Jeffrey Frankel Harpel Professor, Harvard University

1. In the Aftermath of Global Financial Crisis: Implications of a New Economic Order with the G20 Jeffrey FrankelHarpel Professor, Harvard University 25th anniversary of the KAEAAllied Social Science Association Meetings Atlanta, January 4, 2010

2. Congratulations to the Korea-America Economic Associationon its 25th anniversary • Where were we 25 years ago? • Korea • US • What has changed? • Where are we headed now, after the 2007-09 crisis, and with Korea chairing the G20?

3. 25 years ago in Korea: January 1985 • The Korean economic miracle was well under way, • although income was still far below that of industrialized countries. • After decades of dictatorship, the country was taking its first major steps to democracy, • including toward a two-party system in the National Assembly elections in Feb.1985.

4. 25 years ago in the US: January 1985 • Pres. Reagan was starting his 2nd term • proclaiming “Morning in America” • The $ was about to peak at its all-time high; • the G-7 had not yet agreed on a managed depreciation. • The current account was hitting record deficits. • The Treasury’s interpretation of the deficits: capital was flowing into the US because it was a wonderful place to invest.

5. Others interpreted the US trade deficit much more negatively • The US was said to be in decline • The “hollowing out” of manufacturing. • Paul Kennedy’s The Rise and Fall of the Great Powers. • Japan was thought a juggernaut, taking over the world economy. • Ezra Vogel’s Japan as Number One • Chalmers Johnson’s MITI and the Japanese Miracle, etc.

6. Japan (and the Asian NIEs) were said to have a superior model of capitalism • “Asian values” • Long horizons • Keiretsu / chaebol • Low cost of capital • Relationship banking • Government guidance • Pro-saving financial system • Lifetime employment (in the case of Japan) • Firms maximize size (capacity or market share)

7. In between “US in decline” and “Morning in America” was a reasonable middle position: • The US trade deficit and Japanese surplus were problems, but they resulted from National Saving patterns: • Low NS in the US (<= budget deficits) and • High NS in Japan (<= budget surplus & aging-driven household saving). • US global leadership was not exhausted. • Joe Nye’s Bound to Lead

8. As soon as the 1990s started,1980s assumptions were proven wrong • The US triumphed militarily in the Gulf War (1991). • The US triumphed politically with the fall of the Soviet Union (1991). • The Japanese model burst, • along with its land-stock-market bubble (1990) • and economy (1991-…) .

9. And as the 1990s progressed, • the US experienced the longest economic expansion of its history; • America was declared to have a New Economy. • Currency crises hit Korea, and Southeast Asian countries in 1997-98. • And Asians were told to emulate the US model, especially its financial system: • corporate governance, accounting standards, • consumer finance, innovative products, • securities markets, rating agencies, and • Anglo-American style banking (market-oriented & arms-length)

10. But as soon as the 2000s started,the 1990s assumptions were proven wrong • Bursting of the US dot-com bubble (2000). • Failure of US electoral institutions (Nov.2000). • Failures of Sept.11(2001) & US response (Iraq, Guantanamo) • Failure of US corporate governance in scandals of Enron, etc. (2001). • Decade of flat median income and rising debt.

11. Financial crisis (2007-2009) • Bursting of US housing bubble (2006) • inevitably led to sub-prime mortgage crisis (2007). • Less predictably, failures of US financial system led to disappearance of liquidity (2008) • and the 2nd recession of the decade, • the worst since the 1930s. • The rest of the world followed.

12. Who got pieces of it right, beforehand? • Krugman: If a Depression can happen in Japan, it can happen in any modern economy. • Rajan: Failures of corporate governance. • BIS (Borio & White): Too-easy credit, via asset prices, leads to crises -- with no inflation in between. • Shiller: US housing price bubble. • Gramlich: Homeowners are taking mortgages that they can’t repay. • Rogoff: “This Time Is Not Different.” • Roubini: The recession will be severe.

13. The US has lost its claim as an exclusive model for others to emulate The desirable principles haven’t changed, only the claim that the US uniquely embodies them • Open democracy, rule of law • Competition in goods markets • Corporate governance focused on long-term shareholder value, • not executives’ options prices • nor empire-building. • Government intervention to address market failure • E.g., tax pollution (don’t subsidize fossil fuels). • Supervise banks, under rules (don’t take them over).

14. The US is in a hole • Adroit monetary & fiscal management has succeeded in limiting the length & severity of the recession. • The turning point was probably early summer, 2009 • => we have avoided the mistakes of • the Depression, • or Japan’s lost decades. • But the long-term fiscal outlook – already bad – has gotten worse.

15. The same with other major industrialized economies. • A remarkable role-reversal: • Debt/GDP of the top 20 rich countries • (≈ 80%) is already twice that of the top 20 emerging markets; • and rising rapidly. • By 2014 (at ≈ 120%), it could be triple.

16. The US financial positionhas deteriorated internationally • The twin deficits • China is now our largest creditor • The dollar appears in long-term decline.

17. Exorbitant Privilege of $ • Among those who argue that the US current account deficit is sustainable are some who believe that the US will continue to enjoy the unique privilege of being able to borrow virtually unlimited amounts in its own currency.

18. When does the “privilege” become “exorbitant?” • if it accrues solely because of size & history, without the US having done anything to earn the benefit by virtuous policies such as budget discipline, price stability & a stable exchange rate. • Since 1973, the US has racked up $10 trillion in debt and the $ has experienced a 30% loss in value compared to other major currencies. • It seems unlikely that macroeconomic policy discipline is what has earned the US its privilege !

19. The “Bretton Woods II” hypothesis • Dooley, Folkerts-Landau, & Garber (2003) : • today’s system is a new Bretton Woods, • with Asia playing the role that Europe played in the 1960s—buying up $ to prevent their own currencies from appreciating. • More provocatively: China is piling up dollars not because of myopic mercantilism, but as part of an export-led development strategy that is rational given China’s need to import workable systems of finance & corporate governance.

20. My own view on “Bretton Woods II”: • The 1960s analogy is indeed apt, • but we are closer to 1971 than to 1944 or 1958. • Why did the BW system collapse in 1971? • The Triffin dilemma could have taken decades to work itself out. • But the Johnson & Nixon administrations accelerated the processby fiscal & monetary expansion (driven by the Vietnam War & Arthur Burns, respectively). • These policies produced: declining external balances, $ devaluation, & the end of Bretton Woods.

21. There is no reason to expect better today: • Capital mobilityis much higher now than in the 1960s. • The US can no longer necessarily rely on support of foreign central banks: • neither on economic grounds(they are not now, as they were then, organized into a cooperative framework where each agrees explicitly to hold $ if the others do), • nor on political grounds(China & OPEC are not the staunch allies the US had in the 1960s). 3) A possible rival currency to the $ exists.

22. Central banks’ reserve holdingsFrankel & Chinn (2007)estimated effects of country size, market depth, ability to hold value, and network effects Simulation suggests € could overtake $ by 2022.

23. When will the day of reckoning come? • Not in 2008: In the short run, the financial crisis caused a flight to quality which evidently still meant a flight to US $. • Chinese warnings in 2009 may have marked a turning point: • Premier Wen worried US T bills will lose value.On Nov. 10 he urged the US to keep its deficit at an “appropriate size” to ensure the “basic stability” of the $. • PBoC Gov. Zhou in March proposed replacing $ as international currency, with the SDR.

24. The global monetary systemmay move from dollar-based to multiple international reserve currencies • The € could challenge the $. • The SDR is again part of the system. • Gold in2009 made a comeback as an international reserve too. • Someday the RMB will join the roster with ¥ & ₤. • = a multiple international reserve asset system. SDR

25. Lessons from the global financial crisis of 2008-09 • For emerging markets • Decoupling? • What characteristics suited countries to weather the storm of 2008-09 better than others? • For the field of macroeconomics: • phylloxera analogy. • For global governance: the G20.

26. Decoupling? • Initial hopes of decoupling succumbed at the height of the crisis: • Financial contagion • Asian exports were especially hard-hit.

27. Asian exports plummeted via RGE Monitor 2009 Global Outlook

28. But, in the end, there was a measure of decoupling after all. • Asia has come roaring back. • Asia now constitutes an independent “growth pole” in the world.

29. Which bystanders got hit the worst by the global liquidity crisis of 2008? • Most emerging markets had followed the lessons of the 1990s crises: • small or no current account deficits • more flexible exchange rates • more reserves • less short-term & $-denominated loans • Those that didn’t are those that got into worse trouble: Central & Eastern Europe.

30. The Early Warning Indicators literature, updated • Reserves • Economists wondered if emerging market reserves had gotten too high by 2007 – • Jeanne (2007), Summers (2006), Rodrik (2006) • But high reserves appear to have paid off in 2008. • Aizenman (2009) and Obstfeld, Shambaugh & Taylor (2009, 2010) • Low short-term foreign debt • Sachs, Tornell & Velasco (1996), Frankel-Rose (1996), Guidotti Rule, • Bussiere, Frankel & Matthieu (2010) • Other leading signals • Equity prices: Kaminsky, Lizondo & Reinhart (1998); Rose & Spiegel (2009) • See also Wei & Tong (2010)

31. “Where should mainstream macro go,inlightofthe2007-09 globalfinancialcrisis?” • Some models that had been thriving in an emerging markets context may now help answer this question. • Some were applications of models originally designed for advanced-country financial markets, but never fully incorporated into the mainstream macro core. • A possible explanation why they had been transplanted to emerging markets: assumptions of imperfections in financial markets were considered more acceptable there, than in the context of advanced economies.

32. Financial crises: Not just for emerging markets anymore.An analogy • In the latter part of the 19th century most of the vineyards of France were destroyed by Phylloxera. • Eventually a desperate last resort was tried: grafting susceptible European vines onto resistant American root stock. • Purist French vintners initially disdained what the considered compromising the refined tastes of their grape varieties. • But it saved the European vineyards, and did not impair the quality of the wine. • The New World had come to the rescue of the Old.

33. Implications of the 2008 financial crisis for macroeconomics? • In 2007-08, the global financial system was grievously infected by “toxic assets” originating in the United States. • Many ask what fundamental rethinking is necessary to save orthodox macroeconomic theory. • Some answers may lie with models that have been applied to the realities of emerging markets. • Purists may be reluctant to seek help from this direction. • But they should not fear that the hardy root stock of emerging market models is incompatible with fine taste.

34. What are some of these models? • Asymmetric information • Credit rationing (Stiglitz…) • Need for collateral (Kiyotaki & Moore, Caballero…) • The credit channel (Bernanke & Gertler… ) • Balance sheet effects (Calvo…) • Bank runs & multiple equilibria (Diamond & Dybvyg; Velasco…) • Speculative attacks (Krugman; Obstfeld; Morris & Shin…) • Moral hazard & incentive incompatibility (Dooley; McKinnon & Pill…)

35. Also newly relevant are some almost-forgotten and less-formalized notions of cycles: • the credit cycle of von Hayek, • the bubbles & panics of Kindleberger, • the Minsky moment, and • Irving Fisher’s debt deflation.

36. The G-20 • G-20 meetings in 2009: • London in April • Pittsburg in October

37. How successful were the measures supported by US & Korea at the G-20 meetings (2009)? • Coordinated fiscal stimulus to fight the recession • as in the locomotive plan of G7’s Bonn Summit of 1978: • no formal agreement, but it seemed to happen anyway. • Unexpected revival of the SDR and tripling IMF resources • The usual agreement for a standstill/rollback in trade barriers. Some backsliding followed, & little progress in Doha Round; • on the US side: • tariffs on Chinese tires, • inability to ratify FTAs. • But, so far, not a bad trade record, for a severe recession. SDR

38. Whatever the causes of the great recession, the policy response avoided 1930s mistakes: • No Smoot-Hawley tariffs • No failed London Economic Summit • Aggressive monetary expansion rather than contraction. • Fiscal expansion too.

39. The true significance of the G-20 in 2009 • The G-20 accounts for 85% of world GDP. • A turning point: The more inclusive group has suddenly become central to global governance, eclipsing the G-7, and thereby at last giving major developing/emerging countries some representation, • after decades of fruitless talk about raising emerging-market representation in IMF.

40. The G-20 and Korea • Korea has assumed the presidency • this week (Jan. 4, 2010) • The first non-G7 host of the G20. • Canada & Korea will host the meetings in June & November, respectively.

41. Implications for Korea • Korea is the bridge between the G-7 and developing countries. • Especially China & India • What can the G-20 accomplish for Korea? • What can the G-20 accomplish for the world?

42. Opportunity/burden for Korea • Will chairing the G-20 help consolidate Korea’s status as an advanced economy? • Yes, as did: • hosting the Olympics, • joining the OECD, • attaining the per capita income of some industrialized countries ($20,000 ≈ Portugal). • But Korea should now seize the chance to exercise substantive leadership. • Otherwise, the risk is Czech presidency of EU…

43. Four items on G-20 agenda for 2010 • Possible financial regulatory reform • Some steps underway in Basle, Financial Stability Forum • The Europeans would like more, but are unlikely to get it. • Personally, I might favor a small global tax on financial transactions. • Macroeconomic exit strategies • Global imbalances between developing countries and industrialized • US and China should both admit responsibility • US: the budget deficit is too big. Needs to be fixed. • China: RMB is too low. Needs to be unfixed. • Post-Copenhagen progress toward new agreement on climate change to take effect 2012.

44. Two principles of multilateral institutions 1. It is inevitable that more power go to large-GDP countries than small. • This is why IMF works better than UN . • The problem is that China, India, Korea, Brazil, etc.,are larger than Canada, Netherlands… Hence the G-20. • The outcome must leave small countries better off, of course, or they will not go along. 2. Conversation is not possible with more than 20 in the room.

45. Example: many rounds of trade negotiations under the GATT. • Worked well for years, • with small steering groups (US-EU, the Quad & G-7) • and few demands placed on developing countries. • Failed when developing countries had become big enough to matter, • but were not given enough role: • Doha Round

46. Conversation is not possible with more than 20 people in the room. • Delegates just read their talking points. • The latest evidence: The Climate Change CoP in Copenhagen • The UNFCCC proved an ineffectual vehicle • Incompetent management of logistics • Small countries repeatedly blocked progress • Obama was able to make more progress at the end with a small group of big emitters. • Korea is in a good position to build on this progress • As the 1st non-Annex I country to take on binding emission targets. • To be honest, the G-20 is too big. • My recommendation: an informal steering group within G-20.

48. Addenda • 1. Origins of the financial crisis. • 2. The US current account deficits • What about the economists who argue that they are sustainable? • 3. Global climate change negotiations. • A proposed new architecture.

49. 1. Origins of the crisis in the US Well before 2007, there were danger signals: Real interest rates <0, 2003-04; Early corporate scandals (Enron 2001…); Risk was priced very low, • housing prices very high, • National Saving very low, • current account deficit big, • leverage high, • mortgages imprudent…

50. US real interest rate < 0, 2003-04 Source: Benn Steil, CFR, March 2009 Real interest rates <0