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In a similar fashion to financial globalisation, I define real globalisation as the cross-border integration of markets for goods, services and factors of production. In the extreme case when real side globalisation has run its full course, all goods would be traded, there would be no domestic non-traded goods sector. Furthermore, there would be instant factor mobility, implying that real factor returns are equalised across borders and the domestic output gap becomes irrelevant and meaningless. In fact, there would be no specific national resource constraint, except land.
This might seem far-fetched and in some sense it is. Yet it demonstrates the direction we are heading in. Moreover, we already see several signs of these phenomena emerging. You only need to think about how the inflow of labour has played a significant role in relieving labour market pressures in countries like the United Kingdom and Iceland in recent years. Switzerland is another long-standing example.
We now add full financial globalisation to the picture. Then the real risk-adjusted yield curve is, through speedy arbitrage, completely determined by the global curve and unaffected by domestic monetary policy, even in the short run. Monetary policy would then lose all its countercyclical force. It is anyhow not needed as there is no domestic output gap that needs to be stabilised. However, monetary policy would, through the exchange rate channel, be able to deliver any inflation target that the authorities want, by creating deviations of the domestic nominal policy rate from the global rate. Monetary policy has, however, no real effect. It can only determine the inflation rate, which is also neutral in its effect on the real economy.
We are still far from this extreme case. Furthermore, a plausible argument could be made that financial globalisation might progress more rapidly than real globalisation. We would then have a situation where the countercyclical force of monetary policy would still be useful but the interest rate channel would be significantly weakened, or even fully blocked. To what degree that would constitute a problem would depend partly on how well the exchange rate channel operates.
Yet this is where the concerns rise. Evidence seems to suggest that foreign exchange markets exhibit excess volatility and that exchange rates diverge from fundamentals for lengthy periods. The existence of carry trade can in some sense be taken as evidence of this, as it involves a bet that interest rate differentials are not fully compensated by exchange rate movements, that the so-called uncovered interest rate parity does not hold. According to the theory of uncovered interest rate parity, low-yielding currencies should be expected to appreciate and high-yielding currencies should be expected to depreciate. However, what we observe over lengthy periods is the reverse, followed by sharp corrections. In this regard, one could reflect on the yen versus the New Zealand dollar, or the situation here in Iceland.
What can small and medium-sized countries do when faced with a weakened interest rate channel and a misbehaving exchange rate? It seems to me that they have basically three options.
First, they can decide to live with it. After all, they will eventually be able to deliver their inflation target. The road will be bumpy in terms of exchange rate volatility and potential misalignments but it is not clear how strong the detrimental effects on the traded goods sector really are, partly because a sophisticated financial sector can provide hedging instruments.
Second, they can try to sharpen and realign existing instruments in order to reduce the burden on monetary policy and exchange rate adjustment with the aim of reducing adverse effects on the traded goods sector. This would involve measures like shifting the policy mix in the direction of fiscal policy, recalibrating prudential instruments with a view to minimising procyclicality, reviewing the tax and incentive structures of asset markets, particularly housing, and, maybe, even an occasional foreign exchange intervention. This seems to me to be the road that New Zealand, the pioneer of inflation targeting, is currently embarking on. However, it remains to be seen how much mileage can be got out of measures of this type; there are, for instance, well known problems with using fiscal policy for short-run stabilisation purposes, especially if there is already a significant fiscal surplus.
Finally, they could radically change the framework by entering a monetary union. Each country faces different options and its particular pros and cons in such regard. However, it is clear that, as both real and financial globalisation progress, the relative attractiveness of entering a monetary union increases, everything else being equal. The reason is of course that we are heading in a direction where for small economies that are unable to influence global interest rates; countercyclical monetary policy will be both impossible and unnecessary.
Concluding remarks
Chairman, ladies and gentlemen, let me conclude. Financial globalisation has big benefits and we hope that it will continue to make progress. Yet, as with most good things in life, it carries risks, and creates challenges for prudential and monetary authorities. There is no blame intended when I say that the public sector response is lagging. These are difficult problems and political structures are still to a significant degree nationally based. However, prudential and monetary regimes will probably have to adjust. There are several possible scenarios and it will be interesting to see how this unfolds. Could it be that after several decades we will have significantly fewer currencies in the world and fewer financial regulators as well, at least for internationally active banks?
Thank you very much.
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Már Gudmundsson is the Deputy Head of the Monetary and Economic Department of the Bank for International Settlements. The views expressed are the author’s and not necessarily those of the BIS.
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