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European Affairs
Finance and Banking
Monetary Policy: Working Together Across the Atlantic
Henry Willmore
Chief U.S. Economist, Barclays Capital
There are two broad reasons why European and U.S. monetary policies should be coordinated. The first is that countries are sometimes tempted to conduct policy in a way that solves their own problems but creates difficulties for other countries. If that is done too often, the other central bank reacts, and a "zero sum game" or a "negative sum game" usually ensues. Those kinds of policy choices should be avoided because they make everyone a loser.
The second reason is that mistakes are occasionally made in the private sector, usually in the financial markets. As the financial crises in Asia, Latin America and Russia demonstrated in 1997 and 1998, those kinds of mistakes can have serious consequences for other economies. When policy-makers agree that the financial markets have gone seriously wrong, a good case can be made for a coordinated response.
Competitive devaluations are obvious examples of policies that are adopted at the expense of others. Coordination could avoid the problems that would arise if the European Union and the United States both tried simultaneously to increase or to lower the values of their currencies so as to stimulate growth or control inflation.
Countries are tempted to engage in such policies when there is a negative external shock, such as the two big oil price rises of the 1970s or the Gulf crisis after Iraq invaded Kuwait in 1990.
Most economists are not yet ready to label the recent rise in oil prices a shock of the same magnitude. But the longer oil prices stay high, the more important a factor they will become in the calculations of central banks, with regard to growth or inflation. With these kinds of episodes, attempts to manipulate exchange rates for domestic purposes, at the expense of other countries, may seem particularly appealing.
The obvious example of a mistake by financial markets is the Asian financial crisis that began in Thailand in 1997. One might argue that policy-makers contributed to the problem, but private investors were largely to blame. No one forced investors to invest massively in Thailand. They decided to do so by themselves, even though Thailand was running enormous current account deficits, which eventually proved unsustainable.
That was arguably an instance when policy-makers should have taken early joint action. An agreed response might have prevented the development of such large imbalances and the subsequent contagion that did so much damage to other economies around the world.
The interesting question is whether circumstances exist today that warrant a response by central banks. The biggest misalignment that comes to mind is the U.S. current account deficit, which now stands at well over four percent of GDP.
Back in the mid-1980s, after the dollar's big appreciation, the current account deficit never got much larger than three percent of GDP. We are clearly in a range that we have not seen before.
There are some aspects of this that make it a difficult call for policy-makers. One could argue that the private sector has been reacting rationally to differing outlooks for growth, profits and returns in general in the United States and in the euro zone.
In the United States, one could say, there has been a great deal of investment and rapid technological change. The outlook for profits is better than in Europe. The magic of Silicon Valley is powering the U.S. economy, but has not had such a significant effect on the other side of the Atlantic.
For these reasons, it may make sense for Europeans to invest heavily in the United States, because the returns will be superior. That thinking is behind all the European purchases of American companies, apparently largely inspired by a belief that there is some sort of "American know-how" that can be only acquired through takeovers.
The main examples are in financial services, although there has been quite a bit of activity recently in the field of electronic commerce. Given the length of the U.S. expansion, and the possibly superior dynamics of the U.S. economy, it has made sense for European investors to do this. But it is difficult for policy-makers to decide whether some sort of intervention is necessary to steer markets in the right direction.
People like Alan Greenspan, Chairman of the Federal Reserve Board, and his counterparts at the European Central Bank have to decide whether they agree with the view that the high current account deficit is justified by a superior outlook for the U.S. economy. If they think the view is exaggerated, and that a big element of the deficit is unjustified, it is important that they say so.
If they do not, the markets will eventually correct the problem. But the longer policy-makers stay silent or ambiguous, the larger the misalignment becomes, as demonstrated by the recent examples of Russia, Asia and Latin America.
I am not calling for dramatic action by policy-makers. But if the ECB and the Fed agree that there is a big element of unsustainability in the current account deficit, the coordination required is fairly simple: the two central banks should send a unified message to the markets. It need not be repeated very often, just every now and then.
Financial markets listen to policy-makers, and particularly to Mr. Greenspan. Europeans should also be heard. But the markets are more likely to listen to them if they are speaking with a single voice and their message is clear. Central Bankers in Frankfurt could take lessons from the way that Washington has learned to transmit a single, steady signal on the dollar, by limiting the number of voices that are permitted to be heard.