Macroeconomic Interactions and Policy Design in Interdependent Economies David Currie and Marcus Miller

Macroeconomic Interactions and Policy Design in Interdependent Economies
David Currie and Marcus Miller

CEPR has recently received major grants from the Ford Foundation and the Sloan Foundation for a joint programme of activities with the Brookings Institution in the area of 'Macroeconomic Interactions and Policy Design in Interdependent Economies'. They are complemented by other research project grants to the Centre from the Economic and Social Research Council (in collaboration with the Centre National de la Recherche Scientifique), the Rockefeller Foundation and the Leverhulme Trust, and CEPR is currently seeking funding for further components of the programme. The work is now well under way. The programme covers five broad areas:

Empirical analysis of macroeconomic interactions
Regimes and policies: the international environment and national options in history, theory and practice
Regional monetary and trade cooperation: the European experience
The evolution of markets and the implications for policy
Potential gains from improved cooperation about macroeconomic policies.

Organization
The Brookings Institution has primary organizing responsibility for the first and fifth of these topics, with a significant CEPR input. As part of the first, Brookings held a major conference in March 1986 to analyse the available empirical models of the international economy, using them to examine the effects of monetary and fiscal actions in the US and Europe. CEPR's contributions to work in the first and fifth areas mainly involve Andrew Hughes Hallett and Patrick Minford, as well as Michael Artis, David Currie and Willem Buiter. CEPR has primary responsibility for the second, third and fourth areas of research outlined above, with corresponding contributions from Brookings.

The joint programme naturally stresses British and American roles and perspectives, both historically and in current policy-making (see Richard Portes, CEPR Discussion Paper No. 100). There is a significant component involving continental Europe (see especially the Franco-British project discussed below), as well as North-South interactions (notably work by Michael Beenstock, Ravi Kanbur, Sweder van Wijnbergen and David Vines, from the CEPR side).

Objectives
Economic interdependence in the world economy poses problems of measurement and management. The extent and nature of interdependence must be measured to establish a sound factual basis for private and governmental decision-making. Economic interdependence may need to be managed to avoid outcomes which are undesirable for individual economies or for the world economy as a whole. Management can be achieved either through the operation and extension of markets or through government policies and intergovernmental cooperation.

Research on the measurement of interdependence is primarily 'positive' economic analysis: its overriding aim is to deepen our factual understanding of the world economy. Research on the management of interdependence, however, requires not only positive but also normative analysis: the researchers seek to make recommendations about how the functioning of the world economy might be improved.

A better factual understanding of the macroeconomic interactions among national economies is a necessary precondition for making any type of sound normative recommendation. CEPR and Brookings seek in particular to stimulate improved empirical research that will permit better quantitative estimates of cross-border spillovers of policy actions and non-policy shocks.

A second basic objective is to clarify the normative aspects of macroeconomic policy choices and of the design of international 'regimes'. Recently developed but now widely accepted methods of analyzing intertemporal decision-making can be applied to practical problems of macroeconomic policy design and coordination. Research already under way will apply these techniques in an international setting and thereby deepen understanding and illuminate public debate.

These basic objectives underlie the programme's other priorities: to assess the effects on the performance of the world economy of the growing internationalisation of asset and goods markets; to discuss how this changes the role of international institutions and 'rules of the game'; and to improve understanding of the potential gains and costs associated with greater intergovernmental cooperation in setting national macroeconomic policies. The programme will also stress better dissemination of knowledge about macroeconomic interactions, with a special emphasis on improving understanding within the policy communities in major countries: this in turn can help to reduce cross-country divergences in policy views.

Regimes and Policies

For the first two and a half decades of the post-war era, international macroeconomic relations followed the rules agreed at Bretton Woods. These rested on an adjustable-peg system for the management of bilateral exchange rates against the dollar, in which parities were to change only to correct an underlying balance of payments disequilibrium. In the 1960s, however, the growing internationalisation of financial markets, together with the tendency of the US to exploit the privileged position of the dollar in the system by running large external deficits, led other governments to seek policy independence through a system of floating exchange rates. It has since become apparent that a floating-rate regime does not eliminate but only modifies policy interdependence. In particular, the scope for manipulating the exchange rate for domestic stabilisation purposes, particularly in reducing inflation via an appreciating exchange rate, leads to important and potentially undesirable policy spillovers.

This has created strong interest in two questions. What agreed 'rules of the game' would be appropriate to guide the macroeconomic policies of individual countries? What institutional framework could ensure sustained cooperation within agreed rules of the game? The CEPR project tackles these questions with a variety of research methods.

One major effort will take a historical approach to investigating regime performance, to ensure that the lessons of history are not overlooked. For example, Barry Eichengreen and Richard Portes (in Discussion Paper No. 75) have studied the issues of sovereign borrowing and debt service problems in the 1920s and 1930s, with a view to comparisons with the 1970s and 1980s. This work examines the causes and consequences of default for both lenders and borrowers, the role of financial intermediaries and the response of international capital markets. Eichengreen and Jeff Sachs have examined the interrelationship between exchange rates and economic recovery in the 1930s.

A different approach is to use models of interdependent macroeconomies to investigate the performance and sustainability of alternative macroeconomic 'rules of the game' for the international economy. This analysis also provides a framework for quantifying the potential gains from cooperation between governments in macroeconomic policy design. With a model of the international economy, the performance of the system under full cooperation may be compared with the alternative where governments do not cooperate, but play a 'Nash policy game' among themselves (see, for example, Discussion Papers No. 77 by Andrew Hughes Hallett and No. 81 by Gilles Oudiz; and the papers by Currie and Levine, Miller and Salmon, Minford, and Oudiz and Sachs in International Economic Policy Coordination, edited by Buiter and Marston).

In dynamic models with forward-looking (rational) expectations there are intricate problems regarding the sustainability of fully optimal policy rules, because of the problem of time inconsistency: the incentive for the government to renege on its announced policies grows with the mere passage of time (see for example the work of Paul Levine and David Currie in Discussion Paper No. 94 as well as that of Daniel Cohen and Philippe Michel). If the government realises that the private sector or other governments may therefore treat its announced policy stance sceptically, it may seek to establish credibility by developing over time a reputation for eschewing 'U-turns'. But we now understand how to derive policies for linear stochastic systems which take into account reputation effects, and these techniques are now being applied to empirical models of the international system.

Several further issues arise within this approach. First, it is probably unrealistic to suppose that cooperation among governments could extend across the entire range of macroeconomic policy. Instead it is more sensible to think of limited cooperation over certain key aspects of policy (e.g., exchange rates), with governments free to determine other aspects of policy independently. On this view, the art of designing cooperative rules involves the creation of appropriate limited rules that prevent the most damaging policy spillovers. A related point is that international agreement over policy may be possible only in the form of simple rules, not the complex designs implied by fully optimal policy. Researchers may therefore seek to design simple policy rules which will have desirable properties (see for example Discussion Paper No. 4 by Currie and Levine). Third, some countries may want the benefits of cooperation without the restrictions it entails; this raises the important question of the enforcement of cooperative agreements between countries, to avoid free-rider problems. Moreover, countries may misinterpret the policy actions of other countries if the authorities in each country may be presumed to have private information about developments in their own economy; Charles Bean is investigating how the design of appropriate international institutions might mitigate this problem. Finally, John Driffill is studying strategic interactions between the government and private sector agents within an economy (see his Discussion Paper No. 63, with David Backus); this work will be generalized to an open economy.

The Regional Experience: the EEC and EMS

Contemporary experience of policy cooperation within regional blocs can also further our understanding of policy design. This is the focus of the second area of CEPR research.

The experience of cooperation in macroeconomic policy among the EEC countries participating in the European Monetary System provides important lessons for policy coordination on a wider scale. CEPR research in this area has been funded by the ESRC and CNRS, and has taken the form of collaboration between French and British economists.

One strand of this research has been concerned with a number of features of the EMS itself. First, there is the empirical question of its effects on the short-run volatility and longer- term misalignment of exchange rates both within the Exchange Rate Mechanism and externally vis-a-vis other key currencies, such as the dollar, the yen and sterling. Second, some argue that the success of the EMS in stabilising both real and nominal exchange rate fluctuations has been made possible only by the introduction of capital controls in participating countries, so that the EMS, paradoxically, has impeded full integration in the financial sphere (see Francesco Giavazzi and Alberto Giovannini in Economic Policy No. 2, April 1986, and the report in CEPR Bulletin No. 8 of the discussion meeting given by David Begg and Charles Wyplosz). Conversely, the ECU represents integration along a different line (discussed in research by Daniel Cohen reported in Bulletin No. 12). There is also the issue of whether the EMS operates, in effect, as a Deutschmark bloc, with the Bundesbank pursuing a money-supply target and other countries determining their bilateral exchange rates vis-a-vis the DM; or whether the position of member countries is actually more symmetric. The fall in the dollar may place particular strains on existing currency alignments within the EMS, and Jacques Melitz explores this pressing policy issue in Discussion Paper No. 97.

These issues lead naturally to the question of UK entry to the EMS, which has been much debated in Britain in the past two or three years. Is British entry feasible without full alignment of UK and German macroeconomic policies, given that both economies have almost no restrictions on international capital movements? (Among participants in the research programme, Michael Artis has acted as adviser to both the House of Lords and House of Commons Select Committee enquiries on the issue; he and Marcus Miller helped to prepare the recent report of the Public Policy Centre, whose committees considered the research output of the CEPR project.)

Another strand of the research is designed to elicit the more general lessons of the EMS experience. This requires a strategy for modelling the EMS and an evaluation of alternative rules for its operation. Given concern about the effects of fiscal policy on the international economy, a key issue is whether cooperation over exchange rate and monetary policies will constrain the use of fiscal policy by participants, or whether there is still scope for fiscal-policy independence. Finally, the research will inquire how far cooperation in one area of policy would be beneficial because it requires a regular exchange of information among governments about other policies, and so enhances appreciation of their consequences in an interdependent world.

Markets and Policies

Can markets manage better than governments? Recent years have seen the emergence not only of the floating exchange-rate system but also of new financial markets and instruments. There has been rapid institutional change too, associated with widespread deregulation. The consequences of this for the feasibility and desirability of macroeconomic policy coordination are potentially far-reaching. This is an area in which little research has been done: more is needed, and CEPR is keen to develop this as part of its programme. The aim is to bring together specialists in finance and in international macroeconomics, in order to encourage an important integration of research efforts in these two areas.

Several issues are currently being pursued. The first is concerned with the reaction of the private sector to exchange rate volatility. The response of corporations to exchange rate uncertainty, whether by hedging or by diversifying risk more generally, is clearly important. It is related to CEPR research on currency substitution and portfolio behaviour, funded by the Leverhulme Trust and reported in a forthcoming Discussion Paper by Artis and Gazioglu, as well as to separate work by Mike Wickens. Second, private sector behaviour has important implications for macroeconomic policy, including exchange rate policy and capital controls as well as more generally. This issue also affects the research on regimes and policies, particularly when considering possible regime designs, such as those proposed by McKinnon and others (see Artis and Gazioglu). Third, changes in domestic financial markets have undoubtedly altered the mechanisms, and not just the effects on capital mobility, through which shocks are transmitted internationally. Empirical and theoretical research will be required to elucidate the implications of these institutional changes for policy coordination; David Begg is among the CEPR researchers in this area. Fourth, new financial instruments have extended the range of markets which exist, although this is still incomplete. 'Second-best' arguments might therefore justify policy intervention; and market failures, such as 'bubbles' in foreign exchange markets, might also bring forth policy responses. Finally, recent research on bargaining models in industrial organisation and strategic trade policy may have implications for macroeconomic policy bargaining among countries. This area of research will explore links between industrial and macroeconomic policies in the international sphere.

Workshops, Conferences and Papers

A series of workshops and conferences are being planned as part of this overall research programme. Research output from CEPR will take the form of Discussion Papers and conference volumes. These will be reported in future issues of the CEPR Bulletin and the policy implications will also be discussed at CEPR lunchtime meetings.

Marcus Miller is Professor of Economics at Warwick University and a Research Fellow in the Centre's International Macroeconomics programme. David Currie is Professor of Economics at Queen Mary College, London and Co-Director with Christopher Bliss of the International Macroeconomics programme. Further information may be obtained from Christopher Bliss and David Currie at the Centre.