Jürgen Stark: Globalisation and monetary policy - from virtue to vice?
Speech by Mr Jürgen Stark, Member of the Executive Board of the European Central Bank,
at the Federal Reserve Bank of Dallas, Dallas, 29 November 2011.
* * *
Ladies and gentlemen,
I am very honoured to be here today. Reading about the origins of the Globalisation and
Monetary Policy Institute, I came to learn that it was established in 2007 in order to promote
a deeper understanding of the global environment in which US monetary policy operates.
The establishment of the Institute could not have been more timely, as the deep-seated and
systemic nature of the current crisis is certain to provide numerous interesting questions for
researchers to explore in the years to come.
The good news, therefore, is that we live in challenging times and that for those of you who
work in the Institute this will mean important and policy relevant work today and in the future.
The bad news is that the crisis is still on-going, and insofar as this is the case and its ultimate
outcome remains uncertain, there is an inherent peril to provide analysis and possible policy
prescriptions on the basis of events which are either happening in real time or have recently
elapsed.
We have seen many dimensions of the crisis since it started in August 2007, spreading from
the periphery of the financial system to its core, and then onto sovereigns with weaker
balance sheets, which in turn contributed to increasing the vulnerability of the core financial
system even further. In recent months, this negative and self-reinforcing dynamic of adverse
feedback loops between weak sovereign and financial sector balance sheets has been all
too apparent in parts of the euro area. At every step of this process entailing the
transformation of risk from one party to another, policymakers in various domains
- regulatory, financial, fiscal, monetary - had to search for workable solutions. At a minimum,
the evolving character of the crisis has forced policy makers to work on an effective response
under exigent circumstances.
In the remainder of my remarks today, I would like to shed light on the on-going policy
response from the point of view of a monetary policy practitioner in a central bank. I will do
this by drawing on the relationship between globalisation and monetary policy in recent years
and considering the extent to which both variables have influenced each other in either a
"virtuous" or "vicious" manner. This will not only be useful to understand what has happened
in the recent period but also to frame the challenges that might lie before us as a result of the
changed global environment under which monetary policy must operate.
Before going any further, I think two disclaimers are in order. First, I will not purport to be
exhaustive but selective in my discussion of the factors conditioning monetary policy
frameworks in the global environment. Second, I do not intend to be taxative but reflective,
as the assessment of monetary policy frameworks will necessarily continue even if the
aftermath of the crisis.
1. The road to virtue
The road to virtue between globalisation and monetary policy was built on two inter-related
premises. First, that the process of globalisation itself was largely irreversible. And second,
that the by-products of such a process complemented improvements in monetary
policymaking such that the battles of yesteryear had been decisively won in a durable
manner and the new challenges appeared to be manageable. The relationship between
monetary policy and globalisation could thus be best described as one which was both
symbiotic in nature and mutually beneficial. I will review these arguments in turn.
The perceived inevitability of globalisation
First, asserting the irreversibility of globalisation in the midst of a systemic crisis such as the
one we are currently experiencing may seem far-fetched. However, if one were to look back
at the enthusiasm which prevailed in both the economics and international relations fields
during the early 1990s, this appeared as an inescapable conclusion. The growth of world
merchandise export volumes had already consistently outpaced that of real GDP for
decades1, while the world stock of outward FDI had dramatically increased in the period from
1980-19902. These favourable trends looked set to receive a further boost on account of the
expected integration of central and eastern European economies as well as the states of the
former Soviet Union and China into the mainstream of the world economy. Many observers
therefore agreed with Francis Fukuyama that this marked "the end of history"3.
The intensified scope and depth of economic and financial exchanges in the global economy
which followed seemed to confirm this premise. But "globalisation" as a concept was - and
remains - elusive to define even within the narrower remit of economics and finance, such
that observers interpreted these developments in a slightly different manner. On the one
hand, theorists such as Ohmae (1990)4 tended to focus on the globalisation of production
and the shifts in global finance that underpinned this trend to argue that a new capitalist
system would progressively emerge, with the relevance of nation states as economic actors
dwindling in importance. In contrast, other observers saw the growing internationalisation of
the world economy as part of a broader and longer-dated trend where sharp intensifications
in trade and financial exchanges underpinned by growing economic liberalism were not
without historical precedent (for example during the period ranging from 1870 to 1913)5.
These observers were thus more bullish as regards the ability of nation states to retain their
economic power going forward, consolidating this inter alia through strategic alliances in
economic blocks6. In spite of these nuances, the common thread between the two views was
that the underlying economic forces were seen as inevitable in the international (or global)
domain.
Complementarities between globalised economic performance and policymaking
Second, following the broad acceptance of the premise that the globalised world would be
durable in nature, academics and policymakers devoted their attention to fleshing out the
practical implications of globalisation in different policy environments. Insofar as monetary
policy was concerned, the debate was broadly captured by the relative weight of improved
policymaking versus globalised factors in accounting for successful economic outcomes.
A first dimension in this regard was backward looking in nature and stemmed from the sharp
reduction in the variability of both inflation and output during the 1990s. This phenomenon,
which became known as "the great moderation", coincided with both the intensification of
1
According to WTO data, the average growth of world merchandise export volumes per annum was 15% from
1960 to 1990 inclusive, as compared to average real GDP growth per annum of 8% over the same period.
2
According to UNCTAD data, the world stock of outward FDI increased from USD 564 billion in 1980 to
USD 1763 billion in 1990.
3
See The End of History and the Last Man, book by F. Fukuyama (1992).
4
See The Borderless World (1990) and The End of the Nation-State (1995) , books by K. Ohmae
5
See for example Globalisation, History and Development: a tale of two Centuries, article by D. Nayyar (2006).
The author notes that export shares in GDP for selected industrialised countries (e.g. UK, Germany, Japan)
were broadly comparable in 2000 relative to 1913, and that the relative increase in export shares to GDP for
these same countries between the periods 1900-1913 and 1973-2000 was also comparable. In addition, the
stock of FDI as a proportion of world GDP was about 9% in the mid-1990s, similar to the ratio in 1913.
6
See for example Globalisation in Question, book by P. Hirst and G. Thompson (1999) and Globalization: A
Short History, book by J. Osterhammel and P. Petersson (2005).
globalisation in its broadest possible interpretation (namely the growth of cross-border trade
in goods, services and financial assets, complemented by improvements in information and
technology transfer) as well as with the establishment of price stability-oriented monetary
policy frameworks under independent central banks. In principle, each of these factors could
help to account for improved macroeconomic performance. On the one hand, globalisation
and the associated increase in international flows of capital, goods and services should have
resulted in greater pressure towards price equalisation and convergence as well as greater
shock resilience of our economies. On the other hand, an independent and price stability
oriented monetary policymaking should contribute to overall greater macroeconomic stability
with lower output and inflation volatility. A debate ensued among policymakers and
academics to assess the relative merits and contributions of globalisation and monetary
policy for macroeconomic stability, with some also suggesting that the improved
macroeconomic performance was only accidental in nature reflecting "good luck"7.
I will not try to settle this debate today, which is bound to continue in both academic and
policy quarters, although - not surprising for a central banker - I personally believe that
monetary policymakers deserve significant credit to this end, not least as inflation is
ultimately a monetary phenomenon and hence ultimately determined by monetary policy. But
the more fundamental point which I would like to make is that there seemed to be a large
degree of positive complementary between globalisation outcomes and monetary
policymaking. Whether one thought that policy frameworks largely managed to keep inflation
in check once it was already low with the aid of global factors, or alternatively considered that
the low inflation responded to policy frameworks successfully harnessing the forces of
globalisation, both trends appeared to be working in the same "virtuous" direction.
A second dimension of the debate involving monetary policymaking in a globalised
environment was more forward-looking in nature, relating to the perceived ability of monetary
authorities to continue to deliver on their price stability mandates. The main concerns in this
regard had to do with the possible effects of globalisation in domestic product and labour
markets as well as financial conditions, and the extent to which these should be incorporated
into the central bank's reaction function so as to ensure the effectiveness of monetary policy
in a changed environment.
As regards product and labour markets, observers differed on whether from a theoretical
vantagepoint globalisation should make the short run Phillips curve either (i) steeper as a
result of greater price responsiveness to shifts in demand (e.g. Rogoff 20068); or (ii) flatter as
a result of other factors including increased openness reducing the responsiveness of
inflation to the domestic output gap or squeezed profit margins due to competition from
labour abundant countries (e.g. Bean 20069). Yet other observers (e.g. Taylor 200810) argued
that the correlation between globalisation and the sort of effects which were purported to
have on policy response functions were spurious in nature. Empirical studies (e.g. Borio and
Filardo, 200711) showed some support for a flattening of the Phillips curve and that measures
of global slack had become relatively more important to account for domestic inflation relative
to domestic ones, albeit not in the case of the euro area.
The integration of low cost and labour abundant producers such as China into the global
system led to the common perception that such emerging markets were "exporting deflation".
This view, however, downplayed the cost-push factor which those same emerging markets
could have on relative prices, for example through rising demand for commodities, working
their way into short-run fluctuations of headline inflation. Therefore, it is clear that the
widespread presumption of favourable "tail-winds" from globalisation on inflation is turning
more and more into "head-winds" posing challenges to the maintenance of price stability. In
addition, policymakers can choose to act to dampen the effect of these relative price
changes on the absolute price level to the extent that they are able to distinguish between
temporary shocks and permanent inflation trends.
Concerning financial globalisation, the main source of concern for policymakers in the run-up
to the crisis stemmed from the potential impact of more integrated financial markets on the
monetary policy transmission mechanism, for example by increasing the sensitivity of
investors to (now lower) interest rate differentials. From a theoretical point of view, some
observers argued that key determinants of long-term interest rates - such as the global
riskless real rate of interest and the real risk premium - had indeed been influenced by the
globalised environment12.
In these circumstances, the ability of short-term interest rate changes to influence long-term
rates could be more problematic than would otherwise be the case. There was some
empirical evidence pointing to this end for a number of advanced economies including the
euro area13, as well as to suggest that global factors had become increasingly important in
the determination of national real bond yields14. At the same time, there was also some
evidence to suggest that the responsiveness of longer-term yields to unanticipated changes
in short-term rates remained unhindered15.
Public remarks by policymakers in the run-up to the crisis show that officials were cognisant
of the increased challenges for monetary policy brought about by financial globalisation. The
remarks by former Federal Reserve Chairman Greenspan noting that the diverging evolution
of short-term versus long-term rates in the US represented a "policy conundrum"16 received
ample media attention in this regard. In a speech in March 2007, current Federal Reserve
Chairman Bernanke also acknowledged that the central bank's analysis of financial and
economic conditions was becoming more complex17. Former ECB vice-President
Papademos noted similar challenges to the central bank's monetary analysis in another
speech in June 200718. However, these same public interventions also show that
policymakers at either side of the Atlantic remained confident on the ability of monetary
policy to continue to effectively transmit monetary impulses to financial markets and the real
12
See Globalization's Effect on Interest Rates and the Yield Curve, article by T. Wu, Federal Reserve Bank of
Dallas (2006).
13
See Panel remarks at the Thirteenth International Conference "Financial Markets and the Real Economy in a
Low Interest Rate Environment" by L. Reichlin (2006).
14
See The Equilibrium Level of the World Real Interest Rate, article by D. Giannone, M. Lenza and L. Reichlin
(2007)
15
See for example The High-Frequency Response of Exchange Rates and Interest Rates to Macroeconomic
Announcements, article by J. Faust, J. Rogers, S. Wang and J. Wright (2007).
16
See Testimony of Chairman Alan Greenspan Before the Committee on Banking, Housing, and Urban Affairs,
U.S. Senate, Federal Reserve Board's semi annual Monetary Policy Report to the Congress, February 2005
17
See Globalisation and Monetary Policy, speech by B. Bernanke, Board of Governors of the Federal Reserve
System, March 2007.
18
See The Effects of Globalisation on Inflation, Liquidity and Monetary Policy, speech by L. Papademos, ECB,
June 2007.
economy, notably through well-anchored inflation expectations, effective communication, and
medium-term orientation of monetary policies.
Overall, the "virtuous" view of the relationship between globalisation and monetary policy
prevailing in the run-up to the crisis was one where the potential challenges to policy
frameworks posed by more integrated product, labour or financial markets appeared to be
manageable. This view was partly conditioned by the favourable experience during "the great
moderation", with stability oriented monetary policymaking and globalisation trends
seemingly complementing each other to yield a stable macroeconomic environment.
2. The seeds of vice
As we now know, the "virtuous" view of the relationship between globalisation and monetary
policy came to an abrupt end in September 2008 as a result of the Lehman bankruptcy and
the events which have followed to the present day. With the benefit of hindsight, it has
become evident that while policymakers in different areas of the economy thought to have
things under control, a "perfect storm" was simmering beneath the surface. The policy
failures in many domains, notably supervisory and regulatory regimes as well as risk
management and compensation practices by financial institutions, were significant in the
runup to the crisis. And once the crisis hit and public balance sheets were burdened with the
respective costs of supporting financial sectors, fiscal stimulus and the operation of
automatic stabilisers in a sharp economic downturn, other vulnerabilities emerged.
However, it is legitimate to ask about the relative responsibility of monetary authorities in
contributing to the crisis, whether actively or inactively. I would thus like to highlight three
elements which helped to sow the seeds of a vicious relationship in this regard.
Complacency and insufficient medium-term orientation of monetary policy
The first was complacency. With inflation seemingly under control following "the great
moderation" of the 1990s amid intensified globalisation, many observers thought that
monetary policy had greater degrees of freedom to devote to short-term demand
management. Proponents of this view referred to this as "fine-tuning"19, whose theoretical
counterpart was a form of "flexible inflation targeting" with an added emphasis on output
stabilisation beyond inflation stabilisation. The pre-crisis focus on the output gap was in many
ways paradoxical insofar as consensus macroeconomics had run full circle back to the
intellectual climate of the 1970s, where policymakers' exaggerated real time measures of
economic slack was at the root of many policy failures. This was the same environment that
had favoured the Great Inflation.
Too much emphasis on short run economic developments, or - in my view - an insufficient
medium-term orientation of monetary policies has certainly contributed in part to the build-up
of monetary and financial imbalances. Although monetary policy frameworks oriented
towards the medium-term could probably not have completely prevented the current crisis, I
am convinced that they would have helped to make it less disruptive. As you know, the ECB
has never subscribed to the view that monetary policy has a primary role to play in the
management of aggregate demand and we think that this element of the pre-crisis monetary
policy paradigm should be revised on the basis of subsequent events.
Underappreciation of monetary and credit dynamics
A second element fostering a vicious relationship between monetary policy and globalisation
in recent years was the underappreciation of monetary and credit dynamics on the part of
policymakers. In hindsight, the crisis has been a sober reminder that the seeds of financial
instability are often alike, including high leverage, rapid growth of financial institutions, and
balance sheet mismatches. Some of these trends can be picked up when closely looking at
monetary and credit variables, even if such trends may not be addressed by conventional
monetary policy tools and require macro-prudential action instead.
As you know, liquidity and money lie at the core of the ECB's second pillar in its monetary
policy strategy, but this emphasis was seen by mainstream modellers as somewhat of a relic
of the past. However, the crisis has shown that liquidity and various definitions of money are
critical elements in the transmission mechanism. The use of these indicators at the ECB has
proved useful during the crisis, for example by providing insights into bank behaviour,
financing conditions and the overall state of the business cycle (Papademos and Stark
201020). There is evidence to suggest that, without taking such monetary analysis into
account, inflation in the euro area would have been distinctly higher at times of financial
exuberance and would have fallen deep into negative territory in the wake of the financial
markets' collapse21. We thus think that this is one reason to revisit the role of monetary and
credit variables in monetary policy strategies going forward.
Moreover, disregard for monetary and financial phenomena by policymakers had a more
profound implication insofar as found a theoretical underpinning in the risk management
approach to asset price trends. The consensus view in the run-up to the crisis - to which the
ECB did not subscribe to - was that the best that central banks could do was to "clean-up"
following a bubble burst through a loosening of the monetary policy stance. Subsequent
events have shown that these "bubble bursts" can be very costly and that aggressive ex post
action may not suffice. This is because the expectation that the central bank will aggressively
protect the markets from "tail events" in bad times can encourage markets' tendency towards
risky strategies, over-exposures and exuberance (Stark 2010)22.
In my view, this asymmetry in responding to shocks where downside risks to the economy
received a greater weight in central bankers' "policy preferences" than upside risks to price
stability contributed to the build-up of financial imbalances in some advanced economies.
The main ex ante policy tools to prevent such situations from developing in the first place are
surely to be found in the regulatory and supervisory domain, which is at times not under the
authority of the central bank. However, without prejudice to this, a greater focus on monetary
phenomena by central banks through closely scrutinising credit and money developments
inspires a "leaning-against-the wind" stance which can help smooth financial cycles and
stabilise the economy in the medium term.
Confusing "known knowns" with "known unknowns"
A third element of vice in the relationship between monetary policy and globalisation in
recent years has been the failure of policymakers to think through the possible ways in which
they might be called to act as a result of situations which they have helped to bring about. In
their well-cited book, Reinhart and Rogoff (2009) make a compelling case to show that
financial bubbles throughout history have shared a number of common elements, such as
rising home prices and financial innovation. Yet as these authors point out, in spite of these
common traits, policymakers have at times fallen prey of the "this time is different"23 illness.
Moreover, the record shows that as far back as 2004 both policymakers and academics were
alerting on some of the emerging tail risks which have subsequently materialised. To name a
few examples, Borio and White (2004)24 cautioned on the greater prominence of credit and
asset price boom-and-bust cycles even in a low inflation environment; Rajan (2005)25 did a
careful review of some worrying trends associated with globalised financial markets; and
Rogoff (2006)26 noted that the "great moderation" had not been associated with lower asset
price volatility. The record also shows that monetary authorities echoed many of these and
other concerns (such as the possible disorderly unwinding of global imbalances) in their
public discourse, including through speeches and official publications27. Thus, even if novel, it
is not correct to say that policymakers were unaware of the potential risks associated with a
globalised environment.
So why did such risks still materialise in the end? Part of the answer was the insufficient
policy traction with the authorities that were competent to heed such warnings. However, it is
also true that while the onset of the crisis can be largely seen as the result of vulnerabilities
and imbalances which had been growing steadily and which had been identified fairly early
on in the process, they combined in ways that few would have anticipated. This was
especially the case as regards the functioning of the financial system as its wider
interconnections. Policymakers thus confused risks which they thought they knew ("known
knowns") with risks which they knew they didn't know ("known unknowns"). This is what the
IMF and others have deemed as a "failure to connect the dots"28.
Insofar as monetary authorities are concerned, this "failure to connect the dots" refers to the
unanticipated burdens on central banks resulting from their own contribution to the creation
of global excess liquidity and the latter's role in the development of asset price
boom-andbust cycles. The burst of the bubble and the chain of events set in motion as a result would
ultimately reverberate back on central bank activity by impinging on the price stability outlook
through severe threats to financial stability. This was the case regardless of whether
monetary authorities were formally responsible for safeguarding financial stability or not,
which is one reason why monetary policy should systematically incorporate financial analysis
into its assessment of the risks to price stability (Moutot and Vitale, 2009)29. In addition,
threats to price stability through severe strains on governments' fiscal solvency also arose in
some cases. This would call for unprecedented central bank action at the limit of policy
mandates in response to exceptional and exigent circumstances.
Overall, the seeds of vice in the relationship between monetary policy and globalisation in
recent years - including complacency, underappreciation of monetary and credit dynamics
and the confusion of "known knowns" with "known unknowns" - have a common thread: the
potential for unintended consequences. I would therefore like to outline some of the
challenges we may expect in this context in the period ahead.
24
See Whither Monetary and Financial Stability? The Implications of Evolving Policy Regimes, article by
C. Borio and W. White, BIS, 2004.
25
See The Greenspan Era: Lessons for the Future, speech by R. Rajan, IMF, August 2005.
26
K. Rogoff (2006), op. cit.
27
For example, the ECB's Financial Stability Report consistently alerted on the vulnerabilities that were building
up in the financial system, including through the significant underpricing of risks across a variety of asset
classes, while official policy meetings (G7, G20, BIS-based) routinely warned on the possibility of a disorderly
unwinding of global current account imbalances.
28
See Initial Lessons from the Crisis, IMF, February 2009.
29
See Monetary Policy Strategy in a Global Environment, article by P. Moutot and G. Vitale, ECB, 2009. In the
EU, we have since attempted to correct for this "failure to connect the dots" with the establishment of the
European Systemic Risk Board (ESRB) as the main body for macro-prudential oversight and surveillance of
EU financial markets.
3. Globalisation and monetary policy in the period ahead
The nature of the relationship between monetary policy and globalisation must be redefined
in the period ahead to maintain its virtues while correcting its vices. Let me give you the key
policy elements needed for this to be successful.
What kind of global system will emerge in the aftermath of the crisis?
First, we should not take the process of globalisation for granted. Measures introduced in
response to the crisis have in some cases reversed aspects of globalisation. Contrary to the
experience of the Great Depression, we have not seen a rise in trade protectionism in recent
years. However, we have witnessed a broad-based increase in financial protectionism that is
equally if not more worrying. For example, banking systems have been renationalised in
some advanced economies, including in the euro area, and other market segmentations
have been re-introduced along national lines. If this trend were to be sustained in the future,
the euro area could be particularly affected as financial integration is a key aspect for the
smooth functioning of monetary union and the broader viability of the single market. Another
prominent case of rising financial protectionism in recent years has been the introduction of
measures to curb capital inflows in some emerging economies. This was partly done in an
effort to contain the fallout from too easy monetary policy in key advanced economies.
In their landmark publication, Rajan and Zingales (2003)30 offer powerful insights into the
nature and functioning of financial markets. The authors warn that the establishment might
exploit the wave of public anger during economic downturns in order to restrict competition
and access to capital. The authors also note that open borders help to keep economic and
political elites in check and preserve competitive markets. These policy prescriptions should
be heeded if the mistakes of the 1930s (or similar ones) are not to be repeated. This is also
why the G20 process to achieve a level playing field with uniform rules of the game in the
global financial and economic system, including as regards capital flow management, is so
important.
Once we accept that globalisation is not an irreversible or uniform process, the need to invest
in better governance through co-operative outcomes at a global scale will follow.
Policymakers at all levels should internalise this concept and act accordingly.
Shock transmission and policy degrees of freedom in a globalised era
Second, I would argue that globalisation (and in particular financial globalisation) has
changed the risk and reward matrix associated with policy failures and successes,
respectively. Globalisation may be initially more forgiving with policy mistakes on account of
higher thresholds of tolerance, for example as regards current account or public debt
positions. However - as the crisis has forcefully taught us - by enabling these imbalances to
remain unaddressed for longer, the eventual cost of adjustment of unsustainable policies
would be higher than would otherwise be the case - and the adjustment may occur in a very
swift manner.
It is the sudden operation of these centripetal (as opposed to centrifugal) forces of
globalisation enabling the rapid propagation of shocks across borders which has led
observers such as Rogoff to deem the euro area "the ultimate contagion machine"31. The key
policy elements to restore normalcy in the euro area thus require (i) redressing the
macroeconomic imbalances and unsustainable fiscal policies that lie at the heart of the
sovereign debt crisis in the euro area; (ii) much greater economic policy co-ordination among
monetary union members; and (iii) ensuring that there is an effective governance framework
in place which can guard against similar instances from occurring in the future, inter alia
through macroeconomic and fiscal surveillance and early correction mechanisms.
Emerging challenges to monetary policy frameworks
Third, as regards the challenges for monetary policy looking forward, central banks are likely
to be subject to greater peer and public scrutiny in a world of higher interconnectedness. At
the same time, however, monetary authorities are also more liable to be burdened with the
spillovers resulting from the actions of other parties. Crucial challenges in this regard include
the risk that monetary policy is overburdened by fiscally dominant regimes caused by
government's irresponsible fiscal behaviour and unsustainable public finances. There is also
the risk that monetary policy is dominated by financial stability concerns, implying that price
stability would be subjugated by financial stability.
Monetary policy frameworks have to be made robust against the challenges ahead and I
believe a number of principles for robust monetary policy frameworks should be strongly
reaffirmed as a result.
First, we should recognise the centrality of price stability for monetary policy. This is the best
contribution that monetary authorities can make to overall economic welfare. Price stability
should thus remain the primary task and the key "deliverable" for central banks in the period
ahead. The crisis has confirmed the importance of a clearly defined objective for price
stability by contributing to anchor expectations during periods of turbulence when otherwise
the private sector would become disoriented. There is also a "credibility premium" to be
obtained from an undisputable definition of price stability during such turbulent peri