In Discussion Paper No. 264, Research Fellow David Vines investigates three problems which have plagued the world economy since the collapse of the Bretton Woods system. First, the price mechanism has become unreliable. Commodity prices rose very rapidly between 1972 and 1974, and again in the late 1970s; they then fell gradually but markedly through the 1980s. The emergence of wage inflation as a significant problem in the 1970s and 1980s was due in part to the behaviour of commodity prices, while the decline in commodity prices has, in turn, caused distress in less developed countries. Prices in financial markets have also moved erratically, as evidenced by the collapse of world stock markets in October and the US dollar crisis in December 1987.

The second problem, spending imbalances, is not confined to the United States: Japan, Taiwan and Korea all have persistent current account surpluses, in the last two cases 20% and 8% of GNP respectively. The third difficulty is a significant increase in the intensity of technological competition among nations.
Though rarely addressed by macroeconomic theorists, Vines argues that the third of these problems is the most fundamental, and in no small measure causes the first two. In his theoretical analysis, Vines uses a 1953 model first developed by Sir John Hicks to explore the effects on international trade of persistent differences in the rate of growth of productivity. Vines considers two stylized regions, `Asia' and the `North'. In the first scenario, of continuing productivity advance in Asia in the production of goods which the North does not produce but only imports, the North faces no problems of adjustment. The effect of cheaper imports on the North's real income means that the fall in demand for its own goods is likely to be small. Instead, because Asia is producing more export goods for which it needs to find a home in world markets, Asia's goods must become cheaper relative to those of the North.
Vines then examines the case of continuing productivity advance in Asia in the production of goods in which the North specializes. If money wages remain constant in Asia, the North must lower the prices of its goods in order for them to continue to find a home in world markets, creating wage adjustment problems. Also the real income of the North will have shrunk since, as a result of the lowering of the prices of its own goods, the North has to sell more exports to pay for its full employment level of imports. Consequently the North must also undertake spending reductions to maintain balance of payments equilibrium.
Productivity growth in Asia requires painful adjustments of wages and spending in both Asia and the North. Yet adjustment processes in the world economy are not working well, owing to political pressures in the United States and the reluctance of Germany and Japan to engage in fiscal action on a scale sufficient to correct global imbalances. These fundamental problems provide an explanation for the financial market crises of 1987, Vines argues. The markets became increasingly afraid that the required adjustments would not occur: they feared both that the dollar might be defended, causing high interest rates and recession in the US, and that the dollar might fall freely, causing US inflation followed by recession. As the necessary adjustments seem unlikely to occur, Vines concludes that world recovery without inflation is improbable, and that there may be further problems on world currency and stock markets.

Technical Progress, Global Imbalances, and World Economic Recovery Without Inflation David Vines.

Discussion Paper No. 264, August 1988 (IM)