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Monetary Determinism

Andrew Womer examines the impact of financial globalisation on monetary policy independence

Any of those who have glanced at an undergraduate economics textbook will be familiar with the idea of the so-called ‘policy trilemma’ or ‘impossible trinity’. Frequently accredited to the economists Robert Mundell and Marcus Fleming, the policy trilemma suggests a country cannot simultaneously have free capital flows, a fixed exchange rate, and independent monetary policy. The underbelly of why are three cannot be concurrently pursued lies in the uncovered interest rate parity, which asserts that the interest rate differential between two countries is equal to the change in the exchange rate between each other’s currencies. If this principle did not hold, then there would be the opportunity for investors to make risk-free profit on the market. To understand the mechanics of the trilemma, it is helpful to use a hypothetical.

Bangistan’s Woes
Let’s say the fictional small open economy Bangistan is trying to achieve free capital flows, a fixed exchange rate and autonomous monetary policy, and is now going through a recession. Bangistan sets the interest rate below the world interest rate by increasing the money supply in order to stimulate the economy. Domestic investors will sell Bangistan dollars and buy higher yielding foreign currency, putting downward pressure on the price of Bangistan dollars on the foreign exchange market. If Bangistan wishes to sustain the fixed exchange rate it must sell its foreign currency reserves and buy back Bangistan dollars on the foreign exchange market, putting further downward pressure on the currency. Of course, this cycle ends with Bangistan’s efforts trivialised; it will eventually run out of foreign currency reserves and its currency will depreciate after all.

In part because of neoclassical models of international finance, it has become the norm to accept free capital flows and to choose between a fixed exchange rate and independent monetary policy. Most major economies (like the US and UK) have chosen independent monetary policy and a fiat currency or floating exchange rate, while many developing and some smaller developed countries have chosen the fixed exchange rate system. Some notable exceptions to these generalisations are China, who to some degree has enacted capital controls, and the countries in Eurozone bloc, who de facto have a fixed exchange rate due to their currency union.

What Trilemma?
The consensus around the basic underpinnings of the trilemma is fraying, however. Hélène Rey at the London Business School has mounted a serious charge against the policy trilemma. She has stipulated that allowing free capital flows may actually induce a loss of monetary policy independence regardless of the exchange rate regime in place. Instead of a trilemma, Rey’s results suggest that there is instead an ‘irreconcilable duo’: a choice between free capital flows and independent monetary policy. The culprit? Financial globalisation. Rey argues that there is indeed a global financial cycle involving capital flows, asset prices and credit growth. Further, across the different exchange rate regimes, the prices of risky assets—i.e. equities and corporate bonds—move in ‘lockstep’ with the VIX (volatility index). But perhaps more unsettling, through examining the dynamic interrelations of the VIX and the Federal Funds Rate (FFR), Rey has found that movements in the FFR affect global credit flows and bank leverage. Essentially, this means that in an international financial system with free capital mobility, the monetary policy of the Federal Reserve (the US central bank) plays a key role in driving global monetary conditions, fiat currency or not. If true, would this really trivialise the role of central banks in controlling prices and unemployment domestically? Yes. While interest rates in the broader economy are determined through a number of factors, asset prices and bank leverage are crucial to the process. As we’ve seen through the central banks’ post-financial crisis bond purchasing programs (a.k.a. quantitative easing), rises in the prices of government and corporate bonds pushes down interest rates in the broader economy. Further, the leverage of banks in a given country impacts the access to credit for consumers. For instance, if banks wish to restrict the amount of credit they give to borrowers, they would reduce their leverage, pushing up interest rates on loans.

In her paper, Rey calls for a serious revaluation as to the benefits of keeping the capital borders open, particularly for developing countries who tend to have the highest capital inflows and are the most vulnerable to volatile capital movements. Even prior to Rey’s paper, there has been claims to the effect that changes in the Federal Reserve’s policies influence capital movements in emerging markets. Many economists have asserted that the easy policies of the Federal Reserve in the wake of the financial crisis contributed to the mass influx of capital to emerging market economies—in search of high returns on investment. In between April of 2009, when the FFR was lowered to 0.18%, capital inflows to emerging market economies rested at just 1.56%. After two years of easy monetary policy, capital inflows surged to 7.47%, nearly quintupling. Moreover, economists explain the recent decline in capital inflows to emerging markets as a function of the real and expected increases in the FFR, which has taken place over the past two years. However, there is room for rebuke. In their own analysis, the Federal Reserve found that the spike in capital flows to emerging markets actually began in the mid-2000s, well before the financial crisis and easy monetary policy from the Federal Reserve. On the contrary, the surge seen in the 2009-2011 period reflects instead a ‘bounce back’ in capital inflows following a temporary decline during the financial crisis. So, if not the FFR and global financial cycle, then what can explain the variation in capital flow across emerging market economies? The Federal Reserve contends that endogenous factors are at work primarily. They say the decline in capital flows post-2010 have been a response to dwindling emerging market output-growth and the global weakening of commodity prices, of which many emerging market economies are reliant.

So What Now?
Of course, it is not hard to see why the Fed would want to make the case that their policies are contributing to economic volatility in the developing world. Nevertheless, the case for financial globalisation as a significant determinant of monetary policy around the world is not clear-cut. However, Rey’s arguments do not fall on deaf ears in a world where there is much more financial interconnectedness and volatility. What is the way forward? Unlike some economists, Rey does not suggest to hop on the capital controls train, despite her proclamations of the ‘irreconcilable duo’. Instead, the Federal Reserve and other major central banks should concentrate on the potential spill over effects of their policies when setting policy. Yet, it is difficult to imagine the central bank of a single country assuming responsibility for global finance, particularly considering the political climate in the US and elsewhere. Although economists still tend to agree that open borders are a good idea, it will be a challenge to convince developing countries that capital controls are all doom and gloom when there are instances, like China, where it has proved to be effective.

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