To be effective, international economic cooperation has several preconditions: a common understanding of the goals that are being pursued; an awareness of the economic environment within which national economies interact; an analytical framework for assessing the international impact of the economic policies and performance of individual countries; and a set of procedures that allow international considerations to be properly taken into account in framing national policies. Some of these aspects of cooperation were described in an earlier article: “International Economic Cooperation and Policy Coordination” by Jocelyn Home and Paul Masson, Finance & Development, June 1987.
The present article is concerned with the analytical framework for policy coordination; it reports on work being done in the Fund to develop indicators of policy actions and economic performance. If they can be developed sufficiently to serve as the basis for multilateral discussion, indicators will strengthen the international surveillance and exchange of information between countries that is critical to effective cooperation.
This article draws partly on the author’s paper, “Strengthening International Cooperation: the Role of Indicators in Multilateral Surveillance” in The Quest for National and Global Economic Stability, published by Kluwer Academic Publishers, Dordrecht, The Netherlands, May 1988.
The encouragement of constructive international economic relationships has long been a major consideration in the design of the international monetary and financial system. Two basic approaches to the task are possible. The first is to design the system so that in pursuing their own national objectives, member countries tend to support the objectives of other countries, or at least do not interfere with them. In this approach, which characterized the Bretton Woods system of fixed exchange rates, the cooperation comes in designing the system, and the operational coordination of policies is less central. The alternative approach, which characterizes the present system, is to have international monetary arrangements that do not in themselves constrain policies, but to provide for cooperative decisionmaking in areas of common interest.
Even in the rule-based Bretton Woods system, multilateral discussions of national policies were not absent. Under that system a series of regular consultations between the IMF and its member countries helped to ensure that countries observed the “code of conduct” embodied in the Fund’s Articles of Agreement. Also, the main industrial countries held regular discussions of economic policies in various forms, to identify potential difficulties in the operation of the adjustment process and devise cooperative solutions.
It can be argued, however, that such multilateral discussions assume more importance in a system which, like the present one, gives countries substantial discretion in policies affecting the exchange rate. This is formally recognized in the revised Article IV of the 1978 Amendment to the Fund’s Articles, which states, in part, that”…The Fund shall exercise firm surveillance over the exchange rate policies of members, and shall adopt specific principles for the guidance of all members with respect to those policies.”
Neither fixed exchange rates nor the floating exchange rates of the period since 1973 have proved capable in themselves of protecting countries from negative spillovers from developments in their trading partners. It is thus not surprising that recent efforts have sought to improve international policy consistency in more direct ways.
Two significant events occurred in 1985 that colored the subsequent debate. First, the US dollar reached a level that all major countries agreed was unsustainably high. Cooperative action was taken that helped to bring it down. The lessons were that it was possible for markets to produce exchange rates that were not sustainable over the medium term, and that it was possible for official action to do something about this.
Second, two reports were published on the functioning of the international monetary system (see IMF Occasional Paper No. 50, Strengthening the International Monetary System, 1987). That by the Group of Twenty-Four developing countries was sharply critical of the way in which the system had been operating. That by the Group of Ten industrial countries was less critical, though it recognized some significant shortcomings. But both reports took the view that large swings in exchange rate relationships among major countries were potentially harmful, that such swings arose from divergences in underlying economic policies, and that the solution lay in mechanisms that would encourage better harmonization of policies among the major countries.
Target zones. In the ensuing discussion of ways to pursue better harmonization, most developing countries and some industrial countries favored the adoption of target zones for exchange rates. In principle, target zones have several advantages: they can improve the international consistency of policies (because the zones and the associated policies must be agreed through negotiation); they can encourage more disciplined macroeconomic policies (because they rule out the “easy option” of exchange rate movement); and, if credible, they can act as a focus to encourage stabilizing speculation. It is also sometimes claimed that the constraints on national policies imposed by a target-zone system would increase the scope for effective surveillance to be exercised over the major countries, and would thus contribute to the symmetry and evenhandedness of the system’s disciplines.
It has to be recognized, however, that target zones are but an indirect way of promoting their intended goal. Deficiencies in international economic performance are rooted in the shortcomings and inconsistencies of national economic policies; misalignments in exchange rates are merely the symptom. Focusing on the symptoms can, in certain circumstances, make the underlying problems even worse.
Consider, for example, a situation in which fiscal expansion in a major industrial country leads to a strong growth in domestic demand, upward pressure on domestic interest rates, and an appreciation of the national currency. Given the stance of fiscal policy, to resist currency appreciation would require an expansionary monetary policy designed to lower interest rates. Such a policy would, however, keep the expansionary effects of fiscal policy “bottled up” in the domestic economy, giving rise to inflationary pressures. In other words, though to avoid exchange rate appreciation it would be appropriate to use fiscal restraint, the pursuit of a target exchange rate might result in monetary expansion instead. Thus the exchange rate would be stabilized at the cost of compounding the initial policy mistake.
Of course, agreements on target zones could specify the types of policies to be used to hold exchange rates within the zones. But once the system is extended in this way, the question arises “why not simply use guidelines for domestic policies, and allow exchange rates to reflect this?”
Indicators. Interest in the use of objective indicators in multilateral surveillance revived in 1986. (The subject had been explored in 1972-74 as a potential means of allocating the burden of adjustment to international payments imbalances, but was dropped when the major countries moved to a floating rate system, on the assumption that issues of balance of payments adjustment would then loom less large.) In 1986 the Interim Committee of the Board of Governors of the Fund asked the Fund’s Executive Directors to explore “the formulation of a set of objective indicators related to policy actions and economic performance, having regard to a medium-term framework.” Subsequently the Tokyo economic summit declaration (May 1986) also gave strong support to the use of indicators, and stated that a specific list of indicators would be used in appraising economic developments in the seven major industrial countries.
The statements of these two meetings signaled a commitment to the objective of greater coordination of economic policies, but they did not give very clear guidance on how objective indicators are to be used to this end. It remains to define the purposes for which indicators are to be used and the analytical framework within which they are to be interpreted. Beyond this, a number of practical issues arise, such as the list of indicators to be employed, the country coverage of multilateral surveillance, and the procedures to be used when economic variables depart from their intended course.
The list of indicators provided in the Tokyo economic declaration was as follows: GNP and domestic demand growth; inflation; unemployment; trade and current account balances; monetary growth rates; fiscal balances; exchange rates; interest rates; and international reserves.
These statistics have always been used in the description and analysis of economic developments. But three aspects of the use of indicators are emphasized in the current debate that potentially go beyond the traditional uses of these statistics.
First, it is the intention to use indicators to analyze the international interactions among economic policies and performance. This means that trends in domestic policy and performance variables have to be viewed in terms of their implications for international variables such as exchange rates and payments patterns. This in turn requires an analytical framework for relating trends in domestic variables to external objectives.
A second aspect of the present interest in indicators is the emphasis on a medium-term approach. This means that short-term developments are assessed in the light of their medium-term implications, and of the sustainability of the medium-term trends over time.
Third, it is envisaged that actual developments in particular indicators will be measured against standards or criteria that would establish a desirable pattern. The communique of the April 1987 Interim Committee, for example, states that “actual policies should be looked at against an evolution of economic variables that could be considered sustainable or desirable.”
When developments in an individual economy give rise to disturbances that create unanticipated shifts in trade and capital flows, its partners may be forced to reallocate their resources. The transfer of factors of production from one application to another may involve temporary unemployment, uncertainty costs, and the obsolescence of physical or human capital. Subsequently, quick reversals of policy are likely to be required when, for one reason or another, current trends come to be perceived as unsustainable.
For example, the rapid growth of imports into the United States in 1983- 84 helped to lead the international economy out of recession and to mitigate the worst effects of high interest rates on heavily indebted countries. However, the situation was not sustainable: the rapid build-up of domestic and international debt by the United States undermined the confidence of holders of dollar-denominated financial assets, while the growing US trade deficit generated strong pressures for trade protection at home. Thus a policy reversal and/or a change in exchange rates had to occur, and by 1987 both reactions were well under way. The policy and exchange rate changes now taking place should make the US economy less dependent on net imports, either of goods or of the foreign savings to finance them, and other economies less dependent on net exports.
On this reasoning, a central feature of the use of indicators in surveillance must be an assessment of the sustainability of current economic trends. To make such an assessment, one must first analyze the implications of current policies for external developments over the medium term and then identify the medium-term position that could be considered sustainable or desirable on efficiency criteria.
The main point of interaction between national economies is trade and capital flows. These flows are influenced by demand and output growth in individual economies, by relative price and cost levels, by relative interest rates, and more generally by the whole range of economic policies that underlie these developments. To assess the implications of current policies for actual external developments, the implications of these policies for relative rates of demand growth and relative competitiveness must be estimated. These estimates are made on the basis of relationships involving the indicators listed in the Tokyo declaration: the impact of fiscal and monetary policy on the rate of growth of domestic demand and GNP; the relationship between output and demand growth, on one hand, and trade and current account imbalances, on the other; the implications of monetary policy for inflation and interest rate differentials; the combined effect of domestic costs and exchange rate developments on international competitiveness; and the relationship between international competitive positions and trade flows. Artus and Knight have shown how these relationships can be used to estimate a country’s underlying payments balance. (See IMF Occasional Paper No. 29, Issues in the Assessment of the Exchange Rates of Industrial Countries, 1984.)
What has been described so far is the use of indicators for forecasting; it is positive economics. To give the analysis the normative content that it needs to be useful in the context of surveillance, one must compare the forecast of the medium-term balance of payments outturn with an estimate of what can be considered sustainable or desirable. A disparity between the underlying position and the sustainable position would then indicate a need to shift policies so as to align the two.
This general approach is hard to disagree with in principle but it carries considerable practical difficulties.
For one thing, a sustainable balance of payments position is a difficult concept to define and may change with circumstances. For example, energy discoveries in the Netherlands, Norway, and the United Kingdom substantially changed the payments positions that were sustainable for those countries. Thus rather than defining the sustainable payments position on the basis of what has been normal in the past, a more promising approach is to define it in terms of the sustainability of the domestic and external financial balances with which it is associated. Using the national income accounting identity, the current account deficit (or surplus) of a country is equal to the budget deficit less the excess of private domestic saving over private investment. If an estimate is made of the underlying determinants of domestic private saving and investment, and if the government’s objective with respect to the fiscal deficit is known, then the implied “consistent” balance of payments position can be calculated as a residual.
The virtue of an approach that emphasizes savings and investment balances is that it draws attention to the need for mutual consistency between developments in the balance of payments and trends in domestic economic variables. It therefore underlines the fact that an unsustainable balance of payments position can be dealt with both through measures that have a direct effect on incentives to trade flows (e.g., exchange rates and competitiveness) and through measures that affect underlying saving and investment propensities in the domestic economy. Indeed, for a durable solution, the two must go hand in hand.
How is the above approach applied in practice? There are basically two dimensions to this. First is the requirement of short-term consistency: the international implications of countries’ domestic objectives must satisfy necessary adding-up constraints in terms of payments positions and trade flows. If these adding-up constraints are not satisfied, ex ante, the intended objectives will not be achieved. If, for example, countries are all seeking to curb domestic demand and allow net exports to take up the slack, demand and output will not meet the desired targets since not all countries can increase net exports together.
The second dimension is that the external balance must be compatible with a medium-term evolution of the financial system that does not lead to future disruptions. A situation in which one country has a large decline in government and national savings (i.e., an increase in the fiscal and current account deficit) may be consistent in the short term with the policies of its trading and investment partners, provided they make counterpart increases in savings. But if markets are unwilling to finance the implied resource transfer over the medium and longer run, the situation will lead eventually to a policy reversal or to a market reaction that brings to a halt the resource transfer.
The way forward
Despite the various difficulties of policy coordination, it seems clear that a cooperative approach to managing the world economy is essential if the pitfalls associated with competitive or incompatible policies are to be avoided. However, to attempt a detailed blueprint for policy formation would be unduly mechanical. It would constrain the flexibility of policy action in ways that might well diminish the capacity to respond appropriately to unexpected disturbances. For this and other reasons, a high degree of precision in managing coordination would probably be rejected by the countries concerned.
Nonetheless, the following seem to be essential ingredients in a strengthening of effective policy coordination:
- The existence of a recognized set of forums in which the aims and instruments of policies could be regularly reviewed. It is important that there be both a forum where a limited number of large countries can make politically sensitive “bargains” and a forum in which the rest of the world can effectively communicate its views and concerns to the large countries. The participation of the Managing Director of the Fund in meetings of the major industrial countries offers one way of providing a link between these two forums.
- The establishment of a quantitative framework of analysis that commands a broad basis of acceptance among the parties concerned. This involves a common view of the impact of domestic policy instruments on economic variables, and the acceptance of general criteria for judging the sustainability and acceptability of economic outcomes.
- The development of a mechanism for recognizing and dealing with situations in which actual and prospective developments diverge from the intended or desired path. This is an area in which progress will be extremely difficult and will have to take place gradually. One possibility would be to establish agreed criteria for assessing the evolution of agreed variables, then to provide for discussions in circumstances where there was a departure from such an evolution. This last stage is where indicators could be given a larger role in multilateral surveillance.
The Fund’s use of indicators
The Fund’s Articles of Agreement provide that “The Fund shall oversee the international monetary system in order to ensure its effective operation, and shall oversee the compliance of each member with its obligations. …” (Article IV, Section 3 (a)), and that “In order to fulfill its functions under (a) above, the Fund shall exercise firm surveillance over the exchange rate policies of members…” (Article IV, Section 3 (b)).
The main vehicles for the Fund’s exercise of surveillance are its periodic Article IV consultations with members and its regular discussions of the World Economic Outlook (WEO) report, which is published twice a year. Article IV consultations provide the most comprehensive interaction between the Fund and its members, giving the opportunity for a thorough examination and assessment of the individual member’s economic situation and policies. Discussions of the WEO allow for a comprehensive review of the world economy and the exchange rate system, and thus provide a framework for multilateral surveillance over the exchange rate policies of individual members.
A basic element of surveillance is the monitoring of developments in exchange rates and exchange arrangements. One element of such monitoring is the Information Notice System, initiated in 1983. Information notices are issued to the Fund’s Executive Board when changes in a member’s real effective exchange rate index exceed ten percent since the last occasion on which the Board had an opportunity to consider the member’s exchange rate policy. Recently the Board endorsed the proposal to publish in International Financial Statistics the monthly indices of nominal and effective exchange rates monitored under the INS, subject to the agreement of member countries.
The Interim Committee in April 1987 “encouraged the [Fund’s] Executive Board to examine ways in which the existing principles and procedures for Fund surveillance could be updated to incorporate the use of indicators; [and] to explore a strengthened use of indicators. … In pursuing this work, the Executive Board was encouraged to focus on a limited set of key indicators and to appraise the international interactions of domestic policies and performance in the light of medium-term scenarios. Indicators would also be designed for use in the assessment of world economic developments, including the impact of industrial countries’ policies on developing economies, and in the Fund’s continuing analysis and policy advice in the context of regular Article IV consultations.” The use of indicators received further endorsement in the Venice Economic Summit Declaration of June 1987.
Progress in the use of indicators has been gradual, and pursued within the context of the Fund’s existing approaches and procedures. The focus, at least for the time being, is on points of interaction among major economies, and for this purpose emphasis is given to the sustainability of balance of payments positions and of the factors underlying balance of payments flows. In this work it is recognized explicitly that a country’s external position depends critically on the evolution of domestic variables—that the whole range of domestic policies has implications for exchange rates, even if these consequences were not intended, and even if they are small relative to their effects on the domestic economy.
By extending the use of key indicators in the analysis underlying the WEO, the Fund staff have established a more detailed and explicit framework for the analysis of potential sources of tension in the interaction of policy developments in the short and medium term and of means of resolving these tensions. Starting with its October 1987 issue, the WEO provides a quantitative assessment of the implications of current policies for the evolution of the key indicators, set in a medium-term framework. To some extent experimentally, it attempts to give quantitative content to the concept of a “desirable and sustainable evolution” of these variables.
The use of indicators in the WEO is tied in with the use of indicators in the Fund’s continuing Article IV surveillance. Greater reliance on indicators in the context of Article IV consultations with major countries will, it is hoped, strengthen the assessment of policies in individual countries against the background of earlier multilateral assessments of policy interactions.
At its meeting of April 1988 the Interim Committee encouraged the Executive Board to continue developing its use of indicators. For the time being, monitoring procedures are being used on an experimental basis; when actual developments are seen to be diverging from those that were expected or desired, the Fund Managing Director will use his discretion to judge whether the circumstances warrant a special review by the Fund.