Conferences: Spring, 2003

New Development in Empirical International Trade

The 15^th annual TRIO conference -- one in a series sponsored by the NBER, CEPR, and TCER to bring together economists from the United States, Europe, and Japan -- on "New Development in Empirical International Trade" took place in Tokyo on December 10 and 11, 2002. This year the Japanese Research Institute of Economy, Trade, and Industry was also a co-sponsor of the event. Kyoji Fukao, Hitotsubashi University; Takeo Hoshi, University of California, San Diego; Sadao Nagaoka and David Weinstein, NBER and Columbia University, organized this program:

• Stephen Redding and Anthony Venables, London School of Economics, "Explaining Cross-Country Export Performance: International Linkages and Internal Geography"
• Discussants: Peter Debaere, University of Texas, and Shumpei Takemori, Keio University
• Donald Davis and David Weinstein, NBER and Columbia University, "Why Countries Trade: Insights from Firm-Level Data"
• Discussants: Motoshige Itoh, University of Tokyo, and Stephen Redding
• Kyoji Fukao; Hikari Ishido, Institute of Developing Economies; and Keiko Ito, ICSEAD, "Vertical Intra-Industry Trade and Foreign Direct Investment in East Asia"
• Discussants: James Harrigan, Federal Reserve Bank of New York, and Shujiro Urata, Waseda University
• James Harrigan and Rohit Vanjani, Federal Reserve Bank of New York, "Is Japan's Trade (Still) Different?"
• Discussants: Eiichi Tomiura, Kobe University, and Ryuhei Wakasugi, Yokohama National University
• Keith Head and John Ries, University of British Columbia, "Foreign Direct Investment versus Exports: A Test of the Selection Hypothesis"
• Discussants: Kyoji Fukao and Jota Ishikawa, Hitotsubashi University
• Simon Evenett, World Trade Institute, "Do All Networks Facilitate International Commerce? U.S. Law Firms and the International Market for Corporate Control"
• Discussants: Takeo Hoshi and Sadao Nagaoka
• Takamune Fujii, Aichi University, and Fukunari Kimura, Keio University, "Globalizing Activities and the Rate of Survival: Panel Data Analysis on Japanese Firms"
• Discussants: David Weinstein, and Laixun Zhao, Hokkaido University

Stephen Redding and Venables investigate the role of the international product market in determining export performance. They seek to explain the wide variations in countries' export performance over the last quarter century. For example, East Asian countries have seen real exports increase by more than 800 percent since the early 1970s, while those of Sub-Saharan Africa have increased by just 70 percent. The authors decompose the growth in countries' exports into the contribution from increases in external demand versus those from improved internal supply-side conditions. Building on the result of this decomposition, Redding and Venables analyze the determinants of export performance. They find that poor external geography, poor internal geography, and poor institutional quality contribute in approximately equal parts to explain Sub-Saharan Africa's poor export performance.

Davis and Weinstein examine the determinants of exporting by Japanese. They begin by documenting the tremendous concentration in Japanese exporting: four firms account for 20 percent of all Japanese exports, and 12 firms account for 40 percent of exports. Japan is a particularly interesting laboratory for studying export behavior because Japanese data enables researchers to estimate productivity, returns, and capital stocks using more sophisticated techniques than they can with U.S. data. The authors use the Japanese estimates to link firm-level exports to three explanatory variables: relative productivity differences; differences in production techniques; and increasing returns. Their results suggest that standard models of comparative advantage seem to be quite relevant for understanding specialization and export behavior. In particular, there seems to be a very robust relationship between exporting and firm-level total factor productivity. Moreover, firms with the highest growth in capital intensity also have the highest growth in export shares and the propensity to export. Interestingly, the authors find very little support for the monopolistic competition model.

In a related paper, Keith Head and John Ries investigate whether productivity differences explain why some Japanese manufacturers sell only to the domestic market while others serve foreign markets through exports or foreign direct investment (FDI). They show that firms that export and do FDI are more productive than firms that only export. However, they fail to find that higher productivity is associated with either the export decision or the ratio of FDI to exports.

Fukao, Ishido, and Ito show that although intra-industry trade (IIT) in East Asia is significantly less than in Europe, this form of trade has grown at a very rapid rate. Moreover, while the share of IIT remained almost constant from 1996 to 2000 for most EU countries, it increased rapidly among East Asian countries. According to the authors' calculations, the share of vertical IIT in total intra-East Asian trade grew from 16.6 percent in 1996 to 23.7 percent in 2000, while the share in total intra-EU trade increased only slightly, from 37.5 percent to 40 percent during the same period. Most interestingly, vertical intra-industry trade (VIIT), that is trade of goods with very different prices within very narrow product categories, has risen even faster. The increase in VIIT in these countries seems to have a strong positive correlation with the extent of the activities by Japanese electrical machinery MNEs.

Harrigan and Vanjani explore whether Japanese trade in manufactured goods differs from the rest-of-the world average and from that of the United States. Using a simple industry-level gravity model, they construct a measure of normalized imports by dividing bilateral industry-level imports by the importer's aggregate absorption and the exporter's industry output. They find that Japan imports less than one might expect, but also exports less. Moreover, they find that relative to the United States, Japanese export performance is half as strong today as it was in the mid-1980s, and Japan is more open to imports from the United States than the United States is to imports from Japan.

Evenett estimates the impact of global networks of American law firms on overseas mergers and acquisitions (M&A) by U.S. corporations. Now that many nations can review proposed mergers, U.S. law firms can help clients overcome regulatory hurdles abroad, effectively greasing the market for corporate control. However, they can also oppose transactions that are inimical to their clients' interests. His findings suggest that Baker & McKenzie -- the U.S. law firm with the most overseas offices -- has facilitated such transactions, whereas the combined effect of five smaller global U.S. law firms has tended to reduce outward U.S. M&A.

Kimura and Fujii present evidence on how globalizing activities affect the rate of survival of Japanese firms. In "Globalizing Activities and the Rate of Survival: A Panel Data Analysis of Japanese Firms," they show a positive correlation between survival and the share of foreign sales after controlling for a series of standard variables. They also present evidence that small firms that are members of Japanese corporate groups tend to fail at even higher rates than unaffiliated firms do.

These papers will be published in a special edition of the Journal of Japanese and International Economies scheduled for December 2003.

Fourth Annual Conference in India

On January 13-15, 2003 the NBER and India's National Council for Applied Economic Research (NCAER) again brought together a group of NBER economists and about two dozen economists from Indian universities, research institutions, and government departments for their fourth annual conference in India. Raghuram G. Rajan, NBER and University of Chicago, and Martin S. Feldstein, NBER and Harvard University, organized the conference jointly with Suman Bery and Shashanka Bide of NCAER.

The U.S. participants were: Isher J. Ahluwalia, University of Maryland; John H. Cochrane, NBER and University of Chicago; David M. Cutler, Mihir A. Desai, Martin S. Feldstein, and Jeffrey A. Frankel, NBER and Harvard University; Anne O. Krueger, on leave from the NBER at the IMF; Michael Grossman and Robert E. Lipsey, NBER and City University of New York; and Michael H. Moskow, NBER Director and President of the Federal Reserve Bank of Chicago.

After introductory remarks about the U.S. and Indian economies by NBER President Feldstein and Suman Bery of NCAER, the participants discussed: trade policy and foreign direct investment; fiscal deficits and how to deal with them; monetary policy and financial sector reforms; economic reforms (including privatization), employment, and poverty; and health issues.

Inflation Targeting

An NBER conference on Inflation Targeting, organized by Michael Woodford of NBER and Princeton University, took place on January 23-25. The conference agenda was:

• Mervyn A. King, Bank of England, "What has Inflation Targeting Achieved?"
• Lars E. O. Svensson and Michael Woodford, NBER and Princeton University, "Implementing Optimal Policy through Inflation-Forecast Targeting"
• Discussant: Bennett T. McCallum, NBER and Carnegie-Mellon University
• Laurence M. Ball, NBER and John Hopkins University, and Niamh Sheridan, International Monetary Fund, "Does Inflation Targeting Matter?"
• Discussant: Mark Gertler, NBER and New York University
• Stephen G. Cecchetti, NBER and Ohio State University, and Junhan Kim, Ohio State University, "Inflation Targeting, Price Level Targeting, and Output Variability"
• Discussant: N. Gregory Mankiw, NBER and Harvard University
• Marc P. Giannoni, Columbia University, and Michael Woodford, "Optimal Inflation Targeting Rules"
• Discussant: Edward Nelson, Bank of England
• Athanasios Orphanides, Federal Reserve Board, and John C. Williams, Federal Reserve Bank of San Francisco, "Imperfect Knowledge, Inflation Expectations, and Monetary Policy"
• Discussants: George W. Evans, University of Oregon
• Christopher A. Sims, NBER and Princeton University, "Fiscal Implications of Inflation Targeting"
• Discussant: Stephanie Schmitt-Grohe, NBER and Rutgers University
• Marvin Goodfriend, Federal Reserve Bank of Richmond, "Inflation Targeting in the United States"
• Discussant: Donald Kohn, Federal Reserve Board
• Jiri Jonas, International Monetary Fund, and Frederic S. Mishkin, NBER and Columbia University, "Inflation Targeting in Transition Economies"
• Discussant: Olivier J. Blanchard, NBER and MIT
• Ricardo J. Caballero, NBER and MIT, and Arvind Krishnamurthy, Northwestern University, "Inflation Targeting and Sudden Stops"
• Discussant: Ben S. Bernanke, Federal Reserve Board
• Panel Discussion: "Is Deflation a Threat for the U.S.?"
• Martin Feldstein, NBER and Harvard University, Michael Woodford, and Ben S. Bernanke

King spoke about the experience of inflation targeting in the United Kingdom. Following its exit from the Exchange Rate Mechanism in September 1992, the UK adopted inflation targeting as a means of providing a direct and transparent framework for monetary policy. A key component in the successful implementation of the framework was a willingness to explain how the economy was evolving, particularly in the Bank of England's Inflation Report. In May 1997, the framework was sharpened by making the target symmetric, and by setting up an independent committee at the Bank of England to set monetary policy. The Committee structure has proved invaluable in introducing a range of accountable views into the discussion. Many issues still remain to be resolved. For example, what types of central banks benefit from an inflation targeting framework? And, over what horizon should the central banks bring inflation back to target?

Svensson and Woodford consider the way in which inflation-forecast targeting should be conducted in order to bring about a socially optimal equilibrium, with an optimal long-run average inflation rate and optimal transitory responses to disturbances. They evaluate variant schemes from the point of view of avoiding stabilization bias, incorporating the kind of history dependence that is needed to cause expectations to respond optimally to shocks, and achieving determinancy of equilibrium. They also evaluate these variants in terms of the transparency of the connection with the ultimate policy goals and the robustness of the policy rule to perturbations of the model. A suitably designed inflation-forecast targeting rule can implement an optimal equilibrium, at the same time have a more transparent connection to policy goals, and be more robust than competing instrument rules, they conclude.

Ball and Sheridan examine the effects of inflation targeting on economic performance, as measured by the behavior of inflation, output, and interest rates. They compare seven OECD countries that adopted inflation targeting in the early 1990s to thirteen that did not. During the targeting period, performance improved along many dimensions for both targeting countries and non-targeters. In some cases the improvement was greater for targeters; for example, they decreased their average inflation levels by more than the non-targeters. However, this result is explained by the fact that targeters had worse performance in the pre-targeting period, and regression-to-the-mean exists and is unrelated to targeting. Once one controls for this effect, there is no evidence that inflation targeting is beneficial.

The dramatic improvement in macroeconomic outcomes during the 1990s -- stable, low inflation and high, stable growth -- can be ascribed at least partly to improved monetary policy. Central banks became more independent and many of them adopted inflation targeting. Cecchetti and Kim examine the potential for further improvements by refining the concept of inflation targeting. They construct a general model that encompasses a broad array of possible target regimes and apply it to the data. Their results suggest that the vast majority of countries could benefit from moving to price-path targeting, in which the central bank makes up for periods of above (below) target inflation with later periods of below (above) target inflation.

Giannoni and Woodford characterize optimal monetary policy for a range of alternative economic models, applying the general theory developed in an earlier paper (NBER Working Paper No. 9419). The rules they compute have the advantage of being optimal regardless of the assumed character of exogenous additive disturbances, although other aspects of their model specification do affect the form of the optimal rule. In each case that they consider, optimal policy can be implemented through a flexible inflation targeting rule, under which the central bank is committed to adjusting its interest-rate instrument so as to ensure that projections of inflation and other variables satisfy a target criterion. The authors show which additional variables should be taken into account, beyond the inflation projection, and how much weight the variable should get for any given parameterization of the structural equations. They also explain what relative weights should be placed on projections for different horizons in the target criterion, and the manner and degree to which the target criterion should be history-dependent.

The authors then assess the likely quantitative significance of the various factors considered in the general discussion by estimating a small, structural model of U.S. monetary transmission with explicit optimizing foundations. They compute an optimal policy rule for the estimated model, and it corresponds to a multi-stage inflation-forecast targeting procedure. Finally, they consider the degree to which actual U.S. policy over the past two decades has conformed to the optimal target criteria.

>Orphanides and Williams investigate the role of imperfect knowledge about the structure of the economy in the formation of expectations, macroeconomic dynamics, and the efficient formulation of monetary policy. Economic agents rely on an adaptive learning technology to form expectations and continuously update their beliefs about the dynamic structure of the economy based on incoming data. The process of perpetual learning introduces an additional layer of dynamic interactions between monetary policy and economic outcomes. The authors find that policies that would be efficient under rational expectations can perform poorly when knowledge is imperfect. In particular, policies that fail to maintain tight control over inflation are prone to episodes in which the public's expectations of inflation become uncoupled from the policy objective and stagflation results, in a pattern similar to that experienced in the United States during the 1970s. More generally, the authors show that policy should respond more aggressively to inflation under imperfect knowledge than under perfect knowledge.

According to Sims, inflation targeting may do more harm than good if there is a substantial chance that the central bank in fact cannot control inflation. A prerequisite for central bank control of inflation is appropriate coordination with, or backup by, fiscal policy; the nature of the required coordination will depend on whether and how central bank independence from the fiscal authority has been implemented. These considerations suggest that in those countries where inflation control has been most difficult in the past, inflation targeting may be least useful. Where inflation control has been successful in the past, the benefits of inflation targeting may have more to do with the associated changes in the policy process and in the central bank's communication with the public than with the inflation target itself.

Goodfriend begins by tracing the origins of the case for inflation targeting in postwar U.S. monetary history. He describes five aspects of inflation targeting practiced implicitly by the Greenspan Fed. He argues that low long-run inflation should be an explicit priority for monetary policy. Further, as a practical matter, it is not desirable for the Fed to vary its short-run inflation target. Strict inflation targeting can be regarded as efficient, constrained, countercyclical stabilization policy. Finally, Goodfriend suggests that the Fed publicly acknowledge its implicit priority for low long-run inflation, that Congress recognize that priority, and that representatives of the Federal Open Market Committee in return consider participating in a monetary policy forum to better inform the public and Congressional oversight committees about current monetary policy.

Jonas and Mishkin examine the inflation targeting experience in three transition countries: the Czech Republic, Poland, and Hungary. While these countries have missed inflation targets, often by a large margin, they nevertheless progressed well with disinflation. A key lesson from the experience of the inflation targeting transition countries is that economic performance will improve, and support for the central bank will be higher, if the central banks emphasize not undershooting the inflation target as much as they avoid overshooting. Also, economic performance will be enhanced if inflation targeting central banks in transition countries do not engage in active manipulation of the exchange rate. The relationship between the central bank and the government in these countries has been quite difficult, but this can be alleviated by having direct government involvement in setting the inflation target and with a more active role for the central bank in communicating with the government and the public. In addition, having technocrats rather than politicians appointed to head the central bank may help in depersonalizing the conduct of monetary policy and increasing support for the independence of the central bank. The authors also address the future perspective of monetary policy in the transition economies and conclude that, even after the EU accession, inflation targeting can remain the main pillar of monetary strategy in the three examined accession countries before they join the EMU.

Emerging economies experience sudden stops in capital inflows. During these sudden stops, having access to monetary policy is useful, but mostly for "insurance" rather than aggregate demand reasons. In this environment, a central bank that cannot commit to monetary policy choices will ignore the insurance aspect and follow a procyclical rather than the optimal countercyclical policy. The inefficiency is exacerbated by the presence of an expansionary bias. In order to solve these problems, Caballero and Krishnamurthy propose modifying the central bank's objective to include state-contingent inflation targets and to target a measure of inflation that overweights non-tradable inflation.

In the panel discussion, Feldstein emphasized that deflation is particularly damaging if the rate of deflation is so great that nominal wages must fall and short-term interest rates are approximately zero. Businesses and households suffer because the value of real assets falls relative to the value of nominal debts. Although the United States is not close to that situation now, a failure to achieve a strong enough recovery might cause the low inflation rate to shift over time to deflation. In addition to a more expansionary monetary policy that includes action with longer-term securities, the United States could reverse deflation by a fiscal stimulus. It is possible to have a fiscal stimulus without increasing the budget deficit by combining a temporary investment tax credit with a temporary increase in the tax on business income.

Bernanke noted that deflation often is associated with bad macroeconomic outcomes (as in the 1930s, or in Japan today) but not always (China today). A key issue is whether the zero bound on nominal interest rates is binding at full employment; in a rapidly growing economy, in which the real interest rate is high, the bound is unlikely to be relevant, but in a slack economy the bound may pose a crucial constraint. Bernanke argued that the chances of protracted deflation in the United States are remote, as the financial system and inflation expectations are both stable, and policymakers are prepared to act aggressively to resist deflationary shocks. Should deflation occur, even if the nominal interest rate reached zero, the Federal Reserve could respond by purchasing assets (including Treasury securities, foreign securities, and securities issued by government-sponsored enterprises), by lending aggressively through the discount window, and by cooperating with fiscal authorities. Bernanke noted that in a monetarist framework, in which money is a substitute for a variety of assets, increasing the money supply has the potential to affect a spectrum of asset yields. He concluded by suggesting that central bank anti-deflationary policies might be made more precise by targeting asset prices rather than by stipulating quantities of assets to be purchased.

Woodford agreed that the risk of deflation in the United States seems minimal, but argued that the ability of expansion of the monetary base through open-market operations to increase nominal aggregate demand is relatively limited once the zero lower bound on short-term nominal interest rates is reached, as it has been in Japan. Substitution of money for other short-maturity, riskless nominal assets (also with interest yields near zero) in the portfolios of private agents makes very little difference to the situation of those agents and hence their behavior; and the idea that open-market purchases of longer-maturity debt or other assets can substantially change relative prices of alternative financial assets ignores the failure of central-bank attempts to manipulate the term structure of interest rates in the past. Nonetheless, warnings that deflation is like a "black hole" from which an economy may be unable to leave once the state is entered are too pessimistic, because they assume a completely mechanical, backward-looking model of expectations formation. A public commitment to a price-level target should instead create a situation in which deflation will not create expectations of deflation but rather increased expectations of inflation, which will tend to automatically limit the extent of the deflation.

These papers and their discussion will be published by the University of Chicago Press in an NBER Conference Volume, Inflation Targeting. Its availability will be announced in a future issue of the NBER Reporter. They are also available at "Books in Progress" on the NBER's website.