Economic Policy Panel
Policy Choices Across Europe

The second meeting of the Economic Policy Panel took place in London on November 11-12. The Panel comprises 20 leading European academic economists, noted also as policy advisers, and meets twice yearly to discuss specially commissioned papers on current economic issues. The papers and Panel proceedings are subsequently published in the new journal, Economic Policy, the first issue of which was published in November. The London meeting was the occasion for the launch of the journal, and a variety of topics were discussed in preparation for the second issue.

In the first paper presented to the Panel Jeff Sachs (Harvard University) and Charles Wyplosz (INSEAD, Paris) examined the French economic experience under President Mitterrand. According to many commentators this is a prime example of the bankruptcy of socialist economic policies, but Sachs and Wyplosz argued that Mitterrand's policies have in fact been both responsible and at least moderately successful. The battle against inflation has been conducted successfully and with only small losses in terms of increased unemployment, in comparison with other European economies and the previous French administration of President Giscard d'Estaing. Except for a short-lived and badly-timed expansion in 1981-82, demand management had been extremely responsible. Inflation has fallen and balance has been restored in the current account. Unemployment has risen, but this has been the case throughout Europe [see table below].

France's relative economic performance is more remarkable. West Germany, for example, has a comparable unemployment rate yet inflation there has fallen from 4.5% to 2%, while it has fallen from 11.5% to 5% in France since Mitterrand took office. The French budget deficit has also been stabilized, at around 3% of GDP, well below the levels reached throughout Europe in recent years.

Sachs and Wyplosz argued, however, that Mitterrand's policies have failed on the supply side, as in other countries. Increased import prices and higher taxes will tend to raise wage demands by unions and increase the non-accelerating inflation rate of unemployment (NAIRU), the rate of unemployment at which a constant rate of inflation can be sustained. Labour taxes have continued to rise under Mitterrand, and legislation giving protection to workers, increases in the minimum wage and shorter working hours have all tended to push up labour costs. The result has been a continued rise in the NAIRU, argued Sachs and Wyplosz; this picture was confirmed by their estimates of the Phillips curve, which showed a strong impact of taxes on the NAIRU. These estimates suggested that whereas in 1973 an unemployment rate of around 2.5% would have been compatible with no tendency for inflation to rise or fall, the corresponding unemployment rate now is around 9.0%. Sachs and Wyplosz argued that a substantial fall in labour costs would be necessary if this rate were to be reduced and advocated a cut in labour taxes to accomplish this. To prevent conflict over who should gain from this, they believed that some form of 'social contract' was also necessary. The tax cuts should be financed mainly by reduced government spending, especially on subsidies, although some expansion in the deficit would certainly be manageable. Finally, a devaluation of the Franc might be necessary to avoid a current account deficit.

Sachs and Wyplosz gave particular emphasis to the external constraints on domestic economic policies. Although the 1981-82 demand expansion was relatively modest, it not only led to difficulties with the current account of the balance of payments, but also caused significant capital outflows. This reflected a lack of confidence in socialist policies by the financial markets, a picture confirmed by the simultaneous fall in the stock market and the associated reduction in investment activity. Mitterrand was forced to choose between a reversal of policy or a continuing devaluation against the Mark. Given the unfavourable results of municipal elections and the French commitment to the European Monetary System, policy changes were the only feasible option. Sachs and Wyplosz conjectured that UK membership of the EMS might similarly limit the room for manoeuvre of a future Labour government.

In the ensuing panel discussion Willem Buiter (Yale and CEPR) highlighted the central role played by the authors' empirical estimates in their argument. Buiter found the Phillips curve estimates unconvincing, because they did not incorporate other factors which might also affect the NAIRU. Sachs and Wyplosz had also dismissed deficient aggregate demand as an explanation of the increase in French unemployment. This was unwarranted, argued Buiter: they had made no serious attempt to investigate this alternative Keynesian story. These reservations were shared by other members of the panel.

Privatization is a major plank of Mrs. Thatcher's economic programme. But the virtues of privatization have been greatly overemphasized, according to George Yarrow (Hertford College, Oxford).

Yarrow argued that current policy has too often failed to distinguish between a transfer of ownership to the private sector and measures to improve economic efficiency. Privatization will often affect the performance of firms by changing the incentives facing managers. Whether privatization leads to improved efficiency depends on the degree of competition and the regulatory environment subsequently; assessment by profitability is incorrect, Yarrow argued. Privatization of a public monopoly, unaccompanied by measures to stimulate competition, is likely to lead to a misallocation of resources which will not be reflected in its subsequent profits. It was important not to confuse 'technical efficiency', i.e. whether a firm uses its inputs efficiently, with 'social efficiency', i.e. whether resources are allocated in a manner beneficial to society as a whole.

Yarrow argued that the incentives normally faced by managers in the private sector can in general be duplicated in the public sector by well-designed incentive schemes. The choice between privatization and public ownership therefore rests on a comparison of 'market failures' in the private sector with 'monitoring failures' in the public sector. Private ownership is unlikely to be superior to public ownership in all circumstances, and a case-by-case appraisal is required. If a market is already competitive, then privatization is likely to be beneficial; but if there is only limited competition, it will be damaging.

Yarrow argued that when the privatization of monopolies like British Telecom and British Gas is contemplated, careful consideration should be given to changes in the regulatory environment before any decision on ownership is taken. Strong measures to deter the abuse of market power should be the rule. In addition regulatory agencies need to be independent of pressure groups.

He then went on to examine the Thatcher privatization programme in detail. There is evidence that privatization of the smaller companies may have improved their technical efficiency, especially in the case of Cable and Wireless and the National Freight Corporation, where profitability has increased; this may also have benefitted society as a whole by improving resource allocation. On the other hand the post-privatization performance of larger enterprises such as British Oil and British Aerospace is less encouraging. Of course an assessment on the basis of profitability alone is inappropriate, because such firms are now free to exploit their dominant role in the market, but there is little evidence even of increased technical efficiency. The most worrying case is that of British Telecom, where the regulatory environment is quite inadequate to prevent the abuse of monopoly power. Yarrow concluded that the privatization programme has only served to distract attention from the fundamental issues of competition and regulation.

Finally Yarrow argued that the privatization programme has not achieved its stated aim of wider share ownership. Most small shareholders have sold their shares quickly, and privatization has tended to benefit certain groups of individuals at the expense of society at large.

Commenting on the paper Mervyn King (London School of Economics and CEPR) said that Yarrow's focus on productive assets was too narrow. Privatization of health, education and public sector housing stock was also an issue. He agreed with Yarrow that little consideration had been given to the appropriate regulatory environment in the privatization of firms such as British Telecom. A major problem with the programme, according to King, was that it catered to the interests of the managers of the firms being privatized rather than those of the public.

Patrick Minford (Liverpool University and CEPR) also thought that the focus on productive assets was too narrow. There was no reference to the privatization of local authority services, which had been a great success, according to Minford. Jacques Melitz (INSEE, Paris) and others focussed on the redistribution of wealth involved in the privatization programme. It was important to devise equitable methods for the sale of public sector assets.

The future direction of the EMS is at the centre of European policy debates. The liberalization of capital flows within Europe, the desirability of further movements towards monetary unification, and full UK membership of the EMS were among the issues addressed by Francesco Giavazzi (University of Venice) and Alberto Giovannini (Columbia Business School).

An analysis of daily exchange rate movements indicated that an appreciation of the US dollar tends to be associated with a depreciation of the Deutschmark (DM) relative to other European currencies. Giavazzi and Giovannini found, however, that this statistical regularity only seemed to be present in the data from 1973 to the creation of the EMS in 1979, and during periods of strain within the EMS.

Giavazzi and Giovannini assessed two possible explanations of this relationship between the DM and the US dollar, the first involving international portfolio diversification. The authors' calculations suggested that conventional models of portfolio behaviour cannot explain this relationship, particularly under the EMS. The second explanation pointed to differences across European countries in restrictions on international capital flows. The authors argued that models which analyzed capital controls as lump sum transaction costs are likely to prove the most useful in understanding the behaviour of the EMS.

Giavazzi and Giovannini suggested that even without these asymmetric movements of the DM relative to other currencies, a system of fixed but adjustable exchange rate parities like the EMS is always likely to be fragile. Member countries have an incentive to alter the exchange rate in order to shift onto their trading partners the burden of adjustments to supply disturbances such as the oil price rise. The possibility of exchange rate realignments encourages speculation against weak currencies. To defeat such speculation governments must be prepared to raise interest rates, often to very high levels, or else restrict international capital movements. Within the EMS, countries have too often relied on the second solution. Capital controls may have reduced the volatility of interest rates but only at the cost of limiting the integration of European financial markets. Giavazzi and Giovannini concluded that instead of promoting European monetary integration, the EMS has actually encouraged restrictions which have retarded it!

David Begg (Worcester College, Oxford and CEPR) commented that, although he would not wish to underestimate the importance of capital controls, the authors' dismissal of portfolio models was a little too hasty and, as the paper acknowledged, its analysis was over-simplified. In the ensuing discussion a number of panel members emphasized the crucial importance of using a structural model to interpret the correlations between various currencies. Bi-variate correlations alone, it was argued, told us very little about the underlying causal relationships. Conventional modelling approaches within a theoretical framework were likely to be more fruitful.

Reduced growth and an increasing volume of imported manufactures have led to increased protectionism in the developed economies during the last decade. It is widely thought that these protectionist pressures will increase, further restricting developing country exports to the developed economies, intensifying the LDC debt problem and destabilizing the international financial and trading system. A paper presented by Gordon Hughes (University of Edinburgh and CEPR) and David Newbery (Churchill College, Cambridge and CEPR) argued that the real situation is more complex.

Most of the Newly Industrialised Countries (NICs) were able to sustain a high rate of growth of manufactured exports despite greater protectionism in the OECD. Although NIC export growth slackened after 1973, Hughes and Newbery attributed this to rising labour costs and reduced world demand rather than the effects of protectionism. Hong Kong, Korea, Singapore, and Taiwan were forced to limit exports of certain goods to the developed countries, but quickly adjusted by increasing their exports to other markets, especially the oil producers, and by expanding their product range [see table below].

Table: The Growth of LDC Manufactured Exports [Average Annual Percentage Growth Rates]

Note: TABLE GIVES AVERAGE ANNUAL PERCENTAGE GROWTH RATES OF LDC MANUFACTURED EXPORTS.
Source: Table 4 in Hughes and Newbery, 'The Effect of Protection on Manufactured Exports from Developing Countries', presented to the Economic Policy Panel.


Protectionist measures have therefore had little effect on the overall export growth of the NICs. Protectionism may actually have benefitted middle-income countries with large manufacturing sectors, such as Malaysia and the Philippines. Since 1973 these countries have actually grown faster than the NICs [see table below], taking advantage of the reduced competition in developed country markets to increase the prices of their exports there. In addition multinational corporations expanded their operations in these countries, thus transferring technology and expertise from the developed economies.

The performance of the larger poor countries was the greatest disappointment, according to Hughes and Newbery. Although the Multilateral Fibre Agreement was directed primarily against Hong Kong, Korea, Singapore and Taiwan, it seems to have had a more pronounced effect on the countries of South Asia, such as India and Pakistan. They were less able to adapt than the more sophisticated and agile exporters of the Far East. In so far as protectionist measures have any effect it seems to be on the poorest countries, rather than on those countries against whom they were primarily directed.

Hughes and Newbery concluded that the major losers from increased protectionism were the developed countries themselves. Protection is a costly and ineffective way of maintaining employment, they argued. It cannot protect export markets and can only delay the inevitable adjustment to changing trading patterns. At the same time it reduces real incomes and exacerbates inflationary pressure.

In the discussion Ravi Kanbur (University of Essex and CEPR) commented on the lack of explicit econometric estimates in the paper. Hughes and Newbery had chosen instead to present a considerable amount of data in tabular form. This made it difficult, Kanbur argued, to quantify the relative significance of supply and demand factors. This criticism was raised again by Paul Krugman (MIT), who also argued that prices should have been analyzed as well as quantities, in order to evaluate fully the impact of protectionist measures.

Lower inflation has been the first priority for most European countries in the 1980s. They have achieved this objective, but at the cost of rising unemployment. But the inflationary problems of the European economies pale in comparison with that of Israel, where prices almost sextupled in 1984. How can such inflation be brought under control? Michael Bruno (Hebrew University of Jerusalem and CEPR) is one of the principal architects of the counter-inflationary programme introduced by the Israeli government in 1985. In his paper delivered to the Economic Policy Panel, he outlined the reasoning which underlies the programme and evaluated the initial evidence on its success.

Bruno argued that the astronomical inflation rate was the result of two features of the Israeli economy. First, there was an enormous public sector budget deficit. Some of this is simply a consequence of the high level of interest payments on the public debt, but even if interest payments are excluded, there is still a large deficit [see table below]. These deficits moreover have been sustained; the result is that the ratio of public debt to GDP in Israel is 1.5 - among the highest in the world.

The second source of inflation, Bruno said, was the direct linking of liquid assets to the exchange rate, through the use of dollar-denominated deposits. In order to maintain competitiveness, the exchange rate was allowed to fall in response to domestic inflation, and liquid assets therefore increased. This left no asset in the economy whose nominal magnitude was fixed; there was nothing to anchor the price level.

Bruno argued that any successful counter-inflationary programme must tackle both of these problems. A scheme which aimed to reduce inflation gradually would require continued restraint by both government and private sector, and hence would be unlikely to be sustained. A policy which aimed to move the economy to a lower inflation rate rapidly would be more credible and was more likely to be successful. Bruno also argued that the unpredictability of cash holdings and bank deposits during periods of high and volatile inflation made monetary targetting very difficult, and that therefore a policy of fixing the exchange rate was more sensible. The programme introduced in July 1985 specified large cuts in government expenditure, especially subsidies. The exchange rate was devalued by 20% and frozen at its new level, in order to provide an anchor for prices.

Table: The Israeli Budget Deficit

Source: Table 1 in M Bruno, 'Stabilization of the Israeli Economy', presented to the Economic Policy Panel.

But one nominal anchor was not enough, he argued. If unemployment was to be prevented from rising it was also essential that wages should rise no faster than prices. Nominal targets were therefore necessary for other variables such as wages, in order to prevent their real counterparts moving out of line. Although prices were expected to rise more than wages in the early months of the package, the purchasing power of workers was to be maintained by cutting income taxes, in order to avoid a wage explosion.

Bruno believed the first few months of the programme had been quite successful. In July prices rose 27.5%, but by September the rise was only 3%. Inflationary expectations had clearly fallen, and public opinion still supported the new measures. Nevertheless, continued control of the public sector deficit and wage restraint were essential if this initial success was to be maintained and unemployment prevented from rising.
Patrick Minford (Liverpool and CEPR) supported the programme's emphasis on a rapid rather than gradual downward adjustment in inflation and on reductions in the government deficit. But he believed that the use of two nominal anchors rather than one was especially dangerous. Wage and price controls led to market distortions and to an undesirable politicization of economic decisions. The controls were likely to become a focus for discontent and lead to a breakdown of the stabilization programme.

Restrictions on bank lending were in force in many countries throughout the 1960s and 1970s; more recently many countries have abandoned them in favour of more broadly-based methods of monetary control. Carlo Cottarelli, Giampaolo Galli, P Marullo and Giovanni Pittaluga (Bank of Italy) examined the historical effectiveness of credit controls and asked whether governments might be tempted to reintroduce them.

The authors listed a number of reasons why credit controls have fallen into disuse. First, in many countries the supply of credit from unregulated sources increased to replace bank credit. Second, there was political pressure to allow exemptions from the controls, which reduced their effectiveness. Third, credit controls introduced distortions into the banking system. Finally, new and more efficient methods of monetary management had been developed subsequently.

Drawing particularly on the Italian experience, the authors argued that, despite these limitations, the temporary use of controls can be effective in reducing demand. Using an econometric model of the Italian financial system, they calculated that credit controls reduced Italian GNP by 3.5% in 1974-75. Such temporary credit restrictions, they argued, may be an effective way of curtailing demand without requiring large swings in interest rates. Permanent controls were unlikely to remain effective, however, as the financial system learns to circumvent them. The increased flexibility of financial markets and the wider range of loan instruments now available (such as leasing) suggest that controls are now likely to be much less effective than in the past.

The authors went on to examine the distortionary effect of credit controls on the financial system. Using microeconomic data on the Italian banking system they found that controls distorted the allocation of credit to final users and reduced competition among banks. In addition, the impact of the credit ceilings appeared to be extremely inequitable. The authors concluded that the removal of controls has not generally caused major problems of monetary management or resulted in increased instability in the financial system.

Commenting on the paper Giorgio Basevi (University of Bologna) argued that the neglect of external considerations in the authors' analysis was worrying. Basevi also questioned the reliability of their simulations of the effects of credit controls. He thought that the model incorrectly attributed the effects of the oil price shock to credit controls. Jacques Melitz stressed that credit controls were intrinsically distortionary and therefore undesirable, even if they did succeed in controlling demand temporarily.

The papers discussed at this Panel meeting will be published with the Panel's comments in the second issue of Economic Policy, available in April. The November 1985 issue of Economic Policy is available now.

The Panel will meet again in Paris on April 24-25. Topics for discussion at the third Panel meeting will include: trade and industrial policy in open economies, work sharing in Europe, the dynamics of unemployment and the effect of budget deficits on the current account.

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