China’s Place in the Global Economy

Last week’s announcement that China’s GDP grew at an annualized rate of 7.4% in the first quarter of this year has stirred speculation about that country’s economy. Some are skeptical of the data, and point to other indicators that suggest slower growth.  Although a deceleration in growth is consistent with the plans of Chinese officials, policymakers may respond with some form of stimulus. Their decisions will affect not just the Chinese economy, but all those economies that deal with it.

The latest World Economic Outlook of the International Monetary Fund has a chapter on external conditions and growth in emerging market countries that discusses the impact of Chinese economic activity. The authors list several channels of transmission, including China’s role in the global supply chain, importing intermediate inputs from other Asian economies for processing into final products that are exported to advanced economies. Another contact takes place through China’s demand for commodities.  The author’s econometric analysis shows that a 1% rise in Chinese growth results in a 0.1% immediate rise in emerging market countries’ GDPs. There is a further positive effect over time as the terms of trade of commodity-exporters rise. Countries in Latin America are affected as well as in Asia.

These consequences largely reflect trade flows, although China’s FDI in other countries is acknowledged. But what would happen if China’s capital account regulations were relaxed? Financial flows conceivably could be quite significant. Chinese savers would seek to diversity their asset holdings, while foreigners would want to hold Chinese securities. Chinese banks could expand their customer base, while some Chinese firms might seek external financing of their capital projects. A study by John Hooley of the Bank of England offers an analysis of the possible increase in capital flows that projects a rise in the stock of China’s external assets and liabilities from about 5% of today’s world GDP to 30% of world GDP in 2025.

While the study points out that financial liberalization by China would allow more asset diversification, it also acknowledges that world financial markets would become vulnerable to a shock in China’s financial system.  Martin Wolf warns that the down-side risk is quite large. He cites price distortions and moral hazard as possible sources of instability, as well as regulators unfamiliar with global markets and an existing domestic credit boom. Similarly, Tahsin Saadi Sedik and Tao Sun of the IMF in an examination of the consequences of capital flow liberalization claim that deregulation of the Chinese capital account would result in higher GDP per capita and lower inflation in that country, but also higher equity returns and lower bank adequacy ratios, which could endanger financial stability.

There could be another result. A sizable Chinese presence in global asset markets would lead to even more scrutiny of Chinese monetary policy. A policy initiative undertaken in response to domestic conditions would affect financial flows elsewhere, and foreign policymakers most likely would voice their unhappiness with the impact on their economies. The Peoples Bank of China, accustomed to criticism from the U.S. over its handling of its exchange rate, might find the accusation of “currency wars” coming from other emerging market countries.  The price of a successful integration of Chinese financial markets with global finance will be calls for more sensitivity to the external impacts of domestic policies.

Capital Liberalization and Inequality

Inequality, which has drawn a great deal of comment and analysis following the publication of Thomas Piketty’s Capital in the Twenty-First Century, has sometimes been seen as a byproduct to increased international trade. But now other international economic linkages are being investigated. The International Monetary Fund’s Managing Director, Christine Lagarde, has acknowledged the need to take distributional consequences into consideration when designing IMF policy programs. Moreover, Fund economists have contributed to the research on the linkages between financial globalization and inequality.

Davide Furceri and Prakash Loungani of the IMF have investigated the effect of capital account liberalization on inequality. They looked at 58 episodes of capital account reform in 17 advanced economies, and found that the Gini coefficient (a measure of inequality) increased by about 1% a year after liberalization and by 2% after five years. One channel of transmission from the capital account to inequality could be the Increased borrowing by domestic firms that allows them to hire skilled workers, who pull ahead of the less-skilled workers.

A similar impact was found by Florence Jaumotte, Subir Lall and Chris Papageorgiou, also of the IMF. They analyzed the effect of financial globalization and trade as well as technology on income inequality in 51 countries over the period of 1981 to 2003. They reported that technology played a larger role in increasing inequality than globalization. But while trade actually reduced inequality through increased exports of agricultural goods from developing countries, foreign direct investment played a different role. Inward FDI (like technology) favored workers with relatively higher skills and education, while outward FDI reduced employment in lower skill sectors. Consequently, the authors concluded, while financial deepening has been associated with higher growth, a disproportionate share of the gains may go to those who already have higher incomes.

Jayati Ghosh of Jawaharlal Nehru University of New Delhi has examined the role of capital inflows in developing countries. She maintains that the inflows appreciate the real exchange rate and encourage investment in non-tradable sectors and domestic asset markets. The resulting rise in asset prices pulls funds away from the financing of agriculture and small firms, hurting farmers and workers in traditional sectors. Eventually, the asset bubbles break, and the poor are usually those most vulnerable to the ensuing crisis.

After the Asian crisis of 2007-08, Barry Eichengreen of UC-Berkeley analyzed some of the other linkages that could tie inequality to capital account liberalization. He dismissed claims that capital mobility hinders the ability of governments to maintain social safety nets or to use macroeconomic policy to stabilize output. He agreed that developing countries were more likely to suffer the negative effects of capital mobility. But the problem lay in the combination of an open capital account and inadequate institutions and regulations.

The global financial crisis demonstrated that weak regulation and volatility in financial flows are not unique to emerging markets and developing countries. Moreover, while the U.S. economy now shows signs of increased growth, the long-term unemployed are not sharing in the recovery.  The U.S. Senate has passed a bill that would extend benefits to this group of workers, but it faces opposition in the House of Representatives. On the other hand, those households that own substantial financial assets have benefited greatly from the increase in their value since 2009, which is due in large part to monetary policy. Similar patterns can be found in Europe.

Those most hurt by the outcome of financial instability should be the first to benefit from government policies intended to mitigate its impact. But we know that politicians are much more responsive to their more affluent constituents, who hold financial assets. The uneven recoveries that follow financial crises injure those least capable of dealing with misfortune, thus exacerbating the disparity between those at the top of the income distribution and those at the bottom.

The IMF and Ukraine

The International Monetary Fund last week announced an agreement with Ukraine on a two year Stand-By Arrangement. The amount of money to be disbursed depends on how much other financial support the country will receive, but will be total at least $14 billion. Whether or not this IMF program will be fully implemented (unlike the last two) depends on the government’s response to both the economic crisis and the external threat that Russia poses. There is also the interesting display of the use of the IMF by the U.S., the largest shareholder, to pursue its international strategic goals even though the U.S. Congress will not approve reforms in the IMF’s quota system.

Ukraine’s track record with the IMF is not a good one. In November 2008 as the global financial crisis intensified, the IMF offered Ukraine an arrangement worth $16.4 billion. But only about a third of that amount was disbursed because of disagreements over fiscal policy.  Another program for $15.3 billion was approved in 2010, but less than a quarter of those funds were given to the country.

The recidivist behavior is the product of a lack of political commitment to the measures contained in the Letters of Intent signed by the government of Ukraine. Ukraine, like other former Soviet republics, was slow to move to a market system, and therefore lagged behind East European countries such as Poland and Romania in adopting new technology. Andrew Tiffin of the IMF attributed the country’s economic underachievement to a “market-unfriendly institutional base” that has allowed continued rent-seeking. Promises to enact reform measures have been made but not fulfilled.

Are the chances of success any better now? Peter Boone of the Centre for Economic Performance at the London School of Economics and Simon Johnson of MIT are not convinced that there has been a change in attitude within the Ukrainian government, despite the overthrow of President Viktor Yanukovych (see also here). Consequently, they write: “There is no point to bailing out Ukraine’s creditors and backstopping Ukrainian banks when the core problems persist: pervasive corruption, exacerbated by the ability to play Russia and the West against each other.”

Leszek Balcerowicz, a former deputy prime minister of Poland and former head of its central bank, is more optimistic about the country’s chances. The political movement that drove out Yankovich, he claims, is capable of promoting reform. Further aggression by Russia, however, will threaten whatever changes the Ukrainian people seek to undertake.

The “back story” to the IMF’s program for Ukraine has its own intramural squabbling. The U.S. Congress has not passed the legislation needed to change the IMF’s quotas so that voting power would shift from the Europeans to the emerging market nations. The changes would also put the the Fund’s ability to finance its lending programs on a more regular basis. Senate Majority Leader Harry Reid sought to insert approval of the IMF-related measures within the bill to extend assistance to the Ukraine, but Republicans lawmakers refused to allow its inclusion. While U.S. politicians expect the organization to serve their political ends, they reject changes that would grant the IMF credibility with its members from the developing world.

The Economist has called the failure of Congress to support the IMF “shameful and self-defeating.” Similarly, Ted Truman of the Peterson Institute for International Economics warns that the U.S. is endangering its chances of obtaining support for Ukraine. The Europeans, of course, are delighted, as they will keep their place in the Fund’s power structure while the blame is shifted elsewhere. And the response of the emerging markets to another program for Ukraine, despite its dismal record, while they are refused a larger voice within the IMF? That will no doubt make for some interesting discussions at the Annual Spring Meetings of the IMF and the World Bank that begin on April 11.

Tapering and the Emerging Markets

The response of the exchange rates of emerging markets and their equity markets to the Federal Reserve’s “taper,” i.e., reduction in asset purchases, continues to draw comment (see, for example, here). Most analysts agree that these economies are in better shape to deal with capital outflows than they were in the past, and that the risk of another Asian-type crisis is relatively low. But that does not mean that their economies will react the way we expect.

Gavyn Davies of Fulcrum Asset Management, who has a blog at the Financial Times, has posted the transcript of a “debate” he organized with Maurice Obstfeld of UC-Berkeley, Alan M. Taylor of UC-Davis and Dominic Wilson, chief economist and co-head of Global Economics Research at Goldman Sachs, on the financial turbulence in the emerging markets. “Debate” is not the best word to describe the discussion, as there are many areas of agreement among the participants. Obstfeld points out that there are far fewer fixed exchange rate regimes in today’s emerging markets, and many of their monetary policymakers have adopted policy regimes of inflation targeting. Moreover, the accumulation of foreign exchange by the central banks leaves them in a much stronger position than they were in the 1990s. Taylor adds fiscal prudence and less public debt to the factors that make emerging markets much less risky.

But all the participants are concerned about the winding down of the credit booms that capital inflows fueled. Wilson worries about economies with current account deterioration, easy monetary policy, above-target inflation, weak linkages to the recovery in the developed markets and institutions of questionablestrength. He cites Turkey, India and Brazil as countries that meet these criteria. Similarly, Taylor lists countries with relatively rapid expansion in domestic credit over the 2002-2012 period, and Brazil and India appear vulnerable on these dimensions as well.

Another analysis of the determinants of international capital flows comes from Marcel Förster, Markus Jorra and Peter Tillmann of the University of Giessen. They estimate a dynamic hierarchical factor model of capital flows that distinguishes among a common global factor, a factor dependent on the type of capital inflow, a regional factor and a country-specific component. They report that the country component explains from 60 – 80% of the volatility in capital flows, and conclude that domestic policymakers have a large degree of influence over their economy’s response to capita flows.

But are “virtuous” policies always rewarded? Joshua Aizenman of the University of Southern California, Michael Hutchison of UC-Santa Cruz and Mahir Binici of the Central Bank of Turkey have a NBER paper that investigates the response in exchange rates, stock markets and credit default swap (CDS) spreads to announcements from Federal Reserve officials on tapering. They utilize daily data for 26 emerging markets during the period of November 27, 2012 to October 3, 2013. They looked at the response to statements from Federal Reserve Chair Ben Bernanke regarding tapering, as well as his comments about the continuation of quantitative easing. They also looked at the impact of statements from Federal Reserve Governors and Federal Reserve Bank Presidents on these topics, as well as official Federal Open Market Committee (FOMC) statements.

Their results show that Bernanke’s comments on winding down asset purchases led to significant drops in stock markets and exchange rate depreciations, but had no significant impact on CDS spreads. There were no significant responses to statements from the other Fed officials. On the other hand, there were significant responses in exchange rates when Bernanke spoke about continuing quantitative easing, as well as to FOMC statements and announcements by the other policymakers.

The countries in the sample were then divided between those viewed as possessing “robust” fundamentals, with current account surpluses, large holdings of foreign exchange reserves and low debt, and those judged to be “fragile” due to their current account deficits, small reserve holdings and high debt. Bernanke’s tapering comments resulted in larger immediate depreciations in the countries with current account surpluses as oppose to those with deficits, more reserves and less debt.  Similarly, Bernanke’s statements led to increased CDS spreads in the countries with current account surpluses and large reserve holdings, while lowering equity prices in countries with low debt positions. The immediate impact of the news regarding tapering, therefore, seemed to be tilted against those with strong fundamentals.

The authors provide an explanation for their results: the robust countries had received larger financial flows previous to the perceived turnaround in Fed policy, and therefore were more vulnerable to the impact of tapering. Moreover, as the change in the Federal Reserve’s policy stance was assimilated over time, the exchange rates of the fragile nations responded, and by the end of the year had depreciated more than those of the more robust economies. Similarly, their CDS spreads rose more. By the end of 2013, Brazil, India, Indonesia, South Africa and Turkey had been identified as the “Fragile Five.”

What do these results tell us about the impact on emerging markets from future developments in the U.S. or other advanced economies? There may be a graduated response, as the relative standings of those nations that have attracted the most capital are reassessed. However, if capital outflows continue and are seen as including more than “hot money,” then the economic fundamentals of the emerging markets come to the fore. But financial markets follow their own logic and timing, and can defy attempts to foretell their next twists and turns.

Too Much of a Good Thing?

Global banks do not have much to cheer about these days. Earnings are falling, and the banks are responding by cutting jobs. The Federal Deposit Insurance Corporation has charged 16 banks of colluding to rig the London Interbank Offer rate (LIBOR). And the Federal Reserve has approved a rule that requires foreign banks with $50 billion of assets in the U.S. to establish holding companies for their American units that meet the same capital adequacy standards as do their U.S. peers. The latter move has been interpreted as a sign of the fragmentation of global finance that will hinder the global allocation of credit.

The Federal Reserve supported the foreign banks in the fall of 2008 when the it lent to distressed institutions. The U.S. units of European banks accounted for $538 billion of the Federal Reserve’s emergency loans, over half of the total. Federal Reserve Chair Ben Bernanke had to answer criticism from U.S. lawmakers that the loans did not benefit U.S. taxpayers. At the same time, the Federal Reserve was establishing swap lines with central banks in 14 countries. The dollars those monetary authorities acquired were used to prop up their banks that needed to finance their holding of U.S. debt.

Banks have various ways to meet the new capital adequacy standards. They can hold back on dividend payouts from their earnings, although that may not be popular with their stockholders. They can raise funds in the capital markets. And some banks, such as Deutsche Bank, will shrink their balance sheets in order to comply with the regulations. This has led to fears of cutbacks in lending.

The announcement of the new standard came as the Bank of International Settlements (BIS) was publishing its quarterly report on the international banking markets. The BIS data showed that the cross-border claims of BIS reporting banks fell by $500 billion in the their quarter of 2013, the biggest contraction since the second quarter of 2012. Most of this decline occurred in Europe, as lending between parents banks and their subsidiaries in the Eurozone and the United Kingdom declined.

Would a contraction in bank credit have negative consequences? It certainly will for those firms in Europe that are unable to obtain credit. But there are also grounds for believing that a reduction in banking activity may under some circumstances be advantageous for an economy. The same issue of the BIS Quarterly Review that reported the international banking data also carried an article by BIS economists Leonardo Gambacorta, Jung Yang and Kostas Tsataronis. They compared the impact of bank and capital market activity on economic growth, and found that increases in both contributed to higher growth, but only up to threshold levels of GDP. After those thresholds are reached, further expansion in banking or capital markets had negative impacts on growth. Similar results have been reported by Jean-Louis Arcand, Enrico Berkes and Ugo Panizza of the IMF, Stephen G. Cecchetti and Enisse Kharroubi also at the BIS, and Sioong Hook Law of Universiti Putra Malaysia and Nirvikar Sinth of UC-Santa Cruz in the Journal of Banking & Finance (working paper version here).

These studies deal with the domestic impacts of financial activity. How about bank lending across borders? The record there also demonstrates that bank lending can have adverse consequences. Martin Feldkircher of Oesterreichische Nationalbank (the National Bank of Austria) has a paper in the Journal of International Money and Finance (working paper version here) that examines the determinants of the severity of the global financial crisis in 63 countries, using 97 candidate variables. He reports that the change in domestic credit provided by the banking sector is a robust determinant of crisis severity. When he further investigated by interacting the bank credit variable with measures of risk, including macro, external, fiscal, financial and contagion and spillover risk, he found that the interaction of bank credit with foreign claims from banks in advanced countries robustly explained crisis severity. He concludes: “Countries with high credit growth and considerable exposure to external funding saw their economies more severely affected during times of financial distress.”

There is a line between financing new economic activities and bankrolling speculation. The former promotes welfare, the latter ends in volatility and distress. Unfortunately, that line shifts as new opportunities appear. Trying to find it is a constant challenge for regulators.

Riding the Waves

The volatility in emerging markets has abated a bit, but may resume in the fallout of the Russian takeover of the Crimea. The capital outflows and currency depreciations experienced in some emerging market nations have been attributed to their choice of policies. But their economic situations reflect the domestic impact of capital inflows as well as their macroeconomic policies.

 Fernanda Nechio of the Federal Reserve Bank of San Francisco, for example, shows that exchange rate depreciations of emerging markets are linked to their fiscal and current account balances, with larger depreciations occurring in those countries such as Brazil and India with deficits in both balances. Kristin Forbes of MIT’s Sloan School also draws attention to the connection between the extent of the currency depreciations and the corresponding current account deficits. Nechio and Forbes both advise policymakers in emerging markets to make sound policy choices to avoid further volatility.

Good advice! But Stijn Claessens of the IMF and Swati Ghosh of the World Bank have pointed out in the World Bank’s Dealing with the Challenges of Macro Financial Linkages in Emerging Markets that capital flows can exacerbate prevailing economic trends. Relatively large capital inflows to emerging markets (“surges”) tend to take the form of bank and portfolio debt, which contribute to increased domestic bank lending and domestic credit. Claessens and Ghosh write (p.108) that “…large inflows in net terms are the financial counterpart to the savings and investment decisions in the country and affect the exchange rate, inflation, and current account positions.” They also endanger the stability of the financial system as bank balance sheets expand and lending standards deteriorate. These financial flows contribute to increases in asset prices and further credit extension until some domestic or foreign shock leads to an economic and financial downturn.

Are the authorities helpless to do anything? Claessens and Ghosh list policies that may reduce macro vulnerability, which include exchange rate appreciation, monetary and fiscal policy tightening, and the use of capital controls. They also mention, as do the authors of the other chapters of the World Bank volume, the use of macro prudential policies (MaPPs) aimed at financial institutions and borrowers. But they admit that the evidence on the effectiveness of the MaPPs is limited.

Moreover, the macroeconomic policies they enumerate may not be sufficient to deal with the impact of capital inflows. Tightening monetary policy can draw more foreign capital. Fiscal policy is not a nimble policy lever, and usually operates with a lag

What about the use of flexible exchange rates as a buffer against foreign shocks? Emerging market policymakers have been reluctant to fully embrace flexible rates. More importantly, as pointed out here, it is not clear that flexible rates provide the protection that the theory of the “trilemma” suggests it does. Hélène Rey of the London Business School claimed last summer that there fluctuating exchange rates cannot insulate economics from global financial cycles in capital flows and credit growth. Macroprudential measures such as higher leverage ratios are needed, and the use of capital controls should be considered.

Last week we learned that capital flows to developing countries fell in February, with syndicated bank lending falling to its lowest level since 2005. This was followed by the news that domestic credit growth is falling in many emerging markets, including Brazil and Indonesia. The ensuing changes in fundamentals in these countries may or may not alleviate further depreciation pressures. But they will reflect the procyclical linkage of capital flows and domestic credit growth as much as wise policy choices. And there is no guarantee that the reversals will not overshoot and bring about a new set of troubles. The waves of capital can be as tricky to ride as are ocean waves.

High Road, Low Road

Among the many thorny issues that would arise if Scotland were be become an independent nation is the question of its choice of a currency. The first minister of Scotland claims that an independent Scotland would continue to use the pound. But Mark Carney, the governor of the Bank of England, has raised several caveats and stipulations—including limitations on fiscal autonomy—that would be required if a currency union were to be formed. Moreover, British elected officials have thrown cold water on the idea. And that could be a problem for an independent Scotland, as there is no obvious good alternative.

Scotland could unilaterally decide to continue using the pound, just as Panama and Ecuador use the U.S. dollar. But dependence on the United Kingdom for its money is not fully compatible with political independence. Nor is it congruent with the international status that the new country would undoubtedly seek.

How about adopting the euro? Scotland would join the current 18 members of the Eurozone, and would have to hope that it did not suffer from any Scotland-specific shocks. Optimal currency theory spells out the alternative mechanisms a country needs to address an asymmetric shock: mobile labor, flexible prices and wages, and/or a fiscal authority that can direct funds to the area facing the shock. The sight of Irish, Spanish, etc., workers leaving their respective homelands in search of work outside of Europe has hardly been reassuring to prospective members. The Baltic states have shown that prices and wages will fall in response to a policy of austerity, but the economic cost is severe. And no Scottish government would survive the harsh policy conditions attached to the financial assistance extended to Greece, Ireland and Portugal by their European partners and the IMF. Joining the Eurozone at this stage of its existence would not be consistent with Scottish canniness.

If Scotland can not—or will not—join an existing monetary union on terms it deems acceptable, should its create its own currency? The prospect of a Scottish currency has drawn a fair amount of comment: see, for example, here and here and hereA study by Angus Armstrong and Monique Ebell of the National Institute of Economics and Social Research makes the point that the viability of an independent currency for the country would depend on the amount of sovereign debt the new government would have to take on after a breakup witht the United Kingdom versus its anticipated oil revenues. Standard & Poor’s issued a nuanced assessment of how it would rate Scotland’s debt that noted the country’s economic wealth, which is largely based on oil and gas. But the report also raised concerns about the viability of Scotland’s financial sector in the absence of a reputable lender of last resort.

If an independent Scotland issued its own currency, it would be joining other north European countries that either do not belong to the European Union (Iceland, Norway) or have not adopted the euro (Denmark, Sweden). These countries have certainly suffered bouts of volatility and instability (particularly Iceland), but have not fared any worse than many members of the Eurozone. Their decision not to enter the Eurozone itself is interesting and worth further analysis.

But none of them is as deeply tied to another single country as Scotland is to the United Kingdom. Disentangling those ties for the purpose of establishing national autonomy would be difficult and most likely costly. Proclaiming monetary independence, therefore, would be a policy action that makes limited sense in economic terms but carries a great deal of nationalistic baggage. And those types of ventures do not usually end well.

Group Therapy

Pop quiz:  which U.S. policymaker said last week: “We can’t solve everyone else’s problems anymore” in response to foreign criticism of U.S. handling of what issue?

a—Federal Reserve Chair Janet Yellen, responding to criticism by foreign central bankers of the Fed’s tapering of its asset purchases;

b—Treasury Secretary Jack Lew, following denunciations of the refusal of the U.S. Congress to pass legislation that would enable IMF quota reform;

c—an anonymous White House aide, defending the Obama  administration’s  response to the turmoil in the Ukraine.

The correct response is c. But Ms. Yellen and Mr. Lew, who are attending the conference of G20 finance ministers and central bank heads in Sydney, might be forgiven if they held similar (but unspoken) sentiments.

The Federal Reserve has been criticized for not coordinating its policies with its peer institutions, particularly in those emerging markets that have had capital outflows and declines in equity market prices. But the critics have not spelled out precisely what they believe the Federal Reserve should do (or not do), given its assessment of the state of the U.S. economy. Domestic central banks respond to domestic conditions. In some cases, those conditions are linked to the global economy, and a central banker who ignored those linkages would only be postponing the implementation of stronger measures. But is that the case here?

The IMF came the closest to offering a specific criticism:

Advanced economies should avoid premature withdrawal of monetary accommodation as fiscal balances continue consolidating. Given still large output gaps, very low inflation, and ongoing fiscal consolidation, monetary policy should remain accommodative in advanced economies. There is scope for better cooperation on unwinding UMP, including through wider central bank discussions of exit plans.

Does anyone think that the Federal Reserve no longer intends to “remain accommodative”? Are more discussions the only missing element of the Federal Reserve’s plans? That would be surprising, since central bankers have many opportunities to speak to each other, and usually do.

The IMF did not let the emerging market countries off the hook:

In emerging market economies, credible macroeconomic policies and frameworks, alongside exchange rate flexibility, are critical to weather turbulence. Further monetary policy tightening in the context of strengthened policy frameworks is necessary where inflation is still relatively high or where policy credibility has come into question. Priority should also be given to shoring up fiscal policy credibility where it is lacking; subsequently buffers should be built to provide space for counter-cyclical policy action. Exchange rate flexibility should continue to facilitate external adjustment, particularly where currencies are overvalued, while FX intervention— where reserves are adequate—can be used to smooth excessive volatility or prevent financial disruption.

Critics are on firmer grounds when they criticize the U.S. for not passing the necessary legislation to change the IMF’s quota allocations. But perhaps they should not take their annoyance out on Mr. Lew. The U.S. Congress did not approve the needed measures for a number of reasons, none of them particularly compelling. Mr. Lew would be delighted to see the situation change, but that is unlikely to happen.

What, then, can be done at the G20 meeting? If allowing everyone to voice her or his frustrations with the U.S. serves some useful purpose, then all the air miles on the flights to Sydney will have been earned. Perhaps IMF Managing Director Christine Lagarde can serve as mediator/therapist. But before everyone piles on, it may be worth reflecting that the Federal Reserve is not the only central bank with policy initiatives that may ripple across national borders.

Been There, Done That

President Barack Obama has nominated Stanley Fischer to the Board of Governors of the Federal Reserve Board, where he will succeed Janet Yellen as Vice-Chair of the Board. Fischer’s accomplishments are well-known. But he also brings an interesting set of credentials to the Board at a time when it has been criticized for ignoring the impact of its policies on other countries.

Fischer received his doctoral degree from MIT, and returned there after a stint on the faculty at the University of Chicago. During the 1970s and 1980s he taught or advised such future luminaries as Ben Bernanke, Greg Mankiw and Mario Draghi. He served as Vice President and Chief Economist of the World Bank from 1988 to 1990. He was the First Deputy Managing Director of the IMF from 1994 through 2001, a period when financial crises recurred on a regular basis in the emerging market countries.

Fischer’s experience with those crises gives him a perspective that macroeconomists who work only on the U.S. economy do not possess. Paul Krugman has written about how the financial instability of the post-Bretton Woods era has affected the views of those who follow these events. In 2009, for example, when our profession was castigated for not foreseeing the global financial crisis, Krugman wrote: “

…the common claim that economists ignored the financial side and the risks of crisis seems not quite fair – at least from where I sit. In international macro, one of my two home fields, we’ve worried about and tried to analyze crises a lot. Especially after the Asian crisis of 1997-98, financial crises were very much on everyone’s mind.

Similarly, in 2011 Krugman wrote:

Indeed, my sense is that international macroeconomists – people who followed the ERM crises of the early 1990s, the Latin American debt crisis, the Asian crisis of the late 90s, and so on – were caught much less flat-footed.

The IMF, of course, was widely criticized at the time for its crisis-management policies and its advocacy of deregulating capital flows.  In retrospect, Fischer’s arguments in favor of capital account liberalization appear overly zealous, and he has drawn criticisms for those positions. The IMF has recently adopted a more nuanced position on the use of capital controls as a macro prudential tool.

And yet—in 2000, after the resignation of the IMF’s Managing Director Michel Camdessus, Fischer, who was born in Rhodesia (now Zambia), was nominated to be Camdessus’ replacement by a group of African nations. (Miles Kahler presents the story in his Leadership Selection in the Major Multilaterals.) This was a challenge to the European governments that had always claimed the prerogative of naming the Managing Directors of the IMF since it commenced operations in 1945. But the nomination was also an indication of the respect that Fischer enjoyed amongst the African and other developing countries. In the end, it was impossible to change the IMF’s traditional governing procedures, and Horst Köhler of Germany became the new Managing Director.

After Fischer left the IMF, he went to work at Citigroup. In 2005 he was appointed Governor of the Bank of Israel, and served there until last year. Under his leadership the Bank received praise for its policies. Fischer was widely admired and received an “A” for his stewardship from the magazine Global Finance. Those pouring through his recent speeches and writings for indications of what he might do as a Federal Reserve Governor believe that he endorses the Fed’s accommodative stance, but may have a nuanced approach on the benefits and costs of forward guidance.

Stanley Fischer, therefore, brings several attributes to the Federal Reserve. First, he has an unquestioned command of macroeconomics, and in particular, monetary policy. Second, he has a wealth of experience in dealing with financial calamities. And third, he earned the trust and respect of policymakers in developing nations while he served at the IMF. Those qualities will be much appreciated as foreign officials and financial markets deal with the Federal Reserve’s policy pivot.

Affairs, Domestic and Foreign

Raghuram Rajan, ex- faculty member of the Booth School of Business at the University of Chicago, ex-head of the research department of the IMF, and currently Governor of the Reserve Bank of India (its central bank), set off a storm of comment when he warned of a breakdown in the global coordination of monetary policy. Frustrated by the decline in the foreign exchange value of the rupee that followed the cutback in asset purchases by the Federal Reserve, Rajan claimed that the Federal Reserve was ignoring the impact of its policies on the rest of the world.  Does he have a valid cause for concern?

Quite a few folks have weighed in on this matter: see here, here, here, here, here and here. Rodrik and Subramanian make several interesting points. First, the Federal Reserve was criticized when it lowered rates, so complaints that it is now raising them are a bit hypocritical (but see here). Second, blaming the Fed for not being a team player as the emerging markets were when they lowered their rates in 2008-09 is not a valid comparison. The emerging markets lowered their rates then because it was in their interest to do so, not out of any sense of international solidarity. Third, their governments allowed short-term capital inflows to enter their economies; did they not realize that the day could come when these flows would reverse? Finally, their policymakers allowed the inflows to contribute to credit bubbles that resulted in inflation and current account deficits, which are significant drivers of the volatility.

Moreover, the Federal Reserve is constrained by law to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S., not the global community But couldn’t turmoil in the emerging markets threaten U.S. conditions? Robin Harding at the Financial Times thinks this is an unlikely scenario. He points to two channels of transmission between the U.S. and the countries that have shown the most turbulence: exports and financial markets. The emerging market nations that have witnessed the most volatility account for very small proportions of U.S. exports. (China, on the other hand, does claim 7.5% of our exports, but so far has not suffered any signs of distress (but see here).) In addition, financial flows might be affected, but to date these have resulted in lower interest rates in the U.S. due to a flight to safety. Previous shocks from the emerging markets pushed U.S. stock prices down, but these effects were short-lived. Therefore, Harding claims, “…it would have to become much more of a crisis…” to endanger the U.S. economy.

The problem with this assessment is that it assumes that we know the extent of our financial vulnerability to a decline in the fortunes of these economies. But one lesson of the 2007-09 global financial crisis is that there may be much we do not know about our financial structure. U.S.-based institutions can be vulnerable to shocks in ways that we do not recognize. Subprime mortgages were not themselves that significant a share of the liabilities of U.S. banks and shadow banks, but they were the foundation of a range of derivatives, etc., that took down the financial markets when these mortgages became toxic.

The threat of more declines in foreign asset prices does not mean that the Federal Reserve should retreat from its current policies. A situation with some interesting similarities took place in the early 1980s. U.S. banks, awash with recycled oil revenues, had lent extensively to countries in Latin America and elsewhere in the 1970s.  A debt crisis ensued after Paul Volcker and the Federal Reserve raised interest rates (see Chapter 4). Volcker recently reflected on these events in an interview with Martin Feldstein in the fall 2013 issue of the Journal of Economic Perspectives:

“What were you going to do? Were you going to conduct an easy-money policy and go back on all the policy you’d undertaken to try to save Mexico, which wouldn’t have saved Mexico anyway? We did save Mexico, but by other means.”

U.S. policymakers have always claimed (with some justification) that a healthy U.S. economy is the best remedy for a troubled world economy, and monetary officials will no doubt proceed as they think best. But we should take a look around before we proceed. The February ice underneath our feet may be a bit thinner than we realize.