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Affairs, Domestic and Foreign

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Raghuram Rajan, ex- faculty member of the Booth School of Business at the University of Chicago, ex-head of the research department of the IMF, and currently Governor of the Reserve Bank of India (its central bank), set off a storm of comment when he warned of a breakdown in the global coordination of monetary policy. Frustrated by the decline in the foreign exchange value of the rupee that followed the cutback in asset purchases by the Federal Reserve, Rajan claimed that the Federal Reserve was ignoring the impact of its policies on the rest of the world.  Does he have a valid cause for concern?

Quite a few folks have weighed in on this matter: see here, here, here, here, here and here. Rodrik and Subramanian make several interesting points. First, the Federal Reserve was criticized when it lowered rates, so complaints that it is now raising them are a bit hypocritical (but see here). Second, blaming the Fed for not being a team player as the emerging markets were when they lowered their rates in 2008-09 is not a valid comparison. The emerging markets lowered their rates then because it was in their interest to do so, not out of any sense of international solidarity. Third, their governments allowed short-term capital inflows to enter their economies; did they not realize that the day could come when these flows would reverse? Finally, their policymakers allowed the inflows to contribute to credit bubbles that resulted in inflation and current account deficits, which are significant drivers of the volatility.

Moreover, the Federal Reserve is constrained by law to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S., not the global community But couldn’t turmoil in the emerging markets threaten U.S. conditions? Robin Harding at the Financial Times thinks this is an unlikely scenario. He points to two channels of transmission between the U.S. and the countries that have shown the most turbulence: exports and financial markets. The emerging market nations that have witnessed the most volatility account for very small proportions of U.S. exports. (China, on the other hand, does claim 7.5% of our exports, but so far has not suffered any signs of distress (but see here).) In addition, financial flows might be affected, but to date these have resulted in lower interest rates in the U.S. due to a flight to safety. Previous shocks from the emerging markets pushed U.S. stock prices down, but these effects were short-lived. Therefore, Harding claims, “…it would have to become much more of a crisis…” to endanger the U.S. economy.

The problem with this assessment is that it assumes that we know the extent of our financial vulnerability to a decline in the fortunes of these economies. But one lesson of the 2007-09 global financial crisis is that there may be much we do not know about our financial structure. U.S.-based institutions can be vulnerable to shocks in ways that we do not recognize. Subprime mortgages were not themselves that significant a share of the liabilities of U.S. banks and shadow banks, but they were the foundation of a range of derivatives, etc., that took down the financial markets when these mortgages became toxic.

The threat of more declines in foreign asset prices does not mean that the Federal Reserve should retreat from its current policies. A situation with some interesting similarities took place in the early 1980s. U.S. banks, awash with recycled oil revenues, had lent extensively to countries in Latin America and elsewhere in the 1970s.  A debt crisis ensued after Paul Volcker and the Federal Reserve raised interest rates (see Chapter 4). Volcker recently reflected on these events in an interview with Martin Feldstein in the fall 2013 issue of the Journal of Economic Perspectives:

“What were you going to do? Were you going to conduct an easy-money policy and go back on all the policy you’d undertaken to try to save Mexico, which wouldn’t have saved Mexico anyway? We did save Mexico, but by other means.”

U.S. policymakers have always claimed (with some justification) that a healthy U.S. economy is the best remedy for a troubled world economy, and monetary officials will no doubt proceed as they think best. But we should take a look around before we proceed. The February ice underneath our feet may be a bit thinner than we realize.

Shake, Rattle and Roll

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The selloff last week of the currencies of many emerging market countries while stock prices also declined can be seen as the result of “known unknowns” and “unknown unknowns.” How these will play out will become evident during the rest of the year. Either set of factors would be unsettling for the emerging market countries, but the combination of the two may lead to a long period of chaotic financial conditions.

The “known unknown” is the magnitude of the increase in U.S. interest rates following the scaling down of asset purchases by the Federal Reserve and the ensuing impact on capital flows to developing economies. A recent analysis at the World Bank of the response established a baseline assumption of an increase of 50 basis points in U.S. long-term interest rates by the end of 2015 and another 50 basis point rise in 2016. The European Central Bank, the Bank of Japan and the Bank of England would also relax their quantitative easing policies. The result, according to their model, would be a slow rise in global interest rates and a gradual tightening in capital flows to developing countries of about 10%, or 0.6% of their GDP. The biggest declines would occur in portfolio flows to these countries.

However, the World Bank analysts also allowed for alternative scenarios. If there is a “fast normalization,” then U.S. long-term interest rates will rise by 100 basis points this year and capital inflows to the developing economies drop by up to 50% by the end of the year. In the “overshooting scenario,” long-term rates rise by 200 basis points, and capital inflows could decline by 80%. These developments would raise the probability of financial crises in the emerging markets, particularly in countries where there have been sizeable increases in domestic credit fueled in part by foreign debt

But the U.S. is not the only source of anxiety for policymakers in emerging market economies.  A decline in Chinese manufacturing activity in January may be reversed next month, and by itself likely means little. The decline in Asian stock prices that followed the announcement of the fall, however, demonstrated the importance of China’s economy for the region, and why China’s economic performance is the “unknown unknown.” The financial system in China has become overextended, and the Bank of China has fluctuated between signaling that it would rein in the shadow banking system while also injecting credit when short-term interest rates rise. How long the authorities can continue their delicate balancing act is unclear.

The state of the financial system is only one of the aspects of the Chinese economy that raises concerns. Given the uncertainty about the impact of demographic and migration trends, the continuation of FDI flows, etc., any forecast is conditional on a host of factors.  The IMF reported increased growth in China at the end of 2013, but warned that it will moderate this year to around 7.5%.

The conundrum is that we do not know what we should be concerned about in China, whereas we can imagine all too well what may happen to financial markets in emerging markets following higher interest rates in the advanced economies. The result is likely to be continued declines in exchange rates and financial asset prices, as the vulnerabilities of individual countries are revealed. As Warren Buffet warned, “Only when the tide goes out do you discover who’s been swimming naked.”

Update: See Menzie Chin’s views on these issues here.

 

Birds of a Feather

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

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

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

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

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

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

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

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

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

The Stars and Stripes Forever?

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

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

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

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

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

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

1944, 1976, 2013?

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When the financial crisis of 2007 was changing into the Great Recession of 2008-09, national leaders such as French President Nicolas Sarkozy and British Prime Minister Gordon Brown turned to the Bretton Woods conference of 1944 for inspiration. They invoked the spirit of the conference as they sought to resolve the crisis and devise regulations that would allow them to rein in the financial institutions that they held responsible for instigating the crisis. Indeed, Bretton Woods is often used as a model of international cooperation. (See, for example, here and here.)

But Bretton Woods is an odd choice for a prototype of international collaboration. Benn Steil in The Battle of Bretton Woods has shown how the conference proceedings were controlled by the U.S. delegation headed by Harry White, the U.S. Assistant Secretary of the Treasury. John Maynard Keynes, a member of the British delegation, was out-maneuvered by White, and the final agreement reflected the U.S. vision for the post-war international monetary regime more than anyone else’s. While the conference had a Quota Committee, for example, in reality the quotas assigned the members were chosen by the U.S. officials.

A more apt historical precedent may be the negotiations that took place during the early 1970s over the design of an international monetary system to replace Bretton Woods. Michelle Frasher has provided an account of these consultations in Transatlantic Politics and the Transformation of the International Monetary System. The U.S. had ended the conversion of gold for dollars by foreign central banks in August 1971. This act, according to Frasher, reflected the belief of U.S. President Richard Nixon and his Treasury Secretary John Connally that maintaining gold conversion limited their domestic and foreign policy options rather than any ideological view regarding Bretton Woods.

However, George Schultz, Connally’s successor as Treasury Secretary, came to favor floating exchange rates after the breakdown of the Smithsonian agreement in 1973. But while the U.S. had been able to dominate its Allies in 1944, it faced a different situation in the early 1970s.  It could not ignore the wishes of its major European allies, France, West Germany and Great Britain, which were concerned about unconstrained markets. The French in particular sought to place restraints on the ability of nations to maintain floating rates. In the end, the U.S. and French negotiators agreed to amend the IMF’s Article IV to include a commitment by the IMF’s members “to assure orderly exchange arrangements and to promote a stable system of exchange rates…” The IMF is still struggling to explain what this means in terms of which practices are permissible and which are not.

Over three decades later, many of the same tensions persist. Now, however, it is China and other Asian countries that express concerns about the U.S. Frasher (p. 135), for example, describes the source of the Europeans’ resentment in the 1970s:

…the US tendency to behave paternally and use its reserve status to disregard European opinions, act unilaterally on major policy initiatives, frame the relations in terms of US interests, and dictate the conditions of international monetary reform constantly frustrated European views about partnership. The economic and political differences within the transatlantic alliance made for an unconstructive, uneven, and often tense partnership.

Substitute “Asian” for “European” and “transpacific” for “transatlantic,” and we have a good summary of the Asians’ current views of the U.S. For example, Justin Yifu Lin, a former Chief Economist of the World Bank and the founding director of the China Center for Economic Research, wrote in Against the Consensus: Reflections on the Great Recession (p. 156)

One of the main flaws in the nonsystem that evolved in the post-Bretton-Woods period eventually led to the 2008-9 global crisis: the potential conflict of interest between US macroeconomic policy for domestic objectives and the dollar’s role as a global reserve currency…Inevitably, national economic concerns guided US fiscal and monetary policies, at times in ways that were detrimental to global stability.

Similarly, Xu Hongcai of the China Center for International Economic Exchanges in an article in the Global Summitry Journal co-authored with Yves Tiberghien wrote (p. 10):

Despite the status of the US as anchor for the global monetary system, the US central bank, the Federal Reserve is strictly mandated to set its monetary policy with consideration for US inflation, growth, and employment only. There is no channel for inputs from the rest of the world in managing the world’s currency. Thus, the major international reserve currency issuer continues to implement quantitative easing monetary policies in light of the needs of its own economy without considering the global spillover effect of such policies. These policies have caused inflationary pressures on emerging economies, and in turn increased the systemic risks of the global financial system.

After 1976, France gave up trying to devise a rule-based global system and turned to a regional system. What are China’s options? It has already shown a willingness to join with other Asian nations in a currency swap arrangement, the Chiang Mai initiative. It has the potential to do more, and could become a regional reserve currency. But to increase the use of the renminbi would require further financial decontrol, and until recently it did not appear that the government was ready to move in that direction. Most observers thought that a “fully global renminbi was a distant goal.”

The political battles over the debt ceiling, however, may push the Chinese government to rethink its long-run plans for the renminbi. Chinese officials expressed their frustration with the indifference of the U.S. to the global consequences of its domestic political discord. If Chinese policymakers now advance their timetable for expanding the renminbi’s use as a global currency, we may look back at 2013 as an inflection point.

U.S. and Them

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Among the causalities of the U.S. budget dispute has been the chance to enact crucial changes at the IMF. Leaders of the G20 nations agreed in 2010 on the proposals that require approval by member governments to be implemented. The U.S., however, is delaying its endorsement, and as a result the enactment of the measures has been put on hold.

There are two proposals under review. One stems from the IMF’s 14th General Review of Quotas, and the second takes the form of an amendment to the IMF’s Articles of Agreement. Among the changes that would follow from their implementation are:

  • A doubling of the amount of funds available to the IMF through the quotas of its members to about $720 billion, scheduled to take place in January 2014.
  • A shift of six percentage points of quota, which are the basis of voting shares as well as financial contributions, to emerging market countries.
  • The establishment of an all-elected 24-member Executive Board in place of the current system that allots individual seats to the Fund’s five largest members. A reallocation of two seats from the European members to emerging market countries will also occur.

Are these changes important? The increase in total quota would not change the IMF’s current capability to assist countries in crisis. Member governments agreed to lend directly to the IMF in the wake of the 2008-09 crisis through a plan known as the New Arrangements to Borrow. The proposed quota increase would make access to the additional credit consistent with the IMF’s use of its quota resources, and would be offset by a reduction of the NAB.

The change in relative quota shares, on the other hand, would lead to a long-overdue realignment of the relative quotas of the member countries. All four BRIC nations would appear on the list of the ten members with the largest shares. The current ten largest members and the proposed new line-up are:

Rank Current Proposed
1. United States (17.67) United States (17.41)
2. Japan (6.56) Japan (6.46)
3. Germany (6.11) China (6.39)
4. France (4.50) Germany (5.59)
5. United Kingdom (4.50) France (4.23)
6. China (4.00) United Kingdom (4.23)
7. Italy (3.31) Italy (3.16)
8. Saudi Arabia (2.93) India (2.75)
9. Canada (2.67) Russia (2.71)
10. Russia (2.49) Brazil (2.32)

The reallocation of seats on the Executive Board is the logical counterpart of the quota realignment. The change in how representation is arranged would open the way for the Europeans to form coalitions to appoint common representatives, such as one for the Eurozone. Such a grouping, because of the size of its combined quota, could increase the influence of the Europeans at the IMF.

James Boughton, former IMF historian, believes that changing quotas and votes should have little impact on decision making. Votes are rarely taken, and the emerging market nations are unlikely to push the IMF in a different direction, particularly now that the IMF has adopted a new view on capital flows and the use of capital controls. But Boughton also claims that the reforms are vital to preserve the IMF’s creditibility. The current allocation of quotas and seats on the Executive Board is a relic of the political and economic landscape of the post-World War II era when the IMF was established. The Europeans are overrepresented on the Executive Board and the Managing Director of the IMF continues to be a European. Officials of the emerging market countries have expressed their impatience with the delay in changing the allocations in response to their growth.

Ratification of the reform measures requires approval of 85% of the total voting power of the IMF’s members, and the U.S. has a share large enough (16.75%) to prevent passage. Why has the U.S. not approved the changes? Congressional support is needed, and that has been held back. The basic reason for the delay is the same as the reason why Congress resisted raising the debt ceiling: politics. The Republican Chair of the House Financial Services Subcommittee has stated that he will consider the quota increase only if it is included within a proposal for fiscal consolidation.

But the failure of the U.S. to support the reforms also reveals an emerging drift towards isolationism. This reflects weariness with foreign wars as well as the slow recovery from the 2008-09 crisis. The latter was marked by the end of the domination of the G7 in international economic governance. We are still waiting to see whether the G20 will be an effective replacement. But the ability of any coalition to exercise leadership will be limited if the world’s largest economy turns away.

Chinese officials were incensed at the possibility of a default on U.S. debt. Further delay of the IMF reforms only reinforces the impression that the U.S. no longer takes its international responsibilities seriously. The inward turn of U.S. politics signals a further retreat from the internationalist vision that created the IMF and other multilateral institutions.

Great Britain, it was claimed, gained an empire “…in a fit of absence of mind.” The U.S. may, on the other hand, lose its global position through indifference.