, dating from 1957 through the mid-1970s (with some occasional excursions into private banking). Toyoo Gyohten was a career official in the Japanese Ministry of Finance, whose distinguished career culminated with appointment to the key policy position of Vice Minister for International Affairs.

The book is built around a series of lectures given by the two authors at Princeton during 1990 and 1991. Each writes on a particular period—such as the breakdown of the par-value system—from his particular vantage point. Throughout the book, Volcker and Gyohten remind us that in some respects history does indeed repeat itself, and that efforts to cope with today’s problems could benefit from the insights gained from earlier experience. Consider for example, the following excerpt:

“Once the principle of easy exchange rate changes, however small, was agreed, it seemed to me that speculative changes in the market would make it extremely difficult to resist larger changes and would probably cause them quickly…Experience strongly suggests that a “flexible fixed-rate system” is more than a verbal oxymoron; it has inherent contradictions that tend either to tear it apart or to drive it to greater fixity.” [Or both, I would add], (pg. 69)

This is not a comment on recent developments in the European exchange rate mechanism, although much of the quote could certainly apply. Instead, it is Paul Volcker reflecting on the efforts of the United States to introduce flexibility into the Bretton Woods par value system in 1969, when it was becoming increasingly clear that the dollar was overvalued and that a devaluation was needed.

More than once we are reminded of the problems that can spread in a monetary system when the anchor country—and currency—is unable to deal with fiscal strains at home. For example, there were many factors that contributed to the demise of the par value system, but certainly one of them was the difficulty the United States experienced in responding to the economic pressures of the Vietnam War. To quote Volcker in two separate but related passages, “our inability…to take actions to restrain the economy against the economic stimulus of Vietnam spending seems to me and many others the beginning of the inflationary process that plagued us for years…. Shouldn’t the United States have been more rather than less responsive to the discipline of the system in shaping domestic policy?” (pg. 38)

One might find some parallels here (undoubtedly debatable and imperfect) with US fiscal performance in the 1980s, or even with the German role in recent ruptures in the European exchange rate mechanism. Although the factors underlying the recent market-forced depreciation of the pound and the lira are complex—and derive substantially from difficulties in the United Kingdom and Italian policies themselves—Germany’s contribution to the problem as the anchor of Europe cannot be overlooked. High interest rates in Germany, which have had such a dampening effect on growth prospects throughout Europe, are a direct reflection of the difficulty that Germany has had in taking the measures needed to offset the spending increases brought about by unification.

This raises a perplexing question relating to all three post-war international monetary “systems”—the par value system, the “wide open” flexible rate system of the late 1970s and early 1980s, and the more “constrained” flexible system of the mid- to late-1980s: why have we been unable to devise a system that exerts some degree of discipline, short of abrupt market-imposed pressures, on the domestic (particularly fiscal) policies of the major industrial countries? A common answer is that our parliamentary democracies do not lend themselves well to internationally coordinated fiscal policy. In addition, as Volcker points out, the lags involved in fiscal policy formulation and execution make delivery and monitoring particularly complicated. These are undoubtedly legitimate points. And yet one is inclined to conclude after reading this book that we have little choice but to continue searching for a more effective approach if we are to preserve the open trade and payments system and expanding world economy that have characterized the post-war system to date. Can anyone really look at the current global economic outlook and not see the pressing need for more external constraints on G-7 fiscal policies?

The discussion by Volcker and Gyohten of the efforts in the mid-1980s to develop a system of economic policy coordination following the Plaza Accord sheds further light on this dilemma. Although much of the attention at the time of the Plaza was given to the exchange rate provisions of the Accord, Gyohten does an excellent job in this book sketching out the process of economic policy coordination that evolved following the Plaza, including the nascent development of a set of “economic indicators” to help guide policies and performance toward mutual goals. (Since this was a Finance Ministry-driven exercise, Volcker was somewhat less involved in the formative stages.)

As Gyohten states, at the Tokyo Summit in May of 1986, “Economic Indicators were introduced and accepted, and there were some efforts, particularly from the American side, to introduce a certain amount of automaticity in this policy coordination—targets would be set, and if actual economic performance deviated significantly, a government would have to act to try to meet the goals of growth, inflation, or whatever.” (pg. 262)

The effort produced some results, including the coordinated interest rate moves of 1986 and 1987. Fiscal measures were somewhat less pronounced; although the Japanese supplementary budget of October 1986, the commitment by the German Government to accelerate tax reductions in early 1987, and the US bipartisan budget agreement of late 1987 all were influenced, to some degree, by the policy coordination framework. As Gyohten suggests, “the initiative taken by the United States to institutionalize coordination and align exchange rates was a very positive and an almost historic step.” (pg. 263)

Almost, indeed. A major opportunity to strengthen the system has been missed, as the policy coordination process was not adequately institutionalized, and its impact on policy in recent years has waned. The policy coordination thrust represented a genuine effort on the part of the United States, with strong support from France, to reintroduce some “rules of the game” into the international monetary system that could have applied to the domestic policies of major industrial countries, both deficit and surplus countries.

Both Gyohten and Volcker correctly point out that the effort was not without its flaws. Gyohten argues that the process was dominated too heavily by US efforts to make a political deal while Volcker underscores the technical difficulties encountered and the fact that “objective indicators” could never substitute for informed policy judgment.

I can agree with all of those criticisms, but I remain perplexed as to why none of the leaders of the other G-7 countries, with the exception of France, seized the opportunity to address a growing preoccupation—how to steer US policies toward, what they saw as, an internationally responsible course. Perhaps each country was more concerned about the potential constraints on its own policy choices than with the potential benefits to all, from the collective discipline that could have been developed. It seemed to me, then and now, that policy coordination held out the best hope of developing a framework of “pragmatic discipline,” which could turn on a “yellow caution light” when a country veers off an intended course, and direct an even stronger spotlight on the need for corrective action if the deviation is a substantial and persistent one. Although a presumptive indicator system will never substitute for political will, it can help foster the pressures for remedial action, and can assist in the building of a monistic consensus in support of needed policy changes.

The title of the book speaks to the declining fortunes of the United States and the improving fortunes of Japan during the postwar era. It is a story that is well known and well documented, but the series of lectures embodied in this book give this evolution a special definition, as each author describes the evolution of his country’s fortunes from his own national perspective.

In the end, however, the US/Japan story comes across as a secondary one. At the heart of this work is the story of dedicated financial leaders, such as Paul Volcker and Toyoo Gyohten, serving their country but also advancing the broader interests of the global commonwealth through their sagacity and vision. Indeed, the postwar economic prosperity realized by the industrialized countries has been no accident, nor was it simply the result of farsightedness of those present at Bretton Woods. The system required attentive nurturing and active management by capable men such as Volcker and Gyohten.

This book serves as a clear signal of the risks of taking for granted what the open trade and payments system has brought us, and of the need for continuous efforts to reinforce and strengthen that system. If we are to succeed in this effort, we will need broad-minded and dedicated individuals to help guide us through the 1990s, and to continue our collective efforts to find a global monetary system that can help frame a renewed expansion of the world economy with low inflation.

Charles Dallara

Former US Executive

Director at the IMF

Roger D. Stone

The Nature of Development

A Report from the Rural Tropics on the Quest for Sustainable Economic Growth

Alfred A. Knopf, New York, NY, USA, 1992, ix + 286 pp., $23.

In an earlier generation it was (a trifle prematurely?) the fashion to say “we’re all Keynesians now.” Well, are we all environmentalists now? What began, some decades ago, as a marginal, quaint eccentricity has mushroomed into a generalized concern. The activists, in spite of some of their more bizarre (and comical) pretensions, have succeeded in raising public consciousness on the questions of ecological balance, diversity, and even survival; they should be commended for it.

Making people aware is one thing; propelling them into effective action and persuading them to pay for it—in terms of a check on living standards in the North and perhaps lower growth rates in the South—is another. In economic parlance, is the trade-off between economic progress and environmental protection acceptable?

That, at least, has been the dilemma as traditionally posed. Now the argument has shifted, and this book is a good exemplar of the new approach, namely that there is a natural convergence between development and environmentally sound policies, and that, in truth, there is really no trade off. Higher growth and a better environment go hand in hand. “Synergy” is the new byword.

This reviewer is an agnostic suppliantly yearning for conversion. Specifically, if the postulate that it is possible for the world economy, in particular the poorer segments of it, to achieve more sustainable and at the same time environmentally sound growth, and hence to leave behind the abyss of world poverty while improving the environment, then all power. Seen in the perspective of economic growth of the past two centuries, the argument certainly appears counterintuitive. But the combination of a broadly accepted conviction, together with rapidly developing technologies, may make it possible.

Roger Stone makes an important contribution to the debate. Neither sanctimonious nor alarmist, he has written a serious book that has the immediacy of a good travelogue. There is much first-hand anecdotal evidence that should be as instructive as the reams of suspect “data” so portentously dredged up in the public debate. Stone presents a breezy synthesis of economic history, development, and environmental issues, melding the general with the particular, and marshaling a mass of disparate information into a highly readable, cohesive narrative.

The book is not totally without blemish: the population issue is largely neglected; too much credence is given to the views of development economists; the paucity of aid is lamented while recognizing its limited contribution to development; “bottom-up” planning (whatever it means) is highly commended, but it is not clear what happens when the “bottom” becomes wealthier, develops interests beyond survival, and changes its priorities; and so on (including several factual errors).

A fundamental question in the public debate on this issue has been, do people have to become rich before they can afford the luxury of worrying about the environment? Some, including many in the South, have answered yes. Others maintain that this is a false question, and that the only way to grow out of poverty is to combine development with environmental concerns. Stone is firmly of the latter persuasion; for all our sakes, let us hope he is right.

Bahram Nowzad

Paul Krugman

Geography and Trade

The MIT Press, Cambridge, MA, USA, 1991, vii + 142 pp., $17.95.

Read this book! Too busy? Then cancel a meeting, let a report go unread, stay up all night on your next transatlantic flight—whatever you need to do, just read this book. Why? Krugman is a master at getting sharp insights out of simple ideas—here, insights into the economic development of nations from basic principles of economic geography.

Nonagricultural economic activity is not evenly spread across the map, but is highly concentrated. Geographers studying this concentration usually focus on the formation of cities. But the same patterns are found in concentration of industry (and more recently, services) in certain “core” regions, leaving other regions on the “periphery.” Examples of core regions are the old manufacturing belt in the United States from the Great Lakes to New York City, the “industrial triangle” in northwestern Europe, and on a grand scale, the industrial countries as a whole.

Concentration of industry requires economies of scale and significant transportation costs. Because of transportation costs, industries wish to be close to markets. But economies of scale mean that it is not economical to have tiny production units evenly spread across space. If each firm is only going to have one plant, firms will want to locate that one plant where other firms are located, in order to be close to the markets created by other firms’ purchases (and those of their workers). The formation of the core region will be a circular process: final goods producers locate where the input suppliers are, and the input suppliers locate where the final goods producers are. Producers of highly specialized services find it attractive to locate in the core, in turn making the core even more attractive. Companies in the core benefit from technological spillovers through the easy sharing of information at close proximity. Multiple virtuous circles make the core region dominant and long-lasting.

The viewpoint of Krugman’s geography models is the opposite of the traditional economic model. In the traditional model, underdeveloped regions should find it easy to attract capital because of their cheap labor. In Krugman’s model, backward regions find it hard to attract capital because no other capital is there to provide a compact market, and to share specialized services and technological knowledge. If a critical mass of capital can be attracted, the region will take off; if it cannot, it will not. The original establishment of a core is as often as not an historical accident—many regions could potentially be a core if only somebody can get the ball rolling.

This point has not been lost on developing country governments, who often try to get a core for their nation through industrial policy, export processing zones, tax holidays, or even protectionist trade policy. Why do these efforts so often fail, yielding nothing but vacant industrial parks? Such failures are not limited to developing countries. The documentary Roger and Me described the ludicrous attempt of Flint, Michigan, to replace the declining auto industry with an amusement park called “AutoWorld.” It is often too hard for governments to compete with the existing core regions—what is a virtuous circle for the core is a vicious circle for the periphery.

But all is not lost for the periphery. Krugman points out that economic integration—openness to international trade—will in the long run benefit both core and periphery. And while cores last a long time, they do not last forever. The US manufacturing belt, dominant for a century, is now called the Rust Belt; the former periphery is now the vibrant Sun Belt. New cores may be forming in the developing world in coastal China, southeast Asia, northern Mexico, and elsewhere. The former Soviet Union and Eastern Europe are ripe for development of new cores. Read this book to get your own insights into the fascinating geography of regional development.

William Easterly

Isher Judge Ahluwalia

Productivity and Growth in Indian Manufacturing

Oxford University Press, New Delhi, India, 1992, xiii + 242 pp., Rs. 250.

In her first book, Industrial Growth in India: Stagnation Since the Mid-Sixties (Oxford University Press, 1985), which showed how infrastructural bottlenecks inhibited Indian industrial growth, Isher Ahluwalia did not give Indian policymakers much cause for cheer. But in this, her latest book, she has better news. After analyzing a vast amount of data on the organized sector of Indian industry both across branches and over time, she concludes that, after a decade and a half of “industrial drift,” there are definite signs, since 1980–81, of not only a boost in industrial growth but also of improvement in productivity of Indian industry.

The focus of the book is on total factor productivity growth (TFPG)—the growth in industrial output or value added that cannot be accounted for by growth in capital and labor—in Indian industry. Ms. Ahluwalia arrives at two clear findings. First, compared to the Far Eastern Tigers (Hong Kong, Republic of Korea, Singapore, and Taiwan Province of China), and many other economies (including Argentina, Chile, Egypt, Indonesia, and Thailand), India has done rather poorly in terms of the TFPG. Second, there was a marked increase in the ratio of capital to labor in the Indian manufacturing sector and negligible TFPG during the early 1960s.

After the emphasis on capital intensive heavy industries up to the mid-1960s, there followed a period of industrial drift to the late 1970s, with a slowdown in the growth of value-added and capital stock, while TFPG continued its disappointing show. The change for the better came in the first half of the 1980s, with a pronounced acceleration in industrial growth, stemming not from a corresponding step-up in factor deployment but from a distinctly better TFPG performance.

Ms. Ahluwalia offers some plausible explanations for the turnaround in Indian industrial performance during the early 1980s: better investment and management of the infrastructural sector, absence of a wage goods constraint, and liberalization of the restrictive industrial and trade policy framework. Alas, these hypotheses have not been, and cannot be, tested within her TFPG framework of analysis. For by its very nature, TFPG, in her framework, is at best a variable “explained” by time or, at worst, a residual of an econometric exercise. More research will be needed to test Ms. Ahluwalia’s important conjectures.

Further, Ms. Ahluwalia neglects to discuss the role, if any, that oil price shocks, transfer of technology from abroad, and indigenous research and development have played in changing TFPG in Indian industry. Similarly, a more complete story will be needed about the relative TFPG in public enterprises and the private sector, as well as the impact of relative prices on aggregate productivity in Indian industry. Did the infrastructural bottlenecks, wage goods constraint, and policy framework progressively deteriorate or remain unchanged at their inefficient levels during the period before the turnaround in the early 1980s? If they remained inefficient, why did profit maximizing firms produce less and less with the same amount of inputs, as evidenced by the negative TFPG during the period of the industrial drift?

As Ms. Ahluwalia has shown in her analysis of interindustry differences in TFPG, growth in value added improves TFPG performance. Since TFPG promotes growth by definition, there is a virtuous circle between industrial growth and TFPG. It is the exploitation of this virtuous circle that is the engine of economic development. Ms. Ahluwalia has made an important contribution in identifying different phases of this circle in India. It will be invaluable if future research can determine with more precision the policy decisions and exogenous circumstances that led to the transition from a period of mediocrity to one of dynamism.

Ashok Lahiri

Richard N. Cooper

Economic Stabilization and Debt in Developing Countries

The MIT Press, Cambridge, MA, USA, 1992, xv + 195 pp., $24.95.

This small volume based on three public lectures given by Cooper—two Ohlin lectures in Stockholm, and a Wallenberg lecture in Washington, DC—covers the links between stabilization and growth. Cooper examines the experience of developing countries faced with the oil shocks of the 1970s and the debt crisis of the 1980s. He points out that the global slowdown in growth has shifted the main economic concern in developing countries from long-term growth to stabilization and adjustment. The ordering of the book is largely chronological; for those readers who lived through the past twenty years, it provides perspective on events, and for younger readers, it offers a good, concise account of recent economic history.

The first two chapters present an extremely lucid description and analysis of how developing countries adjust to external shocks. To illustrate this, Cooper draws on World Bank empirical data covering 18 developing countries. In particular, he carefully analyzes the retrenchment these economies had to make following the two OPEC oil shocks and a disturbance in the coffee market. This approach is useful for several reasons, not least because it develops the causes of the debt crisis. There is also a critical but balanced discussion of the role of the IMF in adjustment programs. The author makes use of data and details in a way that complement and aid the analysis. His discussion of political institutions is also fashioned around the economics in effect during that period.

Perhaps the most interesting part of the book is chapter 3, in which Cooper debunks four conventional explanations for why developing countries have historically had such disparate performance. He argues convincingly that there is no correlation between the size of the shock, the openness of the system, political institutions, or inflation, and growth. Rather, he states that relatively stable real exchange rates, disciplined fiscal policy, and occasional financial assistance are important in fostering growth and development.

The final two chapters examine the question of external debt. In looking for the origins of the debt crisis, Cooper eschews the practice of many writers to blame either the banks for bad lending practices, or policymakers for bad policy, not because errors were not made—they certainly were—but because, by and large, economic agents and institutions were behaving as they were expected to, and as they had in the past. Instead, Cooper suggests that the roots of the debt crisis are to be found in the large shocks to the international system—primarily the two oil shocks—and that there was no way of avoiding the negative repercussions. He goes on to make a case for Professor Kenan’s International Debt Discount Corporation and perhaps gives less credit to the successes of market-based debt reduction schemes than some other analysts would, but this is something that will only be known with the passage of time.

Richard Haas

NEW readers who wish to receive Finance & Development regularly should apply in writing to Subscription Services, Finance & Development International Monetary Fund, Washington, DC 20431, USA, specifying the language edition and briefly stating the reasons for their request. The contents of Finance & Development are indexed in Business Periodicals Index, Public Affairs Information Service (PAIS), and Bibliographie Internationale des Sciences Sociales. An annual index of articles and reviews is carred in the December issue.

Cover: Richard Stoddard. Photo in cover: Ray Witlin; Art on pages 2,3,41,44,45: Luisa Watson; pages 5,6,7,28,37: Lew Azzinaro; pages 24 and 34 Eric Westbrook; page 9: Dale Glasgow. Charts: Dale Glasgow, Luisa Watson, Betty McGuire. Bank photos: M. lannacci. IMF photos Dento Zara and Padraic Hughes-Reid.

A.J.C. Britton

Macroeconomic Policy in Britain: 1974–87

Cambridge University Press, New York, NY, USA, 1991, x + 365 pp., $59.50.

This book, by the director of the National Institute of Economic and Social Research, follows two well-known studies of earlier historical periods by Christopher Dow (1964) and Frank Blackaby (1978). Like its predecessors, it is sure to become a basic text for students of British economic policy. The period it surveys is without doubt the most eventful in postwar economic history, spanning as it does the aftermath of two major oil shocks, the demise of the Keynesian consensus, and the great “monetarist experiment.” It ends, perhaps fortuitously, just as customized monetarism was giving way in Britain to a new phase in policy, characterized first by shadowing of the deustche mark and later by EMS membership.

A collection of essays, this book ranges in form from historical narrative, through economic philosophy, to a technical exposition of original empirical work. The first part is a fairly detailed, but nicely paced, description of the main economic events of the period. It begins with the crisis-ridden years of the last Labour government, and continues through the early hardships during Margaret Thatcher’s first term, to the strong economic recovery under the second Conservative administration.

The next two parts provide a context for the remainder of the book, explaining the intellectual shift in policy-making circles (a shift that was not wholly coincident with the arrival of Mrs. Thatcher) and describing the trends and disturbances that affected the world economy during the late 1970s and most of the 1980s. In the final sections, estimated reaction functions and other statistical techniques are used in an attempt to discern how monetary and fiscal policies were in fact conducted during this period, and an assessment is made of their impact on the standard policy objectives (output, inflation, unemployment and external balance).

Of the conclusions Mr. Britton offers, two in particular stand out as especially topical. The first is his claim that the United Kingdom could have achieved disinflation at a significantly lower output cost had it entered the EMS at its inception in 1979. The second, related but less controversial, point is that the move to floating exchange rates, financial liberalization, and the abandonment of incomes policy made the behavior of the economy more difficult both to predict and to manage. With their popular reputation at an all-time low, this is a judgment that most of the economics profession in Britain would no doubt happily accept.

Hugh Bredenkamp

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