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The Global Impact of the Fed’s Pivot on Asset Purchases

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Federal Reserve Chair Jerome Powell announced last month that the Fed would slow its purchases of bonds, most likely by the end of this year. The timing of the cutback will depend on several factors related to the economy, and last week’s disappointing employment report if repeated could push back the date. The financial markets will now begin anticipating the impact of the reduction in the Fed’s asset holdings.

The origins of the increase in the Fed’s holdings of Treasury bonds and mortgage-backed securites can be traced back to the global financial crisis. The Fed’s assets grew from $870 billion in August 2007 to $2 trillion in early 2009. When the Fed introduced its quantitative easing program, it claimed that the purchases of bonds would lead to lower long-term interest rates more quickly than if it relied only on lowering the Federal Funds rate. In addition, the purchases showed the Fed’s commitment to keeping interest rates low in order to boost the economic recovery. This latter form of signaling was called “forward guidance.”

Subsequent quantitative easing programs eventually raised its holdings to $4.5 trillion by 2015. The Fed maintained that level until 2018, when it allowed its holdings to fall as bonds matured. But it reversed course in 2019, and the Fed responded to the pandemic in the spring of 2020 by ramping up its purchases of assets in order to support the financial markets. Its asset holdings now total about $8.3 trillion.

The Fed has not been alone in using asset purchases as a tool of policy. The European Central Bank increased its holdings of bonds during the period preceding the pandemic from 2 trillion Euros at the end of 2014 to 4.6 trillion Euros. It accelerated its purchases last year and now holds about 8.2 trillion Euros in assets. The Bank of Japan and the Bank of England have their own versions of asset purchase programs. Many of these central banks have also announced changes in the pace of their asset purchases.

When then Fed chair Ben Bernanke noted in 2013 that continued strengthening of the economy could lead to a cutback in asset purchases, this was interpreted as a sign that the Fed would also allow interest rates to rise. This led to the infamous “taper tantrum,” as financial markets overreacted to the prospects of higher interest rates. The response included capital outflows from emerging market countries such as India as their exchange rates depreciated and their own asset markets fell in value. Stability was eventually reestablished once the Fed clarified that it had no plans to enact a contractionary policy, but the incident demonstrated the volatility of financial markets, particularly in the emerging market countries.

Powell has sought to avoid such an outcome by explicitly delinking asset purchases from interest rates. He pledged to keep the Federal Funds rate at its current setting until “maximum employment and sustained 2% inflation” area achieved. The (lack of a)  response in the financial markets to Powell’s speech seemed to indicate that this promise was seen as credible, despite concerns about inflation.

But there will be consequences when the Fed cuts back on its asset purchases. The increases in the Fed’s balance sheet, as well as those of the other central banks, released a wave of liquidity with wide-ranging consequences. In the U.S. it has kept stock price valuations at elevated levels, which contributes to widening wealth inequality. For example, in 2019 families in the top 10% of the income distribution owned 70% of total stock values. Similarly, the provision of easy credit has contributed to rising housing prices that also reflects demand and supply conditions.

The increase in liquidity also benefited emerging markets and developing economies. In the period immediately before the pandemic the World Bank warned that the world had experienced a rise in debt, both private and government. Total debt in the emerging markets and developing economies had risen from 114% of their GDP in 2010 to 170% at the end of 2018. Part of this increase reflected accommodative monetary policies in the advanced economies and a search for higher yield by investors in those countries. A rising global demand for the bonds of the emerging market and developing economies countries was met by an increase in their issuance.

These countries suffered massive reversals of foreign capital in the spring of 2020. The “sudden stops” confirmed the existence of a global financial cycle that can overwhelm vulnerable economies. But the withdrawals were soon reversed, in part because investors were reassured by the rapid responses of central banks in the advanced economies to the financial meltdown.

There are many who voice concerns about the ending of the current financial cycle. Mohammed El-Erian, president of Queens’ College of Cambridge University, is worried about the excessive risk-taking that the financial sector has undertaken in response to its “unhealthy codependency” with central banks.  Raghuram Rajan of the University of Chicago’s Booth School of Business is alarmed about the impact that future interest rate hikes could have on government finances. Jeremy Grantham of asset management firm GMO believes that the stock market will experience a massive crash. And IMF Managing Director Kristalina Georgieva is concerned about a diveregence in the prospects of advanced economies and a few emerging markets versus those of most developing economies that could lead to a debt crisis.

Much of the impact of the policy changes at the Federal Reserve depends on how the financial markets respond to the slowdown in purchases, and whether the Fed is successful in delinking a cutback in asset purchases from its interest rate policy. The lack of a strong response in the bond markets suggests that there has not been a change in expectations of future interest rates. But ouside the U.S. there is always the prospect that a slowdown in economic growth and the continuation of the pandemic imperil the solvency of corporate and government borrowers. These developments would be enough to fuel a debt crisis despite the Fed’s careful footwork.

The Long Reach of U.S. Monetary Policy

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The spillover of U.S. monetary policy on foreign economies has become an active area of research. Analysts seek to identify the channels of transmission between the policy stance of the Federal Reserve and foreign interest rates and credit extension. The usual account is that an expansionary Fed policy leads to capital outflows and an appreciation of foreign currencies as investors seek higher yields abroad. Two recent papers have focused on different aspects of this linkage.

Silvia Albrizio of the Bank of Spain, Sangyup Choi of Yonsei University, Davide Furceri of the IMF and Chansik Yoon of Princeton University investigated the impact of monetary tightening on cross-border bank lending in an IMF working paper, “International Bank Lending Channel of Monetary Policy.” Previous work was divided on whether a contractionary U.S. policy would lead to a decline or an increase in international bank lending. These economists used data on exogenous policy shocks in the U.S., which are based on the narrative approach of  Romer and Romer (2004), to examine their impact on cross-border bank lending in 45 countries.

The results show clear signs of a significant negative effect of U.S. monetary policy shocks on cross-border lending. A 100 basis point rise in the policy rate leads to a sizable more than 10% fall in lending after two quarters. When the authors extended their analysis to include monetary policy shocks in Canada, Germany, Italy, Japan, the Netherlands, Spain, Sweden and the U.K., they again found that exogenous monetary tightening in these economies led to a decline in cross-border bank lending. These results hold even when the authors control for global uncertainty or liquidity risks.

Sebnem Kalemli-Özcan of the University of Maryland focused on the impact of U.S. monetary policy changes on risk in her 2019 Jackson Hole presentation, “U.S. Monetary Policy and International Risk Spillovers.” In her analysis, there are two components of risk, global risk and country-specific risk, and these are crucial elements in the transmission of changes in U.S. policies to the emerging market economies. In these countries, a tightening of U.S. monetary policy leads to a rise in global risk as well as an increase in country risk. These changes in the risk premia affect the domestic response to the U.S. policy. The advanced economies, on the other hand, do not show similar responses.

For example, in the empirical analysis Kalemli-Özcan finds that an increase in the U.S. Treasury rate leads to an increase in the differential with domestic government bond rates in her sample of 46 emerging market economies, but a decline in the same differential in her sample of 13 advanced economies. However, the differential in the emerging market countries falls when a measure of global risk aversion (VIX) is added to the analysis, and becomes insignificant when an indicator of country risk (Emerging Market Bond Index Global of JPMorgan) is also utilized.

Risk premia also affect the linkage of domestic policy rates and lending rates. The presence of risk injects a wedge between the two domestic interest rates. If domestic bank rates are regressed on the policy rate in the emerging markets, the pass-through is less than complete, whereas the pass-through is almost complete in the case of the advanced economies. But the impact in the emerging markets rises when the two indicators of risk are included in the empirical analysis.

Kalemli-Özcan infers that the central banks of the emerging markets loosen their policies when risk rises, and tighten when risk falls. This response is determined in part by the type of exchange rate regime that a country has. Those emerging markets that manage their exchange rates raise their policy rates in response to the increased risk premia following a U.S. tightening. These interest rate upswings in turn affect domestic economic activity. A flexible exchange rate regime, on the other hand, mitigates the undesirable effects of the risk spillovers by absorbing the response to the higher risk. The differences in exchange rate regimes, therefore, may explain the divergence in the responses of emerging market and advanced economies to U.S. policy shocks.

Both papers acknowledge that U.S. policies have significant effects on foreign economies. Albrizio, Choi, Furceri and Yoon conclude that U.S. monetary policy is a contributor to the “global financial cycles” that Rey (2015) and others have identified. Kalemli-Özcan finds that U.S. policies are a “powerful force in driving international risk spillovers.” While global trade flows may have fallen, capital flows until the coronavirus were robust. As long as the U.S. dollar is dominant in international commerce and finance, the Fed’s influence will continue to unsettle foreign nations.

Is Inflation a Global Phenomenon?

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The persistence of inflation at relatively low rates despite years of monetary stimulus has led to wide-ranging investigations into its determinants. Traditionally the rate of inflation has been linked via a Phillips curve relationship to domestic factors, such as slack in the labor market. But is there also a global element?

Maurice Obstfeld, who has returned to UC-Berkeley from his post as chief economist at the International Monetary Field, examines some of the mechanisms by which global factors could affect U.S. inflation in a new National Bureau of Economic Research working paper, “Global Dimensions of U.S. Monetary Policy.” He reviews the evidence on the Phillips curve, and reports that there is little evidence that globalization has had a direct impact on the response of wages to unemployment. An indirect linkage, however, may exist through labor’s lower share of GDP, which could respond to foreign factors such as global supply chains. There may also be a relationship through the correlation of import prices and Consumer Price Index (CPI) inflation.

Another mechanism is based in the linkages of U.S. financial markets with those abroad. If these markets are integrated, then the natural rate of interest (r*) depends on foreign savings and investment as well as the domestic counterparts. An increase in foreign savings will lower the global r* which will stimulate domestic spending. Former Federal Reserve Board Chair Ben Bernanke claimed that this effect the cause of the housing boom in the U.S. that led to the global financial crisis.

Obstfeld points out this financial linkage is intensified by the status of the U.S. dollar as a safe asset and as a reserve currency. He also cites the special role of the U.S. currency as an invoice currency for international trade and a vehicle currency for cross-border lending. Consequently, actions taken to affect domestic spending have significant spillover effects.

Kristin Forbes of MIT also examined the role of global factors in the determination of prices in her Bank for International Settlements working paper, “Has Globalization Changed the Inflation Process?” In this analysis she uses three methodologies: principal components, the Phillips curve and trend-cycle decomposition. In the principal component investigation she looks at inflation in 43 advanced economies and emerging market countries from 1990 through 2017. She reports that 40% of the total variance in CPI inflation is explained by one common principal component. Moreover, this global component of CPI inflation has increased over time. On the other hand, the common component of core inflation (a measurement of inflation without volatile food and energy costs) is smaller and has fallen.

In the Phillips curve analysis, she includes changes in the real exchange rate, the world output gap, changes in oil and other commodity prices, and world producer price dispersion, with the domestic variables. The results for CPI inflation indicate that the foreign variables are significant in explaining inflation. The results for core inflation, however, do not show the same pattern of responses.

When Forbes tests the stability of the coefficients over time, she finds that the global output gap and world commodity prices, which were insignificant in the determination of CPI inflation at the beginning of the sample period, were significant during the period that began in 2007. But these changes are not seen when the measure of inflation is core inflation. As a further test, she compares the predicted changes in CPI and core inflation in regressions using the full set of variables and others with only the domestic variables. The results indicate that the models using the full set of coefficients do better in predicting both inflation rates than the domestic alternatives.

Finally, Forbes utilizes a “trend-cycle” approach that separates inflation into a persistent trend component and a cyclical component. She calculates these components of CPI and core inflation, and then investigates how the trend component and the variables in the Phillips curve analysis affect cyclical inflation. As in the Phillips curve results, she reports that most of the global variables are significant in the regressions for CPI inflation, but not core inflation. She also finds that there was a change in these relationships over time. But when she uses trend inflation as the dependent variable, she finds that the global variables are less significant, even with CPI trend inflation.

Forbes concludes that the evidence she has presented show that global variables should not be considered as ancillary in models of inflation dynamics. Moreover, these dynamics are evolving. Changes in the world output gap and commodity prices now have an impact on CPI inflation that was not evident before the most recent period. Whether or not they will continue to do so is a topic for future research.

Obstfeld’s and Forbes’ results pose a challenge for monetary policymakers. If it is difficult to formulate policies based on domestic economic conditions, it is even more so with foreign factors. This challenge is exacerbated by the constraints on central bank actions due to the current low levels of interest rates. Coordination among central bankers could provide some assistance, but it comes with its own limitations.

Even if the Trump administration is successful in scaling back the trade and financial ties of the U.S. with the rest of the world, inflation will continue to possess a global dimension. The cross-border integration of markets will not be reversed, and domestic prices will respond to foreign shocks. Central bankers are expected to avert another slowdown,  but their ability to maneuver the economy has become more constrained.

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

 

Crises and Coordination

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Policy coordination often receives the same type of response as St. Augustine gave chastity: “Lord, grant me chastity and continence, but not yet.” A new volume from the IMF, edited by Atish R. Ghosh and Mahvash S. Qureshi, includes the papers from a 2015 symposium devoted to this subject. Policymakers in an open economy who take each other’s actions into account should be able to reach higher levels of welfare than they would working in isolation.  But actually engaging in coordination turns out to be harder–and less common– than many may think.

Jeffrey Frankel of Harvard’s Kennedy School of Government uses game theory to illustrate the circumstances that hamper coordination. One factor may be a fundamental divergence in how different policymakers view a situation. Many analysts on this side of the Atlantic, for example, use the “locomotive game” to show that Germany should engage in expansionary fiscal policies that would raise output for all nations. But (most) German policymakers have different views of the external impact of deficit spending. In the case of the Eurozone, a deficit in one country increases the probability that it will need a bailout by the other members of the monetary union. Only rules such as those of the Stability and Growth Pact that limit deficit expenditures can eliminate the moral hazard that would otherwise lead to widespread defaults.

Charles Engel of the University of Wisconsin (working paper here) also examines the recent literature on central bank coordination. He points out that the identifying the source of shocks is necessary to assess the benefits of cooperation to address them, and suggests that financial sector shocks may be most relevant for modeling open-economy coordination. But widespread cooperation could undercut the ability of a central bank to credibly commit to a single target, such as an inflation target.

Policymakers in emerging markets who must deal with the consequences of policies in advanced economies have been particularly mindful of their spillover effects. Raghuram Rajan, for example, who is back at the University of Chicago after serving as head of India’s central bank, has urged the Federal Reserve and other central banks to take into account the impact that their policies have on other nations, particularly when unwinding their Quantitative Easing asset purchases. He pointed out: “Recipient countries are not being irrational when they protest both the initiation of unconventional policy as well as an exit whose pace is driven solely by conditions in the source country.”

If international cooperation is viewed as a bargaining game, what incentives do the advanced economies have for cooperative behavior in light of the asymmetries among nations? Engel points out that in such circumstances, “…the emerging markets may believe that they have too little say in this implicit agreement, which is to say that they may perceives themselves as having too little weight in the bargaining game.” Conversely, central banks in the upper-income countries may in ordinary circumstances see little need to extend the scope of their decision-making outside their borders.

This attitude changes, however, when a crisis occurs, as Frederic Mishkin of Columbia shows in his examination of the response of central bankers to the global financial crisis. The Federal Reserve established swap lines to provide dollars to foreign central banks in countries where domestic banks faced a withdrawal of the funding they had used to acquire dollar-denominated assets. In addition, six central banks—the Federal Reserve, the Bank of Canada, the Bank of England, the European Central Bank, the Sveriges Riksbank and the Swiss National Bank—announced a coordinated reduction of their policy rates. Coordination becomes quite relevant in a world of sudden stops and capital flight.

The need for such activities could increase if there is a global financial cycle, as Hélène Rey of the London Business School has stated. She presents evidence of the impact of global volatility, as measured by VIX, on international asset prices and capital flows. An important determinant of such volatility is monetary policy in the center countries. Rey agrees with Rajan that: “Central bankers of systemically important countries should pay more attention to their collective policy stance and its implications for the rest of the world.”

Perhaps a better motivation for the need for joint action comes from Charles Kindleberger’s list of the responsibilities that a hegemonic power such as Great Britain played in the period before World War I. These included acting as a lender of last resort during a financial crisis; indeed, it was the lack of such an international lender in the 1930s that Kindleberger believed was an important contributory factor to the Great Depression. Since the end of World War II the U.S. has vacillated in this role while the international monetary system has moved from crisis to crisis. Meanwhile, offshore credits denominated in dollars have grown in size, and could conceivably constrain the Federal Reserve’s ability to undertake purely domestic measures.

A policy of “America First” that means “America Only First and Last” ignores the fragility of the international financial system. Just as there are no atheists in foxholes, no one doubts the merits of coordination when there is a disruption of global markets. But suffering another crisis would be an expensive reminder that the best time to minimize systemic risk is before a crisis erupts.

The Search for an Effective Macro Policy

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Economic growth in the advanced economies seems stalled. This summer the IMF projected increases in GDP in these economies of 1.8% for both 2016 and 2017. This included growth of 2.2% this year in the U.S. and 2.5% in 2017, 1.6% and 1.4% in the Eurozone in 2016 and 2017 respectively, and 0.3% and 0.1% in Japan. U.S. Treasury Secretary Jack Lew has called on the Group of 20 countries to use all available tools to raise growth, as has the IMF’s Managing Director Christine Lagarde. So why aren’t the G20 governments doing more?

The use of discretionary fiscal policy as a stimulus seems to be jammed, despite renewed interest in its effectiveness by macroeconomists such as Christopher Sims of Princeton University. While the U.S. presidential candidates talk about spending on much-needed infrastructure, there is little chance that a Republican-controlled House of Representatives would go along. In Europe, Germany’s fiscal surplus gives it the ability to increase spending that would benefit its neighbors, but it shows no interest in doing so (see Brad Setser and Paul Krugman). And the IMF does not seem to be following its own policy guidelines in its advice to individual governments.

One of the traditional concerns raised by fiscal deficits rests on their impact on the private spending that will be crowded out by the subsequent rise in interest rates. But this is not a relevant problem in a world of negative interest rates in many advanced economies and very low rates in the U.S. The increase in sovereign debt payments should be more than offset by the increase in economic activity that will be reinforced by the effect of spending on infrastructure on future growth.

On the other hand, there has been no hesitation by monetary policymakers in responding to economic conditions. They initially reacted to the global financial crisis by cutting policy rates and providing liquidity to banks. When the ensuing recovery proved to be weak, they undertook large-scale purchases of assets, known in the U.S. as “quantitative easing,” to bring down long-term rates that are relevant for business loans and mortgages.The asset purchases of the central banks led to massive expansions of their balance sheets on a scale never seen before. The Federal Reserve’s assets, for example, rose from about $900 billion in 2007 to $4.4 trillion this summer. Similarly, the Bank of Japan holds assets worth about $4.5 trillion, while the European Central Bank owns $3.5 trillion of assets.

The interventions of the central banks were successful in bringing down interest rates. They also elevated the prices of financial assets, including stock prices. But their impact on real economic activity seems to be stunted. While the expansion in the U.S. has lowered the unemployment rate to 4.9%, the inflation rate utilized by the Federal Reserve continues to fall below the target 2%. Investment spending is weaker than desired, despite the low interest rates. Indeed, many firms have sufficient cash to finance capital expenditures, but prefer to hold it back. The situations in Europe and Japan are bleaker. Investment in the Eurozone, where the unemployment rate is 10.1%., remains below its pre-crisis peak. Japan also sees weak investment that contributes to its stagnant position.

If lower interest rates do not stimulate domestic demand, there is an alternative channel of transmission: the exchange rate, which can improve the trade balance through expenditure switching. But there are several disturbing aspects of a dependence on a currency depreciation to increase output (see also here). First, there is an adverse impact on domestic firms with liabilities denominated in a foreign currency, as the cost of servicing and repaying that debt rises. Second, expansionary monetary policy does not always have the expected impact on the exchange rate. The Japanese yen appreciated last spring despite the central bank’s acceptance of negative interest rates to spur spending. Third, a successful depreciation requires the willingness of some other nation to accept an appreciation of its currency. The U.S. seems to have accepted that role, but Mohammed A. El-Erian has pointed out, U.S. firms are concerned “…about the impact of a stronger dollar on their earnings…” He also points to “…declining inward tourism and a deteriorating trade balance…” Under these circumstances, the willingness of the U.S. government to continue to accept an appreciating dollar is not guaranteed.

There is one other consequence of advanced economies pushing down their interest rates: increased capital flows to emerging market economies. Foreign investors, who had pulled out of bond markets in these countries for much of the last three years, have now reversed course. The inflows may help out those countries that face adverse economic conditions. But if/when the Federal Reserve resumes raising its policy rate, the attraction of these markets may pall.

The search for an effective macro policy tool, therefore, is constrained by political considerations as much as the paucity of options. But there is another factor: is it possible to return to pre-2008 economic growth rates? Harvard’s Larry Summers points out that those rates were based on an unsustainable housing bubble. He believes that private spending will not return us to full-employment, and urges the Fed to keep interest rates low and the government to engage in debt-financed investments in infrastructure projects. Ken Rogoff (also of Harvard), on the other hand, believes that we are suffering the downside of a debt supercycle. Joseph Stiglitz of Columbia University blames deficient aggregate demand in part on income inequality.

The one common theme that emerges from these different analyses is that there is no “quick fix” that will restore the advanced economies to some economic Eden. Structural and other forces are acting as headwinds to slow growth. But voters are not interested in long-run analyses, and many will turn to those who claim that they have solutions, no matter how potentially disastrous those are.

 

Monetary Policy in an Open Economy

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

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

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

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

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

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

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

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

Can Systemic Financial Risk Be Contained?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Enduring Relevance of “Manias, Panics, and Crashes”

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The seventh edition of Manias, Panics, and Crashes has recently been published by Palgrave Macmillan. Charles Kindleberger of MIT wrote the first edition, which appeared in 1978, and followed it with three more editions. Robert Aliber of the Booth School of Business at the University of Chicago took over the editing and rewriting of the fifth edition, which came out in 2005. (Aliber is also the author of another well-known book on international finance, The New International Money Game.) The continuing popularity of Manias, Panics and Crashes shows that financial crises continue to be a matter of widespread concern.

Kindleberger built upon the work of Hyman Minsky, a faculty member at Washington University in St. Louis. Minsky was a proponent of what he called the “financial instability hypothesis,” which posited that financial markets are inherently unstable. Periods of financial booms are followed by busts, and governmental intervention can delay but not eliminate crises. Minsky’s work received a great deal of attention during the global financial crisis (see here and here; for a summary of Minksy’s work, see Why Minsky Matters by L. Randall Wray of the University of Missouri-Kansas City and the Levy Economics Institute).

Kindleberger provided a more detailed description of the stages of a financial crisis. The period preceding a crisis begins with a “displacement,” a shock to the system. When a displacement improves the profitability of at least one sector of an economy, firms and individuals will seek to take advantage of this opportunity. The resulting demand for financial assets leads to an increase in their prices. Positive feedback in asset markets lead to more investments and financial speculation, and a period of “euphoria,” or mania develops.

At some point, however, insiders begin to take profits and withdraw from the markets. Once market participants realize that prices have peaked, flight from the markets becomes widespread. As prices plummet, a period of “revulsion” or panic ensues. Those who had financed their positions in the market by borrowing on the promise of profits on the purchased assets become insolvent. The panic ends when prices fall so far that some traders are tempted to come back into the market, or trading is limited by the authorities, or a lender of last resort intervenes to halt the decline.

In addition to elaborating on the stages of a financial crisis, Kindleberger also placed them in an international context. He wrote about the propagation of crises through the arbitrage of divergences in the prices of assets across markets or their substitutes. Capital flows and the spread of euphoria also contribute to the simultaneous rises in asset prices in different countries. (Piero Pasotti and Alessandro Vercelli of the University of Siena provide an analysis of Kindleberger’s contributions.)

Aliber has continued to update the book, and the new edition has a chapter on the European sovereign debt crisis. (The prior edition covered the events of 2008-09.) But he has also made his own contributions to the Minsky-Kindleberger (and now –Aliber) framework. Aliber characterizes the decades since the early 1980s as “…the most tumultuous in monetary history in terms of the number, scope and severity of banking crises.” To date, there have been four waves of such crises, which are almost always accompanied by currency crises. The first wave was the debt crisis of developing nations during the 1980s, and it was followed by a second wave of crises in Japan and the Nordic countries in the early 1990s. The third wave was the Asian financial crisis of 1997-98, and the fourth is the global financial crisis.

Aliber emphasizes the role of cross-border investment flows in precipitating the crises. Their volatility has risen under flexible exchange rates, which allow central banks more freedom in formulating monetary policies that influence capital allocation. He also draws attention to the increases in household wealth due to rising asset prices and currency appreciation that contribute to consumption expenditures and amplify the boom periods. The reversal in wealth once investors revise their expectations and capital begins to flow out makes the resulting downturn more acute.

These views are consistent in many ways with those of Claudio Borio of the Bank for International Settlements (see also here). He has written that the international monetary and financial system amplifies the “excess financial elasticity,” i.e., the buildup of financial imbalances that characterizes domestic financial markets. He identifies two channels of transmission. First, capital inflows contribute to the rise in domestic credit during a financial boom. The impact of global conditions on domestic financial markets exacerbates this development (see here). Second, monetary regimes may facilitate the expansion of  monetary conditions from one country to others. Central bankers concerned about currency appreciation and a loss of competitiveness keep interest rates lower than they would otherwise, which furthers a domestic boom. In addition, the actions of central banks with international currencies such as the dollar has international ramifications, as the current widespread concern about the impending rise in the Federal Funds rate shows.

Aliber ends the current edition of Manias, Panics and Crashes with an appendix on China’s financial situation. He compares the surge in China’s housing markets with the Japanese boom of the 1980s and subsequent bust that initiated decades of slow economic growth. An oversupply of new housing in China has resulted in a decline in prices that threatens the solvency of property developers and the banks and shadow banks that financed them. Aliber is dubious of the claim that the Chinese government will support the banks, pointing out that such support will only worsen China’s indebtedness. The need for an eighth edition of Manias, Panics and Crashes may soon be apparent.