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Analytical Studies

Objectives by Issue (Evaluative Criteria): 1999 Köln Summit

Macroeconomics and the New Financial Architecture

Introduction ~ Review of the Birmingham Summit
Priorities For The Cologne Summit ~ Issues Likely To Be Addressed ~ Conclusion

Introduction

With the creation of the Louvre Accord in 1987 (the agreement reached by the G7 to cooperate in stabilizing exchange rates), a level of stability and tranquillity has characterized inter-G7/G8 financial and exchange relations. In the 1990s, the real challenges to the G7, and now the G8, have been presented by crises outside its membership: the European Monetary System (EMS) Crisis of 1992 and 1993, the Peso Crisis of 1994, and the Asian Crisis of 1997-1998. The EMS Crisis affected the European members of the G7 while the Peso Crisis threatened Canada and the US through the newly formed North American Free Trade Agreement (NAFTA). In 1997-1998, the Asian Crisis not only exacerbated Japan's economic problems, but also had a serious effect on the Russian and Latin American economies. Moreover, this last crisis had the greatest impact given its lengthy duration, its economic and social devastation of the Asia Pacific region, and the repeatedly frustrated attempts to contain it.

Review of the Birmingham Summit

At the Birmingham Summit, the G7 Finance Ministers and Central Bank Governors made several recommendations to help strengthen the international financial system. In a joint statement on the world economy on October 30, 1998, the G7 Leaders reached agreement on a number of these recommendations. In particular, they agreed to:

  • promote greater openness in financial operations of individual countries, domestic financial and corporate institutions, and international financial institutions;

  • strengthen the international financial system by enhancing the surveillance of national financial and regulatory systems;

  • liberalize capital accounts in an orderly and progressive manner;

  • develop and implement measures to ensure the orderly and cooperative resolution of future crises, including mechanisms to involve the private sector; and

  • generate principles of good practice in social policy for the purposes of protecting the most vulnerable groups in society.

Priorities For The Cologne Summit

There are four main issues which ought to be addressed at the Cologne summit, with the first three having been prioritized in the wake of the Asian Crisis:

  1. Crisis Management
    • How and when should the G7/G8 intervene in financial and other macroeconomic crises?
  2. International Financial Architecture
    • How should the international financial system be reformed to prevent future crises and ensure global economic prosperity?
  3. Appropriate Exchange Rate Regimes
    • Is the current informal and semi-flexible exchange rate mechanism adequate?
    • What are the most appropriate exchange rate regimes for developing countries?
  4. Creation of the Euro
    • How will the creation of the euro affect the European Union and the European economy?
    • Who ought to control the euro?

The first two issues are clearly not new. In fact, they are the very questions upon which the Summit was founded to tackle in the mid-1970s, in the aftermath of the collapse of the Bretton Woods system and the disturbances created by the two oil crises. Moreover, they are the questions to which the Summit regularly returns. The most recent and serious attempt at reform was undertaken in preparation for the Halifax Summit in 1995, where the G7 Finance Ministers defined the following reform concerns at their meeting in February of that year:

  1. the capacity of institutions to respond to shocks;
  2. resource allocation;
  3. policy direction, including debt relief for the poorest; and
  4. management and governance centred around concerns about overlap and duplication among the many Bretton Woods- and UN-based institutions.

Added to these issues, are concerns over the social repercussions of financial crises and the need for creating social safety nets in countries that do not have them in order to minimize the human costs of financial disturbances. The third issue is somewhat more complicated. There are a number of academics in the field of international macroeconomics who claim that the current informal and semi-flexible inter-G7 exchange rate mechanism, the so-called Plaza-Louvre Accord, is not adequate. Some even call for the creation of what can be termed a G8 Monetary System (G8MS). The structure to be assumed by this system and its proposed membership vary from author to author, but the current models have several aspects in common. The proposed new exchange rate system is modeled on the EMS. A central role is assigned to the triumvirate of the United States, Germany (now replaced by the eleven countries adopting the Euro), and Japan - the so-called G3. All proposals call for the establishment of target zones or bands for bilateral exchange rates between currencies of the G3. In addition, the proposals recognize the need for coordinated foreign exchange interventions and harmonized fiscal and monetary policies between the G3 and other members of the G8MS.

In addition to these issues a possible additional concern is the question of rebuilding Kosovo and Yugoslavia. This will of course be contingent on the end of hostilities in the region. Once this happens the G8 will have the come up with a package for the economic recovery of the region. How ambitious this will be is still unknown, but some have seen it as a chance to stabilize the Balkans, drawing the analogy of the post WWII Marshal Plan.

Issues Likely To Be Addressed at the Cologne Summit

There are two conditions that will determine which of the four concerns will be addressed at the Summit and successfully resolved:
  1. the existence of a crisis; and
  2. consensus on systematic weaknesses and the type of reforms that will be needed.

1. Crisis Management

This is a very important issue that is likely to garner a lot of attention at the Summit. Indeed, in a statement made on the world economy on October 30, 1998, the G7 Leaders called upon their finance ministers and central bank governors to draft detailed proposals on crisis management which are to be addressed in Cologne in June. More specifically, the leaders of the G7 want their ministers to develop new ways to prevent and respond to crises, including developing new forms of official finance and investigating new methods of encouraging the private sector to play a greater role in containing and resolving crises.

2. International Financial Architecture

The restructuring of the international financial architecture, and more specifically, the regulation and supervision of financial institutions is also an extremely important issue which the leaders are likely to address in Cologne. In October, the G7 Leaders agreed to keep the following issues under constant review: investigating ways of establishing a process for surveillance of the international financial system that draws upon national and international regulatory and supervisory experts and brings together the key institutions and authorities, examining the implications of operations of highly leveraged and offshore institutions for the purpose of encouraging offshore centres to comply with internationally agreed standards, and assessing proposals for strengthening the IMF, including the Interim and Development Committees of the IMF and the World Bank. In particular, the leaders will call for greater progress to be made in the work of the newly established Financial Stability Forum.

3. Exchange Rate Regimes

Since it is primarily an academic concern and not one shared by the policy makers, the question of a new monetary system created by, and around, the G7 will probably receive no considerations. Furthermore, there is no indisputable and crippling defect or crisis in the functioning of the current Plaza-Louvre system that would compel the G8 to examine the possibility of the creation of a G8MS.

4. Creation of the Euro

The question of how the G8 will deal with the changes brought about by the euro is an extremely important one. The euro will be a major currency simply because of the strength of the European economy and due to the fact that it is heir to the deutsche mark, franc, and lira. In all likelihood, the introduction of the euro is the final stage in the evolution of a tripolar currency system. Additionally, if the Economic and Monetary Union (EMU) is successful, then the creation of a monetary union may be emulated by other regional organizations.

The most important question, however, is how the EMU, and the changes it imposes on the structure of Europe, will impact world monetary cooperation. Specifically, how will it impact the G8 and the future of exchange rate cooperation in the developed world? One only needs to consult the 1998 G8 Communiqué to see that the G8 has not adequately addressed this issue. The Birmingham Communiqué merely endorses the European Union's decision to begin the third stage of the EMU. However, it has taken no steps to address the implications that the EMU will have on both the functioning and structure of the G8. This attitude of the G8 is unacceptable, as the member states should be doing more to solve the problems arising from the emergence of the euro.

The problem of who speaks for the 'EMU-group' is also important. Currently, there is no strong and unified political counterpart to the European Central Bank (ECB) which has the capacity to conduct and negotiate international monetary policy. According to Maastricht, this responsibility will be delegated to the ECOFIN Council of Ministers. It is unlikely, however, that the ECOFIN Council of Ministers will be able to present a coherent position on external monetary policy of the early years, especially since the ECOFIN Council is represented by non-EMU members. Although recently this worry has been somewhat eased by the creation of the EURO-11, which consists of the finance ministers of the eleven countries that adopted the euro. Nonetheless, this development has caused some concern among academics who worry about the prospect of reaching decisions in the same manner as ones which are reached on non-EU trade - that is, reaching decisions officially, through a qualified majority vote, but in reality by means of the lowest common denominator. Academics charge that this process could lead to a halt in G7 cooperation on monetary policy issues. This concern is further complicated by the fact that Britain, a member of the G8 and of the EU, is not part of the EMU.

Another issue of great significance is how the system will function now that three members (Germany, France, and Italy) have merged their currencies and Britain has not followed suit. The fact is that this consolidation is not merely an aggregation of currencies but a change in the character of the participants where three relatively small and open economies are being replaced by one large and relatively closed economy. This transformation will mean that the new 'Euro-group' will most likely be less interested in policy coordination and currency regulation and more interested in letting its currency float. Such an outcome, however, will clearly depend on who becomes the dominant voice of European exchange rate policy. Indeed, the 'Euro-group' will likely engage in Louvre-type agreements and interventions to address misalignments, but only if such misalignments are severe enough to attract Europe's attention.

The lack of a strong and coherent central EU policy-setting institution should lead the US and Japan to pressure Europe to rationalize its monetary policy setting process. This is all the more likely to happen if severe misalignments occur. In the meantime, however, the decision to rationalize the process will be left to the discretion of France, Italy, and Germany. A likely compromised solution will be to expand the meeting of the finance ministers and central bank governors to include the competent representatives of the eleven EMU countries, without removing France's, Italy's, and Germany's representatives. These developments will clearly affect the effectiveness of the G7/G8 Summit process, as it may become more difficult to arrive at workable solutions on international financial issues.

Also of concern is how the introduction of the euro will affect the currently very sluggish European economy. There will likely be much proding by the US aimed at forceing the Europeans to stimulate their economy. The US will be equilly adament in its pressure on the Japanese to do the same. But, it is very much an open question as to how successful the US will be in this.

Conclusion

In short, there are four main macroeconomic issues which ought to be addressed at the Cologne Summit: the management of international financial crises, the restructuring of the international financial system, the sustainability of exchange rate regimes, and the implications of the creation of the euro. Of these four concerns, the first two are likely to garner the bulk of the Summit's attention while the third issue, the sustainability of exchange rate regimes, will likely receive no consideration. Finally, the implications resulting from the creation of the euro serves as an important issue that ought to be addressed in Cologne, although it has not received considerable attention in the past.

How far the G8 will advance on these issues, and in particular, on the first two, is entirely a different question. Some progress will be inevitable given the recent experience of the Asian Crisis and the general consensus among the G8 that some reforms are necessary. However, sufficient disagreement remains to make only marginal progress likely. This is all the more so given that the institutions and bureaucracies involved (the central banks, the IMF and others) favour a more gradual evolutionary process of change while some politicians prefer revolutionary and sweeping reforms. The question of reform of the international financial system is one that the G8 Leaders and Finance Ministers will have to return to in the next couple of Summits

Compiled by: Ivan Savic, Eleni Maniatis, Diana Juricevic
June 1999

~ Objectives by Issue (Evaluative Criteria): 1999 Köln Summit ~


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