Business Cycles, Open Economies and Wandering Bubbles

In a previous post we commented on some aspects that are relevant for business cycles in the context of open economies. We also showed that in not a few cases the Mises-Hayek theory of business cycles is offered as an explanation of what went wrong. Even though business cycles have multiple causes and issues going on simultaneously, the Mises-Hayek hypothesis helps to explain part of the dynamics that provoked e.g. the Financial Crisis of 2008. But when one takes into consideration the context of open economies, some other relevant issues come to the surface.

One of them is the relative size of the periphery with respect to the center. Let the center by represented by a big economy (for example, the United States), and the periphery by a set of small open economies. Is the periphery small with respect to the center, or is it small but big enough that feedback effects can in turn have a non-trivial effect on the center? These two scenarios point to interesting problems that deserve attention.

Small Periphery

If the periphery is small, then changes in monetary policy that are trivial for the center can cause a boom and bust in the small open economies. This fact points to the problematic issue that optimal domestic monetary policy may not be the same as the optimal international monetary policy. This, of course, is particularly present in the case where the central bank in the center issues the currency used in international trade and held as reserves by other countries. In ‘Monetary Nationalism and International Stability’ (1937), Hayek referred to this problem as ‘monetary nationalism’. How to choose the optimal domestic policy without some nationalist basis? This is just another difficulty that central banks must deal with that is absent under free banking. If there are no regional monopolies of currency issuance, then there cannot be a problem of monetary nationalism. Ronald McKinnon (Stanford University) suggests that the Federal Reserve overlooked the international signs of monetary imbalances because it was too focused on domestic variables.

“Beyond the Taylor Rule violation, however, the persistent weakness of the dollar from 2002 to mid-2008 should have also signaled to the insular Fed that American monetary policy was far too loose. The asset bubbles themselves were not the only indicator. Both the euro area and smaller countries close to the USA with floating exchange rates, such as Canada and several in Latin America, were discomfited by the sharp appreciations of their currencies. China, which was trying to maintain a stable dollar peg, experienced hot money inflows that made it increasingly difficult to control its monetary base. The People’s Bank of China had to undertake massive sterilisation efforts to mop up excess monetary liquidity that was contributing to the bubble in commodity prices, and then re-impose controls on capital inflows. But the Fed, with its orientation towards only domestic monetary indicators, ignored all this.” (2010, p. 11).

This is nothing other than the ‘national monetarism’ that Hayek pointed out in 1937. Similar arguments were offered by other economists, for instance by Axel Leijohunfvud. Namely, that in a context of open economies with stable foreign exchange policies, the price level stability can become an erratic policy.

Not so Small Periphery

If the periphery is small, but big enough, then the joint performance of the small economies can have a significant effect in the center. Just as foreign exchange becomes the channel that transmits excess of credit between fiat currencies, exporting the artificial boom, when the periphery goes into a bust the feedback effect on the center is important enough for the big central bank to have to make a decision on monetary policy. If the central bank in the center is inclined to follow a loose monetary policy, then the same problem is put into motion once again.

Even though a periphery that is big enough may contribute to shorten the distance between domestic and international monetary policy, the feedback effects that come from the periphery can result in wandering bubbles moving from region to region as long as central banks react by lowering interest rates when the foreign bust hits the domestic economy.

Andreas Hoffmann and Gunther Schnabl offer Japan and Southeast Asia as an example of this problem. When the crisis hit Japan in 1989, Japan decided to follow a loose monetary policy by lowering the interest rates. The result was an unsustainable boom in the periphery, the countries in Southeast Asia. Among others, the export sector experienced a boom fueled by credit coming from Japan. However, when the boom became a bust, the feedback effect from Southeast Asia was big enough to be felt in Japan. This came through two particular channels. First, the Japanese export industries could not locate their products in the roaring Southeast Asia anymore. Second, the Japanese banks were overexposed to the countries in Southeast Asia; now Japanese banks were facing too many non-performing loans. The Bank of Japan decided, once more, to lower interest rates by expanding credit supply. Hoffmann and Schnabl also point out that the European Central Bank and the countries in Center and Eastern Europe offer a similar case.

Even though the core of the business cycle theory still holds in the case of open economies, certain interesting dynamics come to surface. It is not just that central banks cannot follow monetary policy that is optimal for both domestic and international requirements, but that the different bubbles are related to each other, rather than being isolated events.

The optimal monetary policy is constrained by the monetary institutions in place. Achieving sound money is not just about setting the best monetary policy, but also about having the optimal monetary institutions. Regional monopolies that issue fiat currencies face a hard challenge on this area.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

Image: Chris Sharp/ FreeDigitalPhotos.net

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