Originally built for the 1964 New York World’s Fair, the “It’s a small world” exhibition re-opened at Disneyland two years later in 1966. At the time, the international monetary system was characterized by fixed exchange rates and widespread capital controls.
A half century later, global finance has been transformed so that exchange rates are now mostly flexible and cross-border capital mobility is generally high. As they say in Disneyland, it’s a small world after all.
These sweeping changes have been associated with an explosion in cross-border transactions. And, as national borders have become more open to both trade and finance, policy spillovers have risen as well. One symptom of this is that policymakers in open economies, especially those that are smaller and less developed, feel increasingly victimized by the actions of their large economy counterparts. It is in this context that the Fed has come in for particularly heavy criticism in recent years – both when it eases policy and when it tightens. For the FOMC, the world probably seems annoyingly small.
Why have the complaints about policy spillovers become so much louder and more frequent?
Our answer is that global financial markets are far more integrated than ever before. And, this integration magnifies the importance of changes in the cost of obtaining U.S. dollars.
On the first point, the extensive historical work of Obstfeld and Taylor (see here and here) leads to the conclusion that – since the mid-1990s – capital markets have been more open than they were at any time in the past 150 years, including the period of the classical gold standard prior to World War I.
Moreover, during the past 20 years, cross-border financial integration has proceeded by leaps and bounds. The following chart traces the recent evolution of international investment positions for 127 countries as a percentage of world GDP. From 1995 to 2014, gross international asset positions climbed steadily from 75% to 175% of world GDP. In nominal terms, that’s an increase from $23.4 trillion to $135.7 trillion (at market exchange rates). (For a more detailed discussion, see here.)
Gross cross-border asset and liability positions (percent of world GDP)
Extensive global integration allows countries to be sizable net creditors or debtors. The chart includes both assets (which are positive) and liabilities (which are negative), so their sum represents a country’s or region’s net position with respect to the rest of the world. For example, at the end of 2014, the United States was the world’s largest net debtor to the tune of 9% of global GDP, or about $7.0 trillion. On the other side, China and Japan are the largest net creditors, with the world owing them a total of $5.1 trillion.
The chart also highlights a key point that is often missed: what usually matters for financial vulnerability is the gross asset and liability positions, not their annual changes. Even today, many observers focus on large persistent flows – measured by the balance on current account – as their principal international concern. They note correctly that large current account deficits are often a precursor to crises. Yet, while these flows are important, financial risks can emerge directly from fragilities in a country’s gross financial positions, which are now bigger than ever and still expanding for many economies. And a run, whether on a bank or a country, becomes devastating at least in part because of the scale of the overall assets and liabilities.
You can think of the growth of cross-border asset holdings as a proxy for the rising impact of developments abroad on domestic markets and economies. For example, the bigger the cross-border positions, the more important foreign investor attitudes become for a country’s financial health. To the extent that interest rates and equity valuations influence the real economy, it follows naturally that changes in cross-border holdings (both prices and quantities) are then more important for determining growth and employment (see the discussion here).
This brings us to the second part of the argument: the unique role of the U.S. dollar. As we wrote previously in other contexts (see here and here), the dollar is the foundation of the international monetary system. It is the dominant currency in foreign exchange markets, the primary currency for trade finance, the invoicing currency for a large fraction of global trade, and the unit of account for most commodities. Based on these factors, as well as the perception of safety and stability, the dollar is the currency of choice for many international investors, both private and official. This preference has naturally led to (and been reinforced by) the development of an enormous dollar-based financial system outside U.S. borders that is now at least as large as the internal U.S. banking system and exceeds 20% of global GDP (see our earlier post).
In blunt terms, the U.S. dollar is at the center of today’s globally integrated financial system.
Now, it has usually been the case that the central bank at the center of the international monetary system was the first among equals, so its policies matter for others in a way that is not true in reverse. In the 19th century, this role was played by the Bank of England. Today, it is the Federal Reserve.
Like any central bank, the Fed sets monetary policy by altering the scarcity value of its currency. This intertemporal price is the interest rate. If people outside of the United States price their products in dollars, use dollars to finance their business operations, and purchase dollar-denominated assets, then, when the Federal Reserve changes the dollar interest rate, it changes their costs and their investment decisions, too. Put another way, by changing U.S. financial conditions, the Fed also changes the entire global configuration of prices and asset returns, prompting a re-pricing and spurring cross-border flows.
In theory, every central bank’s policy actions have this same impact both domestically and externally. That is, when they change the cost of doing business in their currency, they alter the relative attractiveness of holding the assets issued in that currency. So, what is true for the Fed is true for the Bank of Japan, the South African Reserve Bank and every other central bank in the world. But the fact is that the dollar is special in a way that the yen and rand are not. What that means is that when the Fed acts, virtually everyone is affected. When others act, fewer people notice. [Let’s not overdo it: reflecting the economic scale and international linkages of the euro area and China, actions by their central banks also have significant spillover impact.]
Now, we aren’t quite done. The dollar has been central to the international financial system at least since 1945. But, under the Bretton Woods system from 1945 to 1971, many countries had capital controls. This meant both that cross-border asset holdings were small and that these countries could use domestic policies to cushion themselves from the impact of Federal Reserve policy changes. Spillovers emerged after the collapse of Bretton Woods in 1971, but with trade and financial flows still relatively small, they were initially modest.
It is only in the last 20 years, with the combination of flexible exchange rates, mature global capital markets, and the explosion of cross-border international investment positions, that Federal Reserve policy has become so important globally. Indeed, detailed research at the IMF indicates that U.S. monetary policy spillovers have increased substantially over the past decade.
So, there is reason for policymakers outside the United States to be more concerned about what the Fed does on a day-to-day basis. On top of this, tighter global financial integration means that cross-border contagion is a bigger risk than in the past. So, while Federal Reserve officials properly argue that their legislative mandate obliges them to focus on domestic economic and financial conditions, they must take account of the feedback from the international impact of their actions. And, because the U.S. financial market cannot be an oasis of stability amid global financial turmoil, they also have an unavoidable responsibility for global financial stability. This means both integrating concerns about external spillovers into their regular decisions, and, as we have argued before, developing tools to cushion offshore shortages of U.S. dollar liquidity if and when they occur.
All in all, the “small financial world” we now live in is far more efficient than the segmented one of years past. We firmly believe that global financial integration has contributed to prosperity in the past and continues to provide the foundation for improved economic prospects in the future. But living in this smaller world means that all of us have to take increasing account of how our actions affect others. Of course, loud complaints from neighbors can become irritating (just like that saccharine “small world” refrain). Yet, like it or not, the FOMC can expect this theme to persist and recur. Get used to it.