August 27, 2013 8:55 pm
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.
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 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.