rethinking central banking web
TRANSCRIPT
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Think Tank 20:Macroeconomic Policy Interdependence
and the G-20
Rethinking CentralBankingCommittee on
International EconomicPolicy and Reform
Barry Eichengreen
Mohamed El-Erian
Arminio Fraga
Takatoshi Ito
Jean Pisani-Ferry
Eswar Prasad
Raghuram Rajan
Maria Ramos
Carmen Reinhart
Hlne Rey
Dani Rodrik
Kenneth Rogoff
Hyun Song Shin
Andrs Velasco
Beatrice Weder di Mauro
Yongding Yu
SEPTEMBER 2011
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Rethinking CentralBankingCommittee on
International EconomicPolicy and Reform
Barry Eichengreen
Mohamed El-Erian
Arminio Fraga
Takatoshi Ito
Jean Pisani-Ferry
Eswar Prasad
Raghuram Rajan
Maria Ramos
Carmen Reinhart
Hlne Rey
Dani Rodrik
Kenneth Rogoff
Hyun Song Shin
Andrs Velasco
Beatrice Weder di Mauro
Yongding Yu
SEPTEMBER 2011
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Preace
The Committee on International Economic and
Policy Reorm is a non-partisan, independent
group o experts, comprised o academics and
ormer government and central bank ocials. Its
objective is to analyze global monetary and nan-
cial problems, oer systematic analysis, and ad-
vance reorm ideas. Te Committee attempts to
identiy areas in which the global economic archi-
tecture should be strengthened and recommend
solutions intended to reconcile national interests
with broader global interests. Trough its reports,
it seeks to oster public understanding o key issues
in global economic management and economic
governance. Each Committee report will ocus on
a specic topic which will emphasize longer-term
rather than conjunctural policy issues.
Te Committee is grateul to the Alred P. Sloan
Foundation* or providing nancial support and
to the Brookings Institution or hosting the com-
mittee and acilitating its work. Quynh onnu pro-
vided excellent administrative and logistical sup-
port to the Committee.
Committee Members
Barry Eichengreen, University o Caliornia, Berkeley
Mohamed El-Erian, PIMCO
Arminio Fraga, Gavea Investimentos
akatoshi Ito, University o okyo
Jean Pisani-Ferry, Bruegel
Eswar Prasad, Cornell University and Brookings Institution
Raghuram Rajan, University o Chicago
Maria Ramos,Absa Group Ltd.
Carmen Reinhart, Peterson Institute or International Economics
Hlne Rey, London Business School
Dani Rodrik, Harvard University
Kenneth Rogo, Harvard University
Hyun Song Shin, Princeton University
Andrs Velasco,Columbia UniversityBeatrice Weder di Mauro, University o Mainz
Yongding Yu, Chinese Academy o Social Sciences
*Brookings recognizes that the value it provides to any donor is in its absolute commitment to quality, independence and impact. Activitiessponsored by its donors reect this commitment and neither the research agenda, content, nor outcomes are inuenced by any donation.
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Executive Summary
This report lays out a ramework or rethink-
ing central banking in light o lessons learned
in the lead-up to and afermath o the global
nancial crisis.
By the early 2000s, a growing number o central
banks, in advanced countries and emerging mar-
kets alike, had converged on a policy ramework,
exible ination targeting, which seemed capable
o achieving price stability and delivering mac-
roeconomic stability at the national and interna-
tional levels. Tis ramework had many practical
achievements, including bringing price stability
to many emerging markets. Now, however, there
is growing recognition that the conventional ap-
proach to central banking needs to be rethought.
Te relationship between price stability and the
broader goals o macroeconomic and nancial sta-
bility clearly needs to be redened. Moreover, the
evolution o monetary and exchange rate regimes
has resulted in incompatibilities among the poli-
cies o some key countries. Central banks are also
being pulled into new roles by the post-crisis envi-
ronment, which eatures high levels o public and
private debt in advanced economies and concerns
about capital inows and currency appreciation
in emerging markets. While some aspects o these
roles are not new, they are risky, as central bank
actions can inict collateral damage on domestic
nancial systems and have the potential o raising
new domestic and international tensions.
Te report analyzes these issues rom academ-
ic and practical policy-oriented perspectives.
Drawing on this analysis, it recommends changes
to the dominant ramework guiding central bank-
ing practice.
Te rst recommendation is that central banks
should go beyond their traditional emphasis on
low ination to adopt an explicit goal o nancial
stability. Macroprudential tools should be used
alongside monetary policy in pursuit o that ob-
jective. Mechanisms should also be developed to
encourage large-country central banks to inter-
nalize the spillover eects o their policies. Spe-
cically, we call or the creation o an International
Monetary Policy Committee composed o repre-
sentatives o major central banks that will report
regularly to world leaders on the aggregate conse-
quences o individual central bank policies.
Tere is substantial pressure on central banks to
acknowledge the importance o still other issues,
such as the high costs o public debt management
and the level o the exchange rate. Central banks
are more likely to saeguard their independence
and credibility by acknowledging and explicitly
addressing the tensions between ination target-
ing and competing objectives than by denying
such linkages and proceeding with business as
usual. Central banks should make clear that mon-
etary policy is only one part o the policy response
and cannot be eective unless other policiess-
cal and structural policies, nancial sector regula-
tionwork in tandem.
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The Golden Age o Infation Targeting
High ination in the advanced economies in the
1970s and in emerging economies in the 1980s and
1990s was instrumental in shaping modern think-
ing about the practice o central banking. Te tenets
o the resulting ramework are amiliar and, to a
large extent, uncontroversial. First, there is no per-
manent tradeo between ination and unemploy-
menta sustained higher level o ination does not
lead to higher growth and a sustained lower level o
unemployment. Second, high and volatile ination
depresses growth and distorts the allocation o re-
sources. Tird, ination disproportionately harms
the poorest segments o society, which lack instru-
ments or protecting themselves rom its disruptive
eects. For all o these reasons, price stability is the
cornerstone o monetary policy.
Te actions needed to achieve price stability, such
as the maintenance o high interest rates, can be
politically unpopular, among other reasons be-
cause they slow growth. It ollows that the pur-
suit o price stability can be made more credible
and thus more eective by granting independence
or at least operational autonomy to the central
bank. Otherwise, central banks may be subject to
political pressure to attach greater weight to other
objectives, making it harder or them to containinationary expectations and deliver desirable
outcomes.
By the early 2000s, a growing number o central
banks, in advanced countries and emerging mar-
kets alike, had converged on a policy ramework,
exible ination targeting, that seemed capable o
achieving these desiderata and delivering macro-
economic stability at the national and internation-
al levels. In the conventional view, there are our
explanations or this happy outcome:
Flexible ination targeting, under which
the central bank aims to stabilize ination
around its target but also minimize the
output gap, delivers low ination at the
national level, thereby avoiding the need
or large nominal exchange-rate adjust-
ments and the kind o overshooting that
characterized the 1980s.1
Flexible ination targeting, by allowing
or exchange rate variability, acilitates in-
ternational adjustment. Countries experi-
encing demand shocks can cushion them
1 Although neither the Fed nor the ECB had ormally endorsed ination targeting (I), both were aiming at price stability, which made theirpolicies similar to those o the central banks on a strict I regime.
CHAPTER 1
Introduction
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through interest-rate changes and associ-
ated movements in exchange rates.
Flexible ination targeting makes re-
serve accumulation unnecessary, since
exchange-rate intervention is rare andlimited to short-term responses to market
disruptions and to a signaling role in cases
o serious misalignments.
Te combined policy stance o the coun-
tries ollowing this strategy is supposed to
ensure an appropriate level o aggregate
demand at the global level.
Te generalization o ination targeting cum oat-
ing exchange rates could thus be regarded as thetriumph o the own house in order doctrine in
the international monetary eld. National macro-
economic stability was seen as sucient or inter-
national macroeconomic stability. Te domestic
and international aspects were essentially regarded
as two sides o the same coin.2
An added benet o exible ination targeting,
according to the emerging orthodoxy, was that it
allowed the objectives o price stability and nan-
cial stability to be pursued through separate toolsmonetary policy or the ormer and micro-pru-
dential regulatory and supervisory measures or
the latter. inbergens separation principle, i.e. the
idea that each goal should be pursued with a sepa-
rate and dedicated instrument, was widely invoked
in this context.
In this orthodox view, monetary policy ocuses
on controlling ination and works by managing
expectations o uture policy rates, which by the
expectations theory o the yield curve determinethe long-term interest rates that inuence ag-
gregate demand. Financial stability is attained by
microprudential regulation o bank capital that
counteracts the moral hazard generated by deposit
insurance, together with periodic supervisory as-
sessments and the necessary strictures meant to
prevent excessive risk taking and maleasance. Re-
gardless o whether the microprudential regulator
is situated in the central bank or a separate special-
ized regulatory agency, nancial regulation is seen
as a separate activity.
Central bankers nowadays ofen observe that ex-
ible ination targeting was never as straightor-
ward as this ramework suggests and that issues
o nancial stability and spillovers were always on
their minds. Still, it remains accurate to say that
the basic theoretical ramework sketched above
did much to shape their thinking. Its clarity and
simplicity enabled it to gain adherents in academia
and nancial markets as well as in central banks.
Rethinking the Framework
Some o the practical achievements o the exible
ination targeting ramework are indisputable.
Te adoption o price stability objectives by coun-
tries at dierent levels o economic development
was a major step orward afer decades o domes-
tically-generated instability. Tis ramework can
be credited, at least in part, or the drop in globalination and the abatement o exchange-rate con-
troversies among the advanced economies.3
Now, however, there is growing recognition that
the conventional approach to central banking
needs to be rethought. Critics reach this conclu-
sion or several related reasons:
Te conventional approach ails to ac-
count adequately or nancial-sector risk
and is thereore too narrowly ocused.
Te conventional ramework assumes lim-
ited or nonexistent cross-border spillovers
2 Looking ahead, some even regarded this regime as the solution to perennial international monetary controversies (Rose, 2007).3 o what extent I can be credited or the disination o the 1990s and the early 2000s is a matter or discussion. Another important actor was
the disinationary pressure coming rom the emerging countries exports. We return to the issue below.
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o monetary policies, while in act spill-
overs are requently o rst-order impor-
tance. Tey can complicate monetary pol-
icy management, accentuate the volatility
o real activity and increase nancial-sec-
tor risk.
Te incompatibility o national monetary
policies in the ace o spillovers is height-
ened when countries ollow dierent de
acto monetary policy regimes (e.g., ina-
tion targeting and exchange rate target-
ing).4
Spillovers may be urther accentuated
when central banks pursue unconven-
tional monetary interventions (e.g., wheninterest rates are at their oor and con-
strained by the zero bound). Because o
weak domestic demand, as well as dis-
tressed banks that are unwilling to lend,
the portolio adjustments prompted by
unconventional policies may largely serve
to increase capital ows to countries with
stronger growth prospects rather than
boosting domestic credit as intended.
High levels o government debt in ad-vanced countries and the slowing growth
o traditional export markets or develop-
ing countries create new sources o po-
litical pressure that central banks will nd
dicult to ignore.
In this report, we start by considering the valid-
ity o these criticisms. We then go on to ask how
central banking theory and practice need to be up-
dated in light o this shif in thinking. Te report
consists o our chapters (afer this one) ollowedby our recommendations.
In Chapter 2, we describe how the global nancial
crisis has recast the debate over central banking.
We ocus on the relationship between the tradi-
tional emphasis on price stability and the broader
goals o macroeconomic and nancial stability. We
discuss why the traditional separation, in which
monetary policy targets price stability and regula-
tory policies target nancial stability, and the two
sets o policies operate largely independently o
each other, is no longer tenable.
I central banks do in act embrace the goal o
nancial stability in addition to price stability,
monetary policy-making and policy communica-
tion will become more challenging. We thereore
consider the practical issues that arise when the
central bank is orced to juggle multiple mandates.
We then turn in Chapter 3 to a criticism o theconventional policy ramework: it assumes not
just that central banks practice exible ination
targeting but also that they allow the exchange rate
to oat reely. Under these assumptions, each cen-
tral bank has the independence necessary to target
price stability and ull employment.
Te problem is that policy independence in theory
may exceed policy independence in practice. In
other words, the conventional ramework ails to
take into account that national policies can havepowerul cross-border repercussions that the a-
ected partner may not be able to adequately o-
set with exchange rate movements. In part this
is because the existing system is not, in act, one
o ully exible exchange rates. In practice, some
countries eectively target exchange rates (Chinas
tight management o its currencys value relative
to the US dollar being a prominent case in point).
In part it is because international transmission oc-
curs even under exible exchange rates, through
both trade channels and capital ows. Te conse-quences include the prospective re-emergence o
global imbalances as well as the prolieration o
trade and capital controls when countries seek ur-
ther insulation rom cross-border spillovers.
4 Tough the choice o regime itsel may partly be a reaction to spillovers.
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o analyze these issues, in this chapter we provide
a global perspective on the evolution o monetary
policy and exchange rate regimes. We examine the
problems that arise out o the incompatibility o
national regimes with similar domestic objectives.
We then discuss the challenges that arise in rec-
onciling domestic monetary policies with global
macroeconomic stability.
In Chapter 4, we describe how central banks are
being pulled into new roles by the post-crisis en-
vironment and by the unavailability o alternative,
potentially more suitable instruments.While some
aspects o these roles are not new, they nonetheless
move central banks into risky territory insoar as
central bank actions can inict collateral damage
on domestic nancial systems and have the po-tential o raising new domestic and international
tensions. We highlight two sets o issues: (a) the
consequences o high levels o public and private
debt in the advanced economies and the attendant
pressures towards nancial repression; and (b)
the perceived dangers o currency misalignments
and overvaluation, and the attendant pressures to-
wards currency intervention and capital controls.
In Chapter 5, we draw on the analysis in previous
chapters to recommend changes in the dominantramework guiding central banking practice. In
the ramework we propose, central banks should
go beyond their traditional emphasis on low ina-
tion to adopt an explicit goal o nancial stabil-
ity. Macroprudential tools should be used along-
side monetary policy in pursuit o that objective.
Mechanisms should also be developed to encour-
age large-country central banks to internalize the
spillover eects o their policies. Specically, we
call or the creation o an International Monetary
Policy Committee composed o representatives o
major central banks that will report regularly to
world leaders on the aggregate consequences o
individual central bank policies.
While this report suggests more responsibilities or
central banks, we also recognize the environment is
one where there is substantial pressure on centralbanks to acknowledge the importance o still other
issues, such as the high costs o public debt manage-
ment and the level o the exchange rate. While these
pressures, i internalized, can make central bank ob-
jectives hopelessly diuse, they are not reasons to
postpone rethinking the overall policy ramework.
o the contrary, a ramework that is seen as de-
cient will become an easier political target.
For all these reasons, we believe it is time to re-
think the existing paradigm. Te rest o the reportlays out what this rethinking should entail.
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CHAPTER 2
The Scope o Monetary Policy
I
n this chapter we describe how the global nan-
cial crisis has recast the debate over the scope ocentral banking unctions. We ocus on the re-
lationship between the traditional narrow goal o
monetary policyprice stabilityand the broader
goals o macroeconomic and nancial stability. We
explain why the traditional separation, in which
monetary policy targets price stability and regula-
tory policies target nancial stability and the two
sets o policies operate independently o each oth-
er, is no longer tenable. We then review some prac-
tical issues that arise in connection with attempts
to coordinate the two sets o policies.
Central Banks and Financial Stability
Te global nancial crisis shook condence in mi-
croprudential tools o regulation as the primary in-
strument or ensuring nancial stability. Yet many
central bankers still subscribe to the traditional di-
chotomy between monetary policy and nancial
stability, except that microprudentialtools have given
way to an embrace omacroprudential tools o -
nancial regulation (countercyclical capital adequacyrequirements, or example). Tese tools or policies,
which mitigate risks to the nancial system as a
whole rather than solely at the level o the individual
institution, are to be developed and implemented by
specialists in nancial stability, not by central bank-
ers responsible or the conduct o monetary policy.
Te case or this separation rests on the belie that
interest rates are too blunt an instrument or the
eective pursuit o nancial stability. Te question
is commonly ramed as whether the central bankshould raise interest rates in response to asset bub-
bles. In the 1990s and early 2000s, central bankers
discussed at length whether and how to respond
to asset market developments.5 Te conclusion o
that debate was that central banks had a mandate
to react to bursting bubbles but not to target asset
prices. Not everyone, however, shared this conclu-
sion. Te lean vs. clean debate remained active in
the run-up to the crisis.6
5 Te early debate was ramed by the stock market boom o the late 1990s. Arguments in avor o leaning against the wind when it comesto nancial developments have been given by Blanchard (2000), Bordo and Jeanne (2002), Borio and Lowe (2002), Borio and White (2003),Cecchetti, Genberg, Lipsky and Wadhwani (2000), Crockett (2003), Dudley (2006) and Goodhart (2000) among others. Te argument against isgiven in Bean (2003), Bernanke and Gertler (1999, 2001), Bernanke (2002), Greenspan (2002), Kohn (2005), Mishkin (2008) and Stark (2008).
6 A policy school, primarily associated with economists rom the Bank or International Settlements and the Bank o Japan, was critical o narrowination targeting and maintained that central banks could not orgo their responsibility or nancial stability. Bank o Japan economistsregretted having allowed the bubble to become too large in the second hal o the 1980s. Te European Central Bank never ully endorsed thestandard ormulation o ination targeting and argued that the growth o monetary aggregates and credit developments were also importantindicators o potential risks to price stability over a longer-term horizon.
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Te case against attempting to prick bubbles rests
on the ollowing arguments.
Identiying bubbles is hard.
Even i there is a bubble, monetary policy
is not the best tool with which to address
it. An asset price bubble will not respond
to small changes in interest rates; only a
sharp increase will suce to prick a bub-
ble. However, a drastic increase in interest
rates can cause more harm than good by
depressing output growth and increasing
output volatility.
Te claim that an asset price bubble will not re-
spond to a small change in interest rates has beenmade in the context o stock market bubbles,
where the proposition is most plausible. When the
stock market is rising by 20 percent a year, a small
increase in interest rates will not outweigh the e-
ects o rapid asset price increases.
However, the stock market may not be the best
context in which to discuss the nancial stability
role o monetary policy. Te housing market, with
its more prominent role or leverage and credit,
and markets in the derivative securities associatedwith housing investment may be more pertinent.
Monetary policy stands at the heart o the lever-
age decisions o banks and other nancial inter-
mediaries involved in lending or housing-related
investments. In this setting, even small changes in
unding costs may have an impact on risk-taking
and unding conditions. Financial intermediaries,
afer all, borrow in order to lend. Te spread be-
tween borrowing and lending rates is thereore a
key determinant o the use o leverage and has im-
portant implications or the interaction betweenbanking sector loan growth, risk premia, and any
ongoing housing boom.7
Focusing on risk taking by banks and other nan-
cial intermediaries will lead the policy maker to ask
additional questions about risks to the stability o
economic activity. Rather than waiting or incontro-
vertible proo o a bubble in housing markets, or
example, a policy maker could instead ask whether
benign unding conditions could reverse abruptly
with adverse consequences or the economy. Even
i policy makers are convinced that higher housing
prices are broadly justied by secular trends in pop-
ulation, household size, and living standards, policy
intervention would still be justied i the policy
maker also believed that, i lef unchecked, current
loose monetary conditions signicantly raise the
risk o an abrupt reversal in housing prices and o
nancing conditions, with adverse consequences
or the nancial system and the economy.
Not responding in this way has led to a dangerous-ly asymmetric response to credit market develop-
ments. Central banks have allowed credit growth
to run ree, ueling booms, and then ooded mar-
kets with liquidity afer the crash, bailing out -
nancial institutions and bondholders. Tis asym-
metry has contributed to stretched balance sheets,
with aster lending growth and leverage in times o
low risk premia, more violent deleveraging when
risk premia rise, and requent booms and busts.
For all these reasons, there is a case or centralbanks to guard against credit market excesses. An
ination-targeting central bank may argue that it
does so automatically insoar as higher asset prices
boost aggregate demand through wealth eects
and create inationary pressures. However, some
additional leaning against credit market develop-
ments would be advisable even in the absence o
aggregate demand eects once it is determined
that unding conditions and reduced risk premia
indicate a nascent credit boom. Put dierently,
ination-targeting central banks may want to straybelow target when conditions are boom-like
when rapid asset price growth is accompanied by
substantial credit expansionsince policy would
otherwise become asymmetric and execerbate
macroeconomic volatility.
7 See Adrian and Shin (2011) or a discussion o these linkages.
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Retiring the Separation Principle
A consequence o this doctrine o leaning against
the wind is that the neat inbergen assignment o
dierent tools to dierent objectives becomes more
dicult to implement in practice. Interest rates aectnancial stability and, hence, real activity. Equally,
macroprudential tools impact credit growth and ex-
ternal imbalances with consequences or macroeco-
nomic and price stability. When consumer credit is
growing rapidly and the household debt ratio is high,
or example, restraining credit growth by changing
guidance on loan-to-value (LV) or debt service-to-
income (DI) ratios over the business cycle will have
important macro-stabilization eects.
Rather than viewing the allocation problem as hav-ing a corner solution where one instrument is de-
voted entirely to one objective, the macro-stabiliza-
tion exercise must be viewed as a joint optimization
problem where monetary and regulatory policies
are used in concert in pursuit o both objectives.
Believers in a strict interpretation o inbergen
separation will ret that blurring the assignment o
instruments to targets will jeopardize the central
banks operational autonomy, the central banks
mandate will become uzzier, and its actions willbecome more dicult to justiy.
Tese are valid concerns. Central bankers will ex-
perience more political pressure than i monetary
policy were primarily targeted at price stability.
Here, however, it is important to remember that
central bank independence is a means to an end
rather than an end in itsel. Limiting the scope o
monetary policy purely or the sake o deending
central bank independence risks undermining the
institutions legitimacy by giving the impressionthat the central bank is out o touch and that it is
pursuing a narrow and esoteric activity that does
not square with its democratic responsibilities.
Ultimately, political reality will thrust responsibility
or nancial stability on the central bank. As hap-
pened in the UK ollowing the ailure o Northern
Rock, the central bank will be blamed or nancial
problems whether or not it was ormally responsi-
ble or supervision and regulation. As lender o last
resort, it will be charged with cleaning up the mess.
It ollows that it would be better o devoting more
o its resources and attention to attempting to pre-
vent the crisis, the elegance and analytical appeal o
the inbergen principle notwithstanding.
Macroprudential Policy Tools
Macroprudential tools are designed to buttress the
stability o the nancial system as a whole, which
is distinct rom ensuring the stability o individ-
ual institutions. Tese tools are intended to help
mitigate externalities and spillovers at the level o
the system as a whole. For example, interlockingclaims and obligations create externalities i the
ailure o one higly leveraged institution threatens
the solvency o other institutions and the stability
o the entire nancial system. Fire sales o assets
may magniy an initial shock and lead to vicious
circles o alling assets prices and the need to de-
leverage and sell o assets. Externalities also arise
over the course o the cycle i the structure o capi-
tal regulation allows an increase in leverage in -
nancial booms while dampening it in busts.
It is useul to distinguish between dierent mac-
roprudential tools that address these dierent as-
pects o nancial risk. In particular, dierent tools
should be used address the time- and cross-sec-
tional dimensions o risk.
Te ime Dimension in Macroprudential
Supervision
In terms o the time dimension, the macropruden-
tial supervisor should develop a range o tools ca-pable o tempering nancial procyclicality. Coun-
tercyclical capital buers, as recommended by the
Basel Committee, are a case in point, although they
are conned to the banking system. A supplement
would be to impose a systemic levy or all levered
nancial institutionsthat is, an additional charge
levied on the unstable (non-core) portion o a
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nancial institutions unding, as suggested by the
IMF (2010). Tis levy could be varied over the the
lie o the cycle.
Restraints on bank lending such as loan-to-value
(LV) or debt service-to-income (DI) guide-
lines could useully complement traditional tools
o bank regulation, such as capital requirements.
Capital requirements can themselves consist o
a core o long-dated equity or equity-like instru-
ments supplemented with an additional buer o
contingent capital instruments.
Te interaction between these prudential mea-
sures, as well as their cumulative costs, need to be
careully considered while rolling them out, with
a view to adjusting measures based on experience.And governments should guard against the temp-
tation to use such levies as just a revenue-gener-
ating mechanism rather than a tool to promote
nancial stability.
Some measures (e.g., capital requirements) are
likely to have implications or cross-border compe-
tition between nancial institutions and thereore
may need to be harmonized across countries. Tis
will make it harder to tie them to local economic
conditions, or such harmonization will have to bedone in an objective and mutually agreeable way
across countries. Others like LV or DI guid-
ance need not be harmonized across countries and
could vary substantially with the domestic cycle.
Te systemic levy is a orm o capital charge, mak-
ing harmonization important or countries with
many cross-border banks, something that will ad-
mittedly make it more dicult to tie it to the cycle.
Te Cross-sectional Dimension in
Macroprudential Supervision
In terms o the cross-sectional dimension, policy
should ocus on systemically important nancial
institutions (SIFIs). Better resolution regimes to
deal with ailing nancial institutions could re-
duce the need or reliance on ex ante buers such
as capital. Following the near collapse o Northern
Rock, the United Kingdom was among the rst
to enact a resolution regime that provides super-
visors extensive authority to stabilize a ailing in-
stitution.8 Germany enacted a similar law in Janu-
ary 2011 and the United States is in the process
o empowering regulatory agencies to deal with
uture insolvencies o systemically relevant insti-
tutions. An important complication is that many
systemically relevant institutions are active across
geographical and product borders. Tese new laws
have not been coordinated, and they are unlikely
to be adequate or dealing with a large cross-bor-
der or cross-market ailure. Te new resolution
regimes consequently do not solve the moral haz-ard problem implicit in too big to ail (BF). It
ollows that the implicit public subsidy or BF
institutions remains intact; hence the need or ex
ante measures.
Macroprudential tools could be used to reduce
this incentive to become too big to ail. Tey could
include a systemic risk tax as suggested by the IMF
(2010). Eorts to quantiy systemic risk exposure
or the purposes o regulation are now underway,
but much else remains to be worked out, includingwho would impose this tax, on whom, and under
what circumstances.
Alternatively, surcharges on capital requirements
that vary with the systemic risk they create could
be applied to SIFIs. Te Swiss government com-
mission on BF institutions has shown how this
could be done. In addition to increasing capital bu-
ers to nearly double the level o Basel III, the Swiss
proposal makes the surcharge sensitive to systemic
risk, calculated as a unction o the balance sheetsize and the market share o the institution.
Proposals have also been mooted to eliminate cer-
tain activities o SIFIs (e.g., proprietary trading),
8 Japan enacted an emergency resolution mechanism in 1998, ollowing the banking crisis o 1997. When the emergency term ended, thegovernment set up a permanent resolution mechanism.
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ringence certain activities (such as retail banking,
as discussed in the context o the Vickers Commis-
sion in the UK), or even break up SIFIs. Tere is
no consensus among the authors o this report on
what approach is most appropriate. But in devel-
oping all these proposals, care should be taken that
they in act reduce lower systemic risk and do not
just shif risk to entities that are less visible to the
regulatory authorities (including to entities less ca-
pable o managing that risk). Risk that is shunted
out o sight in good times comes back to haunt the
system in bad times.
Finally, supervisors need to identiy direct and in-
direct exposures and linkages, cross border as well
as national, in order to make supervision more
eective. Tey need to identiy institutions andtrades where activity is disproportionately con-
centrated. While collecting the relevant data (on,
or example, inter-bank derivative exposures) or
their own supervisory needs, they should also dis-
seminate more aggregated inormation to market
participants and the general public. Such dissemi-
nation will allow market participants to manage
risks better and allow the public in turn to better
monitor supervisory behavior. While individual
countries now have eorts underway to collect and
disseminate data (or example, the Oce o Finan-cial Supervision in the United States), we are still
some distance rom eective cross-border data
collection and sharing.
Institutional Responsibility
Who should be responsible or nancial stability
at the national level?9 Tere are two answers to this
question. Te coordinated approach gives multiple
institutions (central bank, systemic risk boards,
micro- and macroprudential supervisors) inter-locking mandates, their own instruments, and a
directive to cooperate. In contrast, the unied ap-
proach vests one institution, possibly the central
bank, with multiple mandates and instruments.
Te coordinated approach dominated prior to the
nancial crisis and, despite its ailures, has largely
survived the reorm process. In countries like In-
dia and the United States, administrative bodies
have been set up to coordinate the eorts o mul-
tiple supervisory and regulatory bodies, although
these bodies tend to lack enorcement power. In
Europe, the push or greater regional coordination
has been urther complicated by the superimposi-
tion o an additional layer o supervisory institu-
tions with ew powers o their own. Supervisory
colleges, which collect relevant home- and host-
country supervisors o a large cross-border insti-
tution, are one o the tools or coordination among
countries. But overall, the problem o incomplete
coordination remains.
In particular, the problem that EU-wide banks are
still largely supervised by national regulators is yet
to be ully solved. A new body, the European Sys-
temic Risk Board (ESRB), has been charged with
macroprudential supervision but is endowed with
only weak powers and ew eective instruments.
Te ESRB is large and unwieldy, comprising the
central bank governors and nancial supervisors
o every EU country, plus a number o other unc-
tionaries. Moreover, the ESRB can only issue rec-
ommendations and has no enorcement powers.
While there is little consensus as to the best mod-
el, our contention that nancial stability should
be a core objective o the central bank increases
the weight o arguments or giving central banks
primary responsibility or regulatory matters. I
central banks have a mandate to ensure nan-
cial stability and also the powers needed to wield
macroprudential corrective instruments, they can
optimally choose trade-os between the use o
the interest rate instrument and macroprudentialmeasures. Moreover, the central bank will have,
or should have, its nger on the pulse o nancial
markets through its monetary policy operations. It
possesses a sta with macroeconomic expertise. It
9 Alternatively, at the regional level in places where multiple national economies share a single central bank (e.g., Euroland).
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is the one institution with the balance sheet capac-
ity to act as lender o last resort.
Tere are also compelling arguments against a uni-
ed model. One disadvantage is that it makes the
central bank more susceptible to political interer-ence. Te central bank will have to work hard to
establish the legitimacy o its actions in circum-
stances where the nature o threats to nancial sta-
bility may be poorly understood and its actions are
unpopular. Te public and its elected representa-
tives may not be happy, or example, i the central
bank curbs credit growth and causes asset prices
to all, and they will pressure the authorities to re-
verse course.
Te unied model may also pose a conict o in-terest or the central bank, which may, or example,
be tempted to keep interest rates ariticially low in
an eort to aid distressed nancial institutions, or
to treat a bank acing a solvency problem (a mat-
ter properly addressed by the scal authority or its
agents) as i it were acing a liquidity problem.
I, on balance, the decision is to make the central
bank the macroprudential supervisor, this ap-
proach should go hand in hand with measures to
strengthen its independence rom political pres-sure. o this end, it is important or the central
bank to participate in the public discussion o how
its perormance will be evaluated. More regular
communication o the rationale or its policies will
also become increasingly important.
In sum, there are advantages to both models, and
individual countries institutional characteristics
and political settings will determine what works
best. Whatever the mechanism, it is clear that e-
ective coordination between monetary and nan-cial regulatory policies will be the lynchpin o -
nancial stability.
Exchange Rates and Monetary
Policy
Te external dimension o monetary policy is criti-
cally important or small open economies with open
capital accounts. Capital ows and exchange ratemovements are important or price-level develop-
ments. Tey are important or nancial stability as
well: in open economies, monetary policy may have
limited eectiveness in inuencing credit develop-
ments because, inter alia, nancial intermediaries
can substitute external unding or domestic unding.
Macroprudential tools that lean against credit de-
velopments can give the central bank some mea-
sure o monetary policy autonomy, weakening the
link between domestic monetary policy and capi-tal inows. For instance, by leaning against credit
expansion, the central bank may be able to reduce
the incentive or banks to borrow externally when
domestic interest rates are increased.
Te tensions between these dierent acets o eco-
nomic stabilization become more acute when the
currency is strong relative to undamentals and the
government wants to prevent excessive apprecia-
tion. Tis puts the central bank in a corner when
domestic demand is also too strong. Tere is thenthe need to cool an overheating economy by allow-
ing the appreciation o the currency, on the one
hand, but pressure to guard against the erosion o
competitiveness rom what might prove to be only
a temporary appreciation, on the other. Capital
controls that moderate nancial inows, especially
short-term inows that are channeled through the
domestic banking sector, may alleviate the policy
dilemma but their role as a legitimate part o the
policy makers toolbox remains controversial.
Much commentary takes or granted that capi-
tal controls dont work.10 Commentators making
10 See, or instance, the ollowing editorial in the Wall Street Journal: Capital-Control Comeback: As Money Flows to Asia, Politicians Play KingCanute, 2010, June 17. http://online.wsj.com/article/SB10001424052748704289504575312080651478488.html
http://online.wsj.com/article/SB10001424052748704289504575312080651478488.htmlhttp://online.wsj.com/article/SB10001424052748704289504575312080651478488.html -
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such claims typically assume that the objective is
either to hold down the exchange rate or to sup-
press the total volume o inows. In this approach
the emphasis is on the exchange rates inuence on
the trade balance and thus also the attempt to hold
back currency appreciation by limiting nancial
inows, whatever their precise orm.
But i capital controls and related macropruden-
tial measures are seen not as instruments o ex-
change rate management but as part o a package
o policies targeted at nancial stability, then it is
the composition o capital ows that takes center
stage rather than their volume.11 Foreign direct
investment (FDI) and portolio equity ows are
less likely to reverse direction abruptly. And even
when portolio ows do reverse, the impact onunding may be less damaging than any sudden
loss o access by the banking sector. Foreign sell-
ers o stocks in a crisis ace the double penalty o
lower local currency prices when they sell and a
sharply depreciating exchange rate, the implica-
tion being that the dollar-equivalent outow as-
sociated with repatriation o portolio equity sales
proceeds tends to be small compared to the pre-
crisis marked-to-market value o oreign holdings
o equity. And the typical equity investor (such as
a pension und or mutual und) is not leveraged.
In contrast, when oreign unding o the banking
sector evaporates abruptly, the consequences are
more damaging. I the local bank is leveraged and
debt is denominated in dollars, then outows can
set o the well-known cycle o distress in which
belated attempts by banks to hedge their dollar ex-
posure drives down the value o the local currency,
making the dollar-denominated debt even larger.12
I the crisis erupts afer a long build-up o such
mismatches, the coincidence o the banking crisiswith the currency crisis (the twin crisis) can un-
dermine banking sector solvency, with signicant
economic costs.
Capital controls are not, o course, the only tool or
dealing with inows. Microprudential tools such
as minimum capital ratios should be part o the
policy response. Even these tools, however, may
not be enough to dampen the upswing o the cycle.
Bank capital ratios ofen look strong during booms
when banks are protable and the measured qual-
ity o loans is high. In addition, the application
o discretionary measures, such as higher capital
requirements, must surmount concerted lobbying
by vested interests that benet rom the boom.
Currency appreciation may also help to moder-
ate the size o capital inows, as oreign investors
perceive less o a one way bet. However, when
banking sector ows orm the bulk o the inows,
merely allowing the currency to appreciate maynot suce. Te behavior o banks and other lever-
aged institutions is additionally inuenced by their
capital position and their perception o risks. Cur-
rency appreciation and strong protability coupled
with tranquil economic conditions can be seen by
banks as a cue to expand lending rather than to
curtail their activity.
In sum, capital controls can, under some circum-
stances, be useul or managing maturity and
currency mismatches and, in particular, or ore-stalling dollar shortages in the banking system.
Judiciously employed along with other macropru-
dential policies, they can reduce nancial instabil-
ity as well as boom-bust cycles, thereby serving as
a useul complement to conventional monetary
policy instruments. As with other instruments,
care should be taken that they are used to reduce
macro-economic volatility rather than merely
to suppress it, only to see it emerge in other, po-
tentially more destructive ways. Moreover, with
capital accounts becoming more open and giventhe increasing ungibility o unds across dierent
orms o capital, even controls limited to specic
types o capital ows are becoming an increasingly
11 For an extensive discussion, see Ostry, Ghosh, Habermeier, Chamon, Qureshi, and Reinhardt (2010).12 Figuratively, the attempt to clamber out o the ditch by buying dollars merely drags others into the ditch.
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weak substitute or good macroeconomic and pru-
dential policies.
Conclusion
Tis chapter has made the case or augmenting thetraditional narrow price stability ocus o mon-
etary policy with the additional goal o nancial
stability. Te conventional separation in which
monetary policy targets price stability and micro-
prudential policies target nancial stability, and
the two sets o policies operate independently o
each other, is no longer tenable.
Tis has a number o implications.
Policy makers need a new set o policiesthat are macroprudential in nature, target-
ing the build up o risks to nancial stabil-
ity. Tese policies range rom countercy-
clical capital ratios to capital controls.
Te neat inbergen separation o two
tools or two objectives is no longer ea-
sible. Interest rates aect nancial stability
and, hence, real activity. Equally, macro-
prudential tools impact credit growth and
external imbalances, which have conse-
quences or macroeconomic and price
stability. Central bankers thereore will
have to consider tradeos as they optimize
among their policy tools to achieve their
multiple objectives.
We believe that explicit recognition o such trade-
os will, in some cases, move theory closer to prac-
tice. In other cases it will make adopting ination
targeting more attractive insoar as the ramework
now recognizes issues that some policy makershitherto thought were missing. And in the case o
the ew who still adhere to narrow ination target-
ing, it might prompt a welcome reconsideration.
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CHAPTER 3
Cross-Border Spillovers
I
n the last chapter we discussed how national
monetary policy rameworks should be re-thought to better incorporate nancial-stability
considerations. But there is another equally im-
portant reason or rethinking the ramework: in-
ternational spillovers.
I national policies have important cross-border
eects, then there is a prima acie case or coordi-
nating them internationally. Tis observation was
o course the main point o the voluminous 1980s
literature on spillovers and policy coordination.
But it has since been rendered more compelling bychanges in the world economy in the last quarter
century. Te world today is more connected than
ever by cross-border nancial ows. Te policy
choices o individual countries, especially those o
large, systemically signicant countries, can have a
substantial impact on their neighbors. When gov-
ernments and central banks change their macro-
economic policy stance dramaticallyas they did
in the recent world nancial crisisthe spillovers
on other nations can be sizeable.
Cross-border spillovers may also have increased as a
result o the nature o policy responses to economic
shocks and business cycle conditions. A commonly
voiced concern is that unconventional monetary
policies may have especially large and complex
cross-border spillovers. For instance, monetary in-
jections when the nominal interest rate is at its zerobound might result in capital outows rather than
in more domestic activity, i domestic demand is
weak and banks are reluctant to lend.13
And while concern in the 1980s centered on the
interaction o the United States and Europe, two
economic blocs with oating exchange rates, spill-
overs today involve one bloc that oatsthe major
advanced countriesand one, led by China, with
xed or semi-xed exchange rates. Tis asymme-
try gives rise to important new issues.
In this chapter we review various channels or in-
ternational transmission o domestic policies and
discuss their implications. We then discuss the
tensions that arise in reconciling domestic mon-
etary policies with the larger objective o global
macroeconomic and nancial stability.
Cracks in the Framework of
(Mostly) Flexible Exchange RatesTe international properties o the de acto regime
o exible exchange rates were never as desirable
as asserted by its champions. o start with, the new
regime was not, in act, universally adopted. It was
13 Tis combination o circumstances is not unusualwitness what happened during the recent nancial crisis.
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not widely adopted in Asia, or example, where de
jure or de acto pegging remained the reality and a
large volume o oreign exchange reserves was ac-
cumulated in the 2000s, contrary to the presump-
tion that reserves would become superuous with
the breakdown o the Bretton Woods system o
xed exchange rates.
Moreover, large current-account surpluses and
decits (imbalances) persisted over much o the
last decade without prompting macroeconomic
and exchange-rate responses. Imbalances persist-
ed in countries with very dierent exchange rate
arrangements, including countries that did not
maintain dollar pegs, such as Japan and Germany.
Questions also remained about the ability o ina-tion targeting cum oating exchange rates to cope
with the volatility o international capital ows.
While stability-oriented monetary policies at the
national level could help to limit the magnitude
o sudden inows and reversals, and while strong
regulatory and supervisory rameworks could help
limit their consequences, it was unclear whether
such measures would be sucient to protect
emerging economies rom macroeconomic and
nancial instability.
Nor did the I-oating ramework eliminate the
special role o the dollar as the key international
currency. Te dollar remains the worlds most im-
portant reserve currency and a leading invoicing
currency or international trade. It is also the cur-
rency that underpins the global banking system as
the unding currency or global banks. Tis raises
important questions about access to dollar liquid-
ity by non-US banking systems in times o stress.14
Reconsidering the Conventional Wisdom
In light o the nancial crisis and subsequent de-
velopments, several reasons have emerged or re-
visiting the conventional wisdom:
Convergence towards the ination target-
ing cum exible exchange-rate ramework
remains incomplete. While a large part o
the world economy has adopted this mod-
el, some ast-growing emerging markets
have not. Te coexistence o oaters and
xers thereore remains a characteristic
o the world economy. It can even be said
that the incidence o pegging has risen
over time with the export drive o East
Asia and, toward the end o the most re-
cent decade, the rise o the relative price
o oil.
Te period in which the I regime was test-
ed was exceptionally benign. Chinas en-
try into global trade and other emergingmarkets acted as a strong disinationary
orce, making or price stability globally.
Commodity prices remained subdued un-
til the late 2000s, and there were ew in-
ation spillovers. Since then the situation
has changed. In a new context where com-
modity prices respond strongly to aggre-
gate demand, a major question is whether
central banks take into account spillovers
through global commodity prices when
making monetary policy decisions.
Capital market spillovers between ad-
vanced and emerging economies have
grown. While Obstelds (2009) character-
ization o the world economy as compris-
ing a single nancial system may not apply
to all countries, it is certainly correct or
North America, Europe, East Asia, and
a number o emerging market countries.
Private gross capital ows to and rom
both the US and Europe grew massively inthe course o recent decades. o be sure,
this was in large part or reasons indepen-
dent o monetary policy, including nan-
cial liberalization, the unique role o the
14 For an extensive discussion o these issues see Farhi, Gourinchas, and Rey (2011).
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US as supplier o sae nancial assets, and
the attractiveness o emerging markets
as destinations or investment. Still, the
resulting nancial interpenetration im-
plies that the stock o diversiable assets
and cross-border holdings that respond
to changes in monetary conditions have
grown enormously.15 Tis creates chal-
lenges or countries on the receiving end
o capital ows. In practice, many o those
recipients are emerging market economies
that are struggling to prevent the surges in
capital inows rom leading to exchange
rate misalignment and unsustainable
lending booms.
Unconventional monetary policies are likelyto accentuate international spillovers. Such
policies are typically undertaken when
traditional instruments are exhausted and
traditional channels have ceased working.
In such situations, unconventional poli-
cies could result in less domestic demand
creation and more demand shifs between
countries. Critics argue that purchases by
central banks o long-dated bonds and pri-
vate-sector-issued securities create liquid-
ity that can spill abroad (because domesticchannels or credit creation are blocked),
causing capital ows to and undesirable
relative price changes in other countries.16
Central banks in countries conducting
quantitative easingthe US Federal Re-
serve and the Bank o Englandargue
that Quantitative Easing (QE) is no dier-
ent conceptually rom conventional mon-
etary policy but merely its continuation
through other means in a situation where
interest rates approach the zero bound.Central banks in several emerging market
countries, in contrast, claim that QE is a
beggar-thy-neighbor strategy.
Tese observations suggest that convergence to-
wards a common policy template in the 2000s was
not general. Moreover, where convergence has
take place, it may not last long in view o the chal-
lenges currently conronting monetary policy. It is
thereore important to assess whether a reormed
consensus can and will be ormed and to contem-
plate its implications or the conduct o monetary
policy and or the own house in order doctrine in
particular.
Challenges to the IT-plus-foating Regime
1. Uneasy coexistence: oaters and fxers
Te idealized I-plus-oating ramework has not
worked out as anticipated, because countries havenot converged to similar monetary and exchange
rate arrangements.
In Latin America, a substantial number o coun-
tries, some o them large and economically im-
portant, resist moving in this direction. While the
two largest countries Brazil and Mexicoand an
important set o middle-sized and small nations
Colombia, Peru, Chile, Uruguayhave adopted
it, another sizeable group including Venezuela, Ar-
gentina, Bolivia, and Ecuador continues to pursuexed or semi-xed exchange regimes, sometimes
with multiple exchange rates or dierent current
and capital account transactions. Few countries
in the Middle East and Arica have converted to
I plus oating, though economically important
South Arica has adopted it.
In Asia, several countries have adopted the rame-
work, albeit with dierent degrees o commit-
ment. Ination targets are explicit in Tailand,
Korea, Indonesia, and the Philippines. In Tailandand Korea, low and stable ination was achieved
in the 2000s. Singapore has achieved low and sta-
ble ination using a basket-based exchange rate
15 Lane and Milesi-Ferretti (2001) and Kubelec and S (2010) provide a quantitative account o nancial integration and the participation in it omajor emerging economies.
16 See Portes (2010) or a discussion.
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regime, since the economy is small and highly open
to nancial ows. Usually, however, Asian central
banks have multiple objectives: growth, price sta-
bility, and exchange rate stability, some o which
temper the conventional ramework. It is air to
say that many East Asian countries deal with in-
ation more on the basis o discretion than pre-
set rules. In Cambodia and Vietnam, dollarization
and the lack o independence o the central bank
is a serious problem in stabilizing ination. India
has a hybrid regime without an explicit ination
objective and with exchange rate management in
principle limited to moderating sharp movements
in the currencys value.
China is the largest nation with a managed ex-
change rate. Te renminbi was delinked rom itsUS dollar peg in 2005 but remains tightly managed
against the dollar. Among the explanations or this
choice o exchange rate regime are the governments
objective o promoting export-led growth. Another
is the desire to sel-insure against external shocks
by accumulating a large stock o reserves. Chinas
oreign exchange reserves now exceed $3 trillion,
dwarng by a wide margin all evaluations o the
reserve buer necessary to insure against sudden
stops o inows or a surge o capital outows.
National and regional dierences aside, a common
eature o policies in these countries is a reluctance
to allow exchange rates to move as much as needed
to accommodate external disturbances, especially
those originating in the capital account. Non-oat-
ers monitor nominal and sometimes also real ex-
change rates and use not just oreign exchange mar-
ket intervention but a whole array o instruments to
prevent unwanted exchange rate movements.
In sum, notwithstanding the perceived success oination targeting with exible exchange rates,
countries operating a reely oating exchange-
rate regime, whether measured in terms o global
GDP or global exports, have not increased over
the last two decades. o the contrary, the share
o such countries, so measured, has actually de-
clined (Figure 1).
Te main consequence is that the adjustment
mechanism implied by the standard I-plus-oat-
ing arrangement has not been allowed to operate.
Tis is one explanation or the size and persistence
o global imbalances. According to the IMFsWorld
Economic Outlook, these imbalances reached 3%
o world GDP in 2007, beore the advent o the
crisis.17 Te subsequent crash then reduced cur-
rent account decits in countries such as the US
and the UK as their demand or imports dropped
sharply. But according to the April 2011 WEO, im-
balances once again began to grow starting in 2010
and will hover around 2% o world GDP betweennow and 2016.
A prominent instance o the uneasy coexistence
o oaters and xers is the tug o war between
US monetary policy and exchange rate policy in
emerging market xers such as China. A highly
stimulative US monetary policy is potentially u-
eling ination elsewhere, including in emerging
markets that have closed their output gaps and are
acing inationary pressures. O course, emerg-
ing market central banks could raise interest ratesmore rapidly, but they would then attract capital
inows and experience aster exchange rate appre-
ciation. Meanwhile, emerging market resistance
to exchange rate appreciation is limiting export
and employment growth in industrial countries
already experiencing high and persistent unem-
ployment. In normal circumstances, the United
States and other advanced economies would ad-
just by cutting interest rates. But these countries
are already at the zero bound. In this context, the
exchange rate policy o emerging market xers isimposing a negative demand externality on the ad-
vanced economies. In tandem with the ination-
ary externality imposed by US monetary policy,
this has created severe policy complications or
17 Tat is the size o the current account surpluses in countries like China, Japan, Germany, Switzerland, and the oil producers, matched (up toerrors and omissions) by the corresponding decits in the US, the UK, Spain and elsewhere.
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Figure 1:Shares o countries under alternative exchange-rate regimes in world GDP and
world exports, 1980-2007
World GDP
World Exports
Source: Angeloni et al. (2011). Calculations are based on the Ilzeztki-Reinhart-Rogo classication. Euro area countries aretreated separately throughout in order not to introduce a break in the series.
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other countries, especially emerging markets that
are oaters.
Collective action problems arise rom these asym-
metric exchange rate arrangements. Many emerg-
ing market countries in East Asia, even those that
ostensibly oat, explicitly or implicitly monitor
their real exchange rates. Tey are reluctant to see
their currencies appreciate excessively, especially
relative to other countries in the region. Tis reluc-
tance hinders nominal exchange-rate adjustment
between East Asia and the advanced economies at
a time when asymmetries between the two groups
urgently call or real exchange-rate adjustment.
Concerns about exchange rate appreciation and
overshooting are not limited to the emerging mar-kets, o course. Te recent intervention in oreign
exchange markets by committed oaters such
as Japan and Switzerland highlights the tensions
building up in the global economy as public debt
levels in the major reserve currency areasthe
US and Europeimpose more o a burden on the
Federal Reserve and the European Central Bank to
maintain lax monetary policy with attendant spill-
overs to the rest o the world (as discussed in more
detail in the next chapter).
Fixing also creates policy dilemmas or countries
seeking to x. Tese countries are by choice de-
pendent on their partners monetary policy de-
cisions, especially but not only when they have
opened the nancial account. Attempting not to
import oreign monetary conditions while xing
has required extraordinary measures.
ake China, whose capital account is only partial-
ly open. Experiencing large balance o payments
surpluses, the Peoples Bank o China (PBOC)has regularly intervened in the oreign exchange
market to limit the appreciation o the renminbi.
Te resulting increase in Chinas oreign exchange
reserves accounts or almost all the increase in
Chinas monetary base. o sterilize the increase
in the money supply created by its intervention in
the oreign exchange market, the PBOC has been
orced to sell all o its holdings o government se-
curities and to sell central bank bills to state-owned
commercial banks. Tis strategy has been abetted
by repressed interest rates, creating distortions innancial markets and in eect taxing households
who receive negative real returns on their massive
stock o bank deposits.
Te nancial crisis heightened these tensions. Its
size and depth increased the incentive or emerg-
ing markets experiencing sharp capital ow rever-
sals to sel-insure by accumulating even larger re-
serves.18 Moreover, the instability o world demand
has caused a number o countries, not all o them
in Asia, to place an even greater premium on man-aging the level o the real exchange rate. Tis has
led them to deploy a broad array o tools, includ-
ing capital controls, to prevent unwanted apprecia-
tion (or a more detailed discussion o this issue,
see Chapter 4 below).
Tere are two possible assessments o these trends.
One minimizes the importance o the asymme-
try o exchange rate policies on the grounds that
what matters or international adjustment is real
exchange rates, which governments cannot controlin the long run. Tus, recent price and wage ina-
tion in China is causing non-trivial appreciation o
the renminbi in real terms vis--vis the dollar even
while the nominal bilateral exchange rate remains
relatively stable.
Te alternative view, which we share, is that inter-
national adjustment via wage and price ination
is slow and inecient. Te world economy would
be better served by a speedier mechanism involv-
ing greater exchange rate exibility. I exibilityis not easible or domestic political reasons, then
incentives need to be put in place to make sure
large nations among both groupsxers but also
oatersinternalize the international eects o
their actions.
18 Tat actor alone suggests that xed or semi-xed exchange rate arrangements will be around or some time in emerging markets.
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2. Controlling ination in a less benign
environment
For the second time in three years, rising commodi-
ty prices are uelling global ination. Tis ination-
ary pressure is superimposed on the background o
still-large output gaps and high unemployment in
virtually all advanced countries. Tis combination
is problematic or an ination-targeting strategy in
which central banks ocus on the components o
ination that are under their direct control. Indeed,
or central banks in commodity-importing coun-
tries, a rise in oil or commodity prices is an exog-
enous supply shock, and the standard model says
that the central bank should only respond to the
extent that the shock has second-round eects and
increases expected uture ination.
argeting domestically-generated ination was an
appropriate strategy and did not raise concerns
about collective action problems in the 1990s and
the early 2000s, when an ample supply o com-
modities and the entry o China and other devel-
oping countries into the global labor orce helped
subdue global ination. Against the background o
a steep global commodity supply curve, however,
expansionary monetary policies by major econo-
miesadvanced and emerging alikemay createnegative externalities that are not adequately inter-
nalized in the standard ramework.
Tis shortcoming is especially evident in the strict
ination-targeting ramework in which the central
bank commits to keeping the orecast rate o ina-
tion (conditional on market expectations or the
policy rate) on target. In this setting, the global en-
vironment is taken as given and is not aected by
domestic monetary policy responses. As a conse-
quence, the global monetary policy stance is likelyto be suboptimal.
In small open economies, monetary policy is rea-
sonably geared to domestic objectives. Te same,
however, does not apply to the large-economy
central banks, such as the Fed, the ECB, and the
PBOC. Tese economies are large enough or their
policy choices to involve signicant externalities.
It would thereore be desirable that these central
banks, and perhaps a handul o others, include
in their policy objective a measure o these e-
ects. Clearly, however, such a move would involve
a collective-action dimension, which calls or anexplicit dialogue among these central banks about
the amendment o their policy rameworks. We re-
turn to this later.
3. Financial channels o transmission
In the idealized world in which all central banks
pursue I and allow their exchange rates to oat,
an individual central banks monetary policy ac-
tionssay, a cut in the interest rateare transmit-
ted to the rest o the world mainly through twochannels:
Te cut in local interest rates stimulates
domestic demand, some o which spills
over to additional imports. Te magni-
tude o this eect on the rest o the world
depends on the countrys share o world
GDP.
Te countrys nominal and real exchange
rates depreciate, shifing demand awayrom the rest o the world. Again, the size
o this cross-border eect depends on the
size o the country in question.
In this stylized model, capital ows only have an
indirect role, with the potential or outows rom
the country undertaking an expansionary mon-
etary policy causing movements in the value o its
currency. Prices bear the burden o adjustment.
In contrast, recent experience points to the exis-tence o additional channels whose role and im-
pact may well be large and potentially destabiliz-
ing. While the act that the impact o capital move-
ments can dwar that o the more traditional trade
eects has long been understood, the new and
novel observation concerns the size o the cross-
border capital movements triggered by the supply
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20
o liquidity or small changes in interest rates in ad-
vanced countries. Tis reects the accumulation o
a huge pool o ootloose assets responsive to small
changes in expected returns.
Te composition o these investment portolios is
interest-rate sensitive and likely to respond sharp-
ly to dierences in expected rates o economic
growth in recipient countries. An example is the
massive capital ows to emerging markets in 2010
in response to the growth slowdown and record-
low interest rates in major advanced countries.
Policy spillovers to the rest o the world can be
sizeable in the case o the United States, which
hosts branches o some 160 oreign banks whose
main unction is to raise wholesale dollar undingin capital markets. Foreign bank branches collec-
tively raise over one trillion dollars o unding, o
which over 600 billion dollars is channeled to their
headquarters outside the United States.19
Although the United States is the single largest net
debtor, it is a substantial net creditor in the glob-
al banking system. In eect, the US borrows long
through the issue o treasury and other securities
while lending short through the banking sector.
Tis is in contrast to countries like Ireland and Spainthat nanced their current account decits through
their respective banking sectors, which subsequent-
ly aced runs by their wholesale creditors.
Some borrowed dollars will nd their way back to
the United States. But many will ow to Europe,
Asia, and Latin America, where global banks are
active local lenders. At the margin, the shadow val-
ue o bank unding will be equalized across regions
through the portolio decisions o global banks,
making global banks the carriers o dollar liquidityacross borders. In this way, permissive US liquidity
conditions are transmitted globally, and US mon-
etary policy becomesglobalmonetary policy.20
An additional channel o transmission is through
commodity prices. Low interest rates in the G-3
countries have a tendency to push up primary-
commodity prices, both because the associated
low borrowing costs mean high consumption and
investment demand or these products, including
rom emerging markets, and because a low inter-
est rate reduces the nancial cost o holding stocks
o storable commodities, thus making them more
attractive as investment vehicles.
From the point o view o a commodity-producing
country, lower world interest rates thus improve
the terms o trade and increase local wealth and
creditworthiness. A rating upgrade may ollow. All
this makes the country even more attractive or
ootloose international capital, creating pressuresor currency appreciation.
Tese cross-border eects can be magnied by
dierences in exchange rate regimes. In recipi-
ent countries with reely oating exchange rates,
standard theory suggests that the local currency
should appreciate in response to a cut in oreign
interest rates. It could even appreciate beyond its
new steady-state level on impact, beore then de-
preciating until reaching its new equilibrium level.
But i the country in question has a managed oat
or semi-xed exchange rate, the required apprecia-
tion will not occur on impact. Even so, expecta-
tions o appreciation will eventually set in, making
it more attractive to shif capital toward the coun-
try. Tis may bring orth additional inows, in
turn creating additional pressure or the exchange
rate to strengthen.
Te situation is even more complicated i interven-
tion in the oreign exchange market is sterilized. Teneed to issue local bonds to mop up the liquidity re-
sulting rom the purchase o oreign exchange may
cause local interest rates to rise, attracting even more
19 Bank or International Settlements (2010).20 See also Cetorelli and Goldberg (Forthcoming).
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inward capital ows. And since local interest rates
are likely to be higher to begin with (i the recipient
country is an emerging market), this sterilization
will be expensive. I sustained over a suciently
long period, sterilized intervention can weaken s-
cal accounts, causing expectations o monetization
and higher ination, which in turn will cause local
nominal rates to go up. Tis, in turn, can call orth
yet another round o destabilizing capital inows.
Te conventional view o international spillovers
has also relied on the assumption o smoothly-
adjusting international capital markets, something
that seems less than tenable today. Te 2007-09
nancial crisis serves as a reminder that nancial
ows can reverse abruptly, placing intense pressure
on the unctioning and integrity o markets andmarket participants. Tis has been pointed out re-
peatedly afer recent capital-account currency cri-
sesMexico, Asia, Russia, Brazil, and Argentina.
What is new in the 2007-09 crisis was that it hap-
pened even in some advanced countriesor ex-
ample, some European economies, such as Ireland.
A nation previously ooded with capital can thus
become the subject o a sharp reversal in ows.
Margin and borrowing constraints can suddenly
become binding, leading to a painul process odeleveraging. I the need to raise cash causes one
round o asset sales, the prices o those assets will
all, reducing the value o collateral and calling orth
urther asset sales and additional price drops. Tis
can cause massive destruction o value, as rms nd
themselves liquidity-constrained and abandon un-
nished potentially protable investment projects.
Policy makers in countries on the receiving end o
these ows ace an unappetizing choice. I they al-
low the currency to appreciate, they expose them-selves to accusations o overvaluation, loss o com-
petitiveness, and de-industrialization. But i they
ght the appreciation via intervention, they may
nd themselves on the receiving end o ever-larger
inows. Te central bank may end up allowing
some appreciation anyway, but not beore accu-
mulating a large stock o expensive domestic li-
abilities and a large stock o international reserves
on which it will take a capital loss (in domesticcurrency terms) i and when the exchange rate ad-
justment eventually happens.
While the conventional model o I-plus-oating
acknowledged these complications, it did not place
them at the center o the analysis. o the extent
countries targeted core ination, spillovers through
global commodity prices were lef unattended. Tis
was not a serious concern in the1980s and 1990s,
the period o the Great Moderation, but is a more
serious one in the presence o large global imbal-ances and the need to accommodate large stocks
o internationally mobile capital looking or yield.
4. Normal versus crisis times
Te conventional wisdom was developed in tran-
quil times. In crises, in contrast, central banks have
resorted to an array o non-conventional mon-
etary policies such as quantitative easing (QE)
the printing o money to buy bonds. What do such
policies imply or the question o internationalspillovers o monetary policy?
One view is that unconventional policies are no
dierent rom conventional policies in their cross-
border implications. I oating exchange rates can
adjust to make international coordination o con-
ventional policies unnecessary, then the same must
be true o unconventional policies. Tis was the
view o the United States ollowing the adoption
o QE2. In response to complaints rom emerging
market policy makers who eared the wave o li-quidity coming their way, Fed ocials essentially
argued that, everything will be okay i you just let
your currencies appreciate.21
21 As indicated, or example, by the ollowing excerpt rom the speech by Fed chairman Ben Bernanke on November 19, 2010 at the ECB CentralBanking Conerence: An important driver o the rapid capital inows to some emerging markets is incomplete adjustment o exchange rates inthose economies, which leads investors to anticipate additional returns arising rom expected exchange rate appreciation.
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Te alternative view is that beggar-thy-neighbor
impacts are greater when using unconventional
instruments. Te diculty arises in evaluating
whether the use o such instruments is consistent
with the normal policy ramework or represents
an attempt mainly to weaken the currency and
boost exports in the absence o a positive domes-
tic demand response. Te same causes that jus-
tiy recourse to unconventional policies make the
ination-targeting compass lose precision. When
ination signicantly undershoots its target and
central banks resort to instruments with which
they have little experience, it is much harder to
say whether a policy stance is in line with the I
ramework or whether it represents an attempt at
competitive devaluation.
In addition, spillovers may work dierently in times
o crisis. During a crisis, local credit demand is likely
to be weak and banks willingness to lend domesti-
cally will be especially limited. For every additional
dollar o liquidity that is created by monetary policy,
a larger share will end up abroad in crisis times than
in normal times, thereby depreciating the exchange
rate at the expense o trade partners. It ollows that
spillovers are potentially larger during episodes o
local nancial distress.
Te presence o international spillovers suggests
that coordination can lead to better global out-
comes. In addition, the current situation high-
lights the need or principles and procedures or
deciding when an unconventional monetary pol-
icy is beggar-thy-neighbor in its eect. In turn,
these principles should orm the basis or correc-
tive action.
Conclusion
Te cross-border spillovers rom monetary policy
provide yet another reason or rethinking not justthe domestic monetary policy ramework but also
mechanisms or ensuring compatibility between
large-country policies. We will turn to recommen-
dations that ollow rom this analysis in Chapter
Five. But beore oering recommendations, we
turn to a discussion o some additional policy bur-
dens on central banks in the afermath o the crisis.
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CHAPTER 4
Additional Pressures on Central Banks
I
n this chapter we describe how central banks are
coming under additional pressures in the post--nancial-crisis environment. While some o these
additional pressures are not entirely new, they
threaten to orce central banks onto risky terrain.
We highlight two sets o pressures: (a) the conse-
quences o high public and private debts; and (b)
the perceived dangers o currency appreciation
and overvaluation.
While maniestations o these pressures are already
evident in individual countries, it is important tounderstand them as part o a broader global picture.
We do so in the next two sections, which look at the
consequences o high public and private debts in the
advanced economies and at worries abo