Kindleberger (1986) defines global public goods as “the set of goods accessible to all states that do not necessarily have an individual interest in producing them”. The most frequently cited global public goods are peace and the preservation of the planet, whether it be in terms of biodiversity or climate change. From an economic point of view, the Great Depression of the 1930s brought to the fore such public goods as the importance of an open, regulated international trading system and of political and economic institutions that guarantee financial stability. These institutions must, of course, seek to avoid crises, but also be capable of dealing with them when they do occur, thanks in particular to the existence of a global lender of last resort.
It's worth recalling here the enormous cost of financial crises. Laeven and Valencia (2020) estimate the average cumulative production loss during a banking crisis (as a deviation from the trend) at around 20% over the duration of the crisis, which averages two years. Financial crises cause economic, social, and political devastation that are very long-lasting. The most severe financial crises hit groups of countries (Reinhart and Rogoff, 2009), with contagion effects through trade and financial ties. Crises sometimes spread through the supply of capital, due to shocks to the balance sheets of non-resident investors who can rapidly withdraw their capital in various countries. Sometimes, it's the very psychology of the markets that leads to massive capital flight from emerging countries or countries considered risky: the term “risk on, risk off” is used to describe these fluctuations in risks that international investors take.
Financial stability is therefore a global public good, and one of the most important. It depends on the regulation of financial systems, capital and currency flows, as well as on the institutions that make it possible to implement stabilizing policies in normal times and in times of crisis. It requires not only good governance of national and regional financial systems, but also considerable cooperation between governments and currency zones, both in terms of regulation and implementation, and through direct coordination between central banks and multilateral institutions, such as the International Monetary Fund (IMF). Each government may be tempted to let its banking and financial systems take on too much risk, because by doing so its bankers and financiers – often effective lobbyists – can reap substantial short-term returns, and the economy may appear to be stimulated. A government may adopt a laissez-faire attitude towards financial flows or credit creation, since this may be more profitable and easier to manage in the short term. But such policies are no more and no less than attitudes of free-riders when it comes to international financial stability. If some financial institutions take on too much debt, it's often because others lend too much.
The current shortcomings of the international financial system are apparent. We have gone from a long period without financial crises after 1944, under Bretton Woods, when financial flows were restricted and banks tightly regulated, to an era of liberalization and deregulation, during which there has been one financial disaster after another. We have lived through the recycling of petro-dollars and the Latin American debt crisis in the 1980s, the Mexican crisis of 1994-95, the Asian financial crisis of 1997, the Russian crisis and the LTCM bankruptcy in 1998, the Turkish and Argentine crises of 2001, the Great Financial Crisis of 2008, and the eurozone crisis of 2011-13. The strengthening of regulations and micro-prudential requirements (Basel III) has been a vector of progress, but there is still an urgent need to review the organization of the financial system to give a better chance to this global public good that is financial stability.
In section 1 of this article I discuss the influence of US Federal Reserve (Fed) monetary policy on the Global Financial Cycle. Section 2 presents a more general discussion of the role of the hegemon in the stability of the international financial system. In Section 3, I analyze the contribution of macroprudential policies, of regulation, and of the IMF to financial stability. Section 4 concludes.
Us Federal Reserve (FED) monetary policy
and the Global Financial Cycle
Financial globalization has increased over the last fifty years; financial deregulation has strongly encouraged the development of international capital flows. Globalization has led to a high degree of co-movement in risky asset prices, capital flows, leverage, and financial aggregates worldwide, a phenomenon dubbed the Global Financial Cycle by Rey (2013). The global components of risky asset prices and gross capital flows are increasing along with the appetite of investors for risk. They are positively correlated with each other and evolve negatively in relation to the VIX,1 which is often interpreted as the “fear gauge” of international markets (Miranda-Agrippino and Rey, 2022). The size of positions and financial asset prices increase considerably during periods when there is a strong propensity for risk-taking. These are periods when leverage climbs and flows to emerging markets swell. The balance sheets of financial intermediaries grow and become more vulnerable to sudden variations in asset valuations.
The exposure that countries have to global financial conditions has an important impact on their ability to conduct an independent monetary policy and avoid financial crises. There is no “divine coincidence” that guarantees international financial conditions will align with the goals of national authorities. As a result, central banks in emerging markets and advanced economies may be confronted with “exuberant” international investors at the same time that they are trying to tighten monetary policy at home and avoid bubbles in the real estate sector, for example. They may also be unable to find sufficient liquidity when trying to increase domestic demand and boost investment.
Origins of the Global Financial Cycle
Recent research has shown that US monetary policy2 has an important effect on the Global Financial Cycle (Rey, 2013; Kalemli-Ozca, 2019), in particular via a “risk-taking mechanism” (Borio and Zhu, 2012; Bruno and Shin, (2015). Bauer et al. (2023) and Coimbra and Rey (2023) show how monetary policy that is accommodating and a large injection of liquidity encourage financial players to take on more risk, notably by making it possible for certain intermediaries to increase their indebtedness. Given the dollar's importance as a funding currency and its prevalence on the international balance sheets of financial intermediaries and investors, it's not surprising that the Fed's monetary policy has a considerable impact on risk-taking. Risk-taking then determines the creation of loans, leverage, and capital flows in and out of emerging markets, as well as asset valuations around the world. To sum up, a powerful Global Financial Cycle exists. The risk-taking channel is an important monetary policy transmission mechanism that affects financial stability, and the Fed's monetary policy has important ripple effects far beyond the borders of the United States.
The exposure of the international financial system to the Fed is also reflected in the importance of the availability of dollar liquidity during periods of turmoil. During the 2008 crisis, for example, the swap lines set up between the Fed and the European Central Bank (ECB) were decisive in stabilizing the European banking system. It is therefore the Fed that acts as lender of last resort for the international financial system, since only it is able to provide normally unlimited amounts of dollars to deal with liquidity crises. The IMF also plays an important role, as described in section 3, but its firepower is limited since it is not a Central Bank and cannot issue currency.
Hegemony and stability
of the international financial system
Beyond the Global Financial Cycle, but related to it, the importance of the United States to international financial stability is reflected more generally in the central role of the dollar, the reserve currency par excellence. The United States took over leadership of the international monetary system from Great Britain after the Second World War. For Kindleberger (1973), it is essential that a hegemon stabilize the international financial system. According to this point of view, periods of transition between great powers such as the 1930s, when the economic influence of the United Kingdom was waning while that of the United States had not yet been fully established, are particularly dangerous for financial stability. The hegemon's economic leadership has often been challenged. For example, in the 1960s France became increasingly frustrated by the asymmetries inherent in Bretton Woods. On February 16, 1965, Valéry Giscard d'Estaing, De Gaulle's Finance Minister, echoed the General's remarks at a February 4 press conference, famously summing them up by saying that the country issuing the reserve currency enjoyed an “exorbitant privilege”. In the event of a deficit, the United States would not have to take restrictive measures, since it could issue securities that would always be in great demand in the rest of the world, due to the dollar's international role.
The roles of a dominant international currency are manifold and involve the three classic functions of money: medium of exchange, store of value, and unit of account. There are many synergies between the international use of a currency in its various roles. These complementarities reinforce and perpetuate the domination of the hegemonic currency. It is hard to replace established international currencies. One of the essential facts underlying the architecture of the international monetary and financial system is that the hegemon provides the rest of the world with secure assets. As Gourinchas and Rey (2007b) show, the United States is a “global banker”, with long positions in risky foreign assets and risk-free liquid liabilities in dollars, which is a response to strong demand from the foreign public and private sectors. The dollar's exchange rate is a key relative price in the global economy, whether it be in commodity markets or in international financial markets. Furthermore, the issuance of the international currency provides the hegemon with excess returns on its net foreign asset position, thus facilitating the process of international adjustment (“exorbitant privilege”; Gourinchas and Rey, 2007a). These excess returns that the “global banker” enjoys in normal times are, however, associated with net transfers of wealth to the rest of the world in times of global crisis when the value of safe US assets held by the rest of the world appreciates while the prices of risky assets held by the US abroad fall. These wealth transfers reflect the fact that the hegemon provides insurance to the rest of the world in times of global turbulence, a process we have termed “exorbitant duty” in Gourinchas and Rey (2022). For the hegemon, this means nothing more or less than contributing to international financial stability by transferring resources and liquidity in the event of a global crisis, as in 2008. This is the flip side of its “exorbitant privilege” in normal times.
The new Triffin dilemma
The asymmetry inherent in a hegemonic system can, however, create financial fragilities that eventually lead to its demise. In the early 1960s, economist and Yale professor Robert Triffin noted that the United States would not be able to simultaneously provide the international liquidity needed by the world economy while maintaining the dollar's parity with gold - as required by the Bretton Woods system. Either the world would face a growing shortage of international liquidity, or confidence in the value of the dollar would collapse. This is the famous “Triffin Dilemma” (Triffin, 1961), whose analysis proved prescient. Faced with growing dollar liabilities in excess of their gold holdings, American policymakers encountered a flight of capital and were finally compelled to abandon the fixed parity between the dollar and gold in the early 1970s. Triffin's analysis was incomplete, however, because despite the abandoning of dollar-gold parity, the dollar's dominance has increased since the collapse of the Bretton Woods exchange rate system, in a more globalized world. Interestingly, we can extend Triffin's analysis to the current situation: in a world where the U.S. can supply international currency at will and invest it in illiquid assets (role of “global banker”), it needs for the rest of the world to continue to have confidence in it. There could be a flight of capital, not because investors would fear the abandoning of gold parity, as in the 1960s, but because they would fear a drop in the dollar exchange rate if the United States' fiscal capacity to honor its debts (Treasury bonds held in the four corners of the planet) were put into question. In other words, the international monetary and financial system is facing a “new Triffin Dilemma” (Gourinchas and Rey, 2007b; Obstfeld, 2013).
The role of macroprudential policies,
financial regulation and the IMF
To guarantee financial stability as much as possible and deal with the Global Financial Cycle, various economic policy tools need to be employed. A non-exhaustive list of these tools could include: (1) national macroprudential policies and prudential regulations; (2) capital controls; (3) monetary policy coordination, with a key role for the Fed; (4) action taken by the IMF.
Macroprudential policies and prudential regulations
Given that, historically, for a country the most dangerous effect of “overly exuberant” global financial conditions is an excessive growth of credit, it seems advisable to directly monitor leverage and the quality of credit. In some jurisdictions, a great deal of effort has been devoted to setting up macroprudential authorities with this mandate. The arsenal contains multiple weapons, of which I will mention just a few here. Basel III introduced a counter-cyclical capital cushion. For real estate, which has always been associated with the worst financial crises, limits on debt service/income ratios for borrowers, or additional sector-specific capital cushions for banks can be used, depending on the jurisdiction. At the heart of an excessive risk-taking mechanism is often to be found the ability of financial intermediaries to quickly take on high levels of debt when financing conditions are favorable. Credit seems excessively sensitive to financing costs. Regulation must aim to prevent risk-taking from becoming excessively procyclical. By imposing stricter limits on leverage, by limiting the extent of exposure, and by requiring liquidity cushions, we can profitably curb the financial system's ability to enter into destabilizing spirals. A complementary option would be to conduct frequent stress tests on the balance sheet of the (banking and non-banking) financial sector. Recently a wealth of experience has been accumulated on the practical implementation of macroprudential tools. A centralized record of the knowledge and experience accumulated to date by supervisors and macroprudential authorities would be extremely valuable.
Capital control
Cyclical or permanent capital controls can be envisaged to insulate economies from the Global Financial Cycle. It is difficult to accurately assess the effect of such a policy on financial stability and its side effects, because in the recent period permanent controls have been implemented exclusively in a very select subset of low-income countries. Temporary controls, particularly on credit and portfolio flows during the upward phase of the cycle, have been tested in various contexts: Chile's encaje (1991-1998); Brazilian taxes on capital inflows in 2010 and 2011, and so on. Often, however, controls have been used to prevent “excessive” exchange rate appreciation. When excessive credit growth is the main concern, capital controls should be seen more as partial substitutes for macroprudential tools which tend to be more targeted. But capital controls may be appropriate if there is a lot of direct cross-border trade.
Coordination of monetary policies, with the Fed playing a key role
Monetary conditions in the major financial centers determine the Global Financial Cycle through the reaction of leverage and the procyclicality of cross-border credit flows. The effects of the central bank policies of the main countries, and primarily of the Fed, on other countries are not internalized. Central bankers in systemically important countries should pay more attention to their collective position and its implications for the rest of the world. One practical way of implementing this, proposed in Eichengreen et al. (2011), would be for “a small group of systemically important central banks to meet regularly under the auspices of the Committee on the Global Financial System of the BIS. This group would discuss and assess the implications of their policies for global liquidity, leverage, and exposures, and the appropriateness of their joint monetary and credit policies from the perspective of global prices, output, and financial stability”. The challenges of such a policy are obvious: international cooperation can conflict with the national mandates of central banks. It is important to note that in crisis situations (like in 2008) the Fed and a subset of central banks collaborated by using swap lines to provide dollar liquidity and support banking systems. But only the central banks chosen by the Fed were able to take advantage of this system.
The IMF
In contrast, the IMF operates on a multilateral basis with 190 member countries. Its activities include surveillance, financial assistance, and developing administrative technical capacities. The IMF is the Bretton Woods institution that is in charge of the “global financial safety net”. Granting loans and concessional financial assistance to member countries facing balance-of-payments problems is one of the Fund's main responsibilities. It must be said, however, that the IMF's striking power has not increased over time in proportion to global capital flows: it has only around $1 trillion at its disposal for loans3, while central bank reserves alone amount to over $15 trillion! Moreover, the IMF cannot act as lender of last resort for large countries because, since it is not a central bank, it cannot issue unlimited amounts of liquidity. Nevertheless, the IMF can play a key role in debt crises by coordinating lenders. More generally, the IMF actively participates in coordinating macroeconomic policies. However, the difficult geopolitical situation currently poses a constant threat to the multilateralism of the Bretton Woods institutions. Restructuring the debts of the least developed countries is hampered by the fact that China, for example, does not belong to the Paris Club.
Conclusion
Financial stability is therefore a global public good, and one of the most important. It requires not only good governance of national financial systems, but also extensive cooperation between governments and monetary zones, both in terms of regulation and implementation, as well as through direct coordination between central banks (swap lines) and multilateral institutions like the IMF. This global public good is threatened by lobbies that seek to minimize regulation and the scope of macroprudential policies, by the emergence of less-regulated players (non-banks, perhaps cryptos or fintechs if they grow in size) and by the size of the IMF's balance sheet, which is too small when measured against international capital flows. It is also threatened by the fact that economic policies fail to sufficiently take into account the fundamental links between monetary policy – particularly that of the Fed – and risk-taking, giving rise to phenomena such as the Global Financial Cycle that affect the financial stability of many countries. More structurally, financial stability is linked to the hegemonic role of the United States in the international monetary system. The United States plays the role of global banker and insurer thanks to the structure of its foreign investments and the status of the dollar. But a “New Triffin Dilemma” could put this equilibrium into question in the long term if another currency and another financial ecosystem were to seem robust enough to become a competitor.
Moreover, in the current dollar-based financial system, cross-border financial flows mainly reflect two global factors: the Global Financial Cycle and the Global Commodity and Trade Cycle (Miranda-Agrippino and Rey, 2022). Up until now, the existing financial archi tecture has seemed incapable of channeling capital to where it would have a high marginal social value, for example to help confront climate change and the loss of biodiversity. Meanwhile, the financial engineering of dollar-based financial systems has created vast quantities of dollar-denominated asset-backed securities (ABS), collateralized debt obligations (CDOs and CDOs-squared), and so on, which have been disseminated in the main financial centers and which contributed to the mayhem of the 2008 crisis. Our incomprehensible and unjustifiable tolerance of offshore centers has allowed capital flows to proliferate that are, to no small extent, driven by tax evasion and money laundering (Lane and Milesi Ferretti, 2011; Coppola et al., 2021). This trend could even be amplified by the growing use of crypto-currencies. It is becoming more than urgent to change investment incentives and develop an infrastructure that transforms and adds to the Bretton Woods institutions (WTO – World Trade Organization –, IMF and World Bank) in order to address climate change and biodiversity loss. Greenhouse gas pricing, the massive scaling-up of mixed private and public financing to invest in the energy transition, climate change, and biodiversity, and the structuring of properly regulated carbon offset markets must now take center stage. All of this can probably be done within the framework of our current dollar-based system, but should – quite intentionally – profoundly alter the patterns of international capital flows.
July 27, 2023