It is gratifying when no less a person than the Governor of Bank of England Mark Carney breaks ranks from orthodoxy and summarises our book, The Rise of Finance. The core of the speech goes to the heart of what we have argued in our book. The global financial and monetary system is broken and the role of dollar is central to the problem.
In his speech at the annual Jackson Hole gathering of central bankers, Carney highlighted the problems associated with the world's reliance on the US dollar and spillovers especially on emerging economies from US monetary policy actions. He questioned the macroeconomy stabilisation orthodoxy on flexible inflation targeting and floating exchange rates. He advocated the creation of a new international monetary and financial system (IMFS) based on many more global currencies, where IMF could play a role to avoid having countries self-insure themselves against sudden-stops and capital flight by the inefficient and wasteful hoarding of US dollar assets, and greater global monetary policy co-ordination.
On the problems with the prevailing system,
Globalisation has steadily increased the impact of international developments on all our economies. This in turn has made any deviations from the core assumptions of the canonical view even more critical. In particular, growing dominant currency pricing (DCP) is reducing the shock absorbing properties of flexible exchange rates and altering the inflation-output volatility trade-off facing monetary policy makers. And most fundamentally, a destabilising asymmetry at the heart of the IMFS is growing. While the world economy is being reordered, the US dollar remains as important as when Bretton Woods collapsed. The combination of these factors means that US developments have significant spillovers onto both the trade performance and the financial conditions of countries even with relatively limited direct exposure to the US economy.
He argues that these developments have lowered the global equilibrium interest rates, which in turn influences domestic monetary policy actions, which in turn become a bigger problem when the US economic conditions warrant tightening by the UD Federal Reserve even as economic condition elsewhere are weakening. The result is a structural disinflationary bias in the world economy.
Greater cross-border trade, growth of global value chains, and globalisation in general have synchronised producer prices globally and also introduced a disinflationary bias on the world economy. This increase in global trade has been accompanied by the DCP or trade invoicing in dollars even when the trade does not involve the US, thereby weakening the automatic (external side) stabilisation effects of a floating exchange rate.
The resulting stickiness of import prices in dollar terms means exchange rate pass-through for changes in the dollar is high regardless of the country of export and import, while pass-through of non-dominant currencies is negligible. As a result, import prices do not adjust efficiently to reflect changes in relative demand between trading partners, in part because expenditure switching effects are curtailed, and global trade volumes are heavily influenced by the strength of the US dollar.
It has been shown that, controlling for the global business cycle, a 1% appreciation of the dollar against all other currencies leads to a 0.6% contraction in trade volumes in the rest of the world within one year.
In addition to trade invoicing, dollar is also the dominant currency in the financial markets, and all this creates a self-reinforcing spiral that predominates dollar ever more,
As well as being the dominant currency for the invoicing and settling of international trade, the US dollar is the currency of choice for securities issuance and holdings, and reserves of the official sector. Two-thirds of both global securities issuance and official foreign-exchange reserves are denominated in dollars. The same proportion of EME foreign currency external debt is denominated in dollars and the dollar serves as the monetary anchor in countries accounting for two thirds of global GDP. The US dollar’s widespread use in trade invoicing and its increasing prominence in global banking and finance are mutually reinforcing. With large volumes of trade being invoiced and paid for in dollars, it makes sense to hold dollar-denominated assets. Increased demand for dollar assets lowers their return, creating an incentive for firms to borrow in dollars. The liquidity and safety properties encourage this further. In turn, companies with dollar-denominated liabilities have an incentive to invoice in dollars, to reduce the currency mismatch between their revenues and liabilities. More dollar issuance by non-financial companies and more dollar funding for local banks makes it wise for central banks to accumulate some dollar reserves.
And the net result is that actions of US government and the Federal Reserve have enormous spill-overs on the world economy, even in countries which have limited US exposure. Helene Rey has described the global financial cycle as a dollar cycle. Carney points to evidence on the harmful effects of spillovers,
For EMEs, this manifests in volatile capital flows that amplify domestic imbalances and leave them more vulnerable to foreign shocks. One fifth of all surges in capital flows to EMEs have ended in financial crises, and EMEs are at least three times more likely to experience a financial crisis after capital flow surges than in normal times. While the typical EME receiving higher capital inflows will grow 0.3 percentage points faster, all else equal, the typical EME with higher capital flow volatility will grow 0.7 percentage points slower... Bank research suggests that the spillover from tightening in US monetary policy to foreign GDP is now twice its 1990-2004 average, despite the US’s rapidly declining share of global GDP. Financial instability in advanced economies also causes capital to retrench from EMEs to ‘safe havens’, as it did during the 2008 financial crisis and the 2011 euro-area crisis. Connally’s dictum “our dollar, your problem” has broadened to “any of our problems is your problem”... Bank of England work finds that redemptions by EME bond funds (with large structural mismatches) in response to price falls are five times those for EME equity funds (with lower structural mismatch). In turn, EME equity funds are twice as responsive as advanced economy equity funds.
So what does he suggest? In the short-run he suggests transparent pursuit of flexible inflation targeting, with focus on trading off domestically generated inflation and output volatility, as well as co-ordination with fiscal and regulatory policies, at both national and international levels.
In the medium term, policymakers need to reshuffle the deck. That is, we need to improve the structure of the current IMFS. That requires ensuring that the institutions at the heart of market-based finance, particularly open-ended funds, are resilient throughout the global financial cycle. It requires better surveillance of cross border spillovers to guide macroprudential and, in extremis, capital flow management measures. And it underscores the premium on re-building an adequate global financial safety net... EMEs can increase sustainable capital flows by addressing “pull” factors including... expanding the scope and application of their macroprudential toolkits to guard against excessive credit growth during booms. Bank of England research finds that tightening prudential policy in EMEs dampens the spillover from US monetary policy by around a quarter... At the same time, it is in the interests of advanced economies to moderate push factors, including risks in their markets and institutions... Pooling resources at the IMF, and thereby distributing the costs across all 189 member countries, is much more efficient than individual countries self-insuring. To maintain reserve adequacy in the face of future larger and more risky external balance sheets, EMEs would need to double their current level of reserves over the next 10 years – an increase of $9 trillion. A better alternative would be to hold $3 trillion in pooled resources, achieving the same level of insurance for a much lower cost.
In the longer term, we need to change the game. There should be no illusions that the IMFS can be reformed overnight or that market forces are likely to force a rapid switch of reserve assets... Any unipolar system is unsuited to a multi-polar world. We would do well to think through every opportunity, including those presented by new technologies, to create a more balanced and effective system... Multiple reserve currencies would increase the supply of safe assets, alleviating the downward pressures on the global equilibrium interest rate that an asymmetric system can exert. And with many countries issuing global safe assets in competition with each other, the safety premium they receive should fall. A more diversified IMFS would also reduce spillovers from the core and by so doing lower the synchronisation of trade and financial cycles. That would in turn reduce the fragilities in the system, and increase the sustainability of capital flows, pushing up the equilibrium interest rate.