The International Economy magazine (Winter 2013) asks 16 authorities, “Can Changes in Exchange Rate Valuations Affect Trade Imbalances?“   It is referring to the claim in a recent book by Stanford economist Ron McKinnon that pressure on China to let the renminbi appreciate against the dollar is fundamentally misconceived because such a movement in the exchange rate would not reduce China’s trade surplus nor American’s trade deficit.  This is part of an old debate that pre-dates the rise of the China trade problem.  Ron has long claimed that exchange rates don’t determine trade balances because they are “instead” determined by national saving versus investment.   I thought Paul Krugman demolished the argument pretty effectively 25 years ago, with a textbook graph of internal balance versus external balance.   But evidently many still fall for the argument (including some of the experts in the TIE symposium).   So I try again:

Ron McKinnon has made many important contributions to international macroeconomics over the years. But on this issue, he is simply wrong.

It goes without saying that the current account is equal to the difference between national saving and investment. But it does not follow that we should try to improve the current account in the short run by increasing national saving. Under current conditions, that would send the United States back into recession.

The national saving identity is a tautology: it does not in itself imply causation. True, many of the big movements in the U.S. current account deficit can be explained by changes in national saving: the fiscal expansion of the early 1980s, the investment boom of the late 1990s, and the new fiscal expansion of the 2000s. But the important point is that we care about a lot of things besides just external balance (the trade balance and current account). We care at least as much about internal balance (growth, employment, and inflation). To say that an increase in the budget balance and national saving would improve the trade balance does not imply that this would be good policy or that it is the only way to improve the trade balance.

Of course we need to address the budget deficit in the long run, in balanced sensible ways.  But under current circumstances — a still-weak economy, high unemployment, low inflation, rock-bottom interest rates — a reduction in public or private spending would send the economy straight back into recession. That is why the fiscal cliff of January 1, 2013, was such a danger. To observe that the trade balance would have improved if the sharp fiscal contraction had gone fully into effect would have been small consolation for the self-inflicted recession.

The U.S. trade deficit and Chinese trade surplus have diminished and so are today not quite the problems that they were five years ago. But if improving the U.S. trade balance is considered an important goal, then a devaluation or depreciation of the currency is a better tool for the job. (This proposition does not violate the national saving propositions. Nor, on the other hand, does it justify China-bashing.) Because a real devaluation would also raise demand for U.S. products — admittedly with a lag — and thus move us closer to internal balance, it would be a far more appropriate tool for improving the current account under present-day conditions than would cutting national spending or raising taxes.

     I recently visited Cuba for the first time, to participate in scholarly meetings.  For an American citizen this short voyage requires a leap through hyperspace.   It was my third attempt over ten years to get there.  Obstacles had included both the US government and the Cuban government.

     This was a trip back in time, to 1959.   For one thing, a majority of the (few) autos on the street in Havana are large American cars from the 1950s.  Most are beautiful.   One hears about the cars, but I had thought the reports must be exaggerated.   

     Cuba’s economic system is out of Alice in Wonderland.   It has one of the world’s longest lasting dual exchange rate systems.  Currently the cost of dollars in the market is 25 times higher than the official rate of one peso per one dollar.  This means that a worker in the hotel sector or restaurant sector who is able to keep dollar earnings has an income 25 times higher than one who must turn them in to the government.

      The island long ago developed an advantage in skilled services such as medicine and education.  But doctors and professors earn far less than those who join the fledgling private economy.  The latter features 178 possible approved jobs.  The possible choices on the list by design make no use of an educated person’s skills.   They include waiter, bathroom attendant, taxi driver, automobile battery repairman, mule driver, and wheel barrow operator.   Most people are still employed by the state, however.

      Perhaps American consumer society has too many goods available; but Cuba has far too few.  Most things that one would want — a toaster to make breakfast, leather to make shoes, tools for auto repair, software to upgrade a computer, spare parts to keep all those appliances from the 1950s running, …everything - is only available either by rationing, waiting in line, or going to the black market.  Many are not available at all.    

      How can such a system have persisted for so long?   Why doesn’t everyone see the folly?  

      Repression and fear don’t explain it.  The fact is that the advantages of the market system are not hard-wired into human brains — not anywhere, and especially not when they have been portrayed as the allies of selfishness and corruption, in opposition to such noble ideals as cooperation, fairness, and equality. 

     When the Soviet Union was collapsing, Robert Shiller and co-authors surveyed residents of Moscow and New York regarding their attitudes toward free markets.   Unsurprisingly, many of the Russians gave answers that strike an economist as failing to appreciate adequately the virtues of the marketplace as a mechanism to bring supply and demand into equality.  For example 66% of the Russian respondents thought it was unfair of flower-sellers to charge higher prices on holidays.  The surprising finding, however, was that just as high a percentage of Americans thought it was unfair of the flower-sellers to raise prices!  (Economists, of course, point out that  demand is much higher on holidays, and that without the higher prices flower-growers would have no incentive to increase the supply at such times.) 

      People in Eastern Europe eventually figured out that communism does not work and that the market system does.  If the United States of America did not exist, or if the embargo did not exist, Cubans could do likewise: infer that there is something fundamentally wrong with an economic system that involves so much time wasted and so many simple desires frustrated.  But in the case of Cuba, there is an alternative explanation right at hand.  Many of these goods would be imported from the United States, or produced at home with inputs from the United States.  Therefore it must be the US and its embargo that is to blame.  So it seems to many Cubans.

      When makers of foreign policy ”get tough” with another country, they often under-estimate the extent to which the opponent’s government can derive long-lasting legitimacy by pointing to the external threat to rally its people.   The citizens of the last two countries still clinging to communism, Cuba and North Korea, both vividly remember military conflict with the United States (the Bay of Pigs and the Korean War, respectively) and both countries have long been subject to American sanctions.   The first communist country to experiment with market reforms, Poland, was one that never came into military conflict with the West.    Lesson:  the US should end its obsolete embargo against Cuba.  Let those private-sector auto mechanics have their spare parts!

      Harvard’s Jorge Dominguez likens the Cuban reform path to an accordion that alternately goes in and out.  Liberalization took hold out of the desperate economic situation (”special period”) that followed the 1991 collapse of the Soviet Union, Cuba’s long-time benefactor.  The reform process was then slowed from 1996 to 2005 — even stopped altogether — in part because Venezuelan support made it less necessary.  

     Reforms have been renewed in recent years– now under “los lineamientos,” translated as “the guidelines.”  For example, the government announced in 2011 it would let people buy and sell houses. Farmers can sell directly to the market, to hotels and restaurants, rather than just to the government.  One explanation for the recent reforms is that the more pragmatic Raul Castro took over after his brother became ill in 2006.  But another explanation is that money from Venezuela has lately begun to level off and appears uncertain in the future.  (For one thing, Venezuela’s oil production has declined during a period when everyone else’s has boomed, due to mismanagement by Hugo Chavez of his own economy.)  

      Referring to the heavy economic dependence on the US that had ended abruptly after the 1959 revolution and to the heavy dependence on the Soviet Union that had ended abruptly after the 1989 fall of the Berlin Wall, Cuba’s Minister for Heavy Industry in 1995 vowed, “We will never let this happen to us for the third time.” (Jatar, 1999, p.38).  Yet that is what is now happening with respect to dependence on Venezuela.

      For now, Cuba is casting about for a model to follow.  The example of Sweden shows that it is possible to combine a strong social safety net with a strong private economy.  But what Cuba seeks is a model of transition out of communism.   

      The Chinese economic miracle is the obvious model, beginning with the reforms of Deng Xiaoping.  This judgment assumes that income equality is in reality not as important to Cuba as the requirements that the Communist Party maintain control and the country’s leaders never have to say they were wrong.  The Cuban slogan has long been “Socialism or death!” Cubans are proud, and mindful of their history of ill-treatment by larger powers.  In this they resemble the Chinese, who have converted to capitalism more energetically than the capitalists while yet leaving the giant picture of Chairman Mao up in Tiananmen Square.  

      But when the Chinese and Soviets split in the 1960s, Cuba went with the latter.  Only in some American college dorm rooms did posters of Mao and Che appear side-by-side.   So for now the model is Vietnam, rather than China.  (Unfortunately, the Vietnamese economy has been troubled of late.)

      Four things will happen soon, probably at approximately the same time:  the aging generation of Cuban émigrés who have dictated American policy on Cuba will give way to the next generation; the Castros will pass from the scene as well; American-Cuban relations will be normalized; and the world’s 2^nd-to-last museum of communism will spontaneously convert to a rapidly growing service-exporting economy.   Lineamientos and models will no longer seem so necessary. 

      I just hope that before the wave of American money and tourists arrives on its shores, the government of Cuba undertakes the appropriate regulatory intervention:  a zoning law that all car bodies in some designated part of Old Havana must date from 1959 or earlier.

 References 
•·   Jorge I. Dominguez “Hello from Havana,”  Harvard Magazine, July-August 2009.
•·   Dominguez, et al, eds., Cuban Economic and Social Development (Harvard University Press), 2012.
•·   Anna Julia Jatar-Hausmann, The Cuban Way (Kumarian Press), 1999.
•·   Robert Shiller, Maxim Boycko & Vladimir Korobov, “Popular Attitudes Towards Free Markets: The Soviet Union and the United States Compared,” American Economic Review 81, no.3, pp.385-400, June 1991.

[A shorter version of this column was published by Project Syndicate. Comments may be posted there.]

         A survey of economists is published in the November 2012 issue of Foreign Policy.  One question was whether we thought that the US unemployment rate would dip below 8.0% before the election.   When the FP conducted the poll at the end of the summer, unemployment was 8.1-8.2%.  Now it’s 7.8%.  Only 8% of the respondents said “yes.”   (I was one.  I basically just extrapolated the trend of the last two years.)   

My fellow economists choose defense spending and agricultural subsidies as the two categories of US federal budget that they think the best to cut.  They rate the euro crisis as the greatest threat to the world economy now and are particularly worried about Spain.   

For a slideshow presentation of the results, see “The FP Survey: The Economy.”   Or in a magazine format:  “If we’re ever going to get out of this slump, what will it take?  We asked more than 60 leading economists to tell us.”   

        Also, here is a recent poll from The Economist, asking similar questions of NBER and NABE economists:   “Asking the Experts,” Oct. 6.

     I have argued that the best way to think of “black swan” events is as developments that, even though low-probability, can in fact be contemplated ahead of time.  Even if they are the sort of thing that has never happened before within an analyst’s memory, similar things may have happened before in the distant past or in other countries.   

     What current possible shocks have probabilities that, even if fairly low, are high enough to warrant thinking about now?  Some have been discussed ad infinitum, others hardly at all.

• Most widely discussed is the danger of a break-up of the euro. Considered unthinkable a short time ago, the probability that one or more euro members will drop out is now well above 50%. Currency unions have disintegrated before.
• Another is the possibility of a hard landing in China, analogous to the crisis that hit Korea and other East Asian markets in 1997.
• An oil crisis in the Mideast is the classic black swan event. Each one catches us by surprise: 1956, 1973, 1979, and 1990 (among others). Oil prices can rise for lots of reasons, not just crises in the Mideast, and have done so in recent years. But the most likely crisis scenarios currently stem from either military conflict with Iran or instability in some Arab government. The threatened loss of supply to world markets typically shows up as a sharp increase in demand for oil inventories and thus in prices.
• The most worrisome financial threat is a crash of currently over-priced bond markets. In theory such a crash could be precipitated by inflation (particularly commodity-induced inflation as in 1973 or 1979). But this seems unlikely. More likely triggers are (i) a breakdown in the eurozone or (ii) political dysfunction in Washington. A default in Greece or some other Mediterranean country could trigger a global debt crisis any time. The evidence of extreme dysfunction in US politics is already there for all to see, in the attempts by some politicians to repeat the macroeconomic policy mistakes of 1937 and in the debt-ceiling show-down of August 2011 (which led S&P to downgrade US government credit rating from AAA to AA). The obvious crunch date comes after the American election, as the “fiscal cliff” approaches in the last two months of this year. In theory, fears of what will happen January 1 should lead investors to start dumping bonds now. But it is still considered a sign of sophistication in financial markets to opine that, precisely because the consequences of going over the cliff would be so bad, the politicians will again find a last-minute way to avoid it. In truth, the fact that we haven’t gone over the cliff before does not necessarily mean we won’t this time. Perhaps observers think that a clear result in the election, one way or the other, would help settle things. A true black swan in the mix would be a repeat in November of the disputed 2000 presidential election; there has been no reform in the meantime to assure people that their votes will be counted or that a disputed outcome would be resolved by independent institutions rather than by interested political appointees.
• Scariest on the list is a terrorist attack with weapons of mass destruction. When politicians have used the specter of a September 11 repeat to scare the American public into supporting unhelpful policy responses, the mistake has been in the unhelpful policy responses, not in the “scare” part. There is long-standing gap between the probability of a nuclear event as perceived by terrorism experts and the probability as perceived by the public. Admittedly the probability is lower now that Osama bin Laden is dead.
• Last on this list is an unprecedented climate disaster. Environmentalists sometimes underestimate the benefits of technological and economic progress when they reason that a finite supply of resources must of necessity be exhausted eventually. But the disbelievers are just as faulty in their reasoning that because a global climate disaster has not happened in the past it can’t happen in the future.

        The world is waiting to see whether China has successfully achieved a soft landing, slowing down the economy from its overheated state of a year ago to a more sustainable rate of growth. Some China-watchers fear it could hit the ground in a crash landing as have other Asian dragons before it. But others, particularly American politicians in this presidential election year, talk only about one thing: the trade balance.
        Here the important message is that long-term forces of adjustment are at work in the Chinese economy.  Foreign perceptions need to be adjusted as well. It is true that not long ago the yuan was substantially undervalued and China’s trade surpluses were very large. But the situation is changing.
        China’s trade surplus peaked at $300 billion in 2008, and has been declining ever since. In fact it even reported a trade deficit in the month of February ($31 billion, its largest deficit since 1998). It is not hard to see what is going on. Ever since the Middle Kingdom rejoined the world economy three decades ago, its trading partners have been snapping up exports of manufacturing goods, because low Chinese wages made them super-competitive on world markets.  It was known as the unbeatable “China price.”  But in recent years, following the laws of economics, relative prices have adjusted to the demand.
        The change can be captured by real exchange rate appreciation. This comprises in part nominal appreciation of the yuan against the dollar, and in part Chinese inflation. Government officials would have been better advised to let more of the real appreciation take the form of nominal appreciation (dollars per RMB). But since they didn’t, it has shown up as inflation instead. (See charts below, which show both nominal and real appreciation, against the dollar or against an index.)
        The natural process was delayed. In the first place, as is well-known, the authorities intervened to keep the exchange virtually fixed against the dollar, in the years 1995-2005 and 2008-2010. In the second place, workers in China’s increasingly productive coastal factories were not paid their full value. The economy has not completed its transition from Mao to market, after all. As a result of these two delaying mechanisms, Chinese continued to undersell the world.
        But then two things happened. First, the yuan was finally allowed to appreciate against the dollar during 2005-08 and 2010-11, by 25% cumulatively [=17% + 8%]. Second, and more importantly, labor shortages began to appear and Chinese workers at last began to win rapid wage increases. Major cities raised their minimum wages sharply over each of the last three years [FT, Jan. 5]: 22% on average in 2010 and 2011 (somewhat less this year, in response to slowing demand: 8.6 % in Beijing, 13% in Shenzhen and Shanghai).  Meanwhile another cost of business, land prices, rose even more rapidly.
        As a result, whereas all signs still pointed to a substantially undervalued yuan as recently as four or five years ago, this is no longer the case. One important measure of undervaluation — a comparison of China’s prices with what is normal given the country’s level of income (the so-called Balassa-Samuelson relationship) – showed the renminbi as undervalued against the dollar by as much as 36% on 2000 data (Frankel, 2005) .  Even after an improvement in the international  price data, Balassa-Samuelson regressions estimated the undervaluation at roughly 30% in 2005  and 25% as recently as 2009.   (Others had other ways of estimating undervaluation; see Goldstein, 2004, and those surveyed by Cline and Williamson, 2008.)   
       The renminbi’s real appreciation against the dollar over the last three years has amounted to 12%, reducing the degree of undervaluation by roughly half, depending on whether one measures it against the dollar or against all countries.  More is to be expected, as Chinese relative wages continue to rise.  In any case, China’s real exchange rate is already closer to this measure of equilibrium than are most countries’ exchange rates (Cheung, Chinn and Fuji, 2010).

      In response to the new high level of costs in the factories of China’s coastal provinces, five types of adjustment are gradually taking place. First, some manufacturing is migrating inland, where wages and land prices are still relatively low. Second, some export operations are shifting to countries like Vietnam and Bangla Desh where wages are lower still. Third, Chinese companies are beginning to automate, substituting capital for labor. Fourth, they are moving into more sophisticated products, following the path blazed earlier by Japan, Korea, and other Asian countries in the “flying geese” formation. Fifth, multinational companies that had in the past moved some stages of their production process out of the US, or out of other high-wage countries, to China are now moving back (”reshoring”). Productivity is still higher in the US, after all. All five of these ways of reallocating resources represent the economic process operating as it should. A sixth seems still to lag behind, despite the consensus in favor of it: expansion of the services sector.
        None of this comes as news to most international observers of China. But many Western politicians (and, to be fair, their constituents) are unable to let go of the syllogism that seemed so unassailable just a decade ago: (1) The Chinese have joined the world economy; (2) their wages are $0.50 an hour; (3) there are a billion of them, and so (4) their exports will rise without limit: Chinese wages will never be bid up in line with the usual textbook laws of economics because the supply labor is infinitely elastic. But it turns out that the laws of economics do eventually apply after all — even in China.

       My next post will recall the precedent of Japan’s trade balance.

[A version of this post was published by Project Syndicate, which has the copyright.]

Chinese relative prices have risen as much (since 2009) via inflation as via RMB appreciation

(click her for larger image) 

References

     Chang, Gene Hsin, 2008, “Estimation of the Undervaluation of the Chinese Currency by a Non-linear Model,” Asia-Pacific Journal of Accounting & Economics Vol.15, No. 1, April, 29-40.

      Chang, Gene H. , 2012, “Theory and Refinement of the Enhanced-PPP Model for Estimation Equilibrium Exchange Rates — with Estimates for Valuations of Dollar, Yuan and Others”, SSRN abstract=1998477,  Feb. 2.

      Cheung, Yin-wong, Menzie Chinn and Eiji Fuji, 2010, “China’s Current Account and Exchange Rate,” in China’s Growing Role in World Trade, edited by Rob Feenstra and Shang-Jin Wei (University of Chicago Press, 2010).

     Cline, William, and John Williamson, 2008, ‘Estimates of the Equilibrium Exchange Rate of the Renminbi,” in Debating China’s Exchange Rate Policy, edited by M.Goldstein and N.Lardy (Peterson Institute for International Economics), 155-165.  

      Frankel, Jeffrey, 2005, “On the Renminbi,”  CESifo Forum, vol.6, no.3, Autumn (Ifo Institute for Economic Research, Munich): 16-21.

      Subramanian, Arvind, April 2010, “New PPP-Based Estimates of Renminbi Undervaluation and Policy Implications,” PB10-08, Peterson Institute for International Economics.

Emerging markets have performed amazingly well over the last seven years. They have outperformed the advanced industrialized countries in terms of economic growth, debt-to-GDP ratios, and countercyclical fiscal policy.  Many now receive better assessments by rating agencies and financial markets than some of the advanced economies.

As 2012 begins, however, emerging markets may be due for a correction, triggered by a new wave of “risk off” behavior among investors. Will China experience a hard landing? Will a decline in commodity prices hit Latin America? Will the sovereign-debt woes of the European periphery spread to neighbors such as Turkey in a new “Aegean crisis”?

Engorged by large capital inflows, some emerging market countries were in an overheated state a year ago. It is unlikely that the rapid economic growth and high trade deficits that Turkey has experienced in recent years can be sustained. Likewise, high GDP growth rates in Brazil and Argentina over the same period could soon reverse, particularly if global commodity prices fall - not a remote prospect if the Chinese economy falters or global real interest rates were to rise this year. China, for its part, could land hard as its real-estate bubble deflates and the country’s banks are forced to work off their bad loans.

The World Bank has now downgraded economic forecasts for developing countries in 2012 (Global Economic Prospects, Jan.18, 2012).    Brazil’s economic growth, for example, came to a halt in the third quarter of 2011 and is forecast at only 3.4 percent in 2012 …well below the rapid 2010 growth rate of 7.5 percent.  Reflecting a sharp slowdown in the second half of the year in India, South Asia is coming off of a torrid six years, including 9.1 percent growth in 2010.  Regional growth is projected to ease further to 5.8 percent in 2012.

But will economic slowdown turn to financial crash?   Three possible lines of argument support the worry that emerging markets’ performance are fated to suffer dramatically in 2012: empirical, literary, and causal. Each line of argument is admittedly tentative.

The empirical argument is just historically based numerology: emerging-market crises seem to come in 15-year cycles. The international debt crisis surfaced in Mexico in mid-1982, and then spread to the rest of Latin America and beyond. The East Asian crisis erupted 15 years later, in Thailand in mid-1997, and then spread to the rest of the region and beyond. We are now another 15 years down the road. So is 2012 the time for the third round of emerging markets crises?

The hypothesis of regular boom-bust cycles is supported by a long-standing scholarly literature, such as the writings of Carmen Reinhart. But I would appeal to an even older source: the Old Testament - in particular, the story of Joseph, who was called upon by the Pharaoh to interpret a dream about seven fat cows followed by seven skinny cows.

Joseph prophesied that there would come seven years of plenty, with abundant harvests from an overflowing Nile, followed by seven lean years, with famine resulting from drought. His forecast turned out to be accurate. Fortunately the Pharaoh had empowered his technocratic official (Joseph) to save grain in the seven years of plenty, building up sufficient stockpiles to save the Egyptian people from starvation during the bad years. That is a valuable lesson for today’s government officials in industrialized and developing countries alike.

For emerging markets, the first phase of seven years of plentiful capital flows occurred in 1975-1981, with the recycling of petrodollars in the form of loans to developing countries.  The international debt crisis that began in Mexico in 1982 was the catalyst for the seven lean years, known in Latin America as the “lost decade.” The turnaround year, 1989, was marked by the first issue of Brady bonds, which helped write down the debt overhang and put a line under the crisis.

The second cycle of seven fat years was the period of record capital flows to emerging markets in 1990-1996.  Following the 1997 “sudden stop” in East Asia came seven years of capital drought. The third cycle of inflows, often identified as a “carry trade,” came in 2004-2011 and persisted even through the global financial crisis. If history repeats itself, it is now time for a third sudden stop of capital flows to emerging markets.

Are a couple of data points and a biblical parable enough to take the hypothesis of a 15-year cycle seriously?  We need some sort of causal theory that could explain such periodicity to international capital flows.

Here is a possibility: 15 years is how long it takes for individual loan officers and hedge-fund traders to be promoted out of their jobs. Today’s young crop of asset pickers knows that there was a crisis in Turkey in 2001, but they did not experience it first hand. They think that perhaps this time is different.  

If emerging markets crash in 2012, remember where you heard it first - in ancient Egypt.

[This article was published in Project Syndicate, which holds the copyright.]

The parties to the UN Framework Convention on Climate Change are meeting once again in Durban, South Africa, from November 28 to December 9.  The period covered by the Kyoto Protocol ends in 2012 and the clock is running out on negotiations for a successor agreement.  Progress at Copenhagen two years ago and Cancun one year ago was slow.   Negotiations have been blocked by a seemingly insurmountable obstacle. The United States is at loggerheads with the developing world, especially China–now the world’s largest emitter of greenhouse gases (GHG)–and India.  

Fortunately, there might be a way to break through this roadblock.  A formulas-based approach, building on existing commitments, could attain desired mitigation of concentrations of Greenhouse Gases, while yet avoiding the imposition of disproportionate economic costs on any single country or group of countries.  The political feasibility of our proposal has been borne out over the last year, in that the specifics have turned out to be consistent with positions recently taken by the important players.  This despite what appears to be a Gordian knot too big to be untied.

On the one hand, the leaders of India and China are clear: They won’t cut emissions until after the United States and other developed countries have cut theirs first. After all, the industrialized countries created the problem of global climate change, and got rich in the process. Developing countries shouldn’t be denied their turn at economic development, they argue. As the Indians point out, Americans emit more than 10 times as much carbon dioxide per person as they do.

On the other hand, the U.S. Congress is equally clear: It will not impose quantitative limits on U.S. GHG emissions if it fears that emissions from China, India, and other developing countries will continue to grow unabated. Indeed, that is why the Senate was unwilling to ratify the Kyoto Protocol ten years ago. Why should U.S. firms bear the economic cost of cutting emissions if energy-intensive domestic aluminum smelters and steel mills, for example, would just migrate to countries that have no caps and cheaper energy (a problem known as leakage)? Global emissions would simply continue their rapid rise in a different part of the world. Emission cap legislation will not pass the Senate as long as major developing countries haven’t accepted quantitative targets of their own.

Global issues of leakage and competitiveness can only be effectively addressed at the multilateral level. The climate change negotiators need to coalesce on a specific mechanism for setting the actual numbers for future emission targets. The framework must address the three gaping holes in the Kyoto Protocol: the absence of a mechanism for setting targets in the long run, the lack of participation by many major emitting countries, and the lack of faith that signatories will fulfill their commitments.

I see one practical solution to the apparently irreconcilable differences between the United States and the developing countries regarding binding quantitative targets: Washington would agree to join Europe in adopting emission targets that would cut substantially over the next 40 years. Simultaneously, in the same agreement, China, India, and other developing countries would agree to a path that immediately imposes binding emission targets on them. These would be targets that in the first five-year period simply follow the so-called business-as-usual path, defined as the rate of increase in emissions that these countries would experience in the absence of an international agreement, as determined by experts’ projections.

The idea of developing countries committing only to business-as-usual targets will be met with loud objections from both environmentalists and U.S. business interests because it doesn’t obligate China or other developing countries to cut emissions. But this commitment is far more important than it may sound at first. Specifically, it precludes carbon leakage from undermining the environmental goal of the agreement. The developing countries can’t go above their set business-as-usual paths as they would in the absence of this commitment and, therefore, can’t exploit developed states’ emissions reduction efforts by expanding carbon-intensive industries. This step mitigates the competitiveness concerns of carbon-intensive industries in developed countries.

Such an approach recognizes the reality that it would be irrational for China to agree to substantial cuts in the short term. Indeed, the developing countries, for their part, may object when asked to take on any kind of binding targets at all, at this stage.  But they should realize that they would gain in strictly economic terms from such an agreement.  The commitment, in an international system of emission permits trading, would give China the ability to sell permits at the world market price. How do we know Beijing would come out ahead? It is currently building roughly 100 power plants per year to accommodate its rapidly growing energy demand. The cost of shutting down an already-functioning U.S. coal-fired power plant is far higher than the cost of building a new low-carbon plant in China. For this reason, when a U.S. firm pays China to cut its emissions voluntarily, thereby obtaining a permit that the U.S. firm can use to meet its emission obligations, both parties benefit, even in strictly economic terms. The environmental benefit is that China’s aggregate emissions would voluntarily fall below its business-as-usual commitment from the beginning.

Of course, the next step to this solution requires that China and other developing countries make cuts below their business-as-usual path in future years and, eventually, make cuts in absolute terms as states gain confidence in the framework. But the developing countries must agree to the principle of making cuts similar to those made by Europe, the United States, and others who have gone before them, taking due account of differences in income. Emission targets can be determined by formulas that follow from four important guidelines:

(1) They give lower-income countries more time before they start to cut emissions.

(2) They ask richer countries for steeper cuts than poorer countries. This is a principle that turns out to have been embodied in the targets accepted by countries last year at Cancun. (See Figure 1, where the relationship between agreed emission cuts and income per capita is highly significant statistically.)

(3) They lead to a gradual convergence of emissions per capita over the course of the century.

(4) They take care not to reward any country for joining the system late.    

 Figure 1: Estimated progressivity in Cancun emmission targets (including former Soviet countries)

 An application of FEEM’s WITCH model reveals that these formulas produce emission targets that obey common-sense constraints:  no country or group of countries is asked to adopt targets that would cost it more than 1% of GDP over the century as a whole or more than 5% of GDP in any single five-year time period.

Realistically, no country (rich or poor) will abide by targets in any given period that entail extremely large economic sacrifices relative to the alternative of simply not participating in the system. It is time to stop making sweeping proposals that assume otherwise, and to pursue instead the narrow thread of the politically possible.

[The specifics of the formula's proposal are explained in "Sustainable Cooperation in Global Climate Policy: Specific Formulas and Emission Targets to Build on Copenhagen and Cancun," a background paper co-authored with Valentina Bosetti, for the annual Human Development Report just released by the UN Development Programme, Nov. 2011.  All estimates were updated in light of recent developments, relative to our earlier paper, "Politically Feasible Emission Target Formulas to Attain 460 ppm CO2 Concentrations," forthcoming, Review of Environmental Economics and Policy (Oxford University Press) Winter 2012.]

This column appears at Vox.  Comments may be posted there.

All of a sudden, the renminbi is being touted as the next big international currency.   Just in the last year or two, the Chinese currency has begun to internationalize along a number of dimensions.   RMB bank desposits are now available in Hong Kong.  A RMB bond market has grown rapidly there as well, with the issuers including major multinationals such as McDonald’s.   Some of China’s international trade is now invoiced in the currency.  Foreign central banks have been able to hold RMB since August 2010, with Malaysia going first. 

Some are now claiming that the renminbi could overtake the dollar for the number one slot in the international currency rankings within a decade (especially Subramanian 2011a, p.19; 2011b).   The basis of this prediction is, first, the likelihood that the Chinese economy will surpass the US economy in size and, second, the historical precedent when the dollar overtook the pound sterling as the number one international currency during the period after World War I.   

It used to be thought that international currency status was subject to much inertia (e.g., Krugman, 1984).  There was said to have been a long lag between the date when the US economy had passed the UK economy with respect to size (1872, by the criterion of GNP) and the time when the dollar had passed the pound (1946, by the criterion of shares in central banks’ holdings of reserves). 

The “new view,” represented in particular by Eichengreen (2011) and Eichengreen and Flandreau (2010), is that the lag was in fact rather short.  It took until World War I for the dollar to fulfill the criteria of an international currency.  Furthermore, the date when the dollar is said to have challenged the pound in importance has now been moved up to the mid-1920s.   The first point is right. If trade is the measure of size, the US first caught up with the UK during World War I.  The US did not even have a permanent central bank until 1913.  The other important criteria came soon thereafter:  creditor status for the country; the perceived prospects for the currency to remain strong in value; and deep, liquid, open financial markets.  (I have discussed the criteria in earlier papers.  Chinn and Frankel, 2007, evaluate them econometrically and give further references.)  The second point seems a matter of whether or not one wants to distinguish between the concept of “coming to rival” / “catching up with”  the pound (1920s) versus the phenomenon of definitively “pulling ahead” / “displacing” the pound (1945).  Under either interpretation, the dollar’s initial rise as an international currency was indeed rapid, once the conditions were in place. 

The dollar is one of three national currencies to have attained international status during the 20th century.  The other two were the yen and the mark, which became major international currencies after the breakup of the Bretton Woods system in 1971-73.  (The euro, of course, did so after 1999.)  In the early 1990s, both were spoken of as potential rivals of the dollar for the number one slot.  It is easy to forget it now, because Japan’s relative role has diminished since then and the mark has been superseded.  In retrospect, the two currencies’ shares in central bank reserves peaked as the 1990s began.

The current RMB phenomenon differs in an interesting way from the historical circumstances of the rise of the three earlier currencies.  The Chinese government is actively promoting the international use of its currency.   Neither Germany nor Japan, nor even the US, did that, at least not at first.   In all three cases, export interests, who stood to lose competitiveness if international demand for the currency were to rise, were much stronger than the financial sector, which might have supported internationalization.  One would expect the same fears of a stronger currency and its effects on manufacturing exports to dominate the calculations in China.

In the case of the mark and yen after 1973, internationalization came despite the reluctance of the German and Japanese governments.  In the case of the United States after 1914, a tiny elite promoted internationalization of the dollar despite the indifference or hostility to such a project in the nation at large.  These individuals, led by Benjamin Strong, the first president of the New York Fed, were the same ones who had conspired in 1910 to establish the Federal Reserve in the first place.

It is not yet clear that China’s new enthusiasm for internationalizing its currency includes a willingness to end financial repression in the domestic financial system, remove cross-border capital controls, and allow the RMB to appreciate, thus helping to shift the economy away from its export-dependence.  Perhaps a small elite will be able to accomplish these things, in the way that Strong did a century earlier.  But so far the government is only promoting international use of the RMB offshore, walled off from the domestic financial system.  That will not be enough to do it.

[This RIETI perspectives note summarizes the argument in "Historical Precedents for the Internationalization of the RMB," a paper that I have written for a workshop directed by Sebastian Mallaby, for the Council on Foreign Relations and the China Development Research Foundation.]

 Comments can be posted at the version on the Vox site or Seeking Alpha.

References

Chinn, Menzie, and Jeffrey Frankel , 2007, “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” in  G7 Current Account Imbalances: Sustainability and Adjustment, edited by Richard Clarida (University of Chicago Press).  

Eichengreen, Barry, 2011, Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System (Oxford University Press).

Eichengreen, Barry, and Marc Flandreau, 2010, “The Federal Reserve, the Bank of England and the Rise of the Dollar as an International Currency, 1914-39,” BIS WP no. 328, Nov.

Eichengreen, Barry, and Jeffrey Frankel, 1996, “The SDR, Reserve Currencies, and the Future of the International Monetary System” in The Future of the SDR in Light of Changes in the International Financial System, edited by M.Mussa, J.Boughton, and P.Isard (International Monetary Fund).

Krugman, Paul, 1984, “The International Role of the Dollar: Theory and Prospect,” in Exchange Rate Theory and Practice, edited by J.Bilson and R.Marston (University of Chicago Press), 261-78.

Subramanian, Arvind, 2011a, “Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition,” (Petersen Institute for International Economics), September. 

Subramanian, Arvind, 2011b , Eclipse: Living in the Shadow of China’s Economic Dominance (Petersen Institute for International Economics), September. 

     Robert Zoellick put a few sentences about gold toward the end of a column in today’s FT that are drawing a lot of attention.   I doubt very much if the World Bank President has in mind a return to the gold standard, but goldbugs and critics alike are talking as if he does.

      Even if one placed overwhelming weight on the objective of price stability — enough weight to contemplate a rigid straightjacket for monetary policy — gold would not be a suitable anchor.   The economy would be hostage to the vagaries of the world gold market, as it was in the 19^th century:   suffering inflation during periods of gold discoveries and deflation during periods of gold drought.   This is well-known.   I am confident Zoellick understands it.   (He and I were in the same macroeconomics seminar at Swarthmore College in the 1970s.)

      I think he is making another point.  The world is moving away from a monetary system in which the dollar is the overwhelmingly dominant international reserve asset.  The dollar’s share of international reserves has been declining ever since Richard Nixon unilaterally ended the Bretton Woods system in 1971.   The dollar’s unique role is not an eternal god-given constant of the universe, any more than it was for pound sterling.  The US currency of course replaced the pound in the first half of the 20^th century, with a lag of 25 years or more after the US surpassed the UK economically.

      Will some asset replace the dollar, then?  No, not a single asset.  But we are probably moving to a system where there will be as many as a half dozen international reserve assets.  First, there is the euro.  Despite the serious troubles facing it this year, the euro has been a competitor for the dollar since it came into being 11 years ago.  Both the yen and the Swiss franc have to some extent played safe haven roles during the last three years of global financial turmoil.  The pound is not out completely.   Some day the renminbi will be added to the roster of major international currencies, when China’s financial markets are sufficiently developed and open.    Even the SDR (special drawing right) came back from the dead in 2009.

      And, yes, gold too has re-joined the world monetary system.  Gold was seen as an anachronism as recently as a couple of years ago.  The world’s central banks had been gradually selling off their stocks.   But all that changed in 2009.  The People’s Bank of China, the Reserve Bank of India and other central banks in Asia have bought gold.  Understandably, they want to diversify their reserves.    It appears that central banks have stopped selling gold even among advanced countries and that aggregate gold reserves have risen over the last year.   This is a multiple reserve asset system.      

[For those interested in gold and other mineral commodities, I have some relevant writings.  Others' views on Zoellick are at the New York Times.]

Korea may have an opportunity to exercise historic leadership, when it chairs the G-20 meeting in Seoul, November 11-12.    This will be the first time that a non-G-7 country has hosted the G-20 since the larger, more inclusive, group supplanted the smaller rich-country group in April of last year as the premier steering committee for the world economy.  With large emerging market and developing countries playing such expanded economic roles, the G-7 had lost legitimacy.  It was high time to make the membership more representative.    But there is also a danger that the G-20 will now prove too unwieldy, in which case decision-making might then revert to the smaller group.

When countries like China and India used to demand a larger voice in world governance based on their large populations, they did not get very far.   Substantive power in multilateral governance is allocated according to the Golden Rule: “He who has the gold rules.”    But after a few decades of miraculous economic growth rates they now have the economic heft.    China is now larger economically than Japan or Germany.   Brazil is also one of the seven largest economies.

Beyond GDP, we have recently seen a historic role reversal, in which debtor-creditor patterns have changed.    Many developing countries, breaking historic patterns, took advantage of the global boom of 2003-2007 to achieve high national saving rates, particularly in the form of strong government budgets, while the advanced countries did not.   As a result, the debt levels of the top 20 rich countries (debt/GDP ratios around 80%) are now twice those of the top 20 emerging markets.   And it is rising rapidly.   A number of emerging market countries now have higher credit ratings than a number of so-called advanced countries.  A stronger fiscal position is one of the reasons that countries like China could afford to undertake large and sustained fiscal stimulus in response to the 2008-09 global recession.   The United States and United Kingdom, by contrast, had wasted the preceding expansion running budget deficits, and hence by 2010 had come to feel heavily constrained by their debts.

It is understandable if Korea views its hosting of the G-20 as another opportunity for marking its arrival on the world stage (as when it hosted the Olympics) or for consolidating its status as an industrialized economy (as when it joined the OECD).  But it should make more of its opportunity than this.  Korea should seize the chance to exercise substantive leadership.   Otherwise, the risk is that its period in the chair could appear like a replay of the chaotic Czech presidency of the EU in the first half of 2009, which confirmed the feelings of some in the larger European countries that it was a mistake to let smaller countries take their turns behind the wheel.

Korea can serve as a bridge between the G-7 and the developing countries.  But chairing a successful meeting will be a challenge, with respect to both meeting management and substantive issues.

With regard to managing the meeting, the challenge comes from the size of the group.   There is always a tradeoff between legitimacy and workability.   The G-7 was small enough to be workable but too small to claim legitimacy.  The United Nations is big enough to claim legitimacy but too big to be workable.  The latest evidence of this was the Conference of Parties of the UN Framework Convention on Climate Change in Copenhagen last December.  The UNFCCC proved a totally ineffectual vehicle, in part because small countries repeatedly blocked progress.    President Obama was able to make more progress by spending a few minutes in a room with a few big emitting countries than the delegates had achieved in two weeks.

The G-20 has enough legitimacy for its purpose — which is more limited than the purposes of formal institutions such as the UN, IMF, and WTO.  It accounts for 85% of the world’s GDP, for example.    But it is too big to be workable as a steering group.  A principle of multilateral talk-shops is that conversation is not possible with more than 10 in the room.  With 20 delegations, each reads prepared statements;  there is no give and take and the communiqué is a watered down least-common-denominator press release.   Not only does the G-20 have more than 10 delegations; it actually has more than 20.

The G-20 needs a smaller informal steering group within the steering group, a G-6 or G-9 within the G-20.   It could meet in the evening before the main G-20 meeting and discuss how to organize the discussion in the larger group.

Who would be in the G-6 or G-9?   It would be unwise to be too specific at this point.  Nevertheless, the US, Japan, and Europe (represented perhaps by the EU Commission), must be there on the rich-country side; China, India, and Brazil must be there on the developing-country side.   Of course the pressure to expand is always irresistible.  Europe could be represented by both the U.K. and euroland.    In Seoul, Korea has to be there as the host. Who would be the 9^th country in the G-9?   It should be the country of which the person reading this blog post is a citizen.

What about the substance of the meetings?   The group will discuss whatever the bigger countries consider it most useful to discuss at the time.    Five possible topics include:

• At long last, giving more seats on the IMF executive board to big emerging market countries, in proportion to their rising economic clout,offset by consolidation of some of Europe’s seats.
• More financial regulatory reform, such as coordination of any small taxes or penalties that members want to apply to risk-taking banks.
• Global current account imbalances. Perhaps there will be a statement agreeing that large current account deficits or surpluses tend to lead to problem (absent some good economic justification), that exchange rates and budget deficits both bear some responsibility for current large imbalances, and that the burden of adjustment should be born by neither one alone, but rather by both.
• Macroeconomic exit strategies. I personally would favor an articulation of the proposition that concrete steps toward long-term fiscal consolidation in each country need not require premature withdrawal of current fiscal stimulus. An example would be to raise the future retirement age or take other steps today to reform public pensions, even while simultaneously enacting some short-term stimulus in the US and UK.
• Moving toward a new agreement on climate change to take the place of the Kyoto Protocol after 2012. Korea is in a good position to lead, as essentially the first post-Kyoto country to accept emission targets.

Don’t judge the outcome of the meeting by what appears in the media.   Press reviews usually pronounce such summits a let-down.   But occasionally such meetings are important, in ways that are often not clear until later.

Consider the London G-20 meeting of April 2009.    It was not obvious at the time that it had been a success in terms of substantive policies.   Observers even compared it to the infamous failed London Economic Summit of 1933, which was a way of saying that the world had not learned the lessons of the Great Depression.    But the 2009 meeting appears far better in hindsight.  Looking back on 2009, fiscal stimulus turned out to be more widespread in 2009 than one might have guessed.    Similarly, global monetary policy was easy, avoiding another big mistake of the 1930s.  The G-20 unexpectedly agreed to triple IMF resources and bring the SDR back from the dead.  Even in the area of trade policy, despite fears of protectionism, the outcome was not bad at all by the standards of past recessions, let alone in comparison with the Smoot-Hawley tariff of 1930.   Overall, policy-makers’ immediate response to the global recession in 2009 did not repeat the mistakes of the early 1930s.

Currently, however, the advanced countries are in danger of repeating the mistake that President Franklin Roosevelt made in 1937, when he cut spending prematurely and sent the US economy back into recession.  Perhaps the G-20 will be a venue in which the big emerging market countries can remind the U.S. and the U.K. of the lesson they once knew but have now forgotten — what it means to run a countercyclical fiscal policy.

[This column was written for Project Syndicate. Comments can be posted there.]