In turbulent times, one naturally grasps for policy solutions. When policies at one level seem ineffective, some turn to policy cooperation at a higher level. For example, in a much-discussed 2014 speech, then-Governor of the Reserve Bank of India, Raghuram Rajan called for more coordination and cooperation of monetary policy.
What could be wrong with coordination and cooperation? Surely no one would support miscoordination or the lack of cooperation.
In fact, there are two reasons monetary policy cooperation might backfire. First, the coordination may not ultimately come about. Policymakers cheat. And, even if people agree at some point to work together, they might renege down the road when their incentives change.
“We all agree to maintain fixed exchange rates,” they say. But when the economy of your country slows down, you want to inflate. So you do and the exchange rate is no longer fixed. Coordination did not work.
When cheating occurs, coordination is not the problem. It is really the lack of coordination. The coordination agreement pre-slowdown does not lead to coordination of actions post-slowdown because there is a commitment problem. Honorable intentions do not turn into results.
But even when countries do cooperate, policy coordination may backfire. One way is that, when policies are coordinated together, contagion is more likely. The whole system is tied together. Indeed, that’s purpose of the cooperation. But a consequence of such an arrangement is that all of the policy eggs are in one metaphorical basket.
“We all agree to maintain fixed exchange rates,” they say. And they do. But, then, when the economy of your country experiences problems (e.g., natural disaster), problems spill over into the other cooperating countries. Without policy coordination, the shock might not have spread as much.
In a recent NBER working paper, Michael Bordo, Eric Monnet, and Alain Naef explore a historical situation where monetary policy coordination went awry: The Gold Pool (1961-1968). The authors argue that a shock to the pound sterling spread to the U.S. dollar and then to gold. The breakdown of the entire Bretton Woods system soon followed. The problem for the Gold Pool was not a breakdown of coordination. It is that coordination was maintained.
Both problems of coordinating policy—cheating and contagion—have arisen throughout history. At a minimum, it should give us some pause when new efforts to coordinate policy are proposed.