It has long been recognized in many European economies that openness is a mixed blessing. While it offers the opportunity of international and intertemporal trade, it also imposes additional constraints on the design of stabilization policies. The nature of these constraints is not always clear, however, and there remains a great deal of uncertainty about their quantitative importance and their relationship with the exchange rate regime.
Under fixed exchange rates and with restrictions on capital mobility, as for example during the 1950s, economists and policy-makers had a much clearer idea of the nature of the external constraint, and the `stop-go' cycles of the 1950s and 1960s are well documented for many European economies. The current situation differs markedly from this stylized version, but it is changing fast. The commitment to defending the exchange rate may well be far stronger in the 1990s than in the 1970s or 1980s, while private international capital flows are now far greater and far freer than in the 1950s and 1960s, and the Eurodollar market enables many countries to finance their balance-of-payments deficits by borrowing on good terms almost indefinitely.
These developments affect the significance of the external constraint for the formulation and coordination of the macroeconomic policies of the EC member states in the run-up to 1992. Many of these issues were discussed in papers presented at a conference on `Macroeconomic Policy and the External Constraint', held by the Centre for Economic Policy Research and the Bank of Greece in Athens on 24-26 May. The conference organizers were George Alogoskoufis, a Research Fellow in CEPR's International Macroeconomics programme, and Lucas Papademos, Chief Economic Advisor at the Bank of Greece. Additional funding was provided by the Ford and Alfred P Sloan Foundations as part of their support for CEPR's research programme on International Macroeconomics.
Michael Artis (Manchester University and CEPR) and Tamim Bayoumi (International Monetary Fund) presented a paper on `Saving, Investment, Financial Integration and the Balance of Payments', in which they noted that overall net international flows of savings and investment are still markedly lower than either the levels predicted by models with full capital mobility or those under the gold standard. They maintained that this is principally explained by the individual governments' treatment of the current account balance as a policy objective. They argued that the closer integration of capital markets may weaken this role of the current account, although it will remain an important indicator of the net effects of saving and investment decisions and the net contributions of individual countries to the world pool of saving.
In a paper on `The Solvency Constraint and Fiscal Policy in an Open Economy', David Currie (London Business School and CEPR) and Paul Levine (Leicester University and CEPR) examined an open economy in which the real interest rate exceeds the steady-state growth rate and the ratios of both public and external debt to GDP must remain constant. They focused on the role of reputational issues for a government, modelled as an intertemporally optimizing agent, in seeking first to meet an ambitious output target in a deterministic model and second to implement stabilization policy in the face of random shocks. They argued that one possible objection to the time-consistent solution <196> that there may be an incentive to `defer solvency' by postponing the stabilization of the relevant asset/GDP ratios until some time in the future <196> does not apply if the policy-maker knows that solvency will definitely be imposed at some future date.
George Alogoskoufis (Birkbeck College and CEPR) and Chris Martin (Queen Mary and Westfield College, London) presented a paper on `External Constraints on European Unemployment'. They considered a family of models of unemployment in interdependent open economies, focusing on monopolistic competition in the output market and wage-setting by monopoly unions operating at different levels of centralization. Their model indicated that the main stylized facts about unemployment in Europe in the 1970s and 1980s, and the differences between Europe and the USA, may be explained by the more cautious macroeconomic policy stance of the large European countries. They concluded that external constraints may account for the less expansionary macroeconomic policy stance in Europe. These external constraints may be attributed to the greater openness of the European economies, to asymmetries in the international monetary system, and to the strong preference of European policy-makers for stable exchange rates.
Barry Eichengreen (University of California, Berkeley, and CEPR), in a paper on `Relaxing the External Constraint: Europe in the 1930s', examined the role of the external constraint in the propagation of the Great Depression from the United States to Europe in a world of high capital mobility and fixed exchange rates. He argued that the devaluation entailed in abandoning the `gold standard' was a necessary precondition for recovery, because the lack of agreement among national policy-makers made it impossible to achieve the level of international cooperation required to implement reflation without devaluation.
Eichengreen analysed the effects of devaluation for some three dozen countries, and he found that their policies were quite effective, although they entailed costs in terms of increased uncertainty about nominal and real exchange rates. He also contrasted the experience of managed exchange rates in the 1930s with that of floating rates in the 1920s, and he found that exchange rate management reduced the variability and unpredictability of short-run nominal and real exchange rates, but such intervention appears to have aggravated real exchange rate uncertainty and interest rate volatility over the longer term.
In a paper on `The Current Account and Incomes Policy', written jointly with James Symons, Andrew Newell (University of Sussex) considered two models of the connections between the current account and incomes policy in an intertemporal perspective. He argued that in a model with hysteresis effects, the reduction in real wages and the increase in employment associated with an incomes policy will initially drive the current account into deficit: current income will increase by less than permanent income, and the real wage reduction and the rise in profits will stimulate capital formation. On the other hand, in a model without hysteresis effects, an incomes policy will have the `conventional' positive effects on the current account, but for `unconventional' reasons: the current account goes into surplus because agents are saving for the grim times after the policy lapses. Their empirical work suggested that incomes policies have had only a mild positive effect on output and the current account, and far from causing an increase in investment, as the hysteresis models would predict, appear to have deterred it.
Fabio Schiantarelli (Boston University) presented a paper entitled `Business Cycle Fluctuations in Open Economies in the 70s and 80s: A Structural Interpretation', written jointly with Vittorio Grilli, in which they used a small multivariate time-series system to examine the relative sizes of the shocks faced by the EC national economies and the transmission of these shocks through their economic systems. He described the evolution of output, inflation, the real interest rate and the exchange rate, distinguishing between temporary and permanent shocks and between internal and external shocks.
The results of applying their system to Germany, Italy and the UK showed that both the relative significance of the shocks and the responses of the economies to them differed substantially between the 1970s and 1980s. A comparison of their results for Germany and Italy on the one hand and the UK on the other suggests that the development of the EMS provides only one explanation at best for these changes.
Panayiotis Athanasoglou and George Zombanakis (Bank of Greece) presented a paper on `The Balance of Payments and Macroeconomic Policy in a Small Open Economy: The Case of Greece', in which they examined a three-equation short-run econometric model of the Greek economy incorporating functions for aggregate supply and money demand and an equation determining net exports. They also presented simulations for fiscal, exchange rate, monetary and trade policies.
There then followed a very interesting panel discussion that spanned an entire morning, chaired by Lucas Papademos (Bank of Greece and University of Athens). Charles Wyplosz (INSEAD and CEPR), Richard Portes (CEPR and Birkbeck College, London), Anthony Latter (Bank of England) and Jacob Frenkel (International Monetary Fund) discussed the impact of monetary union on macroeconomic policy in Europe. Each panellist offered views on issues such as fiscal policy, the problems of the transition and international aspects. The panellists' presentations were followed by a wide-ranging general discussion, with contributions by most of the participants in the conference.
Daniel Cohen (University of Nancy II, Centre d'Etudes Prospectives d'Economie Mathématique Appliquées à la Planification, Paris, and CEPR) and Charles Wyplosz (INSEAD and CEPR) presented a paper on `France and Germany in the EMS: The Exchange Rate Constraint'. In their model, real exchange rates have an impact on policy-making through their effects on both inflation and the balance of trade (and hence output) for two closely integrated economies. They found that the tradeoff depends on the relative size of these two effects, both between the two economies themselves and also vis-à-vis the rest of the world.
In an empirical application to France and Germany they found some evidence that the trade balance is quite sensitive to the intra-EMS effective exchange rate, but not to the extra-EMS rate, while the opposite applies to inflation. This finding is consistent with the view that French and German policy actions have been dominated by the need to maintain stability in the trade balance, and hence in output and employment, and it indicates that both countries still have unexploited inflation-output trade-off gains, which may be reaped through beggar-thy-neighbour policies vis-à-vis the rest of the world.
The paper by Charles Bean (LSE and CEPR), on `The External Constraint in the UK', examined the historical record of UK payments balances. It highlighted in particular the central role played by foreign asset income in ensuring the strong performance of the current account in the period before World War I and the role of both world wars in eliminating this foreign asset buffer. Although trade performance in fact improved in the post-war period, this only partly offset the fall in interest income. Bean found that the match between periods of external pressure and periods of a strongly rising supply price of foreign borrowing was not very good, and that for most of the sample period the external constraint has been little more than an intertemporal solvency requirement.
In regard to the sharp deterioration in the UK current account in the late 1980s, Bean found that the fall in savings was probably accounted for by a combination of financial deregulation and optimistic permanent income expectations. Since both these factors should be largely temporary, the current account deficit should be self-correcting. He argued that if the government nevertheless seeks to influence the national savings rate, it should do so through fiscal rather than monetary policy, since financial deregulation is a real shock, notwithstanding its monetary effects.
Hugo Keuzenkamp (Universiteit Tilburg) examined the Dutch case in a paper on `Fiscal Policy, Real Wages and the Current Account: The Dutch Experience', written jointly with Frederick van der Ploeg. He discussed a number of constraints on employment policy, and he presented a macroeconomic framework for the analysis of the persistence of unemployment, and the relevance of tax smoothing, consumption smoothing and the lack of capital mobility. Applying their model to the Netherlands, he concluded that domestic demand can only be expanded if the rest of Europe does the same; hence they advocate a supply-friendly European fiscal expansion. He also discussed the influence of a variety of microeconomic measures on patterns of unemployment in the Netherlands.
George Alogoskoufis (Birkbeck College, London, and CEPR) and Nicos Christodoulakis (Economic University of Athens) examined the Greek experience in the 1980s and assessed a number of possible stabilization policies in their paper on `Fiscal Deficits, Seigniorage and External Debt: Greece in the 1980s'. They used a model of optimal private sector savings, and they suggested that to the extent that the private sector is forward-looking and able to engage in consumption smoothing, there is no separate external constraint. They argued that if the government respects its own intertemporal solvency constraint then the ratio of external debt to GDP will also be stabilized, and so they attributed the explosive growth of Greece's external debt in the 1980s to unsustainably high levels of public sector deficits.
They examined three options for the stabilization of public and external debt: a fall in government expenditure, a rise in taxes, and a rise in steady-state seigniorage. Their estimates of money demand suggested that steady-state seigniorage is maximized at current rates of inflation (of the order of 20%). Thus a rise in steady-state inflation is likely to result in a reduction of seigniorage revenue and therefore cannot be used to stabilize the ratio of external debt to GDP. Considering the other two options, they found that the stabilization of the ratio of public debt to GDP at its current level through a rise in taxation will result in a much higher steady-state ratio of external debt to GDP than a similar stabilization effected by means of a reduction in government expenditure.
Juan Dolado (Banco de España) examined the Spanish experience of macroeconomic policy-making in a paper entitled `Macroeconomic Policy and External Targets and Constraints: The Case of Spain', written jointly with José Viñals. He argued that it may be rational for governments to monitor short-run fluctuations of the external account in order to anticipate and therefore avoid difficulties, even though the true external constraint is binding only in the long run. Moreover, whenever distortions and market imperfections are important in the short run, governments may be justified in setting specific external targets. He argued that Spanish macroeconomic policy over the last twenty years has been characterized by a number of clear and unambiguous examples of major policy changes following unfavourable developments in the external accounts. The results of Dolado and Viñals indicated that the Spanish economy is currently more than respecting its external solvency constraint. Dolado nevertheless argued in favour of further fiscal restraint and supply-side policies and warned against complacency in the face of the removal of capital controls in the run-up to 1992.
In a paper on `Macroeconomic Policy and the External Constraint: The Danish Experience', Soren Bo Nielsen (Kobenhavn Universitet and CEPR) and Jörgen Sondergaard (Economic Council of Denmark) examined Denmark's long history of current account deficits and a variety of possible explanations for its very high and rising external indebtedness. These include both exogenous and policy shocks, as well as explanations based on a number of structural features of the Danish economy, such as the exchange rate regime, the tax system, and capital, product and labour markets. They found no single explanation sufficient, arguing that the external constraint has to date been a soft constraint, but one that is likely to become tighter as a result of further integration into the European Community.
Yannis Stournaras (Bank of Greece) presented the final paper of the conference, on `The Two Deficits under Credit Rationing and Real Wage Rigidity: The Case of Greece during the 1980s'. Starting from the observation that the current account deficit did not worsen in the 1980s as much as the dramatic increase in public sector deficits would lead one to expect, he argued that this finding might be explained by a simple model that focused on real wage rigidity and credit rationing, while abstracting from intertemporal considerations.
The papers presented at this conference will be published in early 1991 in a volume edited by George Alogoskoufis, Lucas Papademos and Richard Portes.