Dani Rodrik's weblog

The new religion on financial (and trade) globalization

The IMF sounds a cautious note on financial globalization:

While, in principle, financial globalization should enhance international risk sharing, reduce macroeconomic volatility, and foster economic growth, in practice the empirical effects are less clear-cut. Risk sharing has increased somewhat in advanced countries—consistent with their greater levels of financial openness—but has not been noticeably affected in emerging market and developing countries. International financial integration has not increased macroeconomic volatility or crisis frequency in countries with well-developed domestic financial systems and a relatively high degree of institutional quality; it has, however, increased volatility for countries that have failed to meet these preconditions or thresholds. The link between financial globalization and economic growth is also complex. Although foreign direct investment and other non-debt creating flows are positively associated with long-run growth, the impact of debt seems to depend on the strength of a country’s policies and institutions.

The paper’s empirical results are broadly supportive of the IMF’s “integrated” approach, which envisages a gradual and orderly sequencing of external financial liberalization and emphasizes the desirability of complementary reforms in the macroeconomic policy framework and the domestic financial system as essential components of a successful liberalization strategy. For countries that do not yet meet the relevant thresholds, the focus of policy makers should lie squarely with improving the relevant economic fundamentals. In addition, opening up to foreign direct investment (FDI)—a type of flow that appears to be beneficial even for countries with relatively weak fundamentals—would seem desirable at an early stage. Liberalization to other types of flow should be delayed until country fundamentals are more in line with the relevant thresholds. For countries that are closer to meeting the thresholds, opening to debt flows is unlikely to have strong adverse effects on volatility, though, equally, growth benefits have not been identified as being particularly significant in this case.

This is a clear statement of the new conventional wisdom on financial globalization: reaping the benefits is by no means automatic, and you need to have the complementary institutions to make sure you do. This parallels a similar line on trade liberalization from across the street, which also takes the view that the gains are contingent on supporting institutions.

What I think about all this is here.

When good news for markets is bad news for the economy

The governing party in Turkey has just been re-elected with a comfortable majority of seats in the parliament, ensuring that it will return to power single-handed. Markets breathe a sigh of relief and the Turkish LIra appreciates, reaching a record high against the U.S. dollar.  Good news, or bad news?

Obviously good news for financial markets, but what about the real economy? If, as I have argued before, a competitive currency is good for economic growth, what do we make of the exchange-rate appreciation? 

What has just happened in Turkey is a common occurrence in emerging markets. Once you open up to capital flows and adopt a floating exchange rate regime, financial markets determine the value of your currency. And the better you are at managing the economy, the more you get "rewarded" with an appreciating currency--except that you would have been far better off without the reward. It is a veritable Catch-22.

There are exceptions of course. Argentina has deliberately avoided monetary policy orthodoxy, and its Central Bank is actively pursuing an undervalued currency (with the help of capital controls, price controls, and some fiscal restraint). China and some other Asian countries are intervening in currency markets to prevent appreciation and are accumulating huge reserves. But neither of these strategies is sustainable.

Is there a way out? I think maintaining a competitive currency under today's rules of the game requires a three pronged approach:

1. A large enough structural fiscal surplus to make room for looser monetary policy. A more competitive real exchange rate requires increased domestic saving relative to investment, and reduced national expenditures relative to income--and hence the need for a surplus.

2. A modified monetary policy framework, which gives explicit role to the value of the currency. The central bank will have to have a view as to what the appropriate range is for the exchange rate, and take action to move it there. This does not imply or require targeting a specific level of the real exchange rate, which would be much harder (if not impossible).

3. The use of tax and prudential instruments to reduce capital inflows and manage foreign-borrowing-led consumption booms (such as deposit requirements a la Chile or increased liquidity requirements on financial intermediaries).    

This is a tough menu. But let me know if you have better suggestions.

UPDATE: The day after I wrote this, the TL was hit by the global market sell-off and took a nose dive. Such is the way of international finance.

UPDATE2: Here is a longer version of the argument, written for Project Syndicate.

John Taylor, the global financial warrior

Whenever John Taylor's name comes up, I can't help but think of his roasting by Princeton doctoral students sometime in 1983 or 1984 during the annual student skits. Taylor had recently moved from Columbia to Princeton, and was now being courted by Harvard and Stanford. And apparently he could not quite make up his mind. Or rather, he could too easily--only to change it a little while later. While we students were not privy to the specifics of the negotiations, we could follow Taylor's flip flops from the news bulletins the Department would stick in our mailboxes. "Taylor is going to Harvard," or "Taylor is staying," or "no, he is leaving" they would announce periodically. So the students in the skits had this great moment when they first paid tribute to Taylor and then invited Taylor, who was sitting at the back of the auditorium, to join them on stage to receive an award. Taylor got up and was making his way down, only to be interrupted halfway by the students, who went: "Nah, we changed our mind..." Sheepishly, Taylor had to turn around and go back to his seat.

Taylor eventually did move to Stanford, and rose to new heights when he was appointed undersecretary for international affairs at the Treasury in 2001, shortly before 9/11. If he suffered from indecision in that position it is not in evidence in this interesting book, his first-person account of financial diplomacy in the post-9/11 world. The book focuses on his efforts at the Treasury to freeze assets of terrorists, restore financial stability in Iraq, finance the reconstruction of Afghanistan, deal with the Argentinean financial crash, and reform the IMF and the World Bank.

One wishes that there was a little more economics in this book, and a bit less of a blow-by-blow account. But what I like about the book is the gentleness of spirit with which it is written. Taylor dutifully reports the occasionally harsh criticism he received--Joe Stiglitz once accused him of not being up to date with the relevant economic theory and practice on emerging markets--while avoiding the temptation to respond in kind, a rarity in books of this kind.

The book documents time and again how thin the line between U.S. policy and the policies of the IMF and the World Bank has become in practice, with the U.S. intent on using these agencies to advance its own particular agenda at every turn. Taylor puts his card on the table at the outset. His efforts were designed to support U.S. foreign policy first and foremost:

In the past, finance experts have tried to insulate themselves from foreign policy. As George Shultz and Kenneth Dam put it in their book Economic Policy Behind the Headlines: "The Treasury and the Federal Reserve Board have always considered this field their special preserve and have seldom welcomed advice from other parts of the executive branch." To counteract this attitude, i began telling my Treasury staff to be on the lookout for ways that financial ideas could help our foreign policy, creating a different mind-set from that where they only worried that sound economic policy was threatened by foreign policy issues.

Disappointments of financial globalization, continued

Here is a new paper by Ayhan Kose, Eswar Prasad, and Marco Terrones that provides the strongest evidence to date that financial globalization has not provided better risk-sharing for emerging market economies. In the authors' words:

Our main conclusion is that, notwithstanding the prediction of conventional theoretical models that financial globalization should foster increased risk sharing across all countries, there is no evidence that this is true for developing countries. Even for the group of emerging market economies—which have become far more integrated into global markets than other developing countries—financial globalization has not improved the degree of risk sharing. For advanced industrial economies, there is indeed some evidence that risk sharing has improved in the last decade and a half. Our formal econometric analysis confirms that
increased financial openness improves risk sharing among industrial economies, but this effect is absent for the other two groups of countries.

If anything, the authors detailed results suggest a decline in risk-sharing in developing countries during the recent period of financial globalization, despite a huge increase in gross financial flows.

Why? The authors speculate that maybe it has to do with developing countries' reliance on forms of external finance which do not do a great job of providing insurance or with the boom-and-bust cycles that financial globalization has sometimes stimulated.

The bottom line?

One interpretation of our results is that there is a threshold effect in terms of how financial globalization improves risk sharing, in that only countries that are substantially integrated into global markets (in de facto terms) appear to attain these benefits.

Note the caveat, "in de facto terms." In other words, there is a there there, and you get there when you get there.   

A (crazy?) solution to the U.S.-China trade problem

No, I am not referring to plans under way in the U.S. Congress to slap punitive tariffs on U.S exports. What I have in mind is a proposal that is suggested by the underlying  economics of the situation, but which no-one has yet put forward. It entails granting China an exemption from WTO rules that prohibit subsidization of its export industries in return for a commitment by the Chinese government to let its currency appreciate. Crazy? Perhaps, but read on.

First, let's agree that China's currency is part of the problem. China's large external surplus (and its corresponding huge bilateral surplus vis-a-vis the U.S.) is driven partly by the undervaluation of the remninbi. Here is one estimate (from my ongoing work), which suggests an undervaluation of the remninbi of the order of 50% in real terms.

The precise extent of the undervaluation is a matter of debate, and that particular question need not detain us here.

Second, while Chinese currency policies may seem purely mercantilist, let's also understand that there are sound economic reasons behind it. Chinese economic growth for the last 10-15 years has been driven by a policy of encouraging tradable (and mainly export-oriented) industries. As these modern industries expand, they draw labor from significantly less productive rural and other economic activities, generating an increase in overall labor productivity and GDP per head. An undervalued currency is the linchpin of this growth strategy, as it provides the incentive needed by investors (foreign and domestic) to establish and expand exportable industries. Why would the incentives be inadequate without a hyper-cheap currency? Because market and institutional barriers prevent modern industries from getting started in poor countries without extra inducements. Using economics jargon, currency undervaluation is a second-best mechanism for overcoming market failures.

The trouble is that an undervalued currency also taxes consumption of tradables at home, and this combination of subsidizing output and taxing consumption of traded industries results in a trade surplus for China and a trade deficit elsewhere. (The only exception are commodity exporters, who benefit from increased demand from China.) The U.S deficit is particularly worrisome, as it has spawned a backlash against China that is growing in importance and political salience. Let's not forget that macroeconomic imbalances have often been at the root of rising protectionism.

Hence the current dilemma: Pushing China to revalue its currency is damaging to China's economic growth, and ultimately to its social and political stability. But doing nothing on the currency front risks dangerous unilateralism on the part of the U.S.

But there is a way to de-couple China's trade balance from its need to encourage exportable industries, and that is to allow China to subsidize its industries directly, instead of through the exchange rate. In fact, China can provide any and all inducements it wants to its modern industries through fiscal instruments and still run a balanced trade account.  A subsidy on tradables in conjunction with currency appreciation enables precisely that, as it generates more imports alongside more exports.

(This might seem puzzling at first, because it appears that the appreciation would offset the effect of the subsidy on the profitability of tradables. But the offset is necessarily partial since an appreciation reduces the trade surplus through a second channel, namely by encouraging consumption of importables. To use a numerical example, a 20% subsidy would require, say, a 10% appreciation to offset its effect on the current account, still leaving a roughly 10% increase in the relative profitability of exportables. The actual numbers will depend on elasticities of demand and supply.)

Subsidies are of course costly to the budget, but China can easily afford them. In any case, it is not clear which is the more expensive strategy for China: outright subsidies or accumulating costly reserves to stem the appreciation of the currency?

WTO rules currently do not allow countries to subsidize their industries when these subsidies have an effect on export levels. This prohibition has little economic logic behind it in any case. So exempting China (or any other country for that matter) from these rules will hardly do any damage. And it would have the big advantage of creating the policy space to overcome one of the most important policy challenges of our time. The quid pro quo would be this: you can subsidize your industries as much as you like; but you cannot let the currency stray too far from where it needs to be to generate (rough) external balance. This will allow China to pursue its highly-successful growth strategy without imposing large current account deficits on other countries.   

My candidate for IMF chief

... is Arminio Fraga, central banker extraordinaire and a terrific economist. In any meritocratic search, he would have to come out on or very near the top. But he has the wrong nationality for the job. Europeans are mulling European names, as tradition demands.   

UPDATE: Mali asks what my views are on

the new IMF decision on exchange rate surveillance .... Basically now for each country's report, Fund staff have to provide a view whether the exchange rate is misaligned, and by how much, according to various methods/measurements (which the results sometimes vary in great magnitude and direction).

This is a complicated one, because a country's exchange rate policy has obvious externalities for other countries. So this cannot be a free-for-all and there is indeed some role for exchange-rate surveillance. But if you take the view, as I do, that exchange-rate undervaluation is a second-best policy to overcome distortions in tradable industries, then it is also the case that you must provide developing countries with some leeway in their conduct of exchange-rate policy.  The IMF gets it particularly wrong when it says it will use management of the capital account as an indication of currency manipulation--but that is yet another story. My concern is that the developmental role of currency policies is being neglected in all the focus on "external stability." I hope to return to this topic later.

The inescapable trilemma of the world economy

Sometimes simple and bold ideas help us see more clearly a complex reality that requires nuanced approaches.  I have an "impossibility theorem" for the global economy that is like that. It says that democracy, national sovereignty and global economic integration are mutually incompatible: we can combine any two of the three, but never have all three simultaneously and in full.

Here is what the theorem looks like in a picture:

To see why this makes sense, note that deep economic integration requires that we eliminate all transaction costs traders and financiers face in their cross-border dealings. Nation-states are a fundamental source of such transaction costs. They generate sovereign risk, create regulatory discontinuities at the border, prevent global regulation and supervision of financial intermediaries, and render a global lender of last resort a hopeless dream. The malfunctioning of the global financial system is intimately linked with these specific transaction costs.

So what do we do?

One option is to go for global federalism, where we align the scope of (democratic) politics with the scope of global markets. Realistically, though, this is something that cannot be done at a global scale. It is pretty difficult to achieve even among a relatively like-minded and similar countries, as the experience of the EU demonstrates.

Another option is maintain the nation state, but to make it responsive only to the needs of the international economy. This would be a state that would pursue global economic integration at the expense of other domestic objectives. The nineteenth century gold standard provides a historical example of this kind of a state. The collapse of the Argentine convertibility experiment of the 1990s provides a contemporary illustration of its inherent incompatibility with democracy.

Finally, we can downgrade our ambitions with respect to how much international economic integration we can (or should) achieve. So we go for a limited version of globalization, which is what the post-war Bretton Woods regime was about (with its capital controls and limited trade liberalization). It has unfortunately become a victim of its own success. We have forgotten the compromise embedded in that system, and which was the source of its success.

So I maintain that any reform of the international economic system must face up to this trilemma. If we want more globalization, we must either give up some democracy or some national sovereignty. Pretending that we can have all three simultaneously leaves us in an unstable no-man's land.   

More wisdom from Martin Wolf

Martin Wolf outlines his proposals for the international financial system, as promised:

Is it possible to take advantage of the financial brain’s abilities, while limiting its capacity for irresponsible, short-sighted and destructive behaviour? What are the policy issues that we would be examining if we wanted to do so.

First, for essentially political reasons, we must re-examine the taxation of income and wealth.

Second, we should recognise that emerging and small economies have to manage their involvement with the global financial system cautiously.

Third, we must also realise that the mixture of floating exchange rates with a number of important pegged rates is creating huge distortions.

Fourth, we must look more closely at how monetary policy interacts with the financial sector and asset prices.

Fifth, we should also look once again at how well vast rewards are aligned with risk in financial markets.

Finally, we must encourage regulatory and fiscal authorities to achieve higher levels of co-ordination.

We will have to live with today’s financial markets, since policymakers would seek to curtail them only after a disaster. Even their critics should fear such a disaster. The task is, instead, to exploit the many benefits, while managing the risks. This will never be done perfectly. But it can be done at least tolerably well. The alternative is too awful to consider.

These all make a lot of sense. But do they go far enough? Stay tuned.

Good news from the World Bank

Bob Zoellick is now officially in charge, and there are indications that he may put the fight against corruption where it belongs: among a long list of  challenges, which vary in how badly they constrain development, rather than at the very top of the list. This is Wolfensohn on Zoellick:

“He [Zoellick] understands that you have to return the bank to its main thrust, which is development on behalf of the poor.

“As one of the elements, you want to combat corruption,” Mr. Wolfensohn added. “But you can’t make the bank into the attorney general of the world.”

Well said, and particularly meaningful as Wolfensohn is the person who brought the fight against corruption to the Bank.

Markets and states--and the survey says...

Risk-averse individuals are more likely to prefer protectionism to free trade, and that is true wherever people live. But their protectionist leanings are moderated in countries where the government is bigger (measured by the share of government spending in GDP). This is the remarkable finding in a recent paper  written by my student and co-author Anna Maria Mayda along with two other scholars, Kevin O'Rourke, and Richard Sinnott.  The paper is based on responses by individuals to a survey carried out in 18 countries (drawn from Europe and Asia). The authors speculate that the reason is people feel better insured against the risks of globalization in economies where the public sector is larger. Hence in their sample the country where risk aversion translates to protectionist desire the least is Sweden.

Here is how they summarize their results:

Our results provide microeconomic evidence consistent with the long-standing argument that the state and the market are in fact complementary. Openness and globalization can introduce uncertainty into peoples’ lives, and this additional risk can lead some people to oppose trade. Government expenditure can help to reduce this risk, and thus shore up support for open markets. It would seem that the ‘grand bargain’ that was embedded liberalism is politically effective. Whether that grand bargain can survive the additional political pressures which the interaction of mass migration and the welfare state can give rise to will be one of the key issues determining the sustainability of this institutional compromise in the decades ahead.

UPDATE: Here is the link to the paper from a non-password protected site (thanks to Justin Rietz).