How to Finance Global Reflation

HONG KONG – There is a growing awareness that, in today’s globalized world, financial markets are beyond the control of national policymakers. While a few economies do have the scale to shape interconnected global markets, they face serious constraints, political and economic. As a result, the global economy is stuck in a pro-cyclical financial cycle, with few options for escape.

As Claudio Borio pointed out years ago, the global financial cycle is longer and larger than real economic cycles, and is closely associated with the fluctuating value of the dominant reserve currency, the US dollar. When the dollar is weak, capital flows from the United States to other countries, where it spurs growth through increased credit.

Unfortunately for these countries, typically in the emerging world, the inflows also spur inflation, asset bubbles, and currency appreciation. The result is growing financial and geopolitical risk, which makes the US dollar more appealing for investors. As capital flows back to the US, the dollar gains strength, while emerging economies are left to face the consequences of bursting asset bubbles and currency devaluation.

In a zero-interest-rate world, a strong dollar plays the same deflationary role in global markets as the gold standard did during the 1930s. The US is thus the economy that is best equipped to pull the world out of secular deflation. But that requires a willingness to resolve the so-called Triffin dilemma – the conflict between long-term international interests and short-term domestic interests that issuers of reserve currencies confront – by running increasingly large current-account deficits that enable the US to meet global demand for liquidity.