Jeffrey Frankel Harpel Professor, Harvard University

1

In the Aftermath of Global Financial Crisis
Implications of a New Economic Order with the G20

• Jeffrey FrankelHarpel Professor, Harvard
  University
• 25th anniversary of the KAEAAllied Social
  Science Association Meetings
• Atlanta, January 4, 2010

2
Congratulations to the Korea-America Economic
Associationon 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?

3
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.

4
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 Treasurys interpretation of the deficits
  capital was flowing into the US because it was a
  wonderful place to invest.

5
Others interpreted the US trade deficit much more
negatively

• The US was said to be in decline
• The hollowing out of manufacturing.
• Paul Kennedys The Rise and Fall of the Great
  Powers.

• Japan was thought a juggernaut, taking over the
  world economy.
• Ezra Vogels Japan as Number One
• Chalmers Johnsons MITI and the Japanese Miracle,
  etc.

6
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)

7
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 (lt budget deficits) and
• High NS in Japan (lt budget surplus
  aging-driven household saving).
• US global leadership was not exhausted.
• Joe Nyes Bound to Lead

8
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-) .

9
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)

10
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.

11
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.

12
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 cant repay.
• Rogoff This Time Is Not Different.
• Roubini The recession will be severe.

13
The US has lost its claim as an exclusive model
for others to emulate

• The desirable principles havent 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 (dont subsidize fossil
  fuels).
• Supervise banks, under rules (dont take them
  over).

14
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
• gt we have avoided the mistakes of
• the Depression,
• or Japans lost decades.
• But the long-term fiscal outlook already bad
  has gotten worse.

15
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.

16
The US financial positionhas deteriorated
internationally

• The twin deficits
• China is now our largest creditor
• The dollar appears in long-term decline.

17
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.

18
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 !

19
The Bretton Woods II hypothesis

• Dooley, Folkerts-Landau, Garber (2003)
• todays system is a new Bretton Woods,
• with Asia playing the role that Europe played in
  the 1960sbuying 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 Chinas need to import workable
  systems of finance corporate governance.

20
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.

21
There is no reason to expect better today

• Capital mobilityis much higher now than in the
  1960s.
• 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.

22
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.

23
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.

24
The global monetary systemmay 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
  .
• a multiple international reserve asset system.

SDR
25
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.

26
Decoupling?

• Initial hopes of decoupling succumbed at the
  height of the crisis
• Financial contagion
• Asian exports were especially hard-hit.

27
Asian exports plummeted
via RGE Monitor 2009 Global Outlook
28

• 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.

29
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 didnt are those that got into worse
  trouble Central Eastern Europe.

30
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)

31
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.

32
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.

33
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.

34
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)

35

• 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 Fishers debt deflation.

36
The G-20

• G-20 meetings in 2009
• London in April
• Pittsburg in October

37
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 G7s 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.

SDR
38
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.

39
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.

40
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.

41
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?

42
Opportunity/burden for Korea

• Will chairing the G-20 help consolidate Koreas
  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

43
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.

44
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.
45
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

46
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.
• My recommendation an informal steering group
  within G-20.

47
(No Transcript)
48
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.

49
1. Origins of the crisis in the US

• Well before 2007, there were danger signals
• Real interest rates lt0, 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

50
US real interest rate lt 0, 2003-04
Source Benn Steil, CFR, March 2009
Real interest rates lt0
51
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.
52
Six root causes of financial crisis

• 1. US corporate governance falls short
• E.g., rating agencies
• executive compensation
• options
• golden parachutes
• 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

MSN Money Forbes
53
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.

54
Origins of the financial/economic crisis
Homeownership bias
Predatory lending
Excessive complexity
MBSs
Foreign debt
CDSs
CDOs
Gulf insta-bility
Oil price spike 2007-08
Recession 2008-09
55
Addendum 2The US current account deficits

• Some economists argue they are sustainable

56
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 rentspay for the trade
  deficits. -- Caballero, Farhi Gourinchas
  (2008)
• In one version, the United States has been
  operating as the Worlds Venture Capitalist,
  accepting short-term liquid deposits and making
  long-term or risky investments -- Gourinchas
  Rey (2008).
• US supplies high-quality assetsCooper (2005)
  Forbes (2008) Ju Wei (2008) Hausmann
  Sturzenegger (2006a, b) Mendoza, Quadrini
  Rios-Rull (2007a, b)

57
Global Savings Glut

• Global Current Account Imbalances debate,
  2001-07
• On one sidethose 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

58

• The 2007-09 crisis did not resolve the CA
  imbalances debate.
• Reaction of the unsustainability sidethis is
  the crisis they were warning of.
• One response from the other side the savings
  glut caused the crisis.

59

• 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.

60

• 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 worlds investors?

61

• 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.

62
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 worlds 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?

63
Addendum 3Proposal for a Global Climate
Agreement

64
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
Proposal

• Stage 1
• Annex I countries commit to the post-2012
  targets that their leaders have already
  announced.
• Others commit immediately not to exceed BAU.

• a Progressive Reduction Factor,
• a Latecomer Catch-up Factor, and
• a Gradual Equalization Factor.

65
? Constraints are satisfied -- No country in
any one period suffers a loss as large as 5 of
GDP by participating. -- Present Discounted
Value of loss lt 1 GDP.
? In one version, concentrations level off at
500 ppm in the latter part of the century.
Co-author V.Bosetti
Global peak date 2035
66
What form should border measures take?

• Best choice multilateral sanctions under a new
  Copenhagen Protocol
• Next-best choice national import penalties
  adopted under multilateral guidelines
• Measures can only be applied by
  participants-in-good standing
• Judgments to be made by technical experts, not
  politicians
• Interventions in only a ½ dozen of the most
  relevant sectors.
• Third-best choice no border measures.
• Each country chooses trade barriers as it sees
  fit.
• Worst choice national measures are subsidies
  (bribes) to adversely affected firms.