Growing economic interdependence makes essential the international coordination of economic policies, argued CEPR Programme Director Willem Buiter in a lunchtime talk on 26 March. The lunchtime meeting marked the publication by Cambridge University Press of CEPR's first book, International Economic Policy Coordination. It contains the papers and proceedings of the international conference organized in June 1984 by CEPR and the National Bureau of Economic Research.

In his talk, Buiter discussed some of the issues analysed in the book and their application to current policy questions. Some of the papers in the volume were quite technical. Buiter argued that this was not an academic indulgence, but rather reflected an attempt to deal simultaneously with three complicated issues. First, the effects of national economic policies could be transmitted between interdependent economies. The nature of these "transmission effects' was essential to the analysis. Second, intertemporal issues were also important. Since markets were forward-looking, the expectations of decision-makers must be carefully modelled. The long- and short-run effects of policies could be very different. The anti-inflationary effects of an exchange rate appreciation are likely to be lost in the long run as the loss of competitiveness reverses itself and the economy returns to its long-run equilibrium. Third, strategic interdependence was also crucial. The possible responses of other decision-makers was an essential consideration in forming one's own policy or strategy. The interaction of these three issues complicated the analysis.

Policy coordination is essential, argued Buiter, but is impeded by two fallacies. The first is the closed economy fallacy which is especially prevalent among American economists and, more recently, among policy-makers. It ignores how differently an open economy responds to internal shocks and policy actions, and it ignores the rest of the world as an additional source of favourable or unfavourable impulses. Under fixed exchange rates, openness reduces the size of the short-run "Keynesian' aggregate demand multipliers because of import leakages. The tendency of domestic activity to rise as a result of a fiscal expansion will be checked because part of the increased incomes will be spent on imported rather than domestic goods. Openness also increases the importance of "confidence effects'. These include the "minor disaster' confidence effect - the fear that the government budget deficit will be monetized - and the "major disaster' confidence effect, the fear of default or repudiation of the government's debt. Under a floating exchange rate and capital mobility, the demand effect of expansionary fiscal policy will be limited by exchange rate appreciation if there is a favourable confidence effect or diminished if there is an unfavourable confidence effect. The closed economy fallacy was exposed dramatically by the two OPEC price shocks.

The second fallacy impeding policy coordination, according to Buiter, was the open economy fallacy, the implicit belief that the world itself is an open economy. The world is for all practical purposes a closed economic system. This implies that policy options that appear desirable when undertaken by a single country may be undesirable at the global level, since they involve a zero-sum game and direct conflict between countries. Improvements in competitiveness are one example. Each country separately and all collectively can improve their productivity and efficiency, but any gain in one country's competitiveness necessarily means a reduction in that of another country. Using an appreciation of the exchange rate as an anti-inflationary device is another example. One country's anti-inflationary exchange rate appreciation means depreciation for some other country. Unless there are important asymmetries in the inflationary effects of exchange rate depreciation and appreciation, this simply means depreciation-induced inflation for the other country. There is no evidence that such convenient asymmetries exist.

It is often argued that the invisible hand of the market will generate an efficient allocation of resources. Can we not view questions of international economic policy in the same way? Some economists have indeed argued that, under freely- floating exchange rates, national economic policies would be "priced properly' in terms of their effects on other countries, and that there consequently is no need for cooperation and policy coordination.

This argument is incorrect, according to Buiter. First, a freely floating exchange rate is neither necessary nor sufficient to insulate a country against foreign disturbances or to safeguard the rest of the world against spillovers from domestic policy. There will be both real and nominal spillovers and international transmission. Second, even if markets for goods, services and financial assets were perfectly competitive, there would be non-competitive behaviour by "large' governments. The resulting non-cooperative "games' of economic strategy do not lead to efficient outcomes. Only if the world were to consist exclusively of Lichtensteins could strategic behaviour by governments be ignored.

Externalities and market failures mean that existing markets for goods, services and financial claims do not "price' policies properly, Buiter maintained. If there is Keynesian unemployment, expansionary domestic fiscal policy at a fixed exchange rate will increase demand for imports. The rest of the world's exports will rise and the demand expansion will spill over to trading partners. The expansion will benefit partners who also have Keynesian unemployment, but it will be "underproduced' by a government concerned only with its own domestic economy. If these partners are at full employment, expansion is "overproduced', because its inflationary consequences abroad are not allowed for. Other "market failures', such as credit rationing, mean that domestic interest rates no longer measure adequately the social marginal product of monetary and fiscal policy. The US policy mix, for example, is "priced' improperly in US financial markets.

Since there are spillovers and interdependence, inevitable non- competitive behaviour by large countries, externalities and other forms of market failure, policy coordination and cooperation is essential. The analytical techniques used in the conference volume, Buiter argued, offer a systematic means of assessing the possible gains from moving towards more cooperative policy formation.

International Economic Policy Coordination (ISSN 0521 305543) edited by Willem Buiter and Richard Marston, is now available at a cost of #27.50 or $44.50. Orders can be sent to Cambridge University Press, The Edinburgh Building, Shaftesbury Road, Cambridge CB2 2RU or 32 East 57th Street, New York, NY 10022 USA.