Saturday, January 23, 2016

23/1/16: Financial Globalisation and Tradeoffs Under Common Currency

A paper I recently cited in a research project for the European Parliament that is worth reading: "Trilemmas and Tradeoffs: Living with Financial Globalization" by Maurice Obstfeld. Some of my research on the matter, yet to be published (once the EU Parliament group clears it) is covered here: and see slides 5-8 here:

This is one of the core papers one simply must be acquainted with if you are to begin understanding the web of contradictions inherent in the structure of modern financial flows (in the case of Obstfeld's paper, these are linked to the Emerging Markets, but much of it also applies to the euro).

The paper "evaluates the capacity of emerging market economies (EMEs) to moderate the domestic impact of global financial and monetary forces through their own monetary policies. Those EMEs able to exploit a flexible exchange rate are far better positioned than those that devote monetary policy to fixing the rate – a reflection of the classical monetary policy trilemma.” The problem, as Obstfeld correctly notes, is that in modern environment, “exchange rate changes alone do not insulate economies from foreign financial and monetary shocks. While potentially a potent source of economic benefits, financial globalization does have a downside for economic management. It worsens the tradeoffs monetary policy faces in navigating among multiple domestic objectives.”

Per Obstfeld, the knock on effect is that “This drawback of globalization raises the marginal value of additional tools of macroeconomic and financial policy. Unfortunately, the availability of such tools is constrained by a financial policy trilemma, [which] posits the incompatibility of national responsibility for financial policy, international financial integration, and financial stability.”

This, of course, is quite interesting. Value of own (independent) tools beyond flexible exchange rates rises with globalisation, which normally incentivises more (not less) activism and interference from domestic (or regional - in the case of monetary integration) regulators, supervisors and enforcers. In other words, Central Banks and Fin Regs grow in size (swelling to design, fulfil and enforce new ‘functions’). And all of this expensive activity take place amidst the environment where none of can lead to effective and tangible outcomes, because of the presence of the second trilemma: in a globalised world, national regulators are a waste of space (ok, we can put it more politically correctly: they are highly ineffective).

Give this another view from this argument: ‘national’ above is not the same as sovereign. Instead, it is ‘national’ per currency definition. So ECB is ‘national’ in these terms. Now, recall, that in recent years we have been assured that we’ve learned lessons of the recent crisis, and having learned them, we created a new, very big, very expensive and very intrusive tier of supervision and regulation - the tier of ECB and centralised European Banking regulatory framework of European Banking Union (EBU). But, wait, per Obstfeld - that means preciously little, folks, as long as Europe remains integrated into globalised financial markets.

Obstfeld’s paper actually is a middle ground, believe it or not, in the wider debate. As noted by Obstfeld: “My argument that independent monetary policy is feasible for financially open EMEs, but limited in what it can achieve, takes a middle ground between more extreme positions in the debate about monetary independence in open economies. On one side, Woodford (2010, p. 14) concludes: “I find it difficult to construct scenarios under which globalization would interfere in any substantial way with the ability of domestic monetary policy to maintain control over the dynamics of inflation.” His pre-GFC analysis, however, leaves aside financial-market imperfections and views inflation targeting as the only objective of monetary control. On the other side, Rey (2013) argues that the monetary trilemma really is a dilemma, because EMEs can exercise no monetary autonomy from United States policy (or the global financial cycle) unless they impose capital controls.”

Now, set aside again the whole malarky about Emerging Markets there… and think back to ECB… If Rey is correct, ECB can only assure functioning of EBU by either abandoning rate policy independence or by abandoning global integration (imposing de facto or de sure capital controls).

Of course, in a way, bondholders’ bail-ins rules and depositors bail-ins rules and practices - the very sort of things the EBU and ECB’s leadership rest so far - are a form of capital controls. Extreme form. So may be we are on that road to ‘resolving trilemmas’ already?..

Have a nice day... and happy banking...

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