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Global
Macroeconomics In recent years economists have devoted increasing attention to strategic aspects of interactions between countries, motivated partly by the growth of explicit intergovernmental negotiations over macroeconomic policies. This is an area of research which CEPR has emphasized since its foundation in 1983 and is currently pursuing through a major research programme with the Brookings Institution. In their introduction to the volume arising out of the 1984 CEPR/NBER conference on International Economic Policy Coordination (Cambridge University Press, 1985), Willem Buiter and Richard Marston remarked that policy coordination had not at that time generated as much attention among economists as it deserved, That conference proved to be a major step forward, however, and research into macroeconomic policy interactions has broadened and progressed significantly since 1984. During the same period, the issues addressed by this research have also become more relevant to economic policy. The increasing tendency of the major countries to manage exchange rates has exposed the disagreement and conflict over appropriate relationships among exchange rates. There is also disagreement about the monetary and fiscal policies pursued by individual countries, The United States, for example, is alleged to pursue an excessively expansionary fiscal policy, while European and Japanese fiscal and monetary policies are alleged to be too contractionary .These macroeconomic policy conflicts also have implications for trade policy, as exchange rate fluctuations and persistent trade deficits create political pressures for tariffs and other forms of protection. CEPR was therefore particularly pleased to organize a conference for the International Economic Association (IEA) on Global Macroeconomics: Policy Conflict and Cooperation', held in ,London on 12-13 February. The conference was divided into four sessions, each focusing on a major area of research and, policy debate. The first session examined applications of game theory, which forms the theoretic basis for many empirical approaches to policy coordination. The second session explored the potential for gains from macroeconomic policy coordination. The third session was devoted to the operation of the European Monetary System, and the fourth to macroeconomic interactions between the North and the South. The programme committee .acting for the IEA were Ralph Bryant (The Brookings Institution), Richard Portes (CEPR and Birkbeck College, London), Matthew Canzoneni (Georgetown University), David Currie (Queen Mary College, London, and CEPR), Dale Henderson (Georgetown University) and Marcus MiIler (Warwick University and CEPR). Financial support was provided by the Economic and Social Research Council, the Commission of the European Communities, the Bank of England, the Esmée Fairbairn Charitable Trust and Hambros Bank. Game Theory and Policy
Coordination The need to enrich the
structure of repeated games was widely acknowledged by participants at
the conference, but John Roberts (Stanford University) noted that the
paper was concerned only with the complexity involved in actually
playing the game and executing the strategies, and not with the
complexity of choosing the best strategy at the outset, Thus the model
did not deal with the limited ability of players to evaluate alternative
strategies. Rubinstein's assumptions about the defini- tion and costs
attached to complexity were criticized by other participants as ad
hoc. Rubinstein rejected this argument: he was merely providing, in
one particular way, the additional information that the theory needed to
produce a game with fewer equilibria. Rubinstein's focus had been on
repeated games, in which the set of strategies and pay-offs which
players can choose is assumed to be identical in each period. Chaim
Fershtman (Hebrew University of Jerusalem) explored 'Alternative
Approaches to Dynamic Games' in the conference's second paper. Fershtman
set dynamic games and repeated games within a common framework, in which
there were three possible sources of dynamics: structural, behavioural,
and informational. Dynamic game theory has typically focused only on
structural dynamics, in which actions chosen in one period affect the
game's pay-offs and possible strategies in later periods. The analysis
of repeated games has focused on behavioural dynamics, in which players
condition their actions on the previous strategies of other players, but
has ignored structural dynamics. Little attention had been given so far
to informational dynamics, in which players use the history of the game
to learn about the characteristics of the other players, such as their
objective functions. In principle all three sources of dynamics may be
present in .a game, and Fershtman gave an example in which both
strategic and structural dynamics were important. Analyses of dynamic
games have considered only 'simple' strategies, in which players were
assumed to have no memory, This had the advantage of producing unique
equilibria, but the set of possible solutions is clearly enlarged by
allowing strategies that depend on the past history of the system. Leonard Mirman (University of Illinois) focused on the issues faced by the users of game-theoretic results in deciding what kinds of models and games were appropriate. He suggested that the tractability of models was important to users: on this criterion, dynamic games scored heavily. Willem Buiter (Yale University and CEPR), in his overview of the first session, criticized the direction in which economic applications of game theory had been developing. He described it as being driven by the inner logic of game theory rather than by the needs of users. Both papers, he argued, contained ideas which could not be readily implemented. Rubinstein's notion of the complexity of a strategy was not a natural one, and his concept of the 'finite automaton' did not embody the idea of procedural rationality. The Gains
from Policy Coordination This approach extended and applied their earlier theoretical analyses, reported in CEPR Discussion Paper Nos. 94 and 102, and allowed the consideration of four policy strategies. Each government can choose a policy which is 'fully optimal' over time: this is time-inconsistent, however, since the government will be tempted to renege on its announced policies at some future date. The private sector will realize this, and so the policy is not credible. Such a policy must also therefore be reputational: the government needs to establish a reputation to convince the private sector that it will not succumb to the temptation to renege. As an alternative to the best available reputational strategy, each government can pursue a 'non-reputational' policy: such policies are constructed at the outset so as not to present any incentive in the future for the government to renege on its policy announcements. This policy does not require the government to establish a reputation, but It generally results in smaller welfare gains. In addition, under each of these strategies (reputatlonal and non-reputatlonal), the two governments then choose whether or not to cooperate. The
simulations demonstrated how these four strategies performed in response to a variety of shocks.
Whether cooperation was beneficial (in the absence of reputation} depended on the duration
of the shock: persistent shocks increased the
desirability of
coordination. The uncertain benefits of cooperation arose from the presence of the private sector
in the game: the
actions of a third player meant that cooperation between only two players (the
governments) would not necessarily benefit them.
The authors confirmed
their theoretical predictions that of the four strategies the cooperative and reputational
policy yielded by
far the highest pay-off. The pay-offs from the other three policies were very similar but
much smaller .
The authors also showed that the cooperative reputational policy rule could, under
certain circumstances, be sustained as an equilibrium of a non-cooperative game played by the two
governments and the private sector. Paul Masson (IMF) criticized some features of the empirical models used in the paper. Various
wealth effects had
been removed in order to accelerate the model's dynamic responses, and this had undesirable effects on the
accuracy of the simulation results. Masson also noted that the price level in the policy
simulations was fixed by assuming that a particular price level was an objective of
policy. He recommended modelling monetary policy as operating through variations in the money stock
rather than an interest
rate instrument and by introducing more forward-Iooking expectations into the model, for exam- pie in the
determination of inflation. Simulate Policy rules In ten empirical models The case for coordinating
policies is usually stated. In terms of efficiency gains. .Calculations
of such gains usually
assume that coordinated policies are designed using correctly specified models of the
economies concerned, and simulations which demonstrate the benefits of policy
coordination are often
criticized for The authors found that cooperation yielded consider- able gains
but that the policies necessary to achieve these gains varied greatly across models.
Cooperative
policy rules derived from one model frequently performed worse when applied to other models
than the corresponding non-cooperative policies! Non- cooperative policies appeared to
be more robust with
respect to variations in model specification. This result led the authors to conclude
that risk-averse policy-makers may have little incentive to cooperate. Gilles Oudiz (Compagnie Bancaire and CEPR) welcomed the attempt to compare optimal policies across a variety of empirical models. He suggested that the large gains from coordination found by Holtham and Hughes Hallett, relative to those found in previous studies, could have resulted from the large weight the authors had placed on output relative to inflation in the assumed objectives of policy-makers. Oudlz did not share the authors pessimistic conclusion that model uncertainty may discourage cooperative policy: he argued that model uncertainty rendered tentative any policy advice, not just that concerning cooperative policies. Ralph Bryant (The Brookings Institution) observed that model uncertainty was of great concern to policy-makers and that this analysis of it was a step in the right direction. Participants disagreed, however, about the importance of the differences between the ten models used in the paper, Were they too similar, sharing common databases and in some cases common theoretical structures, as Ralph Tryon (Federal Reserve Board) argued? Or were they too dissimilar, as William Branson (Princeton University and CEPR) argued: the need to attract funding might encourage model builders to differentiate their products excessively. The European Monetary System The channels of interdependence
between the two
economies operate through trade, which affects aggregate demand for goods and aggregate price
levels, and
financial markets in which, in the absence of capital controls, each country's assets are
perfect
substitutes. Each country has only one policy instrument, monetary policy. The countries
not only choose their monetary policies, but also decide whether
to use capital
controls and whether to establish a fixed exchange rate. The two countries' incentive to
adopt an EMS
mechanism is based on the mutual gains which it would produce for the two countries in the execution of an
anti-inflationary policy. Begg and Wyplosz noted that the incentives
to form an EMS were
sensitive to the initial conditions inherited by potential member countries. An EMS formed to
fight inflation might
therefore disintegrate once unemployment not inflation was the main concern of
policy-makers. Begg
and Wyplosz also explored how the imposition of capital controls might affect the choice between the EMS and a floating exchange rate regime. They found that, by modifying the interdependence operating through financial markets, capital controls could make the EMS more attractive and thus more feasible. Capital controls could make the The role played by capital controls in the EMS
was widely
discussed, William Branson believed that the viability of the
EMS depended on minimizing the number of realignments. Capital controls
could thus be seen as a
way of allowing countries in difficulties to maintain exchange rate
parities without an immediate
realignment, while demonstrating a genuine case for an eventual
realignment. Francesco Giavazzi (University of Venice and CEPR) argued that. In
practice capital controls allowed the .EMS to
survive realignments: they did not necessarily enhance the gains for Francesco Giavazzi (University of Venice and CEPR) and Alberto Giovannini
(Columbia University Business School) adopted a more empirical approach in their paper, 'Models of
the EMS: Is Europe a Greater Deutschmark Area?'. Economic theory suggested that asymmetry was an important
feature of exchange rate systems. Asymmetry in the EMS, for example,
theoretically allowed smaller European
countries the benefits of
pegging their exchange rates to a larger country, West Germany, which enjoyed relative price
stability, Without
this commitment to a fixed exchange rate, the smaller EMS countries would suffer a higher
inflation rate due
to the inflationary bias of their domestic monetary policies.
Giavazzi and Giovannini then explored whether in practice the EMS displayed such an asymmetry by examining data on movements in interest rates and on foreign exchange market interventions by the central banks of EMS countries. They concluded that although the EMS had not been designed to work asymmetrically, this was the key to its operation in practice. It had become essentially a 'Deutschmark zone', in which the monetary policy of the Bundesbank exercised a dominant influence. West German macroeconomic policy focused on its money supply, and virtually all the burden of intervention to defend exchange rate parities fell on the other countries. The behaviour of European interest rates appeared to support this interpretation. In April 1986 the market expected an appreciation of the Deutschmark relative to the French franc. As theory would suggest, interest rates on deposits denominated in francs were observed to rise in proportion to the expected appreciation (to a larger extent in the Euromarket, and to a smaller extent at home, because of exchange controls). In a symmetric system German interest rates should fall at the same time, but in practice they hardly moved, either at home or in the Euromarket. The authors' regression analysis also indicated that the advent of the EMS was associated with an increase in the volatility of interest rate 'innovations' in France, and a decrease in West Germanyand Italy. Participants disagreed over the role played by the EMS and how it should be modelled. Richard Marston (University of Pennsylvania) was sceptical about the extent to which the EMS could be viewed as a means for the other European countries to hire a 'conservative central banker' in the shape of the Bundesbank, since it was always possible to realign the member currencies, David Vines (University of Glasgow and CEPR) interpreted the EMS as a mechanism for stabilizing exchange rates and preventing the appearance of speculative bubbles in exchange rate movements, though such a function might be better fulfilled by a 'target zone' system. Some participants felt that Giavazzi and Giovannini's data on interventions were less useful because of their high degree of aggregation, It was also argued that the authors' use of the residuals from equations forecasting interest rates was not a reliable means of identifying the interest rate 'innovations' arising from EMS membership, since a variety of factors could have been responsible for the change in interest rate volatility. Only 15 % debt service/export ratio required for solvency? North-South Macroeconomic
Interdependence Applying this analysis to the situations of
Brazil and of
Mexico, Cohen rejected the notion that a rational debtor country should ever wish to
reduce its debt so
as to make voluntary lending possible in the future. Several participants disputed
this view, arguing that after an adverse real interest rate shock during which outstanding debt had risen, the
level of debt relative to GDP should be reduced to allow for subsequent borrowing in the event of a
similar adverse shock in the future. Jonathan Eaton (University of Virginia) pointed out that Cohen's
analysis had omitted capital productivity and international mobility of private capital, so
that the effects of
investment and of capital flight on the behaviour of debt were excluded. Ravi Kanbur (Princeton University and CEPR) and The discussion
following the papers by Kanbur and Cohen's careful modelling of the domestic as well as the external
aspects of debt problems was welcomed Dornbusch argued for the potential benefits of debt repudiation. In his view the costs to debtor nations been exaggerated; in the 1930s, many countries had repudiated debts and had, he claimed, subsequently enjoyed much faster growth and development than they would otherwise have done. John Williamson disagreed: he insisted that repudiation by big debtors, would be considered solvent on any sensible criteria, would make it harder for the genuinely hard-pressed debtor countries, which tended to be both much smaller and much poorer, to obtain relief. Michael Kaser (St Antony's College, Oxford, and IEA) concluded the conference by placing it in its historical context, in regard to both its topic and the long series of important IEA conferences. He noted that this was the first of the 80 IEA conferences held so far to take place in London. This was surprising, if only because of the prominent role played, by the Royal Economic Society and by Sir Austin Robinson in the IEA. The conference was also noteworthy as the first to be explicitly devoted to international policy coordination and indeed the first since 1974 to be devoted to international interactions. Kaser thought that the conference' s examination of the gains from policy coordination would prove valuable and represented an important harnessing of theory to the fundamentals of economic policy, one of the goals of the IEA. The conference proceedings will be published in late 1987 for CEPR and the IEA by the Macmillan Press, under the title Global Macroeconomics: Policy Conflict and Cooperation, edited by Ralph Bryant and Richard Portes.
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