Euro on the world stage
There were few hotter topics at the meeting than the euro and its future as an international currency and as a major player in the world economy. Weighing in on the subject, and largely with upbeat assessments, were Fred Bergsten, Director of the Institute for International Economics (IIE); Otmar Issing, Chief Economist of the European Central Bank; Peter Kenen of Princeton University; Ronald McKinnon of Stanford University; Michael Mussa, former IMF Economic Counsellor and now senior fellow at the IIE; and Dominick Salvatore of Fordham University.
The roundtable discussants agreed that a number of key factors would determine the degree to which the euro becomes widely used outside the euro area. Among the more crucial factors were the speed with which European capital markets integrated and grew, Europe’s economic performance (including relative to the United States, as Bergsten emphasized), and the growth of European financial and real linkages with the rest of the world. All thought the dollar would long remain the preeminent invoice currency for international transactions, but the euro’s role in financial portfolios would naturally expand as a consequence of diversification. Kenen pointed to an already sharp rise in euro-denominated bond issues and the expansion—albeit a small one—in the euro’s role as an international reserve currency.
On balance, the participants concurred, the euro was good news for the international economy, because it was good news for Europe. What risks lie ahead? Salvatore thought the chief one was the possibility of a major dollar-euro misalignment. Issing cautioned that it was too soon to say whether the move from a hegemonic to a bipolar system would be stabilizing or not.
Currency regimes and pricing
The links between monetary and exchange rate policy, firms’ pricing strategies, and exchange rate pass-through were the focus of a session chaired by Linda Goldberg of the New York Federal Reserve Bank. Michael Devereux, University of British Columbia, and Charles Engel, University of Wisconsin, argued that exporters will generally want to set prices in the most stable currency. High monetary credibility in the importing country thus favors local currency pricing, implying no short-run pass-through.
In an extensive empirical paper, José Campa of IESE and Linda Goldberg provided some support for the view that countries with low pass-through have stable monetary environments. However, changes in pass-through coefficients in industrial countries seem to be driven mainly by changes in import composition rather than by macroeconomic factors.
Giancarlo Corsetti of Yale University and Paolo Pesenti of the New York Federal Reserve explored the interaction between optimal exchange rate policy and firms’ pricing strategies. Pricing in the currency of one’s export markets exposes firms’ revenues to exchange rate fluctuations, validating a currency union as the optimal monetary arrangement, which in turn validates pricing in the shared currency. Under flexible exchange rates, firms find producer-currency pricing optimal. Output correlation is reduced and this again validates the authorities’ choice of monetary regime. Interestingly, although both currency regimes are self-validating, Corsetti and Pesenti find flexible exchange rates superior in terms of efficiency because, in effect, they substitute for flexible prices.
Financial liberalization, Kaminsky and Schmukler also observed, tends to be followed by improvements in financial sector institutions and regulation.
Capital controls, financial liberalization
Capital controls and the effects of capital account liberalization received a good deal of attention at the conference. At least three papers focused on Malaysia’s experience with capital controls during 1998-99. Michael Devereux and David Cook, Hong Kong University of Science and Technology, made a theoretical case for controls. They modeled a financial panic as a sudden, externally induced spike in the risk premium (or alternatively, in the effective international interest rate faced by the country) and viewed controls as a tax that could mitigate the impact of this shock on domestic real interest rates by reducing the net returns that investors earn from taking funds out of a country. The amelioration implied by capital controls is especially significant when exchange rates are fixed; however, the overall impact of the shock remains smaller under flexible exchange rates, even in the presence of controls.
Ethan Kaplan and Dani Rodrik of Harvard University presented empirical evidence on the aggregate effects of Malaysia’s controls. Was it a success? That depends on the counterfactual, they explained. Contrasting Malaysia’s performance with that of other Asian countries during the year after controls were imposed suggests the controls were not successful. If economic performance is compared during the preceding 12 months, however, Malaysia looks like a considerable success (even controlling for differences in the external environment across the two periods). The latter is the right comparison, according to the authors, because the preceding 12-month period is the time when IMF-supported programs—the presumed alternative for Malaysia—began to be implemented by the other Asian crisis countries. Moreover, financial indicators in Malaysia worsened before the imposition of the controls, suggesting that the main crisis was yet to come. Of course, discussant Rudi Dornbusch pointed out, the later deterioration in Malaysia’s indicators may have been driven, in part, by the anticipation of capital controls.
In a closer look at the domestic political economy of Malaysia’s capital controls, Simon Johnson, Massachusetts Institute of Technology, and Todd Mitton, Brigham Young University, made the case that capital controls create a “screen for cronyism” that makes it easier for strong politicians to support favored firms. “Only firms connected to Prime Minister Mahathir,” they found, “experienced a disproportionate increase in stock prices in September 1998.” Following the imposition of capital controls, the stock of politically connected firms rose by about 20 percent more than other similar, but unconnected, firms. Furthermore, among politically connected firms, those that benefited the most had not previously reduced their cost of capital by listing overseas—that is, they stood to gain more from official support.
Two papers by Peter Henry of Stanford University and by Graciela Kaminsky and Sergio Schmukler of George Washington University and the World Bank, respectively, explored the impact of financial liberalization. Using firm-level data, Henry found that opening stock markets to nonresidents in a number of emerging market countries in the early 1990s was associated with significant increases in stock prices and investment by the domestic firms listed on these markets. He did not, however, find that foreign capital necessarily went to the firms whose risk characteristics most warranted investment. Capital account liberalization thus effectively relaxed financing constraints and increased overall inflows, but did not ensure efficient capital allocation. Kaminsky and Schmukler noted that, following financial liberalization, stock market cycles tend to become more pronounced, but over the long run the amplitude of these cycles is reduced. Financial liberalization, they also observed, tends to be followed by improvements in financial sector institutions and regulation.
Financial crises revisited
At least two papers renewed the debate on the effect of monetary policy on exchange rates during the Asian currency crisis. Research by Robert Dekle, Chiang Hsiao, and Siyan Wang—all from the University of Southern California—generally supported the conventional view that tight monetary policy stabilizes the exchange rate. Guiglielmo Caporale and Andrea Cipollini of South Bank University and Panicos Demetriades of the University of Leicester examined the same question, but their results bolstered the “revisionist view”—that tight money in fact encouraged the free fall of the exchange rate. The sharply divergent findings are driven mainly by different “identifying assumptions”—that is, by different approaches to disentangling cause and effect of monetary policy.
Steve Kamin of the Board of Governors of the U.S. Federal Reserve presented a new paper testing for the presence of moral hazard resulting from IMF-led international bailouts. Unlike previous papers that tested for moral hazard during the period between the Mexican bailout and the Russian crisis, Kamin asked if there was evidence of moral hazard today. He compared emerging market bond spreads and capital flows in the recent past to those prevailing prior to the Mexican crisis, when, he argued, moral hazard could not have existed because the size of Mexico’s bailout had no precedent. His results suggested that moral hazard was not currently a problem. In particular, controlling for macroeconomic fundamentals (proxied by credit ratings), spreads are higher and more dispersed today than they were before the Mexican crisis.
Bhagwati and Srinivasan explored the nexus between trade and poverty in poor countries and found little basis for the view that trade accentuated poverty.
Free trade feuds
Robert Feenstra of the University of California, Davis, chaired a stimulating session on free trade versus protectionism. Does the strong cross-country correlation between the average level of tariffs and cumulative growth performance during 1870-1913 indicate that protectionism benefited growth? Not at all, argued Douglas Irwin of Dartmouth College. This apparent relationship, he suggested, is driven by three outliers—the United States, Canada, and Argentina—that enjoyed high growth while maintaining relatively high tariffs. In each case, growth was attributable to factors unrelated to high tariffs, and these high average tariffs were not necessarily protectionist. They were imposed mainly on consumer goods, while intermediate goods often went tariff-free. These countries had low population densities and relied on tariffs for revenue reasons, Irwin said. It was the abundance of land, which allowed them to attract high levels of immigration and foreign investment, rather than tariffs that spurred growth.
Don Davis and David Weinstein of Columbia University asked whether large bilateral trade balances were a signal of protection. They estimated expected bilateral trade balances on the basis of macroeconomic factors and examined “triangular trade” (countries with high demand for particular goods running deficits with countries with a large supply of such goods, as the United States did with Japan with regard to automobiles). These standard theories explained only a small portion of the observed bilateral trade balances, they noted, leaving something of a puzzle. But don’t blame protectionism just yet, Weinstein said; other possible explanations need to be explored.
Finally, papers by Arvind Panagariya, University of Maryland, and by Jagdish Bhagwati, Columbia University, and T.N. Srinivasan, Yale University, looked at the relative merits of protection and free trade. Panagariya surveyed the literature on the costs of protection, noting that, while the marginal cost of protection was small at low levels of protection, at high levels, protection could have large welfare costs through both conventional distortionary effects and other channels, such as scale economies and disappearing products. Bhagwati and Srinivasan explored the nexus between trade and poverty in poor countries and found little basis for the view that trade accentuated poverty. To the extent that trade narrows differences in the prices of production factors across countries, this would tend to raise wages in poor countries, and the positive effects of trade on growth should help boost income levels in general. While models can be built to show that growth is bad for the poor, the experiences of countries like India and China, they said, offer strong evidence to the contrary.
Inequality and growth
Several papers took a hard look at the relationship between growth and inequality. Klaus Deininger, World Bank, and Lyn Squire, Global Development Network, presented new data on income inequality and some negative correlations between inequality and growth. Danny Quah of the London School of Economics noted that the macroeconomic factors that determine cross-country patterns of growth and convergence are crucial for understanding the evolution of the world distribution of income. He also argued that cross-country panel studies shed little light on the true relationship between inequality and growth. In fact, he said, inequality may be irrelevant for economic growth. Michael Keane, Yale University, and Eswar Prasad, IMF, presented some suggestive evidence from transition economies that rising inequality could hinder institutional and macroeconomic reforms and, consequently, economic growth by undermining the social and political consensus needed to implement market-oriented reforms.
Oded Galor, Brown University, and Omer Moav, Hebrew University, attempted to reconcile conflicting empirical evidence. In their model, inequality could promote growth, while the engine of growth is rapid physical capital accumulation. But as human capital accumulation becomes more important, inequality can have a negative effect on growth.
In a related paper, the same authors interpreted the gradual disappearance of class structure in Europe, arguing that capital and skill (human capital) are complements in production. Thus, capital accumulation intensifies the relative scarcity of skill. However, because skill is embodied in its owner, the only way to “accumulate” human capital is to spread it among more people. When credit market imperfections prevent private financing of schools, capitalists have the incentive to invest in public schools. As workers become more skilled, their incomes rise, they begin to save, and class differences eventually disappear. Galor and Moav suggested this mechanism was indeed at work during the late nineteenth and early twentieth centuries.