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World Economic and Financial Surveys

WORLD ECONOMIC OUTLOOK SUPPORTING STUDIES

International Monetary Fund 2000


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CONTENTS

Preface

Chapter I. Globalization and Growth in the Twentieth Century

Nicholas Cmfts

What Has Twentieth Century Economic Growth Delivered? Globalization Then and Now An End-of-the-Century Perspective References

Chapter II. The International Monetary System in the (Very) Long Run

Barry Eichengreen and Nathan Sussman

Early Monetary Arrangements: Private Money Monetary Stability and Monetary Integration Rise of the State: Monetary Sovereignty The Political Economy of Inflation The International Monetary Landscape Paper Money: Beginnings The Nineteenth Century System Stability of the Gold Standard End of the Gold Standard Rebirth of the Gold Standard? Demise of Bretton Woods Recent Developments in Millennia! Perspective References

Chapter Ill. Currency Crises: In Search of Common Elements

Jahangir Aziz, Francesco Cammazza, and Rani[ Salgado

Identifying Crises: Methodology and Data The Correlates of Financial Crises The Macroeconomy Before a Crisis Outcomes of Crises Costs of Crises Conclusions Appendix 3.1. Banking Crises References

Chapter IV. Business Cycle Influences on Exchange Rates: Survey and Evidence

Ronald MacDonald and Phillip Swagel

Exchange Rate Models: Some Scaffolding and an Overview A Review of the Empirical Evidence

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iv

CONTENTS

New Empirical Evidence Conclusions References

Chapter V. The Great Contractions in Russia, the Baltics, and the Other Countries of the Former Soviet Union: A View from the Supply Side

Mark De Broeck and Vincent Koen

Background Considerations Selected Stylized Features Inputs and Outputs: Contraction Accounting Sectoral Reallocation Conclusions Appendix 5.1. Data Description Appendix 5.2. Alternative Summary Statistics for Aggregate Output References

Chapter VI. EMU Challenges to European labor Markets

R·udiger Soltwedel, Dirk Dohse, Christiane Krieger-Boden, and the IMF Research Department

The Optimum Currency Area Criteria The Regional Perspective Enlarging Institutional and Regional Diversity Conclusions References

Tables

l . l . The Human Development Index and Its Components: Long-Run Estimates 1.2. The Human Development Index and Its Components in the Recent Past 1.3. Catching Up and Falling Behind 1.4. Weighted Averages of HDJ 1.5. Growth Rates of Real GDP per Person 1.6. Growth Rates Acljusted for Hours Worked and Mortality 1.7. Annual Hours Worked per Head of Population 1.8. Growth Accounting: Comparisons of Sources of Growth 1.9. Ratios of Merchandise Exports to GOP and to Merchandise Value-Added

1.10. Composition of\1\lorld Merchandise Trade 1.11. Foreign Investment 1.12. Barriers to Trade: Average Tariffs on Manufactures and Import Coverage of 1.13. Immigration to the United States 1.14. The Structure of Employment in Five Leading Economies, 1900-95

l.l5. Sectoral Productivity Growth Rates, 1950-95

1.16. Government Expenditures/GOP, 1870-1998

1.17. Compatisons of Institutional Quality

3.1. Costs of Crises in Lost Output Relative to Trend

4.1. Cointegration Results for the Monetary Model 4.2. Estimates of the Real Exchange Rate-Real Interest Rate Relationship

TBs

142

156

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163

166

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199

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207

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8

9

9

II

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135

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CONTENTS

4.3. Permanent and Transitory Variance Ratios for the Real Exchange Rate 139 4.4. Business Cycle Components of Real Exchange Rates and Real Interest Rate Differentials 151 4.5. Variance Decompositions for the Real E-xchange Rate from the Structural VAR 152

5.1. Contraction Length 164

5.2. Contraction Depth 165

5.3. Depth of the Contractions in Industrial Omput 166

5.4. Length of the Con tractions in Industrial Output 167

5.5. Fall in Industrial Output Across Regions During the First Half of the 1990s 168

5.6. Output and TFP Growth, Period Averages 169 5.7. Contribution of Sectoral Reallocation to TFP Growth 171

5.8. Total Employment Shifts 172

5.9. Total Investment Shifts 173

5.10. Industrial Employment Shifts 173 5.11. Industrial Investment Shifts 174 5.12. Yearly TFP Growth Rates 176

5.13. Cumulative Decline in Measured Real GDP and Electricity Consumption 178

6.1. Coefficients of Specialization in Manufacture, EU Countries, 1980-93 191

6.2. Total and Structural Unemployment in EU Member Countries, 1997 193

6.3. Monetary Union and Labor Market Risks for EU Countries 194

6.4. EU Regions with the Highest/Lowest Unemployment Rates, April 1997 194

6.5. EU Regions with the Highest/Lowest Yolllh Unemployment Rates, April 1997 195 6.6. Unemployment Disparities by Region 1985, 1990, 1995-97 196

6.7. Persistence of Regional Unemploymem Differentials: Rank-Order Correlations,

1985-97 197 6.8. Italian Mezzogiorno and East Germany Compared, 1995 198

6.9. Labor Costs and Labor Productivity Relative to the Rest of the Country 199

Figures

2.1. Percentage of Countries with Fiat Currencies, 1870-1998

2.2. Debasement Minting, Dauphine, 1417-22

2.3. Value of English Currency and the Price Level, 1265-1500

2.4. Value of Silver Currency in Terms of Gold Florin

2.5. Restrictions on Capital Account

2.6. Percentage of Countries with Pegged Exchange Rates, 1870-1988

3.1. Incidence of Currency Crises

3.2. Real Effective Exchange Rates

3.3. Export Growth

3.4. Trade Balance

3.5. Terms of Trade

3.6. Inflation

3.7. Nominal M l Growth

3.8. Nominal M2 Growth

3.9. ominal Domestic Credit Growth

3.10. Real M l Growth

3.11. Real M2 Growth

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CONTENTS

3.12. Real Domestic Credit Growth 107

3.13. Real Interest Rate 108

3.14. Change in Real Stock Prices 110

3.15. Change in Stock Prices (Valued in Foreign Currency) 111

3.16. Change in Foreign Reserves 112

3.17. M2-to-Reserves Ratio 113

3.18. Change in M2-to-Ml Ratio 115

3.19. Output Growth 116

3.20. World Real Interest Rate 117

3.21. Change in the Unemployment Rate 118

3.22. Current Account Balance 119

3.23. Fiscal Balance 120

3.24. Short Term Capital 1n11ows 122

4.1. Germany: Real Bilateral Exchange Rate and Interest Rate 143

4.2. Japan: Real Bilateral Exchange Rate and Interest Rate 143

4.3. United Kingdom: Real Dollar Exchange Rate and Interest Rate Differential 144

4.4. Germany: Real Effective Exchange Rate and Interest Rate Differential 145

4.5. Japan: Real Effective Exchange Rate and Interest Rate DilTerential 145

4.6. United Kingdom: Real Effective Exchange Rate and Interest Rate Differential 146

4.7. United States: Real Effective Exchange Rate and Interest Rate Differential 146

4.8. Germany: Band-Pass Filter of Real Bilateral Exchange Rate and Interest Rate Differential 147

4.9.Japan: Band-Pass Filter of Real Bilateral Exchange Rate and Interest Rate Differential 148

4.10. United Kingdom: Band-Pass Filter of Real Bilateral Exchange Rate and Interest Rate

Differential 148

4.11. Germany: Band-Pass Filter of Real Effective Exchange Rate and Interest Rate Differen tiaJ 149

4.12. Japan: Band-Pass Filter of Real Effective Exchange Rate and Interest Rate Differential 149

4.13. United Kingdom: Band-Pass Filter of Real Effective Exchange Rate and Interest Rate Differential 150

4. 14. United States: Band-Pass Filter of Real Effective Exchange Rate and Interest

Rate Differential 150

4.15. Real Bilateral Exchange Rate: Response to Shocks 153

4.16. Structtu·al VAR: Real Bilateral Exchange Rate 154

4.17. Response of Real Effective Exchange Rate to Shocks 155

4.18. Real Effective Exchange Rate 156

5.1. Finland: Real GDP and Overall Electricity Consumption 179

5.2. Finland: Real GDP and Total Freight Turnover 180

5.3. Finland: Real GDP and Mail 181

6.1. Integration, Specialization, and Asymmetric Shocks 190

6.2. Determination of Labor Market Flexibility 19�

Boxes

1.1. Measuring Long-Run Growth in Living Standards

1.2. Financial Crisis in 1930s America 1.3. Computers and Productivity Growth

3 29

33


2.1. Financial Crises: Continuity and Change

2.2. Monetary Developments Beyond Europe 2.3. The Future of the International Monetary System

6.1. Exchange Rates as Shock Absorbers: Italy and Finland

6.2. Euro Area's Most Prominent Problem Regions

6.3. Trends in Business Organization

The following symbols have been used throughout this volume:

to indicate that dat a are not available;

to indicate that the figure is zero or less than half the final digit shown, or that the ite m does n ot exist; between years or months ( for example, 1997-99 or J anuary-June) to indicate the years or months covered, including the beginning and ending years or months;

between years (for example, 1998/99) to indicate a fiscal or financial year.

"Billion" means a thousand million; "trillion" means a thous and billion.

"Basis points" refer to hundredths of I percentage point (for example, 25 ba sis points are equivalent to \1.1 of l percentage poin t).

"n.a." means not applicable.

Minor discrepancies between constituent figures and tot als are due to rounding.

As used in this volume the term "country" does n ot in all cases refer to a territorial entity that is a state as understood by international Jaw and practice. As used here, the tenn also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis.

C ONTENTS

54 55

82

186

188 200

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PREFACE

Supporting Studies for the World Eronomic Outlook contains background analyses for the World Economic

Outlook exercise carried out by staff in the IMF's Research DepartmenL and by visiting scholars. The

May 2000 World Economic OutlcJok editions for which these papers were prepared were directed by Flemming Larsen, former Deputy Direcwr of the Research Department, together with Graham Hacche and Tamim Bayoumi, former and current Chiefs of the World Economic Studies Division.

The papers have benefited from comments by colleagues throughout the TMF and, in some cases, by

the IMF's Executive Directors. However, the views presented in the papers are those of the authors and

should not be interpreted as representing the views of the Internalional Monetary Fund. The authors

would like to thank Gretchen Byrne and Toh Kuan for research assis1.ance and Lisa Nugent., Marlene

George, Patricia Medina, and ]emilie Tumang for word processing. James McEuen and Jeanette

Morrison of the External Relations Department edited the manuscripts and coordinated production of the publicalion.

ix


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GLOBALIZATION AND GROWTH IN THE TWENTIETH CENTURY Nicholas Crafts

This chapter reviews the experience of

economic growth during the twentieth

century in the context of trends in glob

alization and with a view to highlighting

implications relevant to early twenty-first century

policymakers. The first section provides a de

scriptive analysis of trends in growth and living

standards during the century, which highlights

differences between periods and across coun

tries. The next section looks at the rollercoaster

progress of globalization both in trade and capi

tal flows since the late nineteenth century, with

particular emphasis on explanations for the pro

longed reverse w globalization from the back

lash of the interwar years. The final section uses

the building blocks of the earlier analysis w pro

vide an end-of-century perspective on growth

prospects and the extent to which they are likely

to be:: enhanced by improved policies, technolog

ical progress, and globalization.

The first section presents a basic quantifica

tion of growth during the twentieth century

dra\ving on the economic history literature. The

ccnu·al themes that emerge include the massive

and unprecedented divergence in income levels

and growth performance across countries, espe

cially between the OECD and many developing

countries in both the first and second halves of

the century. The consequences in terms of in

come forgone of poor policy and/or inadequate

institutions were much more serious than in ear

lier centuries. evenheless, a g1·eat deal of

progress has been made everywhere in terms of

the Human Development Index (see UNDP,

1998), and the spectacular improvements in

mortality that have taken place are a major rea

son to believe that historical national income ac

counts tend to underestimate growth in living

standards. The contribution of technological

progress to economic growth both in the ad

vanced and the developing world has varied sub

stantially over time for reasons that are not fully

understood either by growth theorists or eco

nomic historians.

The second section spells out what is known

about the dimensions of globalization over time.

In many respects, the information is patchy, but

a clear pattern emerges of increases in trade

flows and stocks of capital assets relative to levels

of CDP before World War I and in recent

decades, with the opposite characterizing the

1920s through the 1950s. Many aspects of the

current situation are shown to be unprece

dented, driven not only by changes in technol

ogy but also in economic policy. The retreat of

globalization in the interwar period was, of

course, driven by policy not technology and was,

in large part, a response to the Great

Depression. A review of recent historical re

search concludes that a combination of macro

economic policy errors and structural faults in

bankjng systems and labor markets rather than

globalization per se provoked the slump.

ln the final section the historical experience is

linked to insights from modern applied growth

economics to examine growth potential after the

liberalization and globalization of the recent

past. It is argued that globalization itself could be

subject to a renewed backlash either, as in the

1930s, in the event of a major world recession or

in a new context of the impossibility of govern

ments continuing to meet increased demands for

economic security in a world of severe tax com

petition. In a less apocalyptic scenario, the im

pact of globalization on fiscal policy could ad

dress some of the growth-inhibiting effects of the

late t:wemieth century expansion of the public

sector in OECD Europe. Prospects for catch-up

growth and an escape from the divergence in in

comes that has characterized the twentieth cen

tury are argued to depend very largely on pol

icy/institutional reform in the developing world

to reduce problems of agency costs, rent-seeking,

asymmetric information, and opportunism,


2

CHAPTER I GLOBALIZATION AND GROWTH IN THE TWENTIETH CENTURY

thereby facilitating financial development, invest

ment, and innovation. The present policy con

sensus in favor of markets and outward orienta

tion in the developing world potentially

represents a significant improvement from the

state-led industJ·ialization stance that was preva

lent 25 years ago, but the political economy of

supply-side policy is central to further progress

yet little understood. Despite the confidence of

many stock market players, long-run growth

prospects for the United States are particularly

hard to predict, both because theory suggests

that they depend crucially on scale effects in in

novation on which the jury is still out, and also

because at this point of history it t·emains unclear

whether the information and communications

technology revolution will eventually deliver a

major boost to total factor productivity equiva

lent or superior to that of the era of electricity.

What Has Twentieth Century Economic Growth Delivered?

Since World War U, trend growth of real GDP

per person has become a key policy objective in

virtually all counu·ies. This is not surpt·ising since

it is usually thought to be central to raising living

standards and because, despite doubts raised by

economic theorists, it is generally believed that

government policy can influence long-run

growth outcomes. The twentieth century has

seen unprecedented economic growth in many

parts of the world, but the benefits of growth

have often been quite unequally distributed

both between and within countries, and growth

rates have exhibited considerable vat;ation over

time. Moreover, it is now frequently suggested

that GDP growtl1 is a poor, or perhaps quite mis

leading, indicator of changing well-being and,

even within the national accounts framework, it

has become widely accepted that important

measurement issues have to be addressed, partic

ularly when considering the long run.

In this section, experience of economic

growth in me twentieth century is assessed born

in terms of its impact on standards of Jiving and

also with a view to extracting the lessons mat it

can offer on why growth rates differ. Two ques

tions are of central concern:

• What has been the relationship between

economic growth and changes in living

standards?

• What explains me uneven pace and spread

of economic growth ?

The renaissance of research in growth eco

nomics since the mid-1980s makes iliis a good

time to conduct such a survey. So also does the

proliteration of alternatives to national income

accounting for the measurement of standards of

living (Box 1.1). In addition, however, the end

century vantage point suggests answers to these

questions that are somewhat different from ear

lier conventional wisdom simply as a result of re

cent economic history.

Trends in the Human Development Index

One of the most widely discussed measures of

the impact of economic development on well

being is the Human Development Index (l-ID I).

This has been designed to facilitate long-run

comparisons and is a measure of tl1e distance

traveled from minimwn ro maximum develop

ment in tet·ms of iliree components: education,

income, and longevity (see Box 1.1). The focus

of HDI is on the escape from poverty. Human

development is regarded as a process of expand

ing people's choices; income is assumed to im

pact on tl1is primarily at low levels of material

well-being and, above a threshold level, is consid

ered to make a sharply diminishing contribu

tion, eventually tailing off to nothing. Life ex

pectancy and education are taken to be cenu·al

to tl1e enhancement of human capabilities but

not generally dependent on private income,

given tl1e important role that public services usu

ally play in these aspects.

"Vhile, as noted in Box 1.1, there are serious

index number problems associated with the

HDI, it offers an important perspective on

changing living standards to be considered to

geilier wiili me evidence on growili in real GDP

per person. UNDP (1998) provides estimates

only for me period since 1960, but it is possible


WHAT HAS TWENTIETH CENTURY ECONOMIC GROWTH DELIVERED?

Box 1.1. Measuring long-Run Growth in living Standards

Both development economists and economic

historians have become increasingly concerned

to develop measures of li\ing standards that are

more comprehensive than real wages or real

GOP per head. Partly, this is because attention

has increasingly turned to the lives that people

lead rather than the incomes that the} enjo)

and partly because in most circumstances a sub

stantial element of well-being is derived not on

the basis of personal command over resources

but depends on provision by the state--this

tends to be true of health and education in

many countries and is universally the case for

civil and political rights.

Unfortunately. in any attempt to quantif)

changes in a comprehcnsive concept of lhing

standards, index number problems are liable to

be acute, since weights ha\e to be developed for

the various components of a broad concept of

economic welfare. In addition, some important

aspects of well-being may not lend themselves

readily to cardinal measurement.

The Human Development Index (HDI) has

been described and refined in successi\'e issue�

of the Uml£d fo\atumJ DfVflopmml Program's Human Det>tlqpmnlf RL>port. Its focus is the �ape

from poverty, and this is seen a'> depending on

public service� as well as private incomes. The

HDI is a compo�ite of three basic components:

longevity measured by life expectancy at birth

(e0), knowledge measured by a weighted average

of literacy ( U1) and school enrollment

(ENROL). and income ( �'dJ). Human develop

ment is seen a� a procec;s of expanding people\

choices. The componcn� are combined in a sin

gle index by mea,uring them in terms of the di�

tance traveled between the minimum and maxi

mum values ever observed and averaging t.hese

scores into one index. The HDl has been quite

controversial, and a useful extended review of

various criticisms is provided in a technical note

in the 1993 1/umrm Df!Jrlopmml RRport. The precise formula for the version of HOI

used in this paper was adopted by UNDP to ftx the maxima and minima as the most extreme

values observed or expected over a long period

with a view to facilitating histOrical comparisons.

h is as follows:

Life Expectancy ( L) = ( 'o -25) I (85 - 25) Schooling (S) = 0.67 UT + 0.33ENROL Income (I) = ( Y .WJ- 200) I (5385 -200) Each of these componen� ha� a value be-

tween 0 and 1, as does HOI= (L + S + 1)13. Adjusted income is measured b) the following

formula, which heavily di�count.s income above

the threshold level, i' = 5120 CS1990int):

t-:l(lj = y" t 2[ (y -/) l/2) f(u y' < ) < 2i

YadJ = i + 2[(y-'f) l!:Z) +3[(y-2y")1 'J tor2y'<y<3l

and � on. $5,385 i� an approximate ma.ximum

for this formula.

There are problems in using 1101 as a meas

ure of economic welfare. In common \vith

heights, the approach runs into difficulties with

weighting. It is possible in this case to calculate

the implicit set of weighL\ that it embodies, but

when this is done their justification is obscure,

they vary dramatically at diflerent income levels,

and they are quite sensitive to the choice of ex

treme values. The very low wetght given to in

come above an arbitr<�ry threshold level is par

ticular)> hard for man) commentators to accept

(Gormcly, 1995). Moreo,er. if the basic ration

ale of the index stems ft·om a concern with capa

bilities and with the impact of social at-range

mcnts, then the coverage of liD I might well be

rt·garded as too narrow. Despite these reserva

tions about HDI, it may be valuable in historical

research (Costa and Steckel, 1997). Dasgupta and Weale ( 1992) stre'' that the

HOI ignores other important aspects of well

being that depend on sLate pro.,.ision rather

than private income. In particular, they argue

for the inclusion of civil and political rights in a

more comprehensive Quality of Life Index.

Usher ( 1980) provides a detailed r-ationale for

making imputations to growU1 r-ates for environ

mental changes--i.e., for variables that con

tribute to welfare but are not commonly re

garded as part of income where the average

amount enjoyed � changing over time.

3


4


Box 1.1 (concluded)

Pollution, crime, life expectancy, and leisure are potentially important examples. Improvements in environmental variables yield a positive imputation to growth rates.

Real income ( Y*) in )Car 0, the income that makes the representative agent as weU off in the base year as \\ith the average income in year tis defined implicitly in the equation

U(Y*, po, eO)= U( )'1, p•, t1)

where pis an index of prices and tan index of environmental conditions. Tltis can be approximated as

that is, real income in year t with respect to the base year is the value at base year prices of total commodities consumed in the year t plus the change in environmental conditions from the base year to year t e,�aluated at the shadow

prices of the base year. In the case where only

leisure is considered a.<, an environmental variable, Usher suggc�ts the formula

Y*= }'l + w1(L1- LO)

where w is the real wage rate in year t. Nordhaus and Tobin (1972) found that their

attempt ro estimate the long-nm rate of growth

of Measurable Economic Welfare (MEW) for the United States w� totally dominated by adjustments for leLmre or nonmarket work time. This is noteworthy for three reasons. First, leisure ha.� been ignored in all the recent work on living �tandard�. Second, how be. t to handle time use

in measuring living standards is highly controversial; while Usher ( 1980) argued that it is best treated as an environmental variable, he recognized that others might prefer to see it as a regular commodity, in which case the total value of hours not spent in market work needs to be added to income. The environmental assumption valuing change� tend to raise measured growth rates for OECO countries while the commoditv assumption tends to do the opposite un-

less leisure time is assumed to have increasing productivity. Third, an a.�sumption needs to be made whether there is technological progress in the enjoyment of leisure or the performance of non market work. This case is re,'iewed graphlcallv in Crafts (1997b).

The adjustment to real GOP growth suggested by Usher (1980) for changes in monality is as follows

b.QIQ= b.Y/Y+ (b.£/E)/13 (1) where Q is GOP adjusted for mortality changes,

E is an age-structure weighted average of discounted life ex-pectancies, and 13 is the elasticity

of annual utility \vith respect to annual con

sumption. In this formula an increase in mortal

ity is treated as a completely exogenous change

in the consumers' environment that cannot be

bought but for which a price would willing!) be

paid. A more general formulation suggested by

Williamson ( 1984) for usc in historical circum

stances where, for e-xample, nutritional improve

ments may be part of the stOry is

(2)

where z is the proportion of mortaJity change taken to be exogenous. Tl1is ver ion b ltsed to produce the imputations for mortality reported in Table 1.4.

Instead of looking at current flows of income, the sustainability of consumption may be of concern. The standard national accounting concept of relevance here is net national product (N1\rp) per person, which can be thought of as what is available to consume while maintaining capital intact. It is widely recogniLed that this will exag

gerate sustainable consumption if there is unmeasured depletion of natural reoources capital, which is an input to production. It is less widely recognized that NNP is an underestimate of sustainable consumption for an economy that experiences technological progress. In this case,

an estimate of the present value of technological improvements should be added to P and this correction b likely to be much the bigger of the two ( 'ordbaus, 1995).


NNP can be thought of as the annuity equivalent of future consumption. Weitzman (1999) notes that this is calculated as if the present consumption of exhaustible resources will be available indefinitely at mday's real extraction cost, whereas in fact conventional NNP includes an element that is a form of temporary income based on the use of a finite stock that can be measured in principle as (price minus marginal extraction cost} times resource use. This amount expressed as a percentage of NNP represents the required correction.

The implications of future technological progress for sustainable consumption should

to extend this back to 1950 for many countries

and earlier than that for a few cases. These long

run HDI estimates, reported in Table 1.1, pro

vide a comparative context in which to place re

cent Third World development and, taken

together, Tables 1.1 and 1.2 offer a different an

gle on divergence between the First and Third

Worlds from that which emerges from historical

national accounting.

Using these tables, comparisons across coun

tries can be made both of levels of HDJ and also

of the speed of reduction in the distance from

maximum development in different eras. In ad

dition, HDI gaps between advanced and devel

oping countries can be considered. There are, of

course, data problems, but the broad outlines of

the estimates in Tables 1.1 and 1.2 are robust

enough for present purposes (Crafts, 1997a).

The coverage of the tables is determined by data

availability.

The most striking feature of these tables is

that the 1995 HDI scores for poor developing

countries in Table 1.2 are well ahead of the 1870

scores for the leading countries of that time

shown in Table 1.1. Australia's score of 0.539 in

1870 would rank 127th in the world in 1995.

Conversely, Mozambique's 1995 score of 0.281

(166th in the world) is distinctly above the levels

achieved in some parts of Europe (for example,


also be recognized. TFP growth will raise production and thus consumption possibilities. If the average since 1950 were used as a projection for future TFP growth in the United States, then this would raise the annuity equivalent of future consumption to about40 percent above NNP (Weitzman, 1999). This suggests that the ntture productivity of R&D expenditures is critical and that the decline in TFP growth in the last quarter of the twentieth century may well have a big

ger impact on estimates of sustainable consumption than imminent exhaustion of raw materials supplies.

ll:aly and Spain) in 1870. At the same time, as

suming that the HDI score of 0.055 for India in

1913 represents the lowest level, the absolute

HDI gap of 0. 775 in 1995 between the best and

worst in the world (UNDP, 1998) is slightly big

ger than Ln 1913. Since 1950, however, there has

been a substantial fall in the gap between aver

age HDI in Africa and in the advanced counu·ies

of western Europe, Nonh Ameiica, and

Oceania-from 0.608 to 0.391.

Looking at the components of HDl, the low

level of life expectancy at birth (e0) in leading

countries in 1870 is apparent witl1 the highest

figure at only 49.3 years, a level that has now

been exceeded by almost all counu·ies.

Research in historical demography long ago

confirmed that, during the twentieth cenrury,

improvements in mortality resulting from ad

vances in medical science and public health

measur·es have been largely independent of

changes in real income (Preston, 1975). The

levels of life expectancy (and HDI) now en

joyed by countries like Algeria and Tunisia were

simply not attainable in 1870 for any country

given the state of medical technology. By con

trast, levels of literacy, which in 1950 were still

very low in much of Africa and India. still com

pare unfavorably in many cases with tl1e leading

countries of 1870.

5


6


Table 1.1. The Human Development Index (HOI) and Its Components: Long-Run Estimates

1870

GOP/ GOP/ Head HOI Head

Austria 1,875 0.261 3,488 Belgium 2,640 0.429 4,130 Denmark 1,927 0.448 3,764 Finland 1,107 0.151 2,050 France 1,858 0.400 3,452 Germany 1,913 0.397 3,833 Ireland 1,773 2,733 Italy 1,467 0.187 2,507 Netherlands 2,640 0.450 3,950 Norway 1,416 0.374 2,473 Spain 1,376 0.219 2,255 Sweden 1,664 0.412 3,096 Switzerland 2,172 0.457 4,207 United Kingdom 3,263 0.496 5,032

Australia 3,801 0.539 5,505 Canada 1,620 0.411 4,213 New Zealand 3,115 5,178 United States 2,468 0.467 5,330

Argentina 1,311 3,797 Brazil 740 839 Chile 2,653 Mexico 710 1,467

India 558 663 Japan 741 0.160 1,334

Bulgaria 1,498 Czech Republic 1,164 2,096 Hungary 1,269 2,098 Russia 1,023 1,488

The levels of real GDP per person of many countries in 1990 reported in Table 1.2 were still well below those already attained by the leaders of 1870 shown in Table 1.1. Thus, the average of $1,336 for Africa (Maddison, 1995, p. 228) is below the median of $1,894 for the countries of western Europe, North America, and Oceania in 1870. The level of real GDP per person in 1870

of $480 in Africa (Maddison, 1995, p. 228) was about an eighth of the leading country. In 1990,

however, the African level was only about onesixteenth of the leading cou.!)try. The gap between rich and poor measured in these terms has widened enormously or, as one author recently put it, the central feature of growtl1 as measured by the national accounts is "divergence, big time" (Pritchett, 1997).

1913 1950 1996 GOP/ GOP/ 1995

HOI Head HOI Head HOI

0.501 3,731 0.731 17,951 0.933 0.621 5,346 0.833 17,756 0.933 0.677 6,683 0.857 19,803 0.928 0.389 4,131 0.740 15,864 0.942 0.611 5,221 0.818 18,207 0.946 0.632 4,281 0.787 19,622 0.925 0.563 3,518 0.736 15,820 0.930 0.441 3,425 0.666 16,814 0.922 0.676 5,850 0.867 18,504 0.941 0.588 5,403 0.862 22,256 0.943 0.368 2,397 0.581 13,132 0.935 0.628 6,738 0.858 17,566 0.936 0.679 8,939 0.843 20,252 0.930 0.730 6,847 0.844 17,326 0.932

0.781 7,218 0.853 18,169 0.932 0.682 7,047 0.842 19,109 0.960 0.797 8,495 0.868 15,621 0.939 0.733 9.617 0.866 23,719 0.943

0.521 4,987 0.758 8,271 0.888 0.159 1,673 0.371 5,346 0.809 0.360 3,827 0.620 9,250 0.893 0.182 2,085 0.418 4,979 0.855

0.055 597 0.160 1,643 0.451 0.381 1,873 0.607 19,582 0.940

0.332 1,651 0.540 4,301 0.789 0.471 3,501 0.713 7,595 0.884 0.431 2,480 0.634 5,852 0.857 0.252 2,834 0.651 4,120 0.769

In order to fill out this point, Table 1.3 considers catching up and falling behind in real GDP /person in terms of regional aggregates. Over the long run since 1870, the most marked and sustained relative declines have been in Africa and in eastern Europe, areas which account for about 20 percent of the world's population in most of this period. Latin America, then a very small fraction of total world population, improved its relative position during the globalization episode prior to World War I but has subsequently lost some ground relative to tl1e United States. Prior to 1950, however, the most important aspect of divergence was the big decline in real GDP /person in Asia, which accounted for well over half the world's population, relative to the leading country. According



1 870 1913 1950 1955

eo Literacy eo Literacy eo Literacy eo literacy

Austria 31.7 40 42.2 66 65.7 99 76.7 99 Belgium 40.0 66 49.6 86 67.5 97 76.9 99 Denmark 45.5 81 57.7 99 71.0 99 75.3 99 Finland 36.5 1 0 46.2 59 66.3 90 76.4 99 France 42.0 69 50.4 92 66.5 96 78.7 99 Germany 36.2 80 49.0 97 67.5 99 76.4 99 Ireland 53.8 91 66.9 96 76.4 99 Italy 28.0 32 47.2 62 66.0 86 78.0 98 Netherlands 38.9 78 56.1 97 72.1 99 77.5 99 Norway 49.3 55 57.2 98 72.7 99 77.6 99 Spain 33.7 30 41.8 52 63.9 82 77.7 97 Sweden 45.8 75 57.0 98 71.8 99 78.4 99 Switzerland 41.0 85 52.2 99 69.2 99 78.2 99 United Kingdom 41 .3 76 53.4 96 69.2 99 76.8 99

Australia 48.0 64 59.1 96 69.6 99 78.2 99 Canada 42.6 79 52.5 94 69.1 99 79.1 99 New Zealand 61 .4 95 69.6 99 76.6 99 United States 44.0 75 51 .6 92 69.0 97 76.4 99

Argentina 46.3 64 62.7 86 72.6 96 Brazil 31.0 35 51.0 49 66.6 83 Chile 30.3 63 54.1 80 75.1 95 Mexico 29.5 29 50.7 57 72.1 90

India 24.8 9 38.7 19 61.6 52 Japan 37.0 21 44.4 72 64.0 98 79.9 99

Bulgaria 42.3 53 64.1 81 71.2 98 Czech Republic 42.4 92 65.9 96 72.4 99 Hungary 39.5 87 63.9 95 68.9 99 Russia 36.7 38 64.1 90 65.5 99

Sources: HOI from Crafts (1997a), with coverage extended using the same underlying sources, and from UNOP (1998): GOP/head from Maddison (1995, 1997, 1998) measured in purchasing power parity adjusted 1990 dollars and updated where required using IMF (1999) and OECO (various years); GOP data for Latin America are for 1995; Germany refers to west Germany.

w the estimates in Maddison (1998, p. 158) real

GDP/person in China in 1950 was only at the

1870 level while India experienced negative eco

nomic growth from 1920 to 1950 (Maddison,

1995). In recent decades China and east Asia

have, of course, advanced very strongly, although

China's relative position at 11.2 percent of the

United States in 1996 is still below its 13.2 per

cent of Britain in 1890. South Asia now is a simi

lar proportion of the U.S. level to that of 1950.

The estimates in Maddison (1995) permit a

more detailed analysis of changes between 1950

and 1990, years for which he provides a much

more detailed country breakdown of income lev

els. This reveals that 1,123 million people (20.1

percent of the non-U.S. world population) in

1990 lived in countries where the level of real

GDP /person as a proportion of the U.S. level

had fallen since 1950, while another 3,151 mil

lion (56.1 percent) lived in countries where the

level relative to the United States had risen by

less than 5 percentage points. Sixteen countries

with a population of 165 million had a level of

real GDP /person lower in absolute terms than

in 1950, while in only 12 countries (of which

only Hong Kong SAR and Singapore were out

side the OECD area) was the absolute gap in

real GDP I person lower than in 1950.

The HOI measure shows much less diver

gence. This is partly because of its (controver

sial) discounting of higher incomes and partly

through its taking inlO account mortality. ll is

clear, however, that any index of living standards

that gives a substantial weight to life expectancy

1


8


Table 1.2. The Human Development Index and Its Components in the Recent Past

eo Literacy GOP/Head

1950 1995 1950 1995 1950 1990

Algeria 43.1 68.1 18 62 1,383 2,815 Angola 30.0 47.4 3 42 986 654 Botswana 42.5 51.7 21 70 390 4,215 Egypt 42.4 64.8 20 51 517 2,030 Lesotho 37.4 58.1 35 71 324 1 ,027 Malawi 36.2 41.0 7 56 306 584 Mauritius 51.0 70.9 52 83 2,428 6,868 Mozambique 33.5 46.3 2 40 1,001 859 Nigeria 36.5 51.4 1 2 57 547 1 ,118 South Africa 45.0 64.1 47 82 2,251 3.719 Sudan 37.2 52.2 1 2 46 1,014 1,123 Swaziland 35.6 58.8 1 4 77 566 2,052 Tunisia 44.6 68.7 13 67 1,134 3,234

Bahrain 51.0 72.2 13 85 5,424 10,418 China 40.6 69.2 16 82 537 1,858 Hong Kong SAR 60.9 79.0 58 92 2,499 17,434 Iran, Islamic Republic of 46.1 68.5 13 69 1,892 3,662 Iraq 44.0 58.5 12 58 1,046 1 ,882 Indonesia 37.5 64.0 60 84 874 2,525 Malaysia 48.5 71.4 38 84 1,696 5,638 Mongolia 45.0 64.8 60 83 643 2,259 Nepal 36.3 55.9 5 28 729 1,175 Philippines 47.5 67.4 60 95 1,293 2,300 Singapore 60.4 77.1 46 91 2,038 14,663 South Korea 47.5 71.7 77 98 876 8,977 Sri Lanka 59.9 72.5 68 90 969 2.752 Taiwan Province of China 53.3 74.5 56 94 922 10,324 Thailand 47.0 69.5 52 94 848 4,173

Albania 55.2 70.6 46 85 1,007 2,500 Poland 61.3 71.1 94 99 2.447 5,113 Romania 61.1 69.6 77 98 1,182 3,460

Cyprus 67.0 77.2 61 94 2.067 9,501 Greece 65.9 77.9 74 97 1,951 10,250 Portugal 59.3 74.8 56 90 2,132 11,017 Turkey 47.0 68.5 32 82 1,299 4,254 Bolivia 40.4 60.5 32 83 1,884 1,744 Colombia 50.6 70.3 62 91 2,089 4,917 Costa Rica 57.3 76.6 79 95 1,968 3,923 Cuba 58.8 75.7 78 96 3,651 3,000 Ecuador 48.4 69.5 56 90 1,329 3,037 Guatemala 42.1 66.1 29 65 1,677 2,461 Haiti 37.6 54.6 10 45 984 1,037 Honduras 42.3 68.8 35 73 1,036 1,510 Jamaica 57.2 74.1 77 85 1,103 3,079 Nicaragua 42.3 67.5 38 66 1,772 1,505 Panama 55.3 73.4 70 91 1,636 3,481 Paraguay 62.6 69.1 66 92 1,340 2,670 Peru 43.9 67.7 41 89 2,263 3,000 Trinidad & Tobago 57.9 73.1 74 98 4,537 9,310 Venezuela 52.3 72.3 52 91 7,424 8,139

Sources: See Table 1.1.

HOI

1950 1995

0.227 0.746 0.086 0.344 0.170 0.678 0.178 0.612 0.191 0.469 0.113 0.334 0.434 0.833 0.112 0.281 0.124 0.391 0.385 0.717 0.150 0.343 0.134 0.597 0.212 0.744

0.500 0.872 0.159 0.650 0.498 0.909 0.267 0.758 0.201 0.538 0.265 0.679 0.344 0.834 0.297 0.669 0.111 0.351 0.398 0.677 0.454 0.896 0.380 0.894 0.440 0.716 0.363 0.892 0.316 0.838

0.377 0.656 0.612 0.851 0.474 0.767

0.538 0.913 0.558 0.924 0.470 0.892 0.289 0.782 0.284 0.593 0.425 0.850 0.507 0.889 0.620 0.729 0.358 0.767 0.272 0.615 0.157 0.340 0.244 0.573 0.445 0.735 0.304 0.547 0.459 0.868 0.467 0.707 0.363 0.729 0.678 0.880 0.621 0.860


Table 1 .3. Catching Up and Falling Behind

Percent Percent GOP/ World Person in Real GOP/

Population Leading Country Person

1870 Africa 6.6 1 4.7 480 Asia 61 .0 17.8 580 Latin America 3.0 23.3 760 Eastern Europe 11.2 35.4 1,085

1 913 Africa 6.2 10.8 575 Asia 55.0 13.9 742 Latin America 4.5 27.0 1,439 Eastern Europe 14.1 31.7 1,690

1950 Africa 8.9 8.6 830 Asia 54.0 8.0 765 Latin America 6.5 25.9 2,487 Eastern Europe 1 1 . 4 27.4 2,631

1996 Africa 12.7 5.5 1,309 China 21.0 11.2 2,653 East Asia 7.2 23.6 5,587 South Asia 21 .5 6.1 1,456 Latin America 10.0 21.7 5,155 Eastern Europe 7.3 17.8 4,211

Sources: Area GOP and population levels based on definitions and data in Maddison (1995) updated using IMF (1999), except for east and south Asia, which comprise the countries listed under these headings in Collins and Bosworth (1996): the leading country Is defined as the United Kingdom in 1870 and the United States thereafter.

will make present-day developing countries look

much better relative to either past or present

OECD countries than do comparisons based on

real GDP/person. This might provoke one of

two basic reactions, both of which are probably

valid, either that this shows how important it is

not to judge progress in development by GDP

alone or that this underlines how important it is

to pay more serious attention to the index num

ber problems involved in measuring living

standards.

Table 1.4 confirms that international compar

isons of HDI generally exhibit long-run conver

gence rather than divergence at the level of the

large regional bloc, and the contrast with Table

1.3 is suiking. All regions, including south Asia

and Africa, exhibit strong catch-up of the lead

ing countries after 1950. The averages for both

south Asia and Africa in 1995 are quite near to

the North American level in 1870. Indeed, all

developing countries for \Vhich an estimate of


HDI is possible for 1950 reduced the gap with

the leading country both proportionately and

absolutely between 1950 and 1995. In the period

1913 to 1950 there is catch-up in HDI for both

eastern Europe (markedly) and Latin America.

The HDI is most useful in looking at the es

cape from poverty or, in UNDP terminology, the

move from a low to a medium level of human

development marked by HDI exceeding 0.500.

Taking the change in HDI as a measure of the

speed of this transition, we find an interesting

contrast between the late nineteenth and the

twentieth centuries. The 16 countries in Table

1.1 in a state of low human development in 1870

posted an average HDI gain of0.212 by 1913.

The 48 countries in Tables 1.1 and 1.2 with an

HDI below 0.500 in 1950 had achieved an aver

age HDI gain of 0.350 by 1995. The pace of hu

man development has been markedly higher in

the more recent period.

Table 1 .4. Weighted Averages of HOI

Australasia North America Western Europe Eastern Europe Latin America East Asia China South Asia Africa

1870

0.539 0.462 0.374

1913

0.784 0.729 0.606 0.278 0.236

0.055

1950

0.856 0.864 0.789 0.634 0.442 0.306 0.159 0.166 0.181

1995

0.933 0.945 0.932 0.786 0.802 0.746 0.650 0.449 0.435

Sources: Western Europe defined as in Maddison (1995) and east and south Asia as in Collins and Bosworth (1996); weighted averages of countries for which data are available using sources as in Table 1.1 .

Historical National Accounting Growth Estimates

Index number problems loom large in any

long-run economic growth estimates. National

income accounting provides estimates of GDP in current pt;ces that need to be deflated by a suit

able price index to obtain inflation-adjusted esti

mates in constant prices. The longer the period

under investigation, the more difficult this is to

do well because the problem of allowing for new

goods and services and of quality changes result

ing from technological progress becomes much

greater. In addition, if, as is often the case, the

9


10


reason for making the growth estimate is to pro

vide information on changes in living standards, it will be necessary to take account of aspects of

well-being that are omitted from GDP such as

changes in leisure or longevity, and it may also be appropriate to consider the sustainability of

consumption (see Box 1 .1 and the section on

globaJization, below).

It is generally accepted that, in advanced west

ern economies in the recent past, inflation has been exaggerated by conventional measurement

techniques and thus the growth rate of real GDP

has been understated. This has been studied in

tensively for the United States, and in a recem

survey of the evidence, Shapiro and Wilcox (1996) argue that the present-day bias is proba

bly somewhere between 0.6 and 1.5 percentage

points per year. The problem is not new, al

though it has probably become more selious

during the past hundred years as the composi

tion of GDP has moved away from run-of-themill commodities toward services that are more

difficult to measure-government activities, and

durable goods. By conu·ast, in communist coun

tries it is common for official statistics to underestimate inflation; for example, the recent study by Maddison (1998) finds it necessary to reduce

officiaJ estimates of Chinese growth since 1978

by about 2 percent per year-a correction that is

incorporated into the tables in this chapter.

Leaving aside the index number problems for

the moment, Table 1.5 reports the available estimates and changes the focus from levels to

growth rates. The table is based on the peri

odization in Maddison ( 1995), which is useful

for OECD countries in particular for separating

out the disturbed years around the depression

and the two World Wars (1913-50) and what is

often termed the Golden Age of growth plior to

the first OPEC shock (1950-73). Obviously, for

some cow1tries and some purposes, for example,

an examination of the impact of communism on eastern European growth or of reform on

Chinese growth, this &·amework is not so suit

able. Nor is this design set up to highlight shorter-run fluctuations in growth rates such as

the collapse of the early 1930s.

The first point to note from Table 1 .5 is that

twentieth century growth has generally been

much stronger than that prior to 1870. Thus, regions like India and Latin America where citi

zens are perhaps disappointed not to have

matched the east Asian growth rates of the last

four decades have nevertheless performed much

better than in the mid-nineteenth century, and

over the whole period since 1950 they have

grown faster than did the United Kingdom and the United States between 1820 and 1870.

Under mid- and even late nineteenth century

conditions, 1.5 to 1.8 percent a year was about

the maximum growth rate except in a few "re

gions of recent settlement" such as Argentina

and Canada. This, however, represented a major break

through from pre-Indusu·ial Revolution growth

capabilities, where long-run growth at 0.2 per

cent a year was a good resul L. Recen L research

has established that, even during the First

Industrial Revolution, Blitain achieved a growth

rate of real GDP per person no higher than

about 0.4 percent a year between 1780 and 1830

(Crafts and Harley, 1992). Indeed, the experi

ence of Industrial Revolution Britain, while rep

resenting a major breakthrough from the past in

terms of technological advance and resulting in

extremely rapid industrialization and urbaniza

tion, is also remarkable, viewed through a modern lens, for what it reveals about the limits to

growth in the leading economy of the midnineteenth century.

By modern standards, Industrial Revolution

Britain had a very modest growth potential.

Investment rates and formal schooling were

very low relative to twentieth century levels, and

research and development spending was negligible. Market sizes were still small, and tradi

tional rent-seeking occupations absorbed much

of the talent in the economy. The costs both of

inventing and protecting the profits from inven

tion were relatively high compared with later periods. Growth was based on quite different

foundations from those charactelizing success stories during the twentieth century(Crafts,

1998).



Table 1.5. Growth Rates of Real GOP per Person (Percent a year)

1820-70 187Q-1913 191 3-50 1950-73 1973-96

Australia 1.8 Austria 0.7 Belgium 1.4 Canada 1.2 Denmark 0.9 Finland 0.8 France 0 8 Germany 1.1 Ireland 1.2 Italy 0.6 Japan 0.1 Netherlands 1.1 New Zealand Norway 0.5 Spain 0.5 Sweden 0.7 Switzerland United Kingdom 1.2 United States 1.3

Argentina Brazil 0.2 Chile Mexico -0.1

China 0.0 Hong Kong SAR Indonesia 0.1 Korea Philippines Singapore

India 0.1

Bulgaria Czechoslovakia 0.6 Hungary Poland Russia 0.6

Africa 0.1 Latin America 0.2

Sources: See Table 1.1.

The next obvious feature of Table 1.5 is that,

despite twentieth century acceleration, growth

rates for real GDP per person above 2 to 3 per

cent a year have stiU been relatively unusual. For

both western and eastern Europe, the early

post-World War n decades stand out as the

episode of by far the most rapid growth followed by a marked slowdown. One way of reading the

table might seem to be that in the late decades

of the LWentieth century OECD economies have

returned to historically normal modern eco

nomic growth after periods of disruption followed by recovery. Indeed, the hypothesis that

growth has returned to the pre-1914 u·end rate

0.9 1.5 1.0 2.2 1.6 1.4 1.5 1.6 1.0 1.3 1.4 0.9 1.2 1.3 1.2 1.5 1.5 1.0 1.8

2.5 0.3

1.7

0.6

0.8

0.4

1.4 1.2

0 9

04 1.5

0.7 2.4 1.7 0.2 4.9 2.0 0.7 3.5 1.8 1.4 2.9 1.5 1.6 3.1 1.7 1.9 4.3 1.7 1.1 4.0 1.5 0.3 5.0 1 .8 0.7 3.1 3.6 0.8 5.0 2.1 0.9 8.0 2.5 1.1 3.4 1.6 1.3 1.7 1.0 2.1 3.2 3.4 0.2 5.8 1.8 2.1 3.1 1.2 2.1 3.1 0.5 0.8 2.5 1.6 1.6 2.4 1.6

0.7 2.1 0.2 1.9 3.8 1.4 1.0 1.2 2.7 1.0 3.1 0.8

-o.3 2.1 5.4 5.1 4.9

-o.1 2.5 3.6 -o.2 5.2 6.8 -Q.2 1.8 0.8

4.3 6.1

-0.3 1.6 2.9

0.3 5.2 -0.8 1.4 3.1 0.3 0.5 3.6 0.2

3.4 0.4 1.8 34 -1.2

1.0 2.0 -D.3 1.5 2.5 0.6

cannot be rejected for six of Maddison's 16

countries, although in all but LWo of these cases

at a higher level of GDP per person than would

have resulted from simple extrapolation of the pre-1914 growth rate (Crafts and Mills, 1996).

Nevertheless, as later sections will establish, this

would be a seriously misleading view of the evo

lution of the LWentieth century growth process.

Table 1 .1 shows that during the first half of

the twentieth century the Urrited States established a large lead in real GDP per person rela

tive to Europe and east Asia. The American lead

was based on successful exploitation of natural

resources and a large domestic market, together

11


12


with prowess in high technology based on terti

ary education, that other countries found hard

to emulate. Also, the World Wars did not dam

age the American economy, as they did Germany

and Japan. Since 1950, many western European and east Asian countries have considerably re

duced the percentage (if not the absolute) gap

with the United States. Thus, in 1950 levels of

GDP per person in France and South Korea

were 54 and 9 percent, respectively, of that in

the United States, but 77 and 54 percent, respectively, in 1996 and 1969, and 21 percent for both

in 1900. While the gap between the richest and poorest has continued to widen, there has been

a significant catch-up with the leader by OECD

and "Tiger" economies. The fastest growth has been achieved by

economies that are successfully catching up from

well behind the leader, such as high-performing

east Asian economies in recent decades, while the United States has not exceeded 2.4 percent a

year in any of these periods. The fast growth in

postwar Europe also benefited from catch-up

and seems to owe a good deal to the reduction

in bar.-iers to the emulation of American technology, as well as the reversal of earlier policy er

rors and the return to peacetime. Nelson and

Wright ( 1 992) stress the reduction in the advan

tage that America had gained from cheap natu

ral resources and a large domestic market as

u·ansport costs fell and European integration

and trade liberalization proceeded. Investment�

by Europeans in human capital and in research

and development (R&D) facilitated the codifica

tion and spread of technological know-how,

while high volumes of physical investment were achieved on either side of the Iron Curtain.

Growth, however, slowed down again well before

the Europeans (or the japanese) had completed

their catch-up with the United S tates.

This is especially true of the communist coun

tries, which in the 1960s were sometimes

thought likely to overtake the United States be

fore the end of the twentieth century. Although

they mobilized huge investment programs, capital accumulation ran into severely diminishing

returns, and incentive structures under commu-

nism were not conducive to sustaining hlgh rates of innovation (Easterly and Fischer, 1995). Had

catch-up been as successful as in western

Europe, countries like the Czech Republic and

Hungary could have been expected to have GDP

per person in 1996 at around the level of Auso·ia

or Italy-that is, at least $10,000 (1990 interna

tional) higher (Fischer and others, 1998).

Table 1.5 reports striking differences in

growth performance among the now advanced

economies, which have been reflected in relative

advance and decline in levels of real GDP per

person. The United Kingdom, which in 1900 still

had the highest real GDP per person, was by

1996 only thirteeth of the countries listed and

had been overtaken by most European and several Asian couno·ies, including Hong Kong SAR and Singapore. Conversely, japan ranks eighth

in 1996 but in 1900 had an income level below

that of Russia. The damage done by communism

is underlined by comparing the post- 1950 per

formance of former Czechoslovakia and

Hungary (data refer to the area of those coun

tries as in 1990) with that of Austria and Italy.

At first glance, Table 1.5 may seem to suggest that there was more r·eason to be bullish about

1:\'lentieth century growth in 1973 than now. The obstacles of colonialism, the World Wars, and

the Depression seemed to be in the past and to

many it seemed reasonable to suppose that rapid

catch-up growth might spread much more

widely. For the West, the power of technology, and th.e computer revolution in particular,

seemed to promise sustained fast growth. Clearly, there has been a substantial slowdown in

world growth in the last quarter century from which only Asia (until recently) ha.s largely

escaped.

So the growth experience of the last quarter

century has produced several puzzles for growth

economists. One is to produce an adequate ac

count of the reasons for very strong growth in

east Asia while many other regions, including

most of Afr-ica, have had a dismal growth failure.

It seems clear that a full explanation of these

contrasting outcomes requires something more

than can be found in conventional growth mod-


els, and this has promoted investigations of what,

following Abramovi tz ( 1 986), might be termed

"social capability" for catch-up growth. Another

new issue that has emerged following the devel

opment of endogenous growth models is to ex

plain the failure of growth to accelerate in the

United States despite increased investment in

human capital and R&D (Jones, 1995).

Adjusted GOP as a Guide to long-Run living Standards

During the twentieth century there have been

big changes in hours spent on market work and

in mortality in the countries for which we have

long-run estimates. Table 1 . 1 showed that aver

age life expectancy at birth has roughly doubled

since 1870 in leading OECD economies. In the

same period, hours worked per person em

ployed have roughly halved (Maddison, I 995).

Both of these are aspects of improved living stan

dards that would not have been captured by

growth in real GOP. Usher (1980) argues that it

is both possible and desirable to augment meas

ures of economic g1·owth to include these com

ponents of well-being (see Box 1 . 1 ) . Although

there is no consensus on exactly how best to ac

complish imputations of this kind, it is useful to

consider illustrative calculations along the lines

proposed by Usher simply because the changes

have been so great.

Crafts ( 1 997a) explains in detail the method

used to obtain the undeniably crude estimates in

Table 1.6, which are almost certainly underesti

mates of the imputations that should be made

for changing market work hours and mortality.

Improvements in life expectancy that are unre

lated to personal consumption expenditure are

valued on a willingness to pay basis based on

nineteenth century rather than twentieth cen

tury behavior, which would yield much bigger

welfare gains (Nordbaus, 1998), while reduc

tions in market work, valued using wages for

gone, ignore the possibility of technical progress

in nonmarket work. Even so, the results raise

growth rates an.d, in some cases, by a substantial

amount. Applications of this methodology would


not always give this result-for example, in

Industrial Revolution Britain there may well

have been periods when the adjustment would

tend to reduce growth (Crafts, 1999b).

Table 1.7 highlights the variability of hours

worked per person over time and across coun

tries. These differences result partly from demo

graphic factors, partly from female labor force

participation, and partly from hours worked per

employee. With regard to this last, Latin

American and east Asian countries are now simi

lar to western Europe in the 1950s and the

1920s, respectively, but work years in both re

gions are well below the level of almost 3,000

charactel"istic of late nineteenth century

Europe.

Labor inputs per person are reported in Table

1.7 for Latin America in 1992 to be much lower

t11an for western Europe in 1870. This has im

portant implications for comparative productiv

ity performance as well as for welfare compar

isons. Thus, while t11e real GDP per person in

Latin America in 1996 of$5,155 reported in

Table 1.3 is less than 60 percent ahead of the U.K. level of $3,263 in 1870, real output per

hour worked was over three times that of the

U.K. level in 1870. The gap in real GDP per per

son clearly hugely understates the extent to

which economic welfare in Latin America has

outstripped the level attained in Britain in 1870,

not only because life expectancy is so much

higher but also because labor inputs are so

much lower.

Differences in the age structure of the popula

tion or in hours worked per person employed

per year can also mean that comparative real

GDP per person is a poor indicator of labor pro

ductivity in the present day. This turns out tO matter most when comparisons are made be

tween east Asia and Europe. Thus, wbereas by

1996 the leading Tiger economies, Hong Kong

SAR and Singapore, had overtaken most of west

ern Europe in real GOP per person, there was

still a substantial gap in terms of labor productiv

ity. Their continued fast growth prior to the re

cent Asian crisis is less paradoxical when it is rec

ognized that their scope for catch-up of the

13


14


Table 1 .6. Growth Rates Adjusted for Hours Worked and Mortality (Percent a year)

GOP/Head Mortality Adjustment Work Adjustment Augmented GOP/Head

1870-1950 Australia 0.8 0.5 Austria 0.9 0.8 Belgium 0.9 0.6 Canada 1.9 0.6 Denmark 1 .6 0.6 Finland 1.7 0.7 France 1.3 0.6 Germany 1 .0 0.7 Italy 1 .1 0.9 Japan 1.2 0.6 Netherlands 1.0 0.8 Norway 1 .7 0.5 Sweden 1.8 0.6 Switzerland 1.8 0.6 United Kingdom 0.9 0.6 United States 1 .7 0.6

1950-96 Australia 2.0 0.5 Austria 3.5 0.6 Belgium 2.6 0.5 Canada 2.2 0.5 Denmark 2.4 0.2 Finland 3.0 0.5 France 2.8 0.6 Germany 3.3 0.5 Italy 3.5 0.6 Japan 5.2 0.8 Netherlands 2.5 0.3 Norway 3.1 0.3 Sweden 2.1 0.4 Switzerland 1.8 0.5 United Kingdom 2.0 0.4 United States 2.0 0.4

Source: Updated from Crafts (1997a); see text.

leading OECD economies continues to be quite

substantial (Crafts, 1999a).

The adjustments considered thus far have tended to give reasons why conventionally meas

ured real GDP growth per person may underesti

mate the improvement in living standards, at

least for the OECD economies in the twentieth cemury. There are, of course, a number of other

omissions from GDP that impinge on living stan

dards and where a more negative view might be

appropriate. The reason most often advanced

for why growth measured by historical national accounting might exaggerate growth in living

standards is the neglect of environmental dam

age and depletion of nonrenewable resources,

which might imply that net national product

0.3 1.6 0.4 2.1 0.3 1.8 0.3 2.8 0.1 2.3 0.2 2.6 0.2 2.1 0.1 1.8 0.4 2.4 0.5 2.3 0.3 2.1 0.2 2.4 0.3 2.7 0.3 2.7 0.2 1.7 0.2 2.5

0.0 2.5 0.3 4.4 0.7 3.8

-o.2 2.5 0.5 3.1 0.5 4.0 0.9 4.3 0.8 4.6 0.5 4.6

-D.1 5.9 0.6 3.4 0.6 4.0 0.5 3.0 0.2 2.5 0.5 2.9

-0.1 2.3

(NNP) is an overestimate of sustainable con

sumption (Hicksian income).

This argument clearly has some validity. A recent calculation by Weitzman (1999) suggests

that depletion of the most significant ex

haustible minerals costs the world the equivalent of a little over 1 percent of average consumption

each year compared with a counterfaccual of a

constant flow of resources at this year's extrac

tion cost. On the other hand, it is necessary to

correct NNP not only for unmeasured natural

resource capital depletion but also for additions

to knowledge capital coming from technological

advances to infer correctly sustainable consump

tion. Depending what is assumed about future

technological progress, this may well imply a


Table 1.7. Annual Hours Worked per Head of Population

1870 1950 1996

Australia 1,145 778 749 Austria 1,349 916 725 Belgium 1,245 883 595 Canada 1,004 720 794 Denmark 1,279 1,058 797 Finland 1,318 995 732 France 1,364 1,058 600 Germany 1,213 1,047 661 Italy 1,425 866 641 Japan 1,598 925 976 Netherlands 1,133 833 592 Norway 1,198 996 686 Sweden 1,360 952 693 Switzerland 1,439 1,022 874 United Kingdom 1,251 989 764 United States 1,089 859 931

China 1 '11 0 Hong Kong SAR 1,127 Indonesia 903 Korea 1,099 Philippines 679 Singapore 1,193 Taiwan

Province of China 988 Thailand 1,394

Bangladesh 671 India 852 Pakistan 638

Argentina 642 Brazil 697 Chile 679 Colombia 648 Mexico 608 Peru 643 Venezuela 548

Sources: Maddison (1995) updated for 1996 as in Crafts (1999a); estimates for south Asian and Latin American countries refer to 1992.

much bigger correction to NNP in a positive di

rection, as Nordhaus ( l 995) has argued.

It is, in fact, the possibility that returns to

R&D may be falling (with an implication of re

duced future productivity growth), rather than

natural resource depletion, that is by far the

most important reason to suppose that in recent

decades sustainable consumption has been grow

ing much less fast than real GOP. Amendments

to the correction to NNP for growth in knowl

edge capital as projections of fuLUre technologi

cal progress are revised are likely to dominate

other adjustments to national accounts measures

in assessing sustainability.


Economic historians have rightly warned that

economic growth as measured by historical na

tional accounts is not always a good guide to the

rate of improvement of average livi11g standards.

For most of the twentieth century, it seems likely

that, on balance, GDP growth has been an un

derestimate in a world of falling mortality, in

creasing leisure, new goods, and greater techno

logical prowess.

The Sources of Economic Growth

A useful technique with which to examine

long-run growth is growtJ1 accounting. This ap

proach, which is well explained in Sarro ( 1998)

and Maddison ( 1987), seeks to attribute growth

to its proximate sources in terms of growth of

factor inputs and of total factor productivity

(TFP). TFP is the weighted average of the

growili of productivity of the individual factor in

puts. The basic formula used in growth accoum

ing is the following:

.:lY/ Y= a.AK/ K+ �llL/ L + M/ A

where ilie growth rate of output ( Y) is ac

counted for in terms of tJ1e contribution of ilie

growth of the capital stock (.:lK/ K) times the

elasticity of output wiili respect to capital (<X), ilie contribution of the growili of the labor force

(M/ L) times the elasticity of output with re

spect to labor (�) and the growili ofTFP

(.:lA/ A). In practice, <X and � are approximated by the

shares of profits and wages, respecdvely, in GDP,

and TFP growth is found as a residual when all

the other components of ilie growth accounting

equation have been entered. Capital stocks are

estimated using the perpeLUal inventory method

of adding up past investment nows and assuming

a lifetime for capital assets, while labor inputs

are usually measured in hours worked adjusted

for the educational composition of the. labor

force based on human capital theory. This for

mula would be exactly right if, as in traditional

neoclassical growth tl1eory, tl1e economy could

be iliought of as an aggregate Cobb-Douglas

production function, Y = A�l.J. operating un-

15


/6


der conditions of perfect competition and con

stant returns to scale. The parameter A would re

flect the state of technology, and TFP growth

would measure exogenous (Hicks-neutral) tech

nological change.

Caution is required before assuming that

residual TFP growth actually measures the con

tribution of technological change to economic

growth. According to traditional analysis, the

bias may go in either direction. First, technologi

cal change may be less than TFP growth if there

are scale economies or improvements in the effi

ciency with which resources are used or if im

provements in the quality of factors of produc

tion are underestimated, for example due to

unmeasured human capital accumulation

(Abramovitz, 1993). Second, if the elasticity of

substitution between factors of production is less

than 1 and technological change has a Hicks

labor-saving bias, as many analysts think is the

case, then conventional TFP growth underesti

mates the contribution of technological change

and the mismeasurement increases with the

growth in the capital to labor ratio, the degree

of labor-saving bias, and the inelasticity of substi

tution (Rodrik, 1997a).

Faster technological change raises the steady

state rate of growth of the capital stock in a tra

ditional neoclassical growth model, and so part

of its impact on growth compared with the coun

terfactual of no technological change shows up

in capital's measured contribution. The advent

of endogenous growth theory strengthens this

kind of reason to believe that the contribution

of technological change exceeds TFP growth.

Thus, in models that envisage endogenous inno

vation driving growth through expanded vari

eties of capital inputs, a fraction of the contribu

tion of the growth in varieties of capital

facilitated by R&D accrues to capital and is not

captured by the Solow residual. The undermea

surement will be greater the larger the endoge

nous component in technological progress

(Barro, 1998).

Table 1.8 reports a selection of growth ac

counting results that permit a long-run view of

the sources of growth in some G-7 counu·ies.

The main u·ends are as follows. First, in the

United States the contribution of capital seems

to have been stronger in the nineteenth century

than in the twentieth both absolutely and p•·o

portionately. In other countries, the strongest

absolme contribution of capital came in the

Golden Age investmem boom after World

War n. The late twenti.eth century decline in

capital's conu·ibution is associated both with ris

ing capital to output ratios and falling shares of

investment in GDP, but gross nonresidential in

vestment rates in most G-7 counu·ies are several

percentage points above their late nineteenth

century levels (Maddison, 1992).

Second, the contribution of labor inputs to

growth has been strongest in the United States

reflecting, in particular, higher population

growth there than elsewhere in the G-7 coun

tries. Measured on this neoclassical basis, educa

tion's contribution has been steady but not spec

tacular-for example, contributing a little less

than 0.5 percent per year in each period since

1913 in the United States where years of formal

education rose from about 6 at the stan of the

century to 9.5 in 1950 and 13.5 in 1995

(Maddison, 1996; OECD, various years). ln

much of the OECD, declining hours worked has

been a significant restraint on the growth of la

bor inputs during the twentieth century.

Third, the contribution from TFP growth has

been highly va•·iable, ranging from 0.2 percent a

year in the United States in 1973-92 to 3.6 per

cent per year in japan in 1950-73. The interwar

productivity surge in the United States appears

to owe a good deal to electrification, which

raised TFP growth across the board in U.S. man

ufacturing (David and Wright, 1999a, b). By con

trast, catching up, scale effects, and improve

ments in resource allocation made strong

contributions to TFP growth in Golden Age

Europe and Japan (Maddison, 1996). The broad

picture is that generally TFP growth rose from

the late nineteenth century through the Golden

Age and then declined sharply in the recent

grO\vth slowdown. The low TFP growth in both

Britain and the United States in the nineteenth

century is suggestive of the limits to growth at



Table 1 .8. Growth Accounting: Comparisons of Sources of Growth (Percent a year)

Capital Labor TFP (percent) (percent) (percent) Output

1855-90 United States 2.0 (50) 1 .6 (40) 0.4 (10) 4.0

1873-1913 United Kingdom 0.8 (42) 0.6 (32) 0.5 (26) 1.9

1913-50 Japan 1.2 (55) 0.3 (13) 0.7 (32) 2.2 United King 0.8 (62) 0.1 (7) 0.4 (31) 1.3 United States 0.9 (32) 0.6 (21) 1.3 (47) 2.8 West Germany 0.6 (46) 0.4 (31) 0.3 (23) 1 .3

195D-73 Japan 3.1 (34) 2.5 (27) 3.6 (39) 9.2 United Kingdom 1.6 (53) 0.2 (7) 1.2 (40) 3.0 United States 1 .0 (26) 1.3 (33) 1.6 (41) 3.9 West Germany 2.2 (37) 0.5 (8) 3.3 (55) 6.0

1973�92 Japan 2.0 (53) 0.8 (21) 1.0 (26) 3.8 United Kingdom 0.9 (56) 0.0 (0) 0.7 (44) 1.6 United States 0.9 (38) 1.3 (54) 0.2 (8) 2.4 West Germany 0.9 (39) -o.1 (-4) 1.5 (65) 2.3

1978-95 China 3.1 (41) 2.7 (36) 1.7 (23) 7.5

196D-94 Hong Kong SAR 2.8 (38) 2.1 (29) 2.4 (33) 7.3 Indonesia 2.9 (52) 1.9 (34) 0.8 (14) 5.6 Korea 4.3 (52) 2.5 (30) 1.5 (18) 8.3 Philippines 2.1 (55) 2.1 (55) -o.4 (-10) 3.8 Singapore 4.4 (54) 2.2 (27) 1.5 (19) 8.1

196D-94 South Asia 1.8 (43) 1.6 (38) 0.8 (19) 4.2 Latin America 1.8 (43) 2.2 (52) 0.2 (5) 4.2 Africa 1.7 (59) 1.8 (62) -0.6 (-21) 2.9 Middle East 2.5 (56) 2.3 (51) -0.3 (-7) 4.5

Sources: 1855-90 United States from Abramovitz (1993). 1873-1913 UK from Matthews et al. (1982). G-7 countries: 1913-50 from Maddison (1991), 195�92 from Maddison (1996). East Asia from Collins and Bosworth (1996) except for Hong Kong SAR, which is based on Young (1995) and China based on Maddison (1998), both with factor shares adjusted to match Collins and Bosworth's as-sumptions. South Asia, Latin America, Africa, Middle East from Collins and Bosworth (1996).

that time, discussed above. Rising TFP growth

through the 1970s correlates with spending on

R&D, which was negligible in the nineteenth

century, around 0.2 and 0.5 percent of GDP in

the interwar United Kingdom and United States,

respectively (Edgerton and Horrocks, 1994), and

rose to 2.3 and 2.9 percent, respectively, by the

1960s (United Nations, 1964). However, the de

cline in American (and G-7) TFP growth in the

last period occurred despite increased R&D

spending.

The contrasts in TFP growth over time in the

United States probably do reflect real changes in

the contribution of technological change to growth but surely exaggenue the movements. The

nineteenth century American economy experi

enced a rapid dse in 1.he capital to labor ratio

combined with strongly labor-saving technological

change such that the share of profits in national

income rose. Early in the twentieth century, 1.he

bias in technological change seems to have

ceased to be labor saving and to have been re

placed by a capital saving (human capital using)

bias and the share of profits fell (Abramovitz,

1993). In recent decades, this capital-saving bias

has been less apparent, and the share of profits

11


18


has fluctuated with no su·ong trend. In the light

of the earlier discussion, it seems probable that

conventionally measmed TFP growth significantly

understates the role of technological change in

the nineteenth century and overstates it between the 1920s and the 1960s. The recent decline in

TFP growth in the United States appears paradox

ical in the light of the computer revolution and

this has prompted many to suspect that it may be, at least to some extent, a statistical artifact (G1;liches, 1994). We return to this issue in the

next section.

The developing world clearly offers some

striking comparisons with the advanced world,

although data limitations resu·ict measurement

LO the post-1960 period. The starLiing contrasts

in this period are between the much faster

growth in east Asia in a still to be completed

process of catching up with the OECD and the

growth failure in Mrica, which has fallen fur

ther behind and has seen real GDP per person

in the continent declining in the last quarter

century. Table 1 .8 shows negative TFP growth for

Mrica in the period 1960-94, and contributions

from factor inputs that look respectable until it

is recalled that population growth was nearly

3 percent a year. Probing behind these numbers,

the invesunem rate in Mrica has been held

down in real terms by the very high price of cap

ital goods in highly protectionjst economies, and

educational levels have remained low, rising

from 1.6 years in 1960 to only 3.5 years in 1994

(Collins and Bosworth, 1996). In east Asia the

invesunent rate has been high relative to histori

cal norms and has translated into a strong con

tribution from the capital stock because of un

usually low capital to output ratios (Fukuda,

1999). The contribution from labor inputs has

been boosted by a favorable demographic transi

tion and rapid increases in schooling, from an

average of 2.7 years in 1960 to 7.2 years in 1994

(Collins and Boswo1·th, 1996). The stronger TF P

growth in east Asia may partly reflect effective

ness in technology transfer that compares very favorably with other Third World experience

(Dahlman, 1994).

Comparisons of east Asian with European

g1·owth in the recem past are somewhat beside

the point given the differences in capital tO out

put ratios, scope for catch-up in TFP, and de

mography. Examining differences in tbe sources

of recent fast growth in east Asia and of 1·apid

growth in Europe during catch-up in the 1950s

and 1960s is instructive, however. Here, the obvi

ous point to stand out from Table 1.8 is that east Asian growth has relied much more heavily on

factor inputs, boLI1 labor and capital, and less on

TFP growth than that of Golden Age western

Germany. Although measurement error occa

sioned by factor-saving bias may exaggerate the TFP growth difference somewhat, the conclusion

that east Asian TFP growth has been outstanding relative LO that of Afr·ica but not so impressive by earlier European standards seems robust (Crafts,

1999a).

Convergence and Divergence

The large divergence in income levels and

growth rates that has emerged since L11e stan of modern economic growth seems hard to square

wiLI1 the traditional neoclassical growL11 model

that assumed constant returns to scale, diminish

ing returns to capital accumulation, and univer

sal technology that improved like manna from

heaven. Although some early work in the growth

regressions literature argued that differences in

income levels across the world could largely be

explained by human and physical capital per

worker (Mankiw, Romer, and Weil, 1992) and

tended to interpret P-convergence (i.e., the neg

ative relationship between growth rates and ini

tial labor productivity levels found in cross

section regressions when enough conditioning

variables are included) as consistem with the

augmemed-Solow growth model with conver

gence at 2 percent per year (Barro and

Sala-i-Martin, 1991), these interpretations are

now generally rejected (Temple, 1999).

Economic historians reviewing the experience

have tended to stress L11e importance of techno

logical congruence and social capability

(Abramovitz and David, 1996). The former re-


lates to the profitability of using technology de

veloped in the leader(s) in potemial follower

countries with different factor endowments and

demand conditions. Thus, in the first half of the

twentieth century, U.S. technolog)', which was

natural-resource-intensive, physical capital-using,

and scale-dependent, was frequently not the op

timal choice of technique in European condi

tions. Greater integration of world markets and

reductions in the cost advantages of domestic

natural resource endowments combined with in

creased importance of intangible capital (R&D and education) subsequently reduced the obsta

cles to catch-up first within the OECD and later

elsewhere in east Asia. Social capability refers to

a counu-y's culture, institutions, and policy

framework tl1at influence the attractiveness of in

vestment and innovative activity and the effi

ciency with which technological possibilities are

exploited. The productivity gap with the leader

informs the potential for rapid catch-up growth

but catching up is not automatic. This coheres

with the more recent econometric evidence.

Prescott ( 1998) explores the possibilities of

calibrating a neoclassical production function to

account for cross-country labor productivity dif

ferences in terms of human and physical capital

per worker with TFP common to all countries

and concludes tl1at the evidence is not remotely

consistent with this hypothesis. While economet

ric evidence strongly supports diminishing re

turns to (broad) capital accumulation, estimates

of rates of conditional convergence are now

known to be highly sensitive to econometric

specification and there appears to be strong evi

dence both of differences in levels or rates of

growth ofTFP across countries. This strongly

suggests tllat both policy and institutions matter

for growth performance (Temple, 1999).

Globalization Then and Now

Many economists have discussed the twentieth

century in terms of a phase of globalization end

ing with World War [, followed by a phase of dis

integration through and until the reconstruction

after World War H. The past 50 years is then

GLOBALIZATION THEN AND NOW

seen in terms of a gradual liberalization of trade and capital flows followed by a new and deeper

version of globalization in the last quarter cen

rury or so. In both the OECD and the Third

World, perspectives on the advantage of outward

orientation have clearly varied dramatically over

time, as has the impetus to globalization from

technological change. The objectives of this sec

tion are to establish some of the key dimensions

of globalization and to explain why the process

was reversed in tl1e interwar period as govern

ments retreated to fmancial autarchy and trade

protectionism.

Globalization in Trade and Factor Flows

I t is widely known that for many coumries the

proponion of merchandise trade to GDP has

now returned to levels quite similar to those at

the start of the cenwry. At first glance, it might

appear tllat the world economy has simply re

turned to its old level of economic integration

and that international trade has merely resumed

its earlier importance. As has increasingly been

recognized, however, that view is seriously mis

leading. The nature of international trade is in

several respects quite differem now compared

with a hundred years ago, and it plays a much

larger part in world economic activity (Bordo,

Eichengreen, and Irwin, 1999).

Table 1.9 reports ratios of world merchandise

trade relative to world GDP and largely matches

the stylized facrs set out above. The trade ratio

was increasing rapidly before World War l, did

not exceed the 1913 level until the late 1960s,

and has risen sharply in recent decades.

However, the present level is unprecedentedly

high and represents both a massive increase over

the estimate of 1 percent for 1820 and a near

doubling of the 7 percent eslimated for 1950

(Maddison, 1995, p. 233). On tl1e other hand, in

the United Kingdom, the leading player in the

global economy of the late nineteenth century,

merchandise trade is now a much smaller pro

portion of GDP than it was then, and for the

United States the increase in the tTade ratio is

quite modest.

19


20


Table 1 .9. Ratios of Merchandise Exports to GOP and to Merchandise Value-Added (Percent)

1890 1913 1960 1970 1990

Merchandise exports/GOP Australia 15.7 21.0 13.0 11.5 13.4 Canada 12.8 17.0 14.5 18.0 22.0 Denmark 24.0 30.7 26.9 23.3 24.3 France 14.2 15.5 9.9 11.9 17.1 Germany 15.9 19.9 14.5 16.5 24.0 Italy 9.7 14.4 10.0 12.8 15.9 Japan 5.1 12.5 8.8 8.3 8.4 Norway 21.8 25.5 24.9 27.6 28.8 Sweden 23.6 21.2 18.8 19.7 23.5 United Kingdom 27.3 29.8 15.3 16.5 20.6 United States 5.6 6.1 34 4.1 8.0

World 6.0 9.0 8.0 10.0 13.0

Merchandise exports/ Merchandise value-added Australia 27.2 35.6 244 25.6 38.7 Canada 29.7 39.4 37.6 50.5 69.8 Denmark 47.4 66.2 60.2 65.9 85.9 France 18.5 23.3 16.8 25.7 53.5 Germany 22.7 29.2 24.6 31.3 57.8 Italy 14.4 21.9 19.2 26.0 43.9 Japan 10.2 23.9 15.3 15.7 18.9 Norway 46.2 55.2 60.0 73.2 74.8 Sweden 42.5 37.5 39.7 48.8 73.1 United Kingdom 61.5 76.3 33.8 40.7 62.8 United States 14.3 13.2 9.6 13.7 35.8

Sources: Feenstra (1998) except estimates for world, which are derived from Maddison (1995).

The picture is rather different when changes

in the structure of OECD economies are taken

into account, in particular, the shift away from

commodity to service sector production.

Table 1.9 shows that when merchandise trade is

expressed as a percentage of merchandise value

added, most countries now have a much higher

ratio than in 1913. Most obviously, this is true of

the United States where the trend since 1970 is a

su·iking new development. The United States has

also experienced a rapid growth in service seclOr

exports, which by the mid-1990s were around 40

percent of merchandise exports up from 30 per

cent in 1960 and dwarfing the 3 percent or so of

1900 (Bordo, Eichengreen, and Irwin, 1999).

This probably reflects both the increasing tract

ability of some services and also shifts in compar

ative advantage. It is not unprecedented, how

ever, in the sense that service/merchandise

proportions around 40 percent also character

ized British exports in the period 1870-1913

(Im1ah, 1958).

The composition ofworld merchandise u·ade

has changed very substantially during the twenti

eth century, as Table 1.10 reports. The most ob

vious change is the huge relative decline of pri

mary products and rise of manufactured goods,

especially since World War II. In many ways, per

haps the most significant development is the rise

of the developing countries' share of manufac

tured exports, which was very low and showed

no upward tendency through the 1960s but has

grown dramatically in the past 30 years (to

around 25 percent by the mid-1990s).

Also notewonhy in Table 1 . 10 is the steady increase throughout the century from a Low initial

level in the proportion of capital goods, repre

sented here by machinery and transport equip

ment, in manufactured trade. It also seems clear

that this has been accompanied in the recent

past by a rapid increase in both outsourcing and

vertically specialized trade, which may now have

reached 20 to 25 percent of world u·ade

(Hummels and others, 1998). I n the United


Table 1 .1 0. Composition of World Merchandise Trade (Percent, current prices)

Categories of Goods 1913 1955

Primaries 64.1 54.8 Manufactures 35.9 45.2 Machinery/transport equipment 6.3 17.5

Manufactured exports shares Developed market 95.4 85.2 Developing 4.6 4.4 (Former) Iron Curtain 10.4 9.5

1973 1994

39.5 25.3 60.5 74.7 28.7 38.3

83.9 72.9 6.6 24.7 2.4

Sources: UNCTAO (1983, 1997) except for 1913: Yates (1959).

States, imports of SITC 7 manufactures (machin

ery and transport equipment) were still only 5

percent of total merchandise imports as recently

as 1955 but are now around 50 percent (Yates,

1959; UNCTAD, 1997).

Another interesting development dltring the

twentieth century has been the part played by

multinationals in world trade and production.

Multinational enterprise was already quite well

established in the early twentieth century, as

Table 1 . 11 reports, and the book value of foreign

direct investment relative to world GDP is proba

bly only a couple of percentage points higher

now than in 1914. Nevertheless, the market

value of U.S. direct investment abroad has been

estimated as 20 percent of GNP in 1996 com

pared with around 7 percent in 1914 (Bordo,

Eichengreen, and Irwin, 1999). Also, in recent

decades, multinationals have become more im

portant in technology transfer (Nelson and

Table 1 .11 . Foreign Investment

A. Foreign Assets/World GOP (percent)

1870 6.9 1900 18.6 1914 1�5 1930 8.4


Wright, 1992) and in the proliferation of out

sourcing (Lawrence, 1 996).

The story of foreign portfolio investment in

the twentieth century is of flourishing growth

through World War I followed by a pronounced

retreat from the 1930s through the 1950s and

then accelerating growth from tl1e 1960s to the

present. Table 1 . 1 1 repons that the stock of total

foreign assets relative to world GDP regained the

1914 level around 1980 and has risen dramati

cally since that time.

Obstfeld and Taylor ( 1999) interpret these

trends in terms of a macroeconomic policy

''Lrilemma," i.e., that a counu·y can have at most

two of a ftxed exchange rate, free capital move

ments, and independent monetary policy. At the

start of the century, the advanced counu·y norm

was to eschew the last of these in an era when

politicians denied responsibility for the level of

domestic economic activity and working class

votes still did not matter in most countries. In

the crisis of the 1930s, independent monetary

policy ruled the roost, widespread capital con

trols were introduced, and devaluations were

commonplace. During the Bretton Woods pe

riod, fixed exchange rates returned and capital

conu·ols were retained in a world in which aggre·

gate demand management was widely attempted,

while since the early 1970s the trend has been

toward floating exchange rates, independent

monetary policy, and abandonment of capital

controls.

1945 1960 1980 1995

4.9 6.4

17.7 568

B. Foreign Direct Investment Accumulated Stocks (millions of U.S. dollars) and Multinationals Active in British Manufacturing

Stock of FDI (current) Stock of FD I ($1990)

Multinational enterprises in British manufacturing

1914

14 153

1 1 1

1938

26 350

361

1960

66 362

718

1995

2464 2053

1507

Sources: Foreign assets/GOP lrom Obstfeld and Taylor (1999); stock of FOI from Jones and Schroter (1993) except for 1995 from OECO (vari· ous years); multinationals from Bostock and Jones (1994) except for 1995 from OECO (1997b).

21


22


This macroeconomic background is central to

explaining trends in quantities of foreign invest

ment but other factors have impinged on the

composition of capital flows. It has long been

recognized that portfolio investment before

World War I was heavily concentrated in lending

to the transportation and government sectors,

while relatively little went to banks or industry.

According to estimates in Simon (1967), 69 per

cent of British portfolio investment between

1865 and 1914 was in social overhead capital, 35

percent went to governments, and only 4 per

cent was in manufacturing. Lending to emerging

markets in the 1990s involves much more expo

sure to the financial sector and much less to in

frastructure (Bordo, Eichengreen, and Irwin,

1999). A plausible explanation for this may be

that problems of asymmetric information and

contract enforcement are, on average, somewhat

reduced relative to the pre-1914 era.

The disintegration of world trade after World

War I resulted from a surge of protectionism.

Prior to World War I, the use of quantitative

trade restrictions was negligible (Gordon, 1941)

but during the 1930s they proliferated. Some estimates suggest that as much as 70 percent of

world u·ade was affected, although Gordon her

self suggests the figure was more like 50 percent.

Trade liberalization after World War II centered

initiaJJy in Europe on removing import conu·ols,

but during the 1970s and 1980s there was a re

turn to higher non-tariff barriers to trade

(NTBs), including new devices such as voluntary

export resu·aints that evaded the General

Agreement on Tariffs and Trade (GATT). Many

of these NTBs embodied levels of protection

equivalent to quite high tariffs. The Uruguay

Round placed considerable emphasis on remov

ing NTBs with some success, as Table 1 . 12

reports.

Trends in tariff protection are similar in some

respects but differ in others. The late nineteenth

and early twentieth century was a period when

tariff barriers to trade were generally increasing

somewhat. Although the United Kingdom stood

out as a committed free trader prior to World

War I, the United States was a high-tariff country

throughout and until World War ll. Tariffs in

creased markedly during the trade wars trig

gered off by the Smoot-Hawley tariff of 1930 but

were reduced steadily under the various multilat

eral GATT rounds, especially from the Kennedy

Round on. These reductions were not reversed

during the macroeconomic turbulence of the

1970s. In sum, it seems quite probable that

Bordo, Edelstein, and Rockoff (1999) are 1ight

to claim that trade barriers today are quite likely

lower than a century ago.

Table 1 .12. Barriers to Trade: Average Tariffs on Manufactures and Import Coverage of NTBs (In percent)

1875 1913 1930s 1950 1989 Post UR

Tariffs France 12-15 20 30 18 Germany 4-6 17 21 26 Italy 8-10 18 46 25 Spain 15-20 41 63 United Kingdom 0 0 17 23 European Union 5.7 4.6 United States 40-50 44 48 14 4.6 3.0

Nontariff barriers (NTBs) France 0 58 Germany 0 100 Italy 0 100 Spain 0 United Kingdom 0 8 European Union 11.6 3.8 United States 0 5 10.1 2.1

Sources: Tariffs from Bairoch (1993) and Schott (1994); NTBs based on Gordon (1941) and Daly and Kuwahara (1998). For the 1930s, tariffs are for 1931. except United Kingdom for 1932. and NTBs are for 1937. UR, Uruguay Round.


The early twentieth century was also a time of

high international migration characterized in

particular by emigration from Europe, increas

ingly from southern and eastern Europe, and

immigration to the New World. This had a sub

stantial impact in reducing wage gaps between

sending and receiving regions and put down

ward pressure on wage rates of the Lmskilled in

the United States (Williamson, 1996). Tn turn,

the adverse implications for unskilled workers

appear to have been a major reason for the

tightening of restrictions from the 1860s on

wards and ultimately the shutting of the door to

immigrants in the United States and other coun

tries in the 1920s (Timmer and Williamson,

1998). Thus, by the 1930s, tendencies to factor

price equalization were much weakened by ob

stacles to factor flows and protectionism.

There has been no comparable rei<Lxation of

immigration controls to accompany the liberal

ization of trade and capital flows. As Table 1 . 1 3

reports, the proportion of foreign-born popula

tion in the United States has risen from the

nadir reached in 1970, and immigrant flows

have revived a little. In western Europe the pro

ponion of foreign-born population has risen

from 3.6 percent in 1965 to 6.1 percent in 1990

{Ziotnik, 1998), a record figure, but this period

has also seen severe immigration restrictions im

posed in a region previously accustomed to sub

stantial net emigration. Indeed, absent these bar

riers, one might have anticipated very much

larger co tal flows of migrants, given lower trans

port costs and higher incomes in less-developed

countries.

Table 1 .13. Immigration to the United States

1870 1890 1910 1930 1950 1970 1990

Immigration Rate I 1.000 population

6.4 9.2

10.4 3.5 0.7 1.7 2.6

Source: U.S. Bureau of the Census.

Foreign-Born as Percentage of Population

(in percent)

13.9 14.6 14.6 11.5

6.9 4.7 7.9


Explaining Trends in Protectionism

It is now widely accepted that openness is

good for productivity growth {Edwards, 1998),

and the relative decline of economies that

adopted import-substituting industrialization

strategies rather than outwardly oriemated poli

cies in recent decades has both strengthened

this conventional wisdom and encouraged u·ade

liberalization in the Third World. These beliefs

and policy stances were not widely shared until

recently. And, in any event, big countries may

seek to exploit optimal tariff policies even at

some cost in productivity performance, while in

depressions considerations of external and inter

nal balance may make expenditure-switching

policies an attractive short-term fix. The rise of

protectionism Lhrough the middle of the cen

tury resulted fi·om a combination of adverse

macroeconomic shocks, the aggressive behavior

of the new "hegemon," the United States, and

an absence of the link between openness and

growth that emerged in more recent times.

It is well-known that downturns in economic

activity are conducive to protectionism in soci

eties where governments respond to the balance

of interest group pressures (Gallarotti, 1985).

Trends in protectionism in the United States

during the twentieth century have repeatedly

been shown broadly to conform with this gener

alization (Bohara and Kaempfer, 1991; Takacs,

1981). It is not, therefore, surprising that the

world economic crisis of the 1930s saw a surge in

trade restrictions of aJI kinds.

American tariff policy in the late 1920s was es

sentially the outcome of logrolling by special in

terests in Congress rather than a carefully calcu

lated foreign policy move by the administration

(Irwin and Kroszne1� 1996). Nevertheless, the

trade wars of the 1930s can also be seen as equiv

alent to a move by the United States to exploit

its position as a big country, a move that back

fired. The inu·oduction of the Smoot-Hawley tar

iff in 1930 provoked retaliation on a wide scale

notably by larger countries and, in retrospect,

represents a serious miscalculation. The tactics

adopted later in the decade follo\ving the

23


24


Reciprocal Trade Agreements Amendment were

a better way of seeking optimal tariffs that effec

tively distinguished between countries of rela

tively high and low bargaining power

(Conybeare, 1987). During the Pax Americana

after World War II, the United States moved to

ward subordinating trade policy to foreign pol

icy, and this aided considerably the shift back to

ward trade liberalization.

In recent decades protectionism seems to

have reduced growth rates as a consequence of

the distortions to which it gave rise. A detaiJed

analysis of long-run Latin American growth per

formance by Taylor ( 1 998) found that the key

impact worked through a whole series of distor

tions that raised the price of capital goods rather

than high tariffs per se. Similarly, Ades and di

Tella (1997) have argued that there are serious

adverse impacts of industrial policy from the cor

ruption that it generally spawns, which is fos

tered by protected markets.

In the early twentieth century, the inverse cor

relation between tariffs and growth was absent. A

careful study by O'Rourke (1997), which uses all

the obvious controls, confirms the intuitions of

earlier writers like Bairoch (1993). The reason

for this result may well be that, in general, tariffs

at this time tended to reduce the relative price

of capital goods and thus to stimulate rather

than to discourage real investment. This is sug

gested by the evidence in Collins and

Williamson ( 1 999) who found that prior to 1950

tariffs tended to lower the price of capital goods

relative to consumer goods. More speculatively,

it may also be that in an era when "industrial

policy" was in its infancy there was less reason to

associate protection with additional distortions.

Origins and Nature of the Great Slump

The tendency to disintegration of the world

economy in the interwar period was hugely exac

erbated by the slump of the early 1930s. I t seems

highly probable that a return to global economic

crisis of similar proportions would provoke simi

lar antipathy to international capital mobility and

free trade leading to widespread adoption of

policies aimed at reimposing controls.

Understanding the reasons for the depression, in

particular of the parts played by structural faults

and policy errors, is central to assessing the risk

of a repeat and is thus a key building block in

weighing up the likelihood of a future backlash

against globalization. Also, understanding the

propagation of the initial adverse shocks is fun

damental to averting a repetition of a major

slump and an associated retreat from openness.

The traditional literature on the Great

Depression stressed catasu:opbic errors in

Ame1ican monetary policy, which provoked a

huge aggregate demand shock that reduced out

put and prices both domestically and then,

through secondary effects, in the rest of the

world (Friedman and Schwartz, 1963). This is

still a valid, but now clearly incomplete, picture

as more recent research has brought out the im

portance of wage stickiness and aggregate supply

in real output falls, of the operation of the newly

restored gold standard in the inadequacy of the

world macroeconomic policy response, and of

the fragility of banking systems in the onset of fi

nancial crisis.

Those who argue for the fragility of the world

economy prior to the depression are typically

pointing to various legacies of World War T such

as adjustment problems linked to world agricul

tural overproduction and loss of export markets

by European counu·ies (Kindleberger, 1973).

Their claims are not that the world economic

crisis was inherent in early twentieth century

globalization but that the shock delivered by the

wa1· seliously impaired subsequent macro

economic policymaking, led to increased pres

sures for protection, or had adverse implications

for the volatility of capital Oows. Indeed, the

main line of argumen t is now that the war shock

was primarily responsible for the instability of

the interwar gold standard, but the significance

of the changed economic environment was per

ceived too late (Temin, 1989).

Eichengreen ( 1992) established a picture of

the pre- 1 9 1 4 Gold Standard as an era in which

Britain was frequently able to operate as a

Stackelberg leader because of sterling's reserve


currency role and as a world in which interna

tional cooperation sustained the system when

under pressure. The pdority given to gold con

vertibility coexisted with quite high volatility in

domestic levels of economic activity but domes

tic politics permitted neglect of internal balance

objectives. By the 1920s all this had changed

wilh the rise of New York as a financial center,

the differing views of major players on the ap

propriate conduct of monetary policy, and the

pursuit of working-class votes. American mone

tary policy first provoked a general world tightening and then presided over a sensational col

lapse in the domestic money supply and output.

This episode is discussed in detail below.

A substantial rise in real interest rates and real

wages ensued in the economically advanced

world. Newell and Symons (1988) estimated that

in the representative European counu·y, real

wages rose by 13.8 percent and the real interest

rate increased by 7.2 percentage points between

1928 and 1931, while the price of traded goods

fell by 27.2 percent and domestic p1;ces by 15.2

percent. The prices of primary goods fell dra

matically from an index value of 28.01 in 1928 to 10.15 in 1932 compared with 48.31 in 1920

(Grilli and Yang, 1988). The terms of trade

moved very sharply against primary producers

in Latin America by about 32 percent between

1929 and 1931. Capital flows from First to Third

World ceased and were then reversed; capital ex

ports of $355 million in 1929 became inflows or

$1.4 billion and $1.7 billion in 1931 and 1932

(Maddison, 1985). Currency and debt crises followed for many Third World countries.

The depression was also notable for financial

crises in many advanced countries featuring significant bank failures, switches from bank money

into cash, and drying up of the supply of bank

loans (Bemanke andjames, 1991) . The most

spectacular of these debacles was in the United

States (Box 1.2). Here research has established

that a badly regulated banking system had en

gaged in excessive risk taking in the boom years

preceding the depression and that the interrup

tion to supplies of credit in the financial crisis of

lhe early 1930s added extra deflationary pres-


sure to lhat expected from a conventional nega

tive money supply shock ( Calomiris, 1993).

Money wages generally proved to be very

sticky downwards such that during 1931-34 real

wages were 20 to 40 percent above the 1929 level

in mosl countries. Estimated wage acljustment

equations for a panel of 22 countries confirm

that wages generally reacted very sluggishly to

price declines (Bernanke and Carey, 1996). This

ensur·ed that the deflationary shocks were trans

lated into output reductions. In some cases, like

that of Britain, the spread of collective bargain

ing arrangements and the implications of unem

ployment benefits in placing a floor under nomi

nal wages may partly explain this (Crafts, 1989).

The stickiness of money wages remains quite

puzzling, however, especially in view of the much

greater flexibility that they displayed both in

Britain and the United States in the early 1920s.

Calibrations of a Taylor overlapping-conu·acts

model for lhe United States indicate that a

change to much slower wage adjustment in the

eal"ly 1930s than a decade earlier is implied, and

the explanation of this is not yet clear (Bordo

and others, 1997).

Recent r·esearch has placed the operation of

the noncooperative interwar gold standard at

the heart of tJ1e problems of d1e early 1930s. In

the absence of cooperative monetary expansion,

the fLXed exchange rate regime buttressed by fis

cal orthodoxy ensured that the representative

counu·y faced adverse aggregate demand shocks

to which there was no effective policy remedy.

It has also become clear that leaving the gold standard was the key to early recovery, which was

associated with the pursuit of independem mon

etary policies (which mitigated price declines

and thus real wage increases) besides having

more conventional implications for aggr-egate

demand (Campa, 1990; Eichengreen and Sachs,

1985). Early devaluation also helped prevent

currency crises, which translated i.nto banking

crises (Grossman, 1994). At the same time, im

posing capital controls and erecting barriers to

trade were seen as attractive ways to escape from

conflicts of external and internal balance; in ef

fect, openness was increasingly seen as an obsta-

25


26


cle to prosperity at least in the short term. Even

in the hitherto staunchly free-trade United

Kingdom the macroeconomic downturn

prompted the imposition of the General Tariff

as long-standing protectionist interest groups

seized their moment (Rooth, 1992).

lf, ex post, the interwar gold standard turned

out so badly, why ex ante did so many counnies

seek to return to gold after World War I?

Obviously, a major reason was that the pre-1914

system had operated as an effeCLive commitment

technology for many countries (Bordo and

Kydland, 1995), and the advantage of a rules

based system for macroeconomic policy was

highly valued-as Montague Norman said it was

"knave proof." Recent research has also stressed

the role of gold standard membership as the

best available signal to capital markets of finan

cial rectitude and thus as a means to borrowing

from abroad at substantially lower interest rates

(Bordo, Edelstein, and Rockoff, 1999). In this

way, globalization was tied to the gold standard

and thus, given the international economic pol

icy context of the early 1930s, carried with it the

seeds of its own demise.

The upshot of this research is to highlight

three key ingredients of the Great Depression

inappropriate international monetary and ex

change rate policy, frag.ile banking systems, and

inflexible labor markets. The chances of avoiding

a replay of the 1930s will be better the less these

apply in f·uture. As noted above, the solution to

the policy trilemma increasingly is to drop the

fLXed exchange rate, and this removes a key as

pect of the 1930s crisis. I t might also be noted

that in a world of floating exchange rates the G-7

response to the stock market crash of 1987 indi

cates that policymakers were both alive to the les

sons of history and able to take appropriate ac

tion. Inflexible labor markets seem to remain a

problem, notably in Europe. The reasons for

wage stickiness in the 1930s are not yet under

stood and are a priority for further research. At

present, it is unclear whether there would now

be greater downward wage flexibility in response

to deflationary pressure, but it would be unwise

to rely on it (Ak.erlof and others, 1996).

The Asian crisis in 1997-98 is a reminder of

the acute problems that can be created by the

policy trilemma in the face of inadequately su

pervised and regulated banking systems.

Attempts to use interest rate policy for domestic

demand management with a pegged exchange

rate were counterproductive in the face of capi

tal inflows, and the excessive •·isk taking tJnt en

sued threatened financial stability (Mishkin,

1999). In turn, as bank balance sheets deterio

rated sharply, the fiscal implications of implicit

goven1ment guarantees risked a currency crisis

that itself would exacerbate the banking crisis

(Burnside and others, 1999). The unholy combi

nation of inapp.-opriate monetary and exchange

rate policy together •Nith a fragile banking sys

tem, is quite reminiscent of 1930s America. As

with that episode, ex post, these errors seem to

be widely recognized and improvements in the

design of policy can be expected.

In sum, the message from the interwar period

is that economic policymaking rather than glob

alization per se was the root of the Great

Depression. Accordingly, tl1ere seem to be rea

sons to be optimistic both that a similar down

turn can be averted in future and, if so, the

probability of a reversal of globalization is lower.

An End-of-the-Century Perspective

The Paradoxical OECD Growth Slowdown

One of the most discussed aspects of twentieth

century economic growth is the productivity

slowdown of tl1e past quarter century in the

OECD economies, and especially in the United

States. In tl1e context of the information and

communications technology revolution, this has

been seen by many as a considerable puzzle. The

episode raises a number of important issues

both for economic poUcymakers and growth

economists. These include

• Is sn·uctural change responsible for slower

OECD growth?

• Is there a post-Golden Age hangover effect?

• ls the growth slowdown sufficient to refute

the endogenous growt11 hypothesis?


The most straightforward reason why fast growth comes to an end is that it is based on an investment boom that runs inw diminishing returns or involves an episode of catch-up growth at the end of which productivity growth will natUJ·ally slow down. It is generally agreed that there are diminishing .returns to routine physical investment and that, as productivity gaps with leading countries narrow, other things being equal, TFP growth will decline (Temple, 1999). These are clearly facets of the growth slowdown of the 1970s in OECD countries. At that point, however, catch-up of the United States was clearly far from complete, and subsequent slower TFP growth seems to reflect something more than this. And, of course, for the United States itself the catch-up effect carries no weight, and greater investments in innovative activity

AN END-OF-THE-CENTURY PERSPECTIVE

might have led to faster growth accorcting to some recent growth theorizing.

A SITiking feature of twentieth century economic g1·owth in leading economies has been the associated structural change, as Table 1.14

reports. There has been a large decline in the proportion of employment devoted to agriculture and manufacturing and a substantial rise in the shares of both marketed and nonmarketed services. This has made the measurement of economic growth more difficult and has probably exacerbated the underestimation of productivity growth. In addition, these structural shifts may also have reduced potential productivity improvement.

The measurement problem should not, however, be exaggerated since the sectoral shift has been gradual and is unlikely to account for

Table 1 .14. Structure of Employment in Five Leading Economies, 190D-95

France Germany Japan United Kingdom United States

Circa 1900 Goods 74.7 78.9 79.3 56.7 66.8

Agriculture 43.4 39.9 64.8 13.0 38.3 Manufacturing 26.0 28.5 12.4 32.1 21.0

Market services 19.5 15.7 16.6 36.4 27.2 Nonmarket services 5.8 5.4 4.1 6.9 6.0

1950 Goods 61.6 66.3 68.9 50.9 43.7


Market services 21.9 24.2 26.0 36.6 40.1 Nonmarket services 16.5 9.5 5.1 12.5 1 6.2

1973 Goods 48.0 54.5 53.3 44.8 32.4


Market services 29.6 30.8 38.9 38.5 43.9 Non market services 22.4 14.7 7.8 16 7 23.7

1995 Goods 30.3 38.4 41.1 26.7 21.8


Market services 38.4 41.7 50.1 53.1 52.6 Non market services 31.3 19.9 8.8 20.2 25.6

Sources: 1950, 1973, and 1995 from O'Mahony (1999). For 1900, France: Carre and others (1972); Germany and United States: Bairoch (1968); Japan: Ohkawa and Rosovsky (1973); United Kingdom: Feinstein (1972). Goods comprise agriculture, manufacturing, construction, min-ing, and public utilities; market services include transport and communications, distributive trades, financial services, and personal and domestic services; and non market services are government employment plus education and medical services. Except for 1900, Germany refers to west Germany.

27


28


much of the recenL productivity slowdown since

the shift to hard-to-measure sectors was similar

before and after 1973. Using the assumptions in

Sichel ( 1997a), an upper-bound estimate of l11e

impact of the change in employment weights

since 1973 in the economies shown in Table 1 . 1 4

is in no case more than 0.4 percent a year, while

the difference between 1900 and 1995 weights

might add up to about 1 percent a year.

Table 1 . 15 confirms that there have been no

table differences in sectoral productivity growm

rates in G-7 cotmu·ies in the postwar period.

Estimated growm of both labor productivity and

TFP in manufacn.1ring has been appreciably

higher than in services. If these estimates are ac

curate, this appears to suggest that the marked

deindustrialization of the last 30 years or so has

reduced OECD growt.h potential. Again, however,

a glance at Tables 1 . 1 4 and 1 . 1 5 suggests that the

impact of deindustrialization cannot have been

large compared with fue within-sector productiv

ity slowdowns. An interesting question is whel11er

technological change in fue age of computers

will eventually stimulate productivity growth in

services and manufactures in fairly equal meas

ure, whereas in the ages of steam and electricity

the impact on l11e latter was much greater.

The person in the su·eet might well suggest

fuat macroeconomic shocks bring fast growth to

an end. It is certainly true that severe recessions

and currency and financial crises can have a se

vere short-term impact on growth as occurred in

the West both in the 1930s and 1970s. Il is much

less clear that mere will be a long-run effect and

conventional macroeconomics would suggest

that fui.s should only be d1e case if fue reaction

to the crisis involves policy responses that dam

age the long-run growth rate of productive po

tential. Clearly this does happen, as with d1e

adoption of inwardly orientated policies in Latin

America in the 1930s. On the other hand, the

United States in fue 1930s rehabilitated its bank

ing system, adopted an expansionary monetary

policy, and by the end of the 1930s had resumed

its earlier strong trend growfu, which continued

on through the 1960s (see Box 1.2).

Table 1 .15. Sectoral Productivity Growth Rates, 1950-95 (Percent per year)

France Germany Japan United Kingdom United States

Output/hour worked

195D-73 Goods 5.4 6.3 7.0 4.2 2.7 Manufacturing 5.8 6.6 8.5 4.7 2.8 Market services 3.7 4.8 7.5 2.4 1 .9 Nonmarket services 2.3 3.4 0.1 0.0 0.4

1973-95 Goods 3.8 2.7 3.3 2.7 1.6 Manufacturing 3.7 2.9 4.6 3.3 2.1 Market services 1.5 2.7 2.5 1.9 1.1 Nonmarket services 1.9 1 .4 1.9 0.4 -0.3

Total factor productivity (TFP)

1950-73 Goods 3.7 3.7 3.5 2.8 1.6 Manufacturing 4.2 4.1 4.0 3.3 2.0 Market services 2.2 2.1 3.0 0.7 0.9 Nonmarket services 1 .8 3.0 -0.2 -o.3 0.4

1973-95 Goods 2.6 2.6 1.2 2.0 0.8 Manufacturing 2.5 2.5 2.3 1.8 1.2 Market services 0.2 0.2 0.2 1.0 0.3 Nonmarket services 1.6 0.9 1.6 0.2 -0.3

Source: Derived from O'Mahony (1999).


Box 1.2. Financial Crisis In 1930s America

Recent discussions of the 1930s U.S. Great

Depression have emphasized the importance of

a financial crisis in which the role of asymmetric

infom1ation was central rather than treating the

event simply as a monetar}· shock to aggreg-cue

demand. The implication is that there was a dry

ing up of the supply as well as a collapse in the

demand for loans. This has been most clearly

shown in the analysis of New York City banks by

Calomiris and Wilson (1998). In the economic

downturn, depositors (who were not insured)

faced increased risks of default by banks, and

banks faced strong incentives to limit deposit

risk. Adverse economic shocks impaired bank

capital, sharph· raised adverse selection costs of

raising equily, and reduced quasi rents from

lending. Faced with this situation, banks opted

for holding much higher reserves, thereby low

ering asset risk and curtailing loans, while de-

positors held more of their moner in the form

of cash. The symptoms of these problems are re

ported in the table in the form of high deposit

defauh premia reflecting the decline in bank

stock values and of the doubling in bid-ask

spreads on bank shares which indicates the in

creased issuing costs that banks faced.

It follows, as contemporaries realized, that

economic recovery needed not only policies to

raise spending, which in a large economy could

be provided by domestic demand stimulus fol·

lo\\ing the suspension of the gold standard. but

also a gO\·ernment strategy to rehabilitate the

banking system and rt:SLore t11e supply of credil.

Tackling the banking crisis proved too difficult

for the Hoover presidency. although the plan ul

timately adopted under Rooseveh with the legiti·

maC} of a newly elected leader had actually been

formulated by the outgoing administration

(Olson. 1988). The plan involved, firstly. the March 1933

Bank Holiday in which banks were inspected and

relicerued if they were perceived to be :.ound.

This was deemed crucial to re�toring public con

fidence and was followed b) the 1934 Federal

Deposit Insurance Act, under which qualifYing

banks had to achieve appropriate capital adc-


quacy, and tlte Class-Steagall Act that separated

commercial and investment banking. The

Emergency Banking Act allowed new powers to bank recei,·ers to pre,ent a small minority of

shareholder� obstructing capital restructuring by

refusing to accept losses and to waive a propor

tion of creditors' claims pro\'ided 75 percent ap

proved (O'Connor, 1938). About three--quarters

of the 4,000 banks (25 percent of the total) that

were initially refused Jicen�es after the Bank

Holiday were eventually recapitalized and

reopened and the others were dosed. This was

facilitated by substantial purcha�cs of preferred

capital by government credit agencies. notabl}

the Reconstruction Finance Corporation, which

also made substantial loans to aid both recapital

ization and to speed up papucnt of di\idends to

depositors. By the end of 1935, the government

in effect owned about a third of all bank capital

and total state aid extended to the financial sys

tem including loans was $9.-.1 hillion-i.e., about

13 percent of GNP (Chandler, 1971, p. 268). This was a clear departure from the previous

approach to bank failure that amounted to

�traightfonvard liquidation and payoff in \\hich

depositors typically lost about a third of all dc

posiL<> and shareholden; usually lost all their cap

i tal (Upham and Lamke, 1934). The switch from

liquidation toward recapitali7ation was not, how

ever, a bailout and the government appears to

ha\'e suffered no overall losses on its temporary

banking investments and loans (O'Connor,

1938). Shareholders were.' usually called upon to

make as substantial a contribution to the recapi

tali.t.ation as possible, large depositors were still

exposed to los.�es in the event of bank failure,

and, with new tighter regulation, moral hazard

was contained while the danger of bank runs

was much red\lced and nonviable banks were

eliminated fairly quickly.

Clearly, difTerent options for bank restructur

ing involve trade-ofls (\\TorJd Bank, 1998. p. 19), and the Roosevelt administration sacrificed

speed in favor of sustaining conlidence in the

banking !))'stem and limiting the fiscal coM.:. of

intervention. The outcome reflected in the table

29


30


Box 1 .2 (concluded)

was one in which banks continued to hold far more resenes than in the 1920s, where bank failures \'inuall) ceased and bank deposits parlly recovered but in whkh the costs of issuing new bank equity remained high. The politicians appear to have overreacted in Lhe prohibition of

Aspects of the American Great Depression GNP Real MO M2 Deposits/ {$bn) GNP ($bn) ($bn) Reserves

1929 104.4 100.0 7.1 46.2 13.0

1933 55.6 71.1 8.2 30.8 8.2

1937 90.8 104.5 13.4 45.0 5.0

universal ban.lJng, which subsequent research has shown threatened neither capital adequacy not the liquidit) of the banking system and also did not lead to widespread defrauding of investors (K.rosmcr and Rajan. 1994; White. 1986) .

Deposits/ EqUJties Bank Bid/Ask Dep. Del. IN Currency Index Failures Spread Premium (In percent)

11.0 260.2 658 2.74 33.46 15.5

5.1 89.6 3,252 5.41 41.69 0.4

7.1 154.1 58 4.28 0.60 13.4

Sources: Temin (1976) except Bank Fallures: U.S. Treasury Department (1938); Bid-Ask Spread In percent of share price and Deposit Default Premium in basis points: Calomlrls and Wilson (1998). These last data relate to a sample of New York banks; see text.

Although these usual suspects have some rele

vance to the growth slowdown, a deeper underly

ing problem lay in the difficulty of adapting to

new circumstances--i.e., in the political econ

omy of growth. In early postwar western Europe,

many countries sought to create a "social con

tract" that sought to generate wage moderation

in return for high investment and in which the

expansion of welfare state provision was an inte

gral part (Eichengreen, 1996). The downside of

these postwar settlements emerged later on in

the 1970s and 1980s, when catch-up growth

weakened and the macroeconomic environment

turned sour. At that point, however, a form of

status quo bias (Fernandez and Rodrik, 1991)

seems to have meant that an implicit coalition of

definite and possible losers was powerful enough

to prevent reform. The bad news came in the

form of growth of Lhe public sector (de Ia

Fuente, 1997) and intlexible labor and product

markets (KoedUk and Kremers, 1 996), which

were detrimental to productivity performance.

An acute version of this phenomenon has

emerged in Japan, which has suffered a severe

decline in TFP growth and has failed to fulfil tl1e

prqjections of catch-up made by authoritative

observers in the 1970s (Denison and Chung,

1976). Disappointing japanese TFP growth re

flects excessive investment and industrial policies

that have diverted resources away from high

growth sectors toward declining industries and

did not have a positive effect on TFP growth

during 1960-90 (Beason and Weinstein, 1996).

The Japanese economy has also been heavily reg

ulated, which has been costly in terms of pro

ductivity, and has continued to have high hidden

unemployment in nontradables. The scope for

TFP gains from deregulation in Japan appears to

be about six times larger than in the United

States (Blondal and Pilat, 1997).

Fast growth in Golden Age Japan was predi

cated on a number of institutional innovations

made in the 1940s, including the main bank sys

tem, the keiretsu and lifetime employment based

on deferred compensation (Noguchi, 1998)

geared to deliver rapid mobi.lizal.ion of resources

based on low cost rather than efficient use of

capital (Ide, 1 996), and productivity growd1

concentrated on manufacturing while shel

tcred/nono·adables sectors of the economy sus

tained employment based on low labor produc

tivity. By the 1990s, these features of the


Japanese economy were increasingly seen as ob

stacles to further catch-up with the United States

but very difficult politically to reform (Ito,

1996). Japan is perhaps a good example of both

of the need for and rhe difficulties of transition

from the institutions designed to achieve a

Gerschenkronian escape from backwardness

(see below).

The issue of endogenous growth continues lO excite economists. It seems increasingly clear

that the study of (conditional) convergence

based on the Summers- Reston data set cannot

provide answers. The common finding that

growth is inversely related to the initial income

level or labor productivity gap does not discrimi

nate well between rival growth models even

though this clearly is a prediction of the neoclas

sical Solow or augmented-Solow growth models.

For example, if there are obstacles lO technologi

cal diffusion, then should the costs of technol

ogy transfer fall, there may be periods of catch

up even when the underlying growth process is

endogenous and long-run growth rates show no

tendency to equalize across counu·ies (Sala-i

Martin, 1996). In fact, this seems a possible in

terpretation of recent OEGD experience, given

that time-series analysis of the Maddison data set

rejects the hypotheses that long-run forecasts of

differences in output per person tend to zero or

are proportional with a single long-term u·end

(Mills and Crafts, 1999).

Jones (1995) argues that long-run time-series

evidence is indeed the key to evaluarjng the en

dogenous growth hypothesis. He stresses that the

failure of OECD, and especially U.S. trend

growth rates to acceleraLe in recent decades ap

pears to contradict the predictions of endoge

nous growth models that increased investments

in human capital and R&D will permanently

raise the growth rate, and thus also calls into

question the central claim of endogenous

growth, namely that good policy can raise the

growth rate rather than merely have a levels ef

fect as in the Solow model.

The growth accounting estimates discussed

earlier provide a useful input tO this discussion.

It has already been noted that the changes over


time in measured TFP growth, which inform the

discussion in .Jones (1995), are not necessarily a

good gLLide to the rate of technological change

and so a fortiori need not be a good guide to

the rare of endogenous innovation. Indeed, the

TFP growth exhibited by the United States at

mid-century is "too good to be true" in the sense

that it would imply a phenomenal rate of return

on the R&D expenditure of the time. This opens

the possibility that TFP growth may have slowed

down for reasons other than declining reLUrns to

innovative effort. Economeu·ic investigation of

the TFP growth slowdown in American manufac

turing in the 1960s and 1970s su·engthens this

suspicion, since it finds that the underlying rate

of technological change (which accounted for

less than half of conventionally measured TFP

growth) did not decline, but productivity im

provement from economics of scale fell substan

tially (Morrison, 1992).

lf there arc diminishing returns to research

effort, then increases in the share of national in

come devoted to R&D will raise 1he level of GDP

per person and will have a transitory but not a

permanent positive effect on the growth rate,

which in the long run will be determined by the

exogenous natural rate-i.e., we are back in an

augmented-Solow world. This can be illustrated

by the following simplified model (Jones, 1999):

Y= flaLY where A is the s1ock of ideas and L_'" is labor used

in goods production;

LlA = 8LAM where <P < 1 .

In the steady stale, M/ fl and thus the growth

of income pe•· head is n/ ( 1 - cp), where n is the

population rate and is independent of the allo

cation of labor to research.

Modelers have also discussed the impact of a

proliferation of product varieties. Suppose

LlA/ A = 8LA/ V, where Vis the variety of products

available: then, Lhc nature of scale effects will de

pend on whether the number of varieties grows

more or less rapidly than population. The

growth rate will depend only on allocation of la

bor w research and not on scale when popula

tion and variety grow at the same rate.

31


32


Jones ( 1 997) claimed that not only is this permutatjon on the augmented-Solow model the best available interpretation of the long-run data on productivity growth but also, since investment

in R&D and human capital have been r·ising rela

tive to U.S. GDP, the economy must have been growing above the steady-state rate. He therefore projected a substantial slowdown when this transition phase is complete. A long-run perspective suggests, however, that the historical experience has been variable and would inrucate some caution before accepting jones's projection.

In particular, the impact of innovative effort on overall TFP growth seems to depend on whether it results in the invention of new gen

eral purpose technologies such as electricity in the early twentieth century (David and Wright, l999a) or unconnected real costs reductions in individual sectors as in recent decades (Harberger, 1998). In Harberger's striking metaphor, the former is a yeast-type growth process, and the latter is a mushroom-type

growth. Moreover, general purpose technologies are also thought by some economists to be likely to involve a productivity slowdown prior to a subsequent acceleration as a result of the adjust

ment costs of the new opportunities. The information and communications tech

nology revolution is clearly the big technological development of the late twentieth century. At least until quite recently, however, it has not had dramatic effects on either labor productivity or TFP growth, and economists' assessments of its likely impact have tended to be skeptical (Gordon, 1999).

Growth accounting estimates suggest that this is because computers remain a relatively small, although fast-growing, component of the capital stock and because there appears to be relatively little evidence of strong spillover effects (Jorgenson and Stiroh, 1999) (Box 1.3). This will not surprise new economic historians, since a staple finding in the cliometric literature is that even dramatic changes in technology like railways or the steam engine have modest effecL� on overall GDP growth, especially in the early clays (Fogel, 1964; von Tunzelmann, 1978).

1 evertheless, the long-run TFP implications of changes in technology are often unclear initially. Thus, while American productivity surged in the 1920s \Vhen electrification was developed

as a general purpose technology, this was fully 40 years after electricity was first commercially generated (David, 199 1 ) . On this analogy, it is

too soon to assess the productivity implications of the computer revolution. Moreover, it seems likely that well-informed observers at the end of either the eighteenth or nineteenth centuries would have failed to predict subsequent productivity improvement given the very limited implications of steam and electricity at those junctures. If, howeve1� substantial yeast-like

implications for TFP growth are to come from the computer revolution, it will need to progress

to a new phase, such as a massive increase in teleworkjng, that has substantial implications for capital saving in terms of transport infrasu·ucture and commercial buildings (David and Wright, 1999b).

The bottom line of this review of the OECD productivity slowdown is tl1at only a small pan seems to be due to the impact of su·uctural change including associated increases in meas

urement error. The end of the Golden Age left a legacy of much expanded public sectors that probably has reduced growth rates somewhat (see below). The modest impact of the information and communications technology revolution on economic growth thus far is not surprising from a growth accounting perspective. The growth slowdown is paradoxical in the light of some endogenous growth theorizing and it remains unclear whether the long-run rate of pro

ductivity improvment from technological progress will respond positively to more innovative effort. Depending on one's prior views about scale effects in innovalion, a case can be made that OECD growth in the first quarter of the next century is about to speed up as the delayed effects of greater spending on R&D feed through or slow down as u·ansitional dynamics unwind.


Box 1.3. Computers and Productivity Growth

Everyone is familiar with Robert Solow's 1987 remark that ''you can see the computer age

everywhere but in the productivity statistics.··

Since that lime a great deal of research has been

done to clari1} the impact of information tech

nology on economic growth (see the fme survey

in Tripleu. L999). Much of this investigation has

been in the growth accounting tradition. This treats the contribution of computers to growth

as partly coming directly through additions to

Lhe capital �tock (quantity and quality) and tl1e

income accruing to t11c owners of this new form

of capital and partly indirectly through TFP

growth either because there are spillovers or be

cause the conventional assumption of normal

profits is too conservative.

Four hypo theses to explain the absence of a

dramaLic impact of computers on growth that

deserve some discussion have emerged from this

literature. These are the following:

• Computer capital is a relatively small pan of

the capital stock and has to a substantial ex

tent substituted for other capi taL • Spillover effects from computers have been

�mall so their impact on TFP growth has

been modesL

• There is a serious mismeasurement prob

lem such that both growLh in output and

compmers' contribution have been under

estimated.

• The main impact of the information and

communications technology revolution on

productivity perfonnance has yet to come.

The table reports growth accounting estimates

that address the first two hypotheses. I These in

ctica£C that computers accounted directly for

about 0.12 percen tage points of growth in

1973-90 and 0.16 percentage points in 1990-96. This should not be too surprising, since comput

ers accoum for only about 2 percent of tile capi

tal stock. At the same time tllere was a substan-

'The �tudy does not take account of the recent change in National Income Accowll definitions. which have led to a signilicam upward revision in reccm growlh ratcs, largely through reclassifying �pending on computer softw·<�re ru. im..:.o.unent.


tial reduction in tile contribution of other capi

tal to growth-in 1990-96 it was roughly half

tllat of 1948-73-and in TFP growth, which con

tinued to slow to 0.23 percent in 1990-96. Jn ad

dition. Stiroh ( 1998) found tllat at tbe l;ectoral

level in manufacturing there is no evidence of a

positive relationship between office, compming.

and accounting machinery capital stock growtll

and TFP growth, suggesting tllat spillovers are

weak. Very similar estimates of the direct com

ponent can also be found in Sichel ( l 997b), who undenook a sensitivity analysis in particular

of tile possibility tllat excess rewrns should per

haps be assumed to have accn1ed to computing

capitaL He shows botll that this is unllkelv to

have happened and also rhat the ma.ximum

likely impact might be to double the estimated

0.2 pcrcem contribution.

Computers are intensively used in relatively

few sectors of the economy-78 percem of the

1996 stock was in just ten sectors. Many of the

biggest users are service secwr activities (finance, real estate, wholcS<tle trade, business serv

ices) . This makes mismcasuremcm of output

(and thus productivity) growth potentially serious. The most detailed study hru. been under

taken by McGuckin and Stiroh (1999), who used

estimates of the output elasticity of computer

capital in relatively well-measured manufactur

ing sectors to obtain an upper bound figure for

the understatement of output growth in 13 com

puter-intensive, nonmanufacturing industries

comprising around a sixth of GDP in which the

measurement problem is probably most seriouJ>.

They concluded that increasing measurement

problems have led LO an understatement of aggregate productivity growth by an additional

0.36 percent a ycru in the 1990s (0.22 percent

rising ourpm share ellect and 0.14 percem

within sector effecL) . This could raise comput

ers' apparent contribution to growt11 apprecia

bly wit.hom implying a productivity miracle.

The suggestion that the best is yet to come

from the computer revolution is often based on

lhe analogy between t11e computer and tl1e dy

namo presented in David (1991). The main pro-

33


34


Box 1.3 (concluded)

duclivity impact of electriiicalion in American manufacturing showed up in a surge ofTFP growth that was delayed until the 1920s, some

40 yearl> imo the electricity era. Thii> comparison may be misleading, however, for two reasons. First, there has already been a really enormous fall in the price of computing power-a decline of more than 2,000-fold in about 45 years--far

in excess of Lhe fall in the cost of clecuic power prior to 1920 (Triplett, J 999. pp. 323-4) . Second, it is clear that to have a really big impact, computerization would parallel the lransformalion in the American factoq• in the 1920s. A future productivity surge from the reorganization in production remains possible, but the author of the computer and dynamo paper cautions against placing too much weight on

projections based on this historical comparison (David and Wright., 1999b).

The spectacular decline of the real price of computing has surely benefited consumers. Their gains are, however, unlikely to have been

captured by the price index numbers that are used to deflate output measured in current

Sources of U.S. Economic Growth, 1948-96 (Percent per year)

Capital Services Computers Other

Consumer Durable Services Computers Other

Labor

TFP

GOP

Source: Jorgenson and Stiroh (1999)

Expansion of the Public Sector in the OECD

1948-73

1.07 0.02 1.05

0.55 0.00 0.55

1.01

1.39

4.02

To the Victorians perhaps the most surprising

feaLUre of late twentieth century economies

would be the very large share of government

prices. To captw·e the full effect of new goods in

measured economic growth, an estimare is required of the (nonobscn•ed) plice at which demand would have been zero. ln practice, new goods arc inu·oduced into the price index number at much lower prices ob erved at some

point later in the diffUsion process. This problem is likely to be acute where, as with complllcrs, the services delivered are radically different from anything previously available (Shapiro and Wilcox, 1996, pp. 25-36) . It may be that Lhe proliferation of new goods and services has con

tributed tO an increasing understatement of Lhe growth of real incomes in the national accountS (Nakamura, 1995).

The growth accounting explanation of the

limited impact of the computer revolution on Amedcan economic growth is fairly plausible but it should not be accepted uncritically. In

particular, there are good reasons to believe that

the producti\�t)' implications of the r('vohHion have been underestimated in some services ec

tors. and the well-known new goods problem looms large in this context.

1973-90 199Q-96

0.95 0.63 0.11 0.12 0.84 0.51

0.42 0.28 0.01 0.04 0.41 0.24

1.15 1.22

0.34 0.23

2.86 2.36

spending, especially on transfer paymentS, in na

tional income in the rich cotmtries. Two ques

Lions need to be addressed:

• Has the rise of the public sector now come

to an end?


• Is the growth of public spending an important reason for slower OECD growth?

Table 1.16 reports the rise of public spending in a number of OECD economies since 1870.

This shows that a major difference before and after World War l l was that in the latter period government expenditure as a share of GDP expanded, primarily due to increased social trans

fers that had been negligible in late Victorian times. The period of the most rapid growth in this aggregate was generally from the 1940s through the 1970s, and in some countries there has been a noticeable retreat from a peak reached in the early 1980s. Understanding why public expenditure has grown over the long run may be helpful in projecting its future trajectory.

At one level, the growth of public expenditure can be understood in terms of its roles in correct-

Table 1 .16. Government Expenditures/GOP, 187D-1998 (Percent)

1870 1913

Total outlays

Australia 18.3 16.5 Belgium I 1 3.8 France 1 2.6 1 7.0 Germany 14.8 ltaly1 11.9 11 .1

Japan 8.3

Netherlands I 9.1 9.0 Norway 5.9 9.3 Sweden 5.7 10.4 United Kingdom 9.4 12.7

United States 7.3 7.5

1880 191 0

Social transfers

Australia 0.0 1 .1

Belgium 0.2 0.4

France 0.5 0.8 Germany 0.5 na Italy 0.0 0.0

Japan 0.1 0.2 Netherlands 0.3 0.4

Norway 1 .1 1.2

Sweden 0.7 1 .0

United Kingdom 0.9 1.4 United States 0.3 0.6


ing market failure. The urst of these roles predominated a century ago in terms of the provision of the classic public goods (defense, law and order, and the like.) . The later expansion of government economic activity generally included provision of public utilities, infrasu·uctw·e, regulation, and secondary/tertiary education where there were typically important market failure issues to do with market power and/or externalities. Concerns about government failure through

rent-seeking, agency problems, and the like were certainly well-understood by nineteenth century economists but did not reemerge as a big issue until the 1970s (Tanzi, 1997). In response both lo the recognition of the inefficiency of public sector production and to fiscal pressures, the past 15 years has seen an acceptance of privatization that would have seemed unlikely w most OECD citizens during the Golden Age.

1 937 1960 1980 1998

14.8 21.2 31.6 32.9 21.8 30.3 58.6 49.4 29.0 34.6 46.1 543

34.1 32.4 47.9 46.9 24.5 30.1 41 .9 49.1 25.4 1 7.5 32.0 36.9 19.0 33.7 55.2 47.2

11 .8 29.9 37.5 46.9 16.5 31.0 60.1 58.5 30.0 32.2 43.0 40.2 1 9.7 27.0 31.8 32.8

1930 1960 1980 1990

2.1 7.4 12.8 15.4 0.6 1 3.1 30.4 29.7

1.1 1 3.4 22.6 27.8 5.0 18.1 25.7 21.2

0.1 1 3.1 21.2 24.5 0.2 4.0 11.9 16.1

1.2 11.7 28.3 31 .7

2.4 7.9 21 .0 23.0

2.6 10.8 25.9 21.3 2.6 10.2 16.4 16.8 0.6 7.3 15.0 16.3

Sources: Total outlays from Tanzi and Schuknecht (1997) updated using OECD (1999): social transfers, defined to include spending on pen-sions. welfare, unemployment compensation. and health by national and local governments. from Lindert (1994, 1996) updated using Oxley and MacFarlan (1995) and OECD (1997a).

1 Central government only through 1937.

35


36


As the privatization movement suggests, the claim ofWagner's Law-that there is an income elastici ty for government real output greater than unity-is rejected empirically in time-series tests (Gemmell, 1990). There has, however, been a powerful impetus to the growth of the ratio of

government consumption to overall activity, especially since the 1950s, from the relative price effect first brought to prominence by Baumol (1967). This is not surprising given the large share of wages in the public sector and the relative productivity performance reponed in Table l . l5.

Another type of market failure (for example, due to severe problems of adverse selection and

moral hazard) is associated with government's increased role in protecting people against risk. Here, however, considerations of redistributing income and vote seeking were also prominent. Rodrik (1997a) showed that there is a strong correlation in OECD countries in recent times between the exposure of an economy to external risk and the amount of government spending on social security and welfare systems. The interwar

period plainly saw very large shocks from the international economy both through trade and capital Oows. It is perhaps not surprising, therefore, that postwar attempts to restore international economic integration were accompanied by much stronger government efforts to reduce the risks to citizens-an undertaking that was to prove very expensive in some countries, for example, Sweden, in the renewed economic turbulence of the 1970s.

An econometric study of the growth of social u·ansfers reported in Lindert ( 1994) found that the most important influences through 1930 were the extension of the electoral franchise, which in some countries profoundly altered the identity of the median voter, and the aging of the population. For the 1960s to the 1980s, when democracy was already mature, population age structure was by far the dominant factor in explaining the rise of social spending over time (Linden, 1996). In both periods there was also evidence of a weak Wagner's Law effect.

If Lindert's model is used to project the future course of social spending, then the rise in social spending as a share of OECD GDP is forecast to cease at about present levels because many OECD countries have reached the point (285 elderly per 1,000 adults aged 20-64) at which the further aging of their populations is estimated to stop raising social spending (Linden, 1996, p. 14, 31). There are, however, built-in increases in state spending on pensions in all OECD countries, which result from the interaction of demographics and pay-as-you-go pension schemes established several decades ago (Roscveare and others, 1 996). These entail rises from the 1995 level that, with entitlements unchanged, will by 2030 raise pension expendiLUres by about 7 percentage points of GDP in Finland, Germany, Italy, Japan, and Portugal, the counu·ies where the impact will be largest, but by only 1 percentage point in the United Kingdom as a result of its greater reliance on private pensions

and the reduced generosity of its scheme stemming from the Thatcher years. The policy response to tl1is problem in a period that is likely to experience increased tax competition between countries will be intriguing.

The implications of fiscal policy for economic growth remain quite controversial. Theoretical predictions are sensitive to model specification, particularly in terms of the magnitude of effects, while empirical studies vary considerably in their

conclusions (Tanzi and Zee, 1997). Nevertheless, there are good reasons to suppose that in general governmenL capital spending has a positive but diminishing impact through raising expected returns to private investment while taxation does the opposite. This implies that, eventually, tl1e disincentive effects of tl1e taxes dominate. Economeu·ic modeling by Dowrick ( 1996) found that OECD countries are already

past tl1e break-even point. The general tendency of recent empirical

work has been that larger governmem budgets and their associated tax burdens have had a negative effect on growth in OECD countries. Based on growth regressions, de Ia Fuente ( 1 997) estimated that a reduction of 5 percentage points in


government C\.IITent spending would raise the growth rate by 0.6 percentage points. A slightly smaller effect is suggested by Engen and Skinne1· (1996). Their "bottom-up" aggregation of the U.S. evidence argued for impacts on human capital formation, physical investment, and R&D such that a reduction of 2.5 percentage points in the average tax rate from a 5 percentage poinr cut in all marginal tax rates would raise growth by about 0.2 percentage points. Taken together, this evidence suggests that the increase of about 15 percentage points in the ratio of government

spending to GDP in the average OECD counu·y since 1960 may well have reduced the OECD

growth rate by 1 percentage point or more.

Will Rapid Catch-Up Growth Become More Widespread?

This section considers growt11 prospects for regions that have missed out on rapid catch-up

growth in recent decades-Africa, eastern Europe, India, and Latin America. Two questions are considered:

• Is growt11 severely constTained by geography or history?

• Will institutional quality be conducive to rapid catch-up growth?

Earlier sections stressed two important aspects of twentieth century economic growth: tJ1at the

long-run experience has mostly been of divergence rather than convergence, and iliat achiev

ing rapid catch-up growth is relatively rare and has required social capabiUty that derives from appropriate policies and institutions. Two kinds of society appear to have been especially disadvanr.aged, colonies and communist couno·ies. Postcolonial experiences have been very different thus far-compare South Korea with Angola-and early signs are that ilie same may be true for the former communist bloc-compare Poland with Ukraine.

Economic historians have always stressed ilie importance of institutions for growth outcomes. The huge literature on the rise of the West has traditionally pointed to its relative success in containing rent seeking and enJorcing well-defined


property lights, which promoted market-based activities and innovation on an increasingly wide scale (Rosenberg and Bi1·dzell, 1986). North ( l 990) has developed these ideas the furthest. He argues that well-defined, enforceable property rights that ensure low transactions costs and limit opportunism and that. are predicated on strong but limited government are the central underpinnings of growth capability. Transactions costs are seen as still much greater in the Third World than in the earlier history of OECD counu·ies. North also points out., however, that what is much less well understood is t.he political economy of successful insitutional reform.

In practice, the optimal solution t.o u·ansac

tions costs problems may well diffe1· in the early stages of development. and later on in ilie catchup process. The developmental state approach to industrialization adopted in some east Asian countries (Amsden, 1989; Wade, 1990) and, indeed, the ·well-known Gerschenkronian schema for escape from economic backwardness

(Gerschenkron,l962) through investment. banking, state-directed investment, vertically integrated enterprises, and weak antitrust policy can be iliought of as the rational substitution of hier

archies for markets to cope witJ1 initially severe problems of asset specificity, moral hazard, and unreliable legal systems. At the same time, these market-substituting arrangements have a downside in terms of dulling incentives to productivity improvement. and may be highly vulnerable to capture by rent-seeking groups. In practice, outside east Asia, this seems to have been the typical outcorne.

Since the mid-1990s the growth regressions literature has followed the lead given by North and other economic historians and has tended to emphasize the role of social capability (both through institutional quality and policy choice) in growth outcomes with impacts both through investment and TFP growth. 111e variance in these characteristics across countries means that

recent experience has offered some interesting experiments from which to make inferences about these aspects of growth. Broadly speaking, it seems clear t11at strong commitment to en-

37


38


forcement of property lights, the development

of a legal system that reduces moral hazard and

opportunism and policies of openness tOward in

ternational trade are all positive for growth

(Edwards, 1998; Knack and Keefer, 1995; Levine,

1998; Sachs and Warner, 1995) .

Equally clearly, east Asian countlies have on

average scored far better on all these aw·ibutes

than do countries fi·om regions of the world in

which catch-up has been relatively weak such as

Africa (Collier and Gunning, 1999), India

(B�pal and Sachs, 1996), or Latin America

(Burki and Perry, 1997). The vast m�jority of

countries in these regions from the 1950s

through the 1980s sought economic develop

ment through heavy reliance on the state to

promote industrialization while paying relatively

little auention to strengthening the micro

economic institutions required to sustain

market-based growth, perhaps reflecting an un

derstandable suspicion of governments and

multinational enterprises in the advanced world.

The potential for rapid catch-up growth depends

on the size of the productivity gap. Since this has

become much larger in recent decades, the

penalties in terms of forgone growth for having

infelior institutions and policies and attempting

state-led industrialization have become much

greater.

Civil war also has a severe impact on growth

outcomes. By reducing expected returns and

the security of property lights, it lowers the de

sired capital stock and promotes capital flight.

vVhether there is a postwar boost to growth

turns on the extent to which, in the new peace

environment, investment is revitalized by mak

ing good some or all of the wartime reduction

in capital conditional on expectations of sus

tained peace and renewed enforceability of

property rights. Growth regressions reponed in

Collier ( 1999) predict a growth reduction of

over 2 percent a year during the war and, in the

case of short wars, tor a further five years after

ward. Only in the case of long wars (five years or

over) does the estimated model predict that

postwar growth will be higher than the peace

time norm.

The message of these growth regressions rein

forces a central theme of the new growth eco

nomics-that incentive structures that affect ex

pected rewrns to investment or to innovation

matter for growth. Given the sunk-cost nature of

much of this activity, it is crucial that holdup

threats, whether by plivatc agents or by govern

ment, are kept in check. Similarly, it is impera

tive that a solution be found to problems atising

from asymmeuic information that may otherwise

vitiate the financing of investment and innova

tion. IL is also clear, however, that productivity

outcomes depend on how well agency problems

in large organizations in both public and private

sectors are mitigated and it seems likely that this

also depends both on institUtional design and

the extent to which competition can operate.

Recent developmentS in the growth regres

sions literature have taken inw account both the

impact of natural resource endowments, climate,

and ease of access to sea transport on the one

hand and the policy framework reflected in

openness, property rights, and t11e legal infra

su·ucture on the otl1er. Two points emerge, both

of which resonate with nineteenth century eco

nomic history (Morris and Adelman, 1988): ge

ography can indeed be a handicap, but its ef�

fects are quite small relative to tl1e difference

made by good policy choices. Thus, Sachs and

Warner (1997, p. 357) found that the contribu

tion of policy and institutions to slow African

growth has been more than six times large•- and

their results imply that, vviLh appropliate re

forms, African countries could achieve per

capita income growth of 5 percent or more (as

suming tl1at demographic transition ensues).

Analysis of growth in other regions comes to

rather similar conclusions. Progress in reform in

the transition economies has been a more im

portant determinant of growth outcmnes than

the initial economic su·ucture or institutional

legacy, the impact of which has been weakening

steadily (de Melo and others, 1997). India's

weak productivity performance from the 1950s

through the 1980s has reflected rent seeking

(HamillOn and others, 1 988) and protectionism

(Ahluwalia, 1991), both ofwhich persisted in the


absence of an appropriate policy response. In the 1990s, lhis has been partly forthcoming, but bolder ref<)rms could deliver more Uoshi, 1998). Latin American growth outcomes were held back by weak institutions and unfortunate policy frameworks, but growth potential can be expected to have strengthened as a result of recent moves to greater openness, privatization, and liberalization (Edwards, 1995).

Clearly, there are some grounds for optimism in the new consensus in favor of less intervention and a greater role for the market economy, prompted by earlier failure, the east Asian miracle, and macroeconomic crises. At the same time, it is important not w confuse privatization and trade liberalization witl1 t11e development of a wider set of institutions conducive to long-run growth. To name but the most obvious example, Russia has tl1e former but not the latter, as has been highlighted by the EBRD ( 1998) in its

measurement of transition in banking and corporate governance. It is clear on standard measures that, despite recent progress, a widespread shortfall in institutional quality still exists, as Table 1 . 17 report5.

The TCRG (International Country Risk Guide) variable, an indicator of t1·1e quality of institutions developed to inform foreign investors (Table 1 .17) has been much used in growth regressions. The variable is typically estimated to

Table 1 .17. Comparisons of Institutional Quality

Corruption ICRG ENFORCE Perception

Western Europe and Japan 44 9.4 7.8

Central Europe 44 5.2 East Asia 40 7.0 4.8 Latin America 32 5.4 3.0 South Asia 30 4.5 2.4 Russia 28 2.3 Africa 26 4.7 2.5

Sources: ICRG for 1995 from International Country Risk Guide. High scores are better, maximum = 50. The index is based on sur· vey data relating to five components: corruption in government. Quality of bureaucracy, expropriation risk, rule of law, and repudiation of contracts by government. ENFORCE is an Index of the last two of these, high scores are better, maximum = 10, which is used by Levine (1998) as a key predictor of banking development. Corruption perception, high scores are least corrupt, maximum =

1 D. is from Tanzi (1998).


have a big impact on growth, for example, the ICRG difference bet\veen Singapore and Somalia would account for 2.1 percentage points of the growth rate difference between these countries using the estimated equation in Knack ( 1996). Taking account of this leads w much less optimistic growth projections than those based on equations Lhat only consider broad capital ac

cumulation and the initial productivity gap. The basic rationale for lhc TCRG variable can

be found in the idea that reducing u·ansactions costs and asymmetric information problems is central to achieving adequate inveslmenl and supply of external finance. It is much less clear exactly what this variable may capture. For example, is it primarily failure of the legal system to enforce contracts that hobbles the financial system, as suggested by Levine ( 1 998), or do tl1e main effects work tl1rough the impact of corruption as a kind of tax on foreign direct investment, as argued by Wei ( 1 997)? Nevertheless,

both aspects of JCRG give cause for concern, as Table 1 . 1 7 report�.

The economeu·ic analysis of Latin American

growth in Taylor (1998) suggests that retardation in financial development has been at least as important as lack of openness in holding back private sector investment and growth. Yet, across the developing world, progress in achieving t11e institutional reforms needed to address this issue has generally been much slower than the moves to privatization and u·ade liberalization. It may be tl1at lhe lead time required to improve the legal environment is longer or that the political obstacles are even harder to overcome or that the lessons from east Asia have been less helpful.

Given that further institutional reform is required, will it happen? Here the lessons from history are less clear. There have been striking examples of policy and institutional reform promoting episodes of fast growt11-for example, in recent decades, Chile and South Korea. Generally speaking, however, changes in ICRG scores have been small since the inception of the index in 1982. And the conclusions reached by economic hisro1ians are not very encouraging. North (1990) su·essed that not only is lhere no

39


40


natural selection process that ensures the replacement of inefficient with efficient institutions but that network externalities, informal constraints, and the vested interests that surround existing arrangements tend to make institutional change a slow, incremental process and give it a path-dependent character.

What Future for the East Asian Developmental State?

The assessment in World Bank ( 1993) has been highly influential. High-performing east Asian economies were seen as benefiting from excellent TFP growth linked to their outwardly oriented policies and their unusual success was attributed to governmental success in solving coordination problems while adopting policy frameworks that contained rent seeking and were generally market-friendly. Rapid deepening of financial markets was taken to be a big stimulus to investment and growth, while industrial and directed credit policies were not seen as

damaging. These countries have rightly been praised for thei1· policies to foster human capital accumulation and high domestic savings rates, and for the quality of their government bureaucracies. Country dummy variables in growth regressions suggested that these economies had outperformed the world sample by about 1.7 percent a year compared with underperformance signaled by Latin American and African dummies of 1.3, and 1.0 percent, respectively (World Bank, 1993, p. 54).

To the economist in the street brought up on 'The East Asian Miracle," the trauma that began in 1997 and brought growth in many countries to an abrupt halt must have come as a dreadful surprise. Two questions arise:

• Were there aspects of the east Asian development model that exposed the region to the crisis?

• How should the crisis affect assessments of east Asian growth?

Economic history offers many examples of financial crises occurring in basically sound and strong economies with high growth potential but

exposed to macroeconomic shocks where the banking system was fragile, for example, in nineteenth and early twentieth century America, and most notoriously in the American Great Depression of the 1930s.

Recent appraisals of east Asian banking systems have commented on a number of serious weaknesses that were common, although with differing severity, through much of the region. These include low capital-adequacy ratios of banks, excessive exposure of banks to single borrowers, unduly lenient provisioning rules for nonperforming loans, weak supervision, absence of proper auditing and accounting, and so on that, combined witl1 high leverage of the corporate sector, have implied vulnerability to financial shocks (World Bank, 1998). The implication of these weak balance sheets was a high risk of financial crisis with mounting asymmetric information problems if the macroeconomic environment turned difficult (Mishkin, 1999). Financial liberalization in many east Asian countries overburdened the regulatory authorities and incurred a high risk of a subsequent financial crisis.

What then does the current crisis tell us about the preceding east Asian growth process? It should not be taken to suggest that several decades of strong growth should be seen as some sort of mirage. Rather, it reminds us that a key lesson of history is that, without adequate

regulation of the banking system, severe disruptions to economic growth are always likely. It probably reinforces suggestions that capital has been badly used in some counu;es. lt need not, however, imply that, in general, long-term growth potential is weak or has been permanently damaged. Favorable features of east Asian growth noted by the World Bank such as high savings, strong human capital formation, and effective technology u·ansfer mechanisms are unlikely to be damaged by the financial crisis.

Indeed, the 1 930s American experience (see

Box 1.2) may have some optimistic implications for Asian crisis countries. In the long run, the trend rate of growth was unaffected despite the severity of the economic shock (Ben David and Papell, 1995). While this example suggests that


even a massive financial crisis need not damage long-term growth potential provided that the banking system is rehabilitated and reregulated, this does not detract from the case for widerranging reforms to the conduct of both firms and governments in east Asia if future growth potential is to be fully realized.

From Table 1.8, it is clear that east Asian growth has relied much more on the contribution of rapid factor accumulation, of both capital and labor, than did Europe's fast growth during its Golden Age. Normalizing for the opportunities for catch-up presented by the ini

tial productivity gaps and levels of education, the Tigers' TFP growth seems rather disappointing (Crafts, 1999a). Growth accounting reveals that Lhe east Asian dummies in the World Bank's growth regressions were largely the result of favorable demography and initial capital to output ratios rather than superior policy.

The east Asian developmental states delivered

a long period of high investment and very rapid growth bur their policy prescriptions appear to have been much more successful in promoting high levels of investment than in achieving exceptional productivity performance. Recent econometric studies have found that selective interventions on balance retarded rather than stimulated growth. ln Korea, directed loans and the clout of the chaebols appear to have distorted credit flows to the detriment both of profitability and productivity growth (Borensztein and Lee, 1999). An analysis of industrial productivity growth across sectors in Korea dwing 1963-83 found that tax and financial incentives did not enhance productivity growth, while NTBs re

duced both capital accumulation and TFP growth (Lee, 1995). A comprehensive review of industrial policy in east Asian countries concluded that government intervention has generally had adverse effects (Smith, 1995).

In the absence of effective conu·ol by shareholders, the best restraint on inefficient management of firms is competition (Nickell, 1996). Yet competition policy in east Asia has been seriously neglected; for example, ASEAN counu·ies with the exception of Thailand do not have anti-


trust laws, and in the Thai case the law has been used as an instrument of price control rather than to promote economic efficiency (Lall, 1 997). This is also an area where reform seems to be urgently required.

I n the longer term, it seems likely that in the later stages of developmem it will be desirable for east Asian countries to move away from bankdominated finance and to develop better methods of corporate governance. In most cases, this

will entail the establishment of better legal rights for outside shar·eholders and will be facilitated by the emergence of ownership characterized by large and powerful investors (La Porta and other·s, 1997). The importance of investor protec

tion and availability of equity finance appears to be especially important in fostering growth in R&D-intensive activities, which are starting to be important in the leading Tiger economies (Carlin and Mayer, 1998).

The industrial poljcy prescriptions of the de

velopmental state, which are liable to result in the support of declining industries at the expense of the rapid exploitation of new service sector opportunities, ar·e likely to be still less helpful to funher catch-up in east Asia. Su·onger market disciplines are likely to be conducive to better productivity performance.

Recognizing both the need for and some of the difficulties of a move back [rom hierarchies toward markets to strengthen productivity performance as development progresses is dearly

important in refining perspectives on the east Asian developmental state. Nevertheless, these are, in an important sense, problems of success and still appear to leave the Asian developmental state as an escape route out of economic back"wardness. The deeper problem for other counu·ies may be tl1at tl1is model is hard to replicate in that po)jtical economy will pervert its interventions much further in the direction of rent seeking and wasteful investment.

Is Another Globalization Backlash likely?

The retreat from globalization in the interwar period was much accelerated by the depression.

41


42


At the same time, there were other forces that

pulled in the same direction. Losers from the

operation of free world markets put pressure on

governments to protect them, and trade wars

loomed la1·ge in any case. Clearly, similar issues

have surfaced in the context of the renewed

globalization of recent decades. There have

been fears that increasing regionalism will give

rise to u·ade hostilities and that the consensus in

favor of free u-ade in OECD countries, especially

the United States, might evaporate in the face of

the problems of sunset indusu·ies and unskilled

workers.

A new focal point for unease in First World

countries is the suggestion that, in a world of

greatly increased capital mobility, tax competi

tion may jeopardize the provision of social insur

ance just when the external economy is seen as a

source of increased risk exposure. In the Third

World, whjle the evidence of recent times has

persuaded most policymakers that greater open

ness is conducive to faster economic growth in

the long run, there may yet be risks that old na

tionalist resentments directed at perceived ex

ploitation by multinational enterprises return

and obstacles to foreign direct investment are re

instated, especially in counu·ies where the in

come gap with the rich continues to grow.

The early twenty-first century differs from the

1930s in several important respects. There was

no equjvalent to the GATT /WfO with tariff

binding in place then. The range of policy in

struments with which to shield losers is rather

wider now in many countries. Globalization has

much deeper roots. The egregious macroeco

nomic policy errors of the interwar period are

widely recognized, and lessons have been learnt.

It is generally agreed among "informed econo

mists" that the problems of unskilled workers in

the OECD countries are very largely due to skill

biased technological change rather than factor

price equalization through trade (Slaughter,

1999). So, at first glance, there may be less risk

of a backlash. Nevertheless, the pressure points

highlighted above deserve some consideration.

It is well-known that larger countries typically

will have higher optimal tariffs in a noncoopera-

tive u·ade environment. Retaliatory trade policy

was a distinct feature of the 1930s retreat from

globalization. ll does not, however, follow rJ1at

end-century moves toward greater regionalism

imply a retun1 to the trade wars of the interwar

period, especially given the results of that

episode. ll might be argued that, at the intergov

ernmental level, the current situation is more

akin to an infinitely repeated game in which co

operation is preserved by the prospect of future

payoffs (Perroni and Whalley, 1996).

Nevertheless, the circumstances that gave rise

to unequivocal support for freer trade in early

postwar U.S. policymaking have been eroded.

Changing patterns of comparative advantage

and the catching up of other countries have in

creased the number of indusu·ies that fear for

eign competition; organized labor and a signifi

cant part of the Democratic Party has become

protectionist as many workers' real wage rates

have stagnated; and the elite consensus that

arose as a foreign policy reaction to the 1930s

has evaporated (Destler, 1992). To many interest

groups, protectionism is attractive. Similar con

siderations have informed the European

Commission's use of non tariff barriers such as

antidumping measures in tl1e recem past

(Tharakan, 1991).

The policy processes at work in the earlier re

treat from globalization in the United States

have been the object of a good number of de

tailed analyses. These tend to emphasize the im

portance of shifting coalitions in Congress as

well as political responses to substantial numbers

of losers. Thus, Goldin ( 1994) found both that

immigration impacted heavily on unskilled

wages and that trends in wages informed the

votes of legislators on immigration policy i11 the

early twentieth cemury. But she also found that

the coalition that eventually was formed to pass

the acts of the 1920s depended on the South's

urge to protect its relalive population share and

political clout and a growing antipathy to immi

gration by other rural Americans who were not

threatened in any direct way.

The Fordney-McCumber ( 1 922) and the

Smoot-Hawley (1930) tariffs offer similar lessons.


The former exhibits a clear pauern of protec

tion for labor-intensive indusu·ies, industries that

were geographically concentrated or produced

agriculturally based consumer goods products

(Hayford and Pasurka, 1992). The latter pro

vided relief for agricultural distress in a log

rolling coalitions process that also raised tat;ffs

for specific industrial inte1·ests (Eichengreen,

1989; and Irwin and Kroszner, 1996). The impli

cation of these examples is that, absent the early

postwar consensus, American trade policy is li

able to be unpredictable. Although the represen

tatives of unskilled labor have been unable to

prevent NAITA, there may yet be new protec

tionist coalitions.

RodriJ< ( 1997a) pointed to the danger of an

eventual globalization backlash as a result of the

tension between its implications of, on the one

hand, increased demands for social protection

of workers and, on the other hand, reduced abil

ity to finance these from taxes on capital. He

supported this argument empirically by suggest

ing that capital taxes have been reduced in the

face of increased capital mobility and that, other

things equal, exposure to terms of u·ade volatil

ity is correlated with greater social insurance ex

penditure by governments. This would hardly

have been an issue in the 1920s when govern

ments generally relied very little on direct taxes

other than those on real estate and when social

transfers were very modest (see Table 1.16).

While Rodrik's regressions point to a potential

problem, the experience of OECD countries thus

far appears more benign. The evidence reviewed

in Schulze and Ursprung ( 1999) does confirm

that capital tax rates started to decline modeJ·

ately from the early 1980s but also shows that cap

ital tax revenues have been stable and that capital

market integration effects depend heavily on po

litical institutions with a tendency to increase so

cial transfers in corporatist, high consensus

democracy countries. They conclude that global

ization so far has had its main impact in terms of

a modification of tl1e tax structure rather than

through reu·enchment of the weliare state. Detailed empirical research on the impact of

fiscal policy on growth in advanced countries for


the 1970-95 period has con firmed that "produc

tive expenditures" by government on infrastruc

ture, education, etc. are growth enhancing while

distortionary (direct) taxation is growth reduc

ing (Kneller and others, 1999). II might be ex

pected that competition fo1· footloose investment

'��11 tend to push governments both to reduce

distortionary taxes and to raise expenditures

that encourage private capital formation. The

implication may be tl1at tl1e pressures of global

ization are actually helpful in steering Ciscal pol

icy to a more pro-growth stance.

Although tl1ere is clear evidence in both Latin

America (Taylor, 1998) and Africa (Collier and

Gunning, 1999) that closed economy develop

ment strategies have been expensive failw-es,

there is a danger that recent liberalizations may

deliver less than their proponents expect and

tl1at, at some point, there will be a backlash. For

example, there is no evidence that abolishjng

capital conu·ols per se raises the rate of growth

(Grilli and Milesi-Feretti, 1995) but quite good

reason to believe that financial liberalization sig

nificantly increases Lhe risk of a subsequent fi

nancial or currency crisis (Kaminsky and

Reinhart, 1 999). As recent Malaysian experience

testifies, tl1is may undermine support for liberal

ization. The issue is perhaps one of sequencing,

but history suggests that there may have been a

tendency to premature reform in the absence of

adequate financial supervision and regulation.

Similarly, earlier nationalist critics probably

were right to question the impact of multina

tional enterp1;ses on host developing counu·ies.

A recem summary of tl1e evidence in Caves

( 1 996) concluded that both theory and empiri

cal evidence is ambiguous as to t11e implications

of multinationals for host country growth.

Positive spillovers and crowding ouL can both be

envisaged. In the case of exu-active industry in

particular, linkage effects may be weak and repa

triated profits high (Rodriguez-Clare, 1996).

Moreover, indiscriminate attraction of foreign di

rect investment can be welfare reducing when it

is based on tariff protection (Encarnalion and

Wells, 1986). Thus, despite the potential advan

tages of multinational enterprise as a vehicle for

43


44


technology transfer, it would not be surprising to find some of the resentments that were so evident in the 1950s through the 1970s resurfacing.

Conclusions

The preceding material contains a great deal of detail and will not be summadzed here. Rather, the opportunity will be taken to underline a few central arguments around the general theme that an assessment of fumre growth prospects now must be less confident (in both

senses-less optimistic and less precise) than would have been the case 30 years ago. Now, there is much less consensus among mainstream

growth economists and we arc more aware of the transience of epochs in world economic development

Three points from the evidence explored in this section deserve to be underlined. First, and foremost, is that policy matters for growth outcomes. This is most obviously true and has the largest impact on growth outcomes in developing economies, but it is also evident in the OECD, as is confirmed by the contrasting fortunes of Ireland and Sweden since the end of

the Golden Age. Second, this is a point at which there are wildly different beliefs about the likely future growth of the leading economy. While the new paradigmists and some believers in endogenous growth theory seem to imagine that the information and communications technology revolution will lead to much-enhanced producti,rity growth, many economic historians and those still wedded to some version of the augmented-So low

growth model are unconvinced. At the very least, the next two or three decades should be an interesting test for competing ideas in growth theory.

Finally, it should be recognized that the analysis in this section is quite skeptical of the projections of future growth performance that international organizations such as OECD seem to favor (Richardson, 1997). In the view developed here, sustaining strong catch-up growth performance is seen as rather difficult and dependent on unpredictable success in achieving policy reform

and institutional innovation as the economy de

velops. Thus, China faces the problems of moving on from initial success that have caused

Japan to falter. We know that policy reform can turn around "basket cases" and that crises can initiate long-needed reform or encourage seriously growth-retarcljng policy responses, as in Lhe 1930s. These decisions lie fundamentally in the realm or political economy and we still know remarkably little about what determines the outcomes.

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_, 1998. East Asia: The !Wad to Rerover)•

(Washington).

Ymes, P.L., 1959, Forty Yem.- of Foreign Trade (London:

Allen and Unwin).

Young, A., 1995, "The Tynmny of Numbers:

Confronting Lhe Statistical Rea liLies or the East

Asian Growth Experience," Qtwl·terlyjou,·rwl of

Economics, Vol. I 10, pp. 641-80.

Zlowik, H., 1998, "International Mignuion,

1965-1996: An Overview," Popul.alion and

Development Reuiew, Vol. 24 ( l ) , pp. 429-68.

51

©International Monetary Fund. Not for Redistribution 52

THE INTERNATIONAL MONETARY SYSTEM IN THE (VERY) LONG RUN Barry Eichengreen and Nathan Sussman

The dawn of the new millennium is an appropriate time to take stock of the evolution of the international monetary system. In most of the literature on this

subject, a long view is any1.hing thai. considers the behavior of exchange rates and associated policies pdor to the breakdown of the Bretton Woods System of par values in 1973. Thus, Baxter and Stockman ( I 989), in a widely cited swdy of exchange rate regimes, extend their data set all the way back 1.0 1960!

In this chapter we go to the other extreme, and analyze exchange ra1.es and monetary relations over the last thousand years. I It is not clear how to think about the domestic and international monetary systems over such a long period. Some would emphasize the trend from commodity money to fiat money, from market-determined money supplies to government-determined money supplies, and from price stability to innalion. The exchange rates between national currencies were not actively managed by governmental authorities in the commodity-money world that prevailed for more than 90 percent of the past millennium; rather, the exchange rate was a corollary of the metallic basis of the circulation (typic.:llly silver or gold, although other metals were also used) and 1.he fineness (thai. is, the purity) of the circulating coins. Two gold coins of equal weight and fmeness u-aded for one another at a fixed •-ate of one to one. Two gold coins of differem weight or fineness traded for one another at a differenl but still fixed rate of exchange. In contrast, the rate of exchange between gold- and silver-based monies fluctuated

with the relative price of the two metals. This makes it tempting to think of earlier international monetary arrangements in terms of a pair of gold- and silver-based monetary blocs.

With the transition to fiat money, the rate of exchange came to depend on the relative supplies and demands of the national monies that central banks and governments now actively managed. Those exchange rates could be pegged, if the authorities chose to adjust policies accordingly, or be allowed to float if other policy objectives took precedence. Because changes in economic theory, economic policy, and domestic politics increasingly caused other objectives to take precedence, we observe over time a shift from fixed to flexible rates.

In fact, this simple story begs as many questions as it answers. It ignores the fact that the governments could and did debase the coinage in the age of commodity money. 1t ignores that there were pe1;ods of inflation coinciding with these episodes of debasement and that price levels were far from stable even while gold and silver convertibility prevailed. l t does not explain the deeper factors that account for the shift from silver to gold in the nineteenth century and from gold Lo fiat money in the twentieth (summarized in Figure 2.1) .2 ll does not explain why we currently appear to be witnessing a "return to the past," with declining inflation and the reemergence of monetary blocs.

In this chapter we present a more elaborate analysis of these issues designed to place recent international monetary developments in their (very) long-run context.3 At the outset, it is

1We are conscious thai the coverage is necessarily selective, both geographicaUy and themalically, reflecting the limits of our own expertise.

2For purposes of Figure 2.1, we define countries "�th fia1 currenc-ies as those not on a gold �tandard, no1 dollarized, and not having a currency board. Thus, for present purposes we take the alternath·e 10 fiat money not as commodity money but as any hard-and-fast monetary rule (where a simple exchange r.lle peg does not quality).

'The sntdy covers a lo1 of ground and tma,·oidably skims over a variety of important topics. While we hope to answer some of the questions previously begged, it is ine,�table that we also leave important issues unresolved.


worth explicitly asking what policymakers can

hope LO Jearn by adopting mis long-term per

spective. Above all, a long-term hisLOrical per

spective makes clear that many of me issues cur

rently facing policymakers are not new. In particular, periods of rapid inflation and ex

change rate volatility associated with chronic

government budget deficits, like the 1970s and

early 1980s, have been seen before (Box 2.1 ).

Similarly, the reaction against inflation over the

last decade or so, driven by those who dispropor

tionately bear the costs of monetary instability,

and the resulting shift from inflationary finance

to sound money are by no means unprece

dented; they have a number of historical prece

dents. Finally, the reorganization of the interna

tional monetary and financial system into a small

number of regional blocs, arguably under way as

we speak, has also occurred before, and not only

in the twentieth century. If the issues have his

totical precedent, then we can reasonably hope

to learn somemmg from an analytical review of

prior experience.4

Early Monetary Arrangements: Private Money

At the turn of the last millennium, western

Europe was an underdeveloped region com

pared to tl1e Muslim world and me Far East

(Box 2.2). Its political system was fragmented.

While me continent was nominally ruled by

monarchs, most of the latter had very limited

conu·ol of tl1e territories they claimed. The map

was dotted witll de facto independent, semj

dependent, and dependent political units vary

ing in size and economic activity. The over

whelming majority of the population lived in

rural settings and was engaged in agriculture.

There was little trade, and strikingly little eco

nomic activity. Society was partitioned into a rul

ing class of nobility and clergy, on the one hand,

and the peasantry on the other.

41n Figure 2.1, countries with fiat currencies are defined as those not on the gold standard, those not dollarized, and tl1ose not having a currency board.

EARLY MONETARY ARRANGEMENTS: PRIVATE MONEY

Figure 2 .1. Percentage of Countries with Fiat Currencies, 187D-1998

-1.2 - 1 .0 � -0.8 -0.6 - 0.4

=-:C:_.___.____.__.____._..____.__--L...-..J...___.______.'----'----.J-1 0.: 1870 80 90 1900 10 20 30 40 50 60 70 80 90 98

53


54

CHAPTER II THE INTERNATIONAL MONETARY SYSTEM IN THE (VERY) LONG RUN

Box 2.1. Financial Crises: Continuity and Change

Financial mania, crises, and panics are as old as financial markets. as Kindleberger (1978) has amply demonstrated. The tendency for asset valuesincluding the value of the assets to which the monetary circulation is linked-to reach unsustainable levels before adjusting downward will1 a crash is no new phenomenon. From the modern poim of view, however, the question is whether the sharp recessionary effects of currency and fi

nancial clises, which have been so disruptive in recem years, are also a historical constanL

This is not a question on whose answer historians agree. But it is reasonable that lhese effects were smaller prior to the eighteenth century, when the monetary system was to a large extent (in any case, to a greater extent than today) disconnected from the real economy. Many producers and consumers transacted in nonmonetized segments of the economy. (Recall for example the importance of feudal dues paid in kind.) In western E.w·ope, litis siwation changed with the Commercial Revolution and the rise of long-distance u-ade. Both events increased the

The monetary system was based on a single

denomination silver coin, the penny (or denier) ,

a descendent of the Carolingian monetary re

form." The mints that sprung up with the revival

of trade in the tenth century produced an array

of penny coins ranging from the almost pure

sterling penny to the impure, low-weight coins of

northern ltalian cities. The monetary systems of

the m(\jor political unjts varied in size, scope,

and control, although they all shared a relatively

high degree of decentralization, reflecting Lhe

weakness of state authority and bureaucratic

monetization of the economy, then gave birth to banks. and finally encouraged the development of markets on which securitized financial assets were traded. Governments' increasing reliance on debt to .finance wars created u1creasingly deep and liquid government debt markets. The great trading companies (the Dutch and English East fndia Companies and the Bank of England) were the fu·st commercial concerns that issued debt and equity (with the aid of officially sanctioned monopolies). The emergence of this secondary market set the stage for rhe first financial bubbles and cr-ashes, witll significant consequences for the real economy: the Soulh Sea and Mississippi Bubbles of tl1e begimting of the eighteenth century (see above), the collapse of both of which was widely thought to have had depressing effects on the real economy. Ultimately, however, thls crisis ushered a wave of regulation that on tile one hand enhanced the stability for the markets and on the other band promotC'd financial deepening and econontic development.

control. On the other hand, broad differences

among major political and economic units can

be discerned. In England, for example, the mint

system was directed by the crown, and all mints

issued the same coin, whereas in France there

existed a multitude of issuing authorities, coins,

and accounting systems, and Italy's largely au

tonomous cities all issued their own coins.6

The seignorage from coin production was a

feudal right and an important source of rev

enue.? Mints had to compete with each other for

silver and seignorage. The industry can best be

5The mouetary reform of 794 consti tutes the issuing of a heavy bodied (1.7 grams) silver penny that circulated throughout Charlemagne's empire.

6The industrial organization of coin production was broadly similar throughout western Europe. The production process was catTied out in mints operated by mint masters and supervised by wardens. Coins were su·uck from dies using a manual production process that allowed substantial variability in their weight and fineness. Fineness refers to the pu.-ity of tl1e silver content of the coin. Unlike contemporary monetary arrangements. most mints did not mint on state account. Coins were minted from privately supplied silver, either from silver bullion or used coins. The merchant would bring lO t11e mint the bullion which he desired to coin. The mim would charge a fee-seignorage-for tl1is service.

7As we shall see later, it was also the impetus for commodity money inflation.


Box 2.2. Monetary Developments Beyond Europe1

The monetary experiences of Asia, the Middle

East, and Africa share both similarities and differences with that of western Europe. A promi

nent element in common was the association of

fiscal and political crises with episodes of de

basements, inflation, and stabilization. Perhaps

the most important difference was that most of

the money-issuing authorities were large central

ized states, in some cases empires that spanned

wide geographical areas. These states tended to

monopolize minting activity and in most cases

were the dominant suppliers of precious metal

to the mints. The more economicaJJy advanced and com

mercialized economies of the Muslim and

Byzantine world had highly monetized

economies and were able to circulate gold cur

rencies-the bezam and dinar, respectively

well in advance of Europe. Eventually the politi

cal and military decay of the Byzantine Empire

led to debasements of its gold coinage, leaving

the dinar the leading international currency. In

J I 09 Saladin shifted the monetary standard to

ward the silver coin-the dirham-which be

came the unit of account. Again, political de

cline led to currency instability. Substitution

toward now more stable and prized European

gold coins proved iJTeversible for many cen

turies. Even the Ottoman Empire, which en

joyed substantial political and military success

for three centuries, failed to develop a monetary

system comparable to that of Western Europe;

its circulation was dominated by foreign coins.

for during periods of war the sultan (the main

is.�uer of coins) debased the silver currency.

ln India and southeast Asia the degree of

monetization was less. These regions were heav

ily agricultw·al and supported mainly local mar

kets. As was true also of most of Africa, mone·

tary requirements were fulfilled by perty

currency: cowry shells in Bengal and copper in

LThis box is largely based on articles in Richards (1983). The space consrrainlS allow us only to state the most salient faclS, doing considerable injustice to the complex historical development.

EARLY MONETARY ARRANGEMENTS: PRIVATE MONEY

Asia, including China and Japan. Monetary sys

tems of the sort that had developed in Europe

and the Middle East did not exist. Gold and sil

ver were mainly hoarded ramer than used in monetary exchange (although they were also

used to settle international trade deficits). V.'ben

used in domestic exchange, they circulated ac

cording to weight rather than tale. The Japanese

also used copper coinage until the seventeenth

century. The silver they mined was largely ex

ported to China in return for Chinese copper

coins. The only marked change occurred in India with the Muslim conquest that brought

with it the monetary practices of the Muslim

world.

The Chinese story is one of innovation on Lhe

one hand and underdevelopmem on the other.

By the sixteenth century, as in many other as

pects of economic growth and technological in

novation, the forces of relative decline came to

dominate. Since the Chinese economy was heav

ily agricultural, most of the circulation took the

form of copper coins suited for small transac

tions. Gold and silver were hoarded and used at

weight value, uncoined, in large transactions. A

key difference with Europe was that while coins

were used as a medium of exchange, they were

not generally accepted by the government in payment of taxes, a practice that tended to rein·

force the low degree of monetization of the

Chinese economy.

Interestingly, China pioneered the usc of pa

per money. The sheer size of the empire encour

aged the use of paper to minimize shipments of

precious metal. By 800, some 400 years before

Europe, China had developed a system of bills

of exchange. Unlike Europe, the government as

sumed responsibility for the note issue relatively

early. Less than a quarter of a cemury after pa·

per money, backed by silver, was first issued by

private merchants (around 1000). the govern

ment took over paper money production. The

monetary system thus was composed of copper

coins and silver-backed paper money. Evenrua!Jy,

military conflicts, especially the struggle with tl1e

Mongols, led to larger note issues which re--

55


56


Box 2.2 (concluded) suited in accelerating inflation as the end of the

Chin dynasty neared. The fuan dynasty managed to issue stable paper cu•-rency for a short

while and subsequently gave paper money fiat status by demonetizing precious metal allogether. From 1280 to 1350, the money supply

characterized, except perhaps in England, in

terms of monopolistic competition. a Each mint

would offer a "mint price" for silver in terms of

newly minted coins, and competition yielded

high- and low-quality coins and both stable and

unstable currencies. The variety and uncertain

quality of coins made it inefficient to use a coin

outside the immediate area in which it was is

sued-a situation that was perhaps tolerable so

long as trade volumes were low and economies

were relatively autarkic. Once trade revived, how

ever, the eJdsting monetary system proved inade

quate, creating an opportunity for emerging

cenu·alized monarchies.

The international monetary system was a hy

brid of fixed and flexible exchange rates, not

unlike our current system (in this respect at

least) .9 The dual nature of the exchange rate system followed from the dual nature of the unit of

account. On the one hand, a monetary system

based on a commodity such as silver or gold

made it relatively easy to arrive at a system of

fixed exchange rates between different coins.

Private and official money changers set ex-

was controlled in such a way as to generate mild

inflation. The system finally collapsed in the

mid-ftfteenth century, after which silver cur

rency came to dominate. Thus, at the very time Europe was starting to experiment with paper money, China ironically decided to abandon it.

change rates between the coins on the basis of

their precious metal content.IO On the other

hand, there existed a flexible exchange rate be

tween silver or gold and the unit of account, and

consequently between two countries' monies.

In addition, the fact that the media of ex

change-the coins-were valued independently

of the unit account or the price level made them

closer substitutes than modern fiat currencies.

Throughout most of the period, foreign coins

circulated side by side witl1 domestic ones.

"CwTency substitution" was a prevalent

phenomenon.

Monetary Stability and Monetary Integration

The commercial revolution that started

around 1 1 00 ushered in a period of trade expan

sion, urbanization, and growth. Regional and

long-distance trade and the establishment of the

first Europe-wide u·ade fairs in Champagne cre

ated demand for additional money.l l The re

sponse was not only an expansion of the existing

8£ngland was geographically compact and, being insular, offered the crown easier conrrol over imported bullion. The Saxon conquest of Danish-held lands allowed 1.he crown to impose its coinage. The Norman conquest also allowed the im· position of a monetary order.

9ln its modern usage, the "exchange rate" relates to the relative price of t:wo currencies--the relative price of the numeraire in two economies. Bl!t defining the numeraire in the medieval period is problematic. Before the elevemh century, all coins were valued at one penny in a different money of accoum, and these coins had varying silver comem; was the numeraire therefore the penny or the silver? For presem purposes it is convenient to take the numeraire as the penny and to think of silver as being valued (or measured) , like any other commodity, in terms of the prevailing money of account. We adopt this convention in what follows.

tOModified by the variability of that contem and the cost of minting them. 110ne is reminded of modern arguments that European integ1·ation, by stimulating inu·a-European u-ade, su·engthened

the demand for a single European money. We return to this below. It is also likely that the ino·eased demand for silver for monetary uses associated with this revival of n-ade led to the discovery of silver mines in cenrral Emope that irrigated the arteries of western Ew·ope's economies.


monetary system as a number of new mints

sprang up, but also a demand for a more uni

form currency. This led to a consolidation phase

in which the more efficient and reputable mints

exploited economies of scale and reputation w drive their less efficient rivals out of business. I 2

The provision of this widely accepted medium of

exchange required its producers to guarantee its

quality-that is, its metallic content. To supply

the growing needs of merchants for a variety of

denominations and handle large volumes of

minting, minting became an industry character

ized by large factories with multiple furnaces

and many workers. This undertaking required

capital and an ability to produce reputation by

creating a monitoring and enforcement mecha

nism to combat fraud and counterfeiting. IS

Consolidation was carried out mainly by mar

ket forces rather than .fiat. The mints that pre

vailed were those that produced trustworthy

coins at low cost. At the risk of sounding

anachronistic, we can say that the dynamics of

Darwinian selection and survival of mints and

coins guaranteed, along its path, monetary poli

cies that benefited consumers, namely, policies

that conduced to monetary stability and mone

tary integration. Similar to the current establish

ment of the euro, a variety of currency areas

formed in medieval Europe, each based on a sin

gle or set of mints that issued a stable, reputable

coin. A key difference from the present day was

that the medieval system was allowed to emerge

endogenously, through the operation of market

forces.14

While commodity money was hardly unique to

Europe, the institutional arrangements support

ing it were. The overwhelming majority of

RISE OF THE STATE: MONETARY SOVEREIGNTY

commodity-based monetary systems, from the

Roman Empire to the Ottoman Empire to

China, involved substantial minting of state

owned precious metal, in contrast to Europe

where much of the metal was privately owned.

Consequently, the Roman, Ottoman, and

Chinese states all had a high degree of control

over the money supply. Western European states,

in contrast, did not have sufficient amounts of

precious metal to afford them direct control

over the quantity of coins they issued. The au

thorities may have set tl1e mint price, but the

quantity of money and seignorage were deter

mined endogenously, forcing western European

rulers to stay closely attnned to market signals.

That states operated in a competitive, market

driven environment helps to explain Europe's

development of a vibrant market economy and,

in particular, a relatively sophisticated financial

system.

Rise of the State: Monetary Sovereignty

The most likely candidate to take advantage of

these opportunities was the state. The state en

joyed several advantages in the provision of a

universally accepted medium of exchange.

Under feudal law, only the king e1�oyed seignor

age in all the kingdom, while local authorities

(dukes, bishops, and cities) enjoyed seignorage

rights only in those regions falling directly under

their jurisdiction. Hence the state was in an ad

vantageous position in a competition character

ized by economies of scale in enforcement and

monitoring.l5 The state also enjoyed supreme le

gal authority throughout the area it controlled,

allowing it to prosecute counterfeiters and re--

12"fhe elimination of smaller mints and reduction in the variety of circulating coins can be understood in terms of modern models of media of exchange (Kiyotaki and Wright, 1989, and Sargent and Smith, 1997). These models predict that a universally accepted, stable medium of exchange will be dominant. They also suggest that there are multiple equilibria of commodity money circulation in some of which Gresham's law prevails and in others just the opposite.

LSGandal and Sussman (1997) treat the issue of monitoring and quality control during the medieval commodity money regime.

L4We do not claim that market power was unimportanl. Nonetheless, while sovereigns always enjoyed legal superiority and were allowed to mint and circulate coins in all parts of their realms, they had (except, perhaps, in England) limited power to exercise these rights.

15Another \vay of putting the poim is that only the state could efficiently defray the high fiXed costs associated with operating a monetary bureaucracy.

57


58


solve disputes related to the use of money. It

could authorize payment of the taxes it collected

with the coins it issued, creating an automatic

market for the latter. Finally, as an independent

issuer of a currency, it mitigated moral hazard

problems that could arise when one party to the

transaction used self-issued coins.

Advisors to medieval monarchs were aware of

these considerations. They advocated the consol

idation of the minting system, with the idea of

creating a minting monopoly (in other words,

monetary sovereignty) . This would enhance the

state's (and the bureaucrats') power at the ex

pense of local and feudal rivals. Viewed nar

rowly, the state's objective was to acquire a tax

base composed of every coin (user) in the

realm. The wider the circulation of its coins, the

greater its seignorage tax base. A broader view

(expressed by writers at the time) was that mon

etizing the economy promised to increase effi

ciency and productivity and incidentally to in

crease the state's revenues.

The emergence of a national coinage was slow

and uneven. England pioneered the successful

circulation of a u·uly national currency. As early

as the beginning of the thirteenth century, the

English crown managed to consolidate coinage

in the two mints of London and Canterbury.

The process took longer in France, due lO the

size of the economy and the lesser economic

and political integration of its regions. Only by

the fourteenth century did the French crown

achieve a reasonable degree of control over

coinage throughout its realm. The Italian city

states achieved monetary sovereignty following

their independence from the Holy Roman

Empire.

Most state-run mints were run by a mint mas

ter, either an employee of the crown or a fran

chise holder. 16 The mint was supervised by state

bureaucrats charged with preventing fraud and

ensuring that the mint master produced coins of

the requisite degree of fineness and standardiza

tion. Public acceptance was cultivated by the rep

utation ( commitment)-creating mechanism of

public assaying.17 Assaying a sample of coins pro

duced by state mints signaled the state's resolve

to circulate reputable coins. The final step in the

development of European monetary systems was

the minting of gold coins.18 The high inu·insic

value of such coins encouraged the development

of strict quality control measures.

The Political Economy of Inflation

Centralized states created national currencies

not by fiat but by driving out of business inde

pendent coin producers and cotmterfeiters. As a

result of this competitive pressure, western

European money remained stable for almost two

centut;es. One sign of this stability is that most

people, most of the time, appear to have traded

coins at face value.I9 Another is the tendency of

feudal landlords and the church to commute

dues in kind into monetary dues. But by enter

ing into long-term nominal contracts, landlords

and the chtu·ch were later exposed to the risk of

inflation. This in turn created a powerful con

stituency for stable money.

So long as this process was still under way,

competition from lords and counterfeiters pro

vided a source of market discipline that miti

gated the state's commitment problem. Once

the state acquired near monopolistic control

over the issue of coins, however, its commitmen t

problem reemerged. Rulers faced the choice be

tween the maintenance of stable money and ma

nipulation of the currency.

There were two methods of extracting addi

tional revenue from the coinage. One was the

16See Mayhew and SpufJord ( 1988) for discussion of mint organization in medieval Europe. 17[n England this was referred to as "the trial of the pyx." 18As trade volumes increased and transactions (mainly international) involving large sums of money became prevalent, a

need for coins of greater intrinsic value emerged and gold coins began supplementing silver coins as the large-denomination currency in the mid-thirteenth century.

19See Sussman and Zeira (1999) for a model of commodity money that assumes that agentS trade coins at face v-alue.


production of coins that did not meet the puta

tive standard.2o The second, more prevalent

means of extracting revenue was debasement: re

ducing the silver content of the money of ac

count (Figure 2.2). Put differently, debasement

entailed reducing the intrinsic value of a coin

while maintaining its face value. As a conse

quence, the nominal value of precious metals

(in terms of face-value coins) increased, and so

did the prices of other commoclities. The state

benefited from this manipulation: since it rarely

minted for its own account, it had to attract sil

ver to the mints, and the increase of the nomi

nal price paid for bullion (together with incen

tives to recoin and remint) increased mint

output and the state's seignorage revenues.2t

Debasing the coinage was a convenient mode

of taxation.22 Debasement revenues were easy to

collect and clid not require the approval of the

representative assembly. However, debasement

created inflation and monetary confusion.

Typically, it was resoned to only in periods of

budgetary crisis when immediate benefits out

weighed the loss of future reputation. It was also

implicitly understood (and time-consistent be

havior in a competitive coinage environment)

that once the crisis was over, the currency would

be stabilized, and the state would act to restore

its monetary reputation.

Inflation and debasemem spawned an aca

demic and theological debate on whether

princes had the right to manipulate the coinage.

20'fhis sort of fraud was made possible by tl1e cost and difficulty of establishing, wit:h high precision, tlle intrinsic quality of coins. But tllis practice also created an incentive for private parties to assay coins so as to determine tlleir metallic content. While tllis assay worked imperfect!)'• however, since assaying dissipated real resources (precious me tal was lost in tlle process), it still worked to limit monetary manipulation. An example of tl1is behavior comes from France during tlle second half of tJ1e fourteentJ1 cemury. See Gandal and Sussman (1997).

2tSee Sussman (1993) and Sussman and Zeira (1 999) for models tl1at generate tlle dynamics of debasements: greater seignorage. highe•· inflation, and eventual collapse. For a dissenting view see Rolnick, Velde, and Weber (1996).

22Qn the experience of debasement in medieval Europe see Gould (1970), Kindleberger (1991),

MotOmura (1984), and Pamuk (1997).

THE POLITICAL ECONOMY OF INFLATION

Figure 2.2. Debasement Minting (Dauphine: 1417-22)

Mares 30000-

25000 -

20000 -

15000-

10000-

5000-

1417

Uvres tournois -80

-70

-60

-50

-40

-30

-20

- 1 0

0

59


60


Figure 2.3. Value of English Currency and the Price level , 1265-1500

-250

Price index

- 50

1265 85 1305 25 45 65 85 1405 25 45 65 85 99 0

On the one hand, feudal taw allowed the king LO

charge and profit from seignorage; on the other

hand, it was claimed that the currency was a pub

lic good, which the prince was responsible for ad

ministering for the benefit of his subjects.23

Predating the bullionist controversy of the nine

teenth century, other aspects of this academic de

bate related to pioneering formulations of the

quantity equation linking the money supply to

the level of prices, and an early analysis of the

shoe-leather costs of inflation. Periods of rapid

inflation also introduced indexation to the ac

counting system, to contracts, and even to wages

(see Sussman, 1993). In many respects, political,

academic, and market responses to debasements

were direct precursors of modern developments.

The inflation caused by the debasements re

distributed income from creditors to debtors, ad

versely affecting the landowning elite and the

church and raising transaction costs for mer

chants, creating repeated public outcries against

debasement and inflation. In some stares, no

tably England, representative assemblies struck a

deal trading off stable money in return for

higher taxation. In France, the elites Jacked the

cohesion to gram the king alternative sources of

finance.24 As a result, England enjoyed monetary

stability for centuries, whereas France suffered

from instability and bursts of inflation.

The competitive nature of the commodity

money system and the threat of currency substi

tution disciplined rulers more effectively than le

gal, theological, and political constraints.

Nevertheless, the tensions between monetary sta

bility and inflation were as prevalent in early

modern Europe as they are today. The resulting

monetary regimes can be divided into four

types. The first, that of England, was strictest in

terms of stability. The English currency was sta

ble for very long periods (on average, more than

60 years; Figure 2.3). The currency was debased

23The most famous of these protests was that of Oresme

Uobnson, 1956), who argued that debasements violated the public's property rights and inu·oduced injus[ices and inefficiencies.

24Qn the politics of F1·ench debasement, see Miskimin (1984}.


at infrequent intervals in order to adjust the

mint price to the value of circulating coins since

the constant wear and tear of coins reduced

their purchasing power and made it unattractive

to use them alongside mint coins. The English

crown did not make use of the mint for revenue

purposes.25 In addition, since England was an is

land economy it was easier tO prevent the circu

lation of foreign coins and conduct independent

stable monetary policy. Not surprisingly, the

main advocates of monetary stability were the

nobility and clergy (academics), substantial por

tions of whose incomes derived from nominal

rent contracts and other feudal dues.

The French experience, which was more rep

resentative of other minting authorities, was to

violently debase the currency in times of fiscal

crisis. Two episodes stand out, that of 1351-60

when the coinage fluctuated wildly (more than

60 times) and the price of silver increased by

2000 percent. Similarly, in the period 1418-22

the currency was debased by 4,600 percent (see

Figure 2.2); hyperinflation, this experience

makes clear, is not a uniquely modern phenom

enon. At other times, the currency was debased

more gradually, in a manner similar to

England's debasements, in order to allow for

the wear and tear of older coins. Lack of coop

eration from representative assemblies and the

many defeats suffered during the Hundred

Years War encouraged the crown to resort to de

basement. The political equilibrium that

emerged in France was that of absolute monar

chy, i�n which monetary policy was an instru

ment of the state.26 The interests of the mer

chant and noble elites were not well

THE POLITICAL ECONOMY OF INFLATION

represented, and consequently monetary stabil

ity was not a constraint on the policy.

A tl1ird pattern, common to the Italian city

states (Figure 2.4), was to gradually debase the

silver currency while maintaining the stability of

gold coins. This policy of the Italian communes,

run by a merchant oligarchy, reflected the inter

ests of the business elite. The governments of

the vibrant commercial centers of Italy were first

to pursue monetary policies that were independ

ent of fiscal considerations. They saw a connec

tion between the abundance of coins and the

well-being of the economy and preferred mild

inflation to deflation. By debasing the silver cur

rency, they were able to raise the mint price of

silver and attract fresh bullion to the mints. This

contrasts with English monetary stability, which

kept mint prices constant for generations at a

time, thus creating a gap between the mint price

and the market price of silver (that increased

due to the wea1· and tear of coins in circulation)

and a decline in the growth rate of silver sup

plies relative to the growth rate of the economy.

The bimetallic nature of the Italian monetary

system allowed the simultaneous attainment of

two goals--currency stability and debasement.

The gold coinage remained stable while the sil

ver was debased. The business elite comprised of

bankers and textiles exporters earned income

and held their assets in gold or gold-denom

inated bonds and paid their labor costs in silver.

Thus, their gold coins enjoyed Europe-wide rep

utation and circulaLion (most notably the

Florentine Florin-the almighty dollar of the

Middle Ages), while abundant silver coinage lu

bricated the domestic economy.27

25As noted above, a bargain was struck between Parliament and the crown to supply the crown with sufficient taxes that made it unnecessary to debase the currency. The notable exception to this pattern of monetary stability was Henry VIITs Great Debasement starting in 1542, which was carried out to raise revenues for the war with France. Over a ten-year period, the price of silver was raised by almost 100 percent, and t.hat of gold by 33 percent.. The currency was stabilized after hostilities ceased in 1551.

26While absolute monarchy was fully in place only in the sixteent.h cenrury, its roots lay in t11e Hundred Years War and in particular in the inability of representative assemblies to agree on LaXation, forcing the crown to circumvent them by resorting to debasements administered by a loyal bureaucracy, whose growing power undermined the effectiveness of representative institutions. We return 1.0 the connections between national security concerns and the fiscal role of monetary policy below.

27See Cipolla (1982) for an excellent discussion of the sophisticat.ed monetary policy of Florence.

61


62


Figure 2.4. Value of Silver Currency in Terms of Gold Florin

•

Source: Spufford (1986).

•

• • •

• • •

• •

France

-10000

logarithmic scale. Values tor French debasements are based on Sussman (1999).

Finally, there stood states that constantly engaged in fiscally motivated debasements. A case in point is Castile, where the currency was debased continually for more than a century and a half, interrupted only by brief periods of stability. Castile exemplifies the political fragmentation and constant civil wars that forced the crown to use debasement to finance its troops. Lack of political discourse did not allow for negotiations on monetary policy, and the weakness of the crown did not allow for cessation of inflationary policies.

The four cases discussed above have similarities with modern experience. Then as now, weak political systems-those lacking cohesion and consensu s-building institutions-were inflation prone, sometimes very much so. States with su·onger political systems might succumb to mild deflation or mild inflation, depending on the balance of power between members of the ruling elite inclined toward these differem outcomes. ln states dominated by agricultural interests, such as England and France, the political elite was dominated by landowners who received nominal customary feudal dues that were not easily renegotiated and who consequently preferred price stabili ty (a goal which they achieved more successfully in England, where representative institutions were stronger) .28 Creditors, for self-evident reasons, similarly preferred price stability and made their preference felt where political institutions permitted. It was only in states where industrial and mercantile elites dominated that the profits from real wage erosion figured sufl1ciently prominently in the policy calculus for mild inflation to be pursued. Wage workers bore the costs and, in exu·eme cases, sought to revolt and seize political comrot.29 In

28Sussman (1993) demonstrates the erosion of the nobility's real incomes during the inflation of the Hundred Years War.

29Unlike today, the poorest people-Lhat is, the peasants who comp.-ised 90 percent of society-because they did not engage in significant amountS of monetary exchange, were not direcLiy affected by inflation. Even where agricui[Ure was commercialized, it suffered much more from harvest uncertainties due to, among oL11er things, changes in 1.he weather than from p!'ice-level fluctuations.


Florence, a compromise was reached between

these competing interests: gold remained stable,

but silver was debased.

The International Monetary Landscape

The monetary scene during the Middle Ages

and the early modern pet;od reflected

Europe's political fragmentation. With the ex

ception of England, each region was dotted

with issuing authorities: monarchies, city-states,

towns, and dukedoms. Over 100 different silver

currencies existed in Europe before 1500, com

pared with 38 at the beginning of the nine

teenth century.30 This situation resulted in high

u·ansaction costs as reflected by the growing in

dustry of money changers and exchange manu

als that helped merchants classify and u·ade the

various coins.

Despite the proliferation of silver currencies,

the heavyweight players were those authorities

that could circulate gold coins. The club of gold

issuing states included only 32 political entities,

of which 12 were Italian city-states. The only

truly international currencies were the

Florentine Florin and the Venetian Ducat, al

though the French Ecu and the German cities'

Rhinegeld eftioyed wide circulation in their own

areas. Much like during the gold standard era,

the gold-issuing countries were the economicaUy

advanced ones, which enjoyed superior u·ade

and credit facilities.31 Moreover, there existed a

close connection between financial supremacy,

as measured in number of banks and amount of

international lending, and the circulation of an

internationally renowned gold coin. Like

London in the nineteenth century, Florence in

THE INTERNATIONAL MONETARY LANDSCAPE

the fourteenth and fifteenth centuries issued the

reserve currency of the Middle Ages and was

Europe's leading financial center.

Medieval Europe was composed of a set of

small open economies.32 The share of manufac

tures and luxury good production that was

u·aded was relatively high. While capital flows

were low, they were unrestricted and since most

regions did not have gold or silver mines, the

money supply was determined almost exclusively

in the international money market. Therefore

states could not sterilize or impose exchange

controls, as their nineteenth and cwentieth cen

tury successors were able to do, nor did they

have the luxury of suspending convertibility in

the face of a bullion drain, making it impossible

to conduct an independcm mone tary policy for

any substantial length of time.33 Intentional or

unintentional deviations of the official gold-to

silver ratio at the mint from the international ra

tio sent one metal abroad, leaving in circulation

the less (relatively) valued one. During debase

ments, states increased the price of silver at the

mint to attract foreign silver, which entered the

mints and provided seignorage, while gold that

yielded little in terms of seignorage was ex

ported. When one of the warring parties de

based the currency in an attempt to draw silver

to its mint, its opponents had to reciprocate.

Monetary wars were part of the war effort, in

deed, at times victory in the monetary war was

more important, or a necessary condition to win

ning on tl1e battle£ield.34 During peace times, for

eign coin invasion that resulted from misalign

ment of silver coins could undermine the

monetary policy of even the strongest financial

center in Europe.35

goBased on the currencies listed in Spufford ( 1986). For the nineteenth century. see Lhe article on coins in McCulloch (1837).

:�•or Lhe 33 s tates that. issued gold coins in the early nineteenth century, 17 had already issued gold coins in the Middle Ages.

32See Munro (1979) on bullionistic measures in medieval Britain. :!:�Sussman ( 1998) provides a model of commodity money based on the monetary appmach to the balance of paymems. !14See Sussman (1993) for analysis of the comribuLion of success of the French in winning the moneta�·y war with

England and Burgundy to their ability to prevail in the Hundred Years War. See also Wervcke (1948) for analysis of the monetat-y wars between France and Flanders.

3SSee Cipolla ( 1982) for discussion or the quatt.rini affair-in which Florence was inV"".tded by Pisan quattrinis leading w a debasement. of Florentine silver currency. The episode is also analyzed in Sargent and Smith (1997).

63


64


The exposure of the Em·opean economy to

capital and monetary flows is best exemplified in

two related episodes-the Bullion Famine and

the Price Revolution. During the Bullion

Famine, which is said by scholars of the subject

to have lasted from 1380 to 1460, bullion was ex

ported to the East to cover trade deficits result

ing from the Black Death. The decline in the

money supply sent the economies into a severe

and prolonged recession.36 The flow reversed di

rection following Europe's discovery of America,

which set in motion flows of silver and gold to

Europe. These flows generated what is termed

the Price Revolution, when prices increased at

an average rate of 1 percent per annum for

more than a hundred years. After centuries of

price stability, Europe experienced its first long

period of inflation.

Paper Money: Beginnings

The development of banking in the Middle

Ages and the early modern period led to the in

troduction of new monetary instruments, start

ing with the bill of exchange (a kind of a

banker's draft) and ending with paper money

backed by fractional reserves. Banks settled their

bills in gold or silver. Though the danger of

bank runs limited the tendency to over-issue

notes, the use of bills of exchange became in

creasingly prevalent, preparing the ground for

the eventual introduction of inconvertible paper

currency. In the absence of well-developed bond

markets, private banks and bankers lent to gov

ernments and popes. Default on some of these

debts led to the bankruptcy of some of the lead

ing banking houses of the time.

A prerequisite for the circulation of fiat paper

currency was the establishment of a central

bank. These banks were mostly private but pos

sessed a degree of monopoly power over note is-

sue, which was conferred in return for services

provided in managing tl1e public debt. The cur

rency bills issued by these banks were convert

ible into gold or silver (except in times of crisis).

As with debasements, the issue of inconvertible

paper was in most cases an expedient related to

war. Moreover, each of these episodes, as during

the earlier commodity-money regimes, ended

with stabilization and return to convertibility.

One notable exception was the first experiment

with the large·scale issuance of inconvertible pa

per: the infamous Law affair in France in

1716-20. John Law founded the Banque Generate, which received privileges similar to those of the

Bank of England in return for offering the

crown similar services. I L issued notes re

deemable in specie. In practice, however, note is

sue increased well beyond its assets.37 More than

a few of tl1e notes issued by this bank were used

to purchase the Mississippi Company stock. A fa

mous bubble developed, with Mississippi

Company stock appreciating in price and note

issues ever increasing, until November 1720, when the bubble burst and the bank could not

make specie payments in return for notes.

l t is thus tempting to suggest that central

banking and fiat money emerged as by-products

of state finance. The impetus for granting mo

nopoly power to these private banks was the de

sire to have access to cheap, dependable sources

of funding for the governmenl and to obviate

the need to rely excessively on the market.

Ultimately, these mounting debt burdens ended

up in the lap of the central bank, in episodes of

monetization that occasioned Europe's ftrsl ex

periments with inconvertible fiat currency.

Another episode of inconvertible paper cur

rency occurred in Sweden from 1745 to 1762, where the cenu-al bank (the first government-run

central bank in Ettrope) issued currency to fi

nance a Keynesian type expansionary policy tbat

S6See Sussman ( 1998) for a model of the bullion famine and critique of its assumptions, empirical evideuce, and conclusions. The analysis and data there suppon the hypothesis lhat the decline in minting was a result of fall in economic activity that followed the Black Dealh, which wiped out a third of Europe's population. This created large surpluses of precious metals lhat were hoarded and exponed in return for goods and services.

37Jn 1718 the Banque Generale was taken over by the king and renamed Banquc Royale.


resulted in inflation and depreciation of the ex

change rate (Kindle berger, 1984). Inconvertible

money was also imroduced during the American

War of Independence ( 1776-80) and during the

French Revolution (the Assignat inflation of

1790-94), during which inflation reached 36 per

cent a montJ1.

The British Suspension ofl797-1821 was

probably the most famous such episode. Its im

portance lies both in its duration and in the the

oretical debate it spawned, which laid the foun

dations for classical monetary economics. l l

started with a run on the Bank of England in

1 797, precipitated by fears of a French invasion.

The suspension of specie payments was initially

scheduled to last six months but was repeatedly

extended, ending only in 1821. Unlike its conti

nental counterparts, the Bank of England was

able to manage the money supply to limit infla

tion. This is another indication of tJ1e power of

the stable-money interest that had prevailed in

England for centuries which 'vas strengthened

during tJ1e Glorious Revolution.

High inflation mreatened only in 1809-10,

which brought about the appoinunem of me

Bullion Committee to investigate the causes of

the pound's depreciation. The Bullion

Controversy generated a lively economic debate,

whose participants included ThornLOn and

Ricardo. While the conclusions of Bullion

Report were rejected by Parliament, me politicaJ

and economic debate it spawned acted to disci

pline the Bank of England until convertibility

was resumed in 1821.

Ln me episodes described above, inconvertibil-

ity ,vas not deliberate. It 'vas the inadvertent re

sult of excessive note issue in response to crisis

conditions, typically \var. It was well understood

that inconvertibility 'vas only temporary.

Nevermeless, the adverse consequences of those

unintentional inconvertibility crises strengm

ened me parties advocating specie standards and

price stability at least up to World War J.38

THE NINETEENTH CENTURY SYSTEM

The Nineteenth Century System

The nineteenth century was an era of peace

compared w what came before and went after.

ln 1815, Russia, Austria, Prussia, and Britain

formed the Quadruple AJiiance, agreeing to

meet periodically to discuss meir common inter

est in peace and security. To be sure, this so

called Concert of Europe did not prevent lim

ited conflicts, from tJ1e Crimean War to the

Franco-Prussian War to the Spanish-American

War. But the Congress of Vienna inaugurated a

century when me world was spared a global or

even cominent-wide conflict.

Peace and security provided a favorable con

text for growth. This was the century when the

industrial revolution spread from an isolated

corner of normwest Europe to omer parts of the

globe. It \vaS me century in which trade grew

even faster man output, fueling me increase in

agricultural and industrial production:

Maddison's (1995) estimates suggest mat mer

chandise exports rose from 1 percent of GOP in

1820 to 5 percent in 1870 and approached 10

percent in 1913. [t was a period of rising interna

tional capital flows. The favorable political cli

mate helps to explain mese outcomes. So do the

rapid declines in transportation and communi

cations costs associated with railroadization, the

shift from sailing ships to steam ships. the tele

graph, and the u·ans-oceanic cable.

Exchange rate stability was integral to this

process. For me first two-thirds of the century,

national monetary systems were divided into

three blocs: a gold bloc composed of Britain,

Portugal, and most ofBritain's dominions and

colonies; a silver bloc made up of most of the

German states, Austria, the Netherlands,

Denmark, Norway, Sweden, Mexico, China,

India, and japan; and a group of bimetallic (or

"double standard") countries including France,

Belgium, ltaJy, Switzerland, and the United

States. The adoption of a common monetary

standard by the members of each of these blocs

sssee Sussman ( !997) for discussion of Lhe role of policyrnakcrs in establishing what is now termed "British Monet:.ry Orthodoxy" as a reaction to the convertibility suspension of 1797-1821.

65


66

CHAPTER II THE INTERNATIONAL MONETARY SYSTEM 1N THE (VERY) LONG RUN

(together with their inability to prevent the

inter-circulation of their jJartners' coins) made

for exchange rate stability within the group.

More su-i king still is the stability of the ex

change rates between them_ The relative price

of gold and silver and hence the exchange rate

between gold and silver coins of comparable

weight and fineness held stable around 15\/z to

1 from the early nineteenth century to the

1870s (at which point the price of silver took

of£) .39 This stability is all the more remarkable

given the magnitude of the shocks to world

gold and silver supplies and hence the potential

for the market and mint prices of the metals to

diverge. Typically, these shocks took the form of

the discovery of gold or silver deposits in the

course of agticultural and pastoral penetration

of sparsely settled regions: they included gold

discoveries in California in 1848 and eastern

Australia in 1851 (which together raised world

production of gold tenfold) and the Comstock

Lode silver discovery in Nevada in 1859. The

stability of exchange rates in the face of these

disturbances is typically ascribed to the stabiliz

ing properties of bimetallism.40 \1\lhen the sup

ply of newly mined gold rose, as it did in the

1850s, and its price began to drop (relative to

that of silver), the cheap metal flowed toward

the members of the bimetallic bloc, where it

was coined, and the scarce metal (silver) was

melted down and exported.41 Conversely, when

the supply of silver rose, as it did in the 1860s,

the bimetallic countries imported silver and ex

ported gold, allowing the former to displace

the latter in domestic circulation.42 Mid-century

flows of newly mined gold and silver may have

been large as far as flows go, but they were

small relative to the stocks of the two metals

that circulated in the bimetallic counu-ies. So

long as stocks dominated flows and the commit

ment to bimetallism was su-ong, exchange rates

remained stable. The system operated like a sta

bilizing target zone: the knowledge that France

and its bimetallic paru1ers would absorb one

metal and disgorge the other as soon as their

relative price in tl1e market diverged from their

relative price in the mint (by more than the

narrow margins allowed for by transactions

costs) prevented the market price from hitting

those reflecting barriers.'13

Given the stability of the bimetallic standard,

tl1e speed with which it crumbled after the 1860s

is something of a paradox. Flandreau ( 1 994) dis

tinguishes four explanations for this u·ansforma

tion. The "structural" explanati.on of

Kindleberger ( 1 984) and others points to silver

discove•-ies in Nevada and Mexico and the in

crease in newly minted silver in the 1860s and

1870s. Risil'tg silver output meant falling silver

prices and inflaLion and exchange rate deprecia

tion for silver-standard counuies, undesirable

consequences that pushed them onto gold. But

it is not clear why the same argument that ap

plied to the pre-1870 period (flow supplies of

the two metals, while large, were small relative to

the stocks circulation in the bimetallic coun

tdes) did not also apply to tl1e post-1870 years.

In fact, the rise in silver production in me late

1860s and 1870s was small compared tO the

surge in gold production after 1848:1-1

39We argue in a moment that this stability reflected the operation of systemic factors. 40See, for example, Flandreau (1995). 41The markets responded in this fashion because the governmems of officially bime tallic countries pegged the relative

price of gold and silver at a constant price. (ln practice, countries like the United S tates mjght alter that relative price periodically, but those changes were few and far between.)

42flandreau (1994) estimates that for every dollar of one met<ll added to the world stock, France and its partners absorbed 60 cents, while disgorging 40 cents worth of the other.

43The target-zone model is applied 10 nineteenth cenr.ury bimetallism by Oppers (1995). 44A variation on this theme is the "chain-gang" hypothesis of Gallarotti ( 1995): by purchasing gold and selling silve1�

Germany added to the incipient disequilibrium caused by the Comstock Lode and Mexican silver discoveJ-ies, thereby threatening the bimetallic system. The objection is again the same, namely, that German gold purchases and silver sales, while working in the posited direction, were too limited to undermine the viability of French bimetallism (Oppers, 1996). Oppers calculates that Germany's demonetization of silver would have reduced 1he share of gold in the money supplies of the bimetallic countries from 57 percem in 1873 to 48 percent in 1879, bm that the 15\-1 to 1 mint ratio would not have been threatened.


The second explanation focuses on the mone

tary consequences of rising living standards,

technological progress, and expanding trade.

Prior to the nineteenth century, the smallest

gold coin was still too valuable for everyday use.

One of the attractions of bimetallism was that it

provided a supply of low-value silver coins that

were practical for domestic transactions, along

with more valuable gold coins that were conven

ient for larger transactions, international trans

actions in particular. As trade and living stan

dards rose, the balance shifted bet\veen these

two needs. The problem of producing small

denomination token coins that might circulate

alongside the gold coinage used in large u·ansac

tions, without incurring the risk of significant

counterfeiting, was solved once steam power

came to the mint and token coins could be pro

duced at a higher level of uniformity.45 A gold

based standard consequently became more

attractive.

While there is surely something to this expla

nation, its power should not be exaggerated.

Half a century and more passed between the ad

vent of steam-powered machinery and the shift

to gold. Differences in the cost of settling large

transactions by shipping gold and silver bet\veen

countries were a negligible share of the u·ansac

tions involved. Something else is needed to ac

count for the timing of the event and the simul

taneous adoption of the gold standard in a large

number of different countries.

One possible "something else" is politics. The

expansion of industry relative to agriculture

muted the voice of farmers, a debtor class that

preferred rising prices and declining mortgage

debts, relative to financial interests who pre

ferred stable money. Thus, the final defeat of

the "free silver" lobby in the United States in the

1890s is typically described as the triumph of

creditors over debtors and of the advocates of

stable money over inflationists.46 Again, there is

surely something to this interpretation. After all,

45See the discussion in Redish (1990). 4GSee, for example, Frieden (1994).

THE NINETEENTH CENTURY SYSTEM

the new system would not have been adopted in

the absence of political support. But, as typicaJiy

told, this story neglects the influence of the

lobby with the most to lose in the event of silver

demonetization, namely, the silver lobby itself,

which grew in numbers as the volume of silver

mining continued to expand. Its proponents ap

ply to other countries the American political

constellation, in which the yeoman farmer

played a powerful role, whereas in other coun

tries land was held in large blocs by an aristoc

racy not similarly encumbered. It tends to inter

pret the 1870s and 1880s in terms of a debate

that really only came to a head in the 1890s after

more than two decades of deflation.

The fourth and final explanation (to which we

are inclined) is network effects. With the growth

of international trade and lending, it became in

creasingly convenient to operate the same mone

tary standard as one's neighbors. Transaction

costs and exchange rate uncertainty between the

gold and silver blocs may have been small, but

even small costs mattered with the expansion of

international trade and lending. British investors

understandably preferred foreign investments

denominated in sterling; Madden (1985,

pp. 255) describes as "common knowledge" 1.hat

British investors viewed securities issued by coun

tries not on the gold standard as riskier than

those of countries that were, and that they lent

accordingly. The convenience of a common stan

dard was conducive to trade; Flandreau (1993)

shows that countries sharing a common standard

traded disproportionately with one another even

after conu·oUing for incomes, proximity, and ad

jacency. Thus, the fact that Britain was then a

leading commercial and financial nation for

much of the nineteenth century encouraged

other countries to link up to her monetary stan

dard. And t11ese network effects were reinforced

when the world's two other leading industrial

economies, Germany and the United States,

went over to the gold standard in the 1870s.47

47Meissner (1999) estimates a model of tl1e timing of the adoption of tl1e gold standard in various counu-ies, obtaining some econometric evidence of the importance of tl1ese network effects.

67


68


Finally, the suspicion, however nebulous, that

the gold standard had been an ingredient of

Britain's industrial success encouraged its adop

tion. That Britain had been the first country to

go onto the gold standard and also the first

country to industrialize encouraged the view of

the gold standard as a progressive and modern

monetary arrangement.

In the event, silver and bimetallism were aban

doned ad seriatim, as one country after another

went over to gold. Newly unified Germany led

the way in 1871, using the indemnity it received

as victor in the Franco-Prussian war to carry out

a monetary reform. Otber silver-standard coun

tries that traded heavily with Germany-the

Netherlands, Denmark, Norway, and Sweden

among them-followed suit. France and her

partners in the Latin Monetary Union, Belgium,

Switzeriand, Italy, and Greece, abandoned bimet

allism for gold.48 When the United States com

pleted its recovery from the Civil War and offi

cially restored convertibility in 1879, it did so on

gold rather than a bimetallic basis.49 Once

Russia and Japan adopted gold convertibility in

the 1890s, the gold-standard system of fixed ex

change rates between national currencies was

truly global in scope.

A limited number of countries never went

onto the gold standard prior to 1913. China re

mained on the silver standard, as did a number

of central American countries (Guatemala,

Honduras, and El Salvador). Persia's officially

bimetallic system was effectively silver based. But

by the first decade of the twentieth century, the

largest part of the world was on gold.

Stability of the Gold Standard

Many commentators have noted the striking

stability of the nineteenth-century gold standard

system. To be sure, payments pressures occasion

ally forced countries to suspend convertibility,

most frequently in "emerging markets" at the pe-

riphery of the international system. And banking

and financial crises were not uncommon (as we

describe below). Almost without exception, how

ever, gold convertibility was restored subse

quently, generally at the previously prevailing

rate of exchange. And the leading industrial and

commercial powers remained on gold without

interruption for fully a third of a century up to

World War I . As enumerated above, a few coun

tries in Central and South America and Asia (no

tably China) did not join the gold standard club,

preferring to cling to silver, but they became an

increasingly isolated minority as the period

progressed.

A reasonable degree of price stability was a

corollary of the operation of this system. In t11e

same way that national money supplies were

linked to national stocks of gold, the world

money supply was linked to the world gold

stock. 50 The commitment to gold convertibility

deterred governments from manipulating

money supplies in ways iliat destabilized the

price level. And ilie operation of t11e market

induced changes in the world gold stock to ac

commodate changes in world money demand.

As the world economy expanded, commodity

prices tended to fall (given the more-or-less con

stant supply of money), which raised ilie real

price of gold (since governments were pegging

the nominal price of the latter). The gold-min

ing industry responded with increased supply,

which boosted money supplies and neutralized

the fall in the price level (Barro, 1979). The

mechanism might work slowly, allowing deflation

to persist (as between the mid-1870s and mid-

1890s), but work it did.

From an end-of-millennium perspective, ilie

most remarkable feature of this system was the

success with which it reconciled capital mobility

with exchange rate stability. Today, international

capital mobility is seen as posing an impossible

challenge to countries seeking w hold their ex

change rates stable and at the same time to pur-

48The Latin Union was an arrangement negotiated to harmonize the coinage in these closely linked countries. 49Although limited amounts of silver coinage continued until ll1e passage of the Gold Standard Act of 1900. 50The velocity of circulation fell slowly for most of the period (Bordo andjonung, 1997), but rrends were not large.


sue other economic, political, and social goals.

Capital mobility, it is said, makes it increasingly

difficult for countries to square this circle, en

couraging the adoption of policies of greater ex

change rate flexibility. The gold standard is a

challenge to this conventional wisdom. Capital

mobility was also high under the gold stan

dard-by some measures (current accounts as a

share of GDP, for example) even higher than to

day. 51 And yet countries were strikingly success

ful at holding their currencies stable against

gold, and therefore against one another, under this earlier monetary regime.

What explains their success? The most impor

tant factor was undoubtedly a social and political

setting in which other potential goals of eco

nomic policy were subordinate to the mainte

nance of gold convertibility. 52 In the late nine

teenth century, pressure to direct monetary

policy to other objectives was minimal. There

was no widely accepted theory linking monetary

policy to the state of the economy. Competing policy targets were few: central banks came un

der little pressure to minimize unemployment,

for example, when the very concept (of unem

ployment) was unfamiliar.ss Unions could not ef

fectively demonstrate against monetary austerity

so long as unionization rates were low. Working

class voters could not vote out of office govern

ments that supported defending the exchange

rate over and above other goals so long as the

5ISee Bayoumi (1990) for evidence.

STABILITY OF THE GOLO STANDARD

extent of the franchise remained limited, as it was until the twentieth century.54 The monetary

printing presses did not have to be enlisted in

support of the government finances in an age of

limited government, limited social programs,

and limited defense spending.55

Compared to the situation in Bt;tain, France,

and Germany, this monetary system operated less smoothly at the periphery of this expanding

world economy, where in terms-of-trade shocks

were larger, financial markets were shallower,

policy was more erratic, and capital market ac

cess was irregular. It was the "emerging markets"

of the nineteenth century that were driven off

the gold standard for extended periods, al

though they too typically restored gold convert

ibility eventually at the previously prevailing do

mestic currency price of gold.

Some (for example, de Cecco, 1974) would ar

gue that the favorable environment sustaining

the operation of the gold standard had begun to

deteriorate even before World War I . The arms

race of the first decade of the twentieth century and social movements of the Left (together with

Fabian and other Socialist ideologies) led to in

creases in public spending and growing budget

ary so·ains. Rising diplomatic and military ten

sions made cenu-al bank cooperation more

difficult. The gold standard's days may have

been numbered, but only at the end of a long and successful run.

5lrfhis, of course, is Lhe same factor that enables countries like Argentina and political jurisdictions like Hong Kong SAR to fix their currencies to the U.S. dollar today: Lhat they are willing to subordinate other objectives to the maintenance of "convertibility" (as the Argentines revealing!)' refer tO it).

�3According to Feinstein, Temin, and Toniolo (1997), the noun "unemployment" only appeared in 1888, and tl1e compilation of official statistics came much later.

54To be sure, this emphasis on domestic political suppon for the prevailing monetary system should not be pushed too far. Recall, for example, populist agitation in the United States against the perceived deflationary consequences of the operation of the gold standard, which featured prominently in the 1896 election fought largely on tl1is issue. See Frieden (1994).

5!>To be sure, other factors contributed to this stability. The flexibility of wages and prices allowed economies to adjust without changing their exchange rates in response to internal and external shocks. The absence of major macroeconomic disturbances like those which destabilized the world economy in the 1930s limited dislocations and adjustment costs. Bayoumi and Eichengreen (1995) provide evidence to this effect. The stability of the gold standard (and of economic activity generally) in Great Brita.in, the country at Lhe center of the international monetary and financial system, buttressed stability in other countries to which its finances and economy were linked. International loans in times of crisis, whetl1er organized by governments, central banks, or private financiers, prevented the counu·ies at the core of this system from having to abandon convertibility, !hereby damaging tl1eir reputations, in response to temporary shocks (Eichengreen, 1995).

69


10


End of the Gold Standard

Operating the gold standard entailed real re

source costs. Gold had to be extracted from the

ground-ever more gold as the world economy

expanded. lL had to be transported from the

mines to the mints, from the frontier to the fi

nancial centers. It had to be minted into coin. It

had to be shipped from country to country in

settlement of the balance of payments. Already

in the nineteenth century, governments and

central banks responded with technological and

organizational innovations that economized on

these costs. Gold reserves were concentrated in

government and central bank accounts;

claimants had to acquire a specified minimum of

their obligations in order to obtain gold in re

turn. This was the evolution from the gold coin

standard to the gold bullion standard.

Governments began to supplement gold with

convenible foreign exchange (typically, bonds

and bank deposits held in London or another

leading financial center) , thereby minimizing

the need to accumulate the yellow metal. This

was the evolution from the gold bullion standard

to the gold exchange standard. Central banks

adjusted interest rates in response to payments

imbalances (upward in response to deficits,

downward in response to surpluses) , minimizing

the need for costly gold shipments.

Before 1913 the scope of these developments

was limited. Gold coin continued to dominate

the domestic circulation in England, France,

Germany, and the United States. Foreign ex

change reserves accounted for only 20 percent

of total international reserves on the eve of

World War I, and the vast majority of these were

held by only three countries, Russia, India, and

Japan. Active central bank management of the

gold standard \vas the exception, not the rule, in

an era when national central banks were still few

in number (recall, for example, that the United

States still lacked one) and the phrase "rules of

the game" had not yet been invented.

AU this changed with World War I. Where

gold coin had circulated internally, it was now

concentrated in the governmem's vauJts. With

the establishment of central banks in countries

where they had not existed previously, the gold

standard became a much more managed system.

To avert a deflationary scramble for gold ren

dered scarce by the expansion of the world

economy and the inflation fueled by World War

l, an international monetary conference was

convened in Genoa in 1922 to encourage gov

ernments and central banks to augment their in

ternational reserves with convertible foreign ex

change. This was the first of a series of

less-than-successful efforts to collectively manage

the supply of international liquidity, something

that under the classical gold standard had been

left to the determination of the markets. Partly

as a result of deliberations at Genoa, the share

of foreign exchange in global reserves roughly

doubled, from 20 to 40 percent, between prewar

)'Cars and the late 1920s, the practice becoming

much more general than before.

Moreover, the war undermined the political

and social foundations of the classical gold stan

dard system. Men could no longer be sent off to

fight witl1out being granted tl1e vote. Universal

male suffrage-and, increasingly, female suf

frage-became t11e norm, not the exception.

And as suffrage increased, so did governmenr

spending on social programs.56 Union member

ship expanded in the countries embroiled in

hostilities, as governments sought to identify a

labor partner to participate in corporatist negoti

ations and minimize workplace disruptions that

might hinder the war effort. joblessness now be

came a political issue. Bdtain and various conti

nental European countries adopted systems of

unemployment insurance and relief, initially on

a limited basis but increasingly comprehensive

over time. Keynes and other economists articu

lated theories linking monetary policy to unem

ployment and used the popular press to give

prominence to their views.

56Th is is argued using dat.a on U.S. states by Lou and Kenny ( 1999).


As a result, monetary policy became more

politicized. It became more difficult to subordi

nate other goals of policy to the over-arching ob

jective of exchange-rate stability. The credibility

of the commitment to the gold standard was di

minished, which in turn affected the behavior of

the markets. Previously, when a currency had

weakened (when it dropped toward the gold ex

port point), there was little reason to question

that the central bank would defend it.

Consequently, capital would flow toward the

country with the weak currency in anticipation

of its subsequent recovery. The gold import and

export points acted like the reflecting barriers of

a credible target zone. 57 Now, however, when the

exchange rate weakened, investors began to

doubt whether the central bank had the political

support to defend it. The currency dropping to

the gold export point was seen as a warning that

gold convertibility was about to be abandoned.

Capi tal, rather than flmving in, would flow out.

This was the problem of "destabilizing specula

tion" given prominence by Nurkse ( 1944).

These problems were enough to bring down

the enti•-e international monetary system be

cause they infected the conduct of monetary

policy at its center. Consider Britain, one of the

countries at the center of the gold standard

club.f•>� Britain suffered from double-digit unem

ployment for nearly the entire period she was

back on the gold standard (starting in 1925). As a result, the Bank of England lacked the stom

ach to defend the exchange rate when it came

under attack in 1931 .59 Since sterling was one of

the two leading reserve currencies, its deprecia

tion prompted the large-scale liquidation of for

eign exchange reserves, which other countries

used to back their domestic circulation. The

END OF THE GOLD STANDARD

share of foreign exchange in global reserves fell

from 37 percent at the end of 1929 to 1 1 per

cent at the end of 1931, tightening the monetary

screws. Central banks around the world sought

to substitute gold for foreign exchange, but

there was only so much gold to go around. As each of them raised interest rates in the effort to

attract gold from one another, their efforts were

mutually defeating.

The other countries at the center of the re

constructed gold standard were the United

States and France, whose policies had similarly

destabilizing effects. Before 1913, British capital

had helped to stabilize the world economy by

flowing countercyclically: when British economic

growth slowed and import demand fell off,

British foreign lending tended to rise, moderat

ing the slowdown in the rest of the world. This

pattern reflected the Bank of England's steady

hand on the monetary tiller: if the British econ

omy slowed, given domestic supplies of money

and credit, interest rates would fall in London,

rendering foreign investment more attractive;

gold and capital would flow out. Thus, British

commodity imports and capi tal exports lluctu

ated inversely. ln the 1920s, in contrast, U.S.

monetary policy fluctuated procyclically. The

Federal Reserve cut interest rates in 1924 and

1927 when the U.S. economy was booming. t"n

couraging procyclical capital flows. Similarly, be

cause monetary policy remained tight f()r much

of the Great Depression (Hamilton, 1992), U.S.

merchandise imports and capital exports col

lapsed simultaneously.'i0

French policy similarly heightened the strains.

The Bank of France's gold reserves more than

doubled between 1926 and 1929, more than

tripled by the end of 1930, and more than

'•7See Giovannini ( 1993) and Bordo and MacDonald ( 1997) for evidence that the clas.�ical g-old �tandard displayl·d man1· or the properties of a credible target zone.

<•HLf anything, foreign balances held in sterling may have still exceeded fi>reign balances ht:ld in dollars in the I \l20s. !>!Yfhis is, to be sure, only one of several interpretations of the 1931 sterling crisis; sec I::ichengJ·ecn and .Jeanne ( I \J\l!l)

f(H· evidence in ilS favor. '�'There is no single, universally accepted explanation for what appear in retrospt·ct as a sequence or eg-regious pol in

mistakes. Among the factors emphasized by previous authors are the inexperience of officials in the newly es tablished L" .S. cenu·al bank, the untimely death of iL� leading intellectual light, Benjamin Strong of the Federal Reserve Bank of New York, and the sway of a poorly formulated liquidationist theory of monetary policy. The lorus classicus fi1r this literatun· is of course Friedman and Schwarl'l. ( 1963).

71


72


quadrupled by the end of 1931, at which point

the country held nearly a quarter of global gold

reserves. Surpluses for France meant deficits for

other counuies and pressure on their gold stan

dard parities. In part, the pattern reflected the

relatively late date of France's inflation stabiliza

tion (at the end of 1926), which generated a

predictable "capital inflows problem." In part it

reflected the continued growth of the French

economy in 1930 and 1931, while the rest of the

world had already descended into recession. At a

deeper level, however, it reflected the failure of

the Bank of France to expand the domestic

credit component of the monetary base.61 In re

action against the abuse of credit facilities by

earlier French governments, the Parliament

adopted statutes prohibiting the central bank

from extending credit to the government and

otherwise limiting the scope for expansionary

open-market operations. Thus, the poststabiliza

tion increase in money demand could be satis

fied by gold inflows and gold inflows alone. 52

The problem was aggravated when, starting in

1927, the French central bank began converting

its previously accumulated foreign exchange re

serves into gold.

The interwar gold standard was thus more

fragile than its prewar predecessor. Competing

policy objectives dimjnished the credibiljty of

the commitment to exchange rate stability.

Increased reliance on foreign exchange reserves

magnified the deflationary consequences of a

shock to confidence. It is no surprise, then, that

the interwar system was less successful than its

prewar predecessor at reconciling exchange rate

stability with capital mobility.63

The recession that commenced in the United

States in 1929, even in its early stages, was excep

tionally severe. There is reason to wonder

whether any system of fixed exchange rates

could have survived such a severe downturn in

the world's largest economy, its principal capital

exporter, and the country at the center of the in

ternational monetary system. Be that as it may,

one may question whether the fragile version of

the gold standard erected in the 1920s could

have surmounted even a significantly more mod

erate shock.

The response of governments in this climate

of instability was to cut, or at a minimum to

loosen, their links to the international system.

For some like the Scandinavians, this just meant

cutting loose from the gold standard as a way of

regaining their policy autonomy and insulating

themselves from deflation abroad. Other coun

tlies in central and eastern Europe, led by

Germany, imposed increasingly draconian ex

change controls starting in 1931. With the col

lapse of traded-goods prices and of trade itself,

governments jacked up import tariffs, launching

the volume of trade onto a downward spiral.64 As markets were blockaded, even countries that

61The coumry's gold standard statute required the Bank of France to hold gold i n the amoum of 35 percem of its eligible mone!al'y liabilities. Jn principle, then, a 100 franc increase in money demand could have been met through gold inflows of only 35 francs and through 65 francs' worth of domestic c1·edit creation. In practice, however, gold inflows were forced to do all the work.

62'fo pm the point another way, the failure of the French authorities to adopt a more expansionary monetary policy meant that France remained in su·ong surplus throughom Lhis period, imensifying the strains on the intemational system.

6S'fhis emphasis on policy credibility and international financial fragility does not deny the existence of other problems. The new constellation of exchange rates was not ideal: the British pound was overvalued, the French franc was undervalued, and a variety of other currencies were stabilized at inappropriate levels. War debt and reparation transfers strained the balances of payments of the European economies, heightening their dependence, and the dependence of the imernational system, on the continued willingness of the United States to recycle its surpluses. Wages and prices adjusted Jess fluidly than before, reflecting the public provision of unemployment insurance and relief and the developmem of internal labor markets (a concomitant of the large, multidivisional corporation). The open door having been closed, international migration no longer provided a labor-market safety valve to the same extent. Ceno·al bank cooperation was more difficult to arrange so long as the sour aftertaste of World War I lingered. That the principal agent of international monetary cooperation, the Bank for International Settlements, was also responsible for effecting Germany's reparations transfer led the Bank's motives to be questioned when it attempted to assemble crisis loans.

&!These discretionary policies were reinforced by the interaction of specific tariffs, the most prevalent form of protection i.n the 1930s, wid1 falling prices (Crucini, 1994).


wished to maintain their gold parities found it difficult to generate foreign exchange. And as capital markets closed down, developing countries suspended payments on their external debts; in the absence of new lending, the incen

tive to keep current on their external financial obligations was greatly reduced. In these ways the collapse of the international monetary sys

tem reinforced, and in turn was reinforced by, the collapse of international trade and finance.

To be sure, not all countries were equally

ready to cut their international links. Bri tain's Commonwealth and Empire, along with her

principal European trading partners (Portugal, for example), sought to maintain their u·adi

tional commercial and financial ties, forming the sterling area and pursuing policies of imperial preference. 65 France and several of her

neighbors, including Belgium, the Netherlands, and Switzerland, clung to the gold standard as

long as possible, seeking to maintain an increasingly isolated gold bloc. Germany elaborated her system of exchange control and bilateral clearing into a closed Reichsmark bloc.

A striking aspect of this pattern is how

strongly it resembled the tripartite monetary world of the mid-nineteenth century, with one bloc centered on Britain, another organized around France, and a third around Germany,

and with many of the same countries linked to these three centers as a century before.

Monetary history, it would seem, casts a long shadow. Past monetary history shaped subsequent trade patterns and diplomatic relations, which in turn encouraged countries to coordi

nate their monetary arrangements even in as turbulent a period as the 1930s.

Another striking aspect of this period, in contrast to both the 1920s and 1970s, is that fiat money did not produce fiat money inflation. To

be sure, going off the gold standard and regain-

END OF THE GOLD STANDARD

ing control of mone tary policy allowed central banks and governments to halt deflation. They lowered interest rates and injected additional liquidity into the economy via the discount window. But despite the unemployment crisis that created intense political pressure to get the

economy moving again, few governments used the autonomy they enjoyed as a result of the

shift to flexible exchange rates to aggressively expand their money supplies or increase govern

ment spending. Monetary and fiscal expansion remained tentative, despite an unemployment rate that might exceed 20 percent. This was the downside of the policies of the 1930s, that more was not done to bring down high unemployment. But there was also an upside-that, in contrast to the 1970s (following the next collapse of a pegged-rate system), runaway inflation

did not result. From today's perspective (and with the con

trast with the 1970s in mind), the interesting question is why the inflation problem did not run out of conu·ol. The answer plausibly has three parts. First, Keynesian-style theories of the concerted use of monetary and fiscal policies were still in their very early stages of dissemination. Second, looking back at their experience in the early 1920s (before the gold standard had been restored), when the combination of large budget deficits and monetary autonomy had

proved a recipe for hyperinflation, governments

and central banks were understandably reluctant to simply let policy "rip." Any sign that they were

about to push hard on the monetary and fiscal accelerator might precipitate capital flight, since these same memories were foremost in the minds of investors as well as officials. 56 And third, central banks and governments did not develop an alternative monetary policy operating su·ategy to be substituted for the currency

peg, which might reconcile policy autonomy

00Thus, 1.he members of the Commonwealth and Empire enjoyed preferential access to both British commodity and fi. nancial markets.

66This problem of investor confidence was readily evident in France after 1937, not coincidentally since France had been one of the countries with chronic inflation problems in the first half of the 1920s. More gene1-ally, the proliferation of controls on capital flows limited the extent of this problem, although they did not remove it. Thus, not even countries adopt· ing exchange controls (aside from cases like Japan and Germany where macroeconomic policy was subordinated to rear· mament) engaged in aggressive monetary and fiscal expansion (Eicbengreen, 1992).

73


14


with credibility and confidence. Sweden, which

developed an explicit price-level targeting rule,

was a prominent counterexample. 57 But else

where, central banks and governments failed to

articulate comparable confidence-inspiring

rules. In their absence, aggressive expansion

threatened to excite capital flight. And with this

specter looming, the scope for reflationary ac

tion remained limited.

Rebirth of the Gold Standard?

The United States never entirely abandoned

the gold standard in the 1930s. Franklin Delano

Roosevelt took the dollar off gold in 1933 but

repegged it in january 1934 (in the meantime

having pushed up the dollar price of gold from

$20.66 to $35.00). Clearly, the resumption rule

was no more.68 In an era when unemployment

was a dominant political and economic concern,

pushing down p1;ces in order to restore precrisis

exchange rates and gold prices, at the risk of fur

ther aggravating unemployment, was no longer a

politically viable public-policy strategy.

As the United States recovered from the Great

Depression, gold flowed in to accommodate the

increased demand for money and credit. As an

other war loomed on the horizon, capital flight

from Europe further augmented American re

serves. America's European allies then used

much of the gold they retained to purchase the

supplies needed to sustain their war effort. For

all these reasons, when World War II drew to a

close, the United States possessed a majority of

the (non-Soviet) world's monetary gold.

Given this fact, it is not surprising that the

United States and the countries with which it ne

gotiated the post-World War II monetary order

had different views of the role of gold in the in

ternational system. The United States preferred

a system that resembled the arrangements that

had prevailed for the better part of the previous

century. The dollar was to remain convertible

into gold at $35 an ounce, the rate that had pre

vailed since 1934. Stable exchange rates were ro

be restored, since currency stability was essential

to the reconstruction of trade, which U.S. offi

cials viewed as an economic and political imper

ative. The foreign counterparts to the United

States delegation at Bretton Woods, including

the Keynes-led British delegation, were more

skeptical of both exchange rate stability and free

trade, free trade because they anticipated chronic deficits vis-a-vis the United States, the ex

change rate commitment because they worried

that their efforts to bring down unemploymem

would be hamstrung. The compromise involved

the three key innovations of the Bretton Woods

Agreement. First, exchange rates, although

pegged, could now be adjusted in the event of

fundamental disequilibrium. Second, govern

ments that wished to gain room for maneuver to address domestic problems and w avoid a replay

of the interwar experience with "destabilizing

speculation" were expressly permitted to resort

to capital controls. And third, the International

Monetary Fund was created as a way of placing

international monetary cooperation at one re

move from domestic politics.

Thus, to say that Bretton Woods sealed the

shift from commodity money to fiat money is too

simple. The dollar remained convertible into

gold, although not until the end of the 1950s

did that constraint bind the United States. Other

currencies remained convertible into dollars (for

purposes of current account transactions). Thus,

commodity money was not entirely out of the

picture. Again, the continuity in the structure of

the international monetary system is striking.

Although exchange rates could be adjusted,

adjusunents were infrequent. There was a gen

eral realignment of European currencies in 1949

(accompanied by devaluations by the members

of the sterling area and three of Britain's long-

6i'fhere, it can be argued, economic theory played an important role. Theoris!S like Wick.sell had developed models of

potential conflic!S between exchange rate stability and price stability and played a prominem role in the policy debate. See Berg andJonung (1999).

68Similarly, none of the other counuies that abandoned gold convertibility and depreciated their currencies starting in 1931 restored convertibility subsequently at the previously prevailing rate.


standing trading parUlers-Argentina, Canada,

and Egypt), designed to get the Bretton Woods

System on its feet. Other realignments included

the French franc devaluations of 1957, 1958, and

1969, the sterling devaluation of l967, and the

deutsche mark revaluations of 1961 and 1969.

There were 69 major stepwise devaluations by

(politically independent) developing countries

between 1949 and 1971 .69 Thus, while the

Bretton Woods System was characterized by a

greater degree of exchange rate flexibility than

its predecessors, the extent of that flexibility was

still, in an important sense, limited.

The explanation is not hard to find. The

1920s and 1930s had not enamored officials and

others (aside from a few academic dissenters) of

the me•its of flexible rates. Describing floating

exchange rates in the 1920s, Nurkse had written

of "cumulative and self-aggravating" movements

(Nurkse, 1944). Floating in the 1930s was associ

ated with the collapse of trade and output, al

though the direction of causality could fairly be

regarded as a question. After World War II, gov

ernments did not develop alternative monetary

anchors like monetary targeting or inflation tar

geting. Th•·ough process of elimination, ex

change rate policy became the cornerstone of

their entire economic policy strategy-the sym

bol of their commitment to sound and stable

policies. To devalue cast doubt over that strategy

REBIRTH OF THE GOLD STANDARD?

and over the competence of its framers. 70 And to revalue, as Germany and the Netherlands came

under pressure to do, threatened the postwar so

cial compact which rested on an agreement to

pursue export-led growtb.71

Exchange rate stability was possible because

the economic environment was again favorable.

The world economy was growing rapidly-by 5

percent a year, according to Maddison's esti

mates, more than twice as fast as between 1870

and 1913. This alleviated the pressure to de

value as a way of boosting growth. Commodity

markets were not disturbed by large price move

ments, either upward as in the 1970s or down

ward as in the 1920s and 1930s.72 Wage pres

sures were moderate, reflecting the impact on

labor markets of memories of high unemploy

ment in the 1930s. Cyclical stability was en

hanced by this combination of rapid growth and

stable prices: while Europe expetienced growth

recessions (declines in the positive rate of

growth) between 1950 and 1971, there was no

year in which the output of the continent as a

whole turned negative in absolute-value terms

(Van der Wee, 1986, p. 62). The stability of the

macroeconomy limited the need to use active

monetary and fiscal measures fot- countercycli

cal purposes. With monetary and fiscal policies

steady, policy-induced dislocations to the bal

ance of payments were less.

69"fhis calculation is from Edwards and Samaella (1994), who define a major stepwise devaluation as an adjustment of the official rate of at least 14 percent, following a period of at least two years of fixing the exchange rate. Roughly half of the total took place in the context ofTMF Slalld-By programs starting in 1952.

'1Yfhis is one interpre tation of Richard Cooper's ( 1971) famous finding that currency devaluation typically precipitated the dismissal of the finance minister.

71And, more concretely, to excite the opposition of producers in the export indusu·ies. In addition, the United States would have faced a tech_nical problem had it sought to devalue the dollar. If the U.S. government raised the dollar pdce of gold, which was the only instrument it in fact controlled, other governments would also raise the domestic-curren<.")' ptice of gold, leaving exchange rates and U.S. international competitiveness unchanged_ EUJ-ope and Japan, for all the aforementioned reasons, were reluctant tO see the competitiveness of their exports erode. Export inten:!Sts would scream if their governments acquiesced in policies ''�th this effect, and they were too important to ignore. Germany might agree, under tllC most intense pressure, to revalue, but only to a very limited extent. Moreover, the structure of the Bretton Woods System made more than their mere acquiescence necessary; positive steps on their pan were required in order fo1· the dollar to be devalued against their currencies, given that they had declared par values in terms of the dollar. If the dollar depreciated against gold. non action on their part meant that their currencies would depreciate along with the dollar. There would be no benefits fo1· U.S. competitiveness. And given thei1· domestic political situation, nonacLion was the likely outcome. This was what Treasury Secretary Fowler presumably meant when he said that "the U.S. under the present rules cannot change its own parity." Cited in Duncan, PatLerson, and Yee (1999), p. 604.

72Bayoumi and Eichengreen ( 1994) attempt to recover aggregate-supply and aggregate-demand shocks from time series

on output and prices for a number of OECD countries, and show that these were smaller under Bretton Woods than in the periods tl1at went before and came after.

15


76


Figure 2.5. Restrictions on Capital Account

- 1.2

1950 55 60 65 70 75 80 85 90 95 98

Finally, capital contr·ols remained an integral

component of Bretton Woods System. Controls

were neither universal (Figure 2.5) nor imper

meable; indeed, they became increasingly per

meable as the period progressed. Arguably, they

were considerably more effective in the 1950s,

when an array of other restrictions on current

account u·ansactions and domestic fmancial in

stitutions remained in place, than in the 1960s.

But so long as they continued to work even im

perfectly, they made it possible for governments

to contemplate changes in their par values.

There was at least a limited amount of time to

discuss policy options before the central bank was sttipped bare of reserves.73 Rumors that de

valuation was being contemplated could not pre

cipitate a run of a magnitude sufJicient to ex

haust those reserves overnight.

Demise of Bretton Woods

Ther·e is no shortage of explanations, then,

for the stability of exchange rates under Bretton

Woods. There were also three challenges to the

system's viability: the U.S. balance of payments

deficit, rising capital mobility, and the inade

quacy of international reserves.

In the 1950s as in the 1920s, the United States

was in a singttlarly strong balance of payments

position. U.S. monetary gold reserves at the be

ginning of 1958 were even larger than ten years

73And changes in 1.he speed wii.h which conu·ols were relaxed became one of the mechanisms through which governments regulated the balance ofpaymems (Wyplosz, 1999). In i.he 1950s, members of the European Payments Union accelerated or slowed the rates at which they relaxed controls on current account transactions in response to i.he development of the balance of payments. Germany tightened its exchange controls in 1950 when its balance of payments weakened due to soaring commodity import prices. France suspended i.he liberalization efforts mandated by the OEEC Code of Liberalization in 195 I and again in 1957 when its balance of payments weakened. In the m.id-1960s, to limit capital outflows, the United States imposed an Interest Equalization Tax and voluntary and statutory restraints on foreign lending by U.S. banks and corporations. [n 1970 Germany adopted reserve requirement (of30 percent) on i.l1e growth of i.l1e external Liabilities of its banks. In all these cases, changes in the su·ingency of controls substituted for exchange rate changes as an instrumcm of adjustment.


before. This was the period of the dollar short

age. But it was not to last. The U.S. current ac

count remained in surplus through most of the

1960s, but not by a margin sufficient to finance

the country's foreign investment. Rapid eco

nomic growth abroad attracted foreign direct in

vestment by American corporations and portfo

lio lending by Unlted States banks. As early as

1960, U.S. foreign dollar liabilities exceeded

U.S. gold reserves, raising fears for the stability

of the dollar. In pan, such fears reflected the un

willingness of U.S. officials to subordinate other

goals of policy to the maintenance of the dollar

peg. Other objectives-the New Society and the

Vietnam War, but above all demand-driven

growth-were allowed to take precedence. And

with the rest of the industrial world pursuing

other economic and political priorities

(Germany attached greater importance to infla

tion control, for example, while France was a

less than enthusiastic support of America's for

eign policy goals), diverging fundamentals pro

duced diverging balance of payments out

comes.74 The Kennedy, Johnson, and Nixon

administrations resorted to differential tax u·eat

ment of domestic and foreign investments, re

ductions in the value of the goods American

tourists could bring into the country, and tied

foreign aid, among other devices, in an effort to

remedy the balance of payments problem and

free up monetary and fiscal poUcies for the pur

suit of domestic objectives. But these expedients

failed to address the fundamental conflict be

tween "external pressw·es for higher [interest]

rates and the needs of the domestic economy for

monetary expansion," as the point was put in

the report of the President's Task Force on

Foreign Economic Policy in 1964.75

Devaluing the dollar would have been one way

of squaring the circle. It would have enhanced

the competitiveness of U.S. exports, improved

the u·ade balance (given sufficient time), and al

tered the direction of foreign investment flows

by raising the profitabiUty of domestic produc-

DEMISE OF BRETION WOODS

tion •·elative to foreign production. Why then

was the option shunned? One explanation is

fear that devaluation would damage the credibil

ity of the Bretton Woods System and, perhaps of

more relevance to U.S. officials, of the dollar it

self. Unilateral devaluation would have also an

tagonized the United States' allies and trading

partners, who saw themselves as possessing a col

lective interest in the maintenance of this inter

national monetary system which offered them a

favorable climate for export-led growth. It wouJd

have frayed lhe Western a!Jiance at a time when

Cold War tensions were high. It would have

thrown a w1·ench in the works of ongoing GATT

negotiations. Finally, there was the possibility

that if the U.S. govemment raised the dollar

price of gold, which was the only instrument it

in fact controlled, other governments would also

raise the domestic-currency price of gold, leav

ing exchange rates and U.S. international com

petitiveness unchanged. Authors like Genberg

and Swoboda ( 1994) emphasize this fundamen

tal asymmetry, arising out of these multiple ob

stacles to dollar devaluation, as a further fatal

weakness of the Bretton Woods System.

The pressures emanating from the divergent

stance of macroeconomic policies in the United

States and other industrial countries grew all the

more intense with declining effectiveness of capi

tal controls. The restoration of current account

convertibility allowed individuals engaged in le

gitimate, trade-related transactions to exploit

leads and lags as a way of shifting capital across

borders. And with the gradual relaxation of the

tight controls imposed on domestic financial in

stitutions and markets in the 1930s and 1940s,

market participants found new ways around the

remaining conu·ols; the development of the

Eurodollar market in response to the U.S.

Interest Equalization Tax is a case in point. The

amount of time the government of a deftcit coun

try could take to contemplate policy options, be

fore it was overwhelmed by market pressures,

shrank with the growing permeability of conu·ols.

7'1Both the political context and macroeconomic consequences are ably described by Genberg and Swoboda (1994). 75Reprimed in Dw1ean and others (1999), p. 39.

77


18


And with the declining effectiveness of controls, even a hint that devaluation was under consideration could now lmleash a tidal wave of anticipatory speculation; hence, governments grew loath to consider the option, rendering the system of par values increasingly rigid and brittle.

As controls weakened, con taining and adjust

ing to payments p1·essures both became more difficult. As the British appreciated when they compared the 1967 sterling crisis with its predecessors in 1947 and 1949, capital flows now could force the issue more quickly than before (Cairncross and Eichengreen, 1983, Chapter 3). Even contemplating a change in par values was problematic, for mere rumor tl1at devaluation was in the offing could now precipitate massive capital flight.

It is tempting to tell the story of the collapse of Bretton Woods in terms of this combination of declining U.S. competitiveness and rising capital mobility. There was a third element, of course, namely the inadequacy of international reserves. The 1960s was a decade of rapid expansion i.n Europe, .Japan, and much of the develop

ing world. Countries needed additional international liquidity to buffer their economies from trade-related shocks and therefore sought to run surpluses against the United States. But while integral to the operation of Bretton Woods, this pattern also heightened the fragility of the system, since foreign holders of dollars could "run on" U.S. gold reserves at any time. Seen in this perspective, the problem was less that the dollar was overvalued relative to the yen and the European currencies; it was more that the dollar was overvalued relative to gold, reflecting the inelasticity of monetary gold supplies and the growing stock of foreign do !Jar balances.

This problem of an inadequately elastic supply of international liquidity was not new, of course. It had been evident in the deflationary 1870s and 1880s, in response to which Russia, India,

Japan, and other countries had accumulated

bonds and bank balances denominated in sterling, francs, and marks. I t had been on the minds of the delegates to the Genoa Conference, in response to which governments and central banks had been encouraged to elaborate the practice. It had been on Keynes's mind when he had proposed giving his Clea,;ng Union the power to create a synthetic reserve asset (a recommendation that was not taken up). Unfortunately, the policymakers' solution, the creation of Special Drawing Rights, came tOO late to salvage the Bretton Woods System.

A more comprehensive solution, however, was at hand. As the international monetary system evolved away from a fixed link between the reserve currencies and gold, away from pegged rates, and away from capital controls, it became both feasible and atu-active for central banks to satisfy t.heir demands for reserves by holding diversified portfolios of dollars, pounds, deutsche marks, francs, and otl1er convertible currencies. They could augment those holdings by running current accolmt surpluses or borrowing abroad, depending on need. [n the end, the solution to

the problem of an elastic supply of in ternationaJ reserves was provided through evolution rather than creationism.

The breakdown of Bretton Woods opened the door to the high-inflation 1970s and 1980s, out of which the world economy is now only finally emerging. Cut free from the fixed exchange rate anchor, central banks stepped hard on the monetary accelerator. Budget deficits widened significantly in the 1970s and 1980s, bequeathing a chronic problem of high public debts. While monetary stability and fiscal sustainability were restored at different times in different counu;es, it is a fair generalization that some two decades had to pass before these policy imbalances were significantly brought under control.

Why such a different response from the last

time an international system of fixed rates had collapsed, in the 1930s?76 One can point to sev-

76Conventional explanations point to the two OPEC oil shocks as creating imbalances and worsening unemploymcm, which required governments tO respond aggressively. But the supply and demand shocks and the unemployment of the late 1920s and early 1930s were if anything more pronounced. Hence, the macroeconomic disturbances of the 1970s do not provide a convincing explanadon for the contrast.


era! factors. Keynesian ideas, that fiscal and mon

etary policies should be used to counter unem

ploymem, had gained considerable currency. In

many countries, policies to main tain full employ

ment were an explicit element of the postwar so

cial compaCl of equity and shared growth, leaving

governments no choice but to respond aggres

sively to the rise in unemployment.77 Moreover,

after two decades of stability, the fear that aggres

sive countercyclical action would excite inflation

and capital flight was considerably subdued.

Given that they were entering uncharted terri

tory, it is not surprising that policymakers did not

anticipate the markets' reaction. As governments

responded more aggressively to unemployment,

the markets responded more aggressively to pol

icy. Removing the exchange rate anchor and put

ting nothing in its place fed inflationary expecta

tions. It caused the familiar Phillips Curve

relationship to be replaced with the inflation-aug

mented Friedman-Phelps Phillips Curve. So long

as the framework for policy had been provided by

the commitment to maintain pegged exchange

rates, a total loss of inflationary comrol had not

been regarded as likely. Only under exceptional

circumstances-in response to exceptional prob

lems-would the authorities stimulate demand,

which would therefore mainly boost output

rather than fuel inflation. Because the additional

demand stimulus was regarded as temporary (for

otherwise it could come in to conflict with the ex

change rate commitment), it did not provoke

sharp increases in wage demands and translate

mainly into additional inflation.78 But once that

anchor was lifted, additional inflationary pressure

today simply incited fears of additional inflation

ary pressure tomorrow. Demand stimulus pro

duced mainly inflation rather than additional out

put and employment as wages and p1ices

responded more quickJy to policy (Alogoskoufis

and Smith, 1992). Consequently, as governments

77See, for example, Boltho (1982) on the European cases.

RECENT DEVELOPMENTS IN MILLENNIAL PERSPECTIVE

pushed harder on their policy l.evers, those levers

grew increasingly ineffectual.

Solving this problem-eliminating chronic

policy imbalances and establishing a new

monetary-policy operating framework to replace

the earlier exchange rate-centered policy

regime-has occupied the advanced induso·ial

and developing countries alike for the better

part of the past 20 years. ln some cases, high

costs in terms of growth foregone have been in

curred as a result of the high-interest-rate poli

cies to extinguish inflation.

Recent Developments in Millennia! Perspective

Many accounts have been written of the devel

opment of the international monetary system

over the past 25 years, emphasizing rising capital

mobility, greater exchange rate flexibility

(Figure 2.6), and the declining monetary role of

gold. By way of conclusion, it may be useful to

inquiJ-e how these trends appear when placed in

their long-term context.

SeveJ-al points stand ouL One is the reluctance

of governments to embrace radical changes in

international monetary relations. For example,

European governments responded to the col

lapse of Bretton Woods by seeking to establish a

regional monetary arrangement in the image of

Bretton Woods, complete with capital conu-ols

and Bretton Woods-style fluctuation margins. ln

much of the developing world, they responded

to the collapse of Bretton Woods' par values by

substituting unilateral dollar pegs. Similarly,

while the monetary role of gold was officially

abolished in 1977, central banks continued to

hold substantia.! gold reserves, once again indi

cating their commitment to traditional values. ln

many respects, then, continuity has remained

the order of the day.79

78in other words, occasional recourse to demand slimulus, like temporary suspensions under the gold sJandard, was stabilizing because it occurred in a framework within which there existed a credibility-enhancing nominal anchor.

7\JWhere countries have moved to new arrangements, they have generally done so under duress-that is, when market pressures have left them no choice. See the evidence in Eichengreen and Masson and others (1998).

79


80


Figure 2.6. Percentage of Countries with Pegged Exchange Rates, 1870-1998

1870 90 1910 30 50 70

- 1 . 2

- 1 .0

- 0.8

- 0.6

-0.4

- 0.2

0 90 98

What lends the international monetary system

this strong element of inertia is hard to say. One

possibility is the ideologies that develop in sup

port of prevailing institutional arrangements

(Eichengreen and Temin, 1997). Another is the

strength of vested interests that benefit from pre

vailing arrangements (Frieden, 1994). A third is

the network-externality characteristic of interna

tional monetary arrangements, in particular the

reluctance of countries to adopt arrangements

radically different from those of their neighbors

for fear of sending a negative signal to the mar

kets.

It can be argued that the international mone

tary instability of the past quarter century is ex

plicable, at least in part, in terms of the conse

quent failure to adapt international monetary

arrangements to changing economic, financial,

and political circumstances. The collapse of

Bretton Woods loosened the exchange rate con

straint and cut the last remaining link to com

modit)' money. It removed the o·aditional anchor

for monetary and fiscal policies. In the absence

of an adequate nominal anchor and a coherent

operating su·ategy for policy, the 1970s became a

decade of big budget deficits and high inflation,

as policy was cut loose from its moorings. And

with the failure of policymakers to articulate an

alternative monetary anchor and an adequate

framework for macroeconomic policy generally,

that policy grew increasingly ineffectual.

ln the 1980s and 1990s, alternative monetary

policy operating strategies-monetary targeting,

inflation targeting, "two pillar" systems of both in

flation and monetary targets, and Taylor rules

have been articulated i.n response to the instabili

ties and excesses of the previous decade. To be

sme, the spread of these institmional and concep

tual developments has been slow. But as these al

ternatives are adopted more widely, there may be

reason to hope that confidence will grow and tur

bulence in currency markets will die down.

Finally, the democratization of the Third

World has pointed up the conflict between inter

nal and external objectives that has been a

source of tension in the induso;al countries for

the better part of a century. Now that those con-


cerned with unemployment and distributive poli

cies can make their priorities known via the bal

lot box, it has become harder for governments

to subordinate all other goals of policy to stabi

lizing the exchange rate. As exchange rate policy

has come into conflict with other priorities, it

has lost credibility. But as they gain experience

with democracy, a growing number of societies

have come to recognize the risks associated with

the politicization of macroeconomic policy. They

have responded with institutional reforms, for

example, strengthening the independence of

their central banks and adopting fiscal rules, in

the effort to better insulate policy and the for

eign exchange market from day-to-day political

pressures. An extreme example is the currency

board, an alternative to floating exchange rates

that appears to be gaining adherents by the day,

which is in a sense a throwback to the gold

standard-style exchange rate arrangements of

previous centuries.

There is a sense in which these recent devel

opments represent a turn back from the govern

ment-run international monetary system of the

twentieth century to the more market-based sys

tem that characterized the better part of the pre

ceding millennium. Governments were never en

tirely out of the picture in the age of commodity

money, to be sure, but markets played a more

prominent role in regulating money supplies,

u·ansferring capital across borders, and deter

mining exchange rates. In a sense, the weakness

of governments-in particular, their limited abil

ity to regulate financial transactions and even to

cono·ol the circulation-gave markets the upper

hand. With the development in the nineteenth

century of new military technologies, which im

plied the need to mobilize resources for total

war, governments were forced to develop new

means of commanding and conu·olling re

sources. The levers of monetary control were

placed squarely in the hands of the central bank.

The state bureaucracy, especially its ability to tax,

was elaborated. The banking system was enlisted

RECENT DEVELOPMENTS IN MILLENNIAL PERSPECTIVE

to promote economic development

( Gerschenkron, 1962). This process culminated

in the Great War of 19 13-18, in which the mone

tary printing press, the domestic banking system ,

and tax system were utilized as never before.

And in response to the instabilities of the 1920s and 1930s, government regulation of financial

markets was tightened and macropolicy was ma

nipulated even more actively. Relative to the ear

lier situation, governments had gained the up

per hand.

Today, technology has struck back. The infor

mation and communication revolutions, which

worked in the nineteenth century to strengthen

the state relative to the market, today have the

opposite effect. The high fixed costs characteris

tic of nineteenth and twentieth century informa

tion and communications technologies, which

gave governments an advantage relative to indi

vidual market participants, have no analog in

the electronic age. In the age of the Internet,

controls on private financial transactions be

come increasingly easy to evade. In the age of

cheap international transportation, supporting

relatively inefficient national industries becomes

increasingly expensive. And if a century of wat·

has really drawn to a close (Mazower, 1999), then the willingness of the public to tolerate ex

tensive government intervention in the name of

national security may be less. While the insecuri

ties of globalization continue to fuel the demand

for government social programs to provide in

surance against the uncertainties created by

open international markets (Roclrik, 1997), the

scope for individuals to obtain such insurance

pdvately, on financial markets, is ever growing.

These are reasons for thinking that a century of

dirigisme, which looks increasingly Like an aber

ration in the long sweep of history, may be draw

ing to a close. Markets, by regaining the upper

hand in determining exchange rates and capital

flows, will only then have restored the status quo

ante that prevailed for most of the past

millennium (Box 2.3).

81


82


Box 2.3. The Future of the International Monetary System

How then is the international monetary system likely to look in 2020, when the question is seen from this vantage point? The historical perspective developed here does not suggest a high likelihood of radical changes in the system, such as a single world currency or three regional monetary unions centered on the dollar, d1e ew·o, and the yen. It casts doubt on the viability of pegged-but-a�justable exchange rates, crawling banks, target zones, and other intermediate arrangements in which governments try to have their cake and eat it too. But neither is a floating exchange rate likely to be alu-aclive for small economies that are highly exposed to international u-ade and rmancial nows.

The three ptincipal regions of the world economy, Europe, Asia, and the Americas, are likely to square this circle in different ways. In Europe, where integration is a political as well as an economic and financial phenomenon, monetary integration is likely to deepen and widen. The euro and its associated institutions are likely to provide the basis for an ever larger zone of monetary stability. Greece wants to join Europe's monetary union. The countries of eastern Europe want to join. Turkey wants to join. Others could follow in their train.

In the Americas, in contrasl, the United States will not accede to the formation of an EU-style monetary union anytime soon. This leaves unilateral dollarization as an option, which is likely to be most attractive for small countries with particularly strong economic and financial links to me United States that find it difficult to run an autonomous monetary policy. Some counaies may adopt currency boards as a half-way house while they contemplate this [mal step. Meanwhile, the larger, more economic;ally and financially diversified countries of the region

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Currencies: Seigniorage and Currency Policy in

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Munro, John, 1979, "Bullion ism and the Bill of

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Rolnick, Arthur J., Francois R. Vel de, and Warren E.

Weber, 1996, 'The Debasement Puzzle: An Essay on


Medieval Monetary History," joumal of Economic

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"Coinage, Debasements, and Gresham's Laws,"

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Spufford, Peter, 1986, Handbook of Medieval Exchange

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Sussman, Nathan, 1993, ''Debasements, Royal

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85

©International Monetary Fund. Not for Redistribution 86

CURRENCY CRISES: IN SEARCH OF COMMON ELEMENTS Jahangir Aziz, Francesco Caramazza, and Ranil Salgado

The financial crisis that erupted in east

Asia in Lhe second half of 1997 was Lhe

latest in a series of currency crises that

at various times in Lhe post-Bretton

Woods period have engulfed emerging market

economies and industrial coumries alike.

Financial innovations and the increased interna

tional integration of financial markets appear to

have altered the naLUre of these crises in recent

years; in particular, the spillover effects and the

contagious spread of crises seem to have become

both more pronounced and far-reaching. At a

fundamental level, however, many of the same

forces have often been at work in different

crises. This chapter is concerned with these com

mon characteristics. It examines a large number

of currency crises in an effort to identify similari

ties in the behavior of a variety of macroeco

nomic and financial variables around Lhe times

of crises. The sample spans the period 1975-97 for 50 industrial countries and emerging market

economies. It covers crises that culminated in

large currency depreciation as well as those in

which there was a substantial loss of foreign re

serves. The analysis involves comparing the

monthly or annual pattern of movement of the

various macroeconomic and financial variables

around the time of crisis to their behavior dur

ing tranquil periods. The robustness of the re

sults is tested by subdividing the sample into dif

ferent types of currency crises and carrying out a

similar analysis for each. The paper also exam

ines the behavior of the various variables in the

aftermath of a crisis and assesses the costs of

crises in terms of lost output.

Following Frankel and Rose (1996), the paper

poses the question: Are currency crises aJI alike?

But it differs from that study in several respects.

Whereas Frankel and Rose focused exclusively

on currency crashes characterized by large ex

change rate depreciations, this study instead

considers currency crises that involve both large

depreciations or substantial losses in reserves, or

both. Another difference is that the earlier pa

per analyzed Lhe experience of developing coun

tries only, using annual data, while the sample of

countries in this study comprises both industrial

and emerging market economies. Furthermore,

most of the analysis is carried out using monthly

data, which allows for a more precise dating of

crises and which, given the nature of currency

crises, may be mot·e revealing than annual data.

Annual data is used, nonetheless, both to com

plement the monthly analysis and when variable

of particular interest are not available on a

montJ1ly frequency.

The methodology used is similar to that of

Eichengreen, Rose, and Wyplosz (1995) and

Frankel and Rose (1996). Essentially, for each

variable of interest a graphical "event study" is

conducted to see whether its average pattern of

movement bolh before and after a ct·isis (tJ1e

event) is different from its behavior during nor

mal or tranquil periods. The differences in be

havior between crisis and tranquil periods are

tested for statistical significance. Since the

graphical technique docs not impose any para

metric structure on the data and because tJ1e sta

tistical tests require less demanding assumptions

about the distribution of tJ1e variables, this

methodology has the advantage of often being

more informative in extracting behavioral pat

terns over a longer period of time than formal

econometric procedures. However, the analysis

remains intrinsically univariate. "While many

studies have supplemented the univariate analy

sis with more rigorous multivariate regression

analyses, these have not been fully satisfactory

for a variety of reasons (discussed in "The

Macroeconomy Before a Crisis," below).

Graphical event studies have drawbacks too,

however. For instance, unlike in regression

analysis where various sen itivity tests can be em

ployed to check the robustness of results, there


are no such standard diagnostics available in

graphical analysis. To overcome this problem, in

this paper the robustness of the results are

checked by examining how the average behavior

of different variables changes for different types

of currency crises. In panicular, the sample of

158 currency crises identified in this study was divided into various subgroups: crises in indus

trial countries, crises in emerging market coun

tries, crises characterized mainly by currency

crashes, crises characterized mainly by reserve

losses, "severe" crises, "mild" crises, crises associ

ated with serious banking sector problems, crises

with fast recoveries, and crises with slow recover

ies.' For each of these subgroups, the same

variable-by-variable event study was conducted

and the behavior of these variables was com

pared across the various groupings. Behavioral

characteristics of variables that displayed largely

similar patterns across these groupings were con

sidered to be robust.

To summarize very briefly the main findings,

typically prior to a crisis tbe economy was over

heated, with monetary policy significantly expan

sionary, strong domestic credit growth, an over

valued currency, and in many cases high

inflation. The economy was also increasingly fi

nancially vulnerable, with rising liabilities of the

banking system not backed by foreign reserves

and falling asset prices. Furthermore, some

event, such as an increase in world interest rates

or a deterioration in the terms of trade, usually

exacerbated the vulnerability of the economy to

crisis.

Identifying Crises: Methodology and Data

Financial crises may be grouped into three

broad categories: currency crises, banking crises,

and foreign debl crises. 2 A currency crisis may be

said to occur when a speculative attack on the

IDENTIFYING CRISES: METHODOLOGY AND DATA

exchange value of a currency results in a devalu

ation (or sharp depreciation) of the currency,

or forces the authorities to defend the currency

by expending large volumes of international re

serves or sharply raising interest rates. A banking

crisis generally refers to a situation in which ac

tual or potential bank runs or failures induce

banks to suspend the internal convertibility of

their liabilities or which compels the govern

ment to intervene to prevent tl"lis by extending

assistance on a large scale.3 A foreign debl crisis is

usuaJiy described as a situation in which a coun

try cannot service its foreign debt, whether sov

ereign or private.

This study focuses on currency crises. ln many

instances, however, elements of ctu·rency, bank

ing, and debt crises may be present simultane

ously, as in the recent east Asian crises and in

the Mexican 1994-95 crisis. In contrast, the ERM

1992-93 crises were essentially currency crises,

even though the Nordic countries that experi

enced currency crises also had domestic banking

crises at around d1e same time. Furthermore,

what may start out as one type of crisis may de

velop into other kinds as well. Banking crises

have often preceded currency crises, especially

in developing couni.Jies-for instance, as in

Turkey and Venezuela in the mid-1990s. Banking

problems have preceded debt crises too, as in

Argentina and Chile in 198 1-82. The converse

also has occurred, as in Colombia, Mexico, Peru,

and Uruguay, where the withdrawal of external

financing in 1982 precipitated banking crises.

More recently, what began as currency crises in

some east Asian countries metastasized into

banking and debt crises, as illustrated most

clearly by lndonesia. That one type of crisis pre

cedes another does not necessarily imply causal

ity, however. For instance, when the financial sec

tor is poorly supervised and regulated, banking

system fragilities may be fully revealed only after

1The procedure used in identifying the crises is described in detail and the crisis subgroups are defined later in this chapter.

2This definition follows Bordo (1985), Caprio and Klingebiel ( 1997), and Eichengreen and Rose (1997). 3Not all financial disturbances are viewed as true tinancial crises. Financial disturbances that do not impinge on the pay·

ments mechanism and do not have potentially damaging consequences for economic activity have been characterized as "pseudo-financial crises"-see Mishkin (1994) and Schwartz (1985).

81


88

CHAPTER Ill CURRENCY CRISES

a run on the currency has undermined confidence more generally and precipitated speculative shifts that expose and exacerbate banking and debt problems. This has clearly been a feature of the east Asian crises. Consequently, although banking and debt crises are not analyzed directly in this study, many cases of such crises, such as those of the Latin American debt crisis of the early 1980s and others that involved currency crises, are considered indirectly.

The measurement and dating of currency crises pose various difficulties. In this paper, following procedures adopted in the literature, episodes of significant foreign exchange market pressures are identified and dated using statistical criteria. This approach, while capturing the more serious currency crises, inevitably also

picks up episodes where there were significant but less than critical foreign exchange market pressures. This should be borne in mind in interpreting the results and drawing inferences of general applicability.

A currency crisis could be defmed simply as a substantial nominal currency devaluation or de

preciation.4 This criterion, however, would exclude instances where a currency came under severe pressure but the authorities successfully defended it by intervening heavily in the foreign exchange market, or by raising interest rates sharply, or by other means. An alternative approach is to construct an index of speculative pressure that takes into account not only exchange rate changes, but also movements in international reserves or interest rates that absorb pressure and thus moderate the exchange rate changes. For example, Eichengreen, Rose, and Wyplosz ( 1 996) use a weighted average of changes in the exchange rate, foreign reserves, and interest rates, relative to Germany, the refer-

ence country, to examine currency crises in industrial countries. Crises are then identified as extreme values of the speculative pressure index. Ctises identified using such an index would therefore include not only those occasions in which the currency depreciated significantly, but also occasions where actions by the authorities averted a large devaluation or the abandonment of an exchange rate peg.

For this study, currency crises were identified for a group of 50 countries for the period 1975-97. The group included 20 industrial countries and 30 developing countries. The developing country group consisted mainly of countries commonly referred to as emerging market economies.5 Germany and the United States served as the reference countries for the

European and the non-European countries, respectively.

For each country, an index of foreign exchange market pressure was constructed as a weighted average of (detrended) monthly exchange rate changes and reserve changes. The weights were chosen so as to equalize the vari

ance of the two components, thus avoiding the possibility of one of the two components dominating the index. Interest rates were not included in the index owing to the paucity of comparable, market-determined interest rate data for many developing countries over the sample period. Occasions when values of the index ex

ceeded a specified threshold-set to 1 Y2 times the pooled standard deviation of the calculated index plus the pooled mean of the index-were classified as crises. Weights and thresholds were calculated separately for periods of high inflation, which were defined as periods with 12-

month inflation rates greater than 80 percent. For any one country, crises identified v.rithin

4For example frankel and Rose (1996) ddine a "currency crash" as a nominal depreciation of the currency of at least 25

percent in a year, along with a 10 percent increase from the previous year in the rate of depreciation. The latter condition is included so as lO omit from ctu-rency crashes the large u·end depreciations of high-inflation countries.

5The industrial countries in the sample were Australia, Austria, Belgium, Canada, Denmark, Finland, France, Greece, Iceland, Ireland, ltaly,Japan, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom. The emerging 1TU11·ket ec(»wmies were Argentina, Bangladesh, Brazil, Chile, China, Colombia, Cos ta Rica, Ecuador, Egypt, India, Indonesia, Israel, jamaica, Korea, Malaysia, Mexico, Nigeria, Pakistan, Paraguay, Peru, the Philippines, Singapore, South Africa, Sri Lanka, Taiwan Province of China, Thailand, Turkey, Uruguay, Venezuela, and Zimbabwe


18 months of a previous crisis were considered as part of the earlier crisis and excluded. Cases in which more than one country was affected by a crisis, either because of a common shock or because of contagion effects, were counted as more than one crisis. For instance, the recent

east Asian fmancial crisis comprised five currency crises.6 These criteria are similar to those used by Eichengreen, Rose, and Wyplosz

(1996).

On the basis of these operational criteria, between January 1975 and November 1997, 158 episodes were identified in which countries experienced substantial exchange market pressures. Other studies have identified a similar number of currency crises, taking into consideration differences in sample size. For example,

Kaminsky and Reinhart (1996) identified 71 crises in their sample of 20 countries between

1970 and mid-1995, while Eichengreen, Rose, and Wyplosz (1996) identified 77 crises for a group of 20 industrial countries during 1959-93, using quarterly data.

Currency crises were found to be relatively more prevalent in the first half of the sample period (1975-86) than in the second half (1987-97) (Figure 3.1). The number of currency crises was particularly high in the mid-1970s (a period of large external shocks to many coun

tries) and in the early to mid-l980s (the Latin American debt crises). Comparing industria] and emerging market counuies, it appears that in

dustrial countries had fewer currency crises: the incidence of currency crises in emerging market countries was double that in industrial countries.

It also appears that most of the industrial country currency crises occurred in the first half of the sample period, while for the emerging market countries, the frequency of currency crises

shows no marked u·end.

6The five crises identified by the index were the crises in Indonesia, Korea, Malaysia, the Philippines, and Thailand.

IDENTIFYING CRISES: METHODOLOGY AND DATA

Figure 3.1 . Incidence of Currency Crises

All Crises (number of crises)

- Crises/Country number of crises per country) - Industrial

- Emerging market

- 14

- 12

- 10

8

6

4

2

0

- 0.40

- 0.35

- 0.30

- 0.25

0.20

0.15

0.10

0.05

0

89


90


The Correlates of Financial Crises

Having elated the currency crises, the next step was to choose the set of variables whose behavior could be expected a priori to systemati

cally differ during episodes of intense exchange market pressures from that in tranquil times.

The set of variables chosen was partly determined by the empirical implications of theOt·eti

cal models of exchange rate and balance of payments crises, the literature on "early warning

signals," and previous empirical studies of fmancial crises.

The early literature on currency crises-usually referred to as the "first-generation mod

els"-developed notably by Krugman ( 1979) and Flood and Garber ( 1984)-stressed the role played by economic fundamentals in causing crises. These models typically explained crises as

the result of fundamental inconsistencies in domestic policies, such as a persistent money

financed fiscal deficit and a commitment to a

pegged exchange rate. Such inconsistencies can for·a time be overlooked, as long as the central bank has sufficiently large foreign exchange reserves. But when official reserves fall to a critically low level and are perceived by the market

as insufficient, there will be a sudden speculative attack on the currency. These first-generation

models, therefore, predicted that a deterioration in the fundamentals would be indjcated prior to

a crisis by developments such as high or growing fiscal budget deficits, high rates of monetary

growth, high inOation, overvalued real exchange rates, large current accounr and trade defici£S,

sharp declines in international reserves, and rising domestic interest rates.

The role of domestic macroeconomic imbalances in generating currency crises in first

generation models has been evident in quite a few specific siwations. Overly expansionary mon

etary and fiscal policies have spurred lending booms, excessive debt accumulation, and over

investment in real assets, which have d1;ven up equity and real estate prices to unsustainable levels. The evenwal tightening of policies to contain inOation and facilitate tl1e adjusunent of ex-

ternal positions, and the inevitable correction of asset prices, have then led to a slowdown in economic activily, debt-servicing difficulties, declining collateral values and net worth, and rising

levels of non performing loans that threaten bank solvency. Macroeconomic factors, especially lending booms, have been found to play an important role in creating financial sector vulnerabilit)' in many Latin American countries (Gavin and 1lausmann, 1996, and Sachs, Tornell, and Velasco, 1996) and in other emerging market economies as well.

A drawback of first-generation models was that they represented policy in an essemially unidimensional and mechanical manner-the government automatically monetized all budget deficits while the central bank accommodated the pres

sures on the exchange rate by selling reserves without regard to other developments in the economy. Clearly, the range of policy options available even when budget defici£S are persist

ent goes beyond simply monetizing the deficit. When governments have multiple objecti,,es, however, almost all policy options involve some form of trade-off. Second-generation crisis models (Obstfcld, 1986 and 1994) exploit the tradeoffs among altermnive policies and the tensions in the governmem's objectives to generate mutu

ally conflicting incentives on the part of the authorities both to abandon an exchange rate peg and to defend it. In addition to tl1is policy uncertainty, if the cost of defending the peg is

likely to rise when agents expect the peg to be abandoned, then the exchange market could be subject to self-fulfilling expectations. 1f investors expect that despite sound fundamentals the government would abandon the peg if a specuJative

attack were severe enough, then by acting on those beliefs, investors may force the government to sacrifice the peg. For example, indi,�dual investors may believe a country to haYe generally sound fundamentals, so that there is no

reason for them to withdraw their funds from the country solely on the basis of the fundamentals. llowever, if a sufficient mtmber of other investors withdraw their funds from the country and thus increase the likelihood tl1at t11e govern-


ment would be forced to abandon the peg, then

even the investors who were initially confident

that the country's fundamentals were sound may

also withdraw their investments rather than risk

losses from a devaluation. This, in turn, would

further increase the likelihood that the peg

would be abandoned. Ln such a case, if some

event or shock caused a critical mass of investors

to sell a country's currency, an exchange crisis

could ensue.

While theoretically it is possible that com

pletely extrinsic events ("sunspots») can trigger a

crisis-so that the economy is subject to multiple

equilibria, some involving crises and others

not-it is almost always the case that this possi

bility holds true only for certain ranges of the

fundamentals. There are no equilibrium models

of currency crises that generate sunspot equilib

ria for almost all possible ranges of the funda

mentals, such that sunspot-driven crises are not

generic. Consequently, even in second-genera

tions models, some fundamentals, such as the

composition of external debt (Masson, 1998,

and Cole and Kehoe, 1998) ultimately play the

critical role in generating crises. The role played

by such fundamentals, however, is more su·uc

turaJ than behavioral, in contrast to first

generation models.

A related but separate explanation of crises fo

cuses on contagion effects, where a crisis in one

country triggers crises in others. Contagion ef

fects can be transmitted through u·ade or finan

cial linkages, or may be a result of similarities in

macroeconomic fundamentals. For example, if a

group of countries are closely related through

trade, then a devaluation in one country can

force the others to devalue to maintain price

competitiveness. Also, owing to interdependen

cies in creditors' portfolios, iiJiquidity in one

market can force investors to liquidate assets in

other markets to cover losses or to meet liquidity

needs (Goldfajn and Valdez, 1997). Contagion

effects can also be transmitted through commit

ment costs. For a country, the costs of abandon-

THE CORRELATES OF FINANCIAL CRISES

ing a peg fall if neighboring countries (in an

economic sense, which in most cases is also in

the geographic sense) also abandon their pegs.

The waves of currency crises in the 1990s have

generated a lot of interest in contagion effects

and there is some evidence (e.g., Eichengreen,

Rose, and Wyplosz, 1996, and Glick and Rose,

1999) that they may be an important cause of

crises. Both theoretical and empirical studies of

contagion are silent, however, on why a crisis

originates in a specific countTy among a group

of vulnerable countries. Thus, even if contagion

plays a role in transmitting crises across coun

tries, it is still important to understand the role

played by funclan1entals in precipitating crises in

the first place.7

Another set of studies point to external condi

tions as the pivotal elements in fiJlancial crises,

especially in emerging market economies. Most

notable have been sudden, large shifts in lhe

terms of trade and in world interest rates that

have affected a large number economies simulta

neously (sometimes referred to as ''monsoonal

effects," Masson and Mussa, 1995). An unantici

pated drop in export prices, for instance, can

impair lhe capacity of domestic firms to service

their debts and result in a deterioration in t11e

quality of banks' loan portfolios. Movements in

interest rates in the major industrial coumries

have become increasingly important to emerg

ing market economies worldwide, reflecting the

increasing integration of world capital markets

and the globalization of investment. The sensitiv

ity of capital flows to developing counu·ies to

changes in world interest rates has been empha

sized by an1ongst others, Calvo, Leiderman, and

Reinhart ( 1993, 1996) and Taylor and Sarno

(1997). While sustained declines in world inter

est rates have induced surges in capital flows to

emerging market economies, an abrupt rise in

industrial country interest rates can lead to the

reversal of those flows. The rise in interest rates

not only increases the cost to domestic banks

(and firms) of funding themselves offshore, but

7For an empirical investigation of the role of Lraclc and financial linkages as well as external, domestic, and financial weakness in inducing financial crises, see Caramazza, Ricci, and Salgado (2000).

91


92


also worsens adverse selection and moral hazard

problems and the fragility of the financial sys

tem.s Changes in global financial conditions,

therefore, are another possible factor behind

banking crises in emerging market economies

see Eichengreen and Rose (1997) for supporting

empirical evidence.

This paper does not study contagion effects; it

concentrates instead on investigating whether

countries' macroeconomic and financial charac

teristics during periods of crisis differ systemati

cally from those during noncrisis per·iods.

Consequently, the emphasis is mostly on vari

ables of the type suggested by first-generation

models and only to a lesser extent on those sug

gesting second-generation models. Variables em

ployed in the empirical literature on "early warn

ing signals,''9 such as measures of financial

liberalization, tl1e money multiplier, and credit

growth; proxies for investor confidence in the

domestic currency; the ratio of broad money to

international reserves; and the growth in asset

prices, are also analyzed.

The Macroeconomy Before a Crisis

Methodology

The methodology used in this paper is a mod

ified version of that adopted in other studies of

currency crises, such as those of Eichengreen,

Rose, and Wyplosz (1996) and Frankel and Rose

(1996). The approach employed in those papers

was a version of the "event study" methodology

where for each variable the sample was divided

into crisis windows and tranquil periods. A crisis

window was defined as some number of periods

centered around each crisis date. After all the

observations in each of the crisis windows were

taken out of the sample for a particular variable,

the remaining noncrisis observations were col

lectively deemed to be the sample of tranquil pe

riod observations. Having separated the sample

into crisis and tranquil observations, we com

puted the average across all the separate crisis

events for each period in the crisis window.

These averages for the crisis window were then

ploued against the average for the entire tran

quil period. The pattern displayed in the crisis

window was taken to be the average behavior of

the variable during crises. For the monthly data

in this paper, we considered a 49-month period

centered around each of the 158 crisis dates to be the crisis window. In the case of annual data,

five-year windows centered on the crisis dates

were used.

There are both advantages and drawbacks to

this methodology. The advantages lie largely in

the simplicity of the procedure. Since the graph

ical technique does not impose any parametric

structure on the data, it is more informative in

extracting patterns of behavior. Moreover, since

for this methodology statistical tests require less

demanding assumptions about the dist1ibutions

of the variables, the technique does not run into

a problem commonly encountered in more for

mal econometric procedures-namely the inva

lidity of statistical inferences owing to untenable

assumptions regarding the properties of the un

derlying data.

Among the drawbacks, perhaps the most sig

nificant is that the teclmique is intrinsically uni

variate. As a result it is often difficult to extract

the degree to which a particular pattern dis

played by a variable, before and after a crisis, is

influenced by me behavior of other variables.

Some studies have supplemented tl1e univariate

analysis with more r·igorous multivariate regres

sion analyses, but these have been unsatisfactory for a variety of reasons. The most appropriate

technique to use is a probit or logit-type panel

regression model with a sufficient number of

lags and leads (for example, in this paper it

would have 24 lags and 24 leads for the monthly

data) for the set of control variables. Typically,

this would involve estimates with too few degrees

8The linJ.;s between increases in interest rates and adverse selection and moral hazard problems, and financial ctises have been described in Mishkin (1996).

9See, for example, Goldstein (1996) and Kaminsky, Lizondo, and Reinhart ( 1997).


of freedom even when the number of control

variables is kept small, since for most countries the required data are available only from the

mid-1970s. Because crises are relatively "rare"

events (typically, less than 2 percent of all obser

vations) panel regressions of this sort thus are

likely to encounter overfilling problems. In most

studies, therefore, either panel restrictions are

not respected or a very small number of lags are

used. In both cases, the additional information

has marginal benefit.

A second drawback of the graphical event

study technique is that typically a large number

of diverse countries are included in the sample,

making it difficult to draw conclusions from the

average behavior of variables. In this paper, this

problem is circumvented by standardizing vari

ables with respect to their counu·y-specific

means and standard deviations. This filters coun

try-specific characteristics that affect long-run

levels and volatility (for example, because of dif

ferent levels of development or differences in institutional structures-particularly in the finan

cial sector-some countries may have inherently

higher growth rates or more volatile paths for

monetary variables). It also partly addresses data

problems that may occur because of differences

in measurement and data collection across coun

tries. To some extem, using country-specific

standardized variables is similar to using panel

regressions with fixed and random effects.

A third drawback is that even if the countries

in the sample are similar (for example, all industrial countries or all developing countries), the

crisis situations may not be. For instance, some

variables may have behaved differently in more

severe crises than in the less severe crises, or in

crises where the economic recovery was faster than in crises where the recovery was relatively

slower, and crises involving only reserves losses

could be inherently different from those with

large devaluations. Consequently, while looking

for common behavior across many different

kinds of crises is informative, it can also be misleading-in that some particular type of crises could be dominating the common pattern. To

address this problem, the sample of 158 identi-

THE MACROECONOMY BEFORE A CRISIS

fied crises was djvided into various subgroups:

crises in industrial countries, crises in emerging

market countries, crises characterized mainly by currency crashes, crises characterized mainly

by reserve losses, "severe" crises, "mild" crises,

crises associated with serious banking sector

problems, crises with fast recoveries, and crises

with slow recoveries. For each of these sub

groups, the same variable-by-variable evem study was conducted and the behavior of these vari

ables was compared across the various groupings to verify whether the behavioral patterns of vari

ables in some crisis categories dominated the

overall average behavior. This subgrouping of

crises also provided a check for robustness. If a

variable's behavior remained largely similar

across the different subgroups then it can be

claimed with some degree of confidence that

such behavior was in fact a common feature of

currency crises.

Finally, to test whether the behavior of the var

ious v-ariables differed significantly during peri

ods of crisis from that during tranquil periods,

for each variable the two-standard error bands

for the difference between the average value of the variable during the crisis period and its u·an

quil period average were also drawn in the event-study charts. Following standard t-tests, if

the error band was different from zero, tl1e dif�

ference in behavior was claimed to be significant

at tl1e 95 percent confidence level. As can be

seen in the figures, the standard error bands are

wider tl1an in most other studies. The reason

may be that while other papers (for example,

Frankel and Rose, 1996) show only the error

bands for the crisis period and the value of the

tranquil period average-the implicit assump

tion being that the tranquil period observations

have no sampling error-this paper assumes that

both the crisis and tranquil-period observations

are subject to sampling errors. Consequently, the

appropriate standard errors for the differences be

tween crisis and tranquil period averages are the

square-root of the sum of the squared standard

errors fo1· the crisis and tranquil-period averages. While, this clearly bas the effect of widening the

error bands, it is tl1e right procedure to follow if

93


94


inferences regarding the statistical significance of differences between crisis and noncrisis period behavior are to be made.

Antecedents of Crises

Figures 3.2-3.20 portray the behavior of various macroeconomic and financial variables in the run-up to currency crises and in their aftermath. Each figure includes ten panels, with each panel depicting the average behavior of a variable (denoted by a solid line) from 24 months before to 24 months after the crisis date compared LO its average level during tranquil or· normal times. Since each variable was standardized, units are in terms of country-specific standard

deviations-so that each panel shows the difference in the number of standar·d deviations by which the variable deviated from its countryspecific mean during crisis and tranquil periods. Although this way of presenting the data makes it difficult to interpret the differences in absolute or percentage terms, it goes a long way toward addressing the problems associated with pooling a large number of heterogeneous countries, as discussed in the previous section. The dotted lines display the two-times standard error bands of the differences between crisis and tranquil period behavior. If for any period, the error band does not intersect the zero line, then one car1 infer the difference to be significant at the 95 percent confidence level.

In each figure, the top row, left panel shows d1e difference in average behavior of a variable

during the 49-month crisis window compared to tranquil periods for the overall crisis sample. The oilier nine panels plot the results for various country and analytical groupings of the full sarnple, with a view to checking the robustness of the aggregate results. These groupings in

clude industrial count1·y crises; emerging market countY)' crises; crises mainly attributable to a sharp fall in the exchange rate (currency "crashes"); crises mainly attributable to a sizable decline in reserves ("reserves crises"); currency cr·ises associated with banking crises; relatively

··severe" crises; relatively "mild" crises; crises with fast recoveries; and crises with slow recoveries. JO

Generally, for all crisis groupings (excluding "high-inilation" crises1 1 ) , prior to the outbreak of a crisis the real foreign currency value of the domest.ic currency was significar1tly higher than itS mean during tranquil periods (Figure 3.2). At the beginning of the crisis window, around 24 mond1s before a crisis, the real ejjective exchange

m/.e was about 0.4 standard deviations higher than its u-anquil per-iod level. Although in some

cases the exchange rate declined slightly in the

subsequent two years, the overvaluation re·

mained significant dur-ing most of the precrisis

period. This pattern of real exchange rate overvalua

tion in the period leading up to a crisis was observed for all of the analyt.ical categories. I t

10Cunency "cr,\shes" are crises where the currency component of the exchange market pressure index account� for 75 per·cent of the index when the index signals a crisis. Reserves crises are crises where the reserves component of the exchange market pressure index accor.LntS for 75 percent of t.he index when the index signals a crisis. Currency crises associated with banking crises (also referred lO as banking and currency crises) are occurrences where a banking crisis occurs within two years (before or afler)-see the appendix to tl1is chapter for the definition and description of the incidence of banking crises. Severe crises are identified by increa;;ing the threshold of the exchange market pressure index w three times the pooled standard deviation plus tl1e pooled mean instead of 1.5 Limes the pooled standard deviation. For the severe crises, the tranquil periods are different from that of tl1e full crisis sample as tl1ey are recalculated as periods outside tl1e 49-monLh severe crisis window. Mild crises are those crises in which tl1e tbreshold is between 1.5 and 2.0 times the pooled standar·d deviation plus the pooled mean. For mild crises, tJ1e tranquil periods are the same as those for the full sample. Crises with fast recover-ies are those crises in which GOP returns to trend within two years after the outbreak of the crisis, while crises witl1 slow recoveries are those in which GOP returns to trend after tl1ree years or more. Based on these definitions, tl1ere were 42 industtiaJ country crises, 116 emerging market crises, 55 currency crashes, 55 reserves cr·ises, 45 banking and currency crises, 52 severe crises, 84 mild crises, 98 crises \\�th fast recoveries, and 60 crises witl1 slow recoveries.

1 '"1-ligh-inflation'' crises were defined as crises in which the pr·eceding 12-month inflation rate exceeded 80 percent.



Figure 3.2. Real Effective Exchange Rates1

All Currency Crises

0.9-

0.5�-

0.1- -

-{).3- -

-{).7-

Industrial Country Crises Emerging Market Country Crises Currency Crashes - 0.9 - 0.9 - - 0.9

- 0.5

�-� 0.1

� -{).3

0.1 0.1

-{).3

-{)_7 -{).7

Reserves Crises - 0.9

� 0.5

��: - -{).7

-1.1 -1.1 -1.1 ...._......__.__....__, -1.1 -1.1 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 I 1+12 1+24

Banking and Currency Crises

0.9

0.5

-{).3-

-{).7-

-1.1l--'----'--L--' 1-24 t-12 I 1+12 1+24

Severe Crises - 0.9

Mild Crises Crises with Fast Recoveries Crises with Slow Recoveries

- 0.9 - 0.9 - 0.9

- -{).7 - -{},7

..___..___,_....____, -1.1 1.1 -1.1 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24

'The real effective exchange rate was calculated using weights from the IMF's Information Notice System (INS) database and transfonned by taking logs (index is 0.0 for 1990). The units for each panel are country-specific standard deviations from the country-specific mean. All crises lor which the preceding 12-month Inflation rate exceeded 80 percent were removed. Outliers were also removed by rejecting data that did not fall within variable-specific, symmetric, and wide cut-off paramenters. The

cut-off parameters lor real exchange rate outliers were 6.0 and -6.0. The data were then normalized by subtracting the country-specific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 24 months before a crisis, the month of the crisis, and

24 months after the crisis) for the selected sample of crises, relative to its tranquil-period mean and averaged across all crises. The black lines In each panel represent

the two times standard error bands. using both standard errors for the crisis window and tranquil-period means.

95


96


ranged from about 0.3 standard deviations above

normal around two years prior to emerging mar

ket crises and cdses with slow recoveries to as

much as 0.6 standard deviations for industrial

country crises. It should be noted that these re

sults do not imply, however, that the overvalua

tion was higher in an absolute or percentage

sense in industrial countries, because average ex

change rates in crisis and tranquil periods are

calculated after removing country-specific means

and variance and these are higher for emerging

market countries. In fact, in percentage terms,

24 months prior to a crisis real exchange rates in

indusu·ial countries were on average only about 10 percent higher than in tranquil times com

pared to about 25 percent for developing

couno·ies.

Although the measured real exchange rate

overvaluation was statistically significant at the

95 percent significance level at the beginning of

the crisis window for all of the analytical cate

gories, it was not so throughout the precdsis pe

riod for some of the subgroups. Specifically, for


problems as well as for reserves crises-and to a

lesser extent for emerging market crises and for

crises with fast recoveries-the overvaluation was

not statistically significant in the year preceding

a crisis. For these categories, the real exchange

rate generally depreciated throughout the pre

crisis pe1iod. The real exchange rate overvalua

tion was generally statistically signi1icant at the

90 percent level, however. It is interesting to

note that the relative overvaluation of the real

exchange rate provided little information on the

severity of the crisis or the time it took on aver

age to recover from a crisis, as the precrisis be

havior of the real exchange rate was broadly sim

ilar for severe crises, mild crises, crises with fast

recoveries, and crises with slow recoveries.

It is of course not altogether surprising that

the real exchange rate tended to be appreciated,

relative to its norm, prior to a crisis, since most

currency crises involved significant nominal de

preciations. What this analysis reveals is that al

though real exchange rate overvaluation was a

dominant featw·e in the precrisis phase of most

currency crises, it was by no means present in

all. In particular, for crises that involved banking

sector problems and in those associated with

large reserves losses, the overvaluation was not

significant.

Typically, the real exchange rate appreciation

in precrisis periods was accompanied by a deteri

oration in exjJart performance, especially in tl1e

12 months or so preceding the outbreak of a cri

sis (Figure 3.3). However, the difference be

tween crisis and tranquil period behavior was sta

tistically significant-at the 95 percent

confidence level-only in the four months prior

to a crisis for the full sample of crises, and was

not statistically significant for some crisis group

ings, such as industrial country crises and crises

with large reserves losses. Similarly, the trade bal

ance did not display any significant differences in

behavior in the precrisis period except for a

slight deterioration near the outbreak of a crisis

(Figure 3.4). The terms of trade generally wors

ened in the precrisis period, but differed signifi

cantly from the tranquil pe1iod only in the final

few months before a crisis (Figure 3.5). For

emerging-market counu·y crises and cunency


problems, however, the terms of u·ade were wors

ened sigrlificantly starting almost a year prior to the crisis. In swn, although poor export per

formance, which resulted partly from a loss of

competitiveness owing to an overvalued ex

change rate and deteriorating terms of trade, ap

pears to have played a role in many crises, it was

not a common feature across all crises.

Inflation was significantly higher in precrisis pe

riods than in tranquil periods for the entire sam

ple of crises and for several of the analytical cate

gories (Figl.�re 3.6). Remarkably, for indusuial

counu;es the deviation of the rate of inflation

from its tranquil period level was greater t11an for

emerging market countries. However, this was

tl1e case only for comparisons that abstract from

country-specific means and variances. In absolute

terms, on average for emerging market countries

the inflation rate was 10-15 percent above its

tranquil period mean during the two years lead

ing up to a crisis, but for the industrial counu·ies



Figure 3.3. Export Growth,

All Currency Crises

0.8· Industrial Country Crises Emerging Market Country Crises Currency Crashes Reserves Crises

0.6

·

�:: ¥

·

:

0 -o.2 . -D.4· . -o.6· . -o.8.

0.8 0.8 0.6 0.4 0.2

0 -0.2

. -o.4 · -D 6 - -o.8

0.6

�:: -o.2 -0.4

. --o6 --o.8

0.8 0.6 0.4 0.2

0 -o.2

--oA - -o.s - -o.8

0.8 0.6 0.4 0.2

0 -o.2

-1.0 '---'--'--'---' '---'--'---'---' -1.0 '----'---'--'----' -1.0 ,___.___,__..____, -1.0 ,___.___,__..____,_1_0 1-241-12 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 1+12 1+24


0.8· 0.6· 0.4 0.2

0 1-r·tll-'-'l*HP<HII--Q.4

Severe Crises

0.8 0.6 0.4 0.2

0 . -o.2

-o.4 --o.s --o.8

1.0


0.8 0.6 0.4 0.2

0.8 0.8

0 ·-D.2 ·-D.4 --o.6 �. - �::

. 0.2 . 0

. -o.2 - • -D.4 - - -o.s

--o.8 - -o.8 1.0 '----'---'--'---' -1.0

0.6 0.4 0.2

0 --o.2 --o.4 --o.6 --o.8

1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 1.0

1+12 1+24

'Export growth was defined as the 12-monlh logarithmic growth in exports. The units for each panel are country-specific standard devlations from the countryspecific mean. All crises for which the preceding 12-month inflation rate exceeded 80 percent were removed. Outliers were also removed by rejecting data that did not

fall within variable-specific, symmetric, and wide cut·off parameters. The cut-off parameters for the export growth outliers were 1.0 and -1.0. The data were then normalized by subtracting the country-specific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 24 months before a crisis, the month of the crisis. and 24 months after the crisis) for the selected sample of crises, relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent

the two times standard error bands, using both standard errors for the crisis window and tranquil-period means.

91


98


Figure 3.4. Trade Balance,

All Currency Crises 1.0-

Industrial Country Crises Emerging Markel Country Crises Currency Crashes Reserves Crises 1.0 - 1.0 1.0 1.0

0.6�-

0.2-

-o.2. .

-o.s.

0.6

0.2

-o.2

� n 1 n

�� 0.6

�-::

0.6

0.2

-o.2

- -0.6 - -o.s

� 0 6

0 2

-o.2

- -o.6

1.0 .___.__.__...___, -1.0 '---'---'-----"'--.J -1.0 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 lt12 1+24

Banking and Currency Crises Severe Crises 1.0-

0.6-

-o.2·

-o.6-

1.0

Mild Crises Crises with Fast Recoveries Crises with Slow Recoveries - 1.0 - 1.0 1.0

�� ::: � :.: �·_,, �_,, - -o.s - -o.s

-1.0 -1.0 .___.__.__...___, -1.0 .___.__.__...___, -1.0 .____..___, _ _,___J -1.0 1-24 t-12 I 1+12 1+24 1-24 t-12 I lt12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 1+12 lt24

1The trade balance is defined as the logarithm of exports divided by imports. The units for each panel are country-specific standard deviations from the country· specilic mean. All crises lor which the preceding 12·month lnllation rate exceeded 80 percent were removed. Outliers were also removed by rejecting data that did not fall within variable-specific. symmetric, and wide cut-off parameters. The cut-off parameters lor the trade balance oulliers were 1.0 and -1.0. The data were then normalized by subtracting the country-specific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 24 months before a crisis. the month of the crisis, and 24 months after the crisis) lor the selected sample of crises, relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent the two times standard error bands, using both standard errors for the crisis window and tranquil-period means.



Figure 3.5. Terms of Tradel

All Currency Crises 1.0 . Industrial Country Crises Emerging Mark.et Country Crises Currency Crashes Reserves Crises

0.6.

�� -1 0 · -1.4· -1 .8 '----'--'---''---' r-24 1-12 !t 12 !t24 Banking and Currency Crises 1.0·

�::� -o.2� �:� -1 .8 '----'--'---''---' 1-24 1-12 I It 12 lt24

. 1.0 . 1.0 �.11� 0.6

��: . ·-1.0 ·-1.4

�� :: ��

-o.2 �-.lf\V A AA ·_r M. �:� : �lf''y :-_1.4

L--....L..--'--'---'-1.8 .___.....___,__....____, -1.8 t-24 1-12 1+12 !+24 1-24 1-12 !+12 1+24 Severe Crises Mild Crises

1.8 1-24 1-12 t 1+12 1+24 1-24 t-12 . -1.4 1.8 lt12 1+24

1.0 0.6 0.2

-1.0 .__,___,__....____,_1.8 --1.4

,___.__..___.___, -1.8 1-24 1-12 It 12 1+24 1-24 1-12 1+12 lt24 Crises with Fast Recoveries Crises with Slow Recoveries . 1.0 . 1.0

�# �:: ��:: � -o2 � -o2

��: ��: -�.4 . -�.4 1-24 t-12 1 � 1 � 1+12 1+24 1-24 t-12 I 1+12 lt24

'The terms of trade were defined as export prices divided by import prices. The units for each panel are country-specific standard deviations from the country-specific

mean. All crises for which the preceding 12-month inflation rate exceeded 80 percent were removed. Outliers were also removed by rejecting data that did not fall within variable-specific, symmetric, and wide cut·off parameters. The cut-oft parameters for the terms of trade outliers were 2.0 and -2.0. The data were then normalized by

subtracting the country-specific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window {which includes the 24 months before a crisis, the month of the crisis. and 24 months after the crisis) for the selected sample of crises, relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent


99


100


Figure 3.6. lnflation1

All Currency Crises

1.4. 1.2. 1.0.

! l� o Y\c....,.,.�

-o. 2 · -o.4. -o.6 '---'----'---''---'

1-24 t-12 1+12 1+24

Banking and Currency Crises Severe Crises 1.4 . . • • 1.4

0 6 · . • 0 6 0.4. . . . 0 4 0.2. . . 0 2

0 0 -o 2 . . . . -o.2

Mild Crises 1.4 1.2 1.0 0.8

� 0.6

�� 0.4 �A �-�-A • 0,2 � � 0 'C.J.7

- -o.2

Currency Crashes

Crises with Fast Recoveries 1.4 1.2 1.0 0.8 0.6 0.4 0.2

0 - -o.2

Reserves Crises

1.4 1.2 1.0 �· 0.8 0.6

-'v.../ � 0.4 �� 0.2

\A? --o.� . -o.4

L-....L..--'--'---'-o.6 t-24 t-12 1+12 1+24

Crises with Slow Recoveries 1.4

�?dfj�li . 0.4

. 0.2 0

. . -o.2 -o.4· . -o.4 . -o.4 . -0.4 . -o.4 -o.6 '---'-___.__.....___, '-..:J.....---'-_..___, -o.6 '---'-----'---''-----' -o.s '---'-___.__.....___, -o.s '---'---'--'-----' -o.s

1-24 t-12 I+ 12 1+24 t-24 t-12 t 1+12 lt24 1-24 t-12 lt12 lt24 t-24 t-12 lt12 lt24 t-24 t-12 1+12 tt24

'Inflation was defined as the 12·month logarithmic change in prices. The units for each panel are country-specific standard deviations from the country-specific

mean. All crises for which the preceding 12·month Inflation rate exceeded 80 percent were removed. Outliers were also removed by rejecting data that did not fall within variable-specific, symmetric, and wide cut·off parameters. The cut·off parameters for the Inflation outliers were 1.5 and -1.5. The data were then normalized by

subtracting the country-specific mean and dividing by the country-specific standard deviation. The blue line in each panel portrays the behavior of the variable during the crisis window (which Includes the 24 months before a crisis, the month of the crisis, and

24 months after the crisis) for the selected sample of crises. relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent



it was only 6-8 percent higher. In other words,

the smaller discrepancy between crisis and tran

quil period inflation rates for the emerging mar

ket countries compared to that for industrial

countries, when measured in standard deviations,

was because of the higher mean and volatility of

inflation in emerging market countries. It should

be noted that this difference in behavior of infla

tion mirrors the difference in real exchange rate

overvaluation for these two groups of countries.

The buildup of inflation pressures during the pe

riod leading up to a crisis was evident, in varying

degrees, across most groupings of crises, with the

notable exception of severe crises and of cw·

rency crises associated with banking crises. In

these cases, there were no overt signs of price in

flation. In fact for severe crises, the rate of infla

tion was lower, on average, in precrisis periods

than in tranquil times. l2

Signs of overheating also were evident in the

monetary sector. For the full sample, narrow

money (Ml) and broad money (M2) growth

were significantly higher than normal from

around the eighteenth month before the crisis

date (Figures 3.7 and 3.8). However, monetary

growth slowed from approximately the ninth or

sixth month, suggesting perhaps a tightening of

monetary conditions by the authorities in view

of the above normal inflation. Domestic credit

growth too remained above normal, although

not significantly so at tl1e 95 percent level

(Figure 3.9). ln real terms, Ml growth and M2

growth, although not unusually high, rose

steeply from around the twenty-fourth month to

at least the twelth month before a crisis and

thereafter decelerated (Figures 3.10 and 3.11) .

Real domestic credit growth picked up as the cri

sis date approached (Figure 3.12), but not signif

icantly so.

The behavior of the monetary variables

showed some interesting variations across analyt

ical groupings. For instance, growth of nominal


M l , M2, and domestic credit in the precrisis

phase on average did not exceed the tranquil

period mean for seve1·e crises nor for crises with

fast recoveries. In contrast, for reserve crises and

for crises with slow recoveries, growth of nomi

nal Ml, M2, and domestic credit, as well as

growth of real domestic credit was signi:fican tly

above normal during most of the precrisis

phase. In brief, for many types of crises the over

heating evident in the product markets was mir

rored in the monetary sector.

Interest rate movements have played a signifi

cant role either in precipitating or in preventing

currency crises, both directly through tlleir ef

fects on capital flows and indirectly as a signal of

the authorities' commitment to defend an ex

change rate peg and as a gauge of its monetary

stance. For the full sample of crises, the real in

terest rate in the precrisis period was below the

tranquil period average (Figure 3.13). However,

close to the ci;sis, and when crisis broke, the real

interest rate moved sharply upwards. This behav

ior was not uniform across the various crisis sub

samples. Indeed, except for crises in emerging

market economies, the behavior of the real in

terest rate in the precrisis phase for the most

part was not significantly different from that dur

ing tranquil periods. Furthermore, although in

most crisis groupings there was a run-up in real

interest rates as the crisis approached, the level

of real interest rates was significantly higher than

the tranquil period level only among crises asso

ciated with banking problems and crises tl1aL

ended with slow recoveries. What emerges from

this discussion is that low real interest rates

aided in keeping monetary conditions lax before

emerging market crises (and to a lesser extent

pdor to other crises) and thereby added to the

overheating problem. Whether or not real inter

est rates were low in the precrisis phase, an inter

est rate defense appears to have been attempted

in almost all types of currency crises; however, in

12"fhe tranquil periods for the severe crisis category were different from those for all other crisis categories and for the entire crisis sample. When the severe crisis tranquil periods are replaced with the full sample tranquil periods, the precrisis inflation rates for severe crises are higher than with tranquil periods, on average, as in ail of the other crisis categories. The lower inflation for the severe crises, therefore, is an artifact of the way the tranquil periods ru·e defined for this crisis subsrunple.

101


102


Figure 3.7. Nominal M1 Growth1

All Currency Crises 0.9-0.7-

�:��- N«'' !. 0.1)1"""'1�� -o.1 · .

-o.3 . -o.s-

Industrial Country Crises Emerging Market Country Crises Currency Crashes Reserves Crises � - � � �

- - 0.5 . fvv... • � 0.5 . . 0.5 . 0.5 . 0.7 - - 0.7 J:N:!J 0.7 - - 0.7 0.3 JMM '1./V,v jt o.3 0.3 - 0 3

--o.3 --o 3 - --o.3 - --o.3 . -o.s . . -o.s --o.s - --o.s -o.7.__-'-__.__..___, '---''----'---'-L--1-Q} '---'----'--'-----'-0. 7 -o. 7 -Q.7 1-24 t-12 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 Banking and Currency Crises Severe Crises

E� . M Ari �:! o.3�:11VNA

vf1 0.3

0.1 · 0.1 -\-1---;-IHf\-f-''-,.,tt -o.1· ·-Q.1 -o.3- ·-Q.3 -o.s- --o.s -o. 7.___.___,__..__....J l.:.--''---'---'---'-o. 7

Mild Crises

1-24 t-12 1+12 1+24 1-24 t-12 1+12 1+24 1-24 1-12

0.9 0.7 0.5 0.3 0.1 --0.1 --o.3 --o.s

Crises with Fast Recoveries Crises with Slow Recoveries 0.9 0.9

'Wfi�I-..P..-!L

0.7 0.5 0.3 0.1 --o.1 ·-Q.3

·-0.5

0.7 0.5 0.3

'---'---'--'----'-o. 7 .___.___,__..__....J-o. 7 /-24 t-12 I 1+12 1+24 1-24 t-12 1+12 1+24

'Nominal M1 growth was defined as the 12·month logarithmic growth in Ml. The units for each panel are country-specific standard deviations from the country·

specific mean. All crises lor which the preceding 12·month Inflation rate exceeded 80 percent were removed. Outliers were also removed by rejecting data that did not

fall within variable-specific. symmetric, and wide cut·off parameters. The cut-ofl parameters for the nominal Ml growth outliers were 2.0 and -2.0. The data were then

normalized by subtracting the country-specific mean and dividing by the country-specific standard deviation. The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 24 months before a crisis, the month of the cnsis, and

24 months after the crisis) for the selected sample of crises, relative to its tranquil-period mean and averaged across all crises. The black lines in each panel repres.ent




Figure 3.8. Nominal M2 Growtht

All Currency Crises 1.0 -0.8 . 0.6 . : :� -o.2 . . -Q.4 . -o.6 --o.8 .____.___._____,'--_,

1-24 t-12

Banking and Currency Crises 1.0 .

�r�� -o.4 . -o.6 - .

-o.8 .____._____.__..__, 1-24 t-12 I I+ 12 lt24

Industrial Country Crises Emerging Market Country Crises Currency Crashes Reserves Crises

1.0 - 1.0 1.0 1.0 � :: . � J\i-- :: . I"\ )1/: :: . . :: ��; ��; ��; ��; . -o.6 . -o.6 . -o.6 . -o.6 .____.____.__..__. -o 8 -o.8 -o.8 .____.____.__..__, -o.s

1-24 1-12 I+ 12 1+24 1-24 1-12 It 12 1+24 t-24 t-12 I+ 12 1+24 1-24 t-12 I+ 12 1+24

Severe Crises Mild Crises Crises with Fast Recoveries Crises with Slow Recoveries 1.0 0.8 0.6 0.4 0.2 0

1.0 0.8

�

ll . -o.2 -o.2 . -o.4 . . -Q.4

--o.6 . -o.6 .____.____._�.....__, -o.8 '----'---'-�'---' -o.8

1-241-12 1+12 lt24 1-24 t-12 lt12 1+24

1� 1� . · 0.8 � 08

��· :: ��:; - 0 0 . · -Q2 . -o 2 - . -Q 4 - - o 4

. -o.6 . -o.6 ,__.____.__..__, -o.8 -o.8

1-24 1-12 1+12 lt24 1-24 1-12 1+12 1+24

1 Nominal M2 growth was defined as the 12-month logarithmic growth In M2. The units for each panel are country-specific standard deviations from the country

spec�ic mean. All crises for which the preceding 12·month Inflation rate exceeded 80 percent were removed. Outliers were also removed by rejecting data that did not fall within variable·specific, symmetric, and wide cut-oft parameters. The cut-off parameters for the nominal M2 growth outliers were 2.0 and -2.0. The data were then normalized by subtracting the country-specific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 24 months before a crisis, the month of the crisis, and 24 months after the crisis) for the selected sample of crises, relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent

the two times slandard error bands, using both standard errors for the crisis window and tranquil-period means.

103


104


Figure 3.9. Nominal Domestic Credit Growth,

All Currency Crises 1.0 .

0.6-

-o.6 L-....L---'--'---' 1-24 t-12 I 1+12 1+24

Banking and Currency Crises 1.0-

Industrial Country Crises Emerging Market Country Crises Currency Crashes Reserves Crises 1.0 1.0 1.0 1.0

� :: � :: W :: 4 :: �:: �:.: �:: �:.:

1-24 t-12 I 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 1+12 1+24 1-24 1-12 1+12 1+24

Severe Crises 1.0

Mild Crises Crises with Fast Recoveries Crises with Slow Recoveries 1.0 1.0 . 1.0

- 0.6 0.6

��: � 0.2

� "" -_A��VJr. 1--. ·vv "'V . -o.2

-o.6 -o.6 L--'---'----''--' -o.6 -o.6 '---'----'---'---' -o.6 1-24 t-12 I lt12 1+24 1-24 t-12 I lt12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 1+12 1+24

'Nominal domestic credit growth was defined as the 12·month logarithmic growth in domestic credit. The units for each panel are country-specific standard deviations from the country·specific mean. All crises for which the preceding 12·month inflation rate exceeded 80 percent were removed. Outliers were also removed by rejecting data that did not fall within variable-specific. symmetric, and wide cut-off parameters. The cut·off parameters lor the nominal domestic credit growth outliers were 2.0 and -2.0. The data were then normalized by subtracting the country-specific mean and dividing by I he country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 24 months before a crisis, the month of the crisis. and 24 months after the crisis) for the selected sample of crises, relative to Its tranquil-period mean and averaged across all crises. The black lines In each panel represent the two times standard error bands, using both standard errors for the crisis window and tranquil-period means.



Figure 3.1 0. Real M1 Growth,

All Currency Crises

0.7.

�:ru �.5v� �.9·

Industrial Country Crises Emerging Marltet Country Crises

0.7 . 0.7

0.3 ��.1

. -�.5

. -�.9 �=: -�.9

Currency Crashes Reserves Crises

0.7

-1.3 1.3 ',.--....L...--L--'---' -1.3 1.3 1.3 It 12 lt24 1-24 t-12 I lt12 lt24 t-24 t-12 I lt12 lt24 1-24 t-12 lt12 1+24 1-24 t-12 t lt12 lt24 1-24 t-12

Banking and Currency Crises Severe Crises 0.7.

0.3

. 0.7 Mild Crises Crises with Fast Recoveries Crises wilh Slow Recoveries

. 0.7 . 0.7 0.7

0.3

�.5

�.9

-1.3 -1.3 .__.....__.__..___, _1.3 -1.3 '---'---'--.I<.L.......J -1.3 1-24 t-12 I 1+12 1+24 1-24 t-12 t 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 I lt12 1+24 t-24 t-12 lt12 1+24

'Real Mt growth is defined as lhe 1 2-month logarithmic growth in real M1. The units for each panel are country-specific standard deviations from the country· specific mean. All crises for which the preceding 12-month inflation rate exceeded 80 percent were removed. Outliers were also removed by rejecting data that did not fall within variable-specific, symmetric, and wide cut-off parameters. The cut-off parameters for the real M1 growth outliers were 0.75 and �.75. The data were then normalized by subtracting the country-specific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 24 months before a crisis, the month of the crisis. and 24 months after the crisis) for the selected sample of crises. relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent the two times standard error bands, using both standard errors for the crisis window and tranquil-period means.

105


106


Figure 3.11 . Real M2 Growtht

All Currency Crises 0.8 °


-1.2 '----'-----'---'-----' 1-24 1-12 I 1+12 1+24


0.8 ° 0.8 • 0.8 0.8

'----'-----'---'-----' -1 2

0.4 0.4 0.4

1.2 -1.2 -1.2 1-24 1-12 I 1+12 1+24 1-24 t-12 1+12 1+24 1-24 1-12 1+12 1+24 1-24 1-12 t 1+12 1+24

Severe Crises 0.8

0.4

Mild Crises Crises with Fast Recoveries Crises with Slow Recoveries · M M M

0.4 0.4

. -o.8

'----'---'--'----' -1.2 '---'--'---'----' -1.2 I 1+12 1+24 1-24 1-12 t 1+12 1+24 1-24 1-12 1+12 1+24 1-24 1-12 t

1 Real M2 growth was deli ned as the 12·month logarithmic growth in real M2. The units for each panel are country-specific standard deviations from the country·

specific mean. All crises for which the preceding 12·month inflation rate exceeded 80 percent were removed. Outliers were also removed by rejecting data that did not

fall within variable-specific, symmetric, and wide cut-off parameters. The cut-off parameters for the real M2 growth outliers were 0.75 and -o.75. The data were then

normalized by subtracting the country-specific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 24 months before a crisis, the month of the crisis, and

24 months after the crisis) for the selected sample of crises, relative to its tranQuil-period mean and averaged across all crises. The black lines in each panel represent

the two times standard error bands, using both standard errors for the crisis window and tranQuil-period means.



Figure 3.1 2. Real Domestic Credit Growth1


Industrial Country Crises Emerging Market Country Crises 1.0 . 1 .0

�:� ��: ��: Currency Crashes

1.0

0.6

0.2

�.6�'\f: �A\t�.6 . - � 6

-1.0 � -1.0 -1.0 .___.___.__..__,_1.0

·-0.6

Reserves Crises 1.0

0.6

0.2

�.2

�.6

t-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 1-12 1+12 1+24 1-24 1-12 1.0

1+12 1+24


0.6 .

0.2.

-0.6 .

Severe Crises 1.0

0.6

0.2

�.2

�.6

�n �n

Mild Crises 1.0

0.6 � 0 2

-02

. -�.6

1.0

Crises with Fast Recoveries Crises with Slow Recoveries 1.0 1.0

0.6 0.6

�=: 0.2

- �.2

- -o.6

1.0 1.0 1-24 1-12 I 1+12 1+24 1-24 1-12 I 1+12 1+24 1-24 1-12 1+12 1+24 1-24 1-12 1+12 1+24 1-24 t-12 I 1+12 1+24

'Real domestic credit growth was defined as the 12·month logarithmic growth in real domestic credit. The units tor each panel are country-specilic standard deviations from the country-specific mean. All crises for which the preceding 12-month inflation rate exceeded 80 percent were removed. Outliers were also removed by rejecting data that did not fall within variable-specific, symmetric. and wide cut-off parameters. The cut·off parameters for the real domestic credh growth outliers were

0.75 and �.75. The data were then normalized by subtracting the country-specific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window (which Includes the 24 months before a crisis, the month of the crisis, and 24 months after the crisis) for the selected sample of crises, relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent

the two times standard error bands, using both standard errors lor the crisis window and tranquil-period means.

101


108


Figure 3.13. Real Interest Ratet

All Currency Crises 1.0.

Industrial Country Crises Emerging Market Country Crises . 1.0 1.0

0.6. • 0.6

::� ��: l\-' . �-o.6 -1.0- . -1 .0 . -1.0

Currency Crashes 1.0

0.6

0.2

. -o.2

. -o.6

. -1 .0

Reserves Crises 1.0

0.6

J"vv-v... . /\ , 0.2

� -o.2

� -o.s

. -1.0

-1.4 -1.4 ......__._____.,__,___, -1.4 ....___.__,__.______, -1.4 1.4 1-24 t-12 I 1+12 t+24 1-24 t-12 t 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 t 1+12 1+24

Banking and Currency Crises Severe Crises Mild Crises Crises with Fast Recoveries Crises with Slow Recoveries

1.0· 1.0

0.6

1.0 • 1.0 . 1.0

0.6 0.6 •

0.2 -� 0.2 � 0.2

. -o.2 . . -o.2 �� -o.2

· -o.6 · -Q.6 · yv �- -o.6

--1.0 . -1.0

-1.4 -1.4 -1.4 1-24 1-12 I 1+12 1+24 1-24 1-12 t 1+12 lt24 1-24 1-12 t lt12 1+24 1-24 t-12

. -1.0

1.4 It 12 lt24 1-24 1-12

0.6

0.2

-o.2

-o.s

1.4 1+12 1+24

1The real interest rate was defined as the nominal short-term interest rate less 12-month inflation. The units for each panel are country-specific standard deviations

from the country-specific mean. All crises for which the preceding 12-month inflation rate exceeded 80 percent were removed. Outliers were also removed by rejecting

data that did not fall within variabte-specitic, symmetric, and wide cut-off parameters. The cut-off parameters for the real interest rate outliers were 2.5 and -2.5. The

data were then normalized by subtracting the country-specific mean and dividing by the country-specific standard deviation. The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 24 months before a crisis, the month of the crisis. and

24 months after the crisis) for the selected sample of crises, relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent

the two times standard error bands. using both standard errors for the crisis window and tranquil-period means.


many cases, real interest rates were not increased

above tranquil period levels.

Currency crises have often been preceded by

declining asset prices. For instance, in almost all

of the countries affected by the Asian crisis, real

estate and equity prices rose steeply during the

early 1990s and then declined sharply from

around mid-1996. Consistent with this experi

ence, the growth rate of equity prices, valued in

either local or foreign currency, for the full crisis

sample tended to decline somewhat, on average,

starting around six months before the crisis

(Figures 3.14 and 3.15). This decline before the

crisis was not significantly different from the

tranquil period growth rate for equity prices.

Moreover, the experience is not uniform across

different types of crises. For crises accompanied

by banking sector problems, precrisis equity

prices grew at a lower rate than the tranquil pe

riod rate although the difference was not signifi

cant. Perhaps, this was a reflection of the fact

that banking crises were of much longer dura

tion, and by the time they erupted in a cunency

crisis, asset markets had already suffered a cor

rective contraction. Similarly, for industrial coun

tries, growth in equity prices was slower tl1an

tranquil period growth between the twenty

fourth and twelfth month. Near the crisis date,

however, the growth in equity prices was faster,

on average, than during the tranquil period. For

emerging market crises, currency crashes, severe

crises, mild crises, and crises with slow recover

ies, me decline in the growth rate was more per

ceptible man for me overaJJ sample and other

subsamples. The boom in asset prices seemed to

have peaked prior to tl1e twenty-fourth monm

for the reserves crises, and from around the

eighteenm month the growth in equity prices re

mained around or below normal. From these re

sults, almough tl1ere is some evidence of asset

price collapses in the precrisis phase, it was by

no means uniformly true across various types of

crisis. In some cases, the asset market seemed to

have collapsed earlier than the 24-month precri

sis window, while in others there was no dis

cernible difference in equity price behavior dur

ing the run-up to a crisis.


The behavior of international reserves, meas

ured in months of imports, failed to display any

pronounced pattern, although in absolute dollar

or deutsche mark terms, reserves declined pre

cipitously as the crisis broke (Figure 3.16). The

sharp fall occurred across all categories except

for crises with banking problems and currency

crashes. ln some of the crisis samples, for exam

ple, the severe crises, the decline in reserves

commenced more than a year before a crisis.

Many crises have been associated wim a rever

sal and d1·ying up of capital inflows. Furthermore,

in some cases, holders of Uquid domestic bank

liabilities try to convert them into foreign ex

change. Thus, the banking system's ability to

wimstand pressures on the currency depends, in

part, on the extent to which its domestic liabili

ties are backed by foreign reserves, for instance

approximated inversely by the ratio of broad

money to official international reserves. This ratio

showed a remarkable pattern around the time of

a crisis (Figure 3.17). Starting a little higher

than its u·anquil period average, it rose through

out me 24-month period prior to a crisis with

the growth in the ratio increasing close to the

crisis. Behavior of mis kind was more dramatic,

almost by construction, for reserves crises but

also for severe crises, crises with slow recoveries,

and currency crashes. The latter case shows that

th.e increase in the ratio was not simply a reflec

tion of reserves plumrneting just before a crisis.

Since this ratio in part captures an economy's

ability to witl1stand speculative pressures without

a sharp correction in me exchange rate, it can

be viewed as an indicator of investors' confi

dence in the domestic financial system.

A number of studies have argued that hastily

or badly sequenced financial reforms that open

up the economy to an increased volume of inter

mediation without adequate prudential regula

tions have been important causes of currency

crises. Using the changes in the ratio of M2 to

M l as a proxy for changes in frnancial interme

diation and, therefore, financial liberalization, we

found that this ratio was significantly higher

man normal for the overall sample between the

twenty-fourtl1 and twelfm monms prior to a cri-

109


110


Figure 3.14. Change in Real Stock Prices1

All Currency Crises 1.0·

�:� -o.6· .

-1.0·

Industrial Country Crises Emerging Market Country Crises Currency Crashes Reserves Crises 1.0 1.0 1.0 1.0

?:: � � :: �:: N :: Y

-o.2 � -o.2 _, \f0_--o.2 ��

(\\-o.2

. . -o.6 . v . -o.6 N\.A. A J\r. -o.6 . \JwvJ \ -o.6 -�� - �� . w �v·· - �� - � �

-1.4 -1.4 '--'---'--'-----'-1.4 -1.4 -1.4 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24


1.0·

o.s- .A.. {\ _ • r o.2.!' ... � V\J.

-o.2�

-o.6�

-1.0· .

-1.4'---'---'----'---' 1-24 1-12 r 1+12 1+24

Severe Crises Mild Crises Crises with Fast Recoveries Crises with Slow Recoveries

1.0 1.0 1.0 1 .0

�:: ��:·: • . A - -A 'vvJ � -Q.2 . -Q.2 A 11. A w f'v. -o.s . -o.6 . v � � - �� - �� ,_.....___. _ _._____, -1.4 ,_.....___. _ _._____, -1.4

1-24 t-12 I 1+12 lt24 1-24 t-12 1+12 1+24

0 6

� 0 2

�� -02

� v: -os

·-1.0

'---'---'---'--....) -1.4 1-24 1-12 r 1+12 1+24

0.6

0.2

�\;!/(�:: . '\) · -1.0

.__.__,__.___, -1.4 1-241-12 r 1+12 1+24

'The change in real stock pnces was defined as the 12·month logarithmic change in stock prices less 12·month inflation. The units for each panel are country-specific

standard deviations from the country-specific mean. All crises for which the preceding 12·monlh inflation rate exceeded 80 percent were removed. Outliers were also removed by rejecting data that did not fall within variable-specific. symmetric. and wide cut·off parameters. The cut·off parameters for the change in real stock prices

outliers were 2.0 and -2.0. The data were then normalized by subtracting the country-specific mean and dividing by the country-specific standard deviation. The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 24 months before a crisis. the month of the crisis. and

24 months alter the crisis) lor the selected sample of crises. relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent the two times standard error bands. using both standard errors for the crisis window and tranquil-period means.



Figure 3.15. Change in Stock Prices (Valued in Foreign Currency)1

All Currency Crises 1.1• 0.7.

�:� -o.9·

-1.3-

-1.7 '----'----'--'-----'

1-24 1-12 tt12 1+24


1.1 -

�::��N

�:�

Industrial Country Crises Emerging Market Country Crises Currency Crashes • 1.1 • 1.1 1.i

- 0.7 - . 0.7 • 0.7

0.3 - - 0 3 - 0 3

yv ·11'-./fV_ -os :-..��Ufv'. _os - - -o s JVY v - -o.9 . � w - -o.9 . --o9

Reserves Crises 1.1

• . 0.7 � 0.3 V'\AJ\.Yl"' -o.1

� -o.s

- -o.9

- -1.3 - -1 3 . · -1.3 · -1.3 .___.__..__..____, -1.7 -1.7 -1.7 '---'----'--.1...---' -1.7

1-24 1-12 1+12 1+24 1-24 1-12 tt12 1+24 1-24 1-12 lt12 1+24 1-24 1-12 1+12 1+24

Severe Crises

1.1

Mild Crises Crises with Fast Recoveries Crises with Slow Recoveries . 1.1 - 1.1 1.1

'-""�:A�-h,.-1: iA�k 1i �1: · -o.s -o.s � -o.s

- -o.9 - . -o 9 - - -o 9

0.7

0.3

-1 .3 · • -1.3 - -1.3 • -1.3

-1.7 '---'--'---'---' '---'--l..L.='-'----' -1 .7 '---'----'--'---' -1.7 1.7 .___.____,__..____, -1.7 1-24 1-12 1+12 1+24 1-241-12 1+12 1+24 1-24 1-12 1+12 t+24 1-24 1-12 1+12 1+24 1-24 1-12 1+12 lt24

1The change in stock prices was delined as the 12-month logarithmic change in stock prices valued in U.S. dollars {non-European countries). The units for each panel

are country-specific standard deviations from the country-specific mean. All crises for which the preceding 12-month inflation rate exceeded 80 percent were removed.

Outliers were also removed by rejecting data that did not fall within variable-specific, symmetric, and wide cut-off parameters. The cut-off parameters for the change In

stock prices outliers were 2.0 and -2.0. The data were then normalized by subtracting the country·spetific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window {which includes the 24 months before a crisis, the month of the crisis, and

24 months after the crisis) for the selected sample of crises, relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent


111


112


Figure 3.16. Change in Foreign Reserves,


Industrial Country Crises Emerging Marl!et Country Crises Currency Crashes

�:� -o.6ry : -1.0. -

1.0 1 .0 1.0

0.6

0.2

0.6

0.2

0.6

0 2

--1.0 - -1.0

Reserves Crises 1.0

0.6

0.2

-1.4 '----'----'--.L....-' 1.4 1.4 '--....L..----'---'----' -1.4 '----'----'--...___--' -1.4 1-24 1-12 I 1+12 1+24 1-24 1-12 1+12 1+24 1-24 1-12 1+12 1+24 1-24 1-12 1+12 1+24 1-24 1-12 1+12 1+24


1.0 •

Severe Crises Mild Crises Crises with Fast Recoveries Crises with Slow Recoveries

1.0

0.6

0.2

1.0

0.6

0.2

1.0

0.6

0.2

1.0

0.6

0.2

. -o.2

. -o.6

. -1.0

. -o.2

. -o.6

• -1.0 . -1.0

-1.4 -1.4 .._____.._____,_--'----' -1.4 -1.4 1-24 1-12 I 1+12 1+24 1-24 1-12 I 1+12 1+24 1-24 1-12 1+12 1+24 1-24 1-12 I 1+12 1+24 t-24 1-12

. -1.0

1.4 1+12 1+24

1The change in foreign reserves was defined as the 12-month logarithmic change in reserves valued in U.S. dollars (non-European countries) or deutsche mark (European countries). The units for each panel are country-specific standard deviations from the country-specific mean. All crises for which the preceding 12-month Inflation rate exceeded 80 percent were removed. Outliers were also removed by rejecting data that did not fall within variable-specific. symmetric, and wide cut·oH parameters. The cut-off parameters for the change in foreign reserves outliers were 1.5 and -1.5. The data were then normalized by subtracting the country-specific

mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior ot the variable during the crisis window (which Includes the 24 months before a crisis, the month of the crisis, and

24 months alter the crisis) for the selected sample of crises, relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent

the IWo times standard error bands, using both standard errors tor the crisis window and tranquil-period means.



Figure 3.17. M2-to-Reserves Ratio1

All Currency Crises 1 . 7 .

1 . 3 -

Industrial Country Crises Emerging Marlcet Country Crises Currency Crashes 1.7 1.7

1.3 1.3

1.7

1.3

0.9

0.5

0.1

Reserves Crises 1.7

1.3

0.9

0.5

0.1

--o.3

-o.7 -o.7 -o.7 -o.7 -o.7 1-24 t-1 2 I 1+12 1+24 1-24 1-12 t 1+12 1+24 1-24 1-12 I 1+12 1+24 1-24 1-12 I 1+12 1+24 1-24 1-12 I 1+12 1+24


1.7'

1.3-

0.9-

0.5� 0.1 �

-o.3 �� -o.7 '-�--'--'---'----'

1-24 1-12 I 1+12 1+24

Severe Crises

1.7

1.3

0.9

0.5

0.1

--o.3

'---'--'---'---' -o. 7 1-241-12 I 1+12 1+24


1.7 1.7 - 1.7

1.3 1.3 - 1.3

�:::: ��:: ·�: :.: � 0.1 0.1 - - 0.1

- . -o.3 - - -o.3 - -o 3

.___.___.__..___, -o. 7 -o.7 -o. 7 1-24 1-12 I 1+12 1+24 1-24 1-12 I 1+12 1+24 1-24 1-1 2 I 1+12 1+24

'The M2-to-reserves ratio was defined as the logarithm of M2 divided reserves. The units for each panel are country-specific standard deviations from the countryspecific mean. All crises for which the preceding t2-month inflation rate exceeded SO percent were removed. Outliers were also removed by rejecting data that did not fall within variable-specific, symmetric. and wide cut-off parameters. The cut·off parameters for the M2·to-reserves ratio outliers were 5.0 and -5.0. The data were then normalized by subtracting the country-specific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 24 months before a crisis, the month of the crisis, and 24 months after the crisis) for the selected sample of crises. relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent the two times standard error bands, using both standard errors for the crisis window and tranquil-period means.

113


114


sis, falling sharply after that and then rising

somewhat as the crisis neared (Figure 3.18).

However, as in the case of other variables, this

behavior was not robust across the crisis subsam

ples. In particular, it was more or less absent for

currency crashes as well as other crisis

groupings.

For the entire crisis sample on average,

growth in teal activit)', as measured by the 12-

month change in industrial or manufacturing

production, v.ras significantly below normal

around 24 months before a crisis, then rose

slightly to be insignificantly below normal for

most of the rest of the precrisis window (Figw·e

3.19). In the last few months close to the crisis,

output growth slowed slightly, but not signifi

cantly. The lack of a significant pattern for out

put growth was robust across most of the analyti

cal groupings. The exceptional cases were

currency crashes and crises witl1 slow recoveries,

where growth slowed significantly below tl1at in tranquil times around three to six months be

fore a crisis. As well, for crises associated with

banking problems, output growth was signifi

cantly below normal throughout the 24-month

precrisis period, perhaps suggestive of deeper fi

nancial problems keeping the economy in a

longer-term stagnant state. in contrast, for crises

in industrial countries and those with fast recov

eries, growth was significantly lower than during

the tranquiJ periods before the eighteenth

month, while in the 1 2 months immediately

prior to the crisis, output growth had essentially

recovered to normal levels. These results suggest that the duration of the crises may partly depend

on tile �yclical positions of the economies pdor

to tile crisis. In a crisis where activity after tJ1e

crisis recovered relatively quickly, the economy

may have already commenced a cyclical recovery

when the crisis occurred. On the other hand, for

a crisis where tile return to u·end growth was

slower, the economy may have just entered a

cyclicaJ contractionary phase when the crisis

struck. Surpdsingly, in industriaJ counuies, the

average currency crisis seems to have Slruck at a

point when the economy was past the trough of

a cycle and was on the way to recovery. For

emerging market economies, the average crisis

seemed to have set a cyclical downturn in

motion.

Several studies have pointed to increases in

world interest mtes as potential triggers for cur

rency crises, particularly given the increasing in

tegration of world capital markets and the sensi

tivity of capital flows to changes in these rates.

The results of this paper support that belief.

World real interest rates increased rather

sharply, on average, about five to six months

prior to a crisis for the entire crisis sample and

were significantly above normal periods in the fi

nal precrisis months (Figure 3.20). This pre crisis

pattern generally appeared in all crisis subsam

ples with varying levels of significance. lt was

more pronounced in indusu·ial counuies com

pared to emerging market countries, in ctu-rency

crashes compared to reserves crises, in crises

with slow recoveries compared LO crises witJ1 fast

recoveries, and somewhat surprisingly, in mild

c•·ises compared to severe crises.

Second generation theoretical models usua!Jy

focus on poljcy trade-offs to help explain the on

set of currency crises. One example of such a

trade-off might occur when a government faces

a decision on whether to defend a currency peg

by implementing policies, such as raising interest

rates, which may slow down real economic activ

ity. In instances of high or •·ising ·unemplo)'menl, a

government may be unwilling to accept that

trade-off. In fact, many analysts believed that this

was a significant factor in comributing to the

1992 ERM crisis. For the industrial country crisis

sample, the unemployment rate rose much

faster than normal, and significantly so, thTough

out tl1e precrisis window (Figure 3.21) .L!l

Some previous studies have found that laTge

external current account and fiscal deficitS have

13Note that Figu•·e 3.21 has only two panels: one for the overall c•-isis sample and one for industrial countries. Because unemployment data were unavailable for almost all of 1J1e emerging market economies, the two samples are essentially the same for this variable.


Figure 3.18. Change in M2·to·M1 Ratiot

All Currency Crises 1.2.

08 .

0.4�

0� --{).4.

Industrial Country Crises

� . .

1.2

0.8

0.4

0

---{).4


Emerging Market Country Crises Currency Crashes Reserves Crises 1.2 1.2 1 .2

• 0.8 0.8

Mt�·� � 0.4 � 0.4

0 UJ.!'v/\� 0

� ---{).4 • ---{).4

--{).8 --{).8 ,__.....__..._.....__,--{),8 ,__.....__..._..____,--{),8 -0.8 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 I 1+12 1+24

Banking and Currency Crises 1.2-

0.8-

,,� --{).:�

Severe Crises Mild Crises • 1.2

Crises with Fast Recoveries Crises with Slow Recoveries 1.2 1.2 - 1.2

--{).8 -().8 .__.....__..._.....___, _0.8 .__.....__...._..____,-()_8 --{).8 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 lt12 lt24 1-24 t-12 I lt12 lt24

'The change in the M2-to·M1 ratio was defined as the 12-month change in the logarithm of M2 divided by M1. The units for each panel are counlry-specilic slandard

deviations from I he country-specific mean. All crises for which the preceding 12-month inflation rate exceeded 80 percent were removed. Outliers were also removed by rejecting data that did not fall within variable-specific. symmetric, and wide cut-off parameters. The cut-off parameters for the change in M2-to-M1 ratio outliers were

0.75 and --{).75. The data were then normalized by subtracting the country-specific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 24 months before a crisis, the month of the crisis, and 24 months after the crisis) for the selected sample of crises, relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent

the two times standard error bands, using both standard errors tor the crisis window and tranquil-period means.

115


116


Figure 3.19. Output Growtht

All Currency Crises

1.1 •

Industrial Country Crises Emerging Martcet Country Crises Currency Crashes Reserves Crises

0.7. �:�� -Q.S�v-: -Q.9·

1.1 • 1.1

0.7 . 0.7 � 0.3 � 0.3

��: ��:

1 . 1

0.7

0.3

-Q.1

1.1

0.7 �.� 0.3 ��-Q.1 �-Q.S

·-Q.9

� � 1� 1� �� 1 � 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24


1 . 1 ·

Severe Crises

• 1.1


1.1 . 1.1 • 1.1

-1.3 -1.3 -1.3 -1.3 1.3 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24 1-24 t-12 I 1+12 1+24

'Output growth was defined as the 12·month logarithmic growth in industrial or manufacturing output. The units for each panel are country-specific standard deviations from the country-specific mean. All crises for which the preceding 12·month inflation rate exceeded 80 percent were removed. Outliers were also removed by

rejecting data that did not fall within variable-specific, symmetric, and wide cut·off parameters. The cut·off parameters for the output growth outliers were 0.5 and -{).5. The data were then normalized by subtracting the country-specific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 24 months before a crisis, the month of the crisis, and 24 months after the crisis) for the selected sample of crises, relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent the two limes standard error bands. using both standard errors for the crisis window and tranquii·period means.



Figure 3.20. World Real Interest Rate1

All Currency Crises

0.8.


�8 �8 0.8 0.8

0.4 � 0.4 0.4

0 � 0 0

-o.4. - -o.4

-0.8 -o.8 -o.8 .___.___.__.__-J-o.8 -o.8 1-24 t-12 I 1+12 lt24 1-24 t-12 I 1+12 lt24 1-241-12 I 1+12 1+24 1-24 t-12 1+12 1+24 1-24 t-12 I 1+12 lt24

Banking and Currency Crises Severe Crises Mild Crises Crises with Fast Recoveries Crises with Slow Recoveries

0.8. 0.8 0.8 0.8 0.8

0.4

0

-Q.4

-o.8 o.8 -o.8 -o.8 -o.8 1-24 t-12 I 1+12 lt24 1-24 t-12 I lt12 lt24 1-24 1-12 I lt12 lt24 1-24 1-12 I lt12 1+24 1-24 t-12 I lt12 lt24

'The world real interest rate was defined as the real short-term U.S. (for non-European countries) or German (for European countries) interest rate. The units tor each

panel are country-specific standard deviations from the country-specific mean. All crises for which the preceding 12-month inflation rate exceeded 80 percent were

removed. Outliers were also removed by rejecting data that did not fall within variable-specific, symmetric, and wide cut-oH parameters. The cut-oH parameters for the

world Interest rate outliers were 2.0 and -2.0. The data were then normalized by subtracting the country-specific mean and dividing by the country-specific standard

deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 24 months before a crisis. the month of the crisis, and

24 months after the crisis) tor the selected sample of crises. relative to Its tranquil-period mean and averaged across all crises. The black lines In each panel represent

the two limes standard error bands, using both standard errors for the crisis window and tranquil-period means.

111


118


Figure 3.21 . Change in the Unemployment Rate1

All Currency Crises Industrial Country Crises 1.6-

-o.a<---"'----'-_.....__ _ _, L---'---L---'----' -o.a /-24 t-12 1+12 1+24 /-24 t-12 /+12 /+24

'The change in the unemployment rate was defined as the 12·month change in the unemployment rate (OECD·standardized. where available). The units for each panel are country·specific standard deviations from the country·specific mean. All crises for which the

preceding 12·month inflation rate exceeded 80 percent were removed. Outliers were also removed by rejecting data that did not fall within variable·specific, symmetric. and wide cut· off parameters. The cut·off parameters for the change in the unemployment rate outliers were 0.25 and -o.25. The data were then normalized by subtracting the country-specific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 24 months before a crisis. the month of the crisis, and 24 months after

the crisis) for the selected sample of crises, relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent the two times standard error bands. using both standard errors for the crisis window and tranquil-period means.

played significant roles Ln currency crises. Other

studies have suggested that excessively large

movements in short-term capital may influence

crisis events, particularly if these movements are

reversed. Since monthly da ta were not available

for these variables, annual data were used in this

paper to examine their impact. Figures 3.22-3.24 present these results. These figures are simi

lar to the figures that include monthly data, ex

cept they depict a five-year window centered

around the crisis as well as one additional year

prior to this window and one year after this

window.14

The current account dejicit was significantly

larger than during tranquil periods in the years

leading up to a crisis for the overall crisis sample

and many of the cri.sis subsamples (Figure 3.22).

This result was strongest for crises associated

with banking crises and for crises with slow re

coveries and weakest for reserves crises (except

for the year of the crisis), for industrial country

crises, and for crises with fast recoveries. The fis

cal deficit was also larger, on average, than in nor

mal times for the overall c1·isis sample, but this

result was neither significant (except for the year

of the crisis) nor robust across the crisis subsam

ples (Figure 3.23). Only Ln reserves crises and

crises with fast recoveries was the deficit signifi

cantly larger than normal for any precrisis year.

The fiscal deficit, however, increased on average

for most of the crisis groupings in the years pre

ceding a crisis. Shart-term capital inflows as a ratio

to GDP was at or below normal (though not sig

nificantly, except for tl1e year of the crisis), on

average, during the precrisis pe1iod for the over

all sample and many of the crisis subgroups. On

two occasions, howeve•·, the ratio during the precrisis period was significantly above that during

tranquil periods: at two years prior to a crisis for

crises associated with banking problems and at

one year prior to a crisis for crises with slow re

coveries. There was some evidence, moreover, of

a reversal of tl1ese capital Oows as shown by a de-

14The five-year window was considered the crisis period. Years outside these crisis windows were considered the tranquil pe•·iods.



Figure 3.22. Current Account Balance1

All Currency Crises Industrial Country Crises Emerging Market Country Crises Currency Crashes Reserves Crises 1.0· 0.8. 0.6. 0.4. -

�:� -Q.4. . -o.6 .

-o.8. -1.0· -1.2

1-3 1+3

Banking and Currency Crises 1.0· 0.8. 0.6. 0.4. 0.2.

0 ----;>'�-...,,L -o.2. -D.4. -o.6 . -o.8. -1.0· -1.2 L.......I._J__J_.L......J.-1

1-\3 1+3

1.0 0.8

� 0.6 0.4

� '' -o.�

��· -o.6 -o.8 -1.0

t-3

Severe Crises

-1.2 1+3

. 1.0

. 0.8

�L �:�

0=�l -:-y . -o.8 - . -1.0 L......l--'--'--'-.J.......J -1.2

1-3 1+3

1.0 1.0 1.0 0.8 0.8 0.8 0.6 0.6 0.6

� :l 0.4 � OA 7 ': 0.2

��! -o.2 -o.2

� -Q.4 � -o.4

1-3

-o.6 -o.6 . -o.8 -o.8 . -1.0 . -1 .0 - -1.0

-1.2 1.2 -1.2 1+3 1-3 1+3 1-3 1+3

Mild Crises Crises with Fast Recoveries Crises wllh Slow Recoveries

1.0 1.0 . 1.0 0.8 0.8 . 0.8 0.6 0.6 �- . 0.6

W� �i B00��i �· j -0.4 . . -o.4 . . -o.4

. . -o.s - -o.s . . -o.s . . -0.8 . -o.8 · · -o.s

- � n - � n . - �n L......l--'--'--'-.J.......J -1.2 1.2 -1.2

1-\3 1+3 1-\3 1+3 1-3 1+3

1The current account was defined as the external current account balance as a percent of GOP. The units for each panel are country-specific standard deviations from the country-specific mean. All crises for which the preceding 12·month inflation rate exceeded 80 percent were removed. The data were then normalized by subtracting

the country-specific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window (which includes the 2 years before a crisis, the year of a crisis, and 2 years

after a crisis). plus an additional year before and after the crisis window, tor the selected sample of crises, relative to its tranqull·perlod mean and averaged across all

crises. The black lines in each panel represent the two times standard error bands, using both standard errors for the crisis window and tranquil-period means.

119


120


Figure 3.23. Fiscal 8alance1

All Currency Crises Industrial Country Crises Emerging Maltet Country Crises Currency Crashes

1.0·

0.6·

0.2�0�

-o.2 �

-o.6�

-1 .0 L-J.-'--'-J.......L--' 1-3 lt3

Banking and Currency Crises 1.0·

0 6� 0.2. .

� 2� -o.s - .

-1.0 1-3 1+3

1.0

�:: . -o.2

� -o.6

t.-1.--'--'--J........I.--' -1.0 1-3 lt3

Severe Crises 1.0

0.6

� 0.2

/--JV -G.2

. . -o.s

� -1.0 1-3 I 1+3

1.0

0.6

� 0.2

�-o.2

� - o.6

1-3

Mild Crises

1.0 lt3

1.0

0.6 � 0.2

-o.2

� -o.s

1-3 -1.0 lt3

1.0

0.6

� 0.2

� -o.2

� -o.6

.._.___._........._...___.__, -1.0 1-3 lt3

Crises with Fast Recoveries 1.0

0.6

� r- 0.2 ........., �-o.2

�-o.s 1-3 1+3 1.0

Reserves Crises 1.0

0.6

� ;---- 0.2

� -o.2

� -o.6

.._.___._........._...___.__, -1.0 1-3 1+3

Crises with Slow Recoveries 1.0

0.6 � 0 2

-o.2

�-o.s -1.0 1-3 1+3

1The fiscal balance was defined as the fiscal balance as a percent of GOP. The units lor each panel are country-specific standard deviations from the country·specific

mean. All crises for which the preceding 12-month Inflation rate exceeded 80 percent were removed. The data were then norma.lized by subtracting the country-specific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of the variable during the crisis window (which Includes the 2 years before a crisis. the year of a crisis, and 2 years after a crisis). plus an additional year before and after the crisis window. for the selected sample of crises. relative to its tranquil-period mean and averaged across all crises. The black lines in each panel represent the two limes standard error bands. using both standard errors tor the crisis window and tranquil-period means.


cline in these movements in the years close to

the crisis for many of the crisis groupings. These

results tentatively suggest that while unsustain

able current account deficits tended to be pan

of the general overheating of the economy pre

ceding a crisis, large fiscal deficits played a less

regular role, and excessive short-term capital

played even a smaller role.

Outcomes of Crises

Almost immediately after the crisis date (for

the full sample), the real exchange rate typically

fell to a level significantly below its average dur

ing tranquil periods, remained near that depre

ciated level for many months, and only began to

rise slowly close to 24 months after the crisis (see

Figure 3.2). This pattern occurred despite a sig

nificant rise in the rate of inflation, which peaked

on average about 12 months after a crisis (see

Figure 3.6). Similar behavior was evident for the

real exchange rate in most of the crisis subsam

ples, though with differing levels of significance.

The two exceptions were reserves crises and

crises with slow recoveries. For the former

grouping, the real exchange rate remained

above normal levels even after a crisis but con

tinued to decline gradually until after ten

months the rate was below the tranquil period

average, though not significantly. For the latter

grouping, the exchange rate dropped sharply at

the crisis date but only fell to the tranquil period

level. Upon stabilizing for about six months, the

exchange rate depreciated again over the subse

quent six months before leveling off. This fur

ther depreciation six months later for the slow

recovery group could be the result of inappro

priate policy responses to these crises by the au

thorities; however, it might equally have resulted

from the relatively slower recovery in GDP

growth, by construction. It is interesting to note

that evidence of exchange rate overshooting, at

least in real terms, on average, was present in

only the banking and currency crises, currency

crashes, and severe crisis groupings, despite the

postcrisis acceleration of inflation.

OUTCOMES OF CRISES

The increase in inflation was generally the

case across the analytical crisis categories. The

exceptions were industrial country crises and

mild crises, and, to a lesser extent, crises with

fast recoveries. In even these three samples, how

ever, inflation was significantly higher than nor

mal times in the postcrisis period. The relatively

sharper increase for crises with slow recoveries

compared to crises with fast recoveries, despite

the similar precrisis inflation pattern for these

two groups, is particularly noteworthy. In all the

crisis subsamples, inflation tended to peak at or

not rise after 1 2 months following a crisis.

Export growth rebounded soon after the crisis

date for the overall crisis sample and all the cri

sis subsamples and, by 12 months later, was gen

erally at or near normal levels (see Figure 3.3).

Similarly, the trade balance and curnmt account bal

ance also improved for all the groupings, though

by differing amounts and with differing lags (see

Figures 3.4 and 3.22). Export growth recovered

relatively less for crises with slow recoveries than

those with fast recoveries, perhaps reflecting the

higher real exchange rate compared to normal

for the former subsample. The trade and cur

rent account balances for the slow recovery

group, however, increased more sharply postcri

sis than that for fast recovery group, although

the sharper rebound probably reflects slower

GDP growth leading to relatively lower demand

for imports. The improvement in external sector

was helped by an improvement in the tenns of

trade after crises with serious banking problems,

emerging market crises, currency crashes, and

severe crises (see Figure 3.5). For tl1e overall

sample, however, there was no evidence of an

improvement. ln fact for some categories, partic

ularly crises with slow recoveries, the terms of

trade continued to fall.

The rebound in the external balances, includ

ing the short-term capital balance (Figure 3.24),

helped improve foreign 1-eserves (see Figure 3.16).

Within one year, the growth rate of reserves had

returned to normal for all crisis groupings, and

in most cases, foreign reserves began to accumu

late at a significantly faster rate than normal

soon after. The lack of a significant difference in

121


122


Figure 3.24. Short-Term Capital lnflows1

All Currency Crises

0.8. Industrial Country Crises Emerging Market Country Crises Currency Crashes Reserves Crises

0.4. 0�

7 v-v--�.4�

-{).8.

-1.2 L.......I.....L...J.......L....J.......J 1-3 1+3


0.8.

�.4-

�.8-

-1 .2 L.......I--L-'-...L....J.......J 1-3 1+3

0.8 0.8 � 0.4

��.:

� 0.4 _,.-"\ - / 0 7\/V ��.4

��8 I..�...L.....I......L......l--L....J -1 .2

- �.8 L......l....J..-'--'---'--' -1.2

1-3 I 1+3 1-3 1+3

Severe Crises Mild Crises

0.8 0.8

- �.8

�;J 04

�::

0.4

....._._,__._....__....__, -1.2 .._._.__.__,_....__, -1 .2 1-3 1+3 1-3 1+3

0.8 0.8 �� 04 � OA

�:: J'\::1:: L......l--'--'--'-J......J -1.2 L.......I.....L...J.......L....J.......J -1.2

1-3 1+3 1-3 1+3

Crises with Fast Recoveries Crises wilh Slow Recoveries

0.8 . 0.8

�

04 � OA

��: � �: --0.8 . �.8

1........1.--'--'---l........L....J-1.2 L......J.....J......J_.L....J._J -1.2 1-3 1+3 1-3 1+3

'The short-term capital inflows were defined as short-term capital as a percent of GOP. The units for each panel are country-specific standard deviations from the country-specific mean. All crises for which the preceding 12-month inflation rate exceeded 80 percent were removed. The data were then normalized by subtracting the country"specific mean and dividing by the country-specific standard deviation.

The blue line in each panel portrays the behavior of tile variable during the crisis window (which includes the 2 years before a crisis, the year of a crisis, and 2 years after a crisis). plus an additional year before and after the crisis window. for the selected sample of crises, relative to Its tranquil-period mean and averaged across all crises. The black tines in each panel represent the two times standard error bands, using both standard errors for the crisis window and tranquil-period means.


short-term capital flows between crises \vith fast

recoveries and those with slow recoveries is sur

prising given the poorer growth recovery in the

latter as well as significantly higher warld interest

rates, on average, after crises >vith slow recoveries

(see Figure 3.20) .15

After a crisis, monetary growth, particularly in

real terms, contracted relatively sharply. Real M l

and M2 growth remained significantly below

tranquil period averages for at least the first year

of the postcrisis period in every crisis subsample

(see Figures 3.10 and 3.11), despite reductions

in the real interest rate to levels significantly below

normal (see Figure 3.13). The contraction also

occurred for real domestic credit growth in all

the categories, but growth was not significantly

less than normal, except for a few months, in

the postcrisis period in many of these categories

(see Figure 3.12). Because inflation rates also

generally rose in the frrst 12 months after a cri

sis, the evidence of a monetary slowdown was

weaker for nominal M1, M2, and domestic credit

growth (see Figures 3.7, 3.8, and 3.9).

It is interesting to compare the behavior of

the monetary variables, the real interest rate,

and inflation between crises with fast recoveries

and those with slow recoveries. For crises with

fast recoveries, real interest rates were lowered

less, inflation rose less, and nominal Ml, M2,

and domestic credit growth remained near nor

mal. As a result, the real money supply did not

contract significantly. For the crises with slow re

coveries, tl1e real money supply contracted

more, despite lower real interest rates, because

inflation rose much more. This may have caused

GOP growth to recover more slowly.

The decline in broad money along with the

improving foreign reserves position caused the

ratio of broad money to foreign reserves to return to

more normal levels in ilie postcrisis period (see

Figure 3.17). As this ratio fell, confidence in ilie

domestic currency was restored, leading to a

more s table currency. It is notewortl1y that in

crises with faster recoveries, this ratio was back

OUTCOMES OF CRISES

to normal within six months after the outbreak

of crisis, but for crises wiili slower recoveries, tl1e

ratio was not back to normal, on average, even

after two years.

By construction, industrial o·utput growth de

clined much more following crises with slow re

coveries than those with fast recoveries (see

Figure 3.19). In fact, for the latter group, output

growili was not significantly different from nor

mal. For the overall crisis sample and most of

the otl1er subsamples, output was significantly

below normal at some stage during the postcrisis

period, although the timing and duration of the

below normal output varied by group. The two

exceptions were industrial country crises, for

which output increased, on average, after a crisis

and was at or above normal times, and currency

crashes, where output also increased after a crisis

but remained insignificantly below normal for

about six months.

The output slowdown, along with the decline

in confidence in the currency, led to stock prices

growing more slowly than normal, on average,

after a crisis (see Figures 3.14 and 3.15). By con

struction, the decrease in stock prices was larger,

and generally significant, when valued in foreign

currency. Tn domestic currency, however, stock

price growtl1 was insignificantly different from

normal generally, except for after crises with

slow recoveries. In fact, stock prices continued to

grow at normal rates, on average, for indusuial

country crises and crises with fast recoveries.

Lastly, the .fiscal balance, typically, deteriorated

on the crisis date and remained weak, though

not always significantly, for the entire crisis sam

ple and most of the crisis subsamples in tl1e post

crisis period (see Figure 3.23). For crises with

slow recoveries, tlle fiscal deficit grew larger,

though this might be more a result of, rather

ilian a cause of, relatively slower GDP growth, as

well as a result of tl1e greater costs of financial

and economic resu·ucturing after a relatively

deeper crisis. After a reserves crisis, ilie postcrisis

fiscal balance generally improved.

15 ote that in every other subsample and the full sample, the postcdsis world interest rates are no1 significantly different from normal.

123


124


Costs of Crises

Financial crises can be very costly, both in

terms of the fiscal and quasi-fiscal costs of re

structuring the financial sector and more

broadly in terms of the effect on economic activ

ity of the inability of financial markets to func

tion effectively. In particular, financial crises may

lead to misallocation and underutilization of re

sources, and thus to losses of real outpul. In

some instances, however, crises may not have led

to output losses, such as when a crisis simply

brought about a needed correction of a mis

aligned exchange rate. To provide a rough as

sessment of the costs in terms of lost output,

GDP growth after a crisis was compared to trend

GDP growth. The cost in lost output was then es

timated by adding up the differences between

trend growth and actual growth in the years fol

lowing the crisis until the time when annual out

put growth returned to its trend. It is important

to note that the results presented below were for

the group of countries and time period used in

the analysis in this paper; results will obviously

differ from case to case.

For the entire sample of currency crises, on

average, output growth returned to trend in a

little over 1 Y2 years, and the cumulative loss in

output growth per crisis was almost 4!12 percent

age points (relative to trend) (Table 3.1).16 For

approximately 40 percent of the currency crises,

there were no significant output losses estimated

using this technique.l7 Although the average re

covery time was shorter in emerging market

counu·ies than in industrial countries, the cumu-

lative output loss \Vas on average larger. The dif

ferences in recovery time and cumulative output

losses may have resulted, in part, from the

higher mean and variance of output growth in

emerging market countries compared to indus

trial countries.18 The recovery time and output

losses were similar on average in currency

crashes and reserves crises (respectively, two

years and 7 percentage points, on average) .

However, in a relatively larger proportion o f re

serves crises (about 40 percent compared to 30

percent for currency crashes) , countries suffered

no output losses.

Cunency crises that occurred within two years

of banking crises, not surprisingly, were more

prolonged and more costly than those not asso

ciated with banking crises: on average it took 2!12

years for output growth to return to trend and

the average cumulative loss in output growth was

9 percentage points.l9 Although this may seem

intuitively convincing, some caution is in order,

since the criteria used to identify banking crises

may tend to select occasions when financial sec

tor problems were severe, whereas the statistical

criteria used to identity currency crises are inde

pendent of such judgments. Similarly, in severe

ctises output losses were higher on average (8\/t

percentage points) than in mild crises (5 per

centage points ) , although average recovery

times were similar (2\/t years for severe crises and

2 years for mild crises). By construction, crises

with fast recove1ies had shorter average recovery

times and smaller average output losses than

crises with slow recoveries.

16This cost estimate may be biased downward because instances where output growth did not return to trend over the sample period were excluded from the calculation.

17Th is may be, in part, because in some cases it took several years for the consequences of financial sector weaknesses to materialize or because the ··crisis" brought about a much-needed correction of the exchange rate.

IS'fhe mean and standard deviation of output growth were 4.5 percem and 3.7 percent, respectively, for emerging market countries, while they were 2.7 percent and 2.3 percent, respectively, for indusu·ial counu·ies.

19Th is should be viewed only as indicative of the macroeconomic costs associated with banking crises and not as suggesting that the banking crises caused these output losses. Recessions may give rise to banking crises. which then amplify the recessions. Furthermore the magnitude of output losses fo1· different couJltries may depend on their specific cyclical positions prior to the crisis. While it is, in principle, possible to derive output losses correcting for each country's cyclical position, since the cyclical positions of the 50 countries in the sample have not been closely synchroni.zed, the effect of the correction on average losses will be limited.


CONCLUSIONS

Table 3.1. Costs of Crises in Lost Output Relative to Trend

Cumulative loss Average Cumulative loss Crises with of Output per Crisis

Number of Recovery time2 of Output per Crisis3 Output Losses4 with Output losss Crises Groupings1 Crises (In years) (In percentage points) (In percent) (In percentage points)

All currency crises 158 1.6 4.4 62 7.1 Industrial 42 1.9 3.1 55 5.6 Emerging market 1 16 1.5 4.9 64 7.6

Currency crashes 55 2.0 7.1 71 10.1 Industrial 13 2.1 5.0 62 8.0 Emerging market 42 1.9 7.9 74 10.7

Reserves crises 55 2.1 6.8 61 11 .2 Industrial 12 1.9 4.6 so 9.1 Emerging market 43 2.2 7.5 64 1 1 .7

Banking and currency crises 45 2.4 9.0 73 12.3 Industrial 6 4.7 12.7 83 15.2 Emerging market 39 1.9 8.3 71 1 1 .7

Severe crises 52 2.2 8.3 70 1 1 .9 Industrial 3 1.3 2.5 33 7.4 Emerging market 49 2.2 8.7 72 12.0

Mild crises 84 2.0 5.0 59 8.5 Industrial 33 2.1 3.2 55 5.8 Emerging market 51 1.9 6.5 63 10.3

Crises with fast recoveries 98 1.2 2.3 48 4.7 Industrial 30 1.2 1.0 37 2.7 Emerging market 68 1.2 2.9 54 5.3

Crises with slow recoveries 60 4.8 18.4 100 18.4 Industrial 12 5.9 16.6 100 16.6 Emerging market 48 4.5 18.9 100 18.9

1See text for definitions of crises groupings. 2Average amount of time until GOP growth returned to trend. As GOP growth data is available for all countries only on an annual basis, the

minimum recovery time was one year by construction. 3Calculated by summing the differences between trend growth and output growth from the first year of the crisis until the time when annual

output growth returned to its trend and averaging over all the crises. 4Percent of crises in which output was lower than trend after the crisis began. scalculated by summing the differences between trend growth and output growth from the first year of the crisis until the time when annual

output growth returned to its trend and averaging over all the crises that had output losses.

Conclusions

No two crises have ever been alike. And it is

difficult to fit the characteristics of crises into a

single mold-even when the crises themselves

are grouped into distinct types. Some common

features nonetheless stand out from the analysis

of the behavior of various macroeconomic and

financial variables.

Typically, prior to a currency crisis the econ

omy was overheated: inflation was relatively high

and the domestic currency was overvalued, af

fecting the export sector and the current ac

count balance. Monetary policy was significantly

expansionary, with domestic credit growing

strongly, compromising the exchange rate objec

tive for countries with fixed or inflexible ex

change rate systems. The financial vulnerability

of the economy was increasing, with rising liabili

ties of the banking system unbacked by foreign

reserves and falling asset prices. Furthermore,

some trigger, such as increasing world real inter

est rates or declining terms of trade, usually ex

acerbated the vulnerabilily of an economy to a

crisis. These observations are, of course, specific

to the technique used to identify crisis episodes

and the sample of countries and are not always

robust even for all crisis subsamples examined in

this paper. Moreover, the behavior of variables in

125


126


particular crises has, on many occasions, differed

from this average pattern-to take one example,

in a number of the Asian countries affected by the recent crisis, inflation was relatively low.

Crises in emerging market economies have

tended to be deeper than crises in industrial

countries, but recoveries have tended to be

faster. Generally, faster recoveries have been as

sociated with stronger rebounds in export

growth. While currency crises can be very costly

in terms of lost output, not all are-output

losses are more likely in crises in which the cur

rency "crashes" than in those in which exchange

market pressures are reflected mainly in large re·

serves losses. Most costly and most prolonged

are currency crises accompanied by banking sec

tor difficulties.

Appendix 3.1 . Banking Crises

Banking crises are more difficult to identify

empirically, partly because of the nature of the

problem and partly because of the lack of rele

vant data. While data on bank deposits are read

ily available for most countries, and thus could

be used to identify crises associated with runs on

banks, most banking problems today do not

originate on the liabilities side of banks' balance

sheets. Thus, among the industrial counoies,

neither the banking crises in Finland, Norway,

and Sweden in the late 1980s and early 1990s,

nor the earlier banking problems in several

other countries, such as in Spain in the early

1980s, nor t11e more recent banking problems in

Japan were associated with runs on deposits.

Among the developing countries, large with

drawals of deposits and runs on banks have been

more frequent-for instance, t11e banking crises

in the 1980s and 1990s in Argentina, the

Philippines, Thailand, Turkey, Uruguay, and

Venezuela were associated with bank runs. A fail

ure to roll over interbank deposits, as in Korea

during the 1997-98 Asian crisis, can have results

similar to those of a run on banks. Instances of

Large deposit witl1drawals, however, as in the re

cent financial crisis in Indonesia, have tended to

follow the disclosure of difficulties on the assets

side or widespread uncertainty as tO whether the

currency would maintain its value. Generally,

runs on banks are the result rather than the

cause of banking problems.

Banking crises generally stem from tl1e assets

side of banks' balance sheets-from a protracted

deterioration in asset quality. This suggests that

variables such as tile share of non performing

loans in banks' portfolios, large fluctuations in

real estate and stock prices, and indicators of

business failures could be used to identifY crisis

episodes. The difficulty is tl1at data for such vari

ables are not readily available for many develop

ing countries or are incomplete, as wi th data on

non performing loans in many counu·ies. In

cases where central banks have detailed informa

tion on nonperforming loans, it is usually laxity

in the analysis of, and in follow-up action in re

sponse to, the data that allows the situation to

deteriorate to the poi1u of ciisis.

Reflecting these limitations, banking crises

have usually been dated by researchers on the

basis of a combination of events-such as the

forced closure, merger, or government take over

of financial institutions, runs on banks, or the

extension of government assistance to one or

more financial institutions-or in-depth assess

ments of financial conditions, as in many case

studies. As a result of this methodology, the dat

ing of banking crises is much more approximate

than that of currency crises as it depends on the

occurrence of "events" such as the closure or

governmem takeover of financial institutions,

bank runs, etc. There is therefore a greater risk

of dating crises either "too late"-as financial

problems usually begin well before bank closures

or bank runs occur-or "too early," since the

peak of a crisis is generally reached much later.

Banking crises were compiled from previous

studies for the analysis in this paper. The list of

banking crises was compiled from Caprio and

Klingebiel ( 1 996), Kaminsky and Reinhart

( 1 996), and Demirguc-Kunl and Detragiache

(1997).

Between 1975 and 1997, the sample of 50

counoies had 54 banking clises. Of these, 12


occurred in industrial countries while 42 were in

developing counu·ies. Forty-five of the banking

crises were within two years of currency crises.

Twelve were contemporaneous with currency

crises20 and another 12 preceded currency crises

by one year, while 10 others preceded them by

two years. In 7 cases currency crises were fol

lowed in one year by a banking crisis, while in 4

instances currency crises preceded banking

crises by two years. This evidence, while sugges

tive, should be interpreted with caution in view

of the difficulties in dating the beginning of

banking crises.21

References

Bordo, Michael D., 1985, "Financial Crises, Banking

Crises, Stock Market Crashes and the Money

Supply: Some International Evidence, 1870-1933,"

in Forrest Capie and Geoffrey Wood (eds.),

Financial Crises in tile World Banking System ( ew

York: SL Martin's).

Calvo, Guillermo A., Leonardo Leiderman, and

Carmen M. Reinhart, 1993, "Capital Inflows and

Real Exchange Rate Appreciation in Latin America:

The Role of External Factors," //IfF Staff Papers, Vol.

40 (March), pp. 108-51.

__ , 1996, "Inflows of Capital to Developing

Countries in the 1990s," journal of Economic Perspectives, Vol. 10, No. 2, pp. 123-39.

Caprio,jr., Ccrnrd, and Daniela Klingebiel, 1996,

"Bank Insolvencies: Cross-Country Experience,"

Policy Research Working Paper No. 1620

(Washington: The World Bank, july).

_, 1997, "Banking Insolvency: Bad Luck, Bad

Policy, or Bad Banking," in Ann·ual World Bank

C011jerence on DI!Velopment Economics 1996

(Washington: The World Bank).

Caramaua, Francesco, Luca Ricci, and Rani! Salgado,

2000, "Trade and Financial Contagion in Currency

Crises," IMF Working Paper 00/55 (Vhshington).

Cole, Harold L., and Timothy J. Kehoe, 1998, "SelfFulfiUing Debt Crises," Federal Reserve Bank of

Minneapolis, Staff Report No. 211 Quly).

REFERENCES

Demirguc-Kunt, Asli, and Enrica Detragiache. 1997.

'The Determinants of Banking Crises: Evidence

from Developing and Developed Countries," IMF

Working Paper 97/106 (Washington).

Eichengreen, Barry, and Andrew K. Rose, 1997,

"Staying Afloat When the Wind Shifts: External

Factors and Emerging-Market Banking Crises"

(unpublished; IMF, UCLA, and UC Berkeley).

Eichengreen, Barry, Andrew K. Rose, and Charles

Wyplosz, 1995, "Exchange Market Mayhem: The

Antecedents and Aftermath of Speculative Auacks," Eccnomic Policy: A European Fomm (U.K.), No. 21,

pp. 249-312.

__ , 1996, "Contagious Currency Crises: First Tests,"

Scandinavian joumal �f t:conomics. Vol. 98. No. 4,

pp. 463-84.

Flood, Roben, and Peter Garber, 1984, "Collapsing

Exchange-Rate Regimes: Some Linear Examples,"

joumt1l of lntematitmal Econumics, Vol. 17, pp. 1-13.

Frankel, Jeffrey A., and Andrew K. Rose, 1996,

"Currency Crashes in Emerging Markets: Empirical

Indicators," NBER Working Paper No. 5437

(Can1bridge, Massachusetts: National Bureau of

Economic Research).

Gavin, Michael, and Ricardo Hausmann, 1996, 1be

Roots of Banking Crises: The Macroeconomic

Context,- in R. Hausmann and L. Rojas.Suarez

(eds.), Banking Grists i11 Latin America (WashingtOn:

Inter-American Developmem Bank),

Click, Reuven. and Andrew K. Rose, 1999, "Contagion

and Trade: Why Are Currency Crises Regional?"

juurnal of International Money and Finance (U.K),

Vol. 18, No. 4, pp. 603-17.

Coldfajn, Ilan, and Rodrigo 0. Valdes, 1997, "Capital

Flows and the Twin Crises: The Role of Liquidity,"

JMF Working Paper 97/87 (Washington).

Goldstein. Morris, 1996. "Presumptive Indicators/

Early Waming Signals of Vulnerability lO Financial

Crises in Eme1'ging Market Economies" (unpub

lished; WashingtOn: Institute for International

Economics, January) .

Kaminsky, Crnciela L., Saul Lizondo, and Carmen Yl.

Reinhart, 1997, "Leading Indicators of Currency

Crises," IMF Working Paper 97/79 (Washington).

Kaminsky, Graciela L., and Carmen M. Reinhart, 1996,

'The Twin Crises: The Causes of Banking and

20Currency and banking crises seem to have become more contemporaneous since the late 1980s: 10 of 12 instances in which banking and currency crises occurred in the same year have taken place since 1989.

21Qthers have found evidence that banking crises are statistically significant in helping to predict currency crises, but not conversely. See Kaminsky and Reinhan (1996), for example.

127


128


Balance-of-Payments Problems," International

Finance Discussion Paper No. 544 (Washington:

Board of Governors of the Federal Reserve System,

March).

Krugman, Paul, 1979, "A Model of Balance of

Payments Crises," journal of Money, Credit, and

Banking, Vol. 1 1, pp. 3 1 1-25.

Lindgren, Carl:Johan, GiLJjan Garcia, and Matthew [.

Saal, 1996, Bank Soundness and Macroeconomic Policy

(Washington: International Monetary Fund).

Masson, Paul, 1998, "Contagion: Monsoonal Effects,

Spillovers, and jumps Between Multiple Equilibria,"

IMF Working Paper 98/1 42 (Washington).

Masson, Paul, and Michae.l Mussa, 1995, "The Role of the IMF: Financing a11d Its lntetactions 1vith Adjustment and SurveilJance," Pamphlets Series

No. 50 (Washington: International Monetary Fund).

Mishkin, Frederic S., 1994, "Preventing Financial C1·ises:

An International Perspecti.ve," NBER Working Paper

No. 4636 (Cambridge, Massachusetts: National

Bureau of Economic Research).

__ , 1996, "Understanding Financial Crises: A

Developing Country Perspective," NBER Working

Paper No. 5600 (Cambridge, Massachusetts:

National Bureau of Economic Research).

Obstfeld, Maurice, 1986, "Rational and Self-Fulfilling

Balance of Payments Crises." American Economic

Review, Vol. 76 (March), pp. 72-81 .

_, 1994, 'The Logic of Currency Crises," Cahiers

Economiques et Monetaires, Vol. 43, pp. 89-123.

Sachs, Jeffrey, Aaron Tornell, and Andres Velasco,

1996, "Financial Crises in Emerging Markets: The

Lessons from 1995," Bn>okings Papers on Economic

Activity, Vol. l , pp. 147-98.

Schwartz, Anna, 1985, "Real and Pseudo-:Financial

Crises," in Forrest Capie and Geoffrey E. Wood

( eds.), Financial C1ises in the Wm·ld Ban/ling System

(New York: St. Martin's Press) .

Taylor, Mark P., and Lucio Sarno, 1 997, "Capital Flows

to Developing Countries: Long- and Short-Term

Determinants," The Wo1'ld Bank Econo111ic Review,

Vol. 1 1 (September) , pp. 451-70.


BUSINESS CYCLE INFLUENCES ON EXCHANGE RATES: SURVEY AND EVIDENCE Ronald MacDonald and Phillip Swagel

This chapter examines the relationship

between exchange rates and the busi

ness cycle. A principal goal is to assess

the extent to which exchange rate

movements reflect countries' relative positions

over the business cycle. Are the influences simi

lar across coumries and at different points in

time? The importance of this question is high

lighted by the late 1990s conjuncture of low in

flation, sustained economic growth, and appreci

ated currencies in the United States and United

Kingdom compared to relatively slack conditions

in continen tal Europe and a weak euro. The

conclusion of the research summarized in this

paper is that cyclical movements in activity have

substantial effects on exchange rates, though

these are of course not the only or at all times

the most important innuence on currencies.

There are a number of potential reasons why

the United Kingdom and United States may be

enjoying such a fortuitous inflation/growth com

bination, including productivity improvements

associated with information technology and the

relatively slow growth in competing countries

that has kept a lid on prices of raw materials.

Additionally, the exchange rate may play an im

portant role, with the appreciating currencies in

the United States and UniLed Kingdom helping

to attenuate inflation in each country, both be

cause of the direct effect on the cost of primary

inputs and importables, and from the

feedthrough to the nonu-aded goods sector via

the wage bargaining process. In recent years, the

exchange rate-business cycle link appears to

have worked to the advantage of policymakers in

the United Kingdom and United States, while

the corresponding depreciation of the yen may

also be viewed as beneficial to the Japanese

economy given that country's relatively weak

growth performance.

The srudy first reviews the literature on the

determinants of exchange rates and the relation-

ship with business cycles, and then presents di

rect empirical evidence on the connection.

Somewhat surprisingly, there is liule work that

looks directly at the exchange rate-business cycle relationship. Because of this, a principal fo

cus in this survey is on the role of asset yields

and the corresponding interest rate differemials

between countries and maturities; these are then

used to examine the relationship between ex

change rate movements and the business cycle.

This mechanism and related analytical frame

works are discussed in the econd section, after

which the existing empirical evidence is re

viewed. The next section provides new empirical

evidence, first on tl1e link between real ex

change rates and real interest rate differentials

for a number of key bilateral and effective ex

change 1-ates over the post-1973 period of float

ing exchange rates, and then on the decomposi

lion of exchange rate movements into a

permanent component and business-<:ycle move

ments. The chapter ends by drawing

conclusions.

Exchange Rate Models: Some Scaffolding and an Overview

In thinking about the relationship between

the economic cycle and the exchange rate, it is

instructive to stan with a discussion of models of

nominal and real exchange rates. Since these

arc comprehensively surveyed elsewhere-see,

for example, MacDonald ( 1988), MacDonald

and Taylor (1992), and Frankel and Rose

( 1995 )-the discussion here is not intended to

be exhaustive or rigo1·ous but, rather, to focus on

implicalions for the relalionship between the

business cycle and exchange rates and then to

motivate the empirical work that follows.

Perhaps the simplest nominal exchange rate

model is purchasing power parity (PPP), in

which the equilibrium level of an exchange rate

129


130

CHAPTER IV BUSINESS CYCLE INFLUENCES ON EXCHANGE RATES

is determined by relative prices-absolute PPPor relative PPP, where the exchange rate changes

in response to inflation differentials. Although PPP in itself has limited applicability for the cen

tral focus of this study, it is helpful in motivating the decomposition of real exchange rates into the permanent and transitory components that

are taken to correspond to long-run and cyclical

movements, respectively. Absolute PPP, which relies on arbitrage in the trade account, may be stated as:

(1 )

where s1 denotes the nominal exchange rate (domestic price of a unit of foreign exchange) at time t, fJ1 is the domestic price level, fJt is the for

eign price level (as usual, an asterisk denotes a

foreign variable), and all variables are expressed as natural logarithms. If absolute PPP holds ex

actly, the logarithm of the real exchange rate, q1 = s,-P1 + p�, always equals zero, though of course there is overwhelming evidence against a su·ict version of this model. Rather, what may be refeJ-red to as a traditional PPP view would be that real exchange rates are mean-reverting, or revert to some trend in the presence of a productivity growth differential. This suggests that real exchange rate movements are dominated by the

transitory component, qT, the reversions back to trend. Efficient markets PPP, which relies on capital account arbitrage, posits that the real ex

change rate follows a random walk and therefore all of the exchange rate movements are driven purely by permanent components. Problems and pitfalls in constructing data to examine equation (1) and the empirical evidence are discussed in MacDonald ( 1995a).

Since price and inflation movements are

linked to the business cycle-although there has been widespread discussion of whether in the

current phase of the cycle in the United

Kingdom and United States there has been a decoupling of this relationship-PPP could be

used in a limited sense to address the central issue of this paper. However, since it excludes the variables central to the business cycle-namely, output and interest yields-PPP alone has only limited applicability to the task at hand and is therefore not a direct focus in this survey.

Perhaps the most useful general model in the current context is the two-counu·y open econ

omy TS-LM model with rational expectations, in

which capital is assumed to be perfectly mobile and prices are sticky in the short run, with the cenu·al feature that the exchange rate moves to clear both goods and asset markets. This model is usually referred to as the extended, or eclectic, Mundeli-Fleming modeJ.l This model has been set forth by various authors, including inter alia,

Dornbusch (1976), Frankel (1979), Flood

(1981), and Mussa (1982). Obstfeld (1985) provides a synthesis in a deterministic setting, while Clarida and Gali (1994) present a version with stochastic shocks.

From the perspective of this paper, the key component of the model is the condition of uncovered interest rate parity which governs relative nominal interest rates between countries:

(2)

where E;1st+k denotes the expected change in the exchange rate between periods t and t + k, i1 denotes a nominal interest rate with maturity k, an asterisk denotes a foreign magnitude, a "prime"

( ' ) indicates that a variable is defined as home relative to counu·y (e.g., x' = x - xj, and all variables apart from interest rates are in logs. Using

the standard Fisher decomposition to define the real interest rate, r;, equation (2) can be rewritten as:

where i� is the nominal interest rate difierential,

E,.1jJ[+ 1 = Elp;+ 1 - fJ�), and fit is the relative p1ice level.

1Extended because of the inclusion of forward-looking expectations and an explicit supply side relationship, both of which a1·e feattares missing from the original Mundell-Fleming model.


Equation (2) can also be rewritten in terms of

the real exchange rate as:

E1L1q1+k = r;, (3)

This shows that a relatively lower domestic

real interest rate must be compensated by the

expectation of a real appreciation.

The demand for home output relative to for

eign output, 'f{, is specified an increasing func

tion of the real exchange rate, an aggregate de

mand shock, g;, and a negative function of the

real interest rate:

A price setting equation captures short-run

price inertia:

(4)

(5)

Equation (5) states that the price level in period

t is an average of the market-cleruing price ex

pected at time t-1 to prevail at time t, E,_l'J!!; , and

the price which would actually clear the output

market at time t, pe;. With e = 1 , prices are fully

flexible and output is supply determined, while

with e = 0, prices are fixed and predetermined

one period in advance. Values of() between 0

and 1 impart some short-run price stickiness.

The relative money market equilibrium condi

tion between the home and foreign country is

given by:

(6)

where m' denotes the relative money supply, a is

the income elasticity of demand for money, and

f3 is the interest rate semi-elasticity (the equation

is defined so that a and f3 are positive ) .

In the presence of less than fully flexible

prices, an exogenous fall in aggregate demand

that pushes output below its trend will lead,

other things being equal, to a relatively lower in

terest rate, a capital outflow, and an exchange

rate depreciation (both real and nominal). For

EXCHANGE RATE MODELS: SOME SCAFFOLDING AND AN OVERVIEW

the lower interest rate to be consistent with inter

est parity, the cw-rency must be expected to ap

preciate in both real and nominal terms; this ap

preciation takes place as demand returns w trend. The dynamic path of the exchange rate is

the path that coincides with an increasing rela

tive interest rate-the traditional capital Oow re

lationship between the exchange rate and rela

tive interest rates. Indeed, this is likely to be

compounded if monetary authorities have an ex

plicit reaction function in which interest rates are

raised to attenuate inflationary pressure. If the

recession is instead caused by an adverse supply

shock, this would lead to an initial rise in the in

terest rate (real and nominal) and a currency ap

preciation (both real and nominal), with the

consequent expectation of a currency deprecia

tion being translated into an actual depreciation

as supply retw-ns to trend, with relative interest

rates similarly falling. If a monetru·y tightening is

the source of the recession (either through a fall

in the supply of money or increased demand for

money) , interest rates would initially rise and the

real exchange rate would appreciate on impact,

eventually depreciating back to trend as output

adjusted. The similarity of the effects of these

two shocks means that it is in practice difficult to

distinguish between their relative importru1ce

without imposing restrictions on the causal rela

tionships between the variables, such as in

Clarida and Cali (1994).

Although the Mundeii-Fieming model stresses

the importance of both goods and asset markets

in determjning exchange rates, it does not take

into account stock-flow implications of asset ac

cumulation or allow for time-varying exchange

risk premia.

The "flexible price monetary model of ex

change rates" (FPMM) can be derived from the

above framework by assw-ning that prices are

continuously flexible, purchasing power parity

holds at all times, output is fixed at the full em

ployment level, and there are no demru1d

shocks:2

Zfhis framework can also be derived f1·om the generalj7.ed asset pricing model of Lucas ('1982).

131


132


, • • f3. /3 •.• s1 = m 1 - ay1 + a y 1 + z1 - z ,. (7)

Equation (7) asserts that in a flexible price equi

)jbrium, an exchange rate is driven purely by

conditions of asset market equilibrium (relative

excess money supplies) , with goods market con

ditions having no independent influence. In the

flexible price variant of the monetary model,

equation (7) is assumed to hold continuously in

both the short and long run-see, among

others, Bilson (1978), Frenkel (1978) and

Hodrick ( 1987), while in the sticky price variant

(SPMM) it holds only in the long run (see

Dornbusch ( 1976) and Frankel ( 1979).

How useful is equation (7) from the perspec

tive of thinking about business cycle issues? A

stylized fact is that a currency typically appreci

ates in the upS\ving of an economic cycle and de

preciates in the downswing. Equation (7} neatly

captures this effect: higher income increases

money demand and thus leads to an apprecia

tion of the nominal exchange rate (and vice

versa in a slump). This is consistent with a de

mand shock in the generalized model but not a

supply shock. Since in the FPMM, output

changes are driven only by supply side effects,

the difference in the sign here relates to the fact

that output affects the exchange rate only

through the demand for assets, with relative

prices moving to satisfy asset market equilibrium,

and not through interest rates, which simply

equal expected inflation. The FPMM must thus

be regarded as having limited applicability for

the task at hand since it ignores the relationship

between asset yields and output.

Of course, equation (7) is usually estimated as

a reduced form that could also be consistent

with the more general eclectic model-for ex

ample, if interest rates are given a capital flow in

terpretation. That is, the domestic and foreign

interest rates would, respectively, have negative

and positive signs, and income a positive sign in

the forecasting equation for the nominal ex

change rate. This is brought out clearly by

Frankel (1979) in a real interest differential

(RID) variant of the monetary model. This as.

sumes a form of regressive expectations in which

the exchange rate is expected to change in pro

portion to the gap between the equilibrium and

actual exchange rate and the expected inflation

differential:

M1 - qJ(S,- sJ + (t1P' - t1fj'*),..1, O«p<l. (8)

Equation (8} indicates that in long-run equi

librium, when s; • s, the exchange rate is ex

pected to change by an amount equal to the ex

pected inflation differential. Substituting

equation (8} into the UIP condition (2) gives

the key RID relationship:

s, = s; - qrt [ ( i1 - E,1p,..k) - ( i•, - E,1p•,+«)]. (9)

This indicates that whether s1 is above or be

low s; depends on the real interest differential;

that is, if the domestic real interest rate is above

the foreign rate, the exchange rate appreciates

relative to its Long-run value. Equation (9) there

fore illustrates, in a single equation comext, the

traditional capital account interpretation of the

exchange rate/business cycle relationship re

ferred to above.

The RID model may be thought of as relaxing

the assumption of the FPMM that the expecta

tions model of the term structure holds, replac

ing it instead with an assumption of market seg

mentation, so that a monetary impulse can have

different effects on short and long interest rates.

ln particular, a monetary tightening can increase

the short rate through the liquidity effect, while

at the same time decreasing the long rate

through an expected inflation effect. To the ex

tent that the output expansion emanates from

the supply side and thereby has a moderating in

fluence on inflation (price movements), the

business cycle could have an effect on exchange

rates that is separate from that of interest yields.

This effect relies on price flexibility, and would

thus not be present in the case of sticky prices.

Assuming s; in (9) is determined by equation (7)

and that long rates proxy for expected inflation

and short rates proxy for real interest rates gives

a reduced form of the RID model:

s1 = rp1 m, - Cf'-lm;- (j)3Yt + (/)4]; - f1>5i: + rp6i',"+ <P?�- fPsit;+e, (10)


where the s and l superscripts denote short- and

long-term interest rates, respectively. Although

the RID reduced form is in the spirit of the

eclectic Mundell-Fleming model, in terms of the

relative interest rate effects, it nevertheless con

strains output to have a purely asset market role

in the exchange rate equilibrium process; as in

the FPMM, increased output has a negative in

fluence on the exchange rate. Indeed, this

model has a long-run solution that is equivalent

to that of the FPMM.

The above models all assume that non-money

assets are perfect substitutes. However, propo

nents of the portfolio balance approach-Allen

and Kenen (1980), Branson (1977), and

Dornbusch and Fischer (1980)-argue that non

money assets are likely to be imperfect substi

tutes across countries, so that equation (8) holds

only on a risk-adjusted basis. Dooley and Isard

( 1982) demonstrate that in a model in which

there are two types of money (home and for

eign) and two bonds (home and foreign), the

risk premium, ()1, may be defined by the follow

ing expression (see also Frankel (1983)):

( 1 1 )

where B denotes domestic non-money assets and

B* foreign non-money assets.

In the context of the above framework,

Frankel (1983) and Hooper and Morton (1982)

demonstrate that a reduced form in the spirit of

the portfolio balance approach is:

s1 = m; - ay1 t ay�- f3i11 + Wi·'7 + A.i11- A. *i1; +e1• (12)

Equation (12) is usually referred to as a hy

brid model monetary-portfolio balance reduced

form.3 The relationship between the net supply

of non-money assets (effectively net foreign as

sets) and the risk premium is assumed to be pos

itive in the portfolio model: an increased risk

premium requires a currency depreciation to

equilibrate asset markets. It is not entirely clear

if the adctition of a risk premium to equation (7)

A REVIEW OF THE EMPIRICAl EVIDENCE

or (10) gives much insight with respect to the

impact of the business cycle on the exchange

rate. One way in which risk premia could be re

lated to business cycles is through effects of the

economic cycle on countries' fiscal positions and

thereby relative debt stocks. For example, gov

ernments often use the upswing of a cycle, and

associated buoyant tax revenues, to repatriate

government debt and, conversely, downswings

often have implications for increased govern

ment debt as increased fiscal deficits drive up

the outstanding stock of debt.

A Review of the Empirical Evidence

This section reviews empirical evidence on the

exchange rate-business cycle relationship.

Evidence on the factors that influence nominal

exchange rates is examined first, followed by sev

eral strands of the literature on the influences of

real exchange rates.

Nominal Exchange Rates and the Business Cycle

The most general monetary approach equa

tion may be expressed as a reduced form:

st = <t>t mt + <t><lm*t + <t>sYt + q>4y•t + q>5it +q>6i7 +Et> (13)

where the q>'s are parameters to be estimated

and e1 is a disturbance term. The su·ict form of

the monetary model implies q>1 = -<t><l = 1, while

q>3 and q>4 should take on values that are close to

estimated income elasticities from money de

mand functions, and <t>5 and q>6 should take on

values close to interest rate semi-elasticities also

from money demand functions. The hypothe

sised values of unity for q>1 and <t>2 are those ex

pected, in equilibrium at least, from either the

flex-price and fix-price monetary models.

However, it is important to note that even within

the monetary tradition there is a view that these

coefficients may be less than one in absolute

value; see, for example, Mussa (1979). There is a

3Strictly speaking, this relationship relies for its derivation on a short-long distinction that is not made in tl1is paper.

133


134


large body of empirical work on equation (13)

and variants thereof; MacDonald and Taylor

(1993) provide a survey.4 The focus here is on recent empirical work, the preponderance of

which uses cointegration-based methods. Table 4.1 presents a selection of estimates of

equation (13); as is typical with co integrated sys

tems, the results indicate that the estimation procedure used makes a difference. For example, us

ing the less efficient Engle-Granger method, there is no evidence of the expected long-run re

lationships, whereas there is clear evidence of

cointegration when the more efficientjohansen (1995) method is used. The signs and magnitudes of coefficients are often far from those ex

pected from a pure FPMM interpretation. However, the majority of cases show the negative

association benveen the exchange rate and income consistent with the standard business cycle

story that a country with relatively rapid income

growth should have an appreciating exchange rate. The interest rate coefficients in Table 4.1 do not support a standard business cycle inter

pretation, but are, in general, supportive of the FPMM. For example, all but one of the coefficients on the short term interest rate differential

are positive, thereby favoring the FPMM association benveen the exchange rate and the interest differential. There is, however, somewhat more support for the business cycle relationship when

long interest rates are used (four out of six coefficients are correctly signed here).

Other particularly relevant cointegration

based studies analyze the joint interaction of UIP and PPP; these include Johansen and

Juselius ( l 992),Juselius (1991, 1995), MacDonald and Marsh (1997, 1999), Juselius and MacDonald (1999), and La Cour and MacDonald (2000). This framework leads to a reduced form relationship similar to equation (9), with the empirical component involving esti

mation of a vector of the following form:

x'1 = [(s1 -P1 + p*1) ,(i1 - i*1) ] ,

where the first term may be interpreted as the deviation from PPP, which in terms of equation (9) is s1- Sv and the second term represents de

viations from UIP, which in terms of equation (9) represents the term in square brackets

(some studies, such asJuselius and MacDonald (1999) explicitly adjust the interest rates for in

flation rates). The statistical idea underlying these studies is that the nonstationarity in deviations from PPP (the real exchange rate) is re

moved by the nonstationarity in the interest dif

ferential; that is, the two composite variables cointegrate. It turns out that nearly all of the

studies that combine VIP and PPP in this way produce an association bet\veen the nomina] ex

change rate and the interest differential which is negative and therefore supportive of the interest rat�exchange rate linkage referred to above.

Two sets of results from MacDonald and Marsh (1999) illustrate this:

st?M = ( p!I,"' + P'f'") - 0.132 ( 14"- i�"')'

sYEN = ( <hiPm + P"''") - 0.318(iifm - i"'). I rj 1 I I The first equation is a relationship for the deutsche mark-dollar exchange rate, while the

second is for the yen-dollar rate. Both relation

ships are estimated over the period January 1983

to December 1997 using the Johansen methodology. In addition to showing the negative associ

ation benveen the exchange rate (both real and nominal) and the interest differential, these re

sults indicate that the relationship is much

stronger-by a factor of about 2lh-for Japan than for Germany.

Real Exchange Rates and the Business Cycle

This section examines direct empirical evidence on the real exchange rate-business cycle relationship, with particular emphasis on the relationship between the real exchange rate and real interest rate differentials. This is best ex-

4Hoffman and Schlagenhauf (1983), Finn (1986), Woo (1985) and MacDonald and Taylor (1993) test the rational expectations or forward looking version of this expression; see Dejong and Husted (1995) for a critique of this approach.


A REVIEW OF THE EMPIRICAL EVIDENCE

Table 4.1 . Cointegration Results for the Monetary Model S1 = m1 + m* I + J1 + y• I + i1 + i* I Source, Currencies, Cointegrated? Period m m· y y· ;s ;s· jl ,,. Method?

Baillie-Selover (1987); ¥·$ No 1973:3 to 1983:12 0.065 0.458 0.005 0.035 Engle·Granger

Baillie-Selover (1987); C$-$ No 1973:3 to 1983:12 -o.466 -0.047 0.010 . . . -0.003 Engle-Granger

Kearney-MacDonald ( 1990); A$-$ Yes 1984:1 to 1988:12 0.186 0.946 0.022 . . . -Q.Q12 Engle-Granger

MacDonald-Taylor (1993); OM-$ Yes 1976:1 to 1990:12 -1 0.049 -0.050 Johansen

MacDonald-Taylor (1994); £-$ No 1976:1 to 1990:12 -0.471 1.06 -0.733 -o.284 . . . -0.052 0.004 Engle-Granger

MacDonald-Taylor (1994); £-$ Yes 1976:1 to 1990:12 0.209 -o.49 -o.098 0.646 0.035 0.086 Johansen

Cushman and others (1997); Turkish lira-$ Yes 198103-9204 0.21 -1.13 1.14 Johansen

Kouretas (1997); C$·$ Yes 1970:6-1994:5 -0.12 -o.79 -0.32 0.32 0.08 -o.02 Dynamic OLS

Note: When a single coefficient is reported in two columns, this indicates that the coefficient has been constrained to be equal and opposite across the two variables.

plored by rearranging equation (3), the real UIP

condition as:

(14)

Because the empirical work in the next sec

tion focuses on effective (multilateral) exchange

rates rather than bilateral rates, the real ex

change rate is henceforth written as foreign cur

rency per home currency, so that an increase in

q corresponds to an appreciation of the domes

tic currency. Equation (14) describes the cunent

equilibrium exchange rate as determined by two

components, the expectation of the real ex

change rate in period t + k and the (negative of)

the real interest differential with maturity l + k.

It is commonplace in this literature-for exam

ple, Meese and Rogoff (1988)-to assume that

the unobservable expectation of the exchange

rate, E,(q,+k), is the "fundamental equilibrium exchange rate," which is denoted by 7j1:

(15)

One strand of this literature assumes that

equation (15) is the sticky-price representation of the monetary model. With the further assumption that ex ante PPP holds, then 7j1 can be interpreted as the flexible price real exchange

rate, which, as discussed in the previous section,

simply equals a constant or zero in the absence

of transaction/transportation costs. In this case,

(15) defines the deviation of the exchange rate from its long-run equilibrium in terms of a real

interest differential. This interpretation is taken

by Baxter (1994) and Clarida and Gali (1994), among others. An alternative approach taken by Meese and Rogoff (1988), Coughlin and Koedjik

(1990), Edison and Pauls (1993), Clark and

135


136


MacDonald (1998), MacDonald (1995a, 1997) and Edison and Melick (1995) is not to assume ex ante PPP, but instead to allow instead for the equilibrium exchange rate, q1 , to vary over time in response to factors such as productivity, fiscal imbalances, net foreign asset accumulation, and terms of trade effects. The theoretical justification for the inclusion of these variables is given by Mussa (1984) and Frenkel and Mussa (1985). MacDonald and Nagasuya (1999) demonstrate that the traditional derivation of the real exchange rate-real interest rate model, exploited here, is in fact internally inconsistent, but show that equation (12) can be derived from an open economy macro model, such as the extended Mundeli-Fleming model considered in the previous section.

Regression-based estimates of the relationship between the real exchange rate and the real interest differential can conveniently be split into two groups: one that assumes the equilibrium real exchange rate equals a constant and therefore does not model its determinants, and a second that explicitly focuses on modeling these determinants. Papers that assume a constant equilibrium real rate typically focus on the following regression equation:

(16)

Equation (16) may be derived from (15) by assuming that the equilibrium rate, q1 , is the regression intercept, {30• Edison and Melick (1999) demonstrate that the expected signs of /31 and � are positively proportional to the maturity of the long-term bonds underpinning the interest rates. However, in the derivation of equation (16) proposed by MacDonald and Nagasuya (1999), the only requirement is that /31 and /32 are positive and negative, respectively.

A number of single equation tests of the real exchange rate-real interest rate specification in equation (16) fail to uncover a statistically significant link between real exchange rates and real interest differentials, although the coefficients

typically have the correct sign and are therefore consistent with the predictions of the MundellFleming model. Papers in this category include Campbell and Clarida (1987), Meese and Rogoff (1988), Edison and Pauls (1993), Throop (1993), and Coughlin and Koedijk (1990).5 However, as in the PPP literature, the failure to find a statistically significant result seems to be a consequence of the particular estimator used. For example, MacDonald (1997), Clark and MacDonald (1998), and Edison and Melick (1999) utilize the econometric methods of

Johansen and find clear evidence of both significant cointegration and correctly signed coefficients. Perhaps the most convincing evidence in favor of the real exchange rate-real interest rate relationship is contained in MacDonald and Nagasuya (1999), who use the panel cointegration estimator of Pedroni to examine a panel data set containing data for 14 industrial countries. Clear evidence is found of statistically significant cointegrating relationships and coefficient estimates that are supportive of the real interest rate-business cycle link. Table 4.2 summarizes results from these papers that clearly indicate that the traditional business cycle relationship is in the data for the major currencies.

Using the methods of Beveridge and Nelson to decompose real exchange rates into permanent and u·ansitory components, Baxter (1994) also finds a statistically significant relationship between real exchange rates and real interest rates. Baxter argues that the previous failure to capture the real interest rate-1·eal exchange rate relationship stems from the use of a first difference transformation (for example, Meese and Rogoff (1988) use this transformation). Although the difference operator ensures that 1(1) variables are u·ansformed into stationary cow1terparts, it also removes the meditun and low frequency information from the data, thereby removing any implicit business cycle relationship. Moreover, first differencing the data presupposes that the effect of real interest rates

5Throop (1993) reports some evidence for cointegration between real exchange rates and the real interest rate differential, but this is not robust to a small sample correction.



Table 4.2. Estimates of the Real Exchange Rate-Real Interest Rate Relationship q1 = fJo + {31 r + {J.zr* 1 + v1 Source, Currencies

MacDonald (1998) Sample: 1975-1993, Quarterly

Deutsche mark, effective Yen, effective U.S. dollar, effective

0.116 0.286 0.406

-0.189 -0.185 -0.328

Clark and MacDonald (2000) Sample: 1960-1997, Annual

Canadian $, effective U.K. pound, effective U.S. dollar, effective

0.578 (0.24) 0.817 (0.11) 0.809 (0.51)

MacDonald and Nagasuya (1999} Sample 1974-1994, Quarterly

Panel of 14 bilateral exchange rates 0.834 (0.38)

Notes: When a single coefficient is reported this means that the coefficients on the relative interest rate terms have been constrained to be equal and opposite. Standard errors, where available, are in parentheses.

on the real exchange rate is permanent, while to

the extent that equation (16) represents a re

duced form representation of the sticky price

monetary model, the relationship between the

tvvo variables would be expected to be transitory.

Baxter (1994) regresses the transitory compo

nent of the real exchange rate to the real inter

est differential:

(17)

The dependent variable is obtained from a de

composition of the real exchange rate into tran

sitory and permanent components; the specifica

tion assumes that the permanent component

follows a random walk. Equation (17) is esti

mated for a number of bilateral counu·y pairings,

using both univariate and multivariate Beveridge

Neisen decompositions to derive q·�, and both ex

post and ex ante measures of the real interest dif

ferential. The majority of the estimates turn out

to be positive and statistically significant, the ex

ception being those for the United Kingdom,

and her findings indicate that the favorable re

sults reported above are not estimation-specific.

This approach highlights the importance of ex

amining the components of the variables that

provide the relationship rather than discarding

them by first differencing. The next section pres

ents some new estimates of the real interest-rate

real business cycle relationship using the meth

ods of Baxter. However, before presenting these

results, other methods by which to decompose

real exchange rates into permanent and transi

tory components are first discussed.

Distinguishing Permanent and Transitory Components of Real Exchange Rates

The decomposition of the real exchange rate

into u-ansitory and permanent components can

be represented as:

,p T q, = v, + q "

where q7; is the transiLOry real exchange rate that

corresponds to the cyclical component, and q�

represents the permanent component. Assuming

that the permanent component follows a ran

dom walk gives:

where f.L is a trend representing differential pro

ductivity growth, and £ is a white-noise error.

Since the u·ansitory component simply equals a

random stochastic term, there is dearly no busi

ness cycle-exchange rate relationship. However,

if qT1 is assumed to be mean-reverting, this gives:

7' 7' T q ' = pq 1-1 + £ ,. Oqxl

731


138


ln this case, the real exchange rate has a tran

sitory, mean-reverting component that may be

interpreted as the part of the exchange rate re

lated to the business cycle. The next section dis

cusses methods used to carry out this decompo

sition, followed by a review of empirical results.

Methods to Separate Permanent and Transitory Exchange Rate Movements

Perhaps the most popular method of decom

posing real exchange rates (and indeed a range

of other macro series) into permanent and tran

sitory components is the ARIMA based (time

domain) procedure of Beveridge and Nelson

(1981; henceforth BN). An ARIMA model of the

first difference of the relevant series is estimated,

and then the coefficients used to calculate the

long-run multiplier, C(1). This facilitates con

struction of the permanent component which is

in turn used to derive the cyclical component

from the actual data.

Baxter and King (1995) discuss an alternative

to the BN decomposition into permanent and

u·ansitory components, which is to use band-pass

(BP) filters to decompose a series into compo

nents of movements within specific bands of fre

quencies. For example, Baxter (1994) decom

poses the real exchange rate into three

components: the trend, or long-term, component

corresponding to movements with frequencies of

greater than 32 quarters; the business cycle com

ponent of movements with frequencies bet<.veen

6 and 32 quarters; and the irregular component of high frequency fluctuations (from 2 to 5 quar

ters). Statistical analysis can then be performed

using only the business cycle components or

only the trend/permanent components or some

mix of these, with the aim of allowing a direct

comparison of the business cycle elements of the

various series. A further advantage of the BP fil

ter over the BN decomposition is that it does not

rely on the first difference operator, which as dis

cussed by Baxter removes the frequencies in the

data that are typically interpreted as correspon

ding to the cycle-in quarterly data, for exam

ple, movements with frequencies of 6 quarters or

more.

While the BP ftlter and BN decomposition are

both univariate in nature, there are a number of

multivariate methods of extracting the business

cycle component. The first is the multivariate

version of the BN decomposition, which involves

estimating a VAR model for two or more series

and using matrix of long-run multipliers to ex

u·act the permanent and transitory components

in a manner analogous to the univariate BN ap

proach. An interesting conclusion to emerge

from the widespread use of this method-see

Evans (1989), Cochrane (1990), and King and

others (1991)-is that if the information set in

cludes variables that Granger-cause subsequent

changes in the variable of interest, then the vari

ance of the transitory component derived from

such a system must exceed the ratio of the tran

sitory component to the permanent component

derived from a univariate BN decomposition.

Both the multivariate and univariate BN models

start by first differencing the data. In the pres

ence of cointegrated variables, however, a VAR system constructed using only differences of vari

ables will be misspecified since it fails to incorpo

rate the stationary interactions of the levels of

the variables. Such misspecifications can have

important and significant implications for im

pulse response analysis. Gonzalo and Granger

( 1995) demonstrate how a vector of variables

that exhibit cointegration may be decomposed

into permanent and temporary components.

Empirical Results A useful starting point in testing for the im

portance of permanent components in real ex

change rates are the tests of the time-series prop

erties of real exchange rates using unit root

testing methods. MacDonald (1999) surveys this

literature, finding that real exchange rates typi

cally do contain a unit root, implying that there

is no significant transitory component in real ex

change rates. However, it is well known that such

tests have low power to reject the null of a unit

run when it is in fact false. Using the variance ra

tio test, Huizinga (1987) argues that, on average,

over 10 (industrial) currencies and 11 years of

adjustment, around 60 percent of the variance


of real exchange rates is permanent and 40 per

cent u·ansitory (interestingly, after five years, the

average value suggests that real exchange rates

are driven solely by the permanent component).

Huizinga then uses univariate BN decomposi

tions to construct the long-run components of

his chosen currencies and draw inferences about

the extent of over or undervaluation of particu

lar currencies. For example, the dollar is esti

mated to have been overvalued for the two-year

period 1976-78, undervalued for the four-year

period from late 1978 to late 1982, and overvalued for the three year period from early 1983 to

early 1986. The post-1985 depreciation of the dollar is estimated to have been just right in

terms of returning it to the long-run exchange

value against the pound.

Cumby and Huizinga (1991) use a multivari

ate BN decomposition based on a bivariate VAR

of the real exchange rate and the inflation dif

ferential to compare the permanent component

of the real exchange rate with the actual rate for

lhe dollar against the deutsche mark, yen, ster

ling, and Canadian dollar. The permanent com

ponents generally vary considerably over time but are somewhat more stable than the actual

exchange rate, often leaving large and sustained

deviations of real exchange rates from the pre

dicted "equilibrium" values. These transitory de

viations may be related to the business cycle,

lhough the decomposition does not include a

measure of real activity. Clarida and Cali ( 1994) present both univari

ate and multiv-.u-iate BN decompositions of the

real exchange rates of Germany, Japan, Britain,

and Canada vis-a-vis the U.S. dollar (the latter

are generated from a u·ivariate VAR consisting of

the change in the real exchange rate, output

growth, and the inflation rate). The top half of Table 4.3 reports the results for the ratio of the

variance of the BN transitory component to the

variance of the total real exchange rate change. On average for the four exchange rates, the univariate results show that around 80 percent of

the variance of the real exchange rate is perma

nent and only 20 percent transitory. This sug

gests that only a small part of real exchange rate


Table 4.3. Permanent and Transitory Variance Ratios for the Real Exchange Rate

Currencies Trivariate System Univariate System

Ratio of transitory variance to actual variance'

OM-$ Yen·$ £-$ C$-$

0.705 0.591 0.385 0.210

0.235 0.233 0.146 0.143

Ratio of permanent variance to transitory variance2

OM-$ 1.72 1.94 Yen-$ 0.67 1.68 £-$ 0.75 1.43 C$-$ 0.72 1.45 FF-$ 2.48 2.30

'Source: Clarida and Gali (1994). 2Source: Baxter (1994).

movements are possibly related to business cycle

fluctuations. For Germany and japan, however,

the picture changes quite dramatically with the

multivariate decompositions, with 70 and 60 per

cent of the variance of movements in the respec

tive real exchange rates atu·ibuted to transitory

components. Clarida and Gali ascribe the differ

ence in the results to the fact that in the dollardeutsche mark and dollar-yen systems, inflation

has significant explanatory power for real ex

change rates even after taking into account past movements in real exchange rates and output

Baxter (1994) also reports univariate and mul

tivariate BN decompositions for a number of

currencies; these are summarized in the bottom

half of Table 4.3. The results for the univariate

tests are similar to those of Clarida and Cali in

that the permanent component of the real ex

change rate always exceeds the u-ansitory com

ponent, with the sharpest results for the pound. As with Clarida and Cali, however, the multivari

ate decompositions reveal that the transitory component dominates in several of the currency

pairings, although the variance ratio for the

sterling-dollar rate actually increases in the mul

tivariate setting. Baxter also presents correlations

of the permanent and transitory components

across countries. For the univariate models, the

permanent components are all strongly correlated across countries with correlation coeffi

cients in excess of 0.5, but the transitory compo-

139


140


nents show no such dear-cut pattern, with posi

tive correlations for the deutsche mark-Swiss

franc and French franc-Swiss franc rates (both

vis-a-vis the dollar), but zero or negative correla

tions for most other currencies. The multivariate

correlations, however, reveal much stronger evi

dence of positive correlations across counu·ies;

interestingly, the only currency pairings to pro

duce negative correlations are those involving

sterling. In summary, multivariate anaJysis ap

pears to be necessary to provide substantial evi

dence of a business cycle component in real ex

change rates.

"Direct" Empirical Evidence

The identification scheme proposed by

Clarida and Gali (1994) introduces structural

shocks of supply, demand, and nominal ("mone

tary") into the Mundell-Fleming framework. In

the long run, the real equilibrium exchange rate

is a function of demand and supply shocks,

while in the short run, the existence of price

stickiness means that the real exchange rate re

sponds to nominal shocks as well as to demand

and supply shocks. A positive supply side shock

that boosts U.S. output relative to foreign output

is predicted to produce a real depreciation of

the dollar, a fall in U.S. prices, and higher U.S.

output. A positive permanent demand shock

leads to a permanent real appreciation of the

dollar, a higher price level, and increased output

to the extent that prices are sticky. A negative

U.S. money supply shock results in a nominal

dollar depreciation, higher U.S. price level, and

increased U.S. output with sticky prices. If the

nominal shock is permanent, it leads to a perma

nent dollar depreciation as well, but by consu·uc

tion not a permanent real depreciation. Clarida

and GaJi (1994) estimate the model using a

structural VAR along the lines of Blanchard and

Quah in which restrictions are placed on the

permanent effects of shocks on certain variables

while leaving the transitory, or short-term, effects

unconstrained. The focus is on the sources of

real exchange rate fluctuations since the incep

tion of floating exchange rates for the bilateral

exchange rates between the dollar and lhe

deutsche mark, yen, pound, and Canadian dol

lar ove1- the period 1974:Ql tO 1992:Q1. The im

posed restrictions are that nominal shocks affect

the price level in the long run but have only

transitory effects on the real exchange rate and

output; supply and demand shocks have perma

nent effects on the real exchange rate, but only

supply shocks affect the long-run level of (rela

tive) output. This approach has become increas

ingly popular, with additional exchange rates

and variations on the included variables being

estimated by (among many others) Chadha and

Prasad (1997) for Japan, Astley and Gan-ett

(1996) for the United Kingdom, and Thomas

( 1 997) f01· Sweden.

Clarida and GaJi find that at a horizon of 4

quarters, nominaJ shocks account for about 50

and 30 percent of the variance of the mark and

yen rates, respectively, with the effect evenrually

diminishing to zero at longer horizons. However,

nominal shocks have only a small influence on

exchange rates for Canada and tl1e United

Kingdom, accounting for only around 1 percent

of the movements in these currencies against the

U.S. dollar. For all four real exchange rates, de

mand shocks account for virtually all of the re

maining variance, leaving little role for supply

shocks.

The impulse response analysis for the

dollar-deutsche mark exchange rate suggests

that the real exchange rate depreciates by 3.8

percenl (the nominal rate overshoots by 4 per

cent) in response to a one standard deviation

nominaJ shock, while U.S. output rises relative to

German output by 0.5 percent and U.S. inflation

rises relative to German inflation by 0.3 percent.

The output and real exchange rate effects of a

nominal shock last for 16 to 20 quarters. In re

sponse to a one standard deviation shock to rela

tive demand, the dollar appreciates in real terms

by 4 percent vis-a-vis the deutsche mark, U.S. rel

ative output rises by 0.36 percent, and there is a

0.44 percent rise in U.S. inflation relative to

Germany. The effect of the demand shock on

the exchange rate is permanent, with a 6 per

cent real appreciation after 20 quarters. A one


standard deviation relative supply shock pro

duces a (wrongly signed) 1 percent dollar appre

ciation in quarter 2, but this quickly goes to

zero, with the appreciation after 20 quarters only

0.2 percent above the initial exchange rate.

Chadha and Prasad (1997) apply the Clarida

Cali approach to the yen-dollar real exchange

rate over the period 1975-96. Supply shocks are

found to account for two-thirds of the variance

in japanese output growth relative to the United

States, with demand shocks explaining one-third,

and nominal shocks playing only a very small

role (this is the case for forecast horizons

through 40 quarters) . Mter around 8 quarters,

supply and demand shocks each account for

roughly one quarter of the forecast error vari

ance of the real exchange rate, leaving the re

maining 50 percent explained by nominal

shocks. Chadha and Prasad interpret this as sug

gesting that monetary and fiscal policy have a

substantial effect on the dollar-yen real ex

change rate over the business cycle (the transi

tOry fluctuations), with only a small role for sup

ply shocks such as innovations in productivity

shocks. Although this result suggests that supply

shocks have not been pervasive, it is also fow1d

that these shocks are important when they do

occur, as a "typical" supply shock (that is, a

shock of one standard deviation in magnitude)

leads to a permanent real exchange rate depre

ciation of around 8 percent, while a demand

shock leads to a permanent appreciation, also of

around 8 percent. A nominal shock leads to an

initial real depreciation, but this is eventually off

set with the real rate exchange rate returrung to

the initial level by the end of two years.

Although the approach of Clarida and Cali

and others is insightful and certainly in the spirit

of the relationship between exchange rates and

the business cycle, as discussed by Stockman

(1994), it nonetheless suffers from a number of

important problems. First, the identification pro

cedure forces all temporary shocks that are com-


mon to the three variables of output, inflation,

and exchange rates to have a nominal origin, so

that the transitory effects of events such as oil

price shocks and changes in fiscal policy are sub

sumed under nominal shocks. A similar argu

ment holds for temporary demand shocks.

Second, in setting up the identifying assump

tions, it is assumed that the innovations to de

mand and supply are uncorrelated, which, for a

variety of reasons, seems implausible (i.e., a posi

tive shock to aggregate demand spurs invest

ment, which increases the capital stock and thus

aggregate supply). Third, the finding that nomi

nal shocks generally account for only a small

part of movements in relative output raises the

question of whether this is due to the way nomi

nal shocks are specified.6

The empirical work on real exchange rate re

lationships can be summarized in the following

way. The real exchange rates of leading indus

trial countries have important transitory compo

nents, the magnitude of which depends on the

particular currency and the methods used to de

compose permanent and u·ansitory fluctuations.

In the applications so far, the richer the informa

tion set in terms of the nwnber of variables

used, the larger is the transitory component rel

ative to the permanent component.

Irrespective of the methods used, empirical evi

dence based on the real exchange rate-real inter

est rate model points to the importance of transi

tory components such as business cycle

fluctuations in explaining movements in real ex

change rates. This is particularly the case for the

deutscbe mark and yen, but less so for the pound.

However, these findings are based in a sense on

averages constructed from data for the post-1973

period of floating rates, which could possibly dis

guise important regime shifts such as financial

deregulation that occurred in the 1980s. This

deregulation potentially increased the mobility of

capital and thus affected the relationship between

interest rates and exchange rates.

6Sarte (1994) demonsmnes that identification in structural VARs is sensitive to the assumed restrictions.

141


142


New Empirical Evidence

In this section, new evidence on the exchange

rate-business cycle relationship is provided using

data for the major four pre-EMU currencies

the deutsche mark, yen, pound sterling, and dol

lar. The analysis includes both the bilateral val

ues against the dollar and a real effective

exchange rate for all four currencies.

Data Description and Some Stylized Facts

Since most empirical work on exchange rate

modeling utilizes monthly data, this n-adition is

followed here. To be consistent with the effective

exchange rates, all real exchange rates are con

structed as the foreign currency per unit of do

mestic currency, so that an increase in the real

exchange rate represents a domestic apprecia

tion. The data span the period from january

1975 to October 1997. Real bilateral exchange

rates are constructed for the deutsche mark,

yen, and pound vis-a-vis the U.S. dollar by sub

tracting relative CPI gt·owth-monthly infla

tion-from the (log) nominal exchange rate.

The effective real exchange rates are con

structed by taking a weighted average of the real

bilateral rates of the other 6 industrial countries,

with bilateral trade volumes as the weights. This

permits construction of an effective real ex

change rate for the U.S. dollar vis-a-vis the rest

of the world. Foreign prices and interest rates

are constructed in an analogous fashion, with

real interest rates constructed using a 12-period

backward-looking moving average of inflation.

Annual interest rates are divided by 1,200 to pro

vide monthly rates, while the inflation rate is the

one month change in the log of the price level.

Other measures of the real interest rate such as

the one period ex post and the one period ex

ante rates give quantitatively similar results.

Figures 4.1 to 4.3 show the bilateral real ex

change rates and real interest rates between the

U.S. dollar and the three other currencies.

These charts essentially confirm the point made

in the last section that although many economet

ric studies have failed to unearth a statistically

significant relationship between real exchange

rates and real interest rates, simple observa

tion-an "ocular regression "-suggests that

there is in many instances the expected positive

relationship (positive, given the way the real ex

change rate is defined).

Fot· Germany, Figure 4.1 shows that move

ments in real long-term interest rates coincide

with the appreciation of the deutsche mark in

the late 1970s and the subsequent depreciation

through 1982, as well as the appreciation from

1985-91. However, there are also periods such as

1981-84 and 1992-94 during which there is little

apparent association between the real exchange

rate and the real interest differential. A positive

relationship also emerges when short-term inter

est rates are used, with the positive relationship

working better for the periods from 1981-84

and 1992. This suggests that both short- and

long-term interest rates are needed to pin down

the real exchange rate-real interest rate relation

ship, possibly because long rates capture the de

terminants of capital mobility, while short rates

capture monetary-side liquidity effects arising

from price stickiness.

For the dollat·-yen bilateral rate in Figure 4.2,

the positive real exchange rate-real interest rate

relationship seems to work best when long rates

are used, with the real differential tracking the

exchange rate fairly well through 1986. In con

u·ast to the deutsche mark, short rates do not

seem to add explanatory power to long rates.

Figure 4.3 provides similar results for the U.K. pound, with long- and short-term interest rates

again having differential periods of explanatory

power. Short rates do best in explaining the dra

matic appreciation of sterling in the late 1970s,

although neither interest rate explains much of

the subsequent depreciation (not surprisingly,

since this is thought to have been largely driven

by the dollar). It has become something of a styl

ized fact that the dollar appreciation from

1980-85 is difficult to explain solely in terms of

fundamentals (see, for example, MacDonald

(1988)) . The sterling long-term interest rate dif

ferential does, however, pick up the positive asso

ciation at other times, such as 1989-91 and

1995-96.


Figure 4.1 . Germany: Real Bilateral Exchange Rate and Interest Rate (1975 = 100 for exchange rate; in percentage points for Interest rate) 130-

long· Term Interest Rate

70 -

60 -

- 10

- 8

50 -40 �-L��-L��-L��-L��-L�� 1977 79 81 83 85 87 89 91

130 -120 -

100 -90 80

60-50 -40 I I

1977 I I I I

79 81

Short· Term Interest Rate

I I I I I I I I 83 85 87 89 91

93 95 97

I I I I 93 95 97

- 10

- 8

- 6

4

2

0

- -4 · �

Sources: IMF. lntemational Financial Statistics; and authors· calculations.

NEW EMPIRICAL EVIDENCE

Figure 4.2. Japan: Real Bilateral Exchange Rate and Interest Rate (1975 = 100 for exchange rate; In percentage points for interest rate)

250 -230 -210 -1 90 -

150-130-110 90 70 -

long· Term Interest Rate - 10 - 8

- 6

- 4

2 0

501�97=-=7�79:-'-'L::-81�'::-83:-'-'L::-85::'---"L::-87::'---l'-:-89�'-:-91�'-:-93�'-:-95�'-97� �

250 -230 -210-190 -

110 90 -70 -


Exchange rate (left scale)

- 10

- 8 - 6

- 4 2

0

50 1'::97=-=7�79:;-l-'::81�'::83:;-l-'::85:;-L-L::-87:;-L-L::-89:;-l-'::91�'-:-93�'-:-95�L-'-� �

Sources: IMF. lntemational Financial Statis tics; and authors' calculations.

143


144


Figure 4.3. United Kingdom: Real Dollar Exchange Rate and Interest Rate Differential (1990 = 100 tor exchange rate; in percentage points tor interest rate)

150- - 8

140 -

100-

90

long-Term Interest Rate - 6

-2

- -4

ro- -� 60 -8

1977 79 81 83 85 87 89 91 93 95 97

150- - 8 Short-Term Interest Rate

[n summary, Figures 4.1 to 4.3 suggest two im

portant stylized facts. First, the positive real ex

change rate-real interest rate relationship, syn

onymous with the business cycle in many

exchange rate models, is clearly "in the data" for

the leading currencies. Second, in general

terms, short and long interest rates have differ

ent effects over the business cycle, so that econo

metric work that excludes one or the other in

trying to tie down the real exchange rate-real

interest rate link is likely to produce a misspecified relationship. This is important, since most

of the work surveyed in the previous section fo

cuses on one pair of interest rates at a time.

Figures 4.4-4.7 show the effective exchange

rate counterparts to the bilateral relationships.

These largely confirm the discussion above. A clear positive association is seen between real ex

change rates and the real interest rate differen

tial in all charts, though this is perhaps not as

striking as in the bilateral data, and there are

again some important differences between short

and long rates. Figme 4.7 for the United States

is worth highlighting. There is a close relation

ship between the real effective exchange rate

and the real long-term interest rate differential;

this is particularly evident for the steep rise of

the dollar in the early 1980s and the deprecia

tion starting in 1985. Indeed, interest rate effects o seem to account for much of this episode.

90

80

70

Sources: IMF, International Financial Statistics; and authors' calculations.

Using Band-Pass Filters to Focus on the Business Cycle Relationships

A second set of stylized facts is derived from

the decomposition of the real exchange

rate-real interest rate relationship into irregular,

business cycle, and trend components using

band-pass filters. As discussed above and follow

ing Baxter (1994), the irregular components are

movements with frequencies of 6 to 15 months

(corresponding to 2 to 5 quarters) ; the business

cycle component is composed of movements

with frequencies from 18 to 96 months (corre

sponding to 6 to 32 quarters) ; and the trend

component is movements with frequencies

greater than 96 months (corresponding to 8


Figure 4.4. Germany: Real Effective Exchange Rate and Interest Rate Differential (1990 = 100 for exchange rate; in percentage points for interest rate)

125 -

120

110

1 0 0 -

95 -

90 -

85 1977

125 -

120

110

105 1 0 0 -

95 -

90 -

85 1977

79 81

79 81

Long· Term Interest Rate

83 85 87 89 91 93 95 97


Sources: IMF, International Financial Statistics; and authors· calculations.

6

4

0

-4

6


Figure 4.5. Japan: Real Effective Exchange Rate and Interest Rate Differential (1990 = 100 for exchange rate; in percentage points for interest rate)

1 6 0 -

1 4 0 -

130

120

1 1 0 -

100

90

80 -

- 8 long· Term Interest Rate

- 6

4

2

0

70 -

60�-L��-L��-L��-L��_L��

-4

-6 1977 79 81 83 85 87 89 91

160 -

150 -

140 -

1 3 0 -


93 95 97

- 8

- 6

4

2


145


146


Figure 4.6. United Kingdom: Real Effective Exchange Rate and Interest Rate Differential (1990 = 100 for exchange rate; in percentage points tor interest rate)

130-125-120-

110 105 100 95 90

130-

115 110 105 100 95 90

long· Term Interest Rate

93 95 97


- 8

- 6

- 4

2

8

6

4

2


Figure 4.7. United States: Real Effective Exchange Rate and Interest Rate Differential (1990 = 100 for exchange rate; in percentage points for interest rate)

160- - 6 long-Term Interest Rate

801977 79 81 83 85 87 89 91 93 95 97 -6

1 60 - - 6 Short-Term Interest Rate

801977 79 81 83 85 87 89 91 93 95 97 -6



years or more). The filtered data are constructed

using 36 monthly leads and lags, again corre

sponding to Baxter's use of 12 quarters. This means that 36 observations are lost at each end

of the sample period. The bilateral band-pass re

sults are shown in Figures 4.8-4.10, while Figures

4.11-4.14 provide the results using effective

(multilateral) data.

Figures 4.8-4.10 show that there is a clear

business cycle component to the real exchange

rates and real interest differentials, with in many

instances the expected positive association sug

gested by most models. In some cases, however,

the correlation between exchange rates and in

terest rates is actually not as apparenl with the

bandpass filters as in the raw data of Figures

4.1-4.7. A possible reason for this is that al

though the data have been decomposed into

three separate components, the charts focus on

only one at a time, and the remaining compo

nents also contain information on the relation

ship between exchange rates and business cycles.

For the deutsche mark and the yen, the positive

association seems clearest at the business cycle

and irregular frequencies, while for the pound,

all three frequencies exhibit the positive associa

tion, especially for short-term interest rates.

Figures 4.1 1-4.14 show the decompositions

for effective (multilateral) exchange rates and

interest rate differentials. These are similar to

their bilateral counterparts, with many instances

of the expected positive relationship between in

terest rates and exchange rates at both business

cycle and other frequencies. In contrast to the

bilateral data, however, the decompositions for

the pound sterling in Figure 4.13 suggest a nega

tive association between the exchange rate and

the real interest differential; this is particularly

clear at the business cycle frequency. It is note

worthy that as in the raw data, differences arise

between the results with short- and long-term in

terest rates; this is most notable in the case of

the pound. An interesting result with both bilat

eral and effective exchange rates is that at the ir

regular frequency, the filtered interest rate dif

ferentials often anticipate exchange rate

movements with the correct sign. This is evident,


Figure 4.8. Germany: Band-Pass Filter of Real Bilateral Exchange Rate and Interest Rate Differential

-- Exchange rate (left scale) - Interest rate (right scale)

Irregular Component: 6-15 Month Cycles

8 • Long· Term

- 4 8 -Short-Term

- 4

6 - Interest Rate

4 -

2

0

-2

- 4 -

-6-

- 3

- -3

6 Interest Rate

4

2

0

-2

-4 -6

- 3

0

-1

- -3 -8 I I I I I I I I I I I I I I I I I -4 -8t I I I I I I I I I I I I I I I I -4

1979 82 85 88 91 94 1979 82 85 88 91 94

Business Cycle Component: 18-96 Month Cycles

20 • Long· Term 15 - Interest Rate

- 4 20-

- 3 15

10

- 4

-20 I I I I I I I I I I I I I I I I I -4 -20 I I I I I I I I I I I I I I I I I -4 1979 82 85 88 91 94 1979 82 85 88 91 94

Long-Run Component: 8 Year+ Cycles

- 4 120-

110

100

60-

- 4

- -2

50 I I I I I I I I I I I I I I I I I -3 1979 82 85 88 91 94

50 I ! I I I I I I I I I I I I I I I -3 1979 82 85 88 91 94


141


148


Figure 4.9. Japan: Band-Pass Filter of Real Bilateral Exchange Rate and Interest Rate Differential

-- Exchange rate (left scale) -- Interest rate (right scale)


40 - Long-Term

30 - Interest Rate

-30 -

- 4

- 3 - 2

0

--3

4 0 -Short-Term

30 Interest Rate

20 10

0 -10 -20

-30

- 4 - 3 - 2

- -3 -40 I I I I I I I I I I I I I I I I I -4 -40 I I I I I I I I I I I I I I I I I -4

1979 82 85 88 91 94 1979 82 85 88 91 94

20 10 -

0 -10--20--30-

Buslneu Cycle Component: 18-96 Month Cycles

--3 -30 - - -3 -40- --4 -40- - - 4 -50 I I I I I I I I I I I I I I I I I -5 -50 I I I I I I I I I I I I I I I I I -5

1979 82 85 88 91 94 1979 82 85 88 91 94

Long-Run Component: 8 Year + Cycles

140- Long· Term Interest Rate

130 120-1 1 0 -100-

90 -80-70-

- 4

- 3

- 2

0

--1

--2

140- Short-Term Interest Rate

130

70-

- 4

--2 60, I It! I ! I I I I I I I I I ,_3 60• I I I I I I I I I I I I I I I , _3

1979 82 85 88 91 94 1979 82 85 88 91 94

Sources: IMF, Jnternatiooal Rnancial Statis tics; and author$' caltulations.

Figure 4.10. United Kingdom: Band-Pass Filter of Real Bilateral Exchange Rate and Interest Rate Differential



20 • Long-Term

15 _ Interest Rate

1 0 -

-10 -

- 20 20-Short-Term

_ 15 15 _ Interest Rate

10 1 0 -

--10 -10-

- 20

15

- 10

--10 -15 1 I I I I 1 1 1 1 I I I I I I I 1-15 -15 I I I I I I I I I I I I I I I I 1-15

1979 82 85 88 91 94 1979 82 85 88 91 94

Business Cycle Component: 1&-96 Month Cycles

35 • Lono·Term Interest Rate

2 5 -

3 5 35 - Short-Term Interest Rate - 35

25 25- - 25

-25 I I I I I I I I I I I I I I I I I -25 -25 I I I I I I I I I I I I I I I I 1 -25 1979 82 85 88 91 94 1979 82 85 88 91 94


140 -Long· Term Interest Rate

130-120-1 1 0 -100-

90 80 -70-

20 140 - Short-Term Interest Rate 20

1 5 130' - 15

120-- 10 110 - - 10

- 5 100 -

0 90 - 0 80-

- -5 70- - -5 601 I I I I I I I I I I I I I I I I 10 601 I I I I I I I I I I I I I I I I 1 0

1979 82 85 88 91 94 1979 82 85 88 9 1 94

Sources: IMF, lntemational Financial Statistics; and author$' calculations.


Figure 4.11 . Germany: Band-Pass Filler of Real Effective Exchange Rate and Real Interest Rate Differential


4 - Long· Term

3 - Interest Rate

2 -

0 -1 -2


- 2.0 4 --

--

1.5 3 1.0 2

0.5 0 0

-o.5 -1 --1.0 -2

Short-Term Interest Rate

- 2.0 - 1.5 - 1.0 - 0.5

0 -o.5

--1.0 -3 - --1.5 -3 · --1.5 -4 I I I I I I I I I I I I I I -2.0 -4 I I I I I I I I I I I I I I -2.0

1981 84 87 90 94 1981 84 87 90 94


6 • Long-Term Interest Rate • 3 6 · Short· Term Interest Rate - 3

2

2

0

-8t I I I I I I I I I I I I I -4 -8 1 I I J I I I I I I I -4 1981 84 87 90 94 1981 84 87 90 94


108 • Long-Term Interest Rate - 3 108 - Short· Term Interest Rate - 3 106- 106 104- - 2 104 - 2 102- - 1 102-100 100-98 - 0 98 0 96 - 96 -94 -

-1 94 -92- - -2 92 -90 - 90 -88t I I I I I I I I 1 -3 881 I I I I I I I I -3

1981 84 87 90 94 1981 84 87 90 94



Figure 4.12. Japan: Band-Pass Filter of Real Effective Exchange Rate and Interest Rate Differential



8 - Long-Term Interest Rate - 2.0 8 -

Interest Rate . 2.0

6 - - 1.5 6 - - 1.5 4 .

2 2 0 0 0 0

-2 -o.5 -2

-4

-6 - --1.5 -6 - --1.5 -8 I I I I I I I I I I I I I l-2.0 -8 I I I I I I I I I I I I 1-2.0

1981 84 87 90 94 1981 84 87 90 94


15 · long-Term Interest Rate - 3 15 · Short-Term Interest Rate · 3

-15 I I I I I I I I I I I I I -4 -15 -4 1981 84 87 90 94 1981 84 87 90 94


120 -long-Term Interest Rate

0

110 - • -o.5 100 - --o.5

100 - -1.0 - -1.0 90 -

90 - --1.5 -1.5 80 -

80 - --2.0 --2.0

70 - --2.5 70 - --2.5

60 I I I I I I I I I I l-3,0 60 I I I I I I I I I I 1-3.0 1981 84 87 90 94 1981 84 87 90 94


149


150


Figure 4.13. United Kingdom: Band-Pass Filter of Real Effective Exchange Rate and Interest Rate Differential

- Exchange rate (left scale) -- Interest rate (right scale)


6 · Long-Term Interest Rate • 1·5 6 • Short-Term Interest Rate • 1·5

1.0 4

2

0

-2


8 - Long· Term Interest Rate - 2.0 8 - Short-Term Interest Rate - 2·0

6 · 4 2

o -

-2-

-4 -

-6 -

-8 --101 I I I

1981 84 87 90

- 1.5 6 -

- 1.0 4 - 0.5 2

0 - -o.5 -2---1.0 -4-·-1.5 -6-

--2.0 -8 11 2.5-1011 II 94 1981 84 87 90


120 · Long-Term Interest Rate

115

1 1 0 -

105-

100 -

95-

90-

8 5 -801 I I I I I I I I I

1981 84 87 90

- 3 120- Short-Term Interest Rate

2 1 1 5

- 1

- 0 100

-1

- -2

Sources: 1Mf1 International Financial Statistics; and authors' calculations.

- 1.5 - 1.0

0.5 0

--o.5

--1.0 --1.5

--2.0

I I 2.5 94

- 3

2

Figure 4.14. United States: Band-Pass Filter of Real Effective Exchange Rate and Interest Rate Differential

- Exchange rate (left scale) -- Interest rate (right scale)


5 - Long-Term Interest Rate - 2.0 5 - Short-Term Interest Rate - 2.0 4 - - 1.5 4 - 1.5 3

1.0 3

1.0 - -2

1 - 0.5 1 0.5

0 0 0 0 -1 -o.5 -1 -0.5 -2 -2 -3-

--1.0 -3 -

--1.0

-4 · --1.5 -4· --1.5

-51 I I I I I I I I I I I I 1-2.0 -5 1 I I I I I I I I I I I I 1-2.0 1981 84 87 90 94 1981 84 87 90 94


25 • Long-Term Interest Rate 1.5 25 • Short-Term Interest Rate •

1.S

2 0 - - 1.0 20 - - 1.0 1 5 -

10 -- 0.5 1 5 - - 0.5

1 0 -0 0

5 --o.5 --o.s

0 --1.0 --1.0

-10- --1.5 -10- --1.5

-15 L..L.J....L..J....L..J....l-L..JW...L..J...J.J 2.0 -15 L..L.J....L..J....L-':-'-L..J':-:'-L..J...J.J-2.0 1981 84 87 90 94 1 981 84 87 90 94


140 - Long-Term Interest Rate - 140- Short-Term Interest Rate

120� 3 120

100- -80� 60- -

40-

0

-1

20- - -2

Q t I I I I I I I I I I I -3 1981 84 87 90 94


4

3

2

0


for example, in Figure 4.12 for the yen, where

the n ... o turning points in the yen series in 1988 and 1991 are predicted by pdo1· turns in the

high-frequency interest rate differential.

Table 4.4 presents the results of regressions of

the business cycle component of the real bilat

eral and effective exchange rates on the business

cycle components of the real interest rate differ

entials (both short- and long-term interest rates

in the same regression). The results using bilat

eral exchange rates confirm the expected posi

tive relationship ben...een the real exchange rate

and the interest differential for all exchange

rates and both interest rates. For all three cur

rencies against the dollar, the coefficients are of

the same order of magnitude for each interest

rate maturity, with larger effects of interest rates

on exchange rates for long rates than for short

rates. The U.K pound is different from the

other n...o currencies in that the coefficient on

the short rate, although smaller in magnitude

than that on the long rate, is estimated far more

precisely and accounts for most of the explana

tory power of the regression. This is consistent

with the findings of Baxter (1994) and Clarida

and Cali (1994) that the bilateral relationship

between the pound sterling and the dollar is dif

ferent from the dollar-yen and dollar-deutsche

mark relationships. The regression results for

the multilateral exchange rates are less consis

tent, with a negative relationship benveen the ex

change rate and short-term interest rate differ

entials for the yen, pound, and dollar, and a

negative coefficient for the long-term interest

rate for the deutsche mark and pound sterling.

Clarida and Gali Revisited: A Bilateral and Multilateral Perspective

This section estimates the structural VAR of

Clarida and Cali to examine the influences of

supply, demand, and nominal shocks on ex

change rates. As noted above, this involves plac

ing long-run restrictions on a three-variable VAR

with relative output growth, real exchange rate

growth, and relative inflation. The restrictions

are that nominal shocks are restricted to affect


Table 4.4. Business Cycle Components of Real Exchange Rates and Real Interest Rate Differentials

ql = C1. + f3s(r, - r*t)short + {3,(rt - r• tllong + Ut

Interest Rate

Currency Maturity Bilateral Multilateral

Short 0.331 0.453

(0.98) (2.28)

Deutsche mark

long 1.877 -0.129

(5.20) (-Q.47)

Short 1.033 -1.596

(1.18) (-3.24)

Yen

long 1.135 4.181

(1.69) (5.83)

Short 0.741 -0.364

(21.41) (-1.38)

Pound sterling

Long 1.255 -1.775

(4.12) (-3.49)

Short -4.468

(-4.90)

U.S. dollar

Long 7.616

(6.24)

Note: Robust t·statistics in parentheses.

only prices in the long run with no permanent

effect on output or the real exchange rate; de

mand shocks affect both inflation and the real

exchange rate in the long run but have no per

manent effect on output; and supply shocks have

permanent effects on all three variables. No con

straints are imposed on the short-run effects of

any of the shocks on any of the three variables.

Two important differences ben.,een the imple

mentation here and that of Clarida and Cali are

that the sample pel"iod used is longer, spanning

the period 1978-97, and the use of both bilat

eral and effective exchange rates rather than

solely bilateral rates. Quarterly data are used to

maintain comparability with the results of

151


152


Clarida and Gali, with eight lags in each

equation.

Table 4.5 presents the variance decomposi

tions for the (growth rate of) the quarterly bilat

eral real exchange rates at the forecast horizons

of 1, 4, 12, 20, and 40 quarters. Since 36 quarters

is usually taken as the limit of the business cycle,

these horizons illustrate the extent to which dif

ferent shocks drive the real exchange rate over

the business cycle. Since the demand and nomi

nal shocks have no permanent effects on output,

these can be interpreted as pertaining to the

business cycle, whereas the supply shock reflects

the long-run forces of productivity and thrift

that lead to permanent changes in the output.

Note that demand shocks have permanent ef

fects on real exchange rates-an assumption

that is in itself controversial-however, they are

labeled as a "cyclical" factor because they have

only transitory effects on output.

At all horizons, demand shocks are the most

important influence on movements of the bilat-

eral exchange value of all three currencies with

the dollar, with these shocks being somewhat less

important in Japan, where around 50 percent of

the variance is attributable to demand shocks by

quarter 40, compared to just over 60 percent for

Germany and the United Kingdom. The remain

ing variance in Germany is split roughly evenly

between the supply and nominal shocks, while

for Japan the nominal shock is nearly as impor

tant as the real shock. Nominal shocks hardly

matter in the United Kingdom, a result that

matches the findings of Clarida and Gali.

Following the interpretation that the sum of the

demand and nominal shock represents the busi

ness cycle, the results using bilateral data vis-a-vis

the dollar indicate that around 90 percent of the

variance of the Japanese yen and German mark

exchange rates are driven by business cycle influences, with the remaining 10 percent reflecting

longer-run supply factors. These results are gen

erally similar to those of Clarida and Gali, the

main difference being that in their results the

Table 4.5. Variance Decompositions for the Real Exchange Rate from the Structural VAR

Bilateral Exchange Rate Multilateral Exchange Rate

Quarter Supply Demand Nominal Supply Demand Nominal

Germany 1 12.0 76.4 11.6 14.7 73.1 12.2 4 12.8 67.8 19.4 16.9 70.0 13.1

12 19.7 61.5 18.7 19.1 67.6 13.3 20 20.6 61.0 18.4 19.3 67.3 13.4 40 20.7 60.9 18.4 19.3 67.2 13.5

Japan 1 2.0 60.1 37.9 8.5 13.4 78.1 4 6.2 58.7 35.1 7.8 16.4 75.8

12 8.4 51.3 40.3 8.7 17.8 73.5 20 8.8 50.8 40.4 12.8 17.2 70.0 40 8.8 50.8 40.4 13.3 17.1 69.6

United Kingdom 1 23.9 75.9 0.2 4.5 72.8 22.7 4 23.1 69.8 7.1 9.2 66.8 24.0

12 25.8 63.3 10.9 10.6 66.7 22.7 20 25.6 62.2 1 2.2 10.9 66.4 22.7 40 25.5 61.9 12.6 11.0 66.4 22.6

United States 1 41.7 58.3 0.0 4 49.2 49.3 1.5

12 46.9 45.1 8.0 20 46.2 44.9 8.9 40 46.0 45.0 9.0


German demand shock explains a smaller pro

portion of the total variance than the Japanese

shock.

Figure 4.15 shows the responses of the real ex

change rate to one standard deviation shocks to

supply, demand, and nominal shocks (each

shock represents an increase in the home variable relative to the foreign variable). Demand

and supply shocks have similar effects across the

three currencies, producing an initial apprecia

tion reaching about 4 to 6 percent in the case of

the demand shock and 2 percent for the supply

shock. Although the demand shock is correctly

signed in terms of the underlying model, the

supply shock is not, as the model predicts that

the currency should depreciate in real terms. In

Japan, the effect of the supply shock eventually

goes to zero, in constrast to the permanent ap

preciation:; experienced in Germany and the

United Kingdom. The nominal shock produces

an initial depreciation for the mark and yen with

overshoots of 2 and 4 percent, respectively, be

fore the effect of the nominal shock goes to zero

(by construction). In contrast, for sterling the

nominal shock produces a wrongly signed real

appreciation of 2 percent before dying out.

These results are in general similar to Clarida

and Cali, particularly the perversely signed re

sult of supply shocks for Germany and the

United Kingdom.

The VAR results are next used to pick out the

cyclical component of the real exchange rate.

This is done by using the interpretation given

above that demand and nominal shocks are

cyclically related, in that these two shocks have

only transitory effects on output in the Clarida

Cali framework. The level of the real exchange

rate with no cyclical effects is calculated by su�

tracting the cumulated forecast errors attributed

to demand and nominal shocks from the actual

value of the real exchange rate. Figure 4.16

shows the actual real exchange rates for the

deutsche mark, yen, and pound sterling against

the dollar and the calculated real exchange rate

witl10ut cyclical effects. In interpreting these re

sults, it is important to bear in mind that the

supply side shocks are wrongly signed for all


Figure 4.15. Real Bilateral Exchange Rate: Response to Shocks

- Supply - Demand - Nominal

Germany - 0.08

- 0.06

- 0.04

- 0.02 -------

0

- -Q.02

I I I! I I I ! I! 1! I I I I I I I I I I I I I I I I It I It I I I I I I I I I -o.04 0 5 10 15 20 25 30 35 40

Japan 0.08

0.06

0.04

- 0.02

0

- -o.02

0 I I I I 15 I I I I � 0 I I I ; 5 I I I :1o I I I 25 I I I so I I I 35 I I I �0 -o 04

United Kingdom 0.08

0.06

0.04 - 0.02

0

--Q.02

t I I I 1 I I I It! It I I I I I I I I I I I I I I I I I It I I I I I I I I I ' -G 04 0 5 1 0 15 20 25 30 3 5 40

.

Source: Authors· calculations.

153


154


Figure 4.16. Structural VAR: Real Bilateral Exchange Rate

- Actual - No cycle

Germany - 110

three currencies and that a date must be chosen

for each currency in which it is assumed that

there are no cyclical effects on the exchange

rate; the results are thus relative to this baseline,

as changing the date would not change the pat

tern of the exchange rate calculated without

cyclical effects but would move the whole series

up or down. In the case of the mark, the results

suggest that business cycle factors played little

1980 32 84 86 88 90 92 94 96 40

role in the depreciation of the mark from

1978-81, since the exchange rate with no cycli

cal effects is essentially identical to the actual ex

change rate (that is, supply side factor largely

caused tl1e depreciation). However, cyclical fac

tors had an important role in the further depre

ciation from 1982-85 and the subsequent appre

ciation through 1986-that is, the exchange rate

would have been smoother without cyclical ef

fects. Cyclical factors appear to have mainly con

tributed to the strength of the deutsche mark

against the dollar in late 1994 and early 1995.

For the bilateral yen-dollar rate, the post-1981

depreciation seems to have been driven by both

1980 82 84 86 88 90 92

United Kingdom

1980 82 84 86 88 90 92

Source: Authors' calculations.

94

94

- 200

140 supply and cyclical factors, although the sus

96 60

- 120

- 1 10

- 100

- 90

80

- 60

- 50

96 40

tained post-1985 appreciation is explained in

large measure by cyclical influences (particularly

demand rather than nominal shocks, though

these are not distinguished in Figure 4.16).

Cyclical factors appear to have driven the

strength of the yen against the dollar in 1994.

For sterling, it is interesting to note that supply

shocks played an important role in the post-1986

appreciation of sterling, possibly reflecting the

impact of the Thatcher reforms in labor markets.

Table 4.5 shows that the variance decompositions for the exchange rate using multilateral

data contain some important differences with

tl1e bilateral counterparts. This is most striking

for Japan, where the nominal shock now ex

plains the predominant component of the vari-

ance of the real rate, nearly 70 percent after ten

years, followed by demand and then supply

shocks. For the United Kingdom, nominal

shocks are more important and supply shocks

less with the multilateral data than was the case

against the dollar, while the reverse is the case in


Germany.' The total contribution of the business

cycle shocks (demand and nominal) in explain

ing exchange rate movements is quite similar

across the three currencies-85 to 90 percent

leaving about 10 to 15 percent of exchange rate

movements explained by supply side factors.

This is not the case for the United States, where nominal shocks account for less than 10 percent

of exchange rate movements, with demand

shocks explaining more than supply shocks ini

tially but roughly equal shares after a few

quarters.

The impulse responses using multilateral data

are shown in Figure 4.17. As ·with the bilateral data, demand shocks eventually lead to perma

nent real appreciations of all currencies. A nom

inal shock again leads to initial real depreda

tions before an appreciation back to zero,

though with substantially more persistence in

the case of the yen. However, the key difference

concerns the effect of the supply shock on the

real rate. In the bilateral case this was wrongly

signed for all three currencies. With the multilateral data, however, the initial effects of this

shock are correctly signed for Germany and

Japan, though the long-term effects on the ex

change rate in these countries and the United

Kingdom are fairly small. However, the effect of

a supply shock remains perverse for the dollar.

Figure 4.18 shows the four real effective exchange rates and the values calculated by taking

out business cycle influences. For Germany, the

results are fairly similar to those from the bilat

eral exchange rate with the dollar: supply factors

explain tl1e movements in the effective exchange

value of the deutsche mark through 1984, cycli

cal factors account for the subsequent weakness

and then appreciation and depreciation through 1989, and then supply factors again explain the

appreciation of the deutsche mark from 1991 to 1994. As with tl1e bilateral exchange, the appre-

7For Germany, the VAR with multilateral data is esti· mated starting from 1979 rather than 1978 in order to avoid perverse impulse-responses for the nominal and demand shocks; as a result, the series for the exchange rate without cyclical effects starts in 1981.


Figure 4.17. Response of Real Effective Exchange Rate to Shocks

- Supply - Demand - Nominal

Germany - 0.040

- 0.035

- 0.030

- 0.025

- 0.020

- 0.015

________ _,_ 0.010

- 0.005

��==��======� 0 - -o.oos

I I I I I I I I I I I I 1 I I I I 1 I 1 I 1 I 1 I I 1 I I I I I I I I I I 1 I I I I -o.010 0 5 10 15 20 25 30 35 40

0

United States

5 10

- Japan

- 0.040

- 0.035

--------- 0.030

- 0.025

-------------,_ 0.020

15 20 25 30 35

- 0.015

- 0.010

- 0.005

0

--0.005

0.010 40

- 0.04

--------- 0.03

- 0.02

-

: - 0.01

� ..... } �� 0 5 1 0 1 5 20 25 30 35 40

- 0.04

- 0.03

- 0.02

- 0.01

0

- -o.01

- -o.02

- -{).03

-o.04 0 5 1 0 1 5 20 25 30 35 40

155



ciation from 1994-95 is explained by Germany's

relatively strong cyclical position (relative being

an important word in this instance, since German output returned essentially to trend in

Figure 4.1 8. Real Effective Exchange Rate 1994 after several years above potential). For

Japan, the 1986--90 appreciation of the yen is

- Actual - No cycle again explained by cyclical factors, but the ap-

-120 predation through 1995 is largely driven by posi-

tive supply shocks. The 1996 collapse of the yen,

110 however, is driven entirely by cylical factors. In the multilateral data, the sustained downward

u·end in sterling through the late 1980s is largely

explained by the cyclical nominal and demand

shocks. Indeed, the positive supply side effects of

1980 82 84 86 88 90 90 the Thatcher era would have implied an appreci-

92 94 96 ation of the real effective rate (given the per-

Japan -200 verse result of the impulse response), but this

was offset by demand effects, possibly associated

with financial deregulation. Finally, the results 140 using the effective exchange value of the dollar

-120 suggest that cyclical factors account for an im-

-100 portant part of the dollar appreciation in the

80 first part of the 1980s. 1980 82 84 86 88 90 92 94 96

- United Kingdom - 1 20 Conclusions - 115

- 1 1 0 -105 This study has explored the relationship be--100 t\'leen the business cycle and the exchange rate, - 95 - 90 both through a selective survey of the exchange

85 rate literature and by generating some new em-- 80 - 75 pirical results. That this is the first attempt at

1980 82 84 86 88 90 92 94 96 70 providing a comprehensive overview of this rela-

- 140 tionship may in part reflect the fact that the ex-

change rate-business cycle link is at best only im-plicit in most exchange rate models.

Perhaps the dearest theoretical link between

the economic cycle and the exchange rate is

contained in the extended Mundeii-Fieming

model: a cyclical expansion of output, for exam-

80 pie, squeezes liquidity which, in turn, puts up-1980 82 84 86 88 90 92 94 96 ward pressure on the home interest rate and

Source: Authors' calculations. leads to an appreciation of the exchange rate. It

is this relationship which is most the focus of this

chapter. However, there are other links. For ex-

ample, the monetary model of the exchange

rate also predicts that an output expansion leads

to an exchange rate appreciation, although the

156


channel is more direct: prices must fall to main

tain money market equilibrium and, through

PPP, this leads to an exchange rate appreciation.

In the portfolio balance model, a risk premium

is also an important influence on the exchange

rate, and risk premia could be related to busi

ness cycles through the effect of the cycle on

countries' fiscal positions and thereby relative

debt stocks. However, evidence of a foreign ex

change risk premium is weak at best, so that this

avenue is not explored in this chapter.

Empirical evidence generally supports the the

oretical connection between business cycles and

exchange rates. This is true both for the direct

connection between output and exchange rates

as in the monetary approach, and for the more

general link between exchange rates and interest

rates. This is particularly the case when interest

rates and exchange rates are decomposed into

u·ansitory and permanent components, as is

done in this paper with band-pass filters. Finally,

evidence from structural VARs shows that busi

ness cycle factors are the dominant factor in ac

counting for recent exchange rate movements in

the United States, Germany,Japan, and United

Kingdom.

The existence of a relationship between busi

ness cycles and exchange rates has important im

plications for policy and multilateral surveil

lance. When business cycles are not

synchronized across countries, variations in ex

change rates can play a useful stabilizating role,

especially when economies are open and inter

nationally integrated. The link between ex

change rates and business cycles means that the

existence of desynchronized expansions across

countries in effect provides a "safety valve" for

inflationary pressures, as changes in exchange

rates can lead to a redistribution of demand

from countries near the top of their business cy

cles to those where demand is weak and there is

spare capacity. A challenge for policy evaluation

is to distinguish exchange rate movements war

ranted by international cyclical divergences from

movements due to changes in medium-term fun

damentals or episodes of overshooting or gross

misalignments.

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Vector Autoregressions," Economic Quarterly, Federal

Reserve Bank of Richmond, Vol. 83 (Summer),

pp. 45-67.

Stockman, A., 1995. "Sources of Real Exchange-Rate

Fluctuations: A Comment," Carnegie Rochester Ccnference Series on Public Policy, Vol. 41, pp. 57-65.

Thomas, Alun, 1997, "Is the Exchange Rate a Shock

Absorber? The Case of Sweden," lMF Working


Throop, A., 1993, "A Generalized Uncovered Interest

Parity Model of Exchange Rates," Economic Review,

Fede1·a1 Rese1·ve Bank of San Francisco, No. 2,

pp. 3-16.

Woo, W.T., 1985, "The Monetary Approach to

Exchange Rate Determination Under Rational

Expectations: The Dollar-Deutschemark Rate,"

journal of International Economics, Vol. 18, pp. 1-16.


THE GREAT CONTRACTIONS IN RUSSIA, THE BALTICS, AND THE OTHER COUNTRIES OF THE FORMER SOVIET UNION: A VIEW FROM THE SUPPLY SIDE Mark De Broeck and Vincent Koen

The early years of u-ansition from a com

mand to a market-based economy in

central and eastern Europe have typi

cally wi tnessed considerable output

drops, at least according to official national sta

tistics. Output comractions were even more pro

nounced in the Baltics, Russia, and the other

countries of the former Soviet Union. By 1997, growth had resumed in the vast majority of tran

sition countries. Even though a number of them

faced renewed output declines in 1998, mainly

associated with the financial crisis in Russia, it

appears that the bulk of the transitional reces

sion is now over in most cases. With the benefit

of hindsight, this sLUdy attempts to put the con

tractions endured in the Baltics as well as in

Russia and the other countries of the

Commonwealth of Independent States (CIS) in

perspective, examining them from several

angles.

A first and obvious que Lion arises as to their

magnitude. On many scales, it seems to be very

large. While this impression can be corroborated

in a number of ways, quantification has been,

and remains, a m<Uor challenge because of the

poor quality of available statistics. In fact, be

cause of these uncertainties, any point estimate

is likely to be misleading. Bearing this caveat in

mind, a second issue is how to evaluate the wel

fare consequences of the e contractions. All too

often, the magnitude of the output decline is

equated, at least implicilly, with that of the wel

fare loss. On reflection, however, it turns out

that there is no straightforward, one-to-one, rela

tionship between the former and the latter, as

welfare measures reflect the type of social wel

fare function used.

ext, the stylized features of the contractions

in the Baltics and the CIS countries are de

scribed and contrasted with the experience of se

lected central European transition economies.

While many studies tend to focus on the depth

of the contractions, their length and breadth are

also highlighted here, and performance is set

against countries' longer-run growth record.

The contractions have been ascribed a variety

of causes in the literaLUre, including the disloca

tion of traditional domestic and international

links, fiscal retrenchment, and credit crunches,

with the relative importance of these factors dif

fering across countries. 1 This study does not con

sider such a broad range of factors, but instead

focuses on changes in inputs and the evolution

of productivity to interpret the observed decline

in output, in line with earlier work by Easterly

and Fischer (1994). lt also sheds light on the re

allocation of inputs across seCLors.

Background Considerations

Starting in the late 1980s or early 1990s, offi

cial measures of output and value added de

clined precipitously in the Baltics, Russia, and

the other countries of the CIS. The size of the

actual conu·actions, however, is hard to gauge.

On the one hand, pan of the falling activity

reflected the replacemem of the previous incen

tive to report the (over-) fulfillment of plan tar

gets by the incentive to avoid the scrutiny of the

tax and other authorities (Koen, 1994).

Anecdotal evidence of L11e dynamism of under

ground businesses abounds, at least in some sec

tors. In L11e early years of transition, statistical of

fices generally did not have at their disposal the

1For an empirical cross-country study, see for instance Berg and otl1ers ( 1999) and 1-la\'l')'I)"Shyn and others (2000) and

lhe references lherein. For an in-depth country-specific anai)"Sis. see for instance the anal)-sis by De Broeck and Kostial ( 1998) on Kazakhstan and by ZeLLelmeyer ( 1998) on Uzbekistan. Analytical reviews of the causes of lhe outpm decline are presemed in Conw·ay (forthcoming) and Mundell ( 1997).

161


162

CHAPTER V THE GREAT CONTRACTIONS IN RUSSIA, THE BALTICS, AND THE OTHER COUNTRIES OF THE FORMER SOVIET UNION

tools required to track the volume of economic

activity under the new conditions. Erring on the

conservative side, they typically preferred to base

their published estimates on what was still re

ported to them rather than on their best esti

mate of aggregate output. Some alternative indi

cators of overall economic activity, most notably

electricity consumption, suggested that the offi

cial real GDP estimates were substantially

downward-biased (Gavrilenkov and Koen, 1995;

and Dobozi and Pohl, 1995).

Later on, several of the statistical offices, rec

ognizing those problems, started to incorporate

survey-based evidence and even guesstimates of

hidden activity into their GDP series.2 They also

revisited the series they had published thus far

and implemented some substantial upward revi

sions, in particular in Russia, Kazakhstan, and

Lithuania (Appendix 5.1).3 The GDP series as

revised for the initial transition years are indeed

more in line with what is suggested by independ

ent estimates carried out from the demand side

of the national accounts (in the case of Russia)

or based on physical output statistics (in the case

of Kazakhstan) , and they continue to show a

massive output decline. In addition, alternative

indicatOrs are not necessarily good proxies for

actual GDP (Appendix 5.2), and not all biases

need go in the same direction.'1 Finally, the au

thorities sometimes face political incentives to

publish higher rather than lower GDP figures.5

On balance, it is hard to believe that output

did not contract massively in the early years of

transition, even if the magnitude of the actual

decline may be somewhat overstated by the offi

cial statistics, especially where no efforts were de

ployed to take into account new and under-

ground economic sectors. Further output de

clines beyond the initial transition years are gen

erally measured more accurately in the official

numbers as statistical agencies made progress in

implemenling market-based methodologies and

the overall economic environment became more

stable.

In addition to the practical obstacles standing

in the way of a comprehensive and precise meas

urement of activity, a serious theoretical conun

drum deserves to be highlighted. The quantifi

cation of changes in real GDP relies on the

prices used to aggregate developments in enter

prises and branches. The choice of prices mat

ters a lot for the end result in a period of highly

unstable relative prices. Depending on the issue

under consideration, it may be more sensible to

use actual or notional market prices, currem or

base-period prices. No weighing scheme is in

trinsically superior to all others when aggregat

ing observations. Moreover, when notional

prices are used (e.g., "world" prices instead of

distOrted, actual prices), it must be recognized

that quantities would have been different had

that set of prices prevailed. Thus, even if infor

malion on quantities and prices were perfect, it

can be argued that there would still be no single,

"true" real GDP series.

The scope for divergence across estimates can

be significant, as illustrated by the example of

the Russian economy, which experienced a

seven-year conu-action over the period 1989-96.

The cumulative drop in real GDP in Russia dur

ing the period amounts to 45 percent if volumes

are aggregated at 1989 prices. If prices of the

previous year are used instead, it amounts to 42

percent. If 1996 prices are used, possibly on the

2Methodological guideHnes are spelled out in of the Russian Federation, Goskomstat (1996) and OECD (1997). ln practice, however, non-reported or under-reponed activities seem to have been taken into account, if at all, on a rather ad hoc basis.

3Substantial upward revisions were also carried out in Poland and in Bulgaria. •1For example, the fall in gross output in industry is understated to the extent that it does not control for the spliuing or

large state enterprises, which turns intra-finn transactions into inter-enterprise sale::s (Kolodko and Nuti, 1997). This phenomenon should have no direct impact on v-alue-added in industry, however.

5Gavrilcnkov (1996) conjecwred that the official real GDP series for Russia understated the actual 1995 decline. In the case of such countries as Belarus or Uzbekistan, published changes in real GDP are widely perceived as suffering from a potential upwat·d bias (on Uzbekistan, see Zettelmeyer, 1998).


grounds rbat those are more relevant because

closer to market levels, the cumulative drop is

yet smaller, at 41 percent.6

Assumptions regarding the size and dynamism

of activities in the shadow economy that are not

captured in the official statistics also affect the

size of the decline.7 A conservative assumption

could be that it represented 10 percent of official

GDP in 1989 and expanded at 2 percent per an

num. This would be in line with a perception that

official numbers capture much of the unrecorded

activity, or that there are limits to the speed at

which it can develop. An alternative assumption

would be that the shadow economy represented

20 percent of official GDP in 1989 and expanded

at 5 percent per annum. In the context of the

Russian example, the first assumption implies

that the shadow economy represented 18 percent

of official GDP by 1996 (using a weighing scheme

based upon the 1989 shares) and the second that

it represented 38 percent of official GDP by that

date (a range well within the range of estimates

that are commonly cited for the Baltic and the

CIS countries) .s The conservative view then .im

plies that actual GDP declined by 35 percent be

tween 1989 and 1996, while the alternative view

implies a smaller cumuJative drop of 23 percent.

Relying on electricity consumption as a proxy for

actual GDP would lead to yet another range of es

timates (Appendix 5.2).

Not only is the magnitude of the contraction

difficult to pin down, but its implications for wel

fare are also complex, even abstracting from dis

tributional considerations.9 Part of the output

SELECTED STYLIZED FEATURES

decline may have been welfare-enhancing. This

could apply to the termination or downsizing of

some types of miHtary or prestige investment, for

instance. It could also apply to some heavy,

energy-intensive, and polluting industties pro

ducing unsophisticated intermediate outputs for

which value-added measured at market prices

would be negative. Assigning a social value to

such {dis) investments or recompiling value

added at undistorted prices involves a fair de

gree of discretion, however, over and beyond ac

cess to data that may not be available. tO Another

set of welfare effects disregarded by conven

tional OU[put measures but important in u·ansi

tion economies are those associated with en

hanced access to markets by consumers. The

disappearance, or at least lessening, of ratjoning

and queuing, as well as the increased variety on

offer are tangible benefits that are not directly

reflected in real GDP measures. Again, the size

of such offsetting welfare gains depends on the

type of social welfare function used, but it can be

consequential (Roberts, 1997). In the subse

quent sections, only output movements as cap

tured by the official data are considered, and the

distributional consequences and welfare implica

tions of the output decline are left aside.

Selected Stylized Features

otwithstanding the numerous caveats out

lined in the previous section, official national ac

counts appear to broadly reflect the main char

acteristics of the underlying output movemems

6(}t.her weighing schemes could have been used, producing different. results. The cumulative decline according to the official numbers, which are broadly based on an aggregation scheme using pt·ices of the previous year, is 4 1 'h percent..

7Even in cases where adjustments tO GOP to account fot· hidden activities have been introduced, these Lend to be limited in scope. In Russia, for instance, the ollicial upward revisions for 1991-94 i.ncorporate estimates of hidden activities in trade and other services bm not for underreporting of the gross value of output in other major sectors (World Bank and Goskoms tat of the Russian Federation, 1995).

8Fot· instance, the share of the shadow economy was estimated at 14 percent of GOP in 1996 for Estonia by the Institute for Socio-Economic Analysis (Baltics News Service, April l3, 1997). at 30 percent in 1997 for Kazakhstan (Kulekeev, 1997). at 33 percent of GOP in 1995 for Moldova (in a study sponsot·ed by the Ministry of Economy and the Markets Pt·oblems Research Center ohhe Moldovan Academ)' of sciences, cited in tJ1e IMF (1998), at 43 percent in 1997 for Ukraine by t.he Economics Minist.er (!tar-Tass, January 3, 1998) and at 50 percent. for Russia by a U.S. Treasw·y sponsored repon (Finaucial Times, January 16, 1998).Johnson and others. (1997) estimate tllal in 1995 the shadow economy ranged from as litt.le as 7 percent of official GOP in Uzbekistan to as much as 167 percent in Georgia.

9Gavrilenkov and Koen (1995) quantify the effect of t.he changes in income distribution in Russia. lOOn remaining price distortions, see Koen and De Masi (1997), and on data existence and accessibility, Koen ( 1996) .

163


164


during the transition. In view of the poor quality

of the data, the analysis in the remainder of the

paper is, however, limited to an overview of the

main features of the contraction and to a study

of the relationship between outputs and inputs

at both the aggregate and sectoral levels, data on

which are generally of comparable quality. II

The length of the contraction varied consider

ably across countries, but on the whole was much longer in the Baltics and CIS countries

than in central Europe. Looking at the transi

tion through 1997, the duration of contractions

ranged from four to nine years or more, with a

median of six years (Table 5.1) . In contrast, the

contractions in the six comparator countries of

central Europe lasted between two and five

years, with a median of four years.

Likewise, the depth of the contractions varied

tremendously across countries and was in gen

eral distinctly larger than in central Europe

(Table 5.2). In Uzbekistan, where the contrac

tion was the shallowest, measured real GDP

shrank by 19 percent, compared with a 77 per

cent fall in Georgia at the other end of the spec

trum. On an unweighted basis, the contraction

averaged some 51 percent,12 two-and-a-half times

the 21 percent in central Europe on a compara

ble basis.

An alternative way to gauge the depth of the

contractions which is fairly popular in some tran

sition countries is to compute how far back the

contraction threw tl1e level of economic activity.

On official measures, GDP typically reverted to

levels witnessed two decades or more earlier,13

again over twice as deep in the Baltics and CIS

countries as in central Europe, which "re

gressed" by only about one decade.

The depth of the contractions also varied sub

stantially across sectors. For the fifteen successor

countries as a group, overall (unweighted) out-

Table 5.1 . Contraction Length (In years, based on observations through 1997)

Armenia Azerbaijan Belarus Estonia Georgia Kazakhstan Kyrgyz Republic Latvia3 Lithuania Moldova Russia' Tajikistan Turkmenistan4 Ukraine Uzbekistan

Duration of Contraction'

4 9 6 5 6 7 5 4 5 7 7 8 At least 9 At least 8 5

Comparator countries in central Europe

Bulgaria1.5 5 Czech Republic 4 Hungary 4 Poland' 2 Romania' 5 Slovakia 4

Reversion to Measured Output Level of2

Early 1970s 1 960s Late 1970s Early 1970s Late 1950s Late 1960s Early 1970s Late 1960s 1970s 1950s / 1960s Early 1970s 1950s / 1 960s 1960s or earlier 1960s or earlier Early 1980s

Early 1980s Late 1970s Late 1970s Mid-1980s Mid-1970s Late 1970s

Sources: Yearbooks of national statistical offices; CIS, Statistical Committee; CMEA Yearbooks.

1Contraction from peak year, as given in Table 5.2. 2Based on the revised series. 31ndicative only, since pretransition real output series are gener

ally for net material product. 40utput declined anew following the first recovery. SActivity rebounded modestly in 1990 following a sharp drop in

1989. but GOP contracted again in 1996.

pul dropped by 46 percent between 1990 and

1997. The decline was more pronounced in in

dustry and transport and communication, where

production fell by over half, and most spectacu

lar in the construction sector, where it shrank to

around one third of tl1e level observed in 1990,

mirroring the collapse in investment spending.

In contrast, production in agriculture and o·ade

fell by around one third. Much sharper varia

tions across sectors have been reported in a

number of individual countries.

In most of the counu·ies under consideration,

industry has been the largest sector of me econ-

11The extent of hidden economic activities differs across sectors, and is higher in the trade and services sectors in particular. Since the national statistical agencies take these sectoral differences in to account when adjusting initially reponed data for hidden activities, they should not affect the published oULput data.

12This average reflects outcomes through 1997. Given mat real GDP fell funher in several coLmu·ies, this average is an understatement of the eventual contraction depth.

13The dates shown in Table 5.1 are deliberately less precise for the distant than for the more recent past, owing to the larger margins of uncertainty surrow1eling them.


SELECTED STYLIZED FEATURES

Table 5.2. Contraction Depth (Real GOP level in percent of historical peak)

Peak Year 1990 1991 1992 1993 1994 1995 1996 1997

Armenia 1989 95 83 49 44 Azerbaijan 1988 80 80 62 48 38 34 Belarus 1989 98 97 88 81 71 63 Estonia 1989 94 83 65 60 58 Georgia 1988 83 65 36 25 23 Kazakhstan 1988 95 85 80 72 63 58 Kyrgyz Republic 1990 100 92 79 67 54 51 Latvia 1989 95 85 55 47 Lithuania 1989 95 90 71 59 53 Moldova 1989 98 81 57 56 39 38 35 Russia1 1989 97 92 79 72 63 60 58 Tajikistan 1988 94 86 60 50 44 38 32 Turkmenistan 1988 95 88 84 85 62 59 57 49 Ukraine 1989 96 88 79 68 52 46 41 40 Uzbekistan 1990 100 100 88 86 82 81

Comparator countries in central Europe Bulgaria, .2 1988 90 80 74 73 Czech Republic 1989 99 85 79 79 Hungary 1989 97 85 82 82 Poland, 1989 92 86 Romania1.2 1987 88 77 70 Slovakia 1989 100 85 85 85

Sources: National statistical offices; CIS, Statistical Committee. Note: Through the late 1980s or the early 1990s, real net material product series are typically used as a proxy for real GOP for Russia, the

Baltics, and the other countries of the Former Soviet Union. These data are shown through the end of the contraction, or if it had not ended, through 1997.

1Higher, revised series. 2Qutput declined anew following the first recovery.

omy, prompting the question of the extent to

which the contraction in GDP tracks the collapse

of industrial output. On an unweighted basis,

the peak-to-trough decline in gross industrial

output on average exceeds the fall in measured

GDP only marginally, while the length of the in

dustrial contractions is broadly comparable, also

ranging from four to at least nine years with a

median of six years (Tables 5.3 and 5.4). In con

trast, the depth of the industrial contractions in

the comparator central European countries is al

most twice that of the decline in measured GDP,

although similar in length. Two non-mutually

exclusive conjectures offer themselves. Since out

put in industry is probably less difficult to moni

tor than in other sectors, this evidence might be

taken to suggest that the GDP contractions are

overstated in the Baltics and CIS countries to the

extent industry might be expected to show

larger declines than other sectors.14 It may also

be that the environment in these countries was

less conducive to the development of sectors

other than industry than in central Europe, thus

limiting their cushioning potential.

Most studies of output developments have fo

cused on countrywide indicators. At a more dis

aggregated level, the evolution of output has var

ied as much from one region to another as from

one country to another. In fact, some regions ex

perienced a relatively shallow and brief reces

sion, while in others output continued to con

tract well after the start of the national recovery,

falling much deeper than the average trough.15

Such regional disparities are particularly su·ik.ing

14This interpretation is reinforced by the fact that industry has a higher weight in aggregate value-added in the cenU'lll European countries.

15Th is holds even given the uncertainty associated with r.he unreliability of regional statistics, which are often even less trustworthy than at the national level.

165


166


Table 5.3. Depth of the Contractions in Industrial Output (Gross industrial output level in percent of historical peak)

Peak Year 1990 1991

Armenia 1987 84 77 Azerbaijan 1989 94 98 Belarus 1990 100 99 Estonia 1989 100 91 Georgia 1989 94 73 Kazakhstan 1989 99 100 Kyrgyz Republic 1989 99 100 Latvia 1990 100 99 Lithuania 1989 97 92 Moldova 1990 100 93 R ussia 1989 100 92 Tajikistan 1990 100 96 Turkmenistan 1 1991 95 100 Ukraine 1989 100 95 Uzbekistan 1991 98 100


Bulgaria 1988 82 64 Czech Republic 1989 97 76 Hungaryz 1988 96 83 Poland2 1988 75 69 Romania 1988 79 61 Slovakia 1988 95 77

Sources: National authorities; CIS, Statistical Committee. 1Temporary rebounds were officially recorded in 1993 and 1996.

in vast countries such as Russia, Ukraine, and

Kazakhstan (Table 5.5).16 To some extent, and

like at the nationwide level, the differences

across regions reflect, among other factors, the

diversity in the stance of local policies, as docu

mented by Berkowitz and Dejong (1997) in the

case of Russia.

Inputs and Outputs: Contraction Accounting

The remainder of the paper explores the

sharp output decline in the Baltics and CIS

countries from the angle of the relationship be

tween inputs and outputs. A commonly used ap

proach to link output to inputs and to measure

economic performance over time is to set up a

growth accounting framework lO assess the effi

ciency with which the factors of production la

bor and physical capital are employed. To illus-

1992

40 75 89 58 39 83 74 65 66 68 75 73 85 89 93

54 70 75

48 70

1993 1994 1995 1996 1997

36 69 53 44 41 80 66 58 47 46 29 17 16 71 51 47 55 40 33 45 40 38 43 31 68 49 47 43 65 51 50 48 67 51 43 35 34 89 66 62 74 52 82 60 53 50 49

48 66

67

trate how the transition process has affected the

economic performance of the fifteen transition

counu·ies of the former Soviet Union, a growth

accounting exercise is performed for each coun

try individually and for all fifteen as a group.

Furthermore, to put the output decline during

the transition in perspective and relate it to dis

LOrtions and misallocations inherited from cen

tral planning, the sample period is extended to

include the last two decades prior to the Soviet

breakdown. The exercise covers the overall

economy and the aforementioned six main sec

tors of the cenu·al planning recording system.

The exercise is based upon the assumption

that output is produced according to a neoclassi

cal production function of the following form,

Y( t) = A ( t) f1 K( t), L( t) ] , ( 1 )

where A is an index of total factor productivity

(TFP), K is the capital stock, and L measures the

16AJthough the contraction had not ended by 1997 in Ukraine, the bulk of the decline is captu,·ed.


Table 5.4. Length of the Contractions in Industrial Output (In years, based on observations through 1997)

Duration of Contraction

Reversion to Measured Output Level of

Early 1970s 1960s

Armenia Azerbaijan Belarus Estonia

6 5/7 5 4

Late 1970s/early 1980s 1960s

Georgia Kazakhstan Kyrgyz Republic Latvia Lithuania Moldova! Russia Tajikistan Turkmenistan1 Ukraine Uzbekistan

6 6 6 5 5 6 7 At least 7 At least 6 At least 8 1


Bulgaria2 5 Czech Republic 4 Hungary 4 Poland 3 Romania 4 Slovakia 5

1960s or earlier 1960s or earlier Mid-1970s 1960s Early 1970s Late 1960s Early 1970s 1960s 1970s or earlier 1960s or earlier 1988

Mid-1970s Mid-1970s Mid-1970s Mid-1970s Mid-1970s Late 1970s

Sources: Yearbooks of national statistical oHices; Statistical Committee of the CIS.

1Temporary rebounds were oHicially recorded in 1993 and 1996. 20utput declined anew following the first recovery.

inputs of labor. Differentiation of equation (l ) with respect to time yields, after division by Y,

(2)

where gy, g11, gK, and g1_, are the rates of growth

of 1� A, K, and L, respectively, and where

17K= (K/Y) .(()Fj()K) and 17L = (L!Y).(()Fj()L) denote the elasticities of output with respect to

capital and labor, respectively. Further differenti

ation of equation (2) with respect to time gives

dgl,fdt = dgA/dt + (dTJKf' dt) .gK+ 1JK . (iJgK/()t) + (o1JL/()t) .gL + 17t . (iJgL/()t), (3)

INPUTS AND OUTPUTS: CONTRACTION ACCOUNTING

which allows one to decompose changes in the

growth rate of output period by period.

This type of accounting relies on underlying

assumptions about the nature of the production

function that is specified in equation ( l ) .11 In

the absence of information on factor prices that

would allow one to approximate the elasticities

of output with respect to capital and labor, the

computations below assume that these elastici

ties are constant over time and add up to LIS

The computed changes in TFP should be inter

preted as residuals that reflect, in addition to bi

ases due to methodological assumptions and

measurement errors, a wide range of factors af

fecting the efficiency with which inputs are

used.l9 The remainder of the paper focuses on

analyzing the fall in growth dw-ing the transition

period relative to pretransition growth, in line

with equation (3). This is a valid approach as

long as the biases and errors in the computa

tions are not subject to a regime shift following

the transition. Furthermore, since no correc

tions are made for vru.iations in hours worked

and capacity utilization, or, more generally, for

quality changes and facror obsolescence, this ap

proach also implies that, except for reductions

in reported employment and investment, the im

pact of the transition will be reflected entirely in

changes in estimated TFP.

The computational results are summarized in

Table 5.6, which reports average annual output

and input growth rates, factor contribution rates,

and TFP growth rates by country and by sector for

the periods 1971-90 and 1991-97. TFP growth

turned sharply negative during the transition in

all countries and sectors, after having fallen to

close to zero in the last two decades of central

planning.20 The drop was especially pronounced

1iFor a detailed discussion of these assumpLions, see Barro (1998). 'liThe v-alues chosen are 0.3 for capital and 0.7 for labor. These additional assumptions imply Lhat the production func

tion underlying the computations is of the constant return s-to-scale Cobb-Douglas variety. The elasticity of substitution between capital and labor accordingly is constant and equal to I.

19The computed value of the rate of change ofTFP should therefore not be inte•-p.-cted as simply an estimate of the rate of exogenous technological progress.

2<Yfhe computations for the rate of change ofTFP during 1971-90 confirm the low productivity gains in the Soviet economy during the last two decades of central planning tJ1at are found in swdies of the Soviet economic slowdown, as surveyed in Easterly and Fischer ( 1 994).

161


168


Table 5.5. Fall in Industrial Output Across Regions During the First Half of the 1990s1• 2

Russia Ukraine Kazakhstan

Countrywide Drop

52 50 52

Dispersion3

25 22 32

Maximum

87 74 73

Minimum

23 29

6

Number of Regions

874

26 20

Sources: Regional statistical yearbooks of the national statistical offices and authors' computations. !Between 1990 and 1995 (Kazakhstan), 1996 (Russia) , or 1997 (Ukraine). Peak to trough for each region. 2AII columns in percent except for the last one. 3Coefficient of variation. 4Two regions, Chechnya and lngushetia, are not included.

in conflict-torn countries (Armenia, Azerbaijan,

Georgia, Moldova, Tajikistan) and in Ukraine,

where the output fall continued throughout the

sample peiiod. Negative values for TFP growth

during the transition are also observed on a sec

toral basis, mostly so in construction, industry,

and transport and communication.

To test the robustness of these computations,

alternative calculations are presented based on

labor productivity growth rates, which do not de

pend on assumptions about the nature of the

production function and about output elasticities

with respect to inputs of factors nor on particular

data construction procedures for the capital

stock variable. The results, presented in the last

column of Table 5.6, show a broadly comparable

pattern for productivity measures based upon ei

ther TFP or labor productivity. According to both

measures, in all countries and sectors, productiv

ity fell during 1991-97 by on average more than

6 percent a year. Labor productivity growth rates

were slightly less negative than TFP growth rates

in all countries reflecting the more rapid expan

sion of capital inputs over the period. At the sec

toral level, however, this was not the case in agri

culture, trade, and services. In these three

sectors, labor productivity fell by more than TFP,

reflecting increases in sectoral employment.

The implications of the productivity decline in

the early transition years can be put in perspec

tive by comparing its contribution to the overall

output fall to that from reductions in inputs of

capital and labor. In most countries and sectors,

factor contribution was negative during the tran

sition, reflecting reductions in employment and

investment. Total employment in the 15 succes

sor states as a group fell by more than 12 per

cent in 1991-97, with sharper reductions in the

Baltic countries (by around 20 percent) and in

Russia (by 15 percent), while it actually ex

panded in Turkmenistan and Uzbekistan. On a

sectoral basis, employment in the trade and serv

ices sectors rose significantly, was broadly stable

in agriculture, but shrank by over 35 percent in

industry and by over 40 percent in construction.

The contribution of capital accumulation also

was reduced sharply, reflecting the investment

collapse during the transition. By 1997, real in

vestment fell short of its 1990 level in 14 of the

15 countries and in all six sectors,21 with the av

erage shortfall amounting to around 70 percent.

In most countries and sectors, investment fell to

well below replacement rates and the growth

rate of the capital stock turned negative.

The investment collapse had additional nega

tive repercussions, as it accelerated the aging of

the capital stock. Reflecting the slowdown of in

vestment spending in the second half of the

1980s and its reduced effectiveness,22 capital

stock obsolescence had already begun to set in

before tl1e transition (Akopian, 1992). In Russia,

for instance, the average age of plant and equip

ment had increased to 10.8 years in 1990 from

8.4 years in 1970. With investment collapsing in

21The exception was Azerbaijan, where invesunem boomed in 1996-97 owing to large-scale oil projects. 22'fhe ratio of the annual value of uncompleted construction projectS and uninstaUed equipment to new invesunent rose

significantly dudng this period.


INPUTS AND OUTPUTS: CONTRACTION ACCOUNTING

Table 5.6. Output and TFP Growth, Period Averages

Labor Output Capital Labor Factor TFP Productivity

Period Growth Growth Growth Contribution Growth Growth

Countries

Armenia Avg. 71-97 0.6 3.2 1.1 1.7 -1.1 -0.4 Avg. 71-90 3.9 5.0 2.3 3.1 0.8 1.6 Avg. 91-97 -8.8 -1.7 -2.5 -2.2 �.5 -6.3

Azerbaijan Avg. 71-97 -0.5 3.6 1.7 2.3 -2.8 -2.2 Avg. 71-90 3.1 4.3 2.3 2.9 0.2 0.8 Avg. 91-97 -10.7 1.3 -o.o 0.4 -11.1 -10.7

Belarus Avg. 71-97 1.9 4.8 0.0 1.5 0.4 1.8 Avg. 71-90 4.1 5.9 0.9 2.4 1.7 3.2 Avg. 91-97 -4.4 1.9 -2.3 -1.1 -3.4 -2.1

Estonia Avg. 71-97 0.0 3.4 -o.5 0.7 -Q.7 0.5 Avg. 71-90 2.3 4.1 0.6 1.6 0.6 1.7 Avg. 91-97 -6.4 1.5 -3.5 -2.0 -4.4 -2.9

Georgia Avg. 71-97 -1.4 2.3 0.2 0.8 -2.3 -1.6 Avg. 71-90 2.6 4.0 1.3 2.1 0.5 1.3 Avg. 91-97 -13.1 -2.5 -3.0 -2.9 -10.2 -10.0

Kazakhstan Avg. 71-97 -1.0 3.6 0.6 1.5 -2.5 -1.6 Avg. 71-90 1.4 5.0 1.8 2.8 -1.3 -Q.4 Avg. 91-97 -7.7 -Q.5 -2.8 -2.0 -5.6 -5.0

Kyrgyz Republic Avg. 71-97 -Q.1 3.9 1.6 2.2 -2.4 -1.7 Avg. 71-90 3.2 4.9 2.3 3.1 0.1 0.8 Avg.91-97 -9.5 0.8 -o.5 -0.1 -9.4 -9.0

Latvia Avg. 71-97 -Q.4 2.6 -Q.7 0.3 -0.7 0.3 Avg. 71-90 2.6 3.9 0.6 1.6 1.0 2.0 Avg.91-97 -9.0 -1.1 -4.3 -3.4 -5.6 -4.6

lithuania' Avg. 71-97 -0.4 3.8 -0.1 0.1 -Q.5 -Q.4 Avg. 71-90 3.0 5.2 0.8 2.1 0.9 2.3 Avg. 91-97 -6.3 -Q.5 -2.4 -1.8 -4.5 -4.0

Moldova Avg. 71-97 -2.0 3.9 -Q.3 0.9 -3.0 -1.7 Avg. 71-90 2.8 5.4 0.7 2.1 0.7 2.1 Avg. 91-97 -14.4 -o.5 -3.3 -1.0 -13.5 -11.2

Russia Avg. 71-97 -0.3 3.8 -0.0 1 . 1 -1.5 -0.3 Avg. 71-90 2.2 5.1 0.8 2.1 0.1 1.4 Avg. 91-97 -7.5 -0.1 -2.2 -1.6 -6.0 -5.4

Tajikistan Avg. 71-97 -1.7 3.8 1.9 2.5 -4.2 -3.6 Avg. 71-90 2.6 5.2 3.0 3.7 -1.1 -Q.5 Avg. 91-97 -13.8 -0.3 -1.1 -0.9 -12.9 -12.6

Turkmenistan Avg. 71-97 -0.7 5.9 2.6 3.7 -4.4 -3.4 Avg. 71-90 2.3 6.1 3.2 4.0 -1.7 -0.8 Avg. 91-97 -9.5 5.3 1.2 2.4 -11.9 -10.7

Ukraine Avg. 71-97 -1.1 2.9 -D.1 0.8 -1.9 -1.0 Avg. 71-90 2.1 4.1 0.5 1.6 0.5 1.6 Avg. 91-97 -10.2 -0.3 -1.7 -1.3 -8.9 -8.5

Uzbekistan Avg. 71-97 2.4 5.0 2.7 3.4 -1.1 -0.4 Avg. 71-90 3.7 6.0 3.3 4.1 -Q.4 0.4 Avg. 91-97 -1.5 2.2 1.3 1.6 -3.1 -2.8

Total Avg. 71-97 -{).3 3.7 0.3 1 .3 -1.6 -{).6 Avg. 71-90 2.3 5.0 1.0 2.2 0.2 1.4 Avg. 91-97 -7.9 0.0 -1.9 -1.3 �.6 �.0

most countries, the capital obsolescence prob- 1996, by which time the volume of investment

\em became more severe in the course of transi- had fallen to less than one-fourth of its 1990

tion.23 In Russia, the average age of plant and level. Since the production function in equation

equipment increased further to 14.9 years in (l) does not incorporate vintage effects, effi-

2SJn the cotmtries where investment has picked up in recent years as robust growth resumed, AzerbaUan and the Baltics in particular, large scale capital renewal has begun in earnest.

169


110


Table 5.6 (concluded)

labor Output Capital labor Factor TFP Productivity

Period Growth Growth Growth Contribution Growth Growth

Sectors

Agriculture Avg. 71-97 -1.5 2.9 -o.4 0.9 -2.4 -1.1 Avg. 71-90 0.1 5.0 -o.6 1.1 -1.0 0.6 Avg. 91-97 -B.1 -3.1 0.0 -0.9 -5.2 -B.1

Construction Avg. 71-97 -3.7 3.7 -o.5 0.8 -4.5 -3.2 Avg. 71-90 1.2 5.5 2.2 3.2 -20 -1.0 Avg.91-97 -17.6 -1.2 -8.1 -B.1 -11.6 -9.5

Industry Avg. 71-97 -o.7 4.3 -1.0 0.6 -1.3 0.3 Avg. 71-90 2.8 5.4 0.8 2.2 0.6 1.8 Avg. 91-97 -10.5 1.1 -B.2 -4.0 -6.5 -4.3

Services Avg. 71-97 1 .4 3.2 1.5 2.1 -0.6 -Q.1 Avg. 71-90 2.5 4.5 2.1 2.8 -0.3 0.5 Avg. 91-97 -1.8 -0.3 0.0 -o.1 -1.7 -1.8

Trade2 Avg. 71-97 0.9 3.7 2.1 2.4 -1.5 -1.2 Avg. 71-90 2.8 5.0 1.2 2.3 0.4 1.6 Avg. 91-97 -4.2 -0.2 3.1 2.1 -6.3 -7.4

Transport Avg. 71-97 -0.8 3.9 -o.5 0.8 -1.6 -o.2 Avg. 71-90 2.9 5.0 0.2 1.6 1.3 2.7 Avg. 91-97 -11.4 0.9 -2.5 -1.5 -9.9 -8.9

I Based on the revised aggregate growth rates. 2Assuming the growth rate of employment in the trade sector was the same in 1997 as in 1996.

ciency losses associated with increasing capital

obsolescence are reflected in the TFP growth es·

timates in Table 5.6.

An analysis of productivity developments on a

year·by·year basis offers additional insights (see

Table 5.12). A distinct V·shaped pattern in TFP

growth emerges. TFP growth was generally

sharply negative in the early years of the transi·

tion but turned positive in most countries, in

some cases very significantly so, by 1995-96, indi

cating that part of the initial sharp productivity

decline was temporary, witl1 production factors

being less than fully used. Factors such as trade

disruptions and disorganization related to the

breakdown of central planning played an impor

tant role during this initial period (Blanchard

and Kremer, 1997). Similarly, the rapid increase

in TFP in countries and sectors where outpm

growth turned positive again more recently

likely reflects a recovery in the rate of facto1·

utilization.

Sectoral Reallocation

The output decline during the u-ansition is to

a large extent accounted for by TFP losses.

These losses in turn reflect a range of factors.24

One important factor is tl1e sectoral reallocation

of inputs, which is considered to be one of tl1e

key dimensions of the transition process

(Blanchard, 1997). Since the output and input

data used in this study are available on a broad

sectoral basis, the contribution of changes in the

sectoral composition of inputs to aggregate TFP

growth can be quantified.

Following Bernard and jones ( 1996) and

Cameron and others. (1997), aggregate TFP can

be expressed as a weighted sum of sectoral TFPs,

where the weights are ratios of an index of in

puts in each sector to an aggregate index of

inputs.25

24Further research could consider to relate TFP movements to the same set of variables that are now commonly used as regressors in empirical work, in the vein of Berg and others (1999), for instance, on output movements during the transition.

25This expression assumes that the produCLion process in each sector j is characterized by a common, time-invariaiH. Cobb-Douglas production technology.


where

(4)

and j indexes sectors. Accordingly, the change in

aggregate TFP can be decomposed into a pro

ductivicy change and a share effect. Between

year ( t - 1) and year l

L1A/ A = 1/ A lLj L\Tf'J�.ro.t' + L1 L\O>_j.1Fijl-l) (5} withjn-sector effect share effect

The first effect measures the contribution of

productivicy changes within each of the six sec

tors, and the second one the contribution of

changes in sectoral composition to aggregate

TFP growth, which will be positive if resources

are reallocated from lower to higher-productivity

sectors.

Share effects computed according to Equation

(5) for both the pretransition and the transition

periods are presented in Table 5.7. For the 15 countries as a whole, the share effect accounts

for around 8 percent of the change in TFP in

the early transition years. Broadly comparable

share effects are found in the 15 countries indi

\ri.dually. Since the initial u·ansition years were

characterized by negative TFP growth rates,

these results point to a productivity reducing re

allocation of resources. The share effect is rela

tively small, however, indicating that sectoral in

put reallocation did not have a major impact on

productivity.

The productivity effect stemming from sectoral

input reallocation during u·ansition merits fur

ther examination. The sectoral composition of

inputs changed noticeably during the transition.

The shares of agriculture, trade, and services in

aggregate employment rose, while those of indus

try and, in particular, construction feJl.26 Within

industry, the share of electricicy and other energy

branches in total sectoral employment increased,

SECTORAL REALLOCATION

Table 5. 7. Contribution of Sectoral Reallocation to TFP Growth (Percent)

Pretransition Transition Period Period' Avg.1 971-97

Armenia 8.2 4.7 5.9 Azerbaijan 4.8 0.9 3.0 Belarus 9.6 18.4 12.8 Estonia -2.0 7.9 3.3 Georgia 5.8 3.0 4.2 Kazakhstan -1.1 11.1 2.3 Kyrgyz Republic 2.9 9.3 6.6 Latvia 4.6 10.0 7.3 Lithuania 5.3 13.2 9.1 Moldova -5.1 0.9 -2.2 Russia 2.8 4.9 4.1 Tajikistan -1.2 10.5 6.2 Turkmenistan 4.5 1.6 2.9 Ukraine 1.2 0.2 0.6 Uzbekistan 1.0 1 5.5 5.9

Total 5.0 8.1 7.1 1TFP growth was negative in this period.

while that of machine-building decreased. The

sectoral composition of the capital stock also

shifted, with indusu·y and transport and commu

nication gaining in importance and agriculture

declining.27 Since there was also reallocation or

inpms during the pre-transition period, for the

conu·ibution of r·eallocation to aggregate TIP tO

be different during the transition, the realloca

rion process had to change.

To examine whether this has been the case,

the following approach is adopted. For each sec

tor and counu·y, annual sectoral employment

growth rates relative to the aggregate employ

ment growth rate as well a� annual sectoral in

vestment shares are computed, according to data

availability. ext, the averages of these employ

ment growth rates and investment shares, re

spectively, are computed for the pretransition

and u-ansition periods. Finally, a bootso-ap

methodology is applied to test the hypothesis

that there was no difference between the pre-

2GThe share of agriculture in total employmem rose from less than 19 percent in 1990 tO over :.11 percent in 1997, and that of the u-ade and services sec LOr from 38 to 46!h percent (this increase in the services sector sh;u·c in most countries mainly refleclS employment u·ends in public health and education). The share or construction fel l from I I to 7 percent, and lhat of industry from 28 to 20'h percent.

27Changes in the sectoral composition of in puiS contributed to shift:. in the composition of our pur as well. During the transition, construction and industry declined as a fmction of aggregate output, while the shares of the trade and sen;ces sectors rose.

171


172


Table 5.8. Total Employment Shifts1

Industry Agriculture Transport Construction Trade Other

Armenia + 0 0 Azerbaijan 0 0 + 0 Belarus 0 0 0 Estonia 0 0 0 + 0 Georgia + 0 0 0 Kazakhstan 0 0 0 0 Kyrgyz Republic 0 0 0 0 Latvia 0 0 0 0 0 Lithuania 0 0 0 0 Moldova 0 0 0 Russia 0 0 + 0 Tajikistan + 0 Turkmenistan 0 0 0 0 0 0 Ukraine + 0 0 + Uzbekistan 0 0 0 0 0

Total + 0 + 0 1+ Denotes a significant shift towards the sector; - denotes a significant shift away from the sector; 0 denotes the absence of a significant

shift in either direction.

transition and u·ansition averages.2s The hypoth

esis is rejected if, based upon the frequency of

the outcomes for 1,000 replications, there is a

probability of 1 percent or less that a random

drawing from the sample corresponding to the

whole period would produce a difference be

tween the two sub-periods as large or larger than

the observed one.

According to this procedure, in the 15 successor states as a group, the average growth rate of

employment fell significantly during the transi

tion in industry and construction, while it in

creased in agriculture and trade (Table 5.8).

The same pattern is observed in individual coun

tries in all cases where changes are found to be

significant, with the rare exception of agri.cul

ture in Estonia. Somewhat different results ob

tain for investment (Table 5.9). The average

growth rate of invcstmen t during transition was

significantly lower in agriculture-in contrast

with the finding for employment growth-and

construction and industry, whjle it was signill

cantly higher in the housing, education, and

services sector. The downward shift in invest

ment growth in agriculture is observed in all

15 countries and may be related to the break-up

of the collective farm system with its centralized

investment decisions. The computations for the

other two sectors are inconclusive at the group

wide level, but indicate significant changes in in

dividual countries, reflecting, for instance, addi

tional investment efforts in natural resources

extraction or telecommunications projects.

More disaggregated data on the composition

by major branch of the inputs used in industry shed some light on the factors underlying input

shifts for the sector as a whole. For the successor

states as a group, the growth rate of employment

increased significantly in the electricity, fuels,

metallurgy, and food indusu·ies, whereas it

dropped significantly in machine-building (in

part reflecting the sharp reduction in mili tary

procurement) and light industry (Table 5.10).

The starkest contrasl is bet\veen electricity and

machine-building, with employmenl growth in

creasing significantly in the former branch in

each indjvidual country and falling significantly

everywhere in the latter branch. As regards in

vestment, the results tend to show Jess of an in

flection, although the machine-building branch

again stands out as one from which resources

are most clearly diverted (Table 5.1 1 ) .

28"fhe bootstrap methodology is explained in Veall (1998). The computations were executed using the Resampling S taL� software.


CONCLUSIONS

Table 5.9. Total Investment Shifts1

Industry Agriculture Transport Construction Trade Other

Armenia 0 0 + Azerbaijan 0 0 Belarus 0 + 0 0 t Estonia t 0 t 0 Georgia 0 t Kazakhstan t 0 0 0 0 Kyrgyz Republic t 0 0 0 Latvia t 0 + 0 lithuania 0 t 0 + Moldova 0 0 0 0 t Russia 0 0 0 t Tajikistan 0 t 0 0 Ukraine 0 0 t Uzbekistan t 0 0 0

Total 0 0 +

'See footnote 1 to Table 5.8.

Table 5.10. Industrial Employment Shifts1

Electricity Other Energy Metals Chemical Machines Wood and Paper Construction Light Food

Armenia t 0 t 0 Azerbaijan t t 0 0 Belarus t t t 0 Estonia 0 0 0 0 Kazakhstan t 0 + 0 Kyrgyz Rep. t 0 0 0 Latvia t 0 t 0 Lithuania t 0 0 0 Moldova t 0 0 0 Russia t t t 0 Tajikistan t 0 t 0 Turkmenistan t 0 0 0 Ukraine t t + 0 Uzbekistan t 0 0

Total + + + 0

1See footnote 1 to Table 5.8.

On the whole, these findings are consistent with a pattern of sectoral reallocation of labor inputs during the transition away from the old state firms in construction and industry toward new small-scale activities in agriculture and trade and toward service activities (including public

services), and of scarce investment resources from heavy industry to infrastructure projects in the energy and transport and communications

sectors. This would indicate that the negative

0 0 0 t 0 0 0

0 0 0 t

t 0 t 0 0 0 0 0 0 0 t 0 t t 0 t 0 0 0 t 0 0 t

0 0 0 0 0 0 0

0 0 t 0 0 0

0 0 +

productivity effect stemming from sectoral input reallocation during the early o·ansition could be related to the direction of the reallocation process, as resources appeared to have moved to lower productivity occupations. 29

Conclusions

The depth, length, and breadth of the output

contractions in the Baltic and CIS countries fol-

29.Evidence from olher studies suggests that the new small-scale private sector acth�ties are not a source of major productivity improvements (Commander and others, 1999) .

113


114

CHAPTER V THE GREAT CONTRACTIONS IN RUSSIA, THE BALTIC$, AND THE OTHER COUNTRIES OF THE FORMER SOVIET UNION

Table 5.11. Industrial Investment Shifts1

Electricity Other Energy Metals Chemical

Armenia + 0 Azerbaijan 0 + 0 0 Belarus + 0 0 0 Georgia + 0 0 0 Kazakhstan 0 0 0 Kyrgyz Rep. 0 0 0 Lithuania 0 0 0 0 Moldova 0 0 0 0 Russia + + 0 0 Tajikistan 0 + 0 Ukraine 0 + 0 0 Uzbekistan 0 0 +

Total + + + 0

1see footnote 1 to Table 5.8.

lowing the breakdown of central planning have

been massive, even when compared with the ex

perience in other transition countries in central

Europe. To explore the causes of these particu

larly sharp conu·actions, the analysis has put out

put developments in these 15 countries in a

longer-run perspective, linking the initial transi

tion years with the last two central planning

decades, with a focus on the role of factor input

and productivity changes.

The analysis is based upon official statistics,

with some minor corrections. These data suffer

from various serious weaknesses. Moreover, the

quality of the series for the transition period

varies considerably across countries, as some ex

pended more effort than others to revise initial

estimates and strengthen collection and report

ing procedures. However, alternative output

proxies suggested in the literature appear to be

of limited use to overcome the deficiencies of

the official statistics. Even so, the magnitude of

output and input changes is such that the main

qualitative insights derived from the official data

are unlikely to be affected by even m�jor meas

urement en-ors.

The Baltic and CIS countries started out with

economies that had exhausted their growth po

tential, as reflected in the fall in total factor pro

ductivity growth to near zero in the last two

decades under central planning. Capital obsoles

cence and economic distOrtions inherited from

central planning contributed tO fw·ther declines

Machines Wood and Paper Construction Light Food

0 0 0 0

0 0 + 0 0 0 0 0 0 0 + 0 0 + 0 0 0 +

0 + 0 0

0 0 0 + 0

0 +

in total factor productivity to significantly below

zero early in the transition. The output collapse

was further associated with pronounced reduc

tions in the inputs of capital and labor, as invest

ment spending in panicular was cut deeply in

Lhe early transition years. Some of the effects of

transition-related factors have been temporary,

however, which helps explain the distinct

V-shaped pattern observed for output and pro

ductivity as the transition unfolded.

A more detailed analysis shows that this sharp

faU in investment spendjng, to levels substan

tially below what would be needed for capital re

newal, has reduced both the volume and the ef

ficiency of the capital stock. At the same time,

although perhaps with the exception of the

Baltics, sectoral input reallocation failed to raise

productivity, as labor made redundant in indus

u·y and consu·uction has tended to move into

small-scale activities in agriculture and trade and

into public services, while investment in new in

dustrial activities has been minimal. The data

used here can shed no further light on the

causes underlying the investment slump and the

observed pattern of sectoral resource realloca

tion. More research drawing on additional evi

dence is called for on the incentives to invest, re

structure, and reallocate during transition.


Appendix 5.1 . Data Description3o

National Accounts

The series for output, labor, and the capital

stock are built up starting from the data set used

by Easterly and Fischer ( 1994), covering

1970-89. The data have been cross-checked

against series on the same variables provided by

the Statistical Committee of the CIS for 1980-90,

and some minor corrections introduced. Output

and capital data for the pretransition period are

level data and are expressed in "comparable

prices," a price concept that is considered not to

fully adjust for inflation. An adjustment has been

applied following Unites States Congress, joint

Economic Committee (1990), Kellogg (1990),

and Noren and Kurtzwcg (1993). Labor data re

fer to total employment numbers, unadjusted

for variations in hours worked.

This amended data set is supplemented for

more recem years by information drawn from

national statistical yearbooks (in particular for

the Baltics) , from various publications of the

Statistical Committee of the CIS (notably its CD

ROM Official Statistics of the CIS Countries, various

issues of The Statistical YeadJook of the CIS, The World in Figures (1992) and its foroughtly

Bulletin) and from the World Bank's Statistical

Handboolt, Stales of the Fonner USSR; in a few cases,

data have been obtained directly from the cen

u·al statistical offices (data from these various

sources may differ from the estimates used by

lMF country desks and appearing in the IMF's

World Economic Outloolt or in IMF Staff Country

Reports).

The output, labor, and capital stock data for

the transition period are constructed to ensure

consistency with the 1970-89 series. Output level

data for this period are extrapolated from the

preu-ansition period using information on real

growth rates. Labor data for the period 1990-97

continue to refer to total employment nwnbers,

which in most cases arc broadly consistent with

the pretransition numbers (with the possible ex-

APPENDIX 5.1

ception or employment da ta in the u-ade and

services sectors in 1996-97, which in a number

of counu·ics appear to reflect reclassification of

occupations) . The capital stock data for tl1e tran

sition period arc obtained using 1990-97 gross

investment data and applying depreciation rates

that are impmed from 1970-89 capital stock and

investment data and from information in

Kellogg (1990).

A number of countries have substantially re

vised their COP and sectoral output series, in

cluding Russia (World Bank and the Russian

Federation, Goskomstat 1995), Kazakhstan

(World 13ank, 1997), and Lithuania (for the ag

gregate output series only). ln such cases, the re

vised series are used.

TFP computaLions, in addiLion to data on out

put and inputs of labor and capi tal, require

proxies for the elasticities of output with respect

to capital and labor (Table 5.12). For this pur

pose, observed shares of factOr payments in total

product are commonly used. Reported factor

share data for the 15 countries in the sample

are, however, incomplete and, except for the

most recent yea.-s, do not reflect market

determined factor payments. Share esLimates

that could approximate elasticities of output

with respect to capital and labor can only be ob

tained on the basis of detailed adjustments and

additional information on wages and rentals, as

in Bergson ( 1 978). Rather than ino·oducing

such adjustments, output elasticities with regard

to capital and labor arc posited to equal 0.3 and

0.7 respectively, for all countries, sectors, and

years.

Finally, the statistical yearbooks of the Council

for Mutual Economic Assistance (CMEA) are

used for prctransition data on ceno-al European

comparators when no national yearbooks were

available.

Alternative Measures of Output

Elecu·icity consumption data are taken from

various publications of the International Energy

SOData referred to btl! not displayed in this paper are available from tlle authors on request.

175


176


Table 5. 12. Yearly TFP Growth Rates (Percent)

Armenia Azerbaijan Belarus Estonia Georgia Kazakhstan

1971 1.8 0.1 4.2 1.8 -2.4 0.0 1972 0.6 -0.5 2.7 -2.0 -1.3 4.7 1973 1.8 1.9 3.2 2.4 2.7 -3.2 1974 2.8 7.4 1.9 2.5 7.0 -1.6 1975 3.1 1.0 4.8 2.7 2.8 -5.7 1976 0.5 3.8 0.9 2.4 2.8 3.5 1977 0.2 0.3 -0.3 -0.5 3.3 -8.0 1978 1.7 1.9 2.0 -3.6 2.7 5.4 1979 1.6 3.7 -1.1 1.5 5.6 -1.7 1980 0.4 4.0 -2.1 -0.3 -0.6 -2.1 1981 2.7 2.8 5.3 -2.2 3.1 -3.7 1982 -2.1 -2.4 -1.7 1 .6 -3.0 -9.0 1983 -1.4 -2.5 3.6 0.8 1.0 1.7 1984 3.0 2.0 2.1 0.6 3.8 -4.1 1985 1.9 -0.7 0.8 -1.8 2.2 -0.2 1986 0.1 -0.9 3.9 2.1 -2.4 0.5 1987 -1.5 -7.7 2.7 1.4 -3.3 -1.5 1988 -4.1 7.0 -1.2 2.5 4.4 2.0 1989 7.5 -9.8 3.4 4.8 -3.8 -4.6 1990 -4.7 -8.0 -0.6 -4.0 -14.3 0.7 1991 -10.2 -7.9 -0.2 -9.8 -18.3 -4.8 1992 -59.0 -21.0 -7.3 -28.4 -37.0 -10.4 1993 -7.4 -18.3 -9.6 -11.2 -18.2 -4.5 1994 1 2.9 -17.5 -16.7 -1.4 -9.4 -15.2 1995 5.7 -12.2 -6.5 5.7 -5.6 -7.6 1996 5.1 -1.5 4.1 4.0 10.8 -0.2 1997 7.2 0.6 12.5 10.2 6.4 3.5

Agency, including Electricity in European Economies in Transition, 1994; Energy Statistics and Balances of Non-OECD Countries 1993-1994, 1996; Energy Balances ofOECD Countries, 1994-1995, 1997; and

Electricity lnfrmnation, various issues. For some

countries of cenu·al Europe and for the preu·an

sition period, those sources were supplemented

by the statistical yearbooks of the CMEA. Freight and mail data are taken from the CD

ROM Official Statistics of the CIS Countries, and

from the yearbooks published by the central sta

tistical offices of the Baltics and of the compara

tor countries.

Appendix 5.2. Alternative Summary Statistics for Aggregate Output

The chaotic nature of transition and the con

spicuous deprivation of the statistical agencies

have led some observers to give up altogether on

any attempt at deriving GDP estimates. Rather

Kyrgyz Rep. Latvia Lithuania Moldova Russia Tajikistan

-2.9 2.9 1.3 4.0 0.0 4.3 1.4 0.9 1.4 -2.8 -1.3 -3.2

-0.5 1.2 -0.8 1.9 4.4 -2.5 -1.1 1.1 1.0 -o.8 1.7 2.1 -1.0 2.1 2.2 -Q.4 0.4 1.2 -2.0 1.7 -1.3 5.4 0.2 -3.1 -2.5 -1.4 -2.4 -1.7 0.2 -2.4

0.8 -2.5 -0.8 -1.8 -0.8 0.2 -1.4 0.5 -3.0 4.7 -2.0 0.3

0.9 -1.7 -4.4 -4.2 -0.7 3.0 -0.4 1.9 4.1 -4.9 -1.1 -1.7 -4.6 -0.6 1.9 12.2 -0.7 -5.3

5.1 0.9 -0.1 1.5 0.5 -0.9 0.7 2.8 2.2 2.0 0.2 -1.2

-4.7 -1.4 -3.1 -12.1 0.5 -1.1 -0.4 4.0 5.7 8.5 1.8 1.5

0.0 0.9 4.3 0.9 0.6 -4.6 9.3 3.6 5.4 0.2 1.9 7.5

-1.1 6.4 1.3 4.2 -2.3 -14.5 5.8 -4.2 3.1 -2.2 -1.2 -2.2

-6.9 -3.2 -5.9 -21.4 -4.4 -7.6 -24.8 -41.9 -28.0 -34.4 -15.0 -25.5 -10.7 -14.5 -33.9 8.9 -9.1 -18.9 -26.3 5.3 -8.9 -36.7 -12.8 -12.5

-9.6 3.3 5.0 -6.6 -1.2 -11.0 3.0 5.1 4.1 -5.4 -2.3 -13 2 9.6 6.9 8.7 1.3 3.2 -1.2

than vainly trying to collect, adjust, and aggregate economy-wide data, their line of argument

goes, it is safer to use a single, relatively straight

forward proxy for overall activity. While obvi

ously imperfect, such a proxy is more relevant

than more elaborate but completely opaque and

de-ficient measures such as the official GDP estimates, they contend. This annex discusses the merits and shortcomings of alternative summary statistics, and concludes on a very skeptical

note.

Electricity Consumption

The most popular surrogate measure is elec

u·icity consumption. I t is sometimes casually

claimed that the long-run and even the short

run elasticity of electricity consumption with re

spect to real GDP is close to unity, even though cross-country empirical evidence points to nu

merous and significant departures from unity


Turkmenistan Ukraine Uzbekistan Total

0.7 1.1 -0.9 0.4 -3.6 -0.7 0.9 -0.6

1.0 4.8 1 .1 3.7 3.0 -o.2 5.0 1.3

-0.9 -1.5 -1.6 0.0 -6.2 2.2 3.4 0.9 -2.3 0.5 -1.2 -o.2 -4.4 -0.2 -4.9 -0.4

0.2 -2.7 -1.0 -1.7 -6.6 -2.8 2.2 -1.1 -6.0 -0.4 -2.8 -0.7 -0.7 2.0 -1.1 -o.6 -3.1 2.2 -o.9 0.8 -4.1 1.7 -5.6 0.4 -o.8 -1.0 1 .1 -o.1

0.1 1.9 -2.5 1.7 1.4 5.3 -4.1 1.0 5.1 0.5 4.3 1.7

-8.7 0.7 0.4 -1.4 1.4 -2.7 0.5 -1.7

-6.1 -7.0 -4.2 -5.4 -13.7 -4.8 -9.5 -14.0

2.0 -10.2 -2.2 -9.1 -12.0 -27.3 -5.3 -15.3

-9.7 -11.3 -2.4 -4.0 -26.7 -0.5 -1.1 -1.3 -17.0 -1.1 3.1 3.1

(lEA, 1985).31 Based on this claim, the support

ers of the electricity consumption measure have

proposed to have it replace official real GDP se

ries (Dobozi and Pohl, 1995), and have used it

to estimate the size of the shadow economy

(Kaufman and Kaliberda, 1996; Hermindez-Cata,

1997; and johnson and others, 1997).32,33 Since

electricity consumption was typically much more

resilient than officially measured output during

the great contractions (Table 5.13), those au

thors conclude that much of the underground

activity is overlooked in the published national

accounts.

APPENDIX 5.2

Agriculture Construction Industry Trade Transport

-3.8 0.3 1 .1 0.4 3.1 -10.9 -1.7 1.6 -1.0 1.4

14.7 1.0 3.4 0.4 2.6 -5.5 -o.5 3.1 1.6 3.0

-14.2 -1.1 2.1 0.8 4.7 9.5 -2.6 -0.5 0.6 1 .9 1.0 -3.1 -0.2 -Q.4 -1.6 1.8 -2.9 -0.9 -1.6 1.0

-9.5 -4.3 -0.9 -o.2 -0.2 -8.5 -1.8 -0.9 0.0 1 .5 -3.9 -1.5 -1.1 -o.6 1.2

6.7 -3.9 -1.0 -1.5 -1.6 4.2 1 .1 0.3 0.8 0.8

-3.1 0.6 1.0 1.0 -0.1 -4.5 0.7 0.3 -Q.4 0.8

9.9 2.3 1.2 -1.0 2.4 -4.1 0.0 2.2 0.7 2.8 -o.9 -3.0 2.4 4.1 8.0

6.0 -13.3 -1.2 3.1 1.6 -5.8 -6.3 -o.3 1.8 -6.5

-12.3 -8.8 -6.1 -6.0 -7.9 -12.5 -36.2 -16.5 -11.1 -15.3

0.2 -6.4 -14.6 -12.6 -20.4 -9.0 -15.5 -18.3 -8.1 -16.2 -5.2 -7.4 -o.1 -8.1 -5.0 -2.4 -8.6 1 .0 -1.9 -3.6

5.1 1.7 8.9 -4.9 -1.1

Relying on overall electricity consumption as a

proxy for actual GDP is a bold move, however,

given the numerous reasons for divergence be

tween the two series. On the one hand, sources

of upward bias include the following:

• a significant portion of the electricity con

sumed by enterprises is used for overhead

purposes and hence does not fall as much

as output;

• the share of electricity in the energy mix is

likely to rise over time as modern,

electricity-intensive industrial processes are

being adopted (although arguably this may

SISuch deviations do not mean that GDP is not a key determinant in econometric analyses of electricity consumption. S2"fhe Iauer· authors do not assume universal unit elasticity, but rather distinguish three groups of countries according to

their presumed degree of energy efficiency. Their typology is a welcome recognition of t11e inadequacy of a uniform elasticity assumption, but it is derived on a completely ad hoc basis. FurtJ1ennore, t11ey admit t11at massive energy substitution in Armenia and K)'l·gystan prevents them from applying t11is metJ1odology to t11ose countries. They also exclude Tajikis tan and Turkmenistan from the sample, lacking data on electricity use for those countries.

ssrn a related auempt for Romania, Dobrescu (1998) constructs estimates of the shadow economy in Romania based on total pr·imary energy consumption.

177


178


Table 5.13. Cumulative Decline in Measured Real GOP and Electricity Consumption (Percent decline between historical peak and trough of contraction or 1997)

Fall in Electricity Real GOP Contraction Consumption

Armenia 56 481 Azerbaijan 66 24 Belarus 37 33 Estonia 42 28 Georgia 75 around 50 Kazakhstan 42 30 Kyrgyz Republic2 49 -17 Latvia 53 43 Lithuania 41 45 Moldova 65 58 Russia 42 23 Tajikistan 68 20 Ukraine 60 34 Uzbekistan 1 9 15

Baltics and CIS 44 26


Bulgaria 27 27 Czech Republic 21 1 1 Hungary 1 8 12 Poland 14 12 Romania 30 30 Slovakia 15 13

Sources: National statistical offices; CIS, Statistical Committee; CMEA Yearbooks; lEA publications.

1Quring 199G-93. 2Eiectricity consumption increased between 1990 and 1995.

occur mainly once output and investment

are recovering rather than during the ear

lier phases of transition);

• residential electricity consumption, which

typically represented between one tenth

and one ftfth of total electricity use at the

onset of transition, has displayed consider

able inertia or has even increased in some

countries (e.g., Belarus, Estonia, and

Tajikistan), reflecting increased use of

portable electric heaters as a substitute for

scarce heating oil (e.g., in Moldova) and of

other electrical consumer devices (notably,

kitchen appliances) ;34.

• likewise, network losses have seen their

share in total consumption increase, often

even rising in absolute terms, owing to the

deterioration of the infrastructure in a pe

riod where investment plummets and funds

for maintenance are squeezed.

On the other hand, there are also reasons for

the evolution of electricity consumption to un

derstate that of activity:

• the composition of value-added shifts away

from traditional heavy, energy-voracious in

dustries to services and other activities that

are less energy intensive;

• the resilience of residential electricity con

sumption partly results from the expansion

of private entrepreneurial activity under

taken from private dweJlings due to the lack

of business space (e.g., in Ukraine);

• the rising share of losses partly reflects un

derground activity;

• the relative price of electricity typically in

creases, helping reduce wasteful consump

tion (alLhough in practice electricity bills

are often left unpaid).

When comparing electricity consumption in

peak and trough years, one should furthermore

take into account weather conditions, since tl1ey

influence this variable more than they affect

GDP. On the whole, it is thus very hazardous to

assume any simple relationship between electric

ity use and real GDP. In the Baltics and the CIS

countries as a group, where electricity consump

tion fell by around 27 percenl between 1990 and

1997 compared with a decline in officially re

ported (weighted) output by 43 percent, the ob

served significant shift in inputs of labor and

capital toward electricity production and away

from other industrial activities during the o·ansi

tion further weakens the arguments supporting

the existence of any such simple relationship.

The case for caution is reinforced by a look at

Finland, which also experienced a major reces

sion in the early 1990s (partly for reasons related

to the transition in neighboring Russia). Since

the quality of the national accounts data is far

superior in Finland, it is safe to assume that

measured GDP closely matches actual GDP in

S4]n the case of Belarus, for example, the increase in household consumption of elecuicity was equivalemw 2.9 percent of rotal electricity consumption in 1989 and 4.3 percent of total elecu·icity consumption in 1995.


that country. The evolution of electricity use in

the course of the Finnish recession (Figure 5.1)

shows that it can be a very poor proxy for real

GDP, overstating it by a considerable margin

during a large-scale contraction.35 Indeed, elec

tricity use rose by almost 6 percent in the course

of the three-year GDP contraction, with half of

the increase accounted for by rising residential

consumption. 36

Freight and Mail

Prior to transition, freight was widely consid

ered to be a sturdy proxy for overall economic

activity, both inside the former Soviet Union and

by Western analysts.37 Some observers have ar

gued that this remained true in the 1990s, claim

ing that transportation data are relatively reli

able, especially as regards freight.38 The bulk of

freight trafftc, it is argued, consists of rail and

pipeline transport and as such is mostly correctly

registered. Even road transportation, the con

tention goes, can be estimated fairly accurately,

thanks to police records of vehicle numbers, and

peu·ol production and sales.

In the case of Russia, there exists a roughly

homogeneous series for overall freight, but only

from 1991 and only for turnover (i.e., reflecting

both volumes and distances) .39 It shows a cumu

lative decline of 38 percent between 1991 and

1996 (which is exactly in line with the official

measure of real GDP), followed by a further

S5[t also serves as a reminder that over the longer nm, the elasticity of electricity consumption vis-a-vis real GDP may exceed unity.

S6£xtending the cross<ountry comparison beyond Finland, it can be noted that over the past two decades, Mexico, Portugal, and Turkey saw electricity consumption increase during episodes of significant real GDP con traction.

37ft was also cherished for its timeliness and used as an advance indicator.

38See for instance Russian Economic Trends, Vol. 5,

No.4.

39J'he series for volumes shipped is consistent only from 1993 (wben Goskomstat started to incorporate estimates for private road transpon). It shows a cumulative decline of 44 percent between 1993 and 1996, against a cumulative decline of 19 percent for the turnover series.

Figure 5.1 . Finland: Real GOP and Overall Electricity Consumption

600 -

APPENDIX 5.2

- 80

0 I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I 0 1960 65 70 75 80 85 90 95

Sources: Statistics Finland: and International Energy Agency.

179


180

CHAPTER V THE GREAT CONTRACTIONS IN RUSSIA, THE BALTICS. AND THE OTHER COUNTRIES OF THE FORMER SOVIET UNION

Figure 5.2. Finland: Real GOP and Total Freight Turnover

550 -

500 -

450 -

400--

350 -

Source: Statistics Finland.

Total freight (billion tonsfkm)

(right scale)

I I 85

I I 90

-45

-25

-20

-15

-10

- 5 I I 0

95

drop of 3.6 percent in 1997 (in contrast with a

0.8 percent increase in the official measure of real GDP). Interpreting this evidence one way or

the other is hazardous, however, not least for sev

eral of the reasons already mentioned in the case of electricity consumption.

If in general there were to be a strong correla

tion between freight and real GDP, several fac

tors would weaken it in the countries under con

sideration. Some of the new or expanding

activities, such as financial services, are presum

ably less transportation intensive than traditional

ones, while others, such as trade, may be more

so. In some ways, transportation arrangements

were notoriously inefficient in Soviet Union

(Holt, 1993; and Strong and others, 1996), im

plying that part of the decline in freight may not

correspond to any decline in value·added.

Changes in the relative price of transportation

(adjusted for nonpayments) would also have a

bearing on turnover, discouraging the haulage

of heavy shipments of low value over long dis

tances. Furthermore, the intrinsic reliability of

the transportation data is probably overstated by

the supporters of this proxy. Even so, the case of

Finland suggests that if anything, freight might

be no worse a proxy for real GDP than electricity

consumption, although again it declined much

less than real GDP during the Finnish recession

of the early 1990s (Figure 5.2) .10

Another and more exotic proxy for real GDP

is the number of letters, newspapers, and parcels

mailed. Perhaps surprisingly, given the rapid de

velopment of electronic communications, this

indicator turns out to be a rather better proxy

for real GDP in Finland dUTing the recession

than the two preceding ones, even though the

correlation remains rather loose, especially on

the upturn (Figure 5.3) .11 By and large, mail

traffic also moves in tandem with real GDP in

other OECD coumries, including during the

mid-1970s recession (Bonsall and Rickard,

40Thc long-run elasticity of freight to GDP is clearly less than one, though, in contrast to electricity consumption, which tends to rise faster than GDP.

41As with freight, the long-nm elasticity is clearly below unity.


1988). Analogous data are available for Russia. They show mail traffic rising much less in the 1970s and 1980s than officially measured aggregate output and subsequently collapsing much more abruptly, with a cumulative decline of 83 percent between 1990 and 1996.42 Likewise, the collapse in mail traffic was much more pronounced than that of measured value-added in

the Baltics and in all the other states of the former Soviet Union, for mail in general as well as for letters, newspapers, and parcels separately.43

It may be tempting to interpret the long-run pre·transition relationship as one more sign that the official output series may have been upward biased,44 but it is hard to believe that the real economy would have melted down as much during the first half of the 1990s as this proxy would imply.

Lessons

On closer inspection, none of the three alternative proxies thus seems to constitute a u·ustworthy surrogate for actual GDP. Even if in ad

vanced market economies some of tl1em at times move closely in tandem with GDP, the correlation is too weak to warrant their use as such. Even so, the sharp falls in electricity use, freight, and mail observed in the Baltic and CIS countries support tile view that the magnitude of the economic contraction was indeed extreme.

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·13Qnly for letters in Lithuania are the two indicators commensurate. ln tlte comparator countries of central Europe, the divergence between the two iJldicators was much smaller, and not systematically in the same direction.

�Koen (1994} discusses oilier reasons for tllis probable upward bias.

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Figure 5.3. Finland: Real GOP and Mail

550-

250-

-2500

2000

200 1LL1�LL�'�'LL�� 0 1970 75 80 85 90 95

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183


184

EMU CHALLENGES TO EUROPEAN LABOR MARKETS Rudiger Soltwedel, Dirk Dohse, Christiane Krieger-Boden, and the IMF Research Department

0 n "E-day,"January 1 , 1999, phase 3 of

the Economic and Monetary Union

EMU for shon1-became realicy. The

euro area comprises all European

Union member states and Sweden, Denmark,

and the United Kingdom, which voluntarily

abstained.

In the run-up to the !ormation of monetary

union, questions of ftscal convergence, the ade

quacy of the conversion exchange rates, and the

stabilicy of the euro have been predominant in

the currency union debate. By contrast, relatively

little attention has been paid to the labor market

implications of EMU. This is all the more strik

ing since labor market performance in the euro

area is crucial for the long-run success or failure

of the monetary union: with the introduction of

the euro, the exchange rate and monetary poli

cies will no longer be available at the country

level as tools for macroeconomic adjustmem.

Furthermore, fiscal policy has been constrained

by the Pact on Stabilicy and Growth. The only

way to avoid (or at least reduce) undesirable

quanticy adjustments to shocks is to make mar

kets more flexible. The formation of EMU thus

adds urgency to the need tor structural reform.

A currency area as large and heterogeneous as

the euro area requires a high degree of flexibil

ity to successfully exploit the potential efficiency

effects of the monetary union. That market flexi

bilicy has been seriously deficient in the past,

though, is apparent in the high level and re

gional concentration of unemployment in most

EU member coumric . In this chapter, we focus

on the regional problems of EMU, with "re

gions" referring not only to member states but,

importantly, also to the subnational regions, and

we discuss ways of coping with the adjustment re-

quirements in the various regions of t.he eut·o

area.

We will start our analysis by reviewing the sta

lllS quo in the euro area from the perspective of

optimum currency area (OCA) theory. This fa

ciJitates identifying those countries that may run

into difficulties under the regime of EMU (first.

section) . We will then describe that European

unemployment is to a large extent a regional

problem within counu·ies. This aspect has as yet

not been given much attention in the debat.e on

monetary union. We will argue that any auempt.

to successfully reform European labor markets

and "make them fit for EMU" has to take the re

gional perspective and even a more decentral

ized, firm perspective imo account (second sec

tion). Therefore, structural labor market reform

may also have to bling about a greater institu

tional diversity to deal with the growing need for

choice in employment relationships and tO allow

greater scope for the exploitation of murually

profitable contracts between labor and firms

(third section). The final section presents

conclusions.

The Optimum Currency Area Criteria

Exchange Rates and Asymmetric Shocks

We can be brief on the often described upside

of the prospects for employment: A single cur

rency reduces the transaction costs between

agents in diffe•·ent EMU countries, and hence

raises the static efficiency of the economy. lt

eliminates the exchange rate lisk as well as d1e

costs of currency exchange and hedging, which

is just another way of saying that the reaJ re

sources employed in foreign-exchange u·ading

1Throughout Lhis paper we use the abbreviation EMU for the Economic and :\1onetary Union, following its widespread use in Lhe literature (see Alsopp and Vines, 1998; Calmfors. 1998; Eichengreen, 1998; OECD. 1999; Mauro, Prasad. and Spilimbergo, 1999).


can be shifted to other productive uses (Kenen,

1997, p. 212). Furthermore, transparency in

creases and this increases the intensity of compe

tition in goods and factor markets, raising also

the dynamic efficiency of the economy. This in

turn stimulates innovation, investment, trade,

and growth, thereby improving employment

prospects.

On the downside, monetary union heightens

labor market risks. The Lheary of optimal currency

areas establishes that exchange rates are a useful

tool for macroeconomic adjustment in the case

of asymmetric shocks. Exogenous demand and

supply shocks that hit countries asymmetrically

require a response of real exchange rates be

tween these countries in order to adjust relative

real wages between these countries. This could

be accomplished either by adjusting nominal ex

change rates or else by adjusting nominal goods

and factor prices in one country relative to the

other country-otherwise such asymmetric

shocks might result in an increase in unemploy

ment. Nominal exchange rates can therefore be

seen as "a device whereby depreciation can take

the place of unemployment when the external

balance is in deficit, and appreciation can re

place inflation when it is in surplus" (Mundell,

1961, p. 657). A member of a currency union

loses this device for a spontaneous (in the case

of flexible exchange rates) or discretionary (in

the case of fixed exchange rates) macroeco

nomic response to shocks. Hence, asymmetric

shocks in a currency union exert increased pres

sure on national labor markets and entail a sub

stantial risk of rising unemployment.2 A rise in

unemployment due to the loss of exchange rate

flexibility can only be excluded if (at least) one

of the following three conditions holds:

• the exchange rate mechanism between EMU

countlies does not work in the shock absorb-

THE OPTIMUM CURRENCY AREA CRITERIA

ing way predicted by theory, so that nothing

would be lost by giving up this device, or

• there is little probability that members of

EMU are hit by asymmetric shocks, or

• labor markets are flexible enough to adjust lO

asymmetric shocks without a rise in

unemployment.

With respect to the ftrst condition, there is a

controversy in the literature over whether nomi

nal exchange rates really do act as shock ab

sorbers in the way predicted by OCA theory. An

immediate response of the nominal exchange

rates to a shock cannot be taken for granted, it is

argued, because apart from trade flows a great

number of other factors influence nominal ex

change rates, making their movements look like

a "random walk." Moreover, since the deprecia

tion of a currency leads to an import-price in

duced rise in inflation, domestic workers might

try to raise t.l1eir nominal wages in order to com

pensate for the real wage loss, thereby offsetting

the shock-absorbing effects of the depreciation.

There is evidence that exchange rates be

tween EU member states in the past have in vari

ous instances played an important role as shock

absorbers (with the experiences of Italy and

Finland in the early 1990s as conspicuous cases

in point; see Box 6.1) .3This empitical evidence

is in line with mainstream economic reasoning,

which holds that exchange rates provide a useful

tool for macroeconomic adjustment if

• the change in the nominal exchange rate

leads to the required change in the real ex

change rate, or

• such adjustments do not happen too often

(since they require a certain degree of ex

change rate illusion), or

• the exchange rate adjustment is accompanied

by a credible policy change addressing the

2Shocks can be temporary or pcrmanem, on the demand or supply side, and sector, region, or COlllltry specific. Permanent shocks are typically supply side related, whereas temporary shocks are typically demand side or policy induced (OECD, 1999, p. 91). Thus. when speaking about shocks in the monetary union, we usually have supply side shocks in mind. Nevenheless, one should be aware that even temporary (region-specific) shocks may have long-run effecLS on output if hysteresis effects are evident (OECD, 1999, p. 113; Mauro, Prasad, and Spilimbergo, 1999, pp. 5-11 ).

3More evidence on successful-as well as less successful--currency devaluarions is given in Dohse and Krieger-Bod en (1998, pp. 30-32). See also De Grauwe (1994, 1996) and Dornbusch (1996).

185


186

CHAPTER VI EMU CHALLENGES TO EUROPEAN LABOR MARKETS

Box 6.1. Exchange Rates as Shock Absorbers: Italy and Finland

Italy was hit hard by the shock of

German unification and the ensuing

boom in economic activity in Germany. To keep inflation at bay, the

Bundesbank pursued a Light monetary

policy. The resulting strength of the

deutscbe mark forced Italy-as well as

several other EMS countries--to pursue a tight monetary policy to defend the

lira's external value \ois-a-vis the

deutsche mark (see figure). However,

at the same Lime, Italy went into a re

cession: the lira was ovet·vaJued and the

country's export perfunnance was poor. The EMS crisis in September 1992 caused a sharp nominal deprecia

tion of the lira, and Italy (as well as the

United Kingdom) left the exchange

rate mechanism. In contrast ro earlier

nominal depreciations of the lira, this

Lime the nominal depreciation led to a

similarly strong real depreciation. This was achieved by fundamental reforms

such as the abandonment of the scala mobile in 1992, a wage indexation

mechanjsm that had speeded up the inflationary effects of Italian monetary policy. The depreciation of the lira

proved beneficial for Italy: it improved the country's price competitiveness and

led to fast growth of the export sector, a better external trade balance, and stabi

li7.ation of GDP and employment.

Finland wem into a deep crisis in the

early 1990s: COMECON vanisbed as a major o-ading partner, world recession

hir exports, and pulp and paper prices

fell sharply. A skyrocketing increase in unemployment from a moderate 3.5

percent in 1990 to more than 18 per

cent in 1994 was accompanied by a massive rise in the budget deficit. After

Exchange Rates as Shock Absorbers: Italy and Finland

10 -

5

Economic Development in Italy 198D-97

Effective exchange rate (annual average change, In pen:ent)

Output and employment

5 _ (annual average change. in percent)

3

-3 -

Trade balance with the rest ott he EU (millions of dollars)

1000 -

500 -

-500

Economic Development in Finland 198o-97

Effective exchange rate (annual average change, in percent)

Nominal' - 10

5

0

- -10

Output and employment (annual average change. In percent)

_ 10

I I I I I I I I I I I I I I I I I ' -1Q 198183 85 87 89 91 93 95 97

Trade balance with the rest of the EU (millions of dollars)

--100

-1QQQ I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I t-300

198183 85 87 89 91 93 95 97 t98183 85 87 89 91 93 95 97

Sources: IMF, lntematronal Rnancl81 Statistics (various issues): OECD, Monthly Stallstlcs of

Foreign Trade (various issues): Deutsche Bundesbank, Devisenkursstatistik (various issues):

and authors' calculations.

'Real and nominal effectrve exchange rates of the lira (llnmark) vts·:l-vts the currencres of the other EU member states.

trying to defend the exchange rate vis-a-vis the

deutsche mark, the central bank finally abandoned

this strategy attd allowed a drastic depreciation of

the Finmark. This nominal depreciation translated

into a long-lasting real depreciation. Although a

drastic fall in output and employment could not be

averted, the depreciarion helped the Finnish econ

omy LO become competitive again relatively quickly.

Thus. the foreign sector mitigated the extem of the

ouLput decline (Dornbusch, 1996, p. 31).


root causes of the problems that necessi tate

the need for adjustment.

Hence, we conclude that the exchange rate

mechanism did work as an effective "absorber"

for asymmetric shocks on several occasions in

the past.

However, will there still be much need for

shock-absorbing mechanisms in the euro area?

Sometimes it is argued that the problem of asym

metric shocks will no longer be of much rele

vance because the major sources of asymmetric

shocks have been eliminated (Emerson and oth

ers, 1990): there will be no more country

specific shocks from inconsistent national mone

tary policies or from speculative attacks on

national exchange rates; moreover, the scope for

destabilizing national fiscal policy is constrained.

However, even a common monetary policy in

the euro area may be a source of asymmeu·ic

shocks to member countries (and their regions).

In the case of the U.S., for exan1ple, the federal

monetary policy has been found to create asym

metric shocks to U.S. regions because of struc

tural differences of their economies (Box 6.2; see also Carlino and DeFina, 1998 and 1999;

Ramaswamy and Sloek, 1997).4 Numerous empirical studies have dealt with

the probability of asymmeu·ic shocks in EMU,

analyzing the variability of output fluctuations as

well as real exchange rate va1iability in the past.

In these studies, the experiences of EU member

states have been compared to those of existing

single currency areas such as the United States

and Canada or to those of European regions,


taking pre-euro individual EU countries as cur

rency unions . .? In a nutshell, the result of these

studies is:

• variations of output are more synchronized

among EU member states Lhan among re

gions within individual member states, and

• va1·iations of real exchange rates are smaller

among EU member states Lhan among re

gions within individual member states.

This evidence suggests that several EU mem

ber states have been hit by various asymmetric

shocks in the past and did adjust to them by a

price response (parlicuJarly by a change of the

nominal exchange rate) rather than by a quan

tity (output) response. In a core group of coun

tries-Germany, France, the Benelux countries,

Austria, and Denmark-asymmetric shocks have

been relatively rare as variations of output and of

real exchange rates were quite similar; by con

Lrast, the incidence of asymmetric shocks has

been rather high for Porntgal, Greece, Spain,

ltaly, the United Kingdom, u·eland, Sweden, and

Finland.6

However, these historic patterns of susceptibil

ity to shocks may not persist in the euro area.

The future probability of asymmetric shocks will

depend upon the underlying economic sLruc

tures of the counu-ies participating in the cur

··ency union. The critical question is how EMU

will affect this structure and what the impacr. will

be on the synchronization of their respective cy

cles. Two alternative tendencies are discussed in

the literature:

4ft has also been argued Lhat lixing the enu·y exchange rate at too high a level may represent a shock with long enduring effects that are difficult to overcome (Barrell and Pain, 1998). The decision of Britain in the mid-1920s to return to its prewar gold standard parity may come to mind in lhis context, as well as the case of' cast Germany in the process of reunilica· Lion (see below in Box 6.2). RecenLI)'• Wolf' (1999) has argued along these lines that Germany, by picking roughly the EMS exchange rate, was locked into an overvaluation lhat reduced Lhe competitiveness of the economy, given the wide gap in unit labor cosrs compared to major euro-area countries. However, lhe deutsche mark-ECU exchange rate has prevailed for quite a long time without markets betting on an imminent German devaluation during L11e EMS period.

5See for instance De Grauwe and Vanhavcrbeke (1991), Bayoumi and Eichengreen (1993), Decressin and Fa tas (1995); for an overview see Dohse and Krieger-Boden ( 1998, pp. 19-21).

6These empirical results are in line with standard open-economy macroeconomic 1·easoning that predicts that lhe small. open economies in the EU are subject to asymmetric shocks to a greater extent than the larger economies. The reason is twofold. Small economies are typically less diversified L11ar1 large economies, so lhat indusu·r- or secLOHpecific shocks affect a small economy more su·ongly thar1 a large economy. Moreover, lhe small economics at the periphery of the EU are more exposed to shocks from outside the EU than the economies a1 lhe center-for example, Germany or France (see Hagen and Hammond, 1998, p. 337).

181


188


Box 6.2. Euro Area's Most Prominent Problem Regions1

Germany's "Neue Lander"

In unifYing with west Germany, east

Germany's economy was hit by a conversion

shock: wages, rents, and pensionl. were converted at a rate I :1 from eastern marks into

deutsche mark. This political!) dctennined con

version rate rranslated imo wage costs explosion

for cast German producers exceeding product.iv

it) levels by far. (Based on productivity levels, a

conversion rate of 4:1 or even 5: I would have

been adequate.) The effect was a strong real ap

preciation, sharply raising the prices of e�t

Germany's output and thus jeopardizing the

manufactudng sector's competitiveness. A mas

sh·e deindustrialization took place to an extem

that was unique among the transition countries

in cenu·al and eastern Europe: within one vear

following the economic, social, and mone�y

union in 1990, industrial production dropped to

one-third of its 1989 volume and GDP dropped

by one quarter. In the transition process from a

socialist economy to a market economy a large

part of the east German capital stock became

obsolete.

The problems were aggravated by the fact

that-under the impression that mass migration

might be flooding west German} (in 1989 as

well as in 1990 cast German} lost abom 5 per

cent of its population)2__Lhe east German wage

rates were rapidly adapted to western lew b. im

plying that wages in the east rose much faster

than productivity. The consequence was a fm

t.her loss of competitiveness and a subsequent rise in unemployment. In the second quaner of

1990, monthly wages and salades per employee

were, on average. 20 percent higher than in the

roECD. Eammmc Sun�s (various 1$.\Ues): Boltho and others ( 1997): OIW, IIW and IWII (various i� sues): Fairu and others ( 1997); Gerling and Schmidt (1997): Schau and Schmidt (1992): Soltwedcl (1998a and 1998b).

2J lowevcr, after it became clear that "the dour would remain open" net-migration decreased marked!) and did �tabilizc at a low lc\CI after m•d-1991.

fourth quarter of 1989 and 26 percent higher

than in the third quarter. Funhennore, the west

German wage bargaining system, cllaraClerized

b) its COT.) corporatbm, was extended to east

Germany with the Treaty for an Economic,

Monetary and Social Union that took t'ffect as

of July I, 1990. The combination of ccmraJized

wage bargainmg, too-high aggregate wage levels,

and massive income transfers from the west to the cast has prevented a market re pon� to the

growing labor market disequilibdum and hin

dered the economic reco,·ery of the German

east.

Arguably, it was the combination or conver

sion, wage explosion, and immediate and com

plete opening of the east GermaJl market to

western producers that caused the collapse of

ea�t German manufacturing. A more gradual

process of integration-if possible at all-might have been less costly by allowing a more gradual

adjttstmenL \imilar to the proce...ses in other

highly indu\trialized transition economies.

lta�-y :S Mez.:.ol(iorno hair is used to ha,ing substanual regional dis

parities in employment and income. The north

ern parts of the country are traditionally more

prosperous than the \Outhern rt•gions. It is now

worthy, however, that during the last dl!cadc re

gional unemploymen1 dispadties have in

cre�cd. The observer is confromed with an

empirical puulc, as faJiing migration goes hand

in hand \\ith growing unemplo\mcnt difTeren

tials among Italian regions. What are the reasons for the low and falling labor mobility in

Italy? According to Faini and others (1997) it is a combination of high mobility co�ts. incfficiem

regional matching, and demographic factors. The authors find that the main rc ponsibilit)• for

the high mobility cosL� lies with the housing

market, which is heavily curtailed by rent con

trols and high taxation of housing tran-.action .

Furthermore, large welfare payments and inter

regional transfers reduce the interregional dis

parities in real income, inducing the unemployed to stay in their horne region. The


inefficient matching is due to a peculiarity of the Italian labor market: compared to other countries, Italy's unemployed tend to rely to a disproportionate extent on networks of family and friends in their job search activities. Since these are typically local networks, they don't provide information on job opportunities in

other regions. The aging of the society may be a

Frankel and Rose (1998) argue that an in

creasing synchronization of business cycles

within EMU may be expected, because trade

lirtkages between European regions are likely to

increase further. Any shock that will hit a certain

region or couno·y will thus be passed on quickly

to all other regions and countries by way of

trade linkages. Moreover, it is reasoned that the

tighter international trade linkages between the

participating counu·ies will make their economic

structures and their business cycles more similar

and asymmetric shocks less likely. Such an out

come is considered to be most relevant if de

mand shocks (or other common shocks) pre

dominate or if intraindustry trade accounts for

most of trade.

An opposite line of reasoning has been devel

oped by Krugman (1993) 7 who argues that the

enhanced integration triggered by the monetary

union (and even before by the Single Market)

will entail an increasing specialization of coun

tries (and their regions) that will, in tum, in

crease the likelihood that a given shock will have

asymmetric effects on different regions because

of differences in their production structure. The

Krugman argument focuses on new opportuni

ties for the exploitation of scale economies (e.g.,

localized knowledge spillovers) that foster the

spatial concentration of industries.8 In this case,


further reason for the observed reduction in mobility.

National (sectoral) wage bargaining impedes regional wage flexibilicy and, furthermore, there exists a large informal sector in Italy, such that part of the labor market adjustmenL does not occtJr in Lhe "official" economy but rather outside in the economia sommersa.

EMU will increase sectoral and regional special

ization in Europe, such that the probability of

asymmetric shocks will not necessarily decrease,

but may even increase as a result of EMU (see

Figure 6.1 for a stylized description of the two

lines of reasoning).

On theoretical grounds both hypotheses seem

equally plausible, and the empirical evidence is

inconclusive so far. Frankel and Rose (1998)

present economeu·ic evidence on synchroniza

tion of business cycles using data for 20 industri

alized countries covering a 30 year period.9

Krugman (1991) presents empirical evidence

that the currency union in the U.S. entailed

more regional divergence rather than more ho

mogeneity. For Europe, evidence is scarce and

does not provide clear-cut results. Our estimates

suggest that in the early 1980s regional special

ization increased in most EU countries, whereas

particularly in the early 1990s it decreased in

most counoies (Table 6. 1 ) . A.miti (1997) and

Brulhart ( 1998), too, find evidence of an in

crease in regional specialization within Europe

in the period of l 980-90.

In models of the "new economic geography"

(see Krugman and Venables, 1995) it is even ar

gued that in the long run the relationship be

tween integration and regional concentration

may be nonlinear and possibly reversing.

7DeCrauwe and Vanhaverbeke (I 99 I ) argue along similar lines. 8 Jaffee and olhers (1993) presem empi.-ical evidence on localized knowledge spillovers. 9frankel and Rose (1998) found increasing S)'llChronization in a sample of20 countries including the U.S., Canada, and

Japan. However, !.hey did not go as far as to suggest a currency union for all countries in their sample.

189


190


Figure 6.1 . Integration, Specialization, and Asymmetric Shocks

FrankeVRose line of reasoning

Krugman line of reasoning

Moreover, one may have to take into considera

tion that t.he very formation of EMU represen 1..s a major structural break, which ma)' change the

relationship between integration and specializa

Lion that was effective in the past. Given these

uncertain Lies, t.he proposition that EMU through

its realization will secure its own success has to

be taken with a grain of sail. Policy should there

fore take a cautious stance and prepare for potential shocks.

The Flexibility of National Labor Markets

Without the nominal exchange nue as a shock

absorber. the effects of asymmetric shocks as well

as failures in pursuing an employmem-enhanc

ing wage policy (e.g., real wages rising faster

than productivity in the face of persistent unem

ployment) will hit t.he labor markets more heav

ily than before; hence, labor market flexibility is

cruciat.tu Flexibility i11 labor markets may be at

tained by a broad array of different insu·umems

that to a certain degree are substitmes: (aggre

gate and relative) wage Oexibility, working time flexibility, and spatial and job mobility etc.

(Figure 6.2).

AlLhough there is empirical evidence t11at real

wages do react to changes in uncmploymem

(Larard and others, 1994; Tyrvai nen, 1995)

there is hardly disagreement that agJ.f''l'gate wage jlRxibility in most EU member counu·ies is too

low. Furthermore, the experiences ofvalious

European countries (e.g., Sweden and hal)') sug

gest that even where aggregate wage Oexibility is

relatively high it is not sufficient to resLOre and maintain labor market equilibrium in the era of

increasing global i7.ation and intensified \\'Oriel

wide competition. Aggregate wage flexibility

must be accompanied by a high degree of relative

tol lowevcr, it is not sure whether increased labnr marker !lexibiliry is capable of replacing the buffer function of flexible exchange rates for tmsrnchroni7.ed cyclical fluctuation within tlw euro zone. In fact, casual empiricism seems to suggest that cyclical nuctuations seem to be larger in llexible (e.g., the United States) than in inflexible (e.g .. Fraucc) labor markets.



Table 6.1 . Coefficients of Specialization in Manufacture, EU Countries, 1980-931

Sweden Finland Denmark Germanyz Austria Netherlands United Kingdom France Italy Spain Portugal Greece

Coefficient 1993

34.9 46.6 41.2 18.5 32.1 30.5 12.13 11.2 27.0 29.23 55.2 60.43

Source: OECO (1996b), author's calculations.

1980-85

0.6 -9.7

0.4 3.5 1.0 4.1 0.0 1.3 2.0 1.8 9.9 6.0

Change of Coefficient

1985-91

1.5 3.0 2.7

-2.3 -1.9

0.8 3.4 1.4 1.0 0.9 2.3

-0.2

1990-93

-Q.4 6.8

-1.8 0.5 2.7

-6.8 -2.33 -0.4 -o.3 -0.43 -7.0 -1.23

1A coefficient of specialization (CS) compares the sectoral structure of a given economy with that of a reference economy, here: with the EU average. Definition: CS = l:!sg- s,lwhere Sg and s, are sectoral shares in total value added of manufacture of the given and the reference economy, respectively. A coettic1ent of 0 indicates completely identical structures. whereas the structures are the more divergent the higher the coeffi· cient is. Belgium, Luxembourg, and Ireland are not included due to data limitations. The coefficients have been calculated on the basis of the three-digit I SIC-classification, I.e., on the basis of 20 industrial sectors.

2Western Germany. 30ata for 1992 and 1990-92, respectively.

wage jlexibiliLy, regionally, sectorally, and accord

ing to worker qualifications. However, in Europe

relative wage flexibility is too low to help bring

unemployment down lO acceptable levels. High

levels of unemployment compensation tend LO act as disincentive to work; minimum wages and

high marginal taxes on labor reduce the de

mand for labor, especially for low-income work

ers. Also, existing wage formation systems in

Europe are not designed to cope with the in

creasing heterogeneity of firms (Bickenbach and

Soltwedel, 1998).

WoTking-Lime jlexibilil)�within a certain

range-may substitute for insufficient wage flexi

bility. Increased working-time flexibility can help

raise productivity and thus improve competitiveness. Working-time flexibility is relatively high in

the United Kingdom, Ireland, Portugal, the

Netherlands, and France, and relatively low in

Germany, Greece, and Belgium (Dohse and

Krieger-Boden, 1998, pp. 58-60).

Also, geographical and job mobility (i.e., the will

ingness of workers to change employer, occupa

tion, and/ or place of residence, if necessary)

may ease the strain on wages after a shock and

may help maintain a higher level of employment

at a given wage level (OECD, 1994, p. 64). By

contrast, instimtionaJ constraints on mobility.

like high costs or hiring and firing, may

strengthen insider positions in the wage b<u·gaining process and Lints comribULe to reducing not

only job mobility but also wage flexibility. In

Europe, such constraints are widespread and as

a result the mobility of labor is extremely limited

not only among European countries, but also

within them.

Although some institutional changes have

been made in several EU member states (e.g., by

reductions in the stringency of collective wage

agreements and by increasing working-time Oexi

bility), attempts to reform labor market instiLU

tions thoroughly have been half-hearted. Only

the United Kingdom, the Netherlands, and, to

some extent, Denmark have implemented a

broad and relatively consistent mix of reforms LO raise flexibility. In all other member states of the

EU, current labor market Oexibility is still far too

low. Indeed, several countries are moving in the

wrong direction; for example, France and Italy

by seeking to introduce a compulsory 35-hour

working week. This bleak assessment of labor

market flexibility in the euro area suggests that

in most European countries many modes of la

bor market adjustment are not functioning well.

191


192


Figure 6.2. Determination of labor Market Flexibillity

wage bargaining

system 1------, wage

compensation and

minimum wages

Source: Dohse and Krlejjer-Boden (1998). p. 49

policies to L-----1 increase mobility

The poor flexibility of labor markets in most EU member countries underlies the predominamly su·uctural character of the European unemployment problems (see Bean, 1994; OECD, 1994 and l999;' IMF, 1999). According to the OECD's estimates of the nonaccelerating-wages rate of unemployment (NAWRU) more Lhan 80

percent of unemployment in the EU must be considered to be of a structural rather than cyclical nature (Table 6.2). As long as underlying labor market rigidilics impede adjustment processes, shocks are likely to add to Lhis su·uctural unemployment." \o\1ith the exchange rate no longer available as a "shock absorber," su·uctural reform of European labor markets, certainly warranted on its own right, has been made more urgent by the implementation of EMU.

A Status Quo Assessment of EMU and European labor Markets

If the EMU countries' susceptibility to asymmetric shocks and the structure of European labor markets will 1101. change fundamentally with the introduction of the curo, the countries on the northern and southern pet;phcries of the EU (Finland, Italy, and Spain) face a high risk of increasing unemployment, since the probability that these counu·ies will be hit by asymmetric shocks is high, whereas labor market nexibility is low (Table 6.3) .12 Germany, France, and Belgium face a lower probability that they will be hit by asymmetric shocks.t3 However, if such shocks do occur t11ere is a high risk of a penn anent. increase in unemployment due to the low degree of labor market flexibility in these countries as well.

1 1 This is especially true for supply shocks although demand shocks ma)' also ha\·e long-run impacts on ompu1 and emplormen l (see also foomote 3).

12Fm- an in-depLh ana.lrsis of Lhe labor market nexibilitv or t.hc euro-area countries see Dohse and Krieger-Bodt'n ( 1998, chapLer 4) and OECD (1999, chapter 4).

13Qf course, we have primadly permanem shocks in mind here (however. see also foomow 3).


THE REGIONAL PERSPECTIVE

Table 6.2. Total and Structural Unemployment in EU Member Countries, 1997

Total Unemployment, Structural Unemployment 2 Rates Change Share in total3 Change 1997 199Q-97 1997 1990-97

Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden United Kingdom

Source: OECD (1998a and 1998b).

4.4 9.2 6.1

14.0 12.4 9.7

10.44 10.2 12.05

3.7 5.2 6.8

20.8 10.2

7.1

I Standardized definition, expressed as percentage of labor force.

2.1 2.5

-1.6 10.6

3.4 2.8 3.4

-3.2 2.9 2.0

-1.0 2.2 4.6 8.4 0.0

87.1 0.5 91.3 0.6

1 1 3.2 -o.6 88.3 5.8 82.3 0.9 84.2 2.7 94.2 1.6

107.8 -3.6 86.2 0.9 - 6 98.2 86.6 95.7 83.8

104.3

-1.5 -o.1

0.1 3 5

-1.3

2NAWRU rate of unemployment. For definition see OECD (1990). By the NAWRU concept, total unemployment is divided into a structural and a cyclical component. As the cyclical component may be positive or negative, the structural component may attain more than 100 percent of total unemployment.

3Share of total unemployment (commonly used definition). 4Commonly used definition. 51996. SNot available.

Jreland1•1 and PortugaJ are not subject to a

very high risk of increasing unemployment as a

result of EMU: although the probability that

these countries will be hit by asymmeo·ic shocks

is high, the relatively high degree of labor mar

ket flexibility is an effective insurance against

higher unemployment.

The countries that are, from a labor market

point of view, best prepared for EMU are the

Netherlands and Austria, since there is only a

low probability that they will be hit by asymmet

ric shocks, and labor market flexibility is high

compared with the EU average. Therefore, our

analysis suggests that EMU will affect its member

countries quite differently.

The Regional Perspective

We now focus on an important feature of the

European unemployment probJem that is widely

neglected 15 in the debate on monetary union

but that, in our assessment, may be crucial for a

successful reform of the sticky labor markets in

the euro area. Europe's unemployment problem

is to a Jarge extent a 1'egional problem within

countries and the labor market risks of EMU re

suiL-to a substantive part-from the high prob

ability of region-specific (asymmetric) shocks in

combination with the lack of functioning adjust

ment mechanisms at the regional level:

• The countries panicipating in EMU com

prise very heterogeneous regions.

14AJthough the Irish wage bargaining system is highly cemralized, labor market regulation. wage increases, and non-wage labor costs are moderate compared to continental European standards, thus creating a favorable e::nvironmelll for economic growth and foreign direct invesunem (FDl). Since the severe crisis in the mid-1980s when the unemployment rate climbed up tO 17 percent, the Irish economy has developed much more dynamically than the European <�ver.tge with respect tO growth in employment and output. living standards, and the decrease in unemployment.

150ne of the recem exceptions is Mauro and others (1999).

193


194


Table 6.3. Monetary Union and labor Market Risks for EU Countries

Probability of Asymmetric Shocks1

Current Labor Market Flexibility!

High Low

Low

High

Group 1: Netherlands. Austria

Group 2: Ireland, Portugal (United Kingdom)2

Group 3: Germany, France, Belgium (Denmark)2

Group 4: Finland, Italy, Spain (Sweden, Greece)2

Source: Dohse and Krieger·Boden (1998, p. 95). 1Compared to EU average. 2Not joining monetary union from the start.

Therefore, the monetary union may have

very different effects on the regions of a

country: the "Rhineland" region with its spa

tiai proximity to the Netherlands, Belgium,

and France will arguably profit more from

the benefits of the currency union than the

Oberlausitz, which is adjacent to Poland.

Furthermore, the sectoral structure of the

west German economy is closer r.o the EU

average than the structure of the east

German economy, which implies a higher

susceptibility of east Germany w asymmetric

shocks. The same type of argument holds

for the Mezzogiorno in comparison to the

north and central regions of italy. • The major threat of EMU for the labor mar

ket is the combination ofregional (espe

cially the problem regions') susceptibility to

asymmetric shocks and the lack of regional

adjustment instruments. In addition-and

not to be underestimated-there are sub

stantial moral hazard effects implied in mas

sive regional transfers.

• EMU seems to benefit problem regions

least, as they are typically peripheral regions

(i.e., they do relatively little trade with the

other monetary union countries, profit less

from the elimination of the national cw·

rency, and are more prone to asymmeu·ic

shocks), and labor market stickiness is very

pronounced in these regions.

• Since regional disparities in unemployment

and income are large and a further widen

ing seems unacceptable for political reasons,

the regional problem may become a m�jor

threat w the long-run sustainability of

EMU.

This implies that any attempt LO reform

European labor markets successfully and "make

them fit tor monetary union" has to take the re

gional dimension of the problem into account.

Some Stylized Facts

Unemployment rates among EU member

states vary significantly, the Spanish rate being al

most five times higher than the rates in low

unemployment countries such as Austria or the

Netl1erlands (see Table 6.2). While these na

tional differences are important, the Union's un

employmem problem is most acUle at the re

gional and local level. Unemployment rates in

some problem regions of the community are

more than ten limes higher than unemployment

rates in the best performing regions (Table 6.4). The problem regions are concemratecl at the

periphery of the Union: southern Italy, Spain,

Table 6.4. EU Regions with the Highest/lowest Unemployment Rates, April 1997

Region

Luxembourg Oberosterreich Berkshire, Buckinghamshire, Oxfordshire Niederosterreich Centro (P) Trentino-Aito Adige Burgenland Salzburg

Sicilia Calabria Campania Ceuta y Melilla Ex1remadura Andalucia

Source: Eurostat (199Bb).

Unemployment Rate (percent)

2.5 3.0 3.2 3.4 3.4 3.8 3.8 3.9

24.0 24.9 26.1 26.4 29.5 32.0


Ireland, Finland, and east Germany. 16 Regional

disparities are especially large with respect to

youth unemployment, which is a severe problem

in southern Europe (Italy and Spain) , but less so

in northern and central Europe, as can be seen

from Table 6.5.

The European regional problem-measured

in terms of unemployment disparities-has be

come more acute over time. The dispersion of

regional unemployment rates across the EU in

1995 was three times higher than in the late

1970s (Martin, 1998, p. 20). Regional disparities

vary significantly among EU member states:

France, the Netherlands, the United Kingdom,

Sweden, and Austria show a relatively high de

gree of homogeneity in their regional unemploy

ment rates, whereas Finland, Germany, and espe

cially Italy are characterized by large regional

disparities (Table 6.6).

The regional problem in Germany is aggra

vated by the fact that sLructural adjusLrnent in

east Germany is not really making progress, and

labor market performance in some of the east

German problem regions has been worse than

in any other European region. Another striking

fact is the rapid decline in regional unemploy

ment disparities in the United Kingdom since

1990. It was especially during the recession of

1989-93 that unemployment differentials de

clined to an unprecedemed degree. 17

A characteristic feature distinguishing Europe

from the United States is the high degree of per

sistence in the regional unemployment discrep

ancies over time. Within the four largest EU

member states the ranking of regions by unem-


Table 6.5. EU Regions with the Highest/lowest Youth Unemployment Rates, April 1997

Region Youth Unemployment Rate (percent)

Niederosterreich 5.0 Obertisterreich 5.0 Oberbayern 5. 7 Burgenland 5.7 Berkshire, Buckinghamshire, Oxfordshire 5.7 Drenthe 5.9

Ceuta y Melilla Sicilia Calabria Campania

Source: Eurostat (1998b).

58.4 60.4 62.6 64.9

ployment rates in any given year is highly corre

lated with the ranking in previous years (Table

6.7).18 Tn this respect, regional unemployment

in most EU countries behaves quite differently

from that in the United States, where one pe

riod's high unemployment region can become

the next year's low unemployment region

(Bertola and lchino, 1996). The rank-order cor

relation coefficient for Europe as a whole re

flects the decline of unemployment rates i_n the

Netherlands, Denmark, and the United

Kingdom: the coefficient did decline from 0.96

for 1985-90 to 0.78 for 1985-97, which neverthe

less remains markedly above the U.S. coefficients

of about 0.50.

A Recipe for Failure: Region-Specific Shocks

and Regional Nonadjustment

There is broad agreement in the literature

that asymmeu-ic shocks are much more pro

nounced at the regional than at the national

161L is noteworthy, however, that-at a more local level-high unemployment rates also exist in some of Europe's capitals. for example, London, Berlin, and Brussels (Martin, 1998, p. 18).

171t is tempting to interpret this cnl.irely as a consequence of reforms intended to increase labor market llexibilit)'·

However, evidence from disaggregated da ta gives a more ditferentiated picture (McCormick, 1997): in the nonmanufacturing sectors 1J1ere is indeed a high degree of geographical mobility contributing to the convergence of regional unemployment rates, whereas the manufacturing sector is still charactel"ized by low geographical mobility. Instead of migration or significam '"a•·iacions in relative w·..�ges there has been a tendency for manufactwing l<1bor force participation rates tO decline in comracting regions, which-togel.ber with mjgt·ation by non manuals-explains lhc leveling of regional Lulemploy

ment rates in the United Kingdom. 18M arlin ( 1998) finds similar results for NUTS !-level regions. NUTS is lhe nomenclature of territorial units for staListics

compiled by Eurost.at. Level I (NUTSl) is lhe largest., NUTS2 the medium, and NUTS3 the smallest level of regional disaggregation.

795


196


Table 6.6. Unemployment Disparities by Region, 1985, 1990, 1995-97

Standard Deviation Coefficient of Variation

1985 1990 1995 1996 1997 1985 1990 1995 1996 1997

Belgium 2.25 2.69 3.22 3.26 3.27 0.19 0.36 0.34 0.32 0.35 Greece 2.16 2.22 2.45 3.03 2.59 0.37 0.37 0.33 0.38 0.33 France 1.79 1.72 2.03 2.37 2.55 0.17 0.19 0.18 0.20 0.21 West Germany 2.26 1.92 1.76 1.84 1.98 0.30 0.36 0.26 0.26 0.25 Whole Germany 3.50 3.63 4.69 0.42 0.43 0.47 Italy 3.51 6.50 6.82 7.28 7.31 0.38 0.64 0.55 0.58 0.59 United Kingdom 2.89 3.48 1.63 1.47 1.41 0.23 0.43 0.18 0.19 0.19 Spain 4.78 6.11 5.70 5.40 5.54 0.23 0.38 0.26 0.25 0.28 Netherlands 1.65 1.76 0.98 1.28 1.05 0.16 0.23 0.13 0.20 0.20 Europel 5.03 5.13 5.94 6.01 5.68 0.47 0.59 0.55 0.55 0.54 United States2 1.92 1.10 1.26 1.23 1.21 0.27 0.21 0.24 0.24 0.25

Sources: Eurostat (1998b); United States, Bureau of the Census (1997). 1European countries: regions according to the Eurostat regional classification NUTS level 2. 2United States: state level.

level in the EU, which may be u·aced to a high

degree of specialization of regions within a sin

gle currency area compared to countries with

different currencies. Growth rates of output usu

ally vary almost twice as much in the case of re

gions within a country as among EU countries.19

Similar results are obtained by looking at em

ployment changes (Fariis, 1997). Real exchange

rates, however, exhibit less variability at a re

gional than at the national level, which-to a

considerable extent-seems to be due to t.he ab

sence of nominal exchange rates at the regional

level. Moreover, several studies that analyze the

composition of regional output or employment

changes reveal a considerable relevance of the

region-specific component (Vinals and Jimeno,

1996; Decressin and Fariis, 1995).

A permanent increase in regional unemploy

ment due to adverse region-specific shocks can

only be avoided in well-functioning regional la

bor markets.20 ln the United States, labor migra

tion plays an important role as an adjustment.

mechanism, evidenced by interstate flows of

workers, both trend flows and flows in response

to shocks (Blanchard and Katz, 1992). By con

trast, interregional labor mobility is rather lim

ited in the EU.21 This leaves re!,>ional wage flexi

bility as the main adjustment mechanism within

EU member states.22 Empirical studies show,

however, that in Europe region-specific increases

in unemployment do not lead to a strong differ

entiation in regional labor income growth

(Abraham, 1996; Decressin and Fariis, 1995).

This may be explained by the fact that wage pol

icy is not region-specific, that is, there are

spillovers from wage setting in prosperous re

gions to problem regions.23 These spillovers may

prove especially harmful for the problem re-

19See De Grauwe and Vanhaverbeke (1991 ); Decressin and Fallis (1995); De Nard is and others ( 1996); Vii1als and Jimeno ( 1996): Fallis (1997). It is tempting to argue that this higher degree of specialization is a statistical ani fact being mainly due tO the fact that regions are smaller entities than coumries and hence are less diversified than coumries. However, Krugman (1991) has shown that even regions that are as big as cotult.ries, like the "great regions" in the United States, are more specialized than most EU member countries.

20E\•en temporary regional shocks may add to permanelll unemploymem due to mismatch and hysteresis effects; sec footnote 3.

21See DeGrauwe and Vanhaverbeke (1991); Decressin and Fallis ( 1995); Obstfeld and Peri ( 1998). 22Th is does not assume that all unemployment is due to excess real wages. The argumem is rather that-once unemploy

ment has surfaced-wage llexibility is required to entice new (profitable) employmem opponunities for those workers who have been made redundant (e.g .. by demand shifting to higher value-added products and concomitant higher skill requirements for labor). Moreover, if a region is hit asymmetrically by a common policy shock (such as a change in the common monetary policy-see. e.g., Carlino and DeFina 1998 and 1999) wage flexibility is crucial, in particular in EMU where fiscal policy is severely consuained.

23 See Giersch ( 1969): Giersch and others (1992); and Abraham ( 1996).


Table 6.7. Persistence of Regional Unemployment Differentials: Rank-Order Correlations, 1985-97

1985-90 1985-95 1985-96 France 0.79 0.79 0.84 West Germany 0.96 0 79 0.84 Italy 0.87 0.89 0.89 United Kingdom 0.96 0.90 0.87

EU as a whole, 0.96 0.91 0.83 United States2 0.58 0.41 0.49

Sources: Eurostat (19981>); United States, Bureau of the Census (1 997).

1Europe's l>ig four: NUTS2-Ievel regions. 2United States: state unemployment rates.

1985-97 0.84 0.85 0.85 0.90 0.78 0.50

gions if productivity gTowth in these regions is

slower than in the rest of the economy.

Productivity growth in the prosperous and dy

namic regions creates opportunities for wage in

creases, which are copied by less successful re

gions, aggravating the employment problems of

the lagging and peripheral regions (Abraham,

1996, p. 72).

If there is neither labor mobility nor wage

flexibility, two alternatives remain: increased sub

sidies, or an increase in unemployment in those

regions hit by adverse shocks. Obstfeld and Peri

(1998), Blanchard (1998), and Eichengreen

( 1998) have argued that long-run transfers are

in fact not an adjustment mechanism but a prac

tice that prevents adjustment and structural

change. Therefore, the European unemploy

ment problem-stripped down to its core-ap

pears to be a problem of regional nonadjust

ment to region-specific shocks and/ or persistent

(structural) regional differences.

Europe's Most Prominent Problem Regions

To gain further insights into the causes-and

possible cw·es- of regional labor market rigidi

ties in Europe, we take a closer look at two par

ticularly conspicuous examples of regional un

employment in the EU, namely east Germany


and Italy's Mezzogiorno. Both regions have in

common that GDP per head is far below the re

spective national averages, and the unemploy

ment rate far above average (Table 6.8).

Important structural features of these problem

regions are summarized in Box 6.2.

Italy has been facing a north-south dualism

since its monetary unification in 1862, whereas

the regional economic problem in Germany is

relatively new (encountered since monetary

union in 1990). Nevertheless, the root causes of

labor market stickiness in bolh east Germany

and the Mezzogiorno seem to be similar: a na

tionwide sectoral wage bargaining system that leaves little room to adapt to region-specilic con

ditions, a relatively su-ict regulation of working

time, high costs of hiring and firing that

strengthen the position of insiders and weaken

the position of omsiders, and interregional

transfers and welfare benefits that are-because

of their moral hazard implications-inefficient

in Lhe sense dtat they discourage job search and

(interregional) labor mobility. Rent controls and

heavy taxation of housing u-ansactions add to

impeding interregional mobility.24

Both east Germany and the Mezzogiorno

show productivity gaps in manufacturing vis-a-vis

the rest of tl1e respective countries that is not re

flected in a wage gap of comparable size. The

relatively high unit labor costs make it difficult

for these regions25 to attract mobile resources

for developing a strong industrial base, which

still seems to be a necessary condition for the

concomitant evolution of a modern service sec

tor specializing in high value-added activities.

The malfunctioning of the wage bargaining sys

tem is even more pronounced in east Germany

than in the Mezzogiorno: here it is not only in

the manufacturing sector but also in the service

sector that unit labor costs are higher than in

the more prosperous parts of the country

(Table 6.9).

240ECD, Economic Survll)'>, var. issues; Boltho and others (1 997); OlW, IIW, and LWH, var. issues; Faini and others ( 1997). 2;These regions are handicapped anyway by their economic backwardness, including defic:iem tnfrastmctures and, in

particular in the Mezzogiorno, a tradition of poor work ethics and morale, doubts abom the transparency and credibilit)' of government adminisu·ation, and a bad reputation with respect to the enforcement of law. Wage differentials should, at least to some extent, also compensate for these disadvantages.

197


198


Table 6.8. Italian Mezzogiorno and East Germany Compared, 1995

Mezzogiorno East Germanyl

Percentage of national population 0.34 0.17 Percentage of total unemployment 0.52 0.33 Percentage of national GOP 0.22 0.10 Regional GOP per capita/national

GOP per capita 0.67 0.57

Sources: Eurostat (1998a and 1998b): authors' calculations. 1 East Berlin not included.

While southern Italy has failed to reach any

significant real convergence with the north in the long history of its monetary union, Boltho

and others ( 1997) argue that prospects for east

Germany look better. Howeve1� their argument

that the existence of a flow·ishing market econ

omy in east Germany before World War II and

the tradition of manufacturing, prevailing even

in the socialist era, may prove an important ad

vantage in the convergence process (Boltho and

others, 1997, p. 257) seems to underestimate the

legacy of socialism in affecting work ethics and

morale. The huge amount of transfers, equiva

lent to about 5 percent of German GDP

throughout most of the 1990s, (of which most

was and still is earmarked for social policy objec

tives and not for the upgrading and extension of

the infrastructure) prevents adjustmem to the

needs of a modern society that is subject to the

enhanced competitive pressures of globalization

and European integration. These substamial

transfers from the more prosperous parts of the

economy ensure, however, that consumption

standards are relatively even across all of

Germany. By their very nature, though, these

transfers conu·ibute to, and may even perpetu

ate, a model of regional dependence (Boltho

and others, 1997, p. 242), eventually ending up

in a "Samaritan dilemma" (Giersch).

A glimmer of hope for east Germany can be

seen in the fact that east German firms have in

creasingly opted out of the bilateral monopoly in

collective bargaining. In fact, there has been a

marked "run" to get our of compulsory branch

wage agreements (FHichentarifveru·ag). This in

strument has lost its specific (and legally en

dorsed) property of creating ''orderly condi

tions" in the respective labor markets, and its

binding character is eroding. Having been

pushed close to bankruptcy by the collective

wage agreements that followed the idea of a swift

wage equalization between east and west

Germany, a considerable and increasing number

of firms that did belong to the employers' associ

ations simply ceased to comply with their legal

obligation of following suit and paying the wage

increase. In particular, small and medium-sized

companjes are detaching themselves from the

collective bargaining process. About 47 percem

(40 percent) offirms in manufacturing with

fewer than 20 employees did pay less than the

collective agreement required in early 1998

( 1995).26 These developments in east German

labor marketS indicate that there is a su·ong ten

dency to concest the power of the bilateral cartel

on the labor market and for a wage formation

process that takes more account of relative

scarcities and firms' requirements in east

Germany.27 Nevertheless, it is very likely that east

Germany-as well as the Mezzogiorno and many

other problem regions in Europe-will lose

from EMU because of being peripheral regions

with production su·ucLUres quite different from

the euro area's average. Thus, EMU puts an ad

ditional strain on Europe's problem regions.

26Jn the 20-100 employees bracket this share amounted to roughly 40 percent in 1998 (about one-third in 1995), and w 35 percent for Lhe 100 LO 200 employees firms (20 percent). Even about 13 percent of Lhe firms with more Lhan 500 employees did pay less Lhan Lhe collecLive conLract wage in 1998, up from zero in 1995. Only one-fifth of Lhe enterprises were afJiliated with an employe1·s' association in 1997 (aboUL27 percem in 1994/5). The percentage is lower with respect to Lhe number of employees. though: approximately 45 percem of the employees were paid according lO the f'lachemarifVenrag. For the data see DT\oV, J!W, and IWH (1995, 1998, 1999). See also Kohaut and Schnabel (1998).

2i.Lo cast Germany this process of opting out of the cartel has been endo rsed even by the current insiders because they did con·ectly assess Lhe alternative-immediate bankruptcy of many firms-if not doing so. This is diiTerent from the siwalion in west Germany, where the insiders will (correcll)') see Lhis as an indirecL attack, which threatens to gradually erodt: L11cir privileged positions, and are L11us (still) likely to oppose such a move (see Saint Paul. 1997).


ENLARGING INSTITUTIONAL AND REGIONAL DIVERSITY

Table 6.9. Labor Costs and Labor Productivity Relative to the Rest of the Country

Mezzogiorno East Germany in Percent of Centro-Nord in Percent of West Germany

All sectors Manufacturing All sectors Manufacturing

1 997 (1993) 1997 (1993) 1997 (1993) 1996 (1993)

Labor productivity 81 (81) 77 (80) 59 (51) 64 (55)

labor costs 77 (76) 80 (79) 75 (68) 67 (62)

Unit labor costsl 96 (94) 105 (99) 127 (133) 105 (114)

Sources: SVIMEZ (1998); Boss and others (1998). 1Une two divided by line one; identity constraint not always met due to rounding.

From Regions to Enterprises

To sum up, the euro area is characterized by

substanlial regional unemployment, with prob

lem areas concentrated at the periphet-ies. The

disparities in regional unemployment rates have

not declined but widened in recent years, which

may prove a severe handicap for EMU. I t is

therefore necessary that policymakers pay more

attention to the regional dimension of the

European w1employment problem.

However, we hold that many problems observ

able at the regional level have their root in the

fact that labor market regulations and institu

tional frameworks for bargaining have not been

adequately adjusted to the fundamental changes

going on in many enterprises as a result of pro

gressive globalization and European integration

(Box 6.3). Hence, policy must also consider the

firm perspective in adjusting the institutional

framework of the labor market to the changing

requirements in the environment of a Europe

that is integrating at an increasing speed and

that has to face a more competitive global

environment.

Enlarging Institutional and Regional Diversity

So far, our analysis has substantiated ( l ) that

there are considerable differences between the

euro-area counu·ies with respect to their expo

sure to asymmetric shocks and/or the degree of

labor market flexibility; (2) that the euro area

has a substantial regional unemployment prob

lem with problem areas concenu·ated at the pe

ripheries; and (3) that the existing wage forma

tion systems in most of Europe are not

strucmred to cope with the increasing hetero

geneity of firms.

These conclusions lead to a broad array of

policy considerations. First, we have to acknowl

edge that there is near unanimity among schol

ars that monetary union adds to the urgency of

implementing structural policy measures, in

particular a comprehensive reform of labor

market institutions that is warranted in its own

righ l anyway (see e.g., Artis, 1998; IMF, 1997). 28

Given this broad consensus we first have to ask:

Will monetary union give momentum to com

prehensive labor market reforms, thus bringing

28Indeed. the Oexibility of markets in general should be increased. There can hardly be any doubt that malfunctioning due tO rigidities in product markets and labo1· mm·kets mutually reinforce each other (see Buti and others, 1999, p. 27; Nickell. 1 999). However, the implementation of the common market has substamially spurred market forces in those areas of the economy that, in most of the EU member states, were sheltered from competition. Although subsidization and other protectionist devices are still important in the EU member countries and impair efficiency on product markets, it is labor market rigidities that pose the biggest challenge to policymakers.

199


200


Box 6.3. Trends in Business Organization1

Fiercer global competition, rapid technological change, and increasingly discriminating customers are fundamentally changing the environmem to which firms have to adjust their organizational and managemem strategies. On contemporary markets speed, flexibility, and innovativeness seem to be of increasing importance as compared to the cost-reducing effects of scale economies. The relative efficiency of the hierarchical model with its strict hierarchical organization and the extreme division of labor is obviously giving way toward a �holistic" organizational model that accentuates flexibility. speed of response, and economies of scope when firms are moving from a Fordist-named after Henry Ford who implememed the assembly line--mass production to modern manufacmring.

The Forclist model represenrs a successful and consistent adjustment to an environment for which market conditions are transparenr and

reasonably stable over time. Long product cycles and very specific machinery and equipment allow the ex ante optimization of production

(and, hence, the optimal exploitation of scale economies). To adjust to change the (top) management is able to design, implement, and control the appropriate processes top-down with labor activities narrowed down to highly startdardized casks. Basically, the Fordist concept was a successful attempt to optimize production using exchangeable labor and imermediate products (Womack, 1991, p. 35). The economic superiority of the hierarchical model resrs on the condition that low costs (due to scale economies and extreme specialization) are more important to the customers than quality and product differenliation.

Howe�rer, in the challenging competitive environment of world markets these conditions no longer prevail to give static cost minimization, mass production, and extreme specialization a competitive edge. To a large extent, the guiding principles ofFordism are increasingly dysfunctional:

• Consumers· preferences change quickly, demanding shoner product cycles and more

frequem changes. Thus, the system gets

more prone to problems and disruplions. just extending the safety valves of the Fordist firm (such as inventories) would get too e.xpensive; even inadequate since inventOries are not the appropriate response to more rapid product cycles; these safety valves became counterproductive for solving the adjusm1ent needs at hand.

• Making frequent cl1angcs and the ensuing problems, requires swift reaction at the shop floor. The specialization of traditional Fordist workers is too narrow: they lack the

expertise and the competence to solve the problems creatively and quickly.

• Hierarchical organizations sharpen conflicts of interest between the lop management and employees, entaiJjng an atmosphere of

antagonism. This is not a fertile ground to give incentive to employees to contribute creatively and autonomously to soh�ng problems, thus adding to the problems of satisfying consumers and introducing new

technology effectively. Technological progress, in particular the "rev

olution" in telematics-information technology and telecommunications-dramatically enlarged the possibility for making swift modifications of production processes at low cost, thu giving additional impetus to adjust business organization ro a rapidly changing environment of the firm.

Given the strong complememarities between the different activities within the firm, organizational reforms have to be comprehensive in the way that the communications and decision making structures, the organization of production, and the incentive structures have all to be adjusted in a consistem way and roughly at the same time. Choosing an effective organizational strategy consists of two parts-fundamental change and continuous adjustment, that is, "cl� ciding which hill to cJjmb and then climbing il

as efficiently as possible" (Milgrom and Roberts, 1995, p. 232). For this process to succeed it is indispensable to tap on the e>.:pertise and creativity of the entire staff. The "brain capital� of staff


is increasingly seen as the cutting competitive

edge that has to be mobilized, sustained, and enhanced by an appropriate design of the incentive structure with a specific importance of creating an enterprise culture that is conducive to the evolution of credibility and murual trust between management and employees.

The move from a dominantly Fordist toward a holistic organization paradigm has several important repercussions for labor markets and for labor market institutions. First, the employmem opporrunities of unskilled labor deteriorate relative to those of skilled workers, thus adding to tilt labor demand toward skilled labor. Second, relative wages will tend to reflect this change in the relative scarcities. Third, the efficiency of centralized bargaining is reduced. We will briefly elaborate upon the last point.

There is no generally applicable blueprint for implementing the comprehensive changes in the organization within the firm. On the contrary, the adjustment processes will be very idio

syncratic and experimental, with strong interac

tion between management and labor at the plant level. The increasing importance of these idiosyncrasies can hardly be accounted for in cenu-alized collective agreements in the respective branches.

flexibility to Europe's sticky labor markets?

Second : Is there a model, a promising blueprint for the reform? Third, as we end on a

skeptical tone for the latter question: Is there

sufficient regional and institutional diversity

within member countries of the monetary

union? And, finally, in giving credit to the in

creasing needs for an institutional environment

that takes the changing trends in business or

ganization into account we ask: How to raise

the flexibility of adjustment at the level of the

firm?


Itis not only during the tranSition from Fordism to the holistic organization that centralized collective bargaining will lose importance. Given the increasing intensity of competition (globalization, common market. and common currency) and more dynamic changes in the opportunity set of individual firms, there will be a stronger fragmentation of interests, problems, and problem solutions even after the adjustment has been made.

However, the existing wage formation systems in most of Europe are not structured to cope with the increasing heterogeneity of firms, of plants within firms, and of workers within these plants. Therefore, to help firms adjusting to these substantially changed conditions and to provide enough (]exibility to cope with potential additional pressures that may arise from shocks

hitting the economy more intensely than before, the wage-bargaining system needs to provide sufficient scope and opportunity to agree on appropriate idiosyncratic employment contracts,

covering both wages and working conditions,

given the increasing heterogeneity of emerprise needs and the diverse preferences of employees.

Will EMU Give Momentum

to labor Market Reform?

It seems very likely that European labor mar

kets will change as EMU proceeds. It is some

times even argued that this will happen in a son

of There-Is-No-Alternative (TINA) reasoning

(Allsopp and Vines, 1998, pp. 2 and 6).29 Up to

now, in preparing .tor the monetary union, and

in response to inCJ·easing adjustment pressure,

steps in opposing directions have been taken by

member states. On the one hand, some efforts,

29for a somewhat diverging view on the TINA strategy, see Calmfors ( 1998, p. 142).

201


202


particularly at the European level, tend to stifle

competition and might easily lead to a "vicious

circle." The completion of the Single Market,

the globalization of markets, and the inu·oduc

tion of EMU, it is often argued by politicians,

unions, and interest groups, require a "social di

mension" for the EU to protect Emopeao work

ers against "unfair" competition and "wage

dumping." In this vein the EU opted for the in

troduction of European minimum standards for

working conditions,30 for example, the initiatives

based on the Social Charter and it.s accompany

ing Action Program (Addison and Siebert,

1997) .31 Our assessment is that these standards

reduce the flexibility of labor markets. Moreover,

they are costly, particularly for those member

counu·ies in which standards are comparatively

low. As differences in productivity are likely to

persist for some time to come, more uniform

minimum standards may lead to increased un

employment in low-productivity countries

(Paque, 1997; Solr:wedel, 1997b). High and in

creasing regional unemployment might then

raise demands for more EU regional assistance,

and financing these subsidies is likely to reslrain

the economic dynamics of the remaining areas

(Kronberger Kreis, 1996).

On the other hand, there are indications of a

possible "virtuous circle," as several EU member

states have, though at rather different speeds

and with variations in scope, implemented meas

ures to decentralize and deregulate their

economies and to increase the flexibility of their

labor markets. Other countries may imitate the

examples of the United Kingdom and the

Netherlands who have gone farthest clown that

road and, subsequently, experienced a marked

decline in unemployment. Moreover, in most

member s tates (with the exception of lreland)32

there has been a tendency toward decentralizing

the process of collective bargaining.

It is difficult to assess which of these two diver

gent tendencies will dominate in the long run. In

support of the virtuous circle hypot11esis, one

may argue that by joining EMU tl1e member

coumries did submit themselves to an external

pressure shaping adjustment needs tl1at one

country on its own cannot resist. This may help

remove the roadblocks to political action for

comprehensive labor marker reform. That exter

nal pressure may be conducive to this end be

came apparent in the process of liberalization in

the run-up to t11e completion of the Single

Market. By pointing to the commitment of the

respective governments to the higher-ranking ob

jectives of "European Integration" and the

"Single Market," politicians had an opportunity

to resist the influence of well-organized and pow

erful interest groups and to make successful in

roads into their privileges and exemptions from

competition, for example, in the areas of trans

portation and telecommunications. Likewise, the

convergence of inflation rates through the 1 990s

may be read as a result of the political commit

ment to EMU that allowed national central banks

to resist pressure groups urging a permissive

monetary policy (SVR, 1996, par. 434; Mussa,

1997). Thus, member governments might use

the implementation of the monetary union as

the basis for an (implicit) agreemem ro cut back

on the exuberant welfare state and to bring t11e

incentive structures more into line with eco

nomic sustainability in order lo foster market dy

namics (McKinnon, 1997, p. 228; Salvatore, 1997,

S(T[here is a broad consensus in democratic societies that JJ1ere are unalienable human rights (such as JJ1e prohibition of slavery) and other basic rights (such as union formation). Furthermore, UlCre are some areas where the existence of negative extemalities may warrarH national, or even supranational, minimum standards (such as job safety provisions). However, it has to be taken into account that the quantitative v-aluation of these externaJities as well as the definition of specific dghts (such as the prohibition of child labor) may have to take country-specific idiosyncrasies into accounL in order not to email a substantial net burden for the respective cownries.

3r$eemingly, the European Commission acts as an "agent'' of the social partners. Although unions and employers' associations have been given "voice" i.n the Maasr.richt treaty, no European wage bargaining and no European collective agreement� on common standards are to be expected in the foreseeable future.

32See above, foomote 15.


p. 225). Thus, the inu·oduction ofEMU could facilitate a reduction in the high costs of regulation and of social protection. However, there is no room for complacency that the circle will automatically be virtuous. Policy has to take the initiative and cannot rely upon the monetary union automatically uiggering a process of fundamental reform.

Is There a Blueprint for Reform?

There can hardly be any doubt that tl1e OECD Jobs Strategy currently provides the most scholarly, comprehensive, and consistent labor market reform program, and, as a matter of fact, all OECD member counu·ies did commit themselves to it, albeit without really taking S\Vift action (see IMF, 1999, p. 75). We do not wam to go into tlle details of tlle Jobs Su·ategy in !llis paper. Instead, alluding to tlle argument tllat the various elements of labor market f1exibitity, that is, wage flexibility, working-time flexibility, and geographical mobility (see Figure 6.2), are (to a certain degree) substitutes, we would like to su·ess that tllere is no need for all counu·ies to follow the same reform model to attain higher overall labor market flexibility.33 Country-specific preferences may lead to differem mixes of flexibility characteristics with broadly similar efficiency properties. Nevertheless, we have to take into consideration tl1e "all or notlling" warning issued by Coe and Snower (1997). They argue that piecemeal labor market reforms may have had so little success in reducing unemployment in the past because complementaiities that operate when a broad range of policies is implemented are lost sight of. Hence, what is needed is a fundamental labor market reform tllat is both broad and deep.


National governments, !lle EU, and, above all, employers and employees have to be committed

w institutional reform for m�jor progress in reducing unemployment to be achieved (Siebert, 1998). Hence, there is urgent need for an appropriate assignment of responsibilities.3-l

The main responsibitil)' for establishing the rules or the game is with national governments.

Government has to provide an efficient institutional and legal framework within which labor market agents can act. This framework has to make it uncompromisingly clear to employers and employees that they have to take account of market conditions in their negotiating and contracting in the broad area of working conditions and pay. Furthermore, legal statutes that drive up the costs of employment have to be scniti

nized, made more flexible, or even eliminated.

National govemments have to be alen Lhat the EU level is not grasping more competencies

than is proper under the subsidiarity principle.

The Need for More Regional

and Institutional Diversity

Against the background of widely divergent economic (and social) conditions between countries as well as within countries it seems appropriate not only that reform packages be countryspecific but that a country-specific package pays tribute to the importance of the regional (i.e.,

intranational) dimension. The importance of

the regional perspective has, to our knowledge, hardly ever been given auention in the discus

sion of labor market reform (even the OECD Jobs Strategy does not explicitly tackle tlle regional perspective) or in the discussion of the consequences of EMU.

33for a provocative essay on the "War of tJ1c Models" see Freeman (1998). 34Th is assignmem can, but need not, be accomplished by a consensus between the major relevant groups (as was obvi·

ously the case, e.g., in lhe Netherlands); however, a determined government can by itself and rather abntptJy change the institutional environment so lhat the interest groups have to adjust and take on their responsibility as was lhe;: case, for example, in New Zealand. Note, however, that in the case of 1ew Zealand's refom1 pn)cess there also was a broad (implicit) consensus among the political partie� and social gmups not to initially change the basic institutional framework of lhe labor market. It ""as only after the failure of the sweepiJ1g reform process to reduce unemployment and enhance employment prospecL� tJ1at tJ1e Employment Contracts Act was implemented in 1991 against the opposition of the nnions (Kasper, 1995).

203


204


There is a pervasive lack of institutional vari

ety within national employment systems that

does not allow for the appropriate dynamic reac

tion to idiosyncratic shocks. Institutions such as welfare and unemployment benefit systems, min

imum wages (where they apply) , dismissal pro

tection laws, even working-hours regulations, are mostly shaped at the national level and are usu

ally uniform within a given country. Critical cases

in point are housing market regulations and the

taxation of housing transactions, which form im

portant obstacles to interregional mobility.

There are also a lot of regulations outside labor

markets (e.g., shopping hours) that often apply

nationwide and, void of any economic justilka

tion, allow hardly any regional differentiation.

The hjgh degree of institutional homogene

ity, prevailing in most EMU countries, may en

tail a mismatch between institutions and the

economic conditions that prevail in the problem regions. The greater clifferentiation that ex

ists across European regions than within any in

dividual country strengthens our concern that

pressures toward greater uniformity of labor

market institutions or wage equalization follow

ing monetary union would raise the risk of in

creasing institutional mismatch and hence jeop

ardize the efficiency gains expected from the

implementation of t11e monetary union (see

also Buti and ot11ers, 1998; Mauro, Prasad, and

Spilimbergo, 1999, p. 43). To achieve a broader

regional diversity it should be considered

whether opt-out clauses could be amended to

nationwide regulations that resu·ain regional ad

justment capabilities in the case of asymmetric

shocks. More interregional variety is also a precondi

tion for more effective interregional competition. We view interregional competition as a

competition among regions struggling to design

the most favorable institutional and legal envi-

ronment for employment and growth. Such a

competition may help find innovative institu

tional arrangements facilitating rather than hin

dering adaptation to modern production

processes, to break up "bureaucratic sclerosis,"

to reshape t11e regional production system, and to contest the cartel of the "distributive coali

tions" (Olson, 1982). In t11at sense, interregional

competition can be looked at from t11e perspec

tive of "competition as a discovery procedure"

(Hayek, 1968, 1978).

Furthermore, the policy objective that became

known under the heading of "Europe of the

Regions" (and t11at has been given more promi

nence and clout in the Maastricht Treacy) does

reflect that more institutional variety is an indis

pensable instrument for regions to sharpen their

ow11 profiles in a competitive environment

where national boundaries lose importance be

cause of the completion of the Common Market

and of EMU, and because of me increasing pace

of the international integration of markets.

However, on tl1e rat11er pessimistic assumption that regional nonadjustment will persist or that

there will at least be substantial inertia in effec

tively tackling t11e paramount regional problems,

a discussion is evolving about alternative, non

market mechanisms to protect the regions

against adverse consequences of asymmetric

shocks. Several proposals have been made to set

up an insurance mechanism, designed to chan

nel income from countries (or regions) in a

boom relative to t11e EU average w countries (or

regions) in a relative u·ough.35 It has been

shown, however, that the proposed insurance

mechanisms do not meet basic efficiency re

quirements (Hagen and Hammond, 1998).3<; So

there is no easy escape from the need for struc

tw·al labor market reform in order to improve

the regions' adjustment capabilities in t11e case

of asymmetric shocks.

35See .Belke and Gros (1998) for a recent proposal and Hagen and Hammond (1998) for a critical evaluation of different insurance approaches.

36Basic efficiency requirementS imply that there is significant insurance against asymmetric shocks, no permanent transfers are generated, and that there are no lasting ex ante distributi<>nal consequences.


More Freedom of Contract at the Firm Level

To keep wages in line with productivity at high

levels of employment and to agree on labor mar

ket conditions that are conducive to full employ

ment should be the main responsibility of emj>loy

ers' associations and lmde unions in most EU

member states given their corporatist institu

Lional environment.37 The academic discussion

about the appropriate model for the institutions

of wage policy has long been dominated by the

Calmfors-Drifill (C-D) hypothesis ( 1988), accord

ing to which labor markets work best in those

countt-ies with either very decentralized or very

cenu·alized wage formation systems. However,

the C-D hypothesis seems at odds with recent ex

periences: countries with decentralized wage ne

gotiations have proved more successful than oth

ers with respect to labor market performance in

the last decade (Berthold and Fehn, 1996;

Dohse, 1999).38

Collective bargaining may be even more diffi

cult in the more transparent environment of a

monetary union. German political and eco

nomic unification provides an inu·iguing exam

ple for a "wage and welfare benefit unification."

The implementalion of the west German collec

tive bargaining system with its tight and cozy cor

poratism aiming at swift wage equalization

turned out to be harmful for east German em

ployment: wage policy was decoupled from pro

ductivity developments and turned east

Germany into a high-cost location with unit la

bor costs considerably exceeding those in west

Germany throughout most of the 1990s. In re

cent years, more and more east German firms

are trying-quite successfully-to get out of the

cost-enhancing collective bargaining system (see


above), fostering a fundamental shake-up of the

system also in west Germany toward a more ap

propriate decenu·alized wage-setting

mechanism.

Cenu·alized collective bargaining, guided by

politically induced objectives for wage policy, is

not only inappropriate in situations of widely dif

fering conditions in regional labor markets-as

is the case for EMU member countries-but also

inconsistent with the above-mentioned trends in

business organization (see Box 6.3). The para

digm shift from the su·ictly hierarchical toward a

holistic organization implies that efficient agree

ment<; between employers and employees be

come more complex and diverse and, thus, in

creasingly information-intensive. At the same

time, implicit contracL<; gain in importance and

require more mutual trust and cooperative in

dustrial relations. Standardized problems and so

lutions (such as standardized wage structures

that cover most of an industry) that can be de

termined at a centralized level by employers' as

sociations will be increasingly rare.

Collective norms that are defined at the cen

tral level impede firms in their efforts to provide

effective wage incentives for their employees.

Likewise, firms may feel resu·ained from invest

ing efficiently in the human capital of theit· staff

by an individual mix of formal and informal

measures and a regular rotation of activities.

Firms need considerable room for maneuver for

the adjusm1e1u and specification of tasks, remu

neration systems, and qualificalion policies.

Howeve1� existing wage formation systems in

most of Europe are not su·uctured to cope with

the increasing heterogeneity of firms and jobs.

Therefore, to help firms aqjust to these substan-

37In a totally decentralized institutional environmem where firms arc free to martage, wages will always be "in line" with productivity. To stimulate job creation, wage flexibility will bring the aspiration wage of the unemployed "in line" with profitable employmenL Once full employment is reached employment growth is required only if the labor force is gro"�ng, which need not be the case in £urope in the medium run.

38The Calmfors-Driffil hypothesis as well as the positions mentioned above reflect average relaLionships to which some exceptions stand out such as [reland and the Netherlands. Note that Ireland was not included in the iniLiaJ Calmfors-Driffil paper and, therefore, not in Dohse (1999) . The case of the Netherlands gives a flavor of the difficulties to rank countries along the centrali?.ed-intermediate-decentralized criteria: although the corporatist tradition, in particular in the mid-1980s, has a strong centralist character, the ease at which firms can su·ike a deal on a decentralized level in case of difficulties suggests putting the Netherlands imo the intermediate category (Hartog and Theeuwes, 1997).

205


206


tially changed conditions and to provide enough

flexibility to cope with potential additional pres

sures that may arise from shocks hitting the econ

omy more heavily than before, the wage-bargain

ing system needs to provide sufficient scope and

opportunity for agreement on appropriate idiosyn

cratic employment contracts, covering both wages

and working conditions. Shaping pay systems in a

more performance-oriented way, organizing work

ing hours more flexibly, forging agreements and

contracts on employment and locational security,

and adopting measures for a long-term-oriemed

manpower policy-all of this can be done most ef�

ficiently at tl1e enterprise level.

Conclusions

Without major changes in the instilntional

framework of labor markets in the majo•·ity of

member counuies, EMU may contribute to ag

gravating the unemployment problems in the

euro area. The appropriate response is struc

tural reforms, such as those proposed in the

OECD .Jobs Strategy, to enhance the flexibility of

labor markets. But in addition, considering that

regional nonadjustrnent is the main reason for

EU member counuies' swbborn regional unem

ployment problems, policies are needed that al

low a decentralization of competencies and a

broader diversity of labor market outcomes.

Such diversity is instrumental to interregional

(or locational) competition.

The subsidiarity principle that has gained in

importance in EU politics under the Maasu·icht

Treaty gives more prominence to institutional di

versity. Furthermore, the Amsterdam Treaty gave

labor market policy more prominence at the EU

level. From our perspective, there is an upside

and a downside to these recent changes in the

allocation of competencies.

The Eurapean aut/unities (Cm.tnr:i� Commission,

and Parliament), being emit.led to issue binding

guidelines and directives, can and do play an im

portant role in assisting member s tates to stimu

late competition at the national levels and thus

in increasing the flexibility of their labor mar

kets. EU member governments should be urged

t.o acknowledge their obligations resulting from

endorsement of the OECD Jobs Strategy. To this

end, the European Commission should make de

termined use of its competencies acquired in the

Amsterdam Treaty to embark on a peer pressure re

vieru j>rocedure for surveiJlance of progress with

su·uctural reform in labor markets. The

Commission could benefit from the expedence

of the OECD's Economir Development Review CommiUee (EDRC) and its ongoing review

process.

The European Commission could spur institu

tional reform by setting incentives for a decen

tralized experimentation in implementing its di

rectives at the national level. This would add

substance to the p•inciple of subsidiarity.

There may be a temptation for the European

Commission and nmional governments to ab

sorb increasing adjustmenL pressure at the

European border, or to follow a centralized pol

icy of handing om regional subsidies in order to

make the necessary adjustments more "socially

acceptable.·· Trade unions and employers' associ

ations usually endorse such action. They might

feel taken off the hook to meet the challenges of

the increased competition engendered by glob

alization and monetary union. From this per

spective, there is a risk that the enlarged compe

tencies for employment policies at the EU level

(created by the employment chapter of t.he

Amsterdam treaty) could be used as a protecrive

device. Such a shift of competencies could

su·engthen the zeal of Lhe European

Commission to get additional own funds (in L11e

form of taxing autl1ority or own credit facilities

on capital markets). The member states should

oppose any attempt to implement such an "ac

tive employment policy" at the European level

since Ll1is goes in the wrong direction. More cen

u·alization implies less regional and institutional

dive•·sity that is, as has been argued in this paper,

crucial for the regions' ability to adjust to asym

metric shocks. In this sense, one may argue that

it is the furtl1er evolution of the institmional

framework of European labor markets that will

be decisive for the long-run success or the fail

ure of EMU.


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