Central bankers, unsustainable Imbalances and the crisis in emerging markets

My friend Scott sent me a link to a post by Robin Harding on central bankers and the imbalances in today’s monetary system which I thought was quite good. The crux of the Harding piece was that we need a new global financial system but that central bankers had “given up on fixing global finance”. Let me quote from the piece and make a few comments.

Harding wrote:

The world is doomed to an endless cycle of bubble, financial crisis and currency collapse. Get used to it. At least, that is what the world’s central bankers – who gathered in all their wonky majesty last week for the Federal Reserve Bank of Kansas City’s annual conference in Jackson Hole, Wyoming – seem to expect.

All their discussion of the international financial system was marked by a fatalist acceptance of the status quo. Despite the success of unconventional monetary policy and recent big upgrades to financial regulation, we still have no way to tackle imbalances in the global economy, and that means new crises in the future.

Indeed, the problem is becoming worse…

In an excellent new paper presented at Jackson Hole, however, Professor Hélène Rey of the London Business School argued that a global cycle in credit and capital flows – driven by the US Federal Reserve’s monetary policy – means that even a floating exchange rate does not give a country control over its own destiny. The trilemma is, in truth, a dilemma. The choice is this: impose capital controls or let the Fed run your economy.

[…]

The flaws in the international financial system are old and profound, and they defeat any effort to work around them. Chief among them is the lack of a mechanism to force any country with a current account surplus to reduce it.

I suggest reading the piece in full. There’s a lot more to the post, but those are the main ideas I want to highlight here.

The problem in a nutshell is that the U.S. dollar is the world’s reserve currency. And so, other countries are forced to adhere to Fed dictates in a liquidity crisis because everyone is hoarding dollars, trying to maintain their supply of reserves. At the same time, there is no mechanism to bring into line the countries hoarding the most reserves, with the largest current account surpluses, like Germany and China. These countries impose a cost on the financial system by creating unsustainable imbalances that can only lead to crisis in which those imbalances are forced down dramatically.

Harding says the Bancor proposed by John Maynard Keynes instead of the Bretton Woods system set up in 1944 is the solution to this problem.

Here’s the thing though: the Bancor is never going to happen… at least not without another major crisis and Great Depression. I wrote about this in late 2010, saying “Wait for the next crisis for reform of the monetary system“. And here’s my argument regarding the US-led financial crisis:

“When the crisis was hot and heavy in early 2009, I saw a real need to address this issue. But, policy makers really do not want to upset the apple cart. Unless and until we see a complete economic breakdown, we are going to continue with the same rickety global financial system we had before the credit crisis – the same too-big-to-fail banks, the same unworkable framework in the euro zone and the same unsustainable currency system with the US dollar at its centre. I really do not see this changing in any abrupt way without the mother of systemic crises akin to what we saw in the 1930s and 1940s. That’s pretty much how politicians respond to events – dithering until things blow apart and then trying to put humpty dumpty back together.”

In the comments for that post I added to this by saying the following about the European-based financial crisis:

“The credit crisis proves that, politically, it is hard to make dramatic changes to core institutional arrangements during a crisis. Certainly you can make changes to institutional arrangements that are superficially beneficial – hence the bailouts and talk of an EMF. But invariably it takes economic collapse to really win people over to a new paradigm.

“In Europe, the Euro was implemented with a faulty institutional structure that ensures friction during crisis. We are now seeing that. The problem is that the Euro acts as a gold standard without any failsafe mechanism to prevent external imbalances or to automatically aid with fiscal transfers in crisis This means restricting devaluation as well as monetary and fiscal policy, making government’s actions extremely pro-cyclical, increasing the friction.

“No one wants to address this problem because most people in Europe do not want a more integrated fiscal union across the euro zone. But at the same time, they also want to rear guard their previous political posturing in setting up the euro zone’s mechanisms. Hence Germany’s fixation on budget deficits – despite Ireland and Spain’s having better fiscal record than Germany, pre-crisis and despite Germany’s meeting neither of the two Maastricht criteria. None of this makes real sense except politically – again, I see it as a cover for previous policy mistakes.

“I am not optimistic about Europe. The best we can hope for is default or quantitative easing. But only a realization of the sovereign debt crisis fears will move Europe to a sustainable solution.”

I think this viewpoint – though not particularly optimistic – has proved the right one. Without changes to reserve currencies another crisis is inevitable

Now, of course, we are in the next crisis, an emerging markets crisis. And notice that every time we get one of these crises, there are huge macro imbalances at the core. The imbalances coupled with free movement of capital across countries, asset classes and currencies is what causes the financial crises. Countries like India are getting crushed as the hot money which filled the current account deficit void flees as a result. Likely we are going to see significant economic turmoil in the coming months.

Will that change anything? I doubt it. Hélène Rey of the London Business School makes the right call in saying that, “targeted capital controls, tough bank regulation, and domestic policy to cool off credit booms” are the most we should expect to happen. Translation: try to stop the imbalances from building in your own economy. But if that doesn’t work, impose capital controls (and force through bailouts and easy money to ease the pain). 

And that’s the way it is going to stay unless and until we get a systemic collapse.