“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

I

nflation

T

argeting: 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… 1 st 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

2 nd 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), G-7, IMF, & even the Meltzer Report CFR (1999), (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”)

23 GS Global ECS Research

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”)

GS Global ECS Research 24

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

1) 2)

There is no reason to expect better today:

Capital mobility is much higher now than in the 1960s.

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

 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 1 st 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 H

t

= c + ∑ w(j) Δ logX

(j) t

+ ß {Δ emp

t } + u t

= c + w(1) Δ log $

t

+ w(4) Δ log £

t

+ w(2) Δ log € + …

t

+ w(3) Δ log ¥

t

+ ß {Δ emp

t } + u t

where

H ≡

value of home currency,

X (j)

defined in terms of suitable numeraire, like SDR

≡

value of foreign currency

j ,

w(j)

≡ currency weights in basket, to be estimated ;

Δ emp

t

≡ change in Exchange Market Pressure ≡

Δ log H

t

+ (ΔRes

t )/Monetary Base t 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 7.00

(as in 1990s) Change in

6.00

in % of GDP

Reserves

5.00

(Low- and middle-

Net Capital

4.00

income countries)

Flow

Asia crisis 3 rd boom 3.00

1980-2006 international debt crisis 2 nd boom 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

Current Account Balance

53 -4.00

Best and Worst Performing Countries -- F&S (2010), Appendix 4

GDP Change, Q2 2008 to Q2 2009

-25% Bo tto m 10 To p 10

64 countries in sample

-20% -15% -10% Lithuania Latvia Ukraine Estonia Macao, China Russian Federation Georgia Mexico Finland Turkey Australia Poland Argentina Sri Lanka Jordan Indonesia Egypt, Arab Rep.

Morocco India China -5% 0% 5%

Ta ble Appe ndix 6 Coe fficie nts of Biva ria te Re gre ssions of Crisis Indica tors on Ea ch Inde pe nde nt Va ria ble * (t-sta t in pa re nthe se s)

b olded numb er indicates statistical signficance at 10% level or lower, dark er color shading equivalent to higher statistical significance

F & Saravelos (2010): Inde pe nde nt Va ria ble Bivariate Curre ncy Ma rke t Equity Ma rke t Re course to IMF Industria l Production GDP

Reserves (% GDP)

0.008 Yes (0.27)

(2.52)

(1.6)

(-1.92) (2.22) S ignif ic a nt a nd C o ns is t e nt S ign?^

R E S E R V E S

Reserves (% external deb t) Reserves (in months of imports) M2 to Reserves

(-1.42) (1.58) (0.14)

(2.11) (4.71) (-3.81) (-3.42) (-3.31)

(-1)

(3.62)

(1.48)

(-2.46) 0.000

Yes

(3.07)

0.001 Yes (0.75) 0.000 Yes (1.44)

Short-term Deb t (% of reserves)

-0.000

Yes

(-2.93) (-2.6) (-4.45)

(1.18) (-1.7) R E E R

REER (5-yr % rise)

(-5.4)

(-0.32) (0.99) (-0.01) (-0.85)

REER (Dev. from 10-yr av) GDP growth (2007, %)

(-2.93)

(-0.81) (0.58) (-0.01) (-0.91) -0.002 Yes (-1.21)

(1.7)

(1.58) (1.63)

(2.59)

GDP Growth (last 5 yrs)

G D P (1.08)

(2.14) (1.68) (2.14)

(-1.21)

GDP Growth (last 10 yrs)

(1.59) (1.06) (1.2)

(2.63)

(-0.76)

GDP per capita (2007, constant 2000$)

C R E D I T

Change in Credit (5-yr rise, % GDP) Change in Credit (10-yr rise, % GDP) Credit Depth of Information Index (higher=more) Bank liquid reserves to b ank assets ratio (%) Current Account (% GDP)

(-0.7) (-0.83)

(-2.84)

(-1.34) (1.52)

(-4.69) (-5.42) (-3.9) (-1.72)

(1.51)

(-3.23)

(0.37) (-0.08) (0.19)

(-13.97) (-2.48)

(-1.67) (-1.58) (0.57)

(2.34) (-1.74) -0.065

Yes

(-2.34)

-0.019 Yes (-1.13) (-0.47)

0.001

Yes

(2.58)

0.000 Yes (0.78) (1.57)

(2.18) (-3.46)

(0.42) C U R R E N T A C C O U N T

Current Account, 5-yr Average (% GDP) Current Account, 10-yr Average (% GDP) Net National Savings (% GNI) Gross National Savings (% GDP)

(1.31) (0.72) (0.9) (1.66) (1.46)

(4.5) (-2.76) (-2.63) (-1.88)

(0.53) (0.15)

(2.42)

(0.42) (1.59) 55

0.002

Yes

(2.92) 0.002

Yes

(2.52)

(0.76)

(3.9) (-2.51) (1.99)

M O N E Y

Change in M3 (5-yr rise, % GDP) Change in M2 (5-yr rise, % GDP)

(0.16) (-1.41) (-0.14) (-1.49) (-1.05) (0.09) (-1.5) (0.63) (-1.14) (-0.91)

Trade Balance (% GDP)

T R A D E (0.44) (1.2)

(-2.38)

(-0.78) (0.01) Yes Yes Yes

*OLS with heteroscedaticity rob ust standard errors performed for four continuous variab les; prob it for IMF recourse variab le

^At least two statistically signficant coefficients, of which all must have consistent sign (consistent = same sign, with exception of coefficient on IMF recourse variable, which should have opposite sign) Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes 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 % Changes (H208-H109 Recourse to IMF (SBA only) Equity %Chng (Sep08 Mar09) Equity % Chng (H208 H109) Inde pe nde nt Va ria ble

Reserves (% GDP)

0.010 Yes (0.14)

(3.63) (2.98) (-1.66)

(0.12)

S ignif ic a nt a nd C o ns is t e nt S ign?^

R E S E R V E S

Reserves (% external deb t) Reserves (in months of imports) M2 to Reserves

(1.06)

(2.25)

(0.27) (1.1)

(1.95)

(0.76)

(-2.29) (-3.01)

(-0.91)

(1.81)

(1.32) (0.02)

0.000

Yes

(2.65) 0.009

Yes

(2.32)

(-0.09)

Short-term Deb t (% of reserves)

-0.001

Yes

(-3.11) (-1.97) (-4.22) (2.13) (-2.89)

R E E R

REER (5-yr % rise) REER (Dev. from 10-yr av)

(-5.55) (-3.96) (-3.19) (-2.47) (2.15) (2.56)

(-1.24)

(-1.71)

-0.185 Yes (-1.61)

-0.316

Yes

(-2.1)

GDP growth (2007, %)

(-0.2) (0.94)

(2.58)

(-0.1) (-0.71) G D P

GDP Growth (last 5 yrs)

(-0.81) (0.26)

(2.4)

(-0.26) (-1.15)

GDP Growth (last 10 yrs) Change in Credit (5-yr rise, % GDP)

(0.14) (0.43)

(1.66)

(-0.67) (-1.12)

-0.248

Yes

(-4.13)

(-0.36) (-0.98) (1.02)

(-2.97)

C R E D I T

Change in Credit (10-yr rise, % GDP) Credit Depth of Information Index (higher=more)

(-0.93) (-1.06) (-1.05) (0.05) (1.03)

(2.4)

(-1.65) (-0.37)

(-2.35)

C U R R E N T A C C O U N T

Bank liquid reserves to b ank assets ratio (%) Current Account (% GDP) Current Account, 5-yr Average (% GDP) Current Account, 10-yr Average (% GDP) Net National Savings (% GNI) Gross National Savings (% GDP)

(3.84)

(1.48) (0.48) (0.14) (1.6)

(2.01)

(0.5)

(2.7) (1.82)

(1.39)

(2.33) (2.53) (-11.44) (-2.09) (-1.72) (-2.11)

(-1.22) (-1.36) (-0.54)

(3.84) (2.4) (2.21) (2.92) (3.42)

(-1.33) -0.002 Yes (-0.79)

0.007

Yes

(3.95) 0.006

Yes

(2.74) 0.007

Yes

(2.44) (2.28)

56 Yes

0.006

Yes

(3.03)

M O N E Y

Change in M3 (5-yr rise, % GDP) Change in M2 (5-yr rise, % GDP)

(0.46) (-0.16) (-0.08) (-1.08)

(-2.79)

Trade Balance (% GDP)

(0.33) (-0.29) (0.51) (-1.25)

(-2.86) 0.003

Yes

(1.97)

T R A D E

(1.73) (1.78)

(-1.51)

(2.72)

Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes

*OLS with heteroscedasticity rob ust standard errors performed for four continuous variab les; prob it for IMF recourse variab le

^At least two statistically signficant coefficients, of which all must have consistent sign (consistent = same sign, with exception of coefficient on IMF recourse variable, which should have opposite sign)

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 (Bernanke)  The US appropriately exploits its comparative advantage in supplying high-quality assets to the rest of the world .

• “ 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 20 th 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) 2) Inertia Nonlinearity in determinants lags logistic functional form or dummy for leader GDP 64

0.6

0.4

0.2

0.0

1.0

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 .

Simulation assumes $ depreciation continues at 2001-04 rate.

USD Chinn & Frankel (2005) 0.8

DEM

birth of €

EUR

This scenario showed € overtaking $ as top international reserve currency in 2022.

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

International reserve holdings Vehicle currency for foreign exchange intervention

Private actors

Currency substitution (private dollarization) Invoicing trade and financial transactions Anchor for pegging Denominating trade and local currency 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 $. 69 Still, it is back in the world monetary system.

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. 71  such as temporary credits for investment or hiring.

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.” “Republican & Democratic Presidents Have Switched Economic Policies”

Milken Inst.Rev.

75 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] [3] William Gale & Brennan Kelly, “ The ‘No New Taxes’ Pledge ,”

Tax Notes,

2004 .

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

24 22 14 12 10 20 18 16 (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$)

ρ = 0.86

1 -1 -3 5 3 9 7 15 13 11 Spending/GDP Budget Balance/GDP 77 Source: OMB

(iii) States ranked by federal spending received per tax dollar paid in 2005 versus party vote ratio in preceding election “red” states big inflow of US $

Republican states take home significantly more federal $ (relative to taxes paid)

than Democratic states “blue” states low inflow of US $ 78