Dani Rodrik's weblog

Some good news for EMs

Two pieces of good news for emerging markets today.  One is that the IMF has just announced a new short-term liquidity facility (SLF), which will provide certain countries quick-disbursing assistance with minimal conditionality up to five times their quotas. The other is that the Fed has announced an extension of its swap arrangements to four emerging market economies (Mexico, South Korea, Brazil, and Singapore). This is exactly the kind of initiative that is needed, but two questions remain.  Will the amounts involved be enough?  And what will happen to countries that are not named in the Fed program or will not qualify for the IMF's new facility?   

The emerging market dilemma

From an account of the 1930s:

A particularly destabilizing aspect [during the crisis] was the tendency of fears about the soundness of banks and expectations of exchange-rate devaluations to reinforce each other...  An element that the two type of crises had in common was the so-called "hot money," short-term deposits held by foreigners in domestic banks.  On one hand, expectations of devaluation induced outflows of the hot-money deposits (as well as flight by domestic depositors), which threatened to trigger general bank runs.  On the other hand, a fall in confidence in a domestic banking system (arising, for example, from the failure of a major bank) of ten led to flight of short-term capital from the country, draining reserves ....  Other than abandoning the parity altogether, central banks could do little in the face of banking and exchange-rate crises, as the former seemed to demand easy money policies while the latter required monetary tightening.

Include corporates along with domestic banks among the affected entities, change the language to take into account that what is at stake is not a draining of reserves but uncontrolled currency depreciation, and you have a pretty good description of the dilemma faced by most EMs at the moment.

The author of the above lines?  Why, Ben Bernanke himself...

More on alter-globalization

In an earlier post, I reported some of my quick reactions to Robin Broad's and John Cavanagh's new book Development Redefined: How the Market Met its Match.  Robin and John thought I had caricatured their argument and sent in some comments.  I am happy to reproduce them here, with their permission:

First of all, terminology. As we explain (and as Robin wrote in her previous book, Global Backlash: Citizen Initiatives for a Just World Economy), the term “anti-globalization” is a faulty one. Anyone who observes and analyzes these movements on-the-ground across the globe will discover this. So we, like many others, opt for the more accurate “alter-globalization movement” (taken from the French). This term purposely is meant to convey the reality that such movements combine “alternatives” to economic globalization (for instance, against the globalization of local water resources in Canada and Bolivia) and “alternative ways to globalize economically (for instance, “fair trade” initiatives, corporate codes of conduct, social clauses, etc.)  As the latter suggests, this is not merely a “self sufficiency” model (as your review suggests) – although it is absolutely true that in certain countries such as Thailand, there is a growing movement (that includes the Thai king) to turn from reliance on the global market to increased local production.

This relates also to your caricature of what we’re pushing for as being “romantic” or even worse. As our book stresses, the key thing is not our views (or your views) but the alter-globalization initiatives happening across the globe at local, national, regional, and global levels. The proof is in the pudding.

We do want you and readers of your blog to understand that we (and those involved with these alternatives) are not romancing the past or rural life. But the current food crisis certainly supports the alter-globalization’s focus on increased food sovereignty. “Modernization” of agriculture in the southern Philippines, for instance, has been to the benefit of agribusiness corporations, seed/fertilizer/pesticide companies but not to the average farmer.

We also hope you will let your readers know that our book is not simply an economic critique of the neoliberal development model. Rather, our focus is economic, social and environmental.  We also do not ignore statistics on poverty, inequality, etc. One of our chapters disaggregates what’s happened to inequality within and among countries. In another chapter, our critique builds on fine work by UNDP disputing some of the calculations of extreme poverty rates. New “revised” poverty figures support us. 

We can’t help but add that the current moment in history seems to underscore our main points: market fundamentalism was faulty economically, socially and environmentally. (And, indeed, although our book is more political economy than straight economics – good careful economic analysis would have included those social and environmental costs initially to reveal the bankruptcy of that development model.)  And the post-World-War-II public institutions built to manage the global economy are currently in deep crises – financial crises as well as crises of legitimacy.

Time and time again, over the last 2-3 decades, the mainstream development establishment (by the way, we don’t include you in this category) has ignored and ostracized critics (both academic critics and on-the-ground critics). But, time and time again, the critics have been right. Witness the food crisis, the climate change crisis, the financial crisis, as well, of course, as the development crisis.

Urgent need for IMF action

Paul Krugman frets that we are about to witness the mother of all currency crises in emerging markets, and I am afraid that he is right. As I wrote in my previous post, the financial crisis in the developing world has just started and there are indications that it will get a lot, a lot worse.  What is different with this phase of the crisis is that it cannot be addressed by governments in the affected countries issuing their own fiscal guarantees and domestic currency. These countries need external lines of credit, and they need it fast before the scale of the problem becomes truly unmanageable.  

The solution is clear. The IMF, possibly along with central banks of the G7, has to act as a global lender of last resort to emerging markets. These countries have to have ample access to liquidity in reserve currencies--quickly and with few strings attached--for them to be able to fend off what may otherwise become a historic rout of their currencies.  And China should join in: it should make a portion of its near-$2 trillion of reserves available in support of this global enlargement of credit lines.

Emerging markets have every right to say that they are being swept under by a crisis that is not their own doing. But the real reason the rest of the world needs to move on this front is naked self-interest. Combine a deep recession in the advanced countries with an uncontrolled depreciation of emerging-market currencies, and the pressure to erect trade barriers in the U.S. and Europe will be impossible to withstand.  A vicious cycle of unemployment and protectionism feeding on each other a la 1930s could transform the deep recession everyone is already expecting into a second great depression. It can get worse...

And with this bit of good news just in, Dominique Strauss-Kahn should have no distractions to prevent him from focusing on this most urgent task.  There are some reports that the IMF is moving in this direction.  I have a feeling that this will be the make-it-or-break-it week for emerging markets. I hope the IMF will make an announcement in time to make a difference.  

UPDATE: Jeff Sachs weighs in on the same topic.

The next stage of the crisis

One can make a decent argument that the financial crisis has bottomed out in the advanced countries (with the real-economy consequences still to come of course).  But it is barely starting in the emerging markets, and it could get much, much worse. 

Some of these economies are hurt by (now) declining commodity prices; others by large existing current account deficits; and if you do not have a problem on either account, you are (like China) dependent on export markets in the advanced countries that are about to dry up.  These fundamentals are greatly magnified by risk assessments in financial markets.  Now that advanced countries have bailed out and guaranteed vast portions of their financial systems, there is a much greater demarcation between "safe" and "risky" assets, with emerging markets in the second category.  The flight to safety is already taking a huge toll on them.  And the worst is likely to come when domestic residents join en masse in the capital flight.

All of this means that governments in these economies will be under pressure to mimic the public guarantees and bailouts that we have seen in the U.S. and the EU.  But there is a big difference.  Emerging markets for the most part have weak and fragile fiscal systems, and the magnitude of the potential run is huge relative even to the large mountains of reserves that many of them have built up.  Socialization of private liabilities may enhance confidence in the rich countries; it will likely magnify the run in emerging markets.  So we are talking about economic collapses that could be significantly bigger than what the rich countries will experience.  And this time developing countries can legitimately say: it wasn't our fault! 

Which is why external support is absolutely necessary.  This is the time, if there was any, for the IMF to act as a true global lender of last resort--massively, and without many preconditions.  Credit lines should open up to emerging markets before panic gets worse.  The most that the IMF has lent in any one year in previous crises is in the tens of billion dollars.  What will be required now is more of the order of hundreds of billion dollars.  The IMF has the resources; if need be, it can issue new SDRs.

Up to now governments have been behind the curve.  Let's not repeat this experience in the next phase of the crisis, which is now unfolding in the developing world.              

UPDATE: There are encouraging signs that the IMF may be willing to play a role along the lines sketched out above.

Quote of the day

"Yes, I found a flaw,'' Greenspan said in response to grilling from the House Committee on Oversight and Government Reform. "That is precisely the reason I was shocked because I'd been going for 40 years or more with very considerable evidence that it was working exceptionally well.''

From Bloomberg.

The crisis in one picture

From The Financial Ninja (HT: RGE Monitor)

Some old wisdom from Jim Tobin

... very much worth repeating here. From his famous "sand in the wheels" article:

I believe that the basic problem today is not the exchange rate regime, whether fixed or floating. Debate on the regime evades and obscures the essential problem. That is the excessive international-or better, inter-currency-mobility of private financial capital. ... National economies and national governments are not capable of adjusting to massive movements of funds across the foreign exchanges, without real hardship and without significant sacrifice of the objectives of national economic policy with respect to employment, output, and inflation. Specifically, the mobility of financial capital limits viable differences among national interest rates and thus severely restricts the ability of central banks and governments to pursue monetary and fiscal policies appropriate to their internal economies. Likewise speculation on exchange rates, whether its consequences are vast shifts of official assets and debts or large movements of exchange rates themselves, have serious and frequently painful real internal economic consequences. Domestic policies are relatively powerless to escape them or offset them.

The basic problems are these. Goods and labor move, in response to international price signals, much more sluggishly than fluid funds. Prices in goods and labor markets move much more sluggishly, in response to excess supply or demand, than the prices of financial assets, including exchange rates. ...

There are two ways to go. One is toward a common currency, common monetary and fiscal policy, and economic integration. The other is toward greater financial segmentation between nations or currency areas, permitting their central banks and governments greater autonomy in policies tailored to their specific economic institutions and objectives. The first direction, however appealing, is clearly not a viable option in the foreseeable future, i.e., the twentieth century. I therefore regretfully recommend the second, and my proposal is to throw some sand in the wheels of our excessively efficient international money markets.

But first let us pay our respects to the "one world" ideal. Within the United States, of course, capital is extremely mobile between regions, and has been for a long time. Its mobility has served, continues to serve, important economic functions: mobilizing funds from high-saving areas to finance investments that develop areas with high marginal productivities of capital; financing trade deficits which arise from regional shifts in population and comparative advantage or from transient economic or natural shocks. With nationwide product and labor markets, goods and labor also flow readily to areas of high demand, and this mobility is the essential solution to the problems of regional depression and obsolescence that inevitably occur. There is neither need for, nor possibility of, regional macroeconomic policies. ...With a common currency, national financial and capital markets, and a single national monetary policy, movements of funds to exploit interest arbitrage or to speculate on exchange rate fluctuations cannot be sources of disturbances and painful interregional adjustments.

To recite this familiar account is to remind us how difficult it would be to replicate its prerequisites on a worldwide basis. ...

At present the world enjoys many benefits of the increased worldwide economic integration of the last thirty years. But the integration is partial and unbalanced; in particular private financial markets have become internationalized much more rapidly and completely than other economic and political institutions. That is why we are in trouble. So I turn to the second, and second best, way out, forcing some segmentation of inter-currency financial markets.

...

The proposal is an internationally uniform tax on all spot conversions of one currency into another, proportional to the size of the transaction. The tax would particularly deter short-term financial round-trip excursions into another currency. A 1% tax, for example, could be overcome only by an 8 point differential in the annual yields of Treasury bills or Eurocurrency deposits denominated in dollars and Deutschmarks. The corresponding differential for one-year maturities would be 2 points. A permanent investment in another country or currency area, with regular repatriation of yield when earned, would need a 2% advantage in marginal efficiency over domestic investment. The impact of the tax would be less for permanent currency shifts, or for longer maturities. Because of exchange risks, capital value risks, and market imperfections, interest arbitrage and exchange speculation are less troublesome in long maturities. Moreover, it is desirable to obstruct as little as possible international movements of capital responsive to long-run portfolio preferences and profit opportunities.

How about generalizing this idea to all securities transactions, domestic as well as international? If leverage--short-term debt--is a big part of the problem, isn't taxing it an important part of the solution?

The economics of civil strife

One of my graduate students, Oeindrila Dube, has written a fascinating paper (jointly with Juan Vargas) on the determinants of Colombia's civil war, and how world prices for its major exports (coffee and oil) affect the intensity of the conflict. 

The central question is this: do higher world prices enhance or reduce the conflict?  You could make arguments in both directions.  Lower prices increase reduce incomes, and may make it less difficult for individuals to be recruited into guerilla or militia forces.  On the other hand, lower prices make the underlying resource base less valuable and reduce  the spoils over which the two sides can fight.     

The paper has just been featured in Slate, and here is Ray Fisman's summary of it:

Given these two opposing forces, when should we expect price drops to trigger more violence, and when should we expect less? Dube and Vargas argue that the critical difference is the "labor intensity" of extracting a resource—that is, the value of workers relative to the cost of buildings and machines. For example, a farmer tending his land may need little more than a strong back and a shovel, but an oil rig may cost billions and a pipeline billions more. Subsistence farming is labor-intensive; oil drilling is capital-intensive.

When farm prices (or those of other labor-intensive resources) go up, the benefits are widespread, and many laborers see their incomes increase accordingly. But higher oil prices bring gains only to the privileged few who own the wells (and perhaps also their relatively small workforce), leading to even greater conflict over who controls the increasingly valuable oil.

The empirical analysis by Dube and Vargas shows that exactly this pattern holds.  When world prices for coffee and oil rise, there is less violence in the country's coffee regions and more violence in oil regions.  This is a very neat piece of work that greatly enhances our understanding of the economics of conflict.

More on financial innovation

Some time ago I wrote:

What I would love to hear are some examples ... financial innovation—not of any kind, but of the kind that has left a large enough footprint over some kind of economic outcomes we really care about. What are some of the ways in which financial innovation has made our lives measurably and unambiguously better?

There were a few good suggestions in the comments thread (which I felt still fell below the threshold of significance I had established).  But now Steve Waldman has risen to the challenge and posted a very useful and thoughtful piece on financial innovation.  Most of the examples he offers seem useful and valuable--"venture capital and angel investing, the democratization of access to financial information (e.g. Yahoo! finance), the democratization of participation in financial markets (e.g. the growth of internet and discount brokerages that offer easy access to a wide variety of stocks, bonds, and exchange-traded derivatives, both domestic and international"--although I would need to know a lot more about some of these before I can be sure.  I will leave it to the readers to judge whether any of his examples pass my test of significance.

Steve also offers thoughts on what makes for good and bad financial innovation.  This I thought was the most useful part of his post.  You really have to read it, as I cannot do full justice to it (short of copying and pasting the whole thing).

My question to him would be this: OK, now that we have collectively gotten over our finance fetishism, and are willing to accept that some innovations can be bad, what does this mean for regulatory and supervisory approaches? 

For example, it is one thing to say that good innovations are those that are transparent, and another to figure out how policy sorts out the degree of transparency of innovations and how policy makers treat innovations of different kinds.  Does this line of thinking imply that some degree of paternalism in regulation is unavoidable ("no, you cannot issue this particular complicated derivative!") 

(By the way, I do not quite agree with the nitpicking that Steve does in his post, but I will leave that aside because it may get in the way of the more interesting and important conversation.)