Guy Debelle: Remarks to the International Monetary Fund Research
Conference
Remarks by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of
Australia, to the International Monetary Fund Research Conference, Washington DC,
8 November 2013.
* * *
It is a great honour and pleasure to be here. I, like many in this room, owe Stan Fischer a
great debt. I was the last graduate student that he supervised. You could argue that I drove
him out of academia into policymaking!
When Stan was teaching his macro course at MIT, in the very first lecture he used to say:
you learn [the] ISLM and Mundell-Fleming [models] in your undergraduate course (and most
of us learnt it from [Rudiger] Dornbusch and [Stanley] Fischer), then you come to graduate
school and we cover that in half a lecture before moving onto teaching more advanced
technologies. But then you go out into the real world of policymaking and your first and best
intuition still comes from Mundell-Fleming.
So I must say I was struck by Emmanuel Farhi and Ivan Werning's claim upfront in their
paper1 that, to quote, "because our model has explicit microfoundations and a formal
treatment of general equilibrium, it is better suited for normative analysis than the traditional
Mundell-Fleming models".
That's a pretty big claim. Call me old-fashioned but I'm not sure that I buy it.
Before I get to that, let's think a bit more about some issues that come with a floating
exchange rate. Emmanuel and Ivan talk in their paper about emerging markets, but it's not
just an emerging market issue. I will also draw on the Australian experience.
When the exchange rate is moving in line with the terms of trade, the real fundamentals, it
plays the appropriate macro stabilisation role. Farhi and Werning have that explicitly in their
model. In Australia's case, over the 30 years of the float, the exchange rate has done just
that most of the time.
The problem is when financial factors cause the exchange rate to deviate from the real
fundamentals.
How can that come about?
Well let's think of a country, which I'll call the Usual Suspect or US for short. That country
pursues an extremely expansionary monetary policy, which is completely justifiable from its
perspective. This spills over to the rest of the world which experiences an exchange rate
appreciation as capital flows to earn a higher yield.
Even if the global portfolio reallocation that comes about from this is small from the US'
perspective, it can be large from the point of view of a small open economy that is the
recipient of these flows.
In the emerging market world, the concern is often that the capital inflows will become capital
outflows. In Australia's case, an exchange rate appreciation that is not in line with the
fundamentals, if persistent enough, can lead to Dutch Disease.
This is the fundamental problem, be it a Trilemma, or Dilemma, as Hélène Rey labels it.
But, you might say, isn't a stronger US economy good for the rest of the world? Or in other
words, "suck it up sunshine".
That may well be true for the rest of the world as a whole, but it is not necessarily true for
every other country. There is an income and a substitution effect at work here. The income
effect is the boost from a stronger US in terms of greater global demand. The substitution
effect is the negative effect of the exchange rate appreciation. The substitution effect can
outweigh the income effect, particularly if you don't trade that much with the US and/or if the
capital flows are large relative to the size of your economy leading to a relatively large
appreciation of the exchange rate.
That is the fundamental problem that the authors are getting at in their paper. Though, so far,
Mundell-Fleming has done just as well in getting to this point as their more advanced
technology.
Now let's think about what happens when the capital flow reverses. (I would note that the
term "sudden stop" maybe isn't the right term to use, being a hold-over from a fixed
exchange rate world.)
In Australia's case, the exchange rate depreciates and the main concern is inflation. This is
manageable if the appropriate macro framework is in place, such as an inflation targeting
framework. This is one of the points of Fischer's 2001 lecture at the first incarnation of this
conference.
In the emerging markets world there are two problems. The first are also inflation concerns,
particularly if inflation expectations are less well anchored. The second are balance sheet
effects in the form of unhedged foreign exchange denominated liabilities. This is the genesis
of the fear of floating and was critical in the Asian crisis. Paul Krugman's second generation
models capture this well.
Does the model in the paper here capture this? Mostly. It captures the issue of the exchange
rate not moving in line with the fundamentals. It doesn't capture this balance sheet channel
though, where the exchange rate depreciation hurts so much.
Why doesn't the standard macro response work? That is, when the exchange rate
appreciates, lower interest rates to ameliorate its impact. Mundell-Fleming would say to do
that. It would also say use fiscal policy, which is not discussed in the paper.
Extreme reductions in interest rates can cause problems of excessive price rises in domestic
asset markets. So could one turn to "macro-prudential" measures? These are effectively
domestic capital controls on the locals, rather than the capital controls on the foreigners that
the paper proposes.
Basically one is trying to make yourself less attractive to foreign capital inflow. That's the
fundamental issue here in this paper.
That has posed an interesting conundrum in Australia in recent years. We have been
experiencing a "boom with gloom". We have had the difficult balancing act of trying to tell
foreigners that the economy is not as good as they think it is, so stop sending us so much
capital, while at the same time trying to convince the locals that the economy is not as bad as
they think it is. Now that's a real dilemma!
In the end I see the model in this paper as proposing capital controls to address the distortion
of the exchange rate moving out of line with the fundamentals. Basically it boils down to the
Tinbergen principle. With only monetary policy, there is one instrument and two objectives.
Give me another policy instrument and it is easier to hit the two objectives.
But other potential instruments are not considered in the paper. For example, intervention in
the foreign exchange market in the form of reserve accumulation, which has been used in
many emerging markets. This is helpful on the way in, in terms of dampening the inflows, but
it also helpful in dealing with the outflows when they come.
Moreover, the paper is silent on how to go about applying the capital controls in practice.
Indeed, it is ironic to be discussing the appropriate implementation of capital controls at the
IMF, which for a long time has regarded them as a complete anathema. Capital flows are a
repeated game, an issue I know the authors have addressed in another paper. If you are a
capital importing country, you need capital inflows to sustain growth in the medium term.
In the end, the paper does not convince me of their claim to abandon that long-time stalwart,
the Mundell-Fleming model. The intuition of Mundell-Fleming gets me to the same point as
this more fancy technology. So I'm not sure I'll invest in the technology upgrade. So the first
thing that Fischer said in his macro lecture stands the test of time. In the real world, in the
end you always come back to ISLM and Mundell-Fleming.