Against the tide

By R.A. | LONDON

WITH each great rush of capital into or out of a region of the world, and with the blooming of crisis that seems inevitably to follow such swings, macroeconomists inch ever further away from the assumption that free capital flows are always and everywhere a good thing. Not long ago we were all digesting the IMF's evolution on the issue. After a series of telling research findings on the effects of capital movements the Fund officially updated its view on the matter. Macroprudential measures (by both source and destination countries) designed to temper flows are probably a good idea, the IMF announced, and in rare cases stricter capital flow limits could be warranted.

The matter may not end there, however. The discussion certainly hasn't. This week's Free exchange column looks at new research by Helene Rey, presented at the Kansas City Fed's Jackson Hole conference, on the risks of the "global financial cycle":

Ms Rey reckons...[g]overnments...face a dilemma, or an “irreconcilable duo”: free capital flows may inevitably mean a loss of monetary-policy independence.

Ms Rey points out that prices of risky assets, such as equities and corporate bonds, move in lockstep across the global economy, regardless of what exchange-rate regime is in place. She links these moves to swings in the VIX—an index of market volatility derived from S&P 500 stock-options prices—which is also correlated with capital flows and credit growth. Ms Rey reckons that these movements are indicators of a global financial cycle. The worldwide correlation of price and capital-flow movements suggests that central bankers sitting in one corner of the world cannot easily lean against a barrage of investment coming from another corner.

Exactly as emerging-market finance ministers complain, this global financial cycle is influenced by rich-world monetary policy. Ms Rey reckons changes in the Federal Reserve’s benchmark interest rate can fuel the cycle. A drop in the rate increases the appetite for market risk as captured in the VIX. That, in turn, encourages credit creation, bank leverage and capital flows into risky assets. The boom feeds on itself as credit growth lifts asset prices, further whetting risk appetites. But a flip in monetary policy that raises interest rates can send the dynamic into reverse.

Fed policy is not a lone villain. Ms Rey estimates an interest-rate change can explain between 4% and 17% of variance in the VIX. Yet that may make all the difference given financial feedback loops; a small change in policy could therefore tip the system into boom or bust.

Addressing the problem may mean macroprudential rules, she says, or capital controls. Others are bound to disagree that such moves are wise. Capital controls impose their own costs (ask Chinese consumers). And an important empirical question is just how much control over monetary policy central banks are giving up; on a country-by-country basis, how much less precision is there in targeting inflation (for example) associated with a particular level of financial liberalisation?

Yet the way Ms Rey sets up these trade-offs, such that capital controls buy you monetary independence, could prove seductive to macroeconomists and policy-makers. When the spectrum of trade-offs was a trilemma, such that a country could have two of monetary independence, fixed exchange rates, or free capital flows, the choice for liberals was easy: take independence and free capital flows and let currencies float. But there is a certain sanctity to monetary independence among macroeconomists. If minimal capital flow limits let you float your currency and guarantee monetary independence, well, economists might warm to that compromise.