Jamus Lim's blog

While the world remains largely fixated on the series of unfortunate events playing out in Europe, it may be worthwhile stepping back a little from the immediate crises and thinking about the longer-term consequences of austerity plans in the developed world for the world economy. In particular, thinking about medium- and longer-run budget cutbacks in the developed world---something that even the strongest proponents of short-term Keynesian stimulus recognize---in the context of innovation (and by implication, long-run economic growth) may offer some insight on an unfolding global picture.

The first thing to establish in looking at the phenomenon is the extent to which future fiscal positions are likely to contract. In this regard, the data suggest that the impact of fiscal contraction on developed country discretionary public expenditures (which are directed to, among other things, public funding for research) will be nontrivial. Relative to average expenditures in 2003--08, outlays in the United States can be expected to go down by about 2 percent of GDP by the 2030s (see figure below, top panel), and likewise many European economies, if they hope to attain fiscal sustability, will need to shrink their budgets by about a half percentage point of GDP annually over the next ten years (see figure below, bottom panel). So the first point to take away is that austerity in the developed world is a significant possibility in the medium to long run.

Sources: World Bank staff calculations, using CBO Long-Term Budget Outlook (XLS) and EC Public Finances in EMU (PDF).
Notes: Expenditures for the United States measured as projected noninterest outlays in the extended baseline scenario. Expenditures for the European Union are measured as the projected cumulative budget cuts till 2020 for each respective economy required to attain a 60 percent debt/GDP ratio by 2030. Data for Portugal were not available for the baseline, and consequently the COM forecast was used.

Now, this would not matter as much for global innovation if the developing world (most of which is not expected to experience sharp fiscal contractions in the longer run) makes up for this decline in research output from the developed world by sharply increasing their research output, either through higher productivity or, by dint of their larger populations, a larger absolute number of innovations.

Unfortunately, insofar as research quantity is concerned, the developing world is unlikely to pick up the slack. The number of researchers and technicians involved in research and development activities in high income countries is more than two times that in developing countries (3.6 to 1.7 million, respectively). As for productivity, after adjusting for variable research productivity, the picture is even worse: considering just the Euro-Periphery economies, the United Kingdom, and the United States, versus the emerging BRIICK (Brazil, Russia, India, Indonesia, China, and South Korea) economies, productivity-adjusted research output in the latter group is about a a third that of the former (see figure below, upper panel). And this picture is unlikely to change anytime soon: R&D expenditures, while rapidly rising in the developing world, remain a small fraction of GDP (and smaller GDPs, for that matter) (see figure below, lower panel). So the second point to take away is that it is unlikely that developing countries will be scaling up their innovations to an extent that successfully offsets the anticipated reduction in developed-world research activity.

Source: World Bank staff calculations, using World Development Indicators.
Notes: Productivity-adjusted research output calculated as total number of scientific and technical journal articles as a share of total number of researchers and technicians in R&D. The Euro-Periphery economies are Portugal, Ireland, Italy, Greece, and Spain, and BRIICK economies are Brazil, Russia, India, Indonesia, China, and South Korea.

Taken together, the bottom line is that that world is likely to be worse off, innovation-wise, in the years ahead. To the extent that innovation is the ultimate engine for economic growth, then, we might expect to see modestly slower global growth---led by relative slowdowns in the developed countries---unfold over the next 10 or 15 years.

Some caveats: Even though the focus here is on public sector expenditure on research, this is not to suggest that the public sector is responsible for most, or even much, of the innovation we observe today. Yet the public sector did play/are playing a collaborative, as well as catalytic, role in the creation of, among other things, nuclear energy, the sequencing of the human genome, the early Internet (Al Gore notwithstanding), and, of course, space technology. And even without a direct innovative function, government funding is often central for many private sector research endeavors. Indeed, an entire literature has emerged that explores the case for (or against) public subsidies, insofar as it may help overcome the free rider problem and stimulate research activity (or crowd out private R&D).

Furthermore, the data that we show are available forecasts for public expenditures, rather than expenditures specifically earmarked for funding research. Nevertheless, to the extent that any declines in public sector expenditures will proportionately reduce research funding,[*] then the main message would continue to carry through.

Note as well that the research productivity adjustment only corrects for quantity differences between economies, not quality differences; so the interpretation of the productivity-adjusted research output chart should keep this source of potential bias in mind. However, correcting for quality will likely lower the research output of developing countries even further; after all, the majority of top universities and researchers reside in the high-income countries.

Finally, this is premised on the assumption that the decline in fiscal expenditures in the developed world is pretty much baked into the cake (at least within the time horizon considered). It may yet be the case that the developed world more than overcomes the economic malaise that it currently finds itself in, and rapidly returns to trend rates of growth. This could help resolve (in a positive fashion) the discouraging fiscal outcomes described here. While there may be convincing reasons why this would not be the case, one should not dismiss the optimistic outcome wholesale.

*. The likelihood of which is reasonably high; if anything, politicians may regard cuts in research funding to be relatively easier than cuts to well-established social welfare programs, which tend to have more politically-mobilized (and energized) beneficiaries.

The Swiss National Bank (SNB) recently announced (PDF) that it would be pursuing a price floor on the Swiss franc of EUR/CHF 1.20. Moreover, reports indicate that this intervention will be unsterilized, which suggests a significant commitment to altering the actual franc supply dynamics, rather than simply relying on signaling effects from sterilized intervention (which both research (subscription required) and experience suggest are generally ineffectual beyond the short run). And to top it all off, the SNB heavily sold forward volatility options,[*] effectively seeking to dampen market expectations around the fluctuations in the euro-Swissie rate.

This action came on the back of almost a decade-long strengthening of the franc against the dollar, a two-and-a-half year strengthening against the euro, and---since mid-2010---a sharp increase in both the rate of Swissie appreciation coupled with an increase in the volatility of the currency (see figure). The appreciation has also meant that the SNB has accumulated an unprecedented amount of international reserves, swelling its holdings of foreign exchange on its balance sheet even before the announcement.

Source: World Bank staff calculations, from Thomson-Reuters Datastream and IMF COFER database.

How credible is the Swiss commitment to maintaining the 1.20 exchange rate? One argument is that it is entirely credible. After all, unlike the case where a central bank is defending a (potentially) overvalued currency, the logic of a standard currency crisis model does not actually imply a steady erosion of foreign exchange reserves and the inevitable crash; after all, a central bank has the ability to print unlimited amounts of its domestic currency. Consequently, the process of converting foreign currency to the franc at the 1.20 floor can, in theory, go on forever.

Or can it? As others have pointed out, such frantic printing will ultimately induce inflationary pressures.

Well... maybe. While long-run inflation (and hyperinflation) may be always and everywhere a monetary phenomenon, more modest inflation, especially in the short run, is affected by a host of other factors, including demand slackness, inflationary expectations, and the actual size of the monetary base. For example, were foreign holders of francs not spend their newly-acquired francs on actual goods and services in Switzerland (but instead hoard them in Swiss bank accounts), inflation expectations may well remain in check, especially when coupled with relatively stable domestic demand.

Does this then mean that the Swiss commitment is entirely credible? Unfortunately, no. So long as the SNB cares a little bit about both inflation and output, it will face the circumstance in the future where, were market participants to react positively to its 1.20 commitment, it would have an incentive to renege on its earlier exchange rate target. The logic is entirely analogous to the standard argument of time-inconsistent central banking.[†]

So, what do the travails of a small, rich economy have to do with developing countries? One only needs to look around the world to see that the currencies of emerging economies are now being increasingly viewed as safe havens akin to the Swiss franc (see figure). The Banco Centro do Brasil has been battling real appreciation ever since the (while simultaneously struggling with the one against inflation); many Asian currencies are seeing highs not experienced since the Asian financial crisis; and there is even market talk about shifting portfolios toward fairly thinly-traded Eastern European currencies.

Source: World Bank staff calculations, from BIS effective exchange rate indices.

This leaves developing countries that are currently experiencing a surge in capital inflows (and concomitantly strong exchange rates) in the uncomfortable position of needing to navigate the flood with some compromise of the impossible trinity: relinquish monetary policy independence with a hard peg, impose (leaky) capital controls, or accept currency strength but introduce some limited policy offset via (tighter) fiscal policy and (stricter) regulation.

*. For an excellent primer on the implied volatility surface, check out this Goldman Sachs research note (PDF).

†. More formally, let the loss function of the central bank at time t be given by a fairly standard Barro-Gordon type L_t = (π_t - π*_t)² + a (y_t - y*_t)², where π is inflation, y is output, asterisks indicate targets of each respective variable (so that the first term is the deviation of inflation from the central bank's target, while the second is the output gap), and a is the weight on the output gap. Using the purchasing power parity relation e_t p^f_t = p_t (where e is the spot exchange rate, and p and p^f are home and foreign price levels, respectively. Using the definition of inflation, it is possible to rewrite the above in terms of the exchange rate target: L_t = (π_t - E π*^f)² + a (y_t - y*_t)², where E is the target. If foreign inflation is given (as it would be in a small open economy), then the expression E π*^f effectively contains no control variables. For any central bank that cares about inflation, there will exist a rate of inflation where the optimal solution under discretion and following a rule differ; this implies that the fixed rate E cannot be credible.

The global economy is currently is the throes of a great transformation in economic structure, power, and influence. The economies that have been commonly called "emerging markets" appear to have finally "emerged," and are coming into their own in terms of their contributions to global economic and financial activity, the international corporate landscape, and even the shape of the international financial system (which are discussed in turn below). As they redefine the international economy, it has become ever more important for us to grasp what this phenomenon engenders, both for the major developing economies at the forefront of this change, as well as for those---especially the least developed economies---that remain at the periphery.

As has been discussed on this blog before, the phenomenon of shifting growth drivers is not a new one, at least from the perspective of global economic history. What does appear to be genuinely different this time is the hitherto unprecedented importance of developing countries at the helm of this change: Economies like China and India are increasingly assuming an importance in the global growth picture relative to the advanced economies, such as the United States, the euro area, and Japan (see figure below).

Source: World Bank staff calculations, from IE Singapore Statlink, IMF DOT and IFS, World Bank WDI and WIPO Patentscope.
Note: Multidimensional polarity index generated from the first principal component of trade, finance, and technology-weighted growth shares, measured in constant 2000 U.S. dollars, normalized to the maximum and minimum of the full 1969–-2008 period.

What this translates into is a world that is increasingly multipolar, and will only continue to be so in the future. In fact, from the perspective of relative economic size, the world is more multipolar now than it has ever been since 1968, and this trend of greater diffusion is set to continue into the future---certainly through till 2025 (see figure below, upper line). What is important to recognize here, however, is that a more diffused distribution of global economic activity need not imply a more balanced distribution of economic dynamism. And, as a matter of fact, it does not. The distribution of the relative shares of growth contributions does dip down from the highs of the 1970s, but we are living in the midst of what appears to be a nadir (see figure below, lower line). As we leave the financial crisis of 2007/08, the consolidation in economic growth---coupled with increasing economic size---of emerging powers such as China and India means that the world actually retreats somewhat from the multipolarity in growth contributions that we see today.

Source: World Bank staff calculations.
Note: Multipolarity index calculated as the normalized Herfindahl-Hirschman index of GDP and contribution to global growth shares of the top 15 economies, computed over 5-year rolling averages.

Now, while some have framed this transition in the language of competition and in the context of the “developed” versus “developing” world, this change should really be thought of more in terms of how the global distribution of world economic activity and influence is now simply less concentrated. Hence, the story is not so much one of advanced economy decline or emerging economy might, per se, but a more balanced sharing of the tremendous benefits that comes with economic growth. Put another way, this is the sort of economic convergence in output and incomes that economists have long dreamed about, and which has thus far been elusive, and is now tantalizingly close to being realized, at least for the largest developing countries.

What might the agents of such change be? While governments, especially through their policies, will undoubtedly play a role, emerging market corporations are likely to be the nexus of change. Indeed, the evidence suggests that firms based in emerging economies are increasingly active in the global corporate landscape. Nowhere is this more evident than in cross-border financial activity, which has historically been the domain of the advanced economies.

Cross-border FDI by emerging market firms---comprising both mergers and acquisitions (M&A) as well as greenfield investments---have risen dramatically over the past decade, in parallel with the greater prominence of emerging economies at the global macroeconomic level. Cross-border M&A flows have grown from $27 billion in 1997 to $254 billion in 2010 (a close to tenfold increase), with EM shares of both number and value of deals on an upward trajectory (see figure below, top panel). To a lesser extent, this can also be seen in more modest increases in EM shares of greenfield investments (see figure below, borrom panel).

Source: World Bank staff calculations, from SDC Platinum.
Note: Gross M&A flows comprises publicly-disclosed transactions from 10,000 acquirer companies in 61 emerging market countries, and acquisitions are defined to include any equity stake (even if less than 10 percent of voting shares).

Source: World Bank staff calculations, from fDi Markets and UNCTADStat.
Note: Gross greenfield flows comprises transactions from 5,000 investor companies in 61 emerging market countries, and greenfields are defined to include new outbound FDI projects and expansions of existing projects.

This activity has not been limited to South-North flows, where one may expect emerging market firms to be more active in their pursuit of the latest technology and expertise. Emerging market firms have been also ventured into other developing countries. In a sense, this is intuitive: Having been exposed to challenging business and policy environments back home, emerging market firms are particularly well-suited to contend with similar climates in other developing nations.

The expansion of cross-border private business activity by emerging market corporations can be seen in another important sphere. As the firms transact across national borders, they settle their trades in a designated vehicle currency, track accounts in a common invoicing currency, and book profits in an international asset currency. While the dollar has, since the postwar era, been the international currency par excellence, this is rapidly changing. When the euro entered the international currency stage at the turn of the millennium, European firms (and many emerging market firms that deal primarily with them) naturally moved a significant portion of their business dealings toward transactions in euros. As Chinese firms expand their activity abroad---China is already the dominant regional trading partner (see figure below), and the world's largest exporter---the use of the renminbi will only increase in cross-border transactions.

Source: World Bank staff calculations, from IMF DOT and World Bank WDI.
Note: Map for trade concentration relative to China, 2005--09 period average. Trade concentration of country i relative to country or area j is calculated as TC_ij = (exports of i to j + imports of i from j)/(total trade)_i * 100.

This trend will only be bolstered by official cross-border activity. Chinese sovereign wealth funds are already some of the largest in the world. China's reserve holdings are also massive. The benefits of issuing debt in one's own currency are significant, and there are also nontrivial seigniorage gains from issuing an international currency. Taken together, both private and public uses of money point toward the renminbi as the next likely international currency.

What future does a multipolar world hold for developing countries? Of course, since the major developing countries are at the forefront of the entire multipolarity phenomenon, their greater involvement in the future direction of the global economy means that decoupling between the advanced and emerging world (at least at the trend level) may finally come to pass. To the extent that this greater diversification of growth activity translates to a world that better weathers shocks and is more resilient to crises, developing countries of all stripes (not just the rising powers) will benefit.

Indeed, even economies currently in the periphery of world economy---especially the low-income countries (LICs)---can enjoy greater stability of external demand and experience some mitigation from volatility due to idiosyncratic shocks in any one growth pole. Over the past decade, economic complementarities between the large potential emerging economy growth poles and LICs (the former tend to hold a comparative advantage in manufactures, the latter in commodity inputs) have allowed for a mutually reinforcing trade-growth process between the so-called BRICs (Brazil, Russia, India, and China) and LICs.

It is important to recognize, however, that the specific impact of multipolarity on the developing world is likely to differ according to the country. LICs that are net importers of commodities and mineral resources may face higher global prices due to increased global demand for raw materials. Even in cases where LICs are net commodity or resource exporters, export-biased growth in these economies runs the risk of immiserizing growth. And LICs maintaining floating exchange rate regimes may experience heightened foreign exchange volatility in an uncoordinated multicurrency system, since they typically possess limited hedging capabilities.

A new unfolding reality awaits us, and it behooves us to better understand these developments. This is precisely the aim of the inaugural issue of Global Development Horizons, which seeks to open the conversation on these very issues, and more.

The recent Tohoku disaster---the worst recorded earthquake in Japan, and the worst national crisis since the Second World War---has triggered a veritable wave of analyses (PDF) on the possible economic implications of the disaster.

Much of the analysis has been top-notch, and there is little need to add to the existing discussion. However, it is worth considering one specific aspect of the economic impact of the crisis: the international finance dimension. In particular, it may be a useful exercise to think through the implications that the disaster could have on the current account position of Japan, as well as what they could mean for the Japanese yen.

To structure the discussion, it is useful to recall the current account (CA) identity, where net exports (exports, X, minus imports, M) is decomposed to the various components of national saving (S) net of investment (I):

CA ≡ X - M = S_hh + S_corp + S_gov - I,

where hh, corp, and gov are the household, corporate, and government sector, respectively. Let us consider each of these components in turn.

The most immediate effect of the crisis is that, owing to the disruption of production capacity and transportation logistics, exports would fall. However, imports are likely to head in the same direction (for the same reasons), and so the ultimate short-run effect is likely to be a truncation of trade. This is likely to be temporary, however, and small, given the fact that the major damage from the quake and tsunami was concentrated in the prefectures of Fukushima, Iwate, and Miyagi, and output from these regions constitute only about 4 percent of Japanese GDP.

Still, even a momentary offlining of Japanese intermediate goods suppliers will mean a disruption to the greater East Asian production cycle, especially for the supply chains for which Japan is a part. Furthermore, if one believes that international trade is characterized by internal or external economies of scale, then the indeterminacy of the direction of trade may mean a permanent change in the patterns of trade due to this temporary disruption. By and large, however, supply chain managers appear to be taking it all in their stride, and any permanent shifts in trade patterns are more likely to be driven by long run factors.

Furthermore, history suggests that this most pessimistic scenario is unlikely. The Kobe earthquake saw Japanese trade fall by about two months immediately following the event, but subsequent trade flows made up the lost ground. The ultimate recovery from that episode occurred remarkably quickly (subscription required). The only complication this time is continued uncertainty that may arise from an inability to contain the radioactive emissions from the damaged Fukushima First and Second (PDF) nuclear plants.[*] On balance, while the likelihood of such permanent effects is certainly nonzero, without further information on the path of the real exchange rate, it is difficult to gauge whether such effects will persist. To better understand the path of net exports in the longer run, then, we turn to considering the effects of the quake on the various components of national saving and investment.

Much of the historical current account surplus in Japan (see figure) is supported by a combination of three factors. First, Japan has traditionally had high levels of household saving, which has certainly contributed to the ability of the government to sustain a very large debt-to-GDP ratio of 200 percent (although only about 9 percent of Japanese government bonds are held by foreigners). Second, strong corporate performance in foreign markets has generally yielded stable cash flows, which have in turn been used in part for corporate finance but also maintained as corporate saving. Third, the very low rates of return on capital at home meant that investment levels were been fairly subdued.

Source: World Bank staff calculations, from IMF IFS.

Notes: Quarterly current account balances shown on a non-annualized basis.

Even pre-quake, there was already reason to believe that the historically significant current account surpluses in Japan may face pressures for their reversal. Demographic changes resulting from a rapidly aging population (with the highest life expectancy in the world) would lead to drawdowns on household saving, while bond market chatter about the deteriorating creditworthiness of the Japanese government may have eventually led to increased borrowing costs and hence an even greater primary deficit.

Now, reconstruction would likely mean that the Japanese will be led to accelerate the rate in which they reduce their saving. This is likely to occur through a combination of repatriation of private assets held abroad (both by households and corporates), along with increased dissaving by the Japanese government as it bears the cost of post-quake reconstruction efforts. This reduction in saving will moreover be accompanied by an increase in investment, again due to reconstruction and rebuilding. The bottom line is that the decline in saving and increase in investment will translate into a narrower current account surplus over the medium and possibly even the long run.

What does a narrowing current account surplus (or even a deficit) mean for the real exchange rate? Since the current account identity is, well, an identity, we would expect behavioral factors to govern the response of the decline in net exports. The main mechanism by which this is likely to occur is through a stronger yen. Indeed, the immediate aftermath of the crisis saw a sharp strengthening in the yen (see figure), which must surely be in due to changing expectations about financial flow behavior discussed here.[†] Ultimately, coordinated intervention by the G7 has led to a stabilization---indeed, even a slight weakening---of the yen. Over time, this weakening is unlikely to continue, as the force of trade flow reversals gets reflected in the yen.

Source: World Bank staff calculations, from Datastream.

Postscript: Elsewhere, Ilan Noy discusses the macroeconomic implications of the disaster, drawing on academic research (including his own) on the subject. Satyajit Das, among others, offers a sober take that considers many financial market considerations.

*. While the struggle to contain the effects of Fukushima remain, the most exhorbitant fears---such as how contamination would render all of Northern Japan unhospitable---are almost surely overblown. Radiation intensity follows the inverse square law, and the risks of exposure fall dramatically as one proceeds away from the Fukushima area. Even in the worse case scenarios, it is likely that the fallout will be less than that seen at Chernobyl, although there are concerns that if the problem is not contained soon, the final costs could in fact be greater.

†. There are other plausible explanations for the speed by which the yen strengthened, of course. One would be the surge in demand for the yen as traders were forced to unwind their carry in response to margin calls.

After a lull due to the global financial crisis, commodity prices appear to be resuming their upward march. The post-crisis recovery has seen steady increases in food prices, and these price spikes have fed unrest across the Middle East and North Africa. These geopolitical tensions in turn fuel higher oil prices, and the cycle repeats itself.

Which naturally leads policymakers to wonder whether how long the recent runup in food prices is going to last, especially when it comes so quickly on the heels of the food price spikes of 2008. The potential causes of the current crisis have been well explored elsewhere. Rather than reiterate these issues, it may be worthwhile the extent to which the crisis is real: that is, how much of the crisis is due to the likelihood that the shocks to commodity markets are permanent and persistent, and how much of it is due to either financial speculation [*] or elements for which changes in policy---such as those related to monetary policy, biofuel policy, and trade policy---could credibly tame.

As discussed in an earlier post, QE2 has been accused of being a driver of the commodity price inflation (including in food). Since food commodities trade in global markets priced in U.S. dollars, and greater liquidity must (trivially) be reflected as higher prices (with monetary neutrality), monetary expansion by the Federal Reserve would certainly show up in the nominal dollar price of food. But if countries choose to operate a floating rate, then this purely monetary effect would generally be cancelled out by exchange rate movements (more precisely, by an appreciation).

Now, while developing countries may not actually maintain floating regimes, there are other currencies that do, in fact, float against the dollar, and these offer a way to parse out the monetary effect. [†] Doing so in terms of either the euro or yen (see figure) suggests that there is certainly an element of actual market pressure---from either the supply or demand side---that goes beyond excess liquidity alone. Although the runup in the series denominated in euros or yen is less pronounced than that in dollars, the recent increase is unmistakable: indeed, all three series there is a clear uptrend from the lows in early 2009, and the recent high in the JPY series is even higher than the highs attained in 2008.

Source: World Bank staff calculations, from FAO food price index and Datastream.

Notes: FAO FPI index converted to alternative currencies using average monthly EUR and JPY exchange rates relative to the USD, normalized to unity in 1/2003. The FPI is an index of export share-weighted price quotations for 55 food commodities, based on the 2002--04 average, and measured in USD.

Alternatively, the FPI can also be "deflated" by the overall consumer price index.[‡] To the extent that excess liquidity can be expected to spill over into all classes of goods and services---and not only commodities---we would see an "inflation-adjusted" FPI move in lockstep with the unadjusted FPI. Intuitively, a divergence between the two series captures how much faster food prices are growing, relative to the overall price index. And as is evident (see figure), this divergence increased dramatically in the earlier 2008 crisis, and is once again diverging sharply. In fact, the gap between the two series in the summer of '08 is actually smaller than the gap this past December and January.

Source: World Bank staff calculations, from FAO food price index and BLS.

Notes: FAO FPI index deflated by the monthly U.S. CPI-U, normalized to unity in 1/2003.

These market pressures can also be seen in other classes of commodities, most notably in energy. Of course, the factors affecting food and energy may inherently be different, but there are some notable bridges that may account for some of the spillover effects. One important link is the role of biofuels (corn is both a food staple and the main feedstock in the production of corn-based ethanol). Thus, while it is true that the recent price spike is a little less broad-based than in 2008, corn prices have in fact risen dramatically, and corn has nasty habit of working its way into other commodity prices.

Here, however, the picture is a little more mixed. Energy has certainly risen sice the nadir in early 2009, but even so, its increase has been a lot less dramatic than the increase has been for food, with the index only halfway the highs achieved in the summer of 2008 (see figure). This is the case whether the index is measured in dollars or in pounds (although quantitative easing by the Bank of England may complicate a straightforward interpretation). Moreover, an Aussie-dollar denominated index would hardly have moved at all (again, the complication here is that the AUD is a commodity currency that is heavily affected by the boom in commodity prices more generally). Certainly, the current unrest in the Middle East may rapidly change this picture---especially if there is significant threat of a supply disruption from Saudi Arabia---but right now, it is hard to shrug off the notion that the market appears much more sanguine about the path of energy prices than it is about food prices.

Source: World Bank staff calculations, from IMF Primary Commodity Prices and Datastream.

Notes: The IMF fuel commodities index is an export share-weighted price quotations for petroleum, natural gas, and coal, based in 2005, and measured in USD.

Concerns regarding a rapidly changing oil picture aren't entirely misplaced. Oil shocks have historically brought on economic downturns, and while a temporary spike in oil prices may be shrugged off by a currently fragile (oil-importing) developed world, one cannot say the same for shocks that persist for six months or longer.[§]

Which brings us back to the question of how persistent we can expect these commodity price shocks to be. Here, we can marshall one piece of evidence which suggests that this time, commodity price shocks are different. In particular, food, energy, and metals indices appear to be moving more synchronously than ever before (see figure, top panel). This can be verified by taking rolling correlations of these series, which indicate that such synchronicity in the price cycles of all of these commodities is virtually unprecedented (see figure, bottom panel).

Source: World Bank staff calculations, from World Bank Commodity Price database.

Notes: Top panel: Monthly series for food, energy, and metals. Energy series for 1960--70, 1971--72, and 1973--75 are annual, biannual, and quarterly, respectively. Bottom panel: 36-month rolling bivariate correlations for the three series, smoothed with the 36-month moving average of each correlaation series.

Why might this be the case? There are reasons to believe that demand-side factors---especially growth in rapidly-industrializing emerging economy giants---may be giving rise to this commodity price pressure. While the jury is still out as to how persistent this phenomenon might be---historical price increases have typically been accompanied by supply-side responses---future developments may offer a clue as to whether such a hypothesis is indeed correct. If the correlation patterns we see above start to falter as emerging economies cool from their currently breakneck growth rates, then there may be reason to believe that demand-side pressure really is driving this current spurt in commodity prices.

In closing, it is important to point out that the discussion here about the reality of commodity shocks has centered on macro dimensions. Yet along another dimension, these commodity shocks are indeed very real. For many households in the developing world, these gyrations in global food and energy prices are more than frustrating fluctuations in the prices paid in restaurants, markets, and gas stations. With food accounting for a large share of consumption expenditures in the typical developing country household, a price spike in food may mean forgoing previously planned purchases, or even cutting back on food intake. As academics have repeatedly emphasized, the long-term human -capital consequences of even a transient food price spike can actually be remarkably persistent and severe. Pricey energy may mean that movement of goods is now more costly, which eats into already-thin profit margins for many developing country firms that rely on transportation to bring their goods to market.

Postscript: Recent work by Reuven Glick and Sylvain Leduc apply an event study approach to the issue, and find that while QE1 may have had a significant impact on commodity prices (whether direct or indirect), the effects of QE2 are decidedly more muted.

*. It is useful to remember that financial speculation, in and of itself, occurs primarily in futures markets and only induces real changes in spot markets when speculative expectations lead to actual stockpiling. This hypothesis is also inherently testable: such stockpiling must ultimate show up in inventory data.

†. Yes, of course exchange rates are determined by much more than just purchasing power parity (which only holds in the medium run in any case), and there may be incomplete pass-through. This naturally means that any exchange rate correction may be thrown off by a host of additional factors that may affect short-run exchange rate movements. Nevertheless, the concerted evidence for a range of floating rates (not just in the two reported ones, but even for other exchange rates) allows us to draw stronger conclusions.

‡. Deflating a price index with another is inherently tricky; after all, the FPI does not capture the production of actual goods and services (which a metric such as real GDP does), and the prominence of food items in the CPI itself also means that it is inherently tied to experienced inflation (as opposed to a real index of, say, stock prices). So the exercise does not, strictly speaking, produce a "real" index as much as an index that moderates the price changes in food with nonfood prices.

§. Of course, commodity price shocks are, technically, largely redistributive rather than purely contractionary: thus, while a spike in oil prices may lead consumers in oil-importing nations to cut back on spending on other goods, the additional income to oil-exporting nations will stimulate their respective economies. There may then be additional second-order effects, such as a recycling of this income through purchases of exports from oil-importing countries. Nevertheless, the historical evidence suggests that oil shocks tend to be contractionary at the global level.

America's latest round of quantitative easing---also known as QE2---set sail a few months back, and its departure (or arrival, depending on one's point of view) ushered in approbrium from much of the developing world's central bankers and ministers of finance. In their view, the move is an underhanded way of depreciating the U.S. dollar; indeed, this has already occurred, at least as far as the USD/EUR rate is concerned (see figure). The timing, of course, could not have been much worse: amid talk of global currency wars and a looming food crisis.

Defenders of such Fed action will be quick to point out, of course, that the policy has undeniable real effects, that American monetary policy is, ultimately, geared toward meeting domestic objectives,[*] that a stimulated U.S. economy can have clear benefits for the rest of the world, that global food prices are due more to emerging market demand, and that countries overly concerned with imported inflation can, in any case, simply allow their domestic currencies to appreciate.

Source: World Bank staff calculations, from FRED trade-weighted USD index and Datastream.

One important issue that has been somewhat neglected in the discourse thus far are the international financial dimensions of such a policy.

At one level, the analysis is fairly straightforward. Standard new open economy macro models suggest that unanticipated foreign monetary policy shocks---such as that implied by QE2---typically end up being welfare-positive for agents at home.[†] The standard policy concern of beggar-thy-neighbor competitive devalautions (resulting from monetary expansion) is thus alleviated, and developing countries can rest easy that, if anything, QE2 will be a minor boon for their economies.

Of course, the world is somewhat more complicated than even the most complex two-country open-economy models, and importantly, the implications of QE2 go beyond the (relatively) straightforward impact of monetary expansion on the level of exchange rates, terms of trade, optimal consumption-labor-leisure decisions. There are at least three important considerations that may affect developing countries in a nontrivial way: (1) implications of QE2 for countries with fixed rate regimes against the U.S. dollar; (2) what QE2 may mean for the future role of the dollar in the global economy; and (3) implications for future capital flows to emerging economies.

The most common criticism of the Fed is that QE2 is irresponsible monetary largesse, designed to prop up the U.S. economy while it makes an excruciatingly slow exit from recession. In some ways, this characterization may be a little unfair. After all, the Fed (as well as almost every other central bank in the world) has always been routinely involved in Treasury bond purchases and sales in the regular conduct of monetary policy, through open market operations; the main distinctions this time are mainly a matter of scale and maturity (and of course that pesky zero bound).[‡] Moreover, the expanded money supply in the United States has primarily appeared in the form of reserve holdings by Fed member banks, rather than actual currency in circulation. This is especially so since the Fed started paying interest on these reserves. The danger of galloping worldwide inflation due to a flood of liquidity, ipso facto, is probably overplayed.

That said, there are legitimate reasons---mostly to do with minimizing the real costs of exchange rate fluctuations, and exchange rate targeting being the lesser of two evils in the choice between inflation and exchange rate volatility---where an emerging market central bank may wish to run a fixed (or mostly fixed) exchange rate regime. Taking such a choice as given, QE2 may mean that these emerging market countries would be forced to fun a monetary policy that is far too loose, given the overall absence of spare capacity in their economies. The manifestation of inflation in many of the fast-growing emerging economies, then, is certainly no pure coincidence, and (to the developing country policymaker, at least) a necessary evil.

But is QE2 entirely innocuous for the U.S.? Certainly not. If you were asked to close your eyes and describe what a policy of "large-scale purchases of government debt by a central bank" would be, most would call such an activity (unsustainable) debt monetization. Indeed, this was pretty much the case in Latin America in the late 1970s---and, indeed, the description of such a policy was what inspired Paul Krugman to develop his pioneering first-generation currency crisis model.

Of course, owing the to "exorbitant privilege" that issuing the world's reserve currency confers, monetization need not result in a traditional currency crisis in the United States (since by definition it can always print the reserve currency necessary to finance its deficits). Still, a preponderance of dollars in the system would mean that the dollar becomes less valuable as a store of value: a major function of the dollar in its role as a reserve currency (and asset currency for the private sector). For emerging market central banks, a strategy of diversifying away from dollar holdings may well be a prudent one. Granted, the existing alternatives are not exactly attractive prospects, but with deepening financial markets and a seemingly greater willingness to expand convertibility, the renminbi appears poised to play a greater role as an international currency.

Looking further down the road, it is worthwhile to ask what QE2 may mean for the future of international capital flows. While interest rates on long bonds remain somewhat subdued, the 30-year has been on a steady rise since 2009, and it is not beyond the realm of possiblity that a combined double whammy of a disappointing fiscal outlook and continued loose monetary policy pushes U.S. interest rates significantly higher in a few years' time. Were this to occur, the United States would be competing even more directly with emerging markets for scarce global capital (which some outfits have suggested will only exacerbate over time).

*. As an aside, it should be noted that the stated domestic objectives of the Fed---in particular, reigniting economic growth through exiting the liquidity trap---may well entail pursuing a policy of depreciation.

†. This is regardless of accounting for changes in labor-leisure tradeoffs, the exchange rate, terms of trade, and consumption. Indeed, one of the stark findings in the Obstfeld and Rogoff's Redux paper is that the positive welfare impact experienced at home is irrespective of the source of the monetary expansion, because the effects of expenditure switching and both consumption and leisure reallocation are in fact second-order in nature. Moreover, this result (at least for the non-stimulating economy) holds even when one allows for economic size and terms of trade effects.

‡. More precisely, the Fed's balance sheet is currently holding an unprecedented amount of nontraditional assets (such as mortgage-backed and agency securities), and a much longer-dated maturity distribution than usual.

Talking currencies is back in vogue again. The ebbs and flows of the news cycles surrounding the renminbi, yen, real, and dollar almost resemble the wild swings of the currencies themselves. Why the sudden revival of interest in the mass media about so esoteric a topic as exchange rates? After all, in the rarified world of economic theory, countries would allow their national monies to be freely determined by markets for foreign exchange; in return, the market-established rate would magically eliminate imbalances in national trading accounts. In the real world that we inhabit, however, politics matters, and it matters intimately.

With Nobel laureates and think-tank supremos (PDF) vociferously espousing the merits of direct economic confrontation with China, it is perhaps useful to examine the political economy of Chinese foreign exchange policy a little more carefully.

First, some background: The standard narrative surrounding explanations for Chinese reticence with regard to appreciating the yuan is that the Commerce Ministry---which is aligned with the country's powerful export industry---opposes such an appreciation. Their interests somehow prevail, which is why China has steadfastly refused to allow its currency very much wiggle room at all.

The problem with this story is that it doesn't take the other political-economic interest groups within China very seriously. For starters, producer prices have shot up rapidly during that time (see figure, and note especially the different axes used for CPI and PPI inflation). This casts doubt on the thesis that exporters are unequivocally insistent on currency rigidity, and is a reminder that the Chinese export machine is, after all, built on final goods assembly, making China as much an importer of intermediates from the rest of the world as it is an exporter. And importers clearly do not benefit from a weak renminbi.

Source: IMF IFS.

Even if we accept the view that exporting interests do, on net, prefer that the yuan remain undervalued, the political economic environment includes other major players. One such player is the central bank, which clearly has an interest in keeping inflationary pressures in check. Indeed, consumer prices have steadily crept up since the end of the first appreciation window in the fall of 2008 (see figure again). This is the natural consequence of fixing the nominal exchange rate when the real exchange rate is appreciating over time. Similarly, consumers, like importers, benefit from the stronger purchasing power afforded by a lower yuan-dollar exchange rate.

There is some anecdotal evidence that suggests that China does have such opposing domestic interests insofar as the currency is concerned. The PBoC has been reported to favor a stronger and more flexible currency. Workers unions are becoming increasingly vocal about improving their welfare by demands for higher wages and expanding their purchasing power more generally. It is therefore unclear why the PBoC would allow export alone to determine its choices with regard to inflation and output volatility---especially since it is, after all, in charge of actually implementing any currency interventions.

This concern over price increases goes beyond the CPI and PPI. The major coastal cities are famously facing potential housing price bubbles. Shanghai, for example, saw property prices spike in the middle of 2007, and while the rate of appreciation has since moderated, house prices in coastal metropolitan areas remain under significant upward pressure (see figure).

Source: eHomeday.

Finally, it is helpful to point out that even though China's producers are in a competitive position relative to American manufacturers, the country does, as a whole, have some vested interests in a healthy U.S. economy. China is, after all, the largest foreign holder of Treasury debt, and as a consequence has little incentive to see a tanking U.S. economy threaten the fiscal credibility of the government. Nor would it want to risk the U.S. government being tempted to monetize away its debt, a point that has been repeatedly made by Chinese authorities.[*] Indeed, the desire to avoid a sudden collapse in the value of its foreign reserve holdings may be the central driver behind China's desire to ensure that any yuan revaluation (or, equivalently, dollar devaluation) happens at a measured and controlled pace.

Of course, the bottom line is that we do observe a lack of flexibility in the Chinese renminbi. This is indisputable, and to the extent that this relative stability reflects intervention actions on the part of the PBoC, one must be led to conclude (by a revealed preference argument) that the current USD/RMB exchange rate is one of design. But this does not take away the fact that the individual and institutional drivers behind this ultimate decision are multifaceted, and ultimately a reflection of the often differing motivations of a myriad of domestic actors. A keener understanding of this fact can improve policy responses, since it recognizes that realized exchange rate policy, far from being a monolithic outcome, depends at the margin on the distribution of costs, benefits, and power between different domestic political actors.

The policy take-away from all this is that among the myriad solutions currently proposed by the punditry---some, undoubtedly, very clever---the ones that will ultimately succeed are those whose proposed actions are consistent with the preferences of the central political actors, whether these be powerful special interests, influential legislators, or the electorate at large. With the option of trade protectionism having been taken away by a combination of institutional design (courtesy of the WTO), dire warning (courtesy of economists), and political reality (courtesy of importer and consumer interest lobbies), politicians are now forced to bring an exceedingly blunt instrument, the exchange rate, into the policy spotlight.

*. Of course, the Federal Reserve is an independent central bank and as such has the freedom to resist printing dollars to finance the deficit. But recall that Congress did exercise its authority to do so in 2009, and while the bill did not end up being enacted in its original form, the danger of politicizing Fed decisionmaking in the future seems real.