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The Making of International Monetary Reform

If French President Nicolas Sarkozy had written the prologue to his presidency of the G-20, which just commenced, he could not have done better. The run-up to the G-20 summit in Seoul was marred by a series of currency controversies, bringing international monetary reform to the fore. Whereas French intentions to reform the international monetary system had initially been received skeptically, suddenly reform looks like the right priority at the right time.

The task is anything but simple. The subject is abstruse. No one outside academia has taken any interest in it for the last 20 years. Accordingly, there are hardly any comprehensive proposals on the table.

The United States, for which international monetary reform is synonymous with diminution of the dollar’s global role, is lukewarm. China, which launched the idea, is happy to see the discussion gaining momentum, but lacks precise ideas. As time is on its side, it sees no reason to hurry.

Emerging countries hold a similar opinion: they want their current problems to be solved but are not ready to re-write the rules of the game. Japan is keen, but its views on regional monetary cooperation do not match China’s. And Europe is distracted more than ever with its internal crises.

Nevertheless, international monetary reform remains a legitimate aspiration. As Vladimir Lenin once reputedly put it, “the surest way to destroy the capitalist system [is] to debauch its currency.” This applies to the world economy today.

When the rules of the global monetary game are unclear, inadequate, or obsolete, countries cannot abide by them, and some may attempt to exploit them to their own advantage. This undermines the fabric of international economic relations. 

The agenda for reform boils down to four key problems. The first is exchange-rate relationships. Developed countries’ currencies have been floating against each other for several decades, but this has been only partly true of emerging and developing countries. Many, especially in Asia and the Persian Gulf, are de facto linked to the dollar, others to the euro.

But fixed exchange rates often lead to undervaluation (as in China) or overvaluation (as in Argentina at the beginning of the 2000’s, and, in a different context, several eurozone countries now). And floating and fixed exchange-rate regimes coexist uneasily, because volatility tends to affect the floating currencies (often the euro, and recently the Latin American currencies).

So the system needs a reshuffle. The touchstone is currently the renminbi – not so much because of China’s bilateral relationship with the US, but because other emerging and developing countries monitor the renminbi-dollar exchange rate for setting their own policy. China knows that the current situation is not sustainable, but it remains reluctant to move aggressively to let the renminbi strengthen.

The second problem is imposing discipline on national policies in order to preempt the temptation to export domestic inflation or unemployment. Under the gold standard, discipline was automatic. With floating exchange rates, it is not.

According to an unwritten rule that has emerged over the years, central banks can do as they see fit, given that they keep inflation stable over the medium term. This rule normally ensures a modicum of coherence and avoids overreactions in exchange rates, but it is insufficient in deflationary times.

The US Federal Reserve argues, with some justification, that its quantitative easing is compatible with price stability, while Europe and several emerging countries deem it beggar-thy-neighbor behavior. The problem is that the current context provides no yardstick for assessing when a national policy stops being cooperative.

So we need what the jargon calls “surveillance.” This is the International Monetary Fund’s role, but the IMF’s mandate is just that – surveillance, not enforcement. It is also the G-20’s role, but neither the US nor the emerging countries are keen on collective constraints.

The third problem concerns international liquidity. Financial flows are excessively volatile. Emerging countries are inundated with capital inflows one day, and faced with abrupt and equally destabilizing outflows the next.

To prevent their currencies from appreciating too much in the first case and falling too far in the second, emerging countries have accumulated foreign-exchange reserves, two-thirds of which are denominated in dollars. These reserves now amount to 15% of global GDP, compared to 6% ten years ago. Ultimately, whether this is due to self-insurance or to exchange-rate targeting matters little: this unproductive growth in reserves was yesterday an indirect cause of the crisis, today it is undermining demand.

The goal should be to make self-insurance unnecessary by guaranteeing access to international credit lines in case of abrupt outflows of private capital. The IMF started to do this when it created credit facilities without the Fund’s usual (and humiliating) conditionality. But suspicion of the IMF persists, and most countries, especially in Asia, still prefer costly self-insurance to a form of mutualization perceived as uncertain.

The fourth problem is collective anchoring. Naturally, the major central banks are concerned with the inflation that they can control – homemade inflation. But this neglects global inflation driven by rising commodity prices, which has been increasingly evident.

This was not an issue in the disinflationary environment of the last decade, but it is becoming more of one. Hence probably World Bank President Robert Zoellick’s proposal to restore a role for gold. The notion is absurd – Keynes long ago spoke of gold as a “barbarous relic” – but the problem of anchoring global monetary policy and ensuring its alignment with developments in global supply is nonetheless real.

The Nobel laureate economist Robert Mundell once compared a monetary regime to a political constitution, because it establishes the rules of the game. The analogy is apt. Unfortunately, it also indicates how ambitious and challenging a task it is to reform the international monetary order.

 

Column for Project Syndicate, December 3, 2011

Germany’s hour

A series of events over the last few weeks have created a new situation in Europe.

First, the euro area has failed to turn the tide. Mario Draghi was right to note last week that in spite of numerous ministerial meetings and three summits, implementation of the decision taken in July is still lacking. There are by now growing doubts about the very wisdom of holding them.

Second, and partially as a consequence, the debt of virtually all euro-area countries is trading at a discount to the German Bund. While a more accurate pricing of risk was necessary, it is hard to believe that with a debt ratio nearly twenty percentage points lower, the Netherlands deserves to be assessed more prone to default than Germany. Even the Bund started to suffer from market anxiety last week.

Third, market participants and, increasingly, real businesses are pricing in a break-up scenario. It is still hard to think the unthinkable, let alone to work out the details of it, but any rational player has to consider the possibility of it. If disaster expectations build up and a growing number of players start positioning themselves to protect themselves from it, the consequences could become overwhelming.   

Fourth, Germany has become the undisputed leader of the euro area. Although France continues to play its role in the couple, it has lost weight and initiative. A weaker French economy, weaker public finances and the coming presidential election are all combining to alter the balance in the old couple. Political impetus can defy the laws of gravity, but only up to a point.

In this context Germany finds itself again in a situation akin that of the late 1980s, when the Bundesbank was making monetary policy for the rest of the continent. At that time chancellor Kohl wisely assessed that German economic dominance was not a stable equilibrium and that a better plan for the future was to build on Germany’s weight and influence to create a permanent common monetary order. This is what gave birth to the euro.                 

Today again Germany’s best interest is to ensure lasting stability in Europe. With foreign assets worth 6 trillion euros, most of which consist of claims on euro-area partners, Germany would lose out massively in a fragmentation of the euro area. Claims on entities in partner countries would either be redenominated in weaker currencies or the borrowers would default on them. And, obviously, German exporters would be hurt by substantial currency appreciation.

Chancellor Merkel has sensibly decided to take the lead on reforming the euro area. But many Germans feel deceived by irresponsible euro-area partners. There is therefore the temptation to use Berlin’s current strength to toughen sanctions and coerce weaker partners into adopting constitutional changes, especially in the budgetary field.

This is a risky attitude. For sure, Germany today has far more leverage than it has had at any point in the last twenty years. But to attempt to extract unilateral concessions from partners is a recipe for disappointment. It is one thing is to be sanctioned if you breach the rules, as today with the Stability and Growth Pact, and quite another thing to move to a new system that gives a higher-level authority the power to overrule national parliaments and censor a budget before it is enacted. Partners are unlikely to agree on major reform if Germany does not offer something in exchange. What is likely to emerge from negotiations is, rather, another layer of largely ineffectual sanctions procedures.

The natural quid-pro-quo for ex-ante budgetary control is solidarity through the creation of Eurobonds. Joint and several liability over public bonds is imaginable only if countries offering their guarantee – in effect potential access to their taxpayers – can exercise veto power and prevent a partner country from issuing more debt. So legally binding ex-ante control is a sine-qua-non condition for Eurobonds. Symmetrically, surrender of budgetary sovereignty through the granting of veto power to the partners is acceptable only if it comes in exchange for a guarantee from these partners that they will come to the rescue in case of accident.

Germany therefore should be bold and use its leverage to offer a new contract to its euro-area partners: mutual guarantee over part of public debt in exchange for strict debt limits and a new legal order in the framework of which a euro-area authority could veto a budget passed by a national parliament even before it starts being implemented. Only boldness will deliver.

 

Column for Handelsblatt and Project Syndicate, November 23, 2011

How to stop fragmentation of the Eurozone

The continual rebounding of the Greek crisis is making the headlines. But a less visible yet even more worrying development has appeared in the Eurozone since the summer:  the beginnings of a creeping process of fragmentation.

The first sign is that banks are once again reluctant to lend to each other. Since July the spread between the rate at which they borrow from each other and the zero risk rate has been climbing. Rather than to lend it on the interbank market, financial institutions with liquidity increasingly prefer to deposit their cash with the ECB, which has had to reactivate its direct lending procedures to banks. This is the same situation – though at this stage less acute – than in the 2007-08 crisis. The tension is obvious, and this time it is internal in origin. In London and New York the interbank market is still working. 

The second sign is that one and the same cross-border bank is charging higher interest rates for firms in southern Europe than to similar firms in northern Europe. This cuts to the core of the single market, and it is making the situation for crisis-hit economies worse. Instead of combating this trend, northern European bank supervisors are magnifying it by setting limits to the exposure of their banks to southern Europe.

The third sign is that, in the eyes of international investors, southern European government bonds no longer belong to the same asset class as northern European ones. It is not simply a case of the price of risk, by definition easily reversible. It marks a deeper change in attitude. If it continues to affect lending behaviour to southern countries, it will harm their solvency and economic recovery.  

It is in this light that we must consider the proposed crisis responses which are being discussed in the run-up to a decisive European summit on 23 October and the G20 summit in early November. The heads of state are expected to agree on a higher debt relief for Greece, a boosting of the European financial facility, and the recapitalisation of banks. These would be welcome moves, but the heart of the problem is to determine which set of principles will underpin the construction of a more robust monetary union.     

The main cause of the creeping fragmentation which is observable is the mutual dependence of banks and governments. In the Eurozone banks are vulnerable to sovereign debt because they hold a lot of public paper, frequently issued by their country of origin, and the governments are vulnerable to bank crises because they are individually responsible for rescuing national financial institutions. Every episode in the crisis illustrates how much this interdependence is a source of fragility.  

There are three possible responses to this state of affairs. The first relies on intervention by the central bank in case of a threat to the sovereign debt market. The mutual exposure of banks and the sovereign exists in the UK and the UK’s budget situation is worse than that of Spain, but the certainty that the Bank of England would prevent speculation on the UK’s debt is sufficient to reassure investors. In the Eurozone the ECB has not been equipped with this mandate. It is not meant to be a lender of last resort. It has played this role with Italy and Spain but is up against stiff opposition from within its own ranks, and it may well not continue for much longer. In fact, it does not have the right decision-making structure to take decisions that may end up implying a transfer from one set of countries to another one. The recently created European financial facility is better equipped to take such decisions and may play a similar role but its war-chest is limited. As for changing the mandate and structure of the ECB, this would not be acceptable for Germany, if only for constitutional reasons. 

The second response consists of strengthening the banks through recapitalisation and removing the dividing walls between national banking systems in order to staunch their overexposure to sovereign default. The Eurozone would be healthier with a properly capitalised banking system, holding diversified assets and endowed with common surveillance and deposit insurance. This would sever banks from over exposure to their own sovereigns and sovereigns from exposure to their own banks. However, it is to be feared that European leaders may not be bold enough to fully embrace such a plan as they are reluctant to renounce their national banking champions and access to captive investors. We will soon see how the land lies here when the recapitalisation details become known.   

The third response consists of reducing sovereign risk by means of a system of surveillance and mutual guarantees between the Eurozone countries. This is budgetary union, and the fuller form of this is the issue of bonds jointly guaranteed by all participating states, which are known in Europe as Eurobonds. The principle of them is best summarised if one imagines that each states borrows from a common debt agency that in turn issues debt on behalf of all states and with their joint and several guarantee. Introducing Eurobonds would in fact imply for each state giving its neighbours access to its own taxpayers and this cannot be imagined without ex ante control of the same neighbour’s budgetary decisions. Moving to such a system is a politically very tough choice both for those countries who would perceive themselves as guarantors and those who would benefit from the guarantee. But it probably remains the most practical way forward of the three.     

These three responses are in fact in part complementary, though any durable regime is likely to give priority to one. Even espousing one of them would be a positive sign. It would show that Europe goes beyond mere patches to revisit the fundamental principles upon which monetary union is based. This would be the surest way to regain investors’ confidence.

 

Column published in Handelsblatt, Century Weekly (Caixin) and Project Syndicate, october 2011

Can international monetary reform succeed?

The reform of the International Monetary System (IMS) has been selected by the French presidency of the G20 as its main priority for the Cannes summit in November. This raises two questions: first, is the issue worth the time and energy officials will devote to it? Second, what can these discussions lead to?

When president Sarkozy announced his aim a year ago, most observers expected that at end 2011 the world economy would be cruising at a comfortable speed. The macroeconomy would, so to speak, be taking care of itself. At the same time, burgeoning controversies about ‘currency wars’ suggested that the international monetary discussion was a very necessary one. One year on, unfortunately, other urgent matters call for attention: with the flagging global recovery and the mounting debt crisis on everybody’s mind, longer-term monetary reform is likely to look a distraction.    

A case can, however, be made for keeping discussions on the issue active. Indeed, several of the economic failings of recent years can be traced back to deficiencies in the global monetary system. Excess global liquidity; the overaccumulation of dollar-denominated reserve assets; the very uneven policy response to current-account surpluses and deficits; resistance to necessary exchange-rate adjustments in the emerging world; and the coexistence at global level of inflation and deflation, to name but a few recent phenomena, are all in some way manifestations of the same international monetary deficiencies. Addressing these deficiencies would perhaps not solve today’s economic woes, but it would help limit the build-up of new problems and it would provide guidance as regards the avenues for alleviating today’s concerns.      

This is where the second question comes in. France has paradoxically been cautious neither to make clear which problems global monetary reform is expected to solve, nor to propose a grand plan for it. Rather, it has taken topics one by one and has sought to reach consensus separately on each individual dossier. Discussions within the G20 are evolving around the completion of efforts undertaken by the 2010 Korean presidency to strengthen multilateral schemes for liquidity provision in times of crisis; the strengthening of multilateral surveillance and the search for consensus on the desirable use of capital controls; and preparations for a change in the composition of the basket of Special Drawing Rights, a unit of account used by the IMF that was at its origin expected to evolve into a global store of value.

This piecemeal approach is politically savvy but analytically perplexing, as it does not give any clues as to the big picture. The dots are there, but it is hard to see how to connect them. Since the IMS has experienced few changes in historical terms, efforts to revamp the system should rather be considered as small steps in what is bound to be a long march. Whether small steps are appropriate should be assessed in the light of a longer-run perspective covering at least the next ten to fifteen years.

The most probable scenario at this horizon is a multipolar one that would see, in addition to the US dollar, the emergence of one or several key international currencies. For this role, the euro and the renminbi can be viewed as prime candidates. Each currently has severe shortcomings and it cannot be excluded that only one of these currencies accedes international currency status – nor that other currencies emerge, though at a significantly longer-term horizon. But the economic logic is unambiguously in the direction of multipolarity.

To the extent that it would imply free capital mobility and exchange-rate flexibility between the different poles as well as, in each region concerned, the development of a liquid market for benchmark bonds, such an evolution of the IMS would be positive. However, the stability of a genuinely multipolar system cannot be taken for granted. It will imply each of the monetary poles agreeing to depart from purely domestic priorities and stand ready to fulfil its international duties in quiet times as well as in times of crisis.

Such preconditions are clearly not met today by the main economic and currency blocs, albeit for different reasons. China has already taken significant but incomplete steps in the direction of currency internationalisation. Furthermore its policy system remains very domestically centred. The euro area is currently under severe stress. It could possibly strengthen as a consequence of its current crisis, but to play a significant international role it will have to depart from its traditionally neutral stance towards the internationalisation of the currency. And as far as the United States is concerned, it is not yet willing to accept full responsibility for the international repercussions of its macroeconomic actions.

If the IMS is actually moving towards multipolarity in the medium run, the role of international coordination is to accompany this market-based movement so as to reap the full benefits of it and attenuate the risks involved. The discussions surrounding the enlargement of the SDR basket (through the inclusion of the renminbi) and about the coordination of bilateral swap arrangements should be understood in this perspective.

Does this exclude a multilateral system organised around a quasi-global currency and the centralised management of global liquidity? In the short run, the conditions for this scenario to materialise are not met, not least because no large country is ready to deviate from domestic priorities. In the future, however, such a scenario might return to the fore, for instance in the event of another global crisis. A truly multilateral system remains a possible outcome, but not the most likely one.

These broad perspectives are not likely to be discussed in Cannes. This is perhaps unavoidable, because the leaders have to focus on what they can actually deliver. At the same it would be much preferable to leave the technicalities of the SDR basket and liquidity provision schemes to the finance ministers, and to let the heads of state and government discuss the issue for which they are indispensable: the politics of global currency reform. 

This column for Century Weekly (Caixin) and Project Syndicate, published on september 2011, draws on a recent report I recently co-authored entitled Global currencies for tomorrow (Bruegel and CEPII, 2011). 

 

Europe: the last taboos

You can always trust the Americans, Churchill said, because in the end they will do the right thing, after they have exhausted all the other possibilities. For the last 18 months, Europe has made of this famous phrase its roadmap: it has taken the necessary decisions, but always as a last resort.

Once again, on 21 July, the euro area's leaders proclaimed that what they previously said was unthinkable was in fact necessary. They gave up the pretence that Greece was solvent, agreed to extend more and longer-term loans to it, admitted that excessive interest rates could only make the problem worse, called for private lenders to bear some of the burden, gave a guarantee of continued funding for Greek banks, recognised the need to support growth, and agreed to broaden the scope of the European financial facility, making it a more flexible tool for intervention.

For Germany, France, the European Central Bank and other players in the European game, these about-faces have a cost in terms of reputation, political capital or legal leeway. Although decisions taken on 21 July were wide-ranging enough for everyone to be able to claim success, the players are going to have to explain why red lines were crossed. All no doubt will claim that this is the last time.

Is this true? Have the last taboos been broken? Or will another crisis summit need to be convened soon with even bolder denials and measures?

In the case of Greece, there is real aggiornamento. In place of an equation without a solution, European leaders have substituted another, which no longer seems unsolvable. In deciding to provide cheaper loans and in agreeing to a debt reduction, they have started reducing the burden – though not enough, as far as private lenders are concerned.

A reduction in public debt will not make companies more competitive or create jobs for the unemployed -- even though it will help. There is a view that for Greece to recover, it will be necessary to break the 'euro taboo' and reintroduce a national currency. The certain outcome of this would be immediate devaluation, much beyond what restoring competitiveness requires. When in 2002 Argentina broke its link to the dollar, the peso lost four-fifths of its value. But financial claims in Greece are denominated in euros. Forced conversion would destroy much of the value of savings and resulting currency mismatches would unleash a wave of bankruptcies (in Greece or the rest of the euro area depending on the exact terms of the conversion). Even before the shock, there would be a bank run as savers would move their assets, resulting in a bank collapse. Furthermore, far from being reinforced the rest of the euro area would be weakened, as speculation on the true value of the German, French or Portuguese euros would start. All this renders adjustment within the euro area preferable, despite all the difficulties it presents.

For the euro area as a whole, the measures announced on 21 July will not dispel the concerns about other countries, in particular Italy and Spain. One of the most striking vulnerabilities revealed during the last few months is the correlation between banking crises and sovereign crises. In Greece, the state of the public finances is a threat to the banks, which have a portfolio of government securities twice the size of their capital. The same fear is present in Italy. In Ireland, it was the banks going off course that brought the government to its knees. Spain has been weakened for the same reasons. The vicious circle sucks in one party or the other, but the logic is the same: a state in difficulty weakens the banks because of the falling value of government securities; banks in difficulty weaken the state because of anticipated bailout costs.

This dangerous vicious circle results from the refusal to diversify and share risks. In the United States, banks incorporated in Delaware feel no obligation to hold bonds from that state. Instead, they hold federal securities. And it is Washington DC, not the state of New York, which is responsible for bailing out Wall Street. This does not eliminate all the risks, but spreads them and means that, in the face of financial hurricanes, calls can be made on the central bank. Europe is not a federal state but the weakness of the euro area would be greatly diminished if deposit insurance was pooled -- which obviously implies relevant changes in banking supervision -- and if the banks diversified their bond holdings so that they are more representative of the euro area as a whole (the famous Eurobonds).

Europe has cautiously started to move in this direction by broadening the scope of its financial facility. But the pooling of risk remains taboo. It is not clear if this taboo will remain unbroken by the end of the crisis.

 

Column for Handelsblatt and Project Syndicate, July 26, 2011

London and Washington, DC: economic policy litmus tests

The threat of a downgrade of the US public debt by the rating agency Standard and Poors a few weeks ago was a bolt from the blue. Only recently confined to a few delinquent countries, the public debt issue is now cutting to the core of the advanced economies. The message given loud and clear to all governments was that if the quality of bonds issued by the supplier of safe assets by excellence can be questioned, no country can consider itself immune from attacks. The question is no longer whether it is time to reduce deficits but how fast, how far and by what means.

In Europe Ms Merkel, the German chancellor, is portrayed as a tough deficit-cutter. But while she is wont to raise her voice, she acts with caution – the German budget adjustment is in fact very gradual. The countries where the budget battle will be won or lost are the UK and the US where deficits exceeded 10 percent of GDP in 2010.

In London, Prime Minister David Cameron is on the offensive. On arriving in power, he first entrusted budgetary forecasting to an independent Office for Budgetary Responsibility (OBR), thus forfeiting any possible sleight-of-hand. He then announced a bold consolidation programme to cut the cyclically-adjusted deficit by one-and-a-half points per year in order to reduce the deficit to three-and-a-half percent of GDP in 2013.

The bet was that this adjustment would not hinder growth and would even stimulate it. Since Ireland and Denmark showed the way twenty-five years ago, numerous governments dream of carrying out successful expansionary budgetary contractions. A closer look at these oxymoronic, semi-miraculous episodes reveals however that for the customary recessionary impact to be eliminated or even reversed, the action on the deficit has to have at least one following three impacts: a reduction of the households’ precautionary savings; a drop in long-term interest rates; or a move by the central bank to a more expansionist monetary policy, with the associated weakening of the exchange rate. Absent these conditions, budgetary adjustments are almost always costly in terms of growth. This was confirmed by a recent detailed and careful IMF study of past consolidation episodes.        

In the UK case, no drop in savings could be counted upon (being heavily in debt, households need to save more, not less), nor any decrease in long-term interest rates (they are already very low). That only left monetary policy to support economic activity. But in part as a result of the surge in commodity prices and in part because of weak productivity gains, inflation is higher than expected: the Bank of England forecasts that it will be around three percent at the start of 2012, almost two points higher than what the Bank foresaw last year. It is suddenly more and more difficult to promote growth although it is stagnant - it has been zero for the two last quarters. The latest Bank of England inflation report makes no mystery that such a context makes interest-rate hikes likely. The least one can say is that David Cameron’s bet is not yet won.    

The US stance has been entirely different. Faced with an unemployment which is still close to the post-war maximum, the Obama administration has delayed adjustment in order not to smother recovery. It even gave the economy a further boost at the end of 2010, in part to offset the highly restrictive policies of the US states, most of which have balanced-budget rules and have as a consequence run very pro-cyclical policies. To keep on stimulating in the short term was a perfectly defensible choice but at the same time it made all more apparent the lack, bof any serious thinking about the speed and the manner of future consolidation. Until very recently the feeling of urgency which pervades European conduct was almost entirely absent on the other side of the Atlantic. There were reports to discuss which way to go, but they visibly lacked traction.

A new phase commenced last month with the last-gasp agreement to avoid a shutdown of the federal government, and the approval by the House of Representatives of the budgetary programme prepared by Republican Congressman Paul Ryan. The budget debate is now in full swing. However the objective remains relatively un-ambitious and, even more importantly, disagreements about the means to achieve it are huge. The Obama administration is advocating a balanced approach, whereby two-thirds of the adjustment comes from spending cuts and one-third from tax increases. The Ryan plan on the other hand provides for a steeper reduction in the budget, in particular cuts in social spending in order to finish off what remains of welfare and to finance a cut in taxes. The gap between the two camps is huge.

The head-to-head between the two sides suggests that a kind of war of attrition is being waged in the US. They both focus on the state of public finances but each camp is seeking to use the deficit to push its own preferences with regard to the future of income and spending and to compel the other camp to back down. Unfortunately, as economists Alberto Alesina and Alan Drazen illustrated in a famous paper twenty years ago, this is exactly the type of political configuration that leads to delay budgetary adjustments.

The battle is intrinsically political. It is also uneven, because those whose ambition it is to shrink the State are by definition more prepared to risk bankrupting it than those who are seeking to preserve it. The Obama administration has already made major concessions on tax reductions and spending cuts.

Once again the UK and the US are acting as political-economy laboratories for the rest of the world. The fate of the UK experiment will critically influence the other countries’ resolve to embark on large-scale adjustments; and the result of the US battle will influence further choices about the relative priority of spending cuts and tax increases. The results of the experiments taking place there before our very eyes will have major consequences for the entire advanced world. 

 

Column for Handelsblatt, Project Syndicate and Century Weekly (Caixin), May 2011

 

Cracks in the Mediterranean Wall

In 1989, the wall separating the two halves of Europe suddenly collapsed. Within the space of a few months, a hitherto seemingly immutable order gave way to commotion and impatience. At first, the old countries of Europe were paralyzed with fear of the unknown and anxiety about immigration – before they seized with both hands the opportunity that history had offered to them.

In the course of a few months Europe implemented financial assistance and technical assistance programs, opened trade talks, and promised an eastward enlargement of the European Union, eventually leading to the free movement of workers across the former Iron curtain. It took fifteen years before enlargement became reality and another seven before barriers to intra-EU migrations were abolished. But its perspective was instrumental in facilitating the economic and political transition in Eastern Europe. Two decades later, success is spectacular. The economic and political transition has been swift and deep. After an initial shock a catching-up momentum has been set in motion. Finally, with the dramatic exception of Yugoslavia, the transformation was carried out peacefully

Could a similar story unfold for the southern rim of the Mediterranean? This is the key economic question posed by today’s Arab Spring. Obviously an identical story cannot take place. The Mediterranean countries will not join the EU. But they could strengthen their links with it and benefit from closer integration.

The EU’s 500 million citizens have 170 million neighbors between Agadir (Morocco) in the west of North Africa and Port Said (Egypt) in the east. These millions sit on Europe’s doorstep, eyeing with longing its prosperity and democracy. In Tunisia and Egypt, they have demonstrated their resolve by overturning regimes which many in the West saw as guarantors of stability. They are now asking nothing more than to be able to invest their energies in bringing about their countries’ recovery. But, unless they have reason to believe that improvement is coming, today’s transforming dynamism will become the dynamism of despair – with all the risks that this implies.

The first priority is jobs. The young people driving the Tunisian and Egyptian revolutions are massively underemployed. We do not know if the official data, which report roughly 30% youth unemployment, are correct, but it is clear that these economies were incapable of absorbing the demographic wave of the last decades. Recent growth rates – 5-6% annually in Egypt, Libya, Tunisia, and Morocco – look strong, but they are less impressive in light of ten years of 2.5% annual growth in the working-age population. Much stronger growth is needed if job creation is to keep pace.

The obstacles to growth are not chiefly macroeconomic. It is true that Egypt is fragile, that public finances and current-account balances will slump, and that inflation will take off if governments try to respond to protests by spending money that they do not have. Already there are signs that fear of unrest is leading governments or private companies to give way to demands for major increases in wages – even when executives know the economy cannot afford them in the short term. Looking forward, these countries must invest much more in infrastructure and educate their citizens better, which will inevitably be costly. International assistance will therefore certainly need to be mobilized to help correct macroeconomic imbalances. But these are not the most pressing issues.

The main brake on development lies in these countries’ economic institutions. According to the World Bank, a building permit in Egypt costs three times the average annual income, 11 different steps are needed to register a property transaction in Algeria, and Morocco is ranked 154th out of 183 countries for protection of shareholders against abuse of power by management.

These are only a handful of examples. They all point to economies where development is impeded by bureaucracy, monopoly rents – often the result of political patronage or nepotism – and sclerotic credit markets. These obstacles make entrepreneurship much more difficult than it should be.

It is unworkable, and should thus be unthinkable, to try to export the solutions used in Eastern Europe, which were based on importing EU legislation with a view to enlargement. But the current political revolutions do present a once-in-a-lifetime chance for economic emancipation. The same people who took the streets and shattered sclerotic political system could now contribute to their countries’ development, which the EU can support by creating incentives for reform and mobilizing its development banks.

Given its dominant role in the region, Europe can exert a direct impact on policies affecting trade and mobility. For fear of mass migration mobility between Europe and the Southern Mediterranean countries is extremely circumscribed. This is a significant obstacle to development. Professional mobility must be allowed without delay.

Free circulation of goods is also limited. As a proportion of GDP, Tunisia’s trade with the EU is one-half that of the Czech Republic, and Morocco’s in one-quarter that of Poland. There is therefore a strong potential for trade expansion.

Openness on Europe’s part is needed not only for goods, but also for services. Europe should promote much more than it has so far an outsourcing model in the most labor-intensive segments of the value chain, as Germany has done with great success (particularly in Eastern Europe), which partly explains its bounce-back to export dominance in global markets. While this model may entail some initial job losses in Europe, it would also preserve jobs in the long run by keeping production sites competitive, and create jobs by paving the way for development – and thus export markets – in North Africa.

None of these choices are easy to make. But as French Prime Minister Pierre Mendès-France, who in the 1950’s withdrew his country from war in Vietnam and colonization in Tunisia, famously said, governing is choosing. Europe’s choice now is clear: mobilize to help its neighbors open up their economies and societies, or start beefing up its coastguards and ordering patrol boats.

 

Column published in Caixin and in Project Syndicate on March 2011

Is it EMU 2.0 or 1.7.3?

For a year European policymakers have been busy fixing bugs in the design of Economic and Monetary Union. As with defective software, successive new versions of EMU have been introduced at a frantic pace – only to discover remaining vulnerabilities shortly afterwards. In spite of last-minute hiccups and disagreements over details, they claim this time to have come up with an enhanced, bug-free new version – a sort of ‘EMU 2.0’. Can we now trust it?   

The starting point for a review is where troubles came from: the crisis prevention regime. Before 2010, it was almost entirely based on the surveillance of budgetary deficits within the framework of the Stability and Growth Pact (there was also a procedure for economic surveillance, but it had no traction). The crisis revealed major problems with enforcement of this framework, but also with its design. No light ever flashed red to indicate that Ireland or Spain were in danger.

The new regime will take into account the debt ratio (so that Italy will not be able to keep it at such as high level) and implicit liabilities (so that a country with an oversized banking sector will have to factor in potential rescue costs). Decisions on sanctions will be streamlined by a reverse majority rule. All this is encouraging.

A second plus is the recognition that not all crises are rooted in a lack of budgetary discipline. It is now agreed that financial stability and macroeconomic stability also matter. But the new policy framework looks somewhat unclear. There will be no less than three different, partially overlapping, European procedures – for budgets, macroeconomic imbalances and macro-financial stability. Clumsy intergovernmental processes risk blurring priorities, confusing policymakers and exhausting civil servants.

For this reason it is to be feared that the governance model will soon be in need of reform and that the EU will have to decide where to rely more on reformed national frameworks and where to allocate more responsibility to Brussels. The new emphasis on national budgetary rules is a welcome first step – but only a first step.

For crisis management and resolution there was nothing to reform, because nothing existed. A new pillar has now been added to the edifice. Agreement to create both a liquidity provision facility and an insolvency procedure has implied revisiting fundamental principles – not least the no bail-out clause. EMU will now be equipped with the ability to provide assistance to a country cut off from market access but also to organise the restructuring of its public debt. This shows an ability to reform and learn from experience.

The new regime is, however, not without defects. First, it is strange that Europe has agreed to provide assistance only as a last resort, by unanimity and with harsh conditionality, at a time when the IMF has created first-resort, near-automatic and low-conditionality facilities to help countries hit by sudden capital outflows. There is a risk that the European framework will create an avenue for speculation. Second, the EU has taken the least legally difficult route to debt crisis resolution, the so-called contractual approach which aims at facilitating agreement with private creditors. But the most contentious part risks being agreement with the governments of partner countries. A formal legal procedure would have helped.  

When a new version of a piece of software is introduced, users often experience incompatibility with files created with the older one. Here also, transition to the new regime may prove difficult. Even abstracting from Portugal, several problems still await a solution. There is an urgent need to expedite the resolution of the banking crisis, for which credible and comprehensive stress tests is an indispensable first step. Foot-dragging – not least by Germany – prevents the return of confidence. There is an equally important need to sort out state insolvency cases from illiquidity cases. Greece is likely to find itself insolvent and there are questions about Ireland and Portugal. Again, confidence will only return after an answer is given. Third, markets need to understand what will happen if some sort of debt restructuring takes place before the permanent regime is introduced in 2013. Fourth, the ECB needs to know how it will get rid of the peripheral bonds on its balance sheet. And last but not least, the EU still has to come up with a strategy to revive growth in southern Europe.

So the outcome of months of discussion is probably better characterised as EMU 1.7.3 rather than EMU 2.0. More bugs will have to be fixed, including in the new fixes. This reform process may seem impossibly long and hesitant by market standards. This should not hide the fact that it has been exceptionally fast by the standards of international negotiations and European governance.  

 

Column published in Handelsblatt on March 15, 2011

and in Project Syndicate on April 5, 2011 

 

 

 

 

The Eurozone According to Merkel

We had almost given up waiting for them, but then they came in a quasi-clandestine form. German Chancellor Angela Merkel did not announce her ideas for eurozone reform in a formal speech or in a statement before her peers. Rather, she allowed a quickly cobbled-together and telegraphic Franco-German non-paper to leak ahead of the recent meeting of European heads of state and government.

There was no shortage of outcry in other European Union capitals (because of the paper’s undiplomatic bluntness) or in Brussels (because she did not care about EU procedures and the distribution of competences). But the ideas outlined in the paper deserve serious discussion.

The initiative is, first of all, institutional. Whereas earlier, chancellor Merkel had ruled out the old French idea of eurozone-specific governance for fear of being in a minority among Southern European countries, she has now drawn a lesson from the crisis and is proposing that eurozone countries go ahead and tighten cooperation with any others who are able and willing to join them. This is a significant step.

On the fiscal side, Germany had started by insisting on bolstering sanctions. As is often the case in criminal law, the idea was (and is) more about reassuring public opinion than about preventing wayward behavior. In fact, the EU’s Stability and Growth Pact suffers at least as much from a flawed design as from lack of enforcement (it should never be forgotten that as late as 2007, Ireland and Spain looked like paragons of budgetary virtue). Moreover, for ten years, stewardship from Brussels has failed to bring about reform of national policies, and it is not clear that additional or more automatic sanctions would elicit a greater sense of “ownership” of the rules.

The new paper opens a different path: it suggests revising and harmonizing national accounting, in order to gauge better the vulnerability of eurozone members’ public finances; ensuring that banks’ creditors, rather than governments, pay when crisis strikes; decentralizing fiscal discipline by requiring each country to adopt a constitutional rule on the stability of the debt ratio; and curbing countries’ contingent liabilities by adjusting pension systems to demographic ageing. As long as each government is given enough autonomy in the implementation of these principles to act in accordance with its own institutional framework and traditions, such measures are all on the right track.

But things are less clear when it comes to competitiveness. The paper urges all countries to align real wage growth with productivity gains, to get rid of automatic indexation of wages (long gone in France but still alive in Belgium), and to commit to a minimum rate of investment in research and development, education, and infrastructure. The praiseworthy intention is to avoid a recurrence of the cost and price divergence within the eurozone during the last ten years. The aim is also – and this is equally commendable – to share the burden of European economic modernization.

However, all of the indicators emphasized in the Franco-German initiative are already being monitored, and, since 2005, many – not least European Central Bank President Jean-Claude Trichet – have loud, regularly, and ineffectually warned of divergences within the eurozone.

Moreover, the discussions that started several months ago about imbalances within the eurozone have floundered on the issue of the symmetry of adjustment. Those countries whose prices have shot up over the last decade point the finger, correctly, at German competitive disinflation, which has led the ECB to keep interest rates low instead of helping them to halt the price spiral. Germany responds that it cannot be blamed for improving productivity, which is equally true.

The way out of this dialogue of the deaf requires acknowledging that competitiveness is a relative concept, and that all national policies, including those of surplus countries, must be part of the discussion. We have not reached that point yet.

The last set of proposals addresses a problem that has not been stressed enough: divergences within the eurozone reflect insufficient economic integration, for they would not have continued to widen if firms and workers had reacted more swiftly to price differences.

The Merkel document puts forward two ideas here: mutual recognition of qualifications, which would promote labor mobility, and – with no concern for the sanctity of tax sovereignty – harmonization of corporate-tax bases in order to encourage capital mobility. Neither of these initiatives is a game changer as regards the depth of economic integration within the eurozone, but both promise to open a new debate on the structural underpinnings of monetary union.

It remains to be seen what EU partners will make of these proposals. First reactions have been mostly negative, because of specific concerns such as wage indexation in Belgium or because the EU institutions want to preserve their legal prerogatives. Non-eurozone countries are also concerned that further integration within the core would leave them left out. Leaving bluntness and disregard procedures aside, eurozone members would however be wrong to ignore or dilute these ideas. The eurozone needs a Germany that is engaged, not absent, and the paper delivers a message that needs to be heard: (financial) solidarity goes hand in hand with (economic and budgetary) responsibility. The scene is set for this fundamental conversation.

 

Project Syndicate column published on February 15, 2011

 

Rift and Mastery

PARIS – Like brothers in arms united in combat but divided in peace, Europe and the United States, which had fought depression jointly in 2009, started voicing disagreements in 2010 and begin 2011 with divergent positions on macroeconomic policy. The price of divergence could be steep: though the worst is over, effective coordination of policy is still needed at a time when rebalancing the global economy, as the G-20 has called for, is far from being accomplished.

The transatlantic divide is evident with respect to monetary policy. In November of last year, the US Federal Reserve’s decision to launch a new cycle of “quantitative easing” (buying up government bonds through monetary creation) triggered fierce criticism in Europe. While the European Central Bank has also been buying government bonds since last spring, the amount is relatively small (€70 billion, compared to the Fed’s $600 billion program), and is meant only to support troubled eurozone members, with particular care taken to avoid any impact on money supply.

A similar divergence, though less acute, has appeared with respect to fiscal policy. In December, as Europeans shifted towards fiscal rigor, the US Congress extended for two years the tax cuts initiated by George W. Bush – which almost everyone interpreted as yet another effort to boost the US economy. True, fiscal retrenchment in Germany is more cautious than official rhetoric suggests. But, overall, the eurozone and Great Britain have clearly shifted towards austerity, which the US is still very reluctant to consider.

In Europe, this divergence is often attributed to what French President Charles de Gaulle used to refer to as America’s “exorbitant privilege”: the power to print the principal international reserve currency. But this explanation is only partly satisfying. Yes, China does pile up reserves in dollars. But no one forces it to do so, and the US would much prefer a stronger renminbi. Emerging-market countries could also invest in euros, if only they were offered such liquid assets as US Treasury bonds – therein lies the current debate over the proposed creation of “eurobonds.” And, while countries like Greece and Spain suffer from market constraints, such is not the case for Northern Europe.

A second interpretation of the transatlantic divide is that the two sides’ policies reflect the differences in their situations. This is clearly the case with labor markets and unemployment: American companies have reacted to recession with massive layoffs, whereas European companies – with the exception of Spanish firms, but not of British companies – have been doing their best to hoard labor.

As a result, productivity has stagnated in Europe since 2007, whereas it has improved by more than six percentage points in the US. Of course, another consequence is that the US unemployment rate is close to post-war peaks and will remain high much longer. And unemployed workers in the US lose their benefits after 99 weeks, making the political imperative for macroeconomic action much stronger than in Europe, where unemployment rose more slowly and benefits are more generous. As the economist Joseph Stiglitz puts it, America’s welfare state is, first and foremost, the Fed’s monetary policy.

But there is also a third, subtler reading of the EU-US split, which has to do with beliefs. In the view of most Europeans, none of the ground that has been lost – or only very little of it – can be recovered. So, because supply has shrunk, it would be dangerous for the central bank or the budget to over-stimulate demand. And,because tax revenues, too, will not recover, the gap will have to be bridged by fiscal austerity.

Americans, on the other hand, are convinced that whatever was lost during the recent recession will eventually be regained. The Obama administration says so, as does the Fed (albeit more prudently), and both act accordingly. In other words, Europeans are pessimistic about the future and thus are reluctant to stimulate growth, whereas Americans remain optimistic and prepared to give any policy instrument a chance. Thus, divergence over macroeconomic policy will continue – at least as long as investors remain willing to buy US public debt.

Several consequences follow from this divergence: difficulties in policy coordination, given no agreement on the diagnosis; a very probable return to large US external deficits while Europe remains in balance; and a weaker dollar, which will become evident if the crisis in the eurozone subsides.

All this could greatly complicate managing the G-20, and risks obscuring the question that all should be addressing: how to manage a global economy in which the balance between advanced and emerging countries is shifting at great speed.

 

   Project Syndicate column published on January 28, 2011

The Capitals of Every Country

If French President Nicolas Sarkozy had written the prologue to his presidency of the G-20, which has just commenced, he could not have done better. The run-up to the G-20’s summit in Seoul was marred by a series of currency controversies, bringing international monetary reform to the fore. Whereas French intentions to reform the international monetary system had initially been received skeptically, suddenly reform looks like the right priority at the right time.

The task is anything but simple. The subject is abstruse. No one outside academia has taken any interest in it for the last 20 years. Accordingly, there are hardly any comprehensive proposals on the table.

The United States, for which international monetary reform is synonymous with diminution of the dollar’s global role, is lukewarm. China, which launched the idea, is happy to see the discussion gaining momentum, but lacks precise ideas. As time is on its side, it sees no reason to hurry.

Emerging countries hold a similar opinion: they want their current problems to be solved but are not ready to re-write the rules of the game. Japan is keen, but its views on regional monetary cooperation do not match China’s. And Europe is distracted more than ever with its internal crises.

Nevertheless, international monetary reform remains a legitimate aspiration. As Vladimir Lenin once reputedly put it, “the surest way to destroy the capitalist system [is] to debauch its currency.” This applies to the world economy today.

When the rules of the global monetary game are unclear, inadequate, or obsolete, countries cannot abide by them, and some may attempt to exploit them to their own advantage. This undermines the fabric of international economic relations.

The agenda for reform boils down to four key problems. The first is exchange-rate relationships. Developed countries’ currencies have been floating against each other for several decades, but this has been only partly true of emerging and developing countries. Many, especially in Asia and the Persian Gulf, are de facto linked to the dollar, others to the euro.

But fixed exchange rates often lead to undervaluation (as in China) or overvaluation (as in Argentina at the beginning of the 2000’s, and, in a different context, several eurozone countries now). And floating and fixed exchange-rate regimes coexist uneasily, because volatility tends to affect the floating currencies (often the euro, and recently the Latin American currencies).

So the system needs a reshuffle. The touchstone is currently the renminbi – not so much because of China’s bilateral relationship with the US, but because other emerging and developing countries monitor the renminbi-dollar exchange rate in setting their own policy. China knows that the current situation is not sustainable, but it remains reluctant to move aggressively to let the renminbi strengthen.

The second problem is imposing discipline on national policies in order to preempt the temptation to export domestic inflation or unemployment. Under the gold standard, discipline was automatic. With floating exchange rates, it is not.

According to an unwritten rule that has emerged over the years, central banks can do as they see fit, as long as they keep inflation stable over the medium term.This rule normally ensures a modicum of coherence and avoids overreactions in exchange rates, but it is insufficient in deflationary times.

The US Federal Reserve argues, with some justification, that its quantitative easing is compatible with price stability, while Europe and several emerging countries deem it beggar-thy-neighbor behavior. The problem is that the current context provides no yardstick for assessing when a national policy stops being cooperative.

So we need what the jargon calls “surveillance.” This is the International Monetary Fund’s role, but the IMF’s mandate is just that – surveillance, not enforcement. It is also the G-20’s role, but neither the US nor the emerging countries are keen on collective constraints.

The third problem concerns international liquidity. Financial flows are excessively volatile. Emerging countries are inundated with capital inflows one day, and faced with abrupt and equally destabilizing outflows the next.

To prevent their currencies from appreciating too much in the first case and falling too far in the second, emerging countries have accumulated foreign-exchange reserves, two-thirds of which are denominated in dollars. These reserves now amount to 15% of global GDP, compared to 6% ten years ago. Ultimately, whether this is due to self-insurance or to exchange-rate targeting matters little: yesterday this unproductive growth in reserves was an indirect cause of the crisis; today it is undermining demand.

The goal should be to make self-insurance unnecessary by guaranteeing access to international credit lines in case of abrupt outflows of private capital. The IMF started to do this when it created credit facilities without the Fund’s usual (and humiliating) conditionality. But suspicion of the IMF persists, and most countries, especially in Asia, still prefer costly self-insurance to a form of mutualization perceived as uncertain.

The fourth problem is collective anchoring. Naturally, the major central banks are concerned with the inflation that they can control – homemade inflation. But this neglects global inflation driven by rising commodity prices, which has been increasingly evident.

This was not an issue in the disinflationary environment of the last decade, but it is becoming more of one, which is probably what prompted World Bank President Robert Zoellick’s proposal to restore a role for gold. The notion is absurd – John Maynard Keynes long ago spoke of gold as a “barbarous relic” – but the problem of anchoring global monetary policy and ensuring its alignment with developments in global supply is nonetheless real.

The Nobel laureate economist Robert Mundell once compared a monetary regime to a political constitution, because it establishes the rules of the game. The analogy is apt. Unfortunately, it also indicates how ambitious and challenging a task it is to reform the international monetary order.

 

Published in Caixin and in Project Syndicate

A resistible currency war

Guido Mantegua, the Brazilian finance minister, aptly captured the monetary Zeitgeist a few days ago when he spoke of a “currency war”. What this far looked like a familiar bilateral US-China dispute over the exchange rate of the renminbi has indeed turned into a generalised controversy over capital flows and exchange rates that involves most of the advanced and emerging countries. The issue dominated the last week-end’s discussions at the IMF annual meeting in Washington, DC.

On the face of it every country seems to be aiming at a depreciation of its currency. Japan has resumed unilateral foreign exchange intervention and is being criticised for it by G7 partners; central banks in the US and the UK are alluding at another round of large-scale purchase of government bonds – a method called quantitative easing which results in lowering long-term rates and indirectly weakening the currency; China is fiercely resisting US and European pressures to accelerate the snail-paced appreciation of its currency vis-à-vis the dollar; and emerging countries all over the world are having recourse to an array of techniques to discourage capital inflows or ward off their effects on the exchange rate. Only the euro area seems to buck the trend, as the ECB has allowed a rise in the short-term interest rate, but even it cannot be indifferent to the risks of appreciation, especially as a strong euro may seriously complicate the economic adjustment under way in countries under stress like Spain, Portugal and Ireland.

A situation where everybody wants a weaker exchange rate is not without precedent. It happened also in the 1930s when one country after another went off gold, in effect trying to export its unemployment (then again there was one exception, France, which hung to gold, desperately tried to engineer deflation to regain competitiveness, and ultimately failed). But evidently not everybody can have a weak currency and a major lesson drawn from the 1930s is that a role of the multilateral system is to prevent futile beggar-thy-neighbour depreciation. In 1944 this responsibility was assigned to the IMF whose Article of Agreement give it the mission to “exercise firm surveillance over the exchange rate policies” of member countries.        

So it would seem that the IMF should help extract some additional concessions from China and for the rest declare a truce. This would however ignore a fundamental asymmetry between advanced and emerging countries. True, both have suffered from the crisis, but not at all in the same way. According to the Fund’s latest forecast, this year real output in the advanced countries will still be below the 2007 level, whereas it will be 16% higher in the emerging and developing countries. Looking ahead, advanced countries are set to continue to struggle with the fallout of the 2008 crisis, especially the consequences of the deleveraging of indebted households and the dire state of public finances. The IMF also reckons that the advanced countries need to cut spending or increase taxes by 9 percentage points of GDP on average over the current decade, if they want to bring the public debt ratio to 60% of GDP by 2030. The emerging countries, however, only need minor consolidation to keep their debt ratio at 40% of GDP.

In any sensible model, an asymmetry of this magnitude requires a significant adjustment of relative prices. The relative price of the goods produced in the advanced countries (their real exchange rate) needs to depreciate vis-à-vis the emerging countries in order to compensate for the expected shortfall in internal demand. This is actually going to happen whatever the nominal exchange rate between the two blocks. The only difference is that if this exchange rate remains fixed, advanced countries will have to go through a protracted period of low inflation (or even deflation) which will make the debt burden even harder to bear, and emerging countries will have to enter an inflationary period as capital will flow in, drive up reserves, increase money supply and ultimately result in a price increase. For both sides, it would be much more desirable to let the adjustment take place through a change in the nominal exchange rate – which would help contain deflation in the North and inflation in the South.

This is not happening. Compared to July 2007, at the onset of the crisis, exchange rates between advanced and emerging countries have barely changed. True, some currencies have gone up and some others down, but on average not much has changed. So the adjustment that needs to take place is hampered.

It is easy to understand why. For each central bank the question is not what happens to the emerging countries group as a whole but what happens to its own currency vis-à-vis competitors. So Brazil does not want to appreciate vis-à-vis other Latin American countries, Thailand does not want to appreciate vis-à-vis other Asian countries, and no one wants to appreciate vis-à-vis China. At the same time China’s export regions fear that a renminbi appreciation would lead labour-intensive industries to migrate to Vietnam or Bangladesh. So each and every emerging country resists appreciation individually. This is a typical collective action problem whereby a change that is in the common interest is hampered by lack of coordination among the players.

By the same token, quantitative easing in the advanced countries raises a coordination issue. QE is a legitimate monetary policy instrument, but it is not sure the Fed and the Bank of England would embrace it with the same enthusiasm, were it not for anticipated exchange rate depreciation effects. In fact the ECB’s perceived reluctance to follow suit is likely to add to the expected growth effects of US or UK monetary policy choices, at the expense of the euro area.   

This analysis sheds light on the traditional controversy over Chinese exchange rate policy. It first highlights that what is to be addressed is not a bilateral US-China trade controversy but a much more global macroeconomic problem between the advanced and the emerging countries blocks. Second, it suggests that the solution to monetary wars is not to declare a truce but to recognise the nature of the issue and overcome the collective action problems that stand in the way to a solution. Third, it indicates that there are coordination issues on the side of both the advanced countries and the emerging countries.

This is not to say that the renminbi issue is second-order. It is not. But its importance does not come from the trade imbalance between the US and China, rather from the fact that Beijing holds the key to a global adjustment involving most of the advanced and emerging worlds. Discussions in Washington this week end indicated that this is being realised and that emerging countries criticise China’s inflexibility more and more.

One of the international organisation’s primary tasks is to help solve collective action problems. The IMF did it at the time of the global recession. It should also take the lead on the currency front by proposing a conceptual framework for future discussions, by providing an objective assessment of the adjustments that are needed, and by facilitating settlement within the multilateral framework. It cannot substitute governments that need to make choices or change them. But it can help considerably in the search for a solution.        

(Updated version of Project Syndicate column posted on 14 October 2010)

The Austerity Debate: Marooned in the Past

The controversy that has emerged in the U.S. and Europe between the proponents of further stimulus and the advocates of retrenchment reads very much like a debate about economic history. Both sides have revisited the lessons from the Great Depression of the 1930s but also the centuries-long history of sovereign debt crises. In this unusual controversy, history-based arguments often trump standard economic policy arguments.

The pro-stimulus camp often refers to the 1937 U.S. fiscal retrenchment episode. Indeed it was at that time – four years after Roosevelt’s first election as U.S. president and the launch of the New Deal – that U.S. budgetary policy suddenly turned restrictive. It did not really happen by choice but rather because 1937 was the year when social insurance contributions started being paid and because a one-off bonus to the veterans of the 1914-18 came to its end. According to computations by economist Paul van den Noord, the net result was a fiscal contraction amounting to three percentage points of GDP, certainly not a trivial amount. Economic growth tumbled from 13 percent in 1936 to 6 percent in 1937 and a negative 4.5 percent in 1938 and unemployment rose from 14 percent to about 20 percent of the labor force. Although fiscal policy was not the only reason for the double dip, at the very least an ill-timed retrenchment contributed to the slowdown.

So the question is, are we in 1936 and do the budgetary retrenchment measures contemplated in several countries risk provoking a similar double dip recession? Clearly there are limits to the comparison. To start with, much less time has elapsed since the financial crisis, the recession has been much less pronounced and the recovery has come faster. Second, important episodes took place between the 1929 crisis and the 1937 fiscal retrenchment episode: especially the U.S. turn to protectionism in 1930 and the monetary turmoil of the early 1930s. But the episode nevertheless illustrates the dangers of attempting to consolidate public finances at a time when the private economy is still too weak for the recovery to be self-sustained (another case with similar consequences was the Japanese VAT rise of 1997 which precipitated a collapse of consumption).

Fiscal hawks also rely on history-based arguments. Economists Carmen Reinhart and Kenneth Rogoff have studied centuries of sovereign debt crises and what they remind us is that today’s developed world has a forgotten history of sovereign default. A particularly telling episode was the aftermath of the Napoleonic wars of the early nineteenth century, when a string of exhausted states defaulted on their obligations, but the 1930s are also relevant as there was another series of defaults among European states, not least Germany. What history tells us here is that defaults are not the privilege of poor, under-governed countries. They are a threat to all, especially in times of high capital mobility when governments rely too much on the foreign lenders’ apparent willingness to provide funds and find themselves in a dire situation when capital stops flowing in. Again, there are limits to comparisons: especially, it is hard to infer from past episodes what the limits to public debt are. After all, British public debt exceeded 250 percent of GDP in the aftermath of World War II and the country did not default. But an important insight from history is that unsustainable fiscal policies are more likely to result in defaults when fiscal problems cannot be inflated away. This was the case under the gold-based monetary regimes such as the Gold Standard of the nineteenth century and it is the case today for countries that have relinquished their monetary autonomy, such as the members of Europe’s monetary union.

It may look strange to rely so much on the past. In less turbulent times, history is left to historians and the economic policy debate relies on models and econometric estimates. But attitudes changed as soon as the crisis started in 2007-2008. Indeed at the time, central bankers and ministers were obsessed by the memory of the 1930s and they consciously did the opposite of what their predecessors had done eighty years ago. They were right. In extraordinary times, history in fact is a better guide than models estimated with normal-times data because it is a way to capture a variance ignored by standard time-series techniques. If one wants to know how to deal with a banking crisis, the risk of a depression or the threat of a default, it is after all natural to take inspiration from times when those dangers were around, rather than to models that ignore them or treat them as distant clouds. In other words, in time of crisis the best guides on offer are theory – because it captures the essence of a problem – and history– because it tells the lessons from past experience, while everything in-between is virtually useless.

The danger with reliance on history is that we have no methodology to decide which comparison is relevant. Loose analogies can easily be regarded at proofs, history provides a vast array of experiences that can be enrolled to support a particular view, and scholars are particularly apt at exhuming past episodes that serve their cause. The policymakers (whose economic history culture is generally limited) are therefore at risk of being drown in contradictory historical references.

History was indeed an essential guide at the time when there was an un ambiguous reference to study and draw lessons from. The more we go, the more undisciplined appeal to history risks becoming an erudite, and ultimately confusing way to express opinions. Governance by analogy is not to be advocated.

 

(Published in Caixin on August 4, 2010 and on Project Syndicate)

Read the comment by Mark Thoma on Economist's View

Europe’s Federalism Debate Revived

It is an old debate, but tensions within the euro area have revived it: can a monetary union survive without some form of fiscal federalism?

This issue is of persistent concern for investors worldwide. Holders of European government bonds believed that they knew what they had bought. Sure, there was no such thing as a eurozone sovereign security. But German, French, Spanish, and even Greek bonds all carried roughly the same interest rate, so they were deemed equivalent. Investors now recognize that they did not really understand what these bonds represented – that is, the institutional construct behind the European currency. And if the global financial crisis has taught us anything, it is this: when you do not understand a financial product, you should not buy it. But if investors actually take that lesson to heart, the European crisis will be far from over. So, should Europe embrace fiscal federalism in order to strengthen the eurozone and restore investor confidence? The problem is that fiscal federalism means different things to different people.

Americans think they know what it is: a central government with a large budget (about 20% of GDP), whose macroeconomic role is to carry out counter-cyclical spending and taxation, as most US states are constitutionally committed to some sort of balanced budget. This was clearly true in the case of the stimulus program launched in 2009, which included federal transfers to the states to sustain state-level fiscal spending. Similarly, when a state such as Michigan is hit by recession in its key economic sector (the auto industry), Washington collects less federal tax but maintains – if not increases – local spending, which partially offsets the shock to state income. Economically, therefore, the federal budget cushions regional shocks automatically through discretionary action and stabilizing transfers to the states. Politically, it embodies solidarity and thus helps cement the union.

If this is what is meant by federalism, it is better for the European Union to forget about it. The EU budget amounts to about 1% of GDP, just one-fortieth of total public expenditure. No one, not even die-hard European integrationists, imagines that it can reach 5% of GDP (it is more likely to decrease). But even a 5%-of-GDP budget would be insufficient to play a meaningful macroeconomic role.

A second solution is what can be called “distributive federalism.” The goal is not to absorb shocks but to reduce income gaps across regions. In Germany, tax revenues are redistributed between the Länder. This is another form of solidarity, which also exists in the EU, where regional development funds are allocated to poorer regions to foster catch-up growth. These transfers are significant for poor countries: about €300 per person for Greece and Portugal every year from 2000 to 2006. Europe, in this respect, is not qualitatively different from the US. These transfers have accelerated convergence when put to good use (for example, in several Spanish provinces), but have been ineffective when wasted (as in Greece). This feeds doubts about solidarity’s usefulness. Germans, who since reunification in 1990 know what they are talking about when it comes to such transfers, do not want to hear about a Europe where rich regions would permanently finance pockets of under-development. They are not alone in this.

What, then? Conceptually, the eurozone must include solidarity with countries facing hardship, because this is what unites and gives strength to the whole – but without the heavy machinery of a federal budget or a permanent increase in transfers. It needs some sort of mutual insurance, or what could be termed “insurance-based federalism.”

This is what inspired the decision taken in May to create the European Financial Stability Facility (EFSF), by which assistance can be provided, jointly with the International Monetary Fund, to partner countries in times of crisis. It is also what inspired the European Central Bank to launch an asset-purchase program, which has been used to buy Greek and Portuguese government bonds.

But the uproar caused by these decisions reinforces, rather than dispels, doubts. In Germany, many consider the EFSF a breach of the fundamental principle that EU governments cannot be bailed-out by their partners. And the transformation of the central bank into a quasi-fiscal agent (because if Greek debt is restructured, the ECB will record losses) is regarded with horror, as it violates the separation between money and public finances. Instead, it is claimed, eurozone members should have been allowed to default. No matter that the public debt of the average US state is less than 0.5% of total US GDP, compared to 5% in the eurozone, which implies that the financial impact of a eurozone sovereign default would be much stronger. And no matter that there is no prohibition on the purchase of government bonds on the secondary market: the Rubicon has been crossed, and the Germans are nervous.

So there is no agreement yet to make the EFSF permanent, and it has been designed to be as un-federal as possible. When it comes to ECB purchases of government bonds, no one understands exactly for how long and for what purpose the new weapon is to be used – which reduces its effectiveness. Meanwhile, proposals for pre-adoption assessment of national budgets by the EU have attracted criticism in France and elsewhere, which serves as a reminder of the distance there is between calls for coordination and actual acceptance of its implications.

The Europeans have begun to assemble the bricks for a new building, but without having agreed on its size and design. For the time being, they rather give the impression to have thrown sandbags in disorder in an attempt to stop a wave. This may make skeptics the very people European policymakers wanted to convince. It is time to accept that those who finance EU governments through purchasing their bonds are entitled to ask inconvenient questions, and to expect clear answers.

 

(Published on Project Syndicate on July 27, 2010)