President Obama’s recent trip to Cuba has highlighted both the ongoing tensions between Havana and Washington and the potential for an improved relationship. The tensions were most evident in the president’s contentious discussions with Cuban President Raul Castro about human rights and political openness. On the other hand, the landmark baseball game between the Tampa Bay Rays and the Cuban National Team was a particularly colorful example of the potential of closer ties. But far more consequential for the Cuban people would be a transformation of Cuba’s sputtering state-dominated economy — which the U.S. can help make a reality.

It is well understood that lifting the U.S. trade embargo would be a game-changer. But this depends on Congress, and, at least for now, appears unlikely. But another set of key (and underappreciated) reforms looks much more feasible: the United States could take practical and essential steps to help Cuba develop a fully functioning financial system. The future of its economy depends on it.

The Cuban revolution is well regarded for its accomplishments in raising levels of education and medical care. But the revolution has failed to deliver along other economic dimensions, and has depended on assistance from the Soviet Union and, later, Venezuela. The very difficult “special period” of the 1990s, after the fall of the Soviet Union led to a steep reduction of foreign aid, threatens to be repeated in this era as Venezuela’s economy collapses.

In response to this new reality, Cuba needs to grow its private sector, which now employs nearly 28 percent of the workforce. Given the state of government finances and the loss of Venezuelan sponsorship, the state needs to make further serious cuts in government payrolls. During the president’s trip we heard that the island’s privately-run small businesses, or cuentapropistas, are the most vibrant sector of the economy. Cuentapropistas are only allowed to operate within a narrow government-approved list of categories, including hair salons, restaurants, and tour guides. In an effort to expand the private sector, employ more people, and grow the economy, the Cuban government has been gradually expanding this list of permitted areas.

But small businesses need more than the legal permission to operate. As in any other country, building a business in Cuba will require access to capital. Today, many Cubans who start such endeavors get seed money in the form of remittances from relatives in the United States. But if overseas financing of this type remains the main source of capital for cuentapropistas, they will only contribute to the creation of a stratified class of have and have-nots — if you have family in South Florida, you’re set. If not, you’re out of luck.

The United States should take several steps to help catalyze the nascent Cuban private sector, helping the Cuban economy grow in a way that is more independent of the central government. The Treasury Department stated in January 2015 that a limited range of U.S. projects that support microfinancing (small loans for entrepreneurs) in Cuba will be allowed, although none have yet emerged. While there has been an easing of restrictions on banking, a range of U.S. banking services are still prohibited for Cubans. These prohibitions should also be eliminated, although, even if they are, the Cuban’s government’s willingness to allow the presence of U.S. banks in the country is uncertain.

President Obama should lift the remaining restrictions on banks operating in Cuba, and make clear to banks and microfinance organizations that such work in Cuba is viable and would be welcomed. Of course, this can only happen if the Cuban government allows foreign banks to service the Cuban people for both retail banking and to serve the nascent cuentapropistas.

But serious growth cannot occur through small business expansion alone. Foreign investment and the business of major foreign corporations will be essential for adding jobs and injecting capital into the Cuban economy. U.S. businesses remain largely barred from doing business with Cuba — and will remain severely restricted as long as the congress-mandated embargo remains in place — but other nations have long been able to trade and invest in the island. As U.S. restrictions have eased, such as with the May 2015 removal of Cuba from the list of countries that sponsor terrorism, it has become easier for foreign companies to work in Cuba. But there are still a host of transactions, particularly those denominated in dollars, engaging in which risks severe penalties from the U.S. Treasury. President Obama should use his presidential discretion to ease such policies.

Of course, much of the necessary changes must come from actions of the Cuban government, not from the United States. Foreign capital will not come to Cuba until the country addresses its lack of a sound financial infrastructure, transparent accounting, and legal assurances. Currently, Cuba has too few banks to serve its population.

But a big problem facing Cuba is that, while it has too few banks, it has too many currencies: two, to be precise. While most Cubans are paid in Cuban pesos (CUP) and can buy basic goods in this currency, luxury goods are mostly priced in Cuban convertible pesos (CUC), a much more valuable currency which is pegged to the dollar and most easily obtainable from tourists. The two-currency arrangement leads to serious pricing distortions and economic inefficiencies, not least by segregating the economy into CUP and CUC sectors.

The Cuban government has said that it is committed to eliminating this confusing system, unifying the two currencies on a day declared dia cero (“day zero”). But this will be a challenging task, rife with implications for monetary stability, fiscal balances, and inequality. To accomplish it, Havana would do well to seek technical assistance from international financial institutions, starting with the Inter-American Development Bank (IDB). And the United States can help Cuba in this regard by facilitating its relationship with the IDB, as well as allowing it to become a member country of the IMF and the World Bank. President Obama should make it clear that the United States will not stand in the way of this technical assistance and of closer relationships between Cuba and international financial institutions.

While in Cuba, President Obama rightly took a clear stand in advocating for the expansion of political and civil liberties. Economic freedoms, and the opportunity to better one’s station in life, is likewise an important right, especially since Cuba’s standard of living is relatively low. The Cuban government needs to enable its people to realize their economic dreams and aspirations by allowing the private sector to expand and encouraging foreign firms to aid the country’s development. And it’s time for the United States to do what it can to make this possible.

Editor's note: This piece originally appeared in Foreign Policy.

      

 

 

Tuesday's sudden, surprising move by the Chinese government to devalue the renminbi by almost 2 percent against the US dollar was the biggest one-day decrease in the value of that currency against the greenback in over 20 years.   This policy reflects concerns in Beijing about the recent lukewarm performance of that country’s economy.  It is an effort to spur Chinese exports, an important source of economic growth for that country, in the face of weaker demand in the rest of the world, and weaker demand in China itself as the value of its stock market has plunged. 

This policy is unlikely to have a big impact in China any time soon – which means that yesterday’s move may prove to be the first of several renminbi devaluations.  Renminbi devaluations in the future, like the one that just happened, will lower the value of other currencies against the US dollar, offsetting the desired effect for China.  A falling renminbi could also cause headwinds that slow growth in other countries; but this is less of a beggar-thy-neighbor policy than a reflection of how adjustments come about when economic performances diverge across countries.

A country’s exchange rate is one of its most important prices, translating the local cost of its goods into prices in foreign markets.  But a country does not have just one exchange rate, rather it has a wide range of bilateral rates.   The foreign exchange market response to the Chinese devaluation against the dollar was an immediate depreciation of other currencies against the dollar as well, including the Korean Won,  the Australian dollar, and the Canadian dollar.

This means that there was a much smaller change in the value of the renminbi against these currencies than against the US dollar. In particular, the recent decline in the value of the Canadian dollar against the US dollar, along with a further plunge in its value in the wake of yesterday’s renminbi devaluation, means that the remnimbi is still stronger against the loonie today that it was, on average, in July. 

These offsetting movements in cross rates are not the only reason that the renminbi devaluation is unlikely to provide a quick turnaround for the Chinese economy.  The effects of a fall in a country’s exchange rate movements only fully feeds through to spurring production over a year or more. International trade contracts are written well in advance of the actual delivery of goods. Today’s devaluation could affect orders delivered next year, but that is unlikely to quickly counter current sources of weakness in the Chinese economy.

A slow response to yesterday’s devaluation could mean that authorities reach for another tug at the policy lever before too long. If this happens, or even if it is just considered a likely possibility, the increasing weakness in the renminbi would reduce dollar returns in investments in China, scaring off investors who are already leery of the recent weak economic performance of that country.

While the renminbi devaluation represents a policy move by the government, it should also be seen as a reflection of the natural response of the exchange rate to economic weakness. Currencies tend to weaken when a country’s economy wanes. This serves as a natural shock absorber, offsetting the downturn by making a country’s exports more competitive and bolstering the sales of domestic goods that are competing with imports.

The renminbi devaluation is worrisome, not because it represents an unwelcome move by the Chinese government, but rather because it reflects a weakness in the world’s second largest economy at a time when the world economy itself is showing few signs of strength.

Editor's Note: This post originally appeared on The Globe and Mail.

      

 

 

As more Americans pursue college degrees, it has become less of an obstacle to becoming a leader in the military, hurting their relative quality.

The law of unintended consequences is alive and well in a strange place: more Americans are going to college, which is a good thing, but it has reduced the quality of officers joining the military.

I saw the importance of having a high-quality officer corps firsthand when I was deployed with an infantry company to Sangin, Afghanistan in 2011. For seven frustrating months, our battalion was stuck in a Groundhog’s Day of either finding improvised explosive devices (IEDs) or having the IEDs find us. The only variation was imposed on us by the actions of the other side.

Waiting for the plane home, I joked to another officer, “That was nothing like what the counterinsurgency manual described.”

“I wouldn’t know – I haven’t read it,” he replied. “I don’t need a book to tell me what to do.”

This anecdote of one lieutenant’s antipathy to “book learning” reflects a deeper problem: the decline in the intelligence of military officers, which our recent study found has become significant. This is not just a result of continuing wars in Iraq and Afghanistan, but has been a trend for at least 35 years.

Using data from a Freedom of Information Act request, we found that the average intelligence of Marine Corps officers has dropped since 1980. For example, 41% of new Marine officers in 2014 would not have met the intelligence standards demanded of officers in World War II. This decline is especially surprising because, as others have documented, 2011 saw the most intelligent group of enlistees in the history of the volunteer military. Thus, even as the intelligence of our enlisted troops have been rising, that of our commissioned officers has been declining.

Why the decrease in officer quality?

We didn’t find it was due to more minorities or women in the ranks, as many have assumed. The basic answer is that more people are going to college. Officers in the volunteer military have always been required to have a four-year college degree. The pool of college students has increased by over 50% since 1980, so these days a lot more Americans meet the key qualification to become an officer than was the case three decades ago. That has been very positive for society by increasing social mobility. But perhaps it hasn’t been all good news. The expansion of the pool of college students means a larger, but lower quality, pool of potential officers. While our data were about Marine officers, the results likely apply to the whole military.

Another example drawn from my experience shows the problems created by a lack of intellectual curiosity. The Afghan Army had several large pictures in their bases and on their trucks of Ahmed Shah Massoud, the famous Tajik warlord who fought against the Soviets. Few of the Marine officers knew his history, but more importantly many others didn’t care to learn. They then couldn’t understand why the local Pashtuns were upset with the presence of “foreign” Tajik troops in their village. Wrongly, we measured success as merely counting the number of Afghan Army patrols, which we took as an indicator of closer relations with the local Pashtuns, without recognizing how the locals truly felt.

Our military is being given increasingly complex and diverse missions across the globe; it doesn’t make sense to train a young officer how to fight against the Soviets in World War III and then ask him or her to be a sociologist and diplomat. But as long as the United States relies on the military to conduct foreign affairs, the military needs to be staffed with knowledgeable, intellectually capable officers.

This decline has not been helped by the anti-military culture that has prevailed at elite universities since the Vietnam War. While Harvard University restored its ROTC program following the repeal of ‘Don’t Ask, Don’t Tell’ in 2011, the continued paucity of cadets there belies their claim that it was always about homosexuals in the military. This year, only *one* cadet was commissioned from Harvard into the Navy — hardly the contribution we would need to create a more intelligent officer corps.

This need for critical thinkers was recognized well before the current wars. In the 1990s, Marine General Charles Krulak wrote of the “Three Block War.” In a single city, the military is conducting humanitarian relief on one block; peacekeeping operations are conducted on the next; and in the third, the troops are engaged in a full-out fight for their lives. Krulak’s prediction was eerily prescient; in Iraq and Afghanistan, we would hand out candy to children on one block, on the next we were trying to solve problems of local governance, and on the third we were walking through a minefield of IEDs.

The military needs intelligent, flexible leaders. We are lacking enough of them right now. As a first step, administer the existing enlisted intelligence test (ASVAB) to all potential officers’ intelligence. After a year of results, establish a minimum score as a short-term solution. In the long-term, we will need to critically evaluate what qualifications produce a successful officer and how we measure those qualifications. The long-term solution will be complicated, but it is vital. Not just for national security, but for the sake of the enlistees who entrust their lives to officers.

      

 

 

The question of “Who serves when not all serve?” has been a central issue in the all-volunteer United States military, even before the end of conscription in 1973.^[1]  Advocates for the end of the peace-time draft argued conscription was, in the words of Milton Friedman, “inequitable and arbitrary, seriously interfer[ing] with the freedom of young men to shape their lives.";^[2] Others, however, were concerned with the quality of an all-volunteer force.^[3] While the military services initially faced challenges in attracting high-quality enlisted personnel, the problems seemed to have been resolved by the late 1980s. Bernard Rostker, one of the foremost experts on military manpower analysis, declared in his 2006 RAND monograph I Want You that “the alternative to the draft, the all-volunteer force, has been a resounding success for the American military and the American people.”^[4] Even during the most trying years of conflicts in Iraq and Afghanistan, around 60 percent of new recruits were deemed “high-quality,” possessing a high school diploma and being above the average intelligence of the American population (compared to a low of 27.1 percent of new recruits deemed high-quality in 1977).

The success of the volunteer military in attracting high quality enlisted recruits, however, does not necessarily carry over with respect to its ability to attract high-quality officers.^[5] Commissioned officers comprise about 16 percent of the military, but they make up its leadership and exert a disproportionate impact on military effectiveness.

In this paper, we show that the quality of officers in the Marines, as measured by scores on the General Classification Test (GCT), a test that all officers take, has steadily and significantly declined since 1980.^[6] For example, the GCT score in 1980 that demarcated the lower one-third of new officers that year demarcated the lower two-thirds of the new officers in 2014. While 85 percent of those taking the test in 1980 exceeded 120, the cut-off score for Marine officers in World War 2,^[7] only 59 percent exceeded that score in 2014. At the upper end of the distribution, 4.9% of those taking the test scored above 150 in 1980 compared to 0.7% in 2014. This negative trend could contribute to adverse consequences for military effectiveness and national security.

We also examine the relationship between the annual averages of these test scores and the size and composition of the pool of potential officers (i.e., college graduates), labor market conditions, and the ethnic, racial and gender composition of incoming officers. We find that the dominant correlate to the declining GCT scores over time is the expansion of the pool of potential officers as the ranks of college graduates has risen over the past three decades.

There is no evidence that the increasing proportion of women or African Americans in the ranks of incoming officers are independent causes of the decrease in test scores, and while in some specifications there is a significant effect of the proportion of incoming Hispanic officers on these scores, the quantitative effect of this on the average GCT is very small, representing only about 5 percent of the decline; the other 95 percent is due to the expansion of the pool of non-Hispanic college students.

The next section of this paper traces the history of intelligence testing by the American military in the 20th century. This section also includes a brief discussion of America’s return to an All-Volunteer Force in 1973. Section III presents our analysis of the GCT individual-level data that shows a steady and significant decline in the mean scores across the period 1980 to 2014 as well as a significant shift in the distribution of the scores. Section IV presents a regression analysis of the partial correlates of annual mean test scores with the characteristics of the potential pool of officer recruits, the gender, racial, and ethnic characteristics of the recruits, and labor market and other factors that could potentially affect the quality of recruits and, therefore, the GCT scores. We offer some concluding comments in Section V.

*The GCT is a test of general intelligence and has been shown to have a strong link to military performance. 

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• Military officer quality in the all volunteer force
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Editor's note: This commentary originally appeared in the Dallas Morning News on May 24, 2015.

A hard-earned lesson is only worth the pain if it’s correct.

This month, David Cameron led his conservative party to a resounding victory, gaining a clear majority in the British Parliament. Cameron staked his campaign on his economic policies that, recently, have seen strong output growth in the U.K. Foremost among the Tory claims is the triumph of austerity.

Austerity is a hard-earned lesson. Shredding the social safety net during a recession causes widespread pain, especially among the poor and those who had reached the middle class. This tough medicine could be merited if it produced a quicker turnaround to economic health, but it doesn’t.

The experience of Britain shows this. In the wake of the 2008 crisis, Britain had an even sharper decline in output than the United States, or the eurozone as a whole. From its lowest point in early 2009, the British economy had grown by 2 percent by the time Cameron was elected prime minister in May 2010. Once in office, Cameron made good on his campaign promises.

Austerity did not deliver. Economic growth stalled in the summer of 2010 and stayed flat for the remainder of the year. Only when the austerity policies were reversed did the U.K. start to grow again. Even so, it took over five years for the economy to reach its pre-crisis level. By contrast, the U.S. returned to its pre-crisis level of national income in less than 3 years.

The British experience supports, by counterexample, the standard economic prescription — the government needs to step in when the private sector pulls back. Claims of the growth-enhancing effects of austerity through bolstering confidence were proved wrong in the U.K., just as they were elsewhere in in the wake of the crisis.

Incumbent politicians often count on voters’ short memories. Recent British growth does not support the claims of austerity’s advocates. The true effects of austerity in the United Kingdom were seen in 2010, not in 2015. But in 2015, Cameron’s campaign profited from his claims of economic stewardship (as well as from Scottish nationalism, which drew support from the Labor Party, and his opponent’s weak campaign; The Economist magazine writes that “the Conservative Party was lucky in its enemies”).

Our own, very protracted 2016 presidential campaign has already begun in the U.S. As always, economic issues are sure to be high on the agenda. The financial and economic crisis of the past eight years will continue to cast a shadow over the discussion. The lesson to politicians from the British results might be that claims about economic policies need not be strongly supported by the facts.

This lesson can be proved wrong if American voters remember the events of the past eight years.

Voters should question claims about the growth-enhancing benefits of austerity. They should remember the disruptive effects of the sequestration that shut down the government and contributed to the duration of the weakness of the economy. They should realize that financial sector reform is important to avoid another boom-bust cycle like the one we have just lived through. And they should also consider how austerity directly hurts friends and neighbors, and perhaps themselves, by removing the safety net just when it is most needed.

If they forget these things, there will not be any hard-earned lessons, just hard times.

      

 

 

Some policymakers and pundits have argued that currency manipulation–the effort to keep exports cheap by intervening in the foreign exchange market–is the most important issue international economic policy could address. Friday evening, the Senate rejected an amendment by Sens. Rob Portman (R., Ohio) and Debbie Stabenow (D., Mich.) that would have punished currency manipulators. The White House has responded to pressure from Congress, signaling a willingness to bring exchange-rate provisions into trade negotiations, but does not want binding sanctions against currency manipulators to be part of the Pacific trade agreement under consideration.

Currency manipulation is not like pornography–you don’t know it when you think you see it. It’s hard to define and even harder to prove. At one level, any country that has a fixed exchange rate–such as France, Germany, Greece, and China–is, by definition, a currency manipulator. The question is whether a country has kept its currency artificially cheap to boost exports.

The elephant–and tiger–in the room is China, even though China is not one of the countries in the proposed Trans-Pacific Partnership. Advocates of a currency manipulation mechanism call the yuan as Exhibit A. Examining this evidence is instructive, but perhaps not in the way expected by those pushing for a currency manipulation clause in TPP.

The solid line in the chart above shows that the yuan has strengthened 35% against the U.S. dollar over the past decade. All else equal, this represents an effective rise in the price of Chinese exports to the United States by more than one-third, which is certainly not consistent with the charge of continued intentional underpricing.

The case against China’s currency manipulation is even weaker if we consider a more relevant indicator of the overall cost of Chinese exports: China pegs its currency to the U.S. dollar, but it exports to many countries beyond the United States. The world price of Chinese exports must reflect prices among the full range of its trading partners.

Also, the price of Chinese exports depends on the yuan price of what it costs to manufacture in China, not just the yuan price of foreign currencies, and inflation in China has been higher than that of its trading partners. The multilateral, inflation-adjusted price of Chinese exports (represented by the dashed line in the chart) accounts for both of these factors. The chart shows that the overall real relative price of worldwide Chinese exports has risen more than 50% in the past decade, with almost 40% of this increase in the past two years. This has occurred because of the yuan’s appreciation against the dollar, the yuan’s appreciation against the currencies of its other trading partners (as the dollar has appreciated), and the higher rate of inflation in China than among its trading partners.

The phrase “currency manipulator” is loaded, and not just because the evidence for the most celebrated example does not stand up. Not so long ago, governments in emerging markets decried U.S. policies that contributed to a weakening of the dollar, leading to “currency wars,” as the finance minister of Brazil put it, and “irresponsible monetary policy” according to the Indian finance minister. One could argue that U.S. monetary policy correctly focused on the domestic economy’s weakness, but that’s not necessarily how it has been seen in Sao Paolo or Delhi.

Exchange rates swing around for a range of reasons related to relative economic performance, anticipation of future events, and, yes, even the whims of markets. These fluctuations are part of the international spillover effects of economic policy in our interconnected world, regardless of trade agreements. Spillovers create challenges as well as opportunities, as when recovering foreign markets draw in imports from the rest of the world.

A narrow focus on a single bilateral exchange rate may serve some political interests, but economic analysis demands a more nuanced view.

      

 

 

FRED data on real gross domestic products in the United States, United Kingdom and the eurozone.

We learned this week that, for the first time since 2010, the economies of Germany, France, Italy, and Spain all had a quarter of economic growth. Long-beleaguered Spain led this foursome, growing at a 0.9% rate in the first three months of 2015.

Some will attribute this performance to the success of austerity programs that began five years ago. Outside the eurozone, the conservative victory in Britain’s elections last week was treated by Prime Minister David Cameron as vindication of his austerity program. But the facts cast doubt on these claims.

Austerity is a hard-earned lesson–one worth the pain only if its correct. Shredding the social safety net during a recession causes widespread pain, especially among the poor and those who had reached the middle class. This tough medicine could be merited if it produced a quicker turnaround to economic health. But after a prolonged period of economic weakness, the eurozone as a whole has not yet attained its pre-crisis level of gross domestic product. Austerity did not deliver the promised turnaround in Spain and Italy, and it continues to hamstring growth elsewhere in the eurozone.

Austerity did not deliver in Britain, which experienced an even sharper decline in output than the United States, or the eurozone as a whole, in the wake of the 2008 crisis. From its lowest point in early 2009, the British economy grew 2% by the time Mr. Cameron became prime minister in May 2010. But after that election, growth stalled for the remainder of the year. Only when its austerity policies were reversed did the UK economy start to grow again. And it took more than five years for the economy to reach its pre-crisis level.

By contrast, even though U.S. economic performance since the crisis has been weak, the United States outperformed Britain and the eurozone. National income in the U.S. returned to its pre-crisis level in less than three years, thanks to aggressive monetary policy and a fiscal stimulus that, while limited, did not impose the same austerity as that implemented across the Atlantic.

Experiences with austerity policies support, by counterexample, the standard economic prescription: The government needs to step in when the private sector pulls back. Claims of the growth-enhancing effects of austerity through bolstering confidence have been proven wrong.

Incumbent politicians often count on voters’ short memories. The effects of austerity in the United Kingdom were seen in 2010, not in 2015. But in 2015, Mr. Cameron’s campaign profited from his statements of economic stewardship, as well as from Scottish nationalism, which drew support from the Labor party, and his opponents’ weak campaigns. (As the Economist put it, “the Conservative Party was lucky in its enemies.”)

In the United States, the 2016 presidential campaign has already begun, and economic issues are sure to be high on the agenda. The financial and economic crisis of the past eight years will continue to cast shadows over the discussion. The lesson to politicians from the British results may be that claims about economic policies need not be strongly supported by the facts.

      

 

 

In the Handbook of Safeguarding Global Financial Stability, the chapter “Capital Mobility and Exchange Rate Regimes” begins “Forced to state all the insights of international macroeconomics while standing on one leg, one could do worse than raise a foot off the ground and say something like:

• ‘Governments face the policy trilemma – the rest is commentary.’”

Admittedly, that entry was written by one of us.

The conclusion that countries with open capital markets must choose between monetary autonomy and exchange-rate management is a centrepiece of international macroeconomics. Its real-world relevance has been confirmed by a number of empirical studies over the past decade – for example, Aizenmann et al. (2010) provides recent evidence regarding the tradeoffs suggested by the trilemma.¹

The trilemma challenged

Despite this evidence, the trilemma has come in for some tough times lately in policy debates.

• Some argue that the policy trilemma depicts too restrictive a view of the world.

Governments can 'round the corners' of the triangle representing the policy trilemma (see Figure 1) with intermediate policies such as softly pegged exchange rates or temporary, narrowly targeted capital controls.

Figure 1. The open economy policy trilemma

Others attack the policy trilemma from the opposite direction, arguing that it paints too rosy a picture of the ability of monetary authorities to manage an economy.

While there is some truth in both of these positions, our recent research suggests that the policy trilemma is still a very relevant way to organise one’s thinking about the determinants of a country’s monetary-policy autonomy as it operates in the world economy.

New evidence

The simplest view of the policy trilemma is that countries with fully open capital markets and tightly pegged exchange rates forego all monetary autonomy (side B in Figure 1). A more nuanced view is that the trilemma represents trade-offs, with a country having greater monetary autonomy as it either allows more exchange-rate flexibility or as it prohibits some types of international capital flows.

But do these partial policies afford a full measure of monetary-policy autonomy? The answer from our research is a qualified “no” (Klein and Shambaugh 2013). We find evidence that:

• More exchange-rate flexibility is associated with greater monetary-policy autonomy, so there is some rounding of that corner of the policy trilemma; but
• Temporary, narrowly targeted capital controls do not enable a country with a fixed exchange rate to have greater monetary-policy autonomy than it has under full capital mobility.
• Widely applied, longstanding capital controls break the link between domestic and foreign interest rates under a fixed exchange-rate system.
  That latter finding, of course, is precisely the point of the policy trilemma (both figuratively and, in terms of Figure 1, literally).²

The Rey argument

The argument that the policy trilemma overstates the efficacy of monetary policy has recently been made by Professor Hélène Rey (2013a, 2013b). Her argument is that widespread co-movement in capital flows, asset prices, and credit growth across countries – a global financial cycle – makes the trilemma moot. She declares the death of the trilemma, writing that this financial cycle, “transforms the trilemma into a ‘dilemma,’ or ‘irreconcilable duo’: independent monetary policies are possible if and only if the capital account is managed.”

Rey finds that an important determinant of this cycle is monetary policy in the US, and also that the global financial cycle is correlated with the implied volatility of US S&P 500 index options (i.e. the VIX). This is an issue of interdependence or, perhaps – more darkly – contagion. But this is distinct from whether monetary policy autonomy depends upon the exchange-rate regime.

Credit conditions are important for macroeconomic performance, as has been dramatically demonstrated over the past five years. This period has also surely shown, however, that monetary policy importantly affects interest rates and exchange rates and – through these channels – macroeconomic outcomes.

• It is incorrect to say that monetary policy has no effect because there is also a credit channel, just as it would be incorrect to say that monetary policy has no effect because there is also fiscal policy.

The trilemma does not rule out common shocks that affect all economies, and monetary autonomy does not guarantee insulation from the world economy. Rather, an implication of the trilemma is that there is more scope for addressing shocks with monetary policy in a country with floating exchange rates – or with strong controls on international capital flows – than for a country with a pegged currency and open capital markets.

Events that illustrate the point

Events over the past decades illustrate the real-world relevance of the policy trilemma. For example:

• The Fed raised interest rates by about 180 basis points from 2004 to 2005.
• Countries with pegged exchange rates and open capital markets (represented by side B in Figure 1) followed the Fed’s lead, raising interest rates by an average of 90 basis points.
• Countries with other exchange-rate/capital-account openness configurations did not respond in a similar fashion (see Figure 2).

Figure 2. Change in interest rate from 2004 to 2005

Note: Change in US short term rate from 2004 to 2005 was roughly 1.8 percentage points. The figure shows that on average, only countries pegged to the dollar with open financial markets followed the move.

This single example is representative of a broader tendency.

Figure 3 shows overall averages since 1973, where open pegs move interest rates with the country they peg to more than other countries. Our research demonstrates that soft pegs occupy a middle ground, with more autonomy than pegs, but less than floats (the coefficient on the change in the base interest rate is lower for soft pegs than it is for tighter pegs, but higher than it is for floats – see Table 3 in Klein and Shambaugh 2013).³

Figure 3. Response to base country interest rate change

Note: figure shows the coefficient from a regression of the change in the local country interest rate on the change in the base interest rate. Based on table 2 in Klein and Shambaugh (2013).

In contrast, there is little difference between the coefficients presented in the top two rows, reflecting the result that monetary autonomy in countries with open capital accounts and limited capital controls are quite similar. By comparison, closed capital accounts do provide scope for monetary autonomy.⁴ In addition, our paper shows that countries that follow the base rate more closely react less to local conditions, suggesting these measures are a good proxy for true monetary policy autonomy.

More recent events

The trilemma also speaks to events during the past few years. In the midst of the Global Crisis:

• Countries with open capital markets and floating exchange rates (represented by side A in Figure 1) – such as Australia, Sweden, Poland, and Israel – focused monetary policy on conditions in their domestic economies while allowing their exchange rates to be determined by the market.
• The capital controls in China (a country that would be placed at side C in Figure 1) enabled it to maintain the peg of the renminbi to the dollar even as its policies towards its banks (the form that monetary policy takes in China) helped insulate its economy from some of the initial shocks of the Great Recession. (Although diminished trade in goods, as opposed to trade in assets, has recently proved a drag on China’s economy.)
• Countries in the Eurozone or pegged to it that may have wanted more monetary stimulus than the overall Eurozone could not shift policy on their own because they occupied side B – open pegs.

Concluding remarks

These experiences, along with our research findings, suggest that the trilemma is alive and well. This is important for the current policy debate.

There is a widespread debate over when the Fed will move towards ‘tapering’ its current stimulative monetary policy. Many emerging-market countries are feeling the effects of this. Countries with floating exchange rates have a choice – either to allow their currencies to depreciate, or to raise their own interest rates, or some combination of the two.

Financial cycles and large country interest rates certainly have important impacts around the globe, but our evidence suggests that countries that float or close capital markets maintain some freedom over how they approach these shocks.

References

Aizenmann, Joshua, Menzie D Chinn, and Hiro Ito (2010), “The Emerging Global Financial Architecture: Tracing and Evaluating the New Patterns of the Trilemma’s Configurations”, Journal of International Money and Finance 29(4): 615–641.

Bluedorn, John C and Christopher Bowdler (2010), “The Empirics of International Monetary Transmission: Identification and the Impossible Trinity”, Journal of Money, Credit and Banking 42(4): 679–713.

Chinn, Menzie D and Hiro Ito (2006), “What Matters for Financial Development? Capital Controls, Institutions, and Interactions,” Journal of Development Economics 81(1): 163–192.

Klein, Michael (2013), “Capital controls: Gates versus walls”, VoxEU.org, 17 January.

Klein, Michael and Jay Shambaugh (2013), “Rounding the Corners of the Policy Trilemma: Sources of Monetary Policy Autonomy”, NBER Working Paper No. 19461, September.

Obstfeld, Maurice, Jay Shambaugh, and Alan Taylor (2005), “The Trilemma in History: Tradeoffs among Exchange Rates, Monetary Policies, and Capital Mobility”, Review of Economics and Statistics87: 423–438.

Rey, Hélène (2013a), “Dilemma not Trilemma: The global financial cycle and monetary policy independence”, paper presented at the Jackson Hole Symposium, August.

Rey, Hélène (2013b), “Dilemma not Trilemma: The global financial cycle and monetary policy independence”, VoxEU.org, 31 August.

Shambaugh, Jay (2004), “The Effect of Fixed Exchange Rates on Monetary Policy”, Quarterly Journal of Economics 119(1): 300–351.

1 See Shambaugh (2004), Obstfeld et al. (2005), and Bluedorn and Bowdler (2010) for earlier confirmations of the basic framework of the trilemma.

2 Klein (2013) suggests a framework that focuses on longstanding capital controls (walls) as opposed to open countries or temporary controls (gates) and documents that there are differences between them in terms of their efficacy.

3 These differences are statistically significantly different from zero.

4 This table uses a capital control classification based on Chinn and Ito (2006). Using a classification that focuses on the temporary or permanent nature of the policies, we find that targeted temporary controls provide no more autonomy than open financial accounts. Only comprehensive gates that cover a wide range of asset classes appear to provide any more policy autonomy.

      

 

 

Editor's Note: In an interview with the GlobalPost, Michael Klein explains what made the terms of Cyprus's rejected bailout controversial and this situation might mean for the rest of the eurozone.

Why did the Cyprus bailout package cause such uproar?

[The Cyprus bailout] is a little bit of crossing the Rubicon to start charging depositors a tax on what they perceived to be insured deposits.

The real concern is not so much what’s going on in Cyprus, but if this becomes a method by which bailouts are funded. Then, there is concern that this could lead to bank runs all over Europe, as other countries’ banks are imperiled.

If the same kind of thing happens there, it could be really problematic.

What are the potential risks of a bailout that includes taxes on depositors’ accounts? Is it a bad precedent to set?

I think it is a bad precedent. It doesn’t distinguish between bad banks and good banks. And it means that deposit insurance might not mean what they say it means.

The bank run is an infrastructure thing because then banks start to shut down and it starves the economy of credit. Historically, we've seen that in situations where banks fail, the depressions that ensued were deeper, more severe and more protracted than recessions that arose for other reasons.

Even though concessions were made to let small depositors off the hook for the tax, the bailout was vetoed by the Cyprus government. What does this mean for Cyprus and for the rest of the Eurozone?

There’s a problem with letting small depositors off the hook logistically, because what could happen is people could split up their deposits and all of a sudden big depositors could look like small depositors. Presumably they have information beforehand, so people couldn’t do that. If you had a deposit in excess of a 100,000 euros before, you can’t hide it.

For Cyprus [a veto] means they have to go back to the negotiating table. Either they get cut off from the bailout funds or there’s a realization on all parts that this was a problematic solution and they go back to the table.

The problem is though – people have been talking about this for a while now – if one country exits the Euro area, it could cause a cascade. People have not been focusing on Cyprus so far. People have been focusing on Greece, of course. If Greece were to exit, the concern is, ‘who’s next?’

If Cyprus exits… if they don’t get the bailout and they drop out of the euro, then the question arises again of who’s next. That question has always been one of the big issues in Europe. As market psychology moves against countries, the most immediate problem is that sovereigns have to pay, and everybody else has to pay, much higher interest costs.

These interest costs had been coming down and it seemed like things were settling down as compared to a year or two ago, but now the question arises about whether this will cause interest rates to spike up again.

The Dutch finance minister and Deutsche Bank’s Chief executive have said this is unlikely to be a model for other countries. Why was Cyprus a special case? How would this affect other vulnerable countries like Spain and Italy?

Cyprus is seen as a financial center where the banks are outsized given the size of the economy. There’s also an issue with a lot of foreigners parking their money in Cyprus. But, nonetheless, people might not necessarily perceive it as a special case.

On Monday morning when banks opened in Spain and Italy, there were no bank runs. Some people cite that as evidence that Cyprus is a special case. On the other hand, it could be the case that the tinder has gotten a lot drier and a spark can do a lot more damage.

The fact that it hasn’t happened yet doesn’t mean it’s not going to happen.

Greece is still a real problem. Greece doesn’t show signs of recovery. There has been some shift in other countries, but they’re operating in an environment of very weak growth for Europe as a whole. In the last week or so, Germany has talked about not providing for the stimulus to its economy, which means that Germany’s not going to be an instrument of growth for Europe.

The three problems in Europe are the sovereign debt crisis, the banking crisis and slow growth. They’re all interconnected with each other. You can’t solve one without solving another.

The banking crisis, part of it has to do with non-performing loans, so slow growth affects the banking crisis. The banking crisis means that credit is less available, and that contributes to slow growth. Slow growth makes tax receipts lower for the sovereigns, so their debt crisis is worse because the cyclical part of their deficit is large. And then banks hold sovereign debt, and when that looks more imperiled, the banks are more imperiled. All these three things are very interconnected. You can’t really solve one without solving the other two.

So far they seem to have pushed austerity measures as a way of dealing with the Eurozone crisis. Do you think that’s the wrong approach?

In a lot of countries, ultimately there has to be a scaling back of government spending and a way to raise taxes. However, in the midst of a deep, deep downturn, austerity just makes the situation worse.

It’s sort of an extreme example of what’s happening in the United States. In the United States, we seem to be coming out of a recession, and the government’s deficit has been bigger because of the recession. If we started cutting the deficit right now, we would provide very strong headwinds to the recovery.

In Europe, it’s like that but much more severe. They’re in a much worse situation. These countries are just stuck in a deep cycle of austerity and slow growth, which means further deficit problems, which raises more demands for austerity, and so on.

It seemed like things were getting a bit better but this is raising concerns so the Eurozone crisis may be back in the headlines. There may be second round effects around what’s going on in Cyprus, especially that they’re willing to cross the Rubicon now.

Once you start not distinguishing between banks that are better off and banks that are worse off, once you say insured deposits are not really insured and are open for taxation, that leads to a lot of concern about the banking system. It might start to show up in other countries as well.

      

 

 

Yes, the yen has weakened and the pound has gotten pounded, but worries about an all-out currency war may be overblown.

There's a perception that some countries' economies are being harmed by currency movements that have been undertaken to gain an unfair advantage.

That may be a bit misguided.

In the United States, the threat of a fiscal contraction due to sequestration has prompted the Federal Reserve to take actions that could weaken the dollar.

Signals suggest that the new head of the central bank in Japan will pursue a more expansionary policy in an effort to stimulate that country's long-moribund economy.

These actions are taken for purely domestic reasons, but they could have consequences for currencies.

In anticipation of frictions that could arise, there was an agreement by the G-20 nations at the recent Moscow summit to refrain from so-called competitive devaluations.

But, since then, governments such as South Korea and New Zealand have signaled a desire to pursue explicit policies to weaken currencies, or even to impose capital controls.

Read the rest of the opinion at cnn.com »

      

 

 

The economy has recovered substantially from the situation the president faced at his first inaugural. But challenges remain. The recovery from the Great Recession that began in 2008 has been slower than the recovery from the other recessions over the past three decades, largely because the source of this recession, a major financial upheaval, differs from the sources of recessions of the past.

The first and primary economic goal is to keep the recovery on track. This is important so unemployment will continue to decline. It will also bring down the government budget deficit by raising tax revenues and decreasing social safety net expenditures. The president is typically blamed (or credited) too much for the macroeconomic performance of the country, however. Many important factors are outside the president’s control. For instance, one of the biggest threats to the U.S. recovery now is events in the Euro-area, something over which the president has very limited influence. The recovery could be derailed by ongoing uncertainty due to political fights over tax-and-spending policy. Congress needs to work with the president on this, putting the needs of the nation ahead of narrow partisan goals.

The political fights about the fiscal cliff have raised the issue of tax and entitlement reform. These are difficult political issues. Everyone is for reforming the tax system and reforming entitlements, except for those parts that are essential to the American way of life—that is, those features that they benefit from, such as mortgage interest deductions, farm subsidies, low rates for carried interest, etc. A major reformation of taxes and entitlements would be difficult to obtain; then again, health-care reform eluded past presidents as well.

     

 

 

In these final days of the presidential campaign, both President Obama and Governor Romney are becoming more vocal about their support for immigration reform. While there is still distance between their stances, both agree that it is important to encourage foreign entrepreneurs to come to America and launch their dreams here.

This is smart and sound. By providing a fair and unencumbered immigration path for entrepreneurs and emerging foreign businesses, we lay a foundation both for stimulation of the local economy and for U.S. job growth.

But the best policy intentions are thwarted when the immigration bureaucracy slams the door in the faces of foreign business talent.

Here's an example. A foreign technology company with a very exciting proprietary software product received three rounds of venture capital funding and was ready to launch a major presence in the U.S.  They planned to transfer the two founders and several of their technology experts to New York for a few years to solidify the new U.S. operation, gain U.S. customers, and hire and train new U.S. employees. The rest of the company's staff would remain abroad. They wanted to spend their new infusion of several million dollars in venture capital in the U.S. market. But they wouldn't just spend the company's money to buy office equipment and furniture and hire U.S. workers, lawyers and accountants. They were prepared to lease apartments, buy cars, buy furniture for their apartments, eat at New York restaurants, and take vacations in the U.S.

But before any of this could play out, a U.S. immigration officer denied the visa applications of these talented and eager entrepreneurs.  The official rejected the applications because he did not believe that the applicants' technical knowledge was specialized enough to qualify for a visa, even though they invented and created the technology from scratch.

Visa scenarios like this one are disturbingly common and out of step with encouraging investment in the U.S. The Department of Homeland Security recently published statistics on the approval rates for visa applications for companies seeking to transfer expert personnel to the U.S.  Over the last four years the approval rate for these applications has dropped more than 20 percent!

The cumulative effect of this increasingly hostile attitude towards foreign entrepreneurs and businesses is significant. According to a recent study published by The Kauffman Foundation, immigrant-led businesses have generated $63 billion in sales and have generated a whopping 560,000 jobs since 2006.  But the study goes on to say that immigrant-run high tech companies are no longer growing. Since 2006, the proportion of new companies founded by foreign-born entrepreneurs has begun to decline, after two decades of consistent growth. Silicon Valley experienced an especially steep decrease.  Some of the most exciting new high tech companies are now launching their operations abroad. We are missing out on all of the economic gains that we would have enjoyed had we opened our doors to these companies.

Our immigration bureaucracy is not in step with the administration’s approach of encouraging investment and opportunity in the U.S. Until this is remedied, it's not just foreign entrepreneurs who lose out when their visa applications are denied; our U.S. economy loses as well.

     

 

 

Following the New Democracy party's victory in the Greek elections on June 17, Donald Kohn, Douglas Elliott and Michael Klein discussed the vote's implications for Greece and the euro, the situation in Spain and the G20 summit.

“My point of view: we dodged a bullet, but the gun is still loaded. And even outside of Greece, maybe particularly outside of Greece, there are many other areas where things could go wrong.” - Doug Elliott

“The election is good news for the global financial system because if nothing else it’s going to buy some time and give these guys a chance to adjust to potential downside risk.” - Donald Kohn

Topics covered by Elliott, Klein and Kohn include:

• The worst case scenario that was avoided with the New Democracy party's victory.

• The short- and long-term problems facing Greece, including its unsustainable debt level in the government and the country's lack of competitiveness in private sector business.

• Whether the election's results will effect other European leaders' willingness to help by moving Greece's deficit targets.

• What this result may mean for Spain, Portugal and other countries facing similar situations.

• Europe's negative effect on financial markets and the global economy, including the United States.

Audio

• Conference Call on the Election in Greece

     

 

 

Switzerland is a country with a long and proud tradition of neutrality, but given the perilous state of the surrounding eurozone, it may be find itself in a "currency war" as the Swiss franc strengthens in response to capital inflows.

An appreciation has adverse consequences for Swiss exports, and overall national income. The Swiss central bank combated appreciation with intervention in the foreign exchange market in September, and promises to intervene again if the franc appreciates past Sfr1.20. But Swiss authorities are considering deploying a new weapon as well. Last month, Thomas Jordan, the head of the Swiss National Bank, indicated that he was prepared to use capital controls.

The currency war facing Switzerland is reminiscent of the appreciation of the Brazilian real in 2009 and 2010. Mr. Jordan's proposed use of capital controls echoes the Brazilian response. He would be wise to consider that experience, and its lessons about the efficacy of capital controls. Capital controls offer a limited capacity to prevent appreciations in emerging market countries. They are likely to be even less effective for Switzerland.

In 2009, strong Brazilian growth and low interest rates in advanced countries drove international capital to Brazil, causing a 35 percent appreciation of the real that threatened the country's export sector. Brazilian authorities responded by introducing a 2 percent tax on foreigners investing in Brazilian equities, the IOF (Imposto sobre Operações Financeiras). Brazil's real's appreciation halted after this - but, as in so many cases, correlation does not imply causation, since other emerging market currencies also depreciated after October 2009, notably the Korean won and the Indonesian rupiah. The real began to strengthen again after June 2010. This prompted a tripling of the IOF rate in October 2010 and an effort to tighten its bite by closing loopholes. This policy, too, saw only a temporary slowing in the appreciation of the real.

Capital controls fail to stem appreciations because they are leaky. Investors find ways around regulations intended to limit inflows, often by using different financial instruments than those on which controls are directly imposed. This work-around suggests that capital controls are least effective for countries with the most sophisticated financial markets, that is, for countries like Switzerland. Experience also shows that controls are less effective when they are imposed episodically, in response to current conditions, rather than when they are long-standing.

The first round of capital controls are typically followed by subsequent rounds that ratchet up tax rates and widen coverage. This was the experience of Brazil, with the IOF rate tripling in 2010 and the regulations being expanded to new instruments. It also characterizes recent experiences of other countries, such as Colombia, Peru, and Taiwan.

China provides an example of the exception that proves the rule. The government maintains control over capital inflows which allows it to manage the value of the renminbi. It can do this because it has relatively rudimentary capital markets and, more importantly, a long history of unwavering capital controls. In contrast, Brazil has increasingly sophisticated capital markets. Some of the increasing sophistication is precisely because of incentives arising from capital controls -- just as in other countries, financial markets respond to regulation with innovation. The episodic nature of Brazilian capital controls, as well as those of other countries, also makes circumventing them easier.

There may be a role for capital controls, however, for some countries and in some instances. The financial crisis has prompted a re-examination of the range of policies that may be useful for strengthening financial systems. Notably, the IMF recently has shifted its views towards a greater acceptance of capital controls that aim to reduce financial vulnerability. But the efficacy of these policies remains an open question. Most likely, there is not a single answer to the question of the efficacy of capital controls; rather the answer differs across countries and even across time for a particular country. Nevertheless, experience suggests that efficacy of capital controls is especially questionable for advanced economies like Switzerland.

Battling inflows is a difficult challenge. The battle is not helped, however, by the use of ineffective weapons.

     

 

 

This weekend's meetings of the International Monetary Fund and the World Bank are overshadowed by "dark clouds on the horizon" that threaten the "light recovery blowing in a spring wind," according to Christine Lagarde, the managing director of the IMF.

The main source of the dark clouds is Europe, where recovery remains weak.

More than three years into the crisis, policy options in Europe are limited; fiscal stimulus is out of reach for many countries, and recent efforts by the European Central Bank provided only a temporary respite. In this environment, strong and sustained recovery depends upon rebalancing within Europe, whereby countries' trade imbalances are reduced.

But rebalancing is a two-sided affair. We have all heard the ongoing calls for some European countries to rebalance deficits through painful austerity measures.

These calls need to be balanced with demands that countries with surpluses also move to rebalance.

In particular, Germany must take advantage of its scope for fiscal expansion to bolster European recovery and to forestall its own slippage towards an economic slowdown.

There are those who argue that the German surplus reflects its productivity growth and labor market reform. These people argue that Germany could only rebalance by stifling its own economic dynamism.

There are three responses to this argument:

Shared rewards: Reforms have made labor markets more flexible in Germany. Innovative policies, such as the Kurzbeit, the short-time working policy, limited the unemployment effects of the crisis.

German unemployment briefly peaked at 8% in July 2009 while the U.S. unempoloyment rate spiked to 10% in October of that year. Despite the soft landing, workers have not fully shared in the benefits of the recovery, and trade unions have been demanding higher wages.

Higher wages for workers would raise their demand for consumer goods, including the products from other euro-area nations.

Shared consequences: German exporters, and German producers of import-competing goods, have benefited from the weak euro.

Since 2008, the German real exchange rate has depreciated by almost 9%, even while its economy recovered relatively strongly from the crisis and its economy was strongly in surplus.

In contrast, over this same period the Swiss franc appreciated 16% -- estimates suggest that had the German real exchange rate tracked the Swiss real exchange rates, German export growth would have been cut in half.

Another major surplus country, China, saw an appreciation of its real exchange rate by more than 10% over this period.

If Germany had a free-floating currency of its own, rather than one whose value is determined by the fate of the full set of euro members, it would have seen an appreciation that would have brought down its current surplus.

Shared experiences: Another surplus country offers a striking recent example of rebalancing: China. In 2007, China's surplus exceeded 10% of its GDP.

The IMF projects that the debt to GDP ratio will fall to 2.3% in 2012, well below the 6.3% forecast published in its World Economic Outlook last year. In contrast, the most recent IMF forecast of the 2012 German debt to GDP ratio, of 5.2%, exceeds last year's forecast of 4.6%.

As a member of the euro area, Germany will not see the natural forces of a currency revaluation bring about a reduction in its current surplus.

But the government has the tools available to rebalance, and foster growth both domestically and more widely in Europe, through a stimulative fiscal expansion.

There are other tools available as well, such as policies to promote female labor force participation (which is low relative to other industrial countries) and liberalizing retailing (which could help promote domestic demand), to raise growth and to widen its benefits among its citizens.

Rebalancing needs to occur for both deficit and surplus countries to support and sustain growth during these challenging times.

     

 

 

In 1983, in the midst of a deep recession, Bruce Springsteen recorded the song "My Hometown" that reportedly was based on the closing of the Karagheusian Rug Mill in Springsteen's own home town of Freehold, N.J.

The song's theme of economic hardship from the displacement of manufacturing jobs resonated, propelling it to 6th place on the Billboard charts.

Today, in the midst of an even deeper and more prolonged recession, the 1980s debate about whether manufacturing matters is front and center.

In his State of the Union speech, President Obama said that the blueprint for economic recovery "begins with American manufacturing."

There are, of course, welcome developments. But anecdotes about some firms' successes are not representative of the performance of an entire industry. It is magical thinking to believe that manufacturing can reclaim the role it had in the mid-20th century, and be the main driver behind the resurgence of today's economy.

Let's start with some perspective: the 300,000 new manufacturing jobs created since the depths of the Great Recession represent only 8% of total job growth.

This is less than proportionate to the relative size of manufacturing. Its current share of employment is only about 9% of the nation's overall total.

In the 1980s, manufacturing employment commanded a 21% share of the overall total. Over the past three decades, employment in manufacturing has decreased about 40%.

So while manufacturing has been a bright spot lately, this is a story of productivity gains, not of employment growth.

Thanks to productivity gains, the employment drop occurred while the value added by manufacturing increased by 40%. Hourly compensation to workers has remained stagnant. So the question arises: who benefits from policies to support manufacturing, workers or owners?

It is easy for a casual observer and politician to attribute an outsized role to manufacturing in employment terms, given the attention afforded factory closings or hiring surges by a particular firm.

Manufacturing is characterized by "churning" -- simultaneous job creation and destruction. On average, about one in five manufacturing jobs are either destroyed or created each year, and that churn is not especially concentrated within some narrowly defined manufacturing sector.

And job destruction occurs in good times as well as bad; the Karagheusian Rug Mill closed in 1964 in the middle of a decade-long national economic expansion.

The U.S. experience is shared by other countries, formerly known as "Industrial Nations." Over the past three decades (up to just before the most recent recession), the share of manufacturing employment in the United Kingdom fell from 25 % to 9%.

Even Germany and Japan -- two countries seen as manufacturing powerhouses -- have had substantial declines in the share of employment in manufacturing, declining from 27% in Germany in 1991 to 19% in 2007, and in Japan from 32% to 20% over the same period.

The case has also been made that manufacturing matters because of exporting.

A bit more than half of all U.S. exports are manufactured goods, and two-thirds of these manufacturing exports come from four sectors: chemicals, transportation equipment, computers and electronic products, and machinery.

Policies to promote exporting would, therefore, disproportionately favor a relatively small set of firms in these sectors.

How small a set? Only about 4% of manufacturing firms in the U.S. exported in 2000 and 96% of all U.S. exports are sold by just 10% of this already small set of firms.

It may be possible to expand the set of firms that export, rather than just the export activity of those that already sell abroad, but the extreme concentration of exporting gives one some pause about export-promoting policies.

And exporting is not an end in itself. Is there some special feature of exporting that benefits workers as well as owners?

There is evidence of a wage premium paid to workers in exporting firms, but those workers also tend to have more education and skills than those in non-exporting firms. Part of the premium is due to this.

Since higher education and skills result in higher wages, it would be well worth considering policies promoting the skills and education of workers, regardless of the industry in which they are employed.

Safety nets for those suffering from economic dislocation, regardless of the industry in which they had worked, are also important policies in a modern, dynamic economy on both equity and efficiency grounds.

It is much less apparent that the same can be said of policies targeted to manufacturing industries.

     

 

 

Distinction between episodic and long-standing restrictions is important; recession caused shift in exchange rate policies

SEPTEMBER 13, 2012 -
The recent use of short-term capital controls has not helped governments stop exchange rate appreciations, prevent asset price booms and busts, nor avoid general economic volatility post-Great Recession, according to a new paper presented today at the Fall 2012 Conference on the Brookings Papers on Economic Activity (BPEA). 

In “Capital Controls: Gates and Walls”(pdf), author Michael Klein of the Fletcher School of Tufts University, and former Chief Economist for the Department of the Treasury’s Office of International Affairs, performs an analysis of the use of capitol controls in 44 countries over a 15-year period, looking at the pattern of capital inflows and their effects on financial variables, GDP, and exchange rates.  Given that controls on capital inflows have been receiving increasing support in policy circles, among researchers, and in the general economic debate, especially since the onset of the Great Recession, he looks specifically at the differences between long-standing controls on a broad range of assets (walls) and episodic controls that are imposed and removed, and tend to be on a narrower set of assets (gates).  Klein finds that longstanding controls help reduce both financial vulnerability and increase GDP growth while episodic controls are far less effective, but that in fact neither long-standing nor episodic controls significantly affect exchange rates, which may be one of the central banks’ key goals in pursuing these policies.

Klein writes that  some theories support the use of episodic controls against surging capital inflows, or to guard against a boom/bust cycle, but there is little or no theoretical support for long-standing capital controls.  “Long-standing capital controls are like walls that protect against the vicissitudes of international capital markets… [they] tend to be wide as well as high, limiting all manner of capital flows, including those that could provide cheap capital, financial development, and opportunities to diversify risk. An alternative, episodic capital controls could open like gates during tranquil times to enable an economy to benefit from international capital, but swing shut in the face of capital inflows that threaten to cause an unwanted appreciation or a destabilizing asset market boom. The transitory nature of these controls, as well as having them targeted towards particular categories of assets, would make them less distortionary and inefficient than broad, long-standing controls.”  But he notes that there are problems with the gates: they might not latch shut tightly, they may shut too late or there may be impediments to their closing.

Klein points out that the differences in the effects between long-standing and episodic controls may have been less apparent 15 years ago than today because there was a trend towards the liberalization of long-standing controls up through the mid-1990s. He finds that China’s long-standing controls are important for the government’s ability to manage the value of the Renminbi whereas Brazils’ recent attempts to use episodic controls were ineffective.  

Download the paper (PDF) »

Video

• Central Banks’ Recent Experiments with Capital Controls Haven’t Delivered Results