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Globalization and Monetary Policy Institute 2016 ANNUAL REPORT Federal Reserve Bank of Dallas Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 1 Contents Letter from the President 2 Oil-Rich Venezuela Tips Toward Hyperinflation 4 Q&A with Robert Kaplan and Lord Mervyn King 12 The Potential Impact of Decentralized Virtual Currency on Monetary Policy 20 Interactions Between Exchange Rates and Import Prices: What Have We Learned? 26 Conference on International Economics 32 Summary of Activities 2016 38 Institute Working Papers Issued in 2016 40 Institute Staff and Senior Fellows 42 Research Associates 43 Published by the Federal Reserve Bank of Dallas, April 2017. Articles may be reprinted on the condition that the source is credited and a copy is provided to the Globalization and Monetary Policy Institute, Federal Reserve Bank of Dallas, 2200 N. Pearl St., Dallas, TX 75201. This publication is available online at www.dallasfed.org. 2 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report Letter from the President i n last year’s letter, I wrote about the complexities of being a central banker at this point in our history. Developments over the course of 2016 reinforced that this is, indeed, a complex time. At the beginning of last year, Federal Open Market Committee (FOMC) participants (including me), on average, expected that we would raise interest rates four times during 2016. However, unexpected financial turmoil in China in the first quarter led to a rapid tightening in financial conditions globally that threatened to materially slow the U.S. economy. First- and second-quarter GDP readings were weak due to the financial turmoil as well as a deceleration in inventory builds by U.S. companies. The surprising June U.K. referendum result on Brexit also had an impact on the Fed’s risk-management stance. As a result, FOMC participants revised down their outlook for rate increases, and the Fed ultimately raised rates once in 2016. Due to the underlying strength of the U.S. consumer, U.S. gross domestic product (GDP) growth rebounded in the second half of 2016. Our economists at the Dallas Fed are currently forecasting in excess of 2 percent GDP growth in 2017. This is sluggish growth Due to the underlying strength of the U.S. consumer, U.S. gross domestic product (GDP) growth rebounded in the second half of 2016. by historical standards, but it should be sufficient to allow for further removal of labor market slack and steady progress in achieving the Fed’s 2 percent inflation goal. International Focus In 2016, I made a number of foreign trips to better understand some of the key issues confronting the global economy. I visited London in April and met with business and government leaders to get a better read on the Brexit debate. In August, I spent a week in China meeting with officials and business leaders to deepen my understanding of the transition that is underway there and the Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 3 challenges that Chinese policymakers are to do research that deepens our understand- facing. ing of the linkages between the U.S., Texas China is the world’s second-largest and Mexico. economy and has, in recent years, accounted for about a third of global growth. The coun- The Globalization Institute try is challenged by high levels of overcapaci- The Globalization Institute plays a key role ty in state-owned enterprises, high and rising in advancing our understanding of inter- levels of debt, and a growing issue of capital national economies and global economic outflows despite very strong capital controls. relationships. The core business product of As a result, our team at the Dallas Fed contin- the institute is its working paper series. These ues to closely monitor Chinese conditions. It papers are intended for eventual publication is our view that the world will have to become in peer-reviewed journals, which is a key accustomed to lower levels of Chinese GDP growth in the years ahead and that China’s metric of research success. The institute also has an important challenges will create increased vulnerability public outreach mission. Through our Global to financial turmoil, which could, in turn, Perspectives speaker series, the Dallas Fed have an impact on global financial condi- hosted a Trilateral Conference in February tions. that featured Governor Agustín Carstens We had several visits during the year of Banco de México and Governor Ste- with senior officials of the Banco de México phen Poloz of the Bank of Canada. We also as well as other senior government officials hosted former U.S. Treasury secretaries Hank and business leaders. There has long existed Paulson, Robert Rubin and Larry Summers, a very strong relationship between the Banco Harvard Business School Dean Nitin Nohria de México and the Federal Reserve Bank of and former Bank of England Governor Lord Dallas. The Eleventh District—Texas, north- Mervyn King. The Global Perspectives series ern Louisiana and southern New Mexico— will be a key part of our outreach initiative at has deep cultural and economic ties with the Dallas Fed in the coming years. Mexico. Mexico is Texas’ top trading partner. The world’s economies and financial markets are more interconnected than ever In 2016, Texas exports to Mexico were $92.7 before. The Federal Reserve Bank of Dallas’ billion, and it is estimated that these exports Globalization Institute will continue to do supported approximately 1 million jobs in comprehensive research that explores these Texas. Dallas Fed economists believe that linkages. Our thought leadership and public the trading relationship with Mexico has outreach efforts are intended to provide valu- helped various industries in Texas and the able insight for policymakers and business U.S. gain global competitiveness, and this and community leaders as well as the general relationship has helped create jobs in the public. U.S. In addition, Texas border cities have benefited tremendously from the increasing U.S.–Mexico economic integration—leading to job gains, primarily in service sectors, that have resulted in higher wages and improved standards of living for many Texans. The Dallas Fed’s Globalization Institute will continue Robert S. Kaplan President and CEO Federal Reserve Bank of Dallas Dallas Fed economists believe that the trading relationship with Mexico has helped various industries in Texas and the U.S. gain global competitiveness, and this relationship has helped create jobs in the U.S. 4 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report Oil-Rich Venezuela Tips Toward Hyperinflation v By Janet Koech enezuela, once the wealthi- the Organization of the Petroleum Exporting est nation in Latin America, is Countries (OPEC).2 These foreign exchange suffering a dramatic reversal of earnings are, in turn, used to finance imports. fortunes and the worst eco- Venezuela imports more than 70 percent of nomic crisis in its history. Though the nation its food, and dwindling foreign exchange has crude oil reserves of close to 300 billion earnings are creating severe shortages. Eco- barrels—the world’s largest such holdings— nomic output declined on a year-over-year many Venezuelans go without the most basic basis for eight consecutive quarters through goods in an economy plagued by chronic the end of 2015, the latest year for which data shortages. are available (Chart 1). Growth and infla- 1 The economic collapse—the product of falling oil prices, currency and capital controls, and mismanagement that includes tion outlooks continue deteriorating as the economic crisis deepens. Venezuela’s inflation is the highest in printing money to finance government op- the world. The International Monetary Fund erations—has brought Venezuela to the brink (IMF) anticipated a 476 percent annual price of hyperinflation. increase in 2016 and forecasts inflation of Oil accounts for more than 90 percent of 1,660 percent in 2017. Official government export income in Venezuela and is the largest data show a 12-month inflation rate of 180 source of government revenue, according to percent in December 2015 (Chart 2).3 The country’s economic and monetary developments evoke memories of Zimbabwe at the start of its hyperinflation and subse- Chart 1 Venezuela's Economy on the Decline Since 2014 quent collapse in 2007–09 as well as periods Percent, year/year 40 of persistently high inflation in Latin America in the 1990s. This persistently high inflation Real GDP growth morphed into hyperinflation—defined as 30 inflation exceeding 50 percent per month—in 20 Argentina, Bolivia, Brazil, Nicaragua and Peru. Other countries—Mexico and Chile— 10 managed to avoid hyperinflation.4 Venezuela’s central bank published 0 economic statistics in January 2016 for the first time in a year, confirming that annual –10 inflation had reached triple-digit levels, with –20 anecdotal evidence suggesting that prices have substantially increased since then. The –30 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 SOURCES: Banco Central de Venezuela; Haver Analytics. ’11 ’12 ’13 ’14 ’15 government has increasingly relied on its central bank to print money to finance its spending and fill the fiscal gap created by Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 5 Chart 2 Venezuela's Inflation Skyrockets diminished oil revenues. Rates in the black market, through which much of the economy Percent, year/year 200 operates, indicate much steeper currency devaluation. 180 180.0 160 Lifeblood of Oil 140 Venezuela’s 352,144 square miles on 120 South America’s northern coast—wedged Consumer price inflation 100 between Colombia, Brazil and Guyana—is 80 roughly twice the size of California. The country has a population of 30 million and 60 is rich in natural resources, including gold, 40 minerals and crude oil. 20 The discovery of oil in 1914 transformed 0 Venezuela’s agriculture-dependent economy. –20 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 By the mid-1920s, oil revenue supplied twothirds of the state’s income and was respon- SOURCES: Banco Central de Venezuela; International Monetary Fund World Economic Outlook; Haver Analytics. sible for more than 90 percent of exports. Oil wealth made it possible for the government to build a network of roads and infrastructure and expand its agricultural and manufacturing sectors. As the world struggled with the ing Venezuela, formed OPEC in 1960. The oil embargo of 1973 drove up world Great Depression in the 1930s, the Venezu- energy prices again. Venezuelan govern- elan bolivar appreciated nearly 70 percent ment revenue quadrupled from 1972 to 1974, against the U.S. dollar as oil revenue flowed spawning a splurge of public and private in. consumption.6 The government increased 5 The strong bolivar made coffee and spending and nationalized the oil and steel cocoa exports more expensive and less com- industries. When oil prices began to slip petitive, impacting the nation’s agricultural after 1977, Venezuela’s growth slowed as sector. At the same time, it was a boon for interest rates soared, ballooning the nation’s Venezuelan consumers, who could suddenly external debt to 61 percent of GDP in 1985 afford to import just about everything from from 13 percent in 1976. Oil revenue could food to clothes and electronics. Imported no longer sustain a range of government goods became commonplace. The strong subsidies, price controls and public institu- currency was politically popular, setting off a tions. Moreover, widespread corruption and national spending spree. political patronage flourished at the expense Good times didn’t last. World War II of economic development. These problems disrupted global trade, bringing product intensified when oil prices declined further shortages and economic disarray. Venezu- in the mid-1980s, leading to slow growth, ela’s economy has since largely mirrored high inflation and a diminished standard of oil-price volatility; robust postwar growth living.7 boosted global demand for oil, lifting prices Expanding energy demand from emerg- higher. Geopolitical conflicts in the Middle ing economies, particularly China, drove an East in the early 1950s further supported oil oil-price recovery in the early 2000s. Ven- prices, diverting more funds to Venezuela. By ezuela’s oil revenue rose to levels not seen the late 1950s, however, oil prices had drifted in two decades. The government channeled lower as Middle East production surged. To the proceeds to expand social-spending combat production and price swings, the programs, often at the expense of reinvest- world’s main oil-exporting countries, includ- ment in exploration and production by the As the world struggled with the Great Depression in the 1930s, the Venezuelan bolivar appreciated nearly 70 percent against the U.S. dollar as oil revenue flowed in. 6 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report state-owned oil and gas company, Petróleos ised to make 21st century socialism possible de Venezuela. through government spending. From 1999 to 2014, the government earned more than Volatile Political History $1.36 trillion from oil—more than 13 times Venezuela’s political history has a recur- Venezuela’s economic crisis is marked by a chronic lack of currency, food and other basics, exacerbated by long-standing price and foreignexchange controls. the amount of the (inflation-adjusted) infu- ring pattern: government overspending when sion of aid under the Marshall Plan, which oil prices are high with little saving for lean allowed Europe to recover from World War times. During the 1950s, dictator Marcos II. Venezuela’s expenditures briefly aided the Pérez Jiménez promised to modernize the poor until the economy collapsed yet again country. His government instead became so when oil prices fell in mid-2014.10 Current President Nicolás Maduro took corrupt and wasteful that one of his infrastructure projects—a nine-mile road linking over following Chávez’s death in 2013. Mad- the capital, Caracas, to the coast—cost $5.6 uro has struggled to maintain his mentor’s million per mile (or $53 million per mile in charisma and popular support amid mount- 2015 dollars) and was referred to as the “cost- ing frustration over widespread shortages. liest freeway in the world.” 8 Price Controls and Shortages In the 1970s, President Carlos Andrés Pérez also promised to transform Venezuela Venezuela’s economic crisis is marked into a developed nation. However, at the by a chronic lack of currency, food and other height of the oil boom, in 1974, he ordered basics, exacerbated by long-standing price the hiring of attendants and operators for and foreign-exchange controls. These restric- every bathroom and elevator in government tions and the lack of investment in basic buildings. The country ended up broke and infrastructure have eroded Venezuela’s pro- indebted when oil prices fell a decade later. 9 Hugo Chávez, the nation’s 64th presi- ductive capacity, making the country overly dependent on imports for its consumption. dent and leader of Venezuela’s socialist Yet, foreign currency controls have hindered movement, the Bolivarian Revolution, prom- the ability to pay for imports. Making matters worse, U.S. dollars have been in short supply, the result of an oil-price collapse, which saw Chart 3 Scarcity Index Shows Venezuela Running Low on Store Supplies Percent 30 prices fall from $100 per barrel in mid-2014 to as low as $30 in early 2016 before moving Scarcity index Percent, year/year 200 CPI inflation 25 20 permarket shelves in January 2014, according 160 to the “scarcity index,” a since-discontinued 140 central bank measure of the share of absent 100 10 2008 2009 2010 2011 2012 2013 2014 pers’ daily struggle is evident in the long lines to purchase limited quantities of hard-tofind necessities. Government-imposed price 60 controls make it difficult to produce and earn 40 a profit, so while supermarket shelves are 0 2007 food and household items (Chart 3). Shop- 80 20 5 Nearly 1 in 3 goods was missing from su- 180 120 15 toward $50 at year-end. 2015 NOTE: The scarcity index measures the percentage of food and household items missing from store shelves. Venezuela's central bank stopped reporting scarcity index data in January 2014 and inflation data in December 2015. CPI stands for consumer price index, a measure of the weighted average prices of a basket of goods and services. SOURCES: Banco Central de Venezuela; Haver Analytics. empty, a thriving black market has developed. In March 2016, goods were more than 17 times costlier on the black market than on the conventional market.11 By August 2016, some goods, including staples, cost 100 times the official price. Milk sold for 7,000 bolivars—more than $700 at the official exchange Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 7 Chart 4 Imports to Venezuela Decline in Recent Years rate—or about $7 if one had U.S. dollars, then worth a bit more than 1,000 bolivars to the U.S. dollars (billions) 20 dollar on the black market. However, many residents have neither the bolivars to afford 18 black-market prices nor the U.S. dollars to 16 exchange at the favorable rates.12 Government-imposed controls restrict 14 imports by limiting dollars available to 12 private-sector companies. The value of im- 10 ported goods fell 27 percent in third quarter 8 2015 from the prior-year level—and has declined 47 percent since oil prices peaked 6 in 2012 (Chart 4). Price controls and subsi- 4 dies ensured that many products were much 2 cheaper in Venezuela than in neighboring 0 Colombia, making smuggling to Colombia a 1995 profitable business and further exacerbating 1998 2001 2004 SOURCES: Banco Central de Venezuela; Haver Analytics. shortages. More recently, however, the lack of basic goods combined with rising prices has driven Venezuelans to illegally smuggle these products from Colombia. arbitrage. For instance, at the beginning of 2017, a cup of coffee at a bakery cost 1,100 Capital and Currency Controls The Venezuelan government has main- bolivars—equivalent to $110 or $1.63, depending on which of the two exchange rates tained a system of currency controls and a was applied. The dollar-denominated price fixed (but adjustable) official exchange rate is much cheaper if the black-market rate is since 2003. The government makes dollars applied.14 13 available at multiple exchange rates, allowing Venezuela has experienced a series of some companies and individuals to access currency devaluations associated with its dollars at preferential rates. surging inflation. In 2007, the government There have been two official exchange introduced a new currency, the bolivar fuerte rates since March 2016, when the govern- (the strong bolivar)—the old bolivar with ment announced its dual foreign-exchange- three trailing zeroes removed. Although rate system. The first rate, known as DIPRO, the devaluation made everyday transac- replaced the CENCOEX rate and is set at 10 tions easier, it failed to address the country’s bolivars per $1. This fixed-but-adjustable rate underlying lack of economic discipline and is used for imports of government-authorized policies that undermined sustainable eco- priority goods, including food, medicine and nomic growth. raw materials for production. The second The government devalued the currency rate, DICOM, governs transactions not in January 2010, from 2.15 bolivars to 2.6 covered by the DIPRO rate and is allowed bolivars per $1 for an assortment of food and to “fluctuate according to the country’s health care imports and to 4.3 bolivars for economic dynamics.” The rate had an initial other imports such as cars, petrochemicals opening of 206.5 bolivars per $1 on March 7, and electronics. Two years later, the currency 2016, and was priced at 686.6 bolivars per $1 was devalued again, to 4.3 bolivars for both on Jan. 26, 2017. Venezuela previously had a classes of goods. Once more, in February three-tiered official currency-control system. 2013, the bolivar was devalued to 6.3 bolivars This multiple-exchange-rate arrangement creates numerous opportunities for 2007 amid rising budget deficits. Most recently, in February 2016, President Maduro cut the 2010 2013 2016 8 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report half of the 20th century accompanied the Chart 5 Venezuela Currency Depreciates Sharply on Black Market Bolivar/U.S. dollar 5,000 Latin American bouts of rapid currency Bolivar/U.S. dollar 300 nine of the most populous countries in the region shows that inflation averaged nearly 4,500 4,000 Black-market exchange rate 3,500 250 160 percent per year in the 1980s and 235 percent per year in the first half of the 1990s.17 200 3,000 Some countries experienced hyperinflation. Since the mid-1990s, however, inflation 150 2,500 rates have universally declined, mostly to the single digits. 2,000 100 1,500 Large budget deficits financed by money creation are characteristic of high-inflation 1,000 500 depreciation. A measure of price changes in 50 Official exchange rate episodes. Underlying causes include declining export earnings due to falling commodity 0 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 SOURCES: Federal Reserve Board; DolarToday; Haver Analytics. prices, government overspending on programs not financed through taxes or borrowing, and a lack of central bank independence resulting in monetization of debt. Overexpansionary fiscal and monetary policies are official exchange rate to 10 bolivars per $1. Chronic shortages have inflated the Venezuela’s economic situation is increasingly reminiscent of the beginning of highinflation episodes elsewhere in Latin America and in Zimbabwe. generally followed by wage and price controls that create bottlenecks and shortages, result- black-market value of the bolivar, which ing in currency overvaluation, capital flight, traded upward of 3,600 per $1 in January declining tax revenues, increasing external 2017—far above official exchange rates debt and accelerating inflation. (Chart 5). The largest bill in circulation in 15 In Argentina, Brazil and Bolivia, hyper- November 2016—the 100 bolivar note—was inflation culminated in a lengthy deteriora- worth $10 at the official exchange rate and tion in the countries’ fiscal accounts and pennies at the black-market rate. The bolivar, increased fragility in the financial system due its purchasing power evaporating, has left to a regional debt crisis and a tendency to Venezuelans carrying increasingly large wads accept high inflation. Argentina experienced of cash to purchase everyday items. repeated cycles of hyperinflation followed A large cup of coffee, costing 1,100 by attempts at stabilization. Its stabilization bolivars, required 550 of the lowest, 2-bo- program and emergence from debt default livar-denomination currency and 11 of the included the elimination of the budget 100-bolivar notes at the beginning of the deficit, privatization and monetary reform year. Newly denominated currency—includ- that included a new currency whose value ing 20,000-bolivar notes—was rolled out in was rigidly fixed against the U.S. dollar.18 The mid-January.16 With the IMF forecasting that government, however, defaulted on its debt inflation will reach 1,660 percent in 2017 and during this high-inflation period. 2,880 percent in 2018, purchasing power will quickly erode further. In 1994, Brazil implemented its “real plan” that successfully ended more than a decade of chronic inflation. The plan Inflation, Price Stabilization included the introduction of a new currency, Venezuela’s economic situation is the real, combined with fiscal and monetary increasingly reminiscent of the beginning of policies that restricted government expenses high-inflation episodes elsewhere in Latin and raised interest rates. America and in Zimbabwe (Chart 6). Periods of economic and financial crisis in the latter Bolivia set on the path to hyperinflation because of an overvalued currency, a large Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 9 fiscal deficit and external debt, and an abrupt a 1994 constitutional amendment, Banco de reversal of foreign capital inflows. Mexico México was granted autonomy under which and Chile endured periods of high inflation it has set annual inflation targets since 1996. before successfully reducing price increases Average annual inflation fell to the single dig- that could have led to hyperinflation. its in 2000, where it has remained. Similarly, Mexico maintained a regulated floating- Chile adopted an inflation target in 1990, rate regime from 1985 to 1991, followed by which contributed to gradually declining an exchange rate band until late 1994. That price increases. year, the band became unsustainable amid In Venezuela, the government has market instability and a speculative attack printed more currency to finance its spend- on the Mexican central bank’s international ing. These factors have produced the highest reserves. Additionally, a leading presidential inflation in the world. candidate was assassinated, a rebel uprising Dealing with the Economic Crisis in southern Mexico was renewed and U.S. interest rates rose. Venezuela’s economic crisis is most In response, Mexico’s foreign exchange directly linked to the mismanagement of its commission adopted a floating currency— oil wealth—a combination of corruption, am- which remains in place—prompting a sharp bitious social spending and a lack of savings peso devaluation and financial crisis. Under or investment in the oil industry. The govern- Chart 6 How Venezuela's Inflation Compares with Other High-Inflation Countries Percent, year/year Percent, year/year Mexico 4,000 3,500 3,000 3,000 2,500 2,500 2,000 2,000 1,500 1,500 1,000 1,000 500 500 0 4 8 12 16,000 Chile 4,000 3,500 0 Percent, year/year 4,500 4,500 16 20 24 0 12,000 10,000 8,000 6,000 4,000 2,000 0 0 4 8 12 16 20 24 Percent, year/year 10,000 Percent, year/year 25,000 Bolivia 6,000 5,000 5,000 4,000 4 8 12 16 20 24 24 16 20 24 Zimbabwe 1,000 1,000 0 20 2,000 2,000 0 16 3,000 3,000 0 12 6,000 4,000 5,000 8 7,000 8,000 10,000 4 8,000 Peru 7,000 15,000 0 Percent, year/year 9,000 20,000 Argentina 14,000 0 4 8 12 16 20 24 0 0 4 8 12 NOTES: The charts plot the evolution of consumer price index (CPI) inflation over six years (24 quarters) for a sample of high-inflation countries from the time year-over-year inflation first exceeded 80 percent. The black solid line is the evolution of Venezuela's inflation in 2015, and the dashed lines are estimates of Venezuela's annual CPI inflation for 2016–20 from the International Monetary Fund. SOURCES: National statistical offices; International Monetary Fund; Haver Analytics; author’s calculations. 10 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report ment has been repeatedly caught unprepared weighing stacks of bills to pay for basic items when oil prices have collapsed. The quantity instead of counting them individually before theory of money indicates that sustained the government introduced new, higher- high growth rates of a nation’s money stock denominated currency in January 2017. in excess of its production of goods and To compound the currency crunch, the Venezuelan government announced on Dec. 12, 2016, that it would withdraw all 100-bolivar bank notes from circulation, giving Venezuelans 10 days to exchange the old bills for new ones at the central bank. The larger bills offer only temporal relief, services eventually produces high and rising not a solution to the inflationary distortions. inflation rates. This is what economist Milton Indeed, other countries encountering a Friedman referred to when he said, “Infla- similar situation have found that larger-de- tion is always and everywhere a monetary nominated currency often leads to episodes phenomenon.” of even higher inflation or hyperinflation, Venezuela responded with price as was the case in Austria, Germany and controls. Such controls inevitably lead to Hungary after World War I and Zimbabwe shortages because they encourage demand in 2008. The Zimbabwe government issued at a price lower than what goods would the world’s greatest denomination, the 100 otherwise cost. Profit margins get squeezed trillion-dollar bill, shortly before the currency and shortages worsen when foreign exchange was abandoned in favor of the U.S. dollar in earnings, used to pay for imports, decline. 2009.20 To compound the currency crunch, the Government-imposed currency and capital controls also limit access to foreign currency Venezuelan government announced on Dec. for imports of intermediate goods used in 12, 2016, that it would withdraw all 100-bo- production, triggering additional shortages. livar bank notes from circulation, giving A thriving black market emerges for the Venezuelans 10 days to exchange the old bills trade of goods and currency, though at much for new ones at the central bank. President higher than officially set rates. Maduro called the 100-bolivar bills instru- Consumer prices increased at an ments of an “economic coup” to destabilize average annual rate of 40 percent in 2013, his government and said that the move climbing to 62 percent in 2014. The pace of would strike a blow at “international mafias” increase accelerated through 2015, reaching that hoarded cash. Colombian shoppers 122 percent. By December 2015, year-over- and organized criminals were buying up the year inflation was at 180 percent. Although 100-bolivar bills to go shopping in Venezuela, the government stopped publishing infla- he said, worsening the shortages of basic tion data more than a year ago, evidence is goods. He ordered the closing of the border mounting that inflation has worsened. with Colombia to counter “bolivar smug- In the absence of official statistics, some gling.” The withdrawal of the nation’s largest- analysts now track the prices of specific items to get a sense of price increases. For denomination note came well before instance, Bloomberg News’ Bloomberg Café replacement bills were available. Maduro Con Leche Inflation Index tracks the price backtracked on his decision after a lack of of a cup of coffee at a bakery in Caracas. The fresh banknotes sparked unrest. The govern- price soared from 450 bolivars a cup to 1,100 ment rolled out new replacement banknotes bolivars over a span of 22 weeks ended Jan. ranging from 500 to 20,000 bolivars in Janu- 18, 2017—an annual inflation rate of 768 ary. percent.19 One U.S. dollar brought 3,684 bolivars on the black market on Jan. 25, 2017, up from Cautionary Tale Typically, adoption of an independent 960 bolivars 12 months earlier and from central bank has stabilized chronic inflation 185 bolivars two years before. This steep episodes. It is part of a strategy that often devaluation reflects a loss of confidence in includes an alteration in the fiscal regime the government. Venezuelans resorted to and the institution of a credible exchange- Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 11 Chart 7 Money Supply, Inflation Substantially Increase in Tandem rate stabilization mechanism. The adoption of the U.S. dollar to replace the local currency Percent, year/year 200 immediately ended Zimbabwe’s hyperinflation, while Latin American countries used a CPI inflation 180 combination of stabilization programs to rein 160 in inflation. 140 So far, Venezuela’s measures to deal with its economic crisis have been lacking. Apart 120 from a rise in the price of heavily subsidized 100 gasoline and a devaluation of the essential- 80 goods exchange rate (from 6.3 to 10 bolivars 60 per U.S. dollar in February 2016), the ad- 40 ministration continues to print money while M3 money supply growth 20 maintaining currency and price controls.21 0 The country’s money supply increased –20 458 percent from the beginning of 2015 to 1998 January 2017, sending prices sharply higher 2000 2002 2004 2006 2008 2010 2012 2014 2016 NOTES: M3 is the broadest definition of monetary assets available in an economy. CPI stands for consumer price index, a measure of the weighted average prices of a basket of goods and services. SOURCES: Banco Central de Venezuela; Haver Analytics. (Chart 7). To keep up with the rising prices and erosion of the currency’s value, Maduro raised the minimum wage 50 percent in January 2017, the fifth increase in a year. He also appointed a political supporter to run the central bank. Through the mounting crisis, Venezuela confronts the difficult task of shoring up its economy at a time when the conditions that previously buoyed growth—stronger global growth and higher commodity prices—are less supportive. A recent oil-price uptick has provided little relief. The larger-denominated currency will ease the difficulty of simple transactions, but it doesn’t solve the underlying causes of inflation. As the citizens struggle to make ends meet, they are left to wonder how much worse economic conditions can get and what kind of future their resource-rich country faces. Resolution of Venezuela’s situation remains elusive, though the crisis is a manifestation of how corruption, mismanagement and an addiction to oil can quickly erode the fortunes of a country. Notes Venezuela is the country with the world’s most proven crude oil reserves, according to the 2015 Annual Statistical Bulletin by the Organization of the Petroleum Exporting Countries (OPEC). 2 Venezuela’s oil revenues accounted for about 95 percent of export earnings in 2015. See note 1. 1 Prior to the January 2016 data release, no data were issued for more than a year. 4 “The Monetary Dynamics of Hyperinflation,” by Phillip Cagan, in Studies in the Quantity Theory of Money, Milton Friedman, ed., Chicago: University of Chicago Press, 1956, pp. 25–117. 5 See Crude Nation: How Oil Riches Ruined Venezuela, by Raúl Gallegos, Lincoln, Neb.: Potomac Books, University of Nebraska Press, 2016, p. 60. 6 “Inflation Dynamics in Latin America,” by Carlos Capistrán and Manuel Ramos-Francia, Contemporary Economic Policy, vol. 27, no. 3, pp. 349–62. 7 Venezuela’s annual consumer price inflation reached 100 percent in 1996, and its standard of living declined to 1960 levels—21 percent below its 1977 peak. 8 See note 5, p. 67. 9 See note 5, p. 73. 10 See note 5, p. 15. 11 “A Day Out at the (Black) Market in Venezuela,” by Scott Tong, American Public Media, March 23, 2016, www. marketplace.org/2016/03/23/world/resource-curse/dayout-black-market-venezuela. 12 “Venezuela: Where Flour, Pasta and Milk Can Cost a Month’s Pay,” by Flora Charner and Rachel Clarke, CNN, Aug. 2, 2016, www.cnn.com/2016/08/02/americas/ venezuela-food-prices. 13 In 2003, President Hugo Chávez imposed currency controls to stem capital flight after an oil workers’ strike. At the time, $1 could fetch 1.6 Venezuelan bolivars. Today, that same dollar can buy 172 bolivars at the official government exchange rate, a devaluation of more than 99 percent. 3 As of Jan. 6, 2017, $1 was worth 10 bolivars at the DIPRO rate, 675.4 bolivars at the DICOM rate and 3,241 bolivars on the black market. 15 Data are from DolarToday, dolartoday.com. 16 “2.75 Million New Banknotes Enter into Circulation in Venezuela,” by Jeanette Charles, Venezuelanalysis.com, Jan. 18, 2017, https://venezuelanalysis.com/news/12888. Since Jan. 16, 2016, Venezuela has issued banknotes in denominations of 500, 5,000, and 20,000. In all, six new banknotes will be issued, with 1,000, 2,000 and 10,000 denominations expected at an as-yet-undisclosed time. 17 “Inflation in Latin America: A New Era?” speech by Ben S. Bernanke, Federal Reserve Board of Governors, Feb. 11, 2005. The nine countries are Mexico, Colombia, Venezuela, Brazil, Bolivia, Uruguay, Peru, Argentina and Chile. Inflation is weighted by each country’s gross domestic product. 18 “Stopping Three Big Inflations: Argentina, Brazil, and Peru,” by Miguel A. Kiguel and Nissan Liviatan in Reform, Recovery, and Growth: Latin America and the Middle East, Rudiger Dornbusch and Sebastian Edwards, eds., Chicago: University of Chicago Press, 1995, pp. 369–414. 19 See the Venezuelan Café Con Leche Index, Bloomberg, www.bloomberg.com/features/2016-venezuela-cafe-conleche-index. 20 “Hyperinflation in Zimbabwe,” by Janet Koech, Globalization and Monetary Policy Institute 2011 Annual Report, Federal Reserve Bank of Dallas, 2012, pp. 2–12. 21 The government increased the price of gasoline to 6 bolivars a liter from 9.7 centavos in February 2016. This is a 60-fold increase and equivalent to about 11 U.S. cents per gallon, but prices remain one of the cheapest in the world. 14 12 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report Q&A with Robert Kaplan and Lord Mervyn King Robert Kaplan: Lord King thank you for being here. We really appreciate it. I will start with this, why did you become a central banker? Lord Mervyn King: By accident. I was an academic and I had taught in the states. I went back to London to the London School of Economics and I was asked to be a nonexecutive director of the Bank of England, which is a part-time position and I took that on. And after six months, the then-chief economist decided to leave and move on to something else. So, the governor at the time, Robin Leigh-Pemberton, had to appoint a successor and he said, “Oh, do I really have to have an economist?” He wasn’t very enthusiastic about it, and in light of subsequent events, you can see why. But he was told he had to have one. So, he then thought very hard about it. At the Bank, there was a family sports day once a year and as a nonexecutive director, I had been invited to play in the governor’s tennis match. And it was the best performance I had ever put on court to that date and indeed I I was about to leave again when the Bank of England was made independent by the incoming Labour government in 1997. regret to say, subsequently. I hit the ball really hard and the ground shots went in. So, he was so impressed and he knew I could play cricket as well, so he told me if he had to have an economist, he wanted one who could play cricket and tennis. So, that’s how I was offered the job. I had no intention of staying. I took it for two to three years with every intention of going back to academic life, but each time I tried to go back, something happened. The first time we were forced out of the Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 13 exchange rate mechanism and I came up it would have needed an act of parliament to we had assumed would be the case. We now with the idea of inflation targeting, which change the maximum length of a term, and face the risk that if we abandon indepen- we introduced at the beginning of 1993. And that was too much for anyone. So, I was able dence of central banks, we will throw out then I was about to leave again when the to, at last, leave. the baby with the bath water, and another Bank of England was made independent by decade on, we will find ourselves with high the incoming Labour government in 1997. So, Robert Kaplan: inflation again and then wonder how can we I had to stay on to make that work. What’s the importance of a central bank get it back. being independent? We are having a lot And of course one thing we learned Robert Kaplan: of conversations in this country about about inflation was that once you let inflation Independence in that context meant central bank independence. Why is it rise to a higher level, it’s very costly to bring what? important? it back. You need a deep recession to bring Lord Mervyn King: Lord Mervyn King: expectations of inflation right down again. When we were made independent, it was not Robert Kaplan: that point, the level of interest rates had been so long after the two decades of very high You were the governor during the lead- decided by the Chancellor of the Exchequer and volatile inflation of the '70s and '80s. up to the crisis and during the crisis. and, in fact, we didn’t even have regular Even here in the states, inflation reached 13.5 What are the key lessons you learned in meetings. You could sit in your office in the percent. In the U.K., it reached 27 percent, the aftermath of the crisis? morning and get a telephone call saying that but it was all over the place and that led to the Chancellor would like to discuss interest volatility, not just of inflation, but of output rates after lunch. and employment, too. It meant deciding interest rates. Up until Lord Mervyn King: There are many of them I think. The And so the financial markets had no idea So, we were very keen to get away from when interest rates could change. They could that. And the way to achieve it was a combi- my book, is that I think having created this change at any moment on any day, except of nation of taking the decision on interest rates remarkable period of stability of inflation course when there was an election or there away from political influence, giving it to a and output, we rather got carried away and was some political event where it would be central bank that genuinely had indepen- forgot the basic rule, which is you can never inconvenient to change interest rates. dence, and secondly, introducing an inflation forecast the future. The future is inherently That was completely altered in 1997, so first and biggest, and the one I talk about in target, either overtly or implicitly, in which very uncertain and, therefore, you needed a much so that when Tony Blair stood down as the central bank would bring inflation gradu- system that can be resilient. the prime minister, it so happened that his ally back to the target. And everyone knew announcement that he was standing down that, so expectations of what would happen this, but I think that what happened around as the prime minister coincided to the very in the future were anchored to confidence the world was that the evolution of China as minute with an announcement that we were in how the central bank would behave and I a growing and dominant economy injecting raising interest rates. That could never have think that was very important. a lot of savings into the world economy—the happened under the previous regime. Then I was asked to be governor so I had What is fascinating today of course is There is no point blaming anyone for phrase that Ben Bernanke used was the that at the very moment when central banks savings glut—started to bring interest rates to stay on for that. Then I was going to leave are keeping interest rates very low, the politi- down, especially long-term real interest rates, after my first term, but we were bang in the cians around the world are complaining that and we should have realized that this was middle of the financial crisis. But come 2013, they are too low. This is the reverse of what creating something that was wholly unsus- 14 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report tainable. In a healthy economy, expected get pushed into doing things, which a central long-term real interest rates on 10-year bank shouldn’t do, like take big credit risk inflation-protected securities ought to be with its balance sheet. Those are decisions somewhere in the, I don’t know, 3–5 percent- which ought to be taken by elected officials. a-year range. You can’t find any historical period It was a real genuine loss of confidence, and international trade started to fall even faster than it had in the 1930s. There was the prospect of another Great Depression. If the central bank says, “Well, no one else is going to do it, so I will,” the difficulty where that really was not the case. Over is that after the crisis has gone away, the 25 years, 10-year real interest rates started politicians will say, “What was your authority around 4 percent, and they came down to for doing that?” And then they use this as an zero. That cannot be an equilibrium. I think attack for cutting back the authority of the economists allow themselves to be so ob- central bank. And you have seen some of that sessed with the models that they have created in the debate about Dodd–Frank. but instead of sitting back and saying there is something wrong here, they just carried on Robert Kaplan: with the traditional view that if you don’t see In the aftermath of the crisis, there really enough growth, you cut interest rates. wasn’t much in the way of fiscal policy Central banks in the West were cutting in the Western world and so central interest rates to boost domestic spending, banks in the United States, the ECB and and we were generating current account the Bank of England took extraordinary deficits, trade deficits, which meant that we measures to support growth. Do you were borrowing from abroad on a scale that think that central banks went too far, did could not go on forever. And in the end, it too much? didn’t. Much of that borrowing was mediated through the banking system. So, it was the banking system that collapsed first. That’s one lesson. I think the other big lessons are that we Lord Mervyn King: No. I think that in late 2008/early 2009, what we saw was a collapse of confidence around the world, not just in the industrial- took our eye off the ball of leverage in the ized world where we had experienced the banking system that grew very rapidly in a banking crisis. My opposite number in Brazil period of five years. Nothing went wrong in would telephone me and say, “Car sales col- that period of five years, but we should have lapsed in Brazil but we haven’t got a banking been more alert to the fact that it was creating crisis.” In India, steel sales collapsed; they serious problems. didn’t have a banking crisis either. And it was I don’t think we had thought through a real genuine loss of confidence, and inter- how we would operate the regime of lender national trade started to fall even faster than of last resort. We assumed that what we had it had in the 1930s. There was the prospect of all read about in the textbooks was, if we had another Great Depression. a crisis, the central bank would act as a lender of last resort, lending through the banking So, I think central banks had to act pretty dramatically to head that off. The problem system. But it turned out the banking system was pretty much over by late 2009. The bank- was completely different from the banking ing crisis in my view ended in May 2009, system that was described in the textbooks. when the Federal Reserve and the U.S. Trea- We can come back to that later. sury announced the stress test of the banks I suppose the other lesson I learned is and said, “Well, either the banks themselves that when there is a crisis, politicians will have to raise capital or we will put it in and do everything they can to avoid blame. And, take shares in return.” therefore, central banks were in an exposed That ended the banking crisis. But I position, and that’s when it’s very important think after that, central banks probably made for a central bank to keep its nerve and not a mistake in thinking that the cause of weak Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 15 demand continued to be a Keynesian downturn. In my judgment, demand has been obvious thing. What the source of demand weakness weak because people came to realize during wasn’t, was a temporary headwind, which the crisis that the level of domestic spending of course is the language that central banks in our economies beforehand had been too have come to use to describe the difficulty of high. generating a recovery. Before the crisis, central banks saw that I think the big mistake that’s been our economies were facing a structural trade made is if you misdiagnose the problem and deficit. Well, that’s a drag on total demand, say that the weakness in demand is just a and if you want to maintain stable inflation temporary headwind, whereas in fact, it’s a and stable employment, you have got to get permanent fall in demand, what you will end total demand to run in line with supply. up doing is not just cutting rates and wait un- If net trade is being a drag on demand, til you see a recovery and then getting back you have to boost domestic demand so that to normal again; you cut rates, that generates when you subtract the contribution from the a little bit of a recovery, but that peters out trade deficit, total demand is equal to supply. because the fall in demand is permanent. And central banks were very successful in So, you have to cut again, and you end doing it. But of course, what they did was to up keeping cutting rates until you get to zero. achieve stability but in an unsustainable way Once you are up to zero, then only an econo- because domestic demand can’t run forever mist can really believe that negative interest above the level of productive potential. rates are the way to generate the recovery. What the crisis did was to bring home I feel that’s where we are. There are some to everyone that we all had been spending very good economists who think that if only more than we could afford to in the long run. interest rates could be -5 percent then we So people cut spending, and that gap had to would get a recovery. But of course, if you ask be filled by something; export demand is the people if Janet Yellen were to announce that 16 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report interest rates—far from rising—would be at The other is immigration, where the -5 percent for the next year, most people will principle of the free movement of people say, “What the hell are these people in the within Europe was a fine principle when you Fed doing?” Nevertheless, the economics were just thinking of people moving amongst professionals would cheer and say “Fantastic, a small number of Western European you have done the right thing, now we are countries to other countries. But it came bound to get a recovery.” under pressure when the Eastern European members joined the European Union, and it Robert Kaplan: has come under intolerable pressure when Changing gears somewhat, what’s going a million or more people want to come from to happen now, in first the U.K. and then outside the EU into the EU each year. in Europe, in the aftermath of the Brexit De facto the Schengen Area, where there vote? What do you think the impact of is a passport-free travel zone within the Eu- this will be, and you think more coun- ropean Union, has been abandoned. Those tries in Europe will follow? countries have been forced to put up controls and barriers to prevent illegal immigrants Lord Mervyn King: No, I think not. Let’s start with the European Union. The European Union, I think, faces two existential problems, and they are being shipped on from the first country they arrive at to somewhere else in the EU. I think they have no answer to these questions at all. But what is not an existential problem serious. One is the monetary union, where for the EU is British membership. If you look I don’t think it’s working. I think it has been at what happens in Italy or France in their a disaster, and I don’t think there is any real upcoming elections, the people who vote for prospect of having rapid economic growth in Five Star in Italy or Marine Le Pen in France, the European Union while monetary union they don’t go home in the evening and say, persists. And they have no answer to this at “You know darling, I was very impressed by all. the vote in Britain, and I do wonder whether Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 17 we shouldn’t sort of vote in a similar way of Europe, including in Germany, once their here”; they vote according to domestic condi- elections next autumn are out of the way, and tions in their own countries. they will be very much influenced by the fact So, I don’t think that Britain leaving the EU will actually have much impact on what that the U.K. has a very large trade deficit. Now, there are not many circumstances happens in the rest of the EU. The EU, I think, in which having a big trade deficit is a good has serious problems, but I don’t think they idea, but it just so happens that negotiating a are affected one way or another by the U.K. trade agreement is one of them. staying in it, which was precisely why the U.K. was actually not having a lot of influence Robert Kaplan: on the rest of Europe. There has been a lot of discussion in this Now, in terms of the U.K., I think the country of late about Dodd–Frank bank situation in some ways is relatively straight- regulation. We have been advocating forward. The prime minister said, and this here that small- and mid-sized banks was a fairly obvious thing to do, that there should get substantial relief because will be a bill to repeal the European Com- they are not systemically risky. munities Act of 1972, which is the act under But there has been even discussion which we joined the EU. And then immedi- or suggestion that maybe even on big ately pass a short bill to translate all existing banks there would be a change. What’s legislation that we adopted as a member of your view on what’s an appropriate way the EU directly into U.K. law so that parlia- for us to think about bank regulation ment can take its time to decide which of the here, in the U.K. and in Europe? legislation we have adopted in recent years we want to keep, or to get rid of, or to have another domestic debate about. But it will be the U.K. parliament that decides that. When it comes to trade, I think, it’s a lot Lord Mervyn King: During and just after the crisis, it seemed to me pretty clear that what we had to do was to move to a point where the leverage of the simpler than some people would suggest. I banks was a lot lower than it had been before think there are three groups of countries that the crisis. And of course banks themselves matter. The first are countries outside the EU, were trying to reduce their leverage. but with which the EU has a trade agreement. Going forward, I would like to see a rela- And we go to those countries and say, “Look, tively tough simple leverage ratio. But I think when we leave, why don’t we just roll over the that what we have actually done in practice is treaty we have got with you already by virtue try to ensure that if the same thing that hap- of our membership with the EU and just pened in 2007–08 happened again, that every carry it on?” single detail of that is now closed off. The second group of countries are coun- So, what we have done is to create a tries again outside the EU, but with which the massively detailed set of regulations that EU itself does not have a trade agreement, we would almost certainly be irrelevant for the go to them and say, “We would like to have a next crisis, which inevitably will be rather trade agreement; either we get one, in which different. I think the only way sensibly to case fine, we are better off, or we don’t, in regulate the banking system is not to burden which case we have got the status quo again.” it with such detail. In the U.K. and London, I And the third is obviously the rest of am amazed now that when you talk to people the EU, where we will have to negotiate in banks, they feel they can’t do anything with them. But there is a good cop and bad without taking the advice of their compliance cop routine here; the bad cop will be all the officer. That is not the definition of healthy European institutions, people in Brussels; the regulation. That’s excessive detail. good cop will be politicians around the rest One simple example: Several central I don’t think that Britain leaving the EU will actually have much impact on what happens in the rest of the EU. The EU, I think, has serious problems, but I don’t think they are affected one way or another by the U.K. 18 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report banks now have to approve the chief execu- countries in the world could genuinely say tive and the chairman of a bank. That’s fair today, “If only the rest of the world was grow- enough. But then they also insist on approv- ing normally, we would be fine, but since it ing a whole raft of people below that level isn’t, we aren’t,” and so countries are tempted before they can be appointed. to say, “So, what can we do on our own to Well, if you have approved someone to be a chief executive of a bank, why don’t you trust him or her to make the right decisions about the people they want to employ? get out of this trap, push down the exchange rate?” Well, that’s clearly a zero-sum game. So, we’ve got to find some way of creating a positive-sum game at the level of the world. I am also very worried about the impact of the current level of interest rates on the viability of pension funds and insurance companies and just as worried about young people deciding whether it’s worth bothering to put aside money for pension provision. Robert Kaplan: The IMF ought to be able to do it, but I worry We’ve been calling for broader economic that it's become so political because of its policy actions to support economic relationship with Europe that they would find activity going forward. What types of it very hard to do. policy options would you encourage other policymakers to be considering? Robert Kaplan: What about infrastructure spending? Lord Mervyn King: I think there are three sorts of things that are important. First, greater flexibility in Lord Mervyn King: Infrastructure spending is a good idea exchange rates to prevent the buildup of un- subject to some caveats. The first one is that sustainable trade surpluses and deficits. The some proposals amount to a sort of Keynes- weakness of the euro area is a problem not ian injection of demand. The trouble is, just for Europe but for the world economy. we don’t face Keynesian unemployment Second, on the supply side, maybe people anymore. The unemployment rate is down will think more imaginatively about the kind to 5 percent. So, if you have infrastructure of changes that will be made. They have got spending, it is going to crowd out some other to be sensible ones. But tax reform is one, form of spending. particularly in the area of savings and investments. Education is another if we are going to What is the other form of spending we think is less deserving? That’s not obvious by any means, and the second thing is that it re- deal with the concerns of people who feel ally ought to be something which is financed they have been left behind by globalization. by government because infrastructure The jobs that they were brought up to do sim- spending such as turning JFK Airport into ply don't exist anymore—that’s always going DFW is not going to be cheap, and is going to to be the case. But education and retraining be quite difficult to finance privately, I think. is a fundamental part of dealing with this These are projects we need to pursue and problem. plan, but you can’t just switch it on like that. I am also very worried about the impact of the current level of interest rates on the Robert Kaplan: viability of pension funds and insurance But if we could do private financing, companies, and just as worried about young would you welcome private-sector people deciding whether it’s worth bothering involvement? For example, a lot of these to put aside money for pension provision. So, airports have been turned into shopping I think there is a whole range of things that malls in effect. If we could find a way can be done in this area. to use less government money—more And the third is, international cooperation, and this is going to be the hardest of all. I think the problem at present is that most private money—would you say that was good or bad? Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 19 Lord Mervyn King: government bonds to finance it. Well, there is still a problem. If the an- The problem facing the public finances swer is, let’s do lots of investment in infra- in the United States is not a short-term structure, it doesn’t matter who is financing problem, it’s a long-term problem. One thing it, some other spending gets crowded out, I think can be explained to people and be un- and I only favor private-sector providers for derstood and accepted, is that all our pension genuinely private-sector projects. schemes need to be modified to acknowledge What I am very unhappy about, is what’s that we are living longer. As life expectancy being done in the U.K. and elsewhere, called goes up, we must share the benefits of that the Private Finance Initiative, in which the between working life and retirement. private sector finances a project and the pub- So, the age at which we qualify for pen- lic sector then runs it. What’s bizarre about sion has to keep rising, and this should be this, is that it’s completely the wrong way built into our pension schemes, both private around. The public sector can borrow money and social security. much more cheaply than the private sector That would be one way to make a big and the private sector can run things better dent in the prospective future deficits that we than the government. So, why don’t we do it face. the right way around? Robert Kaplan: One last question to wrap this up. What advice would you be giving to the Fed from here as we watch the next phase of the recovery unfold? Lord Mervyn King: I think if I were to give advice, I think I would say, central banks should now make it very clear that they can’t really provide any more support. We have to be on a path of gradually trying to remove the stimulus that we have given in recent years. The hopes for recovery have to rely on other policymakers. There are a range of different policies but they need to be thought through very carefully. It’s easy to say infrastructure is a good thing, and indeed, there is obviously bipartisan support for infrastructure spending, but as both Martin Feldstein and Larry Summers have pointed out in recent weeks, infrastructure spending should not be carried out simply in order to reduce unemployment even further below what may well be a natural rate of unemployment. And it doesn’t make sense to create artificial ways of financing infrastructure investment merely in order to keep debt off the public-sector balance sheet. If there is a good argument for infrastructure, then issue 20 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report The Potential Impact of Decentralized Virtual Currency on Monetary Policy By G.C. Pieters o ne of the most unexpected be centralized or decentralized. A centralized global monetary developments currency is any currency that is issued and in the past decade has been maintained by a central group or organiza- the emergence of decentral- tion, while decentralized currencies are ized virtual currencies. Bitcoin, the largest not.1 Simulated currencies (also called and best known of the decentralized virtual game currencies) are examples of central- currencies, has well-documented market ized digital currencies. These currencies are properties—including its use as an interna- created to purchase items within a simulated tional vehicle currency. Decentralized virtual system, primarily video games, belonging currencies are of particular interest to central to a nongovernment company or group. bankers because eventually they could For example, the online game Second Life change administration of monetary policy (created by Linden Labs) uses an in-game globally by allowing users to circumvent currency referred to as Linden dollars. World capital controls and managed exchange rates. of Warcraft (WoW) (created by Blizzard Entertainment) primarily relies on a currency Electronic money is a broad term for any money, currency or asset not held in physical form—it can include representations of a sovereign currency or claims on a realworld good. Digital Currency? Virtual Currency? referred to as WoW gold. Eve Online (created Cryptocurrency? by CCP Games) has a currency called ISK. All The terminology used when discussing are designed to be earned through in-game currencies such as bitcoin is rapidly evolving. tasks and spent on in-game items within the Chart 1 is a visualization of the relationship respective simulated system, ranging from ar- between the various terminologies, created mor and clothes to flying pigs and spaceships. by merging definitions suggested by the Eu- Some players may choose to buy ropean Central Bank, Bank of International Linden dollars, WoW gold or Eve ISK using Settlements and Bitcoin Magazine. government-issued currencies on third-party Electronic money is a broad term for any exchanges instead of spending time on in- money, currency or asset not held in physical game tasks. These exchanges tend to be very form—it can include representations of a limited—usually involving only the U.S. dol- sovereign currency or claims on a real-world lar, the euro and the British pound—and may good. The online payment system PayPal dig- be deemed illegal by some companies. An itally represents many sovereign currencies, example of a centralized virtual currency is E- such as the U.S. dollar, and therefore trades in gold, founded in 1996. E-gold was a digitally electronic money. Digital currency is a subset traded currency backed by gold that could of electronic money that has no broadly ac- be traded for sovereign currencies, with the cepted physical counterpart. Finally, virtual issuance and trading system managed by the currency is a subset of digital currency that is company Gold & Silver Reserve. intentionally created, or predominately used, Cryptocurrency refers to any electronic for purchasing both digital and nondigital money created using cryptographic technol- (“real-world,” or tangible) goods. ogy to regulate its creation and ensure the Digital and virtual currencies can either legitimacy of transactions conducted using Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 21 that money. Formally, bitcoin can be described as a decentralized virtual cryptocurrency. However, because all cryptocurrencies are decentralized virtual currencies, the two terms are used interchangeably. Cryptocurrency technology is essential Chart 1 Definitions Based on Issuer and Intended Scope of Use, Transaction Verification and Technology for decentralized digital currencies, which Electronic Money face a severe double-spending problem— Digital Currency someone could “copy and paste” the digital monetary unit and spend it over and over Centralized Currency again because there is no central authority Simulated Currency to validate the authenticity of a transaction. Decentralized Currency Bitcoin’s founder(s) solved this problem with the invention of blockchain technology—an E-gold accounting system in which a complete his- Bitcoin tory of transactions of any bitcoin user is both Virtual Currency unalterable and publicly viewable to ensure that no user can spend more bitcoins than Cryptocurrency they have acquired. This also means that no central entity or organization clears transactions, which is why decentralized currencies are difficult to regulate.2 Table 1 lists the names, U.S. dollar value of the stock of the currency (market capitalization) on Dec. 27, 2016, and founding date of the five most highly capitalized cryptocurrencies. As the oldest and largest of them, bitcoin is frequently studied and is the best understood. Alternatives to bitcoin are collectively referred to as altcoins. Bitcoin Markets Why do people purchase bitcoins? The reasons are evolving as bitcoin becomes more established and integrated into the world economy. Wilson and Yelowitz (2015) find a correlation between interest in criminal activity and interest in bitcoin. Brière, Oosterlinck and Szafarz (2015) show that Table 1 Largest Cryptocurrencies by Market Capitalization, Founding Date Cryptocurrency name Market capitalization (U.S.$) Bitcoin Founding date $13,872,012,671 2009 Ethereum $670,845,473 2014/2016 Ripple $228,099,345 2012 Litecoin $182,040,688 2011 Monero $123,119,681 2014 SOURCE: CoinMarketCap, https://coinmarketcap.com, accessed December 2016. 22 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report bitcoin can be a useful diversification asset in a financial portfolio. Bitcoin can also be Bitcoin is globally traded, yet there is no global regulatory framework for it. Some countries, such as Ecuador, have attempted to ban bitcoin. Bitcoin-Based Exchange Rates Chart 2 shows how $1,000 can be used to buy tangible goods on an increasing directly exchanged for euros using official number of websites such as Amazon and exchange rate markets, at a hypothetical ex- Overstock or in some physical stores as an change rate of $1 for €0.97. Alternatively, one alternative to sovereign currencies. bitcoin (BTC) can be purchased for $1,000, 3 There are multiple ways to acquire a bit- and the bitcoin can then be sold to obtain eu- coin, but one of the most common is through ros at a price of 1 BTC for €970. In this second a bitcoin exchange. It is like any other online scenario, bitcoin is used as a vehicle cur- marketplace: Anyone wishing to purchase (or rency to move from one currency to another. sell) a bitcoin indicates the amount of bitcoin This process is simple to implement on any and pays (or receives) the price in the mon- exchange that allows the sale and purchase etary unit they select from those accepted by in at least two currencies. In Chart 2, both the the exchange. The available electronic money official exchange rate and the bitcoin-based ranges from sovereign currencies such as exchange rate are the same. However, it is U.S. dollars, Chinese yuan, or New Zealand possible that the bitcoin market is too small, dollars, to other cryptocurrencies such as or that bitcoin users ignore and are ignored ethereum or litecoin. Exchanges differ in by international markets, so that bitcoin- the range of electronic monies they accept, based exchange rates are actually uninforma- their fees, regulatory requirements and other tive and bear little similarity to the official properties. The impact of these on the price exchange rate markets. of a bitcoin in an exchange is examined in Pieters and Vivanco (2016). Bitcoin is globally traded, yet there is Pieters (2016) examines exchange rates derived from bitcoin trades and finds that in the absence of a policy of exchange-rate no global regulatory framework for it. Some management, bitcoin-based exchange rates countries, such as Ecuador, have attempted reflect official exchange rates. Addition- to ban bitcoin. Others, such as Cyprus, en- ally, they also provide information on black courage its use. Within the U.S., virtual cur- market exchange rates and capital controls. rency exchanges are regulated by the Finan- Chart 3 shows both the official and bitcoin cial Crimes Enforcement Network (FinCEN). exchange rate between the U.S. dollar and It requires that all bitcoin exchanges collect the British pound, normalized to begin at the the identification of purchasers. Pieters and same exchange rate value. These two curren- Vivanco (2016) test the enforceability of this cies are highly traded with minimal restric- ruling by attempting to purchase bitcoins tions, and movements in bitcoins and official using U.S. dollars from a location within the exchange rates are essentially identical. U.S. While all bitcoin exchanges within the Argentina, in contrast, had a period of U.S. collected information, very few outside financial market restrictions to support a of the U.S. did, circumventing FinCEN regula- desired exchange rate, during which a sub- tions.4 stantial and well-developed black market for Chart 2 Two Methods of Converting U.S. Dollars into Euros trades between the U.S. dollar and Argentine peso arose. This black market was so well established that newspapers quoted both the official (government supported) exchange U.S. $1,000 €970 rate and the unofficial (black market) rate, called the dólar blue. Chart 4 shows the three exchange 1 Bitcoin rates—the official, bitcoin and unofficial dólar blue rates—both during and after the end of the Argentinian exchange rate program in Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 23 Chart 3 Official and Bitcoin-Based U.S. Dollar-British Pound Exchange Rate Relative exchange rates .90 .85 .80 Official .75 .70 .65 Bitcoin .60 .55 .50 .45 .40 1/1/2014 7/1/2014 1/1/2015 7/1/2015 1/1/2016 7/1/2016 SOURCES: Bitcoincharts.com (bitcoin prices); investing.com (official exchange rates); Pieters (2016); author’s calculations. Chart 4 U.S. Dollar–Argentine Peso Bitcoin-Aided Exchange Rates Relative exchange rates 20 18 Bitcoin Official 16 14 12 10 Dólar blue 8 6 4 1/1/2014 7/1/2014 1/1/2015 7/1/2015 1/1/2016 7/1/2016 SOURCES: LocalBitcoins exchange, bitcoincharts.com (bitcoin prices); investing.com (official exchange rates); Àmbito Financiero (unofficial exchange rates); Pieters (2016); author’s calculations. December 2015. The bitcoin exchange rate bitcoin use is not limited to purchases within the relative supply or demand of currencies, does not reflect the official exchange rate a domestic market; it also facilitates transac- the exchange rate is managed. during the period of financial market restric- tions across currencies on a global scale. tions. It, however, mirrors the movement of the unofficial exchange rate. This suggests that the bitcoin market was used as a chan- The trilemma of international finance, illustrated in Chart 5, is a restriction on Trilemma of International Finance The relative value of any two curren- government policy that follows immediately from the interaction of exchange rates, nel to circumvent restrictions on currency cies—the exchange rate—is determined monetary policy and international capital trades. After capital controls ended, bitcoin through their sale and purchase on the global flows. The trilemma states that any coun- and official exchange rates became similar. foreign exchange market. If government try can have only two of the following: (1) These two examples provide evidence that policy interferes with this market by changing unrestricted international capital markets, (2) 24 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report a managed exchange rate or (3) an indepen- is fully backed by a foreign currency (as in dent monetary policy. the case of Hong Kong). In such a situation, If the government wants a managed monetary policy can no longer be used for exchange rate but does not want to interfere domestic purposes (it is no longer indepen- with international capital flows, it must use dent). If a country wishes to maintain control monetary policy to accommodate changes over monetary policy—to reduce domestic in the demand for its currency in order to unemployment or inflation, for example—it stabilize the exchange rate. In the extreme, must limit trades of its currency in the inter- this would take the form of a currency board national capital market (it no longer has free arrangement, where the domestic currency international capital markets). A country that chooses to have both unrestricted international capital flows and an independent Chart 5 Depiction of the Trilemma of International Finance monetary policy can no longer influence its exchange rate and, therefore, cannot have a managed exchange rate. The U.S. has chosen (1) and (3): It allows unrestricted international movement of capital and has an independent monetary policy and, as a result, must accept a marketdetermined exchange rate. Hong Kong maintains a (2) fixed exchange rate and allows (1) unrestricted capital flows, with its monetary xc ea cti gE ve tin loa Mo :F ne ve tar ha yP st oli Mu cy 1 Unrestricted International Capital Markets :R ha exchange rate. Prior to 2016, Argentina had a s Mu ate st eR 2 Managed Exchange Rate policy dedicated solely to maintaining its ng ve ha Choose any two Must have: Restricted Financial Flows 3 Independent Monetary Policy (2) managed exchange rate and (3) independent monetary policy and imposed restrictions on international capital flows. Bitcoin creates a problem for Argentina and similar countries; it makes circumventing capital controls easier. As demonstrated Chart 6 Bitcoin Market Capitalization from July 1, 2010, to Dec. 28, 2016 U.S. dollar value (millions) 20,000 U.S. dollar value (log) 12 Log (value) 18,000 10 16,000 14,000 8 Value (millions) 12,000 10,000 6 8,000 4 6,000 4,000 2 2,000 0 0 1/1/2011 1/1/2012 SOURCES: Coindesk.com; author’s calculations. 1/1/2013 1/1/2014 1/1/2015 1/1/2016 1/1/2017 Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 25 attempts to regulate the globally accessible Chart 7 Bitcoin’s Monthly Share of Cryptocurrency Market Capitalization Declines bitcoin markets are generally unsuccessful, Percent 100 in Pieters and Vivanco (2016), government and, as shown in Pieters (2016) and Chart 4, bitcoin exchange rates tend to reflect the 95 market, not official exchange rates. Should the flows allowed by bitcoin become big 90 enough, all countries will have, by default, unrestricted international capital markets. 85 Thus, with bitcoin, (1) unrestricted international capital markets is chosen by 80 default. Therefore, the only remaining policy choice is between (2) managed exchange 75 rates or (3) independent monetary policy. If the country chooses (1) and (2), it must use 70 reactive monetary policy to achieve the managed exchange rate. If the country chooses (1) and (3), it must have a floating exchange 5/2013 11/2013 5/2014 11/2014 5/2015 11/2015 5/2016 11/2016 SOURCE: CoinMarketCap, https://coinmarketcap.com. rate because it has no remaining tools with which to maintain a managed exchange rate. Ali et al. (2014), the European Central decisions in an environment in which con- Bank (2015) and the Bank for International sumers can opt to use a globally traded and Settlements (2015) all concur that cryptocur- unregulated alternative currency. rencies may eventually undermine monetary policy, but at the time of their writing, all Notes found that the small size of cryptocurrency While not represented on Chart 1, any electronic money that is not a digital currency is centralized. This is because it must, by definition, have a physical representation, which in turn requires implied approval (or disapproval) by an agency (such as a central bank). 2 For an explainer on blockchain technology, see Koch and Pieters (forthcoming). 3 Websites such as coinmap (http://coinmap.org) or usebitcoins (http://usebitcoins.info) maintain lists of businesses that accept bitcoins. 4 Pieters and Vivanco also show that persistent price deviations arise based on the extent of information gathering by a given exchange. Exchanges that require users to provide identification to open an account had prices that did not significantly deviate from the prices of the largest exchange. Those that required ID to transfer a sovereign currency posted slight price deviations over short intervals, while those that required no identification could post large and persistent deviations. markets did not represent any tangible restrictions. However, the market capitalization of bitcoin is growing rapidly, doubling from $7 billion on Jan. 2, 2016, to nearly $14 billion by Dec. 28, 2016 (Chart 6). Additionally, despite bitcoin’s rapid growth, data show that bitcoin’s share of the cryptocurrency market has fallen from a dominating 95 percent to as low as 80 percent (Chart 7). While Table 1 shows that no individual altcoin has a market size comparable to bitcoin, the altcoins are collectively becoming more important. They achieved a combined $2 billion market capitalization on Dec. 28, 2016, for a collective cryptocurrency like the much larger foreign exchange market, References there is high liquidity between currencies. Ali, R., J. Barrdear, R. Clews and J. Southgate (2014), "The Economics of Digital Currencies," Quarterly Bulletin, Bank of England, Third Quarter. ues growing, the size of cryptocurrency flows relative to international financial markets will increase and central banks in economies of all sizes will have to make monetary policy European Central Bank (2015), "Virtual Currency Schemes— a Further Analysis" (Frankfurt, Germany: February). 1 market capitalization of $17 billion—and un- If adoption of cryptocurrencies contin- Committee on Payments and Market Infrastructures (2015), "Digital Currencies" (Basel, Switzerland: Bank for International Settlements, November). Brière, M., K. Oosterlinck and A. Szafarz (2015), "Virtual Currency, Tangible Return: Portfolio Diversification with Bitcoins," Journal of Asset Management 16 (6). Koch, C., and G. Pieters (forthcoming), "Decentralization and Democratization of the Ledger? Blockchains as a Disruptive Technology," Federal Reserve Bank of Dallas Financial Insights. Pieters, G. (2016), "Does Bitcoin Reveal New Information About Exchange Rates and Financial Integration?" Globalization and Monetary Policy Institute Working Paper no. 292 (Federal Reserve Bank of Dallas, December). Pieters, G. and S. Vivanco (2016), "Financial Regulations and Price Inconsistencies Across Bitcoin Markets," Globalization and Monetary Policy Institute Working Paper no. 293 (Federal Reserve Bank of Dallas, December). Wilson, M., and A. Yelowitz (2015), "Characteristics of Bitcoin Users: An Analysis of Google Search Data," Applied Economics Letters 22 (13), 1030–36. 26 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report Interactions Between Exchange Rates and Import Prices: What Have We Learned? g By Mina Kim lobalization has deepened eco- in GDP growth, reflected in export growth nomic interdependence among rates of the same OECD countries (Chart 2).1 countries as firms seek to take advantage of international trade As the global financial crisis illustrates, this interdependence has serious implica- to source production where it is cheapest, tions for the international transmission of and investors look to global financial markets shocks and the ability of monetary policy to to diversify their portfolios. One need only stabilize national economies. Consequently, look at the global financial crisis of 2007–08 policymakers are being forced to take greater and the associated global recession to grasp account of the global economic landscape the extent of globalization. when formulating policy. During the Great Recession, almost all Exchange rates are at the center of the advanced economies and some developing international transmission of shocks via trade economies experienced a drop in gross do- linkages. Given the United States’ growing mestic product (GDP) growth. Chart 1 shows reliance on imports, the potential impact the synchronous decline in GDP growth of exchange rate movements has become rates for selected Organization for Economic more important (Chart 3). These movements Cooperation and Development (OECD) directly affect the competitiveness of U.S. countries that trade frequently with each firms in the global market and at home and, other. Simultaneously, the world experienced therefore, affect firms’ production, employ- a trade collapse that was worse than the drop ment and earnings, and, in turn, consumer prices. Indirectly, exchange rate movements also induce expenditure switching toward Chart 1 GDP Growth Rates for Selected OECD Countries Synchronously Fall countries with cheaper goods, affecting consumer prices. This essay focuses on these Real gross domestic product growth (percent), year/year 8 interactions between exchange rates and prices. 6 Exchange Rates, Trade Prices 4 There is evidence that firms are sensitive 2 to exchange rate changes when setting export prices. Given the U.S.’ increasing reliance on 0 imports, the extent to which exchange rate –2 changes are passed through to import prices Korea –4 Canada (also known as exchange rate pass-through) United States has critical implications for domestic infla- Germany –6 tion and the appropriate response of mon- Japan etary policy. –8 2004 2005 2006 2007 2008 2009 NOTE: OECD stands for Organization for Economic Cooperation and Development. SOURCE: International Monetary Fund World Economic Outlook. 2010 2011 2012 2013 2014 More specifically, exchange rate passthrough is most commonly defined as “the Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 27 percent change in import (or export) prices for a percent change in the exchange rate” (Chinn, 2006). For example, suppose that an exchange rate (defined as the number of units of the domestic currency needed to purchase a unit of foreign currency) increases 10 percent. If the exchange rate pass-through is 1, then the price of imports will increase by 10 percent. If exchange rate pass-through is 0.5, then the price of imported goods will increase by only 5 percent. If pass-through is 0, then the price of imported goods will be unchanged. The academic literature on exchange rate pass-through is expansive, and there is wide variation in the empirical estimates of exchange rate pass-through across countries, goods and time periods.2 The empirical Chart 2 Export Growth Rates Simultaneously Drop for Selected OECD Countries Export growth (percent), year/year 30 20 10 0 Japan Canada –10 United States Germany –20 Korea –30 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 NOTE: OECD stands for Organization for Economic Cooperation and Development. SOURCE: International Monetary Fund World Economic Outlook. evidence for the U.S. shows that pass-through is incomplete and low. In the aggregate data, the long-run pass-through estimate is around 0.4 (Campa and Goldberg, 2005); in productlevel data, the estimate is similar (Gopinath Chart 3 Share of Imports in U.S. GDP Rises Share of gross domestic product (percent) 20 and Itskhoki, 2010). The empirical evidence 18 also shows that exchange rate pass-through 16 in the U.S. has been declining since at least the 1980s.3 These empirical regularities can 14 be explained by understanding the price set- 12 ting behavior of firms. 10 8 Exporter Response to Exchange Rate Fluctuations The literature outlines many factors 6 4 affecting how exporters respond to exchange 2 rate changes, of which four are highlighted: 0 • Menu costs • Desired pass-through • Market structure • Policy environment ’29 ’32 ’35 ’38 ’41 ’44 ’47 ’50 ’53 ’56 ’59 ’62 ’65 ’68 ’71 ’74 ’77 ’80 ’83 ’86 ’89 ’92 ’95 ’98 ’01 ’04 ’07 ’10 ’13 SOURCE: Bureau of Economic Analysis. 28 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report China’s hard peg to the U.S. dollar in 2005 can First, the cost of adjusting prices, or menu costs, matters (Blinder et al., 1998; be used to study how firms change import Schoenle, forthcoming; Fabiani et al., 2006). and export prices in response to changed Small exchange rate movements may not exchange rate policy. The switch in exchange warrant incurring the cost of adjusting prices. rate policy from a hard peg to a managed Instead, the exchange rate change is ab- float resulted in gradual appreciation of the sorbed in firms’ margins. However, firms may Chinese yuan against the dollar (Chart 4). The degree of price stickiness in U.S.– be unable to keep prices fixed when move- When prices are sticky and cannot be adjusted instantaneously, the currency of invoicing determines the amount of exchange rate fluctuation that can be passed through. ments are large. Menu costs result in prices China trade prices is examined using goods- that exhibit infrequent change, what econo- level data on trade prices from the Bureau of mists commonly refer to as “sticky” prices. Labor Statistics (BLS). The duration of U.S.– China trade prices, based on the frequency of When prices are sticky and cannot be adjusted instantaneously, the currency of in- price changes in each month (the frequency- voicing determines the amount of exchange implied duration), appears to have declined rate fluctuation that can be passed through. almost 30 percent since China abandoned its Exporters desiring low exchange rate pass- hard peg to the U.S. dollar. We extend a menu-cost model to reflect through in the short run will choose to invoice in the local currency, or the currency this stylized fact and find that the change of the destination country (Gopinath, 2015). in exchange rate policy can explain about However, exporters desiring high exchange 60 percent of the decline in price stickiness. rate pass-through in the short run will choose In our model, exchange rate fluctuations to invoice in their own (or the producer’s) influence price-setting behavior through ag- currency, the currency of the origin country. gregate demand. The appreciation of the Chi- One explanation is that exporters facing more nese yuan leads to an increase in aggregate competition in the destination market may demand for U.S. exports to China, inducing desire to keep prices stable relative to their U.S. exporters to raise their prices. Our results are complementary to those competitors. Exporters can better maintain stable prices by pricing in the local currency. 4 Third, market structure can affect how found in Floden and Wilander (2006). They present a menu-cost model in which firms firms set prices (Campa and Goldberg, 2005). adjust prices in response to exogenous ex- In competitive sectors, firms are less able change rate fluctuations. In their model, large to absorb any losses from exchange rate exchange rate changes raise the opportunity changes and must thus adjust prices quickly. cost of holding prices fixed, so firms change This is not the case for firms in differentiated prices more frequently, and exchange rate goods sectors. Relatedly, firms with market pass-through is dependent on the size of power are better able to absorb exchange the exchange rate change. Furthermore, the rate shocks and are less likely to adjust prices Floden and Wilander model generates asym- (Atkeson and Burstein, 2008). metric responses to exchange rate changes Lastly, the policy environment can be based on the direction of the change. They important for exporters’ pricing decisions. find that appreciation of the exporter’s cur- For example, in countries that have credible rency leads to higher exchange rate pass- inflation-targeting monetary policy, there through than depreciations, especially during is less inclination for firms to change prices periods of inflation. when exchange rates change since they have confidence that the shocks are temporary Asymmetric and Nonlinear Reponses (Taylor, 2000, and Gagnon and Ihrig, 2004). Evidence of asymmetric and nonlinear Kim et al. (2013) argue that the pricing responses to exchange rate fluctuations has behavior of firms also depends on a country’s important consequences for monetary policy exchange rate policy. The abandonment of and suggests that policymakers and forecast- Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 29 ers at least reconsider the effectiveness of the “rule of thumb” used to estimate how currency movements will affect inflation.5 The appropriate policy response to dollar appreciation may be different than that for de- Chart 4 Monthly Chinese Yuan/U.S. Dollar Exchange Rate Falls After Unpegging Chinese yuan/U.S. dollar 8.5 preciation if the price responses are different. Likewise, the appropriate policy response to a large change in exchange rates may not 8.0 be the same as the one for a small change if nonlinearities are present. 7.5 The asymmetries and nonlinearities described in Floden and Wilander (2006) primarily point to menu costs and strategic 7.0 choice of invoicing currency as the mechanisms generating those price responses. 6.5 Aside from Floden and Wilander (2006), there are several other theories as to why asymmetries in exchange rate pass-through might exist. These mechanisms include: • Competition for market share 6.0 2002 2003 2004 2005 2006 2007 SOURCE: Board of Governors of the Federal Reserve System. • Production switching • Binding quantity constraints When exporters are concerned about importer’s currency depreciates, marginal market share, they adjust markups to in- revenue and marginal cost both decrease, crease their future profits. When the im- and the firm does not change output or price, porter’s currency appreciates, the exporter resulting in zero pass-through. updates prices, but only to increase market In both of these cases, appreciation of share. When the importer’s currency depreci- the importer’s currency results in greater ates, the exporter will instead absorb some pass-through than during depreciation. That of the exchange rate change in order to hold direction of asymmetry will not hold when market share. Under this strategy, exchange exporters face binding quantity constraints. rate pass-through is greater when the im- These binding quantity constraints occur porter’s currency appreciates than when it when firms have limited ability to increase depreciates. production when the importer’s currency Alternatively, the mechanism through appreciates. Instead, the exporter will raise which asymmetries can arise is through pro- markups to hold prices fixed and increase duction switching (Ware and Winter, 1988). profits. On the other hand, when the im- Exporters may switch between domestic porter’s currency decreases, the exporter may inputs and foreign inputs in response to ex- reduce markups, but will still increase prices change rate changes as a means of reducing somewhat to offset increased costs. Thus, cost. Assuming the extreme case in which a appreciation of the importer’s currency will firm can use either the domestic or foreign instead produce lower pass-through than input, the firm switches to the cheaper depreciation. domestic input when the importer’s cur- Recent empirical evidence on nonlin- rency appreciates. Since the marginal cost is earities or asymmetries in exchange rate unaffected, the price of the final good drops pass-through is limited, especially involving as output increases with the marginal rev- the U.S. Older studies focused on how price enue increase. On the other hand, when the responses differed between appreciations 2008 2009 2010 2011 2012 2013 30 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report Unfortunately, economists have little understanding as to why exchange rate pass-through varies along these different dimensions. and depreciations. The results have been asymmetries and nonlinearities in exchange mixed, with no clear evidence whether rate pass-through to U.S. import prices. Un- appreciation or depreciation is associated like Pollard and Coughlin (2004), the authors with higher pass-through. Mann (1986) used use goods-level transaction price data from aggregate U.S. data and found that exchange the BLS and match it with country-level rate pass-through was higher in periods of data on exchange rates and consumer price appreciation than depreciation. However, indexes to better understand the importance the difference was not statistically significant. of asymmetries and nonlinearities to U.S. Kadiyali (1997) and Goldberg (1995) focused inflation. on a single industry and found the opposite Throughout the period considered, the outcome. Other industry studies found that U.S. experienced episodes of appreciation the direction of asymmetry depended on the and depreciation of varying degrees. Chart 5 industry (for example, Mahdavi, 2002, and shows a histogram of the average monthly Olivei, 2002). exchange rate change seen in the data, where Pollard and Coughlin (2004) consider exchange rate is defined as foreign currency both asymmetries and nonlinearities in per dollar. The distribution is bell-shaped and exchange rate pass-through to U.S. import roughly centered around zero, suggesting prices. They use industry-level exchange that asymmetries and nonlinearities might rate changes and find no clear direction of be masked in aggregate data. asymmetry across industries, as in the previ- Unlike Pollard and Coughlin (2004), we ous literature. They find nonlinearities such find no economically significant evidence of that larger exchange rate fluctuations are nonlinearities, even when the data is disag- generally associated with higher exchange gregated by sector. However, we find that rate pass-through, even when accounting for asymmetries in exchange rate pass-through asymmetries. exist to varying degrees across different ag- Kim et al. (2017) incorporate more gregations of the data, with depreciations recent time periods in their examination of tending to pass through faster than appreciations. Stickiness in nominal prices does not seem to drive our results, as these asymmetries persist even when we restrict our analy- Chart 5 Frequency of Depreciations and Appreciations in U.S. Exchange Rates Roughly Symmetric sis to goods that experience at least one price change. On the other hand, nominal price Relative frequency .25 stickiness can explain why we see significant asymmetries disappear in the long run. It may be that the asymmetries found are .20 a result of firms exiting because of currency depreciation. No asymmetries were found .15 when examining the probability of a good exiting the dataset because of exchange rate .10 fluctuation. These preliminary findings suggest that the nature of competition and price setting .05 is important when determining the extent of pass-through. Menu costs may reconcile the 0 –.06 –.05 –.04 –.03 –.02 –.01 0 .01 .02 NOTE: Exchange rate is quoted as U.S. dollar/foreign currency. SOURCES: International Monetary Fund International Financial Statistics; Bureau of Labor Statistics; author’s calculations. .03 .04 short-run and long-run results on exchange rate pass-through, but that mechanism alone cannot explain the strong asymmetries found. Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 31 Extent of Pass-Through The academic literature has made great strides in understanding how exchange rate movements affect inflation. There is little disagreement that exchange rate pass-through is incomplete, and economists have some understanding of why that might be occurring. Burstein, A. and Gopinath, G. (2014), “International Prices and Exchange Rates,” Handbook of International Economics Vol. 4 (Gita Gopinath, Elhanan Helpman and Kenneth Rogoff, eds.): 391–451. Kadiyali, Vrinda (1997), “Exchange Rate Pass-Through for Strategic Pricing and Advertising: An Empirical Analysis of the U.S. Photographic Film Industry,” Journal of International Economics, 43 (3–4): 437–61. Bussiere, M., C. Lopez and C. Tille (2015), “Exchange Rate Appreciations and Growth: The Drivers Matter,” Center for Economic and Policy Research, Aug. 7. Kim, Mina, Logan Lewis and Robert Vigfusson (2017), “Asymmetries and Non-linearities in Exchange Rate PassThrough,” Mimeo. Campa, Jose and Linda S. Goldberg (2005), “Exchange Rate Pass-Through into Import Prices,” Review of Economics and Statistics 87 (4): 679–90. Kim, Mina, Deokwoo Nam, Jian Wang and Jason Wu (2013), “International Trade Price Stickiness and Exchange Rate Pass-Through in Micro Data: A Case Study on U.S.– China Trade,” Globalization and Monetary Policy Institute Working Paper no. 135 (Federal Reserve Bank of Dallas, August). There is less agreement on the extent of pass-through. It seems to vary across time and across industries. It also seems to vary depending on the direction of the exchange rate shock and sometimes the magnitude of the exchange rate shock. Unfortunately, Chinn, Menzie (2006), “Exchange Rate Pass-Through and Dollar Decline,” Econbrowser, May 23. economists have little understanding as to why exchange rate pass-through varies along these different dimensions. As a result, there has been little success predicting how exchange rate changes will affect inflation. More recent studies, such as Forbes et al. (2015), Bussiere et al. (2015) and this author’s work, suggest that the mechanisms behind the exchange rate change could matter. The degree of exchange rate pass-through could depend on whether a supply, demand or nominal shock drives the exchange rate fluctuation, for example. Further investigation can help policymakers effectively respond to exchange rate movements. Notes See Eichengreen and O’Rourke (2010) for more details about the global financial crisis and a comparison to the Great Depression. 2 See Burstein and Gopinath (2014) for a more extensive review of the academic literature on exchange rate passthrough. 3 See, for example, the figures in Marazzi et al. (2005) for an illustration of the decline in exchange rate pass-through into U.S. import prices. 4 Other possible mechanisms are described in Gopinath (2015). 5 According to Forbes et al. (2015), the "rule of thumb" commonly used for the U.S. is a pass-through rate of 5 percent into domestic prices. 1 References Atkeson, A. and A. Burstein (2008), “Trade Costs, Pricingto-Market, and International Relative Prices,” American Economic Review 98 (5): 1998–2031. Blinder, A. S , E. R. D. Canetti, D. E. Lebow and J. B. Rudd (1998), Asking About Prices: A New Approach to Understanding Price Stickiness (New York: Russell Sage Foundation). Eichengreen B. and K.H. O’Rourke (2010), “What Do the New Data Tell Us?” Center for Economic and Policy Research, March 8. Fabiani, Silvia, Martine Druant, Ignacio Hernando, Claudia Kwapil, Bettina Landau, Claire Loupias, Fernando Martins, Thomas Mathä, Roberto Sabbatini, Harald Stahl and Ad Stokman (2006), “What Firms’ Surveys Tell Us about PriceSetting Behavior in the Euro Area,” International Journal of Central Banking 2 (3): 3–47. Floden, Martin and Fredrik Wilander (2006), “State Dependent Pricing, Invoicing Currency and Exchange Rate Pass-Through,” Journal of International Economics, 70 (1): 178–96. Forbes, Kristin, Ida Hjortsoe and Tsvetelina Nenova (2015), "The Shocks Matter: Improving Our Estimates of Exchange Rate Pass-Through," Bank of England External MPC Unit Discussion Paper no. 43. Gagnon, Etienne (2009), “Price Setting During Low and High Inflation: Evidence from Mexico,” Quarterly Journal of Economics, 124 (3): 1221–63. Gagnon, Joseph and Jane Ihrig (2004), “Monetary Policy and Exchange Rate Pass-Through,” International Journal of Finance & Economics, 9 (4): 315–38. Goldberg, Pinelopi K. (1995), “Product Differentiation and Oligopoly in International Markets: The Case of the U.S. Automobile Industry,” Econometrica 63 (4), 891–951. Gopinath, G. (2015), “The International Price System,” Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole. Gopinath, Gita and Oleg Itskhoki (2010), “Frequency of Price Adjustment and Pass-Through,” Quarterly Journal of Economics, 125 (2): 675–727. Mahdavi, Saeid (2002), “The Response of the U.S. Export Prices to Changes in the Dollar’s Effective Exchange Rate: Further Evidence from Industry Level Data,” Applied Economics, 34 (17): 2115–2125. Mann, Catherine L. (1986), “Prices, Profit Margins and Exchange Rates,” Federal Reserve Bulletin 72 (6): 366–79. Marazzi, Mario, Nathan Sheets, Robert Vigfusson, Jon Faust, Joseph Gagnon, Jaime Marquez, Robert Martin, Trevor Reeve and John Rogers (2005), “Exchange Rate Pass-Through to U.S. Import Prices: Some New Evidence,” International Finance Discussion Papers no. 833, Board of Governors of the Federal Reserve System (U.S.). Olivei, Giovanni P. (2002), “Exchange Rates and the Prices of Manufacturing Products Imported into the United States,” New England Economic Review, First Quarter, 3–18. Pollard, P.S., and C.C. Coughlin (2004), “Size Matters: Asymmetric Exchange Rate Pass-Through at the Industry Level,” Working Paper no. 2003–029 (Federal Reserve Bank of St. Louis). Schoenle, Raphael (forthcoming), “International Menu Costs and Price Dynamics,” Review of International Economics. Taylor, John (2000), “Low Inflation, Pass-Through and the Pricing Power of Firms,” European Economic Review, 44 (7): 1389–1408. Ware, Roger and Ralph Winter (1988), “Forward Markets, Currency Options and the Hedging of Foreign Exchange Risk,” Journal of International Economics, 25 (3–4): 291–302. 32 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report Conference on International Economics By Michael Sposi g lobalization has led to increased fundamental level. integration across countries in Current methods of constructing price goods markets and financial indexes and measures of welfare rely on three markets and has changed the distinct approaches: 1) macroeconomic price environment in which policy operates. As a indexes based on time-invariant prefer- result, researchers in the various subfields ences,1 2) microeconomic demand-system have developed new methods to study and estimation with time-varying demand curves measure the consequences of globalization. and 3) actual price data constructed using To better understand these develop- formulas that differ from those implied by ments, the Federal Reserve Bank of Dallas’ macro and micro approaches but that embed Globalization Institute and the University intuitive properties researchers want to ex- of Houston brought together researchers ploit. The micro and macro approaches are from academic institutions and the Federal Reserve System for a conference focusing on mutually inconsistent with each other, and international trade and prices and on inter- neither is consistent with the approaches national finance and sovereign debt. used by statistical agencies, the authors point The goal was to foster a cross-pollination of ideas across these subfields of international economics. out. The authors develop a unified estimation approach to reconcile the discrepancies between micro prices, macro prices and International Trade, Prices practice. In particular, they provide condi- Understanding the welfare implications of tions under which the aggregate utility globalization—or of policy, for that matter— function can be characterized by a constant is of the utmost importance to economists. aggregate demand parameter, in spite of From a practitioner’s perspective, the mea- demand for each good changing over time. surement of welfare is challenging. A central Additionally, the estimation approach in- 2016 Conference Summary difficulty involves constructing indexes that corporates the properties of the approaches When: Oct. 7–8 accurately quantify changes in price levels statistical agencies use most. Where: Federal Reserve Bank of Dallas and the cost of living across both time and The authors demonstrate a new source space. Any reasonable price index must be of estimation bias that arises when one consistent with some notion of consumer ignores changes in demand over time. They Federal Reserve Bank of Dallas; preferences, or consumer utility, and must be show empirically that this bias implicitly University of Houston constructed to use real-world data. Stephen overstates cost-of-living changes by an aver- Redding of Princeton University presented age of 2.8 percentage points per year between the paper “A Unified Approach to Estimat- 2000 and 2014. This bias is roughly as large ing Demand and Welfare” (co-authored with as the bias that would arise if one failed to David Weinstein of Columbia University), account for changes in the varieties of goods which explores a new approach to bridg- and services over time. Sponsors: Globalization Institute, ing price-index theory and data at the most Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 33 Expectations and Export Decisions Not only is accounting for changes in information about what the firm’s expectations actually were when making the deci- varieties important for measuring economic sion. So if a researcher incorrectly specifies well-being, it is also important for under- the expectations on which firms are acting, standing fluctuations in trade volumes. That the estimated fixed costs of exporting will be is, much of the variation in trade volume is biased. This is an important empirical issue due to an extensive margin, reflecting firms given that many questions involve quanti- entering and exiting export markets. Eduardo fying the response of exports to trade cost Morales of Princeton University presented shocks. “What Do Exporters Know” (co-authored To mitigate this bias, the authors with Michael Dickstein of New York Univer- introduce a new econometric technique sity), which examines firms’ export decisions. that allows the researcher to measure firms’ Existing theories of export decisions in- expectations using a few pieces of avail- volve firms balancing a fixed cost of accessing able data, such as lagged aggregate exports, foreign markets with future profits that can lagged domestic sales and distance. The be earned from selling into those markets. authors apply their methodology to Chilean Uncertainty surrounding profits includes the exporters and find that, after accounting firms’ relative competitiveness, local demand for the information available to firms at the conditions and the local policy environment time of the export decision, the estimated in the foreign market. As such, if a researcher parameters for the fixed cost of exporting are observes that a particular firm did not export at least 70 percent lower. One key implica- to a market, it is inferred that either the fixed tion is that, relative to a model in which firms cost is too large or the expected profits are have complete information, firms increase too small. their exports substantially more in response However, the researcher has very little Existing theories of export decisions involve firms balancing a fixed cost of accessing foreign markets with future profits that can be earned from selling into those markets. 34 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report to otherwise equal reductions in trade costs. In addition to the decision of whether Trade costs are clearly an important determinant of the magnitude and direction of trade flows. Pol Antràs of Harvard University presented “On the Geography of Global Value Chains” to export, firms are faced with the challenge (co-authored with Alonso de Gortari of Har- of managing complex global supply chains, vard), which develops a model to character- from initial design to sourcing of inputs, ize the best location for each stage of produc- assembly and final distribution. That is, inter- tion in a global value chain. Key trade-offs national trade involves vertical linkages and include: 1) minimizing the transport costs trade in intermediate goods. To understand between each stage, and 2) assigning each how spillovers occur across countries, one stage of production to the location that has must first develop a framework that accounts a comparative advantage at that stage (i.e., for the specific types of linkages. Chart 1 labor-intensive activities to countries with depicts a typical supply chain for an arbitrary low wages and high productivity at that stage) electronic device. in order to minimize the final consumer cost. Previously, researchers incorporated Between each stage of production, trade trade in intermediate goods, but there were costs are incurred, including transportation, very few attempts to explicitly incorporate storage and potentially tariff costs. After each the sequential nature of the global value stage of production, trade costs accumulate chain, in which various stages of production and further raise the value of the good. Trade specifically make use of output from previous costs tend to be roughly proportional to the stages. value of the good—for example, a tax rate incurring high trade costs at the end of the Challenges to Supply Chain supply chain carries a greater impact than Modeling at the beginning of the chain. Therefore, it From a modeling perspective, many is generally more efficient to incur propor- complications arise, making modeling an tionately smaller trade costs at the end of the optimal supply chain technically challenging. supply chain by, for instance, being closer to Chart 1 Global Value Chain for Electronics Industry Product Design Semiconductors Fab and Packaging SOURCE: IDC Manufacturing Insights (courtesy ventureoutsource.com). Components and Subsystems Final Assembly Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 35 a large market. This feature guides the main finding of tions create additional current demand for international borrowing, driving up the real the model: More upstream or basic activities interest rate. In turn, current imbalances should generally be performed at locations are smaller than they otherwise would have that are less central in the global economy, been, and future imbalances are larger than such as Singapore and Indonesia, while more they otherwise would have been. That is, downstream activities should be performed trade imbalances are postponed to a future at more central locations, such as China. time when they are less costly to finance. As Between the beginning and final stages, each a result, the expectation of future trade-cost step of production should occur at locations declines generates an upward “tilt” in the that are geographically close to the previous magnitude of global imbalances over time. stage, such as Thailand. These predictions are broadly consistent with the data. International trade in goods is not independent of financial considerations. For one, Trade costs are clearly an important a country’s balance of trade must be recon- determinant of the magnitude and direction ciled with the balance of payments so that a of trade flows. Additionally, trade costs are trade deficit is accompanied by net foreign important for determining the balance of borrowing, or a trade surplus is accompa- trade. That is, in order for a country to run a nied by net foreign lending. For another, the trade deficit, it must borrow resources from exchange rate, which is intimately linked to the rest of the world. Ricardo Reyes-Heroles the current account and capital flows, has of the Federal Reserve Board presented his important implications for firms that buy and paper “The Role of Trade Costs in the Surge sell goods across the world. The next set of of Trade Imbalances,” in which he argues that papers explores international capital markets the decline in trade costs since 1970 accounts more closely. for 69 percent of the rise in global imbalances during the period. He identifies two channels through which trade costs affect imbalances. First, International Finance and Sovereign Debt Distortions that generate suboptimal trade costs drive a wedge between the real investment rates come with costly implica- “effective” interest rate (i.e., the real interest tions for economic performance. Liliana rate converted into units of consumption) Varela of the University of Houston presented paid by the borrower and the real effective “Reallocation, Competition and Productiv- rate received by the lender on capital flows ity: Evidence from a Financial Liberalization used to finance the imbalances. During the Episode.” The paper shows that distortions in times when the borrowing country borrows, international capital markets do, in fact, have its consumption basket will be loaded with consequences for the allocation of resources high-cost imported goods, but when that and aggregate productivity within a country. country subsequently repays the loans, its She develops a model with heterogeneous consumption basket will contain relatively firms that use capital for production and for low-cost domestic goods. This composition research and development, which affects effect means that the overall gains to borrow- future productivity and competitiveness. She ing are diminished and, hence, there is less uses the model as a framework to examine incentive to borrow in the first place. As trade the consequences of a financial liberalization costs decline over time, the gap between real episode in Hungary. effective borrowing and lending rates nar- Before 2001, foreign firms in Hun- rows and it becomes less costly to run trade gary were allowed access to international imbalances. credit markets, but domestic firms were not. The second channel involves expectations of declining trade costs. Such expecta- Growth rates for domestic firms were quite similar to those of international firms. After 36 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report 2001, capital controls were removed for all dollar, Swiss franc, Danish krone, euro, Brit- firms. ish pound, Japanese yen, Norwegian krone, Following the financial liberalization, domestic firms grew much faster than international firms did. The paper shows that Empirically, it is rare that governments fully default, though they may pay extremely high spreads to borrow from investors. New Zealand dollar and Swedish krona—visà-vis the U.S. dollar. While this deviation between textbook domestic firms experienced higher growth theory and reality, known as the cross- in labor productivity, and especially greater currency basis, has been documented and R&D and capital intensity. The higher degree studied previously, the authors present of capital intensity was a direct consequence evidence pointing to a new combination of of access to foreign capital. The paper also factors driving it: 1) the increased cost of shows that, following the liberalization, financial intermediation following the crisis, all firms became more competitive as the and 2) the persistent imbalances in invest- foreign firms’ markups decreased relative to ment demand and funding supply across domestic firms’, particularly in sectors that countries. With regard to the first factor, the rely more on external finance. authors argue that because of regulations, International credit and financial mar- financial intermediaries cannot fully hedge kets improve the allocation of resources and their foreign currency positions. They find generate higher efficiency and productivity, that the magnitude of the cross-currency ba- but some features of these markets are not sis is larger at quarter-ends, when quarterly well understood. For instance, the foreign regulatory reports are due, a feature absent exchange market (one of the largest in the prior to the crisis. Concerning the second fac- world) seems to admit systematic arbitrage tor, they show that the cross-currency basis opportunities. Consider a U.S. investor ex- is higher for countries with higher nominal changing one U.S. dollar for euros on the spot interest rates, reflecting greater demand for market, investing those euros in a risk-free investment relative to saving. Moreover, the German government bond and then convert- basis tends to increase with monetary policy ing the proceeds from that bond back into announcements. dollars at a predetermined forward rate. Such Whether CIP holds is crucial for central a transaction should yield the same return banks, whose monetary policy is aimed at as investing that same U.S. dollar in a U.S. targeting the exchange rate of, for instance, risk-free asset, such as a short-term Treasury. small open economies. Manuel Amador of This equality, known as “covered interest the Federal Reserve Bank of Minneapolis parity” (CIP), has failed to hold following the and the University of Minnesota presented Great Recession yet remains deeply rooted in “Exchange Rate Policies at the Zero Lower the way practitioners and researchers think Bound” (co-authored with Javier Bianchi and about financial markets. In fact, the assump- Fabrizio Perri of the Minneapolis Fed and Lu- tion that CIP holds can be found in almost igi Bocola of Northwestern University and the any textbook on international finance. National Bureau of Economic Research). The Wenxin Du of the Federal Reserve Board authors argue that if the nominal interest rate presented “Deviations from Covered Interest consistent with CIP happens to be negative, Parity” (co-authored with Alexander Tepper pursuing an exchange rate objective neces- of Columbia University and Adrien Verdel- sarily implies deviations from CIP given that han of the Massachusetts Institute of Tech- the nominal interest rate is constrained to nology’s Sloan School of Management and be non-negative. This provides an arbitrage the National Bureau of Economic Research). opportunity resulting in capital inflows into The authors show that while CIP was a robust the small open economy that is costly for the feature of the data prior to the financial crisis, central bank because it has to take the nega- it has since broken down among the G-10 tive side of the arbitrage trades by accumulat- currencies—the Australian dollar, Canadian ing foreign reserves in order to manage an Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 37 exchange rate target. July 30, 2014, when Argentina defaulted, the authors refer to these as “desperate deals” be- The authors also argue that there are risk-neutral five-year default probability in- cause the government will have to pay a high welfare losses to the small open economy creased from 40 percent to 100 percent, and spread (over “safe” asset prices) for the credit. that would not exist away from the zero lower the estimates imply that this change alone bound (ZLB). In particular, deeper financial was responsible for a 28 percent decline in eign country can circumvent some conse- integration with the outside world, which the value of Argentine firms. quences of coordination failure that result is typically beneficial when the economy is The authors translate the changes in Under these circumstances, the sover- in a self-fulfilling debt crisis. The model, above the ZLB, becomes a curse when at the the value of the equities into changes in real therefore, produces debt dynamics and vola- ZLB following foreign interest rate increases. economic activity, and find that the present tile spreads more in line with the data than The reasoning is that, at the ZLB, the size of discounted value of gross domestic product what other theories predict. Specifically, the the required reserve accumulation increases. growth declined between 3.6 percent and 6.6 model indicates that: 1) actual default is rare, percent as a result of the default. 2) spreads are volatile in emerging econo- International financial markets play an equally important role in the conduct of fiscal Given that the economic consequences mies and 3) large spikes in spreads are only policy as it pertains to debt issuance and re- of sovereign default are large, it is crucial to weakly correlated with declines in output payment. Governments across the world reg- have a theoretical foundation to understand (e.g., recently in Portugal, Ireland, Italy, Spain ularly tap international credit markets for the the inner workings of the market for sover- and Greece). financing of infrastructure projects as well eign debt. Whether warranted or not, on oc- as for regular spending on payroll and social casion investors may place a high probability programs. In many cases, much financing on the government defaulting or may believe is sourced from foreign investors. When a that there is a high degree of uncertainty in pushed the research frontier for various country’s fiscal authority runs into trouble, or terms of default. This makes it more difficult subfields within international economics, when the debt is denominated in foreign cur- for the government to auction bonds and, including international trade, international rency and the local currency depreciates, the thus, increases the incentive for the govern- finance and sovereign debt. Moreover, the government must decide whether to default. ment to default. In this sense, default can presentations and discussions made evident Benjamin Hébert from Stanford University potentially be self-fulfilling in that investors’ that there are important overlaps between presented “The Costs of Sovereign Default: expectations are the very reason for default. each subfield. The interdependence between Evidence from Argentina” (co-authored with In the previous literature, such situations international trade, trade imbalances and Jesse Schreger of Princeton University and tend to result in failed auctions, in which the capital flows is one such overlap. Another is Harvard Business School). The paper sheds government cannot issue debt at a positive the close relationship between international light on the magnitude of default costs. A key price, and default results. capital markets and sovereign debt and de- issue that any study confronts is the chick- Empirically, it is rare that governments Pushing the Research Frontier The papers presented at the conference fault. en-and-egg problem: Does the economy fully default, though they may pay extremely deteriorate because of the sovereign default, high spreads to borrow from investors. Satya- ticipant discussions, including those by or does the government default because the jit Chatterjee of the Federal Reserve Bank of “Exchange Rate Policies at the Zero Lower economy deteriorates? To examine this, the Philadelphia presented “Self-Fulfilling Debt Bound” co-author Luigi Bocola, Laura Alfaro authors explore legal rulings in the case of Crises, Revisited: The Art of the Desper- of Harvard University, Michael Devereux of Argentina and examine how equity returns ate Deal” (co-authored with Mark Aguiar the University of British Columbia, Jona- and exchange rates responded to changes in of Princeton University, Harold Cole of the than Eaton of Penn State University, Robert the probability of default. University of Pennsylvania and Zachary Johnson of Dartmouth College, Hanno Lustig By assuming that Argentine firms in the Each paper prompted excellent par- Stangebye of the University of Notre Dame). of Stanford University, Benjamin Malin of the economy are not directly impacted by the The paper presents a model that attempts to Federal Reserve Bank of Minneapolis, Vivian legal rulings, they use prices of credit default capture these more realistic features. Yue of Emory University and Jing Zhang of swaps to measure changes in the probability Their model includes “fire-sale auc- the Federal Reserve Bank of Chicago. of Argentine government default. The authors tions,” in which the government can issue compile and isolate 15 rulings that poten- debt at a positive, albeit low, price when Note tially changed the probability of default. investors place a high probability on default. They find that, on average, increases in the That is, the government knows that its fun- The Törnqvist index is one of the more commonly used indexes. likelihood of default reduced the U.S.-dollar damentals are relatively strong enough and value of Argentine assets. Specifically, on is therefore willing to make such deals. The 1 38 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report Summary of Activities 2016 i Institute staff published research in top peer-reviewed journals and added 35 new papers to its working paper series to go with 38 in 2015, bringing the series total to 294. n 2016, the Globalization Insti- • Open Economies Review—“A Quantitative tute continued its tradition of re- Assessment of the Role of Incomplete Asset search excellence by publishing Markets on the Dynamics of the Real Ex- a number of notable academic change Rate,” by Enrique Martínez-García papers and convening leading minds in the • Review of Regional Studies—“Diversification field of economics to discuss topics vital to and Specialization of U.S. States,” by Janet the U.S. and world economies. Koech and Mark A. Wynne, forthcoming Institute staff published research in top In addition, Cambridge University Press peer-reviewed journals and added 35 new in spring 2016 published the proceedings of papers to its working paper series to go with the institute’s 2014 centennial conference as 38 in 2015, bringing the series total to 294. The Federal Reserve’s Role in the Global Econo- Of the 35 new papers, permanent staff in my: A Historical Perspective (Michael D. Bordo Dallas contributed 15 and institute research and Wynne, editors). associates provided the rest. As in years past, At year-end, the staff had papers under a wide range of topics was covered, including review at Econometrica, the Journal of Monetary insight from markets for bitcoin, interna- Economics and the Review of Financial Studies. tional linkages at the level of individual U.S. states, technical contributions dealing with Conferences econometric theory, and the solution of ra- The institute organized one major tional expectations models (a full list of new research conference in 2016, a collaboration working papers is provided elsewhere in this with the University of Houston that is expect- report). ed to become an annual event alternating In addition, the institute hosted a major between Dallas and Houston. The conference research conference with the University of featured presentations from researchers at Houston and revived its public lecture series, the University of Houston as well as the Fed- renaming it Global Perspectives. eral Reserve Board of Governors and Federal Reserve Bank of Minneapolis and Harvard, Academic Research Pennsylvania State, Princeton and Stanford The year 2015 was the institute’s best to date universities. A full summary of the confer- in terms of journal acceptances, with perma- ence by Michael Sposi is presented elsewhere nent staff contributing 13 papers. While the in this report. acceptance rate was notably lower in 2016, Staff presented their work at high-profile staff had papers accepted for publication in conferences and in university seminars several peer-reviewed journals, including: throughout 2016. These included the Carne- • Journal of Monetary Economics (Carnegie- gie-Rochester-New York University Confer- Rochester Conference Series)—“Capital ence Series on Public Policy, Fall Midwest Controls and Monetary Policy Autonomy in a Trade meeting, International Association for Small Open Economy,” by J. Scott Davis and Applied Econometrics conference, Mid- Ignacio Presno west Macroeconomics meeting and RIDGE • Journal of International Economics— Workshop on Trade and Firm Dynamics, “Distribution Capital and the Short- and plus meetings of the Allied Social Sciences Long-Run Import Demand Elasticity,” also by Association, Econometric Society, Midwest Davis with Mario J. Crucini Economics Association, Society for Economic Dynamics, Southern Economic Association, Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 39 Spanish Economic Association, System Com- former U.S. Treasury Secretary Henry Paul- mittee on International Economic Analysis son in March, followed by Harvard Business and Western Economic Association. Staff School Dean Nitin Nohria in June, former also gave seminar presentations abroad at U.S. Treasury Secretary Larry Summers in the Bank for International Settlements–Hong September, former U.S. Treasury Secretary Kong, Reserve Bank of New Zealand, Shang- Robert Rubin in October and, finally, former hai University of Finance and Economics and Bank of England Governor Lord Mervyn University of Exeter (UK) and at home at Ari- King in November. An edited version of the zona State University, Marquette University, conversation between Kaplan and Lord King Purdue University and University of Texas. appears elsewhere in this report. Bank Publications People Institute staff contributed seven articles There were no new hires to the perma- to the Bank’s Economic Letter publication: nent staff in 2016. Agustín Bénétrix (Trin- “Emerging-Market Debtor Nations Likely to ity College Dublin), Daniel Riera-Crichton Follow Fed Rate Boosts,” by Davis; “Con- (Bates College), Jae Won Lee (Seoul National sequences of the Euro: Monetary Union, University), Gina Pieters (Trinity University) Economic Disunion?” by Martínez-García and Nam Vu (Miami University) joined the and Valerie Grossman; “Stock Market Pro- institute’s network of research associates. vides Imperfect View of Real U.S. Economy,” Mina Kim (Bureau of Labor Statistics) and Pi- by Julieta Yung; “Impact of Chinese Slow- eters visited the institute for the fall semester. down on U.S. No Longer Negligible,” by Eric van Wincoop (University of Virginia) also Alexander Chudik and Arthur Hinojosa; visited for a week in the fall. Ariel Weinberger “Global Demographic Trends Shape Policy (University of Oklahoma) and Alejandro Ri- Environment,” by Wynne; “Risk, Uncertainty vera (University of Texas at Dallas) were also Separately Cloud Global Growth Forecast- regular visitors during 2016. ing,” by Chudik, Martínez-García and Grossman; and “U.S. Productivity Growth Flowing Downstream,” by Sposi and Kelvinder Virdi. Economic Letter is designed to disseminate research to a broad nontechnical audience. Institute Public Lecture Becomes Global Perspectives The institute extended its public lecture series, which resumed toward the end of 2015. The series was rebranded as Global Perspectives and featured several high-profile speakers. February’s Trilateral Conference was highlighted by a panel discussion between Dallas Fed President Robert S. Kaplan, Bank of Canada Governor Stephen S. Poloz and Banco de México Governor Agustín Carstens. The series continued with The institute extended its public lecture series, which resumed toward the end of 2015. The series was rebranded as Global Perspectives and featured several high-profile speakers. 40 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report Institute Working Papers Issued in 2016 Working papers can be found online at www.dallasfed.org/institute/wpapers No. 260 Optimal Monetary and Fiscal Policy at the Zero Lower Bound in a Small Open Economy Saroj Bhattarai, Konstantin Egorov No. 261 Inflation as a Global Phenomenon— Some Implications for Policy Analysis and Forecasting Ayse Kabukçuoglu, Enrique Martínez-García No. 262 Quantitative Assessment of the Role of Incomplete Asset Markets on the Dynamics of the Real Exchange Rate Enrique Martínez-García No. 263 The U.S. Oil Supply Revolution and the Global Economy Kamiar Mohaddes, Mehdi Raissi No. 268 Big Data Analytics: A New Perspective Alexander Chudik, George Kapetanios, M. Hashem Pesaran No. 276 Is the Renminbi a Safe Haven? Rasmus Fatum, Yohei Yamamoto, Guozhong Zhu No. 269 The Post-Crisis Slump in the Euro Area and the U.S.: Evidence from an Estimated Three-Region DSGE Model Robert Kollmann, Beatrice Pataracchia, Rafal Raciborski, Marco Ratto, Werner Roeger, Lukas Vogel No. 277 Oil Prices and the Global Economy: Is It Different This Time Around? Kamiar Mohaddes, M. Hashem Pesaran No. 270 China’s Slowdown and Global Financial Market Volatility: Is World Growth Losing Out? Paul Cashin, Kamiar Mohaddes, Mehdi Raissi No. 271 The Deep Historical Roots of Macroeconomic Volatility Sam Hak Kan Tang, Charles Ka Yui Leung No. 264 The Implications of Liquidity Expansion in China for the U.S. Dollar Wensheng Kang, Ronald A. Ratti, Joaquin L. Vespignani No. 272 Optimal Monetary Policy in Open Economies Revisited Ippei Fujiwara, Jiao Wang No. 265 Endogenous Firm Competition and the Cyclicality of Markups Hassan Afrouzi No. 273 Banking Crises, External Crises and Gross Capital Flows Thorsten Janus, Daniel Riera-Crichton No. 266 Wages and Human Capital in Finance: International Evidence, 1970-2005 Hamid Boustanifar, Everett Grant, Ariell Reshef No. 274 The Market Resources Method for Solving Dynamic Optimization Problems Ayse Kabukçuoglu, Enrique Martínez-García No. 267 Economic Fundamentals and Monetary Policy Autonomy Scott Davis No. 275 Breaking Down World Trade Elasticities: A Panel ECM Approach Jaime Martinez-Martin No. 278 On What States Do Prices Depend? Answers From Ecuador Craig Benedict, Mario J. Crucini, Anthony Landry No. 279 Trends and Cycles in Small Open Economies: Making the Case for a General Equilibrium Approach Kan Chen, Mario Crucini No. 280 Exposure to International Crises: Trade vs. Financial Contagion Everett Grant No. 281 Half-Panel Jackknife Fixed Effects Estimation of Panels with Weakly Exogenous Regressors Alexander Chudik, M. Hashem Pesaran, JuiChung Yang No. 282 The Speed of Exchange Rate PassThrough Barthélémy Bonadio, Andreas M. Fischer, Philip Sauré No. 283 Central Bank Communications: A Case Study Scott Davis, Mark A. Wynne Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 41 No. 284 Diversification and Specialization of U.S. States Janet Koech, Mark A. Wynne No. 285 System Reduction and Finite-Order VAR Solution Methods for Linear Rational Expectations Models Enrique Martínez-García No. 286 FDI and the Task Content of Domestic Employment for U.S. Multinationals Alexis Grimm, Mina Kim No. 287 Macroeconomic News and Asset Prices Before and After the Zero Lower Bound Christoffer Koch, Julieta Yung No. 288 Financial Performance and Macroeconomic Fundamentals in Emerging Market Economies over the Global Financial Cycle Scott Davis, Andrei Zlate No. 289 Globalization, Market Structure and Inflation Dynamics Sophie Guilloux-Nefussi No. 290 A One-Covariate at a Time, Multiple Testing Approach to Variable Selection in High-Dimensional Linear Regression Models Alexander Chudik, George Kapetanios, M. Hashem Pesaran No. 291 Do Oil Endowment and Productivity Matter for Accumulation of International Reserves? Rasmus Fatum, Guozhong Zhu, Wenjie Hui No. 292 Does Bitcoin Reveal New Information About Exchange Rates and Financial Integration? Gina Pieters No. 293 Financial Regulations and Price Inconsistencies across Bitcoin Markets Gina Pieters, Sofia Vivanco No. 294 Capital Goods Trade, Relative Prices, and Economic Development Piyusha Mutreja, B. Ravikumar, Michael Sposi 42 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report Institute Staff and Senior Fellows Institute Director Senior Fellows Mark A. Wynne Vice President and Associate Director of Research, Federal Reserve Bank of Dallas Michael Bordo Professor of Economics, Rutgers University Research Associate, National Bureau of Economic Research Staff Mario Crucini Professor of Economics, Vanderbilt University Research Associate, National Bureau of Economic Research Alexander Chudik Senior Research Economist and Advisor Enrique Martínez-García Senior Research Economist and Advisor Scott Davis Senior Research Economist Michael J. Sposi Senior Research Economist Everett Grant Research Economist Julieta Yung Research Economist Janet Koech Assistant Economist Valerie Grossman Senior Research Analyst Arthur Hinojosa Research Analyst Kelvinder Virdi Research Analyst Michael B. Devereux Professor of Economics, University of British Columbia Visiting Scholar, International Monetary Fund Charles Engel Professor of Economics, University of Wisconsin–Madison Research Associate, National Bureau of Economic Research Karen Lewis Joseph and Ida Sondheimer Professor of International Economics and Finance, Wharton School, University of Pennsylvania Codirector, Weiss Center for International Financial Research, 2005–11 Francis E. Warnock James C. Wheat Jr. Professor of Business Administration, Darden Graduate School of Business, University of Virginia Research Associate, National Bureau of Economic Research Research Associate, Institute for International Integration Studies, Trinity College Dublin Globalization and Monetary Policy Institute 2016 Annual Report • FEDERAL RESERVE BANK OF DALLAS 43 Research Associates Raphael Auer Swiss National Bank Silvio Contessi Monash Business School Enisse Kharroubi Bank for International Settlements Simone Auer Swiss National Bank Dudley Cooke University of Exeter Business School Mina Kim Bureau of Labor Statistics Chikako Baba International Monetary Fund Richard Dennis University of Glasgow Agustín Bénétrix* Trinity College Dublin Roberto Duncan Ohio University Robert Kollmann European Centre for Advanced Research in Economics and Statistics Pierpaolo Benigno LUISS Guido Carli Peter Egger Eidgenössische Technische Hochschule Zürich Martin Berka University of Auckland Business School Saroj Bhattarai University of Texas at Austin Aitor Erce Bank of Spain and European Stability Mechanism Javier Bianchi Federal Reserve Bank of Minneapolis Ester Faia Goethe University Frankfurt Claudio Borio Bank for International Settlements Rasmus Fatum University of Alberta School of Business Hafedh Bouakez HEC Montréal Andrew Filardo Bank for International Settlements Matthieu Bussière Banque de France Andreas Fischer Swiss National Bank Matteo Cacciatore HEC Montréal Marcel Fratzscher German Institute for Economic Research Alessandro Calza European Central Bank Ippei Fujiwara Australian National University Máximo Camacho Universidad de Murcia Pedro Gete Georgetown University Michele Ca'Zorzi European Central Bank Bill Gruben Texas A&M International University Bo Chen Shanghai University of Finance and Economics Sophie Guilloux-Nefussi Bank of France Hongyi Chen Hong Kong Institute for Monetary Research Yin-Wong Cheung University of California, Santa Cruz/City University of Hong Kong C.Y. Choi University of Texas at Arlington *New to the institute in 2016 Ping He Tsinghua University Gee Hee Hong International Monetary Fund Jae Won Lee* Seoul National University Charles Ka Yui Leung City University of Hong Kong Nan Li International Monetary Fund Shu Lin Fudan University Tuan Anh Luong De Montfort University Julien Martin Université du Québec à Montréal Jaime Martínez-Martín Bank of Spain Césaire Meh Bank of Canada Arnaud Mehl European Central Bank Fabio Milani University of California, Irvine Kamiar Mohaddes University of Cambridge Philippe Moutot European Central Bank Daniel Murphy University of Virginia Piyusha Mutreja Syracuse University Yi Huang The Graduate Institute Geneva Jair Ojeda Banco de la República (Colombia's Central Bank) Erasmus Kersting Villanova University Gina Pieters* Trinity University (continued on next page) 44 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2016 Annual Report Deokwoo Nam City University of Hong Kong Kozo Ueda Waseda University, Tokyo Dimitra Petropoulou University of Surrey Joaquin Vespignani University of Tasmania Vincenzo Quadrini University of Southern California Nam Vu* Miami University Mehdi Raissi International Monetary Fund Eric van Wincoop University of Virginia Attila Rátfai Central European University Giovanni Vitale European Central Bank Daniel Riera-Crichton* Bates College Xiao Wang University of North Dakota Kim Ruhl Stern School of Business Yong Wang Hong Kong University of Science and Technology Katheryn Russ University of California—Davis Filipa Sá King's College London Raphael Schoenle Brandeis University Giulia Sestieri Banque de France Etsuro Shioji Hitotsubashi University Ariel Weinberger University of Oklahoma Tomasz Wieladek Center for Economic Policy (CEPR) Hakan Yilmazkuday Florida International University Jianfeng Yu University of Minnesota Shigenori Shiratsuka Bank of Japan Zhi Yu Shanghai University of Finance and Economics Ina Simonovska University of California—Davis Yu Yuan University of Iowa Vanessa Smith University of York *New to the institute in 2016 Jens Søndergaard Capital Strategy Research Bent E. Sorensen University of Houston Heiwai Tang Johns Hopkins University Cédric Tille Graduate Institute for International and Development Studies Ben A. R. Tomlin Bank of Canada