Publications by Author: Rogoff, Kenneth S.

Like corruption, crime, and asbestos, “inflation” is a word that many Americans imagine in all-red capital letters, flashing across TV screens amid warnings of crisis. For anyone who remembers the gloomy, scary 1970s, when the inflation rate in the United States reached double digits, the word is shorthand for an economy that has spiraled out of control, the dollar losing value and prices climbing feverishly. “Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man,” said Ronald Reagan in 1978, as nervous citizens imagined the day when they’d have to push a wheelbarrow full of cash to the grocery store in order to buy a loaf of bread.

You might say that Kenneth Rogoff has been one of the guards. As a research economist at the Federal Reserve during the first half of the 1980s, he helped ensure that the word “inflation” would never again flash across American TV screens. His reputation as a conservative-minded inflation hawk followed him from the Fed to the International Monetary Fund to his current position in the economics department at Harvard.

But then came the financial crisis of 2008, and the ensuing slump. And as the economy has continued to stagnate, Rogoff, 58, has become the flag-bearer for an unlikely position: that as we struggle to help the economy find its way out of the darkness, inflation could be the answer. It’s time, Rogoff says, to put Reagan’s “hit man” to work for the good guys.

Over the past several years, Rogoff has emerged as one of the world’s leading experts on the history of financial crises and how they work, a unique perch that has given him a long view on what is happening to our economy and what lies ahead. In the bestselling 2009 book “This Time Is Different,’’ he and Carmen Reinhart, currently a senior fellow at the Peterson Institute for International Economics , laid out a detailed analysis of financial crises that have taken place around the world going back 800 years, and they put forth an alarming idea about our current predicament. What we’re going through, they argued—what we’ve been going through ever since the subprime mortgage crisis—has not been just a typical recession, as our leaders have been treating it, but something much worse, something that demands altogether different tools to stop it.

One of these tools, Rogoff believes, is a temporary burst of inflation. And for the past several weeks, as the stock market has convulsed and debate raged over the Fed’s next move, he has been making his case publicly, through syndicated opinion columns, high-profile TV appearances, and numerous interviews. It’s an argument that Rogoff himself admits is “radical,” and one he says he’d rather not be making. But as he sees it, what’s holding the country back from recovery is not just a lack of consumer confidence or suppressed demand, as in a normal recession, but an immense overhang of debt: thanks to the collapse of the real-estate bubble, millions of American families owe so much to banks that they’re focusing all their energy on paying down their debts instead of spending their money on new investments. There will be no recovery until the painful process of working through that debt is behind us, Rogoff argues, and an increase in the annual inflation rate, which has floated around 2 percent since the early 1990s,would make it easier for debtors to pay down what they owe.

“There’s no penicillin for this,” he said in an interview. “There’s no quick getting better. What you’re really talking about is taking the edge off the downturn and coming back to normal growth somewhat faster.”

Rogoff’s call to raise inflation has come under attack from several different directions. Some economists think it wouldn’t do any good—that trying to raise inflation wouldn’t create demand or spur growth the way Rogoff thinks—while others believe that, given that prices actually seem to be in danger of falling at the moment, the Fed couldn’t make it happen if it wanted to. But perhaps the biggest problem for Rogoff is that, for most policymakers, elected and otherwise, the idea of courting inflation on purpose sounds downright crazy—not to mention politically disastrous.

“Going around the country saying, ‘We need more inflation’ is not going to be a big seller,” said Michael Mussa, a senior fellow at the Peterson Institute and a former adviser to Reagan. “Inflation means that the costs of everybody’s goods and services are going up … And I believe it’s a substantial symbol of mismanagement by the government and the central bank.”

Rogoff, however, remains convinced that as the situation grows more desperate, our leaders will feel pressure to start considering their options with more open minds. “As more and more people realize that we’re not quickly going back to normal,” he said, “they become more flexible.”

Though Rogoff speaks with unflinching steadiness, hearing him explain how badly our leaders misdiagnosed the economy after the crash, one imagines a doctor banging his fists against the door of a surgery ward, trying to warn his colleagues that he has checked their patient’s chart and realized they’re about to make a huge mistake.

The mistake we all made, as Rogoff sees it, was thinking this was going to be nothing more than a regular recession, the same kind of thing that has happened in the United States once or twice every decade for the past 150 years. These cyclical recessions come and go, and we have a pretty reliable playbook for dealing with them: usually, an increase in government spending and lower interest rates to encourage money to flow. Recessions tend to end after about a year, at which point unemployment starts to fall and normal growth resumes.

Far less frequently, something more serious grips an economy: a financial crisis that breaks the pattern, and from which it is much more difficult to recover. Rogoff and Reinhart’s book suggests that such contractions are characterized above all by severe, widespread debt, which leads to long periods of economic stagnation and uncertainty. Rogoff puts our current situation in that category, along with the Great Depression, and he fears that if we do not act quickly and creatively to dig ourselves out of it, we risk settling into a long-term slowdown along the lines of what Japan has been going through since the 1990s. Mistaking this crisis for a typical recession, he says, is like mistaking pneumonia for a stubborn cold. “They’re very, very different animals.”

The animal we’re wrestling with today, of course, was born of the vastly overheated real estate market that collapsed in 2007, temporarily paralyzing the global financial system and taking some powerful banks down with it. Today, its legacy is a towering mountain of consumer debt, government debt, and millions of underwater mortgages that are gumming up the economy and preventing it from coming back to life.

“It’s very unlikely that all these debts are going to get repaid in full,” Rogoff said. Banks have loans on their books that people simply don’t have—won’t have—the money to pay off, and expecting it to happen means we’ll just stay frozen in place, waiting. What needs to happen, Rogoff says, is “some transfer from creditors to debtors.” The ideal way for that to happen, he says, would be through loan renegotiation, whereby banks would forgive some homebuyers and strike repayment deals with others. But that sort of piecemeal renegotiation has proved very difficult to carry out.

A more viable way to start fixing the nation’s balance sheets, Rogoff argues, is by inducing a temporary bout of inflation. If the Federal Reserve raises its target inflation rate by several percentage points—up from around 2 percent, where it’s been for the past decade, to somewhere in the neighborhood of 4 to 6 percent—and injects new money into the economy until it gets there, then debtors will get some relief and the wheels of the economy will once again start to turn.

Rogoff first laid out the argument for embracing inflation in one of his columns in December of 2008—a move that came as such a surprise to people who knew his reputation that he got letters from central bankers who were sure they’d misunderstood him. Rogoff had worked at the Fed under none other than Paul Volcker, whose mandate as Fed chairman was to drive inflation down at any cost. Under Volcker’s watch, inflation fell from 13.3 percent in December of 1979 to just 3.8 percent four years later. And though Rogoff at the time was just starting out as an economist—indeed, he was still transitioning from his first career as a professional chess player—he soon became an intellectual force in the movement to make central banks the economy’s first defense against inflation. In 1985, he published what would become one of his most widely cited academic papers in the Quarterly Journal of Economics, arguing that healthy economies depended on central banks being reliably committed to holding inflation down in all but the most extreme circumstances.

Rogoff says he hasn’t changed his mind on how central banks should behave, and still thinks our fears of runaway inflation are well-founded. He just thinks that right now, it’s a risk worth taking. “There’s certainly some benefit in a society having a very, very strong conviction about keeping low inflation,” Rogoff said. “But I think right now it’s not helpful. You can have a very strong conviction that you don’t want to take medicines … And I respect that, but there are times when there’s really no choice.”

Though Rogoff’s idea about raising inflation has so far not gained much purchase in the economics profession - Mussa, for instance, called it “a hare-brained crackpot scheme”— he is not alone in his thinking. Versions of the same call have been taken up by several prominent economists across the political spectrum, including Olivier Blanchard, the chief economist at the International Monetary Fund; Joshua Aizenman, co-editor of the Journal of International Money and Finance; Harvard’s Greg Mankiw, a former adviser to George W. Bush; and Paul Krugman, the Nobel Prize-winning New York Times columnist.

THOSE WHO disagree with Rogoff cite several key objections. One is that inflation can be hard to stop once it starts: if the Fed turned on the spigot, there’s no guarantee they’d be able to turn it off before inflation got out of hand. Another objection is that if the Fed does raise its inflation target, pumping more money into the system and allowing the dollar to lose some of its value, lenders here and abroad will lose faith in the currency and respond by raising interest rates, which would ultimately make it harder for Americans to borrow money. A third objection is practical: that even if the Fed tried to trigger inflation, it simply might not be able to. The problem with the economy right now, some critics say, is a lack of demand for workers and products, and blowing air into the money supply would not change that.

“This idea that there’s some separate policy instrument called ‘creating inflation,’ I think, is a little problematic,” said Lawrence Summers, the former secretary of the Treasury and Harvard president who also served as the director of President Obama’s National Economic Council. Increasing demand should be the primary goal, with inflation a possible byproduct, Summers said. “I don’t think the idea that you could simply get more inflation by saying you want more inflation is a promising one.”

Rogoff is not swayed by these arguments. He emphasizes that the level of inflation he is calling for is very modest—and that there’s no really no reason to think that the Fed would be incapable of inducing it or reining it in at will. As for damaging the central bank’s credibility, Rogoff reiterates the extraordinary nature of the present circumstances. “This is a very exceptional situation—a once in Halley’s Comet kind of phenomenon,” he said. As he wrote in his column earlier this month, “These are times when central banks need to spend some of the credibility that they accumulate in normal times.”

Trying to persuade central bankers to go for that plan involves a different kind of problem: a political one. Inflation devalues the dollar and makes things more expensive, making it an easy political target. Earlier this month, as Wall Street and Washington waited to hear how the Fed would approach monetary policy going forward, Texas Governor Rick Perry more or less threatened Fed chairman Ben Bernanke with violence if he “prints more money” before the next election. What he was talking about wasn’t even inflation, but a policy called “quantitative easing,” in which the Federal Reserve injects new money into the economy by buying billions of dollars worth of Treasury bonds from banks. The Fed has already tried this twice since 2008, and each time it has been controversial. While Rogoff’s plan to raise the inflation rate target is conceptually different from quantitative easing, it would involve the same mechanism, and would push the same political buttons in an even more extreme way.

Underlying that opposition is more than just patriotism: it’s also a moral objection. Transferring the debt burden from borrowers to creditors, after all, effectively bails out borrowers by punishing the banks that lent them money, as well as devaluing the savings of their more prudent neighbors. That kind of rescue plan strikes many as fundamentally unfair.

Rogoff understands this objection, and doesn’t dispute that what he’s proposing is on some level unfair. But ultimately, he argues, this contraction is dragging us all down together, and even those lenders and savers will be better off if America’s debt overhang is taken care of swiftly. Once that happens, and the economy starts to recover properly, we’ll be able to focus on designing better policies that will make us less vulnerable to financial crisis in the future. For now, a little inflation might just be the cost of getting us to where that might be possible.

“One way or another,” said Rogoff, “we’re going to be doing things we would not dream we would ever do before this is over.”

On Sunday, I talked about about Wall Street's wild week with two of the world's top economists. We discussed what the market volatility means or doesn't mean, and what may lay behind it and what lies ahead of us.

Paul Krugman won the 2008 Nobel Prize in Economics, and he is a columnist for The New York Times. Kenneth Rogoff is a former chief economist at the International Monetary Fund, now a professor of economics at Harvard University. Here's a lightly edited transcript of our conversation:

Fareed Zakaria: Paul, let me start with you. The one thing we saw over the week was markets up, markets down, but the one trend that seemed persistent was there is a great demand for U.S. treasuries despite the fact that the S&P downgraded it.

You've been talking a lot about this. Explain in your view what does it mean that in moments like this U.S. treasuries are still in demand and what that does is push interest rates even lower than they are.

Paul Krugman: Well, what it tells you is that the investors, the market, are not at all afraid of what the policy elite or people like Standard & Poor's are telling them they should be afraid of.

You know, we've got all of Washington, all of Brussels, all of Frankfurt saying debt, deficits, this is the big problem. And what we actually have in reality is markets are terrified of prolonged stagnation, maybe another recession. They still see U.S. government debt as the safest thing out there, and are saying, if this was a reaction of the S&P downgrade, it was the market's saying, "We're afraid that that downgrade is going to lead to even more contractionary policy, more austerity, pushing us deeper into the hole."

So it's a reality test, right? So we just had a wake-up call that said, "Hey, you guys have been worrying about the entirely wrong things. The really scary thing here is the prospect of what amounts toa somewhat reduced version of the Great Depression in  the Western world."

Fareed Zakaria: Ken Rogoff, worrying about the wrong thing?

Ken Rogoff: Well, I think the downgrade was well justified. It's a very volatile world. And the reason there's still a demand for treasuries is they've been downgraded a little bit to AA plus. That looks pretty good compared to a lot of the other options right now.

It's a very, very difficult time for investors. There is a financial panic going on at some level. Some of it's adjusting to a lower growth expectations, maybe a third of what we're seeing. Two-thirds of it is the idea no one's home – not in Europe, not in the United States. There's no leadership. And I really think that's what's driving the panic.

Fareed Zakaria: But you wrote in an article of yours that you think that this is part of actually a broader phenomenon which is that people are realizing this is not a classic recession, this is not a classic cyclical downturn. This is what you call a "Great Contraction". Explain what you mean by that.

Ken Rogoff: Well, recessions we have periodically since World War II, but we haven't really had a financial crisis as we're having now. And Carmen Reinhart and I think of this as a great contraction, the second one, the first being the Great Depression, where it's not just unemployment, it's not just output, but it's also credit, housing and a lot of other things which are contracting. These things last much longer because of the debt overhang that we started with. After a typical recession, you come galloping out. Six months after it ended, you're back to where you started. Another six or 12 months, you're back to trend.

If you look at a contraction, one of these post-financial crisis events, it can take up to four or five years just to get back to where you started. So people are talking about a double dip, a second recession. We never left the first one.

Fareed Zakaria: So, Paul Krugman, what the implication of what Ken Rogoff is saying is spending large amounts of money on stimulus programs is not going to be the answer because, until the debt overhang works its way off, you're not going to get back to trend growth. So, in that circumstance, you'll be wasting the money. Is that – is -

Paul Krugman: No, that's not at all what it implies. I think my analytical framework, the way I think about this, is not very different from Ken's. At least I certainly believed from day one of this slump that it was going to be something very different from one of your standard V-shaped, down and up recessions, that it was going to last a long time.

One of the things we can do, at least a partial answer, is in fact to have institutions that are able to issue debt - namely the government - do so and sustain spending and, among other things, by maintaining employment, by maintaining income, you make it easier for the private sector to work down that overhang of debt.

Fareed Zakaria: Ken, are you in favor of a – a second or a significant additional stimulus in the way that I think Paul Krugman is?

Ken Rogoff: No. I think that's where we part ways on this. I think that creates a debt overhang in the terms of future taxes that is not a magic bullet because it's not a typical recession. I do think, if we used our credit to help facilitate one of these plans to bring down the mortgage debt in this targeted way, and it could involve a significant amount - that I would definitely consider. I mean, that's how I would do it.

Now, obviously, things go from bad to worse, then you start taking out more and more things from the toolkit, but I would start with targeting the mortgages, then higher inflation, try to do some structural reforms and, of course, if things are still going badly, I'm open to more ideas.

Paul Krugman: I would say things have already gone from bad to worse. I mean, this is a terrible, terrible situation out there. You know, we talk about it, we look at GDP, whatever. We have nine percent unemployment and, more to the point, we have long-term unemployment at levels not seen since the Great Depression. Just an incredibly large number of people trapped in basically permanent unemployment.

This is something that desperately needs addressing. And I would be saying we should not be trying one tool after another from the toolkit a little bit at a time. At this point, we really want to be throwing everything we can get mobilized at it.

I don't think fiscal stimulus is – is a magic bullet. I'm not sure that inflation is a magic bullet in the sense that it's kind of hard to get, unless you're doing a bunch of other things. So we should be trying all of these things.

How did the Great Depression end?  It ended, actually, of course, with World War II, which was a massive fiscal expansion, but also involved a substantial amount of inflation, which eroded the debt. What we need - hopefully we don't need a world war to get there - but we need this kind of all-out effort which we're not going to get.

Fareed Zakaria: You say World War II got us out of the Depression. This was a massive stimulus, massive fiscal expansion. But aren't we in a different world?

We are, right now, the United States with a budget deficit 10 percent of GDP, which is the second highest in the industrial world. In two our debt-to-GDP ratio goes to 100 percent. That strikes me as a situation, which presumably has some upper limit. You can't just keep spending money and incur these larger and larger debt loads.

Paul Krugman: I think those numbers are a bit high, about the debt levels a couple years out. It takes longer than that.

But the main thing to say is, look, think about the costs versus benefits right now. Basically, the U.S. government can borrow money and repay in constant dollars less than it borrowed. Are we really saying that there are no projects that the federal government can undertake that have an even slightly positive rate of return? Especially when you bear in mind that many of the workers and resources that you employ on those projects would be otherwise be unemployed.

The world wants to buy U.S. bonds. Let's supply some more, and let's use those bonds to do something useful which might, among other things, help to get us out of this terrible, terrible slump.

Ken Rogoff: Well, I think you have to be careful about assuming that these low interest rates are going to last indefinitely. They were very low for subprime mortgage borrowers a few years ago. Interest rates can turn like the weather.

But I also question how much just untargeted stimulus would really work. Infrastructure spending, if well spent, that's great. I'm all for that. I'd borrow for that, assuming we're not paying Boston Big Dig kind of prices for the infrastructure.

Fareed Zakaria: But, even if you were, wouldn't John Maynard Keynes say that if you could employ people to dig a ditch and then fill it up again, that's fine. They're being productively employed, they pay taxes, so maybe the Boston's Big Dig was just fine after all?

Paul Krugman: Think about World War II, right? That was actually negative for social product spending, and yet it brought us out. I mean, partly because you want to put these things together, if we say, "Look, we could use some inflation." Ken and I are both saying that, which is of course anathema to a lot of people in Washington, but is in fact what the basic logic says.

It's very hard to get inflation in a depressed economy. But if you have a program of government spending plus an expansionary policy by the Fed, you could get that. So if you think about using all of these things together, you could accomplish a great deal.

If we discovered that space aliens were planning to attack and we needed a massive buildup to counter the space alien threat - and really inflation and budget deficits took secondary place to that - this slump would be over in 18 months. And then if we discovered, oops, we made a mistake there aren't actually any space aliens.

Ken Rogoff: So we need Orson Wells is what you're saying?

Paul Krugman: There was a Twilight Zone episode like this, which scientists fake an alien threat in order to achieve world peace. Well, this time we need it in order to get some fiscal stimulus.

Fareed Zakaria: But Ken wouldn't agree with that, right? The space aliens wouldn't work -

Ken Rogoff:  I think it's not so clear that Keynes was right. I mean, there have been decades and decades of debate about whether digging ditches is such a good idea.

And my read of the debate is when the government does really useful things and spends the money in useful ways, it's a good idea. But when it just dig ditches and fills them in, it's not productive and leaves you with debt.

I don't think that's such a no-brainer. There are people going around saying, "Oh, Keynes was right. Everything Keynes said was right." I think this is a different animal, with this debt overhang that you need to think about from the standard Keynesian framework.

Paul Krugman: I guess I just don't agree. I mean, the debt overhang was an issue in the '30s, too - private sector debt overhang. We came into this with higher public debt than I would have liked, right? We're really, in some ways, paying the cost to the Bush tax cuts and the Bush unfunded wars, which leave us with a higher starting point of debt.

But the thing that drives me crazy about this debate, if I can say, is that we have these hypothetical risks. All those hypothetical things are leaving us doing nothing about the actual thing that's happening, which is mass unemployment, mass waste of human resources, mass waste of physical resources.

This is what's happening. We are hemorrhaging economic possibilities and also destroying a lot of lives by letting this thing drift on. And we're inventing these phantom threats (sometimes ghosts are real, I guess) to keep us from acting.

Fareed Zakaria: Do you think that the lesson from history, Ken, in terms of these kind of great contractions - we have not had something like this since the 1930s, but there have been other examples - tells you that until you get these debt levels down, no matter what the government does, it's not going to get you back to robust growth?

Ken Rogoff: I do, because what happens as you're growing slowly, the debt problems start blowing up on you. That's happening very dramatically in Europe. They had a philosophy and approach of things are going to get much better - 'if we can just hang on, we're going to grow really fast, the debt problems will go away.'

Well, guess what? They're not growing fast enough. The debt problems are imploding. That's slowing growth, and it's a self- feeding cycle.

Paul Krugman: I guess I'm a little puzzled here because, again, the thing that's holding us back right now in the United States - although there are those peripheral European countries that are having a very different kind of problem, partly because they don't have their own currencies - but, in the United States, what's holding us back is private sector debt. And, yes, we're not going to have a self sustaining recovery unless that private sector debt could be brought down.

Fareed Zakaria: Just to be clear, Paul, what you mean by that is individuals have a lot of debt on their balance sheets?

Paul Krugman: Yes, that's what's holding us back, and we do need to bring that down - at least bring it down relative to incomes. So what you need to do is you need to have policies to make incomes grow.

That can include government spending, which is going to add to public debt, but it's going to reduce the burden of private debt. It can include inflationary policies, and it can include deliberate forgiveness.

The idea that this has all faded, that we cannot do anything to grow because we have to wait for some natural process to bring that debt down, that doesn't follow from the analysis. There is a huge overhang of debt, which is, at least as I see it, exactly the reason why we need very activist government policies.

Throughout history, rich and poor countries alike have been lending, borrowing, crashing—and recovering—their way through an extraordinary range of financial crises. Each time, the experts have chimed, “this time is different”—claiming that the old rules of valuation no longer apply and that the new situation bears little similarity to past disasters. This book proves that premise wrong. Covering sixty-six countries across five continents, This Time Is Different presents a comprehensive look at the varieties of financial crises, and guides us through eight astonishing centuries of government defaults, banking panics, and inflationary spikes—from medieval currency debasements to today's subprime catastrophe. Carmen Reinhart and Kenneth Rogoff, leading economists whose work has been influential in the policy debate concerning the current financial crisis, provocatively argue that financial combustions are universal rites of passage for emerging and established market nations. The authors draw important lessons from history to show us how much—or how little—we have learned.

Using clear, sharp analysis and comprehensive data, Reinhart and Rogoff document that financial fallouts occur in clusters and strike with surprisingly consistent frequency, duration, and ferocity. They examine the patterns of currency crashes, high and hyperinflation, and government defaults on international and domestic debts—as well as the cycles in housing and equity prices, capital flows, unemployment, and government revenues around these crises. While countries do weather their financial storms, Reinhart and Rogoff prove that short memories make it all too easy for crises to recur.

The first major financial crisis of the twenty-first century involves esoteric instruments, unaware regulators, and skittish investors. It also follows a well-trodden path laid down by centuries of financial folly. Is the “special” problem of sub-prime mortgages really different?

Our examination of the longer historical record, which is part of a larger effort on currency and debt crises, finds stunning qualitative and quantitative parallels across a number of standard financial crisis indicators. To name a few, the run-up in US equity and housing prices that Graciela L. Kaminsky and Reinhart (1999) find to be the best leading indicators of crisis in countries experiencing large capital inflows closely tracks the average of the previous 18 post–World War II banking crises in industrial countries. So, too, does the inverted v-shape of real growth in the years prior to the crisis. Despite widespread concern about the effects on national debt of the tax cuts of the early 2000s, the run-up in US public debt is actually somewhat below the average of other crisis episodes. In contrast, the pattern of US current account deficits is markedly worse.

At this juncture, the book is still open on how the current dislocations in the United States will play out. The precedent found in the aftermath of other episodes suggests that the strains can be quite severe, depending especially on the initial degree of trauma to the financial system (and to some extent, the policy response). The average drop in (real per capita) output growth is over 2 percent, and it typically takes two years to return to trend. For the five most catastrophic cases (which include episodes in Finland, Japan, Norway, Spain, and Sweden), the drop in annual output growth from peak to trough is over 5 percent, and growth remained well below pre-crisis trend even after three years. These more catastrophic cases, of course, mark the boundary that policymakers particularly want to avoid.

It appears likely that the number of currencies in the world, having proliferated along with the number of countries over the past 50 years, will decline sharply over the next two decades. The question I plan to pose here is: where, from an economic point of view, should we aim for this process to stop? Should there be a single world currency, as Richard Cooper (1984) boldly envisioned? Should there remain multiple major currencies but with a much stricter arrangement among them for stabilizing exchange rates, as say Ronald McKinnon (1984) or John Williamson (1993) recommended? Building on Maurice Obstfeld and Rogoff (2000b, d), I will argue here that the status quo arrangement among the dollar, yen, and euro (which I take to be benign neglect) is not far from optimal, not only for now but well into the new century. And it would remain a good system even if political obstacles to achieving greater monetary policy coordination (or even a common world currency) could be overcome. Again, this is not a paper on, say, the pros and cons of dollarization for small and medium-sized economies, but rather on arrangements among the core currencies.

Any blueprint for the future core of the world currency system involves some crystal-ball gazing. But at the same time, recent research in international macroeconomics offers several important insights that can help inform the discussion.

The central claim in this paper is that by explicitly introducing costs of international trade (narrowly, transport costs but more broadly, tariffs, nontariff barriers and other trade costs), one can go far toward explaining a great number of the main empirical puzzles that international macroeconomists have struggled with over twenty–five years. Our approach elucidates J. McCallum's home bias in trade puzzle, the Feldstein–Horioka saving–investment puzzle, the French–Poterba equity home bias puzzle, and the Backus–Kehoe– Kydland consumption correlations puzzle. That one simple alteration to an otherwise canonical international macroeconomic model can help substantially to explain such a broad arrange of empirical puzzles, including some that previously seemed intractable, suggests a rich area for future research. We also address a variety of international pricing puzzles, including the purchasing power parity puzzle emphasized by Rogoff, and what we term the exchange–rate disconnect puzzle.' The latter category of riddles includes both the Meese–Rogoff exchange rate forecasting puzzle and the Baxter–Stockman neutrality of exchange rate regime puzzle. Here although many elements need to be added to our extremely simple model, we can still show that trade costs play an essential role.

This paper develops an explicitly stochastic new open economy macroeconomics' model, which can potentially be used to explore the qualitative and quantitative welfare differences between alternative exchange rate regimes. A crucial feature is that we do not simplify by assuming certainty equivalence for producer price setting behavior. Our framework also provides a sticky–price alternative to Lucas's (1982) exchage rate risk premium model. We show that the level risk premium' in the exchage rate is potentially quite large and may be an important missing fundamental in empirical exchange rate equations. As a byproduct analysis also suggests an intriguing possible explanation of the forward premium puzzle.

It appears likely that the number of currencies in the world, having proliferated along with the number of countries over the past fifty years, will decline sharply over the next two decades. The question I plan to pose here is, where, from an economic point of view, should we aim for this process to stop? Should there be a single world currency, as Richard Cooper (1984) boldly envisioned? Should there remain multiple major currencies but with a much stricter arrangement among them for stabilizing exchange rates, as say Ronald McKinnon (1984) or John Williamson (1985) recommended? Building on Maurice Obstfeld and Kenneth Rogoff (2000b,d), I will argue here that the status quo arrangement among the dollar, yen and the euro (which I take to be benign neglect) is not far from optimal, not only for now but well into the new century. And it would remain a good system even if political obstacles to achieving greater monetary policy coordination – or even a common world currency — could be overcome. Again, this is not a paper on, say, the pros and cons of dollarization for small and medium–sized economies, but rather on arrangements among the core currencies.

In recent years, many countries have instituted monetary reforms aimed at improving anti–inflation credibility. Is it a problem, however, that international welfare spillover effects seldom receive much consideration in the design of monetary reforms? Surprisingly, the answer may be no. Under plausible conditions, as domestic rules improve and international financial markets become more complete, the Nash and cooperative monetary rule setting games converge. We base our analysis on a utility–theoretic sticky–wage (new open economy macroeconomics) model; the question we pose simply could not have been adequately formulated using earlier models of monetary cooperation.