Europeans may find several historical and theoretical reasons why a political government for the euro area would be desirable. But after the global crisis there are technical reasons why it is more than desirable. That conclusion is a necessity in light of three increasingly important aspects of current monetary developments in Europe: (1) the lack of an exchange rate policy; (2) the absence of a European fiscal authority guaranteeing the stability of sovereign bonds; and (3) the collusive relationship developing between the European Central Bank (ECB), the banks, and the national governments hiding the costs to the taxpayers.

(1) In a world where the exchange rate of the dollar and the renminbi are “governed” for domestic purposes, Europe risks being caught as a scapegoat for other countries’ imbalances. The lack of a proper currency policy is the most intuitive argument in favor of establishing a political governing authority in the eurozone. The ECB cannot pursue currency objectives beyond its statutory mandate of inflation control. Trying to achieve the two different objectives of price control and setting the right exchange rate with only one available instrument, interest rates, would set up two conflicting goals and price control in the euro area would lose credibility. So under the pressure of the other countries’ depreciations eurozone economies have to adjust internally and more painfully through deflation or unemployment.

(2) But new and more subtle reasons are emerging for establishing a political head on top of the eurozone economic shoulders. The ECB cannot buy bonds issued directly by governments or directly finance national government debts. There are two reasons for this. One is that the ECB must be free to pursue its only statutory objective, low inflation, which means that it should avoid increasing the monetary base through the purchase of government bonds under political pressure. The second reason is that (some) eurozone member states do not want to share a common fiscal responsibility. Nor do they want to issue common bonds. As a consequence, euro-denominated bonds lack the guarantee of a central bank that in a crisis situation could be able to print money and buy euros even if only for stabilization purposes.

The lack of a political guarantee hinders the development of a fully fledged bond market denominated in euros. This is a problem that goes beyond Europe. For instance, it would reinforce the credibility of Washington’s oft-proclaimed support for a strong dollar if the United States were to issue bonds in euros or yen. After all, such an action would only be taken if the United States were confident that the dollar was not going to depreciate against these other currencies. But in the absence of a fully fledged euro bond market, this remains in the realm of the hypothetical. Actually the global financial crisis has silently broken a few barriers to the ECB’s restrictions on use of monetary policy. The central bank has increased—through repurchase operations—its holdings in European government bonds for an equivalent of approximately 90 billion euros between August 2008 and July 2009. How does the bank determine which bonds to hold? This remains uncertain. The lack of a fiscal backup, i.e., a fiscal authority behind the eurozone, makes it difficult for the ECB to cover the potential losses from its securities investments. Inevitably it will feel compelled to invest in the most secure bonds, even though this can increase the yield differential among government bonds in the eurozone, tarnishing the objective of monetary and fiscal convergence and making monetary policy more difficult to manage. In theory the bank could arbitrarily buy bonds issued by governments whose economies are diverging, but in doing so it would assume a political role.

(3) An even more interesting development has occurred in the relation between the ECB and regular banks. The ECB is granting low-cost money to the European banking system, which reinvests it in government securities, reaping a financial gain that comes at the cost of the taxpayer and ensuring governments the financial breathing room to engage in fiscal deficits without being accountable to political authorities. One could dispute whether this is the most efficient way to manage risks of financial instability. And one could find the circumvention of democracy irritating. But can we really expect banks and governments not to collude in pursuit of their interests behind the scenes? Which government is in the position to let any bank fail when the alternative is this collective and reciprocal bail out?

In the last 12 months, the ECB has increased by 60 percent the supply of liquidity in its open market operations. The effect on the economy has been subdued. Loans to firms tend to lag in economic cycles, so the credit demand is clearly still far from the normal level, not necessarily because of banks placidity. At first banks hoarded the liquidity at the ECB deposit facility, earning a sure and safe differential. More recently they are using low-cost funding (at a 1-percent rate) to invest in government securities, not only earning on the rate differential but improving the quality of their battered balance sheets. Some estimates reckon that half of the government securities issued from the start of the crisis is directly absorbed by banks being financed by the ECB.

In this situation, the problem is that the ECB finds it much more painful to raise interest rates because doing so would reduce the advantage for banks in purchasing government securities. If the ECB were to increase the interest rates that it charges the banks, for fully understandable reasons, government bond rates would have to increase as well to attract investors and compensate for the thinning of the spread between the ECB’s funding facility and government bond rates. The consequences of an excessive rise in short- and long-term interest rates would be an exaggerated appreciation of the euro and a likely recession—unless the ECB and the Fed coordinate an increase in rates. But because such a coordination would likely occur on a broad scale as part of an “exit strategy” from the current crisis, it is inconceivable for the central banks to cooperate in the absence of an agreed strategy between political authorities.

If the ECB for the above reasons delays increasing the interest rates, than the excess liquidity provided to the European banks will, sooner or later, find a way to inflate some kind of new bubble, inviting a new crisis starting from square one….

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE. 

Main Points

The world economy is experiencing a modest recovery after near financial collapse this spring. The strength of the recovery varies sharply around the world:

1. In Asia, real GDP growth is returning quickly to precrisis levels and while there may be some permanent GDP loss, the real economy appears to be clearly back on track. For next year consensus forecasts have China growing at 9.1 percent and India growing at 8.0 percent; the latest data from China suggest that these forecasts may soon be revised upward.
2. Latin America is also recovering strongly. Brazil should grow by 4.5 percent in 2010, roughly matching its precrisis trend. We can expect other countries in Latin America to recover quickly also.
3. The global laggards are Europe and the United States. The latest consensus forecasts are for Europe to grow by 1.1 percent and Japan by 1.0 percent in 2010, while the United Sates is expected to grow by 2.4 percent (and the latest revisions to forecasts continue to be in an upward direction). Unemployment in the United States is expected to stay high, around 10 percent, into 2011.

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Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE. 

Op-ed in Business Standard, New Delhi

October 28, 2009

Never mind that it was a confidential communication. Never mind too that the establishment came down on him and crushed any possibility of his private views translating into public policy. Never mind, in short, that it is back to the status quo with a vengeance. The impact of the leaked letter from Jairam Ramesh, minister of state for the environment, to the prime minister on the terms of India's international engagement was nevertheless seismic with the aftershocks sure to reverberate for some time. The terms of the debate, especially on the tone and possibly also on the substance of India's external entanglements—and not just in the climate change negotiations—have been altered, possibly for good and definitely for the better. Consider in turn the motives, content, and implications.

The provocation was threefold. The emergence of the G-20 means that India suddenly finds itself as an international player, a position it has long aspired to but has consistently been denied. It is not that India has become a superpower à la the United States. Nor has it acquired effective veto power like China. But it is increasingly seen as belonging to the world's steering committee. The job of this committee is to seek and secure cooperation, and to be seen as a cooperation-stymier would sit uneasily with India's new status and its long-run ambitions. That is, if India has finally been invited to the party, its early contributions cannot be those of a party-spoiler.

A second related reason is that India had come to realize, correctly, that in the area of climate change, India was losing the battle of the "narrative." India has discovered that possessing good economic and ethical arguments did not influence people that mattered. In climate change, for example, India found that deploying the rhetoric of recrimination—the argument that rich countries bore responsibility for their historical contribution to pollution and hence had to carry the burden going forward—was proving ineffective. For example, it did little to undermine the legitimacy of the United States and others in contemplating and threatening trade sanctions against India for not cooperating on climate change. More tellingly perhaps, even respected and moderate voices such as Lord Stern and the United Nations Development Program (in a report two years ago) have urged countries like India to undertake substantial emissions reductions. Losing the narrative was proving costly, necessitating a rethink of Indian strategy.

Finally, as in so many policy areas today, there was the China factor. On climate change and trade negotiations (although not on exchange rate issues), China has managed successfully to avoid the label of recalcitrant and is seen as a country that the world can do business with (literally and metaphorically). Indeed the fact that this was already happening—reflected in the US-China bilateral negotiations on climate change—fueled the fear of being sidelined and being presented eventually with a fait accompli that was the product of negotiations between a narrower set of countries. Thus, both the symbolic slight of playing second fiddle to China yet again and the substantive fear of being excluded from international decision making are clearly playing on the minds of India's policymakers.

On content, there is no denying the radicalism of Jairam Ramesh's views. In particular, the call for India to be open to external scrutiny of national policies and willing to undertake international obligations is a challenge to the long-standing principle of regarding sovereignty as a sacrosanct objective to be preserved at almost any cost. Related to this, he makes a strong pitch for India to alter the tone of its international engagement from one that is defensive and "theological" to one that is more open and constructive. The call to de-emphasize financial and technical assistance is also noteworthy because it forces India to abandon its involuntary self-perception as a recipient of largesse, and to start viewing itself also as a contributor to international cooperative efforts.

These views could be portrayed as a "selling out" on India's part and as a cozying up to the United States that is doomed to run up against American self-interest and its variant of sovereignty-obsession. To be sure, the Indo-US relationship is going to be difficult and complicated, not least because of what Pratap Mehta calls the paradox of the American liberal. The northeastern liberals, who populate policymaking in this Obama administration, view India through the idealist perspective, prompting them to call on it to make sacrifices for the global common good. In contrast, China is seen through the realpolitik lens, resulting in greater accommodation and fewer demands being made.

But it would be a pity if Jairam Ramesh's letter did not lead to a debate on India's economic engagement with the rest of the world—not just in climate change but on trade, foreign capital, and investment—that shuns the extremes of sovereignty obsession on the one hand, and the headlong embrace of all things and relationships foreign on the other. An informed and participatory search for the murky middle, what one might call a strategic pragmatism—where the key issues are not how to preserve sovereignty but how much sovereignty to cede, to whom, on what terms, in which areas, and over what horizons—would be a valuable legacy of the recent kerfuffle.

It is a measure of how far India has to go that Jairam Ramesh's letter has made such waves and elicited such a ferocious backlash. It is a measure of how far India has come that a politician close to or even part of the populist wing of the Congress party has called for such a radical break with policy and presentation and not just on one critical issue. For sure, not much will change. But as Tancredi tells his uncle, the prince, in that magnificent Italian novel The Leopard, "If we want things to stay as they are, things have to change."

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Op-ed in the Moscow Times

October 28, 2009

Russia's relations with its neighbors are worse than ever, and this is particularly true among the former Soviet republics. On October 9, the Commonwealth of Independent States (CIS) held its annual summit in Chisinau. The Nezavisimaya Gazeta headline said it all: "Summit in 30 Minutes. CIS Leaders Had Nothing to Tell One Another."

Georgia left the alliance on August 18. Among the remaining 11 members, only six presidents arrived—from Russia, Belarus, Ukraine, Armenia, Azerbaijan, and Kyrgyzstan, while the host country, Moldova, temporarily has no president. Even the strongest proponent of multilateral cooperation in the post-Soviet region, Kazakh President Nursultan Nazarbayev, chose to stay at home. Needless to say, nothing was accomplished.

To aggravate things further, President Dmitry Medvedev refused to meet Ukrainian President Viktor Yushchenko and Belarusian President Alexander Lukashenko. Will Lukashenko attend another CIS meeting after that insult? Everybody left quickly after their half-hour meeting and even skipped the planned gala dinner. The CIS is Russia's baby, and its failure is also Russia's.

Each CIS country has its own complaints, but the four dominant concerns are: Russia's lacking respect for its neighbors' territorial integrity, gas policy, trade conflicts, and financial issues. The Kremlin needs to fix each of these areas to restore Russia's standing in the region.

On August 26, 2008, the Kremlin dealt the most devastating blow to its reputation in the post-Soviet region by recognizing the sovereignty of Abkhazia and South Ossetia. Russia violated its long-standing principles of respecting a nation's sovereignty and territorial integrity inscribed in the Organization for Security and Cooperation in Europe convention, the CIS convention, and multiple bilateral friendship treaties with CIS countries.

President Boris Yeltsin signed as many treaties as he could to reassure the former Soviet republics that Russia would respect their sovereignty. But when Vladimir Putin became president, he revised Yeltsin's policy. He articulated this new policy quite clearly in his 2005 annual address when he said, "The collapse of the Soviet Union was the biggest geopolitical disaster of the century."

Russia's recognition of Abkhazia and South Ossetia after the Russia-Georgia war confirmed that Russia had become a revisionist power in the region. Not one other CIS state has recognized Abkhazia or South Ossetia. The reason is that it could set a dangerous precedent and could ultimately threaten the sovereignty of CIS states as well. Several republics have large ethnic Russian populations and possess former Russian territories. The Kremlin needs to restore its respect for its neighbors' territorial integrity to be able to improve its relations with them.

Russia's gas policy toward its neighbors is just as damaging. It has been right in moving toward market-related prices, but prices offered to different CIS countries vary according to political conditions. After its unjustified cutoff of gas deliveries in January, Gazprom now finds itself in a severe crisis because its current and former customers consider it an unreliable supplier. Because of falling demand, its total output is likely to plummet by some 20 percent this year

For years, Gazprom has tried to monopolize gas supplies from Central Asia, but when European gas demand and prices dropped, Turkmenistan's gas pipeline to Russia blew up just like two gas pipelines to Georgia a few years ago. Now, after the pipeline has been repaired, Gazprom refuses to accept the contracted volumes or pay the agreed-upon price. Therefore Turkmen President Gurbanguly Berdymukhamedov did not go to the CIS summit. Instead, the Chinese are filling the gap by building a large gas pipeline to Turkmenistan. China will buy most of Turkmenistan's gas exports, as it already does from Kazakhstan.

Gazprom needs to recognize that it faces a serious crisis in its relations with both customers and suppliers. Otherwise it will be treated as a rogue company. The most sensible thing to do would be to ratify the Energy Charter Treaty, but last summer Russia took the opposite step: It suspended its signature for this important pact.

The greatest failure of the CIS is not to have established a free trade area. All the CIS countries, except Turkmenistan, signed a multilateral free trade agreement in 1994, but Russia has never ratified it. Instead, most CIS countries have concluded bilateral free trade agreements. Although they have been ratified, they lack legal teeth. Whenever one country wants to undertake protectionist measures against another, it does so with impunity because detailed rules, arbitration, and penalty mechanisms are missing. As a consequence, trade within the CIS is often interrupted. Whenever a successful exporter captures another market, it is blocked through quotas, tariffs or outright prohibition.

There is a clear resolution to this problem: World Trade Organization (WTO) accession for all. The WTO has the requisite rules, arbitration, and penalties. Five CIS countries have become members of the WTO, but Russia has failed to do so. In June, Russia was very close to accession, but Putin surprised everybody, including his own cabinet, by stating that Russia, Belarus and Kazakhstan would enter the WTO as a customs union. WTO Secretary General Pascal Lamy said this was impossible. Only when Russia and the other CIS countries join the WTO can free trade arrangements within the commonwealth become meaningful.

The global financial crisis offered the Kremlin a new chance to rebuild relations with its CIS neighbors. With its large reserves, Russia could offer substantial financial assistance to Belarus, Armenia, Kyrgyzstan, and Moldova. But Belarus, Kyrgyzstan, and Moldova are complaining that Russia has failed to deliver what it promised. Once again Lukashenko and Putin have ended up in public mudslinging. Instead, China is quietly providing larger financial support to Belarus and Moldova.

Thus, the Kremlin is spoiling its relations with its neighbors in a seemingly mindless fashion. In the East, Central Asia is turning to China to expand trade and receive financing. In the West, the European Union's Eastern Partnership has pulled Ukraine, Georgia, Belarus, and Moldova closer to Europe. For the time being, Russia seems to have decent relations with only Armenia and Azerbaijan.

Russia has solidified its reputation as an unreliable and unpredictable partner. It is finding itself increasingly lonely, and in global affairs the lonely are weak. Russia should have an interest in improving its tarnished international reputation. It urgently needs to form a new, constructive and respectful policy toward its post-Soviet neighbors. Perhaps Medvedev and Putin should take a page from Yeltsin's CIS playbook.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.     

The International Monetary Fund (IMF) has had a good year in Eastern Europe. It has been called to help numerous countries and it has acted fast and generously. It has learned several lessons from the East Asia financial crisis of 1997–98, which was very similar. The East European crisis is primarily a current-account crisis, not a systemic or structural crisis. The external payment crisis has resulted in sharp falls in output, which in turn has resulted in temporary but large budget deficits after a long time of more or less balanced budgets and tiny public debt.

Sensibly, the IMF has focused on macroeconomic balances and bank restructuring. It has provided much more financing than before and not only for central bank reserves but also for budget financing. Yet Latvia stands out as a case particularly poorly managed by the IMF. The shortcomings stand out when comparing Latvia with its neighbor Lithuania, which faces a very similar conundrum.

Both countries will have budget deficits this year of about 10 percent of GDP and an anticipated decline in GDP of almost 18 percent. They maintain fixed exchange rates and are cutting public expenditures and wages like crazy, which has resulted in accelerating deflation. The Lithuanian government is cutting public expenditures by 8 percent of GDP this year and plans further cuts of 5 percent of GDP. Latvia’s numbers are similar. They are cutting public wages sharply and prices are currently falling. Also politically, Latvia and Lithuania are similar. They are ruled by center-right coalition governments that may prove unstable. Both have new prime ministers with high moral reputations.

The big difference is that Latvia’s foreign debt in relation to GDP is about twice as large as Lithuania’s. Another distinction is timing. Latvia was hit by the crisis almost half a year before Lithuania. Latvia hit bottom in the first quarter of 2009, while Lithuania’s nadir was reached in the second quarter. Moreover Lithuania’s big GDP fall was a greater surprise than Latvia’s. Financial markets were frozen for both after the Lehman bankruptcy on September 15, 2008, and Latvia needed funds then, so it had little choice but to turn to the IMF, while Lithuania could start large eurobond borrowing in June after the global liquidity freeze had subsided.

After recent personal meetings with both Lithuania’s Prime Minister Andrius Kubilius and Latvia’s Prime Minister Valdis Dombrovskis, I dare say that these are very fine and insightful policymakers. Admittedly, Kubilius is older, more experienced and comfortable, because he was prime minister also in 1998–99 and handled the Russian financial crisis. But both prime ministers have similar views and pursue almost identical policies.

In the international media, however, Dombrovskis is abused as an incompetent lightweight, while few write about Lithuania. The reason is that Latvia obtained an IMF/EU loan package of nearly $10.5 billion in December 2008 (of which the IMF contributed only one-third), while Lithuania borrows on the eurobond market. Lithuania’s yields peaked at 9.5 percent per annum last June, but have now fallen to 6.8 percent per annum.

In fact, the Latvian government record appears much stronger than international media currently suggest. Last June, the Latvian government forecasted that its budget deficit for this year would stay at 9 percent of GDP, while the IMF—incredibly—insisted it would be 15.5 percent of GDP. Dombrovsikis persisted and gained support from the European Union, which decided to issue its second tranche on July 2. Eventually, the IMF yielded and approved its second tranche on July 27. At present, 10 percent of GDP appears the right number, approximately what the Latvian government claimed and far better than the IMF assessment.

In October, the IMF and the European Union demanded that the Latvian government cut public expenditures by another 1.5 percent of GDP ($350 million) for next year. Initially, Dombrovskis refused because he believed that the IMF GDP forecasts once again were far too pessimistic. However, everybody came down like a ton of bricks on him and he had to give in.

In particular, European voices demanded that Latvia raise taxes, but that was poor advice. No post-Soviet economy has exited a financial crisis through significant revenue measures. On the contrary, they typically cut public expenditures by 10 percent of GDP or more over two years exactly as Latvia and Lithuania are doing. Because it was forced to do so Latvia has raised its value-added tax, but that move has not resulted in any higher revenues, as tax collection becomes more problematic with higher tax rates.

Latvia’s IMF program has become a topic of international discussion. The country is persistently scolded, primarily by American economists who want to devalue the lat. All the three Baltic countries stubbornly stick to their pegs to the euro, because they see this as the best means of adopting the euro early, while a slough of American economists argue that devaluation is necessary, which is apparently also the view within the IMF. In fact, Lithuania is likely to adopt the euro in 2013 and Latvia in 2014.

The IMF has gotten every number about the Latvian economy widely wrong, and has been forced to change its mission chief three times in half a year. But evidently the rumors reflected in multiple international media about the incompetence of the Latvian government are being spread from the IMF. Poor Dombrovskis is treated like an outlaw, even though he is resolving his country’s crisis and keeping his fragile coalition government together. JPMorgan predicts the Latvian current account deficit of 22.5 percent of GDP in 2006 and 2007 will turn into a surplus of 4.4 percent of GDP this year, and output has been rising sharply since June.

Do you recognize the East Asian crisis in 1997–98? The IMF is on its way to discrediting itself in Latvia, as it did in South Korea, by exaggerating the length of the crisis and pretending that systemic problems are greater than they are. Very soon, South Korea’s economy came roaring back, and the Baltic economies are now recovering in sharp V curves. After all, the Baltic economic systems were among the finest in the world, and they remain so.

No doctor is supposed to slander his or her patients, but that is what the IMF is doing in Latvia, although its overt public voice is missing. My colleague Arvind Subramanian calls the IMF the Euro-American Monetary Fund, but the IMF underperformance in Latvia detracts from its reputation even in Europe.

Not surprisingly, the Lithuanian government is adamant that it will not ask the IMF for help. It prefers to borrow on the market even when the yields are high, not least because of the international publicity about Latvia. Its policies are not questioned, and it largely escapes unjustified international criticism. The IMF and European Union are not pushing the government around but leaving Kubilius fully in charge,

Although the IMF has improved its policies since the East Asian crisis, the IMF program and the related international public discussion are not reinforcing the Latvian government and its austerity policy but undermining it. The IMF is detracting from Dombrovskis’ political authority, when it should strengthen it.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.     

Michael Mussa, a former student and professor at the University of Chicago, assesses the influence—for good and for ill—of economics as espoused at the University of Chicago.

Recorded October 14, 2009. © Peterson Institute for International Economics.

Steve Weisman: This is Steve Weisman at the Peterson Institute for International Economics. Michael Mussa is our guest today to talk about whether the University of Chicago School of Economics shares any of the blame for the recent global financial crisis and downturn. I’ll explain why I’m asking him that in a second. Michael, thank you for agreeing to have this somewhat unusual conversation.

Michael Mussa: Well, it’s a pleasure to be here. It is unusual, but we shall see.

Steve Weisman: In addition to his many other achievements, notably as a senior fellow here, but also as the chief economist at the IMF and a member of President Reagan’s Council of Economic Advisers, Dr. Mussa taught and studied at the University of Chicago for something like more than 15 years.

Michael Mussa: Between studying and teaching—about 20 years actually.

Steve Weisman: The University of Chicago magazine has a cover story: “Is the Chicago School Thinking to Blame?” That is, to blame for the crisis. What is meant by that question?

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Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.    

Trade and environment intersect in many ways. Aside from the broad debate as to whether economic growth and trade adversely affect the environment, there are linkages between existing rules of the World Trade Organization (WTO) and rules established in various multilateral environmental agreements. Controlling greenhouse gas emissions promises to be a top priority for both national and international agendas, and special attention must be given to the relationship between the WTO and the emerging international regime on climate change. This working paper examines the nexus of the WTO and climate change and discusses challenges and options.

Read Full Analysis

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.   

Nicholas R. Lardy, analyzing the origins of the dispute with China over tire imports, warns that the fight could imperil future US-China economic and political cooperation.

Recorded September 14, 2009. © Peterson Institute for International Economics.

Steve Weisman: This is Steve Weisman at the Peterson Institute for International Economics. Nicholas Lardy, senior fellow at the Institute and coauthor of China’s Rise: Challenges and Opportunities, is here to discuss an eruption of trade frictions between the United States and China. Thanks for joining me, Nick.

Nicholas R. Lardy: Thank you, Steve.

Steve Weisman: The trade dispute has occurred over an American move to impose duties on imported Chinese tires. China is threatening to retaliate on poultry and vehicles. How serious is this dispute?

Nicholas R. Lardy: It’s potentially very serious. So far, we’re in the early stages and the amount of product covered is not large and it’s possible the two sides will be able to manage this, to contain it. But there’s also a chance it could expand dramatically and become quite significant. I think it will have political repercussions, regardless of whether or not it expands to cover more products.

Steve Weisman: In what sense?

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Testimony before the Subcommittee on Asia, the Pacific and the Global Environment, Committee on Foreign Affairs, US House of Representatives September 10, 2009

The Policy Context

The United States and China are the two most important national economies in the world:

• China will shortly pass Japan to become the world's second largest economy behind the United States;

• the two together accounted for almost one half of all global growth during the four-year boom prior to the crisis;

• they are the two largest trading nations;

• they are the two largest polluters;

• they are on opposite ends of the world's largest trade and financial imbalance: the United States is the largest deficit and debtor country while China is the largest surplus country and holder of dollar reserves; and

• they are the leaders of the two groups, the high-income industrialized countries and the emerging markets/developing nations, that each now account for about one half of global output.

It is clear that effective international policy coordination requires the closest possible cooperation between the United States and China. The two countries do not have to agree on every issue, let alone pursue identical policies. But they must be willing and able to work constructively together, in terms of the domestic politics of each as well as their direct diplomatic contacts, if enough agreement is to ensue to permit progress across the entire spectrum of crucial international economic issues—ranging from recovery from the current crisis to creating a new global regime to counter global warming. Their relationship must therefore focus increasingly on the wide range of global economic issues for which they bear systemic responsibility rather than the bilateral frictions that have traditionally been its centerpiece.

In anticipation of these conditions, I proposed five years ago that the United States and China work toward the creation of an informal G-2 that could provide effective joint leadership of the world economy.¹ The idea was, and is, to develop a close working relationship between them that would supplement (not supplant) the existing steering committees, including the G-7/8 and the newly dominant G-20, and the multilateral institutions (notably the IMF and WTO). The overriding goal is to make those institutions function more effectively and thus strengthen the world economy.

My assessment of the initial meeting of the Strategic and Economic Dialogue (S&ED), and of its future prospects, is thus governed largely by an assessment of whether it is helping to create such a G-2. Viewed as a further extension of the earlier Senior Dialogue and Strategic Economic Dialogue (SED), I believe that the S&ED is indeed moving in that direction and holds considerable promise for continuing to do so. I thus strongly endorse the administration's initiative, praise the Chinese for their active participation in the process, and offer a few suggestions for how it can best be used to achieve the desired outcome.

The Conceptual Framework

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Op-Ed in the Moscow Times

Do you remember the Kremlin hubris of the summer of 2008? Forget it! The ruble cannot possibly become a reserve currency for the next half-century. To become a major financial center, Moscow needs many years of serious reforms not even contemplated today.

In June 2008, Prime Minister Vladimir Putin proclaimed, "We have no crisis." Also President Dmitry Medvedev thought that Russia would escape the crisis and said, "Russia has not yet carried out a number of reforms...and has thereby managed to avoid some serious mistakes."

Medvedev's speech to the St. Petersburg International Economic Forum on June 7, 2008, marked the peak of hubris. "We have set ourselves the not very easy goal of setting Russia on an innovative development track and becoming one of the world's five biggest economies by 2020," he said. "The transformation of Moscow into a powerful financial center and the transformation of the ruble into one of the leading regional reserve currencies are the key ingredients to ensure the competitiveness of our financial system." Dreams can be useful if they help people doing the right things, but these mirages were a pure distraction.

Crises offer solid reality tests. This year, the Russian government predicts a GDP slump of an astounding 8.5 percent. Medvedev acknowledged the poor performance of the Russian economy in his web article of September 10, in which he asked, "Should we drag ourselves also into the future with a primitive economy based on raw materials and endemic corruption?" After one year, not one single reform has been accomplished, although crises usually render necessary reforms politically possible.

Berkeley professor Barry Eichengreen is the foremost researcher of reserve currencies and his conclusions are unequivocal. In the last two centuries, the world has seen three significant reserve currencies. The pound sterling dominated in the 19th century. In the course of half a century, the US dollar gradually overtook sterling. In the last decade, the euro has emerged with 27 percent of global currency reserves, while the dollar still holds two-thirds. Sterling and yen account for 3 to 4 percent each, leaving less than 1 percent for other currencies.

The real question is whether the dollar will disqualify itself as a reserve currency and give way to the euro, or possibly the Chinese renminbi in a few decades. But the ruble hardly complies with any of the arduous demands for a reserve currency, having become convertible as late as July 2006.

First, a reserve currency must be characterized by low inflation and macroeconomic stability, but Russia has had persistent double-digit inflation. A reserve currency should preferably have a stable or rising exchange rate. At least, it should be freely floating. Yet the ruble exchange rate policy remains erratic.

Second, only the world's biggest economies can produce a global reserve currency. Both the US economy and the eurozone are still 10 times larger than the Russian economy, which comprises just 2 to 2.5 percent of global GDP. Even the Chinese economy is about three times larger than Russia's at current exchange rates.

Third, a reserve currency country must have great financial depth, which is skin-deep in Russia. Its market capitalization is only a few percent of the U.S. level, and the free float is minimal because of the dominance of state ownership. The ruble bond market barely exists. The Russian banking system is politicized and therefore dysfunctional, with a handful of state banks holding almost half of all banking assets.

Fourth, a good regulatory framework and strong rule of law must prevail. Russia has plenty of good financial legislation from the 1990s, but serious lapses persist, such as a poor bankruptcy law, which facilitates corporate raiding. Worse, the courts are politicized, which undermines property rights to the benefit of vested interests. Worst, however, is that security agencies are allowed to carry out arbitrary interventions and confiscate large corporations to the benefit of related private interests.

Russia ranks 147 on the Transparency International Corruption Perception Index and 120 in the World Bank Doing Business Index of some 180 countries. Doing Business rates Russia at 161 with regard to ease to trade across borders. Who would voluntarily transfer money for safekeeping into such an unsafe country?

A fifth criterion of a reserve currency is what economists call network externalities, which include various international uses, for example, for pricing, invoicing, or transactions outside the country. But the ruble is not used for any purpose outside of Russia. The hyperinflationary ruble zone that collapsed in 1993 remains a bitter memory. Repeated Russian attempts to revive it have only aroused bad blood.

Businessmen in neighboring countries prefer to launch their initial public offerings on the stock exchanges in London, Frankfurt, or Warsaw while all abhor Moscow. So do Russian businessmen, who predominantly favor London. If a state cannot attract its own businessmen to its stock markets, it has a serious reputation problem. If few Russian businessmen desire ruble bonds, why should foreigners embrace them? No country has pegged its currency to the ruble because it is too unstable and poorly managed.

Finally, the power of incumbency of a reserve currency is as great as inertia is monumental. My boss Fred Bergsten has pointed out that the dollar survived even three years of double-digit inflation around 1980 as the dominant reserve currency because it had no competition.

Today, the euro has become a realistic alternative to the dollar, and the renminbi might eventually do so, if China changes many policies. But the ruble is disqualified on all accounts. No preconditions exist for it to become a reserve currency.

Nor would it be beneficial for Russia if the ruble became a reserve currency, because higher demand for the ruble would drive up its exchange rates and reduce Russia's competitiveness. For such reasons, Japan, Germany, and Switzerland have actively opposed their currencies being used in national reserves, and the European Union remains skeptical.

Thus, to make the ruble a reserve currency is no priority for Russia. Nor is it possible or even beneficial. This topic is little but mythmaking for dedicated Kremlin bureaucrats. Russia needs to focus on control of its pervasive corruption and harmful state companies as well as the curtailment of corporate raiding. But real debates are less pleasant.

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