Subacchi, Varghese, Jackson (London - Dec 2010)

Cooperative Behaviour vs. Unilateral Intervention:

Why should we cooperate, and where?

Paola Subacchi, Richard Varghese and William Jackson International Economics, Chatham House

Search for Post-Crisis Growth Models and Policy Tools for Macro-Coordination2-3 December 2010, London

2

Overview

• Converging global goals and diverging domestic goals

• Why should we cooperate?

• Policy spillovers – an obstacle to cooperation?

• What form should cooperation take?

3

Converging Global Goals and Diverging Domestic Goals

4

There is a broad commitment to cooperation

• Rebalancing the global economy and sustaining the global recovery remain the key policy challenges faced by the world leaders today.

• There is a consensus on the need for continued cooperation among the major economic players to guide the world economy to achieve these goals.

5

-4

-2

0

2

4

6

8

10

(GD

P g

row

th,

%)

IMF projection

Emerging economies

World

Advanced economies

Sustaining growth is the goal for all

Source: IMF

Global growth rates (%, real GDP) since the 1990s.

6

Is rebalancing the global economy a goal for all?

JapanGermany

China

USA

UKFrance

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0C

urr

ent

acco

un

t b

alan

ce (

% o

f w

orl

d G

DP

)

IMF projection

Growing current account imbalances (% of world GDP) Source: IMF

7

Will the G20 succeed in driving more cooperation?

• The G20, the premier forum on international economic issues, is trying ‘to ensure an unwavering commitment to cooperation’ to achieve the shared global goals.

• However, the G20 leaders' meeting in Seoul has shown us that the euphoria of the London Summit has subsided.

• “Uneven growth and widening imbalances are fuelling the temptation to diverge from global solutions into uncoordinated actions.”

- The G20 Seoul Summit Leaders’ Declaration

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

GD

P g

row

th (

%,

ann

ual

ised

)

Advanced economies

World

Emerging economies

8

Global growth and cooperation: are they in synch?

Source: IMF

Cooperation was easier when all countries were ‘diving’ together than at present, when some countries and regions are performing much better than others.

November: China unveils fiscal stimulusWashington G20 Summit

February: US fiscal stimulus

April: London G20 Summit

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International public goods vs domestic goals

• Advanced Economies– growth with jobs

– fiscal consolidation

– increasing exports

• Emerging Economies– sustaining growth

– managing inflationary pressure

– managing capital flows

• Though the G20 economies agree on shared goals, the group is no more than a collection of individual economies with their own individual objectives and priorities with no credible enforcement mechanism.

Individual Country Policy Goals

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When does government debt become a problem?

Source: IMF projections for 2010, World Bank external debt data (as of 2010 Q2)

Govt. deficit Govt. debtGovt. external

debtShort-term govt.

external debtGDP growth projections

(% of GDP, 2010) (% of GDP, 2010) (% of GDP, 2010) (% of GDP, 2010)(%, average

2010-15)

Brazil -1.7 66.8 3.1 0.0 4.7

Canada -4.9 81.7 15.2 1.5 2.5

France -8.0 84.2 49.8 9.9 1.9

Germany -4.5 75.3 36.3 2.9 2.0

India -9.2 71.8 4.8 0.1 8.4

Italy -5.1 118.4 50.5 4.4 1.3

Japan -9.6 225.9 13.2 5.8 2.0

UK -10.2 76.7 20.5 2.1 2.3

USA -11.1 92.7 27.5 5.0 2.7

11

When does unemployment become a problem?

Source: IMF, National Statistical Authorities

0

2

4

6

8

10

Un

emp

loym

ent

(% o

f w

ork

forc

e)

Current Average (2000-07)

Unemployment (% of workforce) – a pressing concern in the US.

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Domestic goals: which are the priorities

GDP growth

Reducing unemployment

Fiscal consolidation

Controlling capital flows

Managing inflation

Increasing exports

US +++ +++ + ++

China +++ +++ ++

Germany +++ ++ +++

Japan +++ ++ +++

UK +++ ++ +++ ++

India +++ + ++ +++ +

France +++ +++ ++ ++

Brazil +++ +++ + ++

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Why should we cooperate?

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Why should we cooperate?

• “…there are situations in which rational actors have an incentive to eschew unconstrained independent decision making, situations in which individualistic self-interested calculation leads them to prefer joint decision making (regimes) because independent self-interested behaviour can result in undesirable or suboptimal outcomes.”

- Arthur A. Stein (1982)

• Yet recent events, such as potential fiscal consolidation and ‘currency wars’, suggest that the world economy might be heading towards ‘suboptimal outcomes’.

The G20 and other international fora can be viewed as an attempt to ‘eschew unconstrained independent decision making’ to avoid ‘undesirable or suboptimal outcomes’.

Global fiscal consolidation: a Prisoner’s Dilemma

• Players: Surplus country and deficit country in a two country model.

• Strategies:

Surplus country: cooperate – sufficient spending increase;

defect – insufficient spending increase

Deficit country: cooperate – sufficient fiscal consolidation;

defect – insufficient fiscal consolidation

• Payoff matrix:

Surplus Country

Deficit Country

Cooperate Defect

Cooperate (3,3) (1,4)

Defect (4,1) (2,2)

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Global fiscal consolidation: a Prisoner’s Dilemma

• The desirable outcome is where both players cooperate. The surplus country increases spending sufficiently to offset the contraction in demand caused by the fiscal consolidation in the deficit country. This helps in maintaining world demand while rebalancing the global economy.

• However, there is an incentive for both players to defect. Surplus countries will be unwilling to take on a high debt burden to expand demand for other countries’ production. For deficit countries, if the surplus country cooperates, external demand is forthcoming so they can afford to run higher deficits anticipating higher growth.

• If one country defects, it is in the interest for the other to also defect, leading to an undesirable global outcome - though world demand is maintained, global imbalances widen.

Surplus

Deficit

Cooperate Defect


Defect (4,1) (2,2)

16

17

Currency wars: a further Prisoner’s Dilemma

• If deficit countries wish to boost their demand without using fiscal policy instruments, they might resort to competitive depreciation, leading to another prisoner’s dilemma situation.

• Competitive depreciation, to shift the demand away from imports as well as promote exports, is a ‘beggar-thy-neighbour’ policy used by countries to stimulate their domestic economies.

• When one country depreciates its currency, ceteris paribus, it stands to gain. However, competitive depreciations spark tit-for-tat reactions from rest of the world.

• If all nations unilaterally resort to intervention, this strategy will have no real effect (relative prices will not change) but countries still bear the cost of intervention.

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Currency wars: a Further Prisoner’s Dilemma

• Players: Country A and Country B – two equal sized economies in a two-country model

• Strategies: Cooperate – don’t depreciate the currency;

Defect – depreciate the currency

• Payoff Matrix:

Cooperate Defect


Defect (4,1) (2,2)

Country B

Country A

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Currency wars: a Prisoner’s Dilemma

• The outcome (cooperate, cooperate) is the desired outcome.

• However, this outcome cannot be sustained since there is an incentive for the players to unilaterally defect (competitive depreciation) to obtain better payoff (cooperate, defect) or (defect, cooperate).

• The country not intervening in the above situations will therefore have an incentive to defect in order to improve its payoff.

• The undesirable outcome (defect, defect) is a Nash equilibrium. There is no incentive for any player to unilaterally shift away from defect. In fact, shifting away from defection makes the country worse off.

Cooperate Defect


Defect (4,1) (2,2)

Country B

Country A

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Why defect?

• To maintain the desired outcome in both the cases players need to reach an explicit agreement to coordinate their policy choices.

• This would imply they are agreeing to give up their gains from beggar-thy-neighbour policies in spite of the incentive to cheat.

• But in an infinitely repeated game the gains in the long run from cooperating are higher than the one time additional payoff from defecting.

• Yet we observe defection is a real threat in both the examples we have considered. Why so?

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Why defect?

• The decision to cooperate/defect is not based on a single policy dimension. Often attempts to target pressing domestic goals lead to international policy spillover which is seen as defection by other countries provoking retaliation.

• The interests of domestic actors do not overlap with that of international actors – a scenario in which international cooperation is unlikely.

• Time inconsistency between political (short term) and economic (long term) horizons. Politicians prefer policies that deliver economic gains that parallel short term political cycles.

• There are numerous choices and outcomes that add to the uncertainty making policymakers less certain about the effectiveness of any international agreement.

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Policy Spillovers: An Obstacle to Cooperation?

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Quantitative easing in the US

• Consider the recent quantitative easing in the US – the monetary policy measure used to increase the money supply by buying government bonds and other securities from the market.

• The stated objective of the policy is to increase domestic liquidity.

• However, in a financially integrated world quantitative easing has additional spillovers.

• It leads to capital outflow and depreciation of the domestic currency causing excessive liquidity in other countries, especially emerging market economies.

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Quantitative easing in the US

• This can be viewed by the aggrieved countries as a ‘beggar-thy-neighbour’ policy to stimulate the US economy and may provoke direct retaliation.

• The first decision to defect might not necessarily be a conscious policy choice. However, it might have been an unintended spillover of a policy intervention.

• Yet, this leaves the door open for tit-for-tat reactions, with the risk of leaving all players worse off in an undesirable outcome of defection.

• Furthermore, the retaliations can lead to further rounds of policy spillovers and subsequent retaliations.

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Swiss FX intervention

• Early 2009 saw reduction in the Euro zone interest rate amidst global economic turmoil, causing the depreciation of the Euro.

• This in turn led to a stronger Swiss Franc against the Euro which weakened the economy’s competitiveness and exacerbated the deflationary pressure in the country.

• To stem this appreciation, the Swiss central bank intervened in the FX market until mid-2010.

• The appreciation of the Euro was not a conscious ‘defection’ but a spillover of the ECB policy which in turn led to a conscious Swiss ‘defection’.

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Source: Oanda

0.50

0.55

0.60

0.65

0.70

0.75

0.80E

uro

s/S

wis

s fr

anc

Swiss Central Bank FX interventionOver $200 billion

The Swiss case shows that FX intervention may end up as a self-defeating process.

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• However, Switzerland is heavily dependent on the Euro zone, but the reverse does not hold. Therefore a conscious policy choice by Switzerland to ‘defect’ may not necessarily provoke a Euro zone ‘defection’.

• The Swiss case also shows that unilateral intervention in the currency market was unsustainable. Additionally, it suffered foreign exchange losses of $8 bn due to currency exposure.

• Would a coordinated decision between the two economies have led to a better outcome?

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Policy cooperation: the Franco-British Defence Cooperation Treaty (November 2010)

• The deal can be seen as an example of policy cooperation that captures international spillovers (regional security as a public good).

• France and the UK both seek to reduce government spending while maintaining a military force with a global presence.

• By cooperating on the defence treaty, both countries achieve a global military presence at low cost by pooling expenditure.

• However, if one country defects (i.e. reneges on the treaty), the other will also defect – it is in neither player’s interests to pool defence expenditure if the other is not doing likewise.

• If both countries defect, they each face higher expenditure to maintain a global military presence. This is a sub-optimal outcome – both are worse off than if they had cooperated.

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Why was cooperation possible in this case?

• Long-time horizons: Investing in equipment and developing research facilities is a long-term plan (typically looking over the next decade or so).

The are few short-term gains to be made from defecting, but the other country’s reaction (to defect in retaliation) will be prompt.

• Common Strategic Interests:Franco-British deal was a bilateral deal between two equally sized countries with common strategic interests.

Such a deal would be harder to strike with more countries with different interests, capabilities and priorities.

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What form should cooperation take?

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• The three examples considered in the earlier section depict the need for cooperation to address policy spillovers and achieve common goals.

• Nevertheless, credible cooperation seems to be only achieved when all the countries involved in the attempt are ‘diving’ together such as at the G20 London Summit or are bound together by strategic interests and a long time horizon such as Franco-British Defence Cooperation.

• Even with converging global goals, domestic objectives and priorities pose a threat to cooperative global outcomes – such as recent policies of quantitative easing and FX intervention.

• With diverging growth among member economies the G20 seems to be running out of steam. This raises the question what form should cooperation take.

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• Is multilateral cooperation the only way to solve global challenges? Can regional and bilateral arrangements help in achieving shared goals?

• Where domestic goals converge, regional and bilateral deals may facilitate cooperation (e.g. the Franco-British deal).

• Can higher levels of economic and/or financial integration among partners offer incentives to economic cooperation? – Integration may change the level of commitment towards cooperation by

affecting the size of spillovers.

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• While the G20 consists of some well integrated economies, this does not apply to all members. Moreover, it lacks binding commitment mechanisms. So where else is cooperation required?

• Consider the imbalances within the EU – the discussion concerning the global imbalances seem to mask the equally concerning imbalances within the EU.

• The EU is the most integrated economic bloc (around two-thirds of trade is internal) and does have binding laws on policy-making.

• Even with this degree of sophistication, its enforcement mechanisms have lacked credibility– e.g. France and Germany’s budget deficits breaching the Maastricht Treaty

in the mid-2000s.

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Regional imbalances: the European Union

Source: IMF

GreeceUKItaly

France

Spain

Netherlands

Germany

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5C

urr

ent

acco

un

t b

alan

ce (

% o

f E

U G

DP

)IMF projection

Imbalances within the European Union (% of EU GDP)

Fiscal consolidation in the euro areaConsider Greece and Germany

GDP growth (%, 2010)

Govt. debt (% of GDP, 2010)

Govt. deficit (% of GDP, 2010)

Export growth(% y-on-y, Q2-10)

Unemployment (% of workforce)

Germany 3.3 74.3 -4.5 17.8 6.7

Greece -4.0 130.2 -7.9 -5.0 12.2

Source: IMF projections, EurostatBackground:

Greece: high debt, rising unemployment and uncompetitive economy.

Germany: low budget deficit but high debt and low unemployment

Euro zone: Sovereign debt issues threaten the macroeconomic stability of the Euro zone (macroeconomic stability as a public good)

Objectives:

Germany: fiscal consolidation (domestic political reasons) and ensure macro- stability of the Euro zone.

Greece: fiscal consolidation but also boost economic output and job creation

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Fiscal consolidation in the euro area• In this stylised model, the desirable outcome is where, in the short-term

Germany, maintains expansionary fiscal policy to sustain demand for Greek exports. This allows Greece to enact fiscal consolidation without a severe output loss. Total demand is maintained, while growth and debt are rebalanced.

• Strategies:Germany – Cooperate: spending increase to maintain demand

Defect: insufficient spending increase.Greece – Cooperate: sufficient fiscal consolidation.

Defect: insufficient fiscal consolidation

Payoff matrix:

Cooperate Defect


Defect (4,1) (2,2)

Germany

Greece

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Fiscal consolidation in euro area

• The desirable outcome occurs when both countries cooperate. However, both countries face an incentive to defect.

• Germany will be unwilling to take on a high debt burden (for domestic reasons) to expand demand for Greek exports. For Greece, if Germany is cooperating, external demand is forthcoming so they can afford to run higher deficits, anticipating higher growth.

• If one country defects, it is in the interest for the other to also defect. – If Germany defects, Greece will face weaker external demand. Therefore, it

will have an incentive to not consolidate sufficiently in order to maintain domestic demand.

– If Greece defects, Germany, facing the risk of Euro zone instability, will seek to strengthen its own fiscal position.

• The outcome (defect, defect) may generate sufficient regional demand but exacerbate existing sovereign debt issues in the region.

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Concluding remarks

• Governments are confronted with shared goals at the global level and pressing concerns at the domestic level.

• With some countries and regions performing much better than others, domestic goals have taken higher priority.

• However, in an interdependent world, domestic policy interventions have international ramifications.

• A major economy’s policy choices have spillover effects and often provoke retaliation from other governments, causing the world to move away from cooperative processes to achieve shared goals and towards sub-optimal global outcomes.

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Concluding remarks

• Do governments account for policy spillovers in their decisions to intervene? If they don’t, can the existing policy tools be used to address them? If they do, can the domestic gains they obtain offset the risks arising from undesirable global outcomes?

• Ensuring cooperation to avoid undesirable global outcomes requires credible policy tools.

• Without binding commitments credible cooperation seems to be only achieved when all the countries involved in the attempt are ‘diving together’ or bound together by common strategic interests or long time horizons.

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Concluding remarks

• International fora should consider incentives to make the gains from cooperation compatible with domestic interests.

• There might also be instances when bilateral or regional arrangements present the best opportunity to achieve cooperation in solving global challenges.

• Otherwise individual countries will always be confronted with the option to defect if this will deliver a higher gain – no matter if it is unsustainable in the long run.

Education

Subacchi, Varghese, Jackson (London - Dec 2010)