Progress and Confusion

24. The International Monetary and Financial System: Eliminating the Blind Spot

Olivier Blanchard, Kenneth Rogoff, and Raghuram Rajan
Published Date:
April 2016
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Jaime Caruana

The design of international arrangements suitable for the global economy is a long-standing issue in economics. The global financial crisis has put this issue back on the policy agenda.

I would like to concentrate on an important blind spot in the system. The current international monetary and financial system (IMFS) consists of domestically focused policies in a world of global firms, currencies, and capital flows—but are local rules adequate for a global game? I argue that liquidity conditions often spill over across borders and can amplify domestic imbalances to the point of instability. In other words, today’s IMFS not only fails to constrain the buildup of financial imbalances, but also makes it hard for national authorities to see these imbalances coming.

Certainly, some actions have been taken to address this weakness in the system: the regulatory agenda has made significant progress in strengthening the resilience of the financial system. But we also know that risks and leverage will morph and migrate, and that a regulatory response by itself will not be enough. Other policies also have an important role to play. In particular, to address this blind spot, central banks should take international spillovers and feedbacks—or spillbacks, as some call them—into account, not least out of enlightened self-interest.

Local Rules in a Global Game

Let me briefly characterize the present-day IMFS, before describing the spillover channels. In contrast to the Bretton Woods system or the gold standard, the IMFS today no longer has a single commodity or currency as nominal anchor. I am not proposing to go back to these former systems; rather, I favor better anchoring domestic policies by taking financial stability considerations into account, internalizing the interactions among policy regimes, and strengthening international cooperation so that we can establish better rules of the game.

So what are the rules of the game today? If there are any rules to speak of, they are mainly local. Most central banks target domestic inflation and let their currencies float, or follow policies consistent with managed or fixed exchange rates in line with domestic policy goals. Most central banks interpret their mandate exclusively in domestic terms. Moreover, the search for a framework that can satisfactorily integrate the links between financial stability and monetary policy is still a work in progress, with some way to go. The development and adoption of such a framework represent one of the most significant and difficult challenges for central banks over the next few years.

Discussions of international policy seem to focus mainly on containing balance of payments imbalances, with most attention paid to the current account (i.e., net flows). Not enough attention is given to gross flows and stocks—that is, stocks of debt.

This policy design does not help us to see, much less to constrain, the buildup of financial imbalances within and across countries. This, in my view, is a blind spot that is central to this debate. Global finance matters—and the game is undeniably global even if the rules that central banks play by are mostly local.

International Spillover Channels

Monetary regimes and financial conditions interact globally and reinforce each other. The strength and relevance of the spillovers and feedbacks tend to be underestimated. Let me briefly sketch four channels through which this happens.1

The first channel has to do with the conduct of monetary policy: easy monetary conditions in the major advanced economies spread to the rest of the world through policy reactions in the other economies (e.g., easing to resist currency appreciation and to maintain competitiveness). This pattern goes beyond emerging market economies (EMEs): many central banks have been keeping policy interest rates below those implied by traditional domestic benchmarks, as proxied by Taylor rules.2

The second channel involves the international use of currencies. Most notably, the domains of the US dollar and the euro extend so broadly beyond their respective domestic jurisdictions that US and euro-area monetary policies immediately affect financial conditions in the rest of the world. The US dollar, followed by the euro, plays an outsized role in trade invoicing, foreign exchange turnover, official reserves, and the denomination of bonds and loans. A key observation in this context is that US dollar credit to nonbank borrowers outside the United States has reached $9.6 trillion, and this stock has expanded on US monetary easing.3 In fact, with accommodative monetary policy intended for the United States, US dollar credit has expanded much faster abroad than at home (figure 24.1, top right panel).

Figure 24.1Global credit in US dollars and euros to the nonfinancial sector.

Notes: a. At constant end-Q3 2014 exchange rates. b. Credit to the nonfinancial sector in the United States/euro area from financial accounts, excluding identified credit to borrowers in nondomestic currencies (i.e., cross-border and locally extended loans and outstanding international bonds in nondomestic currencies). c. Cross-border and locally extended loans to nonbanks outside the United States/euro area. For China, locally extended loans are derived from national data on total local lending in foreign currencies on the assumption that 80 percent are denominated in US dollars. For other non-BIS reporting countries, local US dollar/euro loans to nonbanks are proxied by all BIS reporting banks’ gross cross-border US dollar/euro loans to banks in the country, on the assumption that these funds are then extended to nonbanks.

Sources: IMF, International Financial Statistics; Datastream; BIS international debt statistics and locational banking statistics by residence.

Third, the integration of financial markets allows global common factors to move bond and equity prices. Uncertainty and risk aversion, as reflected in indicators such as the VIX index, affect asset markets and credit flows everywhere.4 In the new phase of global liquidity, in which capital markets are gaining prominence and the search for yield is a driving force, risk premia and term premia in bond markets play an important role in the transmission of financial conditions across markets.5 This role has strengthened in the wake of central bank large-scale asset purchases. The Federal Reserve’s large-scale asset purchases compressed not only the US bond term premium but also long-term yields in many other bond markets. More recently, the new program of bond purchases in the euro area put downward pressure not only on European bond yields but apparently also on US bond yields, even amid expectations of US policy tightening.

A fourth channel works through the availability of external finance in general, regardless of currency: capital flows provide a source of funding that can amplify domestic credit booms and busts. The leverage and equity of global banks jointly drive gross cross-border lending, and domestic currency appreciation can accelerate those inflows as it strengthens the balance sheets of local firms that have financed local currency assets with US dollar borrowing.6 In the run-up to the global financial crisis, for instance, cross-border bank lending contributed to raising credit-to-GDP ratios in a number of economies.7

Through these channels, monetary and financial regimes can interact with and reinforce each other, sometimes amplifying domestic imbalances to the point of instability. Global liquidity surges and collapses as a result.

Thus, monetary accommodation at the center tended to create a global easing bias and thereby leads to spillovers and, eventually feedbacks. But these channels can also work in the opposite direction, amplifying financial tightening when policy rates in the center begin to rise, or even seem ready to rise, as suggested by the “taper tantrum” of 2013. Nevertheless, it is an open question whether the effect of the IMFS is symmetric in this regard, creating as much of a tightening bias as it does an easing bias. In both cases, it is important to try to eliminate the blind spot and keep an eye on the dynamics of global liquidity.

Policy Implications: From the House to the Neighborhood

This leads to my second point, that central banks should take the international effects of their own actions into account in setting monetary policy. This takes more than just keeping one’s own house in order; it also requires contributing to keeping the neighborhood in order.

An important precondition in this regard is the need to continue the work of incorporating financial factors into macroeconomics. If policymakers can better manage the broader financial cycle, that in itself would help constrain excesses and reduce spillovers from one country to another.

But policymakers should also give more weight to international interactions, including spillovers, feedbacks, and collective action problems, with a view to keeping the neighborhood in order. How to start broadening one’s view from house to neighborhood? One useful step would be to reach a common diagnosis, a consensus in our understanding of how international spillovers and spillbacks work. The widely held view that the IMFS should focus on large current account imbalances, for instance, does not fully capture the multitude of spillover channels that are relevant in this regard.8

An array of possibilities then presents itself in terms of the depth of international policy cooperation. They range from extended local rules to new global rules of the game.

To extend local rules, major central banks could internalize spillovers so as to contain the risk of financial imbalances building up to the point of blowing back on their domestic economies. Incorporating spillovers in monetary policy setting may improve performance over the medium term. This approach is thus fully consistent with enlightened self-interest. The need for policymakers to pay attention to global effects can be seen clearly in the major bond markets. Official reserve managers and major central banks hold large portions of outstanding government debt (figure 24.2). If investors treat bonds denominated in different currencies as close substitutes, central bank purchases that lower yields in one bond market also weigh on yields in other markets. For many years, changes in US bond yields have been thought to move yields abroad; in the last year, many observers ascribed lower global bond yields to the ECB’s consideration of and implementation of large-scale bond purchases. Central banks ought to take into account these effects when setting monetary policy.

Figure 24.2Official Holdings of US Treasury Securities (in trillions of US dollars).*

Notes: *Different valuation methods based on source availability. a. Covers the euro area, Japan, the United Kingdom and the United States; for the euro area, Japan and the United Kingdom, converted into US dollars using Q2 2015 constant exchange rates. b. For the United States, total marketable Treasury securities, excluding agency debt. c. For euro- and yen-denominated reserves, 80% is assumed to be government debt securities; for dollar-denominated reserves, as reported by the US Treasury International Capital System; for sterling-denominated reserves, holdings by foreign central banks. d. For the euro area, national central bank holdings of general government debt and ECB holdings under the Public Sector Purchase Programme and the Securities Market Programme. e. Agency debt includes mortgage pools backed by agencies and government-sponsored enterprises (GSEs) as well as issues by GSEs; total outstanding Treasury securities are total marketable Treasury securities.

Sources: Board of Governors of the Federal Reserve System; US Department of the Treasury; Datastream; BIS calculations.

However, even if countries do optimize their own domestic policies with full information, a global optimum cannot be reached when there are externalities and strategic complementarities as in today’s era of global liquidity. This means that we will also need more international cooperation. This could mean taking ad hoc joint action, or perhaps even developing new global rules of the game to help instill additional discipline in national policies.9 Given the preeminence of the key international currencies, the major central banks have a special responsibility to conduct policy in a way that supports global financial stability—a way that keeps the neighborhood in order.

The domestic focus of central bank mandates need not preclude progress in this direction. After all, national mandates in bank regulation and supervision have also permitted extensive international cooperation and the development of global principles and standards in this area.


The current environment offers a good opportunity to revisit the various issues regarding the IMFS. Addressing the blind spot in the system will require us to take a global view. We need to anchor domestic policies better by taking financial factors into account. We also need to understand and to internalize the international spillovers and interactions of policies. This new approach will pose challenges. We have yet to develop an analytical framework that allows us to properly integrate financial factors—including international spillovers—into monetary policy. And there is work to be done to enhance international cooperation. All these elements together would help establish better global rules of the game.

The global financial crisis has demonstrated that international cooperation in crisis management can be effective. For instance, the establishment of international central bank swap lines can be seen as an example of enlightened self-interest. However, we must also recognize that there are limits to how far and how fast the global safety nets can be extended to mitigate future strains. This puts a premium on crisis prevention. Each country will need to do its part and to contribute to making the global financial system more resilient—and I would add here that reinforcing the capacity of the IMF is one element in this regard. And taking international spillovers and financial stability issues into account in setting monetary policy is a useful step in this direction.


See Stefan Avdjiev, Robert McCauley, and Patrick McGuire, “Rapid Credit Growth and International Credit: Challenges for Asia,” BIS Working Paper 377, Bank for International Settlements, April 2012; and Philip Lane and Peter Mc-Quade, “Domestic Credit Growth and International Capital Flows,” Scandinavian Journal of Economics 116, no. 1 (2014): 218–252.


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