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111. The Conquest of Worldwide Inflation: Currency Competition and Its Implications for Interest Rates and the Yield Curve

Author:
Randall S. Kroszner
Publication Date:
07-2007
Content Type:
Journal Article
Journal:
The Cato Journal
Institution:
The Cato Institute
Abstract:
In the United States and in virtually every country around the world, inflation has declined, and in most countries dramatically so. In addition, the volatility of inflation and expectations of future inflation have also fallen significantly. I will call these changes experienced around the globe the conquest of worldwide inflation. I will begin by providing a few facts about the substantial improvement of inflation during roughly the past decade compared with the quarter century that preceded it. I will then try to understand why this remarkable decline in inflation has taken place. In particular, I argue that globalization, deregulation, and financial innovation, in part spurred by experiences of high inflation in the 1980s, have fostered currency competition that has led to improved central bank performance and, hence, the recent conquest of worldwide inflation. Friedrich Hayek (1976) had long ago advocated permitting greater competition among currencies, arguing that there would be a race to the top rather than a race to the bottom. Regardless of what one might think of Hayek’s policy proposals, technological change in a globalized and competitive marketplace, I believe, has increased competition among currencies issued by central banks.
Topic:
Economy, Inflation, Interest Rates, Currency, and Economic Competition
Political Geography:
Global Focus

112. Why the U.S. External Imbalance Matters

Author:
William R Cline
Publication Date:
01-2007
Content Type:
Journal Article
Journal:
The Cato Journal
Institution:
The Cato Institute
Abstract:
Last year the U.S. current account deficit (mainly on trade but including capital income and transfers) reached almost 7 percent of GDP, or about twice as large a share as in 1987, the peak of the previous episode of large external imbalances and dollar overvaluation. A major reason is that from 1995 to 2002 the dollar rose by 28 percent against other currencies, after taking account of inflation and weighting by trade. A strong dollar made U.S. exports expensive and imports cheap, driving up the trade deficit after about a two-year reaction time. With large and persistent external deficits, the United States has swung from being the world’s largest creditor nation to its largest debtor, with net foreign liabilities now at about one-fourth of GDP. The dollar has corrected somewhat and is now about 13 percent lower on a trade-weighted basis than its average in 2002, based on the Federal Reserve’s broad real exchange rate index. Without that partial correction the trade deficit would now be even larger. It will likely require a decline of an additional 15 to 20 percent in the dollar to cut the current account deficit back to about 3 percent of GDP. That rate would be consistent with limiting net foreign liabilities to 50 percent of GDP in the long term. Exceeding that ceiling would seem imprudent for both the U.S. and global economies. It will be crucial that China, Japan, and much of the rest of Asia participate in realignment of their currencies against the dollar, because the decline of the dollar so far has been heavily concentrated against the euro and other industrial country currencies except for the Japanese yen. Dollar correction will also need to be accompanied by fiscal adjustment. Otherwise much of the competitive effect of the dollar adjustment would be offset by higher inflation and a dollar rebound from higher interest rates. Fundamentally the external deficit is the excess of resources used over resources produced, and with U.S. household saving near zero, the government cannot be a large net borrower without keeping the nation in large external deficit.
Topic:
Government, Finance, Economy, Currency, and Deficit
Political Geography:
North America and United States of America

113. The Case Against a Dollar Policy

Author:
Samuel Brittan
Publication Date:
07-2006
Content Type:
Journal Article
Journal:
The Cato Journal
Institution:
The Cato Institute
Abstract:
Milton Friedman’s classic “The Case for Flexible Exchange Rates” was published in 1953, but its inception dates back to 1950 when the author was a consultant to the U.S. Economic Cooperation Administration that was responsible for implementing the Marshall Plan. At that time, it was taken for granted that the Western nations were committed to a system of fixed exchange rates, except for periodic adjustments to new parities. Little did he know that in 1952 the British Treasury had proposed—in a very pessimistic vein and as a result of gloomy and wrongheaded forebodings—that sterling should move to a floating rate. The plan, known as “Robot,” was defeated in the British Cabinet. The country had to wait until 1972 to move to floating and another 20 years—after it was forced out of the European Exchange Rate Mechanism—to learn how to operate economic policy under such a system. Internationally the big shift to floating dates to the early 1970s, between President Nixon’s suspension of gold convertibility in 1971 and the collapse of the Smithsonian attempt to rebuild a fixed exchange rate system in 1973. The fixed rate system broke down because of the inherent tensions between the goals of free multilateral trade, national freedom to determine monetary policy, and fixed exchange rates. It is fortunate that a fixed exchange rate regime was the element that gave way in the end. The main force for change was as usual the pressure of events. Insofar as there was an intellectual influence it was the coming together of a coalition of “sound money” economists who wanted to be free to run stable domestic policies and “expansionists” who wanted to experiment with a more rapid increase in domestic nominal demand.
Topic:
Economics, Exchange Rate Policy, Currency, and Exchange Rates
Political Geography:
Global Focus

114. The U.S. Dollar and Prosperity: Accidents Waiting to Happen

Author:
Reuver Brenner
Publication Date:
07-2006
Content Type:
Journal Article
Journal:
The Cato Journal
Institution:
The Cato Institute
Abstract:
Development in the rest of the world depends on the United States because America continues to be the engine of the world economy and the U.S. dollar is the main reserve currency. In this article, I examine the prospects of America remaining an economic superpower and the dollar maintaining its status as a reserve currency. I also show that unless the United States succeeds financial markets and development around the world will suffer. During the last decade, the U.S. dollar has experienced wide fluctuations. The dollar’s real effective exchange rate relative to the seven major currencies varied from about 80 in 1995 to 120 in 2001, and back to 90 in 2005 (BIS 2005: 91). The dollar was up roughly 30 percent relative to commodity prices between 1997 and 2001. Then, between 2002 and the end of 2004, the dollar fell by about 30 percent relative to gold and commodities. During the first 10 months of 2005, all hard currencies (except the Canadian and Australian dollar) were down by another 15 percent relative to gold. Nevertheless, the bond market still expects a stable dollar over the long haul, as reflected in long-term interest rates. The relative stability of the long-term interest rates offers comfort because the world depends on a predictable value of the dollar. The havoc its demise as reserve currency would provoke is hardly imaginable. The significant upward movement in the U.S. dollar during the late 1990s brought financial, political, and social havoc in countries that either pegged their currencies to the dollar or had currency boards, Argentina’s case being the most prominent. Later, the decline in the dollar between 2002 and 2004 has brought about much antagonism in trade relations around the world and cries for protectionism. Even with the dollar’s volatility around a downward trend since 2002, the euro did not displace the U.S. dollar as the world’s main reserve currency—and will not do so unless drastic events happen, which I do not foresee.1 One such drastic event would be an utter mismanagement of the U.S. dollar. Another would be the European Central Bank (ECB) announcing that it was moving toward targeting the price of gold to manage the euro. The ECB would then become a supranational monetary institution independent of all political pressures. Anchoring the euro to the price of gold would reflect changes in global demands for euro liquidity, functioning as a reserve currency. The reason I do not expect the euro to replace the U.S. dollar as the main reserve currency, unless either of these two events happens, is that the euro is the very first paper currency not backed either by a strong government or by gold. It is a unique experiment. For the euro to become a reserve currency, the eurozone would have to run persistent trade deficits, allowing surplus countries to build up their euro reserves. To achieve that outcome, however, the eurozone countries would have to radically reform their fiscal and regulatory policies, to encourage far more domestic entrepreneurship and consumption than they presently do. This scenario does not seem to be in the cards. Indeed, as Europe’s population gets older, meaningful reform becomes less likely, and I do not see any chance for a strong European government to emerge and tackle the situation. Aging baby boomers, who dominate Europe’s voters, prefer the status quo. In sum, the chances of the euro becoming a serious alternative to the U.S. dollar as a reserve currency are slim, or nonexistent. The Federal Reserve would have to seriously mishandle monetary affairs for this to happen.
Topic:
Currency, Economic Development, and Dollar
Political Geography:
Global Focus and United States of America

115. Does China Save and Invest Too Much?

Author:
John H. Makin
Publication Date:
07-2006
Content Type:
Working Paper
Institution:
The Cato Institute
Abstract:
China’s current saving and investment levels are extraordinary— both in terms of its own history, but also by comparison with the current and historical experience of high-saving countries like Japan. The International Monetary Fund’s 2005 World Economic Outlook places China’s gross saving at 50 percent of GDP with gross capital formation, not far behind, at 45 percent of GDP (IMF 2005: 96–97). High levels of saving and investment are usually seen as a good thing. For a developing economy, such as China, a high level of domestic saving and investment means that residents are forgoing current consumption in order to add to the capital stock, thereby increasing growth and labor productivity. For a developed economy like the United States, while absolute levels of saving and investment may not match those in developing economies, a high level of saving and investment would mean that residents are financing most of the increase in the capital stock and are thereby positioning themselves to benefit from future returns earned by the enlarged capital stock. The reality for the United States over the past half-decade—a sharp rise in imports of foreign savings—means that returns from growth in the capital stock are increasingly earmarked for payment to foreign investors. Despite the satisfaction with which most commentators view its high levels of saving and investment, particularly since 2002, China has displayed increasing signs of overinvestment. As used here, the term overinvestment refers to a capital stock either too large or too poorly allocated to generate positive returns at the margin. Misallocated capital and excess capacity in the domestic sector implies a rapid increase in nonperforming loans, which are largely held by China’s state banks. Excess capacity in the tradable goods sector implies a tendency to undervalue the exchange rate in order to maintain the growth of demand for exportables.
Topic:
Economy, Economic Growth, Investment, Currency, and Savings
Political Geography:
China and Asia

116. Renminbi Controversies

Author:
Morris Goldstein
Publication Date:
07-2006
Content Type:
Journal Article
Journal:
The Cato Journal
Institution:
The Cato Institute
Abstract:
No topic in international monetary economics has probably been more debated over the past three years than what should be done about China’s currency regime and about the exchange rate for the renminbi (RMB). In this article, I take up three questions that are at the center of the current debate, namely: (1) Is the RMB undervalued and, if so, by how much? (2) Would an RMB appreciation of 20–25 percent be particularly harmful for China’s economic growth and development, as well as for its domestic financial stability? (3) Was the July 21, 2005, currency reform a large or tiny step forward?1
Topic:
Economics, Economic Growth, Currency, and Financial Stability
Political Geography:
China and Asia

117. Contractionary Currency Crashes In Developing Countries

Author:
Jeffrey Frankel
Publication Date:
02-2005
Content Type:
Working Paper
Institution:
The John F. Kennedy School of Government at Harvard University
Abstract:
To update a famous old statistic: a political leader in a developing country is twice as likely to lose office in the 6 months following a currency crash as otherwise. This difference, which is highly significant statistically, holds regardless whether the devaluation takes place in the context of an IMF program. Why are devaluations so costly? Many of the currency crises of the last ten years have been associated with output loss. Is this, as alleged, because of excessive reliance on raising the interest rate as a policy response? More likely it is because of contractionary effects of devaluation. There are various possible contractionary effects of devaluation, but it is appropriate that the balance sheet effect receives the most emphasis. Passthrough from exchange rate changes to import prices in developing countries is not the problem: this coefficient fell in the 1990s, as a look at some narrowly defined products shows. Rather, balance sheets are the problem. How can countries mitigate the fall in output resulting from the balance sheet effect in crises? In the shorter term, adjusting promptly after inflows cease is better than procrastinating by shifting to short-term dollar debt, which raises the costliness of the devaluation when it finally comes. In the longer term, greater openness to trade reduces vulnerability to both sudden stops and currency crashes.
Topic:
Debt, Economics, Developing World, Exchange Rate Policy, Currency, and Devaluation
Political Geography:
Global Focus

118. The Impact of the Crisis - Decline and Recovery

Author:
Joseph J. Stern
Publication Date:
01-2004
Content Type:
Working Paper
Institution:
The John F. Kennedy School of Government at Harvard University
Abstract:
When the Asian financial crisis broke in mid-1997, the expectation was that Indonesia would weather the crisis with minimal damage. Actual events soon proved these expectations widely wrong and the Indonesian economy was more severely affected than other Asian countries. In part this outcome reflected Indonesia's fundamental institutional weakness that had been overlooked in the euphoria that marked international financial markets during the 1990s, and in part the impact of the financial crisis was magnified by inconsistent internal policies and by an overly ambitious IMF program that tried to achieve too much in to short a period of time. The result was not only a severe economic contraction with rising poverty levels and growing social unrest, but a political change that resulted, in the short-run, in further economic instability and effectively delayed Indonesia's recovery.
Topic:
Politics, Financial Crisis, Banks, Currency, IMF, and Economic Recovery
Political Geography:
Indonesia, Asia, and Southeast Asia

119. Tough Policies, Incredible Policies

Author:
Alejandro Neut and Andrés Velasco
Publication Date:
09-2004
Content Type:
Working Paper
Institution:
The John F. Kennedy School of Government at Harvard University
Abstract:
We revisit the question of what determines the credibility of macroeconomic policies here, of promises to repay public debt. The literature has focused on governments. strategic decision to default (or erode the value of outstanding debt via inflation/devaluation). It has also focused on increasing policymakers. utility costs as a way to deter strategic misbehavior. By contrast, we build a model in which default or inflation can occur deliberately (for strategic reasons) or unavoidably (shocks leave no other option). In addition, when it does occur, default or inflation entail pecuniary costs, not just utility costs for the policymaker. In the model with these two features, much conventional wisdom on the determinants of credibility need no longer hold. Tough policies such a as appointing a conservative policymaker, indexing public debt or denominating public debt in foreign currency may reduce, not increase, the credibility of vows to repay debt in full. For some parameter values, these tough policies may also reduce welfare.
Topic:
Debt, Crisis Management, Macroeconomics, Currency, Credibility, and Commitment
Political Geography:
Global Focus

120. Monetary Policy and the Currency Denomination of Debt: A Tale of Two Equilibria

Author:
Roberto Chang and Andrés Velasco
Publication Date:
09-2004
Content Type:
Working Paper
Institution:
The John F. Kennedy School of Government at Harvard University
Abstract:
Exchange rate policies depend on portfolio choices, and portfolio choices depend on anticipated exchange rate policies. This opens the door to multiple equilibria in policy regimes. We construct a model in which agents optimally choose to denominate their assets and liabilities either in domestic or in foreign currency. The monetary authority optimally chooses to float or to fix the currency, after portfolios have been chosen. We identify conditions under which both fixing and floating are equilibrium policies: if agents expect fixing and arrange their portfolios accordingly, the monetary authority validates that expectation; the same happens if agents initially expect floating. We also show that a flexible exchange rate Pareto-dominates a fixed one. It follows that social welfare would rise if the monetary authority could precommit to floating.
Topic:
Debt, Monetary Policy, Exchange Rate Policy, and Currency
Political Geography:
Global Focus