Policy Coordination
No Accounting for Tastes

Many observers have commented on the extraordinary convergence of European macroeconomic policies: despite their different circumstances and economic structures, European governments seem to have settled for the same deflationary macroeconomic strategies. Of course, the timing of policies has differed across Europe. France, for example, grew faster than its partners in 1981-1982, but is now experiencing a prolonged recession; whereas West German GNP grew very little in the early 1980s, but is now showing faster growth. Despite differences in timing, however, the 'sacrifice ratios' for the leading European economies are quite similar: throughout Europe disinflation has been achieved, at a high cost in terms of lost output.

A variety of reasons including labour market imbalances have been offered for the similarity of European macroeconomic policies, but such explanations ignore an important European characteristic: the multiplicity of policy-makers. In contrast to the United States and Japan, there is no single European macroeconomic strategy. In Discussion Paper No. 81, Research Fellow Gilles Oudiz explores the consequences of this multiplicity of policies and argues that it may help explain the European tendency to adopt deflationary policies.

In recent years analyses of policy coordination have combined concepts developed in game theory with the standard macroeconomic modelling of open economies. This new approach usefully highlights an essential aspect of the policy 'game' which takes place among the European economies, namely 'the spillover effects' which each government's policies have on their partners' economies. The high degree of interdependence of their economies leads European governments to attempt to export their inflation or their unemployment. Governments have no incentive to take account of these externalities or spillover effects in setting their policies, and economic theory suggests that in the absence of policy coordination, there is an incentive for governments to adopt strategies which lead to 'beggar thy neighbour' policies, which are clearly suboptimal for the European Community as a whole.

In his paper, Oudiz evaluates European policy coordination, initially through the analysis of a simplified two-country model. He also uses simulation techniques to quantify the potential benefits of alternative European strategies, extending the methodology used previously by Oudiz and Sachs to the European economies and incorporating into the analysis the working of the EMS.

In his simulations, Oudiz assumes first that there is no change in US macroeconomic policy. He finds that coordinated European policies would involve more fiscal expansion, increasing government deficits by between 0.4% and 2.2% of GNP, while controlling inflation through a 1% average increase in domestic interest rates. The overall impact of such a policy mix on inflation and the current account would be moderate, while output gains of between 1% and 3% could be achieved. This coordinated expansion would lead to a moderate depreciation of the exchange rate of the ECU against the dollar; but no major realignment of the European currencies would be needed. Nevertheless, Oudiz finds that the relatively high gains in output that could arise from coordination are unlikely to be realized, because of the low priority given to growth by most European policy makers. He argues that these simulations are instructive, however, because they reveal that a properly coordinated policy mix should consist of a fiscal expansion accompanied by a restrictive monetary policy.

Oudiz then examined European coordination following a shift in US macroeconomic policies to reduce the budget deficit and permit a more relaxed monetary policy. Oudiz finds that uncoordinated European policies are very costly in terms of European output. In all cases the European governments attempt to reduce the depreciation of the dollar relative to the ECU. In the absence of policy coordination this is achieved by restrictive fiscal policies and expansionary monetary policies, whereas with cooperation the reverse is true. When they do not coordinate their decisions the European governments revert to 'beggar thy neighbour' monetary policies, which prove very costly in terms of European output, while policy coordination allows instead an effective joint reflation. European policy coordination has a marked impact on output, but again this does not lead to a substantial change in policy makers' objective functions because of the low priority they give to output. It remains true however that cooperative policies are preferable to non-cooperation for all countries concerned.

Oudiz concludes that macroeconomic policy coordination could improve the scope for short-run expansion and that the EMS can facilitate cooperation among the European governments. Nevertheless, his estimates of the revealed preferences of European governments show that their strong emphasis on inflation and the current account, as opposed to unemployment, is also a key factor in explaining current deflationary policies. Even if policy coordination did improve, it is very likely that only quite moderate expansionary policies would be adopted given the apparent goals of policy makers.


European Policy Coordination: An Evaluation
G Oudiz

Discussion Paper No. 81, October 1985 (IM)