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The Coming Wave of Debt Restructurings

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The news that the Federal Reserve will raise interest rates in 2022 sooner than anticipated was not surprising in view of the continued high rates of U.S. inflation. While U.S. asset prices are falling in response to the prospect of higher rates as well as a smaller Fed balance sheet, foreign markets are straining to decipher the spillover effects on their economies. But it is only a matter of time until emerging markets and developing economies face higher financing costs and the need for debt restructurings.

The World Bank pointS out in its most recent Global Economic Prospects that global debt levels in 2020 rose to their highest levels relative to GDP in decades. The publication also shows that economic projections for the emerging markets and developing economies excluding China are for lower growth rates than those of the advanced economies. Consequently, servicing and repaying the debt represents a challenge for those countries. World Bank President David Malpass warned that 60% of the poorest countries need to restructure their debt or will need to.

Ayhan Kose, Franziska L. Ohnsorge and Carmen Reinhart of the World Bank and Kenneth Rogoff of Harvard University examine the options that countries with elevated debt levels face in their NBER working paper, ”The Aftermath of Debt Surges.” They divide the possible responses into orthodox and heterodox solutions. The former includes strong economic growth that reduces relative debt levels as well as fiscal consolidation that can generate surpluses to pay off debt. Other measures are the privatization of public assets and higher wealth taxation, both of which can yield needed revenues. All come with associated downsides hazards, such as higher interest rates if growth comes with more inflation, or a lack of the conditions needed for successful privatization.

Heterodox approaches include unexpected inflation to erode real debt levels, financial repression to maintain low interest rate and debt default or restructuring. The authors point out that external defaults and restructuring impose long-term costs in the form of higher bond yields. Nonetheless, they warn that debt default, both external and domestic, may become more common in the wake of the increase in debt in response to the pandemic.

Similarly, Stephan Danninger, Kenneth Kang and Hélène Poirson of the IMF have a post on the IMF’s Blog, “Emerging Economies Must Prepare for Fed Policy Tightening,” that presents measures that the governments of these countries should undertake to limit the fallout from higher foreign rates. These include allowing their currencies to depreciate while raising their own interest rates. Of course, such measures make supporting a weak domestic economy more difficult. They warn that countries with significant nonperforming debt levels will face solvency concerns.

The IMF, the World Bank and the Group of 20 have joined together to implement a “Common Framework” to help low-income countries deal with their unsustainable debt. Creditor Committees will be created on a case-by-case basis to coordinate debt restructuring by private and official creditors. Private lenders, however, have not shown an interest in joining the program and to date, only three countries—Chad, Zambia and Ethiopia—have applied for assistance.

Another challenge facing the Common Framework is the role of China, which has become the largest bilateral lender to the low-income countries. China has not joined the Paris Club, the organization of creditor nations that deals with bilateral debt between advanced economies and low-income countries. However, it has to date followed the policies of the Paris Club members in deferring debt. One possible complication consists of whether loans from Chinese policy banks, such as the China Development Bank and the Export-Import Bank of China, and state-owned commercial banks, such as the Industrial and Commercial Bank of China, should be treated as private or official creditors.

Anne Krueger of Johns Hopkins University has warned that debt restructuring and further lending should be accompanied by appropriate economic policies. Some countries were engaging in unsustainable spending before the pandemic, and any new lending should be used for spending related to the pandemic. She cites Bolivia, Ghana, Madagascar, Pakistan, Sri Lanka, and Zambia as countries that had excessive expenditures before the pandemic.

The possibility of a debt crisis among the emerging markets and developing nations has long been foreseen (see here and here). The wave of new lending to these countries in the period preceding the pandemic was similar to previous surges that had led to financial crises, and the pandemic further raised debt levels. The combination of higher interest rates in the advanced economies, sluggish economic growth and the possibility of further disruptions due to the pandemic pose a challenge to governments with limited abilities to respond.

The Return of Global Imbalances?

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The global economic contraction following the pandemic has led to a massive fiscal response. Governments have acknowledged the need to increase spending in order to offset the declines in consumption and investment. The decreases in public savings can lead to rising current account deficits that offset the capital inflows needed to cover the gap between savings and investment. But will these measures generate a return to the global imbalances that preceded the global financial crisis?

The IMF’s External Sector Report for 2020, subtitled Global Imbalances and the COVID-19 Crisis, appeared in August (see a summary here). The analysis was based on data from 2019, when the global current account imbalance (the absolute sum of all surpluses and deficits) fell by 0.2 of a percentage point to 2.9% of global GDP. But the report’s authors also considered the impact of the pandemic on countries’ balance of payments.

The IMF’s analysis suggested that about 40% of the 2019 current account positions were excessive. Larger than warranted surpluses were registered by Germany and the Netherlands, while deficits were larger than warranted in Canada, the U.K. and the U.S. China’s external position was in line with its fundamentals and policies.

In the report the IMF anticipated that in 2020 the U.S. would report a current account deficit equal to 0.5% of world GDP. Canada and the U.K.’s deficits were each projected to be equal in value to about 0.1% of global output. China was expected to register a surplus of about 0.2% of world GDP, as were Germany and Japan. These forecasts come with a large degree of uncertainty, and the report’s authors acknowledge that global financial stress could lead to more capital flow reversals and larger imbalances.

More recent data show clearly that the U.S. and China are running the largest current account imbalances in absolute terms. Brad Setser of the Council on Foreign Relations points out that Chinese firms have benefitted from the demand for electronic goods as workers stay at home, as well as the need for personal protective equipment. Moreover, the Chinese government has supported its firms that export, with less direct support for households. The U.S. has provided more direct support to households.

The fiscal responses of the two countries to the pandemic also differ. The Economist estimates that the 2020 U.S. budget balance will show a deficit equal to 15.3% of its GDP, while China’s deficit is estimated at 5.6% of GDP. Part of the U.S. fiscal deficit will be offset by household savings, which increased last spring to over 30% of disposable income. The savings rate has slowly come down since then, while households attempt to plan their spending in a world of uncertainty. If the recovery in the U.S. stalls and there is no additional fiscal stimulus, then households will be forced to dip into their savings.

The IMF’s current account forecasts are consistent with the analysis of  Matthew Klein and Michael Pettis in their recent book, Trade Wars Are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace.  The authors claim that these imbalances reflect domestic policies that privilege the more affluent members of a country. The trade wars that divide nations reflect divisions within these countries between asset owners and workers.

Klein and Pettis attribute China’s surpluses, for example, to government decisions in the 1990s to foster development through investments and exports while suppressing Chinese consumption in order to generate savings. The government has since acknowledged this imbalance and sought to rebalance domestic spending, in part by promoting consumption expenditures while curbing shadow banking. But whenever economic growth has slowed, the government has responded by encouraging new investment, including housing, and total credit to the private sector has grown to 216% of GDP.

Similarly, Germany’s current account surpluses reflect its policies designed to encourage growth after the decade of the 1990s, when the costs of reunification weighed down the economy. There was a conscious decision to encourage savings, a shift that benefited capital owners at the expense of labor. Until this year the government took pride in its balanced budgets, despite a need for infrastructure spending. The high personal savings rate reflects in part a high degree of income inequality, with most gains going to those households more likely to save them. There was also an emphasis on the country’s external position, and wage increases were limited in order to hold down costs.

The increases in foreign savings were matched by capital flows to the U.S. These reflected the U.S. position as the financial hegemon, with the most liquid financial markets. Moreover, the U.S. provided something of great value: safe assets. U.S. Treasury bonds have been the preferred asset of central banks and European savers, although before the 2008-09 financial crisis mortgage backed securities with AAA ratings were seen as acceptable substitutes. The financial sector within the U.S. benefitted from the increase in domestic and foreign financial activity. But the capital inflows appreciated the dollar, which undermined the export sector. In the years leading up to the global financial crisis the Federal Reserve kept interest rates low in order to boost spending. A weak recovery after that crisis caused the Federal Reserve to continue its low interest rate policy.

The pandemic has brought a return to past conditions. Whether or not the most recent increase in the Chinese trade surplus is a transitory phenomenon, its current account is on track to record a surplus for the year (although at a much lower level than before the global financial crisis). Similarly, while Germany’s budget balance is forecast to show a deficit of 7.2% of its GDP for the year, its current account is expected to register a surplus equal in value to almost 6% of its GDP.  The U.S. current account deficit, which peaked at 6% of GDP in 2005, was equal in value to 3.5% of GDP in the second quarter of this year.

Klein and Pettis write that past global imbalances reflected a complementarity of interests between American financiers and Chinese and German industrialists, and reinforced inequality.  To change these patterns requires policy reorientations within these countries that will allow more income to be transferred to households. They admit that this is a difficult task, but point out that a new system was devised by the Allied nations at Bretton Woods in 1944 in order to guarantee living standards. The upheaval produced by the pandemic is global in nature and has the potential to bring about another policy transformation. The one necessary element that will be contested by those who profit from current arrangements is the political will.

Is There a Future for FDI?—Update

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The Organization of Economic Cooperation and Development (OECD), which recently reported on foreign direct investment (FDI) in 2019, has released a new study on the impact of the pandemic on future FDI. The OECD points out notes that FDI flows before the pandemic have been on a downward trend since 2015, and FDI flows in 2018 and 2019 were lower than any years since 2010, suggesting that the decline in FDI will not be reversed when the pandemic eases. This comes as policymakers in the U.S. and elsewhere show concern over Chinese acquisition of domestic firms, and the Chinese government clamps down on Hong Kong’s autonomy.

The OECD report’s authors have optimistic, middle and pessimistic scenarios on the effectiveness of public health and economic policy measures, and their impact on FDI flows in the medium term. Under the optimistic scenario, public health measures are effective in controlling the spread of the virus and economic policies successful in restoring economic growth in the latter half of this year. FDI flows would fall between 30% to 40% in 2020 before rising by a similar amount in 2021 to their previous level. Under the middle scenario, public health and economic policy measures are partially but not completely effective, and FDI flows fall between 35% to 45% this year before recovering somewhat in 2021, but would remain about one-third below pre-crisis levels.  The pessimistic scenario is based on the need for continued measures to contain the virus and repair extensive economic damage, which would lead to drop in FDI flows of over 40% this year and no recovery in 2021.

The impact of an extended decline in FDI will be particularly severe for emerging market and developing economies, which have already seen the reversal of portfolio capital flows. The OECD report points out that the primary and manufacturing sectors, which account for a large proportion of FDI in these economies, have been particularly hard hit during the pandemic. Moreover, the corporate earnings that are a major source of the funding of new FDI expenditures by multinational firms fell in 2019 and will decline further this year.

The decline in FDI will be significant for these economies. FDI flows are usually more stable than other forms of capital flows, but even FDI collapses when it by global turbulence. The parent companies often have the financial resources to assist affiliates in troubled economies, but no advanced economy is escaping the downturn. The decline in spending not only affects the employees in the host country, but also harms domestic suppliers and others who benefit from the activities of the multinational.

The pandemic is also motivating governments to monitor and restrict the acquisition of domestic firms. Several U.S. Senators have urged Treasury Secretary Steven Mnuchin to limit the purchase of U.S. firms with depressed stock prices by Chinese firms. The U.S. has already limited Chinese acquisition of domestic firms in critical sectors, and that will now most likely be expanded to include medical goods and services. Portfolio investment is also under scrutiny. The U.S. Senate has passed a bill that requires foreign companies to allow their records to be audited by the Public Company Accounting Oversight Board in order to sell stock or bonds in the U.S., and the House of Representatives is considering a similar bill. While the bill will affect all foreign firms, it clearly is aimed at Chinese firms.

The U.S. is not alone in acting to restrict foreign investment. Several European countries have mechanisms to review foreign investment in order to protect critical technologies, as do India and Australia. These will now be extended to include medical goods and services. The European Union’s competition chief, Margrethe Vestager, has urged the governments of the EU’s members to purchase shares of ownership stakes in companies in order to prevent foreign takeovers.

FDI to China is also likely to suffer from the Chinese government’s enactment of a new security law for Hong Kong. U.S. Secretary of State George Pompeo’s response that the U.S. will no longer consider Hong Kong to have significant autonomy will not only imperil Hong Kong’s status as an international banking center, but also its role as the major source of FDI for China. The Chinese government’s willingness to forsake that source of funding suggests that it no longer believes that FDI has a critical role to play in the country’s economic development.

FDI, then, faces a range of barriers. The pandemic puts multinational plans for expansion, already scaled back, on hold. The division into a world of competing U.S. and Chinese spheres of influence further reduces the scope of foreign investment. Potential host nations can only hope to be viewed as a feasible site for production by multinationals once the world economy revives.

The 2019 Globie: “Capitalism, Alone” by Branko Milanovic

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The time to announce the recipient of this year’s “Globie” is finally here. Each year I choose a book as the Globalization Book of the Year. The prize is—alas—strictly honorific and does not come with a monetary reward. But it gives me a chance to draw attention to a book that is particularly insightful about some aspect of globalization.  Previous winners are listed at the bottom.

This year’s winner is Branko Milanovic’s Capitalism, Alone: The Future of the System That Rules the World. (This is the second Globie for Milanovic, who won it in 2016 for Global Inequality.) The book is based on the premise that capitalism has become the universal form of economic organization. This type of system is characterized by “production organized for profit using legally free wage labor and mostly privately owned capital, with decentralized coordination.” However, there exist two different types of capitalism: the liberal meritocratic form that developed in the West, and state-led political capitalism, which exists primarily in Asia but also parts of Europe and Africa.

The two models are competitors, in part because of their adoption in different parts of the world and also because they arose in different circumstances. The liberal meritocratic system arose from the class capitalism of the late 19th century, which in turn evolved out of feudalism. Communism, Milanovic writes, took the place of bourgeoise development. Communist parties in countries such as China and Vietnam overthrew the domestic landlord class as well as foreign domination. These countries now seek to re-establish their place in the global distribution of economic power.

Milanovic highlights one characteristic that the two forms of capitalism share: inequality. Inequality in today’s liberal meritocratic capitalism differs from that of classical capitalism in several features. Capital-rich individuals are also labor-rich, which reinforces the inequality. Assortative mating leads to more marriages within income classes. The upper classes use their money to control the political process to maintain their position of privilege.

Because of limited data on income distribution in many of the countries with political capitalism, Milanovic focuses on inequality in China. He attributes its rise to the gap between growth in the urban areas versus the rural, as well the difference in growth between the maritime provinces and those in the western portion of the country. There is also a rising share of income from capital , as well as a high concentration of capital income. In addition, corruption has become systemic, as it was before the communist revolution.

The mobility of labor and capital allows capitalism to operate on a global basis. Migrants from developing economies benefit when they move to advanced economies. But residents in those countries often fear migration because of its potentially disruptive effect on cultural norms, despite the positive spillover effects on the domestic economy. Milanovic proposes granting migrants limited rights, such as a finite term of stay, in order to facilitate their acceptance. He points out, however, the potential downside of the creation of an underclass.

Multinational firms have organized global supply chains that give the parent units in their home countries the ability to coordinate production in different subsidiary units and their suppliers in their host nations. Consequently, the governments of home countries seek to limit the transfer of technology to the periphery nations to avoid losing innovation rents. The host countries, on the other hand, hope to use technology to jump ahead in the development process.

The Trump administration clearly shares these concerns about the impact of globalization. President Trump has urged multinational firms to relocate production facilities within the U.S. Government officials are planning to limit the export of certain technologies while carefully scrutinizing foreign acquisitions of domestic firms in tech-related areas. New restrictions on legal immigration have been enacted that would give priority to a merit-based system. Moreover, the concerns over migration are not unique to the U.S.

Milanovic ends with some provocative thoughts about the future of capitalism. One path would be to a “people’s capitalism,” in which everyone has an approximately equal share of both capital and labor income. This would require tax advantages for the middle class combined with increased taxes on the rich, improvements in the quality of public education, and public funding of political campaigns. But it is also feasible that there will be a move of liberal capitalism toward a form of political capitalism based on the rise of the new elite, who wish to retain their position within society.

Milanovic’s book offers a wide-ranging review of many of the features of contemporary capitalism. He is particularly insightful about the role of corruption in both liberal and political capitalism. Whether or not it is feasible to reform capitalism in order to serve a wider range of interests is one of the most important issues of our time.

2018    Adam Tooze,  Crashed: How a Decade of Financial Crises Changed the World

2017    Stephen D. King, Grave New World: The End of Globalization, the Return of History

2016    Branko Milanovic, Global Inequality

2015    Benjamin J. Cohen. Currency Power: Understanding Monetary Rivalry

2014    Martin Wolf, The Shifts and the Shocks: What We’ve Learned–and Have Still to Learn–from the Financial Crisis

The Parting of Ways: The U.S. and China

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The agreement of U.S. President Donald Trump and Chinese President Xi Jingping to restart trade talks put offs planned increases of tariffs on Chinese exports. But there is little doubt that the U.S. intends to move ahead with its intention to undo the economic integration that has been underway since the 1990s. Even when it proves impossible to reverse history, the consequences of such a move will have long-lasting consequences for the global economy.

To understand what is at stake, think of the following simple guide to the status of the world’s nations in the aftermath of World War II. Countries separated into three groups, each anchored on its own tectonic plate. The “first world” consisted of the advanced economies of the U.S., Canada, the West European nations, Japan, Australia and New Zealand. These economies enjoyed rapid growth in the 1950s and 1960s, due in part to the expansion of trade amongst them. The formation of the European Community (now Union) eventually led to a single market in goods and services, capital and labor for its members. The largest of the advanced economies exerted their control through the “Group of Seven,” i.e., Canada, France, Germany, Italy, Japan, the United Kingdom and the U.S. Their leaders met periodically to discuss economic and other types of policies and issued communiques that listed their agreements. Their predominance extended to their control of the International Monetary Fund and the World Bank.

The “second world” included the Communist nations: the Soviet Union and the countries it controlled in Eastern Europe, as well as China and North Korea. These were command economies, run by government ministers. There was some commerce between the Soviet Union and its East European satellites, but all trade was managed. There were virtually no commercial or financial interactions with the first world.

Finally, there was the “third world,” consisting of the remaining nations located in Latin America, Africa, the Middle East and South and East Asia. These countries, also known as the developing economies, encompassed a wide range of economic and political models. Many of them formed an association of “nonaligned” countries that sought to preserve their political independence from the first and second worlds.

The third world had limited trade with the first world nations, and this usually consisted of commodity exports in exchange for imports of industrial goods. Import substitution, i.e., the domestic production of manufactured goods, was proposed in the 1950s as a means to counteract the disadvantageous terms of trade these nations faced for their goods. There was some migration between the first and third worlds, and there was a shift in the home countries of U.S. immigrants from Europe to Latin American and Asia. But the movements of people never approached the magnitudes of the first wave of globalization of 1870-1914.

This account is simplistic, and there are important exceptions. Yugoslavia, for example, escaped the control of the Soviet Union and had its own form of a command economy. Taiwan and South Korea began implementing export-led development policies in the 1970s. There were important differences between the capitalist economies of the U.S. and the Scandinavian nations. But the relative separation of the three “worlds” did limit their interaction, as did the political tensions between the U.S. and its allies on the one hand and the Communist governments on the other.

The partition, however, began to dissolve at the end of the 1980s as the economic tectonic plates underneath these clusters of countries began to split and move. China sought to grow its economy through the use of markets and private firms. The government promoted foreign trade, and allowed investments by foreign firms that could provide capital, technology and managerial expertise.

The dissolution of the Soviet bloc of nations was followed by the integration of the eastern European nations with the rest of Europe. Poland, Hungary, the Czech Republic and other countries provided workforces for foreign–particularly German–firms and their economies grew rapidly. The European Union expanded to include these new members, Russia itself was less successful in adapting its economy to the new configuration, and remained dependent on its oil and natural gas resources.

While the nations of the second world were moving towards those of the first world, the countries in the third world also sought to become part of the global economy. Asian nations, such as India, Indonesia, Thailand and Malaysia, adopted pro-market policies in order to accelerate development. Their expanded trade brought these countries closer to the first world. Global poverty fell, principally due to a fall in the proportion of the poor in the populations of China and India.

But there were serious disruptions to these advances, particularly in those emerging market economies that suffered financial crises: Mexico in 1995, several of the East Asian countries in 1997, Russia in 1998, and Argentina and Turkey in 2001. While some of the crises were the result of unsustainable government policies, there were also outflows of private capital that had fueled credit bubbles. The massive disruption of economic activity in the wake of these “sudden stops” necessitated outside assistance for the countries to recover. The reputation of the IMF suffered a serious blow for its slow response to the Asian crisis, and the Fund subsequently acknowledged that it had underestimated the extent and consequences of their financial fragility.

Moreover, there was collateral damage accompanying the melding of the economic tectonic plates. China’s emergence as a mega-trader had an impact on the production of manufactured goods in the U.S. and other nations. The resulting job losses, that were often conflated with those lost due to technology, turned parts of the populations of the advanced economies against globalization. Migrants were also blamed for the loss of jobs, as were global supply chains by multinational firms.

The global financial crisis of 2007-09 and the ensuing weak recovery increased the questioning of the policies of the previous two decades. Unemployment in the U.S. fell slowly, and debt crises in several European nations kept growth rates depressed. There was an acknowledgement that the benefits of globalization had not been shared equally as public awareness of income and wealth inequality increased.

There was also adverse reactions to political integration. European governments bristled against EU restrictions on their budgetary policies, while In the United Kingdom nationalists argued that EU officials in Brussels had usurped their government’s sovereignty. The waves of refugees who fled to Europe from Syria and elsewhere awakened fears of a loss of national identity.

The election of Donald Trump and the vote in the United Kingdom in favor of leaving the EU made clear the depth of the reaction against the global integration of 1990-2006. Trump’s campaign was based on a pledge to return to some past era when America had been “great,” while proponents of Brexit promised that their country would prosper outside the boundaries of the EU. The bases of support for these policies were not always wide, but they were strongly motivated.

At the same time, the Chinese government has been keen to assert its control of the country’s economic future and to resist outside interference. The Chinese also seek to establish a zone of political domination in Asia. Similarly, Russia’s President Putin has sought to set up a sphere of political and military influence around its borders. Neither government wants to cut their ties with the U.S. and other advanced economies, but they do want to maintain control over their respective geographic areas.

The China-U.S. split, therefore, is part of a larger reaction to the integration of the global economy. The removal of the barriers separating the three post-World War II “worlds” has led to anxiety and fear in those countries that were part of the first world. They look for a return to the economic dominance that they once enjoyed.

But it is not feasible to undo all the ties that have developed over recent decades, and the nations of what had been the second and third worlds will never accept subordinate status. Moreover, it is possible for the U.S. to place barriers on trade and finance that will undo the gains of the last two decades without any offsetting benefits. Even more worrisome is the possibility that economic and political divisions will exacerbate military division and result in conflict.

The earth has several geographic plates, and they move at a rate of one to two inches (three to five centimeters) per year. Over very long periods of time, the plates do collide, and the force of their movements as they smash into each other creates mountain ranges such as the Himalayas. Economic plates can move more quickly, and their collisions can be equally powerful.

We have entered into a reactionary period as self-proclaimed populists promise to segregate their countries from the outside world to achieve some form of national destiny. But it is not feasible to live in isolation, and ignoring the linkages that exist means that we are not responding to global challenges such as climate change. There may be multiple plates, but they all share one planet.

Mars Descending? U.S. Security Alliances and the International Status of the Dollar

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A decade after the global financial crisis, the dollar continues to maintain its status as the chief international currency. Possible alternatives such as the euro or renminbi lack the broad financial markets that the U.S. possesses, and in the case of China the financial openness that allows foreign investors to enter and exit at will. Any change in the dollar’s predominance, therefore, will likely occur in response to geopolitical factors.

Linda S. Goldberg and Robert Lerman of the Federal Reserve Bank of New York provide an update on the dollar’s various roles. The dollar remains the dominant reserve currency, with a 63% share of global foreign exchange reserves, and serves as the anchor currency for about 65% of those countries with fixed exchange rates. The dollar is also widely utilized for private international transactions. It is used for the invoicing of 40% of the imports of countries other than the U.S., and about half of all cross-border bank claims are denominated in dollars.

This wide use of the dollar gives the U.S. government the ability to fund an increasing debt burden at relatively low interest rates. Moreover, as pointed out by the New York Times, the Trump administration can enforce its sanctions on countries such as Iran and Venezuela because global banks cannot function without access to dollars. While European leaders resent this dependence, they have yet to evolve a financial system that could serve as a viable alternative.

The dollar’s continued predominance may also reflect other factors. Barry Eichengreen of UC-Berkeley and Arnaud J. Mehl and Livia Chitu of the European Central Bank have examined the effect of geopolitical factors—the “Mars hypothesis”—versus pecuniary factors—the “Mercury hypothesis”—in determining the currency composition of the international reserves of 19 countries during the period of 1890-1913. Official reserves during this time could be held in the form of British sterling, French francs, German marks, U.S. dollars and Dutch guilders.

The authors find evidence that both sets of factors played roles. For example, a military alliance between a reserve issuing country and one that held reserves would boost the share of the currency of the reserve issuer by almost 30% if there was a military alliance between these nations. They conjecture that the reserve issuer may have used security guarantees to obtain financing from the security-dependent nation, or to serve the role of financial center when the allied country needed to borrow internationally.

Eichengreen, Mehl and Chitu then use their parameter estimates to measure by how much the dollar share of the international reserves of nations that currently have security arrangements with the U.S. would fall if such arrangements no longer existed. South Korea, for example, currently holds 84% of its foreign reserves in dollars; this share would fall to 54% in the absence of its security alliance with the U.S. Similarly, the dollar component of German foreign exchange reserves would decline from 98% to 68%.

In previous eras, such calculations might be seen as interesting only for providing counterfactuals. But the Trump administration seems intent on cutting back on America’s foreign military commitments. The U.S. and Korea, for example, have not negotiated a renewal of the Special Measures Agreement to finance the placement of U.S. troops in Korea.  German Chancellor Angela Merkel has defended her country’s role in NATO in the face of criticism from President Trump that Germany must spend more on defense expenditures. The possibility of a pan-European army to serve as an alternative security guarantee is no longer seen as totally far-fetched.

The dollar may be safe from replacement on economic grounds. But the imminent shrinkage of the British financial sector due to the United Kingdom’s withdrawal from the European Union  shows that political decisions follow their own logic, sometimes without regard for the economic consequences. If the dollar lose some of its dominance, it may be because of self-inflicted wounds.

The 2018 Globie: “Crashed”

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Each year I choose a book to be the Globalization Book of the Year, i.e., the “Globie”. The prize is strictly honorific and does not come with a check. But I do like to single out books that are particularly insightful about some aspect of globalization.  Previous winners are listed at the bottom.

This year’s choice is Crashed: How a Decade of Financial Crises Changed the World by Adam Tooze of Yale University. Tooze, an historian, traces the events leading up to the crisis and the subsequent ten years. He points out in the introduction that this account is different from one he may have written several years ago. At that time Barak Obama had won re-election in 2012 on the basis of a slow but steady recovery in the U.S. Europe was further behind, but the emerging markets were growing rapidly, due to the demand for their commodities from a steadily-growing China as well as capital inflows searching for higher returns than those available in the advanced economies.

But the economic recovery has brought new challenges, which have swept aside established politicians and parties. Obama was succeeded by Donald Trump, who promised to restore America to some form of past greatness. His policy agenda includes trade disputes with a broad range of countries, and he is particularly eager to impose trade tariffs on China. The current meltdown in stock prices follows a rise in interest rates normal at this stage of the business cycle but also is based on fears of the consequences of the trade measures.

Europe has its own discontents. In the United Kingdom, voters have approved leaving the European Union. The European Commission has expressed its disapproval of the Italian government’s fiscal plans. Several east European governments have voiced opposition to the governance norms of the West European nations. Angela Merkel’s decision to step down as head of her party leaves Europe without its most respected leader.

All these events are outcomes of the crisis, which Tooze emphasizes was a trans-Atlantic event. European banks had purchased held large amounts of U.S. mortgage-backed securities that they financed with borrowed dollars. When liquidity in the markets disappeared, the European banks faced the challenge of financing their obligations. Tooze explains how the Federal Reserve supported the European banks using swap lines with the European Central Bank and other central banks, as well as including the domestic subsidiaries of the foreign banks in their liquidity support operations in the U.S. As a result, Tooze claims:

“What happened in the fall of 2008 was not the relativization of the dollar, but the reverse, a dramatic reassertion of the pivotal role of America’s central bank. Far from withering away, the Fed’s response gave an entirely new dimension to the global dollar” (Tooze, p. 219)

The focused policies of U.S. policymakers stood in sharp contrast to those of their European counterparts. Ireland and Spain had to deal with their own banking crises following the collapse of their housing bubbles, and Portugal suffered from anemic growth. But Greece’s sovereign debt posed the largest challenge, and exposed the fault line in the Eurozone between those who believed that such crises required a national response and those who looked for a broader European resolution. As a result, Greece lurched from one lending program to another. The IMF was treated as a junior partner by the European governments that sought to evade facing the consequences of Greek insolvency, and the Fund’s reputation suffered new blows due to its involvement with the various rescue operations.The ECB only demonstrated a firm commitment to its stabilizing role in July 2012, when its President Mario Draghi announced that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro.”

China followed another route. The government there engaged in a surge of stimulus spending combined with expansionary monetary policies. The result was continued growth that allowed the Chinese government to demonstrate its leadership capabilities at a time when the U.S. was abandoning its obligations. But the ensuing credit boom was accompanied by a rise in private (mainly corporate) lending that has left China with a total debt to GDP ratio of over 250%, a level usually followed by some form of financial collapse. Chinese officials are well aware of the domestic challenge they face at the same time as their dispute with the U.S. intensifies.

Tooze demonstrates that the crisis has let loose a range of responses that continue to play out. He ends the book by pointing to a similarity of recent events and those of 1914. He raises several questions: “How does a great moderation end? How do huge risks build up that are little understood and barely controllable? How do great tectonic shifts in the global world order unload in sudden earthquakes?” Ten years after a truly global crisis, we are still seeking answers to these questions.

Previous Globie Winners:

2017    Stephen D. King, Grave New World: The End of Globalization, the Return of History

2016    Branko Milanovic, Global Inequality

2015    Benjamin J. Cohen. Currency Power: Understanding Monetary Rivalry

2014    Martin Wolf, The Shifts and the Shocks: What We’ve Learned–and Have Still to Learn–from the Financial Crisis

 

The Continuing Dominance of the Dollar

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Ten years after the global financial crisis, we are still coming to an understanding of how profound a shock it was. The changes in political alignments within and across nations and the diminished public support for globalization continue. But one aspect of the financial system has not changed: the dominance of the U.S. dollar in the monetary system.

An article by Fernando Eguren Martin, Mayukh Mukhopadhyay and Carlos van Hombeeck of the Bank of England in the BOE’s Quarterly Bulletin documents the different international roles of the dollar. First, it continues to be the main currency in central bank reserves, with a share of about 70% of total holdings. Second, the dollar is used as an invoicing currency for many international transactions, such as commodity sales. Third, firms outside the U.S. obtain funding through dollar-denominated bank loans and debts.

The use of the dollar for finance has also been examined by Iñaki Aldasoro and Torsten Ehlers of the Bank for International Settlements in an article in the BIS Quarterly Review. They report a rise in the use of international debt securities, driven primarily by dollar denominated debt issued by non-U.S. residents. The increase in such funding is particularly noticeable in emerging markets economies in Asia and Latin America. This debt includes sovereign bonds issued by governments that sought to lock in low interest rates.

What about the alternatives? A report on the international role of the euro issued by the European Central Bank acknowledges the primacy of the dollar. An index of the global status of the euro developed at the ECB shows a decline in the last fifteen years, which may have stabilized in the most recent year. This includes a fall in the euro’s share of international debt securities. The report also notes that the deleveraging of Eurozone banks as they built up their capital ratios led these banks to reduce their cross-border lending.

Why does the dollar continue to possess a hegemonic status a decade after the crisis that seemed to signal an end to U.S.-U.K. dominated finance? Gillian Tett of the Financial Times offers several reasons. The first is the global reach of U.S. based banks. U.S. banks are seen as stable, particularly when compared to European banks. Any listing of the largest international banks will be dominated by Chinese banks, and these institutions have expanded their international business.  But the Chinese banks will conduct business in dollars when necessary. Tett’s second reason is the relative strength of the U.S. economy, which grew at a 4.1% pace in the second quarter. The third reason is the liquidity and credibility of U.S. financial markets, which are superior to those of any rivals.

The U.S. benefits from its financial dominance in several ways. Jeff Sachs of Columbia University points out that the cost of financing government deficits is lower due to the acceptance of U.S. Treasury securities as “riskless assets.” U.S. banks and other institutions earn profits on their foreign operations. In addition, the use of our banking network for international transactions provides the U.S. government with a powerful foreign policy tool in the form of sanctions that exclude foreign individuals, firms or governments from this network.

There are risks to the system with this dependence. As U.S. interest rates continue to rise, loans that seemed reasonable before now become harder to finance. The burden of dollar-denominated debt also increases as the dollar appreciates. These developments exacerbate the repercussions of policy mistakes in Argentina and Turkey, but also affect other countries as well.

The IMF in its latest Global Financial Stability (see also here) identifies another potential destabilizing feature of the current system. The IMF reports that the U.S. dollar balance sheets of non-U.S. banks show a reliance on short-term or wholesale funding. This reliance leaves the banks vulnerable to a liquidity freeze. The IMF is particularly concerned about the use of foreign exchange swaps, as swap markets can be quite volatile. While central banks have stablished their own network of swap lines, these have been criticized.

The status of the dollar as the primary international currency is not welcomed by foreign governments. The Russian government, for example, is seeking to use other currencies for its international commerce. China and Turkey have offered some support, but China is invested in promoting the use of its own currency. In addition, Russia’s dependence on its oil exports will keep it tied to the dollar.

But interest in formulating a new international payments system has now spread outside of Russia and China. Germany’s Foreign Minister Heiko Maas has called for the establishment of “U.S. independent payment channels” that would allow European firms to continue to deal with Iran despite the U.S. sanctions on that country. Chinese electronic payments systems are being used in Europe and the U.S. The dollar may not be replaced, but it may have to share its role as an international currency with other forms of payment if foreign nations calculate that the benefits of a new system outweigh its cost. Until now that calculation has always favored the dollar, but the reassessment of globalization initiated by the Trump administration may have lead to unexpected consequences.

Empires, Past and Present

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Economists rarely write about “empires,” unless they are referring to historical examples such as the Roman empire. But Thomas Hauner of the Federal Reserve Bank of Minneapolis,  Branko Milanovic of the Graduate Center of City University of New York and Suresh Naidu of Columbia University have presented a study of empires using criteria drawn from an economics classic, John Hobson’s Imperialism (1902). The same criteria can be used to examine whether any empires exist today.

Hobson was not a Marxist, but his work greatly influenced later Marxist writers who wrote about imperialism, including Vladimir Lenin, Rudolf Hilferding and Rosa Luxemburg. Hobson believed that there was chronic underconsumption in advanced capitalist countries due to unequal distributions of income. This lowered the return on domestic investment, and as a result the owners of financial capital turned to foreign markets where returns would be higher. These investors relied on their governments to guarantee the safety of their foreign holdings from seizure.

Hauner, Milanvic and Naidu demonstrate that there was a high degree of inequality within the advanced capitalist countries in the late 19th century. The foreign assets held by wealthy investors in Britain and France expanded greatly during this period, and these assets generated rates of return higher than those available from domestic investments. They also present evidence of a linkage between the accumulation of foreign assets and militarization that led to World War I. These results are consistent with Hobson’s work.

Hobson’s empires established positive net international investment positions (NIIP) and received income from these foreign investments. The payments appear in the current account of the balance of payments as “net primary income.” This component of the current account records the difference between payments received by domestic residents for providing productive resources, such as their labor, financial resources or land, to foreigners minus the payments made to foreigners for their productive resources made available to the domestic economy. For most countries, receipts and payments on financial assets are the largest component of their net primary income.

Great Britain was a financial center and the preeminent creditor nation during the zenith of its empire, and a net recipient of foreign income. It earned net income worth 5.4% of GDP in the period 1874-1890, and 6.8% from 1891 to 1913 (Matthews, Feinstein and Odling-Smee 1982). The surpluses were large enough to offset a trade deficit and allow the country to continue to invest abroad and expand their foreign holdings.

What are the largest creditor nations today? Are they also Hobsonian empires? Japan is the leading creditor nation, with a net international investment position of $2.8 trillion in 2015, which represented 67% of its GDP. It earned $165.88 billion in net primary income, worth 3.8% of its GDP. Germany is also a creditor nation, with a NIIP of about $1.5 trillion (45% of GDP) in 2015 and net income of $74.6 billion (2.2% of its GDP).

But Japan and Germany nations do not fulfill the other criteria to be called empires. They do not have the disparities in wealth that the U.S. and many developing countries possess. Their Gini coefficients are almost identical: 32.1 for Japan and 31.4 for Germany. These are similar in magnitude to those of other European countries, higher than those of the Scandinavian nations but below those of Portugal and Spain.

Moreover, the two nations are not militaristic powers. Japan’s constitution forbids the use of force, although the country does have Self-Defense Forces. Prime Minister Shinzo Abe is seeking to amend the country’s constitution in order to clarify the rules governing the disposition of these troops. Germany is part of NATO, but the foreign deployment of German forces is strictly supervised by Parliament.

The situation of other large countries is more anomalous. China is a leading creditor nation, with a NIIP in 2015 only slightly lower than Germany’s and equal to 194% of its GDP. But that country registered a deficit of net primary income of $41.8 billion. On the other hand, the country with the largest inflow of income in absolute terms was the U.S., a debtor nation with a NIIP of -$7.8 trillion in 2015, worth about 45% of GDP. Its net income inflow of $204.5 billion represented 1.1% of its GDP.

The explanation for these seemingly inconsistent results lies with the composition of the external assets and liabilities. The U.S. is “long equity, short debt,” with assets largely composed of foreign direct investments (FDI) and portfolio equity, and liabilities primarily in the form of debt (bonds, such as U.S. Treasury securities, or bank loans). In 2015, for example, 60% of its assets were held in the form of FDI or portfolio equity, which earn an equity premium because of their riskier nature. China, on the other hand, is “long debt and short equity,” where the debt includes the central bank’s foreign reserves held in the form of U.S. Treasury bonds. Debt assets and foreign reserves constituted 79% of China’s foreign assets in 2015, and the returns on these have been quite low in recent years. FDI and portfolio equity liabilities, on the other hand, accounted for 74% of the external liabilities.

The unusual nature of these income flows have attracted great attention. Yu Yongding of China’s Academy of Social Sciences, for example, has written about his country’s “irrational IIP structure.” He attributes this to an undervalued exchange rate that has allowed the country to have surpluses in both the current and capital accounts that were balanced by increases in foreign reserves, as well as government policies that favored FDI from abroad.

The positive return that the U.S. receives has been called an “exorbitant privilege” that is due to the status of the dollar as a reserve currency. In 1966 Emile Despres of Stanford University, Charles P. Kindleberger of MIT and Walter S. Salant of the Brookings Institution wrote that the configuration of the U.S. balance of payments was due to its status as the “world’s banker”, issuing short-term liabilities in exchange for long-term assets. More recently, Pierre-Olivier Gourinchas of UC-Berkeley and Hélène Rey of the London Business School updated this description of the U.S. to the “world venture capitalist.”

The global financial crisis might have ended this status of the U.S., but the influence of the U.S. economy and its monetary policies has not diminished. Changes in U.S. interest rates have widespread effects on capital flows and credit creation. Several recent studies, including one by Òscar Jordàof UC-Davis, Moritz Schularick of the University of Bonn and Alan Taylor of UC-Davis, have referred to the existence of a global financial cycle that is very responsive to U.S. monetary policy. Similarly, Matteo Iacoviello and Gaston Navarro  of the Federal Reserve Board have written about the spillover effects of U.S. interest rates on foreign economeis.

It may be time for a new definition of imperialism. If the U.S. possesses an empire, it is based on its ownership of foreign capital that it accumulates in return for the issuance of “safe assets.” It takes advantage of this position to invest in more lucrative equity. In addition, it hosts the largest and most liquid financial markets and networks. Moreover, the U.S. government has shown its willingness to use financial sanctions as a policy tool.

With respect to the other attributes of 19thcentury empires, we no longer send Marines to Central America to safeguard our foreign holdings. But our military spending greatly exceeds that of other nations. Wealth is heavily concentrated; the richest U.S. families—those in the top 1% of the distribution of wealth—own 40% of the wealth in this country. Those assets undoubtedly include direct and indirect ownership in foreign enterprises, which contribute to the returns they receive.

What could end this arrangement? The renminbi and the euro are rival currencies, but it is doubtful that they will attain the global status of the dollar. Under ordinary circumstances, one might expect the U.S. position to continue for the foreseeable future. But these are not ordinary times. The Trump administration seems ready to shred a wide range of international agreements, such as those that established the World Trade Organization and the North American Free Trade Association. Moreover, the tax legislation passed last year that lowered personal and corporate tax rates is pushing up the government’s budget deficit. The Congressional Budget Office’s projection for this fiscal year’s deficit has risen from $563 billion to $804 billion and is projected to reach $1 trillion by 2020. Will U.S. Treasury securities continue to be viewed as safe?

The record of transitions in international monetary regimes does not bode well for the future. The gold standard collapsed in the 1930s as governments sought to escape the world-wide contraction in global economic activity. The Bretton Woods regime began to disintegrate when the Nixon administration ended the conversion of the dollar reserves of foreign central banks into gold in 1971. None of these regime ends were planned and they led to further instability. The end of America’s hegemonic financial position has long been forecasted–and avoided. But the shockwaves of the global financial crisis are still taking place, and eventually may be even more disruptive than we ever imagined.