European Policy Coordination
Europessimism?

According to the Commission of the European Communities the present level of unemployment in Europe will worsen in the foreseeable future. European GDP and industrial production have recently grown at much lower rates than in the United States and Japan. At a lunchtime meeting on 6 November, Research Fellow Gilles Oudiz examined what he termed the 'extraordinary European convergence towards deflationary macroeconomic policies'. He explored the consequences for Europe of a depreciation in the US dollar and argued that, in the absence of effective economic policy coordination, European governments would be tempted to revert to 'beggar thy neighbour' policies which would inflict output and employment losses on all concerned. Oudiz concluded that the European Monetary System (EMS) could facilitate policy cooperation among the European governments, improving the scope for expansionary policies. Nevertheless, the strong priority European governments seemed to attach to low inflation and to the current account suggested that they were likely to adopt only moderately expansionary policies.

Gilles Oudiz is Vice-President of the Compagnie Bancaire, Paris, having previously been with the Institut National de la Statistique et des Etudes Economiques. He is a Research Fellow in CEPR's International Macroeconomics programme and has written extensively on exchange rates and inflation and on economic policy coordination among industrial economies. The lunchtime meeting at which he spoke was one of a series in which CEPR Research Fellows discuss policy-relevant research. The meeting was sponsored by the French Cultural Delegation and the German Marshall Fund of the United States. The opinions expressed by Dr Oudiz were his own, however, and not those of the sponsoring organizations or of CEPR, which takes no institutional policy positions.

Oudiz first described the convergence towards deflationary policies in Europe. Labour market imbalances play a key role in most explanations, but they account for only a portion of present unemployment. Earlier work by Oudiz, reported in Discussion Paper No. 81, suggests that the absence of a single European macroeconomic strategy has been an equally important explanation of the deflationary convergence. Traditional macroeconomics might suggest that in order to combat unemployment European countries should fix their exchange rates, reduce interest rates, and set out together on an expansionary path. This analysis is unsatisfactory, Oudiz argued, because it does not focus on the strategic aspects of the European situation. It cannot explain why such expansionary policies are not currently implemented in Europe, even though all countries would appear to benefit from such policies. The multiplicity of policies and policy-makers suggests that discussions of European macro policy should take into account recent economic research on problems of policy coordination, which has applied concepts drawn from game theory to the macroeconomic modelling of open economies.
Oudiz noted two important aspects of the European policy 'game'. First, governments have a variety of policy goals. They cannot achieve all their targets simultaneously and so they are forced to make trade-offs. By assuming that each European government's observed monetary and fiscal policy actions represent its optimal choices it is possible to estimate the relative weights each government implicitly attaches to various policy objectives. Oudiz's estimates of these revealed policy preferences indicated that policy-makers had over the last three years attached a much higher priority to inflation and the current account than to employment. West Germany attached the same weight to a 5.6% movement in GNP as to a 1% change in inflation. For France this ratio was 2.3:1 and for the United Kingdom and Italy about 1:1 These policy preferences were a key factor in explaining deflationary policies and high rates of unemployment in Europe.

Second, the policy actions of each European government have an impact, or 'spillover effect', on its partners' economies. These spillover effects are essential to an understanding of European macro policy, according to Oudiz. Given the high degree of interdependence of their economies European governments have a strong incentive to 'export' their inflation or unemployment to each other. Policies of fiscal expansion tend to benefit neighbouring economies, while having adverse effects on domestic prices and the balance of trade, as the Mitterrand experiment had shown. Restrictive monetary policies, on the other hand, have negative spillover effects on one's neighbours. Such 'policy competition' among countries which have similar economic structures, policy goals and policy instruments leads to 'beggar thy neighbour' strategies, which are sub-optimal for all concerned.

The EMS is clearly intended to enforce cooperation and policy coordination among the European governments, but its effectiveness in this respect depends very much on how it operates. It could function in a variety of ways: first, as an uncompromising exchange rate zone with wide margins of fluctuation around central exchange rate parities; second, as a Deutschmark zone; and third, as a mechanism for truly cooperative policy formulation. Oudiz discussed simulations of the impact of US dollar depreciation on the European economies within each of these EMS frameworks. These simulations showed that even if the dollar were to achieve a smooth downward fall (a 'soft landing'), there were significant risks of adverse effects on the European economies. Failure to coordinate policies in response to the fall in the dollar could make Europe significantly worse off, Oudiz argued.

Although labour market and structural factors play a large part in European unemployment, Oudiz concluded that far better macroeconomic policies were available than those adopted at present. Even given their current policy preferences, all economies would benefit if the EMS were to function properly as a mechanism for economic policy coordination. There would even be some advantage if all the EMS did was to force governments merely to discuss their policies with each other. Second, reduced emphasis on containing inflation would counter the excessively deflationary and costly effects of present policies. If European governments achieved greater coordination of policy but preserved their current policy preferences, however, they would only adopt mildly expansionary policies. In this respect the 'Europessimism' theory which has flourished in the media might be justified, according to Oudiz.

In the discussion after the talk, one member of the audience argued that the EMS operated as a 'Deutschmark zone', optimizing West German interests, which was no more satisfactory than if the Federal Reserve System fulfilled New Jersey's policy goals. The only alternative role for the EMS was for its members to negotiate their different policy goals democratically. But the EMS could not function in this way, it was argued, since European governments had different policy preferences and did not even agree on how the world economy worked. In addition, game theory assumed that each government seeks to use demand management to optimize short-run macroeconomic policy goals, whereas both West Germany and the United Kingdom choose instead to give priority to medium-term money supply and inflation objectives. Others argued that the EMS prevented member nations from pursuing different policy goals, citing the experiences of the Schmidt and Mitterrand governments, which both ended in a return to more conservative policies.

Oudiz disagreed with all these pessimistic analyses. He argued that the EMS was sufficiently flexible to accommodate differing policy goals noting that France had chosen to stay within EMS in 1982 in order to take advantage of the Bundesbank's credibility. The ideal would be for the EMS to function as a permanent supranational institution, actively working to maintain agreed rates of exchange during the periods between regular meetings of its member states. This would be more effective if the United Kingdom were to become a member, according to Oudiz, since this would reduce West German influence on the System.