Matteo Maggiori on China, Geoeconomics and Exchange Rates

- This is The Capitalism of Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working group where we talk about economics, markets and public policy. I'm Jon Hartley, your host Today. My guest is Matteo Maggiori, who is the mug Hotham family professor of finance at the Stanford Graduate School of Business is a senior fellow at the Hoer Institution. Thanks for joining us, Mateo.

- Thank you for having me and join us. It's great to be here. Well,

- It's really an honor to have you on. I think you're one of the leading international economists in the world and really excited to talk to you and we've known each other a long time and I, I think the work that you're doing is, is really fascinating on all the big issues in international finance. You know, talking about international hegemons, you know, it's, you know, the rise of China exchange rates. So many topics, you know, capital flows that I think are so interesting to people that are global macro practitioners on Wall Street or are economists in academia. I wanna first talk about your personal origins. I mean, how do you originally get interested in economics? Growing up in Italy, working at JP Morgan and London, going to do a PhD at Berkeley. And tell us about your personal origins and how you got into international finance and economics.

- Oh, my, that's a, that's a long story, but I, I guess I'll try to give you the, the quick version in part of my interest, which is common, for example, with economists also from Latin America was the big crisis of the nineties. So Italy underwent several economic crisis that had to do with the exchange rate system when I was growing up. And that seems such a huge topic. It affected everybody's life. It was clearly like on TV a lot. It was something that people will discuss at dinner. And I sort of felt, well, this is interesting. It seems like a big deal and potentially quite interesting. And my grandfather was not an economist, was very interested in financial issues and sort of stuck there explaining to me the basics. And that sort of stuck with me. But I didn't know that you could actually do the job of, you know, a researcher, this, you could make a living doing this. So I went to college, I did study economics, but I interpreted, you know, a re you know, career research to be totally out of the question. I thought the professors were people that would teach and then would have a private sector job or some, you know, one of the liberal professions. So it was not really, you know, it was really, I was graduating and an economist called Lucia Sarno came to visit and told me which

- Schools is that?

- Yeah, I was at Morris, an undergrad university in Rome. And it's a good university, but it, you know, at least back at the, at the time was much more teaching focused. Today they're doing a lot more and they have a lot more research. But, you know, I didn't come from a family background where research and being a university professor was something that people could explain to me. And

- Did you grow up in Rome or, or?

- I grew up in Rome, so I was born and I grew up in Rome. I then went to do an exchange in London through the Erasmus program, but I really didn't think that I was gonna put through this career. I thought I, you know, best case I was gonna be a banker at JP Morgan or, or something like that. And then Lucio was now a, a close friend, he's a professor at Cambridge University in the uk. He came to give a seminar and we met, they told him that I had finished all my exams very fast and that I didn't know what to do. And he explained to me that you could actually put career, like the one that I ended up doing, which was a big change for me. So I ended up doing a master with him, actually in the uk. And then, because UK masters are only one year, you really cannot get the lectures for PhD by the time you want to apply in the fall 'cause you just started. And so I ended up doing a year at JP Morgan. Well eventually ended up being two, but at the beginning I thought it was gonna be just one year trading currents and interest rates. But by that time I was pretty sure I wanted to go and do a doctorate. But I was sort of waiting and it was such an interesting experience actually exposed. It was wonderful. But at the time I didn't know. And that's when I decided to apply to grad school. And then I came to the, to the US I came to Berkeley 'cause it was very strong in international. Marty Al was there, purely was there, Barry was there. It was just like a, an incredible, well actually rich Lions at the time was also, you know, more involved in research and it became a university administrator and it's another chancellor, the university. It, it was just a good environment to do international. But I'm one of those people that stumbled onto this career. I think the conditional probability being born in Rome and from the background I was coming from that I was gonna be a professor at Stanford, was pretty close to zero.

- That's fascinating. I mean, I guess growing up in Europe, you know, this is still, I guess prior to the, the formation of the Euro. I mean, was it things like the European exchange rate mechanism and, and the sort of early stages of the Euro that that was, I mean, part of your interest in

- Yeah, the ERM crisis of the nineties, what a big deal for me, you know, those were happened when I was clearly very young. I didn't quite understand what was going on, but it was such a huge economic event that that's when I just first got sort of interested in these issues. Then of course, for a while I wanted to be a marine biologist or something else, like all kids. But eventually when you came close to university, I would say that that experience of those crisis was probably a big driver of my decision to get into economics.

- That's fascinating. You had the whole Soros and sen I guess who, who played a role in

- Yeah,

- In the bank, bank of England. It's, it's fascinating I guess how influential that, that that moment has, has been. You know, you've had an amazing career, you know, at, at Harvard and, and now Stanford and really wanna talk to you about a lot of your research because I think people, people really, you know, anyone who's interested in international affairs or, or international economics, I think is very much interested in these issues. And, and I wanna just start by talking a little bit about China. I mean, it's one international topic that's attracted a lot of interest in recent decades with rise of its economy, you know, since the Deng champing era, you know, liberalizing in its economy, you know, growing into, you know, being a potential hegemon, competing, competing with the us It's, it's growing mil, military might and so forth. You've written a, a really great paper on China. It's title internationalizing like China. I mean, could you explain, you know, what we've really learned in the data about how far along China's come in your mind in terms of achieving or or seeking to achieve hegemon status? I remember when I was working at Goldman, it was a big deal that China was increasingly entering big benchmark indices, whether they're equity or bond indices. I'm just curious what one, like what are the facts as as they're evolving and, you know, could a multipolar world, you know, led by the US and China work if it were to come into existence and, and what might that look like if, if it, if it were to happen?

- Yeah, I mean these are fantastic questions. We first got interested in China opening up the capital markets 'cause we were seeing more and more foreign mutual funds holding domestic assets, domestic bonds in China. And right now the situation is very peculiar. I would say we have this gigantic bond market domestically in China. It's, you know, depending on how you count the capitalization, it's, you know, the second, the third largest bond market in the world that for many years was totally shut off from international capital markets. It was actually surprisingly difficult if you were a foreign investors to hold these bonds on shore. Over time, China has gradually opened up this market. So the paper that you references with Justice Schrager and Chris Clayton was an attempt to think about this opening up process. They clearly started originally with programs that were almost bespoke. You have to apply, you had to be a qualified investors. There was a holding period, you know, you, you would think of it as almost testing the waters for China, getting familiar with what a foreign investor participating in their domestic market would look like. And then it progressively opened up more and more. So the big watershed moment was in 2017, they instituted a program called the Bond Connect that allows foreign investors through Hong Kong to enter the domestic market of China, the bond market, hold their assets and get out potentially quite quickly. And this was a much faster application process, much lighter requirements and correspondingly so a big sort of inflow coming from foreign private investors, the investors that we normally associate as being a little flight here, like the mutual funds or a hedge fund. Not the very long term passive investors or the official creditors like, you know, foreign central banks, foreign sovereign wealth funds. So we started thinking about this process and we also wanted a model to think about if you are a new entrant like China, you might have many of the characteristics that are associated with a potential reserve currency down the line. You're a large country, you have a deep market, you have a lot of fiscal capacity, you have military powerful, many of the things that we normally associate with a possible contender China has. But currently you have a very low reputation. You're a, you know, you're a new borrower on the block, nobody knows how you're gonna behave. Everybody might be worried that if too much capital comes in and the next crisis you might lock the gates for example. You might not let them get the capital out. And so we started thinking about how you would slowly build the reputation towards competing with the US And it's really like a trial by fire. You sort of start with, you let in very, very few investors, a crisis will eventually happen. They will get scared about you. They'll try to pull out, if you don't do anything, if you don't impair the process and suffer through a crisis when eventually passes, they would've learned that, you know, you might be the good type and they will bring in more capital and you sort of keep going. But one of the things that this process shows you is most countries give up somewhere along the way you have to suffer through a lot of crisis to build up the reputation for being a country like the us. And most countries can take that pain and give up somewhere along the way and get stuck with a relatively bad reputation. And then we started thinking about other issues, which I'm happy to touch on, which are, you know, why would China want to do this in particular, what does it, you know, does he impact the current account? And I really ended up thinking of it as they're trying to generate two way flows. They're trying to have the foreigners potentially come into their domestic market, but they don't necessarily want to move the trade balance or the current account. So what do you do? You let some of the locals take capital abroad so the net doesn't have to change, at least not mechanically. And you sort of, you're building up gross flows. And I think it, it's probably for two motives. One is what we just described. You're trying to slowly build a reputation on global markets as a potentially investible asset and eventually as a very safe one. The other one, which is probably a more immediate concern is if you wanted to generate a financial infrastructure that is separate from the one that the US or the west controls, you need liquidity, you know, not all payments net immediately. Not everything has a counterparty. So you need a liquid store of value. And the domestic bond market of China is really the only one with a size big enough to do it. But to do that you need to progressively relax the capital controls. And I think that that's probably a big motive in their mind right now. Particularly given all of the financial sanctions.

- So have they largely just been focusing on I guess stocks and bonds? Like I, I remember, you know, the China a share h share difference. I mean, you know, they, they've historically, I mean Hong Kong at some level has sort of been this intermediary to attract capital into mainland China and you know, they, they'll have eight shares in in Hong Kong and, and or they'll list some, some Chinese companies there. But I'm, I'm curious like on the real estate side, my my sense is that things are, are still pretty closed in the sense that I, I couldn't buy a house in China, for example, if I wanted to a meal in China, could, could I own a house there?

- Yes, there are, you know, across asset classes from real estate to FDI to bonds and equities, the restriction, the restrictions differ. Part of the recently liberalization was really the bond market very, very recently. There has been also more attempts to even liberalize the use of derivatives, particularly with the swap connect in some sense it comes hand in end with the bond market because it's the derivatives over those instruments. We're still at the beginning of this, you know, it's still a difficult country to invest in. There are liquidity issues, there are credit risk issues, but you know, it's unusual to have a country with markets of that size that starts to open up. So I almost think of it as the reverse of the bernanki saving glass story. The bernanki saving glass story, the early 2000 was, look, China's opening up. It's really a, an amount of savings that are entering the global asset classes and are chasing, for example, US treasuries and are pushing down yields, what we might see over the next few years. It's sort of a reverse shock where China's opening up and it's creating a set of investible assets that is expanding a lot for, for global savings where you could potentially invest in and it, it'd be interesting to see if China manages to do this successfully, are these bonds gonna crowd out emerging markets like Brazil? Are they gonna crowd out the weaker, you know, develop sovereigns like Italy or are they really gonna show up as competing with super high and sort of very safe bonds in the us Probably that's gonna change through time. That's gonna have large effects on yields. So far that hasn't happened in, you know, in particular the geopolitical tensions have meant that western investors like US Europe have largely not reentered China after pulling out in 2022.

- That, that's fascinating. I mean it, it's interesting how, I guess how much it feels like a reversion that we've seen under Xi Jinping in, in terms of, I guess not being completely on the sort of liberalization train that past Chinese leaders ha have been. But you know, at, at some level what's kind of, I think a, a bit of a, a wanting to have a cake and eat to two kind of issue of, you know, obviously wanting to have all the economic benefits of, you know, free capital flows and, and international investors, but also wanting to have, have very strong state control at the same time. I think it's, it's can be a bit difficult. I think that sort of segues into this ne next sort of topic of geoeconomics and you've recently sort of pioneered this, this topic and and concept in area of study geoeconomics. Can you explain to us a little bit about what Geoeconomics is exactly and what your approach to thinking about it is?

- Yeah, so I would define it simply as big countries like China, the US that are hegemons using the existing trade and finance relationships from their economies to achieve political or economic goals abroad. So lemme give you some very quick example. One is I'm the US I'm trying to get European banks not to finance trade with Iran for a geopolitical reason. And one of the things I can threaten them with is losing access to the US banking system. If they don't comply, that's a very powerful threat. If you're a European bank, that's a death sentence. If you get shut off from doing business with the US financial system, and so you're very likely to comply. Or if you're China, you could think of a lot of the belt and road initiative as I'm providing you infrastructure, I'm providing you loans, but I'm also asking in return for you to give a financial treatment to some of my exporters, I might want to control one of the, your key infrastructures like a port or I might ask you to have a particular, you know, leaning in un votes. Those are all typical examples of this kind of economic statecraft. And it's something that economists were keenly aware of and working on in the 1950s. Then we dropped a little bit of bull on this. The political scientists have actually kept thinking about this very hard. And so geoeconomics has a long history. I think what we've been doing is trying to bring modern economics into it, just thinking hard about, you know, clarity. Like from a theoretical perspective, when do you have power? Why do you have power? How do you use optimal policy? But also once you make it precise, you can go and measure things and you can do policy counterfactuals. So I, you know, our argument has been that a lot of macro international and finance theory that it was developed in the last 30 years has very good things to say about these topics. We just haven't really focused and so we're trying to bring it to bear. And it has been, it's been great actually. It's been exciting.

- And, and I think at some level too, I mean just the whole topic or or or tool of sanctions seems to grown a lot. I, I feel like maybe 20 years ago there's, you know, be Iran sanctions that would kind of go back and forth. But even recently, I remember maybe in 20 17 18 when I was working at Goldman Sachs, I remember that Venezuelan bonds were being sanctioned by OFAC at the time, which is the treasury office of Foreign Asset Control. And so, you know, that had had a huge effect on Venezuelan bond prices. And, and now there's, you know, we often hear about sanctioned individuals. I mean there's all sorts of, and and of course places like China and and Russia counter sanctions on, on American individuals or, or people are banned from entering those countries. And so it's, it does feel like with the sort of rise of China or, and, and also with, with what's been happening with Russia, particularly since the Ukraine in invasion, that there, there's been, i I guess a lot more discussion of these sorts of things, you know, what should the US or, or the allies do with the, that the frozen Russian reserve assets and so forth. So it seems like you, you've, your timing couldn't be better in in, in this, I mean, what, I guess what would be the, explain, I guess maybe how, how does that work? Is this largely like a, I guess theoretical frameworks? How would you, I guess maybe empirically think about certain sets of geoeconomics, I feel like the, the toolbox is so broad in the sense that, you know, you've got individuals, you've got financial assets, you've got, you know, countries that you can just sort of, I guess ban flows of some form of assets into, or, or ban, you know, a certain country from accessing banks. What do you think about the various variety of geo-economic tools in, in, in the work that you've been doing in this subject?

- Yeah, so I mean, lemme give you an answer in three part first, you know, touching to your earlier argument is you're totally correct. There has been a resurgence of the use of these instruments probably, you know, particularly in the last few years of which really, I mean the recent past, the last three or four years, this is the biggest change we've seen to the world order, certainly in our lifetime and probably since the Cold War. So this is a, a pretty drastic change, you know, shown up in sanctions, in export controls, it's certainly shown up in the number of threats, the use of tariffs. It's really a big change. The, the second part is you are also correct that the, you know, the canvas and the set of tools that has been used is quite varied. So a lot of what our theoretical work has been doing is trying to put this in all in one framework where you're really thinking about threats that could be threats not to buy, for example, like a, a tariff or an, or a boycott. They could be threats not to sell like an export control. They could be financial aid, they could be enforcement tools. It's actually quite possible to take all these different tools and bring them together and figure out how they enter like an economic model that generally I would say enter through a participation constraint. Now I'm trying to get you to do something that you don't wanna do and either I'm moving your inside option, so I'm trying to make the world better for you and asking you something in return, or I'm trying to worse your outside option. I'm telling you that I'll make your life very difficult if you don't comply. And you know, a lot of our standard toolkit fits into this. Now to make it concrete, it's probably easier to follow at least one example. So let's suppose that we focus on the threat not to give you access to something like an input. Okay? And we can make it semiconductors or we can make it financial services. So it's something that you need that is part of your production function. It's how you sustain economic activity in your country. And I would like you to do something that you don't wanna do. So my threat is gonna be that if you don't comply with my ask, I'm gonna cut you off from these inputs. Well, the first thing that becomes pretty clear is I can try to compute how bad is this for you at the end of the day, whether you're not gonna comply or not depends on the distance between the inside and the outside option. If I ask you for the moon over something that doesn't cost you anything to lose access to, clearly you're not going to comply. So a very simple concept of power, which we call micropower, it's just trying to measure this gaps. Now if you think about it as an economist, then it becomes clear that what matters is, well can you get this from somewhere else? So that's a elastic substitution versus other varieties that are produced by other countries. The typical example I give is oil. If under producer of one variety of oil, I have no power If I cut you off, other varieties are sub sufficiently closed substitutes. Now if I, if I'm OPEC and I control at least in the seventies potentially all of the varieties, then I might have a lot of power because the next thing that matters is, okay, if you cannot get it, how important is this for your production function? Does he enter as a substitute for many other things or is it close to like a Leon F input, something that without it a lot of production collapse. The other things that you start thinking about is, do you have a domestic alternative? Maybe you cannot get it anywhere else in the world, but you can get it in your own country. In fact, normally the first port of call when you get cut off is your own domestic economy can, do you have it or can you easily produce it? You know, a typical example is semiconductors in China right now, if we tell them that they cannot have access to advanced semiconductors, they're clearly gonna try to produce them domestically. And the question is how quickly and how efficiently can you produce them? So if you take this very, very basic framework, one thing that you can do is you can use sufficient statistics approach. You can say, look with us with a model, I'm gonna figure it out. If in a large class of these questions, all I need to figure it out is expenditure shares and elastic substitutions. And then the model might tell me which of these things are essential to you or not. It's something that, you know, trade economists have done for a lifetime, but you can bring it to both of these questions. So that's one approach. And you can see that you're going from a theory to measurement and to counterfactuals where you're thinking about a world where I might cut you off, but we're measuring it from data that we see on the equilibrium path recently. So we've been experimenting a lot with that recently. We're taking also a different approach, which is closer to what our colleague Nick Bloom, for example, has done for years thinking about text from the firms, the firms themself might be talking about it. What are they doing in response, how expensive is this? And so we've been experimenting with artificial intelligence, which is really the, the way I think about it is there's nothing else that a technology that lets us extract so much more information out of the text compared to a simple common find or you know, if you're more sophisticated like a gram. And that has been fun. We've been sort of looking at all the firms around the world and how they're responding to these issues.

- That's fascinating. And I, I, I guess just to get into, you know, the, these big data projects you, you've been working on, you know, what's called the Global Capital Allocation Project that you run with your co-authors for, for a good number of years now. And my understanding of it, and correct me if I'm wrong, you know, you're collecting all this fantastic data on capital flows, and I'm just curious, you know, what are the, you know, some of the challenges, what are some of the challenges been with international economic data that's usually compiled from the IMF, the BIS, the World Bank and so forth? And what's been missing in this data on things like capital flows? I know that with things like tax havens, you know, there's, there's some issues and, and sometimes, you know, there, there's just some challenges with, with actually getting, getting good data or, but sometimes these sort of big international institutions kind of fall short. I, I'm curious what, what's the, how does the Global Capital allocation project fit into that and, and what w do we not know, or what are the things that those big multinational institutions, what are the data that's, or, or pieces of data that they're not tracking?

- This is a great question. So we, you know, we started the lab back in 2017. It was myself, Jesse Schrager and Brian Niman. And the, we had really two interests. The first one was micro data, and immediately after the financial crisis, and then with the sovereign debt crisis in Europe, it became very clear that who owned which asset around the world was an important macro question, not just a micro question, you know, and like when I went to grad school, at least when I started, which was, you know, the year of the financial crisis, there was this attitude of the Central bank moves the interest rate, financial markets do some no arbitrage stuff, we don't really have to care about the plumbing. And then a IG happened and we kind of realized that knowing who is exposed to what or lemon made a huge difference to macro. And of course, you know, people like Bernanki it talking more and company, those models were there, but they weren't really as core to the inter, you know, to the macro finance profession as we think of them now. And, and they were still very aggregate, particularly with the sovereign debt crisis in Europe, it became very obvious that you wanna know who holds those bonds, where are the losses gonna show up? Are the losses gonna be absorbed by the investors or they're gonna get massively amplified 'cause it's gonna cause a, a cascade of failures. So the response to this was both in the private sector, in academia and in the policy institutions, a massive effort to collect data. All of a sudden we wanted to know positions. You know, even in finance traditionally we focused on prices on returns. We didn't spend much time thinking about positions that data was becoming available. And so at the time we decided with just and Brent, that we wanted to jump in on this and we got a little lucky, you know, a lot of research is you try your best, but you also need to get lucky. Our luck was that one of the largest data sets of micro data around the world had become available commercially. This was the data from Morningstar. We had convinced them to give us their entire data. And that was a treasure trove of, because all of a sudden, you know, you could go very, very deep on questions that traditionally only with the aggregate statistics you couldn't really answer. And so for example, we, we worked a lot on home currency bias, which it's pretty obvious once you have the micro data, but without the micro data, it was very difficult to see. That eventually led us to think about, okay, once you can manipulate the data and see what's going on, what's the right lens to look at the data? One thing that appeared very obvious to us is that a lot of positions were in tax sevens. Like you look at the Cayman Islands, the British Virgin Islands, Luxembourg, so much of the world financial assets, either on the investor side or on the issue side, are in these countries. Now, every economist understood that there's no economic activity, there's very little economic activity going on in the Cayman Islands compared to the assets and liability. So the capital is going somewhere else. But you know, when I did my dissertation, you kind of had to live with this. You sort of could decide whether to drop it, dumb it, do something about it, but you couldn't unwind it. And then it became more obvious to us that you can unwind it. And that led to a lot of research or a, or a pipeline for us thinking about how do you get the facts straight when you have all these layers of, of obfuscation. And that has also led to a lot of collaboration with the policy institutions. So you, you know, the BIS, the IMF, the Fed, the ECB, they have people that do fantastic work on these issues. And there's been a collective effort to produce data that is much more representative of what an economist will want to look at compared to a simpler statistical approach. So we now, we have a long-term collaboration with the ECB, where we look at like Luxembourg in Ireland, they're like massive mutual fund centers. They show up as the biggest holders of pretty much most assets worldwide. It's very clear it's not on behalf of the residents, but where do you stick this data? Like is it Italians, is it Germans? Is it the rest of the world? So that has been a lot of fun. I would say that, you know, traditionally the lab, our first wave of research was all on financial positions. Now we're working a lot more with text, which I mentioned. One frontier of research that is still out there to crack is, you know, really good data on how firms trade with each other around the world. Like that data, and particularly in goods and services, that data is very spotty. There are some data sets here and there, but if you think that, you know, if tomorrow we get sanctions and we want to know what is the exposure of every US firm to foreign inputs, how does he aggregate that that data doesn't exist? We get glimpses in some data sets. And so my sense is that with everything that is going on in Geoeconomics, that's gonna be one big sort of next frontier that needs to be tackled.

- Yeah, I mean my sense just as, as a researcher is like data on firms. Yeah. Especially with the us I mean internationally we have Orbis, which terrific, but you know, US data is, it can be challenging to work with, you know, even just like the Dun and Bradstreet data, you know, you might have some sort of imputed number of employees or, or, or, or, or establishments, but it, it, it's pretty limited. We don't know too much about firms and, and it's also hard to find, you know, their information about their exposure to, to various,

- It's pretty difficult. But you know, my sense is that it's gonna become doable and a little bit like the financial positions and now are very routine and 10 years ago were different here. You know, it's kind of amazing how over an article 10 years, the profession collectively makes a lot of pro progress. So I'm sort of somewhat hopeful that 10 years from now, a lot of these issues will look like routine research.

- Well you've also done a lot of work on a lot of great empirical work on, on beliefs and portfolios and, and I think you've shed a lot of really amazing light on, on, on investors. And I, my understanding is I think you run a lot of surveys partnering, I think with Vanguard asking questions of Vanguard clients, about their market expectations. I mean, what, what did you learn from that line of research when you, you're actually going in asking questions about retail investors and you know, there there's a lot of, I think, discussion recently about, you know, to what degree, you know, flows and quantities matter. This is a huge question I think in financial economics right now. Are, you know, equity markets in elastic or elastic, you know, if you had a $1 billion exogenous flow into equity markets, would, what would the effect of that be? And some like Quebec sequoian argue that's, it's a $5 effect, I'd argue it's it's much less than that and and Mark's probably more elastic in in the long run that then in elastic as they might claim. But I'm, I'm curious, like, so so much of these sort of behavioral things in venture markets are, are, are driven by beliefs. What have you learned from that line of research?

- Yeah, this was fun. This was with Stefan Olio, Johan Rabo and Steve Ku, who at the time was a, was at Vanger and the head of one of the research functions. And it was really stimulated from this perspective. So I guess two things got us into this. The first was intellectually there was all this work on expectations moving around a ton and potentially leading people to trade a lot. And therefore to explain the volatility of price is like one of the most classic questions of, you know, financial economics is why are prices so volatile compared to the fundamentals. The second thing that was interesting is survey technology was changing. Like it was clearly very possible to run large scale survey surveys, get people to answer on their phone, on their laptop. You know, that was becoming more and more available and by now it's totally routine. And even when we did it, I mean I'm certainly, we didn't pioneer this, but it, it was sort of clear that we, it could be done and sometimes you just have to again be a little lucky and a little bit ambitious. So we thought like, okay, the thing that is missing is to see people like me and you when we actually make our financial decisions in real life and not in a lab experiment, how do we react to our own reported beliefs and can we get high quality data that links actions in a setup that is in, in some sense is the real world. These people are making their decisions on the actual savings to high quality survey data. And you know, we just got lucky like Vanger was willing to do it and there'd been a wonderful partner as, as an institutions on this, you know, I would love to do it with many more institutions so far no other financial institutions said, great, we'll let, we'll let you do it. And so we ended up designing I would say a medium scale survey. Medium scale for me means the following. It's not one that says, Hey Jonah, you bullish about the market. The problem with that one is it's very easy for you to understand what I have in mind. It's very difficult for me as an economist when I get the answer to translate it into something that will constrain a model. So on the other hand, you can do very large scale surveys where you have to be a professional economist to even understand what it is that they're asking you. So we spent a lot of time designing in a way that we felt a relatively unsophisticated retail investor will understand what, what you're asking and has a view on this. And on the other end, the answers are quite informative for how we design our models. And the, the thing that jumped out immediately was were really two facts. The first one is that beliefs do move a lot. People have all sorts of views, but portfolios don't move that nearly that much. So the sensitivity of portfolio locations to beliefs, it's way low. Now that's a little bit different and, and not to be interpreted directly as the elasticity you have in mind because in some senses an elasticity to report the beliefs that are not margin more volatile than, you know, a rational expectation model would tell you would be the, at, at least for a representative agent, they expect the returns. So that sensitivity was way too low. Now that one, if you take it at face value, it's not great news for the behavioral approach. 'cause it tells you the police could move a ton, very little training occurs and therefore the, you know, this is unlikely to generate at least in a very naive model, huge price for questions. Now, there are ways to go around it, which is to think about like different sizes of investors. Maybe there's a small fringe of investors. The the statements need a lot more to be complete. But that fact was pretty, pretty surprising, pretty interesting. And as you know, has surfaced in different fashions by now in, in lots of different studies. The other thing that showed up is how people changed their mind over time. So when we started, we had the following question, is that right view of the data that you and I change our mind a lot over time? Or is the right view of the data is that you are always very optimistic. I'm always very pessimistic. We both change our mind. But the first third effect is just how far are we in our beliefs to begin with The world is really the second, like these individual fixed effects absorb a tremendous amount of the panel of beliefs. So there's really optimist and pessimist. It's a very persistent effect and we never found it easy to explain based on observable characteristics. Why in the first place is John so optimistic and Mateo so pessimistic. That's still an open question, but that has been a, you know, it has been a very fun, somewhat unusual line of research for me. 'cause there's not any international, but I thought it, I thought it was fascinating and we, we keep working on this, we keep sort of adding pieces of evidence over time

- That, that's fascinating. I mean, I'm, I'm curious, like I I do follow like some of the behavioral literature and, and some of the, you know, both intersections with sort of macro and finance and like, I remember there's all these papers, you know, by I think Ian and Sufi and, and there's a whole literature out there that tries to look at like con you know, consumer confidence and how much does consumer confidence actually matter for really economic variables. And I'd say this is kind of maybe analogous to that. And sometimes they look at like elections for example, and this is almost like a, I feel like a universal law, but basically following an election you can see, I mean, around these periods, you know, if for example, an incumbent gets thrown of office, there's a massive shift in expectations or or in consumer sound. Basically people feel very good when their own, you know, preferred candidates in office and, and they, they generally have positive economic sentiment, you know, for, for people that belong to that political party. Like for example, you know, maybe after the most recent election, you know, you'd, I'm sure you'd observe that, you know, the consumer sentiment of Trump voters would be very high probably right now versus, you know, democrats and, and so, and, and these things flip around elections like pretty mela mechanically and, and using that for identification, I, I think some of these studies like the Ian and Sufi studies basically found like no real economic effect. So I, I think that kind of maybe speaks to some of your findings. I I'd be interested if, if you've ever looked at how these sorts of beliefs change around elections that maybe people sell their portfolios around.

- So we, we looked a little bit, but part of the problem is it's not easy for us to identify who's a Republican, who's a Democrat. You know, one of the great things with working with this type of data sets is I get to see all your wealth and all of that, but precisely because of that, there is a strong limit on not being able to identify people. So that's, you know, i I guess part part of what you get and part of what you don't get. But in general, I'm a huge fan of studies that are trying to figure out how my beliefs or my perceptions really translate into actions. One thing that for example, was shocking to us is during COVID and then more recently during April 2nd, the announcements of tariffs, we looked at changes in beliefs and there were massive changes like, you know, people became very pessimistic about the economy, the stock market. But when you look at their portfolios, it was shocking to me how little they sold. You know, you would think if people become so pessimistic, you would find in the data massive attempt to liquidate equity positions. In reality that's actually pretty small. And you know, I was speaking to my Xavier and we haven't worked on this together, but Xavier Gbe has worked on, on this with in another setup, and it, it's sort of shocking how little it is now whether that translates from big or small asset price movements, that requires a whole sort of different set of assumptions and baggage that comes with it. But just as a, as an economist compared to at least my, my informed prior year, these flows are pretty small. The question is are we mis measuring beliefs or it is the problem, the way they're responding. It's just interesting. It's a mapping that I think is gonna take more time for the profession to fully absorb, but it it's certainly striking how big our largest differences are.

- Yeah, it's fascinating. I think behavioral macroeconomics and behavioral macro finance, I mean, if, if you call out a field, I mean it, it certainly is one finding, you know, good answers to that. I, I think is, it's such a diff difficult thing to do and, and it's, you know, certainly huge gains if, if, if people can make even I think marginal improvements in our, in our understanding in, in that space that, you know, that's commencing. I I wanna just spend, I I guess last, last moments here together talking about exchange rates and you know, one core, it's really a core area of international finance and you published a, a length about exchange rates. I'm curious, like, one, tell us a bit about your own research on exchange rates, but I I'm just curious in general, you know, what in your mind have, have we learned about exchange rates in the past maybe 20 to 30 years and, and maybe it's, it's we've learned more, I guess from getting better data. I feel like we've had okay, exchange rate data in general. Maybe we have more high frequency data now, but we, we kind of had had these periods where, you know, one, like I I think a lot of international economics is, you know, born out of, you know, the Bretton Woods era, I think, you know, Mundell Fleming, the Mundell Fleming tri of, you know, the idea that you can only have two out of, you know, fixed exchange rate, independent monetary policy and free capital flows was an idea that was developed out of the IMF when, when, when Fleming was working there. And, and I think Mondell was, was maybe visiting, but you know, obviously the world's moved away from the Bretton Woods system in the seventies, you know, closing the gold window and the Brenton Woods system breaking up Kane's obviously in the, I think fifties when he was helping to create the IMF and the World Bank, he was in favor of having one international currency being the bankcorp. And I feel like we've sort of gone all over the place and you know, there's, in terms of what we believe about exchange rates in the sixties, mil Friedman went head to head with MONDELL about should we have fixed or flow exchange rates. And Friedman I think kind of won out for a while, but there's still many, many countries around the world, even today that ha still have fixed exchange rates that are pegged to the dollar or some cases to the Euro. But I'm just curious what, you know, there's all these exchange rate puzzles that are out there. I'm curious, what do you think we've learned as, as a discipline in the past few decades about exchange rates?

- Well, I mean this is a huge question. So you know, I'm gonna tell you a little bit of what I've worked on or what I found fascinating also because it's a good study next to, you know, your very first question. So it's a good wrap up of how I got into economics because in, I mentioned I worked for a while as a trade currencies in interest rates and at JPB Morgan, and that was before my PhD. And then what happened is I was on the job market, I had a paper that was on international, was on the roll of the dollar and you know, the US as a world banker vie Beckon, Emanuel Fadi at the time I had a paper on exchange rates and rare disasters and I was in on the job market and I ended up speaking to Xavier on a flyout. And we were both pretty unsatisfied with how exchange rate modeling worked even in our own papers. And we sort of had in mind a different model and we couldn't really, you know, that model, we couldn't make it work. And so we thought like, oh, why don't we work together on this? Which of course for me at the time was a great opportunity, was already like an incredibly established and talented economist. It still is, but I was just a rookie on the job market and I thought, okay, great, let's do it. And I ended up thinking about this through the lenses of what I had seen trading exchange rates, which was a very simple idea of suppose that, you know, today we wake up in the US and there's a bunch of people that really want to hold Brazilian AWA risk and they're very excited about the prospects of Brazil. They wanna buy those bonds, well, who's supply them. It's not gonna be some long-term issue in Brazil, probably it's gonna be, you know, before a financial crisis, some bank like JP Morgan or Goldman, now it's probably some mutual fund that is the marginal intermediary, somebody that is willing to take the other side of that trade. And so it's giving up Brazilian real and it's getting dollars and it's using their balance sheet. I mean these, these institutions are big, they have large balance sheets, but you know, if you're trading a few billions, you're kind of moving the risk. And so they're thinking equilibrium, do I make enough money outta this rate to justify betting the risk? And so we ended up designing a model where the limited risk betting capacity of these intermediaries in the middle, it's sort of crucial if you're pushing dollar risk ment and you're taking away real risk, the exchange rate has to move to guarantee enough returns to these intermediaries to hold the flows in particular, that's gonna cause an immediate appreciation of the real, so that over time you can depreciate generating gains from them. And so it's a model that linked of flows and financial frictions and intermediation to exchange rate determination. And it's an idea that actually had been around for a long time, like Penti Kuri was an economist in the seventies talking about this, but it was surprisingly difficult to make it stick in a mother micro founded general equilibrium model. And so that's what we ended up designing with. Xavier has been a very popular model ever since, has been, you know, adopted a lot in academic research. The IMF, when they revise their policy framework, the financial market side of that exchange with determination comes, builds on that paper. So it that, you know, a fair amount of impact over the last, I guess it's already been more than 10 years, it's almost 15, but for me it was fun. It was, it was a paper that sort of translated an industry experience into an academic, you know, framework that holds together. And I, you know, I didn't go to the industry thinking that that was gonna help me write those papers, but that paper was a, was a pretty direct descendant of that experience. So that, that has been fun. And you asked me what have we learned and what we've not learned. I, I think I would say that we've learned that these market segmentation, it's pretty important that these flows do matter there. They do move exchange rates around, it opens up a toolbox also for policy. We still don't have a lot of imp empirical success. I would say that there's plenty of evidence of financial frictions being important for exchange rate determination. I wouldn't say it's overwhelming. And I think that that's where there's excitement about positions, data exchange rates are particularly tricky because you would think that some of the financial institutions that are most likely to be marginal in these markets are those whose data is the hardest to get, like hedge funds, you know, very levered player. These are probably pretty important and it's pretty difficult to get a complete picture of what they're doing. But again, there's been an incredible amount of progress on this.

- Yeah, it's a great question and in some level, you know, I think it's just very difficult questions in terms of what, you know, what, what actually predicts exchange rates in in the short to medium run. I think it's, it's, it's very hard. You know, I I think in the two thousands there were a lot of both currency and commodity hedge funds out there that now largely don't exist. There's a lot of multi-strategy funds that trade various currency strategies and I mean, FX carry being one, one big strategy and there's been tons of work in academia that's been done on covered interest rate parity and arbitrage that's sort of broken apart. I mean, it's one big area and, and I I think maybe one theme in, in your work, which I think is terrific and, and, and in my sort of young research career here try to do some of this, which is, you know, I I think there's so many, there's, there's such a big chasm between academia and and practice. And I think if, you know, as researchers we knew everything that practitioners knew, we could write better research papers and, and it's challenging in part because, you know, there's a lot of data that they can't share or don't wanna share, and they also don't wanna give away their trade secrets at some level. But I think there's, there's still so much to to be learned there, so it's fantastic to hear, I read Quebec's imagery, I think it's a fantastic paper and I hadn't quite realize how important it was by your JP Morgan experience, so I think that's terrific. I guess like one last sort of just question, I guess sort of big think here is any thoughts on, I guess, you know, just the future of the world you've written in, in sort of these hegemons, you know, you've written really the canonical papers with, on, on the sort of topic of hegemons with E Emmanuel far and, and, and others. You, you wrote a great paper several years ago that talked about the decline of the euro, which something we're continuing to see. I I think the US dollar has held up quite a bit, held up pretty well. I think even through you, the Russian invasion, Ukraine through COVID through the recent early 2020s inflation, the dollar I think is a share of global reserve assets is pretty much still the same. And, and I think this is the same across invoicing, a number of things China I think hasn't made at least as a share of FX reserves the same kind of, I think progress that some people had hoped. There's all this talk about Bricks Bank, you know, d dollarization, which I think is not well founded in the data, but, you know, so many of these things also are sort of proactive and are new and, and maybe it takes time for, for things to change. But I'm just curious, I mean, what your thoughts are about the trajectories of, of China, of, of Europe, of, of the US and, and of elsewhere. And I, I, I just, I think back to this one speech that I, I once heard from Sam Druckenmiller, you know, he's been around for a long time and investing, you know, played a role in the breaking the Bank of England. And he said at one point, you know, everyone thought the USSR was gonna take over the world, they were wrong. Paul Samuelson wrote in a textbook, he thought that the GDP of the USSR was gonna eclipse the US and that was obviously wrong and he updated his textbook at one point in the eighties. People thought that Japan was gonna surpass the us that that obviously was wrong. It's been wrong since the nineties. And and next is sort of the China question, and I'm just curious, you, you study this, you study all, all these areas. I'm just curious if you sort of had any sort of big think thoughts. Obviously, you know, forecasting is always challenging, but I'm just curious, what, what do you think in terms of how these big hegemons are are shifting?

- Yeah, so I mean one thing is for sure, which connects to what we discuss in, in reputation models is that challengers come up, but it's very, very difficult to displace the us I mean ultimately the institutional strength of sustaining large markets with big foreign participations where even in a crisis like oh eight, you don't essentially try to put through policies that intentionally reduce value for foreigners. It's an incredible promise to maintain. It takes a lot of institutional strength and most countries want to make that promise exam as you get good terms on your borrowing and when the time comes can't fulfill it. So it, it's not easy to build the reputation and maintain reputation at these levels. So I'm certainly skeptical of each time there is some promising young entrant thinking that it's gonna be so easy to displace the incumbent. The on the other end it's very clear that we're seeing a big deterioration in the us. I mean the fiscal situation has changed dramatically. You know, we're not quite in trouble, but we're starting to approach that levels where these issues are gonna come up. If interest rates spike, the cost of service and the debt is gonna go up and you know, you also don't want to go to the other extreme. If you look through history, it's not as if, if you once establish yourself to be a cornerstone of markets, you will always be one. In fact, you can be one for a very long time. But history shows us that you can often put through policies that lead to your own demise. So I think the truth is somewhere in the middle, but one aspect that I think I'm, I'm focusing on these days is the difference between the implications of our eyes of sort example and alternative like China for market versus power balances. Lemme put it this way, which is, you know, a little simplistic, but makes the point. You mentioned that China is somewhere around like two or 3% of the international user currency depending on which exact measure you use. Now let's the us, which is like 50% in this I sixties, 60, 70%. Now let's quickly agree to a scenario where 10 years from now, the US is still in the high fifties. China's gone from three to let's say 7% to 10%. Okay? I have no idea whether this is likely or not likely, but we're not talking about neck to neck. We're not talking, we're 50 50. Now. What's the consequence of that? Now, I would say for macro, relatively little, I don't think it's gonna change the transmission of monetary policy the way change rate works. Tons of the usual stuff. Very, very little. But now go back to the question of sanctions or exerting power to the financial system for that question is an absolute disaster. Why? Because imagine functioning account the size of Brazil or Russia, if China is 10% of the usage, that's plenty of liquidity for them to conduct business with. So in power is really about concentration of the shares and coming down from having 95% of the shares to 85 is a big loss in your power compared from 85 to 75 and so on. So I think in, you know, I always invite people to be careful about how we interpret those shares because what they mean really depends on the question. So if China, for example, develops a successful payment and settlement system that is pretty liquid and can easily accommodate a small open economy using it, that's a big loss to Western power. Does it make a huge difference to many other questions in matter? Probably not. So those are also much more realistic than a world where in the next five years China has 50% of the world financial system, which, you know, who knows, but seems rather unlikely. And I think it leads to a bit of a policy mistake because if you're thinking that none of those issues are gonna arise until we're really neck to neck financially, then you can com be very complacent about the development that China financial is gonna look small for a very long period of time. But those small shares can make a very large difference, particularly in Geoeconomics, even if not in market.

- I think it's just so hard, I think at some level to dislodge a hegemon. You, you think about, you know, the last time you, the, the world hegemon, you know, global Reserve currency changed. You know, it took a couple world wars to basically dislodge the UK from having the pound as you know, the world reserve currency. And in, in a world where we have, you know, nuclear weapons and, and across many countries, you know, war becomes increasingly less likely to happen.

- We might end up living in a world where fragmentation really means on the hedges and where the US is still very, very dominant, but all, all of a sudden there are two oth, two or three other players that can provide meaningful, for example, financial services. Now that world for power makes a big difference even if it doesn't look at all like a complete reversal of the current equilibrium.

- Fascinating. Yeah, absolutely. Well, it's a, a real honor to have you on Mateo and, and talking about your amazing career and contributions to international finance.

- Fantastic. Well it was great to do it. I'm glad that we got to do it.

- This is the Capitalism Freedom, the 21st Century podcast and official podcast of the Hoover Institution Economic Policy Working Group where we talk about economics, markets and public policy. I'm John, he your host. Thanks so much for joining us.