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The Global Credit Channel and Monetary Policy

The folks over at Danske Bank's analytical department are really clever people. Too bad then that they don't have an external RSS feed so that you can follow more easily what they have to say; and yes (!), this was a hint. Luckily, I managed to pick up on chief economist Carsten Valgreen's recent paper which deals with the effect of global financial liberalisation on the global economy. Carsten asks some very timely questions I think and in many ways he is close to my own conceptualization as I presented it in a note on the global economy a few weeks back with the notable exception that Carsten also presents an interesting preview of the theoretical background of his arguments. Here are some quotes from the intro ...

Post-war, economic history has seen a long – albeit sometimes slow – process of financial and economic liberalisation. Nowhere is this more true than in the financial markets. The developed world has moved from near financial autarky in the early Bretton Woods days, with managed exchange rates and a miniscule international financial market, to the current system of free float for the major currencies, with largely free flows of international capital and a corresponding stellar growth in the size of international financial markets. Framed within the classic monetary trilemma, the early Bretton Woods system reflected a taste for regulation. Countries chose a mix of fixed currency regimes and independent
monetary policies, leading to a necessity of strict controls of international capital flows. Today the major developed economies have given up on the capital controls while still maintaining monetary policy independence in major currencies. This has lead to floating currencies and capital mobility.


The choice major countries have made in the classical trilemma: ie, Free movements of capital and floating exchange rates – has left room for independent monetary policy. But will it continue to be so? This is not as obvious as it may seem. Legally central banks have monopolies on the issuance of money in a territory. However, as international capital flows are
freed, as assets are becoming easier to use as collateral for creating new money and as money is inherently intangible, monetary transactions with important implications for the real economy in a territory can increasingly take place beyond the control of the central bank. This implies that central banks are losing control over monetary conditions in a broad sense. Historically, this has of course always been happening from time to time. In monetarily unstable economies, hyperinflation has lead to capital flight and the development of ”hard currency” economies based on foreign fiat money or gold.

The new thing – this paper will argue – is that we are increasingly starting to see the loss of monetary control in economies with stable non-inflationary monetary policies. This is especially the case in small open advanced – or semi-advanced – economies. And it is happening in fixed exchange rate regimes and floating regimes alike.


If monetary policy is losing control in these economies, the natural question arises: Who or what is then in control? And what does the loss of control imply for monetary and real economic stability?

This paper argues that the answer is that global financial conditions will matter increasingly. Ultimately global financial conditions will be governed by monetary policy across the major currencies. However, we will also argue that the private credit agencies are gaining power in this process. Increasingly, these institutions can be seen as a new breed of central banks, crucial in directing the extension of credits globally.

Regarding what I have already noted in my recent piece on the global economy as well as my coverage of the CEE economies as of late I think four things stand out from Carsten's piece.

First of all is the notion of how central banks might have lost relative(!) control over credit supply and as such how monetary policy has become a blunt weapon in some countries. In fact, as Carsten also shows in the case of Iceland monetary policy has the potential to have adverse economic effects. However, it goes beyond this I think as I also argue in my recent piece on the global economy (linked above). Think New Zealand, the UK, and perhaps dare I say it the Eurozone(?) which suggests, I believe at least, that this effect might not only be prevalent in small open economies but much more so as a general structural tendency in the global economy.

Secondly, Carsten provides an interesting overview over the theoretical literature which has dealt with the inclusion of credit markets and the 'credit channel' into the standard macroeconomic models such as the IS/LM.

Thirdly, Carsten has a killer graph on p. 4 (graph 4) which shows the amount of loans outstanding in the CEE economies which are denominated in foreign currencies. The underlying current here is of course how financial market innovation and liberalisation have enabled this to actually occur. However, a more interesting perspective is found, I think, when you think of this in relation to the points above on monetary policy. There are two important points here. Firstly there is of course the idea of increasing exposure of these economies to the whim of financial markets. However, following from this is furthermore the notion of how monetary policy is increasingly unable in these countries to stem the flow. In fact, current tendencies suggest that over a wide range of global economies with large current account deficit raising rates only makes more money pour in propping up the domestic currency as well as bolstering domestic demand through terms of trade gains. A more subtle point regarding the CEE economies is also the fact that while things are moving along fine at the moment any sign that some of these countries' monetary authorities were to significantly loosen monetary policy if things turn ill (and they may well do just that) could potentially entail balance sheet issues on the back of the cross-over currency exposure as a result of large pools of foreign currency denominated debt. 

Fourthly and lastly I also think that Carsten's notes on the importance of credit rating agencies are significant. Especially the idea of whether the rating agencies are acting counter- or procyclically

If credit agencies are successfully forward looking and contra-cyclical in their behaviour, they should be able to dampen the global monetary cycles. If not, they could potentially prolong and increase the effect of global monetary policy. Whether rating agencies behave pro- or contracyclical could start to matter a lot. If anything they seem to do the former. The present global discussion of a "liquidity glut" could to some extent reflect the increasing role of the global financial accelerator – and of the credit agencies."

I largely agree with Carsten regarding the rating agencies. Push will come to shove at some point and if the rating agencies really put the whip for example some of the economies with big large debt to GDP ratios they just might be undermining their own existence since what the heck can they really do in these countries? In the end, it is, in part, all a matter of long term management but this is really also a wire act since if the economic mood really turns sour at some point in e.g. Italy or Japan and the rating agencies stick it to them what kind of situation are we looking at then given the underlying demographic dynamics of these countries?

The topic of rating agencies was also noted recently noted in another context of the US subprime mortgage mess where the Economist's financial columnist Buttonwood asked whether in fact not the rating agencies were caught in a bit of a dilemma 

But the agencies are caught in a dilemma. They know that if the cherished triple-A rating is seen as devalued, it would undermine their credibility. Yet they earn so much revenue from CDOs that working with the banks and funds that structure them has proved irresistible.

Indeed a dilemma and also as it were, a conflict of interest. 

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Reader Comments (2)


Just to say I very much agree with you on this topic. I now realise that the Buttonwood Vanishing Vigilante's column (July 19) was all about Carsten's work, which is why when I read his paper the quote you have rang a bell, since I had seen virtually exactly the same thing in Buttonwood some days earlier:

"As central banks lose authority, might credit-rating agencies play the watchdog role? By acting swiftly to downgrade debt, they would constrain companies (and countries) from borrowing too much. But the agencies tend to lean with the wind, rather than against it. They upgrade debt when the economy is booming and downgrade it when recession strikes. If the central banks do eventually slam on the brakes, therefore, the rating agencies will only exacerbate the downturn. As asset ratings fall, investors will be forced to sell their holdings and credit will be withdrawn from the system."

So note here, we are not into IF central banks lose their authority, but AS they do so. That is to say the battle is already over, and the flow of global funds is only likely to increase, especially as people lose their home bias.

Now if markets worked perfectly, we would have no need to worry, but as Cartsen and Buttonwood note, they don't, since there are non-linear reaction curves which are basically pro-cyclical. So we can basically expect trouble, rather than a smooth seamless process of continuous re-adjustment.

The current case of the Italian bank Italease (who are almost going into liquidation) provides a fairly good example:

"Pierantonio Arrighi, the bank's spokesman, said all the bets related to Euribor interest rate contracts. It appears that the derivatives team expected a slower pace of rate rises by the European Central Bank, though it remains a mystery how this could have led to near catastrophic losses in weeks.......“These derivatives were very complex and suddenly turned against us. They started moving in a non-linear way, so the losses were rising exponentially,”

Now in the grand scale of things, Italease is comparatively small beer, but it does provide an indication of how quickly things can turn.

Really I am pretty preoccupied about the new role that is being cast on the Ratings Agencies. They were not built for this, and IMHO are simply not up to the magnitude of the problem when we start to get through to sovereign debt issues of the order of magnitude that you mention. It is unfair that they should be expected to be, and there is really some very irresponsible buck-passing going on here. I mean basically even the EU Commission and the ECB have handed the baton over to them in the case of Italy. This is very worrying.

It is worrying since as Carsten and Bloomberg indicate, the initial response from the agencies when the water gets really choppy will be to try and avoid the issue, not for crass economic motives, but would you really like to be the guy who gets to make the call which pulls the plug on Japanese government debt?

This is too much responsibility for any single pair of shoulders, and other, credible, mechanisms need to be developed, and pronto.

Basically, these agencies might work to some extent (despite the over-reaction process) if the problems were simply cyclical, but they are hardly up to confronting deep structural problems. People often ask themselves what the IMF might usefully get up to these days, well here's an issue for them: sovereign debt vigilantes, but this time not in the emerging market context, where their role is evidently greatly diminished, but in the OECD one.

We can see what Carsten and Buttonwood are talking about when we look at the US sub prime situation. The difficulties which existed there being first systematically underestimated, and then later overestimated. It does not make pleasant thinking to wonder what might happen if this process were repeated in Central and Eastern Europe.
July 26, 2007 | Unregistered CommenterEdward Hugh
With respect to the rating agencies, I think one of the major problems has been that investors, whether institutional or retail, have been accepting the ratings assigned to securities at face value without really digging into the guts of the ratings reports or doing much independent analysis. In the case of portfolio managers for institutions, this is really a kind of failure to perform their job.

I am sure that a conversation between a investment bank rep and an institutional buyer like the following hypothetical has happened many times:

Banker: I have X billion of automaker Y bonds available; they're going fast!

Institution: Moody's says these bonds are BAA; no problem..I'll take $100 million as fast as you can get them to me. I need the yield...

So I agree that the ratings agencies have been incentivized to shade their ratings to the optimistic side, but as always the rule of "buyer beware" applies. Buyers of issues rated by the three major raters used the reputation of the raters to cover their butts in case of default: "Well, Moody's said it was BAA!"...

With respect to the ratings agencies and sovereign debts, I am not all that sympathetic to the agencies. Both the buy-side and the investment banks wanted the agencies in place to help justify pricing of issues, and governments frequently have touted their ratings. All four groups of entities have had a stake in the system as it currently exists. If the raters downgrade a country's debt, instead of complaining about the raters, its up to that country's policymakers to convince the market that the rating is incorrect by providing information or policy changes that demonstrate that the country's issues warrant the desired pricing.
July 26, 2007 | Unregistered CommenterScott Peterson

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