Trilemmas and Financial Instability

Yves here. Looking at some of the tradeoffs in a world with significant international financial flows. Note that several important studies, including Ken Rogoff and Carmen Reinhart’s work on 800 years of financial crises and the BIS’ Global imbalances and the financial crisis: Link or no link? (see Andrew Dittmer’s layperson summary here) suggest that financial crises go hand in hand with high level of international funds movements. So national “what to do?” decisions are important.

By Jospeh Joyce. Originally published at Angry Bear

Whether or not the international monetary trilemma (the choice facing policymakers among monetary autonomy, capital mobility and a fixed exchange rate) allows policymakers the scope for policy autonomy has been the subject of a number of recent analyses (see here for a summary). Hélène Rey of the London Business School has claimed that the global financial cycle constrains the ability of policymakers to affect domestic conditions regardless of the exchange rate regime. Michael Klein of the Fletcher School at Tufts and Jay Shambaugh of George Washington University, on the other hand, have found that exchange rate flexibility does provide a degree of monetary autonomy. But is monetary policy sufficient to avoid financial instability if accompanied by unregulated capital flows?

A recent paper by Maurice Obstfeld, Jonathan D. Ostry and Mahvash S. Qureshi of the IMF’s Research Department examines the impact of the trilemma in 40 emerging market countries over the period of 1986-2013. They report that the choice of exchange rate regime does affect the sensitivity of domestic financial variables, such as domestic credit, house prices and bank leverage, to global conditions. Economies with fixed exchange rate regimes are more impacted by changes in global market volatility than those with flexible exchange rate regimes. They also find that capital inflows are sensitive to the choice of exchange rate regime.

However, the insulation properties of flexible exchange rates are not sufficient to protect a country from financial instability. Maurice Obstfeld of the IMF and Alan M. Taylor of UC-Davis in a new paper point out that while floating rates and capital mobility allow policy makers to focus on domestic objectives, “…monetary policy alone may be a relatively ineffective tool for addressing potential financial stability problems….exposure to global financial shocks and cycles, perhaps the result of monetary or other developments in industrial-country financial markets, may overwhelm countries even when their exchange rates are flexible.”

Global capital flows can adversely affect a country through multiple channels. The Asian financial crisis of 1998 demonstrated the impact of sudden stops, when inflows of foreign capital turn to outflows. The withdrawal forces adjustments in the current account and disrupts domestic financial markets, and can trigger a devaluation of the exchange rate. The fall in the value of the currency worsens a country’s situation when there are liabilities denominated in foreign currencies, and this balance sheet effect can overwhelm the expansionary impact of the devaluation on the trade balance.

The global financial crisis of 2008-09 showed that gross inflows and outflows as well as net flows can lead to increased financial risk. Before the crisis there was a tremendous buildup of external assets and liabilities in the advanced economies. Once the crisis began, the volatility in their financial markets was reinforced as residents liquidated their foreign assets in response to their need for liquidity (see Obstfeld here or here).

International financial integration can also raise financial fragility before a crisis emerges. Capital flows can be highly procyclical, fluctuating in response to business cycles (see here and here). Many studies have shown that the inflows result in increases in domestic credit that foster more economic activity (see here for a summary of recent papers). Moritz Schularick of the Free University of Berlin and Alan Taylor of UC-Davis (2012) have demonstrated that these credit booms can result in financial crises.

What can governments do to forestall international financial instability?  Dirk Schoenmaker of VU University Amsterdam and the Duisenberg School of Finance has offered another trilemma, the financial trilemma, that addresses this question (see also here). In this framework, a government can choose two of the following three financial objectives: national financial regulatory policies, international banking with international regulation, and/or financial stability. For example, financial stability can occur when national financial systems are isolated, such as occurred under the Bretton Woods system. Governments imposed barriers on capital integration and effectively controlled their financial systems, and Obstfeld and Taylor point out that the Bretton Woods era was relatively free of financial crises. But once countries began to remove capital controls and deregulated their financial sectors in the post-Bretton Woods era, financial crises reappeared.

International financial integration combined with regulatory cooperation could lessen the consequences of regulation-shopping by global financial institutions seeking the lowest burden. But while the Financial Stability Board and other forums may help regulators monitor cross-border financial activities and design crisis resolution schemes, such coordination may be necessary but not sufficient to avoid volatility. Macroprudential policies to minimize systemic risk in the financial markets are a relatively new phenomenon, and largely planned and implemented on the national level. The global implications are still to be worked out, as Stephen G. Cecchetti of the Brandeis International Business School and Paul M. W. Tucker of the Systemic Risk Council and a Fellow at Harvard’s Kennedy School of Government have shown. A truly stable global system requires a degree of financial regulation and coordination that current national governments are not willing to accept.

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  1. Colonel Smithers

    Thank you, Yves.

    The final sentence is spot on. “A truly stable global system requires a degree of financial regulation and coordination that current national governments are not willing to accept.” I worked on such matters from 2007 – 16, including with Cecchetti (then at the Basel Committee) and Tucker (then at the Bank of England) in that period, and can testify.

    This is due to regulators and / or finance ministries having to ensure the competitiveness of their financial services sector (and all the parasite behaviour that entails, and whether or not that objective is explicit or implicit) and distrust, in part due to national competitiveness, but also as some, if not most, financial services sectors are poorly regulated and undercapitalised, especially those of global systemic importance. This explains some of the motivation for the Vickers ring fence in the United Kingdom, a structural reform supported by the FDIC’s Tom Hoenig.

    With regard to macro-prudential policy, I don’t think there has been enough debate about having so much power concentrated in the hands of independent central banks and their oversight. The crisis has thrown into starker relief issues that should have been addressed when central bank independence was promoted as a panacea in the 1980s and 1990s. I wrote a masters on the issue in 1994 – 5, opposing such independence in case readers wonder, and often think of updating the masters, in light of the crisis and the evolution of central banks since, into a doctorate.

    1. Colonel Smithers

      I forgot to mention a conversation I had with Paul Tucker, at Mansion House, when the Euro crisis moved up a notch. It was an Anglo-Swiss conference, organised by my Swiss equivalent and me, on a Friday. Tucker was the main speaker and had to pop out from time to time. Merv the Swerve, if memory serves, was watching tennis at SW19 that day and asked to be contacted only in the event of a crisis, which led to much discussion across the road as to whether a crisis was brewing. Tucker talked about the UK having to impose capital controls, abolished under Thatcher in her first term, to stop a flow of capital from the Euro zone driving up Sterling and snuffing out the tiny shoots of recovery. Osborne stamped on the shoots not long after, consequences that the UK suffers from to this day.

    2. Ignacio

      I agree with your last paragraph, but i would like some clarification if you wish. Do “independent” central banks necessarily imply financial industry-captured central banks as it seems to be the case?

      1. Colonel Smithers

        Thank you, Ignacio.

        It does not have to be, but I have yet to find evidence of independent central banks not being captured. It’s not just financial services, but can be other business sectors. The franc fort of the 1990s facilitated / spiked the export of capital by French industrial firms and wealthy individuals.

        In Mauritius, where my parents come from, the central bank kept the Rupee (MUR) high, so that the kleptocrats, who hijacked the country at independence, could get their money out and educate their progeny, often spoilt brats with a sense of entitlement, with less FX spread and risk. This said, the strong rupee policy preceded central bank independence, so that is not a good example.

        Both countries have had debates about families (200, France in the 1930s) and (Mauritius in the 1970s, 14, and noughties, 5) controlling the central bank and economy.

      2. Foppe

        I agree that “beholden to all interest groups” is a much better approach than “independent from all”.

  2. Jim Haygood

    Capital flows can be highly procyclical, fluctuating in response to business cycles.

    No kidding. Tale a look, if you dare, at EEM (iShares MSCI Emerging Markets ETF). It’s up a modest 41.6% since inclusion in the Craazyman Fund on March 3, 2016. Chart:

    This is exactly the phenomenon Michael Pettis described in his 2001 book The Volatility Machine. Pettis was writing after the 1997 Asia crisis, but twenty years on, it’s deja vu all over again.

    A prime cause of this phenomenon is frantic yield seeking, driven by zero and near-zero interest rate policies imposed by rich country central banks. This process goes way too far, until a crisis impels First World investors to claw their funds back, tipping over many apple carts in the emerging world.

    Central banksters: like Sisyphus, they keep rolling rocks uphill, only to have them tumble down and crush the village … just like last time, and the time before that.

  3. Michael

    My disconnect in CB behavior is this:

    Is the yield on CB assets above market? Are the oft stated AAA quality assets still valued below par?

    Why don’t major institutions demand their assets back in exchange for reducing their CB reserves?

    Seems we are far from out of the woods yet?

    Help me understand why this is such a walking on eggshells situation for Yellen.

  4. digi_owl

    More and more i find myself wondering why any sane government would take on liabilities denominated in foreign currency. That path invariably leads to madness.

  5. Susan the other

    what if we just let monetary chaos fly? wouldn’t it self limit – like that very funny “graph” a while back? because all transactions would be confined to the market none of it would go critical… it only goes critical because we panic an believe it will lose its value. Nevermind that it has no value. who needs anything but a sufficient allotment of credit – whether national or international – to keep things running smoothly and not ever crash. let the bubble be the the model – it’s been trying to tell us something here for centuries. Money is irrelevant when there is plenty of it. If money actually had any intrinsic value then of course we’d be fools to not control it. But it does not – apart from what it can facilitate toward a better world. We should let money fly and control the thins that are precious like clean air and water and a temperate climate and good societies. The stuff of policy. The stuff that is never properly controlled.

    1. Left in Wisconsin

      I think the notion that you could simply let things fly, and then that big market players who ended up losers would not come running to the gov’t for bailouts, or that we would be able to prevent this if they did, is naive. That is precisely why they fund politicians. It is simply not true that major financial interests will tolerate, much less ask for, freedom from government interference.

  6. Chauncey Gardiner

    Funny, despite all the renewed yada yada about deregulation, I don’t recall any political candidates who have publicly discussed the economic effects or the wealth transfer and wealth concentration issues of western central banks’ “Quantitative Easing” and 8-plus years of zero and negative real interest rates; the role and non independence of central banks not just from democratically elected representatives, but from Wall Street and from CEOs of large corporations intent on maximizing their personal stock option income through massive corporate stock buybacks funded with low cost debt; the invalidity of the theory of a “Wealth Effect” from financial asset price appreciation; the advantages, disadvantages and perils of repeated financial bubbles and “financialization” of the US economy; or global funds flows that have caused the US dollar to decline about 9 percent against other major currencies since the first of the year.

    Yet, we now find ourselves once again riding the momentum bus in markets devoid of price discovery while leading financial lights finally begin to publicly question the wisdom of another bubble. As an ordinary citizen, one can only wonder about the illusion and artificial nature of it all… who is auditing the algorithms, rising ETFs that lift all boats regardless, effects of debt leverage on productive investment, the desirability of a large foreign corporation with an egregious history of labor abuse being heavily subsidized to open a factory in Wisconsin, the numbers of former Wall Street bankers and their attorneys both in government and at the central banks, etc.

  7. Oregoncharles

    ” monetary autonomy, capital mobility and a fixed exchange rate)”
    The environmental economist Herman Daly argued that international capital mobility is a bad thing – destabilizing, as suggested above; and it cancels the underlying argument for free trade, creating a “race to the bottom.”

    My own thought is that there are obvious but narrow situations where it can be helpful, so the argument is really for severe controls over its movement, the obvious of the present globalization push.

  8. Sound of the Suburbs

    The Asian Crisis.

    The Asian Tigers were doing really well with “window guidance”, where they carefully allocated bank lending into the economy, but they came under pressure to open up their financial markets (financial liberalisation).

    Foreign lenders could now lend into the Asian economies and their interest rates were lower.

    The companies were assured the currency pegs would be maintained and there was no risk.

    The companies borrowed at lower cost from foreign lenders.

    Domestic lenders now had lost their old business market and started lending into real estate, etc ….

    This carried on for a while and everything boomed until the currency speculators attacked the Asian currencies.

    The Asian Crisis had begun

    An ideology is an ideology and you must stick with it and hope something similar doesn’t happen again.

    Lending into emerging markets in dollars, what could possibly go wrong?

    As above.

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