|
|
Interdependence
Does it matter for
policy design?
Over the past
decade, the annual economic summit meetings have shown that Western
policy-makers are as yet unable to design and operate a viable programme
of coordinated economic policies, even though they are fully aware of
the mutual dependence of their economies.
Economic theory has explored the transmission mechanisms between
economies, policy effectiveness and interdependence, and the potential
gains from coordination. But few theoretical models describe how
interdependence should affect policy design, or are even able to
determine the signs of the net policy 'spillovers' between
economies. In Discussion Paper No. 108, Research Fellow Andrew Hughes
Hallett analyses interdependence among the main OECD countries and
how recognition of this interdependence would affect policy design.
Hughes Hallett uses the EEC Commission's COMPACT forecasting and policy
analysis model to evaluate how the 1977-81 policies of the world's three
main industrial blocks, the United States, the EEC and Japan, would have
been affected had these policies taken into account spillovers and
feedbacks from abroad. The research in this Discussion Paper is related
to other work by Hughes Hallett, described in Discussion Paper No. 77
and at a January lunchtime meeting addressed by Hughes Hallett, reported
in Bulletin Nos. 12 and 13 respectively.
Hughes Hallett's policy simulations of the COMPACT model are conducted
in the framework of a dynamic game, in which the various countries act
and react to each other's policies through time. The effects of
interdependence on policy can be measured by considering the behaviour
of a range of policy rules which take account of interdependence in
varying degrees. These range from the benchmark solution, in which
policy is formulated taking full account of interdependence, to the
'myopic' policy, which ignores all spillovers and policy feedbacks.
Hughes Hallett's simulations suggest that for the EEC, the net
spillovers are small and are hardly modified by feedbacks or
counter-measures abroad. Expansionary policies abroad have a small
positive effect on EEC investment, employment, and the balance of trade.
The international transmissions affecting Europe appear to operate
through income and monetary linkages, rather than through changes in the
terms of trade. The simulations suggest that interdependence is also
relatively unimportant for policy-making in the United States. Expansion
abroad has a positive effect on output, which arises mainly through a
larger US trade surplus, but has little effect on inflation or
unemployment.
Japanese policy-making, on the other hand, is sensitive to
interdependence in the simulations. Expansion abroad causes negative
spillovers on output and employment through a deteriorating trade
balance. That contractionary pressure permits a reduction in government
borrowing; the reduced foreign exchange reserves are used to restrict
monetary growth at comparatively low interest rates. The outcome is
therefore lower inflation.
The insensitivity of the EEC and US policies to spillovers and feedbacks
indicates that net spillover effects are small, even though some are
quite large individually. This may occur because the spillovers between
two countries offset each other; for example, EEC and US expansion had
negative spillover effects on Japan and this will offset any positive
spillovers which a Japanese expansion could otherwise have had on the
United States or the EEC. Hughes Hallett also notes that different
policy instruments used by one country can have offsetting spillover
effects on a foreign economy. Finally, Hughes Hallett observes that
policy rules may be insensitive to spillover effects, even though the
economies concerned are sensitive to them. This would happen if the
spillovers from abroad on one domestic policy target called for a policy
instrument to be adjusted in one direction, while the spillovers on
another target call for the opposite adjustment to that instrument.
Hughes Hallett's simulations also suggest that US policies are
substantially more vigorous than those in Japan or the EEC. The
variability of US policy instruments is two to three times higher than
their EEC counterparts in the simulations. Even the Japanese policy
instruments (social security contributions excepted) are used more
vigorously than their EEC counterparts. This may suggest a greater
flexibility of the US economy, because the responses to each vigorous
policy change must have been sufficiently large and quick to warrant
making those changes. This is not true for the EEC, where policy
instruments were adjusted less vigorously. Hughes Hallett suggests that
this lack of flexibility in the European economies may go a long way to
explaining their poor economic record compared to the United States and
Japan, and why it has proved so much more difficult to start a recovery
and overcome unemployment in the EEC economies.
It has often been suggested in the popular debate that the performance
of the world's economies would be improved if they followed parallel (if
not identical) policies. In this context, some economists have suggested
that European governments should accept greater fiscal expansion in
return for reduced US budget deficits.
Hughes Hallett describes two simulations of 'harmonization': the first,
in which the EEC tightens its monetary policy and expands in fiscal
terms (to match US policies), and the second, in which the United States
tightens its fiscal policies and budget while expanding its monetary
position (to match EEC policies).
Under the first policy, Hughes Hallett finds that the only benefit to
the EEC would be that growth would increase by 0.5% per annum. Interest
rates rise and higher social security contributions are needed to
contain the governments' borrowing requirement. The upshot is less
investment and, largely as a result of the recession which this strategy
induces abroad, higher unemployment in the EEC. This strategy also
increases world inflation, so that prices rise faster in the EEC. In
fact the EEC 'exports' most of its recession to the United States, where
growth falls 0.5%, and inflation rises 1%, because US policies do not
adjust. Japan, on the other hand, switches to direct taxation and more
fiscal activity generally. This prevents much loss of growth, but
generates a higher trade balance and greater government borrowing.
The second case, of fiscal restraint and more relaxed money in the
United States, is more favourable. The EEC grows faster, and no longer
experiences lower investment or higher inflation. Meanwhile unemployment
falls an extra 0.5% because of stronger expansion abroad. The United
States reacts with much stronger output growth and - for the first time
- a marked drop in interest rates. This leads to higher inflation
levels. Government expenditures fall somewhat more than receipts,
reducing the government's budget deficit. The upshot of these
contractions is 0.5% more unemployment but a smaller trade surplus in
the United States. Japan experiences a trade surplus as a result of the
US fiscal restraint strategy, but is otherwise hardly affected.
The results suggest, according to Hughes Hallett, that there is a case
for some convergence of policies. The burden would fall mainly on the
United States, since a shift in US policy towards greater fiscal
restraint is found to be more effective than moves by the EEC towards
tighter monetary policy.
The Impact of Interdependence on Economic Policy Design: The Case of
the US, EEC and Japan
Andrew Hughes Hallett
Discussion Paper No. 108, May 1986 (IM)
|
|