Publications by Author: Frankel, Jeffrey

2013
Frankel, Jeffrey. 2013. “On Graduation from Fiscal Procyclicality.” Journal of Development Economics 100 (1): 32-47. Website Abstract
In the past, industrial countries have tended to pursue countercyclical or, at worst, acyclical fiscal policy. In sharp contrast, emerging and developing countries have followed procyclical fiscal policy, thus exacerbating the underlying business cycle. We show that, over the last decade, about a third of the developing world has been able to escape the procyclicality trap and actually become countercyclical. We then focus on the role played by the quality of institutions, which appears to be a key determinant of a country’s ability to graduate. We show that, even after controlling for the endogeneity of institutions and other determinants of fiscal procyclicality, there is a causal link running from stronger institutions to less procyclical or more countercyclical fiscal policy.
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Frankel, Jeffrey. 2013. “Over-optimistic Official Forecasts and Fiscal Rules in the Eurozone.” Review of World Economy 149 (2): 247-272. DOI Abstract
Eurozone members are supposedly constrained by the fiscal caps of the Stability and Growth Pact. Yet ever since the birth of the euro, members have postponed painful adjustment. Wishful thinking has played an important role in this failure. We find that governments' forecasts are biased in the optimistic direction, especially during booms. Eurozone governments are especially over-optimistic when the budget deficit is over the 3% cap at the time the forecasts are made. Those exceeding this cap systematically but falsely forecast a rapid future improvement. The new fiscal compact among the euro countries is supposed to make budget rules more binding by putting them into laws and constitutions at the national level. But biased forecasts can defeat budget rules. What is the record in Europe with national rules? The bias is less among eurozone countries that have adopted certain rules at the national level, particularly creating an independent fiscal institution that provides independent forecasts.
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2012
Frankel, Jeffrey, and Christopher Pissarides, ed. 2012. NBER International Seminar on Macroeconomics 2011. Chicago: University of Chicago Press, 476. Publisher's Version
Frankel, Jeffrey. 2012. “Choosing an Exchange Rate Regime.” The Handbook of Exchange Rates, 767-784. New York: John Wiley. Website Abstract

The single most important aspect of an exchange rate regime is the degree of flexibility. The matter is of course more complicated than a simple choice between fixed exchange rate and floating. One can array exchange rate regimes along a continuum, from most flexible to least, and grouped in three major categories:

  1. Floating corner
    1. Free float
    2. Managed float
  2. Intermediate regimes
    1. Target zone or band
    2. Basket peg
    3. Crawling peg
    4. Adjustable peg
  3. Institutionally fixed corner
    1. Currency board
    2. Dollarization
    3. Monetary Union

    This chapter reviews the state of research concerning how a country should choose where to locate along this continuum of exchange rate regimes.

    The ‘‘corners hypothesis’’ - that countries are, or should be, moving away from the intermediate regimes, in favor of either the hard peg corner or the floating corner - was proposed by Eichengreen (1994) and rapidly became the new conventional wisdom with the emerging market crises of the late 1990s. But it never had a good theoretical foundation. The feeling that an intermediate degree of exchange rate flexibility is inconsistent with perfect capital mobility is a misinterpretation of the principle of the impossible trinity. To take a clear example, Krugman (1991) shows theoretically that a target zone is entirely compatible with uncovered interest parity. The corners hypothesis began to lose popularity after the failure of Argentina’s quasi currency board in 2001. Many countries continue to follow intermediate regimes and do not seem any the worse for it.

    Attempts to address the optimal degree of exchange rate flexibility within a single theoretical model are seldom very convincing. Too many factors are involved. Better instead to enumerate the arguments for and against exchange rate flexibility and then attempt to weigh them up. This chapter considers five advantages of fixed exchange rates, followed by five advantages for exchange rate flexibility. We then turn to analysis of how to weigh the pros and cons to choose a regime. The answer depends on characteristics of the individual country in question.

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Frankel, Jeffrey. 2012. “The Natural Resource Curse: A Survey of Diagnoses and Some Prescriptions.” Commodity Price Volatility and Inclusive Growth in Low-Income Countries. Washington D.C. International Monetary Fund. Book Website Abstract
Countries with oil, mineral or other natural resource wealth, on average, have failed to show better economic performance than those without, often because of undesirable side effects. This is the phenomenon known as the Natural Resource Curse. This paper reviews the literature, classified according to six channels of causation that have been proposed. The possible channels are: (i) long-term trends in world prices, (ii) price volatility, (iii) permanent crowding out of manufacturing, (iv) autocratic/oligarchic institutions, (v) anarchic institutions, and (vi) cyclical Dutch Disease. With the exception of the first channel--the long-term trend in commodity prices does not appear to be downward--each of the other channels is an important part of the phenomenon. Skeptics have questioned the Natural Resource Curse, pointing to examples of commodity-exporting countries that have done well and arguing that resource exports and booms are not exogenous. The relevant policy question for a country with natural resources is how to make the best of them.
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Frankel, Jeffrey. 2012. “Politically Feasible Emission Target Formulas to Attain 460 ppm CO2 Concentrations.” Review of Environmental Economics and Policy 6 (1): 86-109. DOI Abstract
A new climate change treaty must address three current gaps: the absence of emissions targets extending far into the future; the absence of participation by the United States, China, and other developing countries; and the absence of reasons to expect compliance. Moreover, to be politically acceptable, a post-Kyoto treaty must recognize certain constraints regarding country-by-country economic costs. This article presents a framework for assigning quantitative emissions allocations across countries, one budget period at a time, through a two-stage plan: (a) China and other developing countries accept targets at business-as-usual (BAU) levels in the coming budget period, and, during the same period, the United States agrees to cuts below BAU; (b) all countries are asked to make further cuts in the future in accordance with a formula that includes a Progressive Reductions Factor, a Latecomer Catch-up Factor, and a Gradual Equalization Factor. An earlier proposal (Frankel 2009) for specific parameter values in the formulas achieved the environmental goal that carbon dioxide (CO2) concentrations plateau at 500 ppm by 2100. It met our political constraints by keeping every country’s economic cost below thresholds of Y = 1 percent of income in Present Discounted Value, and X = 5 percent of income in the worst period. The framework proposed in this article attains a stricter concentration goal of 460 ppm CO2 but only by loosening the political constraints.
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We investigate whether leading indicators can help explain the cross-country incidence of the 2008–09 financial crisis. Rather than looking for indicators with specific relevance to the recent crisis, the selection of variables is driven by an extensive review of more than eighty papers from the previous literature on early warning indicators. Our motivation is to address suspicions that indicators found to be useful predictors in one round of crises are typically not useful to predict the next round. The review suggests that central bank reserves and past movements in the real exchange rate were the two leading indicators that had proven the most useful in explaining crisis incidence across different countries and episodes in the past. For the 2008–09 crisis, we use six different variables to measure crisis incidence: drops in GDP and industrial production, currency depreciation, stock market performance, reserve losses, and participation in an IMF program. We find that the level of reserves in 2007 appears as a consistent and statistically significant leading indicator of who got hit by the 2008–09 crisis, in line with the conclusions of the pre-2008 literature. In addition to reserves, recent real appreciation is a statistically significant predictor of devaluation and of a measure of exchange market pressure during the current crisis. We define the period of the global financial shock as running from late 2008 to early 2009, which probably explains why we find stronger results than earlier papers such as Obstfeld et al. (2009, 2010) and Rose and Spiegel (2009a,b, 2010, 2011) which use annual data.
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Frankel, Jeffrey. 2012. “Slow Passthrough Around the World: A New Import for Developing Countries?” Open Economies Review 23 (2): 213-251. DOI Abstract
Developing countries traditionally experience pass-through of exchange rate changes that is greater and more rapid than high-income countries experience. This is true equally of the determination of prices of imported goods, prices of local competitors’ products, and the general CPI. But developing countries in the 1990s experienced a rapid downward trend in the degree of pass-through and speed of adjustment, more so than did high-income countries. As a consequence, slow and incomplete pass-through is no longer exclusively a luxury of industrial countries. Using a new data set - prices of eight narrowly defined brand commodities, observed in 76 countries - we find empirical support for some of the factors that have been hypothesized in the literature, but not for others. Significant determinants of the pass-through coefficient include per capita incomes, bilateral distance, tariffs, country size, wages, long-term inflation, and long-term exchange rate variability. Some of these factors changed during the 1990s. Part (and only part) of the downward trend in pass-through to imported goods prices, and in turn to competitors’ prices and the CPI, can be explained by changes in the monetary environment - including a fall in long-term inflation. Real wages work to reduce pass-through to competitors’ prices and the CPI, confirming the hypothesized role of distribution and retail costs in pricing to market. Rising distribution costs, due perhaps to the Balassa-Samuelson-Baumol effect, could contribute to the decline in the pass-through coefficient in some developing countries.
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Frankel, Jeffrey. 2012. “Internationalization of the RMB and Historical Precedents.” Journal of Economic Integration 27 (3): 329-365. Website Abstract

The possibility that the renminbi may soon join the ranks of international currencies has generated much excitement. This paper looks to history for help in evaluating the factors determining its prospects. The three best precedents in the twentieth century were the rise of the dollar from 1913 to 1945, the rise of the Deutsche mark from 1973 to 1990, and the rise of the yen from 1984 to 1991. The fundamental determinants of international currency status are economic size, confidence in the currency, and depth of financial markets. The new view is that, once these three factors are in place, internationalization of the currency can proceed quite rapidly. Thus some observers have recently forecast that the RMB may even challenge the dollar within a decade. But they underestimate the importance of the third criterion, the depth of financial markets. In principle, the Chinese government could decide to create that depth, which would require accepting an open capital account, diminished control over the domestic allocation of credit, and a flexible exchange rate. But although the Chinese government has been actively promoting offshore use of the currency since 2010, it has not done very much to meet these requirements. Indeed, to promote internationalization as national policy would depart from the historical precedents. In all three twentieth-century cases of internationalization, popular interest in the supposed prestige of having the country’s currency appear in the international listings was scant, and businessmen feared that the currency would strengthen and damage their export competitiveness. Probably China, likewise, is not yet fully ready to open its domestic financial markets and let the currency appreciate, so the renminbi will not be challenging the dollar for a long time.

We begin, however, by asking: What is international currency status, and why does it matter?

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Frankel, Jeffrey, and George Saravelos. 2012. “Can Leading Indicators Assess Country Vulnerability? Evidence from the 2008–2009 Global Financial Crisis.” Journal of International Economics. Journal of International Economics. Publisher's Version Abstract

We investigate whether leading indicators can help explain the cross-country incidence of the 2008–2009 financial crisis. Rather than looking for indicators with specific relevance to the recent crisis, the selection of variables is driven by an extensive review of more than eighty papers from the previous literature on early warning indicators. Our motivation is to address suspicions that indicators found to be useful predictors in one round of crises are typically not useful to predict the next round. The review suggests that central bank reserves and past movements in the real exchange rate were the two leading indicators that had proven the most useful in explaining crisis incidence across different countries and episodes in the past. For the 2008–2009 crisis, we use six different variables to measure crisis incidence: drops in GDP and industrial production, currency depreciation, stock market performance, reserve losses, and participation in an IMF program. We find that the level of reserves in 2007 appears as a consistent and statistically significant leading indicator of who got hit by the 2008–2009 crisis, in line with the conclusions of the pre-2008 literature. In addition to reserves, recent real appreciation is a statistically significant predictor of devaluation and of a measure of exchange market pressure during the current crisis. We define the period of the global financial shock as running from late 2008 to early 2009, which probably explains why we find stronger results than earlier papers such as Obstfeld et al. (2009, 2010) and Rose and Spiegel (2009a,b, 2010, 2011) which use annual data.

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2011

Seven possible nominal variables are considered as candidates to be the anchor or target for monetary policy. The context is countries in Latin America and the Caribbean (LAC), which tend to be price takers on world markets, to produce commodity exports subject to volatile terms of trade, and to experience procyclical international finance. Three candidates are exchange rate pegs: to the dollar, euro and SDR. One candidate is orthodox Inflation Targeting. Three candidates represent proposals for a new sort of inflation targeting that differs from the usual focus on the CPI, in that prices of export commodities are given substantial weight and prices of imports are not: PEP (Peg the Export Price), PEPI (Peg an Export Price Index), and PPT (Product Price Targeting). The selling point of these production-based price indices is that each could serve as a nominal anchor while yet accommodating terms of trade shocks, in comparison to a CPI target. All seven nominal anchors deliver greater overall nominal price stability in our simulations than the inflationary historical monetary regimes actually followed by LAC countries (with the exception of Panama). A dollar peg does not particularly stabilize domestic commodity prices. As hypothesized, a product price target generally does a better job of stabilizing the real domestic prices of tradable goods than does a CPI target. CPI-targeters such as Brazil, Chile, and Peru respond to increases in world prices of imported oil with monetary policy that is sufficiently tight to appreciate their currencies, an undesirable property. A Product Price targeter or PEP country would respond to increases in world prices of its commodity exports by appreciation, a desirable property.

12.1.frankel_economia.pdf
2009

We will likely see increasing efforts to minimize leakage of carbon to non-participating countries and to address concerns on behalf of the competitiveness of carbon-intensive industry. Environmentalists on one side and free traders on the other side fear that border measures such as tariffs or permit-requirements against imports of carbon-intensive products will collide with the WTO. There need not necessarily be a conflict, if the measures are designed sensibly. There are precedents—the shrimp-turtle case and the Montreal Protocol—that could justify border measures to avoid undermining the Kyoto Protocol or its successors, if the measures are carefully designed. But if the design is dominated by politics, as is likely, import penalties are likely to run afoul of the WTO, to distort trade, and perhaps even to fail in the goal of preventing leakage. Border measures should follow principles along the following lines:

  • They should follow guidelines multilaterally-agreed by countries participating in the emission targets of the Kyoto Protocol and/or its successors, against countries that are not doing so, rather than being applied unilaterally or by non-participants
  • Measures to address leakage to non-members can take the form of either tariffs or permit-requirements on carbon-intensive imports; they should not take the form of subsidies to domestic sectors that are considered to have been put at a competitive disadvantage
  • Independent panels of experts, not politicians, should be responsible for judgments as to findings of fact—what countries are complying or not, what industries are involved and what is their carbon content, what countries are entitled to respond with border measures, or the nature of the response
  • Import penalties should target fossil fuels and a half dozen or so of the most energy-intensive major industries—perhaps aluminum, cement, steel, paper, glass, iron and chemicals—rather than penalizing industries that are further removed from the carbon-intensive activity, such as firms that use inputs produced in an energy-intensive process
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Forthcoming in Climate Change, Trade and Investment: Is a Collision Inevitable? edited by Lael Brainard. Washington, DC: Brookings Institution Press, 2009. This version revised, March 31, 2009.

Andy Rose (2000), followed by many others, has used the gravity model of bilateral trade on a large data set to estimate the trade effects of monetary unions among small countries. The finding has been large estimates: Trade among members seems to double or triple, that is, to increase by 100-200%. After the advent of EMU in 1999, Micco, Ordoñez and Stein and others used the gravity model on a much smaller data set to estimate the effects of the euro on trade among its members. The estimates tend to be statistically significant, but far smaller in magnitude: on the order of 10-20% during the first four years. What explains the discrepancy? This paper seeks to address two questions. First, do the effects on intra-euroland trade that were estimated in the euro’s first four years hold up in the second four years? The answer is yes. Second, and more complicated, what is the reason for the big discrepancy vis-à-vis other currency unions? We investigate three prominent possible explanations for the gap between 15% and 200%. First, lags. The euro is still very young. Second, size. The European countries are much bigger on average than most of those who had formed currency unions in the past. Third, endogeneity of the decision to adopt an institutional currency link. Perhaps the high correlations estimated in earlier studies were spurious, an artifact of reverse causality. We test the hypotheses regarding lags and size directly; and we address the endogeneity problem by means of a natural experiment involving trade between the CFA countries of Africa and the euro countries of Europe. Contrary to expectations, we find little evidence that any of these factors explains a substantial share of the gap, let alone all of it.

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Presented at NBER conference "Europe and the Euro," October 17-18, 2008.

2006

Many studies have replicated the finding that the forward rate is a biased predictor of the future change in the spot exchange rate. Usually the forward discount actually points in the wrong direction. But virtually all those studies apply to advanced economies and major currencies. We apply the same tests to a sample of 14 emerging market currencies. We find a smaller bias than for advanced country currencies. The coefficient is on average positive, i.e., the forward discount at least points in the right direction. It is never significantly less than zero. To us this suggests that a time-varying exchange risk premium may not be the explanation for traditional findings of bias. The reasoning is that emerging markets are probably riskier; yet we find that the bias in their forward rates is smaller. Emerging market currencies probably have more easily-identified trends of depreciation than currencies of advanced countries.

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Also NBER Working Paper No. 12496. August 2006.

2004

Openness to trade is one factor that has been identified as determining whether a country is prone to sudden stops in capital inflow, currency crashes, or severe recessions. Some believe that openness raises vulnerability to foreign shocks, while others believe that it makes adjustment to crises less painful. Several authors have offered empirical evidence that having a large tradable sector reduces the contraction necessary to adjust to a given cut-off in funding. This would help explain lower vulnerability to crises in Asia than in Latin America. Such studies may, however, be subject to the problem that trade is endogenous. We use the gravity instrument for trade openness, which is constructed from geographical determinants of bilateral trade. We find that openness indeed makes countries less vulnerable, both to severe sudden stops and currency crashes, and that the relationship is even stronger when correcting for the endogeneity of trade.

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Also NBER Working Paper No. 10957.

Countries can still reap substantial economic benefits from external opening – an estimated 0.3 % increase in income over 20 years for each .01 increase in the ratio of trade to GDP. Non–economic effects of trade are more complicated. Taking the case of SO2 pollution, trade can be on net beneficial, while for CO2 the outlook is worse, absent effective global governance, due to the international free rider problem. The paper considers what should be priorities for the form and content of trade negotiations. The conclusion is to favor multilateral negotiations, as in the WTO. The author's back–of–the–envelope attempt to take into account dynamic gains says that the increase in welfare from a truly successful Doha Round might be 2% of global income. Environmental issues increasingly need to be addressed through multilateral institutions as well; they cannot be addressed through the assertion of national sovereignty.

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Working Paper 04–07, Weatherhead Center for International Affairs, Harvard University, October 2004. 


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Recent econometric estimates suggest that currency unions have far greater effects on trade patterns than previously believed. Since currency unions are good for trade, and trade is good for growth, that is one major argument in favor of EMU. If there were evidence that the boost to trade within EMU was likely to come in part at the expense of trade with outsiders, that would imply something stronger, for a neighbor such as the United Kingdom: that life outside EMU would get progressively less attractive in the future. But there is no such evidence, either for currency unions in general (according to Frankel–Rose) or for the first three years of EMU in particular (according to Micco, Stein, and Ordoñez). Furthermore, there are the usual countervailing arguments for retaining monetary independence, particularly the famous asymmetric shocks. One possible argument for waiting is that UK trade with euroland is still increasing, probably due to lagged effects of joining the EU and the Single Market initiative. Estimates suggest that the growing trade links in turn lead to growing cyclical correlation. The implication is that the UK may better qualify for the optimum currency area criteria in the future than in the past. On the other hand, if, as a result of waiting to enter, London loses to Frankfurt its position as the leading financial center in the European time zone, that loss may not be readily recoverable in the future.

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Working Paper 04–01, Weatherhead Center for International Affairs, Harvard University, February 2004. 

2003

This paper was written for Monetary and Financial Cooperation in East Asia, Macmillan Press, 2003, in consultation with the Regional Economic Monitoring Unit of the Asian Development Bank, and Takatoshi Ito and Yung Chul Park, coordinators of the ADB core study on exchange rate arrangements. The author would like to thank Sergio Schmukler for preparing Table 3.

The paper reviews recent trends in thinking on exchange rate regimes. It begins by classifying countries into regimes, noting the distinction between de facto and de jure regimes, but also noting the low correlation among proposed ways of classifying the latter. The advantages of fixed exchange rates versus floating are reviewed, including the recent evidence on the trade–promoting effects of currency unions. Frameworks for tallying up the pros and cons include the traditional Optimum Currency Area criteria, as well as some new criteria from the experiences of the 1990s. The Corners Hypothesis may now be "peaking" as rapidly as it rose, in light of its lack of foundations. Empirical evidence regarding the economic performance of different regimes depends entirely on the classification scheme. A listing of possible nominal anchors alongside exchange rates observes that each candidate has its own vulnerability, leading to the author?s proposal to Peg the Export Price (PEP). The concluding section offers some implications for East Asia.

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Frankel, Jeffrey. 2003. “Globalization and the Environment”. Abstract

Fears that globalization hurts the environment are not well–founded. A survey reveals little statistical evidence, on average across countries, that openness to international trade undermines national attempts at environmental regulation through a "race to the bottom" effect. If anything, favorable "gains from trade" effects dominate, for measures of air pollution such as SO2 concentrations. Perceptions that WTO panel rulings have interfered with the ability of individual countries to pursue environmental goals are also poorly informed. Recent rulings have in fact confirmed that countries can enact environmental measures, even if they affect trade and even if they concern others? Processes and Production Methods (PPMs), provided the measures do not discriminate among producer countries.

People care about both the environment and the economy. As real incomes rise, their demand for environmental quality rises. This translates into environmental progress under the right conditions–democracy, effective regulation, and externalities that are largely confined within national borders and are therefore amenable to national regulation. Increasingly, however, environmental problems spill across borders. Global externalities include climate change and ozone depletion. Economic growth alone will not address such problems, in a system where each country acts individually, due to the free rider problem. Multilateral institutions are needed, and national sovereignty is the obstacle, not the other way around.

673_frankel_final.pdf

WCFIA Working Paper 03-02, May 2003.

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