The Saga Continues: A New Addition to the Currency Unions and Trade Literature

Previously on this blog, I have written about the saga of the Currency Unions and Trade literature. This literature began with Andrew Rose, the famed discoverer of the finding that currency unions, like the Euro, appear to have an effect on trade that is nothing short of miraculous. Effect estimates range in the 100% to 1,300% range, according to researchers at places like Harvard and Berkeley.

I published my very first academic paper about this topic, and found that the earlier large estimates of currency unions (CUs) on trade were driven by rather blunt omitted variables, such as warfare, decolonization, and communist takeovers, and were also sensitive to dynamic controls. I wrote that countries joining the Euro should not expect any large effect on trade.

A new paper by Glick and Rose came out last year which used more recent data, and, once again, found a large impact of CUs, including for the Euro. I was, once again, skeptical, so I assigned my undergraduates a search-and-destroy mission. This was aided in part by Andrew Rose's very laudable practice of posting his data online, which allowed my students to search and destroy. The original authors, to their credit, responded in the comment section of that post. I posted Reuven Glick's thoughtful response here, along with my own response.

In any case, Aleksandr Chentsov and I decided to go ahead and write up a new paper on the topic: "Breaking Badly: The Currency Union Effect on Trade". In the paper, we essentially tested whether these same omitted variables which were driving the effect initially were also driving the effect using this much larger dataset, and whether omitted variables (think the EU) might also be driving the results for the Euro Area as well.

The basic problem can be seen from the evolution of trade between Pakistan and India (Figure 1 below). After the dissolution of the currency union in 1965, trade did, in fact, plummet. By 99.8%. It would thus seem to provide evidence for a large impact of CUs on trade. If Greece leaves the Euro, one might wonder that something similar might happen. However, it doesn't exactly take an expert in International Relations to know that India and Pakistan haven't always gotten along swimmingly. 1965 also happened to be the year when a brutal border war broke out over the legacy of partition, following Pakistan's "Operation Gibraltar". It provides a better guide to what might happen if Greece defaults on all of its debts, gets kicked out of the Euro Zone, and then the EU invades it in retaliation, but Greece fights it to a stalemate.

Figure 1: Trade Between India and Pakistan. The vertical red line shows the end of the Currency Union, which also happened to coincide with the Indo-Pakistani War of 1965.

The example of India and Pakistan was hardly an isolated case. We write in the paper that "In addition, all of the countries which left the French Franc -- Tunisia, Algeria, and Morocco -- did so after major conflicts resulting in independence (see Thom, 2006). These included separatist bombings in the case of Tunisia, a war of independence in the Algerian case, and anti-colonial rioting in Morocco. All five of Portugal's former colonies which had also shared currency unions likewise had to fight for their independence, some of which included prolonged guerrilla wars." When you exclude these cases, the measured CU effect shrinks.

This brings us to the Euro. Just as leaving a currency union -- which, like marriage, are meant to be forever -- is typically a sign of geopolitical turmoil, joining a currency union is typically a sign of good/improved/improving political relations. In the Europe case, my students noted that one would want to control for the entire history of European integration, from the Coal and Steel Community, to the EU. One perceptive student noted that prior to the 1990s, some parts of the Euro Zone today, such as East Germany and other late joiners in Eastern Europe, were all part of the Warsaw Pact.

Our goal, then, was to find appropriate control groups for both Western and Eastern Europe. For Western Europe, we used either (1) other EU countries not in the Euro, or (2) other Western European countries not in the Euro. For Eastern Europe, we compared the evolution of trade between the EE Euro entrants and other EE countries not in the Euro. The results in either case did not suggest a measurable/significant impact on trade. In Figure 2, we plot the evolution of trade in Euro Area countries in Western Europe relative to trade with Non-Euro countries. Relative to 1999, we actually found that Euro members traded slightly more with non-Euro members in 2013, although the difference wasn't even close to statistical significance. However, Euro members had experienced a dramatic increase in trade in the 1950s. Thus, a simple dummy strategy which averages trade before and after the Euro was formed can lead one astray.

Figure 2: Trade intensity of Euro Members relative to Non-Members over time. The vertical red line in 1999 denotes the formation of the Euro. 

We do much more in our paper. Looking at each major CU separately, we find that there really aren't any clear-cut examples for the CU effect, but there are many counterexamples (such as the Euro above). Often, there were dramatic trade declines in the final years of a CU, and then trade recoveries after dissolution. In addition, we also ran the traditional panel gravity regressions, and once again found that the results are sensitive to omitting the CU switches which coincided with war or other major geopolitical events, and adding in other CU-specific controls (such as for the EU).

Some general lessons for empirical research in international trade that research on this topic taught me include:

(1) one should always be mindful of dynamics. Particularly when regressing a level variable that trends on another variable which trends. (Most country pairs have just one CU switch, so any trend in the data could lead to incorrect inference.) This is often my first or second concern when I see papers presented at conferences.

(2) One should always plot their data. I think many authors do not do enough of this. Doing so can allieve the first concern. In the more recent version, Glick and Rose did at least plot pre-treatment trends, a clear improvement. But the existence of pre-treatment trends implies a non-randomness of the treatment.

(3) Are the errors clustered appropriately? In this paper we found we could shrink the t-score on the Euro impact by 80% simply by using multi-way clustered errors.

(4) Is the effect size plausible based on what else we know? In this case, we knew that currency pegs are correlated with much smaller effect sizes, and that indirect pegs -- more likely to be random -- are not correlated with higher trade flows at all. In addition, the effect sizes which have been bandied about in this literature were orders of magnitude larger than, say, the Smoot-Hawley tariff. Simply too large to be believed. And Glick and Rose also had argued that some CUs cause sharp contractions in trade, while others had no effect, even while others had very large positive effects. Why such dramatically different effects for each CU? The answer is that there were simply different historical forces in play for each CU, and these forces overshadowed whatever small effect CUs may have.

(5) Always think about endogeneity! It's such an obvious, and ubiquitous problem that I don't know if it's necessary to add this point. But I do think this deserves to be a textbook cautionary tale of a non-random treatment leading researchers badly astray.

Is this research that important in the end? Admittedly, most countries that joined the Euro did not do so based on their belief of the CUs and trade literature. Nevertheless, the Euro has, in my view, been mostly a catastrophe for southern Europe. I believe the first best option for these countries would be more aggressive pro-growth stimulus from the ECB, but, absent that, I think these countries should think seriously about exit. While the Euro is a bit different from most other currency unions (the definition is that two countries have currencies that trade at a 1:1 par value), there is no hard evidence that Euro Area countries will face a trade collapse if they leave the Euro.

In any case, I did have a senior economist sit me down and tell me not to write this paper. The logic is obvious. You get places in academia by forming close relationships with powerful people, not by pissing them off. These guys no doubt have close relationships with many other economists in the field. They likely also referee lots of papers a year, and will likely be asked to referee this paper. Most editors understandably won't want to touch this controversy with a 10-foot pole, (several websites took a pass on a column about this paper, one on the grounds that my coauthor and myself are at less prestigious institutions than Glick and Rose; how could an MIT Ph.D. be wrong?) while many potential referees are also no doubt close friends with the authors. I expect to submit this paper 7-10 times, but that is relatively normal. The original researchers will no doubt take my criticism of their research personally, and will likely do everything in their power to sabotage my career. Undoubtedly, there are powerful corrupting forces in academia.

Or, maybe not. Maybe the authors will understand that it wasn't personal. Maybe the editor and referees will judge our paper based on its merits. The only way to find out is to write the paper and submit it. So that's what we did.

Public Service Announcement: The US Labor Market is Still Losing Ground Relative to Trend

We keep hearing how good the labor market is these days. We've created more than 16 million jobs since the financial crisis! Unemployment is the lowest since 2001!  Time to raise rates, since the economy is overheating. Of course, this mostly comes from current and former policy makers, all of whom have a stake in trying to tell us that the Obama/Bernanke, or the Trump/Yellen economy has done quite well. However, how does job creation look like these days in terms of the long-run historical rate of job growth in the US? I plot total nonfarm employment relative to the long-run trend below. It looks a bit worse than I imagined, actually. We are now something like 23% below the long-run trend, but the surprise for me is that even in the past couple years, as the Fed tightens MP due to an economy that is supposedly overheating, we seem to still be moving further away from the long-run trend.

Of course, there are caveats here. Population growth did naturally slow a bit, and the absorption of women into the labor force was a one-time event that was mostly played out by the 2000s; 9/11 exogenously reduced immigration, and thus job growth, and the Boomers have been retiring, etc. Certainly, you could also quibble a bit with the trend. Yet, even if you plot the trend from 1945 to 1995, in recent years we still will not really have been gaining on this slower trend growth. These other events/excuses/caveats are not going to explain the relatively sudden collapse of employment some 20% +/- below trend. And why should exogenous negative shocks to labor supply cause wage growth to slow? I'm afraid I'm losing the plot of these other stories.

I have another explanation: maybe the economy is not really that overheated.


Note: you can follow me on twitter @TradeandMoney

In the Idiocy of Kevin Warsh: More Evidence for the 'Self-Induced Paralysis' Thesis

I believe it is clear that the main reason the economy has been growing slowly since the financial crisis is overly tight monetary policy. Inflation has been chronically low. The unemployment rate now admittedly looks good, but this is primarily due to workers leaving the labor force. The employment rate has not recovered, as can be seen below. Certainly, things are improving, and things will look better if you limit to prime-age adults, but then again, you could argue that the prime-age employment rate numbers might look better than usual due to baby boomer retirement. Wage growth is also slow, pointing to a still-weak labor market, nearly 10 years after the recession began. And, yet, despite that, the Fed has taken five consecutive tightening actions in terms of ending QE and raising interest rates. The result of this has surely been to help keep inflation below target and GDP growth below its long-run level.

In particular, look at the above graph in 2009, when the Fed adopted no new stimulus despite headline deflation and mass job losses, on net (in terms of rates or asset purchases, forward guidance was done), or in 2010, when the Fed raised the discount rate. What on Earth could they have been thinking?

Despite this logic, I suspect that many economists have a deep respect for Ben Bernanke, who I also like and respect, even if I disagree with him on some things, and thus wonder how he could have gotten things so wrong. Part of the answer might be that Ben Bernanke, ever a consensus builder, would have liked to do more, but was also constrained by other members of the FOMC. Sam Bell provides some evidence for this in a can't miss article on Kevin Warsh, who now appears to be a front-runner for the Fed Chair job, who was still worried about inflation pressures even after Lehman Brothers failed in 2008.

First, Bell notes that Warsh is a lawyer by training, who was only appointed to the Fed at age 35 with a light resume after his father-in-law, Ronald Lauder, heir to the Estée Lauder fortune and apparently a confidant of Donald Trump, likely influenced his selection with donations.

Even as the economy was tanking in 2008 and 2009, Bell writes that "Warsh adopted a skeptical and increasingly oppositional posture. He doubted the Fed could do much good without creating much bigger problems."

Much bigger problems? What could be a bigger problem than letting the economy burn in a financial crisis?

"In March 2009 he told his Fed colleagues that he was “quite uncomfortable with the idea of purchasing long-term Treasuries in size” because “if the Fed is perceived to be monetizing debt and serving as a buyer of last resort in the name of lowering risk-free rates, we could end up with higher rates and less credibility as a central bank.”"

The Fed should hold off on more stimulus in the worst recession in 75 years because it might actually end up with higher rates and lose credibility? Why wouldn't the Fed lose credibility if it was perceived as not fighting the recession? Warsh continued to warn about the dangers of both monetary and fiscal stimulus in 2010.

Warsh was also far and away not the only crazy one at the Fed at that time. In 2011, when I worked as a Staff Economist at the President's Council of Economic Advisors, I had a conversation with Daniel Tarullo, who told me he believed that Jean-Claude Trichet's interest rate hikes in 2010 -- which are widely seen to have been premature and to have helped ignite the European Debt Crisis -- were justified. These comments suggested to me that Tarullo was somewhere to the right of Genghis Khan on monetary policy. Then, there were also worthies like Richard Fisher, Often Wrong but Seldom Boring, who "warned throughout most of 2008 that inflation was the primary danger to the economy". 

And that, my friends, is how the Tea Party was born.

The other thing to note about the FOMC is that it's a job most people seem to not want to do for very long. It's a revolving door. Most people will do it for 4-5 years, and then quit for greener pastures, as it is not a job that pays that much, particularly by the pornographic standards of finance and banking. Even top university professors can make much more. It's a mix of people who are politically connected, bankers, and academic macroeconomists. And even the latter group can be a mixed bag. And, despite this, (or, should I say, in part because it is a revolving door) the Obama administration never took its appointments seriously. They left in place an FOMC made up mostly of Republicans, including staunch white male MBA-holding Republicans raised in the south in the 1960s. Obama's economic advisors apparently did not see this as potentially problematic.

And, then we had Bernanke, who apparently still holds the view that economic growth in the US economy is still more-or-less OK. In 2011, I also had a conversation with Ben Bernanke. I saw as soon as I began talking to him that he figured I would criticize him for QE, or inciting hyperinflation with all this money printing. He was actually surprised when I asked him why he wasn't doing more, given that core inflation at the time was running around 1.4%. His response is that higher inflation wasn't costless. But I didn't see how inflation of 2% vs. 1.4% would be as costly as millions of people out of work. It seems, few people at the Fed were trying to influence him in the direction of doing more.

What all of this evidence does is make the thesis of "Self-Induced Paralysis", that the major problem with the US economy is overly tight monetary policy, more plausible. You had the competent, but cautious Bernanke who likely wanted some more stimulus, but was surrounded by a group of idiots concerned about inflation in 2008. And, even Bernanke himself clearly seems to be in a state of denial about US growth prospects. The reality is that the people who controlled monetary policy since 2009 are a mix of those who believed hyperinflation was just around the corner, those who believed monetary stimulus in a severe recession would do more harm than good, and on the dovish side a Chairman who hasn't noticed that the US economy that, since 2008, has consistently been growing slower than it used to.

In any case, let's return to Kevin Warsh for a minute. How bad would he be as Fed Chair? Likely a disaster. Certainly a disaster on regulation, and likely also a disaster on monetary policy. The only catch here is that he will be a perfect Fed Chair for Trump, as he'll be a yes-man Trump can control 100%. Although Trump sounded hawkish on monetary policy on the campaign trail, I always imagined he would eventually change his tune as President -- particularly once the election is on and he realizes the Fed can deliver faster growth. Thus, he could, in fact, adopt looser monetary policy and pave the way for a second term for Trump. Or, he could be the Kevin Warsh he was during the Financial Crisis, and continue the Yellen tradition of slightly-too tight policy. I think we won't know the answer to this until it happens, although I would probably put higher odds on the latter.


Note: you can follow me on twitter @TradeandMoney

Ben Bernanke, in Denial? "When Growth is Not Enough"

"When Growth is Not Enough" is the title of a recent Ben Bernanke speech in Portugal. I found it via the NYT article on the "Robocalypse", which contained this bizarre quote from Ben S. Bernanke "as recent political developments have brought home, growth is not always enough."

However, as you can see, something terrible has happened to US GDP growth, which is now more than 20% below its long-run trend, even if it has escaped the attention of our former Fed Chair. On twitter, Kocherlakota and I were both hoping he'd been taken out of context. Unfortunately, that turned out not to be the case. 

In his speech, Bernanke is trying to make sense of how his tenure at the Fed was followed by a populist political rebellion. To his credit, early in the essay, he does admit that the "recovery was slower than we would have liked", but in the round, as the title of his speech suggests, he is a glass-is-half-full kind of guy on the economy "the [Fed] is close to meeting its ... goals of maximum employment and price stability... more than 16 million ... jobs have been created... the latest reading on unemployment, 4.3 percent, is the lowest since 2001." He then writes "So why, despite these positives, are Americans so dissatisfied?" He lists four reasons:

1. Slow median income growth, especially for male workers. Hourly wages for males have declined since 1979.
2. Declining rates of intergenerational mobility
3. Social dysfunction in economically marginalized groups (see Case-Deaton on mortality increases for working-class Americans).
4. Political alienation.

What were the causes of these? Bernanke pushes the Gordon thesis that wartime technologies led to the boom in the early post-war period. He notes that productivity growth has been slow the past 10 years.  He correctly notes that there was a China shock (which is good, would be nice if he also mentioned exchange rates), and also argues that globalization has led to the rise in inequality. In terms of policy, he argues that more could have been done to secure the safety net and help the downtrodden.

There is much to like in the essay, and I'm not opposed to his policy prescriptions. I also agree that inequality could be part of the problem. But that there were several things that struck me.

First, Bernanke also doesn't buy the Reagan/Thatcher revolution as the cause of the growth of inequality in the US and UK. He seems to think some combination of globalization/SBTC is the cause. At least he is in good company -- Krugman, Avent, DeLong, and David Autor -- all people I respect and have learned a lot from, also don't seem to buy it. I have no idea why. 

In my own research with Lester Lusher (see here and here), we concluded that trade almost certainly was not a major cause of the rise of inequality in the US. The aggregate timing just wasn't quite right, inequality increased just as much in sectors not directly affected by trade, and other countries that trade a lot (Germany, Sweden, Japan) did not see anything like the increase in inequality in the US or UK. And when inequality finally did increase in these countries, it followed cuts in top marginal tax rates just like it did in the US and UK.

Second, reading between the lines, Bernanke seems to have caved a bit in his debate with Summers on the source of Secular Stagnation. Now he seems to be closer to the view that there was some autonomous decline in technological growth. I'm very skeptical of this view, although I'll concede it's hard to prove either way.

The big one, of course, is that Bernanke does appear to be in a bit of denial that GDP growth really has slowed. He credits the Fed for price stability, without noting that the Fed has undershot its own stated inflation target for nearly a decade now. He also doesn't mention how/why both he and the ECB raised interest rates in 2010 (no, that isn't a typo). Why shouldn't tight money in a recession lead to slow growth? Of course, it would be nearly impossible for anyone to view such a horrible thing such as the election of Donald Trump, which likely was caused in part by a weak economy (the economy always matters for elections), and realize that one's own policies were at fault. 

Unfortunately, in recent months, the US has gotten more bad news on the GDP front. Is the problem that we've already invented everything worth inventing, and growth will just naturally slow, as Robert Gordon suggests? Or is the Robocalypse upon us, as some would have us believe? Or is it that the Fed ended QE prematurely and then raised interest rates four times in a row despite inflation at 1.5%? 

I'm going to go with the latter. After all, if GDP growth and inflation are both below target, and the Fed tightens monetary policy, tell me what is supposed to happen?