Download On Global Currencies Jeffrey Frankel, Harpel Professor, Harvard

“What’s Hot and What’s Not”
in Global Money
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth,
Harvard University
State Street Institute, SSgA, October 19, 2010
1

Monetary economics, like everything else,
has an element of cycles & fads.

So this lecture is structured in terms of:
“What’s Hot”
& “What’s Not.”
2
5 concepts that
may have peaked
1.
Inflation Targeting
2.
Corners hypothesis
3.
International cooperation
4.
Dollar hegemony
5.
Euro
3
If those 5 are on the way out,
what is taking their place?
4
5 concepts that
may be on the rise
1.
2.
3.
4.
5.
Fighting asset bubbles
Managed floating
“Currency wars”
Multiple international
reserve assets
Sovereign debt worries
5
...
1. Inflation Targeting
(narrowly defined)

Monetary economics has for 3 decades
been built on fighting inflation
by means of a nominal anchor
• The preferred anchor was M1 in the early 1980s;
• … was exchange rate targets in the early 1990s;
• …and became IT in the 2000s.
6
Inflation Targeting:
is now 20 years old among rich countries,
and 10 years old among emerging markets.
Source: IMF Survey. Oct. 23, 2000. A.Schaechter, M.Stone, M.Zelmer IMF.
At: http://www.imf.org/external/pubs/ft/survey/2000/102300.pdf
7
True, EM countries adopting IT experienced less inflation.
Gonçalves & Salles, 2008, “Inflation Targeting in Emerging Economies…” JDE
8
But…
1st drawback of combination of IT (with CPI as the target):
 Gives wrong answer to supply shocks:





E.g., in response to a rise in world oil import prices,
it says to tighten monetary policy and appreciate.
In response to rise in export commodity’s world price,
IT precludes monetary tightening & appreciation.
=> IT (with CPI) is exactly backwards:
We should accommodate trade shocks.
Solution (for countries with variable terms of trade)
• PPT: target an index of product prices or export prices,
• not CPI.
9
2nd drawback of IT
IT says to pay no attention to asset prices,
except to the extent they portend inflation.

Until recently, the Greenspan view
had dominated over the BIS view.
• Greenspan view:

we can’t identify stock or real estate bubbles; and

CBs do better to cut i in the aftermath than to raise i in the upswing.
• BIS view: in a credit cycle, too-easy monetary policy
shows up in asset prices, followed by a costly crash.
There need not be inflation in between.




US crash 1929
Japan bubble 1987-89
East Asia crisis 1997-98
Sub-prime mortgage crisis 2007-08
10
• But the crisis of 2007-09 confirmed the BIS view



The stock & housing bubbles
were easier to identify than future inflation.
The “Greenspan put” exacerbated the bubbles.
The global crisis’ consequences have been severe.
• Of course, regulatory tools are more appropriately
targeted to deal with a bubble than i.

But if/when they are not enough,
monetary policy should pay attention.
11
Fighting Asset Bubbles:
The Credit Cycle

For 30 years, monetary economics has held that excessive
monetary expansion was synonymous with inflation
getting out of control, necessitating monetary contraction
to get back to stability,
• and that this is where recessions come from.
• That pattern did fit recessions of 1974, 80, 81-82, & 90-91.
12

Forgotten were earlier notions of cyclicality:
• the credit cycle of von Hayek,
• the bubbles & panics of Kindleberger,
• the Minsky moment,
and
• Irving Fisher’s debt deflation.
13
Bursting
bubbles

Now Alan Greenspan can be answered:
• (i) Yes, identifying bubbles is hard, but no harder than
identifying inflationary pressures 18 months ahead;
• (ii) monetary authorities do have tools to prick bubbles;
• (iii) the habit of rescuing the markets after the crash
(the “Greenspan put”) created a moral hazard problem
which exacerbated the speculative bubbles; and
• (iv) the cost in terms of lost output can be enormous,
even when the central bank eases very aggressively.
14
2. Corners Hypothesis

The corners hypothesis: the proposition that countries
are—or should be—moving to the corner solutions
in their choice of exchange rate regimes.

They were said to be opting either,
•
•
on the one hand, for floating,
or, on the other hand, for rigid institutional commitments
to fixed exchange rates, in the form of
currency boards or currency union
•
•
with the $ or €.
It was said that intermediate exchange
rate regimes were no longer feasible.
15

Origins,
• In the context of the European ERM:
Eichengreen (1994) & Crockett (1994);
• In the context of emerging market crises: Obstfeld &
Rogoff (1995) , Summers (1999), Eichengreen (1999),
Fischer (2001), Minton-Beddoes (1999), CFR (1999),
G-7, IMF, & even the Meltzer Report (2000). ….
16


The Corners proposition was never properly
demonstrated, either theoretically or empirically.
The collapse of Argentina’s convertibility plan
in 2001 marked the beginning of the end.

Today, most countries continue to occupy the vast area in
between floating and rigid institutional pegs.

It is much less common to hear that intermediate regimes
are a bad choice generically.
• A target zone/ basket would make sense for the RMB.

Thus I declare the Corners Hypothesis dead.
†
17
Replacing the corners:
Managed floating
As massive inflows return to emerging markets,
most central banks are taking them

partly in the form of reserve inflows
• = a rise in the quantity of money,

and partly in the form of currency appreciation
• = a rise in the price of money.
18
Reserves


Even though many developing & emerging market
countries described themselves as floating,
most took advantage of the boom of 2003-2008
to build up reserves to unheard of heights,
• in the aftermath of the crises of 1994-2001.

in contrast to past capital booms (1975-81, 1990-97).
19

When the 2008-09 global financial crisis hit,
• those countries that had taken advantage of
the 2003-08 boom to build up reserves did better.



E.g., Obstfeld, Shambaugh & Taylor (2009)
Frankel & Saravelos (2010),
This had also been the most common finding
in the many studies of Early Warning Indicators
in past emerging market crises.
20
Capital flows to emerging markets, especially Asia,
recovered quickly from the 2009 recession.
These countries again show big balance of payments surpluses
Goldman Sachs
21
Although China continues the most salient case,
Korea, Singapore & Taiwan are also
adding heavily to reserves.
GS Global ECS Research
22
Others, such as India & Malaysia, are currently
taking the inflows in the form of currency
appreciation, more than reserve accumulation.
more-managed floating
less-managed floating
(“more appreciation-friendly”)
GS Global ECS Research
23
In Latin America as well, inflows have returned,
reflected mostly as reserve accumulation in Peru,
but as appreciation in Chile & Colombia.
more-managed floating
less-managed floating
(“more appreciation-friendly”)
24
GS Global ECS Research
Intermediate regimes
are back in:
• a majority of IMF members,
• especially if one uses de facto classification.
• target zone (band)
• basket peg
• crawling peg
• adjustable peg
25
3. International cooperation

The G7 steering group gave us
• Rambouillet, to ratify floating (1975).
• the Plaza, to bring down the $ (1985), and
• the Louvre, to halt $ depreciation (1987).

The rise of the G20 in 2009 was a historic
development membership
• Representation of big emerging
market countries was long overdue.
• How can you talk about RMB
without China at the table?
26
The G20 London Summit,
April 2009
Fears of a re-run of the failed London Economic
Conference of 1933 proved misplaced.
 The G20 in 2009 did not repeat
the mistakes of the Great Depression:
• Monetary & fiscal policy were both expansionary.
• Feared protectionism did not materialize,



compared to the milder recessions of 1981 & 2001,
let alone the Smoot-Hawley tariff of 1930.
The IMF was strengthened.
27
The IMF



Just three years ago, the conventional wisdom
was that the Fund no longer had a job to do in
fighting crises, and that it was in danger of
irrelevance.
The staff was cut back, taking effect just
as the international financial crisis started.
Now the IMF is once again busy
• Country programs
• The membership agreed to increase its resources.
28
Currency Wars




In the news this month.
Starting with a warning
from Brazil’s Finance
Minister Guido Mantega:
countries everywhere are trying
to push down the value of their currencies,
to gain exports and employment,
a goal that is not globally consistent.
29
Currency Wars?

Japan intervened this month to push down the ¥
• for the first time in many years,
• joining Switzerland.

Some consider FRB policy another instance.

Renewed flows to emerging markets
have met with intervention
• e.g., by Korea, host of November G20 summit.
• Brazil, Thailand, India & others must decide how to manage inflows:



Capital controls?
Appreciation?
Buying $ to prevent appreciation
• a course of action supported by evidence that those who used the 2003-08 boom
to build up forex reserves did better in the 2009 global financial crisis.

China’s RMB remains the dominant issue.
30
Is the currency war metaphor applicable?

Fear of non-cooperative “competitive devaluation”
is an argument for fixed exchange rates
• rooted in the 1930s.
• That is why the architects of
the post-war monetary order
chose fixed exchange rates
at Bretton Woods, NH, in 1944.

But it is now used to argue that China
should move from fixing to floating.
• US Congressmen don’t
care about regimes;
• they just want a stronger RMB vs. $.
31
Is the currency war metaphor applicable?



continued
Economic historians have decided
competitive devaluation under 1930s
conditions was not a problem after all.
True, countries couldn’t all devalue
against each other,
But they could and did all devalue against gold
• which worked to ease global monetary policy,

just what was needed.
32
Is the currency war metaphor applicable?

continued
The same is true today:
• QE by the Fed will not just raise the money supply in the US;
• it will also loosen globally,

to the extent that foreign central banks react by buying $
• to prevent their own currencies from appreciating.
• which is what the world needs.

Multilateral cooperation is not necessary for this.
33
Is the currency war metaphor applicable? continued

But other kinds of international cooperation are needed;
• the currency war & 1930s metaphors are not totally misplaced:

Currency war could turn into trade war
• if Congress follows through on legislation to impose (WTO-illegal)
tariffs on China as punishment for non-appreciation.
• Until now, the US & G20 have held the line on protectionism well



compared to the milder recessions of 1991 & 2001,
let alone the Smoot Hawley tariff of 1930.
The G20 meeting Nov. 11-12, in Seoul,
is the next forum for multilateral cooperation.
34
Ideally the US & China would reach agreement
on how to address current account imbalances:

China would take some responsibility
• to reallocate its economy away from
exclusive reliance on exports & manufacturing

toward domestic consumption & services,
• health, education, housing, environment, insurance & other services.
• How? By allowing the RMB to appreciate,
• but also by increasing domestic demand.

Meanwhile, the US would ideally also take responsibility.
• Even while prolonging expansionary policy this year,

including fiscal expansion designed with high bang-for-the-buck,
• the US should take steps today to lock
in a future return to fiscal responsibility,

e.g., by putting Social Security on a firm footing.
35
4. Dollar Hegemony

Some argue the US current account
deficit is sustainable indefinitely.
• They believe that the US will continue to enjoy
its unique “exorbitant privilege,”


able to borrow unlimited amounts in its own currency
because it is the dominant international reserve asset.
36
“Bretton Woods II”

Dooley, Folkerts-Landau, & Garber (2003) :
• today’s system is a new Bretton Woods,

with Asia playing the role that Europe played
in the 1960s—buying up $ to prevent
their own currencies from appreciating.
• More provocatively:
China is piling up dollars
not because of myopic mercantilism,
but as part of an export-led development strategy
that is rational given China’s need to import workable
systems of finance & corporate governance.
37
My own view on Bretton Woods II:
•
•
The 1960s analogy is indeed apt,
but we are closer to 1971 than to 1944 or 1958.
•
Why did the BW system collapse in 1971?

The Triffin dilemma could have taken decades
to work itself out.

But the Johnson & Nixon
administrations accelerated
the process by fiscal & monetary expansion
(driven by the Vietnam War & Arthur Burns, respectively).

These policies produced: declining external balances,
$ devaluation, & the end of Bretton Woods.
38
There is no reason to expect better today:
1)
Capital mobility
is much higher now than in the 1960s.
2)
The US can no longer rely
on support of foreign central banks:

neither on economic grounds
(they are not now, as they were then,
organized into a cooperative framework where
each agrees explicitly to hold $ if the others do),

nor on political grounds
(these creditors are not the staunch allies
the US had in the 1960s).
39
The financial crisis caused a flight to quality
which evidently still means a flight to US $.


US Treasury bills in 2008-09 were more in demand
than ever, as reflected in very low interest rates.
The $ appreciated, rather than depreciating as the “hard
landing” scenario had predicted.

=> The day of reckoning had not yet arrived.

Chinese warnings (2009) may be turning point:
• Premier Wen worried US T bills will lose value.
• PBoC Gov. Zhou proposed
replacing $ as international
currency.
40
Multiple International
Currency System

The € now exists as a rival to the $.

The ¥ & SF are also safe havens.

The SDR came back
from the dead in 2009.

Gold made a comeback as
an international reserve too.

Someday the RMB will join the roster.

= a multiple international reserve currency system.
41
The euro project is looking
far less successful than just a few years ago

Many predictions of euro skeptics have come true:
• Periphery countries and core countries have had trouble
reconciling asymmetric monetary needs.
• Euro members have not had enough labor mobility
or flexibility to make up for it.
• Efforts to prevent excessive debt & bailouts have failed:


The Stability & Growth Pact failed with members big & small.
The “No bailout clause” has failed with Greece.
42
Frankfurt & Brussels
made 3 mistakes regarding Greece

2002-09: Did not allow spreads to open up
between sovereign debt of Greece & Germany.

Winter 2010: Did not tell Greece to go to the IMF.
Preferred instead to “handle it internally.”

Still today: No “Plan B” to restructure Greek debt
(and save the bailout fund for more deserving banks & PIIGs).
43
Judging from spreads, 2001-07,
investors put zero odds on a default by Greece
or other Mediterranean countries
Council on Foreign Relations
44

Suddenly, in 2010, the Greek sovereign spread
shot up, exceeding 800% by June.

Even when the Greek crisis erupted,
leaders in Brussels & Frankfurt
seemed to view it as a black swan,
• instead of recognizing it as a close cousin
of the Argentine crisis of ten years earlier,

and many others in history,
• including among European countries.
45
Predictions

Greece will have re-structure its debt.

The euro-zone will not break up.
• There is no legal provision for members to leave.
46
Sovereign debt worries
...
• The next big asset market to fall
• after the stock market in 2000
• the housing market in 2006
• and banking in 2008
• will be sovereign debt
• among the advanced economies.
• The big emerging market countries
are in much better shape,
• in an amazing & historic role reversal.
47
Sovereign spreads for 5 euro countries
shot up in the 1st half of 2010
Creditworthiness: Some advanced economics
have fallen, as emerging markets have risen.
48
Ratings for “Advanced Economies”
Ratings for “Emerging Economies”
49
A remarkable role-reversal:
• Debt/GDP of the top 20 rich countries
(≈ 80%) is already twice that
of the top 20 emerging markets;
• and rising rapidly.
• By 2014 (at ≈ 120%), it could be triple.
50
http://ksghome.harvard.edu/~jfrankel/index.htm
51
Technical appendix on intermediate regimes:
Synthesis of techniques for inferring flexibility parameter
and for inferring basket weights
(Frankel & Wei, IMF Staff Papers, 2008; Frankel PER, 2009)
Δ log Ht = c + ∑ w(j) Δ logX(j)t + ß {Δ empt } + ut
= c + w(1) Δ log $ t + w(2) Δ log € t + w(3) Δ log ¥ t
+ w(4) Δ log £t + … + ß {Δ empt } + u t
where H ≡ value of home currency, X(j) ≡ value of foreign currency j,
defined in terms of suitable numeraire, like SDR
w(j)
≡ currency weights in basket, to be estimated;
Δ empt ≡ change in Exchange Market Pressure
≡ Δ log Ht + (ΔRest )/Monetary Baset
ß ≡ flexibility parameter, to be estimated:
ß=1 => the currency floats purely (no changes in reserves);
ß=0 => the exchange rate is purely fixed.
52
Appendix: Accumulating reserves has paid off
In the 2003-08 boom, many countries used inflows
to build up forex reserves,
rather than to finance Current Account deficits (as in 1990s)
7.00
6.00
5.00
4.00
% of GDP
3.00
Change in
Reserves
in % of GDP
Net Capital
(Low- and middleFlow Asia crisis
income countries)
1980-2006
2nd boom
3rd boom
international debt crisis
2.00
1.00
0.00
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
-1.00
-2.00
-3.00
-4.00
Current
Account
Balance
53
Best and Worst Performing Countries -- F&S (2010), Appendix 4
GDP Change, Q2 2008 to Q2 2009
Lithuania
Latvia
Ukraine
Estonia
Macao, China
Russian Federation
Bottom 10
Georgia
Mexico
Finland
Turkey
Australia
Poland
Argentina
Sri Lanka
Jordan
Indonesia
To p 10
Egypt, Arab Rep.
Morocco
64 countries in sample
India
China
-25%
-20%
-15%
-10%
-5%
0%
5%
54
10%
Table Appendix 6
Coefficients of Bivariate Regressions of Crisis Indicators on Each Independent Variable* (t-stat in parentheses)
bolded number indicates statistical signficance at 10% level or lower, dark er color shading equivalent to higher statistical significance
Currency
Market
Equity
Market
Recourse to
IMF
Industrial
Production
GDP
S ignif ic a nt a nd
C o ns is t e nt
S ign?^
Reserves (% GDP)
0.082
(2.52)
0.850
(1.6)
-1.020
(-1.92)
0.155
(2.22)
0.008
(0.27)
Yes
Reserves (% external debt)
-0.000
(-1.42)
0.000
(2.11)
-0.010
(-3.42)
0.000
(3.62)
0.000
(3.07)
Yes
Reserves (in months of imports)
0.002
(1.58)
0.103
(4.71)
-0.089
(-3.31)
0.006
(1.48)
0.001
(0.75)
Yes
M2 to Reserves
0.000
(0.14)
-0.026
(-3.81)
-0.067
(-1)
-0.001
(-2.46)
0.000
(1.44)
Yes
Short-term Debt (% of reserves)
-0.000
(-2.6)
-0.007
(-4.45)
0.000
(1.18)
-0.000
(-1.7)
-0.000
(-2.93)
Yes
REER (5-yr % rise)
-0.293
(-5.4)
-0.303
(-0.32)
0.889
(0.99)
-0.000
(-0.01)
-0.029
(-0.85)
REER (Dev. from 10-yr av)
-0.292
(-2.93)
-0.920
(-0.81)
0.671
(0.58)
-0.000
(-0.01)
-0.041
(-0.91)
GDP growth (2007, %)
0.003
(1.7)
0.078
(1.58)
0.039
(1.63)
0.010
(2.59)
-0.002
(-1.21)
GDP Growth (last 5 yrs)
0.002
(1.08)
0.118
(2.14)
0.052
(1.68)
0.009
(2.14)
-0.003
(-1.21)
GDP Growth (last 10 yrs)
0.005
(1.59)
0.087
(1.06)
0.042
(1.2)
0.016
(2.63)
-0.004
(-0.76)
GDP per capita (2007, constant 2000$)
-0.003
(-0.7)
-0.296
(-4.69)
-0.221
(-3.23)
-0.027
(-2.48)
-0.010
(-1.74)
Change in Credit (5-yr rise, % GDP)
-0.029
(-0.83)
-1.979
(-5.42)
0.139
(0.37)
-0.092
(-1.67)
-0.065
(-2.34)
Yes
Change in Credit (10-yr rise, % GDP)
-0.024
(-2.84)
-0.904
(-3.9)
-0.011
(-0.08)
-0.046
(-1.58)
-0.019
(-1.13)
Yes
Credit Depth of Information Index (higher=more)
-0.005
(-1.34)
-0.115
(-1.72)
0.009
(0.19)
0.006
(0.57)
-0.003
(-0.47)
Bank liquid reserves to bank assets ratio (%)
0.000
(1.52)
0.022
(1.51)
-0.000
(-13.97)
0.002
(2.34)
0.001
(2.58)
Yes
Current Account (% GDP)
0.001
(1.57)
0.032
(2.18)
-0.032
(-3.46)
0.000
(0.42)
0.000
(0.78)
Yes
Current Account, 5-yr Average (% GDP)
0.001
(1.31)
0.030
(1.66)
-0.032
(-2.76)
0.000
(0.53)
0.000
(0.42)
Current Account, 10-yr Average (% GDP)
0.000
(0.72)
0.034
(1.46)
-0.038
(-2.63)
0.000
(0.15)
0.001
(1.59)
Net National Savings (% GNI)
0.000
(0.9)
0.048
(4.5)
-0.020
(-1.88)
0.003
(2.42)
0.002
(2.92)
0.000
0.047
-0.028
0.003
0.002
F & Saravelos (2010): Bivariate
Independent Variable
R
E
S
E
R
V
E
S
R
E
E
R
G
D
P
C
R
E
D
I
T
C
U
R
R
E
N
T
A
C
C
O
U
N
T
Gross National Savings (% GDP)
Yes
55
Yes
Yes
Table Appendix 7
Coefficients of Regressions of Crisis Indicators on Each Independent Variable and GDP per Capita* (t-stat in parentheses)
bolded number indicates statistical signficance at 10% level or lower
F & Saravelos
(2010):
Multivariate
Exchange
Market
Pressure
Currency % Recourse to
Changes
IMF
(H208-H109
(SBA only)
Equity
%Chng
(Sep08Mar09)
Equity %
Chng
(H208H109)
S ignif ic a nt
a nd
C o ns is t e nt
S ign?^
Independent Variable
R
E
S
E
R
V
E
S
R
E
E
R
G
D
P
C
R
E
D
I
T
C
U
R
R
E
N
T
A
C
C
O
U
N
T
Reserves (% GDP)
0.164
(3.63)
0.087
(2.98)
-1.069
(-1.66)
0.011
(0.12)
0.010
(0.14)
Yes
Reserves (% external debt)
0.000
(1.06)
0.000
(1.1)
-0.006
(-2.29)
0.000
(1.81)
0.000
(2.65)
Yes
Reserves (in months of imports)
0.004
(2.25)
0.003
(1.95)
-0.119
(-3.01)
0.006
(1.32)
0.009
(2.32)
Yes
M2 to Reserves
0.000
(0.27)
0.000
(0.76)
-0.044
(-0.91)
0.000
(0.02)
-0.000
(-0.09)
Short-term Debt (% of reserves)
-0.000
(-1.97)
-0.000
(-4.22)
0.000
(2.13)
-0.001
(-2.89)
-0.001
(-3.11)
Yes
REER (5-yr % rise)
-0.440
(-5.55)
-0.210
(-3.19)
1.728
(2.15)
-0.182
(-1.24)
-0.185
(-1.61)
Yes
REER (Dev. from 10-yr av)
-0.475
(-3.96)
-0.230
(-2.47)
2.654
(2.56)
-0.316
(-1.71)
-0.316
(-2.1)
Yes
GDP growth (2007, %)
-0.000
(-0.2)
0.001
(0.94)
0.070
(2.58)
-0.001
(-0.1)
-0.007
(-0.71)
GDP Growth (last 5 yrs)
-0.003
(-0.81)
0.000
(0.26)
0.084
(2.4)
-0.003
(-0.26)
-0.014
(-1.15)
GDP Growth (last 10 yrs)
0.000
(0.14)
0.001
(0.43)
0.064
(1.66)
-0.012
(-0.67)
-0.020
(-1.12)
Change in Credit (5-yr rise, % GDP)
-0.021
(-0.36)
-0.035
(-0.98)
0.552
(1.02)
-0.274
(-2.97)
-0.248
(-4.13)
Change in Credit (10-yr rise, % GDP)
-0.017
(-0.93)
-0.011
(-1.05)
0.210
(1.03)
-0.089
(-1.65)
-0.089
(-2.35)
Credit Depth of Information Index (higher=more)
-0.008
(-1.06)
0.000
(0.05)
0.224
(2.4)
-0.006
(-0.37)
-0.018
(-1.33)
Bank liquid reserves to bank assets ratio (%)
0.000
(3.84)
0.000
(0.5)
-0.000
(-11.44)
-0.002
(-0.54)
-0.002
(-0.79)
Yes
Current Account (% GDP)
0.001
(1.48)
0.002
(2.7)
-0.023
(-2.09)
0.009
(3.84)
0.007
(3.95)
Yes
Current Account, 5-yr Average (% GDP)
0.000
(0.48)
0.001
(1.82)
-0.025
(-1.72)
0.007
(2.4)
0.006
(2.74)
Yes
Current Account, 10-yr Average (% GDP)
0.000
(0.14)
0.002
(1.39)
-0.035
(-2.11)
0.008
(2.21)
0.007
(2.44)
Yes
Net National Savings (% GNI)
0.002
(1.6)
0.001
(2.33)
-0.013
(-1.22)
0.006
(2.92)
0.004
(2.28)
Gross National Savings (% GDP)
0.003
(2.01)
0.001
(2.53)
-0.015
(-1.36)
0.008
(3.42)
0.006
(3.03)
Yes
56 Yes
Yes
Appendix: More on $ hegemony
When does the “privilege” become “exorbitant?”



if it accrues solely because of size and history, without
the US having done anything to earn
the benefit by virtuous policies such as budget
discipline, price stability & a stable exchange rate.
Since 1973, the US has racked up $10 trillion
in debt and the $ has experienced a 30% loss
in value compared to other major currencies.
It seems unlikely that macroeconomic policy discipline
is what has earned the US its privilege !
57
Some argue that the privilege to incur $
liabilities has been earned in a different way:

Global savings glut

The US appropriately exploits its comparative advantage
in supplying high-quality assets to the rest of the world.
(Bernanke)
• “Intermediation rents…pay for the trade deficits.”
-- Caballero, Farhi & Gourinchas (2008)
• In one version, the US has been operating as the World’s
Venture Capitalist, accepting short-term liquid deposits and
making long-term or risky investments -- Gourinchas & Rey (2008).
• US supplies high-quality assets:
Cooper (2005); Forbes (2008); Ju & Wei (2008);
Hausmann & Sturzenegger (2006a, b);
Mendoza, Quadrini & Rios-Rull (2007a, b)…
58


The argument that the US offers assets of superior
quality, and so has earned the right to finance its
deficits, was undermined by the dysfunctionality
revealed in the financial crisis of 2007-08.
American financial institutions suffered a severe
loss of credibility (corporate governance, accounting
standards, rating agencies, derivatives, etc.),

How could sub-prime mortgages be
the superior type of assets that uniquely
merit the respect of the world’s investors?
59

But the events of 2008-09 also
undermined the opposing interpretation,
the unsustainability position:


Why no hard landing for the $, as long feared?
The $ appreciated after Lehman Brothers’
bankruptcy, & US T bill interest rates fell.

Clearly in 2008 the world still viewed
•
the US Treasury market as a safe haven and
•
the US $ as the premier international currency.
60
Though arguments about the unique high quality
of US private assets have been tarnished,
the idea of America as World Banker is still alive:
the $ is the world’s reserve currency,
by virtue of US size & history.


Is the $’s unique role
an eternal god-given constant?
Or will a sufficiently long record of deficits &
depreciation induce investors to turn elsewhere?
61
Historical precedent: £’s loss of premier
international currency status in 20th century

By 1919, US had passed UK in
1. output (1872)
2. trade (1914)
3. net international creditor position (1914-19)

Subsequently,
$ passed £ as #1 reserve currency (1940-45).
62
From the literature
on reserve currencies
Determinant:
Proxy:
1.
Size
GDP
2.
Depth of Fin.mkt.
FX turnover
3. Rate of return
inflation,
LR depreciation,
Exch. rate variance
63
From the literature, continued
Network externalities
=> Tipping
captured by:
1)
Inertia
lags
2)
Nonlinearity
in determinants
logistic functional form
or
dummy for leader GDP
64
Projection of $ vs €
as shares of central banks’ foreign exchange reserves:
a function of country size, financial market depth, & rate of return,
with parameters estimated on 1973-98 data.
1.0
Simulation assumes $ depreciation continues at 2001-04 rate.
USD
Chinn & Frankel
(2005)
0.8
0.6
0.4
0.2
0.0
birth
of €
DEM
EUR
This scenario showed €
overtaking $ as top international
reserve currency in 2022.
65
75 80 85 90 95 00 05 10 15 20 25 30 35 40
Appendix: More on a multiple-asset
international reserve system
International Currency Roles
Table B
Adapted from Kenen
Function
of
money:
Store of
value
Medium
of
exchange
Unit of
account
Governments
Private actors
International reserve
holdings
Vehicle currency for
foreign exchange
intervention
Anchor for pegging
local currency
Currency substitution
(private dollarization)
Invoicing trade and
financial transactions
Denominating trade and
financial transactions
66

A multiple reserve currency system is inefficient,
in the same sense that barter is inefficient:
money was invented in the first place to cut down
on the transactions costs of exchange.

Nevertheless, if sound macro policies
in the leader country cannot be presumed,
the existence of competitor currencies gives
the rest of the world protection against the leader
exploiting its position by running up too much
debt and then inflating/depreciating it away.
67
Gold

Gold was seen as an anachronism just a few years ago:
• the world’s central banks were selling off their stocks.

Gold re-joined the world monetary system in 2009:
• The PBoC, RBI, & other Asian central banks
bought gold, to diversify their reserves.
• Even in advanced countries, central banks
appear to have stopped selling.
68
Special Drawing Rights






The SDR has made a surprising comeback as a potential
international money, from near-oblivion.
The G20 in 2009 decided to create new SDRs ($250b).
Shortly later, PBoC Gov. Zhou proposed replacing
the $ as lead international currency with the SDR.
The IMF is now borrowing in SDRs.
The proposal has been revived for an international
substitution account at the IMF, to extinguish an unwanted
$ overhang in exchange for SDRs.
The SDR has little chance of standing up as a competitor
to the € or ¥, let alone to the $.
Still, it is back in the world monetary system.
69

Appendix: U.S. fiscal policy in 2010-2011

What changes in American fiscal policy
would be desirable at the current juncture,
• if politics were not an obstacle?

On the one hand, the economy is still weak.
On the other hand, the U.S. can’t wait until the recovery
is complete to tackle the long run fiscal problem.

A two-part strategy:

Current steps to extend the fiscal stimulus,

• designed to maximize bang for the buck.

Current steps to lock in future progress
back toward fiscal discipline in the long run.
70
U.S. fiscal policy in 2010-2011, continued


Maximizing bang for the buck ≡ fiscal stimulus that
gives the most demand per $ added to long-term debt.
Example that would minimize bang for the buck:
• proposal to make permanent the 2010 estate tax abolition .
• Almost as poorly targeted: proposal to prevent the Bush tax
cuts from expiring in 2011 for those households > $250,000.

If the stimulus has to take the form of tax cuts,
then the best options are:
•
•
•
•
extending President Obama’s “Make Work Pay” tax cuts,
fixing the Alternative Minimum Tax, and
extending the Bush tax cuts for those households < $250,000.
Some business tax cuts could also give high bang for the buck.

such as temporary credits for investment or hiring.
71
U.S. fiscal policy in 2010-2011, continued

But spending boosts demand more than tax cuts do,
• because the latter are partly saved.

Extend elements of the Obama stimulus
• such as infrastructure investment and
• giving money to the states

so that they don’t have to lay off teachers, policemen,
firemen, subway drivers & construction workers.
72
U.S. fiscal policy in 2010-2011, continued

How does one take steps today
to lock in future fiscal consolidation?
• Not by raising taxes or cutting spending today (see above);
• nor by promising to do so in a year or two (not credible).
• There are lots of economically sensible proposals



for spending to eliminate,
more efficient taxes to switch to,
and “tax expenditures” to cut.
73
U.S. fiscal policy in 2010-2011, continued

One big reform might work best:
pass legislation today to put Social Security
on a sound financial footing in the long term.

It would consist of a combination
• of raising the retirement age

just a little (in proportion to lengthening life spans)
• and slowing the growth of benefits for future retirees


just a little (perhaps by “progressive indexation).
If Washington could fix Social Security,
• it would address the long-term fiscal outlook,
• yet would create no drag for the current fragile recovery.
74
The US public discussion is framed like a battle between
conservatives who philosophically believe in strong budgets &
small government, and liberals who do not.
Not the right way to characterize the debate. [1]

(1) The right goal should be budgets that allow
surpluses in booms and deficits in recession.

(2) The correlation between how loudly an American
politician proclaims a belief in fiscal conservatism and
how likely he is to take corresponding policy steps < 0.
[1] Forget that small government is classically supposed to be
the aim of “liberals,” in the 19th century definition, not “conservatives.”
75
“Republican & Democratic Presidents Have Switched Economic Policies” Milken Inst.Rev. 2003.
“Pledging”: Three pieces of evidence to support
the claim that “fiscal conservatives” are not:

(i) The voting pattern among the 258 Congressmen
who signed an unconditional pledge not to raise taxes:
• They voted for more spending than
those who did not sign the pledge. [2]

(ii) The pattern of spending
under Republican presidents.[3]

(iii) The pattern of states whose Senators win pork
& other federal spending. [4]



[2] William Gale & Brennan Kelly, “The ‘No New Taxes’ Pledge,” Tax Notes, 2004.
[3] JF “Snake-Oil Tax Cuts,” EPI, Briefing Paper 221. 2008.
[4] JF Red States, Blue States and the Distribution of Federal Spending, 3/31/2010.
76
(ii) Spending & deficits both rose sharply when
Presidents Reagan, Bush I, & Bush II took office.
Vs. the 1990s: The Shared Sacrifice approach succeeded
in eliminating budget deficits, importantly by slowing spending.
Spending and Budget Balance(inverse) as % of GDP (Current US$)
15
24
13
22
11
20
9
18
7
ρ = 0.86
5
16
G.W. Bush
R. Reagan
G.H.W. Bush
10
1
-1
-3
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008 Est
2009 Est
2010 Est
12
J. Carter
14
W.J. Clinton
3
Spending/GDP
Budget Balance/GDP
Source:
77
OMB
(iii) States ranked by federal spending received
per tax dollar paid in 2005
versus party vote ratio in preceding election
“red”
states
“blue”
states
big inflow of US $
Republican states take home
significantly more federal $
(relative to taxes paid)
than Democratic states
low inflow of US $
78