European Economic Review 18 (1982) 81-84. North-Holland Publishing Company

COMMENTS .

‘The Transmission of International Disturbances: A French-German Cliometric Analysis, 1972-l 980’

by de Mknil and Westphal

Terry BURNS

H.M. Treasury, London SWIP 3AG, UK

This paper sets out to achieve a difficult objective - to compare the response of the French and German economies to the international disturbances of the past eight years. To do this comprehensively would be a very ambitious task.

The technique adopted here attempts to do this by simulation experiments using two large national quarterly econometric models. A basic solution is set up by applying residuals to each behavioural equation so that the model solution tracks the actual outcome. Alternative scenarios are then produced corresponding to changes in one or other of the important exogenous variables. As the authors stress this is very much a partial approach. The simulations are not complete assessments of the consequences of, say, an oil price shock. They show merely the isolated view of the effects of, for example, an increase in the real price of oil on the French and German economies. As we shall see this causes some major problems of interpretation.

The paper contains a very brief historical description and more detailed tables as an annex. There is little mention of policy responses and, indeed, policy reaction functions are absent from the simulations. We are familiar with the general story for the post-1972 period. World inflation accelerated, output slumped in 1975 and on average grew distinctly less rapidly over this period than over the previous 10 years. Unemployment rose sharply taking one cycle with another. Over the period 1973 to 1980, France had an annual inflation rate of 11%. Growth averaged 2.9% and unemployment rose every year from 1972 onwards from 2.3% in 1973 to 6.3% in 1980. The effective exchange rate in 1980 was 10% below its 1973 level. German inflation was a little under 5% over the same period; growth averaged 2.4% and its effective exchange rate rose 35% over the seven years from 1973. Unemployment rose initially from 1.1% in 1972 to

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82 T. Burns. Comments on the de Me’nil und Wesrphal paper

4.7% in 1975 and then declined to 3.8%. The DM-FF bilateral rate changed between 30% and 40% over the period. It would perhaps have been useful to have included a brief pre-1972 comparison. In particular it would have been interesting to know how far the French/German inflation comparison has changed since 1972, and how relative growth has changed pre- ‘and post- 1972. Does a casual examination of the data suggest that the strong exchange rate, anti-inflationary German policy has led to slower growth relative to France? At a first glance it does not seem to have added to relative unemployment but obviously there are other factors at work.

What can we learn from the results of the six simulations? Examining the results of models is always a chancy business. It is often difficult to decide whether simulation results tell us more about the model than about the real world. I would first like to make a general point about the methodology. If it is to succeed, this kind of exercise must involve sequential changes of exogenous variables. But of course we can never agree what is truly exogenous apart from time. In my view this study suffers primarily because of its particular specification of exogenous variables. Is it helpful to divide the effects of higher world oil prices, higher world inflation and lower world output in this way? For example the partial nature of the simulations gives the result that a rise in world inflation leads to a boom in German and French output.

I am prepared to accept that a large part of the 1973 oil price shock was exogenous - and maybe even more of the 1979 shock. But some of the oil price rise was undoubtedly the result of the excessive world demand created in part by the failure of governments to appreciate how the unemployment rate, consistent with stable inflation, had moved up. Given the excessive world demand and the exogenous oil price shock, much of the subsequent high inflation and low output followed. Governments tightened policy in 1974, and in Europe again in 1977, and expanded in 1978. The response pattern in Stanley Fischer’s paper which he describes as the result of shocks to relative prices corresponds to my interpretation of the result of the oil price shock. I would argue that the shocks and responses presented in this paper need looking at as a series of packages of the simulations presented here, if we are to get sensible results. Thus the first simulation might be the oil price change plus that part of the change of world inflation and world output that we think followed from the change to oil prices. A second simulation might then look at the additional slowdown in world output that needed to be explained - Nordhaus’ paper dealt with this. A third simulation might have been the upward trend of inflation that is independent of oil prices and which has been evident since about 1960. This phenomenon should ideally be bracketed with the domestic policy responses and the exchange rate changes if they are to form a coherent package of the relative effects of these pressures on individual countries. In other words,

T. Bums. Commenls on the de M&nil and Westphal paper 83

rather than a series of separate exercises we need to think carefully of groups of effects that make for a coherent simulation exercise, preferably with some endogenous policy responses although I appreciate the difficulties involved in that. To do this would require a careful analysis of the causes of and responses to each cycle. To some extent this might seem like a demand for a world model to which the individual models can be attached. That would not be feasible but without some attempt to relate the shocks to each other we are left with a sense of simulations that are difficult to interpret and compare.

Turning to the numbers themselves, my instinct is that in general the responses appear to be too small. By 1980 world production is 14% below trend, on the basis of calculations used to derive the imaginary paths of output used in simulations, and the world price level is 80% above trend. But according to the calculations for France, the combined effect of these two simulations plus the oil and commodity price shocks and the exchange rate simulations was to lower French output by 7% and raise prices by some 20%. The combined effect is estimated to add only 1.2% to the unemployment rate.

One reason for believing that the estimates given here may be an underestimate is the observation of the remarkable similarity between French and average world experience over the historical period for both trend output movements, cyclical variations and inflation changes. I admit that this comparison is not very rigorous, but it is nonetheless striking. ,I would have expected that the combination of factors listed above should explain a larger proportion of the shortfall of output and excess of inflation over historical trends. In part this apparent discrepancy possibly arises because of the model and partly because of the absence of policy responses. The broad specification of the model used is given together with some coefficients. But the lag structures are not revealed in detail. Some of the questions on international linkage in the model that emerge are:

(i) the use of absolute rather than relative capacity utilisation terms in export and import functions. Should not a fall in world output relative to domestic output make exporting more difficult and imports more likely?

(ii) the apparent absence of inflation effects depressing domestic demand. If anything they seem to increase it by raising the terms of trade and lowering real interest rates. The only offsetting effect is from fiscal drag, unless the wealth term in the absorption equation is endogenous.

(iii) the absence of strong international monetary effects through either the balance of payments or the exchange rate (which is adjusted in such a way as to maintain long-run purchasing power parity).

84 T. Burns, Comments on the de Meidl and Wesrphal paper

The policy response problem shows up most clearly in the balance of payments effects. By 1980 the combined effect of all shocks is to produce a French current account deficit equal to 4% of GDP. I would expect that any automatic or policy induced process to remove this would lead to both lower output and higher prices.

Overall I would like to stress the problems of using models for this kind of simulation exercise. Even though equation residuals are added back to the model equations for use in simulations, the validity of the simulations will

.depend in part on the validity of the model in representing an accurate description of the events that haue taken place. There is little discussion of the tracking performance of the two models used for France and Germany, and on the degree to which they are better simulation rather than forecasting models. Neither is there any discussion of potential nonlinearities in relationships, or of the pros and cons of multiplicative and additive residuals. One important aspect of the validity of using the models for simulations is touched upon; even if the models have perfectly well explained the past, the Lucas critique regarding expectations and the need to consider policy reaction functions are clear reminders of the limitations of this type of exercise. But despite all this some interesting comparisons between the French and German responses to the 1970’s shocks do emerge from this paper.

Of particular interest are the institutional differences highlighted in the cases of an international price shock. Both the increased tendency towards indexation of taxes and transfers in France and the apparently defensive pricing policy in a recession imply that a greater responsibility for adjustment falls to wage behaviour and to the government’s policy reactions.