What happens when countries' economic policies diverge? The European Central Bank's (ECB) decision to increase interest rates in the eurozone from 1% to 1.25% seems at odds with the US Fed's decision to continue its accommodating monetary policy.
Will the ECB's decision undermine growth in the euro area while 'exporting' inflation to its main trade partners? Will the Fed's policy stance push the burden of the US recovery to other countries, in particular emerging market economies?
Countries' domestic economic policies can have a global impact. Over the last twenty years the world economy has become more integrated through a complex network of trade and financial linkages. Prosperity has increased as a result, but so too have economic interdependencies.
The complexity of interdependencies, and our inability to understand them fully, became evident during the recent economic and financial crisis. What started in August 2007 as an episode of turbulence in the subprime niche of the US domestic mortgage market turned out to be the beginning of a far-reaching global crisis, with shockwaves extending to economies around the world. Even countries that were thought to be safe because of their relatively modest size and limited financial sectors were affected.
International impact assessments
A new report jointly published by Chatham House and CIGI calls on governments to evaluate thoroughly the international implications of domestic economic policy decisions before these policies are implemented. Domestic policies with internationall ramifications should be accompanied by international 'impact assessments'. Such recognition, and the resulting international accountability, could provide a step-change in the way nations think about policy-making and about which policies are considered to be in the national interest.
In practice, this means that in deciding monetary policy the ECB, for instance, takes into account international spillover effects - positive and negative - of its decisions. Domestic considerations would inevitably have a greater weight in the final decision than international considerations, but embracing the practice of assessing spillover effects could help reduce international instability and national exposure to high-impact shocks.
The recent financial crisis generated an unprecedented period of international policy cooperation. This was relatively easy when countries were experiencing a synchronized fall. But in the post-crisis world the need for cooperation will be less obvious. The relative decline of advanced economies and a more unbalanced world economy, as well as a persistent divergence in fiscal stances among G20 members, are leading to unilateral policy actions and a political discourse that tends towards a zero-sum game mentality. In addition, lack of follow-through on commitments made at the time of crisis poses a risk to the sustainability of progress to promote global economic and financial stability.
The G20 should lead the way
The challenge today is to foster an understanding that the benefits of an internationally integrated economy do not come without increasing national exposure to shocks, and that it is in each country's national interest to manage pressures in the system through a framework for multilateral policy cooperation.
The Chatham House-CIGI report sets out a schedule for G20 leaders to achieve more cooperative solutions to international economic challenges. The G20 can play a key role in promoting a framework for international policy cooperation that not only prevents future crises, but promotes growth. Policy cooperation lies at the heart of the G20 - it is its raison d'être. The G20 proved to be effective at firefighting during the financial crisis, but now it must look beyond its role as a 'crisis steering committee' and promote international policy cooperation as the normal practice in policy-making.
Preventing Crises and Promoting Economic Growth: A Framework for International Policy Cooperation
Chatham House/CIGI Report
Paola Subacchi and Paul Jenkins, April 2011