Could easy US monetary policy cause a widening of global imbalances?

Torrens had a nice day today – he got to peruse through some really interesting policy pieces – and for one reason or another, it got him thinking about whether US monetary policy, for which the well known Dire Straits tune seems aptly titled, could spill over to the rest of the world, and if so, how.

Apart from the psychological effects of getting the lyric “money for nothing” into the heads of Specie-Flow readers around the world, there are a variety of channels through which US monetary policy is generally thought to affect another country and these are associated with the exchange rate regime. Here are the traditional explanations. If the US shares a fixed exchange rate with another country with a closed capital account, like China, then an expansionary monetary policy in the US will stimulate US spending, including spending on imported Chinese goods, which in turn makes China’s trade surplus larger. This then requires greater amounts of foreign exchange intervention by the Chinese government to maintain the fixed exchange rate, which in turn creates inflationary pressure in China (the specie flow mechanism). If, however, the country has a flexible exchange rate and an open capital account, then the expansionary US monetary policy causes US interest rate to fall, which generates a capital outflow to the other country (as money flows in search of yield), and a depreciation of the US exchange rate. The weaker dollar tends to boost US exports to and weakens US demand for goods from such countries. It also might cause asset prices to get inflated in the foreign economy, which could be be a create additional financial risks.

So, everything else taken as given, it is likely, that US policy is expansionary for China and contractionary for, say Brazil. This is the mainstream view out there.

But TH wondered whether there were other linkages. He is sure that there are many, but here is one that came to mind. He probably read it somewhere, but doesn’t remember where; so apologies in advance if that is the case.

The linkage he has in mind is via the global banking system. Since international interbank markets often depend on the borrowing having high quality, liquid US dollar assets as collateral, US monetary policy, which affects the value of these assets, will affect international banking via these markets. So it seems reasonable to think that an easing of monetary policy that increases the supply of the most highly liquid US dollar assets will affect international borrowing conditions as well as US domestic borrowing conditions.

For countries with open capital accounts that are net borrowers from the rest of the world (such as, say, Australia and Canada), US monetary easing thus amounts to a credit easing policy, which causes these countries to increase their borrowing from the rest of the world. Since the borrowing is likely to result in a capital inflow (which causes the foreign currency to appreciate as capital flows in) and an increase domestic expenditure (as the borrowed money gets spent). These two effects tend to have offsetting effects on the foreign economy. So, in Australia, for example, the overall effect of the US monetary policy is to create increased indebtedness with the rest of the world (i.e. a larger current account deficit), without much effect on inflation.

But what about surplus countries, those like Germany, for example, that are net lenders to the rest of the world? What is the effect on them? Well countries like Australia have to borrow the money from somewhere, and, effectively, the US credit easing policy makes it easier for their banks to lend to the rest of the world. These countries experience the opposite effect – a capital outflow, which reduces domestic spending by diverting money that would have gone into the domestic economy abroad, and a depreciation, which increases their exports.

Thus, loose monetary policy in the US, could be exacerbating the global imbalance problem, or preventing it from rectifying itself as it should. It’s not clear how big this problem is. And it is certainly only one of many distortions that are currently messing up international banking and capital flows, but it could be a distortion that policy makers need to think about. And, who knows, perhaps they already are.

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