What if the US looses its reserve currency privilege?

Since the Bretton Woods agreement in 1945, the United States have enjoyed the so-called "Exhorbitant Privilege." During the fixed exchange rate regime, the US could conduct monetary policy without regard to what was happening in other countries. The US dollar was a reserve currency, which also helped the US maintain low interest rates and a guarantee that US dollars (and Treasury bonds) would always find a buyer. With flexible exchange rates, not much has changed. But with the recent shenanigans in a Congress that considered reneging on its debt, the likelihood of this advantage changing has dramatically increased. What would the consequences of the loss of the Exhorbitant Privilege be?



Wenli Cheng and Dingsheng Zhang study this scenario using a general equilibrium model where a peripheral country (say, the Asian economies) pegs its currency to the money of a central country (say, the United States), the latter being used as the vehicle currency for international trade. In addition, the foreign exchange reserves of the periphery are invested in government bonds of the center. This means that no matter what current account deficit of the center, it is always financed by the periphery. Yet the center may be tempted to inflate it away. This limitless and to some extend free borrowing is the Exhorbitant Privilege.



Now remove it by assuming that the periphery does not want to invest in the center, either because it views the Treasury bonds are excessively risky or because it does not peg to the dollar any more. This would lead to a dramatic readjustment of the terms of trade to favor the tradable sector of the center. This decpraciation of the dollar would be more pronounced of the center is incapable of raising taxes and finances its debt with inflation. This already all sounds familiar.

Trade constraints of developing countries

With all the current posturing in the US and Europe, while addressing doubtlessly important problems, it is easy to forget that there are much bigger issues that need to be solved: how to get the poor and especially the poorest economies to a decent standard of living. We have been blessed to be born in the right families and in the right countries, and we should share this luck with those who were no so fortunate. This does not necessarily mean to give to the poor, just giving them a fair chance may be enough.

Jean-Jacques Hallaert, Ricardo Cavazos Cepeda and Gimin Kang consider the consequences of trade barriers on developing economies. The latter should be able to benefit greatly from selling on world markets goods produced with the factor they are relatively rich of, unskilled labor and to some extend land, while importing the complementary goods, likely capital-intensive investment goods. This OECD study finds that developed economies cannot do much more in terms of reducing import tariffs. Where there is more potential is with home-grown issues: unreliability of electricity, high transportation costs, poor education, bad governance, and instability. These results have been obtained by regressing exports, imports or their sum on a number of indicator for a panel of data. I am not particularly keen on these exercises due to poor data quality, gigantic endogeneity and especially the fact that proxies for essentially unquantifiable variables are used, like property rights and governance. But I suppose this is the best one can do, and the results appear to be rather stark. Now as to how to solve these economic problems, that is a gigantic task that we should be really talking about these days, instead of posturing for political gain.

Shortsightedness and tariffs

International trade theory is in large part about optimal trade theory, yet it is incapable to explain the observed level of tariffs. While under rather general circumstances theory will tell you that zero tariffs will improve general welfare, once you take into account that governments threaten and negotiate in a Nash equilibrium, tariffs should be at about 30%. They are generally far below that. It is a big challenge to explain the difference.

Mario Larch and Wolfgang Lechthaler argue that all that is needed is for trade theory to finally catch up with the rest of economics and use some dynamics. Specifically, transform the problem into a dynamic Nash equilibrium, take into account transition paths, and you get some realistic numbers if you assume that the negotiating politicians are short-sighted, which is certainly not far from the truth. This is important because the various transitional effect of a tariff change take different times. Indeed a decrease in tariffs has a faster and positive impact on consumption through an immediate increase in consumption. A counter-effect through the closing of inefficient firms takes much longer. Impatient politicians discount heavily the latter.

Cross-border banking and financial stability

Should banks be allowed to do business across borders? The answer is not obvious. For one, it is beneficial that they have the opportunity to better diversify their risks, but they can do this without having to open branches in other states or countries. The counterpart is that doing business elsewhere increases opportunities for adverse shocks. Finally, regulatory competition in an international banking market leads to a large systemic risk.

Dirk Schoenmark and Wolf Wagner try to sort this out in the case of Europe and come to the conclusion that it depends. They argue that Germany and the UK are well diversified and thus can sustain cross-border banking, even though there appears to be overexposure to the US, as exemplified by the large negative consequences in Europe of the recent crisis in the US. For the countries on the fringes of Europe, though, there seems to be very poor diversification. Indeed, these economies seem to be very dependent on a few large foreign banks, and consequences could be dire if they run into difficulties or decide to pull out.

This analysis is entirely based on asset shares and thus diversification. This neglects a major advantage of foreign banks: they bring lending capital that would otherwise not be available. The case for cross-border banking is thus understated in this paper.

Should there be international trade in pollution rights?

A basic principle in Economics is that of comparative advantage: a country will produce the goods that it is relatively better at producing, even it is bad at it. The traditional story usually includes relative endowments in capital and labor, and the capital intensity of goods matters. Now add environmental externalities. Comparative advantage would say that polluting production should take place were pollution is the "cheapest," that is. where it would have fewer consequences. This is the principle being the introduction of an international market for pollution rights. Such markets are already active within countries, with the idea that firms that can best control pollution will produce the polluting goods, as they need fewer pollution rights. Would this basic principle also hold across countries?

Jota Ishikawa, the late Morihiro Yomogida and Kazuharu Kiyono claim that it is not necessarily beneficial to have an international market. Indeed they point out that rich countries could import pollution rights from the poor countries, thereby further deteriorating the environment in the developed economies. So instead of relocating production, pollution is imported. It all depends on comparative advantage.

Using the WTO to overcome a prisoner's dilemma

It looks like the threat of competitive increases in trade tariffs has vanished, at least for the moment, as economies are getting back in shape. This episode highlighted how tariffs are part of a prisoner's dilemma: increasing tariffs is good for you, at least in the short term, as it gives more market share to local firms and/or more revenue to the state. But it hurts the foreign country, and if everybody does it, joint welfare is reduced because of the lower gains from exchange, the misallocation of productive resources and the loss of competitiveness of protected industries. It is precisely because of this prisoner's dilemma that the GATT (General Agreement on Tariffs and Trade) and then the WTO (World Trade Organization) were put in place.

Renee Bowen takes this reasoning further by looking a at a multilateral prisoner's dilemma, and interestingly the optimal institution that emerges looks very much like WTO's dispute settlement mechanism, in that countries cannot retaliate while a dispute is being settled. The key is that once a large enough number of countries participate in the WTO, the threat of sanctions is sufficient to obtain settlement and nobody is compelled to jump the gun with retaliations.

The Dalai Lama effect on international trade

Since the Nobel Peace Prize was announced this year, the Chinese government has been putting heavy pressure on many foreign authorities to prevent them from showing up at the award ceremony. China has been in particular been using the threat of trade sanctions to ruin the party of Liu Xiaobo. Is this effective?

Andreas Fuchs and Nils-Hendrik Klann note that China is a regular with these tactics, but regarding contacts with the Dalai Lama. Are those threats carried out? Using a gravity model, they find exports to China have been curtailed after high-level visits only recently, and this effect vanishes after two years. This is quite interesting, as it confirms the existence of a "Dalai-Lama effect." But I wonder how this effect could appear at a time where the Chinese government has less control over imports with the liberalization of the economy. Is it that it cares that much more about the Dalai Lama?

Sovereign debt and the age pyramid

The papers about sovereign debt I come across always assume that the debt is held by some social planner who implicitly is acting on the behalf of representative and identical agents. But not all international debt is held by governments, and not everyone in a country has the same opinions regarding this debt.

Martín Gonzalez-Eiras deviates from this literature by including demographics, and in particular how there can be intergenerational conflict about the handling of debt. Obviously, reneging has different consequences whether you are young or old. He also looks at how outcomes can differ if the demographic structure of a country changes.

The paper highlights one interesting mechanism that should provide larger incentives to prevent default. Important transfers between generations are welfare improving, and they can further improved by having access to international insurance. This implies that these intergenerational transfers act as international collateral, and thus make it possible to obtain self-enforcing contracts. A country with a large retirement pension system provided by the state is this less likely to default and more likely to obtain gains in efficiency through participation in international insurance.

How good is the Big Mac index?

The Big Mac index, created in 1986 by the Economist to estimate the over- or under-evaluation of currencies, is based on the price comparison of a uniform good across countries. In the best case, purchasing power parity would hold, and it typically does not. But the choice of McDonald's Big Mac always struck me as poor for such an exercise. Its major ingredient, meat, is subject to regulation and subsidies that vary considerably across countries, including trade barriers. And a major part of its price is the "service" which is offered by the restaurant, which is non-tradable. In short, it would even be a surprise were purchasing power parity to hold.

Kenneth Clements, Yihui Lan and Shi Pei Seah have looked at this more formally than I just did. They find that the Big Mac index indeed suffers from biases, and thus its predictions are biased. But they can be corrected. The index even beats the best predictor of exchange rates, at least at medium to long range, the random walk. This should not surprise us, however. After all, if there are strong deviations from purchasing power parity, they should correct themselves in the long run.

I prefer the iPod index that the Commonwealth Bank of Australia computes periodically. iPods are traded, identical (once you choose which one to index), and widely available. Only drawback: Apple has the ability to price to market thanks to its market power. I am waiting for someone to use it to see whether it beat the Big Mac index.

Is fair trade unfair?

US colleges make big money from the sale of all sorts of items imprinted with their logo, in particular clothes. Of course, to maximize the margins on these goods, their production has been mostly outsourced off-shore, to factories that were often likened to sweatshops. Whether a large portion of those factories were indeed providing substandard working conditions is a debate I do not want to enter for now. The fact is that student activists demanded that those factories should not be retained for production. As universities and their suppliers complied, the poorest workers were out of a job, and the university gift stores are making less of a profit. Unintended consequences.

Aurélie Carimentrand and Jérôme Ballet explore a similar story with fair trade. Their case study is about quinoa from Bolivia. The goal of fair trade is to give local producers in developing countries a larger share of the retail price of their product. But beneficiaries need to get certified, and this process does not necessarily favor the most needy, in particular as they need to obey some rules. In the case of Bolivian quinoa, this works through the membership in a growers' association which markets crops to fair trade networks. As associations typically are, this one is dominated by the big producers. The latter are located in the big plains, where they could get the full advantage of mechanization. The small producers are on steep terrain and cannot use tractors. The latter are the poorest, but, as the authors argue, they benefit the least from fair trade, often even skipping membership. Indeed, the association pays the same unit price to all members, and given the differences in production costs, this exacerbates inequalities.

The authors claim that fair trade has failed here. It made inequities among producers worse. But was domestic income equality really the primary role? Isn't it really about world income inequality? There, clearly fair trade is transferring some rents to developing economies. Whether they are large enough to be worth the trouble is another question.

Trade theorems revisited

International trade economics is a constant disappointment to me. It still relies on the Hecksher-Ohlin model, which is static and thus cannot say anything reliable about dynamics. And the vast majority of the empirical work uses linear reduced forms and is only out there to test signs, not to find out how large an effect is. It is then refreshing to see a paper that steps out of this morass, and into the right direction.

Yu Sheng and Xinpeng Xu get back to the foundations of the Hecksher-Ohlin model and integrate some frictions that go beyond the usual iceberg costs. Specifically, they take into account that the reallocation of labor across sectors takes a while by including a Mortensen-Pissarides search framework. Even in steady-state, it turns out some classic trade theorems may not hold. For example, factor price equalization does not hold for labor, as there is unemployment and the expected wage is equalized. Endowments determine the labor force, but employment is endogenous. This allows also to explain why countries with similar endowments still trade a lot: cross-country sectoral differences in unemployment mean the factor content of trade is not a sufficient statistic. All this also means that empirics of the Hecker-Ohlin model need to be adjusted, in particular unemployment needs to be factored in.

Large plants and distance to customers

Understanding why some firms export and some others do not is important for industrial policy. In empirical studies, one factor that always appears to be important is plant size: larger plants have a higher propensity to export. This has been rationalized, for example, by some fix cost of exporting, for example learning about foreign markets and producing to their specifications. But there is more to the story.

Thomas Holmes and John Stevens find that the distance to domestic markets is also associated to plant size. As export markets typically also distant, the link is clear. In fact, Holmes and Stevens claim that 50% of the plant size-export relationship can be explained by distance. Then how are we going to rationalize this? But it is clear from this that it makes little sense to assist a plant in exporting if it does not ship across the country.

Are New Economic Geography models any good?

The New Economic Geography Model pioneered by Paul Krugman has revolutionized our thinking about the location of factors of production, yet there has so far been little empirical support for this theory. Empirical tests suffer from massive endogeneity problems, and simulations seem to replicate very poorly the data, in part because they use very sparsely the data. But combining both approaches coax out their advantages while not revealing too many of their disadvantages. One attempt was by Kristian Behrens, Giordano Mion, Yasusada Murata and Jens Südekum, who estimate a structural model and then simulate border effects.

Eckhardt Bode and Jan Mutl take a somewhat different approach. They take a fully specified structural model, take a Taylor expansion around the empirical steady-state, and then estimate the resulting reduced form. And the model is soundly rejected on US county data, mostly because migration does not vary in the way the model would want. Not imposing theoretical restrictions improves the estimates considerably, which is not reassuring.

Does this mean the NEG models can be dumped now? Not yet. They still gives us good insight, and if they fail on migration, they appear to be holding rather well with regard to the links between wages and good prices. And the empirical methods can certainly be improved, especially regarding spatial autoregression.

How can very small economies survive?

I find very small countries fascinating. They are link small scale representations of the economies we usually study, to a scale that would correspond to an experiment we would want to perform. But these very small countries are not perfect replicas of the larger ones. Because of their size, they are less diversified, need more per capita overhead for governing, their capital accounts are more vulnerable, but they can play very well with tax competition.

Patrice Pieretti, Skerdilajda Zanaj and Benteng Zou, fittingly based in Luxembourg, set up a linear, small open economy where government set tax rates (and thus productivity enhancing public amenities) and household firms locate à la Hotelling around the country border. The result is that there are three possible paths, as so often in dynamic systems: the economy either collapses, explodes or finds its way towards a steady-state along a saddle path.

But do we really learn something from this exercise? The entities here are really P.O. box firms that can move from one country to the next on a whim, except that each firm takes a worker with it. What if there are moving costs? Concave production? People who stay in the country when capital leaves? I bet you would easily find multiple, stable equilibria, some with low taxes, low returns and ovecrowding, some with high taxes, high returns and high amenities. And now things become really interesting and more realistic.

The impact of political violence on tourism

Now that Lebanon and Israel are at it again, one can ask whether this can have an economic impact. The prime candidate (a part for the defense industry) is the tourism industry. Casual empiricism seems to indicate that tourist react very strongly to very small probabilities of danger and thus should be deserting those countries.

David Fielding and Anja Shortland look at the case of Egypt, which has suffered from Islamist fundamentalist violence for the last two decades, sometimes targeted at tourists. They find that tourists stay away when violence has occurred, but only when it was directed towards tourists. Violence among locals has no impact. And when the Egyptian government takes (usually heavy-handed) counter-terrorism measures, European tourists stay away, while US ones are not affected. Interestingly, there is substitution: Egypt's tourism industry benefits when things turn sours in Israel, at least if it does not mean local trouble.

Globalization and the size of the public sector

To finance public goods, taxes need to be levied. But with globalization and international tax competition, the ability of governments to levy taxes is curtailed. Indeed, raising taxes may increase the cost of labor compared to other locations, and outsourcing takes over. The same reasoning applies to other taxes, which become more distortionary with globalization. Of course, it is never bad to put some pressure on governments to keep taxes as low as possible and thus remain efficient, but one may hit a feasibility constraint here.

Torben Andersen and Allan Sørensen think we should not worry too much, though. First, one consequence of globalization is that increased trade leads to a lower cost of goods. This decreases the marginal cost of public funds. Second, there is not necessarily a race to the bottom among tax authorities because terms of trade work to counteract the after-tax disadvantage of higher taxes, apparently for a wide set of parameter values. In other words, gains from trade and general equilibrium effects can absorb the increased distortions from taxes.

Deviations from PPP: a micro-macro disconnect?

Purchasing power parity (PPP) implies that adjusted for exchange rates, similar goods should have the same price across countries. However, this does not hold true, and for extended periods. Why this happens is a puzzle, which is even more confounding considering that deviations from aggregate PPP have a longer half-life than deviations from good-level PPP. Jean Imbs, Haroon Mumtaz, Morten Ravn and Hélène Rey have claimed that this apparent micro-macro disconnect can be explained by a composition effect.

Not so fast, say Paul Bergin, Reuven Glick and Jyh-Lin Wu. Their point is that macro- and micro-PPP follow different processes, the first following aggregate shocks and the second mostly relative-price shocks. Using a vector error correction model, which controls for these shocks, they show then that the remaining deviations are consistent between macro and micro data and have very similar half-lives. This means that the previous explanation based on the heterogeneity of goods and different price stickiness does not hold water. Back to the drawing board...

Increasing trade by creating more borders

What is the difference between macroeconomics and international macroeconomics or trade? There is a border. Just splitting an economy in two seems trivial, yet it matters. A lot. There is plenty of empirical evidence that borders matter. They inhibit trade. They allow for purchasing-power-parity deviations to persist. The economic well-being can differ dramatically across a border despite geographic similarities.

Emmanuelle Lavallée and Vincent Vicard note that the number of borders has considerably increased since World War II, with the number of countries going from 72 to 192. Given the border effect, this should be bad. But this has also a important side effect: transactions that were internal become international, thus boosting international trade statistics. Lavallée and Vicard find that measured international trade has increased by 9% solely because of new borders, but actual trade would have been 4% higher without those borders. While this is not negligible, we need to keep in mind that world trade has increased by a factor of 30 during this period.

Lords, bondage, Hegel, and ... the US-China current account balance

Current global imbalances are mostly the mark of what is happening in the United States and China. And how the two are interacting, one could argue, is all that is going to matter. Pessimists view the current imbalances as the result of large domestic distortions and problems in international financial and monetary markets. Optimists consider the situation to be part of a normal adjustment and everything will automatically be fine.

Célestin Monga tries to reconcile both views using Hegel's approach of self-consciousness and the lordship-bondage relationship. Yes, we can apparently understand global imbalances using philosophy. The idea is the following: The Unites States and China have become largely interdependent and cannot ignore each other. Even if one has dominating position on the other, it can exploit the situation. Think of a fight to death between two adversaries. The winner becomes the master, but there is nothing left to dominate as the other is dead. The same would happen with the other winning. Both realizing that they so reliant the other, the solution is not to kill the loser, but to enslave him. But over time, the slave adapts and makes the master totally dependent on him and becomes more powerful.

How does this brings us to US-China relations? First ignoring each other, the US takes center stage with the Industrial Revolution, and China's 5000 year history takes a back seat. But since China has regained economic power and is on the verge to become the second economy in the world, both economies wage a battle for economic supremacy, best visible on the position with respect to the "manipulated" renminbi/dollar exchange rate (US position) and the "concerns" about the US dollar (China position). But both cannot ignore how intertwined they are, just have a look at the trade and capital accounts. This implies that they cannot unilaterally take policy decisions without considering very seriously how they other would react. They are locked in a Nash equilibrium, and at this point both are masters and slaves.

Should we not use philosophy and psychology instead of macroeconomics to understand global imbalances? Is this an example of behavioral economics going too far? We tend too often to think that countries act like a representative agents, and this analysis takes it to the extreme. One cannot ignore that some factors here are solely dependent on government decisions (exchange rate, monetary policy), that make it look a country acts as one, and is thus locked in a two player game. But this hides considerable heterogeneity of agents within, but while they face the same prices, their impact varies a lot: some are exporters, some importers, some directly, some indirectly. And government policies are a reaction to all this heterogeneity. I think our macroeconomic models are still more useful than Hegelian conjectures.

National drought insurance

Some aggregate shocks can have a very large and costly impact. Not your typical business cycle in a developed economy, but rather shocks like earthquakes, droughts or major hurricanes. They put a lot of strain on affected regions, who would clearly gain from acquiring some sort of insurance against such adversities. Robert Shiller has been advocating cross-country insurance mechanisms against GDP fluctuations (say ... markets), but it calamities would have an even more pressing need for that.

Joanna Syroka and Antonio Nucifora explore this in the case for draught insurance in Malawi. With the help of the World Bank, this country is now offering a derivative contract based on index computed from the measurements of 23 weather stations in the country. The hope is that if international markets buy these instruments, the financial consequences of weather fluctuations will be born outside of the country, and macroeconomic stability will help growth and poverty alleviation.

It will be interesting to see whether there will be demand for these derivatives. Experiments have run in Ethiopia and Mexico, but in both cases it was with re-insurers. This time, a government is directly involved. If this works, there are many other candidates for this, think for example Bangladesh, whose GDP depends crucially from the yearly monsoon. And once such markets are well developed, smaller risks like GDP fluctuations in GDP countries may be insurable as well for governments.