Liquidity Giveth, Liquidity Taketh - The IMF on International Capital Flows

To be an economist these days is a rare privilege and especially; it is a privilege to be a blogging economist since there is just so much good material to write about at the moment. On the one hand, there is the unfolding unravelling of Goldman Sachs (loads of material out there already, but just read Felix and you will be fine) and on the other there is the increasingly ominous signs that the Eurozone as we know it is about to become a thing of the past [1].

I hope that I will get to deal with these specific topics at a later time, but for now I would like to point,  in the most obscure of all directions, to chapter 4 [2]of the IMF's part released Global Financial Stability Report which deals with the transmission of global monetary supply to international capital flows and global asset prices as well as inflation (hat tip: Tracy Alloway at FT Alphaville). Essentially the IMF report takes up the baton of some fundamental issues of global capital markets and issues which I have discussed on numerous occasions. The issue can be summarize through the two following questions;

1 - Can increasing nominal interest rates to quell domestic inflationary pressures be counterproductive and actually lead to overheating?

2 - What is the global effect of near ZIRP policies in a number of big developed economies and what will the effect be if this persists? 

My own answer to the questions above is yes to the first with the qualifying remark that this implies a relative loss over the domestic monetary transmission mechanism both from the point of view of receiving (high interest rate) as well as sending (low interest rate) economies. And as for the second question I tend to see it as an externality to the global economy and crucially so, an externality which adds considerable volatility to global asset prices [3] since implied risk aversion in the market will determine whether the open taps by the G4 are used (or not) to build carry trade positions [4].

In their recent analysis on global capital flows (see link above), the IMF produces quantitative results and a well tailored methodology to boot to support these claims:

The global liquidity cycle started in 2003 and accelerated from the second half of 2007 when country authorities began to undertake unprecedented liquidity-easing measures to mitigate the effects of the crisis (Figure 4.1). While helping stabilize the financial system and support the return to growth, current easy global liquidity conditions and the accompanying surge in capital flows pose policy challenges to a number of countries where the crisis did not originate, with the primary challenge being an upside risk of inflation expectations in goods and asset markets. Such “liquidity-receiving” countries have had to ease domestic monetary conditions in response to both the slowdown in global demand and the acceleration in global liquidity, adding further pressure to asset prices. The policy challenge posed by easy monetary conditions is greater in economies—primarily emerging markets—that, in addition to strong growth prospects, have fixed or managed exchange rate regimes.1 The associated surges in capital inflows also raise early concerns about vulnerabilities to sudden stops once the global liquidity is unwound, with implications for financial stability.

Thus, what the IMF coins as liquidity receives are those economies subject to carry trade inflows (e.g. Brazil, Australia, New Zealand, South Africa etc) and liquidity senders on the other are developed economies with low interest rates. Recently, these were confined to Switzerland and Japan, but in the context of the financial crisis the UK, Europe (to some extent), and the US have also move short term interest rates to the floor and flooded their banking systems with cheap money for the wholesale market. This has even led some to dub it as the mother of all carry trades.

Now, I am tinkering at the moment with a model of international capital flows and global liquidity transmission which exactly seeks to incorporate this effect. In this sense, I think IMF's results are very welcome. I am of course including demographics which I see as the missing link here since while I suspect the US (and the UK) may ultimately succeed in creating inflation which would force them to pull back liquidity provision others will not. Japan is the famous example here, but as the world ages there will be more and more.

In the jargon of the IMF; old age makes economies structurally prone to being a liquidity sender [5] and as the world ages we will have relatively more liquidity senders than receivers. This poses an externality to the global system and also adds to volatility of asset returns and growth over time.

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[1] - Please note that I am in no way favor of this as I am personally a big believer in the European project but Germany has neither the capacity nor willingness to keep paying for others regardless of the fact that Germany's economy is also, itself, an integral part of the problem.

[2] - See a web cast of the conclusions here

[3] - Which, by the way, is why I see great risks from the policy advice that central banks should target asset prices since there is a hidden volatility multiplier in the works here from tinkering too much with short term nominal interest rates.

[4] - I have even made my own humble contribution to a growing body of literature on this.

[5] - C.f. My master's thesis I think this can be explained through intertemporal preference, but I am open to other interpretations.