Unforeseen Future Global Unforeseen Future Global DevelopmentsDevelopments

Jeffrey FrankelJeffrey FrankelHarpel ProfessorHarpel Professor

Windsor ConferenceWindsor ConferenceHarvard Faculty Club Harvard Faculty Club

September 20, 2010September 20, 2010

22

As a rule, it is highly probable that As a rule, it is highly probable that something improbable will happensomething improbable will happen

Consider 3 events that occurred last spring Consider 3 events that occurred last spring over the span of over the span of less than one monthless than one month::

A volcano in Iceland shuts down A volcano in Iceland shuts down European air traffic European air traffic (April 14, 2010)(April 14, 2010)

An oil platform explosion leaks An oil platform explosion leaks some 30 million gallons into some 30 million gallons into the Gulf of Mexicothe Gulf of Mexico (BP, April 20).(BP, April 20).

Some unknown glitch briefly sends Some unknown glitch briefly sends the stock market down aboutthe stock market down about 7% 7% in 15 minutesin 15 minutes -- -- some stocks some stocks almost to zeroalmost to zero (flash crash, (flash crash, May 6).May 6).

Who would have thought, beforehand, Who would have thought, beforehand, to put a probability as large as 1% on any of these events?to put a probability as large as 1% on any of these events?

33

I will make three passes at the subject:I will make three passes at the subject:

Black SwansBlack Swans

Some possible developments, Some possible developments, each of which is highly improbableeach of which is highly improbable

Some more probable future paths.Some more probable future paths.

44

Black SwansBlack Swans

We have heard a lot about “black swans” We have heard a lot about “black swans” ever since the 2007-08 financial crisis.ever since the 2007-08 financial crisis.

Unfortunately, the phrase is used Unfortunately, the phrase is used simply to mean a very unlikely event. simply to mean a very unlikely event.

55

In 1998, LTCM managers said that they could In 1998, LTCM managers said that they could not be expected to have allowed for their crisis, not be expected to have allowed for their crisis, because it was a 7-standard-deviation event, because it was a 7-standard-deviation event, • or even a 22-std.dev. event.or even a 22-std.dev. event.

In 2007, Goldman Sachs’ CFO said the sub-In 2007, Goldman Sachs’ CFO said the sub-prime mortgage crisis was a 25-s.d. event.prime mortgage crisis was a 25-s.d. event.

Nonsense. Nonsense.

• My guess: My guess: if our normal if our normal distribution tables distribution tables reported numbers out reported numbers out to 22 standard deviations, we would be in the realm to 22 standard deviations, we would be in the realm of the probability that 2 meteors hit Earth at once. of the probability that 2 meteors hit Earth at once.

66

Slightly more enlightened are people who cite Slightly more enlightened are people who cite Knightian uncertainty or “unknown unknowns”: Knightian uncertainty or “unknown unknowns”: • Ignorance with humility Ignorance with humility

is better than ignorance without it.is better than ignorance without it.

A still better interpretation is A still better interpretation is that distributions have fat tails. that distributions have fat tails. • Why? Unconditional distributions Why? Unconditional distributions

may have fat tails because conditional distributions, may have fat tails because conditional distributions, even if normal, have time-varying variances;even if normal, have time-varying variances;

• Perhaps, in crises, people’s actions become less independent. Perhaps, in crises, people’s actions become less independent.

It would be nice, however, to get beyond the Jurassic It would be nice, however, to get beyond the Jurassic Park lesson Park lesson (“don’t be surprised if things go wrong”),(“don’t be surprised if things go wrong”), to say intelligent things about the tail events. to say intelligent things about the tail events.

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Definition of black swan?Definition of black swan? In my view, “black swan” In my view, “black swan” shouldshould refer to refer to

an event that is considered virtually impossible an event that is considered virtually impossible by those whose frame of reference is limited by those whose frame of reference is limited in time span and geographical area, in time span and geographical area, but that is well within the probability but that is well within the probability distribution for those whose data set includes distribution for those whose data set includes other countries and other decades/centuries.other countries and other decades/centuries.

Consider 5 examples of mistakes made Consider 5 examples of mistakes made by those whose memory did not extend beyond a by those whose memory did not extend beyond a few years or decades of personal experience in a few years or decades of personal experience in a small number of countries.small number of countries.

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Example #1: “All swans are white.”Example #1: “All swans are white.”

The origin of the black swan metaphor was the The origin of the black swan metaphor was the belief, which might have been held by a 19th belief, which might have been held by a 19th century Englishman based on induction from a century Englishman based on induction from a lifetime of personal experience, lifetime of personal experience, that all swans were white. that all swans were white. [1][1]

But ornithologists already knew that there existed But ornithologists already knew that there existed black swans, because explorers had discovered black swans, because explorers had discovered them in Australia in 1697. them in Australia in 1697.

[1][1] The proposition that all swans are white goes back to ancient Roman philosophy, The proposition that all swans are white goes back to ancient Roman philosophy, where it was considered a truism. But induction from observation has its limits, where it was considered a truism. But induction from observation has its limits, as pointed out by Hume (as pointed out by Hume (1739), 1739), followed by Mill (1843) & Popper (1959): followed by Mill (1843) & Popper (1959): All it takes is a single black swan to falsify a generalization based on thousands All it takes is a single black swan to falsify a generalization based on thousands of observations of white swans. of observations of white swans.

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Example #1: “All swans are white.”Example #1: “All swans are white.” An Englishman encountering a black swan might have An Englishman encountering a black swan might have

considered it a 7-standard deviation event, even when considered it a 7-standard deviation event, even when the relevant information to the contrary had already the relevant information to the contrary had already been available in ornithology books.been available in ornithology books.

It seems to me a waste of a good metaphor to use the It seems to me a waste of a good metaphor to use the term just to mean a highly unexpected event; term just to mean a highly unexpected event; [2][2]

a better use of it is to refer to an event that a better use of it is to refer to an event that would not have been so unexpected ex ante if would not have been so unexpected ex ante if forecasters had adopted a perspective broader forecasters had adopted a perspective broader than their immediate personal experience.than their immediate personal experience.

. .

[2] Taleb (2007).[2] Taleb (2007).

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Example #2: Example #2: “Terrorists don’t blow up tall office buildings”“Terrorists don’t blow up tall office buildings”

Before Sept. 11, 2001, some terrorist experts warned that Before Sept. 11, 2001, some terrorist experts warned that terrorists might try to blow up big US office buildingsterrorists might try to blow up big US office buildings. . [1][1]

The warnings were not taken seriously The warnings were not taken seriously by those in power at the time, nor by the public.by those in power at the time, nor by the public.

• ““It’s never happened before.”It’s never happened before.”• Most Americans probably did not know the history Most Americans probably did not know the history

of terrorist events in other countries & in other decades. of terrorist events in other countries & in other decades.

Still today, there is a large gap between the probability Still today, there is a large gap between the probability of a nuclear event as perceived by the public and of a nuclear event as perceived by the public and the probability as perceived by terrorism experts the probability as perceived by terrorism experts (Graham Allison, (Graham Allison, 2005:2005: 50% ). 50% ). [2][2]

[1][1] They included the anti-terrorism director at the National Security Council in the Clinton & Bush They included the anti-terrorism director at the National Security Council in the Clinton & Bush Administrations. ClarkeAdministrations. Clarke (2004): (2004): Against All EnemiesAgainst All Enemies..

[2][2] “…on the current trend line, the chances of a nuclear terrorist attack in the next decade are greater “…on the current trend line, the chances of a nuclear terrorist attack in the next decade are greater than 50 percent.” than 50 percent.”

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Example #3: Example #3: “Housing prices don’t fall.”“Housing prices don’t fall.”

Many Americans up to 2006 assumed that nominal Many Americans up to 2006 assumed that nominal housing prices, even if they slowed down, would not fall. housing prices, even if they slowed down, would not fall.

After all, “they never had before,” After all, “they never had before,” [1][1]

• which meant that they had not fallen in living U.S. memory. which meant that they had not fallen in living U.S. memory. • Few Americans were aware that housing prices had fallen Few Americans were aware that housing prices had fallen

in other countries, and in the US before the 1940s.in other countries, and in the US before the 1940s.

Needless to say, many a decision would have been made Needless to say, many a decision would have been made very differently, whether by indebted homeowners or very differently, whether by indebted homeowners or leveraged bank executives, if they had thought there was a leveraged bank executives, if they had thought there was a non-negligible chance of an outright decline.non-negligible chance of an outright decline.

[1][1] Shiller (2007). Shiller (2007).

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As of 2006, 30 years of house prices seemed As of 2006, 30 years of house prices seemed

to show a clear upward trend,to show a clear upward trend, with no declines in nominal termswith no declines in nominal terms

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But 100 years of data could have revealed But 100 years of data could have revealed that the last decade was an aberration: that the last decade was an aberration:

Housing prices can fall, even in nominal terms, Housing prices can fall, even in nominal terms, and in real terms tend to revert to their 1950-75 leveland in real terms tend to revert to their 1950-75 level

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House prices had also fallen in other countries.House prices had also fallen in other countries.

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The crashThe crash

Irish home prices

1616

Example #4: Example #4: Volatilities are low.Volatilities are low.“The Great Moderation”“The Great Moderation”

Financial markets perceived risk as very lowFinancial markets perceived risk as very low• especially during 2004-07.especially during 2004-07.

This was most directly visible via the implicit This was most directly visible via the implicit

volatilities in options prices such as the VIX.volatilities in options prices such as the VIX.

But it was also manifest in But it was also manifest in • junk bond spreads, junk bond spreads, • sovereign spreads, sovereign spreads, • and other financial prices. and other financial prices.

Sovereign spreads, 1998-2007

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17

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.

Source: “The EMBI in the Global Village,” Javier Gomez May 18, 2008 juanpablofernandez.wordpress.com/2008/05/

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Example #4: Low volatilities.Example #4: Low volatilities.

Why this historic mis-pricing of risk?Why this historic mis-pricing of risk?• Traders plugged into their Black-Scholes formulas Traders plugged into their Black-Scholes formulas

variance estimates that went back only a few years, variance estimates that went back only a few years, • or at most a few decades, or at most a few decades,

the period of the late Great Moderation.the period of the late Great Moderation.

• Risk officers did the same with VaR models.Risk officers did the same with VaR models.

They should have gone back much farther – They should have gone back much farther – or better yet, formed judgments based on or better yet, formed judgments based on a more comprehensive assessment of what risks a more comprehensive assessment of what risks might lie in wait for the world economymight lie in wait for the world economy .[1].[1]

[1] E.g., Frankel (2008).[1] E.g., Frankel (2008).

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Example 5: “European governments don’t default.”Example 5: “European governments don’t default.”

Greece’s recent debt troubles should Greece’s recent debt troubles should not have caught anyone by surprise,not have caught anyone by surprise,

• least of all northern Europeans. least of all northern Europeans.

The same with Portugal, Spain, Italy & Ireland. The same with Portugal, Spain, Italy & Ireland.

And yet from the time they joined the euro,And yet from the time they joined the euro,until 2009, these governments could borrow at until 2009, these governments could borrow at interest rates virtually as low as Germany. interest rates virtually as low as Germany.

Among the reasons: a perception that advanced Among the reasons: a perception that advanced countries in general, countries in general, and euro countries in particularand euro countries in particular, , were fundamentally different from emerging were fundamentally different from emerging markets and would never default. markets and would never default.

2020

Judging from spreads, 2001-07, Judging from spreads, 2001-07, investors put zero odds on a default by Greece investors put zero odds on a default by Greece

or other Mediterranean countriesor other Mediterranean countries

Council on Foreign Relations

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Example 5: “European governments don’t default.”Example 5: “European governments don’t default.”

Suddenly, in 2010, the Greek sovereign spread Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. shot up, exceeding 800% by June.

Even when the Greek crisis erupted, Even when the Greek crisis erupted, leaders in Brussels & Frankfurt leaders in Brussels & Frankfurt seemed to view it as a black swan, seemed to view it as a black swan, • instead of recognizing it as a close cousin instead of recognizing it as a close cousin

of the Argentine crisis of ten years earlier, of the Argentine crisis of ten years earlier, and many others in history,and many others in history,

• including among European countries.including among European countries.

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Are these examples hindsight?Are these examples hindsight?

How can one gauge risk, How can one gauge risk, other than time series estimation?other than time series estimation?

Consider a talk I used to give, 2005-07Consider a talk I used to give, 2005-07

This particular slide is taken from a version This particular slide is taken from a version I gave to State Street Global Investors, May 24, 2006.I gave to State Street Global Investors, May 24, 2006.

Did I predict the financial crises? No. But…Did I predict the financial crises? No. But…

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Medium-term global risksMedium-term global risksOdds of each alone small; but cumulative odds > 1/2Odds of each alone small; but cumulative odds > 1/2

Hard landing of $: foreigners pull out =>Hard landing of $: foreigners pull out =>$ ↓ & $ ↓ & ii ↑ ↑ => possible return of stagflation in US. => possible return of stagflation in US.

Bursting bubbles Bursting bubbles => consumption would fall .=> consumption would fall .• Bond market: conundrum of low LT rates 2004-05.Bond market: conundrum of low LT rates 2004-05.• Housing market: valuations very high .Housing market: valuations very high .

New oil shocks, New oil shocks, • e.g.,e.g., fromfrom Russia, Venezuela, Nigeria, Iran, S.Arabia… Russia, Venezuela, Nigeria, Iran, S.Arabia…

New security setbacksNew security setbacks• Big new terrorist attack, perhaps with WMDBig new terrorist attack, perhaps with WMD• Korea or Iran go nuclear/and or to warKorea or Iran go nuclear/and or to war• Islamic radicals take over Pakistan, S.A. or EgyptIslamic radicals take over Pakistan, S.A. or Egypt

This bubble indeed burst soon after this presentation

The other risks remain.

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Some possible events Some possible events -- -- each of which is improbable taken alone --each of which is improbable taken alone --

in four categoriesin four categories

Financial marketsFinancial markets

MacroeconomicMacroeconomic

Geopolitical Geopolitical

Environmental & miscellaneousEnvironmental & miscellaneous

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Financial marketsFinancial markets

Housing prices fall another 1/3 Housing prices fall another 1/3 Equity prices fall by ½Equity prices fall by ½ Bond prices fall by ½ Bond prices fall by ½

• US US ii 10 yr. 10 yr. rises from 2 ½ % to 5%+rises from 2 ½ % to 5%+

Hard landing: Dollar falls by ½ Hard landing: Dollar falls by ½ Repeat of financial crisis: Repeat of financial crisis:

interbank spreads in major countries interbank spreads in major countries go back to Sept. 2008 high go back to Sept. 2008 high (350 basis pts.)(350 basis pts.)

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Financial markets, continuedFinancial markets, continued

Sovereign default crisis,Sovereign default crisis,

• beginning with debtbeginning with debtrestructuring in Greece -- P=½restructuring in Greece -- P=½

• spreading through Europe -- P= ½ ½ = ¼spreading through Europe -- P= ½ ½ = ¼

• and to the US -- P = ½ ½ ½ = 1/8and to the US -- P = ½ ½ ½ = 1/8by contagion

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Desmond Lachman, Euro Will Unravel, and Soon, American Enterprise Institute, Sept.2010

Debt dynamics: Greece can’t achieve primary surplus & keep its GDP growth rate above its interest rate.

=> Its debt/GDP could rise to 175% over the next few years.

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MacroeconomyMacroeconomy Return of high inflation Return of high inflation

• the monetary base more-than-doubled in 2008, the monetary base more-than-doubled in 2008, and that money is still out there.and that money is still out there.

Deflationary trap Deflationary trap • central bank loses ability to expand monetary policy: central bank loses ability to expand monetary policy:

higher real interest rates higher real interest rates • <= negative inflation<= negative inflation• + zero-lower-bound + zero-lower-bound

on nominal interest rates.on nominal interest rates. Like Japan.Like Japan.

Unemployment stays veryUnemployment stays very high forhigh for aa decade,decade,as the long-term unemployed lose skillsas the long-term unemployed lose skills

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GeopoliticsGeopolitics

Military conflict Military conflict • between Iran and US or Israelbetween Iran and US or Israel• between North Korea and USbetween North Korea and US• Between India and PakistanBetween India and Pakistan• Other new serious military conflictOther new serious military conflict

Islamist extremists take over in:Islamist extremists take over in: • Saudi Arabia Saudi Arabia (oil)(oil)• Egypt Egypt (population & cultural center of Arab world)(population & cultural center of Arab world)• Or Or Pakistan Pakistan (nuclear weapons) (nuclear weapons)

Nuclear or biological or radiological terrorismNuclear or biological or radiological terrorism

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Environment Environment & miscellaneous& miscellaneous

Severe contagion, Severe contagion, • like SARS, Avian flu, H1N1,… but worselike SARS, Avian flu, H1N1,… but worse

Price of oil goes above $200/barrelPrice of oil goes above $200/barrel

Price of wheat goes above $500/metric ton Price of wheat goes above $500/metric ton

Severe drought, probably brought Severe drought, probably brought on by global climate changeon by global climate change

Some other environmental catastropheSome other environmental catastrophe

Some IT disasterSome IT disaster

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More-probable scenariosMore-probable scenarios

We are seeing We are seeing a historic reversal of roles between those countries a historic reversal of roles between those countries traditionally viewed as advanced/industrialized traditionally viewed as advanced/industrialized and those viewed as emerging/developing. and those viewed as emerging/developing.

No longer do industrialized countries automatically No longer do industrialized countries automatically have higher creditworthiness than the latecomers.have higher creditworthiness than the latecomers.

Indeed, China, Chile, and others have been able to Indeed, China, Chile, and others have been able to follow fiscal countercyclical policy over the last follow fiscal countercyclical policy over the last decade, while the US & UK have forgotten how to.decade, while the US & UK have forgotten how to.

The advanced countries are now the debtors.The advanced countries are now the debtors.

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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.

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1. Fairly likely scenario.1. Fairly likely scenario.

Muddling through in short-term: Muddling through in short-term:

• Recovery is long & slow among advanced countries, Recovery is long & slow among advanced countries, especially with no further fiscal stimulus, because politiciansespecially with no further fiscal stimulus, because politicians

• are either unwilling are either unwilling (Hoover economics)(Hoover economics) • or unable or unable (as a legacy of Bush economics).(as a legacy of Bush economics).

Growth barely above potential Growth barely above potential • => unemployment comes down only slowly.=> unemployment comes down only slowly.

• No more major disruptions for a while. No more major disruptions for a while.

• Long-term debt problems lead to eventual crises.Long-term debt problems lead to eventual crises.

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World Economic OutlookWorld Economic Outlook Projections Projections, IMF, IMF, , July 2010July 2010

      Growth ratesGrowth rates (% change)(% change) Year over Year  Q4 over Q4 Year over Year  Q4 over Q4

Projections  Estimates Projections Projections  Estimates Projections 

20082008 2009 20102009 2010 2009 2009 2010 2010 2011 2011 

World OutputWorld Output 3.03.0 –0.6–0.6 4.64.6 4.3  4.3  4.2 4.2 4.3  4.3  

Advanced EconomiesAdvanced Economies 0.50.5 –3.2–3.2 2.62.6 2.4  2.4  2.3 2.3 2.6  2.6  

United StatesUnited States 0.40.4 –2.4–2.4 3.33.3 0.1 0.1 3.2 3.2 2.6  2.6  

Euro AreaEuro Area 0.60.6 –4.1–4.1 1.01.0 –2.1 –2.1 1.1 1.1 1.6    1.6    

JapanJapan –1.2 –1.2 –5.2–5.2 2.42.4 –1.4 –1.4 1.1 1.1 3.0  3.0  

United KingdomUnited Kingdom 0.50.5 –4.9–4.9 1.21.2 –3.1 –3.1 2.1 2.1 1.9  1.9  

CanadaCanada 0.50.5 –2.5–2.5 3.63.6 –1.1 –1.1 4.0 4.0 2.6  2.6  

Other Advanced Econ.sOther Advanced Econ.s 1.71.7 –1.2–1.2 4.64.6 3.1 3.1 3.4 3.4 4.6    4.6    

NewlyNewly Ind.AsianInd.Asian EconomiesEconomies 1.81.8 –0.9–0.9 6.76.7 6.1 6.1 4.3 4.3 6.3  6.3  

EmergingEmerging && Developg.Developg. Ec.sEc.s 6.16.1 2.5 2.5 6.86.8 5.7 5.7 6.9 6.9 6.86.8

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2. Hard landing for the dollar:2. Hard landing for the dollar: Definition: foreigners lose willingness Definition: foreigners lose willingness to continue accumulating US assets to continue accumulating US assets => $ ↓ & => $ ↓ & ii ↑ ↑ => possible return of stagflation in US=> possible return of stagflation in US

• Many have warned of this possibility for some time.Many have warned of this possibility for some time.

• So far, foreigners have happily financed US deficits.So far, foreigners have happily financed US deficits.

• But just because the $ has been the leading international But just because the $ has been the leading international currency for 70 years, doesn’t mean it always will.currency for 70 years, doesn’t mean it always will.

• Cautionary tale: £ (1914-1956)Cautionary tale: £ (1914-1956) With a lag after US-UK reversal With a lag after US-UK reversal of economic size & net debt, of economic size & net debt, $ passed £ as #1 international currency.$ passed £ as #1 international currency.

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Global current account imbalances – China’s surplus and America’s deficit –

are now widening again, with recent recovery in US income & the $.

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37

Pre-2007, economists were split betweenPre-2007, economists were split between

Martin Feldstein Martin Feldstein Ken Rogoff Ken Rogoff ** Maury ObstfeldMaury Obstfeld Nouriel RoubiniNouriel Roubini Larry SummersLarry Summers Menzie ChinnMenzie Chinn MeMe Lots moreLots more

Ben BernankeBen Bernanke Ricardo Caballero *Ricardo Caballero * Richard CooperRichard Cooper Michael DooleyMichael Dooley Pierre-O. GourinchasPierre-O. Gourinchas Alan GreenspanAlan Greenspan Ricardo HausmannRicardo Hausmann Lots moreLots more

those who saw the US deficit as those who saw the US deficit as unsustainable, requiring a $ fall,unsustainable, requiring a $ fall,

and those who saw and those who saw no problem.no problem.

* Some claim that the financial crisis of 2007-09 fits their theories.

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The 2007-09 financial crisis did not help resolve The 2007-09 financial crisis did not help resolve the debate over current account imbalancesthe debate over current account imbalances

Those of us who predicted an unsustainable Those of us who predicted an unsustainable US current account deficit and a $ hard landing US current account deficit and a $ hard landing were proven wrong by the 2008 movement were proven wrong by the 2008 movement intointo $. $.

Meanwhile, those who said the US CA deficit was Meanwhile, those who said the US CA deficit was sustainable because of the superior quality & sustainable because of the superior quality & desirability of US assets were also proven wrong.desirability of US assets were also proven wrong.

corporate governance, rule of law, corporate governance, rule of law, accounting system, rating agencies,accounting system, rating agencies, securities markets, …securities markets, …

MSN Money & Forbes

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0.0

0.2

0.4

0.6

0.8

1.0

75 80 85 90 95 00 05 10 15 20 25 30 35 40

USD

DEM

EUR

Chinn & Frankel Chinn & Frankel (2005)(2005)

Projection of $ vs € Projection of $ vs € as shares of central banks’ foreign exchange reserves: as shares of central banks’ foreign exchange reserves:

a function of country size, financial market depth, & rate of return, a function of country size, financial market depth, & rate of return, with parameters estimated on 1973-98 datawith parameters estimated on 1973-98 data..Simulation assumes $ depreciation continues at 2001-04 rate.Simulation assumes $ depreciation continues at 2001-04 rate.

birthof €€

This scenario showed € This scenario showed € overtaking $ as top international overtaking $ as top international

reserve currency in 2022.reserve currency in 2022.

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Multiple International Multiple International Currency SystemCurrency System

The € is now a rival international currency.The € is now a rival international currency.

The The ¥ & Swiss franc have gained a bit too.¥ & Swiss franc have gained a bit too.

The SDR came back The SDR came back from the dead in 2009.from the dead in 2009.

Gold has also made a comeback Gold has also made a comeback as an international reserve asset.as an international reserve asset.

Someday the RMB will join the roster.Someday the RMB will join the roster.

= a multiple international reserve currency system.= a multiple international reserve currency system.

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3: Global crisis in3: Global crisis insovereign debt sovereign debt

• EU has long-term debt problems as bad as the US,• esp. future liabilities related to retirement & health.• Not just the PIIGS countries.

• Japan is perhaps even worse.

• Only Canada has done things better.

• Worldwide savings shortage is in the offing.

• I now think that a sharp fall in bond markets among advanced countries generally is somewhat more likely than a hard landing for the US per se, relative to the others.

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4. The best of the four scenarios, 4. The best of the four scenarios, is the least likelyis the least likely

• Recovery becomes firmly established, and thenRecovery becomes firmly established, and then• the US and other major advanced countries the US and other major advanced countries

seriously address their long-term fiscal situations, seriously address their long-term fiscal situations, to reduce chance of long-term crisisto reduce chance of long-term crisis. .

• Good economic policy would combine, in my view, Good economic policy would combine, in my view, Fiscal stimulus today,Fiscal stimulus today, designed with high bang-for-buck: designed with high bang-for-buck:

• More money for states, to avoid lay-offsMore money for states, to avoid lay-offs• Infrastructure investment, for the futureInfrastructure investment, for the future• Among tax cuts, extending Bush benefits for super-rich Among tax cuts, extending Bush benefits for super-rich

should be last priority (e.g., 2010 abolition of estate tax)should be last priority (e.g., 2010 abolition of estate tax)

together with steps today to lock in together with steps today to lock in long-term return to fiscal disciplinelong-term return to fiscal discipline

• including social security reform,including social security reform, e.g., raising retirement agee.g., raising retirement age

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The euro-zone breaks upThe euro-zone breaks up

China has a financial crisis at some stageChina has a financial crisis at some stage

China-US military conflictChina-US military conflict• over Taiwan, or South China Seaover Taiwan, or South China Sea

Mexico collapsesMexico collapses (narcotics violence)(narcotics violence)

Other possible events around the world Other possible events around the world -- each of which is improbable taken alone ---- each of which is improbable taken alone --

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China could suffer the rite-of-passage China could suffer the rite-of-passage of any new tradeof any new trade++manufacturing power: manufacturing power:

an asset market bubble & collapsean asset market bubble & collapse

Real Beijing land prices

4545

4646

ReferencesReferences

Allison, Graham, 2005, Allison, Graham, 2005, Nuclear Terrorism: The Ultimate Preventable Catastrophe Nuclear Terrorism: The Ultimate Preventable Catastrophe (Henry Holt)(Henry Holt)

Clarke, Richard, 2004Clarke, Richard, 2004, , Against All Enemies: Inside America's War on Terror Against All Enemies: Inside America's War on Terror (Free (Free Press).Press).

Frankel, Jeffrey, “Responding to Crises,” Frankel, Jeffrey, “Responding to Crises,” Cato JournalCato Journal, , vol. 27, no. 2, Spring/Summer vol. 27, no. 2, Spring/Summer 2007, pp.165-178. 2007, pp.165-178.

FrankelFrankel, , & George Saravelos, 2010, "Are Leading Indicators of Financial Crises Useful & George Saravelos, 2010, "Are Leading Indicators of Financial Crises Useful for Assessing Country Vulnerability? Evidence from the 2008-09 Global Crisis"  NBER for Assessing Country Vulnerability? Evidence from the 2008-09 Global Crisis"  NBER WP 16047.WP 16047.

Hume, David, 1888, Hume, David, 1888, Hume's Treatise of Human NatureHume's Treatise of Human Nature (Oxford, Clarendon Press). (Oxford, Clarendon Press). Originally published 1739–40. Originally published 1739–40.

Mill, John Stuart, 1843, Mill, John Stuart, 1843, A System of Logic: Ratiocinative and InductiveA System of Logic: Ratiocinative and Inductive . (Harper & . (Harper & Bros.).Bros.).

Popper, Karl, 1959, Popper, Karl, 1959, The Logic of Scientific DiscoveryThe Logic of Scientific Discovery (Basic Books). (Basic Books). Reinhart, Carmen, and Kenneth Rogoff, 2009, Reinhart, Carmen, and Kenneth Rogoff, 2009, This Time is Different: Eight Centuries of This Time is Different: Eight Centuries of

Financial FollyFinancial Folly (Princeton University Press). (Princeton University Press). Shiller, Robert, 2007, Shiller, Robert, 2007, Understanding Recent Trends in House Prices and Home Understanding Recent Trends in House Prices and Home

OwnershipOwnership Cowles Foundation Discussion Paper No. 1630 . Cowles Foundation Discussion Paper No. 1630 . Taleb, Nassim Nicholas,Taleb, Nassim Nicholas, 2007, 2007, The Black Swan: The Impact of the Highly ImprobableThe Black Swan: The Impact of the Highly Improbable

(Penguin).(Penguin).

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AppendicesAppendices

Doubling of US monetary baseDoubling of US monetary base

Creditworthiness: Some advanced economics Creditworthiness: Some advanced economics have fallen as emerging markets have risenhave fallen as emerging markets have risen

Competing international currenciesCompeting international currencies

4848

48

Federal Reserve AssetsFederal Reserve Assets ($ billions)($ billions)

have more-than-doubledhave more-than-doubled, through new , through new facilities, rather than conventional T bill purchasesfacilities, rather than conventional T bill purchases

Source: Federal Reserve H.4.1 report

4949

Sovereign spreads for 5 euro countries shot up in the 1st half of 2010

Creditworthiness: Some advanced economics Creditworthiness: Some advanced economics have fallen, as emerging markets have risen.have fallen, as emerging markets have risen.

5050

Ratings for “Emerging Economies”Ratings for “Advanced Economies”

5151

When will the US day of reckoning come?When will the US day of reckoning come?

It didn’t come in 2008: It didn’t come in 2008: The financial crisis caused a flight The financial crisis caused a flight to quality which evidently still means a flight to US $. to quality which evidently still means a flight to US $.

Chinese warnings in 2009 Chinese warnings in 2009 may have augured a turning point:may have augured a turning point:• Premier Wen worried US T bills will lose value.Premier Wen worried US T bills will lose value.

HHe urged the US to keep its deficit at an “appropriate size” e urged the US to keep its deficit at an “appropriate size”

to ensure the “basic stability” of the $ to ensure the “basic stability” of the $ (Nov.)(Nov.) . .

• PBoC Gov. Zhou proposed PBoC Gov. Zhou proposed replacing $ as international replacing $ as international currency, with the SDR currency, with the SDR (March 09).(March 09).

5252

Multiple International Multiple International Currency SystemCurrency System

The € has gained share as an international currency,The € has gained share as an international currency,even if it won’t challenge the $ by 2022.even if it won’t challenge the $ by 2022.

The The ¥ & Swiss franc have gained a bit too.¥ & Swiss franc have gained a bit too.

The SDR came back from the dead in 2009.The SDR came back from the dead in 2009.

Gold has also made a comeback Gold has also made a comeback as an international reserve asset.as an international reserve asset.

Someday the RMB will join the roster.Someday the RMB will join the roster.

= a multiple international reserve currency system.= a multiple international reserve currency system.

5353

Special Drawing RightsSpecial Drawing Rights

The The SDR’s surprising comeback from near-oblivion. SDR’s surprising comeback from near-oblivion. The G20 & IMF decided to create new SDRs ($250b). The G20 & IMF decided to create new SDRs ($250b). Shortly later, PBoC Gov. Zhou proposed replacing Shortly later, PBoC Gov. Zhou proposed replacing

the $ as lead international currency with the SDR. the $ as lead international currency with the SDR. The IMF is now borrowing in SDRs. The IMF is now borrowing in SDRs.

• The proposal has been revived for an international substitution The proposal has been revived for an international substitution account at the IMF, account at the IMF,

to extinguish an unwanted $ overhang in exchange for SDRs. to extinguish an unwanted $ overhang in exchange for SDRs.

The SDR has little chance of standing up as a competitor The SDR has little chance of standing up as a competitor to the € or ¥, let alone to the $. to the € or ¥, let alone to the $.

Still, it is back in the world monetary system.Still, it is back in the world monetary system.

5454

GoldGold

Until very recently, central bank holdings of Until very recently, central bank holdings of gold was considered an anachronism.gold was considered an anachronism.• Central banks were gradually selling it off.Central banks were gradually selling it off.

Now gold is back on the list of international Now gold is back on the list of international reserve assetsreserve assets• China bought gold in early 2009.China bought gold in early 2009.• India bought 200 tons in November.India bought 200 tons in November.• Sri Lanka…Sri Lanka…

5555

A multiple reserve currency system is inefficient, A multiple reserve currency system is inefficient, in the same sense that barter is inefficient: in the same sense that barter is inefficient: money was invented in the first place to cut down money was invented in the first place to cut down on the transactions costs of exchange. on the transactions costs of exchange.

Nevertheless, if sound macro policies Nevertheless, if sound macro policies in the leader country cannot be presumed, in the leader country cannot be presumed, the existence of competitor currencies gives the existence of competitor currencies gives the rest of the world protection against the leader the rest of the world protection against the leader exploiting its position by running up too much exploiting its position by running up too much debt and then inflating/depreciating it away.debt and then inflating/depreciating it away.

5656

Historical precedent: £ ‘s loss of premier Historical precedent: £ ‘s loss of premier international currency status in 20international currency status in 20thth century century

By 1919, US had passed UKBy 1919, US had passed UK in in

1.1. output (1872)output (1872)

2.2. trade (1914)trade (1914)

3.3. net international creditor position (1914-19)net international creditor position (1914-19)

Subsequently, $ passed £ as #1 reserve Subsequently, $ passed £ as #1 reserve currency (1940-45)currency (1940-45)

5757

US overtakes UK, by trade, US overtakes UK, by trade, 1900-19571900-1957Data sources: Data sources: UK Export Data: Department of Trade and Industry, UK; UK exchange rate (1946-1970): Global Financial Data;UK Export Data: Department of Trade and Industry, UK; UK exchange rate (1946-1970): Global Financial Data;

US Export Data: US Export Data: Historical Statistics of the United States, Colonial Times To 1970Historical Statistics of the United States, Colonial Times To 1970; Published by the U.S. Census Bureau; Published by the U.S. Census Bureau

Value of Exports (in millions of dollars)

0.E+00

5.E+03

1.E+04

2.E+04

2.E+04

3.E+04

19

00

19

03

19

06

19

09

19

12

19

15

19

18

19

21

19

24

19

27

19

30

19

33

19

36

19

39

19

47

19

50

19

53

19

56

USA UK

5858

From the lit. on reserve currenciesFrom the lit. on reserve currencies

Determinant: Determinant:

1.1. SizeSize

2.2. Depth of Fin.mkt.Depth of Fin.mkt.

3. Rate of return3. Rate of return

Proxy:Proxy:

GDPGDP

FX turnoverFX turnover

inflation,inflation,LR depreciation,LR depreciation,Exch. rate varianceExch. rate variance

5959

From the literature, From the literature, continuedcontinued

Network externalities Network externalities

=> Tipping => Tipping captured by:captured by:

1)1) InertiaInertia lagslags

2)2) NonlinearityNonlinearity logistic functional formlogistic functional form

in determinantsin determinants oror

dummy for leader GDPdummy for leader GDP

6060

Cautionary tale, contCautionary tale, cont.. UK loss of international currency paralleled loss of its economic UK loss of international currency paralleled loss of its economic

pre-eminence, military hegemony, colonies pre-eminence, military hegemony, colonies & other trappings of international power.& other trappings of international power.• Suez crisis of 1956 is often recalled as occasion on which Britain was Suez crisis of 1956 is often recalled as occasion on which Britain was

forced under US pressure to abandon imperial designs. forced under US pressure to abandon imperial designs. • Often forgotten: A run on the £ was the mechanismOften forgotten: A run on the £ was the mechanism. .

Paul Kennedy’s Paul Kennedy’s (1989)(1989) suggestion suggestion -- that imperial overreach hypothesis -- that imperial overreach hypothesis might apply to US hegemony – might apply to US hegemony – may have been essentially correctmay have been essentially correct• but 15 years premature, but 15 years premature, • much like those in early 1990s who warned much like those in early 1990s who warned

prematurely over $’s imminent demiseprematurely over $’s imminent demise (Kindleberger, 1995...)(Kindleberger, 1995...)

Jeffrey FrankelJeffrey FrankelJames W. Harpel Professor of Capital Formation & GrowthJames W. Harpel Professor of Capital Formation & Growth

Harvard Kennedy SchoolHarvard Kennedy School

http://ksghome.harvard.edu/~jfrankel/index.htmhttp://ksghome.harvard.edu/~jfrankel/index.htm

Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/