CIAO DATE: 09/2008
Volume: 28, Issue: 2
Spring/Summer 2008
Editor's Note (PDF)
James A. Dorn
The Fed’s Road toward Greater Transparency (PDF)
Ben S. Bernanke
Montagu Norman, the governor of the Bank of England from 1921 to 1944, reputedly took as his personal motto, “Never explain, never excuse.” Norman’s aphorism exemplified how he and many of his contemporaries viewed the making of monetary policy—as an arcane and esoteric art, best practiced out of public view. Many central bankers of Norman’s time (and, indeed, well into the postwar period) believed that a certain mystique attached to their activities and that allowing the public a glimpse of the inner workings would only usurp the prerogatives of insiders and reduce, if not grievously damage, the effectiveness of policy.
Norman’s perspective on central banking now seems decidedly quaint. Over the past few decades, central banks around the world have worked assiduously to become more open about their activities. In fact, Norman’s own institution, the Bank of England, has in recent years been a leading exponent of increased transparency in central banking. Monetary policymakers have adopted a range of methods to improve their communication with the public, including timely announcements of policy actions, expanded testimony before members of the legislature, the release of minutes of policy meetings, frequent public speeches, and the regular publication of reports about the economy and monetary policy. This increased openness is a welcome development for several reasons. Most importantly, monetary policymakers are public servants whose decisions affect the life of every citizen. Consequently, in a democratic society, they have a responsibility to give the people and their elected representatives a full and compelling rationale for the decisions they make. Good communications are a prerequisite if central banks are to maintain the democratic legitimacy and independence that are essential to sound monetary policymaking....
Renminbi Exchange Rates and Relevant Institutional Factors (PDF)
Yi Gang
In recent years, China has experienced rapid social and economic development. Against this backdrop, growing pressure for renminbi appreciation emerged and China’s trade surplus and foreign reserves increased rapidly. This article explains the development of the RMB exchange rate by examining productivity growth and institutional factors, such as the transformation of the foreign exchange rate system and legal reforms to strengthen the rule of law.
The Future of the Renminbi and Its Impact on the Hong Kong Dollar (PDF)
Eddie Yue, Dong He
This article outlines our thoughts on the following three issues. First, will the renminbi become an international currency in the foreseeable future? Second, what does the international use of the renminbi mean for Hong Kong? Third, should the Hong Kong dollar exchange rate be repegged to the renminbi?
The Costs and Implications of PBC Sterilization (PDF)
John Greenwood
Since China revalued its currency against the U.S. dollar by 2.1 percent in July 2005, from RMB 8.27 per US$ to RMB 8.11, the RMB has appreciated by a further 14 per cent percent to about RMB 6.97 per US$ (as of May 2008). On a trade-weighted basis, however, the currency has appreciated less than half this amount. Using J.P. Morgan’s trade-weighted index (broad basis) for the RMB, the currency appreciated just 6.1 percent in nominal terms between August 2005 and May 2008. Although the currency has been very gradually appreciating, the flexibility promised by China’s leaders has been more illusory than real, and, more importantly, the underlying international payment imbalances have continued to widen both in absolute terms and as a fraction of GDP.
In this article, I set out the magnitude of the problem of China’s international payment imbalances, summarize the techniques used by the People’s Bank of China to sterilize China’s overall balance of payments surplus, and assess the costs and benefits of the PBC’s sterilization strategy—both from a theoretical perspective and in the light of the experience of other East Asian currencies that have witnessed large-scale sterilization operations in the past. I also consider whether, for the purpose of ensuring satisfactory monetary arrangements in the 21st century, it is appropriate for a country of the size and stature of China to delay adjustment by means of large-scale sterilization.
The Role of the Renminbi in the World Economy (PDF)
Fred Hu
As China’s economy has continued its remarkable expansion and gained an increasingly important role in the global economy, China’s currency, the renminbi (RMB), has also captured growing attention from investors and policymakers around the world. In this article, I briefly discuss three significant issues concerning the renminbi— namely, the near-term direction of the exchange rate, the renminbi’s convertibility in the medium term, and the currency’s international role down the road in the future.
Lessons from Monetary and Real Exchange Rate Economics (PDF)
Arnold C. Harberger
This article is intended to be a sort of flyover, examining certain key aspects of monetary and real exchange rate economics from a convenient distance. In it I try to avoid getting into technicalities that are interesting mainly to specialists. I focus instead on essentials that are critical to a proper understanding of the economic processes involved, and on a few real-world examples that show the usefulness and relevance of our fundamental theoretical constructs.
It pays to simplify by dividing our analysis into two parts: one concerned with the “real economy” dealing with quantities and relative prices, and the other dealing with the determination of the absolute level of prices. This is called the classical dichotomy; it has for years been a critical pillar of economic theory.
When we try to apply the classical dichotomy, we need to settle on a unit, in terms of which we express relative prices. While in theory this unit, called the numeraire, could be any price (e.g., that of oil, sugar, or copper), in practice it is greatly simplifying to use a general price level as the unit of analysis—either the GDP deflator, a general index of the prices of all the goods and services produced in the economy, or the consumer price index, a general index of the prices of all the goods and services consumed in the economy.
Monetary Stability, Exchange Rate Regimes, and Capital Controls: What Have We Learned? (PDF)
Miranda Xafa
Few topics in macroeconomics are as contentious as capital account liberalization and exchange rate regimes. This article attempts to briefly summarize what we have learned through the turbulent 1990s and the relatively benign 2000s. It is obviously not intended to review the massive literature on these topics, only to distill the main policy conclusions—or at least what I think are the main policy conclusions.
In contrast to current account liberalization, which is enshrined in the Articles of Agreement, the International Monetary Fund has no explicit mandate to promote capital account liberalization. Even so, the IMF seeks to be a “center of excellence” in analyzing capital account issues, in light of the growing financial globalization and its implications for macro management in member countries. To deal with surges in capital inflows, the IMF has generally advocated tightening fiscal policy to prevent overheating and limit real appreciation (IMF 2007a). Such a policy response helps reduce the economy’s vulnerability to a “hard landing” after the inflows abate. However, counter-cyclical fiscal policy is no panacea, because governments may be unable to change the fiscal stance to the extent and at the speed required to offset the impact of shifts in capital inflows.
The Case for Price Stability with a Flexible Exchange Rate in the New Neoclassical Synthesis (PDF)
Marvin Goodfriend
The New Neoclassical Synthesis is a natural starting point for the consideration of welfare-maximizing monetary arrangements in the international context. Alternatively known as the New Keynesian model, this consensus model of monetary policy deserves our attention because it embodies cumulative advances in theory and policy informed by decades of monetary experience from around the world. The consensus model with its prescription for price stability serves today as the foundation for thinking about monetary policy at central banks and universities worldwide.
The purpose of the article is to review the fundamental principles of monetary policy in terms of the New Synthesis. The first section describes briefly the structure of the baseline NNS model. The second section presents the case for price stability in the NNS model. The third section extends the discussion to the open economy and presents the NNS case for a flexible exchange rate. The fourth section tells why monetary policy is fragile that simultaneously attempts to fix the foreign exchange rate and pursue interest rate policy to sustain price stability.
Monetary Policy and the Legacy of Milton Friedman (PDF)
Anna J. Schwartz
So many well-deserved tributes have been paid to the memory of Milton Friedman that I propose to pay him tribute in a special way by talking about my long association with him. Before I do so, I note his activities before the 1950s, when we started working together. For the record, Friedman was not a monetarist when our collaboration began.
The National Bureau of Economic Research was then located at 1819 Broadway, now the site of the Time Warner Center. At that time, the research program of that organization was divided between the measurement of national income and the study of business cycles.
Milton Friedman and the Euro (PDF)
Antonio Martino
Milton Friedman did not like the euro. In early 1999 I wrote to him mentioning my daughter Erika’s thesis and, in a letter dated March 12, 1999, he wrote back:
Erika’s thesis on “The Euro and the Dollar” is one of the subjects I have been maintaining a real interest in. As you know, I am very negative about the euro and I am very doubtful about how it will work out. However, I am less pessimistic about it now than I was earlier simply because I never expected that the various countries would display the kind of discipline that was required in order to qualify for the euro. The convergence in inflation rates, interest rates, and so on was greater and more rapid than I would have expected.
I believe that the monetary-fiscal constitution adopted with the introduction of the European single currency is consistent with Friedman’s intellectual legacy. Let me explain.
The ideas of Milton Friedman on money have been so largely spread and absorbed that it may appear trite to repeat them once again. But, since there still is a lot of misunderstanding on the issue, I may be forgiven for giving a summarized version of them.
Friedman: Float or Fix? (PDF)
Steve H. Hanke
With the passing of Milton Friedman on November 16, 2006, we lost one of the great champions of free markets. Friedman’s obituaries and commentaries on his life’s work and enormous influence have invariably mentioned his advocacy of floating exchange rates, leaving the impression that he always favored floating rates. This was not the case.
Milton Friedman and the Case against Currency Monopoly (PDF)
George Selgin
A longstanding tradition in economics, dating back at least to Adam Smith, looks askance at statutory monopolies, condemning almost all of them as unnecessary barriers to economic progress. Thanks largely to this tradition most of the monopolies present in Smith’s day are no longer tolerated. The few exceptions are found mainly in less developed countries, where they remain a cause of impoverishment. Needless to say, economists have also generally opposed the monopolization by fiat of undertakings that were already at least somewhat competitive in Smith’s day.
But there is one set of notable exceptions to the last claim: government monopolies of paper money. During the late 18th and the 19th century such money consisted almost entirely of redeemable notes issued by commercial banks; and while complete legal freedom of entry into the paper currency business was rare, so were outright monopolies. In some countries, moreover, the paper-money industry “playing field” was more or less level, with numerous banks sharing similar privileges.
The Federal Reserve’s Role in the Great Contraction and the Subprime Crisis (PDF)
Richard H. Timberlake
Milton Friedman liked to recall that his experience with the Great Depression as a young man living in New York had a major effect on his career decision to study economics. So, we can count at least one good thing that came out of that tragic, unnecessary experience.
I had about the same reaction to the Depression as Milton Friedman, as did many others who were born early enough to witness the prosperity of the 1920s and experience the inexplicable poverty of the 1930s. Several of my fellow students and I, who were lucky enough to have studied under Friedman at the University of Chicago, subsequently concentrated our professional research on monetary economics to find out just what made the monetary system tick, and especially what circumstances made it go awry. The 1929 experience was the worst, but not the only one.
Milton Friedman’s and Anna Schwartz’s epic account of the Great Contraction (1929–33) in their Monetary History tells most of what happened (Friedman and Schwartz 1963: chap. 7). It is empirical and analytic economics at its best. Anyone who followed in their footsteps has had this superb model of economic research to guide his own efforts.
Despite the evidence in the Monetary History, misconceptions about the Great Contraction still abound in laymen’s minds, more so in popular media accounts, and, to some extent, even among economists. Here, I summarize an important unpublicized incident of that period to emphasize the policy decision that triggered the Depression, and what the experience should have taught policymakers to do and not to do. My brief review is meant to emphasize how that Fed-provoked disaster speaks to Federal Reserve policy in the recent state of disequilibrium in financial markets.
Economic Development and the Role of Currency Undervaluation (PDF)
Surjit S. Bhalla
This article is concerned with the determinants of economic growth, and, in particular, with the role of policy in directing the pattern of growth in developing economies. Over the years, economists and policymakers have focused primarily on fiscal and exchange rate policy. While the role of fiscal deficits is well understood, the same agreement does not hold with regard to exchange rate policy.
Part of the reason for the controversial nature of exchange rate policy is that it comes in various styles—floating, dirty float, managed, dirty managed, pegged, and fixed. Besides floating, the success or failure of a particular exchange rate policy appears to be contingent not on the nature of the regime but rather on the direction of the misalignment of the currency. Bad exchange rate policy, in the form of an overvalued exchange rate, has been much analyzed and the results are well known. A persistently overvalued exchange rate leads to factor misallocations, loss in efficiency, higher inflation, and lower GDP growth. This conclusion is widely accepted, but the parallel theoretical and analytically equivalent conclusion—that exchange rate undervaluation is helpful to growth—is not. Moreover, even if accepted in theory, in practice the discussion gets involved with definitional and measurement issues. How do we define the real exchange rate? How does one measure it? Most important, how does one measure equilibrium? It is the latter that allows misalignment to be measured.
Most of the empirical results to date do not support the conclusion that exchange rate undervaluation is helpful for growth. Easterly (2005) concludes, on the basis of an updated Dollar (1997) measure of currency undervaluation, that a policy of undervaluation does not matter as a determinant of economic development. Acemoglu et. al (2003) and the IMF (2005) reach the same conclusion, and find the impact to be even weaker if institutions are introduced into the growth model. Lately, however, some evidence of the positive growth effects of currency undervaluation is beginning to surface. In various articles (Bhalla 2002, 2005, 2008a, 2008b), I document this effect, as do Johnson, Ostry, and Subramaniam (2007, hereafter JOS) and Rodrik (2007).
The plan of this article is as follows. In the next two sections, I discuss the definition of the real exchange rate and the different methods of measurement. I then examine the empirical basis for the notion that the “real exchange rate is endogenous (RERIE).” Phrased differently, the RERIE argument is the same as saying that the “impossible trinity” holds—namely, that it is impossible to simultaneously target the nominal exchange rate, have freely floating capital, and have an independent monetary policy. Next, I explain the mechanism through which exchange rate undervaluation is likely to work—by increasing the profitability of investment, leading to higher growth and savings and, therefore, to the operation of a virtuous cycle of investment growth- savings. Empirical results are then presented for the effect of currency undervaluation (and overvaluation) in standard growth models. This section documents the large empirical role of two variables related to currency undervaluation: the valuation in the initial year, and the average change in undervaluation over the period examined. The latter variable is found to be particularly significant, and it helps explain the fast growth episodes of several economies. In the final section, I offer some policy conclusions.
Book Review: Freedom from Want: American Liberalism and the Global Economy by Edward Gresser (PDF)
Daniel Griswold
Freedom from Want: American Liberalism and the Global Economy
Edward Gresser
Brooklyn, N.Y.: Soft Skull Press, 2007, 230 pp.
Trade policy has become a partisan affair in Washington. Major trade bills in Congress typically pit pro-trade Republicans backed by big business against trade-skeptic Democrats aligned with labor unions. And as the two major parties arm themselves for the 2008 general election, trade policy promises to provide one of the sharper contrasts between them.
Throwing a welcome curve ball into the debate is Edward Gresser, trade policy director of the Progressive Policy Institute, a Democratic think tank in Washington, D.C. Gresser is a pro-trade liberal who has worked for such prominent Democrats as Sen. Max Baucus of Montana and Charlene Barshefsky, former U.S. trade representative for Bill Clinton. Gresser has written an important new book, Freedom from Want: American Liberalism and the Global Economy, that should be on the nightstand of every Washington Democrat who cares about the party’s heritage and its best ideals.
Peter Van Doren
The Cult of Statistical Significance: How the Standard Error Costs Us Jobs, Justice, and Lives
Stephen T. Ziliak and Deirdre N. McCloskey
Ann Arbor, Mich.: University of Michigan Press, 2008, 352 pp.
How do many scientific disciplines estimate and report results? Practitioners estimate regression models or conduct difference-ofmeans tests through experiments. And they report which results are significant and which are not (i.e., different from zero with 95 percent confidence). In this important book, Ziliak and McCloskey have three objectives: to remind us that such research may be mindless, unscientific, and costly; to explicate the intellectual history of significance testing and the struggles among those professors who developed sampling and statistical testing; and to illustrate the correct way to conduct research and praise those few who report their research properly.
Ilya Shapiro
My Grandfather’s Son
Clarence Thomas
New York: HarperCollins, 2007, 289 pp.
Supreme Discomfort: The Divided Soul of Clarence Thomas
Kevin Merida and Michael A. Fletcher
New York: Doubleday, 2008, 422 pp.
Whatever you think of his politics or jurisprudence, Clarence Thomas is a remarkable man. Born into desperate poverty in the Jim Crow South and raised by his illiterate grandfather, he would graduate from (and be completely disillusioned by) Yale Law School while battling personal and political demons that would have felled lesser mortals many times over. Now on the Supreme Court bench for over 15 years, Justice Thomas has established himself as a force to be reckoned with, a strong voice who has accepted and transcended his unfortunate notoriety.
Book Review: Rumsfeld’s Wars: The Arrogance of Power by Dale R. Herspring (PDF)
Ionut Popescu
Donald Rumsfeld will go down in history as one of the worst secretaries of defense since the end of World War II. This is the conclusion reached by Dale Herspring, a political science professor at the University of Kansas, in a new book transparently titled Rumsfeld’s Wars: The Arrogance of Power. Without much effort to give the former secretary any benefit of the doubt, Herspring blames him directly for causing our military to become “demoralized” and “broken.”
Book Review: World War IV: The Long Struggle against Islamofascism by Norman Podhoretz (PDF)
Christopher Preble
“9/11 constituted an open declaration of war on the United States and … the war into which it catapulted us was nothing less than another world war.” So says Norman Podhoretz in the opening passage of this alarmist, rambling screed. The enemy is Islamofascism, a “monster with two heads, one religious and the other secular.” This scourge, Podhoretz warns darkly, may be “even more dangerous and difficult to beat” than Nazi Germany or the Soviet Union.
Podhoretz admits most Americans disagree. So, too, do most terrorism and foreign policy experts. The purpose of this book, therefore, is to repudiate the collective wisdom of both the chattering classes and the public, and rally support behind the policies of George W. Bush, who invited Podhoretz to the White House to discuss the book in August of last year, and his presumptive heir, John McCain, whom Podhoretz hopes to influence. Each of the particulars that Podhoretz cites to buttress his claim that we are in the midst of a new world war is easily refutable.
His argument, such as it is, runs off the rails before the train even leaves the station. The central problem is Podhoretz’s conception of the enemy, the so-called Islamofascists, which draws heavily from the writings of Daniel Pipes. Quoting Pipes, he notes that they have “potential access to weapons of mass destruction.” But don’t we all? Nuclear weapon designs can be downloaded from the Internet.