Washington, DC—The Group of Seven (G-7) finance ministers have become almost totally ineffective in recent years and the world economy has suffered substantially as a result. The group achieved dramatic successes in the past, however, and could again assert effective leadership of the world economy through adopting new systemic arrangements to promote currency stability and to avoid Mexico-type financial crises. The summit of G-7 political leaders in Lyon, France on June 27-29 should launch this process by building on steps initiated at their last two meetings in Naples and Halifax.

The decline of the G-7, its causes and possible remedies are analyzed in Global Economic Leadership and the Group of Seven, a new Institute book by C. Fred Bergsten and C. Randall Henning. The authors argue that the G-7 has failed repeatedly in recent years:

• global economic growth has been subpar throughout the 1990s, adding to high unemployment in Europe and Japan and wage stagnation in the United States, despite the ready availability of a global growth strategy that would have reduced European interest rates and stimulated domestic demand in Japan;
• every G-7 country has experienced a major currency crisis during this period, all of which could have been avoided or handled much better by the adoption of alternative exchange rate arrangements;
• the American and Japanese trade imbalances soared again, generating new threats to the world trading system, after G-7 cooperation in the 1980s had succeeded in reducing them to modest levels in 1990-91;
• the Mexican financial crisis was permitted to erupt despite ample warnings, and the response was handled so badly that G-7 relations remain severely strained as a result;
• a historic opportunity to support Russian economic reform after the collapse of the Soviet Union was squandered, jeopardizing both economic and political prospects in a major nuclear power;
• the rest of the world repudiated G-7 proposals for renewed creation of the IMF's "international money" (Special Drawing Rights), dramatizing doubts about the group's effectiveness and its political legitimacy; and
• the G-7 was initially rebuffed by newly emerging economic powers (such as Korea and Spain) that it asked to provide additional funding for the IMF, to help deal with "future Mexicos," because it was unwilling to grant them any meaningful role in its decisionmaking procedures.

This dismal record derives in part from traditional disagreements within the group, particularly between the United States and Germany, over its basic goals. Should it give priority to fighting unemployment or inflation? Should surplus or deficit countries lead in adjusting international imbalances? Should the G-7 members address financial problems globally as a group or divide up responsibilities along regional lines? These conflicts have become more acute with the relative decline in American power, the growth in the relative power of Germany as leader of an increasingly integrated Europe that focuses on its internal problems, and the reduced proclivity of Japan to side with the United States within the G-7.

The major source of G-7 decline, however, is a growing consensus within the group that effective coordination is beyond its grasp. Its members have implicitly concluded a "nonaggression pact" under which they eschew serious criticism of each other even when policies are far off track. The United States, despite the stated goal of the Clinton Administration to "revitalize the G-7," was afraid to ask for foreign help in rescuing Mexico or supporting the dollar on some occasions. The G-7 did not even address the European monetary crises of 1992- 93, and has not addressed the potentially huge global implications of monetary union in Europe. Bergsten and Henning argue that this loss of will by the G- 7 is based on an erroneous interpretation of several fundamental shifts in world economic conditions:

• The G-7 fear that international capital flows have become so large that they will overwhelm any official efforts to intervene. But new currency arrangements among governments can convert the periodically destabilizing impact of these flows into a stabilizing feature of the system.
• The G-7 reject international policy coordination because all major countries are seeking to reduce their budget deficits and fiscal policy is therefore no longer available. But monetary policy can be deployed to advance international stability in ways that promote the domestic economic objectives of the countries involved, as argued forcefully by former Federal Reserve Board Chairman Paul Volcker and demonstrated in numerous cases over the past two decades.
• The G-7 note that independent central banks (notably the Bundesbank and Federal Reserve) have become much more important international players and that they resist coordination by governments. But new institutional arrangements can be fashioned that recognize the positions of the central banks and in fact capitalize on their strengths by giving them a much bigger role in the process.

The authors conclude that the G-7 can and in fact must be revived, albeit with a different focus than in the past. It should seek to create a more stable currency and financial system, rather than attempting to fine tune the world economy à la earlier "locomotive strategies." It can emphasize the use of currency arrangements to avoid international imbalances now that the United States, the European Union and Japan are structurally similar in their (moderate) reliance on trade. It should seek to induce closer policy coordination through the new currency commitments, as has been achieved under the Bretton Woods system of fixed exchange rates in the 1960s and the European Monetary System during the past fifteen years.

Based on these principles, Bergsten and Henning recommend an action plan to revive the G-7:

• adaption of announced target zones (+/- 10 percent for the major currencies) to improve the management of flexible exchange rates by avoiding large currency misalignments, inducing better policy coordination, and channeling private capital flows in constructive directions;
• institution of an effective early warning system to preempt currency crises in emerging market economies and in G-7 countries themselves, providing full authority to the IMF to "blow the whistle" on governments that refuse to act preventively;
• provision of much larger resources to the IMF to respond to Mexico-type crises when they do occur, including through offering new donor countries full participation in the related decisionmaking procedures; and
• institutional reform of the G-7 to restore its legitimacy through conferring sharply increased authority on the IMF, converting the group into a G-3 as soon as Europe can be represented by a single spokesperson, and remaining alert to the need to bring new powers (China? Russia?) into the group as their economic weight and political orientation evolve (and actively using the pending incorporation of such countries into the related G-10 as a way station).

Installation of a new exchange-rate system is particularly important. An effective target zone regime could have deterred Japan from its easy monetary policy in the late 1980s, thereby avoiding both the "bubble economy" and the weakening of the yen that produced Japan's subsequent huge trade surpluses. It would have promoted timely appreciation of the German mark shortly after unification in the early 1990's, avoiding high interest rates and prolonged recession in Europe. It would clearly have avoided the excessive rise of the yen in early 1995, prolonging the Japanese recession and raising widespread fears of a financial crisis in that country. It might even have limited the excessive rise of the dollar in the middle 1980s, and pushed the United States toward lower budget deficits.

The authors conclude that the G-7 financial officials are unlikely to reform themselves. They have never done so historically, and all major monetary advances have been decided by political leaders. The monetary authorities have a particularly strong bureaucratic preference for the current regime of flexible exchange rates, despite its poor results, because it enables them to blame "the market" for all problems and to shift the burden of responsibility to other parts of their governments (notably the trade officials who must battle protectionist pressures that result from currency misalignments).

Bergsten and Henning thus call on the G-7 summit of political leaders to launch the reform program, in light of its potential for substantially improving both global economic outcomes and overall relations among nations. They applaud the initial steps that the leaders took in this direction at Naples in 1994, when they expressed considerable concern about international financial developments and called for a review of their institutional structure, and at Halifax in 1995, when they directed initial steps to deal with future Mexico-type crises. The upcoming summit at Lyon on June 27-29 should expand the latter initiatives and commence the needed effort to stabilize currency arrangements, with final decisions to be taken at the 1997 summit in the United States. The United States and Japan should begin the currency stabilization program by agreeing on a yen-dollar target zone centered at 100:1, in light of the critical impact of that particular exchange rate and the destabilizing gyrations that it has experienced over the past twenty-five years.