Monthly Archives: January 2016

Monetary Policy in an Open Economy

The recent research related to the trilemma (see here) confirms that policymakers who are willing to sacrifice control of the exchange rate or capital flows can implement monetary policy. For most central banks, this means using a short-term interest rate, such as the Federal Funds rate in the case of the Federal Reserve in the U.S. or the Bank of England’s Bank Rate. But the record raises doubts about whether this is sufficient to achieve the policymakers’ ultimate economic goals.

The short-term interest rate does not directly affect investment and other expenditures. But it can lead to a rise in long-term rates, which will have an effect on spending by firms and households. The relationship of short-term and long-term rates appears in the yield curve. This usually has a positive slope to reflect expectations of future short-term real rates, future inflation and a term premium. Changes in short-term rates can lead to movements in long-term rates, but in recent years the long-term rates have not always responded as central bankers have wished. Former Federal Reserve Chair Alan Greenspan referred to the decline in U.S. long-term rates in 2005 as a “conundrum.” This problem is exacerbated in other countries’ financial markets, where long-term interest rates are affected by U.S. rates (see, for example, here and here) and global factors.

Central banks that sought to increase spending during the global financial crisis by lowering interest rates faced a new obstacle: the zero lower bound on interest rates. Policymakers who could not lower their nominal policy rates any further have sought to increase inflation in order to bring down real rates. To accomplish this, they devised a new policy tool, quantitative easing. Under these programs, central bankers purchased large amounts of bonds with longer maturities than they use for open market transactions and from a variety of issuers in order to bring down long-term rates. The U.S. engaged in such purchases between 2008 and 2014, while the European Central Bank and the Bank of Japan are still engaged in similar transactions. As a consequence of these purchases, the balance sheets of central banks swelled enormously.

In an open economy, there is another channel of transmission to the economy for monetary policy: the exchange rate. If a central bank can engineer a currency depreciation, an expansion in net exports could supplement or take the place of the desired change in domestic spending. A series of currency depreciations last summer led to concerns that some central banks were moving in that direction.

But there are many reasons why using exchange rate movements are not a solution to less effective domestic monetary policies. First, if a central bank wanted to use the exchange rate as a tool, it would have to fix it. But it then would have to surrender control of domestic money or block capital flows to satisfy the constraint of the trilemma. Second, there is no simple relationship between a central bank’s policy interest rate and the foreign exchange value of its currency. Exchange rates, like any asset price, exhibit a great deal of volatility. Third, the impact on an economy of a currency depreciation does not always work the way we might expect. Former Federal Reserve Chair Ben Bernanke has pointed out that the impact of a cheaper currency on relative prices is balanced by the stimulative effect of the easing of monetary policy on domestic income and imports.

Of course, this does not imply that central banks need not take notice of exchange rate movements. There are other channels of transmission besides trade flows. The Asian crisis showed that a depreciation raises the value of debt liabilities denominated in foreign currencies, which can lead to bankruptcies and banking crises. We may see this phenomenon again in emerging markets as those firms that borrowed in dollars when U.S. rates were cheap have difficulty in meeting their obligations as both interest rates and the value of the dollar rise (see here).

Georgios Georgiadis and Arnaud Mehl of the European Central Bank have investigated the impact of financial globalization on monetary policy effectiveness. They find that economies that are more susceptible to global financial cycles show a weaker response of output to monetary policy. But they also find that economies with larger net foreign currency exposures exhibit a stronger response of output to monetary policy shocks. They conclude: “Overall, we find that the net effect of financial globalization since the 1990s has been to amplify monetary policy effectiveness in the typical advanced and emerging markets economy.”

While their results demonstrate the importance of exchange rate in economic fluctuations, that need not mean that monetary policy is “effective” as a policy tool. As explained above, flexible (or loosely managed) exchange rates are unpredictable. They can change in response to capital flows that react to foreign variables as well as domestic factors. The trilemma may hold in the narrow sense that central banks maintain control of their own policy rates if exchange rates are flexible. But what the policymakers can achieve with this power is circumscribed in an open economy.

Can Systemic Financial Risk Be Contained?

Risk aversion is a basic human characteristic, and in response to it we seek to safeguard the world live in. We mandate airbags and safety belts for automobile driving, set standards for the handling and shipment of food, build levees and dams to control floods, and regulate financial transactions and institutions to avoid financial collapses. But Greg Ip in Foolproof shows that our best attempts at avoiding catastrophes can fail, and even bring about worse disasters than those that motivate our attempts to avoid them. Drivers who feel safer with antilock brakes drive more quickly and leave less space between cars, while government flood insurance encourages building houses on plains that are regularly flooded.

Is the financial sector different? The traditional measures implemented to avoid financial failures are based on attaining macroeconomic stability. Monetary policy was used to control inflation, and when necessary, respond to shocks that destabilized the economy. When a crisis did emerge, the primary responsibility of a central bank was to act as a lender of last resort, providing funds to institutions that were solvent but illiquid. There was a vigorous debate before the global crisis of 2008-09 over whether central banks should attempt to deflate asset bubbles, but most central bankers did not believe that this was an appropriate task.

Fiscal policy was seen as more limited in its ability to combat business downturns because of lags in its design, implementation and effect. A policy that established a balanced budget over the business cycle, thus limiting the buildup of public debt, was often considered the best that could be expected. Automatic stabilizers, therefore, were set up to respond to cyclical fluctuations.

In open economies, flexible exchange rates provided some insulation against foreign shocks, and avoided the dangers that a commitment to a fixed rate entailed. Countries that did fix, or at least manage, their exchange rates stockpiled foreign exchange reserves to forestall speculative attacks. IMF surveillance provided an external perspective on domestic policies, while IMF lending could supplement foreign exchange reserves.

The global financial crisis demonstrated that these measures were inadequate to provide financial stability. The Federal Reserve led the way in implementing new monetary policies—quantitative easing—to supplement lower policy rates that faced a zero lower bound. But policymakers also responded with a broad range of innovative financial regulations. A new type of regulation—macroprudential—was introduced to minimize systemic financial risk, i.e., the risk associated with the collapse of a financial system (as opposed to the microprudential risk of the failure of an individual institution). These measures seek to prevent speculative rises in asset prices and credit creation, and the establishment of risky balance sheet positions. They include limits on interest rate and foreign exchange mismatches on balance sheets, caps on bank loan to value ratios, and countercyclical capital requirements (see here for an overview of these measures).

In the international sector, the Basel Committee on Banking Supervision produced “Basel III,” a new set of regulations designed to strengthen the resilience of its members’  banking systems. Capital control measures, once viewed as hindrances to the efficient allocation of savings, are now seen as useful in limiting inflows of foreign funds that contribute to asset bubbles. Swap lines allow central banks to draw upon each other for foreign exchange to meet the demand from domestic institutions, while the IMF has sought to make borrowing more user-friendly. Meetings of the member governments of the newly-formed Group of 20 allow them to coordinate their policies, while the IMF’s surveillance purview has expanded to include regional and global developments.

Are these measures sufficient? The lack of another global crisis to date is too easy a criterion, given that the recovery is still underway. But there may be inherent problems in the behavior of financial market participants that could frustrate policies that seek to prevent or at least contain financial crises. Moral hazard is often blamed for shoddy decision-making by those who think they can dodge the consequences of their actions. Many who were involved in the creation and sale of collaterized securities may have thought that the government would step in if there were a danger of a breakdown in these markets. But many banks held onto these securities, indicating that they thought that the reward of owning the securities outweighed the risks. Bank officials who oversaw the expansion of mortgage lending generally lost their jobs (and reputations). It is difficult to believe after the crisis that anyone thought that they could manipulate the government into absorbing all the consequences of their actions.

But if moral hazard is not always at fault, there is ample evidence that asymmetric information and behavioral anomalies result in hazardous behavior. Will the regulatory provisions listed above minimize the incidence of risky financial practices? There is some evidence that the provisions of the Dodd-Frank Act are working. But the regulatory framework continues to be implemented, and bankers and other financial market participants will always seek to find loopholes that they can exploit.

Regulatory practices on the international level are also subject to manipulation. Roman Goldbach, a political economist at Deutsche Bundesbank, in his book Global Governance and Regulatory Failure: The Political Economy of Banking points out that the overlap of national and global standards in what he calls the “transnational regulatory regime” results in layering “gaps.” The resulting loopholes in the policymaking process allow private interest coalitions to have a disproportionate influence on policy formulation. Moreover, policy officials consider the competitiveness of domestic financial structures as a goal (at least) equal to financial stability in international negotiations over regulatory standards. While there have been substantial changes since the global crisis, including the formation of the Financial Stability Board, the incentives in the governance structure of global finance have not changed.

Even regulations that work as intended may have unintended and unwanted consequences due to externalities. Kristin Forbes of MIT and Marcel Fratzscher, Thomas Kostka and Roland Straub of the European Central Bank examined Brazil’s tax on capital inflows from 2006 to 2011. They found that the tax did cause investors to decrease their portfolio allocation to Brazilian securities, as planned. But other countries also felt the impact of the tax. Foreign investors increased their allocation to economies that had some similarities to Brazil, while cutting back on those countries that were likely to impose their own control measures. Capital control measures that are imposed unilaterally, therefore, may only divert risky funds elsewhere, and are not a tool for controlling global financial risk.

The flow of money looking for higher yields outside the U.S. may diminish in the wake of the rise in the Federal Funds rate in the U.S. But Lukasz Rachel and Thomas D. Smith of the Bank of England claim that long-term factors account for a decline in the global real interest rate that will not be soon reversed. This poses a challenge for policymakers, as measures implemented in one country to contain a domestic credit boom may be undermined by foreign inflows. Domestic actions, therefore, ideally would be matched by similar measures in other countries, which would require macroprudential policy coordination.

Barry Eichengreen of UC-Berkeley has studied the record of international policy coordination, and finds that it works best under four sets of circumstances: when the coordination is centered on technical issues, such as central bank swaps; when the process is institutionalized; when it is aimed at preserving an existing set of policies, i.e., regime preserving, rather than devising new procedures; and when there exists a sense of mutual interests on a broad set of issues among the participants. Are such conditions present today? At the time of the crisis, central bankers cooperated in setting up the currency swap agreements while discussing their monetary policies. The formation of the Group of 20 provided a new forum for regular consultation, and there was widespread agreement in preserving a regime that encouraged international trade while preventing competitive currency devaluations. But the passage of time has weakened many of the commitments made when the crisis threatened, and the uneven recovery has caused national interests to diverge.

Perhaps a more basic issue is whether it is possible to design a financial system free of volatility. A government that is willing to replace markets in directing financial flows and allocating financial returns can maintain stability, but at a price. Such a system is characterized as “financial repression,” and includes limits on interest rates received by savers, control of banks and their lending, and the use of regulations to prevent capital flows. These regulations penalize household savers, and allow the government and state-sponsored enterprises to receive credit at relatively low rates while blocking credit to firms that do not enjoy government backing.

China used these types of measures during the 1980s and 1990s to finance its investment- and export-led growth, and its self-imposed financial isolation allowed it to escape the effects of the Asian financial crisis. But more recently China has engaged in financial liberalization, removing controls on interest rates and bank activities while deregulating its capital account and allowing more exchange rate flexibility. The responses have included the emergence of a shadow banking system and a boom in private credit, which will require government actions to avoid a crisis.

Several years ago Romain Rancière of the Paris School of Economics, Aaron Tornell of the University of California-Los Angeles and Frank Westermann of Osnabrueck University coauthored a paper (here; working paper here) on the tradeoff between systemic financial crises and economic growth. They showed that financial liberalization leads to more growth and a higher incidence of crises. But their empirical estimates indicated that the direct effect on growth outweighed the negative impact of the crises. They contrasted the examples of Thailand, which had a history of lending booms and crises with that of India, which had a more controlled financial sector, and showed that Thailand had enjoyed higher growth in per capita GDP. In a subsequent paper (here; working paper here), they explored the relationship between crises that produced a negative skewness in the growth of real credit, which in turn had a negative link with growth.

If there is a tradeoff between the volatility associated with financial liberalization and economic growth, then each society must choose the optimal combination of the two. Financial innovations will change the terms of the tradeoff, and lead to movements back and forth as we learn more about the risks of new financial tools. The advantages of novel instruments at the time when they seem most productive must be weighed against the possible (but unknown) dangers they pose. Perhaps the greatest threat is that the decisions over how much control and regulation is needed will be made not by those public officials entrusted with preserving financial stability, but by those who will profit most from the changes.