Monday, January 11, 2010

The most recent salvos in the Fed's culpability for the global financial crisis are centered on a reasonably esoteric debate over the Taylor rule. Ben Bernanke recently defended Fed policy choices by pointing to how monetary policy was in fact not massively inconsistent with a Taylor rule, when inflation forecasts (as opposed to observed inflation levels) are used to determine the inflation gap. John Taylor continues his skewering of the Fed by making clear that measurement issues are insufficient to absolve the Fed from its substantial errors in deviating from the rule, and that in any case using the Fed's inflation forecasts were faulty to begin with.

To better understand the contours of the debate, it is helpful to recall a (very simplified) version of the Taylor rule:

i = A + b*(inflation gap) + c*(output gap),

where i is the policy interest rate, A is a constant term, and b and c are positive parameters. The inflation gap is the difference between the central bank's target inflation and the actual inflation rate, and the output gap is the difference between the economy's current and potential levels of output.

Laid out in this way, the different dimensions of possible disagreement immediately become clear:

  • Disagreement over gap measures: Although it is abundantly clear what the inflation and output gaps are in theory, in practice, there is a need to operationalize the gaps with appropriate measures of inflation and output. This is the crux of Bernanke's most recent defense; more precisely, he claimed that inflation forecasts, as opposed to contemporaneous CPI, were a superior measure. However, as David Papell so accurately points out, this is a red herring. The source of Bernanke's different implied Taylor rule rates stem from the use of core PCE inflation, as opposed to headline CPI inflation. Indeed, using the GDP deflator yields yet different Taylor rule recommendations.
  • Disagreement over parameter values: This is an empirical question, although it can be seen as a specification issue as well. Glenn Rudebusch has previously argued that using a slightly different specification of the Taylor rule---mainly by allowing some difference to the original Taylor parameters, but also accompanied by tweaks to the functional specification---it is possible to show that the Fed's errors of commission over the pre-crisis period were not that great after all (technical version here).
  • Disagreement over specification: This is, implicitly, the second part of Bernanke's defense, where he claims that controlling capital inflows may have been more important for addressing housing bubbles (and since interest rates influence capital inflows into the economy, this implies that the simple version of the Taylor rule may be suffering from an omitted variable).

Two recent articles about fixed rates---one by Martin Wolf on the deflationary consequences of the Eurozone (free registration required), and the other by Jim Hamilton on the inflationary consequences of the renminbi peg---appear, at first glance, to be marginally related about the implications of choosing rigid exchange rate regimes. But it is important to recognize that choosing a is, to begin with, policy decision that is premised on economic and political-economic factors.

As Wolf discusses, the decision to form the Eurozone is premised as much, if not more, on Europe's historical experience with conflict as it is with economic factors (if anything, Europe's recent experience vindicates Marty Feldstein's concern---which dates as far back as 1992---that Europe simply does not fulfill the standard criteria for an optimum currency area). Likewise, China's peg to the dollar is based on a notion of core-periphery interactions as a driver for development: such a strategy is concerned as much with the political consequences of nonabsorption of excess labor, as it is with exports and growth and per se.

The common thread, then, is that since the decision to adopt a fixed rate regime is as much political as it is economic, the regime is likely to be durable even if the economic rationale for the regime has changed. This could explain why, in spite of routine violation of the Stability and Growth Pact, no country has exited the euro; likewise, China has maintained its peg to the dollar in the face of inflationary consequences and constant haranguing by the the United States.

What would change the policy calculus, however, is a change in the political-economic constraints faced by the relevant actors. In this regard, the risks for the continued integrity of the Euro area would be the extent to which economic conditions in the deflationary countries become unbearable for the citizenry, or when widespread inflationary pressures in China threaten to derail growth altogether. In those cases, the economic and political stars would be aligned, and policy realignment can naturally be expected to follow.

Tuesday, December 15, 2009

Fixing bankers’ compensation is all the rage these days. The latest salvo in the ongoing tussle is the recent joint proposal by France and Britain to impose a windfall tax on the bonuses of bankers has raised eyebrows across the financial and political spectrum, mainly because it is viewed as a populist measure aimed at placating taxpayers upset over governmental support for a financial system many regard as the primary villians of the global economic crisis. At the very least, it is argued, such a tax is justified since the unprecedented profits of banks would not have been possible in the absence of government largesse.

There are, at least, three economic arguments behind imposing a contingent windfall tax on firms in the financial sector.

First, such a tax would serve to (partially) offset the part of fiscal deficits that were incurred for the purposes of government-financed bailout packages. This goes beyond the government getting its fair share of the upside—presumably, such an upside had been priced into the interest on bailout loans as well as any options or warrants received as part of an original rescue package. This is effectively a premium payment for future government assistance, which may be much more difficult to collect (both economically and politically) once supernormal profits erode and the memories of the crisis fade.

Second, the tax would act as a mechanism that could dampen the moral hazard that is a direct result of these bailouts. If firms expect that their future profits from risk-taking activity will be accompanied by a commiserate tax should such risky activity lead to the need for a bailout, then they are more likely to factor such a cost into their investment decisions, which in turn reduces the chances of moral hazard.

Third, to the extent that tax revenues are ultimately rebated to taxpayers (either directly or indirectly by paying down on the fiscal deficit), the tax would serve to reduce the deadweight losses that have arisen in the financial sector as a consequence of (one would hope temporarily) greater market concentration.

Of course, financial sector firms will resist such a move. The most likely concern, from the perspective of a given financial center, is that such a move would lead to an exodus of staff from, say, London to New York. Even if governments were to fail to coordinate on the imposition of a windfall tax, such a threat is, ultimately, not credible. The tax will be levied on profits from the previous financial year, and would need to be paid regardless of whether the firm relocates in the following year or not. But since it is also meant to be an extraordinary tax, the cost will have been sunk, and so any relocation decision would be based on weighing the future likelihood of another extraordinary tax versus the costs of relocating today; this calculus is far different from weighing the paying the tax versus moving.

In practical terms, the windfall tax should be levied on banks, and not on individuals directly. While this does open up the possibility of accounting mischief to sidestep the tax, it allows financial firms the maximum flexibility to distribute the costs of the tax in a manner most consistent with internal firm goals. Besides, with the spotlight shining so brightly on banker bonuses, it seems unlikely that the financial glitterati would be able to nonetheless richly reward themselves at the expense of their shareholders. The tax should also be contingent on profitability; the objective of such a tax is, after all, to reduce the monopoly rents accruing to the net beneficiaries of an implicitly government-supported financial sector, not to punish firms that are continuing to struggle simply because they happen to be in the financial sector. Finally, if the tax revenue is in fact not directly rebated (perhaps as part of a stimulus package), the proceeds should be placed in a special fund designed for funding future bailouts, as and when needed.

Thursday, November 19, 2009

The movement of emerging market currencies relative to the USD can be divided into two distinct phases. During the first phase, capital flight into the dollar led to a significant depreciation of EM currencies vis-à-vis the USD. This was led by Latin American economies, especially Brazil and Chile (whose floating rates are generally less subject to intervention by their respective central banks), but also to a lesser extent East Asian economies (the SGD, for example, appreciated 7 percent between Sep 08 (the collapse of Lehman) and Mar 09, and the KRW rose by a massive 28 percent). In the second phase, however, EM currencies gave up much of the earlier gains as the risk trade returned and capital flowed into emerging markets in search of yield. This has led to an appreciation of most EM currencies---an ironic "reward," if you will, for their pursuit of prudent macroeconomic policies both before and after the crisis. The two distinct phases can be seen across a broad range of EM currencies, as detailed in the figures below.

There are two things to note here. First, the movement of these currencies against the USD is essentially equivalent to the cross-rate movement of these currencies versus the RMB, since the latter currency has remained more or less stable at about 6.8 yuan to the dollar. Second, the longer view makes it clear that recent appreciation since Mar 09 against the Chinese currency remains less than the levels that existed prior to the collapse of Lehman. The figure below clearly illustrates this point. Of course, the internal and external environments faced by these EM economies are much more fragile than they were at the start of 2008, which may explain their greater reluctance to allow further erosion of currency competitiveness. It is notable that Brazil's capital controls were instituted in spite of an almost 9 percent depreciation of the BRL relative to the RMB (for the period between Jan 08 and Sep 09).

What does this mean from a policy perspective? I think it calls for a more nuanced understanding of the merits (and demerits) of currency intervention and the selective use of capital controls. The traditional defense for a floating exchange rate and unfettered capital flows is that intervention to support a given rate is too blunt to be of use, and the eroded reserves resulting from any stabilization attempt could have been better used for other purposes, such as providing targeted fiscal support during a crisis. Even if this were true, the cost of such exchange rate volatility on export-dependent nations is enormous. What's worse, if wild swings in terms of trade is detrimental to growth volatility, and growth volatility has a negative impact on growth, then perhaps targeting a blunt instrument like the exchange rate may not be such a bad idea after all.

Thursday, October 08, 2009

The post-WW2 Gold Standard collapsed in 1971 due to the inability of the U.S. to maintain the $35-an-ounce peg. This, in turn, was---in large part---due to the inflating costs of (paying for) the Vietnam War. Nonetheless, due to the position of the U.S. in global affairs, the world simply moved to a Dollar Standard. We appear to be in a moment in time when, analogously, the wars in Afghanistan and Iraq has left no fiscal space for the U.S. government to deal with the 2007/08 subprime crisis, and if history is any guide, we may be headed toward away from the Dollar Standard and toward an alternative standard without the dollar at the center. The rumblings thus far from the big players are starting to sound increasingly ominous.

Thursday, September 03, 2009

Proliferating bilaterals are back on the agenda, especially given the moribund state of the Doha Round. The Economist rehashes three standard arguments about why the spaghetti bowl may not be all that saucy, after all: Welfare gains from trade diversion may dominate trade creation; increased transactions costs due to the complexity of administering multiple rules of origin, and the fact that bilaterals do not appear to be exercised by traders in practice (an argument less commonly made but certainly not novel).

This raises an interesting issue about what to do about the ever-expanding mess. After all, it appears that bilateral and regional trade agreements are here to stay, so the question confronting global policymakers would be how best to control the cancer. One strategy would be to fold in PTA elimination into global multilateral trade negotiations.

This already happens in an organic fashion. Prior agreements with terms that are superseded by multilateral agreements---such as when MFN tariff ceilings adopted in a new round end up becoming lower than the binding commitments in a bilateral---die a natural death. Still, there is a case to be made for explicitly placing the dismantling of sets of prior agreements in concrete terms. Practically, this would mean starting negotiations on the basis of establishing the binding MFN tariff at a level that is at or below those that apply to a group of PTAs.

Of course, such a proposal would mean that there is yet another potential bottleneck to deal with in WTO negotiations (as if they didn't have enough issues to come to deadlock already; recall that the breakdown of the July 2008 ministerial was largely due to the seemingly esoteric issue of agricultural safeguards). Nonetheless, there needs to be greater attention paid to the idea of systematically removing PTAs via the multilateral system, before we all down in the bolognese.

Monday, August 31, 2009

The Fund has a new working paper out on practical issues associated with establishing a sovereign wealth fund (SWF). Beyond the many interesting (and largely academic) issues that have been explored about SWFs in recent times---see especially the important paper by Aizenman & Glick on the determinants and effectiveness of such funds, and the monograph by Setser on the implications of reliance on SWF financing, along with the more recent (theoretical) take by Carroll & Jeanne that models the precautionary motive for SWF establishment---the operational questions have been only tangentially addressed. The IMF paper thus provides a firm basis for thinking about SWFs from the perspective of the developing country seeking to establishing such a fund.

The paper distinguishes five main classes of SWFs, consistent with their purported objectives: (1) reserve investment corporations; (2) pension-reverve funds; (3) fiscal stabilization funds; (4) fiscal savings funds; and (5) development funds. The authors do an excellent job of summarizing how a given SWF established along one of these lines can be designed to fulfill these objectives. What is missing from the discussion, however, is a discussion of how the institution can be designed to better attain these goals. The distinction is akin to classifying central banks according to their mandates---meet a specific inflation target, maintain price stability, or appropriately manage the inflation-unemployment tradeoff---versus proposing principles that would better allow it to achieve these goals (such as via the appointment of a conservative central banker or one whose contract is tied to inflation).

One important design consideration is whether SWFs can be designed to avoid the resource curse so common in developing country institutions. After all, what is to prevent an SWF from being raided by politicians in order to ensure re-election by passing out goodies? Alternatively, even a benevolent dictator may have an incentive to engage in time-inconsistent SWF management policies if such actions could somehow lead to ex post optimal outcomes.

The traditional manner by which developed countries have attempted to resolve time inconsistencies is to ensure institutional independence. However, this is largely a red herring, since the institutional framework in developing countries is often insufficiently developed to support such a first-best policy (think of how successful developing country central banks have been in preventing the monetization of their fiscal debt).

It's not clear that there is a straightforward solution. However, one (admittedly risky) strategy is to provide such institutional independence by privatizing the SWF. There is a fundamental difference between a public institution that has been granted independence, versus a private institution. For one, the privatization option is far more irreversible. Raids on a privatized SWF would essentially entail the seizure of private assets followed by their nationalization; in contrast, thefts from a nominally independent SWF is mainly a matter of accounting changes made to the books of two relevant government entities.

Thursday, June 05, 2008

I just came from a talk by Bill Easterly that rehashes many of the arguments he first made in The Elusive Quest for Growth. Easterly essentially took the argument he first made there a step further: That the recent gains in poverty reduction and growth worldwide occurred in spite of, rather than because of, development experts. His view, espoused in this recent FT column, was that individual freedom, guided by the spirit of entrepreneurship, is the true secret of development.

My beef with this claim comes from the implicit assumption that the solution to development is to simply allow individual liberty. Now, I have no problems with individual freedom, of course, given my libertarian leanings. My problem is the belief that this liberalization can occur spontaneously once we recognize that this is what is required. In some ways, this seems almost tautological: Does not economic freedom simply imply getting the hell out of the interventionist policy? Perhaps it does, but we have too many examples of how letting things rip does not bring freedom to pass. Thus, even if we accept Easterly's premise that liberty is the solution, we are far from understanding the mechanisms that can bring about such liberty.

Consider Russia. What we have there today---normal country notwithstanding---is a form of wild-west capitalism where economic freedom mingles with multiple failures in the rule of law. There is a whole literature on transition economics that argues over whether big-bang or small-step (economic) liberalization is the better strategy. The literature on democratic transitions is similarly mixed in its understanding of key drivers of the process, noncredible transfers notwithstanding. Moreover, political freedom appears to be neither necessary nor sufficient for economic growth. While democracy may be a laudable goal in and of itself, the linkages between democracy and development are tenuous at best, and is much more likely to be a second rather than first-order effect.

Likewise, more than two decades of experience with Latin America and elsewhere has taught us that financial repression is widespread among developing countries. Trade restrictions are similarly common, and despite substantial progress over the past century, remain bones of contention in international economic relations. Hyperinflationary economies encourage speculation and profiteering, rather than legitimate economic activity. All over the world, we see macroeconomic policy failures that result from a poor understanding of what not to do when it comes to macroeconomic management.

Finally, the many state failures in Africa point to how social and civil conflict can drive out any semblance of economic activity and lead to breakdowns in the society and economy. These failures are potentially preventable, but require that we build institutions that can help mitigate the multiplicity of interests arising from heterogeneous actors in society. While institution-building is often a painfully slow and laborious process---with tremendous uncertainty---we do know that easing pre-conflict tensions and bringing about post-conflict stability is possible, and attainable in a remarkably short time span.

The point is that government policymakers and political-economic actors do not stand still just because individual liberty is a laudable objective, whether philosophically or pragmatically speaking. If we want to relax the constraints faced by agents in the economy in order to unlease the forces of bottom-up growth, we need to understand the institutional constraints faced by these agents operating in that economy, and in so doing, engage in governance reforms that would facilitate their private actions. After all, it is not difficult to imagine how a talented, enterprising young individual can choose to be a paramilitary leader, a robber baron, or exploitative dictator, rather than a business magnate or financial manager, if the institutional environment rewarded the former professions more richly than the latter. In order to make progress in development, we still need to understand how political economies work, and help real-world economies achieve the best institutional environment possible.