By Oliver Bush
This is an abridged and altered version of Bush, O, Farrant, K and Wright, M (2011), ‘Reform of the International Monetary and Financial System’, Bank of England Financial Stability Paper no. 13.
The most striking message from Carmen Reinhart and Ken Rogoff’s seminal book1 is hammered home by the authors: time and again, lenders, borrowers and policymakers delude themselves into believing that ‘this time is different’, that large increases in asset prices and financial activity are more miracle than mirage. As if to prove their hypothesis, they end their original paper on the topic on an optimistic note, by suggesting that Greece and Spain may have graduated from their history of serial default.2
A second finding that jumps out at us is that some eras appear to have been less crisis-prone than others. In particular, the Bretton Woods period (from WWII until 1972) stands out as markedly more stable. The authors suggest a link to capital flows: in the aggregate data, there is a correlation between capital mobility and banking crises.
Keynes would not have been surprised by this association. In a short memorandum written the same weekend as his famous Clearing Union proposal, he pinned the economic turmoil preceding the Second World War on capital flight:
[a reversal of speculative flows from America and Britain to Europe in the interwar years] became, in the end, the major cause of instability…We have no security against a repetition of this after the present war though not perhaps on the same scale or necessarily in the same direction. … The whereabouts of ‘the better ’ole’ will shift with the speed of the magic carpet. Loose funds may sweep round the world disorganising all steady business.3
For Keynes, the policy prescription was clear:
Nothing is more certain than that the movement of capital funds must be regulated; – which in itself will involve far-reaching departures from laissez-faire arrangements.4
Along with the lead American negotiator Harry Dexter White, he argued that capital controls should be a feature of the post-war policy regime. By and large, they got their way: it was not until the 1980s that capital controls were rolled back in most developed countries.
But for most of the past two hundred years, people in advanced economies have been able to buy and sell foreign assets more or less as they pleased. This reflected in no small measure the liberal consensus originating in the Enlightenment. The case for economic integration across countries was made particularly strongly by Immanuel Kant in his essay Perpetual Peace. In it, he argued that:
Just as nature wisely separates nations, which the will of every state, sanctioned by the principles of international law, would gladly unite by artifice or force, nations which could not have secured themselves against violence and war by means of the law of world citizenship unite because of mutual interest. The spirit of commerce, which is incompatible with war, sooner or later gains the upper hand in every state. As the power of money is perhaps the most dependable of all the powers (means) included under the state power, states see themselves forced, without any moral urge, to promote honourable peace and by mediation to prevent war wherever it threatens to break out.5
What weight Kant put on integration in financial, as well as goods, markets isn’t completely clear, although he does remark elsewhere in the essay that accumulating foreign debts should be seen as ‘above suspicion’ unless the funds were used to finance war.6 For the purposes of this article, let us tie him to the mast of capital mobility.
Today’s more worldly philosophers have extended the arguments for the Kantian view on capital mobility beyond war avoidance, citing a host of reasons why capital should be mobile:
• funds should be allowed to seek out their most productive use
• countries should be able to borrow to smooth consumption when hit by bad luck
• countries should be able to take out insurance against bad luck
• inward investment has positive spill-overs such as technology and skill transfer
• subjecting a country to the discipline of international financial markets can improve the quality of its institutions.
Which of these two titans was correct? Whose advice should policymakers follow as they seek to avoid crises but promote long-term prosperity? For Keynes and Kant, this issue made the difference between war and peace. And it is certainly playing on the minds of economic policymakers today in many emerging markets and some advanced economies too. Drawing on post WWII experience, this article attempts to shed some light on the issue.
Economic performance before and after the fall of Bretton Woods
Table 1 summarises a range of metrics of economic performance across different eras. It shows the Bretton Woods period stood out, coinciding with remarkable financial stability and sustained high global GDP growth. Moreover, solid growth does not appear to be only the result of post-war reconstruction efforts – growth in real per capita GDP was slightly stronger in the 1960s than it was in the 1950s.
In contrast, the post-Bretton Woods era has performed poorly, at least relative to the previous twenty-five years. The table shows that, on average, it suffered from: slower, more volatile, global growth; more frequent economic downturns; higher inflation and inflation volatility; and more frequent banking crises, currency crises and external defaults.
The really striking thing about these data is that during the Bretton Woods era, growth was both stronger and more stable. This was the case for almost every world region, although the picture at the country level is more mixed. Is there a link with capital flows? In other words, did Keynes’ capital flows angst protect the world economy from crises until Kantian ideology took over?
The link with capital flows
A cursory glance at Table 1 suggests that capital flows should be on the list of prime suspects in explaining the contrast between performance during and after the Bretton Woods era. Although we don’t have good measures of gross capital flows spanning both eras, net capital flows, current account balances, were on average much smaller during the Bretton Woods regime than during any other era. Qualitative studies of capital mobility corroborate this.
A growing body of evidence suggests that increased capital mobility has been associated with more frequent periods of volatility and instability in financial markets. Much of it focuses on episodes of large current account deficits. A series of studies7 have shown how large deficits are often followed by abrupt improvements in the current account balance (current account reversals), banking crises and poor macroeconomic outcomes.
This was certainly the pattern over the recent crisis. Chart 1 plots the change in GDP growth during the crisis against the size of the current account reversal for 57 advanced and emerging economies. The picture is very clear: countries with larger current account reversals saw larger growth slowdowns. These same countries also tended to run larger current account deficits before the crisis.
In the Bretton Woods period, capital controls put a lid on current account imbalances. Large current account reversals, banking crises and recessions were much rarer. More recently, policymakers have become increasingly exercised by large imbalances and as a result, capital controls have gained popularity in some parts of the world.
Why the international dimension is important
Some have challenged the notion that global imbalances warrant particular focus on the grounds that there is nothing essentially international about the phenomena described above. Regional imbalances within a country could equally well lead to abrupt reversals, banking crises and recessions. It is hard to disagree that the problems underlying these phenomena – such as missing financial markets, imperfect information and nominal rigidities – exist within countries too. However, aside from the empirical evidence cited above, there are good a priori reasons to expect that the international dimension is important. First, the underlying problems are likely to be more severe between countries than within a country and second, there are a number of mitigating factors within countries which limit their costs. An example will illustrate.
Imagine one region of the UK, Yorkshire, was borrowing heavily from other regions. The funds are largely raised by branches of the (imaginary) Yorkshire Bank elsewhere in the country and lent out to Yorkshire households and businesses. The imperfect information problems are unlikely to be crippling. The bank has established relationships with local households and businesses and uses this judgement to limit its risk-taking. Likewise, its large creditors have sufficient information to do a reasonable job in monitoring the bank’s activities and are unlikely to reduce their funding at the drop of a hat. A large proportion of the bank’s funding comes from retail depositors covered by deposit insurance. They provide a very stable source of funding, but do not monitor the bank. The regulator does this for them and, because all of the bank’s activities are national, has a very good view of the bank and the risks to which it is exposed.
But let us imagine that, worried about competition from large national banks, the Yorkshire Bank did extend so much credit to households and businesses that could not repay, that investors worried about its solvency. How bad might the impact be on the region? It is likely that the supply of credit to Yorkshire households and businesses would be hit and spending and hiring would fall. But there would be two important cushions. First, some of those who lost their jobs would find employment elsewhere in the country. This would limit the rise in Yorkshire unemployment. Second, automatic stabilisers would support Yorkshire’s income. Lower tax payments and higher unemployment benefits would act as insurance against this scenario. In effect, the rest of the country would be transferring funds to Yorkshire to prevent very bad outcomes.
Now contrast this picture with international imbalances. Investors know less about the international activities of cross-border banks and are less likely to be small, insured depositors. As well as worrying about the solvency of the bank, foreign investors must also factor in exchange rate risk. They take little comfort in the fact that these banks are regulated as the regulators find it hard to judge the risks that these banks are taking abroad. As a result, cross-border funding tends to be short-term and much less stable than domestic funding. In a crisis, it vanishes. The immediate impacts on the borrowing country are severe. Those who have lost their jobs are slow to move abroad and the state finds it hard to support the unemployed as its tax receipts have fallen and investors begin to worry about its solvency too.
Of course, with sufficient integration across countries, underlying problems such as imperfect information could be mitigated and more effective shock absorbers put in place. This is the dream of the multilateralists, but the debate over European integration shows how hard it is to achieve.
Should we move back to Bretton Woods?
Keynes appears to have been correct about the risks posed by unstable capital flows. In another memorable piece,8 Keynes highlighted the dangers of international financial integration, concluding that we should ‘above all, let finance be primarily national’. Should we follow his advice? Moving back to such a world would no doubt limit international imbalances and the costs associated with them. But is such a move really necessary for stability? And what would the costs be?
Almost as striking as the strength of the relationship between current account reversals and GDP performance during the crisis is the lack of one between financial openness and GDP performance. Chart 2 shows this. Even with outliers (financial centres such as Hong Kong, Singapore and Ireland) removed, or reserves subtracted, the association is very weak. This suggests to us that it may be possible to manage the risk of current account reversals without closing the capital account. We return to the question of how to do this below.
The costs of closing the capital account are of course the flipside of the benefits of capital flows listed above. How much evidence is there that capital flows do in fact raise long-term income through better allocation of resources and technology transfer, facilitate international risk sharing and improve institutions as theory suggests they should?
There is surprisingly little consensus in the empirical literature on growth and capital flows9 given how important a topic it is. Some find a positive relationship, some negative. Some find that the relationship varies with the level of development. The fact that capital has tended to flow ‘uphill’ from developing to developed countries is often highlighted since some theories linking capital flows to growth predict the opposite. But once capital flows are disaggregated, net direct investment flows, most commonly associated with technology transfer, do flow downhill. A number of papers seek to control for the possibility that capital controls might protect countries from crises. Typically, these papers find a positive effect in crisis times, but no discernable effect in other times. In short, the jury is still out over the direct links between capital flows and GDP growth.
The data on risk sharing are clearer. Theory suggests that as countries become more financially integrated, this should allow more hedging of national macroeconomic risks. This would allow consumption smoothing in the face of income shocks and would tend to increase the correlation of consumption growth across different countries. In fact, consumption has become more volatile relative to income across recent decades and consumption growth has not become more correlated across countries. So the evidence does not suggest that countries have harnessed the risk-sharing benefits of financial openness.
The evidence on the collateral benefits of financial openness, through institutional improvement, is somewhat more encouraging, but still not decisive. As Kose et al10 discuss, the literature finds that financial openness is associated with higher financial development, better corporate governance and more disciplined macroeconomic policy. Although it is not clear that the direction of causality runs from financial openness to institutional development, these findings are at least consistent with the theory that financial openness raises income indirectly.
On balance, the empirical literature has struggled to show large benefits of capital account openness. But it has tended to ignore Kant’s original motivation for proposing more economic integration: the avoidance of war. In fact, this topic has drawn some attention, notably from Eric Gartzke, Quan Li and Charles Boehmer.11 They find that two states are much less likely to go to war if they have strong bilateral financial links. So Kant appears to have been proven correct. Although Gartzke et al put a slightly different theoretical interpretation on these empirical findings than the one Kant proposed, this kind of evidence should surely have some weight in the debate over capital mobility.
In sum, while Keynes was right to worry about flighty capital flows, we believe there are ways that countries can reduce the probability and costs of current account reversals without closing their capital accounts. Furthermore, rather than bemoaning the lack of evidence that mobility has delivered many of the benefits that simple theories would suggest, one might instead ask: ‘what can policymakers do to get more out of financial globalisation?’
We conclude with a brief discussion of what policymakers can do to reduce the costs and increase the benefits of capital mobility. To reduce the probability of current account reversals, efforts could be made to prevent large current account deficits and to discourage unstable sources of funding.
Tighter fiscal and regulatory policies could go some way in preventing large current account deficits. But their effect could be hampered, or could have the side-effect of reducing employment, if other countries fail to boost domestic demand and allow real exchange rates to adjust. But options are still available. International policy co-operation could play a role in encouraging surplus countries to allow real exchange rate appreciation and a rebalancing of global demand (this is one rationale for the G20 Framework for Strong, Sustainable and Balanced Growth). Fiscal devaluation – shifting the tax base from income to spending – can have a similar effect to a real exchange rate devaluation. Sufficiently broad and strict price-based controls on capital inflows could play a similar role in preventing large deficits. But this would likely come at the cost of discouraging both capital inflows and outflows, preventing countries from enjoying the benefits of capital mobility, so should be used as a last resort.
Tax, regulatory and capital account policies could also be used to encourage more stable funding. Tax policy currently gives incentives for debt financing in many advanced countries. Eliminating this bias (or indeed incentivising equity finance) should improve the resilience of household and corporate balance sheets, reducing foreign investors’ propensity to pull funding at the first sign of trouble. Regulatory policy can play a similar role for banks’ balance sheets. And price-based capital controls could discriminate between different types of flows, for instance discouraging debt but not equity inflows, at the point of entry into the country (although in practice it has proved difficult to prevent leakages from these types of controls, especially in countries with more developed financial systems).
The policies suggested above are not fail-safe. Policies that reduce the costs of a current account reversal as and when it arises should also be considered. A flexible exchange rate removes the need for falling domestic prices and wages in the adjustment process. As the contrast between recent experience in Iceland and the Baltics attests, internal devaluation can be extremely costly. Should the sovereign retain access to foreign finance, fiscal policy can help to smooth the adjustment over time. And, if significant capital flight is expected, temporary controls on outflows can play a similar role.
Although there is much uncertainty about the costs and benefits of all these policy options, we are unaware of any country which has tried several of them and yet still suffered a costly current account reversal. The coming years should shed more light on which policies work best in which circumstances. The most important policy lesson is that policymakers should not wait to act when faced with a large current account deficit.
But it would be a mistake to stop here, without striving to make the most of the opportunities offered by capital mobility. To us, the single biggest barrier to this is missing markets. Specifically, it is far too hard to borrow without taking on large risks over which borrowers have little or no control. For instance, local currency corporate bond markets are still highly illiquid or non-existent in many EMEs. To borrow from abroad, many companies have to expose themselves to foreign exchange risk. If they do borrow from abroad, they collectively render the whole economy vulnerable to a large exchange rate depreciation and balance sheet distress. If they do not, they are not taking advantage of the benefits of tapping foreign markets for funding. But this is far from just an EME problem.
Households and governments in advanced economies would also benefit from a wider set of financial markets. They can of course borrow in domestic currency, but it tends to be harder for them to hedge risks to their income and wealth. Hence they too are rendered financially fragile by borrowing. New financial instruments such as GDP-linked bonds and mortgages linked to house prices would make it easier for governments and households to improve the match between the risk profiles of their income and wealth and their debt, thus making their balance sheets more resilient. Furthermore, such instruments would increase the scope for cross-country risk sharing, one of the large potential benefits of financial globalisation which is as yet far from being fully realised.
Many, although not all, of the policies listed above are on domestic and G20 agendas. This is encouraging, but even as some countries suffer the consequences of past current account deficits, others risk making similar mistakes as we write. Our plea is that even if policymakers reject Keynes’ policy prescription in favour of Kant’s, as we believe they should, they do not ignore the risks that Keynes highlighted.
The views expressed in this paper are those of the author, and are not necessarily those of the Bank of England.
About the author
Oliver Bush is an economist in the Financial Stability Directorate of the Bank of England.
1.Reinhart, C and Rogoff, K (2009), This Time is Different: Eight Centuries of Financial Folly, Princeton Press, Princeton.
2.Reinhart, C and Rogoff, K (2008), ‘This time is different: a panoramic view of eight centuries of financial crises’, NBER Working Paper no. 13882.
3.Keynes, JM (1941), ‘Post-War Currency Policy’, in Moggridge, D, ed., The Collected Writings of John Maynard Keynes, Cambridge University Press, Cambridge.
5.Kant, I (1970), ‘Perpetual Peace. A Philosophical Sketch’, in Reiss, H, ed., Kant Political Writings, Cambridge University Press, Cambridge.
7.E.g. Barrell, R, Davis, E P, Karim, D and Liadze, I (2010), ‘The impact of global imbalances: does the current account balance help to predict banking crises in OECD countries?’, NIESR Discussion Paper no. 351, Edwards, S (2004), ‘Financial openness, sudden stops and current account reversals’, NBER Working Paper no. 10277 and Reinhart, C and Reinhart, V (2008), ‘Capital flow bonanzas: an encompassing view of the past and present’, NBER Working Paper no. 14321.
8.Keynes, JM (1933), ‘National Self-Sufficiency’, Yale Review.
9.See e.g. Eichengreen, B (2002), ‘Capital account liberalization: what do the cross country studies show us?’, World Bank Economic Review 15, no.3, pages 341-366 and Kose, MA, Prasad, E, Rogoff, K and Wei, SJ (2006), ‘Financial globalization: a reappraisal’, IMF Working Paper, WP/06/189.
10.Ibid. 11.Gartzke, E, Li, Q and Boehmer, C (2001), ‘Investing in the peace: economic interdependence and international conflict’, International Organization 55 no.2, pages 391–438.