Lucas Papademos: Globalisation and central bank policies
Speech by Mr Lucas Papademos, Vice President of the European Central Bank, at the
Bridge Forum Dialogue, Luxembourg, 22 January 2008.
* * *
I. Introduction
For years now, globalisation has been, and continues to be, a buzzword in the public debate.
Its persistent significance is certainly also due to the fact that it is such a multi-faceted
phenomenon which has yet to be fully understood and assessed. Globalisation
encompasses a broad range of aspects - economic, social, political, cultural and intellectual
- and many of these are of relevance to public policy. Even though public discourse often
focuses on the economic consequences of globalisation - the integration of markets and its
associated distributional effects - globalisation is about more than the free exchange of
goods, services and capital on global markets. It is also about an unprecedented opportunity
to exchange knowledge and ideas across the globe. And the Bridge Forum Dialogue here in
Luxembourg provides an excellent platform to see this intellectual facet of globalisation in
action. I should like to thank Governor Mersch, the President of the Forum, for having invited
me, and I am looking forward to an enriching debate with my fellow panellists and the
audience on the theme of this year's event: "Globalisation: how to manage it?"
Exploiting my professional comparative advantage, I will elaborate on the central bank
perspective. In my remarks, I intend to address three aspects of globalisation and their
potential impact on central bank policies:
•
First, I will discuss to what extent globalisation may affect the conduct and
effectiveness of monetary policy in controlling inflation and influencing domestic
economic activity. Or: does globalisation alter the job of a central bank, and if so,
how?
• Second, I will explore the impact of globalisation on the functioning of financial
markets, which is of course a particularly pertinent issue during the ongoing financial
market turmoil, and its potential implications for financial stability. Or: did we sow the
wind of financial globalisation, only to reap the whirlwind of market turbulence?
•
Third, I will briefly seek to shed some light on links between monetary policy and
financial stability, and how globalisation may affect this interrelation. Or: did past
central bank policies worldwide play a part in building up imbalances in global
financial markets whose correction and unwinding we are witnessing at present?
II. Globalisation and monetary policy
In recent years, it has been argued that globalisation has had - or is likely to have -
significant implications for the conduct and effectiveness of monetary policy in controlling
inflation and influencing domestic economic activity. It has been suggested by some that the
effectiveness of monetary policy could be impaired as a consequence of the impact of
globalisation on the structure and functioning of markets - product, labour and financial
markets - which would affect - and in the extreme disrupt - important channels of the
transmission mechanism of monetary policy. Various effects have been discussed and
analysed, and a number of empirical studies have attempted to estimate their quantitative
significance. Simply put, globalisation could undermine the effectiveness of monetary policy
as a result of its impact on both domestic aggregate demand and aggregate supply. The
channels through which monetary policy influences aggregate demand could be impaired if
domestic interest rates and domestic aggregate demand are increasingly determined by
global factors rather than domestic monetary policy. On the supply side, globalisation could
affect inflation dynamics in various ways, notably by reducing the responsiveness of
domestic inflation to domestic firms' marginal cost increases, by making "global economic
slack" rather than the domestic output gap an important determinant of domestic inflation
pressure, and possibly by influencing the trend rate of change in the terms of trade.
Effects of globalisation on aggregate demand
With regard to the influence of globalisation on domestic aggregate demand, two arguments
have been advanced. First, in a financially integrated world it has been argued that it is
global monetary liquidity rather than domestic liquidity which affects domestic interest rates
and domestic economic activity, mainly - though not exclusively - through its effects on
liquidity premia. Second, it has been claimed that the level of longer-term domestic real
interest rates is likely to be determined by global savings and investment rather than its
national components. These influences can be expected to be more pronounced for smaller
economies. Therefore, a smaller country which cannot affect the global supply of liquidity to
any significant degree could then lose effective control of inflation. This reasoning, however,
is dubious, and not supported by theory or confirmed by empirical evidence. For example, in
a two-country new Keynesian model, it has been shown that, provided exchange rates are
flexible, global monetary factors can affect the domestic price level only through their
potential short-term effects on global output.1 Interestingly, the sign of the spill-over effect is
the opposite of what would be expected from the global liquidity hypothesis. A comparatively
loose foreign monetary policy induces a depreciation of the foreign currency and has a
negative impact on domestic demand and prices in the home country. The main conclusion
of rigorous theoretical analysis is that monetary policy can affect domestic demand even in a
fully financially integrated world and even in a small country, as long as exchange rates are
flexible. The exchange rate channel plays a more prominent role than the interest rate
channel in the monetary transmission mechanism, to an extent which depends on the
relative size of a country and the degree of financial market integration. This result is fully
consistent with basic economic theory. Thus, the ability of central banks to control price
developments over the medium term by influencing aggregate demand is not undermined,
although the role and relative importance of different transmission channels might be
affected by increasing global financial integration.
What is the empirical evidence about the potential impact of globalisation on this channel of
the monetary transmission mechanism? It is theoretically plausible that globalisation can
influence to a certain extent key determinants of long-term interest rates, such as the global
riskless real interest rate and the real risk premium.2 Moreover, inflation expectations and the
inflation risk premium may also have been influenced to some degree by the forces of
globalisation, though monetary policy across the globe has certainly been the main factor.
There is some empirical evidence that in the euro area, as well as in a broader sample of
OECD countries, long-term rates are reacting less to changes in short-term rates than they
used to.3 Global factors seem to be increasingly important in determining national real bond
yields.4 Furthermore, the co-movement of US, German and Japanese bond yields has been
exceptionally high over the past few years.5 My interpretation of these findings is that,
although global forces have played an important role in determining domestic long-term
interest rates, they do not provide sufficient evidence to conclude that the effectiveness of
monetary policy in controlling inflation has been reduced. The increased significance of
global factors identified by empirical analysis is likely to reflect common trends as well as the
similar orientation of monetary policies and their success in containing inflationary pressures.
If national monetary policies diverge from such a common orientation, which itself has been
fostered by increasing competition between currencies,6 the observed regularities are likely
to be affected. A central bank is still able to influence aggregate demand and preserve price
stability under floating exchange rates.
Effects of globalisation on aggregate supply
Let me now turn to the effects of globalisation on the aggregate supply and on the dynamics
of inflation. Several effects have been identified or suggested, some of which are relatively
direct and others indirect. Globalisation can affect inflation dynamics through various
channels: (1) by influencing the responsiveness of wages and prices to measures of
domestic slack in the labour and product markets (that is, by affecting the slope of the
shortterm Phillips curve and the sensitivity of profit margins to cyclical factors); (2) by affecting
trend productivity growth; and (3) by causing shifts in the "natural rate of unemployment" or
NAIRU; (4) by making a measure of "global economic slack" an important determinant of
domestic inflationary pressure; and (5), more directly, by affecting the trend rates of change
of the relative prices of imported final goods, intermediate products and commodities. It is
important to keep in mind the various channels and potential effects because their impact
can be offsetting, and also because theoretical arguments and empirical analyse often focus
only on some of the potential channels, thus providing a partial picture. I will elaborate on
some of these effects and the empirical evidence for the euro area.
Economic theory does not provide unambiguous conclusions about the impact of
globalisation on the slope of the short-term Phillips curve, that is, on the responsiveness of
domestic inflation to measures of domestic economic slack, e.g. the output gap and/or the
deviation of unemployment from its natural rate. Arguments can be advanced - and have
been advanced - that imply that globalisation would tend to make the Phillips curve flatter7 or
steeper.8 Kenneth Rogoff has agued that inflation becomes more responsive to domestic
excess demand if price rigidities are reduced and the economy becomes more flexible as a
result of increased competitive pressure induced by globalisation.
The proposition that a measure of "global economic slack" rather than the domestic output
gap is a more important determinant of domestic inflation pressure has been discussed
extensively. This hypothesis, if valid, would imply that the slope of the short-term Phillips
curve, which depicts the responsiveness of inflation to domestic excess demand, becomes
flatter.9 Thus, in a globalised world - so it has been argued - a much stronger monetary
policy response would be required, other things being equal, to preserve price stability over
the medium term in the presence of adverse shocks. But also in this regard there exists no
robust empirical evidence or solid and convincing theoretical foundation to support the claim
that a structural change has taken place.10 Empirical estimates for the euro area do not show
a significant change in the slope of the short-term Phillips curve. Furthermore, it would be
misleading to interpret the recently observed low correlation between domestic output gaps
and domestic inflation in some countries as a structural change in the short-term Phillips
curves. A reduced correlation - or even a lack of it - could simply be a consequence of the
effective monetary policies of central banks which have succeeded in anchoring inflation
expectations to price stability.11
Direct effect of globalisation on domestic inflation
The two more direct effects of globalisation on world and domestic inflation dynamics have
been more visible but have partly offset each other, and the relative impact may be changing
over time. On the one hand, raw materials and basic commodities, notably oil and other
sources of energy, have become scarcer relative to world demand, leading to substantial
upward pressure on prices. [see Chart 1] For example, Brent crude oil prices have increased
almost tenfold over the last nine years, reflecting to a very large extent the impact of rising
demand, especially in emerging market economies [see Chart 2], although supply-side
factors have also played a role during some periods. On the other hand, the integration of a
large reserve of low-cost, skilled labour in the international economy and the increasing
production of manufactured goods in emerging market economies have put downward
pressure on import prices of manufactured goods as well as on wage demands in industrial
economies. As a consequence, the prices of a wide range of manufactured goods have been
declining since 2000. This is reflected in the unit value of imports of manufactured products
in the euro area, which in mid-2007 was virtually at the same level as in 2000. [see Chart 3]
The counteracting effects of these global price pressures on euro area inflation can be
observed more clearly if we take a look at the development of the overall Harmonised Index
of Consumer Prices (HICP) and selected components (energy and non-energy industrial
goods). [see Chart 4] The prices paid by consumers for energy products, which account for
approximately 9% of euro area private consumption, surged at an average rate of 5.4% per
annum following the series of sharp oil price increases over the period 1999-2007. But, the
prices of other consumer goods, such as non-energy industrial goods, which account for over
30% of total private consumption, increased at a more moderate rate of 0.7% per annum on
average during the same period.
In an environment of significant and persistent changes in the relative prices of energy goods
and agricultural products, the price increases of these goods, which are comparatively more
visible to consumers than the relatively more stable prices of many other consumer goods,
may, therefore, adversely affect inflation expectations. Consequently, it is crucial for
monetary policy to anchor inflation expectations to price stability, and to ensure that
secondround effects of increases in energy prices and other commodity prices on price and
wagesetting do not materialise.
All in all, the empirical evidence on how globalisation has directly affected consumer price
inflation in the advanced economies reveals a rather muted impact. Inflation in the euro area
is likely to have been 0.0-0.3 percentage points lower per annum as a result of the net impact
of the inflation-dampening effect of non-commodity import prices and the
inflationaugmenting effect of commodity import prices over the past decade.12 The two effects are
linked and have partly offset each other as they reflect the impact of emerging market
economies on the prices of manufactured goods and world commodity prices. The size and
sign of the net impact on the inflation of advanced economies in the future are surrounded by
uncertainty, and are likely to change as globalisation unfolds.
Impact on monetary policy strategies
Do central banks need to adapt their monetary policy strategies to cope with the challenges
of globalisation? It has been shown that the rationale for maintaining price stability - the
primary objective of the ECB and of many other major central banks - is strengthened by
financial globalisation for at least two reasons. First, if international risk-sharing loosens the
link between domestic consumption and domestic output, optimal monetary policy would
tend to increase the relative weight on price stability at the expense of output variability, as it
is real consumption which ultimately matters for social welfare. Second, the
welfaremaximising weight to be attributed to price stability also increases when international
risksharing is obtained by means of cross-border holdings of nominal assets (e.g. non-inflation
indexed bonds), as inflation would seriously distort effective risk-sharing. These interesting
arguments bring me to the second part of my presentation on the potential implications of
globalisation for financial stability.
III. Globalisation and financial stability
Let me now focus on the effects of globalisation on the functioning of financial markets and
institutions and the potential implications of these effects for the performance of the central
bank task of safeguarding financial stability. This issue is both important and topical as the
pace of global financial integration has accelerated in recent years and as the ongoing
financial market turmoil has clearly demonstrated. Financial globalisation involves the
increasing integration of financial markets and the growing presence of cross-border financial
institutions. Financial globalisation is often defined and measured by the extent to which
countries are linked through cross-border financial holdings. A commonly used indicator of
financial globalisation is the sum of countries' gross foreign assets and liabilities as a
proportion of GDP. The evolution of this indicator documents the impressive dynamics of
financial globalisation since the mid-1990s, especially for advanced economies (and to a
lesser extent for emerging markets and developing countries). [see Chart 5]. In the euro area
alone, the ratio of the sum of foreign assets and liabilities to GDP increased from 190% in
1999, the year the euro was launched, to 280% in 2005. It is also impressive and relevant
that the pace of financial integration for advanced economies was much faster than that of
their trade integration from the early 1990s onwards. This is evidenced by the ratio of the
sum of external assets and liabilities to the sum of exports and imports [see Chart 6].
Interestingly, this same ratio has been roughly stable for emerging market economies and
developing countries over the same period. Finally, another pertinent indicator measures the
extent and rapidly growing importance of the total cross-border bank assets and liabilities
since the early 1990s, which increased fivefold from about 5 trillion US dollars in 1990 to
almost 25 trillion US dollars in 2006. [Chart 7].
Globalisation and the development of financial markets
The fast pace of financial globalisation has reflected, and at the same time has contributed
to, the rapid development of financial markets. Both financial integration and development
have been driven by several factors: deregulation, capital liberalisation, financial innovation
and advances in communication and information technology. These factors have contributed,
in a mutually reinforcing manner, to the exceptional growth of the overall size of financial
markets relative to GDP [Chart 8] and the consolidation of the banking sector, with the
emergence of large and complex financial institutions. They have also contributed to the
exponential growth of new financial instruments, the adoption by banks of the "originate and
distribute" business model and the increasing presence of new financial intermediaries. In
addition, the distribution of net saving flows across the globe, with large excess saving
(relative to domestic investment opportunities) in some emerging market economies
searching for higher global investment returns also contributed to the fast pace of financial
globalisation and development in recent years. When examining and assessing the effects of
globalisation on the financial system - its efficiency and stability - it is important to keep in
mind the role of the other factors, e.g. financial innovation, new business models, risk
management practices, which have simultaneously exerted a significant impact on the
functioning of financial markets and institutions.
The securitisation of bank loans and the development of credit risk transfer (CRT)
instruments and complex structured finance products have fundamentally changed the
functioning of the financial system and the distribution of risk across sectors and borders.
Since the mid-1980s, an unprecedented growth in the development and issuance of new
financial market instruments has allowed the transfer of risks across market participants also
in connection with previously relatively illiquid assets like bank loans and mortgages. While
initially the focus was on transferring market risk, credit risk transfer instruments have
increasingly gained in importance since the 1990s.13 With respect to securitisation, this
development can best be described by pointing out that the outstanding value of US agency
mortgage-backed securities grew from about 100 billion US dollars in 1980 to about 4 trillion
dollars in 2006 [Chart 9]. Annual securitisation is about 3 trillion US dollars a year in the US
and about 500 billion euro in Europe. In both areas, mortgage-backed securities account for
the bulk of the total. With respect to credit risk transfer instruments, the increase in the
notional value of global credit default swaps has been phenomenal, from 90 billion US dollars
in 2001 to 34 trillion US dollars in 2006. Over the same period, the share of credit default
swaps in the overall derivatives market increased from 1 to 11% [Chart 10]. Collateralised
debt obligations (CDOs) are another major type of security used to transfer credit risk. The
global issuance of CDOs more than tripled between 2004 and 2006 [Chart 10]. One
prominent feature of the development of the financial system is that it has become much
more "leveraged", as indicated by the ratio of total monetary and financial assets relative to
the monetary base (central bank money).
Financial globalisation and economic growth
What have been the effects of financial globalisation and development on the efficiency and
stability of the financial system, on trend economic growth and on output and financial market
volatility? Let me first examine the impact on efficiency, growth and output volatility. The
available empirical evidence supports the view that the development of the financial sector,
as measured by financial market size and other indicators of its features and sophistication,
has had positive effects on the efficient functioning of product markets and has fostered (total
factor) productivity gains and output growth.14 The evidence on the impact of financial
globalisation on economic growth is not as conclusive or sufficiently robust.15 This partly
reflects the fact that the impact is conditional on the macroeconomic policies pursued as well
on the institutional and regulatory framework in place, which makes it difficult to isolate
empirically and estimate its net contribution. Moreover, the impact of financial globalisation
on growth may take some time to become visible as it exerts its influence through various
channels, some of which involve indirect effects. Indeed, a new approach which emphasises
the indirect effects of financial globalisation growth by promoting the development of the
financial sector, by strengthening competition and by enhancing market discipline on
macroeconomic policies suggests that the total impact on growth of financial globalisation
through these indirect effects can be significant. In particular, for advanced economies their
integration into global financial markets fosters (total factor) productivity growth and improves
risk-sharing. Moreover, there is some evidence that financially integrated economies can
absorb shocks - and can tolerate a higher level of volatility - without this volatility having an
adverse effect on growth.16
Globalisation and the volatility and liquidity of financial markets
An important issue for financial system stability is whether financial globalisation has been -
or can be- a key factor in reducing volatility and increasing liquidity in financial markets. Over
a number of years, before the current financial market turmoil, global financial markets were
characterised by abundant liquidity which had indeed reached unprecedented levels.
Financial market liquidity, a concept distinct from monetary liquidity, is a measure of the
ability of market participants to undertake transactions without triggering large changes in
asset prices. The abundant financial market liquidity over the period 2003 until the summer of
2007 was associated with very low market volatility, especially in equity and bond markets
[chart 11], low risk aversion [chart 12], low corporate bond yield spreads [chart 13] and credit
spreads, high leverage and high market turnover. It also reflected the "search for yield" and
confidence in the smooth functioning of the market. A composite indicator of financial market
liquidity in the euro area equity, bond, credit and foreign exchange markets,17 constructed at
the ECB [chart 14] shows that financial market liquidity had increased significantly since
2001, rose sharply in 2003 and 2004 and remained at high level until the summer of 2007. A
similar indicator constructed by the Bank of England for the UK financial market highlights
the global dimension of this phenomenon and a similar trend. It has been argued by some
that increasing financial market integration -the liberalisation of international capital flows-
was a key determinant of this increase in market liquidity and the associated decline in
market volatility. But a more careful analysis shows that other factors played an important
role, such as the rapid growth of new financial instruments, the increasing presence of very
active and highly leveraged financial market participants. Moreover, ample market liquidity
also reflected an increase in risk appetite and a rise in leverage. And the recent market
developments showed that an abrupt and sizeable increase in risk aversion caused an
evaporation of liquidity in many markets and a rise in market volatility. Therefore, although
financial globalisation can play a role in containing market volatility, it cannot be expected to
have a dominant and permanent impact.
Impact on financial stability - the financial market turmoil
What are the broader potential implications of financial globalisation for the stability of
financial systems? How are real and financial shocks likely to propagate across borders and
asset classes in a financially integrated world? On the one hand, there is obviously an
augmented risk of cross-border contagion of asymmetric shocks to the rest of the world if
cross-border asset holding is widespread. On the other hand, this risk has to be weighed
against the positive side of the very same coin, which is the benefit gained from an increase
in international risk-sharing by means of diversification. The resilience of financial asset
prices to negative shocks is improved when the market is more liquid and the investor base
more heterogeneous. On balance, despite the ongoing financial turmoil, I would argue that
financial integration has had a stabilising influence on the global financial system for the
reasons just mentioned.18 If, however, risk assessment and management is inadequate,
asset valuation is difficult and highly uncertain, and incentives are distorted, the risks to
financial stability could increase.
The current financial turmoil provides a clear example of how a shock to a relatively small
segment of a national financial market can spread globally across borders and across other
markets. As early as 2005, US sub-prime loan delinquencies started to rise. Consequently
the value of credit products based on sub-prime mortgages rated lower than AA started
falling. But it was not until two hedge funds from Bear Stearns with active exposure in the
sub-prime market had almost lost all their capital by June 2007 and when some rating
agencies in early July announced that they would downgrade many asset-backed securities
(ABSs) and collateralised debt obligations (CDOs) that a significant reassessment of the
expected returns of structured finance products took place and AA and AAA-rated
assetbacked securities (or ABS) also started falling in value. The following general re-pricing of
risk [see Chart 15] and tensions in credit markets (e.g. also the corporate bond market) now
affected several countries other than the US (e.g. the corporate bond markets in the US and
Europe). Financial market liquidity for most structured credit products started evaporating
[Chart 16]. Equity markets have also been affected by the increase in risk aversion and a
general flight to quality.19 As a consequence of inadequate risk management, and in
particular liquidity risk management, the interbank money market came under pressure. Due
to the complexity of pricing structured credit products and the lack of transparency of banks'
exposures to investment vehicles heavily in need of refinancing their ABS investments
(which, at that time, were more or less fully illiquid), an adverse selection problem in the
interbank market led to concerns about systemic risk. Banks were reluctant to lend to each
other because of concerns about the counterparty's exposure to sub-prime related assets
and also uncertainty about their own liquidity needs. In August 2007, interest rates in the
unsecured money market started to rise significantly above the policy rates, also for very
short-term maturities. Indicators of financial market liquidity, in a number of markets, declined
dramatically.
Since August 2007, the ECB has launched a series of market operations aimed to address
pressures in the money market, to ensure that very short-term money market rates remain
close to the ECB's policy rates and thus to contain spill-over effects to the financial system
and the real economy. These operations have succeeding in stabilising the very short-term
interbank rate and reduced tensions in the long-term money market. Because money market
pressures had remained at elevated levels globally until December [Chart 17], a global
response was called for, in the form of a joint action of major central banks in the advanced
economies, including the ECB, to provide US dollar liquidity to financial institutions also
outside the US. Overall, the central bank operations have had a positive impact on money
markets worldwide and contributed to mitigating the effects of the turmoil on the financial
system and the economy. However, persisting uncertainty in financial markets - which these
actions cannot address, and were not intended to address - imply that pressures in the
longer-term money market remain, although at significantly reduced level since December
2007. The European Central Bank continues to stand ready to act in a swift and decisive
manner in order to ensure the orderly functioning of money markets.]
Causes of the financial market turmoil
What have been the underlying main causes of the financial market turmoil? What have been
the key weaknesses in the functioning of the financial system that have been revealed? And
what are the appropriate further responses of market participants and policy-makers? A full
diagnosis of the causes and weaknesses is not yet complete and, indeed, not possible as the
market adjustment is still ongoing. Nevertheless, I would like to highlight four areas that are
also pertinent to the issues of financial integration and development we are discussing.
• First, the underlying causes and triggers are to be found in the price dynamics of the
US housing market and the excesses and shortcomings (in the practices) in the US
sub-prime mortgage market. So, a main determining factor of the financial market
turbulence is that same one - property price overvaluation - that characterised
previous episodes, as emphasised by Kenneth Rogoff.
• Second, weaknesses in the functioning of the market for structured finance
products. These included valuation uncertainties due to the complexity of many
products, the imperfect information available about the underlying asset
characteristics, inadequate appreciation by investors of the embedded risks, and
excessive reliance on the ratings of such products by credit rating agencies.
• Third, weaknesses in the implementation of the "originate-and-distribute" model by
banks and in the chain of distribution and acquisition of credit risks. These
shortcomings included inappropriate incentive structures for banks, as well as other
financial entities and agents in the securitisation process, which fostered moral
hazard and contributed to the inadequate assessment and management of credit
and funding-liquidity risk.
•
Fourth, the role and features of new financial entities - the off-balance sheet
conduits and structured investment vehicles (SIVs) - which were linked to banks
through management and financing, and played a key role in the transmission of
tensions from the structured finance product markets to the money markets, as a
result of the maturity mismatch on their balance sheets and the associated funding
liquidity risk. The creation of these investment vehicles and the associated
substantial off-balance sheet exposures of banks to the structured credit products
was the unin