This lecture is structured in terms of: “ What’s Hot” & “What’s Not.”

1. “What’s Hot and What’s Not” in Global Currency EconomicsJeffrey Frankel,Harpel Professor, Harvard University Beijing Government Senior Executive Management ProgramHarvard Asia Program and Mass InsightNovember 10, 2009based on "What’s 'In' and What’s 'Out' in Global Money," Finance and Development, IMF, September 2009; and “On Global Currencies,” ECB, June 2009.

2. This lecture is structured in terms of: “What’s Hot” & “What’s Not.” • 5 concepts that seem to me rising in importance • and 5 concepts that they would be replacing.

3. 5 concepts that seem to me to have peaked • the G-7 • corners hypothesis • “currency manipulation” • inflation targeting • exorbitant privilege of $ global savings glut, Bretton Woods II,… 7 IT

4. 5 concepts that seem to me to be on the rise • the G-20 & the IMF • intermediate regimes • reserves • fighting asset bubbles • 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 • But the G-7 membership is out-of-date • Expanded to G-8, but much too little (and too late). • How can we talk about RMB without China at the table?

6. 1. The G-20 • The meetings of the G-20 in London in April and Pittsburg in October had some substantive successes (and some failures). • A turning point: The more inclusive group has suddenly become more central than the G-7, thereby at last giving major developing/ emerging countries some representation. • That is the most important thing that happened at the meetings.

7. 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: Iceland, Hungary, Romania, Latvia, Ukraine, Pakistan… • Hiring • The membership has agreed to increase Fund resources.

8. 2. 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.

9. 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.†

10. 2. 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

11. 3. “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).

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

13. 3. 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.

14. This time(2003-08),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

15. 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 apparently did better: • e.g., Obstfeld, Shambaugh & Taylor (2009) . • Having said that, China has carried reserve accumulation too far for its own good.

16. 4. 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.

17. Inflation Targeting:is now 20 years old among rich countries, and 10 years old among emerging markets. IT Source: IMF Survey. Oct. 23, 2000. A.Schaechter, M.Stone, M.Zelmer IMF. At: http://www.imf.org/external/pubs/ft/survey/2000/102300.pdf

18. 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?

19. IT • But many countries who say they are doing IT aren’t. Fear of floating. Why? 1st drawback of combination of IT(with CPI): • 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.

20. IT 2nd drawback of IT • 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 • Central Banks 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 crash 1929 • Japan bubble 1987-89 • East Asia crisis 1997-98 • Sub-prime mortgage crisis 2007-8

21. IT • But the crisis of 2007-09 confirms the BIS view • The stock market 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.

22. 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 recessions of 1974, 80, 81-82, & 90-91.

23. 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.

24. Bursting bubbles • 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; • (iii) the habit of rescuing 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.

25. 5. 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.

26. 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 !

27. Some argue that the privilege to incur $ liabilities has been earned in a different way: • Global savings glut(Bernanke) • The US appropriately exploits its comparative advantage in supplying high-quality assets to the rest of the world. • “Intermediation rents…pay for the trade deficits.” -- Caballero, Farhi & Gourinchas(2008) • 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, b);Mendoza, Quadrini & Rios-Rull (2007a, b)…

28. Global Savings Glut • Global Current Account Imbalances debate, 2001-07 • 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, 05) ; Roubini (2004); Summers ( 2004); Chinn (2005) ; Blanchard, Giavazzi & Sa (2006) ; Frankel (2007b) … • On the other side (sustainability): • Global savings glut: Bernanke, Clarida…; • Other arguments, e.g.,exorbitant privilege, dark matter…

29. 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.

30. 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. †

31. 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.). • Some 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?

32. But 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 after Lehman Brothers’ bankruptcy, & 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.

33. Though arguments about the unique high quality of US private assets have been tarnished, the idea of America as World Banker is still alive: the $ is the world’s reserve currency, by virtue of US size & history. • Is the $’s unique role an eternal god-given constant? or • will a sufficiently long record of deficits & depreciation induce investors to turn elsewhere?

34. “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.

35. 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.

36. There is no reason to expect better today: • Capital mobilityis much higher now than in the 1960s. • 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).

37. There is now a potential rival: the € . • In Chinn & Frankel(2007)we estimated & projected shares of the major currencies in the reserve holdings of central banks.

39. In the short run, the financial crisiscaused a flight to quality which evidently still means a flight to US $. • Although the day of reckoning did not arrive in 2008, • Chinese warnings in 2009 may have marked a turning point: • Premier Wen worries 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.

40. 5. Multiple International Currency System • I have said the € could challenge the $. • The SDR has come back from the dead in 2009. • Gold has made a comeback as an international reserve too. • Someday the RMB will join the roster with ¥ & ₤. • = a multiple international reserve currency system. SDR

41. SDR SDR • More surprising is the comeback from near-oblivion of the Special Drawing Right as a potential international money. • The G20April & IMF decided to create new SDRs ($250b). • Shortly later, PBoC Gov. Zhou proposed replacing the $ as lead international currency with the SDR. • The IMF is now borrowing in SDRs. • The proposal has been revived for an international substitution account at the IMF, to extinguish an unwanted $ overhang in exchange for SDRs. • The SDR has little chance of standing up as a competitor to the € or ¥, let alone to the $, without some major region or country, such as China itself, adopting it as home currency. • Still, it is back in the world monetary system.

42. Gold • Until very recently, central bank holdings of gold was considered an anachronism. • Central banks were gradually selling it off. • Now gold is back on the list of international reserve assets • China bought gold in early 2009. • India bought 200 tons in November

43. A multiple reserve currency system is inefficient, in the same sense that barter is inefficient: money was invented in the first place to cut down on the transactions costs of exchange. • Nevertheless, if sound macro policies in the leader country cannot be presumed, the existence of competitor currencies gives the rest of the world protection against the leader exploiting its position by running up too much debt and then inflating/depreciating it away.

44. http://ksghome.harvard.edu/~jfrankel/index.htm

45. Appendix 1: (1a) Origins of the Corners Hypothesis (1b) Inferring Intermediate Regimes • Origins of the Corners Hypothesis, • 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) ….

46. Synthesis of techniques for inferring flexibility parameter and for inferring basket weights(Frankel & Wei,IMF Staff Papers, 2008; FrankelPER, 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.

47. Appendix 2: International Currency Roles

48. 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 differetial (π) -0.143 [0.063] Ex. rate variability (σ) -0.055 [0.032] FX turnover (to) 0.023 [0.016] GDP leader 0.026 [0.014] Lagged share (sharet-1)0.904 [0.029] 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. Adj. R2: 0.99