International Coordination

Jeffrey FrankelHarpel Professor of Capital Formation and Growth

Harvard Kennedy School

2015 Asia Economic Policy ConferencePolicy Challenges in a Diverging Global Economy

Federal Reserve Bank of San FranciscoNovember 19-20, 2015

Calls for international macroeconomic policy coordination are back

• after a 30-year absence.

• Origins in scholarship: Cooper (1969) and Hamada (1976).

• Heyday of coordination in practice: the decade 1978-1987,– from the Bonn Summit to the Louvre Accord.

Calls for international macroeconomic policy coordination are back

• Coordination then fell out of favor.– Historically,

• The Germans, in particular, regretted what they had agreed at the Bonn Summit: reflation turned out to be the wrong objective in the inflation-plagued late 1970s.

• Most summit communiques had little effect, – for better or worse.

• Another problem: the structure of the G-7 did not allow a role for EM countries.

– Skeptic scholars: Oudiz & Sachs (1984), Rogoff (1985), Tabellini (1990), Kehoe (1987), Feldstein (1988), Fischer (1988), Frankel (1988), Ghosh & Masson (1988).

The return of international policy coordination

• G-20 leaders summits – 1st summits: DC, Nov. 2008, & London, April 2009,– to deal with GFC.

• Agreements to refrain from competitive depreciation– Ceasefire, G-7 ministers in February 2013– Side agreement to TPP, November 2015.

• EM calls for FRB to coordinate, – after “taper tantrum” of 2013 –– RBI Gov. Rajan: “International monetary cooperation has broken

down…The U.S. should worry about the effects of its policies on the rest of the world” (1/30/14).

The return of international policy coordination

• This time the issues go by names like – currency wars, – taper tantrums, – and fiscal compacts.

• Some scholars have returned to the subject:– E.g., Blanchard, Ostry & Ghosh (2013), Ostry & Ghosh (2013),

Subacchi & Van den Noord (2012), Taylor (2013) and Engel (2014, 2015).

– And to the question whether floating exchange rates insulate: Rey (2015)…

Outline

• Four possible frameworks for proposals to coordinate fiscal or monetary policy: 1) the locomotive game (“exporting unemployment”), 2) the discipline game (moral hazard), 3) the competitive depreciation game (“currency war”)4) and the competitive appreciation game (“exporting inflation”).

• The paper also considers– claims that monetary coordination has been made necessary by

the loss of the short-term interest rate instrument.

• Proposals for the direction of coordination vary widely,– due to different models and– different domestic interests.– These differences weaken the calls for coordination

• which can deflect attention from dealing with important domestic issues.

1) The locomotive game (as seen, esp., by US):

When cooperation means joint expansion

Historical examples:

• G-7 London Summit, 1977; Bonn Summit, 1978– to promote recovery from 1975 recession.

• G-20 leaders’ summit in London, April 2009– to deal with GFC.

• G-20 meeting in Brisbane, November 2014 – after a new slowing of global growth. – It agreed to “strengthen policy cooperation,”

including to “boost demand and jobs.”

FISCAL POLICY

Table 1: The locomotive game US pursues

contractionary fiscal policy

US pursues expansionary fiscal policy

Europepursues contractionary fiscal policy

Non-cooperative “beggar-thy-neighbor” equilibrium: global recession.

US runs trade deficit; complains on behalf of its exporters and import-competing firms.

Europepursues expansionary fiscal policy

Europe complains, on behalf of its exporters and import-competing firms.

Cooperative “locomotive” outcome: nobody achieves a trade surplus, but higher spending lifts all boats.

When cooperation means joint expansion

Figure 1: The locomotive game

= USspending

= German spending

••

But that’s not how the Germans see it…

In their view, • Fiscal expansion is not expansionary. E.g., AS is vertical.• And one country’s fiscal expansion is a negative

externality, not a positive one:– competing for funds in global marketplace

• e.g., Chang (1990);

– or gambling on bailout in the event of fiscal crisis• E.g., from IMF • or fellow members of a European Monetary Union

– e.g., Glick and Hutchison (1993), Aizenman (1998).

For that matter, it’s not how US congressional Republicans see it either.

2) The discipline game When cooperation means joint fiscal rectitude

(moral hazard): When cooperation means joint fiscal rectitude

Other euro member runs budget surplus

Other euro member runs budget deficit

Germany runs budget surplus

Cooperative agreement on fiscal rules, to eliminate moral hazard.

Germans fear that they will have to bail out the other member.

Germany runs budget deficit

Other member fears it will have to bail out Germany.

Uncoordinated equilibrium: Everyone runs excessive deficits because of moral hazard from possible bailouts.

Table 2: The discipline game

= spendingof US, or of euro partners

= German spending

Figure 2: The discipline game

••

(3) The competitive depreciation gameor “Currency Wars”

Historical examples• Competitive devaluations in the 1930s, esp. FDR dropping

out of London Monetary Conference of 1933 – – as seen by Europe at the time and historians.

• China currency manipulation, as seen by US politicians.– 2003-13, when PBoC bought dollars– and even 2014-15, when it has been selling dollars.

• US QE2, 2010-11 – as seen by Brazilian leaders.• Japan’s QQE (Abenomics), 2012-13 – as seen by US.• ECB QE, 2014-15.

MONETARY POLICY

“Currency wars”

• Brazilian complaints:– Finance Minister Guido Mantega, 2010: “We’re in

the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness” (9/27/2010).

– President Dilma Rousseff continued the currency war accusation, criticizing QE by the US and other advanced countries as a “monetary tsunami” that had detrimental effects via the exchange rate (April 2012).

Table 3a: The competitive depreciation game(currency wars):

US pursues contractionary monetary policy

US pursues expansionary monetary policy

Other countrytightens monetary policy

Superior cooperative equilibrium: all agree to refrain from currency warfare.

Dollar depreciates. Trading partners complain, on behalf of their exporters .

Other country expands monetary policy

Dollar appreciates. US complains, on behalf of its exporters.

“Currency war” non-cooperative outcome: said to be bad for all, because none achieves de-preciation & trade stimulus.

When cooperation means keeping interest rates high

Examples of cooperative agreements to prevent competitive depreciation

• Rules to avoid currency wars by requiring floating.– IMF’s 1977 Surveillance Decision & Article IV (3.1), 1978:

each member shall “avoid manipulating exchange rates…to prevent effective balance of payments adjustment…“

– “G-7 ceasefire in the currency war,” February 2013“We, the G7 Ministers and Governors, reaffirm our longstanding commitment to market determined exchange rates… [O]ur fiscal and monetary policies have been and will remain oriented towards meeting our respective domestic objectives using domestic instruments.”

– Side-agreement to TPP, November 2015.– Proposals to go further, to put currency manipulation rules

into trade agreements, backed up by trade sanctions.• e.g., Bergsten (2013, 2015a) and Gagnon (2012, 2013).

Doubts about the currency wars paradigm:

• Revisionist view of 1930s competitive devaluations– Eichengreen-Sachs (1985, 1986); Eichengreen (2015).– When all devalued against gold, money became easier,

which is just what was needed.

• Monetary easing ≠ currency manipulation.– It isn’t even clear whether effect on TB >0 or <0:

• Spending effect offsets normal effect via exchange rate.• E.g., Blanchard, Ostry, Ghosh & Chamon (2015).

– Would EMs really have wanted G-7 CBs to refrain from fighting the 2008-09 recession?

Floating lets each choose its own monetary stance.

• Asymmetries in appropriate stance– Brazil in 2010 had excess demand, calling for a higher interest

rate than in the US.• It’s natural for capital to flow US → Brazil

and for the real to appreciate.• Brazil’s tradable sector was unhappy. But half the problem was too-

high government spending; there is no reason why the interest rate-sensitive sector should bear all the crowding-out, rather than sharing it with the exchange-rate-sensitive sector.

– The situation has run in reverse recently.• US economic strength led to taper tantrum/end of QE in 2013,• and expectations of Fed lift-off in 2015.• Capital flows from EMs → US and the $ appreciates.

– Floating allows maximum monetary independence.

Floating lets each choose its own monetary stance.

• The arguments for maximizing independence via floating– Economic: to suit local conditions.– Political economy (Friedman, 1953): locate decision-

making where the political accountability lies.

Claims that monetary coordination has now been made necessary by the loss of

the short-term interest rate instrument i:

• among advanced countries -- due to ZLB.– ZLB & coordination: Chinn (2013), Engel (2014), Portes (2014),

Caballero, Farhi & Gourinchas (2015), Devereux & Yetman (2013).– If i were the only domestic monetary instrument,

then its loss would leave only the exchange rate and would thus turn monetary policy into a zero-sum game.

– But there are other domestic monetary channels:• long-term interest rates, corporate interest rates, equity prices, real

estate prices and the credit channel.• which can be influenced by Unconventional Monetary Policy• and reinforced by a positive inflation target.

• among EMEs -- due to finicky financial markets. (More below.)

Some claim that EMEs are in practice not able to set i independently, even if they float.

• Rey (2014) and Agrippino & Rey (2014) argue that floating does not give insulation, challenging the Trilemma.– Floating has not been sufficient to insulate against financial

shocks • originating in US interest rates • or in investor risk attitudes.

– Especially for EMEs.

• In some recent models, capital market imperfections may prevent floating rates from performing the shock absorber role claimed in traditional macroeconomic analysis. – E.g., Farhi & Werning (2014).

• But there is empirical evidence that exchange rate flexibility does give some monetary independence– Di Giovanni & Shambaugh (2008),– Aizenman, Chinn & Ito (2010, 2011),– Klein & Shambaugh (2013);– Obstfeld (2015).

• The question for coordination is whether the big players like the United States , the eurozone, or China would set macroeconomic policies very differently if they were taking into account the interests of other countries than they do in the pursuit of their own economic interest. – Even if one thinks the 2008 GFC or the 2010 EZ crisis can be

attributed to mistakes by the respective policy-makers, it hardly helps to tell them to improve their own economies for the sake of the rest of the world.

• EMEs fear that US monetary policy is too tight, putting downward pressure on non-$ currencies.

• E.g., in the aftermath of the 2013 “taper tantrum,” RBI Governor Rajan was provoked to complain: “Central banks should assess spillover effects from their own actions…For example, this would mean that while exiting from unconventional policies, central banks would pay attention to conditions in emerging markets…” -- 4/10/2014.

• Precedents: – Precipitation of EM crises:

• Volcker tightening led to the international debt crisis of 1982 • and the 1994 Greenspan tightening led to Mexico’s peso crisis.

– Response to crises: Simultaneous interest rate reductions• 1987 (post stock market crash), • 1998 (post Asia crisis), and • 2009 (post Global Financial Crisis).

(4) The competitive appreciation game

Another precedent among advanced countries

• Early 1980s: High US interest rates => a strong dollar. • One view was that it represented competitive appreciation:

• US policy mix exported CPI inflation to other countries. • Sachs (1985).

• In any case, the $ provoked complaints among trading partners and in 1985 led to one of the most renowned coordination agreements:– the Plaza Accord,

• in which G5 ministers agreed to bring the dollar down.

• 30th anniversary this year.

– Cooperation meant fx intervention to depreciation the $• whereas today it seems to mean refraining from intervention.

Table 4: The competitive appreciation game(exporting inflation)

When cooperation means keeping interest rates low

US raises interest rates US keeps interest rates low

Other countryraises interest rates

Non-cooperative equilibrium:High interest rates everywhere. The world is stuck in recession.

Dollar depreciates, raising US CPI inflation

Other country keeps interest rates low

Dollar appreciates, lowering US CPI inflation at the expense of other countries

Cooperative equilibrium: Low interest rates everywhere. Exchange rates unchanged, but growth is sustained.

To summarize, differences in perceptions and domestic politics are as big as the difference between cooperation and non-

cooperation.

• Who was right about the 1933 London Monetary Conference? – FDR or the Europeans?

• Who was right about the 1977-78 locomotive proposal?– The US or Germany?

• Which is the negative externality in the eurozone:– fiscal austerity or fiscal irresponsibility?

• Which has a negative spillover on EMEs:– when the US eases money (2010) or tightens (2015)?

Disagreement as to the nature of the spillover effect and the direction desirable proposals wreaks havoc

with the whole idea of coordination.

• 1st , if countries disagree on the model, the officials might not even be able to carry on a coherent discussion of the potential gains from coordination and how to achieve them. – Think of the negotiations between the new Greek government in

January 2015 and its euro partners.– The precedent of cooperation in other areas suggests that a common

model may be a pre-requisite: Cooper (2001).

• 2nd , even if negotiators come up with a coordinated package of policIes that each believes will leave them better off – which technically they can, though they don’t understand why the other side wants to make the deal – it could make things worse. – Frankel & Rockett (1998).

Concluding thoughts• Regular meetings of officials (within reason!) are useful.

– Consultation, to minimize surprises.– Perhaps they can narrow differences in perceptions.– But each country has an incentive to claim to believe in whatever

model suits its interest in the bargaining process• Ostry & Ghosh (2015).

– Officials may come increasingly to believe the models that suit their claims • – “cognitive dissonance.”

• Calls for international coordination are sometimes less useful,– when they blame foreigners to distract attention from domestic

constraints and disagreements.

Examples where calls for coordination distract:

• In 2010, Brazil’s budget deficit was too large and the economy overheated.– Domestic demand was going to be crowded out one way or

another,• if not via currency appreciation, then via higher interest rates.

– When Brazilian officials blamed the US and others for a strong real, it may have obscured the problem.

• In 2015, US wages continue to stagnate.– Politicians’ efforts to ban currency manipulation in trade

agreements are scapegoating Asians rather than dealing with the problem.

International Coordination

Jeffrey Frankel

2015 Asia Economic Policy ConferenceFederal Reserve Bank of San Francisco

November 19-20, 2015