International Finance and Macroeconomics.

• Author: Frankel, Jeffrey A.

Jeffrey A. Frankel [*]

This summary of research by members of the NBER's Program on International Finance and Macroeconomics describes work on particular parts of the world, including the emerging markets, Japan, and Europe, as well as studies of international economic integration and flexible exchange rates that have universal relevance.

Recent Crises in Emerging Markets

Recurrent crises in emerging markets warrant much thought, and NBER researchers have responded accordingly. Some of their work has been discussed in a series of conferences organized by NBER President Martin Feldstein and in annual meetings of the NBER's InterAmerican Seminar in Economics and the East Asian Seminar in Economics.

The most recent three-year period began with a number of postmortems on the Mexican peso crisis, including discussions of the origins of the crisis in 1994--by Sebastian Edwards, Andrew M. Warner, and Sergio L. Schmukler and me -- and analysis of its aftermath in 1995-- by Edwards and Miguel Savastano and Anne Krueger and Aaron Tornell. [1]

The return of crises in East Asia in 1997, and their spread to emerging market countries around the world in 1998, likewise raised a number of questions, including what had caused this turmoil. [2] Several explanations were considered, including the high and variable volume of flows in modern, liberalized international capital markets. [3]

Another possible explanation is increases in world interest rates, which seem to have been proximate causes in earlier crises, although less relevant in 1997-8. [4] A third possibility is the behavior of foreign investors, and a fourth is the composition of capital inflows. [5] A high level of foreign direct investment seems to be helpful, but a concentration of short-term dollar-denominated debt, especially relative to reserves, is a danger signal. Rodrik and Velasco show that the short-term debt-to-reserves ratio is a robust predictor of financial crises. [6]

Another possible explanation for the crises is attempts to maintain pegged exchange rates. [7] Such attempts in the crisis countries ended when foreign exchange reserves were depleted. The impact on the economy from the resulting devaluation was greater than if the currency peg had been abandoned earlier. Policies to fix exchange rates in Latin America were often the legacy of attempts to stabilize from high inflation rates in the 1980s. [8] In East Asia these policies have been complicated by rapid growth and by movements in the yen-dollar exchange rate. [9]

For some time there has been a division between those who attribute currency crises to traditional fundamentals, including overly expansionary monetary policy and other macroeconomic policy mistakes--for example, Michael D. Bordo and Anna J. Schwartz--and those who attribute it to investor panic and multiple equilibriums, such as Steven Radelet and Jeffrey D. Sachs. [10] These competing theories of balance-of-payments crises have been classified as first-versus second-generation models of speculative attacks. Research by Robert P. Flood and Nancy P. Marion, Maurice Obstfeld, and Velasco has put the different models into context. [11]

In East Asia, most of the countries had relatively good macroeconomic fundamentals. As a result, diagnoses of crises there emphasize a different sort of fundamentals instead of macroeconomic policies: distortions in the financial structures of emerging economies. [12] Specifically, a third generation of models of currency crises sought to explain "crony capitalism," defined more formally as implicit government guarantees for poorly regulated banks and corporate debtors, which create moral hazard. The pioneering leader of these models, writing before the East Asia crisis began, was Michael P. Dooley. [13] Others who developed the models include Chinn, Dooley, and Sona Shrestha; Craig Burnside; Martin S. Eichenbaum and Sergio Rebelo; and Aizenman. [14]

An important question to address is why the crises were so severe once they occurred, inflicting recession, bankruptcy, and poverty on much of the economy. Chang and Velasco have emphasized the post-devaluation burden of short-term dollar-denominated debt. [15] Banks and firms find that they cannot service their dollar-denominated debt after the devaluation because their revenues are primarily in local currency. James Levinsohn, Steven Berry, and Jed Friedman show that, in part because of debt problems, the poor in Indonesia indeed were hit the hardest. [16]

At the same time, there has been a rethinking of the traditional view that a country that abandons its exchange rate target has the solace of lower interest rates and a related stimulus to growth and employment. Even in looking at Western Europe, Robert J. Gordon challenges the conventional wisdom that those who devalued in 1992-3 were rewarded with noninflationary growth. [17] In the case of East Asia, especially, the crisis victims suffered from high interest rates and sharp recessions regardless of whether they devalued early, late, or not at all.

Another topic our program addresses is contagion: the tendency for a currency crisis in one emerging-market country to be followed by troubles in others far away. Such situations have now gone beyond correlations that can readily be explained by competition in export markets. For example, the contagion from Russia to Brazil in August 1998 cannot be explained easily by trade links between these two countries, nor by competition in third markets. A number of IFM Program members have been studying contagion. [18]

How can crises be prevented in the future, or at least be made less frequent and less severe? Some researchers have begun to study proposals for restrictions on capital flows. Chile maintained penalties on short-term capital inflows, which appear to have succeeded in changing the composition of its inflows at least. However, Edwards warns that these penalties do not explain Chile's success. [19] Leonardo Bartolini and Drazen point out that liberalization of capital outflows sends a positive signal to investors and can result in increased inflows. [20] Karen K. Lewis also looks at official international restrictions on capital flows. [21]

Some proposals for modification of the international financial architecture call for a reform of multilateral institutions. [22] Work by Feldstein and Ricardo J. Caballero and Arvind Krishnamurthy offers some innovative ideas about the provision of international collateral by developing country borrowers. [23]

Japan and the European Union

Members of the IFM program have continued to watch the...