After the Global Financial Crisi_savings by liuqingyan


									In the Aftermath of Global Financial Crisis:
   Implications of a New Economic
         Order with the G20
             Jeffrey Frankel
       Harpel Professor, Harvard University

         25th anniversary of the KAEA
       Allied Social Science Association Meetings
                Atlanta, January 4, 2010
   Congratulations to the Korea-
   America Economic Association
      on its 25th anniversary
• Where were we 25 years ago?
  – Korea

  – US

• What has changed?
• Where are we headed now,
  after the 2007-09 crisis,
  and with Korea chairing the G20?   2
 25 years ago in Korea: January 1985

• The Korean economic
  miracle was well under way,
• although income was still
  far below that of industrialized countries.
• After decades of dictatorship, the country was
  taking its first major steps to democracy,
  – including toward a two-party system in the
    National Assembly elections in Feb.1985.
  25 years ago in the US: January 1985
• Pres. Reagan was starting his 2nd term
  – proclaiming ―Morning in America‖

• The $ was about to peak at its all-time high;
  – the G-7 had not yet agreed
    on a managed depreciation.
• The current account was hitting record deficits.
• The Treasury’s interpretation of the deficits:
  capital was flowing into the US because
  it was a wonderful place to invest.
      Others interpreted the US trade
       deficit much more negatively

• The US was said to be in decline
  – The ―hollowing out‖ of manufacturing.
  – Paul Kennedy’s The Rise and Fall of the Great Powers.

• Japan was thought a juggernaut,
  taking over the world economy.
   – Ezra Vogel’s Japan as Number One
   – Chalmers Johnson’s MITI and the Japanese Miracle, etc.
Japan (and the Asian NIEs) were said to have
    a superior model of capitalism
•   ―Asian values‖
•   Long horizons
•   Keiretsu / chaebol
•   Low cost of capital
•   Relationship banking
•   Government guidance
•   Pro-saving financial system
•   Lifetime employment (in the case of Japan)
•   Firms maximize size (capacity or market share)   6
In between ―US in decline‖ and ―Morning in
America‖ was a reasonable middle position:

 • The US trade deficit and Japanese surplus
   were problems, but they resulted from
   National Saving patterns:
    – Low NS in the US (<= budget deficits) and
    – High NS in Japan (<= budget surplus &
      aging-driven household saving).

 • US global leadership was not exhausted.
    – Joe Nye’s Bound to Lead
       As soon as the 1990s started,
   1980s assumptions were proven wrong

• The US triumphed militarily
  in the Gulf War (1991).

• The US triumphed politically with
  the fall of the Soviet Union (1991).

• The Japanese model burst,
  – along with its land-stock-market bubble (1990)
  – and economy (1991-…) .                           8
      And as the 1990s progressed,
• the US experienced the longest
  economic expansion of its history;
• America was declared to have a New Economy.
• Currency crises hit Korea,
  and Southeast Asian countries
  in 1997-98.
• And Asians were told to emulate the US model,
  especially its financial system:
  –   corporate governance, accounting standards,
  –   consumer finance, innovative products,
  –   securities markets, rating agencies, and
  –   Anglo-American style banking (market-oriented & arms-length)
     But as soon as the 2000s started,
the 1990s assumptions were proven wrong
• Bursting of the US
  dot-com bubble (2000).
• Failure of US electoral institutions (Nov.2000).
• Failures of Sept.11(2001) &
  US response (Iraq, Guantanamo)
• Failure of US corporate governance
  in scandals of Enron, etc. (2001).
• Decade of flat median
  income and rising debt.                            10
         Financial crisis (2007-2009)
• Bursting of US
  housing bubble (2006)
• inevitably led to sub-prime
  mortgage crisis (2007).
• Less predictably,
  failures of US financial system
  led to disappearance of liquidity (2008)
• and the 2nd recession of the decade,
  – the worst since the 1930s.
  – The rest of the world followed.          11
  Who got pieces of it right, beforehand?

• Krugman: If a Depression can happen in Japan,
  it can happen in any modern economy.
• Rajan: Failures of corporate governance.
• BIS (Borio & White): Too-easy credit, via asset
  prices, leads to crises -- with no inflation in between.
• Shiller: US housing price bubble.
• Gramlich: Homeowners are taking
  mortgages that they can’t repay.
• Rogoff: ―This Time Is Not Different.‖
• Roubini: The recession will be severe.               12
         The US has lost its claim
as an exclusive model for others to emulate

The desirable principles haven’t changed, only
the claim that the US uniquely embodies them
– Open democracy, rule of law
– Competition in goods markets
– Corporate governance focused
  on long-term shareholder value,
   • not executives’ options prices
   • nor empire-building.
– Government intervention to address market failure
   • E.g., tax pollution (don’t subsidize fossil fuels).
   • Supervise banks, under rules (don’t take them over).   13
            The US is in a hole
• Adroit monetary &
  fiscal management
  has succeeded in limiting the length
  & severity of the recession.
  – The turning point was
    probably early summer, 2009
  – => we have avoided the mistakes of
     • the Depression,
     • or Japan’s lost decades.

• But the long-term fiscal outlook
  – already bad – has gotten worse.
    The same with other major
     industrialized economies.

A remarkable role-reversal:
 • Debt/GDP of the top 20 rich countries
 (≈ 80%) is already twice that of
 the top 20 emerging markets;
 • and rising rapidly.
 • By 2014 (at ≈ 120%), it could be triple.

       The US financial position
     has deteriorated internationally

• The twin deficits

• China is now our largest creditor

• The dollar appears in long-term decline.

      Exorbitant Privilege of $

• Among those who argue that the US
  current account deficit is sustainable
  are some who believe that the US will
  continue to enjoy the unique privilege
  of being able to borrow virtually unlimited
  amounts in its own currency.
    When does the ―privilege‖ become ―exorbitant?‖

•    if it accrues solely because of size & history,
     without the US having done anything to earn
     the benefit by virtuous policies such as budget
     discipline, price stability & a stable exchange rate.
•    Since 1973, the US has racked up $10 trillion
     in debt and the $ has experienced a 30% loss
     in value compared to other major currencies.
•    It seems unlikely that macroeconomic policy
     discipline is what has earned the US its privilege !
  The ―Bretton Woods II‖
• Dooley, Folkerts-Landau, & Garber (2003) :
  – today’s system is a new Bretton Woods,
     • with Asia playing the role that Europe played
       in the 1960s—buying up $ to prevent
       their own currencies from appreciating.

  – More provocatively:
    China is piling up dollars
    not because of myopic mercantilism,
    but as part of an export-led development strategy
    that is rational given China’s need to import workable
    systems of finance & corporate governance.          19
My own view on ―Bretton Woods II‖:

•   The 1960s analogy is indeed apt,
•   but we are closer to 1971 than to 1944 or 1958.
•   Why did the BW system collapse in 1971?
    •   The Triffin dilemma could have taken decades
        to work itself out.
    •   But the Johnson & Nixon
        administrations accelerated
        the process by fiscal & monetary expansion
        (driven by the Vietnam War & Arthur Burns, respectively).

    •   These policies produced: declining external balances,
        $ devaluation, & the end of Bretton Woods.          20
  There is no reason to expect better today:
1) Capital mobility
   is much higher now than in the 1960s.
2) The US can no longer necessarily rely
   on support of foreign central banks:
     • neither on economic grounds
        (they are not now, as they were then,
        organized into a cooperative framework where
        each agrees explicitly to hold $ if the others do),
     • nor on political grounds
        (China & OPEC are not the staunch allies
        the US had in the 1960s).
3) A possible rival currency to the $ exists.                 21
         Central banks’ reserve holdings
 Frankel & Chinn (2007) estimated effects of country size,
market depth, ability to hold value, and network effects
Simulation suggests € could overtake $ by 2022.




   0.2                            EUR

         75 80   85   90 95   00 05   10   15 20   25 30   35   40 22
    When will the day of reckoning come?
• Not in 2008: In the short run, the financial crisis caused a
  flight to quality which evidently still meant a flight to US $.

• Chinese warnings in 2009
  may have marked a turning point:
   – Premier Wen worried US T bills will lose value.
     On Nov. 10 he urged the US to keep its deficit at an
     ―appropriate size‖ to ensure the ―basic stability‖ of the $.
   – PBoC Gov. Zhou in March proposed
     replacing $ as international
     currency, with the SDR.
        The global monetary system
          may move from dollar-based
    to multiple international reserve currencies

•     The € could challenge the $.

•     The SDR is again part of the system.

•     Gold in2009 made a comeback
      as an international reserve too.

•     Someday the RMB will
      join the roster with ¥ & ₤.
•     = a multiple international reserve asset system.
       Lessons from the global
      financial crisis of 2008-09
• For emerging markets
  – Decoupling?
  – What characteristics suited countries to weather
    the storm of 2008-09 better than others?
• For the field of macroeconomics:
  – phylloxera analogy.

• For global governance: the G20.

• Initial hopes of decoupling
  succumbed at the height of the crisis:

  – Financial contagion

  – Asian exports were
    especially hard-hit.

Asian exports plummeted

      via RGE Monitor 2009 Global Outlook
• But, in the end, there was
  a measure of decoupling after all.
   – Asia has come roaring back.
   – Asia now constitutes
     an independent ―growth pole‖
     in the world.

 Which bystanders got hit the worst by the
        global liquidity crisis of 2008?

• Most emerging markets had followed
  the lessons of the 1990s crises:
  – small or no current account deficits
  – more flexible exchange rates
  – more reserves
  – less short-term & $-denominated loans
• Those that didn’t are those that got into
  worse trouble: Central & Eastern Europe.  29
       The Early Warning Indicators
            literature, updated
• Reserves
  – Economists wondered if emerging market reserves
    had gotten too high by 2007 –
         – Jeanne (2007), Summers (2006), Rodrik (2006)
  – But high reserves appear to have paid off in 2008.
         – Aizenman (2009) and Obstfeld, Shambaugh & Taylor (2009, 2010)

• Low short-term foreign debt
         – Sachs, Tornell & Velasco (1996), Frankel-Rose (1996), Guidotti Rule,
         – Bussiere, Frankel & Matthieu (2010)

• Other leading signals
     • Equity prices: Kaminsky, Lizondo & Reinhart (1998); Rose & Spiegel (2009)
     • See also Wei & Tong (2010)                                           30
―Where should mainstream macro go,
in light of the 2007-09 global financial crisis?‖
• Some models that had been thriving in an emerging
  markets context may now help answer this question.

• Some were applications of models originally designed
  for advanced-country financial markets, but never fully
  incorporated into the mainstream macro core.

• A possible explanation why they had been
  transplanted to emerging markets:
  assumptions of imperfections in financial markets
  were considered more acceptable there,
  than in the context of advanced economies.          31
                Financial crises:
   Not just for emerging markets anymore.
                      An analogy
• In the latter part of the 19th century most of the
  vineyards of France were destroyed by Phylloxera.
• Eventually a desperate last resort was tried:
  grafting susceptible European vines
  onto resistant American root stock.
• Purist French vintners initially disdained
  what the considered compromising
  the refined tastes of their grape varieties.
• But it saved the European vineyards,
  and did not impair the quality of the wine.
• The New World had come to the rescue of the Old.     32
  Implications of the 2008 financial crisis
           for macroeconomics?

• In 2007-08, the global financial system was grievously
  infected by ―toxic assets‖ originating in the United States.
• Many ask what fundamental rethinking is necessary
  to save orthodox macroeconomic theory.

• Some answers may lie with models that have been
  applied to the realities of emerging markets.
• Purists may be reluctant to seek help from this direction.
• But they should not fear that the hardy root stock of
  emerging market models is incompatible with fine taste.
 What are some of these models?
• Asymmetric information
  – Credit rationing (Stiglitz…)
  – Need for collateral (Kiyotaki & Moore, Caballero…)
• The credit channel (Bernanke & Gertler… )
• Balance sheet effects (Calvo…)
• Bank runs & multiple equilibria
  (Diamond & Dybvyg; Velasco…)
• Speculative attacks
  (Krugman; Obstfeld; Morris & Shin…)
• Moral hazard & incentive incompatibility               34
  (Dooley; McKinnon & Pill…)
Also newly relevant are some almost-forgotten
  and less-formalized notions of cycles:

  – the credit cycle of von Hayek,

  – the bubbles & panics of Kindleberger,

  – the Minsky moment,                and

  – Irving Fisher’s debt deflation.

             The G-20

• G-20 meetings in 2009:

  in April

  in October
  How successful were the measures supported
   by US & Korea at the G-20 meetings (2009)?

• Coordinated fiscal stimulus to fight the recession
   – as in the locomotive plan of G7’s Bonn Summit of 1978:
   – no formal agreement, but it seemed to happen anyway.

• Unexpected revival of the SDR
  and tripling IMF resources
• The usual agreement for a standstill/rollback in trade barriers.
  Some backsliding followed, & little progress in Doha Round;
   – on the US side:
      • tariffs on Chinese tires,
      • inability to ratify FTAs.
   – But, so far, not a bad trade record,
     for a severe recession.
 Whatever the causes of the great recession,
the policy response avoided 1930s mistakes:

• No Smoot-Hawley tariffs

• No failed London
  Economic Summit
• Aggressive monetary expansion
  rather than contraction.

• Fiscal expansion too.
The true significance of the G-20 in 2009
• The G-20 accounts for 85% of world GDP.
• A turning point: The more inclusive group
  has suddenly become central to global
  governance, eclipsing the G-7,
  and thereby at last giving major
  developing/emerging countries
  some representation,
• after decades of fruitless talk
  about raising emerging-market
  representation in IMF.                      39
         The G-20 and Korea
• Korea has assumed the presidency
  – this week (Jan. 4, 2010)

• The first non-G7 host of the G20.

• Canada & Korea will host the meetings
  in June & November, respectively.

          Implications for Korea
• Korea is the bridge between
  the G-7 and developing countries.
   – Especially China & India

• What can the G-20
  accomplish for Korea?

• What can the G-20
  accomplish for the world?
   Opportunity/burden for Korea
• Will chairing the G-20 help consolidate
  Korea’s status as an advanced economy?
• Yes, as did:
  – hosting the Olympics,
  – joining the OECD,
  – attaining the per capita income of some
    industrialized countries ($20,000 ≈ Portugal).
• But Korea should now seize the chance
  to exercise substantive leadership.
  – Otherwise, the risk is Czech presidency of EU…
 Four items on G-20 agenda for 2010

• Possible financial regulatory reform
  – Some steps underway in Basle, Financial Stability Forum
  – The Europeans would like more, but are unlikely to get it.
  – Personally, I might favor a small global tax on financial transactions.

• Macroeconomic exit strategies
• Global imbalances between
  developing countries and industrialized
  – US and China should both admit responsibility
      • US: the budget deficit is too big. Needs to be fixed.
      • China: RMB is too low. Needs to be unfixed.
• Post-Copenhagen progress toward new agreement
  on climate change to take effect 2012.      43
Two principles of multilateral institutions
1. It is inevitable that more power go
    to large-GDP countries than small.
   –   This is why IMF works better than UN .
   –   The problem is that China, India, Korea, Brazil, etc.,
       are larger than Canada, Netherlands… Hence the G-20.
   –   The outcome must leave small countries
       better off, of course, or they will not go along.

 2. Conversation is not possible
     with more than 20 in the room.
      Example: many rounds of trade
       negotiations under the GATT.

– Worked well for years,
  • with small steering groups
    (US-EU, the Quad & G-7)
  • and few demands placed on developing countries.

– Failed when developing countries
   had become big enough to matter,
  • but were not given enough role:
  • Doha Round
Conversation is not possible with more
    than 20 people in the room.
• Delegates just read their talking points.
• The latest evidence:
  The Climate Change CoP in Copenhagen
  – The UNFCCC proved an ineffectual vehicle
     • Incompetent management of logistics
     • Small countries repeatedly blocked progress
  – Obama was able to make more progress
    at the end with a small group of big emitters.
     • Korea is in a good position to build on this progress
         – As the 1st non-Annex I country to take on binding emission targets.

• To be honest, the G-20 is too big.
  – My recommendation: an informal steering group within G-20.
• 1. Origins of the financial crisis.

• 2. The US current account deficits
  – What about the economists who
    argue that they are sustainable?

• 3. Global climate change negotiations.
  – A proposed new architecture.

  1. Origins of the crisis in the US
• Well before 2007,
  there were danger signals:
  – Real interest rates <0, 2003-04;
  – Early corporate scandals
    (Enron 2001…);
  – Risk was priced very low,
  – housing prices very high,
  – National Saving very low,
  – current account deficit big,
  – leverage high,
  – mortgages imprudent…               49
US real interest rate < 0, 2003-04
 Source: Benn Steil, CFR, March 2009

                         Real interest rates <0

Source: “The EMBI in the Global Village,” Javier Gomez May 18, 2008

               In 2003-07, market-perceived
               volatility, as measured by
               options (VIX), plummeted.
               So did spreads on US junk
               & emerging market bonds.
               In 2008, it all reversed.

       Six root causes of financial crisis
1. US corporate governance falls short
  – E.g., rating agencies;
  – executive compensation …
      • options;
      • golden parachutes…                             MSN Money & Forbes

2. US households save too little,
  borrow too much.
3. Politicians slant excessively
  toward homeownership
      • Tax-deductible mortgage interest, cap.gains;
      • Fannie Mae & Freddie Mac;
      • Allowing teasers, NINJA loans, liar loans…
         Six root causes of financial crisis,   cont.

4. Starting 2001, the federal budget
  was set on a reckless path,
        • reminiscent of 1981-1990

5. Monetary policy was too loose,
   during 2003-05,
        • accommodating fiscal expansion,
          reminiscent of the Vietnam era.

6. Financial market participants during
  this period grossly underpriced risk.

             Origins of the financial/economic crisis
                       Underestimated     Failures of               Households            Federal
                          risk in         corporate                 saving too little,
 policy easy
                       financial mkts
                                         governance                  borrowing too
                                                                         much             deficits
                                                  Homeownership bias
                          Excessive leverage in             Predatory
                           financial institutions                       Housin             national
       Stock                                                                                saving
       market                                       Excessive
                                                   complexity           bubble
       bubble                                                    MBS
                                         CDSs                                                         Foreig
China’s                                                                                               n debt
growth                                                           CDO
                     Stock                                       s
                     market              Financial                                g
 insta-              crash                 crisis                               crash
  bility                                   2007-08
                                                                                         Lower long-
            Oil                                                                          econ.growth
                                        Recession                                 Eventual loss
                                                2008-09                          of US hegemony 54
            Addendum 2:
    The US current account deficits

• Some economists argue they are sustainable

       Some argue that the privilege to incur $
    liabilities has been earned in a different way:
• Global savings glut                    (Bernanke)

• The US appropriately exploits its comparative advantage
  in supplying high-quality assets to the rest of the world.
    – ―Intermediation rents…pay for the trade deficits.‖
      -- Caballero, Farhi & Gourinchas    (2008)

    – In one version, the United States has been operating
      as the World’s Venture Capitalist, accepting short-term liquid deposits
      and making long-term or risky investments -- Gourinchas & Rey (2008).

    – US supplies high-quality assets:
      Cooper (2005); Forbes (2008); Ju & Wei (2008);
      Hausmann & Sturzenegger (2006a, b);
      Mendoza, Quadrini & Rios-Rull (2007a, b)…                           56
                   Global Savings Glut
•       Global Current Account Imbalances debate, 2001-07
•       On one side:
        those who argued that US current account deficits
    –     had domestic origins (low National Saving),
    –     were unsustainable, and
    –     would eventually cause abrupt $ depreciation.
    –     Obstfeld-Rogoff (2001, 05) ; Roubini (2004); Summers ( 2004);
          Chinn (2005) ; Blanchard, Giavazzi & Sa (2006) ; Frankel (2007b) …

•       On the other side (sustainability):
    –     Global savings glut: Bernanke, Clarida…;
    –     Other arguments, e.g.,exorbitant privilege, dark matter…
•   The 2007-09 crisis did not resolve
    the CA imbalances debate.
      • Reaction of the unsustainability side:
        this is the crisis they were warning of.
     • One response from the other side:
       the savings glut caused the crisis.

•   Regardless,
    – Saving will now fall globally.
      •   In the short run, governments are responding to the
          recession by increasing their budget deficits.
      •   In the long run, spending needs created by retiring
          population & rising medical costs will continue to
          reduce saving, both public & private.
    – In response, long-term real interest rates
      should rise, from the recent low levels.

•   Thus, I declare the savings glut dead.            †    59
•   The argument that the US supplies assets of
    superior quality, and so has earned the right to
    finance its deficits, has been undermined by
    dysfunctionality that the financial crisis suddenly
    revealed in 2007-08.
•   American financial institutions suffered a severe
    loss of credibility (corporate governance, accounting
    standards, rating agencies, derivatives, etc.).
•   Some banks & non-banks have ceased to operate.
•   How could sub-prime mortgages, CDOs, & CDSs
    be the superior type of assets that uniquely merit
    the respect of the world’s investors?              60
•       The events of 2008 also
        undermined the opposing interpretation,
        the unsustainability position:
•       Why did the $ not suffer
        the long-feared hard landing?
•       The $ appreciated after Lehman Brothers’
        bankruptcy, & US T bill interest rates fell.
•       Clearly in 2008 the world still viewed
    •     the US Treasury market as a safe haven and
    •     the US $ as the premier international currency.
  Though arguments about the unique
  high quality of US private assets have been
  tarnished, the idea of America as World Banker
  is still alive: the $ is the world’s reserve
  currency, by virtue of US size & history.

• Is the $’s unique role
  an eternal god-given constant?                or
• will a sufficiently long record of deficits &
  depreciation induce investors to turn elsewhere?
              Addendum 3:
Proposal for a Global Climate Agreement
•   Stage 1:
    • Annex I countries commit to the post-2012
    targets that their leaders have already announced.
    • Others commit immediately not to exceed BAU.
•    Stage 2:
When the time comes for developing country cuts,
targets are determined by a formula incorporating
3 elements, designed so each is asked only to take
actions analogous to those already taken by others:
   – a Progressive Reduction Factor,
   – a Latecomer Catch-up Factor, and
   – a Gradual Equalization Factor.
◙ In one version, concentrations level off at 500 ppm
in the latter part of the century.
◙ Constraints are satisfied:
 -- No country in any one period suffers
                                               Co-author: V.Bosetti
a loss as large as 5% of GDP by participating.
 -- Present Discounted Value of loss < 1% GDP.
                World Industrial Carbon Emissions

      25                                           bau



                                                   Sim ulated
                                                   Em is s ions

                                             Global peak







                                             date ≈ 2035







 What form should border measures take?

1. Best choice: multilateral sanctions
   under a new Copenhagen Protocol
2. Next-best choice: national import penalties
   adopted under multilateral guidelines
     1. Measures can only be applied by participants-in-good standing
     2. Judgments to be made by technical experts, not politicians
     3. Interventions in only a ½ dozen of the most relevant sectors.
3. Third-best choice: no border measures.
4. Each country chooses trade barriers as it sees fit.
5. Worst choice: national measures are subsidies
   (bribes) to adversely affected firms.

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