"Globalisation and the Irish Economy: A Macro-Financial Perspective"
Philip R. Lane, Governor of the Central Bank of Ireland
Geary Lecture, Economic and Social Research Institute
November 15th 2018
Introduction
It is an honour to be invited to deliver the Geary Lecture. Roy Geary played a critical role in
the development of social science research in Ireland, both through his personal
contributions and his leadership roles at the CSO and the ESRI. In addition, Roy Geary made
a significant global contribution, both through his research and as head of the national
accounts division of the UN Statistical Office during 1957-1960. Especially for later-stage
researchers, it is also inspiring to know that many of his publications were written late in his
career, with more than half published after his 65th birthday (Spencer 1993).
Since the mid-1960s, the Geary Lecture series has proven to be an important conduit for the
transmission of the advances in research in the social sciences by exposing Irish audiences
to the world's finest scholars. Indeed, in preparing this lecture, the 21st and 24th Geary
Lectures delivered by Rudi Dornbusch and John Dunning were important references. As an
undergraduate student, I was privileged to be in the audience for the Dornbusch lecture and
was immensely impressed by his erudition, clarity of expression and expertise: he was a role
model for anyone interested in applied macroeconomics. I will return to the topic of the
Dornbusch lecture - European monetary integration - later in this lecture. The Dunning
lecture remains highly relevant today, in terms of emphasising the role of the State in
economic development in a globalised system.
Finally, the Geary Lecture is also an occasion to reflect on the central role played by the ESRI
in the analysis and formulation of economic and social policies in Ireland. During my time on
the ESRI Council during 2009-2015, I gained a particular appreciation for the sustained
scholarship undertaken by the ESRI, which is the home of so many long-term research
programmes that are irreplaceable in terms of shaping our understanding of the forces
driving economic and social development in Ireland.
In this lecture, I wish to address the implications of globalisation for the macro-financial
policy framework. Of course, the macro-financial sphere is just one dimension of the
relationship between globalisation and national policymaking.1
In relation to economic policy, a trio of trilemmas capture the tensions in determining policy
choices in an integrated world economy. First, the monetary trilemma postulates that only
two of the following three choices are simultaneously feasible: an independent monetary
policy; a stable exchange rate; and unrestricted international capital mobility (Obstfeld et al
2005). Among the advanced economies that largely adhere to the principle of unrestricted
capital mobility, we see many large countries with independent monetary policies and
floating exchange rates and some smaller countries prepared to live under a pegged
exchange rate. Twenty years ago, an extra policy option was introduced: the sharing of a
common monetary policy through the elimination of national currencies in the form of
European monetary union: I will return to an evaluation of the single currency later in this
lecture. Finally, in the cases of some major emerging economies, restrictions on
international capital mobility are imposed in order to target both a stable exchange rate and
some independence in domestic monetary policy.
Second, the financial trilemma has it that only two of the following three options are
possible: financial stability; independent national financial policies; and cross-border
financial integration (Schoenmaker 2011). A restrictive approach to cross-border financial
trade can enable a country to combine the maintenance of financial stability with purely
domestic financial sector policies, while liberalisation in financial services trade typically
requires considerable cross-border policy collaboration if financial stability is to be achieved,
especially during periods of financial turmoil.
Third, as developed by Dani Rodrik, the political economy trilemma lays out the restrictive
choices between: deep economic integration; democratic politics; and national policy
autonomy (Rodrik 1997, 2010). In analysing the scope for international policy cooperation in
managing globalisation, the limits imposed by the national nature of democratic politics
need to be taken seriously. In Europe, the strategy has been to develop the institutional
development of the European Union in order to provide sufficient democratic foundations
for enhanced integration across various policy dimensions: we return to the political
economy of the euro later in this lecture.
This triple set of trilemmas constrains the conduct of macro-financial policies in a globalised
economy. In order to maintain my focus on the macro-financial dimension, I do not attempt
to provide a wider analysis of globalisation. In particular, I fully recognise that the
globalisation of trade patterns, technological diffusion and international production chains
have profound implications for long-term living standards and environmental sustainability,
while also affecting the distribution of income across borders, across different types of
workers and across different factors. In turn, this means that policymakers should
incorporate the implications of globalisation in the design of environmental, education,
productivity, and social protection policy frameworks (Dunning 1993, Rodrik 1997, Rodrik
2010). It also means that European-level and global-level policy institutions are necessary if
cross-border spillovers are to be adequately addressed.
As indicated, I do not explore these wider topics, in order to give due attention to the
implications of globalisation for the macro-financial policy framework. Of course, this also
reflects my comparative advantage, in terms of my research career and my current position
in central banking.
In what follows, I divide my remarks into two parts. First, I will discuss the measurement
challenges generated by the globalisation of finance and production: the assessment of
macro-financial risk turns on the analysis of the available data and it is dangerous to rely on
uninformative or misleading information. Second, I will examine the implications of
globalisation for the macro-financial policy framework, in the particular context of the Irish
economy.
Measurement and Globalisation
Evidence-based macro-financial policymaking relies on the availability of useful information
about macroeconomic and financial developments. Over the last two decades, the
globalisation of production chains and the increased global footprint of multinational firms
have moved ahead of the empirical implementation of national accounting methods
(Avdjiev et al 2018, Torslov et al 2018). In relation to international finance, the scale and
complexity of cross-border financial positions are difficult to map to the traditional
analytical frameworks underpinning financial stability analysis (Lane and Milesi-Ferretti
2001, 2007, 2018).
In relation to macroeconomics, it has been understood for a long time that the large role of
multinational firms in Ireland means that adjustments are required in order to measure
national income. In relation to the financial system, the large size of the international
financial services sector in Ireland means that the underlying financial positions of Irish-
domiciled firms and households are not visible in the headline data, which are dominated by
matched inward and outward flows by international financial intermediaries.
These measurement challenges have the potential to distort risk assessments and policy
analysis. For instance, the increased systemic risk taking by Irish retail banks in the mid
2000s was not immediately visible in the aggregate financial statistics, which were
dominated by the internationally-orientated foreign-owned banks that were far bigger than
the domestic retail banks (Honohan 2006, Lane 2015). This posed interpretation problems
not only for domestic policy analysts but also the international financial community that
inevitably relies on the aggregate data for a snapshot view of each economy and financial
system.
In relation to multinational firms, a long-standing adjustment was to focus on GNI (gross
national income) or its close cousin GNP (gross national product) rather than GDP (gross
domestic product). This adjustment captured that the (net-of-tax) profits earned by foreign
firms operating in Ireland - were not available for domestic consumption or investment,
even if partially offset by the foreign earnings of Irish-domiciled multinational firms.
Moreover, this adjustment was robust to the well-known transfer problem by which
multinational firms might set prices for intra-firm cross-border transactions to allocate
profits to the jurisdictions with the most favourable corporation tax regime.
In relation to multinational firms, the increasing global economic share of superstar firms in
a number of industries has resulted in greater sensitivity of national accounts to the
production and financial choices of these firms. This trend is compounded by the increasing
importance of intangibles such as intellectual property assets in global production, since the
assigned ownership of these assets can be easily moved across borders and across legal
entities. It is further compounded by the expansion of global production chains, which has
enabled multinationals to combine management expertise in one location with IP assets in a
second location and labour and production facilities in a third location (Lane 2015,
Economics Statistics Research Group 2016, Lane 2017, Advjiev et al 2018, Fitzgerald 2018).
With some effort, it is possible to look through the headline data. In relation to net
international financial flows, Galstyan and Herzberg (2018) find that the most effective risk
indicator for Ireland is the stock of net external debt liabilities of domestic banks, with a
suggested threshold value of 17 percent of GNI*.2 This strips out the net external debt of
internationally-orientated banks, investment funds and multinational firms and recognises
the close linkages between cross-border debt flows and domestic credit expansion (Lane
and McQuade 2014).
Such a metric would have raised a red flag about Irish external debt by the first quarter of
2004 and peaked at 44 percent in the third quarter of 2008. The Irish retail banks held net
external debt assets of around 16 percent at the end of 2017, such that current
international balance sheet risk is low.
In similar fashion, Galstyan (2018) strips out the foreign assets and foreign liabilities of
externally-orientated and externally-owned entities from the Irish international investment
position data. The outcome of this exercise is a far smaller international balance sheet,
which more accurately represents the external exposures of Irish households and Irish-
domiciled entities.
In line with the recommendations of the Economic Statistics Review Group (ESRG) (2016)
that was formed to address the impact of globalisation on the measured national accounts,
the CSO now produces supplementary national accounts estimates in the forms of adjusted
gross national income (GNI*) and an adjusted current account balance (CA*). The two main
forces driving these adjustments are the mobility of IP assets and the ability of firms to re-
domicile (that is, change headquarters) across countries.
The underlying principle is that activity taking place elsewhere should only have minimal
impact on the measurement of the Irish national accounts. In the case of mobile IP assets, a
decision by a firm to transfer these assets from a legal entity in some other location to a
legal entity resident in Ireland should only matter for Irish activity data if it is associated with
a change in production patterns. In contrast, if these IP assets are primarily deployed
elsewhere (with the Irish legal entity charging royalties to the overseas production facility),
it would be highly misleading to include the depreciation charge on the IP assets in the Irish
national accounts.3
In relation to a firm that re-domiciles into Ireland, this should have no impact on the
allocation of the profits earned by this firm if there is no associated change in the
shareholder register. However, due to a quirk in the differences in the treatment of
corporate income across the direct investment and portfolio equity components of the
balance of payments, re-domiciles are not neutral in the standard accounts, such that the
correction introduced by the CSO is required.
Taken together, these corrections make a big difference. The 2017 data show that GDP is 62
percent ahead of GNI*. To state the obvious, an accurate measure of the size of the
economy is fundamental to the conduct of macro-financial policy and, more widely, for the
evaluation of a wide range of public policies. In related manner, the headline current
account measure shows a large surplus, whereas CA* is close to zero : this makes a big
difference in terms of assessing the risks facing the Irish economy.
Given the extreme nature of the Irish data (especially since 2015), the CSO has taken the
lead in addressing the implications of globalisation for national accounts data. These
innovations are being closely watched elsewhere and it is evident that a significant number
of other countries should take similar steps. Even if the corrections at a macroeconomic
level would not be as quantitatively significant in most cases, such adjustments can have a
substantial impact at the sectoral level. For instance, Guvenen et al (2018) calculate that the
level of productivity in R&D-intensive industries in the United States is under-stated by
about 8 percent due to offshore profit shifting.
The limitations of balance of payments data have been partially addressed through the
publication of more detailed sectoral data. Although take-up is patchy, more countries now
release information on the sectoral distribution of cross-border flows and positions. This is
helpful since the identity of the holder of an asset or the issuer of a liability may matter for
the transmission of shocks and the stability of these positions (Galstyan and Lane 2013,
Galstyan et al 2016). For some countries, it is now also possible to examine security-level
data that provides a more granular insight into the trading of individual assets, with the
evidence suggesting that different investor types respond differently to asset price
fluctuations (Timmer 2018, Bergant and Schmitz 2018a, 2018b).
A further step in making cross-border financial data more useful is to establish the currency
exposures embedded in these positions. This is a fundamental issue since the response of
an economy to exchange rate movements depends on its net foreign currency exposure.
Although standard balance of payments reports do not routinely report currency positions,
it is possible to obtain plausible estimates through the judicious merging of a range of
datasets, together with some modelling of the likely currency holdings in a given sector
(Lane and Shambaugh 2010, Benetrix et al 2015).
An additional strategy is to integrate the external balance sheet with the domestic sectoral
financial accounts (Allen 2018a, 2018b). For instance, if a country is a net external debtor,
at least one domestic sector must be a net debtor. This matters for the likely
macroeconomic implications of external debt, given plausible differences in behaviour
across households, non-financial corporates, the government and the financial sector. For
instance, Allen (2018a) shows that the standard list of factors that are understood to
correlate with external imbalances show more systematic co-variation with the imbalances
in the non-financial corporate and government sector. This stands in contrast to the typical
textbook model that focuses on household imbalances as the driver of external imbalances.
This pattern suggests that greater attention should be paid to the net financial positions of
non-financial corporates and governments in terms of the analytics of the net external
position.
In the other direction, the evolution of external debt also depends on the drivers of
imbalances at the domestic sectoral level. For instance, Allen (2018b) finds that house price
appreciation improves the balance sheet of the household sector and, in turn, is associated
with an increase in external debt. This is consistent with home values playing a collateral
role and inducing a wealth effect, with both channels consistent with a negative correlation
between house prices and the external balance.
At the same time, it is important to recognise that further measurement improvements are
required, both in Ireland and internationally. At the domestic level, as advocated by the
ESRG, it would be illuminating to obtain a greater disaggregation of the accounts of
multinational firms between activities that call on domestic resources versus activities that
largely take place elsewhere but are booked in Ireland. This is necessary if we are to
understand properly their role in the Irish economy, even if it poses serious methodological
and practical challenges.
At the international level, improved data sharing across borders would be helpful across
many dimensions. In relation to production, a common understanding across jurisdictions
in relation to the global operations of multinational firms would improve the consistency of
national accounts. In relation to international finance, a full matrix of information linking the
ultimate owners of a financial asset and the ultimate obligors of the corresponding financial
liability would facilitate much more accurate assessments of international financial
exposures and international transmission channels.
It should be recognised that these aspirations collide with the current reality that statistics
are primarily collected under national laws, which make it difficult or impossible to share
granular data across borders for statistical purposes. Of course, this is just one
manifestation of the Rodrik political economy trilemma, whereby there is a tension between
international economic integration and the national nature of legislatures and politics.
The Macro-Financial Policy Framework and Globalisation
In the introduction, I outlined the monetary, financial and political economy trilemmas in
policymaking under economic and financial integration.
In thinking about the impact of globalisation on macro-financial dynamics, it is important to
recognise that the international mobility of capital, labour, finance, firms and technologies
can either amplify or dampen domestic shocks.
In relation to amplification, a boost to the domestic business environment can trigger a
larger output response than would be possible in a closed economy, since the prospect of
higher investment returns and higher wages draws in capital and labour from overseas. In
reverse, a negative shock may be amplified by capital outflows and net emigration. In terms
of cross-border financial integration, a domestic boom-bust cycle can be further amplified if
domestic residents take on extra foreign leverage during the upswing that in turn requires
additional deleveraging during the downturn.
In relation to dampening, firms can opt to extend overseas production or switch to imported
inputs if a boom triggers rising domestic cost pressures. In the other direction, if a recession
is associated with a decline in domestic costs, the end of the recession can be brought
forward by the entry of foreign firms and foreign capital that are attracted by the
improvement in the cost base. The dampening of the cycle is also facilitated by international
financial risk sharing, with domestic risks partly transferred to foreign investors through
direct ownership and portfolio equity claims and domestic residents holding diversified
foreign portfolios (Lane 2000a, Benetrix 2015).
Both amplification and dampening forces have been active in shaping Irish economic
performance. If we focus on the last fifteen years, the construction and lending booms were
clearly amplified by the pulling in of foreign funding, foreign inputs and foreign workers
during the 2004-2007 period. At the same time, the expansion in the export-orientated
sector (including the industries dominated by foreign multinationals) was restricted by the
adverse impact of a decline in competitiveness (Giavazzi and Spaventa 2011, Lane and Pels
2012, Benigno et al 2015). The sensitivity of traded-sector output to the real exchange rate
is especially high in an economy dependent on multinational firms, since the location and
reinvestment decisions of these firms provide extra margins of adjustment (Bradley and
Fitzgerald 1988). Another dampening factor was that foreign investors held a significant
share of the equity in domestic entities (including domestic banks), such that part of the
gains during the boom were distributed to foreign investors.
In turn, the intensity and severity of the crisis was amplified by the withdrawal of funding
from the domestic financial system, which was a central element in the playing out of the
crisis dynamics. However, the improvement in cost competitiveness as a result of the
downturn served to accelerate the recovery, with foreign multinationals best placed to take
advantage of a lower-cost business environment. More generally, the dual nature of the
Irish economy provided important stabilisation, with the multinational-dominated sectors
less affected by the contraction in domestic demand.
The decline in property prices and equity values (including bank shares) also triggered
significant asset sales to foreign investors, which contributed to the stabilisation and
recovery in asset markets. The severity of the crisis was also limited by the transfer of losses
to foreign investors who had taken risks during the boom period, both through their equity
investments in domestic entities and the significant decline in the value of the subordinated
debt instruments issued by Irish banks.
It follows that the relation between domestic shocks and globalisation is quite nuanced,
with both amplification and dampening mechanisms at work. Of course, globalisation also
means that the Irish economy is exposed to foreign shocks: even if the domestic
fundamentals are in good shape, it is still possible to experience positive or negative shocks
to the trend and cyclical components of output or to the financial cycle purely on the basis
of external developments.
Taken together, these characteristics mean that a globalised economy has the capacity to be
quite volatile, since it is exposed to both cyclical and trend shocks which are further subject
to an array of amplification and dampening mechanisms that may operate to different
timelines. Furthermore, this intrinsic volatility interacts with the difficulty of forming
reliable beliefs in such an environment, with the dynamics of expectations constituting
another mechanism driving macro-financial dynamics (Gennaioli and Shleifer 2018).4
It follows that the design of a stability-orientated macro-financial framework should seek to
weaken amplification mechanisms and reinforce dampening mechanisms in relation to
cyclical shocks. In terms of execution, this is especially tricky for volatile economies, since it
is typically difficult to tell apart trend shocks and cyclical shocks. For instance, if there is an
improvement in the underlying sustainable growth rate of the economy, a persistent
current account deficit can be desirable in terms of smoothing the funding of associated
investment and consumption patterns. In contrast, a current account surplus may be the
desired response to a transitory boost in output. The analytical importance of trend-cycle
decompositions means that data diagnostics and forecasting are primary functions in
policymaking, while exercising due humility given the intrinsic uncertainty involved in such
exercises.
In relation to cyclical shocks, the optimal fiscal response requires a counter-cyclical pattern
in the budgetary stance, anchored by a strong public financial balance sheet - a
combination of low gross public debt and a reserve stock of liquid financial assets - that is
robust to solvency risk even under stressed scenarios. In addition, fiscal policy can be
deployed at a microeconomic level. In particular, time-varying tax rates on consumption and
investment can replicate some properties of national-level exchange rate and interest rate
policies by altering the intra-temporal and intertemporal terms of trade.
While Ireland achieved small headline budget surpluses during the boom period, the
underlying budget balance was much less healthy, given the reliance on construction-
intensive tax revenues (Lane 2010). The scale of the boom was such that significantly more
positive budget surpluses were warranted, with the deterioration in fiscal discipline towards
the end of the boom period especially unfortunate. In 2007, the fiscal surplus in Ireland was
just 0.2 percent of GDP, whereas it was 5.1 percent in Finland, 5 percent in Denmark, 3.3
percent in Sweden and 2 percent in Spain.
Through the introduction of national fiscal responsibility laws and independent fiscal councils
(together with the operation of the EU-level Stability and Growth Pact), the revised
institutional environment for the conduct of fiscal policy is intended to support the long-term
fiscal discipline that is required if the cyclical component of fiscal policy is to be deployed in a
stabilising manner. At the same time, these frameworks can only play a supporting role: the
path for fiscal policy is ultimately determined by the decisions of the political system.
In relation to macroprudential policy, the counter-cyclical capital buffer (CCyB) is intended
to limit the amplification of downturns through the accumulation of additional capital by
banks during cyclically-strong periods. In the event of an adverse cyclical shock, this capital
buffer can be released, thereby mitigating the damaging pro-cyclical withdrawal of credit
supply under adverse conditions. In order to be effective in building resilience, it is essential
that the CCyB is activated sufficiently early during upswings in the financial cycle (Lozej and
O'Brien 2018, O'Brien et al 2018). Otherwise, there is a risk that the CCyB is activated too
late, especially taking into account the one-year lead-time in its implementation. Given the
lack of historical evidence in relation to novel instruments such as the CCyB, the calibration
of such buffers benefits from the insights of macroeconomic models that enable simulations
of alternative rules (Clancy and Merola 2016, 2017).
In relation to new mortgage lending, borrower-based measures that impose (flexible)
ceilings on loan-to-income (LTI) and loan-to-value (LTV) ratios have built-in features that
limit pro-cyclical dynamics. In the absence of such ceilings, cyclically-strong economic
conditions might otherwise drive mortgage market dynamics towards more aggressive LTI
and LTV ratios due to upward revisions (by lenders and borrowers) in projections of future
levels of house prices and incomes. In addition, by limiting the risks of over-borrowing by
households and over-lending by banks, household and bank balance sheets should be more
resilient in the event of a future downturn.
More generally, the resilience of the financial system is dependent on its structural
soundness (Lane 2013). If financial institutions are well capitalised and hold sufficient
liquidity buffers, the system can more easily absorb cyclical shocks. Resilience is also
boosted by a supportive institutional environment. For instance, a legal system that has the
capability to facilitate the restructuring of non-performing loans and the cleaning up of
insolvencies limits the risk that cyclical downturns mutate into phases of persistent
underperformance. Equally, a structurally-robust financial system is stabilising for the real
economy by avoiding pro-cyclical fluctuations in credit availability.
So far, I have primarily focused on fiscal and macroprudential policies. How should we think
about the role of the currency system in addressing the implications of globalisation for
macro-financial stability? The obvious starting point is the monetary trilemma: financial
integration calls for a choice between a stable exchange rate and an independent monetary
policy. In Europe, the monetary union provides a unique option: the sharing of monetary
autonomy among the member countries through the elimination of national currencies,
with the external value of the euro fluctuating against the rest of the world.5 This
arrangement facilitates the potential gains from financial integration, while the elimination
of intra-area currency volatility supports the durability of the Single Market by ruling out
politically-divisive nominal exchange rate adjustments (Dornbusch 2003).
A shared currency is especially effective in managing common cyclical shocks, since the
single monetary policy works in the same direction for all member countries (Lane 2000b).
The elimination of national currencies also limits the scope for financial shocks to drive
macroeconomic outcomes, even if country-specific financial speculation is still possible
through sovereign bond and bank funding markets. Moreover, the potential stabilising role
of country-specific exchange rate adjustment can be overstated, especially if one takes into
account the balance sheet, wealth and political economy effects associated with currency
movements (Lane and Stracca 2018).
In related manner, it is open to question whether an independent interest rate policy is
necessarily stabilising for small, open economies under a high degree of financial integration
(Bruno and Shin 2015, Lane 2015, Lane 2018). For instance, a positive interest rate
differential may induce an increase in foreign-currency borrowing, while currency
appreciation may encourage extra risk taking by increasing the collateral value of local-
currency assets.
Finally, a fundamental difference between a currency union and a system of fixed exchange
rates is the operation of the common central banking liquidity facility. During the crisis,
cross-border central bank liquidity flows were extremely high, acting to cushion the impact
of private capital flight (Gros and Alcidi 2013, Lane 2013, Fagan and McNelis 2013, Whelan
2014, Lane 2015). More generally, the existence of a common liquidity facility acts as a
deterrent to speculative attacks, with market traders aware that the common central bank
can replace run-induced withdrawals of liquidity.
While the crisis dramatically exposed the institutional weaknesses in the original design of
the euro, the reforms that have been introduced in response to the crisis has strengthened
the common currency along a number of dimensions. First, the European Stability
Mechanism stabilises sovereign debt markets by providing an official funding reserve option
(subject to conditionality). Second, the ECB's Outright Monetary Transactions (OMT)
programme has clarified the commitment of the ECB to rule out redenomination risk for
countries that demonstrate commitment to fiscal solvency. Third, the development of a
common supervisory approach to financial regulation - which is hardwired in banking
through the Single Supervisory Mechanism - serves to reduce the risk of national policy
errors in the oversight of the financial system. Fourth, the introduction of improved
recovery and resolution frameworks (including the operation of the Single Resolution
Mechanism) helps to reduce the risk that individual bank failures trigger a system-wide
crisis. Fifth, the activation of national macroprudential policy frameworks (typically absent
or weak before the crisis) is necessary to mitigate cyclical financial risks. Sixth, the
strengthening of the European fiscal framework is a necessary precondition for greater
cross-border integration, in view of the close relationship between fiscal stability and
financial stability.
Looking to the future, the completion of banking union and capital markets union can further
help to mitigate national macroeconomic shocks. First, banking union and capital markets
union may facilitate more diversified international ownership of bank equity and contingent
debt instruments, such that the costs of distressed banks are not solely concentrated in the
domestic economy. Second, banking union may lead to more geographi