Month: December 2022

In the aftermath of the debacle that is the cryptocurrency trading company FTX, the motivations of Sam Bankman-Fried have come under some scrutiny. He often seems to advocate an “earn to give” philosophy: basically, it’s ethically fine to earn extraordinary amounts money if you give it away (for references to the idea, see here and here). Or to put it another way, consider the situation of a person who would like to do as much good as possible in the world. The choice is whether to do good directly, or whether to earn money and contribute to those who are doing good correctly. It is at least possible, given the specific skills and abilities of that person, that they may be more effective at doing good by the “earn to give” approach.

Of course, it’s very much an open question whether this philosophy was an actual motivation or just a high-sounding excuse for Bankman-Fried. But here, I wanted to look back at a predecessor of the “earn to give” philosophy, from John Wesley’s Sermon 50: “The Use of Money.” For those of you not familiar with John Wesley (1703-1791), he was the English theologian and cleric who is typically credited with being the founder of Methodism. His Sermon 50 is sometime summarized, and not just among economists, as “gain all you can, save all you can, give all you can.”

Wesley describes the social role of money this way:

“The love of money,” we know, “is the root of all evil;” but not the thing itself. The fault does not lie in the money, but in them that use it. It may be used ill: and what may not. But it may likewise be used well: It is full as applicable to the best, as to the worst uses. It is of unspeakable service to all civilized nations, in all the common affairs of life: It is a most compendious instrument of transacting all manner of business, and (if we use it according to Christian wisdom) of doing all manner of good. It is true, were man in a state of innocence, or were all men “filled with the Holy Ghost,” so that, like the infant Church at Jerusalem, “no man counted anything he had his own,” but “distribution was made to everyone as he had need,” the use of it would be superseded; as we cannot conceive there is anything of the kind among the inhabitants of heaven. But, in the present state of mankind, it is an excellent gift of God, answering the noblest ends. In the hands of his children, it is food for the hungry, drink for the thirsty, raiment for the naked: It gives to the traveller and the stranger where to lay his head. By it we may supply the place of an husband to the widow, and of a father to the fatherless. We maybe a defence for the oppressed, a means of health to the sick, of ease to them that are in pain; it may be as eyes to the blind, as feet to the lame; yea, a lifter up from the gates of death!

Wesley’s sermon is loosely divided into three rules for the use of money: “gain all you can,” “save all you can,” and “give all you can.” But Wesley is also quite careful to specify that some ways of gaining money are unacceptable. His list includes:

• 1) “we ought not to gain money at the expense of life, nor (which is in effect the same thing) at the expense of our health”;
• 2) “we may not engage or continue in any sinful trade, any that is contrary to the law of God, or of our country. Such are all that necessarily imply our robbing or defrauding the king of his lawful customs”;
• 3) “without hurting our neighbour. But this we may not, cannot do, if we love our neighbour as ourselves. We cannot, if we love everyone as ourselves, hurt anyone in his substance”;
• 4) “Neither may we gain by hurting our neighbour in his body. Therefore we may not sell anything which tends to impair health. Such is, eminently, all that liquid fire, commonly called drams or spirituous liquors” (although Wesley includes an exception for limited medicinal use!);

With these rules in place, Wesley then exhorts:

These cautions and restrictions being observed, it is the bounden duty of all who are engaged in worldly business to observe that first and great rule of Christian wisdom with respect to money, “Gain all you can.” Gain all you can by honest industry. Use all possible diligence in your calling. Lose no time. If you understand yourself and your relation to God and man, you know you have none to spare. If you understand your particular calling as you ought, you will have no time that hangs upon your hands. Every business will afford some employment sufficient for every day and every hour. That wherein you are placed, if you follow it in earnest, will leave you no leisure for silly, unprofitable diversions. You have always something better to do, something that will profit you, more or less. And “whatsoever thy hand findeth to do, do it with thy might.” Do it as soon as possible: No delay! No putting off from day to day, or from hour to hour! Never leave anything till to-morrow, which you can do to-day. And do it as well as possible. Do not sleep or yawn over it: Put your whole strength to the work. Spare no pains. Let nothing be done by halves, or in a slight and careless manner. Let nothing in your business be left undone if it can be done by labour or patience.

Gain all you can, by common sense, by using in your business all the understanding which God has given you. It is amazing to observe, how few do this; how men run on in the same dull track with their forefathers. But whatever they do who know not God, this is no rule for you. It is a shame for a Christian not to improve upon them, in whatever he takes in hand. You should be continually learning, from the experience of others, or from your own experience, reading, and reflection, to do everything you have to do better to-day than you did yesterday. And see that you practise whatever you learn, that you may make the best of all that is in your hands.

In describing the “save all you can” rule, Wesley calls for living a simple life in all ways. For eample,

I do not mean, avoid gluttony and drunkenness only: An honest heathen would condemn these. But there is a regular, reputable kind of sensuality, an elegant epicurism, which does not immediately disorder the stomach, nor (sensibly, at least) impair the understanding. And yet (to mention no other effects of it now) it cannot be maintained without considerable expense. Cut off all this expense! Despise delicacy and variety, and be content with what plain nature requires.

Do not waste any part of so precious a talent merely in gratifying the desire of the eye by superfluous or expensive apparel, or by needless ornaments. Waste no part of it in curiously adorning your houses; in superfluous or expensive furniture; in costly pictures, painting, gilding, books; in elegant rather than useful gardens. … Lay out nothing to gratify the pride of life, to gain the admiration or praise of men.

For his final step, “give all you can,” Wesley offered the following guidance:

If you desire to be a faithful and a wise steward, out of that portion of your Lord’s goods which he has for the present lodged in your hands, but with the right of resuming whenever it pleases him, First, provide things needful for yourself; food to eat, raiment to put on, whatever nature moderately requires for preserving the body in health and strength. Secondly, provide these for your wife, your children, your servants, or any others who pertain to your household. If when this is done there be an overplus left, then “do good to them that are of the household of faith.” If there be an overplus still, “as you have opportunity, do good unto all men.”

I have read that, later in life, Wesley was prone to lamenting that his followers were perhaps more zealous about “gain all you can” than about “save all you can,” and more zealous about “save all you can” that “give all you can.” Still, his advice only to gain in ways that do not injure your neighbors or break the law, and only to consume “what plain nature requires” seem clearly to have been violated in extreme ways by Bankman-Fried’s personal interpretation of the “earn to give” philosophy.

The distribution of income in the United States is decidedly more uneven than in countries across the European Union. But the underlying cause of that inequality is not so much a lower level of redistribution by the US government, but instead the much higher level of US income inequality before taxes and transfer payments. Indeed it is precisely because the US distribution of income is comparatively so unequal that the US tax system is more progressive than other countries–that is, those with high incomes in the US pay a large share of taxes than those with high incomes in other countries, because the high incomes in the US are so much higher than in other countries. The US starts with such a high level of income inequality that it can redistribute more than other high-income countries in the form of taxes and transfer payments, while still ending up with greater inequality.

In a post last week, I referred to these comparisons of inequality and redistribution between the US and nations of Europe as the issue of “predistibution” vs. redistribution. Here, I want to set aside the issue of redistribution and instead look at “predistribution.” That is, I want to discuss a few examples of labor market institutions in European countries that make the distribution of pre-tax, pre-transfer income more equal in other countries–and in particular, institutions that boost the share of income going in the form of wages to the bottom of the income distribution.

The Fall 2022 issue of the Journal of Economic Perspectives (where I work as Managing Editor) takes up this topic in a four-paper symposium on “Labor Market Institutions.” Here are a few thoughts:

Claus Thustrup Kreiner and Michael Svarer discuss “Danish Flexicurity: Rights and Duties.” They describe the basic setting in this way:

The Danish labor market model has come to be known as “flexicurity.” A stated strategy underlying this approach is the so-called “right and duty” principle (in Danish, “ret og pligt”). Unemployed individuals have a right to receive income support and to receive public assistance in getting back into work. But it is also their duty to search actively for jobs, to take on appropriate work, and to participate in active labor market policies. Correspondingly, society has a right to make demands of recipients of income support, but also a duty to help improve their job prospects.

In Denmark, national wages guideline are negotiated for each occupation by representatives of labor and business, with final wages being set in local negotiations at the firm level. About two-thirds of Danish workers belong to a union, and about five-sixth of Danish workers are in jobs where the union negotiations determine their pay. However, Denmark has never had a minimum wage. Moreover, it is easy for employers to hire and fire workers in Denmark, and rates of job turnover are similar to the US.

Denmark has much longer and more generous unemployment benefits than the United States. But in order to receive these benefits, all unemployed workers in Denmark are assigned a caseworker who monitors job search activities and provides support, including setting up connections to government-supported job training, along with short-term practice jobs or subsidized jobs. If the unemployed person doesn’t participate actively, then the generous unemployment benefits can be cut off and the person instead must fall back on the less-generous social support system. About one-eighth of the unemployed are cut off in this way, at least for a time.

Making this system of “active labor market participation” work is costly. Denmark spends about 2% of GDP on this system of caseworkers and job training and subsidized training. The equivalent in the US would be spending about $450 billion a year, with perhaps 100,000 or more job caseworkers, to run such a system. Denmark’s is a small economy operating with high levels of automation and international trade, but with relatively high wages and low unemployment rate for low-income workers. But low-wage workers in Denmark need to develop and improve their skills–because otherwise firms paying the union-negotiated wages can and will fire them.

As an alternative model, Simon Jäger, Shakked Noy, and Benjamin Schoefer discuss “The German Model of Industrial Relations: Balancing Flexibility and Collective Action.” As the authors describe, the German approach is built on a basic tension:

The German labor market is shaped by large-scale collective bargaining agreements containing schedules of minimum requirements for wages, hours, working conditions, entitlements, and promotion criteria for workers in different industries, regions, and occupations, and with different levels of skill and experience. These agreements, typically negotiated at the industry-region level, have broad coverage and create significant standardization in wages and working conditions … At the same time, the collective bargaining system in Germany allows for an unusual degree of decentralization and flexibility in wage-setting relative to the more rigid bargaining systems of many of its European neighbors—and even makes it relatively easy for employers to avoid coverage altogether.

This combination of national guidelines but local flexibility means a really large number of collective bargaining agreements at any one time: apparently 82,000 of them in 2021. About 15% of German workers actually belong to a union, but slightly more than half of all German workers have their wages set by a collective bargaining agreement signed by their employer. In the US, workers vote on whether to unionize; in Germany, individual firms decide whether to join an employer association and participate in union negotiations. The authors point out that this employer flexibility is a defining feature of Germany’s labor institutions. The authors write:

Why do German employers ever join employer associations, thereby restricting their wage-setting discretion? First, membership in an association guarantees employers access to peaceful, coordinated, and widely legitimate mechanisms of dispute resolution through sectoral bargaining. In fact, active collective bargaining agreements preclude unions from strikes pertaining to any matters regulated in the pertinent collective bargaining agreement (Friedenspflicht). Second, membership brings various side benefits, including access to strike insurance, legal advice, lobbying support, and professional networking. Third, employers—especially large ones—may face pressure to join from workers and sectoral unions. Tesla’s 2022 expansion into Germany provides an illustrative example. During the first half of 2022, a new Tesla factory near Berlin has faced several complaints over its wage policies. In particular, wages are low relative to nearby manufacturing firms covered by sectoral agreements (Raymunt 2022), and Tesla has begun raising the wages offered to new hires in an effort to increase recruitment, which has introduced a wage gap between new recruits and identically qualified incumbents (Der Spiegel 2022). Discontented workers have appealed to the local IG Metall (manufacturing union) branch, which has begun publicly agitating for Tesla to enter collective negotiations.

But in Germany, the share of firms that choose to be part of unions and the share workers covered by collective bargaining has been declining, and even within the union framework, the amount of flexibility in local agreements has been rising. The overall belief seems to be that the less-flexible German labor markets of several decades ago had high wages but also high unemployment, while today’s more-flexible markets have lower unemployment, but also lower wage growth and higher inequality. The authors write:

[T]he increasing flexibility of the German system means that Germany is no longer a poster child for strong sectoral bargaining. Bargaining coverage in Germany is middling, and decreasing. The flexibility to which Germany’s strong macroeconomic performance is often attributed involves the omission of large segments of the labor market from bargaining coverage. Germany is now starting to face many of the challenges that its historically more rigid industrial relations system used to suppress: significant increases in earnings inequality, the spread of precarious work, and the gradual expansion of a low-wage sector that is now larger than the OECD average (though still 25 percent smaller than in the United States).

For yet another perspective, Manudeep Bhuller, Karl Ove Moene, Magne Mogstad, and Ola L. Vestad offer an overview of Facts and Fantasies about Wage Setting and Collective Bargaining,” with some discussion of labor market institutions in Norway. They emphasize that intro-level textbook models often assume that wages are determined in a negotiation between a firm and a worker, but in many countries, most wages are in fact determined by a collective bargaining process, not a series of individual bargains. However, these collective processes can differ considerably. They write:

Even economies with the same share of unionized workers (“union density”) or with the same share of workers
whose terms of employment are covered by a collective agreement (“bargaining coverage”) can negotiate their wages rather differently. Countries like Germany, Sweden, and Norway typically have export-led pattern bargaining, in which unions in the metalworking sector and the chemical sector set the path for wage increases in private and public services. Other countries such as Israel, France, and Portugal have much less coordination across types of workers. Such differences in so-called horizontal coordination are important for how centralized the wage
setting is and for how centralization works. Equally important is the level of so-called vertical coordination, reflecting whether wage bargaining takes place at level of the firm, the industry, or the nation. As we shall see, there is also a wide variation across otherwise comparable countries in terms of vertical coordination. …

More than 100 years ago, when the United Mine Workers of America teamed up with the National Progressive Unions of Miners and Mine Laborers, basically every organized miner in the United States became a member of the same union organization. With all substitute workers organized under the same union leadership, the leadership could safely be more militant in their wage demands. When the American Railway Union almost at the same time became an industrial union, organizing all the crafts that worked within the US railroad system, it expanded by organizing workers who were each other’s complements. Consequently, the leadership of the union had to be more careful in its wage demands, as lower activities caused by higher wages to some workers would threaten the employment and wages of many other members of the same industrial union. These two examples illustrate a simple and forceful principle, what we call the Hawk-Dove divide: Coordinating substitutes induces militancy, coordinating complements induces acquiescence.

They argue that across a range of countries, labor negotiations have tended to become more decentralized, both horizontally and vertically. They also discuss what they call “tiered” labor agreements in Norway, where an overarching collective bargaining agreement sets wage floors at the level of lower-productivity firms in a given industry but then allows higher-productivity firms in that industry to pay more.

What does all of this mean for the United States, and in particular for workers with below-average levels of wages and income? What if the US wanted to focus some of its policy attention on “predistribution,” which would raise wages of lower-income workers? After all, a country like Denmark with less than 6 million people and about twice as large as Massachusetts, may not be a workable model for the US economy. In the JEP issue, Suresh Naidu asks, “Is There Any Future for a US Labor Movement?”

Naidu points out that unions remain popular in US survey data, with 70% approval rates. He also emphasizes that US labor law follows a “one establishment at a time” philosophy. He writes:

The National Labor Relations Act protects collective action at the “bargaining unit” level, which is a mix of job categories and geographic establishment. The premise of the law is that the establishment-level bargaining unit is the natural level at which workers share interests, and implicitly, that the barriers to collective action at that level are relatively easy to overcome. However, a hostile legal regime and transformations in employment have invalidated the presumptions on which establishment-level bargaining was built. As a result, the NLRA is as much a legal graveyard as it is a sanctuary for American unions. In the United States, any worker that wants a union cannot just join one, but instead needs to persuade 50 percent of their coworkers …

Naidu points out that in countries where the labor movement has more success than in the US tend to have one or both of two features. One is sectoral bargaining, so that multiple firms and their employees across a sector participate in the bargaining agreement. In this situation, individual firms don’t feel the same need to push back against unions, because they know that their competitors in that sector will have (roughly) the same labor contract. Another is “Ghent-style” unions that take on the responsibility for administering other programs, like health care, training, or retirement.

Supporters of stronger US labor movement have a longer wish-list, of course. For example, they often support legalizing sympathy strikes, where if one firm is arguing with a union, then all the unions for suppliers or transportation needs of that firm might refuse to deal with the firm as well. There could be more aggressive enforcement against unfair labor practices.

Naidu also emphasizes the difficulties of organizing unions in a modern American workplace, with a wide range of workers with different jobs and different skills, different levels of commitment to the company, across different departments, perhaps working different shifts. Old-time US unions of some decades ago were both workplace and social organizations, which tended to reinforce each other. “Social capital” connected to the workplace may have diminished. Naidu writes:

One tentative hypothesis is a decline of social capital created at work as a part of a general decline in social capital, particularly among low-education workers. While convincing evidence of this hypothesis must wait, some suggestive evidence can be found in the General Social Survey data on the share of friends who are coworkers, for the group of private-sector workers with a high school education or less declined from 21.5 to 16.4 percent between 1986 to 2002, while it increased from 17.8 to 19.2 percent for those with more than high school education. The Social Capital Project (2017) published by the Joint Economic Committee writes, based on data from the American Time-Use Survey: “Between the mid-1970s (1975–1976) and 2012, the average amount of time Americans between the ages of 25 and 54 spent with their coworkers outside the workplace fell from about two-and-a-half hours per week to just under one hour.” Union decline might be seen as yet another form of associational life that has declined for all the same reasons other forms have declined. In this sense, the decline of unions may be as akin to the decline of churches as the decline of heavy manufacturing.

Naidu offers this overall judgement:

Rapid increases in union density are like wildfires (or pandemic waves), and I have little confidence in predictions about whether worker organizations will grow, or even persist, in the twenty-first century. If they do, I suspect they will be very different from the labor organizations of the twentieth century. These new organizations, possibly incubated inside or alongside existing labor unions, will depend on government in new and multiple ways, deploy collective action at multiple scales for both economic and political goals, and use and bargain over technology in ways that are hard for any middle-aged academic to anticipate.

For example, he points out that while it may seem difficult to organize gig workers, from the standpoint of the traditional US model of a labor union, when a group of workers is connected by a platform, that platform can also be a target for labor organization. Areas like health care, elder-care, day-care, counseling, education, job training and mental health all offer possible targets for future labor movements.

My own sense is that labor movements of the future need to be increasingly self-conscious about what they are providing to both workers and employers. As Naidu points out, many US unions have become closely identified with all the causes and candidate of Democratic politics, which is nice for the Democrats, but also means that union causes become a hostage to party politics, and will have a hard time succeeding in locations with a substantial number of Republicans. Unions which can make the day-to-day case that they are helping workers build skills, receive benefits, and providing a useful flow of feedback about workplace issues will be more appealing than unions that surface every couple of years to fight a grudge match against employers, and then vanish until the next grudge match. I don’t think the enormous US economy can just import labor market institutions from other countries; after all, those institutions emerged in different places from different historical context. But surely there is something for the US to learn from other high-income nations about how to predistribute higher wages to the bottom half of its highly unequal income distribution.

Posts at this blog have been light in the last week. My son brought home COVID from college, and apparently during one of his rare exits while he was isolating in his bedroom, I managed to catch it as well. This is my second time around with COVID. So far, it feels much like the first time: like a very severe flu for a couple of days, then another day or two of getting back to full functionality. As I write this, I’m sitting upright, sucking down cough drops, and feeling better–and I’m grateful that for me, at least, it’s not any worse.

It’s well-known that inequality of wages and incomes is greater in the United States than in many countries of Europe. But does that happen because of a greater equality of wages themselves? Or does it happen because European countries are more active in redistributing from higher to lower incomes? Or some mixture of both? Thomas Blanchet, Lucas Chancel, and Amory Gethin tackle this question in “Why Is Europe More Equal than the United States?” (American Economic Journal: Applied Economics, October 2022, 14: 4, pp. 480-518, subscription needed; working paper version freely available here). Here’s the abstract:

This article combines all available data to produce pretax and posttax income inequality series in 26 European countries from 1980 to 2017. Our estimates are consistent with macroeconomic growth and comparable with US distributional national accounts. Inequality grew in nearly all European countries, but much less than in the US. Contrary to a widespread view, we demonstrate that Europe’s lower inequality levels cannot be explained by more equalizing tax and transfer systems. After accounting for indirect taxes and in-kind transfers, the US redistributes a greater share of national income to low-income groups than any European country. “Predistribution,” not “redistribution,” explains why Europe is less unequal than the United States.

In their data, Norway (5.4 million people and a lot of oil) and Luxembourg (650,000 people and a lot of banks) have higher average incomes than the United States. But when it comes to pre-tax income, the US stands out for the low share of total income going to the bottom of the income distribution. The authors write:

Of the 27 countries considered in this paper, the United States thus ranks third in terms of average national income per adult, but nineteenth when it comes to the average income of the poorest 50 percent. On average, pretax income inequality at the bottom is lowest in Northern Europe (with a bottom 50 percent share of 24 percent), followed by Western Europe (21 percent) and Eastern Europe (20 percent). With a bottom 50 percent pretax income share of only 11.7 percent, the United States is by far the most unequal of all countries, followed by a distant Serbia (16 percent) and very far from the values observed in the Czech Republic, Iceland, Norway, and Sweden (all above 25 percent). These differences appeared even more pronounced at the very bottom of the distribution: the average income of the poorest 20 percent was €11,600 in Northern Europe in 2017, more than 3 times larger than its counterpart in the United States (€3,800).

Here’s a figure to illustrate the theme. The left-hand panel is US data. It shows that the share of pre-tax income for the top 1% rising and the bottom 50% falling over time. The right-hand panel shows data for Europe. Again, the share for the top 1% is rising and for the bottom 50% is falling–that is, pretax inequality of incomes has been rising in Europe, too, But rising pre-tax inequality in Europe is substantially less.

It’s true that the size of taxes and government in European countries is, on average much higher than the United States. However, a lot of European countries both impose high taxes on the middle-class (for example, through a value-added tax) and then also provide a high level of social services for the middle class; that is, the amount of redistriution is less than you might expect.

As a simple measure of the tax burden across groups, the authors looked at the ratio of taxes paid by the top 10% relative to taxes paid by the bottom 50%. As the figure shows, the ratio is much higher in the United States. This perhaps not a surprise, given the greater inequality of the US pre-tax distribution of incomes. But again, the belief that European countries are using high tax rates on those with top incomes as a method for redistribution of income doesn’t seem correct.

However, the US does transfer a smaller share of GDP to those below, especially in the area of pension benefits (green bars) and unemployment/disability payments (blue bars).

Overall, the authors conclude: “[P]retax income inequality appears to be considerably higher in the United States than in Europe, and accounting for redistribution only marginally affects the US- Europe inequality gap. If anything, taxes and transfers reduce inequality more in the United States than in Europe.”

These patterns suggest that, along with policies focused on post-tax redistribution of incomes, it’s legitimate to inquire into the much greater equality of Europe’s pre-tax predistribution of income.

Once every three years, the Bank of International Settlements carries out a survey on the dimensions of markets for foreign exchange, as well as for various financial derivatives products. The December 2022 issue of the BIS Quarterly Review includes five articles discussing results from the latest survey. Here, I’ll focus on “The global foreign exchange market in a volatile time,” by Mathias Drehmann and Vladyslav Sushko.

The headline finding of the most recent survey is that daily turnover in foreign exchange market has reached $7.5 trillion per day–on an annual basis, about 60 times the level of world GDP.  Clearly, most of this market has nothing to do with trading foreign exchange for financing imports and exports. Instead, it’s about hedging and arbitrage in financial markets.

In this figure, the total height of the bars on the left-hand panel show the rise in the FX market over time. The shading within the bars show the types of trades: spot market, FX swaps (in which two parties who are each receiving a future payment in different currencies agree to “swap” these payments and receive the other currency instead); forward contracts (which can be thought of as customized contracts traded over-the-counter, unlike futures contracts which are standardized and traded on an exchange); options; and currency swaps (similar an FX swap, except that what is swapped is not just two payments in different currencies, but also a stream of interest payments over time). The right-hand panel shows that the share of this market accounted for by spot markets has been declining over time, while the share in FX swaps and forward contracts has been rising.

The survey results also emphasize the central importance of the US dollar in foreign exchange markets. Every foreign exchange transaction involves two different currencies: in almost 90% of all the trades in this market, the US dollar is on one side of the transaction. In practice, this means that if someone wants to trade two non-US-dollar currencies A and B, what actually happens behind the scenes is that A is first turned into US dollars, and then US dollars are turned into B. There is an ongoing debate in recent years over whether the US dollar will or might be losing its status as the global “reserve currency,” but this evidence suggests that the US dollar continues to play an extremely central role. However, one shift with regard to the role of the US dollar, which I have noted here in the past and is discussed in these survey results, is that when central banks around the world hold reserves of foreign exchange, the US dollar is playing a smaller role than in the past.

The raw size of this market suggests a certain degree of concern. What happens, for example, if there is a currency swap where a party has agreed to make a payment in, say, US dollars in the future, but when the time comes to make that payment, the party is unable to do so?  Two of the papers in this issue look at potential flashpoints. For example,   Marc Glowka and Thomas Nilsson write in “FX settlement risk: an unsettled issue:”

FX settlement risk, the risk that one party to a trade of currencies fails to deliver the currency owed, can result in significant losses for market participants, sometimes with systemic consequences. The failure of Bankhaus Herstatt in 1974, the best known example, eroded confidence in interbank relations and caused a freeze in money market lending (Galati (2002)). Recent examples include KfW Bankengruppe’s €300 million loss when Lehman Brothers collapsed in 2008 (Hughes (2009)), and Barclays’ $130 million loss to a small currency exchange in March 2020 (Parsons (2021)). Almost 50 years after the Herstatt bankruptcy, nearly a third of deliverable FX turnover remains subject to settlement risk, according to new data from the 2022 BIS Triennial Survey.

In a related spirit, Claudio Borio, Robert N McCauley and Patrick McGuire look at that issue in “Dollar debt in FX swaps and forwards: huge, missing and growing.” They write:

FX swap markets are vulnerable to funding squeezes. This was evident during the Great Financial Crisis (GFC) and again in March 2020 when the Covid-19 pandemic wrought havoc. For all the differences between 2008 and 2020, swaps emerged in both episodes as flash points, with dollar borrowers forced to pay high rates if they could borrow at all. To restore market functioning, central bank swap lines funnelled dollars to non-US banks offshore, which on-lent to those scrambling for dollars. This off-balance sheet dollar debt poses particular policy challenges because standard debt statistics miss it. The lack of direct information makes it harder for policymakers to anticipate the scale and geography of dollar rollover needs. Thus, in times of crisis, policies to restore the smooth flow of short-term dollars in the financial system (eg central bank swap lines) are set in a fog.

At least so far, the main “answer” when these problems arise has been for central banks to carry out their own currency swaps, to make a scarce currency more available. This approach has proven workable so far, but as these gigantic markets grow in size, and come under stresses beyond those currently imagined (a combination of negative economic events and a cybercrime attack, perhaps?), some additional advance consideration of fail-safe mechanisms seems worthwhile.

The World Trade Organization has released its World Trade Statistical Review 2022, which includes an overview of world trade patterns in 2021 and the first half of 2022. In the big picture sense, it’s no surprise that global trade slumped hard in the pandemic year of 2020 and the rebounded briskly in early 2021. Here, I wanted to pass along three of the figures from later in the report that had something interesting to say about shifts in the underlying patterns of world trade.

This first figure shows trade in “digitally delivered services (mode 1),” which refers to cross-border trade involving “insurance and pension services, financial services, charges for the use of intellectual property n.i.e., telecommunications, computer and information services, other business services, and personal, cultural and recreational services. Notice that from 2005 up through about 2012, growth in digitally delivered trade was increasing at about the same rate as trade in goods. But since then, trade in goods has increased only modestly, while trade in digitally-delivered services has nearly doubled. The gap seems to have widened in 2021, as the first force of the pandemic eased.

Just to be clear, this graph does not show the levels of trade in digitally-delivered services and in goods. The level for each category is set at a index number of 100 for the year 2005. The graph only lets you compare rates of growth since then. For a perspective on levels, global exports of digitally-delivered services was $3.7 trillion in 2021, while merchandise trade was roughly six times as large at $21.7 trillion. But the trendlines strongly suggest that digitally-delivered services will be a growth area for international trade in the future, while trade in goods may not be.

A second figure shows the quantity of container shipping from January 2015 through August 2022. The drop in can container shipping around April 2020 captures one aspect of the supply chain shocks that were happening at that time. Measured by the adjusted (orange) line, the quantity of containers shipped has reached an all-time high. But as the WTO notes: “Shipping indices showed global container throughput at an all-time high in September 2022 but not much higher than in 2021, suggesting weak trade growth in 2022.”

Finally, the third figure shows the number of international commercial flights from January 2020 through August 2022. You can see the 80% fall in such flights in the pandemic, and the gradual recovery since then. The WTO describes the patterns this way: “International commercial flights are classified as transport services and are closely associated with travel expenditure by international tourists. Both cargo and passenger flights also carry significant quantities of goods, so they are linked to both merchandise and commercial services trade. Daily commercial flights, including flights within the European Union, finally exceeded their level at the start of 2020 during the summer of 2022. However, flights excluding those within the EU remained below their prepandemic
level in August 2022. Rising fuel costs and increased economic uncertainty are expected to weigh on commercial flights in the remaining months of 2022 and in 2023.”

Imagine that you are policymaker in a low- or middle-income country. Interest rates go up in high-income nations, like the United States. When firms and the government in your country borrow, it has often been done in terms of US dollars–that is, US dollars were borrowed, then converted to home currency and spent in the domestic economy, but repayment needs to happen after converting home currency back to US dollars. The reason for this practice is that there wasn’t much demand in international capital markets to own debt denominated in your home currency.

But when global interest rates rise, this creates a double-whammy for the debt of the low- or middle-income country. Higher interest rates for US dollars mean that the dollar tends to appreciate on foreign exchange markets, which is indeed happening. As a result, when it comes time for a low- or middle-income country to convert its own currency back into US dollars to repay its debts, it’s more costly to do so. In addition, higher interest rates from the US Federal Reserve often pressure central banks around the world to raise interest rates as well.

What is to be done? Gita Gopinath offers a framework for thinking about these questions in “Managing a Turn in the Global Financial Cycle,” delivered as the 2022 Martin S. Feldstein Lecture at the National Bureau of Economic Research (NBER Reporter, September 2022).

A key policy question therefore is how emerging and developing economies should respond to this tightening cycle that is driven to an important degree by rising US monetary policy rates. The textbook answer would be to let the exchange rate be the shock absorber. An increase in foreign interest rates lowers domestic consumption. By letting the exchange rate depreciate, and therefore raising the relative price of imports to domestic goods, a country can shift consumption toward domestic goods, raise exports in some cases, and help preserve employment.

However, many emerging and developing economies find this solution of relying exclusively on exchange rate flexibility unsatisfying. This is because rising foreign interest rates come along with other troubles. They can trigger so-called “taper tantrums” and sudden stops in capital flows to their economies. In addition, the expansionary effects of exchange rate depreciations on exports in the short run are modest, consistent with their exports being invoiced in relatively stable dollar prices. …

Consequently, several emerging and developing economies have in practice used a combination of conventional and unconventional policy instruments to deal with turns in the global financial cycle. Unlike the textbook prescription, they not only adjust monetary policy rates but also rely on foreign exchange intervention (FXI) to limit exchange rate fluctuations, capital controls to regulate cross-border capital flows, and domestic macroprudential policies to regulate domestic financial flows. This common practice, however, lacks a welfare-theoretic framework to guide the optimal joint use of these tools. This shortcoming limited the policy advice the IMF could give to several of its members. Accordingly, to enhance IMF advice, David Lipton, the former first deputy managing director of the fund, championed the need to develop an Integrated Policy Framework that jointly examines the optimal use of conventional and unconventional instruments.

In the longer run, many of these issues could be ameliorated if at least some low- and middle-income countries around the world developed a greater ability to borrow in their own home currency, a pattern which does seem to be slowly emerging. But in the immediate present, developing economies must be concerned that if their exchange rates move too much, it could become difficult or impossible to repay existing loans. Thus, many countries are resorting to policies that would manage exchange rate fluctuations and limit international capital flows.

For long-time watchers of international macroeconomics, what’s perhaps most interesting here is not just that these alternative policy tools are being used, but that they are being used with the blessing of mainstream organizations like the International Monetary Fund. Gopinath was chief economist at the IMF from 2019 to 2022, and is now First Deputy Managing Director of the IMF. Up to about 2005, the official position of the IMF was basically to avoid or phase out international capital controls wherever possible. But that conventional wisdom had already shifted substantially a decade ago, and under the Integrated Policy Framework that Gopinath mentions, discussed in some detail in this 2020 white paper, the costs and tradeoffs of interventionist macroeconomic policies are to be weighed and balanced in the context of imperfect and potentially overreacting global financial markets.

Economists view the existence of urban areas as a balancing act between economies and diseconomies of agglomeration. The benefits (“economies”) of agglomeration include both aspects of production, like the gains from having workers, firms, and suppliers geographically close together, and also aspects of consumption like the clustering of entertainment activities (like restaurants, theater, sports, fireworks, and so on). The diseconomies of agglomeration include congestion, crime, and aspects of health including pandemics.

David M. Cutler and Edward Glaeser remind us that this tradeoff is not a new one in “Cities After the Pandemic” (Finance & Development, December 2022). They write:

[T]here are downsides to density; contagious disease is the most terrible of these. Humans have millennia of experience with urban epidemics. The first well-documented urban plague struck Athens in 430 BCE. It helped Sparta defeat Athens in the Peloponnesian War and brought an end to Athens’ golden age. … The Plague of Justinian, which hit Constantinople in 541 CE, may have done even more harm. It helped plunge Europe into centuries of darkness, widespread poverty, and political chaos. … The beginnings of globalization in the 19th century hastened the spread of diseases like yellow fever and cholera. Each killed a vastly higher share of the population than COVID-19.

But as they point out, the attractions of urban areas are such that they have continued to expand for several centuries now, especially when public investments in clean water and other infrastructure pushed back against the risks of disease. They write: “Yet despite the deaths, cities continued to attract migrants by the millions. Rural life was difficult and not rewarding economically. The very poor will do most anything to escape poverty, which explains why COVID-19 will likely do little to deter urbanization in poor countries.”

Cutler and Glaeser readily admit that the pandemic poses a challenge for the existing structures and interconnections of urban areas, and that sizeable adjustments are likely to occur. But they also suggest four main reasons that “hat cities as a whole—in both rich and poor countries—will survive and even thrive.”

First, the hypothesis that technology will make face-to-face contact obsolete is old and has been discredited many times. The late journalist Alvin Toffler predicted empty offices in 1980, but for most of the past 40 years, the problem has been too few offices, not too many. Technological change does more than just enable long-distance communication. It radically increases the returns to learning, which is fostered by being around other people.

For an overview of the research literature on how proximity increases productivity, the Journal of Economic Perspectives (where I work as Managing Editor) published a three-paper symposium on “Productivity Advantages of Cities” in the Summer 2020 issue:

• “The Economics of Urban Density,” by Gilles Duranton and Diego Puga
• “How Close Is Close? The Spatial Reach of Agglomeration Economies.” by Stuart S. Rosenthal and William C. Strange
• “Tech Clusters,” by William R. Kerr and Frederic Robert-Nicoud

Cutler and Glaeser argue that a common pattern during the “work-from-home” period in the pandemic was that while it proved possible to keep many of the existing processes moving forward in many organizations, there were ongoing problems when it came to issues like generating new ideas or processes and spreading them through an organization, or how to make promotion decisions. Here are their other three reasons:

Second, cities thrive as places of consumption as well as production. Urban agglomeration produces better restaurants as well as better accountants. Cities allow people to share the fixed costs of museums or concert venues. Between the 1970s and the 2000s, urban prices went up much faster than urban wages, which is compatible with the view that people increasingly wanted to be in cities for the amenities they provide. While some older people have decided never to return to in-person office work, plenty of younger people have shown enormous hunger to get back to face-to-face social interactions; a job can be a source of enjoyment as well as income.

Third, prices will adjust to ensure that offices don’t remain permanently empty, at least in cities where there is reasonable demand for office space. Before the pandemic, commercial real estate was in very short supply in cities like New York, San Francisco, and London, and many smaller, newer, or less profitable businesses were priced out of these markets. Landlords with unoccupied offices will cut rents and eventually find firms eager for that space. Of course, in some lower-end markets, which were near the edge of survival before COVID, demand may fall to the point where landlords prefer to walk away from their buildings rather than rent them out at bargain-basement prices. They can be turned into housing or, worse, left empty.

Fourth, much of the world remains poor, and for the poor, the economic appeal of urbanization easily overwhelms fears of health costs. Google mobility data show that workplace visits are substantially higher now than they were before the pandemic in cities such as São Paulo, Brazil, and Lagos, Nigeria. Moreover, skilled workers in poorer cities will actually benefit because videoconferencing makes it easier to connect to the wealthy world. The slowdown in business travel may, however, reduce foreign direct investment in developing-world cities. Before the pandemic, air links between cities were significant predictors of financial ties (Campante and Yanagizawa-Drott 2018).

More broadly, Cutler and Glaeser argue that the world is engaged in neglectful and apathetic sort of science experiment, in which we wait for the next global pandemic to hit rather than think about preventing it in advance.

In the past six decades, the bulk of “spillover events”—health-related events that spread disease beyond a country’s borders—have originated in some of the poorest parts of the planet. In regions plagued by poverty, people often have more contact with disease-carrying wildlife, vectors such as mosquitos survive longer, and sanitation is more limited. Consequently, the world seems to be engaging in a deadly science experiment in which it is waiting to see what new plague will emerge from the relatively unmonitored and under-resourced regions and spread globally.

What can be done to reduce the risk of another pandemic? … A natural path forward is for the rich world to engage in a massive health exchange with the poor world. In exchange for significant aid for public health infrastructure, recipient countries would agree to measures that keep humans away from animal carriers of disease, better monitor new illnesses, and commit to rapid response and containment. Fortunately, the world and its cities seem to have survived COVID-19 largely intact. We may not be so lucky next time. The result of complacency in 2020 was millions of deaths and enormous economic disruption. The world must heed this warning and invest in the entire world’s hygiene or risk being hit by a pandemic that is even worse.