New Papers on International Finance: Crises, Puzzles, and Exchange Rates

Summertime is conference season, especially for those of us who don’t live close to a major airport hub. The first conference I attended was the NBER’s International Seminar on Macroeconomics, co-organized by Lucrezia Reichlin and Ken West. The conference was broken up into several sections: Financial Crises, International Economic Puzzles, Exchange Rates and Financial Development. Lot’s of interesting papers, and plenty of stimulating discussion. I can’t do justice to the proceedings, but I can provide the summaries of the papers.


vothpix1.gif

Figure 1: Legend: Each observation represents average equity market correlation coefficient in a group of
16 countries, for a four-year panels, 1890-2001. The sixteen countries in our dataset are Australia, Belgium, Canada, Denmark, Finland, France, Germany, Great Britain, Italy, the Netherlands, New Zealand, Norway, Spain, Sweden, Switzerland, and the United States.
“Uncorrected” is the equity market correlation of a pair of countries, and is taken from Global Financial Data. The Forbes-Rigobon volatility adjusted equity correlation is proposed in Forbes
and Rigobon (2002), and used here. Source: D. Quinn and H.-J. Voth, “Free Flows, Limited Diversification: Openness and the Fall and Rise of Stock Market Correlations, 1890-2001”.

In the abstract to “Free Flows, Limited Diversification: Openness and the Fall and Rise of Stock Market Correlations, 1890-2001”, Dennis Quinn and Hans-Joachim Voth write:

Using a new dataset on capital account openness, we investigate why equity return correlations changed over the last century. Based on a new, long-run dataset on capital account regulations in a group of 16 countries over the period 1890-2001, we show that correlations increase as financial markets are liberalized. These findings are robust to controlling for both the Forbes-Rigobon bias and global averages in equity return correlations. We test the robustness of our conclusions, and show that greater synchronization of fundamentals is not the main cause of increasing correlations. These results imply that the home bias puzzle may be smaller than traditionally claimed.

The abstract to “The Default Puzzle: Underwriters and Sovereign Bond Markets 1815-2007”, by Marc Flandreau, Juan H. Flores, Norbert Gaillard, Sebastian Nieto-Parra reads:

We provide a comparison of salient organizational features of primary markets for foreign government debt over the very long run. We focus on output, quality control, information provision, competition, pricing, charging and signaling. We find that the market set up experienced a radical transformation in the recent period and interpret this as resulting from the rise of liability insurance provided by rating agencies. Underwriters have given up their former role as gatekeepers of liquidity and certification agencies to become aggressive competitors in a new speculative grade market.

Romaine Ranciere and Aaron Tornell summarize their paper, “Systemic Risk-Taking and the US Financial Crisis”, thus:

The recent macroeconomic experience of the US resembles the boom-bust cycles of emerging markets more so than the tame postwar US business cycles. We present a model in which a feebdack loop between credit and prices generates the boom and the bust, and accounts for several stylized facts that characterize of the US experience.

The next section of the conference departed from the issues of crises, and moved onto puzzles. The first puzzle tackled was a prominent one in international finance, namely the Feldstein-Horioka finding that saving and investment are highly correlated, despite the fact that capital mobility is widely perceived to be high (see additional discussion here).


In “The Feldstein-Horioka fact”, Domenico Giannone and Michele Lenza, write:

This paper shows that general equilibrium effects can partly rationalize the high correlation between saving and investment rates observed in OECD countries. We find that once controlling for general equilibrium effects the saving-retention coefficient remains high in the 70’s but decreases considerably since the 80’s, consistently with the increased capital mobility in OECD countries.

The next paper addressed the reason for the famous Meese-Rogoff finding that ex post historical simulations using structural models cannot outperform a random walk (see discussion here). From the abstract of the paper “Can Parameter Instability Explain the Meese-Rogoff Puzzle?” by Philippe Bacchetta, Eric van Wincoop and Toni Beutler:

The empirical literature on nominal exchange rates shows that the current exchange rate is often a better predictor of future exchange rates than a linear combination of macroeconomic fundamentals. This result is behind the famous Meese-Rogoff puzzle. In this paper we evaluate whether parameter instability can account for this puzzle. We consider a theoretical reduced-form relationship between the exchange rate and fundamentals in which parameters are either constant or time varying. We calibrate the model to data for exchange rates and fundamentals and conduct the exact same Meese-Rogoff exercise with data generated by the model. Our main finding is that the impact of time-varying parameters on the prediction performance is either very small or goes in the wrong direction. To help interpret the fndings, we derive theoretical results on the impact of time-varying parameters on the out-of-sample forecasting performance of the model. We conclude that it is not time-varying parameters, but rather small sample estimation bias, that explains the Meese-Rogoff puzzle.

(This paper is closely related to a very interesting paper “On the Unstable Relationship between Exchange Rates and Macroeconomic Fundamentals”, by Bachetta and van Wincoop). My comments are here [ppt], while my update (with Cheung and Fujii) of the Meese-Rogoff exercise is here [pdf].


In the final section, the first paper presented was by Kathryn M. E. Dominguez, entitled ” International Reserves and Underdeveloped Capital Markets”. From the abstract:

International reserve accumulation by developing countries is just one example of the puzzling behavior of international capital flows. Capital should flow to where its return is highest, which ought to be where capital is scare. Yet recent data suggest the opposite — net capital flows from developing countries to industrialized countries. This paper examines the role of financial market development in the accumulation of international reserves. In countries with underdeveloped capital markets the government’s accumulation of reserves may substitute for what would otherwise be private sector capital outflows. Effectively, these governments are acting as financial intermediaries, channeling domestic savings away from local uses and into international capital markets, thereby offsetting the effects of domestic financial constraints that lead to excessive private sector exposure to potential capital shortfalls.

For a slightly different perspective on reserve accumulation, see this post.


Next, in “The Nontradable Goods’ Real Exchage Rate Puzzle”, my colleague Lukasz Drozd, and Jaromir Nosal write:

This paper studies empirically and theoretically the decomposition of the real exchange rates into tradable and nontradable components, in the spirit of Engel (1999). Empirically, using an extended decomposition, we find that the contribution of the relative price of nontradable goods to local nontradable output to the overall real exchange rate movements is at best modest. Theoretically, we argue that this finding is a puzzle for the standard models in which the law of one price holds, and fluctuations of the real exchange rate for tradable goods are fully accounted for by the relative price movements of the differentiated home and foreign tradable goods. Specifically, we find that, in the best case scenario, the standard model overshoots the contribution of non-tradable goods to the overall real exchange rate fluctuations by a factor of two.

The final paper, by Lone Christiansen, Alessandro Prati, Luca Antonio Ricci, Stephen Tokarick, and Thierry Tressel, tackled a difficult issue, namely “Assessing External Equilibrium in Low Income Countries”. From the abstract:

This paper investigates empirically the external performance of low income countries, as measured by the real exchange rate, the current account, and the net foreign assets. The paper focuses on indicators which are specific to low income countries, such as the quality of policies and institutions, the special financing access, and the role of shocks. It also offers a metric for linking the external indicators via a calibration of trade elasticities.

The paper builds upon the research program at the Fund which uses the macroeconomic balance approach to inferring norms in current account balances; this approach is closely related to the methodology implemented in Chinn and Prasad (JIE, 2003) (discussed in this post.)

The final segment involved a panel discussion on “Monetary Policy in a Low Interest Rate Environment,” chaired by Athanasios Orphanides (the Governor of the Central Bank of Cyprus). The participants were:



This was a fascinating panel discussion, which covered among other things quantitative easing/credit easing, whether QE can occur even above the zero interest rate bound, and the lessons from Japan’s (successful) experience in QE without inflation.


Some representative pieces here: For Pill; for Reinhart; for Volker; and for Williams.