Introducing the global central bank solution | FT Alphaville

Introducing the global central bank solution

Someone has gone and done it – pitched the idea of a global central bank as the solution to the current financial crisis.

Writing on the blog, a platform set up by the Centre for Economic Policy Research, Guillermo Calvo, professor of economics, international and public affairs at Columbia university and former chief economist of the Inter-American Development Bank makes his case (our emphasis):

Credit availability is not ensured by stricter financial regulation. In fact, it can be counterproductive unless it is accompanied by the establishment of a lender of last resort (LOLR) that radically softens the severity of financial crisis by providing timely credit lines. With that aim in mind, the 20th century saw the creation of national or regional central banks in charge of a subset of the capital market. It has now become apparent that the realm of existing central banks is very limited and the world has no institution that fulfils the necessary global role. The IMF is moving in that direction, but it is still too small and too limited to adequately do so. If, as in the past, IMF lending is tied to elaborate conditionality, it may be also too slow.

According to Calvo, financial regulation without a lender of last resort holds little value. Creating a global lender of last resort (as he puts it) is therefore the only solution to the global crisis.

Of course, he admits knocking up a global central bank isn’t exactly the sort of thing that can be done overnight. In the meantime he proposes the creation of something he calls an Emerging Markets Fund to help stabilise their bond prices. Getting to the next stage, however, would involve a fundamental overhaul of the foreign-exchange system. As he explains:

I doubt that unbridled floating exchange rates could be sustained in a new global system in which there is a much greater role for the public sector (in the form of a global LOLR and regulations). Moreover, large devaluations, which are a natural counterpart to flights to quality, could be detrimental to global coordination and cooperation by raising suspicions that they may be prompted by beggar-thy-neighbour motives. To be sure, these suspicions existed prior to current crisis and, as a general rule, do not seem to have had a major impact on international relations or trade in advanced economies.2 However, conditions have changed — finance will not be so readily available to smooth out the effects of large devaluations. Consequently, damage inflicted by large devaluations is likely to be more severe. Policymakers will likely find it harder to ignore them, because their effects will become easily apparent to the general public.

In other words, some sort of return to a fixed exchange system – a revival of Bretton Woods and the re-linking of the dollar to the gold standard perhaps? He doesn’t go into the details, saying the proposal of a global LOLR is a major issue which he will not attempt to provide a full road map on at this juncture.

However, a curiosity worth noting is the hint he gives us in his belief that “damage inflicted by large devaluations is likely to be more severe”.  Is it the case that a global LOLR will be needed to stamp out the effects of massive QE programmes?

We also note that Calvo thanks Carmen Reinhart, among others, for her contributions and comments to his work. Reinhart — professor of economics at the University of Maryland — is of course the co-author of a much-cited work on previous financial crises with Ken Rogoff the former cheif economist of the IMF “Banking Crises: An Equal Opportunity Menace“.

As she observed in November:

The US enjoyed a capital inflow bonanza that funded yawning current account deficits, and asset prices spiralled upward only to crash. While the crash has constricted credit and is redrawing the financial landscape, the US has not been punished by investors in typical Act-Three fashion.  If this had happened to any other government in the world whose national financial institutions were in as deep disarray as those of the US, investors would have run for the hills — cutting off the offending nation from global capital markets. But for the US, just the opposite has happened.

The answer lies in part with the exchange market practices of key emerging market economies.  Since the last global market panic, the Asian Financial Crisis of 1998, many governments have stockpiled dollars in their attempts to prevent their exchange rates from appreciating. At the same time, the long upsurge in commodity prices has swollen the coffers of many resource-rich nations. As a result, and as shown in the latest forecast in the World Economic Outlook of the International Monetary Fund, international reserves of emerging market economies are expected to have increased $3.25 trillion in the last three years. According to the Fund’s survey of the currency composition of those holdings, the bulk is in dollars (see Figure 1).

And she goes on…

Herein lies the special status of US government securities. For a few of the world’s key decision makers, it is not in their economic interest to stop, or even slow, the purchase of Treasury Bills. As Keynes once said: “If you owe your bank a hundred pounds, you have a problem. But if you owe a million, the bank has a problem.” Potential capital losses on existing stocks keep foreign investors locked into US government securities.

But that could change if QE devalues foreign reserves to such a degree that appetite for new sovereign bond purchases is impacted; note China’s concerns on the matter. We speculate Calvo believes in that eventuality some sort of global bank would be needed to manage the fallout.

Related links:
G20: discussing the shape of international reserves to come
– FT Alphaville
Lender of last resort: Put it on the agenda!