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Global Economic and Financial Developments in the 1990s and Implications for Monetary Policy

Luncheon Speech by
Flemming Larsen*
Deputy Director of Research
International Monetary Fund

27thEconomics Conference:
"Possibilities and Limitations of Monetary Policy"
Oesterreichische Nationalbank
June 10-11, 1999

Madam Governor, ladies and gentlemen:

When Mr. Mussa asked me just a few days ago to replace him at this conference I immediately jumped at the opportunity to visit Vienna once again. Then he told me that he had not yet prepared his speech, which I thought I could just take over. His topic was to have been on the challenges of restoring high employment conditions in Europe.

I am very pleased now that I did not in fact choose that topic because it has been discussed extensively this morning. This is unquestionably the most important policy issue Europe is facing but I think it has been covered very well.

Instead I will discuss global economic and financial trends in the 1990s and implications for monetary policy. This is the bland version of my title (appropriately bland as suits an international civil servant). Somewhat bolder titles could have been: Does the restoration of global price stability suggest that exchange rate stability is becoming easier to achieve in the future? Or: Is the euro weak and is that a problem? Or: Is there any link between high unemployment in Europe and the Asian crisis? As I will try to convince you, there may well be such a link and it is a different one to the one most people have in mind.

When working on my presentation on my way to Vienna, I was getting worried that my views may be a bit too audacious in such a forum, an audience of central bankers. But after listening to Professor Streissler's excellent presentation yesterday I no longer think that my views are all that audacious. In fact I believe that I have found a soul mate in Professor Streissler. I am grateful that he has prepared the ground for some of the things I am going to say. I am also particularly happy to note, as Mr. Streissler pointed out, that some of these views are in fact related to the thinking of famous Austrian economists like Hayek. That there is some sort of connection with the Austrian school makes it even more appropriate to present those views here in Vienna.

First, a few words about the emerging market crisis of the past couple of years. The 1990s have, as you know, been marked by a great deal of volatility in global financial markets, most recently in the form of the emerging market crises of 1997 to 1999 that engulfed first South East Asia and subsequently Russia and much of Latin America. As a result of these crises, together with the severe recession in Japan, world economic growth slowed markedly in 1998 and is expected to remain quite subdued this year. But the crises have eased considerably in recent months.

There are now signs of a turnaround in the Asian crisis—afflicted economies. This has justified upward revisions to our growth projections for these countries in recent months as their recovery profiles increasingly display the V-shaped pattern that we have often observed elsewhere after sharp output contractions. For Brazil, there are also encouraging signs of an early turn- around in confidence. In Russia, economic activity has been less seriously affected than had been expected in the wake of last August's crisis, and the commitment by the new government to sustain the reform process suggests that the worst may also be over there even though there is still a great deal of uncertainty about the outlook for Russia.

So does this now imply that the global crisis is over and that world growth will quickly return to the 3 -4 percent trend growth rate that we have observed during the past quarter century? Maybe. The recoveries in the emerging market countries recently in crises may well surprise on the upside. Although there is always a danger of policy setbacks, market disappointments, and renewed contagion, financial markets may soon come to the view that these crises have actually contributed to enhancing the long-term prospects of emerging market countries through the reforms and stronger institutions that are now being put in place. Moreover, the most recent data that have appeared in the euro area and Japan also suggest that the sluggishness in these economies and especially in Japan may also be coming to an end.

Overall, it is now apparent that our global growth forecast for 1999, which was estimated at 2 percent as recently as at the time of the Interim Committee meeting at the end of April, may be too pessimistic. I expect our next projections to show a somewhat higher growth rate for 1999.

However, significant downside risks still attach to the global outlook for next year and for 2001. The greatest uncertainties now seem to emanate from the industrial world. Indeed, a key concern stems from the unbalanced pattern of growth that we have seen recently among the three large currency areas. The strong U.S. economy has played a critical role in avoiding a more serious global economic down-turn in the past couple of years but continued above-potential growth carries the risk that the eventual slowdown could be more sudden and pronounced than most forecasters and financial markets expect at present.

If the U.S. economy were to slow significantly, there would be reason for concern about the ability of other countries to provide sufficient support for global activity. This applies especially to Japan, where the recession seems to be bottoming out but where it is not yet clear that conditions for a self-sustaining strong recovery are in place despite considerable fiscal and monetary policy support.

In the euro-area growth has been quite weak recently, especially in Germany and Italy, and it still remains to be seen whether the easing by the ECB will be sufficient to restore the momentum of recovery in domestic demand in Europe.

Of course, cyclical divergences between the major countries can in principle be worked off gradually. And it is perfectly reasonable to think that a soft landing is possible for the United States and that recoveries in Europe and Japan will compensate for a period of consolidation in the United States. But it is almost equally reasonable to expect a less benign adjustment process, one that could involve a harder landing for the United States and a situation where the negative forces would again exert themselves in Japan and Europe.

I suspect that many of you will agree that both the generously valued U.S. stock market and the present constellation of exchange rates among the major currencies—seen together with the widening of current account imbalances in recent years—contain the potential for significant and disorderly corrections in financial markets. It is this risk that warrants a cautionary distinction between the emerging market crisis, where the worst indeed seems to be over, and the overall health of the world economy, where it is still too early to know how the present global imbalances are going to be resolved.


The 1990s have seen great achievements for global policy makers but also a number of new challenges associated with significant changes in the working of the global economy and in the nature of international economic and financial linkages. Among the achievements the reestablishment of broad price stability in the industrial countries stands out as a particularly remarkable accomplishment and there has also been impressive progress in fiscal consolidation in many countries. But as we have seen, however necessary these two conditions are for safeguarding reasonably robust and stable economic growth, they are clearly not sufficient. Eliminating fiscal and monetary policy shortcomings addresses the source of some macroeconomic disturbances but certainly not all. Indeed, it is now generally accepted that the private sectors' decisions—even when they are taken in the context of well functioning and undistorted markets—can result in booms and busts.

What I would like to focus on here are the policy complications that arise because of several closely interrelated features of the global economy that are either new or at least appear to have become more dominant in the 1990s. These features or developments are all associated with the process of globalization.

First, economic linkages across countries and regions in the world economy seem to have changed quite significantly. There is a great deal of empirical evidence on the transmission of economic disturbances through trade flows and commodity prices, consistent with the historical pattern of a positive correlation between the business cycles of the industrial countries and those of the developing countries or emerging markets. But in the 1990s private capital flows have increasingly dominated the international linkages to such a degree that business cycles have become desynchronized. In the early 1990s, for example, most of the major industrial countries all experienced economic slowdowns, first in the United States with a mild and brief recession and in Japan in the wake of the bursting of its asset price bubble, and then in much of Europe in connection with the tensions and pressures that also led to the ERM crisis. During those years the emerging market countries did not seem to be negatively affected by the weakness in the industrial world. If anything, they seem to have been receiving further impetus to their economic expansions, an impetus that eventually contained the seeds of the Asian crisis.

During the Asian crisis, we have now observed another example of unexpected linkages. As demand and imports in the crisis countries collapsed, their external deficits swung sharply into surpluses, a swing of about USD 130 billion in a little more than one year. This obviously had a negative impact on exports and industrial production in the United States, Europe and Japan. In Europe and Japan this did have the expected negative impact on growth but not in the United States. In the U.S. it now looks as if the Asian crisis was a fortuitous event that may well have helped prolong an already very long economic expansion.

There are several reasons for considering that the emerging market crisis was fortuitous for the United States. First, because the redirection of capital flows added liquidity to the U.S. bond and stock markets. Second, because declining import prices stimulated real incomes and lowered inflation. This not only permitted the Federal Reserve to keep interest rates steady at a late stage in the cycle, it eventually allowed the Fed to ease interest rates by 75 basis points last fall in the face of widespread fears of a credit crunch following Russia's default and the near-collapse of the hedge fund LTCM. Throughout the Asian crisis episode the U.S. economy continuously outperformed even the most optimistic forecasts. I find it hard to avoid the conclusion that the U.S. economy may have been stimulated by the Asian crisis, at least in the near term.

The second change that has occurred in the 1990s, which helps to explain the seemingly inverse linkages, has been the marked increase in cross-border private capital flows. In particular, the increase in private flows to emerging market countries in the 1990s clearly marked a break with the relatively moderate levels of such flows observed in the 1980s.

What explains this increase? Financial market liberalization, removal of capital controls, search for high yields, and desire for portfolio diversification probably all played a role but there have also been some less benign reasons, including underestimation of risk and moral hazard effects resulting from various explicit and implicit government guarantees (not only in the capital importing countries).

While these factors help explain the massive rise in gross capital flows, we also need to recognize that the large net capital flows into emerging market countries would not have been possible in the early 1990s without the large and growing external surpluses of Japan and what is now the euro-area during this period. For example, the lacklustre performance at home and low cost of funds provided strong incentives for European and Japanese banks to try their luck abroad.

The third feature of the global economy that seems to have become more pronounced or more dominant in the 1990s is the sensitivity of exchange rates to cyclical developments. The cyclical sensitivity of exchange rates has been observed for some time for the G7 and now the G3 currencies, where it is apparent that countries with a strong economic performance tend to experience exchange rate appreciation because they offer the best prospects for international investors. Over the cycle, however, as cyclical divergences narrow or even reverse the same forces may tend to produce relatively large realignments in exchange rates. One would like to think of such movements as essentially stabilizing, provided of course they are not excessive relative to the cyclical divergences.

Beyond the G3 currencies the 1990s have also witnessed a general and very pronounced further shift towards greater flexibility in exchange rate regimes among the emerging market countries. Whether it is in response to financial crises, contagion, or spillovers through trade and commodity prices, the increasingly flexible exchange rates among emerging market countries have frequently depreciated significantly in response to adverse developments. This has helped moderate cyclical slowdowns in many cases, often without triggering sustained increases in inflation.

The fourth development that is striking in the 1990s has been the general reduction in inflation worldwide. Not only has inflation come down to the lowest levels in 40 years, as I mentioned earlier, but it has come down more or less simultaneously across the industrial countries, and increasingly also in the emerging market countries. As the average inflation rate has come down, divergences across countries have also come diminished.

Why is that the case? Is that because central bankers are breathing the same air and subscribe to the same anti-inflation policy paradigm? Yes, that is probably part of the explanation but I also believe that there are global forces at work in the form of increased competition, deregulation, very low transport costs, and the information revolution that have all contributed to the decline in inflation expectations and easing of inflationary pressures
worldwide. The fact that world inflation is generally subdued unquestionably helps individual countries in their efforts to reduce inflation.

These developments, which I consider to be some of the salient features of global economic trends in the 1990s, have some important implications for policy spillovers, especially for the international transmission of monetary policy. One key lesson is that the integration of capital markets implies that monetary conditions in a given country can be affected quite substantially by developments elsewhere.

Let me offer a couple of examples that relate to the earlier interpretation of developments in the 1990s. In the first part of the 1990s emerging Asia clearly appeared to be stimulated by the progressive easing of monetary conditions in Japan and Europe during this period. This does not imply, of course, that the easing of monetary policy in Japan and Europe was a mistake. The problem was that the spillovers through capital markets were not taken sufficiently into account in the setting of policies in the emerging market countries. With the benefit of hindsight, it is now clear that the response should have been a tightening of monetary conditions and fiscal policies in these countries and perhaps an appreciation of these countries' currencies in order to reduce excess demand pressures and the risk of overheating. That did not happen so their monetary and financial conditions became much to loose. The consequences for asset markets, external positions, and banking system fragilities are now well known.

Has something similar been happening in the case of the United States during the past couple of years? As I argued, I believe the United States have been stimulated by the reorientation of capital flows away from emerging market countries and from the continued weak economic conditions in Japan and to some extent in Europe. As a result of these capital inflows, and the terms of trade gain associated with falling import prices it can be argued that overall financial conditions in the United States became easier than intended and possibly too expansionary, inadvertently contributing to the continued run-up in asset prices, particularly the stock market. It is impossible to know with absolute certainty whether the generously valued stock market in the United States constitutes an asset price bubble. But I am struck by the growing concern among many economists around the world that this may well be the case and that the current U.S. expansion may eventually end in tears as has happened in so many other countries in the wake of strong upturns that eventually proved unsustainable.

Are we destined to experience such forces and potential macroeconomic instability also in the future? I do not know the answer but it is better to be prepared. We cannot expect to eliminate the macroeconomic disturbances that provoke large shifts in cyclical positions, in capital flows, and in exchange rates, but we should at least avoid adding to those disturbances through policy errors. This is where economic policies, and especially monetary policies, which are our primary cyclical stabilizer, are facing considerable challenges. These challenges arise from the possibility or maybe even the likelihood that traditional inflation indicators, i.e., measures of inflation in goods and services prices, may not provide sufficiently unambiguous signals at very low inflation rates to allow policymakers to rely primarily or exclusively on them in gauging the extent of potential pressures that may be developing in the economy as an economic expansion matures.

Many economists argue that monetary policy should aim at stabilizing inflation as traditionally measured, for example, by consumer price developments. However, there is a good deal of evidence that overheating can manifest itself even under conditions of price stability as conventionally defined and that it may show up in balance sheets, in asset prices, or in the form of financial fragilities. I also believe that there is a basis at least for the hypothesis that the forces of globalization in both goods markets and financial markets are contributing to dampen pressures on goods and services prices while at the same time increasing the risk that potential inflationary pressures show up in asset markets instead. This is consistent with the view of some economists that the risk of asset market bubbles may be greater at low rates of inflation in goods and services prices. The question then arises whether the focus of monetary policy should be expanded to help stabilize asset markets.
Let me stress immediately that I share the concern of those who argue that monetary policy should not attempt to target asset prices. However, this does not imply that monetary policy should not pay attention to the consequences of asset price developments.

These issues have become more pressing in light of the integration of capital markets which may be contributing to cyclical divergences across countries. I have already mentioned several aspects of the processes that may contribute to cyclical divergences. For example, experience from the 1990s has shown that international capital flows tend to benefit the most dynamic countries and regions. At the same time, global competitive forces help to keep goods prices inflation relatively low in countries with strong economic expansions. The tendency for the capital inflows to lead to exchange rate appreciation is also a factor that is helping to keep our traditional measures of inflation in check, thereby muting or delaying the signals of inflationary pressures that we are accustomed to monitor. As a result, there is a risk that we may continue to experience macroeconomic instability with boom and bust cycles as seen in the past, even in the absence of strong inflation signals from our traditional indicators. To reduce this risk, I believe that monetary authorities need to pay more attention to asset markets and to unsustainable balance sheet developments. The implication is that interest rates will probably still need to vary a great deal over the business cycle even if inflation is relatively low.


Let me come back to the questions I raised in the alternative titles of my presentation. First, greater exchange rate stability: can we expect that to follow from price stability? No, because of cyclical divergences across countries, differences in monetary stances, and associated shifts in capital flows, we probably have to envisage continued significant volatility in the exchange rates of key currencies. Many countries would probably not be comfortable with that degree of volatility, particularly smaller open economies. I would not be surprised if we see more interest in a return to fixity in the form of currency unions as we have seen here in Europe, in the form of dollarisation which is discussed extensively now in Latin America, or in the form of currency boards that have withstood the pressures associated with the recent crises.

The second question concerns the euro. Is the euro weak and should this be a cause for concern? If one takes a longer term perspective and looks at the past value of the euro by using a synthetic measure of the real effective exchange rate based on the exchange rates of the participating currencies, then it is apparent that the current value of the euro is not particularly weak. It is well within the trading band that has been experienced over the past ten or twelve years. The fact that the value of the euro is towards the weaker end of this trading band seems to be consistent with the differences in cyclical positions, especially relative to the United States. Putting things in perspective gives one quite a different picture than assessing the euro on the basis of the bilateral exchange rate vis--vis the dollar since the beginning of 1999.

The third question: Is there a link between Europe's unemployment problems and the Asian crisis? I think there is a link and I would tend to concur with Professor Streissler who argued convincingly that there was a link between the weak economic performance of Europe and Japan in the 1990s and the asset bubbles we have seen in Asia, and which we may now be experiencing in the United States. There does indeed seem to be a good deal of evidence and support for the notion that the expansionary policies in Europe and Japan are spilling over to the rest of the world, and while there may be a liquidity trap in Japan, there was no such problem elsewhere in Asia in the buildup to the recent crises, and there is certainly no liquidity trap problem today in the United States. But this does not imply that policies are too expansionary in Japan and Europe. The problem is rather that economic policies in the United States may not have allowed sufficiently—as was the case previously in Asia—for the expansionary impulses coming from capital inflows and from the external environment. Another problem is that the European and Japanese economies are not reacting sufficiently vigorously to the appropriately stimulatory macro-economic policies. It is in this way that there seems to be a link between Europe's labor market problems and the structural weaknesses in Japan on the one hand, and the large and potentially destabilizing capital flows we have experienced in the 1990s, on the other.

Indeed, greater efforts to tackle Europe's and Japan's long-standing structural deficiencies may well be an essential part of what is needed to make the world economy less unstable.

*The views expressed in this speech represent those of the author and should not be attributed to the IMF.


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