by C. Fred Bergsten, Peterson Institute for International Economics
Article published in The International Economy, Fall 2003
November 24, 2003
© Institute for International Economics
Absolutely! Now More Than Ever
There are three reasons why the G7 should launch a major new effort to coordinate their economic policies, especially over the next year as the United States assumes the chair for next year's summit and associated meetings. First, the world economy stands at a crucial crossroads. There are strong positive signs of recovery in the United States and the beginnings of pickups in Europe and Japan. However, the outcome remains uncertain and needs policy reinforcement. Moreover, the sustainability of the U.S. expansion is unclear, in particular whether private investment will achieve the needed acceleration.
Second, global growth needs to proceed on a much more balanced geographical basis. The U.S. trade and current account deficits are approaching $600 billion and have risen by almost one full percent of GDP in five of the last six years. The net foreign debt of the United States now approaches $3 trillion and is growing by 20-25 percent per year. The situation is clearly on an unsustainable trajectory. The dollar will have to fall considerably further to restore a sustainable equilibrium in the United States and world economies if it remains the primary tool of adjustment. The adverse impact on other countries' economies could be severe, especially in Europe, where the euro has already shouldered most of the counterpart appreciation.
The better solution by far would be a coordinated global growth strategy in which Europe and Japan adopted both the structural reforms and macroeconomic policy changes needed to achieve the much faster growth of which they are capable. The United States' external deficit could then fall as a result of increased exports to more rapidly growing trading partners, rather than through a further, perhaps precipitous, decline of the dollar.
The third reason for pursuing G7 policy coordination now is to help restore overall harmony in transatlantic relations. Deep scars remain from the debate over Iraq earlier this year and could flare again at almost any time. Such an agreed G7 strategy could thus strengthen the international security as well as economic outlook.
The record of the past thirty years shows that there are four strong reasons for the main industrial countries to pursue active coordination of their economic policies, all of which obtain now. First, successful coordination improves the economic results for each individual country. Second, coordination at high political levels can facilitate tradeoffs across issue areas that would otherwise be impossible. Third, both the process and substantive results of policy coordination strengthen overall relations between the participating countries.
Fourth, and most importantly, international coordination bargains can help political leaders in individual countries win domestic support for their economic policy initiatives. National leaders often launch constructive reform programs that encounter strong domestic opposition. But embedding those reform efforts in an international agreement, where each country undertakes an obligation to do its part in a global deal and demonstrably benefits from the overall package, can overcome that resistance and convert stalemate into consensus.
There have been numerous examples of effective policy coordination. The most dramatic have taken place in Europe throughout the evolution of the European Union, especially in the run-up to the creation of the euro and its subsequent implementation. Those successes have obviously not come without controversy but they have clearly achieved the four purposes enumerated above: enhancing policy impact, facilitating cross-area tradeoffs, strengthening political relations, and especially overcoming resistance to domestic reform.
Coordination has occurred less frequently at the global level but there have been two noteworthy episodes of success. In 1978, the Bonn summit adopted a comprehensive global growth package in which several countries committed to implement specific expansionary measures. These measures were faithfully adopted and the desired results were beginning to be realized when the Iranian revolution in early 1979 led to the second oil shock, disrupting the entire world economy and derailing the macroeconomic side of the summit effort.
The Bonn package nevertheless had two profound and lasting effects, both of which made major contributions to global growth and stability. The United States, as part of its G7 commitment, agreed to decontrol domestic energy prices and thus reduce world demand for oil. President Carter (and President Ford before him) had already attempted to achieve decontrol but had been thwarted by the U.S. Congress. Carter was able to convince Congress that the total Bonn package was in the national interest of the United States, however, and that the United States thus had to fulfill its part of the bargain.
In addition, the G7 leaders at Bonn pledged to bring a successful conclusion to the Tokyo Round of global trade negotiations in the GATT, which were floundering at the time. The Round concluded shortly thereafter and U.S. Trade Representative Robert Strauss testified subsequently that it would never have succeeded in the absence of the political commitment at Bonn.
The second major episode of successful G5/G7 coordination came via the Plaza Accord of 1985. Through direct cooperation in the currency markets, the countries managed an amazingly orderly adjustment of the massive disequilibrium in exchange rates that had developed during the first half of the 1980s. They steered the dollar down by a trade-weighted average of more than 30 percent, with corrections of more than 50 percent against the individual key currencies (deutschemark and yen), with very little adverse effect on global growth or any of the national economies. In so doing, they also averted the outbreak of massive trade protectionism in the United States that was threatened by the surge in its trade deficit to then unprecedented levels.
When the decline of the dollar threatened to become disruptive, in early 1987, the G7 shifted from Plaza correction to Louvre stabilization to avoid the risk of a "hard landing." Some observers of that arrangement, especially in Japan, have blamed the subsequent asset bubble in that country on the Louvre accord. In fact, the currency "reference ranges" adopted at the Louvre were retained for only a few months and could hardly be blamed (or credited) for anything that occurred over the next few years. (Japan's bubble developed in 1988-89 and burst in 1990-91.) Indeed, a continuation of the Louvre compact might well have prevented the Japanese bubble: an effective agreement to avoid renewed dollar appreciation and yen decline, as occurred in the late 1980s, would have pushed Japan to stimulate domestic demand through fiscal rather than monetary policy and thus obviated the direct cause of its subsequent travail.
It is thus clear that policy coordination among the major countries can be achieved and can deliver positive results. The strategy now should be to devise a package which the individual leaders could use, as they did in 1978 and again in 1985-87, to overcome domestic resistance to reforms they have already proposed. Prime Minister Koizumi could use such a program to win comprehensive reform of the Japanese banking system. Chancellor Schröder could use the package to galvanize support, both from his own party and the opposition-controlled Bundesrat, for his efforts to modernize the German welfare system and labor practices. Similar gains could be achieved in each of the G7 countries. The results would include a stronger world economy, a more balanced recovery, and a significant restoration of political and security harmony between the United States and several of its traditional allies. With leadership from the United States, the G7 should devise and implement such a package in the coming months.