Tag Archives: U.S.

Not All Global Currencies Are The Same

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The dollar may be the world’s main global currency, but it does not serve in that capacity alone. The euro has served as an alternative since its introduction in 1999, when it took the place of the Deutschemark and the other European currencies that had also been used for that purpose. Will the renminbi become the next viable alternative?

A new volume, How Global Currencies Work: Past, Present and Future by Barry Eichengreen of the University of California-Berkeley and Arnaud Mehl and Livia Chiţu of the European Central Bank examines the record of the use of national currencies outside their borders. The authors point out that regimes of multiple global currencies have been the norm rather than an exception. Central banks held reserves in German marks and French francs as well as British sterling during the period of British hegemony, while the dollar became an alternative to sterling in the 1920s. The authors foresee an increased use of China’s renminbi and “..a future in which several national currencies will serve as units of account, means of payments, and stores of value for transactions across borders.”

Camilo E. Tovar and Tania Mohd Nor of the IMF examine the use of the reminbi as a global currency in a IMF working paper, “Reserve Currency Blocs: A Changing International Monetary System.” They claim that the international monetary system has transitioned for a bi-polar one based on the dollar and the euro to a tri-polar system that also includes the renminbi. They provide estimates of a dollar bloc equal in value to 40% of global GDP that is complemented by a renminbi bloc valued at 30% of global GDP and a euro bloc worth 20% of world output. The renminbi bloc, however, is not primarily Asian, but rather dominated by the BRICS countries (Brazil, Russia, India, China, South Africa). This suggests that its increased use may be due to geopolitical reasons rather than widespread regional use.

If relative size is a driving factor in the adoption of a currency for international transactions, then an increasing role for the renminbi is inevitable. But the dollar will continue to be the principal currency for many years to come. Ethan Ilzetzki of the London School of Economics, Carmen Reinhart of Harvard’s Kennedy School and Kenneth Rogoff of Harvard examine the predominance of the dollar in a NBER working paper, “Exchange Arrangements Entering the 21st Century: Which Anchor Will Hold?” They show that the dollar is far ahead of other currencies in terms of trade invoicing , foreign exchange trading, and most other measures.

The U.S. also holds a dominant role in international financial flows. Sarah Bauerle Danzman and W. Kindred Winecoff of Indiana University Bloomington have written about the reasons for what they call U.S. “financial hegemony” (see also their paper with Thomas Oatley of the University of North Carolina-Chapel Hill and Andrew Penncok of the University of Virginia). They point to the central role of the U.S. financial system in the network of international financial relationships. They claim that the financial crisis of 2008-09 actually reinforced the pivotal position of the U.S., in part due to the policies undertaken by U.S. policymakers at that time to stabilize financial markets and institutions. This included the provision by the Federal Reserve of swap lines to foreign central banks in countries where domestic banks had borrowed dollars to invest in U.S. mortgage-backed securities. (Andrew Tooze provides an account of the Federal Reserve’s activities during the crisis.)

The central position of the U.S., moreover, evolved over time, and reflects a number of attributes of the U.S. economy and its governance. Andrew Sobel of Washington University examined the features that support economic hegemony in Birth of Hegemony. He cites Charles Kindleberger’s claim of the need for national leadership in order to forestall or at least offset international downturns, such as occurred during the depression (see The World in Depression 1929-1939). Kindleberger specifically referred to the need for international liquidity and the coordination of macroeconomic policies by a nation exercising economic leadership.

Sobel, drawing upon the history of the Netherlands, Great Britain and the U.S., maintains that the countries that have provided these collective goods have possessed public and private arrangements that allowed them to provide such leadership. The former include adherence to the rule of law, a fair tax system and effective public debt markets. Among the private attributes are large and liquid capital markets and openness to foreign capital flows. Sobel shows that these features evolved in the historical cases he examines in response to national developments that did not occur in other countries that might have been alternative financial hegemons (such as France).

Will a new dominant financial hegemon appear to take the place of the U.S.? It is difficult to see the European Union or China assuming that role in the short- or medium-term. European leaders are dealing with disagreements over the nature of their union and the discontent of their voters, while China is establishing its own path. (See Milanovic on this topic.) U.S. financial institutions are dedicated to preserving their interests, and not likely to surrender their predominance. It would take a major shock, therefore, to current arrangements to upend the existing network of financial relationships. But we now live in a world where such things could happen.

After the Global Financial Crisis: Are We Safe Now?

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A decade after the global financial crisis the global economy seems (finally) to be enjoying a robust recovery. Economic growth is widespread and includes increased expenditures on investment, a sign that business firms expect continuing demand for their products. With the crisis finally behind us, we can revisit it to reassess its causes and the response. We can also ask whether our ability to respond to another crisis is adequate.

Reappraisals of the roots of the crisis have focused on the fragility of the financial sector, and the consequences of inadequate capital and liquidity shortfalls. Low interest rates due in part to foreign savings contributed to a rise in housing prices in the U.S., and the extension of mortgage loans to borrowers who sought to profit from further price increases. Bankers were willing to extend credit in part because they could pass along any risk through the sale of mortgage-backed securities, in some cases to financial firms in Europe. Credit booms in the housing sector also occurred in other countries, most notably Ireland and Spain.

But by 2007 as interest rates and the price of servicing the debt rose, housing prices stalled and mortgage borrowers who expected capital gains began to exit the market. The mortgage-backed securities lost their value, which led to a chain of liquidations of positions that pushed their prices further down. In the summer of 2008 the federal government was forced to take over the government-sponsored agencies, the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), that were active in the secondary market for mortgage securities. The failure of Lehman Brothers in September 2008 signaled a financial collapse that quickly spread to Europe.

In the aftermath of the crisis there was a wave of new rules in the financial sector. National bank regulators acting together at the Basel Committee on Banking Supervision revised capital adequacy ratios. In the U.S. the Dodd–Frank Wall Street Reform and Consumer Protection Act was enacted to overhaul and update our regulatory rules and institutions. The bill consolidated government supervisory agencies, extended their reach and introduced new tools, including a mechanism to allow the orderly closure of financial companies that have failed. The Consumer Financial Protection Bureau (CFPB) was established to prevent the predatory mortgage and other lending practices that had contributed to the crisis.

While national leaders were criticized at the time for an initially fumbling response, Daniel Drezner of the Fletcher School at Tufts University appraised the macroeconomic and financial policies undertaken at the time of the crisis and concluded that the system “worked,” i.e., the policy measures undertaken adverted a much worse outcome. The leaders of the Group of 20 nations (the successor to the Group of 7) agreed to increase government spending and to expand the resources of the International Monetary Fund to allow it to lend to a range of countries. Just as importantly, they also agreed to refrain from implementing trade barriers or engaging in competitive exchange rate depreciations. The Federal Reserve, aware of the central role of the dollar, instituted swap agreements with foreign central banks that enabled them to assist their banks with dollar obligations.

Ten years later, is the global economy safe from another financial meltdown? If one did occur, could we respond as aggressively? Because of the slow recovery, credit growth does not seem excessive—with the significant exception of China. Global stock markets, on the other hand, continue to set new records. The U.S. cyclically adjusted price earnings ratio has reached a level only seen in 1929 and during the “tech bubble,” leading inevitably to explanations of why this time the valuation is justified. Bitcoin, supposedly a new form of currency, continues to draw investors with a scarce understanding of what they are purchasing, and many are doing so by borrowing on their credit cards. A collapse in prices could lead to an unraveling of positions and a new round of liquidations that could extend into other financial markets.

Unfortunately, central banks will have limited room to respond. While the Federal Reserve is increasing the Federal Funds rate, it currently stands at only 1.50%. But even this is higher than the Bank of England’s target rate of 0.5% or the European Central Bank’s 0.0%. Central banks could return to quantitative easing operations but they would be beginning with much larger balance sheets than they had in 2008. A fiscal stimulus would be effective in the event of an economic contraction, but the U.S. has just enacted tax cuts that are expected to add $1.5 trillion to the federal debt. How would financial markets respond if a new downturn lowered tax revenues further as the government sought to increase spending?

Moreover, the financial sector in advanced economies is just as large as it was before the crisis. The size of financial sectors has been cited as a cause of concern by economists at the Bank for International Settlements and also a team at the IMF. The latter paper finds: “The effects of financial development on growth and stability show that there are tradeoffs, since at some point the costs outweigh the benefits.” There seems little doubt that we reached that point years ago.

There also seems to be no recognition of the fragility of the financial sector, and the threat it can pose. The success of governments in preventing a recurrence of the Great Depression precluded a public accounting of the causes of the crisis and the dangers of financial excess. A recent column in The Economist concluded:

“The success of the response to the downturn helped avoid some of the disasters of the 1930s. But it also left the fundamentals of the system that produced the crisis unchanged. Ten years on, the hopes of radical reform are all but dashed. The sad upshot is that the global economy may have the opportunity to relearn the lessons of the past rather sooner than hoped.”

If such a disaster occurs, it is difficult to imagine how the current administration in the U.S. would respond. There is no sense of common purpose or even an acknowledgement of the global interdependence of economies. Economic nationalism during a period of volatility will surely set off a round of tit-for-tat responses that in the end would leave no country better off.

In the meantime the financial sector enjoys continuing growth in earnings and the U.S. Congress is preparing to loosen some of the Dodd-Frank banking restrictions. But, as Martin Wolf of the Financial Times has warned, “The world at the beginning of 2018 presents a contrast between its depressing politics and its improving economics.” Markets can and do change rapidly,and there are many potential sources of disruption. And the greatest danger is always the one you do not see coming.

Economic Consequences of Populism

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Who is the true populist: Bernie Sanders, who promises single-payer health care and college without tuition, or Donald Trump, who campaigned on a promise to “drain the swamp”?  Jeremy Corbyn of the UK’s Labour Party, who wants to nationalize public-sector firms, or Marine Le Pen of France’s National Front, who wants to take France out of the Eurozone? And what would be the consequences of their policies?

To answer these questions requires first an understanding of populism. One definition of populism, such as the one found here, refers to it as policies for the “common people.” Populism, therefore, divides the world into two groups: the good “common people” and the evil “them.” “They” deprive the “people” of the rewards of their hard work and exclude them from the political process. But just who are these “common people”? And who are not?

Dani Rodrik of Harvard’s Kennedy School in one recent paper and a second coauthored with Sharun Mukand of the University of Warwick proposes an analytical framework for understanding the different strands of nationalism. Rodrik and Mukand suggest that populist politicians obtain support by exploiting divisions within a society, and envisage two kinds of separation. The first is an ethno-national split, such as occurred in Europe in the 1930s and again in modern-day Europe, and is usually associated with right-wing movements. The second is a partition by economic class, as seen in the U.S. in the 1890s, Peron’s Argentina and contemporary Venezuela, and is often found in left-wing organizations.

Under this classification, Trump and Le Pen are nationalist populists while Sanders and Corbyn have a class-based agenda. Once we understand this demarcation, we can see they will advocate different policies. The nationalist populists are suspicious of all foreign contact. They regard trade pacts as zero-sum transactions: one side to an agreement wins, and the other loses. Similarly, immigrants hurt native workers and impose fiscal costs on society. These populists are in favor of government expenditures for the “people,” but not anyone else. They favor domestic firms and will support measures to benefit them.

Class-based populists, on the other hand, are concerned about the “workers,” who includeindustrial laborers and farmers. They are suspicious of property owners and the financial sector. They seek to use taxes and other measures to redistribute property. They may also advocate government control of the economy through public ownership or the use of licenses and other means to guide production. They can grant subsidies for the purchase of basic needs, such as food or fuel. They will oppose foreigners if they are seen as allied with domestic financiers.

Initially, populist measures of either type may lead to prosperity, as more domestic and/or government spending leads to more jobs. But less efficient firms are subsidized, which increases costs. Over time these costs must be paid, as well as those made directly to households. If the bond markets are reluctant to finance government budget deficits (except at very high interest rates), the government may turn to the central bank to finance its expenditures. But the resulting inflation leads to more spending and monetary creation. A country with a fixed exchange rate, like several in Latin America, eventually runs out of foreign exchange. The resulting crises are blamed on “foreigners” or “capitalists,” and eventually may lead to a collapse.

Rudiger Dornbusch and Sebastian Edwards (currently at UCLA’s Andersen School of Management) wrote an analysis of the populist policies of Latin American governments that appeared in the Journal of Development Economics in 1990 (see working paper here). In their view:

“We mean by “populism” an approach to economics that emphasizes growth and income redistribution and deemphasizes the risks of inflation and deficit finance, external constraints and the reaction of economic agents to aggressive non-market policies.…populist policies do ultimately fail; and when they fail it is always at a frightening cost to the very groups who were supposed to be favored.”

The most prominent manifestations of President Trump’s nationalist populism have come in the negotiations over NAFTA  and the administration’s refusal to abide by the decisions of the World Trade Organization. In addition, there are its policies that affect illegal immigrants and its support of measures to cut legal migration. None of these will lead to an immediate crisis in the U.S.  economy, but they will have long-run consequences for the growth of the economy. Moreover, the law of unintended consequences has a wide reach, The Trump administration may find that retaliation can sting.

 

Trump and International Finance

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International trade and immigration were flashpoints of Donald Trump’s presidential campaign, and in his first year he has shown that he intends to fulfill his promises to slow down the movements of goods and people. Last month negotiations over NAFTA began with Canada and Mexico, with the U.S. trade representative Robert Lighthizer announcing that current bilateral deficits “can’t continue.” The President threatened to shut down the government if Congress does not approve the funding for a wall with Mexico—a threat that seems to have been retracted in view of the need to approve funding for relief funds to Texas. But another aspect of globalization—international financial flows—seems to have escaped the President’s wrath. The reason for this divergence tells us much about the reasons for the President’s opposition to economic globalization.

President Trump has complained about exchange rates, particularly those of China and Germany, insisting that their governments lower the value of their currencies to increase exports to the U.S. But the U.S. Treasury did not label either country a currency manipulator in its latest report, although they made the “watch list.” (How Germany manipulates the euro has yet to be demonstrated.) Similarly, Trump received considerable press coverage during his campaign when he attacked U.S. firms that allegedly transferred U.S. jobs abroad. Recently his indignation seems to have trailed off, and has been replaced by the assertion that lower corporate tax rates will serve as an incentive for U.S. firms to repatriate funds held abroad that they will spend on domestic investments—a claim with little evidence to back it up. The President has rarely voiced any concern about the impact of financial globalization.

While Senator Bernie Sanders did not make international finance a focus of his campaign for the Democratic nomination for the presidency, he sharply criticized the financial sector. He called for the breakup of the largest financial institutions, and proposed a tax on financial transactions to finance public colleges and universities. Any of these actions would certainly affect capital flows. And Sanders expressed strong disapproval of the IMF’s programs with Greece.

The reason for the different stances on finance by Trump and Sanders can be explained using a framework recently proposed by Professor Dani Rodrik of Harvard’s Kennedy School of Government. He distinguishes between the sorts of cleavages that can divide societies. One of these is an ethno-national/cultural cleavage, which differentiates people by nationality and/or race. The other is an income/social class cleavage, which distinguishes people by income class. The former results in right-wing populism that targets foreigners as the source of the hardships that domestic citizens experience. The second form of division leads to left-wing populism, which criticizes the wealthy, banks and corporations.

Trump’s appeal has been to a base that is largely white, and who often live in economically distressed areas. They are receptive to the argument that foreigners are the cause of their economic distress, and that the country needs a strong leader who can stand up to the external threat. Research by Diana Mutz and Edward D. Mansfield of the University of Pennsylvania has shown that opposition to globalization is often based on attitudes and views outside the economic realm. They cite as sources of opposition to globalization: first, a belief that the U.S. is superior to other nations; second, a desire to avoid engagement with the rest of the world; and third, negative feelings towards those who are racially and ethnically different.

Trump’s opposition to trade and immigration allows him to show these voters that he will support them against the foreign menance. International finance, on the other hand, lacks a clear foreign villain. It is difficult to attack foreign central banks for helping to finance our fiscal deficits, and the financial crisis of 2008-09 originated in this country.

But Rodrik points out that there are countries where international capital movements have been much more controversial. Latin American countries have often faced financial shocks, which led to a left-wing populism that opposed foreign banks. More recently, Greece has been receptive to populists who oppose the austerity measures imposed by other European governments and the IMF.

In the case of the U.S., Sanders’ campaign showed that a leftist form of populism would include opposition to the financial sector. This form of activism can, of course, be found in U.S. history. The populist movement of the 1890s called for the abandonment of the Gold Standard and an increase in the provision of credit to farmers. More recently, opponents of the Federal Reserve have included members of Congress from both parties.

While Trump was willing to criticize Wall Street during his campaign, he has adopted a very different stance since his election. He has called for repeal of most of the Dodd-Frank Wall Street Reform Act. Steve Mnuchin, the Secretary of the Treasury and Gary Cohn, Director of the National Economic Council, both worked at Goldman Sachs. But Trump’s opposition to trade and migration allows him to maintain his base of support among Republican voters.

International bankers know that they have nothing to fear from a Trump administration—except perhaps his incompetence. Any threats to the stability of financial markets will come from self-inflicted wounds, such as a government shutdown over the debt ceiling. The low market volatility foreseen by the VIX index may soon be upended.

Crises and Coordination

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Policy coordination often receives the same type of response as St. Augustine gave chastity: “Lord, grant me chastity and continence, but not yet.” A new volume from the IMF, edited by Atish R. Ghosh and Mahvash S. Qureshi, includes the papers from a 2015 symposium devoted to this subject. Policymakers in an open economy who take each other’s actions into account should be able to reach higher levels of welfare than they would working in isolation.  But actually engaging in coordination turns out to be harder–and less common– than many may think.

Jeffrey Frankel of Harvard’s Kennedy School of Government uses game theory to illustrate the circumstances that hamper coordination. One factor may be a fundamental divergence in how different policymakers view a situation. Many analysts on this side of the Atlantic, for example, use the “locomotive game” to show that Germany should engage in expansionary fiscal policies that would raise output for all nations. But (most) German policymakers have different views of the external impact of deficit spending. In the case of the Eurozone, a deficit in one country increases the probability that it will need a bailout by the other members of the monetary union. Only rules such as those of the Stability and Growth Pact that limit deficit expenditures can eliminate the moral hazard that would otherwise lead to widespread defaults.

Charles Engel of the University of Wisconsin (working paper here) also examines the recent literature on central bank coordination. He points out that the identifying the source of shocks is necessary to assess the benefits of cooperation to address them, and suggests that financial sector shocks may be most relevant for modeling open-economy coordination. But widespread cooperation could undercut the ability of a central bank to credibly commit to a single target, such as an inflation target.

Policymakers in emerging markets who must deal with the consequences of policies in advanced economies have been particularly mindful of their spillover effects. Raghuram Rajan, for example, who is back at the University of Chicago after serving as head of India’s central bank, has urged the Federal Reserve and other central banks to take into account the impact that their policies have on other nations, particularly when unwinding their Quantitative Easing asset purchases. He pointed out: “Recipient countries are not being irrational when they protest both the initiation of unconventional policy as well as an exit whose pace is driven solely by conditions in the source country.”

If international cooperation is viewed as a bargaining game, what incentives do the advanced economies have for cooperative behavior in light of the asymmetries among nations? Engel points out that in such circumstances, “…the emerging markets may believe that they have too little say in this implicit agreement, which is to say that they may perceives themselves as having too little weight in the bargaining game.” Conversely, central banks in the upper-income countries may in ordinary circumstances see little need to extend the scope of their decision-making outside their borders.

This attitude changes, however, when a crisis occurs, as Frederic Mishkin of Columbia shows in his examination of the response of central bankers to the global financial crisis. The Federal Reserve established swap lines to provide dollars to foreign central banks in countries where domestic banks faced a withdrawal of the funding they had used to acquire dollar-denominated assets. In addition, six central banks—the Federal Reserve, the Bank of Canada, the Bank of England, the European Central Bank, the Sveriges Riksbank and the Swiss National Bank—announced a coordinated reduction of their policy rates. Coordination becomes quite relevant in a world of sudden stops and capital flight.

The need for such activities could increase if there is a global financial cycle, as Hélène Rey of the London Business School has stated. She presents evidence of the impact of global volatility, as measured by VIX, on international asset prices and capital flows. An important determinant of such volatility is monetary policy in the center countries. Rey agrees with Rajan that: “Central bankers of systemically important countries should pay more attention to their collective policy stance and its implications for the rest of the world.”

Perhaps a better motivation for the need for joint action comes from Charles Kindleberger’s list of the responsibilities that a hegemonic power such as Great Britain played in the period before World War I. These included acting as a lender of last resort during a financial crisis; indeed, it was the lack of such an international lender in the 1930s that Kindleberger believed was an important contributory factor to the Great Depression. Since the end of World War II the U.S. has vacillated in this role while the international monetary system has moved from crisis to crisis. Meanwhile, offshore credits denominated in dollars have grown in size, and could conceivably constrain the Federal Reserve’s ability to undertake purely domestic measures.

A policy of “America First” that means “America Only First and Last” ignores the fragility of the international financial system. Just as there are no atheists in foxholes, no one doubts the merits of coordination when there is a disruption of global markets. But suffering another crisis would be an expensive reminder that the best time to minimize systemic risk is before a crisis erupts.

The Emerging Market Economies and the Appreciating Dollar

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U.S. policymakers are changing gears. First, the Federal Reserve has signaled its intent to raise its policy rate several times this year. Second, some Congressional policymakers are working on a border tax plan that would adversely impact imports. Third, the White House has announced that it intends to spend $1 trillion on infrastructure projects. How all these measures affect the U.S. economy will depends in large part on the timing of the interest rate rises and the final details of the fiscal policy measures. But they will have consequences outside our borders, particularly for the emerging market economies.

Forecasts for growth in the emerging markets and developing economies have generally improved. In January the IMF revised its global outlook for the emerging markets and developing economies (EMDE):

EMDE growth is currently estimated at 4.1 percent in 2016, and is projected to reach 4.5 percent for 2017, around 0.1 percentage point weaker than the October forecast. A further pickup in growth to 4.8 percent is projected for 2018.

The improvement is based in part on the stabilization of commodity prices, as well as the spillover of steady growth in the U.S. and the European Union. But the U.S. policy initiatives could upend these predications. A tax on imports or any trade restrictions would deter trade flows. Moreover, those policies combined with higher interest rates are almost guaranteed to appreciate the dollar. How would a more expensive dollar affect the emerging markets?

On the one hand, an appreciation of the dollar would help countries that export to the U.S. But the cost of servicing dollar-denominated debt would increase while U.S. interest rates were rising. The Bank for International Settlements has estimated that emerging market non-bank borrowers have accumulated about $3.6 trillion in such debt, so the amounts are considerable.

In addition, Valentina Bruno and Hyun Song Shin of the BIS have examined (working paper here) a “risk-taking” channel of U.S. monetary policy that links exchange rate movements to cross-border banking flows. In the case of an appreciation of a foreign currency, domestic banks in the affected countries channel funds from global banks to firms with local currency assets that have risen in value. A domestic currency depreciation in response to U.S. monetary policy will lead to a contraction in such lending.

Jonathan Kearns and Nikhil Patel of the BIS have sought to determine whether the “financial channel” of exchange rates offsets the “trade channel.” The sample of countries they use in their empirical analysis includes 22 advanced economies and 22 emerging market economies, and the data for most of these countries begins in the mid-1990s and extends through the third quarter of 2016. They use two exchange rate indexes, where the indexes measures the foreign exchange values of the domestic currency, in one case weighted by trade flows and the second by foreign currency-denominated debt.

Their results provide evidence for both channels that is consistent with expectations: the trade-weighted index has a negative elasticity, while the debt-weighted index has a positive linkage. For 13 of the 22 emerging market economies, the sum of the two elasticities is positive, indicating than an equal appreciation of the domestic currency would be expansionary. The financial channel is stronger for those emerging market economies with more foreign currency debt.

Does this indicate that further appreciation of the dollar will lead to the long-anticipated debt crisis in the emerging markets? When Kearns and Patel replaced the debt-weighted exchange rate index with the bilateral dollar rate, they found that the debt-weighted index does a better job in capturing the financial channel than the dollar exchange rate alone. The other foreign currencies in the debt-weighted index included the euro, the yen, the pound and the Swiss franc, so a rise in the dollar is not as important when the debt is denominated in the other currencies.

Domestic policymakers in the emerging market countries seem to have done a good job in restraining domestic credit growth, which is often the precursor of financial crises. There is one significant exception: China. One recent estimate of its debt/GDP ratio placed that figure at 277% at the end of 2016. The government is attempting to slow this expansion down without destabilizing the economy, which now has a growth target of 6.5%. What happens if the dollar appreciates against the renminbi as it did last year, when China used up a trillion dollars in foreign exchange reserves in an attempt to slow the loss in value of its currency? About half of China’s external debt is denominated in its own currency, so it has less to fear on this score than do other borrowers.

A team of IMF economists that included Julian Chow, Florence Jaumotte, Seok Gil Park, and Yuanyan Sophia Zhang examined in 2015 the spillovers from a dollar appreciation. They noted that many emerging market economies are currently less vulnerable to a dollar appreciation than they were during previous periods. However, they also reported that some countries in eastern Europe and the Commonwealth of Independent States have short positions in dollar-denominated debt instruments. They investigated corporate borrowing, including debt denominated in foreign currencies, and performed a stress test analysis based on higher borrowing costs, a decline in earnings and an exchange rate depreciation to see which countries had the most vulnerable firms. They reported that increases in foreign exchange exposure would be largest in Brazil, Chile, India, Indonesia and Malaysia. They concluded their report: “Should a combination of severe macroeconomic shocks affect the nonfinancial sector, debt at risk would further rise, putting pressure on banking systems’ buffers, especially in countries where corporate and banking sectors are already weak. “

Another team of Fund economists, led by Selim Elekdag, also investigated rising corporate borrowing in the emerging market economies in the October 2015 Global Financial Stability Report. They attributed the rise in corporate debt in these countries to accommodative global monetary conditions. Consequently, these firms are quite vulnerable to changes in U.S. interest rates.

Some analysts see signs of a “virtuous cycle” in many emerging market economies. The motivating factors range from pro-growth policies in India to China’s ability (to date) to avoid a severe slowdown. But these economies are quite vulnerable to external developments. The Federal Reserve recognize this, and takes the foreign impact of its policies into account. But no such assurance comes from the rest of the U.S. government. President Trump’s fulfillment of his promise to disrupt the normal policy process in Washington will have a broad impact outside the U.S. as well.

The Changing Fortunes of the Renminbi and the Dollar

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Last fall the International Monetary Fund announced that China’s currency, the renminbi, would be included in the basket of currencies that determine the value of the IMF’s reserve asset, the Special Drawing Right (SDR). The IMF’s statement appeared to confirm the rise in the status of the currency that could at some point serve as an alternative to the U.S. dollar as a global reserve currency. But in retrospect the renminbi is a long way from achieving widespread use outside its regional trading partners, and recent policies will only limit the international use of the currency.

It has been widely speculated that the drive to include the renminbi in the IMF’s currency basket was a tool by reformers such as People’s Bank of China governor Zhou Xiaochuan to move their country towards a more liberal economic regime. The SDR currencies are supposed to be “freely usable” by foreign and domestic investors, so capital controls were eased in the run-up to the SDR announcement. But Chinese authorities are loath to give up their ability to control foreign transactions.

This has become particularly true as a result of China’s recent capital outflows. These have in part reflected outward foreign direct investment by Chinese firms seeking to expand. But the outflows are also due to Chinese firms and individuals moving money outside their country. These movements both reflect and contribute to a continuing depreciation of the renminbi, particularly against the dollar. Chinese authorities have burned through almost $1 trillion of their $4 trillion in foreign exchange reserves as they sought to slow the slide in the value of their currency.

To reduce pressure on the renminbi, the authorities are imposing controls on the overseas use of its currency. But these regulations to protect the value of the currency reduce the appeal of holding the renminbi. As Christopher Balding of the HSBC Business School in Shenzhen points out, monetary authorities can not control the exchange rate and the money supply while allowing unregulated capital flows.

Even if the authorities manage to weather the effects of capital outflows, the long-term prospects of the renminbi becoming a major reserve currency are limited. Eswar Prasad of Cornell University has written about the role of the renminbi in the international monetary system in Gaining Currency: The Rise of the Renminbi. After reviewing the extraordinary growth of the Chinese economy and the increased use of the renmimbi, Prasad evaluates China on the criteria he believes determine whether it will graduate to the status of a global currency. China had until recently been removing capital controls and allowing the exchange rate to become more flexible, benchmarks followed by foreign investors. Its public debt is relatively low, so there are no fears of sovereign debt becoming unmanageable or inflation getting out of hand.

On the other hand, the rise in total debt to GDP to 250% has drawn concerns about the stability of the financial sector. This is troubling, because as Prasad points out, this is the area of China’s greatest weakness. This vulnerability reflects not only on the increasing amount of private debt but also precarious business loans on the books of the banks, the growth of the shadow banking system and stock market volatility. Prasad writes: “China’s financial markets have become large, but they are highly volatile, poorly regulated, and lack a supporting institutional framework.” This is crucial, since ”… financial market development is likely, ultimately, to determine winners and losers in the global reserve currency sweepstakes.”

The growth in the use of renminbi has not eroded the primacy of the dollar in the international monetary system.. An investigation by Benjamin J. Cohen of UC-Santa Barbara and Tabitha M. Benney of the University of Utah of the degree of concentration in the system indicates that there is little evidence of increased competition among currencies. The dollar is widely used as a vehicle currency for private foreign exchange trading and cross-border investments, as well as for official holdings of reserves. Expectations for the euro have been scaled back as the Eurozone area struggles with its own long-term stability.

Carla Norrlof of the University of Toronto examines the sources of the dominance of the dollar. She investigates the factors that contribute to “monetary capability,” the resources base necessary for exercising currency influence. These include GDP, trade flows, the size and openness of capital markets, and defense expenditures. Norrlof’s empirical analysis leads her to confirm the status of the U.S. as the monetary hegemon: “The United States is peerless in terms of monetary capability, military power and currency influence.”

Cohen and Benney stress that their analysis holds for the current system, which could change. What could undermine the status of the dollar? Benjamin Cohen worries that President-elect Trump’s policies may increase the government’s debt and restrict trade, and possibly capital flows as well. These measures need not immediately demolish the role of the dollar. But Cohen writes, “…the dollar could succumb to a long, slow bleeding out, as America’s financial rivals try to make their own currencies more attractive and accessible.”

The renminbi, therefore, does not represent any short-term threat to the dollar’s place in the international monetary system. But the U.S. itself could undermine that status, and a potential opening may spur Chinese efforts to establish a firmer basis for the use of its currency, just as it has done in international trade in the wake of the demise of the Trans-Pacific pact. The transition could take decades, and during that period the global system could disintegrate into regional alliances that encourage unstable trade and financial flows. Those in the U.S. who voted for change may rue the consequences of President-elect Trump’s efforts to deliver on that electoral promise.

The 2016 Globie: “Global Inequality”

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Each year I name a book as the “Globalization Book of the Year” (also known as the “Globie”). The selection is a recognition of its author’s contribution to our understanding of the causes and effects of globalization. There is no money attached to the prize—recognition is the sole reward. Recent winners can be found here and here.

This year’s awardee is Global Inequality by Branko Milanovic. The book has received a great deal of well-deserved attention for its analysis of how inequality has evolved in an era when goods, services and money—but not people—have been able to cross borders more easily than during any other period since the first era of globalization of 1870-1914. The returns from these transactions, Milanovic demonstrates, have been distributed in a very unequal fashion, which has changed the global distribution of income.

A graph of the gains in real per capita income over the periods of 1988-2008 (see here) shows that those at the bottom of the distribution of global income received some increases. But income rose more quickly for those in the middle percentiles, the 40th to the 60th. This group includes one-fifth of the world’s population, most of whom live in Asia, primarily China and India. Growth in those countries elevated their middle classes to become the world’s middle class. However, despite these advances these “winners” of globalization would still be considered poor by the standards of the upper-income countries.

The other group that recorded large gains during this period comprises the world’s richest people, the upper 1% whom Milanovic calls the “global plutocrats.” Their gains shrink if the data are extended to include the global financial crisis and its immediate aftermath. Nonetheless, this relatively small group benefitted enormously from the expansion of the global economy. While they are located around the world, one half of this group lives in the U.S.

The intervals of the income distribution space between the global middle class and the top 1% include the “lower middle class of the rich world” in Western Europe, North America, Oceania and Japan. They saw few gains during this period. Consequently, the benefits of globalization were skewed to those who knew how to benefit from it. Inequality as measured within countries increased in recent decades in the U.S. and other upper income countries.

What about the “Kuznets curve,” which predicts rising and then falling inequality in a country over time as it develops? Milanovic extends this concept to “Kuznets cycles” with alternating increases and decreases in inequality. Since the Industrial Revolution, wages have generally increased as income has grown in the advanced economies. But inequality also increased as the manufacturing sector with its higher wages attracted workers from the rural sectors. Inequality subsequently fell during the twentieth century  due to “benign forces,” which included increased education and government policies as well as “malign forces,” such as wars and civil conflict. That downswing ended sometime during the 1970s-1980s, and the upper income countries commenced on a new upswing that Milanovic attributes to a new technological revolution and globalization.

What does the future hold? Milanovic is careful in framing answers to that question, but emphasizes two main trends. The first is convergence, the diminution of the gap in income between poor and rich nations due to higher growth rates in the former as they catch up with the latter. If it continues, then global inequality will shrink. However, not all poor countries have recorded relatively higher growth rates, and African nations have recorded relatively lower growth rates. Overall, though, Milanovic judges that global convergence is more like to continue than to reverse.

The other trend to follow is inequality within countries. Milanovic writes that “…inequality in the United States is either still rising or is about to reach a peak of the second Kuznets wave.” The same pattern is found in other upper-income nations. How can these countries further the reversal of inequality? In the past inequality was lowered through government measures that included increased taxation and social transfers, as well as episodes of hyperinflation and wars. But increased taxes are harder to impose in a global environment. Milanovic, therefore, urges equalization in assets and in education. The former can be achieved through high inheritance taxes, corporate tax policies that distribute shares of ownership to workers, and tax and administrative policies that enable the poor and middle classes to hold financial assets. State-funded education is needed as well to equalize educational returns across all schools.

In the current political environment, however, elected officials seem more interested in reducing inequality by upending globalization. In the U.S., President-elect Trump has made renegotiating trade deals a top priority. Congressional representatives are looking at changes in the tax code that would encourage exports and discourage imports. The incoming Attorney General, Jeff Sessions, has hard-line views on migration. Moreover, the new Secretary of Education, Betsy DeVos, is an advocate of charter schools, not public schooling, while estate taxes may disappear as part of an overhaul of the tax system that will benefit the wealthy. In Europe, the government of Great Britain and officials of the European Union are preparing to negotiate the terms of Britain’s withdrawal from the EU.

Milanovic’s book provides a valuable perspective on inequality. It shows that there has been an historic turnaround  in inequality across national borders after a long period when Western countries kept drawing ahead of other nations. But inequality within many nations, including some emerging market economies, has risen. The challenge is to reverse the latter movement without offsetting the former. How countries deal with this challenge has become the dominant political issue of our time.

Milanovic ends his book by posing the question: “Will Inequality Disappear as Globalization Continues?” His answer: “No. The gains from globalization will not be equally distributed.” Milanovic deserves credit for putting that issue squarely on the global agenda.

The Search for an Effective Macro Policy

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Economic growth in the advanced economies seems stalled. This summer the IMF projected increases in GDP in these economies of 1.8% for both 2016 and 2017. This included growth of 2.2% this year in the U.S. and 2.5% in 2017, 1.6% and 1.4% in the Eurozone in 2016 and 2017 respectively, and 0.3% and 0.1% in Japan. U.S. Treasury Secretary Jack Lew has called on the Group of 20 countries to use all available tools to raise growth, as has the IMF’s Managing Director Christine Lagarde. So why aren’t the G20 governments doing more?

The use of discretionary fiscal policy as a stimulus seems to be jammed, despite renewed interest in its effectiveness by macroeconomists such as Christopher Sims of Princeton University. While the U.S. presidential candidates talk about spending on much-needed infrastructure, there is little chance that a Republican-controlled House of Representatives would go along. In Europe, Germany’s fiscal surplus gives it the ability to increase spending that would benefit its neighbors, but it shows no interest in doing so (see Brad Setser and Paul Krugman). And the IMF does not seem to be following its own policy guidelines in its advice to individual governments.

One of the traditional concerns raised by fiscal deficits rests on their impact on the private spending that will be crowded out by the subsequent rise in interest rates. But this is not a relevant problem in a world of negative interest rates in many advanced economies and very low rates in the U.S. The increase in sovereign debt payments should be more than offset by the increase in economic activity that will be reinforced by the effect of spending on infrastructure on future growth.

On the other hand, there has been no hesitation by monetary policymakers in responding to economic conditions. They initially reacted to the global financial crisis by cutting policy rates and providing liquidity to banks. When the ensuing recovery proved to be weak, they undertook large-scale purchases of assets, known in the U.S. as “quantitative easing,” to bring down long-term rates that are relevant for business loans and mortgages.The asset purchases of the central banks led to massive expansions of their balance sheets on a scale never seen before. The Federal Reserve’s assets, for example, rose from about $900 billion in 2007 to $4.4 trillion this summer. Similarly, the Bank of Japan holds assets worth about $4.5 trillion, while the European Central Bank owns $3.5 trillion of assets.

The interventions of the central banks were successful in bringing down interest rates. They also elevated the prices of financial assets, including stock prices. But their impact on real economic activity seems to be stunted. While the expansion in the U.S. has lowered the unemployment rate to 4.9%, the inflation rate utilized by the Federal Reserve continues to fall below the target 2%. Investment spending is weaker than desired, despite the low interest rates. Indeed, many firms have sufficient cash to finance capital expenditures, but prefer to hold it back. The situations in Europe and Japan are bleaker. Investment in the Eurozone, where the unemployment rate is 10.1%., remains below its pre-crisis peak. Japan also sees weak investment that contributes to its stagnant position.

If lower interest rates do not stimulate domestic demand, there is an alternative channel of transmission: the exchange rate, which can improve the trade balance through expenditure switching. But there are several disturbing aspects of a dependence on a currency depreciation to increase output (see also here). First, there is an adverse impact on domestic firms with liabilities denominated in a foreign currency, as the cost of servicing and repaying that debt rises. Second, expansionary monetary policy does not always have the expected impact on the exchange rate. The Japanese yen appreciated last spring despite the central bank’s acceptance of negative interest rates to spur spending. Third, a successful depreciation requires the willingness of some other nation to accept an appreciation of its currency. The U.S. seems to have accepted that role, but Mohammed A. El-Erian has pointed out, U.S. firms are concerned “…about the impact of a stronger dollar on their earnings…” He also points to “…declining inward tourism and a deteriorating trade balance…” Under these circumstances, the willingness of the U.S. government to continue to accept an appreciating dollar is not guaranteed.

There is one other consequence of advanced economies pushing down their interest rates: increased capital flows to emerging market economies. Foreign investors, who had pulled out of bond markets in these countries for much of the last three years, have now reversed course. The inflows may help out those countries that face adverse economic conditions. But if/when the Federal Reserve resumes raising its policy rate, the attraction of these markets may pall.

The search for an effective macro policy tool, therefore, is constrained by political considerations as much as the paucity of options. But there is another factor: is it possible to return to pre-2008 economic growth rates? Harvard’s Larry Summers points out that those rates were based on an unsustainable housing bubble. He believes that private spending will not return us to full-employment, and urges the Fed to keep interest rates low and the government to engage in debt-financed investments in infrastructure projects. Ken Rogoff (also of Harvard), on the other hand, believes that we are suffering the downside of a debt supercycle. Joseph Stiglitz of Columbia University blames deficient aggregate demand in part on income inequality.

The one common theme that emerges from these different analyses is that there is no “quick fix” that will restore the advanced economies to some economic Eden. Structural and other forces are acting as headwinds to slow growth. But voters are not interested in long-run analyses, and many will turn to those who claim that they have solutions, no matter how potentially disastrous those are.

 

The Role of the U.S. in the Global Financial System

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The mandate of the Federal Reserve is clear: “…promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” How to achieve those goals, of course, has been the subject of great debate: should the central bank use interest rates or monetary aggregates? should it rely on rules or discretion? The ongoing controversy within the U.S. over the benefits and costs of globalization opens up the issue of the geographic scope of the Fed’s responsibilities: does the Fed (and for that matter the U.S. Treasury) need to worry about the rest of the world?

Stanley Fischer, Federal Reserve Vice Chair (and former first deputy managing director of the IMF) sees a role for limited intervention. Fischer acknowledges the feedback effects between the U.S. and the rest of the world. The U.S. economy represents nearly one quarter of the global economy, and this preponderance means that U.S. developments have global spillovers. Changes in U.S. interest rates, for example, are transmitted to the rest of the world, and the “taper tantrum” showed how severe the responses could be. Therefore, Fischer argues, our first responsibility is “to keep our own house in order.” It also entails acknowledging that efforts to restore financial stability can not be limited by national borders. During the global financial crisis, the Fed established swap lines with foreign central banks so that they could provide liquidity to their own banks that had borrowed in dollars to hold U.S. mortgage-backed securities. Fischer cautions, however, that the Fed’s global responsibilities are not unbounded. He acknowledges Charles Kindleberger’s assertion that international stability can only be ensured by a financial hegemon or global central bank, but Fischer states, “…the U.S. Federal Reserve System is not that bank.”

The U.S. did hold that hegemonic position, however, during the Bretton Woods era when we ensured the convertibility of dollars held by central banks to gold. We abandoned the role when President Richard Nixon ended gold convertibility in 1971 and the Bretton Woods system subsequently ended. Governments have subsequently experimented with all sorts of exchange rate regimes, from fixed to floating and virtually everything in between.

While many countries do not intervene in the currency markets, others do, so there is a case for a reserve currency. But perhaps more importantly, we live in an era of global finance, and much of these financial flows are denominated in dollars. The offshore dollar banking system, which began in the 1960s with the Eurodollar market, now encompasses emerging markets as well as upper-income countries. This financial structure is vulnerable to systemic risk. Patrick Foulis of The Economist believes that “The lesson of 2007-08 was that a run in the offshore dollar archipelago can bring down the entire financial system, including Wall Street, and that the system needs a lender of last resort.”

Are there alternatives to the U.S. as a linchpin? The IMF is the international agency assigned the task of ensuring the provision of the international public good of international economic and financial stability. Its track record during the 2008-09 crisis showed that it could respond quickly and with enough financial firepower to deal with global volatility (see Chapter 10). But it can only move when its principals, the 189 member nations, allow it to do so. The Fund’s subsequent dealings with the European nations in the Greek financial crisis demonstrate that it can be tripped up by politics.

Is China ready to take on the responsibilities of an international financial hegemon? Its economy rivals, if not surpasses, that of the U.S. in size, and it is a dominant international global trader. China’s financial footprint is growing as well, and the central bank has established its own series of swap lines. This past year the renminbi was included in the basket of currencies that are used to value the IMF’s Special Drawing Rights. But the government has moved cautiously in removing capital account regulations in order to avoid massive flows in either direction, so there is limited liquidity. Chinese debt problems do not encourage confidence in its ability to deal with financial stress.

The Federal Reserve is well aware that international linkages work both ways. Fed Chair Janet Yellen cited concerns about the Chinese economy last fall when the Fed held back its first increase in the Federal Funds rate. And Fed Governor Lael Brainard believes that the global role of the dollar and the proximity to a zero lower bound may amplify spillovers from foreign conditions onto the U.S.

Whether or not the U.S. has a special responsibility to promote international financial stability may depend in part on one’s views of the stability of global capital markets. If they are basically stable and only occasionally pushed into episodes of excess volatility, then coordinated national policies may be sufficient to return them to normalcy. But if the structure of the global financial system is inherently shaky, then the U.S. needs to be ready to step in when the next crisis occurs. Andrés Velasco of Columbia University believes that “Recent financial history suggests that the next liquidity crisis is just around the corner, and that such crises can impose enormous economic and social costs. And in a largely dollarized world economy, the only certain tool for avoiding such crises is a lender of last resort in dollars.”

Unfortunately, if a crisis does occur it will take place during a period when the U.S. is reassessing its international ties. Donald Trump, the presumptive Republican candidate, achieved that position in part because of his argument that past U.S. trade and finance deals were against our national interests. He shows little interest in maintaining multilateral arrangements such as the United Nations. Trump has announced that he would most likely replace Janet Yellen because of her political affiliation. It is doubtful that the criteria for a new Chair would include a sensitivity to the international ramifications of U.S. policies.

The interest of the U.S. public in international dealings has always waxed and waned, and Trump’s nomination is a sign that we are in a period when many believe we should minimize our engagement with the rest of the world. But this will be difficult to do as long as the dollar remains the predominant world currency for private as well as official use. Regardless of domestic politics, we will not escape the fallout of another crisis, regardless of where it starts. It would be better to accept our international role and seeks ways to minimize risk than to undertake a futile attempt to make the world go away.