Knowing one's deficits

In Max Corden we have one of today's leading international economists. And in his latest book we surely have an essential addition to the library of any serious student of international monetary economics.

I was particularly attracted to Corden's treatment in part one of the book, which deals with open economy macroeconomics, of two issues that lie at the heart of the current policy debate. How important is devaluation as an instrument for policy adjustment? And do balance of payments deficits matter? Corden sees the answer to the first question as depending on the extent to which devaluation can succeed in lowering real wages in the short-run. In the long run, nominal wages will catch up with prices eliminating the competitive gains brought by devaluation. Corden devotes a chapter to a discussion of the merits and demerits of tying the exchange-rate to a "nominal anchor" such as the United Kingdom attempted when joining the European Monetary System in October 1990. He concludes that while a case can be made for an inflation-prone country adopting such a policy, it is not a strong one. Changes in nominal rates are needed to adjust to exogenous shocks, while the costs of failure are severe. This was surely the lesson to be drawn from Britain's sudden departure from the EMS following "Black Wednesday" in September 1992. If credibility is to be established, the authorities must be prepared to raise short-term interest rates to whatever level is required regardless of the cost to the real economy.

With regard to whether balance of payments deficits matter, Corden successfully demonstrates that, in the current climate of private capital mobility and where a deficit is a reflection of an excess of private investment over private savings, governments are mistaken in worrying unduly about the current account. Only if the current account deficit causes an excessive appreciation of the real exchange rate that inflicts lasting damage on the tradable goods sector, or excessive borrowing by certain private investors (by raising country risk) has a contaminating effect on other borrowers, need the authorities be concerned. Where, however, current account deficits are the result of a budget deficit, the deficit does matter, but then it is the budget deficit which needs correcting and not the current account deficit.

I found part two, which deals with the EMS and monetary integration, the most interesting section of the book. Corden's analysis of monetary integration makes it clear that, whereas a single currency in Europe will have benefits, these cannot be achieved without some cost. If that cost is to be minimised, Europe must give serious thought to how downwards wage flexibility can be increased. Labour mobility within Europe is too low to be of any help, although capital mobility may be able to play a role in helping member states adjust. Large-scale fiscal transfers could play a role, as in German monetary unification, but this will imply an integrated tax and benefits system on a scale which is certain to be rejected by the member states.

In chapter ten, Corden rightly questions the strength of the political commitment of member states which is necessary if the gradualist approach to unification is to work. If rates are to be kept stable in the run up to unification, markets must be convinced that member states will adjust monetary policy to support fixed rates, come what may.

Corden is critical of the long transition period and tough convergence conditions stipulated in the Maastricht treaty. He sees the latter as creating "unnecessary obstacles" to the monetary integration process included largely for the benefit of the Germans concerned about inflation in other member states. Not surprisingly, few countries have succeeded in fulfilling the requirements. One wonders whether the cause of European monetary union might have been better served had Maastricht adopted the "all-at-once" or "giant leap" approach. That could have taken the form of a single currency being introduced at an agreed date, initially alongside national currencies, but eventually replacing them, and the immediate establishment of a European Central Bank with a common monetary policy.

Part three deals with the post-Bretton Woods system of managed floating in an environment of enhanced international capital mobility. The section finishes with an interesting discussion of "target-zones" and other rules-based schemes for achieving greater international macroeconomic policy coordination. Corden is sceptical about the target zone proposal first advanced by John Williamson whereby countries would use monetary policies to stabilise exchange-rates within a pre-agreed range. He sees the benefits as few since central rates would still be alterable, while the need to make elaborate calculations of fundamental equilibrium exchange rates, and secure agreement on these rates, would make the system unworkable. One wonders, however, whether Corden underestimates the gains to be reaped from eliminating severe short-term fluctuations. The large and contradictory swings in the yen-dollar and Deutschmark-dollar rates over the past 12 months have imposed a heavy cost on both the Japanese and German economies which could have been avoided had G7 central banks acted earlier and with more determination to prevent rates from drifting.

In part four, Corden returns to the subject of exchange rate protectionism developed in his earlier works. He is surely right to caution developing countries against seeking to stabilise exchange-rates -through the use of a nominal anchor - in advance of a policy of trade liberalisation. However, I remain unconvinced that, on balance, a flexible exchange rate regime is more likely to avoid increases in protectionism than a fixed one. If, as Corden argues, intra-European exchange rate fluctuations are not harmful to the goal of a single market, it is desirable that countries should retain the power to devalue so as to restore lost competitiveness or to counter adverse shocks. However, as the recent experience of wider bands within the EMS has demonstrated, large, uncontrolled devaluations increase tensions between member states and increase pressures for a protectionist response.

The institutional/legal issues at the centre of current trade policy debate are splendidly dealt with by Michael Trebilock and Robert Howse of Toronto University in The Regulation of International Trade. This neatly combines an up-to-date exposition of current regulatory law, including the results of the recently concluded Uruguay Round, with a good understanding of the theoretical issues which underlie the arguments of liberal trade economists on the subject matter. This makes the book a very useful text for students of both economics and international law and one which reveals the extent to which these two disciplines depend on each other. A particularly valuable feature of the book is the in-depth treatment which it contains of the North American Free Trade Area agreement written from the viewpoint of two Canadians.

The book provides a comprehensive coverage of the subject of trade regulation. The first three chapters provide the background with a discussion of the intellectual and institutional history of trade policy, an examination of the treaty framework and a discussion of the link between trade policy and exchange rates. The remaining chapters contain in-depth analysis of the main areas of trade regulation, including both "old issues" such as tariffs, antidumping, subsidies, trade adjustment policy and agricultural protectionism and the "new issues", such as trade in services, trade-related intellectual property rights (Trips) and trade-related investment measures (Trims). In each case, there is an extensive treatment of both the legal and economic issues involved. Later chapters address some of the issues which are fast becoming concerns dominating the newly-created World Trade Organisation, including trade-related environmental issues and labour standards.

Nigel Grimwade is principal lecturer in economics and head of economics, South Bank University.