The IMF’s Position in a Fragmented Global Economy

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Ten years ago Cambridge University Press published my book, The IMF and Global Financial crises: Phoenix Rising? I had written a series of journal papers on the IMF and used the format of a book to summarize what I had learned about the Fund. I also made some evaluations and projections about the IMF and its reputation; a decade later, how has the IMF done?

The book reviewed the history of the IMF from its founding at Bretton Woods through the global financial crisis. One of the theses of the book was that the IMF had paid a high price for its handling of the Asian financial crisis. The Fund had formulated programs for Indonesia, South Korea, and Thailand that proved to be controversial. Among the charges levied against the Fund was:

  • Condemnation for imposing harsh macro policies in the conditions of the programs;
  • Criticism for including inappropriate structural conditions;
  • Blame for indirectly precipitating the crisis through its support of capital decontrol.

In the aftermath of the Asian crisis as well as subsequent crises in Russia, Turkey and Argentina, the global economy entered a period of steady real growth and moderate inflation rates. The demand for the Fund’s assistance declined, and the IMF used the occurrence of relative stability to undertake post-mortem reviews and changes in its recommended policies. These included a retreat from its advocacy of full capital decontrol, and a reassessment of the purposes and scope of conditionality.

When the global financial crisis of 2008-09 occurred, it was an opportunity for the IMF to show that it had learned the lessons of the previous crisis and could adapt its playbook.  The IMF set up 17 Stand-By arrangements during the period of September 2008 through the following summer. The policy conditions attached to these programs were based on an understanding that the contractions in economic activity in the program countries were the result of falling international trade that followed the financial collapse in the advanced economies. Subsequent reviews of the programs found that credit was disbursed more quickly and in larger amounts than in past crises.

In addition to providing financial resources, the IMF called for a coordinated response to the crisis and the use of fiscal stimulus to offset its effects. The Fund’s economists completed its turnaround in its position on capital account regulation and acknowledged that capital controls could mitigate financial fragility. The IMF’s activist stance was acknowledged by the newly formed Group of 20, which approved an increase of the IMF’s financial resources, and called upon it to institute surveillance of their economies.

The IMF, therefore, came out of the global financial crisis with its reputation as a crisis manager restored. The whimsical subtitle of my book came from a line in Don Quixote that referred to a phoenix that rose from the ashes of a fure.  How the IMF used its reputation and handled new crises, however, could only be revealed with the passage of time.

The IMF does much more than serve as a crisis lender. The results of its surveillance of the global economy are published in reports such as the World Economic Outlook, and updates to its economic forecasts are widely reported. The IMF’s Managing Director, Kristalina Georgieva, has a high public profile, and speaks out a range of global issues. The research of its economists has grown to include work done on income inequality, gender and climate change.

The next major challenge the IMF faced was the Greek debt crisis, when it joined the “troika” of the European Central Bank and European governments in arranging a resolution. The loans extended to Greece were controversial because of the conditions the Greek government had to implment. As the crisis deepened, the IMF differed from its troika partners in advocating for debt relief. Greece eventually repaid its loans from the IMF two years earlier than planned, but in retrospect the IMF’s inclusion in the troika constrained its ability to set sustainable debt levels.

More recently, during the pandemic the IMF was active in providing financial assistance to its poorest members. Some of its funds were given through new facilities, such as the Rapid Credit Facility and the Rapid Financing Instrument, with (at most) minimal conditionality. Brad Setser of the Council of Foreign Relations pointed out that lending from the IMF and the World Bank to lower middle-income countries rose just as private credit flows fell. Setser observed:

“Such a surge made financial sense, and was a moral imperative as well. The Bank and the IMF, and thus President Malpass and Managing Director Kristalina Georgieva, deserve credit for making it a reality. The system, in a sense, worked. Low income countries had to struggle through the pandemic, but they didn’t lose access to new financing at the same time.”

But not all agree that such lending by the IMF is consistent with its core missions. Kenneth Rogoff of Harvard, who was chief economist at the IMF from 2002 to 2003, points out that the Fund, unlike the World Bank, is not an aid agency. It uses conditionality in part to ensure that it is repaid so that it can continue to lend.  He also argues that “forceful IMF conditionality is essential to establish financial stability and ensure that its resources do not end up financing capital flight, repayments to foreign creditors, or domestic corruption.”

More recently the IMF has become involved with a number of developing nations that can not meet their debt obligations, including Egypt, Sri Lanka and Pakistan. According to The Economist, this work is likely to escalate:

“Debt loads across poorer countries stand at the highest levels in decades. Squeezed by the high cost of food and energy, a slowing global economy and a sharp increase in interest rates around the world, emerging economies are entering an era of intense macroeconomic pain… All told, 53 countries look most vulnerable: they either are judged by the imf to have unsustainable debts (or to be at high risk of having them); have defaulted on some debts already; or have bonds trading at distressed levels.”                                                 The Economist, 7/20/2022

The Fund recently published a Staff Discussion Note on “Geoeconomic Fragmentation and the Future of Multilateralism.” The authors of the Note point out that the pace of globalization slowed notably after the global financial crisis, and geopolitical tensions have led to a reversal of economic integration. They examine the consequences of fragmentation on international trade, the diffusion of technology and the international monetary system.

Could the IMF be replaced? It is difficult to imagine how a new global organization could be organized. On the other hand, regional blocs may become more widespread. For example, the IMF’s Note on fragmentation notes that global liquidity has four sources: central bank reserves, bilateral swap agreements, regional financial arrangements, and the IMF. Bilateral swap lines and regional arrangements have grown rapidly, leaving  the Fund as the only provider of universal coverage. Further growth of regional arrangements based on geopolitical blocs would increase their coverage, but it would be uneven across blocks and could be inadequate to deal with large shocks.

I argued in my book that it is crucial to remember that the IMF is an agent for its 190 principals. Its ability to address global challenges depends on the willingness of the sovereign members to use the IMF to organize responses to the challenges. A world that is divided by U.S.-China frictions gives the IMF limited scope to play the role it seeks to have.

The 2022 Globie: Money and Empire

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Every year we name a book the “Globalization Book of the Year” (aka the “Globie”). The prize is (alas!) strictly honorific and does not come with a monetary award. But announcing the award gives me a chance to draw attention to a recent book—or books—that are particularly insightful about globalization. Previous winners are listed at the bottom of the column (also see here and here).

This year’s recipient is Money and Empire: Charles P. Kindleberger and the Dollar System by Perry Mehrling, Professor of International Political Economy at the Pardee School of Global Studies of Boston University. The book is an intellectual biography of Charles Kindleberger, who came to MIT in 1948 after having served at the U.S. Treasury, the Federal Reserve Board, the Bank of International Settlements and the U.S. Department of State. He was the author of a number of articles and books on international macroeconomics and economic history that have retained their relevance long after their initial publication date. In his work he often focused on the policies needed to achieve international stability in a world of different national currencies and policies. He had a insightful perspective on the circumstances that led to the Great Depression, and what needed to be done to avoid a repeat of that catastrophic occurrence.

Among the topics that Mehrling covers is the evolution of Kindleberger’s views on the global economic role of the dollar. The dollar became the international reserve currency under the Bretton Woods regime, which was designed to avoid a repeat of the relative chaos of the 1930s. Foreign central banks held dollars to stabilize the value of their currencies, while the U.S. stood ready to exchange these dollars for gold. What had been a dollar shortage in the period after World War II became a dollar glut in the 1950s and 1960s, however, and the stability of the link to gold was questioned by Robert Triffin and others.

Kindleberger, on the other hand, believed that the dollar was serving an important international function as a key currency, as the pound had done in the pre-WWI ear. The responsibility of the U.S. was to set monetary policies that took account of the state of the world economy. In 1966, he joined with Walter Salant and Emile Despres in writing an article for The Economist, “The Dollar and World Liquidity: A Minority View,”  which advanced the view that the U.S. served as the “world’s banker,” i.e., as a financial intermediary with respect to Europe that issued short-term deposits and invested long-term capital around the world. The result was an unplanned but functional international monetary system. In that perspective, gold was an unnecessary distraction.

The debate over the architecture of the international monetary system seemed to end when Richard Nixon terminated the exchange of gold for dollars in 1971. The U.S. and the European nations also began the transition away from fixed exchange rate regimes, although the Europeans would move to their own “fixed currency” with the euro. But the dollar did not recede into the mix of the international monies. The end of Bretton Woods also meant the end of the acceptance of capital controls, and capital began to flow more freely, first among the advanced economies and then to the emerging market nations. Private capital flows rose in importance in financing corporate and government debt, and in the cases of external finance these debt instruments (particularly of emerging market economies) were denominated in dollars.

By the 2000s the existence of a “global financial cycle”, based on U.S. monetary policy, became widely accepted. The dollar was indeed the international currency, although this was decided by private markets as much as governmental decrees. Pierre-Olivier Gourinchas of UC-Berkeley and Hélène Rey  of the London Business School, in explaining the central role of the U.S., updated the 1966 title given to the dollar by Kindleberger and his associates to the world’s “venture capitalist.”

One of Kindleberger’s most well known contributions came from his analysis of the Great Depression. Previous work usually placed the blame on the outbreak and/or duration of the crisis to misguided national policies. Kindleberger realized that there was an international dimension: the lack of a country that acted as a leader in providing the international public goods needed for stability. These included maintaining an open market for distress goods, providing long-term lending and overseeing a stable system of exchange rates, ensuring the coordination of macro policies among nations and acting as a lender of last resort. In the 1930s Britain was no longer able to act as the global leader, while the U.S. was not willing to accept that roel. Kindleberger’s insight became the basis of a body of work known as “hegemonic stability,” one of the tenets of international political economy.

Kindleberger offered yet another perspective on financial instability in his Manias, Panics and Crashes. As the title implies, the book is an account of financial crises dating back over time and their common elements. The book was first published in 1978. Robert Aliber took over the job of updating the book after Kindleberger’s death, and the latest edition (the eighth) has Robert N. McCauley as the newest co-author.

 In the book Kindleberger extended Hyman Minsky’s model of financial instability, which was a domestic model, to include an international dimension. Minsky had proposed that credit expansion and contraction followed a cycle of initial displacement, boom, euphoria, profit taking, and panic. In a global context, this cycle can be amplified by short-term international capital flows, that increase the amount of credit that is available during the early stages of the cycle. But the money is rapidly withdrawn by foreign investors when doubts arise about the solvency of the projects they have financed. The withdrawal of foreign capital exacerbates the instability of the last stages of the cycle. Kindleberger’s adaptation of Minsky’s work proved to be remarkably prescient during the emerging market economies’ crises of the 1990s, such as the Asian crisis, as well as the global financial crisis.

Mehrling, therefore, has done a valuable service in explaining Kindleberger’s contributions to our understanding of the global economy. Because his analyses were not based on mathematical models or econometric testing, Kindleberger did not receive the same degree of respect as did his colleagues at MIT and elsewhere who used these tools. But the passing of time demonstrates that Kindleberger possessed a keen understanding of how capital and credit flows functioned, and the need for some form of governmental oversight. Any lack of attention to this work at the time when Kindleberger was active tells us more about the blindfolds of economics than it does about Charles Kindlberger.

“Globies”

2016    Branko Milanovic        Global Inequality

2017    Stephen D. King          Grave New World: The End of Globalization, The Return of History

2018    Adam Tooze                Crashed: How a Decade of Financial Crises Changed the World

2019    Branko Milanovic        Capitalism, Alone

2020    Tim Lee, Jamie Lee      The Rise of Carry

             and Kevin Coldiron

2021    Anthony Elson             The Global Currency Power of the Dollar

             Jeff Garten                  Three Days at Camp David

The Struggle for Hegemony

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The restrictions by the Biden administration on the sale of semiconductor chips and the equipment to manufacture them represent a new stage in the division between China and the U.S. The belief that increased trade would lead to a convergence of Chinese and U.S. interests faded years ago. The history of globalization shows clearly that the chances of Chinese as well as Russian acceptance of a liberal order overseen by the U.S. were unlikely, and a struggle for control inevitable.

The study of hegemonic power can be used to illustrate how discord can arise over the distribution of the global benefits of economic growth. MIT economic historian Charles Kindleberger made the case in The World in Depression, 1929-1939 that international economic prosperity needs a nation to provide leadership. The duties of the hegemonic power include maintaining an open market for imports from countries in distress, providing long-term capital and acting as a lender of last resort. More generally, the hegemonic country provides the public good of rules that govern international transactions and ensures compliance to them by other nations.

Great Britain was the hegemonic power of the 19th century and its dominance lasted until the first World War. This was a period of rapid growth for the European countries and Britain’s “offshoots,” i.e., Canada, the U.S., Australia and New Zealand. The shared economic prosperity made the outbreak of a war among the industrial powers seem unlikely. Norman Angell made the case in The Great Illusion, first published in 1909, that the costs of a war among the industrial powers were so great that they would deter their governments from engaging in conflict.

But the predominance of Britain during this period was being questioned by the U.S. and Germany.  Each country had leaders—President Theodore Roosevelt in the U.S. and Kaiser Wilhelm II in Germany—who made clear that they would not accept subordinate positions. The Germans were particularly resentful of their inability to match the size of Britain’s colonial empire, as the colonies had largely been claimed before Germany’s emergence as a nation in 1871after its defeat of France in the Franco-Prussian War.

Graham Allison of Harvard’s Kennedy School wrote about these tensions, and the British response, in his Destined for War: Can America and China Escape Thucydides’s Trap? The “trap” that Allison draws from the work of the Greek historian Thucydides is the confrontation that arise when a rising power threatens a ruling one. Thucydides wrote about the Peloponnesian War between Athens and Sparta, which occurred when Sparta responded to what it saw as a threat to its dominance of the Greek states by the growing Athenian empire.

In the 19th century, Britain was the dominant power facing challenges from other nations. British statesmen decided that Germany posed a more immediate security threat, and accommodated U.S. demands in the Western Hemisphere without surrendering their own interests. But Britain also built up its already powerful battle fleet and created an alignment with France and Russia, the Triple Entente, to counter a German threat.

This deterrence was not enough to avoid the breakout of World War I. The costs of the war hindered Britain’s ability to resume its hegemonic role, and the U.S. was not willing to take its place. As a result, Kindlerberger claimed, the economic crisis of the 1930s was deeper and more extended than it would have been if an international hegemon had been present. The response of the U.S. in creating the United Nations, the International Monetary Fund, and other multilateral organizations after World War II showed that by that time it had learned the lesson of the need for international institutions.

Allison presents other examples of challenges to hegemonic powers by rising powers. In the 17th century, the Dutch Republic was the leading maritime power. It possessed trading posts and colonies in Asia, Africa, and the Americas, and a formidable fleet of warships to defend them. England resented this control and engaged in three maritime wars with the Dutch. The hostilities between the two countries only ended when William of Orange became King William III of England, and the Dutch and English waged war together on the predominant European land power, France.

Allison makes clear that the rivalry between China and the U.S. need not result in war. Besides the British accommodation of U.S. interests in the late 19th century, he points to the “Cold War” between the Soviet Union and the U.S. as an example of a struggle that did not lead to direct conflict. One of the reasons for the avoidance of the escalation of hostilities to total war was the existence of nuclear weapons,, which dramatically raised the cost of using the full range of weapons. But the Cuban missile crisis showed that it was possible to come perilously close to moving into a full-blown conflict. The expansion of trade and finance to new markets creates opportunities for rivalries and competition that can trigger responses that lead to unforeseen consequences.

Making Friends in the New Global Order

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U.S. Treasury Secretary Janet Yellen gave a talk at the Atlantic Council last April on the future role of cooperation in the global economy. In October Chrystia Freeland, Deputy Prime Minister of Canada and its Minister of Finance, gave an address at the Brookings Institution that presented a similar perspective on how the global economy must be reorganized to meet security demands. Their speeches raise questions about how the new arrangements would operate, and how the rest of the world would fit into the proposed framework.

Yellen declared that the war between Russia and Ukraine had “redrawn the contours of the world economic outlook…” The sanctions imposed by the U.S., the other members of the Group of 7 and the European Union were in response to Russia’s “…having flaunted the rules, norms, and values that underpin the international economy.” She also drew attention to China’s ties with Russia and declared that “The world’s attitude towards China and its willingness to embrace further economic integration may well be affected by China’s reaction to our call for resolute action on Russia.”

Looking forward, she enunciated several propositions to govern future action. The first of these dealt with the need to modernize the existing multilateral approach. Yellen proposed basing economic integration by confining the “friend-shoring” of supply chains to “a large number of trusted countries…” This orientation would lower our vulnerability to countries using their economic resources to “disrupt our economy or exercise unwanted geopolitical leverage.” Left unsaid were the issues of which countries merited trust, and how to deal with those that do not fulfill that criterion.

Freeland spelt out some of the details in her address. She spoke of “a brutal end to a three-decade-long era in geopolitics,” and proposed a new orientation based on three pillars. The first is a strengthening of the connections among democracies, and Freeland specifically cites Yellen’s “friend-shoring” as one way to accomplish this.

The second pillar deals with “in-between countries” in Asia, Africa, the Middle East and Latin America. Freeland insisted that friend-shoring should be open to any countries that “…share our values and is willing to play by collectively agreed upon rules.” She made the claim that a rules-based order will be valuable to smaller countries “…most susceptible to coercion by larger and more hostile economies.”

Finally, with respect to authoritarian governments, Freeland advocated a sharp break with the assumptions of the 33 years. These states have little respect for a rules-based disorder, she claimed, and are hostile to the democracies. The democracies can continue to trade with the authoritarian states but should avoid strategic vulnerabilities in their supply chains.

Yellen and Freeland, therefore, agree that the economic relationships of democratic nations should be based on common values and goals. This is a major pivot from the guiding principles of the last three decades that more trade and investment would lead to shared prosperity, the development of democratic political systems and a diminution of conflict. It is also much more of a “top-down” approach, with governments overseeing the relationships of domestic firms with the rest of the world and evaluating the entry of foreign firms into domestic markets.

These ambitious proposals have met a variety of reactions. Branko Milanovic has called the trading links “trade blocs,” similar to those in the past such as the United Kingdom’s imperial preferences, and “mercantilism under a new name.” But mercantilism was a characteristic of President Trump’s trade policies, as he saw trade as a zero-sum relationship with trade deficits as a loss for the country that sustained them. The new proposals seek security and freedom from the weaponization of trade.

How will other countries, particularly those in Freeland’s second group, respond to these initiatives? The new lineup of countries bears many similarities to the post-World War II division among the “first world” of advanced economies, the “second world” of the Communist bloc that included the Soviet Union and China and the “third world” that was the category of every other country, which included nations with colonial pasts in Asia, Africa and Latin America. Many of the third-world countries sought to establish their independence from the first and second worlds.

Today there are a wide variety of economic and political systems outside the advanced economies. Many would undoubtedly desire to continue exporting to the U.S., the European Union, Japan and Australasia. But do they qualify for Freeland’s friend shoring club?

Vietnam has taken the place of China for many multinationals as a source of low-wage production, and its trade with the U.S. and other countries has propelled its growth. Its government, on the other hand, is a one-party system led by the Communist Party, and Freedom House ranks it as “Not Free.” Bangladesh is another country where growth has been driven by exports, mainly in garments. The Awami League keeps a firm hold on political power and the country is characterized by Freedom House as “partly free.”

The transition to “green energy technologies,” will require the use of cobalt, and the Democratic Republic of Congo supplies more than 63% of the world’s use of the element, as well as other natural resources. But the inhabitants of that country do not benefit from their extraction and export, and their political system has been volatile at best. Freedom House rates it as “not free.”

Many other countries that engage in transactions with the advanced democracies will not qualify for membership in the friend-shoring club as defined by Freeland. Moreover, they may not want to choose ideological sides between the two sides in the new order. How will Yellen and Freeland’s democracies deal with these countries? Will they be excluded from trade and financial flows? Or will economic relationships with them be allowed to avoid dependence on the authoritarian countries that are viewed as threats to the security of the democracies? The diversity of economic and political systems in the emerging markets and developing countries will resist easy categorization and pose challenges to Yellen’s and Freeland’s configuration of the world’s economies.

Has the Third Era of Globalization Ended?

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Behind the headlines forecasting a global economic recession there is another narrative about the end of globalization. This reflects political tensions over trade, the impact of the pandemic on global supply chains and the shutdown of economic ties with Russia. But dating the beginning and end of the most recent era of the integration of global markets poses challenges.

All chronological assignments for the purpose of establishing historical eras are arbitrary. Did World War II begin in 1939 when Germany and the Soviet Union invaded Poland? Or in 1937 when Japan invaded China? When was the First Industrial Revolution succeeded by the Second Revolution? Mid or late 19th century? And good luck finding agreement on when the golden age of rock and roll took place.

The dating of economic eras also involves assumptions. Did the First Era of Globalization begin in the early 1870s as usually stated, and if so, why? Germany’s adoption of the gold standard at that time is usually seen as a shift in monetary regimes that facilitated international capital flows, but trade and migration flows had expanded prior to the 1870s. Assigning a date to the end of the First Era is easier to do, as currency convertibility was suspended during World War I and borders were shut to migration.

The commencement of the Bretton Woods (BW) system marks the beginning of the Second Era of Globalization. The agreement was signed in 1944 and the IMF commenced operations in 1947, so 1945 can be seen as the beginning of the post-war era. But the system actually described in the agreement did not operate until 1958 when European currencies became fully convertible for current account transactions. Did the BW regime end in 1971, when President Richard Nixon ended the convertibility of foreign central bank holdings of dollars to gold? Or in 1973, when attempts to establish new fixed exchange rate values ended and the major currencies began to float? The IMF’s Articles of Agreement were not amended to reflect the new practices until 1976.

The Bretton Woods system ended in the 1970s, but globalization did not go into reverse. The post-World War II era can be extended to include the following decades, but that would overlook several important changes in how international economic affairs were conducted. The elections of Margaret Thatcher and Ronald Reagan in 1980 are widely seen as marking the beginning of what has been called the neoliberal era, which has been characterized as a shift to dependence on market outcomes. (Gary Gerstle of Cambridge University, however, shows that the term “neoliberal” encompasses a number of political agendas, not all of them consistent, in a compelling account in his book The Rise and Fall of the Neoliberal Order: America and the World in the Free Market Era.) The initial policy changes occurred domestically, but this was also the period when the IMF began to promote the removal of capital controls. On the other hand, the 1980s was a “lost decade” of growth for those countries, mainly in Latin America, that were embroiled in the debt crisis.

The year 1990 is another candidate for dating the start of a new era of globalization. Douglas Irwin of Dartmouth College has described the era of 1985-1995 as the period of “the greatest reduction in global trade barriers in world history.” China began to allow private enterprises to flourish at the end of the 1980s, while East European nations sought to integrate their economies with those of Western Europe and the rest of the global economy after the collapse of the Soviet Union in 1991. The North American Free Trade Agreement (NAFTA) signed in 1994 by Canada, Mexico, and the U. S. created a trilateral trade area amongst the three countries.  In 1995, the World Trade Organization was established, with a mission to facilitate international trade. The new international agency sought to promote new trade agreements while administering a mechanism to resolve trade disputes amongst its members. Economic inequality among nations narrowed during this period as many emerging markets enjoyed rapid growth, although inequality within nations rose as the benefits of global trade and financial flows were not equally shared.

But if the Third Era of Globalization is no longer operating, when did it cease? The global financial collapse of 2008-09 demonstrated the fragility of extended financial sectors even in the advanced economies, and lacerated confidence in the ability of regulators to anticipate sudden collapses of financial flows. The response of domestic governments and international agencies to the crisis led to a revival of economic activity but the recovery was slow, particularly for those who did not benefit from the rise in asset prices that low interest rates fostered. Foreign expansion by multinational firms continued but the pace of foreign direct investment slackened, while the IMF issued a reappraisal of its policy recommendations regarding capital flows to include capital controls as an acceptable macro policy tool.

The year 2016 has a strong claim for marking the end of this era of globalization. Donald Trump campaigned advocating the use of tariffs to end trade deficits and the erection of a wall along the border with Mexico to halt illegal immigration. He sought to implement those policies after his election, including the imposition of tariffs on Chinese goods. The votes in favor of Britain leaving the European Union (“Brexit”) in the same year demonstrated the distrust of many British citizens of multilateral governance as well as a fear of immigration. The result in that country has been a reduction in trade and migrant flows, with no evidence of a positive economic payoff.

Whatever momentum was left in international economic expansion was throttled by the pandemic and then the Russian-Ukraine war. The pandemic exposed the vulnerability of global supply chains to national shutdowns, and the dangers of dependence on single suppliers of strategic goods, such as medical equipment. In response to the invasion of Ukraine, the U.S. and European allies have sought to cut off trade and financial flows with Russia, which in turn seeks to use higher oil and gas prices to lower Western morale. The U.S. hopes to slow down Chinese technological advances by scrutinizing Chinese acquisition of U.S. firms while supporting U.S. firms in areas where they may fallen behind.

Whether or not the third era of globalization expired in 2016, 2020 or 2022, there is a strong sense that a new era has begun. But is it the end of globalization? Richard Baldwin of the Geneva Institute in his NBER paper, “Globotics and Macroeconomics: Globalisation and Automation of the Service Sector” and in a series of blog posts argues that changes in global economic activity have been misunderstood and misinterpreted. The drop of world trade/GDP since 2008 was largely a function of the decline in the value of commodities, particularly mining goods and fuels.

There has also been a slowdown in the transfer of manufacturing from advanced economies to a handful of emerging economies, as well as a reorganization of supply chains. But Baldwin shows that a new wave of globalization is taking place in the provision of intermediate service activities, which include accounting, financial analysis, legal analysis, and other activities. Advanced economies still account for the majority of service exports but emerging economies including China, India, Korea, Poland, the Philippines and Brazil have recorded rapid growth in these activities. The barriers to further expansion are technological, not regulatory, and those barriers are falling rapidly.

It is premature, therefore, to proclaim the end of globalization. Trade in manufactured goods may not be advancing at the same pace as it has in the past but that slowdown was inevitable. Trade in services, on the other hand, has grown continuously since 1990, although some deceleration in the current economic environment is inevitable. However, advances in artificial intelligence (AI) will alter the supply of both goods and services. Its impact on national economies and global markets is a matter of speculation, but the widespread use of AI may herald the start of the next era of glovalization.

China and the Debt Crisis

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Sri Lanka is not the first developing economy to default on its foreign debt, and certainly won’t be the last. The Economist has identified 53 countries as most vulnerable to a combination of “heavy debt burdens, slowing global growth and tightening financial conditions.” The response of China to what will be a rolling series of restructurings and write-downs will reveal much about its position in the 21st century international financial system.

Debt crises are (unfortunately) perennial events. In the 1970s many developing countries, particularly in Latin America, borrowed from international banks to pay energy bills that had escalated after oil price increases enacted by the Organization of Petroleum Countries (OPEC). Repaying those loans became more difficult after the Federal Reserve raised interest rates in 1979 to combat U.S. inflation. Mexico announced that it could no longer make debt payments in August 1982, and other governments soon followed (see here for more detail).

The U.S. government supported negotiations that brought together the governments unable to make payments, the banks that had made the loans, and the International Monetary Fund. The banks were willing to restructure the debt while the IMF lent funds to the governments that allowed them to keep up their interest payments while staving off acknowledging their inability to pay off the debt. But this only delayed a final resolution of the crisis and led to a “lost decade” in Latin America. In 1989 Secretary of the Treasury Nicholas Brady proposed a plan that led to reductions of the loan principals in return for the issuance of “Brady bonds” by the debtor governments.

The U.S. allowed the IMF to take the lead during subsequent crises, including the East Asian crisis of 1997-98, Russia in 1998 and Argentina in 2000. As the member with the largest quota, the U.S. could influence the design and implementation of the IMF’s programs. It also took a more active role when U.S. interests were directly affected, as it did with Mexico in 1994-95. While U.S. attention was focused on its own crisis in 2008-09, the IMF took on the task of lending to middle- and low-income countries that were caught up in the economic shock waves of the financial collapse. The Federal Reserve, however, established currency swap lines with the central banks of other advanced economies as well as those of four emerging markets: Brazil, South Korea, Mexico and Singapore.  The Fed reactivated the swap lines in March 2020 in response to the disruption in international credit markets caused by the pandemic and also set up a new facility to provide dollar funding to foreign official institutions.

China has taken a different position with regards to the debt of developing nations. Its state-owned banks have made bilateral loans as part of the Belt and Road initiative, with many of these loans made to African governments for infrastructure projects. But the amount of lending and the terms have not always been made transparent. Sebastian Horn of the University of Munich, Carmen Reinhart, currently Chief Economist at the World Bank while on leave from Harvard University’s Kennedy School, and Christoph Trebesch of the Kiel Institute for the World Economy developed a database of Chinese lending over the period of 1949-2017 which they published in a 2021 NBER paper, “China’s Overseas Lending.” They found “…that a substantial portion of China’s overseas lending goes unreported and that the volume of “hidden” lending has grown to more than 200 billion USD as of 2016.” Another study from AidData, a research lab at William & Mary, also documented Chinese lending to low- and middle-income countries, and found that many loans are collateralized against future commodity export receipts.

Some of these loans have already been restructured, with China pushing back repayment dates. If there is a systemic wave of defaults, the Chinese government must decide whether it will continue to negotiate directly with the governments that borrowed, or whether it will join the governments that belong to the Paris Club, a group of official creditors that attempt to devise sustainable solutions to debt problems, in designing a mechanism to reduce the volume of debt.

In 2020, the Group of 30 working with the IMF and the World Bank instituted the Debt Service Initiative (DSSI), which suspended debt service payments from low-income countries to official creditors, including China. Forty-eight countries participated in the program, which ended in December 2021.  The DSSI has been followed by the Common Framework, which brings together official creditors and low-income borrowers to provide some form of assistance to insolvent nations. However, private lenders have not agreed to participate and only three nations have requested relief through the Common Framework. There are concerns about the process, and there will undoubtedly be calls for broad-based debt cancellation as countries with mounting food and energy bills seek relief.

The decisions that China makes regarding its participation in new initiatives have implications for its future role in the international financial system. The government has sought to enhance the role of its currency, the renminbi, and its share in the foreign exchange reserves of central banks has risen as trade with China has grown. Serkan Arslanalp of the IMF, Barry Eichengreen of UC-Berkeley and Chima Simpson-Bell, also of the IMF, have documented the decline in the relative share of dollar-denominated foreign reserves and the increase in renminbi-denominated reserves in “The Stealth Erosion of Dollar Dominance and the Rise of Nontraditional Reserve Currencies” in the Journal of International Economics (working paper here). They find, however, that the changes in the composition of foreign reserves involve more than the Chinese currency, and show increases in the relative shares of the Australian dollar, the Canadian dollar, the Korean won, the Singapore dollar and the Swedish krona as wells. They attribute these changes in part to more active management of reserves by central bankers and also the existence of more liquid foreign exchange markets that facilitate non-dollar trading.

The use of the dollar-based international financial system as a financial weapon against Russia, including seizure of more than $300 billion of its central bank assets, could be an opportunity for another system to take its place, and there has been much speculation about the emergence of a Chinese-based rival. But Adam Tooze of Columbia University has pointed out that

“It (the dollar system) is a sprawling, resilient network of state-backed, commercially driven, profit-orientated transactions, lubricated by the easy availability of dollars, interwoven with American geopolitical influence, a repeated game in which intelligent players continuously gauge their advantages and disadvantages and the (very few) alternatives open to them and then, when all is said and done, again and again come back for more.”

A new system would take years to establish. Whether China’s government wants to allow its financial markets to become enmeshed in a global system by removing the remaining capital controls is unclear. The combination of drought, COVID-19 and its real estate crisis fully occupy the attention of the Chinese government. It may have to deal with a debt crisis among the developing nations however, and its response will be monitored for signs of how it sees its position within the global financial network of rules and institutions.

The Global Financial Cycle and Emerging Market Economies

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The Federal Reserve’s latest increase in its policy rate is a signal of its desire to reestablish its credibility after U.S. inflation rose to 8.6% in May, and a precursor of more hikes.  Similar increases have been implemented by the Bank of England and the Swiss National Bank, and the European Central Bank has announced that an increase in its policy rate will occur in July.  These and other policy moves by central bankers indicate that we are in a new global financial cycle (GFC), which will have wide-ranging implications for emerging market and developing economies (EMDEs).

Maurice Obstfeld of UC-Berkeley and former chief economist of the IMF explains the linkages between monetary policy in advanced economies and economic activity in other countries in a Peterson Institute Working Paper, “The International Financial System after COVID-19.” Recent research has shown that U.S. financial conditions and Federal Reserve monetary policy, as well as conditions and policies in other advanced economies, affect asset prices, capital flows and commodity prices across a broad range of economies, evidence of a global financial cycle.

Researchers have devised measures of the cycle and studied its behavior. An index of global financial conditions shows a close correlation with output in the EMDEs. Part of this linkage is exerted via the dollar’s exchange rate, which appreciates in response to higher U.S. interest rates. Obstfeld lists several mechanisms that drive the relationship (see also here). He cites the impact of dollar appreciation on the tightening of trade finance credit, the role of the dollar as a safe haven during periods of heightened risk aversion, the contractionary impact of a stronger dollar on export demand when exports are denominated in dollars, a global decline in investment and a fall in real commodity prices. Exchange rate flexibility can mitigate the impact of shocks in the global financial cycle, but spillover effects are always present.

Obstfeld warns that higher interest rates in the advanced economies will affect the EMDEs. While the levels of government debt to GDP in many EMDEs are below those in most advanced economies, the rises in these ratios since the pandemic have been similar in magnitude. Refinancing will force these countries to deal with higher financing costs, and foreign-currency denominated debt adds another source of stress. Obstfeld cautions that one particular source of financial fragility is the concentration of sovereign debt on the balance sheets of banks in EMDEs.

An empirical assessment of the factors that drive capital flows to EMDEs is provided by Xichen Wang of the Chongqing Technology and Business University and Cheng Yan of the Essex Business School in their paper in the current IMF Economic Review, “Does the Relative Importance of the Push and Pull Factors of Foreign Capital Flows Vary Across Quantiles?  (working paper version here). They contrast the impact of “push” factors that are external to capital flow recipients and domestic “pull” factors on capital flows to 51 emerging markets. They use quantile analysis, which allows them to investigate the effect of the independent variables on different quantiles of the distribution of the dependent variable. The lower quantiles (such as the first 20%) are periods of relatively low capital flows, the median quantiles are tranquil and smooth periods, and the higher quantiles are periods of abundant capital financing.

The authors use several indicators of a GFC, including the U.S. 3-month Treasury bill rate deflated by U.S. inflation and the VIX index, which is based on the volatility of S&P 500 stock options. They also utiliized U. S. economic growth and average net capital flows to other countries in the region. For pull variables they utilized domestic variables, such as the domestic real interest rate, economic growth, public indebtedness, private credit expansion and the current account.

Wang and Yan’s results show that VIX and regional capital flows are highly significant for all the quantiles of gross capital inflows.  An increase in risk, as manifested in a rise in VIX, lowers capital flows to the emerging markets while an increase in capital flows to other countries in the region has a positive effect. Several of the domestic pull factors, such as economic growth and international reserves, are statistically significant at the lower quantiles, but their significance diminishes in the higher quantiles. Foreign investors pay attention to domestic conditions when capital flows are relatively limited.

The authors also present results for disaggregated capital flows (FDI, portfolio equity, portfolio debt, bank). The significance of VIX remains for all forms of capital, including FDI which is sometimes seen as less affected by global conditions. The domestic push factors are significant for the non-FDI flows at the lower quantiles, but not at the upper quantiles.

The authors conclude that policymakers need to pay attention to the manifestation of GFCs, as they can lead to a sudden fall in gross inflows. VIX has risen this year from 16.60 on January 3 to a high of 36.45 on March 7, and currently stands at 27.53. The nominal Treasury bill rate rose from 0.09% at the beginning pf the year and has risen to 1.59%.  But the rate of inflation rose from 7.5% to 8.6% over the same period, largely offsetting the rise in the nominal rate.

The World Bank has evaluated the prospects of the EMDES in the June edition of its Global Economic Prospects. They forecast a slowdown in economic growth in the EMDEs from 6.6% in 2021 to 3.4% this year, and warn that the war in Ukraine has increased the risk of a further negative adjustment. The World Bank also cites global financial conditions as a cause of concern:

“As global financing conditions tighten and currencies depreciate, debt distress—previously confined to low-income economies—is spreading to middle-income countries. The removal of monetary accommodation in the United States and other advanced economies, along with the ensuing increase in global borrowing costs, represents another significant headwind for the developing world.”

There is a well-established link, therefore, from monetary policies in the U.S. and other advanced economies to the rest of the global economy. As the Federal Reserve and its counterparts show their determination to face down inflation, they can trigger spillovers that exacerbate capital outflows from the EMDEs. The result will be a further deterioration in the economies of countries that have already endured a series of negative shocks.

The Rising Dollar

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The foreign currency value of the dollar has been rising. The nominal broad dollar index of the Federal Reserve shows the dollar has incresed by by about 9% since its low point a year ago while other indexes register larger gains. What does this mean for the U.S. and other economies?

The appreciation reflects several factors. First, higher interest rates make investing in dollar-denominated assets more appealing, particularly since many other major central banks lag the Federal Reserve’s in its monetary tightening. The European Central Bank will not begin to raise its rates until July, while the Bank of Japan has no plans to change its accomodative policy stance. Second, the dollar’s “safe asset” status draws investors who fear the economic and political uncertainty due to the Russian invasion of Ukraine. Third, the COVID19 lockdowns in China have disrupted its economy, while the U.S. has not (yet) exhibited any significant slowdown.

A rising dollar will contribute to the increasing U.S. trade deficit. American consumers may be losing confidence because of inflation, but they are still purchasing foreign goods. Lower import prices will assist the Fed in combatting inflation, which could slow future hikes in interest rates..

 The dollar’s appreciation will also have an impact on the foreign-based revenues and profits of U.S. based multinationals. A 2018 S&P 500 research paper by Philip Brzenk showed that changes in the value of the dollar had an impact on S&P 500 companies with significant foreign activities. An appreciation (depreciation) of the dollar lowers (raises) the value of the foreign earnings of those companies with major foreign currency exposure, which is accompanied by decreases (increases) in the values of their share prices relative to those firms in the S&P 500 with little foreign exposure. A decline in foreign-sourced income will also affect the net income balance of the U.S. balance of payments, contributing to a further weakening of the current account.

The impact on foreign economies of the rising dollar is also mixed. On the one hand, those countries that export to the U.S. should benefit from lower prices for their goods. However, this effect is mitigated when their export prices are denominated in dollars.  Emine Boz, Camila Casas, Georgios Georgiadis, Gita Gopinath, Helena Le Mezo, Arnaud Mehl and Tra Nguyen of the IMF drew attention to the growing use of the dollar as a vehicle currency and the implications for trade balances in a 2020 IMF working paper, “Patterns in Invoicing Currency in Global Trade.”

Moreover, any expansionary effect due to increased trade can be offset by what has been called the “finance channel.” The financial channel reflects the impact of the exchange rate on the value of foreign currency liabilities, such as loans taken in a foreign currency. An appreciating dollar will raise the domestic value of those liabilities. Jonathan Kearns and Nikhil Patel of the Bank for International Settlements examined these channels in their article, “Does the Financial Channel of Exchange Rates Offset the Trade Channel?”, which appeared in the December 2016 issue of the BIS Quarterly Review. They found evidence that the financial channel partly offsets the trade channel for emerging market economies (EMEs) but that it is weaker for the advanced economies.

Similarly, Boris Hoffman and Taejon Park of the BIS reported that a dollar apperciation contributes to a deterioration of growth prospects of emerging market economies in their 2020 BIS Quarterly Review paper, “The Broad Dollar Exchange Rate as an EME Risk Factor.” They found that a dollar appreciation dampens investment growth, and even export growth. These effects were larger in countries with high dollar debt and high foreign investor presence in local currency bond markets, which conttibute to the financial channel.

Another examination of the impact of changes in the value of the dollar on emerging market economies was undertaken by Pablo Druck, Nicolas E. Magud and Rodrigo Mariscal of the IMF in “Collateral Damage: Dollar Strength and Emerging Markets’ Growth,” which appeared in the North American Journal of Economics and Finance in 2018 (IMF working paper version here). They found evidence of a negative relationship between the strength of the dollar and emerging markets’ growth. They attributed this empirical relationship to two channels of transmission: first, a negative linkage with commodity prices that depresses demand for the exports of commodity producers; second, an increase in the cost of imported capital imports that are necessary for growth. While supply shocks will keep commodity prices elevated, the price of capital imports has already risen due to widespread inflation.

The impact of the appreciation of the dollar will spread far outside U.S. borders. These effects will occcur in countries already grappling with higher food and energy costs, and the consequences of a slowing Chinese economy. A global recession is not inevitable, but the IMF’s Managing Director Kristalina Georgieva is not exagerating when she says that the world economy faces “its biggest test since the second world war.”

The IMF’s Proposed Policies on the Management of Capital Flows

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The IMF’s views on the advantages and drawbacks of capital flows have substantially evolved over time. The Fund reversed its opposition to capital controls in the wake of the global financial crisis of 2007-09, when it adopted the “Institutional View on the Liberalization and Management of Capital Flows.” That framework included capital flows measures (CFMs) as one of the policy measures available to a government facing surges of capital inflows, i.e., large inflows that could destabilize an economy. The Fund has now moved further in the direction of using CFMs, proposing that they can be used in a preemptive manner to avoid future instability.

The IMF had advocated the removal of capital controls before the Asian financial crisis of 1997-98, so that developing economies could benefit from capital flows. That crisis demonstrated the volatility of capital flows and the catastrophic impact of “sudden stops” on economic activity. Subsequently, the Fund refined its position on deregulation, advising governments to implement adequate supervisory and regulatory regimes before liberalizing their capital accounts, and to begin with opening to foreign direct investment before allowing short-term capital. The IMF moved further during the global financial crisis when it allowed Iceland to implement controls. The Institutional View was adopted in 2012, when countries such as Brazil used CFMs to manage the inflows of foreign capital seeking higher yields than those available in the U.S. The CFMs were part of a toolkit that also includes Macroprudential Prudential Measures (MPMs), which are designed to limit systemic risks. CFM/MPMs are measures designed to limit such risk by controlling capital flows.

The IMF’s new proposals are presented in an IMF Policy Paper, “Review of the Institutional View on the Liberalization and Management of Capital Flows.”  The first proposal extends the Institutional View by allowing the preemptive use of CFM/MPMs on foreign currency debt inflows in order to address the systemic risk that could result from foreign exchange mismatches on balance sheets. Such mismatches can occur slowly, and not just following surges. They increase the probability of capital flow reversals and exchange rate depreciations that disrupt economic activity and could not be adequately addressed with conventional policy tools.

The proposal would also allow CFM/MPMs in the case of high foreign investor participation in local-currency debt markets. In these cases, the danger is a “sudden stop” by foreign investors, which would have particularly adverse consequences if there were illiquid capital markets. Other domestic measures may be unavailable, and the CFM is a second-best solution.

The second proposed policy change exempts certain types of capital control measures that are enacted by governments for specific purposes from review. These include: first, measures adopted for national or international security; second, measures based on international prudential standards, such as those related to the Basel Framework on banking; third, measures designed to deal with money laundering and the combating of financial terrorism; and fourth, measures related to international cooperation standards related to the avoidance or evasion of taxes.

The usefulness of preemptive policies has been demonstrated in a new NBER working paper, “Preemptive Policies and Risk-Off Shocks in Emerging Markets” by Mitali Das and Gita Gopinath of the IMF and Sebnem Kalemli-Özcan of the University of Maryland. The authors investigate the impact of preemptive CFMs on the external finance premia in 56 emerging markets and developing economies during the Taper Tantrum and the COVID-19 shocks. The premia are measured by deviations from uncovered interest rate parity. They consider the impact of CFMs on inflows and outflows, as well as the effect of domestic MPMs.

The paper’s authors report that countries with preemptive CFMs on inflows in place during the five-year period preceding the shocks experienced lower premia and exchange rate volatility. They infer that use of the CFMs provide enhanced access to international capital markets during volatile periods. CFMs on outflows, on the other hand, had a positive effect on the UIP premiums, which may reflect the demand by foreign investors for higher returns to compensate for the CFMs in outflows.

The IMF’s capital flow policies under the Institutional View had been reviewed by the IMF’s Independent Evaluation Office (IEO) in its 2020 report , “IMF Advice on Capital Flows.” The report praised the IMF for the changes in its policy stance, and called the adoption of the Institutional View “a major step forward.” The IEO’s report, however, also called for further changes, including revisiting the Institutional View to take into account recent experience with capital flows, building up the monitoring, analysis and research of capital acccount issues, and strengthening multilateral cooperation on policy issues.

Anton Korinek of the University of Virginia, who wrote a briefing paper for the IEO report, Prakash Loungani, assistant director of the IEO and co-leader of the 2020 report, and Jonathan Ostry of Georgetown University, who was at the IMF when it issued the Institutional View, have written a review of the IMF’s latest policy proposals, “The IMF’s Updated View on Capital Controls: Welcome Fixes but Major Rethinking Is Still Needed.” While welcoming the new measures, they bring up several additional issues that should be addressed. These include the use of capital controls for domestic objectives, such as the impact of capital flows on income inequality and also real estate prices. Such a move would in many ways be consistent with the original aims of the Bretton Woods agreements.

The authors point out that the targets for the IMF’s capital policies are the host countries that receive capital inflows. But challenges associated with capital flows should also involve the countries that are the source of the capital flows. Since these are usually the advanced economies which have a major role in the IMF’s governance, such a move would require the cooperation of the IMF’s most influential members.

Korinek, Loungani and Ostry also urge the IMF to investigate the use of controls on capital outflows. The Fund’s current policy stance only approves the use of such measures during crises. Given the current economic and financial situation (see, for example, here), governments of developing countries are concerned about a repeat of the outflows of March and April 2020. The IMF should be working with these policymakers now to minimize the turbulence that large capital outflows would bring.