International macroeconomic policy coordination

Jeffrey Frankel

09 December 2015



Calls for international coordination of macroeconomic policy are back, after a 30-year hiatus (e.g. Rajan 2015). To some it looks anomalous for the Fed to raise interest rates at a time when most major central banks see a need to extend further monetary stimulus.

The heyday of coordination in practice was the decade 1978-1987, beginning with a G7 Summit in Bonn in 1978 and including the Plaza Accord of 1985, of which this year is the 30th anniversary. Economists were able to provide a good rationale for coordination based in game theory. (The literature started with Cooper 1969, and Hamada 1976. I review the subject of coordination, with an emphasis on recent policy developments in Frankel 2015c; similarly, the Plaza Accord in Frankel 2015b.)

Then coordination fell out of fashion. The Germans, for example, regretted having agreed to joint fiscal expansion at the Bonn Summit; reflation turned out to be the wrong objective in the inflation-plagued late 1970s. The Plaza Accord and associated intervention in the foreign exchange market were successful in bringing down an overvalued dollar, but the Japanese had come to regret the appreciated yen by 1987. Some of the other G7 summit communiques had little effect, for better or worse. Furthermore, as the economies and currencies of emerging market countries became increasingly important, their lack of representation in global governance became problematic.

The return of calls for international coordination

Attempts at coordination have made a comeback since the Global Crisis of 2008. The larger emerging market countries got more representation when the G20 became the pre-eminent leaders group. The G20 leaders agreed on coordinated economic expansion at the London Summit of April 2009. They agreed at the Seoul Summit in 2010 to give emerging markets quota shares in the IMF that would be more commensurate with their economic weight (though the US congress has yet to pass the necessary legislation, to its shame).

Many calls for coordination lament the outbreak of ‘currency wars’, a phrase that Brazil’s Finance Minister in 2010 adopted for the old phenomenon of competitive depreciation.  The concern recalls the competitive devaluations of the 1930s. The idea is that a single country can depreciate its currency, gain international competitiveness for its exporters, and thus improve its trade balance; but if all countries try to do this at the same time they will fail. One manifestation of the currency wars concern has been foreign exchange intervention by China and other emerging market countries to prevent their currencies from rising (Frankel 2005). Another manifestation arose from successive rounds of quantitative easing by the Federal Reserve in 2010-11, the Bank of Japan in 2012-13, and the ECB in 2014-15; the results were in turn depreciations of the dollar, yen, and euro, respectively.   

The US has led some international attempts to address competitive depreciation, including an agreement among G7 ministers in February 2013 to refrain from foreign exchange intervention and a November 2015 side-agreement to the Trans-Pacific Partnership to address currency manipulation. But critics are agitating for a stronger agreement backed up by the threat of trade sanctions (e.g. Bergsten 2015, Gagnon 2013).

The most recent fear – articulated, for example, by Raghuram Rajan, Governor of the Reserve Bank of India in 2014 – is that the US central bank will not adequately take into account adverse impacts on emerging economies when it raises interest rates.

In traditional game theory terms, the existence of spillovers implies that countries are better off if they coordinate policies than under the Nash non-cooperative equilibrium.  But what is the nature of the spillover and the coordination? In this column, I interpret recent macroeconomic history in terms of four possible frameworks for proposals to coordinate fiscal policy or monetary policy: the locomotive game, the discipline game, the currency war or competitive depreciation game, and the competitive appreciation game. Perceptions of the sign of spillovers and proposals for the direction of coordination vary widely. The existence of different models and different domestic interests may be as important as the difference between cooperative and non-cooperative equilibria. In some cases, complaints about foreigners’ actions and calls for cooperation may obscure the need to settle disagreements domestically.

Fiscal policy games

Consider, first, fiscal policy. When the US urges German fiscal stimulus, as at the G7 Bonn Summit of 1978, the G20 London Summit of 2009, and the G20 Brisbane Summit of 2014, it has in mind the ‘locomotive game’. The assumption is that fiscal stimulus has positive ‘spillover effects’ on trading partners. Each country is afraid to undertake fiscal expansion on its own, for fear of worsening its trade balance, but the world can do better if the major countries agree to act together as locomotives pulling the global train out of recession.  

But Germans think they are playing a ‘discipline game’. They view budget deficits as creating negative externalities or spillover effects for neighbours due, for example, to the moral hazard of bailouts, not positive externalities. Their idea of a cooperative equilibrium is the Fiscal Compact of 2013 under which Eurozone members agreed yet again to rules for limiting their budget deficits.

When two players sit down at the board, they are unlikely to have a satisfactory game if one of them thinks they are playing checkers and the other thinks they are playing chess. Think of the ‘dialogue of the deaf’ that took place between the Greek government elected in January 2015 and its Eurozone partners.

Monetary policy games

Interpretations vary just as much when it comes to monetary policy. Some think monetary expansion in one country shifts the trade balance against its trading partners due to the exchange rate effect; others think it is transmitted positively, via higher spending. Some think that the problem is competitive depreciation and too-low interest rates; others that the problem is competitive appreciation or too-high interest rates.  Some think that the way to solve competitive depreciation for good is to fix exchange rates, as the architects of Bretton Woods did in 1944. Others, such as some US politicians today, think that the way to do it is the opposite: an agreement against seeking to influence exchange rates at all, enforced by trade penalties.

Concerns about competitive depreciation often seem to ignore that the virtue of floating exchange rates is precisely that they allow each country to choose the monetary policy appropriate to its own economic conditions. If some need monetary tightening while others need stimulus, as today, floating will accommodate the difference (Friedman 1953, Bénassy-Quéré et al. 2014). If all need monetary stimulus at the same time, as in the 1930s or 2008-09, flexible rates can deliver that outcome as well (Eichengreen and Sachs 1985, 1986, Eichengreen 2013).   

Some new writings argue that under recent conditions floating rates can no longer allow each country to achieve its own monetary goals because central banks have lost the freedom to set their own short-term interest rates. The reason is the zero lower bound in the case of advanced countries and exposure to finicky international financial markets in the case of emerging market economies. The Trilemma proposition that floating rates insulate has been challenged (Agrippino and Rey 2015, Farhi and Werning 2014, Rey 2015). But others offer empirical evidence that floating rates do still deliver independence as promised (Klein and Shambaugh 2013, Di Giovanni & Shambaugh 2008, Aizenman et al. 2010, 2011, Obstfeld 2015). Coordination may not be necessary after all.

Yes, regular meetings of officials can be useful. Consultation can minimise surprises. Crisis management often requires cooperation. Exchange of views might help narrow differences in perceptions. But some calls for international coordination are less useful, particularly when they blame foreigners in order to distract attention from domestic constraints and disagreements.

Two examples of calls for coordination obscuring domestic problems; first was Brazil’s budget deficit in 2010, which was too large. The economy overheated. Private demand was going to be crowded out one way or another, if not via currency appreciation then via higher interest rates. When Brazilian officials blamed the US and others for a strong real, it may have been a way to divert attention so as to avoid confronting the domestic issue. Second, US politicians’ ongoing efforts to ban currency manipulation in trade agreements may be rhetorical attempts to scapegoat Asians for stagnation in the real incomes of American workers (Frankel 2015a).

Officials would often be better advised to improve their own policies, before they tell others what to do.


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Topics:  Global governance Macroeconomic policy

Tags:  macroeconomic policy coordination, global governance, emerging economies, Currency wars

Professor of Economics, Harvard Kennedy School