On Global Currencies Jeffrey Frankel, Harpel Professor, Harvard University

1. On Global CurrenciesJeffrey Frankel,Harpel Professor, Harvard University Keynote speech for workshop onExchange Rates: The Global Perspective,sponsored by the Bank of Canada and the European Central Bank, Frankfurt,19 June, 2009.

2. Although it hurts our self-image as scientists to say it, our field has an element of cycles & fads. • Currency boards were as popular in the 1990s as they were unknown before. • And so, with apologies, this lecture is structured in terms of: “What’s Hot” and “What’s Not.”

3. 8 concepts that seem to me to have peaked • the G-7, • global savings glut, • corners hypothesis, • proliferating currency unions, • inflation targeting, • exorbitant privilege of $, • Bretton Woods II, • currency manipulation. 7 IT

4. 8 concepts that seem to me to be on the rise • the G-20, • the IMF, • SDR, • credit cycle, • reserves, • intermediate regimes, • commodity currencies, • multiple international currencies. SDR

5. 1. The G-7 7 • The global steering group gave us • Rambouillet, to ratify floating (1975). • the Plaza, to bring down the $ (1985), and • the Louvre, to halt $ depreciation (1987). • But the G-7 membership is out-of-date • Expansion to G-8: much too little (and too late). • How can you talk about RMB without China at the table?

6. 2. Global Savings Glut • Global Current Account Imbalances debate, 2001-08 • On one side:those who argued that US current account deficits • had domestic origins (low National Saving), • were unsustainable, and • would eventually cause abrupt $ depreciation. • Obstfeld-Rogoff, 2001, 2005; Roubini, 2004; Summers, 2004; Chinn, 2005; Blanchard, Giavazzi & Sa, 2006; Frankel 2007b… • On the other side (sustainability): • Global savings glut: Bernanke, Clarida…; • Other arguments (dark matter, exorbitant privilege…).

7. The 2007-09 crisis has not resolved the CA imbalances debate. • Reaction of the unsustainability side:this is the crisis they were warning of. • One response from the other side: the savings glut caused the crisis.

8. Regardless, • Saving will now fall globally. • In the short run, governments are responding to the recession by increasing their budget deficits. • In the long run, spending needs created by retiring population & rising medical costs will continue to reduce saving, both public & private. • In response, long-term real interest rates should rise, from the recent low levels. • Thus, I declare the savings glut dead. †

9. 3. Corners Hypothesis • The corners hypothesis: the proposition that countries are—or should be—moving to the corner solutions in their choice of exchange rate regimes. • They were said to be opting either, • on the one hand, for floating, or, • on the other hand, for rigid institutional commitments to fixed exchange rates, in the form of currency boards or currency union with the $ or €. • It was said that the intermediate exchange rate regimes were no longer feasible.

10. Origins, • In the context of the ERM: Eichengreen (1994) & Crockett (1994); • In the context of emerging market crises: Obstfeld & Rogoff (1995) , Summers (1999), Eichengreen (1999), Fischer (2001), Minton-Beddoes (1999), CFR (1999), G-7, IMF, and even the Meltzer Report (2000) ….

11. The Corners proposition was never properly demonstrated, either theoretically or empirically. • The collapse of Argentina’s convertibility plan in 2001 marked the beginning of the end. • Today, most countries continue to occupy the vast area in between floating and rigid institutional pegs. • It is much less common to hear that intermediate regimes are a bad choice generically. • A target zone/ basket would make sense for the RMB. • Thus I declare the Corners Hypothesis dead.†

12. 4. Proliferating Currency Unions • The successful attainment of EMU 10 years ago was truly historic. • In many ways, skeptics were proven wrong (American economists in particular) : • The disappearance of 11 national currencies in 1999 took place without a hitch; • the first 5 eastward additions also went smoothly. • After some early bumps, • the € established a reputation for strength and • the ECB established a reputation for rectitude • with board members voting in the European best interest rather than for national constituencies.

13. In some other parts of the world, dormant regional solidarity movements perked up. • Inspired in large part by the Euro example, monetary integration was actively discussed in • East Asia, • Africa (particularly within West, Southern, & East Africa, respectively), and • the Gulf. • The GCC set 2010 for adoption of a common currency.

14. Now, the bloom is off the rose. • In euroland, some of the drawbacks that skeptics had warned of have come true after all. • 1st , the SGP proved utterly unenforceable. • 2nd, forcing the same interest rate on Dublin as Frankfurt has proven inconvenient indeed. • Easy monetary policy helped carry Ireland from Celtic Tiger to real estate bubble, and arguably is the cause of the country’s severe recession.

15. Should we score the promotion of intra-euroland trade as a “plus” or a “minus” for the €?. • On the one hand, estimates show a significant effect of 15% over the first 8 years of the €, • better than would have been expected before 1999; • and with no trade diversion. • On the other hand, these estimates fall far short of the tripling found in earlier smaller currency unions by Rose (2000) & successors. • In Frankel (2009),I : • find the gap is not shrinking, • list three possible explanations, • and present evidence against each of the three. • I.e., the gap remains a mystery.

16. Table 2 -- Frankel (2009) Effect becomessignificant in 1999 Reaches 16% in 2001 Steady through 2006 16

17. Meanwhile, the proposals for monetary integrations in other regions have gone nowhere. • The Gulf MU survived the blows of an Omani demurral & Kuwaiti revaluation, but could not withstand the direct hit by the United Arab Emirates when it withdrew in May 2008. • It may be some time before the world sees another new currency union.

18. 5. Inflation Targeting(narrowly defined) IT • Monetary economics has for 3 decades been built on fighting inflation by means of a nominal anchor • The nominal anchor in the early 1980s was M1; • … in the early 1990s was exchange rate target; • …in the 2000s has been IT.

19. Inflation Targeting:is now 20 years old among rich countries, and 10 years old among emerging markets. IT Source: IMF Survey. October 23, 2000. Andrea Schaechter, Mark Stone, Mark Zelmer IMFt. Online at: http://www.imf.org/external/pubs/ft/survey/2000/102300.pdf

20. Inflation targeting is the reigning orthodoxy IT among economists, central bankers, IMF… • Of course, “flexible inflation targeting” says you can respond in part to output in the short run, as in Taylor Rule. • “Have a long run target for inflation, and be transparent.” • Who could disagree?

21. IT • But many countries who say they are doing IT aren’t. Fear of floating. Why? 1st drawback of combination of IT(with CPI) + float: • Gives wrong answer to supply shocks: • E.g., in response to a rise in world oil import prices, it says to tighten monetary policy and appreciate. • In response to rise in export commodity’s world price, IT precludes monetary tightening & appreciation. • => IT (with CPI) is exactly backwards: • We should accommodate trade shocks. • Solution (for countries with variable terms of trade) : • target PPI or export price index, not CPI.

22. IT 2nd drawback of IT (for advanced countries) • IT says to pay no attention to asset prices, except to the extent they portend inflation. • Until recently, the Greenspan view had dominated over the BIS view. • Greenspan view: • we can’t identify stock or real estate bubbles; and • CBs do better to cut i in the aftermath than to raise i in the upswing. • BIS view: in a credit cycle, too-easy monetary policy shows up in asset prices, followed by a costly crash. No inflation in between. • US 1929 crash • Japan 1986-98 bubble • East Asia 1997 crisis

23. IT • But the crisis of 2007-09 confirms the BIS view • The stock and housing bubbles were easier to identify than future inflation is. • The “Greenspan put” exacerbated the bubbles. • The global crisis’ consequences have been severe. • Of course, regulatory tools are more appropriately targeted to deal with a bubble than i. • But if/when they are not enough, it now seems clear that monetary policy should pay some attention.

24. 6. 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.

25. When does the “privilege” become “exorbitant?” • if it accrues solely because of size and 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 long-term loss in value compared to other major currencies. • It seems unlikely that macroeconomic policy discipline is what has earned the US its privilege.

26. Some argue that the privilege to incur $ liabilities has been earned in a different way: • The US appropriately exploits its comparative advantage in supplying high-quality assets to the rest of the world. • Caballero, Farhi and Gourinchas(2008):“Intermediation rents…pay for the trade deficits.” • In one version, the United States has been operating as the World’s Venture Capitalist, accepting short-term liquid deposits and making long-term or risky investments (Gourinchas & Rey, 2008). • US supplies high-quality assets:Cooper (2005); Forbes (2008); Ju & Wei (2008):Hausmann & Sturzenegger (2006a, 2006b);Mendoza, Quadrini & Rios-Rull (2007a, b)…

27. The argument that the US supplies assets of superior quality, and so has earned the right to finance its deficits, has been undermined by dysfunctionality that the financial crisis suddenly revealed in 2007-08. • American financial institutions suffered a severe loss of credibility (corporate governance, accounting standards, rating agencies, derivatives, etc.), • Many banks & non-banks have ceased to operate. • How could sub-prime mortgages, CDOs, & CDSs be the superior type of assets that uniquely merit the respect of the world’s investors?

28. But the last year’s events have also undermined the opposing interpretation, the unsustainability position: • Why did the $ not suffer the long-feared hard landing? • The $ appreciated strongly after Lehman Brothers’ bankruptcy, and US T bill interest rates fell. • Clearly in 2008 the world still viewed • the US Treasury market as a safe haven and • the US $ as the premier international currency. • Although the more exotic arguments about the uniquely high quality of US private assets have been tarnished, the basic idea of America as World Banker is still alive: the $ is the world’s reserve currency, by virtue of U.S. size & history.

29. Is the $’s unique role an eternal god-given constant? or • will a sufficiently long record of deficits & depreciation induce investors to turn elsewhere? • There is now a potential rival: the € . • In Chinn & Frankel (1997) we estimated & project shares of the major currencies in the reserve holdings of all central banks.

30. Table 2: Determinants of Reserve Currency Shares (logit form) Pre-EMU Panel Regression, 1973-98(182 observations) Coefficient estimates Standard errors GDP ratio (y) 0.115 [0.049] Inflation diff (π) -0.143 [0.063] Exrate var (σ) -0.055 [0.032] FX turnover (to) 0.023 [0.016] GDP leader 0.026 [0.014] lagshare (sh t-1)0.904 [ .029] Adj R2 0.99 Source: Chinn & Frankel (2007). • Notes: Dependent variable is shares. • Estimated using OLS, no constant. • All variables are in decimal form. • GDP at market terms. • Figures in bold face are significant at the 10% level.

32. In the short run, however, the financial crisis caused a flight to quality which evidently still means a flight to US$. • US Treasury bills in 2008 were more in demand than ever, as reflected in very low interest rates. • The $ appreciated in 2008, rather than depreciating as the “hard landing” scenario had predicted. • => The day of reckoning had not yet arrived. • Recent Chinese warnings may be a turning point: • Premier Wen worried US T bills will lose value. • PBoC Gov. Zhou proposed replacing $ as international currency.

33. 7. Bretton Woods II • 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.

34. My own view on Bretton Woods II: • The 1960s analogy is indeed very 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 process by expansionary fiscal & monetary policies (driven by the Vietnam War & Arthur Burns, respectively). • These policies produced: declining external balances, $ devaluation, & the end of Bretton Woods. • There is no reason to expect better today. • 1st , capital mobility is much higher now than in the 1960s. • 2nd, the US can no longer 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(these creditors are not the staunch allies the US had in the 1960s).

35. 8. Currency Manipulation • In 2007, the IMF was made responsible for exchange rate surveillance, • by which the US meant telling China the RMB was below the appropriate level. • “Unfair currency manipulation” has had official status in US law for 20 years and in IMF Articles of Agreement for longer. • In practice, the supposed injunction on surplus countries to revalue upward has almost never been enforced, in contrast to the pressure on deficit countries to devalue. • Some would say it is time to rectify the asymmetry. [1] • My view: it is time to recognize two realities: • (1) One cannot normally tell with confidence the fair value of a currency. • (2) Creditors are, and will always be, in a stronger power position than debtors. • Let’s retire the language of unfair currency manipulation, which dilutes the legitimacy of the language of international trade agreements. [1] E.g., Goldstein (2003, 04, 07).

36. Message to US politicians: Be careful what you wish for! $2

37. If those 8 are on the way out,what is taking their place?

38. 1. The G-20 • The meeting of the G-20 in London in April had some substantive successes and some failures. • A turning point? The more inclusive group may now be more central than the G-7, thereby giving major developing/emerging countries some representation at last. • If so, that is the most important thing that happened at the meeting.

39. 2. The IMF • Just two years ago, the conventional wisdom was that the Fund no longer had a job to do in fighting crises, and that it was in danger of irrelevance. • The staff was cut back, taking effect just as the international financial crisis started in 2007. • Now the IMF is once again busy • Country programs • Hiring • The membership has agreed to increase its resources.

40. SDR 3. SDR • More surprising is the comeback from near-oblivion of the Special Drawing Right as a potential international money. • The G20 in April decided to create new SDRs. • Shortly later, PBoC Gov. Zhou proposed replacing the $ as lead international currency with the SDR. • The proposal has been revived for an international substitution account at the IMF, to extinguish an unwanted $ overhang in exchange for SDRs. • Some major region or country, such as China itself, would have to adopt the SDR as its home currency – unlikely – before it stood much chance of standing up as a competitor to the € or ¥, let alone to the $. • Still, the SDR is back in the world monetary system.

41. Roles of International Currency

42. 4. Credit Cycle • For 30 years, monetary economics has held thatexcessive monetary expansion was synonymous with inflation getting out of control, necessitating monetary contraction to get back to stability, • and that this is where recessions come from. • That pattern did fit the recessions of 1974, 1980, 1981-82, and 1990-91. • Forgotten were earlier notions of cyclicality: • the credit cycle of von Hayek, • the bubbles & panics of Kindleberger, • the Minsky moment, and • Irving Fisher’s debt deflation.

43. Now Alan Greenspan can be answered: • (i) Yes, identifying bubbles is hard, but no harder than identifying inflationary pressures 18 months ahead; • (ii) monetary authorities do actually have tools to prick speculative bubbles, and; • (iii) the habit of coming to the rescue of the markets after the crash (the “Greenspan put”) created a moral hazard problem which exacerbated the bubbles; and • (iv) the cost in terms of lost output can be enormous, even when the central bank eases very aggressively.

44. Thus another reason why central banks should not focus exclusively on inflation. • Perhaps the credit cycle even provides the long-lost rationale for the ECB’s continued insistence on placing the M1 pillar alongside the inflation pillar !

45. 5. Reserves • Developing & emerging market countries took advantage of the boom of 2003-2008 to build up reserves to unheard of heights. • in the aftermath of the crises of 1994-2001. • (Floaters did it as much as peggers.) • In contrast to past capital booms.

46. This time(2003-07),many countries used the inflowsto build up forex reserves, rather thanto finance Current Account deficits(as in 1990s) Asia crisis 3rd boom 2nd boom international debt crisis

47. A mere 2 years ago, economists thought reserves were excessive in many of these countries. • L. Summers • D. Rodrik • O. Jeanne. • Most of the reserves were held in the form of US Treasury bills, which earn low returns, because of both low US Treasury bill rates and trend depreciation of the $. • The implication: central banks should • (i) allow more appreciation / less reserve accumulation, • (ii) diversify the reserves they do hold. • But when the crisis hit them in 2008 • Those countries that had high reserves did better • e.g., Obstfeld, Shambaugh & Taylor (2009)

48. 6. Intermediate regimes are back in: • a majority of IMF members, • especially if one uses de facto classification. • target zone (band) • basket peg • crawling peg • adjustable peg

49. Synthesis of techniques for inferring flexibility parameter and for inferring basket weights(Frankel & Wei, IMF Staff Papers, 2008; Frankel PER, 2009) Δ log Ht = c + ∑ w(j) Δ logX(j)t + ß {Δ empt } + ut = c + w(1)Δ log $ t+ w(2) Δ log € t + w(3) Δ log ¥ t + w(4) Δ log £t + … + ß {Δ empt } + u t where H ≡ value of home currency, X(j)≡ value of foreign currency j,defined in terms of suitable numeraire, like SDR w(j) ≡currency weights in basket,to be estimated; Δ empt≡ change in Exchange Market Pressure ≡ Δ log Ht + (ΔRest )/Monetary Baset ß ≡flexibility parameter,to be estimated:ß=1 => the currency floats purely(no changes in reserves);ß=0 => the exchange rate is purely fixed.

50. 7. Commodity Currencies • Agricultural & mineral commodities were “out” in the 1990s; and back “in,” this decade. • A few countries with commodity-concentrated exports float. They have “commodity currencies”: • they tend to appreciate when the world market for their export commodities is strong, as during 2001-08, and depreciate when it is weak, as in 1990s & late 2008 . • Plenty of references. E.g., • some Bank of Canada papers for C$; • Chen & Rogoff (2003) for Australia & NZ $; • and Frankel (2007) for South African rand.