International Finance and Macroeconomics Program Meeting

March 29, 2013
Gita Gopinath, Harvard University, and Hélène Rey, London Business School, Organizers

Andrew Rose, University of California, Berkeley and NBER

The March of an Economic Idea

Conventional wisdom holds that protectionism is counter-cyclic: tariffs, quotas, and the like grow during recessions. While that may have been a valid description of the data before World War I, it is now inaccurate. Since World War II, protectionism has not been counter-cyclic: tariffs and non-tariff barriers simply do not rise systematically during downturns. Rose documents this new stylized fact with a panel of data covering over 180 countries and 40 years, using over a dozen measures of protectionism and six measures of business cycles. He tests and rejects a number of potential reasons why protectionism is no longer counter-cyclic. A "diagnosis of exclusion" leads him to believe that modern economics may well be responsible for the decline in protectionism's cyclic behavior: economists are more united in their disdain for protectionism than virtually any other concept. This in turn leaves one optimistic that the level of protectionism will continue to decline along with its cyclicality.

Alberto Cavallo, MIT; Brent Neiman, University of Chicago and NBER; and Roberto Rigobon, MIT and NBER

Product Introductions, Currency Unions, and the Real Exchange Rate (NBER Working Paper No. 18563)

Cavallo, Neiman, and Rigobon use a novel dataset of online prices of identical goods sold by four large global retailers in dozens of countries to study good-level real exchange rates and their aggregated behavior. First, they demonstrate that the law of one price holds perfectly within currency unions for thousands of goods sold by each of the retailers, implying good-level real exchange rates equal to one. Prices of these same goods exhibit large deviations from the law of one price outside of currency unions, even when the nominal exchange rate is pegged. This clarifies that it is the common currency per se, rather than the lack of nominal volatility, that results in the lack of cross-country differences in the prices of these goods. Second, they use a novel decomposition to show that most of the cross-sectional variation in good-level real exchange rates reflects differences in prices at the time products are first introduced, as opposed to the component emerging from heterogeneous pass-through or from nominal rigidities during the life of the good. In fact, international relative prices measured at the time of introduction move together with the nominal exchange rate. This stands in sharp contrast to pricing behavior in models where all price rigidity for any given good is due simply to costly price adjustment for that good.

Javier Bianchi, University of Wisconsin, Madison and NBER; Juan Hatchondo, Indiana University; and Leonardo Martinez, International Monetary Fund

International Reserves and Rollover Risk (NBER Working Paper No. 18628)

Two striking facts about international capital flows in emerging economies motivate the paper by Bianchi, Hatchondo, and Martinez: 1) Governments hold large amounts of international reserves, for which they obtain a return lower than their borrowing cost. 2) Purchases of domestic assets by foreign agents and purchases of foreign assets by domestic agents are both pro-cyclical and collapse during crises. The authors propose a dynamic model of endogenous default that can account for these facts. The government faces a trade-off between the benefits of keeping reserves as a buffer against rollover risk and the cost of having larger gross debt positions. Long-duration bonds, the counter-cyclical default premium, and sudden stops all are important for the quantitative success of the model.

Alessandro Dovis, University of Minnesota

Efficient Sovereign Default

Sovereign debt crises are associated with severe output and consumption losses for the debtor country and with reductions in payments for the creditors. Such crises also are accompanied by trade disruptions that lead to a sharp fall in the imports of intermediate inputs. Dovis studies the efficient risk-sharing arrangement between a sovereign borrower and foreign lenders in a production economy where the sovereign government cannot commit and has some private information. He shows that the ex-ante efficient arrangement involves outcomes that resemble sovereign default episodes in the data. These outcomes are ex-post inefficient, in the sense that if the borrower and the lenders could renegotiate the terms of their agreement, committing not to do it again in the future, then both of them could be made better off. The resulting efficient allocations can be implemented with non-contingent defaultable bonds and active maturity management. Defaults and periods of temporary exclusion from international credit markets happen along the equilibrium path and are essential to supporting the efficient allocation. Furthermore, as in the data, interest rate spreads increase and the maturity composition of debt shifts toward short-term debt as the indebtedness of the sovereign borrower increases.

Gianluca Benigno, London School of Economics; Huigang Chen, JD Power; Christopher Otrok, University of Missouri; Alessandro Rebucci, Inter-American Development Bank; and Eric Young, University of Virginia

Capital Controls or Real Exchange Rate Policy? A Pecuniary Externality Perspective

In the aftermath of the global financial crisis, a new policy paradigm has emerged in which old-fashioned policies, such as capital controls and other government distortions, have become part of the standard policy tool kit (these are so-called macro-prudential policies). On the wave of this seemingly unanimous policy consensus, a new strand of theoretical literature contends that capital controls enhance welfare and can be justified because of second-best considerations. Within the same theoretical framework adopted in this fast-growing literature, Benigno, Chen, Otrok, Rebucci, and Young show that a credible commitment to support the exchange rate in times of crisis always welfare-dominates prudential capital controls because it can achieve the unconstrained allocation.

Emmanuel Farhi, Harvard University and NBER, and Ivan Werning, MIT and NBER

Fiscal Unions (NBER Working Paper No. 18280)

Farhi and Werning study cross-country insurance in a currency union with nominal price and wage rigidities. Two of their results build the case for the creation of a fiscal union within a currency union. First, they show that if financial markets are incomplete, the value of gaining access to any given level of insurance is greater for countries that belong to a currency union. Second, they show that even if financial markets are complete, private insurance is inefficiently low. A role emerges for government intervention in macro insurance, both to guarantee its existence and to influence its operation. The efficient insurance arrangement can be implemented by contingent transfers within a fiscal union. The benefits of such a fiscal union are larger, the bigger are the asymmetric shocks affecting the members of the currency union, the more persistent are these shocks, and the less open are the member economies.

Wenxin Du and Jesse Schreger, Harvard University

Local Currency Sovereign Risk

Most emerging market sovereign borrowing is now denominated in local currencies. Du and Schreger introduce a new measure of sovereign risk, the local currency credit spread, defined as the synthetic dollar spread on a local currency bond after using cross-currency swaps to hedge the currency risk of promised cash flows. Compared with traditional sovereign risk measures based on foreign currency denominated debt, local currency credit spreads have lower means, lower cross-country correlations, and are less sensitive to global risk factors. The authors rationalize these findings with a model allowing for different degrees of integration between domestic and external debt markets.

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