The prospect that the Federal Reserve will soon ease off on its purchases of long-term assets has increased financial-market uncertainty and contributed to a retrenchment in global capital flows. This turbulence has revived discussion of the need to enhance the global financial safety net—i.e., the set of arrangements to provide international liquidity to countries facing sharp reversals in capital inflows despite following sound economic and financial policies.1
The dominant lessons from the financial crises of the past decade are:
The world is more financially integrated than anyone imagined two decades ago.
Consequently, financial stability is more dependent on global liquidity conditions.
The clock cannot be turned back. The option of returning to comprehensive capital controls and other forms of financial repression is unrealistic as well as unwise.
The international monetary system needs better tools to deal with threats to the globalized financial system. The International Monetary Fund (IMF) and regional financial arrangements can play a role, but they are not big enough for today's global shocks. They do not have the balance sheet leverage to provide effective cushions for volatile financial flows.
Only central banks have the balance sheet leverage to respond to volatile capital flows on the necessary scale. This has been amply demonstrated over the past five years as central banks, principally the Federal Reserve, have mobilized massive swap facilities.
Global liquidity is poorly understood. An excellent report by a group of central bankers chaired by Jean-Pierre Landau (CGFS 2011) substantially clarified the concepts, measurement, and policy implications of global liquidity. Unfortunately when the report addressed cooperative, multilateral measures, it recommended the status quo, that is, the continued reliance on ad hoc arrangements. A more recent paper by Francesco Papadia (2013) reaches a similar conclusion. I disagree.
What we need is an institutionalized global swap network. It is possible to establish a global swap network that has the capacity to meet the demonstrated need and at the same time meet the concerns of central bankers. I have proposed (Truman 2010a and 2011) a global swap network with three keys to unlock it:
The first key would be held by the IMF. Based on objective criteria, the IMF would declare a need for global liquidity to support the international financial system and recommend that central banks consider providing liquidity to private financial institutions in other countries via their central banks. The criteria employed by the IMF should be objective and linked to generalized global conditions, not country-specific circumstances associated with heightened stress events affecting individual countries.
The second key would be held by the group of central banks that had previously established the global swap network. Participation in the global swap network would be pre-determined by the central banks based, for example, on the independence of the central banks and assessments of the stability of their financial systems. The central banks would meet and, using their own criteria, would agree or not with the IMF that there was a global need for liquidity that could and should be met by activating the network. The criteria used by the central bankers should be transparent, but they might differ from those used by the IMF. For example, they might give greater emphasis to financial conditions and the risk of global inflation.2
The third key would be held by each individual central bank (or pair of central banks) deciding to respond to the decisions of the IMF and the central banks as a group with a specific swap operation or sequence of operations. Importantly, no central bank would be required to activate the third key. Individual central banks would retain the capacity to enter into swap agreements outside of the three-key framework.
Why do central banks resist the establishment of a structure such as the one I have proposed?
First, in this area, central bankers appear to prefer constructive ambiguity. They argue that permanent swap arrangements contribute to moral hazard behavior on the part of governments and private sector banks:
The crises over the past six years have demonstrated conclusively the high costs of such ambiguity. Central banks responded eventually but only after a great deal of economic and financial damage had been done. Predictability adds to stability and reduces the need for inefficient and distortionary insurance mechanisms such as owned reserves, which are likely to be insufficient in the event of a global crisis in any case.
Second, central bankers argue that they need to protect their independence and do not want to be drawn into external entanglements. The reality is that the central banks will have no choice in crisis situations. And they should prepare, in advance, their own crisis prevention activities.
Central bankers also argue that they do not want to be told by the IMF to engage in lending to other central banks because it is an institution largely dominated by finance ministries and, therefore, inherently more political.3 Here we have unhealthy institutional rivalry. When a multilateral organization, such as the IMF, declares that the global economic and financial situation demands global cooperative solutions, a national central bank gains credibility and protection against domestic criticism in responding positively to that declaration.
Would national central banks come under pressure to use their third keys?
Yes, but those pressures would be there anyhow. A structured approach, such as the one I have proposed, would establish the context for activation of the global swap network and identify in advance those countries that are most deserving of assistance.
Global financial crises are not a thing of the past. They are often caused by buildups of excessive domestic and foreign debt. But successfully addressing such crises and limiting negative spillovers often requires coordinated actions to prevent a contraction in global liquidity. Establishment of a more robust global financial safety net centered on central banks—because that is where the money is—would be a useful tool for addressing the inevitable future crises.
Also posted on Vox.
CGFS (Committee on the Global Financial System). 2011. Global Liquidity: Concept, Measurement, and Policy Implications. Report submitted by an ad-hoc group established by the Committee on the Global Financial System chaired by Jean-Pierre Landau. CGFS Paper 45. Basel, Switzerland: Bank for International Settlements.
Papadia, Francesco. 2013. Central Bank Cooperation During the Great Recession. Bruegel Policy Contribution Issue 2013/08. Brussels: Bruegel. Available at www.bruegel.org (accessed September 10, 2013).
Truman, Edwin M. 2008. On What Terms is the IMF Worth Funding? Working Paper 08-11. Washington: Peterson Institute for International Economics.
Truman, Edwin M. 2010a. The IMF as an International Lender of Last Resort. RealTime Economic Issues Watch. October 12. Washington: Peterson Institute for International Economics. Reprinted as chapter 17 in Reform of the International Monetary System: The Palais Royal Intiative, eds. Jack T. Boorman and André Icard. New Delhi, India: Sage Publications.
Truman, Edwin M. 2010b. Strengthening IMF Surveillance: A Comprehensive Proposal. Policy Brief PB10-29. Washington: Peterson Institute for International Economics. Reprinted as chapter 10 in Reform of the International Monetary System: The Palais Royal Initiative, ed. Jack T. Boorman and André Icard, New Delhi, India: Sage Publications.
Truman, Edwin M. 2011. Three Evolutionary Proposals for Reform of the International Monetary System. Extension of prepared remarks delivered at the Bank of Italy's Conference in Memory of Tommaso Padoa-Schioppa, December 16. (accessed September 10, 2013).
1. The communiqué of the G-20 Finance Ministers and Central Bank Governors meeting in Moscow on July 20, 2013 reflected this concern in paragraphs on regional financial arrangements and studies by the IMF and Bank for International Settlements (BIS) on global liquidity. See http://www.g20.utoronto.ca/2013/2013-0720-finance.html.
2. The potential recipient central banks might also be limited to those of countries in the top tier of the comprehensive pre-qualification framework that I have proposed should be applied, as part of the Article IV review process, to all IMF members that potentially may need to borrow from the IMF, in other words to countries that potentially qualify for a flexible credit line. See Truman (2010b) for more details on this aspect of my proposals.
3. An alternative more IMF-centered approach would, as I have also proposed (Truman 2008), involve a system of special drawing rights (SDR) swaps between the IMF itself and the central banks that issue international currencies. Central bank exposure would be to the IMF and they would receive a transferable claim. The IMF would loan the currencies to other central banks to support their financial institutions.