have international reserves that are equal to the stock of short-term (less than one year) external liabilities. Other authors have used modeling techniques to evaluate the optimal level of foreign currency reserves— particularly, in the context of the recent massive rise in emerging market reserve holding.<sup>104</sup> There is a cost to holding more international reserves: higher inflation if the reserve accumulation is not sterilized and quasi-fiscal costs if the accumulation is sterilized using domestic securities that have a higher interest rate than the return on reserve assets.<sup>105</sup> A more recent literature has focused on risks arising from the “double drain;” that is, weaknesses in the domestic financial system can result in national residents fleeing the system. This is the first “drain,” and if those depositors then try to convert their local currency into foreign currency, a second (this time, external) “drain” develops. Obstfeld et al (2010) develop this concept in a model of optimal reserve holdings and provide empirical evidence that emerging markets with larger banking systems tend to hold more international reserves. Concerns over the domestic banking system can be another motivation that leads to reserve accumulation that might otherwise be considered “excessive.” Much of this discussion at the country level revolves around the concept of the macroeconomic policy “trilemma”: the impossibility of simultaneously achieving the three objectives of independent monetary policy, exchange rate stability and capital account openness. Only two of these objectives can be attained simultaneously. Recent narratives are consistent with the “trilemma:” China maintains exchange rate stability with sterilized reserve accumulation to limit inflation; however, it maintains rather strong capital controls. The United States, on the other hand, maintains open capital accounts and has independent monetary policy but a relatively unstable exchange rate _vis-a-vis_ other key currencies. Following the 2008-9 global crisis, Brazil has raised interest rates to combat overheating in a context of rather open capital accounts, and the result was a sharp appreciation of its currency against the US dollar. These are caricatures, as countries attempt to allow some adjustment to the exchange rate and some capital mobility; however, Obstfeld et al (2005) find empirical evidence that the “trilemma” broadly holds over the last century.

The general tendency toward more open capital accounts since the latter part of the Bretton Woods period has implied a substantial increase in the degree of financial integration across countries. As the 2008-9 financial crisis revealed, the connectedness of financial institutions across borders poses new risks for the global economy as well as new challenges for international safety net arrangements. Naturally, the lender of last resort function relates to the quality and effectiveness of financial sector regulation and supervision. The safety net will not be activated as often or in such great scale if prior action can be taken via bank regulation and supervision. There are numerous proposals for strengthening these roles at the international level; however, these topics are beyond the scope of this paper.

# c. Global Liquidity (during “Normal” Times)

Under a pure gold standard, the overall supply of global liquidity is determined by the gold mining industry. If a paper currency’s value is tied to a pre-determined quantity of gold, then base money cannot be created by national central banks unless the gold is “earned” from other central banks via a balance of payments surplus. On aggregate, however, if the world supply of gold is more or less fixed in the short-run, then the global supply of base money is fixed. As a result, a pure gold standard can create a drag on economic growth or create deflationary pressures in countries facing a balance of payments 104 See Jeanne and Rancière (2008) and Alfaro and Kanczuk (2009).

105 Saraiva and Canuto (2009) use the Brazilian pre-payment of debt to the IMF in early 2006 as a benchmark event signaling reserve accuracy. They then calculate that the carrying cost of additional reserve accumulation from that point to mid-2009 reached an amount equivalent to 2 percent of Brazilian GDP. The interest differential in Brazil is larger than many other emerging market countries; however, this back-of-the-envelope estimate is illustrative of the potential for substantial costs from high levels of reserve accumulation. IMF (2011c) estimates that, for the median country, the reserve costs averaged about 0.5 percent of GDP over 2001-2009.

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