What does cooperation among major industrial countries imply? The issues and prospects explained
Jocelyn P. Home and Paul R. Masson
Considerable attention has recently been directed to potential benefits of increased economic policy coordination among the larger industrial countries as a way of improving the functioning of the international monetary system and sustaining economic growth and price stability worldwide. The Fund, of course, has a key role in this process since one of its stated purposes is “to promote international monetary cooperation through a permanent institution which provides the machinery for consultation and collaboration on international monetary problems” (Articles of Agreement, I(i)). Recent attempts to lay the groundwork for enhanced coordination include the 1985 reports of the Deputies of the Group of Ten and of the Group of Twenty-Four, the September 1985 meeting of the Group of Five (the “Plaza Agreement”), the Tokyo Economic Summit of May 1986, and meetings of the Interim Committee in the spring of 1987. This article explains the reasons behind the current interest in international cooperation, analyzes recent initiatives, and discusses prospects. First, however, it tries to clarify a confusing terminology.
Several closely related concepts—including cooperation, coordination, and convergence—have frequently been used interchangeably in the literature and in recent policy discussions, and have sometimes been interpreted in different ways. The term cooperation is here used in a very broad sense to encompass coordination, as well as all forms of interchange between countries relating to economic developments and policy intentions. It is, however, useful to make a distinction between cooperation and coordination in view of the several—and looser—types of interchange that are covered by the former, including consultation, exchange of information, and international surveillance. Policy coordination refers to agreements between countries to adjust their policies in the light of shared objectives, or to implement policies jointly. Convergence denotes developments in which the levels, or rates of growth, of economic variables move closer to each other over time. Convergence of either policies or performance need not require coordinated or cooperative policies, nor policy coordination necessarily imply convergence of policies.
International economic cooperation can take different forms, the most basic being an exchange of information between countries. Systematic exchange of information, directly or through an intergovernmental body, about the policy intentions of, and recent developments in, other countries is vital to effective policy coordination. Knowledge of developments in important variables—such as the balance of payments, growth, and inflation—will help to identify possible global inconsistencies and the need for policy coordination. In recognition of these considerations, the Interim Committee has recently requested the IMF to analyze the use of indicators of policy actions and economic performance in its surveillance over members’ policies.
A more ambitious form of cooperation is policy coordination, which can be of two types: first, ad hoc or episodic coordination characterized by discussion among the interested parties, with action in specific areas undertaken only once agreement is reached; and, second, institutionalized coordination, or centralized decision making, in which decisions are taken either collectively by member countries (as in the European Monetary System), or by an institution acting on behalf of its membership. To date most examples of coordination have been episodic, although international institutions contribute to the exchange of information and the surveillance that are important forms of international cooperation. Another useful distinction is between those coordinated policy decisions that involve short-term discretionary demand management, and those that are taken with regard to their medium-term consequences. International policy coordination for short-run stabilization purposes is subject to the same criticism as domestic “fine-tuning,” namely that in the absence of detailed information concerning the effects of policies, such coordination may do more harm than good.
Perceived need for cooperation
The interdependence of national economies has increased in recent years mainly through a greater integration of goods and asset markets. Policy objectives may also have become more interdependent—for instance, countries may share a concern for world inflation (not just inflation in their own country) or for economic growth in developing countries. These developments have led to sharpened concerns about the potentially harmful effects of actions taken by countries on each other and have prompted calls for greater cooperation among governments.
At a basic level, the global economy can be considered a closed economy, implying, for example, that national trade balances and current account balances are interdependent because they have to sum to zero (apart from any errors of measurement which in fact can be substantial—they currently sum to about $50 billion). Similarly, changes in reserves—or the overall balance of payments—when summed over all countries must equal the change in the global supply of reserves. In this framework, if a country takes action to change its balance of payments, this action will have repercussions for at least one other country. These “zero-sum” constraints on such national policy objectives as current account balances and holdings of international reserves—though of course consistent with a wide range of rates of output growth—however give rise to the likelihood of international inconsistencies in policy targets. These inconsistencies, in turn, imply a potential need for cooperation and coordination among countries.
Interdependence underscores the importance of taking account of the policy environment in other countries, and understanding the ways in which economic policies and exogenous shocks are transmitted between countries. It is probably fair to argue that, because of the complexity of the international economy, policy makers at present do not fully understand, let alone take into account, developments abroad when formulating policies. International sharing of information helps policy makers to understand better how the effects of their policies are modified by events in other countries.
Cooperation may also involve a further stage, namely the adjustment of policy goals in each country to make them internationally consistent and compatible. This is most obvious when countries target the same variable—for instance, if two countries each target their bilateral exchange rate or bilateral current account balance. The source of possible incompatibilities has been termed the “nth country problem,” which manifests itself in different ways under different exchange rate regimes. For example, under a key currency system (where one currency is used for most international transactions), if all countries attempt to adjust the level of international reserves, and the sum of reserve targets exceeds the world reserve stock, then policies have a global deflationary bias; if they fall short of the supply, then the world economy will experience inflationary pressures. If the key-currency country (the nth country) is willing to act passively as a residual, and does not adopt a (net) reserve target, it ensures that the global supply of reserves can eventually be distributed according to the preferences of the other n-1 countries.
TheInterimCommittee at its spring 1987 meeting “strongly welcomed recent improvements in the international coordination of economic policies, especially among major countries. They discussed ways in which the process of policy coordination and multilateral surveillance could be strengthened through further development of the use of economic indicators. The application of indicators in the Fund’s review of the world economic outlook was viewed as extremely useful in clarifying the interactions between national economies and in identifying potential sources of tension. Committee members considered that actual policies should be looked at against an evolution of economic variables that could be considered desirable and sustainable.”
In principle, a regime in which exchange rates float freely eliminates the need for official reserves, and allows each country to choose its money supply and rate of inflation. In practice, of course, no country is indifferent to its current account balance, its real effective exchange rate, or the level of its reserve holdings. If countries have targets for these variables, there must either be an nth country that does not have an explicit target, or else some way of making the targets globally compatible. This is the fundamental consideration that has given rise to the impetus for policy coordination in the present international monetary system, with its diversity of exchange rate arrangements and high degree of exchange rate flexibility. Concern with the effectiveness of the present international monetary system has arisen from a perception that there is excessive exchange rate volatility, misalignment of the currencies of the main industrial countries, and continuing payments imbalances, especially of the United States, the Federal Republic of Germany, and Japan.
The charts present data on the current account positions and real exchange rates for the seven major industrial countries since generalized exchange rate flexibility began in 1973. As can be seen, large current account imbalances have persisted during this period, in particular for the United States, Japan, and Germany since 1980. At the same time, real effective exchange rates have also persistently deviated from their historical values (calculated in the chart as averages for the period 1976-85); however, since early 1985 exchange rate movements for the three largest industrial countries have gone in the direction needed for the reduction of those current account imbalances.
Though it is generally agreed that large swings in real exchange rates and persistent current account imbalances are in some circumstances undesirable, a system of fixed, but adjustable, exchange rates, as existed under the Bretton Woods system, would not necessarily be preferable. The hybrid system that has been in place since 1973 has proved resilient to large shocks to the international monetary system; it is doubtful whether the Bretton Woods system would have withstood the two major oil price increases, for instance. However, a desire to improve the functioning of the current system has inspired attempts to use policy coordination in order to reduce external imbalances.
Recent attempts at coordination
Since 1975, an important new instrument for achieving international coordination has arisen—the annual Economic Summit of the G-7 countries. (See “From G-5 to G-77: international forums for discussion of economic issues” by Michael Blackwell, December 1986 issue.) The distinctive feature of Economic Summits is that they are limited to a small group of countries (currently the G-7) that carry most weight in international economic decision making. Summits do not impose binding agreements on countries and the subjects considered may alter each year. This flexibility has proven to be both an advantage (in the face of a changing economic environment), and, on occasion, a drawback.
The earlier summits placed considerable emphasis on the importance of each country “putting its own house in order.” One important exception to this domestic focus was the Bonn Summit of 1978, which achieved agreement on a coordinated package of macroeconomic policies by the United States, Germany, and Japan. The form of macroeconomic coordination implemented was, to a large extent, a modified version of the “locomotive” model that had dominated discussion at the London Summit a year earlier, whose proponents argued that the larger industrial countries should undertake more expansionary policies than otherwise in order to foster the conditions for an export-led world recovery. In retrospect, the Bonn measures placed insufficient emphasis on the medium-term consequences of fiscal expansion, and failed to provide sufficient flexibility for anti-inflationary monetary policies that were subsequently made necessary by the second oil shock. As a result, the expansionary measures decided upon at Bonn were soon revised, and the Bonn summit is widely considered to be an example of the pitfalls of international “fine-tuning.”
Major Industrial countries’ currant account balances and real effective exchange rates, first quarter 1973—third quarter 1986
Sources IMF, international Financial Statistics and Fund staff estimates.
1Seasonally adjusted at annual rates: data for Italy extended from 1975 to 1985: data for France and United Kingdom from first quarter 1973 to second quarter 1986.
2 Relative normalized unit labor costs adjusted for exchange rate changes, calculated using export weights.
An important step taken at the Versailles Summit of 1982 was to establish the G-5 forum of officials of the five major industrial countries, joined by the Managing Director of the IMF, for conducting “mutual surveillance” of macroeconomic policies with a view toward encouraging policy convergence and exchange rate stability. One of the advantages of the G-5 forum has been that, unlike the Summit, it has included central bank governors as well as finance ministers.
More recent policy initiatives, beginning with the September 1985 agreement of the G-5 (the “Plaza Agreement”) have also attracted considerable attention. The Plaza Agreement was a commitment by the major industrial countries to cooperate more closely to further the orderly appreciation of other major currencies against the US dollar. This may be considered a significant procedural achievement insofar as it signified the increasing acceptance among G-5 countries that payments imbalances constituted a common problem. The Agreement also clearly distinguished between the usefulness of short-run intervention as a temporary expedient, and the need for medium-run macroeconomic policies to influence the underlying market fundamentals and to achieve a permanent realignment of major currencies.
The coordinated reductions in the discount rates of major industrial countries (and some smaller industrial countries) achieved in March and April 1986 may also be interpreted as an outgrowth of the Plaza Agreement, and as an example of successful coordination of monetary policies, when there is a common perception of the goal to be attained—in this case, the need to lower nominal (and real) interest rates in the face of slow growth of output. They were also justified by the desire to avoid further exchange rate changes, in view of the substantial depreciation of the dollar that had already taken place.
The commitment to policy coordination was further strengthened at the Economic Summit in Tokyo in May 1986, and there have been two major initiatives since then. In October 1986, the United States and Japan reached an agreement concerning monetary and fiscal policy actions, and declared that the then-prevailing yen-dollar exchange rate was broadly appropriate. In February 1987 those two countries, joined by Germany, France, the United Kingdom, and Canada, announced specific policies—which included fiscal restraint in the United States and fiscal stimulus in some of the other countries—aimed at bringing about an adjustment of current account imbalances and a more balanced global growth. Prevailing exchange rates were judged consistent with underlying economic fundamentals, and the countries agreed to cooperate closely to foster the stability of those exchange rates.
Useful lessons for international policy coordination may also be drawn from the experience of the group of European Community member countries whose currencies participate in the exchange rate mechanism (ERM) of the European Monetary System. The focus on monetary stability has meant that the control of inflation has formed a cohesive primary objective for member countries whose currencies participate in the exchange rate arrangement. The agreement to place a high weight upon reducing inflation has also served to weaken any threats to stability that might otherwise arise from conflict between internal and external balance, and any inconsistency between inflation targets desired by smaller members and larger countries. The common goal of reducing inflation over 1979-85 required that monetary policies of member countries follow a policy of restraint. While the convergence toward monetary restraint in ERM member countries (measured by monetary and domestic credit aggregate growth rates) has been well documented, it is also apparent that this experience is not unique to this group of countries; other industrial countries, also facing the inflationary oil price increase, moved to restrictive monetary policies. Fiscal policies, in contrast, were not directed toward the exchange rate, and showed increasing divergence for ERM (and major non-ERM industrial countries) over the period 1979-85, although the EMS may have placed constraints on fiscal policies of particular countries in specific periods. Furthermore, indicators of unemployment and current account imbalances show an increased divergence for both ERM countries and G-7 countries not included in the exchange rate arrangement.
The discipline of fixed but adjustable exchange rates has served as the chief mechanism for achieving convergence in inflation for ERM countries, but it is clearly not a necessary instrument for monetary discipline. Nor, it appears, is the exchange rate mechanism a sufficient instrument for achieving convergence in other measures of performance, in particular output growth and the reduction of current account imbalances, unless it is also accompanied by coordination of both fiscal and monetary policies.
Obstacles and prospects
If there are clearly recognized gains from international economic policy coordination, why is such coordination not more pervasive? An important reason is that these gains are less likely to be realized when there exists uncertainty about the way the world economy operates. Furthermore, there are a number of other obstacles to the achievement of coordination, including costs of negotiation and incentives not to implement agreed policies.
One important obstacle to achieving policy coordination is disagreement concerning the way the economic system functions, and, in particular, the strength and even the direction of the transmission mechanisms for economic policies. Disagreement among domestic policy makers may also impede international coordination. In most countries domestic objectives reflect the outcome of considerable bargaining among interest groups, which may leave little scope for compromise at an international level. However, international agreements have also been achieved in recent years precisely when substantial disagreement within governments has existed, for example, between monetary and fiscal authorities, leaving some scope for coalitions of officials across countries with similar objectives.
A second obstacle is the incentive to renege on agreements and a reluctance of governments to limit their own freedom of maneuver. In some circumstances, countries may benefit from being followers; this is also termed the “free rider problem,” which can occur if there is an international public good from which all countries benefit, but to which each would like to minimize its contribution. An example that is sometimes cited is the attempt to stimulate aggregate demand by increased government expenditure. If fiscal stimulus is transmitted positively to other countries, then all will experience an increase in demand; however, each country individually may not want to carry out fiscal stimulus because of unfavorable balance of payments consequences. Under these circumstances, it may seem attractive for governments to agree, for instance, to stimulate aggregate demand, but to fail to “carry out their end of the bargain” though benefiting from the actions of the other parties to the agreement. The incentive for this type of behavior, if perceived to be pervasive, might make cooperative behavior impossible, unless there are penalties attached to noncompliance.
Cooperation is likely to be more successful when there are clear criteria for monitoring performance and it is easy to verify that a party is holding up its side of the bargain. Monitoring is easier when there is regular exchange of information and contact within established institutions, such as the European Community. A related issue is that cooperation in a number of fields may allow bargains to be struck such that a gain in one area is traded off against concessions in another; thus agreements may be easier when policy packages are concluded on a regular basis.
Coordination among governments is costly in terms of the negotiating process and time lags in reaching agreement. Economic summits and negotiations among lesser officials may involve a considerable diversion of attention away from domestic economic and political issues. Furthermore, agreements, even if achieved, are likely to involve substantial further efforts of implementation, as there are often incentives for cheating that must be minimized—possibly through monitoring, cajoling by the other participants in the agreement, or threats of retaliation.
The costs of coordination are likely to rise with the number of participants, so that limited cooperation, whether among the larger industrial countries or within regional groups, or cooperation, in the form of an established international organization, is more likely than ad hoc cooperation among large numbers of countries. The effectiveness of summits might also be enhanced by representation from international institutions, although in practice the spring Interim Committee and OECD meetings indirectly contribute to the preparations for a summit. Such institutions may contribute significantly to the negotiating process by their global focus and by representing the interests of developing and smaller industrial countries.
One of the main implications of the interdependence between countries and the considerable uncertainty pertaining to developments and policies abroad is that there are clear benefits to be derived from international cooperation in the form of information interchange and international surveillance. Exchange of information—and a framework for interpreting that information—is an essential step in cooperation, since achievement of this step means that governments would be less likely to choose policies that would lead to unexpected international feedback effects even if they did not actively coordinate their policies.
Under the present international monetary system, it is likely that international cooperation can be enhanced by a widely (if not universally) shared analytical framework and information base that permits the identification of serious imbalances affecting one or several countries. The Fund currently exercises surveillance over the policies of major countries through bilateral consultations on an annual frequency as well as biannual discussions of the World Economic Outlook. A further initiative is work at the Fund on indicators of policy actions and economic performance for major countries. By serving as the basis for multilateral discussion, indicators would strengthen international surveillance and information interchange between countries that is critical to effective cooperation. Progress in this area may also serve to identify the need for policy coordination, and to increase the likelihood of its being effective in improving the functioning of the international monetary system.