New Research

Are these results surprising? Not to me. And given the high barriers to entry for bargaining, we should expect to see regulations benefit large firms with a history of lobbying activity.

The Dynamics of Firm Lobbying
William R. Kerr, William F. Lincoln, Prachi Mishra 

NBER Working Paper No. 17577 

We study the determinants of the dynamics of firm lobbying behavior using a panel data set covering 1998-2006. Our data exhibit three striking facts: (i) few firms lobby, (ii) lobbying status is strongly associated with firm size, and (iii) lobbying status is highly persistent over time. Estimating a model of a firm's decision to engage in lobbying, we find significant evidence that up-front costs associated with entering the political process help explain all three facts. We then exploit a natural experiment in the expiration in legislation surrounding the H-1B visa cap for high-skilled immigrant workers to study how these costs affect firms' responses to policy changes. We find that companies primarily adjusted on the intensive margin: the firms that began to lobby for immigration were those who were sensitive to H-1B policy changes and who were already advocating for other issues, rather than firms that became involved in lobbying anew. For a firm already lobbying, the response is determined by the importance of the issue to the firm's business rather than the scale of the firm's prior lobbying efforts. These results support the existence of significant barriers to entry in the lobbying process.

This next one seems very inventive, in a "create your own science" kind of way. Has anyone else done anything like it?

Testing the Global Financial Transparency Regime
J. C. Sharman 

International Studies Quarterly Vol. 55 No. 4 

How can we tell whether rules that apply in theory actually do so in practice? Realists argue that the gap between what formal rules proscribe and their effectiveness may be particularly wide at the international level. Furthermore, dominant states may impose costly standards on others that they themselves choose not to implement. To test these propositions, the article assesses the effectiveness of international soft law standards prohibiting anonymous participation in the global financial system by seeking to break these standards. The findings indicate that the prohibition on anonymous corporations is relatively ineffective and is flouted much more in G7 countries than in tax havens. The article contributes to and extends the work of realist scholars in international political economy, both in their skepticism of formal rules and focus on the effects of power. Evidence is drawn from the author’s solicitations and purchases of anonymous shell companies from 45 corporate service providers in 22 countries.

The IPE work on exchange rate regimes continues to improve.

Fear of Floating and de Facto Exchange Rate Pegs with Multiple Key Currencies Thomas Plümper and Eric Neumayer 

International Studies Quarterly Vol. 55 No. 4

This paper adopts and develops the “fear of floating” theory to explain the decision to implement a de facto peg, the choice of anchor currency among multiple key currencies, and the role of central bank independence for these choices. We argue that since exchange rate depreciations are passed-through into higher prices of imported goods, avoiding the import of inflation provides an important motive to de facto peg the exchange rate in import-dependent countries. This study shows that the choice of anchor currency is determined by the degree of dependence of the potentially pegging country on imports from the key currency country and on imports from the key currency area, consisting of all countries which have already pegged to this key currency. The fear of floating approach also predicts that countries with more independent central banks are more likely to de facto peg their exchange rate since independent central banks are more averse to inflation than governments and can de facto peg a country’s exchange rate independently of the government.

And, lastly, an extension of Kydd's 2003 by UNC's Mark Crescenzi and co-authors:

A Supply Side Theory of Mediation
Mark J.C. Crescenzi, Kelly M. Kadera, Sara McLaughlin Mitchell, and Clayton L. Thyne 

International Studies Quarterly Vol. 55 No. 4 

We develop and test a theory of the supply side of third-party conflict management. Building on Kydd’s (2003) model of mediation, which shows that bias enhances mediator credibility, we offer three complementary mechanisms that may enable mediator credibility. First, democratic mediators face costs for deception in the conflict management process. Second, a vibrant global democratic community supports the norms of unbiased and nonviolent conflict management, again increasing the costs of deception for potential mediators. Third, as disputants’ ties to international organizations increase, the mediator’s costs for dishonesty in the conflict management process rise because these institutions provide more frequent and accurate information about the disputants’ capabilities and resolve. These factors, along with sources of bias, increase the availability of credible mediators and their efforts to manage interstate conflicts. Empirical analyses of data on contentious issues from 1816 to 2001 lend mixed support for our arguments. Third-party conflict management occurs more frequently and is more successful if a potential mediator is a democracy, as the average global democracy level increases, and as the disputants’ number of shared International Organization (IO) memberships rises. We also find that powerful states serve as mediators more often and are typically successful. Other factors such as trade ties, alliances, issue salience, and distance influence decisions to mediate and mediation success. Taken together, our study provides evidence in support of Kydd’s bias argument while offering several mechanisms for unbiased mediators to become credible and successful mediators.

This Is What Adjustment Looks Like (an ongoing series)

Martin Feldstein:

China’s government may be about to let the renminbi-dollar exchange rate rise more rapidly in the coming months than it did during the past year. The exchange rate was actually frozen during the financial crisis, but has been allowed to increase since the summer of 2010. In the past 12 months, the renminbi strengthened by 6% against the dollar, its reference currency. ...

There are two fundamental reasons why the Chinese government might choose such a policy: reducing its portfolio risk and containing domestic inflation.

Consider, first, the authorities’ concern about the risks implied by its portfolio of foreign securities. China’s existing portfolio of some $3 trillion worth of dollar bonds and other foreign securities exposes it to two distinct risks: inflation in the United States and Europe, and a rapid devaluation of the dollar relative to the euro and other currencies. ...

Looking back on the past year, the 6% rise in the renminbi-dollar exchange rate might understate the increase in the relative cost of Chinese goods to American buyers because of differences in domestic inflation rates. Chinese consumer prices rose about 6.5% over the past year, while US consumer prices rose only about 3.5%. The three-percentage-point difference implies that the “real” inflation-adjusted renminbi-dollar exchange rate rose 9% over the past year (i.e., 6% nominal appreciation plus the 3% inflation difference.)

There are obviously political interests in China for keeping the RMB's value low, but the most recent Five-Year Plan calls for increasing households' purchasing power above the rate of economic growth. We may start to see (more) political cleavages in China pitting consumers and against producers. Remember: politics exists even in authoritarian regimes.

New Economics Research

How Reliable are De Facto Exchange Rate Regime Classifications?
Barry Eichengreen, Raul Razo-Garcia
NBER Working Paper No. 17318

We analyze disagreements over de facto exchange-rate-regime classifications using three popular de facto regime data series. While there is a moderate degree of concurrence across classifications, disagreements are not uncommon, and they are not random. They are most prevalent in middle-income countries (emerging markets) and low-income (developing) countries as opposed to advanced economies. They are most prevalent for countries with well-developed financial markets, low reserves and open capital accounts. This suggests caution when attempting to relate the exchange rate regime to financial development, the openness of the financial account, and reserve management and accumulation decisions.

They do not cite this paper by Guisinger and Singer, which they should. Nor do they include the Aizenmann-Chinn-Ito "trilemma indexes" in the analysis, which they probably should. Still potentially interesting for those who do quantitative work involving exchange rates.

Country Size, International Trade, and Aggregate Fluctuations in Granular Economies
Julian di Giovanni, Andrei A. Levchenko
NBER Working Paper No. 17335

This paper proposes a new mechanism by which country size and international trade affect macroeconomic volatility. We study a multi-country, multi-sector model with heterogeneous firms that are subject to idiosyncratic firm-specific shocks. When the distribution of firm sizes follows a power law with an exponent close to -1, the idiosyncratic shocks to large firms have an impact on aggregate output volatility. We explore the quantitative properties of the model calibrated to data for the 50 largest economies in the world. Smaller countries have fewer firms, and thus higher volatility. The model performs well in matching this pattern both qualitatively and quantitatively: the rate at which macroeconomic volatility decreases in country size in the model is very close to what is found in the data. Opening to trade increases the importance of large firms to the economy, thus raising macroeconomic volatility. Our simulation exercise shows that the contribution of trade to aggregate fluctuations depends strongly on country size: in the largest economies in the world, such as the U.S. or Japan, international trade increases volatility by only 1.5-3.5%. By contrast, trade increases aggregate volatility by some 15-20% in a small open economy, such as Denmark or Romania.

Does this contradict the PSST story in the case of the stagnating US economy?

Would A Yuan Appreciation Narrow the Trade Imbalance?

Probably not:

Moreover, the impact of higher dollar prices for Chinese goods might well be to raise the U.S. import bill. In particular, U.S. spending on Chinese goods would rise unless higher prices induced a proportionately larger decline in import volumes. For example, if a 10 percent rise in the price of Chinese products resulted in only a 7 percent decline in the volume purchased, spending would rise by roughly 3 percent. Significantly, empirical studies have been as likely to find that higher prices raise U.S. import spending as lower it. Regardless of the direction of the spending impact, these offsetting price and volume effects imply that the impact of a Chinese currency appreciation on U.S. import spending would be small.

Finally, the impact of a stronger renminbi on U.S. imports would be limited by the fact that most goods purchased from China come from industries in which U.S. producers no longer have a substantial presence. Indeed, out of more than 400 detailed production categories, 60 categories account for some 80 percent of U.S. purchases from China. The same 60 categories account for less than 15 percent of U.S. manufacturing shipments. With little U.S. capacity at the ready, higher Chinese import prices might be more likely to spur increased imports from Korea or Vietnam than increased U.S. production. If so, a smaller U.S. trade deficit with China would be offset by larger deficits with other countries.

The last point is key, I think. I'm not as concerned about the short-run elasticities as the long-run structural issues.

Trade, Exchange Rates, and Public Opinion

Drezner wants to know what's up with Republicans not supporting free trade these days:

What's more disturbing, however, and uncommented until now, was the total lack of support for freer trade among the GOP field.

This came through loud and clear through what was said and what was not said in New Hampshire. Trade didn't come up all that much during the debate. Tim Pawlenty provided the only comment of substance, and it wasn't a productive one...

The other thing that was striking was what wasn't said during the debate. All of the candidates focused like sharks with frikkin' laser beams attached to them on the economy. The standard GOP litany of solutions for jump-starting the economy were offered: tax cuts, cutting regulation, tax cuts, cutting government spending, tax cuts, reigning in the Fed, tax cuts, ending Obamacare, tax cuts. Not one of the candidates, however, mentioned trade liberalization as part of their fornmula for getting America moving again.

This is more off-the-cuff observation than analysis, and I'm not sure how far it reaches (as Scott Lincicome points out in Drezner's comments), but let's take it as given and think about why might this be the case. Another of his commenters presents a typical explanation:

The obvious thing is that when most of the American people have been economically hammered for decades, they're not in an economically liberal mood. They've seen repeated free trade agreements lead directly to lower wages and layoffs, despite what the various propagandists have said.

Call this the "business cycle theory of trade attitudes": When economic times are good, public support for further liberalization is high. But during downturns, everyone wants protection. It's a fairly standard argument, and Drezner's co-blogger at FP makes it every day.

Thing is, there are good reasons to doubt it. Dr. Oatley recently published an article arguing that real exchange rate movements better predict calls for trade protectionism than the business cycle. His central finding?

The empirical analysis therefore provides robust support for the real exchange rate hypothesis. The number of antidumping petitions rises as currencies strengthen and falls as currencies weaken. This relationship holds even once we control for other likely causes of industry demand for protection such as import growth and changes in macroeconomic conditions. ...

Thus, real exchange rate movements provide at least as strong an explanation for temporal variation in protectionism than the most popular alternative business cycle hypothesis.

Douglas Irwin has a recent article on the link between exchange rates and trade policy in historical perspective. So what's happened to real exchange rates in the US?



Looking at this in light of Oatley's paper, it's not all that surprising that Bush wasn't able to do much on trade during the 2000s. He entered office during a period immediately following a huge exchange rate appreciation that peaked with the early-naughties recession. Second, though the exchange rate depreciated during the decade, that process slowed and mildly reversed in 2008-2009. Recall, as Drezner does, the anti-trade competition that Hillary Clinton and Obama engaged in during the 2008 primary. We're still living through that, so it shouldn't be too surprising that momentum for new trade agreements has stalled in both parties.

In other words, Drezner, Lincicome, and Oatley could all be right: elite Republican opinion on trade might not have changed all that much (Lincicome), but they are choosing to remain eerily quiet on the issue (Drezner) as real exchange rates have yet to depreciate enough to restore American competitiveness (Oatley). The optimistic take for the globalist is that real exchange rate movements are occurring, and if recent trends continue we should expect greater enthusiasm for more liberalized trade in the coming years.

Actually, Let's Not Start a Trade War With China Just Now

(click for larger image)

Brad DeLong links to Jared Bernstein, who suggests some policies that Obama could pursue (without deficit spending) to help the U.S. employment malaise. Many of them are fine, but this one isn't:

Currency Management: this would be a very bad time to let up on countries who subsidize their exports by suppressing their currency values in foreign exchange markets, most notably China. I’d push the Levin bill on this. And it’s bipartisan: the darn thing got 99 R votes in the last Congress!

The Levin bill proposes slapping tariffs on goods coming from countries that manipulate their exchange rates to boost exports. Levin has proposed a variant of it for years (here's one from 2006), but finally got traction during the recession. Krugman agrees that this is a good idea, but I think there are a number of problems with it.

1. It's most likely illegal. If China is violating trade rules with its exchange rate policies, then the USTR should take them to the WTO. The fact that that hasn't been done at any point over the past decade, despite the fact that it would have been politically popular, indicates to me that the USTR believes it would lose such a case. There's a reason why exchange rate policy has been referred to the IMF (which conducts monitoring and surveillance but has no authority) rather than the WTO. It's also not clear that China is violating any WTO rules. For one thing, the WTO doesn't have a lot to say about which exchange rate regimes are legal and which aren't. And although using the exchange rate to subsidize exports could be illegal, there's a fairly high bar to clear. This (several years old) thread on the excellent International Economic Law and Policy blog describes the three simultaneous conditions under which currency manipulation could be WTO-illegal: 1. It must entail a "financial contribution"; 2. It must be specific; 3. It must confer a benefit on exporters. The comments to that post get into specifics, but according to IELP, "If [currency policy] is contingent in law or de facto upon export performance, it is then prohibited and deemed specific automatically".

The graph above shows the nominal dollar-yuan exchange rate over the past five years. Does it look like the exchange rate is contingent upon export performance? The yuan has appreciated against the dollar by nearly 25% over the past five years, and I'm not sure the trend clearly indicates responsiveness to changes in Chinese export performance.

2. There are growing concerns about inflation in the U.S. These concerns may be misguided, but they play well in Republican circles and among certain Governors at the Federal Reserve. Slapping an import tariff on China would cause immediate price spikes across a wide range of consumer goods, which would likely lead to increased calls for the Fed to tighten monetary policy. That, of course, would not be good for economic recovery. Nor would it be good for standards of living. A Chinese undervaluation of the yuan is equivalent to the Chinese giving us free money. Let me say that again: a Chinese undervaluation of the yuan is equivalent to them giving us free money. It's not clear to me that trading lower standards of living for more jobs is a net win. Jobs are certainly important, but they're not the only important thing.

Moreover, as we've discussed on this blog repeatedly, the nominal exchange rate is less significant than the real exchange rate, and the real exchange rate is shifting faster than the nominal rate as inflation in China out-paces inflation in the U.S.

3. It's not at all clear that a tariff targeted specifically at China's exchange rates would have any effect on U.S. jobs. Not only would importers suffer, but there is no reason to believe that manufacturing jobs would come back to the U.S. en masse. Manufacturing employment was collapsing before the recession (see also here), and even if China lost some jobs via a U.S. tariff those jobs would likely go to Vietnam and Taiwan and South Korea and any number of other places before coming back here. A tariff would make U.S.-produced goods cheaper relative to Chinese goods (in U.S. markets), but would not affect the price of Vietnamese goods at all. The magnitude of this shift, and the timing of it, isn't obvious to me, and to some extent it offsets #2 above, but the world is dynamic.

4. Those dynamics are not limited to economics; they also involve politics. The Chinese would not simply accept tariffs as the new cost of doing business. They would fight back. First, they would take the U.S. to the WTO. Second, they would likely enact retaliatory tariffs. The WTO cases would take years to be resolved (i.e. hopefully after the recovery from the recession), but the tariffs would immediately damage U.S. exporters. Obama's stated policy goal is to double American exports over the next several years. It's going to be hard to do that if you can't sell into the world's fastest-growing major market, now the second-largest economy on the globe.

5. The U.S. runs the risk of pot-meets-kettle reactions from the rest of the globe. The world already believes that U.S. monetary policy, with interest rates at 0% and two rounds of quantitative easing already conducted, constitute "currency manipulation" of a different sort. Putin called it "hooliganism", Brazil imposed capital controls, S. Korea has expressed concern about exchange rates at the G20, etc. I agree with Krugman and others that this criticism is over-blown; the U.S. is in a deep recession and should be using monetary expansion to help get out of it. But a round of tariffs targeting exchange rate policy will leave the U.S. open to a dose of its own medicine. Other countries are already wary of U.S. policy, and more aggressive measures could quickly lead to a cycle of more prevalent beggar-thy-neighbor policies. Right now it is critical that international economic cooperation move forward, not back. We've seen from the Japan crisis how badly economies are damaged when global supply chains are disrupted.

6. The U.S. needs to know its role. The global economy is still terribly damaged. 1937 isn't the worst analogue. Right now the U.S. needs to do everything it can to keep markets open, maintain international cooperation, provide liquidity into the global system, and maintain a market for goods. In other words, it needs to live up to Kindleberger's charge. That involves allowing some free-riding. It involves setting policy based on global, not domestic, circumstances. Myopically trying to get back every lost job as quickly as possible runs the risk of damaging global economic relations over the medium- and long-run, which could easily have adverse effects on growth and prosperity. Letting China sell us goods at below-market prices seems like a very small price to pay for averting a seriously negative outcome.

Spain Feels the Pressure

To this point Spain's economy hasn't suffered as much as Portugal, Greece, or Ireland, but that doesn't mean things are going well. Economic pressures continue to mount, and Spain faces the same exchange rate pressures as those other countries. A currency devaluation would help boost competitiveness and thus employment, but that isn't possible under the euro. In a fixed exchange rate system, internal devaluation via wage cuts and increased unemployment is the only option. And democratic publics don't like that very much:

About 28,000 people, most of them young, spent Friday night in Puerta del Sol, a main square in downtown Madrid, the police said. They stayed even as the protest ban went into effect at midnight under rules that bring an official end to campaigning before the election in 13 of Spain’s 17 regions and in more than 8,000 municipalities.

Fueling the demonstrators’ anger is the perceived failure by politicians to alleviate the hardships imposed on a struggling population. The unemployment rate in Spain is 21 percent.

And Spain looks likely to be the next European country to tilt right since the economic crisis:

Sunday’s election is expected to result in a countrywide sweep by the Popular Party, the main center-right opposition, at the expense of the governing Socialists, whose popularity has plummeted because of the economic crisis. The most recent opinion polls suggest that the Socialist Party may lose in regions and municipalities where it has been in power since Spain’s return to democracy in the late 1970s, notably Castilla-La Mancha.

There are other issues at stake, including concerns about corruption, but those get magnified when unemployment is at 21%. Some folks on Twitter are saying that the police tried to break up some protests, but I haven't seen a credible report on that yet. Either way, these issues aren't going away.

Hooliganism and the Unholy Trinity

I’m with Krugman on this:

Putin says we’re hooligans; Brazil accuses us of “currency wars”; and the Chinese are, well, being their usual charming selves. But what’s going on in the international currency scene?

I don’t know why I didn’t think to put it this way before — and I don’t know if anyone else is saying this — but what we have here is a classic example of the Mundellian impossible trinity, aka the trilemma, which says that you can’t simultaneously have free movement of capital, a stable exchange rate, and independent monetary policy. …

So, how does this apply to current issues? Advanced countries, very much including the United States, are weighed down by the aftereffects of the 2008 financial crisis; this has led to low investment returns. Meanwhile, emerging markets are in much better shape, so capital wants to go there.

And this creates a problem for the EMs. They don’t want their currencies to rise sharply…

But not letting the currency rise would be inflationary – that is, Brazil doesn’t want to give up on its independent monetary policy. So what’s the answer?

All those accusation of hooliganism, currency wars etc. are in effect demands that the trilemma be resolved by having America give up having an independent monetary policy — basically, that the Fed give up on trying to stabilize the US economy so that emerging markets aren’t faced with the uncomfortable tradeoff between massive appreciation and imported inflation. But this shouldn’t and won’t happen.

Yes. And thinking in terms of the Trilemma is important because it helps us understand domestic politics within an international context. Brazil and the other EMs are worried about (nominal) exchange rate appreciation because it hurts their exporters, which is a politically powerful group. Inflation hurts consumers (and creditors), which is also bad for democratically-elected politicians. So that leaves capital controls, which remains the preferred trade-off of many EMs.

This is an illustration of how the U.S. really is still the most powerful global economic actor, as everyone else is having to adjust to U.S. policy rather than the other way around. The same thing happened (in slightly different ways) during the collapse of Bretton Woods, as Yglesias noted:

This is one reason why I’ve grown impatient with nostalgia for the good old days of the Bretton-Woods system.This system, which really was working great in its heyday, essentially involved the United States playing precisely the role that we now reject. The dollar was pegged to gold, other currencies were pegged to the dollar, foreign countries could change the dollar price of their currencies, and we couldn’t reset the value of the dollar. This worked fine as a means of facilitating catch-up growth in Japan and Western Europe but that growth make it impossible to sustain, so it wasn’t sustained and there’s no practical method of bringing it back.

I would add one thing. The Trilemma refers to the ubiquitous "small, open economy" and therefore leaves out a component that is highly salient for politics: one country in the system can have all three of free capital movement, fixed exchange rates, and independent monetary policy. As Dr. Oatley explained awhile back, this is because exchange rates are not monads:

But in what sense does the US not pegging the dollar imply that the dollar is not pegged? China and the other East Asian governments peg to the dollar. And even Japan, which doesn't peg the yen, does limit its fluctuation as if it has a target zone. For all practical purposes, then, the dollar is pegged against many of its most important creditors (the Euro is the only exception, but the euro area as a whole is a debtor rather than creditor area). If this wasn't the case, we wouldn't be having this conflict.

More generally, any discussion about the unholy trinity needs to recognize the n-1 problem. In any system of n countries there are n-1 independent exchange rates. Think about a three-country system. If China pegs to the dollar and South Korea pegs to the dollar, the China-South Korean rate is fully determined by the cross rate.

As a result, every exchange rate system (other than a gold standard) has one degree of freedom: one country can attain a fixed exchange rate, and capital mobility, and monetary independence. Whichever country holds this position gets to set monetary policy for the system as a whole. International monetary politics revolve who gets this degree of freedom and how it is employed. …

This suggests that we are back in a world very much like the late Bretton Woods: the US has a pegged exchange rate against many of its major creditors and capital mobility and monetary autonomy. The current conflict is a consequence of East Asian governments forcing the US to accept a peg at a rate it does not think is appropriate. Like Geithner and Co. now, the Nixon administration believed it couldn't devalue an over-valued dollar unilaterally.

And this is why the U.S. gets called “hooligans” and everything else.

This Is What Adjustment Looks Like (An Ongoing Series)

A dollar decline is what we would expect from a country with a large current account deficit and weak demand-side of the economy. And that's what we're getting. This is a bad thing for consumers, but a good thing for producers (at least exporters), and right now the country needs jobs more than anything. It's bad the US's external creditors, but good for the US's internal debtors (including the sovereign). If the dollar stays low, it will be interesting to see how other countries react. Another round of competitive devaluations? Internal macroeconomic adjustment, leading to a rebalancing?

I don't think this has much to do with QE2; it's exactly what we'd expect from a country in the US's position. But changes in the dollars value will force change on the US's trading partners, which is more or less everyone. It will be interesting to see what choices other countries make.

The Lesson of Iceland

I've been thinking a lot lately about exchange rates, capital flows, and related issues. While looking for something else, I came across many news articles since the crisis Iceland's bid to join the EU, including the EMU. Many of the articles focused on how Iceland's refusal to pay Icesave's creditors might jeopardize their accession, but the screening process appears to be at a fairly advanced stage already, so negotiations leading to accession in 2013 or so are realistic. Emmanuel's discussed some of this.

All that reminds me of Krugman's constant arguing that Iceland was doing so much better than Ireland and the Baltics, because having their own currency allowed them to depreciate quickly. As I noted here, that's all fair and good, but a large depreciation massively increases the burden of external debt, and also leads to a large increase in costs of living for a small open economy. Particular one as small and open as Iceland. Iceland's 50% currency depreciation made them much poorer, and their debt-to-GDP not only quadrupled after the crisis but became much more expensive to service. Note that before the crisis, Iceland had no desire to join the EMU, and no intention of doing so, although it did "Euroize" the krona somewhat.

In other words, I was right. Iceland is applying for EMU membership so as not to be as exposed to currency risk and balance of payments problems as they are now, and they're willing to give up plenty of policymaking flexibility to achieve that. Including the right to depreciate.

We'll see whether the EU lets them in. I imagine that will have a lot to do with what happens to Greece, Ireland, and Portugal in the meantime.

This Is What Adjustment Looks Like (An Ongoing Series)

Wen Jiabao gave a long press conference at the end of China's national legislative conference, at which the new five year plan was approved. Some highlights:

Its strategy promises a surge in government spending on domestic security and social programs like medical insurance, but offers little in the way of legal, political or banking reform. One principal goal, the government has said, is to lessen economic dependence on factory exports and build up innovation and domestic consumption.

Mr. Wen described the war on inflation as the government’s top priority. Figures released three days earlier showed that consumer prices rose 4.9 percent in February compared with the same month a year before, the latest in a series of indications that China’s economy is beginning to overheat.

The prime minister partly blamed international factors for the soaring costs, among them spiking oil prices because of the unrest in the Middle East and North Africa. He also pointed to looser monetary policy in the United States, where the Federal Reserve had expanded monetary supply in recent months — a policy known as quantitative easing — in an effort to assist the economy. ...

Mr. Wen promised that the increase in the renminbi’s value would continue. But he added: “It should be a gradual process because we must bear in mind its impact on Chinese businesses and the employment situation.”

He stressed that China’s five-year target of a 7 percent annual rise in the gross domestic product should not be considered low, insisting, “it will not be easy for us to achieve.”

High Chinese inflation + nominal remnimbi appreciation = fairly significant real exchange rate appreciation.

The Dollar and the Global Economy

I want to briefly highlight two recent pieces on international monetary policy by Barry Eichengreen, who is always worth reading on the topic. The first highlights similarities between the current international monetary system and that of the 1960s, which ultimately culminated in the collapse of the Bretton Woods regime. It's a nice short article, and succinctly summarizes the positions of the major players. The gist: it's hard for trade-surplus countries to continue to hold down their nominal exchange rates while large deficit countries -- i.e. the U.S. -- pursue an expansionist monetary policy, as that creates high domestic inflation in the surplus countries. Dr. Oatley once referred to the U.S. Fed's policy of "smoking out China's yuan undervaluation", and I think that puts it nicely. A similar confrontation broke Bretton Woods I, and this could break Bretton Woods II.

The second previews Eichengreen's new book, on the role of the dollar as the world's reserve currency, and why it isn't going to change any time soon. He runs down the list of likely contenders and finds them all seriously wanting. He doesn't mention path-dependence, but that is another contributing factor. He also sounds a warning, that U.S. fiscal rectitude is needed to maintain stability in the global economy. Because if the dollar goes down, everything goes down with it.

With exorbitant privilege comes exorbitant responsibility. Responsibility for preventing the international monetary and financial system from descending into chaos rests with the United States. How much time does it have? Currency crises generally occur right before or after elections. Can you say November 2012?

Why Imbalances Will Persist, For Awhile At Least

Martin Feldstein is bullish on macroeconomic imbalances, and walks through the relevant savings-over-investment accounting identities (pdf available here). I recommend reading the whole thing, as its short and gives a very good overview of the situation. Basically, what he's saying is that the U.S.' current account deficit can be, and likely will be, shrinking sharply over the coming years, and it may disappear entirely:

Feldstein imagines the U.S. national saving rate rising by 2% of gross domestic product and budget deficits declining to 3% of GDP from 8%, producing a combined saving rise of 7% of GDP.

“These assumptions about private and public saving may be too optimistic but they indicate that closing the U.S. current account deficit is potentially feasible,” he said.

Meanwhile, China is directing more investment internally–spending more on health care, education and housing–as it looks to raise living standards.

“If China reduces its national saving rate from the current 45% of [gross domestic product] to 40% without a corresponding fall in investment, the result would be to shift China from having a current account surplus to a current account balance or even a small deficit,” he said.

If savings increase in the U.S. and investment does not, our current account deficit necessarily narrows. Likewise, if savings shrink in China and investment does not, their current account surplus necessarily narrows. It's as simple as that, and yet the political and economic forces behind those movements are a bit more complex. So as an outline of what is feasible his analysis is correct. As an outline of what is likely I'm not so sure. I do think imbalances will shrink some over the coming years, but probably not as much as Feldstein alleges. Here's why.

It will likely take five or more years for the U.S. to get back to full employment, which means that the public deficit is not likely to shrink to 3% of GDP any time soon. Politicians talk a lot about that, and so do voters, but I haven't seen any real momentum to get it done. In the meantime, as the financial sector strengthens and the real economy stays weak (prompting the Fed to continue to make cash available at low rates), credit will likely become more available more rapidly than incomes rise. When that happens I would expect savings rates to grow less slow or even decline. Moreover, the continuing aging of the population means that more and more of us will be drawing down private (and public) savings rather than building them up.

It's true that China is allowing the RMB to appreciate at 5% a year, and that internal inflation changes the real exchange rate faster than that, but it's not clear how long those two things will persist. If China has its own property bubble that then pops, we may see savings rates there increase or at least hold steady. Or we may see lower growth rates that again cause savings to go up as wealth creation drops. To me, political reform will have to happen in China before major economic reform happens, and that doesn't seem likely over any short time horizon. In any case, China is only one country, so even if the bilateral Sino-U.S. imbalance lessens, U.S. imbalances with other countries might increase. If enough of that happens simultaneously the overall effect is not clear.

Consider Europe. Europe's real exchange rate has depreciated fairly significantly over the past few years, and Germany has benefited from that as an export-oriented economy. Is it likely that the euro will appreciate much over the next few years? It doesn't look that way to me. How about Africa? While not without problems, several African countries have been growing recently, and the medium-run prospects for the region appear to be improving. This development will likely occur by running current account surpluses with Europe and the U.S. Meanwhile, resource-exporters in the Middle East and elsewhere will continue to benefit from increasing demand and will maintain high current account surpluses.

The politics of current account imbalances is clear: there is no coordination now, and as the global economy remains weak there is not likely to be. Everyone wants everyone else to adjust. Eventually this will change, since things cannot persist this way forever. But over the time period Feldstein is talking about I'm not so sure.

The Afghan Currency Along the Pakistani Border

Many traders in East Afghanistan will not accept their own currency as payment. They would rather sell their goods for Pakistani rupees - to the anger of the Central Bank. Whether cookies or cars: salesmen prefer rupees.

An afghani is actually worth almost twice as much as a Pakistani rupee. But taxi drivers in East Afghanistan think otherwise, which often leads to conflict. Recently, for instance, in the vegetable market in the centre of Jalalabad, a rickshaw driver got into a fight with a customer. The client paid the agreed 50 rupees with a 50 afghani note and demanded change. About 25 afghani. But the driver refused, saying: “As far as I’m concerned, afghanis and rupees are the same”.

For decades, the Pakistani rupee was the main currency in markets and shops in Jalalabad. It still is, despite President Karzai’s financial reforms a few years ago, whereby the introduction of the afghani provided a stable currency for the first time in many years.

1 afghani is worth 1.88 rupees - at least in theory

Pakistan is only a few kilometres away from Jalalabad. Most imports and exports come across this border. Because Afghanistan does not have its own access to the sea, it depends on the Pakistani port of Karachi. Furthermore, roughly 1.7 million Afghan refugees still live in Pakistan. They also contribute to the fact that the economies of both countries in the border region are so closely linked.

Bilal, for example, has a fruit and vegetable shop near Jalalabad. He buys his produce mostly with rupees, so prefers his clients to also pay him in Pakistani money. When he himself goes shopping, he likes to pay in the foreign currency. In this way, he saves himself the hassle of having to exchange money. He also saves money, since money changers give him only half an afghani for every rupee, despite rupees and afghanis having equal value in the market place.

I also found this nugget of information incredibly interesting:

Many government workers benefit from being paid in afghani. As the head of the union of money changers, Ghulam Mustafa Rahimi, confirms, many employees immediately exchange their salary into rupees at the official rate, and so receive more for their money.

There's more on the Afghan currency at Afghanistan Today.

Iceland Is Not A Good Example For Running An Economy

Krugman posts the above graphic showing GDP declines in the Baltics as compared to Iceland. He uses it to argue that the Baltics, which chose internal devaluation rather than sacrifice their exchange rate pegs to the Euro, did much worse than Iceland, which had no currency peg to defend, and so devalued their currency rather than their internal economy. The below picture, covering roughly the same time period, shows this:



Ignore that sharp downward tick at the end and what you see is that the krona fell by roughly half against the euro from the end of 2007 to its 2009-2010 levels, which then stayed fairly constant. To which Krugman says:

Now it’s true that the Baltic countries have been able to maintain their fixed exchange rates. And this is crucial because ….?

I'm not sure if "crucial" is the right word, but a 50% currency devaluation hurts a small open economy like Iceland quite a lot. Before the crisis Iceland mostly produced two goods: fish and finance. It imported almost everything else, and many of those imports came from the eurozone. When its currency dropped in value by 50%, that means that those imports became 100% more expensive. This represents a huge drop in standards of living.

Krugman approvingly references this IMF report on Iceland, noting:

Iceland, as even the IMF says, has been able to “preserve the Nordic social model”; there has been a lot of distress, but not much extreme hardship.

Yes, but according to that report Iceland has only been able to preserve the Nordic social model by exploding sovereign debt from under 30% of GDP pre-crisis to over 115% of GDP now. Of course, servicing that debt becomes much more expensive when the krona is devalued. The IMF also suggests that to get its fiscal house in order Iceland will need to go on its own austerity program to run a 6% of GDP primary surplus over the medium-run. Also note that the Icesave situation has not been resolved; Iceland may yet need to redistribute funds to depositors in Britain and the Netherlands. This will be much more expensive with a devalued currency, but Iceland's IMF funding is contingent upon reaching an agreement.

None of this is to say that the Baltics have had it any better. Output and employment losses have indeed been more severe there, partially because they kept their exchange rate pegs, but also because they are just generally not as well developed politically or economically as Iceland (a member of the OECD with strong economic ties to Europe's center, remember). The point is that these crises are just not easily resolved. The choice between internal devaluation and currency devaluation is not simple for small open economies. Both involve major reductions in standards of living, even if only one of them shows up in the GDP statistics.

The Effect of the Unholy Trilemma on the International System

McMegan can't find anything wrong with Drezner's post about international politics and the unholy trilemma. Let me try to help her. Drezner's is a decent post, but it reads like he might have been a bit short of time because it's a bit under-developed. First, his claim:

The unholy trinity in open economy macroeconomics is pretty simple. It's impossible for a country to do the following three things at the same time:

1) Maintain a fixed exchange rate

2) Maintain an open capital market

3) Run an independent monetary policy

One of the issues with macroeconomic policy coordination right now is that different countries have chosen different options to sacrifice. China, for example, has never opened its capital account. The United States, in pursuing quantitative easing, has basically chucked fixed exchange rates under the bus, no matter how many times Tim Geithner utters he "strong dollar" mantra in his sleep to reporters.

So far so good -- although I'd emphasize more than him that it is possible to do any two of those three, so the choice is which one to neglect, not which one to pursue -- and he's honing in on an important dimension of IPE right now: what happens when the major economies disagree about which two to prioritize? Bretton Woods I emphasized #s 1 and 3; Bretton Woods II emphasized #s 2 and 3 (see graph above). Right now there doesn't appear to be a consensus.

As Drezner notes, right now the U.S. is letting the exchange rate float (which is nothing new; it has been official policy since the early 1970s), China maintains a closed capital account, Brazil is trending towards that direction, the E.U. has sacrificed independent monetary policy within its borders and fixed exchange rates beyond them, the U.K. is allowing sterling to float, Japan is also eschewing a fixed exchange rate, while open exporting economies like S. Korea and Switzerland have worked to protect their exchange rates. Right now nobody is stressing too much about maintaining capital account openness, but this is a relatively new development.

The interesting part of this, to me, is that divergent policies could put states, especially major trading partners, at cross-purposes. This could under-cut the effectiveness of states' domestic policy goals, which could lead to confrontation and instability. Unfortunately Drezner ultimately neglects the question of why different countries will prioritize different policies, and what the implications of those choices are for the macro system. Instead, he argues that we'll see "a lot more capital controls". That's true, but we'll also probably see a lot more central bank activity and a lot more exchange rate manipulation, depending on the domestic political incentives of states. We've already seen increased management along all of these dimensions recently. In other words, I think we should expect a more active role overall for states in managing their economies in the coming decade that in the past one, but different states will prioritize different goals.

What intrigues me is how the financial sector responds to a situation in which their freedom of action in emerging markets becomes more and more constrained. It's possible that they could pressure the Fed to change its position in the future. It's also possible, however, that big firms could see these controls as a useful barrier to entry for new firms.

My money is on the former response, however.

Or they could revert to their default position: the Washington Consensus. The major criticism from the advanced economies of emerging economies prior to the Asian financial crisis was the persistence of capital controls. The major IPE controversy from 1973-2000 or so was the use of the IMF to break those controls down. It's definitely possible that that debate flares up again in the coming years, precisely because capital owners in emerging countries benefit from a more-closed financial system while capital owners in developed countries benefit from a more-open financial system.

We'll have to wait and see, but the longer it takes the global economy to rebound, the stronger these pressures will become.

In Which I Don't Understand What Smart People Are Saying

I guess I'm an idiot, as I can't understand simple things. Paul Krugman says:

One clear result of the midterms is that we won’t have anything like a further round of stimulus. And this, in turn, means that the narrative all the Very Serious People will tell is that fiscal policy was tried, it failed, and that’s that.

To support this he presents two points of data, and only two. They are:

1. Germany's economic decline has been worse than the U.S.'s.

2. Germany's government spending has been higher than the U.S.'s.

From this, he concludes:

3. U.S. government should spend more in order to boost growth. (Or, alternatively, the U.S. didn't really try fiscal stimulus at all.)

As far as I can see, that conclusion is a non sequitur given the data he's presented. He updates the original post to say "Just to be clear, I’m not saying that the Germans were big Keynesians; the point is that neither of us were". Fine. But if there is a correlation between government spending and economic growth during this downturn, that correlation is very clearly negative given the data he's given us. How can we conclude from this that the election narrative that "fiscal policy was tried, it failed" is wrong? The data that he's given supports that very conclusion.

This is not a sophisticated analysis, and there are all kinds of relevant variables that aren't included. But Krugman doesn't say which of those might be mitigating factors. He doesn't qualify the data he presents. It's a really strange conclusion for him to reach. As I've noted before, Germany really messes with the standard Keynesian analysis. Tyler Cowen built off of that post here.

Brad DeLong writes about this post, but doesn't square the circle either. Like Krugman, DeLong is much smarter than me, so I guess I'm missing something obvious. I wish they'd point out what it is.

Also note that this crude analysis supports this recent study on the fiscal multiplier, since Germany has a fixed exchange rate with many of its trading partners, while the U.S. does not.

What am I missing?

Fiscal Stimulus and The Unholy Trilemma

A new NBER working paper (earlier ungated version here) presents a more nuanced view of the effectiveness of fiscal stimulus:

How Big (Small?) are Fiscal Multipliers?

Ethan Ilzetzki, Enrique G. Mendoza, Carlos A. Végh

We contribute to the intense debate on the real effects of fiscal stimuli by showing that the impact of government expenditure shocks depends crucially on key country characteristics, such as the level of development, exchange rate regime, openness to trade, and public indebtedness. Based on a novel quarterly dataset of government expenditure in 44 countries, we find that (i) the output effect of an increase in government consumption is larger in industrial than in developing countries, (ii) the fiscal multiplier is relatively large in economies operating under predetermined exchange rate but zero in economies operating under flexible exchange rates; (iii) fiscal multipliers in open economies are lower than in closed economies and (iv) fiscal multipliers in high-debt countries are also zero.

In other words, maintaining an open economy with flexible exchange rates prevents a country from using fiscal policy to stimulate during downturns. Note that under their definition (total trade = 60% of GDP), the U.S. is far from being an open economy. As such, the authors find that the post-1980 multiplier in the U.S. is 0.3 - 0.4. Additionally, when debt-to-GDP is greater than 50%, fiscal multipliers are nil or negative.

It appears that, once again, governments face a tradeoff between maintaining an open economy and being able to effectively moderate downturns using countercyclical policy tools. More specifically, the effect of monetary vs. fiscal stimulus appears to be moderated by exchange rate policy. Under fixed exchange rates, either capital mobility or monetary independence must be sacrificed. Under floating exchange rates monetary independence may be kept, but there's less room to maneuver on the fiscal side. That can leave a country in trouble if it runs up against the zero lower bound.

We may have to further complicate the Unholy Trilemma. In any case, this is a reminder that policy choices can have far-reaching effects.

FOTD

Currency trading volume around the world has hit $4 trillion a day... None of the BRICs currently account for even 1% of global FX trading (which of course is 0.5% if you try to account for the double-counting.) Meanwhile, the Swedish krona is still 2.2%, and the Norwegian krone is 1.3%.

More here.

More on the Tobin Tax

One of the bloggers at From Davos to Seattle thought I was too harsh on the Tobin Tax last week:

[W]hile the Tobin Tax is certainly not ‘the answer’, it might well be an answer. At the least, it has the potential to become a progressive and effective tool in global economic governance. The strange thing is that however much it might irk the city and financial institutions, the Tobin Tax is an idea that never quite seems to go away. Its simplicity and elegance, together with the fact that it’s not a tax that (directly) impacts much on the ordinary citizen make it perennially popular. One gets the feeling that however much structural power is wielded by those who stand to lose by it, every idea that manages to be both good and popular at the same time will have its time come eventually.

More specifically, the post argues that it doesn't matter if the two given goals of the Tobin tax are in contention (as I claimed), because the primary point is to limit hot money flows in and out of the developing world. Any revenue raised by the tax would be a nice bonus, especially if that cash is given to an international organization for global redistribution (potentially making it a progressive, not regressive, tax), but is not required.

Last part first: no way is that going to happen. Developed countries aren't even living up to their Millenium Development aid promises, and sovereign debt has exploded since the onset of the financial crisis and ensuing recession. These governments are not going to agree to tax investment into their countries and then redistribute the proceeds to poorer countries.

More importantly, if we want to limit hot money flows (and esp. mitigate their negative consequences, like pressures on exchange rates), aren't there ways of doing that more directly? We could institute capital "curfews" that prevent investors from pulling money out of a country during a panic. Indeed, this was advocated during the Asian financial crisis, put in place in Malaysia, and is now part of the IMF's program. Or we could require minimum investment periods upfront as a condition of large financial investment in LDCs, so investors know they cannot prematurely withdraw their funds without steep penalties. All capital controls have their downsides, but at least these would be attacking the problem directly.

Not that that has much of anything to do with our current crisis and recovery. Even proponents of the Tobin tax (like Rodrik) do not imagine that a Tobin tax would have made our present circumstance less dire. Neither would a Tobin tax actually protect countries from exchange rate pressures from capital flight unless it was very large.

So what's the point? What can a Tobin tax do that other, more direct, capital controls cannot do? Perhaps it is more politically palatable than stricter capital controls, but given that the Tobin tax has yet to be tried despite its "simplicity and elegance" (I thought those were derogatory words in economics these days?), that argument doesn't persuade me either. I just don't see the value-added of a Tobin tax relative to the policy options already in our toolkit.