Central Banking and Globalization

GLOBAL ECONOMIC STUDIES SERIES

CENTRAL BANKING AND GLOBALIZATION

No part of this digital document may be reproduced, stored in a retrieval system or transmitted in any form or by any means. The publisher has taken reasonable care in the preparation of this digital document, but makes no expressed or implied warranty of any kind and assumes no responsibility for any errors or omissions. No liability is assumed for incidental or consequential damages in connection with or arising out of information contained herein. This digital document is sold with the clear understanding that the publisher is not engaged in rendering legal, medical or any other professional services.

GLOBAL ECONOMIC STUDIES SERIES The U.K.’s Rocky Road to Stability Nicoletta Batini and Edward Nelson (Editor) 2009. ISBN: 978-1-60692-869-1 The Financial Crisis and the European Union Klaus G. Efenhoff (Editor) 2009. ISBN: 978-1-60741-987-7 Inflation: Causes and Effects Leon V. Schwartz (Editor) 2009. ISBN: 978-1-60741-823-8 Performances of Asia-Pacific Countries: A New Approach Krishna Mazumdar 2009. ISBN: 978-1-60876-174-6 Economic Growth and Development in the Caribbean Region Walker A. Pollard, Nannette Christ, Judith Dean, Katherine Linton, Patricia M. Thomas and Arona M. Butcher 2009. ISBN: 978-1-60741-030-0 Cross-Cultural Economic Management Rongxing Guo 2009. ISBN: 978-1-60741-343-1 Trade and Development: Focus on Free Trade Agreements William R. Stevens (Editor) 2010. ISBN: 978-1-60741-640-1 Consumer Behavior: Global Shifts and Local Effects (CD Included) Rajagopal 2010. ISBN: 978-1-60876-276-7 Central Banking and Globalization Marlon Cappello and Cristian Rizzo (Editors) 2010. ISBN: 978-1-60876-056-5 The AIG Debacle: Global Impact and the Need for Government Intervention Peter A. Wayland (Editor) 2010. ISBN: 978-1-60741-990-7

U.S. Trade, Protectionism and the Global Economic Downturn Andrew J. Caldwell (Editor) 2010. ISBN: 978-1-60876-966-7 U.S. Trade, Protectionism and the Global Economic Downturn Andrew J. Caldwell (Editor) 2010. ISBN: 978-1-61668-512-6 (Online Book) Conditions for Foreign Direct Investment in India Brent M. Cardenas and Zackary R. Berg (Editors) 2010. ISBN: 978-1-60456-862-2 Conditions for Foreign Direct Investment in India Brent M. Cardenas and Zackary R. Berg (Editors) 2010. ISBN: 978-1-61668-882-0 (Online Book) The Economy of Southern Kurdistan Almas Heshmati 2010. ISBN: 978-1-61668-336-8 The Development of China's Economy under the International Financial Crisis Xiaoxi Li and Biliang Hu (Editors) 2010. ISBN: 978-1-61668-486-0 Global Financial Crisis Haley J. Scott (Editor) 2010. ISBN: 978-1-61668-631-4 Global Financial Crisis Haley J. Scott (Editor) 2010. ISBN: 978-1-61668-651-2 (Online Book) Direct Investment Abroad Caleb J. Blackwell (Editor) 2010. ISBN: 978-1-61668-857-8

GLOBAL ECONOMIC STUDIES SERIES

CENTRAL BANKING AND GLOBALIZATION

MARLON CAPPELLO AND

CRISTIAN RIZZO EDITORS

Nova Science Publishers, Inc. New York

Copyright © 2010 by Nova Science Publishers, Inc. All rights reserved. No part of this book may be reproduced, stored in a retrieval system or transmitted in any form or by any means: electronic, electrostatic, magnetic, tape, mechanical photocopying, recording or otherwise without the written permission of the Publisher. For permission to use material from this book please contact us: Telephone 631-231-7269; Fax 631-231-8175 Web Site: http://www.novapublishers.com NOTICE TO THE READER The Publisher has taken reasonable care in the preparation of this book, but makes no expressed or implied warranty of any kind and assumes no responsibility for any errors or omissions. No liability is assumed for incidental or consequential damages in connection with or arising out of information contained in this book. The Publisher shall not be liable for any special, consequential, or exemplary damages resulting, in whole or in part, from the readers‟ use of, or reliance upon, this material. Any parts of this book based on government reports are so indicated and copyright is claimed for those parts to the extent applicable to compilations of such works. Independent verification should be sought for any data, advice or recommendations contained in this book. In addition, no responsibility is assumed by the publisher for any injury and/or damage to persons or property arising from any methods, products, instructions, ideas or otherwise contained in this publication. This publication is designed to provide accurate and authoritative information with regard to the subject matter covered herein. It is sold with the clear understanding that the Publisher is not engaged in rendering legal or any other professional services. If legal or any other expert assistance is required, the services of a competent person should be sought. FROM A DECLARATION OF PARTICIPANTS JOINTLY ADOPTED BY A COMMITTEE OF THE AMERICAN BAR ASSOCIATION AND A COMMITTEE OF PUBLISHERS. LIBRARY OF CONGRESS CATALOGING-IN-PUBLICATION DATA Central banking and globalization / [editors], Marlon Cappello and Cristian Rizzo. p. cm. Includes index. ISBN 978-1-61761-667-9 (Ebook) 1. Banks and banking, Central. 2. Monetary policy. 3. International finance. 4. Globalization--Economic aspects. I. Cappello, Marlon. II. Rizzo, Cristian. HG1811.C4573 2009 332.1'1--dc22 2009037472

Published by Nova Science Publishers, Inc. New York

CONTENTS Preface

ix

Chapter 1

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime Meixing Dai

Chapter 2

Trade Remedies: A Primer Vivian C. Jones

35

Chapter 3

Towards New Metrics to Measure Sustained Competitiveness in the Caribbean Robertico R. Croes

71

Chapter 4

Central Banking and Deflationary Depression : A Japanese Perspective Toichiro Asada

91

Chapter 5

Central Bank Independence in Words and in Deeds: Lessons from Brazil and Chile Taeko Hiroi and Douglas Block

115

Chapter 6

Water: A Global Risk Factor István Orlóci and Károly Szesztay

129

Chapter 7

An Original Use of Foreign Exchange Reserves: When a Central Bank Can Use Its FX Reserves to Recapitalize Banks Victoria Miller

141

Chapter 8

Identity Globalization and Experience Tourism Miguel Vidal González

147

Chapter 9

On The Equivalence between a Fiscal Stimulus Financed by Public Debt and by Central Bank Money Emanuel R. Leao and Pedro R. Leao

153

1

viii

Contents

Chapter 10

On Inflation Targeting in MENA Countries Magda Kandil

157

Chapter 11

Should Monetray Policy Respond to Private Sector Expectations? Michele Berardi

161

Index

167

PREFACE A central bank, reserve bank, or monetary authority is the entity responsible for the monetary policy of a country or of a group of member states. It is a bank that can lend money to other banks in times of need. Throughout the world, the everyday life of individuals is increasingly influenced by phenomena of social and economic change such as globalization, computerization, or the pluralization of life-courses. Globalization is often used to refer to economic globalization: the integration of national economies into the international economy through trade, foreign direct investment, capital flows, migration, and the spread of technology. This new book takes a look at the central banking industry and globalization, highlighting topics such as the central bank's use of foreign exchange reserves to recapitalize banks, a new metrics measurement that is based on the concept of economic value, and that is embedded in the rational choice theory, the roles of central banking in the period of deflationary depression both empirically and theoretically, and an explanation of the argument that the effect on aggregate demand and output of a fiscal stimulus financed by public debt is markedly different from the effect of a stimulus financed by the Central Bank. This book also examines laws known as trade remedies that mitigate the adverse impact of various trade practices on domestic industries and workers. As discussed in Chapter 1, the inflation-targeting literature makes the strong assumption that the central bank can exactly target the interest rate that affects investment and consumption decisions, and hence the money supply plays no role in the monetary policy strategy. This assumption is equivalent to admitting the perfect credibility of inflation target announced by the central bank, the perfect functioning of money and financial markets and that the central bank is willing to inject as much liquidity as the economic agents demand. None of these assumptions corresponds to reality. In effect, the inflation expectations can not be easily anchored by the cheap talk of central bankers. On the other hand, the central bank may have many difficulties to target, in a context of financial instability, the interest rates which affect the real and financial decisions of private agents. The authors suggest that under an inflation-targeting regime, money and credit markets carry the inflation expectations that can be anchored with a well-specified feedback money-growth rule. The latter, in contrast to the Friedman‟s k-percent money growth rule, can help manage the inflation expectations in a manner to guarantee the dynamic stability of the economy. Furthermore, the model can be easily used to discuss the implications of the zero interest rate policy and the quantitative easing policy.

x

Marlon Cappello and Cristian Rizzo

The United States and many of its trading partners use laws known as trade remedies to mitigate the adverse impact of various trade practices on domestic industries and workers. U.S. antidumping (AD) laws (19 U.S.C. § 1673 et seq.) authorize the imposition of duties if (1) the International Trade Administration (ITA) of the Department of Commerce determines that foreign merchandise is being, or likely to be sold in the United States at less than fair value, and (2) the U.S. International Trade Commission (ITC) determines that an industry in the United States is materially injured or threatened with material injury, or that the establishment of an industry is materially retarded, due to imports of that merchandise. A similar statute (19 U.S.C. § 1671 et seq.) authorizes the imposition of countervailing duties (CVD) if the ITA finds that the government of a country or any public entity has provided a subsidy on the manufacture, production, or export of the merchandise, and the ITC determines injury. U.S. safeguard laws (19 U.S.C. § 2251 et seq.) authorize the President to provide import relief from injurious surges of imports resulting from fairly competitive trade from all countries. Other safeguard laws authorize relief for import surges from communist countries (19 U.S.C. § 2436) and from China (19 U.S.C. § 2451). In each case, the ITC conducts an investigation, forwards recommendations to the President, and the President may act on the recommendation, modify it, or do nothing. In the 110th Congress, several bills seek to amend trade remedy laws. First, H.R. 708 (English, introduced January 29, 2007) and S. 364 (Rockefeller, introduced January 29, 2007) seek, in slightly different ways, to strengthen U.S. antidumping, countervailing, and safeguard statutes. Second, H.R. 1127 (Knollenberg, introduced February 16, 2007) seeks to give manufacturers that use of goods subject to AD or CVD proceedings standing as interested parties in those proceedings. Third, several bills, including H.R. 782 (Ryan/Hunter, introduced January 31, 2007), its companion bill S. 796 (Bunning, Stabenow, introduced March 7, 2007), S. 974 (Collins, introduced March 22, 2007), and H.R. 1229 (Davis/English, introduced February 28, 2007), seek to amend the trade remedy laws, in part, to address issues regarding the applicability of these laws to China or other nonmarket economy countries. Fourth, S. 122 (Baucus, introduced January 4, 2007) seeks to expand Trade Adjustment Assistance to apply to workers adversely affected by trade that results in the imposition of AD, CVD, or safeguard measures. Chapter 2 explains, first, U.S. antidumping and countervailing duty statutes and investigations. Second, it describes safeguard statutes and investigative procedures. Third, it briefly presents trade-remedy related legislation in the 109th Congress. The appendix provides a chart outlining U.S. trade remedy statutes, major actors, and the effects of these laws. This report will be updated as events warrant. The purpose of Chapter 3 is to provide a measurement metrics for competitiveness. The concept of competitiveness is elusive and the conventional measurement metrics currently used are not suitable for small island destinations. The study suggests a new metrics measurement that is based on the concept of economic value, and that is embedded in the rational choice theory. It compares the conventional metrics with the proposed measurement metrics, and aims at providing these more suitable metrics for small island destinations with characteristics such as market and natural vulnerabilities. The study uses ordinary least squares to estimate the coefficients of both the conventional and measurement metrics for comparison purposes. The measurement is applied to several island destinations in the Caribbean, a region highly dependent on tourism development and keenly affected by globalization. The results of the study indicate that the new metrics measurement is more

Preface

xi

robust and profound in the information and implications that are necessary for policymakers and business managers to measure competitiveness. It suggests a new incentive structure for practitioners in the region that communicates that more is not necessarily better; especially in the context of facing the challenges of improving tourism performance and adjusting to new and often adverse, circumstances. In Chapter 4, the authors investigate the roles of central banking in the period of deflationary depression both empirically and theoretically, especially in reference to the Japanese economy in the 1990s and the 2000s. In the first part of the paper, the authors summarize the empirical facts on the inferior macroeconomic performance of the Japanese economy and problematical monetary policy of BOJ (Bank of Japan) in the period of the socalled „lost decade‟(the 1990s) and the continued deflationary depression period( the 2000s). In the latter part of the paper, the authors consider some theoretical models which are useful for the interpretation of the above mentioned phenomena. Political independence of the central bank is considered to bring financial stability to a nation and therefore to foster economic growth by providing safe investment environments. However, granting a central bank autonomy is politically contentious because of the implications such independence will entail for politicians in terms of their ability to influence monetary policy. Chapter 5 analyzes central bank independence in words and in deeds. The first part discusses the existing literature on central bank independence and problems associated with its measurement. The implications of this debate are analyzed with two Latin American countries, Brazil and Chile. In Brazil, the difficulty in reaching a political consensus on granting the central bank formal independence has led the government to confer “operational” independence since the mid-1990s. Despite the improvement in the financial stability of the country, the Brazilian central bank remains politically vulnerable because its independence is not guaranteed by the constitution, and the credibility of prudent monetary policy is not strong enough to deter speculative attacks in critical moments. The Brazilian experience is then contrasted with the Chilean case in which the central bank‟s independence is constitutionally guaranteed. A fundamental contradiction emerged in human history during the last few centuries. On the one hand, technological tools and the total production of the world economy rose to a hitherto unimaginably high level. On the other hand, human activities deteriorated the life support services of our planet at an unprecedented rate; if continued unchanged we would soon reach the limits of sustainability. Coping with the risks generated by this contradiction requires a shift in environmental and water management policies. Departments of water resources administration are facing a fundamental dilemma when fulfilling their role within the local, national and regional governance. These departments are held responsible for the protection and the rational utilization of water resources, but the crucial activities affecting the quality and availability of these resources are planned and decided upon by departments of agriculture, industry, transportation and many others. Chapter 6 analyses conceptual approaches towards overcoming these difficulties and presents results and experiences of a master plan and policy analysis elaborated recently for water resources management and administration in Hungary. These elaborations are based on the concept of “socially significant (valued) properties” of the water availabilities within a given region. The coordination of all the water related activities by the respective governments is facilitated by a comprehensive informational infrastructure formulated and presented according to the specific viewpoints of the major departmental branches and institutions.

xii

Marlon Cappello and Cristian Rizzo

In 2003, the central bank of China used part of its huge stock of foreign exchange reserves to recapitalize two of its largest banks. Chapter 7 considers when a central bank can successfully execute such a policy without compromising a currency peg. Globalization fosters a cosmopolitan identity. In such case, the multidimensional identity comes from a plurality of countries and cultures, and the relationship between identity and place vanishes. Obviously intangible forms of heritage, as folklore or traditions, are involved, because costumes fixed in time become the predominant part of identities. At the same time, existential authenticity is predominant in developing countries, as developed ones follow a homogenization process due to globalization. As a result, there is an increasing experience intangible heritage tourism from developed countries to developing ones. Accordingly, developed countries press developing ones to protect intangible heritage as they do with wild nature. Chapter 8 also studies the trade off between protecting intangible heritage and modernity within a place. Finally, it makes a prospecting approach about this phenomenon in the future, taking in consideration an agoraphobic tendency to defensive identities in developed countries, an increasing dual cosmopolitan identity and a tension between intangible heritage and development in developing countries. Chapter 9 has two main sections. Section 2 summarizes the conventional view that the effect on aggregate demand and output of a fiscal stimulus financed by public debt is markedly different from the effect of a stimulus financed by the Central Bank. In section 3 the authors present our argument about the equivalence between the two types of fiscal expansion financing. Section 4 concludes. As discussed in Chapter 10, inflation has surged in many parts of the world in the last few months, On account of high food and fuel prices. The exogenous shock has, once again, drawn attention to the appropriate monetary policy to weather external shocks and manage domestic liquidity. Many industrial countries, under a flexible exchange rate system have aligned monetary policy to stem inflationary pressures. Some would argue that tight monetary policy may have pulled the trigger on the latest episode of credit tightening, forcing global financial meltdown and posing the risk of global recession. Chapter 11 analyses the implications, in terms of determinacy and E-stability of equilibrium, of a policy rule that responds to private sector expectations in forward looking models. In the literature, this type of policy has been both recommended and criticized. The authors try to understand the reasons for such different conclusions and shed some light on the desirability of this type of policy rules.

In: Central Banking and Globalization Editors: M. Cappello and C. Rizzo, pp. 1-33

ISBN: 978-1-60876-056-5 © 2010 Nova Science Publishers, Inc.

Chapter 1

ON THE ROLE OF MONEY-GROWTH TARGETING UNDER AN INFLATION-TARGETING REGIME Meixing Dai BETA-Theme University of Strasbourg, France

Abstract The inflation-targeting literature makes the strong assumption that the central bank can exactly target the interest rate that affects investment and consumption decisions, and hence the money supply plays no role in the monetary policy strategy. This assumption is equivalent to admitting the perfect credibility of inflation target announced by the central bank, the perfect functioning of money and financial markets and that the central bank is willing to inject as much liquidity as the economic agents demand. None of these assumptions corresponds to reality. In effect, the inflation expectations can not be easily anchored by the cheap talk of central bankers. On the other hand, the central bank may have many difficulties to target, in a context of financial instability, the interest rates which affect the real and financial decisions of private agents. We suggest that under an inflation-targeting regime, money and credit markets carry the inflation expectations that can be anchored with a wellspecified feedback money-growth rule. The latter, in contrast to the Friedman’s k-percent money growth rule, can help manage the inflation expectations in a manner to guarantee the dynamic stability of the economy. Furthermore, the model can be easily used to discuss the implications of the zero interest rate policy and the quantitative easing policy.

Keywords: Interest rate rule, imperfect money and credit markets, inflation targeting, monetary targeting, inflation expectations, Friedman’s k-percent money growth rule, feedback money growth rule, macroeconomic stability, zero-interest-rate policy, quantitative-easing policy. JEL Classification: E43, E44, E51, E52, E58.

2

Meixing Dai

1. Introduction Over the last eighteen years, inflation targeting has increasingly become a popular monetary-policy regime among the central banks in the world, since its initial adoption by the central bank of New Zealand in 1990. It has gained more and more popularity among academic economists and central bankers in a context of rapid financial liberalization and innovations, which causes the reported unstable relationship in the short run between monetary aggregates and inflation and hence the failure of monetary targeting. That leads Mishkin (1999) to present the inflation targeting, which can be implemented via an (optimal) interest-rate rule, as being more effective in the control of inflation than the monetary targeting and thus the natural successor of the latter. The emergence of inflation targeting in practice and in theory is clearly related to research on the interest-rate rules since the 1990s to reflect best the fact that the central bank of the United States conducts the monetary policy by choosing the federal funds rate (Goodfriend, 1991), a very short-term nominal interest rate, and that central banks of other industrialized countries have a similar behavior, including Bundesbank. The latter was considered for a long time as the classical example of a central bank which targets the monetary aggregates. This research was stimulated in particular by the discovery of Taylor (1993) which shows that simple interest-rate rules seem to coincide quantitatively with the behavior of the Federal Reserve over various periods. Conceptual questions, concerning the determination of macroeconomic variables for a given interest-rate rule, were tackled within various theoretical frameworks (Clarida, Gali and Gertler, 1999; King, 2000). All that research shares the same consensus, namely that the money and hence the credit do not have any crucial and constructive role to play in the monetary policy. In other words, the money market is only useful for determining the supply of money which responds endogenously to the demand of money, and hence can be largely ignored in making monetary policy decisions (Woodford, 1998; Rudebusch and Svensson, 1999). This consensus forged for ten years has substituted to the one forged by Milton Friedman, according to which inflation is “always and everywhere a monetary phenomenon”. However, the new consensus is confronted by timid but incessant empirical and theoretical contests as well as the new challenges revealed by the present financial and economic crises. The experience of the 1970s showed that the inflation expectations of the public can lose their anchor in a context of high oil prices and depreciating U.S. dollars. Monetary targeting such as Milton Friedman’s k-percent money growth rule was progressively abandoned by central banks in favor of implicit interest rate rules like that discovered by Taylor (1993).∗ To stabilize the inflation expectations, monetary authorities proactively increase (reduce) the nominal interest rate when the evidence suggests that inflation will rise above (respectively fall below) some numerical objective. By recommending the adoption of an interest rate rule by the central bank, economists advocate that the supply of money is automatically determined by the demand. In other words, the monetary authority implicitly confer to the private sector the following message: any quantity of money that you wish at given nominal interest rate will be provided. Under ∗ In an interview, Milton Friedman admits that the use of the quantity of money as target was not a success (London, 2003).

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

3

these conditions, a badly specified interest rate rule could lead to the existence of multiple equilibriums or Wicksellian-type dynamic instability. An important lesson of this literature is that, to avoid the existence of multiple equilibriums as well as Wicksellian-type dynamic instability, it is necessary that the interest rate rule reacts in a sufficiently strong manner to the current or expected rate of inflation. Recently, by considering some of the leading arguments for assigning an important role to tracking the growth of monetary aggregates when making decisions about monetary policy, Woodford (2008) concludes that none of them provides an indisputable reason to assign a big role to monetary aggregates in the conduct of monetary policy. For him, ignoring money does not mean returning to a conceptual framework that allows the high inflation of the 1970s. Woodford also rejects the view according to which the models of inflation determination with no role for money are incomplete, or inconsistent with elementary economic principles. However, he stresses the importance of avoiding the traps which are the bad estimate of output gap and the ignorance of the endogenous nature of inflation expectations. Consequently, it is necessary for the central bank to use all the sources of information to judge if the interest rate policy is consistent with the expected future trend of the economy (Svensson and Woodford, 2005). Within the framework of the IS-LM model (neo-classical synthesis or New Keynesian), there exist two conventional strategies to use equation LM as a not so indispensable accessory in the literature relating to the interest rate rules (King, 2000). The first uses LM to specify money supply rules and to compare them with interest rate rules. The second describes the monetary policy strategy using the interest rate rule and LM is used to determine the endogenous money supply. Within a static framework where the central bank adopts an interest rate rule, LM does not interact with other equations and has thus no importance in the absence of real balance effect. Moreover, the last effect is more hypothetical than real. However, as argued by Romer (2000), one area in which both the IS-LM and IS-MP (where MP stands for monetary policy, i.e., interest rate rule) may have simplified too far is in their treatment of financial markets. In both approaches, the only feature of financial markets that matters for the demand for goods is ‘the’ real interest rate that monetary policy can powerfully and directly influence as the central bank desires. In practice, the demand for goods depends on interest rates that the central bank may not be able to control directly and tenuously as well as the level of credit that is available at those rates. An analysis, which takes more careful account of the impacts of various developments in financial markets on the demand for goods as well as the mechanism through which the monetary policy affects these interest rates and the level of credit, would highlight many of the difficulties and uncertainties of actual policy-making. Recent experiences of monetary policy in the context of unprecedented financial and economic crises have shown that monetary policy defined in terms of interest rate rule may lose its effectiveness in stabilizing the financial markets and the economy. The zero-interestrate policy coupled with the quantitative easing policy previously practiced by the central bank of Japan and now by the Fed implies that monetary aggregates have an important role to play. The question is why the central bank, paying special attention to monetary aggregates during financial crisis, must neglect them when the economy is booming. In this respect, the European central bank (ECB), with its two-pillar monetary policy strategy, may be better inspired.

4

Meixing Dai

In this chapter, by adopting a more complicated view of financial markets, we will supply some new arguments in favor of the use of monetary aggregates under an inflation targeting regime and show how to do it. The approach that we adopt in this chapter is narrowly related to some previous works (Dai, 2007; Dai and Sidiropoulos, 2009) which also consider the use of money growth rules under the inflation-targeting regime and where the money market is considered as a link between different economic agents and a coordination device for their inflation expectations. One important point of the present chapter is that the target of interest rate does not automatically become the interest rate practiced by lenders on the credit market. The transmission mechanism from the repo interest rate, to money market interest rate and then to the lending interest rate can break down due to macroeconomic and financial instability. When the monetary and financial markets are imperfect, the central bank can lose its control over the inflation expectations due to the fact that it controls with imperfect precision the liquidity that private banking and financial sectors can also expand or reduce depending on expectations about future inflation and output. In the next section, we discuss why the role of money is important in the monetary policy strategy and why the inflation-targeting literature cannot neglect the money and discard the monetary targeting without adopting some very strong assumptions about the functioning of money and financial markets. In the section after, we examine some lessons from the monetary targeting experiences and argue that inflation targeting can be submitted to similar problems. In section 4, we incorporate money and credit markets in a simple New Keynesian model and specify a monetary policy strategy which consists of adding a feedback money growth rule to the inflation targeting regime. In section 5, we discuss why the feedback money growth rule can be useful, in comparison with Friedman’s k-percent rule, in dynamically stabilizing the inflation expectations, under a backward-looking or forwardlooking solution. In section 6, we discuss how the framework can be easily used to discuss the zero-interest-rate and quantitative easing policies. We conclude in the last section.

2. Why the Money May Be Useful and Important Even though the proponents of inflation targeting do not deny the long-run relationship (correlation) between monetary aggregates and inflation, they tend to neglect or deny the causality relationship which runs from monetary aggregates to inflation and hence the role of money as efficient instrument of controlling inflation. Under an inflation targeting regime, the causality of the relationship can be inverted since the supply of money is endogenous and automatically adapts to the evolutions of output and inflation. The inversion of causality cannot be achieved without making some implicit and explicit strong assumptions. Notably, in the inflation-targeting literature, it is assumed that an independent and transparent central bank without inflation bias can credibly anchor the inflation expectations of private sector by fixing nominal interest rate. This assumption is equivalent to assume that the money market and financial markets are perfectly functioning and hence can be put into a black box without loss of information. From many points of view, these assumptions are very questionable. Although a typical interest rate rule (Taylor rule or optimal interest rate rule) can be effective in anchoring the inflation expectations in certain models, the result is not robust with

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

5

the modifications, weak but empirically plausible, of model specifications. In effect, there is considerable uncertainty about the correct model specifications (Benhabib, Schmitt-Grohe and Uribe, 2001, 2002a, b; Christiano and Rostagno, 2001; Carlstrom and Fuerst, 2002, 2005). Sharing this concern, Christiano, Motto and Rostagno (2007) describe two examples which illustrate in different manners how the money and the credit can be useful in the conduct of monetary policy. Their first example presents a channel for monetary policy on the supply side and creates the possibility that the inflation expectations lose their anchoring. Illustrated with the help of an IS-LM model augmented of a supply curve, this example shows how the monitoring of money and credit can help anchor the inflation expectations of private agents. Their second example, which recapitulates the analysis of Christiano, Ilut, Motto and Rostagno (2007), shows that a monetary policy which narrowly concentrates on inflation can, in an unintended way, contribute to reduce the welfare via cycles of expansion and depression in the real and financial variables. Being aware of the importance of money and credit markets, Benjamin Friedman (2003) also worries about abandoning the role of money and the analytical tool which is curve LM. He argues that such an abandonment makes more difficult to take into account how the functioning of banking system (and with it credit markets more generally) can affect the monetary policy and also leaves open the fundamental question in the way in which the central bank manages to fix the interest rate in the first place. Similarly, for Goodhart (2007), the central banks must still give attention to the monetary aggregates, in particular the growth rate of the bank credit allocated to the private sector. Government and central bank might have incentive to care about the stability of monetary aggregates since there is an empirically proved strong long term relationship between inflation and money growth. Söderström (2005) demonstrates how a target for money growth can be beneficial for an inflation-targeting central bank acting under discretion. As the growth rate of money is closely related to the change in the interest rate and the growth of output, delegating a money growth target to the central bank makes discretionary policy more inertial, leading to better social outcomes. In comparing this delegation scheme with other schemes suggested in the literature, he finds that stabilizing money growth around a target can be a sensible strategy for monetary policy, although other delegation schemes are often more efficient. In a dynamic context, central bank can lose the capacity of controlling inflation expectations with only the instrument of interest rate at its disposition. Independent central bank may verbally persuade the public that it has the firm intention of attaining its inflation target by building its credibility and by making its objective, preferences and operational procedures, data and economic model transparent to the public. But due to economic uncertainty, model uncertainty or operational errors, the central bank cannot always attain its objective. This result may induce some doubts of the public about the future realization of inflation target. Outside of equilibrium, the central bank has the risk of losing its persuasion power and all the verbal persuasion efforts may not be sufficient to convince the public to adhere entirely to its monetary policy strategy (Dai, 2007).

6

Meixing Dai

Furthermore, temporary but persistent shocks could make difficult the conduct of monetary policy only based on the control of interest rate.∗ Workers, who have a finite horizon, could claim a compensation of fall in their purchasing power as soon as they observe a rise in the rate of inflation without awaiting the cancellation of current inflationary shocks by future shocks. If these behaviors are dominant, rational expectations based on information restrained to the goods market and the Philips curve, as it is generally admitted in the research on inflation targeting, could irrelevantly reflect the expectation behavior of private agents. It is contrary to the essential idea of the rational expectations hypothesis, which stipulates that the private agents use any information available to form their expectations. Consequently, one can reasonably suppose that information concerning the money and credit markets is used by the private sector. Considering the money market as device of coordination of private inflation expectations, Dai and Sidiropoulos (2003, 2005, 2009), Dai (2006, 2007), and Dai, Sidiropoulos and Spyromitros (2007) provide theoretical justifications of the utility of this market other than only determining in an endogenous way the money supply within a typical framework of inflation targeting. These theoretical concerns also found some empirical echoes which show that money is not superfluous. Milton Friedman (2005), using data covering three periods of expansion in the USA and Japan, proves that the quantity of money exerts a determining effect on national revenue and stock prices. Hafer, Haslag and Jones (2007) discover that there is a significant statistical relationship between the delayed values of the money and the output, even when delayed values of real interest rate and output are taken into account. Adding the money into a dynamic IS model, Hafer and Jones (2008) find that money growth usually helps predicting the GDP and that the predictive power of short-term real interest rate is much lower than previous works have suggested. Their results imply that the omission of the money seems to come at a high cost for dynamic IS models like that employed by Rudebusch and Svensson (1999). To understand the lacunae in the mainstream literature studying inflation targeting or interest rate rules, consider the traditional IS-LM diagram. By assuming that money is endogenous, the inflation targeting literature assumes that IS, LM and MP curves cross by divine coincidence at the same equilibrium point (Figure 1). The MP curve represents monetary policy stipulated in terms of interest rate rule and can be represented by a horizontal line if the interest rate rule does not depend on output. In effect, by assuming that money supply automatically adjusts to demand, whatever is the interest rate chosen by the central bank, LM moves to cut the two other curves (IS and MP) at their point of intersection. By assuming that money supply adjusts imperfectly to demand, given the inflation expectations, it is possible that these three curves do not cross at the same point as illustrated in Figure 2 after that some shocks have disturbed the initial equilibrium and dislocated these three curves. The resulting disequilibrium could lead private agents to modify their inflation expectations, allowing IS, LM and MP curves to shift so that, after some dynamic adjustment, these three curves cross again at the same equilibrium point.

∗ Random shocks can also take the appearance of persistent shock when the same shock repeats itself consecutively.

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

i

7

LM

it

MP

IS y Figure 1. Money supply is perfectly elastic.

i

LM

it

MP

IS y Figure 2. Money supply is imperfectly elastic.

As we have seen in the recent developments in financial markets, the central bank cannot easily control the interest rates (which correspond to the intersection point between IS and LM curves in Figure 2) at which the interbank loans and other lending are made. It can neither easily control the inflation expectations, since fear of deflation and fear of hyperinflation simultaneously appear in the actual financial turmoil. Actually, many central banks (some of them are explicit inflation targeter) have massively injected the central liquidity to stabilize the financial markets. However, they do not do a symmetrical work during the boom period, i.e. reducing the liquidity when the economy is expanding too quickly. This reveals why the neglect of money in the inflationtargeting framework is one of the lacunae in its theoretical foundations. The mainstream theories of inflation targeting assume that money and financial markets are perfect, and the central bank is perfectly credible and transparent. In the absence of inflationary bias and persistent shocks, these assumptions lead to the equality between the inflation target and the expected rate of inflation as well as the equality between the repo interest rate fixed by the central bank and the interest rate determined on financial markets.

8

Meixing Dai

We contest the view popular in the inflation-targeting literature according to which the central bank can be assumed to be completely credible in the sense that its inflation target automatically becomes the nominal anchor for current and future periods, thus evacuating the possibility that central bank could lack credibility and means to control inflation expectations. In effect, this credibility cannot be always ensured due to the existence of financial and economic uncertainty. For example, when there are major and persistent supply shocks inducing an inflationary pressure, the central bank might have difficulty to explain why it cannot fight inflation without provoking either a fall of employment or a fall in real wages during an extending period. The inflation-targeting literature focuses on the imperfections on the supply-side of goods and services and is completely unaware of those on money and financial markets. In order to ignore the later, it is implicitly assumed that these markets, in particular the money market, are perfectly functioning. As all financial assets are implicitly assumed to be perfectly substitutable, controlling only the repo interest rate is equivalent to controlling all other lending interest rates. Consequently, the curve of money supply coincides with that of money demand and one can completely ignore the existence of money and financial markets in the theoretical construction of inflation targeting. The assumption of imperfect money and financial markets allows understanding better the functioning of the economy and how a monetary policy is implemented. In effect, the central liquidity is not accessible at unlimited quantity because the central banks limit the quantity, the quality and the types of assets accepted as collateral as well as the types of financial institutions which have direct access to the central liquidity. That implies that there could be a potential imbalance (excess of liquidity or crisis of illiquidity) on the money market. Central bank’s interventions defined in terms of injection or withdrawal of liquidity become essential. These interventions have the advantage of being more flexible than the instrument of interest rate because the latter must generally follow a well defined trend and is only modifiable (except in the event of financial crisis) with much longer intervals separating two interest rate decisions. The failure of transmission mechanism running from the repo interest rate to other interest rates as well as the zero bound for nominal interest rate could greatly limit the possibility of actions through fixing the nominal interest rate for central banks adopting inflation targeting. A central bank too aggressive in reducing the repo interest rate can quickly find itself without interest rate instrument and hence the means of sufficiently reducing the lending interest rates and anchoring the inflation expectations. The imperfect money and financial markets hypothesis also gives a better account of the dynamic of inflation expectations. The evolutions of the expected rate of inflation deduced from the difference of return between the indexed and un-indexed obligations show that the inflation expectations are not as static as predicts the mainstream inflation targeting literature. Some introductive teachings treat the expected rate of inflation even as fixed in the presence of stochastic shocks (Romer, 2000; Walsh, 2002). Using information from money market and financial markets generally allows improving the inflation expectations of private sector compared to the case where private sector uses only information extracted from the interest rate rule, the Philips curve and the goods market equilibrium condition as it is admitted in the literature of interest rate rules and inflation targeting.

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

9

By assuming imperfect financial markets, we admit that the target of lending interest rate, decided by the central bank and expressed as optimal interest rate rule and function of other variables in the inflation-targeting regime, cannot be directly fixed and is not always realized due to malfunctioning of money and financial markets or shocks affecting these markets. In effect, the central bank fixes the repo interest rate, which is determined by taking account of inflation and output targets and economic model (including money and financial markets). A modification of repo interest rate allows inducing a change in the interbank money market interest rate, affecting hence the lending interest rate determined on the credit or debt market at which firms and consumers can borrow. If this transmission mechanism is perturbed by exogenous shocks or endogenous instability, adopting monetary targeting under inflation-targeting regime may have some advantages in terms of monitoring the inflation expectations and controlling the money market interest rate and the lending interest rate. There is then some good reasons for the inflation-targeting central bank, by designing an appropriate money growth rule, to flexibly monitor the level of liquidity in the monetary market and hence in the economy (i.e., to target other interest rates) and to control the inflation expectations in order to ensure the dynamic stability for the economy. The design of appropriate money growth rule is determinant for the success of monetary targeting since the renowned k-percent money growth rule of Milton Friedman is not successful. In effect, in an experiment of overlapping generations economies, Marimon and Sunder (1995) found no evidence that a ‘simple’ rule such as a constant growth of the money supply, can help coordinate agents’ beliefs and help stabilize the economy.

3. Monetary Targeting versus Inflation Targeting The strategy of monetary targeting (or targeting of monetary aggregates) comprises three elements: reliance on information conveyed by a monetary aggregate to conduct monetary policy, announcement of targets for monetary aggregates, and some accountability mechanism to preclude large and systematic deviations from the monetary targets (Mishkin, 2002). Monetary targeting is generally associated with the monetarism. Even though the monetarism represents an important advance over prior conventional wisdom and the lessons learned from the monetarist controversy are not to forget, it has lost its steam in modern development of monetary theory and policy. Woodford (2008) argues that the most important of these lessons, and the ones that are of continuing relevance to the conduct of policy today, are not dependent on the thesis of the importance of monetary aggregates.∗ In other words, the ECB’s continuing emphasis on the prominent role of money in its deliberations is not theoretically well justified. It is explained by the concern not to ignore the lessons of the monetarist controversies of the 1960s and 1970s. The monetary targeting experiences in major industrial countries are mitigated (Bernanke and Mishkin, 1992; Mishkin and Posen, 1997; Mishkin, 2002). It is found that while ∗ The most important lessons from the monetarism, according to Woodford (2008), are that monetary policy can do something about inflation, the central bank can reasonably be held accountable for controlling inflation and a verifiable commitment by the central bank to a non-inflationary policy is important.

10

Meixing Dai

Germany and Switzerland could be considered successful monetary targeters, the monetary targeting was not particularly successful in the United States, Canada and the United Kingdom. There are two interpretations for why monetary targeting in these three countries was not successful in controlling inflation. The first is that because monetary targeting, as part of the central bank game playing, was not pursued seriously, it never had a chance to be successful. The second is that growing instability of the relationship between monetary aggregates and goal variables such as inflation (or nominal income) due to financial liberalization and innovations introduced since 1980s meant that this strategy was doomed to failure and indeed should not have been pursued seriously. However, it is not by pure chance that the Bundesbank (and to some degree the National bank of Swiss) that took on board monetarist teachings to the greatest extent, had the best performance with regard to inflation control in the 1970s and 1980s. The monetary aggregate chosen by the Germans was central bank money, which is less affected by the ulterior financial liberalization and innovations. The key fact which may explain the success of monetary targeting regimes in Germany and Switzerland is that the targeting regimes were very far from a Friedman-type monetary targeting rule.+ The latter implies that a monetary aggregate is kept on a constant-growth-rate path and is the primary focus of monetary policy. In effect, the Bundesbank, could miss its targets in the short-run by allowing growth outside of its target ranges for periods as long as two to three years while subsequently reversing overshoots of its targets. Monetary targeting frameworks in Germany and Switzerland are best viewed as a mechanism for transparently communicating the strategy of monetary policy that focused on long-run considerations and the control of inflation, and as a means for increasing the accountability of the central bank. The success stories of monetary targeting, in the case of Bundesbank and Swiss National Bank, are explained by some economists as due to that the monetary policy is actually closer in practice to inflation targeting than it is to Friedman-like monetary targeting and thus might best be thought of as “hybrid” inflation targeting.+ The Bundesbank’s monetary targeting is quite similar to inflation targeting as it announced inflation target and transparently communicated to the public and market participants. Central bankers (Freedman, 1996; King, 1996) have also noted the close similarity in the use of central bank instruments and the reaction of central banks to news and shocks under inflation forecast and monetary targeting. That suggests that choice of one or other monetary regime does not seem to matter much for the day-to-day conduct of monetary policy. Empirically, inflation targeting seems to have made little if any difference for inflation and interest rate dynamics (or conduct of interest rate policy) in the countries that adopted this strategy in the 1990s (Groeneveld et al., 1998; Almeida and Goodhart, 1998). However, using real-time data, Gerberding et al. (2005) find that the Bundesbank took its monetary targets seriously, but also responded to deviations of expected inflation and output growth from target.

+ Issing (1996) noted: “one of the secrets of success of the German policy of money-growth targeting was that ... it often did not feel bound by monetarist orthodoxy as far as its more technical details were concerned.” + See Clarida and Gertler (1997), Bernanke and Mishkin (1997), Bernanke and Mihov (1997), Laubach and Posen (1997), Clarida et al. (1998), Mishkin (1999, 2002) and Svensson (1999a, b, 2000).

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

11

The recent debate about monetary policy strategy generally opposes monetary targeting to inflation targeting and questions over whether the ECB has to move to full-fledged inflation targeting. Alesina et al. (2001) argue that it is hard to see why the growth rate of M3 should have a special role and the ECB could improve its policy by adopting inflation targeting. The empirical study based on US data by Rudebusch and Svensson (2002) has revealed that monetary targeting is quite inefficient, yielding both higher inflation and output variability and therefore, there is no support for the prominent role given to money growth in the Eurosystem’s monetary policy strategy. Evans and Honkapohja (2003) have shown that Friedman’s k-percent money supply rule performs poorly in terms of welfare compared to optimal interest rate rule.∗ For Laubach (2003), monetary targeting facilitates communication of the central bank’s type. But, this advantage is outweighed for most parameter values by the advantage of inflation targeting in terms of inflation control. Cabos et al. (2003), using German data from the end of the Bretton Woods system until 1997, support also that control problems involved in targeting broad or narrow money are larger than for direct inflation targets. Moreover, Gersbach and Hahn (2003) suggest that inflation targeting is superior to monetary targeting as it makes it easier for central banks to commit to low inflation. In a quite consensual manner, the monetary targeting is too quickly pushed out as a credible monetary policy strategy. In practice, the ECB continues to attach importance to monetary analysis in its two-pillar strategy. But it is theoretically contested by proponents of inflation targeting. One prominent and systematic attack of the two-pillar strategy is recently given by Woodford (2008). Lessons learned from monetary targeting only indicate that the instability of the relationship between monetary aggregates and goal variables (inflation and nominal income) make monetary targeting problematic, but not necessarily the failure of monetary targeting. In the presence of instability relationship between instrument and goal variables, a central bank with high credibility can successfully stabilize inflation and output through monetary targeting if it is flexible, transparent and accountable (Mishkin, 2002). However, that includes too many conditions and explains why many economists argue against monetary targeting (Mishkin, 1999). One must not be surprised that the argument used against monetary targeting can be returned against inflation targeting which uses nominal interest rate as instrument. In a context of financial instability, it is difficult to ignore the developments in money and financial markets and consider that they have no influence on the strategy of inflation targeting which can be theoretically formulated only on the base of New-Keynesian Phillips curve and IS curve. In effect, the relationship between nominal interest rate that the central bank can directly control and goal variables such as inflation and output gap can be very instable. If this is the case, it will become difficult for central banks to credibly and transparently communicate their monetary policy strategy in the framework of inflation targeting. Furthermore, inflation targeting regimes, focusing on inflation and output targets, could lead to very ample movements in interest rates and consequently in monetary and financial ∗ However, Friedman’s rule can generate equilibriums that are determinate and stable under learning. In the contrary, open-loop interest rate rules are subject to indeterminacy and instability problems. Minford et al. (2003) compare Friedman’s k-percent money supply rule with Taylor’s rule to see how they are different.

12

Meixing Dai

aggregates and asset prices, creating difficulties for ulterior monetary policy decisions. That is actually the case in many developed and emerging market economies where many financial and real bubbles burst simultaneously. However, we do not argue against the use of inflation targeting regime. We consider that it is possible to combine monetary targeting with it as in Dai (2007) and Dai and Sidiropoulos (2009). Using this new monetary policy strategy, central banks could simultaneously dispose of two policy instruments (repo interest rate and money supply) to affront an increasingly uncertain economic environment. More instruments could allow stabilizing the economy with less social costs, particularly in the presence of possible dynamic instability or multiplicative uncertainties (Brainard, 1967).

4. The Model The economy is described by a stylized new-Keynesian model (Clarida, Gali and Gertler, 1999):

π t = βΕtπ t +1 + λxt + ε tπ ,with 0 < β < 1 , λ > 0 ,

(1)

xt = Et xt +1 − ϕ (itc − Etπ t +1 ) + ε tx , with ϕ > 0 ,

(2)

where π t ( ≡ pt − pt −1 ) denotes the rate of inflation, pt the general price level, xt the output gap (i.e., the log deviation of output from its flexible-price level), itc the nominal lending interest rate at which non-financial private sector can borrow from banks. Equation (1) represents the New-Keynesian Phillips curve, where the rate of inflation is related to the expected future rate of inflation ( Ε tπ t +1 ) and current marginal cost, which is affected by the output gap. The inflation shock, ε tπ , is due to productivity disturbances. Equation (2), an expectational IS curve, relates the current output gap to the expected future output gap ( Et xt +1 ), the real lending interest rate. The real lending interest rate is defined as the difference between the nominal lending interest rate and the expected future rate of inflation. In this model, we assume that the individual saver can save at itc if she directly buys bonds emitted by firms, which offer a rate of return equal to itc . We assume that savers also save in a deposit account bearing no interests at banks and hence their intertemporal arbitrage between saving and present consumption depends only on itc . The demand shock, ε tx , reflects either productivity disturbances which affect the flexible-price level of output or, equivalently, changes in the natural real interest rate. The model is completed with money and credit market equilibrium conditions in the spirit of Bernanke and Blinder (1988):

mt − pt ≡ bt + hitm − pt = l1xt − l2itm + ε tl , with l1 , l 2 > 0 ,

(3)

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

13

− κ1itm + κ 2itc = δ1 xt − δ 2itc + ε tc , with κ1 , κ 2 , δ1 , δ 2 > 0 ,

(4)

where itm is the rate of interest determined on the money market at which the banks can refinance, mt represents the money supply, bt is the base money that the central bank can control, ε tl is a random shock that could incorporate both money supply and money demand shocks, ε tc is a random shock that could incorporate both credit supply and credit demand shocks. The lending interest rate, itc , at which the banks lend, and firms and households borrow is determined on the credit market for given itm . Some modifications relative to the model of Bernanke and Blinder have been introduced to reflect recent developments in money and financial markets. Notably, ample disturbances affect the money market interest rate and the lending interest rate applied to the borrowing of non-financial private agents. We do not include public bonds in this model. The private bonds are assumed to be a perfect substitute to bank lending. Furthermore, in this model, it is the rate of interest itm (instead of the rate of return on the public bonds) which determines the demand and supply of liquidity on the money market. For simplification, we assume that itm does not affect consumption and investment decisions. Despite these simplifications, by giving a special attention to money and credit markets, we can quite realistically examine how the interest rate decision of the central bank makes its way into the economy and how the inflation expectations adjust in this process. In equation (3), it is assumed that the central bank has not a total control over the money supply. Financial market innovations (e.g., credit derivatives) and private equity activities could create important endogenous liquidity ( hitm ) that cannot be moped up by monetary policies except when higher interest rates undermine economic growth, curtail the flow of investor funds to “alternatives” and widen risk spreads in debt markets.∗ Instead, if the central bank desires, control can be exercised over a narrow monetary aggregate such as monetary base, and its variations are then associated with these in broader measures of money supply. The money supply is endogenous but it is imperfectly elastic as the banking system will increase or decrease the internal money in taking account of money market interest rate as well as collateral, and will not satisfy the money demand whenever it appears. The link between the money supply and the base, used here as a second policy instrument besides nominal interest rate, is given by m = b + hitm , where b is the (log) monetary base, and money multiplier ( m − b in log terms) is assumed to be an increasing function of money market interest rate (i.e. h > 0 ), a money-multiplier disturbance is not explicitly considered but is implicitly incorporated in the shock ε tl . Equation (3) could arise under a financial reserve system in which excess reserves are a decreasing function of interest rate (Modigliani et al., 1970; McCallum and Hoehn, 1983; Walsh, 1999).

∗ See “In the new liquidity factories, buyers must still beware” by M. El-Erian, president and chef executive of the Harvard Management Company, published in Financial Times, March 22, 2007.

14

Meixing Dai Equation (4) gives the condition for clearing the credit market. The supply of loans

decreases with itm and increases with itc . The demand of loans decreases with itc . The dependence of loan demand on xt captures the transactions demand for credit, which might arise, for example, from working capital or liquidity considerations. Taking the difference between equation (3) and its equivalent in period t − 1 yields:

μt + hΔitm − π t = l1Δxt − l2 Δitm + Δε tl ,

(5)

where μt = Δbt = bt − bt −1 . Equation (5) implies that, in average or at steady state, the monetary base growth rate μ must be equal to the current and expected rates of inflation, adjusted for the growth rate of output, i.e., μ = π + l1Δx* = π e + l1Δx* . An inflation-targeting central bank can reinforce the credibility in its capacity of monitoring the inflation expectations by keeping an average long-term growth rate of monetary base consistent with its inflation target, i.e. μ = π T + Δx* . However, monetary base targeting must not be considered as a unique and independent strategy for achieving price stability by stabilizing inflation around a given inflation target since it faces, as shown by Svensson (1999a), an unpleasant choice between being either inefficient and transparent or efficient and non-transparent. The model is closed with the specification of central bank’s objective function. The latter translates the behavior of the target variables into a welfare measure to guide the policy choice. We assume that this objective function is over the target variables xt and π t , and takes the form:

LCB =

1 ∞ i 2 Et ∑ β [αxt + i + (π t + i − π T ) 2 ] , 2 i =0

(6)

where the parameter α is the relative weight on output deviations. The central bank’s loss depends on output gap variability around of zero and inflation variability around of its constant target π T which can be zero or positive. Since xt is the output gap, the loss function takes potential output as the target. The minimization of loss function (6) taking account of the Phillips curve given by equations (1) leads to the following targeting rule in the sense of Svensson (2002):

xt = −

λ (π − π T ) , α t

(7)

This rule is also valid for the next period, hence we have:

Et xt +1 = −

λ ( Etπ t +1 − π T ) . α

(8)

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

15

Using equations (1)-(2) and targeting rules (7)-(8), we obtain the following instrument rule in the sense of Svensson (2002):

itcT =

αϕ (α + λ2 ) + λ (αβ −α − λ2 ) αϕ (α + λ2 )

Εtπ t +1 +

λ3 πT αϕ (α + λ2 )

+

λ επ ϕ (α + λ2 ) t

+ ϕ1 ε tx .

(9)

The optimal target of lending interest rate, itcT , corresponding to the central bank’s optimization solution, must react positively to the expected future rate of inflation if

αϕ (α + λ2 ) + λ (αβ − α − λ2 ) > 0 . It reacts positively to variation in π T , and shocks ε tx and ε tπ . The lending interest rate defined by equation (9) is not an instrument directly manipulated by the central bank. Given its target, the central bank must use some instruments to achieve it. One instrument is the repo interest rate that we have not explicitly modeled in this chapter and we assume that it is the same as the money market interest rate as the central bank is resolute to counterbalance any financial perturbation that can cause the money market interest rate to deviate significantly from the repo interest rate. In the inflation-targeting literature, it is assumed that the central bank directly controls the interest rate affecting the goods demand. In practice, controlling the interest rate which affects economic agents’ decisions is quite indirect and hence submitted to many disturbances on money and credit markets. Generally, central banks manipulate the repo interest rate in order to influence the money market interest rate and then through the mechanism of arbitrage the lending interest rate on the credit market, which is determinant for consumption and investment. Under normal financial market conditions, the money market interest rate is almost identical to the repo interest rate if the banking sector is considered as sound and transparent. Similarly, the lending interest rate in the credit market is not far higher than that practiced on the money market for short-term borrowing between banks. Consequently, it is indifferent to fix the repo interest rate so that itm = itcT (if the central bank believes that the credit market is perfect) or itc = itcT . Then using equation (4), we can determine the other interest rate which is not targeted in the first place. However, disturbances in financial and corporate sectors can create dislocation on financial markets and enlarge the difference between the repo interest rate, the money market interest rate and the lending interest rate. Furthermore, absorbing negative disturbances in goods market may require a low lending interest rate which may not be within the reach of the central bank due to negative financial market disturbances and the zero-bound for the nominal repo interest rate. Non-orthodox monetary policy, such as the quantitative easing policy, must be used to ease the tension on the money market or more audaciously the credit market through strengthening banks’ balance sheet and/or buying private debts on the credit market by the central bank or Treasury. During the last decade, even though inflation-targeting central banks’ principal objectives, i.e. stabilization of inflation and output gap, are relatively well achieved, too much

16

Meixing Dai

disequilibrium on the financial markets has been accumulated, translating into bubbles in real and financial asset prices. One reason for this to happen repeatedly is that central banks do not give anymore attention to the increase in the quantity of money (or liquidity) and credits. However, they pay a particularly great attention to these aggregates when the financial system and the real economy are facing with the risk of collapsing. This asymmetrical behavior with regard to quantity of money and credits is at the origin of dramatic financial shocks that we live actually, with devastating effects on the real economy. To avoid large self-inflicted financial shocks in the future without rejecting the recent advances in the central banking such as inflation targeting which puts accent on central bank’s independence and transparency, one solution is to combine the inflation targeting with an appropriate monetary targeting (Dai, 2007; Dai and Sidiropoulos, 2009) through the specification of appropriate money growth rules which are compatible with the dynamic stability of inflation expectations and asset prices. As we do not include asset prices in this simple model, we consider in the following how a well-specified feedback money growth rule can stabilize the inflation expectations, hence helping stabilize the economy. By manipulating only the repo interest rate to indirectly affect the lending interest rate, the central bank has no credible instrument of anchoring the inflation expectations besides the cheap talk about its firm intention to attain its inflation target. The real challenge appears whenever the economy is outside of equilibrium. When the rate of inflation moves away from the target announced by the central bank, verbal persuasion via the publication of the minutes, the monthly reports, the data, the procedures of decisions and the models used could be not enough to convince the public to adhere to the central bank’s monetary policy. Temporary but persistent shocks could make further difficult the conduct of monetary policy based only on the control of interest rate. Therefore, private agents may find rational to lose some precious time to collect all information about the economy to form their inflation expectations instead of using only the Phillips curve, IS curve and central bank’s targeting rule, not to say that using Phillips curve is also submitted to instability of the relationship in the long-run and some important pitfalls. If private agents adopt this dynamic approach of expectations based on all available information, the central bank might be able to more effectively anchor the inflation expectations by controlling the liquidity available in the financial system. Since the constant money growth rule has been considered as failure in stabilizing inflation and inflation expectations, we consider a feedback rule which reacts to output gap.∗ The central bank desires that the private sector believes in its objective even though shocks can deviate the realized rate of inflation from its inflation target. Knowing that the non-financial private sector scrutinizes the money and financial markets to find out the market inflation expectations before determining its own ones, the central bank, concerned with ensuring its credibility, controls the rate of growth of the money supply (in the narrow definition) at a level, which in average is consistent with its inflation target. A money (base) growth rule can be specified to neutralize the shocks affecting the money market (if they are observable, if not, we exclude them from the feedback money growth rule) and to react to variation of output gap: ∗ For alternative feedback money growth rules in a framework which combines monetary targeting and inflation targeting, see Dai (2007).

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

μt = ηΔxt + μ + Δε tl , with μ = π T + l1Δx .

17 (10)

This rule is similar to the one considered by Taylor (1985), McCallum (1988a, b), Judd and Motley (1991), Hess, Small and Brayton (1993), and Feldstein and Stock (1994). It is a variant of the Friedman’s k-percent rule, adjusted for shocks affecting the money market and variation of output gap. It can be implemented thanks to a kind of rationing or limitation of access to the central liquidity by the commercial banks. It is a more flexible instrument rule since the quantity of liquidity can be modified at every instant between two interest rate decisions by the central bank. It complements the interest rate as another powerful instrument of monetary policy. In this monetary policy strategy of duo instruments, one admits that the money growth rate is maintained in the medium and long term at a level compatible with the inflation target of the central bank.+ The most important thing is that the value of η must be chosen to ensure the dynamic stability of the adjustment process of inflation expectations. By specifying a money growth rule, we introduce the possibility of endogenous and more complex adjustment of inflation expectations in this model. These expectations are not only concerned with inflation dynamics reflected in the Phillips curve and IS curve, but also that reflected in information concerning money and financial markets. The monetary targeting rule given by equation (10) implies that it is not necessary for the central bank to scrupulously make the inflation target equal to the growth rate of a chosen monetary aggregate, which may be subjected to exogenous shocks or even disturbances due to speculative behaviors of financial operators. When the monetary targeting rule is well specified, the inflation target of the central bank is always realizable when the effects of shocks disappear. Although the expected and realized rates of inflation can be temporarily different from the inflation target, their difference will decrease since the dynamic stability is embedded in the economic system through an appropriate control of money growth rate. Without this control, an exogenous change in the inflation expectations could lead the economy to deviate far from the equilibrium corresponding to the inflation and output objectives announced by the central bank. If the inflation target represents a potential nominal anchor of the economy, the control of money growth rate makes it more credible in the eyes of private agents and provides a kind of additional nominal anchor for their inflation expectations. Private agents could revise as fine as possible their inflation expectations by using all available information about the state of the economy, including that concerning the money and credit markets.

5. The Dynamics of Inflation Expectations under InflationTargeting Regime with Feedback Money Growth Rule Equilibrium solutions of endogenous variables can be easily determined once the expected future rate of inflation is determined. Consequently, we will not give more details

+ Feldstein and Stock (1996) suggest that, with periodic adjustment, a monetary aggregate can be a useful intermediate target.

18

Meixing Dai

about these solutions and will instead focus on the dynamic stability of the adjustment process of the expected rate of inflation. We assume that the central bank can target the optimal lending interest rate i cT and exclude the possibility that the zero-bound for nominal interest rate is attained. Using equations (1)-(2) and the targeting rule (7), we solve the current rate of inflation and output gap as function of the expected future rate of inflation, inflation target, and supply shocks as follows:

αβ λ2 α Επ + επ , πt = πT + 2 t t +1 2 2 t α +λ α +λ α +λ

(11)

βλ λ λ πT − ε tπ . Επ + 2 t t +1 2 α +λ α +λ α + λ2

(12)

xt = −

Equation (11) can also be interpreted as a difference equation of inflation rate which relates the current rate of inflation to the expected future rate of inflation and inflation shocks. It can be solved in a forward-looking manner. Consequently, in the inflation-targeting literature, the inflation dynamic is not interesting to examine and hence generally neglected. One criticism that can be addressed to the use of equation (11) to obtain solution of the expected rate of inflation is that rational economic agents are not so rational since they will neglect all information coming from money and credit markets. Given the target of lending interest rate, itcT , the central bank must determine the money market interest rate that shall be attained through rule-based (and discretionary if necessary) variations in monetary base. Using equation (4), where we substitute itc by itcT given by instrument rule (9) and eliminate xt with the help of equation (12), we obtain:

itm =

(κ 2 + δ 2 )[αϕ (α + λ 2 ) + λ (αβ −α − λ 2 )] + αβλϕδ 1

αϕκ 1 (α + λ ) 2

+

λ (κ 2 + δ 2 + δ 1ϕ ) ϕκ 1 (α + λ ) 2

Ε t π t +1 +

ε tπ + κ ϕκ+δ ε tx − κ1 ε tc . 2

2

1

λ [(κ 2 + δ 2 ) λ 2 −αϕδ 1 ] αϕκ 1 (α + λ 2 )

πT (13)

1

Following a variation of inflation target and potential output, a supply shock or a shock affecting the goods or credit markets [or eventually the money market if the monetary shock is not perfectly counterbalanced as is assumed in the money growth rule (10)], the private sector will revise its inflation expectations. In practice, shocks affecting money and credit markets can generate major dislocations on goods and labor markets as well as modification in inflation expectations. These shocks affect the goods markets through their effect on the lending interest rate at which the banks or investors lend to firms and households. And through this channel, they affect the level of current output, employment and inflation.

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

19

Anyone who wants to form good inflation expectations cannot neglect these developments since inadequate monetary policy response to these shocks can put the economy either on diverging inflationary or deflationary paths for long times. It is to notice that, in some introductive studies to inflation targeting (Romer, 2000; Walsh, 2002), by excluding equation LM, the model made up of AS-AD-MP equations cannot generate a dynamic adjustment process for the expected rate of inflation. In effect, the expected rate of inflation is given by the inflation target of the central bank whatever is the nature of the random shock affecting the economy. The model becomes primarily static. In other words, the endogenous variables instantaneously attain their equilibrium value. The instantaneous adjustment is far from being the case in practice, in particular when the rate of inflation is weak. In effect, empirical studies show inertia in the adjustment of the rate of inflation (Gordon, 1997). Consequently, even the inflation-targeting central bank is very credible, private agents have no reason to stick to its announced inflation target when forming their inflation expectations. To reflect in the inflation-targeting framework the empirically observed inflation dynamics, one must either introduce persistent shocks or formulate an ad hoc difference equation of inflation in order to introduce a more realistic dynamic analysis of the current or expected rates of inflation.∗ The way that we borrow here is very different from that adopted by the literature on the interest rate rules and the inflation-targeting. We admit in particular that the private agents use all information at their disposal to rationally form their inflation expectations, including that provided by the money and credit markets. This is translated by the use of equations (4)(5) in our analysis of the dynamic adjustment of the expected rate of inflation, which also takes account of other equations of the model, including the reaction function of the central bank. We admit that the expected rate of inflation is a predetermined variable so that it cannot instantaneously adjust to its equilibrium value.+ This assumption is based on the fact that, in an environment of weak inflation, the adjustment of prices and wages, and consequently that of inflation, depend much on the price and wage contracts negotiated in the past. Due to the relatively high adjustment costs compared to the rate of inflation, the instantaneous adjustment of prices and wages is not an advantageous action for private agents. They collectively adopt a partial adjustment as what is generally allowed in the New Keynesian models. The expected rate of inflation, which partially reflects the evolution of current inflation, must behave in the same manner. The expected rate of inflation, as implicitly reflected in the prices of inflation-indexed bonds, could show more stable evolution than the actual rate of inflation. Indeed, the rise of the rate of inflation in the euro area in 2008 involves only a moderate rise in the expected rate of inflation, translating the confidence of financial operators in the monetary policy of the ∗ One can for example organize contests of forecasts where the best forecasters are rewarded, which makes it possible to have regular information on the inflation expectations of private agents. + Assume that the current and expected rates of inflation are predetermined variable is compatible with the forwardlooking rational expectations. Indeed, in dynamic models with rational expectations, the adjustment of current and expected rates of inflation takes into account the impacts of all news on the equilibrium, even if they are not instantaneously and completely reflected in the expected inflation. See Buiter and Panigirtzoglou (2003) for a similar assumption. This type of behaviour is more often observed in an environment of weak inflation. However, it is not good working assumption in episodes of high inflation or hyperinflation where the current and expected rates of inflation adjust very quickly.

20

Meixing Dai

ECB in the medium and long term, knowing that the ECB uses also the pillar of monetary analysis in its decision of monetary policy. We examine in the following the dynamic stability of inflation expectations adjustment process under forward-looking or backward-looking solutions respectively.

Forward-Looking Expectations Economic agents expect that the economy will behave in period t + 1 in a similar manner as in the current period t . The only difference is that they cannot estimate exactly future monetary policy and shocks affecting different markets. Taking one period forward equations (5) and (10)-(13), using them together with equations (12)-(13) to eliminate other endogenous variables except expected rates of inflation, and taking expectations of resulting difference equation, we obtain (Appendix):

Εtπ t +2 =

Ω Ω − α βϕκ 1 2

Ε tπ t +1 +

Θt

Ω − α 2 βϕκ 1

,

(14)

with

Ω = αβϕλκ1(l1 − η ) + αβϕλδ1 (h + l2 ) + (h + l2 )(κ 2 + δ 2 )[αϕ (α + λ2 ) + λ (αβ − α − λ2 )] ,

⎤ ⎡− αϕκ1 (α + λ2 )μ − αϕλ2κ1π T ⎥ ⎢ Θt = ⎢+ [αλ (κ 2 + δ 2 + δ1ϕ )(h + l2 ) + αϕκ1 (l1 − η )]ε tπ ⎥. ⎢+ α (α + λ2 )(h + l )(κ + δ )ε x − αϕ (α + λ2 )(h + l )ε c ⎥ t t ⎦ 2 2 2 2 ⎣ Recursively using equation (14) and assuming that future shocks are randomly distributed, the forward-looking solution of the expected rate of inflation for period t + 1 is given by: n

⎡ Ω − α 2 βϕκ1 ⎤ 1 Εtπ t +1+ n − Θt . Εtπ t +1 = ⎢ ⎥ Ω Ω ⎣ ⎦

(15)

Given that the rate of inflation in period t + 1 + n when n → ∞ is well controlled and thus not explosive, a convergent solution of Εtπ t +1 satisfying equation (15) exists if the eigenvalue has a modulus superior to unity, which is translated by:

Ω − α 2 βϕκ 1 < 1. Ω

(16)

If η = 0 , i.e. the money growth rule defined by equation (10) is reduced to Friedman’s kpercent rule adjusted for change responding to shocks affecting the money market, we have

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

21

Ω 0 > 0 , with Ω0 = αβϕλκ1l1 + αβϕλδ1 (h + l2 ) + (h + l2 )(κ 2 + δ 2 )[αϕ (α + λ2 ) + λ (αβ − α − λ2 )] .

Then according to inequality (16), the expected rate of inflation is converging to its equilibrium solution if Ω0 − α 2 βϕκ1 > 0 . For η > 0 , the stability condition defined by inequality (16) is always satisfied if we have simultaneously Ω − α 2 βϕκ1 > 0 and Ω > 0 . These conditions are satisfied at the same time, if η is small enough so that Ω − α 2 βϕκ1 > 0 . That implies:

η < l1 + Φ − where Φ =

α . λ

(17)

( h + l 2 ){αβλϕδ 1 + (κ 2 + δ 2 )[αϕ (α + λ 2 ) + λ (αβ −α − λ 2 )]}

αβλϕκ 1

. Condition (17) means that the

central bank must conceive a monetary targeting rule which do not respond excessively to the variation of output if Ω 0 − α 2 βϕκ 1 > 0 . A feedback rule has in this case the advantage of increasing the modulus of the positive eigenvalue of the difference equation (14) (i.e. reducing

Ω −α 2 βϕκ 1 Ω

since (

Ω −α 2 βϕκ 1 ' )η Ω

= −

α 3 β 2ϕ 2 λκ12 Ω2

< 0 ) and increasing the speed of

convergence according to equation (15). Consider now the plausibility of the case where we have Ω 0 − α 2 βϕκ1 < 0 , i.e.:

αβϕκ 1 (α − λl1 ) > (h + l2 ){αβλϕδ 1 + (κ 2 + δ 2 )[αϕ (α + λ2 ) + λ (αβ − α − λ2 )]} .

(18)

Condition (18) can be checked if the weight assigned by the central bank to the output target, α , is sufficiently high (so that (α − λl1 ) > 0 ), κ1 sufficiently large, λ sufficiently small, and the terms (h + l2 ) and (κ 2 + δ 2 ) sufficiently small. We notice that the terms κ1 and (h + l2 ) represent respectively how the supply and demand on the money and credit markets are sensible to the money market interest rate, and the term (κ 2 + δ 2 ) represents how the supply and demand on the credit market are sensible to the lending interest rate. 2 If Ω 0 − α βϕκ 1 < 0 , then Friedman’s k-percent rule helps anchoring the inflation

expectations if

α 2 βϕκ 1 2

< Ω < α 2 βϕκ 1 . If Ω <

α 2 βϕκ 1 2

, the economy will not converge to

the equilibrium and hence indeterminate. Consider now the design of the feedback money growth rule by defining an interval η if Ω 0 − α 2 βϕκ 1 < 0 . The latter implies that l1 + Φ − αλ < 0 .

Case 1: Choosing η so that Ω > 0 , Ω − α 2 βϕκ1 < 0 and condition (16) are satisfied simultaneously. Condition Ω > 0 implies anther interval for η , i.e.:

η < l1 + Φ .

(19)

22

Meixing Dai

Then condition (16) implies

Ω −α 2 βϕκ 1 Ω

> −1 , that leads to

η < l1 + Φ −

2Ω > α 2 βϕκ1 and hence:

α . 2λ

(20)

Furthermore, condition Ω − α 2 βϕκ1 < 0 yields:

η > l1 + Φ −

α . λ

(21)

Combining conditions (19)-(21) leads to:

l1 + Φ −

α α < η < l1 + Φ − . 2λ λ

(22)

Condition (22) suggests that if Ω 0 − α 2 βϕκ1 < 0 , then a feedback money growth rule with η neither too high nor too low helps anchor the inflation expectations. However, choosing a value for η in the interval defined in condition (22) could reduce more or less the speed of convergence to the equilibrium. As the value of

Ω −α 2 βϕκ1 Ω

Ω −α 2 βϕκ 1 Ω

> −1 and an increase in η will reduce

and make the latter nearer to −1 , it is better to choose a value for η

nearer the inferior limit given in inequality (22) in order to ensure a speedier convergence to the equilibrium. Case 2: Choosing η so that we have simultaneously Ω > 0 and Ω − α 2 βϕκ1 > 0 . These two conditions imply that

η < l1 + Φ − αλ

[see condition (17)]. The condition

Ω 0 − α 2 βϕκ1 < 0 implies that l1 + Φ − αλ < 0 and hence η < 0 . Since

Ω −α 2 βϕκ 1 Ω

decrease

when η increases, by choosing a negative value for η which is inferior but as close as possible to l1 + Φ − αλ , we make the dynamic adjustment process stable and increase at maximum the speed of convergence to the equilibrium as the central bank may desire. Case 3: Fixing η so that Ω < 0 , i.e.

η > l1 + Φ . Then, condition (16) yields

Ω −α 2 βϕκ 1 Ω

(23)

< 1 . The last condition cannot be checked since it

leads to Ω < Ω − α 2 βϕκ1 or − α 2 βϕκ1 > 0 .

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

23

The above discussion of dynamic stability conditions shows that a well-specified feedback money growth rule is necessary for stabilizing inflation expectations when the money and credit markets have certain characteristics. This explains why when financial innovations perturb the relationship between monetary aggregates and goal variables, simple approaches of monetary targeting which accompanies the fixation of repo interest rate by the central bank are not successful. In contrast, a well-specified feedback rule can dynamically stabilize the economy and increase the speed of convergence to the equilibrium.

Backward-Looking Expectations We assume that private agents do not automatically take the central bank’s announced inflation target as a credible anchor of inflation expectations. We admit the view according to which, in relatively unstable environments, they base their forecasts more on observed fluctuations than on the announcements of stabilizing monetary policies (Marimon and Sunder, 1995). The backward-looking solution of the expected rate of inflation corresponds well to this view. Taking the difference of equations (12)-(13), we obtain:

Δxt = −

Δitm =

βλ λ λ ΔΕtπ t +1 + Δπ T − Δε tπ , 2 2 2 α +λ α +λ α +λ

(κ 2 + δ 2 )[αϕ (α + λ2 ) + λ (αβ −α − λ 2 )] +αβλϕδ 1

αϕκ 1 (α + λ ) 2

ΔΕtπ t +1 + λ

[(κ 2 + δ 2 ) λ 2 −αϕδ 1 ]

αϕκ 1 (α + λ 2 )

(24)

Δπ T (25)

κ 2 + δ 2 + δ 1ϕ ) 2 +δ 2 + λ (ϕκ Δε tπ + κ ϕκ Δε tx − κ11 Δε tc . (α + λ 2 ) 1 1

Knowing that Δπ T = 0 and using equations (10)-(11) and (24)-(25) to eliminate π t , μt , Δxt and Δitm in equation (5), we obtain the following difference equation for the expected rate of inflation after some arrangements of terms:

Ε t π t +1 =

Ω Ω − α βϕκ 1 2

Εt −1π t +

Ψt

Ω − α 2 βϕκ 1

,

(26)

⎡− αϕκ1 (α + λ2 ) μ − αϕκ1 (α + λ2 )l1Δx + αϕκ1λ2π T ⎤ ⎢ 2 π⎥ with Ψt = ⎢− [αλ (h + l2 )(κ 2 + δ 2 ) + αϕλκ 1 (l1 − η ) + αϕλδ 1 (h + l2 ) − α ϕκ1 ]Δε t ⎥ . ⎢− α (h + l )(α + λ2 )(κ + δ )Δε x + αϕ (α + λ2 )(h + l )Δε c ⎥ 2 2 2 2 t t ⎣ ⎦ Under backward-looking expectations, the adjustment process of the expected rate of inflation is stable if the modulus of the eigenvalue is inferior to unity:

24

Meixing Dai

Ω Ω − α 2 βϕκ 1

< 1.

(27)

When η = 0 , we have always Ω 0 > 0 . If Ω0 − α 2 βϕκ1 > 0 , the stability condition (27) cannot be checked if we maintain η = 0 since Ω 0 > Ω 0 − α 2 βϕκ1 . The Friedman’s k-percent money growth rule will fail to stabilize the inflation expectations around the inflation target announced by the central bank. In contrast, the feedback money growth rule allows stabilizing inflation expectations if

η is specified so that Ω < 0 and hence Ω − α 2 βϕκ1 < 0 . Thus, we have

Ω Ω −α 2 βϕκ 1

< 1 and the

stability condition (27) is satisfied. To ensure Ω < 0 and hence the dynamic stability under backward-looking expectations, η must satisfy the following condition:

η > l1 + Φ .

(28)

By increasing η to a value far greater than l1 + Φ , the speed of convergence could be reduced since

Ω Ω −α 2 βϕκ1

will be nearer to 1. So, we must keep η superior but as close as

possible to l1 + Φ . Another case to consider is based on the observation that when η = 0 , we could have simultaneously Ω 0 > 0 and Ω0 − α 2 βϕκ1 < 0 . Specifying η so that Ω > 0 , Ω − α 2 βϕκ 1 < 0 and condition (27) are simultaneously checked. The condition Ω > 0 implies condition (19). The condition Ω − α 2 βϕκ1 < 0 is always true if η is not too small, i.e.:

η > l1 + Φ −

α . λ

(29)

The condition Ω0 − α 2 βϕκ1 < 0 implies that the right hand of inequality (29) is negative. The stability condition (27) implies that we must have

Ω Ω −α 2 βϕκ 1

> −1 , which is equivalent to

2Ω > α 2 βϕκ1 . That yields:

η < l1 + Φ −

α . 2λ

(30)

Combining conditions (19) and (29)-(30) leads to the interval of η for which the dynamic stability is ensured:

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

l1 + Φ −

α α < η < l1 + Φ − . λ 2λ

25

(31)

Condition (31) is the same as condition (22) and implies that the growth rate must be defined over an interval with the lower limit being negative. Increasing the value of η will increase (

Ω Ω −α 2 βϕκ 1

the )η' =

modulus α 3 β 2ϕ 2 λκ 12 ( Ω −α 2 βϕκ 1 ) 2

of

the

eigenvalue

(i.e.

increase

Ω Ω −α 2 βϕκ 1

since

> 0 ) and hence the speed of convergence. Therefore, in order to

increase the speed of convergence, η must be chosen to be as near as possible to l1 + Φ − 2αλ . Under backward-looking expectations, the dynamic stability of the economy can be ensured with a feedback money growth rule which responds positively and sufficiently to variations of output if the money and credit markets and the structure of the real economy have certain characteristics (i.e., Ω < 0 and Ω − α 2 βϕκ1 < 0 ). However, the stability must be ensured by a feedback money growth rule which can react positively or negatively to variations of output with a reaction parameter in a well-defined interval if other economic and financial conditions prevail (i.e. Ω > 0 and Ω − α 2 βϕκ1 < 0 ).

6. Zero-Interest-Rate Policy and Quantitative Easing Policy Recent experiences of monetary policy at the Fed have shown that after having brought down the repo interest rate to zero, the quantitative easing policy is one of the last options that the central bank can use in a context of financial turmoil. There is no conceptual difficulty for discussing these two monetary policies in our framework, since we consider already the money and credit markets while assuming that the central bank practices inflation targeting.∗ In this section, we just briefly discuss how our framework allows examining such issues without fully carrying out the dynamic analysis as we have done before. We have admitted that the central bank targets the lending interest rate, but cannot directly fix this latter. It must make the desired change in the lending interest rate through its action on the money market by fixing the repo interest rate, which is not explicitly considered in our model and is implicitly assimilated to the money market interest rate. In effect, the repo interest rate and the money market interest rate can be assimilated if the financial institutions are solid and transparent. Otherwise, a risk premium might be applied to money market interest rate. However, the central bank or the Treasury can reduce the premium to zero by implicitly or explicitly guaranteeing all lending on the money market or by supplying an amount of liquidity as large as demanded by financial operators. In this model, the zero interest rate policy becomes necessary if the money market interest rate defined by equation (13) becomes zero or negative:

∗ For a review of Japanese experience of zero interest rate policy coupled with quantitative easing policy, see Spiegel (2006).

26

Meixing Dai

itm =

(κ 2 + δ 2 )[αϕ (α + λ 2 ) + λ (αβ −α − λ 2 )] +αβλϕδ 1

αϕκ 1 (α + λ ) 2

+

λ (κ 2 + δ 2 + δ 1ϕ ) ϕκ 1 (α + λ ) 2

Εtπ t +1 +

λ [(κ 2 + δ 2 ) λ 2 −αϕδ 1 ] αϕκ 1 (α + λ 2 )

πT

ε tπ + κ ϕκ+ δ ε tx − κ1 ε tc ≤ 0. 2

2

1

(32)

1

Since there is zero bound for the nominal interest rate, then the central bank must fix:

itm = 0 .

(33)

As the zero interest rate policy cannot allow the realization of the optimal lending interest rate due to malfunctioning of the money and credit markets, the effective lending interest rate determined by the credit market will be superior to the target of lending interest rate determined by equation (9). Consequently, the targeting rule (9) will not be effective. Inflation expectations dynamics and equilibrium solutions of economic variables are determined by equations (1)-(5), (10) and (33). The zero interest rate policy can correspond to a suboptimal equilibrium since it cannot always bring down the lending interest rate to a level which is optimal for the central bank. To make the monetary policy effective, when large negative shocks on financial markets imply a need for the zero interest rate policy, the quantitative easing policy sometimes becomes necessary. The quantitative easing policy, targeting the liquidity in the banking and financial system, is used in order to allow increasing the supply on the credit markets and so to bring down the lending interest rate to its target level. The quantitative easing policy can be directed to the money market only or the money and credit markets simultaneously. It modifies equations (3)-(4) as follows:

q m + bt + hitm − pt = l1 xt − l2itm + ε tl ,

(34)

q e − κ1itm + κ 2itc = δ1 xt − δ 2itc + ε tc ,

(35)

where q m and q e represent the discretionary injection of liquidity on the money and credit markets respectively. If the quantitative easing policy is fully executed so that the target and effective lending interest rate are equalized (i.e., itc = itcT ) under the zero interest rate policy (i.e., itm = 0 ), the economic system can be described by equations (10)-(12) and (34)-(35). These equations allow examining the adjustment dynamics of inflation expectations and determining the equilibrium solutions of endogenous variables under the zero interest rate policy coupled with the quantitative easing policy.

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

27

7. Conclusion In a closed economy New-Keynesian model in which we introduce imperfect money and credit markets, we have shown that inflation-targeting central banks have good reasons to use monetary targeting together with inflation targeting. We defend the view that the quantity of money must be regulated with a rule but not in the way conceived by Milton Friedman who proposes a k-percent money growth rule. In practice, the money growth rate can be adjusted more flexibly to answer to shocks affecting real as well as money and financial markets between two interest rate decisions by the central bank. Given that the repo interest rate is an indirect instrument, without regulating the liquidity on the money market, central bankers may find that the cheap talk is not always sufficient to ensure the announced inflation target as credible nominal anchor of private inflation expectations. This view finds strong support in recent financial and economic turmoil where many central banks massively inject liquidity in the financial system to avoid the collapse of the financial and economic system and where manipulating the repo interest rate is not anymore sufficient. Another support is found in the long-term relationship between money and inflation found in empirical study, which is not a simple correlation but a causal relationship in the sense that a high growth rate of money supply will systematically lead to high inflation rate. A strict control of money supply always allows controlling the inflation rate in the medium and long term. The model is sufficiently rich so it allows us to illustrate the complex transmission mechanism of monetary policy, which may be perturbed by malfunctioning of the money and credit markets or shocks affecting these markets. We can use it to explain why the central bank cannot directly (and hence always perfectly) control the lending interest rate which effectively affects the investment and consumption by modifying only the repo interest rate. We have shown that the inflation expectations are not easily controlled in this framework as it is optimistically conceived in the mainstream literature on interest rate rules and inflation-targeting. As the central bank controls the growth of money supply by limiting the access to the central liquidity in order to ensure good functioning of money and credit markets, private agents will give much attention to this strategy and consider that future inflation depends narrowly on the monetary growth rule as well as developments in money and credit markets. A well-conceived money growth rule, according to the type of expectations (forwardlooking or backward-looking) and depending on the structural parameters of the economy, can help anchor the inflation expectations and increase the speed of convergence to the equilibrium. Finally, our framework can be easily used to discuss the recent developments in the monetary policy strategy of the Fed, which adopts quantitative easing policy after having adopted zero-interest-rate policy.

28

Meixing Dai

Appendix: The Difference Equation under Forward-Looking Expectations Taking one period forward equations (5) and (10)-(13) yields:

μt +1 + h(itm+1 − itm ) − π t +1 = l1 ( xt +1 − xt ) − l2 (itm+1 − itm ) + (ε tl+1 − ε tl ) ,

(A1)

μt +1 = η ( xt +1 − xt ) + μ + (ε tl+1 − ε tl ) .

(A2)

α λ2 αβ Εt +1π t + 2 + επ , πT + π t +1 = 2 2 t +1 2 α +λ α +λ α +λ

(A3)

βλ λ λ πT − επ , Εt +1π t + 2 + 2 2 α +λ α +λ α + λ2 t +1

(A4)

xt +1 = −

(κ 2 +δ 2 )[αϕ (α + λ2 ) + λ (αβ −α − λ2 )]+αβλϕδ 1

itm+1 =

αϕκ1 (α + λ2 )

+

λ (κ 2 +δ 2 +δ1ϕ ) ϕκ1 (α + λ2 )

π

ε t +1 +

κ 2 +δ 2 ϕκ1

ε tx+1

−

Ε t +1π t + 2 +

λ [(κ 2 +δ 2 ) λ2 −αϕδ1 ] αϕκ1 (α + λ2 )

πT (A5)

εc . κ1 t +1 1

Using equations (12)-(13) and (A4)-(A5) to calculate the following difference equations:

itm+1 − itm = +

(κ 2 + δ 2 )[αϕ (α + λ 2 ) + λ (αβ −α − λ 2 )] +αβλϕδ 1

αϕκ 1 (α + λ ) 2

λ (κ 2 + δ 2 + δ 1ϕ ) ϕκ 1 (α + λ ) 2

xt +1 − xt = −

(ε tπ+1 − ε tπ ) +

κ 2 +δ 2 ϕκ 1

(Ε t +1π t + 2 − Ε tπ t +1 ) +

λ [(κ 2 + δ 2 ) λ 2 −αϕδ 1 ] αϕκ 1 (α + λ 2 )

Δπ T

(ε tx+1 − ε tx ) − κ11 (ε tc+1 − ε tc ),

(A6)

βλ λ λ (Εt +1π t + 2 − Εtπ t +1 ) + Δπ T − (ε tπ+1 − ε tπ ) . (A7) 2 2 2 α +λ α +λ α +λ

Taking account of the assumption of constant inflation target, i.e., Δπ T = 0 , then using equations (A2)–(A3) and (A6)–(A7) to eliminate other endogenous variables except the expected rates of inflation in equation (5b), we obtain: ⎡ (κ 2 +δ 2 )[αϕ(α +λ2 ) +λ (αβ −α −λ2 )]+αβλϕδ1 (Ε π − Ε π ) + λ (κ 2 +δ 2 +δ1ϕ ) (ε π − ε π )⎤ t +1 t + 2 t t +1 t +1 t ⎥ ⎢ αϕκ1 (α + λ2 ) ϕκ1 (α + λ2 ) (h + l2 )⎢ ⎥ κ +δ x x c c ⎢⎣+ 2ϕκ1 2 (ε t +1 − ε t ) − κ11 (ε t +1 − ε t ) ⎥⎦ −

αβ α + λ2

Εt +1π t + 2 +

λ2 πT α + λ2

+

α επ α + λ2 t +1

[

= (l1 −η ) −

βλ α + λ2

(Εt +1π t + 2 − Εtπ t +1) −

λ α + λ2

(A8)

]

(ε tπ+1 − ε tπ ) − μ .

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

29

Taking mathematical expectations of equation (A8) conditional on information available at time t and assuming that the best estimates at time t of future shocks are zero, i.e., Et ε tl+1 = Ε tε tπ+1 = Ε tε tc+1 = Ε t ε tx+1 = 0 , we obtain: ⎡ (κ 2 + δ 2 )[αϕ (α + λ2 ) + λ (αβ −α − λ2 )]+αβλϕδ 1 (Ε π − Ε π ) ⎤ t t +2 t t +1 ⎥ 2 ⎢ αϕκ1 (α + λ2 ) ( h + l2 ) ⎢ − αβ 2 Εtπ t + 2 + λ 2 π T ⎥ (A9) + + α λ α λ λ (κ 2 + δ 2 + δ1ϕ ) π κ 2 +δ 2 x c 1 ⎥ ⎢− ϕκ (α + λ2 ) ε t − ϕκ1 ε t + κ1 ε t ⎦ ⎣ 1

[

= (l1 − η ) −

βλ α + λ2

(Ε tπ t + 2 − Εtπ t +1 ) +

λ α + λ2

]

ε tπ − μ .

Simplifying and rearranging the terms in (A9) leads to the difference equation (14).

Acknowledgments I am grateful to Professor Gilbert Koenig for very helpful discussions about the new ideas which are introduced in this present paper and some of my previous papers closely linked to this one.

References [1]

[2]

[3] [4] [5] [6] [7]

[8] [9]

Alesina, A. & O. Blanchard & J. Gali & F. Giavazzi & H. Uhlig (2001), Defining a Macroeconomic Framework for the Euro Area. Monitoring the European Central Bank 3. London: CEPR. Almeida, Alvaro & Charles A. E. Goodhart (1998). Does the Adoption of Inflation Targets Affect Central Bank Behaviour? Banca Nazionale del Lavoro Quarterly Review (Rome), 204 (supplement), 19-107. Benhabib, Jess & Stephanie Schmitt-Grohe & Martin Uribe (2001). Monetary Policy and Multiple Equilibria. American Economic Review, 91(1), 167-86. Benhabib, Jess, Stephanie Schmitt-Grohe & Martin Uribe (2002a). Chaotic InterestRate Rules. American Economic Review, 92(2), 72-78. Benhabib, Jess, Stephanie Schmitt-Grohe & Martin Uribe (2002b). Avoiding Liquidity Traps. Journal of Political Economy, 110(3), 535-563. Bernanke, Ben S. & Blinder, Alan S. (1988). Credit, Money, and Aggregate Demand. American Economic Review, vol. 78(2), 435-439. Bernanke, Ben S. & Frederic S. Mishkin (1992). Central Bank Behavior and the Strategy of Monetary Policy: Observations from Six Industrialized Countries. In Olivier Blanchard & Stanley Fischer (Eds.), NBER Macroeconomics Annual, 183-238, Cambridge: MIT Press. Bernanke, Ben S. & Ilian Mihov (1997). What does the Bundesbank target? European Economic Review, Volume 41, Issue 6, 1025-1053. Bernanke, Ben S. & Frederic S. Mishkin (1997). Inflation Targeting: A New Framework for Monetary Policy? Journal of Economic Perspectives 11, no. 2, 97-116.

30

Meixing Dai

[10] Brainard, W. (1967). Uncertainty and the effectiveness of policy. American Economic Review 57 (2), 411–425. [11] Buiter W. H. & N. Panigirtzoglou (2003). Overcoming the Zero Bound on Nominal Interest Rates with Negative Interest on Currency: Gesell’s Solution. Economic Journal, 113, 723-746. [12] Cabos, Karen & Michael Funke & Nikolaus A. Siegfried (2003). Some Thoughts on Monetary Targeting vs. Inflation Targeting. The German Economic Review, Vol. 5, Iss. 3, 219 – 238. [13] Carlstrom, Charles T. & Timothy S. Fuerst (2002). Taylor Rules in a Model that Satisfies the Natural-Rate Hypothesis. American Economic Review, 92(2), 79-84. [14] Carlstrom, Charles T. & Timothy S. Fuerst (2005). Investment and Interest Rate Policy: A Discrete Time Analysis. Journal of Economic Theory, 123(1), 4-20. [15] Christiano, Lawrence & Massimo Rostagno (2001). Money Growth Monitoring and the Taylor Rule. NBER Working paper No. 8539. [16] Christiano, Lawrence J., Roberto Motto & Massimo Rostagno (2007). Two Reasons Why Money and Credit May be Useful in Monetary Policy. NBER Working Paper No. W13502. [17] Christiano, Lawrence & Cosmin Ilut & Roberto Motto & Massimo Rostagno (2007). Monetary Policy and Stock Market Boom-Bust Cycles. Manuscript. [18] Clarida, Richard & Mark Gertler (1997). How the Bundesbank Conducts Monetary Policy. In Romer, C. & D. Romer (Eds.), Reducing Inflation: Motivation and Strategy, University of Chicago Press, Chicago, 363-406. [19] Clarida, Richard & Jordi Gali & Mark Gertler (1998). Monetary policy rules in practice: Some international evidence. European Economic Review 42, 1033-1068. [20] Clarida, Richard & Jordi Gali & Mark Gertler (1999). The Science of Monetary Policy: A New Keynesian Perspective. Journal of Economic Literature, vol. 37, 1661–1707. [21] Dai, Meixing & Moïse Sidiropoulos (2003). Règle du taux d’intérêt optimale, prix des actions et taux d’inflation anticipé: une étude de la stabilité macroéconomique. Économie Appliquée, tome LVI, n°4, p. 115-140. [22] Dai, Meixing & Moïse Sidiropoulos (2005). Should Inflation-Targeting Central Banks care about dynamic instabilities in an open economy? Ekonomia, Vol. 8(2), 1-20. [23] Dai, Meixing & Moïse Sidiropoulos (2009). Money growth rule and macro-financial stability under inflation-targeting regime. Working paper of BETA n° 2009-5. [24] Dai, Meixing (2007). A two-pillar strategy to keep inflation expectations at bay: A basic theoretical framework. Working paper of BETA n° 2007-20. [25] Dai, Meixing, Moïse Sidiropoulos & Eleftherios Spyromitros (2007). La transparence de la politique monétaire et la dynamique des marchés financiers. Economie Appliquée, Tome LX – n° 4, 141-162. [26] Dai, Meixing (2006). Inflation-targeting under a Managed Exchange Rate: the Case of Chinese Central Bank. Journal of Chinese Economic and Business Studies, Vol. 4, No. 3, 199-219. [27] Evans, George W. & Seppo Honkapohja (2003) “Friedman’s money supply rule vs optimal interest rate policy. Scottish Journal of Political Economy, vol. 50, 550-566.

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

31

[28] Feldstein, Martin & James H. Stock (1994). The use of a monetary aggregate to target nominal GDP. In N.G. Mankiw (Ed.), Monetary Policy, University of Chicago Press, Chicago, 7–62. [29] Feldstein, Martin and James H. Stock (1996). Measuring Money Growth when Financial Markets Are Changing. Journal of Monetary Economics, 37:1, 3–27. [30] Freedman, C. (1996). What operating procedures should be adopted to maintain price stability? Practical issues. In: Federal Reserve Bank of Kansas City, Achieving Price Stability. Kansas City. [31] Friedman, Benjamin M. (2003). The LM curve: a not-so-fond farewell. NBER Working Paper n° 10123. [32] Friedman, Milton (2005). A Natural Experiment in Monetary Policy Covering Three Episodes of Growth and Decline in the Economy and the Stock Market. Journal of Economic Perspectives, Vol. 19, issue 4, 145-150. [33] Gersbach, Hans & Volker Hahn (2003). Signalling and Commitment: Monetary versus Inflation Targeting. CEPR Discussion Papers No. 4151. [34] Goodfriend, Marvin (1991). Interest Rates and the Conduct of Monetary Policy. Carnegie-Rochester Conference Series on Public Policy, vol. 34, 7–30. [35] Goodhart, Charles A. E. (2007). Whatever Became of the Monetary Aggregates?. National Institute Economic Review 200, 56-61. [36] Gordon, R. J. (1997). The Time Varying Nairu and its Implications for Economic Policy. Journal of Economic Perspective, Vol. 11, n° 2, 11-32. [37] Groeneveld, H., Koedijk K.G. & Kool C.J.M. (1998). Inflation Dynamics and Monetary Strategies: Evidence from Six Industrialized Countries. Open Economies Review, Vol. 9, No. 1, 21-38. [38] Hafer R.W. & Garett Jones (2008). Dynamic IS Curves With and Without Money: An International Comparison. Journal of International Money and Finance, vol. 27(4), 609-616. [39] Hafer R.W., Joseph H. Haslag & Garett Jones (2007). On money and output: Is money redundant?” Journal of Monetary Economics, Volume 54, Issue 3, 945-954. [40] Hess, Gregory D., David H. Small & Flint Brayton (1993). Nominal income targeting with the monetary base as instrument: an evaluation of McCallum’s rule. Proceedings, Board of Governors of the Federal Reserve System (U.S.). [41] Issing, Otmar (1996). Is Monetary Targeting in Germany Still Adequate? In Siebert, Horst (ed.), Monetary Policy in an Integrated World Economy, Institut für Weltwirtschaft an der Universität Kiel, Mohr Tübingen, 117-30. [42] Judd, John P. & Brian Motley (1991). Nominal Feedback Rules for Monetary Policy. Economic Review, Federal Reserve Bank of San Francisco, Number 3, 3-17. [43] King, M., (1996). Direct inflation targets. In Deutsche Bundesbank (Ed.), Monetary Strategies in Europe. Vahlen, MuKnchen. [44] King, Robert G. & Alexander L. Wolman (1999). What Should the Monetary Authority Do If Prices Are Sticky? In John B. Taylor (Ed.), Monetary Policy Rules. Chicago: University of Chicago Press, 1999. [45] King, Robert G. (2000). The new IS-LM model: language, logic, and limits. Economic Quarterly- Federal Reserve Bank of Richmond, issue Sum, 45-103. [46] Laubach, Thomas (2003). Signalling commitment with monetary and inflation targets. European Economic Review, Vol. 47, Iss. 6, 985-1009.

32

Meixing Dai

[47] Laubach, Thomas & Posen, Adam S. (1997). Disciplined discretion: the German and Swiss monetary targeting frameworks in operation. Federal Reserve Bank of New York, Research Paper No. 9707. [48] London, Simon (2003). Lunch with the FT: Milton Friedman. Financial Times, June 7, 2003. [49] Marimon, Ramon & Sunder, Shyam (1995). Does a Constant Money Growth Rule Help Stabilize Inflation? Experimental Evidence. Carnegie-Rochester Conference Series on Public Policy, vol. 43, 111-56. [50] McCallum, Bennett T. & James G. Hoehn (1983). Instrument Choice for Money Stock Control with Contemporaneous and Lagged Reserve Requirements: Note. Journal of Money, Credit and Banking, Vol. 15, No. 1, 96-101. [51] McCallum, Bennett T. (1988a). Robustness Properties of a Rule for Monetary Policy. Carnegie-Rochester Conference Series on Public Policy 29, 173-204. [52] McCallum, Bennett T. (1988b). Targets, Indicators, and Instruments of Monetary Policy. in Monetary Policy in an Era of Change, Washington, D. C.: American Enterprise Institute. [53] Minford, P. & F. Perugini & N. Srinivasan (2003). How different are money supply rules from Taylor rules?” Indian Economic Review, Vol. 38, Iss. 2, 157-166. [54] Mishkin, Frederic S. & Adam S. Posen (1997). Inflation targeting: lessons from four countries. Economic Policy Review, Federal Reserve Bank of New York, issue Aug, 9110. [55] Mishkin, Frederic S. (1999). International Experiences with Different Monetary Policy Regimes. Journal of Monetary Economics, Vol. 43, No. 3, 579-606. [56] Mishkin, Frederic S. (2002). From Monetary Targeting to Inflation Targeting: Lessons from Industrialized Countries. In Banco de Mexico, Stabilization and Monetary Policy: The International Experience (Bank of Mexico: Mexico City, 2002), 99-139. [57] Modigliani, Franco, Robert Rasche & J Philip Cooper (1970). Central Bank Policy, the Money Supply, and the Short-Term Rate of Interest. Journal of Money, Credit and Banking, Vol. 2(2), 166-218. [58] Romer, D. (2000). Keynesian Macroeconomics without the LM Curve. The Journal of Economic Perspective, Vol. 14, n° 2, pp.149-169. [59] Rudebusch, G. & Svensson, Lars E. O. (1999). Policy Rules and Inflation Targeting. in Taylor, J.B. (Ed.), Monetary Policy Rules. University of Chicago Press, Chicago, 203246. [60] Rudebusch, Glenn D. & Svensson, Lars E. O. (2002). Eurosystem Monetary Targeting: Lessons from U.S. Data. European Economic Review, Vol. 46, Iss. 3, 417442. [61] Söderström, Ulf (2005). Targeting Inflation with a Role for Money. Economica 72 (288), 577–596. [62] Spiegel, Mark M. (2006). Did Quantitative Easing by the Bank of Japan ‘Work’? RBSF Economic Letter, Number 2006-28, 1-3. [63] Svensson, L.E.O. (1999a). Inflation Targeting as a Monetary Policy Rule. Journal of Monetary Economics, 43, 607-654. [64] Svensson, L.E.O. (1999b). Monetary Policy Issues for the Eurosystem. CarnegieRochester Conferences Series on Public Policy 51(1), 79-136.

On the Role of Money-Growth Targeting under an Inflation-Targeting Regime

33

[65] Svensson, L.E.O. (2000). The First Year of the Eurosystem: Inflation Targeting or Not? American Economic Review: Papers and Proceedings 90, 95-99. [66] Svensson, Lars E.O. (2002). Inflation Targeting: Should It Be Modeled as an Instrument Rule or a Targeting Rule? European Economic Review 46, 771-780. [67] Svensson, Lars E.O. & Michael Woodford, (2005). Implementing Optimal Monetary Policy through Inflation-Forecast Targeting. In B.S. Bernanke and M. Woodford (eds.), The Inflation Targeting Debate, Chicago: University of Chicago Press. [68] Taylor, John B. (1985). What Would Nominal GNP Targeting Do to the Business Cycle? Carnegie-Rochester Conference Series on Public Policy 22, pp, 61-84. [69] Taylor, John B. (1993). Discretion versus Policy Rules in Practice. Carnegie-Rochester Conference Series on Public Policy 39, 195-214. [70] Walsh, Carl E. (1999), Monetary Theory and Policy, the MIT Press. [71] Walsh, Carl E. (2002). Teaching Inflation Targeting: An Analysis for Intermediate Macro. Journal of Economic Education 33(4), 333-347. [72] Woodford, Michael (1998). Doing without Money: Controlling Inflation in a PostMonetary World (Keynote address at the annual meeting of the Society for Economic Dynamics and Control in Mexico City, June 1996). Review of Economic Dynamics 1, 173-219. [73] Woodford, Michael (2008). How important is Money in the Conduct of Monetary Policy? Journal of Money, Credit and Banking, Vol. 40, No. 8, 1561-1598

In: Central Banking and Globalization Editors: M. Cappello and C. Rizzo, pp. 35-69

ISBN: 978-1-60876-056-5 © 2010 Nova Science Publishers, Inc.

Chapter 2

TRADE REMEDIES: A PRIMER* Vivian C. Jones International Trade and Finance Foreign Affairs, Defense, and Trade Division

Summary The United States and many of its trading partners use laws known as trade remedies to mitigate the adverse impact of various trade practices on domestic industries and workers. U.S. antidumping (AD) laws (19 U.S.C. § 1673 et seq.) authorize the imposition of duties if (1) the International Trade Administration (ITA) of the Department of Commerce determines that foreign merchandise is being, or likely to be sold in the United States at less than fair value, and (2) the U.S. International Trade Commission (ITC) determines that an industry in the United States is materially injured or threatened with material injury, or that the establishment of an industry is materially retarded, due to imports of that merchandise. A similar statute (19 U.S.C. § 1671 et seq.) authorizes the imposition of countervailing duties (CVD) if the ITA finds that the government of a country or any public entity has provided a subsidy on the manufacture, production, or export of the merchandise, and the ITC determines injury. U.S. safeguard laws (19 U.S.C. § 2251 et seq.) authorize the President to provide import relief from injurious surges of imports resulting from fairly competitive trade from all countries. Other safeguard laws authorize relief for import surges from communist countries (19 U.S.C. § 2436) and from China (19 U.S.C. § 2451). In each case, the ITC conducts an investigation, forwards recommendations to the President, and the President may act on the recommendation, modify it, or do nothing. In the 110th Congress, several bills seek to amend trade remedy laws. First, H.R. 708 (English, introduced January 29, 2007) and S. 364 (Rockefeller, introduced January 29, 2007) seek, in slightly different ways, to strengthen U.S. antidumping, countervailing, and safeguard statutes. Second, H.R. 1127 (Knollenberg, introduced February 16, 2007) seeks to give manufacturers that use of goods subject to AD or CVD proceedings standing as interested parties in those proceedings. Third, several bills, including H.R. 782 (Ryan/Hunter, introduced January 31, 2007), its companion bill S. 796 (Bunning, Stabenow, introduced March 7, 2007), S. 974 (Collins, introduced March 22, 2007), and H.R. 1229 (Davis/English, introduced February 28, 2007), seek to amend the trade remedy laws, in part, to address issues regarding the applicability of these laws to China or other nonmarket economy countries. Fourth, S. 122 (Baucus, introduced January 4, 2007) seeks to expand Trade Adjustment Assistance to apply *

Excerpted from CRS Report RL32371. Updated May 1, 2007.

36

Vivian C. Jones to workers adversely affected by trade that results in the imposition of AD, CVD, or safeguard measures. This report explains, first, U.S. antidumping and countervailing duty statutes and investigations. Second, it describes safeguard statutes and investigative procedures. Third, it briefly presents trade-remedy related legislation in the 109th Congress. The appendix provides a chart outlining U.S. trade remedy statutes, major actors, and the effects of these laws. This report will be updated as events warrant.

Introduction The United States and many of its trading partners use trade remedy laws to lessen the adverse impact of various trade practices on domestic industries, producers, and workers. These laws are deemed consistent with U.S. international obligations provided they conform to the trade remedy provisions agreed to as part of the Uruguay Round of multilateral trade negotiations (1986-1994) and other trade agreements to which the U.S. is a party.

Overview The three most frequently applied U.S. trade remedy laws are antidumping, countervailing duty, and safeguards. Enforcement of these laws is primarily carried out through the administrative investigations and actions of two U.S. government agencies: the International Trade Administration (ITA) of the Department of Commerce, and the International Trade Commission (ITC). Antidumping (AD) laws provide relief to domestic industries that have been, or are threatened with, the adverse impact of imports sold in the U.S. market at prices that are shown to be less than fair market value. The relief provided is an additional import duty placed on the dumped imports. Countervailing duty (CVD) laws are designed to give a similar kind of relief to domestic industries that have been, or are threatened with, the adverse impact of imported goods that have been subsidized by a foreign government or public entity, and can therefore be sold at lower prices than similar goods produced in the United States. The relief provided is an additional import duty placed on the subsidized imports. Safeguard (also referred to as escape clause) laws give domestic industries relief from import surges of goods that are fairly traded. The most frequently applied safeguard law, Section 201 of the Trade Act of 1974, is designed to give domestic industry the opportunity to adjust to the new competition and remain competitive. The relief provided is generally an additional temporary import duty, a temporary import quota, or a combination of both. Safeguard laws also require presidential action in order for relief to be put into effect. This report outlines the statutory authority, investigative procedures, and statistical outcomes for (1) U.S. AD and CVD actions and (2) U.S. safeguard actions. Other trade remedy laws not discussed in this report include Section 337 of the Tariff Act of 1930, as amended, which treats as unlawful imports sold through unfair competition or products infringing U.S. intellectual property rights. Sections 301-310 of the Trade Act of 1974, as amended, give the U.S. Trade Representative authority to enforce U.S. rights under international trade agreements and act against unfair foreign trade practices that burden U.S.

Trade Remedies: A Primer

37

trade. Trade Adjustment Assistance (TAA) programs provide readjustment assistance for firms and workers who have suffered due to increased imports as a result of trade agreements. A brief description of these trade remedy laws appears in an appendix to this report.

Congressional Interest Trade remedies have been the focus of much domestic and international debate in recent years. On the domestic front, the preservation of U.S. authority to “enforce rigorously its trade laws” was a major negotiating objective included in presidential Trade Promotion Authority (TPA) in the 107th Congress (P.L.107-210) and is likely to be part of any future grant of TPA. At the outset of the WTO Doha Round of multilateral trade negotiations, other WTO member nations were concerned about the intensive worldwide use of trade remedies since the enactment of the Uruguay Round Agreements in 1995. Developing nations, such as India and South Africa, had begun using trade remedy actions more frequently, whereas they were tools used almost exclusively by developed nations in the past. This international concern led several countries to press for negotiations on changes to the WTO Antidumping (formally known as the Agreement on Implementation of Article VI) and Subsidies (Agreement on Subsidies and Countervailing Measures), despite the efforts of U.S. trade negotiators and some in Congress to keep them off the table. In recent years, the number of AD and CVD cases worldwide has been declining, but modifications to these WTO agreements are still expected to be a key focus of debate should Doha Round talks resume. Some congressional observers were also concerned when WTO dispute settlement and Appellate Body panels made determinations against two U.S. trade remedy provisions, the Antidumping Act of 1916 and the Continued Dumping and Subsidy Offset Act (CDSOA) — finding that these measures violated U.S. obligations under the WTO.[1] The Antidumping Act of 1916 was repealed in the Miscellaneous Trade and Technical Corrections Act of 2004 (Section 2006 of P.L. 108-429, December 3, 2004). Despite considerable congressional resistance to repealing the CDSOA, a section proposing its repeal was included in the House version of the FY2006 budget reconciliation bill (H.R. 4241, introduced November 7, 2005). This measure was subsequently included in the version of the budget reconciliation bill that passed the House and Senate (with a provision that will allow disbursements under the act to continue for all goods entering until October 1, 2007), and was signed by the President on February 8, 2006 (P.L.109-171). An administrative practice used in AD and CVD investigations known as “zeroing” was also challenged in a WTO dispute, and on January 9, 2007, the Appellate Body also determined against the United States in a dispute on zeroing. Compliance in this dispute could be accomplished without legislative action, and the Commerce Department began implementing new administrative procedures in mid-April 2007.[2] These WTO determinations, which some consider to adversely affect U.S. interests, have caused some in Congress to call for greater congressional scrutiny of WTO dispute settlement and Appellate Body decisions involving the United States.

38

Vivian C. Jones

Action in 110th Congress In the 110th Congress, these and other emerging factors have led to renewed interest in trade remedies. U.S. manufacturing job losses that many believe are due to increased imports and offshore outsourcing have caused some in Congress to call for strengthening trade remedy laws and other statutes that provide relief for workers. In addition, the trade deficit, especially the rapidly growing deficit with China, have led to increased congressional interest in implementing a variety of trade remedy options — including amending trade laws to apply countervailing action to nonmarket economy countries such as China. Third, some believe that adverse rulings on U.S. trade remedy actions by World Trade Organization (WTO) dispute settlement panels, along with some adverse U.S. court decisions, have led to a weakening of U.S. trade remedy laws. Legislation. Several bills introduced in the 110th Congress seek to address these issues, including the following: •

•

•

•

S. 364, Strengthening America’s Trade Laws Act (Rockefeller, introduced January 23, 2007) seeks, first, to strengthen the U.S. response to WTO dispute settlement panels and decisions. Second, it expands the authority of the International Trade Commission and the Commerce Department to impose countervailing action on nonmarket economy countries. Third, if the ITC makes recommendations to implement a China-specific safeguard, it would require the President to implement the agency’s recommendations. With regard to WTO dispute settlement action, it would permit U.S. citizens in support of the U.S. position on WTO dispute settlement cases to participate in WTO dispute consultations, panel and appellate body proceedings. S. 364 would also establish a Congressional Advisory Commission on the operation of the WTO dispute settlement system and require congressional approval before any agency modifies its regulations or practices following an adverse WTO decision. S. 910 (Collins, introduced March 22, 2007) and H.R. 1229 (Davis/English, introduced February 28, 2007) seek to apply countervailing duty laws to nonmarket economy countries, such as China. These bills would also provide that nonmarket economy status could only be revoked if determined by the administering authority and approved by a joint resolution of Congress. An ITC study of China’s use of government intervention to promote investment, employment, and exports would also be mandated. S. 122 (Baucus, introduced January 4, 2007) and H.R. 910 (English, introduced February 8, 2007) seek to expand Trade Adjustment Assistance, in part, by extending program eligibility to workers adversely affected by unfair trade that results in imposition of antidumping, countervailing duty, or safeguard duties. H.R. 708 (English, Trade Law Reform Act of 2007). With regard to antidumping laws, the bill seeks to amend current trade remedy laws to revise factors that the International Trade Commission must consider in making material injury determinations in countervailing and antidumping duty proceedings. It would also repeal a one-year monitoring program for cases involving persistent dumping and require the initiation of an expedited antidumping duty in such cases. In nonmarket economy proceedings, H.R. 708 would amend certain factors used to value freight

Trade Remedies: A Primer

•

•

39

for inputs in nonmarket economy dumping calculations. It would also apply countervailing provisions to nonmarket economy countries and require a joint resolution of Congress in addition to the administering authority’s determination for NME status to be revoked. With regard to safeguard laws, the bill changes the standard from “substantial cause of serious injury” to “cause or threatens to cause serious injury” for determining if imports of a targeted product should be subject to safeguard action. It urges the U.S. Trade Representative (USTR) to reject any trade agreement proposal that would weaken U.S. trade remedy laws and requires that the President certify that each proposal would not make obtaining relief under U.S. trade laws more difficult, uncertain, or costly. It would permit U.S. citizens in support of the U.S. position on WTO dispute settlement cases to participate in WTO dispute consultations, and panel and appellate body proceedings and establish a Congressional Advisory Commission on the operation of the WTO dispute settlement system. H.R. 782 (Ryan/Hunter, Fair Currency Act of 2007, introduced January 31, 2007) and its companion bill S. 796 (Bunning/Stabenow), with regard to trade remedy legislation, seek to provide a methodology for application of countervailing action to nonmarket economy countries. These bills would also identify “exchange-rate misalignment” as a countervailable subsidy, and the undervaluation of China’s currency as actionable under the China-specific safeguard laws. H.R. 1127 (Knollenberg, American Manufacturing Competitiveness Act, introduced February 16, 2007) seeks to amend existing AD and CVD laws so that downstream manufacturers may be considered “interested parties” and may participate fully as such in trade remedy proceedings. The bill would also instruct the International Trade Commission, when considering injury, to “weigh harm to United States industrial users as a whole” by taking into account the economic impact of an AD/CVD duty order on downstream industries to ensure that it is not more injurious to industries than the dumping alleged to be occurring.

AD and CVD Laws and Investigations U.S. Statutes and Eligibility Criteria Statutory authority for AD investigations and remedial actions is found in Subtitle B of Title VII of the Tariff Act of 1930, as added by the Trade Agreements Act of 1979, and subsequently amended. The law permits the imposition of antidumping duties if (1) the Department of Commerce[3] determines that the foreign subject merchandise is being, or likely to be, sold in the United States at less than fair value, and (2) the U.S. International Trade Commission (ITC) determines that an industry in the United States is materially injured or threatened with material injury,[4] or that the establishment of an industry is materially retarded, by reason of imports of that merchandise.[5] Statutory authority for CVD investigations is found in Subtitle A of Title VII of the Tariff Act of 1930,[6] as added by the Trade Agreements Act of 1979 and as subsequently amended. The statute provides that countervailing duties will be imposed, first, when Commerce determines that the government of a country or any public entity within the territory of a

40

Vivian C. Jones

country is providing, directly or indirectly, a countervailable subsidy with respect to the manufacture, production, or export of the subject merchandise that is imported or sold (or likely to be sold) for importation into the United States. Second, in the case of a country that is party to the WTO Subsidies Agreement, that has assumed similar obligations with respect to the United States, or that has entered into certain other agreements with the United States, the ITC must determine that a domestic industry is materially injured or threatened with material injury, or that the establishment of a domestic industry is materially retarded, by reason of imports of that merchandise.[7] Petition and Eligibility. AD and CVD investigations are conducted on the basis of a petition filed simultaneously with the ITC and the ITA on behalf of a domestic industry, or by the ITA on its own initiative.[8] Industry representatives may include domestic manufacturers, producers, or wholesalers of a product like the investigated imports, unions, other groups of workers, trade associations or other associations of manufacturers, producers or wholesalers. Petitioners may allege (1) a subsidy (CVD petition), (2) sales at less than fair value (AD petition), or (3) that both conditions exist.[9] If a proceeding is initiated by petition, the ITA must determine within 20 days (1) whether the petition accurately alleges the existence of dumping or subsidies, (2) whether there is enough information in the petition to support the investigation, and (3) whether the petition has been filed by or on behalf of an industry.[10] If the ITA’s determination at this stage is negative, the petition is dismissed and the proceedings end.[11]

U.S. International Obligations Disciplines regulating the use of antidumping laws appear in Article VI of the General Agreements on Tariffs and Trade (GATT) and in the Antidumping Agreement adopted in the Uruguay Round (1986-1994) of trade negotiations. The Uruguay Round Antidumping Agreement outlines requirements regarding procedures to be used in antidumping investigations and the implementation and duration of AD measures. Article XVI of the GATT and the Subsidies Agreement negotiated during the Uruguay Round regulate the use of subsidies and countervailing measures. The Subsidies Agreement defines the term “subsidy” as a financial contribution by a government or public body within the territory of a WTO member, which confers a benefit. Three categories of subsidies are identified: (1) prohibited subsidies, (2) actionable subsidies, and (3) non-actionable subsidies. Also, to be covered by the Subsidies Agreement, subsidies need to be specific to an industry, except that prohibited subsidies (i.e., export subsidies and import substitution subsidies) are considered per se specific.[12] The Subsidies Agreement also provides transitional rules for developed countries and Members in transition to a market economy, as well as special and differential treatment rules for developing countries. Other trade agreements that the United States has adopted also include specific AD and CVD articles. For example, article 1902 of the North American Free Trade Agreement (NAFTA) states that each party to the agreement reserves the right to apply its antidumping and countervailing duty laws to any other party. The right of parties to change or modify these laws is also retained, provided the amending statute specifically states that the amendment applies to the other NAFTA parties; the other parties are notified; and the changes are either consistent with the GATT and WTO agreements, or the object and purpose

Trade Remedies: A Primer

41

of the NAFTA and its AD and CVD chapter. Articles 1903 and 1904 allow a review of statutory amendments and a review of final AD and CVD determinations by a binational panel. The Agreement also puts a consultation and dispute settlement system in place so that other parties to the agreement may challenge statutory changes. In addition, final determinations in AD and CVD cases may be subject to binational panel review instead of judicial review.

AD and CVD Investigations Although antidumping and countervailing duty laws address fundamentally different forms of unfair trade behavior, the remedies provided (a duty reflecting the “dumping margin” or amount of subsidy), the investigation processes, and the economic effects of the actions are similar. In some cases, AD and CVD investigations are also conducted simultaneously on a targeted product. Therefore, for purposes of this report, the investigation of AD and CVD petitions will be addressed together. Prior to the imposition of an AD or CVD order, the ITA and ITC conduct a detailed investigative process. Some political economists opposing this type of import relief have pointed out that the administrative nature of the AD and CVD investigative processes makes it easier to institute protectionist measures. They maintain that since the statutes delegate to the administrative agencies the authority to investigate and to impose the duties, the decisions (and possible negative political fallout) are removed from the President and Congress.[13] In addition, since a certain amount of prior knowledge is necessary in order to follow the procedure, the process is engineered so that it does not lend itself to close public or media scrutiny.[14] Some analysts have also criticized the administrative agencies (particularly the ITA) for conducting investigations that are biased in favor of domestic industries.[15] Supporters of trade remedies point out that current AD and CVD procedures have been worked out through painful and difficult multilateral trade negotiations, and that this is one of the reasons that the investigative procedure is so detailed. Furthermore, supporters maintain that the process is detailed because investigations must be transparent and provide a voice for all parties concerned.[16]

Preliminary Determinations As soon as a petition is filed, the ITC begins to investigate whether there is a reasonable indication of injury. If the ITC’s preliminary determination is negative, or the ITC determines those imports of the subject merchandise are negligible, the proceedings end. The ITC must make its preliminary determination within 45 days after a petition is filed or an investigation is begun by the ITA on its own initiative.[17] If the ITC’s preliminary determination is affirmative, the ITA begins its preliminary investigation to determine whether the alleged unfair practice exists. In CVD cases, the ITA has 65 days to make a preliminary determination, or 130 days at the petitioner’s request or if the case is extraordinarily complicated.[18] In AD cases, the ITA must make its determination within 140 days, or within 190 days at the petitioner’s request or if the case is extraordinarily complicated.[19] If the ITA determines in the affirmative, it also estimates a

42

Vivian C. Jones

subsidy margin or a weighted-average dumping margin for each exporter or producer individually investigated, and an “all-others rate” for all other exporters.[20] If the ITA finds that there is a reasonable indication of dumping or subsidies, it orders the U.S. Customs and Border Protection (Customs) to delay the final computation of all duties on imports of the targeted merchandise (suspension of liquidation) until the case is resolved and to require the posting of cash deposits, bonds, or other appropriate securities to cover the duties (plus the estimated dumping or subsidy margin) for each subsequent entry into the U.S. market. If the ITA’s determination is negative, both the ITA and the ITC continue the investigation.

Final Determinations In CVD investigations, the ITA makes its final determination within 75 days after the date of its preliminary determination. In AD cases, ITA’s final determination must be made within 75 days after the preliminary determination, or within 135 days at the request of exporters (if the preliminary determination was affirmative) or at the request of the petitioner (if the preliminary determination was negative).[21] Before issuing a final determination, the ITA must hold a hearing upon request of any party to the proceeding. If the ITA’s final determination is negative, the proceedings end, and any suspension of liquidation is terminated, bonds and other securities are released, and deposits are refunded. If the ITA’s final determination is affirmative, it orders the suspension of liquidation if it has not already done so. If the ITA’s preliminary determination is affirmative, the ITC must make its final determination (a) within 120 days of the ITA’s preliminary affirmative determination or (b) within 45 days of an affirmative final determination by the ITA, whichever is later. If the ITA’s preliminary determination was negative, the ITC’s determination must be made within 75 days of the ITA’s affirmative final determination. If the final determination of the ITC is affirmative, the ITA issues a countervailing or antidumping duty order within seven days of notification of the ITC’s decision. The duty imposed is equal to the net subsidy or dumping margin calculated by the ITA. If the final determination of the ITC is negative, no AD or CVD duties are imposed, any suspension of liquidation is terminated, bonds or other security are released, and deposits are refunded.

Critical Circumstances If a petitioner alleges that critical circumstances exist in an AD or CVD case, an extra step in the investigation is required. In CVD cases, the ITA must promptly determine whether there is a reasonable basis to expect that the alleged subsidy is inconsistent with the WTO Subsidies Agreement and that massive imports of the subject merchandise have occurred over a relatively short period. In AD cases, the ITA determines (1) if there is a reasonable basis to suspect either that there is a history of dumping and there is material injury by reason of dumped imports in the United States or elsewhere, or if the importer knew or should have known that the exporter was selling the merchandise at less than fair value and knew that there was likely to be material injury by reason of such sales; and (2) whether massive imports of the merchandise have occurred over a relatively short period. If the ITA makes an affirmative critical circumstances finding, it extends the suspension of liquidation of any

Trade Remedies: A Primer

43

unliquidated entries of merchandise into the United States retroactively to 90 days before the suspension of liquidation was first ordered. Whether or not the ITA’s initial critical circumstances determination is affirmative, if its final determination on subsidies or dumping is affirmative, the ITA includes with its overall final determination an additional determination on critical circumstances. If the final determination on critical circumstances is affirmative, retroactive duties, if not yet ordered, are ordered on unliquidated entries at this time.[22] The ITC also makes a critical circumstances injury finding along with its final determination. If both the ITC and the ITA make affirmative critical circumstances determinations, any AD or CVD duty order applies to the goods for which the retroactive suspension of liquidation was ordered. If the final critical circumstances determination of either agency is negative, any retroactive suspension of liquidation is terminated.[23]

Termination of Investigation and Suspension Agreements The ITA may terminate or suspend antidumping or countervailing duty proceedings at any point in favor of an alternative agreement with the foreign government (in the case of subsidies) or the exporters (in the case of dumping). The ITA or the ITC may terminate an investigation if the petitioner withdraws the petition, or the ITA may terminate an investigation it initiated.[24] If the ITA decides to terminate an investigation in favor of accepting an agreement with the foreign government (CVD) or exporter (AD) to limit the volume of imports, the ITA must be satisfied that the agreement is in the public interest. Public interest factors include (1) a finding that the imposition of duties would have a greater adverse impact on U.S. consumers than an alternative agreement; (2) an assessment of the relative economic impact on U.S. international economic interests; and (3) a consideration of the relative impact of such an agreement on the domestic industry producing like merchandise.[25] The ITA may suspend an investigation if (1) the government of the country alleged to be providing the subsidy, or the exporters accounting for substantially all of the subject merchandise agree to eliminate the subsidy or dumping margin, to offset the net subsidy completely, or to cease exports of the subject merchandise into the United States within six months of the suspension of the investigation; (2) if there are extraordinary circumstances[26] and the government or exporters agree to take action that will completely eliminate the injurious effect of the subject imports (including a quantitative restriction agreement with a foreign government); or (3) the agreement concerns alleged sales at less than fair value from a non-market economy country and that country agrees to restrict exports of its merchandise into the United States.[27] Before suspending an investigation, the ITA must be satisfied that the suspension is in the public interest and that the agreement can be effectively monitored by the United States.[28] WTO Negotiations. Article 18 of the WTO Subsidies Agreement authorizes the termination and suspension of investigations through the use of voluntary “undertakings.” These undertakings may involve (1) the government of the exporting Member agreeing to eliminate or limit the subsidy, or take some other action concerning its effects; or (2) the exporter agreeing to revise its prices to eliminate the injurious effects of the subsidy. A similar measure (Article 8) in the Antidumping Agreement allows the use of “price undertakings,” or voluntary, mutually agreed upon, price increases on the part of the importer

44

Vivian C. Jones

to eliminate the injurious effects of the imports. Price increases may not be higher than the duty necessary to eliminate the dumping margin, and if a lower increase would be adequate to remove the injury, a lesser increase is recommended. Many WTO members are critical of the rapidly expanding use of antidumping and subsidies measures in general and, in particular, the perceived U.S. use of inflated dumping and subsidies margins. As a result, these countries have recommended that Doha Round negotiations on the Antidumping and Subsidies Agreements strengthen the undertaking provisions and require increased use of these voluntary measures in AD and CVD actions.[29]

Administrative and Sunset Reviews Each year, during the anniversary month of the publication of an AD or CVD duty order, any interested party may request in writing an administrative review of the order. The ITA may also self-initiate a review. If none of the interested parties request a review, and if there is no objection, the review may be deferred for an additional year. During the review process, the ITA recalculates the amount of the net subsidy or dumping margin and may adjust the amount of AD or CVD duties on the subject merchandise. Suspension agreements are also monitored for compliance and reviewed in a similar fashion. The ITA must make a preliminary determination in CVD administrative reviews within 120 (or 180 days if the 120 day deadline is not practicable), and a final determination within 245 days (which may be extended up to 365 days). Preliminary determinations in AD reviews must be made in 90-150 days, and final determinations in 180-300 days.[30] Administrative reviews are also mandated under certain circumstances by the WTO Antidumping and Subsidies Agreements. Article 11.2 of the Antidumping Agreement and Article 21.2 of the Subsidies Agreement require authorities to periodically review the need for continued imposition of duties, where warranted. Authorities must also conduct examinations at the request of interested parties to examine whether the continued imposition of the duties are necessary to offset the dumping or subsidies, and whether the injury would be likely to continue or recur if the duty were removed, or varied, or both. Changed Circumstances Review. An interested party may also request a “changed circumstances” review at any time. In this case, the ITA must determine within 45 days whether or not to conduct the review. If the ITA decides that there is good cause to conduct the review, the results must be issued within 270 days of initiation, or within 45 days of initiation if all interested parties agree to the outcome of the review.[31] “New Shipper” Reviews. If the ITA receives a request from an exporter or producer of merchandise subject to AD or CVD orders who (1) did not export the subject merchandise during the initial period of investigation and (2) was not affiliated with any producer or exporter who did, it must conduct a review to establish an individual AD or CV duty rate for that exporter or producer.[32] A preliminary determination in a new shipper review may take up to 180 days (or up to 300 days if “extraordinarily complicated”). Final determinations of the duty rate may take from 90 to150 days, depending on complexity.[33] While the new shipper review is being conducted, the ITA is required to direct the Customs Service to allow (at the option of the importer) the posting of a bond or security in lieu of a cash deposit for each shipment of merchandise entering the United States until the review is completed and the AD or CV duty rate is established. Some U.S. producers have

Trade Remedies: A Primer

45

complained that Customs had difficulty collecting the actual amount of AD/CV duties owed on subject merchandise, and have cited the new shipper bonding privilege as a “loophole” that importers exploit in order to circumvent the duties. For example, Louisiana crawfish producers estimated, and Customs confirmed, that between 2002 and 2004, Customs collected only $25.5 million of about $195.5 million in AD duties owed on crawfish. An estimated 80 percent of the duties owed were assessed on targeted merchandise from the Peoples’ Republic of China.[34] Language seeking to suspend new shipper bonding privilege was inserted, along with other trade provisions, into H.R. 3, the Pension Protection Act of 2006 (Boehner). As enacted, the provision suspended the new shipper bonding privilege from April 1, 2006, to June 30, 2009 (sec. 1632 of P.L.109-280). Sunset Reviews. Before passage of the Uruguay Round Agreements Act (P.L. 103-465, URAA), AD and CVD orders had no set termination date, and generally were revoked only if the ITA determined through three consecutive annual administrative reviews that no dumping or subsidies had occurred. Currently, sunset reviews must be conducted on each AD or CVD order no later than once every five years.[35] The ITA determines whether dumping or subsidies would be likely to continue or resume if an order were to be revoked or a suspension agreement terminated, and the ITC conducts a similar review to determine whether injury to the domestic industry would be likely to continue or resume. If both determinations are affirmative, the duty or suspension agreement remains in place. If either determination is negative, the order is revoked, or the suspension agreement is terminated.[36] Sunset reviews are required in the WTO Antidumping (Article 11.3) and Subsidies (Article 21.3) Agreements.

Outcome of AD and CVD Investigations Table 1 lists the possible outcomes of AD/CVD investigations. From 2000-2006, there were 241 antidumping cases initiated.[37] Four investigations (1.7%) were withdrawn by the ITA prior to an ITC preliminary determination (the first stage in the process). Forty-eight investigations were determined in the negative by the ITC, and terminated at that point (about 20%). Six investigations were terminated by the ITA (2.5%), and the ITA made negative final determinations in 11 cases (4.6%, since ITA preliminary determinations result in a continuation of the investigation they are not listed here). The ITC made negative final determinations in 55 investigations (about 23%), and 8 investigations were pending at the end of 2006. One hundred and nine AD orders were issued during the period (45.2%). Therefore, the “success rate” of U.S. industries seeking relief through the AD process was 45.2%. During the same time period (see Table 1), administrative authorities conducted 41 CVD investigations. In the preliminary stage, the ITC made 4 (about 10%) negative determinations, and 37 affirmative determinations (meaning that the investigations continued further). Five cases (12.2%) were determined in the negative by the ITA. The ITC made 7 negative final determinations (17%). Two investigations (4.8%) were pending. CVD orders were issued in 22 cases (53.7%), but one (2.4%) was revoked at a later date.[38] The “success rate” for U.S. industries seeking relief through CVD action was 53.7%.

46

Vivian C. Jones

Table 1. Outcome of AD and CVD Investigations Initiated in Calendar Years 2000-2006 Antidumping Investigations Petition Withdrawn ITC Negative Preliminary Determination ITA Terminated ITA Negative Final Determination ITC Negative Final Determination Pending Investigations (2006 investigations not yet resolved) AD Order Issued Countervailing Duty Investigations

Total = 241 4 48 6 11 55 8 109

1.7% 19.9% 2.5% 4.6% 22.8% 3.3% 45.2% Total = 41

Petition Withdrawn 0 0% ITC Negative Preliminary Determination 4 9.8% ITA Terminated 0 0% ITA Negative Final Determination 5 12.2% ITC Negative Final Determination 7 17.1% Pending Investigations (2006 investigations not yet resolved) 2 4.9% CVD Orders Issued 22 53.7% Order Revoked at later date 1 2.4% Source: ITA Statistics, CY2000-2006; Import Administration home page [http://ia.ita.doc.gov].

Source: ITC

Figure 1. AD and CVD Orders in Place by Product Group.

AD and CVD Duty Orders by Product Group. Figure 1 illustrates the make up of AD and CVD orders in effect as of October 23, 2006, by product group. The largest group of these orders are applied to imports of products associated with the steel industry, including mill products (carbon steel wire rod, hot-rolled carbon steel flat products, etc.), iron and steel pipe

Trade Remedies: A Primer

47

products (such as welded large diameter line pipe, and oil country tubular goods), and other products of iron and steel (stainless and carbon steel butt-weld pipe fittings, ball bearings, barbed wire and barbless wire strand, etc.). The next largest group of duty orders applies to chemicals and pharmaceuticals — the vast majority of which are chemicals used in manufacturing processes. The third largest group consists of agricultural and forest products including softwood lumber, honey, pasta, sugar, preserved mushrooms, shrimp, crawfish tail meat, and pistachios. Compared to the number of AD and CVD orders in these categories, there are relatively few orders in effect on finished goods reflected in the miscellaneous manufactures, transportation, textiles, and electronics categories (includes metal chairs and tables, stainless steel cookware, petroleum wax candles, and paper clips). Orders by Country. Figure 2 shows AD and CVD duty orders in effect as of October 23, 2006, by product country of origin. Products from China lead this group with 61 AD orders, followed by the European Union with forty-six AD orders and 11 CVD orders, Japan (twenty-three AD orders), and South Korea (sixteen AD orders, six CVD orders). The actual numbers of orders by country and product group changes frequently due to administrative and sunset review processes.

Source: ITC

Figure 2. AD and CVD Orders In Place by Country.

Number of Initiations. Figure 3 illustrates AD and CVD initiations from 1980-2006. Initiations peaked in 1982 (60 CVD, 35 AD), 1986 (83 AD, 28 CVD), again in 1992 (84 AD,

48

Vivian C. Jones

22 CVD), and again in 2001 (77 AD, 18 CVD). Some observers have pointed out a decline in trade remedy initiations in recent years, and have mentioned several reasons for the trend. One reason for the downward trend may be that some U.S. domestic manufacturers now import some portion of their product lines from overseas, reducing their interest in bringing trade remedy cases. For example, a 2004 AD investigation on wooden bedroom furniture from China created a deep and vocal controversy in the U.S. furniture industry because some larger U.S. companies had decided to import certain furniture lines from China while continuing domestic production of more high-end items. Many furniture retailers reportedly became furious with furniture industry petitioners because they feared that the higher prices caused by possible AD duties would depress sales and result in the layoffs of retail employees. Furniture makers and unions supporting the investigation countered that far more manufacturing jobs were being lost than would have been lost on the retail side.[39] The debate was so heated that the ITA took the unusual step of polling the industry to determine whether there was sufficient industry support for the petition, which resulted in a finding that only slightly more than half of the industry approved.[40] AD duties ranging from 2.3 to 198.08 percent were ultimately imposed on the targeted merchandise.[41] In addition, some observers have also mentioned that more foreign manufacturers are operating plants in the United States. For example, the largest steel manufacturer in the United States, for example, is now Mittal Steel USA, the subsidiary of a global firm based in Luxembourg. Since these multinational firms often import goods from foreign subsidiaries to fill out U.S. product lines, they also may be less inclined to favor trade remedy actions.

Figure 3. AD/CVD Initiations and GDP Growth, 1980-2006.

Trade Remedies: A Primer

49

Another reason that trade remedy initiations have declined in recent years may be the growth rate of the U.S. economy. As Figure 3 illustrates (see GDP Growth, right scale), AD and CVD petitions have historically tended to increase during periods of economic recession and decrease during growth periods.

Recent U.S. AD/CVD Disputes in WTO Antidumping Act of 1916 The earliest U.S. antidumping measure, the Antidumping Act of 1916,[42] made it unlawful to systematically import articles into the United States at prices substantially lower than the actual market value or wholesale price of the imports with the intent of destroying or injuring a domestic industry in the United States. The statute assigned criminal penalties and provided for a civil award of triple damages to the injured party. A WTO dispute resolution panel and the Appellate Body found that the law provided penalties not authorized by the Antidumping Agreement or the GATT, and therefore violated U.S. WTO obligations. Congress repealed the law in Section 2006 of the Miscellaneous Tariff and Technical Corrections Act of 2004 (P.L. 108-429).

Continued Dumping and Subsidy Offset Act Section 1003 of P.L. 106-387, the “Continued Dumping and Subsidy Offset Act (CDSOA) of 2000,” amended the Tariff Act of 1930 by requiring that all duties collected as a result of AD and CVD orders be redistributed to the petitioners (“affected domestic producers”) that have been injured by the subject imports. The funds must be used for certain “qualifying expenditures,” including employee training, research and development, manufacturing facilities, or equipment. Disbursements under the act amounted to $231 million in FY2001, $330 million in FY2002, $190 million in FY2003 (an additional $50 million is held in reserve pending the resolution of a court case), $284 million in FY2004, $226.1 million in FY2005, and $380.1 million in FY2006.[43] The CDSOA was controversial for several reasons. Opponents believed that the measure encourages the filing of AD and CVD petitions, limited the benefits of collections under the act to petitioners (placing other domestic producers at a competitive disadvantage), and exacerbated market inefficiencies caused by AD and CVD actions. Some also found it controversial because it was inserted into the legislation during conference and received no committee or floor consideration in either House. Supporters, including many in Congress and many domestic industry representatives, believed that money distributed through the CDSOA is a relatively small amount to invest in assisting U.S. companies to remain competitive. WTO dispute settlement panels determined that the law violated U.S. obligations under the WTO Antidumping and Subsidies Agreements. The level of retaliation was determined through arbitration, and most of the co-complainants in the case, including the European Union, India, Japan, and Korea, received formal WTO authorization to “suspend concessions” on targeted U.S. goods in late November 2004. Canada began assessing additional tariffs on U.S. exports of live swine, cigarettes, oysters, and specialty fish in May

50

Vivian C. Jones

2005.[44] The European Union established an additional 15% tariff on imports of certain women’s apparel, office supplies, crane trucks, sweet corn, and spectacle frames, also beginning on May 1, 2005.[45] Mexico began retaliating in a similar manner on August 17, 2005, and Japan on September 1, 2005.[46]According to WTO agreements, any retaliation is temporary, and may only occur if “recommendations and rulings are not implemented in a reasonable period of time.[47] The CDSOA was repealed as of February 8, 2006 in section 7601 of P.L. 109-171, the Deficit Reduction Act of 2005. The repeal language specified, however, that “all duties on entries of goods made and filed before October 1, 2007 ... shall be distributed as if [the CDSOA] had not been repealed.”[48] The European Union, Canada, Mexico, and Japan indicated that they would continue to retaliate until the disbursements cease.[49]

Zeroing “Zeroing” is an administrative practice used in the calculation of dumping margins. In U.S. law, AD orders imposed on targeted merchandise must be equal to the dumping margin or “the amount by which the normal value exceeds the export price or constructed export price of the subject merchandise.”[50] The ITA typically calculates the margin by first identifying, to the extent possible, all U.S. transactions, sale prices, and levels of trade for each model or type of targeted merchandise sold by each company in the exporting country. These model types are then aggregated into a subcategories, known as “averaging groups,” which are used to calculate the “weighted average export price.” The export prices for each subgroup are then compared to the corresponding agency-calculated “weighted average normal value.” Finally, the results of all of these comparisons are added up to establish the overall dumping margin of the targeted product.[51] When authorities add up the dumping margins of each of the subgroups to establish an overall dumping margin for the subject merchandise, they sometimes encounter negative margins in a subgroup (an indicator that the items in that subcategory not being dumped). However, rather than including the negative margin in their calculations, which could result in a lower overall dumping margin, ITA officials factor in the results of that subgroup as a zero.[52] Officials use a similar practice when re-calculating dumping margins in administrative reviews of AD orders or suspension agreements. One justification for the zeroing practice is that the dumping margin could be skewed if, when determining the weighted average dumping margin, the subgroup that has the negative dumping margin represents a substantial percentage of export sales. The U.S. practice has been challenged in the WTO on a number of fronts. In two disputes, WTO dispute settlement and Appellate Body panels have found that the U.S. practice of zeroing is in violation of its obligations under the WTO Antidumping Agreement.[53] On February 6, 2004, the European Union formally requested the establishment of a dispute settlement panel on zeroing, citing 31 U.S. AD cases targeting products of the EU. The EU claimed that the dumping margin would have been minimal, or even negative, if U.S. officials had not used zeroing. A panel was established on March 19, 2004. In a split decision in late October 2005, the dispute settlement panel report found for the United States in its use of zeroing in the course of administrative reviews, but against U.S. practice when conducting initial investigations.[54] On April 18, 2006, the Appellate Body found that the practice of zeroing could be challenged as it relates to original investigations

Trade Remedies: A Primer

51

and upheld the panel’s finding that the practice is inconsistent with Article 2.4.2 of the Antidumping Agreement.[55] In October 2006, the EU filed an additional complaint against the United States regarding zeroing.[56] The use of zeroing was also challenged by Japan in November 2004. On September 20, 2006, a dispute settlement panel also concluded in this case that the U.S. zeroing methodology, when used in certain instances, was inconsistent with the Antidumping Agreement.[57] In January 2007, the Appellate Body made a similar determination.[58] Since these rulings challenged a U.S. administrative practice, rather than U.S. statutes, they do not necessarily require legislative action to implement. In the first dispute, in May 2006 the United States indicated to the Dispute Settlement Body (DSB) that it intended to implement the recommendations and rulings of the panels, and on February 22, 2007, the ITA initiated proceedings under section 129 of the Uruguay Round Agreements Act (URAA). The ITA recalculated the weighted-average dumping margins in twelve of the fifteen EU cases found to violate WTO rules (three of the AD orders had been previously revoked). The final recalculated dumping margins for eleven of the cases were announced on May 1, 2007,[59] but the implementation of the finding in the twelfth case was delayed due to a clerical error in the underlying investigation.[60] The ITA also announced that it would “no longer make average-to-average comparisons in antidumping duty investigations without providing offsets for non-dumped comparisons.” [61] In the dispute brought by Japan, the United States has informed the DSB that it also intends to implement the ruling but needs a reasonable period to do so.[62]

AD/CVD Issues in the 110th Congress Application of Countervailing Duties to Nonmarket Economy Countries Total U.S.-China trade rose to $343 billion in 2006. China, a nonmarket economy (NME) country, is the United States’ second largest trading partner, the second largest source of U.S. imports, and its fourth largest export market. The $232.6 billion (2006) U.S. trade deficit with China and the adverse impact of Chinese imports on competing U.S. industries and workers, among other things, has led some in Congress to support increased enforcement of U.S. trade remedy laws against Chinese products.[63] China is currently the chief target of U.S. antidumping action (with 61 AD duty orders outstanding and six investigations pending as of March 30, 2007). However, CVD laws have not applied to nonmarket economy (NME) countries since a 1984 determination by ITA (also statutorily responsible for making NME determinations) that there is no adequate way to measure market distortions caused by subsidies in economies that are not based on market principles.[64] Some Members of Congress are especially concerned that the Peoples’ Republic of China, currently classified by ITA as a nonmarket economy country,[65] is providing subsidies to many Chinese industries engaged in international exports. A related source of concern is that China is pegging its currency, the yuan, to the U.S. dollar at artificially low levels, which some also believe is an unfair government subsidy.[66] Legislation. Legislation introduced in the 110th Congress to prevent further exemption of NME countries from countervailing action includes S. 364 (Rockefeller, introduced January

52

Vivian C. Jones

23, 2007), S. 974 (Collins, introduced March 22, 2007), H.R. 708 (English, introduced January 29, 2007), H.R. 782 (Ryan/Hunter, introduced January 31, 2007) and its companion bill S. 796 (Bunning/Stabenow, introduced March 7, 2007), and H.R. 1229 (Davis/English, introduced February 28, 2007). H.R. 571 (Tancredo, introduced January 18, 2007), would place an additional tariff on imports from all NME countries. A more detailed discussion of the operative provisions of these bills is found in CRS Report RL33550, Trade Remedy Legislation: Applying Countervailing Action to Nonmarket Economy Countries. Bush Administration Actions. The Bush Administration has also taken some recent steps to address the issue. First, on November 27, 2006, the ITA initiated a CVD investigation against an NME country (China) for the first time since 1991. In the first phase of the investigation, the International Trade Commission (ITC) preliminarily determined on December 15, 2006 “that there was a reasonable indication that a U.S. domestic industry is materially injured or threatened with material injury” by reason of allegedly subsidized coated paper from China — thus referring the case back to the ITA for a preliminary determination on subsidization. On March 30, 2007, the ITA announced an affirmative preliminary determination of subsidy in the CVD investigation. Preliminary estimates of net countervailable subsidy rates were set, ranging from 10.9 to 20.35 percent.[67] Second, on February 2, 2007, U.S. negotiators requested World Trade Organization (WTO) talks with China on subsidies, and consultations with China are ongoing as of this writing.

WTO Panel Participation and Oversight Some in Congress believe that adverse findings (particularly on trade remedy issues) by WTO dispute settlement panels have “added to the obligations and diminished the rights of WTO members,” by establishing certain obligations not expressly agreed to through multilateral negotiations. As a result, some Members have introduced legislation that seek to respond to these concerns. S. 364 (Rockefeller) first would allow private citizens supportive of the U.S. position in a WTO dispute to participate in consultations, dispute settlement panel, or Appellate Body proceedings. Second, the bill would establish a Congressional Advisory Commission on WTO Dispute Settlement to provide advice to Congress on the operation of the WTO dispute settlement system. Third, the bill seeks to amend the Uruguay Round Agreements Act to require congressional approval before any modification of an agency regulation or practice due to an adverse WTO decision. Fourth, S. 364 would direct the United States to negotiate with the WTO to clarify its obligations under the Uruguay Round Agreement if the United States, Congress, or Commission finds that a WTO decision created obligations never agreed to by the United States. H.R. 708 (English) in similar, but not identical, language, seeks to establish a Commission on WTO Dispute Settlement. It also would permit private U.S. persons to participate in WTO dispute settlement proceedings. In addition, H.R. 708 seeks to amend the Trade Act of 2002 to (1) urge the U.S. Trade Representative (USTR) to reject any trade agreement proposal, whether through the World Trade Organization (WTO) or with any country, that would weaken existing U.S. trade remedy laws; and (2) require the President to report on any proposals in multilateral negotiations that would require amendments to the AD, CVD, or safeguards statutes.

Trade Remedies: A Primer

53

“Interested Party” Status for Downstream Producers. Many goods subject to trade remedy actions are manufacturing inputs (such as steel and cement) used by downstream U.S. industries (such domestic automobile and construction manufacturers). Since affirmative AD and CVD actions lead to higher prices for targeted merchandise, many industrial consumers are concerned that their products, in turn, are less competitive due to the price increases on inputs. H.R. 1127, the American Manufacturing Competitiveness Act (Knollenberg, introduced February 16, 2007), seeks to amend existing AD and CVD laws so that downstream manufacturers may be considered “interested parties” and may participate fully as such in trade remedy proceedings. The bill further seeks to instruct the International Trade Commission, when considering injury, to take into account the economic impact on downstream industries and the U.S. economy as a whole.

Safeguard (Escape Clause) Measures “Safeguard” or “escape clause” trade laws are designed to provide domestic industries with relief from injurious import surges resulting from fairly competitive trade. In order to obtain relief, the ITC must determine that a domestic industry is substantially injured by import surges. Presidential action is necessary to obtain relief under these statutes. Although individual U.S. safeguard actions (in particular, the 2002 action on steel) have been the subject of intense debate, on the whole, many economists find safeguard measures less objectionable than AD or CVD actions. Some reasons for this include their temporary nature, the requirement that industries take steps to positively adjust to import competition, the higher injury threshold, and the requirement of Presidential action.[68]

Statutory Authority Sections 201-204 of the Trade Act of 1974, as amended,[69] provide relief for imports from all countries. Investigations under this statute are often known as “section 201 investigations.” Section 406 of the same Act, as amended,[70] provides a similar relief for market-disruptive imports from communist countries. Section 421, added to the Trade Act of 1974 in October 2000,[71] is a country-specific trade remedy that applies only to injurious imports from China. Another provision, Section 302 of the NAFTA Implementation Act,[72] provides similar relief due to injurious imports originating in Canada or Mexico.

Section 201 Eligibility Criteria A Section 201 investigation may be initiated by the filing of a petition by any group considered to be representative of an industry, including a trade association, firm (especially if the firm is the sole domestic producer), a certified or recognized union, or group of workers.[73] An investigation may also be initiated at the request of the President, the United States Trade Representative (USTR), the House Ways and Means or Senate Finance Committees, or by the ITC itself.[74] The ultimate goal of a section 201 action is to facilitate a domestic industry’s positive adjustment to import competition. The petition for relief must also include a statement

54

Vivian C. Jones

describing specific purposes for which the action is being sought (e.g., to allow time for the domestic industry to transfer its resources into other productive pursuits) and may include a plan submitted by the petitioner to facilitate the industry’s positive adjustment to import competition (if a plan is not filed with the petition, it must be filed within 120 days). Section 201 relief may apply to imports of the targeted merchandise from all countries or from any country specifically identified as a cause of the import surges.

U.S. International Obligations Article XIX of the GATT, Emergency Action on Imports of Particular Products, authorizes contracting parties to “suspend the obligation in whole or in part or to modify the concession” in the event of “unforseen developments” caused by obligations or tariff concessions under the Agreement.[75] The WTO Safeguards Agreement provides rules for the application of Article XIX. Under the Agreement, safeguard measures are considered “emergency”actions with respect to imports of particular products. WTO provisions require that safeguard measures: (1) be time-limited; (2) be imposed only when imports are found to cause or threaten serious injury to a competing domestic industry; and (3) be applied on a non-selective (i.e., most-favored-nation) basis, and (4) be progressively liberalized while in effect. In addition, the Member imposing a safeguard is expected to maintain a substantially equivalent level of concessions between it and exporting Members affected by the safeguard. To achieve this, Members may agree on compensation; if negotiations fail, the exporting Member may, in certain circumstances, suspend concessions vis a vis the Member imposing the safeguard.

NAFTA Provisions Article 8 of the NAFTA allows any party subject to the agreement to use bilateral (within the NAFTA) “emergency actions” if an import surge or a duty reduction is a substantial cause of serious injury to a domestic industry. Consultations between affected parties are required. The remedy allowed is a suspension in the further reduction of a duty, or an increase in the rate of duty at a level not to exceed (1) the most-favored-nation (MFN) applied rate of duty in effect at the time the action is taken, or (2) the MFN applied rate of duty in effect on the day immediately preceding the date of entry into force of the NAFTA. In the case of seasonal products, the duty rate applied cannot exceed the MFN applied rate of duty that was in effect on the good for the corresponding season immediately preceding the date of entry into force of the NAFTA. For most products, the term of a safeguard action may not last more than three years. Each party to the NAFTA also retains the right to engage in global safeguard actions under Article XIX of the GATT, but must exclude other parties to the NAFTA unless (1) imports from a party, considered individually, account for a substantial share of the imports and (2) imports from a party, considered individually, or in extreme circumstances, collectively, contribute importantly to the injury, or threat thereof, caused by imports. Proposed emergency actions are not subject to dispute settlement proceedings under the NAFTA.

Trade Remedies: A Primer

55

Safeguard provisions are also included in the U.S.-Jordan Free Trade Agreement (FTA), the U.S.-Singapore FTA and the U.S.-Chile FTA.

Section 201 Safeguard Investigations ITC Role The ITC determines whether the targeted merchandise is being imported in such increased quantities that it is a “substantial cause of serious injury, or threat of serious injury”[76] to the domestic industry producing articles “like or directly competitive with” the imported article.[77] The ITC must normally make its injury determination within 120 days, but it may take up to 30 additional days to make a determination if the investigation is extraordinarily complicated. If the ITC finds in the affirmative, it also provides the President with one or more remedy recommendations. The ITC’s report must be submitted to the President within 180 days of the petition, or within 240 days if critical circumstances are alleged.[78] Provisional Relief. If critical circumstances are alleged to exist and the petitioner requests that provisional relief be provided, the ITC must make a determination on critical circumstances within 60 days of receiving the petition. If the critical circumstances determination is affirmative, the ITC must also recommend the amount of relief necessary (preference is given to increasing or imposing a duty on imports) to prevent or remedy the injury. The ITC must immediately report its findings to the President.[79] Within 30 days of receipt of an affirmative determination from the ITC, if the President finds that provisional relief is warranted, he may proclaim whatever provisional relief he believes necessary for a period not to exceed 200 days.[80] Perishable Products. Provisional relief may also be requested if the targeted merchandise is a perishable agricultural or citrus product. In these cases, the industry representative files a request with the USTR (in advance of a section 201 petition) for monitoring of imports of the product. The USTR determines (within 21 days) (1) if the imported product is a perishable agricultural or citrus product and (2) if there is a reasonable indication that the product is being imported in such increased quantities as to be, or likely to be, a substantial cause of serious injury, or threat of serious injury, to the domestic industry. If these determinations are affirmative, the USTR requests the ITC to monitor and investigate the imports for a limited time period, not to exceed two years.[81] In order to receive provisional relief, the perishable product must be the subject of ITC monitoring for at least 90 days prior to initiation of the investigation, and the petitioner must request provisional relief. The ITC has 21 days to make an injury determination, and immediately reports its findings and remedy recommendations to the President. If the ITC makes an affirmative determination the President has seven days to proclaim whatever provisional relief he considers necessary to prevent or remedy the serious injury. If the ITC’s determination is negative, no relief is given and the proceeding is terminated.[82]

56

Vivian C. Jones

Presidential Action Within 60 days of receipt of an affirmative ITC determination and report, the President is instructed to “take all appropriate and feasible action within his power which the President determines will facilitate efforts by the domestic industry to make a positive adjustment to import competition and provide greater economic and social benefits than costs.” On this basis, the President may (1) implement the ITC’s recommendations, (2) modify the ITC provisions or provide another form of remedy, or (3) take no action due to U.S. economic or national security interests.[83] Import relief may be granted for an initial period of up to four years and extended one or more times.[84] The total period of relief, however, may not exceed eight years. If the President decides not to provide relief, or to provide relief other than that recommended by the ITC, his decision may be overridden by a congressional joint resolution (adopted within 90 days), in which case the ITC’s recommendations would be implemented.[85]

Midterm Review The ITC is required to monitor section 201 actions as long as they stay in effect, especially with respect to the efforts and progress of the domestic industry and workers to adjust positively to import competition.[86] If the initial period of the action exceeds three years, the ITC is also required to submit a midterm review to the President and Congress. The ITC holds a hearing in which any interested parties may participate, and upon request, advises the President of the probable economic impact of any reduction, modification or termination of the action.[87] After the President receives the ITC review and seeks the advice of the Secretary of Commerce and the Secretary of Labor, he may modify, reduce, or terminate the action if he determines that changed circumstances warrant such actions either because: (1) the domestic industry has not made adequate efforts to adjust positively to import competition, or (2) the effectiveness of the action has been impaired by changed economic circumstances. He may also terminate, modify, or reduce the action if the majority of industry representatives petition the President to do so on the basis of positive adjustment to import competition.[88] The President may also extend an action. Between six and nine months before the safeguard action is scheduled to terminate, at the request of the President or if an industry petition is filed, the ITC must investigate to determine whether an extension of the action is necessary and if the domestic industry is making positive adjustment to import competition. Within 60 days of the termination date, the ITC must transmit the results of the investigation and its determination, unless the President specifies a different date.[89]

Section 201 Outcomes In the seventy-three section 201 safeguard investigations conducted from 1975 to date, the ITC has recommended some form of relief 47% of the time. The President has provided import relief in 26 instances (35.6%). Figure 3 illustrates the outcome of section 201 cases from FY1975 to the present. In the cases in which the President granted relief, the most common form has been tariff increases, followed by adjustment assistance, tariff rate quotas, or some combination thereof.

Trade Remedies: A Primer

57

Source: ITC

Figure 4. Outcome of Section 201 Safeguard Cases, 1975-Present.

Figure 4 shows section 201 safeguard petitions and their outcome by product group. The largest number of petitions has been filed in the category of miscellaneous manufactures, such as footwear, stainless steel flatware, fishing tackle, fishing rods, and clothespins. Agricultural products are the second largest category, including asparagus, mushrooms, shrimp, honey, roses, and cut flowers. It appears, generally, that a greater percentage of domestic producers of end-use consumer goods have filed and obtained relief through safeguard petitions as opposed to AD or CVD orders.

Figure 5. Safeguard (Section 201) Petitions and Outcome by Product Group.

58

Vivian C. Jones

2002 Steel Safeguard Action On June 5, 2001, President Bush responded to steel companies, union representatives, and many in Congress by requesting that the ITC begin a broad section 201 investigation on steel import surges. The request, covering more than 500 steel mill products, was forwarded to the ITC by then-USTR Robert Zoellick on June 22. The ITC staff grouped this large number of products into 33 product categories under four broad groupings. For each of these 33 categories, the ITC investigated whether or not imports of the subject merchandise were a substantial cause of serious injury to the domestic steel industry. On September 17, 2001, the ITC began a series of hearings on the issue of injury to the domestic steel industry, and on October 22, 2001, made an affirmative determination in 16 of the 33 product categories. Products in the remaining 17 categories were dismissed from further consideration. The ITC continued the remedy phase of the investigation for the 16 categories, and held hearings in November 2001. On December 19, 2001, the ITC submitted its findings and remedy recommendations to the President.[90] On March 5, 2002, President Bush announced trade safeguard remedies for all products that the ITC had found substantial injury, except for two steel specialty categories.[91] The President’s implementation of safeguard measures on steel was controversial both domestically and internationally. A number of U.S. trading partners challenged the decision through the WTO, and on July 11, 2003, the dispute settlement panel found that the safeguard measures were inconsistent with U.S. WTO obligations. An Appellate Body determination confirmed the main points of the panel decision on November 10, 2003. After the WTO panel rulings, the European Union announced that it would retaliate by establishing substantial tariff penalties against $2 billion in imports from the United States beginning in December 2003. The President terminated section 201 safeguard measures on steel in December 8, 2003.[92] The USTR stated that the termination was the result of a midterm review of the progress of the steel industry to cope with the increased competition and changed economic circumstances. The United States faced retaliation from the European Union equivalent to $2.2 billion in increased tariffs on U.S. exports due to WTO dispute settlement and Appellate Body findings. In the proclamation, the President continued the licensing and monitoring of imports of certain steel products and delegated the function to the Secretary of Commerce.

Section 406 Relief Section 406 of the Trade Act of 1974,[93] as amended, was established to provide a remedy against market disruption caused by imports from Communist countries. This statute applies to any Communist country, whether or not it has received nondiscriminatory (normal trade relations) treatment. This provision was enacted out of concern that trade remedy laws already in place were insufficient to deal with a rapid influx of imports that can result from a Communist government’s control of its industry pricing levels and distribution processes. Section 406 investigations follow a similar format to section 201 proceedings, however, (1) the standard of injury (market disruption as opposed to “substantial cause of serious injury” or threat thereof) is lower; and (2) domestic industries are not required to plan for or demonstrate positive adjustment to import competition.

Trade Remedies: A Primer

59

Import relief may apply only to imports from the subject Communist country or countries. If the President decides to grant relief, he may do so for up to five years, with a possible additional three-year extension.

“Surge Protection” from Chinese Imports A country-specific safeguard on imports from China is found in section 421 of the Trade Act of 1974.[94] This provision, enacted in section 103 of Public Law 106-286, superseded section 406 with respect to goods from China after the President extended permanent nondiscriminatory (normal trade relations) treatment to China following its accession to the WTO.[95] The legislation implemented an anti-surge mechanism established under the U.S.-China Bilateral Trade Agreement, concluded on November 15, 1999. This transitional safeguard measure is scheduled to terminate 12 years after China’s WTO accession. According to the Protocol on the Accession of China to the WTO, import relief may be granted “only for such period of time as may be necessary to prevent or remedy the market disruption.” If import relief is granted due to a relative increase in imports, China may retaliate by suspending equivalent trade concessions or obligations if the measure remains in effect for more than two years. If relief is granted due to an absolute increase in imports, China may retaliate after three years.[96] Although the procedure under section 421 action is similar to that under section 201, the section 421 safeguard is different in four major respects: (1) the statute provides relief for subject merchandise from China only, whereas the remedy in section 201 applies to subject imports from all countries; (2) consultations with Chinese trade authorities are required; (3) in addition to the ITC, the USTR takes part in the procedure and also submits recommendations to the President; and (4) the standard for relief is “market disruption” — a lower standard than in section 201 proceedings. To date, there have been six completed section 421 investigations, as follows: Pedestal Actuators (ITC case number TA-421-1), Wire Hangers (TA-421-2), Brake Drums and Rotors (TA-421-3), and Ductile Iron Waterworks Fittings (TA-421-4), Uncovered Innerspring Mattress Units (TA-421-5), Circular Welded Non-Alloy Steel Pipe from China (TA-421-06). The ITC made affirmative determinations in four of these cases and negative determinations in two cases (brake drums and rotors and innerspring mattress units). The President decided not to grant relief each of the four affirmative investigations because he determined that providing such relief was not in the national economic interest of the United States.

Safeguard Legislation in the 110th Congress H.R. 708 (English, introduced January 29, 2007), seeks to make several changes to sections 201-204 of the Trade Act of 1974 (19 U.S.C. 2251-2254). These amendments include, first, a change in the injury standard in the law from “substantial cause of serious injury” to “cause or threaten to cause” serious injury. Thus, the imports need not be equal to or greater, or more important, than any other cause of injury. Second, the bill also seeks to

60

Vivian C. Jones

add to the criteria for determining serious injury by including changes in the level of sales, production, capacity utilization, profits and losses, and employment as factors that the ITC should take into account when making injury determinations. The bill also seeks to establish that when making these evaluations, the timing and volume of the imports should be assessed in order to determine whether there has been a substantial increase in imports over a short period of time. Third, H.R. 708 seeks to amend the criteria for presidential action in safeguard cases. Instead of determining whether or not implementing a remedy will provide “greater economic and social benefits that costs,”[97] the bill seeks to require the President to ensure that providing a remedy would “not have an adverse impact on the United States clearly greater than the benefits of such action.” Fourth, H.R. 708 would also instruct the President to place more weight on (1) the economic and social costs to U.S. taxpayers, communities, and workers, and (2) the impact of safeguard implementation on consumers and on domestic competition for inputs than on the impact on U.S. industries due to international obligations regarding compensation. According to the bill’s supporters, these amendments were proposed to increase the likelihood that the President would implement safeguard measures.[98] H.R 782 (Ryan, introduced January 31, 2007) seeks to clarify that China’s exchangerate misalignment is actionable under the countervailing duty provisions, as well as product-specific safeguard measures in U.S. trade laws. This bill would apply this provision only to the China-specific safeguard, section 421 of the Trade Act of 1974 (19 U.S.C. 2451).

Conclusion Many in Congress support trade remedy laws and actions because they can assist in mitigating the adverse effects of international trade on domestic industry, producers, and workers. Certain key industries are currently facing the adverse effects of increased import competition, which can lead to factory closures and loss of domestic manufacturing jobs. Some workers in the service sector are also feeling the effects of import competition due to increased offshore outsourcing. These factors, among others, are reasons that many in Congress support strengthening these laws and insist that the United States must preserve the ability to “rigorously enforce its trade laws” in international negotiations. Competitive advantage and a liberalized world trading system create both winners and losers in domestic economies. Acting on legislation in a manner consistent with previously agreed upon multilateral commitments, balancing that action with the need to regulate and minimize unfair trade practices, and assisting domestic import-competing industries to become more internationally viable presents Congress with unique challenges.

Appendix. Summary of U.S. Trade Remedy Laws Statutory Authority Countervailing Duty (CVD). Tariff Act of 1930, Title VII, as amended (19 U.S.C. 1671 et seq.)

Antidumping (AD). Tariff Act of 1930, Title VII, as amended (19 U.S.C. 1673 et seq.)

Administering Agencies To offset any unfair and injurious advantage that International Trade foreign manufacturers, producers, or exporters of Administration a class or kind of merchandise might have over (ITA) of the U.S. producers as a result of a foreign authority Department of providing a financial contribution, any form of Commerce U.S. income or price support, or a payment to a International Trade funding mechanism to provide the above. Commission (ITC) Purpose

To offset any unfair and injurious advantage that ITA, ITC a class or kind of foreign merchandise might have over a similar U.S. product as a result of the imported product being sold in the United States at less than fair market value (less than comparable goods are sold in the home market, or in other export markets. Sections 201-204 of Provides for investigations as to whether an ITC, President the Trade Act of 1974, article is being imported into the United States in as amended (19 U.S.C. such increased quantities to be a substantial 2251 to 2254) cause of serious injury, or the threat thereof, to a domestic industry producing an article like or directly competitive with the imported article. Gives the President authority to withdraw or modify concessions and impose duties or other restrictions for a limited period of time on imports of any article which causes or threatens serious injury to the domestic industry producing a like or directly competitive article.

Remedy Countervailing duties are imposed when two conditions are met: (a) Commerce determines that the government of a country or public entity is providing, directly or indirectly, a countervailable subsidy with respect to the manufacture, production, or export of the subject merchandise; and (b) the USITC determines that a U.S. industry is injured, threatened with material injury, or that the establishment of an industry is materially retarded, due to imports of that merchandise. Antidumping duties are imposed when two conditions are met: (a) Commerce determines that the foreign subject merchandise is being, or is likely to be, sold in the United States at less than fair value; and (b) The USITC determines that a U.S. industry is materially injured, threatened with material injury, or that the establishment of an industry is materially retarded, because that merchandise is imported. Action may be taken in the form of an increase in or imposition of a duty, a tariff-rate quota, a modification or imposition of a quantitative restriction, one or more appropriate measures of trade administration assistance, or a combination of these actions.

Appendix. Continued Statutory Authority Section 406 of the Trade Act of 1974, as amended (19 U.S.C. 2436). Section 421 of the Trade Act of 1974, as amended (19 U.S.C. 2451)

Section 301 of the Trade Act of 1974, as amended (19 U.S.C. 2411 et seq.)

Administering Agencies Provides for remedy against market disruption caused by ITC, President imports from communist countries. Purpose

Provides for remedy against market disruption caused by ITC, USTR, imports from the Peoples’ Republic of China President

USTR Provides for investigations into allegations that (1) foreign countries are denying rights or benefits under trade agreements or violating trade agreements to which the United States is a party; or (2) the act, policy, or practice of a foreign country is unjustifiable and burdens or restricts U.S. commerce. Sec. 301(a) requires mandatory action, if the USTR determines that the above conditions have occurred, unless the WTO has adopted a report, or a dispute resolution proceeding under any other trade agreement has found, that rights of the United States have not been violated, or the USTR finds inter alia that the country has agreed to eliminate the practice, or taking action would cause serious harm to U.S. national security. Sec. 301(b) provides for “discretionary action” if an act, policy, or practice of a foreign country is “unreasonable or discriminatory and burdens or restricts United States commerce.”

Remedy Action may be taken in the form of increased rates of duty or quantitative restrictions that will prevent or remedy the market disruption. Temporary emergency action may also be taken. Action may be taken in the form of increased rates of duty or quantitative restrictions that will prevent or remedy the market disruption. Temporary emergency action may also be taken. Consultations with China are also required to attempt to resolve the market disruption. Benefits of trade agreement concessions may be suspended, withdrawn, or prevented; or duties or other import restrictions may be imposed. Binding agreements with the foreign country to eliminate or phase out the action or restriction may also be entered into.

Appendix. Continued Statutory Authority “Special 301.” Section 182 of the Trade Act of 1974, as amended (19 U.S.C. 2242)

Section 337 of the Tariff Act of 1930, as amended (19 U.S.C. 1337 et seq.)

Purpose

Administering Agencies USTR

The USTR is required, no later than 30 days of release of the National Trade Estimates Report (NTE) to identify foreign countries that (1) deny adequate and effective protection of intellectual property, or (2) deny fair and equitable market access to U.S. persons that rely on intellectual property protection. The USTR is also required to determine which of these are priority foreign countries, that is, those with the most onerous or egregious practices. Declares unlawful unfair methods of competition ITC and unfair acts in the importation or sale of articles. “Section 337” investigations most often involve intellectual property rights, including allegations of patent, trademark or mask work infringement. Other forms of unfair competition, such as misappropriation of trade secrets, false advertising, and violations of antitrust laws may also be asserted.

National Security Import Applies to imports that may threaten to impair Restrictions. Sections 232 national security and 233, Public Law 87794, Trade Expansion Act of 1962 (19 U.S.C. 1862, 1864, as amended)

Department of Commerce, Defense, President

Remedy The USTR is required to initiate Section 301 investigations with respect to priority countries or consult with the countries (unless he determines that an investigation would be detrimental to U.S. economic interests) and if possible, secure agreements for the elimination of barriers.

The ITC may issue an exclusion order instructing Customs to bar the products at issue from entry into the United States. The ITC may also issue a cease and desist order against named importers and other violating parties to cease certain actions. Expedited relief in the form of temporary exclusion orders and temporary cease and desist orders may also be available in certain exceptional circumstances. The ITC’s exclusion orders become effective within 60 days of issuance unless disapproved by the President for policy reasons. Commerce investigates and holds public hearings. Commerce consults with the Defense Department on methodological and policy questions. Restrictions may be imposed on these imports.

Appendix. Continued Statutory Authority Trade Adjustment Assistance for Firms. Chapter 3 of Title II of the Trade Act of 1974 (19 U.S.C. 2431 et seq.)

Purpose

Administering Agencies Department of Commerce

Provides technical assistance to eligible firms which (1) apply to Commerce for certification of eligibility and (2) propose adjustment proposal that describes the firm’s recovery strategy and type of technical assistance it is seeking. Trade Adjustment Assistance Provides trade adjustment assistance for eligible U.S. Department of Labor for Workers. Chapter 2 of workers if (1) a group of workers or their certified or (Labor), State agencies Title II of the Trade Act of recognized union or representative files a petition with 1974 (19 U.S.C. 2271 et the Department of Labor’s Office of Trade Adjustment seq.) Assistance for certification of eligibility, and (2) the individual worker is approved for benefits by the State agency administering benefits.

Remedy Eligible firms may apply for technical assistance to implement recovery strategy.

Eligible workers may receive trade readjustment allowances, training and reemployment services, and relocation and/or job search allowances.

Sources: U.S. International Trade Commission. Summary of Statutory Provisions Related to Import Relief. USITC Publication 3125, August 1998. United States Code Annotated (USCA) Title 19, Customs Duties. U.S. Congress, House Committee on Ways and Means. Overview and Compilation of U.S. Trade Statutes (2005), WCMP 109-5.

Trade Remedies: A Primer

65

References [1] 9 U.S.C. 1675c, P.L. 106-387, Title X. Also known as the Byrd Amendment, the act requires that duties collected pursuant to antidumping or countervailing duty orders be distributed annually to “affected domestic producers” for certain qualifying expenditures. See CRS Report RL33045, The Continued Dumping and Subsidy Offset (“Byrd Amendment”), by Jeanne J. Grimmett and Vivian C. Jones. [2] Ibid. [3] The International Trade Administration (ITA) of the Department of Commerce conducts AD and CVD investigations. [4] “Material injury” is defined in 19 U.S.C. 1677(1) as “harm which is not inconsequential, immaterial, or unimportant.” [5] U.S. International Trade Commission (U.S. ITC). Summary of Statutory Provisions Related to Import Relief. Publication 3125, August 1998, p. 2. [http://www.usitc.gov/]. [6] 19 U.S.C. 1671 et seq. [7] U.S. ITC Publication 3125, p. 1. [8] CVD: 19 U.S.C. 1671a(a); AD: 19 U.S.C. 1673a(a). [9] CVD: 19 U.S.C. 1671a(b)(1); AD: 19 U.S.C. 1673a(b)(1). Both citations refer to a definition of “interested party” found in subparagraphs (C),(D),(E),(F), or (G) of 19 U.S.C. 1677(9). [10] As a general rule, the ITA determines that a petition has been filed on behalf of an industry if (1) the domestic producers or workers supporting the petition account for at least 25 percent of the production of the domestic like product, or (2) the domestic producers or workers who support the petition account for more than 50 percent of the domestic like product produced by that portion of the industry expressing support for or opposition to the petition (CVD:19 U.S.C. 1671a (c)(4)(A); AD: 19 U.S.C. 1673a(c)(4)(A)). The statute allows for an extension of the 20-day time period if Commerce determines that the petition does not establish sufficient industry support and must poll or survey the industry in order to determine adequate support for the petition. [11] CVD: 19 U.S.C. 1671a(c)(3); AD 19 U.S.C.1673a(c)(3). [12] The non-actionable subsidies category was applied provisionally for five years ending December 31, 1999 and was not extended. [13] Finger, J.M.; Hall, H. Keith; Nelson, Douglas R. “The Political Economy of Administered Protection,” American Economic Review, 72:3 (June 1982), p. 452. [14] Ibid. [15] Ibid. [16] Mastel, Greg. Antidumping Laws and the U.S. Economy, New York: Economic Strategy Institute, 1998, p. 103. [17] CVD: 19 U.S.C. 1671b(b)(2); AD: 19 U.S.C.1673b(b)(2). If ITA has extended its deadline, the ITC must make its preliminary determination within 25 days after the ITA informs the ITC of the initiation of the investigation. [18] 19 U.S.C. 1671b(b) and (c). [19] 19 U.S.C. 1673b(b) and (c). [20] CVD: 19 U.S.C. 1671b(d); AD 19 U.S.C. 1673b(d). [21] CVD: 19 U.S.C. 1671d; AD: 19 U.S.C. 1673d.

66

Vivian C. Jones

[22] CVD: 19 U.S.C. 1671e; AD: 19 U.S.C. 1673e. [23] U.S. International Trade Commission, Publication 3125, p.5. [24] CVD: 19 U.S.C. 1671c(a)(1); AD: 19 U.S.C. 1671(a)(1). According to 19 U.S.C. 1671c(a)(3) and 19 U.S.C.1673c(a)(3), the ITC may not terminate an investigation until a preliminary determination is made by the ITA. [25] CVD: 19 U.S.C. 1671c ; AD: 19 U.S.C. 1673c. [26] “Extraordinary circumstances” are described in 19 U.S.C. 1671c(c)(4)(A) and 19 U.S.C. 1673c(2)(A) as circumstances in which “(i) the suspension of an investigation will be more beneficial to the domestic industry than continuation of the investigation, and (ii) the investigation is complex.” [27] CVD: 19 U.S.C. 1671c(b)(c); AD: 19 U.S.C. 1673c(b)(c). [28] CVD: 19 U.S.C. 1671c(d); AD: 19 U.S.C. 1673c(d). [29] World Trade Organization. Doha Ministerial Declaration 2001 (WT/MIN/(01)/DEC/1), November 20, 2001, Article 28. See also CRS Report RL32810, WTO: Antidumping Issues in the Doha Development Agenda, by Vivian C. Jones. [30] 19 U.S.C. 1675 and 19 C.F.R. 351.213. [31] 19 U.S.C. 1675(b). [32] 19 U.S.C. 1673d(c)(B). In investigations of non-market economy countries, an individual rate is established only if the exporter or producer is able to provide sufficient evidence that government controls over the decision-making process on export-related investment, pricing, and output do not exist. [33] 19 U.S.C. 1675(a)(2)(B). [34] “Louisiana Delegation Queries Customs Regarding Missing Duties on Crawfish.” International Trade Reporter, April 14, 2005. [35] 19 U.S.C. 1675(c). [36] 19 C.F.R. 351.218. [37] CRS calculations based on trade remedy statistics U.S. International Trade Administration, CY2000-2006. [http://ia.ita.doc.gov]. [38] Ibid. [39] Becker, Denise. “Government Delays Ruling on Tariffs; the Furniture Industry Must Wait Until June 17 for Action, if Any, on China,”Greensboro News and Record, April 13, 2004. [40] 19 U.S.C. 1673a(c)(4) requires that the ITA determine if the petition has been filed by or on behalf of the industry. For purposes of this memorandum, ITA officials Maria Dybczak and John Herman were interviewed by telephone on June 24, 2004. [41] Department of Commerce, ITA. Wooden Bedroom Furniture from China. Fact Sheet, December, 28, 2004. [42] 15 U.S.C. 72. [43] U.S. Department of Homeland Security. U.S. Customs and Border Protection. CDSOA FY2004 Annual Report. [http://www.customs.gov/xp/cgov/import/add_cvd/]. [44] Canada Department of Foreign Affairs and International Trade. “Byrd Amendment: Canada to Retaliate Against United States,” United States,” News Release No. 56, March 31, 2005. [45] Commission on the European Communities. Proposal for a Council Regulation Establishing Additional Customs Duties on Imports of Certain Products Originating in the United States of America. Brussels, March 31, 2005.

Trade Remedies: A Primer

67

[46] World Trade Organization. Dispute Settlement Body. Minutes of Meeting on 31 August 2005, September 30, 2005, WT/DSB/M/196. [47] World Trade Organization. Understanding on Rules and Procedures Governing the Settlement of Disputes, Article 22:1. [48] Section 7601(b) of P.L. 109-171. [49] World Trade Organization. Dispute Settlement Body. Minutes of Meeting on 17 February 2006, March 31, 2005, WT/DSB/M/205. [50] 19 U.S.C. 1677f-1(d)(A)(i) and (ii). [51] See Department of Commerce, Import Administration. Antidumping Manual, Chapter 6, “Fair Value Comparisons.” 1997 edition [http://ia.ita.doc.gov/admanual/index.html]. [52] Ibid. [53] World Trade Organization, Dispute Settlement Body. United States — Laws, Regulations, and Methodology for Calculating Dumping Margins (“Zeroing”). Request for the establishment of a panel by the European Communities, WT/DS294/7, February 6, 2004. Ruling of the Panel distributed October 31, 2005. Available at [http://docsonline.wto.org/]. See also Appellate Body Report, United States — Laws, Regulations and Methodology for Calculating Dumping Margins (“Zeroing”), WT/DS294/AB/R (April 18, 2006). [54] Ibid. [55] Ibid. [56] WTO. Request for Consultations by the European Communities, United States — Continued Existence and Application of Zeroing Methodology. WT/DS350/1 (October 3, 2006), and Addendum, WT/DS350/1/Add.1 (October 11, 2006). [57] World Trade Organization, Dispute Settlement Body. United States — Measures Relating to Zeroing and Sunset Reviews. Report of the panel. WT/DS322/R (September 20, 2006). [58] Appellate Body Report, United States — Measures Relating to Zeroing and Sunset Reviews, WT/DS322/AB/R (January 9, 2007). [59] International Trade Administration. “Final Results for Section 129 Determinations,” [http://ia.ita.doc.gov/ia-highlights-and-news.html]. [60] International Trade Administration, Issues and Decision Memorandum for the Final Results of the Section 129 Determination, April 9, 2007. [http://ia.ita.doc.gov/download/zeroing/zeroing-sec-129-final-decision-memo-20070410. pdf]. [61] 72 F.R. 9306, March 1, 2007. [62] For a more detailed review of WTO dispute panel findings in these cases, see CRS Report RL32014, WTO Dispute Settlement: Status of U.S. Compliance in Pending Cases, by Jeanne J. Grimmett. [63] See CRS Report RL33536, China - U.S. Trade Issues, by Wayne M. Morrison for a more comprehensive treatment of these issues. [64] The ITA last made this determination in two 1983 investigations of steel wire rod from Czechoslovakia (49 F.R. 19370) and Poland (49 F.R. 19374). The determination was challenged by the steel industry in the U.S. Court of International Trade, which reversed the ITA’s decision and held that CVD law covers non-market economies (Continental Steel Corp. v. United States, 9 C.I.T., 614 F. Supp. 548, 550; C.I.T. 1985). This decision was subsequently overturned by the U.S. Court of Appeals for the Federal Circuit

68

[65]

[66] [67] [68] [69] [70] [71] [72] [73] [74] [75] [76]

[77] [78] [79] [80] [81] [82] [83] [84] [85] [86] [87] [88] [89] [90]

Vivian C. Jones (Georgetown Steel Corporation, et al. v. the United States, 801 F.2d 1308; Fed. Cir. 1986). See also CRS Report RL33550, Trade Remedy Legislation: Applying Countervailing Action to Nonmarket Economy Countries, by Vivian C. Jones and CRS Report RL33976, United States’ Trade Remedy Laws and Non-market Economies: A Legal Overview, by Todd B. Tatelman. ITA is responsible for NME classification pursuant to 19 U.S.C. 1677(18)(B). The applicability of NME classification with regard to China was determined in the Preliminary Determination of Sales at Less than Fair Value, Greige Polyester Cotton Print Cloth from China (48 F.R. 9897). Any determination that a foreign country is a non-market economy country remains in effect until revoked by the ITA (19 U.S.C.1677(18)(C)(i)). Trade figures are from International Trade Commission Trade Data Web [http://dataweb.usitc.gov]. Other NME countries include Vietnam and the Ukraine. See CRS Report RL32165, China’s Currency: Economic Issues and Options for U.S. Trade Policy, by Wayne Morrison and Marc Labonte. 72 F.R. 17484. Lawrence, Robert Z. and Litan, Robert E. Saving Free Trade: A Pragmatic Approach, Washington, D.C.: Brookings, 1986, p. 97. 19 U.S.C. 2251-2254. 19 U.S.C. 2436. 19 U.S.C. 2451, as added by section 103 of P.L. 106-286, Division A, Normal Trade Relations for the People’s Republic of China. 19 U.S.C. 3352. 19 U.S.C. 2252(a)(1). 19 U.S.C. 2252(b)(1)(A). General Agreement on Tariffs and Trade, Article XIX.1(a) and (b). “Substantial cause” is defined in 19 U.S.C. 2252(b)(1)(B) as “a cause which is important and not less than any other cause.” Criteria for assessing “serious injury” are described in 19 U.S.C. 2252(c)(1)(A). 19 U.S.C. 2252(c). 19 U.S.C. 2252(f)(1). 19 U.S.C.2252(d)(1)(E) and (F). 19 U.S.C. 2252(d). 19 U.S.C. 2252(d)(1)(B) and (C). 19 U.S.C. 2252(d)(1)(A). 19 U.S.C. 2253. 19 U.S.C. 2253(e)(1)(A) and (B). 19 U.S.C. 2253(c). 19 U.S.C. 2254(a)(1). 19 U.S.C. 2254(a)(2) and (3). 19 U.S.C. 2254(b). 19 U.S.C. 2254(c). All public documents regarding the ITC steel investigation are available on the ITC website, [http://www.usitc.gov/trade_remedy/731_ad_701_cvd/investigations/2003/ 204_steel/finalphase.htm].

Trade Remedies: A Primer

69

[91] To Facilitate Positive Adjustment to Competition from Certain Steel Products, Proclamation 7529, March 5, 2002 (67 F.R. 10593). [92] Proclamation 7741, 68 F.R. 68481. [93] 19 U.S.C. 2451. [94] P.L.93-618, Section 421, as added by section 103(a)(3) of P.L. 106-286, 19 U.S.C. 2451. [95] To Extend Nondiscriminatory Treatment (Normal Trade Relations Treatment) to the Products of the People’s Republic of China, Proclamation 7616 of December 27, 2001, 67 F.R. 479. [96] An absolute increase in imports is indicated if imports of the subject merchandise surged in one year and were very low or zero previous years. A relative increase means that the ratio of imports relative to domestic production has rapidly increased from one year to the next. [97] 19 U.S.C. 2253(a)(1)(A). [98] Office of Representative Phil English, “English Calls for Real Reform of U.S. Trade Laws.” Summary of Trade Law Reform Act of 2006, p. 6.

In: Central Banking and Globalization Editors: M. Cappello and C. Rizzo, pp. 71-90

ISBN: 978-1-60876-056-5 © 2010 Nova Science Publishers, Inc.

Chapter 3

TOWARDS NEW METRICS TO MEASURE SUSTAINED COMPETITIVENESS IN THE CARIBBEAN Robertico R. Croes∗ Rosen College of Hospitality Management University of Central Florida, Orlando, Florida, USA

Abstract The purpose of this study is to provide a measurement metrics for competitiveness. The concept of competitiveness is elusive and the conventional measurement metrics currently used are not suitable for small island destinations. The study suggests a new metrics measurement that is based on the concept of economic value, and that is embedded in the rational choice theory. It compares the conventional metrics with the proposed measurement metrics, and aims at providing these more suitable metrics for small island destinations with characteristics such as market and natural vulnerabilities. The study uses ordinary least squares to estimate the coefficients of both the conventional and measurement metrics for comparison purposes. The measurement is applied to several island destinations in the Caribbean, a region highly dependent on tourism development and keenly affected by globalization. The results of the study indicate that the new metrics measurement is more robust and profound in the information and implications that are necessary for policymakers and business managers to measure competitiveness. It suggests a new incentive structure for practitioners in the region that communicates that more is not necessarily better; especially in the context of facing the challenges of improving tourism performance and adjusting to new and often adverse, circumstances.

Introduction The purpose of this chapter is to measure tourism competitiveness in the context of small island tourist destinations. The literature is somewhat elusive about the concept of ∗ E-mail address: [email protected].

72

Robertico R. Croes

competitiveness, and contributes little to the understanding of the competitiveness of small island tourist destinations. This paper aims at filling this gap and assists practitioners in the daily decision-making process necessary to achieve enhanced and sustained tourism performance. It builds upon the previous work of Croes (2005) and contends that the conventional measurement for competitiveness based on visitation levels is not an appropriate measure for small island tourist destinations. It suggests instead an alternative method based on economic logic-value, and applies this method to track the competitiveness of small island destinations particularly with reference to the Caribbean region. Traditionally, visitation levels have been used to measure a destination’s tourism performance. Visitation levels are measured in terms of growth rates of arrivals and receipts. A destination with a higher level of visitation is perceived as a better performer than one with a lower level of visitation. Governments, international organizations, such as the World Tourism Organization (WTO), regional organizations, such as the Caribbean Tourism Organization (CTO), and scholars have used this approach (Croes, 2005). For example, the World Bank, in its report about a vision for the Caribbean region by 2020, used visitation levels to estimate the impact of tourism on job creation by the year 2020 (World Bank, 2000). A number of recent studies, however, have questioned the validity of this practice (Croes, 2005; Papatheodorou & Song, 2005). These studies contend that visitation levels are not an appropriate measurement to provide meaningful information to support the decision-making of practitioners with regard to the competitiveness and sustainability of the tourist product. Growth rate studies conceal the complexity and multidimensional nature of the tourism product. Important elements that influence the quality and attraction (i.e., price, incentives, scarcity, tastes, etc.) are omitted from those studies. These deficiencies prevent practitioners from developing sound sustainable pricing strategies. More specifically, measurement based on growth rates penalizes those destinations that base their tourism on prudent choice. From this cautionary perspective, growth rates of these destinations seem to run counter to sustainable practices because they seek moderate growth rate of arrivals rather than higher numbers of arrivals. Because of this, these destinations risk an unsubstantiated idol profile that could result in a negative image and thus a negative market appeal. In actuality, a policy of sustainable tourism inevitably slows growth rates because it contends that unlimited growth will generate negative externalities and eventually lead to the industry’s own destruction. Further, measurement of performance based on average growth rates also penalizes those destinations constrained by size. Tourism supply in small island destinations, for example, is related to travel opportunities, which is determined by the size, structure and quality of tourist attractions, infrastructures and superstructures, and the management capabilities present at the destination. Small countries’ economies cannot grow consistently at the rates of larger countries because of supply constraints imposed by limiting factors, such as land, attractions, and human resources. For the purpose of this study, small island destinations are defined by the Commonwealth Secretariat (1997) as islands that contain a population of less than 1.5 million inhabitants. Accordingly, the study considers the islands that are located in the Caribbean region. The Caribbean region is broadly defined as a regional agglomeration of small countries in and washed by the Caribbean Sea. They post a high reliance on international trade, a heavy

Towards New Metrics to Measure Sustained Competitiveness in the Caribbean

73

concentration on one to three exports, and high dependency on few export markets. These countries suffer growth costs associated with the small size of their domestic markets, making them prone to risks and vulnerabilities. In addition, the Caribbean is distinguished by the persistence of natural disasters. Tourism is an undisputable important engine for economic growth in the Caribbean. Without tourism, the countries in this region would face economic decline and a migratory drain on their population. Unfortunately, many countries in the Caribbean that desperately need economic growth do not get the maximum advantage from their tourism potential. Recent performance of the tourism industry in the region has been troubling (Croes, 2005). As globalization instigates changing conditions in the international market, the region, in general, has not been keeping pace. In addition to the rapid globalization is the specter of uncertain economic impact that the eventual reintegration of Cuba into the North American orbit brings to the region. These issues are confronting the region in a moment when social and economic conditions have worsened due to increasing unemployment and poverty (World Bank, 2000). The countries of the region are part of a continuing erosion of two of the three main elements of their economies: offshore financial services, and preferential trade treatment of commodities by the European Union (World Bank, 2000; Bernal, Bryan & Fauriol, 2001). To replace the lost revenues from these two sources, Caribbean countries must rely on other revenue sources. As the third engine of economic growth in the region, they depend on tourism for revenues as these two other sources have declined (Croes & Schmidt, 2007). Indeed, tourism has achieved remarkable results for the region, but must now carry an even greater share of the burden of generating growth for the region. The challenges and vulnerabilities pervasive in those island destinations require that competitiveness performance among those countries be compared. This is necessary in order to generate more complete and precise information that is fundamental for small destinations to shift resources from activities with lower values, productivity growth, or beneficial activities to higher valued activities. Resource mobilization may be impeded by information gaps, unpredictable learning costs, linkages, or missing institutions. Because of these failures, resources cannot be mobilized to their most valuable use, and thus prevent destinations from extracting the greatest rent from the tourist product. This study provides a new measurement metrics for competitiveness more suitable to small island destinations. The first section examines the literature of tourism performance of small countries in the region in the context of the special nature of production and consumption of the tourism product. The second section suggests an empirical model to address the deficiencies of the visitation level approach. The third section makes a comparison of the visitation level and an alternative approach through the analysis of the findings. The fourth and final section discusses the conclusions and implications of the study.

Tourism Life Cycle, Competitiveness and Sub-Optimality Performance measurement has become an important issue for destination management (Sheenan & Ritchie, 1997). Measurement is critical in providing timing and quality information for the purpose of designing and tweaking organizational strategies. It also is

74

Robertico R. Croes

critical in assessing achieved goals and nurturing learning and innovation (Kaplan & Norton, 1992). Measurement is an essential element of strategy because it validates claims of performance and provides evidence of a destination’s long run economic viability. The outcome variable of this study (i.e., tourism receipts) corresponds to goals that destination practitioners are aiming to achieve. Many destinations promote tourism precisely for generating foreign exchange (Sinclair, 1998). A large proportion of a tourist’s spending is the consumption of non-traded goods at the destination. Through this consumption, a destination generates foreign exchange. The analysis of the economic performance of tourist areas has already a long history. Both the Tourism Area Life Cycle (TALC) and the competitiveness frameworks have been used to gauge the economic performance of destinations, where the latter is the unit of analysis (Butler1980; Crouch & Ritchie, 1999). The reason for this is that the fundamental product in tourism is the destination experience. Tourism tends to become a competitive activity among regions which are compelled to enhance their performance in order to attract more tourists and increase their revenues (Crouch & Ritchie, 1999; Dwyer, Forsyth & Rao, 2000). The tourism life cycle model proposes that a destination goes through six stages: exploration, involvement, development, consolidation, stagnation, and decline and/or rejuvenation. A destination therefore enjoys varying degrees of popularity over time, resulting in an S-shaped path. A close relationship has been established between TALC and the sustainability concept and the principles at the heart of sustainability are similarly implicit in the TALC model — long-term view, keeping development within social and environmental limits, an emphasis on the community, a respect for the environment, and the need for regulation and responsibility — except inter and intra generational equity is not implicit in TALC. Greenidge and Whitehall (2000) and Malcolm (2003) applied the TALC framework to Barbados and Jamaica respectively and they found symptoms of life cycle phenomena in these two countries. Whitehall and Craigwell (2006) applied the same framework to the Caribbean region and they also found an inverse relationship between popularity of a destination and the over utilization of resources and a decrease in utility. These studies seem to indicate that the TALC model could be a useful variable in explaining competitiveness. Yet the concept of competitiveness appears to be elusive in terms of meaning and economic relevance. Competitiveness has often been equated with macroeconomic issues (e.g., changes in exchange rates) or microeconomic issues (e.g., economic incentives, regulations, firm-level capabilities and institutional support). Several studies extended the concept of competitiveness from the firm-level to the national level, thereby assuming that the nature of competition in firms and in countries is identical. While competitiveness is readily defined at the firm level, it becomes somewhat ambiguous and troublesome at the industrial and national level (Krugman, 1996); Lall, 2001). In spite of the lack of clear evidence as to relationship of competitiveness to economics, the concern with competitiveness has been relentless and has generated several composite indices. They include the World Economic Forum’s Global Competitiveness (WEF), the World Competitiveness Report prepared by the International Institute for Management Development (IMD), and the World Travel and Tourism Council Competitiveness Report

Towards New Metrics to Measure Sustained Competitiveness in the Caribbean

75

(2006). The rankings derived from the indices, have been the object of criticism. The flaws of these rankings are disclosed especially by Lall (2001) on definitional, modeling, determinant, and indicator aspects of competitiveness, thereby reiterating the inadequacy of such indices for explaining the level of competitiveness as it pertains to small countries. These indices typically have neglected the world’s smallest economies (Wignaraja, Lezama, & Joiner, 2004).

Defining Tourism Competitiveness In the tourism context, and based on Porter’s (1990) model, Crouch and Ritchie (1999) developed a conceptual model of tourist competitiveness. They maintained that the endowment and deployment of resources at the micro and macro environment levels simultaneously affect the competitiveness of a destination. In their view, achieving superior performance and position in the global market depends on the ability of the destination to logically manage and organize its resources. Several other studies discussed the concept of tourism competitiveness, but neglected to explain why tourism should have a separate model of competitiveness (Dwyer & Kim, 2003; Enright & Newton, 2004; Gooroochurn & Sugiyarto, 2005; Mazanec et al., 2007; Chen et al., 2008). According to Mazanec et al., (2007), it seems that the only consensus within the literature about tourism competitiveness implies that competitiveness is the antecedent of a prosperous quality of life. One main reason for this is the lack of definitions reflecting a cause-effect relationship between competitiveness and quality of life, hampering hypothesis-building and testing. Most of the existing definitions neglect to distinguish the dependent from the independent variables, thus producing several hidden assumptions. Nevertheless, in spite of the confusion regarding competitiveness, economic success has been closely associated with the ability to compete. Competitiveness has been increasingly identified with the ability of an economy to raise or maintain the standard of living of the population. Therefore, competiveness may raise tourism spending and provides memorable experiences to tourists, while enhancing the quality of life of the residents and simultaneously preserving the integrity of its natural capital (Crouch & Ritchie, 1999). However, the issue is in defining the relevant entities involved in generating and nurturing this ability. Compounded the issue is the complexity of the nature of production and consumption of the tourism product. This latter reality stems from the intangibility of the product, the sub-optimality level of tourism production, and the presence of non-priced goods in the production of the tourism product (Gray, 1982; Mules & Faulkner, 1996; Burgan & Mules, 2001; Mak, 2003). This complexity and multidimensionality generate market distortions in the manufacturing of the tourism good. Typically, when a tourist spends his vacation in a destination, he does not consume a product from one supplier, but rather a bundle of services. Many different service suppliers participate in creating a tourism experience. This requires vertical cooperation because the tourist’s overall quality assessment depends on a cumulative quality perception. As far as the tourist is concerned, the product covers the complete experience from the time he leaves home to the time he returns. Furthermore, the tourist is engaged in making

76

Robertico R. Croes

the product by selecting the bundle of goods (i.e., rooms, meals, entertainment, transportation, scenery, etc.). Since tourism is an experience good in which the characteristics cannot be fully discovered until after the purchase, there is difficulty in determining the quality of a tourism product. Add to this factor the characteristic of heterogeneity and the difficulty in assessing the honesty of multiple sellers, and tourism becomes riddled with reputation, quality, and trust issues and decisions (Keane, 1997; Crase & Jackson, 2000). The perishability feature of the product implies that an unused offer cannot be stored, which makes efficient capacity utilization one of the big problem areas in tourism. Seasonality issues may be especially pronounced in some contexts, demanding some flexibility such as labor mobility. This applies to all tourism services in accommodation, catering, travel agents, transport systems, and all other businesses related to the tourism value chain. Tourism suppliers are not always able to capture the full amount of benefits from the tourist. For example, a hotelier may promote his destination and in the process capture the tourist. However, he is not guaranteed that the tourist will not buy goods and services (e.g. meals, shopping, transportation, and entertainment) from other businesses. If the tourist consumes products from other businesses then the hotelier does not reap all the benefits possible. Therefore, spillovers due to the presence of the tourist at the destination cannot be captured completely by the provider initiating the promotion. This situation engenders both a sub-optimality issue as well as a free riders problem with the end result that the private sector is unable to provide the goods in appropriate amounts (Gray, 1982; Mules & Faulkner, 1996; Burgan & Mules, 2001). The sub-optimality problem is compounded by the presence of non-priced goods in the composition of the tourism product. Non-priced goods are essentially public goods for which the enjoyment of the goods does not carry any price tag. This is due to the nature of collective consumption and the inability to charge users an appropriate fee for the use of the good (Gray, 1982). Examples include enjoying the beach, the sun, the mountains, and the scenery. These could be overused to the point of jeopardizing the proper resource base on which the attractiveness and prestige of a destination is embedded (Gray, 1982; Mak, 2003).

Addressing Issues Related to Sub-Optimality in the Consumption and Production of Tourism The structural reality depicted previously imposes requirements on the growth strategy of a destination in order to remain competitive. A growth induced economy through tourism seems to take place through two channels: increasing exploitation of natural resources, which in the long run does not seem sustainable; or working the tastes and preferences of tourists in such a way that tourists goods are increasingly valued in international markets thereby off setting the increase in cost production. The latter seems to propel long term sustainability.

Towards New Metrics to Measure Sustained Competitiveness in the Caribbean

77

There are therefore valid reasons concerning national competitive ability under condition of imperfect markets. One could argue however that in developed countries missing or imperfect markets are not as pervasive as in developing countries, and hence, even if its discussion seems required from a theoretical perspective, from a practical standpoint it is doubtful whether governments have the ability to intervene successfully. This seems to be the line of argument of Krugman (1996) pressing upon the futility of trusting governments in building dynamic comparative advantage. This study takes issue with this line of contention. Tourism development is not about the tackling of impediments to optimal resource allocation due to the degree of existence of market failures and the stage of economic development of a country, but in overcoming the nature of market imperfections caused by the nature itself of tourism production and consumption. This condition makes intervention theoretically justifiable and takes the concept of competitiveness beyond its initial intuitive appeal into the realm of looking into the ability of destinations to compete with each other. This ability refers to policies that increase the economy’s potential of a destination. This implies that tourism can only develop or function with regular and robust government management. Governments are more involved than ever in the production of the tourism good. Tourism has become a major sector of the economy, generating income and jobs for millions. Governments strive to maintain or enhance their market share of travel and tourism by attracting increasing numbers of tourists from the same generating countries. By the end of 1990s, there were 30 countries producing over 90% of the total global tourist spending, while the ten top countries accounted for over two-thirds of this spending (Vanhove, 2005). Governments supervise, promote, preserve, provide public goods, and skim off any rent to benefit the general economy. This intervention manifests itself with the funding of promotion of the destination, research, training, infrastructure, and more recently, the support of events in order to support the demand pull of a destination (Croes & Severt, 2007). In fact, many governments have established special bodies (ministries or corporations) whose charter is to attract tourists with the potential to generate large economic impacts. Government intervention in the production and consumption process of the tourism goods typically requires that tax dollars should be accounted for in a transparent manner. Through their tax dollars, citizens fund events, facilities, or programs in order to enhance the attractiveness of a destination for tourists. In turn, these tourists spend their money at the destination based on its attractiveness, which, in turn, generates income, jobs, and taxes for the region. Residents, therefore, should be aware of the return on investment (ROI) of the tax dollars being invested in the tourism product. Each dollar invested in tourism should be justified to the public. Tourism also relies on the scarcity of renewable and non-renewable resources (Gray, 1982). The optimal economic management of these resources is at the heart of the sustainability of tourism. The literature on the long-run economic perspective of tourism is mixed. Some opponents stress the negative effects of tourism, such as dependence on foreign capital, volatility of demand, Dutch disease effects, etc. (Sinclair, 1998). Proponents, however, suggest that these negative effects can be overcome by a careful management of natural resources, ensuring the long-term availability of these resources while increasing the tourist’s willingness to pay in the process, and hence the tourism receipts (Croes, 2006).

78

Robertico R. Croes

Central to the discussion of an optimal tourism development, is the lower than average productivity gains of supply which are contrasted with high demand elasticity to income from tourism, potentially generating the terms of trade gains (Lanza & Pigliary, 2000). However, a deeper concern about the future of the tourism industry in island destinations is the issue of sustainability. So, the major challenge for a small island destination becomes the orientation of its growth strategy. A growth induced economy through tourism seems to take place via two channels: increasing exploitation of natural resources, which in the long-run does not seem sustainable; or, managing the tastes and preferences of tourists in such a way that tourists’ goods are increasingly valued in international markets; thereby off-setting the increase in cost production. A key question is, therefore, whether a destination’s transformation will be a result of a rational attempt to meet tourist preferences or whether as perverse effects of the suboptimality use of natural resources (Gray, 1982; Mazzanti, 2002). This study attempts to answer to shed light on this question. The central tenet of this study is that the growth rate in tourism expenditures can be decomposed into components that can be attributed to the growth of inputs to create the tourism product and a residual growth rate that is not attributed to the growth of inputs. The latter is the value gained by the destination in for its tourism product: the higher the value reflected in the destination price the higher the competitiveness of that destination.

Tourism in the Caribbean The Caribbean is acknowledged to be the most tourism dependent region in the world, given that in many of its 32 countries, tourism accounts for more than 25% of the GDP and is the largest provider of jobs and earner of foreign exchange. The World Travel and Tourism Council (WTTC) estimated that in 2004, tourism contributed 14.8% of the region’s GDP; accounted for 2.4 million jobs representing 15.5% of total employment; grew at an annual real rate of 4.1% in terms of GDP, and 2.8% in terms of travel and tourism employment. This performance should take the share of GDP and employment to 16.5% and 17.1% respectively by 2014. Tourism grew regionally at an annual average of 3% and 6% in international arrivals and receipts, respectively, throughout the period under review and solidly demonstrated its continuing status as a growth industry. Research shows that revenues from tourism are stable and are two to five times more reliable as a source of revenues than the sale of goods, such as agricultural and mineral commodities (Maloney & Rojas, 2001). Recent studies of the smaller countries in the Caribbean also have shown that tourism is a stable growth enhancing policy and that specializing in tourism as a development strategy is a sound option for these countries (Modeste, 1995; Easterly & Kraay, 2000; Lanza & Pigliaru, 2000; Grassl, 2003; Jayawardena & Ramajeesingh, 2003; Durbarry, 2004; Algieri, 2006). The key issue here is to ascertain patterns of performance and provide analytical insights as to the competitiveness level of the countries within the region.

Towards New Metrics to Measure Sustained Competitiveness in the Caribbean

79

Measuring Sustained Competitiveness The method for measuring tourism performance of countries is traditionally based on visitation and spending levels (Crouch & Ritchie, 1999; Ritchie & Crouch, 2000; Johnston, 2001). This method is premised on the notion that more tourist arrivals and receipts is a good indication of a destination tourism performance. The conventional methodology of growth rates estimation method is based on the following model: TARRjt = γеδTime

(1)

TAEjt = ηеθTime

(2)

Where TARRjt and TAEjt are tourist arrivals and tourist receipts for the j region in period t respectively, Time represents a time trend, and δ and θ multiplied by 100 give values of the average annual growth rates. After taking logs on both sides, equations (1) and (2) can be specified as: log TARRjt = log γ + δ Time.

(3)

log TREjt = log η + θ Time.

(4)

The main critique to this method is that the estimation is based on nominal values: therefore, it cannot capture tourism’s contribution in deflated terms (‘inflation illusion’). Furthermore, the aggregate tourism series which gauge the overall importance can be deceiving, because they may penalize those destinations that choose to guide their tourism sector based on a deliberate choice of prudence and caution. Such destinations may be seeking moderate growth rates of arrivals but more spending through a more sustainable approach toward tourism, rather than simply by promoting a higher number of arrivals. For example, the Aruba government adopted a policy in 1995 to limit the number of hotel rooms and thereby create a constraint on further expansion of tourism supply. Also, in 1995, the government suspended the tax-holiday package available to hotel and resort owners and developers. By limiting expansion, the government sought to establish a tourism sector in which tourist receipts rose proportionally faster than tourist arrivals. In other words, a shift occurred in the emphasis of policy based on quality rather than quantity, i.e., to increase the amount spent per tourist visitor by attracting “up-market” visitors as opposed to simply attracting larger numbers of visitors (Croes, 2000). Based on this policy, visitation annual growth rates should slow down or even flatten out, while the real spending per tourists should increase. Using visitation levels in this context could generate, however, unnecessary political turmoil because the public might perceive the looming situation as a policy failure. Unfortunately, the government could succumb under political pressure and continue pursuing an expansionist policy affecting the quality of the destination experience. The incentive under this condition is expansion of supply, but expansion ultimately could bear its own seeds of destruction (e.g., image, congestion, over-crowdedness, lower level of quality of the product, etc.). Rather, changing

80

Robertico R. Croes

to the incentive by changing the measurement concept is essential to attain and keep sustained competitiveness. The study’s main position is, therefore, that using the concept of value is a more appropriate measurement unit as it is embedded in rational choice theory. Rational choice theory infers that the value a consumer places on a product can be identified by observing their consumption of the product without having to discuss the reasons or motives behind consumer choice. From this perspective, it can be stated that a consumed good provides greater utility than a good that has not been consumed. In other words, consuming Barbados rather than Antigua means that the Barbados product provides greater utility than Antigua does to the consumer. The assumptions of the study are therefore derived from the optimizing models, i.e., destinations attempt to maximize tourism receipts. Since we are interested in the factors that compose the total tourism receipts, we can articulate tourism receipts as a part of the theory of demand (p=D(x)). This theory says that the quantity demanded for the product is influenced by the price of the product, consumer’s income, tastes and preferences by prices of selected goods. From this optimizing perspective, growth in output should exceed the contribution of inputs. The difference between the rate of growth of the output (receipts) and contribution of tourism production inputs (private and public goods) represents the rate of growth of value of the tourism product. Based on the theoretical underpinnings of the TALC model, we can construe costs as the mirror image of the destination life cycle curve: average costs are likely to decrease as more tourists visit a destination but they may see an upturn if they bump against capacity constraints, regulatory, or agency problems, reaching a saturation point. We assume therefore that the average costs are a nonlinear function of the volume of output (Whitehall & Craigwell, 2006). We based our model on four assumptions: (1) the output level reflects the maximization of value, (2) value is defined as the difference between total tourist receipts and total product costs, (3) total receipts reflect the price of the product and the quantity of the product sold (R(x)=xp=xD(x)) and (4) total costs reflect some function of the average cost of the product (C(x)). By substituting the definitions of total revenues and total costs into the definition of value, we obtain a destination’s value function: kt

(5) Value = p*q – aq , or Value = f [Q] for short, where p stands for average price or expenditure, q stands for quantity, p multiplied by q represents total revue, k is the relative growth rate in period t, while a stands for a constant. The income elasticity has shown to be very significant for demand purposes. As disposable income increases, a larger proportion of that disposable income will be spent on tourism goods, reflecting in a longer stay at a destination. The duration of the stay therefore is a good proxy for the income of the tourists (Alegre & Pou, 2006). As income increases, the probability of buying more tourism products increases, but at decreasing rate (diminishing return). Promotional efforts are also geared to increase demand and hence revenues. Promoting the product through advertising can increase market share, but excessive advertising will attract little additional tourist revenues. Advertising is not free meaning that it will reduce value of the product. Thus, a nonlinear functional form should do a good job describing

Towards New Metrics to Measure Sustained Competitiveness in the Caribbean

81

value-promotion patterns due to the diminishing returns that come with too much advertising. High value is associated with a high quality/high expenditures tourist and potentially higher multipliers, while a low value is associated with a low-spending tourist. Low quality tourism may have a higher externality cost in congested areas, road conditions, and pollution, reducing the carrying capacity of the destination and hence negatively affecting the value of the tourist product than high quality tourism. The former may potentially hamper the sustained competitiveness of the destination under those conditions. Revenues can increase over time due to inflation. In order to get the price that truly reflects the cost of the product, the study proceeded to deflate and to detrend the revenues. Consequently, destination performance can be evaluated through a measurement of value by the following reduced-form tourism spending equation: RealTSPt = f (TOUVt, INCt, TOUMt, TSPt-1,RealGOVPt, εt,)

(6)

Where RealTSPt is the deflated and detrended total spending level of the visitors in year t, TOUVt is the visitation level in year t, Pt is the price variable captured by the consumer price index, INCt is the disposable income of the tourist proxied by the fraction of tourism spending per tourist multiplied by the average length of stay of each visitor in year t, TOUM is maturity of the destination proxied by the ratio of total arrivals to population in year t, TSPt1 is the tastes, preferences and habits of the visitors, RealGOVPt is the deflated and detrended government’s promotion expenditure in year t, εt is the disturbance error capturing value of the product. Notwithstanding the study’s specification of a multiple regression model, the emphasis in this analysis only focuses on one variable out of the complete set of variables- the effect of value added to the tourism product on the generation of spending. The question to consider here is what computations are involved in obtaining, in isolation, the residuals in equation (6). To pursue this objective, the study transformed equation (6) into the following regressions: Log RealTSPt = B0 + B1Log TOUVt + B2 Log Pt + B3 Log INCt + B4 Log TOUMt + B5 LogTSPt-1 + B6LogRealGOVPt + εt

(7)

To capture the residuals, we can write, therefore εt = LOG RealTSP - Σβ(X i )

(8)

The study assumed international receipts are exogenous to each of the independent variables, thereby justifying the use of Ordinary Least Squares. The procedure effectively partitioned the variance of the revenues into two categories, that predicted by demand and supply conditions and that which is not attributable to those conditions. The unobservable predictors –captured by the error term- could be due to differences in quality, sophistication, managerial competence, etc. The relevance for practitioners is that some predictors are within the control of the managers (e.g., product offerings, level of arrivals and satisfaction) and

82

Robertico R. Croes

those that are not (e.g., market conditions in the generating area and the extent of competition).

Data Sources, Estimation and Empirical Results A sample of five countries (Aruba, The Bahamas, Barbados, Dominican Republic, and St. Lucia) was selected for the purpose of this study. Country inclusion was based on convenience (e.g., availability of data). Data was collected from the World Tourism Organization (WTO), the Caribbean Tourism Organization (CTO), the World Travel and Tourism Council (WTTC) and the International Financial Statistics of the International Monetary Fund (IMF). The data cover a time span from 1989 to 2003.

Study Results and Implications The study assumes stationarity in the time series under review, and therefore it maintained the level form. The reason for this is that the sample of the study was extremely small (n=15), and therefore it is difficult to reject the null hypothesis of a unit root if the process approximates a unit root. Insisting on a unit root might lead not only to low power of the tests, but also could lead to erroneous conclusions about the existence of unit root and cointegration vectors (Harvey, 1997). With this cautionary note, the study relied on the theoretical underpinnings of our model instead. The results in Table 1 indicate that the Dominican Republic, Aruba, and St. Lucia outperformed the Bahamas and Barbados and attracted a higher level of visitation compared with the regional average in the Caribbean. In terms of spending, only the Dominican Republic and Aruba outperformed the regional average level of the Caribbean. The other three countries, St. Lucia, Barbados, and the Bahamas underperformed the regional result. Table 1. Tourism Annual Growth Rates in Percentage 1989–2003.

Visitors Spending

Caribbean

Aruba

Bahamas

Barbados

3.0 6.0

5.0 8.0

0.0 3.0

1.0 3.0

Dominican Republic 6.0 9.0

St. Lucia 5.0 4.0

Source: Author’s estimation based on data from WTO and CTO.

The study further assessed the suggested model in equation (7). The model was parsimonious because the covariates provided a high degree of explanation of the variance in tourist expenditures. Autocorrelation, a common concern in time series data, was tested using the Durbin-Watson test statistic. The study detected no autocorrelation at the 95% confidence level for all destinations. The R-square value suggests a good fit as the model is able to explain between 85% (The Bahamas) and 99% (the Dominican Republic) of the variance in the dependent variable. The joint F-test suggests that the independent variables included are jointly statistically significant.

Towards New Metrics to Measure Sustained Competitiveness in the Caribbean

83

The results are presented in Table 2 and provide some interesting insights with regard to the performance of the sample of countries. All the countries in the sample had value enhancement of their tourism product during the time under review. Value enhancement ranged from 2% in the case of the Bahamas to 44% in the case of the Dominican Republic. Table 2. Regression Results. Aruba

Bahamas

Barbados

Dominican Republic

St. Lucia

0.540*

0.577*

0.252*

0.953*

0.599*

t=(3.37)

t=(3.71)

t=(4.22)

t=(9.32)

t=(3.92)

0.733*

0.07

0.404

0.069

0.165

t=(9.38)

t=(0.67)

t=(1.85)

t=(0.86)

t=(0.81)

1.18

-3.04*

-5.129*

1.717*

3.832*

t=(1.69)

t=(0.79)

t=(3.91)

t=(11.11)

t=(3.64)

1.732

0.831

1.418*

0.916

3.096

t=(1.63)

t=(1.77)

t=(3.79)

t=(1.46)

t=(1.65)

0.132

0.038

0.018

0.438

0.06

Adjusted R

0.977

0.935

0.848

0.994

0.925

F-value

11.309

47.464

15.529

453.842

33.164

Durbin Watson

2.015

2.211

2.199

2.253

1.785

Variables Income Taste and Preferences Maturity Visitation 1

Value

2

1

Value is captured by the error term Significant at the .05 level

*

m

According to the model, value is captured by the residual [Y-Σβ(X i -X )], and it measures the extent to which a destination performance differs from expectation (See Table 2). The mean value equals to .1372(13.72%) and it implies that only the Dominican Republic performed better than expectation (43.8%), while Aruba was second with 13.2% (very close to expectation). The Bahamas (1.8%), Barbados (3.8%) and St. Lucia (6%) all under performed by the expectations level. The Dominican Republic is clearly an outlier in this sample of countries. If the Dominican Republic is deleted from the sample, the expectation performance would equal to 5%. In this case, only Aruba and St. Lucia would exceed the expectation level. Table 2 provides an explanation about the value performance of the sample of countries. As expected, the income variable was large and significant in all cases, which confirms the theory that tourism is income elastic. On the other hand, tastes and preferences may have captured the effect of repeat visitation, which was positive and significant only in the case of Aruba. This suggests that the supply of tourism goods in Aruba is influenced positively by its past behavior. Government promotion was dropped from the equations as it was found not to be significant in all cases in the sample of countries.

Table 3. Real Visitor Spending and ROI*. Aruba

Barbados

Bahamas

Dominican Repub

St Lucia

Real Real Real Real Real RealSpending/ Promotion$/ RealSpending/ Promotion$/ RealSpending/ Promotion$/ RealSpending/ Promotion$/ RealSpending/ Promotion$/ Year Per Capita Per Capita Per Capita Per Capita Per Capita Visitor Visitor Visitor Visitor Visitor Spending Spending Spending Spending Spending 1989

1231.4[rc1]

11.4

1383.6

13.8

979.4

34.9

723.5

8.1

1393.3

12.3

1990

1051.0

11.4

1418.4

12.7

1041.1

39.0

708.2

10.5

1380.5

12.9

1991

979.3

10.9

1371.5

12.7

972.0

31.9

771.9

12.0

1390.9

13.9

1992

1015.2

12.4

1375.4

13.1

992.1

35.8

771.6

12.0

1397.6

15.0

1993

993.7

12.5

1437.7

12.5

955.9

39.9

796.5

10.1

1336.7

15.3

1994

923.3

14.1

1591.1

14.0

949.1

36.2

721.7

8.3

1178.8

13.3

1995

947.0

14.1

1718.7

15.8

892.3

30.2

973.2

11.4

1281.7

19.0

1996

1045.2

15.0

1679.7

14.3

929.0

31.2

1000.6

11.9

1249.8

15.4

1997

1096.3

15.3

1559.2

14.8

926.4

28.9

992.5

10.4

1246.8

15.5

1998

1181.9

18.1

1426.3

13.8

911.2

26.9

953.9

9.3

1232.8

16.7

1999

1185.9

18.1

1345.8

11.7

1019.9

30.0

968.1

11.6

1219.4

17.2

2000

1178.4

18.8

1304.6

11.8

1124.4

26.9

962.0

11.6

1025.9

14.8

2001

1248.1

18.2

1320.1

11.0

1049.5

24.6

944.7

9.7

877.9

10.9

2002

1311.1

17.0

1267.8

10.3

1115.7

25.2

936.4

9.1

956.1

12.2

2003

1191.9

15.9

1364.9

11.8

1139.9

25.6

881.6

12.2

954.8

14.7

*The ROI is a mathematical calculation that takes the form of real dollars (base year 2000) tourist receipts divided by real marketing dollars invested by the

Government. It is assumed that travel decisions were influenced by marketing funded by the Government.

Towards New Metrics to Measure Sustained Competitiveness in the Caribbean

85

Maturity, on the other hand, seems the only variable indicating variance in the outcome in the sample of countries. The results suggest a correlation between destination maturity and value of the product. Maturity had a negative sign and was significant in two cases, The Bahamas and Barbados, while it had a positive sign and was also significant in the cases of the Dominican Republic and St. Lucia. The former two cases also were the poorest performers in the sample, while the Dominican Republic was the best performer and St. Lucia was an average performer. The results further suggest that both the Dominican Republic and St. Lucia have not reached the saturation point. These results are in line with the TALC model and corroborate the findings of Greenidge and Whitehall (2000), Malcolm (2003), and Whitehall and Craigwell (2006). Aruba, on the other hand, does not fit neatly into the TALC framework. Aruba was the second best performer in the sample of countries and coupled with its strong growth in the last ten years should have placed it in the mature category. In other words, Aruba should have indicated traces of more growth opportunities and expansion of its supply base, similar to the Dominican Republic and St. Lucia. This expectation is further supported by the large support of its repeat visitation (habits), which was both significant and large (β = 0.733 with t =9.38). Prestige attached to the Aruban product may be a reason why it does not perform the way the theory predicts. And yet, there are indications that Aruba may resemble Barbados and the Bahamas more than the Dominican Republic and St. Lucia in the future. Table 3 suggests that Aruba is experiencing declining growth rates in some vital areas compared to the other four countries in the sample. Both real spending per visitor as well as government spending per visitor (adjusted for inflation) has been declining since 2002, which raises some doubts about the return on the investment of tax dollars. The decline is pronounced in real spending per visitor, i.e., 10%, while return on investment as measured by real spending by tourists divided by real marketing dollars by the government also showed a decline of 7%. This decline does not seem to be induced by the events of 9/11, as both indicators in the other four countries in the sample do not suggest a similar trend (see Table 3). The question is whether this decline is incidental or structural in nature. The results indicate that destinations in the sample occupy different stages in the product life cycle. This means that it is crucial for both private and public sectors to identify the status and evolution of their tourism business environment. The existence of a heterogeneous development highlights the need for a constant monitoring of the supply of each destination. Supply conditions vary at the destinations and make a uniform approach impractical. Managing issues of carrying capacity seem to be the driving force behind changes in the tourism business at each destination. Carrying capacity limitations may be affecting the overall quality of the tourism product of at least two of the countries in the sample, which determines the level of competitiveness of their overall product. Carrying capacity issues also may be becoming one of the most critical factors on demand. Finally, the tourism development stage of each destination dictates different policy measures. The Dominican Republic and St. Lucia are in the growth stages and therefore their strategies should focus on pursuing supply expansion with an emphasis on which segments are most suited to their supply. For example, these destinations must attract new investments for hotel and other activities.

86

Robertico R. Croes

The Bahamas and Barbados, on the other hand, should pursue a strategy of product rejuvenation and revitalization to counter waning product quality and declining competitiveness. Upgrading of standards, improvement in management practices and a marketing focus on attracting high-end market demand are needed. Lastly, Aruba is reaching a stagnation point, which may be eroding its quality reputation with a high degree of standardization and jeopardizing its price elasticity of demand. This will cause a tightening of profit margins of local firms, which provides further incentives to “cut corners” with regard to the quality of service rendering. Government intervention to provide the appropriate incentives, for example through tax incentives, could be a solution.

Conclusion The study compared two approaches to measure the performance of a sample of countries in the Caribbean. The first approach was the conventional growth rates model based on the level of visitation and visitor spending. Higher visitation level and greater visitor spending were attributed to better performance according to this approach. This approach has been widely used by both scholars and practitioners alike. The second approach was based on a value model embedded in economic theory. Visitor spending is captured by disposable income level of visitors, the cost of making the tourism product, government expenditures, preferences and tastes, and a residual which cannot be attributed to any one of these variables. Value in this reasoning is a residual after taking all these variables into account. The findings of the first approach indicate that the Dominican Republic, Aruba, and St. Lucia outperformed the Bahamas and Barbados throughout the period of interest. The second approach not only corroborates the findings of the first approach, but also provides an explanation of why some countries are more competitive than others. The destination life cycle of the product appears to be the most prominent variable in explaining the visitor spending in the sample of countries. The findings suggest that there are at least three groups of countries derived from the sample: growth countries (Dominican Republic and St. Lucia); mature countries (The Bahamas and St. Lucia) and maturing country (Aruba). The findings further suggest the need for a diversified strategy based on the stages of the product life cycle. No single approach will work in this context. At least three strategy approaches are required in order to respond to the special needs of the three categories of destinations. The first group requires an expansionist response, the second one dictates an aggressive rejuvenation and innovative approach, and the third merits a prudent approach focused on the domestic business environment. Knowing the stage in the product life cycle may assist the destination in aligning the right type of incentives to shape behavior of stakeholders in accordance to the needs of the destination. This will prevent costly negative externalities at the destination level and will mitigate against coordination efforts of collective action nature required in the production of the tourism product. Care should be taken, however, not to draw the conclusion that a destination finds itself in a determinate stage in its life cycle simply because of its growth rate. This growth rate of the tourism product may be due to specific policy measures or other causes unrelated to the characteristics that determine the stage of the life cycle, such as the impact of 9-11 or changes

Towards New Metrics to Measure Sustained Competitiveness in the Caribbean

87

in the makeup of tourists of a destination. It seems that visitors to a destination no longer consist of the two traditional groups, namely tourists and excursionists. Rather, there is a new emerging group of second homeowners, and its presence may create challenges in data collection. For example, in Aruba foreign owners of condos and second homes (a rapidly emerging segment in the local real estate sector due mainly to high incidence of repeat visitation) are considered as tourists in terms of arrivals, and their spending is partially incorporated as tourist receipts. This may distort the value of the tourism product slanting it towards being too conservative. In conclusion, the second approach appears more theory driven. The results are more robust and richer in information and implications for policymakers and business managers. It suggests a new incentive structure for practitioners in the region that more is not necessarily better, especially in the context of facing the challenges of improving tourism performance and adjusting to new, and often adverse, circumstances. The results suggest that an efficient trade-off between asset management and maximization of rents is possible in the Caribbean, at least over the time period under review. The study has its limitations. On the one hand, the number of destinations should increase in order to have a better perspective with regard to the sustained competitiveness of product types. On the other hand, the time series should include more observation points in order to facilitate not only the assessment of inter-temporal changes, but also to provide higher power of the tests. In this regard, it is important to conduct a full-scale co-integration test in order to make the study more meaningful. Finally, this study assumes implicitly that the tourism market is homogeneous, ignoring the possibility of sequential entry into different markets due to different dynamics in the source markets (US, UK, Latin America, etc.). Future research in additional sub-markets might be useful in order to confirm the notions and findings entertained in this study. Future studies addressing the particular brand and relationship components of the destination in order to measure lifetime tourist value would make for an additional means of comparisons. Finally, by using a portfolio of comparisons that focus attention on value or quality of arrivals rather than simply the total number of arrivals, it is possible for a destination to maximize return on tourists. Yet, at the same time, it can offer a sustainable competitive tourism strategy, which, in turn, is accountable to the destination’s stakeholders including locals who provide taxes for the advertisement of tourism.

References [1] [2] [3]

[4]

Alegre, J. & Pou, L. (2006). The length of stay in the demand for tourism. Tourism Management 27(6), 1343-1355. Algieri B. (2006). International tourism specialization of small countries. International Journal of Tourism Research 8(1), 1-12. Bernal R., Bryan A. & Fauriol G. (2001). The United States and Caribbean Strategies: Three Assessments. Policy Papers on the Americas. CSIS Americas Program, April: Washington DC. Burgan, B. & Mules, T. (2001). Reconciling cost-benefit and economic impact assessment for event tourism. Tourism Economics 7(4), pp 321-330.

88 [5] [6]

[7] [8] [9] [10]

[11]

[12]

[13] [14] [15] [16] [17] [18] [19] [20] [21]

[22] [23] [24]

Robertico R. Croes Butler, R. (1980). The concept of a tourism area cycle of evolution: implications for management resources. The Canadian Geographer 24(1), 5-16. Commonwealth Secretariat (1997). A Future for Small States: Overcoming Vulnerability. Report of a Commonwealth Advisory Group, London: Commonwealth Secretariat. Crase, L. & Jackson, J. (2000). Assessing the effects of information asymmetry in tourism destinations. Tourism Economics 6(4), 321-334. Croes, R. (2000). Anatomy of Demand in International Tourism: the Case of Aruba. Assen: van Gorcum. Croes, R. (2004). Value as a measure of tourism performance in the era of globalization. Tourism Analysis 9(4), 255-267. Croes, R. (2006). A paradigm shift to a new strategy for small island economies: embracing demand side economics for value enhancement and long-term economic growth. Tourism Management 27(3), 453-465. Croes, R. & Severt, D. (2007). Evaluating short-term tourism economic effects in confined economies: conceptual and empirical considerations. Tourism Economics, 13(2), 289-307. Croes, R. & Schmidt, P. (2007), Promoting tourism as U.S. foreign aid: building on the promise of the Caribbean Basin initiative, Journal of Multidisciplinary Research, 1(1), 1-15. Crouch, G., & Ritchie, J. (1999). Tourism, competitiveness, and societal prosperity. Journal of Business Research 44(3), 137–152. Dollar, D. & Wolff, E. (1993). Competitiveness, Convergence, and International Specialization. Cambridge: MIT Press. Durbarry, R. (2004). Tourism and economic growth: the case of Mauritius. Tourism Economics 10(4), 389-401. Dwyer, L., Forsyth, P. & Rao, P. (2000). The price competitiveness of travel and tourism: a comparison of 19 destinations. Tourism Management 21(1), 9-22. Dwyer, L. & Kim, C. (2003), ‘Destination competitiveness: determinants and indicators’, Current Issues in Tourism, 6(5) 369-414. Easterly, W. & Kraay, A. (2000). Small states, small problems? Income, growth and volatility in small states. World Development 28(1), 2013-27. Enright, M. & Newton, J. (2004). Tourism destination competitiveness: a quantitative approach. Tourism Management, 25(6), 777-788. Gooroochurn, N. & Sugiyarto, G. (2005), Competitiveness indicators in the travel and tourism industry, Tourism Economics, 11(1), 25-43. Grassl W. (2003). Why and how to specialize in Tourism: An Agenda for Jamaica. In: The Role of Government in Tourism. McDavid, H. (ed.). University of the West Indies Press: Kingston. Gray, H. (1982). The contributions of economics to tourism. Annals of Tourism Research 9, 105-125. Greenidge, K. & Whitehall, P. (2000). Tourism Maturity and Demand. Caribbean Center for Monetary Studies, 5 &6, 161-189. Harvey, A. (1997). Trends, Cycles, and Autoregressions. Englewood Cliff. NJ: Prentice Hall.

Towards New Metrics to Measure Sustained Competitiveness in the Caribbean

89

[25] Jayawardena C. & Ramajeesingh D. (2003). Performance of tourism analysis: a Caribbean perspective. International Journal of Contemporary Hospitality Management 15(3), 176-179. [26] Johnston, C. (2001). Shoring the foundations of the destination life cycle model, part 1: ontological and epistemological considerations. Tourism Geographies 3(1), 2-28. [27] Kaplan, R. & Norton, D. (1992). The Balanced Scorecard –Translating Strategy into Action. Boston, MA: Harvard Business School Press. [28] Keane, M. (1997). Quality and pricing in tourism destinations. Annals of Tourism Research, 24(1), 117-130. [29] Krugman, P. (1996).Making Sense of the Competitiveness Debate. Oxford review of Economic Policy 12(3), 17-25. [30] Lall, S. (2001). Competitiveness indices and developing countries: an economic evaluation of the competitiveness report. World Development, 29(9), 1501-25. [31] Lanza, A. & F. Pigliaru, (2000). “Why are tourism countries small and fast growing?” In Fossati A.and Panella, G. (eds.). Tourism and Sustainable Economic Development. Dordrecht, Neth.: Kluwer pp 57-69. [32] Maloney W. & Montes Rojas G. (2001). Demand for Tourism. The World Bank: Washington DC. [33] Mak, J. (2003). Tourism and the Economy. Honolulu: University of Hawaii Press. [34] Malcolm, O. (2003). Tourism Maturity and Demand: Jamaica. Bank of Jamaica, mimeo, August. [35] Mazanec, J., Wober, K. & Zins, A. (2007). Tourism destination competitiveness: from definition to explanation. Journal of Travel Research, 46(1), 86-95. [36] Mazzanti, M. (2002). Tourism growth and sustainable economic development: a note on economic issues. Tourism Economics 8(4), 457-462. [37] Modeste N. (1995). The impact of growth in the tourism sector on economic development: the experience of selected Caribbean countries. Economia Internazionale, 48, 375-385. [38] Mules, T. & Faulkner, B. (1996). An economic perspective on special events. Tourism Economics 2(2), 107-117. [39] Papatheodorou, A. & Song, H. (2005). International tourism forecasts: time-series analysis of world and regional data. Tourism Economics 11(1), 11-23. [40] Porter, M. (1990). The Competitive Advantage of Nations. New York: The Free Press. [41] Ritchie, J. & Crouch, G. (2000).The competitive destination: a sustainable perspective. Tourism Management 21, 1-7. [42] Sheenan, L. & Ritchie, J. (1997). Financial management in tourism: a destination perspective. Tourism Economics 3(2), 93-118. [43] Sinclair, M. (1998). Tourism and economic development: a survey. Journal of Development Studies 34(5), 1-54. [44] Vanhove, N. (2005). The Economics of Tourism Destinations. Oxford: Elsevier Butterworth-Heinemann. [45] Whitehall, P. & Craigwell, R. (2006). Does Tourism Potential Influence Tourism Demand in the Caribbean? Paper presented at the Second International Conference on Tourism Economics, Department of Applied Economics, University of the Balearic Islands, Palma de Mallorca, Spain, 18-20 May, 2006.

90

Robertico R. Croes

[46] Wignaraja, G., Lezama, M. & Joiner, D. (2004). Small States in Transition: From Vulnerability to Competitiveness. London: the Commonwealth Secretariat. [47] World Bank (2000). Toward a Caribbean Vision 2020. CGCED: Washington DC.

In: Central Banking and Globalization Editors: M. Cappello and C. Rizzo, pp. 91-114

ISBN: 978-1-60876-056-5 © 2010 Nova Science Publishers, Inc.

Chapter 4

CENTRAL BANKING AND DEFLATIONARY DEPRESSION : A JAPANESE PERSPECTIVE Toichiro Asada∗ Faculty of Economics, Chuo University, Tokyo Japan

Abstract In this paper, we investigate the roles of central banking in the period of deflationary depression both empirically and theoretically, especially in reference to the Japanese economy in the 1990s and the 2000s. In the first part of the paper, we summarize the empirical facts on the inferior macroeconomic performance of the Japanese economy and problematical monetary policy of BOJ (Bank of Japan) in the period of the so-called ‘lost decade’(the 1990s) and the continued deflationary depression period( the 2000s). In the latter part of the paper, we consider some theoretical models which are useful for the interpretation of the above mentioned phenomena.

Keywords: Central banking, deflationary depression, Japanese economy, Inflation expectation, Inflation targeting

“The view that monetary policy is, at least in part, about managing expectations is by now standard fare both in academia and in central banking circles. It is no exaggeration to call this a revolution in thinking.” (Blinder et al. 2008, p. 911) “The profession no longer believes that only unanticipated money matters.” (Blinder et al. 2008, p. 918)

1. Introduction In this paper, we consider the role of central banking in the period of deflationary depression especially in reference to the Japanese economy from the 1990s to the 2000s. ∗ E-mail address: asada @ tamacc.chuo-u.ac.jp

92

Toichiro Asada

Source: Kitasaka (2001) p35.

Figure 1. Nikkei average stock price (E) and Index of land price (R) in Japan (value of R in March 1990 is standardized as 100).

Source: Iwata (2005) p.69 (original data source is the Statistic Bureau and the Cabinet Office of Japan).

Figure 2. Rate of unemployment (u), growth rate of real GDP (g) and rate of inflation of GDP deflator (π) in Japan.

It is well known that Japanese economy fell into the serious depression in the 1990s after the prosperous 1980s which was accompanied by the stock and land bubble(cf. Figures 1 – 2). In the 1990s in Japan, the rate of unemployment steadily rose, and the growth rate of the real GDP declined cyclically. Furthermore, the GDP deflator began to decrease mildly in 1995, and this tendency continued almost every year in the 2000s as well as the late 1990s.∗ This means that the Japanese economy could not get out of the ‘deflationary depression’ during almost 15 years since the mid 1990s.+

∗ In Figure 2, the growth rate of the GDP deflator became positive temporarily in the period 1997 – 1998. This is due to the fact that the Japanese government raised the consumption tax rate in 1997, which turned out to cause the sharp decline of the real growth rate and the increase of the rate of unemployment. + The 1990s was called ‘the lost decade’ in Japan, but in fact the Japanese economy has been experienced the ‘lost twenty years’ during the period 1990s – 2000s.

Central Baning and Deflationary Depression: A Japanese Perspective

93

Source: Harada (2003) p. 173. πc= rate of inflation of consumer price index u = rate of unemployment Q = quarter

Figure 3. Phillips curve in Japan (1980/1Q~2002/2Q).

We can confirm the above mentioned facts from a different point of view by using Figure 3, which is the Phillips curve in Japan during the period 1980 – 2002. In this figure, the nearly vertical left half part corresponds to the prosperous 1980s, and the nearly horizontal right half part corresponds to the deflationary depression period of the 1990s and the early 2000s.€ Japanese economy moved from the northwest position to the southeast position along this nonlinear curve in the period from the 1980s to the early 2000s, and it turned out that even the mild deflation causes the sharp increase of unemployment, so that even the mild deflation is quite dangerous for the national economy(cf. Hamada 2004). Another characteristic of the Japanese economy in the deflationary depression period from the 1990s to the 2000s is that the nominal policy rate of interest that is adopted by the Bank of Japan(BOJ) became nearly zero since the mid 1990s.§ This means that the Japanese economy fell to the difficult situation in which the nominal policy rate of interest stuck to its lower bound. Krugman(1998) called this situation ‘liquidity trap’, and he presented a formal model which arrived at the conclusion that the central bank’s commitment on the sufficiently large positive rate of inflation targeting is effective to get out of the deflationary depression.¥ After Krugman(1998), several authors presented formal models on the effectiveness of the monetary policy in case in which the nominal rate of interest is already fallen to its lower bound ( cf. MacCallum 2000, Reifschneider and Williams 2000, Iwata 2002, Eggertsson and Woodford 2003, Asada 2006, 2008). BOJ opposed strongly against Krugman(1998)’s policy recommendation of inflation targeting, and as a result the Japanese economy is still in the deflationary depression even at the late 2000s. Before 2007, the problem concerning the effectiveness of the monetary policy with the lower bound of the nominal rate of interest was the problem that is peculiar to the Japanese economy, but it became important also for the economies of other countries after the financial € Ironically enough, the shape of the Japanese Phillips curve in Figure 3 is quite similar to that of the original Phillips curve due to Phillips(1958). § BOJ formerly adopted the ‘official discount rate’ as the policy rate of interest, but now(the late 2000s) the ‘call rate’ is playing the role of the policy rate of interest. ¥ As for systematic interpretation of the inflation targeting, see Bernanke et al.(1999) and Ito and Ban(2006).

94

Toichiro Asada

crisis which was caused by the so called ‘sub prime mortgage crisis’ that occurred in USA and rapidly propagated into the world outside USA in 2008, because in 2009 the central banks of several countries such as FRB of USA, Bank of England, ECB of the European Union etc. sharply reduced their nominal policy rates of interest until nearly zero lower bound. In section 2, we explain the so called ‘too late too small’ hypothesis which tries to interpret the inferior macroeconomic performance of the Japanese economy in the 1990s and the 2000s by means of the inferior monetary policy of BOJ empirically as well as theoretically. The theoretical interpretation in section 2 is rather intuitive and elementary textbook-like graphical interpretation. In section 3, we present more rigorous formal dynamic model of inflation targeting by means of the Taylor rule, in which the expectation formation by the public and the speed of central bank’s policy response play the central roles. In section 4, we consider the problem of ‘optimal’ versus ‘permissible’ monetary policies. Finally, in section 5, we observe that our dynamic model is immune from the notorious ‘sign reversal’ which is peculiar to the so called ‘New Keynesian’ dynamic model with rational expectations.

2. ’Too Late Too Small’ Hypothesis of Japanese Monetary Policy : Empirical and Informal Theoretical Analyses Iwata(2005) presented the following interpretation of the ‘great stagnation’ of the Japanese economy in the 1990s and the 2000s, which was called the ‘deflation hypothesis’ by himself in contrast with the problematical ‘structural hypothesis’, which asserts that the vaguely defined ‘structure’ of the Japanese economy suddenly deteriorated in the 1990s. “The drastic monetary restraint by BOJ in 1989 induced the crash of the bubble, which caused the debt deflation. The monetary relaxation by the BOJ in the 1990s and after that was so insufficient that the Japanese economy fell into the trap of the debt deflation. In other words, the deflation in which the price level continues to decline because of the lack of the demand intensified asset deflation and the converse was also true. The occurrence of deflation fixed the deflationary expectation among the people, which induced the further reduction of the demand so that the GDP gap expanded. Then, the rate of capacity utilization of the capital stock decreased and the rate of unemployment increased. These phenomena in fact occurred in the period of ‘great stagnation’ of the 1990s and the 2000s in Japan. This means that the ‘deflationary hypothesis’ is consistent with the actual movement of the Japanese economy.” (Iwata 2005, pp. 81-82, original text is in Japanese)

It seems that this Iwata(2005)’s hypothesis is consistent with the empirical data such as Figures 4 and 5.∗ In particular, Figure 5 compares the movement of the real rate of interest (nominal rate of interest – rate of inflation) in the period 1989 – 1995 in Japan and that in the period 1998 – 2004 in USA. In case of the 1990s in Japan, the decrease of the real rate of interest was quite insufficient even if the nominal rate of interest fell to nearly zero, because of the negative rate of inflation (deflation). On the other hand, in case of the early 2000s in USA, the recession turned out to be relatively mild because of the sufficient reduction of the real rate of interest due to the adequate quick response of FRB.

∗ See also Bernanke(2000) and Harada and Iwata(eds.)(2002).

Central Baning and Deflationary Depression: A Japanese Perspective

95

Source: Kitasaka (2001) p. 86 (original data source is the Bank of Japan).

Figure 4. Official discount rate (r) and growth rate (u) of nominal money supply (M2+CD) in Japan.

Source: Harrigan and Kuttner (2005). ρJ = real rate of interest in Japan = call rate- rate of inflation of core CPL. ρA = real rate of interest in USA = FF rate- rate of inflation of core PCE. Base period (period 0) is 1991 in Japan and it is 2000 inUSA.

Figure 5. Real rates if interest in Japan and USA.

Sadahiro(2005) called de facto same hypothesis as that of Iwata(2005) ‘too late too small’ hypothesis, and he provided an intuitive theoretical interpretation by using a graph such as Figure 6.∗ In Figure 6, the position of the IS curve, which corresponds to the equilibrium condition of the goods market, depends on the public’s expected rate of inflation (π ). If e

π e increases

(decreases), the IS curve shifts upward (downward) because both of the consumption and investment expenditures increase(decrease) when π increases(decreases). Furthermore, it is assumed that the central bank (BOJ) adopts the nominal rate of interest (r ) as a policy e

variable and it accommodates the money supply passively to the level that is consistent with the given nominal interest rate. In this case, the money supply becomes an endogenous variable in the sense that the position of the LM curve, which corresponds to the equilibrium ∗ Figure 6 is an adaptation of the graph in Sadahiro(2005) p. 166. In his graph, LM curves are omitted unlike Figure 6 in this paper.

96

Toichiro Asada

condition of the money market, is determined passively at the level in which it intersects with the IS curve at the given nominal interest rate that is controlled by the central bank.+ Suppose that the initial position of the national economy is located in E 0 of Figure 6, which corresponds to the excessive euphoric business condition. Suppose, next, that the central bank raises the nominal interest rate from r0 to r1 in order to calm the euphoria. Then, the position of the economy moves from E 0 to E1 . However, the output level corresponding to E1 is less than the ‘natural’ output level corresponding to the ‘natural’ rate of unemployment. This means that the recession caused by the central bank’s excessive monetary restraint turns out to be too drastic, and the resulted excess supply situation produces the downward pressure on the actual rate of inflation. If the public forms the inflation expectation adaptively, the expected rate of inflation also decreases and the resulting effect is the downward shift of the IS curve.

r = nominal rate of interest. Y = real national income (real output level). Y* = ‘natural’ real output level corresponding to ‘natural’ rate of unemployment. πe= expected rate of inflation.

Figure 6. Theoretical interpretation of ‘too late too small’ hypothesis.

(π

e 0

> π 1e > 0 > π 2e > π 3e

).

Suppose that the central bank responds to this situation by reducing the nominal rate of interest. If, however, the speed of the monetary relaxation is too slow, the central bank cannot stop the downward shift of the IS curve that is caused by the decrease of the expected rate of inflation. In this case, the economy moves along the trajectory ( A) in Figure 6 until the position of the economy is settled into E 4 , at which the nominal rate of interest is stuck to its + This assumption is consistent with BOJ’s assertion that BOJ cannot control money supply directly because its control variable is not the money supply but the nominal rate of interest. It is also consistent with every type of interest rate policy, which includes the ‘Taylor rule’ due to Taylor(1993).

Central Baning and Deflationary Depression: A Japanese Perspective

97

zero bound and the economy is trapped into the deflationary depression. This situation is nothing but the ‘liquidity trap’ situation which was pointed out by Krugman(1998). On the other hand, if the monetary relaxation by the central bank is sufficiently quick, the economy moves along the trajectory ( B ) in Figure 6, which leads the output level to its ‘natural’ level corresponding to the ‘natural’ rate of unemployment, avoiding the ‘liquidity trap’ that is entailed by the deflationary depression.

Figure 7. Nominal rate of interest.

Figure 8. Growth rate of nominal money supply.

The time trajectories of the main variables corresponding to the cases ( A) and ( B) in Figure 6 are illustrated in Figures 7 – 10. Without doubt, monetary policy is ‘permissible’ in case of ( B), while it is ‘impermissible’ in case of ( A) under the common sense standard of policy evaluation. Unfortunately, however, the time trajectories of the main variables in case of ( A) in Figures 7 – 10 well simulates the empirical data of the Japanese economy in the 1990s and the 2000s, which are summarized by the Figures 1 – 5. This completes the intuitive theoretical explanation of the ‘too late too small’ hypothesis due to Hirosada(2005). Needless to say, we support this hypothesis as a useful tool to explain the deflationary depression of the Japanese economy in the 1990s and the 2000s, because this hypothesis is quite consistent with the empirical data of the Japanese economy.

98

Toichiro Asada

Figure 9. Expected rate of inflation.

Figure 10. Real output (employment).

3. A Formal Theoretical Interpretation by Means of a System of Dynamic Equations In this section, we shall present a formal theoretical model which supports the ‘too late too small’ hypothesis. Our model consists of the following system of equations.∗

Y = Y (r − π e , G,τ ) ; Yr −π =

∂Y ∂Y ∂Y ＜0, YG = ＞0, Yτ = ＜0 e ∂G ∂τ ∂(r − π )

(1)

∗ In this formulation, capital accumulation effect of investment is neglected, so that this is a ‘short run’ model in the sense of Keynes(1936). As for ‘long run’ models with explicit capital accumulation effect, see Asada(2006), Asada(2008), Asada et al.(2003), and Asada et al.(2006).

Central Baning and Deflationary Depression: A Japanese Perspective

99

∂L ∂L ∂L M = L(Y , r , π e ) ; LY = ＞0, Lr = ＜0, Lπ = ＜0 ∂Y ∂r p ∂π e

(2)

π = ε (Y − Y ) + π e ; Y ＞0, ε > 0

(3)

⎧ if α (π − π ) + β (Y − Y ) r = ⎨ ⎩max[0, α (π − π ) + β (Y − Y )] if

r＞0 r=0

π e = γ [θ (π − π e ) + (1 − θ )(π − π e )] ; γ＞0, 0 ≦ θ ≦1

(4)

(5)

where the meaning of the symbols are as follows. Y = real national income(real output)＞0. Y = ’natural’ output level corresponding to the ‘natural’ rate of unemployment(fixed)＞0. G = real government expenditure(fixed)＞0. τ = marginal tax rate(fixed, 0＜τ＜1). M = nominal money supply＞0. p = price level＞0. π = p / p = rate

π e = expected rate of inflation. π = target rate of inflation. r = nominal rate of e interest 0. r − π = expected real rate of interest.

of inflation.

Eq. (1) is the reduced form of the IS equation, which corresponds to the equilibrium condition of the goods market.+ Eq. (2) is the LM equation, which corresponds to the equilibrium condition of the money market. It is convenient to rewrite this equation as follows. Differentiating this equation with respect to time, we have the following equivalent ‘dynamic’ expression of the LM equation.

Y r M π e μ = π + ηY − η r − ηπ e ; μ = Y r M π where

ηY = (

(6)

∂L L ∂L L ∂L L ) /( )＞0, η r = −( ) /( )＞0, and η π = −( e ) /( e )＞0 are ∂Y Y ∂r r ∂π π

elasticities of the real money demand with respect to changes of the real national income, nominal rate of interest and the expected rate of inflation respectively.∗ Eq. (3) is the quite conventional ‘expectations-augmented Phillips curve’. Eq. (4) describes the monetary policy rule of the central bank in spirit of the ‘Taylor rule’. It is assumed that the central bank adopts the nominal rate of interest ( r ) as a policy variable, and the central bank raises or reduces r according to the predetermined policy rule that is specified by Eq. (4). In this equation, the ‘nonnegative constraint’, which means that the nominal rate of interest cannot become negative, is explicitly considered, and it is assumed + In this formulation, it is assumed that the expected rate of inflation affects the aggregate demand only indirectly through the effect of the expected real rate of interest. Even if we consider another root of the direct positive dependence of the aggregate demand on the expected rate of inflation such that

Y = Y (r − π e , π e , G ,τ ),

however, the main qualitative conclusion is unchanged.

∗ Needless to say, in general, these elasticities are not constant but variables.

100

Toichiro Asada

that two policy parameters

α and β are positive. We can consider that this monetary policy

rule means a kind of ‘inflation targeting’ as well as ‘employment targeting’, because it means that the central bank aims at the realization of the ‘target rate of inflation’ (π ) that is announced by the central bank as well as the realization of the ‘natural level of output’ (Y ). Eq. (5) is a formalization of the inflation expectation formation, which is the mixture of the ‘forward looking’ and ‘backward looking’ or ‘adaptive’ expectations.+ The parameter θ is the weight of the ‘forward looking’ expectation formation. If the public strongly believes that the actual rate of inflation will be governed by the target rate of inflation that is announced by the central bank in the long run, we shall have θ = 1. On the other hand, we shall have θ = 0 if the public does not believe the announcement by the central bank or the central bank does not announce the target rate of inflation at all as the case of Japan in the 1990s and the 2000s. Hence, we can consider that the value of the parameter θ reflects the ‘degree of credibility’ of the central bank’s announcement. A system of five equations (1), (3), (4), (5) and (6) can determine the dynamics of five endogenous variables (Y , π , r , π , μ ). Substituting equations (1) and (3) into equations (4) e

and (5), we have the following equations.

⎧ f 1 ( r , π e ; α , β , ε , G ,τ ) if r = ⎨ e ⎩max[0, f1 (r , π ;α , β , ε , G ,τ )] if

r＞0 r=0

π e = f 2 (r , π e ; γ ,θ , ε , G ,τ )

(7)

(8)

where

f 1 (r , π e ;α , β , ε , G ,τ ) = α [ε {Y (r − π e , G ,τ ) − Y } + π e − π ] + β [Y (r − π e , G ,τ ) − Y ], and

G f 2 (r , π e ; γ , θ , ε , G,τ ) = γ [θ (π − π e ) + (1 − θ )ε {Y (r − π e , G,τ ) − Y }]. Substituting equations (1) and (3) into Eq. (6), we obtain the following relationship.

μ = ε {Y ( r − π e , G,τ ) − Y } + π e + η Y

Yr −π (r − π e ) π e r η η − − r π r πe Y ( r − π e , G,τ )

(9)

A system of equations (7), (8) and (9) can determine the dynamics of three variables ( r , π , μ ). But, this system is a decomposable system. In other words, the e

dynamics of r and π are determined by two equations (7) and (8) independent of Eq.(9), and Eq. (9) only plays the role to determine the value of μ . This means that the growth rate e

+ This formulation is due to Asada et al.(2003), Asada(2006), and Asada(2008).

Central Baning and Deflationary Depression: A Japanese Perspective

101

of money supply ( μ ) becomes totally endogenous variable in this model. Therefore, we have only to analyze a two dimensional system of equations (7) and (8). First, let us consider the ‘normal’ equilibrium point such that r = π = 0 and Y = Y . If e

we neglect the nonnegative constraint of r , the values ( r*, π *) at the ‘normal’ equilibrium e

point are determined by the following system of equations.

Y ( r * −π , G,τ ) = Y

(10)

π e* = π* = π

(11)

Substituting equations (10) and (11) into Eq. (9) and considering r = π = 0, we obtain e

the equilibrium value of

μ as follows. μ* = π

(12)

Eq. (10) means that the ‘natural’ output level is realized at the normal equilibrium point. Eq. (11) means that the expected rate of inflation is realized and the realized rate of inflation is equal to the target rate of inflation at the normal equilibrium point. Eq. (12) implies that the growth rate of nominal money supply at the normal equilibrium point is equal to the target rate of inflation. This means that the target rate of inflation that is set by the central bank determines the equilibrium growth rate of money supply and not the other way round in this model. The nominal rate of interest at the normal equilibrium point (r*) is determined as follows. First, the equilibrium real rate of interest ( ρ *) is determined by the following equation.

Y ( ρ *, G,τ ) = Y Solving this equation with respect to

(13)

ρ *, we have

ρ * = ρ * (G,τ ) ;

∂ρ * ∂ρ * ＞0, ＜0. ∂G ∂τ

(14)

Then, we have

r* = ρ * (G,τ ) + π .

(15)

If r * in Eq. (15) is negative, the economically meaningful normal equilibrium point does not exist. The condition r *＞0 is equivalent to the following condition.

π ＞ − ρ * (G,τ )

(16)

102

Toichiro Asada

If G is sufficiently small and/or τ is sufficiently large, the equilibrium real rate of interest ρ * may become negative. In this case, the inequality (16) is not satisfied so that the normal equilibrium point does not exist when the target rate of inflation π is not sufficiently large even if π ＞0. Needless to say, the deflationary biased central bank that selects nonpositive π can easily fail to satisfy the inequality (16). From now on, we assume that in fact the inequality (16) is satisfied so that the equilibrium nominal rate of interest r * is positive. Next, let us investigate the local stability/instability of the normal equilibrium point of the above system. The Jacobian matrix of the system of equations (7) and (8), which is evaluated at the normal equilibrium point, becomes as follows.

⎡f J = ⎢ 11 ⎣ f 21

f 12 ⎤ f 22 ⎥⎦

(17)

where f 11 = (αε + β ) Yr −π ＜0, f 12 = −(αε + β ) Yr −π + α＞0, f 21 = γ (1 − θ ) Yr −π ＜0, ( −)

(−)

( −)

and f 22 = γ [−θ − (1 − θ ) Yr −π ]. Then, we have the following relationships. (−)

traceJ = f 11 + f 22 = {αε + β − γ (1 − θ )}Yr −π − γθ

(18)

det J = f 11 f 22 − f 12 f 21 = −γ {(αε + β )θ + α (1 − θ )}Yr −π ＞0

(19)

(−)

(−)

Let us denote two roots of the characteristic equation Γ(λ ) =

λI − J = 0 as λ1 and

λ 2 . Then, it is easy to show that traceJ = λ1 + λ 2 , det J = λ1λ 2 . Now, we can prove the following result.

Proposition (1) Suppose that the inequality

αε + β＞γ {(

1 Yr −π

− 1)θ + 1}

(20)

(−)

is satisfied. Then, the normal equilibrium point of a system of equations (7), (8) becomes locally asymptotically stable. (2) Suppose that the inequality

Central Baning and Deflationary Depression: A Japanese Perspective

αε + β＜γ {(

1 Yr −π

− 1)θ + 1}

103

(21)

(−)

is satisfied. Then, the normal equilibrium point of a system of equations (7), (8) becomes totally unstable.

(Proof) (1) Suppose that the inequality (20) is satisfied. Then, we have traceJ＜0 and det J＞0, which means that the characteristic equation Γ(λ ) = 0 has two roots with negative real part. This proves the local stability of the equilibrium point. (2) Suppose that the inequality (21) is satisfied. Then, we have traceJ＞0 and det J＞0, which means that the characteristic equation Γ(λ ) = 0 has two roots with positive real part. This proves that the equilibrium point becomes totally unstable.∗ □

Figure 11. Stable region (S) and unstable region (U).

We can illustrate ‘stable region’ ( S ), in which the inequality (20) is satisfied, and ‘unstable region’ (U ), in which the inequality (21) is satisfied, as Figure 11. Incidentally, at the line

AB in Figure 11, we have traceJ = λ1 + λ 2 = 0 and

det J = λ1λ 2＞0, which means that the characteristic equation Γ(λ ) = λI − J = 0 has a pair of pure imaginary roots at that line. This implies that the line AB in this figure is the ‘Hopf bifurcation’ line, and there exist non-constant closed orbits at some range of the ∗ See Gandolfo(1996) for the mathematical theories of dynamic stability/instability of a system of differential equations.

104

Toichiro Asada

parameter values which are sufficiently closed to the line AB. + In other words, the cyclical fluctuations around the normal equilibrium point occur at some range of parameter values which are sufficiently close to that line. We can summarize the results of the above analyses as follows. (1) Suppose that either of the monetary policy parameters

α or β is sufficiently large.

Then, the normal equilibrium point becomes locally asymptotically stable irrespective of the value of the credibility parameter θ ∈ [0,1]. (2) Suppose that the parameter

θ , which reflects the credibility of the inflation targeting

by the central bank, is sufficiently close to 1. Then, the normal equilibrium point becomes locally asymptotically stable irrespective of the values of the policy parameters α＞0 and β ＞0. (3) Suppose that all of the parameters

α＞0, β＞0 and θ ≧ 0 are sufficiently small.

Then, the normal equilibrium point becomes totally unstable. (4) At some intermediate range of the combination of the parameter values (α , β , θ ), the cyclical fluctuations around the normal equilibrium point occur. (5) The increase of the speed of adjustment of the inflation expectation (γ ) induces the expansion of the unstable region in Figure 11. In this sense, the increase of the parameter value γ has a destabilizing effect. The above conclusion (3) implies that the validity of the ‘too late too small’ hypothesis has been proved analytically in this model. Next, let us consider some typical phase diagrams of this system corresponding to various combinations of the parameter values (α , β , θ ). Totally differentiating the equation f 1 = 0 with respect to r , π and rearranging terms, e

we obtain

dπ e 1＞ dr

= − f 11 / f12 ＞0. r = 0

(−)

(22)

(+)

Next, totally differentiating the equation f 2 = 0 with respect to r , π

e

and rearranging

terms, we obtain

dπ e dr

= − f 21 / f 22 . π = 0 e

(−)

(23)

(?)

From these relationships, we have the following result.

+ As for Hopf bifurcation theorem, see Gandoffo(1996) chap. 25 and the mathematical appendix of Asada et al.(2003).

Central Baning and Deflationary Depression: A Japanese Perspective

dπ e dr

− r = 0

dπ e dr

=− π = 0 e

f11 f 22 − f12 f 21 = − (det J )/( f12 f 22 ) f12 f 22 (+) ( + ) (?)

105

(24)

It is worth to note that f 22＞0 is a necessary (but not sufficient) condition for the instability of the normal equilibrium point, and f 22＜0 is a sufficient (but not necessary) condition for the local stability of the normal equilibrium point. Considering the above facts, we can construct the typical phase diagrams such as Figures 12 – 14 corresponding to some typical cases. In these figures, the dotted line

ρ e = ρ * (Y = Y ) corresponds to the natural

output level (natural rate of employment), where interest. On the other hand, we have that line, and we have

ρ e = r − π e is the expected real rate of

ρ e＜ρ * (Y＞Y , over-employment) at the region above

ρ e＞ρ * (Y＜Y , under-employment) at the region below that line in

these figures.

Figure 12. A typical phase diagram in which the normal equilibrium point is globally unstable (f22>f11>0). (αε +β, θ) ∈ U.

Figure 12 is a typical phase diagram in which the normal equilibrium point ( E 0 ) is globally unstable. In this case, there exists an untypical equilibrium point ( E1 ) other than the

106

Toichiro Asada

normal equilibrium point, and both equilibrium points are dynamically unstable. Trajectory abcde " in this figure is a typical trajectory. In this case, initial inflationary boom( the process ab) is converted to the disinflationary recession (the process bc ) and then the deflationary depression (the process cd ), and at last, the economy is stuck to the ‘great stagnation’ with the so called ‘liquidity trap’ (the process de "). This trajectory well simulates the movement of the main variables in the Japanese economy in the 1980s and the 1990s – 2000s.

Figure 13. A typical phase diagram in which the normal equilibrium point is locally stable, but it is not globall stable (-f11>f22>0). (αε +β, θ) ∈ S.

Figure 13 is a typical phase diagram in which the normal equilibrium point is locally stable, but it is not globally stable. In this case, there exists a closed orbit around the normal equilibrium point, and the trajectory converges to the normal equilibrium point when the initial position is inside the closed orbit (inside the ‘corridor’), and the trajectory converges to the deflationary depression with the liquidity trap when the initial position is outside the closed orbit (outside the ‘corridor’). This situation corresponds to the so called ‘corridor stability’, in which the economy at the normal equilibrium point is insensitive to ‘small’ shocks, but it is vulnerable to ‘large’ shocks.∗ Incidentally, the trajectory abcde " in Figure 13 has qualitatively the same properties as those of the trajectory abcde " in Figure 12. ∗ The situation that is depicted in Figure 13 corresponds to the situation in which the Hopf bifurcation is ‘subcritical’(cf. Gandolfo 1996 chap. 25).

Central Baning and Deflationary Depression: A Japanese Perspective

107

Figure 14 is a typical phase diagram in which the normal equilibrium point is globally stable. In this case, the economy can escape from the ‘liquidity trap’ situation such as the points e or d , and the trajectory moves toward the normal equilibrium point. The situation of Figure 14 occurs when f 22＜0. This corresponds to the situation in which

θ is close to 1,

which means that the inflation targeting by the central bank is sufficiently credible. The increase of the ‘credibility’ of the inflation targeting by the central bank changes the phase diagram from Figure 12 to Figure 13, and further increase of the credibility can change it from Figure 13 to Figure 14. This is nothing but the ‘structural change’ or the ‘regime switching’ of the monetary policy.

Figure 14. A typical phase diagram in which the normal equilibrium point is globally stable (f22<0). (αε +β, θ) ∈ S.

4. ’Permissible’ versus ‘Optimal’ Monetary Policies In this section, we shall present the following quite practical criterion of the ‘permissibility’ and the ‘impermissibility’ of the monetary policy by the central bank.

108

Toichiro Asada

Criterion The monetary policy that can avoid the deflationary depression with the ‘liquidity trap’ is permissible, while the monetary policy that cannot avoid it is impermissible. If we apply this criterion to the model in the previous section, the monetary policy is impermissible in case of Figure 12. The monetary policy is permissible only if the initial position is inside the ‘corridor’, and it is impermissible if the initial position is outside the ‘corridor’ in case of Figure 13. Monetary policy is always permissible in case of Figure 14. But, the above criterion says nothing about the ‘optimality’ of the monetary policy. If we want to say something about the ‘optimal’ monetary policy, we must introduce the objective functional of the central bank. Now we shall consider such a typical approach to the ‘optimal’ monetary policy in the context of our model. We can define a typical ‘loss function’, which the central bank is supposed to try to minimize, as follows.

K ∞ L = ∫ {ξ (π − π ) 2 +(1 − ξ )(Y − Y ) 2 }e − ρt dt ; 0＜ξ＜1, ρ＞0

(25)

0

where

ξ and ρ as well as π and Y are constant parameters.

We assume that the central bank selects the time trajectory of the nominal interest rate that minimizes Eq. (25) subject to equations (1), (3), and (5), and the nonnegative constraint of the nominal rate of interest. Then, we can rewrite the optimal problem of the central bank as follows.∗ ∞

Min ∫ [ξ [ε {Y ( r − π e ) − Y } + π e − π ] 2 + (1 − ξ ){Y (r − π e ) − Y }2 ]e − ρt dt r≧0

0

(26)

subject to

π e = γ [θ (π − π e ) + (1 − θ )ε {Y (r − π e ) − Y }] = f 2 (r , π e ).

(27)

In this formulation, the expected rate of inflation (π ) is treated as a state variable, and e

the nominal rate of interest ( r ) is treated as a control variable. We also assume that

γ , θ,

ε , G, and τ are constant parameters. If the central bank can control some of these parameters, the solution of the above problem does not teach us what is the ‘true’ optimal monetary policy. We shall return to this problem later. We can solve this problem by using the ‘Pontryagin’s maximum principle’ as follows (cf. Chiang 1992, Part 3). First, the current value Hamiltonian of this system becomes H ( r , π e , λ ) = ξ [ε {Y (r − π e ) − Y } + π e − π ] 2 + (1 − ξ ){Y (r − π e ) − Y }2 + λf 2 ( r , π ) e

(28)

∗ This formulation is somewhat similar to Taylor(1989)’ s formulation of the optimal monetary policy. See also Chiang(1992) chap. 2.

Central Baning and Deflationary Depression: A Japanese Perspective

109

where λ is a costate variable. Then, a set of necessary conditions of optimality becomes as follows together with Eq. (27).

Min H for all t ≧ 0

(29)

r≧0

λ = ρλ −

∂H ∂π e

(30)

lim π e λe − ρt = 0

(31)

t →∞

Solving Eq. (29) with respect to λ and substituting it and Eq. (27) into Eq. (30), we have the following complicated nonlinear differential equation with respect to the control variable

(r ). r = ϕ (r , π e )

(32)

A set of two dimensional differential equations (27) and (32) together with the ‘transversality condition’ (31) defines the optimal solution of this model. The complicated differential equation (32) defines the ‘optimal Taylor rule’ in this model. We can show that the equilibrium solution of this system is the same as the ‘normal equilibrium’ solution of the model in the previous section such that

π e = π = π and

Y = Y , and the equilibrium with positive nominal rate of interest exists if the value of the target rate of inflation (π ) is positive and sufficiently large. Furthermore, we can show under reasonable conditions that the equilibrium point becomes a saddle point, which means that the characteristic equation of this system at the equilibrium point has one positive real root and one negative real root. The meaning of this result is as follows. In this model, the expected rate of inflation (π ) is treated as a state variable, so that the e

central bank cannot select the initial condition

π e (0) freely. On the other hand, the nominal

rate of interest ( r ) is treated as a control variable or the so called ‘jump variable’, so that it can select the initial condition r (0) freely. Suppose that

π e (0) is given at some value other

than its equilibrium value (π ). In this case, there exists only one initial condition r (0) that ensures the convergence to the equilibrium point, and all of the other initial conditions of r entail the divergence of the system from the equilibrium point. However, the transversality condition (31) is satisfied only in the convergent path, so that the monetary policy is optimal only if the central bank selects the initial condition r (0) which ensures the convergence to the normal equilibrium point. In this case, the deflationary depression with the ‘liquidity trap’ is avoided. This means that the above mentioned ‘optimal’ monetary policy is one of the ‘permissible’ monetary policies. However, it is highly impractical for the central bank to stick to such an ‘optimal’ monetary policy because of the following reasons. First, it is virtually impossible to know the

110

Toichiro Asada

correct parameter values as well as the correct functional forms in the equations (1), (3), and (5), which must be used as the constraints when the central bank derives the ‘optimal’ monetary policy rule. Second, some parameter values, in particular, the parameter values of the public’s expectation formation equation, may change responding to the central bank’s monetary policy in an unexpected way for the central bankers.∗ In these cases, the so called ‘optimal’ monetary policy rule is not in fact optimal. On the other hand, the simple Taylor type monetary policy rule that is formulated in Eq. (4) in the previous section does not burden the central bankers with accurate knowledge concerning the ‘correct’ economic structure. Nevertheless, the monetary policy can be ‘permissible’ rather than ‘optimal’ in wide range of the combinations of the parameter values, and the monetary policy rule in the region S , which is not on the line AB in Figure 11, is ‘robust’ in the sense that the small changes of the parameter values do not affect the qualitative conclusion concerning the ‘permissibility’ of the monetary policy. Therefore, the practical way to design monetary policy in a world with imperfect knowledge is to pursue the ‘permissible’ rather than ‘optimal’ policy. Needless to say, the monetary policy in Japan in the 1990s and the 2000s was ‘impermissible’ in reference to our practical criterion.

5. On The Problem of ‘Sign Reversal’ in the ‘New Keynesian’ Dynamic Model The model that has been developed in this paper is somewhat resemble to the so called ‘New Keynesian’ dynamic model which was developed by Woodford (2003), Galí (2008) and others. However, there are some important differences in these models. The most important difference is that our model is immune from the notorious ‘sigh reversal’ problem of the ‘New Keynesian’ Phillips curve, which was pointed out by Mankiw (2001) and later discussed by Asada et al. (2006) and Flaschel and Schlicht(2006). A typical ‘New Keynesian’ Phillips curve is expressed by the following type of the stochastic difference equation (cf. Woodford 2003 and Galí 2008).

π t = ε (Yt − Y ) + E t π t +1 + ς t ; ε＞0 where

(33)

ς t is a random variable and Et π t +1 is the expected value of the rate of inflation at the

period t + 1 that is expected by the public at the period t. In the typical ‘New Keynesian’ model, the ‘rational expectation hypothesis’ concerning the rate of inflation is adopted, which is equivalent to assume ‘perfect foresight’ ( E t π t +1 = π t +1 ) if there is no stochastic disturbance. For simplicity of exposition, let us assume that there is no stochastic disturbance (ς t = 0). Then, we can rewrite Eq. (33) as

π t = ε (Yt − Y ) + π t +1 ∗ This fact is somewhat related to the so called ‘Lucas critique’ (cf. Lucas 1976).

(34)

Central Baning and Deflationary Depression: A Japanese Perspective

111

or equivalently,

Δπ t = π t +1 − π t = ε (Y − Yt ) ; ε＞0.

(35)

If we approximate this difference equation by the continuous time model, we have the following differential equation (cf. Asada et al. 2006 and Flaschel and Schlicht 2006).

π = ε (Y − Y ) ; ε＞0

(36)

This equation means that the rate of inflation accelerates whenever the actual output level is below the natural output level (the actual rate of unemployment is above the natural rate of unemployment), and it decelerates whenever the actual output level is above the natural output level (the actual rate of unemployment is below the natural rate of unemployment). As Mankiew (2001) correctly pointed out, this property of the ‘New Keynesian’ Phillips curve apparently contradicts the empirical facts of the most countries such as USA, Japan, UK, Germany, Korea and other European and Asian countries. This is the notorious ‘sign reversal’ problem of the ‘New Keynesian’ Phillips curve.∗ Mankiw (2001) wrote as follows. “Although the new Keynesian Phillips curve has many virtues, it also has one striking vice: It is completely at odds with the facts. In particular, it cannot come even close to explaining the dynamic effects of monetary policy on inflation and unemployment. This harsh conclusion shows up several places in the recent literature, but judging from the continued popularity of this model, I think it is fair to say that its fundamental inconsistency with the facts is not widely appreciated.” (Mankiw 2001, p. C52)

It is worth to note that this Mankiw’s comment is appropriate even in 2009. Incidentally, in ‘New Keynesian’ dynamic model there is another type of ‘sign reversal’, although it was not pointed out by Mankew(2001), Asada et al.(2006), and Flaschel and Schlicht(2006). A typical ‘New Keynesian IS curve’ is represented by the following equation if we ignore the stochastic disturbance for simplicity (cf. Woodford 2003 and Galí 2008).

Yt = Et Yt +1 − δ (rt − E t π t +1 − ρ *) ; δ＞0 where

(37)

ρ * is the equilibrium real rate of interest. Under the rational expectation hypothesis,

we have E t Yt +1 = Yt +1 and in this case Eq. (37) is reduced to the following equation.

ΔYt = Yt +1 − Yt = δ (rt − E t π t +1 − ρ *) ; δ＞0

(38)

This equation means that the real output continues to increase whenever the actual expected real rate of interest is above the equilibrium real rate of interest, and it continues to decrease whenever the actual expected real rate of interest is below the equilibrium real rate ∗ See also Asada et al.(2006) and Flaschel and Schlicht(2006) as for the related topics.

112

Toichiro Asada

of interest. Apparently, this also contradicts the empirical facts of most countries. The combination of equations (35) and (38) supplemented by a standard Taylor rule produces quite paradoxical and unconvincing behaviors of the main macroeconomic variables. Apart from the ‘sign reversal’ problem, Mankiw(2001) pointed out that the ‘New Keynesian’ dynamic model contradicts another empirical fact that the effect of monetary policy on inflation is ‘delayed and gradual’, because in ‘New Keynesian’ dynamic model the rate of inflation is treated as a ‘jump variable’ rather than the ‘state variable’ which cannot jump. Mankiw (2001) wrote as follows. “In these models of staggered price adjustment, the price level adjusts slowly, but the inflation rate can jump quickly. Unfortunately for the model, that is not what we see in the data.” (Mankiw 2001, p. C54)

As Mankiw (2001), Asada et al. (2006), and Flaschel and Schlicht (2006) pointed out, these paradoxical properties of the ‘New Keynesian’ dynamic model comes from the ‘forward looking’(rational expectation) nature of the model combined with the special ‘New Keynesian’ dating of the variables. As Mankiw (2001) pointed out, such paradoxical behaviors do not occur in the ‘backward looking’(adaptive expectation) model. In the model that was formulated in section 3 of this paper, such paradoxical counterfactual behaviors do not occur because our modeling strategy is more traditional than ‘New Keynesian’ modeling strategy. In this model, the actual and expected rates of inflation as well as the nominal rate of interest are treated as the state variable, although some ‘forward looking’ aspects of the inflation expectation formation as well as the ‘backward looking’(adaptive expectation) aspects are considered. In other words, in our model the initial conditions of these variables are historically given and the adjustment occurs gradually, and there is no ‘jump’ variable. Nevertheless, it is possible to analyze the effects of the sudden ‘structural change’ or the ‘regime switching’ of monetary policy by using this model in the following way. Suppose that some of the monetary policy parameters or the parameters of the inflation expectation formation equation changes discontinuously. Then, the phase diagram of the dynamical system changes discontinuously, and the behaviors of the main variables change without any ‘jump’. In fact, this was our main theme of the analysis in section 3 of this paper.

Acknowledgment This research was financially supported by the Japan Society for the Promotion of Science (Grant-in Aid (C) 20530161) and Chuo University. Needless to say, however, only the author is responsible for possible remaining errors.

References [1]

Asada, T. (2006): “Inflation Targeting Policy in a Dynamic Keynesian Model with Debt Accumulation: A Japanese Perspective.” In Chiarella, Franke, Flaschel and Semmler (eds.) pp. 517-544.

Central Baning and Deflationary Depression: A Japanese Perspective [2]

[3]

[4] [5]

[6] [7]

[8] [9] [10] [11]

[12] [13] [14] [15] [16] [17]

[18] [19] [20] [21] [22]

113

Asada, T. (2008): “Inflation, Deflation and Employment : A Macrodynamic Approach.” In D. T. Bentley and E. P. Nelson (eds.) Inflation: Roles, Targeting, and Dynamics, Nova Science Publishers, New York, pp. 77-99. Asada, T., P. Chen, C. Chiarella and P. Flaschel (2006): “Keynesian Dynamics and the Wage-Price Spiral: A Baseline Disequilibrium Model.” Journal of Macroeconomics 28, pp. 90-130. Asada, T., C. Chiarella, P. Flaschel and R. Franke (2003): Open Economy Macrodynamics; An Integrated Disequilibrium Approach. Springer, Berlin. Bernanke, B. (2000): “Japanese Monetary Policy: A Case of Self-Induced Paralysis?” In R. Mikitani and A. Posen (eds.) Japan’s Financial Crisis and its Parallels to U. S. Experience, Institute for International Economics, Washington D. C. Bernanke, B., T. Laubach, F. Mishkin and A. Posen (1999): Inflation Targeting: Lessons from the International Experience. Princeton University Press, Princeton. Blinder, A. S., M. Ehrmann, M. Fratzscher, J. De Haan, and D. J. Jansen (2008): “Central Bank Communication and Monetary Policy: A Survey of Theory and Evidence.” Journal of Economic Literature 46, pp. 910-945. Chiang, A. (1992): Elements of Dynamic Optimization. McGraw-Hill, New York. Chiarella, C., R. Franke, P. Flaschel and W. Semmler (eds.) (2006): Quantitative and Empirical Analysis of Nonlinear Dynamic Macromodels. Elsevier, Amsterdam. Eggertsson, G. S. and M. Woodford (2003): “The Zero Bound on Interest Rates and Optimal Monetary Policy.” Brookings Papers on Economic Activity 1, pp. 139-233. Flaschel, P. and E. Schlicht (2006): “New Keynesian Theory and the New Phillips Curves: A Competing Approach.” In Chiarella, Franke, Flaschel and Semmler (eds.) pp. 113-145. Galí, J. (2008): Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework. Princeton University Press, Princeton. Gandolfo, G. (1996): Economic Dynamics (Third Edition). Springer, Berlin. Hamada, K. (2004): “Policy Making in Defrationary Depression.” Japanese Economic Review 55, pp. 221-239. Harada, Y. (2003): When will the Great Stagnation in Japan End? Nihon Hyoron-sha, Tokyo. (in Japanese) Harada, Y. and Kikuo Iwata (eds.) (2002): Empirical Analysis of the Deflationary Depression. Toyo Keizai Shinpo-sha, Tokyo. (in Japanese) Harrigan, J. and K. Kuttner(2005): “Lost Decade in Translation : Did US Learn from Japanese Post-Bubble Mistakes?” in T. Ito, H. Patrick and D. Weinstein (eds.) Reviving Japan’s Economy: Problems and Prescriptions, MIT Press, Cambridge, Massachusetts. Ito, T. and T. Ban (2006): Inflation Targeting and Monetary Policy. Toyo Keizai Shinpo-sha, Tokyo. (in Japanese) Iwata, Kazumasa (2002): “Possibility of the Occurrence of the Deflationary Spiral.” In Komiya and Research Center of Japanese Economy (eds.) pp. 121-156. (in Japanese) Iwata, Kikuo (2005): Learning Japanese Economy, Chukuma Shobo, Tokyo. (in Japanese) Keynes, J. M. (1936): The General Theory of Employment, Interest and Money. Macmillan, London. Kitasaka, S. (2001): Introduction to Modern Japanese Economy, Toyo Keizai Shinposha, Tokyo. (in Japanese)

114

Toichiro Asada

[23] Komiya, R. and Research Centor of Japanese Economy (eds.) (2002): Issues of the Controversy on Monetary Policy. Nihon Keizai Shinbun-sha, Tokyo. (in Japanese) [24] Krugman, P. (1998): “It’s Baaack: Japan’s Slump and Return of the Liquidity Trap.” Brookings Papers on Economic Activity 2, pp. 11-114. [25] Lucas, R. (1976): “Economic Policy Evaluation: A Critique.” In K. Brunner and A. Meltzer (eds.) The Phillips Curve and Labor Markets, Carnegie-Rochester Conference Series, Vol. 1, North-Holland, Amsterdam, pp. 19-46. [26] MacCallum, B. T. (2000): “Theoretical Analysis Regarding Zero Lower Bound on Nominal Interest Rates.” Journal of Money, Credit and Banking 32, pp. 870-904. [27] Mankiw, G. (2001): “The Inexorable and Mysterious Tradeoff between Inflation and Unemployment.” Economic Journal 111, pp. C45-C61. [28] Phillips, A. W. (1958): The Relation between Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861 – 1957.” Economica 25, pp. 283- 299. [29] Reifschneider, D. and J. C. Williams (2000): “Three Lessons for Monetary Policy in a Low-Inflation Era.” Journal of Money, Credit and Banking 32, pp. 936-966. [30] Sadahiro, A. (2005): Macroeconomic Analysis of Post War Japanese Economy. Toyo Keizai Shinpo-sha, Tokyo. (in Japanese) [31] Taylor, D. (1989): “Stopping Inflation in the Dornbusch Model: Monetary Policies with Alternate Price-Adjustment Equations.” Journal of Macroeconomics, Spring pp. 199216. [32] Taylor, J. B. (1993): “Discretion versus Policy Rules in Practice.” Carnegie-Rochester Conference Series on Public Policy Vol. 39, pp. 195-214. [33] Woodford, M. (2003): Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton University Press, Princeton.

In: Central Banking and Globalization Editors: M. Cappello and C. Rizzo, pp. 115-128

ISBN: 978-1-60876-056-5 © 2010 Nova Science Publishers, Inc.

Chapter 5

CENTRAL BANK INDEPENDENCE IN WORDS AND IN DEEDS: LESSONS FROM BRAZIL AND CHILE Taeko Hiroi∗ and Douglas Block+ Department of Political Science, The University of Texas at El Paso El Paso, Texas, USA

Abstract Political independence of the central bank is considered to bring financial stability to a nation and therefore to foster economic growth by providing safe investment environments. However, granting a central bank autonomy is politically contentious because of the implications such independence will entail for politicians in terms of their ability to influence monetary policy. This chapter analyzes central bank independence in words and in deeds. The first part discusses the existing literature on central bank independence and problems associated with its measurement. The implications of this debate are analyzed with two Latin American countries, Brazil and Chile. In Brazil, the difficulty in reaching a political consensus on granting the central bank formal independence has led the government to confer “operational” independence since the mid-1990s. Despite the improvement in the financial stability of the country, the Brazilian central bank remains politically vulnerable because its independence is not guaranteed by the constitution, and the credibility of prudent monetary policy is not strong enough to deter speculative attacks in critical moments. The Brazilian experience is then contrasted with the Chilean case in which the central bank’s independence is constitutionally guaranteed.

I. Introduction Central bank independence is one of the major areas of research in political economy. A common belief suggests that a politically independent central bank brings about price stability. Alesina and Summers’ (1993) figure showing an almost perfect inverse relationship between inflation and the degree of legal central bank independence among industrial ∗ E-mail address: [email protected]. + E-mail address: [email protected].

116

Taeko Hiroi and Douglas Block

countries is quite famous. Some even argue that the effects of central bank independence reach beyond inflation control to promote performance in such areas as economic growth, exchange rate stability, and fiscal discipline of the government, although such relationships are still disputed. At the heart of the improved economic performance that independent central banks bring about lie the constraints imposed upon opportunistic or ideologically motivated politicians. Succinctly, independent central banks deter political business cycles based on the use of monetary instruments either by preventing expansionary monetary policy before elections (Nordhaus 1975; Clark and Hallerberg 2000) or by easing partisan effects on policy following elections (Hibbs 1977; Alesina and Roubini 1997). If monetary policy is in the hands of politically insulated conservative central bankers (Rogoff 1985), the society will enjoy low and stable inflation regardless of electoral or partisan cycles. According to Fischer (1995, 201), “The case [for central bank independence] is a strong one, which is becoming part of the Washington orthodoxy.” Indeed, developing countries with episodes of high and hyper inflation have been advised to make their central banks independent to gain much desired economic stability. But what kind of independence should they pursue? The question of central bank independence is not as straightforward as it may appear at first. Since the 1990s, scholars have attempted to examine two dimensions of central bank independence—de jure and de facto—and the effects of each on policy outcomes. At first there was a strong focus on legal independence. However, scholars began looking beyond statutory provisions to analyze the actual behavior of central banks with the recognition that while a central bank may be independent in law, it may be politically controlled in practice. This problem may be particularly pronounced in developing countries where institutions are generally weak. This chapter examines central bank independence in words and in deeds. The next section reviews the debate on central bank independence and problems associated with its measurement. The implications of this debate are analyzed with two Latin American countries. We first examine the case of Brazil, a country that has gone through numerous economic instabilities and stabilization programs. Since the 1990s, Brazilian policymakers have been discussing central bank independence as a key component of financial stability in the country. Yet the difficulty in reaching a political consensus on granting the central bank formal independence has led the government to confer “operational” independence since the mid-1990s. Despite the improvement in the financial stability of the country, the Brazilian central bank remains politically vulnerable because its independence is not guaranteed by the constitution, and the credibility of prudent monetary policy is not strong enough to deter speculative attacks during critical moments. The Brazilian experience is then contrasted with the Chilean case in which the central bank’s independence was constitutionally guaranteed by the military government two months prior to Chile’s return to democratic rule in 1990. Initially the democratic opposition threatened to repeal the law giving broad autonomy to the central bank. However, low inflation and stable economic growth have helped the bank maintain a high level of de jure and de facto independence while weathering a massive scandal that led to the resignation of the central bank governor in 2003.

Central Bank Independence in Words and in Deeds

117

II. Central Bank Independence in Words and in Deeds A central difficulty in examining the effects of central bank independence on economic performance is measuring the independence of the central bank. Cukierman (1992) notes that central bank independence depends on a variety of legal and non-legal factors. However, because it is difficult to measure informal characteristics, such as the personality of key bank employees, a large body of scholarly work on central bank independence has focused on legal independence. Additionally, measuring legal independence allows researchers to analyze how much independence the legislators actually wanted to give the central bank (Cukierman, Webb, and Neyapti 1992). One of the first measures of legal central bank independence was created by Alesina (1988, 1989). This measure, which builds on Bade and Parkin’s (1988) pioneering work of central bank independence, focuses primarily on political independence based on the following criteria: appointment of board members, the presence of government officials on the central bank’s governing board, informal contact between the government and the central bank, and the presence of laws requiring the central bank to accommodate the government’s fiscal policies. Each component is then given a score ranging from 1, indicating the least independent, to 4, the most independent. In contrast to Alesina, Grilli, Masciandaro, and Tabellini (1991) classify central bank independence based on two categories: political independence and economic independence. Political independence is defined as “the capacity to choose the final goal of monetary policy” while economic independence is “the capacity to choose the instruments with which to pursue these goals” (1991, 366). The aggregate category of political independence is based on the appointment of board members, the board’s relationship with the government, and the bank’s formal responsibilities. Meanwhile, economic independence is based on the government’s influence in determining how much it can borrow from the central bank and the monetary instruments available to it. In theory, each bank has the potential to score 8 points in both the political independence and monetary independence categories. In the study, actual scores range from 3 to 13. Although Grilli, Masciandaro, and Tabellini’s measure of central bank independence is more encompassing than Alesina's index, broad generalizations may inflate the value of political independence. For example, one question asks whether or not the entire central bank board was appointed by the government. However, rather than creating a numerical score based on the percentage of board members who are appointed by the government, they code the question as a dummy variable. It is therefore impossible to differentiate between a bank where a single board member is a political appointee and a bank where all board members except for one are political appointees. A third index of central bank independence, which was developed by Cukierman (1992) and Cukierman, Webb, and Neyapti (1992), measures independence using 16 variables nested in four broad categories: (1) the appointment, dismissal, and term of office of the bank's chief executive officer, (2) policy formation, (3) objectives stated in the legal charter, and (4) limitations on lending to the government. Each variable is initially coded on a uniform scale of 0 (lowest level of independence) to 1 (highest level of independence). They are subsequently aggregated into a single index of independence based on different weights. We

118

Taeko Hiroi and Douglas Block

should note that there is little information about how the authors came to decide on different weights for the index's components. This review of three respected measures of legal central bank independence shows that while the concept seems simple at first, it is actually quite difficult to measure. This is further reflected in Eijffinger and Haan’s (1996) findings that there is a low degree of correlation among the three measures of legal independence.∗ They argue that two key factors explain this divergence. First, because scholars are more familiar with certain countries, they will interpret relevant banking laws differently. Second, each measure focuses on different aspects of legal independence. For example, Eijffinger and Schaling (1993) argue that Grilli, Masciandaro, and Tabellini’s measure is weak because it has too many variables that erode the value of the most important elements of central bank independence. Overall, this indicates that studies utilizing these measures of legal independence should be viewed with caution since there is no consensus on how to measure legal autonomy. Another question concerns actual behavior of central banks. Although there is a certain advantage in examining the degrees of independence explicitly written into law, one should not presume that central banks always have the level of independence accorded to them legally. While legal status may be a good indicator of central banks’ actual independence in advanced industrial democracies, it may not be an accurate indicator of effective independence in many developing countries. In general, institutions and the rule of law are much feebler in developing countries than in advanced industrial democracies. Consequently, a central bank that is independent on paper may not deter electorally or partisan induced monetary cycles because it is in fact politically controlled. Moreover, many central bank laws are either imprecise or incomplete (or both), which leaves much room for interpretation. As such, we must pay close attention to the actual behavior of central banks as well as their statutory status. In the end, “There is no theory that says it matters what the rules say. There is only a theory that says it matters what the behaviour is” (Forder 1996, 44). Few people would dispute with such a statement, but the greater challenge is: how do we measure it? Measuring actual, rather than formal, central bank independence is quite complicated. As Cukierman, Webb, and Neyapti (1992, 355) state, actual independence depends “not only on the law, but also on many other less structured factors, such as informal arrangements between the bank and other parts of government, the quality of the bank’s research department, and the personality of key individuals in the bank and the (rest of the) government.” One of the most commonly used proxies for actual central bank independence was developed by Cukierman (1992) and Cukierman, Webb and Neyapti (1992). The Cukierman measure is based on the turnover rate of central bank governors.+ Its underlying assumption is that politically vulnerable central banks will have their governors replaced frequently before they complete their legally defined term limits (if there are any). One would also expect that bank governors replaced simultaneously with or shortly after changes in the

∗ The correlation between the Alesina and Grilli, Masiandaro, and Tabellini indices was only .58 and the unweighted correlation between the Alesina and Cukierman indices was .38 (Eijffinger and Haan 1996, 25). + Cukierman also proposed a measure based on a survey of central bank staff (Cukierman 1992) and another indicator called political vulnerability defined as the percentage of political transitions followed within 6 months by the replacement of the central bank governor (Cukierman and Webb 1995). However, the measure based on central bank governors’ turnover rates is the most commonly used proxy for actual degrees of central bank independence.

Central Bank Independence in Words and in Deeds

119

government would have lower independence than governors who serve across different administrations. An example may help illustrate the relationship between turnover rates and central bank independence. The Argentine central bank, at least on paper, is one of the most independent banks in Latin America and its governor’s legal term is four years. However, there is an informal tradition that a central bank governor resigns whenever there is a change of the government, or even a change of the finance minister. In Cukierman’s study, governors’ actual terms of office averaged only 10 months during the 1980s (Cukierman 1992, 369). This example suggests that turnover rates may be a good indicator of actual independence. In fact, Cukierman (1992) and Cukierman, Webb, and Neyapti (1992) find that turnover rates explain well cross-country variation in inflation between 1950 and 1989 in a sample comprised of both developed and developing countries. In contrast, formal independence is inversely related to inflation in industrial democracies, but not in developing countries. Although the Cukierman measure may represent the current state of art in assessing actual central bank independence, it is not a perfect measure. Its most serious drawbacks are that, as is often the case with any aggregate data, it may be insensitive to cross-national and longitudinal variations. For instance, central bank independence based on governors’ turnover rates requires one to average the rates over certain period of time—in the study by Cukierman (1992) and Cukierman, Webb, and Neyapti (1992), the averages are for a ten-year period. As a result, the measure will not capture variation during this time frame. Central bank governors may also stay in office for different reasons in different countries. Although turnovers of central bank governors may be low in some countries because governments are constrained from intervening in bank affairs, central bank governors in other countries may stay in office because they do whatever is necessary to please the governments. In the latter case, turnover rates are low precisely because central banks are subservient (de Haan and Kooi 2000, 646, footnote 2). Perhaps as a result of the imprecise measures of central bank independence by either statute reading or turnover rates, recent research on the relationship between central bank independence and macroeconomic outcomes (such as inflation) has been inconclusive (de Haan and Kooi 2000). The question of de jure versus de facto independence also has policy implications. Most importantly, many economically unstable countries are advised to make their central banks independent to achieve low and stable inflation and to help establish credibility in governments’ commitments to sound macroeconomic policy. But to what extent is legal independence relevant? What causes the gap between legal and actual levels of independence? If all that is needed is de facto independence, policymakers of these countries may well avoid going through the cumbersome legislative process to enact the bank’s legal status change, which often involves a constitutional change. However, it is our contention that even though informal independence may help promote economic stability in the short run, such status without formal backing keeps central bankers vulnerable to political pressures. Therefore, macroeconomic policy in these countries will not have strong credibility, and any signs of economic or political problems can trigger exaggerated fears about their economic prospects, as the Brazilian experience shows.

120

Taeko Hiroi and Douglas Block

III. Central Bank Independence and Macroeconomic Performance in Brazil The late 20th century witnessed a wave of major economic reforms in Latin America. During the 1990s, after recurrent high and hyper inflation and economic stagnation, a number of Latin American countries introduced legislation aimed at increasing central bank independence (Jácome and Vázquez 2005). Like many of its neighbors, the Brazilian government, particularly under President Cardoso (1995-2002), sought to reform the country’s constitution to promote monetary stability. However, the difficulty in reaching a political consensus on granting the central bank formal independence led the government to confer “operational” independence in the mid-1990s. Despite the improvement in the financial stability of the country, the Brazilian central bank (Banco Central do Brasil, or BCB) remains politically vulnerable because its independence is not guaranteed by the constitution and the credibility of prudent monetary policy is not strong enough to deter speculative attacks during critical moments. This section discusses central bank independence, monetary policymaking, and economic performance since Brazil’s return to democracy in 1985. Originally established in December 1964, the degree of the BCB's effective independence has changed over time as the institution’s roles have been redefined. Many scholars argue that independent central banks should focus on preserving price stability as their primary objective and should not be required to finance governments’ fiscal deficits (e.g., Grilli, Masciandaro, and Tabellini 1991). However, until recently the BCB assumed many responsibilities that one would not expect an independent bank to perform. Until 1986, Brazil had no treasury department in the Ministry of Finance. The BCB therefore performed the tasks of the National Treasury and worked with the Ministry of Finance. It was also possible for the government to influence the money supply directly during the first year of the Sarney administration (1985-90). During this period, there existed an account called the “movement (or monetary) account” in the BCB through which the central bank supplied funds to the state-controlled Banco do Brasil that in turn provided credit lines for government programs. In 1986, this account was extinguished, the Secretariat of National Treasury was finally established, and the national budget accounts were unified.∗ In return, the BCB began to issue notes and bonds that year. Although the Bank was relieved from acting as the Treasury,+ these changes did not grant the central bank much independence. One aspect of central bank independence concerns appointment and dismissal of the central bank governor and board of directors. In Brazil, the central bank governor serves at the pleasure of the president. The president of the republic appoints the central bank governor and directors, and the national Senate confirms the nominations. There are no fixed terms for these positions and the president alone can dismiss the governor for policy or other subjective reasons. Between 1985 and 1995, Brazil had 15 central bank governors (excluding 3 interim positions), averaging 1.4 new governors per year! The Bank’s missions also mounted to 22 items, ranging from price stability to economic growth and the government frequently intervened in BCB affairs. For example, President ∗ Before the unification of the national budget accounts, there were at least three such accounts that were not centrally controlled, which made it difficult to monitor and control the national budget. + The 1988 Constitution prohibits BCB lending to the National Treasury.

Central Bank Independence in Words and in Deeds

121

Itamar Franco fired BCB Governor Paulo Cesar Ximenes Alves Ferreira (March 26 – September 9, 1993) over a dispute on the treatment of pre-dated checks (Hiroi 2009). Whether in legal or effective terms, the BCB was not politically or operationally independent. Today, the Bank has two missions: price stability and stability of financial institutions (Hiroi 2009). Although there was no legal change in the BCB statute, the Bank enjoyed much independence during the two terms of the Cardoso government. Monetary policymaking occurred in the National Monetary Council (Conselho Monetário Nacional) presided over by the Minister of Finance in which the BCB governor participated with a vote.∗ The Council determined monetary policies in the meeting held during the last week of every month. The BCB then executed these policies without government interference. Hence, the BCB gained “operational independence” from the government. In fact, President Cardoso never called BCB Governor Armínio Fraga for the purpose of intervening in the bank's operation (Hiroi 2009). Scholarly work also attests to the BCB’s increased autonomy. Holanda and Freire (2002), for instance, measured BCB independence based on economic outcomes and found that there has been a tendency for an increase in independence since 1994. The Cardoso government sought to institutionalize the BCB's independence by granting the central bank governor fixed tenure that would not coincide with political cycles, but such a move required a constitutional amendment. With fierce opposition from leftist parties and without the prospect for securing the three-fifths vote required for a constitutional amendment, the proposal muddled through Congress very slowly, and it was never voted on in the Chamber of Deputies during Cardoso's two terms.+ During 2002, with the victory of the left-wing Workers’ Party's candidate in the presidential race seeming unavoidable, preserving central bank independence earned during the Cardoso presidency gained renewed attention, but no proposal was formally approved by Congress. After taking office in January 2003, President Luiz Inácio Lula da Silva and his economic team pursued remarkably conservative economic policies both to fight inflationary pressures and to gain investors’ confidence. Granting the BCB formal independence was one of them. With the support of the Lula government and opposition parties, Congress approved and promulgated a constitutional amendment to Article 192 on financial institutions in May 2003, thereby opening a door towards granting formal independence to the Bank. Yet, the Lula government found strong opposition within its legislative coalition, especially the president’s own Workers’ Party and other leftist parties. As such, despite many talks about central bank autonomy, the government did not vigorously pursue its realization. During this period, segments of Congress and even Lula's vice president made public demands that the BCB lower interest rates set high to offset inflationary pressures. BCB Governor Henrique de Campos Meirelles was also under constant attack in a series of scandals that allegedly involved him. Then in August 2004 President Lula issued a decree (Medida Provisória no. 207) granting the central bank governor the status of a minister. The national press reported that Lula issued the decree to protect the BCB governor.¥ However, ∗ This continues to be the structure of monetary decision making under President Lula (2003-06; 2007-present). + The author of the proposal was José Serra, Cardoso's key ally in the Senate before he joined the government. Serra proposed the bill in November 1997 and the Senate approved it in 1999, but it was subsequently tabled in the Chamber of Deputies. ¥ With the ministerial status, any charge against the BCB governor must be handled only by the Supreme Federal Court. Without such status, the BCB governor would have to answer any charges and questions at the lower courts, which would make it impossible for him to perform his duties as the BCB governor.

122

Taeko Hiroi and Douglas Block

proponents of central bank independence immediately and severely criticized this measure. Congressional and legal disputes followed. Eventually, the decree was converted into law and the constitutionality of the measure was upheld by the Supreme Federal Court, but with a remark by the Court’s president: “With the upholding of the decree, we will have a central bank governor who will be subject to the appointment and dismissal by the President of the Republic. As such, the intended autonomy of the Central Bank is incompatible with this model.”∗ Based on statutory documents and anecdotal evidence, we consider the BCB as legally and effectively dependent until 1995 and effectively independent throughout the two Cardoso administrations (1995-98; 1999-2002) and the beginning of the Lula government. We consider the BCB’s independence diminished once again from August 2004 with the issuance of the controversial decree and its conversion into law (Law No. 11036 of 2004). Article 2 of the law reads “The rank of Governor of the Central Bank of Brazil is at this time transformed into the rank of Minister of the Republic” (Brazil 2008). A consensus exists among leading works on central bank independence that a central bank is not independent if its governor is subject to at will appointment and dismissal by the head of government as implied by the ministerial status. Therefore, Brazil’s current model compromises the Bank’s independence even though the BCB continues to enjoy relative autonomy granted informally by the president. 3000

Annual % Change

2500

2000

1500

1000

500

Money Supply M1

Inflation CPI % Change

Source: International Financial Statistics, International Monetary Fund, online version.

Figure 1. Inflation in Brazil, 1985-2007.

∗ “Meirelles tem status de ministro,” Correio Braziliense, 6 May 2005: A-11.

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

0

Central Bank Independence in Words and in Deeds

123

Brazil's post-authoritarian economic history shows the pattern consistent with the evolution of BCB independence depicted in this chapter. In the earlier years, Brazil experienced enormous economic instabilities and its economy was literally a mess. As Figure 1 shows, triple digit inflation was common during this period, exceeding 3,000 percent in 1990. The central bank increased the money supply to keep up with inflation, which fueled inflationary pressures even more. Successive governments launched numerous stabilization measures to no avail. Between 1985 and 1994, Brazil implemented at least nine major stabilization plans and underwent six different currencies to fight chronically high inflation and balance of payments crises.∗ During the period of only one decade (1985-1995), there were 14 finance ministers and 15 central bank presidents. 70 65 60

Annual % Change

55 50 45 40 35 30 25 20 15 10 5

Money

CB Discount Rate

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

0

CPI % Change

Note: The shaded vertical lines denote presidential and legislative election years. Source: International Financial Statistics, International Monetary Fund, online version.

Figure 2. Inflation and Interest Rates in Brazil, 1995-2007.

Economic stabilization finally came to fruition with the success of the Real Plan in 199495. Inflation declined from the annual rate of 2,076 percent in 1994 to 66 percent in 1995 and 6.9 percent in 1997 (see Figure 2). The BCB served as a gatekeeper of inflation and guardian of economic stability in the post-Real era. Even under recurrent pressure by politicians and businesses to reduce interest rates, which are set primarily to achieve inflation targets, the operationally independent BCB has been able to pursue a conservative interest rate policy. Data in Figure 2 evince that inflation has been respectably low in Brazil since the mid-1990s, ∗ See Baer and Paiva (1998) for Brazil’s economic stabilization plans.

124

Taeko Hiroi and Douglas Block

and there are no detectable electoral or partisan cycles with respect to monetary policy, be it the BCB discount rate or money supply. Therefore, even without formal independence, de facto independence has worked to stave off political business cycles and provided relative price stability. Nevertheless, it appears that informal independence has not been able to generate the degree of credibility needed to repel speculative attacks during challenging times. The first test of credibility ensued after the 1997 Asian financial crisis, followed in 1998 by Russia's economic collapse. International investors speculated that Brazil was next in line for an economic crisis. By November, the country’s international reserves that amounted to nearly US $75 billion in April dwindled to US $41 billion, and Brazil’s crawling peg exchange rate regime was under constant attacks. The government raised interest rates to nearly 40 percent annually to protect the exchange rate arrangement and prevent capital flight, but international reserves continued depleting, forcing the government to negotiate emergency loans with the International Monetary Fund. The crisis eventually resulted in the abandonment of Brazil's crawling peg in January and the replacement of the central bank governor in March 1999. The second test of credibility took place in 2002-2003 in the midst of uncertainty regarding the successor to President Cardoso. The prospect for Lula's victory, a former union leader candidate seen as a radical leftist, was frightening to both domestic and international investors. The BCB's independence that generated relative economic stability during the Cardoso terms was not anchored by law. Since autonomy was granted by discretion, it could also be taken away at will, and there was no guarantee that the next president would appoint a conservative individual as the BCB governor. With the country's currency rapidly losing its value and fear of capital flight and return of high inflation, the BCB raised the overnight lending rate to close to 30 percent, but the market remained wary about the next government's economic policy and thus the country's economic prospects. Upon assuming office in January 2003, Lula sought to calm investors by pursuing unexpectedly conservative economic policies, including his appointment of an internationally renowned investment banker, Henrique de Campos Meirelles, as the BCB governor. The high interest rate policy also continued throughout Lula's first term, and the fear of economic instability due to political succession gradually subsided.

IV. Chile: Delegation without Democracy In contrast to Brazil where the independence of the central bank is dependent on the will of the president, in Chile it is firmly entrenched in the law. Since its return to democracy, Chile has been viewed as having one of the most independent central banks in the world (Boylan 1998). However, the road to autonomy came about through undemocratic means. On September 11, 1973 a military junta led by General Pinochet, responding to public unrest and vast economic problems, overthrew the democratically elected government of Salvador Allende. Initially, the junta had great success in stabilizing the economy. The inflation rate declined from 508.1 percent in 1973 to 31.2 percent in 1980. Likewise, the real GDP growth rate increased from -5.6 percent to 7.8 percent (Banco Central de Chile 1983, 46, cited in Loveman 2001, 281). But in the early 1980s economic problems reappeared due to a combination of domestic blunders and an international financial crisis.

Central Bank Independence in Words and in Deeds

125

By 1987 the economy was beginning to recover and in 1988 the junta, in accordance with the 1980 Constitution, held a plebiscite to determine whether General Pinochet would be allowed to govern for 8 more years. Although Pinochet was confident going into the polls, he lost by a vote of 43 percent to 54 percent and elections were scheduled for December 1989 (Rector 2003). Two months prior to the election, the government passed a constitutional act giving the Chilean central bank broad independence that included: the expressed prohibition on financing public expenditures except during times of war, ten year term limits for board members, and control of the foreign exchange rate∗. The timing of this constitutional change was not coincidental. Boylan (1998) argues that Chile’s authoritarian leaders, recognizing their imminent loss of power, gave the central bank broad autonomy to protect their economic interests by limiting the policy options of the democratically elected government and maintaining orthodox economic policies. This was particularly important in Chile since the democratic opposition consisted of a large coalition of political parties that varied from moderate to extreme left. Although the new government could remove the central bank’s legal autonomy, such changes would risk massive outflow of foreign capital (Boylan 1998). Comments by both opposition members and government supporters lend credence to this argument. According to one report, Admiral Jose Toribio Merino, a member of the military junta, stated that central bank autonomy was implemented to deny the democratically elected government the ability “to introduce a socialist economy” (Latin American Markets 1989). Despite initial threats by opposition leaders to repeal the law on central bank autonomy, the democratic government did not follow through on its threats. This may be due in part to negotiations between the military junta and incoming leaders that led to the appointment of Andrés Bianchi Larre, the consensus candidate across the political spectrum, as the first independent central bank governor (The New York Times 1989). Since then politicians have mostly refrained from challenging central bank autonomy even when the opportunity presented itself. For example, when in 2003 central bank Governor Carlos Massad discovered that his secretary had been selling sensitive market information to a local financial group, there were not widespread public comments by politicians calling for the abolishment of central bank autonomy. In addition to providing the central bank with legal autonomy, the law governing the Chilean central bank also increased de facto independence. Between 1981 and 1989, before the law went into effect, the average term of central bank governors in Chile was approximately 13.6 months. In contrast, after the central bank was given autonomy in October 1989, the average term of central bank governors jumped to 54 months+, an increase of almost 400 percent (Central Bank of Chile official website at www.bcentral.cl/eng/). The broad autonomy given to the Chilean central bank has proven effective as Figure 3 demonstrates. During the 1980s, even under the economically conservative, heavy-handed military dictatorship, Chilean inflation averaged 21 percent. Since 1990 the average inflation has been 7.92 percent. Moreover, Chile's positive economic performance extends beyond monetary stability. Although many Latin American countries--Argentina, Brazil, Mexico, and Peru to name a few --were hit by economic crises in the 1990s and 2000s, Chile has been ∗ Law 18,840, which gave the central bank autonomy, can be found at http://www.bcentral.cl/eng/about/basicconstitutional-act/index.htm. + This was for the time period between December 1989 and December 2007.

126

Taeko Hiroi and Douglas Block

enjoying strong and sustained economic growth. In fact, Chile has been one of the region's fastest growing economies and the International Monetary Fund’s poster child for marketoriented economic reforms. While it is difficult to determine exactly how much of this success can be attributed to the central bank's legal and effective independence, there is no doubt that it has provided price stability and a safe investment environment needed for the economy to grow. 50 45 40

Annual % Change

35 30 25 20 15 10 5

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

-5

1982

0

-10

Money Supply M1

Inflation CPI % Change

Source: International Financial Statistics, International Monetary Fund, online version.

Figure 3. Inflation in Chile 1982-2007.

Conclusion A politically independent central bank deters manipulation by politicians of monetary policy instruments and thus is believed to bring about price stability and promote healthy economic performance. Since the 1990s, scholars have attempted to gauge de facto central bank independence in addition to legal independence. This new approach stems from the understanding that while a central bank may be independent in law, it may be politically controlled in practice. The problem may be particularly pronounced in developing countries where institutions are generally weak. This chapter examined central bank independence in words and in deeds. We reviewed some of the most commonly used indices of central bank independence and problems associated with these measures. Most studies focused on statutory independence but the Cukierman measure of de facto independence, based on the turnover rates of central bank governors, gained prominence over the last decade. We analyzed the implications of these debates with two Latin American countries—Brazil and Chile. Brazil is a country where the

Central Bank Independence in Words and in Deeds

127

central bank gained operational independence in the mid-1990s without legal changes. Despite the improvement in the financial stability of the country, absent a constitutional guarantee the Brazilian central bank remains politically vulnerable, and the credibility of prudent monetary policy is not strong enough to deter speculative attacks during sensitive moments. The Brazilian experience is in contrast to the Chilean case where the outgoing military government constitutionally guaranteed the central bank’s independence two months prior to Chile’s return to democratic rule in 1990. Initially the democratic opposition threatened to repeal the law giving broad autonomy to the central bank. However, low inflation and strong economic growth have helped the bank maintain a high level of de jure and de facto independence despite a massive scandal in 2003. Our findings have an important implication for the study of central bank independence and for those contemplating granting the central bank greater autonomy. We believe that the de jure-de facto discrepancy that characterizes many developing countries will lessen as countries transition to democratic rule and the rule of law strengthens. As democracy strengthens, formal rules and institutions matter more, and statutory independence of central banks becomes more important. In a global economy in which economic crises transmit across countries instantly, having strong institutional credibility is vital to avert speculative attacks. Neither de facto independence without legal reinforcement nor legal independence without substance can offer this shield, but central banks that are constitutionally and effectively independent are better positioned to provide economic stability.

References [1] [2] [3] [4]

[5] [6]

[7] [8] [9]

Alesina, Alberto. 1988. “Macroeconomics and Politics.” NBER Macroeconomic Review 3: 13-52. Alesina, Alberto. 1989. “Political and Business Cycles in Industrial Economies.” Economic Policy 4(8): 57-98. Alesina, Alberto, and Nouriel Roubini (with Gerald Cohen). 1997. Political Cycles and the Macroeconomy. Cambridge, Massachusetts: MIT Press. Alesina, Alberto, and Lawrence Summers. 1993. "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence." Journal of Money, Credit, and Banking 25: 151-62. Bade, Robin, and Michael Parkin. 1988. “Central Bank Laws and Monetary Policy.” University of Western Ontario. Baer, Werner, and Claudio Paiva. 1998. “Brazil’s Drifting Economy: Stagnation and Inflation During 1987-1996.” Pp. 89-126 in What Kind of Democracy? What Kind of Market?: Latin America in the Age of Neoliberalism, eds., P. Oxhorn and G. Ducatenzeiler. University Park: Pennsylvania State University Press. Banco Central de Chile. Informe Económico de Chile. Cited in Loveman, Brian, Chile: The Legacy of Hispanic Capitalism. New York: Oxford University Press, 2001. Boylan, Delia M. 1998. “Preemptive Strike: Central Bank Reform in Chile’s Transition from Authoritarian Rule.” Comparative Politics 30(4): 443-462. Brazil. 2008. LEI No 11.036, DE 22 DE DEZEMBRO DE 2004. Presidência da República.

128

Taeko Hiroi and Douglas Block

[10] Central Bank of Chile Official Website. “Other Information of Interest.” Accessed: 10 Feb 2009. < http://www.bcentral.cl/eng/about/functions/08.htm> [11] Chile. 2008. Law 18,840, 10 October 1989. Official Gazette. [12] Clark, William Roberts, and Mark Hallerberg. 2000. “Mobile Capital, Domestic Institutions, and Electorally Induced Monetary and Fiscal Policy.” American Political Science Review 94(2): 323-346. [13] Correio Braziliense. 2005. “Meirelles tem status de ministro.” 6 May 2005: A-11. [14] Cukierman, Alex. 1992. Central Bank Strategy, Credibility, and Independence. Cambridge: MIT Press. [15] Cukierman, Alex, and Steven B. Webb. 1995. “Political Influence on the Central Bank: International Evidence.” World Bank Economic Review 9(3): 397-423. [16] Cukierman, Alex, Steven B. Webb, and Bilin Neyapti. 1992. "Measuring the Independence of Central Bank and Its Effects of Policy Outcomes.” The World Bank Economic Review 6: 353-398. [17] De Haan, Jakob, and Willem J. Kooi. 2000. “Does Central Bank Independence Really Matter? New Evidence for Developing Countries Using a New Indicator.” Journal of Banking and Finance 24: 643-664. [18] Eijffinger, Sylvester C.W., and Eric Schaling. 1993. “Central Bank Independence in Twelve Industrial Countries. Banca Nazionale del Lavoro Quarterly Review 184: 1-41. [19] Eijffinger, Sylvester C.W., and Jakob De Haan. 1996. The Political Economy of Central Bank Independence. Department of Economics, Princeton University. [20] Fischer, Stanley. 1995. “Central-Bank Independence Revisited.” American Economic Review 85(2) Papers and Proceedings: 201-206. [21] Forder, James. 1996. “On the Assessment and Implementation of ‘Institutional’ Remedies.” Oxford Economic Papers, 48 (1): 39-51. [22] Grilli, Vittorio, Donato Masciandaro, and Guido Tabellini. 1991. “Political and Monetary Institutions and Public Financial Policies in the Industrial Countries.” Economic Policy 6(13): 342-392. [23] Hibbs, Douglas A. 1977. “Political Parties and Macroeconomic Policy.” American Political Science Review 71: 1467-1487. [24] Hiroi, Taeko. 2009. "Exchange Rate Regime, Central Bank Independence, and Political Business Cycles in Brazil." Studies in Comparative International Development 44(1): 1-22. [25] Holanda, Marcos C, and Leonardo P. Freire. 2002. Medindo a Independência do Banco Central do Brasil. Manuscript. [26] International Monetary Fund. International Financial Statistics. Online version. [27] Jácome, Luis I., and Francisco Vázquez. 2005. Any Link Between Legal Central Bank Independence and Inflation? Evidence from Latin America and the Caribbean. IMF Working Paper WP/05/75. Washington D.C.: International Monetary Fund. [28] Latin American Markets. 1989. “Chile: Autonomy for Central Bank.” [29] The New York Times. 1989. “International Report; Chile is Getting Independent Central Bank.” December 11 1989: D-1. [30] Nordhaus, William. 1975. The Political Business Cycle.” Review of Economic Studies 42: 169-190. [31] Rector, John L. 2003. The History of Chile. Westport Conn.: Greenwood Press. [32] Rogoff, Kenneth S. 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target.” Quarterly Journal of Economics 100(4): 1169-89.

In: Central Banking and Globalization Editors: M. Cappello and C. Rizzo, pp. 129-140

ISBN: 978-1-60876-056-5 © 2010 Nova Science Publishers, Inc.

Chapter 6

WATER: A GLOBAL RISK FACTOR István Orlóci∗ and Károly Szesztay+ Budapest University of Technology and Economics in Budapest, Hungary

Abstract A fundamental contradiction emerged in human history during the last few centuries. On the one hand, technological tools and the total production of the world economy rose to a hitherto unimaginably high level. On the other hand, human activities deteriorated the life support services of our planet at an unprecedented rate; if continued unchanged we would soon reach the limits of sustainability. Coping with the risks generated by this contradiction requires a shift in environmental and water management policies. Departments of water resources administration are facing a fundamental dilemma when fulfilling their role within the local, national and regional governance. These departments are held responsible for the protection and the rational utilization of water resources, but the crucial activities affecting the quality and availability of these resources are planned and decided upon by departments of agriculture, industry, transportation and many others.The paper analyses conceptual approaches towards overcoming these difficulties and presents results and experiences of a master plan and policy analysis elaborated recently for water resources management and administration in Hungary. These elaborations are based on the concept of “socially significant (valued) properties” of the water availabilities within a given region. The coordination of all the water related activities by the respective governments is facilitated by a comprehensive informational infrastructure formulated and presented according to the specific viewpoints of the major departmental branches and institutions.

1. Introduction Technological and organizational capabilities to modify the planetary environment according to short-term interests of the world economy grew much faster during the last few centuries than the intellectual abilities to understand the long term consequences of these ∗ E-mail address: [email protected]. Dr. István Orlóci is Honorary Reader of the Budapest University of Technology and Economics in Budapest, Hungary. + E-mail address: [email protected]. Dr. Károly Szesztay is Honorary Professor of the Budapest University of Technology and Economics in Budapest, Hungary.

130

István Orlóci and Károly Szesztay

modifications. As a result, unwanted and unexpected changes started to occur and accumulate in the planetary life support services. Therefore, predictions and decisions concerning future social and economic scenarios involve uncertainties and risks of rapidly increasing proportions. The paper analyses major water related factors affecting such unwanted and unexpected external side effects in the light of the results of a recent elaboration of policies for water management in Hungary. Special attention is given to informational infrastructures as a tool for facilitating the transition from industrial economies towards a global ecoeconomy.

2. The Water Cycle and the Planetary Life Support Services An almost complete recycling has appeared to be the characteristic approach towards the provision of food and other life support services for the vegetation and animal kingdom of the biosphere and for their maintenance for billions of years. Focusing on the plant ecology of the continents the global water cycle and its numerous sub-cycles driven by climate and coupled to the cycles of the basic biogeochemical elements are playing the central role in the provision of these services and in their harmonization at different scales. As depicted schematically in Figure 1 within scale „1” of the plant ecological units the water cycles of the unsaturated zone of the land surface are the major transmitters and accumulators of the interactions among climate, soil and vegetation. With regard to interactions among the various plant ecological units there are two characteristic scales.

Figure 1. Internal and external flow of energy (e), water (w) and biogeochemical elements (b) within and among the plant ecological units, as a symbolic representation of the Earth’s life supporting services.

Water: A Global Risk Factor

131

At scale „2” of the continental fluvial basins interactions are tied to the recharge and discharge processes of rivers and groundwaters. At scale „3” of regional, hemispherical and global climate formation (within which the troposphere as a closed water vapour reservoir conditions an almost complete recycling of water) the existence and type of forest cover provided a significant positive feedback mechanism promoting the penetration of the water cycle toward the interior of the continents. As a reversed manifestation of this slow but strong feedback effect, the removal or modification of the natural forests on about one third of the land areas significantly contributes to the increasing aridity and desertification observed recently in the semi-arid and arid zones of the continents. Conceptually the scheme of Figure 1 confirms that ecological units, fluvial basins and climatic regions are natural entities of assessments and planning for integrated water management. It also suggests that in order to cope with the increasing risks and uncertainties, limits and potentials concerning the role of water in the life supporting environmental services should be part of formulating future scenarios and policies within all the water related sectors of the economy from the very beginning of these elaborations.

3. The Water Cycle and Water Management Man is only one among the millions of species of the biosphere but he uses and regulates more then half of the global water availabilities (Sachs 2008). The efficiency of using water and other natural resources is extremely low in comparison to the planet’s performance in providing life support services. The reasons for this (and the directions of changes required for sustainability) are rooted in the conceptual foundations and practical solutions of industrialization of the last few centuries approaching the global scale during the lifetime of this generation.

3.1. Water as a Free Gift of Nature Economic theory initiating and shaping industrialization is based on the axiomatic assumption that „value” (directing the selection of objectives, as well as the ways and means of achieving them) might only come from human actions. As a consequence, the life supporting services of the planet – symbolically visualized in Figure 1 – are regarded as „free gifts” of nature. Following this logic the water management component of the successes of industrialization was essentially based on supply-oriented solutions, i.e. primarily on large scale river basin and inter basin development projects. This is reflected and reinforced by global assessments and international recommendations on various aspects of integrated river basin and inter basin development (United Nations 1970 and 1977). By the end of the 20th century the axiomatic emphasis on supply-oriented development led to rapidly rising costs in satisfying water demands when river basin and groundwater basin development has reached or has approached its potential limit, the rate of recharge of the aquifer systems within the major fluvial basin of the arid and semi-arid zones. One of the necessarily emerging new threats was the rapid decline of food reserves and the global food market becoming suddenly and heavily demand-oriented (Brown 2005).

132

István Orlóci and Károly Szesztay

3.2. Beginnings and Barriers of Demand-Oriented Water Management Having recognized the limits of river basin development, the attention of national and international water management organizations turned towards efficiency of water use and other demand-oriented solutions (United Nations 1976). Impressive progress has been achieved on the level of research and experimental demonstrations, but large scale application was and still is surprisingly low. Irrigation might serve as an indicative example. Already decades ago irrigation technologies have been developed reaching the 0,8 – 0,9 water use efficiency of rainfall (sprinkler irrigation) and even surpassing these values (drip irrigation). However, these solutions represent a very tiny fraction if compared to traditional irrigation practices (with efficiency coefficients of around 0, 2 or below). It has also been repeatedly demonstrated that an almost complete recycling and reuse can be achieved in most industrial water uses, but the efficiency of large scale application is far behind these possibilities. There are four deeply rooted barriers hindering the elimination of these contradictions: (I) the „free gift” assumption (which was reasonable during the early phases of industrialization, but is clearly unsustainable today) still dominates the mainstream of societal and political thinking; (II) the market mechanism and the competition principle as the major drivers of industrialization are partially or entirely inadequate in most cases for water resources management; (III) in the selection of technologies and the implementation criteria most of the critical decisions are made outside the competence of the water management organizations (i.e. within departments of agriculture, industry, transportation and many others); (IV) there is no generally accepted universally applicable conceptual and strategical solution for the application of the principles of integrated water management which would combine supplyoriented and demand-oriented thinking and practices according to broad societal interests. Out of these four barriers the last one seems to be critical as it plays an important role also with regard to the previous three.

4. Towards Society-Oriented and Ecology-Based Water Management Until human interventions in the natural water cycle were negligibly low the „free gift” assumption was a reasonable simplification and water management activities were essentially guided by the emerging „ad hoc” demands for the utilization of water related natural potentials, or the prevention against water related natural hazards. This situation started to change rapidly during the second half of the 20th century when through increasing interventions conflicts and misallocations among the various water related projects and with regard to the life supporting services of the environment reached disturbing proportions. The following questions might give a tentative and general indication of the required extension and integration of the concepts and strategies of water management (Orlóci 1977, Orlóci et al. 1985): -

What are the socially significant roles (the „valued components”) of the country’s hydrological processes? How can these components be analytically described and quantitatively assessed?

Water: A Global Risk Factor -

-

133

What are the natural factors and human activities within and outside the country area that have a significant impact on those valued hydrological components? What is the role of water in the utilization of land and other natural resources? What is the extent of human interventions in the country’s water balance and water quality processes, and what are the critical levels of eventual future interventions? What are the major social and economic demands for water and water-related services, and what are the major alternatives for satisfying, or for influencing these demands? What are the major possibilities and modalities for the protection and development of the country’s water resources?

The answers to these and other similar questions require (I) a set of basic studies on water-related implications of major policy factors as a point of departure (II) analytical planning and impact assessment exploring future scenarios with alternative options of human responses and their environmental consequences, and (III) a series of carefully designed publications disseminating findings and messages of the studies in easily accessible form and language for the various groups of addressees. Table 1. offers a tentative classification and characterization of the socially significant properties (the „valued components”) of the aquifer systems as a point of departure for formulating and answering the above questions. Group „II” and „III” in Table 1 contain concise summaries and reformulations of characteristic features of the categories „Resources” and „Hazards” of a supply-oriented water management. Group „I” and „IV” refer, however, to new features of ecological and social integration requiring a few additional comments. Regarding the application of the scheme of Table 1 in long term assessments and policy formulation it should be emphasized that there is no inherent conceptual or strategic difference among the importance of the four categories of socially significant properties. Each category should be introduced and evaluated within its own context and its relevance to the given specific conditions. Attaching general and a „priori” dominance to category „I” of the ecological role of water (as it is fashionably done by activists of the green movement) is as biased and damaging as neglecting it entirely. In fact, the elaboration of concepts and methodologies for unbiased assessments and comparisons between the environment’s life support services (category “I”) and the direct demands of society for water and water related services (category “II” and “III” of Table 1) is one of the crucial tasks of water related international research and policy. As water related preparatory steps of the transition towards an eco-economy (Brown 2001 and Sachs 2008) externalities generated by the impact transmitting and impact accumulating role of the global water cycle should be approached and analyzed according to three different points of view (Daly-Cobb 1989; Orlóci-Szesztay 2008): (1) Identification of causes and processes of risk generation in industrial societies; (2) Elaboration of principles and methods for the translation and evaluation of risks in terms of socially significant roles of the aquifer systems; (3) Co-ordination as a tool for preventing and managing water related risks.

134

István Orlóci and Károly Szesztay Table 1. The socially significant properties of the aquifer systems.

4.1. Generating Water Related Risks in Industrial Societies Land and water are important components of both industrial activities and processes of the natural environment. Industrial societies conceive, manage and supervise their related activities according to the requirements and viewpoints of stability and efficiency of producing various goods and services. Within the natural environment land and water are inseparable components of the planetary life support services depicted schematically in Figure 1.The fundamental differences between these two approaches are made explicit conceptionally in Table 2. This Table is structured following the processes of generating ecological and socioeconomic impacts leading to changes in the socially significant properties of the environment and locates the great diversity of the impact generating activities into this structure by 25 indicative examples. The confrontation of the viewpoints of industrialization and environmental protection leads to three important conclusions: (a) The impacts are generated usually by specific activities of a relatively narrow segment of the industrial society. However, they concern and have an impact on a much broader segment. (b) Institutions and departments of water resources administration are concerned by the scheme of Table 2 in two different ways:(i) they are impact generators in relation to water uses and regulations and (ii) they have a conceptual responsibility for preventing and reducing all the 25 types of impacts without having informational and

Water: A Global Risk Factor

135

institutional access in relation to activities of land uses and mining (impact types ‘16’ to ‘25’). (c) Institutions and departments of land uses and mining have neither the informational basis nor the institutional responsibility for preventing and reducing the impacts. However, they are held ethically and politically responsible by the implication of the “polluter pays” principle. Practical consequences of these three unresolved dilemmas are reflected by the surprisingly rapid and simultaneous pollution of rivers, lakes and groundwaters, during the 1960’s within virtually all industrialized countries, as well as by the small progress in water quality augmentations.

4.2. Informational Basis for Water Related Risk Management In order to establish a comprehensive unified informational basis for the prevention and management of water related risks generated by the activities of industrial societies, the environmental impacts of land and water uses have to be expressed in terms of the socially significant properties of the environment -- as it is done symbolically in the top and bottom boxes of Table 2. In terms of the underlying processes and in quantitative terms this transformation requires the mobilization of a wide range of disciplines of natural and social sciences and the involvement of a great number of governmental departments, as it is formulated conceptually through the interactive elaborations of Figure 2.Within this scheme the relationship between nature and society is structured to a matrix of four components which show the environmental and social impacts of the economy as direct and internalized processes of analytic planning. Concerning its substantive content and applicational prerequisites such planning procedure should satisfy the following basic conditions (Orlóci et al.1985): The socially significant properties of a given landscape (aquifer system) (T) are to be assessed systematically alongside the environmental factors carrying these properties (t) as well as the relationship T(t) specifying the pattern of the changing conditions (field ‘C’of the Figure); An inventory is to be compiled containing individually or by groups all the existing and constructed or planned land and water using structures and activities (H) alongside the environmental factors (h) influenced by these structures and activities, as well as the relationship H(h) describing the impacts quantitatively (field ‘A’ of the Figure); By inventories of a hydrological and hydroecological nature the relationship between the property- carrying factors (t) and the impact receiving-factors (h) is to be quantified (t(h) (quadrant ‘B’of the Figure) and finally by making use of the previously specified relations the relationship between significant properties (T) and the impact producing entities (H) is to be determined ( field “D” of the figure); With regard to the societal-institutional dimension of the processes and impacts of a given region or aquifer system, the administrative, economic and informational organizations are also to be included alongside the laws, regulations and rules of procedures pertaining to the respective parts of the inventory ( field ‘ E’ of the scheme of Figure 2).

Table 2. Ecological and socioeconomic impacts of water and land uses.

Indicative examples of the specific activities: 1) Riparian waterworks with surface intake and return; 2) Hydropower with lateral canal; 3) Waterworks with groundwater supply and surface return; 4) Hydropower with interbasin transfer; 5) Irrigation with no return flow; 6) Cooling pond with complete recirculation; 7) Hydropower plant; 8) Flood control dykes; 9) Navigation; 10) Recreation; 11) Waste disposal; 12) Storage reservoirs; 13) Utilization of rainfall in crop production and forestry; 14) Conservation of wetlands; 15) Piped drainage; 16) Changes in the soil cultivation; 17) Forest management; 18) Changes in paved land surfaces; 19) Mininng applying shafts and strip mining; 20) Gravel and clay pits; 21) Tunnels and pipelines; 22) Use of fertilizers and pesticides; 23) Salt spaying for frost prevention; 24) Disposal of liquid manure; 25) Sanitary landfills and disposal of toxic wastes.

Water: A Global Risk Factor

137

Figure 2. Informational basis for the prevention and reduction of water related environmental risks in industrialized societies.

4.3. The Role of Co-Ordination in Integrated Water Management The need for interdisciplinary and interdepartmental co-operation in the formulation and quantification of the matrices of Figure 2. is reinforced and extended by changing conditions of satisfying the demands for water and water related services under the constrains and expectations of integrated water management. During periods of historical conditions when water related development capacities were abundant and cheap (i.e.water could be regarded as a free gift of nature) the satisfaction of society’s demands for water and water related services followed the general pattern of various branches of the economy formulating their demands in practically complete details and the department or institution of water management responded in the form of concrete proposals for increasing the capacity of the respective water related services (in most cases through structures and measures of hydraulic engineering).These conditions illustrated schematically in Figure 3.A prevailed in most leading countries of Europe and North America until about the middle of the 20th century. At this point of time the prices of providing water and water related services begun to rise abruptly (mainly because of pollution caused by non-point sources) and the market mechanism failed to give proper warning signals in advance. Changes in the approaches towards demand satisfaction

138

István Orlóci and Károly Szesztay

had to be introduced according to the scheme of Figure 3.B as water became suddenly an economic commodity with a rapidly growing social and political significance.

Figure 3. Changes in the role of interdisciplinary and interdepartmental co-operation under the pressures of increasing demands for water and water related services.

Planning and decision-making for water management became a central issue of local, national and regional governments, and required broad scale co-operation in the identification of reasonable alternatives and the selection among them. Interdisciplinary and interdepartmental co-operation was particularly crucial under hydrological regimes when the chemical impacts transmitted by the water cycles were accumulating in time towards certain threshold values of acidity or alkalinity triggering abrupt changes of a “time bomb” nature in the broader environment. The co-operative efforts following the scheme of Figure 3.B. can function properly only when (i) the water management institutions provide comprehensive and quantified informational basis for the evaluation of expected future scenarios, and (ii) the central government plays a catalytic role in the initiation and organization of the respective institutional services.

5. Conclusion The concept of “eco-economy” is based on the recognition that the planetary environment is the first order system into which human economies must be accommodated as second order sub-systems (Brown 2001). This recognition means that contrary to earlier assumptions and practices, there are environmental limits to economic growth and that environmental inputs of the economies can no longer be regarded as “free gifts “of nature. In water related terms these new recognitions mean that all human activities modifying the flow or quality of natural

Water: A Global Risk Factor

139

water cycles are to be included in the concept and practice of water management. In other words this means that only a balanced and harmonized consideration of all the four major categories of the socially significant properties of the aquifer systems might correspond to the requirements of integrated water management, oriented towards the common good principles of society ( as discussed briefly in relation to Table 1). The concepts above are rather firmly elaborated in terms of practical application and political action in the primary need to set the transition towards sustainability in motion. However, this transition can be smooth and efficient only if political actions are reinforced by a corresponding change in societal consciousness and worldview. Within the classifications of anthropology the last large epoch of human history was dominated by a reductionist worldview motivated and paralleled by the “myth of the machine” (Mumford 1970) and culminating with the industrialization of the last three centuries. In terms of human consciousness the reductionist way of thinking and acting has to be replaced by a “generative” worldview oriented towards the genesis of planet Earth and her life supporting capabilities leading to the rise of humanity. As illustrated schematically in Figure 4 the continuing degradation of the planetary environment, the general decline of the quality of life, as well the growing inequalities among and within the countries are powerful motives for a paradigm change in worldview and there are numerous signs in research and civil movements that a change is already taking shape and place.

Figure 4. Transition from the reductionist to a generative worldview.

140

István Orlóci and Károly Szesztay

References [1] [2] [3] [4] [5]

[6]

[7]

[8] [9] [10] [11]

Brown, L.R. 2001 – Eco-Economy, Earthscan, London Brown, L.R. 2005 – Outgrowing the Earth, Earthscan, London Daly, H.E., J.B.Cobb 1989 – For the Common Good, Beacon Press, London Mumford, L. 1970 – The Myth of the Machine,Harwest Books, New York Orlóci, I. 1977 – Irányelvek az Országos Vízgazdálkodási Keretterv továbbfejlesztéséhez (Guidelines for the elaboration of a master plan and policy analysis for the water management of Hungary), Vízgazdálkodási Intézet, Budapest Orlóci, I., Szesztay K., Várkonyi L. 1985 – National infrastructures in the field of water resources, A contribution to the International Hydrological Programme, UNESCO, Paris – Budapest Orlóci, I.,Szesztay K. 2008 – Water management in the world of globalization, Natural Resources Forum, United Nations, No. 32, Blackwell Publishing Ltd., Malden MA,USA. Sachs, J.D 2008 – Common Wealth, The Penguin Press, New York United Nations, 1970 – Integrated river basin development, Sales No.E.70.11.A.4 United Nations 1976 – The Demand for Water, Sales No.E.76.11.A.1, New York United Nations 1977 – River basin development policies and planning, Sales No.E.77.11.A.4, New York – Budapest.

In: Central Banking and Globalization Editors: M. Cappello and C. Rizzo, pp. 141-146

ISBN: 978-1-60876-056-5 © 2010 Nova Science Publishers, Inc.

Chapter 7

AN ORIGINAL USE OF FOREIGN EXCHANGE RESERVES: WHEN A CENTRAL BANK CAN USE ITS FX RESERVES TO RECAPITALIZE BANKS Victoria Miller* Universite du Quebec a Montreal, Montreal, Canada

Abstract In 2003, the central bank of China used part of its huge stock of foreign exchange reserves to recapitalize two of its largest banks. This note considers when a central bank can successfully execute such a policy without compromising a currency peg.

Keywords: Central bank policy, fixed exchange rates, banking weakness. JEL: F3, G2

The last few decades have seen numerous banking systems in slight distress or worse, on the complete brink of collapse. Many of these fragilities have developed and grown in environments of state-ownership, deregulation and mis-regulation. While restructuring is essential in the medium- to long-run, new capital is usually needed immediately to ensure that these systems remain afloat. Governments have obtained the necessary new capital by selling domestic debt (as in the seventies S&L crisis and to a large extent for the present crisis in the United States) or borrowing abroad (as in the 1997 IMF loan to Argentina). However, when the government has been unable to tax and borrow, then money creation, whereby the central bank provides the necessary liquidity, has been the only option. Unfortunately, this last option may be in conflict with a stated currency peg and result in a loss of central bank credibility or even currency crisis. Indeed, the 1995 devaluation of the Mexican peso can be linked to the * E-mail address: [email protected]. Université du Québec à Montréal, Dept of Economics, POBox 8888, station A, Montreal , Quebec H3C3P8.

142

Victoria Miller

monetization of bank weaknesses (see Sachs, Tornell and Velasco (1995)). Thus, as illustrated in Miller (2000), credit constrained governments in fixed exchange rate regimes have often had to choose between bank solvency or currency stability. Recently however, the central bank of China used a different approach to recapitalizing banks. Rather than print money, it used part of its enormous stock of foreign exchange reserves to recapitalize two of its largest banks. In so doing, the two banks were successfully infused with fresh capital while the money supply, the Yuan and central bank credibility remained unchanged. This note examines the plausibility of this original response to bank fragilities in fixed exchange rate regimes. It will be shown that when the financial sector is not “very” fragile, then policies of recapitalization with foreign exchange or money creation are similar and will not affect a currency peg. However, when the currency is vulnerable to speculative attack or banks are extremely weak, then foreign exchange reserves cannot provide an antidote to bank difficulties. In this latter situation, the central bank can only alleviate capital deficiencies with money creation and then, at the cost of currency stability. The following section presents a framework to illustrate this point.

Model In the model, insufficient fiscal revenues constrain the government’s ability to finance a bailout.∗ An under-developed financial market also prevents banks and the government from borrowing directly from the market. Thus, the only option for a bank recapitalization is for the central bank to infuse new capital directly into banks. Central bank credit may take two forms: Either the central bank may extend new domestic credit to banks (by financing a government bailout) or it may lend banks some of its foreign exchange reserves.+ In the former case the money supply increases, while in the latter it remains unchanged. However, in the case of a foreign exchange loan, part of the central bank’s liquid foreign exchange reserves, become illiquid loans to banks. The model is based on equations (1) through (3) below: m - p = α + βy - γi

(1)

p = p* + e

(2)

i = i* + ρ + ėe ρ=ρ(Z), ρ(0)=0, ρZ >0.

(3)

The first two equations are the standard money market equilibrium condition and purchasing power parity respectively. m is the money supply which equals the sum of central bank foreign exchange reserves, R, and domestic credit, DC. p is the price level, y is output, e is the exchange rate and i is the domestic interest rate. All lower case variables except interest ∗ The model is a much abridged version of the one used in Miller (2006) to ascertain whether the Chinese central bank can successfully recapitalize its banking system its with foreign exchange reserves. + A third more complicated option of lending directly to banks is not considered since such a policy affects the monetary base and the money supply differently. Here, for simplicity, these two monetary aggregates are assumed the same.

An Original Use of Foreign Exchange Reserves

143

rates are in logs and an asterisk indicates a foreign variable. It is assumed that the central bank defends the currency as long as its reserves are greater than a minimum tolerable level which is exogenously set and denoted Rmin. If reserves fall below Rmin, then the central bank will allow the currency to float and the exchange rate will be market determined. Equation (3) is the modified interest parity condition. It includes a risk premium, ρ, for perceived bank insolvency and the expected rate of depreciation, ėe. As capital flows are instantaneous, prices are perfectly flexible and steady-state money growth is zero, the expected rate of depreciation is zero. i*, p* and y have also all been set equal to zero since they play no role in the analysis that follows. Insolvency risk (ρ) is a function of Z, the amount by which banks are under-capitalized. If capital-asset ratios are adequate, Z and therefore ρ will both be zero. However, the more under-capitalized banks, the larger Z and thus ρ. Both Z and ρ can then be reduced only if the central bank infuses new capital into the banking sector either in the form of domestic credit or foreign exchange. To simplify the analysis, such loans are assumed to be of infinite maturity. Finally, no shocks are expected beyond the present period. Substituting equations (2) and (3) into equation (1) for p and i respectively, yields equation (4), the general equation which illustrates the relationship between the central bank’s policy, the risk premium (i.e., domestic interest rate) and the equilibrium exchange rate. m = α - γρ(Z) + e

(4)

Before any shock to bank capital-ratios, equation (4) is ln(R0+DC0) = α + ē.

(5)

R0 and DC0 are initial foreign exchange reserves and domestic credit respectively and ē is the official fixed exchange rate. Suppose now that a negative shock causes the level of under capitalization to jump to Z0 and the risk premium becomes ρ0=ρ(Z0). To re-establish money market equilibrium, either the money supply must fall, the risk premium be reduced or the currency, devalued. If the central bank does nothing to shore up bank capital ratios, then capital will flow out of the domestic economy (i.e., foreign exchange reserves will fall) until the increase in the domestic interest compensates depositors for the new perceived risk as measured by the premium. Suppose that a drop in the money supply of X0 will cause the interest rate to increase by ρ0 . Thus, if R0-X0> Rmin (i.e., X0 is less than net free reserves), equation (4) becomes ln(R0-X0+DC0) = α - γρ0 + ē

(6)

and the exchange rate remains unchanged. If on the other hand R0-X0< Rmin then the money supply will only fall to Rmin + DC0 and the currency will depreciate to maintain money market equilibrium. In this latter scenario, the money market equilibrium condition will be given by ln(Rmin+ DC0) = α - γρ0 + en.

(7)

144

Victoria Miller

where en is the equilibrium exchange rate for the case that the central bank does nothing and R0-X0< Rmin. Since Rmin> R0-X0, it follows that en >ē.

a. Printing Money Now suppose that rather than doing nothing, the central bank monetizes banks’ woes and extends new domestic credit to this end (i.e., the central bank finances a government bailout). Assume further that an amount Z0 of new capital is needed to cause the risk premium to fall to zero. If less than this amount of new capital is provided to banks then the risk premium will remain strictly positive. First, if R0-Rmin>Z0, then the central bank will be able to reduce the risk premium to zero without violating the currency peg. To see this, note that after the central bank infuses new capital into banks, the equilibrium interest rate will return to its initial value and so the equilibrium money supply will also be the same as initially. This implies that the increase in domestic credit will be offset by an equal drop in the central bank’s foreign exchange reserves. That is, after equilibrium is restored, the money market equilibrium condition will again be given by equation (5) with the exception that the foreign exchange component of the money supply will be, R0-Z0, while the domestic credit component will equal DC0+Z0. Now suppose again that the central bank extends new credit to shore up capital ratios but that the amount of new capital needed to cause the premium to become zero will cause a depletion of foreign exchange reserves (i.e., R0-Rmin. < Z0). Here the central bank may have two alternatives available to it: Either it can “over-monetize” and eliminate the risk premium but cause a collapse of the fixed exchange rate regime, or it may be able to provide an amount of credit, Zmax, that will just avoid a depreciation of the currency and slightly reduce the risk premium. If the central bank chooses to give banks Z0 of new domestic credit, then the risk premium will be reduced to zero. However, since only R0 -Rmin of foreign exchange reserves will be available to finance capital outflows, the resulting money supply will be given by Rmin+DC0+Z0. As the money supply will be larger than initially while the equilibrium premium and interest rate will have returned to zero, the currency will depreciate to reestablish money market equilibrium. In this case, the asset market equilibrium condition will become ln(Rmin+DC0+Z0) = α + eDC

(8)

where eDC is the equilibrium exchange rate in this scenario. It should be clear that since Rmin+Z0 >R0, eDC >ē. Even if R0-Rmin
(9)

where ρZZmax is the reduction in the premium that results from the capital infusion. It should be clear that since the risk premium will remain strictly positive after the infusion of new

An Original Use of Foreign Exchange Reserves

145

capital, the money supply which is given by (Rmin+DC0+Zmax) will be less than initially (i.e., R0+DC0) and so Zmax must be less than R0-Rmin.

b. Lending Reserves Finally consider the Chinese antidote and suppose that the central bank lends foreign exchange reserves to banks to shore up capital ratios. Again an amount Z0 is necessary to cause the risk premium to become zero. While central bank assets and the money supply will not change as a result of the loan, the amount of foreign exchange available for an immediate currency defense will fall. The central bank will therefore not lend more than R0-Rmin of its reserves. If Z0 < R0-Rmin, then a bank “bail-out” which is financed with foreign exchange reserves will not compromise the currency peg. After equilibrium is re-established, equation (5) will again describe asset market equilibrium. In this case, recapitalization with domestic credit and foreign exchange are roughly equivalent. The only difference between the two policies is in their effects on the composition and liquidity of central bank assets. In the former case domestic credit will decrease and foreign exchange reserves will increase by Z0. In the latter case, the total amount of domestic credit and foreign exchange reserves will remain unchanged but an amount Z0 of foreign exchange reserves will become illiquid. If on the other hand, Z0>R0-Rmin, then a foreign exchange financed recapitalization of banks will compromise the fixed parity. To see this, suppose that Z0>R0-Rmin, and that the central bank uses all of its net-free reserves to recapitalize banks. Since more than this amount is needed to cause the premium to become zero, the premium will remain strictly positive after recapitalization. As the domestic interest rate will still be below its equilibrium value of i*+ρ, capital will flow out of the economy to reestablish asset market equilibrium. However, since the central bank will not have the reserves available to satisfy the demand for foreign exchange, depreciation will be necessary to re-equilibrate asset markets. These results can be summarized as follows: If the amount of new capital needed to recapitalize a banking system is less than net-free foreign exchange reserves (and there is no other pressure on the currency), then a central bank can use its foreign exchange reserves to recapitalize its banks. Moreover, when reserves are sufficient, then a bailout/recapitalization with a foreign exchange loan is roughly equivalent to a bailout which is financed with credit creation. The only difference between the two methods will be in the composition and liquidity of central bank assets. If on the other hand, capital requirements exceed net free reserves, then banks can only be fully recapitalized with money creation and necessarily at the expense of the currency peg. That is when Z0>R0-Rmin, then the central bank faces a remedial trade-off between banks and the currency and the Chinese “cure-all” cannot successfully ameliorate bank difficulties.

References [1] [2]

The Economist (2003), Reforming China’s banks: Don’t bank on a bail-out, New York, Dec. 6, pp.66-67. Miller, V (2000). Central bank reactions to banking crises in fixed exchange rate regimes. Journal of Development Economics 63, 451-472.

146 [3]

[4]

Victoria Miller Miller, V (2006). Getting out from between a rock and a hard place: Can China use its foreign exchange reserves to recapitalise its banks? Journal of International Financial Markets, Institutions and Money 16, 345-354. Sachs, J., Tornell, A. and A. Velasco (1995). The collapse of the Mexican peso: What have we learned? NBER working paper no. 5142, NBER, Cambridge, MA.

In: Central Banking and Globalization Editors: M. Cappello and C. Rizzo, pp. 147-151

ISBN: 978-1-60876-056-5 © 2010 Nova Science Publishers, Inc.

Chapter 8

IDENTITY GLOBALIZATION AND EXPERIENCE TOURISM Miguel Vidal González∗ IFPS Misericordia, Spain

Abstract Globalization fosters a cosmopolitan identity. In such case, the multidimensional identity comes from a plurality of countries and cultures, and the relationship between identity and place vanishes. Obviously intangible forms of heritage, as folklore or traditions, are involved, because costumes fixed in time become the predominant part of identities. At the same time, existential authenticity is predominant in developing countries, as developed ones follow a homogenization process due to globalization. As a result, there is an increasing experience intangible heritage tourism from developed countries to developing ones. Accordingly, developed countries press developing ones to protect intangible heritage as they do with wild nature. This short commentary also studies the trade off between protecting intangible heritage and modernity within a place. Finally, it makes a prospecting approach about this phenomenon in the future, taking in consideration an agoraphobic tendency to defensive identities in developed countries, an increasing dual cosmopolitan identity and a tension between intangible heritage and development in developing countries.

Keywords: Globalization, identity, intangible heritage, development.

Introduction This research note examines the relation between existential intangible heritage tourism and globalization. Its purpose is to illustrate how globalization can foster a cosmopolitan identity (Vidal 2008). In this note, Japanese flamenco tourism may be used to shed light on the theme in general. Due to the globalization impact, we’re facing a new paradigm, with an increasing variability, insecurity and uncertainty, due to the recent impotence of traditional boundaries. ∗ E-mail address: [email protected]

148

Miguel Vidal González

In this new environment, Beck points the Second Modernity as a cosmopolitan modernity, with experiences worldwide becoming a structural part when building personal identities (Beck 2004) rather than a simple enjoyment. While in the recent years most of the studies in heritage tourism are related to places, even for the existentially based group of scholars (Dahles 1998; Moscardo 2001; Poria et al 2001, 2003; Richards 1996) this research note will remark the differences when more intangible forms of heritage, as folklore or traditions (Chhabra et al 2003) are involved as the key elements in the heritage tourist activity. In the heritage tourism, experience has nebulous limits. The issue that will be analyzed in this point revolves around the fact that in the same way a heritage place can have different meanings for different tourists (Cheung 1999) intangible heritage elements also have different meanings for different people. For some tourists, intangible heritage represents a hedonistic experience, while for others it provides an existential one. In such case, the multidimensional identity comes from a plurality of countries and cultures, and the relationship between identity and place vanishes. Obviously intangible forms of heritage, as folklore or traditions, are involved, because costumes fixed in time become the predominant part of identities. In this sense, for existential intangible heritage tourists, authenticity is related to a “pure” approach, remarking the genuine elements that make that tradition part of a profound experience. Existential experience is equated as authentic when it is close to the original “spirit”, going further ahead than a merely active participation (even not knowing the rules) as Daniel (1996) proposes with the rumba in Cuba, and helps tourists to feel their real selves (Handler and Saxton 1988) being related to a “existential authenticity” (Wang 1999:351). Accordingly, there is a learning experience in the difference rather than a hedonistic experience of the different. Accordingly, there is a deeper distinction than from a mere passive to active participation.

Existential Tourism and Development There is a significant difference between heritage places and intangible heritage. In such sense, when heritage places are in concern, we mostly understand that we face “die” traditions, which are consistent with a modern image of the destination, including other activities, as industry or services. As for example, when talking about Viking tourism, it is compatible with a developed image of Scandinavia. Nevertheless, in heritage tourism it is often the more stereotyped image that attracts tourists (Halewood and Hannam 2001), having a collateral impact in the image destination. Although, when heritage places are in concern, this impact is limited, as we are frequently talking about the past, as it is present in the Viking heritage tourism. In an opposite way, existential intangible heritage tourism relays in the fact that traditions and folklore are perceived more authentic if they are still alive in the destination, being as less reconstructed as possible. Accordingly, a danger of inconsistence arises in the destination, being incompatible with an image of modernity and development in the region. That is the special case for flamenco in Spain, and especially in Andalusia, but not with the heritage tourism based on places, as in Seville, or Granada. In fact, for many people in Spain, flamenco has a negative association with an old image of the country that everybody wants to forget, and especially when international tourism is in consideration. In the seventies, many

Identity Globalization and Experience Tourism

149

tourists came to Spain searching an stereotyped image that was sold in their country, giving a folklorist view of the culture, forcing local people to act as “singers” (Estevill 1979). When authenticity is linked to tourism in Spain, a conformity with the stereotyped is expected, and an authentic “visit to Spain should involve some element of sunshine, bullfights, excitable locals, and so forth” (Waller and Lea 1998:125). As a result of that, as flamenco had in Spain a mental association with the undeveloped reality that the country tried to forget in the recent years of democracy, the insistence of foreign tourists in searching this obscure authenticity was observed as a prevalence of this reality. Due to this, flamenco has not been considerate for many years part of the key elements to promote international tourism. Is in this sense that the flamenco guitarist Paco de Lucía (Principe de Asturias award 2004) says Flamenco is a mistreated music, pointing the difficulty to use existential intangible heritage tourism in order to develop the local pride, as MacDonald (1997) proposes, or to reinforce preservation in order to generate revenues (Chhabra et al 2003). In the global environment, tourism is a potent agent capable to “provide the means by which local people can be identified” (Palmer 1999:318; Pritchard and Morgan 2001), but there is a lack of studies about the fact that marketing the intangible heritage tourism can affect negatively to the developing image of the destination, especially when still alive heritage is in concern. Therefore, it is interesting to observe that most of the increasing offer of existential intangible heritage tourism is being offered in developing countries. As a resume, there is a trade off between existential intangible heritage tourism and development and modernity within the destination. As a result of that, the wide impact of flamenco in Japan has never been studied deeply enough, renewing the stereotypes about a technophile country searching for a lost soul in an authentic country. As a paradox, there is more interest by the Japanese tourist agencies to promote the flamenco trips to Spain that in Spain to attract them. In such sense: “Japanese travel agencies offer flamenco tours to Spain and hundreds of women travel every year to watch and/or learn flamenco from teachers in Spain” (Waki 2003) Ironically, the lack of interest in Spain cannot stop this growing experience tourism reality, especially focused in Andalusia. In this sense, “If you travel to Spain and go to tablaos, you will surprise more than thirty percent of audience are Japanese” (Otsuka 2001) But now those things are changing. Due to the recent Spanish society development, a crescent self-confidence is growing, and a new approach to flamenco is rising. Spain has become a developed country. Consequently, flamenco is becoming a reconstructed intangible heritage. It brings a discussion between flamenco purists and “developers”. As a result of that, flamenco is becoming less authentic but politically correct. Recently, flamenco served as a promotion element, taking advantage of his growing international notoriety. A new agreement made the famous flamenco dancer, Sara Baras, Andalusia's international symbol of tourism, as the official image for Turismo Andaluz' (2002) in a campaign sponsored by Andalusia's official cultural board. At the same time, flamenco was present in Fitur (2002) and in the World Trade Market in London, and a second World flamenco Fair took place in Seville (2002). This changing situation, from rejecting to promote flamenco, still shows the main contradiction present in intangible heritage tourism, as it is present in this declaration, by José Hurtado, at that time tourism counsellor for the Junta de Andalucía, saying Sara Baras represents "a modern image based on tradition". Leaving behind authenticity, the reconstructed intangible heritage has a possible correlation with development and modernity.

150

Miguel Vidal González

Conclusion Existential tourists search a deep integration is the tradition, involving a previous and posterior interaction, because experience intangible heritage tourism is equated as authentic when it is close to the original “spirit”. Therefore, there is an experiential authenticity rooted in the still alive traditions. Existential authenticity is predominant in developing countries, as developed ones follow a homogenization process due to globalization. As a result, there is an increasing experience intangible heritage tourism from developed countries to developing ones. Developed countries press developing ones to protect their biodiversity. In a similar way they start to press them to protect their intangible heritage. As tourists use to visit natural parks and protected areas, they will go to interact with intangible heritage in developing countries. Accordingly, there is a trade off between protecting intangible heritage and modernity within a place. In the future, globalization will increase a dual cosmopolitan identity, with developing countries acting as a reserve of existential authentic traditions. As a result, there will be a tension between intangible heritage and development in developing countries.

References [1] [2] [3] [4] [5] [6] [7] [8] [9] [10]

[11] [12] [13]

Beck, U. 2004 Poder y Contra-Poder en la era global. Barcelona: Editorial Paidós. Cheung, S. 1999 The Meanings of a Heritage Trail in Hong Kong. Annals of Tourism Research 26:570–588. Chhabra, D. Healy, R. and Sills, E. 2003 Staged Autheticity and Heritage Tourism. Annals of Tourism Research 30:702–719 Dahles, H. 1998 Redefining Amsterdam as a Touristic Destination. Annals of Tourism Research 25:55–69. Daniel, Y. 1996. Tourism Dance Performances: Authenticity and Creativity. Annals of Tourism Research 28:780–797 Estevill, J. 1979 Lloret de Mar: destruccions i resistències d’un poble en mans del turisme. Papers. Revista de Sociología, n.10 Halewood, C. and Hannam, K. 2001 Viking Heritage Tourism: Authenticity and Commoditisation. Annals of Tourism Research 28:565–580. Handler, R and Saxton, W. 1988 Dissimulation: Reflexivity, Narrative and the Quest for Authenticity in “Living History”. Cultural Anthropology 3:242-260 MacDonald, S. 1997 A People’s Store: Heritage, Identity and Authenticity. In Touring Cultures. Rojek, C. and Urry, J. eds., pp. 155-175. London: Routledge. O’Connor, B. Moscardo, G. 2001 Cultural and Heritage Tourism: The Great Debates. In Tourism in the 21st Century, B. Faulkner, G. Moscardo and E. Laws , eds., , pp. 3– 17. London: Continuum Otsuka, Y. 2001 Historia del Flamenco. (http://www.eunavi.com) Palmer, C. 1999 Tourism and the Symbols of Identity. Tourism Management 20:313– 321. Pine II, J.B. and Gilmore, J.H. 1998 Welcome to the experience economy. Harvard Business Review 76(4):97-105

Identity Globalization and Experience Tourism

151

[14] Poria, Y. Butler, R. and Airey, D. 2001 Clarifying Heritage Tourism. Annals of Tourism Research 28: 1047–1049 2003 The Core of heritage tourism. Annals of Tourism Research 30: 238–254 [15] Richards, G. 1996 Production and Consumption of European Cultural Tourism. Annals of Tourism Research 32:261–283 [16] Vidal, M.2008 Intangible heritage tourism and identity. Tourism Management 29(4):807-810 [17] Waller, J. and Lea, S. 1998 Seeking the Real Spain? Authenticity in Motivation. Annals of Tourism Research 25:110–129. [18] Wang, N. 1999 Rethinking Authenticity in Tourism Experience. Annals of Tourism Research 26:349–370 Waki 2003 (http://www.flamenco-world.com).

In: Central Banking and Globalization Editors: M. Cappello and C. Rizzo, pp. 153-156

ISBN: 978-1-60876-056-5 © 2010 Nova Science Publishers, Inc.

Chapter 9

ON THE EQUIVALENCE BETWEEN A FISCAL STIMULUS FINANCED BY PUBLIC DEBT AND BY CENTRAL BANK MONEY Emanuel R. Leao1,∗ and Pedro R. Leao2,+ 1

Departament of Economics, ISCTE- Lisbon University Institute and Dinamia, Avenida das Forcas Armadas, Lisboa, Portugal 2 Department of Economics, Instituto Superior de Economia e Gestao, Technical University of Lisbon and UECE, Rua Miguel Lupi, Portugal

1. Introduction There has been much discussion about the type of policy stimulus that should be adopted by governments across the world to tackle the current economic crisis. One of the questions of the debate has been the following one: will a fiscal expansion financed by public debt be sufficient to stimulate aggregate demand and output? Or do governments need to carry out fiscal stimulus financed by Central Bank money? In this paper, we argue that under the current monetary regimes (where the Central Bank sets the level of short-term interest rates, and the quantity of money is endogenously determined by the demand from the non-banking sector) there is no significant difference between the two types of policies. In particular, we argue that, under the current endogenous monetary regimes, a fiscal expansion to tackle the current crisis will ultimately be financed by Central Bank money – even if in the first instance it is financed through the sale of government debt to the public. The article has two main sections. Section 2 summarizes the conventional view that the effect on aggregate demand and output of a fiscal stimulus financed by public debt is markedly different from the effect of a stimulus financed by the Central Bank. In section 3 we ∗ E-mail address: [email protected]. Phone 00351217903236,Fax 00351217903933. + E-mail address: [email protected].

154

Emanuel R. Leao and Pedro R. Leao

present our argument about the equivalence between the two types of fiscal expansion financing. Section 4 concludes.

2. The Conventional View Under the current monetary regimes, the Central Bank sets the level of very short-term interest rates (e.g. the two weeks main refinancing rate of the ECB, or the overnight federal funds rate of the Fed). On the other hand, budget deficits financed by the public typically involve debt instruments of much longer horizons (from 3 months up to 20 years or more). In this context, economists usually draw a clear distinction between the impact of a fiscal stimulus financed by public debt and the impact of a fiscal stimulus financed by Central Bank money.

The Effect of a Stimulus Financed by Public Debt A fiscal stimulus financed through the sale of bonds to the public raises the interest rates of the correspondent maturities – which are typically greater than three months (see, for example, Mishkin, 2007, pp. 95-104). The Central Bank may very well keep its very shortterm interest rates unchanged. However, because consumption and investment expenditures are financed through loans involving longer-term interest rates, this decision of the Central Bank is irrelevant. The higher longer-term interest rates brought about by the fiscal stimulus will crowd out consumption and investment and, therefore, the net impact of the fiscal stimulus on aggregate demand and output will be small. For example, one widely used macroeconometric model in the US, the Data Resources Incorporated (DRI) model, estimates fairly small fiscal multipliers based on public-debt financing: a government-purchases multiplier of only 0.6 and a tax-cut multiplier of only 0.26 (see Mankiw, 2007, p. 310). Some economists even argue that the net effect of the fiscal expansion on aggregate demand will be nil: the money that will now be spent by the Government must come from somewhere – it is money otherwise destined for private expenditure on consumption and investment goods. This means that the sale of government bonds must bid up the interest rate by the exact magnitude required to induce an equal (and thus offsetting) reduction in private consumption and investment.∗ Two current reassertions of the ‘Treasury View’ can be found in Fama and in Cochrane. Here is Fama: “Stimulus plans are funded from issuing more government debt. (The money must come from somewhere). The added debt absorbs savings that would otherwise go to private investment. In the end … [stimulus plans] just move resources from one use to another.” Cochrane is even clearer: “If money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs

On The Equivalence between a Fiscal Stimulus Financed by Public Debt…

155

created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but a fiscal stimulus can’t help us build more of both”.

The Effect of a Stimulus Financed by Central Bank Money A fiscal stimulus financed by Central Bank money does not lead to an increase in the supply of bonds in the public-debt markets. Therefore, and as long as it does not have any effect on expectations, a fiscal stimulus financed by the Central Bank does not have any effect on the interest rates of those markets.∗ As a result, there will not be any crowding out of private spending, and the fiscal stimulus will exert its full impact on aggregate demand and output. The DRI model mentioned above estimates much bigger fiscal multipliers in this case than in the case of public-debt financing: a government-purchases multiplier of 1.93 and a tax-cut multiplier of 1.19 (Mankiw, 2007, p. 310).

3. The Equivalence Between a Fiscal Stimulus Financed by Public Debt and by the Central Bank We now present our main thesis: under the current endogenous monetary regimes, there is not a significant difference between the effect on aggregate demand and output of a fiscal expansion financed by public debt and the effect of a fiscal stimulus financed by the Central Bank. Our argument is as follows. For simplicity, assume there are only two types of interest rates – a short-term interest rate set by the Central Bank, and a long-term interest rate for Government debt. In this framework, a fiscal stimulus financed by long-term debt raises the long-term interest rate and its spread over the short-term interest rate (which, by assumption, is held constant by the Central Bank). As a result, and everything else constant, short-term debt holders will move from short-term debt to long-term debt: they will sell short-term debt and use the money to buy long-term bonds. What happens next? First, the increase in the sales of short-term debt puts upward pressure on the short-term interest rate above the level set by the Central Bank. As a result, the Central Bank is forced to buy the short-term debt, and thereby is led to pump new money into the hands of the public. The money received by the public from the sale of short-term debt is then used to buy long-term bonds. Hence, the interest rate of these bonds declines back towards its initial level.

∗ This is known as the ‘Treasury View’ – the view of the British Treasury before Keynes’s impact on economic thought. ∗ A change in expectations can of course alter this result. Indeed, if the fiscal stimulus financed by Central Bank money is viewed as inflationary, economic agents will revise up their expectations of future short-term interest rates, and this will push long-term rates up. However, this is not the case in the context of the current crises. More generally, it is not the case in the typical circumstances when a fiscal stimulus is required – circumstances when monetary policy has been used up to its limit, and the economy is still operating, or moving away, from its full-employment level.

156

Emanuel R. Leao and Pedro R. Leao

In sum, while in the first instance the fiscal stimulus is financed by money that would otherwise be spent on private consumption and investment; ultimately, the fiscal stimulus ends up being financed by new Central Bank money:

Money

Money Central Bank

Debt-holders

Short-term debt

Government

Long-term debt

One final question: will the long-term interest rate exactly return to its initial level prior to the fiscal stimulus? The long-term interest rate is an average between the current and the expected future short-term interest rates, plus a risk premium. On the other hand, if the fiscal stimulus is not viewed as inflationary - as it is likely to be the case under the current crisis there is no reason for the public to expect any significant increase in future short-term interest rates by the Central Bank. Hence, we should expect the long-term interest rate to return exactly to its initial level. Now, the fact that the fiscal stimulus does not affect the long-term interest rate means that it does not have any crowding out effect on private consumption and investment. Hence the following conclusion: all the money used to finance the increased government spending apparently comes from money otherwise destined for private expenditure on consumption and investment goods. But, in fact, all that money ultimately comes from the Central Bank.

Conclusion In this paper, we have argued that under the current endogenous monetary regimes the impact on aggregate and output of a fiscal stimulus financed by public debt and the impact of a fiscal stimulus financed by the Central Bank are similar. In particular, we have argued that, under the current endogenous monetary regimes, a fiscal expansion to tackle the current crisis will ultimately be financed by Central Bank money – even if in the first instance it is financed through the sale of government debt to the public.

References [1] [2]

Mankiw, G. (2007), Macroeconomics, 6th Edition, Worth publishers, New York. Mishkin, F. (2007), The Economics of Money Banking, and the Financial Markets, 8th Edition, Pearson Education Inc., Boston.

In: Central Banking and Globalization Editors: M. Cappello and C. Rizzo, pp. 157-159

ISBN: 978-1-60876-056-5 © 2010 Nova Science Publishers, Inc.

Chapter 10

ON INFLATION TARGETING IN MENA COUNTRIES Magda Kandil University of Wisconsin-Milwaukee, US

Inflation has surged in many parts of the world in the last few months, On account of high food and fuel prices. The exogenous shock has, once again, drawn attention to the appropriate monetary policy to weather external shocks and manage domestic liquidity. Many industrial countries, under a flexible exchange rate system have aligned monetary policy to stem inflationary pressures. Some would argue that tight monetary policy may have pulled the trigger on the latest episode of credit tightening, forcing global financial meltdown and posing the risk of global recession. Even countries that have subscribed to inflation targeting have been struggling to adhere to the pre-announced targets. Some countries have realized that the spillover inflationary shock cannot be stemmed with available tools for monetary policy, under tight constraints. Accordingly, they were forced to widen the targeted band for inflation. Revisiting the topic of inflation targeting is very timely for the MENA region. As the last episode of inflationary pressure has demonstrated, the success of inflation targeting policy hinges on vigilant monetary policy to strike the right balance between domestic priorities in the face of external shocks. Inflationary pressures could be a function of international shocks, e.g., a surge in food and fuel prices, domestic policies, e.g., lax monetary and fiscal policies, or External vulnerability, e.g., exchange rate depreciation or capital flows. The Central Bank should have on its radar screen all these developments to establish priorities for monetary policy in the near term. The design of monetary policy should be compatible to the announced targets. Having established and announced priorities for monetary policy, movement in monetary instruments should provide a transparent signal of the policy stance with respect to imminent shocks. However, the Central Bank, in many developing countries, including MENA region, has been constrained from taking a leading role to be in charge of guarding against inflation.

158

Magda Kandil

Exchange rate policy: Traditionally, many developing countries have taken the safest and easiest route to guard against inflation. Classified as small open economies, Central Banks realized that the highest risk on inflation stems from currency depreciation that could easily spillover to domestic inflation in light of the high share of imported goods for which domestic substitutes are not readily available. Under the peg, the Central Bank aligned priorities for domestic monetary policy with priorities for monetary policy in the U.S., having confidence that the U.S. has a successful track record of guarding against inflation. Moreover, the peg has the advantage of establishing a credible anchor for monetary policy to ensure transparency and reduce the risk of hijacking monetary policy to finance lax government spending or establishing independent monetary policy while lacking instruments for liquidity management. Recently, many countries have realized the inflationary risk of pegging their currency to the US dollar. As the value of the US dollar has plummeted relative to the currencies of other major trading partners, e.g., the Euro, countries in the region have been exposed to higher prices of imports from the Euro Area. Higher inflation forced some Central Banks to depart from aligning interest rates with the US interest rate, while resorting to some form of capital controls to create a scope for independent monetary policy under the circumstances. The pressure has become clear. The Central Bank has to create the scope for independent monetary policy to align the necessary instruments with domestic priorities, mindful the implications on the exchange rate and capital flows. Some countries in the region have moved in this direction. To succeed, the scope for independent monetary policy has to be supported by domestic policies and constraints on the function of monetary policy have to be relaxed. A flexible exchange rate policy is necessary under inflation targeting to allow monetary policy the opportunity to decouple domestic interest rates from the requirement under the peg, in line with domestic priorities. This does not mean a pure floating exchange rate system. MENA countries with limited international reserves need to ensure movement in the exchange rate is within a band. Accordingly, the Central Bank could intervene to stem appreciation, as the exchange rate approaches the upper limit, to maintain competitiveness, and intervene to stem depreciation, as the exchange rate approaches the lower limit, to stem inflationary pressures. Domestic policies, particularly fiscal policies, should be compatible to the inflation target. Priorities for government spending should aim at relaxing supply-side constraints to increase productive capacity and improve the investment climate for private activity. Financing of government spending should be dependent on domestic tax revenues. This has been the major challenge for fiscal policy in MENA countries, as the government remains in charge of economic activity, while lacking the scope to generate tax revenues. Governments in MENA countries should gradually reduce their dominance on economic activity to provide the scope to advance private sector activity. In addition, reforming the tax system to widen the base and improve efficiency is necessary to provide the necessary resources to keep up with rising fiscal spending on social and development priorities. Deficit financing will remain a feature of fiscal management in the near term. External financing of the budget deficit should be limited. External financing increases public debt and debt service commitment in foreign exchange. As the external share of public debt increases, foreign exchange liability, absent compensating financial and trade flows, could threaten the stability of the exchange rate, raising the risk of higher inflation.

On Inflation Targeting in MENA Countries

159

Domestic financing from the Central Bank should be limited to ensure independence towards liquidity management, in line with inflation targeting. Monetizing the budget deficit increases liquidity increasing inflationary pressures, while constraining the function of the Central Bank to align the interest rate towards inflation targeting. Domestic banking financing should be limited to excess liquidity in the banking system. Government borrowing could squeeze available credit, crowding out private investment, and discourage banks from seeking what they could deem as risky opportunities for private credit. Both scenarios are detrimental to private activity and efficient financial intermediation. Excess liquidity in the banking system, e.g., during periods of a slowdown, could be tapped in by the government, provided that these resources are used to revive momentum for private activity. Non-bank financing is the best pool of resources for deficit financing. Market-based government securities should be auctioned and made available to the public as deemed necessary. However, this method of financing could shrink available resources in the banking system to finance private sector activity. To mitigate the risk, central bank independence is necessary. The Central Bank should be fully equipped to manage domestic liquidity via open market operations, intervening, as necessary, to mop up liquidity and stem inflation or inject liquidity towards availing resources for private spending and growth. To mitigate the risk, fiscal priorities are necessary. Government spending should be geared towards providing support for private sector growth via spending on infrastructure and development projects to relax capacity constraints and ease structural bottlenecks. Inflation targeting should be the overarching theme of monetary policy in MENA countries in the period ahead, supported by independent design of monetary policy to establish priorities in light of pending domestic and external pressures, flexible exchange rate policy with minimum intervention by the Central Bank, and prudent fiscal policy that limits deficit financing and align spending in line with growth and inflation priorities. Market-based monetary policy should provide the Central Bank flexibility to intervene, as necessary, for liquidity management. To enhance the effectiveness of monetary transmission and capitalize on the benefits of global financial integration, it is necessary to develop a financial system that adheres to prudent indictors, in line with international standards and domestic regulations, To summarize, the success of inflation targeting hinges on a set of perquisites. Committing to these conditions should provide the overarching theme to define macroeconomic priorities in the period ahead towards enhancing growth and development in the MENA region. A primary pillar for this growth is reviving private sector growth and incentives to enhance diversification and ensure competitiveness in the global economy.

In: Central Banking and Globalization Editors: M. Cappello and C. Rizzo, pp. 161-166

ISBN 978-1-60876-056-5 c 2010 Nova Science Publishers, Inc.

Chapter 11

S HOULD M ONETRAY P OLICY R ESPOND TO P RIVATE S ECTOR E XPECTATIONS ? Michele Berardi∗† University of Manchester

Abstract This work analyses the implications, in terms of determinacy and E-stability of equilibrium, of a policy rule that responds to private sector expectations in forward looking models. In the literature, this type of policy has been both recommended and criticized. We try to understand the reasons for such different conclusions and shed some light on the desirability of this type of policy rules.

Key words: Monetary policy, expectations, learning, determinacy, E-stability. JEL classification: E52, C62, D84.

1.

Introduction

In the standard forward-looking New Keynesian model, as presented, e.g., in Clarida, Gali and Gertler (1999), the optimal fundamentals-based policy rule generates both indeterminacy of rational expectations equilibria and instability of learning dynamics, as shown in Evans and Honkapohja (2003). In the same framework, these authors show, a policy rule that responds also to private sector expectations is able to amend these shortcomings: the ensuing recommendation for policymakers is to use this type of rules. On the contrary, previous works had argued against the same type of policies. In particular, Bernanke and Woodford (1997) found that conditioning the policy rule on private expectations increases the possibility of generating indeterminacy, and thus advised policymakers not to respond to private expectations. The purpose of this paper is to shed some light on the reasons why ∗

E-mail address: [email protected]. Contact information: Economics, SoSS, Arthur Lewis Building, University of Manchester, Manchester M13 9PL (UK). † I would like to thank John Duffy and Ben McCallum for helpful comments and discussions. All remaining errors are my own.

162

Michele Berardi

such different results have been obtained, in order to understand whether or not a policymaker should respond to private expectations. We find that the criticism put forward by Bernanke and Woodford (1997) doesn’t survive to a more careful specification of what an expectations-based policy should respond to, provided the policy parameters are optimally tuned.

2.

New Keynesian Models

2.1.

With Current Expectations

The model used in Evans and Honkapohja (2003) (hereafter E&H) is the standard forward-looking New Keynesian framework, as presented, e.g., in Clarida, Gali and Gertler (1999). The two relevant equations are: yt = −ϕ (it − Et π t+1 ) + Et yt+1 + gt

(1)

π t = λyt + βEt π t+1 + ut .

(2)

Equation (1) is a forward-looking IS equation and (2) an expectations-augmented Phillips curve; yt is the output gap, it the interest rate, here taken to be the policy instrument, and π t is the inflation rate. E indicates expectations. The two exogenous shocks gt and ut follow AR(1) processes with damping coefficients µ, ρ ∈ [0, 1).

2.2.

With Past Expectation

The system used by Bernanke and Woodford (1997) (B&W) is described by the following equations: y˜t = Et y˜t+1 − σ (it − Et π t+1 − ρt )

(3)

π t = βEt−1 π t+1 + kEt−1 (˜ yt − θt ),

(4)

where y˜t represents real output. In this model it is assumed that any price change chosen at time t takes place at time t + 1, and this is the reason for the different timing of expectations in equation (4) compared to equation (2), where it is assumed that price changes take place in the same period they are decided. Therefore in B&W inflation at time t depends only on information available at time t − 1, when pricing decisions were taken. The two exogenous disturbances ρt and θt follow AR(1) processes with damping coefficients λ, δ ∈ [0, 1).

2.3. 2.3.1.

Policy Rule Fundamentals-Based Policy Rule

The policy problem is to minimize expected deviations of output gap and inflation from their target levels over the infinite future horizon. E&H show that an optimal fundamentalbased policy rule1 in their setting leads to indeterminacy of equilibria, i.e., to multiple 1

This is a policy rule that responds only to fundamentals of the economy, in particular here to the two exogenous shocks.

Should Monetray Policy Respond to Private Sector Expectations?

163

stable RE solutions; moreover, the minimum state variable (MSV) solution is E-unstable, which implies that it can not be learned by agents through recursive least square (RLS) procedures.2 When we derive an optimal discretionary fundamentals-based policy in the B&W framework, we find that the system is indeterminate and the fundamental equilibrium is E-unstable for values of the autoregressive parameter δ close to 1. 2.3.2.

Expectations-Based Policy Rule

To overcome the negative results outlined above, E&H propose an alternative policy that responds also to private sector expectations. The optimal expectations-based discretionary policy they derive3 takes the form   λβ λ 1 1 it = 1 + (5) ut + gt . Et π t+1 + Et yt+1 + 2 2 ϕ ϕ ϕ(α + λ ) ϕ(α + λ ) Equations (1), (2) and (5) represent the new system describing the evolution of the economy given private sector expectations. E&H show that the MSV REE of this model is both determinate and E-stable (see their Proposition 3). Note that in equation (5) the Taylor principle is satisfied, since the nominal interest rate responds more than proportionally to changes in inflation expectations.4 But here is the puzzle: B&W showed that when a policy rule of the form it = φπ π ft+1 + φy y˜t ,

(6)

where π ft+1 is the forecast of time t + 1 inflation announced by private forecasters at time t, is used, the problem of indeterminacy found under the fundamentals-based policy is likely to increase instead of decreasing. The ensuing advice for the policymaker is not to condition its policy on private expectations. The policymaker is assumed here to observe all the past history of inflation and output, up to time t, but not the value at time t of the fundamental shocks. He thus responds to current output and private sector inflation expectations, both of which he can observe. We extend now B&W analysis and study E-stability of the MSV solution in their original setting, in order to compare results with E&H. Rewriting the system in the standard form xt = AEt xt+1 + Bvt , with A=

β

k

σ(1−φπ ) 1+σφy

1 1+σφy

(7) !

,

(8)

we find the actual law of motion (ALM) for the economy and derive the map from the perceived law of motion (PLM) of agents to the ALM, which governs the E-stability properties 2

For the relation between E-stability and learnability, see Evans and Honkapohja (2001). Here we assume that the target values for both inflation and output gap are zero. 4 Note also that policy rule (5) complies with Proposition 4 in Bullard and Mitra (2002), which indicates necessary and sufficient conditions for a policy rule to induce determinacy in this type of models. 3

164

Michele Berardi

of the system.5 It turns out that the eigenvalues governing E-stability are the eigenvalues of the A matrix (8) that govern determinacy, multiplied by the two AR(1) coefficients for the shocks. Therefore, if the system is determinate, then the unique solution is also Estable. If instead we are in the indeterminacy region, E-stability depends on the value of the autoregressive parameters λ and δ. We find that for some sensible parameter values of the structural and policy parameters, at least one eigenvalue lies outside the unit circle. Therefore, both indeterminacy and E-instability may plague this economy.

3.

Why Such Different Results?

We want to understand here why such different conclusions were reached about the opportunity to base a policy rule on private expectations. Comparing the E&H model with the B&W one, both closed with an expectations-based discretionary policy rule, we can see that equation (3) is qualitatively the same as equation (1). Differences come from the Phillips curve and the policy rule. The Phillips curve (4) differs from (2) for the timing of expectations: while in equation (2) the relevant variables are current output gap and expected future inflation, in equation (4) current inflation depends on past expectations of future inflation and on past expectations of current output gap. Policy rule (6) differs from policy rule (5) in a more substantial way: equation (5) includes expectations of both output gap and inflation, in addition to fundamental shocks. On the contrary, equation (6) responds only to inflation forecasts, and to current output. It does not respond to the exogenous shocks, which are not supposed to be known to by policymaker. But if we look carefully, we can see that a policy rule of the form (6) does not actually respond to private expectations. In fact, when the system is put into the standard form (7), the Phillips curve (4) is moved forward: this implies that the current variables are time t output and time t + 1 inflation, exactly those the policymaker responds to,6 while expected variables in the Phillips curve, Et π t+2 and Et y˜t+1 , do not enter into the policy rule. Therefore, the authority can not offset private expectations in an effective way and can not prevent them from introducing self-fulfilling elements in the system. To better grasp the differences in the two models and their impact on the relevant equilibrium properties, we take progressive steps from the B&W’s towards the E&H’s setting. In moving from B&W to E&H the first step is to change the timing in the Phillips curve. We suppose that inflation is no longer determined one period in advance, but within the period, as in most models. Equation (4) becomes π t = βEt π t+1 + k(˜ yt − θt ).

(9)

Using equation (3) and policy rule (6), and writing the system in the standard form, the A matrix governing determinacy is now   k π) β + kσ(1−φ 1+σφy 1+σφy  A= (10) σ(1−φπ ) 1 1+σφy

5

1+σφy

The complete analysis is available from the author upon request. Since in the model it is assumed that prices are predetermined, that private agents have all the relevant information at time t and that they make their forecasts by minimizing the variance of their forecast error, it follows that π ft+1 = Et π t+1 = π t+1 . 6

Should Monetray Policy Respond to Private Sector Expectations?

165

whose two eigenvalues depend, among other things, on the value of the policy parameters, and at least one is found to lie outside the unit circle when φπ is positive and greater than one and φy is a negative small number. By changing the timing in the Phillips curve, we have made inflation a nonpredetermined variable: using a policy rule of the form (6), the policymaker is now actually responding to expectation of a current endogenous variable. But he is not responding yet to expectations of output, which are still free to float and affect the outcome of the system. The authority is also not responding to fundamental shocks, but this feature clearly doesn’t affect equilibrium determinacy and E-stability, which only depend on the values of the entries in matrix A. We make now the policymaker respond to expected future output instead of to current output. The system, thus, is now the same as the one analyzed in E&H, except that here the policy parameters are left general and are not derived through optimality conditions.7 The new policy rule is (neglecting the terms pertaining to the shocks, which we have just seen are irrelevant for determinacy and E-stability analysis) it = φπ Et π t+1 + φy Et y˜t+1

(11)

and matrix A becomes A=



β + kσ(1 − φπ ) k(1 − φy ) σ(1 − φπ ) 1 − σφy



;

(12)

again, at least one of its eigenvalue is found to lie outside the unit circle for sensible values of the policy coefficients and structural parameters. But if we derive the policy coefficients through optimality conditions, then both eigenvalues are constrained to lie inside the unit circle for any choice of the parameter values, and therefore both determinacy and E-stability obtain.8 In particular, an optimal policy is able to completely offset the effect of expected future output on current output and on inflation. Mathematically, this makes the right column of the A matrix equal to zero, leading to a zero eigenvalue.9 We also find that even in the original setting of B&W, as represented by equations (3) and (4), the expectations-based discretionary policy generates both determinacy and Estability when it is optimally tuned. But to obtain these results, the policy rule must respond to the variables that make the system forward-looking; thus, in B&W setting, to Et y˜t+1 and Et π t+2 . We want also to emphasize that if the central bank cannot respond to fundamental shocks, as assumed in B&W, it still can induce determinacy and E-stability of equilibrium (which in this case will not be the one with fully stabilized inflation and output gap) by responding solely to expectations in the optimal discretionary way. Stabilizing the economy w.r.t. exogenous fundamental shocks is a completely different task from that of inducing a 7 Another difference is, of course, that here output, as opposed to output gap, enters the policy rule; but this doesn’t affect our argument. 8 The two eigenvalues are 0 and αβ/(k2 + α), with the second always less than one for the restrictions on structural parameters: 0 < β < 1, α > 0, k > 0. kβ 9 The optimal value for φy is σ1 , while that for φπ is 1 + σ(α+k 2) .

166

Michele Berardi

unique learnable equilibrium: while the first task requires a policy response to the shocks, the second calls for a response to expectations. The economic intuition behind the determinacy and E-stability results outlined above goes as follows: a policy rule that responds optimally to private sector expectations is able to offset their impact on current variables and can thus prevent them from becoming selffulfilling and generating a multiplicity of equilibria; in addition, if expectations fail to be rational, the policy response guides them back towards rationality, thus assuring E-stability.

4.

Conclusions

We have shown that different results present in the literature about the desirability of an expectations-based policy rule can be attributed to two reasons. First, given the timing in their setting, the type of policy presented by Bernanke and Woodford (1997) as one that targets private forecasts doesn’t really respond to private expectations but to current values of the endogenous variables. Secondly, the policy parameters need to be optimally tuned in order to effectively offset the destabilizing influence of expectations on current variables.

References [1] Bernanke, B. S., Woodford, M. (1997). Inflation forecasts and monetary policy. Journal of Money, Credit and Banking 29, 653-684. [2] Blanchard, O. J., Kahn, C. M. (1980). The solution of linear difference models under rational expectations. Econometrica 48, 1305-1311. [3] Bullard, J., Mitra, K. (2002). Learning about monetary policy rules. Journal of Monetary Economics 49, 1105-1129. [4] Clarida, R., Gali, J., Gertler, M. (1999). The science of monetary policy: a New Keynesian perspective. Journal of Economic Literature 37, 1661-1707. [5] Evans, G. W., Honkapohja, S. (2006). Monetary policy, expectations and commitment. Scandinavian Journal of Economics 108, 15-38. [6] Evans, G. W., Honkapohja, S. (2003). Expectations and the stability problem for optimal monetary policies. Review of Economic Studies 70, 807-824. [7] Evans, G. W., Honkapohja, S. (2001). Learning and Expectations in Macroeconomics. Princeton, NJ: Princeton University Press.

INDEX assets, 8, 145 assumptions, vii, 1, 4, 7, 75, 80, 138 asymmetry, 88 access, 8, 17, 27, 63, 135 asymptotically, 102, 104 accountability, 9, 10 attacks, ix, 115, 116, 120, 124, 127 accounting, 43 attractiveness, 76, 77 acidity, 138 authenticity, x, 147, 148, 149, 150 actual output, 111 authority, vii, 2, 36, 37, 38, 39, 41, 61, 164, 165 ad hoc, 19, 132 autocorrelation, 82 adaptation, 95 autonomy, ix, 115, 116, 118, 121, 122, 124, 125, 127 adjustment, 6, 17, 18, 19, 20, 22, 23, 26, 53, 54, 56, 58, average costs, 80 64, 104, 112 averaging, 50, 120 administration, ix, 61, 120, 129, 134 B administrative, 36, 37, 41, 44, 45, 47, 50, 51, 135 advertising, 63, 80, 81 bail-out, 145 Africa, 37, 47 balance of payments, 123 agent, 149 agents, vii, 1, 4, 5, 6, 9, 13, 15, 16, 17, 18, 19, 20, 23, balance sheet, 15 Balanced Scorecard, 89 27, 76, 155, 163, 164 Bangladesh, 47 aggregate demand, vii, x, 99, 153, 154, 155 Bank of England, 94 aggregates, 5, 12, 16 Bank of Japan, ix, 32, 91, 93, 95 agricultural, 47, 55, 78 bankers, 10 agriculture, ix, 129, 132 banking, 4, 5, 13, 15, 26, 91, 118, 141, 142, 143, 144, aid, 88 145, 159 alkalinity, 138 banks, vii, x, 2, 5, 7, 8, 10, 11, 12, 13, 15, 16, 17, 18, alternative, 16, 43, 72, 73, 133, 163 27, 94, 116, 118, 119, 120, 124, 127, 141, 142, 143, alternatives, 13, 133, 138, 144 144, 145, 146, 159 amendments, 41, 52, 59, 60 Barbados, 74, 80, 82, 83, 84, 85, 86 Amsterdam, 113, 114, 150 barriers, 63, 132 analysts, 41 base year, 84 annual rate, 123 behavior, 2, 6, 14, 16, 41, 83, 86, 116, 118 anther, 21 Belarus, 47 anthropology, 139 antidumping, viii, 35, 36, 38, 39, 40, 41, 42, 43, 44, 45, benefits, 49, 56, 60, 62, 64, 76, 159 Bernanke, Ben, 29 49, 51, 65 bifurcation, 103, 104, 106 Antidumping Agreement, 40, 43, 44, 49, 51 biodiversity, 150 antitrust laws, 63 biosphere, 130, 131 Appellate Body, 37, 49, 50, 51, 52, 58, 67 board members, 117 appendix, viii, 36, 37, 104 Board of Governors, 31 application, 39, 54, 132, 133, 139 bonding, 45 appointees, 117 bonds, 12, 13, 19, 42, 120, 154, 155 arbitrage, 12, 15 borrowing, 13, 15, 141, 142, 159 arbitration, 49 Brazil, ix, 47, 115, 116, 120, 122, 123, 124, 125, 126, Asian countries, 111 127, 128 assessment, 43, 75, 87

A

168

Index

Brazilian, ix, 115, 116, 119, 120, 127 Bretton Woods system, 11 budget deficit, 154, 158, 159 Bush Administration, 52 business cycle, 116, 124 business environment, 85, 86 Byrd Amendment, 65, 66

C Canada, 10, 47, 49, 50, 53, 66, 141 capacity, 5, 14, 60, 76, 80, 81, 85, 94, 117, 137, 158, 159 capital accumulation, 98 capital flight, 124 capital flows, vii, 143, 157, 158 capital outflow, 144 Capitalism, 127 carbon, 46, 47 Caribbean, viii, 71, 72, 73, 74, 75, 77, 78, 79, 81, 82, 83, 85, 86, 87, 88, 89, 90, 128 Caribbean countries, 73, 89 Caribbean Sea, 72 causal relationship, 27 causality, 4 certification, 64 channels, 76, 78 Chile, ix, 47, 115, 116, 124, 125, 126, 127, 128 China, viii, x, 35, 38, 39, 45, 47, 48, 51, 52, 53, 59, 60, 62, 66, 67, 68, 69, 141, 142, 145, 146 Chinese imports, 51 cigarettes, 49 citizens, 38, 39, 77 citrus, 55 classical, 2 classification, 68, 133, 161 clay, 136 closed economy, 27 Cochrane, 154 collateral, 8, 13, 148 commerce, 62 Commerce Department, 37, 38 commercial bank, 17 commodity, 138 communication, 11 communist countries, 35, 53, 62 communities, 60 community, 74 comparative advantage, 77 compensation, 6, 54, 60 competence, 81, 132 competition, 36, 53, 54, 56, 58, 60, 63, 74, 82, 132 competitiveness, viii, ix, 71, 72, 73, 74, 75, 77, 78, 80, 81, 85, 86, 87, 88, 89, 158, 159 complexity, 44, 72, 75 compliance, 44 components, 78, 87, 118, 132, 133, 134, 135 composition, 76, 145 computation, 42

computerization, vii conceptual model, 75 conditioning, 161 confidence, 19, 82, 121, 158 conflict, 141 conformity, 149 confrontation, 134 confusion, 75 Congress, 35, 36, 37, 38, 39, 41, 49, 51, 52, 56, 58, 59, 60, 64, 121 consensus, ix, 2, 75, 115, 116, 118, 120, 122, 125 consolidation, 74 Constitution, 120, 125 constraints, 72, 80, 110, 116, 157, 158, 159 construction, 8, 53 consumer choice, 80 consumer goods, 57 consumer price index, 93 consumers, 9, 43, 53, 60 consumption, vii, 1, 12, 13, 15, 27, 73, 74, 75, 76, 77, 80, 92, 95, 154, 156 Continued Dumping and Subsidy Offset Act, 37, 49, 50, 66 contracts, 19 control, 2, 3, 4, 6, 7, 8, 9, 10, 11, 13, 16, 17, 27, 58, 81, 96, 108, 109, 116, 120, 125, 136 convergence, 21, 22, 23, 24, 25, 27, 109 conversion, 122 coordination, ix, 4, 6, 86, 129 corporate sector, 15 corporations, 77 correlation, 4, 27, 85, 118, 149 costs, 12, 19, 56, 60, 73, 80, 131 counterbalance, 15 country of origin, 47 Court of Appeals, 67 courts, 121 CPI, 122, 123, 126 crawling peg, 124 credibility, vii, ix, 1, 5, 8, 11, 14, 16, 100, 104, 107, 115, 116, 119, 120, 124, 127, 141, 142 credit, vii, x, 1, 2, 3, 4, 5, 6, 9, 12, 13, 14, 15, 17, 18, 19, 21, 23, 25, 26, 27, 120, 142, 144, 145, 157, 159 credit market, vii, 1, 4, 5, 6, 12, 13, 14, 15, 17, 18, 19, 21, 23, 25, 26, 27 criticism, 18, 75, 162 crop production, 136 cross-country, 119 crowding out, 155, 156, 159 CRS, 35, 52, 65, 66, 67, 68 Cuba, 73, 148 cultivation, 136 culture, 149 currency, x, 39, 51, 124, 141, 142, 143, 144, 145, 158 Customs and Border Protection, 42, 66 Customs Service, 44 CVD, viii, 35, 36, 37, 39, 40, 41, 42, 43, 44, 45, 46, 47, 48, 49, 51, 52, 53, 57, 61, 65, 66, 67 cycles, 5, 116, 118, 121, 124, 130, 138, 139

169

Index

D data collection, 87 debt, 9, 13, 15, 94, 141, 153, 154, 155, 156, 158 debt service, 158 decision making, 121 decision-making process, 66, 72 decisions, vii, 1, 2, 3, 8, 12, 13, 15, 16, 17, 27, 37, 38, 41, 76, 84, 130, 132, 162 defense, 145 deficit, 38, 159 Deficit Reduction Act, 50 deficits, 120, 154 definition, 16, 65, 80, 89 deflate, 81 deflation, 7, 93, 94 degradation, 139 demand, vii, 1, 2, 3, 6, 8, 12, 13, 14, 15, 21, 77, 78, 80, 81, 85, 86, 87, 88, 94, 99, 137, 145, 153, 154 democracy, 120, 124, 127, 149 Department of Commerce, viii, 35, 36, 39, 65, 66, 67 Department of Homeland Security, 66 dependent variable, 82 deposits, 42 depreciation, 143, 144, 145, 157, 158 depression, vii, ix, 5, 91, 92, 93, 97, 106, 108, 109 deregulation, 141 derivatives, 13 desire, 22 destruction, 72, 79 Deutsche Bundesbank, 31 devaluation, 141 developed countries, x, 40, 77, 147, 150 developed nations, 37 developing countries, x, 40, 77, 89, 116, 118, 119, 126, 127, 147, 149, 150, 157, 158 deviation, 12 dictatorship, 125 differential equations, 109 differential treatment, 40 diminishing returns, 81 discipline, 116 discount rate, 93, 95, 124 discretionary, 5, 18, 26, 62, 163, 164, 165 discretionary policy, 5, 164, 165 discriminatory, 62 disequilibrium, 6, 16 dislocation, 15 dislocations, 18 disposable income, 80, 81, 86 disposition, 5 dispute settlement, 37, 38, 39, 41, 49, 50, 51, 52, 54, 58 Dispute Settlement Body (DSB), 51, 67 disputes, 50, 122 distortions, 51, 75 distress, 141 distribution, 58

divergence, 109, 118 diversification, 159 diversity, 134 Doha, 37, 44, 66 domestic credit, 142, 143, 144, 145 domestic economy, 143 domestic industry, 36, 40, 43, 45, 49, 52, 53, 54, 55, 56, 60, 61, 66 domestic markets, 73 dominance, 133, 158 Dominican Republic, 82, 83, 85, 86 download, 67 drainage, 136 dumping, 38, 39, 40, 41, 42, 43, 44, 45, 50, 51 duration, 40, 80 duties, viii, 35, 38, 39, 41, 42, 43, 44, 45, 48, 49, 50, 61, 62, 65, 121 dykes, 136 dynamical system, 112

E ecological, 130, 131, 133, 134 ecology, 130 economic activity, 158 economic change, vii economic crisis, 124, 153 economic development, 77, 89 economic growth, ix, 13, 73, 88, 115, 116, 126, 127, 138 economic incentives, 74 economic performance, 74, 116, 120, 125, 126 economic policy, 124 economic problem, 124 economic reform, 120, 126 economic reforms, 120, 126 economic stability, 116, 119, 123, 124, 127 economic theory, 86 economics, 74, 88 Ecuador, 47 education, 33, 156 elaboration, 130, 133, 140 elasticity, 78, 80 election, 123, 125 employees, 48, 117 employment, 8, 18, 38, 60, 78, 98, 100, 105 energy, 130 entertainment, 76 environment, 12, 19, 74, 75, 126, 129, 132, 133, 134, 135, 138, 139, 148, 149 environmental factors, 135 environmental impact, 135 environmental protection, 134 epistemological, 89 equality, 7 equilibrium, x, 5, 6, 8, 12, 16, 17, 19, 21, 22, 23, 26, 27, 95, 99, 101, 102, 103, 104, 105, 106, 107, 109, 111, 142, 143, 144, 145, 161, 163, 164, 165, 166 equipment, 49

170 equity, 13, 74 erosion, 73 Estonia, 47 euphoria, 96 Euro, 29, 158 Europe, 31, 137 European Central Bank, 29 European Union, 47, 50, 58, 73, 94 evolution, 19, 85, 88, 123, 163 exaggeration, 91 examinations, 44 excess supply, 96 exchange rate, x, 74, 116, 124, 142, 143, 144, 145, 157, 158, 159 exchange rate policy, 158 exchange rates, 74, 141 expectations-augmented Phillips curve, 99 expenditures, 49, 65, 78, 81, 82, 95, 154 exploitation, 76, 78 export subsidies, 40 exporter, 42, 43, 44, 66 exports, 38, 43, 49, 51, 58, 73 external shocks, x, 157 externalities, 72, 86, 133

Index fluvial, 131 food, x, 130, 131, 157 footwear, 57 Ford, 118, 128 foreign aid, 88 foreign direct investment, vii foreign exchange, vii, x, 74, 78, 125, 141, 142, 143, 144, 145, 146, 158 forestry, 136 forests, 131 free riders, 76 freight, 38 Friedman, Milton, 31 FTA, 55 fuel, x, 157 funding, 61, 77 funds, 13, 49, 120, 154 furniture, 48

G

gauge, 74, 79, 126 GDP, 6, 31, 48, 49, 78, 92, 94, 124 GDP deflator, 92 gene, 117 F General Agreement on Tariffs and Trade, 40, 49, 54, 68 failure, 2, 8, 10, 11, 16, 79 generalizations, 117 Fair Currency Act, 39 generation, 81, 131, 133 federal funds, 2 generators, 134 Federal Reserve, 31, 32 Germany, 10, 31, 111 Federal Reserve Bank, 31, 32 gift, 132, 137 fee, 76 gifts, 131, 138 feedback, vii, 1, 4, 16, 21, 22, 23, 24, 25, 131 global economy, 127, 159 fertilizers, 136 Globalization, vii, viii, x, x, 1, 35, 71, 73, 88, 91, 115, finance, 119, 120, 123, 142, 144, 156, 158, 159 129, 140, 141, 147, 149, 151, 150, 153, 157, 161 financial crisis, 3, 8, 124 GNP, 33 financial instability, vii, 1, 4, 11 goals, 74, 117 financial institution, 8, 25, 121 goods and services, 76, 134 financial institutions, 8, 25, 121 governance, ix, 129 financial markets, vii, 1, 3, 4, 7, 8, 9, 11, 13, 15, 16, 17, government, viii, ix, 35, 36, 38, 39, 40, 43, 51, 58, 61, 26, 27 66, 77, 79, 81, 85, 86, 92, 99, 115, 116, 117, 118, financial sector, 4, 142 119, 120, 121, 122, 123, 124, 125, 127, 129, 138, financial shocks, 16 141, 142, 144, 153, 154, 156, 158, 159 financial stability, ix, 115, 116, 120, 127 government expenditure, 86, 99 financial system, 16, 26, 27, 159 government intervention, 38 financing, x, 125, 142, 154, 155, 158, 159 government securities, 159 firms, 9, 12, 13, 18, 37, 64, 74, 86 governors, 118, 119, 120, 125, 126 fiscal deficit, 120 graph, 95 fiscal policy, 158, 159 groundwater, 131, 136 fish, 49 groups, 40, 50, 86, 87, 133, 135 fishing, 57 growth rate, 11, 14, 17, 25, 27, 49, 72, 78, 79, 80, 85, fixation, 23 86, 92, 95, 100, 101 fixed exchange rates, 141 guardian, 123 flat products, 46 H flexibility, 76, 159 floating, 158 Hamiltonian, 108 flow, 13, 130, 136, 138, 143, 145 harm, 39, 62, 65 fluctuations, 23, 104

Index harmonization, 130 Harvard, 13, 89, 150 hazards, 132 hearing, 42, 56 heart, 74, 77, 116 heterogeneity, 76 heterogeneous, 85 Hispanic, 127 Homeland Security, 66 homeowners, 87 honesty, 76 honey, 47, 57 Hong Kong, 150 horizon, 6, 162 hot-rolled, 46 human, ix, 72, 129, 131, 132, 133, 138, 139 human actions, 131 human resources, 72 Hungary, ix, 129, 130, 140 hybrid, 10 hydrological, 132, 133, 135, 138 hyperinflation, 7, 19 hypothesis, 6, 8, 82, 94, 95, 96, 97, 98, 104, 110, 111

I impact assessment, 133 imperfect knowledge, 110 implementation, 40, 51, 58, 60, 132 Import Administration, 46, 67 import restrictions, 62 import substitution, 40 imported article, 55, 61 importer, 42, 43, 44 imports, viii, 35, 36, 37, 38, 39, 40, 41, 42, 43, 44, 46, 49, 50, 51, 52, 53, 54, 55, 58, 59, 60, 61, 62, 63, 69, 158 impotence, 147 in transition, 40 incentive, ix, 5, 71, 79, 80, 87 incentives, 72, 86, 159 incidence, 87 inclusion, 82 income, 10, 11, 31, 61, 77, 78, 80, 81, 83, 86, 96, 99 increased competition, 58 independence, ix, 16, 115, 116, 117, 118, 119, 120, 121, 122, 123, 124, 125, 126, 127, 159 independent variable, 75, 82 indeterminacy, 11, 161, 162, 163, 164 India, 37, 47, 49 Indian, 32 indication, 41, 42, 52, 55, 79, 132 indicators, 85, 88 indices, 74, 75, 89, 118, 126 Indonesia, 47 industrial, x, 9, 39, 53, 74, 115, 118, 119, 130, 132, 133, 134, 135, 157 industrial democracies, 118, 119 industrialization, 131, 132, 134, 139

171

industrialized countries, 2, 135 industrialized societies, 137 industry, vii, viii, ix, 35, 36, 39, 40, 43, 45, 46, 48, 49, 52, 53, 54, 55, 56, 58, 60, 61, 65, 66, 67, 72, 73, 78, 88, 129, 132, 148 inequality, 21, 22, 24, 102, 103 inertia, 19 infinite, 143, 162 inflation target, vii, 1, 2, 4, 5, 6, 7, 8, 10, 11, 12, 14, 16, 17, 18, 19, 23, 24, 25, 27, 28, 31, 93, 94, 100, 104, 107, 123, 157, 158, 159 inflationary pressures, x, 121, 123, 157, 158, 159 inflation-indexed, 19 information asymmetry, 88 infrastructure, ix, 77, 129, 159 infringement, 63 initiation, 38, 44, 55, 65, 138 injection, 8, 26 injury, viii, 35, 38, 39, 40, 41, 42, 43, 44, 45, 52, 53, 54, 55, 58, 59, 60, 61, 65, 68 innovation, 74 insecurity, 147 instabilities, 30, 116, 123 instability, 3, 9, 10, 11, 12, 16, 102, 103, 105, 124, 161 institutions, ix, 73, 116, 118, 126, 127, 129, 138 instruments, 10, 12, 15, 17, 116, 117, 154, 157, 158 intangible, x, 147, 148, 149, 150 integration, vii, 132, 133, 150, 159 integrity, 75 intellectual property, 36, 63 intellectual property rights, 36, 63 interactions, 130, 131, 150 interdisciplinary, 137, 138 interest rates, vii, 1, 3, 7, 8, 9, 11, 13, 121, 123, 124, 154, 155, 158 interference, 121 international markets, 76, 78 International Monetary Fund, 82, 122, 123, 124, 126, 128, 141 international standards, 159 international trade, 36, 60, 72 International Trade, viii, 35, 36, 38, 52, 53, 61, 64, 65, 66, 67, 68 International Trade Administration (ITA), viii, 35, 36, 40, 41, 42, 43, 44, 45, 46, 48, 50, 51, 52, 61, 65, 66, 67, 68 International Trade Commission, viii, 35, 36, 38, 39, 40, 41, 42, 43, 45, 46, 47, 52, 53, 55, 56, 57, 58, 59, 60, 61, 62, 63, 64, 65, 66, 68 interpretation, ix, 91, 93, 94, 95, 96, 118 interval, 21, 22, 24, 25 intervention, 38, 77, 86, 159 interview, 2 intuition, 166 inventories, 135 inversion, 4 Investigations, 39, 41, 45, 46, 53, 55 investigative, viii, 36, 41

172

Index

investment, vii, ix, 1, 13, 15, 27, 38, 66, 77, 85, 95, 98, 115, 124, 126, 154, 156, 158, 159 investment bank, 124 investors, 18, 121, 124 ions, 15, 36, 49, 53, 58, 59, 81, 82, 88, 133 Iran, 47 iron, 46, 47 irrigation, 132 island, viii, 71, 72, 73, 78, 88 IS-LM, 3, 5, 6, 31 IS-LM model, 3, 5, 31 isolation, 81

J Jacobian, 102 Jacobian matrix, 102 Jamaica, 74, 88, 89 Japanese, ix, 25, 91, 92, 93, 94, 95, 97, 99, 101, 103, 105, 106, 107, 109, 111, 112, 113, 114, 147, 149 job creation, 72 job loss, 38 jobs, 48, 60, 77, 78, 155

K Kazakhstan, 47 Keynes, 98, 113, 155 Keynesian, 3, 4, 19, 30, 32, 94, 110, 111, 112, 113, 161, 162, 166 Keynesian model, 161 Korea, 47, 49, 111

L labor markets, 18, 76 land, 72, 92, 130, 131, 133, 134, 135, 136 land use, 135, 136 landfills, 136 Latin America, 87, 116, 119, 120, 125, 126, 127, 128 Latin American countries, 120, 125, 126 Latvia, 47 law, 36, 39, 49, 50, 59, 67, 116, 118, 122, 124, 125, 126, 127, 163 laws, vii, viii, 35, 36, 37, 38, 39, 40, 41, 51, 52, 53, 58, 60, 63, 117, 118, 135 layoffs, 48 lead, 3, 6, 7, 11, 17, 27, 47, 53, 60, 72, 82, 155 learning, 11, 73, 74, 148, 161 legislation, viii, 36, 39, 49, 52, 59, 60, 120 legislative, 37, 51, 119, 121, 123 lenders, 4 lending, 4, 7, 8, 9, 12, 13, 15, 16, 18, 21, 25, 26, 27, 117, 120, 124, 142 liberalization, 2, 10 licensing, 58 life cycle, 74, 80, 85, 86, 89 lifetime, 87, 131 likelihood, 60 limitation, 17

limitations, 85, 87, 117 linear, 166 liquidation, 42, 43 liquidity, vii, x, 1, 4, 7, 8, 9, 13, 14, 16, 17, 25, 26, 27, 93, 97, 106, 107, 108, 109, 141, 145, 157, 158, 159 liquidity trap, 93, 97, 106, 107, 108, 109 Lithuania, 47 loans, 7, 14, 124, 142, 143, 154 London, 2, 29, 32, 88, 90, 113, 140, 149, 150 long-term, 14, 27, 74, 77, 88, 155, 156 long-term bond, 155 losses, 38, 60 Louisiana, 45, 66 low power, 82 lower prices, 36 Lula, 121, 122, 124 Luxembourg, 48 lysis, 48

M macroeconomic, ix, 1, 2, 4, 74, 91, 94, 112, 119, 159 macroeconomic policy, 119 mainstream, 6, 7, 8, 27, 132 maintenance, 130 Malaysia, 47 management, ix, 72, 73, 77, 86, 87, 88, 89, 129, 130, 131, 132, 133, 135, 136, 137, 138, 139, 140, 158, 159 management practices, 86 manipulation, 126 manufacturer, 48 manufacturing, 38, 47, 48, 49, 53, 60, 75 manure, 136 market, viii, 2, 4, 6, 8, 9, 10, 12, 13, 14, 15, 16, 17, 18, 20, 21, 25, 26, 27, 36, 40, 42, 49, 51, 58, 59, 61, 62, 63, 71, 72, 73, 75, 77, 80, 82, 86, 87, 95, 96, 99, 124, 125, 126, 131, 132, 137, 142, 143, 144, 145, 159 market access, 63 market disruption, 58, 59, 62 market economy, 40 market failure, 77 market share, 77, 80 market value, 36, 49, 61 marketing, 84, 85, 86, 149 markets, 3, 8, 9, 13, 18, 20, 21, 26, 27, 61, 73, 76, 77, 78, 87, 145, 155 mask, 63 Massachusetts, 113, 127 matrix, 102, 135, 164, 165 Mauritius, 88 meals, 76 meanings, 148 measurement, vii, viii, ix, 71, 72, 73, 80, 81, 115, 116 measures, viii, 13, 36, 37, 40, 41, 44, 53, 54, 58, 60, 61, 83, 85, 86, 117, 118, 119, 123, 126, 137 meat, 47 media, 41

173

Index MENA region, 157, 159 merchandise, viii, 35, 39, 40, 41, 42, 43, 44, 45, 48, 50, 53, 54, 55, 58, 59, 61, 69 messages, 133 Mexican, 141, 146 Mexico, 32, 33, 47, 50, 53, 125 Mexico City, 32, 33 military, 116, 124, 125, 127 military dictatorship, 125 military government, 116, 127 military junta, 124, 125 Milton Friedman, 2, 6, 9, 27, 32 mining, 135, 136 mirror, 80 misappropriation, 63 missions, 120, 121 MIT, 29, 33, 88, 113, 127, 128 Mittal Steel, 48 mobility, 76 modalities, 133 model specification, 5 modeling, 75, 112 models, ix, x, 3, 4, 6, 16, 19, 80, 91, 93, 98, 110, 112, 161, 163, 164, 166 modernity, x, 147, 148, 149, 150 modulus, 20, 21, 23, 25 Moldova, 47 momentum, 159 monetary aggregates, 2, 3, 4, 5, 9, 10, 11, 23, 142 monetary policy, ix, x, 1, 2, 3, 4, 5, 6, 8, 9, 10, 11, 12, 15, 16, 17, 19, 20, 25, 26, 27, 91, 93, 94, 97, 99, 100, 104, 107, 108, 109, 110, 111, 112, 115, 116, 120, 124, 127, 155, 157, 158, 159, 166 monetary targeting, 1, 2, 4, 9, 10, 11, 12, 16, 17, 21, 23, 27, 32 money, 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 15, 16, 17, 18, 19, 20, 21, 22, 23, 24, 25, 26, 27, 30, 31, 32, 49, 77, 91, 95, 96, 97, 99, 101, 120, 123, 124, 141, 142, 143, 144, 145, 153, 154, 155, 156 money multiplier, 13 money supply, vii, 1, 3, 6, 8, 11, 12, 13, 16, 27, 30, 32, 95, 96, 97, 99, 101, 120, 123, 124, 142, 143, 144, 145 mortgage, 94 motion, 139, 163 motives, 80, 139 mountains, 76 movement, 94, 106, 120, 133, 157, 158 multidimensional, x, 72, 147, 148 multilateral, 36, 37, 41, 52, 60 multinational firms, 48 multiple regression, 81 multiplicity, 166 multiplier, 154, 155 mushrooms, 47, 57 music, 149

N narrow money, 11 nation, ix, 115 national, vii, ix, 6, 56, 59, 62, 63, 74, 77, 93, 96, 99, 120, 121, 129, 132, 138 national economies, vii national security, 56, 62, 63 natural, viii, 2, 12, 71, 73, 75, 76, 77, 78, 96, 97, 99, 100, 101, 105, 111, 131, 132, 133, 134, 135, 138, 150 natural capital, 75 natural disasters, 73 natural environment, 134 natural hazards, 132 natural resources, 77, 78, 131, 133 neglect, 3, 4, 7, 18, 19, 75, 101 negotiating, 37 New York, 32, 65, 89, 113, 125, 127, 128, 140, 145, 156 Newton, 75, 88 nominal rate of interest, 93, 94, 95, 96, 99, 101, 102, 108, 109, 112 nonlinear, 80, 93, 109 non-renewable, 77 non-renewable resources, 77 normal, 15, 50, 58, 59, 101, 102, 103, 104, 105, 106, 107, 109 North America, 40, 73, 137 North American Free Trade Agreement, 40, 41, 53, 54 NTE, 63 null hypothesis, 82

O obligations, 8, 36, 37, 40, 49, 50, 52, 54, 58, 59, 60 offshore, 38, 60, 73 oil, 2, 47 omission, 6 online, 122, 123, 126 open economy, 30 open market operations, 159 operational independence, 121, 127 opposition, 65, 116, 121, 125, 127 opposition parties, 121 optimal resource allocation, 77 optimization, 15 organization, 138 organizations, 72, 132, 135 orientation, 78 orthodox, 125 output gap, 3, 11, 12, 14, 15, 16, 17, 162, 163, 164, 165 outsourcing, 38, 60 oysters, 49

174

Index

P paradigm shift, 88 paradox, 149 paradoxical, 112 parameter, 11, 14, 25, 100, 104, 110, 163, 164, 165 passive, 148 pasta, 47 pears, 37 pegging, 51, 158 penalties, 49, 58 perception, 75 performance, ix, 10, 71, 72, 73, 74, 75, 78, 79, 81, 83, 86, 87, 88, 91, 94, 116, 117, 120, 125, 126, 131 performers, 85 periodic, 17 permit, 38, 39, 52 personal, 148 personality, 117, 118 persuasion, 5, 16 perturbation, 15 Peru, 125 pesticides, 136 petitioners, 48, 49 petroleum, 47 pharmaceuticals, 47 phase diagram, 104, 105, 106, 107, 112 Phillips curve, 12, 14, 16, 17, 93, 110, 111, 164, 165 pipelines, 136 plague, 164 planetary, 129, 130, 134, 138, 139 planning, 131, 133, 135, 140 plants, 48 plausibility, 21, 142 plebiscite, 125 plurality, x, 147, 148 policy instruments, 12, 126 policy rate, 93, 94 policymakers, ix, 71, 87, 116, 119, 161 political parties, 125 politicians, ix, 115, 116, 123, 125, 126 polling, 48 pollution, 81, 135, 137 pond, 136 population, 72, 73, 75, 81 portfolio, 87 positive feedback, 131 potential output, 14, 18 poverty, 73 power, 5, 6, 56, 82, 87, 125, 142 predictors, 81 preference, 55 premium, 25, 143, 144, 145, 156 presidency, 121 president, 13, 120, 121, 122, 124 President Bush, 58 pressure, 8, 79, 96, 123, 145, 155, 157, 158 prestige, 76

prevention, 132, 135, 136, 137 price changes, 162 price elasticity, 86 price index, 81 price stability, 14, 120, 121, 124, 126 prices, x, 2, 12, 16, 19, 36, 43, 48, 49, 50, 53, 80, 137, 143, 157, 158, 164 prior knowledge, 41 priorities, 157, 158, 159 private, vii, x, 1, 2, 4, 5, 6, 8, 12, 13, 15, 16, 17, 18, 19, 23, 27, 52, 76, 80, 85, 154, 155, 156, 158, 159, 161, 162, 163, 164, 166 private citizens, 52 private investment, 154, 159 private sector, x, 2, 4, 5, 6, 8, 12, 16, 76, 158, 159, 161, 163, 166 probability, 80 producers, 36, 40, 44, 45, 49, 57, 60, 61, 65 product life cycle, 86 production, viii, 35, 40, 48, 60, 61, 65, 69, 73, 75, 76, 77, 78, 80, 86 productive capacity, 158 productivity, 12, 73, 78 productivity growth, 73 profit, 86 profit margin, 86 profits, 60 program, 38 promote, 38, 74, 76, 116, 119, 120, 126, 149 property, 36, 63, 111, 135 prosperity, 88 protected area, 150 protected areas, 150 protection, ix, 63, 129, 133, 134 proxy, 80, 118 prudence, 79 public, vii, viii, x, 2, 5, 10, 13, 16, 35, 36, 39, 40, 41, 43, 61, 63, 68, 76, 77, 79, 80, 85, 94, 95, 96, 100, 110, 121, 124, 125, 153, 154, 155, 156, 158, 159 public debt, vii, x, 153, 154, 155, 156, 158 public expenditures, 125 public goods, 76, 77, 80 public interest, 43 public sector, 85 publishers, 156 purchasing power, 6

Q quality of life, 75, 139 quality of service, 86 quotas, 56

R race, 121 radar, 157 radical, 124 range, 103, 104, 110, 117, 135

175

Index rate of return, 12, 13 rational expectations, 6, 19, 94, 161, 166 real estate, 87 real national income, 96, 99 real rate of interest, 94, 95, 99, 101, 111 real wage, 8 reality, vii, 1, 75, 76, 149 reasoning, 86 recession, x, 49, 94, 96, 106, 157 recognition, 116, 138 reconciliation, 37 recovery, 64 recycling, 130, 131, 132 reduction, 54, 56, 94, 137, 144, 154 REE, 163 Reform Act, 38, 69 regional, ix, 72, 82, 89, 129, 131, 138 regressions, 81 regulation, 52, 74 regulations, 38, 74, 134, 135, 159 reinforcement, 127 relationship, x, 2, 4, 5, 6, 10, 11, 16, 23, 27, 74, 75, 87, 100, 115, 117, 119, 135, 143, 147, 148 relationships, 102, 104, 116 relaxation, 94, 96, 97 relevance, 9, 74, 81, 133 rent, 73, 77 repo, 4, 7, 8, 9, 12, 15, 16, 23, 25, 27 reputation, 76, 86 research, 2, 6, 49, 77, 87, 112, 115, 118, 119, 132, 133, 139, 147, 148 research and development, 49 reserves, vii, x, 13, 40, 124, 131, 141, 142, 143, 144, 145, 146, 158 reservoirs, 131, 136 residuals, 81 resistance, 37 resolution, 38, 39, 49, 56, 62 resources, ix, 54, 72, 73, 74, 75, 76, 77, 78, 88, 129, 131, 132, 133, 134, 140, 154, 158, 159 responsibilities, 117, 120 restructuring, 141 retail, 48 retaliation, 49, 50, 58 returns, 75 revenue, 6, 73 rings, 115 risk, x, 5, 13, 16, 25, 72, 125, 133, 143, 144, 145, 156, 157, 158, 159 risks, ix, 73, 129, 130, 131, 133, 135, 137 rivers, 131, 135 rods, 57 ROI, 77, 84 Romania, 47 Rome, 29 rule of law, 118, 127 Russia, 47, 124

S safeguard, viii, 35, 36, 38, 39, 53, 54, 56, 57, 58, 59, 60 safeguards, 36, 52 sales, 40, 42, 43, 48, 50, 60, 155 sample, 82, 83, 85, 86, 119 satisfaction, 81, 137 saturation, 80, 85 savings, 154 scandal, 116, 127 Scandinavia, 148 scarcity, 72, 77 scores, 117 search, 64, 150 searching, 149 Secretary of Commerce, 58 secrets, 10, 63 securities, 42 security, 42, 44, 56, 62, 63 seeds, 79 selecting, 76 self-confidence, 149 semi-arid, 131 Senate, 37, 53, 120, 121 September 11, 124 series, 58, 79, 82, 87, 121, 133 services, 8, 64, 73, 75, 76, 129, 130, 131, 132, 133, 134, 137, 138, 148 shape, 86, 93, 139 shaping, 131 shares, 2 shock, x, 6, 12, 13, 18, 19, 143, 157 shocks, x, 6, 7, 8, 9, 10, 13, 15, 16, 17, 18, 19, 20, 26, 27, 29, 106, 143, 157, 162, 163, 164, 165, 166 short period, 42 short run, 2, 98, 119 short-term, 2, 6, 15, 88, 129, 153, 154, 155, 156 short-term interest rate, 153, 155, 156 shrimp, 47, 57 side effects, 130 sign, 85, 94, 111, 112 signals, 137 signs, 119, 139 social benefits, 56, 60 social costs, 12, 60 social impacts, 135 social integration, 133 socialist economy, 125 socioeconomic, 134, 136 solutions, 17, 18, 20, 26, 131, 132, 163 solvency, 142 South Africa, 37, 47 South Korea, 47 Spain, 89, 147, 148, 149, 151 specialization, 87 spectrum, 125 S-shaped, 74

176

Index

stability, vii, ix, 1, 5, 9, 14, 16, 17, 18, 20, 21, 23, 24, 25, 30, 31, 102, 103, 105, 106, 115, 116, 119, 120, 121, 123, 124, 125, 126, 127, 134, 142, 158, 165, 166 stabilization, 15, 116, 123 stabilize, 2, 7, 9, 11, 16, 23, 24 stages, 74, 85, 86 stainless steel, 47, 57 stakeholders, 86, 87 standard of living, 75 standardization, 86 standards, 86, 159 statistics, 66 statutes, viii, 35, 36, 38, 41, 51, 52, 53 statutory, 36, 41, 116, 118, 122, 126, 127 statutory provisions, 116 steady state, 14 steel, 46, 47, 48, 53, 57, 58, 67, 68 steel industry, 46, 58, 67 steel mill, 58 steel pipe, 46 stereotypes, 149 stimulus, vii, x, 153, 154, 155, 156 stochastic, 8, 110, 111 stock, x, 6, 92, 94, 141, 142 stock price, 6, 92 strategic, 133 strategies, 3, 72, 73, 85, 132 stress, 77 subgroups, 50 subjective, 120 subsidies, 40, 42, 43, 44, 45, 51, 52, 65 subsidization, 52 subsidy, viii, 35, 39, 40, 41, 42, 43, 44, 51, 52, 61 substitutes, 158 substitution, 40 success rate, 45 sugar, 47 summaries, 133 suppliers, 75, 76 supply, 2, 4, 5, 6, 7, 8, 9, 13, 14, 18, 21, 26, 72, 78, 79, 81, 83, 85, 132, 136, 143, 155 supply curve, 5 supply shock, 8, 18 support services, ix, 130, 131, 133, 134 surprise, 149 sustainability, ix, 72, 74, 76, 77, 78, 129, 131, 139 sustainable tourism, 72 switching, 107, 112 Switzerland, 10 symbolic, 130 symbols, 99 symptoms, 74 synthesis, 3 systems, 76, 131, 133, 134, 139, 141

T Taiwan, 47

Tajikistan, 47 target variables, 14 targets, 2, 9, 10, 11, 25, 31, 123, 157, 166 tariff, 50, 52, 54, 56, 58 Tariff Act, 36, 39, 49, 61 tariffs, 49, 58 tax incentive, 86 tax incentives, 86 taxes, 77, 87 taxpayers, 60 Taylor rules, 32 teachers, 149 technical assistance, 64 technology, vii telephone, 66 tension, x, 15, 147, 150 tenure, 121 term limits, 118, 125 territory, 39, 40 test statistic, 82 textiles, 47 Thailand, 47 The Economist, 145 theory, vii, viii, 2, 9, 71, 80, 83, 85, 87, 117, 118, 131 thinking, 91, 132, 139 threat, 54, 55, 58, 61 threatened, viii, 35, 36, 39, 40, 52, 61, 116, 127 threats, 125, 131 threshold, 53, 138 time, x, 2, 16, 21, 29, 43, 44, 45, 50, 52, 54, 55, 56, 59, 60, 61, 65, 74, 75, 79, 81, 82, 83, 87, 97, 99, 108, 111, 119, 120, 122, 125, 137, 138, 147, 148, 149, 162, 163, 164 time bomb, 138 time frame, 119 time series, 82, 87 timing, 60, 73, 125, 162, 164, 165, 166 Tokyo, 91, 113, 114 total costs, 80 total employment, 78 total product, ix, 80, 129 total revenue, 80 tourism, viii, ix, x, 71, 72, 73, 74, 75, 76, 77, 78, 79, 80, 81, 83, 85, 86, 87, 88, 89, 147, 148, 149, 150, 151 tourist, 71, 72, 73, 74, 75, 76, 77, 78, 79, 80, 81, 82, 84, 87, 148, 149 TPA, 37 trade, x, 35, 36, 37, 38, 39, 40, 41, 45, 48, 49, 50, 51, 52, 53, 58, 59, 60, 61, 62, 63, 64, 66, 68, 72, 73, 78, 147, 149, 150, 158 Trade Act, 36, 52, 53, 58, 59, 60, 61, 63, 64 trade agreement, 36, 37, 40, 62 trade deficit, 38, 51 Trade Representative, 36, 39, 52, 53 trade-off, 87, 145 trading, viii, 35, 36, 51, 58, 158 trading partners, viii, 35, 36, 58, 158 tradition, 119, 148, 149, 150

177

Index training, 49, 64, 77 trajectory, 96, 97, 106, 107, 108 transactions, 14, 50 transactions demand, 14 transfer, 54, 136 transformation, 78, 135 transition, 118, 127, 130, 133, 139 translation, 133 transmission, 4, 8, 9, 27, 159 transparency, 16, 158 transparent, 4, 5, 7, 11, 14, 15, 25, 41, 77, 157 transport, 76 transportation, ix, 47, 76, 129, 132 travel, 72, 76, 77, 78, 84, 88, 149 Treasury, 15, 25, 120, 154, 155 trend, 3, 8, 48, 79, 85 troposphere, 131 trust, 76 Turkey, 47 Turkmenistan, 47 turnover, 118, 119, 126

U U.S. economy, 49, 53 U.S.-China trade, 51 Ukraine, 47, 68 unemployment, 73, 92, 93, 94, 96, 97, 99, 111 UNESCO, 140 unification, 120 unions, 40, 48 United Kingdom, 87, 111, 114, 161 United Nations, 131, 132, 140 United States, 2, 10, 35, 36, 37, 39, 40, 42, 43, 44, 48, 49, 50, 51, 52, 58, 59, 60, 61, 62, 63, 64, 66, 67, 68, 87, 141 Uruguay Round, 36, 37, 40, 45, 51, 52 Uzbekistan, 47

V values, 6, 11, 73, 79, 101, 104, 110, 132, 138, 163, 164, 165, 166 variability, 11, 14, 147 variables, 2, 5, 9, 10, 11, 17, 19, 20, 23, 26, 28, 81, 86, 97, 99, 100, 106, 112, 117, 118, 142, 164, 165, 166 variance, 81, 82, 85, 164 variation, 15, 16, 17, 18, 21, 119 verbal persuasion, 5, 16 Victoria, 141, 142, 144, 146 Vietnam, 47, 68 volatility, 77, 88 vulnerability, 118, 157

W wages, 19 water resources, ix, 129, 132, 133, 134 water vapour, 131 welfare, 5, 11, 14 West Indies, 88 wetlands, 136 wholesale, 49 wholesalers, 40 workers, vii, viii, 35, 36, 37, 38, 40, 51, 53, 56, 60, 64, 65 World Bank, 72, 73, 89, 90, 128 World Economic Forum, 74 World Trade Organization, 37, 38, 39, 40, 42, 43, 44, 45, 49, 50, 51, 52, 54, 58, 59, 62, 66, 67, 72, 82 world trading system, 60

Y yuan, 51