To some extent countries have coordinated their policies for a long time. The Bretton Woods par value system indirectly required a large measure of policy coordination. But the premise that there is a need to actively coordinate macroeconomic policies, rather than letting countries independently pursue their own economic interests, is a relatively radical and novel one, especially with regard to fiscal policy.
The recent impetus toward policy coordination has come from at least three directions. First, the belief that the economic, and specifically the fiscal, policies of the major industrial countries have been widely misaligned in the 1980s. Second, the growing recognition that the economies of the world, and especially those of the industrial countries, have become much more interdependent than they were in the past. Third, the argument that there are important externalities in policymaking; this implies that when countries act independently and in their own self-interest, policy changes may not be carried out to the degree necessary to maximize the collective welfare of the group of countries to which they belong.
For a longer paper on this subject, see “International Coordination of Fiscal Policies: A Review of Some Major Issues” by Vito Tanzi, issued as IMF Working Paper WP188170, and available from the author.
This article examines some of the practical difficulties that would be encountered in coordinating fiscal policies aimed at demand management. These difficulties are specific to fiscal policies and only to a limited extent are relevant to the coordination of monetary or exchange rate policies.
Misalignment of fiscal policies
The main issue in the misalignment of policies during the 1980s has been the size and the sustainability of the fiscal deficit of the United States. Other factors, such as the balance of payments, interest rates, investment flows, and exchange rates, were in various ways tied to this issue. The US federal fiscal deficit rose by about 3 percent of gross national product between 1980–81 and 1983–85. This increase occurred in spite of the fact that the US economy was entering an unusually long upswing; therefore, the “structural” deficit—that is, the measure of the fiscal deficit that is independent of the business cycle, increased even more. This increase may have facilitated the upswing in economic activity that started in 1983 and accelerated in 1984, but, in the opinion of many observers, it created difficulties for both the United States and the rest of the world.
The large increase in the US fiscal deficit coupled with that country’s low rate of saving was at least partly responsible for the high level of real interest rates in the United States during the 1980s. The initial upward push to real interest rates may have come from the restrictive monetary policy of 1979 and the early 1980s but, when monetary policy became accommodating after 1982, these rates were kept high by large fiscal deficits. While the structural fiscal deficit of the United States rose sharply after 1981, those of the Federal Republic of Germany and Japan, two countries with much higher saving rates, became smaller. This reduction may have helped contain the rise in the world’s real rates of interest.
As a consequence of these developments, the balance of payments on current account of the United States deteriorated rapidly—from a surplus of $6.9 billion in 1981 to deficits of $138.8 billion in 1986 and $154.0 billion in 1987. Meanwhile, Japan’s balance of payments on current account went from a deficit in 1970 into a small surplus in 1981 and 1982, growing to above $85 billion by 1987. A similar pattern emerged for Germany, its deficit in 1971 changing to a surplus in 1984 that grew to $40 billion in 1986 and $45 billion in 1987.
The worsening US current account affected its international investment position. The net position of the United States vis-à-vis the rest of the world changed from a positive figure of $106.3 billion in 1980 to a negative figure of $263.6 billion in 1986. Up to 1981 the United States was the world’s largest creditor nation. By the end of 1986 it had become the world’s largest debtor nation. The following year, the net foreign indebtedness of the United States exceeded 8 percent of its GNP, while Germany and Japan had become net creditors to the tune of 16.5 percent and 14.1 percent of their respective GNPs.
The 1980s also witnessed wide swings in exchange rates. The value of the dollar first rose sharply up to 1985 and then fell equally dramatically. The changes vis-à-vis the deutsche mark and the yen were particularly significant. The rise in the value of the dollar was widely attributed to the increase in US interest rates although the different rate of expansion in the US and other major economies may have also played a role. The subsequent fall of the dollar has been attributed by some observers to the growing reluctance of foreigners to keep raising the share of dollar-denominated assets in their portfolios. The earlier sharp increase in the value of the dollar and the continuing large current account deficit in the United States have generated protectionist pressures and other difficulties. These problems concentrated the attention of policymakers (see “International Economic Cooperation and Policy Coordination” by Jocelyn Home and Paul Masson, Finance & Development, June 1987).
The Plaza Agreement of September 1985, the Tokyo Summit of 1986, and the Louvre Accord of February 1987 represented several milestones on the road to policy coordination. The Louvre Accord was generally seen as an arrangement on exchange rates even though it implied some commitment on economic policies by the participating countries. The “Statement of the Group of Seven” released on December 22, 1987 was more specific in listing the policy intentions and undertakings agreed upon by the Finance Ministers and Central Bank Governors of the seven major industrial countries.
Interdependence and externalities
There is considerable evidence to indicate that industrial countries have become much more interdependent than they used to be. The internationalization of the financial and goods markets, together with the wide and immediate availability of information, has guaranteed that what happens in one country, and especially in a large country, will be felt rapidly and strongly by other countries. The most dramatic recent evidence of this interdependence was undoubtedly the behavior of the stock markets around the world after the 508 point fall in the New York stock exchange on October 19, 1987 (“Black Monday”). The changing shares of imports and exports in national incomes of major industrial countries in recent decades, the size of capital movements, and the attention that policymakers now pay to the economic policies of other countries all point to the demise of the “closed economy” of economic textbooks.
What this means is that the domestic effects of fiscal policy actions taken by a single country no longer have the same strength and results that they once did. The smaller and more open a country, the less it can affect its current economic activity with fiscal policy actions, since those fiscal actions will largely spill out of the country. There are obvious benefits associated with this interdependence and openness. International trade of products and factors among countries encourages specialization and brings about a more efficient international allocation of resources. Under normal assumptions, international trade raises the level of world income. This interdependence, however, has important implications for the conduct of fiscal and monetary policy.
Interdependence also implies that there are important externalities, or outside influences, relating to some policy actions. These externalities may create inefficiencies in the sense that policy actions may not be carried to an extent that would be considered optimal from an international point of view. In a closed economy, both the costs (political and economic) and the benefits of fiscal policy actions would be fully internalized. However, in an interdependent world, some of the benefits (and some of the costs) of that action will spill over to other countries.
An example often mentioned to prove the above point is the expansionary fiscal policy pursued by the Mitterand Government in the early 1980s. It is maintained that the domestic beneficial effects of that policy were partly dissipated by the openness of the French economy. Soon the expansion had to be stopped because of the deterioration in the French balance of payments. It can also be argued that a good part of the benefits, as well as some of the costs, of the US fiscal expansion since 1982, has accrued to other countries, either because these other countries could maintain a higher level of economic activity because of higher exports to the United States, or because they had to bear the consequences of higher real interest rates, fluctuating real exchange rates, and changes in terms of trade. Countries that exported little to the United States but were net borrowers, and were closely linked to the financial markets, were adversely affected. Their cost of borrowing (or of servicing their debt) went up. The distribution of costs and benefits varied according to their trade with the United States and whether they were net lenders or borrowers in the international financial market.
This argument has implications for the coordination of fiscal policy among countries, especially when economic activity needs to be stimulated. Acting independently, countries may be reluctant to pursue expansionary fiscal policies, because of the balance of payments effects of these policies. But, in theory at least, they could all benefit, and neutralize the effects on the balance of payments, if they all pursued fiscal expansion at the same time. However, given different propensities to import, different interest elasticities of investment demand, and different trade relations with countries that are not part of the coordinating group, the balance of payments results are not likely to be neutral. Further, the countries would have to consider the inflationary implications—probably at different rates—of their joint expansion.
The situation gets more complex when one takes into account not just the benefits but also the costs of fiscal policy actions, and when coordination calls for expansion on the part of some countries and contraction on the part of others. Experts on policy coordination, using game theory and other analytical tools, have described situations in which policy coordination may reduce rather than increase the group’s welfare. However, much of the literature seems to conclude that in normal circumstances international coordination would be more beneficial than independent policymaking, although the benefits may not always be substantial.
Conditions for success
Coordination can have several meanings which may range from a tacit understanding that each country will do its best independently to keep, or to put, its own economy (and its own fiscal accounts) in good shape, to a formal commitment by each country to take specific policy actions agreed jointly in coordination with other countries. In a world in which the policies of individual countries attract much attention from other countries and international organizations (IMF, Organization for Economic Cooperation and Development, the European Community, etc.), it is safe to assume that some implicit coordination of policies is always taking place in the sense that countries pay some heed to the impact that they are having on other countries or to what other countries expect them to do.
An actively coordinated fiscal policy that aims at demand management on a global scale rather than at correcting major fiscal imbalances in particular countries needs various conditions to be effective. The following discussion focuses on fiscal policy involving demand management. There are, of course, many other kinds of coordination, including those related to structural policies, for instance tax reforms. Given the increased interdependence of national economies that results from greater capital mobility, coordination in the area of tax reform is likely to be essential.
Economic forecasts. A successful policy of fiscal coordination aimed at demand management would require, as a first condition, that the relevant group of countries has jointly recognized the need for a coordinated change in policy to attain a common objective at an agreed point in the future. Thus, the first basic requirement for successful coordination would be a jointly agreed and reliable forecast. There are at least two issues that arise from this requirement: the reliability of forecasts, and the agreement on the part of the countries on one of them as being the right one.
It is a well-known fact that forecasts are partly applied science, partly art, and partly divination. Moreover, it often takes some time before fiscal policy changes, coordinated by a group of countries, can be implemented and begin to affect the world’s economies. This lag is likely to be somewhat longer than the period for which acceptably reliable forecasts can be made. Forecasts are relatively reliable for the first six months and somewhat less so for the following 12 months. As the period is extended beyond that, the forecasts are unlikely to provide a reliable basis for making fiscal policy decisions. Further, even when an agreement has been reached on a fiscal policy, it may be a long time before it can be put into effect. But experience with economic forecasting, even with the carefully crafted World Economic Outlook (WEO) of the International Monetary Fund, indicates the difficulty of making longer-term predictions. There have been errors in the forecasts made for a period just one year ahead. Such a period is often far too short for the coordination and execution of fiscal policy. The errors appear to be particularly large in periods when economic conditions are changing rapidly, such as 1974 and 1982. But these are exactly the periods when one would want to have fiscal coordination of the demand management type. Moreover, in some cases, there are significant differences between national forecasts (e.g., by the Council of Economic Advisors in the United States and the Government of Japan) and those made by the WEO of the IMF, or by the OECD, or the EC.
In conclusion, one of the basic requirements for successful fiscal coordination, namely the availability of a jointly agreed and reliable forecast, is difficult to realize. This has serious implications for fiscal coordination that aims at global demand management through fiscal policy changes.
Economic objectives. Assuming that an agreement has been reached by the coordinating policymakers as to the relevant forecast, the next step must be to agree on the economic objectives that should be achieved through coordination. The main objectives could be, say, an acceleration of economic activity, a reduction in the unemployment rate, and a reduction in the rate of inflation. If more than one objective is important, how should the various objectives be ranked in terms of priority? And what kinds of tradeoffs are acceptable?
In democratic countries economic policy must, to a large extent, reflect the priorities of the citizens. If these priorities are ignored, elected policymakers are not likely to remain policymakers for long. Fiscal policy is predominantly made by elected officials who have to worry about the next election and who have to coordinate their actions with the legislature, while keeping an eye on the electorate. It would be unrealistic to assume that in the fiscal area the policymakers of a country would, to a substantial degree, subordinate the priorities of the country’s electorate to those of the policymakers of other countries.
Process of policy change. Between the time a decision is made, at some international meeting, to change the fiscal deficit and the time when that decision becomes the actual policy of a country, lies the hurdle of national legislation. In the political process of getting agreement from the legislature, domestic priorities are likely to take precedence over international priorities.
There are also unavoidable lags between the drawing up of fiscal proposals and their final disposal by legislatures. Further, there are lags between the time a fiscal action is implemented and the time its effects are felt in the economy. In summary, therefore, a long time is likely to have passed between the original agreement by the coordinating group, the enactment of the fiscal measures, and the time their effects are felt by the economy. That time is likely to be well beyond the period for which reliable forecasts can be made.
Policy instruments and objectives
The issues discussed here are not limited to fiscal policy but extend to all policies. Economics has not advanced to the point where it can give definite answers to the question of what effect, say, a given expansion in the money supply or an increase in the fiscal deficit would have on some basic objective such as the rate of growth, inflation, the current account in the balance of payments, and so forth. Sometimes even theoretical answers are not easy. Often, governments rely on the results of econometric models for some of these answers. If all of these different national models produced generally similar answers, and those answers were correct, coordination would be easily and correctly implemented. If all the answers were the same but were the wrong ones, the gains from coordination would be reduced but policymakers might still find it easy to agree on what to do.
A more serious practical problem arises when the answers that the models give to the same questions are different. A recent experiment at the Brookings Institution in Washington addressed this specific issue.
In this experiment those in charge of 12 multicountry models were asked to simulate, independently, the effects of carefully specified policy changes to see how similar the results would be. Two of these changes concerned fiscal policy: one a permanent increase of US real government expenditure of 1 percent of baseline GNP; the other a permanent increase in non-US government expenditure also of 1 percent of baseline GNP. The growth of monetary aggregates was assumed to be given.
A remarkable feature of the results was their wide variance. When the leading econometric models give such widely varying results, and when none of these models may give the true answer, one can sympathize with the difficulties faced by those who negotiate agreements on policy coordination—or, for that matter, faced by policymakers reacting to purely domestic considerations. It is not easy to produce a package of policy changes that would be accepted by all participants as a clearly optimal one.
Given the uncertainties related to the effects of fiscal policies, it would seem desirable to be cautious in its use for demand management. Consequently, the best form of international policy coordination, especially in the fiscal area, is one that encourages countries, first, to pursue policies that over the medium term put their fiscal accounts in order while paying some attention to the pace at which changes are made.
A successful policy of fiscal coordination would be facilitated (a) if all of the participating countries had the same degree of political and economic influence; or (b) if the one country that had more leverage, either economically or politically, was also the one with an economy that was not facing major disequilibria in some of the areas to be coordinated. One of the reasons for the success of the EMS in reducing the rate of inflation of the member countries has undoubtedly been the fact that Germany was the major economic power in the group, and that Germany’s inflation rate was very low. Therefore, the other EMS countries were forced to pursue monetary policies that became progressively more consistent with Germany’s. Moreover, restrictive monetary policies became more credible.
There is, of course, always the danger that international coordination of fiscal policy may create pressures on those countries that have been successful in correcting their fiscal imbalances to relax their fiscal policy to bring it more in line with that of countries where less adjustment has taken place. These pressures will become stronger as countries in the latter group fail to put their fiscal houses in order. If these pressures succeed, fiscal coordination might not generate over the medium run the desirable results, even if it succeeded in bringing some short-run stimulation to aggregate demand.
Coordination of fiscal policy may, however, be highly relevant to the planning and implementation of structural reforms, including tax reform. Well designed major tax reforms, even if they have no net effect on revenue flows, are likely to have important impacts on growth, and on the movements of financial capital and factors of production. Countries can use tax reforms to gain a competitive edge over one another. This is an area where coordination could yield large dividends, despite the serious practical difficulties in implementing it.
The International Monetary Fund
Economic Policy Coordination
This volume contains the proceedings of a seminar held in Hamburg in May 1988, with Wilfried Guth as moderator. Practitioners and theoreticians discuss the extent of international policy coordination, its effectivenesss, and how it can be expected to work in the future. Available in English. 1988. US$15.00.
English, (paper) xi + 219 pp. ISBN 1-55775-025-4.
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