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 KoreaAmerica 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.
3
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.
4
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.
5
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
7
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)
9
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.
14
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.
15
The US financial position
has deteriorated internationally
• The twin deficits
• China is now our largest creditor
• The dollar appears in long-term decline.
16
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.
17
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 !
18
The “Bretton Woods II”
hypothesis
• 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.
1.0
USD
0.8
0.6
0.4
DEM
EUR
0.2
0.0
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.
23
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 ¥ & ₤.
•
24
= 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.
25
Decoupling?
• Initial hopes of decoupling
succumbed at the height of the crisis:
– Financial contagion
– Asian exports were
especially hard-hit.
26
Asian exports plummeted
via RGE Monitor 2009 Global Outlook
27
• 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.
28
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.
33
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
(Dooley; McKinnon & Pill…)
34
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.
35
The G-20
• G-20 meetings in 2009:
–London
in April
–Pittsburg
in October
36
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.
37
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.
38
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.
40
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?
41
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…
42
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.
44
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
45
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.
46
– My recommendation: an informal steering group within G-20.
47
Addenda
• 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.
48
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
50
Source: “The EMBI in the Global Village,” Javier Gomez May 18, 2008 juanpablofernandez.wordpress.com/2008/05/
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.
51
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…
52
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.
–
53
Origins of the financial/economic crisis
Monetary
policy easy
2004-05
Underestimated
risk in
financial mkts
Failures of
corporate
governance
Households
saving too little,
borrowing too
much
Federal
budget
deficits
Homeownership bias
Stock
market
bubble
Excessive leverage in
financial institutions
Predatory
lending
Excessive
complexity
Stock
market
crash
Gulf
instability
CDO
s
Financial
crisis
2007-08
Oil
price
spike
2007-08
Housin
g
bubble
MBS
s
CDSs
China’s
growth
Low
national
saving
Recession
2008-09
Foreig
n debt
Housin
g
crash
Lower longterm
econ.growth
Eventual loss
of US hegemony 54
Addendum 2:
The US current account deficits
• Some economists argue they are sustainable
55
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…
57
•
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.
58
•
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.61
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?
62
Addendum 3:
Proposal for a Global Climate Agreement
•
Stage 1:
Proposal
• 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.
64
◙ 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.
W orld Industrial Carbon Emissions
25
bau
15
10
Sim ulated
Em is s ions
5
0
20
05
20
20
20
35
20
50
20
65
20
80
20
95
GtC
20
Global peak
date ≈ 2035
65
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.
66