An endless cycle of bubble, financial crisis and currency collapse?

Posted by Robin Harding, Financial Times

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The world is doomed to an endless cycle of bubble, financial crisis and currency collapse. Get used to it. At least, that is what the world’s central bankers – who gathered in all their wonky majesty last week for the Federal Reserve Bank of Kansas City’s annual conference in Jackson Hole, Wyoming – seem to expect.

All their discussion of the international financial system was marked by a fatalist acceptance of the status quo. Despite the success of unconventional monetary policy and recent big upgrades to financial regulation, we still have no way to tackle imbalances in the global economy, and that means new crises in the future.

Indeed, the problem is becoming worse. Since the collapse in 1971 of the old fixed exchange rate system of Bretton Woods, the world has become used to the “trilemma” of international finance: the impossibility of having free capital flows, fixed exchange rates and an independent monetary policy all at the same time. Most countries have plumped for control over their own monetary policy and a floating exchange rate.

In an excellent new paper presented at Jackson Hole, however, Professor Hélène Rey of the London Business School argued that a global cycle in credit and capital flows – driven by the US Federal Reserve’s monetary policy – means that even a floating exchange rate does not give a country control over its own destiny. The trilemma is, in truth, a dilemma. The choice is this: impose capital controls or let the Fed run your economy.

The shrugging acceptance of this gloomy analysis in Jackson Hole was striking, especially at a time when capital is fleeing the emerging world – pulling down exchange rates – as the Fed ponders a tapering of its asset purchases from $85bn a month. At a minimum, that threatens developing countries with higher inflation and higher interest rates; those that enjoyed the capital inflows a bit too much, such as India and Indonesia, could suffer something worse.

Yet all the debate was about how individual countries can damp the impact of capital flowing in and out. Prof Rey’s own conclusion was that it is hopeless to expect the Fed to set policy with other countries in mind (which would be illegal). She recommended targeted capital controls, tough bank regulation, and domestic policy to cool off credit booms.

In practice, this will never work well. It requires every country in the world to react with discipline to constantly changing capital flows. It is like saying we can cure the common cold if only everyone in the world would wash their hands hourly and never leave the house. Even if it did work, the necessary volatility of policy would still impose painful economic costs on the countries acting this way.

But it is not the only choice. Five years ago, after the collapse of Lehman Brothers, there was appetite and momentum for a new kind of international financial system. That appetite is gone – but we desperately need to get it back.

The flaws in the international financial system are old and profound, and they defeat any effort to work around them. Chief among them is the lack of a mechanism to force any country with a current account surplus to reduce it. Huge imbalances – such as the Chinese surplus that sent a flood of capital into the US and helped create the financial crisis – can therefore develop and persist.

Indeed, running a surplus is wise because there is no international central bank to rely on if investors decide they want to pull capital out of your country. There is the International Monetary Fund – but Asian countries tried that in 1997, and the experience was so delightful they have been piling up foreign exchange reserves ever since to avoid a repeat.

A reliable backstop is impossible when the international system relies on a national currency – the US dollar – as its reserve asset. Only the Fed makes dollars. In a crisis, there are never enough of them – a shortage that will only get worse as the world economy grows relative to the US – even if the problem for emerging markets right now is too many of them.

The answer is what John Maynard Keynes proposed in the 1930s: an international reserve asset, rules for pricing national currencies against it, and penalties for countries that run a persistent surplus. After the financial crisis there was a flood of proposals along these lines from the UN, from the economist Joseph Stiglitz, and even from the governor of the People’s Bank of China. None has gone anywhere.

Even the most basic first step towards that goal – boosting the IMF’s resources and handing more voting power to emerging markets so they can rely on it in time of need – has stalled in the US Congress.

The potential for reform, however, is greater than it has been for decades. The crisis and recession have reduced global imbalances – if only temporarily. So China, for example, would no longer have to make a big immediate adjustment to reduce its surplus. The financial crisis also gave the US a vivid lesson in the disadvantages of supplying the world’s reserve currency. Emerging markets are getting a reminder of the perils of importing US monetary policy.

Gradual change is more plausible than a sudden revolution – but the time to make progress is now. A stable international financial system has eluded the world since the end of the gold standard. The first condition for creating one, however, is the ambition to try.