International Finance and Macroeconomics (IFM).

• Author: Frankel, Jeffrey A.
• Position: Program Report

In 2003, the Program in International Finance and Macroeconomics celebrated its tenth anniversary as a separate program of the NBER. Research on emerging market countries represents a rapidly growing share of the agenda of the NBER's IFM Program. While members of the Program continue to work on many other topics as well, this article focused on the last four years will concentrate on the emerging markets theme. This research includes a major project, directed by Martin Feldstein and me, on "Financial Crises in Emerging Markets." This project in turn included eight meetings on crises in specific countries--the Mexican crisis of 1994, the East Asian crises during 1997-8, through Argentina's crash in 2001--along with many, other conferences. (1) It produced eight NBER books. (2)

Institutions

Economists' interest in those countries that have become integrated into world financial markets over the last few decades can be seen as part of a larger increase in attention paid to developing countries in general. The field of development economics has recently been granted more of the priority and prestige that it deserves. Why some poor countries have been able to join the ranks of the rich and others have stayed behind is one of the most important questions of our time. Research on the deepest determinants of growth now emphasizes three strong influences: openness to trade; tropical geography; and, especially, the quality of a country's institutions, such as protection of property rights, efficacy of the legal system, and absence of corruption. (3) Financial market institutions, such as those charged with protection of shareholder rights, receive particular emphasis. (4) Shang Jin Wei and his co-authors document that corruption in a country makes foreign investors skittish. (5)

Research by members of the IFM Program tends most often to deal specifically with macroeconomic questions, such as the choice of monetary and exchange rate policy, or a country's decision whether to open its financial markets to international capital flows. But Daron Acemoglu, Simon Johnson, James Robinson, and Yunyong Thaicharoen argue that macroeconomic policies in developing countries are often the manifestation of deeper institutions and interest groups. (6) For example, an IMF requirement that a country devalue in order to raise the domestic price of export commodities may be offset simply by some other policy to restore the preceding political equilibrium. Some of the more interesting findings discussed in this article concern the interaction of countries' institutions with these macroeconomic decisions.

Exchange Rate Regimes

One major question addressed by IFM members is a country's, choice of currency regime: a fixed exchange rate, a floating exchange rate, or a regime with an intermediate degree of flexibility (such as a target zone). The debate is an old one, but it acquired some new features in the late 1990s. One new development was the decision of some countries to abandon their independent currency for a device to fix its value firmly, such as a currency board or official dollarization. Sebastian Edwards and Igal Magendzo find that dollarization and currency unions have delivered lower inflation, as promised, but with higher income volatility. (7)

One of the arguments for a firm fix was that it would force domestic institutions to evolve in a favorable way, and would help prevent the chronic monetization of fiscal deficits that had undone so many previous attempts at macroeconomic stabilization. (8) Argentina's currency board, for example, appeared to work very well during most of the decade. It was believed that this "convertibility plan" had encouraged reforms that by the late 1990s had turned Argentina's banking system into one of the best among all emerging markets. (9) But when Argentina's crisis crested in 2001, neither the supposedly deep pockets of foreign parents that had been allowed local bank subsidiaries (10), nor any of the country's other innovative reforms, were able to protect its banking system. This outcome can only have had a dampening effect on the earlier enthusiasm for currency boards. (11)

Another new argument for monetary union has been the influential empirical findings of Andrew K. Rose and his co-authors that the boost to bilateral trade has been significant, and larger (as large as a threefold increase) than had been assumed previously. (12) Many others have advanced critiques of the Rose research, but the basic finding has withstood perturbations and replications remarkably well, even though the estimated magnitudes are sometimes smaller. (13) Some developing countries seeking enhanced regional integration may now try to follow Europe's lead. (14)

There are plenty of arguments in favor of floating currencies as well, and most of the victims of the last eight years of crises in emerging markets have responded by increasing exchange rate flexibility. One advantage that is beginning to receive renewed emphasis is that floaters are partially insulated against fluctuations in the world market for their exports. (15)

A relatively new realization is that attempts to categorize countries' choice of regime (into fixed, floating, and intermediate) in practice differ from the official categorization. (16) Countries that say they are floating, for example, in reality often are not. (17) Indeed, neat categorization may not be possible at all. That Argentina was in the end forced to abandon its currency board, in 2001, also dramatizes the lesson that the choice of exchange rate regime is not as permanent or deep as had previously been thought. (18) The choice of exchange rate regime is more likely endogenous with respect to institutions, rather than the other way around. (19) The "corners hypothesis"--that countries are, or should be, moving away from the intermediate regimes, in favor of either the hard peg corner or the floating corner--became fashionable in the late 1990s; but it is now another possible casualty of the realization that no regime choice is in reality permanent, and that investors know that. (20)

If a country decides against setting a target for the exchange rate, that still leaves the question of what alternative target or targets will guide monetary policy instead, as Lars E. O. Svensson has emphasized. Setting a target for the money supply is no longer in fashion, for good reason. (21) One popular alternative is inflation targeting. (22) Another is the Taylor rule. (23) An open area for research is whether and how such rules can be adapted for the special circumstances facing emerging market countries, such as lower credibility of their monetary institutions. (24)

Opening up Financial Markets

Another major question that a country must decide is whether to liberalize financially, and in particular how much to remove controls on international capital movements. This is part of the larger debate over globalization. Do the advantages of open financial markets outweigh the disadvantages? (25) There are many potential gains from international trade in financial assets, analogous to the gains from international trade in goods. Peter B. Henry and Anusha Chari, for example, have shown that when countries open their stock markets, the cost of capital facing domestic firms falls (stock prices rise), with a positive effect on their investment and on economic growth). (26) Controls designed to moderate capital inflows thus may raise the cost of capital and slow growth. They may have a particular impact on small firms. (27)

Nevertheless, financial liberalization has often been implicated in the crises experienced by emerging markets over the last ten years. Certainly a country that does not borrow from abroad in the first place cannot have an international debt crisis. Perhaps, then, there is a role for capital controls. Dani Rodrik finds that Malaysia's decision to impose controls on outflows in 1998 helped it weather the Asia crisis. (28) But Johnson and Todd Mitton find that Malaysian capital controls mainly worked to provide a screen behind which politically favored firms could be supported. (29) Research more often has been sympathetic to a specific kind of capital control--Chile-style penalties on short-term capital inflows--under the theory that they tilt the composition in favor of more stable long-term inflows. (30)

A blanket indictment (or vindication) of international capital flows would be too simplistic. Some of the most interesting research examines the...