Devaluations are Often Associated with Changes in Government

The possibility of devaluation is apparently an issue in the upcoming Argentine elections.  (The forward rate for next year is about 13 pesos per dollar, which is close to the informal rate and suggests a big  devaluation relative to the current official exchange rate of 8.)   In this connection, an Argentine newspaper has asked me about “Contractionary Currency Crashes,” a paper that I presented as the 5th Mundell-Fleming Lecture of the  IMF’s Annual Research Conference. 

1) Do you think the conclusions about the connections between devaluation and elections are still valid in 2015 even though your article was published in 2005?

My most relevant finding was that political leaders had historically been twice as likely to lose office in the six months following a big devaluation as otherwise.  It is true that some things have changed over the last ten years.  Medium-sized emerging market countries used to have pegs or targets as their exchange rate policies, with occasional forced devaluation.   Since the turn of the century, the typical medium-sized emerging market country has switched to a managed float.   Thus changes in the exchange rate are more commonplace.   Nevertheless, I think most of the conclusions are still relevant in 2015.

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Does the Dollar Need Another Plaza?

We are at the 30th anniversary of the 1985 Plaza Accord.  It was the most dramatic intervention in the foreign exchange market since Nixon originally floated the US currency.   At the end of February 1985 the dollar reached dizzying heights, which remain a record to this day.  Then it began a long depreciation, encouraged by a shift in policy under the new Treasury Secretary, James Baker, and pushed down by G-5 foreign exchange intervention.  People remember only the September 1985 meeting at the Plaza Hotel in New York City that ratified the policy shift; so celebrations of the 30th anniversary will wait until this coming fall.

The dollar has appreciated sharply over the last year, surpassing its ten-year high.   Some are suggesting it may be time for a new Plaza, to bring the dollar down.   In its on-line “Room for Debate,” the New York Times asked, Will a strong dollar hurt the economy and should the Fed take action?”   Here is my response:

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Will Fed Tightening Choke Emerging Markets?

CAMBRIDGE – As the Federal Reserve moves closer to initiating one of the most long-awaited and widely predicted periods of rising short-term interest rates in the United States, many are asking how emerging markets will be affected. Indeed, the question has been asked at least since May 2013, when then-Fed Chairman Ben Bernanke famously announced that quantitative easing would be “tapered” later that year, causing long-term US interest rates to rise and prompting a reversal of capital flows to emerging markets.

The fear, as IMF Managing Director Christine Lagarde has reminded us, is of a repeat of previous episodes, notably in 1982 and 1994, when the Fed’s policy tightening helped precipitate financial crises in developing countries. If the Fed decides to raise interest rates this year, which emerging markets are most vulnerable to a capital-flow reversal?

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The Non-Problem of Chinese Currency Manipulation

CAMBRIDGE – America’s two political parties rarely agree, but one thing that unites them is their anger about “currency manipulation,” especially by China. Perhaps spurred by the recent appreciation of the dollar and the first signs that it is eroding net exports, congressional Democrats and Republicans are once again considering legislation to counter what they view as unfair currency undervaluation. The proposed measures include countervailing duties against imports from offending countries, even though this would conflict with international trade rules.

This is the wrong approach. Even if one accepts that it is possible to identify currency manipulation, China no longer qualifies. Under recent conditions, if China allowed the renminbi to float freely, without intervention, it would be more likely to depreciate than rise against the dollar, making it harder for US producers to compete in international markets.

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The End of Republican Obstruction

CAMBRIDGE – What a difference two months make. When the Republican Party scored strong gains in last November’s US congressional elections, the universally accepted explanation was that voters were expressing their frustration with disappointing economic performance. Indeed, when Americans went to the polls, a substantial share thought that economic conditions were deteriorating; many held President Barack Obama responsible and voted against his Democratic Party.

Now, suddenly, everyone has discovered that the US economy is doing well – so well that Senate Majority Leader Mitch McConnell has switched from blaming Obama for a bad economy to demanding credit for a good one. Recent favorable economic data were, he claimed, the result of “the expectation of a Republican Congress.”

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Currency and Commodity Markets in 2015

This is the third and final installment of an interview on the outlook for the New Year.

Part 3. Forecasts for International Currency and Commodity Markets

Q – What is your forecast for the U.S. dollar? Do you think maintaining the strong dollar could ultimately help the U.S. economy, or hurt it?

A – The appreciation of the dollar against the euro and the yen in 2014 was precisely what we should have expected from the economic fundamentals: the strengthening of the US recovery at the same time that the euro and Japanese economies have been slumping and the end of US monetary easing at the same time that the ECB and the Bank of Japan have redoubled their efforts at monetary stimulus.

When trying to forecast exchange rates, one does well to recall the “random walk” principle.  One is doing well if one gets the direction of movement right slightly more than half the time.  Having said that, I would guess that the dollar is more likely to appreciate further in 2015 than to fall, for the same macroeconomic reasons as last year.

Would that be a good thing?  Moderate appreciation of the dollar against the euro and yen is the natural concomitant of the monetary and real economic fundamentals.  Europe and Japan need the stimulus of easy money and competitively priced-currencies.   If the US recovery were to falter in the future, the Fed could reverse its plans to raise interest rates and the dollar in that case would probably come back down.   But as of now, the US economy seems to be doing well.

Q -The oil price continues to fall to near $50 a barrel. How do you forecast the oil price for 2015 and beyond? How will it impact the world economy?

A – Among the reasons for the fall in the price of oil, of course, is the US shale energy boom (techniques associated with “fracking”).  Even though the new shale activity will moderate at these low prices, its ability to resume relatively quickly will work to prevent oil prices from rebounding.

The price decline goes beyond oil. Mineral and commodity prices have also fallen over the last year, at least in terms of dollars.  Disappointing levels of economic activity in much of the world are an obvious explanation.  But the business cycle doesn’t explain why commodity prices are down especially in the US, where economic activity strengthened in 2014.  The Economist commodity price index in 2014 was actually up in terms of euros; it was down only in terms of dollars, though that is what everybody focuses on.

The other factor is monetary policy: the end of quantitative easing in the US and renewed monetary stimulus elsewhere.  That is consistent with some commodity prices falling in dollars while simultaneously rising in terms of other currencies.   We could see more of this in the coming year.

I would say that oil prices and other commodity prices are more likely to continue falling in 2015 than to rise.  To the extent that oil prices are down because of the fracking boom or because some of the worst geopolitical fears have not materialized, this is good for the world economy (even though bad for oil producing countries).

The US Economy in 2015

Following the first installment of a year-end interview on the global outlook, I turn in the second installment to the domestic economy.

Part 2. The US Economy

Q – As economic adviser to President Clinton, you oversaw one of the most prosperous periods in recent U.S. history. How do you assess the economic strategy of the Obama administration? What would you have done differently were you an adviser?

A – In my view President Clinton’s policies did contribute substantially to the outstanding performance of the American economy in the late 1990s.  People did not give him enough credit at the time.  (I myself had nothing to do with it, I assure you.)

The situation that President Obama inherited from the second President Bush was quite different from the situation that Bill Clinton had inherited from the father in January 1993.  As of the day Obama took office in January 2009, the worst financial crisis since the 1930s was still underway, US GDP and employment were in free fall (the numbers turn out to have been much worse, even, than we knew at the time), and the budget deficit was skyrocketing.  People like to say that a favorable judgment regarding Obama’s reaction rests solely on the unprovable proposition that the US would otherwise have experienced a Great Depression.  But in fact a turnaround in the economic statistics is visible to the naked eye. GDP and the rate of job loss stabilized almost immediately after Inauguration Day and the recession ended in June 2009. In my view the three main reasons that things began to turn around so quickly were the Obama fiscal stimulus, the new improved TARP program, and continued innovative monetary expansion by the Fed.

A majority of Americans still don’t yet see it that way.  Among other things, they haven’t seen the data on the 2009 turnaround and they don’t know that the US Treasury was paid back for the “bailouts” with a substantial overall profit.

So I think Obama’s policies did a lot of good during the first two years of his presidency.  This is especially true if one includes two big longer-term reforms: the Affordable Care Act (“Obamacare”) and financial reform (the Dodd-Frank bill).  But it is more difficult to attribute the path of the economy during 2011-2014 to the President, because the Republican Congress blocked almost every bit of legislation that he wanted during this period.

Q – What is the outlook for the US economy?

A – We should be able to grow at 3 per cent in 2015.   In 2001, 2012, and 2013, economic growth was impaired by dysfunctional fiscal politics in Congress – fiscal cliffs, debt ceiling stand-offs, government shutdown, and sequesters.  In my view that knocked at least one percentage point off of the growth rate in each of those years.   This is a more obvious explanation for the slow pace of the recovery in those years than the secular stagnation hypothesis.   In 2014 the Congress managed to refrain from actively impeding the economy in this way.  I believe that is a major reason why economic growth in the second and third quarters of this past  year was so much stronger than in the preceding three years.  On top of that, we have had the frackingboom and lower oil prices.   I see no reason why the good performance should not continue in 2015 – unless Congress screws it up again.

Q – If the Federal Reserve raises interest rates as expected in June 2015, might that choke off the recovery?

A – The Fed might in the end wait slightly longer.   (There is no more sign of inflation now than there has been since the period of near-zero interest rates began.)  But when the Fed does raise interest rates, it will be because the US economic recovery is very well-established.   So that would be good news, not bad news.

Q – Name a threat to the global economy.

A – Many countries are hampered by their own politicians’ habit of following pro-cyclical fiscal policy.  That is, they raise government spending and cut taxes in boom times, which exaggerates the upswing, and then cut spending and raise taxes in recessions, worsening the downturn.  Exactly backwards.

Q – Upon release of Capital in the 21st Century by Thomas Piketty, capitalism again became a hotly debated topic around the world. Do you think the current global economic system is sustainable? What aspects could be improved?

A – No doubt one of the reasons that most Americans are skeptical of the economic recovery is that they don’t feel it because virtually all the gains have gone to the rich.  Real median family income is still more than 8 per cent below where it was in 2000.

I disapprove of the recent increase in inequality in the US and other countries.  But I do not see the inequality either as an inevitable aspect of capitalism nor as unsustainably containing the seeds of destruction of the system.  Piketty’s book treats the big decline of inequality in the years 1913-1973 as a temporary reversal in a long-term trend toward unequal wealth that began in Jane Austen’s time, the early 19th century.  To do so is to treat the rise of democracy as a temporary blip, which it is not.  There is no reason why a democratic system cannot choose policies that give a good combination of growth in the overall size of the pie together with a somewhat more equal distribution of the pie.  Scandinavian countries have done this in their own way.   In the US case, I support such policies as universal pre-school education, universal health care insurance, expansion of the Earned Income Tax Credit, and a more progressive structure to the payroll tax, among others.

The World Economy in 2015

I am posting in three parts the results of an interview on the year-end outlook.  (The questions come from Chosun Daily, leading Korean newspaper. The interview is to be published there January 1.)

Part 1. The Global Economy in 2015

Q: Around this time next year, which countries do you predict will be the winners, and which will be the losers of the year?

A: The big gainers will be oil-importing economies, particularly China, India and other Asian countries.

Russia will be the big loser. It has now become clear to all how fragile and vulnerable the Russian economy was, especially with respect to world oil prices. It is easy to forget that commentators a few months ago were declaring Russia less vulnerable to Ukraine-related sanctions than Western Europe. Before that, they were judging the $50 billion 2014 winter Olympics in Sochi a triumph.

Q: Even up to last year, Russia was considered a promising market. Which country could be the ‘Next Russia’ in 2015?

A: Cuba. Obama’s decision in December to normalize relations between Washington and Havana is a historic opening. Cuba is a small country, of course, but once it is opened up, the potential for investment and rapid growth is big. Many Republicans in the US Congress will oppose ending the trade embargo; but they are on the wrong side of history and on the wrong side, even, of domestic public opinion.

Q: What key word do you predict will emerge in the global economic scene in the new year? Why?

A: CoP21.  The 21st Conference of Parties of the UN Framework Convention on Climate Change, to be held in Paris in December 2015. The odds of a substantive agreement by countries, rich and poor, to limit their emissions of greenhouse gases are better than they have ever been. The catalyst is the November 2014 breakthrough between Chinese leader Xi Jinping and US President Barack Obama.  That, in turn, was made possible because China’s air pollution has gotten so bad that its government is ready to take serious measures.

Q: What in your opinion is the greatest unforeseen risk to world economy going into 2015?

A: By now, possibilities such as plunges in asset prices or a return of the euro crisis are sufficiently prominent in market awareness that they are not unforeseeable risks or unknown unknowns. Rather they are the known tail of the probability distribution.   I suspect that some of the true black swans come from such areas as technology, the weather, and health.   An example would be a disease that is more contagious than the ones we have seen. Or cyber warfare. Or WMD terrorism. I think of black swans as risks that are supposedly unknowable but in fact should be on the list of possibilities if one takes a broad enough perspective. Of course the risk of any single such disaster happening in any given year is small.

Q: According to the IMF, China has replaced the U.S. as the largest economy (in PPP) this year. Despite that, the Chinese government declared a ‘new normal’ and hinted at slowing down. What is your assessment of the Chinese economy in 2015? Will China eventually replace the U.S. as the superpower in the near future?

A: China has accomplished an economic miracle in raising the standard of living of most of its people over the last three decades and the new PPP measures from the International Comparison Project are indeed the best reflection of this.   However China still has a long way to go. For one thing, if the question is income per capita, then China is still a poor country, even in the ICP rankings. For another thing, if the question is the overall size of the economy, then in my view China’s GDP should be compared to the US economy by means of current exchange rates, not by the PPP measure. The reason is that what matters is how much a yuan buys on world markets, not how much it buys in the interior of China. At current exchange rates, US GDP is still about 80% greater than Chinese GDP.   China is likely to catch up, not this decade, but in the next decade.

Why Are Commodity Prices Falling?

Oil prices have plummeted 40% since June – good news for oil-importing countries, but bad news for Russia, Venezuela, Nigeria, and other oil exporters. Some attribute the price drop to the US shale-energy boom. Others cite OPEC’s failure to agree on supply restrictions.

But that is not the whole story. The price of iron ore is down, too. So are gold, silver, and platinum prices. And the same is true of sugar, cotton, and soybean prices. In fact, most dollar commodity prices have fallen since the first half of the year. Though a host of sector-specific factors affect the price of each commodity, the fact that the downswing is so broad – as is often the case with big price swings – suggests that macroeconomic factors are at work.

So, what macroeconomic factors could be driving down commodity prices? Perhaps it is deflation. But, though inflation is very low, and even negative in a few countries, something more must be going on, because commodity prices are falling relative to the overall price level. In other words, real commodity prices are falling.

The most common explanation is the global economic slowdown, which has diminished demand for energy, minerals, and agricultural products. Indeed, growth has slowed and GDP forecasts have been revised downward since mid-year in most countries.

But the United States is a major exception. The American expansion seems increasingly well established, with estimated annual growth exceeding 4% over the last two quarters. And yet it is particularly in the US that commodity prices have been falling. The Economist’s euro-denominated Commodity Price Index, for example, has actually risen over the last year; it is only the Index in terms of dollars – which is what gets all of the attention – that is down.

That brings us to monetary policy, the importance of which as a determinant of commodity prices is often forgotten. Monetary tightening is widely anticipated in the US, with the Federal Reserve having ended quantitative easing in October and likely to raise short-term interest rates sometime in the coming year.

This recalls a familiar historical pattern. Falling real (inflation-adjusted) interest rates in the 1970s, 2002-2004, and 2007-2008 were accompanied by rising real commodity prices; sharp increases in US real interest rates in the 1980s sent dollar commodity prices tumbling.

There is something intuitive about the idea that when the Fed “prints money,” the money flows into commodities, among other places, and so bids their prices up – and thus that prices fall when interest rates rise. But, what, exactly, is the causal mechanism?

In fact, there are four channels through which the real interest rate affects real commodity prices (aside from whatever effect it has via the level of economic activity). First, high interest rates reduce the price of storable commodities by increasing the incentive for extraction today rather than tomorrow, thereby boosting the pace at which oil is pumped, gold is mined, or forests are logged. Second, high rates also decrease firms’ desire to carry inventories (think of oil held in tanks).

Third, portfolio managers respond to a rise in interest rates by shifting out of commodity contracts (which are now an “asset class”) and into treasury bills. Finally, high interest rates strengthen the domestic currency, thereby reducing the price of internationally traded commodities in domestic terms (even if the price has not fallen in foreign-currency terms).

US interest rates did not really rise in 2014, so most of these mechanisms are not yet directly at work. But speculators are thinking ahead and shifting out of commodities today in anticipation of future higher interest rates in 2015; the result has been to bring next year’s price decrease forward to today.

The fourth of the channels, the exchange rate, has already been functioning. The prospect of US monetary tightening coincides with moves by the European Central Bank and the Bank of Japan toward enhanced monetary stimulus. The result has been an appreciation of the dollar against the euro and the yen. The euro is down 8% against the dollar since the first half of the year and the yen is down 14%. That explains how so many commodity prices can be down in terms of dollars and up in terms of other currencies.

8 Policy Recommendations for Newly Elected Members of Congress

On December 3, 2014, I participated in a panel of Harvard University’s Bipartisan  Program  for  Newly Elected Members of Congress.   After establishing that the median US household has not shared in recent strong economic gains, I went on to consider policy remedies.

I offered the Congressmen eight policy recommendations.  Some will sound popular, some very unpopular; some associated with “liberals”, some with “conservatives.”   I would claim that they all have in common heavy support from economists, regardless of party – even the very unpopular ones.

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A Blog by Jeffrey Frankel