Ten years have passed since the publication of my book The Road to a Free Economy: Shifting from a Socialist System–the Example of Hungary. It was the first book in the international literature to put forward comprehensive proposals for the post–socialist transition. This paper sets out to assess the book as the author sees it ten years later.
Two systems can be said to have dominated the 20th century: the capitalist system and the socialist system. This paper discusses the complexities of this seemingly simple statement.
Our argument, in short, is that most of the risks being generated in modern industrialized societies are the product of technologically induced structural transformations inside na–tional labor markets. Increasing productivity, changing consumption patterns, and saturated demand for products from the traditional sectors of the economy are the main forces of change. It is these structural sources of risk that fuel demands for state compensation and risk sharing.
Monetary rules matter for the equilibrium rate of employment when the number of price–wage setters is small. If the central bank is non–accommodating, sufficiently large unions, bargaining independently, have an incentive to moderate sectoral money wages, and thereby expected real wages. The result is an increase in the real money supply, and hence higher demand and employment. This does not hold, however, with accommodating monetary policy since unions? wage decisions cannot then affect the real money supply. A similar argument holds for large monopolistically–competitive price setters. Rational expectations, complete information, central bank pre–commitment and absence of nominal rigidities are assumed.
This paper investigates the design of an exchange rate policy for an economy where the domestic capital market is segmented from the global financial market, producers rely on credit to finance working capital needs, and the labor market is characterized by nominal contracts. We show that the choice of an exchange rate regime is intertwined with the financial structure — greater reliance on working capital to finance input needs, and greater segmentation of the domestic capital market increase the desirable exchange rate stability. This result follows from the observation that greater exchange rate stability is likely to reduce the real interest rate facing the producer, thereby increasing output. Hence, greater reliance on working capital increases the welfare gain attached to the lower interest rate associated with lower flexibility of the exchange rate, thereby increasing the desirability of a fixed exchange rate. Similarly, greater integration with the global capital market reduces the real interest rate benefits from exchange rate stability, increasing thereby the optimal flexibility of the exchange rate, and reducing the demand for international reserves.
This article discusses this "political economy" side of redesigning the international financial architecture. It draws heavily from our previous work (Fernández–Arias and Hausmann 2000a, 2000b). The next section reviews the problems of international financial markets. We subsequently assess their importance in light of the evidence and discuss for whom they are crucial. The last section reviews the solutions that are being proposed and discusses the distribution of their costs and benefits. Concluding remarks follow.
This paper discusses different views about what is wrong with the world, or as an economist would say, the principal distortions that are present. The intent is to clarify the logic behind the proposals for reforming the international financial architecture and provide a means of assessing them. (The actual assessment is performed in the companion paper "Getting it Right: What to Reform in International Financial Markets," Fernández–Arias and Hausmann, 2000.)
Countries that are classified as having floating exchange rate systems (or very wide bands) show strikingly different patterns of behavior. They hold very different levels of international reserves and allow very different volatilities in the movements of the exchange rate relative to the volatility that they tolerate either on the level of reserves or in interest rates. We document these differences and present a model that explains them as the optimal response of a Central Bank that attempts to minimize a standard loss function, in an environment in which firms are credit–constrained and incomplete markets limit their ability to avoid currency mismatches. This model suggests that the difference in the way countries float could be related to their differing levels of exchange rate pass–through and differences in their ability to avoid currency mismatches. We test these implications and find a very strong and robust relationship between the pattern of floating and the ability of a country to borrow internationally in its own currency. We find weaker and less robust evidence on the importance of pass–through to account for differences across countries with respect to their exchange rate/monetary management.
This paper asks whether the composition of capital flows is at all related to the likelihood of crises. The dominant view is quite straightforward. FDI involves a long–term commitment to a country and is "bolted down" in such a way that it cannot leave at the first sign of trouble. Hence, it is unlikely to be associated with crises for two reasons: first, because there must be something right about the country if capital is coming in as FDI; second, because even if there were problems, FDI does not have the explosive characteristics of other flows. As expressed by the World Bank (1999) "FDI also is less subject to capital reversals and contagion that affect other flows, since the presence of large, fixed, illiquid assets makes rapid disinvestment more difficult than the withdrawal of short–term bank lending or the sale of stock holdings."
This paper studies the proposition that capital inflows tend to take the form of FDI (i.e. the share of FDI in total liabilities tends to be higher) in countries that are safer, more promising and with better institutions and policies. It finds that this view is patently wrong since it stands the historical record on its head. It then uses alternative theories to make sense of the facts. It begins by studying the determinants of the size and composition of the flows of private capital across countries. It finds that while capital flows tend to go to countries that are safer and have better institutions and financial markets, the share of FDI in total flows is not an indication of good health. On the contrary, countries that are riskier, less financially developed and have weaker institutions tend to attract less capital but more of it in the form of FDI. Hence, interpreting the rising share of FDI, as a sign of good health is unwarranted.
This paper provides an overview and assessment of reform initiatives, both those currently on the table and those that are not but we think should be. The intent is to clarify the logic behind these proposals and assess them from a Latin American perspective. Our discussion is based on the extent to which reform initiatives alleviate the problems we identified in the companion paper "What?s Wrong with International Financial Markets," (Fernández–Arias and Hausmann, 1999). The overall conclusion is that the current approach to reforming the international financial architecture is not appropriate for the task and a paradigm shift is required.
What difference does it make, and for whom, whether the nonperforming debts of emerging market borrowers are restructured? This paper begins by positing a set of counterfactual conditions under which restructuring would not matter, and then shows how several ways in which the actual world of international lending departs from these conditions give both lenders and borrowers ample reason to care whether nonperforming debts are restructured. One implication of the way in which debt restructuring matters is that restructuring should not be too' easy. Further, with a greater frequency of defaults, some credit flows to emerging market countries would not be extended in the first place. An important element driving this line of argument is moral hazard, but (unlike in much of the recent literature of emerging market debt problems) what is central here is not the availability of credit from the IMF or other official lenders but the more fundamental moral hazard inherent in all uncollateralized borrower–lender relationships.
The threat to monetary policy from the electronic revolution in banking is the possibility of a decoupling' of the operations of the central bank from markets in which financial claims are created and transacted in ways that, at some operative margin, affect the decisions of households and firms on such matters as how much to spend (and on what), how much (and what) to produce, and what to pay or charge for ordinary goods and services. The object of this paper is to discuss how this possibility arises and what it implies, to dismiss as unessential to the argument various extreme characterizations that have arisen in the recent debate on this issue (for example, that no one will use money for ordinary economic transactions), and to address the specific arguments on the issue offered by Charles Goodhart, Charles Freedman and Michael Woodford.
Monetary policy is one of the two principal means (the other being fiscal policy) by which government authorities in a market economy regularly influence the pace and direction of overall economic activity, importantly including not only the level of aggregate output and employment but also the general rate at which prices rise or fall. The ability of central banks to carry out monetary policy stems from their monopoly position as suppliers of their own liabilities, which banks in turn need (either as legally required reserves or as balances for settling interbank claims) in order to create the money and credit used in everyday economic transactions. Important developments both in research and in the actual conduct of monetary policy in recent decades have revolved around the choice of a short–term interest rate versus a reserve quantity as the central bank's direct operating instrument, whether to use some measure of money as an intermediate target, whether to constrain the central bank to follow some fairly simple policy rule, what degree of political independence a central bank should have, and whether to target inflation. Some key areas of ongoing research in this area, as of the beginning of the 21st century, are whether the behavioral process by which monetary policy affects nonfinancial economic activity centers more on money or on credit, quantitative measurement of whatever is the mechanism at work, the –off between price inflation and real aspects of economic activity like output and employment, and just why it is that the public in most industrialized countries is as averse to inflation as is apparently the case.
Most central banks, including the U.S. Federal Reserve System, implement their monetary policy by setting interest rates. This paper reviews the major changes that have taken place along the way from the Federal Reserve's interest rate–based policy structure of the 1960s to the interest rate–based structure in place today, and then goes on to consider three open questions that this way of conducting monetary policy presents: (1) whether there is a nominal anchor' problem, and if so whether explicit inflation targeting would solve it, (2) whether there is a role in this policymaking process for interest rates other than whatever particular rate the Federal Reserve chooses to set, or equivalently for equity prices, and (3) to what extent the electronic revolution now under way in banking threatens the efficacy of an interest rate–based monetary policy. The paper concludes by considering the implications of the rules–versus–discretion debate for the role of interest rates in monetary policymaking.
This paper looks again at the U.S. deficit debate of the 1980s, this time with the benefit of the Commerce Department's newly revised data for that period and also in light of the experience of the 1990s when sizeable budget surpluses replaced chronic large deficits. The familiar conclusion that sustained government deficits at full employment depress private capital formation has stood up well in both regards. By contrast, the more recent experience in particular has sharply contradicted any simple notion that the government balance and the current account balance move in parallel. Other relevant issues include the equilibrium (that is, noninflationary) unemployment rate, the response of private saving to government dissaving, and the role of debt and equity in financing private capital formation.
In history, a new rising power usually experiences great trouble in the existing world order. With the renaissance of Europe and emergence of China, will the world avoid a repetitive painful experience of the old days and register the twenty–first Century as a peaceful century in human history? The answer will very much depend on how these countries manage their foreign affairs.
Gravity–based cross–sectional evidence indicates that currency unions stimulate trade; cross–sectional evidence indicates that trade stimulates output. This paper estimates the effect that currency union has, via trade, on output per capita. We use economic and geographic data for over 200 countries to quantify the implications of currency unions for trade and output, pursuing a two–state approach. Our estimates at the first stage suggest that belonging to a currency union more than triples trade with the other members of the zone. Moreover, there is no evidence of trade–diversion. Our estimates at the second stage suggest that every one percent increase in trade (relative to GDP) raises income per capita by roughly 1/3 of a percent over twenty years. We combine the two estimates to quantify the effect of currency union on output. Our results support the hypothesis that the beneficial effects of currency unions on economic performance come through the promotion of trade, rather than through a commitment to non–inflationary monetary policy, or other macroeconomic influences.
Globalization of trade and finance has gone a long way over the last –century. But it is less impressive than most non–economists think, judged either by the standard of 100 years ago or by the hypothetical standard of perfect international integration. The paper documents the extent of globalization, and some reasons for the barriers that remains. It then briefly considers the implications for economic growth and the implications for goals not measured by GDP equality and the environment. The conclusion is that globalization is not the primary obstacle to efforts to address such concerns.
The corners hypothesis holds that intermediate exchange rate regimes are vanishing, or should be. Surprisingly for a new conventional wisdom, this hypothesis so far lacks analytic foundations. In part, the generalization is overdone. We nevertheless offer one possible theoretical rationale, a contribution to the list of arguments against intermediate regimes: they lack verifiability, needed for credibility. Central banks announce intermediate targets such as exchange rates, so that the public can judge from observed data whether they are following the policy announced. Our general point is that simple regimes are more verifiable by market participants than complicated ones. Of the various intermediate regimes (managed float, peg with escape clause, etc.), we focus on basket pegs, with bands. Statistically, it takes a surprisingly long span of data to distinguish such a regime from a floating exchange rate. We apply the econometrics, first, to the example of Chile and, second, by performing Monte Carlo simulations. The amount of data required to verify the declared regime may exceed the length of time during which the regime is maintained. The amount of information necessary increases with the complexity of the regime, including the width of the band and the number of currencies in the basket.
