Monday, September 22, 2014
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Emerging Economies on Their Own

NEW YORK – There was a remarkable similarity between European Central Bank President Mario Draghi’s statement after a recent meeting of the ECB Governing Council and US Federal Reserve Chair Janet Yellen’s first testimony to Congress: both asserted that their policy decisions would take into account only domestic conditions. In other words, emerging-market countries, though subject to significant spillover effects from advanced economies’ monetary policies, are on their own.

This confirms what emerging-country authorities have known for a while. In 2010 – following the Fed’s announcement of a third round of quantitative easing – Brazilian Finance Minister Guido Mantega accused advanced countries of waging a global “currency war.” After all, advanced economies’ policies were driving large and volatile capital flows into the major emerging markets, pushing up their exchange rates and damaging their export competitiveness – a phenomenon that Brazilian President Dilma Rousseff later referred to as a “capital tsunami.”

Recently, the impact of the advanced economies’ withdrawal of monetary stimulus has been just as strong. Since last May, when the Fed announced its intention to begin tapering its asset purchases, capital has become less accessible and more expensive for emerging economies – a shift that has been particularly painful for countries whose large current-account deficits leave them dependent on foreign finance. In response, Raghuram Rajan, Governor of the Reserve Bank of India, has called advanced-country policies “selfish,” declaring that “international monetary cooperation has broken down.”

To be sure, emerging economies have plenty of their own problems to address. But there is no denying that these countries have been victims of advanced economies’ monetary policies, which have increased capital-flow volatility over the last three decades. According to the International Monetary Fund’s April 2011 World Economic Outlook, though the volatility of capital flows has increased worldwide, it is higher in emerging market economies than in advanced economies. Boom-bust financial cycles are driven largely by shocks generated in advanced economies, but they are key determinants of emerging markets’ business cycles.

Moreover, the spillover effects of advanced economies’ monetary policies extend beyond financial shocks. Emerging economies are also suffering from the effects of developed countries’ external imbalances – particularly the eurozone’s swelling current-account surplus.

In the last few years, the deficit economies of the eurozone’s periphery – and, more recently, Italy – have undertaken massive external adjustments, while Germany and the Netherlands have sustained their large surpluses. As a result, the burden of offsetting the eurozone’s rising surplus has fallen largely on emerging economies, contributing to their growth slowdown.

Such spillover effects are precisely what international policy cooperation – such as the “mutual assessment process” that the G-20 established in 2009 – was supposed to prevent. The IMF has created an elaborate system of multilateral surveillance of major countries’ macroeconomic policies, including the “consolidated multilateral surveillance reports,” the spillover reports for the so-called “systemic five” (the US, the United Kingdom, the eurozone, Japan, and China), and the “external sector reports” assessing global imbalances.

But this system has proved to be utterly ineffective in preventing spillovers – not least because the Fed and the ECB simply ignore it. Given that the US dollar and the euro are the top two international reserve currencies, spillovers should be considered the new normal.

Adding insult to injury, the $1.1 trillion appropriations bill for federal-government operations agreed last month by the US Congress does not include any money to recapitalize the IMF, the main instrument of international monetary cooperation. That decision represents yet another setback for IMF reforms aimed at increasing the influence of emerging economies.

Given the considerable benefits that stable and prosperous emerging countries bring to the world economy – exemplified by the role that they played in propping up global growth in the wake of the recent crisis – it is in everyone’s interest to change the status quo. The G-20 and the IMF’s International Monetary and Financial Committee must work to align reality with the rhetoric of macroeconomic-policy cooperation. For that, the recent statements by Draghi and Yellen should be treated as ground zero.

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  1. CommentedProcyon Mukherjee

    The BIS paper by Taylor, http://www.bis.org/events/conf130620/taylor.pdf, delves into this topic with some great points. First of all the success of the 1980’s approach “gains from
    international coordination of monetary policy would be quantitatively small compared to the
    gains achieved from each central bank simply following a monetary policy which optimized its
    own country’s economic performance”, shifting somewhat “by choosing policies which worked well domestically with relatively little concern about spillover effects, central banks contributed—in “invisible hand” like fashion—to better global economic conditions”.

    However things started to change and this international cooperation that led to a Nash equilibrium changed dramatically when spillover effects became a dominant issue while as Yellen pointed out, “the times are by no means normal now, and the simple rules that perform well under ordinary circumstances just won’t perform well with persistently strong headwinds restraining recovery and with the federal funds rate constrained by the zero bound”. As trade-offs came into force between price stability and output stability, it was then that Bernanke’s argument became noteworthy that, “The benefits of monetary accommodation in the advanced economies are not created in any significant way by changes in exchange rates; they come instead from the support for domestic aggregate demand in each country or region. Moreover, because stronger growth in each economy confers beneficial spillovers to trading partners, these policies are not ‘beggar-thy-neighbor’ but rather are positive-sum, ‘enrich-thy-neighbor’ actions.”

    Taylor’s paper ends not in any definitive prescription, however the two explanations he has given for the current disputes are noteworthy, “The first explanation for the current situation holds that discretionary deviations from rules-based monetary policy at several central banks created incentives or pressures on other central banks to also deviate from such policies. Reasons for the spread of these deviations—which can be documented empirically—include the desire to minimize interest rate differentials or other measures of relative monetary conditions between countries and thereby prevent excessive exchange rate appreciation and risky capital flows.
    “The second explanation either does not see significant deviations from rules-based policy
    or does not stress such deviations as a problem. Instead, it characterizes the recent unusual
    monetary policy, including near-zero interest rates, pledges of near-zero interest rates in the
    future or quantitative easing in the G7 countries, as appropriate to the current economic situation.”

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