The 2008-09 Global Financial Crisis: Lessons for Country Vulnerability

After the currency crises of 1994-2001, and especially the East Asia crises of 1997-98, a lot of research investigated what countries could do to protect themselves against a future repeat.  More importantly, policy makers in emerging markets took some serious measures.  Some countries abandoned exchange rate targets and began to float.   Many accumulated high levels of foreign exchange reserves.  Many moved away from dollar-denominated debt, toward other kinds of capital inflow that would be less vulnerable to currency mismatch, such as domestic currency debt or Foreign Direct Investment.   Some instituted Collective Action Clauses in their debt contracts to facilitate otherwise-messy restructuring of debt in the event of a severe negative shock.  A few raised reserve requirements or otherwise tightened prudential banking regulations (clearly not enough, in retrospect). And so on.

When the Global Financial Crisis hit ten years later, it was bad news for everyone, except that it was good news for econometricians:  we could observe which countries got hit badly by this common external shock in 2008-09 and which did not, and could try to draw inferences about which strategies helped countries withstand the shock better than others.  The NBER is holding a public symposium in Washington on September 22.   The topic of the 3^rd and final session is: What ex ante policies can help reduce vulnerability to future shocks?

Three papers that were presented at the earlier NBER conference in Bretton Woods (the culmination of a project on the Global Financial Crisis  sponsored by the Sloan Foundation) fall naturally into this category:

• International Reserves and the Global Financial Crisis, Kathryn Dominguez (University of Michigan), Yuko Hashimoto (IMF), and Takatoshi Ito (University of Tokyo);
• Managing Capital Inflows: The Role of Controls and Prudential Policies,  Jonathan Ostry, Atish Ghosh, Marcos Chamon, and Mahvash Qureshi (all of the IMF);
• International Financial Crises and the IMF: What the Historical Record Shows, Bergljot Barkbu (IMF), Barry Eichengreen (UC, Berkeley), and Ashoka Mody (IMF).

To simplify a bit, Dominguez and co-authors study whether holding high levels of reserves helped countries do better in the Global Financial Crisis;  Ostry and co-authors study whether capital controls and bank regulation helped; and Barkbu, Eichengreen and Mody consider possible new mechanisms to improve the risk structure of capital inflows and to smooth adjustment to shocks, such as sovereign CoCos (Contingent Convertible bonds) and indexing of debt.

The question that Dominguez, Hashimoto, and Ito address in International Reserves and the Global Financial Crisis, had been actively debated in the years before 2008.   Some economists thought that China, especially, but other emerging market countries as well, were holding far more foreign exchange reserves than they needed to withstand shocks.  Larry Summers (2006) was one prominent example; I must admit that his argument sounded sensible to me at the time.  When the global financial crisis hit, it was possible to test the proposition.   Some of the early studies found that reserve holdings did not seem to help countries withstand the crisis better.  Blanchard, Faruqee and Klyuev (2009) was one.   A series of papers by Andy Rose and Mark Spiegel (2009a, b) also found no significant effect.   But others found an important effect.    One of the technical contributions of the paper by Dominguez and co-authors is to subtract estimates of interest income and valuation changes from officially report levels of reserves in order to get at the actively managed component.  Their single most important finding is that real GDP growth recovery after the global financial crisis was stronger for countries that had accumulated large reserve holdings before the crisis.

This is the same thing I had found in a study with George Saravelos (NBER WP no.16047, 2010) .   Out of dozens of potential early warning indicators, foreign exchange reserves are the indicator that had been most often identified as significant by eighty pre-2008 studies conducted on earlier data.  We found that reserves are also the indicator that was the strongest predictor of which countries got into trouble in 2008-09. A particularly useful indicator is the ratio of reserves to short-term debt (Guidotti, 2003).   We found that the second most consistently important early warning indicator was overvaluation of the currency by criteria like PPP.   Also important in the recent crisis were measures of national saving.

Why did the Dominguez paper and my paper find that reserves had a significant effect, and others did not?    My guess is that it has to do with different definitions.  In particular, we define the crisis period as late 2008 and early 2009, whereas the earlier papers I mentioned ended in 2008.

In Managing Capital Inflows: The Role of Controls and Prudential Policies, Ostry, Ghosh, Chamon, and Qureshi do something very important.  Too many discussions lump financial regulations together (speaking indiscriminately of Tobin taxes, Chile-style or Brazil-style controls on short-term capital inflows, Venezuela’s  controls on outflows, etc., even though these are completely different things).  Chamon and co-authors develop three new country indices: one for financial-sector capital controls, one for prudential regulation of foreign exchange transactions in the domestic banking sector, and one for domestic prudential policies.  This helps avoid exacerbating what is often a sterile oversimplified debate.  For example, even if one is ideologically opposed to capital controls, or has been persuaded by research such as Kristin Forbes (2007) that the famous Chile controls caused undesirable distortions, it is hard to be opposed to prudential banking regulations, especially in light of the origins of the 2008 crisis.   Chamon and co-authors find that capital controls and FX-related prudential measures can both help shift the composition of lending, away from FX-denominated bank loans and toward equity and FDI components of capital inflows.   Previous researchers have found that shifts of this sort in the composition of inflow, as opposed to reductions in the level of inflows per se, reduce the probability of a crisis. (Frankel and Rose, 1996, among many others.)   Probably the most important finding by Chamon et al is a reasonably strong statistical association between pre-crisis prudential and capital control policy and resilience to the sudden stop.   Countries in the upper quarter of restrictiveness of FX-related prudential measures do better in a crisis than those in the bottom quarter, by a whopping margin of 2 ½ – 3 ½ % percentage points of growth.  An important lesson for countries facing large inflows today.

One of the co-authors of International Financial Crises and the IMF: What the Historical Record Shows, Barry Eichengreen, is not just the pre-eminent economic historian of this field but also supplied a lot of the intellectual force behind the adoption of Collective Action Clauses after the preceding round of emerging market crises (e.g., Eichengreen, 2003; and Eichengreen and Mody, 2004).  Thus it is well worth listening to what they have to say about further ideas for structuring capital flows ex ante in such a way as to avoid messy and costly restructuring ex post.

Barkbu, Mody, and Eichengreen explore how to automate the restructuring decision.  Automating the process has key advantages: it preserves the integrity of the contract (which avoids the uncertainties involved in triggering CDS); it is predictable; and it can be priced.   It can also avoid the need for what otherwise might be a lengthy process of renegotiation between debtors and creditors during which time economic activity falls and everyone suffers.  To this end, they discuss the idea of adding to future government bond issues so-called sovereign cocos, contractual provisions that automatically lengthen maturities or reduce interest and amortization payments when a pre-specified debt/GDP ratio is reached.

There are also other ways of improving risk sharing and avoiding the need for costly restructuring negotiations.  An idea that is older but that I think merits more of a try-out than it has received — applicable for countries that export oil, minerals or agricultural commodities — is to index the debt to the world price of the export commodity.  Also in this category is the basic movement away from dollar-denominated debt and toward domestic-denominated debt, equity and FDI .  It seems to me that countries that heeded such lesson of the 1990s (including many emerging markets in Asia and Latin America) came through the GFC relatively well, whereas those that did not (Eastern Europe), did not.

References

Barkbu, Bergljot, Barry Eichengreen, and Ashoka Mody, International Financial Crises and the IMF: What the Historical Record Shows, NBER Conference on The Global Financial Crisis, Bretton Woods, NH, June 2011, organized by C.Engel, K.Forbes, and J.Frankel.
Berkmen, Pelin, Gaston Gelos, Robert Rennhack, and James P Walsh (2009), “The Global Financial Crisis: Explaining Cross-Country Differences in the Output Impact“, IMF Working Paper 09/280.
Blanchard, Olivier, Hamid Faruqee, and Vladimir Klyuev (2009), “Did Foreign Reserves Help Weather the Crisis“, IMF Survey Magazine, October.
Chamon, Marcos, Atish Ghosh, Jonathan Ostry, and Mahvash Qureshi, Managing Capital Inflows: The Role of Controls and Prudential Policies,   NBER Conference on The Global Financial Crisis, Bretton Woods, NH, June 2011, organized by C.Engel, K.Forbes, and J.Frankel.
Dominguez, Kathryn, Yuko Hashimoto, and Takatoshi Ito, International Reserves and the Global Financial Crisis, , NBER Conference on The Global Financial Crisis, Bretton Woods, NH, June 2011, organized by C.Engel, K.Forbes, and J.Frankel.
Eichengreen, Barry, 2003, “Restructuring Sovereign Debt,” The Journal of Economic Perspectives, Volume 17, Number 4, 1 November , 75-98.
Eichengreen, Barry and Ashoka Mody. 2004, “Do Collective Action Clauses Raise Borrowing Costs?,” Economic Journal, v114 (495,April), 247-264.   NBER WP 7458.
Forbes, Kristin, “One cost of the Chilean capital controls: Increased financial constraints for smaller traded firms,” Journal of International Economics,  71, Issue 2, April 2007, Pages 294-323
Frankel, Jeffrey and George Saravelos (2010), “Are Leading Indicators of Financial Crises Useful for Assessing Country Vulnerability? Evidence from the 2008-09 Global Crisis,” NBER WP 16047, June.
Frankel, Jeffrey, and Andrew Rose (1996) “Currency Crashes in Emerging Markets,” Journal of International Economics 41, no. 3/4, 351-66.
Guidotti, Pablo (2003), in J Antonio Gonzalez, V.Corbo, A.Krueger, and A.Tornell, (eds.), Latin American Macroeconomic Reforms: The Second Stage, University of Chicago Press.
Obstfeld, Maurice, Jay Shambaugh, and Alan Taylor (2009), “Financial Instability, Reserves, and Central Bank Swap Lines in the Panic of 2008,” American Economic Review, 99(2):480-486.
Obstfeld, Maurice, Jay Shambaugh, and Alan Taylor (2010), “Financial Stability, the Trilemma, and International Reserves“, American Economic Journal: Macroeconomics.
Rose, Andrew and Mark Spiegel (2009a), “The Causes and Consequences of the 2008 Crisis: Early Warning,” Global Journal of Economics. NBER Working Paper 15357.
Rose, Andrew, and Mark Spiegel (2009b), “The Causes and Consequences of the 2008 Crisis: International Linkages and American Exposure,” Pacific Economic Review.
Summers, Lawrence, 2006,  “Reflections on Global Account Imbalances and Emerging Markets Reserve Accumulation,” March 24.

High Noon: The Outcome to the Debt Ceiling Standoff

After a month of high drama the Senate at high noon today voted to pass a bill to raise the debt ceiling.    How to evaluate this outcome?    If I must give a one-word verdict, it would be “good.”   If I can expand to two words, it would be “not good.”   If I can elaborate to 20 words: “The legislation confirms the sorry state of our public deliberations, but it is probably the best that could be hoped for,” given where the negotiations were as the big hand on the clock approached twelve.

In what sense was the outcome to the debt ceiling standoff good?   It was much better than a number of alternatives that could have easily happened.  After the pin had been pulled out of the hand grenade, Washington managed to put it back in.   Specifically, it is good that:

1. Those who favored a US default — in some cases deliberately, not just as a bargaining tactic — did not prevail.
2. Those who sought to force the Congress and White House to go through the madness of voting on the debt ceiling every few months between now and the next presidential election did not prevail.
3. The bill’s 10 years of spending cuts are not front-loaded. Frontloading would have substantially raised the chances of going back into a new recession. (So would have default or an uncertainty-maximizing short-term fix.)
4. The bill has a mechanism that just might in November demonstrate to the arithmetically innumerate that it is literally impossible to eliminate the budget deficit if the cuts are to come primarily in discretionary non-security spending.  Instead, military spending, entitlements, and tax revenues will have to be part of the eventual solution — as also favored by the American people in polls, even a majority of Republicans. This epiphany on the part of the people who are described as die-hard fiscal conservatives is needed before we can break the political log-jam.  A solution is not possible so long as the extremists are under the mistaken belief that the deficit can be eliminated with cuts concentrated in domestic discretionary spending and so long as they have veto power in the eyes of the Republican leaders.

The mechanism is to force Congress to confront an unpleasant but clear choice between (i) on the one hand, deep automatic cuts that hit defense, which are anathema to most Republicans, and Medicare, which are anathema to Democrats, and (ii) on the other hand, the more thoughtful recommendations of a bi-partisan Joint Select Committee on Deficit Reduction, which would certainly spread out the pain more to include increased tax revenues, anathema to Republicans, and other entitlement cuts, anathema to Democrats.  The 12-member panel is to report its recommendations in late November, and the Congress is to vote on them in December.  This mechanism is of course crude, but may be just the sort of thing we need to force individual congressmen to confront arithmetic.
Some have asked how this panel will differ from the ill-fated Simpson-Bowles commission.   A critical difference is the requirement that the Congress must vote up-or-down on the recommendations.   (This was also a feature of the original version of what became the National Commission on Fiscal Responsibility and Reform; but the provision was voted down by Senate Republicans, including some who had sponsored the proposal until President Obama came out in favor of it in January 2010.)

In what sense was today’s outcome to the debt ceiling stand-off “not good?”   It would have been better if:

1. The Republicans had agreed to some of President Obama’s various compromise proposals over the last year and a half; or
2. The showdown had at the last minute forced a “$4 trillion” Grand Bargain in which all sides had ceded ground in order to adopt a workable and credible plan to get back to fiscal responsibility gradually over the coming decade, rather than subsisting on political rhetoric.
3. The outcome had included something to help the current faltering recovery.
4. President Obama had come off looking like Gary Cooper.

Escape from Procyclicality: Fiscal Policy in Developing Countries

[This column is co-authored with Carlos Végh and Guillermo Vuletin and was published in VoxEU.]

Everywhere one looks, problems of fiscal policy are now center stage.   Among advanced countries, the news is bad:   Europe’s periphery teeters, the U.K. slashes, the U.S. deadlocks, Japan muddles.  But in the rest of the world there is better news:   In an historic reversal, many emerging market and developing countries have over the last decade achieved a countercyclical fiscal policy.

In the past, developing countries tended to follow procyclical fiscal policy:   they increased spending (or cut taxes) during periods of expansion and cut spending (or raised taxes) during periods of recession.  Many authors have documented that fiscal policy has tended to be procyclical in developing countries, in comparison with a pattern among industrialized countries that has been by and large countercyclical. (References for this proposition and others are available.)   Most studies look at the procyclicality of government spending, because tax receipts are particularly endogenous with respect to the business cycle.  Indeed, an important reason for procyclical spending is precisely that government receipts from taxes or mineral royalties rise in booms, and the government cannot resist the temptation or political pressure to increase spending proportionately, or even more than proportionately. One can find a similar pattern on the tax side by focusing on tax rates rather than revenues, though cross-country evidence is harder to come by.

Figure I (which is a version of evidence presented in Kaminsky, Reinhart and Vegh, 2004) depicts the correlation between government spending and GDP for 94 countries over the period 1960-1999.   More precisely, it shows the correlation between the cyclical components of spending and GDP;  the longer term trends are taken out.   The set includes 21 developed countries, which are represented by black bars, and 73 developing countries, represented by yellow bars.  A positive correlation indicates government spending that is procyclical, that is, destabilizing.  A negative correlation indicates countercyclical spending, that is, stabilizing.

[Click here for enlargement of Figure I.]

There is no missing the message.  Yellow bars lie overwhelmingly on the right hand side:  more than 90 percent of developing countries show positive correlations (procyclical spending).  Black bars dominate the left hand side:  around 80 per cent of industrial countries show negative correlations (countercyclical spending).

Over the last decade there has been a historic shift in the cyclical behavior of fiscal policy in the developing world.     Figure II updates the statistics, showing the period 2000-2009.  The number of yellow bars on the left side of the graph (negative correlations) has greatly increased.   Around 35 percent of developing countries [26 out of 73] now show a countercyclical fiscal policy, more than quadruple the share during the earlier period.

[Click here for enlargement of Figure II.] 

Figure III presents a scatter plot with the 1960-1999 correlation on the horizontal axis and the 2000-2009 correlation on the vertical axis.  The lower right quadrant shows the graduates from procyclical to countercyclical fiscal policy.  The star performers include Chile and Botswana; but 24 developing countries altogether (out of 73) have made this historic shift.

[Click here for enlargement of Figure III.] 

The evidence of countercyclicality among many emerging market and developing countries matches up with other criteria for judging maturity in the conduct of fiscal policy:    debt/GDP ratios, rankings by rating agencies, and sovereign spreads.  Low income and emerging market countries in the aggregate have achieved debt/GDP levels around 40 percent of GDP over the last four years.  [The IMF estimates the 2011 ratio at 43 per cent among emerging market countries and 35 per cent among low-income countries]. This is the same period during which debt in advanced countries has risen from about 70 per cent of GDP to 102 percent.   The financial markets have ratified the historic turnaround.   Spreads are now lower for many emerging markets than for some “advanced countries.”    Rating agencies rank Singapore as more creditworthy than Belgium, Korea ahead of Portugal, Mexico ahead of Iceland, and just about everybody ahead of Greece.    Euromoney ranks Chile as less risky than Japan, Korea less risky than Italy, Malaysia less risky than Spain, and Brazil less risky than Portugal.

Largely as a result of their improved fiscal situations during the period 2000-2007, many emerging markets were able to bounce back from the 2008-2009 global financial crisis more quickly than advanced countries.

What explains the ability of some countries, particularly emerging market and developing countries, to escape the trap of procyclical fiscal policy? Many researchers have pointed to the importance of institutions.  In new research we find that the cyclicality of a country’s fiscal policy is inversely correlated with the country’s institutional quality (which includes measures of law and order, bureaucracy quality, corruption, and other risks to investment).    The relationship holds also when instrumental variables are used.

Although one thinks of institutions as slow-moving, they can change over time.   Chile’s institutional quality has risen strongly since the early 1980s, during which time its fiscal policy has turned from procyclical to countercyclical.   A country with good institutional quality in the general sense of rule of law can help lock in countercyclical fiscal policy through specific budget institutions.   Chile did it with the structural budget reforms of 2000 and 2006.   Chile’s approach could be emulated by others.

Fiscal rules, such as euroland’s  Stability and Growth Pact, may accomplish little in themselves.   Rules can actually worsen the tendency of governments to make overly optimistic forecasts for economic growth and budget balance.   Chile’s key innovation was to give responsibility for forecasting to independent expert commissions, insulated from politicians’ wishful thinking.

Even advanced countries have something to learn about countercyclical fiscal policy from Chile and others to the South.  Saving during expansions such as 2001-06 is critical for weathering the storm in recessions such as 2008-09.  Otherwise there may be no way out but to adjust at the worst possible time.

The Federal Government Races to the Cliff

In the 1955 movie Rebel Without a Cause, James Dean and a teenage rival race two cars to the edge of a cliff in a game of chicken.  Both intend to jump out at the last moment.  But the other guy miscalculates, and goes over the cliff with the car.

This is the game that is being played out in Washington this month over the debt ceiling.  The chance is at least 1/4 that the result will be similarly disastrous.    

It is amazing that the financial markets continue to view the standoff with equanimity.   Interest rates on US treasury bonds remain very low, 3% at the ten-year maturity.   Evidently it is still considered a sign of sophistication to say “This is just politics as usual.  They will come to an agreement in the end.”  Probably they will.  But maybe not.   (I’d put a ½ probability on an agreement that raises the debt limit, but just muddles through in terms of the genuine long term fiscal problem.  That leaves at most a ¼ probability of a genuine long-term solution of the sort that President Obama apparently proposed last week – described as worth $4 trillion over ten years.)

My advice to investors is to shift immediately out of US treasuries and into high-rated corporate bonds.  If the worst happens, you will probably save yourself from a big capital loss within the next month.  If not, there is no harm done.

The game is not symmetric.  The Republicans are the ones who are miscalculating.   Evidently they are confident of prevailing:  they rejected the President’s offer, even though he was willing to cut entitlement programs.

The situation is complicated because there are a number of different people crammed into the Republican car.    There is one guy who is obsessed with the theory that, come August 3, the federal government could retain its top credit rating if it continued to service its debt by ceasing payment on its other bills.  But this would mean failing to honor legal obligations that have already been incurred (paying suppliers for paper clips that have already been bought, paying soldiers their wages for last month’s service, sending social security recipients their checks, etc.).  This is like observing that the cliff is not a 90 degree drop-off, but only 110 degrees.   It doesn’t matter: the car would still go crashing into the ocean far below.   The government’s credit would still be downgraded and global investors would still demand higher interest rates to hold US treasuries, probably on a long-term basis. 

There are other guys (and gals) in the car who are even more delusional.   They are dead set on a policy of immediately eliminating the budget deficit (e.g., those opposed to raising the debt ceiling no matter what, or those campaigning for a balanced budget amendment), and doing it primarily by cutting nondefense discretionary spending.  This is literally impossible, arithmetically.  But they honestly don’t know this.   It is as if they were insisting that the car can fly.   Sometimes it can be a good bargaining position to adopt a very extreme position.  But if you are demanding that the car flies, you are not going to get your way no matter how determined you are. 

It seems likely that the man in the driver’s seat – House Speaker John Boehner – does realize that his fellow passengers don’t have the facts quite right.   But there is also a game of chicken going on within the Republican car.  The crazies have said they will oppose in the next Republican primary election any congressman who votes to raise the debt ceiling or to raise tax revenues.   (Yes, they think they would support someone who would eliminate the budget deficit primarily by cutting non-defense discretionary spending; but remember, this is arithmetically impossible.)   The guy who is riding shot-gun in the car – the one who believes the car can fly — is trying to put his foot on top of Boehner’s on the accelerator pedal.   

It seems to me that Boehner, too, is miscalculating.  Given that the car can’t fly, the crazy guy is probably going to oppose him in the primaries no matter what he does.   So I don’t see what his plan is.   But whatever it is, he has made it clear that he doesn’t plan to agree to any increase in tax revenues.   

As a result the Republican leadership is in the remarkable situation of refusing to agree to Obama’s offer to solve the problem so long as the solution includes raising tax revenue, even if it is via such measures as ending distortionary subsidies for ethanol, oil companies, and corporate jets.

If I had to guess:   The financial markets will wake up just before August 3.   US bond prices will finally fall.  The market reaction will shock the Republican leadership into action.  (Precedents include the delayed congressional passage of the unpopular TARP legislation in the fall of 2008 and the delayed passage of an unpopular IMF quota increase 10 years earlier.)   They will finally make the small but necessary concessions on tax revenues.   But by then it might be too late.

Combating Volatility in Agricultural Prices

 

Under French President Nicolas Sarkozy’s leadership, the G-20 has made addressing food-price volatility a top priority this year, with member states’ agriculture ministers meeting recently in Paris to come up with solutions. The choice of priorities has turned out to be timely: world food prices reached a record high earlier in 2011, recalling a similar price spike in 2008.

 

Consumers are hurting worldwide, especially the poor, for whom food takes a major bite out of household budgets. Popular discontent over food prices has fueled political instability in some countries, most notably in Egypt and Tunisia. Even agricultural producers would prefer some price stability over the wild ups and downs of the last five years.

 

The G-20’s efforts will culminate in the Cannes Summit in November. But, when it comes to specific policies, caution will be very much in order, for there is a long history of measures aimed at reducing commodity-price volatility that have ended up doing more harm than good.

 

For example, some inflation-targeting central banks have reacted to increases in prices of imported commodities by tightening monetary policy and thereby increasing the value of the currency. But adverse movements in the terms of trade must be accommodated; they cannot be fought with monetary policy.

 

Producing countries have also tried to contain price volatility by forming international cartels. But these have seldom worked.  

 

In theory, government stockpiles might be able to smooth price fluctuations, releasing commodities in times of shortage and adding to stocks when prices are low.   A free-marketer will point out that they can undermine the incentive for the private sector to hold stockpiles.  A valid response is that this incentive is undermined regardless, because political economy never allows “hoarders” to “price gouge” in times of food crisis.    It all depends on how stockpiles are administered.  The record in practice is not encouraging.

 

In rich countries, where the primary producing sector usually has political power, stockpiles of food products are used as a means of keeping prices high rather than low. The European Union’s Common Agricultural Policy is a classic example – and has been disastrous for EU budgets, economic efficiency, and consumer pocketbooks.

 

In many developing countries, on the other hand, farmers lack political power.  Some African countries adopted commodity boards for coffee and cocoa at the time of independence. Although the original rationale was to buy the crop in years of excess supply and sell in years of excess demand, thereby stabilizing prices, in practice the price paid to cocoa and coffee farmers, who were politically weak, was always below the world price.  In response, production fell.

 

Politicians often seek to shield consumers through price controls on staple foods and energy.  But the artificially suppressed price usually requires rationing to domestic households. (Shortages and long lines can fuel political rage as well as higher prices can.). Otherwise, the policy can require increased imports in order to satisfy the excess demand, and so can raise the world price even more.

 

If the country is a producer of the commodity in question, it may use export controls  to insulate domestic consumers from increases in the world price. In 2008, India capped rice exports, and Argentina did the same for wheat exports, as did Russia in 2010.

 

Export restrictions in producing countries and price controls in importing countries both serve to exacerbate the magnitude of the world price upswing, owing to the artificially reduced quantity that is still internationally traded. If producing and consuming countries in grain markets could cooperatively agree to refrain from such government intervention, working through the World Trade Organization, world price volatility could be lower.

 

In the meantime, some obvious steps should be taken.  It is too bad that the G20 attempt to do away with bio-fuel subsidies has failed, so far. Ethanol subsidies, such as those paid to American corn farmers, do not accomplish policymakers’ avowed environmental goals, but do divert grain and thus help drive up world food prices. By now this should be clear to everybody. But one cannot really expect the G-20 agriculture ministers to be able to fix the problem. After all, their constituents, the farmers, are the ones pocketing the money. The US, it must be said, is the biggest obstacle here.

 

It is probably best to accept that commodity prices will be volatile, and to create ways to limit the adverse economic effects – for example, financial instruments that allow hedging of the terms of trade.

 

What the G-20 farm ministers — meeting for the first time June 23 — have agreed is to forge an Agricultural Market Information System to improve transparency in agricultural markets, including information about production, stocks, and prices. More complete and timely information might indeed help.

 

The broader sort of policy that President Sarkozy evidently has in mind, however, is to confront speculators, who are perceived as destabilizing agricultural commodity markets. True, in recent years, commodities have become more like assets and less like goods. Prices are not determined solely by the flow of current supply and demand and their current economic fundamentals (such as disruptions from weather or politics). They are increasingly determined also by calculations regarding expected future fundamentals (such as economic growth in Asia) and alternative returns (such as interest rates) – in other words, by speculators.  

  

But speculation is not necessarily destabilizing. Sarkozy is right that leverage is not necessarily good just because the free market allows it.  And that speculators occasionally act in a destabilizing way. But speculators more often act as detectors of changes in economic fundamentals and provide the signals that smooth fluctuations. In other words, they often are a stabilizing force.

 

The French have not yet been able to obtain agreement from the other G-20 members on measures aimed at regulating commodity speculators, such as limits on the size of their investment positions. I hope it stays that way. Shooting the messenger is no way to respond to the message.

 

[This op-ed appeared via Project Syndicate.  Comments can be posted at that site.]

The IMF Head Can’t Come from Emerging Markets Unless They Get Behind a Candidate

It is time for the Managing Director of the International Monetary Fund to come from an emerging market country. But that has been said often before. Whining about the injustice of the 65-year duopoly under which the IMF MD comes from Europe and the World Bank President comes from the US won’t change anything. Only if emerging market countries were to unify quickly behind a single strong candidate would they have a shot at the post. They are evidently too fragmented even to make an effort to come together in this way. Thus the job will probably go to a European yet again.

Why should the person come from the South instead of Europe?  After all, the oft-repeated principle that the IMF Managing Director should be chosen on merit rather than nationality need not necessarily mean a departure from the past practice of choosing Europeans. Europe of course has some well-qualified candidates. Christine Lagarde is very impressive and capable (though I would ideally have preferred someone with economics training for this job rather than a lawyer).

But the proposition that the ongoing sovereign debt troubles in Europe’s periphery are a reason to appoint a European is wrong. Ms. Lagarde herself seems to acknowledge this.   If anything, someone without a stake in Europe might be better situated to deal with the Greeks and the others.

The important point is that Europe has by now lost its implicit claim to be the best source of serious sober adults with the experience required to run the world monetary system. There may have been a time when the adult-child metaphor had a kernel of truth. In the 1980s, for example, the Fund was run by highly capable Managing Directors from France, during a period when huge budget deficits and even hyperinflations ran wild in the developing world. But that time is past.

There are three respects in which Europe can no longer claim to be the special seat of wisdom and responsibility. In the first place, many of the emerging market governments have done better jobs running their economies over the last decade than has Europe. I refer in particular to excessive debts that many European countries accumulated during the last expansion, culminating in the mis-managed sovereign debt crisis of the last year or two. In the second place the Europeans now have three strikes in a row in choosing Managing Directors for the IMF: Each of the last three MDs resigned before the end of his term. True, neither of Dominique Strauss-Kahn’s two predecessors left in the sort of scandal that he faces. But both of their resignations revealed that the men in question had not been taking the job seriously enough.  (Incidentally, over the last decade the US has screwed up as badly as Europe: enacting fiscally reckless policies during the last economic expansion and installing an inappropriate president of the World Bank in 2005.)

Thirdly, and most importantly, it so happens that many of the best candidates this time are not from Europe nor from the United States, but rather from emerging markets. So the merit criterion happens to coincide well with the much-recognized but never-honored need to give emerging market countries more weight in the governance of the IMF, in line with their new weight in the world economy.

Indeed, it is remarkable how many excellent candidates there are now from emerging markets. That is not to say that everyone put forward by his or her government is in truth a good prospect. When Turkey’s leaders say they have at least ten good candidates, they illustrate that politicians often don’t know what qualifications are required for the job. (No country has ten good candidates.)

I count ten emerging market individuals who are unusually well-qualified for the post.  Seven of them appear to be live candidates. They come from every part of the globe.
• Agustin Carstens, current governor of Mexico’s central bank, is described as the leading prospect among the group – because his government lost no time nominating him. He indeed would be good.  And has IMF experience, which is desirable whatever the critics say. But even Latin America is not unifying behind him (for example Brazil has not been supportive), let alone other developing countries. He may be perceived as too close to the US by developing countries to get their support – and also by the Americans who might worry that having him as head of the IMF would undermine their claim to the World Bank presidency.
• Arminio Fraga, former governor of Brazil’s central bank, is another good candidate, with extensive experience. But, again, it is not clear that governments even within Latin America are prepared to unify behind someone from the region’s largest country. Perhaps as a general matter any candidate who is identified with a large regional power is more likely to provoke jealousy than solidarity from the neighbors.  Mexico is unlikely to support a candidate from Brazil and vice versa.    India is unlikely to support a candidate from China, and vice versa.
• Tharman Shanmugaratnam is my favorite candidate. He has excelled as Singapore’s Finance Minister and was just promoted to Deputy Prime Minister. In March he was chosen to head the International Monetary and Financial Committee, the panel of ministers that advise the IMF on strategy twice a year. (The incumbent was forced to leave in a hurry, because he had been Egypt’s finance minister.) I can attest to Shanmugaratnam’s intelligence.  He was my student at Harvard in 1988-89. (He caught a number of errors in a draft of my textbook.)  He also has great political skills. I think he is the sort of candidate behind whom emerging market countries might be able to unify; they need not feel threatened by Singapore.
• Sri Mulyani Indrawati is another candidate from Southeast Asia with all the right credentials. She became one of the three Managing Directors of the World Bank last year, after apparently having been forced out as Indonesia’s Finance Minister for doing too good a job. Incidentally, she is young and could be a good candidate next time around too (as could the first three).
• Leszek Balcerowicz (Poland’s former Finance Minister, deputy PM, central bank governor, and Mr. Shock Therapy) is a credible candidate. Poland would be a compromise with respect to nationality, because it is both an EU country and an emerging market.
• Trevor Manuel was a great success as South African Finance Minister, and it would be good to make better use of him than the current government seems to be doing.
• Zhu Min, former Deputy Governor of the People’s Bank of China and currently a high-ranking IMF official, is another obvious candidate.

I can think of at least three others who would also do a great job, but are apparently not as actively in contention.
• Kemal Dervis (Turkey’s former Minister of Economic Affairs) would have been excellent, but he took himself out of the running early.
• I thought they should have picked Stanley Fischer for Managing Director in 2000. A stellar economist and manager, he was Deputy Managing Director of the Fund at the time. It would have been a first step toward accommodating the legitimate desire of developing countries to break the monopoly of Europe-born and US-born officials on the top jobs in the IMF and World Bank, as Fischer was born in Zambia and had the support of a surprising number of African countries. (Disclosure: He was a professor of mine at MIT in the 1970s.) The US was not prepared to oppose Europe in support of his candidacy because in practice it would have meant having to give up the US claim on the World Bank presidency.  But he would have been the best person for the job, and still is.
• Montek Ahluwalia, the last of the ten, is Deputy Chairman of India’s Planning Commission, a position that is far more important than it sounds. But there is a presumption that the candidate should not be over 65, which would let him out if followed (and Fischer).

June 10 is the deadline for nominations. Any of the ten would do a good job. Personally, I would urge emerging market governments to unite behind Shanmugaratnam. More likely, they will remain disunited. And then it will go to Lagarde.

Comments can be posted on the sites of Project Syndicate (which holds the copyright to the op-ed), the East Asia Forum, or SeekingAlpha.

.

[Crosstalk debate, "What the Fund?" May 30.]

How Europe Should Treat Sovereign Debt in the Future

My preceding blogpost identified three mistakes made by leaders of the European Economic and Monetary Union in dealing with Greece.   But what is done is done.  The mistakes now lie in the past.  How can Europe’s fiscal regime be reformed to avoid future repeats of this crisis?  

The reforms that are now underway are not credible.  (”We are going to make the fiscal rules more explicit and make sure to monitor them more tightly next time.”)    Similarly, most proposals for how to put teeth into the rules are not credible — penalties such as monetary fines or loss of voting privileges. 

It is too late for Greece. But it is not too late for a euroland reform that would help avoid the re-emergence of unsustainable sovereign debt levels next time around by applying the lesson of mistake number two: to adjust the ECB policy of accepting the debt of all member states as collateral.  This is the policy that short-circuited warning signals that the private markets would otherwise have sent via interest rates during 2002-2007.  

My proposal:   The eurozone should in the future adopt a rule that whenever a country violates the fiscal criterion of the Stability and Growth Pact (say, a budget deficit in excess of 3% of GDP, structurally adjusted), the ECB must stop accepting that government’s debt as collateral.  This system would achieve the elusive objective of true automaticity.   If a country exceeded the threshold for justifiable reasons, such as natural disaster, the private markets could perceive that and impose little or no default risk premium.   No judgment of the merits by bureaucrats or politicians would be required.   More likely, for periphery countries, the result of such a re-classification would be the re-emergence of sovereign spreads of moderate magnitudes, in between the extremes of the 2002-07 lows and the 2009-11 highs (see chart).  The interest rate premium would send a message far more credibly, forcefully, and promptly than any warning that any Brussels bureaucracy will ever turn out.  

This is how it works among the U.S. states and municipalities.  Despite the absence of their own currencies, the recurrence of dysfunctional local politics and excessive deficits, and even a history of state defaults in the 19^th century, federal bailouts are not delivered and are not expected.   Without some such device, the new European Stability Mechanism is in danger of becoming a mechanism for instability.

[Niels Thygesen made the case in favor of the current reform track in "Governance in the Euro Area" at the Challenge of Europe session of INET's Annual Conference, Bretton Woods, NH, April 10, 2011. I gave my comment there as well. (Video)]

[Comments can be posted on the Vox.eu site (which has the copyright.)]