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About the Author
John H. Cochrane is a senior fellow at the Hoover Institution. Before joining Hoover, he was a professor of finance at the University of Chicago’s Booth School of Business. He is also a research associate of the National Bureau of Economic Research.
Kyle Palermo is marketing communications manager at the Hoover Institution. He reports on conferences, research projects, and other academic and institutional activities.
John B. Taylor is the George P. Shultz Senior Fellow in Economics at the Hoover Institution and the Mary and Robert Raymond Professor of Economics at Stanford University. He chairs the Hoover Working Group on Economic Policy and is director of Stanford’s Introductory Economics Center.
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International Rules of the Monetary Game
Prachi Mishra and Raghuram Rajan
In order to avoid the destructive beggar-thy-neighbor strategies that emerged during the Great Depression, the postwar Bretton Woods regime attempted to prevent countries from depreciating their currencies to gain an unfair and sustained competitive advantage. The system required fixed, but occasionally adjustable, exchange rates and restricted cross-border capital flows. Elaborate rules on when a country could move its exchange rate peg gave way, in the post-Bretton Woods world of largely flexible exchange rates, to a free-for-all where the only proscribed activity was sustained unidirectional intervention by a country in its exchange rate, especially if it was running a current account surplus. For more normal policies, a widely held view at that time was that each country, doing what was best for itself in a regime of mobile capital, would end up doing what was best for the global equilibrium. For instance, a country trying to unduly depreciate its exchange rate through aggressive monetary policy would see inflation rise to offset any temporary competitive gains. However, even if such automatic adjustment did ever work, and our paper does not take a position on this, the global environment has changed. Today, we have:
Weak aggregate demand, in part because of poorly understood consequences of population aging and productivity slowdown
A more integrated and open world with large capital flows
Significant government and private debt burdens
Sustained low inflation.
The pressure to avoid a consistent breach of the lower inflation bound and the need to restore growth to reduce domestic unemployment could cause a country's authorities to place more of a burden on unconventional monetary policies (UMP) as well as on exchange rate or financial market interventions/repression. These may have large adverse spillover effects on other countries. The domestic mandates of most central banks do not legally allow them to take the full extent of spillovers into account and may force them to undertake aggressive policies so long as they have some small, positive domestic effect. Consequently, the world may embark on a suboptimal collective path. We need to reexamine rules of the game for responsible policy in such a context. This paper suggests some of the issues that need to be considered.
THE PROBLEM WITH THE CURRENT SYSTEM
All monetary policies have external spillover effects. If a country reduces domestic interest rates, its exchange rate also typically depreciates, helping exports. Under normal circumstances, the "demand creating" effects of lower interest rates on domestic consumption and investment are not small relative to the "demand switching" effects of the lower exchange rate in enhancing external demand for the country's goods. Indeed, one could argue that the spillovers to the rest of the world could be positive on net, as the enhanced domestic demand draws in substantial imports, offsetting the higher exports at the expense of other countries.
Matters have been less clear in the post-financial crisis world and with the unconventional monetary policies countries have adopted. For instance, if the interest rate-sensitive segments of the economy are constrained by existing debt, lower rates may have little effect on enhancing domestic demand but continue to have demand-switching effects through the exchange rate. Similarly, the unconventional "quantitative easing" policy of buying assets such as long-term bonds from domestic players may certainly lower long rates but may not have an effect on domestic investment if aggregate capacity utilization is low. Indeed, savers may respond to the increased distortion in asset prices by saving more. And if certain domestic institutional investors such as pension funds and insurance companies need long-term bonds to meet their future claims, they may respond by buying such bonds in less distorted markets abroad. Such a search for yield will depreciate the exchange rate. The primary effect of this policy on domestic demand may be through the demand-switching effects of a lower exchange rate rather than through a demand-creating channel. (See, for example, Taylor 2017 for evidence on the exchange rate consequences of unconventional monetary policy in recent years and the phenomenon of balance sheet contagion among central banks.)
Other countries can react to the consequences of unconventional monetary policies, and some economists argue that it is their unwillingness to react appropriately that is the fundamental problem (see, for example, Bernanke 2015). Yet concerns about monetary and financial stability may prevent those countries, especially less institutionally developed ones, from reacting to offset the disturbance emanating from the initiating country. It seems reasonable that a globally responsible assessment of policies should take the world as it is, rather than as a hypothetical ideal.
Ultimately, if all countries engage in demand-switching policies, we could have a race to the bottom. Countries may find it hard to get out of such policies because the immediate effect for the country that exits might be a serious appreciation of the exchange rate and a fall in domestic activity. Moreover, the consequences of unconventional policies over the medium term need not be benign if aggressive monetary easing results in distortions to asset markets and debt buildup, with an eventual disastrous denouement.
Thus far, we have focused on exchange and interest rate effects of a country's monetary policy on the rest of the world. A second, obviously related, channel of transmission of a country's monetary policy to the rest of the world in the post-Bretton Woods system has been through capital flows. These have been prompted not just by interest differentials but also by changes in institutional attitudes toward risk and leverage, influenced by sending country monetary policies. Figure 1.1.1, for example, shows that post-global crisis capital flows to EMs have been large. This is despite great reluctance on the part of several EMs to avoid absorbing the inflows.
As a consequence, local leverage in emerging economies has increased (figure 1.1.2). The increase could reflect the direct effect of cross-border banking flows, changes in global risk aversion stemming from source country monetary policy (Rey 2013; Baskaya et al. 2017; Morais, Peydro, and Ruiz 2015), the promise of abundant future liquidity on borrowing capacity (see Diamond, Hu, and Rajan 2017, for example), or the indirect effects of an appreciating exchange rate and rising asset prices, which may make it seem that emerging market (EM) borrowers have more equity than they really have (see Shin 2016, for example).
The unintended consequence of such flows is that they are significantly influenced by the monetary policies of the sending countries and may reverse quickly — as they did during the Taper Tantrum in 2013. This means that they are not a reliable source of financing, which then requires emerging market central banks to build ample stocks of liquidity (that is, foreign exchange reserves) for when the capital flows reverse. Moreover, the liquidity insurance provided by emerging market central banks to their borrowers is never perfect, so when capital flows reverse, they tend to leave financial and economic distress in their wake. Capital flows, driven or pulled back by the monetary policy stance in industrial countries, create risk on the way in and distress on the way out. They constitute both a costly spillover and a significant constraint on emerging market monetary flexibility.
The bottom line is that simply because a policy is called monetary, unconventional or otherwise, it may not be beneficial on net for the world. That all monetary policies have external spillovers does not mean that they are all justified. What matters is the relative magnitude of demand-creating versus demand-switching effects and the magnitude of other net financial sector spillovers, that is, the net spillovers (see Borio 2014; Borio and Disyatat 2009, 292; Rajan 2013 and 2014, for example).
Of course, a central contributor today to policy makers putting lower weight on international spillovers is that almost all central banks have purely domestic mandates. If they are in danger of violating the lower bound of their inflation mandate, for example, they are required to adopt all possible policies to get inflation back on target, no matter what their external effect. Indeed, they can even intervene directly in the exchange rate in a sustained and unidirectional way, although internationally this could be seen as an abdication of international responsibility according to the old standards. The current state of affairs means that central banks find all sorts of ways to justify their policies in international fora without acknowledging the unmentionable — that the exchange rate may be the primary channel of transmission and external spillovers may be significantly adverse. Unfortunately, even if they do not want to abdicate international responsibility, their domestic mandates may give them no other options. In what follows, we will examine sensible rules of monetary behavior assuming the domestic mandate does not trump international responsibility.
PRINCIPLES FOR SETTING NEW RULES
Monetary policy actions by one country can lead to measurable and significant cross-border spillovers. Such spillovers can influence countries to undertake policies that shift some of the cost of the policy to foreign countries. This temptation to shift costs can create inefficiencies when countries set their policies unilaterally. If countries agree on a set of new rules or principles that describe the limits of acceptable behavior, it can reduce inefficiencies and lead to higher welfare in all the countries. This does not mean countries have to coordinate policies, only that they have to become better global citizens in foregoing policies that have large negative external effects. We had such a rule in the past — no sustained unidirectional intervention in the exchange rate — but with the plethora of new unconventional policies, we have to find new, clear, and mutually acceptable rules.
What would be the basis for the new rules? As a start, policies could be broadly rated based on analytical inputs and discussion. To use a driving analogy, polices that have few adverse spillovers and are even to be encouraged by the global community could be rated green; policies that should be used temporarily and with care could be rated orange; and policies that should be avoided at all times could be rated red. To establish such ratings, the effects of any policy have to be seen over time, rather than at a point in time. We will discuss the broad principles for such ratings in this section. We will then discuss whether the tools economists have today allow empirical analysis to provide a clear-cut rating of policies. (To preview the answer, it is "No!") We will then argue that it may still be possible to make progress, once broad principles of the sort discussed in this section are agreed on.
A number of issues would need to be considered in developing a framework to rate policies.
Should a policy that has any adverse spillovers outside the country of origin be totally avoided? Or should the benefits in the country of origin be added to measure the net global effects of the policy? In other words, should we consider the enhancement to global welfare or the net spillovers to others only in judging policy?
Should the measurement of spillovers take into account any policy reactions by other countries? In other words, should the policy be judged based on its partial equilibrium or general equilibrium effects?
Should domestic benefits weigh more and adverse spillovers weigh less for countries that have run out of policy options and have been stuck in slow growth for a long time? Should countries be allowed "jump starts" facilitated by others?
Should spillovers be measured over the medium term or evaluated at a point in time?
Should spillovers (both positive and negative) be weighted more heavily for poorer countries that have weaker institutions and less effective policy instruments?
Should spillovers be weighted by the affected population or by the dollar value of the effect?
Some tentative answers follow.
In general, policies that have net adverse outside spillovers over time could be rated red and should be avoided. Such policies obviously include those that have small positive effects in the home country (where the policy action originates) combined with large negative effects in the foreign country (where the spillovers occur). For example, if unconventional monetary policy actions lead to a feeble recovery in some of the advanced countries leading to small positive effects on exports to emerging markets, but large capital flows to, and asset price bubbles in, the EMs, these policies could be rated red. Global welfare would decrease with this policy.
If a policy has positive effects on both home and foreign countries, and therefore on global welfare, it would definitely be rated green. Conventional monetary policy would fall in this category, as it would raise output in the home economy and create demand for exports from the foreign economy. A green rating for such policies would, however, assume that the stage of the financial and credit cycle in the home and foreign economies is such that financial stability risks from low interest rates are likely to be limited.
It is possible to visualize other policies that have large positive effects for the originating country (because of the value of the policy or because of the country's relative size) and sustained small negative effects for the rest of the world. Global welfare, crudely speaking, may go up with the policy, even though welfare outside the originating country goes down. While it is hard to rate such policies without going into specifics, these may correctly belong in the orange category: permissible for some time but not on a sustained basis. Even conventional monetary policies to raise growth in the home economy could fall in the orange category if countries are at a financial stage where low interest rates lead to significant financial stability risks in the home and foreign economies.
Clearly, foreign countries may have policy room to respond, and that should be taken into account. Perhaps the right way to measure spillovers to the foreign country is to measure their welfare without the policy under question and their welfare after the policy is implemented and response initiated. So, for instance, a home country A at the zero lower bound may initiate quantitative easing (QE) and a foreign country B may respond by cutting interest rates to avoid capital inflows and exchange rate appreciation. The spillover effects of QE would be based on B's welfare if QE were not undertaken versus B's welfare after QE is initiated and it responds.
A policy could also be rated green if it acts as a booster shot for an economy stuck in a rut and if it can jump-start that economy (for example, Lars Svensson's proposal for Japan to engage in exchange rate targeting in order to alter inflationary expectations), but creates temporary negative spillovers for the foreign economy. Even if there are temporary adverse spillovers on foreign countries, the policy — through its effect on home economy growth and demand for foreign goods — can eventually provide offsetting large positive spillovers to the rest of the world. Of course, it is important that the home economy, after receiving the booster shot and picking up growth, not follow policies (such as holding down its exchange rate longer term) that minimize positive spillovers to other countries. A policy rated red on a static basis could thus be deemed green based on commitments over time. This also means that policies should be rated over the medium term rather than on the basis of one-shot static effects.
What we have just argued is that countries stuck in a rut for a long time and with few other options should temporarily be allowed policies that may have adverse spillovers. But what if the policy is sought to be employed over the medium term? Here, "rut" is a relative term both over time and across countries. If a stagnant, rich country is allowed a free pass, should historically stagnant, and therefore poor, countries have a permanent pass to do whatever is in their best interests? It would be difficult to carve out exceptions to developed countries based on relative stagnation, or deviations from trend growth, without admitting a whole lot of other exceptions.
In this vein, poorer countries typically have weaker institutions — for example, central banks with limited credibility and budgetary frameworks that are not constrained by rules and watchdogs. As a result, their ability to offset spillovers with policies is typically more limited. Furthermore, poorer citizens live closer to the minimum margin of sustainability and poorer countries typically have weaker safety nets. So there is a case for weighting spillovers to poor countries more. However, it will be difficult to determine precisely what weight to place. Nevertheless, this facet could be kept in mind in deciding how to rate a policy when it is on the borderline.(Continues…)
Excerpted from "Currencies, Capital, and Central Bank Balances"
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Table of Contents
1 International Rules of the Monetary Game Prachi Mishra Raghuram Rajan 3
Discussant Thomas J. Sargent
General Discussion John H. Cochrane Michael D. Bordo Sebastian Edwards Gita Gopinath Paul Tucker Raghuram Rajan
2 Dollar Dominance in Trade and Finance Gita Gopinath 53
Discussant Adrien Auclert
General Discussion Juliane Begenau Michael D. Bordo Juhi Dhawan Robert Hall Michael Melvin Robert Heller Jim Dorn John Smyth John H. Cochrane Andrew T. Levin Paul Tucker George P. Shultz Gita Gopinath
Symposium on: Capital Flows, the IMF's Institutional View and Alternatives 83
Introduction George P. Shultz 83
3 Managing Capital Flows: Toward a Policy Maker's Vade Mecum Jonathan D. Ostry 87
4 The IMF's Institutional View: A Critique Sebastian Edwards 97
5 Capital Flows, the IMF's Institutional View, and an Alternative John B. Taylor 105
General Discussion Robert Hall John H. Cochrane George P. Shultz John B. Taylor Jonathan D. Ostry
6 Monetary Policy with a Layered Payment System Monika Piazzesi Martin Schneider 125
Discussant Oleg Itskhoki
General Discussion Michael D. Bordo Arvind Krishnanmurthy Robert Hall Jeff Lacker Martin Schneider
7 Liquidity Regulation and the Size of the Fed's Balance Sheet Randal K. Quarles
Discussant Paul Tucker
General Discussion Andrew T. Levin Charlie Siguler Donna Borak Sebastian Edwards William Nelson Michael D. Bordo Randal K. Quarks Paul Tucker 153
Symposium on: The Future of Central Bank Balance Sheets 193
Introduction Kevin Warsh 193
8 Normalizing the Federal Reserve's Balance Sheet and Policy Implementation Lorie K. Logan 197
9 Get Up Off the Floor William Nelson 213
10 The Fed's Balance Sheet Strategy: What Now? Mickey D. Levy 221
11 Should the Fed 'Stay Big5 or 'Slim Down'? Peter R. Fisher 239
General Discussion John H. Cochrane Andrew Levin Kevin Warsh Lorie K. Logan William Nelson Mickey D. Levy Peter Fisher
12 Anchoring Inflation Expectations in a Low R-star World John C. Williams 263
General Discussion Robert Heller John C. Williams Sebastian Edwards Beat Siegenthaler
Symposium on: Monetary Policy and Reform in Practice 279
Introduction Charles I. Plosser 279
13 Monetary Policy and Reform in Practice Esther L. George 283
14 US Economic Conditions and Monetary Policy Considerations Robert S. Kaplan 291
15 Remarks Raphael Bostic 301
General Discussion Paul Tucker Mickey D. Levy Michael D. Bordo William Nelson Andrew Filardo Charles I. Plosser Robert Kaplan Esther L. George Raphael Bostic 301
About the Contributors and Discussants 319
About the Hoover Institution's Working Group on Economic Policy 333