Challenges Ahead: Managing Spillovers

By Olivier Blanchard, Luc Laeven, and Esteban Vesperoni

The last five years have been a reminder of the importance of interconnections and risks in the global economy. They have triggered intense discussions on the optimal way to combine fiscal, monetary, and financial policies to deal with spillovers, and on the need and the scope for coordination of such policies.

The IMF’s 15th Jacques Polak Annual Research Conference, which took place in Washington DC on November 13 and 14, 2014, focused on Cross-Border Spillovers, and took stock of what we know and do not know.  The summary below picks and chooses some papers, and does not do justice to the full set of papers presented and discussed at the conference.  They can all be downloaded, and videos of each session are available, at

Setting the stage

The Mundell-Fleming lecture by Helene Rey set the stage for the discussion of these issues. In her lecture, Helene made two main points.  The first is that there are large correlated movements in capital flows, risky asset prices and credit growth across developed and emerging economies, that there is in effect a “global financial cycle”.  The second, a more controversial one, is that countries cannot insulate themselves through exchange rate flexibility.  Looking at the effects of the capital flows or valuation changes triggered by a change in monetary policy in the United States, she showed that the effects on mortgage spreads were roughly the same for countries that adjusted their interest rate and those that did not. This suggests that, in contrast to the traditional Mundell-Fleming model, capital flows and valuation changes linked to the important international use of the dollar have substantial and complex effects on the domestic financial system of recipient countries, quite apart from their effect on the exchange rate.  This led Helene to conclude that only macro prudential and capital controls may be able to provide sufficient insulation.

A first set of papers looked at specific spillovers. Among them:

Two papers on unconventional monetary policy examined in more detail some of the spillovers that Helene was referring to in her lecture.  Simon Gilchrist, Vivian Yue, and Egon Zakrajek—from Boston University, Emory University and the Federal Reserve—contrasted the effects of conventional and unconventional US monetary policy on foreign sovereign yields.   They showed that conventional monetary policy surprises in the United States steepened foreign yield curves, while unconventional policies instead flattened foreign yield curves.   A paper by Marcel Fratzscher, Marco Lo Duca and Roland Straub—DIW Berlin and the European Central Bank—looked at the use of unconventional monetary policy in Europe.  It found that ECB policies had positive spillovers on equity prices across a wide set of countries, but the impact on yields was limited to the euro area, especially Italy and Spain.  ECB policies increased market confidence—i.e., reduced implied volatilities and sovereign and banks spreads—but had little impact on international portfolio flows.

On the fiscal side, an innovative paper by Alan Auerbach and Yuriy Gorodnichenko—from the University of California at Berkeley—tackled the contradiction between models predicting that higher public spending should lead to exchange rate appreciation, and the empirical evidence that so far pointed to depreciations. Their hypothesis is that, for the shocks to spending which have been used in econometric work,  it is likely that investors knew about them earlier, and that the appreciation actually happened, but happened earlier than the change in spending itself.   Using U.S. daily data on defense spending commitments to obtain a better identification of public spending shocks, they find that these shocks were indeed typically associated with an appreciation, thus validating theoretical predictions.

Trade linkages have evolved over time, one of the reasons being the development of global supply chains. Christoph Boehm, Aaron Flaaen and Nitya Pandalai Nayar—from the University of Michigan— presented work looking at the spillover effects of the 2011 tsunami and earthquake in Japan.   They indeed find strong effects of the disruptions in Japan on the imports and the production of Japanese affiliates in the United States. Their main conclusion is that, at least in the short run, supply chains are very rigid, and disruptions can affect the whole chain.

Another set of papers looked at the effects and the potential role of measures aimed at reducing specific spillovers. Among them:

Anton Korinek—from Johns Hopkins—provided an analytical framework to characterize the conditions under which spillovers should or should not be a source of concern, the conditions under which the market equilibrium is efficient.  His results do not lend themselves to a simple characterization.  But he showed for example that a world in which countries use FX intervention to provide insurance to the tradable sector in response to capital flows can lead to an efficient allocation.

Marcos Chamon and Márcio Garcia—from the IMF and PUC-Rio—examined the effectiveness of capital controls in Brazil.  They showed that controls helped segmenting Brazil’s domestic financial market from the global one, opening a wedge between onshore and offshore prices of similar assets. The initial measures had limited success in mitigating exchange rate appreciation, but the tax on the notional amount of derivatives adopted in mid-2011 triggered a significant depreciation—likely driven by complementarities with previous measures and supported by the beginning of the monetary easing cycle as well.

Julien Bengui and Javier Bianchi— from the University of Montreal and the Minneapolis Fed—analyzed challenges associated with the implementation of capital controls, suggesting that despite leakages  due to  the presence of unregulated agents, stabilization gains from preventing financial crises remain large.

A final panel took on the discussion on policy challenges raised by increasing financial integration—including the scope for policy autonomy—and potential areas for policy coordination.

Maurice Obstfeld— a member of the Council of Economic Advisers, on leave from Berkeley—highlighted that financial openness inevitably challenges prudential tools. Channeling some of the conclusions from the Mundell Fleming address, he stressed that, even with effective monetary policy in the presence of exchange rate flexibility, financial stability issues are difficult to manage in the context of an open capital account. Cross-border lending curbs the ability to control domestic credit, and a ‘financial trilemma’ arises under any exchange rate regime; i.e. the fact that financial integration with global markets, national control over financial supervision and regulation, and financial stability are not all mutually compatible.  This leads to an important conclusion: the need for international policy coordination depends largely on the efficacy of macro prudential policies to deal with financial stability issues.  Maury stressed that critical areas for coordination going forward are financial regulation, clear rules of the road for capital controls, and enhanced facilities for international liquidity support in key currencies to counteract downsides of gross reserve accumulation.

Jean Boivin—former Canada’s co-chair of the G-20 Framework Working Group and chief strategist at BlackRock—emphasized that coordination at the political level is complex, and a critical precondition to agree on a strategy is the acknowledgment at the country level of the importance of international spillovers on economic conditions. Hector Torres—alternate executive director at the IMF Board—noted that unconventional policies put the global economy in unchartered waters, and uncertainty and disagreements made cooperation harder to achieve.  He argued that the Fund had an important role to play in clarifying and fostering consensus about spillovers. Finally, David Vines—Oxford University—argued that full coordination might be too hard to achieve,  and called for  ‘concerted unilateral reforms’ in which opportunities created by reforms in some countries influence the extent to which other countries pursue their own domestic reforms, a strategy adopted by the G-20.

Asynchronous monetary cycle

One potential take away from the set of papers, relevant to the current monetary policy challenges, relates to asynchronous exit from unconventional monetary policies.  If it is indeed the case that (i) as Helene Rey stresses, the impact of U.S. monetary policy is a driver of a global factor in assets prices, risk premia, mortgage spreads, etc,  and that the impact of U.S. monetary policy on global liquidity is stronger than the effect from changes in future short term rates; and (ii) unconventional monetary policy by the ECB has a milder impact on capital flows and global liquidity than U.S. unconventional policies, as suggested by the paper by Marcel Fratzscher, Marco Lo Duca and Roland Straub, then an asynchronous monetary cycle between the US and Europe going forward might raise significant policy challenges and require serious policy dialogue, in particular among central bankers in advanced economies.

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