Monetary and fical policy cooperation in a liquidity trap

We are living interesting times in terms of macroeconomic policy: the world faces big shocks and substantial challenges, and many current circumstances have no historical precedents. This means that policy makers cannot draw from experience and need to invent new policies from somewhere better than their guts. And after a few hesitations, theory is now in much better shape to answer questions from policy makers. For example, what should one do when there is a liquidity trap in a globalized economy, especially if the trap itself is globalized?

David Cook and Michael Devereux show how, and it borders on a political miracle. Not only does one need to get the cooperation of fiscal and monetary authorities (something the US is not close to acheiving) but one needs the cooperation across countries even if it entails some costs to the "winners" (something the Chinese have so far refused and the Swiss recently abandoned).

Specifically, Cook and Devereux show that with so many countries currently with negative real interest rates, we have a worldwide liquidity trap. In an open economy, the policy prescription differs from a closed economy. If there is a negative demand shock, fiscal policy needs of course to raise aggregate demand, but with a global economy, this can come from anywhere in the world and thus a coordinated fiscal policy is due. But to channel the impulse to the relevant countries, monetary policy coordination is necessary to raise interest rates in the foreign countries, even if they are in a liquidity trap. And this takes some serious courage. One can always dream.

What if the US looses its reserve currency privilege?

Since the Bretton Woods agreement in 1945, the United States have enjoyed the so-called "Exhorbitant Privilege." During the fixed exchange rate regime, the US could conduct monetary policy without regard to what was happening in other countries. The US dollar was a reserve currency, which also helped the US maintain low interest rates and a guarantee that US dollars (and Treasury bonds) would always find a buyer. With flexible exchange rates, not much has changed. But with the recent shenanigans in a Congress that considered reneging on its debt, the likelihood of this advantage changing has dramatically increased. What would the consequences of the loss of the Exhorbitant Privilege be?



Wenli Cheng and Dingsheng Zhang study this scenario using a general equilibrium model where a peripheral country (say, the Asian economies) pegs its currency to the money of a central country (say, the United States), the latter being used as the vehicle currency for international trade. In addition, the foreign exchange reserves of the periphery are invested in government bonds of the center. This means that no matter what current account deficit of the center, it is always financed by the periphery. Yet the center may be tempted to inflate it away. This limitless and to some extend free borrowing is the Exhorbitant Privilege.



Now remove it by assuming that the periphery does not want to invest in the center, either because it views the Treasury bonds are excessively risky or because it does not peg to the dollar any more. This would lead to a dramatic readjustment of the terms of trade to favor the tradable sector of the center. This decpraciation of the dollar would be more pronounced of the center is incapable of raising taxes and finances its debt with inflation. This already all sounds familiar.

Trade constraints of developing countries

With all the current posturing in the US and Europe, while addressing doubtlessly important problems, it is easy to forget that there are much bigger issues that need to be solved: how to get the poor and especially the poorest economies to a decent standard of living. We have been blessed to be born in the right families and in the right countries, and we should share this luck with those who were no so fortunate. This does not necessarily mean to give to the poor, just giving them a fair chance may be enough.

Jean-Jacques Hallaert, Ricardo Cavazos Cepeda and Gimin Kang consider the consequences of trade barriers on developing economies. The latter should be able to benefit greatly from selling on world markets goods produced with the factor they are relatively rich of, unskilled labor and to some extend land, while importing the complementary goods, likely capital-intensive investment goods. This OECD study finds that developed economies cannot do much more in terms of reducing import tariffs. Where there is more potential is with home-grown issues: unreliability of electricity, high transportation costs, poor education, bad governance, and instability. These results have been obtained by regressing exports, imports or their sum on a number of indicator for a panel of data. I am not particularly keen on these exercises due to poor data quality, gigantic endogeneity and especially the fact that proxies for essentially unquantifiable variables are used, like property rights and governance. But I suppose this is the best one can do, and the results appear to be rather stark. Now as to how to solve these economic problems, that is a gigantic task that we should be really talking about these days, instead of posturing for political gain.

Shortsightedness and tariffs

International trade theory is in large part about optimal trade theory, yet it is incapable to explain the observed level of tariffs. While under rather general circumstances theory will tell you that zero tariffs will improve general welfare, once you take into account that governments threaten and negotiate in a Nash equilibrium, tariffs should be at about 30%. They are generally far below that. It is a big challenge to explain the difference.

Mario Larch and Wolfgang Lechthaler argue that all that is needed is for trade theory to finally catch up with the rest of economics and use some dynamics. Specifically, transform the problem into a dynamic Nash equilibrium, take into account transition paths, and you get some realistic numbers if you assume that the negotiating politicians are short-sighted, which is certainly not far from the truth. This is important because the various transitional effect of a tariff change take different times. Indeed a decrease in tariffs has a faster and positive impact on consumption through an immediate increase in consumption. A counter-effect through the closing of inefficient firms takes much longer. Impatient politicians discount heavily the latter.

Cross-border banking and financial stability

Should banks be allowed to do business across borders? The answer is not obvious. For one, it is beneficial that they have the opportunity to better diversify their risks, but they can do this without having to open branches in other states or countries. The counterpart is that doing business elsewhere increases opportunities for adverse shocks. Finally, regulatory competition in an international banking market leads to a large systemic risk.

Dirk Schoenmark and Wolf Wagner try to sort this out in the case of Europe and come to the conclusion that it depends. They argue that Germany and the UK are well diversified and thus can sustain cross-border banking, even though there appears to be overexposure to the US, as exemplified by the large negative consequences in Europe of the recent crisis in the US. For the countries on the fringes of Europe, though, there seems to be very poor diversification. Indeed, these economies seem to be very dependent on a few large foreign banks, and consequences could be dire if they run into difficulties or decide to pull out.

This analysis is entirely based on asset shares and thus diversification. This neglects a major advantage of foreign banks: they bring lending capital that would otherwise not be available. The case for cross-border banking is thus understated in this paper.

Should there be international trade in pollution rights?

A basic principle in Economics is that of comparative advantage: a country will produce the goods that it is relatively better at producing, even it is bad at it. The traditional story usually includes relative endowments in capital and labor, and the capital intensity of goods matters. Now add environmental externalities. Comparative advantage would say that polluting production should take place were pollution is the "cheapest," that is. where it would have fewer consequences. This is the principle being the introduction of an international market for pollution rights. Such markets are already active within countries, with the idea that firms that can best control pollution will produce the polluting goods, as they need fewer pollution rights. Would this basic principle also hold across countries?

Jota Ishikawa, the late Morihiro Yomogida and Kazuharu Kiyono claim that it is not necessarily beneficial to have an international market. Indeed they point out that rich countries could import pollution rights from the poor countries, thereby further deteriorating the environment in the developed economies. So instead of relocating production, pollution is imported. It all depends on comparative advantage.

Using the WTO to overcome a prisoner's dilemma

It looks like the threat of competitive increases in trade tariffs has vanished, at least for the moment, as economies are getting back in shape. This episode highlighted how tariffs are part of a prisoner's dilemma: increasing tariffs is good for you, at least in the short term, as it gives more market share to local firms and/or more revenue to the state. But it hurts the foreign country, and if everybody does it, joint welfare is reduced because of the lower gains from exchange, the misallocation of productive resources and the loss of competitiveness of protected industries. It is precisely because of this prisoner's dilemma that the GATT (General Agreement on Tariffs and Trade) and then the WTO (World Trade Organization) were put in place.

Renee Bowen takes this reasoning further by looking a at a multilateral prisoner's dilemma, and interestingly the optimal institution that emerges looks very much like WTO's dispute settlement mechanism, in that countries cannot retaliate while a dispute is being settled. The key is that once a large enough number of countries participate in the WTO, the threat of sanctions is sufficient to obtain settlement and nobody is compelled to jump the gun with retaliations.