VI Rationale for Policy Coordination
- Paul Masson, Morris Goldstein, and Jacob Frenkel
- Published Date:
- June 1991
Previous sections have raised the issue of the need for policy coordination; in this section we step back and take a general look at the rationale for it, as well as at doubts about its effectiveness.36
The most logical starting point is to ask why international policy coordination would be beneficial in the first place. After all, if in the domestic economy the working of the invisible hand under pure competition translates independent decentralized decisions into a social optimum, why should the same principle not apply to policy decisions by countries in the world economy?
The answer is that economic policy actions, particularly those of larger countries, create quantitatively significant spillover effects or externalities for other countries, and that a global optimum requires that such externalities be taken into account in the decision making. Coordination is then best seen as a facilitating mechanism for internalizing these externalities.
This conclusion can perhaps be better appreciated by emphasizing the departures from the competitive model in today’s global economy. Cooper (1987) has identified several such departures, and his analysis merits some extension here.
Unlike the atomistic economic agents of the competitive model that base their consumption and production decisions on prices that are beyond their control, larger countries exercise a certain degree of influence over prices, including the real exchange rate. This of course raises the specter that they will manipulate such prices to their own advantage and at the expense of others. Two examples are frequently cited—one dealing with inflation, and the other with real output and employment. Under floating rates, a Mundellian (1971) policy mix of tight monetary and loose fiscal policy allows an appreciated currency to enhance a country’s disinflationary policy strategy—but at the cost of making it harder for trading partners to realize their own disinflation targets. Similarly, under conditions of high capital mobility and sticky nominal wages, a monetary expansion under floating rates leads to a real depreciation and to an expansion of output and employment at home. But the counterpart is that output and employment contract abroad.37 Seen in this light, the role of coordination is to prevent—or to minimize—such intentional as well as unintentional beggar-thy-neighbor practices. Most international monetary constitutions have injunctions against “manipulating” exchange rates or international reserves.
The existence of public goods—and their role in resolving inconsistencies among policy targets—constitute a second important point of departure from the competitive model. When there are n currencies, there can be only n-1 independent exchange rate targets. Similarly, as discussed above, not all countries can achieve independently set targets for current account surpluses.
Adherents of decentralized policy making—sometimes rather inappropriately labeled the “German school”—argue that such inconsistencies do not justify intervention.38 Much as in the competitive model, the economic system will generate signals—in the form of changes in exchange rates, interest rates, prices, and incomes—that will lead to an adjustment of targets such that they eventually become consistent. If, however, the path to consistency involves large swings in real exchange rates, or, even more problematically, the imposition of restrictions on trade and capital flows, then reliance on decentralized policymaking may not be globally optimal. That a certain degree of stability in real exchange rates and an open international trading and financial system are valued in and of themselves (that is, they are public goods) is implicit in this conclusion. (In contrast, the market signals that resolve supply/demand inconsistencies in the competitive model are not regarded as public goods.) If that is accepted, there is a positive role for coordination, both to identify target inconsistencies at an early stage and to resolve them in ways that do not produce too little of the public good(s).39 It is of course possible for groups of countries who value the public good highly to attempt to obtain more of it by setting up regional zones of exchange rate stability or of free trade, and some have done just that (see the discussion in Section IV).40 But the essence of a public good is that it will tend to be undersupplied so long as some large suppliers or users act in a decentralized fashion.
Once we leave the realm of atomistic competitors and enter the realm of nontrivial spillovers of policies— whether those spillovers occur in goods, assets, or labor markets—national governments may not be as effective in achieving their objectives independently as when their policies are coordinated with other governments.41 A popular example illustrates this point. Whereas any single country acting alone may be reluctant to follow expansionary policies designed to counter a global deflationary shock for fear of unduly worsening its external balance, coordinated expansion by many countries will loosen the external constraint and permit each country to move closer to internal balance.
All of this establishes a presumption that there can be valid reasons for deviating from the tradition of decentralized decision making when it comes to economic policy, that is, that there is scope for coordination. This presumption is reinforced by two empirical observations. First, the world economy today is considerably more open and integrated than it was in 1950, or 1960, or even 1970. Not only have simple ratios of imports or exports to GNP increased, but also—and probably more fundamentally— global capital markets are more integrated.42 With larger spillovers, there is more at stake in how one manages interdependence. Second, it is by now widely recognized that the insulating properties of floating exchange rates are more modest than was suspected prior to their introduction in 1973.43
But a presumption that cooperation could be beneficial is not the same as a guarantee—nor does it preclude the existence of sometimes formidable obstacles to its implementation.
Suppose national policymakers have a predilection for inflationary policies but are restrained from implementing them by the concern that relatively expansionary monetary policy will bring on a devaluation (or depreciation). Yet, as outlined by Rogoff (1985), if all countries pursue such inflationary policies simultaneously, none has to worry about the threat of devaluation. Here, coordination may actually weaken discipline by easing the balance of payments constraint. Similarly, as noted by Feldstein (1988), there is the potential risk that a coordinated attempt to stabilize a pattern of nominal or real exchange rates could take place at an inappropriately high aggregate rate of inflation, hence the concern for establishing a nominal anchor, as discussed in Section II. Equally troublesome would be a coordination of fiscal policies that yielded an aggregate fiscal deficit for the larger countries that put undue upward pressure on world interest rates. The basic point is straightforward: there is nothing in the coordination process that reduces the importance of sound macro-economic policies.44 There can be coordination around good policies and coordination around bad ones—just as with the exchange rate regime, where there are good fixes and bad fixes and good floats and bad floats.45 Welfare improvements are not automatic.
It is only realistic, too, to acknowledge that there are barriers to the exercise of coordination. Four of the more prominent ones are worth mentioning.46 First, international policy bargains that involve shared objectives can be frustrated if some policy instruments are treated as objectives in themselves. Schultze (1988), for example, offers the view that it would have been difficult to have reached a bargain on target zones for exchange rates in the early 1980s given President Reagan’s twin commitments to increased defense spending and cutting taxes. In some other countries, the constraints on policy instruments may lie in different areas— including structural policies—but the implications are the same.
Second, countries can at times have sharp disagreements about the effects that policy changes have on policy targets. These differences may extend beyond the size to include even the sign of various policy-impact multipliers.47 The harder it is to agree on how the world works, the harder it is to reach agreement on a jointly designed set of policies. This point is discussed further in Appendix I, where it is argued that, in fact, uncertainty may provide an incentive to coordinate policies internationally.
Third, whereas most countries have experienced a marked increase in openness over the past few decades, huge cross-country differences in the degree of interdependence remain. Large countries (the United States being the classic example) are generally less affected by other countries’ policies than small ones. Coordination is not a matter of altruism, but rather the manifestation of mutual self-interest. To the extent that large countries are less beset by spillovers and feedbacks than small ones, the incentive of the former to coordinate on a continuous basis may be lower.48 In this regard, the high degree of trade interdependence shared by members of the EMS can be seen as a positive factor in reinforcing incentives to coordinate in that group.
Finally, as Polak (1981) has reminded us, international bargaining typically comes after domestic bargaining. More specifically, the compromise of growth and inflation objectives at the national level may leave little room for further compromise on demand measures at the international level.
These barriers to coordination should not be over-estimated: one of the clearest examples of true coordination—the Bonn economic summit of 1978—occurred just when domestic bargaining over the same issues was most intense;49 the growing integration of capital markets—of which the global stock market crash of October 1987 is but one reminder—has brought home even to large countries the implications of interdependence; and continued empirical work on multicountry models should be able progressively to whittle down the margin of disagreement on the effects of policies.50 If the scope of coordination is to expand beyond the efforts of the past, these obstacles will need to be over-come.
This section draws on Frenkel, Goldstein, and Masson (1988).
The conclusion that monetary expansion under floating rates affects real output in opposite directions at home and abroad is associated with the Mundell (1971)-Fleming (1962) model. For a recent evaluation of this model, see Frenkel and Razin (1987); a broader survey of the international transmission mechanism can be found in Frenkel and Mussa (1985). Econometric models are more divided on whether a monetary expansion under floating rates has negative transmission effects on real output abroad; see Helliwell and Padmore (1985) and Bryant and others (1988).
We regard the label as inappropriate, both because the proponents of decentralized macroeconomy policymaking—including Corden (1983, 1986), Feldstein (1988), Niehans (1988), Stein (1987), and Vaubel (1985)—are geographically quite diverse, and because some prominent German economists, such as Pohl (1987), have stressed the importance of coordination.
Corden (1986) has argued that there may be a case for asking large countries to slow their speed of adjustment to desired policy targets so as to dampen movements in real exchange rates that could cause difficulties for others.
Another constraint on regional attempts to create more of the public good is that they may divert or discourage its production outside the region; the argument here is analogous to the concepts of “trade creation” and “trade diversion” in the customs union literature.
To reach this conclusion, it is necessary to assume that each player does not have sufficient policy instruments to achieve all its policy targets simultaneously, and that coordination alters the trade-offs among policy targets; see Gavin (1986). Without those assumptions, the motivation for coordination would disappear.
See Goldstein (1984). This is not to say that the insulating properties of floating rates are inferior to those of alternative regimes. Indeed, it is hard to see any other exchange rate regime surviving the shocks of the 1970s without widespread controls on trade and capital.
See Bockelmann (1988) for a similar conclusion.
See Frenkel (1985).
Another barrier is disagreement over forecasts for key economic variables over the medium term; on this point, see Tanzi (1988).
See Bryant and others (1988) and Helliwell and Padmore (1984) for a comparison of open-economy multipliers from different global econometric models.
See Fischer (1987). Dini (1988) argues further that when the incentives to coordinate differ widely among group members, there may be a tendency for bilateral bargains to take place among those who have the most to trade.
See Putnam and Bayne (1984). At the same time, the Bonn summit is regarded in some quarters as illustrative of the pitfalls of coordinating macroeconomic policies when the economic outlook is changing rapidly.
Appendix II gives a preliminary evaluation of some simple coordination rules using the Fund’s model, MULTIMOD.