Macroeconomic Policy Interdependence and the

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Macroeconomic Policy Interdependence and the Powered By Docstoc
					             Think Tank 20:
Macroeconomic Policy Interdependence
           and the G-20

             Rethinking Central
             Committee on
             International Economic
             Policy and Reform

             SEPTEMBER 2011

             Barry Eichengreen   Carmen Reinhart

             Mohamed El-Erian    Hélène Rey

             Arminio Fraga       Dani Rodrik

             Takatoshi Ito       Kenneth Rogoff

             Jean Pisani-Ferry   Hyun Song Shin

             Eswar Prasad        Andrés Velasco

             Raghuram Rajan      Beatrice Weder di Mauro

             Maria Ramos         Yongding Yu
Rethinking Central
Committee on
International Economic
Policy and Reform


Barry Eichengreen   Carmen Reinhart

Mohamed El-Erian    Hélène Rey

Arminio Fraga       Dani Rodrik

Takatoshi Ito       Kenneth Rogoff

Jean Pisani-Ferry   Hyun Song Shin

Eswar Prasad        Andrés Velasco

Raghuram Rajan      Beatrice Weder di Mauro

Maria Ramos         Yongding Yu

      he Committee on International Economic and                             in global economic management and economic
      Policy Reform is a non-partisan, independent                           governance. Each Committee report will focus on
      group of experts, comprised of academics and                           a specific topic which will emphasize longer-term
former government and central bank officials. Its                            rather than conjunctural policy issues.
objective is to analyze global monetary and finan-
cial problems, offer systematic analysis, and ad-                            The Committee is grateful to the Alfred P. Sloan
vance reform ideas. The Committee attempts to                                Foundation* for providing financial support and
identify areas in which the global economic archi-                           to the Brookings Institution for hosting the com-
tecture should be strengthened and recommend                                 mittee and facilitating its work. Quynh Tonnu pro-
solutions intended to reconcile national interests                           vided excellent administrative and logistical sup-
with broader global interests. Through its reports,                          port to the Committee.
it seeks to foster public understanding of key issues

                                                        Committee Members

                                   Barry Eichengreen, University of California, Berkeley
                                   Mohamed El-Erian, PIMCO
                                   Arminio Fraga, Gavea Investimentos
                                   Takatoshi Ito, University of Tokyo
                                   Jean Pisani-Ferry, Bruegel
                                   Eswar Prasad, Cornell University and Brookings Institution
                                   Raghuram Rajan, University of Chicago
                                   Maria Ramos, Absa Group Ltd.
                                   Carmen Reinhart, Peterson Institute for International Economics
                                   Hélène Rey, London Business School
                                   Dani Rodrik, Harvard University
                                   Kenneth Rogoff, Harvard University
                                   Hyun Song Shin, Princeton University
                                   Andrés Velasco, Columbia University
                                   Beatrice Weder di Mauro, University of Mainz
                                   Yongding Yu, Chinese Academy of Social Sciences

*Brookings recognizes that the value it provides to any donor is in its absolute commitment to quality, independence and impact. Activities
 sponsored by its donors reflect this commitment and neither the research agenda, content, nor outcomes are influenced by any donation.

                                                     Rethinking Central Banking
                                  Executive Summary

    his report lays out a framework for rethink-             Drawing on this analysis, it recommends changes
    ing central banking in light of lessons learned          to the dominant framework guiding central bank-
    in the lead-up to and aftermath of the global            ing practice.
financial crisis.
                                                             The first recommendation is that central banks
By the early 2000s, a growing number of central              should go beyond their traditional emphasis on
banks, in advanced countries and emerging mar-               low inflation to adopt an explicit goal of financial
kets alike, had converged on a policy framework,             stability. Macroprudential tools should be used
flexible inflation targeting, which seemed capable           alongside monetary policy in pursuit of that ob-
of achieving price stability and delivering mac-             jective. Mechanisms should also be developed to
roeconomic stability at the national and interna-            encourage large-country central banks to inter-
tional levels. This framework had many practical             nalize the spillover effects of their policies. Spe-
achievements, including bringing price stability             cifically, we call for the creation of an International
to many emerging markets. Now, however, there                Monetary Policy Committee composed of repre-
is growing recognition that the conventional ap-             sentatives of major central banks that will report
proach to central banking needs to be rethought.             regularly to world leaders on the aggregate conse-
The relationship between price stability and the             quences of individual central bank policies.
broader goals of macroeconomic and financial sta-
bility clearly needs to be redefined. Moreover, the          There is substantial pressure on central banks to
evolution of monetary and exchange rate regimes              acknowledge the importance of still other issues,
has resulted in incompatibilities among the poli-            such as the high costs of public debt management
cies of some key countries. Central banks are also           and the level of the exchange rate. Central banks
being pulled into new roles by the post-crisis envi-         are more likely to safeguard their independence
ronment, which features high levels of public and            and credibility by acknowledging and explicitly
private debt in advanced economies and concerns              addressing the tensions between inflation target-
about capital inflows and currency appreciation              ing and competing objectives than by denying
in emerging markets. While some aspects of these             such linkages and proceeding with business as
roles are not new, they are risky, as central bank           usual. Central banks should make clear that mon-
actions can inflict collateral damage on domestic            etary policy is only one part of the policy response
financial systems and have the potential of raising          and cannot be effective unless other policies—fis-
new domestic and international tensions.                     cal and structural policies, financial sector regula-
                                                             tion—work in tandem.
The report analyzes these issues from academ-
ic and practical policy-oriented perspectives.

                                        Rethinking Central Banking
        CHAPTER 1


The Golden Age of Inflation Targeting                                         political pressure to attach greater weight to other
                                                                              objectives, making it harder for them to contain
High inflation in the advanced economies in the                               inflationary expectations and deliver desirable
1970s and in emerging economies in the 1980s and                              outcomes.
1990s was instrumental in shaping modern think-
ing about the practice of central banking. The tenets                         By the early 2000s, a growing number of central
of the resulting framework are familiar and, to a                             banks, in advanced countries and emerging mar-
large extent, uncontroversial. First, there is no per-                        kets alike, had converged on a policy framework,
manent tradeoff between inflation and unemploy-                               flexible inflation targeting, that seemed capable of
ment—a sustained higher level of inflation does not                           achieving these desiderata and delivering macro-
lead to higher growth and a sustained lower level of                          economic stability at the national and internation-
unemployment. Second, high and volatile inflation                             al levels. In the conventional view, there are four
depresses growth and distorts the allocation of re-                           explanations for this happy outcome:
sources. Third, inflation disproportionately harms
the poorest segments of society, which lack instru-                                 •	    Flexible inflation targeting, under which
ments for protecting themselves from its disruptive                                       the central bank aims to stabilize inflation
effects. For all of these reasons, price stability is the                                 around its target but also minimize the
cornerstone of monetary policy.                                                           output gap, delivers low inflation at the
                                                                                          national level, thereby avoiding the need
The actions needed to achieve price stability, such                                       for large nominal exchange-rate adjust-
as the maintenance of high interest rates, can be                                         ments and the kind of overshooting that
politically unpopular, among other reasons be-                                            characterized the 1980s.1
cause they slow growth. It follows that the pur-
suit of price stability can be made more credible                                   •	    Flexible inflation targeting, by allowing
and thus more effective by granting independence                                          for exchange rate variability, facilitates in-
or at least operational autonomy to the central                                           ternational adjustment. Countries experi-
bank. Otherwise, central banks may be subject to                                          encing demand shocks can cushion them

    Although neither the Fed nor the ECB had formally endorsed inflation targeting (IT), both were aiming at price stability, which made their
    policies similar to those of the central banks on a strict IT regime.

                                                       Rethinking Central Banking
              through interest-rate changes and associ-                         counteracts the moral hazard generated by deposit
              ated movements in exchange rates.                                 insurance, together with periodic supervisory as-
                                                                                sessments and the necessary strictures meant to
        •	    Flexible inflation targeting makes re-                            prevent excessive risk taking and malfeasance. Re-
              serve accumulation unnecessary, since                             gardless of whether the microprudential regulator
              exchange-rate intervention is rare and                            is situated in the central bank or a separate special-
              limited to short-term responses to market                         ized regulatory agency, financial regulation is seen
              disruptions and to a signaling role in cases                      as a separate activity.
              of serious misalignments.
                                                                                Central bankers nowadays often observe that flex-
        •	    The combined policy stance of the coun-                           ible inflation targeting was never as straightfor-
              tries following this strategy is supposed to                      ward as this framework suggests and that issues
              ensure an appropriate level of aggregate                          of financial stability and spillovers were always on
              demand at the global level.                                       their minds. Still, it remains accurate to say that
                                                                                the basic theoretical framework sketched above
The generalization of inflation targeting cum float-                            did much to shape their thinking. Its clarity and
ing exchange rates could thus be regarded as the                                simplicity enabled it to gain adherents in academia
triumph of the “own house in order” doctrine in                                 and financial markets as well as in central banks.
the international monetary field. National macro-
economic stability was seen as sufficient for inter-                            Rethinking the Framework
national macroeconomic stability. The domestic
and international aspects were essentially regarded                             Some of the practical achievements of the flexible
as two sides of the same coin.2                                                 inflation targeting framework are indisputable.
                                                                                The adoption of price stability objectives by coun-
An added benefit of flexible inflation targeting,                               tries at different levels of economic development
according to the emerging orthodoxy, was that it                                was a major step forward after decades of domes-
allowed the objectives of price stability and finan-                            tically-generated instability. This framework can
cial stability to be pursued through separate tools                             be credited, at least in part, for the drop in global
—monetary policy for the former and micro-pru-                                  inflation and the abatement of exchange-rate con-
dential regulatory and supervisory measures for                                 troversies among the advanced economies.3
the latter. Tinbergen’s separation principle, i.e. the
idea that each goal should be pursued with a sepa-                              Now, however, there is growing recognition that
rate and dedicated instrument, was widely invoked                               the conventional approach to central banking
in this context.                                                                needs to be rethought. Critics reach this conclu-
                                                                                sion for several related reasons:
In this orthodox view, monetary policy focuses
on controlling inflation and works by managing                                        •	   The conventional approach fails to ac-
expectations of future policy rates, which by the                                          count adequately for financial-sector risk
expectations theory of the yield curve determine                                           and is therefore too narrowly focused.
the long-term interest rates that influence ag-
gregate demand. Financial stability is attained by                                    •	   The conventional framework assumes lim-
microprudential regulation of bank capital that                                            ited or nonexistent cross-border spillovers

    Looking ahead, some even regarded this regime as the solution to perennial international monetary controversies (Rose, 2007).
    To what extent IT can be credited for the disinflation of the 1990s and the early 2000s is a matter for discussion. Another important factor was
    the disinflationary pressure coming from the emerging countries’ exports. We return to the issue below.

                                                        Rethinking Central Banking
              of monetary policies, while in fact spill-                         We focus on the relationship between the tradi-
              overs are frequently of first-order impor-                         tional emphasis on price stability and the broader
              tance. They can complicate monetary pol-                           goals of macroeconomic and financial stability. We
              icy management, accentuate the volatility                          discuss why the traditional separation, in which
              of real activity and increase financial-sec-                       monetary policy targets price stability and regula-
              tor risk.                                                          tory policies target financial stability, and the two
                                                                                 sets of policies operate largely independently of
        •	    The incompatibility of national monetary                           each other, is no longer tenable.
              policies in the face of spillovers is height-
              ened when countries follow different de                            If central banks do in fact embrace the goal of
              facto monetary policy regimes (e.g., infla-                        financial stability in addition to price stability,
              tion targeting and exchange rate target-                           monetary policy-making and policy communica-
              ing).4                                                             tion will become more challenging. We therefore
                                                                                 consider the practical issues that arise when the
        •	    Spillovers may be further accentuated                              central bank is forced to juggle multiple mandates.
              when central banks pursue unconven-
              tional monetary interventions (e.g., when                          We then turn in Chapter 3 to a criticism of the
              interest rates are at their floor and con-                         conventional policy framework: it assumes not
              strained by the zero bound). Because of                            just that central banks practice flexible inflation
              weak domestic demand, as well as dis-                              targeting but also that they allow the exchange rate
              tressed banks that are unwilling to lend,                          to float freely. Under these assumptions, each cen-
              the portfolio adjustments prompted by                              tral bank has the independence necessary to target
              unconventional policies may largely serve                          price stability and full employment.
              to increase capital flows to countries with
              stronger growth prospects rather than                              The problem is that policy independence in theory
              boosting domestic credit as intended.                              may exceed policy independence in practice. In
                                                                                 other words, the conventional framework fails to
        •	    High levels of government debt in ad-                              take into account that national policies can have
              vanced countries and the slowing growth                            powerful cross-border repercussions that the af-
              of traditional export markets for develop-                         fected partner may not be able to adequately off-
              ing countries create new sources of po-                            set with exchange rate movements. In part this
              litical pressure that central banks will find                      is because the existing system is not, in fact, one
              difficult to ignore.                                               of fully flexible exchange rates. In practice, some
                                                                                 countries effectively target exchange rates (China’s
In this report, we start by considering the valid-                               tight management of its currency’s value relative
ity of these criticisms. We then go on to ask how                                to the US dollar being a prominent case in point).
central banking theory and practice need to be up-                               In part it is because international transmission oc-
dated in light of this shift in thinking. The report                             curs even under flexible exchange rates, through
consists of four chapters (after this one) followed                              both trade channels and capital flows. The conse-
by our recommendations.                                                          quences include the prospective re-emergence of
                                                                                 global imbalances as well as the proliferation of
In Chapter 2, we describe how the global financial                               trade and capital controls when countries seek fur-
crisis has recast the debate over central banking.                               ther insulation from cross-border spillovers.

    Though the choice of regime itself may partly be a reaction to spillovers.

                                                         Rethinking Central Banking
To analyze these issues, in this chapter we provide        the framework we propose, central banks should
a global perspective on the evolution of monetary          go beyond their traditional emphasis on low infla-
policy and exchange rate regimes. We examine the           tion to adopt an explicit goal of financial stabil-
problems that arise out of the incompatibility of          ity. Macroprudential tools should be used along-
national regimes with similar domestic objectives.         side monetary policy in pursuit of that objective.
We then discuss the challenges that arise in rec-          Mechanisms should also be developed to encour-
onciling domestic monetary policies with global            age large-country central banks to internalize the
macroeconomic stability.                                   spillover effects of their policies. Specifically, we
                                                           call for the creation of an International Monetary
In Chapter 4, we describe how central banks are            Policy Committee composed of representatives of
being pulled into new roles by the post-crisis en-         major central banks that will report regularly to
vironment and by the unavailability of alternative,        world leaders on the aggregate consequences of
potentially more suitable instruments.While some           individual central bank policies.
aspects of these roles are not new, they nonetheless
move central banks into risky territory insofar as         While this report suggests more responsibilities for
central bank actions can inflict collateral damage         central banks, we also recognize the environment is
on domestic financial systems and have the po-             one where there is substantial pressure on central
tential of raising new domestic and international          banks to acknowledge the importance of still other
tensions. We highlight two sets of issues: (a) the         issues, such as the high costs of public debt manage-
consequences of high levels of public and private          ment and the level of the exchange rate. While these
debt in the advanced economies and the attendant           pressures, if internalized, can make central bank ob-
pressures towards financial repression; and (b)            jectives hopelessly diffuse, they are not reasons to
the perceived dangers of currency misalignments            postpone rethinking the overall policy framework.
and overvaluation, and the attendant pressures to-         To the contrary, a framework that is seen as defi-
wards currency intervention and capital controls.          cient will become an easier political target.

In Chapter 5, we draw on the analysis in previous          For all these reasons, we believe it is time to re-
chapters to recommend changes in the dominant              think the existing paradigm. The rest of the report
framework guiding central banking practice. In             lays out what this rethinking should entail.

                                        Rethinking Central Banking
     CHAPTER 2

                  The Scope of Monetary Policy

  n this chapter we describe how the global finan-                          way to an embrace of macroprudential tools of fi-
  cial crisis has recast the debate over the scope of                       nancial regulation (countercyclical capital adequacy
  central banking functions. We focus on the re-                            requirements, for example). These tools or policies,
lationship between the traditional narrow goal of                           which mitigate risks to the financial system as a
monetary policy—price stability—and the broader                             whole rather than solely at the level of the individual
goals of macroeconomic and financial stability. We                          institution, are to be developed and implemented by
explain why the traditional separation, in which                            specialists in financial stability, not by central bank-
monetary policy targets price stability and regula-                         ers responsible for the conduct of monetary policy.
tory policies target financial stability and the two
sets of policies operate independently of each oth-                         The case for this separation rests on the belief that
er, is no longer tenable. We then review some prac-                         interest rates are too blunt an instrument for the
tical issues that arise in connection with attempts                         effective pursuit of financial stability. The question
to coordinate the two sets of policies.                                     is commonly framed as whether the central bank
                                                                            should raise interest rates in response to asset bub-
Central Banks and Financial Stability                                       bles. In the 1990s and early 2000s, central bankers
                                                                            discussed at length whether and how to respond
The global financial crisis shook confidence in mi-                         to asset market developments.5 The conclusion of
croprudential tools of regulation as the primary in-                        that debate was that central banks had a mandate
strument for ensuring financial stability. Yet many                         to react to bursting bubbles but not to target asset
central bankers still subscribe to the traditional di-                      prices. Not everyone, however, shared this conclu-
chotomy between monetary policy and financial                               sion. The ‘lean vs. clean’ debate remained active in
stability, except that microprudential tools have given                     the run-up to the crisis.6

  The early debate was framed by the stock market boom of the late 1990s. Arguments in favor of “leaning against the wind” when it comes
  to financial 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. The argument against is
  given in Bean (2003), Bernanke and Gertler (1999, 2001), Bernanke (2002), Greenspan (2002), Kohn (2005), Mishkin (2008) and Stark (2008).
  A policy school, primarily associated with economists from the Bank for International Settlements and the Bank of Japan, was critical of narrow
  inflation targeting and maintained that central banks could not forgo their responsibility for financial stability. Bank of Japan economists
  regretted having allowed the bubble to become too large in the second half of the 1980s. The European Central Bank never fully endorsed the
  standard formulation of inflation targeting and argued that the growth of monetary aggregates and credit developments were also important
  indicators of potential risks to price stability over a longer-term horizon.

                                                     Rethinking Central Banking
The case against attempting to prick bubbles rests                       additional questions about risks to the stability of
on the following arguments.                                              economic activity. Rather than waiting for incontro-
                                                                         vertible proof of a bubble in housing markets, for
        •	    Identifying bubbles is hard.                               example, a policy maker could instead ask whether
                                                                         benign funding conditions could reverse abruptly
        •	    Even if there is a bubble, monetary policy                 with adverse consequences for the economy. Even
              is not the best tool with which to address                 if policy makers are convinced that higher housing
              it. An asset price bubble will not respond                 prices are broadly justified by secular trends in pop-
              to small changes in interest rates; only a                 ulation, household size, and living standards, policy
              sharp increase will suffice to prick a bub-                intervention would still be justified if the policy
              ble. However, a drastic increase in interest               maker also believed that, if left unchecked, current
              rates can cause more harm than good by                     loose monetary conditions significantly raise the
              depressing output growth and increasing                    risk of an abrupt reversal in housing prices and of
              output volatility.                                         financing conditions, with adverse consequences
                                                                         for the financial system and the economy.
The claim that an asset price bubble will not re-
spond to a small change in interest rates has been                       Not responding in this way has led to a dangerous-
made in the context of stock market bubbles,                             ly asymmetric response to credit market develop-
where the proposition is most plausible. When the                        ments. Central banks have allowed credit growth
stock market is rising by 20 percent a year, a small                     to run free, fueling booms, and then flooded mar-
increase in interest rates will not outweigh the ef-                     kets with liquidity after the crash, bailing out fi-
fects of rapid asset price increases.                                    nancial institutions and bondholders. This asym-
                                                                         metry has contributed to stretched balance sheets,
However, the stock market may not be the best                            with faster lending growth and leverage in times of
context in which to discuss the financial stability                      low risk premia, more violent deleveraging when
role of monetary policy. The housing market, with                        risk premia rise, and frequent booms and busts.
its more prominent role for leverage and credit,
and markets in the derivative securities associated                      For all these reasons, there is a case for central
with housing investment may be more pertinent.                           banks to guard against credit market excesses. An
Monetary policy stands at the heart of the lever-                        inflation-targeting central bank may argue that it
age decisions of banks and other financial inter-                        does so automatically insofar as higher asset prices
mediaries involved in lending for housing-related                        boost aggregate demand through wealth effects
investments. In this setting, even small changes in                      and create inflationary pressures. However, some
funding costs may have an impact on risk-taking                          additional leaning against credit market develop-
and funding conditions. Financial intermediaries,                        ments would be advisable even in the absence of
after all, borrow in order to lend. The spread be-                       aggregate demand effects once it is determined
tween borrowing and lending rates is therefore a                         that funding conditions and reduced risk premia
key determinant of the use of leverage and has im-                       indicate a nascent credit boom. Put differently,
portant implications for the interaction between                         inflation-targeting central banks may want to stray
banking sector loan growth, risk premia, and any                         below target when conditions are “boom-like”–
ongoing housing boom.7                                                   when rapid asset price growth is accompanied by
                                                                         substantial credit expansion—since policy would
Focusing on risk taking by banks and other finan-                        otherwise become asymmetric and execerbate
cial intermediaries will lead the policy maker to ask                    macroeconomic volatility.

    See Adrian and Shin (2011) for a discussion of these linkages.

                                                        Rethinking Central Banking
Retiring the Separation Principle                               Rock, the central bank will be blamed for financial
                                                                problems whether or not it was formally responsi-
A consequence of this doctrine of “leaning against              ble for supervision and regulation. As lender of last
the wind” is that the neat Tinbergen assignment of              resort, it will be charged with cleaning up the mess.
different tools to different objectives becomes more            It follows that it would be better off devoting more
difficult to implement in practice. Interest rates affect       of its resources and attention to attempting to pre-
financial stability and, hence, real activity. Equally,         vent the crisis, the elegance and analytical appeal of
macroprudential tools impact credit growth and ex-              the Tinbergen principle notwithstanding.
ternal imbalances with consequences for macroeco-
nomic and price stability. When consumer credit is              Macroprudential Policy Tools
growing rapidly and the household debt ratio is high,
for example, restraining credit growth by changing              Macroprudential tools are designed to buttress the
guidance on loan-to-value (LTV) or debt service-to-             stability of the financial system as a whole, which
income (DTI) ratios over the business cycle will have           is distinct from ensuring the stability of individ-
important macro-stabilization effects.                          ual institutions. These tools are intended to help
                                                                mitigate externalities and spillovers at the level of
Rather than viewing the allocation problem as hav-              the system as a whole. For example, interlocking
ing a corner solution where one instrument is de-               claims and obligations create externalities if the
voted entirely to one objective, the macro-stabiliza-           failure of one higly leveraged institution threatens
tion exercise must be viewed as a joint optimization            the solvency of other institutions and the stability
problem where monetary and regulatory policies                  of the entire financial system. Fire sales of assets
are used in concert in pursuit of both objectives.              may magnify an initial shock and lead to vicious
                                                                circles of falling assets prices and the need to de-
Believers in a strict interpretation of Tinbergen               leverage and sell off assets. Externalities also arise
separation will fret that blurring the assignment of            over the course of the cycle if the structure of capi-
instruments to targets will jeopardize the central              tal regulation allows an increase in leverage in fi-
bank’s operational autonomy, the central bank’s                 nancial booms while dampening it in busts.
mandate will become fuzzier, and its actions will
become more difficult to justify.                               It is useful to distinguish between different mac-
                                                                roprudential tools that address these different as-
These are valid concerns. Central bankers will ex-              pects of financial risk. In particular, different tools
perience more political pressure than if monetary               should be used address the time- and cross-sec-
policy were primarily targeted at price stability.              tional dimensions of risk.
Here, however, it is important to remember that
central bank independence is a means to an end                  The Time Dimension in Macroprudential
rather than an end in itself. Limiting the scope of             Supervision
monetary policy purely for the sake of defending
central bank independence risks undermining the                 In terms of the time dimension, the macropruden-
institution’s legitimacy by giving the impression               tial supervisor should develop a range of tools ca-
that the central bank is out of touch and that it is            pable of tempering financial procyclicality. Coun-
pursuing a narrow and esoteric activity that does               tercyclical capital buffers, as recommended by the
not square with its democratic responsibilities.                Basel Committee, are a case in point, although they
                                                                are confined to the banking system. A supplement
Ultimately, political reality will thrust responsibility        would be to impose a systemic levy for all levered
for financial stability on the central bank. As hap-            financial institutions—that is, an additional charge
pened in the UK following the failure of Northern               levied on the unstable (non-core) portion of a

                                           Rethinking Central Banking
financial institution’s funding, as suggested by the                       deal with failing financial institutions could re-
IMF (2010). This levy could be varied over the the                         duce the need for reliance on ex ante buffers such
life of the cycle.                                                         as capital. Following the near collapse of Northern
                                                                           Rock, the United Kingdom was among the first
Restraints on bank lending such as loan-to-value                           to enact a resolution regime that provides super-
(LTV) or debt service-to-income (DTI) guide-                               visors extensive authority to stabilize a failing in-
lines could usefully complement traditional tools                          stitution.8 Germany enacted a similar law in Janu-
of bank regulation, such as capital requirements.                          ary 2011 and the United States is in the process
Capital requirements can themselves consist of                             of empowering regulatory agencies to deal with
a core of long-dated equity or equity-like instru-                         future insolvencies of systemically relevant insti-
ments supplemented with an additional buffer of                            tutions. An important complication is that many
contingent capital instruments.                                            systemically relevant institutions are active across
                                                                           geographical and product borders. These new laws
The interaction between these prudential mea-                              have not been coordinated, and they are unlikely
sures, as well as their cumulative costs, need to be                       to be adequate for dealing with a large cross-bor-
carefully considered while rolling them out, with                          der or cross-market failure. The new resolution
a view to adjusting measures based on experience.                          regimes consequently do not solve the moral haz-
And governments should guard against the temp-                             ard problem implicit in “too big to fail” (TBTF). It
tation to use such levies as just a revenue-gener-                         follows that the implicit public subsidy for TBTF
ating mechanism rather than a tool to promote                              institutions remains intact; hence the need for ex
financial stability.                                                       ante measures.

Some measures (e.g., capital requirements) are                             Macroprudential tools could be used to reduce
likely to have implications for cross-border compe-                        this incentive to become too big to fail. They could
tition between financial institutions and therefore                        include a systemic risk tax as suggested by the IMF
may need to be harmonized across countries. This                           (2010). Efforts to quantify systemic risk exposure
will make it harder to tie them to local economic                          for the purposes of regulation are now underway,
conditions, for such harmonization will have to be                         but much else remains to be worked out, including
done in an objective and mutually agreeable way                            who would impose this tax, on whom, and under
across countries. Others like LTV or DTI guid-                             what circumstances.
ance need not be harmonized across countries and
could vary substantially with the domestic cycle.                          Alternatively, surcharges on capital requirements
The systemic levy is a form of capital charge, mak-                        that vary with the systemic risk they create could
ing harmonization important for countries with                             be applied to SIFIs. The Swiss government com-
many cross-border banks, something that will ad-                           mission on TBTF institutions has shown how this
mittedly make it more difficult to tie it to the cycle.                    could be done. In addition to increasing capital buf-
                                                                           fers to nearly double the level of Basel III, the Swiss
The Cross-sectional Dimension in                                           proposal makes the surcharge sensitive to systemic
Macroprudential Supervision                                                risk, calculated as a function of the balance sheet
                                                                           size and the market share of the institution.
In terms of the cross-sectional dimension, policy
should focus on systemically important financial                           Proposals have also been mooted to eliminate cer-
institutions (SIFIs). Better resolution regimes to                         tain activities of SIFIs (e.g., proprietary trading),

    Japan enacted an emergency resolution mechanism in 1998, following the banking crisis of 1997. When the emergency term ended, the
    government set up a permanent resolution mechanism.

                                                     Rethinking Central Banking
ringfence certain activities (such as retail banking,                            The coordinated approach dominated prior to the
as discussed in the context of the Vickers Commis-                               financial crisis and, despite its failures, has largely
sion in the UK), or even break up SIFIs. There is                                survived the reform process. In countries like In-
no consensus among the authors of this report on                                 dia and the United States, administrative bodies
what approach is most appropriate. But in devel-                                 have been set up to coordinate the efforts of mul-
oping all these proposals, care should be taken that                             tiple supervisory and regulatory bodies, although
they in fact reduce lower systemic risk and do not                               these bodies tend to lack enforcement power. In
just shift risk to entities that are less visible to the                         Europe, the push for greater regional coordination
regulatory authorities (including to entities less ca-                           has been further complicated by the superimposi-
pable of managing that risk). Risk that is shunted                               tion of an additional layer of supervisory institu-
out of sight in good times comes back to haunt the                               tions with few powers of their own. Supervisory
system in bad times.                                                             colleges, which collect relevant home- and host-
                                                                                 country supervisors of a large cross-border insti-
Finally, supervisors need to identify direct and in-                             tution, are one of the tools for coordination among
direct exposures and linkages, cross border as well                              countries. But overall, the problem of incomplete
as national, in order to make supervision more                                   coordination remains.
effective. They need to identify institutions and
trades where activity is disproportionately con-                                 In particular, the problem that EU-wide banks are
centrated. While collecting the relevant data (on,                               still largely supervised by national regulators is yet
for example, inter-bank derivative exposures) for                                to be fully solved. A new body, the European Sys-
their own supervisory needs, they should also dis-                               temic Risk Board (ESRB), has been charged with
seminate more aggregated information to market                                   macroprudential supervision but is endowed with
participants and the general public. Such dissemi-                               only weak powers and few effective instruments.
nation will allow market participants to manage                                  The ESRB is large and unwieldy, comprising the
risks better and allow the public in turn to better                              central bank governors and financial supervisors
monitor supervisory behavior. While individual                                   of every EU country, plus a number of other func-
countries now have efforts underway to collect and                               tionaries. Moreover, the ESRB can only issue rec-
disseminate data (for example, the Office of Finan-                              ommendations and has no enforcement powers.
cial Supervision in the United States), we are still
some distance from effective cross-border data                                   While there is little consensus as to the best mod-
collection and sharing.                                                          el, our contention that financial stability should
                                                                                 be a core objective of the central bank increases
Institutional Responsibility                                                     the weight of arguments for giving central banks
                                                                                 primary responsibility for regulatory matters. If
Who should be responsible for financial stability                                central banks have a mandate to ensure finan-
at the national level?9 There are two answers to this                            cial stability and also the powers needed to wield
question. The coordinated approach gives multiple                                macroprudential corrective instruments, they can
institutions (central bank, systemic risk boards,                                optimally choose trade-offs between the use of
micro- and macroprudential supervisors) inter-                                   the interest rate instrument and macroprudential
locking mandates, their own instruments, and a                                   measures. Moreover, the central bank will have,
directive to cooperate. In contrast, the unified ap-                             or should have, its finger on the pulse of financial
proach vests one institution, possibly the central                               markets through its monetary policy operations. It
bank, with multiple mandates and instruments.                                    possesses a staff with macroeconomic expertise. It

    Alternatively, at the regional level in places where multiple national economies share a single central bank (e.g., Euroland).

                                                         Rethinking Central Banking
is the one institution with the balance sheet capac-                            Exchange Rates and Monetary
ity to act as lender of last resort.
There are also compelling arguments against a uni-
                                                                                The external dimension of monetary policy is criti-
fied model. One disadvantage is that it makes the
                                                                                cally important for small open economies with open
central bank more susceptible to political interfer-
                                                                                capital accounts. Capital flows and exchange rate
ence. The central bank will have to work hard to
                                                                                movements are important for price-level develop-
establish the legitimacy of its actions in circum-
                                                                                ments. They are important for financial stability as
stances where the nature of threats to financial sta-
                                                                                well: in open economies, monetary policy may have
bility may be poorly understood and its actions are
                                                                                limited effectiveness in influencing credit develop-
unpopular. The public and its elected representa-
                                                                                ments because, inter alia, financial intermediaries
tives may not be happy, for example, if the central
                                                                                can substitute external funding for domestic funding.
bank curbs credit growth and causes asset prices
to fall, and they will pressure the authorities to re-
                                                                                Macroprudential tools that lean against credit de-
verse course.
                                                                                velopments can give the central bank some mea-
                                                                                sure of monetary policy autonomy, weakening the
The unified model may also pose a conflict of in-
                                                                                link between domestic monetary policy and capi-
terest for the central bank, which may, for example,
                                                                                tal inflows. For instance, by leaning against credit
be tempted to keep interest rates aritificially low in
                                                                                expansion, the central bank may be able to reduce
an effort to aid distressed financial institutions, or
                                                                                the incentive for banks to borrow externally when
to treat a bank facing a solvency problem (a mat-
                                                                                domestic interest rates are increased.
ter properly addressed by the fiscal authority or its
agents) as if it were facing a liquidity problem.
                                                                                The tensions between these different facets of eco-
                                                                                nomic stabilization become more acute when the
If, on balance, the decision is to make the central
                                                                                currency is strong relative to fundamentals and the
bank the macroprudential supervisor, this ap-
                                                                                government wants to prevent excessive apprecia-
proach should go hand in hand with measures to
                                                                                tion. This puts the central bank in a corner when
strengthen its independence from political pres-
                                                                                domestic demand is also too strong. There is then
sure. To this end, it is important for the central
                                                                                the need to cool an overheating economy by allow-
bank to participate in the public discussion of how
                                                                                ing the appreciation of the currency, on the one
its performance will be evaluated. More regular
                                                                                hand, but pressure to guard against the erosion of
communication of the rationale for its policies will
                                                                                competitiveness from what might prove to be only
also become increasingly important.
                                                                                a temporary appreciation, on the other. Capital
                                                                                controls that moderate financial inflows, especially
In sum, there are advantages to both models, and
                                                                                short-term inflows that are channeled through the
individual countries’ institutional characteristics
                                                                                domestic banking sector, may alleviate the policy
and political settings will determine what works
                                                                                dilemma but their role as a legitimate part of the
best. Whatever the mechanism, it is clear that ef-
                                                                                policy maker’s toolbox remains controversial.
fective coordination between monetary and finan-
cial regulatory policies will be the lynchpin of fi-
                                                                                Much commentary takes for granted that “capi-
nancial stability.
                                                                                tal controls don’t work.”10 Commentators making

     See, for instance, the following editorial in the Wall Street Journal: Capital-Control Comeback: As Money Flows to Asia, Politicians Play King
     Canute, 2010, June 17.

                                                        Rethinking Central Banking
such claims typically assume that the objective is                               Capital controls are not, of course, the only tool for
either to hold down the exchange rate or to sup-                                 dealing with inflows. Microprudential tools such
press the total volume of inflows. In this approach                              as minimum capital ratios should be part of the
the emphasis is on the exchange rate’s influence on                              policy response. Even these tools, however, may
the trade balance and thus also the attempt to hold                              not be enough to dampen the upswing of the cycle.
back currency appreciation by limiting financial                                 Bank capital ratios often look strong during booms
inflows, whatever their precise form.                                            when banks are profitable and the measured qual-
                                                                                 ity of loans is high. In addition, the application
But if capital controls and related macropruden-                                 of discretionary measures, such as higher capital
tial measures are seen not as instruments of ex-                                 requirements, must surmount concerted lobbying
change rate management but as part of a package                                  by vested interests that benefit from the boom.
of policies targeted at financial stability, then it is
the composition of capital flows that takes center                               Currency appreciation may also help to moder-
stage rather than their volume.11 Foreign direct                                 ate the size of capital inflows, as foreign investors
investment (FDI) and portfolio equity flows are                                  perceive less of a one way bet. However, when
less likely to reverse direction abruptly. And even                              banking sector flows form the bulk of the inflows,
when portfolio flows do reverse, the impact on                                   merely allowing the currency to appreciate may
funding may be less damaging than any sudden                                     not suffice. The behavior of banks and other lever-
loss of access by the banking sector. Foreign sell-                              aged institutions is additionally influenced by their
ers of stocks in a crisis face the double penalty of                             capital position and their perception of risks. Cur-
lower local currency prices when they sell and a                                 rency appreciation and strong profitability coupled
sharply depreciating exchange rate, the implica-                                 with tranquil economic conditions can be seen by
tion being that the dollar-equivalent outflow as-                                banks as a cue to expand lending rather than to
sociated with repatriation of portfolio equity sales                             curtail their activity.
proceeds tends to be small compared to the pre-
crisis marked-to-market value of foreign holdings                                In sum, capital controls can, under some circum-
of equity. And the typical equity investor (such as                              stances, be useful for managing maturity and
a pension fund or mutual fund) is not leveraged.                                 currency mismatches and, in particular, for fore-
                                                                                 stalling dollar shortages in the banking system.
In contrast, when foreign funding of the banking                                 Judiciously employed along with other macropru-
sector evaporates abruptly, the consequences are                                 dential policies, they can reduce financial instabil-
more damaging. If the local bank is leveraged and                                ity as well as boom-bust cycles, thereby serving as
debt is denominated in dollars, then outflows can                                a useful complement to conventional monetary
set off the well-known cycle of distress in which                                policy instruments. As with other instruments,
belated attempts by banks to hedge their dollar ex-                              care should be taken that they are used to reduce
posure drives down the value of the local currency,                              macro-economic volatility rather than merely
making the dollar-denominated debt even larger.12                                to suppress it, only to see it emerge in other, po-
If the crisis erupts after a long build-up of such                               tentially more destructive ways. Moreover, with
mismatches, the coincidence of the banking crisis                                capital accounts becoming more open and given
with the currency crisis (the “twin crisis”) can un-                             the increasing fungibility of funds across different
dermine banking sector solvency, with significant                                forms of capital, even controls limited to specific
economic costs.                                                                  types of capital flows are becoming an increasingly

     For an extensive discussion, see Ostry, Ghosh, Habermeier, Chamon, Qureshi, and Reinhardt (2010).
     Figuratively, the attempt to clamber out of the ditch by buying dollars merely drags others into the ditch.

                                                         Rethinking Central Banking
weak substitute for good macroeconomic and pru-                    •	   The neat Tinbergen separation of two
dential policies.                                                       tools for two objectives is no longer fea-
                                                                        sible. Interest rates affect financial stability
Conclusion                                                              and, hence, real activity. Equally, macro-
                                                                        prudential tools impact credit growth and
This chapter has made the case for augmenting the                       external imbalances, which have conse-
traditional narrow price stability focus of mon-                        quences for macroeconomic and price
etary policy with the additional goal of financial                      stability. Central bankers therefore will
stability. The conventional separation in which                         have to consider tradeoffs as they optimize
monetary policy targets price stability and micro-                      among their policy tools to achieve their
prudential policies target financial stability, and                     multiple objectives.
the two sets of policies operate independently of
each other, is no longer tenable.                              We believe that explicit recognition of such trade-
                                                               offs will, in some cases, move theory closer to prac-
This has a number of implications.                             tice. In other cases it will make adopting inflation
                                                               targeting more attractive insofar as the framework
    •	   Policy makers need a new set of policies              now recognizes issues that some policy makers
         that are macroprudential in nature, target-           hitherto thought were missing. And in the case of
         ing the build up of risks to financial stabil-        the few who still adhere to narrow inflation target-
         ity. These policies range from countercy-             ing, it might prompt a welcome reconsideration.
         clical capital ratios to capital controls.

                                          Rethinking Central Banking
        CHAPTER 3

                                Cross-Border Spillovers

  n the last chapter we discussed how national                               cross-border spillovers. For instance, monetary in-
  monetary policy frameworks should be re-                                   jections when the nominal interest rate is at its zero
  thought to better incorporate financial-stability                          bound might result in capital outflows rather than
considerations. But there is another equally im-                             in more domestic activity, if domestic demand is
portant reason for rethinking the framework: in-                             weak and banks are reluctant to lend.13
ternational spillovers.
                                                                             And while concern in the 1980s centered on the
If national policies have important cross-border                             interaction of the United States and Europe, two
effects, then there is a prima facie case for coordi-                        economic blocs with floating exchange rates, spill-
nating them internationally. This observation was                            overs today involve one bloc that floats—the major
of course the main point of the voluminous 1980s                             advanced countries—and one, led by China, with
literature on spillovers and policy coordination.                            fixed or semi-fixed exchange rates. This asymme-
But it has since been rendered more compelling by                            try gives rise to important new issues.
changes in the world economy in the last quarter
century. The world today is more connected than                              In this chapter we review various channels for in-
ever by cross-border financial flows. The policy                             ternational transmission of domestic policies and
choices of individual countries, especially those of                         discuss their implications. We then discuss the
large, systemically significant countries, can have a                        tensions that arise in reconciling domestic mon-
substantial impact on their neighbors. When gov-                             etary policies with the larger objective of global
ernments and central banks change their macro-                               macroeconomic and financial stability.
economic policy stance dramatically—as they did
in the recent world financial crisis—the spillovers
on other nations can be sizeable.
                                                                             Cracks in the Framework of
                                                                             (Mostly) Flexible Exchange Rates
Cross-border spillovers may also have increased as a
result of the nature of policy responses to economic                         The international properties of the de facto regime
shocks and business cycle conditions. A commonly                             of flexible exchange rates were never as desirable
voiced concern is that unconventional monetary                               as asserted by its champions. To start with, the new
policies may have especially large and complex                               regime was not, in fact, universally adopted. It was

     This combination of circumstances is not unusual—witness what happened during the recent financial crisis.

                                                       Rethinking Central Banking
not widely adopted in Asia, for example, where de                                    •	   Convergence towards the inflation target-
jure or de facto pegging remained the reality and a                                       ing cum flexible exchange-rate framework
large volume of foreign exchange reserves was ac-                                         remains incomplete. While a large part of
cumulated in the 2000s, contrary to the presump-                                          the world economy has adopted this mod-
tion that reserves would become superfluous with                                          el, some fast-growing emerging markets
the breakdown of the Bretton Woods system of                                              have not. The coexistence of floaters and
fixed exchange rates.                                                                     fixers therefore remains a characteristic
                                                                                          of the world economy. It can even be said
Moreover, large current-account surpluses and                                             that the incidence of pegging has risen
deficits (‘imbalances’) persisted over much of the                                        over time with the export drive of East
last decade without prompting macroeconomic                                               Asia and, toward the end of the most re-
and exchange-rate responses. Imbalances persist-                                          cent decade, the rise of the relative price
ed in countries with very different exchange rate                                         of oil.
arrangements, including countries that did not
maintain dollar pegs, such as Japan and Germany.                                     •	   The period in which the IT regime was test-
                                                                                          ed was exceptionally benign. China’s en-
Questions also remained about the ability of infla-                                       try into global trade and other emerging
tion targeting cum floating exchange rates to cope                                        markets acted as a strong disinflationary
with the volatility of international capital flows.                                       force, making for price stability globally.
While stability-oriented monetary policies at the                                         Commodity prices remained subdued un-
national level could help to limit the magnitude                                          til the late 2000s, and there were few in-
of sudden inflows and reversals, and while strong                                         flation spillovers. Since then the situation
regulatory and supervisory frameworks could help                                          has changed. In a new context where com-
limit their consequences, it was unclear whether                                          modity prices respond strongly to aggre-
such measures would be sufficient to protect                                              gate demand, a major question is whether
emerging economies from macroeconomic and                                                 central banks take into account spillovers
financial instability.                                                                    through global commodity prices when
                                                                                          making monetary policy decisions.
Nor did the IT-floating framework eliminate the
special role of the dollar as the key international                                  •	   Capital market spillovers between ad-
currency. The dollar remains the world’s most im-                                         vanced and emerging economies have
portant reserve currency and a leading invoicing                                          grown. While Obstfeld’s (2009) character-
currency for international trade. It is also the cur-                                     ization of the world economy as compris-
rency that underpins the global banking system as                                         ing a single financial system may not apply
the funding currency for global banks. This raises                                        to all countries, it is certainly correct for
important questions about access to dollar liquid-                                        North America, Europe, East Asia, and
ity by non-US banking systems in times of stress.14                                       a number of emerging market countries.
                                                                                          Private gross capital flows to and from
Reconsidering the Conventional Wisdom                                                     both the US and Europe grew massively in
                                                                                          the course of recent decades. To be sure,
In light of the financial crisis and subsequent de-                                       this was in large part for reasons indepen-
velopments, several reasons have emerged for re-                                          dent of monetary policy, including finan-
visiting the conventional wisdom:                                                         cial liberalization, the unique role of the

     For an extensive discussion of these issues see Farhi, Gourinchas, and Rey (2011).

                                                        Rethinking Central Banking
           US as supplier of safe financial assets, and                       These observations suggest that convergence to-
           the attractiveness of emerging markets                             wards a common policy template in the 2000s was
           as destinations for investment. Still, the                         not general. Moreover, where convergence has
           resulting financial interpenetration im-                           take place, it may not last long in view of the chal-
           plies that the stock of diversifiable assets                       lenges currently confronting monetary policy. It is
           and cross-border holdings that respond                             therefore important to assess whether a reformed
           to changes in monetary conditions have                             consensus can and will be formed and to contem-
           grown enormously.15 This creates chal-                             plate its implications for the conduct of monetary
           lenges for countries on the receiving end                          policy and for the ‘own house in order’ doctrine in
           of capital flows. In practice, many of those                       particular.
           recipients are emerging market economies
           that are struggling to prevent the surges in                       Challenges to the IT-plus-floating Regime
           capital inflows from leading to exchange
           rate misalignment and unsustainable                                1. Uneasy coexistence: floaters and fixers
           lending booms.
                                                                              The idealized IT-plus-floating framework has not
     •	    Unconventional monetary policies are likely                        worked out as anticipated, because countries have
           to accentuate international spillovers. Such                       not converged to similar monetary and exchange
           policies are typically undertaken when                             rate arrangements.
           traditional instruments are exhausted and
           traditional channels have ceased working.                          In Latin America, a substantial number of coun-
           In such situations, unconventional poli-                           tries, some of them large and economically im-
           cies could result in less domestic demand                          portant, resist moving in this direction. While the
           creation and more demand shifts between                            two largest countries –Brazil and Mexico—and an
           countries. Critics argue that purchases by                         important set of middle-sized and small nations
           central banks of long-dated bonds and pri-                         –Colombia, Peru, Chile, Uruguay—have adopted
           vate-sector-issued securities create liquid-                       it, another sizeable group including Venezuela, Ar-
           ity that can spill abroad (because domestic                        gentina, Bolivia, and Ecuador continues to pursue
           channels for credit creation are blocked),                         fixed or semi-fixed exchange regimes, sometimes
           causing capital flows to and undesirable                           with multiple exchange rates for different current
           relative price changes in other countries.16                       and capital account transactions. Few countries
           Central banks in countries conducting                              in the Middle East and Africa have converted to
           quantitative easing—the US Federal Re-                             IT plus floating, though economically important
           serve and the Bank of England—argue                                South Africa has adopted it.
           that Quantitative Easing (QE) is no differ-
           ent conceptually from conventional mon-                            In Asia, several countries have adopted the frame-
           etary policy but merely its continuation                           work, albeit with different degrees of commit-
           through other means in a situation where                           ment. Inflation targets are explicit in Thailand,
           interest rates approach the zero bound.                            Korea, Indonesia, and the Philippines. In Thailand
           Central banks in several emerging market                           and Korea, low and stable inflation was achieved
           countries, in contrast, claim that QE is a                         in the 2000s. Singapore has achieved low and sta-
           beggar-thy-neighbor strategy.                                      ble inflation using a basket-based exchange rate

   Lane and Milesi-Ferretti (2001) and Kubelec and Sá (2010) provide a quantitative account of financial integration and the participation in it of
   major emerging economies.
   See Portes (2010) for a discussion.

                                                      Rethinking Central Banking
regime, since the economy is small and highly open                              the last two decades. To the contrary, the share
to financial flows. Usually, however, Asian central                             of such countries, so measured, has actually de-
banks have multiple objectives: growth, price sta-                              clined (Figure 1).
bility, and exchange rate stability, some of which
temper the conventional framework. It is fair to                                The main consequence is that the adjustment
say that many East Asian countries deal with in-                                mechanism implied by the standard IT-plus-float-
flation more on the basis of discretion than pre-                               ing arrangement has not been allowed to operate.
set rules. In Cambodia and Vietnam, dollarization                               This is one explanation for the size and persistence
and the lack of independence of the central bank                                of global imbalances. According to the IMF’s World
is a serious problem in stabilizing inflation. India                            Economic Outlook, these imbalances reached 3%
has a hybrid regime without an explicit inflation                               of world GDP in 2007, before the advent of the
objective and with exchange rate management in                                  crisis.17 The subsequent crash then reduced cur-
principle limited to moderating sharp movements                                 rent account deficits in countries such as the US
in the currency’s value.                                                        and the UK as their demand for imports dropped
                                                                                sharply. But according to the April 2011 WEO, im-
China is the largest nation with a managed ex-                                  balances once again began to grow starting in 2010
change rate. The renminbi was delinked from its                                 and will hover around 2% of world GDP between
US dollar peg in 2005 but remains tightly managed                               now and 2016.
against the dollar. Among the explanations for this
choice of exchange rate regime are the government’s                             A prominent instance of the uneasy coexistence
objective of promoting export-led growth. Another                               of floaters and fixers is the tug of war between
is the desire to self-insure against external shocks                            US monetary policy and exchange rate policy in
by accumulating a large stock of reserves. China’s                              emerging market “fixers” such as China. A highly
foreign exchange reserves now exceed $3 trillion,                               stimulative US monetary policy is potentially fu-
dwarfing by a wide margin all evaluations of the                                eling inflation elsewhere, including in emerging
reserve buffer necessary to insure against sudden                               markets that have closed their output gaps and are
stops of inflows or a surge of capital outflows.                                facing inflationary pressures. Of course, emerg-
                                                                                ing market central banks could raise interest rates
National and regional differences aside, a common                               more rapidly, but they would then attract capital
feature of policies in these countries is a reluctance                          inflows and experience faster exchange rate appre-
to allow exchange rates to move as much as needed                               ciation. Meanwhile, emerging market resistance
to accommodate external disturbances, especially                                to exchange rate appreciation is limiting export
those originating in the capital account. Non-float-                            and employment growth in industrial countries
ers monitor nominal and sometimes also real ex-                                 already experiencing high and persistent unem-
change rates and use not just foreign exchange mar-                             ployment. In normal circumstances, the United
ket intervention but a whole array of instruments to                            States and other advanced economies would ad-
prevent unwanted exchange rate movements.                                       just by cutting interest rates. But these countries
                                                                                are already at the zero bound. In this context, the
In sum, notwithstanding the perceived success of                                exchange rate policy of emerging market “fixers” is
inflation targeting with flexible exchange rates,                               imposing a negative demand externality on the ad-
countries operating a freely floating exchange-                                 vanced economies. In tandem with the inflation-
rate regime, whether measured in terms of global                                ary externality imposed by US monetary policy,
GDP or global exports, have not increased over                                  this has created severe policy complications for

     That is the size of the current account surpluses in countries like China, Japan, Germany, Switzerland, and the oil producers, matched (up to
     errors and omissions) by the corresponding deficits in the US, the UK, Spain and elsewhere.

                                                        Rethinking Central Banking
Figure 1: Shares of 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-Rogoff classification. Euro area countries are
treated separately throughout in order not to introduce a break in the series.

                                                Rethinking Central Banking
other countries, especially emerging markets that                             in the money supply created by its intervention in
are floaters.                                                                 the foreign exchange market, the PBOC has been
                                                                              forced to sell all of its holdings of government se-
Collective action problems arise from these asym-                             curities and to sell central bank bills to state-owned
metric exchange rate arrangements. Many emerg-                                commercial banks. This strategy has been abetted
ing market countries in East Asia, even those that                            by repressed interest rates, creating distortions in
ostensibly float, explicitly or implicitly monitor                            financial markets and in effect taxing households
their real exchange rates. They are reluctant to see                          who receive negative real returns on their massive
their currencies appreciate excessively, especially                           stock of bank deposits.
relative to other countries in the region. This reluc-
tance hinders nominal exchange-rate adjustment                                The financial crisis heightened these tensions. Its
between East Asia and the advanced economies at                               size and depth increased the incentive for emerg-
a time when asymmetries between the two groups                                ing markets experiencing sharp capital flow rever-
urgently call for real exchange-rate adjustment.                              sals to self-insure by accumulating even larger re-
                                                                              serves.18 Moreover, the instability of world demand
Concerns about exchange rate appreciation and                                 has caused a number of countries, not all of them
overshooting are not limited to the emerging mar-                             in Asia, to place an even greater premium on man-
kets, of course. The recent intervention in foreign                           aging the level of the real exchange rate. This has
exchange markets by committed floaters such                                   led them to deploy a broad array of tools, includ-
as Japan and Switzerland highlights the tensions                              ing capital controls, to prevent unwanted apprecia-
building up in the global economy as public debt                              tion (for a more detailed discussion of this issue,
levels in the major reserve currency areas—the                                see Chapter 4 below).
US and Europe—impose more of a burden on the
Federal Reserve and the European Central Bank to                              There are two possible assessments of these trends.
maintain lax monetary policy with attendant spill-                            One minimizes the importance of the asymme-
overs to the rest of the world (as discussed in more                          try of exchange rate policies on the grounds that
detail in the next chapter).                                                  what matters for international adjustment is real
                                                                              exchange rates, which governments cannot control
Fixing also creates policy dilemmas for countries                             in the long run. Thus, recent price and wage infla-
seeking to fix. These countries are by choice de-                             tion in China is causing non-trivial appreciation of
pendent on their partners’ monetary policy de-                                the renminbi in real terms vis-à-vis the dollar even
cisions, especially but not only when they have                               while the nominal bilateral exchange rate remains
opened the financial account. Attempting not to                               relatively stable.
import foreign monetary conditions while fixing
has required extraordinary measures.                                          The alternative view, which we share, is that inter-
                                                                              national adjustment via wage and price inflation
Take China, whose capital account is only partial-                            is slow and inefficient. The world economy would
ly open. Experiencing large balance of payments                               be better served by a speedier mechanism involv-
surpluses, the People’s Bank of China (PBOC)                                  ing greater exchange rate flexibility. If flexibility
has regularly intervened in the foreign exchange                              is not feasible for domestic political reasons, then
market to limit the appreciation of the renminbi.                             incentives need to be put in place to make sure
The resulting increase in China’s foreign exchange                            large nations among both groups—fixers but also
reserves accounts for almost all the increase in                              floaters—internalize the international effects of
China’s monetary base. To sterilize the increase                              their actions.

     That factor alone suggests that fixed or semi-fixed exchange rate arrangements will be around for some time in emerging markets.

                                                       Rethinking Central Banking
2. Controlling inflation in a less benign                       policy choices to involve significant externalities.
   environment                                                  It would therefore be desirable that these central
                                                                banks, and perhaps a handful of others, include
For the second time in three years, rising commodi-             in their policy objective a measure of these ef-
ty prices are fuelling global inflation. This inflation-        fects. Clearly, however, such a move would involve
ary pressure is superimposed on the background of               a collective-action dimension, which calls for an
still-large output gaps and high unemployment in                explicit dialogue among these central banks about
virtually all advanced countries. This combination              the amendment of their policy frameworks. We re-
is problematic for an inflation-targeting strategy in           turn to this later.
which central banks focus on the components of
inflation that are under their direct control. Indeed,          3. Financial channels of transmission
for central banks in commodity-importing coun-
tries, a rise in oil or commodity prices is an exog-            In the idealized world in which all central banks
enous supply shock, and the standard model says                 pursue IT and allow their exchange rates to float,
that the central bank should only respond to the                an individual central bank’s monetary policy ac-
extent that the shock has second-round effects and              tions—say, a cut in the interest rate—are transmit-
increases expected future inflation.                            ted to the rest of the world mainly through two
Targeting domestically-generated inflation was an
appropriate strategy and did not raise concerns                     •	   The cut in local interest rates stimulates
about collective action problems in the 1990s and                        domestic demand, some of which spills
the early 2000s, when an ample supply of com-                            over to additional imports. The magni-
modities and the entry of China and other devel-                         tude of this effect on the rest of the world
oping countries into the global labor force helped                       depends on the country’s share of world
subdue global inflation. Against the background of                       GDP.
a steep global commodity supply curve, however,
expansionary monetary policies by major econo-                      •	   The country’s nominal and real exchange
mies—advanced and emerging alike—may create                              rates depreciate, shifting demand away
negative externalities that are not adequately inter-                    from the rest of the world. Again, the size
nalized in the standard framework.                                       of this cross-border effect depends on the
                                                                         size of the country in question.
This shortcoming is especially evident in the strict
inflation-targeting framework in which the central              In this stylized model, capital flows only have an
bank commits to keeping the forecast rate of infla-             indirect role, with the potential for outflows from
tion (conditional on market expectations for the                the country undertaking an expansionary mon-
policy rate) on target. In this setting, the global en-         etary policy causing movements in the value of its
vironment is taken as given and is not affected by              currency. Prices bear the burden of adjustment.
domestic monetary policy responses. As a conse-
quence, the global monetary policy stance is likely             In contrast, recent experience points to the exis-
to be suboptimal.                                               tence of additional channels whose role and im-
                                                                pact may well be large and potentially destabiliz-
In small open economies, monetary policy is rea-                ing. While the fact that the impact of capital move-
sonably geared to domestic objectives. The same,                ments can dwarf that of the more traditional trade
however, does not apply to the large-economy                    effects has long been understood, the new and
central banks, such as the Fed, the ECB, and the                novel observation concerns the size of the cross-
PBOC. These economies are large enough for their                border capital movements triggered by the supply

                                           Rethinking Central Banking
of liquidity or small changes in interest rates in ad-                An additional channel of transmission is through
vanced countries. This reflects the accumulation of                   commodity prices. Low interest rates in the G-3
a huge pool of footloose assets responsive to small                   countries have a tendency to push up primary-
changes in expected returns.                                          commodity prices, both because the associated
                                                                      low borrowing costs mean high consumption and
The composition of these investment portfolios is                     investment demand for these products, including
interest-rate sensitive and likely to respond sharp-                  from emerging markets, and because a low inter-
ly to differences in expected rates of economic                       est rate reduces the financial cost of holding stocks
growth in recipient countries. An example is the                      of storable commodities, thus making them more
massive capital flows to emerging markets in 2010                     attractive as investment vehicles.
in response to the growth slowdown and record-
low interest rates in major advanced countries.                       From the point of view of a commodity-producing
                                                                      country, lower world interest rates thus improve
Policy spillovers to the rest of the world can be                     the terms of trade and increase local wealth and
sizeable in the case of the United States, which                      creditworthiness. A rating upgrade may follow. All
hosts branches of some 160 foreign banks whose                        this makes the country even more attractive for
main function is to raise wholesale dollar funding                    footloose international capital, creating pressures
in capital markets. Foreign bank branches collec-                     for currency appreciation.
tively raise over one trillion dollars of funding, of
which over 600 billion dollars is channeled to their                  These cross-border effects can be magnified by
headquarters outside the United States.19                             differences in exchange rate regimes. In recipi-
                                                                      ent countries with freely floating exchange rates,
Although the United States is the single largest net                  standard theory suggests that the local currency
debtor, it is a substantial net creditor in the glob-                 should appreciate in response to a cut in foreign
al banking system. In effect, the US borrows long                     interest rates. It could even appreciate beyond its
through the issue of treasury and other securities                    new steady-state level on impact, before then de-
while lending short through the banking sector.                       preciating until reaching its new equilibrium level.
This is in contrast to countries like Ireland and Spain
that financed their current account deficits through                  But if the country in question has a managed float
their respective banking sectors, which subsequent-                   or semi-fixed exchange rate, the required apprecia-
ly faced runs by their wholesale creditors.                           tion will not occur on impact. Even so, expecta-
                                                                      tions of appreciation will eventually set in, making
Some borrowed dollars will find their way back to                     it more attractive to shift capital toward the coun-
the United States. But many will flow to Europe,                      try. This may bring forth additional inflows, in
Asia, and Latin America, where global banks are                       turn creating additional pressure for the exchange
active local lenders. At the margin, the shadow val-                  rate to strengthen.
ue of bank funding will be equalized across regions
through the portfolio decisions of global banks,                      The situation is even more complicated if interven-
making global banks the carriers of dollar liquidity                  tion in the foreign exchange market is sterilized. The
across borders. In this way, permissive US liquidity                  need to issue local bonds to mop up the liquidity re-
conditions are transmitted globally, and US mon-                      sulting from the purchase of foreign exchange may
etary policy becomes global monetary policy.20                        cause local interest rates to rise, attracting even more

     Bank for International Settlements (2010).
     See also Cetorelli and Goldberg (Forthcoming).

                                                      Rethinking Central Banking
inward capital flows. And since local interest rates                         find themselves on the receiving end of ever-larger
are likely to be higher to begin with (if the recipient                      inflows. The central bank may end up allowing
country is an emerging market), this sterilization                           some appreciation anyway, but not before accu-
will be expensive. If sustained over a sufficiently                          mulating a large stock of expensive domestic li-
long period, sterilized intervention can weaken fis-                         abilities and a large stock of international reserves
cal accounts, causing expectations of monetization                           on which it will take a capital loss (in domestic
and higher inflation, which in turn will cause local                         currency terms) if and when the exchange rate ad-
nominal rates to go up. This, in turn, can call forth                        justment eventually happens.
yet another round of destabilizing capital inflows.
                                                                             While the conventional model of IT-plus-floating
The conventional view of international spillovers                            acknowledged these complications, it did not place
has also relied on the assumption of smoothly-                               them at the center of the analysis. To the extent
adjusting international capital markets, something                           countries targeted core inflation, spillovers through
that seems less than tenable today. The 2007-09                              global commodity prices were left unattended. This
financial crisis serves as a reminder that financial                         was not a serious concern in the1980s and 1990s,
flows can reverse abruptly, placing intense pressure                         the period of the Great Moderation, but is a more
on the functioning and integrity of markets and                              serious one in the presence of large global imbal-
market participants. This has been pointed out re-                           ances and the need to accommodate large stocks
peatedly after recent capital-account currency cri-                          of internationally mobile capital “looking for yield.”
ses—Mexico, Asia, Russia, Brazil, and Argentina.
What is new in the 2007-09 crisis was that it hap-                           4. Normal versus crisis times
pened even in some advanced countries—for ex-
ample, some European economies, such as Ireland.                             The conventional wisdom was developed in tran-
                                                                             quil times. In crises, in contrast, central banks have
A nation previously flooded with capital can thus                            resorted to an array of non-conventional mon-
become the subject of a sharp reversal in flows.                             etary policies such as quantitative easing (QE)—
Margin and borrowing constraints can suddenly                                the printing of money to buy bonds. What do such
become binding, leading to a painful process of                              policies imply for the question of international
deleveraging. If the need to raise cash causes one                           spillovers of monetary policy?
round of asset sales, the prices of those assets will
fall, reducing the value of collateral and calling forth                     One view is that unconventional policies are no
further asset sales and additional price drops. This                         different from conventional policies in their cross-
can cause massive destruction of value, as firms find                        border implications. If floating exchange rates can
themselves liquidity-constrained and abandon un-                             adjust to make international coordination of con-
finished potentially profitable investment projects.                         ventional policies unnecessary, then the same must
                                                                             be true of unconventional policies. This was the
Policy makers in countries on the receiving end of                           view of the United States following the adoption
these flows face an unappetizing choice. If they al-                         of QE2. In response to complaints from emerging
low the currency to appreciate, they expose them-                            market policy makers who feared the wave of li-
selves to accusations of overvaluation, loss of com-                         quidity coming their way, Fed officials essentially
petitiveness, and de-industrialization. But if they                          argued that, “everything will be okay if you just let
fight the appreciation via intervention, they may                            your currencies appreciate.”21

     As indicated, for example, by the following excerpt from the speech by Fed chairman Ben Bernanke on November 19, 2010 at the ECB Central
     Banking Conference: “An important driver of the rapid capital inflows to some emerging markets is incomplete adjustment of exchange rates in
     those economies, which leads investors to anticipate additional returns arising from expected exchange rate appreciation.”

                                                       Rethinking Central Banking
The alternative view is that beggar-thy-neighbor                 rate at the expense of trade partners. It follows that
impacts are greater when using unconventional                    spillovers are potentially larger during episodes of
instruments. The difficulty arises in evaluating                 local financial distress.
whether the use of such instruments is consistent
with the normal policy framework or represents                   The presence of international spillovers suggests
an attempt mainly to weaken the currency and                     that coordination can lead to better global out-
boost exports in the absence of a positive domes-                comes. In addition, the current situation high-
tic demand response. The same causes that jus-                   lights the need for principles and procedures for
tify recourse to unconventional policies make the                deciding when an unconventional monetary pol-
inflation-targeting compass lose precision. When                 icy is beggar-thy-neighbor in its effect. In turn,
inflation significantly undershoots its target and               these principles should form the basis for correc-
central banks resort to instruments with which                   tive action.
they have little experience, it is much harder to
say whether a policy stance is in line with the IT               Conclusion
framework or whether it represents an attempt at
competitive devaluation.                                         The cross-border spillovers from monetary policy
                                                                 provide yet another reason for rethinking not just
In addition, spillovers may work differently in times            the domestic monetary policy framework but also
of crisis. During a crisis, local credit demand is likely        mechanisms for ensuring compatibility between
to be weak and banks’ willingness to lend domesti-               large-country policies. We will turn to recommen-
cally will be especially limited. For every additional           dations that follow from this analysis in Chapter
dollar of liquidity that is created by monetary policy,          Five. But before offering recommendations, we
a larger share will end up abroad in crisis times than           turn to a discussion of some additional policy bur-
in normal times, thereby depreciating the exchange               dens on central banks in the aftermath of the crisis.

                                           Rethinking Central Banking
        CHAPTER 4

      Additional Pressures on Central Banks

  n this chapter we describe how central banks are          for the United States and other industrial econo-
  coming under additional pressures in the post-fi-         mies. For many if not most advanced countries,
  nancial-crisis environment. While some of these           concerns about those debt burdens will shape pol-
additional pressures are not entirely new, they             icy choices for years. Fiscal adjustment is painful
threaten to force central banks onto risky terrain.         in the short run, which makes it politically difficult
                                                            to deliver. Debt restructuring, for its part, leaves a
We highlight two sets of pressures: (a) the conse-          damaging stigma and is also often associated with
quences of high public and private debts; and (b)           deep recessions.
the perceived dangers of currency appreciation
and overvaluation.                                          Importantly, debt overhangs are not limited to the
                                                            public sector, as was the case following World War
While manifestations of these pressures are already         II, but include a high degree of leverage in the pri-
evident in individual countries, it is important to         vate sector, especially in the financial industry and
understand them as part of a broader global picture.        among households.22 The surge in domestic bank
We do so in the next two sections, which look at the        credit that occurred in most advanced economies
consequences of high public and private debts in the        in 1997-2007 has barely begun to unwind. The
advanced economies and at worries about currency            build-up in external leverage was even greater,
misalignments and overvaluation in emerging mar-            with Iceland and Ireland recording gross external
kets, respectively. Following this positive analysis        debt positions in excess of ten times their respec-
(which asks what kinds of new pressures central             tive GDPs. The debt overhang and associated prob-
banks will find themselves subject to), we turn in          lems are common to most advanced economies.
the concluding section to the normative dimension
(the question of how central banks should respond).         An unsustainable path for the public debt ulti-
                                                            mately needs to be addressed. In some countries
Central Banks and the Debt                                  this will require an extended period of primary
Overhang                                                    budget surpluses. In others it will require debt re-
                                                            structuring. The authorities will of course be reluc-
High levels of public debt are likely to be the most        tant to term their actions restructuring; they will
enduring legacy of the 2007-2009 financial crises           prefer the pretense that they are finding uniquely

     See Reinhart and Reinhart (2010).

                                         Rethinking Central Banking
advanced economy solutions for what are, in re-                                are being “placed” at below market interest rates
ality, emerging market style sovereign debt crises.                            in pension funds and other more captive domestic
Just as in other debt crises-resolution episodes,                              financial institutions is already under way. Spain
their responses will include debt buybacks (as in                              has recently reintroduced a de facto form of inter-
Greece) and debt-equity swaps.                                                 est rate ceilings on bank deposits.24,25 At the same
                                                                               time, however, it remains to be seen whether gov-
Another option, which seemingly holds out the at-                              ernments have the ability to go much further in
traction of avoiding some of the aforementioned                                today’s financially-sophisticated, high-capital-mo-
costs or at least spreading them over time, will be                            bility world.
to attempt to limit the effective cost of debt by re-
quiring domestic financial institutions to hold it.                            If governments do embark on this path, central
While advanced economies are unlikely to call                                  banks are likely to come under pressure to be part
their policies financial repression when more po-                              of this process, as they were in the period after
litically correct characterizations, such as pruden-                           World War II. In many countries, central banks
tial regulation, are available, they could move to                             are financial regulators, so the impetus for, or at
a system more akin to what the global economy                                  least acquiescence to, measures compelling other
had prior to the 1980s market-based reforms. That                              financial institutions to hold government bonds
system of domestic and external financial regula-                              will have to come from the central bank, and the
tion was instrumental in keeping real interest rates                           central bank will come under political pressure to
low (and often negative) and reducing advanced                                 provide it. The central bank may also come under
economies’ government debt levels from their re-                               pressure to support bond prices—or equivalently,
cord highs at the end of World War II.                                         to cap interest rates on treasury bonds—as was the
                                                                               case in the United States prior to the Treasury-Fed-
Some recent moves suggest governments might                                    eral Reserve Accord of 1951 that restored the Fed’s
attempt similar measures today. Basel III provides                             operational independence. The European Central
for the preferential treatment of government debt                              Bank has already engaged in limited purchases of
in bank balance sheets via substantial differentia-                            the government bonds of heavily indebted euro-
tion (in favor of government debt) in capital re-                              area countries and is under pressure (as we write)
quirements. Other approaches may be even more                                  to undertake more, with the effect of transferring
direct. For example, at the height of the financial                            sovereign obligations onto its own balance sheet.
crisis, UK banks were required to hold a larger
share of gilts in their portfolios. The IMF’s April                            The normative question (which we address in the
2011 Global Financial Stability Report documents                               concluding section to this chapter) is whether, un-
how Greek, Irish, and Portuguese banks have al-                                der what circumstances, and how far the central
ready liquidated a substantial fraction of their                               bank should go down this road. As discussed ear-
foreign assets and swapped those into domestic                                 lier, the conceit behind central bank independence
public debt.23 Evidently, the process whereby debts                            and inflation targeting is that monetary policy

   See Figure 1.17 in that report. The question of course being the extent to which this reflects regulation, public pressure, or private incentives.
   Our discussion has focused primarily on Western Europe, but similar trends are emerging in Eastern Europe. Pension reform adopted by
   the Polish parliament in March of this year has met with criticism from employers’ federations and business circles. According to the Polish
   Confederation of Private Employers Lewiatansay, the proposal seeks to hide part of the state’s debt by grabbing the money of the insured and
   passing the buck to future governments. The confederation also points out that moving money from pension funds to ZUS will protect the
   government from having to change the definition of public debt and exceed financial safety thresholds, but will expose future retirees to losses.
   Struggling with budgetary pressure at home, Hungary has nationalized its pre-funded pension schemes and excluded the cost of the reforms
   from their public debt figures. Bulgaria has taken measures in the same direction.

                                                      Rethinking Central Banking
can and should target price stability alone, while            the central bank’s focus on domestic price stability
other economic objectives are best addressed with             and neglect of the exchange rate comes at the ex-
other instruments and by other agencies. But in a             pense of the profitability of key sectors. In emerg-
second-best world, where other instruments are                ing markets, the typical pattern is for an upswing
ineffective or constrained and where uncertainty              in expectations to cause capital inflows that in turn
prevails, this neat separation breaks down. Under             strengthen the exchange rate, squeezing tradable
these circumstances, central bankers need to ask              economic activities. In advanced countries, similar
whether, inter alia, undertaking bond purchases,              problems can arise as a result of safe-haven flows
while creating moral hazard for their governments,            and economic problems abroad (see the recent
interfering with the conduct of conventional mon-             cases of Switzerland and Japan).
etary policy, and sending mixed messages, is better
or worse than standing by idly and potentially forc-          Central banks have traditionally responded to cap-
ing the debt to be restructured, already weak banks           ital inflows with sterilized intervention and various
to take a haircut, and—in the worst case should be            forms of capital-account regulation. But sterilized
joined—financial market meltdown to occur.                    intervention that results in the build-up of reserves
                                                              is costly and ultimately self-defeating when finan-
This debate has taken on a particularly sharp edge            cial markets are open. Unsterilized intervention
in the context of the unfolding European sovereign            (a form of quantitative easing) may help where
debt crisis. As the public discussions among dif-             there is no existing problem of inflation (Switzer-
ferent official players in that context vividly illus-        land, Japan), but it is problematic in the boom-
trate, the right answers are far from obvious and             ing emerging-market setting, where inflation and
outcomes are intimately tied to political rather              overheating risk already exist (see, however, Tur-
than just economic considerations. It is also un-             key for an experiment along these lines). There has
likely that the same answer to these questions will           been an increased tendency therefore in emerging
be correct under all circumstances.                           markets to resort to controls of various types. Now
                                                              that such measures are no longer under attack by
Central bankers face a difficult dilemma. The                 the IMF, more countries have become willing to
more they take these competing objectives                     discuss and institute them: Brazil, Thailand, and
on board, the more they depart from the in-                   Korea being cases in point.
tellectual framework that guides their action,
and the more complicated their task becomes.                  It is easy to dismiss pressure from exporters as self-
But when they overlook such spillovers in the                 interested lobbying. However, there may also be
name of monetary purity, they begin to be                     some broader validity to their claims. The share of
viewed as part of the problem and they risk                   employment in manufactures tends to shrink as a
undermining the political consensus that un-                  country moves through middle- and high-income
derpins their independence.                                   status. But very sharp appreciation of the exchange
                                                              rate can accelerate that process, with disruptive
Dealing with Currency Misalignments and                       effects. Workers with industry-specific skills and
Overvaluation                                                 training may find it hard to redeploy them else-
                                                              where. A long-standing comparative advantage
Another area where this dilemma is experienced is             can be undermined. Recall, for example, discus-
in the relationship between monetary policy and               sions of how the high dollar in the mid-1980s was
trade competitiveness. Central banks frequently               creating a Rust Belt in the Midwest and of how
come under pressure from exporters, industrial-               a strong franc currently threatens to hollow out
ists, and agricultural interests who complain that            Swiss industry.

                                         Rethinking Central Banking
Some of these arguments seem to apply with even                growth.The question is how much weight central
greater force to emerging markets and develop-                 banks should attach to the impact of their policies
ing countries. Manufactures, modern services,                  on the real exchange rate.
and non-traditional agriculture are critically im-
portant for economic growth in these countries.                In principle they can take refuge in the dichotomy
Countries that have initiated and sustained mod-               between nominal and real exchange rates and ar-
ern economic growth have often done so on the                  gue that the conduct of monetary policy has impli-
back of successful expansion of exports. This has              cations for the first but not the second. The real ex-
required the promotion of tradables through the                change rate is an endogenous relative price deter-
adoption of supportive policies.                               mined by real quantities, namely the balance be-
                                                               tween domestic saving and domestic investment.
One economic rationale for emphasizing tradables               Under textbook conditions, the competitiveness of
is that the obstacles that impede structural trans-            tradables can be divorced from monetary policy.
formation affect predominantly modern, high-
productivity economic activities that are tradable.26          There are two counter-arguments, one empirical
Such obstacles can take the form of government                 and the other conceptual. The empirical point is that
failures, for example weaknesses in property rights            prices tend to be stickier than the exchange rate, as
and contract enforcement. Or they can come in the              a result of which nominal and real exchange rates
form of market failures, such as learning externali-           tend to move together. Exporters who see the nomi-
ties or coordination failures. The first, best response        nal value of the domestic currency rise can be pretty
is to eliminate these underlying distortions, but this         certain that this will have an adverse impact on their
is often easier said than done. Alternatively, sec-            profitability over time horizons they care about.
ond-best policies promoting tradables ensure that
resources move from low- to high-productivity ac-              The conceptual point is that economies with large
tivities, generating economic growth in the process.           amounts of surplus labor have quasi-Keynesian
                                                               features, allowing monetary policy to have real ef-
This has been China’s recent growth strategy, as               fects. An excess supply of labor in rural areas (or
well as that of Japan, South Korea, Taiwan, and                informality) pins down the (nominal) wage rate at
other East Asian tigers before it. In contrast, coun-          the margin at some low level. Since wages are a key
tries experiencing shrinkage in non-traditional                determinant of non-tradable-goods prices, an in-
tradables, such as those in Latin America after                crease in the nominal money supply can then raise
1990, have had low rates of economy-wide produc-               the relative price of tradables to non-tradables (i.e.,
tivity growth. Even for emerging markets that have             depreciate the real exchange rate) and have real ef-
followed a less explicit export-led growth strategy            fects. The Chinese economy provided a potential
than those in Asia, the trend toward sustained real            illustration until recently, when labor shortages
exchange rate appreciation has rekindled old con-              began to produce wage increases.
cerns about the “Dutch disease” consequences.
                                                               Whether or not an undervalued real exchange rate
The structure of production depends on the rela-               is useful for promoting structural change in emerg-
tive profitability of different activities.The real            ing market economies (a point about which there
exchange rate, as the relative price of tradables              is no consensus among authors of this report), it
to non-tradables, may therefore shape structur-                has a major disadvantage. An undervalued curren-
al transformation and set the pace of economic                 cy taxes the consumption of tradables (along with

     See Rodrik (2008).

                                          Rethinking Central Banking
subsidizing their production) and so produces a                              Such policies also face well-known difficulties of
trade surplus. Other countries must therefore be                             implementation. Interventions may be poorly
willing to run the counterpart deficits on their trade                       targeted and subject to political capture and rent-
account. Before the financial crisis, the United States                      seeking. Currency policy, because it works across
and some other industrial countries were willing                             the board, is less prone to capture by specific in-
to do so. But as demonstrated by the debate over                             dustrial lobbies. For all these reasons, it is an in-
“global imbalances,” the effects may not have been                           escapable reality that governments have tried to
entirely benign, and the advanced countries may no                           maintain an undervalued currency as a key ele-
longer be happy to resume their traditional role.                            ment of their growth strategy.

This also points to a distinction between small                              The pressure on central banks to keep an eye on
and large countries. A small country that seeks to                           competitiveness can be intense. Inflation targeting
maintain an undervalued exchange rate can do so                              that pays little attention to the level or volatility of
without significant implications for global imbal-                           the exchange rate becomes harder to practice. Cen-
ances and the associated financial risks. Its poli-                          tral banks are more likely to safeguard their indepen-
cies will also have only minor implications for the                          dence by acknowledging such concerns and press-
competitiveness of its emerging market neighbors.                            ing for non-monetary policy measures that achieve
For a large country, this kind of active use of ex-                          similar aims than by playing the game “who, me?”
change rate policy is more problematic on both                               That means, in turn, greater cooperation and coordi-
grounds. This distinction also points to a potential                         nation with fiscal and regulatory authorities to create
fallacy of composition: what could work for an in-                           the conditions for a more competitive real exchange
dividual country may become problematic for the                              rate. Fiscal policy needs to be tight enough to allow
world when pursued by countries as a group.                                  the currency to settle on a lower trajectory. Regula-
                                                                             tors need to be willing to tighten prudential liquidity
One alternative to using monetary-cum-exchange-                              requirements and capital-account measures when
rate policy to promote growth-friendly structural                            too much money is flowing in. Central banks can
change in the direction of producing exportables                             signal their willingness to watch (if not “target”) the
is of course to subsidize tradables directly or re-                          exchange rate, as long as other parts of the econom-
duce input costs. Such policies can in principle be                          ic-policy machinery are doing their respective bits.
effective in promoting structural change, and if
they are combined with macroeconomic policies                                The point that not all countries can simultaneously
that maintain external balance, they need not be                             run trade surpluses obviously still stands. From a
associated with trade surpluses.27 However, such                             systemic standpoint, while policies designed to
policies run afoul of World Trade Organization                               prevent currency overvaluation are not objection-
(WTO) rules and the Agreement on Subsidies, in                               able, those targeting large undervaluations and
particular, which prevent emerging market econ-                              trade surpluses certainly are. Similarly, there is an
omies from utilizing explicit or implicit export                             element of externality in capital controls in that
subsidies. Tax exemptions, directed credit, payroll                          one country’s success in evading capital inflows
subsidies, investment subsidies, domestic content                            only increases the difficulty of other countries do-
requirements, and export processing zones are all                            ing the same. This is certainly a problem at the
potentially actionable under WTO rules.28                                    level of emerging markets as a group.

   A production subsidy on tradables produces an incipient trade surplus, which can be eliminated by allowing the currency to appreciate. The
   appreciation does not remove the production stimulus on tradables entirely as long as tradables consumption is sensitive to the exchange rate.
   See Rodrik (2010).
   Least developed countries are exempt from these rules.

                                                      Rethinking Central Banking
What Should Central Banks Do?                                by acknowledging the tensions between inflation
                                                             targeting and competing objectives than by deny-
We have enumerated a number of additional pres-              ing such linkages and proceeding with business
sures that central banks will face in the post-crisis        as usual. Central bank independence ultimately
economic environment. These will make it dif-                rests on political consensus—on the convergence
ficult for them to implement their policies using            of views among leading political interests that so-
a traditional framework in which price stability is          ciety’s broader economic goals are best served by
the overarching goal. Unavoidably, they will be-             this independence. A central bank perceived as
come entangled in debates over public debt and               insensitive to problems of debt sustainability and
its management and come under pressure to do                 exchange rate overvaluation is likely to be dragged
something to help maintain competitiveness in the            into bruising political battles and will not be able
production of tradables.                                     to maintain its independence for long. This does
                                                             not mean that central banks must become debt-
While the two sets of issues arise most immediately          managers’ and development ministers’ poodles, but
in different sets of economies—high public and pri-          neither can they aspire to the purity of driven snow.
vate debts are mainly a problem for the advanced
economies, while exchange rate overvaluation is              Exceptional circumstances might require excep-
largely a worry for emerging markets (although               tional responses. In those circumstances, it is
Japan and Switzerland are currently experienc-               crucial that the central bank clearly communi-
ing difficulties)—they are related. While emerging           cate what it is doing and why, and how its actions
markets may increasingly look to financial regula-           are consistent with its broader policy framework.
tory measures to keep international capital “out”            When taking unconventional steps to support the
during periods of surging capital inflows, advanced          market in sovereign bonds, central banks need
economies have incentives to keep capital “in” and           to make clear the rationale for their action. If the
create a domestic captive audience to facilitate fi-         justification is disorderly conditions in the market
nancing for the high existing levels of public debt.         due to temporary liquidity problems or panic, its
                                                             purchases are likely to be temporary and should
Concerned about overheating, inflationary pres-              be explained as such. If the action is designed to
sures, and competitiveness issues, emerging                  help give the government extended breathing
market economies may, in some cases, welcome                 space so it can put in place a package of adjust-
changes in the regulatory landscape that keep fi-            ment measures to revive the economy and grow
nancial flows bottled up in advanced economies               out from under the debt burden, purchases may
rather than let them spill across borders. This cre-         have to continue for a lengthier period, and again
ates the possibility that advanced and emerging              this should be explained.
market economies may at some point meet on the
common ground of increased regulation and/or                 An example of what not to do can be seen in the
restrictions on international financial flows and,           case of the European Central Bank, which resumed
more broadly, on returning to a more tightly regu-           purchasing peripheral euro-area bonds without
lated domestic financial environment.                        adequately explaining why it was following this
                                                             course of action. Not surprisingly, its initial action
This much is positive analysis. We turn now to the           did not restore confidence.
normative question of how central banks might
handle these difficult burdens placed on them.               On the exchange rate overvaluation front, cen-
                                                             tral banks will have to devise a communication
A first point is that central banks are more likely          strategy that acknowledges the importance of the
to safeguard their independence and credibility              level and volatility of the exchange rate, without

                                        Rethinking Central Banking
committing to use foreign exchange market inter-            eye on the currency with the goal of preventing
vention or capital controls as the primary instru-          overvaluation as long as the fiscal and regulatory
ment to maintain external competitiveness. This will        authorities are fulfilling their part of the bargain
allow them to take actions to prevent exchange rate         as well. Making the quid pro quo with the govern-
overshooting in exceptional circumstances without           ment explicit not only educates the public, it helps
departing from the inflation targeting framework.           deflect pressure from the central bank.

Central banks should also make clear, however,              Similarly, with regard to the challenges posed by
that monetary policy is only one part of the policy         debt overhangs, particularly those of the public
response. Bond purchases without fiscal and struc-          sector, a communication strategy that addresses re-
tural adjustment achieve nothing. Maintaining a             curring concerns about the central bank’s indepen-
stable and fairly valued real exchange rate is not          dence from the fiscal authorities will be crucial in
exclusively the responsibility of the central bank;         maintaining credibility. More transparency on the
achieving this goal and deriving benefits from it           policy objectives and strategy are especially valuable
also require prudent fiscal policies, sound macro-          in periods (such as that now being experienced by
prudential supervision, and, where necessary, reg-          the Federal Reserve) when a very expansive policy
ulation of the capital account. The message from            stance is observationally equivalent to monetization
central banks has to be: we are willing to keep an          of the debt.

                                        Rethinking Central Banking

                 Rethinking Central Banking

     here is an emerging consensus that the frame-           2. When rapid credit growth or other indi-
     work underpinning modern central bank-                     cators of financial excess accompany as-
     ing must be rethought. A monetary policy                   set price increases, the authorities should
framework focusing on price stability and output                employ stress tests to measure the effects
growth will also affect financial stability through             of changes in credit conditions on asset
its impact on asset valuations, commodity prices,               prices, economic activity, and financial
credit, leverage, capital flows, and exchange rates.            stability. Instead of seeking to identify
One country’s monetary policy can spill over to                 bubbles, the authorities should simply
other countries, especially when central banks fol-             ask whether current financing conditions
low inconsistent frameworks, with cross-border                  are raising the likelihood of sharp rever-
capital flows serving as the transmission channel.              sals in asset prices that are disruptive to
All this suggests that the conventional framework               economic activity.
for central banking is inadequate. It is too narrow
to meet domestic and global needs.                           3. Where the answer to the aforementioned
                                                                question is yes, central bankers should
There may be broad consensus on this point, but                 then lean against the wind using a combi-
there is still little agreement about the particulars           nation of the tools at their disposal, turn-
of the new framework. It is those particulars that              ing first to nonmonetary micro- and mac-
we seek to elaborate in this chapter.                           roprudential tools, but also to monetary
                                                                policy tools when necessary. If this results
Monetary Policy and Financial Stability                         in periods when, in the interests of finan-
                                                                cial stability, the central bank sets policies
    1. Financial stability should be an explicit                that could result in deviations from its in-
       mandate of central banks. Other micro-                   flation target, then so be it.
       and macroprudential policies should be
       deployed first, wherever possible, in the             4. Responsibility for the maintenance of fi-
       pursuit of financial stability, but monetary             nancial stability can be assigned either
       policy should be regarded as a legitimate                to the central bank or to a self-standing
       part of the macroprudential supervisors’                 financial supervisory authority. But in
       toolkit.                                                 both setups, close coordination between

                                        Rethinking Central Banking
    the central bank and other agencies that                      points to the need for further changes in
    contribute to ensuring the stability of fi-                   prevailing policy framework. Specifically:
    nancial conditions is essential. This is par-
    ticularly important when policy makers                        (i)    Domestic political authorities should
    have to evaluate the trade-offs between                              be persuaded to allow such consid-
    the use of monetary tools and prudential                             erations to play an explicit role in
    measures, and make decisions on the ap-                              the central bank’s monetary policy
    propriate mix.                                                       framework in large economies.

5. Central banks already require substan-                         (ii)   Large-country central banks should
   tial operational independence in order to                             pay more attention to their collec-
   pursue their mandates. They will require                              tive policy stance and its global im-
   even greater independence when a finan-                               plications. Where appropriate, they
   cial stability objective is added to those                            should consider coordinated action
   mandates. They will, in turn, have to es-                             to help stabilize the global economy
   tablish the legitimacy of their actions in                            in times of stress.
   circumstances where the nature of threats
   to financial stability is poorly understood.                   (iii) These recommendations are unlikely
   The public and its elected representatives                            to be implemented in isolation. We
   may not be happy, for example, if the cen-                            therefore propose that a small group
   tral bank curbs credit growth in the inter-                           of systemically significant central
   est of financial stability, causing asset pric-                       banks, perhaps called the Interna-
   es to fall. This makes it important for the                           tional Monetary Policy Committee,
   central bank to clearly communicate its                               should meet regularly under the
   assessment of the risks and the rationale                             auspices of the Committee on the
   for its policy actions. It needs to explain                           Global Financial System of the BIS.
   how it seeks to balance the objectives of                             This group would discuss and assess
   price stability, output stability, and finan-                         the implications of their policies for
   cial stability. Better communication and                              global liquidity, leverage, and ex-
   greater clarity on how the central bank                               posures, and the appropriateness of
   will be held accountable for its broader                              their joint money and credit poli-
   mandate are necessary to defend central                               cies from the point of view of global
   bank independence. Independence is po-                                price, output, and financial stability.
   litically viable only with accountability,
   and the best way to enhance accountabil-               Although central bank governors already meet
   ity is for central banks to become more                regularly at the BIS, we recommend a substantial
   transparent and forthright about their                 upgrade for our proposed committee from the
   objectives and tactics.                                current informal and closed-door format. Com-
                                                          munication of central bank actions is important
6. The spillover effects of a central bank’s              at the global level, just as it is for a domestic au-
   policies in other countries are a legitimate           dience. In some ways, it is more important, since
   concern. At present, central banks do little           the global spillovers and coordination can be dis-
   to internalize these effects. Admittedly,              cussed explicitly. For this reason, the committee
   they may have difficulty in justifying ac-             should periodically issue a report assessing and
   tions taken in the effort to do so to do-              justifying their policies from this global perspec-
   mestic political authorities. This tension             tive, pointing out areas of dissent or inconsistency.

                                     Rethinking Central Banking
The report should be submitted to the Group of                                               ratios over the cycle is useful for damp-
Twenty and released more broadly with a formal                                               ening credit booms. Countercyclical and
public presentation.29                                                                       contingent capital requirements, dynamic
                                                                                             provisioning, liquidity buffers, and taxes
Central bankers will of course insist they have no                                           on short-term funds borrowed by finan-
control over one another. Some will claim that such                                          cial institutions are additional possible
matters are already discussed informally at BIS                                              instruments. Given that there is still little
meetings or formally at the G20 meetings. How-                                               evidence on the relative effectiveness and
ever, the current BIS format is not conducive to ac-                                         costs of each of these tools, authorities will
countability, and the current G20 format gives pre-                                          have to learn by doing and from shared
cedence to heads of government and finance min-                                              experience.
isters, not central bank governors. The discussion
that takes place at the margins of the G20 meetings                                    2. Supervisors will need to identify direct
is informal. For these reasons, a separate forum is                                       and indirect exposures and linkages, cross
needed. The need to issue periodic public reports                                         border as well as domestic. They need to
can help central bankers identify and publicly air                                        identify institutions or trades where ac-
the inconsistencies in their policies. With time, this                                    tivity is disproportionately concentrated
should encourage them to internalize some of the                                          (for example, on interbank derivative ex-
external consequences of their policies.                                                  posures). While they should collect such
                                                                                          data for their own supervisory needs, they
The kind of report we have in mind can inform a                                           should also release that information, in ag-
broader discussion of how the mandates of large                                           gregated form, to the broader public, in-
central banks can be altered so as to minimize                                            cluding market participants. Broader dis-
the adverse spillover effects of their policies, even                                     semination will allow market participants
while their responsibilities continue to be domes-                                        to better manage risks, and in turn allow
tic. It would have the ancillary benefit of stimulat-                                     the public to better monitor supervisory
ing research on the definition, determinants, and                                         behavior.
means of control of global liquidity, a notion that
nowadays remains a very abstract and ill-defined                                       3. Cross-border surveillance of conditions
concept in policy discussions.                                                            pertinent to financial stability should
                                                                                          be part of the mandate of the IMF, FSB,
Macroprudential Supervision under the                                                     and BIS. Such institutions should work in
                                                                                          concert with domestic macroprudential
proposed framework
                                                                                          supervisory authorities to collect and dis-
                                                                                          seminate information across countries on
Enhancing financial stability will require supple-
                                                                                          global exposures and risks, as well as ex-
menting traditional micro-prudential measures
                                                                                          perience with macroprudential tools.
with macroprudential tools.

                                                                                       4. Macroprudential tools will be more ef-
        1. Regulatory guidance on loan to value
                                                                                          fective if coordinated and implemented
           (LTV) and debt service to income (DTI)

     Multilateral institutions like the IMF should also, of course, continue to analyze the spillover effects of large-country policies—as part of the
     Mutual Assessment Process (MAP), Article IV consultations, and the World Economic Outlook and Global Financial Stability Reports—and
     use these in evaluating a country’s overall policy stance. The IMF’s newly instituted “spillover reports” are an obvious vehicle for carrying out
     this charge. The IMF should also analyze the collective policy stance of large central banks, and this report could be the starting point for the
     central bankers’ discussions and report. The G-20 needs to develop a mechanism for using these reports to influence domestic assessments of
     central bank performance.

                                                         Rethinking Central Banking
              across countries to dampen credit and                                          and possibly a Financial Stability Con-
              leverage cycles. The IMF or a beefed up                                        tribution along the lines proposed by the
              FSB/BIS should have the mandate to as-                                         IMF. While a start in implementing these
              sess financial stability risks across borders                                  measures should be made now, the precise
              and make recommendations to national                                           form of such levies should be allowed to
              supervisors on the level at which to set a                                     develop in light of experience. Unfortu-
              relevant macroprudential tool.                                                 nately, because any such standard will be
                                                                                             subject to extensive lobbying, the ideal re-
        5. Some countries will benefit more than                                             quirement may be hard to attain, and the
           others from the use of macroprudential                                            initial standards likely to be sticky. This
           tools and may also face lower costs of im-                                        suggests building flexibility into the initial
           plementation. Coordination may be espe-                                           standards so there are alternative ways to
           cially hard, however, when different coun-                                        meet the requirements.
           tries see very different costs and benefits.
           This suggests the multilateral institution                                  7. Although there has been some progress
           responsible for assessing financial stability                                  on cross-border supervision (through the
           should:                                                                        creation of colleges of supervisors, for ex-
                                                                                          ample), there has been little progress on
              a. Persuade all countries to put macro-                                     mechanisms for resolving failures of cross-
                 prudential measures on the books,                                        border financial institutions. Efforts to
                 even if the measures are initially lev-                                  harmonize national bankruptcy and reso-
                 ied at zero rates.                                                       lution regimes should therefore be redou-
              b. Focus less on coordination at the ini-                                   bled. Explicit loss-sharing protocols need
                 tial stages, which will allow experi-                                    to be negotiated, informed by the (soon-
                 ence to be built up on the use of the                                    to-be-written) living wills of large cross-
                 tools in different settings.                                             border banks.30 If no progress is made in
              c. Encourage supervisory authorities to                                     addressing cross-border spillovers, coun-
                 expend greater effort to find tools that                                 tries will be inclined to protect themselves
                 are lower cost relative to efficacy and                                  by mandating that foreign institutions
                 therefore more widely acceptable.                                        place their domestic activities into sepa-
              d. Encourage greater dialogue as sys-                                       rately incorporated and capitalized domes-
                 temic risks build up so as to create the                                 tic subsidiaries, thereby partially reversing
                 possibility of greater coordination.                                     the globalization of finance. The commit-
                                                                                          tee recognizes that this is a second-best op-
        6. The importance of cross-border spillovers                                      tion, and while it may be what the world
           associated with intermediation practices                                       will settle for, urges the regulatory com-
           and conditions of systemically relevant fi-                                    munity to be more ambitious.
           nancial institutions (SIFIs) was highlight-
           ed by the recent crisis. Macroprudential                                    8. Even vigorous countercyclical macropru-
           tools tailored to contain these risks include                                  dential measures such as those recom-
           significantly higher capital buffers for SI-                                   mended here cannot neutralize the effects
           FIs (the new Swiss regime proposes about                                       of incompatible macroeconomic policies.
           19%), contingent capital requirements,                                         In a number of situations, macroeconomic

     A living will is a document prepared by the bank that explains to its supervisors where its assets and liabilities are, and how they will be sorted
     out in a bankruptcy.

                                                         Rethinking Central Banking
              policies such as low interest rates on one                                     Even when such policies may be in their
              side of a border and exchange-rate target-                                     narrow short-term national self-interest,
              ing on the other can give rise to destabi-                                     they should be encouraged by the inter-
              lizing cross-border capital flows. To the                                      national community to move away from
              extent that these are problematic for fi-                                      them because of their implications for the
              nancial stability, it is important for multi-                                  global system.
              lateral institutions to point to the incom-
              patibility of macro-economic policies and                                2. This is not, however, an argument for an
              press countries to make them more con-                                      immediate transition to a freely floating
              sistent instead of forcing countries to rely                                exchange rate. Short-run interventions
              solely on macroprudential measures.31                                       in the foreign exchange market that af-
                                                                                          ford time to adjust may be justified. Oc-
        9. More progress is needed on reducing the                                        casional interventions that smooth out
           uncertainties surrounding the availabil-                                       temporary exchange rate fluctuations that
           ity of liquidity facilities for dealing with                                   threaten serious dislocations may also be
           systemic crises—such as bilateral swaps                                        justified when the temporary nature of the
           between central banks, regional liquidity                                      shock and the costs of sharp exchange rate
           pooling arrangements, and IMF facilities.                                      changes are firmly established.
           While there may be an element of moral
           hazard associated with guaranteeing ac-                                     3. Controls on capital inflows whose main
           cess to such facilities, financial stability                                   effect is to enhance financial stability,
           may require them to be “on the shelf ”—                                        by preventing the build-up of currency
           that is, to be ready for use if a crisis hits.                                 or maturity mismatches or limiting the
           At the very least, some efforts to aggregate                                   growth of intermediation through the do-
           the likely availability of such facilities and                                 mestic banking sector, have a useful role
           set them against potential needs should                                        when other policy tools are not available
           become part of the multilateral stability                                      or less than fully effective in addressing
           surveillance process.                                                          these problems. International standards
                                                                                          should allow rare interventions in the for-
Exchange Rates and Capital Controls                                                       eign exchange market and temporary, fi-
                                                                                          nancial stability-oriented capital controls
Many developing countries have found it helpful                                           while discouraging the use of measures
to intervene in the foreign exchange market as a                                          that attempt permanently to distort the
way of encouraging exports and labor-intensive                                            pattern of comparative advantage. In step
manufacturing. However, this practice can create                                          with the reassessment of capital controls,
problems for the global system when the country                                           blanket strictures against controls in bilat-
or countries concerned are large, either individu-                                        eral investment treaties, European Union
ally or collectively. This leads us to the following                                      rules, and OECD guidelines need to be
recommendations.                                                                          revisited.

        1. Countries need to recognize that such                                       4. Such measures will be more effective when
           policies are not without significant costs                                     applied uniformly to domestic and foreign
           for their own economies and should                                             institutions. Applying them differentially
           move away from such policies over time.                                        can give rise to opportunities for evading

     For instance, this could be one of the tasks of the small committee of systemically significant central bankers proposed earlier.

                                                         Rethinking Central Banking
    these measures through cross-bank trans-                     something that could prove costly to the
    actions.                                                     global community when the country needs
                                                                 foreign support. Moreover, long-term bar-
5. Policy makers should recognize the limita-                    riers to cross-border capital movements
   tions, fiscal costs, and distortionary effects                divert capital flows into less transparent
   of instruments such as intervention in for-                   channels, making it harder to undertake
   eign exchange markets and even selective                      adequate supervision.
   capital controls, especially when used for
   sustained periods. They should not see                Conclusion
   them as substitutes for structural reform
   and macroeconomic policy adjustment.                  Our objective in this report has been to lay out
                                                         a roadmap for central banking in the post-crisis
6. When a number of countries undertake                  world, where financial stability can no longer
   measures to intervene in foreign exchange             be seen as outside the ambit of monetary policy,
   markets, this should be taken as a signal to          cross-border spillovers have increased in scope
   the proposed committee of central bank-               and size, and central banks have come under new
   ers that there are policy inconsistencies at          pressures. The report sets out a strategy for incor-
   the international level that need to be ad-           porating financial stability concerns in the imple-
   dressed. These discussions could improve              mentation of monetary policy without diluting the
   the likelihood of collective solutions that           price-stability objective. It proposes institutional
   minimize adverse spillovers, or at least              mechanisms for dealing with tensions caused by
   reduce the possibility of tit-for-tat escala-         cross-border spillovers of inconsistent domesti-
   tion—for instance, through trade restric-             cally-oriented policies. Finally, it describes how
   tions or competitive devaluations—that                central banks are under pressure from a variety of
   leads to worse collective outcomes.                   new mandates and constraints imposed on them
                                                         by other policies and institutional structures and
7. Cash-strapped governments will be tempt-              what they should do about it.
   ed to use prudential measures to capture
   domestic sources of financing (via statu-             We, of course, recognize that practical central
   tory liquidity requirements on banks man-             banking differs from the theoretical ideal of flexible
   dating the holding of domestic govern-                inflation targeting and that it may already incorpo-
   ment bonds, for example). Such practices              rate some of what we suggest. Still, a framework is
   are likely to become increasingly prevalent           needed to articulate and better guide central bank-
   as governments grapple with the budgetary             ing in the more complicated and interconnected
   consequences of high post-financial-crisis            world that we now live in, especially in light of the
   debt ratios. This makes it important to rec-          lessons learned from the global financial crisis.
   ognize that these measures come with risks.           By tracing the connections among different facets
   They can lead to greater risk concentration           of central banking, we have attempted to create a
   (as, for example, when domestic banks be-             broader framework and set out some concrete pro-
   come exposed to an insolvent government),             posals for making progress.

                                    Rethinking Central Banking

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                                       Rethinking Central Banking
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