By Jeffrey Frankel
Today, we’re fortunate to have Jeff Frankel, Harpel Professor at Harvard’s Kennedy School of Government, as a guest blogger. His blog is here.
The possibility that some Gulf states, particularly the UAE, might abandon their long-time pegs to the dollar is getting increasing attention (from Martin Feldstein and Brad Setser, for instance). It makes sense. The combination of high oil prices, rapid growth, a tightly fixed exchange rate, and the big depreciation of the dollar against other currencies (especially the euro, important for Gulf imports) was always going to be a recipe for strong money inflows and inflation in these countries. The economic dynamism — most striking in Dubai — is admirable and fascinating, but also now clearly indicative of overheating. Indeed inflation, as predicted, has risen alarmingly. Among other ill effects, it is producing unrest among immigrant workers. An appreciation of the dirham and riyal is the obvious solution.
Most often discussed as an alternative to the dollar peg is a peg to a basket of major currencies. This would be an improvement. Kuwait, for example, made this switch a couple of years ago.
But a basket peg does not address the fact that when oil prices rise generally (not just against the dollar), as in recent years, monetary policy is constrained to be looser than it should be. Similarly, when oil prices fall generally (not just against the dollar), as in the 1990s, monetary policy is constrained to be tighter than it should be. A floating exchange rate would be the traditional alternative, on the theory that the currency would then automatically appreciate when oil prices rise and depreciate when they fall. But there are serious disadvantages to small open countries floating, such as the loss of a nominal anchor for monetary policy. Today’s reigning orthodoxy is to add an inflation target as the new nominal anchor. But this doesn’t solve the problem if the price index is the CPI, which gives little weight to oil, the biggest sector in production and exports.
I believe that a better solution would be to include the price of oil in the basket of currencies to which the Gulf currencies would peg. I have laid out the case elsewhere. (I call it PEP, for Peg the Export Price [pdf]) I was pleased to see recently that the Financial Times mentioned this option approvingly (“Dollar-pegged Out,” July 7):
“The Gulf needs to peg to something. A first step (after revaluation) would be to peg to a basket of currencies that included the euro and the yen. A bolder step would be to include the price of oil in that basket, so that currencies would appreciate when oil is strong, and depreciate when it is weak.”
Wow. Pegging to a commodity because fiat money is paper and has no intrinsic value – sounds like an excellent idea (not a new one though).
Interesting Western economics this century;
1) Western Countries go off the gold standard.
2) Western Countries sell their gold.
3) Western Countries sell (privatize) remaining state assets.
If a bank were to sell of its assets would that not expose it to a “run on the bank”?
Meanwhile Russia and other developing nations have been building up state assets (reversing the Reagan/Thatcher trends)
Do they know something we don’t? Help me here? Is there a danger of a run on the bank? Is the West exposed – as there are few “assets” left and mostly IOU’s?
Nations still have assets.
Essentially an equity stake in each citizen/corporation via taxes.
interesting point by frankel but i don’t think it’ll completely solve the gcc’s inflation problems. these are classic dutch disease symptoms. i don’t understand how these governments, while – almost literally – pouring oil money into their economies, act all surprised about the inflation that ensues. if they had any sense they wouldn’t repeat the same mistakes they made in the 70’s. they should cool off the fiscal expansion and invest the money elsewhere.
I agree with camello.
Camello: this is not a Dutch Disease problem. Dutch Disease is about newfound mineral wealth choking off other, existing industries. These countries had no exisitng industries to speak of. They have gone from being camel-herding, pearl-diving, date-farming wandering bedouins to Benz-driving, mansion-dwelling international jet-setters in two generations.
The main source of inflation in the UAE isn’t the money flowing into the economy, but the imbalance between their import and export markets. Everything they sell, they sell in dollars. However, very little of their imports are dollar denominated – almost all of their imported goods come from Europe or the Far East – and they import basically everything. So, the price of everything goes up everytime the dollar (and, hence, the Dirham) loses strength against the Euro, Pound or Yen. Delinking to the dollar means that import prices will stabilize, but the government will then receive fewer Dirhams for each barrel of oil sold. Fortunately for them, the high price of oil makes this a palatable option – it wouldn’t be if oil was $20/bbl. Menzie’s idea of including oil in the peg is an interesting option that addresses this issue.
Abu Dhabi is making an effort to diversify its external portfolio, and they’re also trying to rein in the entitlement culture the locals have. However, cutting back on handouts when you’re swimming in dollars leads to political unrest, and the royal families there rely on popular consent to rule – that’s the history of their culture.
However, they’re spending many of the oil dollars locally to try and create a diversified economy based on trade and tourism that can survive when oil is not the marginal transportation fuel.
Whoops, I was referring to Jeff Frankel’s idea, not Menzie’s.
bartman “So, the price of everything goes up everytime the dollar (and, hence, the Dirham) loses strength against the Euro, Pound or Yen. Delinking to the dollar means that import prices will stabilize, but the government will then receive fewer Dirhams for each barrel of oil sold.”
This doesn’t look like a good explanation to me. The dollar has been stable against the euro for the last four months, and was rising against the yen for much of the past year.
Menzie wrote:
But a basket peg does not address the fact that when oil prices rise generally (not just against the dollar), as in recent years, monetary policy is constrained to be looser than it should be. Similarly, when oil prices fall generally (not just against the dollar), as in the 1990s, monetary policy is constrained to be tighter than it should be. A floating exchange rate would be the traditional alternative, on the theory that the currency would then automatically appreciate when oil prices rise and depreciate when they fall.
Menzie,
Consider that you have this backward. Loose monetary policy causes a rise in oil prices and tight monetary policy cuses a fall in oil prices. If you consider that gold is a leading indicator of inflation of the money supply and prices are a lagging indicator this can be easily seen.
Those who watched Jimmy Rogers make a killing on commodities recently need not be surprised. All he did was read monetary inflation then predict later commodity price increases. Actually not rocket science.
Don: That wasn’t the case for most of the period of 2004-2007, when I lived over there. We’re talking about something a bit more long-lived than 4 months. Concerns over inflation and dollar-linking have been a major topic of discussion in the region for the past 5 years, not just the past 4 months.
Between Feb 2002 and Apr 2008 the dollar lost 45% of its value against the Euro. This is an annualized decline of almost 10%. Given that “official” inflation was claimed to be in the 10% P.A. range in the UAE over this period, exchange rate movements explain almost all of the official inflation. (The $ also lost close to 40% aginst the pound, and 25% against the Yen before the rebound in 2006.) Europe is by far the largest import market in the Gulf.
It is true that there was some demand-pull inflation, but this was largely abated by rapid increases in the availabilty of imported goods – the UAE has fairly low import barriers. The largest component of inflation not captured by currency effects was the increase in rent prices, driven by a shortaqge of rental units and exercises of market power by the landlords.
DickF: The post is written by the guest blogger, Jeff Frankel. I just posted it.
bartman: “Between Feb 2002 and Apr 2008 the dollar lost 45% of its value against the Euro. This is an annualized decline of almost 10%. Given that “official” inflation was claimed to be in the 10% P.A. range in the UAE over this period, exchange rate movements explain almost all of the official inflation. (The $ also lost close to 40% aginst the pound, and 25% against the Yen before the rebound in 2006.) Europe is by far the largest import market in the Gulf.”
So, why change the currency peg now? The dollar may rise against the euro, which should be deflationary by your argument. In any event, it does not appear to be depreciating further, so it should not be adding to inflationary pressures now.
DickF: I think you are referring to U.S. or developed-country monetary policy, whereas JF is talking about monetary policy of the oil exporters.
Menzie,
My apologies. I was totally inattentive and making assumptions, something I criticize in others, it is worse when I must criticize myself. Sorry.
Don,
I see no difference. Monetary policy is monetary policy.
DickF: The economies of the Gulf oil nations are so small that whatever monetary policy they might develop would have little effect on the global price of oil; this will remain especially true if oil markets stay denominated in dollars.
Don: you’re right in the sense that it’s too late to do anything about the diollar decline right now. However, there is an ancilliary idea that the strength of the currencies of those nations should be somehow related to the economic performance of those nations – as it is now, the strength of their currencies are related to the economic performance of the United States. The Gulf oil nations pegged their currencies to the dollar for political, not economic reasons, and I don’t know if those political reasons still exist.
Don and bartman,
This whole issue is what currency will price oil not what the monetary policy of small countries is. If oil is no longer quoted in dollars there will be a huge decrease in demand for dollars and the US should see additional inflation. The result will be that other countries will pay less for oil while we pay more. Right now because oil is quoted in dollars the whole world is impacted by the inflation of the dollar. If oil is no longer quoted in dollars then we will suffer $ inflation alone.
A simple yet realistic enough model can show why depegging their currencies from the USD is not enough for oil exporters. Let’s assume that GCC countries achieve monetary union Eurozone-style, with the Gulfo (GLF) as their common currency. Let’s assume that the Current Account surplus of the Gulfozone is always half their oil exports, implying that as the oil price goes up they spend more abroad. We now consider two possible monetary regimes for the Gulfozone and see what happens per each TWO oil barrels exported as the price of an oil barrel (b) goes from USD 100 to 150 to 200.
Current regime: 1 GLF = 1 USD
1 b = 100 USD; Gulfozone accumulates 100 USD of reserves and prints 100 GLF
1 b = 150 USD; Gulfozone accumulates 150 USD of reserves and prints 150 GLF
1 b = 200 USD; Gulfozone accumulates 200 USD of reserves and prints 200 GLF
Gulf oil standard: 100 GLF = 1 b
1 b = 100 USD; Gulfozone accumulates 100 USD of reserves and prints 100 GLF
1 b = 150 USD; Gulfozone accumulates 150 USD of reserves and prints 100 GLF
1 b = 200 USD; Gulfozone accumulates 200 USD of reserves and prints 100 GLF
Clearly, pegging the GLF to the oil price prevents the acceleration in the internal inflation rate that the current exchange rate regime is causing, but does not prevent the acceleration in the accumulation of USD reserves. Therefore in both monetary regimes Gulf countries are trading their only resource coming from a finite, exhaustible endowment for printed paper worth less and less. This case is completely different from that of factory countries like China, which by revaluating their currencies would render their exports less competitive and eventually bring their CA surplus to zero. That does not happen with oil exports, as oil has no viable substitute and its demand is highly inelastic and moreover has enormous growth potential (unless the Chinese can be convinced that driving cars and SUVs is for losers and that they should keep biking). Therefore, as long as a country can pay for oil with printed paper, it will print as much paper as needed while that paper is accepted as payment.
This problem (for the oil exporters) cannot be solved by switching oil trade to other fiat currencies such as EUR or JPY, because if the problem arises from the fact that the US is getting a free lunch (by having its currency used as the international trade and reserve currency), the solution cannot possibly be just taking that privilege away from the US and granting it to another oil importer like the Eurozone or Japan. The solution can only be that NOBODY gets a free lunch (gold used as international trade and reserve currency) or that Gulf countries themselves start getting a free lunch (GLF used as international trade and reserve currency). The only way to prevent this outcome is to guarantee that the printed paper used today will not be worth less and less, which requires that the USD be pegged (within some reasonable band) to the oil price. This would be equivalent to the person having the free lunch privilege committing to restraining his food intake as necessary so that, in a scenario of constrained food supply, the others can eat too.
Under this hypothetical regime, if the oil price tended to rise too much the US (biggest world oil consumer) would lower its demand as a result of tighter monetary policy. If on the other hand the oil price tended to drop too much, oil exporters could help support it by lowering their production. Needless to say, this regime would delight both Peak Oilers and Global Warmers.
Well, you gotta ask yourself, if:
a) the price of oil, as expressed on the commodities market, is backed by a tangible commodity (unlike fiat money) if less than 99% of contracts traded for each month actually go to delivery,
b) whether the price of oil, as expressed on the commodities market, has anything to do with the basket of crude grades produced in the Middle East when by far the largest and most liquid market for oil futures is light sweet crude in London and New York–not very similar to the bulk of crudes produced in the Middle East,
c) whether pegging to the price of a commodity like oil, as expressed on the commodities markets, isn’t more or less the same as allowing the currency to float freely,
and
d) whether it makes sense, from the perspective of the interests of the UAE to drop the peg, which I imagine they might view as something similar to a swap with the dollar (when the price of oil goes down, relative purchasing power is shored up, when the price of oil goes up, relative purchasing power is somewhat depressed)?
From a risk management perspective, how does pegging the currency of a net oil exporter to a basket of currencies and oil help the net oil exporter diversify away from oil?
If oil continues to be priced and traded in US dollars, then perhaps it makes sense to use a crawling peg to a basket of strong currencies (Euro, Japanese Yen) that excludes the US dollar.
Menzie: Here’s an idea, as in a very rough idea. Might be a paper, might not.
Are you familiar with Shipping the Good Apples Out paper of Alchian and Armen? It is a simple relative price story but may serve to indicate vulnerability to oil price shocks.
Take economies A and B. A has low excise taxes on fuel, B has high excise taxes on fuel. Both A and B have made substantial public and private investments in sunk capital that reflect the oil prices faced by consumers.
Following a capital-shifting ‘significant’ oil price shock, which economy will prove the most robust? In relative terms, the shock to consumers in economy B will be much greater and more costly and time consuming to overcome.
That suggests that a small, resource-poor net oil exporter should peg to the strong currencies of economies with high fuel excise taxes.
A resource-rich, net exporter would adopt some version of price stability/inflation targeting/price averaging policy.
GNP,
I don’t understand why an economy that has gotten used to higer oil prices (i.e. less dependent on oil), would be MORE vulnerable to increases in oil price. Could you explain why? It would seem to be counterintuitive. Here’s how I see is: if producer price of oil is $50 / barrel, and country A taxes it at 0 dollars, and B at $50/barrel, then the economy in country A, is “used to” an effective oil price of $50/bbl and B to a price of $100/bbl
Now if the producer price jumps to $100/bbl, then country A has to deal with a doubling of the price while country B, “only” with an increase of 50% (from $100 to $150).
Explain why this isn’t so
bellanson
Economic dynamism in UAE and Dubai is quiet increasing. But the problem can`t be solved by switching oil trade to other countries some other steps as to be taken.
It seems to me that the world no longer uses the US Dollar as the default currency because it no longer is suitable for the purpose. A currency should hold its relative value and its supply should be increased only by any real increase in its backing..in this case the GDP of the US.
A barrel of oil is now the de facto currency for international trade. The supply of which is fairly constant and the demand is eating up all the supply, thereby making it immune to devaluation and an ideal measure of real value.
The traditional measure of value has been gold, but it lacks the suitability for anchoring a currency because it is too scarce, its demand fluctuates with price, and consumers can sit out a perceived spike in prices.
When measured against the new BO standard, all currencies reflect there devaluation according to its specific inflation.
bellanson:
Sorry, I made a typo. The shock to economy A with lower fuel taxes should be much greater. You seem to have understood the thrust of my argument perfectly.
Economies with relatively less dependency on oil — regardless of source — should withstand the effects of an oil shock much better than other economies.
1.) As you point out, the relative petroleum fuel price increase perceived by the consumer will be less.
2.) The economy with high fossil fuel taxes will have already made a series of adjustments to capital stock that makes much more efficient use of fuel:
=>more humane cities
=> fewer smaller, and more fuel efficient vehicles
=> better designed and insulated buildings
P.S. Apologies in replying. Been busy elsewhere. Interesting to note that President Bush II by opening up reserves to exploitation that will not hit the market for close to 20 years, has clearly signalled to the world that Americans are not serious about using public policy to help conserve fuel, i.e., decrease consumption.
Been doing a little more research here. The USD is very vulnerable right now because of the ongoing fiscal deficit and the accumulating debt. Each dollar now has a smaller share of the intrinsic ability of the US economy to repay what is essentially an IOU, the real backing of the buck. Looking forward there is no end in sight to the upward trend in government spending, the mid east wars may actually expand, with an election coming free spending is on all agendas.
The balance of payments deficit is also ongoing, we are a next exporter of wealth and jobs.
The dollar remains artificially high because the Japanese have been stockpiling bucks in an effort to keep the Yen low and their exports competitive. The Chinese also hold almost one trillion bucks and have the Yuan peggged artificially low to the dollar. Both these countries have more US dollars than the Federal Reserve. If either of them decides to unload their reserves because of their declining value, the buck would fall precipitously. Any move like that could trigger a selling panic amongst all holders of the USD and a flight to commodities, other currencies and gold.