Managing Macroeconomic Crises: Policy Lessons
What does the last decade reveal about which policies for crisis prevention or crisis management seem to work and which do not? Jeffrey Frankel, a professor of capital formation and growth at the Kennedy School of Government at Harvard University came to the Bank recently to discuss a chapter he coauthored with Shang-Jin Wei of the IMF for the forthcoming volume on Managing Volatility and Crises. Frankel and Wei found that crises are more frequent and more severe when short-term borrowing and dollar denominated external debt are high, and foreign direct investment (FDI) and reserves are low. This is in large part because balance sheets are then very sensitive to increases in exchange rates and short-term interest rates. A point emphasized is that these compositional measures are affected by decisions made by policymakers in the period immediately after capital inflows have begun to dry up but before the speculative attack itself has hit. If countries adjust more promptly to a fall in capital inflows rather than procrastinating, they might be able to adjust on more attractive terms.
Brian Pinto, a lead economist in the Bank’s Poverty Reduction and Economic Management unit, provided introductory remarks about the discussants. Cesare Calari, Vice President of the Bank’s Financial Sector, served as the event chair. Frankel said he would give an overview on the crises in emerging markets over the last decade. He cited a study by one of the seminar’s discussants, Morris Goldstein of the Institute for International Economics, which attempted to identify early warning indicators of pending crises, as well as a study by the other discussant, Robert Flood of the IMF, which suggested that one couldn’t predict crises. Frankel said he tried to put together predictive indicators in the past for policymakers and economists. The literature suggest having a large currency deficit is not a good predictor. With each emerging crisis, the uses of currency deficits had to be re-examined, he noted. The magnitude of the capital inflow is not as important an indicator as its composition, he suggested. If there is a high degree of bank debt, short term borrowing or foreign currency denominated, then the chances of a crisis are greater. If the deficit is in the form of a foreign direct investment or is used to grow reserves, then chances of a crisis decrease. The most powerful indicator if there is going to be a crisis is the ratio of short term debt to reserves. Taiwan and Hong Kong had high levels of reserves, and as a result survived the East Asian financial crises most satisfactorily.
Past speculative models sought to identify when a crisis would occur. Early models suggested host countries were at fault for having money and budget deficit problems. Second generation models suggested external factors drove problems. Third generation models focused on flaws in the fundamentals of the host countries financial markets. Frankel doesn’t think past crises fall neatly into one model or another. For example, the East Asia crises was a catalyst for reforms in Korea. Frankel’s model suggests inflation is an important predictor. He also looked at the severity or output loss caused by a crises, as well average performance during the output loss. Budget deficits also seemed to be an important variable, as suggested by first generation speculative models. Inflation, in combination with low reserve levels or unsatisfactory compositions of capital inflows, were triggers for crises. Standard textbook theories suggest open capital markets perform on the whole better, but the financial crisis of the past decade has shifted thinking to a degree, Frankel said. Certain kinds of capital controls such as penalties on short term inflows seem to have increased support among macroeconomists. Others suggest open capital markets may allow for more volatility, but also allow for more growth.
Frankel cited literature that said capital markets are vulnerable to crises until they reach certain stages of development, that open markets reduce volatility, that institutions, governance and the rule of law are factors in market volatility, that overly expansionary policies are influential as well. On exchange rate regimes, Frankel said there is no set rate that will reduce the likelihood of crisis. In fact, the history of the last decade suggested pegs don’t work, and countries were forced to use more flexible regimes. He noted that it is hard to generalize about exchange rate regimes because it is hard to classify them. Frankel discussed how different research came to different conclusions because in his view they had different ways of classifying regimes.
The composition of the inflow of currency is relevant to the probability and severity of crises, Frankel said. Crisis countries experience greater output loss if capital inflows are tilted to short term borrowing rather than FDI or equity inflows. Frankel said the IMF fiscal targets during the Asia crises were too aggressive and needed revision. He suggested that critiques of the IMF’s performance, made by countries in crises and macroeconomists like Jeff Sachs and Joseph Stiglitz, must be viewed as to whether there were counterfactuals. According to Sachs and Stiglitz, he said, there was too much expenditure reduction imposed by the IMF and not enough devaluation. Frankel said he agreed with Stiglitz’s notion that raising interest rates increased the likelihood of bank defaults. Frankel also said textbook theory would suggest devaluation is contractionary in the short term. He discussed some of the reason for these contractionary effects from devaluation. The sudden stop theory was the interval from when danger signs were first becoming apparent for an emerging market and the time it took to implement protective action. On average this is from six to 13 months. During this interval, decisions to run down reserve, shift the currency composition of national debt as ways of postponing adjustments are critical. Delays in decision making, Frankel believes, leave countries without good options to mitigate looming crisis.
Flood said short term debt to reserves and domestic inflation are indicators of crises, but not overwhelmingly so. The sum of the percentage change in the exchange rate and the percentage loss of reserves are for the most part unpredictable. He suggested that Frankel’s research look less closely at the exchange rate and more closely at the impact of reserve losses. He also thought the research should try to identify crises by type. Monetary policy today revolves around interest rates and their targets, which makes short term debt an important variable.
Goldstein said in his view, the paper added much, but Frankel and Wei’s research seemed weak in four areas. They were the treatment of currency mismatch, the interaction between capital accounts, health and the openness of domestic financial systems, the currency regime, and the contagion of crises.
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