Make Multilateral Intervention Great Again (12/17/2016)

Apr 06, 2025

Just so you know that I have been going on about this for almost a decade.

This grows out of a discussion with Matt Klein, when we are talking about the discrepancy between trump fiscal exchange rate and trade policies where he jokingly suggested that the Fed should sell all its USTs and buy Bunds. I thought about it overnight and it struck me that the underlying idea actually makes a great deal of sense. As longtime followers know, I've been insistently pounding the table for a few years now on three related topics-that the combination of floating and large open capital accounts is more destabilizing than stabilizing; that exchange rates frequently overshoot driven by large, instantaneous shifts in desired portfolio balances; and that the interaction of borrowing (domestic vs. foreign currency) and investment behavior ( tradeable vs. nontradeable sector) during such overshoots invalidates the idea that large current account imbalances are an automatic intertemporal smoothing mechanism. Another way to think about this is that in two of four quadrants of a kind of Swan Diagram (that plots Internal and External balance) THERE WILL BE A FUNDAMENTAL CONTRADICTION BETWEEN THE INTEREST RATE REQUIRED TO RESTORE INTERNAL BALANCE AND THE EXCHANGE RATE REQUIRED TO RESTORE EXTERNAL BALANCE.

Sorry to scream, but I'm astounded at how often I've had to explain this to people in the course of a day job. Anyway, this is why I'm increasingly a proponent of capital controls. Nothing new so far for people who have been subjected to real or virtual harangues on this from me. What is new (and the reason for this post), is the idea (2nd best in my view, but potentially best in practice) that maybe the worlds major systemic central banks -- Fed, PBoC, BoJ, ECB (for a start, but think this could eventually make sense at the G20 level)-- should routinely engage in dialogue and coordinated bi-or multilateral interventions whenever a country is identified as being in one of those problematic Swan quadrants where a country might need higher interest rates but a weaker currency or lower interest rates but a stronger currency Right now we have a world in which CBs do indeed have massive balance sheets, but there's a huge difference between EM and DM CBs, with the massive EM CB balance sheets composed to a large extent of foreign assets, while the balance sheets of the Fed and the ECB are composed almost exclusively of domestic assets. This distinction reflects two things--greater financial depth in DMs (i.e. more domestic assets to buy) vs. EMs, but also a preconception among the Fed and the ECB in particular that market set exchange rates are superior to administered ones. This is, of course, ironic on so many levels, starting with the fact that the Euro is a culmination of a 3 decade long project by Europeans to (justifiably in my view) limit and eventually eliminate the impact of the post 1971 forex market on intra-European exchange rates in what was and remains a tightly connected series of small open markets with deeply interlinked supply chains. For those reeling in horror and disbelief at this point, I direct you to my post on why the Euro crisis might not really have been caused by the Euro. ;). http://rajakorman.tumblr.com/post/79194706949/what-might-the-eurozone-crisis-have-looked-like

But it is also ironic because one of the obvious purposes of large domestic balance sheet expansion in DM CBs is precisely to influence the exchange rate. The same goes for negative interest rates. All I'm saying is "Cut the crap." I'm arguing that all major CBs should be prepared to use shifts in the relative size of their domestic and foreign balance sheets as a signaling device (alongside interest rates) as a way to signal not just the aggregate monetary conditions they think of as appropriate, but also the relative contribution of domestic interest rates, the shape of the yield curve, and critically of the exchange rate in determining said monetary conditions.

In other words, central banks should be prepared to use their balance sheets to accommodate and mitigate precisely those large shifts in the private sector's desired foreign portfolio balances that can be inherently destabilizing for both real and financial outcomes. I also think that if CBs do this, they should do it collectively rather than singly, in a coordinated fashion and according to a set of guidelines where it is easy to differentiate purely mercantilist impulses from ones where there is genuine incompatibility between the needs of internal balance and external balance. This also seems to me a much preferable situation to governments messing around with goods market via tariffs and trade barriers when these external balance issues become political Kryptonite. The state of the US-China relationship where divergent cyclical impulses threaten exchange rate behavior that blows up an already fraught politics of trade strikes me as a classic case for such an approach. Market purists will be horrified by the suggestion of routine central bank intervention in yet another market but longtime followers already know I've pinned my flag to the superiority of technocratically driven outcomes over purely market-driven ones. I realize there are technical issues regarding sterilized vs. unsterilized intervention, but coordinated multilateral intervention, even when sterilized, has historically had a pretty strong record of signaling inflection points. See, for example, https://research.stlouisfed.org/publications/review/11/09/303-324Neely.pdf

One other benefit of such an approach is that it would confer the imprimatur of the Fed and the ECB and a broader range of assets (in particular the sovereign liabilities of systemic emerging markets sovereigns denominated in their own currency) as being safe assets. I do not think this is a problem. The dollar's long history of the dominant international safe asset owes a great deal more to geopolitical factors than to its inherent superiority as a store of international value. And perhaps the best thing about such an approach of routine rule-bound multilateral coordinated forex intervention in order to achieve G20 exchange rate target zones is that makes it more possible to return to at least some of the underlying financial conditions of the Bretton Woods 1 era, but in a world with large private portfolio capital flows and large central bank balance sheets (and per the work of Zoltan Poszar, I think there's a compelling case that such large balance sheets are here to stay). What I'm suggesting is that there is a case for using the central bank balance sheets as a way to offset the instability inherent in large private capital flows.

Vive les 30 Glorieuses.

The Home-Groan Globalist

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