After the currency crises of 1994-2001, and especially the East Asia crises of 1997-98, a lot of research investigated what countries could do to protect themselves against a future repeat.  More importantly, policy makers in emerging markets took some serious measures.  Some countries abandoned exchange rate targets and began to float.   Many accumulated high levels of foreign exchange reserves.  Many moved away from dollar-denominated debt, toward other kinds of capital inflow that would be less vulnerable to currency mismatch, such as domestic currency debt or Foreign Direct Investment.   Some instituted Collective Action Clauses in their debt contracts to facilitate otherwise-messy restructuring of debt in the event of a severe negative shock.  A few raised reserve requirements or otherwise tightened prudential banking regulations (clearly not enough, in retrospect). And so on.

When the Global Financial Crisis hit ten years later, it was bad news for everyone, except that it was good news for econometricians:  we could observe which countries got hit badly by this common external shock in 2008-09 and which did not, and could try to draw inferences about which strategies helped countries withstand the shock better than others.  The NBER is holding a public symposium in Washington on September 22.   The topic of the 3^rd and final session is: What ex ante policies can help reduce vulnerability to future shocks?

     Three papers that were presented at the earlier NBER conference in Bretton Woods (the culmination of a project on the Global Financial Crisis  sponsored by the Sloan Foundation) fall naturally into this category:

• International Reserves and the Global Financial Crisis, Kathryn Dominguez (University of Michigan), Yuko Hashimoto (IMF), and Takatoshi Ito (University of Tokyo);
• Managing Capital Inflows: The Role of Controls and Prudential Policies,  Jonathan Ostry, Atish Ghosh, Marcos Chamon, and Mahvash Qureshi (all of the IMF);
• International Financial Crises and the IMF: What the Historical Record Shows, Bergljot Barkbu (IMF), Barry Eichengreen (UC, Berkeley), and Ashoka Mody (IMF). 

To simplify a bit, Dominguez and co-authors study whether holding high levels of reserves helped countries do better in the Global Financial Crisis;  Ostry and co-authors study whether capital controls and bank regulation helped; and Barkbu, Eichengreen and Mody consider possible new mechanisms to improve the risk structure of capital inflows and to smooth adjustment to shocks, such as sovereign CoCos (Contingent Convertible bonds) and indexing of debt.

     The question that Dominguez, Hashimoto, and Ito address in International Reserves and the Global Financial Crisis, had been actively debated in the years before 2008.   Some economists thought that China, especially, but other emerging market countries as well, were holding far more foreign exchange reserves than they needed to withstand shocks.  Larry Summers (2006) was one prominent example; I must admit that his argument sounded sensible to me at the time.  When the global financial crisis hit, it was possible to test the proposition.   Some of the early studies found that reserve holdings did not seem to help countries withstand the crisis better.  Blanchard, Faruqee and Klyuev (2009) was one.   A series of papers by Andy Rose and Mark Spiegel (2009a, b) also found no significant effect.   But others found an important effect.    One of the technical contributions of the paper by Dominguez and co-authors is to subtract estimates of interest income and valuation changes from officially report levels of reserves in order to get at the actively managed component.  Their single most important finding is that real GDP growth recovery after the global financial crisis was stronger for countries that had accumulated large reserve holdings before the crisis.

This is the same thing I had found in a study with George Saravelos (NBER WP no.16047, 2010) .   Out of dozens of potential early warning indicators, foreign exchange reserves are the indicator that had been most often identified as significant by eighty pre-2008 studies conducted on earlier data.  We found that reserves are also the indicator that was the strongest predictor of which countries got into trouble in 2008-09. A particularly useful indicator is the ratio of reserves to short-term debt (Guidotti, 2003).   We found that the second most consistently important early warning indicator was overvaluation of the currency by criteria like PPP.   Also important in the recent crisis were measures of national saving.

Why did the Dominguez paper and my paper find that reserves had a significant effect, and others did not?    My guess is that it has to do with different definitions.  In particular, we define the crisis period as late 2008 and early 2009, whereas the earlier papers I mentioned ended in 2008.

     In Managing Capital Inflows: The Role of Controls and Prudential Policies, Ostry, Ghosh, Chamon, and Qureshi do something very important.  Too many discussions lump financial regulations together (speaking indiscriminately of Tobin taxes, Chile-style or Brazil-style controls on short-term capital inflows, Venezuela’s  controls on outflows, etc., even though these are completely different things).  Chamon and co-authors develop three new country indices: one for financial-sector capital controls, one for prudential regulation of foreign exchange transactions in the domestic banking sector, and one for domestic prudential policies.  This helps avoid exacerbating what is often a sterile oversimplified debate.  For example, even if one is ideologically opposed to capital controls, or has been persuaded by research such as Kristin Forbes (2007) that the famous Chile controls caused undesirable distortions, it is hard to be opposed to prudential banking regulations, especially in light of the origins of the 2008 crisis.   Chamon and co-authors find that capital controls and FX-related prudential measures can both help shift the composition of lending, away from FX-denominated bank loans and toward equity and FDI components of capital inflows.   Previous researchers have found that shifts of this sort in the composition of inflow, as opposed to reductions in the level of inflows per se, reduce the probability of a crisis. (Frankel and Rose, 1996, among many others.)   Probably the most important finding by Chamon et al is a reasonably strong statistical association between pre-crisis prudential and capital control policy and resilience to the sudden stop.   Countries in the upper quarter of restrictiveness of FX-related prudential measures do better in a crisis than those in the bottom quarter, by a whopping margin of 2 ½ - 3 ½ % percentage points of growth.  An important lesson for countries facing large inflows today.

     One of the co-authors of International Financial Crises and the IMF: What the Historical Record Shows, Barry Eichengreen, is not just the pre-eminent economic historian of this field but also supplied a lot of the intellectual force behind the adoption of Collective Action Clauses after the preceding round of emerging market crises (e.g., Eichengreen, 2003; and Eichengreen and Mody, 2004).  Thus it is well worth listening to what they have to say about further ideas for structuring capital flows ex ante in such a way as to avoid messy and costly restructuring ex post.

Barkbu, Mody, and Eichengreen explore how to automate the restructuring decision.  Automating the process has key advantages: it preserves the integrity of the contract (which avoids the uncertainties involved in triggering CDS); it is predictable; and it can be priced.   It can also avoid the need for what otherwise might be a lengthy process of renegotiation between debtors and creditors during which time economic activity falls and everyone suffers.  To this end, they discuss the idea of adding to future government bond issues so-called sovereign cocos, contractual provisions that automatically lengthen maturities or reduce interest and amortization payments when a pre-specified debt/GDP ratio is reached.  

There are also other ways of improving risk sharing and avoiding the need for costly restructuring negotiations.  An idea that is older but that I think merits more of a try-out than it has received — applicable for countries that export oil, minerals or agricultural commodities — is to index the debt to the world price of the export commodity.  Also in this category is the basic movement away from dollar-denominated debt and toward domestic-denominated debt, equity and FDI .  It seems to me that countries that heeded such lesson of the 1990s (including many emerging markets in Asia and Latin America) came through the GFC relatively well, whereas those that did not (Eastern Europe), did not.   

References

Barkbu, Bergljot, Barry Eichengreen, and Ashoka Mody, International Financial Crises and the IMF: What the Historical Record Shows, NBER Conference on The Global Financial Crisis, Bretton Woods, NH, June 2011, organized by C.Engel, K.Forbes, and J.Frankel.
Berkmen, Pelin, Gaston Gelos, Robert Rennhack, and James P Walsh (2009), “The Global Financial Crisis: Explaining Cross-Country Differences in the Output Impact“, IMF Working Paper 09/280.
Blanchard, Olivier, Hamid Faruqee, and Vladimir Klyuev (2009), “Did Foreign Reserves Help Weather the Crisis“, IMF Survey Magazine, October.
Chamon, Marcos, Atish Ghosh, Jonathan Ostry, and Mahvash Qureshi, Managing Capital Inflows: The Role of Controls and Prudential Policies,   NBER Conference on The Global Financial Crisis, Bretton Woods, NH, June 2011, organized by C.Engel, K.Forbes, and J.Frankel.
Dominguez, Kathryn, Yuko Hashimoto, and Takatoshi Ito, International Reserves and the Global Financial Crisis, , NBER Conference on The Global Financial Crisis, Bretton Woods, NH, June 2011, organized by C.Engel, K.Forbes, and J.Frankel.
Eichengreen, Barry, 2003, “Restructuring Sovereign Debt,” The Journal of Economic Perspectives, Volume 17, Number 4, 1 November , 75-98.
Eichengreen, Barry and Ashoka Mody. 2004, “Do Collective Action Clauses Raise Borrowing Costs?,” Economic Journal, v114 (495,April), 247-264.   NBER WP 7458.
Forbes, Kristin, “One cost of the Chilean capital controls: Increased financial constraints for smaller traded firms,” Journal of International Economics,  71, Issue 2, April 2007, Pages 294-323
Frankel, Jeffrey and George Saravelos (2010), “Are Leading Indicators of Financial Crises Useful for Assessing Country Vulnerability? Evidence from the 2008-09 Global Crisis,” NBER WP 16047, June.
Frankel, Jeffrey, and Andrew Rose (1996) “Currency Crashes in Emerging Markets,” Journal of International Economics 41, no. 3/4, 351-66.
Guidotti, Pablo (2003), in J Antonio Gonzalez, V.Corbo, A.Krueger, and A.Tornell, (eds.), Latin American Macroeconomic Reforms: The Second Stage, University of Chicago Press.
Obstfeld, Maurice, Jay Shambaugh, and Alan Taylor (2009), “Financial Instability, Reserves, and Central Bank Swap Lines in the Panic of 2008,” American Economic Review, 99(2):480-486.
Obstfeld, Maurice, Jay Shambaugh, and Alan Taylor (2010), “Financial Stability, the Trilemma, and International Reserves“, American Economic Journal: Macroeconomics.
Rose, Andrew and Mark Spiegel (2009a), “The Causes and Consequences of the 2008 Crisis: Early Warning,” Global Journal of Economics. NBER Working Paper 15357.
Rose, Andrew, and Mark Spiegel (2009b), “The Causes and Consequences of the 2008 Crisis: International Linkages and American Exposure,” Pacific Economic Review.
Summers, Lawrence, 2006,  “Reflections on Global Account Imbalances and Emerging Markets Reserve Accumulation,” March 24.

The international press reports, “At Climate Talks, Danger to Free Trade Mounts.”

The Copenhagen negotiations have essentially failed to include, among the many topics covered, one that will be critical in the coming years:   the question of import tariffs or other trade penalties that individual countries apply against the products of other countries that they deem too carbon-intensive.    Such border measures are already in EU and US legislation (the Waxman-Markey bill, not yet passed by the Senate).    Properly designed, they could turn out to be the missing instrument needed to get each country to cut emissions without fear of others taking unfair advantage, via leakage.   More likely, national politics will turn them into protectionist barriers.

Actions taken multilaterally would probably make the difference as to whether border measures are used for good or ill.  Here is my personal ranking of five possible scenarios.

1. Best choice — a system of multilateral sanctions as part of a new “Copenhagen Protocol” or other treaty, following the precedent of trade sanctions in the Montreal Protocol on Stratospheric Ozone Depletion.

     2.   Next-best choice — national import penalties adopted under multilateral guidelines:

• (i) Measures can only be applied by participants in good standing.
• (ii) Judgments to be made by technical experts, not politicians.
• (iii) Interventions in only a ½ dozen of the most relevant sectors.

   3. Third-best choice — no border measures at all.

   4.  Fourth choice — each country chooses trade barriers as it sees fit.

   5.  Worst choice: national measures are subsidies to adversely affected firms, which may take the form of free emission permits (as is contemplated in EU provisions).    These do nothing to limit carbon leakage.  They function simply as bribes to those industries lucky enough to receive them, in return for political support.

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.]

On her visit to India two days ago, Secretary of State Hillary Clinton was publicly rebuffed when she raised the problem of global climate change.    The Indian environment minister declared “we are simply not in the position to take legally binding emissions targets.”

No single country can address this problem on its own.  Hence the international negotiations that will take place in Copenhagen in December to try to find a successor treaty to the Kyoto Protocol.   But the international effort has run into a seemingly insurmountable roadblock.     On the one hand, the US Congress is clear: it will not impose quantitative limits on US emissions of greenhouse gases if China, India, and other developing countries don’t impose quantitative limits on theirs.   Indeed, that is why the Senate was unwilling to ratify the Kyoto Protocol ten years ago. The logic seems completely reasonable:  why should US firms bear the economic cost of cutting emissions if carbon-intensive activities would just migrate to countries without caps and global emissions continue their rapid rise?   On the other hand, the leaders of India and China are just as clear:   they are unalterably opposed to cutting emissions until after the United States and other rich countries go first.   And why should they?   The industrialized countries created the problem of global warming, in the process of getting rich;  the poor countries should not be denied their turn at economic development.  As the Indians point out, Americans emit more than ten times as much carbon dioxide per person.      

A total impasse.  Or is it?   I see one — and only one – practical solution to this apparent Catch-22:   The United States agrees to binding emission cuts — something like those in the Waxman-Markey bill that passed the House of Representatives on June 26;  and, simultaneously, China, India, and other developing countries agree to a path that immediately imposes on them binding emission targets — but targets that in their early years simply follow the so-called Business-as-Usual (BAU) path.    BAU is defined as the rate of increase in emissions that these countries would have experienced anyway, in the absence of an international agreement, as determined by experts’ projections.

The idea of developing countries committing only to BAU targets would provoke outrage from both environmentalists and US business interests, because it does not obligate these countries to cut emissions.  But both of those groups should realize that this commitment would be far more important than it sounds. It would preclude the carbon leakage which, absent such an agreement, would undermine the environmental goal.  It would mitigate the competitiveness concerns of carbon-intensive industries in the rich countries.  

This approach recognizes the reality that it would be irrational for China and India to agree to substantial cuts in the short term.   Indeed these countries, for their parts, will probably react with outrage at being asked to take on binding targets of any kind at the same time as the United States.   But they should also come to realize that they would actually gain in strictly economic terms from such an agreement, by acquiring the ability to sell emission permits at the world market price.

Of course an environmental solution also requires that China and the others subsequently make cuts below the Business as Usual path in future years, and eventually make cuts in absolute terms.   This can be done in such a way that the developing countries are not asked to make cuts that are different in nature than those made by Europe, the United States, and others who have gone before them, taking due account of differences in income.  But no country – rich or poor – will make sacrifices in any given period that impose huge economic costs on it.   It is time to stop making sweeping proposals that assume otherwise, and to pursue instead the narrow thread of the politically possible.