V Exchange Market Stability as a Public Good
- Paul Masson, Morris Goldstein, and Jacob Frenkel
- Published Date:
- June 1991
Thus far, the discussion has suggested that a successful international monetary system would have the following characteristics. First, it would have a nominal anchor that rested on the commitment of the largest industrial countries to domestic price stability. Second, it would embrace neither the view that “all current account imbalances should be eliminated” nor the view that “current accounts don’t matter”; instead, it would seek to facilitate international adjustment by encouraging countries to eliminate undesirable and unsustainable external imbalances at the source. Third, it would allow for different degrees of exchange rate flexibility (and different exchange rate regimes) across countries, depending on structural characteristics of economies, the advantages of an external discipline for monetary policy, and incentives to regional integration.
Combining the first and third characteristics suggests that exchange rate commitments will be looser and quieter (that is, not involving publicly announced, narrow exchange rate ranges or targets) in the largest industrial countries than in smaller, more open economies—some of which may eventually even opt to join regional currency areas. But such a suggestion still leaves unanswered a key question: how will the system ensure that the major currencies—which after all have the greatest impact on the rest of the world—are not subject to serious misalignments and/or excess volatility? In other words, how can one obtain “… a more appropriate meshing of national sovereignty and international responsibilities”28 now that the international community has come to regard exchange market stability as a public good that has a positive feedback on economic performance?
In seeking to promote exchange market stability, the larger industrial countries would assume a set of responsibilities. First and foremost, by setting the stance of monetary and fiscal policy on a stable, noninflationary course and by endeavoring to correct bad external imbalances at their source, they would provide a more stable focus for exchange rate expectations.29 The issue is not whether misalignments on the order of 1983–85 can recur; it is whether they can recur when fiscal policy is better disciplined and when external imbalances are much smaller. More disciplined policies would go a long way toward more disciplined exchange markets; the coordination of policies is therefore the key element of the ongoing coordination process in the Group of Seven. Second, authorities in these countries would regularly develop their own (quiet) estimates of equilibrium real exchange rates. These estimates may well be subject to substantial margins of uncertainty. Nevertheless, unless one accepts the view that the “market rate is always the right rate,” an independent evaluation is needed. Third, in those (hopefully unusual) cases where there is a “large” difference between the market rate and official views of the equilibrium rate consistent with fundamentals, authorities would intervene. This intervention could take the form of a statement of official views on the desirable direction of exchange rate movements, of concerted, sterilized exchange market intervention, and—when necessary— of coordinated adjustments in monetary policies.30 The Plaza Agreement and its aftermath is a good example. These responsibilities are contingent upon strong evidence of bubbles or large misalignments in exchange markets.
The responsibility to calm financial markets in periods of turbulence may be especially important today, as a result of increased integration of global financial markets. Underlying this increased integration have been a number of interrelated trends and processes, often summarized under the headings of liberalization, globalization, securitization, and innovation. Since these trends have been described in detail elsewhere,31 it is enough here simply to mention the highlights. They include:
the dismantling of capital controls and of limitations on entry of foreign financial institutions into the domestic market;
the deregulation of interest rates on deposit, lending, and investment instruments, in favor of more market-determined levels;
the rapid growth of offshore financial markets, removal of exchange controls, development of 24-hour screen-based global trading, and increased use of national currencies outside the country of issue;
a shift toward use of direct debt markets and away from indirect finance, the packaging of assets not normally traded into tradable securities, and the creation of exchange-traded futures and options markets;
a blurring of separations between commercial banking on the one hand and investment banking and security houses on the other; and
the creation of a host of new financial products, ranging from currency and interest swaps, to floating rate notes, to note-issuance facilities.
Increased capital market liberalization increases the potential risks of beggar-thy-neighbor practices. The shift away from credit rationing and quantitative restrictions on lending means that the transmission mechanism of monetary policy falls more on “market prices,” namely, on exchange rates and interest rates—the “competitive” variables most often cited in beggar-thy-neighbor complaints. Coordination is a way of discouraging such practices, and would likely involve increased exchange rate commitments.
Although such exchange rate commitments by the larger countries would be looser than in many target zone schemes, they would not necessarily be less effective. The stabilizing effect of any official exchange rate commitment on expectations depends on its credibility. One can argue that a looser commitment, wherein authorities react only to large, clear-call misalignments and do not claim that the primary assignment of monetary policy is for external balance, will be more credible than a (nominally) tighter and louder commitment. In evaluating the credibility of a commitment, market participants are also apt to weigh the costs of exchange rate instability against the costs of reduced monetary control. For the largest economies, the costs of reduced monetary control are perceived to be large enough to tip the balance in favor of exchange rates only when exchange markets are seriously misbehaving.
An exchange rate system that exhibits less hegemony and greater diversity of exchange arrangements than did the Bretton Woods system is not likely to function well unless an effective policy coordination process is in place (see Section VI). The absence of a single, dominant leader for the system implies that the assignment of responsibilities will be less obvious—and the structure of decision making more interdependent— than before. In fact, the ongoing policy coordination process in the Group of Seven can be characterized as a pragmatic response to shared leadership. Similarly, the diversity of exchange arrangements probably makes it more difficult to write “.rules of the game” for the system that have wide applicability and yet are specific enough to make noncompliance transparent. The “peer pressure” associated with policy coordination can act to encourage responsible behavior and to compensate for any surfeit of guidance from existing codes of conduct. Without coordination, there would be greater danger that the “poles” of the international monetary system—and the countries grouped around them—might implement policies that would have negative spillover effects on other countries. As the experience of the 1980s has shown, such negative spillovers can arise not merely from misaligned exchange rates and financial market volatility but also—and more fundamentally— from undisciplined fiscal, structural, and monetary policies.
A response that should be avoided would be to attack the symptoms, rather than the fundamental causes, of misalignments and volatility. For instance, one strategy would be to throw “sand in the wheels” of the international capital markets by accepting restrictions or transactions taxes on capital flows. This strategy is based on the assessment that such restrictions would be less costly to the real side of the economy than either subordinating macroeconomic policies to exchange rate targets, or accepting the kinds of exchange rate fluctuations associated with greater policy autonomy.32 There are at least four serious objections to such a strategy.33
First, to be effective, these proposals have to be widely implemented. Yet there is always an incentive for some country to capture more of the world’s business by not imposing the tax. The globalization of capital markets means of course that it will be easier for consumers of financial services to find substitutes for taxed services elsewhere. If only the geographic location of speculation changes—and not its volume or nature—little will be accomplished.
Second, too little is known about asset-price behavior in markets with different levels of transactions taxes to be confident that it will penalize only bad speculators and socially unproductive capital flows—without affecting good ones.34 For example, are asset-price volatility and misalignments systematically lower in, say, real estate markets (with high transactions costs) than in financial markets (with lower ones)? Are bubbles less prevalent in fine art and wine markets (where again transactions costs are relatively high) than in stock markets? If restrictions or taxes are not successful in separating productive from unproductive flows, we sacrifice some of the benefits of liberalization, including increased returns to savers, a lower cost of capital to firms, and better hedging instruments against a variety of risks.
Third, restrictions on capital flows—even if they affected bad flows more than good ones—could weaken support for “outward-looking” policies and could spread to other areas, including the foreign trade sector.
Fourth, once sand has been thrown in the wheels, it may be difficult to get it out, as rent-seeking groups coalesce around the restrictions.
Nevertheless, the liberalization and globalization of capital markets have been accompanied by certain systemic risks, and some official action may be needed to reduce these risks. While this topic extends beyond the scope of this paper, two problems can be mentioned.35
A largely uncoordinated restructuring of capital markets can be unstable because of perverse incentives for risk-taking by financial institutions. While private market participants were exploiting the greater opportunities for arbitraging regulatory and fiscal differences across national and international jurisdictions, financial authorities were not reducing—in fact, they were significantly expanding—implicit and explicit liquidity and solvency guarantees to these participants. If this process is not to create incentives for excessive risk-taking nor to lead to an undue transfer of private credit risk to the public sector, a more coordinated (and probably, harmonized) approach to prudential regulation will be needed. The recently concluded Basle agreement on risk-weighted capital standards for international banks is a good example of a cooperative solution to a problem generated by a competitive approach to bank regulation.
A second problem is that weaknesses in clearance and settlement systems could transform a local financial disturbance into a systemic crisis. Over the past decade, while improvements have made it possible to execute, say, a cross-border equity trade in minutes, clearance and settlement after the execution have not kept pace. Clearance and settlement of foreign currency transactions lean on international netting arrangements and hence have a supernational character. Systemic risk derives from the credit extended in interbank transactions during the settlement period. At issue is whether private cooperative arrangements can reduce systemic risk to acceptable levels when their capacity to discipline members and to provide them with liquidity is limited. Joint undertakings by the public and private sectors may be needed, along with a coordinated approach by central banks and other regulatory bodies.
Camdessus (1988a, p. 237).
The fact that the largest countries have started the 1990s with a significantly better inflation performance than they did in the 1980s should itself be a positive factor.
Persistent misalignments might also indicate the need to examine the appropriateness of other policies—in particular, fiscal and structural policies.
These problems are treated more comprehensively in Folkerts-Landau (1990).