Person:

Frankel, Jeffrey

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.

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. In line with existing literature, we confirm the role of increased financial integration and lower output volatility in reducing overall procyclicality. In this paper, however, we focus on the role played by the quality of institutions. Indeed, the quality of institutions seems to be a key determinant of a country's ability to graduate. We provide a formal analysis, controlling for the endogeneity of institutions and other determinants of fiscal procyclicality, that strongly suggests that there is a causal link running from stronger institutions to less procyclical or more countercyclical fiscal policy.

American fiscal policy has been procyclical: Washington wasted the expansion period 2001-2007 by running budget deficits, but by 2011 had come to feel constrained by inherited debt to withdraw fiscal stimulus. Chile has achieved countercyclical fiscal policy – saving in booms and easing in recession – during the same decade that rich countries forgot how to do so. Chile has a rule that targets a structural budget balance. But rules are not credible by themselves. In Europe and the U.S., official forecasts are overly optimistic in booms; so revenue is spent rather than saved. Chile avoids such wishful thinking by having independent panels of experts decide what is structural and what is cyclical.

Two decades ago, many people had drawn a lesson from the 1980s: Japan's variant of capitalism was the best model. Other countries around the world should and would follow it. Japan's admired institutions included relationship banking, keiretsu, bonus compensation for workers, lifetime employment, consensus building, strategic trade policy, administrative guidance, pro-saving policies, and corporate goals of maximizing companies’ industrial capacity or market share. These features were viewed as elements of Japanese economic success that were potentially worthy of emulation. The Japanese model quickly lost its luster in the 1990s, however, when the stock market and real estate market crashed, followed by many years of severe stagnation in the real economy.

A decade ago, many thought that the lesson of the 1990s had been that the United States’ variant of capitalism was the best model, and that other countries should and would follow. The touted institutions included arms-length banking, competition for corporate control, Anglo-American securities markets, reliance on accounting firms and rating agencies, derivatives, bonus-compensation for executives, an adversarial legal system, deregulation, pro-consumer credit policies, and corporate goals of maximizing companies’ profits or share price. These features were viewed as elements of US economic success and potentially worthy of emulation. The American model quickly lost its attractiveness in the 2000s, however, when the stock market and real estate market crashed. Poor economic performance left per capita income and median household income below their levels of 2000 – even before the severe US-originated recession of 2008–2009.2 "Where should countries look now, for models of economic success to emulate?"

Perhaps they should look to the periphery of the world economy. Some smaller and less-rich countries have experimented with policies and institutions that could usefully be adopted by others. Singapore achieved rich country status with a unique development strategy. Among its many innovations was a paternalistic approach to saving. Costa Rica in Central America and Mauritius in Africa are each conspicuous performance standouts in their respective regions. Among many other decisions that worked out well, both countries have foregone a standing army. The result in both cases has been histories with no coups and with financial savings that could be used for education and other good things. Slovakia and Estonia in Central/Eastern Europe have simplified their tax systems by means of a flat tax.

Some of the lessons from emerging market countries can be useful for the big advanced countries. Two illustrations from microeconomics: First, Singapore pioneered the use of the price mechanism to reduce traffic congestion in its urban center. London emulated Singapore when it successfully adopted congestion pricing in 2003; other big cities should do the same. Second, Mexico pioneered Conditional Cash Transfers (CCT). CCT programs, which make poverty benefits contingent on children's school attendance, have been emulated in many countries, and embraced even in New York City.

Some emerging market and developing countries also have lessons for the United States in areas of macroeconomics, specifically regarding the cyclicality of fiscal policy. To state the message of this paper most succinctly, over the last decade countries from Chile to China learned how to run properly countercyclical fiscal policy: taking advantage of boom periods such as 2003–2008 to achieve high national savings, and in particular to run budget surpluses, which then allows some fiscal ease in response to downturns such as 2008–2009. During this same period, advanced countries such as the United States and United Kingdom forgot how to run countercyclical fiscal policy. Perhaps the ‘leaders’ could look to the ‘followers’ for some tips on how to get back on track.

This paper investigates 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 current crisis, the selection of variables is driven by an extensive review of more than eighty papers from the previous literature on early warning indicators. 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 crises 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. So is the exchange rate regime. We define the period of the global financial crisis as running from late 2008 to early 2009, which probably explains why we find stronger results than earlier papers such as Obstfeld, Shambaugh and Taylor (2009, 2010) and Rose and Spiegel (2009a,b) which use annual data.

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.

By putting together a relatively large data set on bilateral remittances of emigrants, this paper is able to shed light on the important hypothesis of smoothing. The smoothing hypothesis is that remittances are countercyclical with respect to income in the worker’s country of origin (the recipient of the remittance), while procyclical with respect to income in the migrant’s host country (the sender of the remittance). The econometric results confirm the hypothesis. This affirmation of smoothing is important for two reasons. First, it suggests that remittances should be placed on the list of criteria for an optimum currency area. Second, it brings into doubt plans by governments in some developing countries to harness remittances for their own use, in that government spending in these countries generally fails the test of countercyclicality which remittances pass.

In the past, various great powers have taken the stage as models of economic and social development. Examples such as Great Britain, the Soviet Union, Japan, and the United States have had their time in the spotlight that has come and gone as flaws were exposed; and other countries have learned what they did well and what they did poorly. The great powers are not the only models, however. Much can be learned from small countries which are often free to experiment with new institutions and new policies. This paper describes lessons that can be learned from such countries though no one size fits all.

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.

It is striking how often countries with oil or other natural resource wealth have failed to grow more rapidly than those without. This is the phenomenon known as the Natural Resource Curse. The principle is not confined to individual anecdotes or case studies, but has been borne out in econometric tests of the determinants of economic performance across a comprehensive sample of countries. The paper considers six aspects of commodity wealth, each of interest in its own right, but each also a channel that some have suggested could lead to sub-standard economic performance. They are: long-term trends in world commodity prices, volatility, crowding out of manufacturing, civil war, poor institutions, and the Dutch Disease. The paper concludes with a consideration of promising ideas for institutions that could help a country that is rich in, say, oil overcome the pitfalls of the Curse and achieve good economic performance. They include indexation of oil contracts, hedging of export proceeds, denomination of debt in terms of oil, Chile-style fiscal rules, a monetary target that emphasizes product prices, transparent commodity funds, and lump-sum distribution.