Monthly Archives: November 2013

As Time Goes By

Depending on how the beginning of the European debt crisis is dated (2010? 2008? 1999?), it has been several years since the governments of several nations have sought to relieve investors’ fears regarding their debt. The governments of four countries (Cyprus, Greece, Ireland, Portugal) turned to the IMF and other Eurozone nations for assistance, while Italy and Spain have undertaken policies designed to avoid the need for external assistance. To paraphrase a former mayor of New York, how are those governments doing?

To answer that question, we can draw upon Jay Shambaugh’s insight that there are actually three interlocking crises: a macroeconomic crisis, a debt crisis and a banking crisis.

First, we examine current data for the prevailing (2013) macro conditions in the (in)famous PIIGS, as well as the entire Euro area and, for the sake of comparison, the U.S. and Japan. We exclude Cyprus as its crisis occurred more recently:


GDP Growth

Unemployment Budget/GDP

Cur Acc/GDP



27.3 -2.4 0.1


13.2 -7.4




12.5 -3.3




15.6 -5.9




26.6 -7.1


Euro Area


12.2 -3.0




7.3 -4.0



1.9 4.0 -8.3


In the Eurozone countries, only Ireland (barely) has avoided a negative growth rate, while both the U.S. and Japan are doing better. The unemployment rates reflect the depths of the continuing downturns. The budget balances continue to record deficits that largely reflect cyclical conditions; Greece and Italy have primary budget surpluses. The current accounts all register surpluses, unlike the U.S. Nikolas Schöll at Bruegel examined the data to uncover the sources of the reversals of the trade deficits, and pointed out that Ireland, Portugal and Spain recorded large increases in exports, while Greece had a dramatic drop in imports.

Will 2014 be any better? The IMF’s October 2013 World Economic Outlook forecasts a swing to positive growth rates in all of Europe except Slovenia. But, it warned, “Additional near-term support will be needed to reverse weak growth…” and called for further monetary easing. The ECB has obliged by lowering its refinancing rate to 0.25% in response to falling inflation, not a hopeful sign of recovery.

How do these countries do on their sovereign debt? We can compare the debt/GDP data for 2010 with this year’s and next year’s expected levels:

























Euro Area












Several years of recession have pushed the ratios up despite fiscal constraint, and the IMF’s October 2013 Fiscal Monitor does not see any short-term improvement outside of Ireland. The increase in the U.S. ratio is not quite as large thanks to its economic recovery, while Japan continues to serve as an outlier. Charles Wyplosz thinks that Greece will require another debt rescheduling, and there are concerns regarding the need for another bailout in Portugal. Falling real estate prices in Spain continue to threaten its banks, while Italy’s largest burden is its politics. Ireland no longer needs external assistance, but it will take years to pay back the loans it received from the IMF and other European governments.

And interest rates? With the 10-year rate on German government bonds at 1.72%, the spreads for the other European countries last week were (in ascending order): Ireland 1.81%; Spain, 2.36%; Italy, 2.38%; Portugal, 4.29%; and Greece, 7.09%. The rates are not onerous despite mediocre economic conditions and steady debt burdens, and have fallen over the last year. What accounts for this remarkable sangfroid by investors?

The answer may be the status of the third crisis: banking. Last year the European Central Bank (ECB) under Mario Draghi instituted a new three-year Long-term Refinancing Operation (LTRO). Banks in southern Europe took the relatively cheap funds and bought the bonds of their own governments, which still carry zero-risk weights in the Basel capital regulations. As a result, according to Silvia Merler (also at Bruegel), banks in those European countries have “renationalized,” with domestic debt accounting for large proportions of their portfolios, and much of this debt consisting of government debt. Moreover, the ECB also announced that it would purchase a government’s sovereign bonds under its Outright Monetary Transactions program if necessary to maintain its target interest rate. Combine bank purchases of government debt with a guarantee of central bank intervention if markets deteriorate and the fall in yields is the obvious result.

All this has the appearance of a Rube Goldberg machine, with a feedback loop uniting the ECB, European banks and sovereign debtors. But is it sustainable? Must the ECB continue renewing the LTRO to keep the banks solvent? Will the European Banking Authority, currently undertaking stress tests of the banks, accept the arrangement? What if the fragile recovery turns out to be really fragile? And what will happen if/when the Federal Reserve does taper off its asset purchases? However many years this crisis has been going on, the exit is not visible yet.


The Stars and Stripes Forever?

Global imbalances are once again a focus of discussion. This time, however, it is Germany, not China, which is identified as the major surplus country and an obstacle to economic recovery.  The German surplus, it is alleged, makes adjustment harder in the Eurozone’s periphery countries.

Much less attention has been paid to the other side of the imbalances: the deficits in the U.S. current account. The U.S. balance of payments position reflects the dollar’s role as a global reserve currency. Andreas Steiner has shown in “Current Account Balance and the Dollar Standard: Exploring the Linkages” (Journal of International Money and Finance, in press) that the demand for reserves lowers the U.S. current account by one to two percentage points of GDP.

The demand for those reserves is not likely to diminish any time soon. Rakesh Mohan, Michael Debabrata Patra and Muneesh Kapur, in an IMF working paper, “The International Monetary System: Where Are We and Where Do We Need to Go?”, analyze the increase in reserves by major emerging market countries who may turn to reserve accumulation to expand their central bank balance sheets. They project the demand for foreign exchange reserves for seven emerging markets ((Brazil, Hong King, China, India, Korea, Russia, Saudi Arabia) under different scenarios for the mix of domestic and foreign assets, and estimate that their holdings of net foreign assets will increase from $6 trillion in 2011 to between $7.8 trillion and $14.9 trillion by 2017.  They caution that other emerging markets, such as oil exporters, are not included in their projections, and the demand for foreign assets may be higher.

The use of the dollar as an international currency appears in private markets as well. Mohan, Patra and Kapur present data that show the dollar with a 44 percent share of the global foreign exchange market. The dollar’s predominance in the foreign exchange market is matched by its use in international banking and bond markets.

Joseph Gagnon in “Global Imbalances and Foreign Asset Expansion by Developing-Economy Central Banks” has argued that the demand for dollar-denominated assets by central banks drives the balance of payments surpluses in many emerging markets.  If the dollar retains its status as a reserve currency, then there will always be a demand for dollars that feeds into the balance of payments. Until there is a credible alternative (or alternatives), global imbalances that include U.S. deficits will be an inherent feature of the international monetary system.

What could threaten the dollar’s special status? Emmanuel Farhi, Pierre-Olivier Gourinchas and Hélène Rey argue in their Reforming the International Monetary System that the “backing” of the dollar, which took the form of gold under the Bretton Woods system, now exists in U.S. Treasury securities. If there is a change in perception about the reliability of this backing, then the transition to a multipolar reserve currency system may be more abrupt than desired.

Assigned Readings: November 14, 2013

Taking a historical perspective of economic changes, this paper argues that muddling through crises-induced reforms characterizes well the evolutionary process of forming currency unions. The economic distortions facing the euro include structural challenges in the labor and product markets, and financial distortions. While both structural and financial distortions are costly and prevalent, they differ in fundamental ways. Financial distortions are moving at the speed of the Internet, and their welfare costs are determined more by the access to credit lines and leverage, than by the GDP of each country. In contrast, the structural distortions are moving at a slow pace relative to the financial distortions, and their effects are determined by inter-generational dynamics. These considerations suggest that the priority should be given to dealing with the financial distortions. A more perfect Eurozone is not assured without successfully muddling through painful periodic crises.

International financial linkages, particularly through global bank flows, generate important questions about the consequences for economic and financial stability, including the ability of countries to conduct autonomous monetary policy. I address the monetary autonomy issue in the context of the international policy trilemma: countries seek three typically desirable but jointly unattainable objectives: stable exchange rates, free international capital mobility, and monetary policy autonomy oriented toward and effective at achieving domestic goals. I argue that global banking entails some features that are distinct from broad issues of capital market openness captured in existing studies. In principal, if global banks with affiliates established in foreign markets can reduce frictions in international capital flows then the macroeconomic policy trilemma could bind tighter and interest rates will exhibit more co-movement across countries. However, if the information content and stickiness of the claims and services provided are enhanced relative to a benchmark alternative, then global banks can weaken the trilemma rather than enhance it. The result is a prediction of heterogeneous effects on monetary autonomy, tied to the business models of the global banks and whether countries are investment or funding locations for those banks. Empirical tests of the trilemma support this view that global bank effects are heterogeneous, and also that the primary drivers of monetary autonomy are exchange rate regimes.

We analyse global and euro area imbalances by focusing on China and Germany as large surplus and creditor countries. In the 2000s, domestic reforms in both countries expanded the effective labour force, restrained wages, shifted income towards profits and increased corporate saving. As a result, both economies’ current account surpluses widened before the global financial crisis, and that of Germany has proven more persistent as domestic investment has remained subdued.

In contrast to earlier recessions, the monetary regimes of many small economies have not changed in the aftermath of the global financial crisis. This is due in part to the fact that many small economies continue to use hard exchange rate fixes, a reasonably durable regime. However, most of the new stability is due to countries that float with an inflation target. Though a few have left to join the Eurozone, no country has yet abandoned an inflation targeting regime under duress. Inflation targeting now represents a serious alternative to a hard exchange rate fix for small economies seeking monetary stability. Are there important differences between the economic outcomes of the two stable regimes? I examine a panel of annual data from more than 170 countries from 2007 through 2012 and find that the macroeconomic and financial consequences of regime‐choice are surprisingly small. Consistent with the literature, business cycles, capital flows, and other phenomena for hard fixers have been similar to those for inflation targeters during the Global Financial Crisis and its aftermath.

  • Much has been done since 2010 to reduce macroeconomic imbalances in the Euro Area periphery and to bolster economic and financial integration at the EU level
  • Stronger exports may now be stabilizing output after two years of contraction, but headwinds remain with fiscal adjustment continuing and bank lending constrained
  • Market sentiment, underpinned by OMT, has improved with better economic news
  • Challenges remain, however, including the need to restore full bond market access for Portugal as well as Ireland and agree further financing and relief for Greece
  • Italy remains at risk over the longer term, with a return to durable growth requiring deeper structural reforms that political divisions are likely to impede
  • Progress mutualizing sovereign and bank liabilities looks likely to remain limited, leaving Euro Area members vulnerable to renewed weakness in market sentiment

Strategic Retreat or Tactical Pause?

Several recent analyses of financial globalization offer different perspectives on whether the recent contraction in capital flows represents a cyclical decline or a long-term reversal. On the one hand, the expansion of gross financial flows in the last decade among upper-income countries will not continue at the same pace. But the development of financial markets in emerging markets will increase capital flows within that group of countries as well as draw funds from the advanced economies.

Richard Dobbs and Susan Lund of the McKinsey Global Institute note that cross-border flows are more than 60% below the pre-crisis peak. They attribute the decline to a “dramatic reversal of European financial integration” as European banks curtail their lending activities. They also draw attention to “a retrenchment of global banking” due to a reassessment by banks of their foreign activities in light of new capital requirements and regulations. Dobbs and Lund are concerned that too strong a reversal will result in a segregated global financial system.

Greg Ip of The Economist also writes about a reversal of financial integration for a similar set of reasons. Bankers are shrinking their balance sheets while regulators seek to shield their domestic financial markets from foreign shocks. In addition, Ip draws attention to the renewed interest in the use of capital controls to lower volatility. The IMF now includes controls as a tool that policymakers can use to manage the risks associated with surges of capital flows. But like Dobbs and Lund, Ip is concerned about financial fragmentation, and urges financial regulators to cooperate in order to achieve common standards.

The authors of the World Bank’s Capital for the Future: Saving and Investment in an Interdependent World, on the other hand, draw attention to developing countries and emerging markets as both a source and destination of capital flows. These countries are likely to account for an increasing share of gross capital flows, which will be driven (p. 125)  “…by more rapid economic growth and lower population aging in developing countries than in advanced countries, as well as by developing countries’ relatively greater scope for increasing openness and strengthening financial sector institutions.” They see evidence of this trend prior to the global financial crisis, as the share of gross capital inflows to developing countries rose from 4 percent of the total in 2000 to 11 percent in 2007.

Foreign direct investment accounted for most of these inflows, although bank loans have also increased. While portfolio flows have constituted a relatively small share of inflows to these countries, the authors of Capital for the Future believe that in the future a larger proportion will flow through the capital markets. Ultimately, they claim (p. 131), there will be “developing-country convergence with advanced economies in terms of their composition of their capital inflows.” Policymakers can expedite the transition to more portfolio flows through the development of domestic financial markets and their regulatory structure.

China will play a major role in any increase in capital flows to emerging economies. Foreign exchange reserves have been the traditional form of asset accumulation in that country. Tamim Bayoumi and Franziska Ohnsorge of the IMF use a portfolio allocation model to speculate about the effects of the liberalization of capital regulations by the Chinese authorities on the private sector. They infer from their estimates that (p. 14) “capital account liberalization may be followed by a stock adjustment of Chinese assets abroad on the order of 15-25 percent of GDP and a smaller stock adjustment for foreign assets in China on the order of 2-10 percent of GDP.” The acquisition of foreign stocks and bonds by Chinese investors who would seek to diversify their portfolios could offset any continued increase in FDI inflows. The IMF economists contrast this forecast with one for India, which they believe would have more balanced flows following capital account deregulation because of smaller asset holdings by Indian investors and hence a more restricted scope for diversification.

These scenarios for the future of financial globalization need not contradict each other. On the one hand, bank lending in the U.S. and Europe is likely to be limited as governments enact new regulations and Europe continues to deal with its debt crisis. But investors in those countries may look to the emerging and “frontier” markets for higher returns based on their growth, while increased income in the emerging markets will drive a demand for liquid financial instruments that will spill over into foreign markets. In addition, firms in those countries will look to expand their operations in other developing economies through investments. Financial flows may follow a new course, but will not be contained for long.

Here and There: Nov. 5, 2013

  1. Jérémie Cohen-Sutton has a review at the Bruegel blog of the recent discussion regarding the impact of the choice of exchange rate regimes on economic performance. He provides links to the relevant posts.
  2. The IMF holds its Fourteenth Jacques Polak Annual Research Conference at its headquarters in Washington, DC on November 7-8, 2013. The program is here and there is a preview here.
  3. There is an informative summary at Twenty-Cent Paradigms of the discussion over Germany’s current account surplus.

1944, 1976, 2013?

When the financial crisis of 2007 was changing into the Great Recession of 2008-09, national leaders such as French President Nicolas Sarkozy and British Prime Minister Gordon Brown turned to the Bretton Woods conference of 1944 for inspiration. They invoked the spirit of the conference as they sought to resolve the crisis and devise regulations that would allow them to rein in the financial institutions that they held responsible for instigating the crisis. Indeed, Bretton Woods is often used as a model of international cooperation. (See, for example, here and here.)

But Bretton Woods is an odd choice for a prototype of international collaboration. Benn Steil in The Battle of Bretton Woods has shown how the conference proceedings were controlled by the U.S. delegation headed by Harry White, the U.S. Assistant Secretary of the Treasury. John Maynard Keynes, a member of the British delegation, was out-maneuvered by White, and the final agreement reflected the U.S. vision for the post-war international monetary regime more than anyone else’s. While the conference had a Quota Committee, for example, in reality the quotas assigned the members were chosen by the U.S. officials.

A more apt historical precedent may be the negotiations that took place during the early 1970s over the design of an international monetary system to replace Bretton Woods. Michelle Frasher has provided an account of these consultations in Transatlantic Politics and the Transformation of the International Monetary System. The U.S. had ended the conversion of gold for dollars by foreign central banks in August 1971. This act, according to Frasher, reflected the belief of U.S. President Richard Nixon and his Treasury Secretary John Connally that maintaining gold conversion limited their domestic and foreign policy options rather than any ideological view regarding Bretton Woods.

However, George Schultz, Connally’s successor as Treasury Secretary, came to favor floating exchange rates after the breakdown of the Smithsonian agreement in 1973. But while the U.S. had been able to dominate its Allies in 1944, it faced a different situation in the early 1970s.  It could not ignore the wishes of its major European allies, France, West Germany and Great Britain, which were concerned about unconstrained markets. The French in particular sought to place restraints on the ability of nations to maintain floating rates. In the end, the U.S. and French negotiators agreed to amend the IMF’s Article IV to include a commitment by the IMF’s members “to assure orderly exchange arrangements and to promote a stable system of exchange rates…” The IMF is still struggling to explain what this means in terms of which practices are permissible and which are not.

Over three decades later, many of the same tensions persist. Now, however, it is China and other Asian countries that express concerns about the U.S. Frasher (p. 135), for example, describes the source of the Europeans’ resentment in the 1970s:

…the US tendency to behave paternally and use its reserve status to disregard European opinions, act unilaterally on major policy initiatives, frame the relations in terms of US interests, and dictate the conditions of international monetary reform constantly frustrated European views about partnership. The economic and political differences within the transatlantic alliance made for an unconstructive, uneven, and often tense partnership.

Substitute “Asian” for “European” and “transpacific” for “transatlantic,” and we have a good summary of the Asians’ current views of the U.S. For example, Justin Yifu Lin, a former Chief Economist of the World Bank and the founding director of the China Center for Economic Research, wrote in Against the Consensus: Reflections on the Great Recession (p. 156)

One of the main flaws in the nonsystem that evolved in the post-Bretton-Woods period eventually led to the 2008-9 global crisis: the potential conflict of interest between US macroeconomic policy for domestic objectives and the dollar’s role as a global reserve currency…Inevitably, national economic concerns guided US fiscal and monetary policies, at times in ways that were detrimental to global stability.

Similarly, Xu Hongcai of the China Center for International Economic Exchanges in an article in the Global Summitry Journal co-authored with Yves Tiberghien wrote (p. 10):

Despite the status of the US as anchor for the global monetary system, the US central bank, the Federal Reserve is strictly mandated to set its monetary policy with consideration for US inflation, growth, and employment only. There is no channel for inputs from the rest of the world in managing the world’s currency. Thus, the major international reserve currency issuer continues to implement quantitative easing monetary policies in light of the needs of its own economy without considering the global spillover effect of such policies. These policies have caused inflationary pressures on emerging economies, and in turn increased the systemic risks of the global financial system.

After 1976, France gave up trying to devise a rule-based global system and turned to a regional system. What are China’s options? It has already shown a willingness to join with other Asian nations in a currency swap arrangement, the Chiang Mai initiative. It has the potential to do more, and could become a regional reserve currency. But to increase the use of the renminbi would require further financial decontrol, and until recently it did not appear that the government was ready to move in that direction. Most observers thought that a “fully global renminbi was a distant goal.”

The political battles over the debt ceiling, however, may push the Chinese government to rethink its long-run plans for the renminbi. Chinese officials expressed their frustration with the indifference of the U.S. to the global consequences of its domestic political discord. If Chinese policymakers now advance their timetable for expanding the renminbi’s use as a global currency, we may look back at 2013 as an inflection point.