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.

David Beckworth
Calendar Date: 
May 8, 2017
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The US dollar is currently the world’s dominant anchor currency, but that may be subject to change in the near future.

Ethan Ilzetzki on Exchange Rate Volatility, the ECB’s Strategy Review, and the Future of the Euro

Ethan Ilzetzki is an associate professor of economics at the London School of Economics and a research affiliate with the Centre for Economic Policy Research. Ethan is also a returning guest to the show, and he re-joins Macro Musings to talk about the European Central Bank’s big strategy review, the future of the Euro, and whether change is afoot in our international monetary system.

Read the full episode transcript:

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 back to the show.

Ethan Ilzetzki:  Thanks for inviting me back.

Beckworth:  It's great to have you on. We were talking prior to this recording about our glory days at the US Department of Treasury. So if you ever want the background story on me, Ethan is the man to get it. So we had some good times there. I think you sat like three cubicles down from me.

Ilzetzki:  That's probably right. Yeah.

Beckworth:  Yeah. Yeah, and the interesting thing is, Ethan, I think everyone in that office... So, we were in the office. The Western Hemisphere Affairs had an interesting portfolio. Something exciting was happening in their countries. So, for example, our colleague Chris Kushlis had Argentina at the time there was a debt restructuring going on. I remember there was a Dominican Republic bank run crisis in that time, too. Was that in your portfolio?

Ilzetzki:  I was working on Uruguay at the time who also was experiencing a banking crisis, spilling over from the Argentine crisis.

Beckworth:  So a lot of interesting things going on. And my portfolio, lo and behold, was in Mexico and Canada. And so I had this really tame... I hate to say this, but almost boring... portfolio. I mean, lovely countries-

Ilzetzki:  You were Mr. NAFTA.

Beckworth:  Yeah. I mean, it was great. I was wined and dined by their diplomats, but you guys had all the fun, so I got to ride off your excitement and success in the countries that you covered. But great memories, great times there at the US Department of Treasury. And I'm glad to get you back on this show. You've been on before. I encourage our listeners to take a listen to Ethan's first show, if you haven't already. We'll provide links in the show notes. And that was a great discussion about the role of the dollar, the dollar's dominance, all the countries that either implicitly or explicitly peg to the dollar. And today we're going to kind of carry on that conversation, and move over to Europe, and then maybe come back and talk about, again, the international monetary system, of which the dollar is a big part. And I want to begin our conversation about the euro by first moving to a survey that you're a big part of. In fact, you head it up, as I understand.

Beckworth:  And this survey is similar to what we do in the US when they go out and they ask the top experts, "What do you think about certain issue?" So, why don't you walk us through what your survey is like and what you do, how you do it, and all that good stuff.

The Centre for Macroeconomics Panel of Experts Survey

Ilzetzki:  Right. So I manage the Centre for Macroeconomics panel of experts survey. So, the Centre for Macroeconomics is a UK-based research institute that is a collaboration between several top universities in the UK, and we have surveys of the top UK macroeconomists and a separate survey of top European economists. So it's around a hundred economists from all over Europe, very prominent economists, including members of the German Council of Economic Advisers, and very senior officials in the French Treasury, and other academic economists. Every month we conduct some survey of an interesting topical question and see what the consensus of view in the profession is on that topic. I'd be happy to talk about some of the recent interesting findings.

Beckworth:  Yeah, we'll provide links to your surveys. And I want to focus on one question in particular. But I was looking through your list of people that are on the survey, and the few names that stood out to me... And again, there's many, many more. But just some, including Roger Farmer, Jordi Galí, your colleagues Benjamin Moll, Ricardo Reis. They're on that panel. Correct?

Ilzetzki:  Yes. Yeah. Yeah. And many, many others. I don't want to single out any of my members.

Beckworth:  Well, three of those I just mentioned were on the podcast previously. So they deserve some mention. But yeah. Many prominent people. And again, it's very similar to the IGM panel we see here in the US, that people look at. It's fun. It's fascinating. So I want to move to a survey you did on November 2nd, and this one was on the ECB's review of its strategy. So, similar to what the Fed just completed. So, maybe tell us about this review process. And why did you do this survey now?

The ECB’s Strategy Review and Its Inflation Target

Ilzetzki:  Yeah. So, the European Central Bank is in a process of a review of its strategy. The strategy review is supposed to be completed this year, but because of COVID they've postponed it to the middle of next year. And by parsing through some of the statements by Christine Lagarde and other top ECB officials, it looks like a few of the major questions that are going to be on the agenda regard the inflation target, whether something more symmetrical should be done, whether unemployment should be taken more explicitly into account. And so, the reason we did this survey now is that in the US, a similar review did come out. You've talked a bit about how big or not big this change is, or whether this is a nod towards nominal GDP targeting or something else. And so we thought it would be interesting to see what top economists would recommend to the ECB in reformulating its monetary strategy.

Ilzetzki:  So we asked three questions. So, if you look at the mandate of the ECB at the moment, it says that inflation should aim to be at or below 2%. So the asymmetry of the target is almost explicitly stated in the bank's mandate, which is different from the Fed.

Beckworth:  So what does that actually mean? I know there's different interpretations, but what does that mean, "being close to"? What range would you put on that target?

Ilzetzki:  Right. You're absolutely right that this is a topic of disagreement. It requires some sense of humor to think that central banks can target inflation that accurately, so I think this is more about anchoring inflation expectations, but you're absolutely right that it's not clear what they're anchoring expectations to. If you take it quite literally, it seems that the ECB needs to respond aggressively to inflation exceeding 2%, but many statements of the ECB over the past decade, including statements by Mario Draghi and Christine Lagarde, seem to imply that overshooting 2% is not something they would necessarily frown upon. We were asking our panel whether the ECB should be more explicit in stating that it's going to allow inflation to exceed 2% to make up for periods of below 2% inflation, which would maybe come a little closer to doing something like nominal GDP targeting or price level targeting. And on this question, the panel was very, very strongly supportive... in fact, as close to as unanimity as we get on these type of surveys... that the ECB should allow inflation to overshoot and that the target should be more symmetrical.

We were asking our panel whether the ECB should be more explicit in stating that it's going to allow inflation to exceed 2% to make up for periods of below 2% inflation, which would maybe come a little closer to doing something like nominal GDP targeting or price level targeting. And on this question, the panel was very, very strongly supportive.

Ilzetzki:  We then asked whether unemployment should be taken as a second mandate. And again, there is some debate about whether that mandate already exists in the ECB's current mandate. But it's not as explicit as the Fed's dual mandate. And here too there was a strong consensus that unemployment should be at least a secondary aim of monetary policy in Europe. The additional question we asked was whether the panel would support changing the inflation target and raising it to a higher rate. The argument, perhaps, being that, with real interest rates so low, the risk of hitting the zero lower bound becomes higher when inflation is only 2%. Here views were more mixed, but, in fact, the majority opposed this view. I can't remember what I responded to this question myself. I don't feel strongly one way or another. I actually expected to hear more of the panel viewing this... On this question, the status quo won out among the panel.

Beckworth:  Well, that's not too surprising to me if there's a lot of Germans in this survey.

Ilzetzki:  It's pretty equally balanced across Europe.

Beckworth:  Okay. It's equally balanced. Okay. And that's the question I had. Do the Germans, who've been very cautious, and want to guard their reputation and institutionally keep the ECB very similar to the Bundesbank... Do you have any sense whether they were eager to allow any changes?

Ilzetzki:  If you look at recent statements by Jens Weidmann, you do see maybe some softening of the German position on some of these issues. But I find it nearly politically impossible for German officials to give too much ground on this. The objective, in the mind of the German policymakers in creating the euro, was to create a Europe-wide deutsch mark, to be blunt, not to be a Europe-wide Italian lira. And any concessions on this line would, in their view... And I'm not expressing my view. I'm just trying to iterate their opinions on this. Any concession on this is viewed, to them, as failing the mission that they set out with the creation of the euro.

Beckworth:  Well, maybe that's why, or at least one reason why, the overshoot, or making up for lost ground in a target, is more popular than actually raising the inflation target. Because it wouldn't be as big a change.

Ilzetzki:  Yeah. Absolutely. I feel like I've been put in a corner of being the German spokesperson here. So I think, again, the opponents of increasing the target feel like that is a genie that, if you take out of the bottle, you can't put it back in. While saying we need some make-up inflation for periods of low inflation, if inflation is high, that mandate kind of becomes irrelevant. So yes. I do see that there is a substantial... I mean, there's also questions whether the ECB, under the treaty agreements, has the mandate to simply announce a higher inflation target.

Beckworth:  Well, I would make the case to the ECB this way. If you do make-up policy, you're effectively approaching a price level target which is, I think, the ultimate kind of price stability. Inflation target, in theory, could be a random walk. Who knows where the price level is 10, 15, 20 years from now? Price level target, you're even more committed to what the German ideal is. So that'd be my sales pitch to them. But let me switch topics on this question, take it from a different angle. The ECB has not been hitting its inflation target. Is that fair to say?

Ilzetzki:  Yes. I think that's probably true of most advanced economies, central banks. Actually, just to come back to the survey for one second, I'd encourage listeners to actually go to the website, because what's really nice about this survey is that we ask the panel really to elaborate on their responses, so you can really get the whole view of... I recall Lars Svensson, who used to be the head of the Swedish central bank, on the panel, talking about research he's done related to price level targeting. So you can see the heterogeneity of views by reading the responses. But yeah, to come back to your question, yeah, it seems like central banks around the world, at least in high-income countries, have been finding it hard to hit the inflation target from below rather than from above, as we usually thought the problem would be.

It seems like central banks around the world, at least in high-income countries, have been finding it hard to hit the inflation target from below rather than from above, as we usually thought the problem would be.

Beckworth:  And in the Eurozone it seems, at least from my impression, which may not be right, that they're having a particularly tough time even compared to the Fed and other central banks. They've really fallen short. It raises the question, in my mind, as to whether this review, or really any review, is really the right question to be asking. Maybe the first question to ask is, "Why haven't they been hitting the target?" Is it because they can't? You might tell a secular stagnation story. It's beyond the central bank.

Beckworth:  Or you could tell another story. The central bank has been negligent. It simply has been too hawkish. It shouldn't have had rate hikes, or talked up rate hikes, or dialed back on QE. I mean, in the US I think you can make a reasonable case that the Fed shouldn't have tightened in 2015 and 2018. Now, how much difference that would have made on the inflation outcome, I don't know. But I got to think it would've been a little bit better. And so I wonder, in the case of the ECB, could they have done better, even if there are these other secular forces out there?

Ilzetzki:  This really depends on how effective you think measures like quantitative easing and forward guidance are. I think there are limits to what the ECB could have done, and I think that's true also of the Fed. I agree that it may have been premature to raise interest rates when the Fed did in the end of the decade. So you would have to argue that there is a very correlated mistake that all central banks are making, which is a possibility. There's some groupthink, and central bankers are all making the same errors. But if you see a lot of people making the same mistake, you have to wonder whether it's really a mistake or they have more control than they believe they do. To some extent, the world looks a little like what Bob Hall says about inflation, which he says you can treat it as an exogenous variable, that it's not… There's some driving force that has... I might be misquoting him, but I do recall him making that statement a couple of times. It does feel like there are other forces at play. I know we'll talk about my Brookings paper later on. But one of the things we do argue there is that there may be some factors, some secular factors, that are causing low rates of inflation and are making central banks' jobs more difficult in this regard.

Beckworth:  Yeah, I think that's a fair point and a reasonable take. There's something systematic going on. That we know. Right? You don't undershoot for a decade and not have something that... This isn't a case of bad luck. I mean, it would be incredibly bad luck to have this over a decade. Something systematic's going on. And the question is, is it something systematic within policy making or something systematic from outside? And maybe it's a bit of both. But I do think you can make a case something outside. And I look forward to that, as we get to it later in the show. Well, let's segue, then, from the ECB and this review to a discussion of the euro more generally. And you have a great paper titled *Why Is the Euro Punching Below Its Weight?* So let me begin our conversation on this paper by asking, has the euro been punching below its weight? And what evidence is there for that?

Is the Euro Punching Below Its Weight?

Ilzetzki:  Yeah. So that is a joint work with Carmen Reinhart and Ken Rogoff which is now coming out or out in Economic Policy Journal. And the first part of the paper really does try to document the extent to which the euro is punching below its weight. And let me put this maybe in a historical context. The ECB makes it very clear that being an international currency is not part of its mandate. It has a domestic mandate, although that is true of the Federal Reserve as well. But if you go back to the founders of the euro, they certainly had geopolitical considerations in mind in the creation of the euro. So certainly there was this Gaullist view that dates back to Jacques Rueff and Charles de Gaulle, that the exorbitant privilege that the US gains from dollar dominance is a major cost to France and to other European economies.

Ilzetzki:  And so part of the rationale of creating the euro was that the whole is greater than the sum of its parts and that, disposing of these 19 national currencies in favor of one, there would be some economies of scale that would create an international currency. What we do in this paper is we go over metric by metric of the international stature of currencies. And by pretty much every metric, the ratios are pretty much 60% dollar, 20% euro, another 20% for everything else. But what's particularly interesting is if you go look back at the period before the creation of the euro and then you take together the French franc, and the German deutsch mark, and a couple of other major European currencies, then too European currencies had, by many of these metrics, 20% of global market share, so to speak.

Ilzetzki:  And so we do think, to some extent, that there are economies of scale in currencies. That's why each US state does not have its own currency, for example. And so I think it is surprising that, 20 years later, we don't see the euro gaining more prominence. I mean, I can go through some of the metrics if you're interested, but essentially there's a very, very consistent picture of the euro being a far second, while it's an economy that's only about a third smaller than the US economy.

I think it is surprising that, 20 years later, we don't see the euro gaining more prominence... Essentially there's a very, very consistent picture of the euro being a far second, while it's an economy that's only about a third smaller than the US economy.

Beckworth:  Hence it is punching below its weight by every metric. It dawned on me as you were talking, an interesting counterfactual would be what if the UK had given up the pound and joined the euro, the euro had all of that extra weight behind it? Who knows if things would have been different. Maybe not, but that'd be an interesting counterfactual to play out.

Beckworth:  So, Ethan, you and your coauthors list five reasons why the euro punches below its weight, continues to punch below its weight. And it looks like it will be that way going forward. You list five, but there's two key ones that it seems are the most important. I know one you really stress, and that is the lack of safe assets in the eurozone. But also, the other big one was the dollar has a first mover advantage, this network effect. It's hard to break into a strong network effect. The economies of scale you alluded to earlier. So why don't you walk us through those stories?

The Two Stories of Euro Underperformance

Ilzetzki:  Yeah. So, there's one argument that the reason the euro is a far second is because number two is always going to be a far second, and that is simply the nature of international currencies. There are some major economies of scale and network effects that make a single currency the most dominant in the world. You can think of if a country denominates a lot of its trade in dollars, its corporations might also want to borrow in dollars. And then its central bank might want to have a lot of dollar reserves. And so there's some self-reinforcing aspect to all of this. So, just to take two historical examples here, the continental Europeans had tried to create a Latin monetary union during the British pound-dominated gold standard period as an alternative, and a silver-based continental European alternative. And that really never got to the prominence of the pound. Now, that could be because of some structural advantages that Britain had in trade and finance, but it also could be simply that number two is always going to be a far number two.

Ilzetzki:  We also have to remember that it took two world wars to get the pound off the dominance it had. And so there may be room for only one. But we think there are other reasons as well, as you noted. And the most important of which is an enormous scarcity of euro-denominated safe assets. So we have a striking chart in that paper, where we just compare what the quantity of dollar-denominated Treasury debt is compared to the euro public debt that could plausibly be viewed as safe. And the gap is really big. But even if you go to other types of assets... for example, corporate bonds... If you want to have a portfolio of corporate bonds, essentially US corporates are almost the only show in town because most of European corporate lending is through bank lending rather than through corporate bonds.

Ilzetzki:  You could create a synthetic safe asset out of a diversified portfolio of US corporate bonds. It's much harder to do so with euro-based bonds. Now Chinese corporate bonds are higher in volume, I think, than all euro corporate bonds at this point. On many dimensions, not just the public debt, there is a scarcity of euro-denominated safe assets.

Beckworth:  Yeah. That's an interesting issue. Now, the EU did recently issue some debt or is in the process of doing some tied to the COVID crisis. Right? But not enough to make a big dent?

Ilzetzki:  No. So this is still on a scale that is not going to provide enormous liquidity. You can see from the investor appetite for these bonds that there is a shortage. That is, there an enormous appetite for diversifying away from merely holding US Treasuries. But just the quantities aren't enough. And there is a question here of fiscal capacity, because the EU is not a federal government with taxation power. So at the end of the day, any EU borrowing is going to have to be backed by legislation from many countries to pass. So imagine that every time the US federal government wanted to borrow money, every one of the 50 states had to pass that legislation, and only consensus would allow this to happen. You can imagine that the US would never borrow a cent, if that were the case. So that's more or less the procedure that would be required to increase the issuance of euro safe assets. It's not a large quantity now, and there's really no future without major institutional change.

Beckworth:  I also wonder if this safe asset shortage is tied to the first fact, that the dollar's so dominant. There's huge network effects. So last year, at the Jackson Hole meetings, the former head governor at the Bank of England, Mark Carney, made a proposal for a synthetic hegemonic currency. SHC. It's a mouthful. But the idea he articulated was that all the central banks would issue digital currencies which would be backed by their currencies or other currencies. And these currencies would then, I believe, be backed by another one. But ultimately the point was to create a synthetic hegemonic currency, a dominant currency, that could displace the dollar. And there is this whole literature... I know you've worked on it, and you've delved in it... how dollar dominance can have these adverse effects. Whenever the dollar goes up in value, the Fed tightens, and so forth. And his point was we need to get some alternative to it.

Beckworth:  The challenge though, and I was talking to some people afterwards about this, there are just so many dollar assets. You alluded to this earlier. It's not just Treasury debt, but corporate debt, bank account... I mean, all these liquid assets. The US is a banker to the world, right? And so there's just trillions and trillions. One estimate showed 30 trillion in terms of liquid assets, if you count everything. Other measures show more. It doesn't seem very easy or tractable to try to suddenly create that many assets and compete, or at least half of that, if we slice the pie into. So it seems like the fact that the dollar is so dominant, there's this network effect, assets are created in dollar denomination, it's a huge head start that makes it really difficult for the ECB, the EU to catch up.

Ilzetzki:  Yeah. No. So, I agree. I have a lot of respect for the views of Mark Carney on this topic, but we've been there before. If you go back far enough, commentators thought the SDR, the IMF's special drawing rights, are going to be an alternative, going to be sort of a basket currency as an alternative to the dollar. It's not the first time proposals like this come up. But yeah. I would add to the list, when you talk about liquid assets, you might think the stock market is irrelevant because it's really not inherently denominated in any currency. It's simply tied to the dividends of the corporations. But nevertheless, if you want to invest in the S&P 500, then there's going to be some dollar transaction that's going to happen there, and not a pound transaction or a globo currency transaction. The market capitalization of the US stock markets is larger than the stock market capitalization of the rest of the world combined. Even if you think of slightly less safe assets like stocks, simply assets, a portfolio of assets, you're going to end up with a large dollar share.

Beckworth:  Yeah. So some of the global financial cycle literature and then others have dubbed it the global dollar cycle. Whenever there's a crisis, a global crisis, dollar-denominated assets abroad actually grow because people are getting out of these riskier assets. The BIS keeps track of this 13 trillion dollar number that... These are dollar liabilities created outside the US, and they actually grow. It seems like a tough nut to crack. And maybe we've reached this point. So let me ask you a question along these lines, Ethan. I ask lots of folks. I love these counterfactuals. But let's say we could start the Earth over again, and we could run it, say, 10,000 times. So we're going to do Monte Carlo simulations of Earth's history here. Would we always end up with one dominant currency? Because of network effects, have a money of moneys? Is this an inevitable outcome, or could we have multiple reserve currencies?

Ilzetzki:  My sense is that there is a strong network effect. I don't want to say never. I could envision a world that is tri-polar, with, say, the dollar, the renminbi, and the euro taking equal shares. So I could imagine that as an equilibrium to the system. It's very hard to see the transition from the current status quo to that situation. Barry Eichengreen has argued in his books that that's where we're going. But even he appears to acknowledge that, at the moment, Europe is punching below its weight, is far from that position. And it's probably a little premature to think of the Chinese currency, that's still not really an internationally traded currency, as having a global role.

Ilzetzki:  In abstract, I think there could be an equilibrium where there is multiple currencies sharing the stage, and maybe even a stable equilibrium. But I think the current equilibrium is extremely stable, at least for now. In thinking about how this comes about, you would have to see a major disruption in the role of the US in the world, I think on multiple dimensions, for this happen. If you look at what's happening in the world, it's not unthinkable. But I think that's still a tail event.

In abstract, I think there could be an equilibrium where there is multiple currencies sharing the stage, and maybe even a stable equilibrium. But I think the current equilibrium is extremely stable, at least for now.

Beckworth:  Yeah. Again, because there's so many dollar assets out there, the scale just far exceeds anything else, it would take a breakdown of the US as a country, something really serious... breakdown, secession, something really dramatic... that might just be my take. Or we finally get aliens to visit Earth, and we start trading with some other planet where there's something even bigger and stronger than the US. So I agree. I think we're locked into this equilibrium. It seems very stable. And it'd be interesting to see how this unfolds going forward.

Beckworth:  Okay, let's segue into another interesting paper you have coauthored with Ken Rogoff and Carmen Reinhart. And this is one that you gave recently at the Brookings Institute. And this one also deals with international monetary issues. And the title of this paper is *Will the Secular Decline in Exchange Rate and Inflation Volatility Survive COVID-19?* So, why don't you start us off with what are you documenting? What are you bringing to our attention that you want to talk about in this paper?

Secular Declines in Exchange Rates and Inflation Volatility

Ilzetzki:  Yeah. Let me give you a little bit of a background for this paper. We proposed this paper to Brookings, as part of the panel on economic activity, early on during the COVID-19 pandemic. So I think it was around March when we first proposed it. And looking at the world around us, we were pretty persuaded that the stable equilibrium of the Bretton Woods II system... And I'll talk more what I mean by that in a moment. But the stable equilibrium of the international monetary system of the 21st century is going to face a challenge that will end its enormous stability. And as we worked on this paper through the summer, we realized that we can't really write that paper that we wanted to write, because this international monetary system showed a resilience that was surprising to us. And so really, the theme of the paper changed to documenting the surprising resilience and stability, and asking whether that stability can survive going forward.

Ilzetzki:  Now, let me now describe what that stability is. So, there has been a secular decline, so kind of just a trend decline, in the volatility of major high-income country currencies, primarily what we call the G3, the dollar, the euro, and the yen. So we take the three most traded currencies and look at how volatile their exchange rates are. That has been declining systematically since 2000. When you take a closer look, both visually, as you can see in the charts in the paper, and with more formal empirical tests, you see that there is a sharp further downward break in that trend somewhere in the middle of 2014. And since 2014, the stability of the dollar, euro, and yen exchange rates has been, by some metrics, unprecedented.

Ilzetzki:  So what do I mean by that? If you compare the volatility of these currencies to the volatility of other assets like oil or the stock market, you will see that the major currencies are moving more tightly together than they did even during most of the Bretton Woods system of fixed exchange rates. And this is not something we would have predicted. Right? So this is when we moved to a system of flexible exchange rates after Breton Woods, everyone's expectation was that exchange rate would, particularly among these floating major currencies, would be very volatile. And indeed they were for the first few decades. But now it's just been a strong trend towards more stability. That's kind of the remarkable fact that we point out

Since 2014, the stability of the dollar, euro, and yen exchange rates has been, by some metrics, unprecedented... If you compare the volatility of these currencies to the volatility of other assets like oil or the stock market, you will see that the major currencies are moving more tightly together than they did even during most of the Bretton Woods system of fixed exchange rates.

Beckworth:  Yeah. Isn't that something that Robert Mundell was advocating? He almost argued for a fixed global exchange rate system. But we effectively are there already, right?

Ilzetzki:  Yeah. So in some sense, the ambitions of Bretton Woods, or the ambitions of the global currency advocates, may be de facto realizing in front of our eyes. We'll talk, I'm sure, about why this may not persist. But for now, there is a stability that is by some measures unprecedented, and certainly unpredicted.

Beckworth:  Yeah. So, tying this into the news, Judy Shelton looks like she's not going to make it to the Board of Governors. But for a long time she's been advocating this very thing because she's a follower of Mundell. And it's surprising. I wanted to say, "Look, Judy, you have already what you've been advocating. You got this system that effectively has linked..." Not linked, but they definitely look like they're linked, and they move together. This is pretty remarkable, as you said, in a floating exchange rate world. This is not what Milton Friedman predicted, right, in his classic paper.

Ilzetzki:  That's right. Yeah. Well, let me get back to Dornbusch later on, maybe. Or maybe I can talk about Dornbusch.

Ilzetzki:  So, Rudi Dornbusch, who was to some extent the father of modern international macroeconomics, or one of the fathers maybe, predicted in his sort of overshooting theories of exchange rates that once we let go of the pegs, exchange rate volatility would be much larger and that monetary policy would be a major driver of the volatility of exchange rates. And indeed, the first decades seemed to vindicate him. But in this paper, we argue that, actually, also the stability in the recent period seems to vindicate the Dornbusch view that monetary policy is the main determinant of exchange rate volatility. Because, now turning to why we think this is going on, if you try to look at the list of potential culprits for why exchanges rates are so stable... The paper goes one by one through the potential culprits, and most of them are just pretty easy to reject, just based on casual observation. So it could be that exchange rates are more stable because the world is a more stable place.

In this paper, we argue that, actually, also the stability in the recent period seems to vindicate the Dornbusch view that monetary policy is the main determinant of exchange rate volatility.

Ilzetzki:  Now, we're recording this in December 2020, and hopefully the world will be in a better place after the vaccine is distributed, but certainly this year, and the past decade, has not been an uneventful period in terms of economic shocks. If anything, it seems like, in many respects, it's a more volatile period. Indeed, when you look at the stock market, and we show this in the paper, two of the largest volatility events in recorded history of the stock market occurred in the 21st century, which are, obviously, the global financial crisis and COVID-19. But you don't see a commensurate movement in exchange rates. So it's hard to argue that financial stability, general economic stability, is what's driving the stability of exchange rates.

Ilzetzki:  In contrast, if you think about monetary policy, which is now at zero in all major economies, if the main thing that drives exchange rates are interest rate differentials... And in fact, the theory would say that it's long-term interest rate differentials that would determine exchange rate volatility, or the volatility of long-run interest rate differentials. This is an unprecedented period in which all major currencies have essentially zero interest rates, even in 10-year bonds. The variability in interest rates is so small across major currencies that if interest rates or monetary policy are the main drivers of exchange rate volatility, there's nothing really to move exchange rates around.

Beckworth:  Yeah. And I think that's a great explanation. And really enjoyed this paper. But it raises a question. Why have we headed into the zero lower bound world, right? Why has monetary policy converged in the zero lower bound? And think this goes back to safe asset, secular stagnation discussions, that there are these exogenous forces out there. And I think one of the interesting things about safe assets, and something's that tied to what you also mention in the paper, is that inflation also has kind of followed the exchange rate stability down. And the G3 move together.

Beckworth:  I see a connection between the safe asset demand and the low inflation, and one that I don't think's been... I don't know... covered enough in the literature. The safe asset literature often looks at this problem as the contagion, or spread, of equilibrium rates dropping around the world, and dropping below actual market rates, and creates output gaps and eventually gets to inflation. But I think a big part of why we had low inflation... Going back to our earlier question or point about the ECB, the Fed, why has there been persistent low inflation? I think this demand for safe assets is a big part of the story. And I'd like to hear what you think about that.

Inflation and the Lack of Demand for Safe Assets

Ilzetzki:  Yeah. I think that is a plausible explanation. I should preface by saying that I don't know the answer to this question. I'm not sure anybody knows it with much confidence. I think the reasons for low inflation and stable inflation are somewhat elusive. I know that central banks want to claim that this is their making, and I think to some extent this is true. But I'll put it to the following empirical test, that you have 200 countries in the world or so, not all of whose central banks have followed the conventional prescriptions. And with a very small number of exceptions, like Venezuela, Argentina, Zimbabwe, there's really been extremely low inflation throughout the world. So again, coming back to our earlier discussion, there's a possibility that there's about 190 correlated positive events here or that there is something global that's going on. So I think we need to look at these global factors in thinking about that.

Ilzetzki:  So the factor that you're suggesting is perhaps thinking about global liquidity of safe assets vis-à-vis the quantity of goods and services. And indeed, a shortage of the liquidity could lead to a... So that would be a potential explanation. We don't explore that in our paper, but I think that's a very interesting avenue

Beckworth:  No, I'm glad you brought up that quantity theoretic kind of approach to safe assets because that's the angle I'm taking in my work. And as I mentioned, most of the safe asset literature takes more of a... I call a New Keynesian flavor to it. It's all about equilibrium rates marching down through arbitrage and likewise inflation. I mean, the reason this correlation's there is because we've got global capital markets. But again, they tell the story. It's the equilibrium rates are dropping below maybe actual market rates. You get an output gap or a weak economy, and from there, invoking Phillips Curve, thinking you get the low inflation, where I like the story you just told that these safe assets are highly liquid. They're effectively a form of money, especially for institutional investors. They're a transaction asset, and if there's not enough of them in simple quantity exchange, there's going to be some downward pressure on prices. I think that's an important story to tell, one that hasn't been told enough. So pleasantly surprised to hear you bring it up.

Ilzetzki:  Yeah. Keep it up, David. I do think we need to think more about the international economy. In the study of these questions, most of the discussions are thinking about each domestic economy in isolation, or maybe having that isolated economy have a current account and a capital account that is open. But still the shocks and the driving factors are typically domestic to one of those countries, as opposed to being these global trends, which in a world of increased globalization, a trend that may or may not reverse going forward but that has been an uptrend to greater globalization over the past few decades, you would think that there should be more explanations for phenomena that are coming from the global factors. I applaud you pushing in that direction.

Beckworth:  And to be clear, what we're talking about here, a safe asset shortage, is really just a symptom of a deeper problem, right? What's causing that? There's lots of stories have been told. I think many of them are true. Population. The world's aging in the advanced economies, even in China. Productivity growth has slowed down. There's a lot of exogenous things going on simultaneously. They could change in the future. Who knows? Things could change in the future, but for now they seem to be pointing towards a persistent safe asset shortage problem. Let me move to one of the explanations in this paper that you and your coauthors reject. I want to push back a little bit, Ethan.

Beckworth:  You're a good friend, but I'm going to push back here. So, you mentioned that one explanation for the stability is the Fed's interventions, and use of swap lines, and basically jumping into the global financial system and bailing out what I would call the global shadow banking system, all the dollars created around the world as well as the US. And you're right. It happened in 2008. It happened now. And you mentioned... I'll read a quote here. You put, "COVID-19 central bank swap lines never reached the magnitudes of those in the Great Financial Crisis. Further, by now the ECB has almost entirely drawn down its swap line balances, and the Bank of Japan has unwound three-quarters of its holding." So the point you're making is this could be a potential explanation, but it's not, because it really hasn't been used, or the quantities don't seem to be there. But couldn't one take another view of that observation? Say, "Look, this is like FDIC," right? We haven't had a major retail bank run in the US since the Great Depression because of FDIC, but FDIC hasn't been drawn upon a lot, either.

Beckworth:  I mean, the fact the Fed is sitting there, ready to move... And I think that, this year in particular, the extent that it went really demonstrates to the world, "Man, the Fed really is going to backstop every liquid financial asset that's tied to the dollar in some form."

Ilzetzki:  Yeah. So, we don't reject entirely the swap line story, and we don't have a counterfactual of how volatile the system would have been absent the swap lines. So absolutely, we're very open to the notion that that played a role. My colleague Ricardo Reis has empirical work on the role of the swap lines. And there does seem to be some causal link there. Listeners can also the read the discussion of our commentator in the conference, Sylvia Miranda-Agrippino, who also pushed back in a similar vein that swap lines were used. But the reason we believe that that can't be a major part of the story is simply the matter of the timing of the phenomena we're talking about. As I pointed out... And you can see this visually on the charts in the paper. They're quite striking. You just see a staggering drop in volatility somewhere around the middle of 2014. That dating is verified through formal breakpoint tests, statistical breakpoint tests.

Ilzetzki:  So something is happening well before COVID-19. And something is changing around 2014. Now, obviously, a lot of things may have happened around that time. But if you look at the timing, it fits very well with our story, in the sense that this is precisely the time where the ECB goes to negative interest rates for the first time. Around this time, the German and Japanese government bond yields start going negative, even at 10-year maturities. And so the timing fits very, very nicely with this lack of interest rate movement. We're happy to entertain other things that happened around that time, but certainly swap lines were not a major topic of discussion in exchange rate markets at that point in time.

Beckworth:  No. That's completely fair. The timing. Let me reframe this in a complementary fashion. Maybe this complements your story. To me, your story ultimately is, "Is zero lower bounds getting more firm hold on these advanced economies?" 2014's a particularly good inflection point. So let me put it this way. The dollar swap lines, one, further confirm that, because now if you're a global investor, on the margin, should I have a dollar asset in my portfolio? You definitely do because you know the Fed's there. So that's going to increase demand for all dollar-denominated assets. Seigniorage flows to the US. Deflationary pressures. But maybe in 2014, it’s on the margin... I mean, again, this is a complementary story. The zero lower bound is occurring, and it's marching down because there is this expectation maybe the dollar swap lines will be used in the future. I don't think that's the key story here. I think you're right. But it's the demand for safe assets is the core story, but that demand for safe assets might be why the Fed does step in. It's hard to disentangle them entirely.

Ilzetzki:  Sure. Look, I think the swap lines were a big deal, and they were important. And I think their presence is a welcome addition to the policy tool kit. All else equal, the sign of the effect is the right sign. That is it would lead to lower volatility, all else equal.

Beckworth:  But the timing's off. Your point is for the timing, it's not there.

Ilzetzki:  Yeah, definitely.

Beckworth:  Okay. It's icing on the cake. It's not the cake itself. Okay, fair enough. Well, what about inflation? We have a few minutes left. What about the prospects for inflation? One thing you raise in the paper is this low inflation might change. So what might break this equilibrium we're in?

Prospects for Inflation in the Future

Ilzetzki:  Yeah. I want to preface this that in the short run, I am not concerned about inflation. And if I think, for example, about Congress now debating a fiscal package, I would err on just trying to save the economy, and people who are suffering, as much as possible, as opposed to worrying that public debt may lead to inflation someday in the future. So in the short run, I don't want to be alarmist. And to be frank, market expectations are telling us that they don't think inflation is going to be high in the foreseeable future.

In the short run, I am not concerned about inflation. And if I think, for example, about Congress now debating a fiscal package, I would err on just trying to save the economy, and people who are suffering, as much as possible, as opposed to worrying that public debt may lead to inflation someday in the future.

Ilzetzki:  I find the consensus, that there is no way that inflation will be a problem in our lifetime, to be the type of consensuses that worry me a little bit because it's precisely those consensuses that hit us in the face at some point. So while I defer to market participants and others in forecasting what will happen, my coauthors and I wanted to point out that we should not think of it as a foregone conclusion that inflation isn't going to be a problem. And it really depends, at that point, why you think inflation was low to begin with. You mentioned demographics. If you believe that it's demographic factors that have been driving low interest rates and low inflation, those demographic trends are likely to reverse at some point. China has ended its one-child policy. Europe will not age forever. Japanese retirees have very high longevity, but they too will need to spend that money at some point, or their children will do so.

Ilzetzki:  So I think if you think, for example, that demographics are the driving force, then you do have to think about the prospect of a reversal at some point. Now, this is not a forecast. Again, to be very clear that this is neither a forecast, nor am I advocating policies to preemptively deal with some tail event of inflation going up. But I think that tail is fatter, in the sense that it's a more probable event than I think most observers are putting on it at the moment. I think the implied probability of that happening, based on what you hear economists saying and what you see in market trading of inflation-based assets, is essentially zero. And when people think that there's a zero probability of something, that's where I look for the dangers.

While I defer to market participants and others in forecasting what will happen, my coauthors and I wanted to point out that we should not think of it as a foregone conclusion that inflation isn't going to be a problem. And it really depends, at that point, why you think inflation was low to begin with.

Beckworth:  Well, Ethan, our time is up, and it's been a real treat to have you back on. It's always great to chat with you. Now, I understand you're going to have a virtual AEA event that people can follow. So if they want more of you and your work, and a panel... Tell us about that panel. And when is it?

Ilzetzki:  Yeah. So, I'm chairing a session at the American Economic Association meetings at the beginning of January. So registration is still open. I encourage listeners to participate in the meetings and in our session. Our session is about fiscal policy in times of pandemic and war, which is somewhat timely. And there's some very interesting papers there, by some excellent economists, on how fiscal policy works in times like these. My own paper is on the effects of fiscal policy during the Second World War, but there's also papers on fiscal policy during pandemics, and how to deal with long-term debt. And so I think it will be a very interesting session, and I invite everyone to join.

Beckworth:  Sounds fascinating. So check it out. Ethan, thank you again for coming on the show.

Ilzetzki:  Thanks so much, David.

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David Beckworth
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Dec 14, 2020
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The euro continues to punch below its weight compared to the dollar, and there is good reason to believe this will not change in the near future.