G20 GuidelinesG20 Guidelinesfor Persistently Large Imbalancesfor Persistently Large Imbalances

Jeffrey FrankelJeffrey FrankelHarpel Professor of Capital Formation & GrowthHarpel Professor of Capital Formation & Growth

Experts PanelExperts PanelG20 Working GroupG20 Working Group

on the Framework for Strong, Sustainable and on the Framework for Strong, Sustainable and Balanced GrowthBalanced GrowthParis, 13 January, 2011Paris, 13 January, 2011

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Imbalance PreliminariesImbalance Preliminaries

First, we must reject the mercantilist view First, we must reject the mercantilist view that trade deficits are that trade deficits are alwaysalways necessarily bad necessarily bad

Sometimes deficits make sense, Sometimes deficits make sense, e.g., for a country that has just discovered oil.e.g., for a country that has just discovered oil.

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An example of intertemporal optimization in practice:

When Norway discovered North Sea oil in 1970s, it temporarily ran a large CA deficit,

• to finance investment (while the oil fields were

being developed)

• & consumption (as was rational, since Norwegians knew they would be richer in the future).

Subsequently, Norway ran big CA surpluses.

4

Preliminaries,Preliminaries, continuedcontinued

Second, we must equally reject the view that Second, we must equally reject the view that current account deficits always necessarily current account deficits always necessarily represent intertemporal optimization represent intertemporal optimization

A developing country that runs a persistent large A developing country that runs a persistent large deficit risks an eventual crisis,deficit risks an eventual crisis,

due to financial market imperfections due to financial market imperfections default risk, moral hazard, distorted incentives,default risk, moral hazard, distorted incentives, procyclical fiscal policy, procyclical capital flows…procyclical fiscal policy, procyclical capital flows…

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In my judgment, it would indeed be useful if a In my judgment, it would indeed be useful if a current account deficit or surplus of 4% of GDP current account deficit or surplus of 4% of GDP

triggered a G-20 process to consider if the triggered a G-20 process to consider if the “imbalance” was a problem and, if so, what “imbalance” was a problem and, if so, what

combination of policy responses is appropriate.combination of policy responses is appropriate.

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Example: the combination of a big US CA deficit Example: the combination of a big US CA deficit and big Chinese CA surplus could result in a G-20 and big Chinese CA surplus could result in a G-20 agreement that the US national saving rate and agreement that the US national saving rate and Chinese exchange rate are both part of the problem, Chinese exchange rate are both part of the problem, and both require gradual but genuine adjustment.and both require gradual but genuine adjustment.

• It would be better than some alternatives:• hard landing for the $ and new crisis;

•US Congress passes WTO-illegal trade sanctions• as punishment for Chinese “currency manipulation”;

• or China accuses US of QE2 “currency war.”

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Can the academic literature Can the academic literature shed light on indicator variables?shed light on indicator variables?

10 years ago, economic research focused on 10 years ago, economic research focused on two entirely distinct international financial two entirely distinct international financial problems:problems: (I) Crises in emerging markets(I) Crises in emerging markets (II) G-7 current account imbalances.(II) G-7 current account imbalances.

Historic convergence:Historic convergence: a decade later, the two worlds overlap.a decade later, the two worlds overlap.

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Today, major emerging markets: Today, major emerging markets: are in the G-20,are in the G-20, float,float, run current account surpluses, andrun current account surpluses, and have lower debt than advanced economies.have lower debt than advanced economies.

Debt/GDP of the top 20 rich countries (≈ 80%) is twice that of the top 20 emerging markets, and growing.

Some EMsSome EMs have better credit ratings than some advanced economies,have better credit ratings than some advanced economies, have learned how to follow countercyclical fiscal policyhave learned how to follow countercyclical fiscal policy

while the US, UK, and much of Europe have forgotten how to, andwhile the US, UK, and much of Europe have forgotten how to, and were better able to weather the 2008-09 global recession.were better able to weather the 2008-09 global recession.

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(I)(I) What did we learn What did we learn from the empirical from the empirical

literatureliteratureon emerging market on emerging market

crises?crises? Frankel & Saravelos Frankel & Saravelos (2010)(2010) survey 83 contributions survey 83 contributions

in the pre-2009 Earlyin the pre-2009 Early WarningWarning Indicators literature.Indicators literature. The indicators found useful most often, by far:The indicators found useful most often, by far:

Foreign exchange reserves Foreign exchange reserves (e.g., relative to debt)(e.g., relative to debt) Real exchange rate Real exchange rate (e.g., relative to historic PPP).(e.g., relative to historic PPP).

These were also the two indicators most often These were also the two indicators most often statistically significant in predicting, across 5 measures, statistically significant in predicting, across 5 measures, how hard countries were hit by the 2008-09 global crisis.how hard countries were hit by the 2008-09 global crisis.

Also useful: current account and national saving / GDP.Also useful: current account and national saving / GDP.

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EWIs: EWIs: The variables that show up as the The variables that show up as the strongest predictors of country crises in strongest predictors of country crises in

83 studies are: 83 studies are: (i) reserves and (ii) currency (i) reserves and (ii) currency

overvaluationovervaluation0% 10% 20% 30% 40% 50% 60% 70%

Reserves

Real Exchange Rate

GDP

Credit

Current Account

Money Supply

Budget Balance

Exports or Imports

Inflation

Equity Returns

Real Interest Rate

Debt Profile

Terms of Trade

Political/Legal

Contagion

Capital Account

External Debt

% of studies where leading indicator was found to be statistically signficant(total studies = 83, covering 1950s-2009)

Source: Frankel & Saravelos (2010)

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Best and Worst Performing Countries Best and Worst Performing Countries -- F&S -- F&S (2010), (2010), Appendix 4Appendix 4

-25% -20% -15% -10% -5% 0% 5% 10%

China

India

Morocco

Egypt, Arab Rep.

Indonesia

Jordan

Sri Lanka

Argentina

Poland

Australia

Turkey

Finland

Mexico

Georgia

Russian Federation

Macao, China

Estonia

Ukraine

Latvia

Lithuania

GDP Change, Q2 2008 to Q2 2009

Top 10

Bottom 10

64 countries in sample

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Exchange Market

Pressure

Currency % Changes

(H208-H109

Recourse to IMF

(SBA only)

Equity %Chng (Sep08-Mar09)

Equity % Chng

(H208-H109)

Significant and

Consistent Sign?^

Independent Variable

Reserves (% GDP)0.164 (3.63)

0.087 (2.98)

-1.069 (-1.66)

0.011 (0.12)

0.010 (0.14)

Yes

Reserves (% external debt)0.000 (1.06)

0.000 (1.1)

-0.006 (-2.29)

0.000 (1.81)

0.000 (2.65)

Yes

Reserves (in months of imports)0.004 (2.25)

0.003 (1.95)

-0.119 (-3.01)

0.006 (1.32)

0.009 (2.32)

Yes

M2 to Reserves0.000 (0.27)

0.000 (0.76)

-0.044 (-0.91)

0.000 (0.02)

-0.000 (-0.09)

Short-term Debt (% of reserves)-0.000 (-1.97)

-0.000 (-4.22)

0.000 (2.13)

-0.001 (-2.89)

-0.001 (-3.11)

Yes

REER (5-yr % rise)-0.440 (-5.55)

-0.210 (-3.19)

1.728 (2.15)

-0.182 (-1.24)

-0.185 (-1.61)

Yes

REER (Dev. from 10-yr av)-0.475 (-3.96)

-0.230 (-2.47)

2.654 (2.56)

-0.316 (-1.71)

-0.316 (-2.1)

Yes

GDP growth (2007, %)-0.000 (-0.2)

0.001 (0.94)

0.070 (2.58)

-0.001 (-0.1)

-0.007 (-0.71)

GDP Growth (last 5 yrs)-0.003 (-0.81)

0.000 (0.26)

0.084 (2.4)

-0.003 (-0.26)

-0.014 (-1.15)

GDP Growth (last 10 yrs)0.000 (0.14)

0.001 (0.43)

0.064 (1.66)

-0.012 (-0.67)

-0.020 (-1.12)

Change in Credit (5-yr rise, % GDP)-0.021 (-0.36)

-0.035 (-0.98)

0.552 (1.02)

-0.274 (-2.97)

-0.248 (-4.13)

Yes

Change in Credit (10-yr rise, % GDP)-0.017 (-0.93)

-0.011 (-1.05)

0.210 (1.03)

-0.089 (-1.65)

-0.089 (-2.35)

Credit Depth of Information Index (higher=more)-0.008 (-1.06)

0.000 (0.05)

0.224 (2.4)

-0.006 (-0.37)

-0.018 (-1.33)

Bank liquid reserves to bank assets ratio (%)0.000 (3.84)

0.000 (0.5)

-0.000 (-11.44)

-0.002 (-0.54)

-0.002 (-0.79)

Yes

Current Account (% GDP)0.001 (1.48)

0.002 (2.7)

-0.023 (-2.09)

0.009 (3.84)

0.007 (3.95)

Yes

Current Account, 5-yr Average (% GDP)0.000 (0.48)

0.001 (1.82)

-0.025 (-1.72)

0.007 (2.4)

0.006 (2.74)

Yes

Current Account, 10-yr Average (% GDP)0.000 (0.14)

0.002 (1.39)

-0.035 (-2.11)

0.008 (2.21)

0.007 (2.44)

Yes

Net National Savings (% GNI)0.002 (1.6)

0.001 (2.33)

-0.013 (-1.22)

0.006 (2.92)

0.004 (2.28)

Yes

Gross National Savings (% GDP)0.003 (2.01)

0.001 (2.53)

-0.015 (-1.36)

0.008 (3.42)

0.006 (3.03)

Yes

Change in M3 (5-yr rise, % GDP)0.000 (0.46)

-0.000 (-0.16)

-0.000 (-0.08)

-0.004 (-1.08)

-0.004 (-2.79)

Change in M2 (5-yr rise, % GDP)0.000 (0.33)

-0.000 (-0.29)

0.006 (0.51)

-0.005 (-1.25)

-0.006 (-2.86)

Trade Balance (% GDP)0.001 (1.73)

0.001 (1.78)

-0.014 (-1.51)

0.006 (2.72)

0.003 (1.97)

Yes

Exports (% GDP)0.000 (0.93)

0.000 (1.97)

-0.002 (-0.53)

0.000 (0.02)

-0.000 (-0.83)

Imports (% GDP)-0.000 (-0.15)

0.000 (0.57)

0.002 (0.79)

-0.000 (-0.73)

-0.000 (-1.36)

Inflation (average, last 5 yrs)-0.006 (-1.76)

-0.001 (-0.75)

0.094 (3.4)

0.000 (0.01)

0.002 (0.26)

Yes

Inflation (average, last 10 yrs)-0.002 (-2.03)

-0.001 (-1.54)

0.017 (2.04)

-0.000 (-0.16)

0.000 (0.18)

Yes

Stock Market (5 yr % change)-0.006 (-0.86)

-0.006 (-1.34)

0.035 (0.74)

-0.016 (-3.72)

-0.018 (-5.59)

Yes

Stock Market (5 yr return/st.dev.)0.010 (0.31)

-0.024 (-1.02)

-0.394 (-1.17)

-0.097 (-1.92)

-0.042 (-0.93)

Real Interest Rate-0.001 (-0.79)

-0.000 (-0.42)

-0.022 (-1.05)

0.005 (1.81)

0.004 (1.85)

Yes

Deposit Interest Rate-0.014 (-4.43)

-0.003 (-1.72)

0.058 (1.78)

0.019 (3.33)

0.009 (1.39)

Short-term Debt (% of exports)-0.000 (-0.04)

-0.000 (-1.43)

0.000 (0.36)

-0.004 (-3.28)

-0.003 (-2.82)

Yes

Short-term Debt (% of external debt)-0.001 (-1.41)

-0.001 (-2.1)

0.009 (1.17)

-0.001 (-0.34)

-0.000 (-0.03)

Public Debt Service (% of exports)0.002 (3.04)

0.000 (1.18)

-0.036 (-1.14)

0.008 (1.22)

0.005 (0.98)

Public Debt Service (% GNI)0.001 (2.37)

0.000 (0.97)

-0.050 (-0.71)

0.003 (0.33)

0.002 (0.3)

Multilateral Debt Service (% Public Debt Service)0.001 (1.77)

0.000 (0.52)

0.001 (0.17)

-0.001 (-1.05)

0.000 (0.01)

Aid (% of GNI)0.002 (2.81)

0.000 (1.22)

-0.141 (-3.23)

-0.007 (-0.77)

-0.001 (-0.15)

Yes

Financing via Int. Cap. Markets (gross, % GDP)-0.000

(0)-0.000 (-0.48)

-0.011 (-0.57)

-0.012 (-2.14)

-0.005 (-1)

Legal Rights Index (higher=more rights)-0.009 (-1.49)

-0.006 (-1.46)

0.008 (0.15)

-0.017 (-1.52)

-0.015 (-1.78)

Business Extent of Disclosure Index (higher=more disclosure)

-0.002 (-0.39)

-0.001 (-0.32)

-0.024 (-0.52)

-0.001 (-0.13)

-0.000 (-0.1)

Portfolio Flows (% GDP)-0.616 (-2.88)

-0.435 (-3.33)

2.090 (0.74)

-0.979 (-0.77)

-0.889 (-0.77)

Yes

FDI net inflows (% GDP)-0.000 (-2.05)

-0.000 (-0.87)

-0.000 (-0.04)

-0.000 (-2.57)

-0.000 (-2.05)

Yes

FDI net outflows (% GDP)0.000 (1.8)

0.000 (0.81)

-0.000 (-0.45)

0.000 (3.38)

0.000 (2.84)

Yes

Net FDI (% GDP)0.001 (1.15)

0.000 (0.44)

-0.002 (-0.27)

-0.000 (-0.13)

-0.000 (-0.27)

External Debt Service (% GNI)0.000 (0.91)

0.000 (0.05)

-0.000 (-0.04)

-0.016 (-5.11)

-0.013 (-4.87)

Yes

Present Value of External Debt (% exports)0.000 (0.08)

-0.000 (-0.38)

-0.000 (-0.06)

-0.001 (-3.55)

-0.001 (-3.92)

Yes

Present Value of External Debt (% GNI)0.000 (0.16)

-0.000 (-0.82)

0.000 (0.38)

-0.003 (-4.39)

-0.002 (-3.8)

Yes

Peg (1 = peg)0.100 (3.89)

0.055 (3.34)

-0.577 (-1.89)

-0.075 (-1.67)

-0.041 (-1.04)

Yes

Financial Openness (0=open)0.083 (2.76)

0.023 (1.16)

-0.587 (-1.72)

0.059 (0.68)

0.003 (0.05)

Yes

M3 (% GDP)0.001 (4.12)

0.000 (4.47)

-0.020 (-3.45)

0.000 (0.31)

-0.000 (-0.22)

Yes

M2 (% GDP)0.001 (4.24)

0.000 (4.78)

-0.022 (-3.43)

0.000 (0.4)

-0.000 (-0.03)

Yes

Domestic Credit (% GDP)0.040 (1.53)

0.009 (0.61)

-0.593 (-2.66)

-0.010 (-0.22)

-0.027 (-0.62)

Domestic Credit Provided by Banks (% GDP)0.000 (1.81)

0.000 (1.52)

-0.006 (-3.17)

-0.000 (-0.21)

-0.000 (-0.55)

Yes

Domestic Credit to Priv. Sector (% GDP)0.000 (1.87)

0.000 (1.51)

-0.012 (-3.13)

-0.000 (-0.5)

-0.000 (-0.87)

Yes

Market Cap of Listed Companies (% GDP)0.000 (1.65)

0.000 (2.01)

-0.006 (-1.41)

0.000 (1.35)

0.000 (1.47)

South Asia0.045 (0.81)

0.045 (2.12)

0.476 (0.99)

0.158 (1.81)

0.033 (0.54)

Yes

Europe & Central Asia-0.150 (-4.43)

-0.095 (-5.61)

0.636 (2.09)

-0.202 (-4.43)

-0.167 (-4.64)

Yes

Middle East & North Africa0.080 (2.7)

0.061 (2.86)

-0.003 (0.05)

0.049 (0.84)

Yes

East Asia & Pacific0.071 (2.71)

0.034 (1.58)

-0.629 (-1.34)

0.135 (2.63)

0.054 (1.08)

Yes

Sub-Saharan Africa-0.006 (-0.14)

-0.024 (-0.83)

-0.424 (-0.98)

-0.068 (-0.89)

0.047 (0.72)

Latin America & Carribean-0.014 (-0.23)

-0.013 (-0.39)

0.205 (0.47)

-0.049 (-0.84)

-0.048 (-0.93)

North America0.061 (0.92)

0.041 (0.91)

-0.030 (1.1)

0.024 (0.95)

*OLS with heteroscedasticity robust standard errors performed for four continuous variables; probit for IMF recourse variable^At least two statistically signficant coefficients, of which all must have consistent sign (consistent = same sign, with exception of coefficient on IMF recourse variable, which should have opposite sign)

RESERVES

REER

GDP

CURRENT

ACCOUNT

CREDIT

MONEY

STOCK

MKT

TRADE

INFL.

DEBT COMPOSITI

ON

INT

RATE

CAPITAL

FLOWS

EXT DEBT

REGI

ON

FINANCIAL MKT

DEVELOPMENT

F & Saravelos (2010): Multivariate

Table Appendix 7

Coefficients of Regressions of Crisis Indicators on Each Independent Variable and GDP per Capita* (t-stat in parentheses)bolded number indicates statistical signficance at 10% level or lower

13

(II) What did we learn (II) What did we learn from the literature on from the literature on G-7 current account G-7 current account

imbalances?imbalances?

1414

Economists were split betweenEconomists were split between

Ken Rogoff Ken Rogoff ** Maury ObstfeldMaury Obstfeld Larry SummersLarry Summers Martin FeldsteinMartin Feldstein Nouriel RoubiniNouriel Roubini Menzie ChinnMenzie Chinn MeMe Lots moreLots more

Ricardo Caballero Ricardo Caballero ** Richard CooperRichard Cooper Ben BernankeBen Bernanke Michael DooleyMichael Dooley Pierre-O. Pierre-O.

GourinchasGourinchas Alan GreenspanAlan Greenspan Ricardo HausmannRicardo Hausmann Lots moreLots more

those who saw the USthose who saw the US

deficit as unsustainable, deficit as unsustainable, requiring a $ fall, requiring a $ fall,

& those who saw & those who saw the US as providing the US as providing

a service.a service.

* Some claim that the financial crisis of 2007-09 fit their theories.

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Were current account imbalances Were current account imbalances the cause of the financial crisis, the cause of the financial crisis, as many sayas many say? ?

Those of us who predicted an unsustainable Those of us who predicted an unsustainable US current account deficit and a $ hard landing US current account deficit and a $ hard landing were proven wrong by the 2008 movement were proven wrong by the 2008 movement intointo $. $.

Meanwhile, those who said the US CA deficit was Meanwhile, those who said the US CA deficit was sustainable because of the sustainable because of the superior qualitysuperior quality of US of US assets were also proven wrong.assets were also proven wrong.

corporate governance, corporate governance, accounting system, accounting system, securities markets, rating agencies…securities markets, rating agencies…

MSN Money & Forbes

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Were current account imbalances Were current account imbalances

the cause of the financial crisis? the cause of the financial crisis? continuedcontinued

Not in my view. The financial excesses of 2001-2007 Not in my view. The financial excesses of 2001-2007 would have been pretty much the same even if each would have been pretty much the same even if each country’s inflows & outflows had netted out.country’s inflows & outflows had netted out.

The US ran current account deficits (financed by foreign The US ran current account deficits (financed by foreign official $ purchases) as a official $ purchases) as a side effectside effect of excess liquidity of excess liquidity and overspending, not primarily as a cause.and overspending, not primarily as a cause. In net terms, private foreigners financed less of the US CA In net terms, private foreigners financed less of the US CA

deficit than foreign central banks after 2003.deficit than foreign central banks after 2003.

The story is in the gross volume of financial transactions, The story is in the gross volume of financial transactions, not in net cross-border flows.not in net cross-border flows.

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7 challenges to “twin deficits” view7 challenges to “twin deficits” view

• US investment climateUS investment climate• Global savings glut Global savings glut • ““It’s a big world” It’s a big world” • Valuation effects will pay for itValuation effects will pay for it• US as the World’s BankerUS as the World’s Banker• ““Dark Matter”Dark Matter” • Bretton Woods IIBretton Woods II

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Conclusion regardingConclusion regardingsustainability of the imbalances:sustainability of the imbalances:

The 7 arguments are clever, The 7 arguments are clever, but I am not convinced.but I am not convinced.

Some of these arguments rely on $ retaining its Some of these arguments rely on $ retaining its unique role in world monetary system forever.unique role in world monetary system forever.

But the US may not be able to rely But the US may not be able to rely on exorbitant privilege forever.on exorbitant privilege forever.

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Conclusions Conclusions for the G-20/IMF Mutual Assessment Processfor the G-20/IMF Mutual Assessment Process

Regardless whether one thinks that big current Regardless whether one thinks that big current account imbalances caused the global financial account imbalances caused the global financial crisis, 2007-09, they could cause the next crisis.crisis, 2007-09, they could cause the next crisis.

G20 is the forum to consider the controversies.G20 is the forum to consider the controversies. with the IMF supplying the numberswith the IMF supplying the numbers

As in As in G20 Mutual Assessment ProcessG20 Mutual Assessment Process, IMF, Nov. , IMF, Nov. 20102010

atat://www.imf.org/external/np/g20/pdf/111210.pdf .://www.imf.org/external/np/g20/pdf/111210.pdf .

A good G-20 result would be shared recognition A good G-20 result would be shared recognition that China’s currency and America’s budget that China’s currency and America’s budget deficit should deficit should bothboth gradually adjust. gradually adjust.

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Useful indicators for the G20 MAPUseful indicators for the G20 MAPShort list:Short list:

Budget deficit & national saving /GDP.Budget deficit & national saving /GDP.

Current account /GDP.Current account /GDP. NotNot bilateral trade balances, bilateral trade balances,

which are not economically relevant,which are not economically relevant, even though the US Treasury biannual reports use them:even though the US Treasury biannual reports use them:

as shown statistically in Frankel & Wei (2007)as shown statistically in Frankel & Wei (2007)"Assessing China's Exchange Rate Regime,""Assessing China's Exchange Rate Regime,"    

Economic PolicyEconomic Policy.  . 

Real exchange rate.Real exchange rate. relative to the country’s long-run historyrelative to the country’s long-run history and also relative to the long-run equilibrium rate and also relative to the long-run equilibrium rate

predicted by the Balassa-Samuelson relationship.predicted by the Balassa-Samuelson relationship.

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When the concern is global aggregate When the concern is global aggregate demand, rather than imbalancesdemand, rather than imbalances

The locomotive theory:The locomotive theory: In times of global recession, In times of global recession,

the concern is that each country holds back expansion the concern is that each country holds back expansion of demand (esp. fiscal) unless it is done cooperatively.of demand (esp. fiscal) unless it is done cooperatively.

Examples: 1978 Bonn Summit & 2009 London Summit Examples: 1978 Bonn Summit & 2009 London Summit

There may also be times when the concern There may also be times when the concern is that each country will expand too much, is that each country will expand too much, unless they can agree on cooperative discipline.unless they can agree on cooperative discipline.

Then indicators of demand are needed.Then indicators of demand are needed.

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For the longer term, the G20 may For the longer term, the G20 may want to focus on a broader list of want to focus on a broader list of

economic variableseconomic variables Precedent: The Tokyo Summit of May 1986 Precedent: The Tokyo Summit of May 1986

decided that G-7 Finance Ministers of the G-5 decided that G-7 Finance Ministers of the G-5 countries, would focus on a set of 10 “objective countries, would focus on a set of 10 “objective indicators.”indicators.” No pretense was made that the members would rigidly commit No pretense was made that the members would rigidly commit

to specific numbers, in the sense that sanctions would be to specific numbers, in the sense that sanctions would be imposed on a country if it deviated far from the values agreed imposed on a country if it deviated far from the values agreed upon. upon.

But the plan did include the understanding that "appropriate But the plan did include the understanding that "appropriate remedial measures" would be taken whenever there developed remedial measures" would be taken whenever there developed significant deviations from the “intended course.”significant deviations from the “intended course.”

Like Truman’s recent “Strengthening IMF Surveillance” proposal Like Truman’s recent “Strengthening IMF Surveillance” proposal Policy Brief 10-29, PIIE, Dec. 2010. Policy Brief 10-29, PIIE, Dec. 2010. AtAt http://www.iie.com/publications/interstitial.cfm?ResearchID=1730 http://www.iie.com/publications/interstitial.cfm?ResearchID=1730

23

The list of 10 “objective The list of 10 “objective indicators” indicators”

chosen by the G-5 in 1990:chosen by the G-5 in 1990: 4 “locomotive” oriented indicators:4 “locomotive” oriented indicators:

growth rate, inflation, unemployment, growth rate, inflation, unemployment, money; money;

3 “imbalance” oriented indicators:3 “imbalance” oriented indicators: fiscal deficit/GNP, fiscal deficit/GNP, current account & trade balances;current account & trade balances;

3 “currency war” oriented indicators:3 “currency war” oriented indicators: reserve holdings, exchange rate, and reserve holdings, exchange rate, and

interest rate.interest rate.

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Proposal:Proposal: Cut down the list of objective indicatorsCut down the list of objective indicators by focusing on nominal GDP by focusing on nominal GDP

or, better yet, nominal demand.or, better yet, nominal demand.

Nominal GDP is a “sufficient statistic” Nominal GDP is a “sufficient statistic” for each country’s contribution to aggregate for each country’s contribution to aggregate demanddemand

allowing deletion of: real growth, inflation, allowing deletion of: real growth, inflation, unemployment, money. unemployment, money.

Reference: Reference: Frankel, Frankel,

"International Nominal Targeting (INT): A Proposal for Mo"International Nominal Targeting (INT): A Proposal for Monetary Policy Coordination in the 1990s,netary Policy Coordination in the 1990s," " The World EconomyThe World Economy, 13, no. 2 (June 1990), 263-273. , 13, no. 2 (June 1990), 263-273.

At At http://www.hks.harvard.edu/fs/jfrankel/MONTDUMM.R51.PDFhttp://www.hks.harvard.edu/fs/jfrankel/MONTDUMM.R51.PDF

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Appendix:Appendix:Seven Clever Reasons We Have Seven Clever Reasons We Have

Been Told Why We Are Not Been Told Why We Are Not Supposed to Worry About the US Supposed to Worry About the US

Twin DeficitsTwin Deficits [i][i]

[i] But I don’t believe them: Frankel, “Nine Reasons We Are Given Not to Worry About the US Deficits,”  Commission on Growth & Development. At http://ksghome.harvard.edu/~jfrankel/GrowthCommssnReasonsWorryDeficits.pdf

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1. Capital flows to US due to1. Capital flows to US due to favorable investment climate favorable investment climate & high & high

return to capital .return to capital .

ButBut Even before the slowdown, US business Even before the slowdown, US business

Investment Investment

< in 90s IT boom < in 90s IT boom (or 60s, 70s, & 80s).(or 60s, 70s, & 80s). FDI has flowed FDI has flowed out out of the US not in.of the US not in. The money coming into US is largely The money coming into US is largely

purchases of short-term portfolio assets, purchases of short-term portfolio assets, esp. acquisition of $ forex reserves.esp. acquisition of $ forex reserves.

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2. “The problem is a 2. “The problem is a global global savings glutsavings glut, ,

not a US saving shortfall.”not a US saving shortfall.” [1][1]

True, foreign net lending to US is determinedTrue, foreign net lending to US is determinedby conditions among foreign lenders as much as in US.by conditions among foreign lenders as much as in US.

But “savings glut” misleading: Global saving is not upBut “savings glut” misleading: Global saving is not up. . [2][2]

Rather, global investment is down (even before 2008 slowdown). Rather, global investment is down (even before 2008 slowdown).

This pattern is inconsistent with the hypothesis that This pattern is inconsistent with the hypothesis that the exogenous change is an increase in saving abroad: the exogenous change is an increase in saving abroad: that would have shown up as a rise in investment.that would have shown up as a rise in investment.

The pattern is consistent, rather, with the hypothesis that The pattern is consistent, rather, with the hypothesis that the US shortfall is sucking in capital from rest of world.the US shortfall is sucking in capital from rest of world.

________________________________________________________[1] [1] Bernanke (2005).Bernanke (2005).

[2] [2] Japan’s household saving rate = 7% of disposable income, vs. 23% in 1975.Japan’s household saving rate = 7% of disposable income, vs. 23% in 1975.

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3. “It’s a 3. “It’s a big worldbig world.”.” Alan Greenspan, Richard Cooper, & others: Alan Greenspan, Richard Cooper, & others: world financial markets are big, relative even to $3 trillion world financial markets are big, relative even to $3 trillion

of US net foreign debt, and increasingly integrated.of US net foreign debt, and increasingly integrated. => Foreign investors can bail the US out for decades.=> Foreign investors can bail the US out for decades.

Foreign investors moving, even slowly, toward fully Foreign investors moving, even slowly, toward fully diversified international portfolios (away from “home diversified international portfolios (away from “home country bias”), can absorb US current account deficits country bias”), can absorb US current account deficits for a long time. for a long time.

True. True. But , But , for assessing default or country risk, for assessing default or country risk, global wealth may not be the relevant denominator.global wealth may not be the relevant denominator.

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If the US were any If the US were any otherother country…country…

The proper denominator of US debt would be The proper denominator of US debt would be not the size of the world portfolio, but not the size of the world portfolio, but US ability to payUS ability to pay

Measured by US GDP, orMeasured by US GDP, or by US exports or tradable goods productionby US exports or tradable goods production

which is unfortunate, in light of low US X/GDP ratio which is unfortunate, in light of low US X/GDP ratio -- Obstfeld & Rogoff (2001, 2005).-- Obstfeld & Rogoff (2001, 2005).

US Debt/export path may be probably explosive.US Debt/export path may be probably explosive.

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4. US CA deficit need not imply 4. US CA deficit need not imply rising debt & debt-service, due to rising debt & debt-service, due to

valuation effectsvaluation effects Lane & Milesi-Feretti Lane & Milesi-Feretti (2005…)(2005…) compute valuation effects. compute valuation effects.

Gains in $ value of assets held abroad, Gains in $ value of assets held abroad, particularly via $ depreciation, particularly via $ depreciation, have largely offset increased quantity of liabilities have largely offset increased quantity of liabilities

=> US net debt has risen “only” to $2 ½ trillion, => US net debt has risen “only” to $2 ½ trillion, despite much larger increase in liabilities to despite much larger increase in liabilities to foreigners. foreigners.

But how many But how many times can the US times can the US fool foreign investors?fool foreign investors?

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5. US as 5. US as World’s BankerWorld’s Banker

Despite years of deficits, Despite years of deficits, net investment income remained in surplus. Why?net investment income remained in surplus. Why?

US earns higher rate of return on its assets abroad (especially FDI) US earns higher rate of return on its assets abroad (especially FDI) than it pays on its obligations (especially T bills),than it pays on its obligations (especially T bills),

because US has assets of uniquely superior qualitybecause US has assets of uniquely superior quality . . Kindleberger Kindleberger (1960s): (1960s):

US is World Banker, taking short-term deposits & investing long-term. US is World Banker, taking short-term deposits & investing long-term. Gourinchas & Rey Gourinchas & Rey (2005):(2005): US is global “venture capitalist.” US is global “venture capitalist.” Caballero, Farhi & Gourinchas Caballero, Farhi & Gourinchas (2007):(2007):

“Intermediation rents…pay for the trade deficits.” “Intermediation rents…pay for the trade deficits.” Forbes Forbes (2008):(2008): Money flows to US from places less-developed financially Money flows to US from places less-developed financially Also theories by Mendoza, Quadrini & Rios-RullAlso theories by Mendoza, Quadrini & Rios-Rull (2006),(2006), Wei & Wei &

WuWu, , and othersand others

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6. 6. Dark MatterDark Matter

““That US Net Investment Income That US Net Investment Income is still in surplus implies missing assets.” is still in surplus implies missing assets.”

Hausmann & Sturzenegger Hausmann & Sturzenegger (2006)(2006) called hidden US assets called hidden US assets (know-how) that are not properly reflected (know-how) that are not properly reflected in service export numbers in service export numbers “dark matter.”“dark matter.”

The argument probably overemphasizes the reliability The argument probably overemphasizes the reliability of investment income dataof investment income data (relative to service export data)(relative to service export data) KozlowKozlow (2006): (2006): Dark Matter based on faulty interpretation of the dataDark Matter based on faulty interpretation of the data Curcuru, Dvorak, & WarnockCurcuru, Dvorak, & Warnock (2007) (2007) : :

US capital gains on foreign securities are overstated, US capital gains on foreign securities are overstated, and so US international investment income is too.and so US international investment income is too.

Daniel GrosDaniel Gros (2006)(2006): : foreign companies foreign companies understateunderstate profits of US subsidiaries, profits of US subsidiaries,

to avoid taxes; again net US income overstated. to avoid taxes; again net US income overstated.

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7. 7. Bretton Woods IIBretton Woods II: “China’s : “China’s development strategy entails development strategy entails

accumulating unlimited dollars.”accumulating unlimited dollars.” Deutschebank viewDeutschebank view ( (Dooley, Folkerts-Landau, & Garber,Dooley, Folkerts-Landau, & Garber, 20052005…):…):

Today’s system is a new Bretton Woods, with Asia playing Today’s system is a new Bretton Woods, with Asia playing role that Europe played in 1960s.role that Europe played in 1960s.

That much is right. That much is right.

DFL ideas were original:DFL ideas were original: China piles up $ China piles up $

not because of myopic mercantilism, not because of myopic mercantilism, but as part of an export-led development strategy but as part of an export-led development strategy

that is rational given China’s need to import that is rational given China’s need to import workable systems of finance & corporate governance.workable systems of finance & corporate governance.

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But it is not sustainable. But it is not sustainable.

It may be a Bretton Woods system, It may be a Bretton Woods system, but we are closer to 1971 (date of collapse)but we are closer to 1971 (date of collapse) than to 1944 than to 1944 (date of BW agreement)(date of BW agreement) or 1958 or 1958 (when convertibility was first restored).(when convertibility was first restored).

(1) Capital mobility is much higher now than in 1960s. (1) Capital mobility is much higher now than in 1960s.

(2) The US can no longer necessarily rely on support of foreign (2) The US can no longer necessarily rely on support of foreign central banks, either economically or politically.central banks, either economically or politically.

(3) The theory that China imports a world-class system of finance (3) The theory that China imports a world-class system of finance & corporate governance from the U.S. no longer looks so good.& corporate governance from the U.S. no longer looks so good.

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““Dollar holders won’t sell Dollar holders won’t sell because they would be only because they would be only

hurting themselves”hurting themselves”

This factor was the same in 1973. This factor was the same in 1973. In fact the governments holding $ then had an In fact the governments holding $ then had an agreement not to sell (which is not true today).agreement not to sell (which is not true today).

When the time comes, each central bank will be When the time comes, each central bank will be afraid that if it is the only one that doesn’t move out afraid that if it is the only one that doesn’t move out of $, everyone else will anyway, driving the dollar of $, everyone else will anyway, driving the dollar down, and leaving it “holding the bag.”down, and leaving it “holding the bag.”

Just as in any speculative attack.Just as in any speculative attack.

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