International Policy Coordination in crises-- Failure of “Beggar-Thy-Neighbor”
Zizhu PAN
Abstract: Based on the 1979 Oil Crisis and Asian Crisis, this paper builds a simple two-country model to explain the failure of non-cooperative strategy during the crises.
Keyword: Policy coordination, Beggar-thy-neighbor, Oil Crisis, Asian financial crisis
Introduction:
With central banks working more closely together than ever, the current financial crisis has been an occasion for international policy coordination. The importance of macroeconomic policy coordination, no doubt, is the most important lesson the world has learnt from the historical crises. However, during the crisis, countries attempt to remedy the individual economic problems by means which tend to worsen the problems of other countries; such is defined as “Beggar thy neighbor”. The non-cooperative strategies taken during the 1979 Oil Crisis and Asian Crisis significantly pulled down the world economy. Our goal in this paper is to recast the arguments for coordination in terms that consider two symmetric countries’ macroeconomic goals so that to evaluate if the they can each raise economic welfare through coordination. We illustrate that non-cooperative policy making in a two-country model with flexible exchange rates is likely to result in Pareto inefficient equilibria.
In sector one, we will briefly introduce the negative impact of non-cooperative strategies in two major economic crises. Sector two we will build a simple model to explain the failure of non-cooperation and the benefits of coordination intuitively. Sector three states that the existence of uncertainty and lack of clear rules cause the difficulty of coordination. To overcome the obstacles, transparent information and existence of reputation are essential.
1. Historical experiences of financial crisis
Before introducing our model, we need to turn to two major crises to understand the importance of coordination policy. Both have illustrated the failure of “Beggar-thy-neighbor” policy, but in different ways. 1979 Oil Crisis was worsened by the over-contrationary policies; while the Asian Crisis was caused by “competitive devaluations”.
1.1 1979 Oil Crisis
In 1973 and in 1979-1982, there were two dramatic increases in price of oil, which dragged the world economy into the biggest recession since the Great Depression. The interesting point is that facing the same price shock, policy makers adopted two completely different macroeconomic policies in 1973 and 1979. A supply shock situation such as Oil Crisis brings about inflation and high unemployment rate—“stagflation”. Fighting against high unemployment rate leads one to choose expanding policies, which would further worsen inflation. In 1973 crisis, the Western nations' central banks decided to sharply cut interest rates to encourage growth, deciding that inflation was a secondary concern. As a result, a continuous high inflation eroded the health of world economy. In facing another Oil Crisis in 1979, U.S began to adopted the most politically unpopular monetary policy—contraction, which led dollar to appreciate. Dollar’s appreciation passed though the inflation pressure to other countries. In fighting towards the strong dollar, Europe and Japan had to contract as well. Lacking of policy coordination, monetary restrictions in all major countries led to excessive world contraction. Our model in sector two will illustrate the failure of “Beggar-thy-neighbor” policy in 1979 Oil Crisis
1.2 Asian Crisis
The global financial crisis that began in Thailand in 1997 had grown far larger than expected at that time. What many predicted to be no more than a slight blip in unrelenting advance of international capital markets has instead become the gravest threats to the stability of the world’s market economy since the Great Depression and Oil Crisis. The devaluation in Thailand triggered the domino effect—Asian currencies began to devaluate one by one, such as the so called “competitive devaluation”. The domino eventually stopped when China promised not to devaluate despite a huge loss.
The lesson to be learned from the historical experience is that international policy coordination is preferred to pursuing independent strategies that attempt to make one country better off at the expense of others. In order to clearly and intuitively demonstrate this conclusion, next, we are turning to a simple two-country model.
2. A two-county simple model
First of all, there are several assumptions about this model. (1)There are two exactly identical countries--home country and foreign country. (2) The exchange rate is floating. (3) Social welfare loss is defined as the deviation of price and output from the natural level in quadratic form.
The domestic economy produces an output at the price P. Home output competes with foreign output at the price P*. The exchange rate “E” stands for unites of the home currency per unit of foreign currency. An increase in “E” implies a depreciation of the home currency. The real exchange rate Q for the home economy is defined as. It is important to keep in mind that Q could be interpretated as “terms of trade” (tot). As Q increases, the foreign goods become relatively more expensive in home country; therefore, home country gains an advantage in international trade. Taking the log form of each variable, we get equation one as follows.
-------------------------------------------------------------------------------- (1)
A weaker currency (high e) spurs output (y) at the expense of output and abroad (y*) . In another word, the demand for home goods relative to the foreign goods is an increasing function of q.
----------------------------------------------------------------(2)
------------------------------------------------------------------------------------(3)
Next, we turn to aggregate supply and price level determination.The consumer price level, , is a geometrically weighted average of home and foreign goods prices. Foreign goods prices could be expressed in term of home currency by. Therefore, we have home CPI defined as. Denoting the logarithms of upper-case price variables by lower-case variables, we have—
----------------------(4)
-------------------(5)
Every economy has a natural status, where the economic target is achieved. We suppose the price and output level at the natural status are zero. When there is a shock in the economy, both the price and output adjust according to the shock. Denoting the natural status price level by and economic shock by s. B is the coefficient of shock, measuring the sensitiveness of price to a shock.
=0+Bs=Bs--------------------------------------------------------------------(6)
=0+Bs=Bs------------------------------------------------------------------(7)
Plugging equation (6) and (7) into (3), (4) and (5) yields:
-----------------------------------------------------------(8)
------------------------------------------------------(9)
We induce a parameter to simplify our equations. Intuitively, 1-measures the weight of imported goods in one country. The larger 1- is, the more CPI reacts to exchange rate changes. Equation (8) and (9) combined together intuitively describe the situation of 1979 Oil Crisis and Asian Crisis.
When the price shock is positive (s>0), each country has an especially strong temptation to contract. A contractionary policy such as appreciation (q decreases) makes home country’s exported goods relatively more expensive and imported goods much cheaper. By currency appreciation, one country could pass though inflation to others by exporting inflation and importing deflation. However, one country’s contractionary policy is the other country’s expanding pressure; one’s appreciation is the other one’s depreciation. With all countries appreciating at the same time, these attempts will all be canceled out; no one achieves a currency appreciation. While the world economy ends up in a stagflation situation.
However, when the price shock is negative (s<0), is the situation during the Asian Crisis. The fear of deflation during the recession drives countries to depreciate (increase q). But one country’s depreciation is the other countries appreciation; therefore, other countries have to depreciate even more to retaliate the first “devaluater”. This eventually leads to an over-depreciation situation, which will be showed in figure 2 later.
Next, we introduce the welfare function. Welfare loss is measured in terms of the deviations from natural price level and output level. Since we defined the natural level price and output both equal to zero, the loss function could be expressed as :
-------------------------------------------------------------------------(10)
-----------------------------------------------------------------------(11)
The policymakers are assumed to select a rule for the policy variables to minimize a quadratic loss function consisting of deviations in output and inflation from desired levels. Minimize the loss function yields:
-------------------------(12)
-------------------------------------------------------------------(13)
Equation (12) and (13) are the best reaction functions (BCF) for the two countries.
2.1 Positive price shock—1979 Oil Crisis
Figure 1 (s>0, 1979 Oil Crisis)
As showed in Figure 1, point A is the minimum loss point for foreign country, while B for home country. For example, at point A, the output of foreign country remains at zero level; while the shock is undertaken completely by home country, which is the most desirable outcome for foreign country. The dashed ellipses centered on A and B measure the welfare loss suffered by foreign country and home country. Moreover, welfare loss gets larger as the ellipse gets further away from its centre.
The intersect (point C) of two BRF lines is the Nash Equilibrium in our game. Starting from whatever point, the final equilibrium will converge to point C. Suppose that initially the game starts from point A. Home country finds it pays to decrease output. Witnessing home country’s cut in output, foreign country will decrease as well by moving left to the BRF* again. This time, home country will decrease even more in output by moving downwards. Eventually, the equilibrium converges to point C, where no one finds the benefit to deviate any more.
Unfortunately, any point northeast is better than point C. Nash Equilibrium leads to over-contractionary policy, where countries over-tighten their economies. Both countries have high unemployment rate and inflation at point C, exactly the same as the stagflation during 1979 Oil Crisis. The failure of non-cooperative strategy is that when making the decision, each country tries to insulate itself from others. But the negative spillover destinies the inefficiency of such non-cooperative strategies. On the other hand, if coordination policy is induced, both countries will be better off. Assume that we manage to combine these two countries together and the policy maker is assumed to minimize loss function considering the two countries as a whole. Since the policy maker has two identical countries, the coordination equilibrium must be the origin point, where y=y*=0, = *=Bs. Compared with point C, where ,= *=Bs, coordination is absolutely a dominating strategy. And the loss of not coordinating is measured by for each country.
2.2 Negative price shock –Asian Crisis
Figure 2 (s<0, Asian Crisis)
Following the same logic, point C is the converging Nash Equilibrium. While origin o, the cooperative point, is the dominating strategy. Each country tries to spur output by depreciation, because depreciation increases the competiveness of traded goods. Devaluation of one’s currency makes exports cheaper and more competitive, while shifting the demand from other countries to its own. Holding that, each country wants to devaluate more in order to be competitive in international goods market, which resulting in competitive devaluations. But when all try to devaluate, no one gains, and confidence runs out. The negative spillover that one has on the other determines the failure of non-cooperative strategy.
The problem with each country pursuing individual benefit is that it is clearly beggar-thy-neighbor in character. Under a coordination policy stance, however, this negative externality would be internalized and this time a socially desirable level of contraction or depreciation would be achieved.
3. International Coordination and obstacles
Having learnt lessons from historical crisis, the international community set out to implement international policy coordination after World War II. The two most prominent international agencies that emerged were the International Monetary Fund (IMF) and the General Agreement on Tariffs and Trade (GATT). Group seven countries have met periodically to coordinate their policies since 1985. The ASEAN member countries have included the macroeconomicpolicy coordination on their agenda since the crisis in 1997, and established as well anEconomic Review and Policy Dialogue, including Japan, China and Korea, in November1999. The Japanese Vice-Minister of Finance advanced a proposal for an Asianmonetary fund in 1997, but the idea was strongly opposed by the United States and theIMF, and subsequently abandoned. Recently, the closed and homogenous macroeconomic policies set out by U.S. and European Central Bank (ECB) have given current market very positive impacts especially at this worst moment. All these policy coordination prevent the world from repeating the historical mistakes.
However, coordination is never an easy goal to achieve. Recently, China has begun to devalue the yuan for the first time in over a decade, raising fears that it will set off an Asian-Crisis-style race to the bottom and tip the global economy into an even deeper slump. If countries decide to play this beggar-thy-neighbor game, it will cause a deflationary shock for the whole world. Given all our knowledge about the benefits of coordination, deviation still exists, due to the obstacles of cooperation.
Theoretically, one could always find it benefit by unilateral cheating in short term, at least before the retaliation of others. Moreover, the late runners always undertake bigger losses; such is true during the Great Depression. The earliness a country left the gold standard reliably predicted its recovery from the depression. Therefore, it is essential to make everyone believe that the long-run gains of continuing to abide by the coordination outweigh any short-run gains to be had from unilaterally abrogating the agreement.
However, uncertainty of the economic model obstacles the form of agreement first of all. In our paper, we simply assume the loss function is in quadratic form taking into account the deviation of price and output, yet none having yet established itself as the most reasonable one. Over and beyond the debate on the scale of the gains to be expected, a certain number of factors make implementing coordination harder.
Secondly, a lack of surveillance and punishment mechanism turns agreements into empty talk. Therefore, joint targets should be publicly announced, rather than kept secret. Members must be able to monitor each other’s compliance. Punishment is not easy to apply on national level. However, the existence of reputation, are probably sufficient to enforce coordination.
4. Conclusion:
The world learned painful lessons in game theory during the several major crises. By adopting individual dominant strategy, each country had worsened and deepened the overall loss of the depression. Noncooperation is never the better off strategy in this case; such is the failure of beggar-thy-neighbor protectionist policies. Non-cooperative strategies in the 1979 Oil Crisis and Asian Crisis had worsened the world economy. Had the coordination been adopted, both crises wouldn’t spread to a world-wide disaster. Although coordination strictly dominates non-cooperative strategy, in reality, it’s difficult to make agreements among countries, due to the uncertainty and a lack of surveillance and punishment mechanism.
Reference:
1. Sachs, Jeffrey and Gilles Oudiz, “Macroeconomic Policy Coordination among the Industrial Economies”, Brookings Papers on Economic Activity, 1984:1, p. 1-64.
2. Frankel, Jeffrey and Katharine Rockett, “International Macroeconomic Policy Coordination When Policymakers Not Agree on the True Model”, American Economic Review 78(3), June 1988, p. 318-40.
3. Ralph C. Bryant, Brookings Institution, International Monetary Fund, Centre for Economic, Macroeconomic Policies in an Interdependent World, International Monetary Fund, 1989, p.15-23.
