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Inequalities, National and Global

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The publication of Thomas Piketty’s Capital in the Twenty-First Century brought attention to an issue that has been slowly seeping into public discourse. President Obama’s State of the Union address made it clear that we will not need to wait until the 2016 Presidential campaign to hear proposals to rectify the rise in inequality. But the data and trends of global inequality reveal a more complex situation than the national states of affairs that Piketty highlights.

Inequality is often measured by the Gini coefficient. This number is based on the Lorenz curve, which shows the proportion of the total income of a population that is cumulatively earned by different segments of the population, beginning at the bottom. The Gini coefficient (or index) is the ratio of the area under an actual Lorenz curve distribution of a society and the area of the distribution of perfect inequality. It is a number between zero and one (or 100), where zero corresponds to a case of perfect equality, and one is a situation of total inequality. A Gini coefficient above 0.50 is considered to be “high.”

We can compare Gini coefficients across countries and regions. Nations in Europe have Gini indixes between 0.24 and 0.36, while the comparable figure for the United States is 0.36. The coefficients are usually higher in middle- and lower-income nations; the average for Latin America and the Caribbean, for example, is 0.48, and for sub-Sahara Africa it is 0.44.

We can also look at how Gini coefficients change over time. What would we expect? The Kuznets curve, a concept based on the work of economist Simon Kuznets, predicts a rise in inequality within nations as they develop economically. The Gini coefficient would rise as workers move from low-productivity agricultural jobs to the industrial sector where wages are higher. But as a society matures and the agricultural sector shrinks, the gap between urban and rural workers should decline, and inequality fall.

The actual historical patterns, however, have been different. Inequality has been on the rise within many nations at high levels of inequality. Piketty claims that such inequality is a basic feature of capitalism, and will only worsen over time. His thesis is based on the relationship between the rate of return on capital, r, which includes profits, dividends, and interest, and the rate of economic growth, g. Piketty claims that when r > g, wealth accumulates quickly and the incomes of the richest members of society grows faster than those of the middle- and lower-classes.

This trend became strong in England, France and the U.S. in the 19th century. However, it was interrupted during the 20th century by the two World Wars and the Great Depression. Goverments intervened within their economies to improve the position of the poorest members, and the economic growth of the 1950s and 1960s reduced the importance of inherited wealth. But today, Piketty argues, we are returning to a world where economic growth is stagnating, and the rate of return on capital exceeds the economic growth rate. Unless governments intervene again, the result will be – and already has been – a return to the levels of inequality of the 19th century.

But there is another way of measuring inequality: not within nations but on a global basis. This has been done by, among others, economist Branko Milanovic. He points out that there are different ways of doing this. One method is to treat each country as a unit of observation, using the  average income of each nation. We can plot a Lorenz curve with all the countries for which there are data, and then calculate the corresponding Gini coefficients over time. If this method is used, there is little movement in the international Gini coefficient between 1960 and 1980. But during the period beginning in the 1980s through 2000, the international Gini coefficient rises. Richer countries grew faster than did the poorer ones, thus reinforcing inequality. This is the period when international trade and finance began to grow most quickly, and the observed trend would indicate that globalization rewarded the rich.

But if each country is treated as a single unit, we ignore the fact that some countries are much bigger than others. When countries are weighted by their population, a different phenomenon is observed: during the period that began in the 1980s, the international Gini coefficient falls, and has continued to do so over time. Why the difference? China and India had rapid economic growth during this period. Since they are countries with large populations, there was a decline in global inequality using population-weighted Gini coefficients during the period of increased globalization.

We can demonstrate this trend using a perspective that transcends national borders. Milanovic points out that If we arrange the world’s population by income regardless of national origin, we can calculate a global Gini coefficient. There are not many years of data available to do this calculation, but the trend that is observed shows that this global Gini coefficient has dropped.

Christoph Lakner and Milanovic showed this phenomenon another way, using global income data from 1988 to 2008. They calculated the rise in income for each decile of the world’s population. They observed the largest gains for the global top 1%, consistent with Piketty’s observations. But they also saw large gains for the the groups in the middle, most of whom were from Asia. This global perspective shows us that Piketty is correct in showing the growth in inequality within nations. But on a global basis there are some interesting movements across people in different nations.

Is there something about globalization itself that has led to these changes? There have many studies that compared the performance of countries that have opened their economies to international trade and finance with those that did not. Some of these studies also looked at the impact of globalization on the poorest members of society.

David Dollar and Aart Kraay, economists at the World Bank, compared the record of two groups of countries that they called globalizers and non-globalizers. The globalizers were those countries which had the largest growth in international trade between the 1970s and the late 1990s. They found that the globalizer nations grew more quickly than the non-globalizer nations. They also tested the effect of this economic growth upon the poor within these nations, and found that the increases in national income were reflected in increases for the poorest group. The authors concluded that open trade regimes lead to faster growth and poverty reduction in poor countries.

However, their conclusions have been challenged. One line of criticism has pointed out that openness to trade may be a result, not a cause, of rapid growth. Recent work on globalization and inequality shows a more complicated picture. A study by IMF economists Florence Jaumotte, Subir Lall and Chris Papageorgiou found that the rise in inequality within developed and developing countries is largely due to technological change, which primarily benefits those with education at the expense of those without education. These authors claimed that the impact of globalization on inequality has actually been relatively minor. Increased trade tends to reduce income inequality because of cheaper food imports, but more foreign investment leads to higher inequality because of the impact of foreign investment on the wages of skilled workers in both developing and developed countries: the more-educated workers gain while those less-educated fall behind. They concluded that the best remedy for increased inequality is more educational opportunities.

The situation we face today is complicated. On the one hand, inequality within nations has risen. On the other hand, inequality across borders may have fallen. Many are concerned that continued inequality might hinder growth. If those at the bottom of the income ladder do not participate in the benefits of globalization, then economic growth will be stunted. How to promote growth while ensuring that its benefits are shared by all is one of the most significant challenges facing nations today.

Tales of Globalization: Russia and China

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The end of 2014 marked the 23rd anniversary of the dissolution of the Soviet Union and the establishment of the Russian Federation. Like Chinese leaders in the previous decade, Russian policymakers faced the challenge of integrating their nation into the global economy. Russia’s trade openness (exports and imports scaled by GDP) grew from 26% in 1991 to 51% in 2013, very similar to the rise in China’s trade openness from 29% to 50% during these years. Russian exports increased from 13% of its GDP at the beginning of this period to 28% in 2013, while the corresponding figures for China are 16% and 26%. Both counties gradually allowed foreign capital inflows. But the similarities end there.

Russia’s exports are primarily commodities, particularly oil and natural gas. Consequently, sales of these resources account for a large part of Russia’s GDP: 16% in 2012. The plunge in world oil prices, combined with the sanctions imposed by U.S. and European Union governments following Russia’s annexation of the Crimea and its threats against the Ukraine, threaten to push the economy into a recession. The deterioration of the economic situation caused the ruble to plunge against the dollar in December, before recouping part of its value after the central bank intervened in the foreign exchange market and raised its policy rate to 17%.

Russia is particularly susceptible to a currency depreciation because of its external debt, reported to be $678 billion. Capital controls that had been imposed during the 1998 crisis were removed in the 2000s, and capital inflows, including bank loans and bond issues, increased significantly. These capital flows reversed during the global financial crisis, and there was only a modest recovery before the latest period of political tension. The Russian government’s debt includes $38 billion of bonds denominated in dollars, which is not seen as a vulnerability. But the external exposure of Russian companies is much larger. The Russian central bank claims that in 2015 Russian firms owe $120 billion of interest and repayments on their external debt. Much of this money is owed by Rosneft and Gazprom, the state oil and gas producers.

China has followed a very different path. Its main exports now include electronics and machinery. The Great Recession prompted a reevaluation of the structure of the economy by the Chinese government. Chinese leaders realize that the export- and investment-led growth of the past is no longer feasible or desirable, and have emphasized the expansion of domestic consumption. This transition is taking place while the economy slows from the torrid 10% growth rate of the past to about 7.5%.

China also has external debt, which totaled $863 billion in 2013. But China has been more deliberate in opening up its capital account, and its external liabilities primarily take the form of foreign direct investment. Moreover, its foreign exchange reserves of about $4 trillion should alleviate any concerns about its ability to fulfill its obligations to foreign lenders. Of more concern is the growth in domestic credit, which now surpasses 200% of its GDP. While a financial contraction appears inevitable, there are differences over whether this will lead to economic disruption (see also here).

China’s currency appreciated in value between 2005 and 2008, when the renminbi was “re-pegged” against the dollar. In March, the central bank announced that the renminbi would fluctuate within a band of +/- 2%. A recent study by Martin Kessler and Arvind Subramanian indicates that the renminbi is fairly valued by purchasing power estimates. The government is considering whether the renminbi will become an international currency. Its status may get a boost if the IMF decides to include the renminbi as one of the currencies on which its Special Drawing Rights is based.

China and Russia, therefore, have followed very different paths in globalizing their economies. Russia, of course, could not be expected to forsake its energy resources. But commodity exporters live and die by world prices, and the government passed up an opportunity to diversify the Russian economy. China initially used its own “natural resource” of abundant labor, but has moved up the value chain, as Japan and Korea did. Chinese firms are now expanding into foreign markets. In addition, Russia allowed short-term capital inflows that can easily cease, while China carefully controlled the external sources of finance.

Russia’s GDP per capita recorded a rise of 29% between 1991 and 2013, from $5,386 to $6,924 (constant 2005 US $). China started at a much lower base in 1991, $498, but its per capita income increased by over 7 times (719%) to $3,583. The divergence in the two countries’ fortunes shows that there are many ways to survive in the global economy, but some are more rewarding than others.

The BRICS and the Bretton Woods Twins

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The World Cup was not the only event of global significance to take place in Brazil this summer. The leaders of Brazil, Russia, India, China and South Africa met in the city of Fortaleza and announced the formation of two new financial institutions. One is the New Development Bank (NDB), which will finance “sustainable development” projects, with an eventual $100 billion in capital. The second is the Contingent Reserve Arrangement (CRA), which will make $100 billion available to lend to members in financial distress.

If these stated aims seem familiar, they should: they copy the missions of the Bretton Woods “Twins,” the World Bank and the IMF. Why, then, would we need another set of institutions with these mandates? A possible answer could be that these institutions will operate on a smaller scale, and therefore fill a gap between national organizations and international ones.  The principle of subsidiarity states that decisions should be made at the appropriate level, i.e., national policymakers address domestic needs, regional organizations deal with issues of regional relevance, and international institutions address global problems.  In this case, it might be argued that these middle-income nations are better able to make decisions on their level than in a larger forum.

However, economic efficiency is not what is driving this process. The new organizations are a response to the breakdown of quota reform at the IMF and the World Bank. A visitor to Beijing, as I recently was, will hear the complaints that the U.S. government, by not passing the measures needed to implement the reform measures, is frustrating the aspirations of the emerging market nations. Attempts to explain the inaction as the result of domestic politics are dismissed as self-serving justification.

It is difficult not to be sympathetic to these complaints. There is no reason why the long-overdue reallocation of quotas should not proceed. The governments of the emerging market economies have long been promised that an adjustment of their positions would be made, but there was always a procedural hurdle to be cleared. Now, when the world’s governments (including the Obama administration) agree on the particulars, a new reason for inaction appears.

Of course, there are details to be worked out for the new bodies. Who is eligible to borrow from the new development bank? Will it seek to compete with the World Bank by offering more money/fewer conditions? Will there be political “litmus tests” for would-be borrowers?

The new currency arrangement resembles the Chiang Mai Initiative Multilateralization (CMIM), an agreement on currency swaps within Asia, which has been viewed as a complement, and not a substitute, for the IMF. Moreover, as under the CMIM, a country that wants to borrow more than 30% of the maximum access allocated to it would also have to enter an arrangement with —  the IMF! The world, it seems, is not quite ready to cast off the Fund.

But it would be wrong to underestimate the significance of the establishment of these institutions. They are the result of the continuing clash between the G7 countries and the emerging market nations that see themselves as perpetually marginalized within the Bretton Woods institutions. While economic growth in China may be slowing and India continues to strive to accelerate its pace of development, the size of these and other countries in Asia, Africa and Latin America ensure that they will become more dominant over time. If they are frustrated within the traditional bodies of international economic governance, they have the capacity to establish their own forums.

However, economic and financial instability does not respect political camps. Their avoidance are international public goods, requiring cooperation from the full range of nations. A breakdown in global governance only leaves the international economy more vulnerable to volatility that can sweep across borders, as we learned in 2008-09. Perhaps the biggest question about the new organizations is whether they will strengthen the resiliency of the international financial system. It may take another crisis to learn the answer.

China’s Outward FDI

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According to the United Nations Conference on Trade and Development’s latest World Investment Report Overview 2014, Foreign Direct Investment inflows to China reached $124 billion last year, while outflows rose to $101 billion. The Report anticipates that outflows will surpass inflows within the next few years, changing China from a net recipient of FDI to a net supplier. This change will affect China’s external balance sheet, and its response to financial crises.

China’s foreign assets have traditionally been overwhelmingly concentrated in foreign exchange reserves. In 2011, for example, reserves accounted for two-thirds of all the country’s foreign assets.  While the central bank’s holdings of foreign currencies (mostly held as U.S. Treasury securities) allowed it to deter any speculative currency attacks, they carried a low rate of return. That return fell even further during and after the global financial crisis as the Federal Reserve drove down interest rates, both short- and long-term. Therefore, China’s assets have not been very profitable. In addition, the foreign exchange reserves have lost value over time as the dollar depreciated. Menzie Chinn has pointed out that the political theater in Washington, DC only heightened Chinese concerns about their holdings of dollars.

A very large proportion of China’s foreign liabilities, on the other hand, has consisted largely of FDI; in 2011, the share of FDI in foreign liabilities was 59%. These investments were very profitable for the foreign firms that held them, producing a substantial stream of income. Consequently, as Yu Yongding, director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences has emphasized, China’s net return on international investments has usually been negative, despite its status as a net international creditor.  China’s net international investment position in 2011 represented +21% of its GDP, but it recorded a negative net primary income flow of about -1% of its GDP.

More assets held in the form of FDI, therefore, will raise the income that China receives from its assets.  Holding FDI in other countries will also give China a chance to diversity the currency composition of its assets. But there is a downside: equity holders share the risks of the ventures they own. In the past, this meant that China’s negative net FDI position acted as a crisis buffer. China’s net primary income turned positive in 2007 and 2008; its foreign exchange assets continued to pay returns, while the return on domestic FDI fell due to the global financial crisis.  Moreover, a decline in the value of FDI as well as portfolio equity lowered China’s liabilities, contributing to an improvement in the net international investment position.

China is not unique in the composition of its foreign assets and liabilities. Philip Lane of Trinity College/Dublin has written about the “long debt, short equity” position of many emerging markets, which helped them ride out the economic turbulence of the global crisis. Many advanced economies, on the other hand, were “long equity, short debt,” which while profitable in normal times, exacerbated the decline in their economies when the crisis hit.

China’s situation will change if there is a shift towards a net positive FDI position. The flow of income from foreign assets will become more pro-cyclical. Moreover, those assets will lose value in the event of a downturn. A depreciation of the renminbi would only increase this valuation effect.

Chinese firms traditionally moved abroad to secure reliable supplies of natural resources. More recently, the surge of outward FDI has also reflected aspirations to venture into foreign markets. The movement outward will eventually raise China’s net investment return and provide it with the ability to hold assets in currencies other than the dollar. But it will also diminish the role of FDI liabilities to act as a crisis buffer. This is one factor that should be added to the list of benefits and costs of a change in China’s net FDI position.

China’s Trilemma Maneuvers

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China’s exchange rate, which had been appreciating against the dollar since 2005, has fallen in value since February. U.S. officials, worried about the impact of the weaker renminbi upon U.S.-China trade flows, have expressed their concern. But the new exchange rate policy most likely reflects an attempt by the Chinese authorities to curb the inflows of short-run capital that have contributed to the expansion of credit in that country rather than a return to export-led growth. Their response illustrates the difficulty of relaxing the constraints of Mudell’s “trilemma”.

Robert Mundell showed that a country can have two—but only two—of three features of international finance: use of the money supply as an autonomous policy tool, control of the exchange rate, and unregulated international capital flows. Greg Mankiw has written about the different responses of U.S., European and Chinese officials to the challenge of the trilemma. Traditionally, the Chinese sought to control the exchange rate and money supply, and therefore restricted capital flows.

In recent years, however, the Chinese authorities have pulled back on controlling the exchange rate and capital flows, allowing each to respond more to market forces. The increase in the value of renminbi followed a period when it had been pegged to increase net exports. As the renminbi appreciated, foreign currency traders and others sought to profit from the rise, which increased short-run capital inflows and led to an increase in foreign bank claims on China. But this inflow contributed to the domestic credit bubble that has fueled increases in housing prices. Private debt scaled by GDP has risen to levels that were followed by crises in other countries, such as Japan in the 1980s and South Korea in the 1990s. All of this gave the policymakers a motive for trying to discourage further capital inflows by making it clear the renminbi’s movement need not be one way.

Moreover, the authorities may have wanted to hold down further appreciation of the renminbi. The release of new GDP estimates for China based on revised purchasing power parity data showed that country’s economy to be larger than previously thought. The new GDP data, in turn, has led to revisions by Marvin Kessler and Arvind Subramanian of the renminbi exchange rate that would be consistent with the Balassa-Samuelson model that correlates exchange rates to levels of income.  Their results indicate that the exchange rate is now “fairly valued.” With the current account surplus in 2013 down to 2% of GDP, Chinese officials may believe that there is little room for further appreciation.

Gavyn Davies points out that there is another way to relieve the pressure on the exchange rate due to capital inflows: allow more outflows. Even if domestic savers receive the higher rates of return that government officials are signaling will come, Chinese investors would undoubtedly want to take advantage of the opportunity to diversity their asset holdings. As pointed out previously, however, capital outflows could pose a threat to the Chinese financial system as well as international financial stability. Chinese economists such as Yu Yongding have warned of the consequences of too rapid a liberalization of the capital account.

The Chinese authorities, therefore, face difficult policy choices due to the constraints of the trilemma. Relaxing the constraints on capital flows could cause the exchange rate to overshoot while further adding to the domestic credit boom that the central bank seeks to restrain. But clamping down on capital flows would slow down the increase in the use of the renminbi for international trade. As long as the policymakers seek to maneuver around the restraints of the trilemma, they will be reacting to the responses in foreign exchange and capital markets to their own previous initiatives.

Can the U.S. Rebalance without Raising Inequality?

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Last week’s estimate of an anemic U.S. GDP first-quarter growth rate of 0.1% will be revised. Moreover, the good news regarding job growth in April suggests that the U.S. economy is expanding at a quicker pace in the second quarter. But a closer look at the first quarter data reveals a disturbing drop in investment and net exports that does not bode well for a reorientation of the U.S. economy.

The rise in economic activity was entirely due to a rise in consumption expenditures, which rose at annual rate of 2.04%. Gross private domestic investment expenditures, on the other hand, fell. Private nonresidential investment expenditures totaled $2.091 trillion, slightly down from $2.096 in the last quarter of 2013. Moreover, spending on new plants and equipment, when adjusted by GDP, reflects a continuation of a slow cyclical rise after the global financial crisis, with no sign of any acceleration:

Year

Private Nonresidential        Investment/GDP

Federal Budget/GDP

Current Account/GDP

2004

 11.92% -3.36% -5.06%

2005

 12.31% -2.43% -5.63%

2006

 12.82% -1.79% -5.74%

2007

 13.26% -1.11% -4.90%

2008

 13.19% -3.12% -4.61%

2009

 11.33% -9.80% -2.64%

2010

 11.09% -8.65% -3.04%

2011

 11.65% -8.37% -2.94%

2012

 12.13% -6.69% -2.70%

2013

 12.19% -4.04% -2.33%

An investment “dearth” (or “drought’) is not unique to the U.S. Antonio Fatas has shown that investment expenditures as a share of GDP have fallen in the advanced economies.   Restricted spending on new plants and equipment has been blamed for continuing low growth rates in these countries, presaging a new period of “secular stagnation.”

Stephen Roach, former chief economist at Morgan Stanley and currently a Senior Fellow at Yale University’s Jackson Institute, has another concern. In his recent book, Unbalanced: The Codependency of America and China, he writes about the breakdown of the pre-crisis growth models in the two countries. China’s rapid expansion was based on investment and exports, backed by high savings rates. In the U.S., on the other hand, consumption expenditures, financed in part by borrowing against rising home values, were the basis of the economy’s growth. The flows of goods and capital between the two countries established a pattern of co-dependency between them. But the crisis revealed the weaknesses of both patterns of spending, and the two countries need to rebalance and reorient their economies.

Roach believes that China is taking the first steps to change the structure of its economy. President Xi Jinping and Prime Minister Li Keqiang have pledged to increase the role of private markets in allocating resources. Economic growth will be based on domestic demand, which will be focused on consumer expenditures.  Success is not guaranteed, however, as there will be resistance from those who profited from the old export-dependent model and government control of the financial system. The government also faces daunting environmental challenges.

Roach is decidedly not optimistic about the ability of the U.S. to make the corresponding adjustments to its economy. While the deficit in federal budget has shrunk (see above), household savings remain too low. The U.S., he writes “…has ignored its infrastructure, investing in human capital and the manufacturing capacity.” The recent fall of the U.S. current account deficit could be reversed if consumption expenditures remain the engine of economic growth.

Roach is not alone in his concerns about the need for increasing national savings. Former Federal Reserve Chair Ben Bernanke raised the same issue in testimony to Congress last year. Raising savings rates during an economic recovery, however, is difficult, particularly given the slow decline of unemployment. Moreover, the work of Thomas Piketty and others on income distribution has drawn attention to a troubling aspect of this issue: savings are concentrated among the those in highest income brackets who hold such a large share of the wealth in the U.S. Many Americans live paycheck to paycheck, with little opportunity of funding individual retirement accounts to finance their retirements.

Raghuram Rajan, in Fault Lines: How Hidden Fractures Still Threaten the World Economy, pointed to the connection between the U.S. external position and growing inequality. While the U.S. economy has largely recovered from the financial crisis, the “fault lines” that Rajan wrote about still exist.  It will be a daunting challenge for the U.S. to increase national savings without reinforcing the “forces of divergence” that skew income distribution.

China’s Place in the Global Economy

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Last week’s announcement that China’s GDP grew at an annualized rate of 7.4% in the first quarter of this year has stirred speculation about that country’s economy. Some are skeptical of the data, and point to other indicators that suggest slower growth.  Although a deceleration in growth is consistent with the plans of Chinese officials, policymakers may respond with some form of stimulus. Their decisions will affect not just the Chinese economy, but all those economies that deal with it.

The latest World Economic Outlook of the International Monetary Fund has a chapter on external conditions and growth in emerging market countries that discusses the impact of Chinese economic activity. The authors list several channels of transmission, including China’s role in the global supply chain, importing intermediate inputs from other Asian economies for processing into final products that are exported to advanced economies. Another contact takes place through China’s demand for commodities.  The author’s econometric analysis shows that a 1% rise in Chinese growth results in a 0.1% immediate rise in emerging market countries’ GDPs. There is a further positive effect over time as the terms of trade of commodity-exporters rise. Countries in Latin America are affected as well as in Asia.

These consequences largely reflect trade flows, although China’s FDI in other countries is acknowledged. But what would happen if China’s capital account regulations were relaxed? Financial flows conceivably could be quite significant. Chinese savers would seek to diversity their asset holdings, while foreigners would want to hold Chinese securities. Chinese banks could expand their customer base, while some Chinese firms might seek external financing of their capital projects. A study by John Hooley of the Bank of England offers an analysis of the possible increase in capital flows that projects a rise in the stock of China’s external assets and liabilities from about 5% of today’s world GDP to 30% of world GDP in 2025.

While the study points out that financial liberalization by China would allow more asset diversification, it also acknowledges that world financial markets would become vulnerable to a shock in China’s financial system.  Martin Wolf warns that the down-side risk is quite large. He cites price distortions and moral hazard as possible sources of instability, as well as regulators unfamiliar with global markets and an existing domestic credit boom. Similarly, Tahsin Saadi Sedik and Tao Sun of the IMF in an examination of the consequences of capital flow liberalization claim that deregulation of the Chinese capital account would result in higher GDP per capita and lower inflation in that country, but also higher equity returns and lower bank adequacy ratios, which could endanger financial stability.

There could be another result. A sizable Chinese presence in global asset markets would lead to even more scrutiny of Chinese monetary policy. A policy initiative undertaken in response to domestic conditions would affect financial flows elsewhere, and foreign policymakers most likely would voice their unhappiness with the impact on their economies. The Peoples Bank of China, accustomed to criticism from the U.S. over its handling of its exchange rate, might find the accusation of “currency wars” coming from other emerging market countries.  The price of a successful integration of Chinese financial markets with global finance will be calls for more sensitivity to the external impacts of domestic policies.

Group Therapy

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Pop quiz:  which U.S. policymaker said last week: “We can’t solve everyone else’s problems anymore” in response to foreign criticism of U.S. handling of what issue?

a—Federal Reserve Chair Janet Yellen, responding to criticism by foreign central bankers of the Fed’s tapering of its asset purchases;

b—Treasury Secretary Jack Lew, following denunciations of the refusal of the U.S. Congress to pass legislation that would enable IMF quota reform;

c—an anonymous White House aide, defending the Obama  administration’s  response to the turmoil in the Ukraine.

The correct response is c. But Ms. Yellen and Mr. Lew, who are attending the conference of G20 finance ministers and central bank heads in Sydney, might be forgiven if they held similar (but unspoken) sentiments.

The Federal Reserve has been criticized for not coordinating its policies with its peer institutions, particularly in those emerging markets that have had capital outflows and declines in equity market prices. But the critics have not spelled out precisely what they believe the Federal Reserve should do (or not do), given its assessment of the state of the U.S. economy. Domestic central banks respond to domestic conditions. In some cases, those conditions are linked to the global economy, and a central banker who ignored those linkages would only be postponing the implementation of stronger measures. But is that the case here?

The IMF came the closest to offering a specific criticism:

Advanced economies should avoid premature withdrawal of monetary accommodation as fiscal balances continue consolidating. Given still large output gaps, very low inflation, and ongoing fiscal consolidation, monetary policy should remain accommodative in advanced economies. There is scope for better cooperation on unwinding UMP, including through wider central bank discussions of exit plans.

Does anyone think that the Federal Reserve no longer intends to “remain accommodative”? Are more discussions the only missing element of the Federal Reserve’s plans? That would be surprising, since central bankers have many opportunities to speak to each other, and usually do.

The IMF did not let the emerging market countries off the hook:

In emerging market economies, credible macroeconomic policies and frameworks, alongside exchange rate flexibility, are critical to weather turbulence. Further monetary policy tightening in the context of strengthened policy frameworks is necessary where inflation is still relatively high or where policy credibility has come into question. Priority should also be given to shoring up fiscal policy credibility where it is lacking; subsequently buffers should be built to provide space for counter-cyclical policy action. Exchange rate flexibility should continue to facilitate external adjustment, particularly where currencies are overvalued, while FX intervention— where reserves are adequate—can be used to smooth excessive volatility or prevent financial disruption.

Critics are on firmer grounds when they criticize the U.S. for not passing the necessary legislation to change the IMF’s quota allocations. But perhaps they should not take their annoyance out on Mr. Lew. The U.S. Congress did not approve the needed measures for a number of reasons, none of them particularly compelling. Mr. Lew would be delighted to see the situation change, but that is unlikely to happen.

What, then, can be done at the G20 meeting? If allowing everyone to voice her or his frustrations with the U.S. serves some useful purpose, then all the air miles on the flights to Sydney will have been earned. Perhaps IMF Managing Director Christine Lagarde can serve as mediator/therapist. But before everyone piles on, it may be worth reflecting that the Federal Reserve is not the only central bank with policy initiatives that may ripple across national borders.

Shake, Rattle and Roll

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The selloff last week of the currencies of many emerging market countries while stock prices also declined can be seen as the result of “known unknowns” and “unknown unknowns.” How these will play out will become evident during the rest of the year. Either set of factors would be unsettling for the emerging market countries, but the combination of the two may lead to a long period of chaotic financial conditions.

The “known unknown” is the magnitude of the increase in U.S. interest rates following the scaling down of asset purchases by the Federal Reserve and the ensuing impact on capital flows to developing economies. A recent analysis at the World Bank of the response established a baseline assumption of an increase of 50 basis points in U.S. long-term interest rates by the end of 2015 and another 50 basis point rise in 2016. The European Central Bank, the Bank of Japan and the Bank of England would also relax their quantitative easing policies. The result, according to their model, would be a slow rise in global interest rates and a gradual tightening in capital flows to developing countries of about 10%, or 0.6% of their GDP. The biggest declines would occur in portfolio flows to these countries.

However, the World Bank analysts also allowed for alternative scenarios. If there is a “fast normalization,” then U.S. long-term interest rates will rise by 100 basis points this year and capital inflows to the developing economies drop by up to 50% by the end of the year. In the “overshooting scenario,” long-term rates rise by 200 basis points, and capital inflows could decline by 80%. These developments would raise the probability of financial crises in the emerging markets, particularly in countries where there have been sizeable increases in domestic credit fueled in part by foreign debt

But the U.S. is not the only source of anxiety for policymakers in emerging market economies.  A decline in Chinese manufacturing activity in January may be reversed next month, and by itself likely means little. The decline in Asian stock prices that followed the announcement of the fall, however, demonstrated the importance of China’s economy for the region, and why China’s economic performance is the “unknown unknown.” The financial system in China has become overextended, and the Bank of China has fluctuated between signaling that it would rein in the shadow banking system while also injecting credit when short-term interest rates rise. How long the authorities can continue their delicate balancing act is unclear.

The state of the financial system is only one of the aspects of the Chinese economy that raises concerns. Given the uncertainty about the impact of demographic and migration trends, the continuation of FDI flows, etc., any forecast is conditional on a host of factors.  The IMF reported increased growth in China at the end of 2013, but warned that it will moderate this year to around 7.5%.

The conundrum is that we do not know what we should be concerned about in China, whereas we can imagine all too well what may happen to financial markets in emerging markets following higher interest rates in the advanced economies. The result is likely to be continued declines in exchange rates and financial asset prices, as the vulnerabilities of individual countries are revealed. As Warren Buffet warned, “Only when the tide goes out do you discover who’s been swimming naked.”

Update: See Menzie Chin’s views on these issues here.

 

The Spirit of Versailles?

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The newly-approved U.S. budget bill did not include authorization for changes at the IMF in funding and quotas (see also here). Those measures require approval of 85% of the voting power of the IMF’s members, and since the U.S. controls 17.67%, the reforms cannot be enacted. This leaves the U.S and the Fund in difficult positions.

The IMF received loans from its members during the 2007-09, but has sought to convert these to increases in the quotas that provide the funding for the IMF’s lending programs. The IMF is not about to run out of money, but the opportunity to put its financing on a regular basis has been (at best) delayed.  The IMF’s members also agreed to shift quota shares, which also determine voting powers, to the emerging market nations while reducing the European presence on its Executive Board. China has made clear that it wants a larger voting share, and the other middle-income countries have taken a similar position. The postponement in increasing their quotas allows their governments to adopt a position of high dudgeon when the IMF next advocates policy changes in their countries. The Europeans, on the other hand, must be delighted that the they are no longer on the spot for obstructing the realignment.

What important Constitutional principle was at stake in the refusal of Congress to approve the measures? According to the New York Times, it was a lack of willingness to support multilateral financial institutions. This ties in with popular opposition in the U.S. to foreign aid, always a perennial target of right-want opprobrium, and it bodes poorly for the future. If a significant segment of political opinion consistently opposes U.S. involvement in international ventures and forums, then the U.S. will pay a price in diminished global influence.

Is it too dramatic to compare this event with the failure of the U.S. Senate to approve the Treaty of Versailles? Probably, but the similarities are suggestive of what is driving the rejection. A significant part of the American electorate was tired then of foreign wars and wished to retreat from foreign obligations, just as many do today. Anything that seems to support the financial sector is also viewed with suspicion.  Personal enmity between President Woodrow Wilson and Republican Senator Henry Cabot Lodge is echoed in the animosity between President Barak Obama and members of the Republican Congressional delegation. Lodge was concerned that the League would supersede the U.S. government’s ability to conduct foreign affairs, just as many contemporary conservatives are worried about the influence of the United Nations on domestic matters. Both Wilson and Obama have been accused of being unwilling (or unable) to persuade opponents of the need to approve the desired measures.

While the U.S. never joined the League of Nations, it is not about to leave the IMF. But the refusal to ratify the changes in the IMF’s governance will leave the U.S. vulnerable to the charge that it seeks to retain control of an organization that was established at the end of World War II long after its hegemonic position had ebbed. If this were the reason for these developments, it would at least be understandable from a realpolitik perspective. The truth may be more dispiriting: perhaps we do not understand what we have to lose.