Currency Wars: The Euro Crisis & Global Outlook in 2012 Jeffrey Frankel Harpel Professor of Capital Formation &

1. Currency Wars:The Euro Crisis &Global Outlook in 2012Jeffrey FrankelHarpel Professor of Capital Formation & Growth, Harvard University Macquarie Securities Boston, March 1, 2012

2. Origin of “Currency Wars,” Fall 2010 • Warning from Brazil’s Finance Minister Guido Mantega(9/27/2010): “We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness.” • I.e., countries everywhere are trying to push down the value of their currencies, to gain exports & employment, • a goal that is not globally consistent.

3. Currency Wars, Fall 2010 • Two advanced countries had recently fought strong appreciations of their currencies by selling them in forex intervention: • Japan • Switzerland

4. Renewed flows to emerging markets in 2010had met with $ purchases in FX intervention Brazil, Korea, Thailand, Peru … By 2011, even Chile, the cleanest of the floaters, was intervening to dampen appreciation. Currency Wars chronology,continued

5. Currency Wars,continued • China had long been intervening to prevent the RMB from appreciating. • The U.S. tried to enlist help from countries like Brazil in pressuring China to abandon its undervaluation. • The Brazilian Minister’s response: The $ is as much a part of the problem as the RMB. • He was referring to QE2 that fall, which like any other monetary easing could be expected to depreciate the $. • More attacks on Fed action -- • China & Germany: $ depreciation is a deliberate salvo in currency wars • Sarah Palin, Rick Perry & John Taylor: QE2 “debauches the currency.”

6. Today, in 2012, Currency Wars look different • As in a real war: • at first it seems to be about boldness, clever strategic moves, & strength of will. • In practice, wars often turn out less uplifting: • You are shooting yourself in the foot.

7. It’s a tough call Who is screwing up its debt crisis worse: Europe or the US? -- US News & World Report, 11/07/2011 • On the one hand, Europe is much closer to full-fledged crisis. Debt problems in Mediterranean members: • are insoluble at current interest rates, • are pushing Europe back into recession, and • could well result in one or more countries forced to leave the euro. By contrast, there is no true fiscal crisis in US yet; the world’s investors are still buying lots of US bonds at low interest rates.

8. Who is screwing up its debt crisis worse: Europe or the US? – continued • On the other hand, mistakes by US politicians are more gratuitously self-inflicted than across the Atlantic. • In 2001, all we had to do was continue the 1990s’ fiscal progress: • preserve the budget surplus and move on to address the longer term problems of social security & Medicare in a deliberate balanced manner.  • Instead we recklessly enacted huge tax cuts and tripled federal spending growth, in ways guaranteed to generate serious fiscal troubles ten years into the future.  • The debt-ceiling standoff, summer 2011,was but the latest self-inflicted wound, • new evidence that the American political system was not functioning, • which led to the US credit rating downgrade.

9. Greece & the Euro Crisis: Seven Mistakes

10. 7 mistakes made by euroland’s leaders regarding Greece • Slender rays of hope: • The hour of the technocrats • Proposals for the future

11. 3 mistakes made by euro architectsbefore the crisis • Admitting Greece to the € in the first place, • and other countries that were not yet ready -- • neither by traditional Optimum Area Currency criteria • incl. cyclical correlation & labor mobility, • nor by Maastricht criteria, • esp. fiscal criteria: • BD < 3% of GDP & Debt < 60% of GDP. • Pretending after 1999 to enforce the fiscal criteria • via the Stability & Growth Pact. • Allowing Mediterranean countries’ bonds spreads ≈ 0, • helped by investors’ under-perception of risk (2003-07) • and artificial high credit ratings. But also by • ECB acceptance of Greek bonds as collateral.

12. The Treaty of Maastricht (1991) surprised many economists by emphasizing fiscal criteria as qualifications for membership. Why did the designers do it? • Theory I: Jason & the Golden Fleece • Theory II: Theseus& the stone • Theory III: Odysseus & the mast. Frankel, Economic Policy (London) 16, April 1993, 92-97.

13. The motivation fortheMaastrichtfiscalcriteria • was the same as for the No Bailout Clause • and the Stability & Growth Pact (1997): • Skeptical German taxpayers believed that, before the € was done, they would be asked to bail out profligate Mediterranean countries. • European elites adopted the fiscal rules to demonstrate that these fears were groundless.

14. After the euro came into existence • it became clear the German taxpayers had been right • and the European elites were wrong. • E.g., Greece persistently violated the 3% deficit rule. • The large countries violated the rule too. • SGP targets were “met” by overly optimistic forecasts. • SGP threats of penalty had zero credibility. • Yet each year the ostrich elites stuck their heads deeper & deeper into the sands.

15. The Greek budget deficitnever got below the 3% of GDP limit,nor did the debt ever decline toward the 60% limit

16. Yet spreads for Italy, Greece, & other Mediterranean members of € were near zero, from 2001 until 2008. Market Nighshift Nov. 16, 2011

17. When PASOK leader George Papandreou became PM in Oct. 2009, • he announced • that “foul play” had misstated the fiscal statistics under the previous government: • the 2009 budget deficit ≠ 3.7%, as previously claimed, but > 12.7 % !

18. Missed opportunity • The EMU elites had to know that someday a member country would face a debt crisis. • In early 2010 they should have viewed Greece as a good opportunity to set a precedent for moral hazard: • The fault egregiously lay with Greece itself. • Unlike Ireland or Spain, which had done much right. • It is small enough that the damage from debt restructuring could have been contained at that time. • They should have applied the familiar IMF formula: serious bailout, but only conditional on serious policyreforms & PrivateSectorInvolvement.

19. But the ostriches stuck their heads ever further down in the sand. Mistakes #4 & #5: when the crisis hit, leaders buried their heads in the sand: • 2 years ago, sending Greece to the IMF was “unthinkable.” • 1 year ago, restructuring the debt was “unthinkable.”

20. What is wrong with the current debate? • Mistake #6: • 6a: Talking as if a “big bazooka” bailout alone can solve the problem. Or • 6b: Talking as if austerity alone can solve the problem, • which is related to the belief in some places that fiscal contraction is expansionary. • Republican politicians say it, but (from their actions) don’t appear actually to believe it. • UK politicians appear actually to believe it. • & some other Europeans.

21. Any solution to the euro crisis must include a way to prevent repeats in the long term. • German taxpayers are no more supportive of a “transfer union” than ever. • This means finding a way to prevent moral hazard • as the Maastricht architects knew all along -- • preventing individual countries from running big deficits & debts, expecting to be bailed out in the event of a crisis. • Merkel’s “fiscal compact” is the 7th mistake: • yet another declaration of determination to strengthen the SGP, • incl. via budget limits in national laws/constitutions.

22. Perhaps the Fiscal Compact misunderstands the US system • Yes, despite a common currency, the 50 states do not have moral hazard: • the federalgovernment has never bailed one out, • and nobody expects it to do so now. • But that is not because of the budget rules that (49 of) the states have. • Their rules are voluntary, varied, and flexible. • Some states do have debt troubles, • and even default.

23. How the US avoids moral hazardin the 50 states • The principle was established in 1840 when the federal government refused to save 8 states from default. • Government spending at the state level is a far smaller share of income than at the federal level, • let alone on the part of European states. • Is Europe ready for that? No. • When one state begins to run its debt too high, the private market automatically imposes an interest rate penalty. • E.g., California today. • Gives states the incentives to get back in line. • This mechanism conspicuously failed from the euro’s 1st day. • which showed that moral hazard had not been addressed.

24. Slender rays of hope, #1 • Greece, Ireland & Portugal did finally go to the IMF; Germany & banks did finally agree to write down Greek debt. • But it has always been much too little, too late. • The only solution for the short-term: • more money • from ECB & national governments, perhaps via IMF • conditional on reforms + PSI, country-by-country.

25. Slender rays of hope, #2: The Hour of the Technocrats • A government of technocrats under Mario Montiin Italy is a huge improvement over the disaster of Berlusconi. • Similarly Lucas Papademos in Greece • But he has been given even less freedom of action than Monti: his term is very short and he wasn’t allowed to pick his cabinet.

26. Mario Draghi became President of the ECB, Nov.1, 2011 • He was under intense pressure to expand his predecessor’s purchases of large quantities of periphery-country bonds. • The ECB was urged to be the “big bazooka”: • to play the role of “lender of last resort,” an abuse of that term, • which is supposed to refer to back-stopping banks, not countries. • If the ECB interpreted its mandate literally, as no more than keeping inflation low, then the euro might break up. • On the other hand, as Draghi knew: • the ECB is legally prohibited from financing governments directly. • If he had quickly bailed out Italy & the others, he would have: • facilitated a continuation of Berlusconi-style irresponsibility; • been immediately written off by Germans as another profligate Italian.

27. So far, Draghi’s LTRO (Longer-Term Refinancing Operation) has been a brilliant success. • On Dec.22, he caught everyone by surprise by the clever ploy of doing exactly what he had previously announced he would do: • loans to banks for 3 years, at low interest. • High take-up: €489b, 523 banks • especially in troubled countries. • No stigma. • Brought down interbank spreads & country spreads, • while consistent with central bank LoLR mandate.

28. 2nd LTRO, February 29 • Some 800 banks took up €530 b of loans at the 2nd round on Wednesday, • borrowing at 1% for 3 years • with almost any form of collateral. • Citigroup: = €316 b of fresh liquidity, • stripping out renewal of old loans. • Vs. €200 b in extra stimulus at the 1st LTRO • Totalling $1 trillion.

29. My guess Greece will make it past March 20, with usual 3-part formula of bail-out + conditionality + PSI ; but then will default within a year. Greece cannot get back to a sustainable debt path by austerity, as has been clear for awhile. When it succeeds in eliminating its primary budget deficit, it will have no more incentive to keep servicing debt. Possibly Portugal as well.

30. Silver linings of procrastination? • By then, Greece (& Italy et al) may finally have made some of the structural reforms they need, • such as opening up professions , • which can only be done under pressure. • Perhaps EU banks, including those that have written CDSs, will have used the time to provision • making themselves less vulnerable to default. • Analogy would then be to the international debt crisis of 1982: International creditor banks used the lost decade to reduce exposure, • until they were able to mark to market in 1989 (Brady plan). • But I agree with the Macquarie paper on European Banks (Jan. 25) that a better analogy may be Japan’s lost “decade,” 1990-2003, when “prolonging the crisis to give banks time to solve the problems ‘inevitably raised the cost of the final resolution [IMF, 2000] ’.”

31. Risk of contagion is highnot just to rest of euro periphery, but to rest of world. • The outlook • The U.S. recovery, though weak, • has become more fully established. • Who is vulnerable? w

32. OECD Economic Outlook Nov.28, 2011

33. Growth to be sustained by non-OECD Contribution to annualised quarterly world real GDP growth, percentage points World growth OECD Non-OECD Note: Calculated using moving nominal GDP weights, based on national GDP at purchasing power parities. Source: OECD Economic Outlook 90 database. OECD Economic Outlook Nov.28, 2011

34. Obama Inauguration End of recession Jan. 2007 – Dec. 2011, monthly, estimated by Macroeconomic Advisers Source: Macroeconomic Advisers www.macroadvisers.comMon

35. End of recession Obama Inauguration Data Source: U.S. Bureau of Labor Statistics

36. U.S. economic news so far in 2012 has been better than 2011 • Recent statistics: • Unemployment has declined to 8.3% • Growth in Q4 2011 revised up to 3.0% (2/29/12) from 2.8 % • Blue Chip Economic Indicators survey (February) consensus forecast for 2012 GDP growth:Q1 = 2.1 %, Q2 = 2.2 %, Q3 = 2.4 % , Q4 = 2.6 %. • Bernanke’s testimony (2/29/12) was interpreted negatively. • GDP growth in the next few quarters "at a pace close to or somewhat above" the 2 ¼ % seen in the 2nd half of 2011. • Estimates by members of the FOMC range from 2.2 to 2.7, • in the new communications strategy for more transparency.

37. Possible risks to the scenario in 2012 • Euroland: Worsening of sovereign debt crisis • and contagion overseas. • US • new debt ceiling standoff • Emerging markets: hard landing • particularly in China. • Major oil crisis • from military confrontation with Iran.

38. The downside scenario Intensification of euro-area crisis and excessive US fiscal consolidation Downside scenario Downside scenario Baseline Source: OECD calculations. OECD Economic Outlook Nov.28, 2011

39. Sovereign debt worries... • Who is vulnerable? • The emerging market countries are in much better shape than past decades, • in an amazing & historic role reversal.

40. A remarkable role-reversal: • Debt/GDP of the top 20 rich countries (> 80%) is already more than twice that of the top 20 emerging markets; • and rising rapidly. • Nor are the EMs necessarily less “debt tolerant” for a given debt/GDP • as Reinhart & Rogoff thought not long ago.

41. Country creditworthiness is now inter-shuffled “Advanced” countries (Formerly) “Developing” countries AAA Germany, UK Singapore AA+ US, France AA Belgium Chile AA- Japan China A+ Korea A Spain Malaysia, South Africa A- Brazil, Thailand, Botswana BBB+ Italy Colombia BBB- Iceland, Ireland India BB+ Indonesia, Philippines BB Portugal Costa Rica, Jordan B Burkina Faso CC Greece S&P ratings, Feb.2012 domestic currency

42. WhatDetermines CountryVulnerability? Fundamentally: Quality of institutions. This does not mean “tough” rules – like SGP, debt ceiling or BBA – which lack enforceability. Better would be structural budget targets (Swiss) with forecasts from independent experts (Chile). One third of developing countries since 2000 have graduated from pro-cyclical spending to countercyclical, even while US, UK & euro countries have forgotten how to run countercyclical fiscal policy, and instead enact fiscal expansion in booms & contraction after recessions.

43. Correlations between Govt. Spending & GDP 1960-1999 } Adapted from Kaminsky, Reinhart & Vegh, 2004,“When It Rains It Pours” procyclical Pro-cyclical spending countercyclical Counter-cyclical spending G always used to be pro-cyclical for most developing countries.

44. Correlations between Govt. Spending & GDP 2000-2009 procyclical Frankel, Vegh & Vuletin (2011) In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy:Negative correlation of G & GDP. countercyclical

45. It’s not so much the levelof debt/GDP that matters as the risk of getting stuck on an explosive path, with ever-rising debt/GDP because of high primary deficit or interest rates (or low growth), or risk of a sudden deterioration. Early Warning indicators: composition of capital inflows Fx-denominated, ST, bank loans vs. FDI, equity & contracts with automatic adjustment provisions. Plus real currency overvaluation, fx reserves (for peggers)… Fiscal capacity.

46. Early Warning Indicators: Reserves • When the 2008-09 global financial crisis hit, • those countries that had taken advantage of the 2003-08 boom to build up reserves did better. • Frankel & Saravelos (2010). • Aizenman (2009) and Obstfeld, Shambaugh & Taylor (2009) • Vs. Blanchard (2009) and Rose & Spiegel (2009) • This had also been the most common finding in the many studies of Early Warning Indicators in past emerging market crises.

47. The variables that show up as the strongest predictors of countrycrises in 83 pre-2009 studies: (i) low reserves and (ii) currency overvaluation Early Warning Indicators Source: Frankel & Saravelos (2010)

48. Best and Worst Performing Countries -- F&S (2010), Appendix 4

49. F & Saravelos (2010):Multivariate

50. New lesson regarding exchange rate regimes • Old conventionalwisdom: The choice was between • fixing (changes in reserves; not in exchange rate) vs. • floating (changes in exchange rate; no reserves). • Now it appears that: • Intermediate regimes are indeed viable. • Holding reserves and floating are both useful.