Let’s not get ‘carried away’ by Bernanke’s latest twist
from Kevin P. Gallagher
Ben Bernanke, chairman of the US Federal Reserve, should be applauded for boldly putting employment over price stability in his latest move to keep interest rates low and to purchase mortgage-backed securities. Bernanke’s critics (and Bernanke himself) have rightly said that monetary policy is not enough, however. To truly generate employment-led growth in the US, those critics say more fiscal policy is needed.
There is also a need for stronger financial regulation in order to ensure that financial institutions do not steer newfound liquidity into currency and commodity speculation in emerging markets and developing countries—speculation that can wreak havoc on developing countries’ financial systems and growth prospects. Such was the case during previous rounds of interest rate declines and quantitative easing in the US, and could occur again.
Investors may choose not to go down Bernanke’s path but rather to use the carry trade to speculate on foreign currencies. The carry trade is a strategy where investors borrow in low interest rate countries and invest in higher interest rate countries with the “carry” being the difference between the two rates. Profits can increase by orders of magnitude if investors are significantly leveraged and bet against the funding country and on the target country currency.
Earlier this year, the IMF reported that lower interest rates in the US and higher economic growth in emerging markets were associated with a higher probability of a capital inflow “surge”. Surges in capital inflows can cause currency appreciation and asset bubbles that can make exports more expensive and destabilise domestic financial systems. According to that IMF report, one third of the time such surges were accompanied by a sudden reversal of capital flows.
The IMF’s 2011 World Economic Outlook report documents how a “sudden stop” in capital flows can unwind emerging markets and developing economies as well. They show that a 5 basis point increase in US rates could cause capital flight worth 0.5-1.25 per cent of GDP out of the developing world. This is not a short-term problem given that Bernanke has committed to keeping rates low into the future. However, global risk aversion, such as continued euro jitters, can also cause sudden reversals of capital flows.
In 2010 and 2011, many emerging markets and developing countries deployed counter-cyclical capital account regulations such as taxes on inflows or reserve requirements on derivatives transactions to curb the negative effects of cross-border capital volatility. Like earlier studies by the National Bureau of Economic Research and others confirming that regulating capital flows can change the composition of inflows, make for more independent monetary policy and ease exchange rate tensions, new studies by the IMF and others show how countries such as Brazil, Taiwan and South Korea have been at least moderately successful during this recent go-around.
Echoing but formalising work that dates back to Keynes, a new IMF report finds that industrialised countries may need to regulate the outflow of capital as well. The new IMF paper, “Multilateral Aspects of Managing the Capital Account”, argues that when regulating capital inflows is costly or relatively ineffective for borrowing countries, or if the proper regulation would cost too much “collateral damage”, then nations such as the US may need to regulate the outflow of capital.
It may come as a big surprise to learn that the US regulated outflows of speculative capital for close to 10 years, 1963 to 1973. During that period the US administered the Interest Equalisation Tax (IET). The IET was a 15 per cent tax on the purchase of foreign equities. For bond trades the tax variety depending on the maturity structure of the bond, ranging from 2.75 per cent on a three-year bond and up to 15 per cent on a 28.5 year bond. Borrowers looking to float bonds would thus pay approximately 1 per cent more than interest rates in the US, thereby flattening the interest rate differential between the US and Europe.
The proposed Volker Rule would make it harder for US banks to speculate on foreign countries via the carry trade with US deposits. However, an increasing amount of carry trade transactions occur outside the commercial banking system. Moreover, financial interests have led to measures in US trade treaties that make it illegal for trading partners to regulate cross-border finance as well.
Later this autumn, the IMF is set to release a new set of guidelines that will reiterate the need to regulate global financial flows. The fund would do well to incorporate its latest work that shows how industrialised nations may need to regulate capital flows as well. Doing so will help nations across the global economy, regardless of their level of development, achieve their stated economic goals without getting “carried away” by footloose finance.
Kevin P. Gallagher is associate professor of international relations at Boston University and co-chair of the Task Force on Regulating Global Capital Flows for Long-Run Development. With Brittany Baumann, he is the author of the new study “Navigating Capital Flows in Brazil and Chile”.
Published in FINANCIAL TIMES ECONOMISTS’ Blog, September 25, 2012: