Time For a Change?

1 Reply

The imminent (or not) taper of purchases of securities by the Federal Reserve has resulted in a great deal of speculation about its effects on other countries. Among the more intriguing views that have been advanced is the claim that a withdrawal of foreign capital will lead to much-needed reform measures in emerging markets.  This is an interesting assertion, in part because it contradicts the meme that capital inflows act as a catalyst for “collateral benefits” that contribute to the establishment of better institutions. So, which is it—will a reversal of foreign money lead to an improvement in domestic governance or not?

The collateral benefits view was advanced after empirical analyses failed to find evidence that capital account liberalization contributed to economic growth. Then-IMF economists Ayhan Kose, Eswar Prasad, Kenneth Rogoff and Shang-Jin Wei (Prasad is now at Cornell, Rogoff at Harvard and Wei at Columbia) claimed that capital inflows promoted the development of the domestic financial sector, and contributed to institutional development, better governance and macroeconomic discipline. There was an intuitive appeal to this argument: shouldn’t foreign investors favor conditions that facilitate the development of local markets and institutions that lead to profits?

The problem is the (lack of) evidence for this linkage. Indeed, the wreckage of a decade of financial crises in Mexico, East Asia, Russia, Brazil, Turkey and Mexico suggested that foreign lenders had been blind to local conditions. Dani Rodrik and Arvind Subramanian, in their review of the arguments for financial globalization,  were unconvinced that collateral benefits could be found, and pointed to Turkey as a counter-example.

The second perspective builds off this contrasting view that capital inflows serve as a stopgap measure that allows recalcitrant governments to avoid implementing the reforms that domestic lenders demand. Easy money from aboard allows government officials to finance fiscal deficits that may include payments to supporters of the regime. Once the conditions that led to the inflows of foreign money disappear, the government is forced to deal with the domestic creditors.

Another version of this story sees capital inflows as contributing to bubbles in the country’s financial markets and institutions. A reversal of foreign money reveals the fragility of the domestic financial conditions and necessitates reforms. South Korea is sometimes cited as an example of a country that enacted economic and financial reform measures after its 1997-98 crisis that made the country better off.  Of course, a country pays a high price if a capital outflow occurs precipitously.

Recent concerns have centered on the “Fragile Five” of  Brazil, Indonesia, India, Turkey and South Africa. Their currencies depreciated when Federal Reserve Chair Ben Bernanke first raised the issue of cutting back on asset purchases last year. Increasing current account deficits in all but India have revealed a dependence on foreign capital. But it is India that most requires reform of the financial sector. Raghuram Rajan, governor of the country’s central bank, has sought to modernize the financial system, but faces political opposition and inertia. It would be unfortunate if he needed a crisis to get the attention of domestic politicians.

Birds of a Feather

1 Reply

Policy coordination on the international level is one of those ends that governments profess to aspire to achieve but only realize when there is a crisis that requires a global response.  There are many reasons why this happens, or rather, does not. But in one area—monetary policy—central bankers have in the past acted in concert, and their activities provide lessons for the conditions needed to bring about coordination in other policy spheres.

Jonathan D. Ostry and Atish R. Ghosh suggest several reasons for the lack of coordination.  First, policymakers may only focus on one goal at a time, and ignore intertemporal tradeoffs. Second, governments may not agree on the size of spillovers from national policies. Finally, those countries that do not participate in policy consultations do not have a chance to influence the policy decisions. Consequently, the policies that are adopted are not optimal from a global perspective.

All this was supposed to change when the G20 became the “premier forum for international economic co-operation.” The government leaders agreed to a Mutual Assessment Process, through which they would identify objectives for the global economy, the specific steps needed to attain them, and then monitor each other’s progress. How has that worked? Most observers agree: not so well. Different reasons are advanced for the lack of progress (see here and here and here), but the diversity of the members’ economic situations works against their ability to agree on what the common problems are and a joint response.

There is one area, however, where there has been evidence of communication and even coordination: monetary policy. What accounts for the difference?  The linkages of global financial institutions and markets complicate the formulation of domestic policies. Steve Kamin has examined the literature on financial globalization and monetary policy, and summarized the main findings. First, the short-term rates that policymakers use as targets are influenced by foreign conditions. Second, the long-term rates that affect spending are also affected by foreign factors. The “savings glut” of the last decade, for example, has been blamed for bringing down U.S. interest rates and fuelling the housing bubble. Third, the financial crises that monetary policymakers face have foreign dimensions. Capital flows exacerbate volatility in financial markets, and disrupt the operations of banks (see here). Therefore, central bankers can not ignore the foreign dimensions of their policies.

The actions of monetary policymakers during the global crisis are instructive. In October 2008, the Federal Reserve, the European Central Bank, and several other central banks simultaneously announced that they were reducing their primary lending rates. The Federal Reserve established swap lines with fourteen other central banks, including those of Brazil, Mexico, Singapore, and South Korea.  The central banks used the dollars they borrowed from the Federal Reserve to lend to their own banks that needed to finance their dollar-denominated acquisitions. The Federal Reserve also lent to foreign owned financial institutions operating in the U.S.

While the extent of their cooperation in 2008-09 was unprecedented, it was not the first time that the heads of central banks operated in concert. There are several features of monetary policy that allow such collaboration. First, monetary policy is often delegated by governments to central bankers, who may have some degree of political independence and longer terms of office than most domestic politicians. This gives the central bankers more confidence when they deal with their counterparts at other central banks. Second, central banking has been viewed as a more technical policy area than fiscal policy and requires professional expertise. In addition, the benign economic conditions associated with the “Great Moderation” gave central bankers credibility with the public that manifested itself in the apotheosis of Alan Greenspan. Third, central bankers meet periodically at the Bank for International Settlements, and have a sense of how their counterparts view their economies and how they might respond to a shock. A prestigious group of economists have proposed that a group of central bankers of systemically significant banks meets under the auspices of the Committee on the Global Financial System of the BIS to discuss the implications of their policies for global financial stability.

All this can change, and already has to some extent. Monetary policy has become politicized in the U.S. and the Eurozone, and even Alan Greenspan’s halo has been tarnished. Policymakers from emerging markets were caught off-guard by the rise in U.S. interest rates last spring and argued for more monetary policy coordination.

Are there lessons for international coordination on other fronts? The conditions for formulating fiscal policy are very different. Fiscal policies are enacted by legislatures and executives, who are subject to domestic public opinion in democracies.  There is little consensus in the public arena on whether fiscal policy is effective, which can lead to stalemates. Finally, there is no common meeting place for fiscal policymakers except at the G20 summits, where there is less discussion and more posturing in front of the press.

The G20 governments enacted fiscal stimulus policies at the time of the crisis. Since then, the U.S. has been unable to fashion a coherent policy plan, much less coordinate one with foreign governments. The Europeans are mired in their debt crisis, and the G20 meetings have stalled. It is difficult to see how these countries could act together even in the event of another global crisis. Like St. Augustine’s wish for chastity, governments may want to coordinate their policies—but not quite yet.

Assigned Readings: Dec. 30, 2013

Leave a reply

In the run-up to the financial crisis the world economy was characterized by large and growing current-account imbalances. Since the onset of the crisis, China and the U.S. have rebalanced. As a share of GDP, their current-account imbalances are now less than half their pre-crisis levels. For China, the reduction in its current-account surplus post-crisis suggests a structural change. Panel regressions for a sample of almost 100 countries over the thirty-year period 1983-2013 confirm that the relationship between current-account balances and economic variables such as performance, structure, wealth and the exchange rate changed in important ways after the financial crisis.

I discuss how the unconventional monetary policy measures implemented over the past several years – quantitative and credit easing, and forward guidance – can be analysed in the context of conventional models of asset prices, with particular reference to exchange rates. I then discuss alternative approaches to interpreting the effects of such policies, and review the empirical evidence. Finally, I examine the ramifications for thinking about the impact on exchange rates and asset prices of emerging market economies. I conclude that although the implementation of unconventional monetary policy measures may introduce more volatility into global markets, in general it will support global rebalancing by encouraging the revaluation of emerging market currencies.

We study the long-run relationship between public debt and growth in a large panel of countries. Our analysis takes particular note of theoretical arguments and data considerations in modeling the debt-growth relationship as heterogeneous across countries. We investigate the issue of nonlinearities (debt thresholds) in both the cross-country and within-country dimensions, employing novel methods and diagnostics from the time-series literature adapted for use in the panel. We find some support for a nonlinear relationship between debt and long-run growth across countries, but no evidence for common debt thresholds within countries over time.

  • Atish R. Ghosh, Mahvash S. Qureshi, Juk Il Kim and Juan Zalduendo. “Surges.” Journal of International Economics, forthcoming.

This paper examines when and why capital sometimes surges to emerging market economies (EMEs). Using data on net capital flows for 56 EMEs over 1980−2011, we find that global factors, including US interest rates and investor risk aversion act as “gatekeepers” that determine when surges of capital to EMEs will occur. Whether a particular EME receives a surge, and the magnitude of that surge, however, are largely related to domestic factors such as its external financing need, capital account openness, and exchange rate regime. Differentiating between surges driven by exceptional behavior of asset flows (repatriation of foreign assets by domestic residents) from those driven by exceptional behavior of liability flows (nonresident investments into the country), shows the latter to be relatively more sensitive to global factors and contagion.

In bilateral and multilateral surveillance, countries are often urged to consider alternative policies that would result in superior outcomes for the country itself and, perhaps serendipitously, for the world economy. While it is possible that policy makers in the country do not fully recognize the benefits of proposed alternative policies, it is also possible that the existing policies are the best that they can deliver, given their various constraints, including political. In order for the policy makers to be able and willing to implement the better policies some quid pro quo may be required—such as a favorable policy adjustment in the recipients of the spillovers; identifying such mutually beneficial trades is the essence of international policy coordination. We see four general guideposts in terms of the search for globally desirable solutions. First, all parties need to identify the nature of spillovers from their policies and be open to making adjustments to enhance net positive spillovers in exchange for commensurate benefits from others; but second, with countries transparent about the spillovers as they see them, an honest broker is likely to be needed to scrutinize the different positions, given the inherent biases at the country level. Third, given the need for policy agendas to be multilaterally consistent, special scrutiny is needed when policies exacerbate global imbalances and currency misalignments; and fourth, by the same token, special scrutiny is also needed when one country’s policies has a perceptible adverse impact on financial-stability risks elsewhere.

Be Careful What You Wish For

Leave a reply

Policymakers, including finance ministers and central bank governors, are as entitled to have holiday wishes as much as anyone else. But they should be careful with their wish list. Sometimes the law of unintended consequences leads to unexpected and undesirable side effects.

The expansion of domestic financial markets can promote economic growth through a more efficient allocation of savings and other mechanisms.  Foreign participation in these markets can contribute to their development in several ways. Foreign investors, for example, can provide more liquidity that leads to lower yields. Shanaka Pereis found that a 1% increase in the share of foreign investors in government bond markets in ten emerging markets led to a decrease of about 6 basis points in the yield on those bonds. All this suggests that capital flows benefit financial markets.

But larger financial markets can also bring unanticipated consequences. After Federal Reserve Chair Ben Bernanke spoke last spring of tapering the Fed’s asset purchases, the exchange rates of many emerging markets depreciated while their central banks used their foreign reserves to slow the changes. Barry Eichengreen and Poonam Gupta have investigated these reactions. They find that the magnitude of the changes in exchange rates and reserves were linked to the size and openness of a country’s financial markets. They interpret this as evidence that foreign investors rebalanced their portfolios in those markets with the most largest and liquid financial systems. They conclude that “success at growing the financial sector can be a mixed blessing.” Financial regulators need to be ready for the volatility that increased capital flows can bring along with all their benefits.

Who’s In Control?

1 Reply

In the post-financial crisis world, capital controls have become viewed in many quarters as an acceptable policy tool. A number of studies have investigated how controls may affect macroeconomic and financial performance. But how controls are implemented is also a topic of interest, in part because the inopportune use of these measures may exacerbate the conditions they are intended to ameliorate.

Charles Collyns of the Institute of International Finance presents a classification of the use of controls to deal with capital inflows. The first template is the “Classical Chinese”: the capital account is largely closed except for FDI flows, the exchange rate is fixed and there is a repressed domestic financial system.  But China itself is moving away from this method, as are many low-income countries. The second model is the “Textbook” pre-2008 IMF model: flexible exchange rates with the long-run goal of capital account liberalization. This model showed itself vulnerable to financial shocks in 2008. The third scheme is the “Brazilian Defense”: a floating exchange rate and the use of macroprudential and tax tools to restarin capital flows. This approach has also been utilized by India and Turkey. The fourth classification is dubbed by Collyns the “New Orthodoxy,” and is defined by a commitment to both an open capital account and the development of domestic financial markets. Mexico is offered as an example country that uses such an approach.

If the “Classical Chinese” and the “Textbook” models are being discarded, then one popular alternative is the discretionary use of capital controls. But are capital controls used to avoid inflows that lead to credit bubbles and a boom-bust cycle? A new paper by Andrés Fernández, Alessandro Rebucci and Martín Uribe examines whether policymakers use capital controls in a macroprudential manner. If they were, we would expect to see a tightening of controls on inflows and a relaxation of restrictions on outflows during expansions, and the opposite pattern of policy measures during downturns.

The authors use three indicators—the output gap, the cyclical component of the real exchange rate, and the cyclical component of the current account—to date their boom-and-bust episodes. They update Schindler’s index of capital controls, which distinguishes among controls on inflows and outflows on six types of assets. The authors report that over the period of 2005-2011 there was no correspondence of changes in capital controls and macroeconomic conditions. Controls were not responsive to economic expansions or contractions, over- or undervaluations of the real exchange rate or large current account imbalances.

They offer two interpretations for their results. One is that theory has outrun practice, and controls will become increasingly used in a macroprudential fashion as policymakers become accustomed to using them in this fashion. The second interpretation is that there are other factors that determine the cyclical properties of the usage of capital controls. But what?

There was a literature on the political and economic determinants of capital account liberalization in the 1980s and 1990s, summarized by Eichengreen. Among the factors found to contribute to decontrol were the deregulation of domestic financial markets, the abandonment of exchange rate pegs, and a trend towards democratization in many developing countries. But Eichengreen cautioned that there might have been other factors that were difficult to measure but nonetheless significant. The latest contributions to the literature on the use of capital controls indicate that there are still unanswered questions regarding their implementation.

Speaking Truth to Power

Leave a reply

When the full history of the European debt crisis is related, one important part of the story will be the uneasy relationship of the International Monetary Fund with its European partners in the “Troika,” the European Commission and the European Central Bank. The Fund and the Europeans came to hold different views on the nature of the crisis and how it should be handled soon after its outbreak in 2010. Their disagreements reflect the split in the Fund’s membership between creditors and debtors, and the inherent ambiguity of the position of an intergovernmental organization that serves principals with different interests.

Greece obtained $145 billion from the Troika in May 2010. Of that amount, $40 billion was provided by the IMF in the form of a three-year Stand-by Arrangement. This represented 3,200% of the Greek quota at the IMF, far above the usual access limits. Susan Schadler has drawn attention to the modification of IMF policy that was made in order to allow the agreement to go forward.

The IMF has criteria to be met in deciding whether to allow a member “exceptional access” to its resources. One of these of these is a high probability that the borrowing member’s public debt will be sustainable in the medium-term. At the time of the arrangement, the IMF’s economists realized that there was little probability that Greek sovereign debt would be sustainable within any reasonable timeframe. The IMF, therefore, amended the criteria so that exceptional access could also be provided if there were a “high risk of international systemic spillover effects.” There was little doubt that such effects would occur in the event of a default, but whether this justified lending such large amounts was questionable.

It soon became clear that the two of the other four criteria would not be met. Greece would not regain access to private capital markets while it participated in the Fund program (criterion #3). Moreover, there was little prospect of a successful implementation of the policies contained in the original agreement (criterion #4). By 2011, it was evident that the program with Greece was not viable. Talks began on a new program and a restructuring of the debt, which eventually occurred in 2012. Moreover, Ireland received assistance from the Troika in December 2010, as did Portugal in February 2011.

This was the background when newly-appointed Fund Managing Director Christine Lagarde, a former French finance minister, appeared at the annual gathering of central bankers and financiers at Jackson Hole, Wyoming, in August 2011. Ms. Lagarde voiced her concerns that her fellow Europeans were responding too slowly to the dangers posed by the sovereign debt crisis. (Lagarde also called upon U.S. policymakers to undertake steps to resolve the housing crisis.) But her recommendations for more vigorous actions went unheeded. Her call for a more accommodative monetary policy was ignored by outgoing ECB President Jean-Claude Trichet. And European bankers were displeased by her assessment of their capital base as inadequate and her proposal of public injections of capital if private sources were inadequate.

In retrospect, Lagarde’s judgments look prescient. Trichet’s successor at the ECB, Mario Draghi, came to a very different view of what that institution needed to do to maintain financial stability. The ECB lowered its key interest rate in November 2011, and the following month instituted a longer-term refinancing operation for European banks. European banks, however, are still seen as relatively frail.

The IMF subsequently reassessed the response to sovereign debt crises and reviewed the framework for debt restructuring. Its review found that “debt restructurings have often been too little and too late, thus failing to re-establish debt sustainability and market access in a durable way.” The report’s authors claimed that: “Allowing an unsustainable debt situation to fester is costly to the debtor, creditors and the international monetary system.” The policy review raised the possibility of more involvement of the official sector in debt restructuring.

But the development at the IMF of a proposal to write down unsustainable debt at an earlier stage of a crisis has aroused resistance from German and other policy officials. They see the suggestion of a standstill on debt repayments as an assault on the rights of bondholders. Any mention of delay or reduction of payments is viewed as the first step towards the evasion of borrowers’ responsibilities.

Such a position in the wake of the restructuring of the Greek debt is alarming. Other borrowers will suffer financing problems, and relying on exhortations to repay in full will not improve their circumstances. Moreover, ignoring the costs to the debtor of a (attempted) repayment is self-defeating. The Greek economy may have touched bottom, but even under the most optimistic scenario its debt/GDP ratio will not decline for years.

The IMF is the agent of 188 principals. To be credible, it must  serve the interests of all its members, not just its partners in a lending arrangement. Moreover, the IMF has established more credibility in this crisis than those who have consistently refused to acknowledge its extent. In seeking to improve the process of dealing with debt restructuring,  the IMF is fulfilling its mission to provide “…the machinery for consultation and collaboration on international monetary problems.” (IMF Article of Agreement I(i).) Its members should allow it to meet that mandate.

Another Divergence

Leave a reply

The decline in inflation rates in advanced economies to historically low rates has been widely reported.  But inflation is increasing in some of the largest emerging markets. This divergence poses dilemmas for policymakers in those countries.

The annual difference between the GDP-weighted average inflation rates of high income countries and developing nations has fluctuated between 3-4% between 2010 and 2012 (see data here). More recently, the gap has jumped to 4.8%. Among the countries where prices are rising more rapidly are Brazil (5.8% in the most recent month), Egypt (10.5%), India (10.1%), Indonesia (8.3%), Russia (6.2%), and South Africa (5.5%).  Moreover, all except Russia are recording current account deficits.

The increase in prices is drawing attention. In Brazil and Indonesia, rising prices are fueling popular discontent with the governments. The Russian central bank has admitted that it will miss its inflation target for the year. Arvind Subramanian finds inflation in India worrisome, in part because it is unprecendently high.

What fuels the rises? In many emerging markets, the governments have sought to offset reduced demand by their trade partners in the advanced economies by stimulating domestic demand. The result has been increases in domestic credit and household debt, and in these countries escalating prices.

Some central bankers have responded by raising their target interest rates. In India, the new target rate is 7.75%. Brazil’s central bank has raised its target rate to 10%, and Indonesian monetary policymakers have hiked their rate to 7.5%. South Africa’s central bank has kept its rate unchanged, but signaled that this may change.

These increases could leave the central bankers in a quandary. After blaming the Federal Reserve for capital flows to their countries, it would be awkward if the same policymakers were now seen as responsible for creating the conditions that could attract capital. Moreover, higher rates might choke off the domestic spending that it is seen as essential. But allowing inflation to continue unchecked could result in harsher measures later. Of course, higher growth in the advanced economies could alleviate many of these problems. Convergence can work in more than one direction.

As Time Goes By

Leave a reply

Depending on how the beginning of the European debt crisis is dated (2010? 2008? 1999?), it has been several years since the governments of several nations have sought to relieve investors’ fears regarding their debt. The governments of four countries (Cyprus, Greece, Ireland, Portugal) turned to the IMF and other Eurozone nations for assistance, while Italy and Spain have undertaken policies designed to avoid the need for external assistance. To paraphrase a former mayor of New York, how are those governments doing?

To answer that question, we can draw upon Jay Shambaugh’s insight that there are actually three interlocking crises: a macroeconomic crisis, a debt crisis and a banking crisis.

First, we examine current data for the prevailing (2013) macro conditions in the (in)famous PIIGS, as well as the entire Euro area and, for the sake of comparison, the U.S. and Japan. We exclude Cyprus as its crisis occurred more recently:

%

GDP Growth

 Unemployment Budget/GDP

Cur Acc/GDP
Greece

-4.0

 27.3 -2.4 0.1
Ireland

0.3

 13.2 -7.4

4.0
Italy

-1.8

 12.5 -3.3

0.4
Portugal

-1.8

 15.6 -5.9

0.3
Spain

-1.3

 26.6 -7.1

0.8
Euro Area

-0.4

 12.2 -3.0

1.9
U.S.

1.6

 7.3 -4.0

-2.5

Japan

 1.9 4.0 -8.3

1.2

In the Eurozone countries, only Ireland (barely) has avoided a negative growth rate, while both the U.S. and Japan are doing better. The unemployment rates reflect the depths of the continuing downturns. The budget balances continue to record deficits that largely reflect cyclical conditions; Greece and Italy have primary budget surpluses. The current accounts all register surpluses, unlike the U.S. Nikolas Schöll at Bruegel examined the data to uncover the sources of the reversals of the trade deficits, and pointed out that Ireland, Portugal and Spain recorded large increases in exports, while Greece had a dramatic drop in imports.

Will 2014 be any better? The IMF’s October 2013 World Economic Outlook forecasts a swing to positive growth rates in all of Europe except Slovenia. But, it warned, “Additional near-term support will be needed to reverse weak growth…” and called for further monetary easing. The ECB has obliged by lowering its refinancing rate to 0.25% in response to falling inflation, not a hopeful sign of recovery.

How do these countries do on their sovereign debt? We can compare the debt/GDP data for 2010 with this year’s and next year’s expected levels:

Debt/GDP

2010

2013

2014
Greece

148.3

 175.7

174.0
Ireland

91.2

 123.3

121.0
Italy

119.3

 132.3

133.1
Portugal

94.0

 123.6

125.3
Spain

61.7

 93.7

99.1
Euro Area

85.7

 95.7

96.1
U.S.

95.2

 106.0

107.3
Japan

216.0

 243.5

242.3

Several years of recession have pushed the ratios up despite fiscal constraint, and the IMF’s October 2013 Fiscal Monitor does not see any short-term improvement outside of Ireland. The increase in the U.S. ratio is not quite as large thanks to its economic recovery, while Japan continues to serve as an outlier. Charles Wyplosz thinks that Greece will require another debt rescheduling, and there are concerns regarding the need for another bailout in Portugal. Falling real estate prices in Spain continue to threaten its banks, while Italy’s largest burden is its politics. Ireland no longer needs external assistance, but it will take years to pay back the loans it received from the IMF and other European governments.

And interest rates? With the 10-year rate on German government bonds at 1.72%, the spreads for the other European countries last week were (in ascending order): Ireland 1.81%; Spain, 2.36%; Italy, 2.38%; Portugal, 4.29%; and Greece, 7.09%. The rates are not onerous despite mediocre economic conditions and steady debt burdens, and have fallen over the last year. What accounts for this remarkable sangfroid by investors?

The answer may be the status of the third crisis: banking. Last year the European Central Bank (ECB) under Mario Draghi instituted a new three-year Long-term Refinancing Operation (LTRO). Banks in southern Europe took the relatively cheap funds and bought the bonds of their own governments, which still carry zero-risk weights in the Basel capital regulations. As a result, according to Silvia Merler (also at Bruegel), banks in those European countries have “renationalized,” with domestic debt accounting for large proportions of their portfolios, and much of this debt consisting of government debt. Moreover, the ECB also announced that it would purchase a government’s sovereign bonds under its Outright Monetary Transactions program if necessary to maintain its target interest rate. Combine bank purchases of government debt with a guarantee of central bank intervention if markets deteriorate and the fall in yields is the obvious result.

All this has the appearance of a Rube Goldberg machine, with a feedback loop uniting the ECB, European banks and sovereign debtors. But is it sustainable? Must the ECB continue renewing the LTRO to keep the banks solvent? Will the European Banking Authority, currently undertaking stress tests of the banks, accept the arrangement? What if the fragile recovery turns out to be really fragile? And what will happen if/when the Federal Reserve does taper off its asset purchases? However many years this crisis has been going on, the exit is not visible yet.

 

The Stars and Stripes Forever?

Leave a reply

Global imbalances are once again a focus of discussion. This time, however, it is Germany, not China, which is identified as the major surplus country and an obstacle to economic recovery.  The German surplus, it is alleged, makes adjustment harder in the Eurozone’s periphery countries.

Much less attention has been paid to the other side of the imbalances: the deficits in the U.S. current account. The U.S. balance of payments position reflects the dollar’s role as a global reserve currency. Andreas Steiner has shown in “Current Account Balance and the Dollar Standard: Exploring the Linkages” (Journal of International Money and Finance, in press) that the demand for reserves lowers the U.S. current account by one to two percentage points of GDP.

The demand for those reserves is not likely to diminish any time soon. Rakesh Mohan, Michael Debabrata Patra and Muneesh Kapur, in an IMF working paper, “The International Monetary System: Where Are We and Where Do We Need to Go?”, analyze the increase in reserves by major emerging market countries who may turn to reserve accumulation to expand their central bank balance sheets. They project the demand for foreign exchange reserves for seven emerging markets ((Brazil, Hong King, China, India, Korea, Russia, Saudi Arabia) under different scenarios for the mix of domestic and foreign assets, and estimate that their holdings of net foreign assets will increase from $6 trillion in 2011 to between $7.8 trillion and $14.9 trillion by 2017.  They caution that other emerging markets, such as oil exporters, are not included in their projections, and the demand for foreign assets may be higher.

The use of the dollar as an international currency appears in private markets as well. Mohan, Patra and Kapur present data that show the dollar with a 44 percent share of the global foreign exchange market. The dollar’s predominance in the foreign exchange market is matched by its use in international banking and bond markets.

Joseph Gagnon in “Global Imbalances and Foreign Asset Expansion by Developing-Economy Central Banks” has argued that the demand for dollar-denominated assets by central banks drives the balance of payments surpluses in many emerging markets.  If the dollar retains its status as a reserve currency, then there will always be a demand for dollars that feeds into the balance of payments. Until there is a credible alternative (or alternatives), global imbalances that include U.S. deficits will be an inherent feature of the international monetary system.

What could threaten the dollar’s special status? Emmanuel Farhi, Pierre-Olivier Gourinchas and Hélène Rey argue in their Reforming the International Monetary System that the “backing” of the dollar, which took the form of gold under the Bretton Woods system, now exists in U.S. Treasury securities. If there is a change in perception about the reliability of this backing, then the transition to a multipolar reserve currency system may be more abrupt than desired.

Assigned Readings: November 14, 2013

Leave a reply

Taking a historical perspective of economic changes, this paper argues that muddling through crises-induced reforms characterizes well the evolutionary process of forming currency unions. The economic distortions facing the euro include structural challenges in the labor and product markets, and financial distortions. While both structural and financial distortions are costly and prevalent, they differ in fundamental ways. Financial distortions are moving at the speed of the Internet, and their welfare costs are determined more by the access to credit lines and leverage, than by the GDP of each country. In contrast, the structural distortions are moving at a slow pace relative to the financial distortions, and their effects are determined by inter-generational dynamics. These considerations suggest that the priority should be given to dealing with the financial distortions. A more perfect Eurozone is not assured without successfully muddling through painful periodic crises.

International financial linkages, particularly through global bank flows, generate important questions about the consequences for economic and financial stability, including the ability of countries to conduct autonomous monetary policy. I address the monetary autonomy issue in the context of the international policy trilemma: countries seek three typically desirable but jointly unattainable objectives: stable exchange rates, free international capital mobility, and monetary policy autonomy oriented toward and effective at achieving domestic goals. I argue that global banking entails some features that are distinct from broad issues of capital market openness captured in existing studies. In principal, if global banks with affiliates established in foreign markets can reduce frictions in international capital flows then the macroeconomic policy trilemma could bind tighter and interest rates will exhibit more co-movement across countries. However, if the information content and stickiness of the claims and services provided are enhanced relative to a benchmark alternative, then global banks can weaken the trilemma rather than enhance it. The result is a prediction of heterogeneous effects on monetary autonomy, tied to the business models of the global banks and whether countries are investment or funding locations for those banks. Empirical tests of the trilemma support this view that global bank effects are heterogeneous, and also that the primary drivers of monetary autonomy are exchange rate regimes.

We analyse global and euro area imbalances by focusing on China and Germany as large surplus and creditor countries. In the 2000s, domestic reforms in both countries expanded the effective labour force, restrained wages, shifted income towards profits and increased corporate saving. As a result, both economies’ current account surpluses widened before the global financial crisis, and that of Germany has proven more persistent as domestic investment has remained subdued.

In contrast to earlier recessions, the monetary regimes of many small economies have not changed in the aftermath of the global financial crisis. This is due in part to the fact that many small economies continue to use hard exchange rate fixes, a reasonably durable regime. However, most of the new stability is due to countries that float with an inflation target. Though a few have left to join the Eurozone, no country has yet abandoned an inflation targeting regime under duress. Inflation targeting now represents a serious alternative to a hard exchange rate fix for small economies seeking monetary stability. Are there important differences between the economic outcomes of the two stable regimes? I examine a panel of annual data from more than 170 countries from 2007 through 2012 and find that the macroeconomic and financial consequences of regime‐choice are surprisingly small. Consistent with the literature, business cycles, capital flows, and other phenomena for hard fixers have been similar to those for inflation targeters during the Global Financial Crisis and its aftermath.

  • Much has been done since 2010 to reduce macroeconomic imbalances in the Euro Area periphery and to bolster economic and financial integration at the EU level
  • Stronger exports may now be stabilizing output after two years of contraction, but headwinds remain with fiscal adjustment continuing and bank lending constrained
  • Market sentiment, underpinned by OMT, has improved with better economic news
  • Challenges remain, however, including the need to restore full bond market access for Portugal as well as Ireland and agree further financing and relief for Greece
  • Italy remains at risk over the longer term, with a return to durable growth requiring deeper structural reforms that political divisions are likely to impede
  • Progress mutualizing sovereign and bank liabilities looks likely to remain limited, leaving Euro Area members vulnerable to renewed weakness in market sentiment