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Perspectives on the Current International Financial and Macroeconomic Situation Celebrity Speakers Ltd., London, May 14, 2007


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Title: Perspectives on the Current International Financial and Macroeconomic Situation Celebrity Speakers Ltd., London, May 14, 2007

Perspectives on the Current International
Financial and Macroeconomic SituationCelebrity
Speakers Ltd., London, May 14, 2007
  • Jeffrey Frankel
  • Harpel Professor of Capital Formation and Growth
  • Harvard University

Four points to be covered
  • Emerging markets are now in the boom phase of
    the 3rd consecutive 15-yearemerging-market
    cycle. Is this time different?
  • China the miracle is real but the RMB is wrong
  • Commodities and carry trade
  • Twin deficits Is US losing economic hegemony?

We are now in the 3rd big consecutive cycle
ofcapital inflows to developing countries
  • Its the biblical rule
  • 7 fat years followed by 7 lean years
  • 1) Recycling petrodollars 1975-81
  • 1982 international debt crisis, then 7 lean
    years -1989
  • 2) Emerging market boom 1990-96
  • 1997 East Asia crisis, then 7 lean years
  • 3) Current boom, 2003-

The cycles show up in capital flow quantities
They also show up in prices sovereign
spreads.EMBI was up in 1995 98
down in 2003-07Calvo, BIS, 2006
The Economist 2/22/07
Is this time different?
  • Ken Rogoff says no.
  • Some things are different this time
  • Current accounts are stronger (esp. Asia)
  • Reserve holdings are much higher.
  • Exchange rates are more flexible.
  • More countries issue debt in domestic currency,
    vs. (in part due to exchange rate volatility)
  • More debt carries Collective Action Clauses
  • More openness to trade and FDI.
  • This Time Its Not Different, Newsweek
    International, Feb.16, 2004

Most large emerging markets are not usingthe
capital inflows to finance CA deficitsas much as
they did in the 1990s
CAD 2000-04 lt in 90s
CAD 2000-04 gt in 90s
Instead, countries are using the inflows to build
up forex reserves
Export/GDP ratios 2000-04 gt than in 1990s
More open
Less open
New emerging market crises will come but
  • they wont necessarily take currency crisis form
  • (vs., e.g., crashes in land securities
  • they wont necessarily be soon
  • Emerging markets not yet ripe for a new crisis
  • Memories are still fresh.
  • Traders jobs have not yet turned over.
  • Global monetary policy has been easy (as in the
    boom phases of the late 1970s early 1990s).
  • Commodity prices are still near historic peaks

  • China, in its own interest, should let the RMB
  • Despite July 2006, the regime has not genuinely
  • A global cooperative deal would simultaneously
    appreciate the RMB other currencies among Asian
    and oil-exporters, while the US raised national
  • IMF could broker the deal. But it wont happen.
  • The Chinese growth miracle will probably
    encounter a crash somewhere along the road
  • the banking system, real estate, or stock
  • Every new economic power goes through a rite of
    passage financial bubble and crash.

Every new economic power goes through a rite
of passage financial bubble and crash
Hol-land Great Britain US Japan China
Take-off dates 16th century 17th century 19th century 1950s-1980s Current
Change in GDP X 3 (1500-1600) X 6 (1600-1820) X6 (1870-1913) X8 (1950-1973) X10
Bubble Dutch tulip mania South seas bubble Roaring 20s (stocks Fla. land) Late 1980s (stocks land) 2006- (stocks, real estate, banks)
Crash 1637 1720 1929 1990s ?

Why did prices of oil other commodities rise so
much 2001-06?
  • E.g., Copper, platinum, nickel zinc all hit
    record highs in 2006
  • Mankind has to live in the physical world after
    all !
  • Many causes. One neglected cause is monetary
  • high real commodity prices can reflect low
    real interest rates.
  • High interest rates reduce the demand for
    storable commodities, or increase the supply
    through a variety of channels
  • By increasing incentives for extraction today
    rather than tomorrow
  • By decreasing firms desire to carry inventories
  • By encouraging speculators to shift from
    commodities to T bills

Statistical relationship 1950-2005.
Results of regressing real commodity prices
against US real interest rates
  • Statistically significant at 5 level for all 3
    major price indices available since 1950-- from
    Dow Jones, Commodity Resources Board, Moodys
    -- and significant for 1 of 2 with a shorter
    history (Goldman Sachs).
  • All are of hypothesized negative sign.
  • The estimated coefficient for the CRB index,
    -.06, is typical. gt when the real interest
    rate goes up 100 basis pts., real commodity price
    falls by .06, i.e., 6 .

UK regression real commodity prices in on real
interest rates
  • Short Rates Long Rates
  • US r r differential US r
    r differential
  • Coeff. -0.053 -0.086 -0.106
  • s.e. 0.010 0.007
    0.007 0.006
  • indicates coefficient significant at 5.
  • (Robust s.e.s)

  • Theory Dornbusch overshooting model, with spot
    price of commodities replacing exchange rate, and
    convenience yield replacing foreign interest
  • Implication beginning in 2001, easy monetary
    policy low real interest rates among the FRB,
    BoJ, ECB PBoC sent liquidity into commodity
    markets, pushing up real prices.
  • Similar carry-trade arguments apply to other
    markets as well has sent money not only into
    commodities, but also into housing, securities,
    and emerging markets.
  • This phenomenon may start to reverse.

It is still puzzling that long-term interest
rates remained so low, even as short-term rates
rose 2004-2006
  • spreads on high-income corporate debt in
    particular have been inexplicably low.
  • Implied options price volatilities have been too
  • Private equity may also be overdone.
  • Part of a general pattern private markets are
    underestimating risk
  • a result of 5 years of low real interest rates
    of formulas that estimate volatility from lagged
    prices which look calm rather than from an
    intelligent assessment of the macro outlook the
    odds of unexpected shocks.
  • Private markets may in particular be
    under-estimating future budget deficits.
  • In short, both risk curve yield curve are too

Medium-term global risks
  • Bursting bubbles
  • Housing market downturns, underway
  • Bond market crash, not yet
  • Possible new oil shocks,
  • e.g., from Russia, Venezuela, Nigeria, Iran
  • Possible new security setbacks
  • Big new terrorist attack, perhaps with WMD
  • Korea or Iran go nuclear/and or to war
  • Islamic radicals take over Pakistan, S.A. or
  • Hard landing of the foreigners pull out gt
  • ? i ? gt possible return of stagflation

The US Current Account DeficitOrigins and
ImplicationsRevsied version of Our Fiscal
Future, 2006

Trade balance is deteriorating
Trade deficit
  • Current account deficit for 2006 6 GDP, a
  • Would set off alarm bells in Argentina or Brazil
  • Short-term danger Protectionist legislation,
    such as Schumer-Graham bill scapegoating China
  • Medium-term danger
  • CA Deficit gt We are borrowing from the rest of
    the world.
  • Dependence on foreign investors may gt hard
  • Long-term danger
  • US net debt to RoW now 3 trillion.
  • Some day our children will have to pay it back
  • gt lower living standards.
  • Dependence on foreign central banks
  • may gt loss of US global hegemony

The Bush Budget Bungle
Official forecast of US budget deficit vanishing
by 2012 is fantasy
White House forecast of eliminating budget
deficit by 2012 will not be met under their
  • WH and CBO projections still do not allow for
  • The full cost of Iraq and other national
    security spending
  • Fixing the Alternative Minimum Tax
  • Making permanent the tax cuts as it has asked for
  • More realistic forecasts of spending growth,
    e.g., in line with population. (Actually
    spending growth since 2001 has far exceeded
  • More likely, deficits will not fall at all.
  • Just as the budget forecasts were predictably
    overoptimistic throughout the first Bush term.
  • The surplus of 5 trillion forecasted in Jan.
    2001 over 10 years became a 10-year deficit of 5

Further, the much more serious deterioration will
start after 2009.
  • The 10-year window is no longer reported in White
    House projections
  • Cost of tax cuts truly explodes in 2010 (if
    made permanent), as does the cost of fixing the
  • Baby boom generation starts to retire 2008
  • gt soaring costs of social security and,
  • Especially, Medicare

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Appendix I Origins of Current Account deficits
  • Trade deficits are not primarily determined by
    trade policy (e.g., tariffs, NAFTA, WTO, etc.)
  • Rather, by macroeconomics.
  • Deficits are affected by exchange rates and
    growth rates.
  • But these are just the intermediating variables
  • More fundamentally, the US trade deficit reflects
    a shortfall in National Saving

The decline in US National Saving
  • National Saving
  • how much private saving is
    left over after
    financing the budget deficit.
  • US CA deficit widened rapidly in early 1980s,
    more so 2001-06, because of sharp falls in
    National Saving

National Savings, Investment Current Account,
as shares of GDP
Why did National Saving fall in early 1980s, and
  • The federal budget balance fell abruptly both
  • From deficit 2 of GDP in1970s, to 5 in
  • From surplus 2 GDP in 2000, to deficits gt3
  • According to some theories, the pro-capitalist
    tax cuts were supposed to result in higher
    household saving.
  • Both times, however, saving actually fell after
    the tax cuts.
  • U.S. household saving is now lt 0 !
  • So both components of US National Saving fell.

What gave rise to the record federal budget
  • Bush Administration Large tax cuts, together
    with rapid increases in government spending
  • Parallels with Reagan Johnson Administrations
  • Big rise in defense spending
  • Rise in non-defense spending as well
  • Unwillingness of president to raise taxes to pay
    for it.
  • Leads to declining trade balance
  • Eventual decline in global role of the .
  • They had ignored the advice of their CEA Chairmen.

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Best precedent for fiscal expansion that began in
  • Reagans 1980s fiscal expansion is a good
    precedent it too came from a president raising
    defense spending without being willing to pay for
  • Weidenbaum quietly resigned over spending.
  • Feldstein popularized Twin deficits.
  • But 1967-72 Vietnam-era expansion fits even
  • (1) Monetary policy was accommodating then, as
  • (2) The dollars international currency standing
    began a trend decline in the 1970s, which the
    Iraq-era expansion is now restarting.

Appendix II Ten Reasons Why Bush Budget
Forecasts Are Too Optimistic
  • 1. National security spending
  • Iraq cost still not fully counted in defense
  • Also, they want to build up the military to be
    able to take on Iran other countries.
  • New weapons systems (wont enhance security).
  • Not to mention all the pork that is in the
    national security budget.

2. Domestic discretionary spending
  • Government forecast assumes spending rises only
    with inflation,
  • but in fact it started rising at 8 /year when
    Bush came to office, far higher than under
    Clinton with caps PAYGO
  • e.g., agricultural energy subsidies
  • prescription drug benefit
  • manned space program...
  • Likely to continue 1
  • 1 Non-partisan Concord Coalition if spending
    were to stay constant as of GDP, it would add
    1.1 trillion. (Or 1.3 trillion, including
    interest on the additional debt.)

2 quotes from economic advisorsto Reagan McCain
  • Bartlett (2005) In light of Bush's big-spending
    ways, Bill Clinton now looks almost like another
    Calvin Coolidge.
  • Hassett (2005) spending growth under George W.
    Bush has been almost four times as high as it was
    during the same period of Bill Clinton's

3. Now that the congressional Democrats are in
the majority
  • they may have some priorities of their
    own to spend money on, like health
  • In the 1990s, they were persuaded by President
    Clinton and the PAYGO rules to hold back, in
    order to get a budget surplus, having passed the
    1993 budget act without a single Republican vote.
  • Since Bush blew the surplus, and paid no price
    for it, it may be more difficult to put together
    the same Democratic support for budget discipline
    achieved in the 1990s.

  • 4. Some economic technical
    assumptions in CBO OMB forecasts have
    been overoptimistic,
  • e.g., early growth forecast at 3.3 high labor
    share of income.
  • Currently, if real interest rates rise to more
    normal levels, debt service costs will rise

  • 5. White House proposes extending tax cuts passed
    in 2001and 2003, and
  • 6. permanently ending estate tax in 2010.
  • 7. Had also proposed privatizing social security
    and expanding IRAs/401(k)s
  • all of which would have lost revenue esp.
    outside the 5-year budget window.
  • 8. Eliminate Alternative Minimum Tax 1
  • 1 Estimated cost 0.7 trillion .

  • 9. Social Security 1
  • 10. Medicare
  • 1 Official forecasts count 2 1/2 trillion
    in payroll tax revenues that are in fact supposed
    to go to Social Security even that is far from
    enough to pay for promised benefits.

What about the Starve the Beast hypothesis
(tax revenue? gt spending?) ?
  • History shows that the Starve the Beast claim
    does not describe actual spending behavior.
  • Spending is only cut under a regime of shared
    sacrifice that simultaneously raises tax revenue
    (the regime of caps PAYGO in effect throughout
    the 1990s)
  • Spending is not cut under a tax-cutting regime
    (1980s current decade).
  • See Figure 2.

Fig. 2 US Federal Budget Deficit and Spending as
of GDP.
Further, even if the Starve the Beast hypothesis
did describe actual behavior
  • It would contradict the original rationale for
    the tax cuts the Lafferite hypothesis that tax
    rate cuts produce more tax revenue.
  • Starve the Beast would then predict more
    government spending not less.
  • Is Laffer a straw man?
  • President George W. Bush, July 24, 2003
  • OMB Director Joshua Bolten, press conference July
    2003 WSJ, Dec. 10, 2003
  • Treasury Secy.John Snow, Congr. testimony, Feb.
    7, 2006 Lower tax rates are good for the
    economy and a growing economy is good for
    Treasury receipts.

Appendix III Many economists have come up with
ingenious counter-arguments to the twin deficit
  • But I dont buy them.
  • I.e., the twin deficits that face us now and in
    the future should indeed be a source of concern
  • Low US national saving is roughly a sufficient
    statistic for the problem.

7 alternate views that purport to challenge the
twin deficits worry
  • The siblings are not twins
  • Alleged Investment boom
  • Low US private savings
  • Global savings glut
  • Its a big world
  • Valuation effects will pay for it
  • Chinas development strategy entails accumulating

Appendix IV Possible loss of US economic
  • US can no longer necessarily rely on the support
    of foreign central banks, such as China.
  • China may allow appreciation of RMB.
  • Even if China keeps RMB undervalued, it can
    diversify its currency basket out of
  • There now exists a credible rival for
    international reserve currency, the .
  • Chinn Frankel (2007) under certain scenarios,
    the could pass the as leading international
  • US would lose, not just seignorage, but the
    exorbitant privilege of playing banker to the

could surpass as leading international
reserve currency by 2022 Chinn Frankel (2007)
Possible loss of US political hegemony.
  • In the 1960s, foreign authorities supported in
    part on geopolitical grounds.
  • Germany Japan offset the expenses of stationing
    U.S. troops on bases there, so as to save the US
    from balance of payments deficit.
  • In 1991, Saudi Arabia, Kuwait, and others paid
    for the financial cost of the war against Iraq.
  • Repeatedly the Bank of Japan bought to prevent
    it from depreciating (e.g., late 80s)
  • Next time will foreign governments be as willing
    to bail out the U.S.?

Historical precedent (1914-1956)
  • With a lag after US-UK reversal of ec. size net
    debt, passed as 1 international currency.
  • Imperial over-reach the British Empires
    widening budget deficits and overly ambitious
    military adventures in the Muslim world.
  • Suez crisis of 1956 is often recalled as occasion
    when US forced UK to abandon its remaining
    pretensions to an independent foreign policy
  • Important role played by simultaneous run on .

  • Appendix V Estimating
  • the Implicit Weights in the Chinese RMB Basket
  • (Frankel and Wei, 2007)

The new exchange rate regime announced July 2005
  • Minor initial appreciation of 2.1 appreciation.
  • RMB to be set with reference to a currency
  • allowing a movement of up to /- .3 in
    bilateral exchange rates within any given day
  • (in theory, daily band could cumulate to 6.4
  • Governor Zhou revealed 11 currencies (Aug. 2005),
  • though numerical basket weights still

The magnitude of daily movements vs. increased
in the spring of 2006,
Estimating the weights
  • A problem made-to-order for OLS regression.
  • Regress changes in value of RMB against
    changes in values of candidate currencies.
  • ? log RMBt
  • c a ?log t ß1?log t ß2 ?log
  • The coefficients are the basket weights.
  • Can impose a S ß j 1.

  • If China is following a perfect basket peg, the
    fit should be perfect, a rarity in econometrics (
    s.e.r. 0, R2 100).
  • More likely, the basket peg is not perfect, but
    one can still estimate weights with fairly tight
    standard errors.
  • The real questions
  • How wide is the band?
  • How strong is the trend term (c), and
  • How great is the estimated weight on non-

In terms of what numeraireis value defined?
  • It doesnt matter, if basket peg holds well.
  • Previous authors have chosen
  • the SDR, Swiss franc, dollar, purchasing power
    over a consumer basket of domestic goods, a
    GDP-weighted basket of major currencies,
    Canadian dollar.
  • We here use the SDR as numeraire,
  • the price of gold as a robustness check.

References for the technique
  • Pioneered by Frankel (1993), Frankel Wei
    (1994, 95).
  • Used by others, including Benassy-Quere (1999),
    Ohno (1999), Frankel, Schmukler Servén (2000),
    and Benassy-Quere, Coeure Mignon (2004).
  • Applied to RMB by Shah, Zeileis, Patnaik
    (2005), Frankel Wei (2006), Eichengreen (2006)
    and Yamazaki (2006)

Implicit weights in RMB basketTable 11
7/22/05-1/8/07 Estimate (standard error)
  • US Dollar 0.904 (0.021)
  • Euro -0.006 (0.014)
  • Japanese Yen 0.008 (0.006)
  • Korean Won 0.002 (0.009)
  • Singapore -0.018 (0.021)
  • British Pound -0.004 (0.011)
  • Malaysia Ringgit 0.053 (0.015)
  • Russia Ruble -0.018 (0.021)
  • Australian Dollar -0.003 (0.008)
  • Thailand Baht 0.006 (0.010)
  • Canadian Dollar 0.003 (0.008)
  • Trend .00009 (.00003)
  • significant at 5 Change in the log
    value of RMB (in terms of SDRs) is regressed on
    changes in log values of other currencies.

Estimation in sub-periods
  • 6 sub-periods
  • (1) July 22-Oct.31, 2005, (2) Nov.1, 05
    Jan.31, 2006, (3) Feb.1 Apr. 28, 2006, (4)
    May 1- July 31, 2006, (5) Aug.1-Oct.31, 2006,
    (6) Oct.1, 2006 Jan.8, 2007.
  • Tables 11 17 report results.
  • In 1st 2 sub-samples, regime is a US peg.
  • Weight on R2 virtually 1.0. As tight as
    Hong Kong !
  • After Jan.2006, however, weight falls.
  • In Feb.-April, 2006, est. weight on only 0.7.
  • Ringgit, won, ruble, baht receive positive
  • Surprisingly, continue to receive no
    positive weight.
  • Over last 8 months, weight .9
  • Significant trend appreciation .0002 / day gt
    5.2 /yr.

  • Basic results robust with respect to
  • using another numeraire (gold price) Tbs.11A-17A
  • constraining weights to sum to 1,
  • Table 20 gt won estimate sharper
  • Method of moments
  • We allowed for accelerating trend, but found no
    sign of it.

Evolution during the course of the sample period
  • Downward trend in baskets weight on
  • Highly significant if assumed linear - Table 18
  • Trend in level still significant as well, but
    only .0001 appreciation/day, or 2.5 /yr.,
    against basket
  • But we need to specify the time pattern of the
    weights non-linearly, so they wont go lt0 or gt1.

Full specification of weights w(j)on currency
values X(j)
  • ? log RMBt f(t) ? w(j) ? X(j)t
  • To impose the constraint ?w(j) 1,
  • Let 1st currency w()
    1- ?w(j) gt
  • ?logRMBt - ?logt f(t) ? w(j)(?X(j)t -
  • where 0ltw(j)lt1.
  • Now let the weights w(j) depend on time, using
    exponential form.
  • Specification 2 
  • let w(j) b0(j) b1(j) 1- exp(-d t),
  • and f(t) c0 c1 t .

Estimation of nonlinear evolution of weights
7/22/05-1/8/07 in Table 22
  • Confirms
  • in 2005, weight .98 1.
  • significant downward trend in weight
  • Of non- currencies, upward trend in the ringgit
    weight is the strongest statistically.
  • Strikingly, no more statistical significance to
    the trend of appreciation against the basket,
  • let alone to acceleration in that trend.
  • Rather, action comes from falling weight on .

But the estimated shift away from is painfully
slowstarting at .98 in 2005, weight falls
only to .87 over 5 yrs.
We also looked at intra-daily movements
  • Some evidence that intra-daily pattern differs
    from inter-daily pattern, itself consistent with
    declared regime.
  • On purely intra-daily data, there is less sign of
    a downward trend in the very high weight on the

Has US pressure pushed the pace of increased
  • We searched an electronic database of news
    reports (FACTIVA/NewsPlus) , recording the number
    of US news reports of US officials asking China
    to speed up RMB flexibility/revaluation.
  • Two separate time series on the cumulative
    numbers of complaints
  • from US Treasury and
  • from officials of other government agencies (e.g.
    the White House, Congress and Fed)

Complaints Treasury other US
We added complaints as a regressor
  • There is evidence that cumulative complaints are
    associated with a reduction in the RMBs weight
    on the US dollar.