In turn, freer capital movements, the ongoing cross-border financial integration, and the 1  growth of private capital flows that followed undermined pegged exchange rates and thus contributed to the spread of flexible exchange rate regimes and inflation targeting in many parts of the world, but in the European Union this development provided part of the rationale for a monetary union. The current international monetary system and the official part of the global financial safety net largely reflect the contours of the global economy as they were before global financial integration and private capital flows reached the level we have seen in this century. Back then, the global macroeconomic problem was related to global current account imbalances and asymmetric adjustment. Keeping your own house in order was in most cases both necessary and sufficient for maintaining economic stability in individual countries. IMF facilities to lend to sovereigns of debtor countries facing balance of payments difficulties were the most important part of the global financial safety net (GFSN). The world we currently live in is different. Financial imbalances in both net and gross balance sheets can be more important than current account imbalances and certainly were so in the build-up to the great financial crisis (GFC). This is a world of cross-border spillovers and spillbacks. It is a world where, for small and open economies (SOEs), keeping your own house in order is certainly necessary but no longer sufficient, at least not if we restrict ourselves to traditional demand management and prudential instruments.

The evidence suggests that foreign exchange markets exhibit excess volatility and that exchange rates diverge from fundamentals for protracted periods. In some sense, the existence of carry trade can be construed as evidence of this, as it involves betting that interest rate differentials are not fully compensated by exchange rate movements; i.e., that uncovered interest rate parity does not hold, except at long horizons, and then often through sharp and disorderly corrections. This, in turn, gives rise to two concerns: first, regarding detrimental effects on the traded goods sector , and second, on financial stability where volatile capital flows, currency mismatches, and rollover risk of foreign currency debt are among the key players. Adverse effects on financial stability can be particularly severe when a blocked interest rate channel and an erratic exchange rate channel interact badly with other economic and financial risks that can face small, open, and financially integrated economies – such as the global financial cycle, domestic financial vulnerabilities, and policy conflicts. We saw trends before the GFC that were consistent with this story. Data on longterm interest rates and spreads in small advanced economies and in many emerging markets economies showed strong and growing correlations with longterm rates and spreads among core rate setters (mainly the US and the eurozone), although still some way from the theoretical limiting case. The GFC reversed this process somewhat, as risk premia skyrocketed, cross-border banking partly retreated to home base, and restrictions on capital movements were in some cases reintroduced.