State Street Institute, SSgA, October 19, 2010

1. “What’s Hot and What’s Not” in Global MoneyJeffrey FrankelHarpel Professor of Capital Formation & Growth,Harvard University State Street Institute, SSgA, October 19, 2010

2. Monetary economics, like everything else, has an element of cycles & fads. • So this lecture is structured in terms of: “What’s Hot” & “What’s Not.”

3. 5 concepts that may have peaked • Inflation Targeting • Corners hypothesis • International cooperation • Dollar hegemony • Euro IT

4. If those 5 are on the way out,what is taking their place?

5. 5 concepts that may be on the rise • Fighting asset bubbles • Managed floating • “Currency wars” • Multiple international reserve assets • Sovereign debt worries... SDR

6. IT 1. Inflation Targeting(narrowly defined) • Monetary economics has for 3 decades been built on fighting inflation by means of a nominal anchor • The preferred anchor was M1 in the early 1980s; • … was exchange rate targets in the early 1990s; • …and became IT in the 2000s.

7. 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

8. True, EM countries adopting IT experienced less inflation. Gonçalves & Salles, 2008, “Inflation Targeting in Emerging Economies…” JDE IT

9. IT But…1st drawback of combination of IT(with CPI as the target): • 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) • PPT: target an index of product prices or export prices, • not CPI.

10. 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 • 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. There need not be inflation in between. • US crash 1929 • Japan bubble 1987-89 • East Asia crisis 1997-98 • Sub-prime mortgage crisis 2007-08

11. IT • But the crisis of 2007-09 confirmed the BIS view • The stock & housing bubbles were easier to identify than future inflation. • 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, monetary policy should pay attention.

12. Fighting Asset Bubbles:The 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.

13. 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.

14. 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 have tools to prick bubbles; • (iii) the habit of rescuing the markets after the crash (the “Greenspan put”) created a moral hazard problem which exacerbated the speculative bubbles; and • (iv) the cost in terms of lost output can be enormous, even when the central bank eases very aggressively.

15. 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 intermediate exchange rate regimes were no longer feasible.

16. Origins, • In the context of the European 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, & even the Meltzer Report (2000). ….

17. 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.†

18. Replacing the corners: Managed floating As massive inflows return to emerging markets, most central banks are taking them • partly in the form of reserve inflows • = a rise in the quantity of money, • and partly in the form of currency appreciation • = a rise in the price of money.

19. Reserves • Even though many developing & emerging market countries described themselves as floating, • most 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. • in contrast to past capital booms (1975-81, 1990-97).

20. When the 2008-09 global financial crisis hit, • those countries that had taken advantage of the 2003-08 boom to build up reserves did better. • E.g., Obstfeld, Shambaugh & Taylor (2009) • Frankel & Saravelos (2010), • This had also been the most common finding in the many studies of Early Warning Indicators in past emerging market crises.

21. Capital flows to emerging markets, especially Asia, recovered quickly from the 2009 recession.These countries again show big balance of payments surpluses Goldman Sachs

22. Although China continues the most salient case, Korea, Singapore & Taiwan are also adding heavily to reserves. GS Global ECS Research

23. Others, such as India & Malaysia, are currently taking the inflows in the form of currency appreciation, more than reserve accumulation. more-managed floating less-managed floating (“more appreciation-friendly”) GS Global ECS Research

24. In Latin America as well, inflows have returned, reflected mostly as reserve accumulation in Peru, but as appreciation in Chile & Colombia. more-managed floating less-managed floating (“more appreciation-friendly”) GS Global ECS Research

25. 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

26. 3. International cooperation • The G7 steering group gave us • Rambouillet, to ratify floating (1975). • the Plaza, to bring down the $ (1985), and • the Louvre, to halt $ depreciation (1987). • The rise of the G20 in 2009 was a historic development membership • Representation of big emerging market countries was long overdue. • How can you talk about RMB without China at the table? 7

27. The G20 London Summit,April 2009 Fears of a re-run of the failed London Economic Conference of 1933 proved misplaced. • The G20 in 2009 did not repeat the mistakes of the Great Depression: • Monetary & fiscal policy were both expansionary. • Feared protectionism did not materialize, • compared to the milder recessions of 1981 & 2001, • let alone the Smoot-Hawley tariff of 1930. • The IMF was strengthened.

28. The IMF • Just three 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. • Now the IMF is once again busy • Country programs • The membership agreed to increase its resources.

29. Currency Wars • In the news this month. • Starting with a warning from Brazil’s Finance Minister Guido Mantega: • countries everywhere are trying to push down the value of their currencies, to gain exports and employment, • a goal that is not globally consistent.

30. Japan intervened this month to push down the ¥ for the first time in many years, joining Switzerland. Some consider FRB policy another instance. Renewed flows to emerging markets have met with intervention e.g., by Korea, host of November G20 summit. Brazil, Thailand, India & others must decide how to manage inflows: Capital controls? Appreciation? Buying $ to prevent appreciation a course of action supported by evidence that those who used the 2003-08 boom to build up forex reserves did better in the 2009 global financial crisis. China’s RMB remains the dominant issue. Currency Wars?

31. Fear of non-cooperative “competitive devaluation” is an argument for fixed exchange rates rooted in the 1930s. That is why the architects of the post-war monetary order chose fixed exchange rates at Bretton Woods, NH, in 1944. But it is now used to argue that China should move from fixing to floating. US Congressmen don’t care about regimes; they just want a stronger RMB vs. $. Is the currency war metaphor applicable?

32. Economic historians have decided competitive devaluation under 1930s conditions was not a problem after all. True, countries couldn’t all devalue against each other, But they could and did all devalue against gold which worked to ease global monetary policy, just what was needed. Is the currency war metaphor applicable?continued

33. Is the currency war metaphor applicable?continued The same is true today: QE by the Fed will not just raise the money supply in the US; it will also loosen globally, to the extent that foreign central banks react by buying $ to prevent their own currencies from appreciating. which is what the world needs. Multilateral cooperation is not necessary for this.

34. Is the currency war metaphor applicable?continued But other kinds of international cooperation are needed; the currency war & 1930s metaphors are not totally misplaced: Currency war could turn into trade war if Congress follows through on legislation to impose (WTO-illegal) tariffs on China as punishment for non-appreciation. Until now, the US & G20 have held the line on protectionism well compared to the milder recessions of 1991 & 2001, let alone the Smoot Hawley tariff of 1930. The G20 meeting Nov. 11-12, in Seoul,is the next forum for multilateral cooperation.

35. China would take some responsibility to reallocate its economy away from exclusive reliance on exports & manufacturing toward domestic consumption & services, health, education, housing, environment, insurance & other services. How? By allowing the RMB to appreciate, but also by increasing domestic demand. Meanwhile, the US would ideally also take responsibility. Even while prolonging expansionary policy this year, including fiscal expansion designed with high bang-for-the-buck, the US should take steps today to lock in a future return to fiscal responsibility, e.g., by putting Social Security on a firm footing. Ideally the US & China would reach agreement on how to address current account imbalances:

36. 4. Dollar Hegemony • Some argue the US current account deficit is sustainable indefinitely. • They believe that the US will continue to enjoy its unique “exorbitant privilege,” • able to borrow unlimited amounts in its own currency • because it is the dominant international reserve asset.

37. “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.

38. 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.

39. 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).

40. The financial crisis caused a flight to quality which evidently still means a flight to US $. • US Treasury bills in 2008-09 were more in demand than ever, as reflected in very low interest rates. • The $ appreciated, rather than depreciating as the “hard landing” scenario had predicted. • => The day of reckoning had not yet arrived. • Chinese warnings (2009) may be turning point: • Premier Wen worried US T bills will lose value. • PBoC Gov. Zhou proposed replacing $ as international currency.

41. Multiple International Currency System • The € now exists as a rival to the $. • The ¥ & SF are also safe havens. • The SDR came back from the dead in 2009. • Gold made a comeback as an international reserve too. • Someday the RMB will join the roster. • = a multiple international reserve currency system. SDR

42. The euro project is lookingfar less successful than just a few years ago Many predictions of euro skeptics have come true: Periphery countries and core countries have had trouble reconciling asymmetric monetary needs. Euro members have not had enough labor mobility or flexibility to make up for it. Efforts to prevent excessive debt & bailouts have failed: The Stability & Growth Pact failed with members big & small. The “No bailout clause” has failed with Greece.

43. Frankfurt & Brussels made 3 mistakes regarding Greece 2002-09: Did not allow spreads to open up between sovereign debt of Greece & Germany. Winter 2010: Did not tell Greece to go to the IMF. Preferred instead to “handle it internally.” Still today: No “Plan B” to restructure Greek debt (and save the bailout fund for more deserving banks & PIIGs).

44. Judging from spreads, 2001-07, investors put zero odds on a default by Greece or other Mediterranean countries Council on Foreign Relations

45. Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. • Even when the Greek crisis erupted, leaders in Brussels & Frankfurt seemed to view it as a black swan, • instead of recognizing it as a close cousin of the Argentine crisis of ten years earlier, • and many others in history, • including among European countries.

46. Predictions Greece will have re-structure its debt. The euro-zone will not break up. There is no legal provision for members to leave.

47. Sovereign debt worries... • The next big asset market to fall • after the stock market in 2000 • the housing market in 2006 • and banking in 2008 • will be sovereign debt • among the advanced economies. • The big emerging market countries are in much better shape, • in an amazing & historic role reversal.

48. Sovereign spreads for 5 euro countries shot up in the 1st half of 2010 Creditworthiness: Some advanced economics have fallen, as emerging markets have risen.

49. Ratings for “Advanced Economies” Ratings for “Emerging Economies”

50. 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.