Research

Unconventional Fiscal Policy in Times of High Inflation, July 2023 Sintra ECB Forum on Central Banking

Copyright © 2023, European Central Bank

with Mai Chi Dao, Allan Dizioli, Chris Jackson and Daniel Leigh. The surge in energy prices in 2022 has been a defining factor behind the increase in euro area inflation. We assess the impact of “unconventional fiscal policy,” defined as the set of fiscal measures, possibly expansionary, motivated by a desire to mute the effects of the increase in energy prices and to lower inflation. Overall, we find that these unconventional measures reduced euro area inflation by 1 to 2 percentage points in 2022 and may avoid an undershoot later on. The net effect is to keep inflation nearer to the target. About one-third to one-half of the reduction in 2022 reflects the direct effects of the measures on headline inflation, with much of the remainder reflecting the lower pass-through to core inflation. The fiscal measures were deficit-financed but had limited effects on raising inflation by stimulating demand and instead modestly helped to stabilize longer-term inflation expectations. Looking ahead, the prospective decline in inflation in the euro area is partly due to fortunate circumstances, with energy prices falling from their 2022 peaks and their pass-through effects fading, and with less economic overheating than in economies such as the United States. Implementing similar measures in the face of a more persistent increase in energy prices, or in a more overheated economy, would have caused a more persistent rise in core inflation.

International Macroeconomics: From the Great Financial Crisis to COVID-19, and Beyond, 2021 Mundell Fleming lecture, IMF Economic Review, August 2022

Available from Springer. Copyright © 2022, International Monetary Fund

This Mundell–Fleming lecture reviews some of the main developments in international macroeconomics since the early 2000s. It highlights four important areas of progress: (a) on international pricing and invoicing; (b) on sectoral trade and production networks; (c) on the cross-border allocation of capital and the role of global financial intermediaries; (d) on cross-border externalities and prudential policies. It then explores three specific questions, relevant for future research and policy: (a) the implementation of optimal prudential policy via ‘basis control;’ (b) recent developments about the US external balance sheet and its ‘exorbitant privilege;’ and (c) the reform of the International Financial and Monetary System.

Fiscal Policy in the Age of COVID: Does it 'Get in all of the Cracks?',  Kansas City Federal Reserve Jackson Hole Economic Policy Symposium, August 2021

with Sebnem Kalemli-Ozcan, Veronika Penciakova and Nick Sander. 

We study the effects of fiscal policy in response to the COVID-19 pandemic at the firm, sector, country and global level. First, we estimate the impact of COVID-19 and policy responses on small and medium-sized enterprise (SME) business failures. We combine firm-level financial data from 50 sectors in 27 countries, a detailed input-output(I-O) network, real-time data on lockdown policies and mobility patterns, and a rich model of firm behavior that allows for several dimensions of heterogeneity. We find: (a) Absent government support, the failure rate of SMEs would have increased by 9 percentage points, significantly more so in emerging market economies (EMs). With policy support it only increased by 4.3 percentage points, and even decreased in advanced economies (AEs). (b) Fiscal policy was poorly targeted: most of the funds disbursed went to firms who did not need it. (c) Nevertheless, we find little evidence of the policy merely postponing mass business failures or creating many “zombie” firms: failure rates rise only slightly in 2021 once policy support is removed. Next, we build a tractable global intertemporal general equilibrium I-O model with fiscal policy. We calibrate the model to 64 countries and 36 sectors. We find that: (d) a sizeable share of the global economy is demand-constrained under COVID-19, especially so in EMs. (e) Globally, fiscal policy helped offset about 8% of the downturn in COVID, with a low “traditional” fiscal multiplier. Yet it significantly reduced the share of demand-constrained sectors, preserving employment in these sectors. (f) Fiscal policy exerted small and negative spillovers to output in other countries but positive spillovers on employment. (g) A two-speed recovery would put significant upwards pressure on global interest rates which imposes an additional headwind on the EM recovery. (h) Corporate and sovereign spreads rise when global rates increase, suggesting that EM may face challenging external funding conditions as AEs economies normalize.

COVID-19 and Small- and Medium-Sized Enterprises: A 2021 "Time Bomb"?, AEA Papers and Proceedings, May 2021

Available from American Economic Review. 

with Sebnem Kalemli-Ozcan, Veronika Penciakova and Nick Sander.

This paper assesses the prospects of a 2021 "time bomb" in small- and medium-sized enterprise (SME) failures triggered by the generous support policies enacted during the 2020 COVID-19 crisis. Policies implemented in 2020 do not on their own create a 2021 time bomb for SMEs. Rather, business failures and policy costs remain modest. By contrast, credit contraction poses significant risk. Such a contraction would disproportionately impact firms that could survive COVID-19 in 2020 without any fiscal support. Even in that scenario, most business failures would arise not from excessively generous 2020 policies but rather from the contraction of credit to the corporate sector.

The Dollar Hegemon? Evidence and Implications for Policy Makers, in  Asian Monetary Policy Forum, Steve Davis, Edward Robinson and Bernard Yeung eds,  Ch 7, 2021.

Available from World Scientific Connect.

This paper reviews the central role of the US dollar in the global trade, financial and monetary systems. The dominance of the US dollar as an invoicing, issuance, anchor and reserve currency has increased over time, especially so and somewhat paradoxically since the end of the Bretton Woods system. The dollar is now the ‘hegemon’ currency. I propose an explanation based on the growing complementarities between the role of the dollar for international trade and for international financial transactions. I also discuss the implications for policymakers of living in a ‘dollar world.’ The paper concludes with a discussion of some possible challenges to the dollar’s hegemony. 

Flattening the Pandemic and Recession Curves, in Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes, CEPR e-book, Richard Baldwin and Beatrice Weder di Mauro editors, 2020

CEPR ebook available here.

Some Factors Shaping the International Financial Landscape of the Future, in  "Evolution or Revolution," Rethinking Macroeconomics vol IV, O. Blanchard and L. Summers eds., Ch 21. MIT Press 2019.

This paper discusses Gita Gopinath's overview of some of the key outstanding research and policy questions in international macroeconomics. Not surprisingly, I very much agree with her assessment.  Rather than review the issues she raises, my comments will pick up and expand on a few themes, offering along the way slightly different perspectives. I have organized my remarks around three themes: the dilemma versus trilemma debate, the role of the dollar and the link to the modern Triffin paradox, and the safe asset scarcity hypothesis. 

Monetary Policy Transmission in Emerging Markets: An Application to Chile, in "Monetary Policy and Global Spillovers: Mechanisms, Effects and Policy Measures", Enrique Mendoza, Ernesto Pasten and Diego Saravia, eds, Series on Central Banking, Analysis and Economic Policies, vol XXV, 2018, pp279-324

This paper discusses the role of financial spillovers in the transmission of U.S. and domestic monetary policy to emerging market economies. With weak financial spillovers, a U.S. monetary tightening is expansionary. With moderate financial spillovers, a U.S. monetary tightening is contractionary. With strong financial spillovers, a domestic monetary tightening becomes expansionary. Implications for the role of the exchange rate regime and the trilemma/dilemma debate are discussed. The model is adapted and estimated using Chilean data. Results indicate that financial spillovers are intermediate, suggesting that monetary impulses transmit positively from the U.S. to Chile and that a floating exchange rate remains a key plank of the policy response.

Rents, Technical Change and Risk Premia, American Economic Review, P&P, May 2017

Copyright © 2017 by the American Economic Association.

with Ricardo Caballero and Emmanuel Farhi. The secular decline in safe interest rates since the early 1980s has been the subject of considerable attention. In this short paper, we argue that it is important to consider the evolution of safe real rates in conjunction with three other first-order macroeconomic stylized facts: (a) the relative constancy of the real return to productive capital, (b) the decline in the labor share, and (c) the decline and subsequent stabilization of the earnings yield. Through the lens of a simple accounting framework, these four facts offer suggestive insights into the economic forces that might be at work.

Also available as CEPR DP11833, NBER WP23127

The Fundamental Structure of the International Monetary System, in Rules for International Monetary Stability Michael D. Bordo and John B. Taylor, eds, Hoover Institution Press, 2017. 

A fundamental function of the International Monetary System is to allocate scarce safe assets across countries. The system is fundamentally asymmetric. Net global safe asset producers are at the center. They enjoy an external premium and face a slack external adjustment constraint. This fundamental characteristic is largely independent of formal exchange rate arrangements (fixed or flexible exchange rates). Global imbalances mutate at the zero lower bound (ZLB) from benign to malign. Away from the ZLB, safe asset scarcity propagates low equilibrium real interest rates via current account surpluses. At the ZLB, safe asset scarcity propagates recessions via current account surpluses. Away from the ZLB, net safe asset suppliers enjoy a premium. At the ZLB, they must absorb a larger share of the global recession. 

Also available (in shorter version) as NBER Reporter, 2016(1). 

Real Interest Rates, Imbalances and the Curse of Regional Safe Asset Providers at the Zero Lower Bound, November 2016, Sintra ECB Forum on Central Banking.

Copyright © 2016 European Central Bank. All rights reserved. 

with Hélène Rey. The current environment is characterized by low real rates and by policy rates close to or at their lower bound in all major financial areas. We analyze these unusual economic conditions from a historical perspective and draw some implications for external imbalances, safe asset demand and the process of external adjustment. First, we decompose the fluctuations in the world consumption-to-wealth ratio over long periods of time and show that they anticipate movements of the real rate of interest. Second, our estimates suggest that the world real rate of interest is likely to remain low or negative for an extended period of time. In this context, we argue that there is a renewed Triffin dilemma where safe asset providers face a trade-off in terms of external exposure and real appreciation of their currency. This trade-off is particularly acute for smaller economies. This is the “curse of the regional safe asset provider”. We discuss how this “curse” is playing out for two prominent regional safe asset providers: core EMU and Switzerland. 

Also available as: CEPR DP11503, NBER WP22618 

[Media coverage: Vox-EU column]

The Analytics of the Greek Crisis, 2016, NBER Macroeconomics Annual

with Thomas Philippon and Dimitri Vayanos. We provide an empirical and theoretical analysis of the Greek Crisis of 2010. We first benchmark the crisis against all episodes of sudden stops, sovereign debt crises, and lending boom/busts in emerging and advanced economies since 1980. The decline in Greece's output, especially investment, is deeper and more persistent than in almost any crisis on record over that period. We then propose a stylized macro-finance model to understand what happened. We find that a severe macroeconomic adjustment was inevitable given the size of the fiscal imbalance; yet a sizable share of the crisis was also the consequence of the sudden stop that started in late 2009. Our model suggests that the size of the initial macro/financial imbalances can account for much of the depth of the crisis. When we simulate an emerging market sudden stop with initial debt levels (govern- ment, private, and external) of an advanced economy, we obtain a Greek crisis. Finally, in recent years, the lack of recovery appears driven by elevated levels of non-performing loans and strong price rigidities in product markets. 

Also available as CEPR DP11334, NBER WP22370 

[Media coverage: Vox-EU column]

Safe Asset Scarcity and Aggregate Demand, American Economic Review, P&P, May 2016.

Copyright © 2016 by the American Economic Association. 

with Ricardo Caballero and Emmanuel Farhi. We explore the consequences of safe asset scarcity on aggregate demand in a stylized IS-LM/Mundell Fleming style environment. Acute safe asset scarcity forces the economy into a "safety trap" recession. In the open economy, safe asset scarcity spreads from one country to the other via capital flows, equalizing interest rates. Acute global safe asset scarcity forces the economy into a global safety trap. The exchange rate becomes indeterminate but plays a crucial role in both the distribution and the magnitude of output adjustment across countries. Policies that increase the net supply of safe assets somewhere are output enhancing everywhere.

Also available as: CEPR DP11170, NBER WP22044

External Adjustment, Global Imbalances, Valuation Effects, Handbook of International Economics, vol 4, G. Gopinath, H. Helpman and K. Rogoff eds., chapter 10, 2014, pp585-645

available from ScienceDirect. Copyright © 2014 Elsevier B.V. All rights reserved.

Global Imbalances and Global Liquidity, in Asia's Role in the Post-Crisis Global Economy, Asian Economic Policy Conference, R. Glick and M. Spiegel eds., Federal Reserve Bank of San Francisco, February 2012

The financial crisis has entered a dangerous phase. I argue in this article that the retrenchment currently taking place in the European banking sector has broad implications for financial stability. More generally, I argue that the focus should be on "global liquidity imbalances," rather than "global imbalances." Global liquidity imbalances track the liquidity mismatch across countries and over time, which may or may not result in current account deficits and surpluses (that is, global imbalances).

Reforming the International Monetary System, September 2011 CEPR e-Report

with Emmanuel Farhi and Hélène Rey. Executive Summary: Our proposals for the reform of the international monetary system focus on liquidity provision. They will help to limit the effects of individual and systemic crises and to decrease their frequency. We make four principal recommendations: (1) Develop alternatives to US Treasuries as the dominant reserve asset, thereby accelerating the inevitable transition to a multipolar system. In particular, we recommend the issuance of mutually guaranteed European bonds. Also necessary (though in the more distant future) are opening of the Chinese capital account, convertibility of the yuan, and development of a yuan bond market. (2) Make permanent the temporary swap agreements that were put in place between central banks during the crisis. Establish a star-shaped structure of swap lines centred on the IMF. (3) Strengthen and expand such International Monetary Fund facilities as Flexible Credit Lines (FCLs), Precautionary Credit Lines (PCLs), and the Global Stabilization Mechanism (GSM). Also expand the IMF's existing financing mechanisms --notably, the New Arrangements to Borrow (NAB)-- and allow the IMF to borrow directly on the markets. (4) Establish a foreign exchange reserve pooling mechanism with the IMF that will provide participating countries with more liquidity and, incidentally, allow reserves to be recycled in the financing of productive investments. To limit moral hazard, we propose to set up specific surveillance indicators to monitor 'international funding risks'. In addition, our analysis indicates that (a) an international monetary anchor is neither desirable nor realistic; and (b) transforming special drawing rights (SDRs) into a true international currency would be unlikely to solve the fundamental problems of the international monetary system. Capital flows in emerging markets may be excessive and volatile. Under certain specific and predefined circumstances, we recognize the merits of using temporary capital controls (along with prudential and monetary measures) to ensure the macroeconomic and financial stability of such countries. Under certain limited circumstances, capital flows may yield negative externalities in the rest of the world; hence they should be subject to mutual monitoring. Towards this end, we offer our final recommendation as follows. (5) Extend the mandate of the IMF to the financial account, and strengthen international cooperation in terms of financial regulation.

Also available in French as Réformer le Système Monétaire International, Rapport du CAE, September 2011.

[Media Coverage: VoxEU column summarizing the report (September 19, 2011); Wall Street Journal]

Financial Crash, Commodity Prices and Global Imbalances, Brookings Papers on Economic Activity 2008, 2, pp1-55

(click here for the slides from the Brookings Panel meeting in Washington DC, September 2008)

Copyright © 2008 by Brookings.

with Ricardo Caballero and Emmanuel Farhi. In this paper, we argue that the persistent global imbalances, the sub-prime crisis, and the volatile oil and asset prices that followed it, are tightly interconnected. They all stem from a global environment where sound and liquid financial assets are in scarce supply. Our story goes as follows: Global asset scarcity led to large capital flows toward the U.S. and to the creation of asset bubbles that eventually crashed. The crash in the real estate market was particularly complex from the point of view of asset shortages since it compromised the whole financial sector, and by so doing, closed many of the alternative saving vehicles. Thus, in its first phase, the crisis exacerbated the shortage of assets in the world economy, which triggered a partial recreation of the bubble in commodities and oil markets in particular. The latter led to an increase in petrodollars seeking financial assets in the U.S. Thus, rather than the typical destabilizing role played by capital outflows during financial crises, petrodollar flows became a source of stability for the U.S. The second phase of the crisis is more conventional and began to emerge toward the end of the summer of 2008. It became apparent then that the financial crisis would permeate the real economy and sharply slow down global growth. This slowdown worked to reverse the tight commodity market conditions required for a bubble to develop, ultimately destroying the commodity bubble. 

An earlier version of this paper circulated under the catchy title "Financial `Whac-a-Mole': Bubbles, Commodity Prices and Global Imbalances." CEPR DP7064, NBER WP14521.

Valuation Effects and External Adjustment: a Review, in "Current Account and External Financing", Kevin Cowan, Sebastian Edwards and Rodrigo Valdes, eds, Series on Central Banking, Analysis and Economic Policy, vol XII, Banco Central de Chile, 2008, pp195-236

This paper surveys the recent empirical and theoretical literature on valuation effects. The increase in cross-border holdings of financial assets opens the door to significant adjustments in a country's external position in response to fluctuations in asset and currency prices. Access to better data on net and gross international investment positions for a broad range of countries permits careful measurement of these `valuation effects'. We distinguish between predictable and unpredictable valuation effects, and argue that they play separate roles in the adjustment process (for better or for worse). Finally, the paper discusses theoretical conditions under which predictable valuation effects can arise in equilibrium.

From World Banker to World Venture Capitalist: US External Adjustment and The Exorbitant Privilege, in "G7 Current Account Imbalances: Sustainability and Adjustment", Richard Clarida, editor, The University of Chicago Press, 2007, pp11-55

with Hélène Rey. We analyze the structure of US external assets and liabilities since 1952 and break-up the "exorbitant privilege" in a return effect and a composition effect. This paper also contains a detailed description of the dataset that we constructed and used in International Financial Adjustment. 

Also available as: CEPR DP5220, NBER WP11563.

[Media coverage: Bloomberg, Liberation, Le Figaro, Le Monde]

[Data: Gross positions by asset class, flows, and total nominal implicit returns are available here.]

Social Security and Inequality over the Life Cycle, in The Distributional Aspects of Social Security and Social Security Reform, M. Feldstein and J. Liebman, editors, The University of Chicago Press, 2002

with Angus Deaton and Chris Paxson. This paper examines the consequences of social security reform for the inequality of consumption across individuals. The idea is that inequality is at least in part the result of individual risk in earnings or asset returns, the effects of which accumulate over time to increase inequality within groups of people as they age. Institutions such as social security, that share risk across individuals, will moderate the transmission of individual risk into inequality. We examine how different social security systems, with different degrees of risk sharing, affect consumption inequality. We do so within the framework of the permanent income hypothesis, and also using richer models of consumption that incorporate precautionary saving motives and borrowing restrictions. Our results indicate that systems in which there is less sharing of earnings risk such as systems of individual accounts produce higher consumption inequality both before and after retirement. However, differences across individuals in the rate of return on assets (including social security assets held in individual accounts) produce only modest additional effects on inequality. 

Also available as: NBER WP7570.

The Empirical Importance of Precautionary Saving, American Economic Review, P&P, 91(2), May 2001

available from JSTOR. Copyright © 2001 by the American Economic Association. 

with Jonathan Parker. One of the basic motives for saving is the accumulation of wealth to insure future welfare. Both introspection and extant research on consumption insurance find that people face substantial risks that they do not fairly pool. In theory, the consumption and wealth accumulation of price-taking households in an economy without complete markets differs substantially from the behavior of these same households in the equivalent economy with complete-markets. The question we address in this article is whether we find this difference to be large in practice. What is the empirical importance of precautionary saving? We provide a simple decomposition that characterizes the importance of precautionary saving in the U.S. economy.. We use this decomposition as an organizing framework to present four main findings: (a) the concavity of the consumption policy rule, (b) the importance of precautionary saving for life-cycle saving and wealth accumulation, (c) the contribution of changes in risk to fluctuations in aggregate consumption and (d) the significant impact of incomplete markets on aggregate fluctuations in calibrated general equilibrium models. We conclude with directions for future research. 

Also available as: CEPR DP2737, NBER WP8107.