Policy Coordination
Vive la Difference

Two oil-price shocks, an international debt crisis, and increasing 'North-South' inequalities have been powerful reminders of the growing interdependence between national economies. Such mutual dependence through trade and capital movements means that policy choices are also interdependent. Policy makers must therefore condition their actions on the policies they expect to be pursued abroad, and assume that foreign policy will be made on the same basis.

How strong is interdependence in practice, and how much difference does it make to policy design? Politicians and economists have repeatedly called for concerted action by national governments. The danger is clear enough, it is argued; uncoordinated actions may, as the current uneven recovery shows, actually reduce the ability of governments to control their own economies. Yet there are virtually no estimates of the costs of uncoordinated policies, nor of the potential gains from explicit cooperation.

In Discussion Paper No. 77, Research Fellow Andrew Hughes Hallett asks: given optimized policy selections, how much would the US and EEC gain if their policies were coordinated, and how would those gains be achieved? Hughes Hallett analyzes US-EEC policy coordination over the period 1974-78 using an empirical multi- country model, typical of those employed by policy-makers. This is essential, he argues; previous analyses have almost always used simplified models of two economies whose structures are symmetric and have therefore missed the potential policy gains which result from the exploitation of asymmetries. Hughes Hallett's approach also allows each government to choose its policies optimally in a dynamic sense, based on the conjectured responses of other governments. This is in contrast to the static decision procedures assumed in previous studies, which cannot capture the important gains from coordinating the timing of policy changes.

The simulations, Hughes Hallett argues, illustrate the inefficiency of uncooperative strategies and provide empirical confirmation that cooperation restores the effectiveness of domestic policy responses weakened by interdependence. Policy coordination also reduces the costs of intervention by accelerating the system's responses to domestic policies.

Hughes Hallett draws attention to a new and important aspect of policy coordination: the gains from cooperation are due largely to asymmetries between the economic structures of the countries concerned. These differences in economic structure mean that the multiplier effects of policies differ across countries, and policy is most effective when governments specialize in those policies which yield the largest multiplier effects. Coordination is beneficial because it allows governments to specialize in those policies where they have a 'comparative policy advantage': that is, those policies with the largest multiplier effects. Hughes Hallett finds that comparative advantage lies in monetary policy for the US and fiscal policy for the EEC. In a dynamic framework, moreover, governments can coordinate the timing of their policy impacts correctly, which is particularly important in setting monetary policies. Paradoxically, therefore, asymmetries may actually increase decision-makers' autonomy in a cooperative policy agreement and generally make it easier to absorb shocks and policy changes arising abroad. Hughes Hallett argues that this could partly compensate for the evident failure of flexible exchange rates to insulate economies from external shocks over the last decade.

Hughes Hallett concludes that successful coordination depends on the nature of anticipations and on the correct timing of fiscal and monetary policy impacts. The results indicate that the gains from sustainable cooperation are small but significant and mainly benefit Europe.

Andrew Hughes Hallett discussed this and related research at a lunchtime meeting on 21 January 1986. A full report of this meeting will appear in the next Bulletin.


How Much Could the International Coordination of Economic Policies Achieve? An Example from US-EEC Policy Making
A Hughes Hallett

Discussion Paper No. 77, October 1985 (IM)