Globalization in an Age of Crisis: Multilateral Economic Cooperation in the Twenty-First Century 9780226030890

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Globalization in an Age of Crisis

A National Bureau of Economic Research Conference Report

Globalization in an Age of Crisis Multilateral Economic Cooperation in the Twenty-First Century

Edited by

Robert C. Feenstra and Alan M. Taylor

The University of Chicago Press Chicago and London

ROBERT C. FEENSTRA is professor in the Department of Economics at the University of California, Davis, where he holds the C. Bryan Cameron Distinguished Chair in International Economics. He is director of the International Trade and Investment Program of the National Bureau of Economic Research. ALAN M. TAYLOR is professor of economics and finance in the Department of Economics and the Graduate School of Management at the University of California, Davis, and a research associate of the National Bureau of Economic Research.

The University of Chicago Press, Chicago 60637 The University of Chicago Press, Ltd., London © 2014 by the National Bureau of Economic Research All rights reserved. Published 2014. Printed in the United States of America 23 22 21 20 19 18 17 16 15 14 1 2 3 4 5 ISBN- 13: 978-0-226-03075-3 (cloth) ISBN- 13: 978-0-226-03089-0 (e- book) DOI: 10.7208/chicago/9780226030890.001.0001 Library of Congress Cataloging- in-Publication Data Globalization in an age of crisis : multilateral economic cooperation in the twenty-first century / Robert C. Feenstra and Alan M. Taylor, editors. pages ; cm. — (A National Bureau of Economic Research conference report) ISBN 978-0-226-03075-3 (cloth : alk. paper) — ISBN 9780-226-03089-0 (e-book) 1. International economic relations. 2. Globalization. 3. Global Financial Crisis, 2008–2009. I. Feenstra, Robert C. II. Taylor, Alan M., 1964– III. Series: National Bureau of Economic Research conference report. HF1359.G5857 2014 337—dc23 2013014424

o This paper meets the requirements of ANSI/NISO Z39.48-1992 (Permanence of Paper).

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Contents

1.

Preface

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Introduction Robert C. Feenstra and Alan M. Taylor

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Coping with Shocks and Shifts: The Multilateral Trading System in Historical Perspective Douglas A. Irwin and Kevin H. O’Rourke Comment: L. Alan Winters Comment: Rufus Yerxa

2.

International Policy Coordination: The Long View Barry Eichengreen Comment: Charles Bean Comment: Gerardo della Paolera

3.

Can the Doha Round Be a Development Round? Setting a Place at the Table Kyle Bagwell and Robert W. Staiger Comment: Robert D. Anderson

4.

Preferential Trade Agreements and the World Trade System: A Multilateralist View Pravin Krishna Comment: Ernesto Zedillo Comment: Anthony Venables

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5.

6.

7.

8.

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Contents

Trade and Industrialization after Globalization’s Second Unbundling: How Building and Joining a Supply Chain Are Different and Why It Matters Richard Baldwin Comment: Andrés Velasco Facing the Climate Change Challenge in a Global Economy Lee Branstetter and William Pizer Comment: Alex Bowen Multilateral Economic Cooperation and the International Transmission of Fiscal Policy Giancarlo Corsetti and Gernot J. Müller Comment: Domenico Siniscalco Comment: Martin Feldstein The International Monetary System: Living with Asymmetry Maurice Obstfeld Comment: Takatoshi Ito Global Macroeconomic and Financial Supervision: Where Next? Charles A. E. Goodhart Comment: Adair Turner Comment: Richard Berner Panel Discussion Charlene Barshefsky Martin Feldstein Subir Gokarn Paul Keating

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Afterword: How the Financial Crises Have Changed the World Martin Wolf

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Contributors Author Index Subject Index

409 413 419

Preface

The year 2010 was the 150th anniversary of the signing of the Anglo-French Treaty of 1860, also known as the Cobden-Chevalier Treaty after its British and French negotiators. This treaty is credited as being the first to mention the “most favored nation” principle applied in a bilateral setting whereby each country would enjoy the benefits that its partner gave to any other country. The treaty is also seen by many as marking the birth of a multilateralist economic order, often taken for granted in the modern world. Anticipating that anniversary, we felt that the time was right to host a discussion of multilateralism in both trade and macroeconomic issues. Our resolve was strengthened by the global economic crisis of 2008–2009, which posed a threat to globalization and international economic cooperation. With generous funding from the Alfred P. Sloan Foundation, a conference to discuss these issues was held at the Bank of England on September 15–16, 2011, entitled “Globalization in an Age of Crisis: Multilateral Economic Cooperation in the Twenty-First Century.” We thank both those organizations, as well as the National Bureau of Economic Research, for enabling this discussion to go forward. From the initial concept, the NBER president, Jim Poterba; the governor of the Bank of England, Mervyn King; and Sloan’s program director, Danny Goroff, gave us their strongest support. This volume gathers together the papers and discussion from that conference, and we would like to thank all the participants for their contributions as well as everyone who made the project possible. At the Bank of England, conference logistics and other matters were brilliantly managed by the offices of the deputy governor Charles Bean and the executive director Spencer Dale; special thanks are owed to Rohan Churm, Denise Rayner, and Katy Wilson. For warm hospitality, we will remember the Bank of England, especially the Court Room, and the Reform Club, which hosted the conclud-

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ing dinner. We thank Mervyn King and Martin Wolf for their after-dinner remarks on the successive evenings, and we are pleased to include a revised version of Martin’s comments as an afterword. Our organization of this event also benefited from the assistance of Abel Bojar, London School of Economics, in transcribing the discussion from the conference tapes for this volume. At the NBER, despite the conference taking place on another continent, organization was handled with aplomb by Carl Beck’s department, and the publication process has been guided as expertly as ever by Helena Fitz-Patrick. Robert C. Feenstra and Alan M. Taylor

Introduction Robert C. Feenstra and Alan M. Taylor

It was very soon apparent that the global economic crisis of 2008– 2009, aside from its painful economic costs, also raised fears of worrisome prospects for the smooth and harmonious conduct of international policymaking. As has been seen in other large recessions and depressions in times past, it was not long before new policy initiatives started to emerge that placed national concerns at the forefront, even if that went against the grain of seemingly established principles, worked against globalization, irritated specific economic partners, or undermined international economic cooperation more broadly. Whether in fiscal and monetary policies, the control of currencies and capital flows, approaches to protectionism and barriers to trade, or in the regulation of finance, national economic interests are starting to be asserted, often at the expense of commitments (explicit or implicit) to preserve the integration of world markets and to solve problems through cooperative policy actions. Several broad questions thus began to resonate among scholars, policymakers, and economic actors. Is globalization in retreat? What are the economic causes, political channels, and ultimate consequences of these changes? And how can applied economic research (based on theory, history, and empirics) respond to the challenge of making sense of these developments, and offering wise counsel for the future? Robert C. Feenstra is professor in the Department of Economics at the University of California, Davis, where he holds the C. Bryan Cameron Distinguished Chair in International Economics. He is director of the International Trade and Investment Program of the National Bureau of Economic Research. Alan M. Taylor is professor of economics and finance in the Department of Economics and the Graduate School of Management at the University of California, Davis, and a research associate of the National Bureau of Economic Research. For acknowledgments, sources of research support, and disclosure of the authors’ material financial relationships, if any, please see http://www.nber.org/chapters/c12574.ack.

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Prompted by these historic shocks to the global order, and the damage and uncertainty they have imposed on economies and policymakers, we organized this conference to consider the major questions that need to be faced going forward. We saw that there was little in the way of new analytical frameworks for considering such questions in light of current events. We felt there was an acute need to consider some of the critical linkages between many of the pressing issues (for example, exchange rates, global imbalances, and financial regulation). We also saw the need for thinking that embraced the long sweep of history and considered the political and economic outcome of past multilateral economic policies, and the prospective role of such policies in the future path of the global economy. The goal was to advance debate about how the mostly successful multilateral post–World War II global economic order should not merely continue to function, but also now evolve and improve to address the strains created by the pressures of rapid globalization in the last two decades, and now deeply exposed and exacerbated by the crisis. Whilst there are ongoing processes and institutions in each sphere (e.g., Doha Round, UN, IMF/G20, Basel), we also need “blue skies” thinking on new agendas for the next century that will bring research directly to policymakers in ways that are useful to them. The nine chapters in this volume, with comments from leading policymakers, are intended to be a first, important step toward this end. Lessons from History The proceedings begin with two papers that take the long view. International cooperation on economic matters on a significant scale dates back to the nineteenth century. The best- known example was just about 150 years ago, when Britain and France concluded the Cobden-Chevalier trade treaty (1860) which formalized the “most favored nation” (MFN) concept, thus extending tariff reductions by any pair of countries to other partners within the growing web of similar treaties that came to pass in Europe in subsequent years. Even though trade policies were to become restrictive at times, notably in the interwar period, the same principle was later revived and has been central to the operation and success of GATT/WTO (General Agreement on Tariffs and Trade/World Trade Organization) in the postwar era. In monetary affairs the launch of the Latin Monetary Union in 1866 by France, Belgium, Italy, and Switzerland (later joined by seven other countries) could be seen as, if not an early precursor to the eurozone, at least an attempt to coordinate monetary policy at a transnational level, even if the project was soon undermined by the contradictions of the bimetallic system it sought to defend, and the bloc ended up as a de facto member of the soon ubiquitous gold standard area, which began to dominate world monetary affairs after the 1870s. Indeed, the gold standard itself may also stand in, for some, as a better example of a multilateral system of monetary coopera-

Introduction

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tion. It depended on adherence for its smooth functioning, within limits, to certain policies and rules in a decentralized context, and on its ability to deliver price stability; ultimately it failed when, in the 1930s, noncooperative behavior in a deflationary environment tore it apart. Against this backdrop, the first two chapters use the tools of comparative economic history to survey the variety of institutional formats, policy experiments, and their associated economic outcomes over the last two centuries, drawing attention to the success and failures, the political economy forces driving the historical process, and, most importantly, drawing out lessons for our present postcrisis challenges. In chapter 1, “Coping with Shocks and Shifts: The Multilateral Trading System in Historical Perspective,” Douglas A. Irwin and Kevin H. O’Rourke present a panoramic view of the multilateral trading system over the last two postmercantilist centuries, and explore how its sustainability in different historical epochs has depended on its ability to cope with disruptive adjustments. At some catastrophic moments (“shocks”) when the system has lacked shock absorbers capable of handling large macroeconomic, financial, or political disturbances, the trading system has proven to lack resilience, in the sense that political economy forces have then tended to emerge intent on using protectionist devices as an alternative tool to offset, or at least cushion, such shocks. But equally important, lower frequency perturbations (“shifts”) have also from time to time strained the commitment to free trade, as when more gradual but no less powerful trends in comparative advantage (whether for technological or geopolitical or other reasons) have eventually forced dramatic changes in trade patterns, industry structure, and factor rewards, creating a political backlash. They also argue that institutions matter: even if unilateral policymaking could in theory deliver a free trading system with adequate shock absorbers, historical observation of such regimes expose the perils of beggar- thy- neighbor actions and a prisoner’s dilemma outcome. The parallels with the present are clear, and whether we think at the level of the prospective fallout from a possible eurozone crisis or the dim prospects for further progress in the WTO/Doha process, or how trade with emergent China and India has and will yet affect the advanced countries, the chapter draws attention to the important but often neglected linkages between the sustainable success of free trade regimes and the political and technocratic ability of countries to manage the pressures that openness expose. In chapter 2, “International Policy Coordination: The Long View,” Barry Eichengreen takes a long view of the evolution of international coordination in macroeconomic policy areas. The historical record shows a great deal of variation, and in general suggests that there are often constraints on what can be achieved, probably more so than in the area of trade policy: coordination is more likely in limited technical areas, when there is institutional support, when it is needed to preserve an existing regime from failure,

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and when nations are not in conflict on other issues. For example, as the classical gold standard matured, central banks engaged in mutual support operation, often of a technical nature, and although policymakers had not overtly created the regime, once it was there they increasingly had a stake in its continued smooth operation. It was the outbreak of war in 1914 that derailed the gold standard, and despite desperate efforts made in the 1920s to try to rebuild and shore up a patched-up version augmented with reserve currencies, its credibility was weakened as much by increased scarcity of gold as decreased goodwill. Only in the wake of these failures, and the Depression and a second war, did more serious efforts take hold as conflict abated and the costs of earlier mistakes loomed large, with the creation of the International Monetary Fund (IMF) and, following the Marshall Plan, the start of European cooperation ultimately leading to the European Union (EU) and European Monetary Union (EMU). Nonetheless, as financial integration progressed in the late twentieth century, more often than not it would take crises—some severe—to prompt coordinated actions even where institutional structures were in place; examples of reactive rather than proactive efforts being responses to the Asian Financial Crisis, global imbalances, the Great Recession, and notably Europe’s attempts to shore up monetary and fiscal arrangements after a crisis, be it in 1992 or today. In these cases, the gaps between the technocratic solutions and political realities, in the United States, Europe, China, or elsewhere, have often been a key stumbling block. Facing a global disaster in 2008– 2009, central bank and G20 cooperation showed that grave enough dangers could focus minds, but once the cliff edge receded, problems of collective action resurfaced. International macroeconomic cooperation remains as fragile as ever. Trade and Environment In chapter 3, “Can the Doha Round Be a Development Round? Setting a Place at the Table,” Kyle Bagwell and Robert W. Staiger explore whether the current WTO round (now already in progress for more than ten years) can really deliver on one of its main stated objectives, namely to improving the trading prospects of developing countries. They argue that certain features in the design of the current round, as well as a number of pathdependent conditions inherited from past trade rounds, may make this objective difficult to attain. First, they note that the attempt to maintain a “special and differential treatment” (SDT) regime in the negotiations for developing countries—that is, an exception to the usual norm of reciprocity as in the case of developed countries—may prove to be a significant barrier to the achievement of successful negotiations. Qualitatively, by trying to free ride on others’ MFN commitments, the SDT provision may limit the “voice” of these countries in deciding which products actually get included in liberalization; and quantitatively, theory shows that the reciprocity between a pair

Introduction

5

of developed countries can induce terms of trade changes which, though mutually beneficial for them, in the end leave the developing country with no change in trade volume. Lerner symmetry proves to be strong under reciprocal MFN tariff bargaining: the tariff cut boosts export for the negotiating pair, but not for the outsider. Worse still, the developing countries face the problem of being “latecomers” to such negotiations, meaning that developed nations have already removed (and given MFN status) to tariff cuts on a wide range of manufactured goods: but in reciprocal bargaining, where “large” sectors feel the pain of foreign tariffs, the political process and bargaining equilibrium depends on the ability to identify such potential gains on both sides. If developed countries have eliminated most such distortions already then a mutually beneficial deal is harder to find, and history reveals evidence of such problems even in the early postwar GATT rounds. Another design problem in the Doha Round concerns agriculture, where the setup tries to encourage reductions in home agricultural subsidies in exchange for partner import tariff cuts. But the economic logic is weaker here: for example, if the foreign import tariffs are “optimal” (in the terms of trade sense) and if the agricultural subsidy makes their food imports cheaper, the proposed deal may appear lose- lose for the partner; at home, farmers lose subsidies and might gain on exports, but the net effect might be ambiguous. In this setting, unlike symmetric market- access bargaining over tariffs, the gains may be small, hard to identify, or nonexistent. Thus, the authors conclude, significant changes in the design on the Doha Round may be needed if negotiations, stalled for a decade, are to move forward. In chapter 4, “Preferential Trade Agreements and the World Trade System: A Multilateralist View,” Pravin Krishna considers the long- standing trend of creating discriminatory regional or bilateral preferential trade agreements (or PTAs, such as free trade areas, customs unions, etc.) and assesses to what extent this process is compatible with a healthy multilateral world trading system: that is, one might ask, are the two substitutes or complements? To answer this question is, ultimately, an empirical challenge, but with two decades of experience since the proliferation of such agreements began on a large scale, we have a reached a moment when a reasonable assessment can be made using evidence drawn from a broad sample of experiences. The results are mixed, but one can be skeptical that PTAs are, as yet, a big factor. The PTAs currently cover only a small fraction of trade in terms of the actual amount of liberalization achieved (that is, above and beyond multilateral agreements): most PTA trade takes place under zero MFN tariffs. Intra-PTA trade shares are small in most cases, and studies find that the welfare impacts are not clear cut. In addition, the institutional aspects of “deep integration” do not seem to be advanced all that much by PTAs relative to WTO norms. It is not clear that preferential agreements can impair the multilateral negotiation process in general, but there are signs that PTA members may use subtle yet diversionary nontariff

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trade policy more aggressively against nonmembers. That said, some studies do show that, despite this, there are in many cases significant signs of trade diversion resulting from such preferential deals, so they do have some impact at the margin. In addition, as noted in chapter 3, the sequencing of market access to developed countries via special preferences for some developing countries can vary considerably and those with existing access may have very divergent interests compared to those who have no deal in place, a factor that could complicate deal making in the WTO process. The conclusion drawn is that PTAs have not achieved as much as might be thought, and that the multilateral process has been, and remains, central to the trade liberalization process. In chapter 5, “Trade and Industrialization after Globalization’s Second Unbundling: How Building and Joining a Supply Chain Are Different and Why It Matters,” Richard Baldwin asks why so-called high development theory has thus far failed to give a plausible account of how emerging poorer countries can succeed in growth and development, and narrow the divergence in income per capita or productivity between themselves and the rich world. On the one hand, he argues that the actual experience of the last two decades has only served to emphasize the shortcomings of older generations of theories, but that distinct transformations in the workings of trade created by today’s globalization may serve as the foundations of a newer and more accurate theory. The key, he argues, is to note that in its previous workings, the globalization of trade only enabled a “first unbundling” via the separation of the locales of production and consumption, notably after the revolutionary decline in shipping costs in the nineteenth century; this naturally led to highly localized and specialized production as predicted in old trade theories, and led to the division of the world into manufacturers and nonmanufacturers. Once it was technologically feasible and economically worthwhile, the factories were “unbundled” from consumers. But the last twenty years has witnessed the rise of a completely new trade mechanism, the supply chain, where the different parts of the manufacturing process can be split up and along with it, the location of one or more intermediate steps of value creation. Baldwin argues that this “second unbundling” facilitated by even lower transport costs and other logistical developments (like ICT and the Internet) is as revolutionary as the first, if not more so. Creating such niche opportunities can allow all countries to compete for a slice of manufacturing on a more even playing field: for example, instead of requiring an entire and “lumpy” vertically structured automobile industry, built on a huge manufacturing base ranging from basic inputs and parts all the way up to final assembly, the supply chain allows many different value added slices to be produced in myriad different locations. Now that it is technologically feasible and economically worthwhile, the factories themselves are being unbundled. Baldwin sketches this out as a new development theory, which could explain the much more

Introduction

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rapid (and disruptive) ability of emerging countries today to compete and converge with rich countries. In chapter 6, “Facing the Climate Change Challenge in a Global Economy,” Lee Branstetter and William Pizer discuss the global economic challenge posed by mitigating the predicted adverse economic and ecological effects of climate change in the decades to come. Evidence suggests that we are already behind the curve, in that the ongoing stocks and flows of anthropogenic greenhouse gas (GHG) emissions are so substantial as to have already placed us on a trajectory far worse than the agreed and supposedly achievable targets that have been the focus of past international negotiations and treaties. This reflects the historical problems in this domain, where progress, such as it is, from declared objectives to substantive economic policy action has been at a glacial pace—problems that, in turn, reflect the problems of intergenerational and transnational collective action. The first problem is that the full, cumulative benefits of mitigation action today will not be felt until far into the future, and those costs are, to some degree, uncertain; and the second is that, unlike most “local” pollution forms, GHG is by its nature afflicted by a global externality problem, but we live in a world where the locus of political decisions is national. The latter problem is exacerbated by the fact that a large share of future emissions growth will be in latecomer emerging economies, for whom sacrificing economic growth will appear not just costly but inequitable, in that the advanced economies past stock of emissions was not so restrained. In light of these problems, the authors discuss the preferable but unlikely first- best policy solutions to the climate change problems we face, and why current global institutions are not up to the task. For the moment they conclude that negotiations based on “top down” global approaches, like the Kyoto Protocol, may not be fruitful in the near term, although some progress may yet be made in “bottom up” frameworks where countries, or perhaps regions, may implement mitigation commitments more unilaterally. However, if such policies progress at different speeds, comparative advantage could shift, with the possibility of “carbon tariff” policies that protect costly and cleaner energyusing sectors at home from cheap and dirty producers in overseas havens with weaker pollution controls. While in theory such trade barriers might be economically suited to solving the externality problem, they are likely to be politically problematic and could create serious trade tensions for the global economy. Macroeconomics and Finance In chapter 7, “Multilateral Economic Cooperation and the International Transmission of Fiscal Policy,” Giancarlo Corsetti and Gernot J. Müller consider the case for fiscal policy coordination across countries, an aspect of macroeconomic policy that has been thrust into the spotlight since the

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start of the Great Recession once conventional monetary policies reached their limits. Indeed, the global response at the 2009 London G20 summit demonstrated how, in extreme circumstances, such coordination can be achieved, above and beyond the automatic stabilizers. But even if it is feasible, can it be argued to be effective? And in particular, are international spillovers large enough to matter and to justify treating this as a potential coordination problem? The authors attack this question using both theory and empirics. Empirically they use a vector- autoregression model with US and European/UK data, and find evidence that, using standard identification methods, US fiscal shocks do generate quite large spillovers across the Atlantic. To try to explain this, the theoretical model is a fairly standard quantitative two- country business cycle model, with nominal rigidities, a Taylor rule monetary policy, and fiscal policy guided by a debt- stabilizing rule for taxes and spending (so deficits today imply reversals in the future). In this setup it is quite hard to generate large cross- border spillovers, although qualitatively the impacts are present. But the model highlights that the “financial channel” matters, so that anticipated future reversals of policy can deliver lower interest rates in the present. Still, in this setting, any doubts about solvency would undermine the mechanism, implying that sovereign stresses in various countries could weaken the power of fiscal policy tools, and in that case international coordination to create “fiscal space” could be needed to ensure that truly solvent countries avoid self- fulfilling sovereign crises. In chapter 8, “The International Monetary System: Living with Asymmetry,” Maurice Obstfeld examines the problems facing the international monetary system as a result of the growing asymmetry between advanced and emerging nations, which in many key respects echo the travails of the late Bretton Woods system in the 1960s. For one, in an increasingly financially integrated world, where capital controls cannot be perfectly watertight, emerging countries facing the threat of sudden stops (or sudden flight) of capital, unwilling or unable to rely on IMF or other external assistance in times of crisis, have resorted to self- insurance via foreign reserve hoarding in order to maintain a liquidity buffer. At the same time, many of these countries also have “fear of floating” and wish to limit exchange rate volatility through intervention to support currency regimes that range from dirty floats to firm pegs, possibly for competitive export reasons, and/or to avoid boom- bust economic cycles associated with speculative capital inflows and currency overshooting. The author argues that at a fundamental level, this configuration of the world economy is most likely inefficient, resulting from coordination failures and institutional weaknesses. For example, a narrow and rational interest in self- insurance can lead a country to develop a huge war chest of foreign AAA reserve assets, but this creates a negative externality; clearly, not every country can pursue this strategy, and the pool of safe assets is increasingly limited on the supply side, exploding

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on the demand side. Indeed, the configuration may self- destruct if a fiscal variant of the 1960s Triffin paradox eventually undercuts the creditworthiness of the shrinking set of safe haven government, as they either lever up nondeficit finance (gross debt) for risk transformation, or overborrow with deficit finance (net debt) for current expenditure. Moreover, this asymmetry problem is likely to be exacerbated by the growth acceleration in emerging countries relative to advanced economies of late. Gross foreign asset positions have thus expanded on both sides of the emerging versus developed country divide, but with very different composition, resulting in risk shifting more than risk sharing. And within the advanced world, the explosion of gross foreign asset positions has already been problematic, with the foreigncurrency components held on bank balance sheets requiring cross- border lender of last resort action during the recent crisis (routed through central bank swap lines). The chapter then goes on to discuss how these problems could be addressed by a better multilateral cooperation: the need to redesign the role of lenders of last resort nationally and globally rather than via the ad hoc use of swap lines; the case for a more efficient way for emerging countries to access emergency liquidity than costly and potentially destabilizing reserve accumulation; the case for coordinating emerging countries’ exchange rate policies to avoid currency wars; the ways in which the IMF could support these goals with enlarged facilities, redesigned conditionality, oversight of capital flow imbalances, and emerging country currency and capital control surveillance; and the deep political challenge posed by the risk of communal fiscal losses in any such cross- country risk- sharing architecture in cases where illiquidity turns out to be insolvency. The volume concludes with chapter 9, “Global Macroeconomic and Financial Supervision: Where Next?” by Charles A. E. Goodhart. This chapter argues that there are two key challenges to further progress in improving oversight, one political and one analytical. The political problem is the clash between national sovereignty and policymaking and the international cross- border linkages brought about by the unprecedented degree of financial globalization in the last decade. The analytical problem is that macroeconomics has made slow progress, with little consensus: models of financial sectors with plausible frictions, incompleteness, or imperfections, are as of now still in their infancy. On the former, the prospect of any global governance structure is remote, so Goodhart argues that after the crisis, we should expect to see more national- level control and supervision over finance. A key testing ground is the euro area, where the treaty commitments to capital mobility are forcing, belatedly, rapid efforts to create cross- border supervisory structures. Yet key architectural problems stand in the way, such as the lack of a fiscal system to back the monetary union, a sluggish and asymmetric adjustment mechanism between surplus and deficit regions, no well- articulated lender of last resort role for the European Central Bank (ECB), the national nature of most banks, and the fact that such banks

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disproportionately hold the public debt of the subsidiary sovereigns where they are domiciled. In moments of financial crisis and downturn, a subsidiary sovereign may be faced with self- fulfilling bank or sovereign crises, and the one may cause the other (given the codependence caused by the public debt on bank balance sheets). On the macro side, the author argues that to prevent or mitigate crises, some authorities, most likely the IMF, may need to be more assertive in warning about debt- augmenting imbalances ex ante, or even dissuading them by issuing binding risk- weighting changes. And, once solvency is the issue, the IMF or some other arbiter may need greater powers in helping to quickly resolve crises and restructure debts ex post. On the banking side, the author notes that, despite major changes since the 1980s, the crisis shows that the Basel banking regime remains a work in progress. There are substantial concerns associated with the laxness and procyclicality of the current rules. Weaknesses remain in that the regime has no sanctions and defers to nations, that the safe capital ratios may be higher than the current minima, that other tools such as convertible bonds or taxation remain unexplored, and that risk- weighting and stress test concepts are still in play despite their dubious value in the last crisis. Thus, the tasks ahead for macroprudential policy design remain challenging.

1 Coping with Shocks and Shifts The Multilateral Trading System in Historical Perspective Douglas A. Irwin and Kevin H. O’Rourke

1.1

Introduction

How can multilateral cooperation on matters of trade policy be sustained? How has the multilateral trading system been able to cope with the various challenges that have confronted it in the past? The goal of this chapter is to see if history can provide us with guidance in dealing with the challenges in maintaining open, multilateral trade in the years ahead. These challenges are nonnegligible in light of the prolonged economic fallout from the financial crisis of 2008– 2009, the rapid rise of China as a major exporter, and the apparent failure of the Doha Round. This chapter focuses on the extent to which policymakers have been able to construct a multilateral trading system, and how the system has (or has not) responded to the major challenges that confront it. We draw attention to two broad categories of challenges: shocks and shifts. By shocks we mean sudden jolts to the world economy that can take the form of financial crises and deep recessions, or wars and political conflicts. By shifts we mean Douglas A. Irwin is the John Sloan Dickey Third Century Professor in the Social Sciences at Dartmouth College and a research associate of the National Bureau of Economic Research. Kevin H. O’Rourke is the Chichele Professor of Economic History and Fellow of All Souls College at the University of Oxford and a research associate of the National Bureau of Economic Research. Paper initially prepared for the Bank of England/NBER conference “Globalization in an Age of Crisis: Multilateral Economic Cooperation in the Twenty-First Century,” London, September 2011. We are grateful to participants at the conference, in particular Alan Taylor, to Rob Feenstra, and to an anonymous referee for helpful suggestions. The research leading to these results has received funding from the European Research Council under the European Union’s Seventh Framework Programme (FP7/2007– 2013) /ERC grant agreement no. 249546. O’Rourke thanks the ERC for its generous support. The usual disclaimer applies. For acknowledgments, sources of research support, and disclosure of the authors’ material financial relationships, if any, please see http://www.nber.org/chapters/c12575.ack.

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slow- moving, long- term changes in comparative advantage or shifts in the geopolitical equilibrium that force economies to undergo potentially painful and disruptive adjustments. To analyze the consequences of these shocks and shifts, we need a framework. Ours is based on Aesop’s fable of the oak and the reed: “You have reason to complain,” said the Oak. “The slightest breeze that ruffles the surface of the water makes you bow your heads, while I, the mighty Oak, stand upright and firm before the howling tempest.” “Do not worry about us,” replied the Reeds. “The winds do not harm us. We bow before them and so we do not break. You, in all your pride and strength, have so far resisted their blows. But the end is coming.” As the Reeds spoke a great hurricane rushed out of the north. The Oak stood proudly and fought against the storm, while the yielding Reeds bowed low. The wind redoubled in fury, and all at once the great tree fell, torn up by the roots, and lay among the pitying Reeds.1 This fable points to the need for shock absorbers if a trading system is to survive. Some international regimes have been characterized by a greater variety of shock absorbers—or more efficient ones—than others. This helps to explain their relative longevity. At the time of this writing, our own period’s trading system seems reassuringly reed- like, while the reconstructed international system of the 1920s proved to be a bit of an oak. Indeed, the liberal international order of the nineteenth century also turned out to be an oak: while the period saw the development of various economic shock absorbers, in the end its geopolitical shock absorbers proved inadequate. Before describing the ways in which the multilateral trading system can be preserved, we need to define what it is. We begin by discussing the various features of a multilateral trading system that are generally considered desirable. There are a number of aspects of a multilateral order, not all of which are consistent with one another, that policymakers have professed to be worthwhile goals. Section 1.3 examines the history of the international trading system over the past two centuries, focusing on where it has come close to and where it has deviated from the desiderata set out in section 1.2. Section 1.4 discusses and classifies the shocks and shifts to which the international economy has been subjected over the past two centuries. Section 1.5 briefly compares today’s shock absorbers to those of the past. Section 1.6 applies the lessons of history to ask where the international economy goes from here. 1.2

Free Trade and Multilateralism

Robert Keohane (1990) has defined multilateralism as “the practice of coordinating national policies in groups of three or more states,” to which 1. Anonymous (1919).

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13

other political scientists have added the criterion that the coordination take place on the basis of certain agreed-upon principles.2 A multilateral system of world trade, therefore, refers to the cooperative efforts of various countries in the realm of trade policy. Since countries do not need to cooperate with each other to increase trade barriers and diminish trade (something they can manage quite well on their own), the goal of such cooperation is usually to reduce trade barriers and expand trade. For example, the purpose of the 1947 General Agreement on Tariffs and Trade (GATT) is to undertake “reciprocal and mutually advantageous arrangements directed to the substantial reduction of tariffs and other barriers to trade and to the elimination of discriminatory treatment in international commerce . . . with a view to raising standards of living, ensuring full employment and a large and steadily growing volume of real income and effective demand, developing the full use of the resources of the world and expanding the production and exchange of goods.”3 Thus, a multilateral system is a means to an end, the end being a growing world economy and all the benefits that flow therefrom. Does such a system require institutional arrangements such as we have today? After all, one might argue that an idealized world with no trade agreements but universal free trade would also constitute a multilateral trading “system.” Before considering whether institutional arrangements are required to have a multilateral system, it would be useful to consider the desirable properties of such a system. First, a multilateral system of trade should be open. Openness has several dimensions. One is that countries should have access to each others’ markets. This does not necessarily mean free trade in its purest sense, but that government- imposed barriers or hindrances to trade be kept within some defined limits. Another dimension is inclusiveness, that the system be open to the participation of all countries who are willing to abide by the terms agreed to by others. This usually means nondiscrimination, that the system not be an exclusive club, or that the most favored nation (MFN) clause has wide applicability. Second, a multilateral system of trade should be stable. Once again, stability has several dimensions. One is that government trade barriers be predictable or reasonably certain to the entities engaged in trade. No country would want to see its exports suddenly shut out of foreign markets because of an abrupt and unanticipated change in import duties or quotas. This would be disruptive to world commerce and would stifle trade to the extent that it increased uncertainty about the terms on which trade can take place. How can 2. Political scientists have traced the first use of the term “multilateral” in the context of an international system going back to 1858. The term “multilateralism” came into use after World War I. 3. Preamble to the GATT 1947. Available from http://www.wto.org/english/docs_e/legal_e /gatt47_01_e.htm.

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this certainty be provided? This may require formal or informal “rules of the game,” taking the form of informal norms or explicit trade agreements. Another dimension of stability is that the system should have a wellfunctioning adjustment mechanism. This chore is usually performed by the international monetary or financial system. Trade should not be conducted and balanced bilaterally, but rather the system of payments should facilitate multilateral trade. An example of such a system at work is provided by figure 1.1, which gives a stylized representation of the world trade settlements system in 1910. As can be seen, the international trading system on the eve of World War I was a multilateral one, in the sense that countries ran up trade surpluses with some partners that they then used to finance deficits with others. For example, India ran a large trade deficit with the United Kingdom, but ran surpluses with continental Europe, the United States, Japan, and China. The United Kingdom, meanwhile, used its surpluses with India and other countries to finance its deficits with continental Europe and the United States. The polar opposite to a multilateral trading system, in this sense, is a bilateral trading system in which pairs of countries engage in what essentially amounts to barter trade, balancing trade on a bilateral basis. This is not just a theoretical curiosum, since something along these lines has been observed on several occasions over the past century. Communist countries often resorted to barter- style arrangements, for example, in order to keep their domestic price systems insulated from world market conditions, and so did the Nazis when dealing with their informal empire in Southeastern Europe

Fig. 1.1

World pattern of settlements, 1910

Source: Saul (1960, 58).

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during the 1930s. More prosaically, Western European countries typically had inconvertible currencies after 1945, and it took the establishment of the European Payments Union to bring about a properly multilateral trading system during the 1950s. The economic advantages of multilateralism in this sense are obvious and large, since they are the same as the advantages of trade financed by money relative to barter. Yet another aspect of stability is flexibility in the face of shocks. If rules are written to maintain openness, the question is whether openness can be preserved in times of stress when there are pressures to deviate from the open regime. If the pressures are not accommodated to some degree, and find no other outlet, the system could break, as Aesop’s fable reminds us. If the pressures are too easily accommodated, because the system has safety valves, the system may not remain very open. This balancing act lies behind the “escape clause” (Article XIX) of the GATT, which allows countries to restrict imports of goods that threaten serious injury to domestic producers. If interpreted too strictly, it is no escape clause at all; if interpreted too loosely, there will be no discipline in the use of trade restrictions. An optimal mix of rules and flexibility is required in order to make sure that countries agree to join and to remain in a rules- based system, and that those rules effectively discipline behavior. Similarly, there is an optimal mix between the need to constrain individual states’ freedom of action, in the interests of all, and the need to respect national sovereignty and democracy (Rodrik 2011). Bagwell and Staiger (1990) suggest that the escape clause can be rationalized in precisely this way: as a means of avoiding the breakdown of cooperative arrangements at times when trade volumes are unusually high. As we will see in this chapter, different shocks may require different types of shock absorbers, but the basic message of Bagwell and Staiger—that flexibility is required for cooperation not to break down—is a crucial one in our view. Many would also consider fairness to be a desirable attribute of an international trading system. For example, it would not seem fair to many if powerful countries extracted numerous trade concessions from weaker countries without providing much in return. The need for fairness is operationalized via the concept of reciprocity in WTO (World Trade Organization) trade negotiations. Another desirable property of such a system is that trade disputes be settled by negotiation or arbitration, rather than by the use of unilateral economic sanctions or actual violence. Warfare is the antithesis of a multilateral trading system, since during wars states try to prevent their enemies from exporting (in the case of a mercantilist war) or importing (in more modern wars). Furthermore, the fear of such embargos, or preemptive embargoes in anticipation of war, can be an important factor leading to war in the first place. The WTO tries to satisfy the need for peaceful resolution of trade conflicts through its dispute settlement system of arbitration. The next question is whether these goals—openness with deference to national sovereignty, stability with built-in flexibility, and so forth—can

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only be achieved through an institutional multilateral structure. Why is a multilateral trading system necessary, as opposed to having each country determine its own trade policy by itself without interference from others? It is not immediately obvious whether such a system needs to be “created” by policymakers or whether it can arise spontaneously without formal coordination. Many countries have unilaterally chosen policies that conform to these desirable outcomes. In a model with a high initial level of tariffs, most of the features of the current trading system—multilateral negotiations, gradual liberalization, reciprocity, and MFN—can develop endogenously, according to Ethier (2004), if government behavior is dictated by a political support function consistent with how governments claim to behave, and if reasonable substitutes for each country’s exports are produced elsewhere. Yet, as we shall see, historical experience suggests that such good behavior may not arise automatically and spontaneously from countries choosing their own trade policies independently of one another. An institutionalized multilateral system may be necessary to achieve the goals of free and open trade. Without a multilateral system in place, countries may pursue selfish, mercantilist, beggar- my- neighbor policies without regard to the welfare of their trading partners, and the world as a whole may find itself stuck in a prisoner’s dilemma.4 Or perhaps, without the benefit of external constraints, policymakers may succumb to domestic interest groups and impose trade restrictions that are detrimental to the country itself, as well as to others. Therefore, without international agreements on trade policies, countries may pursue policies that restrict trade either to redistribute income to their own country at the expense of others (beggar- my- neighbor policies, as modeled by Bagwell and Staiger 2002) or to redistribute domestic income to politically powerful groups (beggar- myself policies, as modeled by Maggi and Rodriguez-Clare 1998). In either case, politicians have self- interested reasons for reducing trade that can only be overcome to the betterment of all if they agree to refrain from those trade- restricting policies. Thus, a multilateral trading system may be needed to correct these externalities (terms of trade or domestic politics); without an institutionalized system, the world economy will not flourish as much as it could. While such concerns give rise to a powerful reason to adopt multilateral trade agreements (Bagwell and Staiger 2002), such agreements have only emerged relatively recently. Countries may have engaged in mutually destructive beggar- thy- neighbor policies in the past, but this did not automatically give rise to a multilateral institutional response. For this to occur, geopolitical conditions had to be right. Furthermore, key actors had to 4. The analogy is appropriate if countries can benefit from their own protectionist policies, which is true in certain modeling environments, but not in others.

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17

want an international, cooperative outcome. Although many economists dislike the notion, ideas sometimes matter in history. They clearly mattered during the mercantilist era, while the idea that dependence on trade was dangerous mattered a lot after 1918. Flawed ideas about macroeconomic policy have also mattered a great deal for the international trading system, as the history of the Great Depression clearly shows. A complete account of the development of the international trading system therefore has to go beyond the limits of simple economic models, informative though these are, and integrate insights from political science and traditional history as well (Baldwin 1996). 1.3

1860 and All That: A Brief History of the International Trading System

To what extent has the world trading system conformed to these features of a desirable multilateral system? To what extent have governments worked to create such a system with these goals in mind? We examine four different historical epochs: the mercantilist period (between 1492 and the early nineteenth century), the nineteenth century order (lasting until 1914), the interwar period (from 1919 to 1939), and the postwar system of the GATT and the WTO (from 1947 to the present).5 1.3.1

The Mercantilist Era

Broadly speaking, the international trading system between 1492 and the Industrial Revolution can be described as mercantilist. There are several key features of this system, or perhaps nonsystem, that are relevant for us. First, the geopolitical system of the time was essentially Darwinian. The Military Revolution of the period implied rising military costs, and conferred substantial advantages on larger countries, as well as on countries that were more efficient in raising revenue. The costs of not remaining militarily competitive included extinction, and the number of sovereign states within Europe declined substantially during the period. Second, trade and colonization were seen as important means by which states could raise revenue. Aside from the obvious benefits of plunder, monopolizing particular trades could lead to substantial profits for merchants and sovereigns. Monopoly trading companies were thus established, with the active support of the State, and their attempts to monopolize were backed with military force. Because of these links between military force, monopoly, and profits, there was a two- way interrelationship between power and plenty (Viner 1948): plenty was essential for power (as remains true 5. See Irwin (1993) for a discussion of the similarities and differences in trade policy across these time periods.

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today), while power was thought to be essential in securing plenty (something that is no longer the case, whether or not it was, in fact, then). The result was a series of wars in Asia and America, fought between Europeans in order to establish who would manage to secure for themselves these trading profits. It is certainly possible to argue that these wars were mutually destructive, and that Europe (and the world) would have been better off without them. For example, in equilibrium it may well have been that the military costs invested in establishing trading monopolies equaled (on average) the profits these monopolies yielded: states would then have been left with no net revenue benefit, while the world as a whole suffered the costs of war and a fragmented trading system. Indeed, when military gambles went wrong, this could have a catastrophic impact on state finances, with revolutionary consequences. Unfortunately, such considerations might not have been of much practical use to an individual monarch contemplating a unilateral move to peaceful free trade, since his exclusion by force from trades in which his merchants had previously been involved might have been a logical consequence of such a decision. States were thus locked into a prisoner’s dilemma of sorts, and there was no multilateral geopolitical framework to help them escape the trap. Third, the technological environment helps to explain why intercontinental trade was monopolized by state trading companies backed by military muscle. Transport costs were still high, with the result that intercontinental trade typically involved goods with a high value to weight ratio (O’Rourke and Williamson 2002). High prices reflected scarcity in Europe—often caused by a complete absence of locally produced supplies—and thus the prospect of monopoly profits. This mercantilist world was destroyed by the victory of the United Kingdom, as it was by then, in 1815, and by the forces set in motion by the Industrial Revolution. Population growth and industrialization led to Britain becoming a large net importer of food: this gave the country a powerful interest in keeping the sea lanes of the world open for trade. The Royal Navy was sufficiently dominant that it was able to provide the world with this public good, while the Congress of Vienna established a remarkably durable peace within Europe. The war led to the dismantlement of the Iberian empires in Latin America, and the mercantilist trade restrictions that had been associated with them. It also led to the destruction of the Dutch East India Company, and to the loss of the monopoly on the Indian trade, which had been enjoyed by its English counterpart. The Industrial Revolution, meanwhile, eventually led to a dramatic reduction in transport costs that made possible the mass transport of bulky, “competing” commodities across the oceans of the world. Trying to monopolize the trade in a good like pepper was difficult enough; trying to monopolize the trade in basic food grains would have been merely silly.

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1.3.2

19

The Nineteenth-Century Order

The end of the mercantilist era heralded a movement toward a much more open and nondiscriminatory trade regime. Movement in this direction hinged largely on the policy choices of Britain, the world’s largest trading economy. In terms of its immediate post–Napoleonic war commercial policy, however, Britain was split: it sought to protect aristocratic landowners from foreign competition (by enacting the Corn Laws in 1815 to limit imports of wheat) while also seeking trade agreements to open foreign markets for its burgeoning manufacturing sector. Of course, these policies conflicted: unless Britain was willing to open its market to foreign agricultural produce, other countries were unlikely to want a trade agreement allowing Britain to export more of its manufactured goods to their own markets. Other countries lacked a strong domestic constituency in favor of liberalization and, moreover, were suspicious of Perfidious Albion’s motives. Britain failed to convince other countries that it was in their interest to set aside their own ambitions to become a manufacturing power and simply follow the logic of Smith and Ricardo, and import Britain’s industrial goods. Hence, Britain’s early efforts to conclude reciprocity agreements failed miserably. This failure had lasting consequences: more than a generation of British trade policymakers concluded that it was futile and even counterproductive to attempt to persuade other countries to adopt freer trade. When the Irish potato famine occurred during Sir Robert Peel’s reform- oriented prime ministership, Britain unilaterally abolished its Corn Laws without using the repeal as a bargaining chip with other countries. Henceforth, Britain opted for unilateral trade policies, leaving it to other countries to choose for themselves their own best policy. (This even applied to Britain’s self- governing colonies, such as Australia and Canada, which were permitted to impose stiff duties on British manufactured goods.) While it could not use its clout to influence European tariff policies, Britain did use its power to open up markets in Turkey, China, Japan, Persia, and several Latin American states. However, it did so on an MFN basis, open for all other countries to participate. Britain never sought preferential access for its exports, either with Europe or with weaker powers in Latin America and Asia. The decision to remain aloof from commercial bargaining was so deeply instilled in Britain that it nearly scuttled the Cobden-Chevalier Treaty of 1860. This Anglo-French trade agreement was pursued largely for diplomatic rather than commercial reasons, but was negotiated on the British side by Richard Cobden rather than the Board of Trade so that British diplomats did not have to sully their hands with the dirty business of trade. Chancellor of the Exchequer William Gladstone used this opportunity, in his famous 1860 budget, to do a thorough housecleaning of the British

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tariff code, going far beyond the agreement itself. Britain insisted that all the negotiated and unilateral tariff adjustments would be extended to other countries pro bono, on an unconditional MFN basis, without any thought being given to using the changes to extract trade concessions from others. Thus, nineteenth- century Britain firmly rejected the “GATT- think” of today, which views giving market access to imports as a concession and receiving market access for one’s exports as a benefit. France, by contrast, reduced its tariffs on British goods alone; if other countries wanted the same rates, they would have to cough up some concessions of their own in a separate bilateral deal. And that is precisely what happened: other countries began negotiating trade agreements with France, which in turn led to further trade agreements with each other. This patchwork of bilateral trade agreements, with MFN clauses and some tariff concessions, led to the creation of an informal trade treaty network during the mid- nineteenth century (see figure 1.2). There was no multilateral structure behind the bilateral agreements. The agreements led to trade liberalization in certain product categories, but not to free trade as practiced by Britain at this time (Lampe 2009). The nineteenth- century treaty network was a remarkable, spontaneous development that promoted multilateral trade. It was a system open to any country that sought to participate in it, and it led to the widespread use of the MFN clause. However, it fell short of satisfying all the desirable attributes of a multilateral system. The treaty network was confined almost exclusively to Europe, as the United States was not in a position to bargain over its trade policy. Indeed, outside of Europe, protection was high wherever local populations were free to choose their own policies. Where they were not free to choose, free trade was sometimes imposed upon them, inconsistent with the desirability of respecting national sovereignty and democracy. Furthermore, the reduction in trade barriers as a result of the agreements was limited because of domestic political considerations, as well as revenue constraints. Finally, the informal network was not very robust. In terms of its ability to cap trade barriers, it proved to be rather short lived, from about 1860 until the mid- 1870s, when tariff levels started rising again. The problems began in the aftermath of the Franco-Prussian War and the financial crisis of 1873, when the world economy experienced a prolonged slowdown.6 This prompted many countries to allow the tariff reductions in their time- limited commercial agreements to lapse, and even led to general tariff hikes in a number of countries. Similarly, the decline in European grain prices caused by an expansion of overseas production and declining transport costs placed land rents under 6. The period 1873– 1877 has sometimes—misleadingly—been called the Great Depression; it was an era of falling prices but not falling output, although the economic expansion was at a slower pace than before.

Coping with Shocks and Shifts

Fig. 1.2 in 1875

21

The “mother of all spaghetti bowls”: The Cobden-Chevalier network

Source: Lampe (2011, figure 1, 645).

pressure, and sparked a protectionist backlash among agricultural interests (O’Rourke 1997). France came close to abandoning the Cobden-Chevalier Treaty altogether; although it agreed to extend it until 1877, all the French tariff concessions were gone by 1882 when duties were increased. Germany imposed the “iron- and- rye” tariff of 1879, and others followed similarly. Although the MFN clause remained largely intact, European tariffs generally increased from the late 1870s until the early 1890s. The resulting friction produced frequent bilateral trade spats between countries. The nineteenth- century treaty network turned out to be fragile because governments had not agreed to many commitments that constrained state action. And governments had recourse to few alternative domestic policies to address the economic problems of the day. Many governments relied on import duties to raise revenue, making higher tariffs a way of dealing with budget shortfalls. Subsidies to firms and unemployment insurance for workers were not yet part and parcel of government policy. (In those countries that introduced social insurance schemes earlier, trade policies generally remained more open; see Huberman and Lewchuck 2003.) The gold standard, which also arose at this time, facilitated trade by keeping exchange rates fixed but also prevented the use of monetary policy to address the economic downturn. Hence, mindful of their electorates, policymakers resorted to higher tariffs as a way of dealing with the economic problems of the period.

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Britain woke up to the fact that the market access it had taken for granted was now being limited. In 1875, in the bowels of the Foreign Office, some officials conceived of a diplomatic initiative for a European tariff union. However, Britain’s unilateralist instincts were still too strong, and few envisioned that the project could be a success, so it was never pursued (Gaston 1987). Thus, the one time that Britain could have shown leadership in attempting to provide a multilateral framework for trade policy, it shrank from the task. It must be stressed, however, that despite the relapse in commercial policies that left the mid- nineteenth century treaty network in shambles, trade costs continued to fall, the world economy began to boom, and world trade prospered in the two decades prior to 1914. The increases in tariffs were not enough to offset the impact of railroads and steamships in reducing transport costs, and overall trade costs fell. Not only commodity trade but factor movements boomed in the decades immediately preceding the outbreak of World War I (O’Rourke and Williamson 1999). 1.3.3

The Interwar Period

The nineteenth- century order came to an end in 1914 with the outbreak of World War I. This conflict severely disrupted world trade, particularly as the war extended to commercial shipping. The conflict also led to widespread restrictions on trade, with limitations on imports imposed to conserve foreign exchange and to build up domestic defense- related industries. The long- run consequences of the war were even more important (see, for example, Eichengreen 1992, or Findlay and O’Rourke 2007). The Congress of Versailles was as unsuccessful in establishing a stable postwar order as the Congress of Vienna had been successful. Wartime debts and reparations poisoned international relations, and led directly to the hyperinflations and payments imbalances of the 1920s that would have such a damaging effect. The Russian Revolution of 1917 not only contributed significantly to interwar international tensions; as noted earlier, the nature of the Communist economic system meant that it also had a profound disintegrating influence on the international economy—which only finally ended in the 1990s. The Austro-Hungarian empire had collapsed, and there were new states in the Baltic region and in Central Europe, and elsewhere as well (Ireland, for instance). New borders implied new barriers to trade, including in many cases quantitative restrictions of one sort or another. They also created revanchist feelings, for example, in relation to Poland. The one hope for the reparation of world trade relations was that a major attempt at multilateralism was taken with the establishment of the League of Nations. Yet the League had no independent powers and faced a host of problems in trying to reestablish a liberal international trading regime. The accumulation of wartime trade restrictions created obstacles to their removal. Wartime disruptions to trade had created import substituting in-

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dustries in several countries, and led to an overhang of primary commodities in world markets in the 1920s: both created new protectionist constituencies in many countries. The proliferation of new instruments of trade policy took time to work down, including quantitative restrictions, exchange controls, license requirements, and so forth. Furthermore, whereas Britain had anchored the nineteenth- century order—keeping its market open, practicing nondiscrimination, and ensuring that the seas were free—it was now weakened and no longer could serve in that role. The United States, as the new dominant economy, failed to step up and fill the vacuum and remained passively closed by imposing the Fordney-McCumber tariff of 1922 and immigration restrictions. Thus, a weakened United Kingdom was no longer able to provide the global public goods, which it had previously done, and the United States was unwilling to pick up the baton (Kindleberger 1973). The difficulties in restoring monetary and financial stability in the 1920s (countries returned to the gold standard only by the middle or end of the decade) prevented much attention from being focused on trade policy. The World Economic Conference of 1927 was the first attempt to see what might be done by way of multilateral action to restore the MFN clause to its former status and to explore whether some trade liberalization might be feasible. However, any movement down this road was cut short by the start of a recession in 1929 and the failure of the United States, which was not a member of the League, to contribute much to the effort. In fact, the United States had a destructive influence. Still suffering from the after- effects of World War I, the American agricultural sector pressed for what eventually became the Smoot-Hawley tariff in 1930. This tariff hike poisoned international trade relations as other countries resented the fact that the world’s largest creditor was hindering the ability of European countries to earn the dollars they needed to pay back war loans and reparations. Other countries retaliated against the United States, and the American move triggered a move toward preferential trade blocs. Having lost some of its access to the US market, Canada turned to secure its access to the markets of Britain and the empire. This gave impetus to the Ottawa agreements in 1932, which established imperial preferences, and pushed the world trading system further away from being a true multilateral system (table 1.1). The Great Depression led to further international economic disintegration. As in the 1870s, governments had very few alternative policies to address the economic slump. Monetary policy was tied down by the gold standard, and fiscal policy was geared toward balanced budgets in this preKeynesian period. With no formal world trade system in place, and with few trade agreements in existence, trade policy was left untethered to any explicit treaty- bound rules and unbound by any strong convictions in favor of open trade. Modern scholarship denies the argument that protection made the Depression “great”; rather, the chain of causation runs from the

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Table 1.1

The share of formal and informal empire trade, 1929–1938 (percent) In imports

Trade of

Share of

United Kingdom United States France Belgium Netherlands Italy Portugal Japan

Germany

British Commonwealth, colonies; protectorates, etc. Philippines French colonies, protectorates and mandated territories Belgian Congo Netherlands overseas territories Italian colonies and Ethiopia Portuguese overseas territories Korea and Formosa Kwantung Manchuria Rest of China Total Japanese sphere of influence Bulgaria, Greece, Hungary, Romania, Turkey, Yugoslavia Latin America Total German sphere of influence

In exports

1929

1932

1938

1929

1932

1938

30.2 2.9

36.4 6.1

41.9 4.8

44.4 1.6

45.4 2.8

49.9 2.8

12 3.9 5.5 1.5 7.9 12.3 6 1.9 5.8 26

20.9 3.8 5 1.1 10.4 26.2 4 2.7 4 36.9

25.8 8.3 8.8 1.8 10.2 30 1.6 9 4.4 45

18.8 2.6 9.4 2.1 12.7 16.8 4.8 2.5 10.9 35

31.5 1.3 5.9 3.6 13.9 21.6 6.8 1.5 7.3 37.2

27.5 1.9 10.7 23.3 12.2 32.9 13.7 8.1 8 62.7

4.5 12.2 16.7

5.5 11.2 16.7

12 15.6 27.6

5 7.8 12.8

3.9 4.3 8.2

13.2 11.5 24.7

Source: League of Nations (1939, 34– 35).

gold standard constraint and flawed monetary policies to the Depression, and then to protectionism. In countries where adherence to the gold standard was most prolonged, the Depression was most prolonged as well. It is in these countries that the resort to higher tariff barriers and quantitative restrictions on trade was most pronounced (Eichengreen and Irwin 2010; Irwin 2012). The nontariff barriers that arose during this period, including quotas and foreign exchange controls, to say nothing of clearing arrangements, were inherently discriminatory and further detracted from an open multilateral system. The nineteenth- century system showed that nondiscrimination (MFN) could exist without a multilateral institutional framework, but that such a system would not necessarily be one of low trade barriers. The interwar period showed that, without a multilateral framework, the world trading system could be one of high trade barriers and rampant discrimination. In the face of an enormous macroeconomic shock, and when alternative policy instruments were constrained, it was all too easy for countries to resort to protectionism. 1.3.4

The Postwar Period

The one glimmer of hope in the otherwise depressing 1930s was the slow US retreat from isolationism. In terms of trade policy, this was made evident

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by the passage of the Reciprocal Trade Agreements Act of 1934. This act delegated to the president tariff negotiating power that previous executives had lacked. While the United States concluded nearly two dozen bilateral trade agreements, they did little to reduce trade barriers and stimulate trade in the 1930s. Still, the Roosevelt administration used it as part of its postwar plans to establish a multilateral General Agreement on Tariffs and Trade (GATT) in 1947. Furthermore, it helped establish an international monetary system that proved to be much more flexible than the old gold standard (Gardner 1956). Under the Bretton Woods system, countries tied their currency to the dollar, which was constantly growing in supply (unlike gold, whose growth rate was uncertain), and they were allowed to devalue their currency when balance of payments problems arose. The GATT sought to reestablish the central role of the MFN clause in international trade relations. It also sought other rules to constrain the use of trade interventions, such as limits on the use of quotas and regulations on administered protection (the escape clause, antidumping and countervailing duties). The principle of reciprocity in trade negotiations was established. Yet efforts to reduce tariffs came only sporadically. After the initial tariff reductions negotiated in 1947 when the GATT was formed, it took nearly two decades until the next major reductions took place (after the Kennedy Round in 1967). Then it took nearly three decades for the next major round to conclude (the Uruguay Round in 1994). The postwar period was quite different from the nineteenth century and the interwar epoch in terms of the role of the state in the economy. By this time, countries faced fewer fiscal constraints. The rise of the welfare state dampened demands for protectionist trade policies as there were other means for domestic constituencies to obtain relief. Many industries were nationalized and received government subsidies. The GATT and WTO texts read as if they are formidable documents, but in fact the rules are elastic in themselves and have been applied with even greater elasticity. While supposedly banning import quotas and binding tariff levels, the GATT also allows antidumping and countervailing duties and includes the escape clause, all giving policymakers easy access to measures that can restrict trade. Voluntary export restraints were overlooked. The GATT even oversaw the Multifiber Arrangement (MFA), a global web of product- specific, bilateral restrictions on trade in clothing and apparel. While supposedly mandating unconditional MFN, the GATT system has also allowed for preferential and regional arrangements that reduce trade barriers among a subset of members. While the GATT calls for trade negotiations to be held “from time to time” to reduce trade barriers, much of the postwar liberalization of trade has taken place outside the GATT (the European Common Market, the North American Free Trade Agreement) or on a unilateral basis (Japan, India, China, to name but a few). The postwar era saw radically different trends in different parts of the

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world. The familiar story of European integration and trade liberalization under the auspices of the GATT is a regional one, and applied where the United States provided the leadership and global public goods that had once been provided by Britain. While these regions underwent impressive reintegration, after the breakdowns of the interwar period, the story was different elsewhere. The spread of Communism into China and Eastern Europe was one countervailing antiglobalization force; so was decolonization. Import- substituting industrialization strategies, exchange controls, and state monopoly trading boards are as much a part of the postwar scene as successive GATT rounds, until the 1980s and 1990s. That is when China, India, and much of the rest of the developing world opened up to foreign trade, with the results we see today. 1.4

Responding to Shocks and Shifts

This sketch of the broad contours of the world trading system in the past gives us a sense of the strengths and weaknesses of various arrangements. We now turn to how each period has responded to the challenges that have confronted it. We focus on two types of challenges: shocks and shifts. Shocks are sudden, usually temporary, jolts to international trade or the world economy. Shocks include financial crises and severe recessions that create domestic economic problems, and can also be wars, which are directly disruptive of trade. Shifts play out over a longer time horizon and are usually more permanent. Shifts can be long- run changes in world trade due to evolving comparative advantage and the opening of new markets. These are potentially disruptive to the status quo and may elicit a protectionist response as a way of easing the adjustment costs to a new situation. We will look at the major shocks and shifts affecting the world economy and ask whether or not they led to structural transformations in the nature of the international trading system—both promultilateral and antimultilateral. 1.4.1

Shocks

Financial shocks and recessions are easily identified because they have an immediate and visible impact on world trade flows. Figure 1.3 presents the volume of world trade from 1850 to 2010 (in log scale). In considering international trade in the long run, the first thing to note is that the volume of world trade has increased secularly for nearly two centuries with little interruption. While some small dips are evident in the figure, focusing exclusively on the fluctuations would miss the big picture: despite temporary setbacks due to crises, world trade has consistently expanded over time. The two big gaps in the figure reflect World War I and World War II, when trade was severely disrupted and continuous, thus comparable data do not exist.

Coping with Shocks and Shifts

Fig. 1.3

27

The volume of world trade, 1850–2010

Sources: Lewis (1981); United Nations (1962); World Trade Organization.

Figure 1.4 presents the annual percentage change in the volume of world trade. Over the past 160 years, there have only been sixteen years—excluding world wars—in which the volume of world trade fell. The longest and most severe fall was during the three years of the Great Depression (1930– 1932). In two other periods, trade volumes declined in two consecutive years (1861– 1862, 1981– 1982), but to a much smaller degree. The remaining eleven instances were single year declines in world trade, the most significant of which were 2009, 1974, and 1937. Table 1.2 lists all of the recorded declines in world trade volume and our attempts to categorize the underlying shock that caused the decline. The disruptions to world trade tend to fall into one of two broad categories: wars and recessions. Wars can be separated into global or regional conflicts, and recessions can be separated into those associated with a financial panic or banking crisis, and the rest (usually due to a monetary shock). Over this period, there were two global wars (World Wars I and II) and two regional wars (the US Civil War and the Yom Kippur War) associated with absolute declines in world trade. The global wars clearly had a major impact on trade: Glick and Taylor (2010) estimate that the reductions in world trade due to World War I were of the order of 30 percent, and that those due to World War II were as much as 50 percent. The two regional wars that were large enough to bring down aggregate world trade volumes were the US Civil War (1861– 1865) and the Yom Kippur War (1973). While the belligerents involved only a few countries, both conflicts constituted sizable “real” shocks to the world economy, enough to have significant consequences for world trade, which fell about 7– 8 percent in both cases. In these two instances, the wars disrupted the world supply of

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Fig. 1.4

Percentage change in world trade volume, 1850–2010

Sources: See figure 1.3.

an important intermediate good. The North’s blockade of the South during the American Civil War slashed US cotton exports, a key input to British textile mills. In 1973– 1974, following the Arab oil embargo as a result of the Yom Kippur War of October 1973, the world economy was tipped into a recession by a sharp rise in the price of petroleum. Most declines in world trade can be traced to recessions. Of course, a recession in any single country would have a disruptive effect on that country’s trade, but not necessarily on world trade as a whole. Recessions striking several large countries simultaneously are those most likely to reduce total world trade, and these are often associated with world financial crises. Although not all recessions are associated with a major financial panic or banking crisis, the most severe recessions usually are.7 The declines in 1892, 1908, 1930– 1932, and 2009 were associated with financial or banking crises on a global scale. The integration of world capital markets helped ensure that the Barings Crisis of 1891 had international ramifications. Similarly, the Panic of 1907 affected capital markets around the world. Yet not all major financial crises have resulted in a decline in world trade. For example, the world experienced a fairly severe financial crisis in 1873, yet this never led to a decline in world trade volume, although it only grew slowly from 1875 to 1878. 7. For a listing and dating of world financial crises, see Bordo et al. (2001).

Coping with Shocks and Shifts Table 1.2

Name

US Civil War Barings Crisis Panic of 1907 World War I Great Depression Recession of 1937 World War II US Recession OPEC oil shock Volcker disinflation Internet stock bubble US housing bubble

29

Declines in world trade volume since 1850 Year(s) of trade decline 1854 1861– 1865 1885 1892 1900 1908 1914– 1918 1930– 1932 1938 1939– 1945 1958 1974 1981– 1982 2001 2009

Decline in trade (%)

Type

– 3.9 – 8.2 – 1.6 – 2.1 – 1.0 – 2.5 n/a – 28.8 – 5.3 n/a – 2.8 – 7.3 – 2.8 – 0.2 – 12.2

Regional war Recession Financial crisis/recession Recession Financial crisis Global war Financial crisis/recession Recession Global war Recession Regional war Recession Financial crisis/recession Financial crisis/recession

Note: n/a = not applicable.

By contrast, the declines in 1854, 1885, 1900, 1938, 1958, and 1981–1982 are not associated with a financial crisis (although there may have been financial distress, particularly in 1981– 1982). These recessions are largely due to monetary shocks, the most obvious case being the Volcker disinflation policy in the United States in the early 1980s. From our understanding of these financial crises and recessions, it seems appropriate to view them as exogenous to world trade and commercial policy. The question, then, is which of these shocks to the trading system had temporary or permanent effects on trade policies. Our evidence is impressionistic, mainly because we lack adequate time- series data on trade policy measures over time. The two regional wars produced a significant fall in world trade but did not have a major impact on trade policy. However, global wars have proven to be bad for trade and trade policy. Global wars involve extensive government restrictions on trade. Some restrictions are aimed at protecting domestic firms that are producing essential war material, or that limit exports of food or natural resources of strategic value. Other restrictions are more pervasive and seek to limit spending on all foreign goods to conserve foreign exchange or gold reserves for national security reasons. Whatever the rationale, such trade restrictions are usually difficult to remove after the war because of the special interests that grow up behind them and have a stake in perpetuating them. In addition, the extensive disruption of markets and the uncertainty about postwar trade flows make governments cautious about pursuing trade liberalization. Strategic considerations have in some cases made them actively hostile. The Allies’ blockade of Germany was

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important in undermining morale there (Offer 1989), and was maintained after the Armistice until a peace treaty had finally been signed. Hitler drew the lesson that dependence on trade was dangerous, and that a strategy of imperial autarky was preferable. Naval officers in Japan drew very similar lessons, and would get their chance to put these ideas into practice in the 1930s (Barnhart 1987). Furthermore, establishing a sound international payments system after the war usually takes priority over new international trade arrangements. After World War I, it took countries many years before they returned to the gold standard (Britain was among the first in 1925), after which the League of Nations began to consider addressing trade policy problems. After World War II, the Bretton Woods conference establishing rules for the international monetary system took place well before the formation of the GATT, while it was much easier for GATT to deliver meaningful tariff cuts once currency convertibility had been restored in 1958. However, global wars also create opportunities for new trade arrangements. Wars affect the international distribution of power and can shift power toward countries that want a more open system, or not. As we saw in the previous section, World War I ended with a dominant power (the United States) that was unwilling to engage in multilateral negotiations on trade policy. World War II ended with one dominant power, again the United States, that was now willing to engage in multilateral negotiations on trade policy. However, another dominant power, the Soviet Union, had an economic system that was antithetical to open, multilateral trade, and it took its satellites with it in establishing a separate system. To the extent that most recessions are short and mild, they do not have a major immediate impact on trade policy. The recessions of 1885, 1900, 1908, 1938, and 1958 did not produce major changes in trade policy or result in significant trade protectionism. (The recessions of 1885 and 1900, however, were the impetus for tariff revisions in some countries.) Of course, the Great Depression of 1929– 1933 did have a significant impact on trade policy. As we have seen, the monetary and financial problems of the era manifested themselves in a whole host of new trade policy instruments (such as import quotas and import licenses) that seemed to become a permanent feature of world trade. In addition, the period saw the rise of discriminatory trade arrangements, notably imperial preferences. The motivation of such arrangements was not only to guarantee market access, but to conserve on the hard currency needed to make international payments (hence the sterling area, the reichsmark area, etc.). In turn, trade- related disputes were one factor poisoning international relations in the years leading up to World War II. In sum, shocks that emanate from brief financial crises tend to be transitory and have little long- run affect on trade policy, whereas those that play out over longer periods (early 1890s, early 1930s) may give rise to protection-

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ism that is difficult to reverse. Regional wars also produce transitory shocks that have little impact on long- run trade policy, while global wars give rise to extensive government trade restrictions that can be difficult to reverse. 1.4.2

Shifts

Thus far we have identified sharp shocks to the international trading system associated with wars and financial crises. There are other disruptions to the international economy that we also want to take into account, which are more slow- moving, but which can have more profound consequences in the long run. We call these shifts and they are of two types: shifts in comparative advantage that change trade flows, and shifts in geopolitical equilibrium that change the trade policies of leading countries. The first is shifts in comparative advantage. The opening of new markets can change trade patterns and force countries to adjust to the new source of goods. These can take place as a result of transport cost declines, as in the late nineteenth century: a region such as Prussia, for example, which had been land- abundant in the context of Europe, now found itself faced with competition from the even more land- abundant frontier economies of the New World. Not surprisingly, Prussia’s Junkers switched from being supporters of free trade to being ardent protectionists. China’s decision to open itself to international trade in the late twentieth century similarly meant that other economies that had traditionally been labor- abundant, such as Portugal or Mexico, now found that their comparative advantage in laborintensive industries such as textiles was now being eroded. Shifts in comparative advantage can also take place as a result of technological diffusion, and in particular the spread of modern industry around the world. Britain steadily lost comparative advantage in a variety of industrial activities in the late nineteenth and early twentieth centuries, as other countries—particularly Germany and the United States—caught up with Britain and became major industrial powers. The rise of Japan in the 1980s also caused shifts in comparative advantage in certain industries, and the rise of China is doing the same today. Sometimes these shifts elicit a protectionist backlash. The shift in comparative advantage associated with the opening up of New World frontiers, and the subsequent “grain invasion” of Europe, led to higher agricultural tariffs from the late 1870s onwards, which as we have seen reversed the move toward freer trade that had characterized mid- nineteenth- century Europe. In the decades after World War II, Japan’s rapid rise led to trade friction with other countries. Japan’s recovery was accompanied by a sharp increase in its exports of certain product categories: cotton textiles in the 1950s, steel in the 1960s, automobiles in the 1970s, and electronics in the 1980s. In each case, the rapid expansion in Japan’s exports created difficulties for its trading partners and the use of protectionism as a shock absorber. Exports of cotton textiles led to the Short-Term and Long-Term Trade Arrangement

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with the United States, capping the growth rate of its textile exports, and eventually the multilateral Multi-Fiber Arrangement (MFA) that spread to encompass developing countries across Asia. Steel and automobile exports led to voluntary export restraints in the 1970s and 1980s, and antidumping and countervailing duties limited Japan’s exports of electronics. One factor that may influence the trade policy response to such a situation is the speed with which the change in comparative advantage affects domestic producers. If the costs of dislocation are high, political support for open trade will falter. If the costs of adjustment are relatively low or are spread out over many decades, open trade may continue unhindered. On the other hand, perhaps the most remarkable achievement of the trading system in recent years has been the reintegration of Eastern Europe and the former Soviet Union into world trade, as well as the accommodation of China. Given the phenomenal growth rate of exports from China, it is surprising that this has not led to more of a protectionist backlash. One reason is that China started by exporting labor- intensive manufactured goods, such as textiles, which were (largely) no longer produced in the United States, Japan, and Western Europe. Given that these countries already imported such goods from other Asian countries, the domestic disruption was minimal. Second, Western producer interests were largely favorable to the new trade flows, since they were themselves involved in the flow, as a result of the outsourcing of production in the 1990s and 2000s. Third, the international trading system was flexible enough that countries could temporarily protect their markets without overturning the entire system: one such example came in 2005, when the MFA lapsed, and was promptly replaced by moves in Europe and the United States to limit imports of Chinese textiles. And fourth, postwar Western economies have benefited from social safety nets that could shelter displaced workers, at least to some extent, from the consequences of import competition. A second type of long- run shift that may have profound implications for the international trading system is shifts in the geopolitical equilibrium. One such shift was provoked by the unification and industrialization of Germany, which made unsustainable the post- 1815 settlement whereby Britain was the dominant power in Western Europe and the dominant sea power as well. When a leading power—particularly one interested in an open trading system, such as the United Kingdom in the nineteenth century and the United States in the late twentieth century—is no longer the dominant influence in world politics, open trade policies may suffer. As we know, the international system did not cope well with the early twentieth century geopolitical shock of a diminished Britain and a rising Germany and Japan. The “diminished giant syndrome” can lead to demands for protection, such as Joseph Chamberlain’s call for Tariff Reform in Britain in the early years of the twentieth century (Bhagwati and Irwin 1987). In this case, however, these calls would only be acted upon when the Great Depression hit.

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After World War II, the United States emerged in such a dominant position, with other countries devastated from the war, that domestic producers faced little foreign competition. The recovery of Europe was gradual enough that there were no major disruptions to US producers. We are currently living through another major shift in the world economy with the rise of China and India. This is making untenable both the unipolar world of the post–Cold War era and its bipolar predecessor. How the world adjusts to this shift in the balance of power will be one of the main questions of the twenty-first century, and will have major implications for the future of globalization. 1.5

The Importance of Shock Absorbers

On the face of it, it seems there were several reasons to be worried about the future of the international trading system in 2008 and 2009. The world economy was subjected to an enormous international financial crisis, which during its first year saw global industrial production falling at Great Depression rates, and world trade falling even faster (Eichengreen and O’Rourke 2009). Furthermore, this shock was superimposed upon a major long- term shift in comparative advantage, as labor- intensive Asian manufacturers displaced production in the West. Whether and to what extent unskilled labor in the West was harmed by this is a matter of debate, but what has been clear for some time is that less skilled workers in the West are more hostile toward globalization than the more highly skilled (Scheve and Slaughter 2001; Mayda and Rodrik 2005; O’Rourke and Sinnott 2001). Furthermore, in Europe this hostility manifested itself in a very concrete fashion with the French and Irish rejections of European constitutional reform in 2005 and 2008, while in several countries today populist parties are appealing to blue collar workers’ suspicions of open international markets and international elites. As noted earlier, it took the shock of the Great Depression to turn antitrade sentiments aroused by the shift in economic power away from Britain into concrete protectionist action there. Might the shock- cum-shift of 2008 have led to the same outcome? This has not happened to date, and the major reason is that today’s shock absorbers have been better developed than those of the 1930s. In terms of macroeconomics, the major difference has been between the constraints of the classical gold standard, on the one hand, and the flexibility of monetary policy implied by floating exchange rates on the other. As long as interwar governments remained tied to gold, they were unable to use countercyclical fiscal or monetary policy to combat the Depression; indeed, policy was often procyclical, as in the case of the fiscal policies of the dying Weimar Republic, or the interest rate increases that occurred in several countries in 1931– 1932. In 2008– 2009, by contrast, interest rates were aggressively lowered, some central banks engaged in quantitative easing, automatic stabilizers

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were for the most part allowed to operate, and there was some limited, if poorly targeted, fiscal stimulus. In those countries where fiscal policy was procyclical, such as Ireland or Latvia, output fell at Great Depression rates, but these countries were too small to matter globally. The result was that recovery began after just one year, while during the Great Depression activity contracted for several years. This prolonged economic slide is what did the damage politically, both domestically and internationally. Other shock absorbers are also better developed today. Modern welfare states in Europe and elsewhere mean that people who become unemployed do not find themselves immediately hungry and homeless, as was the case in the 1930s. States provide insurance policies to workers facing market risks, either via explicit social insurance programs, or simply because of the share of national economic activity that they represent (Rodrik 1998). And, as stressed earlier, today’s multilateral institutions not only provide a framework that helps to lock in openness, but themselves provide an element of flexibility to states, which allows them to respond to particularly adverse circumstances without walking away from their international obligations altogether. The rules of the trading system are also important in promoting geopolitical stability. The post–World War II international trading system was based on the GATT and the Bretton Woods institutions, but more fundamentally it was based on the principle embodied in the Atlantic Charter whereby the United States and Britain would “endeavor, with due respect for their existing obligations, to further the enjoyment by all States, great or small, victor or vanquished, of access, on equal terms, to the trade and to the raw materials of the world which are needed for their economic prosperity.”8 (Of course, this principle was waived in the case of both cold and hot wars in the late twentieth century.) This dimension of multilateralism relies on—and promotes—the confidence of countries that they can rely on the market to provide them with essential food and raw materials: a confidence that was notably absent in Wilhelmine Germany and interwar Japan, with destabilizing and tragic consequences. Moves by several countries to carve out exclusive sources of supply of grains or other commodities in recent years indicate a decline in such confidence, but it is essential that it be maintained; the belief in an open international trading system is the ultimate geopolitical shock absorber. 1.6

Conclusions

This chapter has provided a historical look at the multilateral trading system and its resilience in the face of various shocks. We contrasted four different periods: the nonsystem of the mercantilist period, the informal 8. Source for the Atlantic Charter is http://avalon.law.yale.edu/wwii/atlantic.asp.

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nineteenth- century treaty network, the nonsystem of the interwar period, and the post–World War II period of the GATT and WTO. The nineteenthcentury network was an open system in which the MFN clause was widely used, but the system could not maintain low trade barriers in the face of various economic shocks and long- term shifts in comparative advantage. An interwar system never had the chance to develop following the disruption of World War I, and whatever remained of the liberal system—nondiscrimination and moderate trade barriers—was destroyed in the Great Depression. From the ashes of the Depression and World War II came, for the first time, a multilateral system with rules about trade policy (including MFN) and negotiations about trade barriers. The system has shown its worth since 2008, when despite a major economic crisis it has been flexible and resilient enough to remain intact. We have distinguished between shocks and shifts and the ways in which the trading system has coped with each. Shocks are short- term problems arising from financial crises or wars, whereas shifts can be long- term changes in comparative advantage, perhaps due to the opening of new markets. In terms of the trade policy reaction, shocks tend to be benign, except in the case of a major war or prolonged economic crisis, whereas shifts often pose more difficult challenges for open trade. For example, many observers have been surprised that the global financial crisis in 2008– 2009 did not result in much protectionism. Yet in light of our discussion of history, this outcome should not have been too surprising. Previous panics and crises have produced significant declines in world trade with little or no change in trade policies (the Panic of 1907 comes to mind). The drop in trade, which was much steeper than the decline in domestic output, meant that demands for protectionism remained muted. In addition, as stressed before, today’s world economy possesses a number of shock absorbers that were absent in the 1930s. Among these are superior macroeconomic shock absorbers, particularly the independent monetary policies that come with the flexible exchange rate regime that operates at the global level (but not at the European one).9 The greater challenge in coming decades will be the shift in world economic activity toward Asia—China and India in particular. Like a movement in the earth’s tectonic plates, this has already created friction with the West. The relative decline of the West and rise of the rest is bound to characterize the coming century. As mentioned earlier, the response of the international system to the rise of Germany and Japan in the early twentieth century was hardly a successful one. Whether the Western economies are flexible enough, and international institutions such as the WTO robust enough, to accommodate this historic change in the world economy is the great question for the twenty-first century. 9. See Bown (2011) for a review of the trade policy response to the recent crisis, and Irwin (2012) for a comparison with the 1930s.

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Comment

L. Alan Winters

This is an interesting and wise chapter. There is little to disagree with. Irwin and O’Rourke suggest that among the things that contribute to making a L. Alan Winters is professor of economics at the University of Sussex, a research fellow and former program director of the Centre for Economic Policy Research, and a fellow of IZA, Munich. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12576.ack.

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system reasonably robust are some rules, a hegemon, an institutional framework, and a reasonable degree of flexibility. None of this can be pinned down precisely, but it seems to me to be correct. I would also add—although perhaps this is part of their institutional framework—that transparency and procedure have a role to play. Transparency is a key ingredient of public acceptability and is also often a precursor to some flexibility: when problems are dealt with in public, the public can often see why it is that new approaches/flexibility are required. Procedure plays a slightly different role. It can assure players of some basic degree of fairness—which the behavioralists tell us is almost hard- wired into the human brain—and, by replacing or supplementing political pressures by technical fixes, it can also draw the political poison from small issues and help to avoid escalation into unmanageable conflicts. I think it is too early to declare victory in dealing with the crisis, both so far as restoring growth in the rich economies and trade policy reactions are concerned. In 2012 the recovery has slowed, and in places reversed, because of an inability to deal with the financial fallout of the boom, and it must still be possible that the 2009 crisis will indeed degenerate into a trade policy rout. It is a matter of relief that it has not done so already, but as fiscal austerity becomes a goal more or less in itself, as it has in Europe, and the ability of expansionary monetary policy to take up the slack diminishes, I wish I could be completely confident that we will not see permanent damage to the liberal world trading order. The basic point made by Irwin and O’Rourke that mostly it is shifts, not shocks, that change things does seem correct to me, and the rest of my comments will be about the shift they identify in the rise of China.1 I have argued elsewhere that while the rise of China is not wholly unprecedented in terms of speed (Korea expanded its exports as fast), it is unprecedented in terms of size (Winters and Yusuf 2007). At the start of its acceleration, China accounted for one-fifth of humankind, and when such a body starts to change at rates as fast as we have ever seen you had better watch out. My question is whether this shift will, as in the past, cause a major disruption to the trading system or whether over two centuries we have learned enough to be more sensible this time around. In terms of the world trading system, I shall consider three manifestations of the shift. First, as Irwin and O’Rourke state, China has placed huge competitive pressure on other producers. This is evident just from thinking about how the emergence of China in trading terms has changed world factor endowments and so altered everyone else’s comparative advantage. It is also seen in the way firms in other countries have been squeezed in terms of their sales, pricing, and existence. The pressures to turn to protection have been resisted so far, perhaps because large western firms do not want to disrupt their profitable trades with China, but the dyke against political 1. The points made in the rest of these comments are elaborated in Winters (2012).

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pressure will not hold indefinitely without a good deal of explicit reinforcement and support from major governments. As Irwin and O’Rourke observe, in the long run the world will have to accommodate a very large China in the world trading system. Second, China has integrated into the WTO in a very institutionpreserving way. Many feared that China, which generally has not liked to join institutions that it did not help to create and has certainly disliked external restraints on its policy discretion, would be disruptive in the WTO; such fears have proved to be quite misplaced. Like other members, China has pursued what it sees as its self- interest within the WTO, but always within the context of the existing rules. In disputes it has bridled against what it sees as discrimination in the use of antidumping duties based on its nonmarket status, but it has brought few cases in retaliation, tried to settle those brought against it by consultation, and complied with rulings as much as other members. China has not contributed as much to the Doha Round as some (e.g., the United States) would wish, but given its extensive liberalization in the accession process and that the Doha Round was partly to complete old business and slated to be over by 2005, this seems to me neither surprising nor inappropriate. If we take a realistic view of the Doha Round, all the evidence is that while China clearly represents a huge shift in world trade it is trying not to be a shock to the institutions of the world trading system. So far, so good. The third area of potential strife is global imbalances. These are due to macroeconomic disequilibria—mainly China’s very high rate of enterprise savings, which arises from the conjunction of low factor prices (subsidies to land and borrowing, and strong rural- urban migration that keeps wages low) and the fact that (even with private firms) dividends are low or zero. They are not due to the institutions of world trade as Rodrik (2011) maintains. Rodrik’s analysis of the imbalances is that countries need to boost their tradables sectors to stimulate growth, which in China is necessary to preserve social harmony, and that, whereas left to itself the Chinese government would use industrial policy to provide the stimulus, membership of the WTO has ruled that out, so the government has to turn to exchange rate undervaluation instead. Given that I reject Rodrik’s diagnosis, it is not surprising that I should reject his prescription that the solution is to require WTO to allow subsidies and instead manage exchange rates multilaterally. This seems almost bound to lead to the collapse of the liberal trading order and without, on past form, any real prospect of managing exchange rates. Likewise, there are substantial difficulties with proposals that have circulated to treat exchange rate- undervaluation as a violation of WTO obligations and thus subject to dispute settlement and eventual retaliation in terms of trade restrictions. The WTO does not have the structure, the political clout, or the retaliatory tools to be able to manage this, and any attempt to get it to do so would very likely fail and thus discredit the whole of the WTO enforcement mechanism.

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Either of these two reactions would turn a somewhat uncomfortable adjustment to a shift into a massive rout of the institutional structure and the level of international trade. They would be precisely the kind of destructive behavior Irwin and O’Rourke identify as the problem in the past. I regret that I also see another opportunity to turn a shift into a rout, and this concerns export restrictions. The WTO has little to say about export restrictions, permitting export taxes almost at will for “ordinary” members, and having only a compromised ability to prevent quantitative restrictions because these are allowed under certain circumstances by the GATT’s Article XX.2 China has already lost one WTO dispute on export restrictions on industrial raw materials and is now subject to another on rare earths, tungsten, and molybdenum. In this case China has a virtual monopoly of global production for inputs that are critical to many modern technologies, including green ones. The fear in the West is that the restrictions will not only increase the cost of climate policy, but also cause the innovative sectors using rare earths to relocate to China, and that this will switch the locus of innovation with serious redistributive consequences. China has been a major beneficiary of the liberal order of the last three decades and if, when it has huge market power, it exploits this strongly, partners will feel that it is just not “playing the game.” Couple this with export restrictions on food, as we saw mainly from middle- income countries in the last food- price hike (2006– 2008), and we could easily see a fracturing of many global trade links. In this case cool heads in China and the emerging markets are what we need to avoid calamity. To summarize, Irwin and O’Rourke have given us a wise account of the history of the world trading system and have categorized the threats as shifts and shocks. By and large, they argue, it is the former that have caused the largest problems to a liberal world trading order and I agree with this. Moreover, as an eternal pessimist I have described how it could all happen again with what is arguably the largest shift we have ever seen—the rise of China. Ill- considered policy reactions to China’s rise, both in China and elsewhere, could undermine the whole trading system. The stakes are as high today as ever. References Rodrik, D. 2011. The Globalization Paradox: Democracy and the Future of the World Economy. New York: W.W. Norton. Winters, L. Alan. 2012. “China and the World Trading System: Thrills, Chills—and a Few Spills?” Unpublished Manuscript. University of Sussex. Winters, L. Alan, and Shahid Yusuf. 2007. Dancing with Giants. Washington, DC: The World Bank. 2. “Ordinary” members in this particular context is everybody but China, because China’s Protocol of Accession tightly controls its recourse to export taxes, an asymmetry that the Chinese resent.

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I found Irwin and O’Rourke’s chapter extremely interesting as an assessment of where we were, where we are, and where we are going from here. In my response, I would like to address some of the broader conclusions that the chapter put forward. Of course, it is hard to disagree with the importance of multilateralism as the ultimate shock absorber. More specifically, the WTO should be seen as the fundamental and ultimate stabilizer in the global system. Instead, I would point to the notion of belief in free trade and multilateralism; what is happening to it and how broadly is it still shared? Also, what dangers could arise from its erosion? As for the time frame being covered, the chapter obviously makes a valuable contribution for its depth in going back before what most trade policymakers usually have in mind. They tend to start their analysis at the Great Depression and the Smoot-Hawley tariff. Also, I found the parallel of the nineteenth- century “spaghetti bowl” with today’s free trade agreements highly illuminating. Yet, I would still propose a closer look at postwar trade history. In particular, I would divide up this period into three subperiods and offer a brief discussion on each. The first of these subperiods, the immediate postwar period, was characterized by the dominance of the United States in the world economy and world trade. Other economies were just about to recover from the ruins of war, so the United States could enjoy unparalleled dominance. The second subperiod was one of rapid globalization. The trading system saw the resurgence of European economies as well as the emergence of Japan and the Asian tigers as new important players. This is also the time when the first signs of tensions and pressures began to emerge, testing the system’s resilience. I personally remember the growing disillusionment with the GATT in the United States in response to a growing perception that it had become more advantageous for emerging export- oriented countries vis-à-vis the United States. On both sides of the Atlantic, the same question was voiced over and over again: Is our commitment to free global trade still in our best interest? That said, despite all these tensions the system had been strengthened by the end of the second subperiod, perhaps best epitomized by the birth of the WTO itself. Hardly coincidentally, this period saw a relatively stable pattern of growing prosperity, only occasionally interrupted by regional crises in Latin American and East Asia. That brings us to our final subperiod, the one following the 2008– 2009 downturn. There are new, dominant players in the world economy—namely, Rufus Yerxa is a deputy director general of the World Trade Organization. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12577.ack.

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China. We are also experiencing the relative decline of the United States and other industrialized economies with significant consequences for support of multilateralism. High unemployment and the decline of manufacturing are hardly propitious developments for maintaining such support. A common complaint I hear all the time in the West is that the Doha Round was supposed to be a development round, but the designated beneficiaries are already doing much better than we are. Why then—the skeptics tend to ask—would we agree to asymmetrical terms benefiting the fast growers? These symptoms underscore a broader problem of multilateral trade: what arguments will be advanced in favor of the next stage of liberalization and rules? We used to think that agriculture would be the main offer on the table from the developed nations, with a commitment to make it look more like industry in terms of tariff levels and subsidies. However, the rationale for this has become less compelling over time, not least because of high commodity prices. Agriculture has thus become less of a driving force to bring people to the negotiation table together. The EU and the United States, in turn, do not see potential gains to achieve on the industry side. The question is thus what will get participants excited about the next stage, what arguments will suggest benefits that they can hope to achieve? Differently put, I see the Doha Round extremely hard to sell in terms of political constituencies. Academics tend to refer to the “bicycle theory,” whereby forward momentum is needed to maintain belief in the system. However, right now, it does not seem to be sufficient to generate further liberalization. I have ample experience—just like my colleague from the United States, Charlene Barshefsky does—in selling the Uruguay round before. Now, however, I just do not see the same degree of belief that would be necessary in going forward. To conclude, I think it is important to ask the obvious question: which of the four periods described in the chapter we would like to live in, if not in the last fifty years strengthened by rule- based multilateralism. However, if the erosion of confidence continues, it will be increasingly difficult to generate support for multilateral trade policy. Reintroducing full-fledged protectionism is definitely not a viable option. Yet if one looks at the trends emerging in many countries it is clear that there is less of a commitment to broad-based liberalization and more of a temptation to think that nationalist economic policies or regional trading blocs may be an alternative to the GATT/WTO model. The ultimate question, I suppose, is whether this is a temporary phenomenon or a more irrevocable erosion of support for the system that served so well for more than sixty years. Those who forget the lessons of history are doomed to repeat them, so it is worth asking this final question: What will it take to reinforce belief in the ultimate shock absorber of the multilateral trading regime?

2 International Policy Coordination The Long View Barry Eichengreen

International policy coordination is a subject about which there is a great deal of talk. The question is whether those who talk the talk also walk the walk. Is international monetary and financial cooperation with a substantive impact a regular occurrence? If not, under what special circumstances does it occur? These questions are something on which history presumably has the capacity to shed light. In an effort to distill lessons from that history, I suggest that international cooperation is most likely in four sets of circumstances.

• First, cooperation is most likely when it centers on technical issues, such as central bank swaps and credits or prudential supervision and regulation, as opposed to more high- profile and politicized monetary and fiscal policies. Discussions of technical issues tend to be undertaken by specialists who, possessing shared training and background, are well positioned to reach common understandings and achieve intellectual consensus on what needs to be done.1 Delegation to specialists can also help to insulate policy coordination from politics, although when the Barry Eichengreen is the George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley, and a research associate of the National Bureau of Economic Research. Prepared for the Bank of England/NBER conference “Globalization in an Age of Crisis: Multilateral Economic Cooperation in the Twenty-First Century,” London, September 15– 16, 2011. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12578.ack. 1. I would probably also place trade policy in the first category, although this is debatable— and it is in any case the subject of another paper. As I note later, specialized training does not always conduce to intellectual consensus; consider, for example, the dispute in 2010 between “freshwater” and “saltwater” economists over the efficacy of fiscal stimulus.

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technical issues in question are important to concentrated interests, even those discussions can become politicized.2 • Second, cooperation is most likely when it is institutionalized—when procedures and precedents create presumptions about the appropriate conduct of policy and reduce the transactions costs of reaching an agreement. One definition of an institution is a set of durable rules and understandings shaping expectations, interests, and behaviors—rules and understandings that can range from informal norms to formal obligations for what constitutes acceptable behavior and that are sometimes embodied in an organization, sometimes not.3 History suggests that international policy coordination is more likely when it is institutionalized in this sense. • Third, cooperation is most likely when it is concerned with preserving an existing set of policies and behaviors (when it is concerned with preserving a “policy regime”) rather than directed at altering policies.4 Having sunk costs in establishing a regime, policymakers with an investment will have an incentive to cooperate in its preservation. Much successful international cooperation is therefore of the regime- preserving type. In contrast, cooperation not directed at preserving an existing regime will generally be more difficult to arrange. • Fourth, monetary, macroeconomic, and financial cooperation is most likely in the context of broad comity among nations. Conflict over other issues, whether economic or not, complicates efforts to reach agreement on even technical economic and financial policies. It does not provide a favorable backdrop for policy coordination. These are the hypotheses that give analytical structure to the historical narrative that follows. My formulation may be idiosyncratic, but the general points are by no means original to me. The idea that the structure of cooperation is affected by the extent of delegation and institutionalization is an organizing insight of Torsten Persson and Guido Tabellini (1995). The idea that cooperation on technical issues delegated to experts is relatively easy to arrange is a premise of the work of Peter Haas.5 The role of institutionalization in shaping outcomes is prominent in the literature in political science on foreign policy in particular.6 And the idea that regime- preserving cooperation has been important in history, and especially in the monetary 2. An example of the latter, from very recent history, is the Basel III capital and liquidity standards, which are of intense interest to the financial services lobby (see the Basel III discussion later in this chapter). 3. A large literature in political science and related disciplines elaborates (and contests) this definition; for a survey see Peters (1999). 4. Again, there is a large literature in international relations seeking to refine this concept of “regimes,” the classic statement of which is Krasner (1983). 5. See the contributions of Haas and collaborators to Haas (1992). 6. See, for example, Smith (2004) and the references cited therein.

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and financial domain, is a theme of Peter Kenen.7 Finally, that the success of efforts to cooperate in addressing economic issues will be influenced by the success or failure of international cooperation in other spheres is a theme of the literature on linked and nested games.8 Although the intuition for these hypotheses is straightforward, it is nonetheless worthwhile to devote some space to its elaboration. The notion that international cooperation on technical issues, negotiations on which are delegated to experts, tends to be relatively easy to arrange rests in part on the idea that such experts constitute an “epistemic community.”9 Interacting with one another over time, this network of professionals will tend to gravitate toward a common diagnosis of the problems under discussion and therefore to a common view of the appropriate response. Contemporaries will recognize the role of these factors in the G20 process.10 Experts will develop shared normative values, compatible causal beliefs, and a common set of practices, all of which facilitate cooperation. Because the issues at hand are technical, the conclusions of the experts will meet with only limited challenges from other parties, including from politicians channeling the interests of special interests potentially disadvantaged by an international agreement that works to the advantage of the majority. Thus, the ability of domestic interests, lacking specialized technical expertise, to block socially advantageous international cooperation and, correspondingly, the need for policymakers to marry cooperation with side payments will be less.11 It follows that cooperation on technical issues is relatively good, if by no means perfectly insulated from political complications. The Basel Committee on Banking Supervision is a prototypical example of an epistemic community that meets regularly, in a manner conducive to fostering international agreement, to discuss capital adequacy and liquidity management, issues whose technical nature partly (but by no means fully) insulates deliberations from lobbying by special interests and other potential political complications.12 In contrast, macroeconomic questions like those addressed in the International Monetary Fund’s 2006 Multilateral Consultation (e.g., should the United States raise taxes in return for Chinese agreement to revalue its exchange rate?), while not entirely nontechnical, raised issues of concern to business, households, and the general public in both countries, complicating efforts to reach international agreement. 7. See Kenen (1990). Kenen distinguishes regime- preserving cooperation from “policyoptimizing coordination,” which in his view is harder to arrange. The importance of regimepreserving cooperation in history is also a theme of Eichengreen (1992). Louis Pauly (1992) has similarly argued that international cooperation is particularly likely to arise in response to shared perceptions of a (regime- threatening) crisis. 8. See Tsebelis (1992). 9. See the introduction to Haas (1992). 10. To which I return below. 11. On the role of side payments in cooperative outcomes, see Cox and McCubbins (2001). 12. I return to this below.

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The intuition that institutionalization is conducive to cooperation is similarly straightforward. In international macroeconomics, policy coordination is often modeled as a prisoner’s dilemma. While the cooperative outcome may be Pareto optimal, it can be impossible to sustain in the absence of a mechanism to deter cheating.13 Repeat play may or may not be enough to bootstrap cooperation, depending on how quickly defections from the cooperative equilibrium are detected and the strength of the sanctions then applied. Institutions can be thought of as enhancing the flow of information on the actions of the players (think multilateral surveillance) and as organizing coalitions of countries to apply effective sanctions. In addition, where preferences are not single peaked and there are a large number of heterogeneous parties, it may be difficult to reach agreement on a cooperative solution. In this context, institutions can be thought of as vehicles for setting agendas, structuring negotiations, invoking precedents, and providing the kind of focal points that facilitate the successful conclusion of negotiations. All this suggests that cooperative agreements are more likely to stick when arranged through, say, decisions taken by the executive board of the International Monetary Fund (IMF) under powers delegated them by the Articles of Agreement, rather than through the negotiation of a “new Plaza Accord.” That regime- preserving cooperation, often negotiated in the context of a crisis, tends to be most prevalent similarly has a plausible ring. While international macroeconomic and financial arrangements evolve for many reasons, one reason (the economist’s functionalist instincts tell him) is that they serve powerful vested interests. The same vested interests that were able to secure the establishment of those arrangements will apply pressure for their preservation. Crises—times when the international regime is under stress— are when international interdependencies tend to be especially visible. They are visible when the perceived stakes are highest. On all these grounds, they are visible when policymakers are driven to international cooperation. These instincts were visible in 2008– 2009, when contagion was on everyone’s lips and evident in financial markets, and when the international spillovers of national policies were powerfully felt. With open international financial and trading systems at risk, the case for international cooperation was compelling. The same pattern is evident in the longer span of history: in exceptional if not always successful efforts to cooperate in the 1992 European Monetary System (EMS) crisis, to avert the breakdown of Bretton Woods, and in response to the 1931 crisis that threatened the gold- exchange standard. Finally, the presumption that economic and financial cooperation is easier among friends than foes is sufficiently straightforward and does not require elaboration. 13. There is, of course, a literature on cases where cooperation is counterproductive, starting with Rogoff (1985). There will be more about specific instances of this later.

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We can ask, in light of these hypotheses, whether the prospects for international policy coordination are brighter now than in the past.14 Haas argues that the domain of public governance has tended to grow increasingly technical over time. The scientific and technical basis for economic policymaking—whether the question is macroeconomic fluctuations, climate change, or infectious disease—has clearly increased. This first set of trends, juxtaposed against the organizing hypotheses of this chapter, suggests increasing scope for macroeconomic and financial cooperation. The trend toward growing institutionalization of international economic and financial relations would similarly seem to bode well for international cooperation. In the course of the twentieth century, there was explosive growth of the number and size of public ministries and agencies as repositories for the technical expertise required to carry out public policy. National and international bureaucracies felt compelled to expand their employment of technical and scientific personnel.15 To cite but one example, there were no permanent institutions of international financial cooperation before 1913: international conferences on the design of the international system and cooperative initiatives among central banks and governments were ad hoc. Standing institutions designed to regularize international cooperation were first created in the interwar period: the Economic and Financial Committee of the League of Nations and the Bank for International Settlements (BIS). But the United States never joined the League, and the BIS remained under a cloud by virtue of having been created to facilitate German reparations payments.16 Now there is a virtually limitless number of international groups, committees, boards, and organizations with standing secretariats under whose aegis officials and experts meet.17 Some regions, most obviously Europe but increasingly Asia, have gone even further in seeking to institutionalize cooperation. That we have moved, one hopes, beyond the era of open military conflict among the major powers would similarly seem to have enhanced the scope for international cooperation; no two G20 countries are at war with one another at the time of this writing.18 Finally, the proliferation of formal regimes points toward growing scope for international cooperation.19 There is Basel III, a regime for capital adequacy and risk management. There is the International Monetary Fund, membership in which creates obligations. There are agreements regarding

14. Or, more generally, we can ask whether these hypotheses help us to understand cooperation’s ebb and flow. 15. Including economists. 16. And for its actions during World War II. 17. Certainly this will be the impression of busy officials. 18. That said, there is no shortage of military conflict globally, and more generally of noneconomic disputes, giving rise to subtler forms of conflict among nations. 19. Refer to the definition of regimes in the third bullet point at the beginning of the chapter.

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supervision and regulation of banks and securities markets and the conduct of macroeconomic policy at the regional level, most obviously in Europe. Other factors also lead one to question this Whig history of international coordination. There is the absence of a well- defined international exchangerate regime analogous to the gold standard or the Bretton Woods system, a fact that complicates policy coordination today. There is the growth in the number of systemically significant players. Not only are there more independent countries, but there are more countries with the size and interconnectedness for their policies to have significant foreign and systemic repercussions. Reaching agreement grows more complex with more countries at the table. The move from the G7/8 to the Group of Twenty may be a step forward, but the sheer size of the new grouping complicates deliberations. There is the fragmentation of epistemic communities. Macroeconomists are polarized between salt- and freshwater species seemingly incapable of reaching a common diagnosis of economic problems, much less agreeing on a common response. Experts in finance are divided into “Anglo-Saxon” and “Continental” schools, one of which worries about threats to financial stability from highly leveraged, too- big- to-fail banks, while the other is preoccupied by hedge funds and money laundering. Experts from emerging markets, where the state has traditionally played a larger role in the economy, have different views again of the nature of desirable policy reform. And if, once upon a time, the G7 was synonymous with the Free World, now the countries that must agree on global initiatives may not be enemies, but neither are they alliance partners. Raising the question: if the prospects for international policy coordination are so difficult to characterize using deductive (top- down) reasoning, might they be better understood working from the bottom up? A perennial problem for this kind of survey is how far back in history to go. The further back one goes, the greater the extent that international economic cooperation means monetary cooperation (modern notions of fiscal policy not predating the twentieth century and financial regulation being minimal).20 One might trace awareness of the problems created by lack of international monetary coordination to Charlemagne’s decision to standardize the coins circulating in his empire. But for the present purposes it is convenient to start with the international monetary conferences of the second half of the nineteenth century, by which time monetary and financial relationships broadly resembled those that will be familiar to modern readers. 20. Note that my focus in this chapter is on monetary, financial, and macroeconomic matters. If one wished to broaden the focus, one could attempt to draw lessons from the history of cooperation in transportation (shipping, standardized railway gauges), communication (the International Postal Union), and public health (management of infectious diseases), as in, among others, Cooper (1989).

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These nineteenth- century conferences reflected an awareness of international economic interdependence. They were an effort to create an international monetary regime from which all the participating countries could benefit. There was awareness that the heterogeneity of national monetary systems and the associated movement of exchange rates created uncertainty and costs of international transactions. Contemporaries seem to have recognized the tendency, documented by modern economists, that countries sharing a common monetary standard and therefore enjoying stable exchange rates trade more with one another.21 They were also aware of the tendency for capital to flow more freely between countries with common monetary standards. They understood the complications created by currency substitution when national monies circulated abroad and policies were erratic. These were among the problems they sought to address in a series of international monetary conferences between 1867 and 1892. In 1867, at the invitation of Napoleon III, delegates from twenty states met in Paris to discuss the adoption of a common monetary standard and agreed to move to gold convertibility as soon as practicable. They also discussed the adoption of a single unit of account and common international coinage, although neither idea bore fruit. While there was widespread agreement on the desirability of coordinating monetary standards, there was less than full consensus on what common standard to adopt: gold, silver, or bimetallism. Britain, whose circulation was already gold based, understandably advocated the gold standard. The representatives of the United States, which had recently experienced an inflationary civil war, were—rather exceptionally—worried about inflation rather than deflation, similarly inclining them toward a gold- based system. The US Secretary of State William Seward appointed James Ruggles, a New York State Assemblyman and promoter of canals, as the American delegate to the conference. Ruggles had attended the 1863 statistical congress and, partly as a result of its influence, was an advocate of the gold standard. Prussia, preoccupied by the process of German confederation, for its part remained on the sidelines. This made France the pivotal country. French financial interests favored bimetallism, this being the traditional basis for the country’s monetary circulation, and because French financial institutions including the Bank of France earned significant income from arbitrage transactions in gold and silver.22 Business interests, on the other hand, favored the gold standard, this being more convenient for trade since it was the basis on which the leading commercial power, Britain, conducted its commercial transactions. 21. See Lopez-Cordoba and Meissner (2003) and Estevadordal, Franz, and Taylor (2002). The growth of international trade following adoption of the Cobden-Chevalier Treaty of 1860 and the subsequent spread of trade liberalization sharpened their incentives (see the discussion later in this chapter). 22. Paris being a center for bimetallic arbitrage.

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The 1860 Cobden-Chevalier Treaty liberalizing trade between Britain and France increased the number of those with a stake in commercial transactions and thus shifted the balance of power between the two sets of interests.23 With France now in the gold camp, it became possible to agree on harmonizing monetary systems on the basis of gold—thus read the concluding summary of the president of the conference. Unfortunately, the Franco-Prussian War in 1870 interrupted progress; we see here an example of international political conflict disrupting attempts at financial and monetary cooperation. Following its conclusion, some countries moved unilaterally; Germany, for example, used its reparations income to unilaterally go onto gold. But for the architects of international cooperation, it was necessary to let memories of the war fade and then start over. Impetus this time came not from France, still reeling from its 1871 defeat, but from the rising power, the United States. At the international monetary conferences of 1878, 1881, and 1892 it sought to secure agreement to create an international bimetallic standard under which silver as well as gold would provide the basis for the monetary circulation. All three conferences were convened at the behest of the United States. None achieved anything of substance. In part, the problem was that while these conferences were sequential, they were not regular, or institutionalized, in any meaningful sense. In addition, the Panic of 1873, memories of which were still fresh, created dissatisfaction with prevailing arrangements without engendering a consensus at the 1878 conference on what constituted a superior alternative.24 The renewed concern of the American delegates with the deflationary effects of the gold standard, deflation having been under way again since roughly 1873, was not shared by their European counterparts. In the United States there was nothing insulating the debate over the monetary standard from politics: the United States was the one country with universal (male) suffrage, enabling farmers and others with nominally denominated mortgage debts to make felt their opposition to the gold standard. Delegation of decision making to specialists was hardly feasible in this context. In countries like Britain, where the franchise was limited to men of property (traditionally, landowners), deflation cut the other way. Lack of agreement on the nature of a desirable standard led delegates to retract the 1867 resolution endorsing the gold standard, instead suggesting that countries should adopt whatever stable standard was to their liking. This was not a victory for international coordination. At the 1881 conference, the scales tipped toward the advocates of silver, there having been several additional years of deflation and France, formerly an important practitioner of bimetallism and still a large holder of silver, 23. Not incidentally, Michel Chevalier was himself a strong advocate of international adoption of the gold standard. 24. Not unlike in the case of our recent crisis.

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having grown increasingly worried about the depreciation of silver against gold. But unable to secure British and German support for an alternative to the gold standard, the conference produced nothing of substance. By 1892, when twenty countries met in Brussels, the scale had tipped still further, what with an additional decade of deflation and the emergence of bimetallic lobbies in Britain and Germany. But again there was less than full agreement on whether the deflation problem was sufficiently severe to justify tampering with an established monetary standard.25 These negotiations, to repeat, were ad hoc rather than institutionalized. They occurred against the backdrop of discomfort with prevailing monetary arrangements but not crisis. They were convened with the goal of creating rather than preserving a regime. And the issues involved were not beyond the grasp of broad publics—recall the controversy in the United States over “free silver” that figured prominently in the 1896 presidential election. All this helps to explain why efforts at international cooperation were less than entirely successful. The failure of the 1878, 1881, and 1892 conferences is consistent with this presumption. However, this was not the case for the (limited) success of their 1867 predecessor, suggesting that this episode deserves further consideration. One explanation is the existence of broad agreement among experts on basic principles. Discussions were informed by the shared values of classical liberalism: limited government, individual liberty, and free markets. Delegates shared a belief that monetary standardization would foster international commerce, economic growth, and world peace.26 They had been influenced by the “scientific movement” of the 1850s to get countries to adopt a common set of weights, measures, and coinage based on the metric system, and by discussions of this objective at a series of international statistical congresses.27 In other words, the delegates constituted a sort of epistemic community. The conference also took place during the mid- nineteenth century peace, before the Franco-Prussian War made such meetings more difficult. Special circumstances like US experience with inflation mitigated in favor of agreement on a gold- based standard, as noted earlier. In Germany there were the special circumstances of confederation—which posed the question of which German state’s particular silver standard the confederation should adopt— that could be finessed by rejecting the adoption of any silver standard at all in favor of gold. There was the fortuitous fact that, in the aftermath of the conference, Germany received reparations as victor in the Franco-Prussian 25. Even among those who sought international agreement on silver coinage as a way of raising the price of silver and the overall price level, there was no agreement on the technicalities (on how, practically, to go about this). 26. See Reti (1998, 3 passim). 27. In Brussels in 1853, Paris in 1855, and Berlin in 1863. Recall their mention in the context of Assemblyman Ruggles’s appointment, described earlier.

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War, which it could use to constitute a gold reserve. Then there was the fact that the economic, commercial, and financial preeminence of Britain, the one major country already firmly on the gold standard, was at its peak. Other countries like Germany and the United States subsequently overtook Britain in per capita and aggregate GDP, respectively, but there was no question about British industrial and commercial preeminence at midcentury. While there is no evidence that Britain as “hegemon” was able to coerce or compel other countries to go onto the gold standard, Britain’s very economic success allowed it to lead by example. The large volume of overseas transactions in which it engaged encouraged others to follow. And when a second large country, Germany, went onto gold in 1871 for essentially incidental reasons, the incentive to link up to Europe’s two leading economic powers became even stronger.28 While these observations help to explain the outcome of the 1867 conference, they also caution against exaggerating the importance of the conference itself. The agreement reached by delegates did not bind governments. It did not survive the Franco-Prussian War, again underscoring how political and military conflict can disrupt the progress of cooperation. It was selfinterested national decisions, often taken on grounds independent of those discussed at the conference, that led to the establishment of the international gold standard. That regime was more a spontaneous order than an international agreement. That said, it is possible to imagine that, at a minimum, movement onto the gold standard would have been less orderly and proceeded more haltingly in the absence of this prior agreement. By the 1880s, then, there was an established international monetary regime to preserve. And on a number of occasions, the leading central banks provided emergency assistance, analogous to the dollar and euro swap lines extended by the Fed and the European Central Bank (ECB) starting in 2008, with the goal of preserving it.29 When the Baring crisis threatened the gold reserve of the Bank of England, the central bank that was effectively the linchpin of the system, the bank arranged to borrow £2 million in gold from the Bank of France, using Rothschilds as intermediary, together with £1.5 million of gold coin from Russia. A few days after its initial commitment, the Bank of France made another £1 million of gold available. The Chancellor of the Exchequer, George Goschen, characterized this foreign assistance as absolutely essential for ensuring confidence in the Bank of England’s ability to stand behind Barings and preserve the sterling exchange rate. Another such episode was in late 1906 and early 1907, when a financial boom in the United States drew gold from the London market.30 The con28. As shown by Gallarotti (1995) and Meissner (2005). 29. My own work emphasizes the importance of these regime- preserving operations (Eichengreen 1992). 30. No doubt this passage will create for those involved in the 2008 crisis a sense of déjà vu all over again.

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ventional response of raising interest rates providing little relief, the Bank of England turned to the Bank of France, which purchased sterling bills to support the British exchange rate. As the governor of the French central bank put it, it was in the interest of French foreign trade to prevent a crisis on the other side of the channel. Foreign bills discounted by the Bank of France rose by more than 65 million francs in the first quarter of 1907. The rise in the supply of francs on the market drained gold from the Bank of France, helping to satisfy increased demands in the United States and replenish the reserves of the Bank of England. The Bank of France resisted the normal response to a gold drain, which would have been raising its own discount rate, in order to facilitate these stabilizing flows. Purchasing sterling bills and maintaining the prevailing level of interest rates also did less than an open loan, like that extended in 1890, to excite fears about the stability of the English gold standard. Evidently, there was not only international cooperation, but learning over time about its efficient implementation. In the second quarter of 1907, the pressure on the Bank of England having subsided, the Bank of France was able to let its portfolio of short- term sterling bills run off. But then the American bubble burst, leading to a rise in nonperforming loans and a wave of bank distress. The result was a shift from deposits to currency in the United States and a surge in the demand for gold. Once again, the Bank of England found itself at the center of the storm. It raised its discount rate to 7 percent, the highest level since the earlier financial crisis in 1873, and contemplated the possibility of having to raise it further or, alternatively, of suspending gold convertibility. Instead, the dilemma was resolved by help from the Bank of France and German Reichsbank. Although both the French and German central banks were not immune from the pressure, they resisted the normal tendency to raise interest rates in order to divert American demands toward their markets and release gold to the Bank of England. In November and December 1907, 95 percent of the gold shipped to the United States came from France, Germany, Belgium, and Russia, less than 5 percent from Britain.31 The Bank of England also resumed its purchases of English bills to support the sterling exchange rate. Techniques pioneered in these crises were used again subsequently. In 1909 and 1910 the Bank of France purchased sterling bills to relieve seasonal strains on the Bank of England. It helped that these operations were technical: they involved discounting foreign bills and making other technical interventions in financial markets. It helped that central banks were in contact with one another. It also helped that they shared a belief in the importance of the prevailing monetary standard and in the desirability of its maintenance. International monetary and financial cooperation was more extensive than it had been in much of the second half of the nineteenth 31. Leaving aside newly mined gold.

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century because it was now of the regime- preserving rather than the regimebuilding variety.32 Perhaps the strongest evidence that international cooperation smoothed the operation of the pre- 1914 gold standard was the priority that policymakers attached to it when reconstructing the system after World War I. They convened international conferences in Brussels in 1920 and Genoa in 1922 with the goal of facilitating the movement of countries back onto gold (only the United States having continuously maintained gold convertibility between 1914 and 1919). Among the problems of transition was that prices had risen significantly since 1914 but global gold production had not kept up, raising the specter of a deflationary shortage of monetary gold. The delegates at Genoa therefore sought an agreement under which central banks could supplement their gold holdings with reserves of convertible foreign exchange. The practice of holding reserves in this form was not unknown prior to the war, but efforts were now made to extend and regularize it, the alternative of pushing prices back down to 1913 levels being understood as painful and disruptive. That these conferences were dominated by technical experts made their deliberations easier; that they occurred against a backdrop of recent military conflict of course worked in the other direction. The result was a more elastic but also a more fragile monetary system. Were the policies of one of the reserve- currency countries, whose bills and bonds were now widely held as reserves, to inspire less than full confidence, the system would implode. If countries with claims on the reserve- center countries all sought to convert them into gold, their lack of confidence might produce a self- fulfilling crisis.33 The implication was that international cooperation was even more important for stability than before. Contemporaries knew it. Kirsch and Elkin in their 1930 manual on central banking devoted an entire chapter to international cooperation. Aus32. Not everyone would agree that these support operations were integral to the operation of the gold standard. Flandreau (1997) observes that central bank cooperation was episodic, not continuous. He argues that central banks helped one another not out of altruism but “selfish” (self) interest. Cooperation was ad hoc rather than institutionalized, and there was conflict as well as cooperation among the central banks of the period. His objections are a caution against emphasizing central bank cooperation to the exclusion of other factors. Paramount among those factors was the credibility of the regime: the overarching belief that other objectives of policy, such as they were, should be subordinated to the maintenance of gold convertibility, leading to what could be called later as “stabilizing speculation.” And, reinforcing this same situation, there was the fact that other objectives of policy, such as minimizing unemployment, were not yet prominent. Because the modern concept of unemployment was still undeveloped, there existed no well- articulated model linking monetary policy to unemployment, and those for whom the fight against unemployment might have been a priority (the working classes) were not yet widely enfranchised (Eichengreen 1992). There was the fact that wages and prices were relatively flexible, allowing the exchange rate to be inflexible. See Bayoumi and Eichengreen (1997) for evidence. 33. Analogous to the kind of self- fulfilling bank run modeled by Diamond and Dybvig (1983) in the domestic context.

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tria, Hungary, Danzig, Estonia, Greece, and Bulgaria received stabilization loans through the League of Nations to help them back onto the gold standard. Belgium, Poland, and other countries received them from consortia of central banks. When the Bank of England needed to strengthen its reserve position, the Federal Reserve provided it with exceptional credits.34 When the governor of the Bank of England, Montagu Norman, needed to engineer some appreciation of sterling in 1924–1925 in order to return to the prewar rate, the Federal Reserve Bank of New York under Benjamin Strong kept interest rates low to encourage the flow of gold and capital toward London. When in 1927 sterling came under strain, Strong and Norman, together with Hjalmar Schacht of the German Reichsbank and Charles Rist of the Bank of France, met secretly on Long Island. Norman agreed to tighten credit, while his French and German counterparts agreed to refrain from engaging in arbitrage operations at the Bank of England’s expense. The critical contribution came from the Fed, which lowered its discount rate and conducted $80 million of expansionary open market operations. In their wake, the pressure on the Bank of England diminished. The financial experts who headed these central banks clearly constituted an epistemic community of sorts. They stayed in constant communication, sharing ideas through memos and telephone calls as well as in-person meetings (Clarke 1967; Ahamed 2009). Much of the literature portrays these initiatives as key to the maintenance of monetary stability in the second half of the 1920s. But there is another view. Foreign support arranged through international cooperation, it is sometimes argued, explains Britain’s failure to adjust. Strong’s assistance created a moral hazard that only set Britain up for an even more painful fall. By deviating from the policies dictated by normal gold- standard practice— that is, policies that would have been optimal for the US economy—and specifically by keeping interest rates lower in 1924– 1925 and again in 1927 in order to aid the Bank of England, the Fed fueled the credit boom that eventually collapsed in a monumental bust.35 Readers will hear echoes here of Martin Feldstein’s view that modern efforts at international cooperation have been counterproductive insofar as they resulted in domestic policies with less than optimal domestic consequences. Monetary policymakers in particular, in this view, should concentrate on their national knitting.36 One can detect here echoes of criticisms of the Fed for having kept interest rates low from 2003 to 2005, thereby fueling a dangerous credit boom and bust.37 34. The $200 million line of credit provided by the New York Fed in early 1925 was never drawn. 35. The definitive statement of this alternative is Meltzer (2003). 36. See Feldstein (1988). 37. Even the language is similar: deviating from the gold standard “rules” in the first case, deviating from the Taylor “rule” in the second.

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Readers will infer that I am skeptical of this dissenting view. I have argued elsewhere that the roots of the recent credit boom and bust lay in flawed supervision and regulation, perverse incentives in financial markets and international imbalances, relative to which the role of monetary policy was secondary. I would argue, similarly, that the fundamental causes of the unsustainable 1920s boom lay elsewhere: in financial innovation unchecked by adequate regulation, in reckless international lending, and in global imbalances (where in the 1920s the United States was on the surplus side).38 The Long Island meeting marked the apex of international cooperation. In the absence of institutionalization, cooperation was built on the personal relationship between Norman and Strong, who had known one another since 1916. Strong died in 1928, and Norman, increasingly ill, never grew close to his successors. Efforts to cooperate were further complicated by the influence of new powers like France, which was sidelined by its own financial problems previously but was now able to reassert itself. The French had different priorities and views of the operation of the international system, complicating negotiations.39 Not long after the 1927 meeting of central bankers, the Bank of France began converting its accumulated British treasury bills and bonds into gold. This policy reflected hostility toward the gold- exchange standard, which, in the view prevailing in French policy circles, unduly favored the reserve- center countries (if not exactly giving them a blank check).40 Tightening the screws on London was a way for French officials to strengthen Paris in the competition for financial- center status. Finally, geopolitical disputes roiled the waters. Thus, when Germany sought to reassert itself by building pocket battleships and negotiating a customs union with Austria in violation of the Versailles Treaty, the French were understandably upset. This backdrop of political and diplomatic conflict did not bode well for monetary and financial cooperation. Thus, when the schilling came under attack in 1931 and there was an attempt to arrange an emergency loan for Austria through the Bank for International Settlements, the initiative was vetoed by the French.41 When the system descended into an existential crisis, it was every man 38. See Eichengreen (2011a). Be this as it may, it is important for historians of international cooperation to have a view of this question. 39. The parallels with the financial emergence of China will be obvious. 40. This dislike of the gold- exchange standard has shades of Giscard d’Estaing’s complaints about America’s “exorbitant privilege” in the 1960s. The parallel is not entirely coincidental, Jacques Rueff having already become an influential policy advisor and Bank of France official in the 1920s, and again influencing Giscard and De Gaulle in the 1960s. 41. The BIS had earlier provided a small loan to Austria, but the substantial loan later required by the Credit-Anstalt crisis was torpedoed by French insistence on unacceptable political conditions (Toniolo 2005). Still, that emergency assistance was organized through the BIS was significant. Creation of the BIS in 1930 as a mechanism for facilitating the smooth transfer of German reparations to the Allies was probably the one positive product of efforts to cooperate monetarily and financially in this period. I will, of course, have more to say about the BIS later.

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for himself. To its credit, the Hoover administration understood that the United States would not be immune from a financial crisis originating on the other side of the Atlantic and proposed a one- year moratorium on allied war debt payments in order to facilitate a moratorium on German reparations (Germany at this stage being at the eye of the storm).42 But the kind of large loans of reserves and other support operations that had been mounted before 1913 when regime- jeopardizing crises erupted were notably absent. Britain’s suspension of gold convertibility in September then precipitated a run on US gold reserves, forcing the Fed to jack up interest rates in the teeth of a ferocious slump. Central banks scrambled to liquidate their foreign exchange reserves, and the gold- exchange standard collapsed into the kind of classical gold standard that the French had always favored, placing the remaining gold standard countries in a deflationary vice. When in the spring of 1933 governments convened one last time, in London, in an effort to agree on a cooperative response to the global slump, there was too much water under the bridge. Trade protectionism and retaliation were widespread. There had been years of financial disputes and disappointed pleas for foreign support. Diplomatic tension escalated further with the assumption of power by the National Socialists in Germany; more generally, the rise of nationalism and political instability complicated efforts to cooperate.43 By 1933 there remained no international system, in any meaningful sense of the term, to preserve. There was no institutional framework to lend structure to negotiations. Different governments saw the causes of the crisis differently; there was no encompassing epistemic community capable of informing action.44 Thus, when Roosevelt issued his “bombshell message” to the conference, announcing in effect that the United States was intent on taking care of itself and not especially interested in cooperating, he was simply giving voice to a realization and tendency that had already become widespread. These very disasters were what informed the effort to institutionalize monetary and financial cooperation after World War II. To be sure, this was not the first such effort: following World War I, an Economic and Financial Organization had been created within the League of Nations to provide information and analysis (including what today is referred to as multilateral surveillance), eventually employing such notable economists as James 42. France, predictably, resisted Hoover’s calls for a moratorium. While French objections did not prevail, this added to the prevailing climate of uncertainty and thereby worsened the German crisis. 43. This is the theme of Wolf’s (2010) meditation on the topic. 44. The only thing their differing interpretations had in common was that they blamed foreigners. The Germans blamed their hyperinflation, which subsequently limited room for policy maneuver, on foreigners. The French blamed the slump on inadequate policy rigor on the part of foreigners. The Americans blamed the slump on foreigners now unwilling or unable to repay the money they had “hired” during World War I and in the 1920s.

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Meade, Gottfried Haberler, Ragnar Nurkse, and Jacques Polak.45 American refusal to join the League was, however, a fatal weakness. The Economic and Financial Organization nonetheless produced some influential analyses, notably Nurkse’s account of interwar monetary problems emphasizing volatile capital flows, the intrinsic instability of floating exchange rates, violations of the gold- standard rules, and beggar- thy- neighbor devaluations.46 The BIS, for its part, provided analysis of money and financial markets; as the “club of central banks” it should have been in a favorable position to facilitate cooperation on monetary policy. But the intensity of disputes between countries over nonmonetary matters did not bode well, especially since the BIS had been created to manage one of the most hotly disputed such matters, German reparations.47 For all these reasons, the creation of the International Monetary Fund and World Bank was a significant departure from past practice. The IMF was established with an eye toward providing a rules- based, treatyenshrined basis for cooperation on exchange rates and, by implication, on related policies.48 Quota shares were specified as a basis for drawings. The Articles of Agreements laid out the IMF’s mandate and procedures. An executive board was formed to take key decisions. Members were obliged to declare par values for their currencies, requesting approval in advance when seeking a change in parity, and restoring current account convertibility after a transitional period. This was very different from the gold standard “rules of the game,” which were never formally codified. And, in contrast to the situation with the League of Nations, the United States was a founding member and committed participant. This was an effort in effect to utilize institutionalization and expert delegation to overcome lingering diplomatic and political enmities and forge a still elusive epistemic consensus. Not that the new organization got off to a smashing start. Large countries, then as now, resisted the application of supranational rules to themselves. The United States rejected Keynes’ proposal for levies on countries in chronic balance- of-payments surplus. In an awkward precedent, the United Kingdom in 1949 did not give the IMF the requisite notice to enable it to review its decision to devalue. The inauguration of financial operations was 45. Hill (1946) and Endres and Fleming (2002) describe the activities of the Economic and Financial Organization of the League. Hill’s book, revealingly, was the outgrowth of a pamphlet prepared for the United Nations Conference in San Francisco to inform the deliberations of delegates there. 46. See Nurkse (1944). In addition, Nurkse, with the help of colleagues, authored a second report suggesting how low inflation and full employment might be reconciled by assigning two instruments—monetary and fiscal policies—to these two targets (Nurkse 1946). 47. The BIS had brought together representatives of twenty- four central banks in May 1931 to discuss the crisis in the international monetary system, but to no avail. Its first three annual reports included a section on “central bank cooperation” but, revealingly, this section was dropped in the fourth report and subsequently (Cooper 2006). 48. The discussion here is limited to the IMF, since the focus of this chapter is monetary and financial—as opposed to development—cooperation.

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delayed until the Marshall Plan was wound up.49 Issues such as what kind of conditions should be attached to IMF loans remained to be worked out.50 The transition to full current account convertibility took considerably longer than foreseen by the drafters of the Articles of Agreement. As a result, the IMF was not the principal venue for policy coordination in the immediate postwar years. Still, the fact that this organization existed, staffed up, and gained members as the period progressed underscores the extent to which cooperation was institutionalized after World War II. A more important venue for international cooperation in the immediate post–World War II period was at the regional level. Already in 1948 the United States made the extension of Marshall aid conditional on its European recipients negotiating a joint plan for its utilization. It made no sense for the United States to provide finance for imports to European countries A and B if country A planned on exporting twice as much to country B as country B planned on importing from country A. It made no sense to provide a variety of European countries the finances to build steel mills if the resulting capacity exceeded their collective requirements for steel. Although European countries were more successful in coordinating some plans than others, even the failures could have positive consequences. Pressure to cooperate led to the creation of the Organization for European Economic Cooperation (OEEC), which grew into another institutionalized value for analysis and exchange of views, the Organization for Economic Cooperation and Development (OECD). It helped European economic and monetary experts to develop a common language. And it encouraged awareness in Europe of the advantages, both economic and political, of ongoing collaboration. It was with this awareness that Western European countries negotiated bilateral and minilateral clearing arrangements in the latter 1940s to permit trade to resume, despite a shortage of gold and foreign exchange reserves with which to finance intra-European deficits.51 These subregional arrangements were then generalized, under OEEC aegis, into the European Payments Union (EPU), a Europe- wide mechanism for settling transactions and providing temporary balance- of-payments financing when a member, in the course of liberalization, experienced a temporary trade deficit. Creating the EPU was possible because the United States provided $350 million of Marshall Plan funds to underwrite the reserve pool. The EPU was tested in 1950 when commodity prices rose due to the Korean War. The German trade balance moved into deficit—German industry then, like Chinese industry today, depended on imported raw mate49. To prevent borrowers from double dipping. 50. See Dell (1981). 51. These had names like the First Agreement on Multilateral Monetary Compensation (1947) and Agreement on Intra-European Payments and Compensations (1949–50). They are discussed in Eichengreen (1994).

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rials. The EPU managing board dispatched two experts, Alec Cairncross and Per Jacobsen, to investigate. Cairncross and Jacobsen concluded that the problem was essentially a liquidity crisis.52 Their report transformed what was potentially a delicate political issue (anything involving German heavy industry was potentially difficult in the wake of World War II) into a technical question. Their findings informed the EPU decision to provide a loan sufficient in size that Germany’s previous steps toward external liberalization could be maintained.53 The other prerequisite for the recovery of German industry, along with finance for imports, was the lifting of occupation- authority- imposed ceilings on the production of militarily relevant products, mainly those of the iron and steel industries. Here joint oversight of the industries in question by France, Italy, Belgium, the Netherlands, and Luxembourg, along with Germany itself, gave the neighbors confidence that the uses of iron and steel production would be benign. The Six, as this group was known, also sought to create a free trade area in coal and steel. While they were less than successful in this immediate aim, the institutions they created—a commission, a high court, and a nascent parliament—were the foundation for the European Economic Community (EEC), established in 1958. Over time, the EEC turned into the leading example of a permanent institution for organizing economic cooperation at the regional level.54 The 1950s were also when the IMF established its modern approach to conditional lending.55 The stage was set for an approach where emergency financial assistance was provided by a combination of multilateral and regional sources—the approach followed again in 2010 when Greece, Portugal, and Ireland negotiated emergency assistance from the IMF and the European Union.56 By the end of the 1950s there was an established international monetary regime, the Bretton Woods system, to operate and defend. In the early 1960s, IMF programs were extended to countries as diverse as Peru, the Philippines, Spain, Syria, and the United Kingdom.57 52. Although there was also a contribution from excessively strong investment demand. 53. As part of the agreement, Germany raised interest rates and tightened import quotas, but only temporarily. 54. The EEC was an example that not only Europe itself but other regions also took to heart. See, for example, the discussion of Asia to follow. 55. It was no coincidence that Per Jacobsen, who had applied a similar approach to conditionality on behalf of the EPU, went on to the managing directorship of the IMF. 56. In 1956, its balance of payments having come under strain as a result of the Suez crisis, the United Kingdom negotiated a program with the IMF and received additional assistance from the US Import-Export Bank. France drew on the IMF late in 1956 and again early in 1958 and arranged swap lines with a consortium of European central banks. Thus, the approach where the IMF, as fair broker, negotiates the conditions but other concerned governments and banks top up the funding has a long history. And with this assistance, a growing number of countries, first within the OECD and then more widely, were able to establish and maintain Article VIII (current account) convertibility. 57. The Bank of England also drew support through the network of swaps negotiated by the Fed (discussed later in this chapter) as well as specially arranged credits from foreign central banks at various junctures in the 1960s.

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One problem not addressed by the availability of IMF assistance was dollar instability. As issuer of the global reserve currency—and given the demand for additional reserves on the part of rapidly growing catch-up economies (in that earlier context, Europe and Japan)—there was no constraint on the ability of the United States to finance its external deficits, only the possibility that financing them might require the United States to reduce the value of the dollar. But the feasibility and consequences of doing so were uncertain, feasibility because other countries might choose to follow the dollar down, preventing the bilateral exchange rate from moving (shades of China today), and consequences insofar as devaluing the dollar against gold might erode confidence in the so-called dollar- gold Bretton Woods system. Aware of their collective interest in maintaining the regime, which they saw as fostering export growth and economic growth generally, at the beginning of the 1960s a group of advanced countries established the Gold Pool, through which the European members committed to reimbursing the reserve- currency country, the United States, for a portion of its gold losses. The Gold Pool was an ad hoc rather than a formal, fully institutionalized arrangement; it had no formal constitution or articles of agreement, and its membership changed over time. Although it did not resolve the fundamental contradictions of the gold- dollar system, it bought time to seek a permanent solution. The contrast with the early 1930s is apparent. On both occasions there was an established international monetary and financial system in whose preservation the leading countries had a shared interest. But, in contrast with the high tensions of the 1930s, the principals this time were allies in the Cold War. In the prevailing climate of low inflation and buoyant growth, moreover, the gold market conditions and currency swaps on which negotiators focused could be seen as mere technical matters. And, finally, cooperation was now facilitated insofar as it was institutionalized, at least in part, through the IMF. But the Gold Pool was only a temporary expedient. Even effective holding action required more. The Fed negotiated a network of swap lines with foreign central banks; by the end of 1962 there was a total of $2 billion of swap lines between the Fed and eight central banks.58 These were utilized not just by the United States, but by Canada in 1962 and Italy in 1963– 1964. Starting in 1961, the advanced economies (the grouping that evolved into the G10) negotiated the General Arrangements to Borrow to enable countries to borrow larger amounts of their currencies through the IMF. This was necessary insofar as the restoration of convertibility increased the scope for capital flows.59 The initiative was significant in that it was not taken in response to a crisis; it was not like the four $30 billion swaps that the Fed provided to foreign central banks in 2008. Rather, it was negotiated 58. Cooper (2006, 7). 59. Convertibility may have been limited to current account, but even this enlarged the scope for capital transfers through mechanisms like misinvoicing and leads and lags.

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in advance of a possible future crisis, not unlike the global financial safety net discussed in 2010 during Korea’s chairmanship of the G20. But none of these expedients obviated the need for more fundamental reform. One venue for discussing it was the regular monthly meetings of central bankers at the Bank for International Settlements.60 Another was meetings of G10 deputies, which quickly became a regular affair under the chairmanship of the US treasury undersecretary for monetary affairs, Robert Roosa, and then Otmar Emminger, vice president of the German Bundesbank.61 The same group then created yet another venue for surveillance and discussions of reform, Working Party 3 of the OECD. To be sure, the discussions in question were not always productive. America’s partners in this endeavor, starting with France, became more assertive as their economies strengthened. The United States complained that the Europeans ganged up on it by caucusing prior to meetings. Developing countries complained that this exclusively advanced- country grouping lacked the legitimacy to reform the international system.62 Moreover, cooperation designed to preserve the existing system was easier than cooperation in reforming it. Different countries had rather different and, in some cases, ill- defined views of how to best go about that reform. The British, in need of international finance, favored issuing a new reserve asset through the IMF. The French, in a stronger balance- of-payments position, saw such issuance as inflationary and as relieving the pressure on the United States to adjust; instead it advocated a pure gold- based system. Responding to arguments that the result might starve the world of liquidity and therefore stifle trade and growth, they argued for an increase in the dollar price of gold.63 There was nothing resembling open conflict between France and the United States in this period, of course, but there was tension, over NATO and defense issues as well as monetary and financial affairs. The contrast with Germany is striking. Berlin, still the obedient ally, faithfully supported the American position.64 A further problem was that there was no American position, at least until Henry Fowler replaced Douglas Dillon as treasury secretary in mid- 1965. Fowler was skeptical that the gold- dollar system could be maintained. Departing from Fowler’s earlier reticence, he indicated a willingness to discuss international monetary reform. The resulting discussions proceeded on two 60. The United States, not yet a member, nonetheless sent senior officials to these meetings. The Gold Pool, for example, was originally an initiative of governments, but agreement on forming it was reached by central bankers meeting in Basel. 61. See James (1996, 164 passim). 62. One can perhaps detect the same kind of complaints about the arbitrary composition and less than universal nature of the Group of Twenty. 63. The question of whether the dollar price of gold could be raised repeatedly as the world economy and its need for liquidity continued to expand was not systematically addressed, at least in Paris. 64. The “obedient ally” label is from Strange (1980).

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tracks: one a Group of Ten study group under Otmar Emminger, the other in the Executive Board of the IMF. Fowler signaled his willingness to contemplate the creation of a new reserve asset. France, finding that its proposal for an increase in the gold price received no support from Germany or other European countries, reluctantly agreed. In August 1967 finance ministers recommended that the IMF should be authorized to supplement gold and dollar reserves by issuing Special Drawing Rights. But activation of the new facility was made contingent on the approval of countries holding 85 percent of voting power in the IMF, effectively giving France and its allies veto power if they sought to exercise it. There was also predictable wrangling about how the new reserve assets would be distributed. When the SDR facility was finally activated in 1970, it was too late to prevent the collapse of the system. Foreign central banks, anticipating the inevitability of dollar devaluation, scrambled out of dollars. It was a request from the Bank of England that the United States convert some of its dollar reserves into gold that prompted the Nixon administration to close the gold window in August 1971. The administration immediately imposed a 10 percent import surcharge as a way of pressuring other countries to revalue. In achieving this immediate aim it was successful; at the Smithsonian Conference in December, other countries revalued against the dollar by an average of 8 percent. But this was not one of the high points of international cooperation. Nixon’s aggressive, unilateralist tactics left hard feelings. Subsequent efforts to negotiate more farreaching reforms of the system took place under a cloud of recrimination. The so-called Committee of Twenty (one finance minister or central banker for each of the twenty country groupings represented on the board of the International Monetary Fund) sought to somehow reconcile the desire for exchange- rate stability with the need for currencies to move against the dollar, without notable success. In the spring of 1973, barely a year and a half after the Smithsonian, the new set of exchange rates so laboriously negotiated by the Committee of Twenty collapsed in a heap. There is a lesson here for those who would argue that the United States should use the threat of a tariff to extract exchange- rate concessions from China. Short- run concessions there might be, but at the cost of ability to cooperate in the longer term. The European response was to intensify cooperation at the regional level. Europe was well placed to pursue this option. Regional initiatives had been prioritized from the outset of the postwar period.65 The Treaty of Rome, establishing the European Economic Community, had identified exchange rates as a matter of common concern; it had established a Monetary Committee comprised of one representative from each central bank and one from each finance ministry, together with two members of the European 65. As we saw above.

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Commission, who met regularly to exchange notes. There was now an institutionalized basis for moving further. There had been completion of the customs union and establishment of the Common Agricultural Policy, both of which made sharp exchange- rate changes problematic. There was, in other words, an established European regime to protect. In 1970 there had been the Werner Report, recommending the adoption of a common currency within ten years. Europeans were united in their desire to create a second international monetary pole to counterbalance the dollar and to establish a zone of monetary stability in Europe. However, they were not united on how to go about it. The analytical rifts that had opened up in the negotiations over the SDR remained. France, for neither the first nor last time, sought a system in which decision- making power was shared. Germany, for its part, realized that resisting French proposals would place it in the driver’s seat. Germany’s competitive strength and commitment to price stability meant that other countries, if they wished to keep their currencies stable against the deutschemark, would have to follow the Bundesbank’s lead. None of the participants was prepared to acknowledge that stabilizing exchange rates within plus- or- minus 2.25 percent bands might require coordinating fiscal policies—not the last time this contradiction would surface in Europe. As a result, France, Britain, Denmark, Italy, and Norway were all driven out of the new exchange- rate arrangement, the Snake, in the six and a half years after its establishment in April 1972. The Europeans tried again in 1978, the dollar’s weakness in the CarterBlumenthal-Miller years lending urgency to efforts to ring- fence the continent from external instability.66 Negotiations among the members of the now- enlarged European Community had become complex, so French and German officials crafted a new plan for what became the European Monetary System bilaterally.67 Their blueprint called for 2.25 percent bands modeled on the Snake. As a sop to those worried that the new system would be German dominated, those bands were to be defined relative to a basket of currencies. There would be unlimited intervention obligations. A trigger mechanism would force strong- currency countries to loosen policy and weak- currency countries to tighten. After two years further steps in the direction of institutionalization would follow: a European Monetary Fund would be established to administer the pooled reserves of the members as a step toward a monetary union. The evolution of this proposal is revealing of yet another influence on international cooperation: domestic institutional and political constraints.68 66. The United States, to address the weakness of its balance- of-payments position, pressured Germany to stimulate demand and reduce its trade surplus; for an inflation- adverse country, this brow- beating was unwelcome. 67. This was not the last time the Franco-German axis delivered prepackaged proposals to the rest of the European Community. 68. This is a theme of Eichengreen and Uzan (1992), among others.

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A trigger mechanism requiring surplus countries to relax policy might conflict with the Bundesbank’s mandate for price stability. Comingling its reserves with those of other central banks, not all of which were insulated from their governments by statute, would threaten its independence, as enshrined in the Bundesbank law. The German central bank thus had leverage to resist demands. This fact was not entirely unwelcome to the Schmidt Government, which could invoke it in negotiations with the French. By the time agreement was reached on the form of the European Monetary System, the trigger mechanism, the reserve pool, and substituting a basket for the deutschmark as the pivot of the system had all disappeared. The Bundesbank received an opt- out from unlimited intervention obligations. There was no more talk of monetary union. After some teething problems, the EMS operated tolerably well. This had a lot to do with the readiness of the participating states to alter their exchange rates periodically, which helped to restore competitive balance. And that readiness to alter parities in turn reflected the maintenance of capital controls, which gave central banks and governments breathing space to organize realignments. One thing on which European policymakers agreed was that capital mobility was an engine of instability. Germany, otherwise a bastion of ordoliberalism, had moved in this direction in the early 1970s in the face of persistent, potentially inflationary capital inflows. This consensus, favoring limited capital mobility, eventually broke down in the 1980s in response to the same deregulatory winds that produced the Single Market. The consequences for the European Monetary System would not be good. Capital mobility was already on the rise of course, what with the deregulation of domestic financial systems and growth of the eurodollar market. Europe may have been able to limit capital flows, but it could not suppress them entirely. The Herstatt crisis in 1974 revealed the extent of foreignexchange exposures and the fickleness of foreign exchange market liquidity, directing the attention of central bankers and other regulators to the importance of adequate capital for internationally active banks; this led, ultimately, to the Basel Concordat of 1975 and then the Basel Capital Accord, negotiated by what was then the G10-based Basel Committee of Banking Supervision.69 The recycling of petrodollars into syndicated bank loans to Latin American sovereigns was yet more evidence of the progressive regeneration of international capital markets. This was another experience that did not turn out swimmingly. The Latin American debt crisis developed as follows. The region’s pegged exchange rates created false confidence that credit risk had been removed. Financial 69. The Basel Accord is interpreted as a prime instance where institutionalized interaction led to the development of an intellectual consensus among key decision makers on how precisely policies should be coordinated (Kapstein 1989).

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capital then flooded into the region, creating an enormous governmentborrowing and private- consumption boom. Boom conditions meant inflation, translating into a cumulative loss of competitiveness. In 1982, following a recession in the United States, the onset of a housingrelated banking crisis in that country, and revelations of problems in one of the heavy borrowers (Mexico), capital inflows ground to a halt.70 Underlying problems of sustainability were revealed. The initial approach to the crisis, a cooperative effort on the part of the United States and Europe, was to urge fiscal consolidation and wage austerity while providing sovereigns with bridge finance in the hope that they would regain their creditworthiness. Cooperation was facilitated by the fact that there existed an international institution, the IMF, that could be adapted to this purpose and in which the advanced countries were, conveniently, the principal shareholders.71 The IMF provided a regular venue for the negotiation of conditionality. Details were delegated to its experts, whose extended deliberations went some way toward forging an intellectual consensus. By 1983, roughly three- quarters of Latin American countries were under some kind of IMF program. This play- for- time strategy worked to the advantage of recessionweakened money- center banks, whose balance sheets would have been seriously impaired by write- downs. In the presence of debt overhangs, however, it was impossible to jumpstart growth. Only at the end of the 1980s, by which time the money- center banks had strengthened their balance sheets, were those overhangs finally removed through a market- based debt exchange of the outstanding bank loans for a menu of tradable bonds collateralized by zero- coupon, thirty- year US treasury securities purchased by the country using IMF and World Bank resources (as well as its own reserves).72 Removing the debt overhangs resolved the crisis by enabling growth to resume. With benefit of hindsight, it would have been better to get to this point in less than seven years; not for nothing are the 1980s known as Latin America’s lost decade. But getting there faster would have required the Americans and Europeans to use resources channeled through the IMF and World Bank to instead recapitalize their own financial institutions, so that they would have been resilient to debt write- downs in Latin America.73 The other challenge posed by capital mobility for international economic policy was its tendency to accentuate movements in the major currencies when policy in the large economies diverged. The early 1980s saw sharp shifts in US policy: first the Volcker shock, which saw the Fed raise policy rates 70. The banking crisis in question was, of course, centered in Savings & Loans. 71. It is important to recall that this was not the purpose for which the IMF had been established; rather, the institution had to be reinvented in order to provide the structure for a coordinated response to the debt crisis. 72. This was the Brady Plan, named after the US treasury secretary associated with it. 73. To those who wish to accuse me of pushing the parallels with peripheral Europe, I plead guilty. The big difference in Latin America was that adjustment also entailed devaluation, although as 1980s experience revealed, devaluation without debt restructuring was no panacea.

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to very high levels in order to wring inflation pressures out of the economy (the Fed funds rate was raised to 21 percent in June 1981); and then the Reagan tax cut (the Economic Recovery Act of 1981), which stimulated domestic spending. Some argued that the combination was the least- cost way of bringing down inflation while avoiding output losses.74 But an inadvertent consequence was to put upward pressure on the dollar by increasing spending on home goods and attracting capital from abroad. By 1984 the overstrong dollar had become a burden for US manufacturing, leading to talk that the Midwest was being turned into a “Rust Belt.”75 In crafting a response, the Reagan administration was hamstrung by its commitment to laissez- faire and to not intervening in the foreign exchange markets in particular. Starting in 1984 it therefore launched a so-called yen/ dollar campaign to bring down the US deficit, moderate the rise in the dollar, and stimulate US manufactured exports, all by pressuring Tokyo to liberalize its financial markets and encourage capital to flow toward Japan. The premise—that liberalization would encourage capital inflows rather than further outflows toward an America where real interest rates were higher— was dubious from the start. Japan’s modest further steps at liberalization did not prevent the dollar from rising by a further 20 percent between mid- 1984 and early 1985. At this point, the overstrong dollar became a major political issue. Protectionist rumbling from the US Congress intensified. Changes in personnel (James Baker and Richard Darman replaced Donald Regan and Beryl Sprinkel at the US Treasury) moved the administration in a more pragmatic direction, enabling it to act on the problem. At the first G5 meeting attended by Baker and Darman in January 1985, it was agreed to intervene in the foreign exchange market; German sales of dollars in response were extensive. Then in September, at the Plaza Hotel in New York, G5 ministers announced their desire for the “further orderly appreciation of the non- dollar currencies.”76 Concerted sales of dollars in London, Frankfurt, Tokyo, and New York followed. Over the course of 1985, the dollar reversed course. Whether this was international policy cooperation successfully eliminating a fundamental imbalance is disputed. Some who regarded the dollar’s further rise in the second half of 1984 as a bubble interpreted what happened in 1985 as simply the tendency for bubbles to burst—for market excesses to correct themselves. Others saw statements of resolve to see “orderly appreciation of the nondollar currencies” and coordinated intervention in foreign exchange markets as signaling an actual commitment to modify future policies.77 The problem 74. Recall Sachs (1985). 75. Google’s Ngram Viewer indicates that the phrase first appeared in 1981, though the number of mentions took off around 1985. 76. Frankel (1994, 304). 77. See, for example, Cooper (2006).

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with this second interpretation was that there was little in actual change in policies. Treasury Secretary Baker continued to push for Germany, Japan, and other countries to expand their economies, but to little avail. The main way in which US policymakers were able to advance their central goal of boosting exports was by talking down the dollar. The G5 as an institutionalized venue for cooperation had the advantage of regularity. But like the Gold Pool before it, participation entailed no formal obligations for members, who could be reluctant when inconvenienced to deliver on their promises. In this instance, the open- mouth operations of Baker and his colleagues were more than successful. By late 1986 the problem for Japanese and German exporters had become an overly weak dollar rather than a strong one. There was then another effort to coordinate policies, this one with impetus from outside the United States. Japanese and US finance officials met bilaterally in San Francisco late in the year, the US side agreeing to intervention in support of the dollar in return for Japan agreeing to fiscal expansion. This may have been the first time that an agreement on international policy coordination entailed an agreement to adjust fiscal as well as monetary policies, fiscal adjustment in the international interest being more difficult in that the policy was not delegated by parliaments and congresses to central banks.78 In February 1987, at the next meeting of G5 finance ministers and central bank governors (plus those of Canada) at the Louvre, it was agreed that the dollar would be stabilized “around current levels,” in return for which Japan would again expand public spending and Germany and the others would cut taxes. The United States, as agreed, intervened heavily in an effort to support its exchange rate. This second agreement, like its 1985 predecessor, received mixed reviews. The dollar continued to weaken for much of 1987 before stabilizing in 1988, again raising questions about whether official pronouncements really mattered for foreign exchange markets. Dollar stability starting in 1988 did not mean economic stability; in 1990 the United States slid into recession. Monetary ease and fiscal stimulus, Japan’s contribution to international coordination, were a mixed blessing for its economy. It is said that this effort to rebalance spending away from the United States and toward Japan fed the bubble whose subsequent collapse inaugurated Japan’s lost decade. The story is not unlike that of the impact of loose Fed policy designed to strengthen the pound sterling in 1924– 1925 in feeding the subsequent bubble on Wall Street (explained earlier). Again, however, there are reasons to question the linkage. Japan’s bubble mainly resulted from the development of 78. There had been previous international commitments to adjust fiscal policies as a condition of receiving Marshall aid in the 1940s and IMF assistance subsequently, but whether these are properly regarded as instances of international policy coordination is arguable. The Carter administration in its final years had argued for fiscal expansion by Germany and Japan (an argument that came to be known as the “locomotive theory”; see Bronfenbrenner 1980), but it did not secure the policy adjustments in Germany and Japan that it sought.

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the country’s securities markets, which gave large corporate borrowers an alternative to bank funding, and the subsequent rush of the banks into real estate–related lending (a fateful decision compounded by the failure of the regulators to take preemptive action). The bubble burst not because US pressure for yen appreciation destroyed the Japanese export sector, which held up relatively well, but simply because bubbles do not last forever. The lost decade resulted not from monetary- and fiscal- policy decisions taken in 1985– 1987, but from the failure of the Japanese authorities to head off first the banking crisis and then deflation.79 Be that as it may, none of these outcomes constituted a ringing endorsement of this kind of coordination. It would be quite a while before something similar was tried again. Policy coordination in the last decade of the twentieth century, like the first, was organized in response to crises and designed to preserve a prevailing regime of open capital markets. In the century’s last decade, like its first, that regime was regional as well as global: where the crisis problem at the outset of the century centered on the North Atlantic, the regime- threatening crises of the century’s end were centered in Europe (1992– 1993), North America (1994– 1995), and East Asia (1997– 1998).80 The first one was an entirely European affair.81 The German reunification boom implied that the prices of German goods had to rise relative to those of other European countries.82 The Bundesbank was reluctant to see this happen through domestic inflation, leading it to raise interest rates repeatedly in 1991 and 1992. Other central banks were equally unwilling to see the adjustment occur through deflation; they hesitated to tighten and bring down their inflation relative to Germany’s, in other words. The result, ineluctably, was the need for exchange- rate changes whether the authorities liked it or not.83 But exchange- rate changes were more difficult to arrange now that all but a few capital controls had been removed as a consequence of the advent of the Single Market. Orderly realignments had grown difficult, so policymakers convinced themselves that they were unnecessary; this was the realignment- free “new EMS” of the post- 1987 years. But absent faster in79. On this subject, see Corbett and Ito (2010). 80. One might also add the Brazilian crisis of 1998 and the Argentine crisis of 2001 to this list, but one chapter cannot cover everything. 81. Although the weakness of the dollar in this period when the United States was only beginning to recover from recession may have played a subsidiary role in the crisis by channeling funds mainly into Germany, whose financial market was the main alternative to the United States, and strengthening the deutschmark relative to other European currencies (in the phenomenon known as dollar- deutschmark polarization). 82. German households spending disproportionately on German goods. 83. The parallels with the choice facing US and Chinese policymakers as China continues to encourage the growth of domestic spending are not incidental.

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flation in Germany and slower inflation elsewhere, it was not clear how adjustment could be accomplished. Ineluctably, competitive pressures built up. They spilled out in August 1992 when George Soros’ big bet against the pound sterling became a focal point for speculative activity. European leaders engaged in desperate, if less than wholly successful, efforts to resolve the crisis. Central bankers stayed in continuous contact. There were the increasingly acrimonious meetings of the Economic and Financial Affairs Council (ECOFIN).84 There were supplementary meetings, like that between French treasury secretary Jean-Claude Trichet and senior German officials on the sidelines of the World Bank–IMF meetings in September. As a result, Germany supplied the Bank of France with additional credits and the Bundesbank finally cut money- market rates. Institutionalized and ad hoc venues for fostering a cooperative response were utilized in tandem in this instance. But this level of institutionalization neither succeeded in producing an intellectual consensus nor compelled central banks and governments to adjust domestic policies as necessary for stable exchange rates. Cooperation was stymied by German insistence that the adjustment burden rested on the weak- currency countries and that it was under no obligation to cut interest rates to ease the pressure on its EMS partners, and equally by the reluctance of those partners to raise interest rates to support their currencies.85 Efforts to cooperate were politicized: British politicians worried about the impact of higher interest rates on homeowners with variable- rate mortgages, and their German counterparts shied away from anything that might be seen as tarnishing their overarching commitment to price stability. The upshot was that Britain and Italy were ejected from the Exchange Rate Mechanism (ERM), while Spain, Portugal, and Ireland were forced to realign.86 The crisis migrated next to a big country, France, in the summer of 1993. Again the sticking point was whether it would be met by France raising rates or Germany lowering them. There came a point where the German finance minister, knowing the arguments and pressures to which he would be subjected, refused to meet with his French counterpart. In August European leaders conceded the inevitable and widened the ERM’s plus- or- minus 2 1/4 percent bands to 15 percent. The lesson drawn, if not universally, was the need to further institutionalize policy coordination. Relying on national central banks to peg exchange rates between national currencies was not enough; rather, it was necessary to create a Euro84. Culminating in the debacle in Bath in late August. 85. The cut in rates in support of the Bank of France in September was an exception. Earlier, UK Chancellor of the Exchequer Norman Lamont is said to have badly badgered his German counterparts at an EU summit in Bath, browbeating them on the need to loosen and all but causing them to walk out on the meeting. Eichengreen and Wyplosz (1993) discuss reasons for reluctance to raise rates in countries like Britain and Italy; some countries, such as Sweden (not officially an EMS member), should of course be exempted from this indictment. 86. Sweden, for its part, was forced to abandon its policy of shadowing the ERM.

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pean central bank and a single European currency, as foreseen in the Delors Report in 1989 and endorsed in the Maastricht Treaty of 1992. Germany, for its part, insisted on further institutionalizing fiscal discipline by adding a Stability and Growth Pact. The alternative, pursued by Britain and Sweden, was to abandon the commitment to pegging exchange rates as an alternative to more extensive monetary and financial cooperation. The next in the series, the Mexican crisis of 1994–1995, was labeled by IMF Managing Director Michel Camdessus as the first financial crisis of the twenty- first century.87 The characterization was apt in that Mexico’s was fundamentally a banking crisis fueled by rapid credit growth, lax lending standards, and low interest rates.88 That boom was made possible by the restructuring of debt under the Brady Plan, which restored Mexico’s access to international capital markets and produced a deceptive surge in foreign reserves. It also was made possible by the country’s entry into the North American Free Trade Agreement (NAFTA) and accession to the OECD, which led many to believe that Mexico had embarked on a period of rapid growth, that credit and country risk had receded, and that interest rates would come down.89 As in Ireland or Spain ten years later, this was not fundamentally a crisis of fiscal profligacy but a private- spending, bankcredit- led boom.90 To be sure, the sovereign added another layer of risk, 1994 being an election year, by funding itself short- term using instruments known as tesobonos.91 It then took only a peasant rebellion in the province of Chiapas, combined with higher world interest rates, to bring the house of cards tumbling down. This put the problem squarely in the lap of the newly elected government of Ernesto Zedillo. Almost immediately the new president devalued by 15 percent, but this helped neither firms, with debts in dollars, nor the government’s own finances, given the tesobono problem, nor the banks, given their exposures to both sectors. The short tenor of bank and government debt meant that there was nothing to prevent investors from running.92 And the fears of those who ran could become self- fulfilling. Reserves continued to dwindle, and the government was forced to stop supporting the currency. The latter then lost nearly half its remaining value in a week, further damaging the balance sheets of firms, banks, and the public sector. 87. Camdessus (1995). 88. These kinds of problems would become evident again in the first decade of the twentyfirst century, first in the United States and then in Europe. 89. Not unlike what was said of countries like Italy when they adopted the narrow bands of the EMS in 1990 or what was said of countries like Spain and Greece when they adopted the euro. 90. The consolidated public sector balance had improved from a deficit of 11 percent of GDP in 1988 to a 1 percent of GDP surplus in 2004 (Calvo and Medoza 1996), although there were some questions about uncounted fiscal skeletons (about the implicit liabilities of parastatals and the like). 91. Instruments that were denominated in pesos but indexed in dollars. 92. Not even capital controls, which were now ruled out by NAFTA.

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The manner in which the Mexican crisis was handled is instructive, for it provided the template for subsequent interventions. The IMF, with heavy input from the United States, negotiated a $17.7 billion standby agreement with the Mexican government. The United States then topped up the package with $20 billion of loan guarantees and currency swaps provided through the Exchange Stabilization Fund.93 At least the appearance of delegation to the technical experts of the IMF made reaching agreement easier for all concerned. After contracting by 7 percent in 1995, the Mexican economy recovered on the back of the rising tide of exports made possible by currency depreciation, austerity measures to restore confidence, and a tolerably efficient bank cleanup. Painful, to be sure. Not without contagion to, among other places, Argentina. But a model had been created for how to organize international cooperation in rescuing other countries. The next opportunity to apply it was in 1997– 1998. The Asian crisis remains difficult to generalize about. The problems of Thailand, Indonesia, and South Korea were all rather different. But once more the crisis, as it manifested itself in different countries, had important elements in common. It was fed by an enormous investment boom. Much of this investment was of dubious productivity, whether in the form of commercial real estate in Thailand or industrial capacity unrelated to the firm’s core competency in South Korea. Recall that this was the heyday of the “Asian Miracle,” when rapid growth was associated with unprecedentedly high levels of investment.94 Across Asia, there was a preoccupation with the quantity of investment to the neglect of its quality. Finance was channeled into investment projects, with official encouragement or acquiescence, by banks to which the firms in question (along with their governments) were connected. Banks funded their lending by borrowing offshore, short- term, in foreign currency—exposing them to reversals in the direction of capital flows.95 Foreigners were willing to lend to their Korean counterparts because stable exchange rates eliminated the perception of currency risk, and because they believed that the Korean government would guarantee bank liabilities in the event of difficulties. In practice, however, stable exchange rates could become unstable, and the capacity to backstop the liabilities of the financial system, increasingly denominated in dollars, was limited by the authorities’ international reserves. In Thailand these imbalances, together with the fact that the country was running a current account deficit of 8 percent of GDP, made the denouement no surprise; the IMF had repeatedly warned the Thai government of impending problems, and high IMF officials traveled to Bangkok to press the case for adjustment. But with economic growth running at 6 percent 93. In addition, Canada provided $1 billion of swaps, and the BIS added a $10 billion credit. 94. The World Bank had published its book by that title in 1993 (World Bank 1993). 95. In the Indonesian case, enterprises bypassed domestic banks and borrowed directly offshore.

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on the back of buoyant construction activity, the markets did not press the issue.96 Then, however, the growth of export revenues decelerated, reflecting a slowdown in the global electronics industry and the intensification of competition from China. There was the rise of the dollar against the yen, which aggravated problems of overvaluation due to the maintenance of dollar pegs in the region. This is probably the best we can do in terms of explaining the timing of the crisis. Its contagious spread reflected the violent revision of expectations; there was a tendency to think that what was true of Thailand—investment had been unproductive, the government lacked the capacity to guarantee their banks’ foreign liabilities, self- dealing among insiders was widespread, and the exchange rate was not really fixed—was equally true of other Asian countries. Contagion also operated through the common- creditor channel: highly leveraged foreign financial institutions taking losses in one Asian country were forced to sell their assets in other countries to restore capital adequacy and liquidity. International efforts to limit the spread of the crisis were again spearheaded by the IMF. The size of the Asian rescues was unprecedented, reflecting the implications of growing capital mobility and international liquidity.97 As in Mexico previously, IMF funding was topped up by other multilaterals (in this case the World Bank and Asian Development Bank) and by a second line of defense from a group of foreign governments led by the United States.98 Conditionality was again in the Mexican mold: it emphasized interest rate hikes to attract back flight capital, fiscal retrenchment, and bank and corporate restructuring. Those viewing the problem as essentially a liquidity crisis argue that the IMF should have provided more ample funding without requiring draconian interest rate hikes and fiscal cuts, while others who see also the presence of solvency problems insist that painful monetary and fiscal measures were unavoidable. Questions also continue to be raised about why the IMF did not press earlier for privatesector involvement—for foreign banks to first roll over their loans and then exchange their claims on Asian banks for government- guaranteed discount bonds in the manner of the Brady Plan.99 In the fall of 1997, Japanese finance ministry officials proposed an Asian 96. There were, however, three speculative selloffs of the baht in the nine months leading up to the crisis. 97. Unprecedented, that is, at the time. 98. This happened in cases like South Korea, where the need for financing was large. 99. This was done eventually in some countries (e.g., Korea), but only in 1998. The argument that private- sector involvement was not possible earlier is that the banks had to appreciate the gravity of the crisis—they had to see that their backs were to the wall and that they would not be able to liquidate their claims and escape whole—before they would agree to being involved in this way. There had been no analogous private- sector involvement in the Mexican rescue, but that episode created an awareness of its desirability and of the need for mechanisms for facilitating it. The result was the Rey Report in 1995, for which Eichengreen and Portes (1994) provided input.

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Monetary Fund to organize the mobilization of funding within the region.100 The proposal quickly fell afoul of US and IMF objections. This dispute is generally interpreted in geopolitical terms: the United States was the much larger and more influential shareholder in the IMF, whereas the opposite would have been true of an Asian Monetary Fund. But there were also economic interests at stake. Japan had relatively high levels of bank exposure to emerging Asia, and Japanese exporters would be disproportionately hit by a recession in the region. It therefore preferred the generous provision of liquidity.101 The United States and Europe were less economically and financially exposed and more preoccupied by the moral hazard that would result from the generous provision of liquidity and duplication of IMFled rescue efforts. While the proposal for a regional monetary fund went nowhere, the notion would resurface soon enough. The Asian crisis and international response had two further implications.102 First, it led to the convening of three study groups on strengthening the international financial architecture under the aegis of an ad hoc grouping of twenty- two advanced and emerging markets—the crisis having shown the emerging markets were now too systemically significant to be denied a seat at the high table. This grouping, the Group of Twenty-Two (G22), which eventually evolved into today’s Group of Twenty, issued three reports in 1998. The first, on transparency and accountability, emphasized the need for disclosure as a means of strengthening market discipline.103 The second, on financial systems, emphasized the need to strengthen supervision and regulation of financial institutions and to develop securities markets as an alternative to bank finance. The third, on managing financial crises, emphasized the importance of limiting implicit government guarantees and ensuring private- sector participation in rescues. These three reports formed, to a considerable extent, the expert consensus forming the basis for subsequent efforts at international financial cooperation.104 The other implication was the rise of regional cooperation, especially in Asia. The role of the IMF and the US government in the Asian crisis was not recalled happily. The crisis also underscored the extent of regional economic interdependence, something that was then reinforced by the rise of China and the further elaboration of regional supply chains and production networks. 100. Where the Japanese government would presumably have provided the bulk of the finance and consequently had a disproportionate impact on decision making. 101. On this see Lipscy (2003). Other Asian countries were generally supportive (how could they oppose a proposal that promised more generous financial assistance at less onerous cost?), although some worried about the implications of Japanese dominance of the new regional entity. 102. Not unrelated to one another. 103. Lack of information on the situation in, among others, Thailand and South Korea has been shown to allow the accumulation of additional risks. 104. Although there remained (and remains) considerable difference of opinion as to how successfully their respective agendas were pursued.

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Southeast Asia already had a nascent regional entity in place, the Association of Southeast Asian Nations (ASEAN). In 1999 a more encompassing grouping, ASEAN+3 (ASEAN plus China, Japan, and South Korea) was organized around this core. ASEAN+3 provided the basis for initiatives to develop securities markets like those that had been recommended by the second of the three G22 reports. ASEAN+3 was also the platform for the Chiang Mai Initiative, essentially the Asian Monetary Fund proposal reformulated to address the issues of moral hazard and conflict with the IMF (by making drawing after the first 20 percent contingent on a country first negotiating a program with the IMF) and potential Japanese dominance (the rise of China allowing Japan and China to have equal voting shares).105 After the turn of the century, the locus of financial risks began to shift, although just how was not adequately appreciated at the time. The period following the end of the high- tech bubble and the 2000– 2001 recession in the United States saw the progressive widening of global imbalances. Current account surpluses and deficits are entirely natural, of course.106 But what seemed unnatural was that one country, the United States, now accounted for the vast majority of global current account deficits. It always could (and not infrequently was) argued that this situation reflected the fact that the country’s flexible economic structure positioned it favorably to capitalize on the new generation of information technologies.107 In this view, the high consumption rates of American households reflected realistic expectations of higher expected future incomes, while the excess of investment over saving reflected the productivity of investment in the United States, which was attractive to foreign as well as domestic savers. But there was also a darker view, which saw high American spending as reflecting distortions: the Bush tax cuts, the Fed’s deviation from the Taylor rule, income inequality, and abundant cheap foreign finance flowing into US treasury and agency markets. At some point, foreign investors full to the gills with dollar- denominated securities would pull the plug. This would mean a sharp fall in the dollar, catching highly leveraged investors on the wrong foot. It would mean a sharp rise in interest rates, compressing activity in interestrate- sensitive sectors. It would mean an equally severe recession in other, export- dependent countries. It was this crisis of global imbalances, not the crisis that we actually had in 2007– 2009, of which the soothsayers warned.108 Statistical discrepancies notwithstanding, global current deficits have to be matched by surpluses. Unlike the situation on the deficit side, where one 105. The Chiang Mai Initiative was announced at the Asian Development Bank meetings in, appropriately, Thailand in April 2000; the voting shares were agreed to only with the multilateralization of its bilateral swap and credit lines at the end of the decade. 106. As explained in textbook models of optimal saving and investment behavior. 107. See, for example, Cooper (2004). 108. See Roubini and Setser (2005).

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country dominated, no single country or group of countries dominated in terms of surpluses. Three groups were of roughly equal importance: China and other emerging Asian markets, the oil exporting countries, and Germany and Japan. In China and elsewhere in emerging Asia, chronic surpluses reflected the desire to accumulate foreign reserves following the traumatic experience of 1997– 1998 and a strategy of export- led growth that required ongoing intervention to limit the appreciation of local currencies. For oil exporters it reflected the bonanza associated with the fastest global growth in more than three decades. In Germany and Japan it reflected the successful restoration of export competitiveness in combination with weak domestic demand. It was this potential crisis that preoccupied summits of the G20, the grouping that progressively superseded the G7/8 as the institutional platform for policy coordination as the decade progressed. This potential crisis also preoccupied the IMF executive board. In addition, it was the subject of the IMF’s first “multilateral consultation” in 2006– 2007, an initiative under which a handful of countries (the United States, the euro area, China, Japan, and Saudi Arabia) was brought together to discuss mutually advantageous adjustments in policies. The idea was to build an intellectual consensus among key decision makers on the nature of the problem and what needed to be done to address it. This was to be accomplished by institutionalizing regular consultations in which the IMF was to act as referee and provide technical assistance. The problem of global imbalances was technical, but it was also political; progress presupposed changes in politically charged issues such as the US budget deficit and the Chinese exchange rate. The result was a report to the executive board of the IMF in which the United States acknowledged the need for “further fiscal consolidation” and China acknowledged the need for “further improvement” of its exchange- rate regime, after which they and other countries returned to doing precisely what they had done before. It should be noted that the 2006– 2007 strategy remains pretty much the way the international policy community now proposes to deal with the risk of a disorderly correction of global imbalances. The difference is that instead of one- off consultations, there is now an ongoing, increasingly institutionalized process. Instead of Multilateral Consultations, we speak of a “Mutual Assessment Process” in which G20 members share policy plans and offer projections for the performance of their economies, while the IMF as fair broker addresses consistency issues and shows how mutually advantageous policy adjustments can produce a superior “alternative policy scenario.” Just how this process, which focuses on building intellectual consensus among officials, will succeed in overcoming domestic resistance to, among other things, fiscal consolidation in the United States and currency appreciation in China is not clear. One response is that the IMF should speak more forcefully when it sees countries pursuing inconsistent policies and resisting

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mutually advantageous policy adjustments. The G20 has provided cautious support for this idea in its summit communiques.109 But the IMF remains reluctant to bite the hand that feeds it; we have yet to see it launch withering critiques of Chinese currency manipulation and US fiscal profligacy. And the record of countries, large countries in particular, bowing to the will of the IMF is not encouraging. International efforts in response to the 2007– 2009 financial crisis are the subject of other chapters in this conference volume, but this one would not be complete without at least a brief attempt to situate them in the broader historical sweep. On the positive side, there have been swap agreements among central banks and governments across the Atlantic and between the Fed and a quartet of emerging markets designed to alleviate shortages of dollar (and, in some cases) euro liquidity. That this cooperation is technical and undertaken by independent central banks has facilitated its extension, although this has not wholly insulated it from political controversy.110 After the collapse of Lehman Brothers, there was the joint commitment of G20 leaders not to permit the disorderly failure of another systemically significant financial institution. There was the agreement of G20 countries in 2009 to go for internationally coordinated fiscal stimulus, designed to avoid an outcome where some countries would free ride on the stimulus of others. There was the commitment in successive G20 communiques to resist succumbing to a protectionist response to the subsequent recession.111 This is an example of the point that cooperation to preserve an existing regime, in this case a regime of relatively free and open trade, is easier to organize than cooperation to create a new system.112 And having the G20 as an increasingly institutionalized forum for these deliberations has clearly been a positive. On the negative side of the ledger, there was the failure of regulators in different countries to communicate adequately with one another (or at least to understand the content of that communication until it was too late) that precipitated the disorderly collapse of Lehman Brothers. There was the failure to more closely coordinate fiscal stimulus (as opposed to simply agreeing on the desirability of stimulus); this could have allowed countries with ample fiscal space to do more while others lacking such space did less, providing the same boost to global demand while avoiding the problems of overindebtedness with which some sovereigns are now saddled. There was the failure 109. The alternative, suggested by the US Treasury, of setting specific thresholds (of plus or minus 4 percent) for acceptable current account surpluses and deficits and committing to take corrective action in the event of their violation was not agreed upon at Seoul. 110. Especially in the United States. 111. Which was mostly honored. 112. Compare efforts under the French presidency of the G20 to create a “new” international monetary regime.

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to internalize the implications of measures taken to stabilize one country’s banking system on neighboring countries (recall the initial impact of the Irish bank guarantee). To this, observers in emerging markets would add the Fed’s failure to take into account the impact of its low- interest- rate policies and second round of quantitative easing on other countries.113 But there is no disputing that the inability at the Seoul G20 summit in November 2010 to agree on what constituted mutually beneficial adjustments in monetary and fiscal policies left potential gains from policy coordination on the table. Observers of Europe, for their part, would want to add instances where EU member states failed to adequately coordinate their policies in the run-up to the current crisis and then in response to it. Enumerating those failures would require another paper. For present purposes, I would note that that international efforts to cope with the consequences were in the mold set by the Mexican and Asian crises: emergency funding was provided by the IMF in combination with national governments; fiscal austerity was required of the supplicants and negotiated with the IMF; and debt restructuring was not part of the initial adjustment strategy, since it would have undermined the position of financial institutions in the creditor countries. It is hard to know whether Basel III should be placed on the success or failure side of the ledger. Logic and experience both suggest that progress in strengthening financial institutions and markets cannot be achieved through unilateral national action alone in a financially interconnected world. National governments acting alone cannot be expected to internalize all the negative implications of domestic financial instability on foreign markets. The temptation to underregulate in the quest for market share will remain in the absence of international cooperation. Regulators evidently understand both these facts and the urgency of their task. That Basel III was produced in a fraction of the time of Basel I and II speaks to the advantages of an institutionalized process and the scope that exists for coordinating policies when the latter are technical and delegated to experts. Among the provisions of Basel III are measures to strengthen capital, liquidity and risk- management standards for financial institutions, plans to render the capital- adequacy regime less procyclical, widen the regulatory perimeter, and reduce counterparty risk, with the goal of preventing another crisis like the one through which we have just suffered. There is also a less favorable reading of Basel III. While the issues were highly technical and delegated to experts, there were far from apolitical. Private financial institutions that anticipated being negatively affected by new regulations were able to enlist their nations’ representatives on the Basel Committee to water down the measures. The initial proposal for increasing the ratio of common equity to risk- weighted assets to 8 percent was scaled 113. Although I myself have doubts about whether this is in fact an example of coordination failure (Eichengreen 2011b).

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back to 7 percent at the behest of countries whose banks were exposed to Greek debt.114 The new higher capital requirements mandated under Basel III will not go into full effect for eight years—an eternity from the perspective of financial stability. This works to the favor of countries whose banks are poorly capitalized. The simple leverage ratio that will supplement these new higher capital requirements will similarly not go into effect for a period of years and has been set at high levels, which works to the advantage of countries in both Europe and Asia, where banks are highly leveraged.115 The same is true of the new liquidity requirements, which have been watered down at the behest of countries whose banks rely on short- term wholesale funding. There has been no agreement on alternatives to banks’ internal models as a basis for gauging risk. There has been no agreement on how to share losses across countries when a large global bank fails (no resolution regime). There has been no agreement to ban over- the- counter transactions in derivative securities whose bespoke nature prevents them from being traded on exchanges or netted through central clearinghouses, reflecting the profitability to banks of their origination. Cooperation in the pursuit of financial reform is ongoing; the eventual outcome of current efforts is not yet known. What is known is that even technical aspects can become politicized. Mancur Olsen’s point that concentrated interests tend to mobilize most effectively applies powerfully in this context.116 Where concentrated interests oppose the efforts of governments to coordinate policies, doing so remains an uphill fight. The preceding historical review underscores the points made in the introduction but also serves to temper them. It lends support to the view that cooperation to preserve a regime, through emergency financial assistance, among other things, is more prevalent than cooperation in implementing a new regime, reflecting the international policy community’s investment in the prevailing system. But it has also pointed to instances where cooperation to preserve an existing system has failed and to a few notable instances of successful cooperation in developing a new one. It has documented the advantages of institutionalizing policy coordination by establishing rules of the road for internationally acceptable policy, creating norms and expectations, and providing a structure for the regular interaction of national policymakers, but has also shown that institutionalization—whether meant informally as a set of norms or formally as a standing organization—is no guarantee of success. It has fleshed out the argument that policy coordination is most likely when governments collaborate on a range of issues, non114. With the support of Canada, whose banks insisted that they should not be “punished” as a result of a crisis in which they were not involved. 115. The proposed leverage ratio at the time of this writing is 3 percent, although this is subject to future review. 116. See Olsen (1965).

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economic as well as economic—when they are friends rather than foes. But there are also examples of countries on delicate political terms—Britain, France, and Germany in 1907, for example—collaborating with one another on specific financial problems. And while coordinating policies tends to be easiest when these problems are technical and can be delegated to specialists who share a common outlook and are insulated from politics, such insulation is by no means guaranteed, especially when the outcome matters for concentrated interests. Is there scope for doing better? Clearly, yes. But nobody said it would be easy, and nobody was right.

References Ahamed, Liaquat. 2009. Lords of Finance: The Bankers Who Broke the World. New York: Penguin. Bayoumi, Tamim, and Barry Eichengreen. 1997. “The Stability of the Gold Standard and the Evolution of the International Monetary Sytem.” In Economic Perspectives on the Classical Gold Standard, edited by Tamim Bayoumi, Barry Eichengreen, and Mark Taylor, 165– 88. Cambridge: Cambridge University Press. Bronfenbrenner, Martin. 1980. “On the Locomotive Theory in International Macroeconomics.” Weltwirtschaftsliches Archiv 115:38– 50. Calvo, Guillermo, and Enrique Mendoza. 1996. “Mexico’s Balance- of-Payments Crisis: A Chronicle of a Death Foretold.” Journal of International Economics 41:235– 64. Camdessus, Michel. 1995. “Drawing Lessons from the Mexican Financial Crisis: Preventing and Resolving Financial Crises: The Role of the IMF.” May 22. Available from www.imf.org. Clarke, Stephen V. O. 1967. Central Bank Cooperation, 1924–1931. New York: Federal Reserve Bank of New York. Cooper, Richard. 1989. “International Cooperation in Public Health as a Prologue to Macroeconomic Cooperation.” In Can Nations Agree?, by Richard Cooper, Barry Eichengreen, Gerald Holtham, Robert Putnam, and Randall Henning, 178– 254. Washington, DC: Brookings Institution. ———. 2004. “US Deficit: It Is Not Only Sustainable, It Is Logical.” Financial Times, October 31. ———. 2006. “Almost a Century of Central Bank Cooperation.” BIS Working Paper no. 198, February. Bank for International Settlements. Corbett, Jenny, and Takatoshi Ito. 2010. “What the US and China Should Learn from Past US–Japan Conflict.” VoxEU, April 30. Available from www.voxeu.org. Cox, Gary, and Matthew McCubbins. 2001. “The Institutional Determinants of Economic Policy.” In Presidents, Parliaments and Policy, edited by Stephan Haggard and Matthew McCubbins, 21– 63. Cambridge: Cambridge University Press. Dell, Sidney. 1981. “On Being Grandmotherly: The Evolution of IMF Conditionality.” In Essays in International Finance, International Finance Section, Department of Economics, Princeton University. Diamond, Douglas, and Philip Dybvig. 1983. “Bank Runs, Deposit Insurance and Liquidity.” Journal of Political Economy 91:401– 19.

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Eichengreen, Barry. 1992. Golden Fetters: The Gold Standard and the Great Depression, 1919–1939. New York: Oxford University Press. ———. 1994. Reconstructing Europe’s Trade and Payments: The European Payments Union. Manchester: Manchester University Press. ———. 2011a. Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System. New York: Oxford University Press. ———. 2011b. “Mr. Bernanke Goes to War.” The National Interest 111:6– 15. Eichengreen, Barry, and Richard Portes. 1994. Crisis, What Crisis? Orderly Workouts for Sovereign Debtors. London: Center for Economic and Policy Research (CEPR). Eichengreen, Barry, and Marc Uzan. 1992. “The 1933 World Economic Conference as an Instance of Failed International Cooperation.” In Double-Edged Diplomacy: The Logic of Two-Level Games, edited by Peter Evans, Harold Jacobson, and Robert Putnam, 171– 206. Berkeley: University of California Press. Eichengreen, Barry, and Charles Wyplosz. 1993. “The Unstable EMS.” Brookings Papers on Economic Activity 1:51– 144. Washington, DC: Brookings Institution. Endres, Anthony, and Grant Fleming. 2002. International Organizations and the Analysis of Economic Policy, 1919–1950. New York: Cambridge University Press. Estevadordal, Antoni, Brian Franz, and Alan Taylor. 2002. “The Rise and Fall of World Trade, 1870– 1939.” NBER Working Paper no. 9318. Cambridge, MA: National Bureau of Economic Research. Feldstein, Martin. 1988. “Thinking about International Economic Coordination.” Journal of Economic Perspectives 2:3– 13. Flandreau, Marc. 1997. “Central Bank Cooperation in Historical Perspective: A Skeptical View.” Economic History Review 50:735– 63. Frankel, Jeffrey. 1994. “Exchange Rate Policy.” In American Economic Policy in the 1980s, edited by Martin Feldstein, 293– 366. Chicago: University of Chicago Press. Gallarotti, Giulio. 1995. The Anatomy of an International Monetary Regime: The Classical Gold Standard, 1880–1913. New York: Oxford University Press. Haas, Peter, ed. 1992. Knowledge, Power and International Policy Coordination. Columbia: University of South Carolina Press. Hill, Martin. 1946. The Economic and Financial Organization of the League of Nations: A Survey of Twenty-Five Years’ Experience. Washington, DC: Carnegie Endowment for International Peace. James, Harold. 1996. International Monetary Cooperation since Bretton Woods. New York: Oxford University Press. Kapstein, Ethan. 1989. “Resolving the Regulator’s Dilemma: International Coordination of Banking Regulations.” International Organization 43:323– 47. Kenen, Peter B. 1990. “The International Coordination of Policies.” In International Policy Coordination and Exchange Rate Fluctuations, edited by William Branson, Jacob Frenkel, and Morris Goldstein, 63– 108. Chicago: University of Chicago Press. Kirsch, C. H., and W. A. Elkin. 1930. Central Banks. London: Macmillan. Krasner, Stephen, ed. 1983. International Regimes. Ithaca: Cornell University Press. Lipscy, Philip. 2003. “Japan’s Asian Monetary Fund Proposal.” Stanford Journal of East Asian Affairs 3:93– 104. Lopez-Cordoba, Ernesto, and Christopher Meissner. 2003. “Exchange Rate Regimes and International Trade: Evidence from the International Gold Standard, 1870– 1913.” American Economic Review 93:344– 53. Meissner, Christopher. 2005. “A New World Order: Explaining the International Diffusion of the Gold Standard, 1870– 1913.” Journal of Economic History 66:385– 406. Meltzer, Allan. 2003. A History of the Federal Reserve, Volume 1, 1913–1949. Chicago: University of Chicago Press.

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Nurkse, Ragnar. 1944. International Currency Experience. Geneva: League of Nations. ———. 1946. The Course and Control of Inflation. Geneva: League of Nations. Olsen, Mancur. 1965. The Logic of Collective Action. New Haven, CT: Yale University Press. Pauly, Louis. 1992. “From Monetary Manager to Crisis Manager: Systemic Change and the International Monetary Fund.” In A New Diplomacy in the Post–Cold War World, edited by Roger Morgan, Stefano Guzzini, and Anna Leander, 122– 30. New York: Macmillan/St. Martins. Persson, Torsten, and Guido Tabellini. 1995. “Double Edged Incentives: Institutions and International Coordination.” Handbook of International Economics 3:1973– 2030. Amsterdam: Elsevier. Peters, Guy. 1999. Institutional Theory in Political Science. London: Continuum. Reti, Steven. 1998. Silver and Gold: The Political Economy of International Monetary Conferences, 1867–1892. Westport: Greenwood Press. Rogoff, Kenneth. 1985. “Can International Monetary Policy Coordination Be Counterproductive?” Journal of International Economics 18:199– 217. Roubini, Nouriel, and Brad Setser. 2005. “Will the Bretton Woods 2 Regime Unravel Soon? The Risk of a Hard Landing in 2005– 6.” Unpublished Manuscript. Stern School of Business, June. Sachs, Jeffrey. 1985. “The Dollar and the Policy Mix.” Brookings Papers on Economic Activity 1:117– 97. Smith, Michael. 2004. “Institutionalization, Policy Adaptation, and European Foreign Policy Cooperation.” European Journal of International Relations 10:95– 136. Strange, Susan. 1980. “Germany and the World Monetary System.” In West Germany: A European and Global Power, edited by Wilfrid Kohl and Giorgio Basevi, 45– 62. New York: Lexington Books. Toniolo, Gianni. 2005. Central Bank Cooperation at the Bank for International Settlements 1930–1973. Cambridge: Cambridge University Press. Tsebelis, George. 1992. Nested Games. Berkeley: University of California Press. Wolf, Nikolaus. 2010. “Europe’s Great Depression: Coordination Failure after the First World War.” CESifo Working Paper no. 3164. September. Munich: Ifo Institute for Economic Research. World Bank. 1993. The Asian Miracle. Washington, DC: The World Bank.

Comment

Charles Bean

First let me say how much I enjoyed reading Barry’s chapter on the history of international economic policy coordination, spanning more than 150 years of trying and—rather more often than not—failing. Barry’s knowledge of this territory is unparalleled among economic historians and the broad historical sweep is masterly, as we have come to expect from him. I cannot claim to be an expert in this field, still less to have been on the scene at most of the attempts at coordination that he discusses, so I do not propose to critique his portrayal of each and every episode. Instead, as someCharles Bean is deputy governor of monetary policy at the Bank of England. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12579.ack.

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one presently engaged in contemporary efforts to coordinate policies in a number of forums, I thought I should offer a perspective on those efforts in the light of Barry’s analysis. By way of explanation, I should perhaps explain that one of my responsibilities as deputy governor is to represent the Bank of England at various international meetings, including G7, G20, and EcoFin, either as the bank’s nominated deputy or sometimes in the place of the governor. I should perhaps also explain that it is the deputies who do most of the grunt work leading up to meetings of G7 and G20 finance ministers and central bank governors. Barry lists four factors that he believes facilitate coordination: if the subject matter is technical, if coordination is institutionalized, if it helps to preserve an existing regime, and if the players share a broad comity. I broadly agree with this list and will illustrate their role in different aspects of recent experience. But I shall have some additional factors to add as well. In particular, strong personal links and trust between the participants is extremely valuable when seeking a coordinated response. And difficult or unthinkable decisions become feasible when the situation becomes critical: as Samuel Johnson observed, nothing focuses the mind like a hanging. Let me start with the G20 process. I label it as a “process” deliberately, because I think it is right to see it as one of ongoing development, rather than a series of isolated meetings, which is how the press often portray it. Although the G20 first met in 1999, I think it is fair to say that, prior to the crisis, attention was still focused on the G7 as the premier forum for economic policy coordination, despite the absence of China and other key emerging economies. But the G20 came into its own after the collapse of Lehman’s, when the seizure in financial markets prompted a broad, sharp, and synchronized slowdown across the global economy. The G20 has been at the center of international policy coordination efforts since. Broadly speaking, one can identify three distinct work streams within the G20 process over the past three years, directed at both crisis management and crisis prevention. They are, respectively: the macroeconomic policy response; the expansion of IMF lending capacity, refinement of its lending facilities, and improvements in its governance; and a thorough recasting of financial regulation. Starting with macroeconomic policies, the appropriate stance of economic policies in early 2009 was reasonably clear. With the threat of a serious and sustained global slump, expansionary fiscal and monetary policies were the order of the day across the membership, almost without exception. It was consequently not too difficult for participants at the G20 meetings in London that spring to adopt a generally expansionary fiscal stance. Matters have become more contentious since. As we all know, the crisis took place against the background of unsustainable current account imbalances, in which capital flowed “uphill” from the emerging economies, especially China, into the United States and some other advanced economies. In one interpretation, these were the result of mercantilist policies in China

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aimed at facilitating rapid development, coupled with underdeveloped domestic financial markets that encouraged excessive saving. In another interpretation, the imbalances reflected excessively expansionary policies in the United States, which exploited the “exorbitant privilege” of being able to borrow large amounts in its own currency. Either way, the imbalances provided the fuel for the excessive expansion in credit in the United States and other advanced economies that preceded the crisis. Correcting those imbalances, as well as identifying the appropriate rate of fiscal consolidation in different countries, raises difficult questions about who bears the burden of adjustment. It is much easier to agree upon coordinated actions when all are pulling in the same direction and all stand to gain, than when there is pain to be shared. Standard economic analysis of policy externalities and the gains from cooperation do not suggest a distinction, but regret theory suggests that losses may matter more than gains of an equivalent absolute magnitude. The G20 Framework for Strong, Sustainable, and Balanced Growth, and the associated Mutual Assessment Process, is an attempt to make progress on this issue, where the earlier IMF- led Multilateral Consultation Process in 2006 failed. This G20 framework has the advantage of taking place after a major crisis that nobody wants to repeat, which has raised members’ commitment to the process. But it is also subtly different from the earlier IMFled process in that it is owned by the G20 members, with the IMF merely acting as a facilitator. Peer pressure is supposed to be the mechanism to encourage compliance. Nevertheless, progress in rebalancing has so far been distinctly limited, with discussions bogged down in rather pointless technical details for much of the past year. There is general agreement on the broad direction of travel, but divergent views of the appropriate speed and distribution of adjustment. All this helps to illustrate the difficulty of agreeing on a satisfactory distribution of the burden of adjustment between surplus and deficit countries, a problem that recurs time and again in history, as Barry documents so clearly. In passing, I might also note that it is central to the resolution of the euro area’s present sovereign debt problems. My own view is that a satisfactory outcome requires a surplus country to be able to see itself becoming a deficit country in the not- too- distant future—in effect replicating a Rawlsian state of primeval ignorance about their economic position. Progress on issues associated with the International Monetary System in the G20 has been somewhat mixed. In a crisis setting, it proved relatively easy to agree to an expansion of the IMF’s resources, though it has taken rather longer to enact. And there have been useful changes to the IMF’s lending armory, with the development of the Flexible and Precautionary Credit Lines, which focus on crisis prevention rather than crisis management. But there has been less progress in addressing the more fundamental flaws in the International Monetary System associated with the asymmetry of the bur-

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den of adjustment. Much effort has instead been expended on negotiating a relatively modest change in quota shares, the archetypal zero- sum game. The G20 has, in my view, been at its most effective in progressing the reform of financial regulation. In accordance with the first of Barry’s principles, that is because the task has been devolved to the Financial Stability Board (FSB), the Basel Committee on Banking Supervision (BCBS), and similar technical bodies. But I do not believe that progress in agreeing to new capital standards and the like would have been as swift without the political direction given by the G20 and the setting of attendant deadlines, often associated with future Leaders’ Summits. That has acted as a commitment device for the technicians and limited the amount of haggling in favor of national interests. At the end of his chapter, Barry is somewhat critical of the issues that have been left unaddressed, such as the cross- border resolution of failing financial institutions, and the regulation of shadow banking. I think this is to miss the progressive nature of the reform agenda. The G20 have been careful not to overburden the FSB, BCBS, and so forth, with an excessive workload that lacks effective deadlines. Instead, they have prioritized two or three things to be the focus of each year’s work. As it happens, issues such as cross- border resolution and shadow banking, though technically difficult to deal with, are indeed on the current work program at the behest of the G20. Whatever one may think of the regulatory proposals themselves, the process followed since the crisis seems to me to have been remarkably effective. While the G20 may have moved to center stage as a result of the Great Contraction, there is an important omission in Barry’s narrative regarding the role of the G7 in the immediate response to the financial collapse precipitated by Lehman’s demise three years ago today. To begin with, in late September and early October 2008, the G7 central banks, together with the Swiss National Bank, made several announcements of coordinated expansions in liquidity provision. Then, on Wednesday, October 8, together with the Swedish Riksbank, these central banks announced a simultaneous reduction in their policy rates of 0.5 percent. Alongside the announcement of extra liquidity provision, this provides a good example of the speed with which central banks can implement coordinated actions when circumstances require them. Such actions are underpinned both by the strong institutional connections between central banks, particularly through the regular bimonthly meetings of governors and senior bank officials under the auspices of the Bank for International Settlements, and by the strong personal bonds forged there and in similar forums. Two days later, on October 10, there was an even more notable intervention by G7 finance ministers and central bank governors as a result of a meeting that took place in the margins of the IMF annual convocation in Washington. In my view, this was one of the most significant meetings ever of the G7.

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At that meeting, G7 principals threw away a vapid draft communiqué produced earlier by their deputies and, working off a blueprint provided by Chairman Bernanke and prompted by some of the actions announced in the United Kingdom earlier that week, announced in a terse statement, a fivepoint plan to stabilize the situation. That plan comprised: a pledge to prevent further failures of systemically important banks; continued abundant liquidity provision by central banks; recapitalization of banking systems, if necessary, by the taxpayer; strengthening of depositor protection; and increased transparency of bank losses. Not only did they announce such a plan, they also implemented it in the following days and weeks. Those actions played a central role in preventing a collapse of the financial system. But the crisis and the closeness of the participants helped to make it possible. In conclusion, I want to make a rather obvious point that connects with the last of Barry’s four principles. Coordination is easier in smaller groups, with relatively strong mutual understanding and trust, together with shared interests. At G7 meetings, there are only about twenty people around the table. The G20, though more representative, lacks the same degree of homogeneity of interest. And in a typical G20 meeting, there are more than sixty people around the table, with the same amount sitting behind them. This is not the sort of environment that encourages frank interchange and decisive decision making. As a consequence, maintaining the G20’s new- found status as the premier forum for economic cooperation once the crisis recedes into history is likely to be a challenge.

Comment

Gerardo della Paolera

In Eichengreen’s chapter, the first question he addresses is whether international monetary and financial cooperation—with a substantive impact on actual economic affairs—has had a regular occurrence throughout our most recent macroeconomic history. To answer that question we have to first ask when, if at all, the global economy has experienced a cooperative international monetary and financial regime. Was cooperation present during the Gold Standard era? Or during the dollar- gold exchange standard regime best known as the Bretton Woods regime? Of course, the author also masterfully describes the problematic international political economy realities during the interwar period. This is probably the most vivid example of a time of generalized leadership failure to assess the economic benefits to cooperation, so as to avoid an economic abyss—something that was apparGerardo della Paolera is the Luis Maria Otero Monsegur Professor of Economics at the Universidad de San Andrés and professor of economics at Central European University. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12580.ack.

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ent to all actors involved in the 1930s, though they were unable to devise the means to tackle the meltdown of the global economy. The chapter describes four sets of circumstances in which international cooperation would be most likely to occur. It is likely to happen if it centers on technical issues, since technocrats know better or share the same technical views about how, for example, financial prudential supervision and regulation might work. Or it is likely when it is institutionalized, as in, say, the Bretton Woods regime. Or when concerned with preserving a policy regime, as with central bank cooperation during the Baring crisis of 1890 to preserve the Gold Standard, or the ill- fated Gold Pool plan to sustain the dollar- gold exchange standard or Bretton Woods system. Finally, macroeconomic and financial cooperation is most likely in a context of broad comity among nations, as in the relatively peaceful span from 1880 until the outbreak of World War I. I am interested in two main issues addressed by Barry Eichengreen that have had a great influence on the fate, and welfare- improving (or welfarereducing) consequences, of international policy cooperation in monetary and financial matters. These two issues are: (1) the actual influence and eventual inbreeding of thinking within an epistemic community; and (2) the importance of an accepted hegemon in monetary and financial matters to lead an international regime. With respect to the epistemic community, I believe that club thinking can sometimes produce devastating results when “cooperating” entails an insistence by the actors on preserving regimes or policies that are destined to fail under a different political economy scenario. Example 1: The initial cooperation to support the return of the United Kingdom to the gold standard in the 1920s at the prewar parity was a deflationary- prone policy in spite of having at hand economists from outside accepted circles who recognized alternative monetary arrangements such as Gesell (1909) and Keynes (1923).1 Example 2: We are always surprised by the recurrence of banking and financial crises while we had at hand proposals in the 1930s by Henry Simons (1933) and Irving Fisher (1933), then in the post–World War II years by Milton Friedman (1959) and Hyman Minsky (1977), and more recently by Tom Sargent (1993). These were all solid proposals to avert an inconsistent and inherently unstable system that blurs money and credit. Until we recognize that the job of private systemic banks cannot be a riskless activity subject 1. Silvio Gesell had a huge influence on Irving Fisher, in particular regarding the topic of Stamp Currency; Keynes also quotes him extensively in his General Theory (1936, chap. 23): “Gesell was a successful German merchant in Buenos Aires who has led to the study of monetary problems by the crisis of the late eighties which was especially violent in the Argentine. . . . Since his death in 1930 . . . its main strength lying today in the United States, where Professor Irving Fisher, alone amongst academic economists, has recognized its significance. . . . The idea behind stamped money is sound.”

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constantly to the risk of bailouts that socialize the losses in a downturn, incentives are just a derivative problem of the distortion created by the blurring of money and credit. Example 3: Consider the eurozone situation. In 1998, with my friend and colleague Alan Taylor, I was fortunate to have an extended lunch with Milton Friedman in San Francisco, where we discussed the imminent launching of the euro currency. He said to us, concerning a stable monetary system: “I could imagine a country without a central bank. However, I cannot imagine a central bank without a country [behind it].” I told that story for many years to a great deal of “established” scholars and policymakers, only to receive a reaction of how dismal and naïve was the statement. Yet now, all too late, it is common to read tons of literature on the explosive situation of centralizing monetary policy without engineering a fiscal union. The “epistemic” community thought that you could in effect adopt a single currency without taking into consideration the other side of the coin of monetary policy, which is to say the solvency of fiscal policy. Example 4: The case of the bailout (bailouts, in plural). Is this a case of immiserizing cooperation? Is it about technocratic or academic ignorance or about political economy vested interests? I am inclined to see the influence of political economy intentionality to force Greece to an unsustainable bailout scheme to delay the sharing of the costs of an exuberant overexposure of German and French banks that were heavily invested in Greek public bonds. In that situation, “cooperation” means to cooperate with banks at the core of the European countries and transfer the bulk of the adjustment to the Greek economy with results that are by now woefully clear (with similarities in the case of Irish bank debt). Cooperation by vested interests to “force” an unsustainable regime can lead to an inferior welfare situation. On the importance of a predominant hegemon to reach a global monetary architecture, let me provide a reminder of some glimpses from economic history. For the author (Eichengreen 2011), the 1880– 1913 Gold Standard period was more of a spontaneous order than the result of a plan or international agreement. However, it is legitimate to ask whether there was a clearly recognized monetary and financial hegemon until 1913. And the answer is yes, it was Great Britain. True, indeed, short- lived central banking cooperative interventions were there—but they shared the benefits of the regime with an undisputed hegemon. Borrowing Barry’s expression, I believe taken from Keynes, “you could travel all around the world until 1913 and you could settle transactions in sterling.” The 1913– 1939 period was a transitional no man’s land until the 1930s when the United States took the lead, almost certainly too late, as many observers would agree. In 1944, the United States heads off Keynes’s proposal to establish a global reserve currency the Bancor. Instead, the Bretton Woods system established a dollar- gold exchange standard and the new hegemon, the United States, desperately attempted to maintain the convertibility of the US dollar in an

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inconsistent regime. In the waning days, the experiment of the “cooperative” Gold Pool failed, and with it the last remains of a metallic regime. From 1973 onwards we enter a world of fully fiduciary regimes in which the world’s key currencies are quoted under the logic of a floating exchange- rate regime. The question here is why do we need cooperation? An international anchor needs cooperation, but an unanchored regime? A shortcut for this is that the role of the US dollar, and its advantages as the world’s key currency, have not diminished, even while, in some instances, it has pursued clear inflationary or expansionary policies. For the post–Bretton Woods period (1973– 2007), the Gaulliste expression “exorbitant privilege” for the reality of a US dollar as the central world reserve currency was in its heyday. However, as mentioned in the chapter, the 2007– 2011 crises have produced some cracks in the façade of a leaderfollower model, but the daunting prospects of the eurozone have put some sand in the wheels concerning discussions about a new global currency. What we have seen is an unending search and thirst to find a global monetary and financial architecture, but do we have a leader- follower model to anchor a viable proposal? The heterogeneity of international actors in terms of the perceived advantages to structure a new regime that is markedly different from the current actual unanchored regime is palpable. Is there some room to imagine a global reserve currency as a composite of key currencies? Can it be a realistic priority given the most basic flaws in many of the biggest domestic economies? The jury is out—until the next big global foreign exchange crisis. References Eichengreen, Barry. 2011. Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System. New York: Oxford University Press. Fisher, Irving. 1933. “The Debt-Deflation Theory of Great Depressions.” Econometrica 1:337– 57. Friedman, Milton. 1959. A Program for Monetary Stability. New York: Fordham University Press. Gesell, Silvio. 1909. La anemia monetaria y la pletora monetaria [Monetary Plethora and Anemia]. Buenos Aires: n.p. Keynes, John Maynard. 1923. A Tract on Monetary Reform. London: Macmillan. ———. 1936. The General Theory of Employment, Interest and Money. London: Macmillan. Minsky, Hyman P. 1977. “A Theory of Systemic Fragility.” In Financial Crises, edited by E. I. Altman and A. W. Sametz. New York: Wiley–Interscience. Sargent, Thomas. 1993. Bounded Rationality in Macroeconomics. Oxford: Clarendon Press. Simons, Henry C., et al. 1933. “Banking and Currency Reform.” Unpublished manuscript, University of Chicago.

3 Can the Doha Round Be a Development Round? Setting a Place at the Table Kyle Bagwell and Robert W. Staiger

3.1

Introduction

A fundamental objective of the Doha Round of World Trade Organization (WTO) negotiations is to improve the trading prospects of developing countries. Toward this objective, the declaration from the WTO Ministerial Conference in Doha, Qatar, November 14, 2001, states in part: We commit ourselves to comprehensive negotiations aimed at: substantial improvements in market access; reductions of, with a view to phasing out, all forms of export subsidies; and substantial reductions in tradedistorting domestic support. We agree that special and differential treatment for developing countries shall be an integral part of all elements of the negotiations. Currently, the Doha Round is in its twelfth year of negotiations, and it seems unlikely to conclude in the foreseeable future with an agreement that achieves its fundamental objectives. What can account for the lack of progress in the Doha Round? Are there changes in the approach to negotiations that were endorsed at Doha that Kyle Bagwell is the Donald L. Lucas Endowed Professor in Economics at Stanford University and a research associate of the National Bureau of Economic Research. Robert W. Staiger is the Stockwell Professor of Economics at the University of Wisconsin and a research associate of the National Bureau of Economic Research. This chapter was prepared for the “Globalization in an Age of Crises: Multilateral Economic Cooperation in the Twenty-First Century” conference, September 14– 16, 2011, London. We thank our discussants, Robert Anderson and Valeria Csukasi, for insightful discussions, and Rob Feenstra, Patrick Low, Petros C. Mavroidis, Peter Neary, Michele Ruta, Alan Sykes, Alan Taylor, Alan Winters, and participants at the preconference, March 24, 2011, Cambridge, Massachusetts, for very helpful comments. For acknowledgments, sources of research support, and disclosure of the authors’ material financial relationships, if any, please see http://www.nber .org/chapters/c12581.ack.

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might help to break the current impasse? In this chapter, we extract insights from the standard economic theory of trade agreements to provide answers to these questions. Our main message comes in three parts. First, the stated aims of the Doha Round are incompatible from the perspective of our economic analysis. Thus, if these aims are pursued as stated, then we conclude that they are unlikely to deliver the meaningful trade gains for developing countries that the WTO membership seeks. Second, after fifty years of successful developed- country liberalization under the General Agreement on Tariffs and Trade (GATT, the WTO’s predecessor), the WTO may face a “latecomers” problem as it attempts to integrate its developing country membership into the world trading system, wherein its developed country members face a kind of “globalization fatigue” and have exhausted their bargaining power relative to developing country members. While this problem also arose in earlier GATT rounds, its scale in the Doha Round is unprecedented, and it could potentially account for the current impasse. And third, we argue that if the Doha Round maintains its stated aims but moves away from the nonreciprocal special- and- differential treatment norm as the cornerstone of the approach to meeting developing country needs in the WTO, and if developing countries prepare, in markets where they are large, to come to the bargaining table and to negotiate reciprocally with each other and with developed nations, then it might be possible to break the impasse at Doha, to address the latecomers problem, and to deliver trade gains for developing countries. To make these points, we rely on a series of simple general equilibrium and partial equilibrium trade models. For the most part, we illustrate the message delivered by these models with the use of schematic figures, providing references to the existing literature for more complete and formal treatments. And we support our use of the models with reference to the relevant empirical research. The remainder of the chapter proceeds as follows. In the next section, we consider the implications of special and differential treatment for developing countries in the context of a negotiating forum where developed countries engage in reciprocal and nondiscriminatory tariff bargaining. In section 3.3 we turn to an analysis of the Doha approach to agriculture negotiations. Section 3.4 considers how the Doha Round might be made a development round according to the economic analysis contained in the previous sections. Finally, section 3.5 offers a brief conclusion. A data appendix includes a number of tables not included in the main body of the chapter. 3.2

Nonreciprocal Negotiations and Developing Countries

A key objective of the current Doha Round of GATT/WTO multilateral trade negotiations is to bring developing countries into the world trading system. A wide range of anecdotal and empirical evidence suggests that

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developing countries have gained little from more than half a century of GATT/WTO- sponsored tariff negotiations. For example, based on interviews with WTO delegates and Secretariat staff members, Jawara and Kwa (2003, 269) offer the following assessment: Developed countries are benefitting from the WTO, as are a handful of (mostly upper) middle- income countries. The rest, including the great majority of developing countries, are not. It is as simple as that. The empirical findings of Subramanian and Wei (2007) are also consistent with this position. They find that GATT/WTO membership is associated with a large and significant increase in trade volumes for developed countries; however, for developing country members, the impact of membership on trade volumes is weak or nonexistent.1 One fact to keep in mind is that, while developed countries have negotiated deep reductions in their nondiscriminatory most favored nation (MFN) tariffs under GATT auspices, developing countries have committed to few tariff cuts over the eight GATT multilateral negotiating rounds that span fifty years. In the data appendix we reproduce four relevant tables taken from the WTO World Trade Report for 2007. Table 3A.1 records the impressive overall results from sixty years of negotiated tariff reductions under GATT and the first decade of the WTO (created in 1995 as a result of the Uruguay Round). Table 3A.2 then confirms that these overall results mask a striking lack of tariff commitments (“binding coverage”) for developing countries prior to the last completed (Uruguay) GATT round, while tables 3A.3 and 3A.4 record the much more significant tariff bindings made by developed countries over the GATT years.2 The asymmetry in GATT/WTO tariff commitments across developed and developing countries is a result of the exception to the reciprocity norm that has been extended to developing countries and codified under “special and differential treatment,” or SDT, clauses. This exception was thought to ensure that developing countries would get a free pass on the MFN tariff cuts that the developed countries negotiated with one another, allowing developing country exporters to then share with exporters from developed countries in the benefits of greater MFN access to developed country markets. Apparently, though, negotiations among developed countries have not generated a significant impact on the trade volumes of developing country members of the GATT/WTO. Why hasn’t GATT/WTO membership generated the anticipated trade1. This particular finding of Subramanian and Wei (2007), that it is mainly large developed countries that have enjoyed significant trade effects of GATT/WTO membership, is confirmed, for example, by Chang and Lee (2011), and also by Eicher and Henn (2011), once controls suggested by the “terms- of-trade theory” of trade agreements are introduced (we describe this theory more fully later). 2. Moreover, as is well known (see, e.g., Diakantoni and Escaith 2009), even the impressive binding coverage for less developed countries achieved in the Uruguay Round is potentially misleading, because a large proportion of those bindings were set significantly above the tariff rates actually applied by these countries.

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volume impact for developing countries? One possible explanation is that developed countries have found ways around the MFN principle, so that their tariff bargaining in fact discriminates against nonparticipating GATT/ WTO members. Bown’s (2004) findings, however, weigh against this explanation. He finds that countries do indeed abide by the MFN principle, at least in the context of GATT/WTO bilateral dispute settlement negotiations.3 Here, we explore a different explanation, namely, that the nonreciprocal approach anchored in SDT itself lies behind the absence of meaningful trade gains for developing countries. Since the nonreciprocal approach is also a feature of the current Doha negotiations, our explanation suggests that these negotiations may also be structured in a way that will fail to generate appreciable impact on the trade volumes of developing country members of the GATT/WTO. 3.2.1

The Problem with SDT

Two distinct and potentially complementary arguments linking SDT clauses to the disappointing developing country experience in the GATT/ WTO may be identified. A first argument is straightforward: SDT may have given developing countries a free pass to the tariff liberalization negotiated by developed countries, but it took away their voice in determining which developed country markets were liberalized through GATT/WTO negotiations, with the predictable result that the developed- country markets that were traditionally the most important to developing countries (e.g., textiles and apparel, certain agricultural products, footwear) experienced the least negotiated trade liberalization under GATT/WTO auspices. Finger (1979) is a strong advocate of this argument, and notes that a small number of active developing country participants in the Kennedy Round of GATT negotiations (1964– 1967) served as “the exception that proves the rule”: Unfortunately, the third world and its spokespersons and institutions have taken a vocal position against a reciprocal role for LDCs. The Kennedy Round, however, provides strong evidence that reciprocity pays. There, the United States made concessions (almost entirely tariff reductions) on $571 million or 33 percent of its (1964) imports from the nine active LDC participants. . . . Of some $6 billion of US imports in 1964 from other LDCs, only 5 percent was subject to concessions. Finger (1979, 435)

3. In examining the outcomes of GATT/WTO bilateral dispute settlement negotiations, Bown (2004) also finds that a country’s potential for retaliatory tariff threats is an important predictor of whether it will receive nondiscriminatory treatment in the settlement of a bilateral dispute between two of its trading partners. Applied more broadly, this finding would suggest that “small” developing countries who lack the capacity for trade retaliation may be at greater risk of facing discrimination in the GATT/WTO system, and this could then help explain why small developing countries have not enjoyed trade gains with GATT/WTO membership. But this explanation could not account for the lack of trade gains from GATT/WTO membership that the larger developing countries have also experienced (see also footnote 12).

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In addition to the evidence cited by Finger, some indirect evidence for the relevance of this first argument in helping to explain the weak trade effects of GATT/WTO membership for developing countries can be found in the implementation of the Generalized System of Preferences (GSP), which was introduced as an SDT provision of GATT under the “Enabling Clause” for developing countries. Under GSP, it was hoped that developing countries might benefit from unilateral grants of preferential market access by developed countries. But the unilateral nature of these market access commitments has in practice limited their impact on developing country trade (e.g., see Ozden and Reinhardt 2005). As Grossman and Sykes (2005) describe, this limited impact has occurred because developed countries have inevitably implemented their GSP programs in a way that minimizes the potential political costs to themselves (e.g., by exempting from GSP eligibility politically sensitive sectors such as certain textiles and apparel products, footwear, and certain agricultural products) and/or have introduced reciprocity in other forms (e.g., by offering tariff preferences in exchange for measures to combat drug trafficking). And finally, in the context of GATT/WTO MFN tariff commitments, which is our focus here, this first argument finds some direct empirical support in Subramanian and Wei (2007). We will return to this argument later in the chapter. But this first argument misses the “free pass” logic that was supposed to capture the anticipated benefits of SDT in the context of MFN tariff bargaining. That logic was never based on the hope that developed countries would offer unilateral MFN tariff reductions on products where developing countries were the principal export suppliers to their markets. Instead, as described before, the logic of SDT was that developing country exporters could “free ride” on the reciprocal liberalization efforts of others; that is, together with exporters from developed countries, developing country exporters would enjoy trade benefits from the MFN tariff cuts that the developed countries negotiated with one another. Central to this logic is the existence of developed and developing country exporters who compete with each other for sales to developed country markets on products that fall within a given tariff line, but competing exporters play no role in the argument we have just described. It is this role that we highlight in a second argument linking the SDT clause to the disappointing developing country experience in the GATT/WTO. To develop this second argument, we begin by sketching a simple general equilibrium model of trade in two goods between three countries. Suppose that the home country imports good x from foreign countries 1 and 2, and that the two foreign countries import good y from the home country, with all goods produced in perfectly competitive markets and each country imposing a tariff on its imports. For simplicity, we assume that the two foreign countries do not trade with one another; notice, however, that they are competing exporters of good x into the home country market. We denote

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Fig. 3.1 The bilateral exchange of reciprocal MFN tariff cuts in the three-country two-good general equilibrium model

the local relative prices in the home and foreign countries as p ≡ px / py and p∗i ≡ px∗i / p∗y i , respectively, where we use an asterisk to denote foreign country variables and where i = 1, 2. The home country selects an ad valorem and nondiscriminatory (i.e., MFN) tariff rate, t, for imports of good x. For foreign country i, the ad valorem import tariff rate on good y is denoted as t∗i. The pattern of trade and trade policies for each country are depicted schematically in figure 3.1. The world price for trade between the home country and foreign country i is pwi ≡ px∗i / py. Notice that pwi is thus foreign country i’s terms of trade. Defining τ ≡ 1+t and τ∗i ≡ 1+t∗i, we have that p = τpwi and p∗i = (1/τ∗i )pwi. Since the home country applies a nondiscriminatory tariff, we thus see that pw1 = pw2 ≡ pw; that is, the two foreign countries must share the same terms of trade when the home country adopts an MFN tariff policy. We thus have that p = τpw and p∗i = (1/τ∗i )pw. Finally, we note that the home country’s terms of trade in this MFN setting is given as 1/pw. In a given country, once the local and world prices are determined, all economic quantities (production, consumption, tariff revenue, imports, exports) are also determined. In turn, for a given set of tariffs, (τ,τ∗1,τ∗2), once we determine a market- clearing world price, p w(τ,τ∗1,τ∗2), then all local prices are determined. This follows since the pricing relationships just presented then yield the local prices as p(τ, p w ) = τ p w and p∗i (τ∗i , p w ) = (1/ τ∗i ) p w , respectively. Finally, the market- clearing world price is determined as the world price that ensures that the home- country imports of good x equals the sum of exports of good x from foreign countries 1 and 2; in other words, p w(τ,τ∗1,τ∗2) is the value for pw, which solves (1)

1 M ( p(τ, pw ), pw ) = E ∗ ( p∗1(τ∗1, pw ), pw ) + E ∗2 ( p∗2(τ∗2, pw ), pw ) .

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As is standard, for each country we assume as well that import and export functions are defined in a manner that satisfies trade balance requirements: (2)

pwM( p, pw ) = E( p, pw ) M ∗i( p∗i, pw ) = pwE ∗i ( p∗i, pw ) for i = 1,2,

where E( p, pw) denotes home- country exports of good y and M∗i ( p∗I,pw) represents foreign- country-i imports of good y. The market- clearing requirement for good y is then implied by (1) and (2). We assume that each of these three countries is “large,” in the traditional sense that a change in the country’s tariff results in a change in the marketclearing world price. We emphasize, though, that for some countries the resulting world- price change may be small in size; that is, some countries may be much less large than are others. We assume that prices depend on tariffs in the “standard” manner. Thus, a country achieves a terms- of-trade gain when it raises its own import tariff: (3)

∂ p w ∂ p w < 0 < ∗i , i = 1,2. ∂τ ∂τ

Likewise, when a country raises its import tariff, the local price of the import good relative to the export good rises in that country: (4)

dp(τ, p w ) dp∗i (τ∗i , p w ) >0> . dτ dτ∗i

Intuitively, if a country raises its import tariff, then some of the incidence is borne by foreign exporters, who receive a lower export price for their product, and some of the incidence is passed on to domestic consumers, who pay a high local price for the imported good. We will discuss later specific evidence relating to the ability of importing countries to impose the incidence of tariffs on foreign exporters, but here we note that there is strong evidence that the incidence of trade costs more generally are borne disproportionately by exporters. For example, according to a recent paper by Anderson and Yotov (2010), sellers/exporters bear a significant portion of trade costs relative to buyers/importers, with exporters’ incidence in the early 1990s roughly five times larger than that borne by importers, according to Anderson and Yotov’s estimates. Having sketched the general equilibrium model of trade, let us now return to the previous discussion and consider the possibility that the home country and foreign country 1 negotiate a reciprocal reduction in import tariffs, while foreign country 2 takes a “free pass” and leaves its tariff unaltered. What can we say about the implications of this negotiation for foreign country 2’s volume of trade? To address this question, we place two restrictions on the negotiation between the home country and foreign country 1. First, the home country

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tariff satisfies the MFN requirement. This restriction is already imposed in the description of the model. Second, the negotiation satisfies the principle of reciprocity for the home country and foreign country 1. In broad terms, this means that the resulting changes in tariffs bring about changes in the volume of each negotiating country’s imports that are of equal value to changes in the volume of its exports. Formally, we suppose that the home country and foreign country 1 undertake a negotiation in which they change their tariffs from some initial tariff pair, (τA,τ∗A 1), to a new tariff pair, (τB,τ∗B 1). The tariff of foreign country 2 is fixed throughout at its initial level, τ∗A 2. We denote the initial and new world prices as p Aw ≡ p w (τ A ,τ∗A 1,τ∗A 2 ) and p Bw ≡ p w (τ B ,τ∗B 1,τ∗A 2 ), and similarly we represent the initial and new local prices in foreign country 1 as p∗A1 ≡ p∗1(τ∗A1, p Aw ), and pB∗1 ≡ p∗1 (τ∗B1 , p Bw ). For foreign country 1, the principle of reciprocity thus requires that the resulting change in tariffs satisfies (5) p w [E ∗1 − E ∗1 ] = [M ∗1 − M ∗1 ], A

B

A

B

A

where M A∗1 ≡ M ∗1( p∗A1, p Aw ), EA∗1 ≡ E ∗1( p∗A1, p Aw ), M B∗1 ≡ M ∗1( pB∗1, p Bw ), and EB∗1 ≡ E ∗1( pB∗1, p Bw ).4 Under GATT/WTO rules, trade liberalization negotiations are not required to satisfy the principle of reciprocity. It is frequently observed, however, that countries seek to obtain a “balance of concessions” in their negotiations. We may thus understand the principle of reciprocity as a negotiation norm. While more evidence is needed before the empirical issue is settled, we note that some recent studies (Shirono 2004; Limao 2006, 2007; Karacaovali and Limao 2008) provide empirical support for the view that actual tariff bargaining outcomes in the GATT/WTO conform to a reciprocity norm. Following Bagwell and Staiger (1999, 2005), we now use the balanced trade condition (2) for foreign country 1, which must hold both at the initial tariffs and the new tariffs, to rewrite the reciprocity condition (5) as (6) [ p w − p w ]E ∗1 = 0. B

A

B

Using (6), we thus see that mutual changes in trade policy for the home country and foreign country 1 satisfy the principle of reciprocity if and only if they leave the world price unchanged. When countries reduce tariffs in a manner that satisfies the principle of reciprocity, therefore, they achieve higher trade volumes even though their terms of trade are unaltered.5 The 4. As we explain in footnote 7, if the described change in tariffs satisfies the principle of reciprocity from the perspective of foreign country 1, then the tariff change also satisfies the principle of reciprocity from the perspective of the home country. 5. If the home country were to violate MFN and adopt discriminatory tariffs, then its bilateral terms of trade with foreign country 1 would differ from its bilateral terms of trade with foreign country 2. The home country’s multilateral terms of trade might then change even when a negotiated tariff change with foreign country 1 preserves its bilateral terms of trade with foreign country 1. We assume here, though, that the home country adopts nondiscriminatory tariffs, and so the home country’s bilateral and multilateral terms of trade are all represented w by a common expression, 1 / p . See Bagwell and Staiger (1999, 2005) for further discussion.

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higher trade volumes arise entirely as a consequence of the induced changes in local prices in each negotiating country. We are now in position to consider the implications of this negotiation for foreign country 2’s volume of trade. The main finding is that foreign country 2 experiences no change in its trade volume, when the home country and foreign country 1 exchange tariff reductions that satisfy the principles of nondiscrimination and reciprocity. To establish this finding, we observe first that foreign country 2’s terms of trade, p w , are unaltered. The principle of nondiscrimination ensures that foreign country 2 enjoys the same terms of trade as does foreign country 1, and as just argued the principle of reciprocity in turn ensures that foreign country 1’s terms of trade are unaltered by the negotiated reduction in tariffs. A second observation is that foreign country 2’s local price, p∗2 (τ∗2 , p w ), is also unaltered. This follows since foreign country 2’s terms of trade are unaltered and foreign country 2 does not undertake a tariff change of its own. With its world and local prices unchanged, foreign country 2 thus experiences no change in its production, consumption, tariff revenue, imports, or exports. This finding is perhaps surprising, since as figure 3.1 reflects and as we have emphasized, foreign country 2 receives a (nondiscriminatory) tariff cut from the home country. How can a country experience no change in its trade volume, when the import tariff of its trading partner is reduced and it offers no tariff cut of its own? The key point is that the negotiation between the home country and foreign country 1 alters the local price in foreign country 1. Following the reciprocal tariff reduction, the local price of the import good relative to the export good in foreign country 1 must fall (i.e., p∗1 must rise). As a consequence, consumers in foreign country 1 substitute consumption toward the import good and away from the export good, and resources for production shift from the import good toward the export good. For both of these reasons, when foreign country 1 cuts its import tariff, its export volume (production minus consumption of the export good) rises.6 The principle of reciprocity then has the effect of ensuring that the expansion in export volume from foreign country 1 exactly satisfies the increased demand for imports coming from the home country. In other words, foreign country 2’s hope of a “free pass” to greater export volume is thwarted by the fact that, while the home country now offers a more open market on a nondiscriminatory basis to all comers, foreign country 2 must compete for sales in that market with a more “high- export- performing” foreign country 1.7 More generally, this finding suggests a simple maxim for trade negotiations: what you get is what you give. A country that reciprocates and cuts 6. This is simply an instance of the Lerner symmetry theorem, which ensures in this two- good setting that a reduction in a country’s import tariff has the same effect as would an increase in its export subsidy. 7. Given that trade volume from foreign country 2 is unaltered, it is now apparent that, if the principle of reciprocity is satisfied from the perspective of foreign country 1, then it is also satisfied from the perspective of the home country.

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its own import tariffs in exchange for MFN tariff cuts in markets served by its exporters will see its exporters gain more export volume from the additional access in those markets than will exporters from countries that did not reciprocate (i.e., that did not agree to tariff cuts of their own). Indeed, in the simple three- country model presented before, if one foreign country liberalizes in a manner that satisfies the principle of reciprocity, while another foreign country does not liberalize on its own, then the latter country sees no change in its trade volume whatsoever. Notice, too, that this maxim does not amount to a simple expression of the gains from unilateral trade liberalization, because it is stated in the context of negotiated reciprocal trade liberalization where, critically, the terms- of-trade impacts of one’s own liberalization are offset by the impacts of the reciprocal liberalization of a trading partner. Hence, it is when countries come together to negotiate reciprocal MFN trade liberalization, as in a GATT/WTO round of multilateral negotiations, that the maxim applies.8 At a general level the practical significance of the finding we report here is supported by a wide body of empirical studies that confirm the key mechanism: a country’s own tariff cuts stimulate its exports. We mention here four recent studies that are of special relevance. Edwards and Lawrence (2006) examine the relationship between South Africa’s export performance and its import tariffs and conclude: “In the long run a 1% rise in tariffs raises domestic prices by 0.48%. This in turn reduces the profitability (both relative and absolutely) of export supply and hence lowers export volumes by 0.31%.” Mukerji (2009) examines the impact of India’s tariff liberalization on its export performance, and finds that India both increased its export volume of traditional export goods (intensive margin effects) and began exporting significant numbers of new goods (extensive margin effects) as a result of its tariff cuts. In another study, Mostashari (2012) focuses on explaining the changing distribution of export shares among countries exporting to the United States and finds that, especially for less developed countries, their own liberalizations have been quantitatively much more important in explaining changes in bilateral trade shares to the United States than the impact of US liberalizations. Finally, Tokarick (2007, 207) reports evidence that “developing countries could expand their exports by a 8. We claim that this maxim applies to developed and developing countries alike. And yet our formal model adopts a number of assumptions that may seem ill suited when applied to particular developing countries (e.g., perfectly competitive and smoothly functioning production sectors). It is therefore important to point out that these assumptions are not central to our main message. For example, even in an “endowment economy” where production is completely rigid and unresponsive to prices, a country’s import barriers would continue to impede its exports, through responses on the demand side of the economy. Hence, the impacts of tariff cuts on own exports that we have emphasized do not depend on the existence of well- functioning markets in a country that can reallocate productive resources smoothly and efficiently across uses. This is also borne out in the data, and indeed much of the relevant empirical evidence that we discuss next concerns developing countries.

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much larger percentage by eliminating their own tariff barriers, rather than waiting for tariff reductions from rich countries.”9 And in policy circles, the fact that a country’s import tariffs act to impede its exports has been recognized for decades. For example, in describing the forces that led to the demise of the import substitution policies popular in the developing countries of Latin America in the 1950s and 1960s, Dornbusch (1992) writes: In the late 1960s and 1970s, protection in developing countries softened in at least one direction. Many countries recognized that protection by tariffs and quotas did keep imports out, but that the resulting decline in demand for foreign exchange also led to an appreciation of the currency and hence a severe tax on exports of both traditional commodities and emerging industrial goods. Unstable real exchange rates added to the hazards of export activities. Moreover, duties on imported intermediate goods first implied a tax on export activities using these goods, and then helped cause a currency overvaluation which hurt export competitiveness of these products.” (71– 72) The novelty in our argument is simply to develop the implications of the import- tariffs- impede- exports observation in a competing exporter setting of reciprocal MFN tariff bargaining.10 3.2.2

SDT and the Doha Round

What are the implications of this discussion for the Doha Round? Here we emphasize two. The first implication is that Doha’s largely nonreciprocal approach, still anchored in a long GATT tradition of SDT, is unlikely to deliver meaningful trade gains for developing countries, just as this approach did not do so over the previous half century. Rather, substantial tradevolume gains for developing countries from negotiated trade liberalization can be achieved most effectively if developing countries prepare, in markets where they are large, to come to the bargaining table and negotiate reciprocally with each other and with developed nations.11 This implication seems 9. There is also related evidence on the link between own tariffs and industry- level productivity. For example, Trefler (2004) examines the impact of Canadian tariff concessions in the Canadian-US free trade agreement and reports that Canada’s own tariff cuts raised labor productivity in Canada by 15 percent in the most impacted, import- competing group of industries, thereby quantifying a large and positive industry- level productivity effect associated with own tariff cuts. 10. The observation that a country’s import barriers act to impede its exports should be distinguished from the question of whether a country’s import barriers impede its growth. This openness- growth linkage is at the center of the debate over the validity of the so-called “Washington Consensus” and has come under intense criticism over the past decade (for a recent contribution to this debate, see Estevadeordal and Taylor 2008). By contrast, the basic link between a country’s import barriers and its exports, which we highlight in our previous discussion, is widely accepted, and is not part of the debate over the Washington Consensus. 11. In this regard, a limited opportunity to gauge the potential trade impacts for a developing country when it cuts its tariffs in a reciprocal fashion in a WTO negotiation is provided by

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to run counter to much current thinking on the Doha Round. For example, the recently released Bhagwati-Sutherland Report (2011) states: The expectation that in most cases developing countries should be entitled to flexibilities in the application of tariff cuts that are not available to developed WTO states has also followed from the widening of the membership and the development of a body of thinking about the pace and depth of liberalization that is appropriate for developing countries. This assumption—that a development friendly trade deal must demand less of countries in a way that is proportionate to their state of development— permeates the Doha Round and the final package will rightly have to be measured against it. This means that developed countries have to accept that the outcome will be asymmetrical, even vis-à-vis large and competitive exporters like China and Brazil who remain in development. (6) Our discussion is at odds with this position, and suggests that, rather than accepting and embracing the nonreciprocal approach embodied in SDT as an appropriate standard for the Doha Round, the success of the Doha Round as a Development Round may hinge on rejecting SDT as the cornerstone of the approach to meeting developing country needs in the WTO.12 accession negotiations that occurred during and after the Uruguay Round, because strict adherence to SDT was not followed in accession negotiations over this period, and instead existing developed country members asked for more or less reciprocal commitments from new member countries as a condition for membership. Subramanian and Wei (2007) exploit this difference in membership requirements across old (pre–Uruguay Round) and new (post–Uruguay Round) developing country GATT/WTO members, and find that developing countries who were asked to make more nearly reciprocal tariff cuts of their own in exchange for WTO membership did indeed enjoy greater trade effects of membership than developing countries who were allowed to not reciprocate under SDT. We also note that the first implication we emphasize earlier shares much with Finger’s (1979, 437– 38) suggestion regarding a possible method for better integrating less- developed countries (LDCs) into the GATT: “An approach to consider is a return to the format of the old reciprocal trade negotiations, concentrating, however, on exchanges between a major industrial country and its major LDC trading partners. The feasibility of such an approach depends on there being substantial bilateral, principal supplier trade flows between the proposed participants that are subject to negotiable trade restrictions.” 12. As will become clear later, to the extent that a developing country is truly “small” in its relevant markets, it should not be expected to offer tariff concessions in a trade agreement according to the terms- of-trade theory; but this observation holds equally for developed countries, and therefore provides no rationale for an SDT- type norm applied to developing countries (see Staiger [2006] for an elaboration on some of these themes as they relate to developing countries and the WTO). In essence, according to the terms- of-trade theory, it is the biggest countries—whether developed or developing—who adopt unilateral trade policies that are the most internationally inefficient, and hence it is the biggest countries that should negotiate the most substantial tariff bindings under an internationally efficient trade agreement. Also, our discussion of SDT has been couched in terms of an escape from the reciprocity norm in the context of tariff bindings and market access negotiations, but as we have noted there are a number of SDT clauses throughout the GATT/WTO. For example, a major sticking point in the Doha Round that contributed to the breakdown of negotiations in 2008 was the special agricultural safeguard mechanism for developing countries, a provision that reflects the SDT clause. The implications we discuss here would be broadly relevant for these other instances of nonreciprocal SDT clauses as well.

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The second, and more speculative, implication concerns the manner in which negotiations must proceed if developing countries are to benefit (i.e., advance their own objectives). To develop this implication, we must dig somewhat deeper and consider the purpose of a trade agreement. According to the terms- of-trade theory, the purpose of trade agreements is to facilitate an escape from a terms- of-trade driven prisoners’ dilemma. In the absence of a trade agreement, governments would set optimal unilateral trade policies. For the government of a large country, a higher import tariff raises the local relative price of the import good and also lowers the relative price of the import good on the world market. This latter effect means that a higher import tariff improves the importing country’s terms of trade and results in a deterioration of the terms of trade for the exporting country. A higher import tariff from a large country thus imposes a negative terms- of-trade externality on its trading partner, whose exporters receive a lower world price. Governments fail to internalize this externality in the absence of a trade agreement, and as a consequence tariffs are higher than would be efficient, where efficiency is measured relative to government preferences. Starting from this inefficient outcome, governments can then gain from a trade agreement in which they reciprocally lower tariffs. The gains come from eliminating the local- price distortions that arise under unilateral tariff setting when foreign exporters pay part of the cost of domestic import protection. A growing body of evidence provides support for the key features of this theory.13 We mention here five sets of findings. First, Broda, Limao, and Weinstein (2008) provide evidence that even seemingly “small” countries (and many developing countries) are large in some markets and that unilateral tariff- setting responds to cost- shifting incentives where countries are large. Second, Broda, Limao, and Weinstein (2008) and Bagwell and Staiger (2011) find that the pattern of GATT/WTO negotiated tariff cuts is consistent with the elimination of the cost- shifting component of unilateral tariffs. Third, empirical work by Ludema and Mayda (forthcoming) indicates that GATT/WTO tariff bindings exhibit remnants of a cost- shifting component where one would expect to find such remnants, given MFN and the pattern of nonreciprocity. Fourth, Eicher and Henn (2011) find that the trade effects associated with WTO membership are largest for countries that were large in world markets at the time of their accession to the GATT/WTO (and hence would be expected to have a significant cost- shifting component in their unilateral tariffs and therefore to negotiate large tariff reductions in the GATT/WTO according to the terms- of-trade theory). And finally, Bown and Crowley (2013) provide evidence for the United States supporting the terms- of-trade theory’s predictions about the tariff responses of WTO members in the face of unexpected changes in trade volumes. The terms- of-trade theory of trade agreements thus suggests that devel13. See Bagwell and Staiger (2010) for a recent survey.

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oping countries stand to gain from reciprocal trade liberalization wherever they are big enough that foreign exporters “feel the pain” of their tariffs (i.e., care about access to their markets).14 When this is true, foreign countries are motivated to engage with the developing country and identify mutually beneficial and reciprocal tariff reductions. Returning to our earlier discussion of the two arguments linking SDT clauses to the disappointing developing country experience in the GATT/WTO, we now observe that these two arguments have starkly different implications for the manner in which negotiations should proceed in the Doha Round. Consider first the argument that, where developing countries have traditionally been the principal export suppliers into developed country markets (e.g., textiles and apparel, certain agricultural products, footwear), SDT has simply resulted in a lack of GATT/WTO sponsored liberalization in developed country markets because it has prevented the liberalizing forces of reciprocity from taking hold. Here the implications of our discussion for the Doha Round are simple: reject SDT, and let reciprocal bargaining between developed and developing countries do for developed- country market access in these sectors what has already been achieved for manufactured goods more generally through reciprocal bargaining between developed countries. In this case, each government involved in the reciprocal negotiations stands to gain in the standard way; that is, from the elimination of local- price distortions that arise under unilateral tariff- setting when foreign exporters pay part of the cost of domestic import protection.15 Next consider the second argument linking SDT clauses to the disappointing developing country experience in the GATT/WTO that we discussed before, which applies to the competing exporter case. Here there is an important difference: it is now relevant that reciprocal bargaining between developed countries has gone on for over fifty years; and as a result, developed country tariffs on most manufactured goods (which account for almost 90 percent of world merchandise exports) are already very low. Developing countries would therefore be “latecomers” to the tariff bargain14. We also note that some of the predictions we emphasize here would be implied as well by alternative views as to what constitutes the international externality that trade agreements are designed to address (see, e.g., Ossa 2011; Mrazova 2011). 15. Even in this simplest case, an interesting complication for the Doha Round arises from the fact that the Uruguay Round agreement that led to the elimination of the Multi-Fiber Arrangement and hence liberalized market access for textiles and apparel in developed country markets has been interpreted as a reciprocal agreement between developed and developing countries, but the form of the reciprocal commitments made by developing countries was not a market access commitment and instead amounted to accepting commitments associated with the TRIPS Agreement. TRIPS commitments are not market access commitments, and arguably they do not have the same own- export- enhancing effects as do tariff commitments, and in any case would not reduce local- price distortions in developing countries in the way that traditional market access commitments would. This in turn suggests that the WTO liberalization of textiles and apparel to date may have (a) eliminated much of the local- price distortions for this sector in developed countries, while (b) not achieving much in the way of eliminating local- price distortions in developing country markets, with the resulting asymmetry between developed and developing countries then exacerbating the “latecomer” problems that we describe next.

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ing arena for these products, and a potential concern is then that developed countries may have already eliminated local- price distortions in these markets through previous tariff negotiations. In other words, given the existing tariffs of developed countries, it may be difficult to identify a substantial set of mutually beneficial and reciprocal tariff bargains with developing countries. This concern is more speculative in nature, but it points to a potential second implication of our discussion: in order to “make room at the table” for developing countries, developed countries may need to find a way to— in effect—renegotiate some of their existing tariff commitments with one another. In particular, for manufactured goods, developed countries may have already achieved the degree of “openness” that they desire. If this is true, then two issues potentially follow. First, developed countries at this point may have preserved an inadequate amount of bargaining power; specifically, developed countries may have little left to offer developing countries in reciprocal bargains. This issue naturally complicates any process under which developing countries are to gain through a reciprocal exchange of tariff reductions with developed countries. A second issue is that a kind of “globalization fatigue” may be present in the developed world. That is, the existing MFN tariffs of developed countries may be broadly efficient for these countries in the world trading system as it currently stands, but may be too low for a world in which developing countries are fully integrated into the world trading system. To the extent that these issues arise, one possibility would be to allow for some degree of renegotiation (upward) of existing tariff commitments among developed countries, in order to “make room” for negotiations (downward) with developing countries.16 The idea would be to find a way to facilitate agreement on the set of negotiated tariff commitments that the current WTO membership would choose to negotiate today if they were not constrained in their negotiations by their preexisting tariff bindings. Of course, this possibility sounds admittedly extreme and raises a host of important issues from which our simple theoretical treatment abstracts.17 We thus introduce this possibility here primarily as a pedagogical device; and indeed, drawing on this discussion, we will later suggest that negotiations to reduce export subsidies could have much the same effect. Importantly, the underlying issues described earlier are far from new or 16. The finding that we reported earlier suggests that if the developed countries were to renegotiate (upward) some of their existing tariff commitments in a manner that satisfies the principles of nondiscrimination and reciprocity, then in principle the trade- volume effects of this renegotiation for other countries could be quite small. 17. An obvious worry is that significant renegotiations could trigger an unraveling of previous gains. For example, in the context of a possible slowdown or reversal of the process of negotiated tariff liberalization, some observers have noted that the GATT/WTO process seems to accord with the “bicycle theory” of trade agreements: unless you keep peddling, you will fall off (see Bhagwati [1988, 41] for an early informal statement of the bicycle theory, and Staiger [1995] and Devereux [1997] for early attempts to formally model this idea).

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unfamiliar to trade negotiators. Rather, a struggle with the basic problem of how to accommodate “latecomers” has been in evidence from very early in the GATT/WTO history. For example, in his assessment of the reasons for the somewhat disappointing outcome of the 1950– 1951 Torquay Round (the third negotiating round sponsored under GATT) auspices, Executive Secretary of the Interim Commission for the International Trade Organization (ITO) E. Wyndham White highlighted the bargaining power issue as follows: Another inhibiting factor was the problem presented by the disparities in the levels of tariffs. A number of European countries with a comparatively low level of tariff rates considered that they had entered the Torquay negotiations at a disadvantage. Having bound many of their rates of duty in 1947 and 1949, what could these low- tariff countries offer at Torquay in order to obtain further concessions from the countries with higher levels of tariffs? The rules adopted by the Contracting Parties for their negotiations stipulate that the binding of a low duty or of duty- free treatment is to be recognized as a concession equivalent in value to the substantial reduction of high tariffs or the elimination of tariff preferences. Some thought that, in observance of this rule, the high- tariff countries should make further reductions in their duties in exchange for the prolongation of the binding of low duties. But although the high- tariff countries were sometimes willing to offer concessions without expecting comparable reductions from countries with low tariffs, they were not prepared to grant what they considered to be unilateral and unrequited concessions. No general solution was found at Torquay, but the question will be further explored in the near future. Meanwhile, the area of negotiations between some of the European countries was restricted by this divergence of view. (Interim Commission for the ITO 1952, 9– 10) And on a smaller scale, there is also evidence that the second issue of “globalization fatigue” was already very real at Torquay as well. As E. Wyndham White wrote at the time: The Torquay negotiations took place under conditions of much greater stress than those which prevailed at the time of the Geneva or Annecy Conferences. Besides, those earlier negotiations had covered much of the ground, and many of the countries participating at Torquay felt that they had largely exhausted their bargaining power or that they had gone as far as was justified in the process of tariff reduction in view of present- day uncertainties. They felt they needed more time to digest and to assess the effects of the concessions already made before making further cuts in their tariffs. (ICITO 1952, 9) Hence, the issues associated with accommodating latecomers at the bargaining table have posed long- standing challenges for the GATT/WTO.18 18. There is also the related but distinct question whether credit should be given in multilateral trade negotiations to developing countries for the autonomous trade policy liberalization they have undertaken (e.g., as part of International Monetary Fund or World Bank programs). On this question see Mattoo and Olarreaga (2001).

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Finally, we note that The Economist also takes the view that the latecomers issue is the central sticking point at Doha: [T]he real bone of contention is the aim of proposed cuts in tariffs on manufactured goods. America sees the Doha talks as its final opportunity to get fast- growing emerging economies like China and India to slash their duties on imports of such goods, which have been reduced in previous rounds but remain much higher than those in the rich world. It wants something approaching parity, at least in some sectors, because it reckons its own low tariffs leave it with few concessions to offer in future talks. But emerging markets insist that the Doha round was never intended to result in such harmonization. These positions are fundamentally at odds. (April 28, 2011) In fact, in light of the expressed intention of the Doha Round to meaningfully integrate its developing country membership into the world trading system, it may be that, as The Economist seems to suggest, it is the latecomers’ problem, rather than the sheer number of countries involved in the Doha Round, that explains the reason for the current impasse.19 In their interim report on the Doha Round, Bhagwati and Sutherland (2011) propose a short- term deadline for the round. In this context, we note that the first implication of our analysis—that developing countries must come to the bargaining table in markets where they are large and negotiate reciprocally with each other and with developed countries—could be implemented over a short time span. Our second and more speculative implication, however, that developed countries may need—in effect—to renegotiate some of their existing tariff commitments, raises a host of important issues beyond our simple model and would appear challenging to implement over a short time span. It is possible, however, to interpret ongoing efforts in the Doha negotiations as helping to achieve ends consistent with our second implication, and after considering in the next section the nature of the agriculture negotiations we return to this possibility in section 3.4. 3.3

Agriculture

Another key objective of the current (Doha) round of GATT/WTO multilateral trade negotiations is to extend GATT/WTO disciplines to the agriculture sector. The central role of this objective is revealed by the prominent 19. This stance finds further support in Neary’s (2004) observation that the eight GATT rounds beginning in 1947 and ending with the creation of the WTO in 1995 exhibited a tight empirical relationship between the duration of the round and the number of countries participating. Based on this empirical relationship, Neary predicted (with a grain of salt) that the Doha Round would be completed in May 2010. Given that anything approaching a true “development” round that would meaningfully integrate the developing country members into the world trading system appears to be years off in the future, it seems safe to say that this empirical relationship has broken down with the Doha Round, and one explanation for the breakdown is the difficulty dealing with the latecomers problem on a scale that has never before been confronted in the history of the GATT/WTO.

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efforts to reduce agricultural subsidies and by the high- profile Doha negotiation failures that have resulted. In the Doha Round so far, the approach has been to encourage negotiations that deliver reductions in trade- distorting agricultural subsidies in exchange for reductions in import tariffs. This approach is strikingly different from traditional GATT/WTO bargaining, in which countries exchange market- access commitments through agreements to reciprocally lower import tariffs. Traditional market- access bargaining has been successful, and the benefits of such a negotiation approach can be readily understood using the terms- of-trade theory of trade agreements. The negotiation approach taken in the Doha Round, by contrast, has fared rather poorly so far, and we argue in this section that one explanation may be that the underlying economics of this approach are less sound. We thus suggest that the liberalization of agriculture should reorient toward a focus on traditional market- access bargaining. Blustein (2009) provides an interesting historical account of negotiations over agriculture policies in the Doha Round. He describes the terms of the agriculture bargain that emerged from Doha in 2005 as follows: The package was based on a hardheaded political calculation, in the finest tradition of WTO- and GATT- style mercantilism. Curbing farm subsidies might be a desirable policy for the United States as a whole, but it was a “sacrifice” that American politicians could accept only if most farm groups were assured that their export opportunities would burgeon. A Kansas wheat grower who might ordinarily rebel at seeing his federal check shrink would presumably acquiesce provided his crops stood a better chance of gaining access to European consumers or the booming emerging markets of India and China. (205– 206) But with the suspension of the round in 2008, Blustein observes: Agriculture groups felt that the deal on the table simply wouldn’t provide enough new market access for US farm exports to compensate for the reduction in the cap on US subsidies . . . the handwriting seemed to be on the wall: Although US exporters would gain additional sales in highincome markets, such as the European Union, for beef, pork, and some other products, they would not gain much, if anything, in the world’s emerging markets, because the loopholes granted to developing countries were too large. (269) As Blustein describes, from the perspective of the United States the essential agriculture bargain that emerged from Doha amounts to cuts in subsidies for US farmers in exchange for greater market access abroad for the exports of US farmers. In light of this experience, it is natural to ask: Why hasn’t Doha’s approach to agriculture liberalization succeeded? To address this question, we begin by emphasizing that, contrary to Blustein’s assertion, exchanging cuts in the export- sector subsidies of one country for cuts in the import tariffs of another country departs from

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the “tradition of WTO- and GATT- style mercantilism” in a number of crucial respects. For one thing, the traditional political trade- off between export interests and import- competing interests that has characterized all previous rounds is absent. Instead, the negotiated changes produce costs (reduced subsidies) and benefits (lower foreign import tariffs) for domestic export interests, with a net effect that may be small or even negative. As a result, there may be no domestic group ready to push for the round. Anecdotal evidence of this possibility is also reported by Blustein: “It was really sobering to hear the ag and NAM [National Association of Manufacturers] people say, ‘Hmmm, this isn’t worth the trouble,’ ” recalls one congressional staffer who attended the meetings. “How would you get that passed in Congress?” (270). By contrast, traditional market- access bargaining exchanges domestic tariff cuts for foreign tariff cuts, ensuring that at least one domestic group in each country (namely, domestic exporters) is ready to push for the round. A second and more fundamental difference between traditional marketaccess bargaining and the Doha approach to agriculture as described by Blustein (2009) concerns the extent to which the negotiation may be expected to generate efficiency gains and thus a potential for a mutually beneficial agreement. As described in the preceding section, under traditional marketaccess bargaining in which reciprocal tariff cuts are exchanged, governments can enjoy mutual gains as they eliminate local- price distortions without suffering terms- of-trade losses. Consider now the Doha approach, under which one country reduces its export- sector subsidy in exchange for a reduction in the import tariff of its trading partner. The basic problem is most easily understood with reference to a pure export subsidy (i.e., a subsidy that is paid contingent on export), and when the exchange is balanced, so that the export subsidy and import tariff are reduced at the same rate. In this case, the net tariff (i.e., the import tariff less the export subsidy) faced by exporters is unaltered; as a consequence, the price received by exporters is unchanged, and so trade volume is unaffected. In fact, the sole consequence of a balanced exchange of this kind is a monetary transfer from the importing country (whose tariff revenue declines) to the exporting country (whose subsidy expenses decline). Clearly, a balanced exchange of this kind cannot lead to mutual gains for the negotiating countries, and from this perspective it is not surprising that an agreement has been difficult to achieve using the Doha approach.20 20. To make our points in the starkest possible way, we focus here and throughout this section on export subsidies as a particular case of the export- sector subsidies that feature prominently in Blustein’s (2009) description of the Doha agriculture negotiations. More generally, these subsidies also include domestic production subsidies offered in export sectors (i.e., subsidies that are paid to each unit of domestic production regardless of where it is sold), and indeed in the Doha agricultural negotiations these so-called “domestic supports” for US farmers have proven to be the most contentious. Our analysis can be extended to include domestic supports,

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Fig. 3.2 Exchanging cuts in export subsidies for cuts in import tariffs in a twocountry one-good partial equilibrium model

The described case of a balanced exchange is somewhat special, and so it is important to emphasize that our concerns with the Doha approach are not limited to this case. Consider, for example, figure 3.2, which illustrates schematically a two- country partial- equilibrium setting where one country exports a good to another country. To fix ideas, suppose further that each government seeks to maximize the real income of its country and that markets are perfectly competitive. The efficient trade volume is then the volume that is achieved when both countries adopt free- trade policies. The efficient trade volume is also achieved, however, when the specific (i.e., per- unit) export subsidy offered by the exporting country (s) equals the specific import tariff imposed by the importing country (t∗), so that the net tariff (t∗ – s) is zero. Starting from such a point, global welfare would drop if export subsidies were banned and import tariffs remained positive.21 Likewise, if the initial net tariff were positive, then trade volume would be inefficiently low. In this case, a reduction in the level of export subsidization would itself lower trade volume further and could only enhance efficiency if it were exchanged for an even greater reduction in the import tariff. There is certainly no guarantee, however, that the importing country would find such an exchange beneficial. For these reasons, we conclude that the agricultural package on the table in the Doha Round is not in the tradition of GATT-WTO market- access bargains. And the main implication of our discussion is even more pointed: the Doha approach of negotiating reductions in export- sector agricultural subsidies in exchange for reductions in agricultural import tariffs may in fact be unworkable, because it is unlikely to lead to an agreement in which and while the analysis then becomes more complex because the domestic production subsidy and the foreign import tariff imply different price distortions (and hence our “net tariff analysis” must be altered), the main points we emphasize throughout this section go through. 21. This is a “second- best” argument, which is analogous to the well- known trade- diversion logic that arises when evaluating free trade areas. Intuitively, if the exporting government removes its export subsidy while the importing country maintains its import tariff, then trade is diverted from potentially more efficient firms in the exporting country to potentially less efficient firms in the import- competing sector of the importing country.

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Fig. 3.3 Cuts in export subsidies combined with traditional market access bargaining in a two-country two-good partial equilibrium model

all parties to the agreement gain. This is not to say that cuts in subsidies could not be part of a broader bargain in which traditional market access bargaining over tariffs also took place. For example, in a setting where each country has a good that it exports to the other, consider a bargain in which the home country agrees to reduce its import tariff t and its export subsidy s in exchange for a commitment from the foreign country to reduce its import tariff t∗, as suggested schematically in figure 3.3. Such a bargain could certainly generate mutual gains for the home and foreign countries, if the agreed reductions in s and t∗ imply a reduction in the net tariff (t∗ – s) on the foreign import good; but our point is that these gains would come in spite of the agreed reduction in s, not because of it. In this sense we suggest that efforts to liberalize agriculture in the Doha Round are more likely to succeed if they reorient toward a focus on traditional market- access bargaining.22 Our agriculture discussion thus far has abstracted from third- country issues, but such issues are certainly relevant for the agriculture negotiations in the Doha Round. It is therefore important to note that the simple insights that we have emphasized extend to a multicountry setting, and in some respects are even strengthened. To illustrate this, we now extend the basic setting depicted in figure 3.3 to a three- country partial equilibrium setting, in which two of the countries utilize export subsidies but the third country does not. The pattern of trade and trade policies for each country are depicted schematically in figure 3.4. 22. In this regard, it is interesting to note that Blustein (2009, 203) describes a meeting of trade ministers in Geneva on June 30, 2006, in which the US trade representative Susan Schwab voiced a position that seems broadly consistent with this view. As Blustein writes, “Schwab, who was accompanied by Agriculture Secretary Mike Johanns, countered that any additional concessions they might offer on subsidies would simply be pocketed, so it was the responsibility of the others in the room to step forward with clear pledges to reduce their import barriers. She stuck to the US argument that in evaluating whether the round was truly successful or not, the best metric would be the degree of new openness in world agriculture markets rather than cuts in farm subsidies. ‘Market access is where the benefits of the round will come from,’ she said, reminding the others of the World Bank studies showing that lowering barriers across the board in agriculture would give developing countries the greatest gains.”

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Fig. 3.4 Cuts in export subsidies combined with traditional market access bargaining in a three-country two-good partial equilibrium model

We refer to the two countries that apply export subsidies as the EU and the US, to convey the fact that it is mainly the developed countries that offer subsidies to their agricultural producers, and we refer to the third country that possesses no export subsidy policies as Brazil. For the moment we continue to assume that these three countries trade two goods (plus the usual traded and untaxed numeraire good in the background of this partial equilibrium setup), with the EU exporting good y and importing good x, the US exporting good x and importing good y, and Brazil exporting both goods x and y. It is now easy to see that our earlier discussion in the two- country setting applies as well to this extended three- country setting, but with one additional complicating effect: owing to Brazil’s exports of x and y to the EU and the US, respectively, any net tariff reductions that the EU and US might negotiate in the context of also reducing their export subsidies will now cause a leakage of some of the joint surplus that their negotiations create to the third country, as Brazil enjoys rising world/export prices (i.e., its terms of trade improve). This, of course, only makes it harder for the EU and the US to find a way to jointly gain from a broader agreement that also cuts export- sector subsidies, and as we emphasized earlier, any such gains would come in spite of the agreed reduction in subsidies, not because of it.23 23. On the other hand, it is easily checked in this setting that: (a) the EU and the US could gain from a negotiation over their tariffs and export subsidies that cut tariffs and raised export subsidies; (b) such a negotiation could be engineered so as to neutralize all third- party effects on Brazil; and (c) such a negotiation could be consistent with worldwide efficiency. So it is the constraint to reduce export- enhancing subsidies that is the problem here, as we emphasize in the text.

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Finally, we note that the addition of a third country does introduce the possibility that the EU and the US could in fact gain from an agreement to reduce their export- sector subsidies, in the sense that their joint gain derives directly from their agreed restriction on subsidies rather than in spite of this agreed restriction. To see this possibility, we now introduce a third good z into the three- country partial equilibrium setting just described, and assume that good z is imported by Brazil and exported by both the EU and the US. We suppose further that Brazil applies an import tariff on good z while the EU and the US each subsidize the exports of z to Brazil, where the net tariff along each trade channel is positive. Figure 3.5 depicts this three- country three- good setting. Relative to our earlier discussion, the novel feature here is that the EU and the US are now competing exporters (of good z) into Brazil, and absent an agreement on export subsidies they are locked in an exportsubsidy competition for Brazil’s market. The important new element is that an agreement between the EU and the US to restrict their export subsidies will raise the world price of good z, which by itself marks a terms- of-trade improvement for the EU and the US and can therefore offer a joint benefit to these two countries. Of course, this joint benefit comes at the expense of Brazil, who suffers the counterpart terms- of-trade deterioration. And it is easy to show that the benefit that the EU and the US enjoy here marks an inefficient victory of exporter interests over importer—and world—interests. Hence, while it is possible to see in this three- country three- good setting how the European Union and the United States could actually benefit from an agreement to restrict their export- sector subsidies, if this describes the underlying logic of Doha’s approach to agriculture then any agriculture

Fig. 3.5 Cuts in export subsidies combined with traditional market access bargaining in a three-country three-good partial equilibrium model

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agreement that does emerge from Doha would not advance the wider goals of the WTO membership.24 We are therefore left with a pessimistic view of the Doha approach to agriculture negotiations when this approach is evaluated on its own merits. Nevertheless, taking a broader perspective and viewing the attempts to limit subsidies within the wider context of the challenges associated with integrating the less- developed- country members into the world trading system, it is possible to interpret the efforts to limit agricultural subsidies in the Doha Round as playing a useful role in helping to address the issues associated with “latecomers” to the GATT/WTO bargaining table as we described these issues in section 3.2. We turn to this interpretation next. 3.4

Making the Doha Round a Development Round

We have suggested that the success of the Doha Round as a development round may hinge on moving away from the nonreciprocal SDT norm as the cornerstone of the approach to meeting developing country needs in the WTO. Rather, if developing countries are to share in the gains from GATT/ WTO market access negotiations, we have argued that they must come to the bargaining table in markets where they are large and negotiate reciprocally with each other and with developed countries. We have also suggested that in the context of the Doha Round the WTO may be facing a critical challenge associated with the problem of “latecomers” to the GATT/WTO bargaining table, in that developed countries at this point may have preserved an inadequate amount of bargaining power with which to engage developing countries in reciprocal bargains; and in addition a kind of “globalization fatigue” may be present in the developed world whereby the existing MFN tariff levels of developed countries may be too low for a world in which developing countries are fully integrated into the world trading system. And we have indicated that to address this problem, developed countries might need to, in effect, renegotiate (upward) some of their existing tariff commitments in order to “make room at the table” and accommodate the entry of developing countries into the world trading system. Finally, we have observed that, when evaluated on its own merits, the Doha approach to agricultural negotiations and its emphasis on the reduction of exportenhancing agricultural subsidies in exchange for cuts in import tariffs seems suspect on economic grounds. We now suggest that, when viewed from the wider perspective of the Doha Round’s central goal of integrating the WTO’s developing country 24. The interpretation of export subsidy agreements that we describe here is formalized and developed more fully in Bagwell and Staiger (2001) and Bagwell and Staiger (2002, chap. 10). See also Bagwell and Staiger (2012) and Mrazova (2011) for alternative possible interpretations of export subsidy agreements.

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members into the world trading system, the emphasis on reducing and eliminating agricultural export- sector subsidies might itself be reinterpreted as an initiative that could effectively “make room at the table” for developing countries, and can in this way be interpreted as a coherent part of this broader whole. In particular, a Doha Round that (a) engages developing countries to come to the bargaining table in markets where they are large and negotiate reciprocally with each other and with developed countries, and, as part of the bargain, (b) reduces and/or eliminates the agricultural export- sector subsidies of developed countries, could be viewed as a way to engineer trade volume gains for developing country members while using the reduction/elimination of agricultural subsidies both as a bargaining chip to entice developing countries to agree to lower their tariffs, thereby generating bargaining power for the “low- tariff” developed world, and as a device to mitigate the overall trade effects of integrating developing countries into the world trading system, thereby addressing the issue of developed- world “globalization fatigue.” That is, if the developed world is struggling with how to handle the latecomers problem, then the negotiated reduction in agricultural export- sector subsidies might be seen as a way to address that problem. This point can be seen both from the perspective of the general equilibrium model that we sketched in section 3.2, and from the partial equilibrium perspectives developed in section 3.3. From a general equilibrium perspective, the point derives from the observation that an import tariff acts like an export tax once its general equilibrium impacts are accounted for, which is why, as we have described in section 3.2, a cut in a country’s own tariffs, in raising the volume of its imports, will also stimulate its exports, acting much like the introduction of a program of export subsidies. By the same token, a cut in a country’s own export subsidies, in reducing the volume of its exports, will also contract its imports, acting much like an increase in the country’s import tariffs. Viewed in this light, a Doha agreement to reduce/eliminate the agricultural export- sector subsidies of the developed countries can “make room at the table” and accommodate the entry of developing countries into the world trading system, because it will have much the same effect as if developed countries (say, the home country and foreign country 1 in figure 3.1) had instead renegotiated (upward) their existing tariff commitments.25 Hence, the negotiated reduction in agricultural subsidies might be seen as helping to address the latecomers problem. To see the same point from a partial equilibrium perspective, it is useful to refer back to figure 3.5. There it is clear, for example, that a cut in sUS x , the 25. When a country’s export- sector subsidy takes the form of a pure export subsidy, cutting it is in fact equivalent to an increase in the country’s import tariff. When the export- sector subsidy takes the form of a domestic production subsidy offered in the export sector, cutting it is equivalent to an increase in the country’s import tariff coupled with an increase in the country’s consumption tax on the export good.

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US export subsidy on good x, would help reorient EU imports of good x away from US exporters and toward Brazilian exporters, at the same time that it would (a) reduce overall import volume of good x into the European Union, and (b) raise the price received by Brazilian exporters of good x. Similarly, a cut in s yEU , the EU export subsidy on good y, would help reorient US imports of good y away from EU exporters and toward Brazilian exporters, at the same time that it would (a) reduce overall import volume of good y into the US, and (b) raise the price received by Brazilian exporters of good y. Clearly, these cuts in export subsidies could then (a) help address “globalization fatigue” in the EU and the US by mitigating the overall trade effects of reciprocal tariff cuts negotiated between the EU and Brazil and between the US and Brazil, and (b) if offered as a carrot to Brazil in exchange for tariff cuts from Brazil, could serve as an extra bargaining chip for use by the “low- tariff ”/developed countries EU and the US in their reciprocal tariff bargains with Brazil. Hence, from this partial equilibrium perspective as well, it is clear that the negotiated reduction in agricultural export subsidies might be seen as helping to address the latecomers problem.26 Two further points follow from this discussion. First, as is apparent from the partial equilibrium perspective of figure 3.5, the negotiated reduction in agricultural subsidies would be most effective in addressing the latecomers problem for developing countries that are large exporters of agricultural products. Hence, negotiated reductions in developed country agricultural subsidies may be an especially powerful instrument for helping to accommodate Brazil’s integration into the world trading system, but perhaps less so with regard to China or India.27 And second, it should be clear from this

26. It is also interesting to note that the effort to reduce/eliminate export- enhancing agricultural subsidies and the effort to more fully integrate developing countries into the world trading system are being attempted in the same round of GATT/WTO negotiations. There could, of course, be many reasons for this, but the interpretation we offer here is one of them. 27. More specifically, and with reference to figure 3.5, in the absence of SDT there are three strategies that would become available for a developed country such as the US to negotiate reductions in the tariffs of a developing country such as Brazil. First, to the extent that Brazil is the traditional principal supplier of a good (say, good y in figure 3.5) into the US market, the existing US tariff on this good is likely to be inefficiently high as a result of the GATT/WTO’s historical reliance on SDT, and the US can then engage Brazil in standard reciprocal market access negotiations offering cuts in the US tariff on imports of good y in exchange for cuts in Brazil’s tariff (say, on imports of good z in figure 3.5). This first strategy may be available with regard to developed country markets such as textiles and apparel, certain agricultural products, and footwear (though on the possible difficulties of applying this strategy for textiles and apparel see note 15). Second, for agricultural goods where the US and Brazil are competing exporters into developed country markets such as the EU (say, good x in figure 3.5), the US can offer reductions in agricultural subsidies to Brazil in exchange for cuts in Brazil’s tariff (on imports of good z in figure 3.5), as we have described in the text. These negotiations could benefit both the US and Brazil, though the EU could be hurt without further multilateral policy adjustments. And third, for nonagricultural goods where a developed country such as the EU

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discussion that the bargain we have outlined here is fundamentally multilateral, in that it cannot be broken down into a series of bilateral bargains that is each mutually beneficial to the parties involved. This is an inherent feature of any solution to the latecomers problem, as we have described that problem earlier, and it creates a special challenge for an institution such as the GATT/WTO with a long history of solving problems via a collection of largely bilateral and mutually beneficial bargains. Finally, it is worth emphasizing the one key change in the substance of the current approach to Doha Round negotiations that is required for the economic interpretation that we have sketched here to hold together: the Doha Round must move away from SDT as the cornerstone of the approach to meeting developing country needs in the WTO. In particular, developing countries (Brazil in figure 3.5) must come to the bargaining table in markets where they are large and offer reciprocal tariff cuts of their own. Absent tariff cuts from developing countries, the analysis we have sketched here cannot lend support to the basic Doha approach to negotiations.28 3.5

Conclusion

A fundamental objective of the Doha Round of WTO negotiations is to improve the trading prospects of developing countries. The 2001 declaration from the WTO Ministerial Conference in Doha, Qatar, commits the member governments to negotiations aimed at substantial improvements in market access with a view to phasing out export subsidies, while embracing special and differential treatment for developing countries as an integral part of all elements of the negotiations. is the traditional principal supplier into the US market (say, good y in figure 3.5) and where US tariffs are likely to be low as a result of commitments made in previous rounds of GATT/ WTO negotiations, the US could in principle renegotiate with the EU on the treatment of good y, with the US raising its tariff binding and the EU lowering its export subsidy, so that the US could then engage Brazil in standard reciprocal market access negotiations offering cuts in the US tariff on imports of good y in exchange for cuts in Brazil’s tariff (on imports of good z in figure 3.5). Once again, the EU could be hurt without further multilateral policy adjustments. In theory, this third strategy provides a direct way to address the latecomers problem and allow developing countries to be integrated into the world trading system where the first two strategies are unavailable, though in practice the prospect of tariff renegotiations between developed countries raises a host of issues from which our simple theoretical treatment abstracts, which is why we present this third possibility as of mostly pedagogical value. 28. The other change we have suggested—that the agriculture negotiations, which are currently focused on negotiating reductions in agricultural export- enhancing subsidies in exchange for reductions in agricultural import tariffs, should be reoriented toward a focus on traditional market- access bargaining—can, from the perspective we offer here, be seen less as a change of substance than a change in emphasis and interpretation within a broader package, because within this broader package export- enhancing subsidies are still cut, but the purpose of an agreement to reduce these subsidies is now solely to facilitate market access (i.e., tariff) negotiations between developed and developing countries.

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The main message of this chapter comes in three parts. First, these stated aims are incompatible from the perspective of our economic analysis; thus, if these aims are pursued as stated, then we conclude that they are unlikely to deliver the meaningful trade gains for developing countries that the WTO membership seeks. Second, in attempting to integrate its developing country membership into the world trading system, the WTO may face a “latecomers” problem that, while occurring also in earlier rounds, is unprecedented in its scale in the Doha Round, and that could potentially account for the current impasse. And third, we argue that if the Doha Round maintains its stated aims but moves away from the nonreciprocal special- and- differential treatment norm as the cornerstone of the approach to meeting developing country needs in the WTO, and if developing countries prepare, in markets where they are large, to come to the bargaining table and to negotiate reciprocally with each other and with developed nations, then it might be possible to break the impasse at Doha, to address the latecomers problem, and to deliver trade gains for developing countries. We close with two final observations. First, our diagnosis of the underlying reason for the current stalemate in the Doha Round has much in common with the views expressed in a recent speech by WTO Director General Pascal Lamy on this point: In trade matters, we need to address competing views among governments as to what constitutes a fair distribution of rights and obligations within the trading system. Before the WTO was established in 1995 there was, in broad terms, an arrangement whereby developed countries agreed to open their markets, while more emphasis was placed on special and differential treatment for developing countries. Developing countries were not called upon to open their markets in a substantial manner. This arrangement reflected basic differences in development levels and capacities. Over time, the differences between developed and at least some developing countries have narrowed, and with it the rather simple dichotomy upon which the GATT trading system rested. As developing- country growth has outstripped developed- country growth and the gap has narrowed, it is becoming harder to find a balance of rights and obligations that is regarded as legitimate and fair in the eyes of all parties concerned. These tensions had already begun to manifest themselves well before the creation of the WTO and China’s accession, but they have clearly increased since. Underlying all this is the question of what constitutes reciprocity. For some, the emerging economies have attained a level of competitiveness and efficiency in key sectors that warrants treating reciprocity as parity in obligations. Others emphasize that emerging economies still face formidable development challenges in many areas of their economies and are still far from enjoying the per capita income levels and standard of living of those in industrialized economies. In this world, it is argued, treating

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reciprocity as equality of obligations is not appropriate, fails to meet a fairness standard, and handicaps development policies. It is not my role as Director-General to take a position on this issue, but in many ways, it is this that has made it impossible for us so far to reach agreement on a big package of new regulations of world trade in the Doha Round. (WTO 2011) Achieving a shared diagnosis of the problems that have led to the impasse at Doha is crucial if WTO- member governments are to move forward on a solution to that impasse. Our economic analysis provides strong support for the views expressed by Director General Lamy in this regard. At the same time, our analysis suggests a possible bridge between the opposing positions described by Director General Lamy regarding what constitutes “a fair distribution of rights and obligations within the trading system”: such a bridge might be built, not by equating reciprocity with a “parity in obligations” per se (though that could be the outcome of reciprocal negotiations), but rather by building on the way that developed countries have traditionally harnessed reciprocity in their GATT/WTO market access negotiations with each other and finding ways to harness reciprocity as a means to achieve meaningful market access commitments for emerging/developing economies as well. And finally, we note that the relatively successful experience of the negotiations regarding the revised WTO Agreement on Government Procurement (GPA), the text of which is now agreed in principle, is potentially relevant for the arguments we have put forward here.29 In particular, as Anderson (this volume) describes, in their GPA negotiations WTO- member governments have adopted a novel approach to SDT that allows reciprocity to be maintained in the negotiations between developed and developing countries. If our arguments are correct, this feature of the GPA negotiations, in combination with the fact that the GPA negotiations did not start from a substantial asymmetry of commitments across existing developed and developing country members and so did not face the kind of “latecomers” problem that we have argued confronts the Doha Round negotiators, may help to explain the relative success achieved by the GPA negotiators as compared to that achieved to date in the Doha Round.

29. We thank our discussant Robert Anderson for bringing this negotiation to our attention and providing the relevant mapping to our analysis.

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Data Appendix The following tables are taken from the WTO World Trade Report 2007. Table 3A.1 Implementation period 1948 1950 1952 1956–1958 1962–1964 1968–1972 1980–1987 1995–1999

GATT/ WTO: Sixty years of tariff reductions

Round covered

Weighted tariff reduction

Weights based on MFN imports (year)

Geneva (1947) Annecy (1949) Torquay (1950– 1951) Geneva (1955– 1956) Dillon Round (1961– 1962) Kennedy Round (1964– 1967) Tokyo Round (1973– 1979) Uruguay Round (1986– 1994)

–26 –3 –4 –3 –4 –38 –33 –38

1939 1947 1949 1954 1960 1964 1977 (or 1976) 1988 (or 1989)

Sources: Geneva (1947): US Tariff Commission, Operations of the Trade Agreements Program, June 1934–April 1948, Part III, table 16 (nonagricultural products). Annecy (1949): US Tariff Commission, Operations of the Trade Agreements Program, April 1949–June 1950, chapter 5, tables 7 and 8. Refers to all products. Torquay (1950– 1951): United States Tariff Commission, Fifth Report, July 1951–June 1952, chapter 4, pp. 149– 70, tables 5 and 6. Geneva (1955– 1956): Estimates based on United States Tariff Commission, Ninth Report, July 1955–June 1956, chapter 3, pp. 100– 08, and US Department of State Publication 6348, Commercial Policy Series 158, released June 1956. Dillon Round (1961– 1962): Estimates based on United States Tariff Commission, 13th Report, July 1959–June 1960, pp. 17– 29 and US Department of State Publication 7408, Commercial Policy Series 194, released July 1962. Kennedy Round (1964– 1967): Preeg, E.(1970), Traders and Diplomats, tables A2 and A3. Refers to four markets (United States, Japan, EEC[6], and United Kingdom). Own calculations for the aggregate based on 1964 MFN import values. Tokyo Round (1973– 1979): GATT, COM. TD/W/315, 4.7.1980, p. 20 and 21, and own calculations. Refers to eight markets (United States, EEC[9], Japan, Austria, Finland, Norway, Sweden, and Switzerland). Uruguay Round (1986– 1994): GATT, The Results of the Uruguay Round of Multilateral Trade Negotiations, November 1994, appendix table 5, and own calculations. Refers to eight markets (United States, EU[12], Japan, Austria, Finland, Norway, Sweden, and Switzerland). Note: Tariff reductions for the first five rounds refer to the United States only. The calculation of average rates of reductions are weighted by MFN import values. MFN tariff reduction of industrial countries for industrial products (excluding petroleum).

Table 3A.2

Pre- and post-Uruguay Round binding coverage for agricultural and nonagricultural products Agricultural products Percentage of imports under bound rates

Percentage of tariffs lines bound Pre-UR Developing economies Transition economies Latin America Central Europe Africa Asia

Post-UR

Nonagricultural products

Percentage of tariffs lines bound

Pre-UR

Post-UR

Pre-UR

Post-UR

Percentage of imports under bound rates Pre-UR

Post-UR

17

100

22

100

21

73

13

61

57

100

59

100

73

98

74

96

36 49 12 15

100 100 100 100

74 54 8 36

100 100 100 100

38 63 13 16

100 98 69 68

57 68 26 32

100 97 90 70

Source: GATT (1994).

Table 3A.3

Canada United States Japan EUa Denmark United Kingdom Austria Finland Sweden Norway Switzerland Australia New Zealand

Status of tariff bindings: Developed countries and industrial products, 1972–2000 Post–Kennedy Round 1972

Post–Tokyo Round 1987

Post–Uruguay Round 2000

74– 74 100– 100 90– 91 98– 99 97– 91 93– 94 86– 87 55– 86 94– 95 79– 81 98– 98

98– 98 100– 100 97– 97 99– 99

99.7 100.0 99.6 100.0

96– 96 97– 97 97– 97 95– 95 99– 99 11– 17 39– 51

100.0 99.7 96.5 99.5

Source: Kennedy Round: GATT (1971) Basic Documentation for the Tariff Study, supplementary tables, Geneva. Tokyo Round: GATT (1987), Importance des consolidations tarifaires établies dans le cadre de l’Accord Général, GATT document: MTN.GNG/NG1/WW /2/Rev.1*, 27 mars 1987. Uruguay Round: WTO (2007), World Tariff Profiles. Note: Percentage—coverage based on tariff lines. Lower end of binding coverage range refers to totally bound tariff lines while upper end includes partially bound tariff lines. a Refers to EEC(6) for Post-Kennedy, to EEC(9) for Post-Tokyo, and to EU(15) for PostUruguay (including ITA).

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Table 3A.4

Status of tariff bindings: Developed countries and agricultural products, 1987 and 2000

Canada United States Japan EUa Austria Finland Sweden Norway Switzerland Australia New Zealand

Post–Tokyo Round

Post–UR Round

90– 91 90– 93 60– 63 63– 65 55– 62 51– 56 46– 50 67– 69 44– 46 26– 32 48– 54

100.0 100.0 100.0 100.0

100.0

10%

PM < 10%

Total

MFN > MFN < 10% 10%

MFN EU–intra Reciprocal regimes NAFTA EU–Switzerland ASEAN* EU–Turkey EU–Mexico

0 63.7 43.7 60.9 56.9 20.1 78.4 51.2

0 9.4 5.8 6.3 3.9 4 15.2 13.5

0 54.3 37.9 54.7 53 16 63.2 37.7

44.8 0 7.6 0.1 1.3 3.6 0.9 0.9

4.9 0 1 0 0.5 0.3 0.5 0.6

Nonreciprocal regimes EU–GSP US–GSP US–AGOA

17.6 13.3 8.3 90.1

1 0.1 0.2 1.5

16.6 13.2 8.1 88.6

26.3 23 62.4 0.1

5.4 5.7 5.6 0

MFN = 0

Trade billions (USD)

40 0 6.6 0 0.8 3.3 0.4 0.3

53.9 34.4 47 38.2 41 72.9 20 43.2

4,874 3,807 2,803 912 261 141 141 58

21 17.3 56.8 0

55.6 63.4 28.8 9.9

2,067 1,012 258 84

Source: World Trade Review (2011).

imports receiving a preference of greater than 10 percent. A similar picture emerges on the exporting side. One of the countries that has actively negotiated PTAs is Chile and 95 percent of Chilean exports go to countries that Chile has a PTA with. However, only 27 percent of Chilean exports are eligible for preferential treatment and only 3 percent of its exports benefit from preference margins greater than 10 percent. Table 4.1 provides an additional breakdown of the volumes of trade that enter on a preferential and on an MFN basis for a number of sample PTAs. Clearly for most PTAs the majority of their trade takes place under zero MFN tariffs. It is only a small fraction of trade that enters on a preferential basis, especially outside of the EU and NAFTA. Taken together, the preceding statistics suggest that the extent of trade liberalization undertaken through PTAs has been quite modest, despite the large number of PTAs that have in fact been negotiated. These observations challenge the claim by proponents of regionalism that preferential agreements are a faster or more efficient way of achieving trade liberalization.6 At some level this should not perhaps be too surprising. It is widely 6. In addition, it may be noted that the discussion and negotiation over particular PTAs has sometimes also taken a significant amount of time—comparable to the duration of multilateral trade negotiation rounds at the WTO. For instance, the CAFTA-DR agreement, a free trade area between the United States and the Central American countries of Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and the Dominican Republic took well over a decade, from 1992, when it was initially conceived, to 2009, when it came into effect in all of the member countries.

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understood that a major factor working against trade liberalization is the political opposition of the import competing lobbies. If this is the case, it is unclear why lobbies that oppose trade liberalization at the multilateral level would easily support liberalization undertaken on a preferential basis. We should therefore expect that political lobbies would mostly only permit preferential agreements in which their rents were protected, either through access to partner country markets, or, more simply, through an exemption of liberalization on imports of those goods that compete with their own production, suggesting complementarities between MFN and PTA tariffs. To explore the question of whether MFN tariffs and PTA tariffs are indeed complements, Baldwin and Seghezza (2010) examined correlations between MFN and PTA tariffs at the ten- digit level of disaggregation for twenty- three of the top exporting countries within the WTO (for which data was available). Consistent with the preceding discussion, they find that MFN tariffs and PTA tariffs are complements, since the margin of preferences tends to be low or zero for products where nations apply high tariffs. This finding of complementarity has been confirmed in the more detailed studies by Joshi (2010a and 2010b) for NAFTA and the EU. All of these studies suggest that third factors, such as vested sectoral interests, drive trade policy at both the multilateral and the bilateral level. The implication is that we should not expect liberalization that is difficult at the multilateral level to necessarily proceed easily at the bilateral level. 4.3

Trade Creation and Trade Diversion

Does preferential trade liberalization in favor of particular trading partners have the same welfare consequences as nondiscriminatory trade liberalization in favor of all imports? Do a simple proportion of the welfare benefits of nondiscriminatory free trade accrue with preferential liberalization? Are free trade areas to be equated with free trade? A thorough answer to these questions would require a deep plunge into the abstruse world of the second best (whose existence and complexities were indeed first discovered and developed by analysts working on the economics of PTAs). But the idea may be introduced in a rudimentary fashion using the following “textbook” representation of Viner’s (1950) classic analysis. Consider the case of two countries, A and B, and the rest of the world, W. A is our “home” country. A produces a good and trades it for the exports of its trading partners B and W. Both B and W are assumed to export the same good and offer it to A at a fixed (but different) price. Initially, imports from B and W are subject to nondiscriminatory trade restrictions: tariffs against B and W are equal. Imagine now that A eliminates its tariffs against B while maintaining its tariffs against W. This is preferential tariff reduction as opposed to free trade, since the latter would require that tariffs against W be removed as well. It is very tempting to think that this reduction of tariffs against B is a

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step in the direction of free trade and therefore that this ought to deliver to country A a proportionate fraction of the benefits of complete free trade. But Viner showed that this need not (and generally would not) be the case. Indeed, while a complete move toward free trade would be welfare improving for country A, Viner demonstrated that the tariff preference granted to B through the FTA could in fact worsen A’s welfare. Figures 4.1 and 4.2 illustrate preferential tariff reform as respectively welfare- enhancing and welfare worsening. The y- axes denote price and the x- axes denote quantities. Variable MA denotes the import demand curve of country A. Variables EB and EW denote the price at which countries B and W are willing to supply A’s demand; they represent the export supply curves of B and W, respectively. In figure 4.1, B is assumed to be a more efficient supplier of A’s import than is W: EB is drawn below EW, and its export price PB is less than W’s export price PW. Let “T” denote the nondiscriminatory perunit tariff that is applied against B and W. This renders the tariff- inclusive price to importers in A as PB + T and PW + T, respectively. With this nondiscriminatory tariff in place, imports initially equal M0 and the good is entirely imported from B. Tariff revenues in this initial situation equal the areas (1 + 2). When tariffs against B are eliminated preferentially, imports rise to MPT. Imports continue to come entirely from B (since the import price

Fig. 4.1

Trade-creating tariff preferences: Change in welfare = (3 + 4)

Preferential Trade Agreements and the World Trade System

Fig. 4.2

139

Trade-diverting tariff preferences: Change in welfare = (3 – 2)

from B now, PB, is lower than the tariff- inclusive price of imports from W, PW + T). The tariff preferences granted to B simply increase the volume of imports. This increase in the volume of trade with the country whose exports were initially being purchased by A anyway (i.e., with the more efficient producer) when tariffs against it are preferentially reduced is referred to as “trade creation.” Trade creation here is shown to be welfare improving. The increase in benefit to consumers (consumer surplus) in A following the reduction in consumption prices from PB + T to PB equals the areas (1 + 2 + 3 + 4). No tariff revenue is now earned and so the loss of tariff revenue equals areas (1 + 2). The overall gain to A from this preferential tariff reduction equals areas (1 + 2 + 3 + 4) – (1 + 2) = areas (3 + 4), a positive number. The trade- creating tariff preference is thus welfare improving. In demonstrating that the tariff preference we have considered is welfare improving for the home country, A, we have assumed that the partner that receives this tariff preference, B, is the more efficient supplier of the good. Figure 4.2 reverses this assumption, making W, the rest of the world, the more efficient supplier of the good. Variable EW is thus drawn below EB. Initial imports are M0. The tariff revenue collected is equal to the areas (1 + 2). When tariffs are eliminated against B, the less efficient partner, the tariff- inclusive price of imports from W is higher than the tariff- exclusive

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price from B (this need not necessarily be the case, it is simply so as drawn). This implies that all trade is now “diverted” away from W to B. What is the welfare consequence of this trade diversion? The increase in consumer surplus is equal to the areas (1 + 3) since consumers now pay a price equal to PB for this good. The loss in tariff revenue is (1 + 2). The overall gain to A equals the area (3 – 2), which may or may not be positive. Thus a tradediverting tariff preference may lead to a welfare reduction.7 The preceding discussion leaves us with three important implications. First, liberalization undertaken in a preferential context may actually result in a greater degree of trade protection (for inefficient partners). Second, measured increases in intra-PTA trade volumes do not automatically indicate an improved economic outcome. Finally, the possibility of welfare reducing liberalization clearly distinguishes preferential liberalization from multilateral liberalization. A variety of recent contributions in the economics literature have examined the trade-creating and trade-diverting effects of preferential agreements. In a recent paper, Romalis (2007) investigates the effects of NAFTA and the previously formed Canada-US Free Trade Agreement (CUSFTA) on trade flows. Romalis finds that NAFTA and CUSFTA had a substantial impact on international trade volumes, but a modest effect on prices and welfare. While he finds that while NAFTA and CUSFTA increased North American output in many highly protected sectors, imports from nonmember countries were driven out, suggesting trade diversionary effects. Other papers analyzing the trade effects of CUSFTA include Clausing (2001) and Trefler (2004). Using cross- sectional variation in the extent of trade liberalization, both papers attempt to estimate the relative magnitudes of trade creation and trade diversion caused by CUSFTA. Both analyses find that trade creation dominated trade diversion and Trefler (2004) reports a positive welfare outcome for Canada overall. A number of studies have used “gravity” specifications to examine the impact of preferential trade agreements on trade. Two prominent recent examples include Magee (2008) and Baier and Bergstrand (2007). Using panel data from over a hundred countries going nearly two decades (1980– 1998), Magee (2008) estimates trade creation and trade diversion effects of preferential trade agreements and finds this trade and welfare impact to be small, 7. The preceding examples illustrate a central issue emphasized in the academic literature on the welfare consequences of preferential trade. Preferential trade liberalization toward the country from whom the good was imported in the initial nondiscriminatory situation creates more trade and increases welfare; preferential liberalization that diverts trade instead may reduce welfare. Subsequent analysis also developed examples of both welfare- improving trade- diversion and welfare- decreasing trade creation in general equilibrium contexts broader than those considered by Viner. However, the intuitive appeal of the concepts of trade creation and trade diversion has ensured their continued use in the economic analysis of preferential trade agreements, especially in policy analysis (see Panagariya [2000] for a comprehensive survey).

Preferential Trade Agreements and the World Trade System Table 4.2

141

Regional orientation of trade and comparative advantage: MERCOSUR

Product

Exports 1998

Exports 1994

RO 1988

RO 1994

∆ RO

Comp. adv.

Nonalcoholic beverages Lead Prepared dairy Nonwheat meal or flour Perfumes and cosmetics Wheat meal or flour Cork manufactures Preserved vegetables Articles of paper Nonmotor road vehicles Alcoholic beverages Agricultural machinery Domestic electrical machinery Road motor vehicles Materials of rubber Glassware Synthetic fibers Rice (glazed) Lace and ribbons Food preparations

349 642 23,495 4 4,766 65 18 23,404 15,763 3,118 4,137 39,608 12,568 206,996 3,636 5,381 13,381 22,583 1,386 7,727

26,238 219 204,019 954 86,282 35,051 721 48,745 72,249 35,854 81,671 121,294 97,322 2,112,750 30,780 45,017 21,170 148,079 13,157 45,412

2.35 3.03 4.31 0.05 5.22 0.22 1.18 17.66 2.16 2.23 1.87 2.08 2.19 1.25 3.13 2.21 6.28 9.28 3.56 2.1

48.47 25.42 22.49 17.26 13.37 5.67 6.3 22.61 7.1 6.88 6.48 5.88 5.94 4.42 6.26 5.09 9.14 11.65 5.86 4.35

46.12 22.39 18.17 17.21 8.16 5.44 5.13 4.95 4.93 4.65 4.61 3.81 3.76 3.17 3.13 2.88 2.87 2.37 2.29 2.25

0.05 0 0.13 0.04 0.14 1.08 0.05 0.13 0.2 0.13 0.19 0.45 0.23 0.45 0.32 0.38 0.11 1.03 0.22 0.28

Source: Yeats (1998).

although trade creation dominates trade diversion in his analysis. Using a similar sample of countries, but going back further in time (1960– 2000), Baier and Bergstrand (2007) estimate trade creation effects by considering explicitly the endogeneity of preferential trade agreements (but excluding by assumption any trade diversion effects) using the following specification. Baier and Bergstrand find the endogeneity of trade agreements to be crucial, and report that accounting for this endogeneity raises by about five times the estimate of the increase in trade flows between member countries (see table 4.2). Specifically, trade between member countries is predicted to double in ten years after the formation of the FTA.8 The preceding discussion covers only a small sample of the research quantifying trade creation and trade diversion effects with trade preferences. Nevertheless, it should suffice to illustrate the wide range of estimates that have been obtained. On the one hand, the findings in many papers suggest that changes in trade flows due to trade preferences will be small. On the other hand, some papers have suggested the possibility of significant trade 8. However, as we have indicated before, increases in intra-PTA trade are not necessarily welfare improving. For this to be ascertained, the extent of trade diversion has to be determined as well.

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diversion, while others have estimated large trade creation effects. The evidence is clearly mixed. One study that is additionally noteworthy because of its detailed and unusual focus on changes in industry trade flows as related to patterns of comparative advantage is Yeats (1998), which investigated trade diversion within PTAs by performing an evaluation of trade patterns within MERCOSUR. Specifically, to study the impact of MERCOSUR on trade patterns, Yeats (1998) characterized goods using two measures. The first measure is a “regional orientation” index (for good i), which is the ratio of the share of that good in exports to the region to its share in exports to third countries. Specifically, ROi = [(Within MERCOSUR exports of good i)/(Within MERCOSUR exports)] [(MERCOSUR exports of good i)/(Total MERCOSUR exports)]

The second measure is the “revealed comparative advantage” (of good i ), which is the ratio of the share of good in MERCOSUR’s exports to third countries to its share in world exports (exclusive of intra-MERCOSUR trade). Specifically, RCAi =

[(MERCOSUR exports of good i)/(Total MERCOSUR exports)] [(World exports of good i)/(Total World exports)]

Yeats then compares the change in goods’ regional orientation index between 1988 and 1994 (before and after MERCOSUR) with their revealed comparative advantage ranking. The results of his study are striking. As he notes, the goods with the largest increase in regional orientation are goods with very low revealed comparative advantage rankings. Specifically, for the thirty groups of goods with the largest increases in regional orientation, only two had revealed comparative advantage indices above unity (see table 4.2). That is, the largest increases in intra-MERCOSUR trade have been in goods in which MERCOSUR countries lack comparative advantage, suggesting strong trade diversionary effects. This is a striking finding and provides a cautionary note against the dismissals of trade diversion as a merely theoretical concern. Bhagwati (2008) has discussed a variety of additional issues surrounding the question of trade diversion in practice. For instance, even though Article XXIV of the GATT prevents PTA countries from raising their tariffs against nonmember countries, this restriction applies to the MFN tariff bindings agreed to by the member countries at the WTO. In practice, MFN tariffs applied by countries often lie below these bound tariffs. Thus despite the disciplines imposed by Article XXIV, PTA countries are able to raise their barriers against nonmembers from the applied level up to the bound level

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(thus increasing the worry of trade diversion), as was the case with Mexico following NAFTA. Furthermore, external barriers may be raised through other forms of administered protection, such as antidumping duties (which we discuss in greater detail in section 4.4.3). Finally, the extensive use of “rules of origin” in PTAs that purport to determine the origin of goods so as to determine whether they qualify for trade preferences offered by the PTA, raise protection to suppliers of intermediate goods within the PTA and may thus divert trade away from more efficient suppliers of intermediates outside. 4.3.1

External Terms of Trade

Thus far, we have focused our discussion largely on trade flows and welfare consequences of preferential trade liberalization on the countries undertaking the liberalization. While we have not explicitly considered this so far, it should be easy to see that changes in demand by PTA members for the rest of the world’s exports could lower the relative price of these exports (i.e., worsen the rest of the world’s terms of trade). In general, the overall effect on the external terms of trade may be seen as a combination of income and substitution effects. The former represents the effect of real income changes due to the PTA on demand for imports from nonmembers and the latter reflects the substitution in trade toward partner countries (and away from nonmembers) due to the preferences in trade. In the case of a real- incomereducing PTA, both effects would combine to lower demand from the rest of the world. This is also the case when substitution effects dominate the income effect.9 Some indication of how the terms of trade may change for nonmember countries in practice is provided by the empirical analysis of Chang and Winters (2002), who examine the impact of MERCOSUR (specifically, the exemption in tariffs that Brazil provided to its MERCOSUR partners) on the terms of trade (export prices) of countries excluded from the agreement. Theory would suggest that trade diversion would worsen the terms of trade of excluded countries and this indeed is what they find. They report significant declines in the export prices of Brazil’s major trading partners (the United States, Japan, and Korea) following MERCOSUR (see figure 4.3). These associated welfare losses sustained by the excluded countries are significant as well—amounting to roughly 10 percent of the value of their exports to Brazil. For instance, the United States is estimated to lose somewhere between 550 to 600 million dollars on exports of about 5.5 billion dollars, with Germany losing between 170 and 236 million dollars on exports of about 2 billion dollars. 9. See Mundell (1964) for an analysis of how such extra- union terms of trade effects may complicate matters further for the tariff- reducing country, whose terms of trade with respect to the rest of the world may rise or fall following a preferential reduction in its tariffs against a particular partner. On this point see also the recent analysis by Panagariya (1997).

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Fig. 4.3

External terms of trade effects: MERCOSUR

Source: Chang and Winters (2002).

4.4 4.4.1

Preferential Trade Agreements and the Multilateral Trade System Expansion of Trade Blocs—Theory

Stimulated by the theoretical results concerning the generally ambiguous welfare results associated with trade preferences, an important literature has studied the design of necessarily welfare- improving PTAs. A classic result stated independently by Kemp (1964) and Vanek (1965) and proved subsequently by Ohyama (1972) and Kemp and Wan (1976) provides a welfareimproving solution for the case of CUs. Starting from a situation with an arbitrary structure of trade barriers, if two or more countries freeze their net external trade vector with the rest of the world through a set of common external tariffs and eliminate the barriers to internal trade (implying the formation of a CU), the welfare of the union as a whole necessarily improves (weakly) and that of the rest of the world does not fall.10 The Kemp-WanOhyama analysis of welfare- improving CUs does not automatically extend 10. The logic behind the Kemp-Wan theorem is as follows: By fixing the combined, net extra- union trade vector of member countries at its preunion level, nonmember countries are guaranteed their original level of welfare. Since there is no diversion of trade in this case, the welfare of the member countries is also not adversely affected. The PTA thus constructed has a common internal price vector, implying further a common external tariff for member

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to FTAs since member- specific tariff vectors in the case of FTAs imply that domestic prices will differ across member countries.Panagariya and Krishna (2002) has, nevertheless, recently provided a corresponding construction of necessarily welfare- improving FTAs in complete analogy with the KempWan CU. Taken together, these contributions suggest that, in principle, preferential trade agreements could expand sequentially to include the whole world, while monotonically raising welfare along the way. But will PTAs expand successively to eventually include all trading nations?11 Will preferential liberalization prove a quicker and more efficient way of getting to global free trade than a multilateral process?12 These questions concerning the interaction between preferential trade liberalization and the multilateral trade system are important and complex in that they involve economic considerations and political factors as well. Recently, several attempts have been made in the economic literature to understand the phenomenon of preferential trade and its interaction with the multilateral trade system—taking into account the domestic determinants (political and economic) of trade policy. Levy (1997) has modeled trade policy as being determined by majority voting and where income distributional changes brought about by trade lead to different degrees of support (or opposition) by different members of society. He finds that bilateral agreements could preclude otherwise feasible multilateral liberalization if crucial voters (or more generally voting blocs) enjoyed a greater level of welfare under the bilateral agreement than they would under multilateral free trade. Grossman and Helpman (1995) and Krishna (1998) have both modeled the influence of powerful producers in decision making over a country’s entry into a PTA, and while their models and analytic frameworks differ in detail, they come to a similar and striking conclusion—PTAs that divert trade are more likely to win internal political support. This is so because governments must respond to conflicting pressures from their exporting sectors, which gain from lower trade barriers in the partner, and their import- competing sectors, which suffer from lower trade barriers at home, when deciding on whether to form or enter a PTA. As Krishna (1998) argues, trade diversion effectively shifts the burden of the gain to member- country exporters off member- country import- competing sectors and onto nonmember producers, who have little political clout inside the member countries. Krishna (1998) also argues that such PTAs will lower the incentives for any subsequent multilateral liberalization—producers in countries. The Kemp-Wan-Ohyama design, by freezing the external trade vector and thus eliminating trade diversion, offers a way to sidestep the complexities and ambiguities inherent in the analysis of PTAs. 11. See the related discussion in Bhagwati (1993) of what Bhagwati has called the “dynamic time- path question.” 12. This question has often been referred to in the literature as the “stumbling- bloc versus building- bloc” question in the phrasing of Bhagwati (1993).

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trade- diverting PTAs may oppose multilateral reform since this would take away the gains from benefits of preferential access that they enjoyed in the PTA that diverted trade to them. Under some circumstances, the incentive for further multilateral liberalization is completely eliminated. Both sets of papers we have just discussed argue that bilateral agreements could impede progress toward multilateral free trade and thus undermine the multilateral trade system. Ornelas (2005b) reconsiders the preceding analyses in a context in which the external tariffs are determined endogenously rather than historically set (as implicitly assumed by Grossman and Helpman [1995] and Krishna [1998]). Through general equilibrium effects having to do with the leakage of protection to partner countries and changes in the difficulty of redistributing surplus through trade policies under an FTA, he finds, contrary to Grossman and Helpman (1995) and Krishna (1998), that it is only sufficiently welfare- enhancing FTAs that are politically viable and also that predict that external tariffs will fall subsequent to the formation of an FTA. However, in subsequent work, Ornelas (2005a) argues that when political lobbies are also allowed to lobby for the decision on the trade regime, one cannot rule out the political viability of welfare- reducing FTAs. Baldwin (1995), on the other hand, has argued that PTA expansion could have domino effects—increasing the size of a bloc increases the incentive for others to join it (as they then gain preferential access to increasingly large markets). In combination with his juggernaut view that initial tariff cuts will lead to increased momentum for greater trade liberalization,13 he argues that PTAs may lead toward multilateral free trade. Yi (1996), using advances in endogenous coalition theory,14 has compared theoretical outcomes with PTAs under two regimes, “open” membership and “unanimous” membership. Under open membership rules any country interested in joining an existing PTA is able to do so while under unanimous membership, and a new country may join only if all existing members agree to admit the new member. The differences in outcomes are striking. Global free trade is an equilibrium outcome with open membership rules, but this is generally not obtained under unanimous membership. Intuitively, while some within- union members may have reasons not to expand membership (for reasons similar to what we have discussed before), outsiders who have had trade diverted away from them will generally be tempted to join, especially as a union expands and yet greater trade is diverted away from them. While unanimous membership rules will stop the expansion of the bloc well 13. In this view, reciprocity within the WTO implies that initial tariff cuts create an increasing momentum for further cuts by altering the domestic political economy in favor of exporting lobbies and against import- competing lobbies. See Baldwin (2004). 14. See also Saggi and Yildiz (2008, 2009) for innovative formulations of the question of preferential agreements using the theory of endogenous coalitions and taking into account country asymmetries in equilibrium determination.

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before global free trade is reached, open membership will accelerate the movement to global free trade. While these results have only been rigorously demonstrated in the context of the specific theoretical structure assumed by Yi (1996), they have strong intuitive appeal. That open membership rules will bring us closer to global free trade can also be seen to hold in a variety of different formulations of the problem.15 Thus, the theoretical literature has highlighted a variety of political and economic forces that may lead PTAs to support or oppose progress toward multilateral liberalization.16 Which of these forces will dominate is an empirical question and it is to empirical evaluations of these linkages that we turn to next. 4.4.2

Tariff Preferences and Multilateral Liberalization—Empirical Evidence

The interplay between trade preferences and multilateral liberalization has been studied in a number of papers in the literature. Estevadeordal, Freund, and Ornelas (2008) has studied the effect of preferential tariffs on external trade liberalization in a group of ten Latin American countries by asking whether the MFN tariff by a country on imports of any given good (defined at the International Standard Industrial Classification [ISIC] fourdigit level) are related to the corresponding preferential tariff applied by the country in the preceding period. They find no evidence that trade preferences in FTAs within Latin America led to higher external tariffs or smaller tariff cuts, but find instead that preferences induce a faster decline in external tariffs.17 In CUs within Latin America, however, preferential liberalization is not associated with any change in external tariffs. Differently, Limao (2006) considered the question of whether liberalization undertaken by the United States in the Uruguay Round was related to 15. Open membership thus appears to be a valuable complement to the preferential integration process. Nevertheless, open membership in combination with preferential trade integration does not imply that discrimination is eliminated—clearly outsiders at any point in time will still face discriminatory trade barriers. Nor does open membership guarantee a faster path to global free trade than the multilateral process. Finally, as a practical matter, it may be noted that no trade bloc in existence has adopted such liberal membership policies. Entry into existing trade blocs is a slow and carefully negotiated process. As Panagariya (1999, 35) notes, “The Canada-US Free Trade Agreement was concluded almost a decade ago and, taking into account NAFTA, its membership has grown to only three so far.” 16. The impact of multilateralism on regionalism has also been studied in the literature. Ethier (1998) and Freund (2000) both view the increased interest in preferential agreements in recent decades as a consequence of successful trade liberalization at the multilateral level. Specifically, Freund (2000) argues that when multilateral tariffs are low, the dangers from trade diversion are small, but the benefits from trade creation remain. This increases the likelihood of self- sustaining preferential agreements. In addition to the papers described earlier, important contributions to this literature include Aghion, Antras, and Helpman (2007); Bagwell and Staiger (1997a, 1997b); Cadot, De Melo and Olarreaga (1999); McLaren (2002); and Saggi (2006). 17. See also Bohara, Gawande, and Sanguinetti (2004), who find links between trade diversion and declining external tariffs in MERCOSUR.

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preferential liberalization prior to the Uruguay Round. More specifically, he examines MFN tariff cuts in the Uruguay Round for a cross- section of products (at HS 8 level of disaggregation) and asks if these cuts were lower on products with a regional preference in place or if the opposite was true. In contrast with Estevadeordal, Freund, and Ornelas (2008), his findings support the argument that trade preferences may indeed impede multilateral progress; MFN tariff cuts were smaller in products that were subject to trade preferences. Karacaovali and Limao (2008) have repeated this exercise for the EU and found similar results. Tovar (2012) used data disaggregated at the HS 6 level to examine the same question in the context of the formation of the free trade agreement signed between Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras, Nicaragua, and the United States in 2004 (CAFTA-DR). Focusing on the four Central American countries for which the agreement has been in force since 2006—El Salvador, Guatemala, Honduras, and Nicaragua—she found that MFN tariffs were raised (or lowered by less) in products with larger reductions in preferential tariffs. Thus, the examination of MFN tariff liberalization and tariff preferences does not yield an unambiguous answer with regard to the question of whether PTAs impede progress toward multilateral tariff liberalization. We turn our attention next to nontariff barriers. 4.4.3

Nontariff Barriers

Bhagwati (1993) and Bhagwati and Panagariya (1996) have argued that an additional worry with respect to PTA members is that they may resort to the use of the more aggressive use of various forms of administered protection against nonmember countries, as administered protection is more elastic and manipulable by domestic players. Thus, while a PTA’s structure, in the first instance, might not be trade diversionary, the endogenous trade policy choices made under the PTA may nevertheless yield a diversionary outcome. In an innovative recent study, Prusa (2011) has evaluated this possibility empirically by examining the use of trade remedy actions (specifically, antidumping duties) by PTA members. The study covers worldwide antidumping activity since 1980 and includes nearly 5,000 antidumping cases initiated by WTO members belonging to at least one PTA. The study proceeds in two steps. First, Prusa examines the number of antidumping disputes initiated by PTA members against other PTA members (“intra-PTA filings”), which is calculated for each importing country, with the goal of comparing trends in intra-PTA filings before and after the formation of the PTA. In a second step, in order to control for global trends in antidumping filing activity, trends in intra-PTA filings are compared with trends in filings by PTA members against nonmember countries. The results are striking. In the pre-PTA period, 58 percent of the filings were against non-PTA countries and 42 percent were against PTA members. By contrast, in the post-PTA

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period, 90 percent of the cases were against non-PTA countries while only 10 percent were against PTA members. As Prusa (2011, 195) notes, these results “clearly raise the specter of protection diversion and more subtle forms of trade diversion” and that even if “tariff preferences are small and might result in only small amounts of trade diversion,” it appears that “other provisions of a PTA might be a greater source of discrimination.” 4.4.4

Intra-PTA and Extra-PTA Trade Volumes

The steady increase in the number of preferential agreements in recent years raises the question of how relevant extra-PTA trade still is for member countries. Have countries already organized themselves into preferential blocs to an extent that most of their trade is with each other and further multilateral liberalization is insignificant? Table 4.3 lists intra-PTA and extra-PTA trade flows for the year 2008 for a number of prominent trade agreements. The EU has the largest intra-PTA shares, with export and import shares both standing at above 60 percent. For NAFTA, intra-PTA exports take up about 50 percent of their overall exports, while intra-PTA imports amount to a smaller fraction (33 percent) of their overall imports. Next, we have ASEAN. However, despite the heavy emphasis that Intra-ASEAN trade has received in the literature on PTAs, especially with reference to the large volumes of “fragmented” trade within ASEAN serving as a possible motivation for deeper integration within ASEAN, it is evident that most ASEAN trade (over 75 percent) takes place with countries in the rest of the world. Extra Union trade is greater than 80 percent for nearly all the remaining PTAs and indeed greater than 90 percent for the majority of them. Thus, despite the rapid expansion of preferences in trade, intra-PTA trade shares (and thus extra-PTA shares as well) are relatively small for most PTAs. This suggests that multilateral initiatives involving trade with the rest of the world remain relevant to most member countries of the WTO. 4.5

PTAs and Deep Integration?

Recently, it has been argued that the motivation for PTAs may have little to do with the lowering of trade barriers, as such, and that PTAs should be understood instead as vehicles for undertaking “deeper” forms of integration to achieve institutional harmonization with partner countries. The institutional and policy dimensions along which this harmonization is sought include both provisions that currently fall under the mandate of the WTO and are subject to some level of commitment in WTO agreements (such as the improvement of customs administration and rules concerning public procurement) and those that currently fall outside of the mandate of the WTO (such as provisions on investment measures, labor market regulations, innovations policy, and human rights).

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Table 4.3 Intra-PTA and extra-PTA trade (2008) World (billions USD) Preferential Trade Agreement ANDEAN Community ASEAN Free Trade Area (AFTA) Asia Pacific Trade Agreement (APTA) Caribbean Community and Common Market (CARICOM) Central American Common Market (CACM) Common Market for Eastern and Southern Africa (COMESA) Commonwealth of Independent States (CIS) Economic Community of West African States (ECOWAS) European Free Trade Association (EFTA) European Union (27) Global System of Trade Preferences (GSTP) Gulf Cooperation Council Latin American Integration Association North American Free Trade Agreement (NAFTA) Pan-Arab Free Trade Area (PAFTA) South Asian Free Trade Agreement (SAFTA) Southern Common Market (MERCOSUR)

Export

Import

Intra-PTA share

Extra-PTA share

Export

Import

Export

Import

94 966

93 929

7 25

8 24

93 75

92 76

2,043

1,897

11

19

89

81

26

29

16

12

84

88

25

44

24

11

76

89

57

115

10

5

90

95

693

456

18

27

82

73

71

58

8

9

92

91

374 5,806

279 6,083

1 67

1 60

99 33

99 40

1,437 704

1,486 366

19 2

22 7

81 98

78 93

814

760

16

18

84

82

2,047

2,882

49

33

51

67

892

607

6

11

94

89

211

374

6

2

94

98

278

249

17

18

83

82

Source: World Trade Review (2011).

To examine the extent of deep integration undertaken in PTAs, we use a data set recently compiled by the WTO (for its 2011 publication of the World Trade Review) that codifies these institutional provisions in over a hundred PTAs notified to the WTO, and additionally indicates which of these provisions are deemed to be legally enforceable.18 18. As noted by the WTR 2011, in the data set, the codification of policy areas and institutional provisions covered by a PTA and the determination of the legal enforceability of PTA obligations in these domains follows the methodology of Horn, Mavroidis, and Sapir (2010). See WTR 2011 for details.

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Table 4.4 provides a list of the policy areas covered in PTAs along with a breakdown of policy areas into those covered by the WTO and those that fall outside of the WTO’s mandate. Table 4.4 also indicates the fraction of PTAs (of the 131 PTAs covered by the data set) in which the particular policy area is not included in the text of the PTA and the fraction in which it is included and also deemed to be potentially legally enforceable. The picture is a mixed one. On the one hand, a number of provisions covered by the WTO are also mentioned in the text of these PTAs and many appear to have legally enforceable status. Thus, over 65 percent of the PTAs in the database include legally enforceable provisions on customs administration, nearly 50 percent of the PTAs include prohibitions on export taxes, and slightly over 50 percent include provisions on the administration of antidumping duties. A smaller, but still significant, fraction, include provisions on the liberalization of services and trade- related intellectual property rights and investment measures. On the other hand, provisions that fall outside of the WTO mandates but are covered by PTAs and are also deemed legally enforceable by the text of the PTA are far fewer in number.19 Only 4 percent of the PTAs include legally enforceable provisions on anticorruption measures, 12 percent include provisions on labor regulation, and 11 percent include provisions on environmental regulations. Regulations on the movement of capital and the protection of intellectual property rights (specifically accession to international treaties not included in the General Agreement on Trade in Services [GATS]) are more significant at 40 percent and 34 percent, respectively, but most of the remaining provisions are simply not referenced in the vast majority of PTAs. This, in itself, permits some skepticism on how much deeper PTAs, on average, have gone beyond the possibilities offered by the WTO. Whether or not the enforceable provisions will have significant economic effects (for instance, whether provisions on cross- border investment will yield greater flow of investments) remains an open question for future research. Separately, it is being argued that the fragmentation of global production provides a new basis for countries to achieve preferential integration regionally and at a “deeper” level (see WTR 2011 for a comprehensive discussion).20 While this argument is gaining currency in some quarters, it would seem that production fragmentation should provide greater incentives instead for broader multilateral liberalization. After all, the most efficient 19. As the WTR 2011 notes, whether or not the actual terminology in a PTA describing a provision “establishes a legally enforceable obligation” is a matter of interpretation. In any event, legal enforceability in theory does not imply easy enforceability in practice, due to a variety of “political factors, resource constraints and other nonlegal considerations.” 20. The fragmentation of trade has been well documented in the economics literature. For instance, Varian (2007) points out that the popular music player, the iPod, is made from well over 400 parts that originate in a number of different countries and are finally assembled in China.

GATS TRIPs

TRIMs

Public procurement

State aid

CVM

AD

STE

TBT

Export taxes SPS

FTA industrial FTA agriculture Customs

Table 4.4

Description of provisions

WTO-plus areas Tariff liberalization on industrial goods; elimination of nontariff measures Tariff liberalization on agriculture goods; elimination of nontariff measures Provision of information; publication on the Internet of new laws and regulations; training Elimination of export taxes Affirmation of rights and obligations under the WTO Agreement on SPS; harmonization of SPS measures Affirmation of rights and obligations under WTO Agreement on TBT; harmonization of regulations Establishment of an independent competition authority; nondiscrimination regarding production and marketing condition Retention of Antidumping rights and obligations under the WTO Agreement (Art. VI GATT) Retention of Countervailing measures rights and obligations under the WTO Agreement (Art VI GATT) Assessment of anticompetitive behavior; annual reporting on the value and distribution of state aid given Progressive liberalization; national treatment and/or nondiscrimination principle; specification of public procurement regime Provisions concerning requirements for local content and export performance of FDI Liberalization of trade in services Harmonization of standards; enforcement; national treatment, most favored nation treatment

PTAs: Depth of integration

61 56

69

70

57

49

40

64

67

52 69

27 27 35

Provision not mentioned

39 43

31

27

39

44

53

34

30

48 21

73 73 65

Provision mentioned and legally enforceable

Fraction of PTAs

Human rights

Approximation of legislation Audio visual Civil protection Innovation policies Cultural cooperation Economic policy dialogue Education and training Energy Financial assistance Health

Data protection Agriculture

Movement of capital Consumer protection

Labor market regulation

IPR Investment

Environmental laws

Competition policy

Anticorruption

WTO-X areas Criminal offense measures in matters affecting international trade and investment Harmonization of competition laws; establishment of an independent competition authority Development of environmental standards; enforcement of national environmental laws Accession to international treaties not referenced in the TRIPs Agreement Legal frameworks; harmonization; national treatment; mechanism for the settlement of disputes Regulation of the national labor market; affirmation of ILO (International Labor Organization) commitments; enforcement Liberalization of capital movement; prohibition of new restrictions Harmonization of consumer protection laws; exchange of information and experts; training Exchange of information and experts; joint projects Technical assistance to conduct modernization projects; exchange of information Promotion of the industry; encouragement of coproduction Promotion of the industry; encouragement of coproduction Implementation of harmonized rules Participation in framework programs; promotion of technology transfers Promotion of joint initiatives and local culture Exchange of ideas and opinions; joint studies Measures to improve the general level of education Exchange of information; technology transfer; joint studies Set of rules guiding the granting and administration of financial assistance Monitoring of diseases; development of health information systems; exchange of information Respect for human rights 100

95 100 100 99 98 98 94 94 95 99

95 93

60 95

85

62 69

85

52

96

0 (continued)

5 0 0 1 1 1 3 5 5 0

3 5

40 4

12

34 30

11

30

4

continued

Description of provisions

Conclusion of readmission agreements; prevention and control of illegal immigration Treatment and rehabilitation of drug addicts; joint projects on prevention of consumption Assistance in conducting modernization projects; facilitation and access to credit to finance Exchange of information; dissemination of new technologies; training Exchange of information and experience; development of joint initiatives Harmonization of standards; technical and administrative assistance Development of laws and regulations; supervision of the transportation of radioactive materials Convergence of the parties’ positions on international issues Technical assistance; exchange of information; joint projects; training Promotion of regional cooperation; technical assistance programs Joint research projects; exchange of researchers; development of public–private partnership Technical assistance; facilitation of the access to finance Coordination of social security systems; nondiscrimination regarding working conditions Harmonization and/or development of statistical methods; training Assistance in conducting fiscal system reforms Exchange of information and experience; joint research and studies Exchange of information; drafting legislation; training

Source: World Trade Review (2011).

Statistics Taxation Terrorism Visa and asylum

SME Social matters

Political dialogue Public administration Regional cooperation Research and technology

Information society Mining Money laundering Nuclear safety

Industrial cooperation

Illicit drugs

Illegal immigration

Table 4.4

98 98 100 85

95 91

100 100 97 93

96 98 100 100

96

100

98

Provision not mentioned

2 2 0 14

2 8

0 0 2 5

3 1 0 0

3

0

2

Provision mentioned and legally enforceable

Fraction of PTAs

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producers of any given intermediate good need not lie within the jurisdictional boundaries of any specific preferential agreement, and the identity and location of the efficient producers of intermediates may be expected to vary faster than any country’s ability to sign new preferential agreements. Furthermore, with increased fragmentation the identification of the origin of goods, so that preferences may be suitably granted, is itself a major challenge.21 As a practical matter, if PTAs were designed to support fragmented production networks, we might expect to see greater geographic concentration of trade over time, as many production networks are regional in nature. As the WTR 2011 notes, however, the share of intra- regional trade in Europe has remained roughly constant at around 73 percent between 1990 and 2009. While Asia’s intra- regional trade seems to have risen from 42 to 52 percent during the same period, North America’s intra- regional trade shares rose from 41 percent in 1990 to 56 percent in 2000, and fell back to 48 percent in 2009. In any event, it is not obvious that the achievement of “deep integration” at a regional level is a desirable goal from either a regional or multilateral perspective. Common policies may benefit countries with common policy preferences, but may be costly if there are wide differences in the preferences of member countries (as is often the case with provisions involving environmental and labor standards, for instance). In the context of NorthSouth agreements, there is an additional concern that the greater resources and organizational ability of government and sectoral lobbies in the North will shift policy in a direction that is closer to their own interests and away from the interests of the South. Furthermore, the establishment of policies and standards at a regional level may inhibit multilateral liberalization if the multilateral standards vary from regional ones and there are costs to switching standards. It is also conceivable that different regional agreements follow quite different templates, making future harmonization difficult, even at the regional level.22 The possibility of negative spillovers on nonmember countries also cannot be ignored. Thus, for instance, prohibition of the use of antidumping duties against partner countries may result in the increased

21. On this point, see the excellent discussion by Bhagwati (2008, 61– 70) on why the “who is who” problem of identification of the “true” origin of goods (i.e., as to whether an importable truly originates in a partner country or elsewhere) provides one of the most important arguments against preferences in trade. 22. The phenomenon of overlapping and crisscrossed preferential agreements, with differing trade rules, especially on the rules of origin that permit goods produced within the agreement to receive duty free treatment, has been famously described by Jagdish Bhagwati as an inefficient “spaghetti bowl” of PTAs. As Bhagwati (2008) has also wittily pointed out, evolving these agreements into multilateral free trade requires turning the spaghetti bowl into a more uniform lasagna, a task that may only be accomplished using flat pasta (identical templates on trade- unrelated issues)! Recent experience, for instance in Asia where the US- led Trans Pacific Partnership (TPP) initiative for trade integration that has collided with China’s vision for trade in the region, has not been reassuring on this count.

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use of antidumping measures against nonmembers as the work of Prusa (discussed earlier) suggests. 4.6

Trade Preferences and the Doha Round

An important issue in the Doha Round concerns the extent to which the reduction of multilateral barriers by developing countries erodes the preference margins to those developing countries that already have preferential access to the developed country markets. For instance, under the Everything but Arms (EBA) regulation signed into effect in 2001, the European Union permitted granting duty- free access to imports of all products from forty- nine LDCs (less- developed countries), except arms and ammunitions, without any quantitative restrictions (with the exception of bananas, sugar, and rice for a limited period). Multilateral liberalization by the EU would then erode the preferential access of the LDCs to the EU market. Amiti and Romalis (2007) have studied the question of preference erosion under Doha and argued that lowering tariffs under the multilateral system will lead to a net increase in market access for developing countries. Nevertheless, preference erosion is likely to have important redistributive and thus political economy effects. In the context of the multilateral liberalization proposed in the Doha Round, LDCs concerned about the loss of their preferential access, especially in the agricultural sector, could be expected to oppose the round, while other developing countries exporters, without prior preferential access to the developed country markets, would likely gain support. Thus, in addition to the fact that developing countries that are net exporters of food have different interests in the round than those that are net importers of food, divisions have developed within the set of developing countries based on their prior preferential access to the developed country markets. Two recent studies confirm these fears. Francois, Hoekman, and Manchin (2005) and Limao and Olarreaga (2005) both estimate significant losses to a number of countries in Africa and South Asia due to a full erosion of preferences. Both studies suggest that Bangladesh will suffer the greatest losses from preference erosion (in the range of about 200 million dollars annually). A number of countries are forecast to lose significant fractions of their GDP, for instance, Malawi (8 percent), Lesotho (2.7 percent), and Sao Tome and Principe (1.6 percent). To counter the opposition to multilateral liberalization due to preference erosion, a number of solutions, each involving some mechanism to compensate the losers, can be contemplated. One possibility is to simply provide “aid for trade.” This would require that countries be given aid money in proportion to their losses. Leaving aside any worries regarding the moral hazard that such policies may generate, such a scheme would require financing to the tune of approximately 500 million to a billion USD annually (see Page

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2005). Even if such aid financing were made available, LDCs could worry that these funds would simply be diverted from other intended forms of aid. This would require a separate fund to be set up and financed, over and above the aid commitments already undertaken by the richer nations. Another possibility, suggested by Limao and Olarreaga (2005), is for the tariff preferences to be replaced by import subsidies in the same magnitude, so that LDCs whose preferences are eroded nevertheless have the same export earnings as before. This has theoretical appeal, but runs into the criticism that it replaces one set of distortions within the WTO system with another (even though this transformation will indeed be Pareto improving). As an alternative to compensation for preference erosion, delaying liberalization or gradually liberalizing trade in those sectors with significant preferences has also been suggested. Lawrence and Rosito (2006) have argued for a more complex approach that combines delayed liberalization with a compensation mechanism; they propose that developed countries should be granted a temporary and limited waiver from meeting their liberalization obligations in particular product categories on the condition that the additional funds so raised are paid as compensation for preference erosion. The ideas just discussed provide a range of policy options for the WTO to consider. It is conceivable that any eventual resolution around the Doha will combine different aspects of these proposals. The political experience with liberalization under Doha nonetheless suggests the subtle, yet important, ways in which preferential agreements have impacted the multilateral process and portends poorly for future rounds that reach beyond agriculture and aim to unwind the preferences enjoyed on a broader set of goods by a wider range of countries in the existing set of PTAs. 4.7

Conclusions

The question of trade preferences is a complex one. While sharp conclusions are hard to reach, this chapter has presented a multilateralist perspective in evaluating this issue in light of recent trends in the international trade system. It has challenged the ideas that PTAs present an efficient alternative to multilateral approaches in achieving genuine liberalization of trade and that PTAs have uniformly enabled the “deep integration” claimed by proponents of preferential trade. It concludes that multilateral initiatives remain desirable and relevant for the member countries of the WTO.

References Aghion, P., P. Antras, and E. Helpman. 2007. “Negotiating Free Trade.” Journal of International Economics 73 (1): 1– 30.

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Amiti, M., and J. Romalis. 2007. “Will the Doha Round Lead to Preference Erosion?” IMF Staff Papers. Washington, DC: International Monetary Fund. Bagwell, K., and R. Staiger. 1997a. “Multilateral Cooperation during the Formation of Customs Unions.” Journal of International Economics 38 (2): 291– 319. ———. 1997b. “Multilateral Cooperation during the Formation of Free Trade Areas.” International Economic Review 42 (1-2): 91– 123. Baier, S. L., and J. Bergstrand. 2007. “Do Free Trade Agreements Actually Increase Member Countries Trade?” Journal of International Economics 71:72– 95. Baldwin, R. 1995. “A Domino Theory of Regionalism.” In Expanding Membership of the European Union, edited by R. Baldwin, P. Haaparanta, and J. Kiander, 25– 48. Cambridge: Cambridge University Press. ———. 2004. “Stepping Stones or Building Blocs? Regional and Multilateral Integration.” Unpublished Manuscript, Graduate Institute of International Studies, Geneva. Baldwin, R., and E. Seghezza. 2010. “Are Trade Blocs Building or Stumbling Blocs?” Journal of Economic Integration 25 (2): 276– 97. Baldwin, R., and A. Venables. 1995. “Regional Economic Integration.” In Handbook of International Economics, vol. III, edited by Gene Grossman and Kenneth Rogoff, 1598– 1644. Amsterdam: Elsevier Science BV. Bhagwati, J. 1993. “Regionalism and Multilateralism: An Overview.” In New Dimensions in Regional Integration, edited by Jaime de Melo and Arvind Panagariya, 22– 57. Cambridge: Cambridge University Press. ———. 2008. Termites in the Trading System: How Preferential Agreements Undermine Free Trade. New York: Oxford University Press. Bhagwati, J., and A. Panagariya. 1996. Free Trade Areas or Free Trade? The Economics of Preferential Trade Areas, American Enterprise Institute. Washington, DC: AEI Press. Bohara, A., K. Gawande., and P. Sanguinetti. 2004. “Trade Diversion and Declining Tariffs: Evidence from MERCOSUR.” Journal of International Economics 64:1– 27. Cadot, O., J. De Melo, and M. Olarreaga. 1999. “Regional Integration and Lobbying for Tariffs Against Non-Members.” International Economic Review 40 (3): 635– 57. Chang, W., and A. Winters. 2002. “How Regional Trade Blocs Affect Excluded Countries: The Price Effects of MERCOSUR.” The American Economic Review 92:889– 904. Clausing, K. 2001. “Trade Creation and Trade Diversion in the Canada-United States Free Trade Agreement.” Canadian Journal of Economics 34:678– 96. Estevadeordal, A., C. Freund. and E. Ornelas. 2008. “Does Regionalism Affect Trade Liberalization towards Non-Members.” Quarterly Journal of Economics 123: 1531– 75. Ethier, W. 1998. “Regionalism in a Multilateral World.” Journal of Political Economy 6:1214– 45. François, J., B. Hoekman, and M. Manchin. 2005. “Preference Erosion and Multilateral Trade Liberalization.” Tinbergen Institute Discussion Paper, 2005-073/2. Freund, C. 2000. “Multilateralism and the Endogenous Formation of PTAs.” Journal of International Economics 115 (4): 1317– 41. Grossman, G., and E. Helpman. 1995. “The Politics of Free Trade Agreements.” American Economic Review 85 (4): 667– 90. Horn, H., P. C. Mavroidis, and A. Sapir. 2010. “Beyond the WTO: An Anatomy of EU and US Preferential Trade Agreements.” The World Economy 33 (11): 1565– 88. Joshi, V. 2010a. “Preferential Tariff Formation: The Case of the European Union.”

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Working Paper, Graduate Institute of International and Development Studies, Number 05/2010. ———. 2010b. “Preferential Tariff Formation in the United States.” Working Paper, Graduate Institute of International and Development Studies, Number 06/2010. Karacavaoli, B., and N. Limao. 2008. “The Clash of Liberalizations: Preferential vs. Multilateral Trade Liberalization in the European Union.” Journal of International Economics 74:299– 327. Kemp, M. 1964. The Pure Theory of International Trade. Englewood Cliffs, NJ: Prentice-Hall. Kemp, M., and H. Wan. 1976. “An Elementary Proposition Concerning the Formation of Customs Unions.” Journal of International Economics 6 (1): 95– 97. Krishna, P. 1998. “Regionalism and Multilateralism: A Political Economy Approach.” Quarterly Journal of Economics 113 (1): 227– 51. ———. 2005. Trade Blocs: Economics and Politics. Cambridge: Cambridge University Press. Lawrence, Robert. 1997. Regionalism, Multilateralism and Deeper Integration. Washington, DC: Brookings Institution. Lawrence, R., and T. Rosito. 2006. “A New Compensation Mechanism for Preference Erosion in the Doha Round.” Working Paper, Kennedy School of Government, Harvard University, RWP 06-044. Levy, P. 1997. “A Political Economic Analysis of Free Trade Agreements.” American Economic Review 84 (4): 506– 19. Limao, N. 2006. “Preferential Trade Agreements As Stumbling Blocs for Multilateral Trade Liberalization: Evidence for the US.” American Economic Review 96:896– 914. Limao, N., and M. Olarreaga. 2005. “Trade Preferences to Small Developing Countries and the Welfare Costs of Lost Multilateral Liberalization.” World Bank Policy Research Working Paper, WPS3565. Magee, C. 2008. “New Measures of Trade Creation and Trade Diversion.” Journal of International Economics 75:340– 62. McLaren, J. 2002. “A Theory of Insidious Regionalism.” Quarterly Journal of Economics 117 (2): 571– 608. Mundell, R. 1964. “Tariff Preferences and the Terms of Trade.” Manchester School of Economic Studies, 1– 13. Ohyama, M. 1972. “Trade and Welfare in General Equilibrium.” Keio Economic Studies 9:37– 73. Ornelas, E. 2005a. “Rent Destruction and the Political Viability of Free Trade Agreements.” Quarterly Journal of Economics 120:1475– 506. ———. 2005b. “Trade Creating Free Trade Areas and the Undermining of Multilateralism.” European Economic Review 49:1717– 35. Page, S. 2005. “A Preference Erosion Compensation Fund: A New Proposal to Protect Countries from the Negative Effects of Trade Liberalization.” Overseas Development Institute, Opinions 35, January. Panagariya, A. 1997. “Preferential Trading and the Myth of Natural Trading Partners.” Japan and the World Economy 9 (4): 471– 89. ———. 1999. Regionalism in Trade Policy: Essays on Preferential Trading. River Edge, NJ: World Scientific Publishing. ———. 2000. “Preferential Trade Liberalization: The Traditional Theory and New Developments.” Journal of Economic Literature 38 (2): 287– 331. Panagariya, A., and P. Krishna. 2002. “On the Existence of Necessarily Welfare Improving Free Trade Areas.” Journal of International Economics 57 (2): 353– 67. Prusa, T. 2011. “Trade Remedy Provisions.” In Preferential Trade Agreement Policies

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for Development, edited by J.-P. Chaffour and J.-C. Maur, 179– 96. Washington, DC: The World Bank. Romalis, J. 2007. “NAFTA’s and CUSFTA’s Effects on International Trade.” Review of Economics and Statistics 89 (3): 416– 35. Saggi, K. 2006. “Preferential Trade Agreements and Multilateral Tariff Cooperation.” International Economic Review 47:29– 58. Saggi, K., and H. M. Yildiz. 2008. “Bilateral Trade Agreements and the Feasibility of Multilateral Free Trade.” Working Paper, Southern Methodist University. ———. 2009. “Bilateralism, Pure Multilateralism, and the Quest for Global Free Trade.” Working Paper, Southern Methodist University. Tovar, P. 2012. “Preferential Trade Agreements and Unilateral Liberalization: Evidence from CAFTA.” World Trade Review 11 (4): 591– 619. Trefler, D. 2004. “The Long and the Short of the Canada–United States Free Trade Agreement.” American Economic Review 94:870– 95. Vanek, J. 1965. General Equilibrium of International Discrimination. Cambridge, MA: Harvard University Press. Varian, H. 2007. “An Ipod Has Global Value, Ask the (Many) Countries That Make It.” New York Times, June 28. Viner, J. 1950. The Customs Unions Issue. New York: Carnegie Endowment for International Peace. World Trade Report. 2011. The WTO and Preferential Trade Agreements. Geneva: WTO. Yeats, A. 1998. “Does MERCOSUR’s Trade Performance Raise Concerns about the Effects of Regional Trade Arrangements?” The World Bank Economic Review 12 (1): 1– 28. Yi, S. 1996. “Endogenous Formation of Customs Unions under Imperfect Competition: Open Regionalism Is Good.” Journal of International Economics 41 (1-2): 153– 77.

Comment

Ernesto Zedillo

At a time when yet another major PTA—the Trans-Pacific Partnership—is being formally negotiated, and there is also talk of an equally ambitious trans-Atlantic EU-US trade deal, Krishna’s review of the consequences of the amazing proliferation of PTAs since the early 1990s is particularly pertinent and illuminating. In what could be disturbing to some proponents of unbiased academic purity, this author discloses at the outset his multilateralist inclination. I think this stance should be well taken, if one believes that a trading system free of barriers toward trade in merchandise and services and universal enforcement of the principles of reciprocity and nondiscrimination would be, in the long run, for reasons of both prosperity Ernesto Zedillo is the Frederick Iseman ’74 Director of the Yale Center for the Study of Globalization, professor in the field of international economics and politics, professor of international and area studies, and professor adjunct of forestry and environmental studies at Yale University. He served as president of Mexico from 1994 to 2000. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12585.ack.

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and international peace, the ideal to attain. With this defensible premise in mind, two basic questions emerge naturally. One, have PTAs complemented or undermined the achievement of that system? Two, are existing WTO rules and procedures up to the task of preventing PTAs, as they have evolved, from undermining the desirable trading system? Krishna does not tackle explicitly the question of how empowered the WTO is to manage the proliferation of PTAs in order to avoid the fragmentation of the trading system—although it is not hard to infer from the evidence he uses to discuss other issues that his answer would not be very encouraging. Fortunately he does an excellent job of responding to the first question. His survey of recent research and evidence shows, at the very least, that the case of those believing that PTAs have helped the construction of a truly open trading system is a rather weak one. Those PTA believers should take notice that in many agreements the amount of liberalization provided by preferential agreements is truly modest, and that despite the manifest tariff preferences instilled in many of those deals, trade among their partners has continued to be a miniscule portion of global trade. Their enthusiasm for PTAs should also be deflated by the fact that particular PTAs have brought about significant trade diversion and that adverse effects on the terms of trade of nonmember countries have also been documented. It is also suggestive that PTAs, far from alleviating, have worsened the discriminatory features of the present system, as demonstrated by the fact that antidumping actions against nonmembers have increased, while their use against partner countries within PTAs has diminished. Lastly, and most revealing, is that despite the considerable political muscle and negotiating capacity applied to their construction, most PTAs have not increased perceptibly their respective members’ intratrade volumes. In light of the evidence that most PTAs ultimately do not foster trade sensibly while they do introduce perceptible discrimination, their supporters are in need of providing another argument for regionalism, which they claim to find in the use of PTAs as instruments to achieve institutional harmonization conducive to deeper integration among partner countries. Krishna not only questions the effectiveness of the majority of PTAs to deploy such harmonization, but more fundamentally, whether attempting such harmonization and deeper integration should be welcome at all in the context of the various arrangements that make up the trading system when there is still much ground to cover to achieve plain merchandise and services liberalization. The purported objective of getting deeper integration through the door of regional harmonization is particularly troublesome for agreements involving both developed and developing countries, given their rather asymmetrical institutional capabilities as well as their respective differing preferences and development priorities. Truly meaningful evidence of why seeking deeper integration through PTAs is problematic was provided, somewhat ironically, by the fact that the only concrete and executed result of the Doha

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talks has been the decision to drop from the negotiating agenda the goals of pursuing multilateral agreements on competition, investment, and government procurement. Furthermore, it is not hard to envision that even PTAs among developed countries such as the one suggested between the EU and the United States would run into serious trouble if such an agreement were to seek deep harmonization of regulation and standards between these partners in those and other nontrade areas. Krishna’s observation, that we should not expect liberalization that is difficult to achieve multilaterally to prove more easily attainable bilaterally, is warranted by the evidence he adequately reports. With sufficient academic tact, this author, nevertheless, succeeds in conveying the message that most likely there is no safe way around the multilateral route to deliver genuine true global liberalization and integration.

Comment

Anthony Venables

In these comments I would like to take up some of the empirical points referred to by the author and also point to some particular successes of PTAs. The context is that the “grand vision” of a multilateral trading system will always be somewhat illusory. The PTAs are here to stay, so setting the debate up as a choice between PTAs and a multilateral world is a false one. Instead, we should assess the successes and failures of PTAs and then draw conclusions on what countries can learn from them, and how they can best be accommodated in the world trading system as a whole. In recapping the three major points argued by the author, I would like to reformulate them in the following manner. Firstly, the chapter argues that despite the burgeoning number of PTAs, only a relatively small share of trade within them is actually preferential. The extent of tariff liberalization brought about by PTAs is thus limited. On this point, I fully agree. Secondly, the chapter cites evidence for widespread trade diversion brought about by PTAs. Here I am a little bit more skeptical; it is very hard to balance the evidence between trade diversion and creation as the empirical record is mixed at best. Finally, the chapter also lamented the fact that PTAs rarely venture beyond trade liberalization into deeper forms of integration. On a simple count of what PTAs have done this is true, but it attaches too little weight to the remarkable successes of PTAs that have achieved deeper integration. Some of the aggregate numbers are not particularly helpful guides here because PTAs are so heterogeneous both in terms of participating countries Anthony Venables is the BP Professor of Economics at the University of Oxford and director of the Oxford Centre for the Analysis of Resource Rich Economies (OxCarre). For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12586.ack.

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and the policy instruments they use. It is therefore perhaps more constructive to take a closer look at different types of PTAs that exist in the world today, and recognize that regional integration has been a driving force behind some of the most successful growth episodes of the last half century. Beginning with the first and most familiar type of PTAs, the ones between rich or upper- middle income countries (European integration and NAFTA are the two most prominent examples), the following points are in order. The motives for these agreements are partly political but also economic to the extent that they deliver real economic gains. Working through intraindustry trade, these gains tend to be efficiency gains brought about by intensifying competition, market opening, and economies of scale. The initial instruments were market access measures followed by deeper forms of integration. There are several distinct mechanisms that ensure these gains. The first one is the firm- selection effect whereby weaker firms are driven out of business and more productive ones increase their market share. Secondly, in an integrated market, the trade- off between economies of scale and competition will be shifted, enabling both more competition and larger firms. Third, a spatial reorganization of production brings further efficiency gains from clustering and agglomeration. Each of these mechanisms raises productivity, as is confirmed by the empirical record. For example, in the European Union productivity was raised substantially across the participant countries. These changes have been associated with both internal and external trade creation, and dwarf any welfare effects due to simple notions of Vinerian trade creation and diversion. Turning to the other prominent type of PTAs, they are best characterized as integrated supply chains, most notably among Asian fast- growth economies. Here, the motives are somewhat different: importing modern technology and management techniques and implementing them in countries with different factor endowments (low- wage labor in particular). These PTAs are dominated by parts and components trade and there is less scope for trade in services compared to their rich country counterparts. The main economic effects that these PTAs deliver are foreign direct investment (FDI) and technology transfers aided by infrastructure, logistics, and regulatory reform. These measures, almost by definition, cannot be trade diverting. Similar to the first type of PTAs, the empirical record here is positive: there is evidence of efficiency gains and job creation. The challenge is therefore not to restrict PTAs in the vain hope of furthering the multilateral trading system, but rather to reap their benefits without sacrificing the broader push toward multilateralism. Decisions to engage in regional integration tell us what trade policies countries actually prefer: they are indicative of countries’ revealed preference. However, achieving the benefits of regional integration requires going beyond the superficial measures implemented by many PTAs. Regional integration offers opportunities for deeper integration and regulatory reform that—as we have seen from

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the quite different European and Asian experiences—increase economic efficiency. At the same time, PTAs should not pose an obstacle to wider global integration. They can be improved by making sure that the rules they operate under become more stable and compatible with each other. For some regions of the world (the lowest income countries in particular) regional schemes will be of limited value. Steps to multilateral liberalization clearly remain important, but it is not helpful to pose this as a choice between PTAs and multilateralism.

5 Trade and Industrialization after Globalization’s Second Unbundling How Building and Joining a Supply Chain Are Different and Why It Matters Richard Baldwin

5.1

Introduction

For most of the nineteenth and twentieth centuries, “industrialized” and “rich” were synonymous. Hence it is no surprise that development economists have long theorized about industrialization and the role of trade in fostering it. Recent work by Rodrik (2011a, 2011b) focuses the development spotlight even more tightly on manufacturing. Lindauer and Prichett (2002) distinguish three generations of development/industrialization theories—or “Big Ideas,” as they call them. The first Big Idea (1945 to 1982) was that governments should drive industrialization; dirigiste policies are needed to get past coordination failures created by the lumpiness of industry. Trade was necessary for importing key inputs, but relying on export markets was questionable. Export pessimism ruled the day. The widespread failure of import- substitution industrialization (or ISI to cognoscenti) was brought home by the 1980s debt crises. The secondgeneration Big Idea—the Washington Consensus (1982– 2002)—pursued the same goal (creating lumpy industry) with different tactics. Governments still mattered, but market forces were also critical and exports were central to achieving scale. Import competition was critical to ensuring market discipline. By 2002, the second- generation Big Idea was past its sell- by date, according to Lindauer and Prichett. Many developing nations had followed its preRichard Baldwin is professor of international economics at the Graduate Institute of International and Development Studies, Geneva, and a research associate of the National Bureau of Economic Research. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12590.ack.

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cepts only to see slowing or negative growth. The good news, which Lindauer and Prichett call puzzling, was the roaring success of Asia, especially China. To explain this, Paul Krugman called for a counter- counterrevolution in “high development theory” (Krugman 1992). The world is still waiting. As Dani Rodrik wrote: “Maybe the right approach is to give up looking for ‘big ideas’ altogether,” (Rodrik 2005, 1009). There is one “economics,” but many ways to apply it. However, as Lindauer and Prichett pointed out: “The current nostrum of one size doesn’t fit all is not itself a big idea, but a way of expressing the absence of any big ideas” (13). This chapter does not propose a new Big Idea. Rather, it argues that the quest for one may have failed because high development theory overlooked the radical change in globalization that occurred from the mid- 1980s. 5.1.1

Globalization’s Transformation

High development theorists are making the common mistake of viewing globalization as driven by the gradual lowering of natural and man- made trade costs. This is a serious misunderstanding. Globalization has been driven by advances in two very different connective technologies: transportation and transmission.1 From the steam revolution until the mid or late 1980s, globalization was mostly about falling trade costs; this was globalization’s first unbundling. Since 1980, trade costs changed little but the ICT revolution radically lowered transmission costs; this was globalization’s second unbundling. The difference in outcomes is startling. Figure 5.1 shows that up to the late 1980s, globalization was associated with rising G7 shares of world income (left panel).2 The radical reversal since 1988 suggests that globalization is no longer working as it was when the Big Ideas were formulated. An equally stark turnaround was seen in the G7’s world trade share (middle panel). These G7 facts reflect a reversal of fortunes rather than some structural break in global trends (right panel).3 Figure 5.2 (left panel) shows that global manufacturing was also transformed. Until the mid- 1980s, “industrialized nations” meant “high- wage nations.” Since then, some low- wage nations are industrializing faster than high- wage nations.4 But the share- winners are few. Just seven have gained more than 1 percentage point of world manufacturing GDP since 1970— China, Korea, India, Indonesia, Thailand, Turkey, and Poland. All of the 1. For details see Baldwin (2006, 2008, 2011). 2. New Economic Geography forces probably explains much of this. As Krugman and Venables (1995) argued, the Home Market Effect—reinforced by expenditure shifting—meant that lower trade costs favored location in economically large nations. 3. The rise in export growth in the 2000s was largely due to trade created by internationalized supply chains; see Yi (2003). 4. Although most G7 manufacturing sectors grew in absolute terms, the output of seven emerging markets grew much faster—especially China’s, whose global share rose from 2 to 19 percent between 1985 and 2010.

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Globalization changed: G7 share of world income and exports

Sources: (Left) World Bank from 1960, Maddison pre- 1960; (middle) WTO online database; (right) UNSTAT online database.

Fig. 5.2

Global manufacturing shares and trade cost trends

Sources: (Left) unstat.un.org, 2005 prices; 6 EMs = China, India, Indonesia, Thailand, Turkey, and Poland; Korea (which gained 3 points) is in RoW. (Right) Jacks, Meissner, and Novy (2011).

G7 are share- losers over this period.5 Apart from India, all of their manufacturing sectors are heavily involved in the international supply chains of Japan (the East Asians) or Germany (Poland and Turkey). The right panel of figure 5.2 suggests that the standard culprit in global5. Taiwan is not in the UN data used for the calculation, but would almost surely qualify if it were.

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ization stories—changes in trade costs—is unlikely to be guilty for the reversals. Estimated trade costs, which encompass trade barriers and transport costs, plummeted from 1870 to 1910. They rose till the 1940s and plummeted again up to 1980. Since then they have stabilized. These figures make the prima facia case that globalization has changed. Baldwin (2006) argues that globalization driven by lower ICT costs is fundamentally different than globalization driven by lower trade costs. In the first unbundling (pre- 1980s), international competition occurred mainly at the level of sectors (say, Japanese versus Thai cars). In the second unbundling (post- 1985), international competition occurs at a finer degree of resolution—the level of production stages (Thai cars may contain Japanese components and vice versa). But has the changed nature of globalization impacted developing nations’ trade and industrialization outcomes? Figure 5.3 shows that something seems to have changed here as well. The top panel of figure 5.3 looks at the shares of manufactures in developing nations’ exports—focusing on nontiny nations, that is, those with populations at least as large as a big city like Paris.6 The bars (one per nation) show the decadal changes in the nations’ share of exports in manufacturing (in percentage points). Here the 1985 to 1995 period stands out as extraordinarily positive—even more so than the initial push that came during the decolonization period (1965– 1974). The changes in manufactured export shares both before and since have been modest by contrast. The bottom panel focuses on the big share- winners—namely nations that had manufactured export shares below 50 percent in 1970 but above 50 percent in 2007 (the last year before the Great Trade Collapse).7 The 1980s to mid- 1990s period was a time of “takeoffs” for most of these. Another clue comes from the geography of shifting export compositions. If we again look at nations that are not tiny and rely on manufactured exports (manufactures accounting for more than 50 percent of exports in 2007– 2008), then a very clear pattern emerges. Some of these nations saw their manufacturing export shares rise and others saw them fall during globalization’s second unbundling. The winners and losers, however, are remarkably clustered geographically around the nations that dominated world manufacturing until the second unbundling—the United States, Japan, and Germany. There seems to be one group of low- wage sharewinners and high- wage share- losers around Germany, another around the 6. China, Czech, Korea, Bangladesh, Philippines, Turkey, Hungary, Poland, Romania, Pakistan, Thailand, Ukraine, Mexico, Malaysia, Sri Lanka, Morocco, India, Vietnam, South Africa, Brazil, Indonesia, Colombia, Kenya, Argentina, Tanzania, Uganda, Ghana, Egypt, Russia, Kazakhstan, Peru, Ethiopia, Chile, Mozambique, Nigeria, Algeria, Iraq, Sudan, Venezuela, Nepal, Afghanistan, Congo, Iran, Korea, Myanmar, Uzbekistan. 7. China, Czech Republic, Bangladesh, Philippines, Turkey, Hungary, Poland, Romania, Thailand, Ukraine, Mexico, Malaysia, Sri Lanka, Morocco, Vietnam, South Africa.

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Fig. 5.3

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The evolution of developing nations’ manufactured export shares

Source: Worlddatabase.

United States, and a third around Japan. India may also be at the center of a cluster of winners (figure 5.4). The final bit of prima facie evidence comes from the link between income levels and participation in supply- chain trade. López-González and Holmes (2011) show empirically that the pattern of sourcing (importing) from inter-

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Fig. 5.4

Richard Baldwin

The tight geographical clustering of manufactures export swings

Source: Author’s calculations on World Bank data. Note: Data for all nations with (1) population over 10 million, (2) manufacturing export share over 50 percent in 2007– 2008, (3) at least 90 percent data coverage from 1985 to 2008.

national supply chains are quite different than selling intermediates (exporting) to them. The sourcing share rises up to about $25,000 and then declines (figure 5.5, left panel). Selling intermediates falls for low income levels but rises beyond a point near $15,000 (right panel). Combining the two measures, a nation’s total involvement in supply chain is tilde shaped. While this research is very recent and needs further testing, the top- line message is very intuitive. When a nation like China moved up from making clothing to assembling electronics and machinery, the import content of its exports rose, but at the other extreme, a nation like Finland has all but exited from the fabrication end of manufacturing, so domestic value added content of its exports tends to be higher. These charts paint a picture of two transformations: one in globalization itself, and one in developing nations’ experiences with industrial exports. The next task is to suggest how the two might be connected.

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Fig. 5.5

171

The Lopez-Gonzales–Holmes curves: Supply-chain trade and income

Source: Lopez-Gonzales and Holmes (2011). Notes: (Left) Sourcing intermediates: share of imported intermediates in exports. (Right) Selling intermediates: share of exports compromising intermediates used in the importer’s exports. The Lopez-Gonzales and Holmes (2011) measures indicate the share of gross exports accounted for by intermediate imported (sourcing), and the share of exports used as inputs into other nations’ exports (sales). The measures are bilateral and direction specific, so each point in the graph corresponds to a single bilateral measure of sales or sourcing supply- chain trade for each year from 1995 to 2007.

5.1.2

Building versus Joining a Supply Chain

When ISI policies worked—as they did for the United States, Germany, Japan, and so forth (Clemens and Williamson 2004)—industrialization meant building the whole supply chain at home. This took decades due to learningby- doing in creating and coordinating the vast array of necessary competencies. Given the simple communication technology available at the time, extreme proximity was essential to coordinating sophisticated manufacturing processes. All the stages of production had to be inside a single factory or industrial district. Most of the necessary competencies had to exist domestically; no nation could be competitive without building a broad and deep industrial base—a hurdle that precious few nations could surmount. The radical change in globalization—globalization’s second unbundling— upended this touchstone fact. The ICT revolution made it feasible to spatially separate some stages of production without much loss in efficiency or timeliness. Once feasible, scale economies and comparative advantage made separation inevitable—especially unskilled labor- intensive stages given the vast international wage differences. In 1985, for example, Japanese wages were forty times higher than Chinese wages even though Shanghai was close to Japan’s automobile hub—just a few days by sea and a few hours by air. The top- line implications for trade and industrialization are threefold.

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• First, with globalization operating at the level of production stages rather than at the level of sectors, industrialization became less lumpy and thus easier. Nations could industrialize by joining a supply chain. • Second, as firms with advanced manufacturing know- how off- shored some stages, they moved their know- how along with the production. Managerial and technical know- how became more internationally mobile. After all, the off- shored stages of production had to mesh seamlessly and evolve in tandem with the rest of the production network. This “technology lending”—which is very different from the 1970s “technology transfer” —could create advanced manufacturing activity in a developing nation in a matter of months. Developing nations no longer had to follow Korea’s decade- long slog up the value chain (a feat that dozens of developing nations tried and failed before the second unbundling). • Third, distance matters more in supply chains (Gamberoni, Lanz, and Piermartini 2010). Even with today’s ICT, coordinating a production network involves some face- to-face and face- to-machine interactions. Technicians and managers must travel from the advance- technology headquarter nations to the developing host nation. And this must be quick; if something goes wrong, the whole production network may suffer until the failing node is back online. This is perhaps one reason why we see most production networks concentrated in low- wage nations that are near, or even contiguous with, hightechnology nations, especially the United States, Japan, and Germany (Baldwin and López-González 2013). Big Ideas Development Theory and International Supply Chains Given these stylized facts and widespread discussion of international supply chains, it is surprising that supply chains have not played a greater role in high development theory. Take, for example, the Spence Growth Commission (2008). The commission’s factual basis rests on thirteen success stories. Every single case started well before globalization’s second unbundling in the mid- 1980s. The lessons in the Spence Growth Commission’s report are all very sensible—good governance, judicious use of domestic and global markets, and so forth—but it seems rather brave to suggest that lessons from Japan’s and Korea’s industrialization in the 1970s and 1980s can be applied to the world of international value chains (Cattaneo, Gereffi, and Staritz 2010).8 Specifically, leading development models continue to view industry as purely national. They assume that national production is a 8. Of course, supply chains are mentioned, but one reads analysis such as: “It should also be said that the global supply chains that run through countries like China and India represent a significant opportunity and not just a threat” (94). No systemic lessons are drawn.

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package containing only the nation’s productive factors and technology.9 As it turns out, it is rather easy to integrate globalization’s second unbundling into a simple version of development frameworks. This is the next task. High development theory starts from the presumption that something is stuck. A nation has not developed modern industry but could, so market forces must be supplemented by direct government action (first Big Ideas like Big Push and ISI), or by removing the barriers that had prevented otherwise profitable industrialization (Washington Consensus). The deep economic logic in both cases turns on multiple- equilibrium economics. Successful Development Policy before the Second Unbundling. To fix ideas, consider the simplest general equilibrium model with multiple equilibriums (the model here is a simplified version of the one in Harrison and RodríguezClare 2009). Assume a small open economy with a single productive factor and two sectors, one of which is marked by external economies of scale (EES). The perfectly competitive, numeraire sector (call it A), produces under constant returns. The perfectly competitive manufacturing sector (call it M) produces one unit of output with aM units of labor, but aM falls as total employment in the sector rises due to EES. Thus: QM =

(1)

LM aM

; aM =

SVMPL M ≡ p 

2  LM

LM 

,

,

Q A = L − LM VMPL A ≡ 1

where QM , LM , and aM are output, labor employed, and the unit labor input coefficient in M; µ (a mnemonic for Marshallian) is the EES parameter and β (a mnemonic for backwardness) governs the nation’s native comparative advantage in M (units are chosen so the unit input coefficient of A is unity). Variables SVMPLM and p are the “social” value of the marginal product of labor (i.e., including EES) and the domestic relative price of M, respectively. Variable VMPLA is the value of the marginal product of labor in A. The model can be solved graphically with the help of figure 5.6. The state variable is LM and the left part of the figure shows the tendency of labor to move between the two sectors assuming the migration of the Krugman (1991) type. When LM is below L′M, competitive wages are higher in the A sector so the equilibrium is at point A and LM = 0. If LM is above L′M, wages are higher in manufacturing so the equilibrium is at M. Leibenstein (1957) calls the unstable equilibrium U the “critical minimum effort”; L′M measures the lumpiness of industry and thus the difficulty of industrializing. 9. See, for example, Hausmann, Hwang, and Rodrik (2007); Hausmann and Klinger (2007); Lederman and Maloney (2007); Klinger and Lederman (2006); and Brambilla, Ledermann, and Porto (2010). Rodrik (2011a, 2011b) continues the tradition.

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Fig. 5.6 Canonical Big Idea model development/industrialization: Multiple equilibriums

Real incomes are higher in M, so the goal of development/industrialization policy would be to shift to point M, for a nation that is stuck at point A. For instance, temporary protection that raised p and thus SVMPLM above VMPLA at LM = 0 (dashed line) would shift labor to M. Once LM passes the critical minimum effort, protection can be removed; the market will complete the nation’s industrialization. This is how ISI was supposed to work. In trade terms, this is a Ricardian model with an endogenous aM. Under A and M equilibriums, the nation’s comparative advantages are in A and M, respectively. This is shown with the private (i.e., ignoring EES) production possibility frontiers (PPFs) in the right panel of figure 5.6. The very intuitive condition for multiple equilibriums to exist—and thus for ISI to succeed—is that SVMPLM is above VMPLA at LM = L, namely: (2)

p L > 1. 

This requires that that nation’s native comparative advantage (as measured by p/wβ) is not too bad, and/or that Marshallian spillovers (as measured by µ) are sufficiently important, and the nation is not too small (as measured by L) to realize sufficient EES. Second Unbundling: Making Industry Less Lumpy and Industrialization Easier. This approach pushes the Marshallian spillovers into a black box—a reasonable modeling strategy before globalization’s second unbundling. To allow for international supply chains, we introduce intermediate goods in a way that mimics the previous model as closely as possible. Specifically, we maintain all the assumptions except those concerning the M- sector technology. Now M is produced from differentiated varieties with an Eitherstyle, constant elasticity of substitution (CES) production function, and the market structure is Dixit-Stigliz monopolistic competition. Specifically QM = ( nD x1−1/ + nF x1−1/ )1/(1−1/) where the subscripts denote domestic, D, D F

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and foreign, F, varieties (number, n, and quantity, x) and > 1 is the elasticity of substitution. Using the well- known Dixit-Stiglitz properties, it is easy to show that: (3)

SVMPL M

⎛L ⎞ = p ⎜ M + nF ⎟ ⎝ 2F ⎠

1/(−1)

⎛ 1−1/  ⎞ ⎜⎝  ⎟⎠ ,

where F is the Dixit-Stiglitz fixed cost and γ > 0 is a collection of parameters related to the optimal mix of varieties. It is easy to show that if σ = 2 and nF = 0 (i.e., no unbundling of production), this model is identical to the previous one with µ = 1/F. The impact of allowing international supply chains is immediately obvious from the formula for SVMPLM. The ability to employ foreign varieties in the domestic production processes (i.e., nF > 0) raises the social value of labor’s marginal product in manufacturing. Looking at figure 5.6, we see this lowers the critical minimum effort (i.e., the U equilibrium shifts left). What this means in practice is that industry is less lumpy and industrialization is easier. Additional Considerations. For simplicity’s sake, we have assumed that the developing nation’s comparative advantage in every variety is identical. Given the range of factor intensities in various production stages, it seems quite likely that the developing nation has a greater comparative advantage in some varieties. Before production unbundling, what mattered was the average comparative advantage across all varieties, so assuming them all equal entailed no loss in clarity. After unbundling, however, the nation can specialize in varieties where its technological disadvantage is least marked, so the symmetry misses an important gateway to industrialization. Until this point, we have been agnostic as to whether M is a final good or simply one component of a larger production process. If we added more structure, say M being a final good that involves two components, unbundling can even further reduce the minimum critical effort since now the nation could industrialize by making only one of the components and exporting it into an international supply chain. Before unbundling, the nation had to make both. If the unbundling of production stages goes far enough, the minimum critical effort might be so low as to be within the reach of individual firms from advanced technology nations. Finally, the ICT revolution made it safer for firms with sophisticated know- how to combine their competencies with low- cost labor in a developing nation. For example, if the developing nation does join an international supply chain, the advanced technology firm behind the network has an incentive to lower its costs by combining advanced technology with developing nation labor; that is, lowering the parameter β and thus making industrialization even less lumpy by shifting equilibrium U to the left. Distance may matter more in a slight extension of this setup. As men-

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tioned before, even with today’s ICT, coordinating a production network still involves some face- to-face and face- to-machine interactions that require technicians and managers to travel from the advance- technology home nation to the developing host nation. This is perhaps one reason we see most production networks concentrated in low- wage nations that are near high- technology nations such as the United States, Japan, and Germany (Johnson and Noguera 2012; Baldwin and López-González 2013). 5.1.3

Why the Difference Matters

The role of governments, trade, and multinationals is completely different when a nation joins a supply chain. Two points:

• Industrialization is easier and faster. • But industrialization is less meaningful. It became faster and easier since the supply chain makes industry less lumpy and less interconnected domestically; it became less meaningful for the same reasons. That Korea could export domestically designed car engines was a testimony to its rich- nation status. Now, exporting sophisticated manufactured goods is no longer the hallmark of having arrived. It may simply reflect a nation’s position in an international supply chain. Moreover, the challenges facing policymakers are quite different. Under the twentieth- century view of industry, a deep industrial base was a prerequisite for export success, but a large market was necessary to support the industrial base. The search for markets was thus a key element of trade and industrialization policy. With international supply chains, however, demand is easy to find. Instead, policymakers face many new questions: Which supply chains should be joined? Should nations strive to set up their own international production networks? What is the optimal technology policy (intellectual property rights, etc.)? What is the role of size; can smaller nations do what China has done on forced technology transfer? Different nations are trying different things without guidance from formal models that explicitly incorporate supply chains. This lacuna at least partly accounts for why Big Ideas do not fit all cases. It is easy to see how a comparison between Brazil and China is puzzling when one ignores supply chains.

• China—which is physically in the middle of “Factory Asia”—is not using Chinese factors of production, Chinese technology, or relying on Chinese policy for most of Chinese exports. • The Chinese content of its “processing exports” is less than 20 percent (Ma and Van Assche 2010), and this type of trade accounts for more than half of the nation’s boom in manufactured trade. Of course, China- specific factors also matter, but if you want to fully understand

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Chinese export success, you have to look at the productive factors, technology, and government policies of Japan, Korea, Taipei, and ASEAN nations—that is where many of the critical components, and most of the design, marketing, and management expertise lie. • Brazil is too far from “Factory North America” and “Factory Europe” to enjoy such a free ride. Most goods Brazil exports depend solely on Brazilian inputs, technology, and policies. 5.1.4

Plan of the Chapter

The next section briefly recalls the main outlines of globalization’s first and second unbundlings to set the stage for an illustrative case study (autos) in section 5.3. Section 5.4 seeks to crystallize the economic logic linking trade and industry when industrialization meant building a supply chain. Section 5.5 extends the framework to allow explicit consideration of supply chains, their internationalization, and the role of multinationals. Section 5.6 explores why the difference between building and joining a supply chain matters. Section 5.7 looks at the implications for multilateral cooperation, and section 5.8 presents the concluding remarks. 5.2

Globalization as Two Unbundlings

Globalization is not a smooth process driven by lower natural and manmade trade costs. Globalization made a giant leap when steam power slashed shipping costs, and advanced in the postwar period when trade barriers erected in the interwar years were reduced. It made another leap when ICT decimated coordination costs. The implications of the two are dramatically different; understanding why requires a bit of background.10 5.2.1

Steam Revolution and the First Unbundling

When clippers and stage coaches were high- tech, few items could be profitability shipped internationally. This forced the geographical bundling of production and consumption; each village had to make most of what it consumed (central illustration in figure 5.7). Steam power changed this by radically lowering transport costs (figure 5.8, left panel).

• Railroads and steamships made it feasible to spatially separate production and consumption.

• Once the separation was feasible, scale economies and comparative advantage made it inevitable. This was globalization’s first unbundling. Trade theory was developed to understand its economic impact. 10. The section draws on Baldwin (2006, 2008).

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Fig. 5.7

Richard Baldwin

Steam and first unbundling and ICT and second unbundling

Source: Baldwin (2011).

Fig. 5.8

Trade costs (left, 1870–2000) and ICT indicators (right, 1975–2011)

Sources: Jacks, Meissner, and Novy (2011). ICT indicators (right panel). World Development Index (WDI) for phone and Internet users; www.isc.org for Internet hosts. Note: Trade cost measure (left panel) estimated from gravity equations.

The first unbundling created what might seem to be a paradox—production clustered into factories and industrial districts even as it dispersed internationally (figure 5.7). The paradox is resolved with three points: (1) cheap transport favored large- scale production, (2) such production is very complex, and (3) close proximity lowers the cost of coordinating complexity. Consumption clustered in cities for reasons that do not concern this chapter. Thoughtful readers will have already guessed what the second unbundling involves. To set the scene, however, consider the forces that produced the local clustering of production.

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ICT Revolution and the Second Unbundling Why does the production of goods and services cluster within buildings and factories? Think of a stylized factory with the production stages as schematically illustrated in figure 5.7. Coordinating the manufacturing process demands continuous, two- way flows among the bays of goods, people, training, investment, and information (double- headed arrows). As productivityenhancing exchanges keep the process in flux, the flows never die down. Plainly, some of proximity’s cost- savings are related to communications. As telecommunications became cheap, reliable, and widespread from the mid- 1980s, the “coordination glue” began to loosen. Telecom advances united with vast strides in computing power, transmission capacities, and software to create the information and communication technology (ICT) revolution.11

• It became increasingly economical to geographically separate manufacturing stages—to unbundle the factories.

• Once the separation was feasible, scale economies and comparative advantage made it inevitable. This is the globalization’s second unbundling; production stages previously performed in close proximity are dispersed to reduce production costs. Theories to understand its implications are only now emerging.12 The unbundling, however, is not global. It is regional. Take, for example, the North American auto industry. “During the 1950s, three- quarters of all auto parts were made in or near Michigan, whereas the state is now responsible for only one- quarter” (Klier and Rubenstein 2008). Figure 5.9 shows that today many parts plants are no longer in Michigan but they are clustered within a 1,000 km radius. The plants further afield, for example in Mexico, are themselves clustered. This is one of the clues on why distance is so important in international supply chains. The timing of the second unbundling has not been definitively identified. The right panel of figure 5.8 shows ICT indicators that suggest the shock that created it unrolled from say, 1985 to the late 1990s; I take 1985 to 1995 to be concrete. Transport costs jumped around a bit during this period (oil prices), but were on average unchanged since the mid- 1970s (left panel, figure 5.8).

11. E- mail, editable files (*.xls, *.doc, etc), and more specialized Web- based coordination software packages revolutionized peoples’ ability to manage multifaceted procedures across great distances. Working methods and product designs shifted to make production more modular. 12. Blinder (2006), Grossman and Rossi-Hansberg (2006, 2008), Markusen (2005), and Baldwin and Robert-Nicoud (2007) are recent contributions. See Jones and Kierzkowski (1988), Deardorff (2001a, 2001b), and Venables (1999) for the seminal work.

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Fig. 5.9

Richard Baldwin

Distance of engine part factories from Detroit

Source: www.chicagofed.org, 2005_aos_klier.pdf.

5.2.2

Transformed International Commerce

The second unbundling transformed trade for a very simple reason. Production dispersion did not end the need to coordinate production stages— it internationalized it (rightmost illustration in figure 5.7). This gave rise to twenty-first century trade—the heart of which might be called the trade- investment- services- intellectual property (IP) nexus (Baldwin 2011). Specifically, the nexus reflects the intertwining of: (a) trade in parts and components; (b) international movement of investment in production facilities, personnel training, technology, and long- term business relationships; and (c) services to coordinate the dispersed production, especially infrastructure services such as telecoms, Internet, express parcel delivery, air cargo, traderelated finance, customs clearance, and so forth. The most radical change in terms of theory and outcomes was the way the second unbundling made it easy for rich- nation firms to combine the high technology they developed at home with low- wage workers abroad.

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The first examples came in 1985 across the US-Mexico border (Feenstra and Hanson 1997) and within East Asia (Ando and Kimura 2005). This created an important distinction—what might be called twentieth versus twenty-first century trade.

• Twentieth- century trade is the selling of goods made in factories in one nation to customers in another; the trade system is largely about demand; that is, selling things. In this world, goods are “packages” of a single nation’s productive factors, technology, social capital, governance capacity, and so forth. Of course, twentieth- century trade is still with us. • Twenty-first century trade involves continuous, two- way flows of things, people, training, investment, and information that used to take place within factories and offices; the trade system is also about supply; that is, making things. Goods are packages of many nations’ productive factors, technology, social capital, and governance capacity; a nation’s trade pattern is inseparable from its position in the supply chain. Comparative advantage shifted from a very national concept to a much more regional concept, as predicted by the analysis of Deardorff (2005). 5.2.3

Transformed Industrialization

The second unbundling also transformed industrialization. Before the ICT revolution and the second unbundling, the nation needed all three figure 5.7 production bays inside the country. After the second unbundling, advanced- nation firms offshored labor- intensive segments of their supply chain to developing nations. This completely changed the industrialization process in the developing nations that received these offshored stages. Stage B arrived with everything needed to export—world- class technology, management, quality control, a ready- made market, and so forth. All the developing nation had to add was reasonably reliable workers, a hospitable business environment, and proximity to an advanced technology nation willing to offshore some of its factories. Note that proximity matters greatly since key personnel must still visit the offshored factory, so being within an easy day’s travel is a tremendous advantage (figure 5.9). At first this was limited to export processing zones (EPZs) and “triangle trade” (e.g., Japan ships computer parts for assembly to China, which ships the final good to Europe). As cost pressure led to growing specialization and scale, multiple developing nations were folded into the supply chain. This is clearest in East Asia, where it can be seen in the 1985 versus 2000 Asian Input-Output tables constructed by Japan’s IDE-JETRO (table 5.1). Each element shows the column- nation’s share of manufactured intermediates that is purchased from the corresponding row- nation. In 1985, the matrix was simple. Most developing East Asian nations

12 36

4 2 4 5 13 11 10

37 11 2

3 4 3 3 17 11 8 6 4 7

3

73

11 5 15

7 5 17 12 14

32 2

5 3

4 6 10

14 7 16

73

Philippines (%)

8 7 36

63

3

Indonesia (%)

2

7 50

Malaysia (%)

9

20 10 5

Singapore (%)

Evolution of Factory Asia, 1985 to 2000

51 4 3 3 15 6 10

4 3

9 2 11

73

Thailand (%)

3

2

88

6

3

90

China (%)

7 5 4

78

9 5 7

78

Korea (%)

4 61 13 6 7

2

79 7 3 9

Taiwan (%)

93

3

94

Japan (%)

Source: Baldwin (2008). Notes: Share of manufactured inputs bought by column nation’s manufacturing sector from the row nation. Numbers less than 2 percent are zeroed out. For details of the original tables, see Inomata and Uchida (2009).

2000 Singapore Malaysia Indonesia Philippines Thailand China Korea Taiwan Japan US EU and RoW

Singapore Malaysia Indonesia Philippines Thailand China Korea Taiwan Japan US EU and RoW

1985

Table 5.1

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supplied most of their own intermediates (diagonal of top panel). The rest was imported from advanced nations. By 2000, the diagonal elements were way down; cross- country reliance was way up. Countries like Thailand and China were supplying lots of intermediates to fellow developing nations. This is “Factory Asia” (Baldwin 2008). 5.3

Suggestive Case Study: The Auto Industry

To bring down the level of abstraction, this section examines a case study: how the second unbundling transformed trade and industrialization in East Asia’s auto sector. 5.3.1

Import Substitution in Autos

Development economists’ first big idea—import substitution—was commonly viewed as having an easy bit and a hard bit. The easy bit was to generate production of light manufactures, such as clothing and shoes. It was easy in the sense that Leibenstein’s “critical minimum effort” was low enough for even small nations to get past. The hard bit was moving up to heavy industry like chemicals and machinery (Balassa 1981, Essay 1). Among the favorite second- stage import substitution targets was the automobile industry. This is odd. Even in the 1970s, making an automobile required a massively complex network of suppliers, and a broad array of advanced technologies, advanced management capacities, and a skilled workforce—exactly the wrong entrylevel industry one might think. Why then was it such a favorite among development planners? The answer is that the advanced- nation car producers helped them contrive the appearance of an auto industry. The trick is so-called complete knockdown kits, often shortened to CKD. “Nearly all kits come from home country plants, where the parts are taken off the assembly line and ‘consolidated’ in shipping containers for transport to CKD assembly plants” (Sturgeon 1998, 8). The assembly plant then puts together the pieces and presto! The nation can pretend it has a car industry. The developing nation’s assembler was almost always a joint venture with the advanced- nation kit producer.13 Assembly, of course, was only meant to be the first step. According to ISI theory, local assembly would create local demand for auto parts and this would create local parts suppliers. The developing nations would build the whole supply chain, working from downstream to upstream. Local content 13. Consolidating and shipping are expensive. Sturgeon (1998, 8) writes that “one automaker manager in Vietnam said that the cars assembled in Vietnam cost the parent company twice what they cost in the home country (because of low plant and equipment utilization rates; assembly costs were said to be five times that of the home country).” Sturgeon reports that a Toyota Corolla that went for $14,000 in the United States cost $26,000 in Vietnam.

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Fig. 5.10

National car Proton Saga (left) vs. Mitsubishi Lancer (right)

Source: Photographer unknown.

requirements were designed to encourage this. Given the sophistication of the components and lack of local competency, firms typically met local content restrictions by repeating the charade for components (local content rules were typically defined in gross cost, not value added). Importantly, the whole system was rigged to prevent the infant industry from growing up. The advance- nation partner companies had no interest in creating new competitors. Malaysia’s first national car, the Proton Saga, bore a striking resemblance to the Mitsubishi Lancer Fiore (figure 5.10), was built on the Lancer platform, and contained a Lancer engine (Rosli 2006). It is easy to see why Mitsubishi had little interest in the Saga becoming an export success. 5.3.2

Korean Success Story

Of all the developing nations that played this game, only Korea managed to build its own supply chain, introduce original models, and become competitive in world markets. The story has been told many times.14 Beginning in 1962, the Ministry of Trade and Industry used all the tools of industrial policy—subsidized loans, tax breaks, distorted tariff schedules, import bans, and so forth—to develop a car industry via import substitution. Korea started with assembly, but multinationals were forced to accept weaker positions than usual; control was handed to chaebols—familyowned conglomerates (Amsden 2001). Four firms were established in the first big push: Shinjin, Hyundai, Asia Motors, and Kia. The second big push came as part of the Heavy and Chemical Industries Project (1973). This required the companies to submit plans for a low- cost car whose specifications, timetable, and costs were laid down by the government. The result was Korea’s first home- designed car (Hyundai’s Pony) and a Mazdadesigned car by Kia called “Brisa.” Local content of these reached 85 percent, but major components were still imported (Green 1992). Hyundai’s Pony enjoyed huge success at home, selling almost 300,000 units by 1982; it also achieved limited success abroad (about 15 percent of 14. See, for example, Amsden and Kim (1989), Ravenhill (2005), or Green (1992).

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production was exported; Ravenhill 2001). Industry output rose more than tenfold by the end of the decade. On the back of this success, another big push came in 1978. Massively ambitious government- set production goals encouraged Korean firms to make big new investments, but the global 1980– 1983 recession hindered these plans and brought the companies near bankruptcy. The Ministry of Trade and Industry led a restructuring and reorientation of the industry; scale was to be achieved by exporting to the United States (the only market that was big enough and open enough). The Ministry also targeted quality upgrading, and Korean companies invested heavily in new production facilities. They negotiated new alliances with major automobile and automobile parts makers for plant layout, body design, the supply of major components, and access to marketing channels. Hyundai also set up its own dealer network in the United States and Canada. Most of this was debt financed.15 With this high volume, Korean automakers pushed further up the supply chain. By the early 1990s, they were producing engines, transmissions, chassis, and brakes with their own technology. Two other highly sophisticated components were brought into the local supply chain in 1996 (the Engine Control Unit, and the Transmission Control Unit). The nature of this success story was completely transformed by the 1997 Asian crisis. From the mid- 1980s until the end of the 1990s, Korean exports were dominated by cars (left panel, figure 5.11). Now, however, the Korean auto industry is a full-fledged participant in the international supply chains. Yet because they built a supply chain before the second unbundling, Korea is a headquarter economy rather than a factory economy. As figure 5.11 shows, its exports of cars and car parts are booming, along with its imports of parts. For example, Korea is not only an important exporter of engines, but an important importer of the ignition wiring sets used in those engines (right panel). 5.3.3

Malaysia’s Failure and Thailand’s Success

Until 1982, Malaysian auto industrialization focused on kit assembly. The already small market was shared by more than a dozen assemblers. “The resulting market fragmentation made it difficult for components producers to achieve economies of scales, thus, the locally produced parts and components were expensive. This hindered the further localization; in 1979, the average local content achieved was merely 8 percent” (Fuangkajonsak 2006, 28). Policy became radically more state directed under Prime Minister Mahathir bin Mohamed. In 1981, he established the government- owned Heavy Industries Corporation of Malaysia (HICOM), which aimed to establish a 15. Timing was fortuitous. The United States imposed Voluntary Export Restrictions on Japanese cars in 1981, cutting out Korea’s main competitor in its chosen segment.

Korean exports of cars and parts, 1988–2010

Note: Exports in black (vehicles solid lines, parts with circles); imports in white.

Fig. 5.11

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Japanese- like fully integrated automobile industry (i.e., to build the whole supply chain). A “national car project”—Proton—was launched as joint venture with Mitsubishi (HICOM held 70 percent of the shares). Unfortunately, the first fruit of this effort (the Saga, figure 5.10) appeared in 1985—the year the second unbundling started to destroy the economic foundations of single- nation automobile production.16 Tariffs and taxes meant that the Saga was 20– 30 percent cheaper than similar models domestically (Fujita 1999); its market share rose to 73 percent (Uzir Mahidin and Kanageswary 2004). Exports started in 1989, mostly to Britain under the GSP (generalized system of preferences) scheme, which allowed in up to 14,000 units duty- free; these were sold below the Malaysian domestic price (Wad and Chandra 2011, 166). Proton upgraded from assembling imported key components and parts to manufacturing them locally. Localization efforts, however, did not go smoothly. Saga continued to rely on Mitsubishi for technology and design. Despite its local and export success, Proton’s sale volumes remained small by industry standards (under 100,000 units per year for all models). A second big push came in the 1990s, as Proton introduced new models and produced them with varying engine sizes. Malaysian production more than doubled from 1990 to 1997. Proton’s plans, however, were even more ambitious. It announced a new project, “Proton City,” which would become an integrated automobile manufacturing city with a production capacity rising to 250,000 units in 2003. During this Proton expansion, a second national car company was set up (Perodua, a joint venture with Daihatsu that produced a modified Daihatsu Mira called the Kancil). For many governments, the 1997 crisis was the moment they realized that the ISI dream was over. Building a supply chain, like Japan and Korea had done, was not optimal and indeed not possible after the second unbundling. Quite simply, offshoring had killed import substitution. The Malaysian government, however, persisted in pursuing its 1980-era strategy as far as possible. Perodua was sold to its Japanese partner, but Proton was renationalized in 2000 and the new, highly advanced plant was completed (Tanjung Malim, with a production capacity of 500,000 vehicles per year). Proton introduced the first Malaysian- designed car—the Waja (Impian in Britain)—with the help of technology it acquired when it bought the British car company Lotus. Proton moved up the value chain to manufacturing its own engine in 2002. Given the high costs of parts production, Proton’s domestic market share continues to fall into 2010. Much of its production capacity is idle. The government is looking for a foreign partner for Proton. After four decades of import substitution, Malaysian auto sector employ16. Moreover, much of the experience gained in the 1960s and 1970s was lost when the government excluded the Chinese-Malaysian firms that had done most of the assembly.

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ment was about 50,000—70 percent worked for Proton or Perodua, and about 80 percent were unskilled laborers (Wad and Chandra 2011). Thailand Thailand’s 1960s auto- industrialization plan also aimed for the whole supply chain, starting with CKD assembly. The Thai Board of Investment provided incentives that attracted automakers from the United States, Japan, and Europe (Fujita 1999). Thailand raised local content requirements and effective rates of protection progressively. Japanese part suppliers established production in Thailand at the request of Japanese assemblers, thus re- creating the close corporate ties that had long existed in Japan. Japanese assemblers also developed their own Thai supplier networks by helping local part firms raise their quality via technical assistance (Techakanont 2007). The economic slowdown and the progressive raising of the local content led GM, Ford, and Fiat to withdraw in the early 1980s just before Thailand’s GDP growth took off. The booming domestic vehicle sales from 1987 came just as Japanese auto companies embraced the second unbundling. Unlike Malaysia, Thailand abandoned the old wave to ride the new wave. Trade and ownership restrictions were relaxed, but some local content rules were tightened. For example, the Engine Production Promotion Scheme required engine assemblers to use only engine parts that had undergone specific local processing.17 Given the small market for each producer compared to the minimum efficient scale, various Japanese joint ventures collaborated on the local production of the five compulsory parts (Techakanont 2007). The implementation of advanced technology in local factories enhanced Thai industrial capacities. Another unique policy move was the concentration on one market segment—light pickup trucks and vans. Domestic taxes shifted domestic demand heavily toward these (more than 60 percent sales inside in Thailand) and this was mirrored in Japanese FDI (foreign direct investment) patterns, and later in export patterns. The next step was exporting—a goal that the Thai government had embraced since the mid- 1980s. However, rather than intervening directly, the government sought to convince Japanese companies that it would avoid the sort of techno- nationalism policy that hindered FDI in Malaysia. The 1993 “Export Promotion Project” also provided incentives for assembling automobiles for export (tariff exemptions on parts, an eight- year tax holiday, etc.). Local content restrictions were eliminated in 1998 and tariffs and excise taxes were liberalized in 1999. The Thaksin government introduced a bevy of incentives aimed at creating the “Detroit of the East.” This worked.

17. “Engine manufacturers had to increase local content every year from 20% in 1989 to 70% in 1998. From 1994, engine manufacturers had to use local cylinder blocks (casting), and local connecting rods (forging) and camshaft (casting) from 1996, cylinder head (casting) from 1997, and crank shaft (forging) from 1998” (Techakanont 2007, 10).

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Comparison of Outcomes

Differences in results only show up dramatically after the 1997 crisis (Wad 2009; see also figure 5.12).

• Thailand embraced the second unbundling and strove to become part of the global supply chains of as many giant auto firms as it could.

• Malaysia persisted with its 1980s strategy of emulating what Korea did in the 1980s and Japan did in the 1970s. Figure 5.12 and figure 5.13 show which strategy worked best. Malaysia is running a wide and growing deficit in both vehicles and parts; Thailand has a large surplus in vehicles and approximate balance in parts (figure 5.13). The results in terms of employment are equally stark. By the mid- 2000s, there were over 180,000 workers in the Thai auto industry compared to 47,000 in Malaysia (Wad and Chandra 2011).

Fig. 5.12

Vehicles produced, Malaysia and Thailand, 1980–2004

Source: Fuangkajonsak (2006, table 1).

Fig. 5.13

Trade in autos and parts, Malaysia and Thailand, 1997–2010

Source: WITS online database, SITC v.3.

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5.4

Trade, Industrialization, and the First Unbundling

Having argued that trade and industrialization were transformed, it is time to be more specific, to lay out a model where the logical relationships can be understood in their entirety. The first step is to present a framework that captures the basic elements of traditional ISI thinking (this section). The framework is then extended to consider supply chains (see section 5.5). 5.4.1

Industrialization before the Second Unbundling

When coordination costs were high enough to keep manufacturing bundled into factories, theorists could safely ignore supply chains. The focus was on lumpiness and complexity (e.g., Rodriguez-Clare 1996; Rodrik 1995). Their basic points can be made graphically. Great Britain versus the Rest Lumpiness of industry comes with external economies of scale, and we capture complexity by assuming that the external economies are linked to the nation’s range of industrial competencies.18 Nations are not endowed with competencies; creating a new competency requires a fixed investment of labor. The diagram (figure 5.14) reflects these keystone assumptions. The salient points are: (a) industry’s marginal- cost curve is downward sloped (external economies mean that the broader is a nation’s range of competencies the lower is its marginal cost); (b) traditional manufacturing techniques (cottage industry) are not subject to scale economies of any kind, so its marginal cost is flat (second- to-top line). The world price of industrial goods is shown as pzw , but this is not the price of imports inside the nation as two wedges intervene: the natural trade costs captured by τ (a mnemonic for transport costs), and the domestic tariff factor, Tz. (N.B.: when transport is costless τ = 1; when tariffs are zero, Tz = 1.) The domestic price is thus the highest line (we assume the nation has tariffs high enough to make cottage industry profitable). Natural and man- made barriers also lessen the attractiveness of exporting, hence the net price received by exporters (the bottom line) shows the world price divided by τ and Tz∗ (1 plus the foreign tariff). The two price lines partition the horizontal axis three ways. From left to right:

• Poverty trap: here steady- state competencies are so low that domestic modern firms cannot compete with domestic cottage industries.

18. We think of these as specialized training, producer services, and so forth. For example, Amsden (2001, 4) lists three generic capabilities needed for industry: production capabilities (e.g., production management, production engineering, logistics, finance, etc.); project execution capabilities (personnel training, undertaking feasibility studies, project execution, project engineering, procurement, etc.); and innovation capabilities (pure science, basic research, applied research, advanced development, etc.).

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Fig. 5.14

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Twentieth-century industrialization

Source: Author’s elaboration of first- generation development theory ideas.

• Stagnant infant: The supply of competencies allows modern industry to outcompete handicrafts, but domestic industry cannot compete abroad.

• Export success: The supply of competencies is high enough to make exporting worthwhile. Before the first unbundling really got going, only Britain was in the third box; Germany and India were in the middle range, and many were in the poverty trap. The question within the diagram (and a linchpin issue facing developing country policymakers) is: What determines a nation’s steady- state range of competency? The market alone cannot answer this; lumpiness and complexity create multiple equilibriums. Industrial competencies are demanded by industry, so if there is no industry, there is no demand, and thus no supply of competencies (“poverty trap”). In the second partition, demand for a nation’s competencies is, so to speak, limited by the extent of the market—the domestic market, that is. Big nations will have big protected industries and thus a wide range of competencies. Small nations will remain uncompetitive. In the third partition, the nation’s industry has become “the workshop of the world.” Demand for its competencies is large, almost boundless, since it is linked to world consumption, not domestic consumption, and this, in turn, supports the large supply of competencies. This means that there are two bifurcations that might require a big push to get past. No industry to some modern industry, and domestic sales only to exporting. A complete model will require a full description of the dynamic

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process that creates competencies, but here we stick with more informal analysis. The First Unbundling The steam revolution shifts the two price lines toward each other (dasheddotted lines in figure 5.14) by lower τ. This widens the first and third partitions at the expense of the second. Some of the nations, like Germany, become export competitive.19 Others, like India, now found themselves in the poverty trap. For the winners, like Germany, the extra demand for competencies generated by export sales boosted demand for and thus supply of competencies. The opposite happened to India. This was the beginning of the big divergence (see Krugman and Venables [1995] for the static economic geography version; Baldwin, Martin, and Ottaviano [2001] for a formal growth model of takeoff and divergence). Big Push, Failed ISI, Outward Orientation, Dutch Disease Trade policy’s role in traditional development thinking jumps right out of the diagram. Getting from the first partition to the second requires (a) investment in competencies starting without demand, (b) demand without any local capacity to satisfy it, or (c) coordinated appearance of the two. Getting past this was the focus of so-called Big Push development strategies. When the world was like this, import- substitution industrialization could make sense for sufficiently large nations. Indeed, in the 1960s and 1970s, it often worked for light industries. Colonialism (captive markets), and the push of the 1960s for South-South free trade agreements can be seen as trying to boost domestic market size for nations in the middle partition. First- generation Big Push ISI theorists wrongly assumed that moving from the first partition to the second would launch a self- sustaining dynamo of rising output and accumulating competencies that would eventually lead to the third partition (export competitiveness). Revelation of this fallacy accounted for much of the dissatisfaction with the theory. Secondgeneration theorists turned their focus to the second bifurcation (transition from second to third partition). Getting over the second bifurcation required a second big push that involves: (a) exporting at a loss initially, (b) investment in competencies for which there is not yet any demand, or (c) the coordination appearance of export demand and extra competencies.20 The Korean and Malaysian auto experiences—as well as many others—embodied efforts to select option (c). 19. Irwin (2003), for example, notes that the United States became a net exporter of manufactures in 1910. 20. Of course, the steady- state range of competencies will be the collective outcome of investment decisions, so for some nations, the multiple equilibrium analysis is not relevant—their cost of creating competencies is so high that even with the whole world as their market, the steady state would be in the first partition.

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The diagram is useful for organizing thinking on many development chestnuts. The Dutch disease can be seen here. The marginal cost curve depends upon local wages. For nations in the second partition (modern, but uncompetitive industry), the nonindustrial sector will typically set the reservation wage and this, plus some industrial premium, determines the modern- sector wage. A boom in commodity prices, or improved productivity in the nonindustrial sector, would raise the industrial marginal cost curve and thus harm the competitiveness of the national industry for any given range of competencies. Depending upon the nation’s initial position and shock size, the nation may deindustrialize (shift into partition one from two, or two from three). Big exchange- rate devaluations are like the Dutch disease in reverse and thus can potentially shift a nation from partition one to two, or two to three. Of course, it need not work this way. If the nation’s initial comparative advantage is poor (it is far from the second bifurcation), the devaluation may only produce a transitory boost in sales but no permanent increase in industrial competency. 5.5

Trade, Industrialization, and the Second Unbundling

To think carefully about things like Malaysia’s versus Thailand’s autos policies, we need to get away from the black box view of industry—the twentieth- century view that a nation’s output is made only with its own factors employing its own technology. We introduce the framework assuming second unbundling has not yet happened. 5.5.1

Industry with a Supply Chain

The key assumptions of the expanded framework are: (a) production of the final good requires intermediate inputs (parts); (b) the parts range from simple to highly sophisticated—the more sophisticated ones are more intensive in their use of competencies; and (c) to reflect developing nation realities, Home is least competitive in the most sophisticated parts. More sophisticated parts are more expensive for Home (the developing nation) to make (figure 5.15). A judicious choice of units let us compare marginal costs and prices across intermediates.21 Finally, we assume trade in parts is costly; in addition to transportation and tariffs, coordination costs are added when parts and final goods are manufactured in different nations. These costs add a new wedge, χ (a mnemonic for coordination), to the separation of the two price lines—the domestic price (top) and net export price (bottom). The range of competencies—denoted by “n” (competencies range from zero to n)—is embedded in the position of the marginal 21. For example, if intermediate good number 1 has a price of $1 per kilogram, and good 12 has a price of $1,000 per kilogram, we measure 1 in kilos and 12 in grams, so both have a price of $1. This makes marginal costs comparable across intermediates.

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Fig. 5.15

A simple supply chain

Source: Author’s elaboration.

cost curve for intermediates (“MC Intermediates” in the diagram). A nation with a wider range of competencies would, all else equal, have a lower MC Intermediates curve. Observe that final- good production is pushed into the background to focus on the supply chain. Figure 5.15 is drawn assuming that the final good is produced in Home (without downstream production there would be no demand for Home intermediates and thus no production or importation of intermediates). Although it does not appear directly, the chicken- and- egg lumpiness of industry is still here. If Home does not produce a sufficiently broad array of intermediates, it will not be competitive in the downstream good. Given prices, the nation produces all parts up to a threshold level of sophistication (left partition of the x- axis); it imports the rest (right partition). The ICT costs are high to start with, so no parts are exported. Where are our three cases from figure 5.14? For example, suppose Home protects the downstream industry in order to create a demand for upstream intermediates, hoping that their supply would be forthcoming. If this works, the nation gets modern industry, which here means downstream production and production of some intermediates but no exports. The third possibility is that the domestic market is so small that nothing works. Protection of the downstream goods creates no modern production of parts or final goods (poverty trap). Such a situation is depicted in figure 5.16; Home’s marginal

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Fig. 5.16

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A simple supply chain: Poverty trap case

Source: Author’s elaboration.

cost of producing intermediates is everywhere above the import price; there is no modern production downstream or upstream. 5.5.2

Second Unbundling without Multinationals

Now the ICT revolution happens and this brings down coordination costs, χ. How does this change the diagram? To answer this, we have to address the role of multinationals. Multinational corporations have been thoroughly involved in the internationalization of supply chains, often playing a dominant role. However, before considering the implications of multinationals’ involvement, it is instructive to think about a “pure” second unbundling—one without multinational corporations (MNCs). This allows us to motivate the rather obvious observation that the second unbundling makes industry less lumpy and thus makes industrialization easier and quicker, even without multinationals. This distinction also helps separate out two very different implications of the ICT revolution. It facilitates geographical separation of production stages, and it heightens the rewards to and need for combining rich- nation hightech with poor- nation low wages. Starting from the figure 5.15 case (only domestic sales), we lower so the price lines get closer together as shown ( just as falling transport costs narrow the gap, as in figure 5.14). The new, dashed price lines now partition the range of intermediates into three segments. The rightmost segment represents the intermediates Home imports (Home marginal cost is above the import price). The middle segment defines the intermediates Home

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produces but does not export (Home marginal cost is low enough to beat imports but not low enough to be competitive abroad). The leftmost segment is new. It depicts a range of intermediates where Home is now competitive in world markets. We immediately see two first- order effects of the ICT revolution: (1) the range of intermediates produced at Home shrinks, and (2) trade in intermediates rises—both imports and exports (as in figure 5.11 and figure 5.13). The first effect stems from the fact that at the high end of the range, imports displace domestic production of intermediates. While bad news for any specific factors involved in the newly uncompetitive intermediates, this is good news for downstream competitiveness. Since the imports are cheaper, downstream competitiveness is improved. More local downstream production is good news for intermediate producers in the middle segment. The second effect stems from the way that lower coordination costs allow Home to export the parts where it has the greatest comparative advantage (leftmost segment). Informal Dynamics: Existing Industry Case We can use this framework to think about the impact of the second unbundling on a nation, say Korea, which had a broad and deep industrial base before the second unbundling. As far as total demand for competencies is concerned, there are two positive effects and one negative effect. The negative channel is the displacement of locally produced high- end intermediates with imports. The positive channel is the extra production of low- end parts for export, and the improved competitiveness of the downstream product, which may promote additional domestic and/or export sales. If the overall effect is positive and large enough, overall demand for competencies will rise—it is due to the new demand arising from the newly export- competitive intermediates, but also possibly from the extra finalgood exports caused by the lower cost of intermediates.22 As usual, this will induce fresh investment in competencies. The knock-on effect of expanding the competency range will be a lowering of the MC Intermediates curve, as shown in figure 5.17. This in turn induces what could be called “moving up the value chain.” Both thresholds—the one for domestic production and the one for exporting—shift to the right, implying that the nation exports more sophisticated goods. This would create something like the famous “flying geese” development pattern.23 Notice that something like New Economic Geography’s cost- linked circular causality, that is, cluster economics—is going on here. The new exports create a demand and thus supply of competencies that lower the nation’s 22. Technically, the opening shifts the production mix toward a less competency intensive range of intermediates, so a simple rise in total production may not raise overall demand for competencies. 23. The original ideas are in Akamatsu (1962); the model is in Kojima (2000).

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Fig. 5.17

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Moving up the value chain: Geese in formation

Source: Author’s elaboration.

marginal cost and thus lead to a second round of new exports, which in turn create new demand/supply of competencies. The process eventually arrives as a steady state, as n stops rising and the thresholds stabilize. In the meantime, however, it would look like export- led growth involving an above- normal rate of savings/investment and a rapid expansion of production and employment in industry. Moreover, the nation would be expanding the range of products it exports. The framework can also be used to think about development of a nation that initially has no domestic production of the final good—for example, the Philippines in autos. In this case, there is no local demand for intermediates and the top price line in figure 5.17 is irrelevant (as is the corresponding threshold). After the second unbundling, the nation starts to export industrial goods, but only intermediates (those in the leftmost segment). The cost- linked circular causality starts as before and the nation “moves up the value chain,” exporting increasingly sophisticated parts as its range of competencies widens. 5.5.3

Multinationals and the Second Unbundling

A critical aspect of global value chains is the cross- border application of advanced know- how (product and process technologies, finance, management, marketing, design, etc.). There is a good reason for this. As manufacturers from advanced economies seek to produce certain parts, or complete certain manufacturing stages more cheaply, they move production facilities

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abroad. However, the output of these new factories must continue to mesh seamlessly with the continually evolving production processes located in other nations. The factories are thus often owned, controlled, or in long- term relations with the parent company. What’s more, combing high technology and low wages is profitable—or at least very cost effective and essential to maintaining competitiveness if everyone else is doing it. This suggests that the analysis so far missed a critical element of the second unbundling—the application of firm- specific, advanced- nation technology in developing nation factories. This has important implications for the connections between trade and industrialization—the sort of thing that explains how Thailand or Vietnam could so rapidly expand its exports of vehicles and parts. To study these new implications, we modify the workhorse diagram to allow for very specific forms of cross- border movement of technology. We do not use the standard moniker— technology transfer—since it is entirely inadequate to today’s realities in at least two ways. First, the internationalization of supply chains involves cross- border applications of very specific slices of the parent company’s know- how. This is not the diffusion of a broad range of productivity- enhancing techniques that is typically assumed in a growth model. A Japanese auto maker, for example, might help a Philippine company learn to sew leather seats onto a frame made in Japan, so they can sell Lexus cars for less. There would be little or no Filipino learning, however, about the design and construction of the seat frames and embedded electronics. Second, if the company can manage it, there will be no transfer of technology at all. Corporations take great care to reduce the dissemination of know- how to the local economy. As such, this cross- border deployment of technology should be thought of more as “technology lending.” If the multinational decides to switch the production of the particular part from, say, China to Vietnam, the producer in China may not be able to continue producing the same part. To capture these aspects in the framework, we start from a situation where the developing nation is not making the downstream product (e.g., cars). We begin, in other words, from the situation depicted in figure 5.15 where there is no intermediates production initially. From this initial condition, the multinational lends a narrow range of technology to a producer located in the developing nation with the aim of getting the offshoring part produced at the lowest possible cost for the requisite quality. An example would be Nokia teaching a Malaysian firm to produce and fasten the plastic screen cover to one of its handsets. In the diagram, this shows up as a downward jump in Home’s marginal costs, but only for the particular part that is offshored. This is illustrated in figure 5.18. The key is that with the help of the technology lending, Home switches from a zero- indigenous- industry situation to being a globally competitive exporter of a particular part.

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Two implications follow immediately from the case at hand.

• First, industry can appear extremely quickly. There is no need for the time- consuming nurturing of an industrial base and investment in a broad range of technical competencies. The multinational arrives and production starts in little more than the time it takes to build the factory. • Second, this industrialization process bears very little resemblance to the successful import substitution policies followed by, say, the United States, or even Korea and Taiwan. This industrialization looks like a big success from the perspective of exporting. After all, the nation is now exporting what shows up as advanced industry goods in the trade statistics. If the analyst is still viewing the world with twentieth- century industrialization theory in mind, this is a very good sign. By the time Korea and Taiwan got to the stage of exporting such things, they were firmly on the road to being rich nations. However, from the perspective of twenty-first century trade and industry, exporting a good tells us much less about the exporting nation’s capacities. There may be only one factory in the whole country that resembles modern industry. This is sometimes called enclave industrialization. The preceding example is akin to the “trade in tasks” discussed by Grossman and Rossi-Hansberg (2008), where offshoring involves no two- way trade in goods. While such forms of production sharing do exist, they are

Fig. 5.18

A supply chain with multinationals and technology lending

Source: Author’s elaboration.

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not the only kind. In many industries, so-called reexporting trade is prevalent. This is where the developing nation imports sophisticated parts, adds some value, and reexports the output. This is also called outward processing trade. We can easily capture this type of trade by reinterpreting figure 5.18. The diagram focuses on the intermediates; the downstream good is in the background. To capture outward processing trade, we assume that the downstream good (typically a component rather than a final consumer good) is being produced in the developing nation under consideration (in this case an intermediate good itself rather than a final good). As a consequence, production of the downstream good requires the full range of intermediates arranged along the horizontal axes of figure 5.18. Home production is competitive only in a narrow range of intermediates— the range where technology lending occurred. All other intermediates are imported. In this case, the industrialization becomes associated with the rapid emergence of both imports and exports of parts. All this would be associated with long- term foreign involvement with the newly created industry. Here the story has been told in a way that makes it look very much like the sort of industry that grew rapidly in export- processing zones in the 1990s. 5.5.4

How the Second Unbundling Killed Import Substitution

Before moving to policy issues, it is worth pointing out that the demise of twentieth- century industrialization strategies may have been caused by second unbundling industrialization. We start by noting that import substitution seems to have disappeared as a viable development strategy at approximately the same time as the second unbundling got going in manufacturing. For example, countries in East Asia followed dual- track industrialization strategies since the 1970s. On one hand, they pursued import substitution in an effort to create industries via import protection. On the other hand, they encouraged export platforms that employed their workers to produce goods (usually components) for export—often employed directly or indirectly by multinationals. As the 1980s and 1990s proceeded, the classic import substitution track failed increasingly while the export- oriented track increasingly succeeded. Eventually, many of these nations embraced policies that turned their whole country into what can be thought of as one great big export processing zone. An unintended result of all this offshore- friendly policy was that it boosted the competitiveness of advanced- nation manufacturing firms. Before offshoring, expensive Japanese labor had to be used for almost all aspects of making Toyotas. In this way, high labor costs partly offset Japan’s technology edge, making it easy for, say, Malaysian- made Proton cars to compete with Japanese cars inside Malaysia. By allowing, say, Toyota, to combine its high technology with cheap East Asian labor, offshoring en-

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hanced Toyota’s cost edge over Proton. The key point is that offshoring does not allow Proton to borrow Japan’s technology when making Protons, but it does allow Toyota to borrow developing nations’ low- wage labor. Note the important distinction here between the competitiveness of advanced- nation manufacturing firms and competitiveness of advancednation industry workers. The offshoring allows the combination of advanced- nation technology with developing nation labor. This clearly makes the offshoring company’s products more competitive, but it tells us nothing directly about how it changes incentives to create jobs in the advanced nation. 5.6

Why Does It Matter?

The Lindauer-Prichett first two generations of “high development theory” disagreed on how best to overcome the chicken- and- egg lumpiness of twentieth- century industry. They share, however, the goal of building the whole domestic supply chain.24 What Lindauer and Prichett (2002) call third- generation theories stress diversity, but they continue to use a twentieth- century view of trade and industry.25 There are at least two issues that arise when the third- generation development models ignore the supply chain.

• Misinterpretation of the data • Inattention to certain policy questions 5.6.1

Misinterpreting the Data

Using a twentieth- century view of industry to interpret twenty-first century data can lead to incorrect inferences. The twentieth- century view is that a nation’s exports embody the nation’s technology, labor, capital, and so forth—the inclusion of foreign factors or technology is a second- order issue. As such, a nation’s exports tell us something about that nation’s technology, labor, capital, and so on. This approach fails, however, for products and nations where international supply chains are important. Product characteristics may tell us something about the embodied factors and technology, 24. The simple framework skipped over all the bread- and- butter of development advice that Lindauer and Pritchett (2002) say define the first and second generation—things such as the role of governments, capital accumulation, trade, and so forth. This omission is not meant to suggest that these are unimportant—they are important. The omission was intended to illustrate common foundations of traditional thinking on industrialization, and to show that this thinking is rooted in nineteenth- and twentieth- century experiences where supply chains could only be internationalized to a limited extent and then only between advanced nations like the United States and Canada, or Germany and France. 25. See, for example, Hausmann, Hwang, and Rodrik (2007); Hausmann and Klinger (2007); Lederman and Maloney (2007); Klinger and Lederman (2006); and Brambilla, Ledermann, and Porto (2010), which stress the importance of the composition of a nation’s export portfolio.

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but very little about the nationality of those factors and technologies. To take a well- known example, China’s iPod exports tell us more about the US industry than they do about Chinese industry. The factor and technology content of a nation’s exports will depend upon the nation’s position in the international supply chain as well as upon its own supply of factors and technology. The same problem becomes more severe when considering periods, countries, and producers where the second unbundling has advanced rapidly. As we saw in table 5.1, the local content in “Factory Asia” shifted massively from 1985 to 2000. To make the point more precisely, consider the widely cited Hausmann, Hwang, and Rodrik (2007) model (HHR henceforth). The message in the model is that nations should search for their own nation- specific comparative advantage and modify this comparative advantage by shifting into more sophisticated goods. The twentieth- century concept of industry is baked into their model when they assume industry can be modeled as a black box linking national factors and technology to national output; the nation’s production contains only its own productive factors and technology. Nothing like Thailand’s export of pickup trucks and engine parts, or China’s processing trade, is possible. When they get to empirics, they use the twentieth- century view of industry to link country characteristics to goods; exports of poor nations must be technology poor in the sense of being products where a nation’s labor is especially low. With our simple framework in mind, we can immediately see a problem with this. The good exported may embody a large amount of foreign- nation factors and technology, so the product- country link is tenuous. In the figure 5.18 case of technology lending, the product- country link may be entirely spurious as the developing nation is using advance- nation technology even in the segment of the value chain it has. The growth implications could also be misinterpreted. We suppose a particular camera is made in Japan and is thus associated with a high measured productivity—what HHR call PRODY—and then Sony offshores assembly to China. However, suppose that in contrast to the HHR model, the productivity of Chinese assembly workers is the same in cameras, cotton shirts, or anything else. In this world, we might see an association between China’s exports of things Japan used to export and Chinese growth, but it would have nothing to do with the HHR message in the model. The creation of any assembly job that draws a worker out of agriculture raises Chinese output since labor productivity is higher in assembly than agriculture. Thus we would see an association between a rise in China’s export sophistication index and its growth, but it has nothing to do with the sophistication of its export mix. If HHR are right, nations might want to target the production of high- tech goods. If the alternative view is right, all that matters is getting more assembly jobs.

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5.6.2

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Different Policy Questions

High development theory generally ignores or skips over the changed nature of industrialization. For example, Rodrik (2011a) argues that: “continued rapid growth in the developing world will require proactive policies that foster structural transformation and spawn new industries—the kind of policies that today’s advanced economies employed themselves on the way to becoming rich.” This, of course, assumes that building a supply chain— which is what advanced economies did—is the same as joining a supply chain, which is the main option faced by a growing number of developing nations today. With the lack of focus on supply chains, one may also miss policy issues raised by the new path to industrialization. There are really two sets of questions. The first concerns issues faced by nations that are trying to join a supply chain. The second concerns issues faced by nations like Korea—who industrialized in the old- fashioned way and now are facing a hollowing out of their industry. New Industrializers New policy issues that arise can be highlighted with an example. The Sinos Valley in southern Brazil had a cluster of small shoe manufacturers in the 1960s producing for the domestic market. In the 1980s, buyers from the United States arrived and integrated Brazilian firms into the US footwear value chain (Humphrey and Schmitz 2002). This facilitated upgrading as the “US buyers studied the market, developed models and specified product, helped producers in the choice of technology, and organized production, inspected quality on site, and organized transport and payment.” (Humphrey and Schmitz 2002) Process efficiency and product quality rose. The authors also noted: “the danger of this strategy became evident when Chinese producers undercut Brazilian products in the US market in the early 1990s, and Brazilian producers were faced with sharply declining prices” (10). The largest local firms upgraded in terms of production process but not in terms of design and marketing. Local business associations promulgated plans for raising the image of Brazil’s footwear and reinforcing design capabilities, but these came to nought. Should the Brazilian government have been active in encouraging a diversification of buyers, or an upgrading to more niche products? Should it have encouraged firms to do more design and marketing in Brazil? This touches on a whole set of issues concerning the most appropriate complementary policies. Once new industrial jobs start appearing, what should be done to ensure raising productivity and sustainability of the production? Should a government activity diversify the nationality of the supply chains its workers are joining? What sort of implications does this sort of fast

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and easy industrialization have for education and training policies? Should foreign language skills be emphasized more? If so, which languages? Is the encouragement of labor unions a good idea for the development strategy? Of course, these questions are not entirely new—they are related to the localization struggle of ISI polices in the 1970s and the early 1980s. However, as the Thai versus Malay auto sector experiences showed, thinking about localization policies without putting global value chains at the heart of the economic logic can lead to some very misguided policies. Today’s nations might do better to look at Thailand starting from the late 1980s, rather than Korea and Taiwan from 1970 to 1997. Another example concerns the contrast between Thailand’s and the Philippine’s joining strategies. Thailand has very successfully attracted a great deal of industry activity in the automobile sector. The Philippines, by contrast, engage in outward processing production in a wide range of products and few final vehicles. How should we evaluate these outcomes and the policy choices that fostered them? What should we recommend to the next supply- chain joiner, say Vietnam or Cambodia? Some nations, such as China, have explicit policies of encouraging the replacement of imported intermediates with local production. They also actively encourage local manufacturers to imitate foreign producers who are selling to the local market. This is plainly a twist on the old importsubstitution policies, and it seems to be working. But is it the right policy? Should other developing nations try to emulate them, or is it only working because of China’s enormous internal market? Consider the figure 5.18 example where the developing nation gets a narrow slice of intermediate production. Should its policymakers try to expand this range? If yes, should they try to fill in below (produce less sophisticated products), or try to build up (produce more sophisticated products)? Issues of geography are clearly more important for joining a supply chain, but they are not well understood—in part because high- level development theory ignores supply chains. One hypothesis is that geography matters because twenty-first century trade—the trade- investment- services nexus— requires technicians and managers to travel among production facilities. While the price of air tickets has fallen, the opportunity cost of time has not. This is probably why supply chains are regionalized rather than globalized: Factory Asia, Factory North America, and Factory Europe, for example. These considerations give rise to additional sets of policy concerns. As geography seems to be so important, it would seem critical to distinguish between policies that might work in the neighborhood of an existing supply chain and policies that might be needed in faraway nations. Surely, we should develop a different set of policy advice for, say, Vietnam, and, say, South Africa, or Argentina. A much larger question concerns the ultimate destination of offshoringled industrialization. Right now, the world seems to be dividing into head-

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quarter economies and factory economies (Baldwin 2006). The factory economies have lots of industry and rapidly growing exports of manufactured goods, but how do they ensure their place in the supply chain is not supplanted by the next low- wage country to get its governance problems under control? Ultimately, how do factory economies become headquarter economies, or is that whole notion an anachronism? The development nations that industrialized before the second unbundling (e.g., Korea, Taiwan, India, South Africa, and Brazil to a certain extent) face a very different set of policy challenges. Should they encourage their industrial companies to join the supply chains of US and Japanese companies? Should they encourage or discourage their manufacturing firms from offshoring certain segments of the production? If so, which segments? Should their governments institute complementary policies that help their firms continue up the value chain? Should they try to prevent nations like China from moving up the value chain? 5.7

What It Means for Multilateral Cooperation

Since globalization’s second unbundling, international commerce involves a richer, more complex, more interconnected set of cross- border flows. This changed nature of trade transformed policymaking globally, first by creating new supply and new demand for deeper disciplines, and second by creating a bond among various strands of policymaking—some of which were always viewed as international, but many are traditionally viewed as domestic policy issues. This section, which draws on Baldwin (2012), considers the implications for multilateral trade cooperation. 5.7.1

The Nexus: More Interconnected Policy

The complexity and interconnectedness of supply- chain trade shifted world trade governance toward regionalism. As is so often the case, there is nothing really new here. The basic challenge of supply- chain trade and the basic response of deeper, regional disciplines has been a feature of global governance for a half century. Before the second unbundling, most trade was simple and could be governed by the simple rules of GATT 1947. The General Agreement on Tariffs and Trade (GATT) rules, however, were not sufficient to underpin the complex cross- border relations implied by supply chains that arose among rich nations in the 1960s and 1970s. To fill this governance gap, North Atlantic nations set up deeper disciplines. Since the trade was regional rather than multilateral, the deeper disciplines were placed in regional trade agreements. One important example was the 1965 US-Canada Auto Pact, which regulated trade and investment in the auto sector.26 26. For details, see Keeley (1983).

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The history lesson here is simple. Complex cross- border flows demand complex rules. Since most supply- chain trade is regional, there is a strong tendency to establish the necessary complex rules at a regional rather than multilateral level. Multilateral rules would almost surely have been more efficient, but negotiating them in the GATT would have been too cumbersome and slow; most GATT members were not involved in this type of international commerce. Which New Disciplines Are Needed? Twenty-first- century trade creates a need for two new types of disciplines. These correspond to the two new elements of the associated international commerce. Supply- chain trade often involves producing abroad, either directly or via long- term relationships with independent suppliers. This is basically the investment and intellectual property part—setting up business abroad is an essential part of twenty-first- century trade. This means that barriers to doing business abroad are now trade barriers. Likewise, much of the internationalization of supply chains involves overseas application of a firm’s advanced know- how. A lack of IP protection therefore becomes a barrier to trade. International supply chains in the 1960s and 1970s were mostly among developed nations whose domestic laws provided reasonable guarantees. As supply chains spread to developing nations with weaker domestic institutions, embedding such disciplines in international agreements became more important. Production among the facilities must be coordinated and this involves the two- way flow of goods, services, people, capital, and training. Barriers to these flows are now barriers to trade. Note that traditional trade barriers are part of this, but the list is much longer as the cross- border flows are more complex (express mail, air cargo, trade financing and insurance, business mobility, etc.). One good source listing the necessary disciplines are the deep regional trade agreements that have been signed among nations where the trade- investment- services-IP nexus trade is important.27 5.7.2

The Second Unbundling and Erosion of World Trade Organization Centricity

Globalization’s second unbundling created a new type of win- win situation in international commerce. The old type was “my market for yours”; the new type is “my factories for your reform.” This spawned massive demand for new disciplines from headquarter economy firms and a massive supply of new disciplines from factory economy governments (i.e., developing nations seeking to industrialize by joining international supply chains). 27. Following a procedure established by Horn, Mavroidis, and Sapir (2010), the WTO recently created a database of deeper disciplines in all the RTAs announced to the WTO by 2010 (WTO 2011).

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As the WTO was occupied with the Doha Round and its emphasis on twentieth- century issues (tariffs and agriculture), supply met demand in regional trade agreements—just as it did in the 1960s. More precisely, the supply- chain governance gap was filled by uncoordinated developments in deep regional trade agreements, bilateral investment treaties, and autonomous reforms in emerging economies. The resulting package of deeper disciplines is what I have called twenty-first- century regionalism (Baldwin 2011)—a theme taken up in the WTO’s 2011 World Trade Report (WTO 2011). Going Forward When it comes to twentieth- century trade and trade issues, the WTO is in perfect health. The basic WTO rules are almost universally respected, WTO’s court decisions are almost universally accepted, and nations—even big nations like Russia—seem willing to pay a high political price to join the organization. In short, the WTO is alive and well when it comes to the types of trade and trade barriers it was designed to govern (the sale of goods made in factories in one nation to customers in another). The twenty-first- century regionalism that has arisen from developing nations’ quest for offshored factories and jobs is a threat to the WTO’s centrality in multilateral trade governance, but not in the way that twentiethcentury bilateralism was. It is not useful to think of twenty-first- century regionalism using the analytic frameworks established by last- century thinkers like Jagdish Bhagwati when regionalism was mostly about tariff preferences (Baldwin 2011). Twenty-first- century regionalism is not primarily about preferential market access as WTO (2011, Chapter B) demonstrated convincingly. Twenty-first- century regionalism is about disciplines that underpin the supply- chain industrialization. Where the WTO’s future seems cloudy is on the twenty-first- century trade front. The demands for new rules and disciplines governing the tradeinvestment- services-IP nexus are being formulated outside the WTO. Developing nations are rushing to unilaterally lower their tariffs (especially on intermediate goods) and unilaterally reduce behind the border barriers to the trade- investment- services-IP nexus. All of this has markedly eroded the WTO’s centrality in the global trade system. The implication of this is clear. The WTO’s future will either be to stay on the twentieth- century sidetrack on to which it has been shunted, or to engage constructively and creatively in the new range of disciplines necessary to underpin twenty-first- century trade. 5.8

Concluding Remarks

Some nations got rich without industrializing—but not many. This is why “high development theory” (as Paul Krugman calls it) focuses on industrial

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development and trade’s roles in fostering it. Recent empirical explorations led by Dani Rodrik continue to find evidence that manufacturing is critical. The current generation of high- development thinking, however, eschews big ideas since yesteryear’s big ideas fail to account for the facts. Some nations are booming while others are stagnating, but there seems to be little correlation between outcomes and the old Big Ideas (ISI), or their replacement (Washington Consensus). One part of the weak correlation might be due to the revolutionary transformation of industry and trade that occurred from 1985 to the late- 1990s but that has not been incorporated into development theory. Starting in 1985, with an important acceleration in the late 1990s, most successful developing- nation industrializers joined the supply chains of firms from high- tech nations, especially the manufacturing giants of the 1980s—the United States, Japan, and Germany. As mentioned in the introduction, joining a supply chain made industrialization radically less complex and radically faster because supply- chain industry is less lumpy and less interconnected domestically. The ICT (information and communications technology) revolution lowered the cost of coordinating complex activities at distance and this made the geographical dispersion of supply chains feasible and profitable. Richnation firms offshored segments of their value chains to developing nations. As the output had to mesh seamlessly with continually evolving production processes in other nations, the multinational typically deployed its firmspecific technology in the foreign factory—especially since this combination of rich- nation technology and low- wage labor could be very profitable. This technology lending could revolutionize the output of a developing nation’s industry almost overnight. Offshored factories arrived with everything needed to export. Much of this was regional as key personnel still had to travel among factories. Oversimplifying to make the point, all the developing nation had to do was be located near the United States, Japan, or Germany, provide reliable workers, and establish a hospitable business environment. But easier and faster does not necessarily mean better. As mentioned in the introduction, the second unbundling made industrialization less meaningful. Before the second unbundling, a nation had to have a deep and wide industrial base before it could export anything (e.g., car engines). Exporting engines was a sign of victory. Now it is a sign that the nation is located along a particular segment of an international value chain. The key development struggle is to continue to reach new equilibriums, thus deepening the exploitation of external economies. Large developing nations like China and India can use their massive internal markets as both carrot and stick in forcing advance technology firms to transfer more technology. The lessons from China in particular have little relevance for smaller

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developing nations. Thailand’s success in becoming the Detroit of Southeast Asia shows supply- chain industrialization can work even without muscular technology transfer policies. In closing, I am not sure that a full understanding of the second unbundling’s development implications will eventually lead to new Big Ideas. I am sure, however, that ignoring such implications will guarantee continuing puzzlement. Global supply chains are now a fixed point in the typology of developing- nation industrial planners; no winning industrialization effort in the past twenty years has been able to ignore them. The goal of this chapter is to make the prima facie argument that incorporation of such considerations into development theory may yield important insights.

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ment in a Globalizing Economy.” Report prepared for Development Strategy Institute, Vietnamese Ministry of Planning and Investment and Medium-Term Industrial Strategy Project—United Nations Industrial Development Organization. Techakanont, K. 2007. “The Evolution of Automotive Clusters and Global Production Network in Thailand.” Discussion Paper no. 6, Faculty of Economics, Thammasat University. Uzir, M., Mahidin, and R. Kanageswary. 2004. “The Development of the Automobile Industry and the Road Ahead.” Journal of the Department of Statistics Malaysia, vol. 2, Department of Statistics Malaysia. Venables, A. J. 1999. “Fragmentation and Multinational Production.” European Economic Review 43 (4): 935– 45. Wad, P. 2009. “The Automobile Industry of Southeast Asia: Malaysia and Thailand.” Journal of the Asia Pacific Economy 14 (2): 172– 93. Wad, P., and V. G. R. C. Chandra. 2011. “Automotive Industry in Malaysia: An Assessment of Its Development.” International Journal of Automotive Technology and Management 11 (2): 152– 71. World Trade Organization. 2011. The WTO and Preferential Trade Agreements: From Co-Existence to Coherence. World Trade Report. Switzerland: WTO publications. Available from http://www.wto.org/english/res_e/booksp_e/anrep_e/world_trade _report11_e.pdf. Yi, K. M. 2003. “Can Vertical Specialization Explain the Growth of World Trade?” Journal of Political Economy 111 (1): 52– 102.

Comment

Andrés Velasco

Reading this chapter has been a great pleasure. The profession would gain if more “think pieces” of this kind were produced. Richard Baldwin speaks of the two great unbundlings. The idea is appealing and clearly spelled out. The second unbundling implies a pattern of industrialization that is above and beyond the nation state. Before the ICT revolution, industrialization used to require country-specific endowments and institutions—roads, engineers, the rule of law, property rights, and so forth. Now that countries have the relatively simpler option of joining a supply chain, the author argues, many of these things do not matter, or matter much less so than they used to. In a way, this is a welcome change, since it simplifies the process of industrialization—all you need is a good geographical location and healthy relations with multinational companies around the world. But industrializing in a small, domestic enclave in order to be part of a Andrés Velasco is the Edward Larocque Tinker Visiting Professor at the School of International and Public Affairs and the Institute for Latin American Studies at Columbia University and a research associate of the National Bureau of Economic Research. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12592.ack.

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global supply chain does not simplify the process of development. In the old scheme of things, industrialization was attractive precisely because of its by-products and positive externalities—institutional development and the rule of law among them. Without those benefits, industrialization becomes less appealing as a road to development. Put differently: Will the new recipe for “success” yield a new set of newly developed countries? Or, alternatively, will it take us back to the enclave economy patterns of Bolivia in the nineteenth century or the Dominican Republic in the twentieth century, where production took place in small, isolated clusters while the rest of society remained underdeveloped and locked in a persistent poverty trap? Despite the dramatic reduction in transport costs, we are still short of truly global supply chains. While the scale dimension clearly matters a lot for MNCs, they still need to coordinate their production processes. What we are experiencing, therefore, is the regionalization—as opposed to the globalization—of supply chains. Where the exact boundaries of these regions lie is not altogether clear, but the outlines of the main regional supply chains can be identified nevertheless. Most obviously, East Asia has developed a tightly connected set of supply and demand relationships. North American and European supply chains share similar features. That said, the Asian unbundling seems to have been a most successful one, begging the question of what these countries got right. Part of the answer, I believe, lies in traditional development theory. We used to think of development as an endogenous process wherein you needed scale to industrialize but you needed industrialization to get the scale right. Hence the “big push” approach to development, which has been around forever but was not fully formalized until late 1990s. In that approach, issues of coordination and multiplicity of equilibria are everywhere, making development extremely tricky. Under the new rules of the game, certain physical constraints on unbundling remain—managers, for instance, may want to return home quickly at the end of the week after visiting their production facilities. But the need for a large domestic market is gone. And whatever coordination needs to be done—which part of the final product should be produced in Vietnam, Malaysia, Thailand, and so forth—is done by managers of large multinationals instead of by governments. Hello industrial development, goodbye coordination failure. In the chapter by Baldwin, my friends and colleagues Ricardo Hausmann and Dani Rodrik come in for some criticism. It seems to me a brief defense of their work is in order. According to Hausmann and Rodrik, development is a process of self-discovery, as nations gradually discover the unique competences they possess that allow them to compete in global markets. In the chapter’s line of reasoning, however, this self-discovery does not matter anymore, since it is multinationals that decide where and what to

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produce. If this is correct, however, we must inquire about what lies behind managers’ decisions to choose locations. Maybe these decisions still depend on certain country-specific attributes after all. And those attributes do depend on local policies—on infrastructure and telecom development, to mention just two. Finally, I must point out that joining a global or regional supply chain is not a guarantee of future growth. Compare, for instance, the growth performance of Central America and the Caribbean (clustered around Mexico and NAFTA) and South America, with Brazil being the largest economy there. While Mexico and its neighbors are clearly more embedded in a global supply chain (that of North America), for much of the last decade they have grown much more slowly than Brazil and its neighbors have. Of course, the countries of the south have benefited hugely from the commodity supercycle, while the resource-poor nations of Central America and the Caribbean have not. As this supercycle comes to an end, the growth balance may begin to turn in Mexico’s favor. Stay tuned.

6 Facing the Climate Change Challenge in a Global Economy Lee Branstetter and William Pizer

6.1

Introduction

As concern about greenhouse gas (GHG) emissions and possible humaninduced climate change has intensified, the volume of economic research on prospective climate change, its negative economic impacts, and costeffective methods of limiting those impacts has grown substantially. We make no effort in this chapter to offer a comprehensive review of the recent literature on the economics of climate change.1 Instead, we focus on the particular challenge of international policy coordination to reduce emissions, the processes through which this coordination is or is not emerging, and the implications for international trade. Even in this narrower domain, there is a substantial and growing literature comprising important contributions from Lee Branstetter is associate professor of economics and public policy, with a joint appointment in the Heinz College and the Department of Social and Decision Sciences, at Carnegie Mellon University. He is also a research associate of the National Bureau of Economic Research. William Pizer is associate professor of the Sanford School of Public Policy and a faculty fellow at the Nicholas Institute for Environmental Policy Solutions, both at Duke University, and a research associate of the National Bureau of Economic Research. The authors thank Peter Adams, Joseph Aldy, Scott Barrett, Alex Bowen, Sean McCoy, Allen Robinson, and participants in two NBER “Globalization in the Age of Crisis” workshops for helpful comments and suggestions. Lee Branstetter recently served as a senior economist on the Council of Economic Advisers. However, the views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research, the Council of Economic Advisers, or any other branch or agency of the US government. For acknowledgments, sources of research support, and disclosure of the authors’ material financial relationships, if any, please see http://www.nber.org/chapters/c12587.ack. 1. Readers interested in a recent, comprehensive survey of key issues and controversies are directed to Aldy et al. (2010). The Stern Review (N. H. Stern and Great Britain, 2007), one of the more recent and most thorough efforts to quantify the economic case for strong action, staked out positions on many of these difficult questions and stirred up considerable debate in the process (see, e.g., Mendelsohn 2006; Nordhaus 2007b; Weitzman 2007).

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scholars working in multiple disciplines. Our aim is to summarize and place in context some of the lessons of this literature for economists interested in the general question of multilateral policy coordination in the twentyfirst century. Because our intended audience is the general community of international economists and policymakers interested in international economic policy issues, rather than the community of climate specialists, our exposition will necessarily cover a broad range of topics, sometimes with limited depth. In the view of the authors, the impressive collection of evidence documented by the successive reports of the Intergovernmental Panel on Climate Change (IPCC) leaves little doubt that anthropogenic GHG emissions are already changing the earth’s climate system.2 Unconstrained growth in GHG emissions is likely to intensify these changes in coming decades, raising the prospect of serious damage to ecological and economic systems worldwide.3 Many scholars and political leaders view an effort to limit climate change as the preeminent policy challenge of our time. But this effort carries with it special challenges that stem from the intrinsic characteristics of the climate change problem. The majority of GHGs, including carbon dioxide (CO2), persist for a very long time in the atmosphere—time spans measured in centuries—which implies that the consequences of our action (or inaction) today, while potentially significant, will only fully emerge over an intergenerational time span. This makes it difficult for democratic political systems with relatively short decision- making time horizons to come to terms with the problem. And, despite the remarkably strong consensus among physical scientists regarding the reality of anthropogenic climate change, significant uncertainties still exist around exactly how and when the earth’s climate system might respond to increases in GHG concentrations. This uncertainty about the earth’s future physical circumstances is only compounded by our general uncertainty about the impact of climate change on human systems, driven by the uncertain evolution of future economic growth, population expansion, and technological change. If our political systems find it difficult enough to reckon with long- run problems when the consequences are well known, it is even more difficult when 2. The IPCC is an international panel of scientific experts charged under the United Nations Framework Convention on Climate Change (UNFCCC) to produce periodic reports on the scientific evidence for the existence and extent of anthropogenic global warming. The most recent IPCC assessment report (Pachauri and Reisinger 2007) was published in 2007 and can be accessed online at http://www.ipcc.ch/publications_and_data/ar4/syr/en/contents.html. The drafting of the fifth assessment report is currently under way. In 2007, the IPCC shared the Nobel Peace Prize with former US Vice President Albert Gore for its efforts to promote public understanding of climate change. 3. A useful nontechnical summary of the basic physical science of climate change can be found in Collins et al. (2007). Concerns over the possibility of small probability catastrophic climate change events have also spurred a line of work questioning the basic notion of (presented discounted) expected utility analysis (Weitzman 2009).

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they are highly uncertain. Meanwhile, the almost direct relationship between carbon dioxide emissions and energy use, and, ultimately, economic activity, often makes the cost of taking action all too palpable. Domestic political difficulties have arisen in many countries seeking to enact policies to mitigate climate change, but most notably—and importantly—in the United States. While no longer the largest emitter in the world (Buckley 2010), policy decisions in the United States are immensely important. US emissions are still the highest among developed countries, and others look to the United States for leadership. Yet, following promising developments toward a legislated emissions trading program in 2009, the political shift up to and including the November 2010 elections led even the president to declare that he was “going to be looking for other ways to solve that problem” (Soraghan 2010). While the political stars may not currently be aligned for a comprehensive legislative solution in the United States, we can expect attention to refocus on the issue once current economic doldrums pass and partisan bickering calms down. More importantly, the developments in 2009 offer important insights into what will ultimately matter in a US policy—particularly the competitiveness concerns we discuss later. Indeed, it is our view that the United States will eventually enact comprehensive climate legislation that motivates interest in how US policy (along with other national, regional, and global initiatives) can be best made operational in a global economy, and how all these policies might or might not coalesce into a global system. This possibility of a jumble of various national, regional, and global policies reflects the final, perhaps most vexing aspect of the climate change problem: its global nature. Most pollutants are essentially local problems. Emissions inflict damage, but the intensity of that damage diminishes sharply with increasing geographic distance from the point of emissions. GHG emissions, by contrast, are a textbook case of a transnational environmental externality. GHG emissions have the same impact on the global climate system, regardless of where they are emitted. A molecule of CO2 emerging from a cooking fire in rural India has the same impact as a molecule of CO2 emerging from the tailpipe of an SUV in the Houston suburbs. Coupled with the high correlation among emissions, energy use, and economic development, this global nature has created an unusually polarizing international dilemma.4 The preponderance of projected growth in GHG 4. Schmalensee, Stoker, and Judson (1998) provide an early and comprehensive look at the historic pattern of emissions per capita as countries have grown over time. They consistently find increasing emissions up to a threshold income level, at which point emissions per capita flatten or peak. Of course, one of the dominant themes in the climate change debate is that currently developing countries must pursue low carbon development strategies (e.g., see material from a 2011 workshop hosted by the EU and US governments; Open Energy Info 2011) However, even low carbon development strategies require some increase in carbon emissions, which raises the same issues.

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emissions over the next several decades will come in developing countries whose ongoing industrialization will bring in its train a rapid increase in per capita energy use and GHG emissions.5 These countries have made it clear in international negotiations that they view the continuation of rapid economic growth as a greater priority than the curbing of emissions, and they expect significant support from developed countries to finance emission mitigation. Meanwhile, many developed countries face severe fiscal constraints that constrain their ability to use public funds to subsidize mitigation in their own, let alone developing, countries (though regulatory tools, like emissions trading, remain a hopeful option). The international system has thus struggled to deal with the reality, on the one hand, that the greatest source of current and especially future emissions sees itself as having relatively little to gain from a strong, self-financed commitment to climate change mitigation and, on the other hand, that other countries will have a hard time paying them to do so. In this chapter, we start by laying out some basic facts about the current and prospective future distribution of emissions across countries. We will also summarize what that the basic economic theory of environmental regulation would prescribe as the first- best solution to the problem of emissions reductions. Unfortunately, we shall see that the ability of current global institutions to practically implement anything like this first- best solution in the near term is practically zero. We will then summarize the recent, major shift in the direction of global negotiation away from the top- down, legally binding developed- country- only targets and timetables of the Kyoto Protocol, and toward a bottom-up set of mitigation commitments by all major economies, provisions for transparent review, and financial support—both public and private—for poorer countries. How and when this might coalesce into a more coherent global system remains an important question. Toward the end of the chapter we address an idea that many international economists may find controversial and unwelcome. As policies to mitigate emissions are strengthened in some countries—particularly through mechanisms that price emissions and effectively raise energy costs—pressure will build to shield domestic energy- intensive, trade- exposed manufacturing industries from competition with producers based in other countries with weak or nonexistent carbon control policies. This has led many countries to consider “carbon tariffs” or other border measures, both to allow progress in those countries seeking to strengthen their carbon control regimes and to convince other, laggard countries that some degree of global cooperation on carbon control is warranted. These ideas raise important legal and economic questions, which we will review.

5. Weber et al. (2008) suggest that much of the growth in industrial carbon dioxide emissions in emerging economies is related to energy- intensive exports to developed countries.

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The Global Distribution of GHG Emissions: Past, Present, and Future

Today, global negotiations on climate change policy are conducted primarily under the aegis of the United Nations Framework Convention on Climate Change (UNFCCC). This is the legal framework under which the Kyoto Protocol was created. The 2009 Copenhagen and 2010 Cancun meetings, which we discuss later, were international negotiating conferences among the parties to this convention focused on further elaborations and extensions.6 The UNFCCC itself is a treaty that came into force in 1994 after first being presented for signing at the Earth Summit in Rio de Janeiro, Brazil 1992. With 195 parties, the treaty enjoys near universal participation among UN member states. Among the provisions of the UNFCCC, the participating developed- country nations—enumerated in “Annex I” to the UNFCCC—made (nonbinding) pledges to reduce GHG emissions below 1990 levels by 2000 while no such quantified target was established for developing countries (see Article 4, specifically 4.1(a) and 4.2(b), United Nations 1994). Given the persistence of this differentiation among countries, particularly the anchoring to developmental status in the early 1990s through inclusion or exclusion to Annex I, it is worth reflecting on the context in which this arrangement took shape. In the early 1990s, the developing world as a whole was slowly and fitfully emerging from the multiple recessions and financial collapses initially triggered by a severe recession in the developed world and sustained by the Third World debt crisis of the 1980s. Throughout that decade, progress in terms of sustained growth in per capita income was minimal, and many regions witnessed substantial declines in the real purchasing power of the median worker. Developing nations in East and Southeast Asia were doing much better, but the growth miracles of China, and especially India, were still at an early stage, and were not yet recognized as such by the global community. The developed world fared much better in the 1980s, with reasonably robust GDP expansion in Japan, Western Europe, and the United States, and most forecasters looked forward to a short- and mediumterm future that would resemble the recent past. This would be a world where wealth, prosperity, and energy consumption were disproportionately concentrated in the advanced industrial countries. Despite their relatively small collective share of the world’s population, these countries accounted for the overwhelming majority of greenhouse gas emissions. As the UNFCCC emerged in 1992, it made sense to concentrate on the advanced industrial countries as a first step, since they were both the primary source of the problem and the set of nations best suited to shoulder the economic costs of reducing emissions. 6. The 2011 meeting in Durban occurred after the drafting of this chapter, but served to further strengthen the outcomes in Copenhagen and Cancun. See Rajamani (2012).

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Legal scholars tell us that founding documents have enduring consequences. By the time serious negotiations surrounding the Kyoto Protocol were taking shape in the mid to late 1990s, observers of the world economy had begun to take industrial Asia much more seriously. But negotiations remained focused on legally binding targets for Annex I countries and no others. The diplomatic die had already been cast, and newly emerging economies were able to evade the efforts made to create legally binding emissions reduction targets that applied to them.7 As the rest of our chapter will attest, this has been a significant omission. Even in the mid- 1990s, observers understood that manufacturers in energy- intensive industries could face a strong incentive to relocate production from countries that imposed a cost of emissions to countries with weak or nonexistent carbon regulation regimes. The development of a high level of manufacturing capacity in East and Southeast Asian nations with no obligations to curb emissions raised the specter of “leakage” of carbon intensive industrial activity from the Western countries to this region. This leakage has an environmental angle—that emission reductions efforts in developed countries could be partially, wholly, or even more than wholly offset by increases in unregulated emerging economies. But equally important, it has an economic angle as jobs are pushed overseas, a concern faced with regard to environmental regulations more generally (Jaffe et al. 1995). It is possible to draw a connection between this feature of the climate change debate and the problems of “special and differential treatment” (SDT) for developing countries in global trade negotiations negotiated under the General Agreement on Tariffs and Trade/World Trade Organization (GATT/WTO), as skillfully identified by Bagwell and Staiger’s contribution to this volume (see chapter 3). Bagwell and Staiger argue that the supposed “free ride” extended to developing countries—their ability to benefit from the MFN tariff reductions negotiated by the developed countries, without having to offer reciprocal tariff concessions of their own—has actually become an important barrier to further progress in global trade negotiations. Paradoxically, developing countries’ own ability to benefit from further global integration is limited by the special treatment afforded to them. With developed countries having already negotiated away much of their own trade barriers in negotiations with one another, the current arrangements leave little room for the kind of give and take that could generate further gains for developing countries. In a loosely similar fashion, the developing nations, who were absolved of any meaningful mitigation obligations under the UNFCCC, are finding that such absolution can be a stumbling block to progress. In this case, it is not a negotiation dilemma, 7. Interestingly, the goal of reducing emissions below 1990 levels, also originally embodied in the UNFCCC’s founding documents, remained the salient benchmark for the Kyoto Protocol negotiations.

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it is simple math. As we shall see, developing country emissions are now both larger and faster growing than developed country emissions, and most targets are not achievable without significant action on the part of developing countries. Meanwhile, developing countries, as a group, are far more exposed to the economic damage created by climate change—and have more to gain from mitigation efforts—than the developed nations. As early as 1997, there were responses to this concern. Prior to the Kyoto meetings (where the final negotiation and signing of the Kyoto Protocol occurred), the United States Senate passed the Byrd-Hagel Resolution (by a vote of 95 to 0) expressing the “sense of the Senate” to oppose any climate change treaty that failed to impose meaningful constraints on developing countries. This meant, of course, that the Kyoto Protocol was effectively dead in the United States even before a final version had been agreed upon by international negotiators. The Clinton administration signed the agreement, but never submitted it to the Senate for ratification, and it therefore never became binding as US law. After the election of President George W. Bush, the United States formally withdrew from the Kyoto Protocol altogether. As resistance to a focus on “Annex I only” obligations was building in the United States and elsewhere, economic developments worldwide were also rendering the Annex I designations increasingly obsolete. The 1990s were a time of dramatically slower economic growth in Japan and in much of Western Europe, lowering the rate of growth of Annex I country emissions.8 At the same time, the growth boom that had begun in China in the 1980s significantly accelerated in the 1990s and India’s economy responded to the liberalization program of the 1990s with a significant growth acceleration of its own. Industrial Asia expanded throughout much of the decade. The global pattern of emissions was shifting away from Annex I countries and toward the set of countries for which no binding emissions limitations existed. These trends accelerated in the 2000s. China’s rapid and sustained growth during this decade led the Asian giant to displace the United States as the world’s single largest emitter around 2006, and the gap between the two widened sharply in the wake of the global financial crisis (World Climate Report 2011). Figure 6.1 illustrates this dramatic shift over the past thirty years, whereby developed countries emissions (“Annex I” in the figure) went from being nearly double those in developing countries (“non-Annex I”) to being barely two- thirds. 8. At the same time, economic sclerosis in Western Europe and Japan limited the growth in emissions in that decade, and made a reduction of emissions below 1990 levels, as eventually called for in the Kyoto Protocol, more feasible for these countries. Relatively robust economic growth in the United States in the 1990s pushed emissions well above 1990 levels by the end of the decade, which meant that the “Kyoto pledge” would be many times more economically costly for the United States to implement than for its European or Japanese trading partners. See Victor (2004), who lays out this contrast.

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The majority of emissions now come from developing countries

Source: Energy Information Administration (2011). Notes: Groupings were chosen to match those used by the Energy Modeling Forum below: Annex I (referring to a listing in the UNFCCC) includes the traditional “developed countries” and former Soviet republics. BRICS includes Brazil, Russia, India, and China.

Looking ahead, at the time of this writing the near universal expectation among market forecasters is that growth in the developed world will continue to proceed at a relatively slow pace—much slower than in the developing world. According to growth projections widely touted by Citigroup, China will exceed the United States in terms of total economic size by 2020, developing Asia will account for 44 percent of world GDP by 2030, and today’s developing regions will collectively account for nearly 75 percent of world GDP by 2050.9 The future consequence for emissions is profound. Figure 6.2 presents one “baseline” estimate of carbon emissions generated by the figure 6.1 groupings of developed and developing countries from the year 2000 through 2100. These estimates arise out of a study undertaken through the Energy Modeling Forum (the study is referred to as EMF- 22) (Clarke et al. 2009). This initiative utilized ten of the world’s leading integrated assessment models to forecast future levels of GHG emissions and atmospheric concentrations over time in the absence of serious efforts to mitigate global warming as well as the climatic and economic implications

9. See the forecasts contained in “Global Economics View: Global Growth Generators, Moving beyond ‘Emerging Markets’ and ‘BRICS’“, by Willem Buiter, available at http://www .nber.org/~wbuiter/3G.pdf. The forecasts of economic size are measured using (prospective) purchasing power parity (PPP) exchange rates.

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Expected emissions growth is overwhelmingly in developing countries

Source: SGM (second- generation model) reference case, Energy Modeling Forum (2009). Notes: Annex I (referring to a listing in the UNFCCC) includes the traditional “developed countries” and former Soviet republics. BRICS includes Brazil, Russia, India, and China.

of various policy efforts to slow down or even reverse this trend.10 Obviously, any exercise of this kind is speculative—the models must incorporate assumptions about population growth, economic growth, technological progress, public policy, and other variables that are hard to predict with any degree of accuracy. However, the general picture that emerges has broad agreement among most experts: while per capita income will continue to rise in the rich countries, slow population growth and a general transition to a postindustrial economy will limit emissions growth. In striking contrast, developing countries and especially the so-called BRICS (Brazil, Russia, India, China, and South Africa) will see rapid and substantial growth in emissions. This particular forecast suggests developing country emissions will be nearly three times those of the current developed countries by the middle of the century, and four times by the end. Against this backdrop, it is clear that even large emissions reductions by the Annex I countries will be insufficient to offset increases in expected emissions by the developing countries over coming decades, let alone be the 10. Integrated assessment models are computer simulation tools that integrate models of the Earth’s physical environment with models of economic growth. Perhaps the best known model of this family for economists is William Nordhaus’s DICE (Dynamic Integrated Model of Climate and the Economy) model, which he has used in numerous papers and in his recent book (Nordhaus 2008). They have become a central analytic tool within the climate change community.

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basis for global reductions. Real reductions (at a global level) in emissions will require that developing countries deviate from their baseline. Depending on how aggressive we want to be, those deviations may need to occur within years rather than decades. This was the central theme of EMF- 22: What does developing country participation imply about the feasibility (as well as costs) of various targets? Figure 6.3 summarizes the EMF- 22 results.11 This figure shows the global emission reductions required in 2050 (y-axis) to achieve increasingly ambitious long- run concentration targets (x- axis), keeping in mind the cumulative nature of emission in the atmosphere.12 The unsurprising pattern is that lower concentration targets require lower emissions by 2050. More specifically, a concentration target of 450 ppm CO2e requires a 50 percent or more reduction in global emissions by 2050. A 550 ppm target could be achieved with roughly level emissions between now and 2050, and a 650 ppm target would allow a roughly 50 percent increase in emissions.13 Within this range, 450 ppm is the target required for an expected average global warming of 2 degrees celsius, the identified goal in the L’Aquila Declaration of Leaders (2009) and both the Copenhagen Accord and Cancun Agreements.14 However, the implied 50 percent reductions by 2050 are virtually impossible without immediate full participation by all countries.15 And, while the 2008 G8 declaration in Hokkaido articulated precisely that kind of 50 percent reduction by 2050, such a global emission target has yet to be endorsed by any emerging economy (perhaps related to the implied need for developing country action). While the EMF- 22 study suggested that many targets are simply infea11. The EMF results (in terms of emission reductions and price per ton of CO2) with full participation and flexibility are not notably different from another recent study (Edenhofer et al. 2010). However, that study did not consider the possible delay of participation or constraints on overshooting. 12. The figure shows a range of results that differ by model—each of the ten participating models and four variants are indicated by different dots in the figure—as well as two key scenario definitions. First, scenarios consider separately whether concentrations can overshoot (“O.S.”) the target or are not- to-exceed the target (“N.T.E.”). Second, they consider separately whether all countries fully participate from the beginning (“Full”) or developing countries delay participation. This “Delay” scenario specifies the BRICS starting in 2030 and other developing countries starting in 2050. For a number of scenarios, the figure indicates outcomes where a particular scenario- model combination “could not be modeled under criteria of study,” meaning the model literally would not solve or the initial solution price was more than $1,000 per ton of CO2e. 13. Concentrations of carbon dioxide (CO2) in the atmosphere are measured in terms of parts per million (ppm)—that is, among a million molecules of gas in the atmosphere, how many are carbon dioxide? CO2e, or carbon dioxide equivalent, converts concentrations of all greenhouse gases into the amount of carbon dioxide that causes the equivalent amount of warming. 14. A 550 ppm target would imply 3 degrees celsius of expected warming, and 650 nearly 4. 15. A 450 ppm target also requires us overshooting 450 before falling back to it—an unsurprising result given atmospheric GHG concentrations are roughly 450 ppm already.

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Fig. 6.3 Limiting warming to 2 degrees celsius (450 CO2e) requires immediate participation by all countries and negative global emissions Source: Clark et al. (2009). Notes: The figure shows the relationship between concentration targets (x- axis) and emissions (y- axis), and highlights the consequences of a delay in developing country actions (“delay”) and the requirement that atmospheric GHG concentrations are not to exceed (NTE) the longrun target.

sible without the participation of major emerging economies, an obvious corollary is that all targets are more expensive without their participation. Common sense suggests that if emerging economies generate a large share of global emissions, they will also contain a large share of cost- effective mitigation opportunities. On top of this first- pass reasoning, compared to developed countries, developing countries also tend to be less energy efficient and face many more first- time (versus retrofit) energy investments, two features that make low- carbon alternatives even cheaper. It should therefore not come as a surprise that the EMF- 22 study found the delayed participation of emerging economies raised the global cost of the (achievable) 550 ppm target by 50 to 100 percent (Clarke et al. 2009). The common sense conclusion that economic efficiency requires global participation enjoys universal support from the climate change modeling community (e.g., Nordhaus 2007a).

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Economic Logic versus Political Reality: The Conception and Failure of Kyoto

This economic logic of reducing costs was, in fact, an important backdrop for the design and implementation of the Kyoto Protocol before it began to fall victim to very deep political rifts. By the mid- 1990s, it was clear that the UNFCCC’s aforementioned goal of returning developed country emissions to their 1990 levels was not being met and even moderate concentration targets required yet larger reductions. Our noted economic logic demanded that any global effort address emission reductions in developing countries, but the world continued to be (legally) anchored in a model with obligations focused entirely on developed countries. The solution envisioned in Kyoto was a system of legally binding reduction targets for developed countries, coupled with the flexibility both (1) to buy and sell emission commitments among those developed countries and (2) to generate offsets in developing countries. While these flexibility measures represented a hard fought victory for economists, the dichotomous developed/developing country architecture ultimately has proven unable to adapt to the dramatic shift in emissions growth to emerging economies. The US delegation in Kyoto led the fight for economic flexibility within the Kyoto framework. The Kyoto targets involved multiple greenhouse gases and emissions from land- use changes, and allowed for trade- offs within this basket of targets. International emissions trading was made a central feature of the protocol, over the initial reservations of the Europeans.16 While only Annex 1 countries were required to reduce emissions, they were allowed to obtain credit against their targets through the funding of emissions reductions in developing countries (as well as through trading with each other). This allowed a separation between the discussion of who would pay for emission reductions and where the reductions would occur—which, from a cost- effectiveness point of view, should be where they are cheapest. Given the importance of US participation (as the world’s then- largest emitter), the other delegations eventually endorsed these flexibility mechanisms. The United States (under both the Clinton and Bush administrations) never sought to ratify the Kyoto Protocol. The sharp distinction between the United States’ “legally binding emission limit” and no limit for China failed to meet the Byrd-Hagel resolution standard for meaningful participation by all countries. Equally important, the targets themselves were viewed by 16. The US team was a strong advocate of a global cap- and- trade style approach to regulating GHG emissions for another reason. The federal government has employed this tool with great success to combat acid rain in the Northeastern United States. Sulfur dioxide emissions had declined more rapidly and at lower economic cost than either industry or environmentalists had anticipated. Interestingly, cap- and- trade was viewed in environmental circles at the time as a “conservative” idea, implemented under George H. W. Bush’s administration and championed by Pennsylvania’s Republican Senator, Jack Heinz.

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many as too costly for the United States. Prominent climate change economists, including Nordhaus, publicly criticized the Kyoto Protocol on the grounds that it imposed unreasonably high (and therefore politically unacceptable) costs of compliance on the United States (Nordhaus and Boyer 1998). The focus on fixed historic emission levels as the benchmark for progress was also a relative disadvantage for the United States (as well as Canada and Australia), who faced, and continue to face, population growth of around 1 percent, versus the European Union and Japan, who do not. Population growth generally involves a proportional increase in emissions, other things equal.17 In addition, 1990 was a particularly advantageous year for Europe because of the subsequent shift from coal to natural gas use in the United Kingdom and, following the reunification of East and West Germany, the collapse and more efficient reconstruction of a highly inefficient East German economy.18 Underlying this issue of the US target is a much deeper schism over the appropriate basis for dividing up any global emission limit.19 As noted, historic baselines favor already- developed countries with low (or negative) population growth. Developing countries often put forward models instead based on per capita emissions or historic cumulative emissions, which are even more difficult for countries like the United States.20 Meanwhile, the United States has emphasized comparability based on cost or effort (Stern 2009b). These conceptual differences give an analytical rationale for the basic point that key countries have wildly different views about what they should be doing relative to other countries. This makes mutual agreement on targets virtually impossible (in fact, one might instead ask, what unusual alignment of the stars led to the Kyoto agreement on targets in the first place?).21 Finally, the notion of “countries having views” is itself an extremely tricky 17. This notion that national emissions are the product of population, income per capita, and emissions per unit of GDP, was developed early in the analysis of climate change economics and is referred to as the “Kaya” or “IPAT” identity (Kaya and Yokobori 1997; Waggoner and Ausubel 2002). 18. The United Kingdom’s 1990 emissions level reflected heavy use of coal that was phased out during the 1990s as the United Kingdom took increasing advantage of North Sea natural gas to replace coal. This transition largely accounts for the United Kingdom’s success in meeting its target. Likewise, Germany benefitted from the fact that its 1990 emissions level includes the emissions of the Eastern Lander. Reunification coincided with a deep and persistent industrial collapse that left emissions in the states of the former East Germany well below 1990 levels even in the late 2000s. This largely accounts for German success at meeting its Kyoto targets. 19. A number of authors and stakeholders have also raised the more fundamental issue of whether we should be counting emissions based on where goods are produced or where they are consumed (e.g., Peters and Hertwich 2008). A consumption approach has some theoretical appeal, but is much more complex and has achieved little traction. 20. See, for example, den Elzen et al. (2009), Houser (2010), and Dellink and Corfee-Morlot (2010), who compare the Copenhagen commitments across various metrics. 21. Internal documents show that US administration views concerning the Kyoto Protocol varied significantly in the months leading up to Kyoto, with economic interests arguing for a much looser target (Sperling, McGinty, and Tarullo 1997). Interestingly, the US delegation ultimately agreed to a target more stringent than anything in the internal documents.

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issue for a country like the United States, with polarized national politics and fickle popular views.22 Even if the particulars of the United States’ Kyoto target could have been fixed—and there was a window of opportunity for the Bush administration to do so (BBC 2001)—the sharp distinction between developed and developing country commitments could not be. At first, this was not as problematic for other, non-US members of Annex I. President George W. Bush formally withdrew the United States from the protocol in 2001 and ceased participating in relevant meetings, but all other Kyoto member states remained in and ratified the protocol. Outside of the European Union, those countries did little to enact national policies that would effectively ensure compliance (New Zealand adopted a cap- and- trade program in 2010; Australia passed an emission pricing program in late 2011—by just two votes in its lower house and four in the upper house). Nonetheless, thanks largely to the US withdrawal, the Annex I countries are as a group likely to meet their Kyoto targets. Without the United States, the generous targets afforded the formerly socialist “economies- in-transition” (EITs) offset the roughly 10 percent shortfall among non-EIT members of Annex I. As negotiations on a second commitment period for Kyoto have intensified, however, other Annex I countries have called it quits. Japan and Russia announced in December 2010 that they would not participate in a second commitment period, while Canada made the same statement in June. All cite the need for a new agreement to include the world’s largest emitters—China and the United States. Meanwhile, the Kyoto model will not change: China and other major developing countries refuse to step up to the kinds of legally binding commitments contained in Kyoto. Why won’t emerging economies agree to Kyoto- style commitments? The developing countries—especially the big ones that really matter, including China and India—harbor grave reservations about signing up for significant limits on absolute emissions.23 These countries understand that industrialization and economic growth will raise their emissions per capita. In fact, they see the current gap between their own emissions per capita and those of the industrialized West as a strong reason for them to refuse to make any concessions whatsoever. These developing country reservations crop up both quantitatively and qualitatively in the written mitigation pledges submitted by all major economies in January 2010 following the Copenhagen meetings. Numerical analyses of these pledges suggest that the emission pledges by China and India are relatively modest when viewed against a US metric of cost or effort 22. Often issues in the United States and abroad can be traced to regional as much as partisan differences, with fossil- rich regions opposing mitigation action and renewable- rich regions supporting such action. 23. A recent article noted recent statements about regional emissions trading in China, but also voiced skepticism (Reklev and Garside 2011).

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(Dellink and Corfee-Morlot 2010; Houser 2010).24 Modeling suggests they could meet their target for less than $1 per ton compared to costs closer to $10–$30 per ton for developed country targets in the EU and United States. Under their submissions, Chinese and Indian emissions are also increasing around 70 percent over 2005 levels. Unlike China and India, who expressed their emissions target in relation to GDP (so emissions would be higher with higher GDP), all other developing countries made reductions pledges— some quite large—but against an unspecified baseline (an interesting exception is Brazil, who codified its baseline and reduction commitment into a domestic law; Hochstetler and Viola 2011). Adding up all of the pledges, the analyses suggest a path toward at least 3 degrees of warming (Pew 2010).25 While the quantitative issues are important, equally if not more important are the qualitative differences reflecting the persistent view among developing countries that developed countries should agree to an internationally binding, economy- wide emission limit on total emissions, while developing countries should make nonbinding pledges.26 Regardless of what developing countries may pledge to do, it is hard to sell the idea that binding commitments are somehow valuable in developed countries when the largest and fastest growing emitter is not part of the system. While this political reality started in the United States, it has clearly spread. It is possible to look at this political reality as the consequence of a greater economic reality. There is no shortage of economic models to drive home the difficulty of negotiating a mutually agreeable means of moving forward when large emitters have a limited interest in mitigation and the global system lacks legal mechanisms to compel participation in emissions reductions by reluctant nations. An extensive game theoretic literature illustrates these problems. Carraro and Siniscalco (1993) and Barrett (1993) show that the presence of asymmetries across countries and the incentive to free ride make the existence of global self- enforcing agreements quite unlikely. When self- enforcing international agreements exist, they are signed by a limited number of countries (Barrett 1994; Hoel 1992, 1994). A grand coalition, in which all countries sign the same agreement, is unlikely to be an equilibrium (Finus and Rundshagen 2003). The difficulties the international community has encountered in practice bear out these theoretical predictions, as can be seen in the history of the Kyoto Protocol. Of course, these same models would never predict why countries like 24. For actual submissions, see http://unfccc.int/meetings/cop_15/copenhagen_accord/items /5265.php. 25. A recent UNEP report suggests as much, but focuses on how pledges could be strengthened to achieve 2 degrees celsius. Even in their most ambitious interpretation of the pledges, they only get to roughly 2.5 degrees celsius (United Nations Environmental Program 2011). 26. See, for example, the February 2011 statement by the “BASIC” countries—Brazil, South Africa (or “Afrique du Sud” in the BASIC acronym), India, and China—who have been particularly vocal about the developed/developing country distinction. See http://www.fmprc.gov .cn/eng/wjb/zwjg/zwbd/t802845.htm.

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the European Union would pursue a unilateral mitigation at exactly the moment the United States announces it is walking away from any commitment. Or why Brazil would unilaterally pass a law to reduce greenhouse gas emissions. This leaves open the question of what economic interest drives national commitments and action—a point highlighted by Kolstad (2011) and Ostrum (2009). Moreover, it points to a way forward internationally: if negotiating mutually and internationally agreed-upon commitments is not possible, both because key developing countries cannot ratchet up their form of commitment to match the Kyoto Protocol and because the range of views on appropriate quantitative targets cannot be bridged, then move to a system of national pledges for all countries. This is the essence of the Copenhagen Accord and Cancun Agreement. Importantly, the history of the protocol has highlighted the limited mechanisms states have under international law to punish states that fail to live up to the full letter and spirit of the agreement. The penalty for a noncompliant state under Kyoto would be a 30 percent reduction in some (unspecified) reduction target that would be negotiated in an (unspecified) successor agreement. But, of course, any state that found itself in a position in which that 30 percent reduction was onerous could simply withdraw in the next round.27 Legally binding targets and timetables often make sense in the context of domestic laws and policies internal to the states that are part of the Western “zone of law.”28 Every day in these countries, reluctant firms, agencies, and consumers are forced to meet the provisions of laws passed over their objections but with which they must comply. However, the international legal environment is a completely different story—in that context, the apparent strengths of the legally binding targets are compromised by the legal weakness of the international system. Countries tend to be very protective of their sovereignty and wary of introducing any precedent that ultimately may play out against them.29 This again suggests a focus on a system of national pledges. 6.4

The Cancun Agreement

At Cancun, all major emitters (including China) made (nonbinding) mitigation pledges in what was effectively a legitimized version of the outcome 27. In the absence of a successor agreement to the Kyoto Protocol that also features binding targets and timetables, member states like Canada, which ratified the protocol but did absolutely nothing to address their noncompliance, have been able to evade any sanction whatsoever. 28. Victor (2004) refers to the Western industrial democracies as residing within a “zone of law” that provides a basis for the trust that must be present before any high level of asset exchange can take place. 29. See, for example, China and Russia’s recent opposition to resolutions against Syria in the UN Security Council (CNN Wire Staff 2011), or the US delegation’s quick reaction to an effort to redefine “consensus” during the UNFCCC meeting in Cancun (where the United States might suffer in other venues if it could not block consensus).

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in Copenhagen.30 In the language of the Cancun decisions, all parties agreed to “take note” of both the “quantified economy- wide emission reduction targets” submitted by developed countries and the “nationally appropriate mitigation actions” submitted by developing countries. All of the developing country submissions contain aggregate quantifications (though relative to GDP or a future baseline, as noted before). And the section heading for developed countries reads “mitigation commitments or actions” while the (separate) developing country heading reads “mitigation actions” only. Thus, all parties were able to interpret the decisions as they saw fit: developing countries could emphasize the differences between developed and developing country commitments, and developed countries could emphasize the similarities. In addition, the negotiations over a second commitment period for the Kyoto Protocol continue despite the absence of the United States, Japan, Russia, and (as of June 2011) Canada. Concrete mitigation pledges by China in an international venue, alongside pledges by other major emitters, represent a significant turn of events since the time of the Kyoto Protocol. In his first public address as the US Special Envoy on Climate Change, Todd Stern emphasized that an international agreement on climate change needed to reflect ambitious national actions by all major economies—an outcome that was far from certain at that time (Stern 2009a). An equally significant and important advance is that all the major emitters have accepted (in principle) provisions for measuring progress toward those mitigation commitments in an internationally transparent and objective way. This was a domain in which the large developing country emitters had been particularly wary.31 In return for these concessions from the major developing country emitters, the developed countries agreed to provisions providing for financial support for developing country mitigation and, especially, adaptation. The developed economies first committed to providing resources approaching $30 billion over the 2010– 2012 period, a substantial short- run commitment offered up in return for the concessions on mitigation commitments and transparent monitoring. In the longer run, the developed countries committed to mobilizing $100 billion per year by 2020 to address the needs of developing countries. However, this latter sum explicitly includes both private and public funding, and the latter explicitly includes both bilateral aid and multilateral development assistance. The Cancun Accord also establishes a committee to improve coherence and coordination of climate finance delivery. 30. In Copenhagen, it proved impossible to achieve more than a general acknowledgment of the existence of the Copenhagen Accord due to severe acrimony over the process leading to the Accord. However, most of the Copenhagen Accord language exists almost verbatim in the Cancun Agreement. 31. Corn and Sheppard (2010) describe the last minute wrangling over this issue in Copenhagen.

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Can the developed countries really mobilize $100 billion per year? In March 2010, the UN Secretary General appointed a high- level advisory group to look at possible sources of finance to achieve this goal. One of us was heavily involved in the work of this group and helped produce the November 2010 report that concluded the goal was “challenging but feasible” (UN SyG 2010). The report argues that the key to effective realization of this goal is the establishment of active carbon markets in the developed world that effectively impose a price on emissions in the neighborhood of $20–$25 per ton of carbon dioxide (CO2). These markets would generate private sector demand for developing country trading or offsets that could supply a large portion of this total on an annual flow basis. More specifically, to the extent that the carbon markets in the industrial West could allow the purchase of permits or offsets in developing countries, this could generate annual flows on the order of $30–$50 billion. And the carbon markets would likely stimulate hundreds of billions of dollars in related capital investments in developing countries over time. Successfully mobilizing the private sector leaves a much smaller role for public sector aid and allows it to focus on those areas where the private sector may fail—including adaptation for the poorest. The report also suggested that domestic carbon markets in developed countries, with a price of $20–$25 per ton, could generate substantial permit auction revenues. Earmarking just 10 percent of these revenues to international climate action could, in principle, generate annual flows on the order of $30 billion. In a related way, pricing emissions from the international transportation industry (maritime and aviation) through domestically implemented but internationally harmonized mechanisms could create revenue with fewer domestic claims and possibly a larger share dedicated to international climate finance purposes, on the order of $10 billion per year. This industry generally requires some form of international harmonization to avoid the rerouting of shipments through unregulated ports in any case. It would also avoid the kind of conflict currently erupting over the EU’s effort to regulate emissions on both inbound and outbound international flights (e.g., Shannon 2011). However, the report notes, all of this hinges on national- level implementation and decision making; the report was particularly negative on any kind of internationally imposed scheme. In a very crude sense, the deal in Cancun can be viewed as a trade where developing countries received pledges of financial support from the developed countries and the developed countries received mitigation pledges and commitments to transparency from the developing countries. But it is considerably more complex than that because the important countries making mitigation pledges—the emerging economies—are not the ones lining up for financial support—the poorest countries and Africa in particular. And it was only through some creative ambiguity, allowing developed and developing countries to interpret the outcome differently, that an agreement was

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reached. This makes elaboration of some elements of the Cancun agreement elusive. For example, the UN climate finance report specifically highlighted divergent views about the relative roles of public and private finance within the $100 billion pledge. Efforts to formalize the review of pledges have also become bogged down.32 And meanwhile, questions surrounding the future of the Kyoto Protocol, minus the United States, Japan, Russia, and Canada, lurk in the background and continue to confound the negotiations. While the serious engagement of emerging economies was a historic development in Cancun, it is hard to see how the UNFCCC moves much beyond a struggle to implement the Cancun agreement in the foreseeable future. This observation is based on the noted challenges and the fact that two years of negotiations and attendance by more than 100 heads of state in Copenhagen failed to deliver more. 6.5

Beyond Cancun

In the much longer run, if emission targets that significantly mitigate climate change are to be enacted, even Kyoto critics like Victor concede that they will most likely result from a strong, broad- based agreement with legally binding targets.33 In the short run, though, the UNFCCC has demonstrated its inadequacy as a framework within which such an agreement could be built. This has given rise to an alternative view about how to proceed. Rather than pursue a “broad and shallow” strategy (the current UNFCCC approach) that seeks to engage the maximal number of states by only requiring commitments that they are all willing to accept, Victor and others instead advocate a “narrow and deep, then broad” strategy that first brings together the subset of states that are willing to engage in meaningful policy experimentation. For advocates of this strategy, there are interesting historical parallels, some of which are the focus of other chapters at this conference. One is the WTO itself. When it first began, as the GATT, it was narrow in focus and in membership. The original agreement’s purview was restricted to trade in physical goods and focused almost solely on a gradual multilateral reduction in tariff rates. The initial membership excluded the Soviet bloc, and as decolonization proceeded in the 1950s and 1960s, many of the newly created states did not rush to join. Over the span of several decades, however, the GATT morphed into the WTO—an international organization with a much 32. Widely divergent views can be seen in the negotiation summary released in June 2011: http:// unfccc.int/ files/ meetings/ ad_hoc_working_groups/ lca/ application/ pdf/ summary_on _ica_17_june_version_0900.pdf. 33. As Cooper (2010) and Nordhaus (2007a) have argued, these international targets can take the form of commitments to specific carbon prices (enforced through taxes) rather than levels of emission reduction. Cooper (2010) points out several theoretical and practical reasons why a price target may be more easily implementable by the international system.

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broader purview (that extended to trade in services, intellectual property, and multinational investment), a near- universal membership, and much more powerful means of adjudicating disputes and punishing offending member states than had ever existed under the GATT. In fact, for Victor, the only current international body that possibly has the clout to enact and enforce a meaningful international agreement to limit climate change is the WTO. In some ways, an even more intriguing parallel is the growth of the EU. What is now the EU originally started as the European Coal and Steel Community, an effort by six European states to coordinate policy and reconstruction in these two sectors. Over time, the depth of cooperation and the extent of policy coordination broadened. Eventually, of course, the European Union became something so important that the states of the postCommunist East and even Turkey were willing to make quite substantial changes and amendments to their own national laws and engage in costly concessions in order to qualify for membership. In similar fashion, a near- term future could emerge in which a handful of states are willing to undertake serious policy experiments to combat global warming. Rather than constrain the progress of this group by forcing it to meet the objections of the least committed states, or trying to negotiate an agreement before each nation resolves its internal political debates, it is far better to permit this group (and other groups) to move forward, engage in policy experimentation that other states could learn from, and turn the zone of law, or at least part of it, into a “zone of experimentation” in climate mitigation policy. As the successes (and failures) of policies within the zones of experimentation become manifest, and the case for action becomes more compelling, others may opt for accession into the zone. At some point, the countries inside the zone become an important enough collective that other countries perceive (or in fact face, through border measures discussed later) a penalty for remaining outside. At this point, the collective experience within the zone and pressure outside the zone is enough to anchor a Kyoto- style agreement. As a prerequisite to even this narrow- and- deep approach, countries will essentially take initial steps unilaterally, as the EU Emissions Trading Scheme (ETS) has done. While exercises like the GATT and the EU itself offered significant and immediate economic benefits (overall gains to trade) for each country to be weighed against the costs (those domestic industries hurt by freer trade), climate cooperation offers only near- term costs and long- term potential benefits. For this reason, it may be hard to negotiate something narrowly that leaders return home to implement within any kind of agreed window. Instead, it may be necessary for key countries to pursue mitigation on their own terms and then seek to weave together cooperation afterwards or as a second step. Ultimately, the weaving together of a global approach is necessary to achieve even modest environmental goals. The simple mathematics of emerg-

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ing country growth means all major economies must eventually participate to achieve any concentration target. There are a variety of arguments for why cooperation could become easier over time: (1) climate change impacts will become more compelling to laggards; (2) higher incomes will engender greater environmental concern; (3) innovation may yield better, cheaper solutions; (4) policy experience will give participants and nonparticipants more confidence in the policies themselves and in each other’s capacity to enact and enforce them; (5) the desire—political as well as economic—to be on the giving rather than receiving end of border measures discussed later. However, we need not agree on why this may happen to recognize that is the logical way forward. Victor coins an evocative phrase, “variable geometries of participation,” to indicate the need for flexibility, multiple approaches, and the need to let the theoretically optimal not get in the way of the practically beneficial. Coupled with Ostrom’s idea for a polycentric approach, with actions at multiple levels of government, we can imagine a variety of alternatives to a globally unified approach in the short- to-medium run that ultimately coalesce to a global approach. Here, we can draw a connection to the important point made by Irwin and O’Rourke in their contribution to this volume regarding the value of flexibility and adaptability in the face of external shocks—in their case, related to exchange- rate regimes (see chapter 1). As those authors point out, the insufficient flexibility of the classical gold standard was a major reason the pre–World War II liberal trading system was unable to survive the onset of the Great Depression. In striking contrast, the Great Recession of 2008 did not lead to a substantial reversion to protectionism, and the authors cite the substantially greater flexibility achievable under the current system of floating exchange rates as a key factor in that outcome. In a loosely similar fashion, the Kyoto Protocol’s sharp distinction between developed and developing country obligations, and the inability for those obligations to evolve in light of developing countries’ increasing economic and emission footprint, have proven to be a major barrier to meaningful carbon emissions reductions. A more flexible approach is likely to be necessary, and the main questions are exactly what form such an alternative approach might take and how much more successful it could be in the long run.34 6.6

The Unsettling World of Border Measures

Moving forward, those states and groups of states taking increasingly ambitious steps to mitigate climate change—whoever they are—will have 34. This view was largely born out in the Durban platform negotiated in December 2011, after this paper was written. A key element is the repeated emphasis on “applicability to all parties” and the absence of references to “equity” or “common- but- differentiated responsibilities,” the usual markers for developed/developing country distinction in the climate regime (Rajamani 2012).

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to deal with slower moving states and the economic and environmental leakage issues generated by their slower movement. The asymmetries of economic size among countries are such that the actions (or inactions) of a large number of developing countries are effectively ignorable. In the grand scheme of things, emissions from Mali or Honduras are and will be simply too small to matter. The real question for the industrial West is what to do about states like China that are large emitters and extremely important participants in the international trading and financial system. Or, what Europe will do about a lagging United States. The unsettling answer we will suggest to this question is that those in the zone of climate policy experimentation may be driven to use tariffs or other measures that tax the carbon content of tradable goods produced in reluctant countries. The literature has referred to these instruments as carbon tariffs or, more generally (and euphemistically), as “border measures,” and we will use both terms in what follows. The good news is that near- term differentials across trading states in terms of the stringency of their carbon control regimes is unlikely to warrant the use of these instruments. The bad news is that, the farther some countries get ahead of others, the more pressure will build to utilize these instruments. We will deal in this section with three questions: (1) Are carbon tariffs WTO- legal? (2) Can those in the zone of climate policy experimentation implement carbon control measures without employing carbon tariffs? (3) Could carbon tariffs be implemented in practice? 6.6.1

Are Carbon Tariffs WTO-Legal?

The WTO- legality of carbon tariffs is an open question among legal scholars. Advocates see in the so-called “shrimp turtle” case a WTO affirmation of principles that could support carbon tariffs, and we offer here a brief review of that case. In the mid- 1990s, environmental groups sued the US federal government over inadequate enforcement of a US law, Public Law (P.L. 101-162, Section 609; now 16 U.S.C. 1537), that was designed to protect sea turtles from shrimp trawlers. The nets of US fleets were equipped with so-called turtle exclusion devices (TEDs) that allowed sea turtles caught in nets to escape through a trap door mechanism. By the mid- 1990s, however, the United States was importing large quantities of shrimp from South and Southeast Asian nations that did not require the use of these devices. The United States imposed an import ban on these nations pending adoption of TEDs. India, Malaysia, Thailand, and several other countries launched a formal dispute against the United States, basing part of their legal argument on a long- standing principle in international trade law that prevents importing nations from discriminating against otherwise identical products on the basis of differences in the processes of production. In its final ruling, the WTO ruled against the United States for technical reasons, but the rul-

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ing explicitly upheld the right of the United States, in principle, to apply discriminating trade measures against the shrimp exporters without TED requirements because sea turtles were an exhaustible natural resource as covered by Article 20 of the GATT. This was true even if the sea turtles in Asia never migrated to US waters. Environmental advocates have seized on this ruling as creating a precedent for carbon tariffs. The atmosphere, they argue, is surely even more of an exhaustible natural resource than are migratory sea turtles. In fact, the extent of the precedent created by the shrimp turtle case is unclear. Chinese trade representatives have flatly declared carbon tariffs illegal under WTO rules and have vowed to launch an immediate case against any nation that enacts legislation requiring the imposition of carbon tariffs. The final legal status of this idea will likely be determined when the first attempt is made to implement it by a WTO member state. Other environmental advocates point to the way the international system has dealt with value- added taxes. China, for instance, obtains the largest portion of government revenue through a value- added tax (VAT) of 17 percent. When foreign goods are imported into China, the customs authority imposes this tax on the imports, in addition to import duties. If the VAT taxes were not imposed, the foreign goods would hold a commanding advantage in the marketplace over the domestically produced goods subject to the VAT. Since the tax is imposed on all goods, regardless of national origin, the tax meets the “national treatment” test. Exporters are entitled to value- added tax rebates to avoid penalizing them in global competition with producers based in other countries without such taxes. In the eyes of some environmental advocates, carbon tariffs would function like a VAT and need pose no more of a threat to free trade than does China’s practice with respect to levying its VAT on imported tradable goods. 6.6.2

Are Carbon Tariffs Necessary? Part 1—The Problem in Theory

The theoretical construct of costless international trade in a homogeneous commodity between two economies illustrates the potential gains from carbon tariffs from the standpoint of nations seeking to reduce emissions. Imagine the home country constructs a carbon regulation regime— for simplicity, consider a carbon tax—to contend with environmental externalities, but the foreign country does not. Imagine the home economy is large enough relative to the global economy that its policies can affect global prices. Consider a carbon- intensive good. The carbon tax would tilt the home country supply curve up, but would not affect foreigners’ export supply curve. Under these conditions, the primary impact of the carbon tax would be to shift home demand from (more expensive) domestic producers to (cheaper) foreign producers. The global price of the carbon- intensive good would rise, but only a little. Foreign supply would expand to meet home demand, and the ability of the domestic carbon tax to reduce emis-

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sions associated with the carbon- intensive good would be largely undermined by international trade. In this context, a carbon tariff that applies to imports of the carbonintensive good the same implicit price on emissions created by the home country’s carbon tax would equalize the playing field for domestic producers, lead to a more substantial rise in the home market price of the carbonintensive good, and a more substantial decline in emissions. The environmental externality would be better addressed. Home producers shrink less under this policy than under a policy of a unilateral carbon tax, and the home economy exploits its international market power to extract surplus from foreign producers. On the other hand, the carbon tariff would cause the foreign price of the carbon- intensive good to decline, as imports are pushed out of the home market. This would lead to a decline in foreign production but an increase in foreign consumption. In simple cases, it is possible that the combination of a carbon tax and a carbon tariff on imports could bring domestic production and consumption of the carbon- intensive good in the home country to the same level that would obtain in a world of uniform global carbon taxes. It is obviously not possible for the combination of domestic carbon taxes and carbon tariffs to bring about the same outcome in the foreign country. Moving away from our stylized example, in the real world quality and technology differences between domestic and foreign products could blunt the impact of (initially) small differences in production cost. On the other hand, to the extent that the foreign economy is open to foreign direct investment, over time the advent of carbon regulation in only the home economy would confer upon home producers of carbon- intensive goods a powerful incentive to transfer their technologies, brand names, and quality- control methods to subsidiaries based in the foreign economy. Also over time, a general equilibrium setting blunts some of the negative impact of a shrinkage of domestic production in the home economy—these resources would find employment elsewhere in the home economy, leading to an expansion of the non- carbon- intensive sectors. While this might mitigate long- term concerns about economic leakage, even a general equilibrium setting does not mitigate the problem of emission leakage, with carbon intensive activity moving from the regulated jurisdiction to the unregulated jurisdiction. 6.6.3

Are Carbon Tariffs Necessary? Part 2— The Problem in Practice in the Short Run

To what extent are these concerns likely to arise in the context of advanced Western (post)industrial economies? Precisely because the US government has long harbored concerns about the impact of adopting carbon regulation on US competitiveness when developing countries were not also similarly constrained, there is a body of research—some of it undertaken by the US government at the behest of nervous legislators—to which we can turn. The

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following paragraphs draw heavily from work by one of the authors (Aldy and Pizer 2011) and from a US government interagency report on the competitiveness effects of the Waxman-Markey bill (H.R. 2454, formally known as the American Clean Energy and Security Act of 2009) in which one of the authors was directly involved (Interagency Competitiveness Analysis Team [2009]; hereafter Interagency Report). For those trade economists eager to avoid conflict between their free trade ideals and their environmental conscience, this work offers some good news. The primary impact of carbon regulation is to raise the price of fossil energy in the economy. The impact of such regulations on US industrial competitiveness is bounded by the fact that on average, energy expenditures account for less than 2 percent of the value of US manufacturing output. This means the vast majority of US industry would be largely unaffected by carbon regulation in the short run: even advocates of such policies suggest that carbon prices would remain relatively modest ($10–$25 per ton CO2-e) in the near- term future, and would imply modest increases in fossil energy prices that would have very limited impact on the overall cost structures of US manufacturers. The second factor limiting impact is that some energy- intensive activities are not subject to much international competition. H.R. 2454 contained provisions for measures to mitigate the impact of the bill on US industrial competitiveness. “Presumptive eligibility” for these provisions was based on an industry’s energy intensity, greenhouse gas intensity, and trade intensity. The Interagency Report concluded that only 44 of about 500 manufacturing industries would be presumptively eligible for relief, as shown in figure 6.4. Together, these energy- intensive and trade- exposed industries collectively account for only 12 percent of total manufacturing output and 6 percent of manufacturing employment—and only half a percent of total US nonfarm employment. On the other hand, these industries account for almost half of manufacturing greenhouse gas emissions.35 It is exactly this concentration of GHG emissions in a relatively small number of industries that allows a cap- and- trade approach to carbon regulation, such as that put forward in H.R. 2454, to compensate vulnerable industries without necessarily invoking carbon tariffs or blunting the overall impact of the regulatory regime on the gradual decarbonization of the US economy. Having recognized that only a small number of industries are potentially impacted, the question of the impact on those industries remains. There is an extensive economic literature on the “pollution haven” hypothesis that evaluates the impact of environmental regulation on the shift of polluting activity to less regulated environments. Important recent papers included Jaffe et al. (1995); Levinson and Taylor (2008); Antweiler, Copeland, and Taylor (2001); Ederington, Levinson, and Minier (2005); and Jeppesen, List, 35. See the Interagency Report, pp. 1– 2.

KEY: 1. Malt Manufacturing (311213) 2. Wet Corn Milling (311221) 3. Rendering and Meat By-product Processing (311613) 4. Yarn Spinning Mills (313111) 5. Tire Cord and Tire Fabric Mills (314992) 6. Reconstituted Wood Product Manufacturing (321219) 7. Pulp Mills (322110) 8. Paper (except Newsprint) Mills (322121) 9. Newsprint Mills (322122) 10. Paperboard Mills (322130) 11. Petrochemical Manufacturing (325110) 12. Inorganic Dye and Pigment Manufacturing (325131) 13. Alkalies and Chlorine Manufacturing (325181) 14. Carbon Black Manufacturing (325182) 15. All Other Basic Inorganic Chemical Mfg. (325188) 16. Cyclic Crude and Intermediate Manufacturing (325192) 17. All Other Basic Organic Chemical Mfg. (325199)

18. Plastics Material and Resin Manufacturing (325211) 19. Synthetic Rubber Manufacturing (325212) 20. Cellulosic Organic Fiber Manufacturing (325221) 21. Noncellulosic Organic Fiber Manufacturing (325222) 22. Nitrogenous Fertilizer Manufacturing (325311) 23. Vitr. China Plumbing Fixture and Other Mfg. (327111) 24. Vitreous China and Other Pottery Mfg. (327112) 25. Porcelain Electrical Supply Manufacturing (327113) 26. Ceramic Wall and Floor Tile Manufacturing (327122) 27. Other Structural Clay Product Manufacturing (327123) 28. Nonclay Refractory Manufacturing (327125) 29. Flat Glass Manufacturing (327211) 30. Other Pressed/Blown Glass and Glsswr. Mfg. (327212) 31. Glass Container Manufacturing (327213)

32. Cement Manufacturing (327310) 33. Lime Manufacturing (327410) 34. Ground or Treated Mineral and Earth Mfg. (327992) 35. Mineral Wool Manufacturing (327993) 36. Iron and Steel Mills (331111) 37. Electrometallurgical Ferroalloy Product Mfg. (331112) 38. Iron/Steel Pipe/Tube Mfg. from Purchsd. Steel (331210) 39. Alumina Refining (331311) 40. Primary Aluminum Production (331312) 41. Primary Smelting and Refining of Copper (331411) 42. Smltg./Rfg. of Nonfrs. Mtl. (ex. Cpr. and Almn.) (331419) 43. Iron Foundries (331511) 44. Carbon and Graphite Product Manufacturing (335991) 45. Iron Ore Mining (212210) 46. Copper Ore and Nickel Ore Mining (212234)

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and Folmer (2002). The general findings in this literature suggest that the ability of industry to profitably relocate to less regulated jurisdictions is significantly constrained by factors that limit the “footloose- ness” of polluting industry, and most studies find the negative impact of domestic environmental regulation on domestic production to be quite limited. The aforementioned studies focus on generic environmental regulation, taking advantage of historic variation in regulatory stringency to understand its effect. It is not possible to take the same approach for carbon regulation because such regulation has only recently been implemented (and only in Europe). The popular alternative has been use detailed, applied general equilibrium models to simulate effects (IPCC 2001). Early analyses found emission leakage ranging from zero to 70 percent, but later analyses found a narrower range of 5 to 20 percent. That is, the ratio of emission increases outside those countries pursuing emission reductions (in these studies, typically Kyoto’s Annex I) to the reductions achieved inside those countries, is some 5 to 20 percent. As an alternative to these studies using assumed parameter values and large simulation models to estimate leakage effects, Aldy and Pizer (2011) take an econometric approach using historic energy price variation to proxy for the effects of GHG pricing. They first define the competitiveness effect as the adverse effect (in terms of the percent decline in production) on domestic industry arising from the absence of foreign regulation when the United States regulates GHGs—a more economic and less environmental measure than the leakage rate just described. They then run regressions of the form Yit = i + t + f (rUS,it ;) + ′ X it + εit where Yit represents an industry and year- specific outcome measure—the natural logarithm of domestic supply and demand measures; the α’s are

Fig. 6.4 ( facing) The bulk of carbon dioxide emissions come from a small number of industries that have high energy and/or trade intensity; these are “presumptively eligible” for free allowances under H.R. 2454 Notes: Petroleum refining is not depicted because it is explicitly excluded from H.R. 2454’s allocations to “trade-vulnerable” industries. Also, 91 other sectors, with 130 MMTCO2e of emissions, are not depicted due to lack of trade-intensity data. One of these, iron and steel pipe and tube manufacturing from purchased steel (331210; 2.6 MMTCO2e) is expected to be eligible based on language in the bill. Four others meet the energy-intensity threshold, each with 2 to 3 MMTCO2e of emissions: beet sugar manufacturing, broad woven fabric finishing mills, steel foundries (except investment), and metal heat treating. Twelve sectors with a calculated trade intensity greater than 100 percent are depicted here with an intensity of 100 percent (the maximum possible intensity). The two copper sectors (212234 and 331411) do not meet the energy- or trade-intensity thresholds specified in H.R. 2454 but are expected to be eligible based on other language in the bill. Energy-intensity and trade-intensity measures are as defined in H.R. 2454 and elsewhere in this report. Source: EPA analysis (Interagency Competitiveness Analysis Team 2009).

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fixed effects for industries (i ), and years (t); rUS,it represents the level of US regulation—the natural logarithm of energy (electricity) prices; Xit is a vector of additional determinants of the industry outcome measures, including average industry tariffs and factor intensity variables (to estimate the returns to human capital and physical capital). They show that the difference in the effect of energy prices on demand and supply—that is, the effect of energy prices on net imports—equals the competitiveness effect under certain assumptions. When they estimate the effect and ask what the impact would be of regulation along the lines of H.R. 2454, they find that even the most energy- intensive industries would face a competitiveness effect of about 1 percent. Ultimately, empirical and analytic work will never be fully satisfying, as it is impossible to tease out any long- term economic or emission leakage from a wide range of other confounding influences. To that end, it is important to consider ways other than border measures to mitigate real or perceived effects. The most promising work in this area has focused on the ability to substantially reduce price impacts when permits are freely allocated and done so in proportion to output (Fischer and Fox 2010). While most climate change economists would support a policy that allocates emissions permits by open auction in the long run, most climate change bills seriously entertained in the US Congress (including H.R. 2454) provide some transition path along which a significant fraction of permits are provided at no charge to emitting industries. If this free allocation is tied to current production, increases in the price of energy- intensive goods can be muted while the incentive to reduce direct emissions within the industry remains. Based on the Interagency Report, the allocation provisions in H.R. 2454 nullify price impacts in the most energy- intensive industries, as seen in figure 6.5. For international economists who understand the importance of protecting the world’s open trading system, this is good news. It suggests that the first steps toward carbon regulation could be taken by groups of advanced industrial countries without imposing on those countries serious competitiveness concerns, and a regulatory framework like a cap- and- trade system can be designed to further minimize these impacts without generating a significant need for trade intervention. Even if there is a political need to include the specter of border measures in a national mitigation policy, their actual scope and use can be constrained to be minimal if not nonexistent in practice. 6.6.4

Are Carbon Tariffs Necessary? Part 3— The Problem in Practice in the Long Run

The previous analyses are limited to the case in which Western carbon prices are held to relatively low levels. However, one can argue for high ($100s per ton CO2) or low ($10s per ton CO2) over the near term based on alternate environmental and economic concerns. The EMF- 22, noted

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Fig. 6.5 Effect of domestic cap-and-trade program on marginal production costs of energy-intensive trade-exposed industries without and with allocations to local distribution companies and output-based allocations to “trade-vulnerable” industries

earlier, found 2020 prices of between $1 and $1,000 depending on the target and modeling assumptions (Clarke et al. 2009). But all economic models find prices rising over time, either because accumulated emissions become an exhaustible resource under a concentration target (Clarke et al. 2007), or because of rising marginal damages on a larger economy (IWG 2009). Thus while both observed and contemplated near- term prices are at the low end of the spectrum, it seems certain they will rise over time. At higher price levels, the aforementioned results emphasizing the limited import of competitiveness concerns vanish and countries enacting carbon regulation will have an increasing need for carbon tariffs if major economies remain outside the system. Such tariffs will be necessary either (or both) as a stick to compel developing country compliance with Western environmental goals or as a wall to defend against an onslaught of carbon intensive imports. If we reach that point without a comprehensive political solution—or without a breakthrough technology solution—the global system will face a number of uncomfortable choices. Those pursuing carbon regulation will have to decide whether continued, ambitious actions can be effective and worthwhile absent some of the largest emitters. And, if the decision is affirmative, they

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will have to choose between an adherence to free trade principles that has brought a greater measure of prosperity to billions, and preservation of the natural environment on which all of humanity ultimately depends. 6.6.5

Could Carbon Tariffs Be Implemented in Practice?

As we wrap up our discussion of carbon tariffs, an important final question raised in some of the literature is whether a carbon tariff could even be implemented in a meaningful way. Two particular issues arise: supply chain and production technology. Carbon tariffs would presumably focus on the country of importation. However, many supply chains involve components manufactured and assembled in a multiple countries. Ascertaining where production and emissions occur, and which emissions occur in countries without appropriate emission regulations could be quite hard. In addition, if one country in a coalition of carbon- regulating countries fails to enact carbon tariffs, it would be possible for nonregulating countries to ship goods to that country for final assembly. The final product could then be imported to other carbon- regulating countries without being subject to carbon tariffs. Distinct from supply chain issues is how one could practically address the differences in production technology and energy supply. Carbon taxes and cap- and- trade systems are relatively simple policies in that they focus on the point of emissions or fossil fuel use, where emissions are easy to measure, and allow product prices to adjust based on the market. In contrast, carbon tariffs on products would have to estimate the carbon content of that product when it appears at the border, including indirect emissions from all subcomponents. A standard tariff could be applied to similar product imports from all unregulated countries, or the rates could be differentiated by country of origin or even by individual producer. Differentiation would create an incentive for foreign producers to improve their technology, but could prove to be prohibitively expensive to implement (Persson 2010). More generally, the government costs to track and apply even standard tariffs would be quite high; an entire government agency might be necessary to implement carbon tariffs, depending on how broad they were. A different concern, and one that will be all too familiar to trade economists, is that it will be impossible for any well- intentioned border measure to remain well- intentioned. Any discretion given to officials responsible for implementing border measures would be ripe for abuse. 6.7

Conclusion

This chapter has reviewed the history of international efforts to curb global warming and the rising specter of carbon tariffs. Despite more than two decades of international engagement on this issue, the international community has made only limited progress toward the goal of substantially reducing GHG emissions. We have argued that the evolution of the Kyoto

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Protocol, its problems, and the difficulty key nations have had negotiating a successor agreement that broadens and extends its binding targets and timetables points to several lessons for policymakers and social scientists. Of particular concern for economists is the degree to which the kinds of policies prescribed by straightforward application of economic theory often conflict with political reality (as well as a more nuanced game- theoretic economic analysis). Economic theory suggests that the most efficient approach to reducing emissions is a global, integrated approach that equalizes carbon prices across countries. To stabilize the volume of greenhouse gases in the atmosphere, it is necessary to bring developing countries into this system, since that is where most emissions growth will occur over the next century and where the most inexpensive mitigation options are located. Recent modeling efforts suggest that even if the developed Annex I nations reduce their emissions to zero by 2050, growth in developing country emissions will make it all but impossible to hit even modest targets for atmospheric stabilization of GHG emissions. The reluctance of key developing countries (and, at the moment, the United States) to accept binding emissions reduction targets of any kind and the inability of the international system to compel a reluctant state to accede to a global climate change agreement makes the theoretically optimal approach impractical in the short- to-medium run. Moreover, developed countries are no longer willing to go it alone. Given that, this chapter suggests that progress in the short- to-medium run is likely to take place at the national or regional level through policies that are not globally enforced. Evidence suggests that the policies envisioned over this horizon on the one hand produce modest carbon prices and limited emissions reductions (relative to a no- control baseline), but on the other hand nations or groups of nations can engage in this meaningful and useful policy experimentation without substantially harming their competitiveness. The international agreements reached at Copenhagen and in Cancun have moved away from top- down, Kyoto- style global agreements with binding targets and instead have embraced a more bottom-up, pluralistic approach along these lines. Current negotiations also establish the practical and political goal to mobilize significant financial flows—public and private—to developing countries to promote climate change mitigation and adaptation. The implementation of modest market- based carbon regulation regimes in the Western countries, along with provisions allowing developing country offsets, could generate private capital flows that would go a long way toward meeting these goals. Market- based policies in developed countries could also generate substantial domestic revenues, of which a portion might be directed toward developing country efforts. As those nations willing to engage in meaningful carbon regulation proceed down this path and other key countries lag behind, there is increasing pressure for them to use “border measures” to prevent the leakage of carbon-

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intensive emissions and economic activity out of these countries and into more lightly regulated jurisdictions. Most analyses suggest that such effects are not large enough over the near term to require such a border- measure response and that alternatives such as output- based free allocation are more effective and practical to implement. Nonetheless, political pressure could easily lead to a roadblock where domestic policies will not proceed without at least the threat of trade measures—as they did during the development of H.R. 2454—bringing the goals of trade openness and effective mitigation of climate change into conflict. Over time, with higher prices and without a comprehensive agreement or a technology breakthrough, ambitious action will almost certainly require border measures, although such action may not make a lot of sense if large sources of unregulated emissions remain unchecked, let alone given the conflicting goal of trade openness. Over time, the simple mathematics of stabilizing atmospheric concentrations of greenhouse gases means a global approach is necessary. In addition to the possible use of border measures, which would provide incentives for laggards to join in as well as help protect participants from leakage, a variety of trends may make such an approach easier in the future: increased evidence of climate change impacts, higher incomes, improved technologies, and experience with domestic regulation will all ease the transition to a global approach. Will border measures become a significant, albeit transitory, fixture in the climate policy debate? For many in the environmental community, the grumblings of economists over conflicts with free trade are virtually inconsequential compared to the broader consequences of having abandoned pursuit of global legally binding targets. However, many of those grumbling economists will disagree. As noted earlier, analyses of the targets agreed to in Cancun and Copenhagen point to 3 degrees or more of warming, which is still less than the counterfactual of no mitigation effort where expected temperature change would be in the 6 degree (or higher) range. Arguably, the incremental advances in Copenhagen and Cancun will reduce the negative economic impact of climate change, but still risk significant impacts including reduced agricultural productivity, water shortages, ecosystem loss and extinctions, increased coastal flooding, and increased health burdens (IPCC 2007). More importantly, they may simply be the necessary and unavoidable institutional steps that precede a more robust international response.

References Aldy, J. E., A. J. Krupnick, R. G. Newell, I. W. H. Parry, and W. A. Pizer. 2010. “Designing Climate Mitigation Policy.” Journal of Economic Literature 48 (4): 903– 34.

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Finus, Michael, and Bianca Rundshagen. 2003. “How the Rules of Coalition Formation Affect Stability of International Environmental Agreements.” Fondazione Eni Ennico Mattei Working Paper no. 2003.62. Fischer, Carolyn, and Alan Fox. 2010. On the Scope for Output-Based Rebating in Climate Policy: When Revenue Recycling Isn’t Enough (or Isn’t possible). Washington, DC: Resources for the Future (RFF). Hochstetler, Kathryn, and Eduardo Viola. 2011. ”Brazil and the Multiscalar Politics of Climate Change.” Paper presented at the Colorado Conference on Earth Systems Governance. Ft. Collins: Colorado State University Press. Hoel, Michael. 1992. “Emission Taxes in a Dynamic Game of CO2 Emissions.” In Conflict and Cooperation in Managing Environmental Resources, edited by R. Pethig, 39– 70. Berlin: Springer Publishing House. ———. 1994. “Efficient Climate Policy in the Presence of Free Riders.” Journal of Environmental Economics and Management 27 (3): 259– 74. Houser, Trevor. 2010. “Evaluating Copenhagen: Does the Accord Meet the Challenge?” February 4. Available from http://www.piie.com/realtime/?p=1173. Interagency Competitiveness Analysis Team. 2009. The Effects of H.R. 2454 on International Competitiveness and Emission Leakage in Energy-Intensive TradeExposed Industries. Available from http://www.epa.gov/climatechange/economics /pdfs/InteragencyReport_Competitiveness-EmissionLeakage.pdf. Interagency Working Group on Social Cost of Carbon (IWG). 2009. Technical Support Document: Social Cost of Carbon for Regulatory Impact Analysis under Executive Order 12866. Washington, DC: IWG. Intergovernmental Panel on Climate Change (IPCC). 2001. IPCC Third Assessment Report: Climate Change 2001: Working Group III: Mitigation. Geneva: IPCC. ———. 2007. Climate Change 2007: Impacts, Adaptation and Vulnerability. Contribution of Working Group II to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change, edited by M. L. Parry, O. F. Canziani, J. P. Palutikof, P. J. van der Linden, and C. E. Hanson. Cambridge: Cambridge University Press. Jaffe, Adam B., Steven R. Peterson, Paul R. Portney, and Robert N. Stavins. 1995. “Environmental Regulation and the Competitiveness of US Manufacturing: What Does the Evidence Tell Us?” Journal of Economic Literature 33:132– 68. Jeppesen, Tim, John A. List, and Henk Folmer. 2002. “Environmental Regulations and New Plant Location Decisions: Evidence from a Meta-Analysis.” Journal of Regional Science 42 (1): 19– 49. Kaya, Yo¯ichi, and Keiichi Yokobori. 1997. Environment, Energy, and Economy [electronic resource]: Strategies for Sustainability. Tokyo: United Nations University Press. Kolstad, Charles D. 2011. Bridging Reality and the Theory of International Environmental Agreements. Symposium in Honor of Tom Schelling, University of Manchester. L’Aquila Declaration of Leaders. 2009. “Declaration of the Leaders: The Major Economies Forum on Energy and Climate.” Accessed August 29, 2011. Available from http://www.g8.utoronto.ca/summit/2009laquila/2009-mef.html. Levinson, Arik, and M. Scott Taylor. 2008. “Unmasking the Pollution Haven Effect.” International Economic Review 49 (1): 223– 54. Mendelsohn, Robert O. 2006. “A Critique of the Stern Report.” Regulation 29 (4): 42. Nordhaus, William. 2007a. “The Challenge of Global Warming: Economic Models and Environmental Policy.” Accessed August 18, 2011. Available from http://nord haus.econ.yale.edu/dice_mss_072407_all.pdf. ———. 2007b. “A Review of the Stern Review on the Economics of Climate Change.” Journal of Economic Literature 45 (3): 686.

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———. 2008. A Question of Balance: Weighing the Options on Global Warming Policies. New Haven, NJ: Yale University Press. Nordhaus, William D., and Joseph G. Boyer. 1998. “Requiem for Kyoto: An Economic Analysis of the Kyoto Protocol.” Energy Journal 20 (special): 93– 130. Open Energy Info. 2011. “LEDS Program Workshop.” Available from http://en .openei.org/wiki/LEDS_Program_Workshop. Ostrom, Elinor. 2009. “A Polycentric Approach for Coping with Climate Change.” Policy Research Working Paper. Washington, DC: World Bank. Pachauri, R. K., and A. Reisinger, eds. 2007. Contribution of Working Groups I, II, and III to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change. Geneva: IPCC. Persson, Sofia. 2010. “Practical Aspects of Border Carbon Adjustment Measures.” Accessed August 19, 2011. Available from http://ictsd.org/downloads/2011/05 /persson- ictsd- practical- aspects- of-border- carbon- adjustment- measures.pdf. Peters, Glen P., and Edgar G. Hertwich. 2008. “Post-Kyoto Greenhouse Gas Inventories: Production versus Consumption.” Climatic Change (86):51– 66. Pew Center on Global Climate Change. 2010. “Adding up the Numbers: Mitigation Pledges under the Copenhagen Accord.” Accessed August 19, 2011. Available from http:// www.pewclimate.org/ copenhagen- accord/ adding-up- mitigation - pledges. Rajamani, Lavanya. 2012. “The Durban Platform for Enhanced Action and the Future of the Climate Regime.” International and Comparative Law Quarterly 61:501– 81. doi:10.107/S0020589312000065. Reklev, Stian, and Ben Garside. 2011. “CO2 Caps Not Enough to Save China CDM.” Point Carbon. August 9. Available from http://www.pointcarbon.com/news /1.1567227?date=20110809&sdtc=1. Schmalensee, Richard, Thomas Stoker, and Ruth Judson. 1998. “World Carbon Dioxide Emissions 1950– 2050.” Review of Economics and Statistics 80 (1): 15– 27. Shannon, Darren. 2011. “ALTA Joins Dissent against EU ETS.” Aviation Week. June 9. Available from http://www.aviationweek.com/aw/generic/story_channel .jsp?channel=comm&id=news/avd/2011/06/09/10.xml. Soraghan, Mike. 2010. “Obama Talks up Gas Drilling, Alternatives to Cap and Trade.” E&E News PM. November 3. Available from http://www.eenews.net /eenewspm/2010/11/03/archive/1. Sperling, Gene, Katie McGinty, and Daniel Tarullo. 1997. Climate Change Scenarios. Washington, DC: George Washington University National Security Archive. Available from http://www.gwu.edu/~nsarchiv/NSAEBB/NSAEBB303/Docu ment%208.pdf. Stern, N. H., and Treasury of Great Britain. 2007. The Economics of Climate Change: The Stern Review. Cambridge: Cambridge University Press. Stern, Todd. 2009a. Keynote remarks at the US Climate Action Symposium. Accessed August 17, 2011. Available from http://www.state.gov/g/oes/rls/remarks /2009/119983.htm. ———. 2009b. Press Roundtable with Todd Stern: Special Envoy on Climate Change. Berlin: US Embassy. Available from http://germany.usembassy.gov/events/2009 /mar- 29-stern/. United Nations. 1994. United Nations Framework Convention on Climate Change. New York: United Nations. United Nations Environmental Program. 2011. “The Emission Gap Report: Are the Copenhagen Pledges Sufficient to Limit Global Warming to 2 Degrees Celsius or 1.5 Degrees Celsius?” Accessed October 11, 2011. Available from http://www.unep .org/publications/ebooks/emissionsgapreport/. UN Secretary-General’s High-Level Advisory Group on Climate Change Financing

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Comment

Alex Bowen

Introduction This chapter by Branstetter and Pizer offers a very good and fair appraisal from a US perspective of the background to and prospects for international negotiations on reducing emissions of greenhouse gases. The chapter’s insights benefit from the authors’ firsthand experience of participating in policy formation, which has led them to extol the virtues of creative ambiguity in international negotiations. It concludes that there will be, in David Victor’s phrase, “variable geometries in participation” in future collective action to mitigate climate change. This analysis recognizes that there is room for “coalitions of the willing” and the evolution of broader- based collective action over time. It leads to a more sophisticated and nuanced conclusion than the recently popular claim that the search for global top- down agreements is likely to be replaced by bottom-up measures by citizens’ groups and nation states in isolation. As far as the ultimate prospects for halting human- induced climate change are concerned, the authors are perhaps surprisingly optimistic at a time when global greenhouse gas emissions may be rising faster than ever1 and revised long- run prospects for emerging- market economies are outweighing the Alex Bowen is principal research fellow at the Grantham Research Institute on Climate Change and the Environment of the London School of Economics and Political Science. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12589.ack. 1. The International Energy Agency estimates energy- related carbon dioxide emissions to have increased by over 5 percent from 2009 to 2010 (press release, May 30, 2011).

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depressing effect of the world’s economic slowdown.2 They write that “it is our view that the United States will eventually enact comprehensive climate legislation.” “Even Kyoto critics . . . concede that they will most likely result from a strong, broad- based agreement with legally binding targets.” “The vast majority of US industry would be largely unaffected by carbon regulation in the short run.” I want to discuss four issues that the chapter raises in my mind. First, what is one to make of the apparent conflict between simple economic logic and political reality that the authors suggest exists? Second, what will the key lines of fracture be among nations in the future as they grapple with anthropogenic climate change? Third, what are the costs and benefits of a gradual ramp-up policy versus a “big bang”? And, finally, what are the consequences of the “variable geometries” approach? The Apparent Conflict between Simple Economic Logic and Political Reality The authors suggest that while simple economic logic might argue for a global unified approach, political reality points toward a future of fragmented carbon regimes. This echoes Elinor Ostrom (2009), who, in a recent paper for the World Bank, discusses what she calls a “polycentric approach” for coping with climate change. Similar to Branstetter and Pizer, she notes that “[t]he classic theory of collective action predicts that no one will change behavior and reduce their energy use unless an external authority imposes enforceable rules that change the incentives faced by those involved.” But she goes on to point out that “[t]wo broad grounds exist for doubting whether sole reliance on the conventional theory of collective action is a wise scientific strategy. The first is the weakness of empirical support for the conventional theory of collective action. . . . The second is the existence of multiple externalities at small, medium, and large scales within the global externality that has been of primary concern in the academic and policy literature” (Ostrom 2009, 32). Charles Kolstad (2011) also takes issue with apparently simple economic logic, drawing attention to the apparent willingness of individual countries to go it alone in tackling transborder environmental issues in the absence of a comprehensive international environmental agreement. He observes that experiments to examine the incidence of free riding, together with casual empiricism in the real world, suggest that far more cooperation takes place than conventional theory would predict. But if one broadens the concept of utility to allow for the possibility of “impure altruism” (Andreoni 1990), these empirical observations make more sense. There may be much more scope for international climate cooperation than conventional economic wisdom suggests. 2. See Blanford, Richels, and Rutherford (2009).

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Certainly, it is striking that a substantial range of climate- change mitigation actions are being planned by small countries, both developed and developing, without an overarching legally binding agreement in place (or, indeed, even on the horizon). By some calculations, pledges before and immediately after the Copenhagen Conference of 2009 amounted to pledges to cut emissions by some 15 percent from business- as-usual levels by 2020 (Stern and Taylor 2010). Admittedly, these pledges are not legally binding, but they were unlikely to have been made without the conference to concentrate minds and cast the glare of international publicity over countries’ aspirations. So perhaps there is good reason for a degree of optimism about the future growth of such policies. The more general message is that if simple economic logic appears to contradict political reality, it is a good idea to review the apparent logic—and the choice of axioms and simplifications used to model economic actors’ behavior. What Will the Key Lines of Fracture Be among Nations in the Future? That brings me to the next issue: who are the key economic actors and what are their interests? I was rather surprised at this chapter’s focus on the divide between developed and developing countries and emphasis on the West versus the rest. That may make sense if one is sticking to a global, topdown view of nation states attempting to negotiate a global agreement, and it reflects the Kyoto Protocol distinction between Annex 1 countries and the rest. But in a more polyvalent world of variable geometries, one might well want to look beyond the veil of the nation state and ask, how would various climate- change policies affect returns to capital, labor, and owners of various natural resources, and how are these factors of production distributed across countries? In the climate- change domain, the distribution of ownership of fossil fuel resources is a key issue. I am struck by how one piece of simple economic logic, Hotelling’s insight into the pricing of exhaustible natural resources, has barely been taken on board in the climate- change policy literature, despite having a long pedigree in the theory—for example, it is not discussed in the JEL article that Branstetter and Pizer cite (Aldy et al. 2010). But back in the 1980s, Hans-Werner Sinn introduced the “green paradox,” by which efforts to support renewable energy development might accelerate fossil fuel depletion and increase emissions (see discussion in Sinn 2008). The relevance of exhaustible resource theory for climate change has been elaborated by a number of authors, such as Michael Hoel (2009) in a fascinating paper entitled “Bush Meets Hotelling.” Yet the Organization of Petroleum Exporting Countries (OPEC) and Russia have in some sense been the “dog that didn’t bark” in international negotiations. If world carbon prices follow the trajectory integrated assessment models suggest is necessary to keep below the 2°C ceiling on global temperature increase to which the vast majority of countries have signed up,

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fossil fuel prices will be depressed. As a recent European Bank for Reconstruction and Development (EBRD) report explained very clearly (EBRD 2011), the oil and gas exporters of the former Soviet Union stand to lose a huge amount from adverse changes in their terms of trade. And the integrated assessment models may themselves underestimate the height to which carbon prices may have to rise to choke off fossil fuel consumption. As far as I am aware, hardly any of them incorporate a Hotelling effect in their structure. I would, therefore, have liked to have heard more from the authors about the role of fossil fuel interests in international climate- change policymaking—not just OPEC’s and Russia’s roles in international negotiations but, for example, the role of coal owners in US climate- change politics. That role is pertinent to the question of whether Europe and the United States are likely to be on the same side of the policy divide in the future, or whether Europe will be lining up with other fossil fuel–poor countries against countries such as the United States, Canada, Russia, Saudi Arabia, and Australia. More generally, economic analysis of international policy should consider who the key stakeholders are and what motivates them, looking behind the veil of the nation state if necessary. In effect, that is what Heckscher, Ohlin, and Samuelson did in international trade theory. Comparing “Ramp Up Policy Gently” and Going for a “Big Bang”? That links to the third issue that I want to raise. The authors argue that standard economic analysis suggests that the efficient pricing path involves setting carbon prices relatively low to begin with, but rising over time. But the natural resource pricing literature suggests that one may have to start with much higher carbon prices, high enough to drive fossil fuel rents to zero. Even if one regards the Hotelling- based argument as a theoretical curiosity, despite the empirical insights to which it has given rise, there is a debate to be had over what “relatively low” means. If one is a proponent of using a very low pure rate of time preference in discounting costs and benefits from public policies, the logic dictates starting with a higher carbon price than otherwise that rises less rapidly thereafter.3 The transition of the capital stock to a low- carbon mix would still be gradual, because of replacement cycles and time to build, but it would be faster than with market- interest- rate- based discounting. The UK Committee on Climate Change reckons the United Kingdom needs a carbon price of £30 per tonne CO2e by 2020 if it is to meet its emission reduction target, which itself is designed to be consistent with European commitments to the 2°C ceiling (Committee on Climate Change 2011). Modeling exercises to calculate price trajectories consistent with the 2°C ceiling suggest that 3. This is the approach adopted in Stern (2007). It is controversial, but has a long pedigree in welfare economics.

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a price of anywhere from $13 to $263 per tonne is necessary by 2020. This distribution suffers from sample selection bias because it excludes the results of studies that imply that it is infeasible to keep below the ceiling. Working back to the present using a real social discount rate of, say, 3 percent (plus a factor to reflect the decay of greenhouse gases from the atmosphere) would yield, for most modeled price trajectories, a current carbon price of more than a few dollars. I concede that, in the immediate future, while many countries face high levels of involuntary unemployment, trying to induce rapid structural change is risky. But there are ways in which the economic slowdown can be turned to the advantage of climate- change objectives (Bowen and Stern 2010). Whether gradually increasing the carbon price from a low base, so that people barely notice, is compatible with the changes in consumption and investment patterns that would reduce emissions is a moot point. Such an approach might also raise doubts about political commitment to the carbonpricing regime over the long term. The alternative big bang approach can be seen as a way of demonstrating commitment and establishing the reputation of the policy authorities. More generally, there is a question of how rapidly to bring in any new international policy regime. Does it make sense to do things by halves? Do some aspects of the regime necessarily require a step change? The literature on policy reform and sequencing after the fall of Soviet communism may have something to teach climate- change analysts. Should National Policies Adopt the “Variable Geometries” Approach? Finally, there is the question of whether the variable geometries approach is applicable nationally. In my view, there are significant dangers in a domestic pick- and- mix approach to tackling climate change. Growing recognition of the threat of global climate change has drawn attention to several important market and policy failures in addition to the central environmental externality of greenhouse gases, including spillovers from innovation, network economies, information asymmetries, moral hazard from policymakers’ difficulties in precommitting, and economically inefficient tax systems. These failures have not now been recognized for the very first time, of course. But their costs now need to be reassessed. If the climate threat can galvanize action across the board, there is clearly scope for a Pareto- superior outcome, if the appropriate side payments—to developing countries and fossil fuel owners, for example—can be arranged. This is why the World Bank, the Organization for Economic Cooperation and Development (OECD), and others are emphasizing the virtues of green growth. But this requires improved policies on several fronts. In this connection, it would have been interesting to learn the authors’ views about the state of play in international discussions about low- carbon technology transfer, intellectual

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property rights, transnational energy infrastructure, and “measurement, reporting and verification.” However, siren voices have been suggesting that effective mitigation can be brought about largely by supporting low- carbon R&D. The advice is to soft- pedal on carbon pricing. Yet a range of studies (e.g., Fischer and Newell 2008) make clear that the overall costs of mitigation are likely to be much higher if we do not use all the tools in the toolbox. That does not seem like good politics, let alone economics. And many national policy mixes are piecemeal, not designed as a whole, and likely to be far from costeffective. The OECD (2011) has amply made that point with respect to the United Kingdom. On some calculations, the implicit carbon price in the United Kingdom varies across sectors and uses from zero to nearly £250 per tonne CO2e. The fact that this conference took place at the Bank of England provokes the thought that environmental policymakers could take a leaf out of the monetary policy book to create a more robust and coherent domestic policy mix. One option would be to give a single public authority constrained discretion to pursue national emissions targets, using a defined set of delegated policy instruments. In the United Kingdom, for example, the Secretary of State for Energy and Climate Change could consider handing over carbon pricing and feed-in tariff rates to the Committee on Climate Change.

References Aldy, J. E., A. J. Krupnick, R. G. Newell, I. W. H. Parry, and W. A. Pizer. 2010. “Designing Climate Mitigation Policy.” Journal of Economic Literature 48 (4): 903– 34. Andreoni, J. 1990. “Impure Altruism and Donations to Public Goods: A Theory of Warm-Glow Giving.” Economic Journal 100:464– 77. Blanford, G. J., R. G. Richels, and T. F. Rutherford. 2009. “Feasible Climate Targets: The Roles of Economic Growth, Coalition Development and Expectations.” Energy Economics 32 (Supp. 2): S82–S93. Bowen, A., and N. Stern. 2010. “Environmental Policy and the Economic Downturn.” Oxford Review of Economic Policy 26 (2): 137– 63. Committee on Climate Change. 2011. Meeting Carbon Budgets—3rd Progress Report to Parliament. June. London: UK Committee on Climate Change. European Bank for Reconstruction and Development (EBRD). 2011. The LowCarbon Transition: Special Report on Climate Change. European Bank for Reconstruction and Development and Grantham Research Institute on Climate Change and the Environment, LSE. Fischer, C., and R. G. Newell. 2008. “Environmental and Technology Policies for Climate Mitigation.” Journal of Environmental Economics and Management 55:142– 62. Hoel, M. 2009. “Bush Meets Hotelling: Effects of Improved Renewable Energy Technology on Greenhouse Gas Emissions.” FEEM Working Paper no. 262. Milan: Fondazione Eni Enrico Mattei.

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Kolstad, C. D. 2011. “Bridging Reality and the Theory of International Environmental Agreements.” Paper prepared for a symposium in honor of Tom Schelling, University of Manchester, October 2010. Revised March 2011, forthcoming in Climate Change and Common Sense: Essays in Honour of Tom Schelling, edited by R. W. Hahn and A. Ulph. Oxford: Oxford University Press. Organization for Economic Cooperation and Development (OECD). 2011. Economic Survey of the United Kingdom 2011. Paris: OECD. Ostrom, E. 2009. “A Polycentric Approach for Coping with Climate Change.” Policy Research Working Paper no. 5095, October. Washington, DC: World Bank. Sinn, H.-W. 2008. “Public Policies against Global Warming: A Supply-Side Approach.” International Tax and Public Finance 15:360– 94. Stern, N. 2007. The Economics of Climate Change. Cambridge: Cambridge University Press. Stern, N., and C. Taylor. 2010. “What Do the Appendices to the Copenhagen Accord Tell Us about Global Greenhouse Gas Emissions and the Prospects for Avoiding a Rise in Global Average Temperature of More than 2°C?” Policy Paper, Grantham Research Institute on Climate Change and the Environment, LSE, in conjunction with UNEP, March.

7 Multilateral Economic Cooperation and the International Transmission of Fiscal Policy Giancarlo Corsetti and Gernot J. Müller

7.1

Introduction

In response to the global financial crisis, fiscal policy has been intensively used as a stabilization tool throughout the globe. In spite of academic contributions raising issues regarding the effectiveness of fiscal policy (see, for instance, Cogan et al. 2010 or Uhlig 2010), there seems to be little doubt among policymakers that multipliers are quite sizable. Even stronger appears to be the belief, shared in policy circles, that fiscal policy measures in a country are likely to have sizable international spillover effects. At least, such a notion seems to have motivated calls for joint fiscal efforts in the context of the global financial crisis, at first to provide global fiscal stimulus to failing global demand, then for a moderation and delay of debt and deficit consolidation measures, especially among large countries with spare fiscal capacity.1 Giancarlo Corsetti holds the chair in macroeconomics in the Faculty of Economics at Cambridge University and is a research fellow of the Centre for Economic Policy Research. Gernot J. Müller is professor of economics at the University of Bonn and a research affiliate of the Centre for Economic Policy Research. Chapter prepared for the “Globalization in an Age of Crisis: Multilateral Economic Cooperation in the Twenty-First Century” conference, organized by the NBER and the Bank of England. We thank James Poterba, Alan Taylor, and our discussants, Martin Feldstein and Domenico Siniscalco, as well as the participants at the conference, at the preconference at the NBER, and at seminars at the ECB and University of Paris 2 for very helpful comments and suggestions. Patrick Hürtgen and Yu Jasmine Xiao provided excellent research assistance. The usual disclaimer applies. Please address correspondence to [email protected] or gernot.mueller@uni- bonn.de. For acknowledgments, sources of research support, and disclosure of the authors’ material financial relationships, if any, please see http://www.nber.org /chapters/c12593.ack. 1. “Our highest priority in Toronto must be to safeguard and strengthen the recovery. . . . We worked exceptionally hard to restore growth; we cannot let it falter or lose strength

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Yet, to date, the evidence on the size of international spillovers arising from fiscal measures taken at the national level is in short supply.2 Moreover, quantitative exercises based on standard models typically predict that crossborder effects are quite contained (see Cwik and Wieland 2011 and Corsetti, Meier, and Müller 2010). Against this background, this chapter pursues two objectives. In the main body of the chapter, after briefly reviewing the fiscal response to the crisis, we reconsider cross- border spillovers of fiscal policy within a vector autoregression (VAR) framework, as well as within a standard business cycle model. In a final section, we discuss the implications of our analysis for policy cooperation in international context characterized by high public debt and vulnerability to sovereign debt crises. Our empirical analysis focuses on the United States as the base country by virtue of their size and role in the world economy, as well as for reasons of data availability. Building on time- series studies on the effects of government spending shocks, we analyze the transmission of fiscal policy innovations originating in the United States on economic activity abroad. We estimate a VAR model on quarterly time- series data for the period 1980– 2007. In light of the current debate on the identification of exogenous shocks to government spending in time- series models, we adopt two different identification schemes. The first identification scheme, following Blanchard and Perotti (2002), posits that government spending is predetermined relative to the other variables in the VAR. The second scheme, which follows Ramey (2011), identifies spending shocks by using forecast errors computed on the basis of the Survey of Professional Forecasters. Our main results—robust across identification schemes—are as follows. Focusing on the euro area (EA) and the UK as trading partners, our estimates suggest that an increase in US government spending by one percent of US GDP raises output by about 0.5 percent in the EA and 1 percent in the UK. These peak effects occur after about two years. In addition, we find that the dollar depreciates strongly in real terms against the currencies of both trading partners. Importantly, we also find the response of trade flows quite moderate, such that it fails to provide a rationale for sizable output spillovers. We therefore attempt to shed light on these findings from the perspective of a standard two- country business cycle model. Each country is assumed now. This means that we should reaffirm our unity of purpose to provide the policy support necessary to keep economic growth strong” (US President Obama in a letter to the G20 meeting in June 2010). On the occasion, the EU called for unity in retrenchment: “Even though the timing, sequencing and scope of exit measures have to be tailored to conditions prevailing in the individual G20 members, coordination between governments can help to take into account possible spillover effects” (EU letter to G20). 2. In an early contribution, Canzoneri, Cumby, and Diba (2003) study the effects of US fiscal expansions on selected European countries. Beetsma, Giuliodori, and Klaasen (2006) provide estimates for spillover effects within Europe. More recently, Ivanova and Weber (2011) employ a national accounts framework to assess likely spillover effects, while Hebous and Zimmermann (2012) provide evidence on the basis of a narrative identification strategy.

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to specialize in the production of a specific set of intermediate goods that are consumed by private households and the government. In the model, while households act so as to maximize their welfare subject to constraints on prices and wage setting, monetary and fiscal policy are characterized by feedback rules. The specification of the monetary rule is a standard Taylortype rule. As regards fiscal policy, motivated by the results from our VAR and previous work of ours (see Corsetti, Meier, and Müller 2012a), we model a budget rule allowing for a systematic response of taxes and government spending to public debt. As a result, an exogenous, debt-financed increase in government spending implies a spending reversal after some time; that is, a decline of government spending below trend after the initial increase. Using model simulations, we find that the model generates spillover effects of government spending shocks on foreign output that align well with the evidence, at least qualitatively, only when we allow for spending reversals (as suggested by the empirical evidence). Only in this case, we find a depreciation of the real exchange rate and a gradual buildup of foreign activity, in line with our VAR results. We argue that this result bears an important general lesson, regarding the importance of a “financial channel” in the international transmission mechanism. Specifically, the model economy emphasizes that, given the monetary and fiscal feedback rules in place, an increase in domestic government spending triggers expectations of adjustment via future spending reversal and reduced real interest rates in the medium run. Expectations of lower future real rates reduce, all else equal, current long- term real rates in both countries. It is through this financial channel that expectations of future fiscal and monetary policies impact on current private expenditure both in the domestic economy and—transmitted via international asset prices—in the foreign economy. The international repercussions of domestic fiscal policy indeed mainly work via the response of consumption and saving decisions to correlated interest rates. In the final section of the chapter, we discuss the implications of our findings—that is, the presence of large cross- border spillovers as well as the importance of the financial channel—for policy cooperation. We do so by refocusing on an international context dominated by the strong deterioration of the fiscal outlook in developed countries documented in section 7.2. An environment of high public debt and vulnerability to fiscal crises, as reflected by large and volatile risk premia charged on sovereign bonds, posits formidable challenges to cooperation, but also magnifies the potential gains from it. To discuss the many facets of these challenges and opportunities properly, we argue that the conventional models underlying calls for cooperation (of the kind we use in the first sections of the chapter) need to be amended. A key empirical fact to be accounted for is the strong correlation of sovereign risk with private borrowing costs, which characterizes countries in fiscal stress. In related work of ours, we indeed have developed a model

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encompassing what we called the “sovereign risk channel” in an otherwise standard closed economy model, where sovereign risk deteriorates the borrowing conditions of the private sector (Corsetti et al. 2013). Drawing on this early analysis, we discuss likely implications of this channel in an international context. While sovereign risk challenges visions of cooperation exclusively focused on stimulus measures, we argue that the tangible threat to global recovery created by it arguably lends strong support for coordinated fiscal initiatives complemented by strong measures aiming at reducing vulnerability to self- fulfilling runs on debt. Such initiatives would need to combine gradualism in budget correction by countries with some fiscal space, with decisive and credible debt consolidation measures in countries facing market pressures. 7.2

The Fiscal Response to the Crisis

In this section we briefly review the adjustment of fiscal policies during and in the wake of the global financial crisis. While global in nature, the crisis impacted countries and regions differently, possibly also as a result of different policy responses. Figure 7.1 displays annual output growth for the world economy, for a sample of advanced economies and a sample of emerging and developing economies (IMF classification).3 The global financial crisis which, according to the common narrative, started in 2007 in the US subprime housing market, made itself felt in terms of economic activity in 2008: output growth declined sharply and turned negative for the world economy in 2009. In fact, output growth declined sharply in both country groups under consideration and by a similar amount in terms of percentage points. Yet as output growth was lower in the advanced countries group during the precrisis period, actual output declined substantially only in this group. The United States and the EA were among the regions hardest hit by the crisis; this has dramatic implications for policymaking. Figure 7.2 illustrates this point by displaying measures of unemployment and the shortterm interest rates in both the EA and the United States for the period from 2005 to 2011. Although the rise of unemployment masks dramatic differences within the EA, the aggregate picture resembles the developments in the United States rather closely (the increase is larger in the United States, however). Monetary policy responded to the crisis by lowering interest rates, quickly running into the zero lower bound problem, and by adopting unconventional measures (on the latter, see, e.g., Meier 2009). Yet the effectiveness of these measures remains an issue of controversy to date (see, e.g., Del Negro et al. [2010] for a positive assessment) and the significant uncertainty 3. According to the IMF classification, there are 34 countries within the advanced economies group and 150 countries within the emerging and developing countries group.

Fig. 7.1 Annual GDP growth (in percentage points) 1992–2011 in world and regions Source: IMF.

Fig. 7.2 Unemployment and short-term interest rates 2005M1–2011M7 (in percentage points) in EA and United States Sources: Bundesbank, St. Louis Fed, and European Central Bank (ECB).

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about the way they transmit to the economy has probably constrained central banks in relying on such measures. Overall, the capacity of monetary policy to stabilize the economy in the aftermath of the global financial crisis has arguably been limited. With the decline in activity, budget deficits soared as a result of revenue losses, and increases of government spending with the objective of providing stimulus to the economy and support to the financial sector. In figure 7.3 we plot general government debt in 2010 as a percentage of GDP for a sample of OECD (Organization for Economic Cooperation and Development) countries. The figure highlights the sharp increase during the period 2007– 2010, reflecting the cumulative effect of government budget deficits in the years 2008, 2009, and 2010. While the recent rise in debt is dramatic, it is not unprecedented. Taking a historical perspective, Reinhart and Rogoff (2008) show that public finances frequently deteriorate on a similar scale in the wake of a financial crisis—with an average increase in the debt- to-GDP ratio of 80 percent in the three years following the crisis. In order to take up the issue of coordinated policy actions, it is of particular interest to identify the discretionary component in the fiscal response to the crisis, a task that in turn requires an estimate of the automatic adjustment of the government budget. According to standard practice, we focus on the cyclically adjusted government budget balances, defined as the government budget balance that would prevail if output were at its natural level. Based on OCED data, we compute a simple measure of the discretionary fiscal response to the crisis: the decrease in the cyclically adjusted primary

Fig. 7.3

General government gross financial liabilities as of 2010 (percent of GDP)

Source: OECD.

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government budget balance (CAPB) in the years 2008, 2009, and 2010 relative to the precrisis level in 2007.4 In principle, the sum of these changes should account for deliberate policy measures taken on top of the automatic budget adjustment to the economic downturn. It thus captures discretionary stimulus measures such as temporary increases in government spending or tax cuts, which have been traditionally considered instruments of stabilization policy. They were also used during the crisis with a view to support economic activity. The most widely discussed measures include the American Recovery and Reinvestment Act, legislated in January 2009, and the European Economic Recovery Plan, introduced in the EU in November 2008. In addition to these “conventional” discretionary fiscal measures, several governments provided substantial support to the financial sector. Such measures included lending and recapitalization operations, as well as asset purchases at market prices. To the extent that these transactions do not necessarily involve capital losses, they raise gross debt, but not net debt. To get a sense of the magnitudes of these “unconventional” discretionary fiscal measures, we thus compute the difference between the increase in gross and net debt. Figure 7.4 provides a graphical representation of the cumulative CAPB decrease and the difference in the increase between gross and net government debt for a sample of OECD countries. It also shows the remaining increase in gross debt, which is unaccounted for by our measures for discretionary fiscal policy. It provides a measure for the automatic deterioration of public finances during the crisis (which, in turn, captures the decline in revenues, lower output growth, and possibly higher interest rates). According to this breakdown, there is substantial cross- country variation in the fiscal response to the crisis.5 The measure of the conventional discretionary fiscal response to the crisis introduced earlier is admittedly crude. In some dimensions, it is likely to overstate the role of discretion. For instance, the budget balances of numerous countries took a beating beyond what can be accounted for by the decline in economic activity, because of the extraordinary declines in tax revenues driven by falling asset prices and financial sector profits (see, e.g., Horton, Kumar, and Mauro 2009). In this respect, the OECD’s measure of the cyclically adjusted primary balance is likely to pick up an excep4. See Girouard and André (2005). The data are constructed on the basis of a disaggregated approach, computing the response of different budget items to the cycle. The approach distinguishes four sources of tax revenues: personal income taxes, social security contributions, corporate income, and indirect taxes. In addition, the estimates take into account unemploymentrelated transfers. For all five categories, the output elasticity is decomposed into (a) the tax- base elasticity of a particular revenue/expenditure type, and (b) the output elasticity of the tax/ expenditure base in question. These components are quantified on the basis of different estimation strategies and combined to compute the output semielasticity of the budget. 5. Benetrix and Lane (2010) also document substantial heterogeneity in fiscal outcomes in a systematic cross- country analysis of the fiscal stance during the crisis. In particular, they find that differences cannot be fully explained by differences in the GDP performance.

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Fig. 7.4 Increase of gross general government debt 2007–2010 (percent of GDP): Cumulative decline of CPAB, gross-net debt increase, and remaining increase Sources: OECD and authors’ calculations. Notes: Cumulative CAPB decline is the sum of change in cyclically adjusted primary balance (as reported by OECD) in each year 2008, 2009, and 2010 relative to precrisis level in 2007.

tional decline in the government budget balance, which is not entirely due to discretionary policy action. Nevertheless, our measure should provide some idea of the importance of various fiscal measures for the increase of government- debt levels. Indeed, a similar picture emerges from International Monetary Fund (IMF) estimates of the size of narrowly defined discretionary stimulus measures, reproduced in the left panel of table 7.1. These estimates are based on an in-depth analysis of national budget documents and medium- term fiscal plans in selected countries. Again, the concerted effort around the globe to provide support to economic activity through discretionary fiscal measures is apparent from the table, despite sizable differences across countries. The right panel of table 7.1 reproduces estimates of the support to the financial sector. While sizable, these measures have not necessarily been recorded in the budget. In spite of the difficulties in estimating automatic and discretionary measures, there is a sense in which a sizable fiscal response to the crisis has been deliberate in most advanced countries. Facing rapidly falling output, governments have been intentionally refraining from undertaking any action to compensate for the automatic increase in their budget deficit in response to the fall in economic activity and asset prices. On the contrary, they have

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Table 7.1 Discretionary fiscal measures Crisis- related stimulus

China Italy France Germany Russia Saudi Arabia Spain UK US

2009

2010

2011

Financial sector support up to 2010

3.1 0 1.2 1.7 4.5 5.4 ... 1.6 1.8

2.7 0 1.1 2.2 5.3 4.2 ... 0.0 2.9

... 0 0.6 1.7 4.7 1.6 ... 0.0 1.7

... ... ... 10.8 ... ... 7.1 7.1 5.2

Sources: International Monetary Fund (2010, 2011). Notes: Numbers are percent of GDP. Discretionary fiscal tightening not shown. “. . .” indicates that there are no observations.

resorted to discretionary expansionary measures, and provided generous (contingent) support to the financial sector. Public debt, risen markedly over the period 2007– 2010, is likely to persist at the new high level for many years, as far as advanced economies are concerned (see figure 7.5). The large fiscal expansion in the first years of the crisis occurred among calls for coordinated stimulus, consistent with the notion of strong crossborder spillovers from fiscal policy. Whether or not global stimulus was truly cooperative—that is, to what extent national policymakers actually internalize international spillovers resulting from their measures—is difficult to say. Nonetheless, it would be a mistake not to recognize the coordinated convergence onto a policy model overruling prescriptions of budget austerity often followed in previous crisis episodes at the national or regional level. More or less explicitly, governments have recognized the mutual benefits from sustaining aggregate demand at the national and global levels, and also from engineering a massive transfer of risk from the private to the public sector balance sheet. Traditional arguments feeding skepticism on coordinated actions fall into three categories, questioning feasibility, sustainability, and size of spillovers in turn. First, coordination is not viable because decision and implementation lags cause coordinated measures to be taken at inappropriate times. Second, the international community does not have effective instruments to ensure that coordinated measures are diligently adopted by the national governments. Third, empirical and theoretical work cast doubts on the size of international spillovers. More specifically, once governments keep their house in order—that is, they implement optimal stabilization policy from an inward- looking perspective—the gains from further refinement of these policies (internalizing cross- border spillovers) are minuscule. The interna-

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Fig. 7.5 General government gross debt (percent of GDP) in advanced economies and emerging and developing economies, according to IMF classification Source: IMF.

tional community thus has much more to benefit from disciplined stabilization policy at the national level (see Corsetti, Dedola, and Leduc 2010, among others). Of these three open issues regarding coordinated policy, the third one has perhaps dominated the recent debate. It is also implicit in concerns expressed by observers raising doubts on the rationale of providing fiscal stimulus in the first place (see Barro 2009 and Cogan et al. 2010, among others), even at the national level. In what follows, we take up the same question but with a distinct focus on cross- border spillovers, partly because this is where the disagreement in both policy and academic circles is most apparent, and partly because the answer to this question appears to be a fundamental prerequisite for any further analysis of policy coordination. 7.3

Cross-Border Effects of Fiscal Expansion

We draw on two distinct approaches to formally assess the importance of cross- border effects of fiscal policy. In both instances we explore the domestic and international repercussions of an exogenous change in government

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spending. This experiment is informative in identifying the specific transmission channels through which fiscal policy measures impact on the (global) economy. In the first part, we rely on an estimated vector autoregression (VAR) model to establish time- series evidence on the basis of a minimum set of a priori assumptions. In the second part, we try to shed light on this evidence using a standard business cycle model. 7.3.1

Time-Series Evidence

As a case study, our empirical analysis focuses on the international repercussions in both the euro area (EA) and the UK, of an exogenous change in government spending in the United States. As explained later, focusing on the United States as the base country allows us to compare results from conceptually distinct identification schemes (see also our discussion in Corsetti, Meier, and Müller 2012a). In addition, we shed light on spillovers from the largest economy in the world, onto economies that differ substantially in their relative size. In our study, we are specifically interested in studying the cross- border effects of a US spending expansion on economic activity in the EA and the UK, as well as on the US bilateral trade with these economies. Identification and Specification During the last decade, a large number of studies have attempted to characterize the fiscal transmission mechanism using VAR models, mainly in a closed economy context. Following Blanchard and Perotti (2002), many of these studies identify fiscal shocks (as opposed to systematic policy responses to economic conditions), assuming that government spending is predetermined relative to the other macro variables included in the VAR.6 This assumption appears plausible to the extent that government spending does not include transfers, which vary automatically with the cycle, and that decision lags prevent policymakers from responding instantaneously to the state of the economy. Yet this approach to the identification of government spending innovations is subject to the criticism that changes in government spending, while unrelated to the state of the economy, may be partly anticipated by economic agents—a point that has been forcefully made by Ramey (2011), among others. In an alternative approach developed by this author, government spending shocks are identified with forecast errors made by professional forecasters. The series of these errors is then included as an additional variable in the VAR model and is ordered first.7 Its dynamic effects are then computed on the basis of impulse response functions implied by a recursively estimated VAR model. 6. Under this assumption, innovations to government spending represent exogenous innovations in a recursively estimated VAR model, with government spending ordered first. 7. Specifically, Ramey computes the forecast error of quarterly government spending growth on the basis of the survey of professional forecasters maintained at the Philadelphia Fed.

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In the following, we report results obtained under both identification schemes. We estimate variants of a VAR model on quarterly time series for the period 1980:1 to 2007:4; that is, we do not consider the crisis period. Our VAR model includes four US time series: government spending and output (in logs and real terms), a measure of long- term real interest rates (quarterly percentage points), and public debt (scaled by quarterly GDP). To analyze the effects of US spending shocks for either the EA or the UK, we include the bilateral real exchange rate and, in order to economize on the degrees of freedom, we rotate, as the last variable, bilateral exports, bilateral imports, the bilateral trade balance, and foreign output, in turn. The VAR model also includes a constant and a linear time trend. The Transmission of Spending Shocks in the US Economy The transmission of US spending shocks in the US economy are displayed in Figure 7.6: the left column (“VAR innovations”) refers to the BlanchardPerotti identification scheme, the right column (“Forecast errors”) to the alternative identification scheme due to Ramey (2011).8 In either column, the size of the shock is normalized so that government spending increases by 1 percent of GDP on impact. In these and all the graphs to follow, the solid lines display point estimates, while the shaded areas indicate 90 percent confidence bounds obtained by bootstrap sampling. The horizontal axis measures quarters. Output and government spending are measured in output units, so that the response of output provides a direct measure of the government spending multiplier. The long- term real interest rate is measured in quarterly percentage points, while public debt is measured relative to quarterly GDP. A comparison of the graphs in the two columns shows that, while the responses are quantitatively different, their pattern is remarkably similar overall.9 Government spending, displayed in the first row, rises on impact, but its increase is not persistent. Under both identification schemes, spending actually tends to undershoot its long- run trend—this happens somewhat earlier under the identification scheme based on forecast errors (see Corsetti, Meier, and Müller 2012a). The response of output is positive on impact in both cases. However, while output displays a hump- shaped adjustment path under the identification scheme based on VAR innovations, its response is more short- lived when we use forecast errors to identify shocks. Regarding long- term real interest rates, we find a decline in the medium 8. In this figure we show results pertaining to US variables obtained from a VAR model that also includes the US-EA exchange rate and EA output. We discuss results for these variables later. 9. Ramey (2011) stresses a number of differences, notably in the responses of consumption and the real wage. We do not include these variables in our model. Corsetti, Meier, and Müller (2012a) provide a more detailed discussion of similarities and differences across both identification schemes.

Effects of US government spending shock on US variables

Notes: The left column shows results for Blanchard-Perotti identification scheme; the right column shows results for forecast error identification scheme. The shock is normalized so that government spending increases by 1 percent of GDP on impact. Horizontal axis measures quarters. Solid lines display point estimates; shaded areas indicate 90 percent confidence bounds. Output and government spending are measured in percent of trend output, long- term rate measures the long- term real interest rate in quarterly percentage points, and public debt is measured relative to quarterly GDP.

Fig. 7.6

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term following the shock. Finally, public debt rises strongly under both identification schemes, although the response is barely significant under the forecast- error approach. While output multipliers are nonnegative, it is worth noting here that the effects are moderate and short- lived. Hence, they are not suited to strengthen the case for extensive fiscal stimulus measures. Yet this evidence reflects merely the average effect of fiscal policy for a sample in which the economy arguably operated close to full employment and financial markets were functioning reasonably well. The effectiveness of fiscal policy, in contrast, may be quite different under other circumstances. Elsewhere, indeed, we have shown that average linear estimates may hide strong differences across economic environments (see Corsetti, Meier, and Müller 2012b). External and Cross-Border Effects In figure 7.7 we turn to our analysis of the external effects of US government spending. As already mentioned, we compute the impulse responses in the figure, by rotating the bilateral variables, one at a time, as the last variable in the VAR model—with the exception of the real exchange rate, which is always included. The trade variables pertain to bilateral US variables and are measured in percent of US trend output. Output in the EA and the UK is instead measured in percentage deviation from trend. The first row in the figure shows the response of the bilateral real exchange rate, which depreciates sharply and substantially, along a hump- shaped adjustment path. Although puzzling in light of the received wisdom, similar results have been documented for the US real effective exchange rate by Kim and Roubini (2008) and several subsequent studies. The second and third rows display the dynamics of US exports and imports, respectively. Exports hardly move on impact, and start to improve over time. Overall, the increase is moderate, reaching a peak of about 0.15 and 0.05 percent of US trend output for the EA and UK as trading partners, respectively. Import responses differ somewhat across identification schemes, but movements in this variable are quite contained and barely significant. As a result, the US trade balance, especially against the EA, moves quickly into surplus after the first couple of quarters, as shown in the fourth row of the figure. This finding is in line with earlier studies providing evidence at odds with the notion of “twin deficits” (see Kim and Roubini [2008], but also Corsetti and Müller [2006] and Monacelli and Perotti [2010] for different findings on the basis of alternative specifications and different samples). Finally, the bottom row of figure 7.7 displays the response of output in the EA and the UK. The point estimate indicates a gradual, but sizable buildup, reaching at least 0.5 and 1 percent of EA and UK output, respectively. The response, however, is only marginally significant. Results are similar both across identification schemes and across countries (EA or UK). At the country level, however, there are a few notable

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Fig. 7.7 Effects of US government spending shock on bilateral trade with EA and UK and on EA and UK output Notes: See figure 7.6. Except for EA and UK output (measured in percentage deviation from trend), variables pertain to the United States and are measured in bilateral terms in percent of US trend output.

differences. The responses of exports and imports, as well as of the trade balance, are smaller in the UK case (although the response of US imports from the UK is positive on impact). The UK output, in contrast, responds more strongly to the increase in US government spending, although its adjustment pattern is quite similar to that of EA output. Overall, the external effects of US spending shocks appear to be nonnegli-

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gible. Empirical findings of substantial cross- border effects are not unusual. For instance, Beetsma and Giuliodori (2011) estimate sizable cross- border effects of fiscal policy within Europe: in response to an exogenous increase in government spending in either France, Germany, Italy, Spain, or the UK, the rest- of-EU output increases by about 0.35 percent, after three years.10 It is worth stressing that the estimated dynamic cross- border effects of fiscal policy may reflect possible reactions by foreign policies. For instance, if government spending in the UK and the EA rises in response to a positive innovation to US spending, the cross- border dynamic effects shown in the figure may simply reflect the endogenous expansionary policy in the foreign economies. Strictly speaking, policy spillovers are defined holding constant the policy instruments abroad. As a way to verify the robustness of our results, we thus consider an alternative VAR model and include US government spending in relative terms; that is, US spending relative to either UK or EA government spending. Figure 7.8 shows results for the key variables of interest, again for both identification schemes discussed before. The dashed lines report the point estimates together with 90 percent confidence bounds (gray area); solid lines, in contrast, show the point estimates for the baseline case. Results are quite similar to our baseline specification, especially for the forecasterror specification. Cross- border effects are slightly muted, however, for the Blanchard-Perotti specification. Incidentally, in the latter case, the puzzling depreciation of the real exchange rate vis-à-vis the UK disappears over the medium run. In summary, the time- series evidence, subject to a number of important caveats common to time- series studies on the fiscal transmission mechanism, lends some support to the notion that fiscal policy has consequential spillovers across borders, a view often voiced in policy circles. According to our point estimates, a US spending expansion of 1 percent of US output can raise GDP in the UK up to a full percentage point of UK output. This result is particularly remarkable, given that the impact of the US expansion on US output is contained to start with. However, contrary to the widespread view in policy circles, the transmission mechanism does not appear to work through an international trade channel. US imports from the EA hardly move in response to a US spending shock; imports from the UK only respond on impact. US exports actually rise over time, after a deterioration on impact of exports to the UK. In the next section, we will resort to theory in order to shed light on the underlying transmission channels. 10. In an early VAR analysis, Canzoneri, Cumby, and Diba (2003), employing a variant of the Blanchard-Perotti identification scheme, also find a delayed but sizable increase in French, Italian, and British output in response to US fiscal expansions. Beetsma, Giuliodori, and Klaasen (2006) combine a VAR model with an estimated trade equation for European countries, and find sizable output spillovers from shocks to German and French government spending.

Effects of US government spending shock on real exchange rates and foreign output

Notes: See figure 7.6. Solid lines reproduce point estimates for baseline specification. Dashed- dotted lines (shaded areas) show point estimates (confidence bonds) for VAR model where US government spending is expressed relative to government spending in the EA (top) and UK (bottom).

Fig. 7.8

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7.3.2

A Quantitative Business Cycle Model

To gain insight on the international transmission of fiscal policy, we resort to a two- country business cycle model. Since our goal is to provide a close-up analysis of transmission, we abstract from a number of economic features, which are not essential for our argument. In particular, we use a simplified version of the model in Corsetti, Meier, and Müller (2012a), as we abstract from investment demand and capital accumulation. As the basic features of the model are standard, we will keep the model outline brief. Instead, we will highlight those equilibrium relationships that are pivotal to the international transmission mechanism. We will also discuss to what extent and under which assumptions the predictions of the model are qualitatively in line with the VAR evidence (including the evidence of a limited role for the trade channel conventionally defined). Quantitatively, however, we will show that the spillover effects in the model turn out to be smaller than in the empirical analysis. Model Outline The model we employ has become a standard workhorse in macroeconomics, providing the theoretical core to large policy models adopted by policy institutions. The model economy includes two countries, referred to as H (Home) and F (Foreign), each producing a variety of country- specific intermediate goods, with the number of intermediate good producers normalized to unity. A fraction n of firms is located in Home, and the remaining firms (n, 1] are located in Foreign. Analogously, Home accounts for a fraction n ∈ [0, 1] of the global population. Intermediate goods are traded across borders, while final goods, which are bundles of intermediate goods, are not. Households supply labor services only within the country where they reside, but trade a complete set of state- contingent assets internationally. The model allows for nominal rigidities. Prices of intermediate goods are sticky in producer- currency terms. Likewise, wages are also adjusted infrequently. In the following, we focus our exposition on Home. When necessary, we refer to foreign variables by means of an asterisk. Households and Firms. Households supply differentiated labor services. Within each country, they are indexed according to labor types on the unit interval as in Erceg, Henderson, and Levin (2000). Households engage in monopolistic competition, but their ability to set wages is restricted: in each period only an exogenously determined fraction (1 – ξw) of households may adjust their wage. Differentiated labor services Ht (h),∈[0,1] are bundled into aggregate labor services according to the following technology (1)

/(−1) 1 Ht = ⎛ ∫ Ht (h)(−1)/ dh ⎞ . ⎝ 0 ⎠

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Letting Wt(h) denote the wage rate for labor services of type h, the unit cost of domestic labor services (i.e., the aggregate wage index) is given by (2)

1/(1−) 1 Wt = ⎛ ∫ Wt (h)1− dh ⎞ . ⎝ 0 ⎠

Optimal bundling of differentiated labor services implies the demand function (3)

⎛ W (h) ⎞ −  Ht (h) = ⎜ t ⎟ Ht . ⎝ Wt ⎠

Households consume a bundle of intermediate goods, which are assembled in order to minimize expenditures given a specific aggregation technology. Let At and Bt denote bundles of domestically produced and imported intermediate goods, respectively; the consumption bundle is defined as follows (4)

Ct = ⎡⎣(1− (1− n) )1/ At(−1)/ + ((1− n) )1/ Bt(−1)/ ⎤⎦

(5)

Ct* = ⎡⎢(n )1/ (At* )(−1)/ + (1− n )1/ (Bt* )(−1)/ ⎤⎥ ⎣ ⎦

/(1−)

,

/(1−)

,

where σ measures the terms of trade elasticity of the relative demand for domestically produced goods, and ω ∈ [0, 1] provides a measure for home bias.11 The bundles of domestically produced and imported intermediate goods, in turn, are defined as follows ⎡⎛ 1 ⎞ 1/ε n ⎤ ε/(ε−1) ⎡⎛ 1 ⎞ 1/ε 1 ⎤ ε/(ε−1) (ε−1)/ε ⎥ (6) At = ⎢⎜ ⎟ ∫ At ( j )(ε−1)/ε dj ⎥ ,Bt = ⎢⎜ B ( j ) dj , ∫ t ⎢⎝ n ⎠ 0 ⎥ ⎢⎝ 1− n ⎟⎠ n ⎥ ⎣ ⎦ ⎣ ⎦ where At( j) and Bt( j) denote intermediate goods produced in H and F, respectively, and ε measures the elasticity of substitution between intermediate goods produced within the same country. Letting P( j) denote the price of an intermediate good expressed in domestic currency and Et the nominal exchange rate (the price of domestic currency in terms of foreign currency) we assume that the law of one price holds, so that P*( j) = Et P( j). Price indices are given by 11. This specification follows Sutherland (2005) and De Paoli (2009). With ω = 1, there is no home bias: if the relative price of foreign and domestic goods is unity, the fraction of domestically produced goods that ends up in the consumption bundle is equal to n, while imports account for a share of 1 – n. Importantly, consumption goods are identical across countries in this case. A lower value of ω implies that the fraction of domestically produced goods in consumption goods exceeds the share of domestic production in the world economy. If ω = 0, there is no trade in goods across countries.

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⎡1 n ⎤ PAt = ⎢ ∫ Pt ( j )1−ε dj ⎥ 0 ⎣n ⎦

⎡ 1 1 ⎤ ,PBt = ⎢ Pt ( j )1−ε dj ⎥ ∫ n ⎣ 1− n ⎦

1/(1−ε)

(7) (8) (9)

1/(1−ε)

1/(1−)

Pt = ⎡⎣(1− (1− n) )PAt1− + ((1− n) )PBt1− ⎤⎦

,

,

1/(1−) Pt* = ⎡⎢ n (PAt* )1− + (1− n )(PBt* )1− ⎤⎥ , ⎣ ⎦

and Qt = Pt Et / Pt* measures the real exchange rate. Given the previous definitions and results, we can write the household’s utility functional as follows (10)

∞ ⎛ H (h)1+ ⎞ Et ∑s ⎜ lnCt+s (h) − t+s ⎟, 1+  ⎠ ⎝ s=0

where β is the discount factor, ϑ is a constant determining labor supply in steady state, and φ is the inverse of the Frisch elasticity of labor supply. We assume that households trade a complete set of state- contingent securities.12 Let Ξt+1(h) denote the payoff in units of currency H in period t + 1 of the portfolio held by household h at the end of period t. With ρt,t+1 denoting the stochastic discount factor, the budget constraint of the household is given by (11) Wt (h)H t (h) + Rt K t (h) + t − Tt − Pt (C t (h) + X t (h))

{

}

= E t t ,t +1 t +1 (h) −  t (h),

where Tt and ϒt denote lump- sum taxes and profits of intermediate good firms, respectively. Both are levied/distributed equally across households. Under complete financial markets, households fully insure against the idiosyncratic income risk that results from their limited ability to adjust wages in each period. Households are, therefore, homogeneous with respect to consumption and asset holdings. By contrast, households are heterogeneous with respect to labor supply as a result of infrequent wage adjustments. Given the household’s marginal utility of nominal income, Λt, a household that is allowed to reoptimize its wage sets W t (h) to meet the following objective (12)

∞ ⎡ H (h)1+ ⎤ max Et ∑ (W )s ⎢ t+s Ht+s (h)Wt (h) − t+s ⎥, 1+  ⎥⎦ ⎢⎣ s=0

subject to the demand for its labor service (3). Producers of differentiated intermediate goods engage in monopolistic 12. Assuming alternatively incomplete international financial markets, allowing for trade in noncontingent debt only, has little bearing on our results. Results are available on request.

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competition. The production function is given by Yt( j) = Ht( j), where Ht( j) denotes domestic labor services employed by firm j ∈ [0, n ] in period t. We assume that prices are set in the currency of the producer and that price setting is constrained exogenously à la Calvo, so that in each period only a fraction of intermediate good producers (1 – ξP) may adjust its price. When firm j has the opportunity, it sets Pt ( j ) to maximize the expected discounted value of net profits: (13)

∞

D t+s P t,t+sYt+s ( j )

s=0

Pt+s

maxEt ∑

⎡⎣ Pt ( j ) −Wt+s ⎤⎦

subject to demand Yt D ( j ). Fiscal and Monetary Policy. Government consumption is financed either through lump- sum taxes, Tt, or through the issuance of nominal debt, Dt, denominated in domestic currency. The period budget constraint of the government reads as follows (14)

Dt+1 +Tt = Dt + Gt , 1+ it

where (1 + it) is the gross return on a one- period nominally risk- free bond, which is equal to 1/Etρt,t+1; Gt denotes government spending which, under the baseline scenario, is a bundle isomorphic to private consumption, except that it falls only on domestically produced goods—reflecting the observation that the import content in government spending is considerably lower than in private spending (e.g., Corsetti and Müller 2006). Define DRt = Dt /Pt−1 as a measure for real beginning- of-period debt, and TRt = Tt / Pt as taxes in real terms. Letting variables without time subscript refer to steady- state values, we specify the following feedback rules (15)

Gt = (1− )G + Gt−1 − G DRt + εt ,TRt = T DRt ,

where εt represents an exogenous i.i.d. shock to government spending. The ψ- parameters, which we posit to be nonnegative throughout, capture a systematic feedback of public debt on government spending (negative) and taxes (positive). We assume that either parameter is sufficiently large to ensure the nonexplosiveness of public debt. For instance, if ψG = 0 we posit that taxes are raised sufficiently strongly in response to higher outstanding debt. Note, however, that ψG = 0 implies Ricardian equivalence, so the specific time path of taxes, for a given time path of government spending, is irrelevant for the real allocation in the economy. This assumption is frequently made in analyses of fiscal transmission; by relaxing the assumption and allowing for a feedback channel from debt to government spending, we allow for richer and arguably more plausible dynamics of government spending (see also Corsetti, Meier, and Müller 2012a).

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Finally, turning to monetary policy, we assume flexible exchange rates and specify policymaking by means of a forward- looking interest rate feedback rule: (16)

ln(1+ it ) =   At+1,

where ΠAt = PAt /PAt– 1 measures domestic (producer price) inflation. Equilibrium. To carry out our analysis, we consider a linear approximation of the model’s equilibrium conditions around a deterministic steady state in which government debt and inflation are zero and trade is balanced. Before turning to simulation results, it is useful to focus first on the equilibrium conditions, which play a critical role in shaping the international transmission mechanism. Regarding notation, for each variable we will use lowercase letters to denote deviations from steady state. Private expenditure is governed by the Euler equation, which, solving forward and assuming a stationary economy, implies (17)

ct =

1 ∞ ∑ i

−

t+1+k ,  k=0 t+k

(

)

≡rrt + k

where πt measures Consumer Price Index (CPI) inflation. Equilibrium condition (17) ties the current level of consumption demand (in terms of deviations from steady state) to the entire path of expected future short- term real interest rates, rrt. By the expectations hypothesis, in turn, the latter is equivalent to the real rate of return on a bond of infinite duration (see, e.g., Woodford 2003, 244), or the long- term real interest rate for short. As stressed in Corsetti, Meier, and Müller (2012a), movements in longterm interest rates are at the heart of the transmission mechanism through which fiscal and monetary policy influence aggregate demand. An obvious consideration is that long- term rates reflect more than the contemporaneous stance of these policies, as they heavily depend on expectations about the future policy course. They “telescope,” so to speak, anticipated future policy changes into today’s financial conditions. By way of example, if households come to expect tight fiscal policy over the medium run, they anticipate correspondingly lower future policy rates. All else equal, these translate into an upfront drop in long- term rates, boosting current consumption. The opposite is true if households anticipate a combination of loose fiscal and tight monetary policy to prevail in the future. This— essentially financial— transmission channel substantiates the classical claim that, while current fiscal retrenchment can be expected to be contractionary, anticipations of future cuts are actually expansionary in the short run. Moreover, it is easy to show that the exchange- rate appreciation depends linearly on the Home- to-Foreign differential in long- term real interest rate:

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this simply follows from combining Euler equations for bonds traded in domestic and foreign currency, and solving forward. In equilibrium, the price for Home consumption rises relative to Foreign consumption—the exchange rate strengthens in real terms—whenever long- term rates at home exceed those abroad (see Corsetti, Meier, and Müller 2012a). To interpret our results below, it is instructive to rewrite the short- term real interest rate as follows (18)

rrt = it − Et t+1 = it − ((1− (1− n) )Et  A,t+1 + (1− n) Et B,t+1 ) = (1− (1− n) )(it − Et  A,t+1 ) + (1− n) (it* − Et *B,t+1 ).

The first equivalence follows from the fact that Home inflation has a domestic and an imported- goods- prices component, which is in turn driven by movements in the exchange rate. The second equivalence is a by-product of uncovered interest parity, stating that Home nominal rates are approximately identical (up to first order) to Foreign nominal rates, plus the expected rate of currency depreciation. The previous expression shows that (under uncovered interest parity and the law of one price for intermediate goods traded internationally) shortterm real interest rates are a weighted average of the difference between policy rates and domestic inflation, in the Home and the Foreign country. This relationship highlights that monetary and fiscal policy in one country affect the short- term real interest rate in the other country. The relative weight of foreign policy on domestic rates is determined by (1 – n)ω, which reflects the average import share in consumption and thus the openness of the economy.13 In summary, the long- term rate, in turn a function of current and anticipated future short rates, drives the response of the private sector demand to temporary (fiscal) shocks. The equilibrium relationships (17) and (18) constitute a financial channel through which both domestic and foreign, current and expected future monetary and fiscal policy impact on the longterm real interest rate. It affects both the domestic and external components of demand—interest and exchange rates interact in equilibrium, depending, among other parameters, on intratemporal and intertemporal elasticities of substitution. Calibration In order to solve the model numerically, we assign the following parameter values. A period in the model corresponds to one quarter. Accordingly, we set β = 0.99. For the Frisch elasticity of labor supply we assume a value of 13. By virtue of the forward- looking nature of the consumption decision, the fact that both the uncovered interest parity and the law of one price may fail in the short run is not a fundamental objection to this transmission channel. What ultimately matters is whether both laws hold in the medium- and long- run.

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one- third by setting φ = 3; see Domeij and Flodén (2006) for recent evidence. Given these assumptions, we set ϑ to ensure that agents spend on average one- third of their time endowment working. The trade price elasticity σ is set equal to 0.5 in the baseline scenario, a value well within the (admittedly wide) range considered in the recent macroeconomic literature; see Corsetti, Dedola, and Leduc (2008) for further discussion. Regarding γ, the coefficient of relative risk aversion, we assume a value of 0.26, in line with the estimates of Amato and Laubach (2003), but somewhat higher than the estimates by Rotemberg and Woodford (1997). This implies, nevertheless, a fairly high value for the intertemporal elasticity of substitution (IES) of private expenditure, as we do not model private investment explicitly. Nominal rigidities play a key role in the transmission of government spending shocks. We assume that ξp = 0.66, implying an average price duration of three quarters—within the range of values discussed, for example, by Nakamura and Steinsson (2008). Regarding wage rigidities we set ξW = 0.75 so that the average wage duration is four quarters. For monetary policy we assume φπ = 1.5. The steady- state output share of government spending is assumed to be 20 percent. The parameter ρ is set to 0.9, capturing the persistence of government spending deviations from trends documented by many VAR studies on US data. In our baseline scenario we set ψG = ψT = 0.02, implying a systematic feedback from higher public debt to government spending and taxes. These parameter values not only ensure debt- stabilizing fiscal policy over time, but also assign some role to spending restraint. Specifically, an initial increase in government spending would be followed after some time by a fall in spending below trend, in line with the VAR evidence.14 Finally, we consider two distinct trade scenarios that are meant to capture bilateral trade relationships between the United States and either the EA or the UK, respectively. In the first one, the Foreign economy is only slightly smaller than the Home economy: we set n = 0.57. Alternatively, we set n = 0.85. In both cases, we set ω to target the import share of the foreign country—that is, 19 and 28 percent, respectively (this implies an import share in Home of 14 and 4 percent, respectively). Note that, under these assumptions, spillovers will tend to be relatively large. An alternative approach would be to set the import share in Home so as to account for EA and UK imports in the United States (about 2 and 1 percent, respectively). Under this 14. Using annual observations to estimate spending and tax rules, Galí and Perotti (2003) report estimates for the coefficient on debt ranging from – 0.04 to 0.03 for government spending, and from 0 to 0.05 for taxes, in a panel of OECD members (no breakdown by country provided). For the United States, Bohn (1998) reports estimates for the response of the surplus to debt in a range from 0.02 to 0.05. To see that our parameter choice ensures the solvency of the government, that is, that fiscal policy is “passive” in the sense of Leeper (1991), consider a linear approximation of the equilibrium conditions around the steady state: abstracting from autocorrelation of government spending and assuming an “active monetary policy,” debt stability holds if 1 – ψG < β .

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approach, spillover effects would be virtually zero—although this possibly understates the actual effect, as spillovers from the United States to the EA or the UK are likely to be transmitted also through third countries. However, in the following we will show that, for either set of assumptions, the model will not be able to match the size of the cross- border output effects estimated in our previous VAR analysis. Simulation Results Figure 7.9 shows results for the baseline specifications, displaying the impulse responses of selected variables to an exogenous increase in government spending in Home. Time is measured on the horizontal axis in quarters. The responses of quantities are measured in percent of domestic output—with the exception of foreign output, which is measured in percent

Fig. 7.9

Effects of government spending shock in Home

Notes: Baseline scenario (for given country size n, ω is set to target import share of EA [19 percent] and UK [28 percent], see lines with white circles and lines with black dots, respectively). All variables pertain to Home (United States) and are measured in output units, except for “Output*”. The real exchange rate is measured in percentage deviations from steady state.

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of foreign output. The real exchange rate is measured in percentage deviations from steady state. The lines with circles reflect results for the US-EA trade specification (n = 0.57 and an import share in Foreign of 19 percent). Lines with crosses reflect results for the US-UK trade specification (n = 0.85 and an import share in Foreign of 28 percent). Government spending increases initially because of the shock, but then tends to undershoot its long- run (steady- steady) state level appreciably between ten and thirty quarters from the shock—the budget adjustment rule brings about a “spending reversal.” In response to the shock there is a sizable, hump- shaped buildup of Home public debt. Home output increases sizably, with an impact response above unity. Home consumption, instead, shows a hump- shaped increase with a peak response of about 0.3 percent of output, after 8 quarters. The real exchange rate depreciates on impact and stays below steadystate level for an extended period. Quantitatively, however, this response is contained relative to the VAR results. Home exports improve slightly in response to the innovation, but then move gradually into negative territory. Quantitatively, the responses are also quite moderate. Home imports, in turn, increase more sizably on impact and return gradually to steady state. The Home trade balance moves into a deficit for the first ten quarters, then improves after about four to five years. Trade balance movements are nonetheless small. Finally, the response of Foreign output is positive on impact and rises further, reaching a peak after about 10 quarters. A few results from these exercises stand out. The responses pertaining to domestic developments in the Home country are virtually identical in both (US-EA or US-UK) specifications. There are, however, differences in the response of trade variables. Home exports and imports, as well as the trade balance, tend to respond more in the US-EA trade scenario. Foreign output, in contrast, increases more strongly in the US-UK scenario. Overall, the predictions of the model are broadly in line with the VAR evidence, discussed earlier, at least qualitatively. Nonetheless, international spillovers on foreign activity are small relative to the point estimates from the VAR model, especially as far as peak responses are concerned. Also, the pattern of the Home trade balance for the US-EA specification of the model is quite distinct from what we documented for the VAR model. To shed further light on the mechanisms underlying these results, figure 7.10 contrasts the responses for the US-EA trade baseline specification (lines with circles) with the responses obtained under the assumption that government spending falls on both domestic and foreign goods (lines with diamonds) and under the assumption that the import share is 2 percent in Home (corresponding to the average import share of imports from the EA, in terms of US GDP), and 2.6 percent in Foreign (lines with crosses). Under these alternative assumptions, perhaps not surprisingly, trade vari-

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Fig. 7.10

283

Effects of a government spending shock in the Home country

Notes: Baseline model with US-EA trade scenario (lines with white circles), alternative specifications with government spending falling on both domestic and foreign goods (lines with diamonds), and imports in Home account for 2 percent of GDP (lines with black dots). See figure 7.9.

ables respond quite differently, at least from a quantitative point of view. Consider first the case of a low import share in the Home country. In this case there is virtually no effect of a Home fiscal expansion on Home trade variables, measured in terms of Home output. Foreign output also appears basically unaffected. If, instead, the import share is left unchanged relative to the baseline scenario, but we assume that government spending falls on goods produced in both the Home and the Foreign country, spillover effects are stronger. Notably, the impact responses of Home imports, the Home trade balance, and Foreign output are much stronger than in the baseline scenario, reflecting the direct effect of increased government spending in Home on goods produced abroad.

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A Close-Up Analysis of Spillovers As we are particularly interested in the mechanism underlying international spillovers, it is appropriate to provide a detailed account on the adjustment process in the Foreign country, when the Home government undertakes a fiscal expansion. Under our baseline scenario, figure 7.11 shows the response of Foreign output, consumption, and trade balance. Since our baseline assumes a relatively small value for the trade price elasticity, we also report responses assuming higher values for σ = {1.5, 3}, displayed by the lines with crosses and the lines with diamonds, respectively. The model’s predictions are sensitive to these alternative assumptions, especially as far as cross- border effects are concerned. As the real exchange depreciates, demand shifts, all else equal, toward goods produced in Home.

Fig. 7.11

Effects of a government spending shock in the Home country

Notes: Baseline specification for US-EA trade scenario (lines with white circles); alternative specification with σ = 1.5 (lines with black dots), and σ = 3 (lines with diamonds). See figure 7.9.

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This is reflected by rising Home exports. Such an effect is stronger the higher the trade price elasticity. For high values of this elasticity, indeed, the increase in Home exports dominates the increase in Home imports (which is driven by the increased level of Home activity), and the Foreign trade balance moves into a deficit. As a result, spillovers from the Home fiscal expansion on Foreign output are also somewhat weaker relative to the baseline scenario. Yet, these results qualify the widespread view that spillover effects operate exclusively or mostly through the trade balance. As already discussed in relation to the expressions (17) and (18), the level of private expenditure is tightly linked to long- term real rates; that is, it is pinned down by an asset price. Since these rates reflect the entire path of current and anticipated future short- term real rates, they are in turn driven by the dynamics of domestic (producer price) inflation in Home and Foreign (affected by fiscal variables), and by the corresponding adjustment of policy rates by the central banks. In our experiments, anticipations of spending reversals lead private agents to foresee a low domestic inflation and, as the Home monetary stance is consistent with an interest rate feedback rule, a path of low short- term real rates (see Corsetti, Meier, and Müller 2012a for a detailed discussion). This, all else equal, drives down long- term real interest rates, suggesting that spending reversal cause (other things equal) a short- run expansion in demand (the larger it is, the sooner the expected reversal is phased- in). From the vantage point of the Foreign country, the dynamics of Home inflation and Home monetary policy have a direct bearing on the domestic long- term real interest rate. It is through this financial channel that domestic fiscal policies generate sizable international spillover effects. In our experiment, the Foreign long- term rate falls gradually over time, in anticipation of the approaching reversal at Home. This drives the dynamic adjustment of Foreign consumption, which rises in a hump- shaped manner in response to the Home fiscal expansion. This is not to deny that openness and trade matter for the international transmission mechanism. Depending on the trade price elasticity, the Foreign trade balance may improve or worsen in response to a Home fiscal expansion, thus affecting the magnitude of the cross- border effects. But Foreign output and consumption still rise, irrespectively of the sign of the trade balance response. Yet the degree of trade integration also matters for the strength of the financial channel, as trade openness, other things equal, magnifies the role of foreign policy rates for domestic real interest rates (a point emphasized by our analytical derivation of [17] and [18]). In our baseline scenario, for instance, the positive impact spillover on output raises Foreign inflation and thus the Foreign policy rate. Yet consumption increases relative to steady state; this is in line with the anticipated spending reversals in Home—reflected in declining Foreign long- term real interest rates.

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The Policy Framework So far we have discussed simulation results against the background of the VAR evidence, which captures the average effect of government spending innovations over the entire sample period. We have shown that the model predictions align well with the evidence along various dimensions and identified dimensions in which the model fails quantitatively. In doing so, we have also identified channels through which domestic fiscal policy measures are likely to spill over onto other countries. Specifically, the hump- shaped increase of Foreign output in response to a Home fiscal expansion is driven by the dynamics of long- term real interest rates. In our baseline model, however, the specific dynamics of the long- term real rate—especially its decline in response to a fiscal innovation—is the result of modeling a fiscal and monetary policy mix that gives rise to spending reversals and a moderate response to inflation by the Central Bank, according to a standard Taylor rule (see Corsetti, Meier, and Müller 2012a). In the following, we discuss further the role of the policy framework. To start with, figure 7.12 displays the dynamic adjustment to a Home fiscal expansion in our baseline scenario, and under an alternative scenario. For the latter, we assume that government spending follows an exogenous AR(1) process, as is commonly posited in the literature (G = 0). Put differently, we now abstract from a budget policy rule that relates public debt accumulation to both tax and spending adjustment over time.

Fig. 7.12

Effects of government spending shock in Home

Notes: Baseline scenario for trade with EA (lines with circles) versus scenario without spending reversal (lines with black dots). See figure 7.9.

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The difference in the results across the two specifications is quite stark. In the absence of a spending reversal, the Home real exchange rate appreciates and the Home long- term real rates rise (not shown), causing Home consumption to decline (not shown). This leads to a fall in Home imports (not shown), and (although Home exports also fall because of real appreciation), an improvement in the Home trade balance. Relative to the baseline scenario, the medium- term policy mix at Home differs considerably. This impacts—via the financial transmission channel—on Foreign too. In particular, Foreign consumption declines. This is consistent with a rise in the Foreign long- term rate reflecting the current and future fiscal- monetary stance at Home in the absence of a spending reversal. Overall, we note that absent a spending reversal, the model predictions are at odds with the VAR evidence along various dimensions. Most importantly, the output spillovers are negative in this case. It is important to emphasize that spending reversals exert a stimulating effect on global private expenditure only to the extent that their effect on inflation is partly accommodated by the central bank. What matters for fiscal transmission is that anticipated reversals induce expectations of lower real rates in the future (in turn reflecting partial accommodation of their deflationary effects over time, by virtue of the assumed Taylor rule). Via the expectations hypothesis, spending reversals then prevent Home long- term real rates from rising on impact in response to the Home fiscal expansion. A related, important aspect of the transmission mechanism is whether monetary policy is constrained by the zero lower bond (ZLB)—a case that has gained renewed attention in the context of the global financial crisis of 2007– 2009. Christiano, Eichenbaum, and Rebelo (2011) and Woodford (2011), among others, have shown that the government spending multiplier is likely to be considerably larger in an economic environment where monetary policy is unable to maintain its interest target due to a binding constraint on policy rates that prevent it from lowering rates. Under these conditions, monetary policy will accommodate a fiscal expansion. Similarly, using a two- country model, Bodenstein, Erceg, and Guerrieri (2010) show that Home demand shocks (including to government spending) tend to have larger effects on Foreign domestic output, if the Foreign central bank is constrained in adjusting domestic policy rates by the ZLB. Against this background, we also assess the extent to which a binding constraint on policy rates alters our results on the international spillovers of fiscal policy shocks. To do so, we posit that policy rates are fixed, either in the Home country, or in both countries (and only later determined by the interest rate feedback rule). Figure 7.13 shows the results for two alternative specifications relative to our baseline case (lines with circles). In the first specification, we assume that Home policy rates are fixed for eight quarters (lines with crosses). In the second specification, rates are fixed for eight quarters in both countries (lines with diamonds).

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Fig. 7.13

Effects of a government spending shock in the Home country

Notes: The baseline US-EA trade specification (lines with white circles) is compared with specifications in which the policy rate is fixed for eight quarters in the Home country (line with black dots) or in both countries (lines with diamonds). See figure 7.9.

For the first specification, relative to our baseline, we only observe a moderate increase in the effects of a fiscal expansion on domestic output, and only a small increase in international output spillovers. The effects of the constraint on the Home output response are limited here, because the reversal already induces a sizable output effect on impact, as explained before. Importantly, with a reversal, Home policy rates fall relative to steady state before the constraint on the policy rate ceases to bind. We should stress that, if we did not posit spending reversals ψG = 0, the Home output response would more than double. In our specification with spending reversals, nonetheless, cross- border effects are sizable when the constraint on policy rates affects both economies (see also Bodenstein, Erceg, and Guerrieri 2010). The cross- border effects are stronger here, because inflation dynamics would imply that the Foreign policy rate, and hence the real interest rate, rises during the first eight quar-

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ters. With the constraint in place, instead, foreign real rates decline, stimulating Foreign private expenditure and hence Foreign output. International effects on Foreign output resulting from a Home fiscal expansion are thus considerably larger, with a binding constraint on Foreign rates. In conclusion, our analysis shows that standard theoretical models imply cross- border effects of national fiscal policy via a financial channel, with long- term rates driving the level of private demand. This channel encompasses the trade and interest- rate channels emphasized in the traditional literature drawing on the Mundell-Fleming model. Importantly, however, these channels cannot be treated as independent of each other. Also, the analysis emphasizes that what ultimately matters for the transmission of fiscal policy is the entire path of current and future mix of monetary and fiscal policy. Hence, the assessment of spillovers from short- run stimulus or retrenchment measures cannot be disjointed from the dynamics of budget adjustment and monetary reaction markets expect to prevail in response to them. 7.4

Taking Stock: Cooperation in the Aftermath of the Global Crisis

In the previous sections, we have provided time- series evidence suggesting that spillovers of fiscal policy measures on foreign economic activity are nonnegligible. Moreover, we have shown that standard business cycle models can account for this evidence provided they adequately account for a strong “financial channel” in international transmission. A key property of this channel is that anticipation of future policy measures, both monetary and real, are as consequential for the level of current private expenditures as current measures.15 In this section, we explore the implications of our findings for crossborder cooperation. We start by noting that the call for cooperation, and actual measures undertaken in its name, have apparently rarefied as the crisis evolved and policymakers refocused from stimulus to consolidation. This development may appear surprising in light of early statements pointing to large spillover effects (and also in light of our earlier findings). To understand the new phase, however, we need to discuss an additional element that has long been neglected in standard models: the presence of sovereign risk. 7.4.1

Cooperation during Stimulus and Consolidation

The evidence of nonnegligible cross- border spillovers, of the kind provided by our analysis, is an essential prerequisite for international policy cooperation. As already mentioned in the introduction, there is a lively 15. The importance of focusing on the behavior of long- term rates to understand the transmission of fiscal policy, recently clarified by Woodford (2011) in a closed economy context, has shaped much of our work on fiscal policy in open economies.

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debate in policy and academic circles on the impact of domestic fiscal measures and the importance of their international repercussions. Widespread beliefs that fiscal spillovers are large arguably motivated repeated calls for coordinated fiscal expansions in the initial phase of the global crisis, with the objective to ensure a sufficiently high level of global demand vis-à-vis a failing economy. Our evidence supports (or at least does not undermine) these beliefs. In other words, it would appear that the call for coordinated fiscal stimulus as an emergency response to the global slump was far from groundless.16 We should note here that, according to our theoretical analysis, a prerequisite for sizable effects of stimulus measures, both in the domestic economy and via spillovers abroad, is that current measures are partly offset by future spending cuts relative to baseline. The VAR evidence for the United States suggests indeed the presence of such “spending reversals.” Yet, the early emergency fiscal measures in 2008– 2009 were rarely accompanied by a clear indication of the future budget correction required to ensure a stable fiscal outlook.17 In any case, the crisis quickly evolved into a new stage when, under the weight of the accumulated public liabilities, market and political pressures to correct the fiscal trajectory intensified. Especially in Europe, starting in 2010, rising and volatile sovereign risk strengthened the case for immediate consolidation at a time when most economies were not on a sound recovery path, and financial markets remained fragile. 16. Our VAR evidence on spillovers is not conditional on the state of the economy. Yet a key lesson from many recent studies is that the transmission of fiscal policy may actually vary substantially depending on whether the economy is in a boom or in a recession, on the conditions of banking and financial markets, as well as the state of public finances (to be discussed in the next subsection). Namely, it may well be that fiscal policy is quite ineffective in stimulating economic activity under normal circumstances, but becomes quite powerful during downturns, especially when these are associated with financial crises and/or a monetary policy constrained by the zero- lower- bound problem. This insight, firmly grounded in theory, has recently received strong empirical support. In joint work with Meier (Corsetti, Meier, and Müller 2012b), for instance, we have shown that, for a sample of OECD countries, multipliers tend to vary moderately across policy regimes (fixed or flexible exchange rate), but quite strongly across state of the economy. Namely, they are quite large in the presence of a banking and financial crisis, systematically associated with economic downturns. By the same token, results by Auerbach and Gorodnichenko (2012) suggest that the transmission of US fiscal policy is stronger in a recession than in an expansion. An interesting question concerns the size of spillovers in estimates that control for the state of the economy. After we wrote this chapter, drawing on our analysis, Xiao (2012) has carried out a study of spillovers adopting an approach similar to Auerbach and Gorodnichenko (2012) in an international context. What makes such an approach particularly interesting is that the state of the economy (recession or expansion) matters both in the country where the fiscal shock originates, and in the country where the shock is transmitted. According to preliminary results from this exercise, the model documents that spillover effects are larger when countries are both in a recessionary state. 17. The argument was often made that a discussion on these measures would have added to uncertainty in private markets. Of course, at the time private agents may have already anticipated the need for budget corrections via a mix of spending cuts and tax increases at some point in the future (see Corsetti et al. 2010 for further discussion), even if these we not the subject of open policy discussion.

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In this new stage, calls for cooperative stimulus have become less frequent, and more selective and asymmetric. Late calls for cooperative measures have indeed been directed toward surplus countries, pointing to the need for them to delay or reverse their consolidation plans, and use spare fiscal capacity to counteract the negative impact on global demand of early consolidation measures by deficit countries. Consistent with the view that spillovers effects are large, the case for coordinated fiscal stimulus would be as important in the new phase. Yet the new calls have been met with very strong skepticism by domestic policymakers, typically based on a precautionary argument, going as follows: with sharply rising sovereign risk spreads in several countries, no government can consider its public finances beyond doubt; market turmoil justifies an exceptionally high degree of fiscal conservatism. One may thus ask whether this argument effectively marks the end of cross- border fiscal cooperation (at least in the policy discourse). In our view, a positive answer would be premature. But the emergence of sovereign risk crises in Europe, and its threat to the global outlook, redefines the terms of the discussion. In the new phase of the policy response to the crisis, such discussion is meaningful only to the extent that it incorporates sovereign risk. In what follows, we will attempt to outline the consequences of sovereign risk for international fiscal policy cooperation, drawing on related work of ours carried out with André Meier and Keith Kuester. While carried out in a closed economy framework, this analysis shares our current perspective on the financial channel at the heart of the (international) fiscal transmission mechanism. It also highlights the role of constraints on monetary policy, such as the one imposed by the zero lower- bound (or a currency union). Especially in the aftermath of the global crisis, a full appreciation of the transmission of fiscal policy, whether domestic or international, as well as the main issues in international policy coordination, cannot abstract from these key considerations. 7.4.2

Sovereign Risk and Macroeconomic Instability

In this subsection, we briefly highlight how sovereign risk impacts on the macroeconomy in general, according to recent theoretical work on stabilization policy. The starting point is the substantive evidence that sovereign and private sector spreads move together, especially in countries that face fiscal strain. Not only can such a pattern be observed for financial institutions (which are directly or indirectly exposed to sovereign default via the composition of their portfolios) and for small (nonfinancial) firms that rely on local bank financing. It can also be documented for large international corporations with direct access to the bond markets, which in principle should be able to insulate their financing conditions from the country- specific problems. In Corsetti et al. (2013), we argue that a key consequence of rising interest- rate spreads on government borrowing is their spillover to the rest of the economy. That is, sovereign risk causes the borrowing conditions in

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the private sector to deteriorate. Based on this insight, we show that these sovereign- risk spillovers constitute a distinct channel, which we dub the “sovereign- risk channel,” through which fiscal policy may have profound consequences for macroeconomic stability. To appreciate how the sovereign risk channel works, consider the possibility that for a given monetary policy stance, aggregate demand falls with an increase in sovereign risk because private spreads and borrowing costs correspondingly rise.18 As such, first the sovereign risk channel tends to exacerbate the severity of recessions, especially when these are large. A slowdown in economic activity will translate into a marked deterioration of the government budget and, holding the monetary stance constant, rising borrowing costs for the public and the private sector will magnify the negative consequences of the initial recessionary impulse. On the upside, one could point out that budget corrections are likely to be less contractionary under these circumstances. In other words, the multiplier effects of spending cuts are smaller, if these are associated with a reduction of the sovereign risk spread and thus of private borrowing costs.19 Second, sovereign risk can become a severe source of macroeconomic instability. Suppose that private expectations about the economy turn gloomier for some (nonfundamental) reason; firms and households expect demand to fall. Holding interest rates fixed, such expectations, in turn, imply an upward revision of the projected government deficit, as weaker economic activity leads to lower tax revenue and primary surpluses. Investors thus immediately ask for a higher risk premium on public debt. Via the sovereign risk channel, however, the cost of private borrowing rises as well. The logic comes full circle as higher credit costs slow down activity, validating the initial adverse shift in expectations. This implication of sovereign risk needs not be particularly damaging for the economy, if monetary policy has sufficient room for maneuver. Namely, in tranquil times, a scenario of a self- fulfilling crisis could arguably be averted by the central bank. The central bank can in fact stem the link between public and private credit conditions through interest- rate cuts or other measures, preventing pessimistic expectations from coming true. In crisis times, however, monetary policy may become increasingly constrained. When interest rates are already closed to zero, and nonstandard measures may be only moderately effective, the central bank may not be able to prevent expectations- driven downturns. 18. In Corsetti et al. (2013), we formalize this idea by building on the model suggested by Cúrdia and Woodford (2009), which allows us to consider the sovereign risk channel within a variant of the canonical New Keynesian model. 19. However, according to our analysis, the overall response to fiscal policy measures is very sensitive to the strength of the spillover effect from public to private spreads and private expectations about the prospective length of the recession. It turns out that, with policy rates at the zero lower bound, small revisions in the anticipated duration of a recession, or small changes in the transmission of financial turmoil from the bond markets to banks and ultimately to borrowers, may fundamentally alter the government spending multiplier, possibly even turning its sign.

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Under these circumstances, we find that many of the standard prescriptions of fiscal policy no longer apply in the presence of severe sovereign risk. For instance, with policy rates at the zero lower bound and a deteriorated fiscal outlook, announcing countercyclical fiscal policy may be counterproductive, because anticipation of expansionary fiscal policy raises the risk of macroeconomic instability. Ex ante, desirable effects of stimulus measures are to be weighted against the possibility of macroeconomic instability—unless the government is able to match the stimulus by committing immediately and credibly to medium- term consolidation measures, stemming sovereign risk at its roots. On the other hand, announcing procyclical spending cuts motivated by keeping sovereign risk under control may not be sufficient to prevent instability. The problem is especially acute when the recession is expected to be long- lasting. 7.4.3

New Challenges to International Cooperation

Sovereign risk has a direct bearing on international fiscal coordination in the context of the ongoing global recession where risk premia at country level have become quite volatile in response to losses of credibility in fiscal policies. First, countries currently paying very low rates on their bonds are wary that further stimulus may have uncertain effects on the economy, as it may turn market sentiments around very quickly. The threat of rising spreads and hence macroeconomic instability of the kind analyzed in the previous subsection justifies to some extent extremely conservative fiscal attitudes. Second, all economies are increasingly likely to be exposed to sizable negative impulses, as market turmoil may at times force governments to resort to emergency consolidation measures or, more importantly, result in negative growth- debt spirals. This consideration also strengthens the case for a precautionary attitude in fiscal policy. Sovereign risk, in light of its adverse consequences for the economy, thus appears to be a priority concern for the design of coordinated policies. For once, there is large consensus on the need to restore policy credibility in deficit countries as a first step in achieving a sustained global recovery. At the same time, the scope for coordinated fiscal expansions by surplus countries is quite limited, because of the considerations noted earlier. In the most benign scenario, deficit countries can rely on moderate stimulus measures abroad, while implementing fiscal retrenchment and debt stabilization policies. This is a problematic scenario at the global level, but especially damaging within the euro area, in which interest differentials on sovereign debt have become comparable with the pre- euro era, when most of the risk was attributed to currency instability. There are several reasons why cooperative agreements on this matter are particularly difficult to reach among countries sharing the common currency. On the one hand, surplus countries in the euro area appear to be reluctant to engage on the ground that any help would do nothing but reduce the incentives for deficit countries to correct their imbalances. According to a widely held view in this respect, for this

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reason even financial assistance purely targeted to stem off a self- fulfilling run easily translates into a net transfer of resources to debtor countries. On the other hand, deficit countries emphasize that risk premia are strongly correlated across borders. This correlation blurs the relationship between painful domestic measures to stabilize debt and/or reform the economy and the market assessment of default risk. As a result, the argument goes, it is the lack of financial assistance, rather than liquidity support, that discourages strong domestic initiatives in deficit countries. Despite the political challenge to break the deadlock created by these diverging positions, in our reading, the current outlook strengthens the rationale for cooperation. It stands to reason that, in a deep crisis, sheltering countries from self- fulfilling runs, while at the same time setting clear conditionality to prevent waste of international resources, would enhance, rather than reduce, the economic and political gains from budget and economic reforms in the deficit countries (see Corsetti, Guimaraes, and Roubini 2006; Morris and Shin 2006; and Corsetti and Dedola 2011). However, liquidity assistance is likely to work only if matched by thorough budget corrections and sensible domestic policies. Provided that cross- border spillovers are sizable, both groups can only gain from reducing the threat to expectationsdriven downturns, which looms large in the presence of the sovereign risk channel. 7.5

Conclusion

The case for fiscal coordination rests on evidence of significant crossborder macroeconomic effects of fiscal measures. In this chapter we have provided novel evidence on this matter, which is broadly in line with widespread priors among policymakers. Focusing on the United States as a base country, our VAR estimates suggest that unexpected fiscal expansions have a large impact on economic activity in the UK and the euro area. These results are robust to alternative identification approaches. Yet, against the equally widespread view that the transmission operates via a trade (external demand) channel, we find evidence that the transmission operates, instead, via a financial channel, which determines the expenditure/saving allocation. We have shown that a standard international business cycle model lends support to this interpretation. We thus provide a new perspective on fiscal spillovers that is potentially consequential for policy coordination. A key role played by the financial channel implies that the impact of short- run fiscal measures on current expenditure crucially depends on expectations of fiscal and monetary adjustment over the medium- and long- run. Long- term bond prices reflect these expectations. It follows that the assessment and design of cooperative policies should not only focus on short- term measures but needs to recognize the importance of providing forward guidance to markets. In fact, coor-

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dination on systematic (policy or budget) rules may be at least as important as coordination of specific measures in response to shocks. In light of these results, in the last part of the chapter we have sketched an analysis of international spillovers and challenges to policy coordination in a context of imperfect credibility. In this context, high sovereign risk premia put pressure on governments to implement strong budget consolidation measures. With markets pricing sovereign default, spillover effects on private borrowing costs profoundly alter the transmission mechanism. Not only do they undermine many of the basic prescriptions of stabilization policy derived from the standard model, they also expose the economy to the risk of downturns driven by self- fulfilling expectations. In this context, the case for international policy cooperation as a necessary step to reduce the risk of a sharp deepening of the ongoing recession becomes even stronger.

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Comment

Domenico Siniscalco

The chapter by Corsetti and Müller provides interesting evidence on the international spillovers of fiscal policy. The analysis is based on the literature on fiscal multipliers and it aims to measure the transmission of discretionary fiscal policy from one large “base country” (the United States) to other important regions (the UK and the eurozone). By comparing VAR models Domenico Siniscalco is vice chairman and head of government coverage EMEA at Morgan Stanley. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12594.ack.

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with simulations of a business cycle model, the chapter reaches three related conclusions: 1. The internal and cross- border effects of fiscal policy can be sizable, with cross- border multipliers ranging from 0.5 to 1. 2. Internal and cross- border effects, or spillovers, are not “mechanical,” but depend on the expectations of fiscal and monetary adjustment in the longer run. 3. Long- term bond prices reflect such expectations about the adjustment after the stimulus. As a consequence, a discretionary fiscal stimulus in a big country can work on a global scale; the transmission mechanism is not only based on foreign demand and trade, but also on the financial channel just described. In particular, if governments lack credibility, the fiscal adjustment must overshoot to ensure the desired outcome. The main results of the chapter, in my view, have both theoretical and policy implications. On the theoretical ground, the existence of international spillovers of fiscal policy calls for an international coordination of policies, which rests on the interdependence among countries and takes into account real as well as financial transmission channels. Such coordination should take place among global macro regions (as in the example provided by the authors), as well as within integrated currency areas such as the eurozone. As the game theoretic literature on coalition formation shows, the scope for cooperation among countries is bigger when the interdependence is higher (Ray 2007). And this is the case in the presence of monetary as well as nonmonetary externalities. The argument, of course, works in the case of a fiscal stimulus, and even more in the opposite case of fiscal austerity. Within this framework, the existence of the cross- border effects of fiscal policy impacts the slope of the reaction functions among players (countries) and hence the gains from cooperation. On the policy grounds, by highlighting the financial transmission channel of fiscal policy, the chapter provides a framework to discuss recent developments. For example: 1. The cross- border effects of public investment and public spending plans by some emerging markets. 2. The persistent high- risk premia in sovereign bond markets, and the need for super- austerity programs to correct them, in countries that traditionally lack in fiscal discipline, as a way to restore credibility and ensure a more efficient working of fiscal policy. 3. The rationale for controlling national adjustment programs within the eurozone (the so-called “fiscal union”). As usual in the literature on fiscal multipliers, one can discuss the empirical robustness of the main numerical results. And the chapter could be pol-

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ished in some theoretical features. But overall, Corsetti and Müller provide a fruitful framework to think about the fiscal policy response to the current crisis in an interdependent global economy. As Martin Feldstein observes, the arguments presented by Corsetti and Muller should definitely be part of technical background materials for G20-like meetings, and I add Ecofin and eurozone meetings as well. The discussion in global as well as European policy forums, in fact, mostly rests on the idea of interdependence among countries, but the channels of transmission of shocks and adjustment are not always clear. Reference Ray, Debraj. 2007. A Game Theoretic Perspective on Coalition Formation. The Lipsey Lectures. New York: Oxford University Press.

Comment

Martin Feldstein

Although the wider issue of fiscal, monetary, and banking coordination lies beyond the scope of this chapter, the arguments and findings presented here should definitely be a part of technical background materials for G20-like meetings in the future. Specifically, how fiscal changes in country A affect output in country B is an issue of utmost importance for policy coordination. In my discussion, I would like to emphasize that government spending on goods and services is only a part of total government expenditure. This is especially so in the American case, where social transfers such as health- care expenditure and transfers to states make up most of government spending. Nevertheless, the findings borne out from the VAR analysis presented in the chapter are definitely interesting, and I shall discuss them in five points. First, I must point out that the authors have made a very brave effort in entering the fiscal multiplier debate, which is one of the most controversial topics among macroeconomists. Upper bounds for the fiscal multiplier estimate tend to be around 0.5, or in other words: an increase in government spending by 1 dollar is expected to raise output by 50 cents at most. Considering the fact that imports to the United States only make up 15 percent of GDP and only a part of these imports originate from the UK and the eurozone, the cross- national impact is likely to be limited. This expectation, which is my second point, is in stark contrast to the empirical findings of the chapter. These findings reveal a comparable crossMartin Feldstein is the George F. Baker Professor of Economics at Harvard University and president emeritus of the National Bureau of Economic Research. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12595.ack.

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national multiplier to what the upper bounds of the domestic multipliers are estimated to be. We must ask ourselves how this could be. That brings me to my third point, which is where I believe the answer mostly lies. As already mentioned, government spending on goods and services is only a part of overall fiscal measures (transfer payments, tax cuts, etc.) and they are likely to be correlated. To illustrate this point, one needs to look at the current job bill by the Obama administration, which amounts to 450 billion dollars. However, very little of that actually falls within the measure that the authors use. Meanwhile, the Fed is considering a new wave of monetary stimulus, further adding to domestic demand. Consequently, the estimates of around 200– 250 billion dollars that these multipliers predict greatly overstate the actual stimulus brought about by just spending on goods and services. In other words, the omission of certain fiscal items and the correlation with monetary policy measures artificially bias the estimate of the multiplier. Fourth, the time period under study deserves a remark. The years between 1980 and 2007 have not exactly been the high point for discretionary fiscal policy. Until the 1970s we used to practice activist fiscal policy, best epitomized by Nixon’s remark: “we are all Keynesians now.” Later on, mostly due to long lags of fiscal measures, activist fiscal policy was discredited. Monetary policy came to the forefront with the severe recession and the subsequent recovery engineered by the Fed under Volcker. During the Greenspan years, the Fed remained the protagonist in macroeconomic management by running monetary policy under a Taylor rule. Discretionary fiscal policy was largely off the table, which makes me skeptical about where the authors’ measures are coming from. Short of looking at actual Congressional Budget Office documents, like Romer and Romer did, and relying on pure statistical techniques, such as the one devised by Blanchard, I suspect that the measures will be strongly correlated with monetary policy measures, again overstating the importance of fiscal policy. Fifth and finally, the chapter makes very specific assumptions on agents’ behavior by postulating that they anticipate the automatic reductions of fiscal measures in the future. However, a large part of where fiscal changes are coming from in the future is through legislated policies today. Stopping short of incorporating these measures’ future impact on spending and taxes, the model thus assumes that only part of future changes will come to be anticipated.

8 The International Monetary System Living with Asymmetry Maurice Obstfeld

The global economic crisis of 2007– 2009 generated calls to rethink the international monetary system, and indeed, the entire institutional framework within which international financial integration has advanced since the fall of the Bretton Woods regime four decades ago. Gaps in national and international structures of financial regulation were an obvious factor in causing the most severe global crisis since the Great Depression; another chapter of this book addresses that topic. Interactions between national macroeconomic policies also played a role, however, and have continued to generate rancor between countries as a geographically uneven recovery from the crisis has unfolded. The crisis and its aftermath exposed stresses in the world’s monetary system, stresses that are still felt.1 This chapter analyzes current stresses in the two critical areas that concerned the architects of the original Bretton Woods system: international liquidity and exchange- rate management.2 Despite radical changes since Maurice Obstfeld is the Class of 1958 Professor of Economics at the University of California, Berkeley, and a research associate of the National Bureau of Economic Research. Vladimir Asriyan provided expert research assistance. The International Growth Centre (London School of Economics) and the Center for Equitable Growth (UC Berkeley) provided essential financial support. I am grateful for comments from participants at the Bank of England/NBER conference, especially my discussants, Takatoshi Ito and Adam Posen. I also benefited from comments at an International Monetary Fund seminar in July 2012. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12596.ack. 1. The crisis brought home vividly the strong two- way interaction between macroeconomic policies and financial- sector stability, demonstrating the adverse consequences of viewing macro and prudential policy as somehow orthogonal to each other. While my discussion thus will focus on macroeconomic policies, I will inevitably touch upon financial- stability considerations at several points. 2. In the present context, the relevant concept of “liquidity” includes both market and funding liquidity, in the sense of Brunnermeier and Pedersen (2009). For illuminating discussions

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World War II in the market context for liquidity and exchange- rate concerns, they remain central to discussions of international macroeconomic policy coordination. To take two prominent examples of specific (and related) coordination problems, liquidity issues are paramount in strategies of national self- insurance through foreign reserve accumulation, while recent attempts by emerging market economies (EMEs) to limit real currency appreciation have relied heavily on nominal exchange- rate management. A key message—an obvious point, but one that nonetheless is a basic starting place for predicting a range of tensions in any system of international monetary arrangements—is that a diverse set of potential asymmetries among sovereign member states provides fertile ground for a variety of coordination failures. Despite the progress of technology, financial innovation, globalization, and development, sharp international asymmetries remain and thus coordination failures with recognizable analogs in earlier historical eras have emerged. Previous efforts at international monetary reform attempted to reconcile individual nations’ demands for domestic economic stability with a smooth international adjustment mechanism. Those attempts had limited success and even the most ambitious and successful of them—the Bretton Woods system—crumbled after a quarter century under the weight of its internal contradictions. The recent global crisis has highlighted the twentyfirst- century incarnations of a range of time- honored systemic strains. Some of the problems have become more severe, or problematic in new ways. The resulting pressures on international economic relations define the current reform agenda. The plan of this chapter is as follows. Section 8.1 sets out some dilemmas, old and new, relating to the supply of international liquidity in settings where the demand for safe foreign exchange reserves grows faster than the supply over the long term. The discussion emphasizes the fiscal dimension of such “Triffin dilemmas.” Section 8.2 describes how financial globalization has increased countries’ needs for international liquidity, and sketches a structure for liquidity provision that would avoid negative externalities inherent in self- insurance through large- scale reserve accumulation. Section 8.3 turns to exchange rates and global imbalances, with emphasis on modern versions of older coordination problems. Section 8.4 concludes. 8.1

International Liquidity and Triffin Dilemmas

Like households and firms, governments need access to liquidity—readily salable assets (including cash, of course) that may be spent on goods or (particularly in crisis situations) on other assets. In a closed economy, the of international coordination problems as seen from the perspective of the IMF’s founding, look at Metzler, Triffin, and Haberler (1947).

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government (through its central bank) is always capable, in principle, of providing for all liquidity needs. In the open economy this is no longer the case. When the need is for a foreign currency, which the central bank cannot print, gross holdings (reserves) and available foreign- currency credits constrain the government’s powers, whether to provide liquidity to markets (as in a foreign exchange intervention) or directly to market actors (as in an emergency loan to a bank). Throughout history, international reserves have been an important source of liquidity. What properties characterize an attractive international reserve asset? In the broadest terms, the asset should be widely acceptable as payment at a predictable value, even when liquidated without notice. But in what numeraire should value be measured? Merely asking the question reveals that “predictability of value” cannot be an absolute norm, unless the numeraire is a particular money—such as the international vehicle currency, which the American dollar overwhelmingly remains—or a particular commodity such as gold. In a world of significant departures from purchasing power parity (PPP), maintenance of real value (in terms of a comprehensive consumption basket) necessarily depends on the beholder. In a global economy, moreover, it may be more relevant to refer to “liquidities” than “liquidity.” If several currencies are widely used internationally as media of exchange and/or units of account, then it may well be desirable for a country to hold liquidity in all of those currencies, regardless of moderate changes in their relative values—a theme I explore further in the following. Changes in value can arise in different ways (again depending on the numeraire against which value is reckoned). Exchange rate and inflation risk are obvious possibilities, but so are default risk, sovereign or private, and political risk. Foreign- currency US bonds issued by the Carter administration inherited the minimal (at the time) default risk of conventional dollar- denominated Treasury obligations. On the other hand, liquid dollar liabilities of London eurobanks (typically counted in reserve measures if owned by monetary authorities) carry counterparty risk (absent an official bailout) but not currency risk vis-à-vis the dollar. Again, safety is in the eye of the beholder. Countries experiencing or anticipating political tensions with the United States—think of cases involving Iran, Iraq, Russia, Libya, or Syria—might prefer the counterparty risk intrinsic to a lightly regulated offshore center to the risk of a retaliatory freeze on assets held in the United States.3 In the early post–World War II economy, with global capital markets dormant and much of the industrial world in ruins, the main forms of interna3. The possibility of holding dollar reserves in banks outside the United States shows that it is not necessarily correct to assert that US balance of payments deficits govern the growth rate of world dollar reserves. Of course, liquidation of such offshore reserves by the non-US holder will ultimately have the same effect on the US balance of payments, as if the reserve assets liquidated were themselves held in the United States.

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tional liquidity were gross holdings of gold and US dollars (and, to a lesser extent, sterling). Eichengreen (2011) paints a vivid picture of this period of virtually unrivaled dollar dominance as a reserve asset in the 1950s. That dominance persisted through the demise of the Bretton Woods system in the early 1970s (and indeed far beyond), but not without increasing tensions. Those tensions arose from one of a class of problems to which any reserve- asset system is potentially susceptible: what may be called a Triffin dilemma. A Triffin dilemma arises any time increasing demand for a reserve asset strains the ability of the issuer to supply sufficient amounts while still credibly guaranteeing or stabilizing the asset’s value in terms of an acceptable numeraire. 8.1.1

The Classic Triffin Dilemma: It’s Mostly Fiscal

Under the Bretton Woods arrangements, countries pegged their currencies to the US dollar, while the US Treasury continued a long- standing commitment (dating from January 31, 1934) to convert dollars held by non-US central banks and governments into gold “for legitimate monetary purposes” at a price of $35 per ounce.4 While the Treasury guarantee of the dollar- gold link reassured foreign official dollar holders that their reserves were “as good as gold,” it also led to at least two potential inconsistencies. The first inconsistency was familiar from the classical gold standard. If world output growth outpaced world gold production, the relative price of gold would likely have to rise, implying secular deflation assuming a fixed market gold price of $35 per ounce. Countries outside the United States could maintain their internal price levels by devaluing against the dollar, but the United States itself did not have this option. For a time in the 1950s and 1960s, various fortuitous developments held off the deflationary threat; for example, the development of new South African mining capacity, along with Russian gold sales (which ended in 1966). Eventually, though, the conundrum was resolved in March 1968 through the two- tier gold market, which allowed the nonofficial gold price to float. It was then that the US currency, and currencies pegged to it, became fiat monies.5 The second inconsistency persisted even after the start of the two- tier market. The official tier (by design) left intact the US obligation to redeem foreign dollar reserves for gold at the old official price. Once again, however, 4. This commitment followed from the Gold Reserve Act of January 30, 1934 (Yeager 1976, 352). The Act also gave licensed users in industry and the arts the right to buy gold at the official price. (The Treasury added a 1/4 percent transaction fee to the official price, and applied an identical discount to its gold purchases.) 5. This stratagem did not, by itself, resolve the (more serious) problem that the dollar itself could be devalued only through a concerted revaluation of foreign currencies (as occurred in August 1971, when the United States coincidentally suspended gold sales to foreign monetary authorities). One solution suggested for the Triffin problem before the gold window was closed was to raise the official dollar price of gold. Apart from other drawbacks, a gold- price change would not automatically have devalued the dollar against other currencies.

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world output growth, and the concomitant growth in world dollar reserves, seemed likely to outpace world gold production. Were the US Treasury to maintain a $35 buying price for an ounce of gold, therefore, US monetary gold stocks could not possibly increase. As famously observed by Triffin (1960), the United States eventually would not have enough gold to redeem all the official dollar reserves at par, even if it used up the entirety of its holdings. The reserve currency issuer would become vulnerable to a run by central banks. The problem might have been manageable had countries not expected their own currencies to appreciate against the dollar—it may be easier for a central bank to forgo a gain than to take a loss—but by the late 1960s the feeling was growing that the dollar would need to be realigned downward, as eventually happened in the August 1971 Smithsonian Accord. Figure 8.1 illustrates the trends. In 1948, the United States held most of the world’s gold reserves. Through 1960, US gold stocks shrank but remained above the growing stock of dollar foreign reserves. And then the lines cross, seemingly making the United States vulnerable to a Triffinesque run. (That event was marked by speculation in the London gold market, causing the formation of the gold pool; see Eichengreen 2011.) The preceding trends continued as world monetary gold stocks failed to keep pace with growing global foreign exchange reserves. Figure 8.2 shows that in 1966— the year that Russian gold sales ceased (Cooper 1969, 580)—world gold production leveled off. In retrospect, the abandonment of the single- tier gold market soon thereafter is not surprising. World dollar reserves began

Fig. 8.1 Gold reserves and nongold reserves held by non-US governments (billions of USD) Source: IMF, International Financial Statistics

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Value of world gold production and dollar gold price

Sources: US Geological Survey and Global Financial Data.

a steep upward ascent in 1970 as heavy speculation against the dollar set in. To defend the dollar parities of stronger currencies such as the deutsche mark and Swiss franc, the issuing central banks undertook massive dollar purchases. Global dollar reserves exploded—without reducing US reserves, absent gold redemptions. On the surface, Triffin’s point seems obvious. But deeper reflection suggests that the classic form of the Triffin dilemma was really a fiscal problem. After all, why couldn’t the US government have purchased more gold on the market, if need be, to pay off foreign central banks? And what strain on the US fiscal position would have resulted? At the end of 1970, the year before US President Richard Nixon suspended official gold convertibility (August 1971), US gold reserves stood at $11 billion dollars, while world nongold reserves outside the United States stood at $53 billion, leaving the United States with $42 billion in potential official claims that it could not cover with its existing gold holdings. The sum of $42 billion, however, amounted to 4.2 percent of that year’s GDP, at a time when the gross US federal debt stood at 28 percent of GDP—a large, but not insuperable, fiscal cost (especially by today’s standards). The preceding calculation, however, assumes that the Treasury could have purchased the gold it needed in the world market at $35 per ounce. But this is surely not the case. World gold production in 1970 (at the $35 price) amounted to $1.8 billion, whereas total world monetary gold stocks outside the United States were $29 billion. The sum of the new flow and the existing

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stock, roughly $31 billion, falls far short of what the United States needed to cover its total $53 billion obligation (an obligation that exploded in the succeeding years). Even if the US Treasury had been able to purchase all the world’s monetary gold and all current production without bidding up the world price—an impossibility—it still would have been $11 billion short. It is clearly unlikely that the Treasury would have been able to buy all the necessary gold at any finite price. Any Treasury attempt to buy gold in private markets on any substantial scale would likely have resulted in a gold price so high as to make the resulting fiscal burden unbearable. This potential fiscal insolvency was the key danger inherent in the Triffin problem. As figure 8.1 shows, of course, the problem became even worse after 1970 as speculative switches out of dollars into foreign currencies accelerated, and as even some central banks exchanged dollars for US gold. The result was the Nixon–Connally policy package of August 1971, leading directly to the Smithsonian realignments in December 1971. 8.1.2

The Modern Triffin Dilemma

After the industrial countries moved to flexible exchange rates in 1973, world reserve growth, surprisingly at the time, continued. Global nongold reserves have expanded (in nominal dollar terms) in all but three of the years after 1971. Starting in 2002, and powered by the demand and growth of emerging economies, global reserves have grown at double- digit rates in every year but one (2008, when the yearly growth rate was 9.7 percent). But between 1972 and 1980, global reserves likewise grew at double- digit rates in all but one year. Motivations for this continuing global demand for international liquidity have been widely discussed in the academic literature. As I take up in the next section, one can make a strong case that the evolution of world capital markets over recent decades has made the potential need for swift and perhaps massive key currency liquidity support—whether from reserves or some other source—much more pressing today than it was even in the days of generalized fixed exchange rates. Nor has the basic Triffin paradox disappeared. The emergence of a modern species of Triffin dilemma has been diagnosed most clearly by Farhi, Gourinchas, and Rey (2011). It is a subtler problem than the Bretton Woods version, because there is no longer a reserve- center promise to redeem liabilities at a fixed price in terms of some scarce numeraire. It is a Triffin problem nonetheless because the underlying asymmetric dynamics of global growth guarantee that eventually, the reserve system will become unsustainable. Moreover, the problem remains even in a multipolar world with several reserve currencies.6 The problem is not simply that, under floating exchange rates, reserves are 6. The general problem had already been discerned by some policymakers in connection with the internationalization of the deutsche mark and yen (see Henning 1994, 317).

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subject to depreciation risk: reserve holders have proved willing to tolerate exchange- rate fluctuations, provided there is not a continuing trend of sudden depreciations. Thus, for example, foreign accumulation of dollar reserve claims on the United States does not inherently require large US current account deficits, which might predict significant future dollar devaluation. Dollar reserve growth may be primarily a result of gross capital outflows from the United States, as was true during the mid- 1960s (when the United States had a sizable trade surplus with trading partners and was still a net foreign creditor). The modern- day Triffin problem resides instead in the nature of the securities central banks hold as reserves. A key feature of a reserve asset is that it is liquid and predictable in value. True, exchange- rate fluctuations are not predictable, but for a country experiencing a localized crisis, any movement of the domestic currency against major foreign reserve currencies is likely to be downward. And the dollar, at least, has shown a safe- haven tendency to appreciate in global crises, which helps explain its attractiveness as a reserve asset (Gourinchas, Rey, and Govillot 2010).7 Thus, central banks have gravitated toward the government liabilities of highly creditworthy countries—or other assets, such as US agency securities, believed likely to come under the protection of a government guarantee. Such assets could include certain liabilities of systemically important financial institutions in the creditworthy advanced countries. So global reserve growth requires the ongoing issuance of gross government debt. This requires, in turn, that the government run continuing deficits, or that it issue debt to acquire assets likely to be inherently riskier than the corresponding liabilities. Just as in the classic Triffin dilemma, global reserve growth is largely driven by deficits—not national balance of payments deficits, but government deficits.8 7. For alternative models of the dollar’s international role, see Canzoneri et al. (2010) and Maggiori (2011). 8. An analogous problem confronted Federal Reserve policymakers in 2000 and 2001 as they contemplated the possibility of a disappearing US federal debt. As Greenspan (2007, 214) puts it: My colleagues at the FOMC [Federal Open Market Committee] seemed a bit disoriented too. In our late-January meeting, we spent hours trying to imagine how the Fed would operate in a brave new world of minimal federal debt. Of course, shedding the debt burden would be a happy development for our country, but it would nevertheless pose a big dilemma for the Fed. Our primary lever of monetary policy was buying and selling treasury securities—Uncle Sam’s IOUs. But as the debt was paid down, those securities would grow scarce, leaving the Fed in need of a new set of assets to effect monetary policy. For nearly a year, senior Fed economists and traders had been exploring the issue of what other assets we might buy and sell. A result was a dense 380-page study that plopped on our desks in January [of 2001]. The good news was that we weren’t going out of business; the bad news was that nothing could really match the treasuries market in size, liquidity, and freedom from risk. To conduct monetary policy, the report concluded, the Fed would have to learn to manage a complex portfolio of municipal bonds, bonds issued by foreign governments, mortgage- backed secu-

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Output shares of advanced and emerging/developing economies (at PPP)

Source: IMF, World Economic Outlook (WEO) database (September 2011).

The additional dynamic element driving the modern- day dilemma is based on two asymmetries. First, the emerging and developing world is growing more quickly than the more creditworthy industrial world. As figure 8.3 shows, in 2009 the total GDP of the emerging and developing world (measured at PPP, and including newly- industrialized Asia) overtook that of the advanced economies, and the International Monetary Fund (IMF) predicts that the advanced economies will fall farther behind over time. The second asymmetry is that the main advanced countries remain more creditworthy on average than the poorer countries. The traditionally rich countries have been able to borrow more easily on world capital markets, and have therefore had less need for international reserves than countries that are much more vulnerable to sudden stops.9 Furthermore, they are less prone to undertake foreign exchange intervention, and have less capacity to sterilize. Together, these asymmetries imply that that the demand for rich- country government

rities, auctioned discount- window credits, and other debt instruments. It was a daunting prospect. “I feel kind of like Alice in Wonderland,” Cathy Minehan, the president of the Federal Reserve Bank of Boston, had said when the issue first came up, and we all knew what she meant. The very fact of the discussion showed how profoundly and rapidly we thought the economic landscape might change. Alas, “the economic landscape” did “profoundly and rapidly” change, but in a way that produced the worst of both worlds: huge US deficits and debt, coupled with big holdings of exotic securities on the Fed’s balance sheet. 9. Of course, recent sovereign debt problems in some of the richer countries show the strains on even advanced- country public finances following the 2007– 2009 crisis.

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Global nongold reserves compared with gross general government debt

Sources: IFS; IMF, International Financial Statistics.

debt is likely to outstrip what can be supplied in the way of safe government debt without bringing the safety of that debt into question. Figure 8.4 gives a rough indication of the trend to date. How will the demand for reserves be satisfied if the richer countries actually succeed in the fiscal consolidation to which they currently aspire?10 A number of developments could head off this unstable dynamic, but might not come into effect soon enough. First, countries’ demand for reserves might level off, with some national wealth shunted into sovereign wealth funds willing to invest in riskier assets. To the extent that reserve demand is driven by the size of the financial system and the latter’s growth rate is high, however, strong reserve growth is likely to continue. Second, growth could decelerate in the emerging and developing world or accelerate in the currently rich countries. That development seems unlikely in view of the fiscal and other burdens that currently afflict much of the industrial world. Finally, some major and swiftly growing emerging markets could graduate in terms of their creditworthiness, reducing their demand for reserves and, potentially, making them suppliers of reserve assets. China (currently lacking a fully convertible currency) is the most likely candidate, but this very 10. Figure 8.4 graphs general gross government debt in the United States and euro area against world nongold reserves. General government debt overstates the debt available for reserve growth, since central government debt is preferred. In addition, much eurozone central government debt would be viewed as riskier than, say, German debt lately, and therefore not ideal for reserve holders.

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observation highlights the significant obstacles to such a development. Thus, the new incarnation of the Triffin dilemma is likely to bedevil the current system of international liquidity provision for some time, absent reforms. Danger signs are already appearing. As the sovereign debts of richer countries have come under pressure, it is no surprise to see the central banks of emerging economies increasing their gold purchases. The same dearth of safe assets is crippling private credit markets through a collateral shortage. The problem is still mostly fiscal. But then, so are the broader questions concerning the adequacy of international liquidity in a world without a true outside reserve asset such as gold. I now turn to those questions. 8.2

Reforming the Liquidity System

The demise of generalized fixed exchange rates in 1973 allowed a solution to the open- economy macroeconomic trilemma based on flexible exchange rates, domestic monetary autonomy, and financial- account liberalization (Obstfeld and Taylor 2004). The process started in the 1970s in the industrial countries. With a lag, and with considerable individual heterogeneity, the emerging market economies have started to follow down this path. Domestic financial liberalization has gone hand in hand with the process of external opening, with strong channels of two- way causation driving the overall freeing of finance, domestic and international alike. How and whether this process will continue in light of the recent global crisis are major open questions. The main trend raising the level of financial fragility in the world economy, and thereby liquidity needs, has been financial globalization, which has brought with it a rapid expansion of both gross international asset positions and the balance sheets of financial intermediaries worldwide. The latter expansion has been driven by a range of factors, including expanded risksharing, financial deepening, and, less benignly, regulatory and tax arbitrage. At a point in time, a country’s net international investment position defines the gap that intertemporal solvency dictates between the present values of expenditure and income. But it is the nature of a country’s gross positions that determines its vulnerability to financial crisis—just as is the case for individual economic actors. Moreover, given the current magnitude of gross external asset and liability positions, asymmetric valuation changes can easily imply changes in net assets that overwhelm the smaller flow increments due to the current account balance. Figure 8.5 illustrates the trend in gross external assets for selected countries, plotting the ratio (Assets + Liabilities)/GDP through 2007 (with data from the update of Lane and Milesi-Ferretti 2007). Particularly for relatively open industrial countries that are also financial centers, the multiplication of gross external positions has been extreme. In such cases, a current account deficit may be a consequence of financial excess, being associated with a domestic credit boom, but it is not itself the prime locus of financial vulner-

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Gross external positions as a multiple of GDP, 1970–2007

Source: Lane and Milesi-Ferretti (2007), updated data.

ability. The main threat is that of a balance-sheet crisis. Thus, while Ireland had an external deficit in the run-up to the crisis, banks in surplus countries like Switzerland and Germany landed in trouble—dragging their governments along with them—because of toxic foreign assets on their balance sheets. Figure 8.6 shows that for emerging and developing countries, gross acquisitions of claims on advanced countries, whether as reserves or as nonreserve (mainly private- sector) claims, far exceed the net current account balance, a reflection of copious gross inflows from the industrial world. These gross flows from poorer to richer economies have been cumulating to economically significant shares of industrial country GDP: in 2007 alone, this annual gross inflow to advanced countries amounted to 6 percent of that group’s GDP. The rapid GDP growth of the poorer countries is not matched by a commensurate importance in world financial markets, but the latter is certainly growing, and doing so relative to the shrinking relative scale of the advanced economies.11 Through their growing gross asset positions, emerging and develop11. The figure understates the trend, because the IMF definition of “advanced economies” includes Taiwan, Hong Kong, Korea, and Singapore. This labeling both reduces the IMF’s measures of emerging and developing country financial flows, and inflates its measure of advanced country GDP.

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Fig. 8.6 Gross asset accumulation and current accounts of emerging and developing countries Source: IMF, WEO database (April 2011), GDP data and online table B18. Projections for 2010.

ing countries, especially the EMEs, are increasingly important players in financial globalization, and their financial stability is becoming increasingly tied to that of the global financial system. Yet they remain more vulnerable to sudden stops in foreign lending than are most of the advanced countries—notwithstanding the sudden emergence of sovereign debt problems in some of the latter. All the while, financial channels of contagious transmission have expanded along with gross positions. If policymakers wish to restructure the international liquidity system so as to enhance financial stability, these facts are central considerations. 8.2.1

The Role of Global Last-Resort Lending

In the late 1970s, the United Kingdom, Italy, Spain, and Portugal all negotiated standby arrangements with the IMF. Between Portugal’s last approach to the IMF in 1983 and Iceland’s in 2008, no industrial country requested IMF resources for balance of payments support—the IMF’s client base came to be viewed as consisting exclusively of developing and emerging economies. By the 1990s and 2000s up to 2007, the high- income countries appeared to be quite creditworthy, unlikely ever to need IMF resources or even to need to use large volumes of international reserves. (For a clear presentation of that perspective, see Williamson 1994.) At the same time, the central banks of high- income countries were perceived to be well

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equipped, and willing, to act as last- resort lenders if their home financial systems got into trouble. Events after August 2007 have changed the picture, highlighting the more complex and (in some respects) more dangerous landscape that financial globalization has produced. Banks throughout the world, and especially in rich Europe, faced urgent needs for foreign- currency liquidity—liquidity that their home central banks could not create by the stroke of a pen (or click of a mouse). The result was the creation of a complex network of central bank swap lines, starting with the US Federal Reserve’s lines to the European Central Bank (ECB) and Swiss National Bank (SNB) in December 2007.12 Furthermore, following Iceland’s collapse, the Greek, Irish, and Portuguese governments suffered funding crises that have been managed so far only with financial support from the EU, ECB, and IMF. Cyprus has now joined them, and Spain and Italy remain in danger of needing such external support as of this writing. These advanced- country crises reflected various prior problems, such as garden- variety fiscal improvidence (the Greek scenario) and government bailout of a collapsed banking system (the primary culprit for Ireland). But in all cases, globalized financial markets fueled easier access to large volumes of foreign credit. Furthermore, globalization allowed the sovereign risks to spread through the European and global banking and shadow banking networks, in some cases increasing bailout risks and thereby weakening sovereigns further. What have we learned? There are at least two major lessons. First, IMF facilities alone, even after being augmented in 2009, remain far below the magnitudes that rich countries with large public debts might need to fend off self- fulfilling bond- market attacks. Also, the speed and flexibility of the IMF remains limited, given the openness of advanced countries to high- speed global financial markets. The large gross liability positions of the advanced countries—think of the external debts of Ireland, Iceland, or Switzerland, even though the last is a huge international creditor—have the potential to infect the government balance sheet, resulting in fiscal crisis. The assets of these countries’ banking systems are in a substantial number of cases substantial multiples of GDP. While the Irish, Spanish, and Cypriot crises have been called crises of the euro—and adherence to a fixed exchange rate indeed has had a downside for these countries—their crises are even more crises of globalized finance. Even in cases where sovereign debt problems arise from government profligacy, as in Greece, globalized finance promotes a potentially wide exposure of financial institutions to the problem, as noted earlier. 12. The precedent for such arrangements is the network of reciprocal central bank credits set up in the early 1960s at the urging of US Treasury Secretary Douglas Dillon and Undersecretary for Monetary Affairs Robert Roosa. The Dillon–Roosa swaps, however, were intended to support foreign exchange intervention for purposes of maintaining par values against the US dollar. See Hirsch (1969, chapter 11).

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Second, a key feature of a globalized multiple- currency world is that traditional lenders of last resort (the central banks) are ill equipped to support the needs of their swollen financial sectors, even when private- sector actors seek to maintain putative hedges on their foreign- currency exposure. For example, European banks in 2007 and 2008 were big holders of US mortgage- backed securities, these assets being funded by short- term dollar borrowing. Credit market disruptions sharply raised the cost of rolling over short- term dollar credits. At the same time, the costs of swapping euros for dollars to repay dollar credits rose far beyond what covered interest parity would imply. While the ECB, for example, could freely print euros and lend them to banks, its ability to supply dollars out of reserves was much more limited (although some national central banks did so). The ECB itself could have borrowed dollars and intervened in spot and forward exchange markets, at the risk of quasi-fiscal costs—costs that would be higher today, now that the finances of even some larger eurozone governments are being questioned by the bond markets. Under the circumstances, it was much more expedient to be able to borrow dollars directly from the Fed, which in any case needed to expand its balance sheet to meet a heightened global demand for dollar liquidity (a demand that was putting strong appreciation pressure on the dollar).13 Effectively, the Fed became an international last- resort lender in dollars—in the absence of which, European banks might have had to unload hard- to-sell assets, worsening fire- sale dynamics and weakening their own capital. Of course, the Fed also lent heavily, and directly, to the US affiliates of foreign banks when they had eligible collateral. At the same time, other central banks—including the ECB, SNB, BOJ (Bank of Japan), and Sveriges Riksbank—eventually stepped up as global last- resort lenders in their own currencies. As of the start of the global crisis in 2007, the usefulness of foreigncurrency last- resort lending to financial institutions was familiar from the EME experience—see Jeanne and Wyplosz (2003) and Calvo (2006) for insightful analyses. But it was less obviously a first- order issue for mature economies, where the main use of foreign exchange reserves (if any) was widely considered to be in cases of foreign exchange intervention. The Fed renewed its swap facility in the spring of 2010 in response to the eurozone debt crisis. The expansion of gross currency- denominated asset positions, given the inevitable gaps in global as well as domestic prudential oversight, suggests a demand for global lenders—to governments as well as central banks and,

13. The Fed was conveniently able to shift any credit risk of direct last- resort lending onto the ECB. On the background for the swap network and its effects, see, for example, McGuire and von Peter (2009); Goldberg, Kennedy, and Miu (2011); and Rose and Spiegel (2012). While controversy remains, most empirical researchers have concluded that the swap arrangements were effective in reducing credit market disruptions.

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through them, to the private financial sector—that is greater than ever before. 8.2.2

Self-Insurance through Reserve Accumulation

Of course, growing financial vulnerability is part of the reason that the emerging and developing nations have accumulated high volumes of precautionary, hard- currency foreign exchange reserves—a trend I noted before, and that shows no sign of abating. Figure 8.7 illustrates that the resulting aggregate reserve stock, mostly US dollars and euros, has now reached the neighborhood of one- third of the holders’ collective GDP, having risen from about 10 percent in 1990, when group GDP was much smaller than it is today. This apparent security does not come without costs, both for individual reserve- holding countries and for international monetary stability. For the holders, the great attraction of reserves is that they provide instantaneous and unconditional liquidity. But even at the level of the individual holder, there are downsides: reserves may come at a high quasi-fiscal cost (costs also incurred if reserves should depreciate against domestic currency), and these costs may be incurred even if the marginal liquidity value of the reserves is illusory (because the process of reserve acquisition generated an equal short- term private foreign- currency debt as an offsetting counterpart on the national balance sheet). Sterilization of reserve flows may lead to financial repression costs. Beyond these individual costs, however, national self- insurance through holdings of gross foreign reserves carries significant potential systemic costs. Reserve accumulation may influence interest rates in reserve centers—helping to fuel international resentments about “exorbitant privilege” that often fail to recognize the root of the problem in systemic congestion. Moreover, such interest- rate effects can complicate the task of monetary policy in the reserve- center country. Similarly, official portfolio shifts between different currencies, or between asset classes within currency areas (think of Chinese transactions in eurozone sovereign debt), alter exchange rates and bond prices, possibly in destabilizing ways. Individual countries’ reserve gains may be strategic complements, in the sense that one country’s gains lower the relative perceived financial stability of its neighbors, in turn raising their marginal benefit from reserve accumulation. In that case, a noncooperative equilibrium will entail excessive accumulation by all. A further coordination problem arises when countries compete to keep their currencies weak and limit domestic demand, so as to generate current account surpluses.14 Finally, in a global crisis, a country may exacerbate problems elsewhere when it draws on its reserves. For ex14. Note, however, that countries need not have current account surpluses to gain reserves if they can attract private financial inflows that exceed their current account deficits.

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Global foreign exchange reserves

Sources: IMF, International Financial Statistics for reserve data (which include gold valued using national methods); IMF, WEO database (September 2011) for GDP data. Note: The “advanced” group excludes Hong Kong, Korea, Singapore, and Taiwan but includes the Czech Republic, Estonia, Slovenia, and the Slovak Republic.

ample, withdrawals of bank deposits in a foreign center may worsen liquidity problems there. A final negative systemic externality is related to the modern- day Triffin dilemma of Farhi, Gourinchas, and Rey, which was described earlier. Each country’s purchase of more reserves may push other demanders into purchasing marginally riskier assets, or render their existing reserve holdings marginally more risky. The basic point is that actions that enhance the apparent financial resilience of the individual country may well, at the same time, undermine that of the international financial system as a whole. The fallacy of composition applies in the domain of international liquidity, just as it does in discussions of the macroprudential approach to domestic financial supervision. Notwithstanding these drawbacks, emerging and developing economies are likely to continue accumulating reserves. And there is no doubt, despite the seeming ambiguity of formal econometric evidence, that these countries found reserves to be useful in the crisis.15 Yet the crisis also illustrated systemic problems of reserve accumulation, as described earlier. Many countries were unwilling to run down their reserves sharply, precisely because 15. A recent study pointing to a positive role for reserves is Dominguez, Hashimoto, and Ito (2012).

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smaller reserves might signal financial weakness compared with neighboring economies (see the related discussion of Aizenman and Sun 2009). Korea, for example, was reluctant to let its reserves fall too low, and thus drew on its $30 billion swap line from the Fed (which itself may have had an important signaling effect) despite substantially larger remaining reserve holdings. To avoid losing too many reserves, EMEs found creative ways to stretch them. Several engaged in nonstandard foreign exchange operations, which effectively targeted specific financial vulnerabilities implied by private foreign exchange positions, while allowing the general demand for foreign exchange by relatively nonsystemic agents to go unsatisfied (see Ishi, Stone, and Yehoue [2009] and, on Brazil, Stone, Walker, and Yasui [2009]). For example, rather than injecting reserves generally into the market to counteract domestic capital flight and the resulting currency depreciation, some authorities provided foreign exchange at bargain rates to strategic banks and corporations with short- term foreign- currency debts. To return to the Korean example once again, the country was able to tolerate extensive won depreciation during the global crisis without the widespread financial distress characteristic of earlier crashes.16 8.2.3

The IMF and Global Liquidity

In principle, a world central bank, as envisioned by Keynes in his original blueprint for an international “Clearing Union,” would be in a position to provide liquidity on a global basis to troubled financial institutions throughout the world—as well as directly to troubled sovereigns, were it not bound by statutory prohibitions against such lending, as the ECB is. Indeed, there is no logical reason why a world central bank would be limited to the issuance and management of a single currency. In an ideal world, an omniscient and benevolent central bank could deal in a multiplicity of different national currencies, allowing exchange rates to float or managing them to whatever degree was optimal. From a political standpoint, of course, the idea is completely infeasible. The IMF is the version of Keynes’s ambitious plan that proved politically feasible, and its capacities, while quite useful and arguably essential (see Fischer 1999; Goodhart 1999), remain severely limited. Historically, the IMF has truly been the last resort for sovereigns, typically when it is too late to fend off a crisis, and subject to conditionality that sometimes strengthens a government’s hand against domestic opposition, but that also may contribute to political and social unrest. The IMF lends exclusively to governments, and not directly to central banks or financial institutions, so as currently designed, it is completely unsuitable for undertaking the type 16. The practice has an analog in the classic debate over whether lenders of last resort should lend into the market or directly to individual institutions. The collateral benefit of the latter approach in the case of foreign- currency operations is the benefit to exporters of a large depreciation. For conceptual discussions see Jeanne and Wyplosz (2003) and Calvo (2006).

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of crisis lending to banks and other financial actors that proved so important during the global crisis. Nor can it mimic the ECB’s role in lending to eurozone banks during that currency area’s crisis. True, the IMF’s resources increased significantly in 2009. Its flexibility to lend them quickly based on ex ante qualification, and with relaxed conditionality, was extended through the Flexible and Precautionary Credit Lines (FCL and PCL). But the FCL and PCL have been little more successful than earlier related initiatives. Among other problems, countries seem to fear stigmatization, both from approaching the IMF to request a credit line and from the possibility that the IMF Executive Board fails to renew it down the road. Thus, the uptake on these facilities has been very limited: Mexico, Poland, and Colombia for the FCL, and only Macedonia for the PCL. In November 2011 the IMF announced replacement of the PCL by a new facility, the Precautionary and Liquidity Line (PLL), which extends the PCL in allowing an IMF member to apply for assistance even if it has an actual crisis at the time the line is approved (rather than just a potential crisis, as the PCL required). One alternative proposal put forward by IMF staff is for a Global Stabilization Mechanism (GSM), which could allow the IMF to respond proactively with aid offers once a systemic event is identified by the Executive Board (see International Monetary Fund 2010). However, this approach remains controversial—as do related proposals for the domestic financial sphere that are based on a systemic trigger—and at this stage there are several versions of GSM on the table, the details of which differ considerably. None seems likely to survive. An obvious problem area concerns the precise criteria under which the IMF would call a systemic event, and the response of markets in anticipation of such a declaration. A prominent mode through which the IMF can augment global liquidity is through the issuance of the Special Drawing Right (SDR). But the SDR is not currently used for private transactions, and considerable obstacles impede development of a private SDR market (Eichengreen 2011). Notwithstanding the SDR’s noncurrency status, some (e.g., Zhou 2009) have argued for an international reserve system centered primarily on the SDR rather than the US dollar. Such recent calls echo the Second Amendment to the IMF’s Articles of Agreement, which in 1978 set the ambitious goal of making the SDR the “principal reserve asset in the international monetary system.” The SDR was launched on January 1, 1970, after long international negotiations motivated by two main concerns. First, policymakers feared that US balance of payments deficits might not, in the long run, provide sufficient international liquidity to meet the demands of a growing world economy. Second, policymakers feared that the dollar- based gold exchange standard would experience increasing instability because of the Triffin dilemma. The SDR, characterized at the time as “paper gold,” was designed as a limited

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Fig. 8.8 SDR holdings as a fraction of total international reserves: Advanced countries, emerging/developing countries, and world Source: IMF, International Financial Statistics.

form of unconditional liquidity, which governments could trade to other governments in exchange for hard- currency reserves.17 Until the recent big allocation of August and September 2009 following the onset of the global crisis, SDR allocations were infrequent, taking place only over 1970– 1972 and 1979– 1981. None of these allocations, not even the most recent one, has pushed the total stock of SDRs to be a large fraction of global foreign exchange reserves. Figure 8.8 illustrates the numbers, based on data in the IMF’s International Financial Statistics. The stock of SDRs has never exceeded about 6 percent of global reserves, and that global figure declined steadily until 2009 following the 1979– 1981 allocation. On the eve of the crisis SDRs were less than 0.5 percent of global reserves, and an even smaller percentage of emerging and developing country reserves. In April 2009 the IMF allocated USD 250 billion worth of SDRs as a response to the global crisis, and a further USD 34 billion in a September 2009 special allocation to endow members that had never received allocations. Except for such extraordinary allocations, SDR allocations are proportional to IMF quotas, so as to achieve an internationally balanced increase in world reserves. Thus, the bulk goes to the advanced economies 17. For accounts of the thinking behind the SDR’s birth, and its early history, see Cumby (1983), Solomon (1996), and Boughton (2011).

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(which also hold much lower stocks of foreign exchange reserves). Even the nominally large 2009 allocations restored the SDR share in global and poorer- country reserves only to the levels of the late 1980s (about 2 percent for the latter group). The SDR framework is in principle a form of reserve pooling. Thus, the prospects of replacing actual reserve currencies such as the dollar and euro with SDRs are inherently limited: because SDRs have no private use and function only as claims on the reserve pool, they cannot themselves supplant the reserve pool.18 While the SDR therefore could not become the world’s principal reserve asset under current arrangements, proposals for a “substitution account” are designed to replace currency reserves with SDRs on a large scale. Such ideas were debated in 1979– 1980, ultimately to no avail, but they have resurfaced recently (e.g., Kenen 2010). Figure 8.8 shows that substitution would have to be on a huge scale to displace a substantial portion of currency reserves. Under a substitution scheme, a country such as China might transfer some of its dollar reserves to the IMF, receiving SDRs of equal current value in return. (These SDRs would have to be created outside the usual allocation process, of course.) Two portfolio shifts occur as a result. China is now long on SDRS, and might (or might not) want to readjust its portfolio in private markets. Presumably, its degree of participation in the scheme will already reflect its diversification goals. More importantly, the IMF is short on SDRs and long on US dollars, and the substitution account’s solvency is at risk if the dollar depreciates. China has passed some of its substantial currency risk to the IMF. Which countries will compensate the IMF for portfolio losses if the dollar declines against the SDR? How will the IMF finance “exorbitant privilege” discrepancies between the interest earned on its dollars and that paid on its new SDR liabilities? In the last discussions of 1979– 1980, some countries involved thought the United States should bear the bulk of the costs, but the United States was unwilling and others refused to step in. Poorer countries were reluctant to see the IMF use its gold holdings to support the account— they hoped gold sales might instead subsidize borrowing by poorer countries. So the negotiations failed. It is unlikely that the United States would be more willing today, and even less so that the eurozone countries—which lack a centralized fiscal organ—would be willing to underwrite a euro/SDR substitution account. 18. As a technical matter, SDRs can be exchanged for dollars not only with non-US dollar holders, but also with the US Treasury, which obtains the dollars from the Fed in exchange for dollar- denominated Treasury obligations called SDR Certificates. (The Fed will routinely sterilize such money creation, and all currency risk resides with the Treasury.) However, it is unlikely that the Treasury and Fed would be willing to undertake such exchanges in the amounts that would be required were SDRs to become the dominant international reserve asset.

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Once again, the fiscal dimension is central. The absence of a fiscal authority at the global level creates a difficult coordination problem for a centralized and coordinated move to an SDR-based system, even though that system might confer some stability advantages (e.g., by discouraging large official portfolio shifts).19 8.2.4

Globalized Last-Resort Lending

The IMF’s traditional function of lending to sovereign governments leaves it ill equipped for the more direct financial- market interventions traditionally associated with domestic lenders of last resort. Even the newer, more flexible lending facilities, which could channel the needed resources through governments in principle, are likely to involve time delays and informational frictions. Furthermore, the known quantitative limits of such facilities can be an obstacle to reassuring markets that the authorities are capable of intervening with overwhelming force. It is no accident that the Federal Reserve found it useful to remove the quantitative limits on some of its swap lines as the 2007– 2009 crisis unfolded. A different approach would institutionalize the network of swap lines between central banks that arose in an ad hoc way during the 2007– 2009 crisis. Operationally, national central banks could extend the swap lines to a central international institution such as the IMF or (as some central bankers might prefer) the Bank for International Settlements (BIS). Other central banks, when in need of foreign currency to support stressed financial sectors, would then be able to draw on the swaps, just as the ECB obtained dollars from the Fed under the recent arrangements. Such a system could be based on the SDR, though it need not be. Truman (2008, 2010) has proposed modifying existing rules to allow countries directly to present SDRs to central banks in return for the currencies the banks issue. Obstfeld (2009) and Farhi, Gourinchas, and Rey (2011) suggest systems based on explicit credit lines. Unlike the recent improvised swap network, a permanent system would be predictable rather than ad hoc and all countries, not just a select few, would have access. But the system would avoid the externalities inherent in large- scale self- insurance through reserve accumulation. For example, there would be no scope for official switches between reserve currencies in order to manage currency risk. Nor would reserve demands depress the interest rates of reserve issuers. The terms of access to the credit network could be conditional. For example, participating central banks might be required to satisfy criteria of independence and supervisory diligence. A variable participation fee might cover potential financial losses, in analogy to the charge Prasad (2011) has 19. For an account of the 1979– 1980 negotiations over a substitution account, see Boughton (2001, 936– 43). McCauley and Schenk (2012) provide a detailed survey of the proposal, including analysis of the fiscal implications.

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suggested for his proposed liquidity insurance pool. The fee could be structured so as to encourage sound macroeconomic and financial policies—for example, rising in the face of an unusual and apparently unjustified credit boom. Staff from the IMF, the BIS, or even from participating central banks could be deployed to carry out the necessary surveillance. Credit limits might also be structured so as to alter incentives. Both graduated participation terms and international surveillance offer partial brakes on moral hazard—the risk that expanded liquidity facilities encourage key actors in the financial system to behave more imprudently than they would in the absence of a safety net. But moral hazard could be limited further by complementary reforms that target government incentives. There are two main ways in which enhanced international liquidity could encourage governments toward actions with negative global externalities: by promoting excessive fiscal deficits (even outside of currency unions), and lax prudential oversight of domestic private- sector finance. Governments would be better motivated to limit deficits if any swap network participation fee depended on fiscal variables, as in Prasad’s (2011) proposal. But more generally, and regardless of the state of international liquidity arrangements, predictable means of restructuring sovereign debts, even the debts of mature economies, can push private incentives into better alignment with society’s interests. Such mechanisms can limit excessive government borrowing through rising marginal costs, but, as Charles Goodhart stresses in his chapter, they also may improve the incentives of the creditor–country governments whose financial institutions may be bankrolling profligate governments (as well as those of the institutions themselves). If governments wish for institutionalized sovereign restructuring mechanisms to be credible, however, they should complement them with limits on the banking sector’s unhedged exposure to risky sovereign debts. Such limits remain difficult to conceive in the eurozone in the absence of a common “safe” euro area bond, simply because of the big role sovereign bonds play as collateral. Mandatory subscription to a set of common regulatory standards and procedures would serve to limit individual governments’ discretion in prudential oversight. These norms would more effectively limit private- sector risk- seeking if they encompassed guidelines on institutional size—so as to mitigate the “too big to fail” problem—as well as predictable and credible resolution procedures for systemically important financial institutions, including resolutions involving multiple governments. As noted before, implementation of these undertakings could be subject to international surveillance, with transgressions resulting in higher participation fees. A general lesson of recent experience is that a system for counteracting illiquidity needs to account for the possibility that the underlying cause of market panic is insolvency. There is no uniquely defined dividing line between the

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two—in no small part because market perceptions are a key driver of borrowing costs and, thus, of the ability to service debt—but there will clearly be cases in which state or institutional bankruptcy becomes inevitable. The possibility of insolvencies raises the potential fiscal cost of any international arrangements to enhance global liquidity. As Goodhart (1999) has stressed, the backing for the lender of last resort in cases of insolvency comes from the fiscal authorities. Thus, as has been painfully evident during the eurozone’s debt crisis, collective action to promote financial stability must be financed through collective action in the fiscal sphere.20 Unfortunately, in today’s world of huge banking sectors there also can come a point at which insolvency problems become so big that they bring the creditworthiness even of governments into question—at which point it may well be that the only remaining resort is again the central bank’s printing press. 8.3

Exchange Rates and Global Imbalances

The final demise of the Bretton Woods system in 1973 took the form of a disorderly retreat to floating exchange rates among the main industrial countries. Despite the unplanned and indeed initially unintended nature of the regime change, a number of eminent economists such as Milton Friedman and Harry G. Johnson had long espoused floating rates as a means of reconciling national policy sovereignty with the benefits of global economic integration. To a considerable degree floating exchange rates have been successful, which explains why, in this century, even a growing number of EMEs have been opting for greater exchange- rate flexibility. Yet, most of the Friedman–Johnson claims have not been borne out fully, and it is increasingly clear that floating rates have left ample room for politically contentious spillovers in economic policy. Predictions that floating rates would remove the need for international liquidity have clearly proven wrong, and the earlier part of this chapter discussed the reasons why. As a group, the EMEs conducted massive foreign reserve accumulation even as many of them were moving to more flexible exchange- rate regimes. Also problematic, in light of experience, have been the claims that floating or flexible exchange rates would painlessly facilitate the adjustment to real (output- market) shocks or ensure the rapid adjustment of current account imbalances. Most fundamentally, two countries share every bilateral exchange rate, and there is no guarantee in general that both will take the same view of its optimal level. Due to asymmetries in economic structure, the difficulties of adjusting to exchange- rate changes have proven greater 20. See the further discussion in Obstfeld (2011). Of course, when insolvent banks are so large that the need to rescue them threatens the solvency of the sovereign itself, the central bank may be left as the ultimate source of finance, but at the cost of price stability.

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for emerging and developing countries, igniting talk of “currency wars” and renewed policy attention to capital controls as a means of exchange- rate management. 8.3.1

Exchange Rates, Resource Allocation, and Coordination in the Short Run

Sharp exchange- rate movements driven by financial- market changes can have unwelcome effects on resource allocation, effects that are especially painful for poorer countries. These effects lead to “fear of floating” behavior in the mode of Calvo and Reinhart (2002), and lie behind the recent attacks of some EME governments on the Federal Reserve’s accommodative monetary response to recession. Figure 8.9 illustrates a configuration typical of many EMEs in the postcrisis period. Assume that domestic nominal wages and nontraded goods prices are sticky, whereas traded goods’ prices show a full pass- through to the exchange rate. Assume also that traded goods are priced in world markets, and that the tradables sector is competitive. Finally, imagine that capital and labor are sector- specific in the short run; that is, unable to migrate between traded and nontraded goods industries. In the figure, the downward- sloping locus NN shows combinations of the nominal exchange rate E (price of foreign currency) and total domestic spending Z such that labor in the nontradable sector is fully (but not overly) employed. (A rise in Z at a constant exchange rate would cause excess demand for nontradables, but currency appreciation lowers tradables

Fig. 8.9

Internal and external balance

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prices and shifts demand toward the latter goods.) The horizontal schedule TT gives the exchange rate at which, given nominal wages, the tradable sector’s labor supply is fully employed. The upward- sloping schedule XX shows combinations of spending and the exchange rate at which the current account is in balance (however defined). The economy is initially at point A, with output above potential in nontradables and a current account surplus. Because product wages are low in tradables, output is also above potential there. There is upward cost pressure in both sectors and upward price pressure in nontradables. Consider the impact, at a constant spending level, of a sharp nominal appreciation that moves the economy to point B. Perhaps a large foreign country has loosened monetary policy; perhaps markets are looking forward to and speculating on tighter domestic monetary policy. In either case, output falls in both sectors and the tradables sector experiences a particularly sharp decline in capital income. In the case shown, inflationary pressures subside but at the cost of underemployment in both sectors. The current account surplus shrinks as the economy moves closer to XX. These impacts are painful, so much so that many EMEs in positions like point A have preferred to resist appreciation, accumulating substantial additional foreign reserves in the process and sterilizing them in an attempt to avoid feeding domestic inflation. Figure 8.10 illustrates the experience of a

Fig. 8.10

Reserve growth and real appreciation, 2009–2010

Source: IMF, International Financial Statistics

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sample of EMEs with respect to real appreciation (bilateral, against the US dollar) and reserve accumulation in 2010. As exchange market pressure rises, countries generally have allowed more appreciation but also have intervened more heavily, and in some cases massively. When EMEs as a group face an expansionary global monetary shock emanating from the industrial countries, the result is a coordination failure reminiscent of the competitive depreciation of old—or at least, it is competitive nonappreciation. But unlike the currency competition of the Great Depression, more recent rounds have been adding fuel to inflationary fires. The problem has gained quantitative importance through the growth of intra-EME trade. How does the coordination failure come about? The Chinese yuan’s relative weakness against the US dollar, for example, makes Brazil even less willing to appreciate the real (and vice versa); so both countries intervene more, and accumulate more dollar reserve claims, the latter being feasible in unlimited amounts. To the extent that sterilization is imperfect, the latter process fuels asset- price appreciation and inflation, in a manner reminiscent of the Bretton Woods system’s collapse in the early 1970s. (Figure 8.1 shows the explosive growth in foreign exchange reserves during those few years.) The problem can conveniently be formalized as a prisoner’s dilemma in a stylized world with three currencies, the real (R), yuan (Y), and US dollar (U).21 If α is the share of intra-EME trade, then using triangular arbitrage in the foreign exchange market we may express the (log) nominal effective exchange rates of the real and yuan in terms of bilateral nominal exchange rates as: eReff = eR/$ + e$/Y , eYeff = eY /$ + e$/R . The payoffs in the game are determined as follows. Both countries face medium- term inflationary pressures, which do not affect the price level adjusted exchange rate in the short run but are counted as costs with present value – 0.9 in both countries. Figure 8.11 shows the game between Brazil and China in normal form, and it includes the information (upper left corner) that if both countries fix to the US dollar, the payoffs are – 0.9 for Brazil (first entry) and – 0.9 for China (second entry). I will assume that if a country appreciates by 1 payoff unit, its payoff from that action is the change in the (log) nominal effective exchange rate (given by the equations just shown), but domestic inflation pressures are eliminated. Thus, in the lower left corner of the payoff matrix, where Brazil appreciates but China continues to peg the yuan, Brazil pays an effective appreciation cost of – 1 (as the cost of future inflation drops to 0), but China pays a cost of only –(0.9 – α), since 21. In a related strategic analysis, Ogawa and Ito (2002) analyze the interdependence of two neighboring countries’ choices of optimal basket pegs for their respective currencies.

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Fig. 8.11

Coordination failure in an intervention game

its inflation cost (equal to – 0.9) is partially offset by an effective nominal depreciation due to the real’s nominal appreciation against the dollar (a gain equal to α as a result of the rise in e$/R by 1 unit). Critical to the example, of course, is my assumption that policymakers view appreciation today as being more costly than inflation tomorrow. Assuming further that α > 0.1, we see that the efficient solution is for both countries to appreciate jointly against the dollar, thereby reducing their losses from inflation as shown in the lower right corner of figure 8.11. But this is not a Nash equilibrium: each country has an incentive to defect so as to free ride on the other’s appreciation. The sole Nash equilibrium—the noncooperative solution—is where both countries fix to the dollar and suffer inflation later as a result. Notice that EMEs lose no matter what (in this simplified game). But even if there is nothing they can do to change US monetary policy, they can limit their losses more effectively if they can coordinate amongst each other. The gains to cooperation are greater the greater is the extent of intra-EME trade (or competition in third markets), as roughly measured by α in the previous example. As a coordination mechanism, the IMF could deploy its staff’s analytical firepower so as to quantify and advertise the availability to such cooperation gains among EMEs. If policymakers want the IMF to be more effective in promoting global cooperation, they should encourage it to provide very concrete illustrations of the gains that such cooperation would provide for individual member countries. The IMF is ideally positioned to explain how the pieces of the global economy fit together.

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The costs of allowing currency appreciation (and larger currency fluctuations in general) appear somewhat lower for the mature industrial economies (with Japan as a possible exception). These economies have larger domestic markets for their tradable goods and more ability to price to market so as to cushion exchange- rate effects on domestic prices. 8.3.2

Capital Inflow Controls

In the example just discussed, countries face a trade- off: appreciation would lower domestic inflation pressure, but at the cost of lower employment. Domestic monetary tightening would dampen inflation, but at the cost of even sharper currency appreciation. This is a classic instance of the trilemma. Some EMEs have turned increasingly to capital inflow controls as a way out, with apparently limited success. (For the moment no mature economy— not even the ultimate safe haven, Switzerland—appears likely to embrace controls, although Switzerland has placed a ceiling on its franc’s value.) The IMF has moved increasingly to acceptance that capital inflow controls are a legitimate policy tool in some circumstances, turning from what once was fairly monolithic opposition to discussions of the appropriate use of controls (see Ostry and others 2010, 2011). In principle there are two (often correlated in practice but conceptually distinct) motivations for inflow controls. First, there is the macroeconomic motivation of reducing exchange market pressure in the form of the volume of capital inflows—basically, escape from the trilemma. Second, there is the macroprudential motivation, which certainly includes changing the composition of capital flows but might also target the volume if the capacity of the financial sector safely to intermediate funds is limited. Available evidence suggests that controls have been more successful in influencing the composition of flows—for example, inducing a lengthening of debt maturities (Chile) or a shift from external debt to equity (India)—than in moderating volumes or real appreciation pressures.22 From a macroprudential standpoint, however, capital inflow controls would often appear to be a second- best tool, the first best being a response that more directly targets the relevant financial distortion. For example, a country concerned about banks’ currency mismatch should restrict or tax all foreign- currency liabilities, not just those contracted with nonresidents. In theory, however, one can certainly devise cases in which the optimal feasible policy intervention, from a nationalistic or even global welfare standpoint (Korinek 2011), is to tax foreign borrowing or debt.23 Ostry and others 22. See Magud, Reinhart, and Rogoff (2011) for a recent survey. 23. I would conjecture that in cases where global rather than just national efficiency is impaired, the second- best intervention could involve not only taxation of capital inflows, but also taxation of outflows on the part of source countries. If true, this result would furnish a formal case for symmetric adjustment on the part of lending and borrowing countries.

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(2011) suggest that capital inflow controls be deployed in preference to macroprudential instruments mainly when financial inflows enter the economy through nonbank entities such as large nonfinancial corporations. Some countries, of course, have used putative macroprudential tools in attempts to escape the constraints of the trilemma. If capital inflow controls were to become generally accepted as part of the policy toolkit, however, transparency would be enhanced if the international community were to develop guidelines as to which instruments are admissible and the circumstances in which they will be used. A regime based on rules, rather than discretion, seems more likely to enhance predictability and thereby avoid financial- market volatility. It should also be recognized that inflow controls entail possible negative international spillovers. A country imposing them unilaterally may simply divert financial inflows to neighboring economies. Capital inflow controls, as in China’s case, give a country more latitude to maintain an artificially competitive exchange rate and thereby contribute to larger global imbalances. Thus, if policymakers wish to reduce global externalities from the use of controls, internationally coordinated surveillance, most plausibly conducted by the IMF, is likely to be helpful. 8.3.3

Global Imbalances

Current account imbalances have not become smaller and less persistent in the era of floating exchange rates. Instead, increasing financial capital mobility (in part supported by floating rates, as suggested by Obstfeld and Taylor 2004) has eased the financing of deficits and allowed easier disposition of excess national savings. Moreover, the “long run” in which the real exchange rate should reflect the requirement of external balance has become considerably more distant. (Figure 8.12 shows the aggregates of measured world current account surpluses and deficits after 1980, which both peaked at about 3 percent of world output just before the crisis broke in 2006.) The time- honored problem of asymmetric adjustment pressure on surplus and deficit countries remains as intractable as ever, as Charles Goodhart emphasizes in his chapter. In the mid- 2000s, Dooley, Folkerts-Landau, and Garber (2008, 2009) advanced a “Bretton Woods II” paradigm according to which the big global imbalances of the period, driven in part by the Chinese authorities’ desire and capacity to industrialize on the back of exports, might be sustainable for a decade or more. That hypothesis led to a lively debate. For examples of the critiques see Roubini (2006), Obstfeld and Rogoff (2007), Wolf (2008), and Hall and Tavlas (2011). The global imbalance configuration of the mid- 2000s appears in retrospect to have been problematic, which should not be too surprising because it bears a resemblance to several other episodes that ended in tears (and perhaps also to the current configuration of imbalances). Asia in general

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World current account surpluses and deficits

Source: IMF, WEO database, April 2011.

(outside of Japan) was growing at a rate exceeding that of the mature economies, with China in particular pursuing a “vent for surplus” growth model (Caves 1965).24 Several mature economies, but most notably the United States, were absorbing Asian exports through growing consumption and indebtedness (not through growing productive investment, much of which was taking place anyway in residential housing). While a soft landing is theoretically possible in this scenario, the rapid increase in US household debt that made America the world’s spending locomotive relied on the collateral of rising and inflated home values, which were bound to collapse, and did starting in 2006. Given actual and prospective US income growth in the middle 2000s, there was no way that China could maintain its own more rapid export- led growth for much longer on the back of growing US household debt, without US households becoming insolvent. The virulence of the resulting financial meltdown, of course, reflected the gross positions that financial actors in the United States and Europe had unwisely assumed prior to the start of the US housing collapse. In analyzing potential perils due to global imbalances, it is once again 24. There are analogies in the early postwar experiences in Western Europe and Japan. On Europe, see Kindleberger (1967).

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important to ask how the pieces fit together. When large surplus countries grow more rapidly than deficit countries, consumption growth in the latter is necessarily increasing faster than income, a process that is very likely to end in crisis unless the debtor’s income growth catches up. Indeed, just this problem underlies the sovereign debt crisis within the eurozone; see the insightful analysis by Giavazzi and Spaventa (2010). Similarly, the current account deficit of the United States in the early 2010s, while diminished compared to 2006, is underpinned by large fiscal deficits that are unsustainable over the longer term. In such situations, a main brake on the behavior of surplus countries is the fear that the assets they are accumulating (whether held by the public sector—Chinese dollar reserves—or the private sector—German banks’ holdings of Greek sovereign debt) might be devalued. (Another is the threat of protection.) If policymakers wish international lenders to be cognizant of risks they are running, then it is important that the international financial system be structured so as to make such fears rational, as Goodhart stresses in his chapter.25 But we should not expect such a system substantially to reduce the adjustment burdens of deficit countries, which will still suffer more tightly constrained or more expensive credit as they appear riskier. The IMF has the standing to speak out when, in its view, large and persistent external imbalances threaten to result in a solvency crisis, whether in the public or private sectors. The IMF also is in a position to urge cooperative policy scenarios that can make the process of reducing global imbalances easier for all participants. If policymakers wish to raise the weight of the IMF’s advice in the international community, they should support reforms of IMF governance that make such pronouncements politically feasible and credible regardless of the countries involved. A system of liquidity credit lines, as described in the last section, could discourage precautionary reserve accumulation, although the latter can occur even in the absence of current account surpluses.26 Proposals to formally tax large reserve holders, either in an SDR-based reserve system or one based on currencies, are unlikely to gain any traction, just as Keynes’s similar proposal failed in the 1940s. 25. Keynes (1924) may have been the first to observe that the risk of default on foreign investments might render their level excessive from a purely nationalistic perspective. The fact that currently, default losses may imperil entire domestic financial systems greatly reinforces Keynes’s insight. Subsequent literature has reiterated the point (e.g., Kemp 1962; Krugman and Obstfeld 1988, 504), but perhaps not often enough. In today’s world of large two- way capital flows, which may be highly unbalanced between bilateral partners even when overall current account imbalances are small, one must recognize that the issue really concerns gross rather than net international investment flows per se. In practice, however, current account surplus countries can reduce their exposure over time by reducing their surpluses. 26. Recall the much discussed “capital inflows problem” of disinflating developing countries. See Borio and Disyatat (2011) for a reminder on the potential decoupling of the current account and balance of payments.

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Conclusion

Problems of international liquidity and exchange- rate management— staple fare in the international monetary reform literature over many decades—remain painfully relevant today, but in forms that sometimes differ from past incarnations. At bottom, many of the coordination problems that arise stem from asymmetries in the structures, growth rates, and cyclical positions of the mature economies and the developing world. These two segments of the global economy are fast approaching (and on some measures have reached) equal size, as measured by real GDP. Many years ago, Richard Cooper (1969, 600) drew an intriguing connection between the extent of policy cooperation over macroeconomic policies and the need for international liquidity. I believe that his point remains valid: The degree of . . . international cooperation . . . influences the amount of liquidity needed to finance imbalances in the face of temporarily divergent and conflicting national policies. The more cooperation, the more carefully coordinated national policies are in timing and nature, the lower the need for international liquidity to finance imbalances. I have argued that, in addition, there is considerable scope for a cooperative approach to global liquidity provision today. A collateral benefit of such cooperation is that it can mitigate other coordination failures in national economic policies. Unfortunately, these continue to cause tensions between governments, and there are no easy solutions in a world of sovereign nations.

References Aizenman, Joshua, and Yi Sun. 2009. “The Financial Crisis and Sizable International Reserves Depletion: From ‘Fear of Floating’ to the ‘Fear of Losing International Reserves’?” NBER Working Paper no. 15308. Cambridge, MA: National Bureau of Economic Research. Borio, Claudio, and Piti Disyatat. 2011. “Global Imbalances and the Financial Crisis: Link or No Link?” BIS Working Paper no. 346. Bank for International Settlements. Boughton, James M. 2001. Silent Revolution: The International Monetary Fund, 1979–1989. Washington, DC: International Monetary Fund. ———. 2011. “Jacques J. Polak and the Evolution of the International Monetary System.” IMF Economic Review 59:379– 99. Brunnermeier, Markus K., and Lasse Heje Pedersen. 2009. “Market Liquidity and Funding Liquidity.” Review of Financial Studies 22:2201– 38. Calvo, Guillermo A. 2006. “Monetary Policy Challenges in Emerging Markets: Sudden Stop, Liability Dollarization, and Lender of Last Resort.” NBER Working Paper no. 12788. Cambridge, MA: National Bureau of Economic Research. Calvo, Guillermo A., and Carmen M. Reinhart. 2002. “Fear of Floating.” Quarterly Journal of Economics 107:397– 408.

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Canzoneri, Matthew, Robert Cumby, Behzad Diba, and David López-Salido. 2010. “Key Currency Status: An Exorbitant Privilege and an Extraordinary Risk.” Typescript, Georgetown University, November. Caves, Richard E. 1965. “ ‘Vent for Surplus’ Models of Trade and Growth.” In Trade, Growth, and the Balance of Payments: Essays in Honor of Gottfried Haberler, edited by Richard E. Caves, Harry G. Johnson, and Peter B. Kenen, 95– 115. Chicago: Rand McNally and Company. Cooper, Richard N. 1969. “Postscript: Updating International Money.” In Money International, edited by Fred Hirsch, 575– 605. Harmondsworth, UK: Penguin Books. Cumby, Robert E. 1983. “Special Drawing Rights and Plans for Reform of the International Monetary System.” In International Money and Credit: The Policy Roles, edited by George M. von Furstenberg, 435– 73. Washington, DC: International Monetary Fund. Dominguez, Kathryn M. E., Yuko Hashimoto, and Takatoshi Ito. 2012. “International Reserves and the Global Financial Crisis.” Journal of International Economics 88:388– 406. Dooley, Michael, David Folkerts-Landau, and Peter Garber. 2008. Asia, Interest Rates, and the Dollar, 2nd edition. New York: Deutsche Bank Securities. ———. 2009. “Bretton Woods II Still Defines the International Monetary System.” Pacific Economic Review 14:297– 311. Eichengreen, Barry. 2011. Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System. New York: Oxford University Press. Farhi, Emmanuel, Pierre-Olivier Gourinchas, and Hélène Rey. 2011. Reforming the International Monetary System. London: Center for Economic Policy Research. Available from http://www.cepr.org/pubs/books/P226.asp. Fischer, Stanley. 1999. “On the Need for an International Lender of Last Resort.” Journal of Economic Perspectives 13:85– 104. Giavazzi, Francesco, and Luigi Spaventa. 2010. “Why the Current Account May Matter in a Monetary Union: Lessons from the Financial Crisis in the Euro Area.” Discussion Paper 8008. Center for Economic Policy Research, September. Goldberg, Linda S., Craig Kennedy, and Jason Miu. 2011. “Central Bank Dollar Swap Lines and Overseas Dollar Funding Costs.” Economic Policy Review, Federal Reserve Bank of New York (May):3– 20. Goodhart, Charles A. E. 1999. “Myths about the Lender of Last Resort.” International Finance 2:339– 60. Greenspan, Alan. 2007. The Age of Turbulence. New York: Penguin Press. Gourinchas, Pierre-Olivier, Hélène Rey, and Nicolas Govillot. 2010. “Exorbitant Privilege and Exorbitant Duty.” Typescript, UC Berkeley, London Business School, and École des Mines, May. Hall, Stephen G., and George S. Tavlas. 2011. “The Debate about the Revived Bretton Woods Regime: A Survey and Extension of the Literature.” Typescript, Bank of Greece, August. Henning, C. Randall. 1994. Currencies and Politics in the United States, Germany, and Japan. Washington, DC: Institute for International Economics. Hirsch, Fred. 1969. Money International. Harmondsworth, UK: Penguin Books. International Monetary Fund. 2010. “The Fund’s Mandate—The Future Financing Role: Reform Proposals.” Washington, DC: Finance, Legal, and Strategy, Policy, and Review Departments, IMF, June. Ishi, Kotaro, Mark Stone, and Etienne B. Yehoue. 2009. “Unconventional Central Bank Measures for Emerging Economies.” IMF Working Paper WP/09/226, October.

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Jeanne, Olivier, and Charles Wyplosz. 2003. “The International Lender of Last Resort: How Big Is Big Enough?” In Managing Currency Crises in Emerging Markets, edited by Michael P. Dooley and Jeffrey A. Frankel, 89– 118. Chicago: University of Chicago Press. Kemp, Murray C. 1962. “Foreign Investment and the National Advantage.” Economic Record 38:56– 62. Kenen, Peter. 2010. “An SDR Based Reserve System.” Journal of Globalization and Development 1 (2): Article 13. Available from http://www.bepress.com/jgd/vol1 /iss2/art13. Keynes, J. M. 1924. “Foreign Investment and National Advantage.” The Nation and Athenaeum 35:584– 87. Kindleberger, Charles P. 1967. Europe’s Postwar Growth: The Role of Labor Supply. Cambridge, MA: Harvard University Press. Korinek, Anton. 2011. “The New Economics of Prudential Capital Controls.” IMF Economic Review 59:523– 61. Krugman, Paul R., and Maurice Obstfeld. 1988. International Economics: Theory and Policy. Boston: Little, Brown. Lane, Philip R., and Gian Maria Milesi-Ferretti. 2007. “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970– 2004.” Journal of International Economics 73:223– 50. Maggiori, Matteo. 2011. “Financial Intermediation, International Risk Sharing, and Reserve Currencies.” Typescript, University of California, Berkeley, November. Magud, Nicolás E., Carmen M. Reinhart, and Kenneth S. Rogoff. 2011. “Capital Controls: Myth and Reality—A Portfolio Balance Approach.” NBER Working Paper no. 16805. Cambridge, MA: National Bureau of Economic Research. McCauley, Robert N., and Catherine Schenk. 2012. “How Is the Substitution Account Doing?” Typescript, Bank for International Settlements and University of Glasgow, September. McGuire, Patrick, and Götz von Peter. 2009. “The US Dollar Shortage in Global Banking and the International Policy Response.” BIS Working Paper no. 291. Bank for International Settlements, October. Metzler, Lloyd A., Robert Triffin, and Gottfried Haberler. 1947. International Monetary Policies. Postwar Economic Studies no. 7. Washington, DC: Board of Governors of the Federal Reserve System. Obstfeld, Maurice. 2009. “Lenders of Last Resort in a Globalized World.” Monetary and Economic Studies 27:35– 52. Bank of Japan, available from http://www.imes .boj.or.jp/english/publication/mes/fmes.html. ———. 2011. “International Liquidity: The Fiscal Dimension.” Monetary and Economic Studies 29: 33– 48. Bank of Japan, available from http://www.imes.boj.or.jp /research/abstracts/english/me29-3.html. Obstfeld, Maurice, and Kenneth Rogoff. 2007. “The Unsustainable US Current Account Position Revisited.” In G7 Current Account Imbalances, edited by Richard H. Clarida, 339– 66. Chicago: University of Chicago Press. Obstfeld, Maurice, and Alan M. Taylor. 2004. Global Capital Markets: Integration, Crisis, and Growth. Cambridge: Cambridge University Press. Ogawa, Eiji, and Takatoshi Ito. 2002. “On the Desirability of a Regional Basket Currency Arrangement.” Journal of the Japanese and International Economies 16:317– 34. Ostry, Jonathan D., and others. 2010. “Capital Inflows: The Role of Controls.” IMF Staff Position Note SPN/10/04, February. ———. 2011. “Managing Capital Inflows: What Tools to Use?” IMF Staff Discussion Note SDN/11/06, April. Prasad, Eswar S. 2011. “Role Reversal in Global Finance.” Paper presented at the

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2011 Economic Policy Symposium of the Federal Reserve Bank of Kansas City, August. Available from http://www.kansascityfed.org/publications/research/escp /escp- 2011.cfm. Rose, Andrew K., and Mark M. Spiegel. 2012. “Dollar Illiquidity and Central Bank Swap Arrangements during the Global Financial Crisis.” Journal of International Economics 88:326– 40. Roubini, Nouriel. 2006. “The BW2 Regime: An Unstable Equilibrium Bound to Unravel.” International Economics and Economic Policy 3:303– 32. Solomon, Robert. 1996. “Creation and Evolution of the SDR.” In The Future of the SDR in Light of Changes in the International Financial System, edited by Michael Mussa, James M. Boughton, and Peter Isard, 25– 40. Washington, DC: International Monetary Fund. Stone, Mark R., W. Christopher Walker, and Yosuke Yasui. 2009. “From Lombard Street to Avenida Paulista: Foreign Exchange Liquidity Easing in Brazil in Response to the Global Shock of 2008– 09.” IMF Working Paper WP/09/259, November. Triffin, Robert. 1960. Gold and the Dollar Crisis. New Haven, CT: Yale University Press. Truman, Edwin M. 2008. “On What Terms Is the IMF Worth Funding?” Working Paper Series WP 08-11, December. Peterson Institute for International Economics. ———. 2010. “The IMF as an International Lender of Last Resort.” Real Time Economic Issues Watch, October 12. Peterson Institute for International Economics. Available from http://www.piie.com/realtime/?p=1767. Williamson, John. 1994. “The Rise and Fall of the Concept of International Liquidity.” In The International Monetary System, edited by Peter B. Kenen, Francesco Papadia, and Fabrizio Saccomanni. Cambridge: Cambridge University Press. Wolf, Martin. 2008. Fixing Global Finance. Baltimore, MD: Johns Hopkins University Press. Yeager, Leland B. 1976. International Monetary Relations: Theory, History, and Policy, 2nd edition. New York: Harper and Row. Zhou, Xiaochuan. 2009. “Reform the International Monetary System.” Typescript, March. Available from http://www.pbc.gov.cn/publish/english/956/2009/20091 229104425550619706/20091229104425550619706_.html.

Comment

Takatoshi Ito

Maury Obstfeld covers three deep topics in this chapter: the Triffin dilemma, liquidity, and global imbalances. This chapter presents the balanced views on a wide range of topics: from old to new and from academic to policy oriented. The first topic is the Triffin dilemma. The classic Triffin dilemma is about the impossibility of having and maintaining credibility of the international reserve currency, namely the US dollar: current account deficits of Takatoshi Ito is dean and professor in the Graduate School of Public Policy, University of Tokyo, and a research associate of the National Bureau of Economic Research. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12597.ack.

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the United States are needed to provide international liquidity, but more liquidity means accumulated deficits, which would eventually lead to loss of credibility and eventual devaluation of the key currency. Obstfeld correctly points out that the classic version of the Triffin dilemma is not valid anymore in the modern world of free capital flows. However, he argues that there is now a modern version of the Triffin dilemma. Since reserve assets of the emerging market economy has to consist of liquid and safe assets, only assets that qualify are US Treasuries. Hence, in order to provide liquidity, the United States has to run fiscal deficits. Or, larger and larger deficits can be absorbed by the emerging market (EM) countries, as long as EM countries continue to grow. This is another way of looking at the exorbitant privilege of the key currency country. A small puzzle is that no other advance country is providing reserve assets. According to the IMF (International Monetary Fund), COFER (Currency Composition of Official Foreign Exchange Reserves) statistics, the US dollar consists of 62 percent of global reserve assets in 2009, down from 72 percent in 2001. The decrease in the US dollar is mostly matched by the increase in the euro (19 percent in 2001 to 28 percent in 2009). So, is the euro on its way to share the status of the reserve currency? We might have thought so, until the European sovereign debt crisis erupted in 2010 and 2011. As of this writing, Greece government bonds are on the verge of default (Credit Default Swap shows the default probability of 98 percent), and yields of several other countries in the eurozone are rising and deviating from German bonds. Obstfeld considers several scenarios for the future of the Triffin dilemma. One possibility is that EM countries start accumulating risky assets rather than traditional reserve assets. This takes off the burden of issuing more and more Treasuries on the part of the United States, and higher returns can be pursued. After accumulating so much reserve assets, China and Korea established their own versions of the Sovereign Wealth Fund, modeling them after a Singaporean one. Having a reasonably high reserve level, extra buffer can be managed in a portfolio with slightly higher risk, and slightly higher return category. Hence, this scenario is very likely to be realized. The second possibility that Obstfeld considers is deceleration of EM countries. But, as convergence in the per capita income is expected to take place, high economic growth of BRICS (Brazil, Russia, India, China, and South Africa) for another decade or two is expected. The third scenario is that some countries graduate from attack- prone EM country status and become stable advanced countries. The best precedent is Japan. The second topic is liquidity. Many EM economies suffered financial crises resulting from sudden capital outflows in the last two decades: the Mexican crisis of 1994– 1995, the Asian crisis of 1997– 1998, and subsequent crises in Russia, Brazil, Turkey, Argentina, and some emerging market economies during the Global Financial Crisis of 2007– 2009. Many of these crises were characterized as a liquidity crisis.

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The IMF was supposed to be a leading organization to provide liquidity to countries that are temporarily in shortage of international reserves. However, for several reasons, the IMF could not provide sufficient liquidity to these crisis- hit countries. One of the reasons was the IMF itself did not have an unlimited source of liquidity—it is not a central bank, after all. Another reason is that there was a limit that one country can borrow from the IMF in proportion to its contribution toward the IMF quota. Countries (i.e., members of the IMF) could borrow under Stand- by Arrangement (SBA) only up to three times of its contribution to the IMF (i.e., quota) before the Mexican crisis occurred. This was called an access limit. During the Mexican crisis management, the access limit was raised to five times. Later, during the Korean crisis management, the access limit was raised to twenty times of quota under a new facility, Supplemental Reserve Facility (SRF). If a liquidity crisis is to be avoided by providing liquidity by the IMF as an international lender of last resort, these two limitations should be removed. Moreover, policy conditions—conditionality—for liquidity assistance have been vastly unpopular among the liquidity recipient countries. (See Ito 2007a.) Whether it is a good thing to have an international lender of last resort is an old question. Most famously, it was debated between Harry Dexter White and John Maynard Keynes at the Bretton Woods conference that essentially created the IMF and the World Bank. Keynes advocated that bancor should be issued by the IMF as international reserve currency, while White, opposed to the idea, instead argued in favor of the gold- dollar peg system that later was adopted. During the EM financial crises in the 1990s, voices that blame EM countries for poor macroeconomic policies and crony capitalism were strong and unconditional liquidity provision was not favored. Instead, the IMF imposed structural conditionalities that might help a country to raise their potential growth rate in the long run, but that were irrelevant to the urgent liquidity needs. The EM countries maintained that they were the victims of volatile capital flows. In order to cope with large capital flows, there are two options: an international lender of last resort providing liquidity or EM countries adopting capital controls to regulate flows. The IMF conditionalities and countries’ not meeting them seriously eroded market confidence in the country. Asian countries felt conditionalities were misguided or mistimed so that they became part of the problem instead of part of the solution. After the dust settled, Asian countries started to accumulate foreign reserves in order to protect themselves from a future crisis. This would become known as a “self- insurance” motive of reserve accumulation, which will be discussed later. During the Global Financial Crisis of 2007– 2009, especially after the Lehman Brothers failure of September 2008, the United States and Euro-

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pean central banks and Treasuries provided almost unlimited dollar provision and capital injection to Western banks. As of this writing, the European sovereign debt crisis of 2010– 2011 has become a test of political will among the euro area countries, whether to provide unlimited liquidity to fiscal deficit countries or to allow Greece to default with a large haircut. In the wake of the Asian crisis, the IMF has attempted to overcome the problems of access limit and stringent conditionality in response to the criticism against the IMF. A basic idea is to certify a country with strong fundamentals to be qualified to a credit line without conditionality or negotiation should the need for liquidity emerge. A series of new facilities have been introduced with little success: Contingent Credit Lines (CCL), Flexible Credit Line (FCL), and Precautionary Credit Line (PCL). The CCL was abolished without any applicant, and FCL and PCL applicant countries are limited to several countries, mostly European peripheral countries. During the Global Financial Crisis, the Federal Reserve Bank of New York extended a swap arrangement to central banks of four emerging market economies (Korea, Singapore, Mexico, and Brazil in October 2008) as well as major advanced countries’ central banks. The swap agreement did help Korea to overcome vulnerability to its currency (see Dominguez, Hashimoto, and Ito 2011). This showed that the Federal Reserve, instead of the IMF, could act as liquidity provider to EM countries, if it chooses to do so. However, this was a very exceptional case where internationally active western banks were in shortage of dollar funds and withdrawing their funds (i.e., deleveraging) from all over the world. As Obstfeld argues, there are several well- known objections to having an international lender of last resort, even if it can be possible. First, it may encourage fiscal authorities to be irresponsible. This is an extension of the logic that the central bank should not buy newly issued government debt in the domestic context. Irresponsible fiscal policy—that is, moral hazard of the fiscal authority—should not be encouraged by unconditional lending to a country. Second, having an international lender of last resort may make EM countries careless in managing its external liabilities of the banking sector as well as fiscal authorities. My comments on this topic are as follows. Moral hazard is not necessarily limited to borrowers. If the lender of last resort is expected to rescue the indebted countries, lenders to EM countries and banks in EM countries may underestimate risks of lending too much. In fact, for every “bailout” operation that the IMF has engaged, a criticism of “who really is bailed out” has been heard. The criticism goes as follows: in the case of the Mexican crisis, it was not Mexico that was bailed out, but the Wall Street lenders (holders of Mexican government debt securities); in the case of Asian crises, it was not Thailand, Indonesia, and Korea that were rescued, but Japanese and

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Western banks that had lent to banks of these countries. Those who emphasize the lenders’ responsibility often advocate the private sector involvement (PSI)—that is, haircut for liabilities—as a part of solving the sovereign/ banking crisis. In order to discuss the lender of last resort, it is essential to distinguish illiquidity and insolvency. For illiquidity, IMF facilities (FCL and PCL) can be expanded, and central banks can provide liquidity, and for insolvency, insolvency procedures can be devised and introduced. The Sovereign Debt Restructuring Mechanism (SDRM) proposed by First Deputy Managing Director Anne Krueger in 2002 was such an attempt, although it did not materialize. But the distinction is often blurred. Illiquid banks and countries may become insolvent, if liquidity is not provided in time. It is often argued that the lender of last resort operation should come with a higher interest rate in order to avoid moral hazard. (This is an application of the Bagehot rule.) The SRF was constructed on this principle. Korea borrowed under SRF at the high interest rate in December 1997, but repaid within a year, by generating large surpluses. Asian countries, most notably China, have massively accumulated foreign reserves from 1999 to 2007. The phenomenon is often called self- insurance, since those countries explicitly desire to avoid future liquidity crisis, without the help of the IMF. They have stigma with IMF conditionality. When the global financial crisis came, some of these countries experienced the capital outflows. Dominguez, Hashimoto, and Ito (2011) showed the following: first, the EM countries did use accumulated foreign reserves to moderate the currency depreciation pressure. There were marked decline in foreign reserves of some of the Asian countries, including Korea. Second, those with higher reserves before the onset of the 2007– 2009 crisis experienced better growth recovery in 2009– 2010. In a sense, self- insurance worked. The third topic is the exchange rate and global imbalances. Obstfeld illustrates that the exchange- rate regime decision may depend on the exchangerate decision of other (export competing) countries. His example is China and Brazil. A Nash equilibrium problem is explained. A similar theoretical framework has been pointed out in the wake of the Asian currency crisis. Ito, Ogawa, and Sasaki (1998) and Ito (2007a) explained why East Asian countries maintained a dollar peg before the crisis. In East Asia, the intraregional trade ratio is as high as the EU area. Hence, if one country departs from the fixed exchange rate and appreciates its currency, the country will be adversely affected in its competition in the region and also final destination of products, the United States. However, if they collectively float against the US dollar and the European currencies, a country in the region may not suffer as much. One way to achieve the joint float is to create an Asian regional monetary unit (RMU), just like ECU before the euro, and each country pegs the currency to the RMU.

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Global imbalances have been a topic of international discussions since the mid- 2000s. First, it was discussed in the IMF multilateral consultation and then the G20 mutual assessment program (MAP). In 2011, the IMF started spillover reports for five countries, which examines the impact of macroeconomic policy on other countries. In general, current account imbalances per se cannot be a major concern. However, if one country continues to run current account deficits, then external liabilities may become unsustainable. If the country to run deficits is the key currency country, like the United States, then the worry of the Triffin dilemma reappears, even in the flexible exchange- rate world for advanced countries. My take on the exchange rate and global imbalances is as follows: global imbalances become a symptom of something problematic, only when it is a reflection of policies that are not consistent or sustainable. If the exchangerate regime of China is a problem, and there are several good arguments for this, then its exchange- rate policy should be discussed instead of global imbalances. Discussing multilateral consultation, MAP, and spillover reports seem to be avoiding the crux of the matter, namely, the exchange- rate policy. In conclusion, in light of Obstfeld chapter and this discussion, the current euro sovereign debt crisis can be put into perspective. The origin of the euro crisis is fiscal deficits. In that sense, the crisis is similar to the repeated crises among the Latin American countries, including one with syndicated bank loans in the 1980s. So, fiscal austerity is the standard textbook recommendation to these countries. If a country is insolvent (debts being unsustainable under plausible assumptions on growth and tax revenues), then debt reduction is necessary. Providing liquidity on the pretense of liquidity crisis will not solve the crisis. In that sense, the solution to the Greek crisis seems to be tilting toward orderly default. Germany insisted on the haircut through “voluntary” rollover to longer maturity bonds, and this is part of the second rescue package. Thus, the crisis is of a different nature than the EM crisis, but the principle and challenges of providing assistance is the same. References Dominguez, Kathryn M. E., Yuko Hashimoto, and Takatoshi Ito. 2011. “International Reserves and the Global Financial Crisis.” NBER Working Paper no. 17362. Cambridge, MA: National Bureau of Economic Research. Ito, Takatoshi. 2007a. “Asian Currency Crisis and the IMF, Ten Years Later: Overview.” Asian Economic Policy Review 2 (1): 16– 49. ———. 2007b. A Basket Currency for Asia. London: Routledge. Ito, Takatoshi, Eiji Ogawa, and Yuri Nagataki Sasaki. 1998. “How Did the Dollar Peg Fail in Asia?” Journal of the Japanese and International Economies 12 (4): 256– 304.

9 Global Macroeconomic and Financial Supervision Where Next? Charles A. E. Goodhart

9.1

Introduction

There are two main problems to be faced in any attempt to improve the architecture of international macroeconomic and financial oversight. The first is structural; the second is analytical. The first difficulty resides in the discord between having a system of national sovereignty at the same time as an international market economy, with a global financial and information technology framework, with largely free movement of goods and capital, though not yet of people. Political and military power remains at the nation state level, and separation between such nation states is reinforced by the different languages, cultures, and legal systems of the countries. The second main problem is one of analysis. Whereas we economists are generally comfortable in our analysis of real shocks, within a neo-Keynesian framework with wage/price stickiness tacked onto an otherwise real business cycle (RBC) dynamic stochastic general equilibrium (DSGE) model, and with a perfect frictionless financial system, we are much less assured when dealing with the analysis of models in which there are financial frictions, with an incomplete financial system, in which default, money, and banks play an essential role. Such complications often interact. Let me give two examples. First, the Basel Committee on Banking Supervision (BCBS) in its attempts to provide an international structure for banking regulation felt that it had no locus Charles A. E. Goodhart is emeritus professor in the Financial Markets Group at the London School of Economics. He was a member of the Bank of England’s Monetary Policy Committee from June 1997 to May 2000. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12599.ack.

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for imposing any (ladder of) sanctions for those banks transgressing their proposed ratios, since the imposition of sanctions/penalties was a national (not a supranational) legal prerogative.1 As a result, their proposed capital adequacy ratios (CAR) came to be treated as required minima (the word “requirement” carries a lot of baggage), and to fall below such a required minimum could involve serious reputational risk. So, the available buffer for loss absorption became the much more exiguous margin, which banks voluntarily held above the required minima. Next, the question of “Why did no one foresee this crisis?”, as put by the Queen to an economist at the London School of Economics (on the occasion of the ceremonial opening of a new academic building) (Agence France-Presse, November 5, 2008), was in part answerable by noting the relative weakness of the analysis of financial frictions, in the face of national insistence that all was satisfactory. Thus, many of the warnings about the dangers of excessive leverage, from Ragu Rajan at the International Monetary Fund (2005, 2006), and from William White (2004, 2006), Claudio Borio (2007), and with Borio and White (2004), and Borio and Philip Lowe (2003, 2004) at the Bank for International Settlements (BIS) were laughed off, denied, or ignored, and often comprehensively watered down by the national authorities involved. Nor was it, at the time, difficult to ignore such warnings. Not only are financial crises relatively rare tail events with a low frequency and unpredictable trigger, but also, according to Basel II and IFRS/GAAP (international financial reporting standards/generally accepted accounting principles) , never in recent decades had the banking systems of developed countries seemed stronger, more profitable, and better capitalized than in 2006 and 2007, just before the crisis stuck. Markets completely concurred; CDS (credit default swap) rates for major banks were then generally at an all- time low (see figure 9.1). We simply did not have the analytical power to demonstrate, over national objections, how objectively dangerous the context had become, though, as noted earlier, several economists working within the international supervisory authorities had perceived this. There is some chance that the current analytical shortcomings of macrofinancial analysis may be rectified, somewhat. There is much less likelihood of any improvement to the deeper structural problem, whereby a global trading and financial system coexists with national sovereignty over political and fiscal powers, separate legal structures, and so forth. There are, of course, two logical and comprehensive responses to this latter state of affairs. The first would be to transfer sovereignty and political (and other) powers to the global level, with each country abandoning sole 1. This self- imposed constraint by the BCBS and Financial Stability Board (FSB) on their own actions is at long last being relaxed in the course of the Basel III negotiations, with any reduction in a bank’s tier 1 core equity capital from 7 percent to the minimum of 4.5 percent being met by the application of sanctions.

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Fig. 9.1 Average of five-year CDS prices for thirty major global banks (New York intraday prices) Source: Bloomberg. Note: The thirty major banks are American Express, BBVA, Banco Santander, JPMorgan, Bank of America, Wells Fargo, Citigroup, BNP Paribas, Societe Generale, Credit Suisse, Commerzbank, Deutsche Bank, Morgan Stanley, UBS, Goldman Sachs, Credit Agricole, HSBC Bank PLC, Barclays, ING, Lloyds TSB, RBS, Nomura, Standard Chartered PLC, Mitsubishi UFJ Financial, Intesa Sanpaolo SpA, Sumitomo Mitsui Banking, Mizuho Corporate Bank Ltd, Royal Bank of Canada, Macquarie Bank Ltd, and UniCredit SpA.

control over its own affairs. Whereas from a utilitarian (or Rawlsian) viewpoint this would be both best and most efficient, it will not happen. The basic reasons are twofold. First, the major inequalities between countries mean that, in a democratic, one- person one- vote, world system, the inhabitants of the wealthy developed West would most likely lose out against the poorer, more populous South and East. The main opposition to a truly world democratic system will come from North America and Europe. Second, fiscal and other redistribution within such a world system would shift resources from within relatively close- knit, self- similar, and cohesive groups to involve shifts between groups who have little in common and little personal contact. Even with the widening international horizons that information technology now brings, forcibly shifting resources from, for example, Canadians to Bangladeshis is not likely to be received happily in Toronto. The world, alas, is not (yet?) ready for a global, unified political system. The second logical response, if one cannot transfer political power to the global level, is to make the trading and financial systems subject to national control, where the political power lies. The greatest loss in efficiency and generalized welfare from having national control relates to trade in goods, though even here the advantages of free trade (without national tariffs and subsidies) have not yet been accepted in agriculture, especially in basic

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Scale of International Flexibility

foodstuffs. So, even within a world of separate nation states, most countries broadly adhere to a global system, managed and monitored by the World Trade Organization (WTO). And even under the extra pressure of the recent crisis, there was little evidence of backsliding on this front. Instead, concern about “unfair” trading practices in goods has become transmuted into disputes about currency manipulation, whereby countries accuse each other of policies whose objective is to achieve competitive trading advantage. We can, perhaps, picture a scale showing the relative concern of nations to retain control, rather than allowing global management, as shown in figure 9.2. At the extremes few currently advocate either reimposing national controls over trade in goods or would seriously propose free global movement of persons. In between there is a general readiness to try to promote greater global freedom of services trade, at the same time as the Washington consensus on freedom of capital movement has come under greater attack. Meanwhile some recent adverse supply shocks in agriculture have underscored the primary responsibility of national authorities to feed their own people at acceptable prices, so the likelihood of any agreement of free trade in agriculture, whatever its long- term overall welfare benefits, has probably receded yet further. But this chapter is macro/finance oriented, rather than having a macro/ trade focus. So we will concentrate on the question of whether the global/ national fault structure could be resolved by making the whole financial system more localized/national in character. This would be easy enough to do in practice. A first necessity would be to require all significant foreign- owned financial entities to establish themselves in each nation state as a nationally incorporated subsidiary, not a branch. New Zealand is, once again in (central) banking practices, the exemplar. All its major banks are foreign (Australian) owned; the Reserve Bank of New Zealand (RBNZ) has required all these subsidiaries to be so structured (e.g., with nationally separate IT and Treasury facilities), that, following the closure of the Australian head office, for whatever reason, the NZ subsidiary could be up and independently running the very next day. The disaster of the enforced closure of Lehman

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Bros. International Europe (Lehman’s London), or of Icesave, would not be such a disaster there, though there would still no doubt be problems (e.g., in disentangling exactly where the claims on, or by, the separate parts of the failing Australian bank resided, notably if rehypothecation remains a common practice). Many financial crises are transmitted from country to country, and sometimes triggered, by sudden surges, or “stops,” in international capital flows (e.g., Calvo, Izquierdoa, and Mejia 2008; Calvo, Izquierdoa, and Talvi 2006; and Calvo 1998, 2009). In the face of this, it is far from clear that trying to enforce complete freedom of capital movements is generally optimal. Besides exchange controls, various instruments (e.g., limits on certain fx positions, taxes on certain forms of international capital flows, differential reserve requirements) are available to national authorities to try to influence such capital flows, with varying degrees of slippage. The climate of opinion has been changing in recent years from steadfast opposition toward somewhat grudging acceptance of national controls over short- term capital flows. But the move in this direction is likely to be limited. One reason for this is that Europe remains adamantly committed to the free movement of capital amongst members of the European Union, despite the role that such capital flows have played in the current crisis there. Indeed it is in the EU, and even more so in the eurozone, that the conflict, the fault line, between supranational and national, reaches its most extreme. The European ideal, that national countries should pool a large part of their sovereign powers in the interests of both European harmony and of broader economic efficiency, is entirely admirable, indeed marvelous in concept. Yet the same countries have not been prepared to go all the way toward a centralized, federal political system with a sizable central federal budget, nor yet a central system for applying macro- and microprudential oversight, though the EU is now moving rapidly in this latter direction with the recent establishment of the ESRB, the European Systemic Risk Board, and the associated three European supervisory boards for banks (EBA), for insurance (EIOPA), and for securities markets (ESMA).2 If (and when), the eurozone can find a way through its current problems, this may give the rest of the world some guidance whether a middle way can be found between supranational (global) political and legal systems (which may have some attractive features but are politically unacceptable) on the one hand and local, national control on the other (practical but suboptimal and inefficient); (see Trichet 2011). The initial analysis, in Europe at least, of the potential problems for such 2. As Rosa Lastra puts it (in private correspondence), “The non- exclusive transfer of sovereign powers from the national to the supra- national arena (monetary yes, fiscal no) has resulted in what constitutional law experts would refer [to] as a dynamic system between centralization and decentralization. And experience shows that those systems evolve, often gravitating towards the centre.”

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a middle way, as in the eurozone, was faulty. It focused unduly on public sector indebtedness, the (in)famous Maastricht criteria, ignoring the fact that private sector indebtedness could be just as corrosive, notably when the funds are used either for immediate consumption or for investment purposes (e.g., housing) that would not generate future receipts to pay off the debt. A problem is that the distinction between a sustainable accumulation of debt (whether public or private) and an unsustainable one is not easy to make, and is, as always, subject to interpretation. Moreover, a national boom, with local expenditures greater than local output, financed by debt accumulation from abroad (i.e., current account deficits), is normally accompanied by a relative worsening of unit labor costs, relative to its trading partners. Indeed, that is part of the standard adjustment process. The problem, however, is that, should that boom come to a sudden end, there needs to be a rapid realignment of relative unit labor costs, especially in the previous boom country, in order to promote adjustment. This is a key role for flexible exchange rates. When exchange rates are fixed, as in the eurozone, the problem becomes much harder. A gradual adjustment downwards in wages/prices in the deficit countries raises real interest rates there and can set off a debt/deflation spiral. A quick, sizable, generalized, fair, common reduction in all forms of remuneration (e.g., wages, salaries, pensions, etc.) can be achieved in small cohesive countries (e.g., Singapore, Latvia, and to some large extent in Ireland). Whether the same (politicoeconomic) response (a quick internal devaluation) can be carried out in larger, more complex, more politically divided countries remains to be seen. One of the pervasive problems of global (or regional) macroeconomic adjustment is that the onus to undertake such adjustment falls asymmetrically, and almost entirely, on the deficit, indebted country, at least when it has borrowed in a foreign currency. The deficit country then has to adjust. When concerns about its ability/willingness to repay debts occur, it either has to reduce its deficit rapidly to zero, or to convince potential lenders that it can/will repay, or seek external assistance from the International Monetary Fund (IMF), or a regional fund such as the European Financial Stability Facility (EFSF) (while it carries out an adjustment process). Moreover, there is a knife- edge, tipping problem. Rising concerns about potential default raise the interest rate that the deficit country has to pay in the market for, either new or rollover, funds, which in turn raises the likelihood of default. When a country has accumulated debts to the rest of the world in its own currency, it has another option, of inflating those (nominal) debts away. That also can be painful, notably to domestic creditors, and disruptive to economic management. Inflation is another form of default. The choice between debt restructuring and inflation, even when the latter is an option, will not necessarily always come down consciously on the side of choosing generalized inflation. In the meantime the surplus countries are under much less pressure to

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adjust. Apart from concerns about currency manipulation and covert barriers to imports, they are, almost by definition, virtuous, competitive with low relative unit labor costs, with high savings and less local expenditure than output. How can one criticize success; apart perhaps from noting that the capital transfers to the deficit countries could in most cases have been used more productively at home. Keynes, notably in his plans for the post–World War II international financial architecture (1941), was worried about the bias toward worldwide deflation that this asymmetry introduced (also see Kregel 2010). Despite Keynes’s attempt to introduce a more symmetric system being thwarted by the main creditor country at the time (i.e., the United States), world history since 1945 has been characterized by inflation, not deflation. This was, however, more the result of poor analysis and policy in the attempt to control inflation rather than a conscious desire to lower high postwar debt ratios by maintaining high inflation, with low, or negative, real interest rates. But now that macroeconomists and policymakers have become more adept at achieving low and stable inflation targets, the “great moderation,” so that surplus countries can hold inflation to around, say, 2 percent, will that mean that the asymmetric deflationary adjustment bias in deficit countries, allied with the zero nominal interest rate bound (ZIRB), will cause more serious debt/deflationary problems in deficit countries? That was the background that led some in the IMF (Blanchard, Dell’Ariccia, and Mauro 2010) to consider whether a revision of generally acceptable inflation targets from 2 to 4 percent might be desirable. Such a change would have had no obvious benefits for countries that either did not need to adjust (i.e., surplus countries) or could use flexible exchange rates to do so quite rapidly, and also carried with it a danger of weakening the credibility of all such targets. Whether for these, or other reasons, this trial balloon was comprehensively shot down by almost all major central banks. But that still leaves the problem that the macroeconomic adjustment process still falls asymmetrically on deficit countries, and in a low inflation context could cause debt/deflation spirals. We turn to this problem at greater length next in section 9.2. We then revert to discussion of global financial supervision in section 9.3. 9.2

Macroeconomic Adjustment Processes

A sovereign has the power to tax and to issue (non- interest- bearing) currency, which it can make legal tender for all debts. This power is subject to the assent of the people and can be overturned by revolution or defeat in war. A subsidiary sovereign has a (possibly limited) power to tax, but cannot issue its own currency. It has to borrow in currencies issued by some other sovereign.

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Nonsovereigns can borrow in the currency of their own sovereign, or another. In the latter case they run an additional foreign exchange (fx) risk. Otherwise they either repay by running surpluses of receipts over outgoings, or default and restructure. Subsidiary sovereigns normally borrow only in the currency of their own sovereign, but can (sometimes) borrow in the currency of another. They have to accept, as exogenously determined, the average rate of inflation in the country as a whole. They too can either repay debt, by raising taxes relative to expenditures, or can default and restructure. In addition, both nonsovereigns and subsidiary sovereigns, when in trouble, may look to the sovereign for financial support, subsidies, and bailouts. As already noted, the sovereign has the additional power of command over the printing press, and can therefore also inflate away the real weight of nominal debt. While the latter has quite often happened in practice, it has rarely been consciously chosen as a policy, or at least publicly espoused as such, perhaps in part because of the reputational consequences to the government in office that adopted such a policy. By this definition, of course, both Portugal and Illinois, Spain and California, are similarly subsidiary sovereigns. What, then, are the main points of difference between the US states and the European eurozone states? First, a much higher proportion of taxes and expenditures flows through the federal center in the United States¸ so the failure of a US state would be both less cataclysmic and less likely in the United States, though individual states there remain responsible for essential activities, such as law and order, health, and education. Second, region- wide integration of financial services is much more complete in the United States than in the eurozone. Most financial services in the United States (e.g., banking, securities markets, and insurance), are provided now by nationwide institutions, whose holdings of state bonds are diversified. The failure of California might bring down some smaller local intermediaries, but it should not cripple the larger American financial intermediaries. By contrast, most banks, insurance companies, and so forth in Ireland are Irish. The financial systems and the eurozone states within the EU are intertwined to a degree that is just not so in the United States. A failure of a euro- state subsidiary government would, for sure, imperil the solvency of its own financial system (as effectively occurred in Argentina). Equivalently, the systemic failure of local financial intermediaries can imperil the economic well- being of the state, whether fully sovereign or subsidiary. The need to prevent economic collapse, with its own implications for government finances, thus has led governments to support their own financial systems, whether by injection of government funds or by guarantees. So within Europe, there is a complex interlinkage between state and financial system problems that is not present, or to anything like the same extent, amongst the subsidiary states of the United States. The eurozone periphery needs to resolve a joint sovereign/financial system problem, rather

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than the simpler problem in the United States. We shall consider how this may be done later in this section. As already emphasized in section 9.1, we live, still, in a Westphalian system, in which outside interference by one sovereign in the internal affairs of another is not allowed, except under very unusual or extraordinary circumstances (an example being the disputed election in the Ivory Coast). So, as a general matter, no other national power, or international collective of nation states such as the International Monetary Fund, has the ability to intervene, or to give economic directives, until the nation state in question has formally requested help. The circumstances in which states ask for such help were in the past in order to provide foreign exchange reserves, usually to maintain a pegged exchange rate. Even with floating rates, short- term inelasticities and debts accumulated in foreign currencies could cause sovereigns to have an urgent need for foreign exchange. The involvement of the IMF with Greece and Ireland has been on a different plane altogether; one can hardly claim that these countries needed euros, since this was their own currency (does Illinois need US dollars?). Why did the EU sovereign (and what exactly is the EU sovereign? the ECB?, the European Parliament?, the EU President?, the Head of the EC?), accept the IMF into its internal affairs? Perhaps a combination of reputational concerns, having the IMF rather than the EU (or Germany) administer the unpleasant medicine, of IMF competence in designing coherent rescue plans, and a shortage of funding to be made available for support within Europe (i.e., the unwillingness to accept a “transfer union” within Germany) have been, I believe, the main factors. But it has, in some ways, moved the position of the IMF a further step forward. Rather than just providing foreign exchange funds for the resolution of balance of payments difficulties, the IMF has now been made a party to the attempt to resolve overindebtedness, irrespective of the currency of the debt, or even of the sovereign status of the country. In a sense this is not new. The excessive accumulation of debt to the rest of the world, the summation of current account deficits, has been a regular precursor of balance of payments and financial crises. The IMF has commonly issued warnings about such developments in its Article IV Reports. As was, however, highlighted in the recent Expert Review of the IMF’s role in the crisis, the IMF has been constrained in “talking truth to power,” both by analytical uncertainties and by the ability of the nation states to enforce a dilution of the language involved, the more so the more powerful the nation state. Even in the case of Iceland, the IMF pulled its punches. And there always remains uncertainty whether debt accumulation is sustainable, or not. So where do we go from here? The most common proposal, usually raised by deficit countries, is that there should be some presumptive indicators of macroeconomic imbalance, that should be symmetric for both surplus and

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deficit countries. Geithner’s suggestion, put forward at the G20 Seoul meeting, that a current account deficit/surplus greater than 4 percent of GDP should serve as such an indicator, is a prime example. The recent Paris G20 meeting also searched for an agreement on such indicators. There are several problems with this approach. First, the scale of a current account deficit/surplus cannot be more than an indicator, since its sustainability depends on context. Surpluses greater than 4 percent were regularly run by France and the UK in the nineteenth century, and equivalently, deficits greater than 4 percent were run by the newly opening countries such as Australia and Canada, less so in the United States (see figure 9.3). The sustainability of deficits depends on the probability of repayment; deficit countries will claim that repayment can and will be made. Almost by definition, surplus countries must believe that they will be repaid; otherwise they would not have provided such capital transfers. Again almost by definition, concern over macroeconomic imbalances implies that, given an assumption of continuing current macropolicies, the probability that current creditor claims will not be repaid is higher than the market appears to think; see, for example, Schumacher, Garzarelli, and Broadbent (2011). If such concerns do become justified, deficit countries have to adjust and/or to default, with or without the assistance of the IMF. Meanwhile surplus countries are not forced to take any action themselves, and there is little leverage that the IMF, or anyone else, can impose on them. If the debt of the deficit country is denominated in its own currency, it could in principle threaten to inflate such debt away; and the Chinese are suggesting that this is a covert purpose of the Fed’s credit easing. But unless such debt was primarily held by foreigners, even then this would amount to cutting off one’s nose to spite one’s face. Thus, surplus countries will stand on the sidelines, taking little action simply as a result of such surpluses, and loudly demand a full adjustment by deficit countries, all the time warning of how awful for the deficit country will be the consequence of any default/ restructuring, rather than adjustment/repayment. There is little pressure that the IMF, or anyone else, can currently place on such surplus countries. Small surplus countries could, perhaps, be bullied by the global community, but by the same token the effect of an adjustment by them on the international pattern of imbalances would be small. With big countries, such as China, or Germany within the eurozone, the international community is pretty much limited to the argument that more domestic consumption (less saving) now would improve these countries’ own intertemporal welfare; that is, reducing their surplus would be of benefit to themselves. Insofar as this argument fails to sway the surplus countries, there seems, at present, little more that can be done to persuade the surplus countries to alter direction. Or is there something more? I argued earlier that the sustainability of debt/deficits depended on the probability of default/repayment, and that the worst problems/crises arose

Fig. 9.3 Current account surplus economics in 1870–1914 (CA balance as percent of GDP) Sources and Data Notes: To calculate current account balances as percentage of GDP, fiveyear moving averages of current account balance values and five- year moving averages of nominal GDP values (GDP at current prices) have been calculated and used (1866– 1870 to 1910– 1914). This was done mainly for the consistency of the data illustrated, as only five- year moving average data were available for the estimates of Canadian current account balances for the period 1868 to 1902. France: Source of GDP and current account data: Mitchell (2007b, 1009– 13 and 1045– 49). UK: Source of GDP and current account data: Mitchell (1988, 831– 33 and 869– 72). Canada: Source of GDP data: Global Financial Data; Bank of Canada. Source of current account data for 1900– 1914: Mitchell (2007a, 840– 41). Source of five- year moving average current account data for 1868– 1872 to 1898– 1902: Hartland (1960, 717– 56). Australia: Source of GDP and current account data: Vamplew (1987, 131, 133, 185, 191). US: Source of GDP and current account data: Carter et al. (2006, vol. 3, 23– 26, and vol. 5, 452– 61).

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when the market switched suddenly from an excessive belief that such repayment was assured to (possibly excessive) belief that such repayment was doubtful, with a significant chance of default/restructuring. It is, perhaps, in this context that the IMF could play a larger role. Clearly it is in surplus countries’ self- interest to press for adjustment/repayment rather than restructuring. It is not so clear that this is the appropriate balance for the IMF. Restructuring places part of the weight of loss on surplus countries. If surplus countries knew that, beyond an appropriate degree of adjustment (how measured?) the IMF would advocate, facilitate, and help to finance a process of restructuring debt in deficit countries, then they might have been more cautious about their prior capital transfers. The IMF’s raison d’etre has largely been to encourage adjustment, and to avoid insolvency, default, and restructuring. Perhaps it has gone too far in this direction. Insofar as some of the problem of economic imbalances is due to the policies of surplus countries, this raises the question of how such countries might share some of the burden when macroeconomic problems then arise. There might be several answers to this question, an assessment that would take us beyond the scope of this chapter. But if the IMF is to support such restructuring, placing more of the cost on surplus countries, these countries could reasonably argue, in turn, that they would need more forewarning of the IMF’s viewpoint. What this might superficially suggest is that the IMF should enter into the business of giving credit ratings to sovereign and subsovereign entities. But could or would the IMF be able to do so? Suppose that the IMF attempted to downgrade the credit rating of the United States! The United States could withhold its subscription and/or use its blocking power on the Board to prevent this from happening. Can the IMF stand up independently of its own member major nations? Probably not. Perhaps all that the IMF can do is to provide countervailing support to the credit ratings agencies (CRAs) when they are imposing downgrades to the credit ratings of major nation states, against the huge, and inappropriate, pressures that such nation states will apply on the CRAs not to do so, including threats of regulatory arm twisting. One possibility would be to explain a procedure for credit ratings. Thus, for example, no country with a current account deficit greater than X percent, and/or a public sector deficit greater than Y percent, could have a credit rating greater than Z, unless it provided a clear, and persuasive, plan for the elimination of such deficits. Thus, within this framework, the potentiality of any sovereign choosing to default and to restructure, even when the debts are in the sovereign’s own currency, is acknowledged. A sovereign with an unsustainable debt in its own currency (Japan?) could quite possibly prefer to restructure (partially) rather than either inflate or to load its citizens with burdensome taxes. So by the same token the risk weighting of all sovereigns cannot be zero. Perhaps the risk weighting for sovereign debt held by financial intermediaries of

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that same country might still be zero, on the grounds that the health of a country’s financial system and of its own sovereign are so closely interwoven that any government would have to support its own systemic financial intermediaries, even when it was defaulting and restructuring against all other holders. The idea that sovereign debt is riskless, let alone subsovereign debt, has become unrealistic. Instead, what is suggested here is that sovereign debt credit ratings, and alongside that risk weightings for the purpose of CARs, should be adjusted presumptively in the light of a number of key indicators, including both flow and stock variables, and relating to both public, financial, and nonfinancial entities. Of course, this would only be a presumption; the role of the IMF could be as a neutral arbiter3 to examine each nation state’s case, as would inevitably be pushed, why the presumption should not be applied in their own case. Unless the nation in question could persuade the IMF to support a positive exception in its own instance, the presumption would remain. The purpose of the exercise would be to raise the risk premium involved in the process of capital transfers from surplus countries to deficit countries, as the position of the latter verges increasingly on being unsustainable, and to give surplus countries additional forewarning that, beyond some appropriate measures of adjustment by deficit countries, the IMF would be prepared to advocate a degree of burden sharing, via orderly restructuring. The basic point being made is very simple. Neither the IMF, nor the global community, has any locus or leverage for putting external pressure on surplus countries to reduce their current account surplus, or net national savings surpluses. But, when such imbalances/savings surpluses are dangerous is when they allow/encourage deficit countries to run up unsustainable debt positions. Where the IMF, and the global community, could get a real purchase on such developments is to underscore just how risky such net capital transfers then really are, both ex ante by ensuring that credit ratings and risk weights for CARs do actually reflect those real risks and ex post 3. Rosa Lastra has told me that: A similar idea has been mentioned in the past by Walter Robicheck, advisor to the IMF Managing Director from 1982 to 1984, by Lee Buchheit, by Arminio Fraga and by Rosa Lastra. In Chapter 14 of Lastra’s Legal Foundations of International Monetary Stability (OUP, 2006) she discusses how the IMF could develop an internal rating system for countries’ banking and financial systems akin to the CAMEL system in the USA. IMF composite ratings could be based upon the results of Article IV consultations, FSAP reports, FSSAs and ROSCs, and upon the data compiled by members in accordance with the Special Data Dissemination Standard or SDDS and the General Data Dissemination System or GDDS. Arminio Fraga wrote in 1996 that the IMF should act as “the permanent auditor of countries, which should voluntarily submit themselves to examination in order to lower their borrowing costs. Annual Article IV consultations could be supplemented by quarterly reviews that would enhance the credibility of the data released under the IMF’s recent initiative [he referred to the Special Data Dissemination Standard] and thus help to reduce the costs of adjustment programs.” (Lastra, private correspondence)

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by supporting debt restructuring in those cases where internal adjustment would go too far in pushing a debtor into a debt/deflation spiral (or into a devaluation/inflation spiral). The IMF should be reviewing the theory of optimal international burden sharing. And so, of course, should the European authorities. Indeed, the problems of macroeconomic imbalances, excessive cross- border capital flows, insufficient appreciation of sovereign/financial risk, and the need for some analysis of optimal burden sharing have been even more acute in the eurozone than in the world at large. Despite brave talk about comprehensive solutions, the eurozone problem has, so far, been treated by emergency patches of liquidity, which simply delays the resolution process. Meanwhile, the bond market, rather than being chided for its prior blind optimism (with Greek bonds playing the role of AAA tranches of collateralized debt obligations, or CDOs), is currently castigated for a reversion to realism. Where will this end? Who knows? But it is difficult to be optimistic. Be that as it may, when the issue is the question of how to handle macroeconomic imbalances, the main problem has been the fault line between the global macro/financial system and the Westphalian national power structure. When we come to examining supervision of the global financial system, to which we turn next, the greater problem, perhaps, has been of analytical failure. 9.3

Global Financial Supervision: Where Next?

In order to see where we may be going next, it is a good idea to know how we got here in the first place. Let me start with structure. The Basel Committee on Banking Supervision did not see itself initially as a body that had the locus, or the ability, to set international rules, principles, or codes of conduct. Instead they saw themselves as a like- minded gathering of (mostly European) regulatory officials, exchanging experiences and discussing practices, with a view to recommending best practices and principles to their own central bank governors. That changed in 1996 when emerging countries applied to the G7 for assistance in devising some core principles for the conduct of banking supervision. Initially the BCBS was hesitant in taking on this task themselves, since it would extend their remit beyond their previous comfort zone. But, when the BCBS realized that the alternative was for the IMF to undertake this exercise, they changed their tune. There was an exchange of letters, and meetings, between Tomasso Padoa-Schioppa, then chairman of the BCBS, and Manuel Guitan of the IMF, now alas both dead, at which a concordat was agreed upon (Goodhart 2011). The BCBS, now supplemented by the Financial Stability Board (FSB), would propose the format for international regulation, while the IMF, supported by the World Bank, would do the supervisory groundwork through the FSAP (Financial System Assessment

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Procedure). In the European context the European Systemic Risk Board may, equivalently, establish some overarching macroprudential principles, leaving it to national authorities to do the detailed supervision. On the whole, the division of responsibilities between the BCBS/FSB as the regulatory body and the IMF/WB as the supervisory arm has worked well. There is much less reason to be content about the content/substance of international regulation/supervision. Again, how did we get here? The catalyst was the fragility (of capital buffers) of the major city- center US banks in the face of the MAB (Mexican/Argentine/Brazilian) LDC (less developed country) crisis of 1982. Congress wanted to enforce higher CARs unilaterally on US banks; but the US banking industry successfully argued that this would just divert financial business to (even less well capitalized) Japanese and European banks—the “level- playing-field” gambit. Thus Volcker was mandated to go to the BCBS and get an agreement, by all the major countries, for a common, higher, accord on CARs. After difficult, and quite protracted, negotiations, described in Goodhart (2011) and Solomon (1995), this resulted in the Basel I Accord (1988). No part of this Accord was influenced by inputs from economics and economists, not that they had, at least at that time¸ much to offer, since the analysis of financial frictions and their interaction with the real economy was then in its infancy and has only had a stunted growth since then. Be that as it may, there were numerous serious shortcomings with Basel I, and these were not rectified, and indeed in one respect worsened, under Basel II. I shall review three such lacunae here. First, the BCBS had no formal legislative role; it saw its function as no more than making generalized recommendations to their own national central bank governors. Hence they felt unable to discuss penalties, or sanctions, for any transgression of their proposed ratios, with the application of legal sanctions being the prerogative of each separate Westphalian nation state independently. So the CARs that they did propose (i.e., 4 percent of risk- weighted assets [RWA] for Tier 1, 8 percent of RWA for Tier 2) were treated as required minima, which could not be encroached without severe reputational cost. But, as minima, they became unavailable for loss absorption. Instead, what became the true buffer was the much more exiguous excess margin of capital above the required minima. As Martin Hellwig has noted (2009, 2010), bank capital plays several roles (e.g., loss absorption, skin- in-the- game, leverage limitation), and economists have made little headway in assessing what ratios might be optimal for any of these various purposes, or on the relative costs of raising such ratios; for exercises in the latter see Miles, Yang, and Marcheggiano (2011) and Admati et al. (2011). What we do know is that as equity capital is eroded, at least amongst SIFIs (Systemically Important Financial Institutions), the potential risks of systemic externalities increase. This would suggest, to me at least, having a much higher estimate of “a fully satisfactory” level of

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equity capital, and then working out, much more carefully, a gradual, and graduated, ladder of sanctions/penalties as equity capital declines below its “fully satisfactory” level to a point at which prompt corrective action (p.c.a.) becomes mandatory. In some part the gap between the higher fully satisfactory level of equity capital, which many finance economists would like to see, and the level that the industry is prepared to tolerate, may be met by a growing use of contingent convertible (CoCo) bonds, or by prenegotiated or statutory bail-in requirements for various categories of bonds, whereby, supported by Collective Action Clauses (CACs), such instruments may become transmuted into additional equity. The triggers, transfer terms and pricing arrangements, will be somewhat complex and the implications for new fund- raising in the midst of a contagious crisis are worrying. Nevertheless, this is a direction in which, in Europe at least, policy appears to be moving. The BCBS/FSB has made a first, initial step in the direction of imposing a ladder of sanctions, with any decline of tier 1 core equity below 7 percent reinforced by constraints on dividends and remuneration, until it reaches the p.c.a. point of 4.5 percent. No doubt, “c’est le premier pas qui coûte,” but policy could go further to extend and to refine a graduated ladder of sanctions, as was first attempted in the FDIC Improvement Act of 1991, and also to study how such regulation can be manipulated and avoided, for example, by the artificial creation of equity capital, such as lending to an agent who uses the funds to buy back equity, perhaps in a concert party arrangement. Whereas constraints on dividends and/or remuneration have a valid, and major, role to play in any such ladders of sanctions, an alternative instrument could be Pigovian taxes (see Masciandaro and Passarelli 2011). The use of taxation to discourage activities with negative externalities has rarely been used, or even considered, in banking or finance, no doubt for several reasons, such as the difficulty of assessing an intermediary’s contribution to systemic risk, that the tax would bite more the weaker the intermediary, and the steadfast opposition of the industry. Nevertheless, bank/finance industry taxation has now been put on the agenda, following Obama’s espousal of such a proposal in early 2010 (Calmes 2010). Rather than using such a tax in an ex ante fashion to influence behavior and to reduce the risk of financial frictions, such taxes have recently more generally been levied to punish banks for paying out high bonuses (UK), to make banks repay ex post the cost of bailouts (Dodd-Frank), to force banks to pay a “fair share” of the extra burden of meeting the enhanced public sector deficit/debt, and because such a tax is generally popular (mitigated only by threats of migration to lower- tax havens). What is needed is a much more comprehensive (holistic?) assessment of how bank taxation might fit within the wider framework of financial regulation. This was discussed at some length at the G7 Finance Minister/Central Bank Governor meeting in Canada in February 2010, but there was no general agreement on the topic. There is a danger that the inter-

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relationship between such taxation and financial regulation will not receive proper assessment and analysis. Since taxes are fiscal, the BCBS/FSB may hesitate to comment; since regulation is for specialist financial authorities, Ministries of Finance may ignore the macroprudential implications and possibilities of such taxes. The second main shortcoming of Basel I and II was that it assumed that the risk weighting (RW) of any asset could not only be approximately assessed by regulators but was constant over time. Neither is true. Moreover, the risk weightings that were adopted were, at least in some large part, politically influenced, notably the zero weighting on Organization for Economic Cooperation and Development (OECD) government debt, and the relatively low weight on residential mortgages. In particular, the RWs were independent of context and of the changing portfolio structures of the banking/ financial system. No attempt then, or since, has been made to adjust the RWs in line with the potentiality for systemic collapse, should that asset category weaken sharply in value. As W. Wagner (2010) and A. Persaud (2000) have shown, the risk to the banking system of a decline in asset prices is a function of how widely and commonly that asset is held amongst all banks. Thus weakness in commercial property prices often poses a threat to banks, whereas weakness in equity prices generally does not. One response to this kind of criticism is to propose putting greater weight on stress tests, as an adjunct to and perhaps a mechanism also for adjusting RWs over time. A problem with this is that such stress tests only examine the exogenous risk of the first- round effect of a shock to asset prices. Of equal concern is the “endogenous risk” of how bank reactions could amplify the problem, see Brunnermeier and Pedersen (2005, 2009) and Danielsson et al. (2001). To focus only on exogenous risk, and to ignore endogenous risk, is to miss out on crucial aspects of the overall picture. Had a stress test been run in, say, June 2007, in which banks were asked to assume what would then have appeared an extreme value for a decline in US housing prices, possibly – 10 to – 15 percent, I am sure that all major US and European banks, on the basis of their best modeling strategies, would have been fully confident of absorbing such a hit successfully. It was the joint switch of financial intermediaries (FIs) toward selling such assets, and the consequent drying up of liquidity, that triggered the crisis. What matters is not so much the action of the individual financial intermediary, but the joint actions of the collection of FIs. You cannot easily assess this by a stress test exercise on individual FIs. What is needed, in addition, is further and better modeling of the financial system as a whole; that is, top- down systemic modeling exercises to complement the bottom-up stress tests. Such top- down models of the financial system as a whole have barely begun to become available. The third, and final, shortcoming of the previous Basel Capital accords was that they caused financial regulation, especially in conjunction with mark- to-market accounting, to become even more procyclical. This was

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particularly so in the case of Basel II. It was a matter of pride for the authors of Basel II that they had aligned regulatory capital more closely with the economic capital that banks want to keep for their own purposes. But, as documented by Adrian and Shin (2008, 2010, 2011), desired leverage of FIs is procyclical. In a boom, bad debts and n.p.l.s are down, profits and capital on a mark- to-market basis are way up, and expectations and credit ratings rise. Never did the banking systems of the developed world look stronger (to most observers, including to their regulators), nor were major bank CDS prices lower than in the early summer of 2007. After a crisis has started, financial regulation is largely otiose. Market pressures, and enhanced risk aversion, will cause FIs to reduce their exposures, to delever, often much more than the authorities would like. Indeed, in the recent crisis there was often a common attempt by the authorities simultaneously to toughen up on capital/liquidity regulations and at the same juncture to encourage them to extend more loans to the private sector (see many of Tim Congdon’s recent papers, notably in Standpoint, July 10, 2011). This patent conflict has been mitigated, at least in part, by allowing extraordinarily long lags before such regulations are to be put in place. Nevertheless, the point is quite general. Financial regulation could/ should have its major impact in reining back the boom; it has less role in the bust. But by the same token, regulation has to operate against the tide of the market, “to take away the punch bowl just as the party gets going.” This is not going to be a popular exercise. Think of what would have been the pressures on the Fed if it had tried to shut down the subprime market in 2005 and 2006! For a Central Bank to oppose the combined ranks of market, politicians, media, lenders, and borrowers (until the crisis, subprime was a great deal for most such borrowers) is not easy. Under Pillar 2 of Basel II any central bank could have raised CARs on their own national banks; none did in the years 2005– 2007. The Spanish dynamic preprovisioning mechanism was one of the few initiatives in this direction (Saurina 2009). Again there were several steps, both fiscal and regulatory, that could have been taken to calm an excessively buoyant housing market in several countries. With a few minor exceptions (e.g., Hong Kong, Estonia), no such action was taken. The authors of Basel III have now accepted the desirability of countercyclical macroprudential regulation in principle, though the potential add-on for this purpose, at a maximum of 2.5 percent, is quite limited. What they have not yet recognized are the obstacles to the activation of countercyclical measures in practice. What they have done, under pressure from the central bank lobby, is to leave the activation of countercyclical measures entirely to the discretion of the individual national central bank. Given the uncertainty of whether a boom is sustainable or not, and the certainty that official steps to check such a boom are likely to be very unpopular, this is

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a recipe for ensuring that countercyclical measures will rarely, if ever, be deployed. Perhaps the European Systemic Risk Board, which is less subject to domestic political pressures, can play a role in recommending the introduction of such countercyclical measures. In section 9.2 , on macroeconomic imbalances, I argued that there would be substantial benefits to some presumptive indicators of sustainability that might, perhaps, lead to subsequent adjustments to credit ratings. By exactly the same reasoning, there might be some presumptive indicators of unsustainable credit/asset price expansion, which might lead to countercyclical macroprudential measures, again on a comply or explain basis. I could continue for far too long with the remaining shortcomings of Basel III. Despite its weaknesses, it has recognized several of the major weaknesses of Basel II, and has gone some way to rectify them. The glass is half full. Nevertheless, it also remains half empty. In the course of discussion of the shortcomings of just three aspects of the Basel regulatory process, I have put the following macroprudential issues forward for future discussion: 1. How to introduce a more graduated ladder of sanctions for transgression of CARs (and liquidity requirements) into the regulatory process 2. How to estimate fully satisfactory and p.c.a. minima levels of capital 3. The use of CoCos and bail- ins 4. The role, if any, of Pigovian taxes in crisis prevention 5. Whether to improve, and if so how, the measurement of asset risk, or to abandon the whole concept of risk weightings 6. The role, if any, of stress tests, and whether these can be complemented by top- down models of the financial system 7. How to strengthen the authorities’ capacity to employ countercyclical macroprudential measures. Can presumptive indicators be found? Can these be used on a “comply or explain” basis? 8. How to respond in the conduct of macroprudential regulation to the Lucas critique This is not a complete agenda, but it is enough to consider for the time being.

References Admati, A. R., P. M. DeMarzo, M. F. Hellwig, and P. Pfleiderer. 2011. “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is NOT Expensive.” Stanford Graduate School of Business Research Paper, no. 2065, March 23. Adrian, T., and H. Shin. 2008. “Liquidity and Financial Cycles.” Bank for International Settlements Working Paper no. 256. Basel: BIS. ———. 2010. “The Changing Nature of Financial Intermediation and the Financial

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Crisis of 2007– 09.” Federal Reserve Bank of New York Staff Reports, no. 439. New York: Federal Reserve Bank of New York. ———. 2011. “Financial Intermediaries and Monetary Economics.” In Handbook of Monetary Economics 3A, edited by B. Friedman and M. Woodford, 601– 50, chapter 12. North Holland: Elsevier. Agence France-Presse. 2008. “Report on Queen Elizabeth Visit to London School of Economics.” Agence France-Press, November 5. Blanchard, O., G. Dell’Ariccia, and P. Mauro. 2010. “Rethinking Macroeconomic Policy.” IMF Staff Position Note, SPN/10/03, January. Washington, DC: International Monetary Fund. Borio, C. 2007. “Change and Constancy in the Financial System: Implications for Financial Distress and Policy.” Bank for International Settlements Working Paper no. 237. Basel: BIS. Borio, C., and P. Lowe. 2003. “Asset Prices, Financial and Monetary Stability: Exploring the Nexus.” Bank for International Settlements Working Paper no. 114. Basel: BIS. ———. 2004. “Assessing the Risk of Banking Crises.” Bank for International Settlements Quarterly Review, Paper 0212, January. Basel: BIS. Borio, C., and W. White. 2004. “Whither Monetary and Financial Stability? The Implications of Evolving Policy Regimes.” Bank for International Settlements Working Paper no. 147. Basel: BIS. Brunnermeier, M., and L. Pedersen. 2005. “Predatory Trading.” Journal of Finance 60 (4): 1825– 63. ———. 2009. “Market Liquidity and Funding Liquidity.” Review of Financial Studies 22 (6): 2201– 38. Calmes, J. 2010. “Taxing Banks for the Bailout.” New York Times, January 14. Available from http://www.nytimes.com/2010/01/15/us/15tax.html. Calvo, G. 1998. “Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops.” Journal of Applied Economics 1 (1): 35– 54. ———. 2009. “Financial Crises and Liquidity Shocks: A Bank Run Perspective.” NBER Working Paper no. 15425. Cambridge, MA: National Bureau of Economic Research. Calvo, G., A. Izquierdoa, and L. F. Mejia. 2008. “Systemic Sudden Stops: The Relevance of Balance Sheet Effects and Financial Integration.” NBER Working Paper no. 14026. Cambridge, MA: National Bureau of Economic Research. Calvo, G., A. Izquierdoa, and E. Talvi. 2006. “Sudden Stops and Phoenix Miracles in Emerging Markets.” American Economic Review 96 (2): 405– 10. Carter, S. B., S. S. Gartner, M. R. Haines, A. L. Olmstead, R. Sutch, and G. Wright, eds. 2006. Historical Statistics of the United States: Earliest Times to the Present, Millennial edition. New York: Cambridge University Press. Congdon, T. 2011. “The Unnecessary Recession.” Standpoint, July 10. Available from http://www.standpointmag.co.uk/node/1577/full. Danielsson, J., P. Embrechts, C. Goodhart, C. Keating, F. Muennich, and H. Shin. 2001. “An Academic Response to Basel II.” LSE Financial Markets Group Special Paper no. 130. London: London School of Economics and Political Science. Goodhart, C. A. E. 2011. The Basel Committee on Banking Supervision: A History of the Early Years, 1974–1997. Cambridge: Cambridge University Press. Hartland, Penelope. 1960. “Canadian Balance of Payments since 1868.” In Trends in the American Economy in the Nineteenth Century, Studies in Income and Wealth, volume 24, 717– 56. Princeton, NJ: Princeton University Press (for National Bureau of Economic Research).

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Hellwig, M. F. 2009. “Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis.” De Economist 157:129– 207. ———. 2010. “Capital Regulation after the Crisis: Business as Usual?” Working Paper Series of the Max Planck Institute for Research on Collective Goods, July 31, 2010. Bonn: Max Planck Institute for Research on Collective Goods. Keynes, J. M. 1941. “Proposals for an International Currency Union.” In The Collected Writings of John Maynard Keynes, vol. 25, edited by D. Moggridge, 69– 94. Cambridge: Cambridge University Press. Kregel, J. 2010. “An Alternative Perspective on Global Imbalances and International Reserve Currencies.” Levy Institute, Public Policy Brief no. 116, October. Lastra, R. 2006. Legal Foundations of International Monetary Stability. New York: Oxford University Press. Masciandaro, D., and F. Passarelli. 2011. “Financial Systemic Risk: Taxation or Regulation?” Paolo Baffi Centre Research Paper Series no. 2011-91, May. Miles, D., J. Yang, and G. Marcheggiano. 2011. “Optimal Bank Capital.” Bank of England, External MPC Unit, Discussion Paper no. 31, January. Mitchell, B. R. 1988. British Historical Statistics. Cambridge: Cambridge University Press. ———. 2007a. International Historical Statistics—The Americas, 1750–2005, 6th edition. New York: Palgrave Macmillan. ———. 2007b. International Historical Statistics—Europe, 1750–2005, 6th edition. New York: Palgrave Macmillan. Persaud, A. 2000. “Sending the Herd off the Cliff Edge: The Disturbing Interaction between Herding and Market-Sensitive Risk Management Practices.” The Journal of Risk Finance 2 (1): 59– 65. Rajan, R. 2006. “Has Finance Made the World Riskier?” European Financial Management 12 (4): 499– 533. ———. 2005. “Has Financial Development Made the World Riskier?” In Proceedings of the Jackson Hole Conference, organized by the Kansas City Fed, 313– 69. Federal Reserve Bank of Kansas City. Saurina, J. 2009. “Dynamic Provisioning: The Experience of Spain.” The World Bank Group, Crisis Response: Public Policy for the Private Sector, Note no. 7, July. Washington, DC: World Bank. Available from http://rru.worldbank.org /PublicPolicyJournal. Schumacher, D., F. Garzarelli, and B. Broadbent. 2011. European Weekly Analyst, Goldman Sachs, March 3. Solomon, S. 1995. The Confidence Game: How Unelected Central Bankers Are Governing the Changed Global Economy. New York: Simon and Schuster. Trichet, J. C. 2011. “Building Europe, Building Institutions.” Available from http:// www.ecb.int/press/key/speaker/pres/html/index.en.html. Vamplew, Wray, ed. 1987. Australians: Historical Statistics. Fairfax, Syme and Weldon Associates. Wagner, W. B. 2010. “Diversification at Financial Institutions and Systemic Crises.” Journal of Financial Intermediation 19 (3): 373– 86. White, W. 2004. “Are Changes in Financial Structure Extending Safety Nets?” Bank for International Settlements Working Paper no. 145. Basel: BIS. ———. 2006. “Procyclicality in the Financial System: Do We Need a New Macrofinancial Stabilisation Framework?” Bank for International Settlements Working Paper no. 193. Basel: BIS.

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Comment

Adair Turner

Charles Goodhart’s chapter starts with the problems created by the divergence between a highly integrated global economy and the fact that political legitimacy—and in particular the legitimacy of regulation, taxation, public expenditure and fiscal transfer—resides at the national level. The problem is that “a global trading and financial system coexists with national sovereignty over political and fiscal powers.” He notes, as many have, that logic would drive us in one of two opposite directions.

• Toward more global or regional political integration. • Or toward more national control of economic and financial processes through, for instance, subsidiarization of banks by country and, possibly, capital controls. But any movement toward the latter option is, in Europe’s case, “likely to be limited,” given the adamant commitment of the European Union to the existence of a single market, including a free flow of capital “despite the role that such capital flows have played in the current crisis there.” Indeed, as Charles says, “it is in the EU, and even more so in the eurozone, that the conflict, the fault line between supranational and national, reaches its most extreme.” It is on these issues of the appropriate balance of national and supranational within the EU, and specifically within the eurozone, that I would like to focus my response today. As Charles notes, the Maastricht Treaty was intended to ensure appropriate fiscal discipline at what he labels the “subsidiary sovereign” level. And that phrase, subsidiary sovereign, usefully focuses our attention on the highly specific feature of the eurozone, which is the existence of political units that are clearly subsidiary in that they do not have currency issuing powers, but which in their fiscal activities, and in the scale of their fiscal revenues and expenditures as a percent of GDP, seem like fully sovereign states. The Maastricht Treaty was intended to address the tensions created by this specific feature. But Charles argues that it focused too exclusively on the issue of public debt positions, ignoring the problems potentially created by private sector indebtedness, indebtedness that might well find its counterpart in external current account deficits. Clearly, however, this poses the following question: Do external current account deficits matter, and if so why? And in particular, do they matter (and why) within the single currency zone? For there has always been a school of thought that says external current account deficits produced by Adair Turner was executive chairman of the Financial Services Authority until March 2013. He is senior fellow at the Institute for New Economic Thinking (INET). For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12600.ack.

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and financed by private debt flows do not matter. Nigel Lawson argued in the 1980s, for instance, that we need to draw a clear distinction between external deficits arising from fiscal deficits and those arising from “consenting adults” in private contracts (quoted in William Cline, International Debt Reexamined ).1 It is therefore on this issue of what categories of debt matter—external or internal, public or private—that I will concentrate in this comment, seeking to identify the relevant specific character of the eurozone in this respect, and ending with a discussion of ways to achieve a coherent balance of national and supranational roles within the eurozone single currency. Do external accounting balances matter in either stock or flow term? Should we, in other words, consider the aggregate of the external indebtedness (gross or net) of all counterparties in a country—the state, the households, and corporations—or should we consider their indebtedness as quite separate issues? At several points in his chapter Charles talks of a “country” being indebted—defining the country balance sheet as the aggregate of state, household, and corporate sectors. But is country actually a useful aggregation? To analyze that question it is useful to consider the different answers that most commentators would give and have in the past given when considering two different cases:

• The emerging markets that got into unsustainable debt positions in the 1980s, in particular in Latin America.

• Or an individual state within the United States, for example, California. In relation to the first, almost all commentators at the time assumed that what mattered was the aggregate external balance. Indeed, both at the time and in subsequent historical accounts, that assumption has been so dominant as to be often unstated. Thus for instance in William Cline’s classic account of the 1980s emerging markets debt crisis (Cline 1995), almost all of the figures given are for the total external balance (whether in stock or flow terms), with only imperfect and incomplete data distinguishing between public and private counterparties, and with no comprehensive data on the domestic internal indebtedness of either private or public sectors. The focus is on the combined indebtedness of public and private sectors, but only on their external indebtedness. The assumption is that what matters is the aggregate external position and the resource flows required to service that debt. At the other extreme, consider the case of California (or any other US state). Within California different counterparties could be in debt—the state of California, Californian households, or corporate businesses or banks registered in California. And there could be concerns about the sustainability of those categories of debt. But in this case, almost no one ever calculates 1. Cline (1995).

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the aggregate (“country”) debt of California, combining the debt of each of these sectors. Conversely, when we do think separately about the sustainability of the debt of each of these sectors (or of specific counterparties within these sectors), we make no distinction between whether this debt is held by investors within California or out of state.

• We therefore do not calculate and worry about the overall current account balance of California as a “country.” Nor is it usually considered relevant whether the debt of Californian • corporations is held by Californian households and institutions or by institutions and households in other states of the United States. • It is also not considered relevant whether Californian state debt is held by investors within the state or outside of it. Thus, Exhibit 1:

• In the Latin American case the usual focus was on external debt only, but on the level of external debt aggregated across all sectors.

• Analysis of debt sustainability for Californian counterparties is typically considered sector by sector, but with no particular importance attached to the distinction between whether that debt is held internally or externally. So was that approach to Latin American debt appropriate? Is this approach to the debt of different Californian sectors appropriate? And should we think about eurozone countries as we thought about emerging market countries in the 1980s, or as we typically think about individual US states? The argument for considering Californian sectoral debt burdens quite separately is that their sustainability appears to be quite separate (Exhibit 2):

• No sector has guaranteed the debt of any other sector. • Californian householders could be in payment difficulties even if the state were financially sound, and vice versa.

• Creditworthy households in California might well be able to get access to credit provided by banks either within or outside California, even in the midst of a Californian state debt default. • And indebted corporations or banks that happen to be headquartered in California could be quite able to service their debt even if the state of California went bankrupt. In the United States, nobody assumes that the credit rating of the corporation cannot exceed the credit rating of the state or city in which it is headquartered. The bankrupt state of California would have no right to grab the assets of Californian corporations in order to pay its debts. • As a result, when New York City teetered on the brink of bankruptcy in 1975, it was not assumed that this had necessary consequences for the

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solvency of banks or corporations that happened to be headquartered in New York City. The logic against aggregating the debt levels of counterparties/sectors that happen to be located in a specific state therefore seems clear: why should we aggregate the debt positions (in either stock or flow terms) of different sectors that are not cross- guarantors and whose economic prospects are not necessary correlated? In general, it seems we have good reasons not to work out current account balances or net external balance sheet positions for individual US states.2 But the reference to the “correlation” of economic and debt sustainability prospects suggests that in some circumstances and to some degree it might actually be useful to look at aggregate debt levels for all Californian sectors, public and private, and perhaps also to look at external aggregate imbalances. Because in several ways sectoral debt sustainability prospects might be correlated, with correlation flowing both from public to private and private to public (Exhibit 3).

• If private household debt has driven property price inflation and a construction boom, and if state revenues are highly dependent on property prices and transactions as well as on the general buoyancy of economic activity, then high and rising levels of private household debt might indicate future problems for state finances when the bubble bursts. • And if state debt is in danger of becoming unsustainable, then the state might in the future have to increase taxes and reduce expenditures, which could undermine the debt- servicing capacity of private households and businesses. • Also, a current account deficit funded from outside the state, while in some circumstances reflecting capital flows that finance revenuegenerating investments, could in other cases indicate that real wages have been driven above competitive levels in the traded sector of the economy because of a debt-financed expansion of nontraded sectors (such as construction). A divergence of real wages that, if the construction boom turns to bust, will then result in some mix of the following: • Unemployment, if real wages cannot flexibly adjust to restore competitiveness. • Increased real debt burdens, if real wages do flexibly adjust, cutting wages relative to debt levels. 2. Indeed, it is possible that if we had worked out current account deficits for US states over the course of the last fifty years, adverse policy reactions to sustainable current account deficits would have resulted. Thus, for instance, if Florida ran a current account deficit continually in the 1950s and 1960s as a result of inward private capital flows (e.g., Northerners purchasing and developing real estate), any attempt to use public policy to reduce these deficits might well have had adverse economic effects.

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• Consequent pressures on state revenue and state debt sustainability as well as on private debt sustainability in either of these cases. Thus, while the presumption that we should not add up sectoral debt levels to produce a country aggregate for individual US states has considerable power, even in these circumstances we must recognize that sectoral debt sustainabilities might be somewhat correlated, and that if they are correlated then there is some value in considering their aggregate cross- sectoral size. The general criterion for useful aggregation, therefore, is the degree to which different sectoral prospects are interrelated or correlated. And the reason it made sense in the 1980s emerging debt crisis to focus on aggregate debt and on external debt was that there were specific factors that justified that focus (Exhibit 4).

• First, there was a high degree of correlation between state and corporate debt prospects. This resulted not only from the factors that apply even in the case of an individual US state, but also additional factors specific to emerging market economies at that time. • The fact that much apparently “corporate” debt was in fact due from parastatal organizations. • The fact that access to foreign exchange to service private debt might be dependent on government capital control and exchange- rate policies that could in turn be influenced by the sustainability of the government’s own external debt position. • The reasonable suspicion of private credit providers that still imperfectly democratic states might use sovereign powers to seize private assets if needed to service its own debt. • And a resulting danger that even inherently creditworthy private projects might become unfundable amid concerns about the state’s creditworthiness, so that a government wishing to ensure a continued flow of credit to the private sector might have to guarantee or take over the private debts—as the Argentinean and Chilean states effectively did in the early 1980s.3

• These special conditions are what make William Cline’s almost exclusive focus on aggregate country debt sensible.

• Equally, there were some specific factors that appeared to make a predominant focus on external rather than internal debt justified. • External debt was foreign currency debt, which, unlike domestic currency debt, could not in extremis be monetized away. • It was assumed that access to external debt was particularly impor3. Cline (1995, chapter 6).

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tant in order to finance net real resources flows, without which economic development and growth would be hampered.

• Together, these factors provide some justification for the focus on the external position alone—though with the caveat that internal state debt levels might still be relevant if they had consequences for the ability of the state to service its total combined debt (internal and external) out of real tax resources rather than using the monetization route to reduce the domestic element. Thus (Exhibit 5) both the tendency of 1980s analysis to focus on aggregate country external debt and the tendency of most analysts to ignore the current account flows or aggregate balance sheets of US states are largely, though not entirely, justified by the different circumstances. There is a spectrum of different circumstances that justifies a spectrum of analytical approaches. Where within the spectrum should we locate eurozone economies? Should we focus on their external balances as we did on those of emerging economies in the 1980s? Or focus solely on state finances, treating, for instance, the debts of Greek shipping owners as utterly separate from the Greek state? The crucial issue is the extent to which the debt sustainability prospects of different sectors are correlated. Analysis of that correlation within the eurozone argues, I suggest, for three things: 1. A far stronger focus than under Maastricht on aggregate debt levels, looking at the combined debt levels of all sectors. 2. A considerable focus on external imbalances as potentially important indicators. 3. However, also and crucially the need to avoid taking false comfort from a balanced external position within which debt is primarily internally financed. 1. Strong Focus on Aggregate Debt Levels We now recognize that high private sector debt levels within the eurozone can make state finances vulnerable (Exhibit 6). This is for the same reasons that could theoretically apply even in the case of a US state, but with added importance in the eurozone due to the absence of automatically stabilizing fiscal transfers, and the much larger fiscal role that Europeans states play compared with US states. US states tax and spend on average about 5 to 10 percent of GDP: they finance neither Medicare/Medicaid nor Social Security. Eurozone states tax and spend somewhere in the region of 35 to 45 percent of GDP. As a result, the fall in eurozone national revenues as a percentage of GDP that will occur following a property bust is likely to be much larger than in the case of a US state, and any fiscal consolidation to offset an emerging deficit is in turn likely to have a larger depressive effect on the country/state economy.

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This absence of automatic fiscal transfers and larger size of the state are, I suspect, more important differences between eurozone countries and US states than the frequently mentioned lack of labor mobility, which in debt sustainability terms is a double- edged sword—positive because the unemployed may emigrate, and negative because taxpayers may migrate away from the increased tax rates required to achieve fiscal consolidation. 2. Focus on External Imbalances as Indicators Equally, we need to place greater weight on external current account imbalances than we did precrisis, though more as indicators of problems than as direct “financing challenges” (Exhibit 7).

• A current account imbalance can represent a “financing challenge” for a country if the attitude of external creditors to the creditworthiness of, say, a well- run Spanish company is influenced by creditor beliefs that in extremis all debts are linked, for example, • Because a Spanish government unable to pay its debts may leave the eurozone, and in doing so not only redenominate its own debt but those of its corporations in New Peseta. • And/or if it is believed that the Spanish state, in order to pay its debts, will impose unavoidable taxes on the creditworthy Spanish company, and/or impose capital controls. • That is, if debt sustainability prospects are closely interrelated.4

• These are the sort of concerns that made the concept of country

financeability relevant in 1980s emerging markets. In extremis they could apply in a eurozone under extreme stress. • But even if the danger of such an absolute financing constraint is slight, external imbalances are certainly important indicators of potential problems, and in the case of, for instance, Spain and Ireland, should have been treated as indicators of disequilibrium in real wage competitiveness, which were likely, once the construction booms bust, to result in high unemployment and rapidly rising state debts even in countries that during the boom appeared to have strong state finances. 3. Avoid Taking False Comfort from Internal Debt Financing External imbalances may matter and should certainly be carefully monitored. But conversely, the absence of external imbalances should not be taken as an indication that high levels of state, private, or aggregate debt pose 4. A key measure of whether the market takes a “country” rather than an individual counterparty attitude toward creditworthiness and thus financability, is whether the CDS spreads of corporations are always higher than those of the countries/states in which they are headquartered/legally domiciled. In emerging markets this is almost always the case; in relation to individual US states it is often not the case; in relation to eurozone countries it is generally the case, but with some exceptions.

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no challenges. For indeed, if we go back to the crucial question of whether debt sustainability prospects in different sectors are correlated, it is clear that large internal holdings of state (or other debt) can in some cases create greater vulnerability than large external holdings. Thus Exhibit 8:

• Suppose California, through some variant of default/renegotiation/ restructuring, imposed a haircut on holders of the state debt. The impact of that on the Californian economy would almost certainly be greater if a large proportion of that debt were held by Californian households and institutions rather than held out of the state, because the impact on those debt holders’ wealth, and in turn their consumption decisions, would produce a further negative impact on California’s state revenue. • The impact would probably be greatest if a large proportion of that defaulting state debt were held by Californian banks, and particularly if those banks held so much state debt that their solvency was undermined by state default. In the eurozone, one of our greatest vulnerabilities derives precisely from the fact that large proportions of national debt are held internally within each country by the banks of that country. It is this exposure, combined with the assumption that fiscal resources for any bank bailouts must come from national budgets, which has created the interlinkage between state finances and banking systems, which is the most dangerous feature of our current predicament. Past assessments of Italy’s level of high state indebtedness have often taken some comfort from the fact that “the debt is primarily internally financed.” But in fact that very internal financing, especially to the extent that it is through the banking system, has created extreme vulnerability. If a Californian state bank held a high proportion of its liquid resources in Californian state bonds, nobody would assume that this made Californian state debt in some senses more sustainable, and it would be recognized that such an undiversified portfolio increases financial instability risks. And conversely, if a larger proportion of Italian debt were held not by the Italian banking system, Italian households, or other Italian institutions, but by investors outside Italy, that would reduce the likely downside effect of Italian debt restructuring on the Italian economy and on Italian banking system fragility.5 5. What is true is that a high proportion of debt held internally may, for a period of time, make it easier to refinance existing debt and to issue new debt, since internal debt providers, as a result of a home bias, may be willing to ignore potential solvency problems for longer than external investors. Countries with higher proportions of debt held internally may therefore be less susceptible to temporary contagion and liquidity effects, and to the danger of irrational self- reinforcing cycles in which market concerns drive increasing debt- servicing costs. If and when debt solvency pressures do result in actual default/restructuring, however, this internal bias becomes a point of vulnerability rather than strength. In addition, the very fact of a home

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Charles observes that the Maastricht Treaty, in attempting to constrain the risks involved in a multination state currency union, focused exclusively on state debt levels.6 But on what should we focus: state debt, total debt, or external debt? There is a case for focusing on all three and thinking through the different implications of each (Exhibit 9).

• We clearly need to focus on total debt levels, internal and external, government and private combined. Because we have learned that debt burdens that legally are quite separate can in economic terms be closely correlated. Once leverage across the whole economy has become high, it turns out to be incredibly difficult to reduce aggregate leverage rather than to simply shift it from one sector to another—deleveraging in the private sector produces an automatic deterioration in public finances, and some would argue a need to accept an increase of public deficits in order to avoid recession. The Japanese experience over the last twenty years illustrates this dynamic (Exhibit 10).7 • We need also to focus on external debt levels, or at least on their flow counterpart—current account imbalances—as important indicators of real wage disequilibria, which may lead to future debt sustainability problems in either the state or private sectors. • We must also focus on total state debt levels, internal or external, and particularly so in any country that does not have freedom in extremis to monetize its debt, a crucial difference between the internal debt burden of, say, Italy today versus Argentina in 1980. For a nation that cannot print its own money, a domestic debt burden can be as unsustainable as an external burden; and in these circumstances indeed, a high proportion of internally held debt, particularly if held by the banking system, can increase the country’s vulnerability to state debt default or haircuts. What is apparent, therefore, is that the eurozone’s current construct—the eurozone’s answer to the questions Charles posed about the appropriate balance of supranational and national responsibilities—is an inadequate one, reflecting inadequate attention in advance of the eurozone launch to the sui generis nature of the eurozone—a zone in which nations are neither equivalent to completely independent countries with their own currency nor fully analogous to US states without their own currencies, but something in between and requiring specific institutional rules to make the system stable. It is the failure to address this sui generis character, and to construct fiscal behavioral bias, particularly if reinforced by regulators who require or encourage the banking system to hold greater debt, may make it more likely that state debt is able to grow to unsustainable levels in the first place. 6. Quite apart from the fact that even in respect of state debt levels, it failed to provide effective discipline. 7. Koo (2008) makes a persuasive case that the increase in Japanese government debt as a percent of GDP was both the naturally arising consequence of corporate deleveraging and essential to prevent a still- deeper recession than in fact occurred.

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and financial stability arrangements appropriate to this character, which helps explain the phenomenon that the eurozone has both the lowest aggregate debt to GDP of the four major developed economy currency zones, and the highest average bond yields (Exhibit 11). Faced with the current predicament, there are two issues:

• First, how to get out of the position we should have never got into. • Second, what is a better set of arrangements for the future? The former is, of course, the harder question. But since Charles largely avoided it in his chapter, I feel justified in doing likewise in response, except for two observations. The first is increasingly accepted, the second is perhaps more controversial.

• The first is that we have to recognize that some of the accumulated national debt levels of individual eurozone countries exceed sustainable levels, and that if these debts remain denominated in euros (i.e., if the countries do not leave the eurozone and are therefore unable to consider monetization options), some degree of restructuring/haircutting is inevitable. A specific example of the wider point that Charles makes that in some circumstances there should be “partial default and restructuring” and that a system that does not allow for controlled restructuring in the face of economic realities will be a suboptimal one in both macroeconomic and financial stability terms. The second obsevation, that even if we focus on the currency blocks • where the sovereign debt issuer is the currency issuer (Japan, UK, United States), or even if we focused on the total eurozone debt burden, ignoring the particular problems created by the national debt versus euro currency split, we may in some cases face levels of debt as a percent of GDP that are very difficult to reduce through the processes of fiscal consolidation alone, without the helping hand of exceptional monetary measures that take us closer to debt monetization. Those comments aside, what structure makes sense for the eurozone for the long term? What is increasingly agreed upon is that the general direction has to be toward a much greater degree of economic policy integration than put in place when the eurozone was launched. With respect to such integration, the UK government in July signaled a significant shift from Britain’s historic approach—still clear that Britain will remain outside the eurozone, but willing to accept and indeed encourage necessary integration within that zone. But the question is what degree of and what form of integration, and with what consequences for national authority over taxes, over expenditure, and over public debt? Let me suggest some contextual thoughts on the fiscal arrangements, but then focus on my key concern, the implications for financial stability arrangements (Exhibit 12).

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I think it is clear that total integration of tax and spend decisions, or even a division of responsibilities between the federal and local level equivalent to US arrangements, will not emerge and indeed does not need to. German taxpayers are not going to take direct responsibility for paying Italian pensions. And there is no reason why the eurozone should not be characterized by significantly different levels of tax and spend as a percent of GDP, reflecting different and sustainable social choices (Exhibit 13). High public spending as a percent of GDP is compatible with eurozone membership and with constrained debt levels—as Finland illustrates, and as I am sure Sweden and Denmark would demonstrate if they were also in the eurozone. What needs to be disciplined is debt issuance, not expenditure levels per se. But potential reforms on the fiscal side might include:

• At least some degree of eurozone level automatic fiscal stabilization, implying some eurozone direct tax revenues and expenditures, which can vary with the economic cycle • Also some elements of countercyclical fiscal transfer from above- trend to below- trend states, a feature that would tend naturally to follow from feature 1 Such arrangements could, however, still leave national states responsible for the vast majority of tax and spend decisions. The crucial question becomes, what will be their degrees of freedom in relation to debt finance? The key to designing a sensible way forward in that respect is, I suggest, a clear focus on Charles’s essential distinction between “full sovereigns” and “subsidiary sovereigns” and the debt that they issue. That distinction suggests some clear design principles (Exhibit 14).

• First, the debt issued by subsidiary sovereigns—by sovereigns that cannot in extremis monetize it away—could be limited by strong political or market disciplines. • Second, we could decouple the noxious interconnection between banking system and sovereign debt—by reducing national banking system exposure to subsidiary sovereign debt. • Third, that the issuance of common liability Eurobonds could bring major funding cost advantages, but that the scale of issue of Eurobonds needs to be subject to effective discipline. Those principles in turn, might suggest something like the arrangements outlined on this exhibit (Exhibit 15) with:

• Eurobonds issued as joint and several liabilities of eurozone governments, funding national governments up to an equalized percentage of GDP, and with debt service contributions equalized as a percent of GDP

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• National bonds issuable in addition, but clearly not jointly guaranteed, and clearly carrying a far greater degree of default/restructure risk, which should be accepted, as per Charles’s proposals, not as something catastrophic and unacceptable, but as a naturally present possibility in any coherent and market discipline system Such proposals, from a public finance perspective, have now been put forward by several commentators, in particular by Jacques Delpla and Jakob von Weizsäcker, in a pamphlet issued by Bruegel Policy Foundation (Delpla and von Weizsäcker 2011).8 The specific point I would like to stress, however, is that for such proposals to work we would have to ensure that these different categories of debt were treated quite separately in bank capital and liquidity regulations, and in central bank operations.

• Eurobonds could be extensively held by banks, favorably treated in liquidity regimes, and awarded low or even zero capital weights (when held by banks with predominantly euro balance sheets), because they would be—in terms of nominal repayment—close to risk free. They would be eligible collateral at the European Central Bank (ECB), key instruments in which the ECB would conduct open- market operations, central to monetary policy transmission mechanisms, and they would be the asset purchased in any quantitative easing operations, and if ever necessary, in more explicit and permanent forms of debt monetization. • By contrast, national bonds could be held entirely outside the banking system, not central to ECB operations, and with no potential for monetization. They would clearly need to pay a significant risk premium over Eurobonds, and one that would vary with perceptions of creditworthiness. But that would be a useful discipline on excessive debt finance. Now of course, even to put up this possible ideal is to illustrate immediately how very far we are from it, and how incredibly difficult it would be to manage the transition. We start with banks whose liquidity buffers are stuffed full of subsidiary sovereign debt. So I am sure that what will actually emerge will be significantly different from this ideal, and will emerge only very slowly and torturously. But it is important, even when groping our way through the pragmatic compromises required to drag ourselves out of a bad position, to at least keep in mind desirable principles and objectives. Charles has identified that one of the central principles of better financial stability design is that “risk weightings of all sovereigns cannot be zero” and 8. An interesting variant of this approach, which does not create a common liability Eurobond, but which creates “safe” and “high risk” tranches out of pooled national debts up to some proportion of GDP, with unpooled national debt in addition, has been suggested by the Euronomics Group. (See The Euronomics Group 2011). In this proposal, as in that which I illustrate in Exhibit 15, there would be a clear distinction between safe bonds, which could be important assets for the banking system, and higher risk national sovereign bonds (or the riskier trades of pooled bonds), which should ideally be held outside the banking system.

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that “the idea that sovereign debt is riskless, let alone subsovereign debt, has to go.” But I think we need to stress still more than Charles’s chapter the importance of the “full sovereign” versus “subsidiary sovereign” distinction, and focus even more than Charles does on the dangers of the banking system/ subsidiary sovereign interconnect. Charles suggests at one point that “sovereign debt held by financial intermediaries of that same country might still be zero weighted.” If we mean here “fully sovereign” debt then maybe yes, but if we mean “subsidiary sovereign” debt, then absolutely no. As Charles stresses, not all sovereign debt is the same. But the most essential distinction (Exhibit 16) is between full sovereign debt issued by a money issuing authority, and subsidiary sovereign debt issued by a subsidiary sovereign with no currency issuing powers. The failure to recognize that distinction drove one of the most crucial design faults of the eurozone, which has left us today with the worst combination of all.

• With no equivalent of the full sovereign debt (i.e., Eurobonds), which banks should hold as the ultimate liquid asset, and which market signals suggest would currently allow the eurozone to raise money at very low rates. • Also with unsustainable levels of subsidiary sovereign debt, held in large and dangerously undiversified portfolios by national banking systems. As best we can, we need to crawl toward a more coherent system. And to sum up, the need clearly to distinguish full sovereign and subsidiary sovereign debts is one of four general themes that I suggest in response to Charles’s chapter. 1. The aggregate scale of all debt in the system—public and private combined—is a crucial potential driver of financial and macroeconomic instability. 2. One of the reasons why we should worry about high aggregate leverage is that once we have it, it is incredibly difficult to reduce, rather than just shift from one sector to another. 3. It is crucial for us to understand the interconnections between different sectoral or counterparty debt burdens, and the extent to which the sustainability is correlated. 4. In the sovereign arena, fully sovereign debt and subsidiary sovereign debt are very different things. References Cline, William R. 1995. International Debt Reexamined. Washington, DC: Institute for International Economics. Delpla, Jacques, and Jacob von Weizsäcker. 2011. “Eurobonds: The Bluebond Concept and Its Implication.” Bruegel Policy Foundation, March.

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Koo, Richard. 2008. The Holy Grail of Macroeconomics, Lessons from Japan’s Great Recession. Singapore: John Wiley and Sons. The Euronomics Group. 2011. “European Safe Bonds, (ESBies).” September.

Comment

Richard Berner

I first met Charles Goodhart when, as a young economist at the Federal Reserve, I sought his advice in understanding the UK financial system. He was then a source of wisdom to me. So it’s hardly surprising to me that Professor Goodhart remains so nearly four decades later in his chapter, “Global Macroeconomic and Financial Supervision.” In my comments on it, I’ll try to be analytical and to explore policy options. Full disclosure: I’m a former colleague and coauthor. Lest I be accused of being too sympathetic to him, I’ll be clear on where I disagree and on those things I think he could have emphasized more. Charles identifies two problems in macro- and financial policymaking:

• Markets are global, but policymakers are local, and surrendering sovereignty is difficult.

• Our macroframework remains flawed, lacking the analytics for a financial system that includes the messy real world phenomena of banks, markets, leverage, default, illiquidity, and fire sales. These two problems are interrelated. And they magnify the tendency of the burden of adjustment to fall both asymmetrically and late on borrowers, and thus to promote, or at least allow, credit excesses to build to the brink of default. Similar cliff effects occur with funding and market liquidity. Charles’s remedies sensibly include efforts to instill gradually increasing market discipline as risks rise and tails grow fat. Asymmetry in Global Macroeconomic Adjustment Charles’s insight that the burden of adjustment for global imbalances “falls asymmetrically” on the deficit, indebted country, at least when it has borrowed in a foreign currency, is a commonplace, but still important. There are exceptions, but for most cases, Charles spells out policy options that could reduce both the asymmetry of adjustment and the amplitude of crises:

Richard Berner is director of the Office of Financial Research of the US Department of the Treasury. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12601.ack.

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• First, he suggests that we need new indicators to warn that imbalances are unsustainable. Credit ratings and risk weightings for the purpose of setting capital requirements that are adjusted presumptively in response to changes in such imbalances could make credit extension progressively more costly for the borrower and riskier for the lender before crisis thresholds are reached. • Second, he observes that sovereign debt is not riskless, and that we must move beyond this notion. • Third, he suggests that authorities should consider supporting debt restructuring when internal adjustment would be so draconian as to promote debt/deflation. And do it sooner rather than later; kicking the can down the road almost never ends well. I’m highly sympathetic to these goals. And the crisis in Europe arguably has made some of the policies described by Charles much more appealing than they would have seemed only eighteen months ago. Yet a look at history suggests why these remedies are hard to implement. At least three factors contributed to the asymmetry of adjustment: the difficulty in assessing default risks and adjusting ratings, the asymmetry in credit, and the expectation of bailouts. Perceptions of default risk and ratings adjustments lag for good reasons. And the best- laid plans for setting out criteria for action are hard to implement; witness the Stability and Growth Pact. Nonetheless, I believe that building Charles’s indicators into debt on origination (like covenants) and more forward- looking and/or through- the- cycle appraisals of creditworthiness would lean against the wind of credit- fueled threats to financial stability. The asymmetry in credit is intrinsic; it derives from lenders always writing options, namely puts on the probability of default. Understandably they feel they should get timely repayment of principal and interest, often with contractual protection, which can stymie negotiated haircuts or workouts. Moreover, intermediation in the “shadow banking” system magnified that asymmetry in the run-up to 2007, because it was backstopped with credit and liquidity puts written on private balance sheets that were significantly underpriced. As a result, there was no natural seller of protection apart from the authorities when all those options came in the money. Finally, limiting moral hazard will always be a challenge. We have relied on sovereign debt as the benchmark, risk- free asset. So the failure of the sovereign would imperil the financial system, and the failure of financial intermediaries could imperil both the economy and the sovereign. As a result, there is a bias to support both, either through a put to the taxpayer or easy monetary policy. Announcing the threat of restructuring in advance might help discipline lenders; the trick, as Charles notes, is exactly

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how.1 In the United States, we have experience with bank resolution, and Dodd-Frank gives us new authority for orderly liquidation, but we all have work to do to establish a credible, cross- border resolution mechanism. (Note that the recent collaboration between the Bank and the FDIC on resolution regimes is encouraging in that regard.) Global Financial Supervision: Where Next? To discuss financial supervision, Charles reviews the shortcomings of capital buffers under Basel I and II. I agree that their flaws arose partly from a lack of global governance and partly from the defects in our macroparadigm. To improve on them, Charles points to three fundamental requirements for any system of capital buffers. First he suggests a ladder of sanctions imposed on financial institutions as equity capital declines below some “fully satisfactory” level and the level at which prompt corrective action becomes mandatory. I read him as wanting capital buffers thick enough to cushion loss, high enough to constrain excessive leverage, but with some leeway to avoid excessive deleveraging in a bust, and with prompt corrective action aimed at restoring the amount of capital needed rather than deleveraging to bring CARs back to the right level. This raises four questions: 1. How to estimate capital levels. Balance is needed; CAR design should balance the need for financial stability and adequate self- insurance with the requirement that a vibrant, efficient financial services industry should be able to earn a reasonable return over its cost of capital. The CAR design, moreover, should also recognize what Charles, Anil Kashyap, and I emphasize in a recent paper: too- high capital ratios will likely drive financial activity into less regulated parts of the financial system.2 2. How to introduce a more graduated ladder of sanctions for transgression of CARs (and liquidity requirements). I think that regulation of dividend and capital policy, as in the US CCAR process, limits on compensation, and dynamic provisioning may all help promote better behavior. 3. The use of CoCos and bail- ins. CoCos, especially with high strikes, may discipline lenders into being more prudent. But I side with Charles’s view that, in a crisis, CoCos won’t help banks who need cash.3 4. Pigovian taxes. Pigovian (not transaction) taxes could discourage excessive risk taking. They could be useful both to influence behavior in banks 1. Two academic proposals to build in such contingencies in advance are sovereign contingent debt and growth- indexed bonds. See Barkbu, Eichengreen, and Mody (2011) and Forbes (2004). 2. Kashyap, Berner, and Goodhart (2011). 3. See Goodhart (2010).

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and in funding markets. One could characterize them as insurance premiums that cover the cost of providing backstops.4 The second big issue is the need for better tools to assess risk. Better models and data will help. I think we can improve stress tests, complemented by top- down models of the financial system; there is progress here, by Charles and his collaborators, among others. Stress tests must recognize the “endogenous risk,” or the inherent instability of the financial system. Likewise, they must capture the joint impact of market participants’ collective actions across the financial system.5 Reverse stress testing may help produce more robust results that are less dependent on specific models. Better, more granular data are also essential. Work to encourage and facilitate data sharing among global regulators is needed. Consistency across borders is also needed for capital regulation and risk metrics. How to navigate consistently ratings provided by ratings agencies also is an unresolved challenge. Finally, we need better ways to reduce procyclicality. Implementing countercyclical macroprudential measures in practice is a daunting challenge. And it’s not because, as Charles charges, we regulators are gutless wimps. Instead, the challenge is analytical and numerical. For example, the creditto-GDP ratio gap, which has been proposed as a reference point for accumulating countercyclical capital buffers, is subject to significant measurement problems, especially for the latest data points, that can mislead policy.6 But I agree that this is fertile ground for research and discussion; we need more work to assess the costs and benefits of countercyclical versus through- thecycle measures that could reduce procyclicality. What about the Lucas critique? Like Charles, I’m concerned that his or any indicators could fall victim to Goodhart’s Law or to other unintended behavioral changes. But in many cases, we want behavioral change; we should seek policies that promote good behavior and restore market discipline. Charles’s list of our tasks ahead is long, but it is nonetheless incomplete. I’ll close with four issues that deserve more emphasis. First, as I already noted, better data are needed. I couldn’t agree more with Charles that our analytical framework needs revamping; I know he agrees with me that better data are needed globally to help assess threats to financial stability. In the United States, Dodd-Frank requires that the new Office of Financial Research (OFR) contributes to both goals. The OFR will function as a shared provider of data and analysis for the Financial Stability

4. See Perotti and Suarez (2011). 5. Recent work has begun to address the need for stress testing across the financial system. See Greenlaw et al. (2011). 6. Edge and Meisenzahl (2011).

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Oversight Council (FSOC) and its member agencies. We are working hard— and I believe thoughtfully—to satisfy our statutory mandates and mission:

• To collect data on behalf of the Council, and to provide them to the Council and member agencies.

• To standardize the types and format of data collected and reported. • To perform applied and essential long- term research. • To develop tools for risk measurement and monitoring. Second, most discussions of macroprudential regulation remain overly bank centric. That’s ironic. As this group knows well, threats to financial stability can arise anywhere, and macroprudential analysis and tools should look across the entire system. We need more explicit capture of nonbank FIs in our analysis. We must analyze the behavior of markets and instruments, in addition to institutions. An analysis of the factors that influence funding liquidity and market liquidity and the connection between them is essential. Tools to limit leverage, maturity mismatch, and to ensure adequate selfinsurance in repo markets may prove helpful in reducing threats to financial stability. And such tools may limit the regulatory arbitrage that stems from elevated CARs. Those are key reasons why Secretary Geithner has called for a global margin regime, specifically in, but not limited to, noncentrally cleared over- the- counter (OTC) derivatives. Such tools can help level the playing field in funding and derivatives markets.7 Third, we need to assess better the implications for monetary policy of macroprudential developments and policies and vice versa, and assess how to resolve conflicts between them. Central bankers are clear that we should use the right tool for the job, but the assignment of instruments to targets does not mean we can ignore the real world considerable scope for one to act as a headwind or tailwind in relation to the other.8 Fourth, the financial crisis required that policymakers address not just illiquidity for institutions, but also solvency and market dysfunction. Repair and reform of markets may enable central banks to be more traditional lenders of last resort, but it makes more sense to encourage regular borrowing from central bank facilities to reduce the stigma. And like it or not, backstopping market functioning is now an explicit part of the financial stability mandate.9 The quid pro quo for such facilities is obviously appropriate prudential oversight. Finally, we must evaluate and manage the risks in the plumbing of the financial system— in payments, settlement systems, and clearinghouses. The CCPs’ netting helps reduce risk in normal times, but their expanded role means that the failure of significant counterparties could threaten them and 7. See Kashyap, Berner, and Goodhart (2011); Ashcraft, Garleanu, and Pedersen (2010); Haldane (2011). 8. See Yellen (2010) and Carney (2009). 9. See Goodhart (2009); Madigan (2009); Mehrling (2010).

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financial stability.10 That is why Dodd-Frank gave the FSOC authority to designate financial market utilities for heightened prudential supervision. Hopefully I’ve added slightly to the rich buffet that Charles has set for us in this chapter. References Ashcraft, Adam, Nicolae Garleanu, and Lasse Heje Pedersen. 2010. “Two Monetary Tools: Interest Rates and Haircuts.” June. Barkbu, Bergljot, Barry Eichengreen, and Ashoka Mody. 2011. “International Financial Crises and the Multilateral Response: What the Historical Record Shows.” NBER Working Paper no. 17361. Cambridge, MA: National Bureau of Economic Research. Bernanke, Ben. 2011. “Clearinghouses, Financial Stability, and Financial Reform.” Presented at the 2011 Financial Markets Conference. Stone Mountain, Georgia, April 4. Carney, Mark. 2009. “Some Considerations on Using Monetary Policy to Stabilize Economic Activity.” Remarks at the Federal Reserve Bank of Kansas City Economic Symposium. Jackson Hole, Wyoming, August. Edge, Rochelle M., and Ralf R. Meisenzahl. 2011. “The Unreliability of Creditto-GDP Ratio Gaps in Real-Time: Implications for Countercyclical Capital Buffers.” FEDS Working Paper 2011-37, September. Forbes, Kristin. 2004. “Growth-Indexed Bonds: A Primer.” Council of Economic Advisers, July 8. Goodhart, Charles. 2009. “Liquidity Management.” Federal Reserve Bank of Kansas City, 157– 68. ———. 2010. “Are CoCos from Cloud Cuckoo-Land?” VoxEu, June 10. Greenlaw, David, Anil K. Kashyap, Kermit Schoenholtz, and Hyun Song Shin. 2011. “Stressed Out: Macroprudential Principles for Stress Testing.” US Monetary Policy Forum, February. Haldane, Andrew. 2011. “Haircuts.” Remarks summarizing a forthcoming paper in the Journal of Monetary Economics, “Complexity, Concentration and Contagion.” August 1. Kashyap, Anil, Richard Berner, and Charles Goodhart. 2011. “The Macroprudential Toolkit.” IMF Review, Spring. Madigan, Brian. 2009. “Bagehot’s Dictum in Practice: Formulating and Implementing Policies to Combat the Financial Crisis.” Remarks at the Federal Reserve Bank of Kansas City Economic Symposium. Jackson Hole, Wyoming, August. Mehrling, Perry. 2010. The New Lombard Street: How the Fed Became the Dealer of Last Resort. Princeton, NJ: Princeton University Press. Perotti, Enrico, and Javier Suarez. 2011. “Systemic Risk Regulation: Pigouvian Taxes or Quantity Regulation?” VoxEu, March 16. Tucker, Paul. 2011. “Clearing Houses as System Risk Managers.” At the DTCCCSFI Post Trade Fellowship Launch, London, June 1. Yellen, Janet. 2010. “Macroprudential Supervision and Monetary Policy in the PostCrisis World.” Remarks at the Annual Meeting of the National Association for Business Economics. Denver, Colorado, October.

10. Bernanke (2011); Tucker (2011).

Panel Discussion

Charlene Barshefsky

In these remarks, I will discuss the four broad trends that bear upon the politics of trade and globalization. In the second part of my discussion, I will highlight a couple of questions on the horizon. The first and perhaps most general of these trends is the accelerated pace of global growth and global economic integration in the second part of the twentieth century. The global economy grew tenfold between 1950 and 2000, accelerating at an even more rapid rate prior to the financial crisis of 2008. That rate of increase in global economic activity had previously taken several hundred years to achieve. There are countless factors lying behind this rapid pace of growth; the information and communication technologies (ICT) revolution has doubtless been one of them, as one of the papers presented at this conference made clear. Accompanying this period of rapid growth is intensified global competition—a function of technology, capital flows, and trade. One of the most important actors in this growth story, which brings me to the second important trend, has been the reemergence of China. Again, there are lots of reasons for the Chinese miracle, such as Deng Xiao Ping’s policy shift, which led to early internal economic reforms—the decollectivization of farming, the creation of labor and product markets, and so on. Perhaps of greatest significance, however, has been the normalization of China’s relations with its immediate neighbors, and the five important regional economic powers in particular: Japan, Korea, Taiwan, Hong Kong, and Singapore. Economic and political normalization resulted in the meshAmbassador Charlene Barshefsky is senior international partner at WilmerHale, Washington, DC. She was the US trade representative from 1997 to 2001. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12865.ack.

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ing of China’s low-cost economy and large labor reserves with capital and advanced technologies from its five wealthy Asian neighbors. The resulting economic benefits to China, the region, and the world are clear. Today, the expansion of interregional trade led by China has reduced the concentration risk to East Asia, in particular, of dependence on the US economy for growth. China’s growth has gone hand in hand with its growing diplomatic and political clout on the world stage. Using its now unrivaled agenda-setting power in the region (which used to unquestionably belong to Japan), China has exerted substantial influence. In this regard, China’s domestic priorities often conflict with Western goals (currency policy or enforcement of intellectual property rights, just to name two), and with its massive trade surpluses, may raise the spectre of zero-sum outcomes. China’s economic reemergence coincides with a third trend—economic weakness and uncertainty in the West. The financial crisis exacerbated the situation: the West has experienced high unemployment, weak consumer confidence, austerity policies, global financial imbalances, and competitive devaluations. Recovery remains fragile even today. All of this comes at a time when global competition is stronger. Fourth and lastly, jobs. The United States has long shed manufacturing jobs as technology and productivity increases in particular have altered the landscape. What has recently changed, however, is that white-collar discontent has begun to emerge. Hostility to globalization and trade is reflected in polling data. Even among those who accept that globalization and trade “are here to stay,” there is significant concern over its pace and consequences— particularly job loss. Among people with a college degree or higher—the group traditionally most supportive of globalization—opinions sharply turn negative when domestic job losses are posited. It has been noted that the WTO framework can be credited for the relative moderation in protectionist responses to deepened integration, China’s reemergence, financial crisis, and job loss—the four broad trends referenced today. Despite this and other mitigating factors, profound concerns remain: a perceived decline in US competitiveness, the fear that our children’s generation will do worse than their parents’ generation, and the perception of the global economy as hostile territory. In light of these concerns, three areas bear watching in the future. The first of these is the reemergence of industrial policy across the globe and the strengthening of state-dominated industries in many countries. The WTO is not well suited to addressing this development given the piecemeal nature of dispute settlement. Firms operating in these economies have faced and will face forced localization, indigenous innovation policies, and other pressures designed primarily to benefit and strengthen local producers at the expense of foreign competition and market-oriented forces. Second, natural resource hoarding has emerged as an area of concern, as global growth and

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development has led to an explosion in energy demand, and states intervene to corner the market in mined ores and rare earth minerals. Third, the post– World War II international order is under increasing strain, with major economic players at odds over fundamental norms of commercial behavior and the role of the state. In this regard, I leave you with a somewhat rhetorical question: Who is in charge?

Martin Feldstein

I will comment on four macroeconomic subjects, each of them touching upon various aspects of macrocoordination and cooperation. First I will briefly discuss the G20 process of macrocoordination. Second, I will say a few words on fiscal versus monetary policy and cooperation. Third, I will look at macropolicy in the eurozone. Finally, I will conclude with a few comments on European policies to assist the struggling peripheral countries. As I already mentioned in my earlier discussion, countries tend to act in their own self-interest, so macroeconomic policy coordination, as usually emphasized and encouraged by the IMF, is inherently difficult to achieve. When the G20 reached an agreement on a global stimulus, it was a relatively easy goal to achieve: every participant had something to gain because it was in the interest of all countries. Moreover, there was no agreement on the specific details of the stimulus packages so countries had sufficient leeway to design them in a way that best suited their needs. The United States is a special case because participating in such global agreements is in a way impossible, in another way easy, but meaningless for it. The US President simply can’t commit to any specific policy because of the need to obtain Congressional approval and because of the independence of the Fed. Therefore, when the US delegation arrives at these meetings, they simply tend to restate the administration’s existing policy. In the current context, the United States will certainly seek to reduce its fiscal deficit over time to attenuate global imbalances. Such commitment disregards the IMF’s view according to which one country’s adjustment should be accompanied by expansionary Martin Feldstein is the George F. Baker Professor of Economics at Harvard University and president emeritus of the National Bureau of Economic Research. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12866.ack.

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policies elsewhere to help the adjusting country’s export sector. While few would dispute this advice, I have hardly ever heard such talk in American policy circles. The US policy process simply doesn’t look too deeply into what other countries are doing, partly because international trade is relatively unimportant for the large American economy. In my view, the stimulus package that the Obama administration finally agreed on was limited not because of considerations of global imbalances but because of the politics of deficit spending. There was very little information on what shape foreign fiscal policy will take and what it would imply for US GDP and balance of payments. Moreover, economic advisers in the United States have very little clue about the size of the domestic multiplier. When I asked my friends in the National Bureau, I got estimates ranging between 0 and 2. Such uncertainty makes coordination with our trading partners all the more difficult. Turning to my second theme, most of the talk these days about stabilization policy is about fiscal policy. Until very recently, however, it hasn’t been the case. In the two decades leading up to 2008, macrostabilization in the United States meant monetary policy. Fiscal policy had been discredited because of its well-known lags. It takes time to recognize a business cycle downturn, it takes further time to design an appropriate fiscal response, and it takes yet more time to implement it. Monetary policy, by contrast, has been aided by the Taylor rule (which ties interest rates to inflation and the GDP gap)—a pretty accurate description of what the Fed was doing during this era. The Taylor rule, however, makes no reference to the fiscal stance. Thirdly, macropolicy in the eurozone basically amounts to monetary policy as conducted by the ECB. What it means, essentially, is an agreement on a single interest rate that is judged to suit best the whole currency area, best defined as achieving price stability. In principle, an easier monetary policy in the United States could help achieve price stability in the eurozone by weakening the dollar versus the euro. Yet I’ve never heard Jean-Claude Trichet saying that he has coordinated monetary policy with the Fed. It seems to me that the ECB takes other countries’ interest rates as given. As for fiscal policy, we now know that the creation of the euro led to growing fiscal deficits in the eurozone. Before the launch of the euro, high deficits had led to higher interest rates and declining currencies, useful market signals that the deficits were too large. This market feedback, however, has been eliminated with the euro. Interest-rate spreads, which should normally be read as warning signals, have stayed very low (about 30 basis points above German rates) for too long. Now that the spreads have massively increased, there is a movement toward imposing tough fiscal rules on each country, leaving only automatic stabilizers to deal with business cycle fluctuations. Germany just passed a constitutional amendment in this regard, and Spain may follow suit. If this movement is completed, there will be little room left for discretionary policies and the need for coordination will hardly surface.

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Finally, on multilateral cooperation to assist Greece and other economies in the European periphery, I find Greece to be in an impossible situation. Greece has to default; every market participant knows that. To reach a sustainable position, Greece needs to reduce its debt dramatically, probably by around 50 percent, significantly above the 20 percent haircut imposed on private creditors. The bailouts and the ECB’s intervention in the bond markets serve one purpose only: postponing the inevitable. Why postpone? If Greece defaults, it will hurt German and French banks. Postponing it will buy them time to rebuild their capital and perhaps sell the toxic bonds on their balance sheets to the ECB. A bigger concern is contagion to Portugal, then to Italy and Spain, which collectively would add up to a financial disaster. The situation in these countries will become clearer in the coming years. We will learn if Spanish banks have become healthy again and whether Italy can veer itself back to a cyclically adjusted balanced budget path. In a nutshell, postponing a Greek default will provide European policymakers with more information whether the other peripheral economies can survive such an incident. If they can’t demonstrate that they are healthy during this period, a default will mean sharply rising interest rates and insolvency soon after. There will be no way for Germany and the EFSF to deal with that and these countries will have to default and leave the euro. That would surely mark the end of the euro in its current form.

Subir Gokarn

The common perspective of this conference, in my view, has been the “global public goods debate.” Four papers were presented on trade and three papers covered structural macroissues, such as financial regulation, the environment, and so forth, all of which form part of this debate. The most recent and topical aspect of global public goods is crisis management. Before that, however, there had been plenty of talk about the positive consequences of globalization in the last twenty to thirty years. Economic integration, free trade, export growth, and so forth, have all been seen as unambiguously beneficial for countries like my own. In India, we quickly bought into the globalization story and it paid off. In the last couple of years, however, we entered a different phase of the debate. Increasingly, the emphasis is on trade-offs, negative externalities, conflicts, crises, and so forth that we can collectively label the “dark face of globalization.” The most important single question today is how to deal with this “dark face.” More specifically, the issue of governance arises over and over again: how are we going to create mechanisms that help us offset these negative externalities while preserving the benefits? This is the broad perspective I have taken away from this conference. I would now like to make a few comments on four issues that have been raised during the discussion. First, on crisis management, there has been a visible shift since 2008, when everyone was affected more or less evenly by the crisis, to more recent times, when fragmentation—some countries are recovering while others are not— is obvious. As currency wars and other frictions have emerged, the pendulum Subir Gokarn is former deputy governor of the Reserve Bank of India. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12867.ack.

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swung from the language of cooperation to one of open conflict. Even more moderate sources of concerns are important, such as the impact of liquidity on assets, in particular commodity prices, something that we have been particularly conscious of in India. Today, many of us have adopted an “us versus them” perspective. The single most important lesson is that cooperation is very difficult to achieve unless the shock is commonly felt. Another, more positive lesson, is that the G20 is a fairly effective forum for crisis management in the context of global crisis. We must recognize, however, that these global groups have limited purposes and they function effectively only within these constraints. After a while, they tend to get overly ambitious and finding a common ground gets increasingly difficult. Secondly, on financial regulation, the general tone of the conference has been a glass “half full.” We have, after all, moved toward a common standard on disclosure practices and risk management. I generally agree with this view and in the current context we should be fairly satisfied with a glass half full because we are dealing with very different environments and capabilities. The Indian experience is illustrative: we have a large number of foreign banks alongside local ones expanding abroad. One of these large local banks without an obvious government guarantee suffered a minor run when its exposure to subprime assets became known. A large bank with a high degree of visibility and a relatively small exposure to toxic assets was sufficient to trigger nervousness. Overall, the shared risk in global exposure is driving the search for a new common standard where the same information can be obtained objectively by everyone and a sufficient capital buffer is built up to ensure sufficient liquidity when such a shock hits. But there are also important differences, particularly in a growth environment, when macroindicators, such as credit-to-GDP ratios, can become misleading. An overly rigid approach can hurt our stability objective despite safeguards and escape clauses. Nevertheless, the broad sense of shared risk and a common need for buffers is quite visible. The lesson, perhaps, is a minimalist or incrementalist approach: it is important to recognize that only those rules should be imposed on different countries that they can accommodate, rather than looking at an “ideal state” situation where the same standards are appropriate for everyone. Despite the relatively long time frame that the Basel III approach allows, incrementalism is the only way this process can move forward. As for the papers on the global trading regime, I was quite struck by Kyle’s and Robert’s proposition on the relatively small benefits that the WTO has offered. This contrasts with Pravin’s argument on revealed preferences according to which countries seem to want to join trade agreements, whether multilateral or preferential ones. I had a bureaucratic hypothesis in mind to account for this observation, but there is perhaps a larger motivation. There is a sense of comfort with fairly objective, technically enforced sets of rules among the business community and governments alike. Based on the Indian

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perspective, I wouldn’t agree that the WTO had any negative impact on us. In the last fifteen years since the WTO was born, trade has become a much larger share of our economy. Admittedly, the biggest benefits accrued from non-WTO-regulated trade in services, software, and so forth. Even more important has been the increase in labor mobility, allowing people to move to other parts of the world. Even so, the general understanding in India is that joining the WTO yielded substantial economic benefits. Charlene’s point on how quickly the US politics of trade can turn against globalization is very important. India has experienced quite the reverse: people see opportunities everywhere; Thomas Friedman is celebrated as a guru, and when John Kerry spoke against outsourcing in the 2004 campaign, public opinion quickly swung toward George W. Bush. Finally, on the environmental debate, I agree with Lee’s and William’s point that it is highly difficult to get a mainstream political movement or even a platform around it. The leadership in the climate change process has shifted from well-known academics like Nick Stern and Joe Stiglitz to a group of more technical experts, putting technology at the center stage. The disadvantage of this, of course, is that it makes it more difficult to communicate the importance of climate change to larger constituencies. What is unique about the Indian context is that the high visibility of the consequences of climate change (deforestation, increasingly hot summers, changing patterns of rainfall, worries about water supply, etc.) have shaped the debate in a constructive way. It is very easy to attribute these phenomena to climate change, generating an increasing consciousness of the issue. Students, for instance, have completely bought the climate change agenda and they are the very people who may suffer the most from its consequences in the future.

Paul Keating

One of the themes I picked up from the discussion thus far is the disquiet that the G20 structure is not working—mainly because the growth of the global economy has moved ahead of politics and our management structures. Whereas we used to live in a world run by sectors until the third quarter of twentieth century, now it is run in “real time” brought about by ICT and globalization. New solutions are going to require global actions in diverse domains, such as climate change, weapons proliferation, and trade, just to name a few. In broad terms, the world has changed dramatically and we have to develop a more representative world structure for it to better work. One of the most influential developments in the global economy is the equilibration of productivity across the world, which is reestablishing the nexus between population and GDP. Before the Industrial Revolution, countries with the largest populations also were the largest by way of GDP. This link was broken by the Industrial Revolution, which enabled a spectacular productivity takeoff in the core countries. Today, new industries and technology jumping the old legacies of the twentieth century allow India, China, and the like to reestablish this lost link. The Chinese economy will probably be as large as the US economy in the foreseeable future. A comparison with Japan brings this point home: before its collapse around 1990, Japan’s per capita income was around 90 percent of that of the United States. Before its industrial miracle took off around 1955, it had been merely 20 percent. This is exactly where China is today. It is conceivable for Chinese per capita income to reach 40–50 percent, if not 70–80 percent, of US levels. Given Paul Keating is former prime minister of Australia. He is a member of the International Advisory Council of China Development Bank. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12868.ack.

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that its population is four times the size of that of the United States, it is easy to do the math. The point here is that the “Vasco de Gama epoch” of European influence in Asia is over—the world has irreversibly changed. We hear a lot of rankling about why this change is happening. All I can say is an old adage: “We are being mugged by reality.” In the following discussion, I want to focus on two crucial discontinuities that I regard as missed opportunities: the end of the Cold War and the financial crisis. In the first respect, the end of the Cold War gave us a chance to remake the world in a more representative way, but we failed to do that. We took some promising steps by incorporating Poland, Hungary, and others into NATO, and more into the European Union. We also tried to bring Russia into some kind of partnership with the Atlantic community. However, in the 1990s, the Asian financial crisis and the IMF’s reactions to it set the stage for a new era of mercantilism in the region. The reaction by Chinese authorities to build foreign reserves was understandable enough. Little changed in four presidential terms: two by Bill Clinton and two by George W. Bush. Something similar is happening with the Obama administration. The intellectual concept of inclusion has all but vanished. We still want to run the world from the Atlantic and at the same time complain that the Chinese are building foreign exchange reserves instead of developing their domestic economy. We have to recognize that China sees itself as a force of nature with its population amounting to a quarter of the world’s total; not willing to allow itself to be marginalized and pushed around. They want materially to be in the game. The United States is the remaining ideological state in the world, propagating its supposedly universal values, both by spreading democracy and in other ways. To this the Chinese answer is that we do not wish to export ideology or extend ourselves geographically, but you have to deal with what we are—the largest society and economy in the world until 1800, now returning to our historical position. We could recognize this, just as Roosevelt acted in proscribing colonialism, when signing the Atlantic Charter with Churchill. Underlying Chinese attitudes are influenced by the US attitudes toward China. The United States, with its quasi-containment policy, is following the path of Britain and France in their relations with Germany at the end of the nineteenth century. As Henry Kissinger put the provocative question in his book, “was it German capabilities or German behavior that brought Britain to its position”—of forming an alliance with France and Russia? The clear answer was capabilities, not behavior. Similarly, today it is Chinese capabilities that present a strategic affront to the United States, not Chinese behavior. Is the United States prepared to accept a communal/collegial structure of shared power in Asia? If so, this would be inconsistent with the supply of weapons to Taiwan. Is the United States seeking to encourage military action or is it simply trying to assuage Taiwan?

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In sum, we had the opportunity to build a representative world structure at the end of the Cold War but we did not do so. In an emergency we brought together the G20 to replace the G7, but this has not represented a strategic sea change. But change will come, even if it is going to be uncomfortable and nasty to some. Illustratively, as Professor Obstfeld pointed out in his chapter, IMF facilities are not being taken up in East Asia. Which brings me back to China. It is suboptimal for the Chinese to invest their reserves in the poor instruments it currently invests. They have better use for their funds, as Professor Goodhart noted earlier. Their capital outfits are not efficient. In the end the Chinese will change their behavior when it is in their national interest. Jaw boning by the IMF or the United States will not carry the day. China is held together by money and coercion, not by ideology. If the money stops rising or slows, it will fall back to nationalism. It will also realize that it can’t forever maintain high levels of employment with savings channelled to capital intensive industries. The story of modern China is one of urbanization, one that will have to accommodate a laborintensive service sector. It will have to increase consumption to GDP vis à vis investment. Some of this will mean “beating up” the Stated Owned Enterprises, the leaders of which have been very strong politically, now embedded in the State Council structure (many of whom are replacing old cadres). If the goal is to promote economic efficiency, earnings by SOEs should not be retained, but rather remitted to the national budget, just as they are in developed countries. However, Chinese SOEs exercise a lot of muscle sheltering themselves from contributions to the public account. It is important to point out that new commitments to a modified social security system, with some elements of universality in health provision, have already been made. These are attempts to reduce the propensity to save and to lift consumption. This will alter the current account and the investible surplus abroad. These influences amount to a sea change in Chinese economic policy. The current Five-Year Plan underwrites a shift toward consumption. But this will take time. Turning to the financial crisis, I am convinced that the impact of East Asian savings flooding the West had a material impact on the growth of financial intermediation, which was required to absorb ever more capital. So it was largely the global environment (the infamous saving glut) that was at the root of the crisis. Of course, regulation, or lack of it, contributed. You are better placed to know the solutions to the latter. Let me just say a couple of things about Australia. While treasurer, I made banks exceptionally free of regulation. However, as a counterpart of that I also put in place a rather strict supervisory structure, and I was very picky about the quality of capital going to that structure. I also would not allow them to amalgamate—to avoid them doing silly things in rapidly growing themselves. The disciplined structure has remained and has served Australia well.

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As a final remark, we are in for a period of low growth in the industrialized world. We are not able to say much about US policy until the next presidential election. In Europe, the Germans will eventually have to lean one way or another. It seems to me that ultimately there are two models for Europe: the center perpetually supporting the periphery with transfer payments and guarantees, or another with exchange rates more suitable to peripheral states. The latter implies a consolidated band of central states—but this would also imply a very much changed euro structure.

Afterword How the Financial Crises Have Changed the World Martin Wolf

The past is a foreign country. Indeed, even the recent past is a foreign country. The crisis that broke upon the world in August 2007 and then caused a widening economic malaise in the high- income countries and turmoil in the eurozone put these economies into a state previously unimagined by the overwhelming majority of well- informed policymakers. In 2004, in a celebrated speech on what economists then complacently called the “great moderation,” no less a man than Ben Bernanke, then still governor of the Federal Reserve, talked not of looming financial crisis and economic malaise, but of enduring economic stability attributable to good monetary policy. Just listen to what he said: “[I]mproved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well.”1 Yes, the reduced volatility of output! We now know a great deal more about that. Today, such complacency seems worse than quaint. The policy establishment failed to understand how the economy worked, largely because it failed to understand financial risk, and it failed to understand financial risk, partly because it failed to understand how the economy worked. Yet the unexpected turmoil has done more than make the orthodox views of even a few years ago look as dead as the dodo. It has changed the world. Here I consider ten ways the world has changed.

Martin Wolf is chief economics commentator of the Financial Times, London. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12870.ack. 1. Ben Bernanke, “The Great Moderation,” February 20, 2004, http://www.federalreserve .gov/boarddocs/speeches/2004/20040220/default.htm.

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1. Economic Transformation Start with the obvious. By 2012, the world economy had turned out to be very different from what most people imagined it would be six years before. In the important high- income countries, output was far below previous trends and rates of growth far below what had previously been considered their potential. In only two of the six largest high- income economies—the United States and Germany—were levels of activity above their precrisis peaks. Indeed, in Japan, Italy, and the UK, output was still well below those precrisis peaks. The concern that a prolonged malaise—similar to the lengthy sickness that had overcome Japan over the past two decades—had hit the high- income countries was, alas, growing ever more credible. Maybe the outcome would turn out to be even worse than in Japan. Meanwhile, emerging economies proved highly resilient. They managed to sustain growth, partly by replacing the external demand they had lost with domestic stimulus. Unquestionably, this worked, remarkably so in China. But such actions also left a difficult legacy: low- quality investments, asset price bubbles, and bad debts. These actions may, for these reasons, be unrepeatable, possibly even unsustainable. At the same time, the emerging countries could not return to the export- led growth cum reserve- accumulation strategies followed by many of the most successful, prior to the crisis. The weakness of private demand within high- income countries precluded that. In all, the legacy of the crisis included deep challenges to policymaking pretty much everywhere. Furthermore, these crises accelerated a transition in economic power and influence that was already under way. Between 2007 and 2011, the gross domestic product of the high- income countries, in aggregate, rose by a mere 1.1 percent, in real terms (at purchasing power parity), according to the International Monetary Fund, with that of the United States rising by 0.8 percent, and that of the eurozone falling by 0.7 percent. Over the same period, the real GDP of the emerging countries grew by 25 percent and those of India and China by 34 and 45 percent, respectively. Such a speedy transformation in relative economic weight among countries with large economies is surely without precedent. It has become extremely plausible that China’s economy will be the biggest in the world, at purchasing power parity, by the middle of the present decade, and the biggest in market prices by the early part of the next decade, at the very latest. The crisis did not create this transformation. That was already well under way. But surely it accelerated it. Recall also that the combination of a huge financial and economic crisis with a transformation in relative economic power happened in the 1930s. The world failed to manage that challenge altogether. Will it manage to do better this time?

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2. Fiscal Deterioration As a result of these unexpected developments, the crisis- hit countries found themselves struggling with far worse fiscal positions than they had previously imagined. Indeed, for the United States and the United Kingdom, the economic and fiscal costs rank almost with those of world wars. Net fiscal debt as a share of GDP is bound at least to double, in both of these cases. The outcome may well turn out to be far worse than that. In this respect, too, they found themselves following the precedent set by Japan. As the work of Carmen Reinhart and Kenneth Rogoff, both now at Harvard University, has shown, fiscal crises are an inevitable consequence of financial crises, largely because of the impact on government revenue and spending of declining profits, falling economic activity, and rising unemployment. These come on top of direct fiscal costs of bank bailouts.2 In the case of the current crisis, as was to be predicted, the biggest adverse fiscal effects were felt in the countries that suffered a direct hit from the financial crises, such as the United States, United Kingdom, Ireland, and Spain, rather than in countries that suffered an indirect hit, via trade. Worse still, the longer- term fiscal position of the crisis- hit countries was always likely to be difficult, because of aging. Now the legacy of the crises will curtail any fiscal room for manoeuvre. In this respect, then, the crisis has accelerated a grim future into the unhappy present. 3. Monetary Transformation Along with the fiscal impact of the crisis has come a monetary upheaval that is even bigger. In today’s credit- based system, central banks are supposed to regulate the price of money, while the central bank and government ensure the convertibility of “deposit money” into “government money,” at par, by acting as a lender of last resort (in the case of the central bank) and provider of overt or covert insurance of liabilities (in the case of the government). But the supply of money itself is normally a by-product of the private creation of credit. In the postcrisis world, this is no longer true. Central banks have gone far beyond standard operations to support the provision of credit and ensure an adequate supply of money. They have also gone far beyond lowering their official intervention rates to the lowest levels ever seen: in late 2012, the highest intervention rate employed by one of the four large western central banks was the European Central Bank’s 3/4 percent. They have enormously expanded their balance sheets, includ-

2. See Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press, 2009), 231– 32.

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ing by purchasing vast quantities of government bonds, with controversial long- term effects. Perhaps even more remarkable, such policies were in effect for years, with only modest effects on economic activity. The apparent ineffectiveness of monetary policy may be a more significant feature of the postcrisis world than the extreme nature of the expansionary policies actually adopted. If one wants to understand why monetary policy has proved so ineffective, one must start by appreciating the implosion of the financial system. 4. Financial Upheaval The most obvious of all the changes is, indeed, the transformed position of the financial system. The crisis established the dependence of the world’s most significant financial institutions on government support, along with the troubling existence of institutions that are too big or too interconnected to fail. The response to the crisis confirmed the previously controversial view that the financial system is rather a ward of the state than a part of a free market economy. The crisis itself has demonstrated the fragility of the financial system. As a result of all this, it has inflicted huge damage on the credibility of the global financial system and, above all, of “AngloSaxon financial capitalism.” One consequence is that the financial system is being forced through substantial and controversial reforms. Another is that a debate about the proper role and structure of the financial industry is inescapable. Yet another is the marked decline in the willingness of emerging economies to integrate into the global financial system. Moreover, the financial system had not yet recovered in 2012. Finally, the prospect of a long period of subdued credit growth makes a prolonged economic slowdown probable. 5. Ruin of Western Prestige As a result of the crisis, the established high- income countries suffered a huge loss of prestige. These countries, above all, the United States, remained dominant throughout the post–World War II era, even though they counted for an ever smaller share of the world’s population. This was partly because they had the largest economies and so dominated global finance and trade. It was also partly because they controlled the global economic institutions. However much the rest of the world might have resented the power and arrogance of the high- income countries, it trusted that, by and large, they knew what they were doing, at least in economic policy. The financial crisis and subsequent malaise have proved this confidence misplaced. Worse, because of the relative success of China’s state capitalism, the blow to the prestige of Western financial capitalism even carried with it a related blow to the credibility of Western democracy.

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6. Global Economy Upended Among the most important features of the precrisis global economy— indeed, one of the causes of the crisis—was the huge net flows of capital from emerging economies into supposedly safe assets in high- income countries. Moreover, the governments of emerging countries organized these flows themselves, largely as a direct result of their massive interventions in currency markets and consequent accumulations of foreign currency reserves. These reached over $10 trillion in 2012, quite apart from around $4 trillion in sovereign wealth funds. The presence of these currency reserves helped emerging countries survive the crisis without undue difficulty. Even so, they were almost certainly excessive: aggregate global currency reserves fell by just $472 billion between July 2008 and February 2009, which was only 6.3 percent of the initial stock. The recycling of current account surpluses and private capital inflows into official capital outflows was also surely one of the causes of the crisis. Indeed, one of the consequences of the global “savings glut,” of which these flows were a symptom, was a sharp decline in the real rate of interest on the liabilities of triple-A rate governments in the late 1990s, in the immediate wake of the Asian financial crisis. This shift also triggered the rise in the prices of long- lived real assets, notably of housing and commercial real estate, which also began at that time in a number of high- income countries, notably the United States, the United Kingdom, Spain, and Ireland. The fall in real interest rates also generated a strong demand for notionally safe, but higher- yielding, securities. The highly liberalized and ever- ingenious financial sector was only too happy to create such pseudo- triple-A securities, in vast quantities, via the invention of asset- backed securities and, in particular, collateralized debt obligations, which were supported by apparently ever- rising house prices. This new form of finance supported the ultimately unsustainable asset- price bubbles that encouraged both strong investment in residential and commercial construction and high household consumption. These, in turn, temporarily generated the demand that absorbed the surpluses of desired savings over investment in large parts of the world economy. The financial crisis brought this apparently benign, but, in fact, entirely unsustainable source of global demand to an end. It cannot be resurrected. The high- income countries have clearly proved themselves unable to use these inflows effectively. Currently, the place of the precrisis financial deficits of the household sector has been taken by fiscal deficits that few believe are sustainable indefinitely either. Thus, what was destabilizing before the crisis is almost certainly unsustainable after it.3 3. The role of the global imbalances in the crisis was the theme of Martin Wolf, Fixing Global Finance (Baltimore and London: Johns Hopkins University Press, 2008 and 2010), especially

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The natural and, it appears, most desirable flow of capital is “downhill,” from rich to poor countries, not “uphill,” from poor to rich ones. Even so, the fact that the poorer countries fear the impact of capital inflows means that creating a world in which capital flows in an appropriate direction may require large reforms in the global financial and monetary architecture. Yet this is a challenge that must, somehow, be met. 7. Globalization Threatened The crisis has also endangered globalization. This is true, above all, of the globalization of finance. Taxpayers have bailed out institutions whose business is heavily abroad. Similarly, they have been forced to protect financial businesses from developments elsewhere, including those caused by regulatory incompetence and malfeasance. This is—or should be—politically unacceptable. Broadly, some combination of two possible outcomes seems possible: less globalized finance or more globalized regulation. This dilemma is particularly marked inside the eurozone, as Adair (Lord) Turner, chairman of the UK’s Financial Services Authority, has noted. This is because financial markets are more integrated and national policy autonomy is more limited than elsewhere.4 Yet the same is also true, to a degree, for the world as a whole, where tension arises between a drive to agree to common regulatory minima and a desire to preserve domestic regulatory autonomy.5 The pressure for “deglobalization” may prove not to be limited to finance. The combination of extraordinarily weak growth with widening inequality, high unemployment, financial instability, the so-called “currency wars,” and fiscal defaults may end up undermining the political legitimacy of globalization in many other respects as well. Certainly, the crisis has eroded the optimism many once felt about how an integrated global economy would work. 8. Global Governance Challenged Inevitably, the legacy of the crises includes large- scale institutional changes in many areas of policy and at national, regional, and global levels. The obvious areas for reform are financial regulation, the functioning of Chapter 8 of the revised edition. See also Òscar Jordà, Moritz Schularick, and Alan M. Taylor, “Financial Crises, Credit Booms and External Imbalances,” National Bureau of Economic Research Working Paper no. 16567, December 2010, www.nber.org, and Alan M. Taylor, “The Great Leveraging,” National Bureau of Economic Research Working Paper no. 18290, August 2012, www.nber.org. 4. Adair Turner, “Financial Risk and Regulation: Do We Need More Europe or Less?”, April 27, 2012, Financial Services Authority, http://www.fsa.gov.uk/library/communication /speeches/2012/0427-at.shtml. 5. Another example of “deglobalization” is the proposed ring- fencing of domestic retail banking from global investment banking proposed by the UK’s Independent Commission on Banking, of which I was a member. This was set up by the incoming Coalition Govern-

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the monetary systems, global governance, and global economic institutions. Substantial reforms are under way. But big questions remain unaddressed and unresolved, notably over the global monetary and exchangerate regimes. One of the main reasons the emerging countries decided to accumulate reserves was their fear of the consequences of becoming net borrowers. That, in turn, was the result of painful experience in waves of previous financial crises, culminating in the Asian crisis. The implication may be that the only countries in a comfortable position when running large current account deficits are ones with reserve currencies they can create at will. But that, in turn, means they must be running policies that generate large financial deficits in the private or fiscal sectors of their countries. That, too, as we have seen, can end in terrible crises. To avoid such crises would require a system of collective insurance. But agreeing on that is probably impossible. A revealing institutional step, taken early in the crisis, was the shift from the group of seven leading high- income countries as the focus for informal global decision making to the group of twenty—a shift that brought with it an increase in relevance at the price of a reduction in effectiveness. This is just one aspect of the complications created by the need to take account of the views and interests of more players than ever before. 9. Europe Shocked Whatever happens at the global level, the crises have created an existential challenge for the eurozone and so for the European “project.” It seems clear that, without substantial changes in policy and substantial longer- term reforms, the eurozone will lose members or even dissolve altogether. That would mark the first time that the European project had gone backwards, with dire consequences for the prestige and credibility of European integration. Such a breakdown would also reflect—and exacerbate—a breakdown in trust among the peoples and countries of Europe, with devastating consequences for their ability to manage common challenges, sustain a cooperative approach to the problems of Europe, and act effectively in the wider world. Such a reversal would certainly imperil the single market. It might destroy the European Union. Even if everything is ultimately resolved successfully, Europe is doomed to become inward looking and distracted for many years, with dire consequences for European influence. If everything is not resolved, the collapse of the European model of integration would permanently shatter the credibility of what was, for all its faults, the most promising system of peaceful international integration there has ever been. ment under the chairmanship of Sir John Vickers. See Independent Commission on Banking, Final Report: Recommendations, September 2011, London, http://bankingcommission .s3.amazonaws.com/wp- content/uploads/2010/07/ICB-Final-Report.pdf, chapter 3.

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10. Ideas in Question Yet perhaps the biggest way in which the successive financial, economic, and European crises have changed the world is intellectual. They have shown that established views of how (and how well) the world’s most sophisticated economies and financial systems work were, quite simply, nonsense. The great moderation masked a lack of financial moderation that would ultimately cause great devastation. Indeed, as Hyman Minsky would argue, the financial immoderation caused the delusion of the great moderation. Similarly, it is quite clear that stable inflation does not begin to be a sufficient condition for economic stability. These brutal facts pose an uncomfortable challenge for economics and an equally uncomfortable challenge for economic policymakers—central bankers, financial regulators, officials of finance ministries, and ministers. In the last resort, ideas matter. Both economists and policymakers need to rethink their understanding of the world in important respects. The precrisis conventional wisdom, so aptly captured in Mr. Bernanke’s speech about the contribution of improved monetary policy to the great moderation, stands revealed as complacent, if not incompetent and vainglorious. The world has indeed changed. The result has to be a ferment of new ideas. Yet what we see, instead, is more a clash of old ideas—Keynesians, both established New Keynesians and radical post-Keynesians, against monetarists, and both Keynesians and monetarists against New Classicals and Austrians. The world needs something better from economists. It is not clear that it will get it. Opportunity and Challenge The opportunity of securing a more prosperous and integrated global economy remains. But the challenge of achieving it seems far more difficult than prior to the crisis. It looks, indeed, as though we have a choice between deeper global cooperation or less globalization. We cannot continue with countries making up their own minds on exchange rate and monetary policies, or on financial regulation. The spillover effects have turned out to be too damaging. It is easy to see how far the financial crises have changed the world. It is far more difficult to know what to do about it. The challenges are extraordinarily complex. But somehow we must rise to the challenge. If not us, who? If not now, when?

Contributors

Robert D. Anderson World Trade Organization Rue de Lausanne 154 1211 Geneva Switzerland Kyle Bagwell Department of Economics Stanford University Landau Economics Building 579 Serra Mall Stanford, CA 94305-6072 Richard Baldwin Graduate Institute of International and Development Studies 1 Av. Richard Wagner, 5th floor 1211 Geneva Switzerland Charlene Barshefsky WilmerHale LLP 1875 Pennsylvania Avenue, NW Washington, DC 20006 Charles Bean Bank of England Threadneedle Street London EC2R 8AH United Kingdom

Richard Berner US Treasury Department 1500 Pennsylvania Ave. NW Washington, DC 20220 Alex Bowen Grantham Research Institute on Climate Change and the Environment London School of Economics and Political Science Houghton Street London WC2A 2AE United Kingdom Lee Branstetter Heinz College, School of Public Policy and Management Department of Social and Decision Sciences Carnegie Mellon University Pittsburgh, PA 15213 Giancarlo Corsetti Faculty of Economics University of Cambridge Sidgwick Avenue Cambridge CB3 9DD United Kingdom

409

410

Contributors

Gerardo della Paolera Universidad de San Andrés Vitorio Dumas 284 1644 Victoria Buenos Aires Argentina Barry Eichengreen Department of Economics University of California, Berkeley 549 Evans Hall 3880 Berkeley, CA 94720-3880 Robert C. Feenstra Department of Economics University of California, Davis One Shields Avenue Davis, CA 95616 Martin Feldstein National Bureau of Economic Research 1050 Massachusetts Avenue Cambridge, MA 02138-5398 Subir Gokarn Reserve Bank of India Central Office Shahid Bhagat Singh Road Mumbai 400001 India Charles A. E. Goodhart London School of Economics and Political Science Houghton Street London WC2A 2AE United Kingdom Douglas A. Irwin Department of Economics Dartmouth College Hanover, NH 03755 Takatoshi Ito Graduate School of Economics University of Tokyo 7-3-1 Hongo, Bunkyo-ku Tokyo 113-0033 Japan

Paul Keating Office of the Honourable Paul Keating PO Box 1265 Potts Point NSW 1335 Australia Pravin Krishna Johns Hopkins University 1740 Massachusetts Avenue, NW Washington, DC 20036 Gernot J. Müller Department of Economics University of Bonn Adenauerallee 24-42 53113 Bonn Germany Maurice Obstfeld Department of Economics University of California, Berkeley 530 Evans Hall 3880 Berkeley, CA 94720-3880 Kevin H. O’Rourke All Souls College Oxford University Oxford OX1 4AL United Kingdom William Pizer Sanford School of Public Policy Duke University Box 90312 Durham, NC 27708 Domenico Siniscalco Morgan Stanley Corso Venezia 16 20121 Milan Italy Robert W. Staiger Department of Economics University of Wisconsin 1180 Observatory Drive Madison, WI 53706

Contributors Alan M. Taylor Department of Economics University of California, Davis One Shields Avenue Davis, CA 95616

L. Alan Winters Department of Economics University of Sussex Brighton BN1 9SL United Kingdom

Adair Turner Financial Services Authority 25 The North Colonnade Canary Wharf London E14 5HS United Kingdom

Martin Wolf Financial Times One Southwark Bridge London SE1 9HL United Kingdom

Andrés Velasco Columbia University School of International and Public Affairs 420 West 118th Street New York, NY 10027 Anthony Venables Department of Economics Oxford University Manor Road Building, Manor Road Oxford, OX1 3UQ United Kingdom

Rufus Yerxa World Trade Organization Centre William Rappard Rue de Lausanne 154 1211 Geneva Switzerland Ernesto Zedillo The Yale Center for the Study of Globalization Betts House 393 Prospect Street New Haven, CT 06511

411

Author Index

Page numbers followed by the letter f or t refer to figures or tables, respectively. Adrian, T., 360 Aghion, P., 147n16 Ahamed, L., 55 Aizenman, J., 318 Akamatsu, K., 196n23 Aldy, J. E., 215n1, 252 Amato, J. D., 280 Amiti, M., 156 Amsden, A. H., 184, 184n14, 190n18 Anderson, J. E., 97 Anderson, R. D., 128 Ando, M., 181 André, C., 263n4 Andreoni, J., 251 Antras, P., 147n16 Antweiler, W., 239 Ashcraft, A., 381n7 Auerbach, A., 290n16 Ausubel, J. H., 227n18 Bagwell, K., 15, 16, 98, 98n5, 103, 103n13, 114n24, 147n16 Baier, S. L., 140, 141 Balassa, B., 183 Baldwin, R. E., 17, 133n3, 137, 166n1, 168, 172, 176, 177n10, 179n12, 180, 182t, 183, 192, 205 Barkbu, B., 379n1 Barnhart, M. A., 30 Barrett, S., 229

Barro, R., 266 Bayoumi, T., 54n32 Beetsma, R., 258n2, 272, 272n10 Benetrix, A., 263n5 Bergstrand, J., 140, 141 Berner, R., 379n2, 381n7 Bhagwati, J., 32, 102, 105n17, 107, 133n3, 142, 145n11, 145n12, 148, 155n21, 155n22 Blanchard, O. J., 258, 267 Blanford, G. J., 251n2 Blinder, A., 179n12 Blustein, P., 108, 109, 109n20, 111n22 Bodenstein, M., 287, 288 Bohara, A., 147n17 Bohn, H., 280n14 Bordo, M., 28n7 Borio, C., 332n26, 344 Boughton, J. M., 320n17, 322n19 Bown, C. P., 35n9, 94, 94n3, 103 Boyer, J. G., 227 Brambilla, I., 173n9, 201n25 Broadbent, B., 352 Broda, C., 103 Bronfenbrenner, M., 68n78 Brunnermeier, M. K., 301n2, 359 Buckley, C., 217 Cadot, O., 147n16 Calmes, J., 358

413

414

Author Index

Calvo, G. A., 318n16, 325, 347 Camdessus, M., 71n87 Canzoneri, M. B., 272n10, 308n7 Carney, M., 381n8 Carraro, C., 229 Cattaneo, O., 172 Caves, R. E., 331 Chandra, V. G. R. C., 187, 188, 189 Chang, P. L., 93n1, 144f Chang, W., 143 Christiano, L., 287 Clarke, L., 222, 225, 243 Clarke, S. V. O., 55 Clausing, K., 140 Clemens, M. A., 171 Cline, W. R., 365, 365n1, 368n3 Cogan, J. F., 257, 266 Collins, W., 216n3 Cooper, R., 48, 58n47, 61n58, 67n77, 75n107, 233n33, 305, 333 Copeland, B. R., 239 Corbett, J., 69n79 Corfee-Morlot, J., 227n210, 229 Corn, D., 231n31 Corsetti, G., 258, 259, 260, 268, 268n9, 270, 274, 277, 278, 279, 280, 285, 286, 290n16, 290n17, 291, 292n18, 294 Cox, G., 45n11 Crowley, M. A., 103 Cumby, R. E., 272n10, 319n17 Cúrdia, V., 292n18 Cwik, T., 258 Danielsson, J., 359 Deardorff, A. V., 179n12, 181 Dedola, L., 280, 294 Dell, S., 59n50 Dellink, R., 227, 229 Del Negro, M., 260 Delpha, J., 375 De Melo, J., 147n16 Den Elzen, M. G. J., 227n20 De Paoli, B., 275n11 Devereux, M. B., 105n17 Diakantoni, A., 93n2 Diamond, D., 54n33 Diba, B., 272n10 Disyatat, P., 332n26 Domeij, D., 280 Dominguez, K. M. E., 317n15, 339, 340 Dooley, M., 330 Dornbusch, R., 101 Dybvig, P., 54n33

Eckaus, R. S., 165 Edenhofer, O., 224 Ederington, J., 239 Edge, R. M., 380n6 Edwards, L., 100 Eichenbaum, M., 287 Eichengreen, B., 22, 24, 33, 45n7, 52n29, 54n32, 56n38, 59n51, 64n68, 73n99, 78n113, 88, 304, 319, 379n1 Eicher, T. S., 103 Endres, A., 58n45 Erceg, C. J., 274, 287, 288 Escaith, H., 93n2 Estevadeordal, A., 49n21, 147 Ethier, W., 16, 147n16 Farhi, E., 307 Feenstra, R., 181 Feldstein, M., 55n36 Findlay, R., 22 Finger, M., 94, 100n11 Finus, M., 229 Fischer, C., 242, 255 Fischer, S., 318 Fisher, I., 87 Flandreau, M., 54n32 Fleming, G., 58n45 Flodén, M., 280 Folkerts-Landau, D., 330 Folmer, H., 241 Forbes, K., 379n1 Fox, A., 242 François, J., 156 Frankel, J., 67n76 Franz, B., 49n21 Freund, C., 147, 147n16 Friedman, M., 87 Fuangkajonsak, W., 185, 189f Fujita, M., 187, 188 Galí, J., 280n14 Gallarotti, G., 52n28 Gamberoni, E., 172 Garber, P., 330 Garleanu, N., 381n7 Garside, B., 228n23 Garzarelli, F., 352 Gaston, J., 22 Gawande, K., 147n17 Gereffi, G., 172 Gesell, S., 87 Giavazzi, F., 332 Girouard, N., 263n4

Author Index Giuliodori, M., 258n2, 272, 272n10 Glick, R., 27 Goldberg, L. S., 315n13 Goodhart, C. A. E., 318, 324, 356, 357, 379n2, 379n3, 381n7, 381n9 Gorodnichenko, Y., 290n16 Gourinchas, P.-O., 307, 308 Govillot, N., 308 Green, A. E., 184, 184n14 Greenlaw, D., 380n5 Greenspan, A., 308n8 Grossman, G. M., 95, 132n1, 145, 146, 179n12, 199 Guerrieri, L., 287, 288 Guimaraes, B., 294 Haas, P., 44, 44n5, 45n9 Haberler, G., 302n2 Hall, S. G., 330 Hanson, G., 181 Harrison, A., 173 Hashimoto, Y., 317n15, 339, 340 Hausmann, R., 173n9, 201n25, 202 Hebous, S., 258n2 Hellwig, M. F., 357 Helpman, E., 132n1, 145, 146, 147n16 Henderson, D., 274 Henn, C., 103 Henning, C. R., 307n6 Hertwich, E. G., 227n19 Hill, M., 58n45 Hirsch, F., 314n12 Hoekman, B., 156 Hoel, M., 229, 252 Holmes, P., 169 Horn, H., 206n27 Horton, M., 263 Houser, T., 227n20, 229 Huberman, M., 21 Humphrey, J., 203 Hwang, J., 173n9, 201n25, 202 Irwin, D. A., 17n5, 24, 32, 35n9, 192n19 Ishi, K., 318 Ito, T., 69n79, 317n15, 327n21, 339, 340 Ivanova, A., 258n2 Izquierdoa, A., 347 Jacks, D., 167f, 178f Jaffe, A. B., 239 James, H., 62n61 Jawara, F., 93 Jeanne, O., 315, 318n16

Jeppesen, T., 239 Johnson, R. C., 176 Jones, R. W., 179n12 Jordà, Ò., 406n3 Joshi, V., 137 Judson, R., 217n4 Kanageswary, R., 187 Kapstein, E., 65n69 Karacaovali, B., 98, 148 Kashyap, A., 379n2, 381n7 Kaya, Y., 227n17 Keeley, J. F., 205n26 Kemp, M., 144, 332n25 Kenen, P. B., 45, 45n7, 321 Kennedy, C., 315n13 Keohane, R. O., 12 Keynes, J. M., 87, 87n1, 332n25, 349 Kierzkowski, H., 179n12 Kim, L., 184n14 Kim, S., 270 Kimura, F., 181 Kindleberger, C. P., 22, 331n24 Klaasen, F., 258n2, 272n10 Klier, T. H., 179 Klinger, B., 173n9, 201n25 Kojima, K., 196n23 Kolstad, C. D., 230, 251 Koo, R., 372n7 Korinek, A., 329 Kovacic, W. E., 128 Krasner, S., 44n4 Krishna, P., 132n1, 133n3, 145, 146 Krugman, P. R., 166, 166n2, 173, 192, 332n25 Kumar, M., 263 Kwa, A., 93 Lampe, M., 20, 21f Lane, P. R., 263n5, 311, 312f Lanz, R., 172 Lastra, R., 347n2 Laubauch, T., 280 Lawrence, R. Z., 100, 134n4, 157 Lederman, D., 173n9, 201n25 Leduc, S., 280 Lee, M. J., 93n1 Leeper, E. M., 280n14 Levin, A., 274 Levinson, A., 239 Levy, P., 145 Lewchuck, W., 21 Lewis, W. A., 27f

415

416

Author Index

Limao, N., 98, 103, 147, 148, 156 Lindauer, D. L., 165, 166, 201, 201n24 Lipscy, P., 74n101 List, J. A., 239 Lopez-Cordoba, E., 49n21 López-González, J., 162, 169, 176 Lowe, P., 344 Ludema, R. D., 103 Ma, A., 176 Madigan, B., 381n9 Magee, C., 140 maggi, G., 16 Maggiori, M., 308n7 Magud, N. E., 329n22 Maloney, W. F., 173n9, 201n25 Manchin, M., 156 Marcheggiano, G., 357 Markusen, J., 19n12 Martin, P., 192 Masciandaro, D., 358 Mattoo, A., 106n18 Mauro, P., 263 Mavroidis, P., 206n27 Mayda, A. M., 33, 103 McCauley, R. N., 322n19 McCubbins, M., 45n11 McGinty, K., 227n21 McGuire, P., 315n13 McLaren, J., 147n16 Mehrling, P., 381n9 Meier, A., 258, 259, 260, 268, 268n9, 270, 274, 277, 278, 279, 285, 286, 290n16 Meisenzahl, R. R., 380n6 Meissner, C., 49n21, 52n28, 167f, 178f Mejia, L. F., 347 Meltzer, A., 55n35 Mendelsohn, R. O., 215n1 Metzler, L. A., 302n2 Miles, D., 357 Milesi-Ferretti, G. M., 311, 312f Minier, J., 239 Minsky, H. P., 87 Miu, J., 315n13 Mody, A., 379n1 Monacelli, T., 270 Morris, S., 294 Mostashari, S., 100 Mrazova, M., 104n14, 144n24 Mukerji, P., 100 Müller, A. C., 127, 128

Müller, G. J., 258, 259, 268, 268n9, 270, 274, 277, 278, 279, 285, 286, 290n16 Mundell, R., 143n9 Neary, P., 107n19 Newell, R. G., 255 Noguera, G., 176 Nordhaus, W., 215n1, 223n10, 225, 227, 233n33 Novy, D., 167f, 178f Nurske, R., 58n46 Obstfeld, M., 311, 322, 324n20, 330, 332n25 Offer, A., 30 Ogawa, E., 327n21, 340 Ohyama, M., 144 Olarreaga, M., 106n18, 147n16, 156 Olsen, M., 79n116 Ornelas, E., 146, 147 O’Rourke, K. H., 18, 21, 22, 33 Ossa, R., 104n14 Ostrum, E., 230, 251 Ostry, J. D., 329 Ottaviano, G. I. P., 209 Ozden, C., 95 Page, S., 156 Panagariya, A., 133n3, 140n7, 143n9, 145, 148 Passarelli, F., 358 Pauly, L., 45n7 Pedersen, L. H., 301n2, 359, 381n7 Perotti, E., 380n4 Perotti, R., 258, 267, 270, 280n14 Persaud, A., 359 Persson, T., 44 Peters, G., 44n3, 227n19 Piermartini, R., 172 Portes, R., 73n99 Porto, G., 173n9, 201n25 Prasad, E. S., 322, 323 Prichett, L., 165, 166, 201 Prit, 201n24 Prusa, T., 148, 149 Rajamani, L., 219n6, 235n34 Ramey, V. A., 267, 268, 268n9 Ravenhill, J., 184n14, 185 Ray, D., 298 Rebelo, S., 287 Reinhardt, E., 95 Reinhart, C. M., 262, 325, 329n22, 403n2

Author Index Reklev, S., 228n23 Reti, S., 51 Rey, H., 307, 308 Richels, R. G., 251n2 Roberty-Nicoud, F., 179n12 Rodriguez-Clare, A., 16, 173, 190 Rodrik, D., 15, 33, 34, 39, 165, 166, 173n9, 190, 201n25, 202, 203 Rogoff, K. S., 46, 262, 329n22, 330, 403n2 Romalis, J., 140, 156 Rose, A. K., 315n13 Rosito, T., 157 Rossi-Hansberg, E., 179n12, 199 Rotemberg, J. J., 280 Roubini, N., 75n108, 270, 294, 330 Rubenstein, J. M., 179 Rundshagen, B., 229 Rutherford, T. F., 251n2 Sachs, J., 67n74 Saggi, K., 146n14, 147n16 Sanguinetti, P., 147n17 Sapir, A., 206n27 Sasaki, Y. N., 340 Saul, S. B., 14f Saurina, J., 360 Schenk, C., 322n19 Scheve, K. F., 33 Schmalensee, R., 217n4 Schmitz, H., 203 Schularick, M., 406n3 Schumacher, D., 352 Seghezza, E., 137 Setser, B., 75n108 Shannon, D., 232 Sheppard, K., 231n31 Shin, H. S., 294, 360 Shirono, K., 98 Simons, H. C., 87 Siniscalco, D., 229 Sinnott, R., 33 Slaughter, M. J., 33 Smith, M., 44n6 Solomon, R., 320n17 Solomon, S., 357 Soraghan, M., 217 Spaventa, L., 332 Sperling, G., 227n21 Spiegel, M. M., 315n13 Staiger, R. W., 15, 16, 98, 98n5, 102n12, 103, 103n13, 105n17, 114n24, 147n16 Staritz, C., 172

Stern, T., 227, 231, 252 Stoker, T., 217n4 Stone, M. R., 318 Strange, S., 62n64 Sturgeon, T. J., 183, 183n13 Suarez, J., 380n4 Subramanian, A., 93, 95, 102n11 Sun, Y., 318 Sutherland, A., 275n11 Sutherland, P., 102, 107 Sykes, A. O., 95 Tabellini, G., 44 Talvi, E., 347 Tarullo, D., 227n21 Tavlas, G. S., 330 Taylor, A. M., 27, 49n21, 252, 311, 330, 406n3 Taylor, M. S., 239 Techakanont, K., 188, 188n17 Tokarick, S., 100 Toniolo, G., 56n41 Tovar, P., 148 Trefler, D., 101n9, 140 Trichet, J. C., 347 Trifflin, R., 302n2 Truman, E., 322 Tsebelis, G., 45n8 Turner, A., 406n4 Uhlig, H., 257 Uzan, M., 64n68 Uzir, M., 187 Van Assche, A., 176 Vanek, J., 144 Varian, H., 151n20 Venables, A., 133n3, 166n2, 179n12, 192 Victor, D. G., 221n8, 230n28 Viner, J., 17 Von Peter, G., 315n13 Von Weizsäcker, J., 375 Wad, P., 187, 188, 189 Waggoner, P. E., 227n17 Wagner, W. B., 359 Walker, W. C., 318 Wan, H., 144 Weber, C., 218n5 Weber, S., 258n2 Wei, S.-J., 93, 95 Weinstein, D., 103

417

418

Author Index

Weitzman, M. L., 215n1, 216n3 White, W., 344 Wieland, V., 258 Williamson, J. G., 18, 22, 171, 313 Winters, L. A., 38, 38n1, 143, 144f Wolf, M., 40n3, 330 Wolfe, N., 57n43 Woodford, M., 278, 280, 287, 289n15, 292n18 Wyplosz, C., 315, 318n16

Yeager, L. B., 304n4 Yeats, A., 141t, 142 Yehoue, E. B., 318 Yellen, J., 381n8 Yi, K. M., 166n3 Yi, S., 146, 147 Yildiz, H. M., 146n14 Yokobori, K., 227n17 Yotov, Y. V., 97 Yusuf, S., 38

Xiao, J., 290n17 Yang, J., 357 Yasui, Y., 318

Zhou, X., 319 Zimmerman, T., 258n2

Subject Index

Page numbers followed by the letter t refer to tables. Agriculture, Doha Round and, 5, 107–14 Annex I countries, 219, 220 ASEAN, 75, 132 ASEAN+3, 75 Asian crisis of 1997–1998, 72–74 Asian Monetary Fund, 75 Association of Southeast Asian Nations. See ASEAN; ASEAN+3 Auto industry, in East Asia, and second unbundling, 183–89 Bank for International Settlements (BIS), 56, 56n41, 58n47, 85 Bank of England, 52–55 Bank of France, 52–54 Baring crisis, 52, 87 Basel I Accord, 357, 359 Basel II Accord, 357, 359–60 Basel III Accord, 78–79, 360–61 Basel Capital Accord, 65, 65n69, 359–60 Basel Committee on Banking Supervision (BCBS), 56, 85, 356–57 Basel Concordat (1975), 65 Big Ideas, 165–66 Bilateral trading systems, 14–15 Brady Plan, 66n72, 71, 73 Bretton Woods system, 25, 30, 61, 324 BRICS (Brazil, Russia, India, China, and South Africa), growth of emissions in, 223

Britain. See United Kingdom Bundesbank, 69 Business cycle model, 274–89 Camdessus, Michel, 71 Canada-US Free Trade Agreement (CUSFTA), 140 Cancun Agreement, 230–33; emission policy after, 233–36 Capital adequacy ratios (CARs), 344, 355 Capital inflow controls, 329–30 Carbon tariffs: implementing, in practice, 243–44; necessity of, in long run, 242– 43; necessity of, in short run, 238–43; necessity of, in theory, 237–38; WTO-legality of, 236–37 Chiang Mai Initiative, 75, 75n105 China, 398–99; reemergence of, and global growth, 385–86 Climate change policy, 395; difficulty enacting changes, 217; global negotiations on, 219 Cobden-Chevalier Treaty (1860), ix, 2, 19, 21, 49n21, 50, 133 Cold War, 398–99 Collective Action Clauses (CACs), 358 Committee of Twenty, 63 Common Agricultural Policy, 64 Congress of Versailles, 22 Congress of Vienna, 18

419

420

Subject Index

Cooperation, international, 2 Corn Laws, 19 Credit rating agencies, 354 Crisis management, 393–94 Current account imbalances, 330–32 Customs Unions, 131 Development/industrialization theories, 165–66 Dillon, Douglas, 62 Doha Round, 91–92; agriculture and, 5, 107–14; developing countries and, 92–94; making, a development round, 114–17; problem with special and differential treatment (SDT) and, 94– 101; special and differential treatment (SDT) and, 101–7; trade preferences and, 156–57. See also World Trade Organization (WTO) Dutch disease, 193 Dutch East India Company, 18 “Dynamic time-path” question, 145n11 Economic and Financial Affairs Council (ECOFIN), 70 Economic crisis. See Global financial crisis Emissions Trading Scheme (ETS), European Union, 234 Emminger, Otmar, 62, 63 Enabling Clause, 131 Energy Modeling Forum (EMF-22), 222, 224–25 European Central Bank (ECB), 9 European Economic Community (EEC), 59, 60, 60n54, 63–64, 132 European Monetary System (EMS), 65, 70 European Monetary Union (EMU), 4 European Payments Union (EPU), 59–60 European Systemic Risk Board (ESRB), 347 European Union (EU), 4 Eurozone, macropolicy and, 390 Exchange Rate Mechanism (ERM), 70 Exchange rates: floating, 324; and resource allocation and coordination in short run, 325–29 Federal Reserve Bank of New York, 55 Financial crisis. See Global financial crisis Financial regulation, 394 Financial System Assessment Procedure (FSAP), 356–57 First unbundling, of globalization, 6, 177– 78, 192

Fiscal policy, 257–60, 390; cross-border effects of, case study, 266–89. See also Global financial crisis Flexible Credit Lines (FCL), 319 Floating exchange rates, 324 Fordney-McCumber tariff (1922), 22 Fowler, Henry, 62 France: international policy coordination and, 49–50; nineteenth-century international trading systems and, 20–21 Free Trade Areas (FTAs), 131 General Agreement on Tariffs and Trade (GATT), 2, 5, 13, 15, 17, 25–26, 30, 34, 35, 40, 41, 92–95, 98, 100–110, 114, 117–19, 131, 132, 142, 152t, 205, 206, 220, 233, 234, 237 General Agreement on Trade in Services (GATS), 151 German Reichsbank, 53, 55 Germany, “iron-and-rye” tariff, 21 Global financial crisis, 399–400; cooperation in aftermath of, 289–94; fiscal response to, 260–66; globalization and, 386; ways world has changed because of, 401–8. See also Fiscal policy Global growth, broad trends of, 385–87 Global imbalances, 330–32 Globalization: first unbundling of, 177–78; growing white-collar discontent in United States toward, 286; impact of, on developing nations, 168, 169; multilateral trade cooperation and, 205–7; second unbundling of, 166, 171, 174– 75; second unbundling of, and erosion of WTO centricity, 206–7; transformation of, 166–71; transportation and transmission technologies as drivers of, 166–71 Global last-resort lending, 322–24; role of, 313–16 Global liquidity. See International liquidity Global macroeconomic and financial supervision, 343–49; adjustment processes for, 349–56; future of, 356–61; problems involved to improve, 343–44 Global Stabilization Mechanism (GSM), 319 Gold Pool, 61–62, 62n60 Gold standard, 2–3, 21, 50 Great Britain. See United Kingdom Great Depression, 30, 32–33; international trading systems and, 23–24

Subject Index Greece, multilateral cooperation to assist, 391 Greenhouse gas (GHG) emissions, 7, 215– 18; global distribution of, 219–25 Group of Five (G5) summit, 67–68 Group of Twenty (G20), 8, 74, 76–77; macrocoordination process of, 289–90 Herstatt crisis (1974), 65 High development theory, 6, 166, 173, 207–8; supply chains and, 172; thirdgeneration, 201–5 Import substitution, 183; second unbundling and, 200–201 Industrialization: before second unbundling, 190–93; second unbundling and, 181–83 Industrial Revolution, 17–18 Inflow controls, capital, 329–30 Information and communication technology (ICT) revolution, 166, 171, 208; second unbundling and, 179–81 Institutionalized trading systems, 16 Intellectual property (IP) protection, supply chains and, 206 Intergovernmental Panel on Climate Change (IPCC), 216, 216n2 International financial crisis. See Global financial crisis International liquidity: IMF and, 318–22; reforming system of, 311–13; Triffin dilemmas and, 302–4 International Monetary Fund (IMF), 4, 10; creation of, 58; global imbalances and, 332; international liquidity and, 318–22 International policy coordination: best circumstances for, 43–48; in last decade of twentieth century, 69–75; operation of pre-1914 gold standard and, 54–55; postwar, 59–69; problems studying, 48–54 International trading systems: Great Depression and, 23–24; interwar period and, 22–24; mercantilist era of, 17–18; nineteenth-century order, 19–22; postwar period and, 24–26. See also Multilateral trading systems Iron-and-rye tariff, 21 Kemp-Wan-Ohyama design, 144–45, 145n10 Kemp-Wan theorem, 144n10 Kennedy Round (1967), 25, 94

421

Korea, auto industry in, 184–85 Kyoto Protocol, 7, 219, 221; conception and failure of, 226–30 Last-resort lending, global, 322–24; role of, 313–16 Latin American debt crisis, 65–66 Latin Monetary Union (1866), 2 League of Nations, 22, 57–58 Lerner symmetry, 5 Liquidity. See International liquidity Macroeconomic adjustment processes, 349–56 Macroeconomic and financial oversight: adjustment process of, 349–56; future of, 356–61; problems improving, 343–49 Malaysia, auto industry in, 185–88 Marshall Plan, 4 Mercantilist era, of international trading systems, 17–18 MERCOSUR, 132, 141t, 142–43, 143 Mexican crisis of 1994–1995, 71–72 Monetary policy, US, 390 Most favored nation (MFN) concept, 2; Britain and, 19–20; France and, 20 Multifiber Arrangement (MFA), 5, 32 Multilateralism, 12–13; Greece and, 391 Multilateral trade cooperation, globalization and, 205–7 Multilateral trading systems, 11, 13; desirable properties of, 13–15; necessity of, 15–16. See also International trading systems Multinational corporations (MNCs): and second unbundling, 197–200; second unbundling without, 195–97 Multiple-equilibrium economics, 173–77 Nontariff barriers, 148–49 Norman, Montagu, 55–56 North American Free Trade Agreement (NAFTA), 71, 132, 140 Organization for Economic Cooperation and Development (OECD), 59 Organization for European Economic Cooperation (OEEC), 59 Plenty, power and, 17–18 Policy coordination. See International policy coordination

422

Subject Index

Precautionary Credit Lines (PCL), 319 Preferential trade agreements (PTAs), 5–6, 131–35; depth of integration and, 149– 56; intra- and extratrade flows, 149, 150t; multilateral trade system and, 144–49; trade creation and, 137–49; trade liberation and, 135–37 Reciprocal Trade Agreements Act (1934), 25 Reserve accumulation, self-insurance through, 316–18 Reserve Bank of New Zealand (RBNZ), 346 Rey Report, 73n99 Risk weighting (RW), 259 Rist, Charles, 55–56 Roosa, Robert, 62 Ruggles, James, 49 Russian Revolution (1917), 22 Schacht, Hjalmar, 55–56 Second unbundling, of globalization, 6, 166, 171, 174–75, 179–81; East Asia’s auto sector and, 183–89; ICT revolution and, 179–81; import substitution and, 200–201; industrialization and, 181–83; industrialization before, 190–93; and multinational corporations, 197–200; without multinational corporations, 195–97 Self-insurance, through reserve accumulation, 316–18 Shifts, 3, 11–12, 26, 32–33; in comparative advantage, 31–32; in geopolitical equilibrium, 31 Shock absorbers, importance of, 33–34 Shocks, 3, 11, 26; responding to, 26–31; transmission of spending, in US economy, 268–70 Single Market, 69 Smoot-Hawley tariff (1930), 23 Snake, the, 64 Sovereigns, 349–50 Special and differential treatment (SDT), 220; Doha Round and, 101–7; problem with, 94–101; regimes, 4 Special Drawing Rights (SDR), 63, 319–22 Spence Growth Commission, 172 Stops, 347 Strong, Benjamin, 55–56 “Stumbling-block versus building-bloc” question, 145n12 Subsidiary sovereigns, 349–50

Supply chains: building versus joining, 171–77; high development theory and, 172; industry with, 193–95; intellectual property (IP) protection and, 206; role of governments, trade, and multinationals when nation joins, 176–77; third-generation development theory and, 201–5 Tariff preferences, multilateral liberalization and, 147–48 Taylor rule, 390 Terms of trade, external, 143 Thailand, auto industry in, 188 Trade blocs, expansion of, 144–47 Trade liberalization: preferential trade agreements and, 135–37; preferential versus nondiscriminatory, 137–43 Trade preferences, Doha Round and, 156–57 Trading systems. See International trading systems; Multilateral trading systems Treaty of Rome, 63 Trichet, Jean-Claude, 70 Triffin dilemmas, 304; classic, 304–7; international liquidity and, 302–4; modern, 307–11 Triffin paradox, 9, 307 Twentieth-century trade, 181 Twenty-first century trade, 181 United Kingdom: international trading systems in interwar period and, 23; nineteenth-century international trading systems and, 19–22; nineteenthcentury trading systems and, 19–20 United Nations Framework Convention on Climate Change (UNFCCC), 219, 233 United States: gold standard and, 50; international trading systems in interwar period and, 22; monetary policy in, 390 Uruguay Round (1994), 25 Washington Consensus, 101n10, 165 Werner Report, 64 World Bank, creation of, 58 World Economic Conference (1927), 23 World Trade Organization (WTO), 386–87; benefits of, 394–95; principle of nondiscrimination and, 131. See also Doha Round World Trade Report (WTR), 135