Lucas Papademos: The effects of globalisation on inflation, liquidity and
monetary policy
Speech by Mr Lucas Papademos, Vice President of the European Central Bank, at the conference on
the "International Dimensions of Monetary Policy" organised by the National Bureau of Economic
Research, S'Agaró, Girona, 11 June 2007.
* * *
I. Introduction
My remarks tonight focus on "the effects of globalisation on inflation, liquidity and monetary policy".
This subject has received increasing attention among academic economists and policy-makers over
the past two years. Indeed, a number of distinguished participants in this conference have contributed
to the ongoing analysis and public debate on this topic. I have observed, however, relatively less
emphasis so far on the impact of globalisation on liquidity and the related implications for monetary
policy and financial stability. For this reason, I will also devote some time on these aspects.
It might be interesting to recall that a number of pertinent issues, which I will also address, were
already very topical more than 400 years ago, in 16th century Spain. As a consequence of what,
undoubtedly, was one of the first and most impressive periods of globalisation - benefiting Catalonia,
however, only 200 years later1 - significant effects on inflation were observed. Of course, I refer to the
Spanish discovery of the Americas and the large influx of gold and silver from the New World. The
resulting rise in inflation in Spain quickly spread to Western Europe as a whole.2 One is thus tempted
to talk about the first evidence of global excess liquidity driving global inflation trends. Economic
historians have labelled that inflationary period a "price revolution".3 Then, as now, there was
academic debate, beginning as early as the 16th century, on whether inflation was due to excess
liquidity or rather diminishing domestic economic slack linked to urbanisation and income growth.4
And, I am sure, it was no coincidence that the quantity theory of money was invented by scholars of
the School of Salamanca who were inspired by the price revolution period in 16th century Spain.5
Even the potential links between globalisation, the flattening of the Phillips-curve and the growing
importance of global economic slack were issues already debated at that time. Historians tell us that
urbanisation also contributed to increased trade between Europe's regions, which made prices more
responsive to distant changes in demand. Another topical issue I will elaborate on - the link between
global excess liquidity and financial stability - also has its roots in 16th century Spain. Rising inflation
and the dependency on gold and silver imports are mentioned as causes of multiple bankruptcies and
economic crashes.6
Following the agenda set by the 16th century globalisation episode, my speech is divided into two
main parts. The first part deals with the effects of globalisation on inflation dynamics and price stability
from a monetary policy perspective. I will elaborate on the likely impact on product and labour markets
as well as the impact on monetary aggregates and financial markets. In the second part, I will reflect
on the link between globalisation and financial stability again focusing on the role of central banks. In
this context, I will point to the risks associated with global imbalances and asset price boom-and-bust
cycles. I will conclude by addressing two pertinent questions, namely (i) whether central banks need to
adapt their monetary policy strategies in order to cope with the challenges of globalisation; and
(ii) whether monetary policy has become less effective as a consequence of globalisation.
As I have already mentioned the term globalisation a number of times, and many more references will
follow, let me briefly define it in fairly broad terms: it is the process of rapidly increasing global
economic integration. Over the past decade, this process involved, and is evidenced by, the
unprecedented and pervasive growth in the cross-border trade of goods and services as well as of
financial and real assets, but it also involves the swift transfer of technologies, information and ideas.
II. Globalisation, price stability and monetary policy
II.1. Impact of globalisation on product and labour markets
Let me start by briefly reviewing both the theoretical arguments and the empirical evidence pertaining
to the effects of globalisation on product and labour markets. It would be too easy to dismiss any
inflationary effects stemming from globalisation with the argument that its impact will essentially and
ultimately result in a change in relative prices and that, ceteris paribus, the overall rate of inflation
should not be affected. Firstly, integration is not a one-off event. Steadily rising integration could
potentially lead to steadily falling unit labour costs and, ceteris paribus, to protracted periods of lower
inflation. Secondly, a higher degree of openness, and thus increased competition could lead to
permanently higher productivity growth and, again other things being equal, to lower inflation. Thirdly,
globalisation could affect other aspects of the inflation process and the conduct of monetary policy: the
slope of the Phillips-curve, the wedge between the "socially optimal" and the "natural" or "potential"
output level, the "natural rate of unemployment" or NAIRU and even the relative emphasis placed on
preserving price stability by the central bank when formulating monetary policy. Thus, globalisation
could eventually affect the inflationary impact of supply shocks and, more generally, inflation dynamics
and the size of the "inflation bias" in the economy.7
Many economists and policy-makers have examined the effects of globalisation on one or several of
these factors and processes, partly in order to better understand or explain the recent period of low
inflation. Interestingly, sometimes the theoretical arguments and empirical findings point in opposite
directions: Some have argued that increasing global competition will tend to impinge on domestic
monopolistic structures and reduce economic distortions.8 Furthermore, the slope of the short-term
Phillips-curve would increase in the short run as national economies would become more flexible.
These two propositions and implied parameter changes imply a permanent reduction in the "inflation
bias". Others have argued instead that the slope of the Phillips-curve should become flatter.9 This
reasoning is based on a variety of potential channels: an increased degree of openness reduces the
responsiveness of inflation to domestic slack, profit margins become more variable under competitive
pressure and wage developments that are influenced by the threat of outsourcing jobs and labour
immigration. There are other factors, however, which potentially could flatten the slope of the
Phillipscurve - the underlying, structural slope or the estimated, effectively observed slope - and which are
not necessarily linked to globalisation: for example, inflation expectations that are well-anchored to
price stability and less frequent price updates of firms in a low-inflation environment.
Alternative or complementary propositions have also been advanced. It has been argued that the
whole debate about the slope of the short-term Phillips-curve is not particularly relevant, if at all.10 In a
highly globalised economic environment, lower inflation could simply be due to a decline in the "natural
rate of unemployment" or NAIRU. Importantly, Assaf Razin, among others, has recently shown how
the degree of trade and financial integration might both flatten the slope of the short-term
Phillipscurve and raise the optimal weight to be placed on the central bank's inflation objective, when
monetary policy maximises consumer preferences.11 This would lead to the conduct of a more
aggressive (optimal) monetary policy in the presence of supply shocks.12
Not surprisingly, this debate has triggered a series of empiried studies trying to shed more light on the
issue. I will focus on evidence for the euro area. In a recent and often-cited BIS paper, Claudio Borio
and Andrew Filardo13 argue that short-term Phillips-curves have become flatter across countries and
that measures of global economic slack have become more important than of domestic slack in
explaining domestic inflation. Their own results, however, show that this is not the case in the euro
area. Moreover, unpublished research at the ECB does not reveal any statistically significant structural
breaks with respect to the slope of the euro area Phillips-curve or any decline in the estimated
coefficient over time. Other evidence regarding a possible change in the slope of the short-term
Phillips-curve in the euro area is also very mixed, especially with regard to the potential effect of
14
increased openness on the slope. The failure to capture econometrically significant globalisation
effects could, of course, be due to the relatively recent nature of certain aspects of this phenomenon
and the impact of other factors that might have had relatively greater influence on inflation dynamics
during the past ten years. For this reason, the potential effects of globalisation on inflation dynamics,
through its influence on behavioural or structural features of the labour and product markets, deserves
close monitoring and further analysis.
The policy relevance of this debate is further complicated by the fact that even if future empirical
studies would confirm a significant drop in the responsiveness of inflation to domestic slack in
Phillipscurve equations, it is not at all clear whether this should be interpreted as a flattening of the aggregate
supply curve in the short term. Such "reduced form" evidence can be observationally equivalent to the
evidence that could result from an unchanged structural relationship in an economy where the central
bank has been successful in reducing inflation and output volatility, which would correspondingly
reduce or could even eliminate the empirical correlation between inflation and the output gap.15 For
this reason, economists and policy-makers have to be particularly careful when using simple reduced
form estimated Phillips-curve equations to calculate the NAIRU and then employ the estimated value
as a benchmark for assessing inflationary pressure.
There are two lessons I derive from this review of theory and evidence. First, there is no consensus at
a theoretical level on the relative importance of the various potential effects of globalisation on the
inflation process through this channel. Second, the available empirical results provide no clear
message either, except that, so far, there is not much evidence to support the view that globalisation
has resulted in a flatter Phillips-curve, particularly in the euro area. This situation is, of course, not very
comforting for a central banker. The good news is that all studies point toward a lower "inflation bias",
although for different reasons.
Another related issue is whether, and to what extent, globalisation has affected prices and wages
more directly in the euro area product and labour markets in the short-to-medium term. Estimates
obtained at the OECD16, employing an accounting framework suggest that the more direct effect of
globalisation (captured by measures of economic openness) on average annual consumer price
inflation is within the range of 0.0 to 0.3 percentage points over the period 2000-2005. The average
size of the estimated impact is not overwhelming, but at least the upper limit of this range is not
negligible either. An internal ECB study finds a comparable effect ranging between 0.1 and 0.2
percentage point over the period 1995-2004. The net direct impact of globalisation on HICP inflation is
the result of two components: an inflation-dampening effect from non-commodity import prices and an
inflation-augmenting effect from commodity import prices, including oil prices. The two effects are of
course linked and may largely offset each other as the economic success of emerging market
economies is largely responsible for higher world commodity prices. Moreover, the interpretation of
such estimated effects is not straightforward. The domestic economy's response to the emergence of
new international low-cost competitors is not captured by these estimates. Furthermore, it is not clear
to what extent and for how long these effects should be expected to persist.
The empirical evidence on the direct impact of globalisation on labour markets is also mixed. Indeed, it
seems that the findings are getting less rather than more robust and it may be difficult to disentangle
the effects of globalisation from those resulting from technological advances. In theory, it could be
expected that the increased openness of the economies may affect the demand for labour by firms in
advanced economies directly, as a result of increased international competition and, indirectly, by
increasing the real wage elasticity of labour demand. There is some evidence confirming these
theoretical propositions.17 The quadrupling of the effective global labour force over the last twenty
years has led to a fall in the labour share of unskilled workers' sectors in advanced economies and to
a - more moderate - rise in the labour share of skilled workers' sectors. In the euro area, shifts in
labour demand are predominantly resulting in changes in employment rather than in wages. The IMF
concludes, however, that technological advances had an even bigger impact on the labour share of
unskilled workers' sectors than globalisation as such.
II.2. Impact on monetary aggregates and financial markets
As you are aware, the ECB's monetary policy strategy attributes a prominent role to the analysis of
monetary aggregates and its counterparts in the assessment of risks to price stability over the medium
to longer run. Two processes associated with globalisation have made the analysis of monetary
aggregates for the purpose of extracting information for assessing future risks to price stability more
complex.18
The first process is the growing size of international capital flows. The sum of the stocks of foreign
assets and foreign liabilities of the total economy as a percentage of GDP - the most frequently used
measure of financial globalisation - has increased threefold in advanced economies between the early
1990s and 2004.19 In the euro area alone, the sum of outstanding foreign assets and liabilities has
increased from 190% of GDP in 1999 to 280% in 2005.20 With larger stocks of foreign assets and
liabilities, the probability of occasionally large and volatile net flows has risen. When euro area
residents sell securities to non euro area residents or when they borrow abroad, the net external
assets of monetary and financial institutions (MFIs) in the euro area rise and the stock of broad money
(M3) expands, if the settlement of these transactions involves domestic and foreign banks.
Crossborder mergers & acquisitions (M&A) activity of non-financial corporations can also account for a
parallel change in net foreign assets and money. Both cross-border portfolio investments and M&A
activity are genuine elements of the process of globalisation. Unfortunately, simply accounting for the
external sources of money growth and then mechanically correcting for cross-border portfolio flows or
M&A activity, on the presumption of their likely remote direct effects on consumer prices, is not an
advisable option. Rather, these transactions have to be analysed with respect to their information
content concerning their potential wealth effects on residents' income and on asset prices.21
Depending on the outcome of this analysis, the policy implications could be far from negligible.
The second process is financial innovation. The increasingly global nature of financial markets and the
low level of world interest rates in recent years have fostered financial innovation. These
developments, in turn, have contributed to the rapid growth of the activities of Other Financial
Intermediaries (OFIs), which include investment funds, financial vehicle corporations as well as
dealers in securities and derivative products. While the overall share of OFIs' money holdings in M3 is
only about 10% in the euro area so far - households account for about 50% - OFIs have contributed
significantly to the annual growth of euro area M3 since 2005, adding up to 2 percentage points in
some months, mainly due to the emergence and expansion of loan securitisation. The motives of OFIs
for holding money balances are likely to be of a fundamentally different nature than those of
households or non-financial corporations. Moreover, the process of securitisation of loans itself
positively affects the capacity of banks (of MFIs, to be precise), to issue new loans and thus it could
have an indirect expansionary effect on M3 growth. How can we deal with the influence of these
factors on money creation and their potential effects on the medium and long-term inflation outlook? In
general, the same answer applies as with respect to changes in net external assets. Given that the
OFIs' money holdings and investment activities could have indirect effects on consumer price
developments via asset prices, it would be premature to automatically exclude, without further
analysis, the money balances held by OFIs from the monetary aggregates when assessing the risks to
price stability.22
The general conclusion that emerges from these considerations is that monetary analysis has become
more challenging in the global economy as it has to explicitly take account of changes in domestic
money and credit markets induced by, or accompanying, financial globalisation. To address this
challenge, the Eurosystem is currently stepping up its analytical efforts to deepen its understanding of
several aspects of these processes and their implications for the assessment of medium to
longerterm risks to price stability.
III. Globalisation and financial stability and the role of central banks
A second set of important issues I would like to briefly address concerns the potential effects of
financial globalisation on financial stability. The safeguarding of financial stability is an objective
embedded, to varying degrees, in central bank statutes, reflecting national or area-wide institutional
arrangements. But in all cases, a sufficient degree of financial stability is a necessary condition for the
preservation of price stability by central banks. Globalisation could have implications for financial
stability through various channels; I will focus on its potential implications through its effects on global
imbalances and asset price cycles.
III.1. Risks associated with an abrupt unwinding of global financial imbalances
Incomplete financial globalisation23, reflecting the low level of financial market development in
otherwise fast-growing emerging market economies, combined with the "savings glut" hypothesis, can
partly account for the current level and evolution of global net foreign asset and liability positions. This
explanation notwithstanding, the possibility of a disorderly unwinding of global imbalances cannot be
excluded for several reasons. First, the structural factors underlying the large financial flows from Asia
and oil-exporting countries into the United States cannot persist forever. Second, economic policies
which have been causing, or have thus far failed to address, a variety of market distortions and
inefficiencies, have also been contributing to existing financial imbalances. Financial market
participants may eventually question the sustainability of some of these policies and change their
behaviour in anticipation of their ultimate consequences. There is no doubt that financial globalisation
fosters international risk sharing, promotes economic growth and reduces macroeconomic volatility.
Nevertheless, the size of and the particular asymmetry in net foreign asset positions observed since
the late 1990s involves potential medium to longer term risks to financial stability. Major and abrupt
asset price adjustments, associated with a disorderly unwinding of global financial imbalances, could
be the main propagation mechanism of a financial turbulence. I would like to add, however, that
currently the probability of such a disorderly unwinding scenario seems rather remote, as economic
policies are shifting in the right direction, although clearly more needs to be done. Furthermore, as
shown by ECB research, historically, the necessary rebalancing of global demand in periods of current
account adjustment was usually achieved in an orderly fashion and involved domestic demand and
supply reallocations and did not require major asset price movements.24
The potential role of monetary policy with regard to global imbalances has been examined but the
conclusions are not clear. Research at the ECB has shown how the combined affects of domestic
monetary policy, fiscal policy and productivity developments could influence current account
positions.25 Related exchange rate movements could lead to additional valuation affects with
implications for gross foreign asset and liability positions. One interesting question to explore is
whether the conduct of symmetric monetary policies - for example, in two countries linked by a fixed
exchange rate regime - could affect the relative current account position between these countries.
Such an outcome could reflect asymmetries in the interest elasticities of saving and different wealth
effects related to heterogeneous financial market development and capitalisation. But these issues,
though theoretically interesting, are very much unchartered territory.26
III.2. Impact through asset price boom-and-bust cycles
Let me now turn to the potential impact of financial globalisation on financial stability through the
effects on asset prices and risk premia. As colleagues at the BIS were first to emphasise, a potential
interaction between globalisation and monetary policy may inadvertently contribute to the creation of
global excess liquidity which could later play a role in the development of asset price boom-and-bust
cycles. The benign effects of global competition and low-cost imports on consumer prices might lead
to an underestimation of the stimulative effects of monetary policy which is consistent with the
preservation of price stability over the medium term, but which can be characterised as
accommodative as evidenced by buoyant credit and money growth over a prolonged period. A strong
and persistent expansion of monetary liquidity could fuel or even trigger an asset price boom. During
the bust phase of the asset price cycle, the associated credit crunch might lead to an economic
downturn and a negative deviation from the objective of consumer price stability, and possibly even to
deflation, which would exacerbate the financial crisis.
The channel through which monetary liquidity could affect the dynamics of asset prices could be
"purely monetarist" or reflect the influence of other factors as more recently explained with reference to
behavioural finance. An environment of high monetary liquidity could affect the risk-taking behaviour of
financial intermediaries and other financial market participants. High monetary liquidity and financial
market liquidity27 could be signs of arbitrage strategies such as carry trades and "liquidity seeking"
behaviour, which could temporarily distort the pricing of risk.28 In fact, ECB research shows that there
is evidence that monetary liquidity shocks have played a role in driving asset prices, particularly
housing prices across OECD countries, during the boom phase of asset price cycles, and that they
have also contributed to explaining the negative effects on economic activity during the subsequent
bust phase.29 Other Eurosystem research has identified effects of an accommodative monetary policy
on housing prices in the euro area and in the United States.30 The intriguing aspect of this hypothesis
and of the associated empirical findings is that the monetary policy stance might be perfectly
appropriate for and consistent with the preservation of price stability over a short-to-medium term
horizon. Nevertheless, the potential implications for asset price boom-and-bust cycles could signal that
the monetary policy stance could prove too accommodative for maintaining price stability in the long
run.
IV. Implications for policy
IV.1. Do monetary policy strategies have to be adapted?
I would like to conclude by addressing the two questions that I raised at the beginning which concern
the potential implications of globalisation for the strategy and effectiveness of monetary policy. More
specifically, the first question is whether monetary policy strategies have to be adapted in order to
cope with the rapidly increasing global economic integration. In providing an answer, I will concentrate
on and highlight the ECB's monetary policy strategy.
A monetary policy strategy comprised two main elements: the policy objective, including the time
horizon for its attainment, and the analytical framework which relates policy instruments and goals and
provides the basis for assessing the prospects for attaining the policy objective and the associated
risks. The ECB's strategy includes a quantitative definition of its primary objective of preserving price
stability and has a medium-term orientation in achieving this goal. Globalisation has no fundamental
bearing on this element of the strategy, but it has some implications: it does underscore the relative
importance of price stability as a central bank goal and the need to formulate and conduct monetary
policy so as to preserve price stability over a medium-to-longer term horizon. As I noted earlier, recent
research has stressed that increased openness to trade and financial interdependence should
reinforce the central bank's emphasis on the objective of price stability relative to minimising output
volatility.31 Such a result can also be derived in a model with endogenous portfolio choices, while
focusing on the risk-sharing properties of cross-border trade in nominal bonds.32 Moreover, in an
environment of price stability but persistent rapid money growth and rising leverage, financial
liberalisation and integration could lead to the accumulation of financial imbalances over a number of
years, increasing the probability of a boom-and-bust cycle in financial markets with repercussion on
price stability over the longer term. This possibility implies that monetary policy should place increased
emphasis on the preservation of price stability over longer time horizon extending beyond the medium
term.
With regard to the analytical framework, globalisation can, in principle, affect market structures,
agent's behaviour and inflation dynamics, thus requiring close monitoring and careful assessment of
its effects. The economic analysis employed by the ECB to assess the short-to-medium term risks to
price stability could be subject to greater parameter or model uncertainty as well as increased
measurement error associated with unobservable variables, such as potential output, which underlie
the assessment of real activity and inflation pressure. However, the econometric evidence in the euro
area has not yet identified significant indirect effects, reflecting structural or behavioural influence of
globalisation on inflation dynamics. Nevertheless, the complexity of economic analysis has increased
and its task has become more challenging, and there is clearly a need to better understand and
measure the impact of globalisation.
In a period of potentially significant structural change in the product and labour markets,
crosschecking the assessment of risks based on economic analysis by monetary analysis becomes more
important. This proposition is conceptually correct. Unfortunately, the influences of financial
globalisation on money and credit growth imply that, in practice, monetary analysis is also becoming
more challenging and requires increased sophistication. It is necessary to rely on a wide range of
analytical tools and models in order to identify the underlying trend in monetary developments and to
assess its implications for price stability. At the same time, as I already stressed, in an environment of
increased global financial integration, a deeper and broader analysis of developments in monetary
liquidity can enhance our understanding of potential risks to financial stability which, if they materialise,
can have repercussions for output volatility and price stability over the longer term. For these reasons,
pertinent research at the ECB will be further strengthened, including the analysis of the interactions
between financial globalisation and innovation, on the one hand, and monetary and market liquidity,
on the other, and their potential implications for monetary policy and financial stability.
All in all, there is no reason to change in any fundamental way the analytical framework we employ for
assessing the prospects for and the risks to price stability in response to globalisation. On the
contrary, I conclude that the ECB's strategy, with its medium-to-longer term orientation and the
prominence it assigns to the analysis of monetary developments and liquidity conditions for
crosschecking the outcome of economic analyses, is well placed to address some of the implications of
globalisation for inflation dynamics and long-term financial and price stability. Nevertheless an
improved understanding of the influence of globalisation on the monetary policy transmission
mechanism will enhance the analysis underlying our decisions. This brings me to the second and last
question on policy effectiveness.
IV.2. Has monetary policy effectiveness been reduced?
Has monetary policy become less effective as a consequence of increased financial integration? More
specifically, has the associated co-movement of long-term interest rates impaired the functioning of
one of the channels of the monetary policy transmission mechanism? Or, alternatively, has monetary
policy gained effectiveness in times of almost perfect capital mobility and floating exchange rates, in
line with the IS/LM paradigm, as recently stressed by central bank colleagues?33
Indeed, it is theoretically plausible to argue that certain features of globalisation have influenced to
varying degrees some of the key determinants of long-term interest rates, such as the global riskless
real rate of interest and the real risk premium.34 In addition, expected inflation and the inflation risk
premium may have been diminished to some degree by forces of globalisation, though successful
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.35 Global factors seem to be increasingly
important for the determination of national real bond yields.36 Furthermore, the co-movement of US,
German and Japanese bond yields has been exceptionally high over the last three years37. My
interpretation of these findings is that, although there is little doubt that global forces have played an
important role in the determination of domestic long-term interest rates, they do not provide sufficient
and convincing 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. But nothing prevents national monetary policies from diverging from
such a common orientation, which itself has been fostered by increasing competition between
currencies.38 A central bank is still able to preserve price stability, or choose and achieve a long-term
inflation objective under floating exchange rates. However, the relative importance of the different
channels of transmission of the effects of monetary policy might be affected by the ongoing global
economic integration. This underscores the importance of a central bank's credible commitment to its
objectives and of effective and consistent communication.39
V. Concluding remarks
To sum up, the effects of globalisation on product, labour and financial markets can be potentially
farreaching. However, the implications for monetary policy are overall fairly contained. The phenomenon
of globalisation neither calls for any fundamental change in the monetary po