The large current account imbalances among the major economies are a cause for serious concern, Jacob A Frenkel told a lunchtime meeting on 15 November. The appropriate response, reduction of the US budget deficit, would be considerably helped by structural reforms in the surplus countries. Monetary policy should continue to be the basis for national and coordinated economic policy-making.
Professor Frenkel is Economic Counsellor and Director of Research at the International Monetary Fund. The meeting marked the launch of a new book on `Macroeconomic Policies in an Interdependent World', of which he is co-editor. The book (see box) is a joint venture of the Brookings Institution, CEPR and the IMF. Financial support for the lunchtime meeting was provided by the Ford Foundation and the Alfred P Sloan Foundation, as part of their support for CEPR's International Macroeconomics programme.

The outlook for growth in the OECD developed economies is encouraging: the growth rate in 1988 was not matched by increases in productive capacity, but the pace of 1989 growth is sustainable. There are nevertheless two matters for serious concern. First, inflation in the OECD economies has risen to around 4.5% a year. Second, external imbalances are a very serious cloud on the horizon, Frenkel warned. The US trade deficit stood at 2.5% of GNP, with Japanese and West German surpluses of 2.5% and 4% respectively. These imbalances are not shrinking sufficiently fast.
Monetary policy has performed well in the face of major crises, such as the stock market crash of October 1987. Frenkel attributed this success to the flexibility of monetary instruments. He warned, however, that monetary policy could not be used simultaneously to deal with stock market crashes, inflation, exchange rates and the debt problem. Monetary policy has a comparative advantage in dealing with inflation, so that should be its main target. But fiscal policy, the main alternative instrument, is too inflexible for economic fine-tuning, even if the latter were desirable. By the time fiscal adjustments are implemented, the circumstances to which they were intended to respond have typically changed again.
It is nevertheless appropriate, Frenkel argued, that fiscal policy should adjust in response to important changes in the economy. The most effective way to deal with the large and persistent global imbalances is for the US fiscal deficit to be reduced. Although this could in principle be achieved without any international coordination, it would clearly help if at the same time Japan took actions to reform its land market, West Germany its labour market, and so on. Now was a very good time for countries to embark on structural reforms, Frenkel added, while the outlook for economic growth remains good.
The case for international coordination is that the major developed economies are highly interdependent, and none can insulate itself from the ills of others. But coordination, though essential, is just a mechanism and is only as good as the policies to be coordinated. Its effectiveness is also limited by differences among national policy objectives and the constraints governments face.
Many proposals for international economic reform are beset with problems. Exchange rate management is flawed, because it is only possible to manipulate nominal rates, whereas real exchange rates matter for economic performance. The fallacy of attempting to affect real variables using nominal policy instruments has been widely exposed, according to Frenkel. Other observers focus on poor savings rates in the United Kingdom and United States in the latter, net dissaving and suggest these difficulties stem from freedom of international capital flows. But such arguments are equivalent to calls for trade protectionism, he argued, and it is anyway impossible to distinguish `good' flows from `bad', purely speculative flows. Nor can exchange market intervention realistically assume from monetary policy the burden of correcting global imbalances. Its effectiveness depends heavily on the signal it gives to the market. Sustained, sterilized intervention can have little effect, especially when working against the grain of the market.
Frenkel concluded by challenging the view that imbalances are not a worry. Just as most exchange results from the free exercise of market preferences, some argue, so external deficits are just the product of decisions to borrow and repay. The problem with this, however, is that such decisions may not be sustainable. In the international context there are no bankruptcy laws, so it is relatively easy to accumulate debt. Ultimately, the deficits and the sovereign debt overhang would probably be self-correcting, but at considerable cost and potential for conflict in the meantime. He could see some merit in distinguishing between borrowing to invest and to consume, since the former generates wealth from which to meet the repayments while the latter does not. But too little is known about the causes of deficits for this distinction to be a basis for policy. In the meantime, economic management should err in the direction of prudence.
In the discussion, Frenkel was asked whether imbalances within an integrated Europe matter. He agreed that the large imbalance between Germany and Spain, for example, was quite sustainable. What mattered more was Germany's overall surplus on the capital account. This contrasted with imbalances within the United States, which had trivial systemic implications. One reason for this was the existence of federal transfer mechanisms as a last resort. This could be taken as a useful lesson for the EC in designing its own monetary institutions.