Hello, welcome to visit Shanghai Forum
If you are going to go for a currency union,you should also go, as a strict minimum, for a full banking union at the sametime.
Reporter:Lin Shu(Professor, Economic School of Fudan University)
Editor：Silvan Griffith
Reporter:You have done considerable research on international monetary systems. Inyour view, what are the main problems of the current system?
Hélène Rey:In my view, the current system has led to an excessaccumulation of reserves. You can see the accumulation of reserves in one way,which is the effect it has on interest rates. As we know, they have beentrending down, which we can probably blame for some effects of the financialcrisis. Since the interest rates are very low, you can have more risk-seekingfrom the point of view of financial institutions, so one possible way to solvethis issue is to help countries building contingent precautionary savings,instead of having reserves. If you don’t have the availability of contingentprecautionary savings via, for example, the International Monetary Fund (IMF),then your line of defence is to accumulate foreign assets, like China. If,however, you have a better-functioning lender of last resort, a better IMF,then you do not need to accumulate so many precautionary savings. Instead, whatyou can do is to grow more on credit lines. In a report I wrote with EmmanuelFarhi and Pierre-Olivier Gourinchas we propose to increase theamount of resources available to the IMF to allow it to borrow on the marketdirectly. Therefore, in crisis times people can borrow from the IMF, countriescan borrow from the IMF, so to put in place more formally in place the systemof swap lines, that was put in a very ad-hoc way in 2008 at the height ofthe financial crisis, and that helped a lot for the dollar shortage. But it wasa very ad-hoc way of doing things, and we suggest there is a way of makingthings a little more formal, in order to have a more efficient defence.
Reporter:I noticed that you createda very interesting idea that is called the new Triffin dilemma.Could you elaborate on that, since you believe that itis one of the causes of the problems of the international monetary system?
Hélène Rey:I’m not sure if it is one of the causes of the troubles,but I can certainly elaborate on what we call the new Triffin dilemma. So turnto gold, that is to say you could convert your dollars into a fixed amount ofgold, but there came a time when external demand for US dollars was very large,so US liquidity was very large in the external world outside the United States,so in the 1960s, there came a time when people had to have doubt whether allthe external dollars could effectively be redeemed into gold at the fixedexchange rate, simply because the stock of gold was not growing as fast as theexternal demand for dollars, so at some point you would have to ask thequestion: with all the people who have these dollars, are hey able to convertthem back into gold. And if you believe that this is not possible, then youhave the possibility for some kind of run, a run against the dollar. If I havedollars now, I want to convert it the first into gold, because if I wait, I maynot get my gold, right? So that’s the idea behind the old Triffin dilemma.
Whatwe learned from this is that a similar type of issue may arise in today’sworld. The dollar is not backed by gold anymore, so it is not exactly the same,but what underpins the value of the dollar and the value of US government bondsis the United States’ fiscal capacity. It is the ability of the US treasury todeliver on the value of US government bonds, US treasury is now being heldabroad. Now the demand for this US liquidity, the demand for these governmentbonds is growing fast, because the world outside the US is growing sometimesfaster than the US itself. There comes therefore a point again where there is alot of external liability for the US in gross terms where there is a big stockof external liabilities of external government bonds which are backedeffectively by the fiscal capacity of the United States. But the size of the US- and its fiscal capacity relatively in the world - is probably decreasing, soat some point we are again faced with the legitimate question of whether the USfiscal capacity will be large enough to back all this foreign liquidity We mayeven consider scenarios in the future in which this will not be the case. Atthat point, countries that want to diversify a little bit more beyond thisdollar liquidity may ask for different types of assets, different types ofcurrencies as liquid assets.
And looking forwardvery far ahead, one can ask what countries can actually issue internationalcurrency, so if we go away from the dollar, who is going to replace the dollar?And it is a question which is obviously full of uncertainty, but one certainty,if we look in history, is that it is always the big countries, the big economicmasses, or the big traders in the world which have given internationalcurrencies. So we had the sterling when the UK was the dominant economy and thebig trading power, and then we shifted to the dollar when the US became bigger,much bigger in fact than the UK, and when it became the biggest world trader interms of trading. So looking forward, in terms of economic masses, we have the EU area on oneside, but right now the EU area has governance issues to overcome.Then there is alsoChinain terms of economic mass. However, to issue an international currency youdo need quite developed financial markets and you would need capital accountliberalisation and things like that.
Reporter:So you mentioned that economic mass is very important, but I also knowthat you have a paper that talks about the role of trade. In that paper youpoint out that the financial center of trade is more important than the singleeconomic size, in terms of international currency.
HélèneRey:Right, but what is usually important is themagnitude of the trade flows and you usually have to be a large economy to havelarge trade flows. It is not one for one, but if we look again historically tothe UK, we see that it was the first country to have an industrial revolution,it had the most advanced economy and it was also the biggest trader. Then theUS became the largest economy, and it became very important in internationalmarkets for goods and services.So in that respect, we wouldn’t see Luxemburg, howeverstable its currency might have been before joining the euro, you wouldn’t see acountry the size of Luxemburg issuing international currency.
Reporter:Do you think that the future of the world financialarchitecture is going to move towards multipolar system or thatthere will be a currency that will be used as a common currency for the wholeworld? Which one do you think is more realistic?
Hélène Rey:I do think that the trend is towardsmore multipolarity, and this is simply because of a shift inrelative economic mass. We have seen a shift towards Asia in terms of GDP, interms of trade, andof coursein terms of population. Let's look at history: When the UK got smallerrelative to the US, the sterling remained the main international currency for awhile, and, in particular, London remained an important financial centre for awhile,
This happened eventhough the size of the UK economy was relatively small compared to the size ofthe US economy, so there was a lot of inertia.When you are a keycurrency you are used by many people, there are very few incentives to deviatefrom this equilibrium. If you are the only one who decides to trade tomorrowusing the RMB, then it is not going to be a very efficient process for you,because you will have tosearch for your counterpart. Everyone else is using dollars, so it is going to be mucheasier finding someone trading dollars,thenthe incentive todeviate is against you. There is a lot of inertia between the systems, so there isa time lag between the time that economic masses shift in real terms, GDP,population, trade flows etc.,and the time when there is a financial change to anothercurrency. So we saw that from the transition from sterling to the dollar, and nowwhat we are seeing is that the economic mass is indeed shifting to Asia interms of GDP and trade flows, but the financial flows have not really shiftedyet, and if history is of any guidance, this will take time, especially if thedevelopment of capital markets in something like China is just not there yet,so we are really talking about a very long process here. But I think the trendis definitely towards multipolarity.
Reporter:People here in Chinaare very interested in how theRMBcan become aninternational currency, and also I know that Shanghai has the dream of one daybecoming a financial cente, not only a regional financial center but a worldclass financial center, like New York or London. But of course that takes a lotof time, so what are the main determinants of a world class financial center?Or what should a country do in order to achieve this goal?
Hélène Rey: Well firstly it seemsthat in order for your currency to be widely used you would have to withdrawquite a few limitations on convertibility. It is still the case in myunderstanding that there are lots of restrictions on portfolio flows and FDI,and so one of the first things to do is to make the currency more freelytradable. That obviously has to be done carefully, because you don’t wantmassive portfolio flows; nor massive volatility if you are not hedged againstthe volatility. You have to take a careful look at the balance sheets ofvarious financial institutions in order to make sure that this is done safely,and all the regulatory environment has to be developed further. This is a veryimportant development for the state. Knowledge builds gradually and you need alot of human capital, so there are lots of agglomeration effects. You need tobuild a critical mass of know-how around a financial centre.
Reporter:Regarding the issue of capital account opennessand a lot of emergingcountries, they want to open their capital accounts, they know the benefits ofhaving free capital flows, but they worry about protecting their currency fromcapital flows. What should policymakers in emerging countries do to enjoy the benefits,but also to prevent a crisis?
HélèneRey:This is obviously a very long question and a bigissue in international economics. It seems to have indeed been the case that alot of emerging markets which have opened up have been very procyclical anddestabilising. Not only emerging markets have suffered in fact, if you look atsome of the capital inflows into Spain or Ireland. When you have free capitalmobility and you are not checking what is going on within particular credit orshort term flows, then it is very likely that you at some point get a capitalflow bonanza which is going to overflow your financial system and eventuallylead to a bubble in asset prices. If it is a bubble in real estate prices thenthat is very serious, and you will have a crisis which is extremely damagingand can potentially blow up your entire financial system. These are things thatare very dangerous. We have suffered from this procyclicality of capital flowsin many crisis situations, the last one being the euro area crisis, so we haveto be very careful with that.
So what can we do?Firstly we have to be awarethat free capital mobilitymay not be the optimal thing to do at all, in particularwhen we look at credit flows which sometimes turn out to be more procyclicalthan, say, FDI flows. So what do we do? We have to put together a set of tools,which we can call macro-prudential tools(or capital controlsdependinga bitonwhat their target isand what they are doing)whichallow you to dampen the procyclicality of thecapital flows,taking the characteristics of the country’s marketinto account. In particularon the real estate market,you have to very careful. There are capital flowsusually in domestic distortions such as subsidies to real estate, for example. When there are a lot offlows coming in from abroad sometimes these subsidies interact with these flowsand with credit growthto create bubbles. If necessary, we therefore have toremove the subsidies, do some fiscal adjustment withinthe country, adjust loan-to-value ratios, adjust debt income ratiosandbe very careful aboutlending standards. Sowe want tokeep a close watch on these issues:on a microlevelthroughthe supervision of banks;onthemacrolevelthroughfiscal policyandmacroprudential policy. We may want additionalcapital cushions at the macrolevel to increase the capital requirements,to make sure that thisprocyclicality does not occur so much.There are lots of people that have experimented with suchsets of tools around the world and now I think we can learn a little bit moreabout how to do that.
Reporter:So, careful surveillance and some kind of prudential mechanism seems to bevery important for emerging countries in terms of capital accounts. Youmentioned earlier that the world GDP is shifting from the West to Asia. We knowthat the economic level of integration is already very high in Europeancountries, but it seems that the economic integration is low in Asiancountries. Should Asian countries take such steps as European countries didseveral decades ago?
Hélène Rey:Integration has different meanings. Firstly, the Europeancountries tried to create a common market for goods and services, and thisseems to have been to have been a very positive step. The integration ofproduct markets has created lots of regulatory issues that have certainly beenchallenging in the European context, and would probably also be challenging inthe Asian context. This is first step is extremely important before evenconsidering going towards a currency union. If, of course, you make that stepand try to make an integration market, then the introduction of a commoncurrency is a way of completing the integration of the region. This is adesirable set, provided you learn from the European experience: if you aregoing to go for a currency union, you should also go, as a strict minimum, fora full banking union. This is because if you have banks with marketcapitalisations which are several times the GDP of certain countries then youhave a link between sovereign risk and banking risk which has proven deadly inthe crisis. The only way to break that link is to have a full banking union,i.e. to keep the size of banks relatively small compared to the aggregate sizeof the area. Irish banks, for example, had several times the size of the IrishGDP. When Irish banks went bankrupt, they actually bankrupted Ireland. The samething happened in both Iceland and Spain, so this is a very very importantlesson which should be adapted in the context of the Asian financial system.This is something that the Europeans have - and still are - learning the hardway.
Reporter:You just made a very interesting point. You highlighted the importance ofa banking union, but I heard a lot of people say that it is important to have afiscal union. Do you think it is also necessary to have a fiscal union?
Hélène Rey:I happen to think it would be desirable to have a fiscalunion, but I do not think it is necessary to have a fiscal union for a viablecurrency union. I do think it is necessary to have a banking union, though. Ifyou do not have a banking union, I believe the currency union will end up beingunstable. However, please note that in a banking union you do need to shareyour resources a bit, in the sense that you need at least some amount of commonresolution fund, full of common money, that you can use if there are big banksthat go bust. You need to be able to have a resolution for these banks and youneed to be able to have a fiscal backstop, just in case of a problem. So you doneed a minimum of resource sharing, but you do not need a fully fledged fiscalunion. I think this makes the whole process more politically feasible, becausea fiscal union requires considerable political will from all member states inwhich they give up a lot of sovereignty, and I do not think we are quite readyfor that yet. So although it is desirable, I do not think it is really feasiblefor the moment - while a banking union might be.
Reporter:What is the situation inthe euro area and how will we solve it?
Hélène Rey:Itdepends completely on the political steps that are stillto be taken.Wehave stabilised the situation for the moment, and now itis up to all the euro area countries to bring a little more momentum into theireconomies, by doing some more reforms and also by having more coordinatedfiscal policy and a little bit less fiscal austerity, a little bit moreaggregate demand, so that you can get out of the feeling by having more accommodating monetary policyandfiscal expansion when possible, by having a little bitmore expansion at the EU level in terms of the European budget.So there are things that definitely can be done there. Each individual country has to take steps which depend ontheir respective situation.
Reporter:Should the EU further extend its monetary policy?
Hélène Rey:Yes, definitely. Wehave seen that suspend-suspense-sustain, the ECB has taken some veryimportant steps. One step was the long term refinancing operation, theLTRO, which has helped thebanking system. Thesecond very important step was the announcement of theOMP by the ECB which has effectively stabilised the yields in some of the bondmarkets of the periphery. These were very important steps, particularly theOMT, which allowedfor a better transmission mechanism of monetary policy, and so now stillmore can be done in terms of expansionary monetary policy, but these were reallydecisivesteps.
Regarding monetarypolicy, I noticed a very interesting shift in monetary policyand thelink between money growth and inflation after the late1990s.Before the middle 1990s there was a very tightrelationship between money growth and inflation in major economies, but sincethe middle of the 90s this link seems to have disappeared.
I have not personally done any research on that topic. Iwill, however, point out that this drop in velocity, this link which has beenbroken between the monetary growth and the inflation, is something that we havealso observed very clearly during the great depression. If you look at thestatement of Irving Fisher written in 1933 that was published in Econometricaand in which he describes all the symptoms of the great depression, he has veryprecise charts in which he points out exactly what you were saying. The linkbetween money growth and inflation completely broke and, again, it was becausethere was a lot of holding and precautionary saving. Therefore, the money thatwas printed - and that was on the balance sheets of the commercial banks andthe reserves of the central bank - was not finding their way into the economyat all. So there was no credit growth, and you could say there was a creditcrunch.
That was in the Great Depression, and that is verysimilar to a pattern that we have observed in the current situation. It is welldescribed by people like Paul Krugman, and it has also been talked about in thecontext of Japan. This is a liquidity trap, where there is a lot of cashholding. There is a lot of liquidity being created, but since it does not findits way into the economy we do not have inflation - in fact, rather milddeflation. So this is something that does not come as a surprise, becausepeople have looked at the liquidity trap issue, have read Krugman, have readKeynes, have look at the Irving Fisher paper of 1933. It is not normal for theeconomy to behave like that, but it is something that from a model point ofview is known.
Hélène Rey Introduction:
Professor of Economics,London Business School Fellow of the British Academy.In 2012 she received theinaugural Birgit Grodal Award from the European Economic Association honoring aEuropean-based female economist who has made a significant contribution to theprofession of Economics. In 2013 she received the Yrjö Jahnsson Award, sharedwith Thomas Piketty.
