Inflation Versus Unemployment

The first switch in priorities among the policy objectives of the major countries is the relative weight attached to the control of inflation on the one hand and the avoidance of more-than-frictional unemployment on the other hand. The received wisdom of the 1960s and early 1970s was that there was a trade-off between these two objectives; the Phillips curve for each country indicated the locus of the trade-off points that the government could choose, and it was seen as one of the advantages of exchange rate flexibility that this regime permitted each country to choose its preferred trade-off.

To be sure, the outbreak of double-digit inflation in all industrial countries in 1973–74, while unemployment rates were still generally low, could explain an increasing relative emphasis on price stability versus employment even without a change in the governments’ trade-off scale; and the same comment might still be applicable to the 1979–80 constellation, with the resurgence of inflation throughout the industrial countries in response to the second oil shock. But this interpretation is clearly not applicable to the current scene, where high unemployment rates—in most European countries—coexist with low-to-zero inflation rates. The persistent concern about actual or potential inflation, in conjunction with the limited action against unemployment rates of 10 percent or more, is an obvious indication of a shift in priorities.

The reordering of priorities has probably been most explicit in the United Kingdom. Under the “medium-term financial strategy,” first presented in the budget for 1980/81, it was stated that “the Government’s objectives for the medium term are to bring down the rate of inflation and to create conditions for a sustainable growth of output and employment” (H.M. Treasury (1980), p.16). In pursuit of this objective, an extremely tight monetary policy was introduced in 1980⁸ which led to a sharp appreciation of sterling and a severe recession, in part because the government’s policy engendered credibility in financial markets, but not in labor markets where wage-push inflation continued unabated. Ultimately, credibility for the anti-inflation policy was established not by the achievement of its monetary targets (they were, in fact, exceeded) but by the refusal of the government to react to a recession which proved deeper than had been anticipated.⁹

In the United States, drastic action against inflation had been inhibited during most of the 1970s by the expectation that the cost in terms of loss in output would be prohibitive. Writing in 1978, Arthur Okun had estimated that cost at 10:1, meaning that a loss of 10 percent of real GNP would be required to bring the annual inflation rate down to 1 percent.¹⁰ Throughout much of the 1970s, the prevailing rate of inflation was decried as “unacceptably high” (a term often used in the Fund’s Annual Report); yet it was, in fact, accepted. A radical attack on inflation did not begin until the autumn of 1979, when the Federal Reserve changed its operating procedures as the only available method to put a stop to its previous, accommodating, monetary policy. The measure produced a sharp recession, with unemployment approaching 11 percent in late 1982. In contrast to earlier recessions, this situation was not met by recourse to a reflationary policy.11 Subsequently, however, an expansionary fiscal policy, a relaxation of monetary policy, and greater wage flexibility in the United States than in Europe made for a gradual decline in the unemployment rate, toward a level close to that of the mid-1970s. The relatively quick improvement in the employment and unemployment figures in the United States while inflation remained low did not raise the issue of the priority of alternative policy objectives as sharply as in the United Kingdom, or elsewhere in Europe.

In the Federal Republic of Germany, unemployment has been about 8 percent since 1983, twice as high as in the late 1970s; even with inflation near zero, this situation has not led to the adoption of general policies to expand demand. In France, the Mitterrand government came to power in 1981 on a strong platform to reduce unemployment;¹² nevertheless, the unemployment rate in France has increased every year to reach about 11 percent in 1987 as against 6.6 percent in 1980. The priorities were clearly switched in 1982. Having decided to stay in the exchange rate mechanism of the European Monetary System (EMS), the government’s immediate objective became to reduce the inflation differential with other participating countries and to achieve equilibrium in the current account. Growth and employment were thus temporarily removed from the forefront of policy objectives. In the process, the approach to incomes policies was reversed. In support first of the devaluation in March 1983 and then of policies aimed at enhancing competitiveness and profitability, a policy of wage restraint was adopted. As a result, the long succession of years during which wages had risen in real terms at the expense of profitability was broken. Fiscal policy became focused toward achieving small, gradual reductions in the budget deficit expressed as a percentage of GDP by means of expenditure reductions. Emphasis was given to strengthening the financial position of newly nationalized enterprises. Over time, the authorities also initiated a major shift toward the deregulation of financial markets and reduced reliance on quantitative controls.

In Japan, unemployment had always been lower than in the other industrial countries and it rose marginally (from 1.4 percent to 2 percent) in the period 1974 to 1978 when inflation was brought down sharply. Even that modest rise may at least in part have been due to a noncyclical rise in Japanese unemployment, which continued throughout the 1980s to a rate of about 3 percent at present.

Output Targeting

With a varying degree of precision depending on the country, policy in the 1960s and 1970s had been formulated in terms of achieving a specified level of output, or, planning ahead from the current level, a specified growth rate for output. Specifically, the concept behind this policy was to approximate as closely as possible the full employment output trend. The pursuit of this concept (even if it was not directly operational) was particularly explicit in the United Kingdom, as well as in the United States, where it was mandated by the Employment Act of 1946. Targeting of a physical level of output was judged to be compatible with the containment of inflation, provided “full” employment was not defined in an excessively ambitious manner and other policy instruments, such as incomes policy and the control over installment sales (hire purchase), were brought in as needed.

In the 1980s, by contrast, output targeting has largely disappeared from economic policymaking in the major industrial countries. To be sure, official “targets” or “projections” for the growth rate of real GNP are still being released in these countries, with the notable exception of the United Kingdom. But these numbers have little if any operational content. They are forecasts or projections of a conditional character, saying essentially that if exogenous factors—such as the exchange rate of the country’s currency against the U.S. dollar, or the upcoming wage round—develop as expected, GNP is expected to grow by – percent over the next year. Since there is room for differences of view with respect to the conditions imposed on the model, there is also room for introducing a certain degree of optimism in the forecasts for real GNP, without doing violence to the model itself. It is not surprising, then, that in some countries official growth “targets” have shown an optimistic bias.

But, whatever the accuracy of these numbers, these targets do not act as policy triggers if the outcome differs from the targets. If performance is reasonably in line with the announced figures, governments congratulate themselves. But if the outcome falls short of the “target,” there is no presumption that policy action will be taken to correct the situation. Instead, there may be explanations: the dollar depreciated more than expected, the winter was excessively severe, etc.; and there may be the announcement of more pleasing “targets” for the next year or the next quarter. Two recent instances of this “jam tomorrow” approach, both relating to the United States, may be recalled.¹³ Early in 1986, a disappointing growth rate for the last quarter of 1985 was reported (1.2 percent, about half of the earlier estimate); the administration announced at the same time a robust 4 percent growth target for 1986.¹⁴ Half a year later, this target was acknowledged as unrealistic (the outcome proved to be 2.2 percent), but again the pill was sweetened by a simultaneous release of an estimate for 1987 growth at 4.5 percent.¹⁵

The abandonment of operationally meaningful growth targets for the economy should not be seen—as it probablv would have been seen 10 or 15 years ago—as a dereliction by governments of their responsibilities. It reflects, rather, a new and chastened view on how growth can be promoted over the long term. The new philosophy was clearly expressed in a December 1985 programmatic paper by the German Federal Ministry of Finance: “In an economic system based on free enterprise, economic growth is not so much the aim as the result of market processes. The task of the public sector is not to realize the highest possible growth rates at the cost of unwarrantable fiscal policy measures, but to ensure that economic activity can develop unhindered and is provided with sufficient incentive. The price signals transmitted by the market must reach the recipients … with as little distortion as possible. Sound public finances will increase the confidence of markets in the dependability of policies. Well-ordered public budgets are thus an important basis for long-term decisions … and part of the foundation of an efficient free-market system.”¹⁶

Similar views on the issue of the most effective policy for economic growth can be found in other industrial countries.¹⁷ Indeed, the extent to which official opinion in general has moved away from the growth activism of earlier decades can be inferred from the radical change in evaluation of the concept of “fine tuning” of the economy: in the 1960s and 1970s, it conveyed the notion of the consummate skill of economic policymakers; in the 1980s, “fine tuning” stands for a new taboo which (like any generally respected taboo) needs no further explanation.

Nominal Targeting

While governments stepped away from attempts to regulate output, they have tended to show more confidence in their ability to keep nominal demand (for example, nominal GNP) on track. Thus, they approach demand management as an exercise of achieving a desired growth rate for nominal demand, without the ambition to determine the split of the growth in nominal GNP between a price component and a quantity component. The authorities in the United Kingdom, a country where policymaking in the past had perhaps suffered more than elsewhere from excessive concern with “real” variables, have been particularly clear on the fundamental difference in approach that is implied in nominal versus real targeting. The medium-term financial strategy, which (it should be recalled) was introduced at a time of double-digit inflation, was addressed to a gradual reduction of the rate of growth in nominal GDP. Since 1985/86, the annual outlook figures at budget time include tentative target ranges for the growth in nominal GDP. In the same context, numbers are also provided for the possible price and quantity components of GDP, but these numbers are described as “assumptions,” not “targets,” to underline the authorities’ position that the distribution of the growth in nominal GDP would be determined entirely by market forces. (Although the distinction between “targets” and “assumptions” establishes a clear hierarchy in the degree of official commitment, the tentative target ranges suggest only a limited commitment even at the top of the hierarchy.)

The switch to nominal GDP or GNP as the target variable for economic policy coincided, not surprisingly, with increased attention to monetary aggregates as intermediate control variables. If the assumption is valid that income velocity in terms of one or another of the wide array of monetary aggregates is stable, then, of course, control of that aggregate will at the same time ensure control over nominal GDP. This is not the place to review in detail the (remarkably short!) story of the rise and decline of monetary targeting in the 1980s. Suffice it to state that the rapid deregulation of the financial system—itself a reflection of the same market-oriented policy stance that lay behind the movement away from fine tuning demand—had the effect of undermining the assumption of stable velocity that would have to be fulfilled to make monetary control effective. Thus both the United States (between 1979 and 1983) and the United Kingdom (over a somewhat longer period), went through a succession of monetary aggregates and finished by not paying a great deal of attention to any of them. The Federal Republic of Germany was more successful in adopting from the start (for the year 1975) a monetary aggregate, namely central bank money, that could be controlled in most years within a relatively narrow band. The central value for the growth rate for money was based on the growth of potential output, a minimum tolerable rate of inflation, and any estimated change in velocity (Deutsche Bundesbank (1985)). Since early 1987, however, certain weaknesses have transpired with central bank money as the monetary target, in particular that its growth might be biased upward, from the the point of view of controlling nominal GDP, by the demand for deutsche mark notes in the grey economy and, in Eastern European countries, as a substitute for the dollar as a parallel currency. In the light of this evidence, the Bundesbank has switched to M3, which in recent years has been growing more slowly than central bank money. One may perhaps wonder how long it will take before it is discovered that the income velocity of M3 is subject to certain quirks too, and the Bundesbank may have to follow the Federal Reserve and the Bank of England in the direction of a more judgmental basis for its monetary policy.

France joined the practice of other central banks in the 1980s of announcing money supply targets. This approach to monetary policy in a country that was struggling with recurrent balance of payments difficulties was open to question, since it tended to invalidate the auto-corrective mechanism by which payments deficits would tighten domestic liquidity. As the smaller members of the EMS had recognized from the start, money supply targeting is not compatible with exchange rate pegging. The same comment would also be of some relevance to monetary policy in the United Kingdom since the time that it has—de facto and approximately—pegged sterling to the deutsche mark.

Of all the major countries, only Japan has not made a radical change in its monetary policy in the 1980s. This is in line with the greater continuity of economic policy in Japan generally, to be discussed presently. Monetary policy, whose main operational target is the level of short-term interest rates, continues to be made on a judgmental basis, in the light of both domestic demand conditions and the exchange rate for the yen. The Bank of Japan does follow the practice of other major countries of announcing each quarter a projection for the growth of broad money (M2 + certificates of deposit), but the operational significance of this projection is minimal, since it is made from the same quarter of the preceding year—that is to say, it covers a year of which nine months have already passed into history.

The distinction made in this section between targeting real growth and nominal GDP was of great importance in countries such as the United Kingdom where the rate of inflation was high. It should be noted, however, that the distinction loses its significance as the inflation rate drops to zero. Of the five countries considered, this observation carries the greatest relevance for Japan, where inflation (as measured by the consumer price index) has been at about 2 percent or less for the last five years (1983–87). This success of Japan in bringing inflation under control may explain why Japan has found it less necessary to abandon the judgmental approach to demand management, in the execution of which it has used both monetary and fiscal policy in a flexible way (see the subsection on fiscal policy in the next section).

Balance of Payments

The balance of payments could not but remain an important objective of policy where (1) the imbalance to be avoided was a deficit, not a surplus, and (2) this deficit posed financing problems. At some stages in the past decade, this applied to France. Large surpluses of Japan and the Federal Republic of Germany could be viewed as a problem from a world point of view; it is less clear that these surpluses were seen as incompatible with the economic objectives of the countries concerned, except in an indirect way as they could lead to protectionist policies abroad. The huge current account deficits of the United States in the 1980s initially provoked a quite different response from that caused by the small payments deficits of the 1960s. In the 1960s, U.S. policy was quite clearly directed toward reducing balance of payments deficits in the framework of the par value system, including the use of such rather unattractive instruments as the Interest Equalization Tax to influence the capital account. In the 1980s, on the other hand, up to September 1985, the current account deficit and the accompanying heavy inflow of capital into the United States were officially regarded as evidence of the strength of the U.S. economy.

Incomes Policy

The clearest case of re-evaluation of an instrument is presented by the virtual disappearance of incomes policies from the policy armory of the main industrial countries, except, as mentioned, France. In the 1970s, when incomes policy was still treated as a respectable instrument, it used to be stressed that that policy should be used “as a supplement to sound fiscal and monetary policies, but not as a substitute for them.”¹⁸ Experience showed, however, that this was a counsel of perfection: countries that relied on incomes policy typically failed to adopt demand policies of sufficient strength or relaxed them in the light of the apparent anti-inflationary success of the incomes policies (see, for example, the United States from late 1971 to 1972). Most countries have drawn the lesson from this that even though incomes policies might assist in the containment of inflation in the very short run, reliance on such policies tends to increase inflation over the longer run. Indeed, the remarkable reduction in the inflation rate in most industrial countries has been brought about without the help of—one could fairly say, thanks to the abandonment of—incomes policies.

The disappearance of incomes policy has, of course, had an immediate effect on the ability (or the presumed ability) of governments to regulate the short-run distribution of the growth in nominal demand between price increases and output increases. Thus, strictly speaking, governments can no longer have objectives for these two variables separately, only for their sum. This is explicitly recognized in the U.K. approach, mentioned above, which recognizes only “assumptions” for these variables. Again, the contrast is less stark in Japan and Germany, where the rate of inflation is both very low and (perhaps therefore) predictable within narrow margins.¹⁹ The implication of this loss of an instrument on the issue of international policy coordination will be taken up in the next section, which deals with the broad implications of coordination.

Fiscal Policy

With respect to fiscal policy as practiced in the 1960s and 1970s, the general experience has also been less than satisfactory. First, the promise of Keynesian anticyclical fiscal policy that the authorities would promptly offset any shortfall in private demand by fiscal stimulus became increasingly regarded as an invitation to inflationary price and wage setting by all groups in the private sector; without some effective nominal constraint, inflationary action by the private sector was virtually risk free. Second, the authorities experienced great difficulties in finding the correct timing for their fiscal action; policies designed to be anticyclical all too often worked out to be procyclical.²⁰ Third, the reverse component of the anticyclical policy, fiscal contraction to offset excessive strength in private demand, often tended to be even less prompt. More generally, the all-pervasive belief that government expenditure was “good for the economy” produced over time an increase in the ratio of this expenditure to GNP that had to be brought to a halt for a number of well-known reasons: the economic cost, in terms of incentives, of attempting to match even in part the growth in official expenditure by raising taxes; the increasing government deficits, and hence the rise in the government debt, as taxes could not be raised as fast as expenditure; and, finally, the risk that the service of the enlarged government debt could itself become the flywheel of ever-increasing deficits.

For all these reasons it became necessary in country after country to take a radically different view of government finance. The variable which, in the hey-day of Keynesianism, had been regarded as an instrument that could be manipulated to achieve the stabilization of the economy, now needed itself the urgent attention of policymakers. In particular, policymakers had to establish credibility for their new approach to fiscal policy, based on the principle that they were no longer prepared to validate any excesses of the private sector. For this purpose, official commitment to a medium-term program of fiscal policy was a particularly important step, and measures of this general intent were most explicitly taken in Japan and the United Kingdom: in the former country by the adoption of the fiscal consolidation plan in 1980, and in the latter by the announcement of a path for the contraction of the public sector borrowing requirement as part of the medium-term financial strategy introduced in 1980. The three-year path for the borrowing requirement in the United Kingdom was raised somewhat in 1981 and 1982, as the recession turned out to be deeper than the authorities had expected, but in fact only part of the automatic stabilizers was accommodated; and between 1983 and 1986, no further significant changes in the path for public borrowing were made, even though there were temporary disturbances such as the coal strike. Changes in fiscal policy in mid-year are no longer made. In the Federal Republic of Germany as well, the process of reducing the government deficit has received high policy priority, which has acted as an obvious constraint to the adoption of more expansionary fiscal action that might bring about a reduction in the current account surplus.

In the United States, too, the concept of adjusting fiscal policy to indicators of the short-term cyclical position has lost a great deal of weight. But the main reason why fiscal policy has become less available as a policy instrument has been the extreme difficulty of introducing any major measures to correct the large deficit that was created by the income tax reductions and the increases in defense spending introduced at the beginning of the Reagan Administration.²¹ Unlike in other countries, fiscal policy in the United States has not been set on a course that is considered desirable and which therefore should not be subjected to needless short-run adjustments; more nearly, in the United States, fiscal policy is immobilized on a course that continues to produce “unacceptable” fiscal deficits. Though to a large extent political, the fiscal immobilism in the United States also reflects an increasing awareness of the economic limitations on the use of fiscal instruments for the control of aggregate demand, in particular, the fear that a reversal of income tax reductions would have undesirable incentive effects on supply.

The change in policy emphasis appears somewhat less pronounced in Japan. Since 1980, the main objective of fiscal policy in Japan has been to strengthen the fiscal position of the central government which had deteriorated in the second half of the 1970s. The medium-term goal of fiscal consolidation was to eliminate deficits on current account of the central government by fiscal year 1984/85. But the announced purpose of the plan was to restore flexibility to fiscal policy, and the pace of consolidation has been adjusted in response to short-term developments in the economy.

Thus, when confronted with weak growth in the early 1980s, the government pushed back the target date for external payments balance to 1990/91. Substantial progress toward the goal had been made by 1986/87, when the deficit on current account had been approximately halved, to 1½ percent of GNP. Capital spending was also reduced and with the improvements in the position of the social security funds and the local governments, the deficit of the general government declined from 4½ percent of GNP in 1979/80 to ½ of 1 percent of GNP in 1986/87.

With the slowdown in growth in 1986, the focus of budgetary policy for 1987/88 shifted again to support economic activity, although fiscal consolidation continued to be pursued. A package of measures was introduced in May 1987 to support domestic demand, but this package consisted mostly of public works expenditure by the central government and local authorities, which does not affect the target of fiscal consolidation. In spite of some tax reduction, the government’s current deficit is expected to decline, but there will be some increase in the deficit of the general government. But that deficit too is expected to resume its downward course in 1988/89 as the economy continues its recovery, in response to a major improvement in the terms of trade as well as the (relatively mild) fiscal stimulus.

Pressure from abroad as well as the need to respond to domestic political factors may well have played a role in the frequent instances in recent years where Japan’s fiscal and monetary policies were adjusted in the light of changing demand conditions; moreover, the adjustments did not always achieve the desired (stimulative or contractionary) effects. Nevertheless, it would appear that Japan has preserved a greater degree of policy flexibility than most of its major trading partners.

In general, concern for the long-run efficiency of fiscal policy in the industrial countries has turned that policy into a much less flexible instrument for the control of aggregate demand than was assumed only a decade ago.²² Fiscal policy does get used to influence aggregate demand—but only when the case for action (domestically or as urged by trading partners) has become overwhelming.

Structural Policy

This is the place to devote some attention to “structural policy,” or “micro-policy,” that did not rank in the major league of economic (macro) policies before the 1980s, but that has since acquired that status.²³ Under optimistic assumptions, structural policy could (operating from the supply side) be expected to fill, in part, the voids left by the disappearance of incomes policy and the retreat of fiscal policy on the demand side.

When conservative governments came into power in Britain, the United States, the Federal Republic of Germany, and France, each announced as a major component of its platform a reduction of the role of the government in the private economy of the country, through such measures as deregulation and privatization.

In principle, such policies could have had a major impact on the performance of the major economies—by increasing competition, lowering costs, reducing the share of government in GNP, and raising efficiency and thus economic growth. Indeed, “structural reform” (or action against Eurosclerosis) has often been put forward as the pre-ferred alternative to fiscal stimulation to bring about higher growth rates in Europe. In Germany in particular, where fiscal and monetary conditions have become less stringent in the last year and real incomes have benefited from improvements of the terms of trade, the scope for increased consumption and investment as inhibiting restrictions are relaxed could be substantial.

In practice, however, the results of the new policy stance have generally been unimpressive. In the United States, the zeal for regulatory reform soon faded as reform of social regulations in particular met too many political impediments.²⁴ Financial deregulation, which had started under the Carter Administration, is still in an uncertain state.²⁵

In the Federal Republic of Germany, too, only little progress was made on deregulation and, contrary to the authorities’ announced intentions, subsidy payments continue to increase. Some progress was, however, made in labor market legislation in 1984–86, which reduced the trade unions’ bargaining power in labor disputes, facilitated the hiring of youths and part-time workers, and increased the flexibility of labor contracts. In France, the new approach is perhaps still too young to permit any assessment. Only in the United Kingdom has there been a sharp change in the business climate. The power of trade unions, which exceeded that in most other countries, has been radically curbed; this has facilitated large-scale labor shedding and raised unemployment, but it has not put an end to the upward pressure of wages of the employed. Privatization of large state-owned enterprises has significantly reduced the government’s role in business, and continues to help the public sector borrowing requirement. The elimination of exchange control and the Big Bang recasting of the London financial markets have been instrumental in consolidating London’s position as the major European financial center.

Monetary Policy

Monetary policy has become the preferred instrument in many countries since 1979, in the hope that the prescription of a certain growth rate for some monetary aggregate would bring about the same growth rate for nominal GDP. (A weaker version of the same hope was that control over a suitable monetary aggregate would provide the much-needed “nominal anchor” that would keep inflation down to a few percentage points below the growth of that aggregate.) Note that under this approach monetary policy was being assigned to a domestic task, the control over GDP, no doubt in recognition of the fact that the earlier expectations for the performance of this task by fiscal policy had been disappointed. However, one instrument cannot serve two purposes; the consequence was that monetary policy was not available to regulate the balance of payments. Thus, the only exchange rate regime compatible with this approach was free floating. This fitted the mood of the major countries at the time.

We can perhaps leave it as a moot point whether this approach to monetary policy fell out of favor because it proved inefficient to its assigned task (owing to unpredictable changes in velocity) or because of disenchantment with leaving the exchange market as the residual of policies in other areas. Thus, without much fanfare, monetary policy in recent years has, to an important extent, been reassigned to the international task of keeping exchange rate movements within acceptable (or unavoidable) limits; that is to say, it has become, to a smaller or larger degree, depending on the country, the instrument to achieve the objectives of exchange rate policy.

There is little doubt that this is a task that monetary policy can normally perform. Moreover, if considerable freedom is allowed to exchange rates (as, for example, under the target zone system with wide bands), monetary policy should frequently be able to take time off from its exchange rate assignment and thus become available to help out with the management of domestic demand.²⁶

GNP Growth Rates

There is no publicly available information on the use made of various possible indicators of the Group of Seven discussions. However, insofar as the debate with regard to growth rates is conducted in public, it would appear to proceed without taking adequately into account (1) policy practices as they have developed in the last decade and (2) rules for policy setting that are essential to achieve the adjustment and growth objectives of the system.

As to (1), public debate seems to focus predominantly on real growth rates, with inflation rates kept in the background as a potential constraint, but one that in present circumstances is considered as virtually negligible in importance. The clear implication is that countries should seek to achieve certain real growth rates and that they fail in their obligations to their partners, as well as in their duties in the context of the debt problem, if they allow their economies to under-perform on this score.

Yet, as we have seen, governments do not wield policy instruments that are directly aimed at real variables. Their instruments influence (“control” would be too strong a term) nominal demand, with the distribution between the real component and the price component no better than an informed guess (“assumption,” the term used in the U.K. approach, should perhaps be qualified as an understatement).

Next to the real/nominal discrepancy, there is the question how output is defined from the point of view of international cooperation. There is no evidence that the indicator for growth endorsed at the Tokyo meeting of the Group of Seven was anything else than the growth rate for total GNP. This overlooks the fundamental point that total demand equals domestic demand plus or minus the foreign balance, with the latter co-determined by the exchange rate and demand policy abroad. In an international context, the proper distribution of responsibilities in terms of demand management is for each country to look after its own domestic demand, and to make that variable grow above or below the growth rate of potential output, depending on the amount of slack or overheating in the economy and the state of the current account of the balance of payments. Any other assignment of responsibilities creates a “free-rider” conflict: countries with an undervalued currency can, without having to face fiscal conflicts, maintain their growth rates thanks to export surpluses, while their trading partners appear to fail in their duties in terms of GNP, even though they maintain domestic demand at an appropriate level.³¹

The importance of the distinction between total and domestic demand for purposes of policy coordination is by no means a new one. It was, indeed, incorporated in the Declaration issued by the 1978 Bonn Summit.³² In a recent statement Helmut Schlesinger notes that “it is uncontested, in particular, that in deficit countries domestic demand must grow more slowly than overall output, while in surplus countries the growth rate of domestic demand should exceed the pace of expansion of GNP.” ³³ With this theoretical point so thoroughly established, it seems surprising that the coordination effort has paid it so little attention.

Is Fiscal Policy up to its Task?

In any system in which exchange rates are not entirely left to market forces—including such wide variations of regime from leaning against the wind, reference rates, target zones in any of the many versions, and “stable but adjustable rates,” up to the gold standard—monetary policy must remain available to help achieve or maintain the exchange rate objectives of the system. Monetary policy may sometimes be available to help out in demand policy; but in some of the most difficult moments of an adjustment program its setting may be determined by the demands of its exchange rate task. Sometimes, this may be helpful to achieve the objectives of demand management, as when the exchange rate needs to be defended and demand disinflated. But in “conflict situations,” such as may be brought about by a recession abroad, the performance of its primary duty by monetary policy may add to the burdens of fiscal policy to regulate demand.

As indicated in the earlier subsection on fiscal policy, such policy in most of the main industrial countries can no longer be treated as the patient workhorse of economic management, ready to move in one direction or the other at a tug at the reins. On the contrary, governments have learned the hard lesson that fiscal policy itself needs to be treated with a considerable dose of Tender Loving Care in the present in order to keep it in good enough health for the uncertain tasks of the future.

While fiscal policy can be assigned the task of influencing nominal domestic demand in the desired direction, governments can no longer credibly promise (or expect credible promises from their trading partners) that moves in the fiscal stance can quickly change the demand situation. Also, with short-run changes in fiscal policy now seen as costly in themselves, governments will want to see relatively large and/or persistent indications of the need for adjustment before changing fiscal course.

These changes in attitude toward the fiscal instrument could well explain at least part of the slowness of the international adjustment process in recent years; and to the extent that the attitude reflects inherent structural limitations of fiscal policy, intensified attempts at international coordination of policy may be more productive in terms of understanding of each others’ problems than in removing imbalances.

Two further considerations need, however, to be adduced to put this finding into proper perspective. The first is that the reduced flexibility of fiscal policy may in part be temporary. This would be the case to the extent that some period of fiscal rigidity may be needed to convince the public that the days of fiscal pliancy (upward pliancy, of course) are over. The experience of the Federal Reserve with a rigid monetary policy after October 1979 is instructive in this connection; once the Federal Reserve had for three years running established a clear track record of resisting inflationary pressures with whatever degree of tightness of the money supply was required, it could relax that tightness to meet deflationary pressures in the U.S. (and the world) economy without provoking a new outbreak of inflation. Over time, a government that has established its fiscal conservatism may thereby have gained a useful degree of flexibility in its use of fiscal policy for the future. As indicated in the previous subsection on fiscal policy, Japan may already have succeeded in overcoming the cycle from excessive flexibility via excessive rigidity to workable flexibility.

The second consideration is that it is very difficult, on the basis of a small number of country cases (each of which has, of course, its own peculiarities) to determine in an objective way the degree of fiscal inflexibility that is needed, first to stamp out the overly optimistic expectations of the past and then, on a permanent basis, to preserve the integrity of the fiscal tool. Inevitably, the operationally relevant opinion presented on this subject—both to the electorate at home and to interested governments and institutions abroad—is that of the authorities in power in the country concerned. That opinion may well represent an inseparable mixture of economic judgment concerning the usability of the instrument and political judgment concerning the desirability of using it. If the lady does not want to tango, she is nicer if she blames a hurting ankle than just says “no.” The outsider may find it difficult to discern the true reason; nor would it help him much if he could. Even if the potential usability of the instrument could be established in an objective way, this might not facilitate much the process of international policy coordination: that process requires not only the availability of instruments to achieve desired objectives, but just as much a unity of view as to what these objectives are.

Helmut Schlesinger

Jacques Polak’s paper provides a stimulating introduction to the national and international economic policy problems currently facing the major industrial countries. Polak’s encyclopedic knowledge of the details of the historical development enables him to analyze penetratingly the profound change of style that has taken place in general economic policy as well as in the monetary policies of many industrial countries. Happily, he does not abstain from economic policy assessments, which bear his own unmistakable stamp. Since I myself belong to a generation whose economic outlook was shaped by the conditions of the tempestuous 1950s and the “golden” 1960s, and no less of course by the disappointments of the turbulent 1970s, I find Polak’s paper very attractive in this respect, too. But although I was exposed to, and influenced by, the pendulum swings in economic policy objectives and philosophies, in retrospect my verdict would perhaps differ slightly in some particulars.

Up to the beginning of the 1970s it was possible to speak of a “post-Keynesian basic consensus” among the leading economic policymakers in the major industrial countries, albeit with national modifications. The thinking behind this consensus reached the Federal Republic of Germany with a distinct time lag. During the successful 1950s the influential economists who built up the intellectual framework of the “social market economy” were no close admirers of Keynes. But then, under the strong influence of Karl Schiller, the ideas of Keynes and Walter Eucken, the architect of “German neo-liberalism,” were amalgamated. Anticyclical behavior was chosen as the guiding principle of German fiscal policy.

This to a large extent common platform, which (as Polak rightly notes) from the outset met with a rather skeptical response from the Bundesbank, seems to have quite disappeared. Today, any comments on fundamental or current questions of national and international economic policy first require the discussants to define where they stand. Polak’s remarks on the special features of “activist” and “non-activist” economic and monetary policies avoid any oversimplified categorization, but if his comments were to be ascribed to an “enlightened neo-Keynesian” rather than to a “pragmatic monetarist,” to use Lamfalussy’s categories, I hope that this would not be unjust.

On the basis of my own experience, I look back on the 1960s and early 1970s with less nostalgia than Polak does. I am also less optimistic than he is that, given the successes achieved to date in the field of stabilization and consolidation policy, monetary and fiscal policy can now be set to work efficiently again in the cause of demand and exchange rate management of the traditional type, even though the number of advocates of such a policy is growing. While I agree with Polak’s overall assessment in many respects, let me take up a few of the points he touched upon in which I detect certain disparities which presumably derive above all from differences in our economic and monetary policy starting points.

In assessing conditions during the 1960s and 1970s, which some advocates of an “activist” budgetary and monetary policy stance today look back upon in rather a favorable light, I would sometimes put the emphases in slightly different places. I have no wish to deny that, during the period when economic policy action was dominated by the use of economic policy tools to achieve the “magic quadrangle,” some industrial countries scored considerable successes in the field of growth and employment policies. The question which arises in this connection is, however, to what extent the economic growth that was achieved is attributable to these policies or to other factors.

Specifically, I have two comments on this question:

(1) The highly satisfactory growth and employment figures recorded in many industrial countries from the mid-1950s to the second half of the 1960s were due in substantial measure to distinctly favorable supply-side conditions. The fact that real GNP in the OECD countries was expanding during that time at an annual trend rate of 4½-5 percent was due, among other things, to the very low level of commodity and energy prices over a long period, the rapid spreading of comparative cost advantages, technology transfer in the wake of the intensification of cross-border trade and capital transactions, the release of labor from shrinking sectors with low labor productivity (such as agriculture), immigration into the more developed industrial countries, and the spreading of cost-curbing mass production to up-market consumer goods. Against this background, an OECD growth study compiled in 1970 for the period up to 1980 concluded with an optimism that is almost unthinkable today: “The risk for modern industrial countries is not that of not achieving growth.”¹

(2) It appears to me—also in the light of German experience—to be certain that the discretionary use of fiscal and monetary policy (with an expansionary “bias”) and the “fine tuning” of aggregate demand at the limits of full employment and beyond, especially in the five to seven years up to the eruption of the first oil crisis in 1973, paved the way for the later emergence of stabilization crises and impediments to growth. Inflationary expectations grew seemingly irresistibly and took on more concrete shape, struggles over income distribution increasingly affected wage and price formation, and the ballooning of public expenditure and tax ratios, the spreading of government intervention in the market, and growing market rigidities lessened the efficiency of the free market system. These signs of crisis were clearly discernible even before the two oil shocks exposed the industrial countries to quite exceptional additional pressures, and these oil price hikes themselves were not solely an exogenous factor but—apart from the hectic movements—a successful endeavor to prevent the real price from falling more sharply, as it had done until 1973.

Against this macroeconomic background, unlike Polak, I would not say so unambiguously that in the late 1970s and early 1980s the economic policy priorities had been shifted deliberately in favor of combating inflation and of “conservative” structural and supply-side policies. The governments in office at that time, regardless of which political party they belonged to, had no choice but to try to protect the market-economy conditions prevailing in the industrial economies from further serious erosion. In the words of a leading U.S. Keynesian (A.M. Okun), during the 1970s the “Phillips curve” became an “unidentified flying object”; administrative price and wage controls foundered either on the lack of a social consensus or because “incomes policy” very often only amounted to an attempt to stop the consequences of fundamental factors, especially inflationary influences, which was bound to fail. In particular countries (such as the United States) the system of fixed exchange rates permitted pent-up inflation to develop at times. However, in the countries where price movements had been relatively moderate at first, massive buying of the U.S. dollar had become necessary, with the result that control over domestic monetary trends was being lost.

In the view of some major central banks there was, therefore, no real alternative to the abandonment of the fixed rate system and hence to a transition to a more nationally orientated monetary policy. However, the strategy pursued from the mid-1970s onward—in fact, from as early as 1975 in a few major countries, if I may add this in amplification of Polak’s paper—of adopting pragmatically handled “monetary growth rate rules” likewise pursued the objective of persuading the general public as well as management and labor that monetary policy would not be accommodating again and that it would be important to keep the cost of fighting inflation as low as possible. At all events, the Bundesbank, which was the first central bank to announce an annual monetary target (at the end of 1974), interpreted its “experiment” along these lines from the very beginning.

As far as the currently pressing issues of international economic policy or monetary and economic policy cooperation are concerned, Polak has generally placed the focal points where I would put them too: in the eyes of world public opinion, the achievement of appropriate noninflationary economic growth has become a key economic policy problem in the industrial countries (unlike the situation as recently as the early 1970s). The outlook in this area can be lastingly improved only if the disturbing disequilibria among the industrial countries can be eliminated and, moreover, the debt problems of the Third World progressively resolved. To this end, cooperative monetary and economic policy strategies appear to be essential, although—as Polak to my mind quite rightly points out—approaches of this kind must not overlook the fact that the style of economic policy has changed during the 1980s. Unless I am much mistaken, the major countries are not on the threshold of a return to old-time religion demand management policies, to fine tuning in monetary policy, to anticyclical fiscal policy, or to a Bretton Woods system in a new guise. (But I may indeed be mistaken; swings of this kind can never be ruled out entirely.) The following points corroborate this view.

A main point of effort in economic policy today is generally deemed to be the improvement of supply-side conditions in the broadest sense. In the international arena, this should first be a matter of lessening the substantial risks which the global economic disequilibria present to investment propensity and the operation of the financial markets. Second, the fight to prevent new restrictions from being imposed on international trade and capital movements, the circumvention of the formal GATT regulations and the like must be continued. (GATT is the General Agreement on Tariffs and Trade.) Similarly, all industrial countries must strive to contain the misdirection by agricultural policy. The ambitious project of the common European internal market planned for 1992, which is being strongly promoted by Germany, might well be instrumental in reducing the numerous international impediments to competition in the shape of regulations, government-owned firms, and subsidized firms. It may be rather an overstatement for the EEC Commission to claim that the planned project might yield a growth gain equivalent to over 4–6½ percent of Community GNP for the European Community countries by the end of the 1990s, but there should be no doubt at all about the economic usefulness of this European initiative, even if particular intractable problems (such as those posed by agricultural, transportation, and communication policy), which have rarely diminished but often actually increased in the last 30 years, set bounds to enthusiasm.

Such efforts, which have an international bias from the start, must be accompanied by stronger national endeavors to put “one’s own house” in order (microeconomically speaking) in the area of structural policy. The OECD in Paris, which relied rather one-sidedly on traditional demand management for a long time, has demonstrated in a recent report the extent to which production and adjustment conditions in many sectors in the industrial countries have deteriorated, primarily as a consequence of undue government intervention.² The moves concerned are not simply distorting and conserving measures but also include the disproportionately rapid expansion of the public sector and social budgets, the increase in taxes and social security contributions, and—not least in Germany—the system of subsidies. However, Germany’s modest successes in the field of deregulation, in the consolidation of the public sector and social budgets, and in the promising reform schemes which are due to be implemented in 1989 and 1990 show clearly that this is an arduous path with limited room for maneuver, since social groups’ and other pressure groups’ thinking in terms of vested interests and inertia may make radical reform packages appear to be politically unattainable. In this connection, the way in which a government is formed (whether it is a coalition government or government by a majority party) is also of some significance.

In this situation, with respect to longer-range global growth prospects, I think we have to admit without illusions that the growth successes of the first decades after the war, which were achieved under exceptionally favorable supply-side conditions, are unrepeatable today in the industrial countries. Nor do they need to be repeated. After all, economic growth is not a final goal. National prosperity is a goal; high employment is a goal; peace between the social groups of a society is a goal; and social fairness is desirable. Preservation of nature as a basis for human existence is a goal which is increasingly being recognized as a duty in the old, densely populated but still fairly prosperous industrial countries. And the figures of the real gross national product, which are often invested with almost mystical properties, reflect this at best highly imperfectly.

This is not to say that there is no reason or room for an active shaping of shorter-term economic activity. The Federal Republic of Germany, for instance, has shown in the last two years that it remains prepared to respond flexibly to unusual internal and external economic policy challenges. Monetary and fiscal policies have been steered onto an expansionary course in consideration of Germany’s surplus position, the steep appreciation of the deutsche mark, and temporary signs of cooling off in domestic business activity. In the process, we have achieved respectable economic growth rates in Germany, with rises in GNP of 2½ percent in 1986 and 1¾ percent in 1987, and are anticipating an increase of 2 percent and more in 1988. Needless to say, the short-term growth prospects for a country that is running down its real external surplus position are not particularly good. In 1986 and 1987 alike, the real foreign surplus declined by an amount equivalent to 1¼ percent of GNP, and this tendency will persist in 1988, albeit less rapidly. These trends gave rise to substantial frictional adjustment burdens for German industry, which is much more dependent on foreign trade and exposed to international competition than is, say, Japanese or U.S. industry; moreover, these burdens cannot be offset at will by domestic stimulatory measures. To be sure, in order to foster the adjustment process and promote orderly exchange rate movements, we have tolerated a marked overshooting of the annual monetary targets more than once; moreover, the medium-term deficit estimates for the public sector budget in Germany have been substantially overshot. Hence it can hardly be maintained that monetary and fiscal policy in Germany have completely forfeited their traditional instrument role.³

By thus departing temporarily from the steadying course of its monetary and budgetary policy over the medium term, Germany is deliberately contributing to a globally coordinated adjustment strategy which Polak, if I understand him rightly, endorses: in the major surplus countries the growth rate of domestic demand should be above that of GNP, while in the deficit countries domestic demand should expand more slowly than total output. Political and institutional obstacles naturally set limits to globally coordinated adjustment strategies of this kind; it would be unrealistic to disregard them. In addition, care must be taken to ensure that the flexible, discretionary use of monetary and fiscal policy instruments does not in the longer run trigger developments which are clearly incompatible with the medium-term stabilization and consolidation goals of the countries concerned.

In this connection I should like to make an—open—remark on the comments which Polak’s paper contains about the relationship between exchange rate management and national monetary policy: for the central banks of the major industrial countries, the stabilization of nominal exchange rates has not of late been a goal “in its own right,” as it was toward the end of the Bretton Woods system; nor can it in the future become the central banks’ main function, regardless of the prevailing circumstances, to try to implement fixed targets for exchange rate movements. It is true that central banks have recently been willing to maintain orderly conditions in the foreign exchange markets, as far as possible, by means of coordinated interest rate measures and interventions, and to foster the real adjustment process; indeed, no central bank outside the United States has the option of adopting an attitude of “benign neglect” vis-à-vis exchange rates. Central banks’ most important function, however, resides in the fact that they collectively bear the ultimate responsibility for the “global rate of inflation” and that each individual major central bank is responsible for the stability of the purchasing power of its own currency. In the long run, these functions inevitably fall to the lot of monetary policy, since they cannot seriously be assigned to government incomes policy without endangering the foundations of free-market systems. This is why the monetary policies of the major industrial countries must provide a nominal anchor for economic policy decisions and thus facilitate the attainment of medium-term stabilization goals. Where the major countries are concerned, however, nominal exchange rate goals cannot form such an “anchor”; indeed, as past experience has shown, they may provide the instrument for synchronized national monetary policies which may expose the world economy to a cycle of unduly expansionary or unduly contractionary monetary influences.

A final remark should not be suppressed either: a forward-looking monetary policy, geared to stable prices over the long term, is possible in principle both with and without pre-announced monetary targets. Indeed, good monetary policy is conceivable without them, and bad monetary policy with them, as I said when they were first introduced 13 years ago. Hence, monetary targets, the benefits of which Polak seemingly rates rather low at present, have never been treated by the Bundesbank as targets in their own right, but have always been regarded literally as “intermediate targets”; however, we thought and still think these targets helpful in making clearer to the public the abstract process of stabilizing the value of paper money. We can also collaborate with central banks which attach less importance than we do to monetary indicators, as well as with central banks which set less store by monetary stability. But those who are counting on our constructive involvement in “blueprints” of international economic and monetary policy cooperation should please bear in mind: participation in cooperative international strategies—both within the EEC and worldwide—should be expected of us only if preservation of the stability of the purchasing power of money continues to be regarded as the principal contribution which monetary policy can make to the maintenance of favorable global growth conditions. This is what German monetary policymakers are prepared to do—no more, but no less; in point of fact, they feel positively under an obligation to act along these lines.

Martin Feldstein

Jacques Polak has given us a fascinating and very useful review and analysis of the changes in macroeconomic policy during the past 25 years. It is especially helpful that he looks at the process of policy formation in each of Group of Five countries and does so within a common analytic framework. The result is a paper that traces the intellectual development of macroeconomic policy during the past quarter century as well as the changes in the policies themselves.

I agree completely with the key theme of Polak’s analysis. He characterizes the development of the past quarter century as a retreat from macroeconomic policy activism. This retreat has not been the result of an ideological shift but of the recognition of the limits of activist government stabilization policy. Polak presents substantial evidence dealing with the experience in all of the major countries. His conclusion is undeniable.

A recurrent theme of the analysis is the growing emphasis on monetary policy as countries recognized that incomes policy and Keynesian fiscal policy are ineffective or actually destabilizing. The combination of reduced activism and a shift to monetary policy also paralleled a change in the focus of macroeconomic policy from the discretionary stabilization of employment and economic activity to a reduction of the rate of inflation.

At one point in his paper Polak discusses the shift in macroeconomic policy in the language of Jan Tinbergen as a shift away from some instruments and suggests that this was because of a change in preferences about the instruments per se. Although this idea that policy officials could have preferences about “instruments” as well as about “targets” is familiar to economists because of the work of Hans Theil, I think Polak’s argument is not convincing. As he himself shows, the instruments of fiscal policy and of incomes policy were dropped not because of a “political aversion” to these instruments but because experience had shown them to be counterproductive.

Toyoo Gyohten

As a practitioner who, almost by accident, happened to be one of the junior participants in the series of Group of Five and Group of Seven meetings over the last three or four years, I found Jacques Polak’s paper extremely intriguing. His very rich assessment and well-balanced, objective analysis also made the paper very persuasive. 1 particularly liked his finding about the role of fiscal policy—that at the moment it needs to be treated with a considerable dose of tender loving care to keep it in sufficiently good health for the uncertain tasks of the future. As a treasury man, I would very much like to compliment this finding.

Being stimulated by Polak’s paper, I would like to remark briefly on the progress of national economic policy coordination, particularly in the 1980s because that decade is still with us and has seen a very dramatic change. In retrospect, the decade of the 1970s was not very pleasant for all of us. It brought the collapse of the Bretton Woods regime, two oil price crises and ensuing stagflation, and, toward the end of the decade, the rather unfortunate experience of the so-called locomotive theory. I think these experiences made policymakers less confident, because it was quite clear that the industrialized world alone could not decide the destiny of the world economy. We also suffered a sense of loss because the world economic system seemed to have lost its anchor. So monetary authorities became more cautious and more conservative in establishing and formulating their policy objectives and the means to attain them. At the same time, this situation provided the rationale for the more self-oriented policy postures in many countries that became very apparent in the early part of the 1980s.

So when the 1980s set in, the macroeconomic policies of the major countries were, I am afraid, rather disorganized. But as I said earlier, there was during the 1980s a very dramatic shift from self-oriented policy formulation to a more world-oriented stance, and, in my view, the single most important determinant of the shift was the very serious international disequilibria which became most obvious in the early 1980s. The policy coordination efforts initiated by the industrialized countries like the Group of Five or the Group of Seven were certainly a product of such developments. These series of efforts to produce better coordination among the major industrialized countries can, in my view, be broadly categorized into three different stages. Interestingly enough, these three different stages were not planned beforehand; rather I think they evolved according to a learning process.

A predominant feature of the first stage of coordination was the strong emphasis on exchange rate realignment. By September 1985 everybody was of the view that the dollar was overvalued and something had to be done to rectify the situation. The famous Plaza Accord which was agreed in September 1985 had made that point very clear, as the communiqué shows. Although we talked about lists of macro-economic policies to be pursued by the members, it was very obvious that the overwhelming thrust was on the exchange rate realignment, and how to weaken the dollar. Since the five countries agreed to make strong concerted actions in the exchange market to achieve that goal, the exercise as a whole involved the intervention and exhortation mentioned by Polak in his paper rather than coordinated action on macroeconomic policy. However, the strategy worked; the dollar depreciated very rapidly. Why? In my view, it was only because the dollar was definitely overvalued at that time. The yen’s exchange rate vis-à-vis the dollar was 240 at the time of Plaza and is, as you know, 125 yen per dollar at present—a very successful outcome of the Plaza coordination effort.

As 1986 went by, a very gradual but subtle change took place in the minds of the policy authorities and the emphasis gradually shifted from exchange rate realignment to macroeconomic policy coordination. This was the second stage of the exercise. The first reason for the shift into this second stage was, 1 think, that exchange rate realignment had been successful. But while its beneficial impact was beginning to be evident from the trade performance of the major countries, for various reasons (including a J-curve effect), progress was not rapid. Meanwhile, the rapid change in exchange rate relationships had started to exert a rather unfavorable impact on the surplus countries’ economic performance. These countries became discouraged because of this over-rapid change in exchange rates and the danger that their domestic economies might slacken. In the deficit countries too, the over-rapid change in exchange rates created a new concern about the credibility of their currency and also the credibility of the economy as a whole.

As a result, as was very clearly demonstrated at the now-famous Louvre Accord of February 1987, the major thrust was clearly shifted to macroeconomic policy coordination. As you recall, the Louvre Accord declared that the exchange rate realignment had been adequate and the priority was now more stability rather than a further change in exchange rate relationships. The ultimate purpose of this macroeconomic policy coordination, in my view, was how to shift the growth patterns of the major economies via fiscal and monetary policies.

In hindsight, these efforts proved reasonably successful if you look at the growth pattern of the major three countries. For instance, in 1987, GNP growth in the United States for the first time exceeded domestic demand growth: GNP grew at 2.9 percent while domestic demand grew at 2.5 percent. On the other hand, in the surplus countries, the Federal Republic of Germany and Japan, there was a reverse pattern of the growth. In Japan in 1987, domestic demand grew at 5.1 percent, but because of the negative contribution of net exports, GNP grew at only 3.7 percent. In Germany, domestic demand grew by 2.9 percent, but GNP grew by 1.7 percent. In other words, the shift in the growth pattern of major deficit and surplus countries was achieved. This point is probably one of the rare cases where Polak is not very accurate. He notes that it seems surprising that the coordination effort has paid domestic demand so little attention. But in fact, the importance of the relationship between domestic demand growth and the external balance has been one of the major interests of the finance ministers and the governors of the central banks in recent discussions of the Group of Five and Group of Seven. This point should be emphasized.

After making reasonable progress in macroeconomic policy coordination, we seem to be in the third stage now, when the emphasis is on structural measures. The ultimate purpose of these measures is how to secure lasting adjustment. As I noted, reasonable progress was made on exchange rate realignment and macroeconomic policy measures. Nevertheless, there has been a strong and persistent concern that these changes may not be sustainable unless more fundamental shifts take place. I believe this is the reason that we now pay considerable attention to this new stage of coordination.

In Japan, structural measures imply both public and private initiatives. I think this is the case in every country. Public initiatives in Japan have so far involved deregulation, privatization, subsidy cuts and market opening, reductions in working hours, and the abolition of tax incentives for savings. But it should be stressed that in our structural reform, private initiative is extremely important. Major industrial restructuring by market mechanisms is, I believe, taking place. Some industries, like coal mining, ship-building and some steel, aluminum and textiles, are really dying now. And other industries that are import competitive or export oriented are reallocating their production facilities offshore. This will certainly contribute to the lasting change in the trade pattern. In addition, in view of very strong domestic demand growth, many industries are shifting their major market from overseas to domestic markets.

But this third stage, as I said, has just started and I am not sure how much we can really achieve in it. But having said that, of the four policy objectives described in Polak’s paper, I think the three goals of high growth, low inflation, and low unemployment still remain very valid. However, I believe that the balance of payments equivalent objective has changed somewhat. Under the Bretton Woods regime, the burden of adjustment fell mostly on the deficit countries, because if a deficit continued, the country had to sacrifice growth and employment. But now it seems to me that the burden of adjustment is falling more on the surplus countries. If a surplus persists, the country must suffer from rising protectionism in export markets and from international condemnation.

In conclusion, I think it is very important for all of us to realize that because of the very much greater international flows of capital, goods, and services, there has been a tremendous increase in interdependence among the major economies. As you know, various markets are also becoming more and more globalized. Therefore, policy objectives must now be pursued in an internationally harmonious way. This very important point is now recognized by the policy authorities in the major countries. I mentioned that we are now in the third stage of coordination. I do not know whether we will have a fourth stage. But I think that probably in the near future the major countries will make an effort to combine the three stages in a better way. I am sure that exchange rates will continue to have a significant role, as will macro-economic policies and structural reforms.

Erik Hoffmeyer

I can go a long way along the lines indicated by Jacques Polak in his interesting paper on the broad policy changes over the last thirty to forty years.

First and foremost, it is clear that a change in priorities has occurred, with price stability becoming more important than full employment. I think, however, that the change has been a gradual process, developing through the tatter part of the 1970s as a consequence of the combination of stagnation and high levels of inflation, and cannot easily be connected with the transition to conservative governments in the major countries.

The attitude toward economic policy has also undergone a substantial evolution. This is basically for three reasons. First the mechanistic view of policymaking has had to be abandoned. We were brought up with post-Keynesian thinking which taught that economic instruments were mutually independent and had a one-way impact. The latter characteristic meant that the economy was assumed not to react to the type of instrument used, nor to the intention of the politicians using it. This has proved to be an erroneous proposition, which the political system—and also professional economists—have found hard to learn.

The central issue is the role of credibility and expectations in the use of instruments. The use of exchange rate changes and the accommodation of inflation, for example, both create serious questions of attitude later on. Economic policy management is much more difficult than has been assumed.

Second, it was also expected that econometric models would become more and more reliable in forecasting economic developments. They have not, and this has been a great disappointment. I do not, of course, expect reliable forecasts of exogenous shocks, of which there have been many, but it was expected that endogenous developments in growth, inflation, key currency exchange rates, and so on could be forecast more reliably. Because they are not, it is not at all always clear whether economic policy should be changed and, if so, how much. Furthermore, explanations of economic performance have a tendency to degenerate into loose casuistic judgments instead of careful analysis. One consequence of this uncertainty is that the level of ambition in policymaking has been severely reduced.

Third—and connected with the second point—is the uncertainty in the interpretation of important events, particularly in the international sphere. I refer to the endeavors to move from the level of discussions and information in international relations to what could be called the coordination of policymaking.

The most illustrious cases are the Bonn Agreement of 1978, the Plaza Agreement of 1985, the Louvre Accord of 1987, and the Japanese expansion of 1987. In each case a really wide range of interpretations is possible—one extreme being that there was hardly any impact of the agreement, the other that it was of major importance. I am most inclined to the view that the impact has been very limited. This means that the level of ambition on coordination of international policymaking must be low.

I have been assigned to say something from a small country point of view but this presupposes that there are basic differences between big and small countries. It is certainly true that small countries do not have much influence in international negotiations, but if policy coordination is of limited importance—if it is, so to speak, one of the empty boxes—the problem does not deserve much comment. As regards the basic issues of policymaking, I do not think that conditions differ among big and small countries.

The balance of payments constraint was important for the United States in the late 1960s and is again now, as it has been for the United Kingdom and France very often and even for the Federal Republic of Germany in the late 1970s. Inflation has been a constraint for all countries—Japan, the United States, the United Kingdom, France, and Germany. Small countries have had the same problems and the same experiences with instruments that are not independent and with one instrument having an impact on several variables. In this respect 1 have never been over-fascinated by Tinbergen’s propositions. I tend to believe that economic laws do not distinguish between big and small countries.

I am not entirely happy about the philosophy in Polak’s paper in one respect. He argues that policy objectives were earlier directed at real magnitudes but are now rather concentrated on nominal goals. I do not find this convincing. When forecasts or objectives are put before parliaments there is always a distinction between real and nominal magnitudes, and as price stability has become more important—which is rightly pointed out in Polak’s paper—this really means that the distinction is taken more seriously than before. I agree—for reasons I have mentioned earlier—that ambitions have had to be scaled back but the awareness of real versus nominal targets has definitely not.

Furthermore, I am inclined to argue that fiscal and monetary policies are used more actively than before, although I would agree they are not used for fine tuning. Experience over the last ten years suggests that it gives the wrong impression to argue that less importance has been given to these two instruments. In both big and small countries fiscal policy has been used to adjust the overall savings rate—a basic Keynesian proposition—and monetary policy has emancipated itself from being tied conventionally to nominal interest rates instead of real rates. I would not maintain that results have been entirely satisfactory but I think that the learning process has had some useful results which should not be overlooked.

In that respect, I am more optimistic than Polak but perhaps not on the issue of reconciling price stability with full employment, on which I wrote a book almost thirty years ago and on which I do not think that we have come much closer to a solution.

To sum up, I agree that there has been a shift of priorities in economic policy. I do not attach much importance to international policy coordination. I do not agree that the distinction between real and nominal targets has much weight and I do not think that fiscal and monetary policies can be said to be used less than in previous periods.