(Following is the fourth and final report based on papers presented at the 2013 Jackson Hole Economic Policy Symposium, hosted by the Federal Reserve Bank of Kansas City. The reports have been published as soon as the authors presented their papers to the symposium.)
A global financial cycle, mainly determined by U.S. monetary policy, constrains national monetary policies when capital is freely mobile regardless of the exchange rate regime, according to a paper presented at the Jackson Hole symposium by Helene Rey of the London Business School.
In her paper, “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence,” Rey shows how global capital flows, asset prices, credit growth and financial leverage tend to move in sync with the VIX, the ticker symbol for the Chicago-traded index that measures uncertainty and risk aversion in financial markets.
The VIX thus becomes a proxy for a global financial cycle that is independent of countries’ specific economic conditions. The symptoms of the cycle can be benign or large asset price bubbles and excess credit growth, one of the best predictors of financial crises.
“Low value of the VIX, in particular for long periods of time, are associated with a build up of the global financial cycle: more capital inflows and outflows, more credit creation, more leverage and higher asset price inflation,” Rey says, adding that asset markets with more credit inflows tend to be more sensitive to this global cycle.
Particularly striking, says Rey, is the consistency of this global factor with the timing of major events, such as the Gulf War from the second half of 1990 and the first quarter of 2009 when the global financial crises reached its climax.
Overall, the index rises from the early 1990s until mid-1998 when the Russian crises erupts and eventually the bursting of the dotcom bubble. From the beginning of 2003, the index increases rapidly until the beginning of the third quarter of 2007.
Rey then looks at other studies to see how the VIX is related to banks with significant trading operations and finds a positive feedback loop between greater credit supply, asset price inflation and compression of spreads. Smaller risk premiums then amplify the credit boom and contributes to the procyclicality of credit flows, which then contributes to a build-up of financial fragility.
Given this procyclicality of credit flows and the way global banks operate, Rey looks at the effect on the global financial cycle of the cost of finance in dollars, i.e. the Federal Reserve’s monetary policy.
“The dollar is the main currency of global banking. Since surges in capital flows – especially credit flows – are associated with increases in leverage worldwide, a natural interpretation is that monetary conditions in the centre country are transmitted worldwide through these cross-border gross credit flows,” she says.
To fully understand this interaction between U.S. monetary policy, risk aversion and uncertainty, leverage and credit flows, Rey builds on earlier work by other economists and analyses the relationship between the VIX and growth, inflation, forms of credit, leverage and the federal funds.
“When the Federal Funds rate goes down, the VIX falls (after about 5 quarters), European banks’ leverage rises, as do gross credit flows (after 12 quarters),” she says.
This helps set up a positive feedback loop between loose monetary policy, a fall in the VIX, a rise in credit, capital flows and leverage and then a further fall in the VIX.
Economists have long understood how capital flows creates booms and busts in emerging markets and advanced economies.
But what Rey adds to our understanding is how capital flows, credit growth and leverage are part of a global financial cycle that is largely determined by monetary policy is the U.S.
This finding allows her to question the so-called “trilemma, ” a popular concept in international economics that says in a world of free capital mobility, independent monetary policies are feasible if and only if exchange rates are floating.
“Instead, while it is certainly true that countries with fixed exchange rates cannot have independent monetary policies in a world of free capital mobility, my analysis suggests that cross-border flows and leverage of global institutions transmit monetary conditions globally, even under floating exchange-rate regimes,” Rey says, adding:
“The “trilemma” morphs into a “dilemma” – independent monetary policies are possible if and only if the capital account is managed, directly or indirectly, regardless of the exchange-rate regime.”
The relevance of Rey’s work has immediate policy implications.
Last month, for example, India’s central bank described how it was currently caught in the “impossible trinity trilemma” by having to tighten, rather than loosen, monetary policy in order to tackle the challenge of capital outflows and a falling rupee.
For years, the total free flow of capital across borders was a basic tenant of economic thinking. However, in recent years this belief has begun to wane, especially in emerging markets, and even the International Monetary Fund has acknowledged that a free flow of capital is not always the best option for every country.
Looking at the effects of the massive rise in cross-border investments from 1980 to 2007 in both advanced and emerging markets, Rey find surprisingly little impact on economic growth.
“I do not claim that there are no benefits to international financial integration, only that they have been remarkably elusive so far given the scale of financial globalization the world has undergone,” she said.
While she acknowledges that the gains from the free flow of capital may be hard to measure, it is still puzzling to her why it hasn’t shown up in growth rates and she concludes that any such gains really can’t be taken for granted.
If the welfare gains from free flow of capital are unclear and the global financial cycle tends to lead to financial instability, Rey questions how to weaken the potency of the global cycle.
Methodically, she examines four options but dismisses the option of acting on the source of the financial cycle itself: the monetary policy of the Fed and other major central banks.
The monetary conditions in the major advanced economies shape the global financial cycle through leverage and credit growth that is transmitted worldwide via flexible exchange rates.
As international cooperation in the monetary sphere conflicts with central banks’ domestic mandates, the next best option is for those central banks to pay more attention to the implications of their policies for the rest of the world.
Citing a proposal by the respected economist Barry Eichengreen, Rey says a small group of systemically significant central banks should meet regularly at the Bank for International Settlements (BIS), discuss the implications of their policies and issue a short report that may “encourage central bankers to internalize some of the external spillovers of the policies.”
Rey proposes that the most appropriate policies would be to take action directly aimed at the source of excessive leverage and credit growth. This includes a combination of aggressive stress-testing, tougher leverage ratios, and in some cases capital controls.