Capital Flows in a World of Low Interest Rates

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Interest rates in advanced economies continue to persist at historically low levels. This trend is due not only to the response of central banks to slow growth, but also fundamental factors. If these interest rates continue close to their current levels, what are the consequences for international capital flows?

The decline in rates in the advanced economies has been widely documented and studied. Lukasz Rachel and Thomas D. Smith of the Bank of England have investigated the determinants of the fall in global real interest rates. They attribute the decline in part to increased savings due to demographic forces, higher inequality and a glut of precautionary savings in emerging markets. Investment spending, which has fallen due to the falling price of capital and lower public investment, also contributes to low interest rates. Most of these factors, they claim, will continue to prevail.

Lukasz Rachel and Larry Summers of Harvard have also looked at falling real rates in the advanced economies, which they attribute to secular stagnation. They point out that since the current rates reflect higher levels of government debt, the interest rate that we would observe if there was only a private sector would be even lower. They urge policymakers to tolerate fiscal deficits and also to engage in policies to increase private investment.

The low rates have been an incentive to potential borrowers, and consequently debt levels have risen. The IMF has updated its Global Debt Database,  which includes private and public debt for 190 countries dating back to the 1950s. The data show that the three currently most indebted countries are China, Japan and the U.S., accounting for more than half of global debt. The increase in the debt of China and other emerging markets is due to increases in private debt. Corporate borrowing in these countries has soared, and much of it is denominated in dollars. Public debt has risen in the advanced economies, and more recently in the emerging market and low-income countries as well.

Last spring IMF Managing Director Christine Lagarde warned of unsustainable debt burdens in some of the low income countries. In recent years, the borrowers have included governments with relatively low risk ratings that may fall lower. In some cases, the increased debt reflects loans from China that are part of that country’s Belt and Road Initiative. IMF officials are concerned that some of these countries will turn to the IMF for assistance of they cannot meet their debt obligations.

The Federal Reserve has indicated that it will not raise its policy rates in the near future.  Consequently, the incentive to search for yield will continue to contribute to the pro-cyclical nature of capital flows in the emerging markets. But the current situation is sustainable for only as long as the existing environment continues.

Martin Wolf of the Financial Times has warned that it is only a matter of time until the next financial crisis erupts. He cites four factors that contribute to the outbreak of such crises. First, over time risk moves out of the most regulated parts of the economy to the least regulated. This makes it more difficult for regulators to assess the fragility of the financial sector. Second, an ideological belief that unregulated markets work best contributes to the proliferation of risky lending. Third, the financial sector is a major contributor to election campaigns. This gives them access to lawmakers who are drafting the laws that govern the operations of the financial sector. Finally, there is the human tendency to forget or ignore past events. This allows the financial sector to engage in risky but profitable activities that enrich those conducting them while the public enjoys access to relatively cheap credit.

Continuing low interest rates, therefore, may alleviate some of the pressure on those borrowers with high debt loads. But they are susceptible to other shocks such as slowing economic growth or the breakdown of trade negotiations between the U.S. and China. If such a shock occurs, we may once again witness a flight to safety that leaves borrowers in emerging markets vulnerable to “sudden stops” of capital that, combined with depreciating exchange rates, will disrupt their economies.

 

 

Mars Descending? U.S. Security Alliances and the International Status of the Dollar

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A decade after the global financial crisis, the dollar continues to maintain its status as the chief international currency. Possible alternatives such as the euro or renminbi lack the broad financial markets that the U.S. possesses, and in the case of China the financial openness that allows foreign investors to enter and exit at will. Any change in the dollar’s predominance, therefore, will likely occur in response to geopolitical factors.

Linda S. Goldberg and Robert Lerman of the Federal Reserve Bank of New York provide an update on the dollar’s various roles. The dollar remains the dominant reserve currency, with a 63% share of global foreign exchange reserves, and serves as the anchor currency for about 65% of those countries with fixed exchange rates. The dollar is also widely utilized for private international transactions. It is used for the invoicing of 40% of the imports of countries other than the U.S., and about half of all cross-border bank claims are denominated in dollars.

This wide use of the dollar gives the U.S. government the ability to fund an increasing debt burden at relatively low interest rates. Moreover, as pointed out by the New York Times, the Trump administration can enforce its sanctions on countries such as Iran and Venezuela because global banks cannot function without access to dollars. While European leaders resent this dependence, they have yet to evolve a financial system that could serve as a viable alternative.

The dollar’s continued predominance may also reflect other factors. Barry Eichengreen of UC-Berkeley and Arnaud J. Mehl and Livia Chitu of the European Central Bank have examined the effect of geopolitical factors—the “Mars hypothesis”—versus pecuniary factors—the “Mercury hypothesis”—in determining the currency composition of the international reserves of 19 countries during the period of 1890-1913. Official reserves during this time could be held in the form of British sterling, French francs, German marks, U.S. dollars and Dutch guilders.

The authors find evidence that both sets of factors played roles. For example, a military alliance between a reserve issuing country and one that held reserves would boost the share of the currency of the reserve issuer by almost 30% if there was a military alliance between these nations. They conjecture that the reserve issuer may have used security guarantees to obtain financing from the security-dependent nation, or to serve the role of financial center when the allied country needed to borrow internationally.

Eichengreen, Mehl and Chitu then use their parameter estimates to measure by how much the dollar share of the international reserves of nations that currently have security arrangements with the U.S. would fall if such arrangements no longer existed. South Korea, for example, currently holds 84% of its foreign reserves in dollars; this share would fall to 54% in the absence of its security alliance with the U.S. Similarly, the dollar component of German foreign exchange reserves would decline from 98% to 68%.

In previous eras, such calculations might be seen as interesting only for providing counterfactuals. But the Trump administration seems intent on cutting back on America’s foreign military commitments. The U.S. and Korea, for example, have not negotiated a renewal of the Special Measures Agreement to finance the placement of U.S. troops in Korea.  German Chancellor Angela Merkel has defended her country’s role in NATO in the face of criticism from President Trump that Germany must spend more on defense expenditures. The possibility of a pan-European army to serve as an alternative security guarantee is no longer seen as totally far-fetched.

The dollar may be safe from replacement on economic grounds. But the imminent shrinkage of the British financial sector due to the United Kingdom’s withdrawal from the European Union  shows that political decisions follow their own logic, sometimes without regard for the economic consequences. If the dollar lose some of its dominance, it may be because of self-inflicted wounds.

Conferences in 2019

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The submission deadlines for several conferences that feature work in international macroeconomics are coming up:

Con Date       Sub Date                Name                                    Location

5/29 – 6/1       1/31             Int’l Trade & Finance              Livorno, Italy

6/9 – 6/11       1/31             INFINITI                                    Glasgow, Scotland

6/13 – 6/16     4/4               Eur Econ & Fin Society           Genoa, Italy

6/27 – 6/28     2/4               Conference on Int’l Econ      Granada, Spain

7/10 – 7/12     3/20             NBER – Int’l Finance               Cambridge, US

7/18 – 7/20      2/2               Central Bank Res Assoc        New York, US

Global Firms, National Policies

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Studies of international transactions often assume that national economies function as separate “islands” or “planets.” Each has its own markets and currency, and international trade and finance occurs when the residents of one economy exchange goods and services or financial assets with those of another. The balance of payments keeps track of the transactions. But in reality firms treat the differences across nations as opportunities to increase their profits, and their decisions on basing the location of their activities–or how they report the basing of the activities–reflect this.

Multinational companies are not new entities; they can be traced back to the European trading companies that colonized the Americas, Asia and Africa. In the twentieth century, firms expanded across borders to get around trade barriers, to obtain access to raw materials, and to produce their goods more cheaply using foreign labor. Advances in the technology of shipping (container ships) and communications (Internet) spurred the development of global supply chains. Firms divided the production of goods among countries in order to manufacture them at the lowest cost before assembly into a final product. Shipments of these intermediate goods have become a major component of international trade, and intermediate inputs represent a significant portion of the value of exports .

This stratification of production has several implications, as Shimelse Ali and Uri Dadush of the Carnegie Endowment for International Peace have pointed out. Bilateral trade balances, for example, are distorted. U.S. imports from China contain a significant amount of intermediate inputs from other countries. Measuring only the value-added by Chinese firms to their exports lowers its trade surplus with the U.S. by a significant amount.

Moreover, tariffs on intermediate goods have impacts all along the global supply chain. The trade restrictions imposed by the Trump administration are rippling through the U.S. economy, raising the costs of production for those firms that depend on foreign supplies of goods that are subject to the tariffs. Daniel Ikenson of the Cato Institute has found that the U.S. transportation, construction and manufacturing sectors are those that are among those most affected by the tariffs. If the tariffs are not removed, firms will reconsider investing in new production facilities.

Global supply links also affect the current accounts of the nations where the multinationals are based. When these firms establish foreign subsidiaries in order to take advantage of cheaper costs abroad, then their home countries record less trade but more primary income resulting from the operations of the subsidiaries. The countries that receive the largest amounts of primary income include the U.S., Japan, France and Germany, all home countries of multinationals with extensive foreign operations. Net primary income does not receive as much publicity as fluctuations in the balance of trade, but the primary income balance has increased in magnitude, and in some cases dominates the current account. Japan’s net income surplus has in some years more than offset its trade deficits, while the United Kingdom’s current account deficit is due primarily to its net income deficit.

These foreign operations also give the multinational firms the opportunity to take advantage of differences in national tax systems. Stefan Avdjiev and Hyun Song Shin of the of the Bank for International Settlements and Mary Everett and Philip R. Lane of the Central Bank of Ireland have shown some of the consequences of these maneuvers. Firms can manipulate the value of their foreign profits in order to lower their tax liabilities. Until recently, the U.S. taxed multinational firms headquartered here on their global profits, with credits given for foreign taxes. The foreign profits were not taxed until they were repatriated. Firms could book profits in low-tax jurisdictions—known as “tax havens”—and keep those profits outside the U.S.

Those foreign profits could be increased by lowering the recorded cost of inputs from the U.S. and raising the value of goods sent back, thus increasing the profits recorded by the foreign subsidiary. Such “transfer prices” should be based on their market value, but in many cases there are none, which give the firms the opportunity to understate their domestic profits and overstate their foreign profits, which are subject to the lower tax. Similarly, intellectual property assets could be shifted to low-tax jurisdictions.

Thomas R. Tørsløv and Ludvig Wier of the University of Copenhagen and Gabriel Zucman of UC-Berkeley have investigated this movement of profits to tax havens. They estimate that about 40% of multinational profits are shifted to tax havens, such as Ireland, Luxembourg and Singapore.  As a result, the home countries of the multinational firms—particularly the non-haven European Union nations—lose tax revenues. The shareholders of the multinationals—particularly those based in the U.S.—are among the main winners.

Governments are well aware of the activities of the multinationals, and the loss of tax revenues. Kim Clausing of Reed College has estimated that profit shifting by U.S. multinational corporations reduces U.S. government tax revenues by more than $100 billion each year. The Organization of Economic Cooperation and Development has taken the lead in formulating policies to tackle what it calls “Base Erosion and Profit Shifting (BEPS). To date over 100 countries have agreed to participate. The recent tax code changes in the U.S. have greatly reduced the incentive for U.S. firms to record and hold profits overseas. Multinationals such as Google and Starbucks are receiving close scrutiny of their international profits, and Apple has been ordered to pay back taxes to Ireland.

The OECD’s initiative, as well as the work of advocacy groups such as the Tax Justice Network, has increased the visibility of the activities of the multinationals designed to lower taxes. But the existence of different factor costs and divergent tax codes will always provide incentives for tax lawyers and accountants to devise new ways of lowering the taxes of the multinationals. In a Westphalian world, domestic governments are reluctant to give up their sovereignty. As a result, multinationals that are much more adept in dancing around national borders will  take advantage of any opportunities they see.

Global Networks and Financial Instability

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The ten-year anniversary of the global financial crisis has brought a range of analyses of the current stability of the financial system (see, for example, here). Most agree that the banking sector is more robust now due to increased capital, less leverage, more prudent balance sheets and better regulation. But systemic risk is an inherent feature of finance, and a disturbance in one area can quickly spread to others through global networks.

The growth of financial markets and institutions during the 1990s and 2000s benefitted many, including those in emerging market economies that became integrated with world markets during this period. But the large-scale extension of credit to the housing sector led to property bubbles in the U.S., as well as in Ireland and Spain. The development of financial instruments such as mortgage backed securities (MBS), collateralized debt obligations (CDOs), and credit default swaps (CDS) were supposed to spread the risk of lenders in order to mitigate the impact of a negative price shock. However, these instruments and the extension of credit to subprime borrowers increased the vulnerability of financial institutions to reversals in the housing markets. Risk increased in a non-linear fashion as balance sheets became highly leveraged, and national regulators simply did not understand the nature and scale of these risks.

The holdings of assets across borders amplified the impact of the disruption of the U.S. financial markets once housing prices fell. European banks that had borrowed dollars in order to participate in the U.S. MBS markets found themselves exposed when dollar funding was no longer available. The gross flows of money between the U.S. and Europe increased the ties between their institutions and increased the fragility of their financial markets. It took the the establishment of swap networks between the Federal Reserve and European central banks to provide the necessary dollar funding.

John Kay has written about the inability to recognize and minimize systemic risk in financial systems in Other People’s Money: The Real Business of Finance. He draws from engineers the lesson that “…stability and resilience requires conscious and systematic simplification, modularity, which enables failures to be contained, and redundancy, which allows failed elements to be by-passed. None of these features—simplification, modularity, redundancy—characterized the financial system as is had developed in 2008.”

Similarly, Ian Goldin of Oxford University and Chris Kutarna examined the impact of rising financial complexity on the stability of financial systems in the period leading up to the crisis: “Cumulative connective and developmental forces produced a global financial system that was suddenly far bigger and more complex than just a decade before. This made the new hazards harder to see and simultaneously spread the dangers more widely—to workers, pensioners, and companies worldwide.”

Goldin and Mike Marithasan of KU Leuven also looked at the impact of increasing complexity on financial systems in The Butterfly Defect: How Globalization Creates Systemic Risks, and What to Do About It. They use Iceland as an example of how complex financial relationships were constructed with virtually no understanding of the consequences if they unraveled. They draw several lessons for dealing with a more complex financial networks. These include global oversight by regulators using systemic analysis, and the use of simple rules such as leverage ratios rather than complex regulations.

The Basel III regulatory regime follows this advice in a number of areas. But the basic vulnerability of financial networks remains. Yevgeniya Korniyenko, Manasa Patnam, Rita Maria del Rio-Chanon and Mason A. Porter have analyzed the interconnectedness of the global financial system in an IMF working paper, “Evolution of the Global Financial Network and Contagion: A New Approach.” They use a multilayer network framework with data on foreign direct investment, portfolio equity and debt and bank loans over the period 2008-15 to analyze the global financial network.

The authors compare the networks for the years 2009 and 2015, and report which countries are systematically important in the networks. They find that the U.S. and the U.K. appear at the top of these rankings in both of the selected years, although the cross-border holdings of U.S. financial institutions has increased over time while those of the U.K.’s institutions fell. China has moved up in the rankings, as have other Asian countries such as Singapore and South Korea. The authors conclude that “The global financial network remains most susceptible to shocks coming from large central countries…and countries with large financial systems (namely, the USA and the UK)…”

A decade after the global crisis, the possibility of the rapid propagation of a financial shock remains. There is more resiliency in those parts of the financial system that failed in 2008, but the current most vulnerable areas may not be identified until there is a new crisis. Policymakers who ignore this reality will be tripped up when the next shock occurs, and they will learn that  “The past is not dead. It’s not even past.”

U.S. Interest Rates and Global Banking in Emerging Market Economies

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The spillover effects of changes in U.S. interest rates are widely recognized (see here and  here). An increase in rates, for example, raises the cost of dollar-denominated financing outside the U.S., which has grown in recent years, while an appreciation of the dollar makes such debt even more expensive to service and refinance. The emerging markets are among the nations adversely affected by the rise in U.S. interest rates. Several recent research papers have shown how global bank lending in these economies is affected.

Stefan Avdjiev, Cathérine Koch, Patrick McGuire and Goetz von Peter of the Bank for International Settlements investigate the impact of a change in U.S. monetary policy on cross-border lending by global banks in their paper, “Transmission of Monetary Policy through Global Banks: Whose Policy Matters?”, BIS Working Paper no. 745. In their analysis they also investigate the effect of changes in the policy stance of the central banks of both the country of the borrower as well as the home country of the lending bank. They use data on cross-border claims denominated in U.S. dollars held by international banks in 32 lender countries on borrowers in 55 countries over the period of 2000-2016.

The authors find that a tightening in U.S. monetary policy does lead to a decrease in dollar-denominated lending, as expected. But they also find that a more contractionary monetary policy in the lending country leads in a rise in cross-border dollar lending out of that country, presumably as the banks within the country switch to the cheaper dollar funding. Similarly, monetary tightening in the country of the borrower also leads to an increase in dollar-denominated credit, although these results are less robust.

The authors then investigate some of the transmission channels and seek to identify which characteristics of the banks are most relevant for these effects. They find, for example, that the negative effect of a tightening in U.S. monetary policy is smaller for banks that are more reliant on short-term wholesale funding and have better access to intragroup funding. These banks may have more alternatives to turn to when the cost of borrowing in dollars rises.

Another analysis of the effects of U.S. monetary policy on credit to emerging markets is offered by Falk Bräuning of the Federal Reserve Bank of Boston and Victoria Ivashina of Harvard Business School in “U.S. Monetary Policy and Emerging Market Credit Cycles”, NBER Working Paper no. 25185. They investigate the impact of shocks in U.S. monetary policy on the issuance of global syndicated corporate loans in a broad range of countries between 1990 and 2016. Dollar-denominated loans represent a large share of cross-border credit in the emerging market economies.

Their results indicate that an easing (tightening) of U.S. monetary policy leads to a rise (decline) in bank flows to the foreign markets. When they distinguish between developed economies and emerging markets, they find that the impact is about twice as large in the latter group. They also report that this result holds for U.S. and non-U.S. lenders, and that this linkage existed before the global financial crisis.

Ilhyock Shim of the Bank for International Settlements and Kwanho Shin of Korea University offer another line of analysis of global bank activity in emerging market economies in “Financial Stress in Lender Countries and Capital Outflows From Emerging Market Economies”, BIS Working Paper no. 745. In their empirical analysis, they use data from bilateral banking flows to construct a measures of capital outflows from the emerging markets to each lender country. To measure stress in lender countries, they use three indicators: an average of bank credit default spreads (CDS) for 66 banks in 29 lender countries, sovereign CDS spreads in the banks’ home countries, and the spread between dollar-denominated corporate bonds in each lender country and the matching U.S. Treasury yield. They also use sovereign spreads for financial stress in the 67 borrower nations.

The authors find that an increase in financial stress in the lending country leads to capital outflows from the emerging markets. When the measure of financial stress in the emerging market is included, it is also significant. But when economic fundamental variables in the emerging markets are added, the significance of stress in the lender countries continues to be strong while stress in the emerging markets is not. In addition, they report that cross-border claims are particularly vulnerable to stress in the lender countries. They also find these results hold in the post-financial crisis period.

Shim and Shin point out that one of the policy implication of their results draw is that strong economic fundamentals in an emerging market economy may not be sufficient to prevent capital outflows during a period of stress in lending countries. The same lesson applies for these countries if U.S. interest rates are rising. Flexible exchange rates, the standard buffer from foreign shocks, may not be able to change global banking flows.

Federal Reserve officials are attempting to pull off a difficult task: raising interest rates without ending the recovery in the U.S. Within the U.S. this challenge has been complicated by the short-run effects of expansionary fiscal policies that are due to run out in coming months. If the rise in rates also contributes to a slowdown in bank lending in other countries, the Fed will face enormous pressure to put further rate hikes on hold.  We have seen the story of higher U.S. rates and emerging market economies before, and the ending is not pretty.

The 2018 Globie: “Crashed”

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Each year I choose a book to be the Globalization Book of the Year, i.e., the “Globie”. The prize is strictly honorific and does not come with a check. But I do like to single out books that are particularly insightful about some aspect of globalization.  Previous winners are listed at the bottom.

This year’s choice is Crashed: How a Decade of Financial Crises Changed the World by Adam Tooze of Yale University. Tooze, an historian, traces the events leading up to the crisis and the subsequent ten years. He points out in the introduction that this account is different from one he may have written several years ago. At that time Barak Obama had won re-election in 2012 on the basis of a slow but steady recovery in the U.S. Europe was further behind, but the emerging markets were growing rapidly, due to the demand for their commodities from a steadily-growing China as well as capital inflows searching for higher returns than those available in the advanced economies.

But the economic recovery has brought new challenges, which have swept aside established politicians and parties. Obama was succeeded by Donald Trump, who promised to restore America to some form of past greatness. His policy agenda includes trade disputes with a broad range of countries, and he is particularly eager to impose trade tariffs on China. The current meltdown in stock prices follows a rise in interest rates normal at this stage of the business cycle but also is based on fears of the consequences of the trade measures.

Europe has its own discontents. In the United Kingdom, voters have approved leaving the European Union. The European Commission has expressed its disapproval of the Italian government’s fiscal plans. Several east European governments have voiced opposition to the governance norms of the West European nations. Angela Merkel’s decision to step down as head of her party leaves Europe without its most respected leader.

All these events are outcomes of the crisis, which Tooze emphasizes was a trans-Atlantic event. European banks had purchased held large amounts of U.S. mortgage-backed securities that they financed with borrowed dollars. When liquidity in the markets disappeared, the European banks faced the challenge of financing their obligations. Tooze explains how the Federal Reserve supported the European banks using swap lines with the European Central Bank and other central banks, as well as including the domestic subsidiaries of the foreign banks in their liquidity support operations in the U.S. As a result, Tooze claims:

“What happened in the fall of 2008 was not the relativization of the dollar, but the reverse, a dramatic reassertion of the pivotal role of America’s central bank. Far from withering away, the Fed’s response gave an entirely new dimension to the global dollar” (Tooze, p. 219)

The focused policies of U.S. policymakers stood in sharp contrast to those of their European counterparts. Ireland and Spain had to deal with their own banking crises following the collapse of their housing bubbles, and Portugal suffered from anemic growth. But Greece’s sovereign debt posed the largest challenge, and exposed the fault line in the Eurozone between those who believed that such crises required a national response and those who looked for a broader European resolution. As a result, Greece lurched from one lending program to another. The IMF was treated as a junior partner by the European governments that sought to evade facing the consequences of Greek insolvency, and the Fund’s reputation suffered new blows due to its involvement with the various rescue operations.The ECB only demonstrated a firm commitment to its stabilizing role in July 2012, when its President Mario Draghi announced that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro.”

China followed another route. The government there engaged in a surge of stimulus spending combined with expansionary monetary policies. The result was continued growth that allowed the Chinese government to demonstrate its leadership capabilities at a time when the U.S. was abandoning its obligations. But the ensuing credit boom was accompanied by a rise in private (mainly corporate) lending that has left China with a total debt to GDP ratio of over 250%, a level usually followed by some form of financial collapse. Chinese officials are well aware of the domestic challenge they face at the same time as their dispute with the U.S. intensifies.

Tooze demonstrates that the crisis has let loose a range of responses that continue to play out. He ends the book by pointing to a similarity of recent events and those of 1914. He raises several questions: “How does a great moderation end? How do huge risks build up that are little understood and barely controllable? How do great tectonic shifts in the global world order unload in sudden earthquakes?” Ten years after a truly global crisis, we are still seeking answers to these questions.

Previous Globie Winners:

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

2016    Branko Milanovic, Global Inequality

2015    Benjamin J. Cohen. Currency Power: Understanding Monetary Rivalry

2014    Martin Wolf, The Shifts and the Shocks: What We’ve Learned–and Have Still to Learn–from the Financial Crisis

 

The Continuing Dominance of the Dollar

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Ten years after the global financial crisis, we are still coming to an understanding of how profound a shock it was. The changes in political alignments within and across nations and the diminished public support for globalization continue. But one aspect of the financial system has not changed: the dominance of the U.S. dollar in the monetary system.

An article by Fernando Eguren Martin, Mayukh Mukhopadhyay and Carlos van Hombeeck of the Bank of England in the BOE’s Quarterly Bulletin documents the different international roles of the dollar. First, it continues to be the main currency in central bank reserves, with a share of about 70% of total holdings. Second, the dollar is used as an invoicing currency for many international transactions, such as commodity sales. Third, firms outside the U.S. obtain funding through dollar-denominated bank loans and debts.

The use of the dollar for finance has also been examined by Iñaki Aldasoro and Torsten Ehlers of the Bank for International Settlements in an article in the BIS Quarterly Review. They report a rise in the use of international debt securities, driven primarily by dollar denominated debt issued by non-U.S. residents. The increase in such funding is particularly noticeable in emerging markets economies in Asia and Latin America. This debt includes sovereign bonds issued by governments that sought to lock in low interest rates.

What about the alternatives? A report on the international role of the euro issued by the European Central Bank acknowledges the primacy of the dollar. An index of the global status of the euro developed at the ECB shows a decline in the last fifteen years, which may have stabilized in the most recent year. This includes a fall in the euro’s share of international debt securities. The report also notes that the deleveraging of Eurozone banks as they built up their capital ratios led these banks to reduce their cross-border lending.

Why does the dollar continue to possess a hegemonic status a decade after the crisis that seemed to signal an end to U.S.-U.K. dominated finance? Gillian Tett of the Financial Times offers several reasons. The first is the global reach of U.S. based banks. U.S. banks are seen as stable, particularly when compared to European banks. Any listing of the largest international banks will be dominated by Chinese banks, and these institutions have expanded their international business.  But the Chinese banks will conduct business in dollars when necessary. Tett’s second reason is the relative strength of the U.S. economy, which grew at a 4.1% pace in the second quarter. The third reason is the liquidity and credibility of U.S. financial markets, which are superior to those of any rivals.

The U.S. benefits from its financial dominance in several ways. Jeff Sachs of Columbia University points out that the cost of financing government deficits is lower due to the acceptance of U.S. Treasury securities as “riskless assets.” U.S. banks and other institutions earn profits on their foreign operations. In addition, the use of our banking network for international transactions provides the U.S. government with a powerful foreign policy tool in the form of sanctions that exclude foreign individuals, firms or governments from this network.

There are risks to the system with this dependence. As U.S. interest rates continue to rise, loans that seemed reasonable before now become harder to finance. The burden of dollar-denominated debt also increases as the dollar appreciates. These developments exacerbate the repercussions of policy mistakes in Argentina and Turkey, but also affect other countries as well.

The IMF in its latest Global Financial Stability (see also here) identifies another potential destabilizing feature of the current system. The IMF reports that the U.S. dollar balance sheets of non-U.S. banks show a reliance on short-term or wholesale funding. This reliance leaves the banks vulnerable to a liquidity freeze. The IMF is particularly concerned about the use of foreign exchange swaps, as swap markets can be quite volatile. While central banks have stablished their own network of swap lines, these have been criticized.

The status of the dollar as the primary international currency is not welcomed by foreign governments. The Russian government, for example, is seeking to use other currencies for its international commerce. China and Turkey have offered some support, but China is invested in promoting the use of its own currency. In addition, Russia’s dependence on its oil exports will keep it tied to the dollar.

But interest in formulating a new international payments system has now spread outside of Russia and China. Germany’s Foreign Minister Heiko Maas has called for the establishment of “U.S. independent payment channels” that would allow European firms to continue to deal with Iran despite the U.S. sanctions on that country. Chinese electronic payments systems are being used in Europe and the U.S. The dollar may not be replaced, but it may have to share its role as an international currency with other forms of payment if foreign nations calculate that the benefits of a new system outweigh its cost. Until now that calculation has always favored the dollar, but the reassessment of globalization initiated by the Trump administration may have lead to unexpected consequences.

The Euro At Twenty: Mody’s EuroTragedy

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The euro will mark its twentieth anniversary in 2019. Is this a cause of celebration and congratulations? Or a case of a well-intentioned policy gone awry? Ashoka Mody in his new book , EuroTragedy: A Drama in Nine Acts, offers an account that shows that the joint currency was flawed from the outset, and has been further weakened by poor policy choices.

Mody, a distinguished research economist at the IMF for many years, is currently the Charles and Marie Robertson Visiting Professor in International Economic Policy at the Woodrow Wilson School at Princeton University. His book is a combination of scholarship and storytelling, as Mody analyzes the background of the euro, its evolution and future prospects. He does a wonderful job in portraying the European figures who advanced the monetary union, often in the face of public indifference or opposition. At the end, he is deeply pessimistic about the viability of the common currency and its impact on the European economies that use it.

The decision to introduce the euro was based on political aspirations, not economic need. The history begins with the European Coal and Steel Community formed in 1951 by France, Germany, Italy, Belgium, the Netherlands and Luxembourg. This was followed in 1958 by the formation of the European Economic Community, a common market and customs union for the same six nations. These associations sought to bind together the economies of Europe, which had been shattered by two world wars and the Great Depression. However, national sovereignty over domestic policies, particularly taxes and government expenditures, was asserted by the leaders of the member countries from the very beginning.

The next step took place in 1969 when French President Georges Pompidou called for a European monetary union. Pompidou was motivated by a desire to end the chronic devaluations of the French franc against the German mark. Despite skepticism over the feasibility of a common currency, West German Chancellor Willy Brandt , whose main priority was the reunion of both halves of Germany, gave a tentative endorsement, based on an understanding that there would be “harmonization” of fiscal policies. But this was a conditional agreement, and the terms were left undefined. The consequences of that ambiguity have bedeviled the implementation of the euro to the current day.

Denmark, Ireland and the United Kingdom joined the original six nations in 1973, and more joined in the 1980s. The formation of the European Monetary System in 1978 to fix exchange rates amongst these nations was a step on the road to a monetary union. The currency crises of 1981 and 1982, however, showed the risks in such integration, and for much of the 1980s further progress seemed stalled. Mody tells well the story of the change in the position of Germany’s leader Helmut Kohl, who sought to unify Europe after his own country came together in 1989. Kohl’s endorsement ensured that there would be sufficient support amongst European leaders for the euro. Kohl, however, never overcame the doubts and concerns of German policymakers and business leaders over how a common currency would affect Germany itself. The Germans were particularly wary of the possibility that they would be required to come to the assistance of other less credit-worthy members.

In addition to German concerns about its responsibilities, there were flaws in the design of the euro. Those countries that join a monetary union lose the ability to use national monetary policy to stabilize their national economies. In theory, this vulnerability can be offset by fiscal transfers from a central source to the areas affected by asymmetric shocks that the union’s central bank does not address, much as the U.S. federal government can allocate funds to areas in emergency.  But such a redistribution mechanism was never established for the Eurozone, in large part due to opposition from Germany and other members. In addition, domestic fiscal policy is constrained by the Stability and Growth Pact (SGP), which puts a limit on budget deficits of 3% of GDP. Since an economic contraction lowers tax revenues, a government facing a recession will already be in danger of violating the SGP mandate, and therefore cannot increase its own spending to counter the downturn.

In addition to this fundamental flaw, the viability of the euro has been hampered by the policies of the European Central Bank (ECB).  The ECB has a single mandate: maintain price stability.  The limitations of that charge became quite clear during the global financial crisis, but were amplified by the unwillingness of ECB President Jean-Claude Trichet to acknowledge the depth of the crisis and formulate an adequate response. Federal Reserve Chair Ben Bernanke was much more aggressive in responding with unconventional policy moves such as Quantitative Easing. This timidity was compounded by premature calls for fiscal austerity during the slow economic recovery.

The Greek debt crisis amply demonstrated the division within the Eurozone over what obligations member governments have to come to the aid of another member in fiscal distress. Mody believes that Italy now poses the biggest current threat to the structure of the Eurozone. That country adopted the euro in the belief that it would act as a “vincolo esterno,” an external constraint that would impose sound policies on a fractious political system. But a common currency cannot improve low productivity growth due to poor governance and institutions.

The protracted pace of the recovery in Italy from the global crisis has frustrated its citizens, who have turned to populist parties—the Northern League and the Five Star Movement—that were once seen as fringe movements. The parties have dropped their opposition to the euro because of public sentiment. But the new government is determined to proceed with its fiscal plans, which include a flat tax rate and a universal income. The resulting deficit would violate the European Commission’s fiscal rules and raise Italy’s debt burden. The current public debt/GDP ratio of 131% is exceeded within the Eurozone only by that of Greece. While an Italian exit from the European Union seems impossible, the Italian government and the European Commission each seem determined to make the other side move first towards a compromise in an international game of chicken.  In such circumstances there is ample opportunity for miscommunication and misunderstanding. Given the size of the Italian economy, any rupture could be catastrophic.

Mody is not anti-European. Indeed, he calls for a renewal of the European identity of a group of nations that compete in the “marketplace of ideas,” and together form a European Republic of Letters. But the euro has not fostered that identity, and in is based on an inherent flaw:

“The original conundrum remains. A single monetary policy for diverse countries cannot operate effectively without a mechanism to share risks in crisis conditions. Eurozone leaders cannot agree to a risk-sharing mechanism based on a democratically legitimate political contract. Under pressure during the crisis years, they agreed on technical agreements to share risks. These arrangements can be undone politically at an inopportune moment.”  (Mody, p. 385)

Mody’s book provides an important lesson: policies imposed by political elites that are not endorsed by the public who are supposed to benefit from them have weak underpinnings. A crisis uncovers the flaws in the institutional architecture, and these exacerbate the impact of the crisis. The resulting tragedy affects everyone, not just those who promoted a solution to a problem that did not exist.