National leaders are meeting at the United Nations in New York today, to discuss the climate change negotiations.    Talks will continue at the G-20 meeting in Pittsburgh later in the week.   But hopes look very bleak for progress sufficient to produce at Copenhagen in December a successor treaty to the Kyoto Protocol.   The biggest roadblock is the familiar game of “After you, Alphonse.”  The United States will not accept quantitative emission targets unless China, India and other developing countries do the same, at the same time.    But the developing countries will not cut their emissions below the Business as Usual path (BAU) unless the rich countries go first. 

My own proposal for how to break the deadlock is a plan that tries in a politically realistic way to assign emission targets, leaving no country feeling it is being asked to incur an economic cost that is unfair or too large.    The targets are derived from a family of formulas   The specific detailed example of the plan that I have given in the past attained an environmental target by the year 2100 of CO2 concentrations equal to 500 ppm.  It did so without violating the political constraints, which included the constraint that no country is asked to accept an ex ante target that costs it more than 1% of income in present value, or more than 5% of income in any single budget period.

The G-7 leaders, meeting in Italy in June 2009, set a more aggressive collective goal, corresponding approximately to concentrations of 380 PPM.   I have recently been trying to hit that goal, working with Valentina Bosetti, within the same political constraints and framework of formulas.    To achieve the more aggressive environmental goal, we advance the dates at which some countries are asked to begin cutting below BAU.  We also tinker with the values for the parameters in the formulas (parameters that govern the extent of progressivity and equity, and the speed with which latecomers must eventually catch up).   The resulting target paths for emissions are run through the WITCH model to find their economic and environmental effects.   We find that it is not possible to attain the 380 ppm goal, subject strictly to our political constraints.  We are, however, able to attain a concentration goal of 460 ppm with somewhat looser political constraints. 

Some may conclude from these results that the more aggressive environmental goals are not attainable in practice, and that our earlier proposal for how to attain 500ppm is the better plan.   We take no position on which environmental goal is best overall.   Rather, we submit that, whatever the goal, our approach will give targets that are more practical economically and politically than approaches that have been proposed by others.

[Readers wishing to post comments are referred to the SeekingAlpha version.]

The field of International Monetary Economics is not without its own cycles and fads.

In a speech at the European Central Bank over the summer, “On Global Currencies,” I identified eight concepts that I saw as having recently “peaked” and eight more that I saw as newly rising in relevance. Those that I viewed as losing traction were: the G-7, global savings glut, corners hypothesis, proliferating currency unions, inflation targeting (narrowly defined), exorbitant privilege, Bretton Woods II, and currency manipulation. Those that I saw as receiving increased emphasis now and in the future were: the G-20, the IMF, SDR, credit cycle, reserves, intermediate exchange rate regimes, commodity currencies, and multiple international currency system.

A condensed version appears this month in Finance and Development, from the IMF, titled “What’s ‘In’ and What’s ‘Out’ in Global Money.”  I boil the list down to five concepts that I pronounce “on the way out” and five more that I see as replacing them:

• The G-7 has been rendered largely obsolete by its lack of representation of developing countries, and thus in the course of 2009 has been overtaken by the G-20.

• The corners hypothesis had become conventional wisdom by the end of the 1990s. This was the idea that all countries were or should be abandoning intermediate exchange rate regimes (bands, baskets, crawling pegs, adjustable pegs, and heavily managed floats) in favor of either the floating corner or the institutionally fixed corner (currency boards, dollarization, or monetary union). Since 2001 the tide has turned against the corners hypothesis, and far fewer economists would now assert it as a sweeping generalization.  Certainly a huge fraction of the members of the IMF continue to follow intermediate regimes.

• The language of “unfair currency manipulation,” has been in US law since 1988 and the IMF Articles of Agreement for longer. China during the years 2004-2008 was pretty much the first large country to face charges of unfairly manipulating its currency to keep it undervalued. But US Congressmen who have for years urged China to abandon its link to the dollar could well live to regret it, if they were to get their way and the People’s Bank of China did in fact stop buying US treasury bills. It is finally beginning to sink in among Americans that having China as its largest creditor carries with it some new constraints.  What concept is “on its way in,” to replace the idea that intervening to prevent one’s currency from appreciating is anathema?   Reserves.  Two short years ago, Western economists were lecturing surplus countries that they were acquiring too many reserves.  Today we see that the developing countries that have weathered the 2007-09 crisis the best are countries that had previously piled up the most reserves, other things equal.

• Most controversially, I assert that Inflation Targeting — narrowly defined, I hasten to add — has seen its best days. The definition of IT I have in mind is the proposition that the monetary authorities should set a target range for the increase in the CPI each year, and then should focus all their efforts on hitting it. This orthodoxy says that the central bankers should pay no attention to asset prices, the exchange rate, or commodity prices, except to the extent that they carry implications for the CPI. For large rich countries, it has become clear since 2007 that Alan Greenspan was wrong when he (plausibly) abjured all attempts to identify or discourage bubbles in real estate and stock markets. As a result, the credit cycle view of monetary policy has been resurrected , after a long period when only inflation was thought to matter. For smaller and developing countries, I would also argue that volatility in commodity prices has made it clear that monetary policy should let currencies depreciate, at least somewhat, when the terms of trade worsen, rather than the opposite as is implied by a strict interpretation of CPI targeting. For them, I would propose replacing the CPI target with a more production-oriented price index, such as a target for the PPI or even an export price index.

• The United States has benefited throughout the post-war period by an unlimited ability to borrow in dollars. A popular view two years ago, supported by some of the best scholars, was that the US had earned the dollar privilege by establishing a unique comparative advantage in supplying a saving-glut world with high-quality assets. Then the sub-prime mortgage crisis in 2007 revealed that US assets were not so high-quality after all. The dollar did retain the benefit of being the safe haven currency in 2008, as an exorbitant privilege — contrary to the predictions of those of us who had predicted that the unsustainable current account deficit would lead to a large depreciation. Nevertheless, some developments in the course of 2009 have suggested a global movement away from the unipolar dollar standard, and toward a new multiple international reserve system. These events include the gradual rise of the euro as an international currency to rival the dollar, the sudden and unexpected resurrection of the SDR from near-death, new interest in the yen and gold as safe haven assets (including among central banks), and the very first glimmerings of an international role for the RMB.

[Any readers wishing to post comments are referred to the Seeking Alpha version.]

Most international summit meetings are long on photo-opportunities and short on substance.   There was a great danger that last Thursday’s G-20 meeting in London would be merit comparison to the failed World Economic Conference of 1933, which was also held in London.   This one, however, did have genuine substance.   

Nobody reads the communiques, or listens to the press conferences of leaders or finance ministers. But here is the substance:

Top of the list of accomplishments was expansion of IMF resources. The new SDR allocation was perhaps the most noteworthy and unexpected decision: those observers who have proposed such a step in the current international crisis, or in past international crises, have usually been dismissed as pipe-dreamers (John Williamson, Dani Rodrik, George Soros, Joe Stiglitz…). In addition, there seems to have been some forward movement on international regulation of the financial sector, as the Europeans wanted. Although President Obama acquitted himself well overall, the failure to achieve agreement for coordinated additional fiscal stimulus, as the Americans wanted, was probably the greatest shortcoming of the meeting.

I believe the G-20 meeting will be remembered historically, but not primarily for the above reasons. It will be remembered as the occasion on which primary emphasis shifted from the G-7, the global steering group that until now has had a monopoly on real economic decision-making power, to the G-20. Of the various substantive ways in which developing countries could and should have been given more representation in recent years, the shift to the G-20 is the first one to have actually taken place.

The members of the G-20 are meeting in Washington on November 15 to discuss reform of the global financial system.  The first thing to say about the calls for a “new Bretton Woods” is that they overreach, in the sense that it is very unlikely that any changes in the structure of the international monetary or financial system will or should, at this point in history, come out of multilateral discussions that are big enough to merit comparison with the first Bretton Woods. Certainly we are not talking about fixing exchange rates, as the 1944 meeting did.

Detour for an anecdote.  In mid-1998, when the crisis that originated in Southeast Asia had reached its one-year anniversary without abating, President Bill Clinton decided to give two important speeches.   He wanted to call for a new Bretton Woods.   His economic advisers (including both at Treasury and in the White House) advised him against this, on the grounds that one should not call for something as portentous as a new Bretton Woods when one was not likely to have proposals substantive enough to merit the name.   Soon after the (successful) speeches, British PM Tony Blair called for a new Bretton Woods.    Clinton asked his advisers, “How come Blair got to call for a new Bretton Woods when you wouldn’t let me do it?”    Our answer was along the lines, “Blair’s Treasury Secretary, Gordon Brown, doe s not necessarily have his interests aligned with his boss, in the way that Bob Rubin does.   So Brown had less incentive to stop Blair from saying something foolish.”   The big irony of the story is that Brown today is himself leading the move for a “new Bretton Woods.”

Even though the effort is virtually certain to fall short of a true “Bretton Woods 2,” it is worth taking the opportunity to consider what changes – whether more ambitious or less — might be made at the multilateral level to improve the functioning of the system.

Changes in government policy at the national level have already been radical in many countries, compared to anything that would have been imagined a short time ago:
• central banks’ extension of credit to institutions and under terms not contemplated in the past,
• governments’ buying up bad assets and recapitalizing, taking over,, or otherwise transforming troubled banks and financial institutions),
• agencies guaranteeing deposits (without limit) and money market funds, and so on.

Some of these steps can be done at the purely domestic level (US takeover of Fannie Mae and Freddie Mac); others require cooperation between a small number of countries (rescue of Fortis by Benelux countries); but others arguably require multilateral agreement, and thus are candidates for a modest “Bretton Woods.”

•  The International Monetary Fund has been given the task of outlining what a new Bretton Woods would look like – appropriate since the IMF is one of the original Bretton Woods institutions (along with the World Bank).
      o An Early Warning system is almost certain to be high on its list. But it already developed early warning indicators, after the East Asia crisis of 1997-98, and they haven’t been much help.
      o Now that the financial crisis is spreading to small economies like Iceland, transition economies in easternmost Europe, and poor countries like Pakistan, the IMF country rescue programs will get back in the saddle.
           This time around, however, the Fund has more competition (including from the ECB, the Gulf countries, China, and Sovereign Wealth Funds), and partly for that reason will probably demand less conditionality from the borrowing countries.    Also the Fund will have to turn to newly-wealthy countries like China to help finance  new facilities and programs.
              • Bill Rhodes has proposed that the Fund facilitate expansion of currency swap arrangements, to allow emerging markets to have the same access that has been made available to developing countries.
              • Michael Bordo and Harold James have suggested that the Fund could manage reserve assets of the new surplus countries; but it is not clear why the latter should want it to.
          The Contingent Credit Lines (CCL) – which were launched by the IMF with some fanfare in the aftermath of the 1997-98 East Asian crisis but were never attractive enough to attract a single client country — are back now, in the form of  new Short-Term Lending Facility.  The idea has always been that countries that have followed blameless policy (or as far as we can come to that in the real world), as judged by pre-crisis criteria, should be able to borrow large amounts from the Fund very quickly when faced with global contagion, without the usual conditionality.    Brazil and Korea look like two countries that had done most things right in recent years (flexible exchange rates, high level of reserves…) and have nevertheless since September seen international investors disappear.    The IMF has responded appropriately, with CCL-type loans that are multiples of country quotas.  
          Only a small number of countries qualify for having followed “blameless policy.”  Morris Goldstein suggests that the larger class of countries that have now been hit by forces beyond their control — the US-originating financial crisis — be helped by a revival of a long-ago IMF loan window, the Compensatory Financing Facility.
• The problem is that the money that the IMF is now able to offer is not only small relative to global capital markets (the IMF has long been used to that circumstance), but also small relative to the countries’ own reserves or to the no-condition funds that the Federal Reserve has now offered them through swap lines.   To expand such facilities, the IMF needs more funding.  Where will it come from?  Sovereign Wealth Funds and central banks in East Asia and Gulf countries.   But that in turn requires giving these countries much greater political representation than they currently have in the Fund.
              o There has been a loose one-year campaign to suggest guidelines for the operations of Sovereign Wealth Funds themselves, to “regulate” them.  But benefits of the SWFs may be more widely appreciated now than a year ago, in the context of the current crisis.   
              o The IMF, just as all the multilateral economic institutions, has moved far too slowly to give added representation to the newly important developing countries such as China, Brazil, Korea, India and Mexico – representation at least in proportion to their economic role, to say nothing of population.
                  A big part of the problem is that larger quotas and voting shares for these countries would have to come to a substantial extent out of Europe’s share.
                  In a fair world, Europe would also give up its stranglehold on the Managing Directorship (especially after the performance of the recent incumbents, who have appeared less interested in their jobs than in domestic politics back in their home countries or in putting new meaning into the phrase “foreign affairs”).  The same goes for the U.S with respect to the World Bank presidency.

•  The G-8 has been increasingly handicapped in recent years by virtue of its obsolete membership.
      o The G-7 still retains some relevance, in its role as self-appointed steering committee for world governance. After all, this financial crisis did not start in the developing countries, as it did those of 1982, 1997 and 2001.
     o But the G-7 cannot discuss the spread of the crisis to developing countries without Korea, Brazil, Turkey, India and Mexico at the table.  It cannot discuss central topics such as global current account imbalances, or the need for exchange rate adjustments, or coordinated global fiscal expansion, or requests that surplus countries fund rescue programs,  without China and Saudi Arabia at the table.     Thus it is appropriate that the G-20 is the group that has been invited to to the November 15 summit in Washington to discuss the new Bretton Woods.   
     o  Coordinated fiscal expansion is the most likely substantive macroeconomic policy outcome of the G-20 meeting.
      
• A probable substantive structural outcome from talk of the need for a bold new multilateral initiative is that there could be a “Basel III” to replace the “Basel II” agreement.
      o It would make capital requirements on banks countercyclical, rather than what has turned out to be procyclical, i.e., destabilizing, under Basel II. (Ironically economists at the BIS in Basel probably deserve credit for being the observers, in addition to Charles Goodhart, who most accurately warned of the procyclicality before the crisis.)
      o A Basel III could also replace the option of self-regulation of banks (under which they could choose their own Value At Risk models) with external regulation.    Dan Tarullo, who could have a  major role on the Obama team, offers some ideas .
      o The highly capable chairman of the Financial Stabilty Forum, Mario Draghi, assures us that already this year substantial progress has been made in such important areas as reducing conflict of interest on the part of credit-rating agencies.
      o International guidelines for guaranteeing deposits (possibly reinstating a ceiling, such as $100,000, after the crisis has passed) should perhaps be coordinated, to avoid flight of the sort that Ireland’s European partners experienced.

• Other possibilities:
      o A more ambitious reform would be to try to agree on guidelines to extend prudential regulation from international banks to non-bank financial institutions, since the latter were such a serious part of the problem in 2008 that many either failed or were bailed out, against all expectations.
      o More radically, regulation of this sort not just agreed multilaterally but carried out multilaterally, rather than at the national level, by the BIS (which now includes major emerging market countries) or a new agency.
      o The IMF, Financial Stability Forum, and other institutions will vie to lead the effort.
      o Other proposals, many of which could be attempted at the national level, but would optimally be coordinated internationally:
           A securities transactions tax, harmonized internationally, to raise revenue in a way that satisfies the public’s understandable feeling that the financial sector, which created this financial crisis, should not benefit from the solution.
           Executive compensation reform (especially in the financial sector).   Options-based bonuses have not been implemented in the incentive-compatible way that the corporate finance theorists anticipate  d, and have instead encouraged inordinate risk-taking.  One possible solution is to discourage compensation by options, in favor of restricted stock.    Another is to regulate corporate governance so as to insure that the CEO’s buddies don’t comprise the committee that determines his or her compensation.
         Regulation of the “originate to distribute” model of mortgage lending. Mortgage-Backed Securities were a useful innovation, but were carried too far.  The banks or mortgage brokers that originate a mortgage loan should be required to reattain a certain slice of each one (some have suggested 1/5), before selling the rest on, so that they have an incentive to monitor the creditworthiness of the borrower.  
           Regulation of Collateralized Debt Obligations.   Perhaps it is enough to raise capital requirement on the holders.  Perhaps something more drastic is required. 
           Regulation of certain derivatives, particularly Credit Default Swaps.  Perhaps it would be enough to standardize CDSs and set up a central clearing house, as many observers have suggested.
           But there is a danger that derivatives regulation could do more harm than good, e.g., a ban on futures markets or short-selling.
  o At the other end of the spectrum, one should consider the possibility that doing nothing might in the end be better than undertaking fundamental reforms in the international financial system, if the latter were driven by clumsy politics.

[To anyone wishing to post a comment:  I recommend you go to the RGE version of this post.]