mar guðmundsson : capital flows and fragmentation of the international financial system speech by mr mar guðmundsson, governor of the central bank of iceland, in session i in the conference “ fragmentation in the international financial system – can the global economy become one again? ”, organised by the central bank of the republic of turkey and the reinventing bretton woods committee, cappadocia, turkey, 14 july 2012. * * * for the most part, i will discuss some flaws in the international monetary and financial system ( s ) ( imfs ) and in the european union ( eu ) framework for cross - border banking and financial stability as they relate to both net capital flows and vulnerabilities in gross capital positions. my perspective on these issues is that of a policy - maker from a very small, open, and what used to be financially integrated economy, but it is also informed by the work i was involved in during my tenure at the bank for international settlements. the current international and monetary and financial system is in some sense a non - system, a hybrid of miscellaneous exchange rate regimes and diverse rules on cross - border capital flows and activities of financial institutions. this opens the door to country choices that, in the aggregate, cause and perpetuate global current account imbalances. this problem and its solution have been discussed extensively, and i will not dwell on that topic here. instead, i want to pose this question : supposing that all countries had free capital movements, freely floating exchange rates, and first - rate macroeconomic policies aimed at internal balance, would everything then be fine, at both the national and global level? i think there are strong indications that it would not be. there are a few reasons for this. first of them is the tendency of exchange rates to move away from equilibrium values for extended periods, with sharp corrections at the end of the process and with excess volatility throughout. the research on this phenomenon is still ongoing, but there are strong indications a number of factors suggest that the process is related at least partly to how asset markets function and how expectations are formed, and would not disappear even if macroeconomic policies were perfect. there will be net capital flows associated with this process, as well as swings in current accounts and effects on domestic financial systems that can ultimately lead to serious financial instability. in a small, open, and increasingly financially integrated economy, the process runs as follows : domestic interest rates at the longer end of the maturity

in 1900. it is obvious at present that the mining expansion is quite concentrated both in its industrial and geographical dimensions, and economic indicators do reflect that. but the mining sector is not the only sector growing. if the recent data are taken at face value, the non - mining economy has grown at about 2 per cent over the past year. mining employment is indeed growing quickly – interestingly enough according to the available data, the increase in mining employment exceeded the fall in manufacturing employment over the past year. but the largest increase of all was in the sector called “ health care and social assistance ”, in which employment rose by about the size of the combined fall in manufacturing and retailing employment over the same period. and while there are clearly differing drivers by industry and by region, there are mechanisms that even out at least some of these differences. spillovers do occur both in the private sector and via the tax and expenditure system. 1 remarkably, in the face of the understandable concern about job losses in particular regions see lowe, p, “ the forces shaping the economy over 2012 ”, address to the committee for economic development of australia, sydney, 16 february 2012. bis central bankers ’ speeches and industries, the dispersion of unemployment rates by statistical region is no larger today than has usually been the case over the past 20 years. hence while there are clearly multiple speeds, the total speed seems to have been one of reasonable growth and low unemployment. the behaviour of households but there is another aspect of the “ multi - speed ” experience, which i suspect explains a good deal of the dissatisfaction we see, and it has to do with the behaviour of the household sector. some parts of the economy that depend on household spending are still experiencing relatively weak conditions, compared with what they have been used to. but this isn ’ t because the mining boom spillovers have failed to arrive. it is, instead, the result of other changes that actually have nothing to do with the mining boom per se, but a lot to do with events that occurred largely before the mining boom really began. the story is summed up in the two charts shown below. the first shows household consumption spending and income, both measured in per capita terms, and adjusting for inflation ( graph 2 ). 2 in brief, household spending grew faster than income for a lengthy period up to about 2005. the arithmetically equivalent statement is that the rate of saving from current income declined, by about 5 percentage points over that period. graph 2