Monetary Nationalism and International Economic Instability

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135

Monetary nationalisM and international econoMic instability

AndreAsHoffmAnn And GuntHer scHnAbl

ABSTRACT : This paper describes the internatinal transmissin f bm-

and-bust cycles t small periphery ecnmies as the utcme f excessiveliquidity supply in large center ecnmies, based n the credit cycletheries f Hayek, Mises, and Minsky. We shw hw t-expansinarymnetary plicies can cause verinvestment cycles and distrtins inthe ecnmic structure n bth the natinal and the internatinal level.Feedback eects of crises in periphery countries on center countries triggernew runds f mnetary expansin in center cuntries, which bring abutnew credit bms and internatinal distrtins. Crisis and cntaginin globalized goods and nancial markets indicate the limits of purelynatinal mnetary plicies in cuntries, which prvide the asymmetricwrld mnetary system with an internatinal currency. This makes the

case fr a mnetary plicy in large cuntries that takes respnsibility fr itslong-term eects on goods and nancial markets in both the center and theperiphery cuntries f the wrld mnetary system.

KEYWORDS: credit cycles, mnetary plicy, crisis, cntagin, Hayek,Mises, Minsky

JEL CLASSIFICATION : E42, E58, F33, F44

Andreas Homann ([email protected]) is Assistant Professor of Economics, and Gunther Schnabl ([email protected]) is Professor of

International Economics and Economic Policy, at the Department of Economics of Leipzig University, Germany. We thank Mari Rizz, an annymus referee, as wellas the editr f this jurnal fr valuable cmments and supprt.

VoL. 16 | No. 2 | 135–164

SUMMER 2013

The

QuArterly

JournAl f

AustriAn

economics



136 The Quarterly Journal of Austrian Economics 16, No. 2 (2013)

“the desirable behavir f the ttal quantity f mney [...] can neverlegitimately be applied t the situatin f a single cuntry which is partf an internatinal ecnmic system, and that any attempt t d s islikely in the lng run and fr the wrld as a whle t be an additinalsource of instability.” (Friedrich von Hayek, 1937a, p. 93)

“The wavelike movement eecting the economic system, the recurrencef perids f bm which are fllwed by perids f depressin is theunavidable utcme f the attempts, repeated again and again, t lwerthe gross market rate of interest by means of credit expansion.“ (Ludwig

von Mises, 1998 [1949], p. 572)

1. INTRODUCTION

The subprime market crisis of 2007 and the following global crisishave led t decisive interest rate cuts twards zer and unprec-

edented quantitative easing in the advanced ecnmies. Central banks, particularly at the cre f the wrld mnetary system such

as the US Federal Reserve (Fed) and the European Central Bank (ECB), have provided ample liquidity to the nancial system tocunteract the threat f a painful glbal credit crunch. Interest cutsand devaluatins were expected t speed up the ecnmic recvery by generating investment, exprt mmentum and grwth.

Yet given liberalized internatinal capital markets, these purelydmestically riented plicies hld severe risks f fuelling bubblesabrad, thereby causing internatinal ecnmic instability. Theliquidity glut in the large advanced cuntries has led t destabilizingcapital ows to emerging market economies, which have triggereddistrting plicy measures such as excessive reserve accumulatin,nn-market based sterilizatin f surplus liquidity, state directedcapital allcatin and the intrductin f capital cntrls.

The crisis reactins have triggered a discussin abut the appr-priate global monetary regime. Steil (2007) argues that monetarysovereignty is the Achilles’ heel of globalization. UNCTAD (2010)and McKinnon (2010) propose policies to put a constraint on

purely dmestically riented mnetary plicies f large ecnmies.Emerging markets such as China and Russia call fr a new inter-natinal system that is less dependent n the mnetary plicydecisions of the US Federal Reserve System (Xiaochuan, 2009).



137Andreas Hofmann and Gunther Schnabl: Monetary Nationalism…

In the 1930s, Hayek (1937a) warned that in an environment of oating exchange rates—as present since the breakdown of theBretton Woods System—insular monetary policies will causedestabilizing capital outows to other countries. “Suspicion thatexchange rates were likely to change in the near future” were arguedto foster one-way bets on appreciation (Hayek, 1937a, pp. 63–64).When central banks lwer interest rates t exceptinally lw levelst stem against painful appreciatin and destabilizing capitalinows, they allow for excessive credit creation. This puts the

stage fr Mises-Hayek style credit cycles, structural distrtinsand cmpetitive depreciatins.

Previous research empirically shows that a fall of interest ratest unnaturally lw levels can cause distrtins r Mises-Hayek style credit cycles in an economy (Keeler, 2001; Young, 2005; andMulligan, 2006). Since the 2007 subprime crisis, there is a growing bdy f literature that applies the Mises-Hayek credit cycle theryto explain causes of the nancial crisis (Garrison, 2009; Leijon-hufvud, 2009; O’Driscoll, 2009; Salerno, 2012; and Young, 2012).

only a little research addresses internatinal linkages as described by Hayek (1937a). Schnabl and Homann (2008) argue that sincethe 1980s, undue monetary expansion in large advanced economieshas caused a wave f wandering bubbles in new and emergingmarkets. Homann and Schnabl (2011) point out that the recurringand grwing bubbles were caused by asymmetric macrecnmicplicy patterns, i.e., a structural decline f mnetary plicy ratestwards zer and a substantial increase f public debt levels.

Borio and Disyatat (2011) provide empirical evidence that interestrates in large advanced ecnmies have reached exceptinally lwlevels. They argue that this is the key behind the internatinalcredit booms after the turn of the millennium. Homann (2010)shws that lw eur area interest rates cntributed t Austrian-type credit cycles in central and eastern Eurpe in the 2000s.Cachanosky (2013) explains the link between low interest ratesin large advanced ecnmies and the develpment f structural

distrtins in small pen emerging ecnmies.Inspired by Hayek (1937a)’s claim that “monetary nationalism”

renders the internatinal ecnmic system fragile, we aim tfurther analyze the limits and risks f dmestically riented




mnetary plicies based n a Mises-Hayek verinvestment1

/credit cycle framewrk.

The paper prvides tw innvatins. First, we extend the standardclsed-ecnmy setting f the Mises-Hayek credit bm thery(as reviewed in section 2) to a two-country partial equilibriumframework to outline the eects of monetary expansion in largeindustrial economies on emerging markets (section 3). We focus onan explanatin f the internatinal transmissin f credit bms viacapital ows from large advanced to small open economies under

dierent exchange rate regimes. To account for risk-taking of banks,which has becme an imprtant aspect f bm-and-bust cycles, weintegrate aspects of Minsky’s (1992) “theory of nancial instability.”

Secnd, we apply ur extended Mises-Hayek framewrk tshw that crisis in emerging markets can have destabilizingfeedback eects on large industrialized countries (section 4). Thiswill highlight the limits f purely dmestically riented mnetarypolicies for large countries and the benet to large countries from atimely exit frm near-t zer interest rate plicies and quantitative

easing. The paper cncludes with plicy implicatins in the spiritof Hayek (1937a) (section 5).

2. THE CREDIT CYCLE IN A CLOSED ECONOMY

We review the credit cycle (overinvestment) theory of Mises(1912, 1928, 1998 [1949]) and Hayek (1976 [1929], 1967 [1935]) in asimplied framework to describe the economic distortions caused by t-expansinary mnetary plicy as a basis fr extensin in

sectin 3. T accunt fr risk-taking aspects we fcus n Hayek’s(1929 [1976]) early works on credit cycles and integrate parts of Minsky’s (1992) “theory of nancial instability.”

2.1. Model setup

We distinguish three types f interest rates t explain credit cycles:First, the natural interest rate i

nis dened as the interest rate which

1 Hayek (1976 [1929]) referred to unsustainable investment as “Überinvestition”r “verinvestment.” T emphasize the distrtins in the prductin structure,often unsustainable investment is also labeled “mal-investment” (see for instanceGarrison, 2006).




balances supply (saving) and demand (investment) on domesticcapital markets (I 1=S

1in Figure 1). Second, the central bank interest

rate icb

is the plicy rate set by the central bank. It represents theinterest rate, which cmmercial banks are charged by the central bank for renancing operations. Third, the capital market interest rate icis dened as the interest rate set by the private banking (nancial)

sectr fr credit prvided t private enterprises. We understand allthree types of interest rates as real interest rates. Because pricesare sticky in the shrt run changes in nminal interest rates are

assumed t be equivalent t changes in real interest rates. Respec-tively, we refer t real investment, real saving and real credit.

We assume the saving-investment decisins in an ecnmy tequilibrate, when the capital market interest rate is equal t the naturalrate of interest , which balances planned saving and investment(Rizzo and O’Driscoll, 1997, p. 203; Garrison, 2006, pp. 36–40). Inur framewrk, the capital market rate is nt slely determined by the market. Instead, it is assumed that the central bank steerscapital market rates via central bank rates as lng as mnetarypolicy and capital markets work smoothly. For simplication, weassume that under nrmal cnditins the central bank and thecapital market rate are identical.

2.2. THE CREDIT CYCLE

In the Mises-Hayek thery a credit cycle begins with a fall f thecapital market rate below the natural rate. Following Mises (1928,

pp. 53–58) and Hayek (1976 [1929], p. 79) this may be caused bya central bank that aims at stimulating the ecnmy by lweringcentral bank plicy rates.2

The fall in policy rates allows for easy renancing conditionss that capital market rates fall as well. In Figure 1a, the central bank lwers the plicy rate frm i

cb1t i

cb2. As the natural rate f

interest stays unchanged, the policy and natural rates diverge (in1

=

in2

= icb1

> icb2

). If commercial banks follow the central bank via credit

2 Hayek (1976 [1929], p. 106) oers alternative reasons for a fall of the capital marketrate belw the natural rate. He stresses the crucial rle f the elasticity f the creditsystem fr the emergence f credit cycles and argues that central bank plicies area possible trigger but not a necessary condition for credit cycles (p. 83).




expansin the capital market rate f interest diverges frm thenatural rate (in2

> ic2

).

Figure 1. Closed Economy Disequilibria

I 1,2 I 2S1

icb2 , ic2

in1,2 , icb1

, ic1icb2

, ic2

in2 , icb3

, ic3

I 1 = S1 I 3 = S3

I 2

i i

S2’ S2

S2ΔC1

S3S2ΔC2

I, S I, S

a) Upswing b) Downturn

According to Hayek (1976 [1929], pp. 98–100), banks have anincentive t fllw the central bank’s interest rate cut because f cmpetitin fr market share. The credit expansin is mdeled by a right shift of the savings (capital supply) curve to S

2 , which

then represents planned savings S1

plus the additinal creditsupply ΔC

1. S

2’represents the lwer planned savings S

1at i

c2.3 The

falling interest rate triggers additional investment. Projects with alower marginal eciency can be nanced that are not backed by

respective saving (I 2 > S2’).

Fllwing the Mises-Hayek credit cycle thery, excessivelending distrts the prductin structure f the ecnmy duringthe upswing.4 If planned saving had increased t S

2tgether with

investment, (future) preferences of households would be in line withthe investment plans as mre saving signals rising cnsumptin inthe future. As interest rates are lwer despite higher investment,

3 We use an apstrphe t mark ex ante planned saving.

4 Garrison (2004; 2006, pp. 67–83) models the eects of monetary policy on thestructure f prductin. He uses prductin pssibility frntiers and the Hayekiantriangle to illustrate the distortionary eects of monetary expansion.




the credit expansin falsely signals that planned saving S2’ (pref -erences of households to forgo present consumption) has increasedt S

2. With cnsumptin being expected t decline in the present

and t increase in the future, high future returns n investmentin capital goods (which aim at producing future consumer goods)are expected (Mises, 1912, pp. 430–432; Hayek, 1976 [1929], p. 101;Hayek, 1967 [1935], p. 89; Mises, 1998 [1949], pp. 550–560).

This cnstitutes an unsustainable disequilibrium betweenplanned saving and investment S

2’< I

2at i

c2

< in

2

(Figure 1a). Anverinvestment bm in the capital gds sectr is induced.Unemplyed capacities and labr are drawn int the prductinf investment gds. Rising emplyment, wages and incmestimulate cnsumptin. Given lw interest rates, the demandfor consumer goods—particularly durable goods—rises as well.Rising demand prvides an incentive t further increase capacities(Garrison, 2004).

Due to rising demand, expected returns in investment goods

industries remain high (Hayek, 1937b) and stock prices rise.Households may want to participate in rising enterprise prots (orare unwilling to consume at higher prices) and decide to investin stck markets. Additinal capital is prvided fr investment(endogenous shift in savings). This dampens the inationarypressure in the cnsumer gds sectrs fr a while. As the equityof rms increases, banks are inclined to lend even more at lowinterest rates. The protability and sustainability of investment becmes even mre dependent n lw capital market rates and

increasing asset prices.In this context, Minsky (2008 [1986], p. 233) argues that low

interest rates stimulate risk-taking f banks. Given lw interestrates, hedge nancing is transformed into Ponzi nancing and“Ponzi nancing may be transformed to speculative nancing” (Minsky,2008 [1986], pp. 231–232).5 While “hedge nance units are vulnerableto diculties in fullling outstanding nancial commitments only if

5 Minsky (2008 [1986]) denes hedge nance as the traditional form of nancing withinvestrs being able t repay lans and interest rates in the future based n thereturns of investment. Speculative nance schemes only cover the cash ows. Inthe case f Ponzi nance , t stay in business investrs have t brrw t meet theirnear-term debt bligatins. It is nly sustainable as lng as asset prices increase.




receipts fall short of expectations,” Ponzi and speculative nancemainly hinges n lw interest rates because debt has t be rlledover to extend nancing after a while (Minsky, 2008 [1986], pp.233–234). Thus, articially low interest rates not only induceverinvestment in capital gds sectrs but als induce leverage,which is unsustainable nce interest rates increase.

Investment and cnsumptin c-mve upwards. At sme pint,labr becmes scarce and capacity limits are reached. Tempraryver-emplyment f resurces may emerge t satisfy furtherincreasing demand.6 But due to overinvestment, resources are bund in the capital gds sectr, leaving the cnsumptin gdssectr eventually unable t cntinue satisfying increasing demandat cnstant cnsumer gds prices. overinvestment in capital-intensive sectrs is fllwed by incmes rising faster than thesupply f cnsumer gds.

The bm turns bust, when ver-emplyment f capital andlabr cannt be sustained t keep up the prductin level and

consumer price ination accelerates. The central bank increases theinterest rate to ght ination (Hayek, 1976 [1929], p. 100; Minsky,1992, p. 8)7 and/or commercial banks tighten credit supply (Hayek,1976 [1929], pp. 100–101). In Figure 1b, credit is tightened by ΔC

2 ,

and central bank rates and capital market rates rise t icb3

and ic3

.This shifts the savings (capital supply) curve back to the right toS

3. The distrtins in the ecnmic structure becme visible and

investment prjects with an internal interest rate belw icb3

= ic3

have t be dismantled.

A cumulative prcess dwnwards shifts the investment curvet the left. If the central bank keeps credit tight, the natural rate is belw the capital market rate. “Debt deation” and “deep depression” follows (Minsky, 2008 [1986], p. 245).

6 In the short run, longer working hours or the over-use of machinery (capitalconsumption as opposed to maintenance) in the overinvested industries mayrelieve the resurce cnstraint. The resulting rapid depreciatin f capital gdsmay look justied in the light of rising expected prots (Garrison, 2004; 2006).

7 This implies that under a at money standard, the central bank feels obliged tokeep consumer price ination under control. If, however, the central bank doesnt tighten credit supply, the bm cmes t an end as well because the increasingprice level brings abut the tightening f real credit.




3. MONETARY NATIONALISM ANDINTERNATIONAL ECONOMIC INSTABILITY

The seminal credit cycle theory of Mises (1912) and Hayek (1976 [1929]; 1967 [1935]) was elaborated as closed economyframewrk.8 Domestic monetary expansion leads to a domesticcredit cycle. T mdel hw mnetary expansin in ne ecnmycan cause a credit cycle in anther ecnmy we augment thecredit cycle thery t a tw-cuntry setting. The augmented

mdel helps t shw hw, in an asymmetric wrld mnetarysystem, mnetary plicy in a large “center” cuntry can cause boom-and-bust cycles in small “periphery” countries. (For asimilar approach see McKinnon, 2010).

In this extended framewrk, we assume that bth the centerand periphery countries are fully open to trade and capital ows.We further assume that center and periphery cuntries have theirown currencies which are linked via exchange rates. Although—reecting the current world monetary system—exchange rates areften de jure exible, we acknowledge a persistent “fear of oating” in periphery countries (Calvo and Reinhart, 2002). This implieseither xed exchange rate strategies or discretionary foreignexchange interventins in periphery cuntries t stabilize exchangerates. In the face f mnetary expansin in the center ecnmy andappreciatin pressure n the currencies f the periphery cuntries,exchange rate stabilizatin leads t an accumulatin f freign(dollar) reserves in the balance sheets of periphery central banks

because of negative growth eects of appreciation. Thus, themnetary plicy stance f the center cuntry is exprted t thesmall pen ecnmy independent f its exchange rate regime.

3.2. international capital Flows and equilibriuM

Figure 2 mdels internatinal brrwing as additinal surcef liquidity in an pen ecnmy. We assume that there are tweconomies, which are populated with individuals that dier in

8 Mises assumed a gld standard in early wrks and recgnized the thery as peneconomy model. But the further elaboration of the credit cycle theory focused ona closed economy setting (Garrison, 2006).




planned saving and consumption. Planned saving in one economyis higher than in the ther. This implies a lwer interest rate levelas lng as capital markets are clsed.

one ecnmy is the center ecnmy, in which mnetary plicydecisions are exogenous (e.g., based on domestic ination andgrowth). The other economy is a group of periphery countrieswhere the exchange rate plays an imprtant rle fr mnetaryplicy making. The mdel des nt pre-impse a restrictin nwhich is the center and which is the periphery. But we assume thatthe ecnmy with lwer planned savings is the periphery. Further,we assume a similar size f the center ecnmy and the aggregatedgrup f periphery cuntries.9

Given pen capital markets, savings are allcated t themost protable international investment opportunities. Higherexpected returns on investment (interest rates) in the peripheryattract savings frm the center ecnmy where expected returnsand capital market interest rates are lwer, as saving is relatively

abundant. The center ecnmy exprts capital t becme thecreditr ecnmy. The periphery imprts capital as the debtrcountry (group). A convergence process as modeled below has, forinstance, been experienced between western and eastern Eurpeafter the fall of the Berlin Wall with the integration of central andeastern Europe into the European (and world) economy.

Figure 2 illustrates the cnvergence prcess. The initially clsedeconomy capital market rate of the creditor (center) economy ic

c0

(at which Sc

0 = I c

0) and the initial debtor (periphery) capital marketrate idc0

(at which Sd0

= I d0) converge towards a common world capital

market rate iwc1

= icc1

= id

c1. The amunt f capital exprts f the creditr

(center) economy is CXc1 , which is equal t the amunt f capital

imprts CMd1

of the debtor economies (periphery).

With capital market rates increasing in the creditor (center)economy (ic

c0< ic

c1= iw

c1) following international nancial liberalization,

saving is stimulated (Sc0

< Sc1), while domestic investment is replaced

by foreign investment (I c0

> I c1). In the debtor economies (periphery),

9 In practice, the capital exprts f ne large creditr cuntry are matched by thecapital imprts f a grup f smaller debtr cuntries, as, fr instance, in the casef Germany and many smaller Eurpean cuntries.




the lower capital market rate (id

c0 > id

c1 = iw

c1) originating in capitalinows discourages saving (Sd0

> Sd1) and promotes investment (I d

0<

I d1). A domestic saving-investment gap arises in both economies with

ppsite signs. Internatinally aggregated saving and investmentare balanced at the wrld capital market interest rate, which is equalto the world natural interest rate (iw

c1= iw

n1).

Given liberalized goods and capital markets, to fulll the balanceof payments identity, the debtor economies (periphery) importgoods from the creditor (center) economy. The gaps between

supply and demand n capital markets are clsed via trade.Capital exprts CXc

1 , capital imprts CMd

1and respective current

account positions (CAc1

and CAd1) in Figure 2 reect an ecient

internatinal allcatin f resurces, which matches natinal pref-erences for inter-temporal saving and consumption (Homann,2010; McKinnon and Pill, 1997).

Figure 2. International Capital and Goods Market Equilibrium

i i i

I, S I, SCX, CM

Sc1I

c1

CXc1

Sc0 = I

c0

iccb1

, icc1

, iwn1

icn0

, iccb0

, icc0

I c1 < S

c1 S

d1 < I

d1

CAc1 = S

c1 - I

c1 > 0 CA

d1 = S

d1 - I

d1 < 0

Sd0 = I

d0

I cd1 S

cd1

CMd1

CMd1

CXc1

CMd1

CXc1

iwn1

, iwc1

idn0

, idcb0

, idc0

idcb1

, idc1

, iwn1

Creditor(Center)

Debtor(Periphery)

InternationalCapital Flows

3.2 international credit booM

Whereas internatinal capital mbility can stimulate investment

and grwth in ecnmies with a shrtage f capital and higherexpected returns f investment, it can cntribute t t-easy liquiditycnditins and bm-and-bust cycles. This is particularly the casewhen interest rate cuts in center cuntries bring abut excessive




capital inows into small open economies with underdevelopedcapital markets. This was, fr instance, bserved in sutheast Asiaprir t the Asian crisis, in central and eastern Eurpe as well asparts f the eur area during the bm perid after the turn f themillennium up to the 2007–08 crisis, and is currently observed ona global level (Homann, 2010; Löer et al, 2010).

In the model of Mises (1912) and Hayek (1976 [1929]; 1967[1935]), a credit boom emerges on a national level if the central bank lwers plicy rates belw the natural rate and the banking

sector nances additional investment by holding capital marketrates below the natural rate (as modeled in Figure 1a). In an asym-metric wrld mnetary system, the internatinal availability f capital originates in large and highly developed nancial marketsf center ecnmies that prvide the internatinal mnetarysystem with internatinal currencies. We assume that the central banks f such center ecnmies take int accunt nly dmesticgoals such as ination and growth10—what Hayek (1937a) called“monetary nationalism.”

Easy liquidity conditions initiate capital ows to peripheryeconomies (with higher interest rate levels), where monetary policydecisins strngly hinge n external factrs such as exchange ratestabilization (Calvo and Reinhart, 2002). If interest rates in thecenter ecnmy are held lw t bst dmestic grwth, investrscan nance (risky) investment in periphery economies that wouldnot have been protable under tighter liquidity conditions.11 Carrytrades and mmentum betting fr interest rate arbitrage and

exchange rate revaluatin gains lead t excessive reserve accumu-latin and mnetary expansin in emerging markets.12

In Figure 3, we illustrate the emergence f a credit bm in theperiphery triggered by liquidity expansin in the center ecnmy,

10 As formalized for instance in the Taylor rule (Taylor, 1993).11 There are alternative reasns fr a drp f capital market rates and speculative

capital inows into emerging market economies. For instance, implicit creditguarantees by the government increase the risk appetite of banks (McKinnon andPill, 1997).

12 McKinnon and Schnabl (2004) show why in emerging markets free oating is nota feasible plicy chice because f underdevelped gds and capital markets(in east Asia).




which we assume t be the internatinal creditr ecnmy. Thestarting pint is Figure 2. Capital market and central bank interestrates in the tw ecnmies have cnverged twards the wrldnatural interest rate iw

n1. Internatinal aggregated saving is equal t

aggregate investment. Capital exprts amunt fr CXc1

and capitalimprts fr CMd

1. The current accunt balance is CAc

1= Sc

1- I c

1> 0 in

the creditor (center) economy and CAd1

= Sd1

- I d1

< 0 in the debtr(periphery) economies.

If the central bank in the center (creditor) economy lowers theplicy rate belw the wrld natural rate f interest t iccb2

t prmtedomestic investment and growth, the nancial sector will createadditional credit ΔCc

1. The credit expansin mimics an increase in

planned saving which is mdeled by a right shift f the savingscurve frm Sc

1t Sc

2(by ΔC

1). The world capital market interest rate

falls frm iwc1

t iwc2

(Figure 3).

Given lwer interest rates, new investment prjects are started.Investment activity increases frm I c

1

t I c2

in the center (creditor)ecnmy and frm I d

1t I d

2in the periphery (debtor) economies.

Due to lower capital market rates, planned saving falls to Sc2’

inthe creditor (center) economy and from Sd

1t Sd

2in the debtr

(periphery) economies. The term Sc2

represents credit supply in thecreditr ecnmy, Sc

2’plus the additional credit expansion ΔCc

1(Sc

2

= Sc2’

+ ΔCc1) at iw

c2. Rising capital exports are reected in a growing

current accunt surplus frm CAc1

t CAc2

(= Sc2’

+ ΔCc1- I c

2= Sc

2- I c

2

>>0) in the center (creditor) economy. In the periphery (debtor)

economies the current account decit CAd1 widens t CAd2 = Sd2 - I d2 << 0, as capital imprts increase t CMd

2(= CXc

2).

Because global planned saving has not increased with the creditexpansin but fallen t Sc

2’+ Sd

2 , the wrld capital market interest

rate is belw the wrld natural interest rate iwc2

< iwn2

= iwn1

. A glbaldisequilibrium between saving and investment emerges, whichamounts for the dierence between I c

2+ I d

2and Sc

2’+ Sd

2. As the glbal

interest rate level has declined t iwc2 , the credit expansin triggers

overinvestment with lower expected marginal returns. Based onHayek (1935) with the fall in interest rates below natural rates theprductin structure f the ecnmies wuld lengthen and capitalintensity increase. This may be accmpanied by bms in the




stck markets r the husing sectrs.13

The average default risk f investment increases as—given resource constraints—the capitalmarket rate has t return t the natural rate in the lng run.

Figure 3. Credit Expansion and Overinvestment

i i i

I, S I, SCX, CM

Sc1I c2

CXc2

I c1I c2 S

d2Sd1 I

d1I d2S

c2’S

c1Sc2

I cd2 S

cd2

CMd2

CXc1CX

c2

CMd1

CMd2

CXc1

iwn2

, iwc1

iwn2

, iwc1

Sc2

Cc1Δ

iwn2

, iwc1

iwc2

CXc2

iwc2

Creditor(Center)

Debtor(Periphery)


It is pssible that there is n credit bm in the center ecnmydespite the interest rate cut. This can be the case in the aftermathof a nancial crisis, when investors and banks do not expect anecnmic recvery despite easy liquidity cnditins. This can beargued t have been the case in Japan after the burst f the Japanese bubble ecnmy.14 A lw interest rate elasticity f dmesticinvestment wuld crrespnd t a clse t vertical investment

curve I c

2 in Figure 3. Then, given sluggish expectatins in the center,after the center ecnmy’s central bank has lwered plicy rates,the additional credit is exported entirely. This amplies the creditand verinvestment bm f the periphery as experienced in eastAsia befre the Asian crisis.

13 Cachanosky (2013) models the eects of a fall in interest rates below the naturalrate based n the Hayekian triangle.

14 Alternatively a restrictive scal policy in the center country may prevent a credit bm thereby amplifying the credit bm in the periphery as in the case f Eurpeafter the turn of the millennium (Schnabl and Wollmershäuser, 2013).




3.3 crisis and contagion

When verinvestment in capital-intensive sectrs f the peripheryecnmies cmes alng with rising asset prices, increasing incmesand high cnsumptin raise the demand fr cnsumer gds.overcnsumptin emerges with cnsumptin being larger thancnsistent with the inter-tempral equilibrium. As resurces are bund in the capital gds sectr the cnsumptin gds sectr becmes unable t satisfy rising demand at cnstant prices.

Ination accelerates.

15

Given exchange rate stabilizatin due t“fear of oating,” the real appreciatin f the currency brings abutgrowing current account decits as observed in the southeastAsian ecnmies befre the Asian crisis, the central and easternEurpean ecnmies befre the 2008 crisis and the current crisiscuntries f the eur area.

The turn-arund becmes inevitable when, n an internatinallevel, interest rates rise. The tightening f internatinal creditcan riginate in either mnetary plicy r the private banking

sectr. Central banks in the center can restrict credit t cunteractination once domestic activity picks up. Alternatively the banking sectr reassesses credit risks nce signs f instability inthe periphery emerge.

15 In the short term the inationary pressure can be dampened by additionalimports, which contributes to a rising current account decit.




Figure 4. Policy Reversal, Credit Crunch and Crisis Contagion

I c3,4

CXc4

I c

4Sc

4Sc

3=

Sc

4’

iwn4

Sc4

iwn4

i i i

I, S I, SCX, CM

I c3

CXc3

I c3 I c2 S

d2Sd3 I

d3I d2S

c2’S

c3

I cd3 S

cd3

CMd3

CXc3CX

c2

CMd3CM

d2

CMd3

CXc3S

c3

iccb4

, iwc3

, iwc4

iccb4

, iwc3

, iwc4

iwn3

, iwc3

iwc2 iwc2

iwn3

, iwc3

iwc2

iwc3

, iwc4

CXc2

Sc2

Cc2Δ

i i i

I, S I, SCX, CM

Sc4

Sc3

Cc3Δ

iwc3

, iwc4

iwn4

CXc

4CX

c

3CM

d4CM

d3

I cd3

I cd4

Scd3,4

Sd

4I d

4I d

3

Creditor(Center)

Debtor(Periphery)


a) Policy Reversal

Creditor(Center)

Debtor(Periphery)


b) Downturn, Credit Crunch and Contagion

CMd3

CMd4

CXc4

CXc3

CMd4

Figure 4a illustrates the policy reversal in the center (creditor)ecnmy and the impact n the periphery ecnmy. When thecentral bank tightens mney supply, the banking sectr has treduce the credit exposure, for instance by ΔCc

2. The central bank

plicy rate increases t iccb3

, which is—for instance—equivalent to

the world natural interest rate (iccb3 = iwn3).16 The saving curve shifts

16 We implicitly assume that due t the asymmetry f wrld mnetary system, thewrld interest rate is determined by the center central bank.




back to its initial position (Sc

3 = Sc

1). Less capital is exported bythe center (creditor) economy (CXc3

< CXc2). Capital imports of the

periphery (debtor) economies fall from CMd2

t CMd3. Wrld capital

market interest rates rise alng with the center plicy rate iccb3

= iwc3

.

This lifts the threshold for the protability of investmentprjects. Structural distrtins are cleared as investment withinternal interest rates belw the natural interest rate iw

n3has t be

dismantled. Investment in the center (creditor) economy falls toI c

3

and investment in the periphery (debtors) to I d3. Planned saving

increases frm Sc2’ t Sc

3 in the center (creditor) economy and fromSd

2t Sd

3in the periphery (debtors). Global planned saving and

investment are balanced again as the wrld capital market rate isequal t the wrld natural interest rate.17

When investment prjects are dismantled, thers becmeunprotable as general demand declines (negative multiplicatoreect). Expected returns of investment fall. As illustrated in Figure4b, the investment curve f the periphery shifts frm I d

3t I d

4. With

falling capital demand the wrld natural rate falls t iw

n4. Accrdingto Hayek (1967 [1935], p. 103), during a crisis, panic in nancialmarkets may arise. Credit markets can dry up if the central bank des nt increase mnetary accmmdatin.18 The dwnturn in theperiphery causes credit defaults. The center ecnmy’s bankingsectr faces lsses n the asset side f the balance sheets and has tdeleverage. Credit t the private sectr is further restricted.

In Figure 4b, the center ecnmy’s banking sectr restrictscredit to the private sector by ΔCc

3.19 The savings curve shifts t

Sc4 and capital market interest rates remain at iw

c4despite a fall in

17 Nte that in this case planned saving is equivalent t verall saving. Thus, we dnt add the apstrphe.

18 “It is als a fact which has been established by lng experience, that in times f crisis central banks shuld give increased accmmdatin and extend therebytheir circulatin in rder t prevent panics, and that they can d it t a great extentwithout eects which are injurious” (Hayek, 1967 [1935], pp. 108–109).

19 T keep the graph simple, the shift in the investment curve in the periphery is

equal t the shift in the capital supply curve in the center. This keeps the capitalmarket rate unchanged at . In reality, the combination of feedback eects fromcredit defaults and rising risk aversion (i.e. panic) are likely to shift the capitalsupply curve mre t the left than the investment curve, shifting the capitalmarket rates further upwards.




investment demand. In the center ecnmy, investment is at I c

4 while planned saving remains at Sc4’. The capital market rate is

held abve the natural rate f interest iwc4

> iwn4

. The internatinaleects of the credit crunch are symmetrically opposed to those of the credit expansin in Figure 3. Capital exprts fall t CXc

4and the

periphery’s capital imprts decline t CMd4

as the capital returns tthe safe haven.

Thus, the unwillingness f banks t lend keeps investment activityin bth the center and the periphery t lw. Given t high wrld

capital market rates, a global capital supply overhang emerges (Sc4’ +

Sd4

> I c4

+ I d4). With lower investment, overcapacities are dismantled,

wages fall, unemplyment rises and incmes decline. Cnsumptincntracts in bth ecnmies. The current accunt balances narrwt match the smaller capital accunt balances. Given lwer incmesand lower consumption, prices deate (capital goods devalue) andinvestment activity remains sluggish.

4. INTERNATIONAL FEEDBACK EFFECTS ANDPOLICY IMPLICATIONS

The eects of national monetary policies in large countries in thecenter f the asymmetric wrld mnetary system n the smallerperiphery cuntries depend n the relative ecnmic size andthe nancial linkages. In our model the economic size of centerand periphery are assumed t be equal. If the center is large, theperiphery is small, and internatinal capital mbility high, even

a mderate credit expansin in the center can trigger a severe bm-bust cycle in the periphery. This is particularly the case if capital outows from large centers are clustered in a few peripherycountries. At the same time, feedback eects of crisis in a smallperiphery n a large center are negligible. Then, a slely dmes-tically riented mnetary plicy is the dminant strategy frm thepint f view f the center.

This changes when the magnitude f internatinal capitalows increases, the periphery economy or a group or periphery

economies become larger, and therefore feedback eects of crisis inthe periphery on the center are signicant. Financial instability inemerging markets then triggers nancial instability and outrightplicy respnses in center cuntries.




4.1 eMpirical evidence For international Feedback eFFects

Feedback eects from crisis in the periphery on center countriesculd be recently bserved in sutheast Asia and Eurpe.20 Fllwing the burst f the Japanese bubble ecnmy starting inDecember 1989, Japan suered from a severe deation in stock andreal estate prices. To contain the negative growth eects of assetprice deation, during the rst half of the 1990s Japanese policymakers cut interest rates to prevent a credit crunch. But domestic

investment remained sluggish—which corresponds to a close tovertical investment curve in the creditor economy—and the rstlarge wave f carry trades directed Japanese capital exprts tsutheast Asia.

In southeast Asia, starting from the early 1990s, capital inowsfrom Japan provided a fertile ground for (US dollar) foreign reserveaccumulatin,21 monetary expansion and credit growth (McKinnonand Pill, 1997). This triggered—in line with our overinvestmentframework—speculative investment in the southeast Asian export

sectrs, stck markets and real estate markets. In Japan, the exprtindustry experienced rising revenues frm declining prductincsts in and rising exprts t the regin. The balance sheets f Japanese banks imprved due t higher revenues frm lending tthe smaller sutheast Asian ecnmies.

At sme pint f the verinvestment cycle the bm turned bust. This marked the starting pint f the Asian crisis, whichreturned t Japan via gds and capital markets as Japanese banks

and enterprises were hit (Schnabl and Homann, 2008). We seethree transmissin channels. First, Japan’s exprt industry, whichconstitutes the most important pillar of Japanese growth, sueredfrom declining exports. Second, Japanese FDI in the smallerSoutheast Asian economies was rendered unprotable. Third, Japanese banks faced a further increasing stck f nn-perfrming

20 Also, signicant feedback eects between monetary expansion in the US andcredit cycles in the dllar periphery, in particular in east Asia, can be bserved.The mnetary interactin between the US and east Asia is mre cmplex due tsterilization operations in the periphery countries (Schnabl and Freitag, 2012).

21 East Asian reserve accumulatin is predminately in US dllars. In cntrast t theUS and the eur area Japan accumulates internatinal assets in dllars instead f in domestic currency (McKinnon and Schnabl, 2012).




loans, now from defaulting credit in Southeast Asia. Thus, (asmodeled in Figure 4b) the Asian crisis triggered the 1998 Japanesenancial crisis via contagion eects in goods and nancial markets.The Japanese central bank respnded with new interest rate cutst stabilize the Japanese ecnmy, which brught the shrt-terminterest rate twards zer.

In Europe, the monetary policy of the European Central Bank cntributed t bm-bust cycles in the inner and uter peripheryof the euro area after the turn of the millennium (Schnabl and

Wollmershäuser, 2013). After the burst of the new economy bubble,German private and public wage austerity (to regain competi-tiveness after the unication boom) combined with ECB interestrate cuts stimulated capital outows from Germany to central,eastern, suthern and western Eurpe. At the EMU peripherycredit bms as mdeled in Figure 3 emerged.

The crises in central and eastern Eurpe and at the suthernand western periphery f the eur area was triggered by the

interest rate increases of the European Central Bank during theyears 2006 and 2007 as well as by a reassessment of credit risk fllwing the US subprime crisis. As mdeled in Figure 4a, the benchmark fr investment in the periphery regins was lifted.Changing sentiment regarding the sustainability f the bms inthe European periphery regions led to a nancial market drivencredit tightening as mdeled in Figure 4b.

The crisis in the Eurpean periphery cuntries triggered mnetaryand credit expansion to forestall negative feedback eects on the

center f the eur area as bserved in east Asia via fur channels.First, substantial interest rate cuts during the crisis and pstpnedECB interest rate increases during the recovery after the slump.Secnd, credit prvided t central and eastern Eurpean cuntries based n IMF credit facilities, the Vienna Initiative and publiccapital injectins t eur area cmmercial banks with large creditexposure in the region. Third, ECB government bonds purchasesf eur area crisis cuntries and ther frms f quantitativeeasing. Furth, credit prvided via Eurpean crisis management

facilities such as the European Financial Stability Facility (EFSF)and the European Stability Mechanism (ESM) etc. All factors can be assumed to have prevented similar feedback eects for theEuropean center (in particular Germany) as observed in Japan




during the Asian and Japanese nancial crisis, but may be followed by unintended cnsequences.

4.2 Monetary policy, crisis ManageMent and

unintended consequences

The interest rate cuts f center central banks in respnse tcrisis in periphery cuntries are mdeled in Figure 5. T preventa meltdown in nancial markets, which is caused by the creditexpsure f the center cuntry’s banking sectr t the periphery,center central banks pull dwn plicy rates. Very lw cst mneyaims t turn arund sentiments f banks t prvide new lwcst credit t the private sectr. In the shrt-run, a credit crunchand defaults of nancial institutions are prevented in the centereconomy. However, as argued by Mises (1929) the well-intendedinterventin may have unintended cnsequences as it maycnstitute new and even larger bm-and-bust cycles, which will

trigger even larger plicy interventins in the future.

Figure 5. Monetary Policy Response to Crisis

i i i

I, S I, SCX, CM

Sc4I

c5

CXc5

I c4 I c5 S

d5Sd4 I

d4I d5S

c5’S

c4’S

c5

I cd5 S

cd5

CMd5

CXc4CX

c5

CMd4CM

d5

CMd5

CXc4S

c3

ΔCc4i

ccb4 , i

wc4 iccb4

, iwc4

iwn4,5 i

wn4,5

iccb5

, iwc5

iccb5

, iwc5

iccb4 , iwc4

iwn4,5

iccb5

, iwc5

CXc5

Sc5

Creditor(Center)

Debtor(Periphery)


In Figure 5, the plicy makers in the center cut central bank rates frm ic

cb4t ic

cb5allwing fr additinal credit expansin. This

improves the banking sectors renancing conditions and undoesthe previus credit cntractin. This is shwn by a shift f the




saving curve frm Sc

4 back t Sc

3 which wuld crrespnd t a mvetwards the wrld natural rate f interest iwn4

. In case f excessivemonetary expansion new additional credit ΔCc

4is created and

wrld capital market rates cnverge twards the plicy rate t iwc5

=iccb5

. The glbal interest rate level has nw fallen belw the naturalrate iw

c5< iw

n4,5again. New verinvestment is triggered by excessive

credit expansin. In Figure 5 capital exprts shift utwards frmCXc

4t CXc

5fuelling new overinvestment in the periphery (I d

5> I d

4).

In Figure 5, the central bank cntinues t supprt grwth via easy

liquidity cnditins and des nt und the previus interest ratecuts by raising the central bank rate twards the natural rate iw

n5.

As the central bank rate and the capital market rate have declinedt an unprecedented lw level, structural distrtins frm theprevious credit cycle are preserved and the marginal eciency of investment further decreases.

A new internatinal verinvestment cycle starts frm a levelof even lower interest rates than the one before (Figure 3). The

upcming crisis will be mre severe and will trigger even lwerinterest rates t prevent a credit crunch and stabilize grwth asthe marginal eciency of investment has declined. An asymmetricinterventin pattern f bm, crisis and interest rate cuts emergesif central banks raise interest rates less in the upswing than theycut them during the crisis (Homann and Schnabl, 2011).

The asymmetric mnetary plicy pattern in the centers f thewrld mnetary system, i.e. the structural decline in nminal andreal interest rates in the large center cuntries, is likely t be trans-mitted t the rest f the wrld, independent frm the exchangerate regime. Lw interest rates in the center are imprted directly by periphery countries if they pursue xed exchange rate regimes.But also a exible exchange does not allow periphery countries toislate themselves frm liquidity expansin in the center, as appre-ciatin pressure n the dmestic currencies wuld put a seriusdrag n grwth.

With exible exchange rates, outright interest rate cuts to shield

against speculative capital inows and appreciation pressuremake the interest level cnverge twards the center’s cuntriesinterest rates. If a gradual appreciatin f the periphery cuntriescurrency is allwed fr, the interest rate level in the periphery




cuntry can fall even belw the interest rate level f the centercuntries, nce appreciatin expectatins becme sustained. Theresulting bm-bust cycles and structural distrtins wuld beeven larger. Such “competitive interest rate cuts” can be seen as theequivalent t cmpetitive depreciatins as in the aftermath f theGreat Depression22 (McKinnon, 2010). The outcome is a historicallw glbal interest rate envirnment, i.e., a glbal liquidity glut.

Based on the extended Mises-Hayek overinvestment cyclethery, the risk f the current lw interest rate envirnment is

fourfold. First, although it is dicult to predict in which corner of the world speculative prot opportunities will emerge, the prob-ability f bm-bust cycles has substantially increased. Secnd,although at a global level consumer price ination still seems toremain under control, inationary pressure has emerged in rawmaterial, fd and asset markets. Third, althugh speculativecapital inows into emerging markets can be (temporarily) tamed by capital cntrls and nn-market based sterilizatin peratins,

distortions in domestic and international nancial and goodsmarkets are the cnsequence. Furth, as nminal interest and realinterest rates have fallen to very low levels, the marginal eciencyf investment has declined n a glbal level.

Increased nancial market volatility, high raw material and foodprices, distrted ecnmic structures, glbal imbalances, and a lwmarginal eciency of investment put a drag on long-term growth,which cntributes t plitical instability. A refrm f mnetaryplicy rules is required t return t a stable lng-term grwth path

and t prevent rising glbal plitical instability.

4.3 iMplications For Monetary policy rules

In line with our ndings, Diamond and Rajan (2009) argue that“a central bank that promises to cut interest rates conditional on stress,or that is biased towards low interest rates […], will induce banks to

22 In 1931, Britain was the rst to exit from the gold standard, which helped to achievea timely recvery frm the great crisis. Lsing exprt shares, the US fllwed in1933 and forced the dollar to depreciate. This led to strong appreciation pressureand a drop in production in continental Europe until it went o the gold parity in1936 (Eichengreen and Mitchener, 2003; McKinnon, 2010).




promise higher payouts or take more illiquid projects. This in turn canmake the illiquidity crisis more severe and require a greater degree of intervention, a view reminiscent to the Austrian theory of cycles.” Tcope with the unintended but severe side eects of asymmetricmnetary plicy patterns, mnetary plicy-making needs t besubject t stricter rules.

Based on the Mises-Hayek framework, to forestall globalnancial and economic instability central banks in the large centercuntries have t keep interest rates clse t the natural interest

rate. Althugh the exact target value f the natural rate f interestis dicult to determine, given the current low interest rate level inthe large cuntries such as Japan, US and eur area interest rateshave t increase t equilibrate saving and investment preferencesn a glbal level.

In a wrld with central banks that cntrl the rate f interest,we suggest that mnetary plicy shuld cncentrate n ne galonly—long-term price stability. This implies that the short-termadjustment process in crisis is to be left to the market. Prices havet decline and prductivity has t increase fllwing an verin-vestment bm. This wuld have a “cleansing eect” as speculativeinvestment and enterprises with low protability would have toleave the market, while unemplyment rises until ecnmic activitypicks up and the economy returns to equilibrium (Schumpeter,1912, pp. 360–369).

We prpse that mnetary plicy makers apply plicy rules ina broader, more forward-looking way. In a nancially globalized

world, the domestic inationary eects of monetary expansion arepstpned, as liquidity expansin takes the detur via internatinalnancial and goods markets until it feeds into higher domesticination. Adalid and Detken (2007) nd that global credit growthis a better predictor for upcoming nancial turmoil than nationalcredit aggregates and domestic ination. As monetary and creditgrowth can fuel foreign asset prices without aecting domesticconsumer price ination in the short-run, a rapid credit growthcmbined with sharp increases in asset prices raises the likelihd

of future nancial instability. Therefore, credit growth should betreated in a respective way in mnetary plicy decisin making.

Because integrating international nancial markets into domesticmonetary policy reaction functions would lead to conicting goals,




as ne instrument is cnfrnted with tw r mre targets, mni-toring monetary and asset aggregates to forecast future inationis necessary to restore international nancial and economicstability. This presumes, hwever, that central banks in large centercountries are willing to take the responsibility for global nancialand economic stability, which brings us back to Hayek’s (1937a)plicy cnsideratins.

5. HAYEK’S INTERNATIONAL SOLUTION

We have shwn that natinal mnetary plicy bears the dangerof international (economic) instability if it aims at stimulatingdmestic grwth withut regard t internatinal repercussins.Particularly if the central bank is a big player that provides the inter-natinal mnetary system with an internatinal currency, a cntrlmechanism against undue mnetary expansin has t be fund.

Hayek (1937a) was pessimistic about a self-restriction of policy

makers as they tend t fllw shrt-term gals. He pinted ut thata system f internatinal free banking r an internatinal mnetaryauthrity culd slve these prblems. In particular, he wrte “a reallyrational monetary policy could only be carried out by an internationalmonetary authority, or at any rate by the closest cooperation of the nationalauthorities and with the common aim of making the circulation of eachcountry behave as nearly as possible as if it were part of an intelligentlyregulated international system” (Hayek, 1937a, p. 93).

Such a monetary system might be based on a symmetric xedexchange rate system which culd imitate the mechanism f theclassical gld standard. Undue mnetary expansins and beggar-thy-neighbor depreciations could be ruled out. Hayek (1937a) was,hwever, skeptical f such cmmitments. He referred t his ideaas a “utopian dream” because the necessary plicy shift was veryunlikely in the 1930s. Therefore, a rule or “principle (such as the goldstandard) which at least secures some conformity of monetary changesin the national area to what would happen under a truly international

monetary system is preferable to numerous independent and indepen-dently regulated national currencies” (Hayek, 1937a, p. 93).

As in the 1930s, today the global conicts about the internationalrepercussins f natinal mnetary plicy making and the plicy




responses at the periphery—as represented by the debate onexchange rate policies between, e.g., China and the US—signalthat intrducing a new internatinal mnetary system based n,e.g., xed exchange rates (McKinnon, 2010) is unlikely to happensn. Nt even rule changes as prpsed in sectin 4.3 are currentlyseriusly envisaged.

Instead, we can bserve a further natinalizatin f mnetaryplicies. This natinalizatin is led by ultra-lw mnetary pliciesin the center ecnmies. The resulting distrtins are extended

via (discretionary) exchange rate stabilization, non-market basedsterilizatin, capital cntrls, state-directed capital allcatin andthe revival f industrial plicy t the periphery cuntries. In shrt,we observe intervention spirals as described by Mises (1929): Well-intended plicies in the center cuntries have unintended negativecnsequences n ther ecnmies that cause further interventinsand new distrtins in bth centers and peripheries that necessitatenew interventins, and s n.

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Monetary Nationalism and International Economic Instability

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