Ethan Ilzetzki on the U.S. Dollar as an Anchor Currency

Ethan Ilzetzki is an assistant professor of economics at the London School of Economics and a research affiliate at the Centre for Economic Policy Research. He joins Macro Musings to discuss exchange rate regimes, anchor currencies, and the new Triffin dilemma, as Ethan points out how the U.S. dollar is connected to a staggering 70 percent of global GDP. David and Ethan also discuss what the dollar’s dominant role in the global economy means for U.S. monetary policy, both at home and abroad.

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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Ethan, welcome to the show.

Ethan Ilzetzki: Thanks for having me, David.

Beckworth: All right, Ethan, with all my guests I always ask them how did you get into economics? What is your story?

Ilzetzki: Well I actually came to economics pretty late in life relatively. I started my working life as an electrical engineer and after a few years of working in high tech I decided I wanted a change and actually went to study international relations. I was very interested in the European Union and wanted to learn more about that. While I was studying that I started being exposed to economics and I really kind of enjoyed the economics courses and I found the rigor of economics to fit I guess my temperament more than some of the other social sciences that I was exposed to while studying international relations. Then I kind of did a basically a career change and became a PhD economist and an academic.

Beckworth: Along the way you worked with some great researchers including your co-authors, right?

Ilzetzki: That's right. Definitely an early influence to get into the academic side of economics was working at the International Monetary Fund. I worked as a research assistant for Carmen Reinhart and Ken Rogoff when Ken was heading the research department and Carmen was his deputy there. I really got my first exposure to economic research through that experience and not, I guess, over time I've graduated to being a co-author.

Beckworth: Right, nice.

Ilzetzki: From that early foray.

Beckworth: Well that's a great, fortuitous placement there being their research assistant. I'll mention to the listeners, soon after that you came to Treasury and that's where we first met. We were actually colleagues.

Ilzetzki: That's right.

Beckworth: At the Western Hemisphere office at the US Department of Treasury. Among other things, we worked for John Taylor of the Taylor Rule.

Ilzetzki: That's right. I remember a few late nights working on the Brazilian economy together.

Beckworth: Yes.

Ilzetzki: It was interesting times.

Beckworth: Interesting times indeed. Okay and now you're in London, you're living there and one question I have to ask about that is has Brexit affected your life? Your school? Your work in any kind of way?

Ilzetzki: On a personal level it's not very tangible yet.

Beckworth: Mm-hmm (affirmative).

Ilzetzki: I'm fortunate enough to have a secure position at a good academic institution which may be affected by Brexit but hopefully not to the extent that that affects my livelihood. More broadly this has been kind of a challenging time for the UK and also for the interaction between academics and public policy. There's sort of been ebbs and flows through this period of how willing policymakers have been to listen to policy advice from academics. Its definitely been an interesting period and kind of eye opening in terms of what our role is as researchers and academics.

Beckworth: Oh, absolutely. It's sobering over here, too.

Ilzetzki: Sure, sure.

Beckworth: In the US the Council of Economic Advisors, for example, has been demoted and economists have lost some of their punch-

Ilzetzki: Definitely, yeah.

Beckworth: At the policy level. In any event, let’s move onto this fascinating paper you have. Again, the name is *Exchange Arrangements Entering the 21st Century, Which Anchor Will Hold?* You are the co-author with Carmen Reinhart and Kenneth Rogoff and we're going to take a deep dive in so before we do that why don't you kind of give us the quick summary, the overview, of what the paper's about and what you find?

*Exchange Arrangements Entering the 21st Century*: Summary and Overview

Ilzetzki: Well from a technical point of view what we're doing is we have a statistical algorithm that allows us to classify an exchange rate regime and an anchor currency or reference currency for every country in the world. Then the paper goes on to give kind of a tour of the international monetary system around 2015 when our dataset ends and a history of how the international monetary system arrived at this point. So I can kind of give you the two headline-

Beckworth: Yeah.

Ilzetzki: Findings and then we can talk in more detail about each of them.

Beckworth: Please do.

Ilzetzki: So the first main finding is that the US dollar remains by far the most predominant anchor or reference currency and by some measure it's in fact the height. We're currently at the height of the dollar's influence internationally. The second main point is that there is this notion that we have moved too far greater exchange rate flexibility since the end of the Bretton Woods system of fixed exchange rates and we find that at best that that perception is greatly overstated. By some measures we're not much less fixed or less rigid than we were under Bretton Woods.

Beckworth: Yeah and those are pretty striking findings, right? They kind of go against the grain. Well, the second one in particular, right?

Ilzetzki: Sure, yeah. Yeah. So we're definitely not the first to point out that the dollar is-

Beckworth: Right.

Ilzetzki: The center of our current system but I think the extent to which, the orbit of other currencies around the dollar is kind of tighter than perhaps what others have suggested.

Beckworth: Yeah, I want to throw a number out there and we'll come back to it but I believe your results show about 70% of world GDP is tied to the dollar. Is that right?

Ilzetzki: Yeah, that sounds about right. I don't have the numbers in front of me but yeah.

Beckworth: Yeah. Well I'm going off your graph here.

Ilzetzki: Okay, yeah.

Beckworth: That's a staggering number. 70% of world GDP has its currency tied in some form or a varying degree to the dollar. We'll talk about the implications of that but that's mind blowing. You put in your paper that US GDP is it 18% of world GDP?

Ilzetzki: That's right, yeah. Yeah.

Beckworth: So we're 18% of the world economy, yet our dollar anchors 70%.

Ilzetzki: Yep, yeah.

Beckworth: That's just amazing.

Ilzetzki: Yeah, I mean, part of that of course when we look at ... We have two measures in the paper. One is to measure what share of world GDP is anchored to the dollar and the other is how many ... What share of countries. Of course when you look at the share of world GDP that's anchored to the dollar we have to take it into account that China is among those 70%.

Beckworth: Yep.

Ilzetzki: If China were to change course that figure could change substantially but in terms of the number of countries that seems to be pretty stable and is also comparable.

Beckworth: Yes and other important point and we'll get to this again later is that relative to all the other alternative, the euro, the yuan, there's no comparison, right? They trail way behind. They're not even close.

Ilzetzki: Yeah so the euro is a far second and I think at some point in the paper we say that the euro's probably best thought of at this point as the regional currency.

Beckworth: Mm-hmm (affirmative).

Ilzetzki: In the extended sphere of influence of the euro is of course the Eurozone and then countries in the European periphery like countries that are in the EU but not in the Eurozone like Poland or Hungary, other countries that are very close like Switzerland. Other than those and a few former French colonies essentially, the dollar is the main anchor.

Beckworth: Okay. Now Let's delve into that a little bit deeper. I want to go back to how you begin your paper and you do that by talking about this idea of an impossible trinity or some people might call the macroeconomic trilemma. But tell us about what that is and how it helps frame a discussion about the topic of this paper?

The Macroeconomic Trilemma

Ilzetzki: Yeah so I mean, Robert Mundell pointed out the impossible, already several decades ago, the impossible trinity that a country can't have independent monetary policy while having a fixed exchange rate and having no restrictions on the mobility of capital. Essentially one of those, if your objective is to have all three of those, you're going to be gravely disappointed and you're going to have to pick which of those three you give up. So you know, different countries in different points of time have tried to I guess square this triangle in a variety of ways. Through long periods of history countries have simply had a fixed exchange rate or a commodity standard in which they just lived with the fact they don't really have an independent monetary policy. Some countries, through actually most of modern history, countries have had pretty big restrictions on capital mobility and that allowed them some degree of monetary flexibility while being in a fixed exchange rate system. Of course some countries have opted for full monetary autonomy and capital mobility like the US for example.

Beckworth: Mm-hmm (affirmative).

Ilzetzki: But then allowed capital to move freely.

Beckworth: So the idea is you can only do two of those three goals, right?

Ilzetzki: That's right.

Beckworth: On a sustainable basis. Again the three options are capital mobility, so you allow funds to flow across the borders. Second possibility is you have a fixed exchange rate and the third one is that you are able to set your own monetary policy but what you're saying is you can only do two of the three. What happens if you try to do all three? Do we have any examples of countries that have tried to do all three and what happened to them?

Ilzetzki: Well for a limited period of time once you open up your capital account, once you allow capital to move freely, those capital flows are so large in quantity that they would really put enormous pressure on your exchange rate if you're attempting to control your exchange rate and pursue some monetary objective that isn't fully just dominated by that desire to have a fixed exchange rate. What happens then in good times what that means is just there's a lot of inflow of capital which means that the central bank has to accumulate a large amount of reserves in order to ... They buy up the foreign currency in order to stabilize their exchange rate and that might be costly financially but is ... That could go on presumably for quite a while. Indeed, we do see in the past couple of decades, I'm sure we'll get to that later, countries that have. For example, China accumulated a large amount of reserves. I think the bigger challenge comes when the capital starts flowing out and these are kind of, we have many examples of currency crises, Argentina in the early 2000s for example where once the capital starts flowing out the force of those capital flows are so great, the pressure is so great on the exchange rate, that it becomes nearly impossible for countries to sustain their exchange rate unless they are willing to do so at any price.

Beckworth: Yeah. I remember when I first was exposed to this idea I think probably was the late '90s when the emerging market crisis in Southeast Asia and spread to-

Ilzetzki: Right.

Beckworth: Latin America and to Russia. I guess the first question I had is why do countries want to try all three? What would maybe motivate them to go down this path of disaster? Any thoughts?

Ilzetzki: Yeah so I mean, each one of these objectives has some benefits and with the cost we just outlined.

Beckworth: Mm-hmm (affirmative).

Ilzetzki: In terms of the benefits I think it's easy to see why a country would want to have monetary autonomy and that is to sort of pursue some domestic macroeconomic objectives. Achieving low inflation, full employment which modern central banks like the Fed or the Bank of Japan try to do. So then in terms of capital mobility countries do want to be attractive to foreign investment, foreign direct investment and other portfolio investment and by opening their capital account they can gain from foreign investment. Some research has kind of questioned how valuable it is to really have fully free flow of capital but still sort of having excessive restrictions probably does spook foreign investors and limits the amount of investment your country gains. Now I think the most interesting from the perspective of our paper is why countries do want to manage their exchange rate and I think there is more than one reason. The dominance of the dollar, for example, or the pound in the 19th Century isn't only because of an official policy decision by governments. A lot of transactions are denominated in dollars. Most international trade is quoted in dollars even if it's not with the United States.

Ilzetzki: A lot of countries, most of Japan's foreign trade is denominated in dollars even if it's not with the United States. Japan is a major, the yuan is a major currency, and yet most Japanese firms quote their exports in dollars. New York is still a major financial center. A lot of both sovereigns and firms want to issue their debt in the US and when they do so they issue it in dollars. You have a lot of these private transactions that are happening in dollars. You have a lot of assets and liabilities on firms and banks balance sheets that are denominated in the dollar or some other major currency. So when the central bank or the government is trying to decide what is the appropriate monetary regime, whether by officially de facto or whether through their ... Whether officially or whether de facto, they end up perhaps paying a lot of attention to the exchange rate and not wanting that exchange rate to fluctuate too much so as not to change the relative price between for example assets and liabilities on bank's balance sheets. I think the financial transactions are at the center and it's really the monetary policy objective that follows.

Beckworth: Okay and so countries, they want to attach themselves, they have an incentive to attach themselves to an anchor currency for stability. You mentioned like the dollar, make your life a lot easier if everything's denominated in dollars and maybe manage the exchange rate so there's less surprises, less volatility.

Ilzetzki: That's right, yeah.

Beckworth: So they have an incentive to try all three but they can't do it on a sustainable basis. Number of countries have learned through trial and error. The emerging market crisis is an example. Something has to give. Now your paper is, what you guys do is you go and you classify where they've gone and where they are now.

Ilzetzki: Yes.

Beckworth: Go through and talk through this process of determining what the anchor currencies are and who attaches to them and compare that to what's already been done. The IMF has a list as you mentioned already. How does your model, your algorithm, build upon what they've already done?

Anchor Currencies and Building Upon Them

Ilzetzki: Right so I don't want to bore the listeners with too much of the technical details. There's a certain statistical algorithm that we use and everyone should feel free to go and look at the paper and see exactly how we do this but you're right to point out that the IMF has its own classification of exchange rate arrangements and there are another couple of researchers who do this, as well. Shambaugh and Klein have their own classification, Levy Yeyati and Sturzenegger have their own classification and again, I don't want to get into the technical details of how they differ. What I would say is that they each measure slightly different things and so they're probably each suited for different purposes.

Beckworth: Okay.

Ilzetzki: In our case, we're really looking at actual exchange rate movements, actual exchange rate volatility as kind of a summary measure of how anchored a certain currency is to its anchor currency. Instead of ... We're not looking at what they officially say they're doing, only perhaps to verify that what they say is true, and we don't look at other measures such as how much reserves they're accumulating, so actually how they're achieving. Whether they're doing it through interest rate policy or through reserve accumulation. We're just looking really at the extent to which your exchange rate is moving relative to the US dollar. In this new classification we've released now we're the first to really look at these two dimensions of policy, or two dimensions of classifications simultaneously. One is who is your anchor? Second is how closely you're anchored to that currency? You can think of this as being orbits where we're sort of saying, "Which solar system is each country in?" Then how close its orbit is to the euro sun or the dollar sun as they're revolving in that solar system.

Beckworth: Well tell us all the potential suns. What are the potential anchor currencies that one can choose from?

Ilzetzki: So we looked at any currency that could potentially be perceived as a anchor currency. We gave a lot of different currencies a shot but obviously the natural possibilities are the US dollar, the euro, before that the Deutschmark and the French franc, the pound, the yuan. For some countries there's sort of a peculiar, I wouldn't say a peculiar, but a regional anchor like South Africa, there are a couple of African countries that are anchored to the South African rand or to the Australian dollar. Those are the main anchors. Now, we also allowed for the possibility that countries are anchored to the renminbi, to the Chinese currency and there there's a little bit of a problem of observation equivalence because given that the renminbi is itself closely anchored to the US dollar it might be difficult to tell if some country in Asia is actually anchored to the dollar or to the renminbi. We're pretty ... At the moment it's very hard to tell the difference and we're pretty open in the paper to the possibility that time will tell that there are a couple of countries that may have been shadowing the renminbi rather than the dollar and we'll find that out if the renminbi loosens its anchor relative to the dollar.

Beckworth: Yeah and to go back again and summarize the headline number that I threw out earlier, in your paper approximately 70% of the world's economy is anchored to the dollar. Now to our listeners as you mentioned there's also an absolute number of countries. You can go down that path but I just jotted down the world GDP one. Just to put these things in perspective, approximately 70% of world GDP is anchored to the dollar. In a distant second you have the euro at 12%, the yuan at 5% and the pound at 2.7. I'm taking from this table four in your paper.

Ilzetzki: Yeah. Yeah. Sure.

Beckworth: It's striking. You have 70% at the front of the race, that's the dollar, and you have to go all the way down to 12% before you get to second place. That's amazing. Its stark difference between the two.

Ilzetzki: Yeah so I mean, the dollar truly is, by most of the measures we've looked at this is sort of the peak of dollar dominance. That might be surprising given that the US dollar had an official role as the main anchor currency, the post war period under Bretton Woods.

Beckworth: Yeah, that was also a very surprising finding is the dollar now is more of an anchor now than it was under Bretton Woods. Let's go back and talk about another currency that was a large anchor currency that historically played a large role but has slowly faded and that's the pound. Tell us about the pounds because you do talk about it. Post World War II it was still pretty dominant and what is its relationship to the growth of the importance of the dollar?

Ilzetzki: Yeah, I mean, World War I and the interwar period were periods in which the pound transitioned from being by far the most dominant reserve currency and anchor currency to the dollar gaining prominence. You can go back and read the economic history of the interwar period and how difficult the monetary policy decisions of the Bank of England were in maintaining the pound's international role. Our paper begins in the post war period and the Bretton Woods system following the second World War really gave the US dollar, against the opposition of kings, gave the US dollar a special role. But what we found, again our classification looks at deeds rather than words and so when we actually look at what countries were doing with their exchange rate, we see that in the post war period there still was a substantial share of countries, probably about 20% of countries that were still anchored to the pound. Primarily countries that were former colonies, part of the British Commonwealth. The way we can tell that is because the pound devalued several times against the dollar during this period. So you can just see whether other currencies stuck to their peg with the dollar or kind of devalued together with the pound.

Ilzetzki: It's not sort of an observation equivalence problem as I suggested currently with the renminbi but as time goes by, by the time the Bretton Woods system collapsed essentially the dollar took over the pound's role as the world's main anchor currency. Then following Bretton Woods there was a certain belief and some good reasons to believe that maybe the Deutschmark and later the euro would gain in prominence. Indeed, there was some gain in that period of time but really what the post Bretton Woods, the immediate aftermath of the end of the Bretton Woods system, really the main story is that many countries become unanchored. They really lose monetary control, they have hyperinflation and so those countries are anchored to no one. They essentially are unable to manage their monetary policy well enough to be anchored to anyone. The current reemergence of the dollar as a historic high in terms of its prominence, is partially coming from these freely falling currencies reestablishing an anchor with the US dollar plus the fact that we had another currency system in the Soviet bloc which was not part of our western monetary system and those countries once the Berlin Wall fell actually did join the dollar orbit rather than the euro or other currencies. The addition of countries like Russia and in central Asia also contributes to the dollar's prominence.

Beckworth: Just to summarize, the dollar's prominence has come at the expense of the pound. The Soviet Union's currency bloc and then some of the countries that had experimented with kind of floating exchange rates after the collapse of Bretton Woods.

Ilzetzki: Right, yes.

Beckworth: Today it's preeminent among other currencies. Well this leads me to a question I've often wondered and that is do you think there's a natural tendency for the world economy to gravitate toward one main reserve currency? You had the pound. We don't have a long data sample to really answer this question empirically. We had our first wave of globalization late 1800s. The pound was the reserve currency, as we mentioned. We've transitioned to the dollar but I'm wondering if we had to start over again and we run this experiment many, many times, would we always see kind of a tendency towards one single or one main reserve currency because the network effects? Maybe the economy scales? Any thoughts on that?

The Natural Tendency for a Main Reserve Currency

Ilzetzki: So I mean, this goes beyond what we can show with our data, but I think there are good theoretical reasons to believe that a single currency would dominate. Historically we do see some periods where we have kind of two centers of gravity but usually those are transitions between regimes. I mean, the theoretical argument comes back to what I was saying earlier that really a lot of this comes not necessarily from official decisions but from decisions in the private sector. If most trade is invoiced in dollars, most trade credit is issued in dollars and a lot of other liabilities and assets are denominated in dollars, balance sheets are going to be overweight on that currency so it could be the dollar, the pound or whatever. That just gives central banks the motivation to accumulate reserves both to have those reserves available for the private sector for those transactions and potentially to reduce uncertainty for foreign looking firms or even domestic looking firms, domestic firms often are dollarized and make transaction in a foreign currency.

Ilzetzki: The central bank then, it looks at what is the best type of monetary policy to pursue and often will decide that anchoring to that currency that happens to be dominant in international transactions, that that would be the best course to follow. Now I think there's sort of certain network externalities about what only one such anchor is likely to be dominant at a given time. Which currency should I denominate my exports in? Well it depends on sort of what reserves other importers have access to and what reserves do they hold. Well that depends on what currency I denominate my exports and so it's kind of a self-reinforcing situation.

Beckworth: Yeah, there's kind of a path dependency.

Ilzetzki: Yeah.

Beckworth: This whole idea of network effects. The more someone else uses it, the more I will use it and my use of it will reinforce their use of it and it just expands the network. So there's a very powerful force, right? It pushes us down whether we like it or not and my suspicion is if we ran this experiment, if we could run this experiment a thousand times we would probably see some dominant currency emerge. Which then leads us to another interesting part of your paper. In this paper, because of what we've seen, this tendency towards a dominant currency, we have this issue called the Triffin dilemma. Can you explain to us what that is and what it means for the US?

The Triffin Dilemma and the US

Ilzetzki: Yeah, so the Triffin dilemma is an idea introduced by the economist Robert Triffin in the 1960s. He was still thinking about the Bretton Woods system and the idea is, I'll maybe paraphrase it into kind of the way I think about it, is the issue of the reserve currency is supplying the international public good of an internationally used asset, a liquid asset. Now, while it's an asset for the rest of the world it's also a liability for the issuer of this currency. Whether you're holding the reserves in the form of actual cash or you're holding the reserves in the form of government bonds, these are liabilities to the US government. Then the question is how does the center country guarantee that it can really maintain these or support these liabilities? Now, under the Bretton Woods system there was a very explicit problem because the dollar was pegged to goal at a specific price. The question was, does the US have enough gold to repay all the liabilities that it's issues as it's guaranteeing? That they're as good as gold? In the currency modern incarnation there is no inherently ... I guess there's nothing on paper that makes it a true dilemma or an impossibility but at the end of the day US dollar liabilities, US government liabilities, are backed by the fiscal capacity of the US government.

Ilzetzki:  As long as people believe that the US can repay these liabilities, then they are happy to hold them but there may be a tipping point at which those liabilities are so large in quantity that people start jittering a little bit and wondering whether these liabilities can be sustained. There's a really nice theoretical treatment of this issue in a paper by Emmanuel Farhi and Matteo Maggiori where they kind of give a theoretical foundation for the possibility of a run on the anchor currency because the liabilities get too large in quantity.

Beckworth: So where would investors run to? What would be the alternative?

Ilzetzki: Well I mean, I guess that's part of the issue that it really is ... At some level there's multiple equilibrial problem.

Beckworth: Yeah.

Ilzetzki: I mean, is 100% of US GDP in debt sustainable? Well as long as demand for US dollar reserves are 1000% of US GDP then that's a drop in the bucket. If the US did have 1000% of its GDP in debt, presumably somewhere between-

Beckworth: Right.

Ilzetzki: At some point along that path, someone would start questioning whether the US, if this is just some kind of Ponzi scheme.

Beckworth: Right, right.

Ilzetzki: That's kind of where the tension comes that the demand is going to greatly outstrip ... The ultimate demand is going to greatly outstrip the supply. What happens when then at that tipping point is anyone's guess, I guess.

Beckworth: Now this raises a number of interesting questions because another way of saying what you just did is that this demand, this foreign demand for dollar denominated assets, is great.

Ilzetzki: Yeah.

Beckworth: People want to hold treasures, foreign exchange reserves, because it's a safe asset. Our capacity for national debt is larger than it would otherwise be, right? We can run larger deficits, accumulate more debt and your point is that at some point there will be a tipping point but until we get there, we may be surprised that it's larger than we would otherwise expect it to be.

Ilzetzki: Yes. That's a good characterization of it, yes.

Beckworth: Of course, no one knows what that tipping point is.

Ilzetzki: Exactly. The challenge is that it's a very sharp cliff. We don't want to be at that tipping point and we don't know where it is. That's kind of a hard strategy to have to play.

Beckworth: But I'm still puzzled though. At some point investors would run from the dollar but there are no good alternatives, right? Let me take that back. There aren't alternatives that can supply reserves, safe government assets, at the level the US has. I've often puzzled, what would people turn to? Commodities? Would they turn to gold?

Ilzetzki: Yeah, that's hard. It's hard to know. To some extent, I'm in no way an expert on the Great Depression but my understanding of Charles Kindleberger's, the economic historians, explanation of the Great Depression is really that that had a lot to do with the transition of the anchor from the pound to the US dollar.

Beckworth: Okay.

Ilzetzki: As the pound was no longer viable, the dollar was not yet a viable anchor and in the confusion that ensued we got the Great Depression. I'm not saying that that's necessarily my preferred explanation for the Great Depression but it's sort of ... It's interesting to contemplate that dislocation of that magnitude could occur because of a transition of that sort.

Beckworth: Yeah and along those lines I remember in the late '90s, yeah, mid to late '90s when the US was running budget surpluses and the national debt was actually going down people were beginning to freak out like, "Oh my goodness. What are we going to do without treasuries?" You know?

Ilzetzki: Right.

Beckworth: We never got there and a long ways from that point but the discussion came up both for monetary policy, "Will the Fed do open market operations," but I think more fundamentally what will the world do without this supply of safe assets?

Ilzetzki: Yeah, yeah.

Beckworth: Interesting discussions and hopefully we'll never get to that point but I don't know. I guess I want to jump to your conclusion. We have more to talk about. Let's jump to your conclusion though. Will the US hold its position as the anchor currency or do you see these other alternatives like the Chinese currency someday emerging as a substitute?

The Emergence of a New Anchor Currency

Ilzetzki: Well I mean, the only two I think potential alternatives to the dollar would be the euro and the renminbi. I think both of those currencies have a short run problem and the euro probably also a long run problem in kind of taking that role. I think the short term problem in the euro zone is pretty clear but the longer term issue with the euro is simply that Europe is declining as a share of world GDP. Whatever problem you see with the dollar as the main reserve currency, presumably the euro would have as well. Kind of short of there being a basket of reserve currencies, which I'm entirely open to that possibility, but short of there being a basket it doesn't seem like the euro could take the US dollar's role from it because many of the same challenges the dollar faces I think the euro faces even to a greater extent. It also has a problem of the fact that there's no centrally issued debt. An Italian bond is not the same as a French bond.

Beckworth: Mm-hmm (affirmative).

Ilzetzki: With China, it's primarily a short term problem. Its capital account is still pretty closed. It itself is still very anchored to the US dollar. It only kind of recently became truly an internationally traded convertible currency. It's really very early to see what the possibility of China is as a reserve currency but clearly China is the rising power in terms of its role in the global economy and so certainly it's something to reckon with. As I mentioned earlier, also kind of China may already have a latent role in the current international monetary arrangement. That's just very difficult to identify statistically because it itself is anchored to the dollar. It would take a major devaluation or revaluation of the renminbi to test whether other currencies in Asia are really in its orbit or maintain a dollar orbit.

Beckworth: Yes. Wasn't too long ago people were talking about the euro displacing the dollar which was interesting and now we've come to this point where it doesn't seem likely. I remember early to the mid-2000s even Saturday Night Live had a skit where they had someone dressed up as a dollar and all the other currencies were people dressed up in outfits like the euro, even the peso, and they come up and they beat up on the dollar, they physically punch and beat up the dollar. Even the peso was beating up on the dollar and that was kind of a joke back then but roles have reversed dramatically since the crisis in 2008. One of the things I want to get to in this, I love this paper and maybe one can call it confirmation bias because it totally fit my prior to the world but it's well done, it's well documented. One of the big implications I see in this and it's not really the scope of your paper but I'd like to hear your thoughts on that is that if 70% of world GDP is anchored to some degree to the dollar, that has huge implications for Federal Reserve policy.

Beckworth: That means when Janet Yellen and FOMC sits down to set monetary policy they're not just setting it for the US economy. They're setting it across a large swath of the global economy.

Ilzetzki: Sure.

Beckworth: Do you see issues there? I mean, the Feds mandate is domestic but it clearly has a global reach because of this. What are your thoughts on that?

Ilzetzki: Yeah, I mean, the Fed has its domestic role. It's not answerable in some sense to the rest of the world and so I think the question becomes how do other central banks mirror what the Fed is doing or how closely they monitor that. I mean, I would sort of more ... I don't know if it has any direct implications for Federal Reserve policy directly. More perhaps on the spillovers that the Fed has on the rest of the world. On that point, I think Helene Rey had a very good paper at The Jackson Hull Conference I think three years ago in which she essentially said that the trilemma that we started our discussion with is actually a dilemma that essentially you ... With the magnitude of capital that we have, essentially everybody has to follow Fed.

Beckworth: Yep.

Ilzetzki: Sort of mimic Fed policy and they really don't have independent monetary policies but I would say that that's something that monetary policy makers in the rest of the world just really need to be cognizant of and cautious as the Fed, for example now, begins on a tightening cycle. I guess in the current environment the Fed is sort of broadcasting via the tightening extremely slowly, you know?

Beckworth: Yep.

Ilzetzki: I think they're giving ample time for anyone who is concerned to manage their strategy.

Beckworth: It's tough though, right? If you're another country and your monetary policy is effectively on autopilot being directed by the Federal Reserve, your business cycle may be very different than the US business cycle so what could be good for the US economy may not be good for your economy. And you're right, the Fed has signaled its desires to raise interest rates, to normalize monetary policy but one example of this that's recent that's happened is if you look at the strength of the dollar ... The Fed begins talking up rate hikes soon after Yellen is appointed. You can see this in futures contracts. I've looked at this a little bit for a paper. If you look at Fed Fund Futures one year out, what does the market think the federal Fund rate's going to be one year ahead? From about mid 2014 all the way up until the first interest rate hike in December 2015, that year and a half period, you see almost a 20% jump in the dollar. It's a real sudden increase in the trade weighted value of the dollar but at the same time you also see this increase in the expected path of the federal fund rate.

Beckworth: The Fed is signaling, "We want to increase interest rates," and then in conjunction of that, of course in Europe and Japan rates are going down, but the Fed is clearly signaling interest rate hikes. The dollar's gotten stronger, it kind of plateaued in 2016 until President Trump got elected and it went up again. It’s come back down but the dollar today is still roughly 20% higher than it was in mid-2014 when they started talking up rate hikes. During that period it put a lot of stress on the global economy. The strong dollar-

Ilzetzki: Yeah.

Beckworth: Did way down on emerging markets. I see this as an ongoing challenge. If the Fed ... We've barely increased rates in the US and we created these problems for the rest of the world. I can't imagine what's going to happen if we're able to push rates up two, three percentage points. Maybe we can't. Maybe we won't be able to because maybe we'll drag down the global economy and it'll come back to bite us in the rear but I do think this is an immense challenge when you set monetary policy in 70% of the world economy is anchored in some degree to you, there's going to be tensions that the Fed cannot avoid.

Ilzetzki: Yeah, absolutely. I mean, coming back to the Helene Rey paper I mentioned, I don't want to put words in her mouth.

Beckworth: Mm-hmm (affirmative).

Ilzetzki: My feeling of the direction her paper takes is that the value of free capital mobility is greatly overstated and so just stop the flow of capital into your and out of your country. I'm a little concerned of the political economy of these type of capital restrictions but that's kind of maybe a separate discussion but that's one possible. The other possibility is obviously fiscal policy as-

Beckworth: Yeah.

Ilzetzki: An alternative to monetary policy if monetary policy is unavailable because it's really shadowing the US's policy.

Beckworth:         Yeah, absolutely. In fact, we have a few minutes left I want to segue into that. You have a fascinating paper titled, *How Big or Small Are Fiscal Multipliers?* You do a cross country analysis examining the size of fiscal multipliers so you're really good at getting these big datasets together and examining these interesting questions. Can you tell us about that paper there? What did you find about the effectiveness of fiscal policy?

Fiscal Multipliers and the Effectiveness of Fiscal Policy

Ilzetzki: Yeah, so what we ... There's obviously a lot of research that tries to figure out how big the fiscal multiplier is and that's a challenging ... You've talked to a few of your past guests about this question. What we try to do is really ask less how precisely what the point estimate is and really to compare where is it larger and where is it smaller? When is it larger and when is it smaller? What we find is that consistent with standard textbook macro theory, the fiscal multiplier is significantly larger when a country has a fixed exchange arrangement than when it has flexible exchange rates. The multiplier is much larger in a closed economy than in a more open economy, open to trade, that is. We also found that multipliers are higher in high income countries. It was actually kind of significantly smaller in developing countries.

Beckworth: So one of the interesting implications or findings that you had and you listed it is that in a country with a fixed exchange rate, the fiscal multiplier is much larger than in a floating one. That's right?

Ilzetzki: That's right, yes.

Beckworth: What is your explanation for that? Because an example that comes to mind would be maybe like the Eurozone, some of the countries in the Eurozone, right?

Ilzetzki: Yes.

Beckworth: They effectively have a fixed exchange rate. Like Greece, let's pick on Greece, I'm getting to Greece here. They had some serious fiscal austerity that probably wasn't the best thing to do in the middle of a deep depression so I can imagine if you went out and measured their fiscal multiplier it was large but what role, is there a story or a mechanism you could tell here?

Ilzetzki: Yeah so I mean, what would tend to happen in a country that had monetary autonomy is that for example if it wanted to pursue austerity it would do so if it needed to do so because of a debt crisis that it's facing or lack of credibility that it's facing. Then it would have a more austere fiscal policy but a central bank would then accommodate, would try to kind of reverse course and lower interest rates in order to try to smooth out whatever dislocation the fiscal austerity is causing. It's really, I mean, the way I would see this distinction between fixed exchange rates and flexible exchange rates as perhaps a special case or maybe an extreme case of monetary accommodation, of how much the central bank is responding to fiscal policy.

Beckworth: My colleague, Scott Sumner here, he likes to call that monetary policy offset.

Ilzetzki: Yes, yeah. Okay, that's a better phrase than I use.

Beckworth: No, no. It's just maybe a more colorful phrase. But just the idea that fiscal policy can be contractionary without having major dislocations if monetary policy is able to offset it.

Ilzetzki: Yes. Yeah. Now, to the specifics of Greece I want to caution that it's not clear what their alternative was. I mean, at some point it's not a matter of policy choice it's really just a question of policy necessity. On the specifics of Greece austerity isn't great but compared to what?

Beckworth: Yeah.

Ilzetzki: I don't know what the other ... Another thing to point out is that when you talk about monetary accommodations we get to these same questions of whether fiscal policy is more effective when you get to the zero lower bounds. You might think of a corollary of our fixed exchange rate result would be that fiscal multipliers could be larger when interest rates get to zero because it just is no longer feasible for the central bank or the central bank would not in those circumstances crowd out the fiscal stimulus that the Treasury is conducting. We don't have episodes of zero lower bound or significant ones in our … really test that directly but that could be corollary to what we find there.

Beckworth: Very fascinating. So the zero lower bounds would be a place that would be effectively an extension of your finding here that fixed exchange rates lead to large multipliers in the sense that monetary policy's kind of bound, it's kind of stuck at a point. Something I would like to hear from you is what about fiscal policy trying to operate in an environment where inflation is rigidly kept at say, 1%, 2%. Let's take the ECB in general. I know they don't have a fiscal policy across the entire Eurozone economy but they've kept inflation relatively, I should have kept, it's been relatively low. I'll make the argument maybe the ECB is a part of that story. If there could have been major fiscal policy, would it have been effective or would the ECB have stepped in and maybe done a monetary policy offset to keep inflation low?

Ilzetzki: Yeah, I mean, I think that's ... Part of this comes to the political economy of the central bank and how they view their role. But if we take from a purely economic perspective a inflation, a very, very strictly inflation targeting central bank, putting aside the zero lower bound problem, would in principal offset anything that the fiscal authority would do and kind of would make that moot. What's the point in using this tool which we, fiscal policy which we would view as being kind of a little more complicated to pass legislatively and might be less well targeted? Why would we use that instrument when we have monetary policy and moreover, the monetary authority would just undo what you're planning to do in the first place. Now, when you're in a currency union that gets a little more tricky because you might be at an inflation ... The average Eurozone country might have a exact correct target. That was not the case in recent years in the Eurozone.

Beckworth: Right.

Ilzetzki: But you know, in principle the Eurozone could be at exactly its objectives and a specific country could be in a very high rate of inflation or a very lower rate or deflationary environment. Their fiscal policy could be the secondary instrument that would come and deal with these sort of regional internal imbalances that ... To some extent we do that all the time. Unemployment insurance in the United States to some extent does that. We don't think about that as some transfer from North Dakota to Nevada but unemployment insurance, maybe North Dakotan's do feel that that's what happened but there was a transfer across states. We are hopefully still a cohesive enough country in the US that we don't view this as a transfer from one nation to the other. While I think the challenge in the Eurozone really comes down to these politics where any such transfer is really viewed through the lens of national fiscal policy and not as a unified economic block.

Beckworth: I think you're right. I think this all comes down to political economy both for Europe but also for the United States and what it's able to do in these deep recessions, how rigidly is it committed to inflation targeting? Well our time is up but it's been a fun discussion and our guest today has been Ethan Ilzetzki. Ethan, thank you for coming on the show.

Ilzetzki: Thank you.