My post last month was a proposal for the European monetary authorities to pursue Quantitative Easing, not by buying euro bonds, but by buying dollar bonds.   I also presented this idea in a speech at a conference sponsored by the Dallas Fed, April 4, “Why the ECB Should Buy US Treasuries.”

But what if the ECB is told by the international community, especially the US, that it doesn’t want them to push the euro down against the dollar, that it fears a re-ignition of the currency wars?   And what if the ECB concludes that it can’t buy US treasuries without US agreement?   After all, it was only February of last year that the G-7 Ministers and Governors agreed not to try to influence exchange rates.

I have a Plan B to propose in that case, a version of the idea that need not put downward pressure on the foreign exchange value of the euro.   The ECB still pursues QE by buying US bonds; but it buys them from the Fed rather than on the open market.

Recall that the goal is for the ECB to expand its monetary base, without flirting with illegality.  And that the Fed’s goal is to taper and then reduce its holdings of Treasury bonds and Mortgage Backed Securities, without yet forcing up long-term interest rates. 

The argument is that everybody gets what he wants.  The Eurozone expands its monetary base.   The Fed gets to reduce the bonds on its balance sheet.  By selling them to the ECB rather than on the private market it avoids upward pressure on interest rates. (And what central bank doesn’t want more foreign exchange reserves, other things equal?)  If the ECB buys its dollar assets from the Fed instead of on the private market it avoids downward pressure on the euro.

The counter-argument from the viewpoint of the ECB is that, even though this is a way to expand its monetary base, it probably doesn’t achieve the objective of lowering Euro interest rates, if the Fed holds the euros as deposits at the ECB.  It would work if the Fed used them to buy longer-term euro bonds, which lots of central banks do these days.  But that idea would not go over well with the American public.  So maybe it has to be Plan A.

         The ECB should further ease monetary policy.  Inflation at 0.8% across the eurozone is below the target of “close to 2%.”  Unemployment in most countries is still high and their economies weak.  Under current conditions it is hard for the periphery countries to bring their costs the rest of the way back down to internationally competitive levels as they need to do.  If inflation is below 1% euro-wide, then the periphery countries have to suffer painful deflation. 

The question is how the ECB can ease, since short-term interest rates are already close to zero.   Most of the talk in Europe is around proposals for the ECB to undertake Quantitative Easing (QE), following the path of the Fed and the Bank of Japan, expanding the money supply by buying the government bonds of member countries.  This would be a realization of Mario Draghi’s idea of Outright Monetary Transactions, which was announced in August 2012 but never had to be used. 

           QE would present a problem for the ECB that the Fed and other central banks do not face.  The eurozone has no centrally issued and traded Eurobond that the central bank could buy.   (And the time to create such a bond has not yet come.)   That would mean that the ECB would have to buy bonds of member countries, which in turn means taking implicit positions on the creditworthiness of their individual finances.   Germans tend to feel that ECB purchases of bonds issued by Greece and other periphery countries constitute monetary financing of profligate governments and violate the laws under which the ECB was established.  The German Constitutional Court believes that OMTs would exceed the ECBs mandate, though last month it temporarily handed the hot potato to the European Court of Justice.   The legal obstacle is not merely an inconvenience but also represents a valid economic concern with the moral hazard that ECB bailouts present for members’ fiscal policies in the long term.  That moral hazard was among the origins of the Greek crisis in the first place. 

Fortunately, interest rates on the debt of Greece and other periphery countries have come down a lot over the last two years.    Since he took the helm at the ECB, Mario Draghi has brilliantly walked the fine line required for “doing what it takes” to keep the eurozone together.  (After all, there would be little point in preserving pristine principles in the eurozone if the result were that it broke up.  And fiscal austerity by itself was never going to put the periphery countries back on sustainable debt paths.)  At the moment, there is no need to support periphery bonds, especially if it would flirt with unconstitutionality.

        What, then, should the ECB buy, if it is to expand the monetary base?   It should not buy Euro securities, but rather US treasury securities.  In other words, it should go back to intervening in the foreign exchange market.   Here are several reasons why.   

First, it solves the problem of what to buy without raising legal obstacles.  Operations in the foreign exchange market are well within the remit of the ECB.    Second, they also do not pose moral hazard issues (unless one thinks of the long-term moral hazard that the “exorbitant privilege” of printing the world’s international currency creates for US fiscal policy).

Third, ECB purchases of dollars would help push the foreign exchange value of the euro down against the dollar.  Such foreign exchange operations among G-7 central banks have fallen into disuse in recent years, in part because of the theory that they don’t affect exchange rates except when they change money supplies. There is some evidence that even sterilized intervention can be effective, including for the euro.  But in any case we are talking here about an ECB purchase of dollars that would change the euro money supply.  The increased supply of euros would naturally lower their foreign exchange value. 

Monetary expansion that depreciates the currency is effective.  It is more effective than monetary expansion that does not, especially when, as at present, there is very little scope for pushing short-term interest rates much lower.

Depreciation of the euro would be the best medicine for restoring international price competitiveness to the periphery countries and bringing their export sectors back to health.  Of course they would devalue on their own, if they had not given up their currencies for the euro ten years before the crisis (and if it were not for their euro-denominated debt).   Depreciation of the euro bloc as a whole is the answer.

The strength of the euro has held up remarkably during the four years of crisis.  Indeed the currency appreciated further when the ECB declined to undertake any monetary stimulus at its March 6 meeting.  The euro could afford to weaken substantially.  Even Germans might warm up to easy money if it meant more exports rather than less.

        Central banks should and do choose their monetary policies primarily to serve the interests of their own economies.  The interests of those who live in other parts of the world come second.  But proposals to coordinate policies internationally for mutual benefit are reasonable.   Raghuram Rajan, head of the Reserve Bank of India, has recently called for the central banks in industrialized countries to take the interests of emerging markets into account by coordinating internationally.  

How would ECB foreign exchange intervention fare by the lights of G20 cooperation?  Very well.  This year the emerging markets are worried about tightening of global monetary policy.  The fears are no longer monetary loosening as in the “Currency Wars” talk of three years ago.  As the Fed tapers back on its purchases of US treasury securities, it is a perfect time for the ECB to step in and buy some itself.


         Jeffrey Anderson and Jessica Stallings, “Euro Area Periphery: Crisis Eased But Not Over,” Institute of International Finance, Feb. 13, 2014.
         Kathryn Dominguez and Jeffrey Frankel, 1993, Does Foreign Exchange Intervention Work? (Institute for International Economics, Washington, D.C.).
         —”Does Foreign Exchange Intervention Matter? The Portfolio Effect,”1993, American Economic Review 83, no. 5, December, 1356-69. 
         Rasmus Fatum and Michael Hutchison, 2002,  ”ECB Foreign Exchange Intervention and the Euro: Institutional Framework, News, and Intervention,” Open Economies Review, 13, issue 4, 413-425.
         Marcel Fratzscher, 2004, “Exchange Rate Policy Strategies in G3 Economies,” in C. Fred Bergsten, John Williamson, eds., Dollar Adjustment: How Far? Against What?  (Institute for International Economics, Washington, DC).
         Stefan Reitz and Mark P. Taylor, 2008, “The Coordination Channel of Foreign Exchange Intervention: A Nonlinear Microstructural Analysis,” European Economic Review, vol. 52, issue 1, January, 55-76.
         Lucio Sarno and Mark P. Taylor, 2001, “Official Intervention in the Foreign Exchange Market: Is It Effective and, If So, How Does It Work?” Journal of Economic Literature, 39(3), 839-868.

[A shortened version of this column appears as my March Project Syndicate op-ed.  Comments can be posted there.]

Commentators are taking note of the five-year anniversary of the fiscal stimulus that President Obama enacted during his first month in office.   Those who don’t like Obama are still asking “if the  fiscal stimulus was so great, why didn’t it work?”    What is the appropriate response?

Those who think that the spending increases and tax cuts were the right thing to do have given a number of responses, which sound a bit weak to me.  The first is that the stimulus wasn’t big enough.  The second was that the Great Recession would have been much worse in the absence of the stimulus, perhaps a replay of the Great Depression of the 1930s.  (The media are fond of this line of reasoning because it allows them to escape making a judgment.  They can just say “nobody knows what would have happened otherwise.”)    The third response is that the fiscal stimulus was short-lived, and in fact was reversed by the Congress by 2010.

I believe that each of these three statements is true.   But they sound weak because they look like attempts to explain away the absence of a visible positive impact.  Listening to these arguments,  one would think that no effect of the Obama stimulus could be seen by the naked eye in the U.S. economic statistics of 2009.    Nothing could be further from the truth.

Recall the timing.  Obama was sworn in on January 20, 2009. The economy and financial markets had been in freefall ever since the Lehman Brothers failure four months earlier (September 15).   The President quickly proposed the American Recovery and Reinvestment Act, got it through Congress despite strong Republican opposition, and signed it into law on February 17.   

If one judges by the economic statistics, the effect could not have been much more immediate, whether the crierion is job loss, GDP, or financial market indicators.   Look at the graphs below.  

The stock market, which had been falling steeply since September, hit bottom on March 9, 2009, and then started a 5-year upward trend.   The index shown in Figure 1 is the S&P 500.  The turnaround can’t be missed.  Wall Street should get ready to celebrate the anniversary on March 9.

Figure 1








Figure 1: Stock Market   
*Click on the chart for larger image

The much-maligned TARP and bank stress-tests also played important roles, unfreezing financial markets.  Bank interest rate spreads were back to pre-Lehman levels by February 2009 and back to pre-subprime-crisis levels by June.

What about the real economy?  That is what matters, after all.   Economic  output was in veritable freefall in the last quarter of 2008: a shattering 8.3 % p.a. rate of decline (BEA).  More specifically, the maximum rate of contraction came in December 2008, according to the monthly GDP estimates from the highly respected MacroAdvisers.   (For charts in the form of growth rates, see Figures 1 and 2 of my post on the 3-year anniversary.)  The free-fall stopped in the first quarter of 2009.   As the GDP graph below shows, economic activity was flat, scraping along the bottom until June, after which growth resumed.   The official end  of the recession thus came in June.   Visible to the naked eye.









Figure 2: Level of GDP, monthly(Dec.2006-Dec.2013)
estimated by Macroeconomic Advisers
*Click on the chart for larger image

The rate of job loss bottomed out in March 2009.  It is there for anyone to see.   The graph shows private sector employment changes.  Thus the turnaround does not count government jobs directly created by the fiscal stimulus.  Job creation turned positive after the end of the year.  Since then, though employment gains have been much too slow, they have on average exceeded the rate during the corresponding period under George W. Bush.

 Figure 2

Figure 3: Change in Private Sector Employment
*Click on the chart for larger image

Of course there are always a lot of things going on. One cannot say for sure what was the effect of the Obama stimulus. And one can debate why the pace of the expansion slowed after 2010. (My own prime culprit is the switch to fiscal austerity.)

But whether looking at indicators of economic activity, the labor market, or the financial markets, the idea that the fiscal stimulus of February 2009 had no apparent impact in the numbers is wrong.

[Comments can be posted at the Econbrowser version or in the always-lively debate at Economist's View.]

My preceding blog post described how market-oriented mechanisms to address environmentally damaging emissions, particularly the cap-and-trade system for SO2 in the United States, have recently been overtaken by less efficient regulatory approaches such as renewables mandates.   One reason is that Republicans — who originally were supporters of cap-and-trade — turned against it, even demonized it.

One can draw an interesting analogy between the evolution of Republican political attitudes toward market mechanisms in the area of federal environmental regulation and hostility to the Affordable Care Act, also known as Obamacare.   The linchpin of the program is the attempt to make sure that all Americans have health insurance, via the individual mandate.  But Obamacare is a market mechanism, in that health insurers and health care providers remain private and compete against each other.   

As has been pointed out countless times, this was originally a conservative approach, designed to work via the marketplace:  The alternative is to have the government either (i) directly provide the health insurance (a “single payer” system, as in Canada; or under US Medicare for that matter) or (ii) directly provide the health care itself (”socialized medicine,” as in the UK; or the US Veterans Administration hospitals).  The new approach was proposed in conservative think tanks such as the Heritage Foundation. It was enacted in Massachusetts by Republican Governor Mitt Romney. By the time President Obama adopted it, however, it had become anathema to Republicans, most of whom forgot that it had ever been their policy.

One can trace through the parallels between clean air and health care.  The market failure in the case of the environment is that pollution is what economists call an externality:  In an unregulated market, those who pollute don’t bear the cost. The market failure in the case of health care is what economists call adverse selection:  Insurers may not provide insurance, especially to patients with pre-existing conditions, if they have reason to fear that the healthy customers have already taken themselves out of the risk pool.  

Government attempts to address the market failure can themselves fail.  In the case of the environment, command-and-control regulation is inefficient, discourages innovation, and can have unintended consequences.   For example, CAFÉ standards (Corporate Average Fuel Economy) were partly responsible for the rise of the SUV.  Corn ethanol mandates raised food prices and accomplished nothing for the environment.  When “New Source Review” requires that American power companies adopt the most stringent available control technology if they build a new power plant, they respond by keeping dirty old plants running as long as possible (Stavins, 2006).  

In the case of health care, a national health service monopoly can forestall innovation and provide inadequate care with long waits.  In general, the best government interventions are designed to target the failure precisely - using cap-and-trade to put a price on air pollution or using the individual mandate to curtail adverse selection in health insurance — and otherwise let market forces do the rest more efficiently than bureaucrats can.

American conservatives often talk as if the alternative they would prefer is no regulation at all.  But few in fact would want to go back to the unbreathable pre-1970 air of Los Angeles, London, or Tokyo.  Even those few who might want to should recognize that most of their fellow citizens feel differently.  Political reality shows that the alternative in practice is an inefficient rent-seeking system in which solar power, corn-based ethanol, and fossil fuels all get subsidies or mandates.  Analogously, few conservatives in fact will say that they want hospital emergency rooms to turn away critically ill patients who lack health insurance.  Even for those who might want this, reality shows that the alternative in practice is hospitals that give emergency care to those who lack insurance, whether because of personal irresponsibility or for reasons beyond their control, and then pass the charges on to the rest of us.

A third example is the Earned-Income Tax Credit.  It was originally considered a conservative idea: an implementation of Milton Friedman’s proposed negative income tax, it was championed by Ronald Reagan as a pro-work market-friendly way of addressing income inequality.   President Obama proposed expanding the EITC in his State of the Union address last month.  But conservatives, again forgetting that it was their own creation, have opposed expansion of the EITC as verboten redistribution.   So proposals to increase the minimum wage get more political traction as a way to address income inequality, even though that approach is more interventionist and less efficient.

[This is the second of a two-part post, which in turn is the extended version of an op-ed published at Project Syndicate.  Comments may be posted there; or join the debate at Economist's View.]

Markets can fail.  But market mechanisms are often the best way for governments to address such failures.  This has been demonstrated in areas from air pollution to traffic congestion to spectrum allocation to cigarette consumption.    Markets for emission allowances - in which those firms that can cheaply cut pollution trade with those that cannot - achieve desired environmental goals at relatively low economic costs.   As of a decade ago, that long-standing economic proposition had become widely recognized and put into action. Yet the political tide on both sides of the Atlantic has been against “cap and trade” over the last five years.

In the United States, the highly successful trading system for allowances in emissions of SO2 (sulfur dioxide) has all but died since 2012.  In the European Union as well, the Emissions Trading System was in effect overtaken by other kinds of regulation in 2013.

Cap-and-trade was originally considered a Republican idea.  Market-friendly regulation was pushed by those who thought of themselves as pro-market, rather than by those who thought of themselves as pro-regulation.  Most environmental organizations were opposed to the novel approach;  many of them thought it immoral for corporations to be able to pay for the right to pollute. The pioneering use of the cap-and-trade approach to phase out lead from gasoline in the 1980s was a policy of Ronald Reagan’s Administration.  Its successful use to reduce SO2 emissions from power plants in the 1990s was a policy of George H.W. Bush’s administration.  The proposal to use cap-and-trade to reduce SO2 and other emissions further was a policy of George W. Bush’s administration ten years ago under, first, the Clear Skies Act proposed in 2002 and then the Clean Air Interstate Rule of 2005. (See Schmalensee and Stavins, 2013, pp.103-113.) 

The problem is not that cap and trade is a theoretical proposal from ivory-tower economists that cannot survive application in the real world.   To the contrary, its performance in action surpassed expectations.  The mechanism in the 1980s allowed lead to be phased out more rapidly than predicted and at an estimate savings of $250 million per year compared to the old-fashioned approach that did not permit trade.  (Stavins, 2003.)   SO2 emissions were curbed at a much lower cost than even the proponents of cap-and-trade had predicted before 1995, let alone what the cost would have been under the old command-and-control approach.   As expected, the electric power sector chose to close down those plants where it was cheapest to achieve pollution cuts. The flexibility of the cap-and-trade system also allowed the industry to take advantage of unexpected developments such as new scrubber technology and newly accessible low-sulfur coal, to a much greater extent than would have been possible without the market mechanism. (Among those explaining why costs came in so low are Ellerman, et al, 2000.)

The Republican candidate for president in 2008, Senator John McCain, had sponsored US legislative proposals to use cap-and-trade to address emissions of carbon dioxide and other greenhouse gases responsible for global warming.  (He had co-sponsored the Climate Stewardship Act with Senator Joe Lieberman in 2003.  It was defeated in the Senate by 55 votes to 43.   They tried again as recently as 2007, but got no further.  McCain continued to advocate a cap-and-trade approach to climate change during the 2008 presidential campaign; Washington Post, May 13, 2008, p. A14; and Financial Times, May 13, 2008, p.4.) 

Republican politicians have now forgotten that this approach was ever their policy.  To defeat the last major climate bill in 2009, they worked themselves into a frenzy of anti-regulation rhetoric.  (The American Clean-Energy and Security Act, sponsored by Congressmen Ed Markey and Henry Waxman, was passed by the House of Representatives that year, but not the Senate.) The Republican rhetoric successfully stigmatized cap-and-trade.  Schmalensee and Stavins (p.113) sum it up: “It is ironic that conservatives chose to demonize their own market-based creation.”

This stance left in its place alternative approaches that are less market-friendly (Stavins, 2011) — especially after court cases pointed out that the 1970 Clean Air Act and its 1990 Amendmentswere still the law of the land (originally signed into law by Republican Presidents Richard Nixon and George H.W. Bush, respectively, with heavy bi-partisan congressional majorities both times).

The non-market alternatives, such as “command and control” regulation requiring that particular energy sources or particular technologies be used, are less efficient.    Nonetheless they are again the dominant regime.   The number of SO2 allowances specified by the cap-and-trade regime has not been adjusted since 2000. As a result, emissions have since 2006 been steadily declining below the ceiling. The cap is no longer binding.  People aren’t willing to pay for something if they already have more of it than they need.  So the price of emission allowances has fallen steeply, essentially hitting zero since 2012, which indicates that it no longer affects behavior in the electric power sector.  (Schmalensee and Stavins, p.106-07; 114.)

*                            *                      *

In Europe, the peak of cap-and-trade came 10 years ago.   The European Union adopted the Emissions Trading System (ETS) in 2003, as a cost-effective way to achieve the commitments it had made under the Kyoto Protocol on Global Climate Change.  It rapidly became the world’s biggest market in the trading of carbon allowances.  But ETS has in recent years been pushed aside by older “command-and-control” approaches, in which the government dictates who should use which technologies, in what amounts, to reduce which emissions.   

European directives say that 20% of energy must come from renewables by 2020.  Renewable energy has been promoted by mandates and subsidies.  These policies along with excessive allocations have collapsed the price of emissions permits in the ETS, because demand for the permits now falls short of any binding constraint.    The price of carbon fell below 3 euros a ton in April 2013, rendering the market almost irrelevant.   It remains very low (5 euros a ton).  This in turn contributes to the burning of coal - the worst energy source, from the viewpoint of global warming or local pollution - which would not have happened if the central policy to address these problems were still a mechanism to put a price on carbon. 

On top of that, the EU methods of encouraging renewables have proven ruinously expensive.  This has been giving pause to European officials as they decide how to extend the 2020 framework to goals for 2030.  The European Council will discuss this at a meeting scheduled for March 2014.    The EU should abandon its numerical targets for renewables and go back to relying on the ETS, with whatever limits on permit quantities are  necessary to keep the price up.  This route can achieve greater progress at reducing Greenhouse Gas emissions at lower cost to the European economies.
                                                            *          *          *

There is nothing inevitable or irreversible about the recent trend away from cap-and-trade.   Indeed in some parts of the world, such as China, governments seem to be moving in the direction of emissions trading as an efficient way to address global climate change.  

Even in the US, where it began, there is still grounds for hope.  The Environmental Protection Agency is currently developing federal guidelines for state programs to reduce CO2 emissions from power plants under the Clean Air Act [Section 111(d)].   As a good model for putting a price on carbon, the EPA should consider the cap and trade schemes that have been developed by the northeastern RGGI, California, and some Canadian provinces. The Regional Greenhouse Gas Initiative (RGGI) began trading permits among large power plants in 2008 and continues to operate among nine northeastern statesCalifornia recently started an important new emissions trading system.  But the Golden State is another example where policies to set standards for particular fuels or particular modes of power generation are in danger of undermining the emissions trading plan ["Assembly Bill 32"].

                                                            *          *          *

[This is the first of a two-part post, which is the extended version of an op-ed published at Project Syndicate.  Comments may be posted there -- or at Economist's View where there is a lively debate. The full version is also to appear at VoxEU.]

A long-awaited reform of the International Monetary Fund has now been carelessly blocked by the US Congress.   This decision is just the latest in a series of self-inflicted blows since the turn of the century that have needlessly undermined the claim of the United States to global leadership. 

The IMF reform would have been an important step in updating the allocations of quotas among member countries.  From the negative congressional reaction, one might infer that the US was being asked either to contribute more money or to give up some voting power.   (Quotas allocations in the IMF determine both monetary contributions of the member states and their voting power.)  But one would then be wrong.  The agreement among the IMF members had been to allocate greater shares to China, India, Brazil and other Emerging Market countries, coming largely at the expense of European countries.  The United States was neither to pay a higher budget share nor to lose its voting weight, which has always given it a unique veto power in the institution.

The change in IMF quotas is a partial and overdue adjustment in response to the rising economic weight of the newcomers and the outdated dominance of Europe.   Voting share in the IMF is supposed to be in proportion to economic weight, not equal per capita or per country.  This acknowledgement of reality, the principle of matching the representation to the taxation, is sometimes known as the Golden Rule: “He who has the gold, rules.”  The principle is probably one of the reasons why the IMF has usually been a more effective organization than others such as the UN General Assembly.

It’s not that President Obama hasn’t tried to exercise global leadership, as just about any US president would.  He pushed for this agreement to reform the IMF at the G20 summit in Seoul in November 2010 (the first meeting of the group of leaders to have been hosted by a non-G7 country).  He prevailed despite understandable European reluctance to cede ground.

Some American congressmen may not be aware of the extent to which the IMF reform agreement represented the successful efforts of the US executive to determine the course of the international negotiations.  But then the rejection by the US Congress of an international agreement that the president had painstakingly persuaded the rest of the world to accept is not a new pattern.    It goes back a century, to the inability of President Woodrow Wilson to persuade a myopically isolationist US Congress to approve the League of Nations (1919).   Examples over the last century also include the International Trade Organization (1948), SALT II (1979), and the Kyoto Protocol (1997), among others.  A past history of trying to re-open international negotiations that the executive has already concluded is also the reason why Congress has to give President Obama trade promotion authority (that is, the usual commitment to fast-track congressional votes on trade agreements), or else our trading partners will not negotiate seriously.  This would impede ongoing talks in the Pacific, with Europe, and globally (in the venues, respectively, of the Trans-Pacific Partnership, Trans-Atlantic Trade and Investment Partnership, and the World Trade Organization).

Commentators have been warning since the 1980s that the US may lose global hegemony for economic reasons, as an effect of budget deficits, a declining share of global GDP, and the switch from net international creditor to net debtor.  One version is the historical hypothesis of imperial overstretch (Kennedy, Rise and Fall of the Great Powers, 1987). 

But the main problem seems to be a lack of will rather than a lack of wallet.   Or perhaps it would be more accurate to describe the problem with US domestic politics as wild swings of the pendulum between excessive isolationism and excessive foreign intervention in reaction to short-term events, untempered by any longer term historical perspective.   After the United States lost 18 rangers in Somalia in October 1993 (Blackhawk Down), Congress became highly resistant to just about any foreign intervention, no matter how big the “bang for the buck.”   Then, after September 11, 2001, it was prepared to follow President George W. Bush into just about any military intervention, no matter how dubious the benefit or how high the cost.   The total cost of the wars in Iraq and Afghanistan has recently been estimated at $4 trillion by my colleague Linda Bilmes, co-author with Joe Stiglitz of The Three Trillion Dollar War, 2008.  (It’s not just that the wars lasted for ten years; the biggest costs of such wars come subsequently, particularly for medical care that veterans need for the rest of their lives.)  These days, the pendulum has apparently swung back to the isolationist direction once again.

One had hoped that short-sighted congressmen had been made aware that among the costs of the foolish US government shutdown three months ago was damage to the country’s global credibility and leadership.   Most visibly, to deal with the shutdown, the White House in October had to cancel its participation at the leaders’ summit of APEC (Asia-Pacific Economic Cooperation) in Bali and thereby stymie progress on the US-led Trans-Pacific Partnership.  It was widely reported that the Asian countries drew from Obama’s absence the conclusion that they should play ball with China instead (Drysdale, “Asia Gets on with It While America’s out of Play,” Oct. 7, 2013.)

The increasing power of China and other major emerging market countries is a reality.  It is precisely what makes it important that the United States support a greater role for these countries in international institutions such as the IMF, the G20, and APEC.

The rise of China could go well or badly for international relations.  It depends in part on whether the status quo powers make room for the newcomer (Nye, 2013).This historical pattern famously goes back to Thucydides’ description of the rising power of ancient Athens and the resulting war with Sparta (History of the Peloponnesian War).  Examples of the consequences of failing to accommodate the new arrival include the role of Germany’s rise in the origins of World War I 100 years ago (e.g., Gilpin, War and Change in International Politics, 1981).  

The new Chinese President, Xi Jin Ping, has used the phrase “New Type of Great Power Relationship.” It sounds anodyne but may carry greater significance.   The phrase apparently demonstrates awareness of the historical “Thucydides trap.”  It signals China’s openness to working with other countries to avoid the tragedies of 460 BC and 1914 AD. It is only sensible to take him up on his offer and so smooth international relations into the future.

The potential for US leadership has survived remarkably well the loss of national status as an international creditor.   This has partly been a matter of luck.  In Asia, historical and territorial frictions among Japan, Korea, and China, have kept US participation far more welcome in the Pacific than it would otherwise be. Meanwhile, in Europe, fiscal follies have been even more egregious than America’s.  Asians are aware that the IMF has stretched the rules to lend into the euro crisis on a greater scale than it did during the Asia crisis of 1997-98.  They understandably feel entitled to a greater say in the running of the Fund.   But the emerging market countries have been so disunited, for example, that no two of them could come together in 2011 to support a common candidate for IMF Managing Director, notwithstanding that the three previous incumbents were European men who flamed out before completing their terms in office.  (The result was a European woman, Christine Lagarde.  She has done a good job rather than kowtowing to Europe; but that is beside the point.)

The latent demand around the globe for enlightened US leadership, which first appeared at the end of World War I, is still there.  It can survive budgetary constraints (and apparently can survive misguided military interventions).  But it cannot survive an abdication of interest on the part of the US Congress.

[This column appears at East Asia Forum. It is an extended version of an op-ed, titled "Absent America," that appeared first at Project Syndicate.  The author would like to thank Joe Nye and Ted Truman for comments.]

          The Federal Reserve and the Bank of England have each recently backed away from “forward guidance” that they had given earlier in the form of thresholds for the unemployment rate.   As a result of their changes in emphasis, they are both being accused of confusing the financial markets.

The Fed at the end of 2012 had said that it planned on keeping monetary policy easy at least until the unemployment rate had fallen below 6 ½ %.     The Bank of England in mid-2013 had made a similar statement, with a threshold figure for UK unemployment of 7%.   

But Governor Mark Carney at Davos Saturday, signaled that he is now moving away from that guidance.  The reason: the British labor market is now “in a different place” from what was expected:  The Bank of England’s forecast had been that the 7% number would not be reached until mid-2016; yet British unemployment, unexpectedly fell to 7.1%  most recently (in the autumn months) and thus is poised imminently to cross the threshold.  And yet, with the economy still weak and inflation still low, the monetary authorities, appropriately do not want to raise interest rates anytime soon. 

Similarly, the Fed said last month that it now expects to keep interest rates low well past the time that the 6 ½ % mark is reached.  After Chair Ben Bernanke’s last FOMC meeting this week, Janet Yellen is in charge.  She will have to re-think forward guidance and use information other than the unemployment rate. And other than the inflation rate, which has been part of the guidance all along.  [The FOMC on Dec. 18: " it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal."]

Again, the reason is obvious.  The Fed hadn’t expected to reach the threshold for tightening in 2014 or even 2015.  But unemployment has fallen unexpectedly quickly, reaching 6.7% in December — not because of unexpectedly rapid growth in the economy which might call for  earlier tightening, but, in large part, because discouraged workers have left the labor force altogether.   (To be sure, a big part of the four-year decline in the unemployment rate has indeed been due to a growing economy; and even part of the decline in the labor force participation rate is due to the benign long-term trend of baby-boom retirement.  Nevertheless unexpected exit from the labor force is probably the biggest component of the unexpected component of the rapid recent decline in the unemployment rate.)

            Both the Fed and the Bank of England are accordingly now subject to much criticism for having delivered forward guidance that they were subsequently unable to stick to.   Some of these attacks are unfair.  No one should want the central bank to slavishly follow statements made in the past if circumstances have changed in an unexpected way.   Any fair critic must acknowledge that the ubiquitous demand for transparency with respect to the central bank’s plans (phrased simply) inevitably conflicts with the reality that the future is unpredictable, in particular with respect to such developments as unexpected fluctuations in the labor force participation rate.   Aware of the uncertainty, the monetary authorities have always hedged their foreign guidance:  nobody is now violating a past promise. Are the critics then being entirely unfair?

            Not entirely.  There was another way.  A year or two ago, many of us were suggesting that the monetary authorities could announce a target or threshold for Nominal GDP, instead of for inflation, real income, unemployment, or other alternatives.    Some of us explicitly warned that a threshold phrased in terms of the unemployment rate would be vulnerable to extraneous fluctuations such as workers exiting the work force, and argued that a nominal GDP threshold would be more robust with respect to such unforecastable developments.

Just over a year ago, for example, I wrote in favor of “a commitment to keep monetary policy easy so long as nominal GDP falls short of the target.  It would thus serve a purpose similar to the Fed’s December 12, 2012, announcement that it would keep interest rates low so long as the unemployment rate remains above 6.5% - but it would not suffer the imperfections of the unemployment number (particularly its inverse relationship with the labor force participation rate…).”  [Central Banks Can Phase in Nominal GDP Targets without Losing the Inflation Anchor blog, December 25th, 2012.]  Other NGDP proponents made similar warnings.

This is yet another instance of a long-standing point: if central banks are to focus attention on a single variable, the choice of Nominal GDP  is more robust than the leading alternatives. A target or threshold is a far more useful way of communicating plans if one is unlikely to have to violate it or explain it away later.


[An updated version of this column is posted at EconBrowser, Feb.11.  Comments can be posted there.]

Politico asked 8 of us for a prognosis on US growth in the new year. This was my response –

Something important will get better in 2014: Fiscal policy will stop hurting the economy. The results should show up as expansion in such service sectors as health, education and construction.

The biggest impediment to economic expansion over the last three years has been destructive budget policy coming out of the Congress: misguided fiscal drag in the short term (crude cuts in spending, especially under the sequester; the expiration a year ago of Obama’s payroll tax holiday); repeated unnecessary disruptive and uncertainty-maximizing political crises (debt ceiling showdowns and government shutdown); and little progress on the genuine longer-term fiscal problem, which is the 40-year prognosis for U.S. debt (a result of projected rapid growth in entitlement spending). These fiscal failures have together probably subtracted well over a percentage point from U.S. growth in each of the last three years.

Private-sector output and employment have been rising for four years, which is what has made this a period of continued economic recovery. Many of the benefits have come in manufacturing and energy, unexpectedly. But real government spending has been falling since 2010 in absolute terms, let alone as a share of GDP. Government employment has been declining since 2009, especially as a share of total employment. This is the No. 1 reason why the overall pace of the recovery has been frustratingly slow until now.

There are good grounds for optimism in 2014. For the first time in four years, Congress will probably not inflict contractionary fiscal policy on the American people. If the government sector stops making a negative contribution, that will show up as economic growth. True, it would be better if fiscal policy could actually make a positive contribution. This would mean spending some money on priority areas such as roads, bridges and other public investment, while simultaneously enacting legislation to address the long-term issue of debt that will otherwise rise relative to GDP in future decades. But ending in 2014 the negative short-term contribution to growth is itself a political development that deserves to be celebrated.

[Responses to the question from the others -- El-Erian, Bernstein, Kotlikoff, Reich, Chinn, Frieden, and Baker -- are at Politico.]

      Now that Janet Yellen is to be Chair of the US Federal Reserve Board, attention has turned to the candidate to succeed her as Vice Chair.  Stanley Fischer would be the perfect choice.   He has an ideal combination of all the desirable qualities, unique in the literal sense that nobody else has them.  During his academic career, Fischer was one of the most accomplished scholars of monetary economics.  Subsequently he served as Chief Economist of the World Bank, number two at the International Monetary Fund, and most recently Governor of the central bank of Israel.   He was a star performer in each of these positions.   I thought in 2000 he should have been made Managing Director of the IMF.  

One has trouble thinking of another economist-at least, since Keynes!-who has done as well as he at combining analytical skill, good policy sense, clear expression, selfless dedication toward making the world a better place, and the ability to get everything done — and with imperturbable good humor as well.

Most relevantly, he has a lot of experience at crisis management, having been on the firing line at the IMF during the currency crises of the 1990s and again having responsibility for the economy of Israel during the Global Financial Crisis of 2008-09.   Janet Yellen, who is expected to be anointed imminently as the new Fed Chair, also has an unusually good combination of qualifications in both the academic and policy realms.  But she is at her best when she has had a chance to prepare meticulously.  She would be usefully complemented by someone who has a lot of experience at dealing with crisis situations where one often does not have time to prepare.  Together they constitute a great team.

     Fischer’s qualities were glowingly attested to at a conference in honor of his 70th birthday last month, the IMF’s Annual Research Conference, November 7-8, in Washington.  Among those doing the attesting were outgoing Fed chairman Ben Bernanke, who in the 1970s was one of Fischer’s many doctoral students when he taught at MIT.  (As was I.)

     The same conference has been much discussed for another reason:  Larry Summers, Paul Krugman, and Fed officials in their presentations to the large gathering each put forward provocative theses concerning the slow pace of economic growth in recent years.   These claims will be important to the Fed’s job in 2014 and beyond.

The controversial Summers explanation for slow growth has received perhaps the most attention over the last month.   He said that the economic crisis is not over until it is over, which is not yet.  He boldly suggested that the reason for sub-par growth over the last ten years is a fundamental structural change, which he identified as secular stagnation: the natural or equilibrium real rate of interest may have fallen below zero permanently, perhaps as low as negative 2 or 3 per cent.  Summers offered two possible reasons for the fall in the real interest rate: a saving glut coming from Asia or a long-term IT-induced decline in the relative price of capital goods that has reduced needed investment relative to saving. (Krugman offers two more possible explanations: a decline in the population growth rate and a decline in the productivity growth rate.) 

If the Summers claim were right, we would really be in trouble.   Central banks already can have difficulty in severe recessions attaining a sufficiently low real financial interest rate — i.e., nominal interest rate adjusted for expected inflation — because the nominal interest rate cannot go below zero.  (This problem used to be called a liquidity trap and is now called the “Zero Lower Bound.”)  At a minimum, they can’t do it without inflation higher than we would like.   In the Summers scenario, the low equilibrium rate would mean chronically low growth.  (He did actually say “forever.”)  

     At the conference, Fischer himself seemed more optimistic that monetary policy can work, even under current conditions.  Quantitative easing can push down the long-term interest rate.  So can forward guidance. And there are other channels besides the real interest rate, whether short-term or long:  the exchange rate, stock market prices, the real estate market, and the credit channel.  As Ken Rogoff said on the same panel, “you throw the kitchen sink at it; you do everything that is possible.”

     Top Fed staff members are not usually the sort of people who go out on a paradigm-shaking limb in the way that professors are prone to do.   But David Wilcox, Director of Research and Statistics, and his Fed co-authors (Dave Reifschneider and William Wascher), did it at the IMF conference.  Their thesis was that US output and employment in the last few years has reflected slow supply growth  — not because of an exogenous structural change of the Summers sort, but as an endogenous consequence of the financial crisis.  The severity and duration of the downturn that began in December 2007 has been steadily eroding the capital stock and the size and skills of the labor force.   Business fixed investment has been low.  (Firms don’t build new factories, even when the cost of capital is low, if they don’t have the customers to sell to.) Long-term unemployment has been high.   (Workers who have been out of a job for a long time have trouble finding someone willing to hire them and may drop out of the labor force altogether.) The result is that productive capacity and the effective labor force have moved onto diminished growth paths.   The cumulated supply shortfall - the authors estimate that potential output is by now 7% below the pre-2007 trajectory –may be larger than the current shortfall in output attributable to the ongoing lack of aggregate demand itself.

What are the implications for policy?  On the one hand, this unfortunate recent history makes the Fed’s job even harder that it has been, because it further limits the ability to stimulate growth without causing inflation.  On the other hand, it makes it all the more important to maintain adequate demand stimulus so long as unemployment is high, because otherwise the negative effects on growth will be long-lasting.  The Wilcox paper, even though representing “the views of the authors alone,” thus supports continued monetary ease in 2014.

      The Krugman thesis is as surprising as the other two propositions presented at the IMF conference:   Concerns about US fiscal deficits and debt are misplaced even in the longer term.  Deficit hawks worry that at some point global investors will lose their enthusiasm for holding ever-greater amounts of US debt, resulting in a sharp depreciation of the dollar.  Krugman’s controversial claim is that, even if this were to happen, interest rates would not rise and the effect of the depreciation on the US economy via an increase in net exports would be expansionary, not contractionary.  No hard landing for the dollar.  (The big difference between the US and the situation of emerging markets in the 1990s - where devaluation was contractionary — is that all the US debt is denominated in its own currency.)  The policy implication is that there is less reason to worry about the long-term debt problem and more reason to worry that fiscal contraction over the last three years has been depriving the economy of needed demand.

     The record of the last few years has indeed been discouraging.  Even though prompt action halted the 2008 financial crisis and the initial monetary and fiscal stimulus helped end the recession itself in 2009, the recovery since then has been painfully slow. 

The bottom line seems to me that the main problem has been destructive fiscal policy coming out of the Congress:  misguided fiscal drag in the short-term in 2010-13; repeated unnecessary disruptive and uncertainty-maximizing political crises in 2011-13 (debt ceiling showdowns, government shutdown, and sequestration); and little progress on the genuine longer-term fiscal problem, which is the 40-year prognosis for US debt (a result of projected growth in entitlement spending).   These fiscal failures have together probably subtracted more than a percentage point from US growth in each of the last three years.  Especially if Wilcox is right about the supply-side exacerbation of slow demand growth, then fiscal obtuseness can explain what is going on by itself; there is no need for Summers’ deus ex machina.

     But there are grounds for optimism in 2014.   For the first time in four years, Congressional fiscal policy will probably not have a negative effect on growth.  True, it would be better if fiscal policy could actually make a positive contribution. But ending the negative contributions is a political development that deserves more celebration than it has received.  

And meanwhile monetary policy will be in good hands, especially if Fischer joins the team.


William English, J. David López-Salido and Robert Tetlow ,”The Federal Reserve’s Framework for Monetary Policy-Recent Changes and New Questions,” IMF Annual Research Conference, Washington, DC, Nov. 2013.

Paul Krugman, “Currency Regimes, Capital Flows, and Crises,” Mundell-Fleming Lecture, IMF Annual Research Conference, Nov. 2013.

Dave Reifschneider, William Wascher, and David Wilcox, “Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy” IMF Annual Research Conference, Nov. 2013.

Larry Summers, “IMF Fourteenth Annual Research Conference in Honor of Stanley Fischer,” transcript,November 8, 2013.

[This is an extended version of a Project Syndicate op-ed.  Comments can be posted there.]


      Most people know that the general trend in the dollar’s role as an international currency has been slowly downward since 1976.   International use of the dollar as a currency in which to hold foreign exchange reserves, to denominate financial transactions, to invoice trade, and to serve as a vehicle for foreign exchange transactions is below where it was during the heyday of the Bretton Woods era (1945-1971). 
But few are aware of what the most recent numbers show.
        It is not hard to think of explanations for the downward trend.   Since the time of the Vietnam War, US budget deficits, money creation, and current account deficits have often been high.  Presumably as a result, the dollar has lost value in terms of other major currencies or in terms of purchasing power over goods.   Meanwhile, the US share of global output has declined.  Most recently, the disturbing willingness of some American congressmen in October to pursue a strategy that would have the Treasury default on legal obligations has led some observers to ask the natural question whether the dollar’s international currency status is now imperiled.
Moreover some EM currencies are joining the list of international currencies for the first time.  Indeed, some analysts have suggested that the Chinese yuan may rival the dollar as the leading international currency by the end of the decade!  (Eichengreen, 2011; and Subramanian, 2011a, 2011b.)
         The trend in the dollar as an international currency has not been uniformly downward, however.  Interestingly, the periods when the public is most concerned about the issue do not coincide well with the periods when the dollar’s share is in fact falling.  By the criteria of international use as a reserve currency among central banks and as vehicle currency in foreign exchange markets, the most rapid declines took place during the intervals 1978-1991 and 2001-2010. (The yen and deutschemark were the rising currencies during the first period, and the euro during the second.) 
In between these two intervals, during the years 1992-2000, there was a clear reversal of the trend, notwithstanding a popular orgy of dollar declinism around the middle of that decade.  Central banks held only an estimated 46% of their foreign exchange reserves in the form of dollars in 1992, but had returned to almost 70% by 2000. 
Subsequently, the long-term downward trend resumed.  According to one estimate, the share in reserves declined from about 70% in 2001 to barely 60% in 2010 (Menzie Chinn).   During the same decade, the dollar’s share in the foreign exchange market also declined:  The currency constituted one side or the other in 90% of foreign exchange trading in 2001, but only 85% in 2010.
      The most recent statistics unexpectedly suggest that the dollar’s standing has again taken apause from its long-term decline.  The International Monetary Fund reports that its share in foreign exchange reserves stopped declining in 2010 and has been flat since then.  If anything, the share is up very slightly thus far in 2013 (COFER, IMF, Sept. 30, 2013).   Similarly, the Bank for International Settlements reported in its recent triennial surveythat the dollar’s share in the world’s foreign exchange markets rose from 85% in 2010 to 87% in 2013 (preliminary global results). That the dollar has been holding up so well comes as a surprise, in light of dysfunctional US fiscal policy.   Or maybe we should no longer be surprised.  After all, when the global financial crisis erupted out of the American sub-prime mortgage mess in 2008, the reaction of global investors was to flee into the United States, not out.  They clearly still regard the US Treasury bill market as the safe haven and the dollar as the top international currency. 
The explanation must be the one that is so often noted: the absence of good alternatives.  In particular, the euro has its own all-to-obvious problems.  Indeed the euro’s share of reserve holdings and its share of foreign exchange transactions have  both fallen by several percentage points over the last three years (reserves from 28% of allocated reserves in 2009 and 26% in 2010, to 24% in the most recent 2013 figures; forex trading from 39% of transactions in 2010 to 33% in 2013).
       What about the vaunted yuan?  According to the IMF statistics, it hasn’t yet broken into the ranks of the top seven currencies in terms of central bank reserve holdings.  The top six are the US dollar and euro, followed by the yen and pound (the latter quietly reclaimed the number three position in 2006 and has been running neck-and-neck with the yen recently), and the Canadian dollar and Australian dollar (also running neck-and-neck). According to the BIS statistics, China’s currency has finally broken into the top ten in forex trading; but its share is only 2.2% of transactions. This is behind the Mexican peso at 2.5%, and still farther behind the Canadian dollar, Australian dollar and Swiss franc.  (See Table 1 and Figures 2 & 3).  
Since 2.2% is much less than China’s share of world trade, it would be more accurate to say that the renminbi is becoming a normal currency than to say that it is becoming an international currency, let alone the top international currency.Despite recent moves by the Chinese government, the yuan  still has a long way to go.  Of the three kinds of attributes that a currency needs to become widely used internationally the yuan  has two - size of the home economy and the ability to hold its value - but still lacks the third:  deep, liquid, open financial markets.
       What might account for the recent stabilization of the dollar’s status?  What do the last three years have in common with the preceding period of temporary reversal, 1992-2000?   Both intervals saw striking improvements in the US budget deficit, both structural and overall.   The federal deficit is now less than half what it was in 2009 or 2010; and the record deficits of the 1980s were converted into record surpluses by the end of the 1990s. Perhaps the fiscal observation is a coincidence.  
It would be foolish to read too much into two historical data points.  It would be even more foolish to believe, just because American politicians have failed to dislodge the US dollar from its number one status over the last forty years, that they could not accomplish the job with another few decades of effort. 
Pound sterling had the top spot in the nineteenth century, only to be surpassed by the dollar in the first half of the twentieth century. It is not an eternal law of nature that the US currency shall always be number one.   The day may come when the dollar too succumbs in its turn.  But that day is not this day.  



Figure 1: The share of the dollar in central banks’ foreign exchange reserves stopped its downward trend in 2010-2013


source: Menzie Chinn (2013), based on IMF’s COFER.



Table 1: The share of the dollar in global foreign exchange trading reversed its downward trend in 2010-2013


Table 1


Source: Bank of International Settlements’ Triennial Central Bank Survey, Sept.2013.


Figures 2 and 3: The share of China’s yuan in foreign exchange trading is rising, but still ranks behind many other currencies

Larger image                                                                Larger image     

Source: Menzie Chinn.  Data from BIS Triennial Central Bank Survey.



Bank for International Settlements, 2013, Triennial Central Bank Survey - Foreign Exchange Turnover in April 2013: preliminary global results, Monetary and Economic Department, September.    

Menzie Chinn, 2013, “What Currencies are Foreign Exchange Reserves Held In?” Econbrowser, Oct. 31.   

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

Barry Eichengreen, 2005, “Sterling’s Past, Dollar’s Future: Historical Perspectives on Reserve Currency Competition,” NBER Working Paper No.11336, May.    

 —— 2011, “The Renminbi as an International Currency.” Journal of Policy Modeling33 (5): 723-730.  

J. Frankel, 1995, “Still the Lingua Franca: The Exaggerated Death of the Dollar,” Foreign Affairs, 74, no. 4, July/August, 9-16  

 ——- 2012, ”Internationalization of the RMB and Historical Precedents,” published in Journal of Economic Integration, vol.27, no.3, 329-65.  Summarized in RIETI & Vox.

International Monetary Fund, 2013, Currency Composition of Official Foreign Exchange Reserves (COFER), Sept. 30.   

Arvind Subramanian, 2011a, “Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition.” Working Paper Series No. 11-14 (Washington, D.C.: Peterson Institute for International Economics, September).   

——. 2011b. Eclipse: Living in the Shadow of China’s Economic Dominance (Washington, DC: Peterson Inst. for Int.Econ.).


[This is an extended version of a Project Syndicate op-ed.  Comments can be posted there.]