Learning from Experiences in International Economic Policy

Last week we had a wonderful symposium in celebration of George Shultz’s 95th birthday. Many of George’s friends and colleagues spoke on the theme “Learning from Experience” in economic policy, security policy, social cohesion, and politics. For my part, I spoke of lessons learned from international economic policy in the 1940s when the International Monetary Fund was created, in the 1980s when the international Plaza Accord was forged, and in the 2000s when I served on the G7 and the G20 and when several international economic initiatives following 9/11 were originated.

U.S. leadership played a role in all three periods, and an especially positive role in the strategy developed in the ‘40s. As Jacob Viner said in 1945, “The United States is in effect, and, as concerns leadership, very nearly singlehanded, trying to reverse the whole trend of policy and practice of the world at large in the field of international economic relations…..It is largely an American blueprint for the post war economic world…. It seems to me a magnificent blueprint.”

One serious economic problem in the 1940s was the continuing threat of competitive devaluations and currency wars which had been a factor leading up to World War II. A second stemmed from extensive “exchange controls.”  Both caused all sorts of distortions and injustices.

To deal with these problems, U.S. policymakers in Treasury and State—working closely with their U.K. counterparts—developed a global strategy in which each country would commit to two basic monetary rules; these rules would become the foundation of a new rules-based international monetary system.  First, countries swore off competitive devaluations by agreeing that any exchange rate change over 10% from certain values, or pegs, would have to be approved by a newly-created IMF. Second, they agreed to remove their exchange controls during a transition period. With commitment to these two rules, the IMF would provide financial assistance with the help of a large contribution from the United States.

In important respects the strategy succeeded. The currency wars ended, exchange controls were removed (though that took more than a decade), and eventually the adjustable peg system gave way to a better flexible exchange rate system.

But today the problems facing the international monetary system have returned with volatile exchange rates and large capital flows in and out of emerging markets. Some are calling for capital controls, and even the IMF is sympathetic, while others are questioning the flexible exchange rate system itself.

In my view the problem traces to deviations from rules-based monetary policies at both the national and international level. These deviations not only helped bring on and worsen the global financial crisis, they have been a factor in the sub-par recovery and the recent global volatility of exchange rates and capital flows.  Recent bouts of quantitative easing (QE) have been associated with large fluctuations in exchange rates akin to currency wars: QE in the United States was followed by QE in Japan which was followed by QE in the Eurozone, with exchange rates moving sharply in each case.

Interest rate decisions at central banks around the world also resemble currency wars.  Whether you ask or watch central bankers, you can tell that they are following each other. Extra low U.S. interest rates were followed by extra low interest rates in many other countries, in an effort to fight off currency appreciations.

So we need a new strategy to deal with these problems.  We now have evidence that the key foundation of a rules-based international monetary system is simply a rules-based monetary policy in each country.  Research shows that the move toward rules-based monetary policy in the 1980s was the reason why economic performance improved in the 1980s and 1990s.  More recent research shows that the spread and amplification of deviations from rules-based monetary policy are drivers of current international instabilities.

Learning from the 1940s we should forge an agreement where each country commits to certain rules.  It would be a flexible exchange rate system in which each country—each central bank—describes and commits to a monetary policy rule or strategy for setting the policy instruments. The strategy could include a specific inflation target, some notion of the long run interest rate, and a list of key variables to react to in certain ways. It would be the job of each central bank to formulate and describe its strategy.  The strategies could be changed if the world changed or if there was an emergency. A procedure for describing the change and the reasons for it would be in the agreement.

For the new agreement to work well, it should include a commitment to remove capital controls analogous to the commitment to remove exchange controls in the 1940s. This would be a substantial reform; currently, there are 64 countries, including China, classified as “wall” or “gate” countries with varying degrees of capital controls, so a transition period would likely be needed as safety and soundness regulations on financial institutions are implemented.

There’s also an important lesson here from the policy of Plaza Accord of the 1980s. The intent of the Plaza Accord, which included the U.S., the U.K, Japan, Germany and France, was to ease down the value of the dollar, and the dollar did come down.  However, under the Accord the Bank of Japan was forced to shift its monetary policy in a way that adversely affected its economy—too tight at first and too easy later—causing a severe boom and bust.  In contrast U.S. monetary policy—according to Fed Chair Paul Volcker—was not affected: the Fed simply clarified in a constructive way what it was doing, and the U.S. economy performed well, starting off the Great Moderation.  The clear lesson is that the process that I am proposing would not impose specific strategies on central banks, except to say that the strategies be reported. Such a process would pose no threat to the national or international independence of central banks.

The time may be ripe for such a reform.  Paul Volcker, the former Fed chair, Jaime Caruana, the head of the Bank for International Settlements, and others have been calling for reform.  But it will be difficult because there is still disagreement about the diagnosis and the remedy, though that was true in the 1940s too. Moreover, some countries are still in the midst of unconventional monetary policies, and even if they normalize there is a question of follow-through and commitment.

Here we can learn from more recent policy strategies such as the so-called G7 Agenda for Growth of 2003. Under this agreement, which was in the form of a G7 communique, each country committed to pro-growth supply-side policies.  However, unlike several other post 9/11 economic initiatives, such as combatting terrorist financing or putting collective action clauses in sovereign debt, the Agenda for Growth agreement eventually lost steam as people supporting the agreement rotated out of leadership positions in their governments.

Last year another very similar Growth Agenda was agreed to in a communique by the G20 countries. It had a goal of increasing economic growth by ½ percent per year for 5 years. Thus far, however, the 2014 Growth Agenda is suffering the same fate as the 2003 Growth Agenda. Countries have not followed up with their pro-growth commitments.

So something is missing in the 2000s compared with the 1940s or 1980s.  In my view insufficient U.S. leadership and commitment compared to those years is a major part of the problem. In the 1940s the U.S. Congress participated with the Administration passing into law the Bretton Woods Agreement Act establishing the IMF and the World Bank. One possibility would be for the Congress to become a partner in the agreement proposed here by passing legislation requiring that the Fed report and commit to a monetary policy strategy as in the proposed agreement.  In fact, such a requirement is already written into legislation—the Fed Oversight Reform and Modernization Act—and has passed the U.S. House of Representatives.

I recognize that the approach suggested here may not be the be-all and end-all, but it is supported by lessons learned from economic policy and extensive research over the years. And it has the practical advantage that each country could choose its own independent strategy, avoid interfering with the principles of free and open markets, and contribute to the common good of global stability and growth.

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