58315 POVERTY THE WORLD BANK REDUCTION AND ECONOMIC MANAGEMENT NETWORK (PREM) Economic Premise DECEMBER 2010 · Number 43 JUNE 2010 · Number 18 Trade and the Yesterday and Today Currency WarsCompetitiveness Agenda José Guilherme Reis and Thomas Farole Milan Brahmbhatt, Otaviano Canuto, and Swati Ghosh The global economic crisis has forced a major rethinking of the respective roles of governments and markets in the processes of trade on growth. Indeed, industrial policy seems to up in recent months, stoked by a talking about An energetic debateandthe danger of a global currency war has flaredbe back in fashion--or, at least,renewed move toit is. But a renewed "activism" United States, resurgenttrade and growth agenda need not mean a return to old-style on "quantitative easing" in the by government in the capital flows to developing countries and strong upward pressure emergingof import substitution and "picking winners." Instead,of the arguments and concludes thatcompetitiveness by policies market currencies. This Economic Premise reviews some it may mean a stronger focus on the current U.S. unlocking the constraints insurance sector­led growth. This note deflation. But it is increasing government in trade monetary easing is a useful to private policy against the risk of globaldiscusses the renewed role ofpressure on developing and growth policy from the competitiveness angle, and it suggests some priorities for as new competitiveness agenda. countries to move toward greater monetary policy autonomy and exchange rate flexibility,the well as to undertake the institutional and structural policies needed to underpin such flexibility. Such reforms will take time. Export-Led Growth, the Crisis, currency End An energetic debate on the danger of a globaland thewar has of the crisis on the them environment regarding trade pacts Another school--call policy"deflation hawks"--sees it differ- of an Era flared up in recent months, stoked by a renewed move to "quan- ently. They think the main problem facing Indeed, in addi- and growth were becoming more apparent.developed econo- titative easing" in the United States, resurgent capital flows to mies is weak aggregate over the global remains mediocre and tion to raising concerns demand. Growthcommitment to trade The dramatic expansion in global trade over on emerging developing countries and strong upward pressure recent decades unemployment crisis has as the political consensus for fiscal liberalization, thehigh, even also led to some serious rethink- has contributed significantly to schools of thought have market currencies. At least two diversification, growth, and ing of some of the conventional wisdom regarding the stimulus has dissipated. The monetary easing undertaken by poverty reduction in exchange rate tensions. One roots these emerged on the presentmany developing countries. This period the Federal Reserve most important result stronger domes- growth agenda--theaims primarily to stimulateof which is the of rapid the problem of has imbalances. Even though cur- tensions inexport growthglobalbeen enabled by two critical tic consumption and investment play a much more activist likelihood that governments willand avert the danger of a self- structural changes in global trade: (1) the vertical and spatial rent account imbalances in China and the United States have role in the coming years. There are three principal reasons reinforcing deflationary spiral between falling prices and weak- fragmentation of since their precrisis peaks, political ten- fallen by around half manufacturing into highly integrated ening aggregate demand that would lead actively involved in why governments are likely to be more to a prolonged period "global production networks," and (2) the rise of services sions over the dollar-renminbi alignment have escalated none- of stagnation or recession, in the coming years. industrial and trade policy as in the Great Depression or in Ja- trade and the growth "global imbalances school," the aim turn, theless. According to theof "offshoring." Both of these, in of First, the the has undone faith in markets and discred- pan duringcrisislast two decades. The weaker dollar is then a were made possible the Federal Reserve is to stimulate the quantitative easing by by major technological revolutions; and side effect of easing. In the deflation hawks' view, the argument ited laissez-faire approaches that rely simply on trade policy U.S. economy primarily by devaluing the dollar, increasing ex- they were supported by multilateral trade policy reforms that competitive devaluations led to increased protectionism liberalization. Instead, governments and local markets have and broad liberalizations trade deficit. trade a "beggar-thy- ports, and reducing the U.S. in domestic This is and investment during the Great Depression is a misreading of history. From been "rediscovered." In this sense, the demand for activist neighbor" policy, it is said, because it attempts to switch global environments worldwide. the perspective of to go well beyond today, the U.S. mone- government is likelydeveloping countriesfinancial markets and The global economic crisis came crashing to the United aggregate demand away from the rest of the world into the middle tary easing has will affect the policy addition to adjustment regulation, and it significant benefits in environment in which States. Other countries will resist through competitive devalua- of this long-running export-led growth party during 2008 costs. Developing countries have a number of trade and industrial strategies are designed. policy options to and of their own. Such currency wars of global demand will tions2009. Between the last quarterover2007 and the second facilitate adjustment. Finding the policies best suited to their Second, the crisis has highlighted the critical importance foster protectionism, harming all concerned, similar to the own needs is one of the important policy challenges facing quarter of 2009, global trade contracted by 36 percent. But of diversification (of sectors, products, and trading partners) Great Depression of the 1930s. countries today. 1 as the recovery started to strengthen in 2010 (at least until in reducing the risks of growth volatility. The recent era of the clouds began to form over Europe), the longer-term im- globalization contributed to substantial specialization of 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise Deflation Risks Figure 2. U.S. Inflation Expectations 2.50 The Federal Reserve's decision to loosen was made in light of a stream of data documenting continued deflationary pressures Bernanke August 27, 2.25 2010, speech in both the United States and other developed economies over the course of 2010. Core consumer price inflation in the Unit- 2.00 ed States fell below 1 percent in the spring and dipped to 0.6 inflation percent in October, the smallest 12 month increase in the his- 1.75 tory of the index, since 1957. Core inflation has also fallen to less than 1 percent in leading Euro area economies such as Ger- 1.50 many and France, while core consumer prices are actually fall- 5 year 1.25 ing at a 1.5 percent pace in Japan (figure 1). Perhaps equally 10 year worrying was the sharp fall over the spring and summer in long- term inflation expectations, as measured by the spread between 1.00 Jan 1 Feb 1 Mar 1 Apr 1 May 1 Jun 1 Jul 1 Aug 1 Sep 1 Oct 1 Nov 1 and nominal and inflation adjusted yields on U.S. government bonds (figure 2). 2010 The recent disinflation is consistent with trends in the real Source: Federal Reserve Bank of St. Louis, FRED database. economy. Unemployment remains close to recession highs, Note: Spread between nominal and inflation adjusted yields on U.S. Treasury running at 9.8 percent in the United States and just over 8 per- Bonds. cent in the Euro area. Real gross domestic product (GDP) growth in the United States slipped to a mediocre 2.1 percent (q-on-q) average in the second and third quarters, not enough to The key concern about deflation arises because nominal in- make a dent in unemployment. Estimated potential output terest rates cannot fall below zero. Significant price deflation gaps remain at about 5 percent in the United States and Japan (even if completely anticipated) means that real interest rates and 3 percent among major European economies (IMF 2010a). will remain high despite recession, further depressing demand Why is deflation a concern? The worry is not a temporary and employment. episode where prices fall for a few quarters; it is when deflation Deflation increases the real burden of households' and becomes self-sustaining, pushing aggregate demand lower, firms' net nominal debts. Debt deflation increases financial dis- which in turn causes further deflation. There are several chan- tress, causing households to cut consumption and firms to cut nels for this process: investments or go out of business. Financial sector fragility in- creases as the nominal value of bank collateral and borrowers' debt-servicing capacity falls. Although some creditors may gain from deflation, bankruptcies and restructurings destroy real Figure 1. Core CPI Inflation resources. 3 Rising fragility worsens asymmetric information problems Germany in financial markets, leading to more severe credit rationing, in- Japan United States creases in corporate credit spreads, and further financial fragil- 2 ity among banks and other financial institutions. Policy Response to Deflation Worries 1 The Federal Reserve has deployed several instruments in re- inflation sponse to the crisis. Special facilities were established to provide 0 low-cost liquidity to banks. The policy interest rate has been close to zero since December 2008. The Federal Reserve also undertook large-scale purchases of long-term government secu- -1 rities between December 2008 and March 2010 to reduce long-term interest rates (the previously mentioned "quantita- Q1 2005 Q3 2005 Q1 2006 Q3 2006 Q1 2007 Q3 2007 Q1 2008 Q3 2008 Q1 2009 Q3 2009 Q1 2010 Q3 2010 -2 tive easing"). At the end of August, Federal Reserve Chairman Ben Bernanke indicated that the central bank would consider renewed easing of this type because of worries about disinfla- Source: Organisation for Economic Co-operation and Development (OECD) Main tion and deflation. The new program began in November. Economic Indicators. Note: Data are for Q1 2005 to Q4 2010 (Q4 2010 is October only); percent change One of the arguments raised against the Federal Reserve's from a year ago. All items, nonfood, nonenergy. new program is that it is a beggar-thy-neighbor policy aimed at 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise devaluing the dollar. This note has cited reasons to think that the central bank is easing primarily to strengthen U.S. domestic Box 1. "Competitive Devaluation" and the End of the Gold demand and ward off deflation, with a weaker dollar being a Standard in the Great Depression side effect. It is also noteworthy that the Federal Reserve is not In their classic study of U.S. monetary policy, Friedman intervening in the foreign exchange market to weaken the dollar. and Schwartz (1963) put the main blame for the Great Box 1 reviews the argument that beggar-thy-neighbor competi- Depression of the 1930s on a mistaken, excessively tight tive devaluations were a primary factor in the Great Depression. stance by the Federal Reserve. As the Depression became worldwide, many countries were forced out of the global Another argument is that high unemployment does not re- fixed exchange rate regime known as the gold standard. flect lack of aggregate demand, but mostly structural factors A common, traditional interpretation of these competitive such as increased skill and geographical mismatches. In this devaluations is that they were counterproductive case monetary easing might only fuel inflation rather than re- beggar-thy-neighbor policies that only worked by taking duce unemployment. However, while these structural factors international markets away from other countries. Scholarship over the last several decades has largely have undoubtedly had some impact on unemployment, recent corroborated Friedman and Schwartz's emphasis on the studies generally find that the cyclical shortfall in aggregate de- importance of monetary factors in the Great Depression, mand accounts for the bulk--two-thirds to three-quarters--of but not the traditional interpretation of competitive the rise in U.S. unemployment (Loungani 2010; Valletta and devaluation (Bernanke [1993]; Eichengreen and Sachs [1985]; Eichengreen [1992]; Eichengreen and Irwin Kuang 2010). [2009]). The newer research instead emphasizes the role A different criticism is that the proposed $600 billion pro- of the gold standard itself in initiating and propagating gram of asset purchases will only have a minor impact on long- the global slump. Faced with an enormous shortfall in term interest rates and therefore a minor impact on demand. aggregate demand and persistent deflation, countries This overlooks the main channel through which the Federal Re- on the gold standard had no independent monetary serve aims to affect demand, which is by raising inflation expecta- policy instrument with which to reflate economies. tions so as to achieve low and possibly even negative real interest Countries that abandoned the gold standard earliest-- that is, devalued--also experienced earlier recovery rates for a time. Starting with Mr. Bernanke's August 27, 2010, from recession, not only because of stronger exports, speech at Jackson Hole, Federal Reserve officials have made it but also because they had more room to expand money clear they consider current inflation--a mere 0.6 percent core supply and cut interest rates. Meanwhile countries that rate in October--too low to be consistent with the Federal Re- stuck with the gold standard were also the ones that-- serve's mandate of full employment and price stability (Bernan- in desperation--resorted most to protectionism as a way ke 2010a). For the first time the Federal Reserve has made ex- to try and boost demand. The optimal policy response to the Great Depression, in this view, should have been a plicit that its mandate-consistent inflation rate is about 2 percent. coordinated, unsterilized devaluation against gold by all Do central banks have the tools to prevent or reverse de- countries suffering deflation. In effect, this would have flation? been a coordinated global monetary easing, but without the beggar-thy-neighbor effects on trade. Some observers have concluded that when the central bank's policy rate falls to zero--its practical mini- mum--monetary policy loses its ability to further stimulate aggregate demand and the economy...this conclusion is clearly mistaken. Indeed, under a fiat ministration's 1933 decision to abandon the gold standard and (that is, paper) money system, a government (in prac- reflate the price level to pre-Depression levels. tice, the central bank in cooperation with other agen- cies) should always be able to generate increased nom- Implications and Options for Developing inal spending and inflation, even when the short-term Countries nominal interest rate is at zero. (Bernanke 2002) The U.S. policy of renewed monetary easing has both potential The latest quantitative easing is therefore best seen as a way benefits and costs for developing countries. Among the bene- to underline the Federal Reserve's credibility in setting a target fits would be to help push back the risk of deflation that is stalk- for inflation and inflation expectations. Figure 2 provides in- ing much of the advanced world. Averting stagnation or re- triguing circumstantial evidence for the effectiveness of this newed recession in developed economies and in world trade approach: after falling all year, inflationary expectations (as would be a major plus for developing countries, whose econom- measured by bond spreads) swung upward right after Mr. Ber- ic cycles remain closely correlated with those in the developed nanke's August 27 speech. Eggertsson (2008) provides evi- world (Canuto 2010; Canuto and Giugale 2010). A second dence that the U.S. recovery from the Great Depression was major benefit would be to greatly reduce the threat of protec- driven by a change in expectations, following the Roosevelt ad- tionism in the advanced world, particularly in the United 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise States. The most plausible scenario for advanced country pro- are pegged. In this situation, importing loose U.S. monetary tectionism would be precisely a long period of deflation and policy will tend to stimulate excessive domestic money growth, economic stagnation, as in the 1930s. inflation in the goods market, and speculative bubbles in asset The U.S. push for monetary stimulus does create adjust- markets. In this case, adjustment will occur through high infla- ment problems in the rest of the world, however. In principle, tion (with its attendant efficiency and equity costs) and appre- the adjustment issue should be relatively easier in other devel- ciation of the real exchange rate. Countries may attempt to oped economies that are also experiencing high unemploy- avert some of these consequences by issuing domestic bonds to ment and are threatened by deflation. In this situation, there sterilize balance of payments inflows. But this course also has could be a rationale not so much for a currency war as for a co- disadvantages, for example, fiscal costs and a tendency to at- ordinated monetary easing across developed economies to help tract yet more capital inflows by pushing up local bond yields. ward off deflation while also reducing the risk of big exchange Countries may therefore be tempted to adopt a third option rate realignments among the major developed economies and try to combine an independent monetary policy with a (Portes 2010). fixed exchange rate by closing the capital account through capi- The case is more complicated for most developing coun- tal controls.2 Such controls may sometimes be a useful tempo- tries, which are experiencing much stronger growth and infla- rary expedient, but they are not unproblematic, especially in tionary rather than deflationary pressures. In this situation, the the longer term: U.S. easing poses more difficult policy choices by creating add- · Capital controls are only likely to be effective in conjunction ed stimulus for capital flows to developing countries, flows that with other supportive macroeconomic policies to form a have already been surging in 2010, attracted both by high consistent policy package. short-term interest rate spreads and the stronger long-term · Evidence suggests that the effectiveness of capital controls is growth prospects of developing countries. of limited duration, so they are best used when the surge of In pure form, there are three macro policy alternatives avail- capital inflows is deemed to be temporary. able to developing countries. · The effectiveness of controls depends on how extensive they The first is the option that a growing number of developing are, whether the country has the necessary administrative countries have been gravitating toward in the aftermath of the enforcement capacity, and on the incentives investors have emerging market crises of the late 1990s, which is to pursue to circumvent them. Circumvention is usually easiest and independent monetary policies that target their own inflation most lucrative the more sophisticated financial markets are and activity levels, combined with relatively flexible exchange in the recipient economy. rates and open capital accounts. Given rising inflation pres- · Evidence suggests that capital controls may be more effec- sures, the appropriate monetary policy in many developing tive in changing the composition and the maturity structure economies at present would likely be to tighten, which will of capital flows than in affecting the overall magnitude of however attract even more capital inflows and further appreci- the flows. ate exchange rates. Sustained appreciation raises concerns Table 1 lists some of the main types of capital controls and about loss of competitiveness and the sometimes contentious some evidence on their varying effectiveness. There is some evi- structural adjustments in the real economy that may then be dence that prudential measures that include some form of required. Rodrik (2009) also argues that undervalued real ex- capital control (such as a limit on bank external borrowing) change rates have long been a key development strategy because may be effective in reducing the volume of capital inflows, of the implicit subsidy they provide for modern tradable goods though their relevance depends on whether inflows are being industries, which, in Rodrik's view, have unique growth-en- channeled through the banking sector, on the prevailing macro- hancing properties. So countries may also fear that large appre- financial conditions, and whether banking sector fragility is a ciations will undercut their long-term growth potential. A stan- significant concern. Foreign exchange taxes can be somewhat dard recommendation for countries in this position is to effective in reducing the volume of flows in the short term, and tighten fiscal policy as a way of reducing upward pressure on can alter the composition of flows toward longer-term maturi- local interest rates and the exchange rate. ties. Unremunerated reserve requirements can also be effective A second pure option would be to maintain a fixed exchange in lengthening the maturity structure of inflows, but their ef- rate peg and an open capital account while ceding control of fectiveness diminishes over time. monetary policy as an independent policy instrument. This ap- Few countries follow one of these three regimes in pure proach tends to suit smaller economies that are highly integrat- form, and there is no regime that is necessarily correct for all ed both economically and institutionally with the larger econo- countries at all times. In practice, most developing countries my to whose exchange rate they are pegged. It is less appropriate combine the three in varying proportions, achieving, for exam- for larger developing countries, such as China, whose domestic ple, some (less-than-perfect) monetary autonomy combined cycles may be quite out of sync with the economy to which they with a "managed" flexible exchange rate. 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise Table 1. Effectiveness of Capital Control Measures Types of capital controls Volume of inflows Composition of inflows Foreign exchange tax Can somewhat reduce the volume in the short term. Can alter the composition of inflows toward longer- term maturities. Unremunerated Reserve Requirements (URRs): Have been effectively applied in reducing short- Typically accompanied by other measures term inflows in overall inflows, but their effect diminishes over time. Prudential measures with an element of capital Some evidence that prudential type controls can be control effective in reducing capital inflows. Administrative controls: These are sometimes used Effectiveness depends largely on existence of other in conjunction with URRs controls in the country. Source: Ostry et al. (2010); IMF (2010b). It is interesting to contrast two major developing econo- Conclusion mies as points on this continuum. China represents a point The current U.S. monetary easing is a useful insurance policy with limited exchange rate flexibility, backed by heavy ex- against the risk of global deflation. But it is increasing pressure change market intervention, low domestic interest rates, and on developing countries to move toward greater monetary poli- some capital controls. China is also experiencing the infla- cy autonomy and exchange rate flexibility, as well as to under- tionary pressures in goods and asset markets predicted by take the institutional and structural policies needed to under- theory. By now the potential macro-management benefits of pin such flexibility. Such reforms take time. What is needed in greater exchange rate flexibility and more monetary autono- global forums such as the G-20 is not necessarily immediate my are well appreciated by Chinese policy makers. But the radical action, but rather immediate incremental action, macroeconomic regime has also become intertwined with backed by credible commitment to substantial progress over deep structural imbalances--high investment relative to con- the medium term. This is needed as much from developed as sumption, corporate profits relative to wages, industry rela- from developing countries, for example, with continued ad- tive to services--each buttressed by vested interests and a com- vanced country macroprudential and financial sector regulato- plex political economy. Policy makers are also concerned ry reform that can help reduce the risk and improve the quality about the size and duration of transitional unemployment of capital flows to developing countries. caused by a downsizing of the tradable goods sectors. Thus the move toward macroeconomic policy reform and more ex- Endnotes change rate flexibility in China, while inevitable, is also likely 1. For statements regarding the "global imbalances" perspec- to be protracted. tive, see, for example, Roubini (2010) and Dadush and Eidel- Brazil, on the other hand, is an example of flexible exchange man (2010). For the "deflation hawk" perspective, see, for ex- rates, autonomous monetary policy and high international fi- ample, Wolf (2010), Eichengreen and Irwin (2010), and nancial integration, and is now experiencing a big exchange rate Hamilton (2010). surge and pressure on competitiveness. A rising current ac- 2. For further details see Ostry et al. (2010) and IMF (2010b). count deficit is raising concerns about the risk of a crisis later, in the event of a sudden stop in capital inflows. In this situation it References is understandable if the authorities turn to some combination Bernanke, Ben S. 1993. "The World on a Cross of Gold." Journal of Monetary of exchange market intervention, sterilization, and capital con- Economics 31: 251­67. trols to try and at least moderate or smooth the pace of appre- ------. 2002. "Deflation: Making Sure `It' Doesn't Happen Here." Remarks be- fore the National Economists Club, November 21. ciation. More fundamentally, Brazil may need to tighten fiscal ------. 2010a. "Speech at the Federal Reserve Bank of Kansas City Economic policy to cool overheating and reduce incentives for capital in- Symposium." Jackson Hole, Wyoming, August 27. flows. Deepening of capital markets and strengthening macro- ------. 2010b. "What the Fed Did and Why: Supporting the Recovery and Sus- taining Price Stability." Washington Post November 4. prudential and financial regulation can help improve the effi- Canuto, Otaviano. 2010. "Toward a Switchover of Locomotives in the Global ciency of capital allocation and reduce the risk of a build-up in Economy." Economic Premise 33. financial fragility, while better safety nets will reduce the costs Canuto, Otaviano, and Marcelo Giugale, eds. 2010. The Day After Tomorrow-- A Handbook on the Future of Economic Policy in the Developing World. Wash- of transitional unemployment. Again, many of these reforms ington, DC: World Bank. will take time to implement. Dadush, Uri, and Vera Eidelman. 2010. "How to Avoid a Currency War." Carn- egie Endowment International Economic Bulletin October 14. 5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise Eggertsson, Gauti B. 2008. "Great Expectations and the End of the Depres- Loungani, Prakash. 2010. "The Global Unemployment Crisis: Costs, Causes, sion." American Economic Review 98 (4): 1476­1516. Cures." The Globalist November 15. Eichengreen, Barry, and Jeffrey Sachs. 1985. "Exchange Rates and Economic Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mah- Recovery in the 1930s." Journal of Economic History 45: 925­46. vash S. Qureshi, and Dennis B.S. Reinhardt. 2010. "Capital Inflows: The Eichengreen, Barry. 1992. Golden Fetters: The Gold Standard and the Great De- Role of Controls." IMF Staff Position Note SPN/10/04. pression, 1919­1939. Oxford University Press. Portes, Richard. 2010. "Currency Wars and the Emerging-Market Countries." Eichengreen, Barry, and Douglas Irwin. 2009. "The Slide to Protectionism in VoxEU November 4. the Great Depression: Who Succumbed and Why." NBER Working Paper Rodrik, Dani. 2009. "Growth after the Crisis." Commission on Growth and 15142, July. Development Working Paper No. 65. ------. 2010. "How to Prevent a Currency War." Project Syndicate, October 12. Roubini, Nouriel. 2010. "Only the Weak Survive." Project Syndicate, October 14. Friedman, Milton, and Anna Schwartz. 1963. A Monetary History of the United Valleta, Ron and Katherine Kuang. 2010. "Is Structural Unemployment on the States. Princeton University Press. Rise?" FRBSF Economic Letter 34 (November 8). Hamilton, James. 2010. "Why Is the Fed Doing This?" Econbrowser, October Wolf, Martin. 2010. "The Fed Is Right to Turn on the Tap." Financial Times 13 2010. November 9. IMF (International Monetary Fund). 2010a. World Economic Outlook. October. ------. 2010b. Global Financial Stability Report. April. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduc- tion and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 6 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise