MONETARY POLICY WITH GLOBAL MARKETS

MONETARY POLICY WITH GLOBAL MARKETS

Most economists support the policy of financial deregulation in
money markets since greater competition between banks – as with
all industry – increases efficiency and brings prices down to the
consumer. Opening frontiers to allow foreign banks to compete is
just the extension of this principle.
The City of London is one of the world’s major financial centres
and the process of deregulation started here back in 1979. The operation
of free enterprise in finance, however, once started built up an
unstoppable momentum. Breakthroughs in technology helped since
it became possible to move money costlessly from one centre to
another across the world with just the push of a few buttons. Most
money, after all, has no physical form – it is just a record on a
computer screen.
Now if banks in one centre can buy and sell money with little
government penalty or tax then clearly banks in other centres
subject to stricter controls will lose custom and profits. Finance
houses in such a situation have usually found ways round central
controls since it is in their interest to do so – the end result is that
deregulation quickly catches on everywhere.
The problem for central banks is that they must inevitably lose
control of their domestic money supplies. Remember that if a
commercial bank’s reserve assets can be reduced by the central
authorities then it must call in its loans, reduce its money supply,
© 2004 Tony Cleaver
by a multiplied amount. But if a bank loses cash reserves to the
central bank and then can compensate for this loss by gaining other
liquid assets from alternative sources (overseas if necessary) it no
longer has to worry about supporting its existing pattern of longterm
loans. Money supplies need not contract. Moreover if all sorts
of financial intermediaries can now enter the industry and buy and
sell money, the reserves of which institutions does the Bank try to
control? Where do you draw the line?
For these two reasons, in a global financial environment, most
countries’ central banks have stopped trying to fine-tune their
domestic money supplies. If a central bank can no longer monopolise
the supply of money in its own backyard, however, it can still
affect the money markets by changing its own discount rate.
Cutting prices will stimulate demand; raising rates will stifle it.
The Transmission Mechanism
The transmission mechanism by which a change in the central rate
of interest impacts on an entire economy can be quite long drawn
out but it is still an important influence.
This is particularly so if the change is unexpected. Since speculation
is rife in financial markets, the decision of a forthcoming meeting
of the central bank committee may have already been built in to the
pricing of marketable assets. (Suppose you think the Bank’s rate will
come down next week and prompt bond prices to rise from 95 to 98
as explained in Box 5.6. If you are selling bonds today, you will hold
out for 98 – bringing forward the fall in the market rate of interest.)
Expectations affect everything in modern economies.
If, of course, the Bank is reducing its discount rate to counter a
prevailing mood of depression then key to the markets’ reactions
will be how the Bank’s actions are interpreted. Is it too little, too
late? A signal of official desperation? Or is it a necessary corrective
measure that everyone applauds and thus comes as a stimulus to
trade sufficient to counter the markets’ gloom? (It is generally
accepted that the actions of the US Federal Reserve to reduce its
discount rate in a continuing series of cuts from 2001 onwards has
helped mitigate an American, and world, economic slowdown.)
A fall in the discount rate will normally be followed by a fall in
most other rates of interest in the market place since, as earlier
© 2004 Tony Cleaver
explained, other rates are based around this. All things being equal,
falling rates bring a boom in asset prices – from speculative paper to
property prices. Mortgages will be cheaper and thus more demand
for houses will push their prices up. People will feel wealthier.
With loans coming easier, if manufacturing industry can quickly
expand production – or where they retain large stockpiles – there
will be more sales of consumer durables. People will buy more cars.
A fall in market rates will bring a reduction in foreign monies
entering the economy to be placed in interest-bearing accounts in
domestic banks. Less demand for the currency, therefore, will cause
a fall in the exchange rate. (This may or may not affect the earnings
from export sales or spending on imports, depending on how
price-elastic the respective demands are. The country’s balance of
payments may thus be affected – see Chapter 6.)
As all these effects cascade through the economy the level of aggregate
demand will rise over time. Particularly influential will be the
impact on investment. Cheaper bank borrowing means it is less costly
to raise funds to invest but an even greater stimulus occurs if business
expectations are shifted. If the change in discount rate secures a more
optimistic business outlook then investment will rise and a multiplied
increase in national income may result (see Chapter 4): Employment
will rise and, providing the economy has the capacity to expand,
output and incomes will increase and inflation will not result.
Exchange Rates
With global financial markets, note that no one country can implement
domestic monetary changes without considering external
influences. If a nation places no restriction on money entering or
leaving its shores then it must take the consequences. In particular,
a country cannot fix its exchange rate with other world currencies,
deregulate its financial markets and hope to pursue an independent
monetary policy. This is known as the ‘impossible triangle’.
As explained above, reducing domestic interest rates to stimulate
domestic demand will result in a DEPRECIATION of the exchange rate.
A country can only keep a fixed price of its currency on the FOREIGN
EXCHANGE MARKETS if it imposes strict capital controls – that is,
prevents dealers from buying and selling the currency in the
quantities they desire.
© 2004 Tony Cleaver
Fixing exchange rates of the domestic coinage to major world
currencies such as the US dollar or the euro (see the gold standard,
Box 5.2) is something that many countries’ governments have
desired – now as in the past – as a means of lending stability to
their own financial systems.
Especially true with a newly introduced currency that people
may not yet have confidence with, if the new paper carries a fixed
value in terms of a trusted external currency then dealers are more
likely to accept it.
Even with well recognised currencies, fixed exchange rates generally
help trade (Box 5.7). For example, if you are planning a foreign
Box 5.7 Discipline in international trade
A fixed exchange rate imposes discipline on central banks and
governments.
Consider the following scenario: if a country is losing out in
trade – such that export revenues are insufficient to cover import
spending – then there are more domestic importers selling the
currency than foreigners wanting to buy it. The price or exchange
rate of this currency will be expected to fall in a free market or, in
a system of fixed exchange rates, a country’s central bank must
sell off its gold or foreign currency reserves to cover the difference
and thus maintain the fixed rate. No central bank can afford
to do this for very long. What a fixed regime ensures therefore, is
that the central authorities must do something to address the
root of the problem: to prevent the country from living beyond its
means and buying more in international trade than it is prepared
to sell. (This generally means cutting back on domestic demand
and attempting to switch resources to promote export production.
It generally implies consuming less – a policy that bankers
and politicians like to recommend for others . . .)
The gold standard, when it operated for all trading counties at
the beginning of the twentieth century, imposed just this discipline
on world economic affairs and some observers with long
memories still hark back to these days and the certainties that
this system embodied.
© 2004 Tony Cleaver
holiday the last thing you want is continually changing foreign
prices – which is exactly what would happen if the exchange rate is
floating, not fixed. Whether it is trying to arrange a holiday or to
secure a vital business contract, varying prices impose a cost – and
thus a disincentive – on trade. Such an argument is particularly
relevant if you are in a small country that deals regularly with a big
neighbour. With so much business at stake, it is better to fix the
exchange rate so everyone knows the costs involved.
FINANCIAL CRISES
The trouble is, trying to maintain fixed exchange rates at times
when global markets question the value of the currency concerned,
has been a contributing factor in most modern financial crashes.
The East Asian currency crisis in 1997, Russia 1998 and Argentina
2001 are only the most recent at the time of going to press. They
are hardly likely to be the last.
At first, international financiers are reassured by fixed exchange
rates. The risk in buying foreign securities is reduced if you know
that the overseas earnings you later receive will not be devalued by
some future fall in price of the currency.
A developing country which perhaps has a change of government
and pegs its currency to the dollar, removes restrictions on the
international movement of money and pursues prudent financial
policies familiar to Western bankers may become very attractive to
overseas investors. Especially if it is resource rich, needful of capital
and with fledgling industry and commerce welcoming to interested
outsiders. Local bankers quick on their feet can now call on far
greater supplies of finance if foreign creditors are confident about
exchange rates. And it is easy to make money when everyone else is
getting in on the act – entrepreneurs find that in setting up a new
company in boom times, everybody wants a share and prices on the
bonds and securities they issue keep rising. Does it matter that
projected future profits are based on scarce or over-optimistic data?
If confidence holds, not really. Those people rushing in to get rich
quick will not worry if the paper they hold is over-priced – so long
as they are confident that they can sell it later for even higher
prices. The market succumbs to feverish buying . . . until sometime,
somehow, somebody blows the whistle.
© 2004 Tony Cleaver
All crashes occur when assets become overvalued in a speculative
bubble. The readjustment that is inevitable and which everyone
knows is coming sooner or later, typically occurs in one traumatic
collapse rather than in a gentle and less painful slowdown over
time. Why? Because no one wants to hold on to their stocks if
prices are falling. Once started, fear of loss terrifies everyone into
panic selling.
To just blame the herd instinct, collective myopia or capitalist
greed getting the better of wisdom is to describe the problem
without explaining it. The reality is that the prices of speculative
assets repeatedly diverge from their underlying values, financial
intermediaries can provoke rather than contain binge buying, unrestricted
international money flows add to the pressure and, when
sentiments change, sudden price readjustment can be catastrophic.
Piling in and out of foreign currencies can quickly force exchange
rates apart. Immature financial sectors in developing countries can
perhaps be forgiven, but when international markets get in on the
act it is not just a few local businesses that go under – no exchange
rate can hold out against vast and rapid speculative money flows
across borders as everyone rushes to sell one currency and buy
another. Then whole countries can suffer.
The history of any one financial crisis will always illustrate
special factors that lead people to think that this time, this place, in
this case, things will be different. In the case of Japan and other East
Asian economies like Thailand, South Korea, and Indonesia they
had been amongst the fastest growing economies in the world for
the last half of the twentieth century and international banks
everywhere were happy to lend them money. The fact that this was
fuelling rapid property price rises was nothing special – owning real
estate in such a dynamic quarter of the globe seemed a good investment.
But, if the backing or collateral on too many bad loans is
unproductive property and banks all try at the same time to cash in
that property to get their money back, then these prices collapse.
Confidence is shaken. Many local intermediaries thought at first to
be rock solid can be exposed as issuing too many risky loans to
undeserving cronies. Then there is panic and wild selling. Foreigners
want to get their money out. Dollar-denominated loans,
incurred from overseas to fund local Asian investment, have then to
be paid back when the domestic currency is skydiving. It can’t be
© 2004 Tony Cleaver
done. Foreign debt holders won’t accept your paper anymore. So
businesspeople go bankrupt. Companies fold. Governments which
have similarly borrowed internationally now have to default on
loans since their interest payments in dollars have soared whilst
their domestic tax revenues have collapsed. Economies as a whole
slump into recession.
Argentina is different. Surely fixed exchange rates were justifiable
here? Rampant inflation at the end of the 1980s was eventually
cured in 1991 when the old currency was reformed by the government’s
Convertibility Plan – which instituted a fixed, one-for-one
peso to the dollar exchange rate. Control of the money supply was
thus secured. The domestic currency could now only be created if
the country possessed equal reserves of US dollars. In one fell
swoop, this prevented financial intermediaries from over-issuing
credit and stoking up more and more spending. From 4,000 per cent
in 1989, the rate of increase in prices came down to single digits
by 1992.
This was a revolutionary reform. Now at last the Argentines had
a currency they could trust. Pesos were interchangeable with dollars
in every shop and on every street corner in the land. The
Convertibility Plan and the government which produced it became
enormously popular. Indeed, the international financial community
led by the IMF widely applauded Argentina’s policies of financial
deregulation and monetary discipline and the country was offered
as a model for other developing countries to emulate.
But one country can only tie its currency to that of another over
the longer run if it experiences similar economic fortunes (growing
or declining in parallel at roughly the same rate) and, in particular,
if domestic monetary policies and practice give foreign investors no
cause for concern (incomes and spending are balanced; borrowing
and lending are transparently prudent).
In the course of the late 1990s neither condition held for
Argentina. The US economy was booming; Argentina was not. The
strength of the dollar meant that Argentine exports – pegged to the
same high rate – struggled to find sales. In January 1999 Brazil
devalued the real to help its own industry compete, which only
increased the difficulties for its South American neighbour.
Meanwhile Argentina’s Achilles’ heel – excessive public sector
spending – became increasingly exposed. Even when domestic
© 2004 Tony Cleaver
incomes were growing in the early 1990s, tax revenues had been
insufficient to cover needs. At the turn of the millennium, with
recession yawning and social spending demands mounting, more
and more resort to foreign borrowing was necessary.
Box 5.8 Central bank independence
Amongst other functions, central banks act as bankers to the
government and so have a direct role in arranging their financial
affairs. In addition, through the exercise of the three monetary
instruments listed earlier in this chapter, and also just by advice
and persuasion, a central bank exerts an important influence on
the overall health of an economy. For both reasons, therefore,
central banks have an important relationship with the country’s
political leaders and there is always the possibility that this
relationship might be manipulated, therefore, for political ends.
Governments in some countries have urged central banks to
directly create more money or to arrange greater and greater overseas
borrowing – in many cases to fund overtly political spending.
Less obviously, central banks regularly come under pressure to
give a boost to aggregate demand and thereby reduce unemployment
before election times. (Any inflationary costs tend to
filter through after people have voted and politicians have been
elected.)
For these reasons there is a growing call for central banks to
be made independent of political influence – enshrined in laws
that limit the authority of governments to overrule central banks
with regard to monetary matters. (Typically, the central bank is
charged by government to keep inflation within a certain maximum
target, say 2 per cent, and politicians are not allowed to
interfere further.) Certainly, recent research shows a correlation
between the independence of central banks and their success in
controlling inflation and facilitating economic growth: Those
countries where political influence is greatest tend to have the
highest rates of inflation and the most unstable growth rates.
Conversely, central banks freer from interference have managed
national finances better.
© 2004 Tony Cleaver
Confidence in the exchange rate evaporated – the real value of
the peso was nowhere equal to the US dollar and foreign and
domestic creditors would accept it no longer. The financial crisis
when it hit at the end of 2001 brought down the government and
ruined the economy. Banks had to close their doors against the
thousands of people clamouring to get their money out. In the end,
many people and businesses had to resort to barter and national
income shrunk by almost 20 per cent in a matter of months. Such is
the result when money fails to fulfil its primary function as a medium
of exchange.