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Theory suggests that the interdependence of national economies leads to externalities in policy-making and inefficient outcomes when governments act non-cooperatively. In principle cooperation can make all parties better off, but some studies have found gains from cooperation that are small relative to the imprecision with which policy can actually be implemented. What then can explain policy-makers' enthusiasm for frequent international meetings? In Discussion Paper No. 201, Research Fellow Patrick Minford and Matthew Canzoneri investigate whether the gains arise not from formal cooperation but merely from acting strategically rather than myopically. It is their lack of knowledge about the structure of the world economy and about the views and preferences of their opposite numbers that creates the need for policy-makers to meet frequently, to trade forecasts, and to state what they intend to do; in this way, they may be thought to gravitate towards a non-myopic but also non-cooperative equilibrium. The authors explore this hypothesis using simulations from the Liverpool World Model, which embodies rational expectations and exhibits, besides the usual trade linkages, substantial monetary interdependence. They examine the effects of a set of unanticipated shocks using a series of examples from recent history, in order to calculate the advantage of strategic over myopic behaviour. Minford and Canzoneri first look at recent US-European disinflationary experience. When Mr Volcker began his deflation in 1979, did he fully anticipate the Reagan fiscal policy and the disinflations of Mrs Thatcher and other European policy-makers shortly thereafter? Did these other policy-makers fully anticipate the commitment of Mr Volcker? The authors assume that in reality neither the US nor Europe expected any response by the other, i.e. that their policies were insular or myopic. The simulations reveal that strategic behaviour would have made both the US and Europe better off. The next example considered by Minford and Canzoneri is President Mitterrand's 'dash for growth' in 1981-2. In this case, the strategic solution within Europe (taking US behaviour as given is only a little better than the insular, but they are still farther apart than the non-cooperative and cooperative solutions; again, behaving strategically seems more important than setting policies cooperatively. Finally, Minford and Canzoneri consider the timing of Mrs Thatcher's disinflation. Here, myopic behaviour is associated with initiating new policies without considering the world economic environment. The authors find that Mrs Thatcher would have done better to wait for the effects of the Volcker-Reagan shock to pass through before starting her disinflation. These examples suggest, according to Minford and Canzoneri, that there are important differences between strategic and insular behaviour in a world of considerable economic interdependence. These differences can be large, as the the US-European example demonstrates. The authors estimate policy-makers' preferences on the assumption that observed policies were set myopically. These estimates suggest that the author's utility gains of up to 15% could have been achieved by strategic behaviour. In general, these differences are larger than the differences between the non-cooperative and cooperative solutions.
Patrick Minford and Matthew Canzoneri Discussion Paper No. 201, October 1987 (IM) |