Download This PDF is a selection from a published volume from the... Bureau of Economic Research Volume Title: NBER International Seminar on Macroeconomics

This PDF is a selection from a published volume from the National
Bureau of Economic Research
Volume Title: NBER International Seminar on Macroeconomics
2011
Volume Author/Editor: Jeffrey Frankel and Christopher Pissarides,
organizers
Volume Publisher: University of Chicago Press
Volume ISBN: 0-226-26035-6; 978-0-226-26034-1 (cloth);
978-0-226-26035-8 (paper)
Volume URL: http://www.nber.org/books/fran11-1
Conference Date: June 17-18, 2011
Publication Date: May 2012
Chapter Title: Comment on "Flexing Your Muscles: Abandoning a
Fixed Exchange Rate for Greater Flexibility"
Chapter Author(s): Jorge Braga de Macedo
Chapter URL: http://www.nber.org/chapters/c12481
Chapter pages in book: (p. 392 - 399)
Comment
Jorge Braga de Macedo, Nova University, Lisbon, and NBER
This empirical paper seeks to uncover the hidden asymmetry in open
economy dynamics between currency depreciation and appreciation. It
does so through a general and specific message, best understood from
related research by the authors: Andy claims that exchange rate regimes
are “flaky” while a previous paper with Barry is relaxed about “an exit
up” for China.
Quoting the specific message, Eichengreen and Rose (2010) claim
that: “The experience of other countries gives little reason to think that
an exit up will have seriously adverse consequences for the Chinese
economy. But economic growth may slow marginally. If the authorities
wish to limit the risk of an excessive slowdown, they can maintain the
level of public spending and redouble their efforts to foster the growth
of private consumption. If more domestic spending means more spending on imported goods, this will represent a Chinese contribution to
global rebalancing.” The general message is clear from Rose (2011):
“The issue of exchange rate regimes is a fascinating question, one that
will surely intrigue economists for the foreseeable future. Still, to me the
truly fascinating thing about exchange rate regimes is that . . . they’re
fascinating. They really shouldn’t be. Governments of similar countries
make different decisions on the exchange rate regime. These views appear to be strongly held and sincere, yet they seem to have neither discernible causes nor visible consequences. Perhaps it is precisely because
these issues appear to be of purely academic interest that they continue
to provide inspiration for our profession; the stakes could not be lower.”
This comment builds on both messages to reinforce a broader policy
implication: instead of “large and well defined impacts on, inter alia,
growth and inflation of nonrandom incidence [selectivity] before the
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Comment
393
fact” found in step devaluations and financial crises with freely falling currencies, there is no such evidence here (Eichengreen and Rose,
chapter 7, this volume). Yet the asymmetry between appreciating and
depreciating exits—which was absent from the IMF’s original articles
of agreement (note 5)—has been visible in the “eight centuries of financial folly” covered in Carmen Reinhart and Ken Rogoff (2009).
Starting with the specific message, the definition of “flexes” (called
“exits up” in Eichengreen and Rose 2010) is based on the classification
of exchange rate arrangements by Ilzetzki, Reinhart, and Rogoff (2008).1
The alphabetical list of 51 cases in table 1 of chapter 7 can be divided
into three subgroups, with the middle category covering the decline
and fall of the Bretton Woods system from August 1971 to December
1973—some way to celebrate the fortieth anniversary. Note also that all
founding members of the eurozone (EZ) except Belgium and Luxembourg, plus Greece and Malta, are in the list (* in box).
1960–1970, 10 cases: Paraguay, Turkey, Costa Rica, Greece*, Peru,
Sri Lanka, Germany*, Canada, Israel, Philippines.
1971–1973, 20 cases: France*, Libya, Costa Rica, Netherlands*,
Hong Kong, Turkey, South Africa, Malta*, United Kingdom, Japan,
Malawi, Germany*, Switzerland, Singapore, Sweden, Portugal*,
Morocco, Italy*, Finland*, New Zealand.
1974–2005, 21 cases: Iran, Australia, Suriname, Mauritania, Tunisia,
Spain*, Kuwait, Malaysia, Mexico, Nepal, Ireland*, Botswana, Iraq,
Jamaica, Haiti, Sri Lanka, Nicaragua, Liberia, Lithuania,
Mozambique, Malaysia.
Eichengreen and Rose (2010) concluded that China was not all that
different. Japan, Hong Kong, Singapore, and Mozambique averaged
double-digit growth for the five years before their exits up, comparable
to China’s growth rate now. They acknowledge that China’s growth
rate vastly exceeds that of most other countries in the sample, and that
its economy also differs in other respects: a much larger population and
average income in the comparison group higher by a factor of around
two. To repeat, they found no sign of any significant relationship for
either banking or payments crises: unlike exits down, flexes were not
associated with any large change in crisis incidence and thus differ fundamentally from regime collapses followed by currency crashes. Nevertheless, the relaxed undertow of Eichengreen and Rose (2010) with
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394
de Macedo
respect to China’s “exit up” is qualified in their current paper as in a
legendary Q&A that led Zhou Enlai to respond “too early to tell”2: Warranted Chinese caution? Too heterogeneous to tell. To understand the
qualification, let’s soldier on to the flaky issue.3
We begin in 1982 at a Bellagio conference where the late Pentti Kouri
complained about the “unnecessary overshooting in exchange rate theory in the past ten years” and voiced the expectation that “painstaking,
time- consuming work” on exchange rates would “ultimately turn us
against the current system of flexible exchange rates in favor of a more
orderly monetary system” (Macedo and Lempinen 2011, 17). Indeed, in
the 1990s, currency crashes underscored the evidence that the combination of pegged exchange rates and open capital accounts are prone
to costly accidents. For example, soft pegs and narrow bands (2.25%
in the European Monetary System) created a one- way bet for speculators, as convergence plays in connection with the Maastricht “cohesion
countries” (reported in my table 1) were encouraged by pegs that assumedly minimized currency risk and thereby created investor moral
hazard. The late Bill Branson, another participant in the Bellagio conference, noted that while intermediate regimes can stabilize real effective
exchange rates of developing country groups, peg to single currency is
exceptional (Macedo, Cohen, and Reisen 2001, 55–76). Flexibility within
a sufficiently wide band allows speculation not to be a one- way bet.
When very wide bands of 15% replaced the normal fluctuation margins, the external discipline provided by the grid no longer obtained
and each central bank could decide whether or not to intervene within
the old bands. They did just that, so that the system regained stability
after the widening of the fluctuation bands, which was then seen as a
necessary step toward the single currency. While the convergence process was not hurt, the lesson that the largely unwritten code of conduct
guiding realignments of the parity grid implied effective coordination
mechanisms among monetary and fiscal authorities led to complacency
in the run up to the EZ.
Kouri’s hope was further shattered by global payments imbalances
between high saving and low saving countries, for example, China and
United States (a.k.a. G2). Mike Dooley et al. (2009) argued that, under
a fixed exchange rate between the renminbi and the dollar, China had
become a periphery of the United States.4 The Bretton Woods II view
of the international monetary system justified complacency about
global payments imbalances, based on the persistence of effective capital controls between the two currency areas and on perfect substitut-
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Comment
395
ability between euro and dollar denominated assets. This view forgot
that financial globalization erodes capital controls and that imperfect
substitutability remained the rule across the countries on both sides of
the North Atlantic. I like to say that seeing the United States as an importer of last resort makes China’s export sector a gigantic Puerto Rico.
The late Jim Ingram (1962) noted: “In its economic planning the Commonwealth government rarely ever considers the possibility of any
payments difficulties, and most observers assume that balance- ofpayments problems cannot arise.” He added that in an open economy
with no exchange controls and a small “foreign- exchange reserve,”
this view demands an explanation: changes in expenditure in Puerto
Rico cause changes in income and imports that quickly affect the balance of payments. When reserves are huge and the export sector is an
enclave, does the parallel still apply or do we need more time consuming, painstaking work on exchange rates such as the one in this
paper?
On this general message, it is worth recalling that the choice of an
appropriate exchange rate regime is a key issue in international finance:
in the introduction to his Selected Readings, Richard Cooper warned that
“the paucity of empirical content is symptomatic of the field, not merely
of the selection for inclusion here” (1971, 7)5. Since both polar cases of
fixing and floating have their difficulties, I remember Barry referring to
the “Eichengreen donut.”6 In the same vein, at the turn of the century I
described the debate as “don’t fix don’t float” and tried to turn that
somewhat skeptical title into an argument for EZ convergence along the
following lines. As there are few currencies available to borrow credibility from, to earn credibility demands a process of institutional development and economic flexibility rather than importing it through a hard
peg and forgetting about domestic reforms. In a world of regional trade
blocs that look for ways to intensify cooperation, both pure floating and
hard pegs make future regional cooperation more difficult. A float is an
inherently unstable regime for countries competing on world markets
for a similar range of products and hence sets incentives for
beggar-thy-neighbor competitive devaluation. Floating induces noncooperative strategies, especially when competing neighbors face a common shock. Hard pegs are hard because it is so difficult to reverse them
and because they lack an exit strategy. They are thus only suited for
countries that aim at joining a monetary union with the anchor currency in not too distant a future. The perspective of joining or creating
a monetary union can make intermediate regimes more robust: the
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396
de Macedo
complexity of basket pegs with bands hampers their verifiability, but is
nevertheless needed for credibility. Once the effectiveness of the multilateral surveillance framework is verifiable, there should be greater tolerance for intermediate regimes, as the argument that they are “too
complicated for locals and for Wall Street” need not apply.
I firmly believe that the way in which geographical peripheries can
acquire a global reputation is by setting up a multilateral surveillance
framework, which involves a group arrangement capable of overcoming the cost of physical distance through financial proximity. Doctrinal controversies often reflect different assumptions about the relative
importance of initial conditions, terminal conditions, and the speed of
adjustment. The time it takes for a nation to acquire a reputation for
financial probity varies, but it typically involves several general elections where alternative views of society may confront each other. To
construct a social consensus domestically, credible signals that the authorities are committed to reform may be needed. If stable democratic
governments succeed in implementing reforms that help to achieve
convergence between poorer and richer nations and regions, they can
set off a self-reinforcing virtuous cycle of stability and growth. Instead,
there will be a vicious cycle if short- lived governments, fearing social
conflicts associated with reforms, delay their implementation.
The EZ did deliver convergence and cohesion in its first ten years
because the new politics of credibility overcame financial hierarchy
among sovereign risks. Trade unions recognized the perverse interaction between price and wage increases (which hurts the poor and unemployed disproportionately) and public opinion accepted the medium
term stance of policy. Yet it took longer to convince voters than markets,
and some countries used the Euro to procrastinate on their unpopular
reforms, threatening the benefits of the stability culture with the “Euro
hold up.” This tendency to procrastinate cast doubt on the efficacy of
the European financial architecture perspective and flexible integration schemes did not manage to increase the reform momentum during
good times.
With the crisis, the timing of exit strategies from the stimulus packages has been constrained by suspicions about the ability of governments to repay their mounting public debts. This has been a greater
problem for advanced countries because their public debts are larger. In
the EZ, there is the additional problem of graduating countries whose
financial reputation is not established enough to avoid negative con-
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Comment
397
sequences of rumors of possible default. While the suspension of the
Stability and Growth Pact to avoid possible penalties on large members
states made future fiscal rules less credible, such rules are needed to
enforce the “no bail- out” provision. The problem, however, goes beyond budgetary performance and even the fiscal monetary mix to the
extent that the financial institutions are essential actors in the global
economy. Thus, central banks are closest to commercial banks and other
financial intermediaries, yet the European Central Bank does not have
information on EZ systemically important financial institutions! This is
particularly serious because, even before the tensions arose in the EZ’s
most indebted countries, former threats on weak currencies were being
replaced by attacks on suspicious balance sheets.
If the exchange rate reflects the medium term credibility of national
policies, it will do so with considerable noise when the entire EZ is
under attack, with immediate impact on spreads relative to Germany
for government bond or credit default swaps. Just like little indication about the credibility of national policy could be gathered from
the realignments that occurred during the turbulent 1992–1993 period,
almost ten years later the same holds for the enlarging EZ periphery.
Speculative attacks on more vulnerable currency parities have more
negative effects on the system if parities are already locked than if they
continue to be flexible. The rise and fall of the EZ periphery is illustrated in table 1. Spreads have also revealed growing disparities within
the “cohesion countries.”7
With “currency wars” involving BRICS (Brazil, Russia, India, and
China) and EZ divergence reigning supreme, this empirical paper fits
in the painstaking, time- consuming work on exchange rates that might
“ultimately turn us against the current system of flexible exchange rates
in favor of a more orderly monetary system.” Upon reflection, however,
it may be “too early to tell.”
Table 1
Default History and Ratings in EZ Periphery
Spain
Ireland
Portugal
Greece
%
1979
2008 Sept.
2011 Mar.
24
n/a
11
51
71
78
52
62
90
92
85
81
72
61
55
47
Source: Percentage of years in default since 1800 and International Investor numerical ratings updated from Reinhart and Rogoff (2009).
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398
de Macedo
Endnotes
For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http: // www.nber.org / chapters / c12481
.ack.
1. The classification comes in the “coarse” and “fine” varieties and contains data since
1940, with 816 observations for 227 countries and territories. The “fine” classification unbundles categories one to six but there are less series than expected: 48 whole series missing (mostly territories); 54 same code throughout (mostly territories); 107 series without
missing values; 74 series with changes in code. A few countries change classification a
lot even among the six “coarse” categories, but most do not. To check for robustness, the
authors supplement the 51 cases with 32 depreciation-free exits; that is, the exchange rate
appreciated or did not move over the subsequent three months after the “flex.”
2. It was recently documented that he meant the riots of 1968 rather than the 1789
revolution (McGregor 2011).
3. Quoting again from Rose (2011): Hong Kong prides itself on having rigorously
maintained a fixed nominal exchange rate since 1983 through its currency board arrangement. Singapore, on the other hand, manages its monetary policy through its exchange
rate. Denmark has stayed fixed to the Euro (earlier, the Deutschemark) at the same rate
since 1987. Sweden has changed its regime a number of times since then, and now has a
flexible exchange rate. Finland has also changed its exchange rate regime repeatedly, and
joined the EMS (European Monetary System) and the EZ. The fact that similar economies
make completely different choices might lead one to despair; as a profession, we have
made little progress in understanding how countries choose their exchange rate regimes.
Still, one should first remember such choices often seem of remarkably little consequence.
4. “In the face of the worst financial crisis since the early 1930s, the fact that risk free,
long term real interest rates were—and still are—low by historical standards and that the
basic patterns of current account imbalance continue suggests that the system is in fact
extremely durable. Three key structures of the global financial system have remained
intact so far in the crisis: the Bretton Woods II system itself, the role of the dollar as the key
reserve currency, the structure of the EZ.A sudden stop of capital inflows to the US and
other industrial countries would cause real interest rates to spike up, especially government rates. The crucial implication of this economic analysis was that the system would
collapse via a collapse of the dollar and Treasury securities, with other assets crashing in
tandem.”
5. In part I, devoted to adjustment under fixed rates, he includes Hume (1752), Triffin
(1964), Johnson (1958), and Ingram (1962). Fellner’s (1966) call for limited exchange rate
flexibility is included in part II, devoted to adjustment through changes in exchange rates.
6. Rose (2011, 31, note 8) does not think much of the donut: “If you squint at the top
left diagram of Figure 1 in just the right way, you might pick out a tendency for the de
jure intermediate exchange rate regimes to shrink through the late 1990s. This was known
as the problem of the ‘disappearing middle,’ a much- discussed idea at the turn of the
century. However, the signs of the disappearing middle seem to vanish themselves when
one uses a de facto classification scheme, as shown by the other graphs in the figure.
Perhaps more importantly, most of the economy simply isn’t in intermediate regimes, if
one weights by GDP.”
7. Portugal five- year credit default swap (CDS) spreads before Greek bailout are presented and discussed in Macedo (2011, 50). Since then the spread with Spain is more
informative.
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