Continued from previous lecture… READING: Finish the textbook. 1

Brazilian President Dilma Rousseff referred to unstable capital flows as a "liquidity tsunami" 11 Apr 2012: 2

Brazilian exports getting crushed by currency appreciation 3

Do trilemma solutions need to be compatible across countries? Brazil is complaining now Used to have a fixed XR Then East Asian Financial Crisis hit Currency value collapses under speculation (Dec 1998/ Jan 1999) MERCOSUR? Argentina’s exports become uncompetitive over night Argentina’s currency collapses in

Commitment mechanisms Argentine Currency Board ( ) –Pegged the Argentine peso to the U.S. dollar in an attempt to eliminate hyperinflation –Credibility? Required legislative vote to change the value of the currency (public discussion undermines the point of a devaluation!) –Then current account deficit widens (after Brazil’s 1998/9 crisis) –And deficit spending ultimately undermined confidence –Tied hands prevented the government from acting –Commitment was, perhaps, too strong… –Run on the currency in 2002  disaster!! 5

What does a “run” look like? 6

Do the world’s 2 largest economies have compatible solutions to the trilemma? US “shock absorber”: –Floating exchange rate China opts for: –restrictions on capital flows –fixes its currency to the dollar How can the dollar adjust if China fixes to it? This is the current monetary system… And it’s doomed 7

Exchange rates & protectionism “Currency manipulator” ?? Should the WTO be involved in regulating the exchange rate? 8

What can China do? Gradual appreciation? –A one-way road to “hot money” and a scary bubble A one-off revaluation? –Catastrophic economic dislocation –Politically possible given the export-oriented sector strength? Status quo? –Unsustainable in the long-run 9

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Complaints from Mexico about Chinese currency But even as their currency appreciated, it was far below where it was before the crisis 12

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So, are global imbalances the fault of the United States? How can the US get away with running Current Account deficits year after year? Capital Account surpluses Why? Are we really a great place to invest? International Reserve Currency –The world has coordinated on the dollar 14

Her Him FootballBallet Football 4,32,2 Ballet 1,13,4 4>3>2>1 “Battle of the sexes” 15

Korea Japan LeftRight Left 4,32,2 Right 1,13,4 4>3>2>1 Which side of the street? There are 2 equilibria! This is a game with multiple solutions This is a game with multiple equilibria! 16

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Good Will Hunting (around min 21…) SKYLAR: Maybe we could go out for coffee sometime? WILL: Great, or maybe we could go somewhere and just eat a bunch of caramels. SKYLAR: What? WILL: When you think about it, it's just as arbitrary as drinking coffee. SKYLAR: (laughs) Okay, sounds good. 18

Is the euro an alternative? Coordination game Present distribution of reserve currencies: –Dollar: ~60% –Euro: ~25% –Pound: ~4% –Yen: ~4% –Swiss franc: ~0.1% –Other: 5% 19

Obstacles A focal point: The more people who use an international currency, the more effective it is (increasing returns to scale) No equivalent to the US treasury the EU level Leadership – who bails you out? –US track record v. EU (…Greece?) 20

Is the renminbi an alternative? 21

Be careful what you wish for… Benefits of international reserve currency –finance fiscal deficits –enhance international prestige –debt denoted in your own currency Costs of international reserve currency –Monetary policy autonomy is hindered - vast quantities of your currency held abroad –Overvaluation leads to uncompetitive export- oriented/import-competing sectors 22

Is the SDR an alternative? 23

In CRYPTOGRAPHY we trust? 24

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Take-homes on Euro Solves the old problem that the IMF failed to solve Still limited as a currency –No EU level bond Will it become the new international reserve currency? –Probably not any time soon –Coordination game –The Dollar is still “noon, Grand Central information booth” 26

Thank you WE ARE GLOBAL GEORGETOWN! 27