Policy Responses to Globalization: Damned If You Do, Worse If You Don’t

These books represent an enormous investigative effort by researchers associated mainly with the premier international governmental organizations (IGOs). Living with Debt is the annual Economic and Social Progress Report from the Inter-American Development Bank (IDB), copublished with Harvard’s David Rockefeller Center; Emerging Capital Markets is a joint issue by Stanford University and the World Bank; Regional Financial Cooperation and Finance for Development are both copublished by the Brookings Institution and the United Nations Economic Commission for Latin America and the Caribbean; and Meeting the Employment Challenge is by economists at the International Labour Organization in Geneva. My greatest surprise in reading them was the degree to which all six, including the volume on employment by Berg, Ernst, and Auer and De la Reza’s study of trade and economic integration, place questions of finance, money, and exchange rates front and center in their analyses.

It may help to review three background issues that are crucial for an appreciation of these works: first, the unholy trinity/trilemma of modern macroeconomic management; second, the extent of contemporary financial globalization; and third, the benefits of national financial development and how globalization influences this. The unholy trinity refers to the Mundell-Fleming model developed in the 1960s, which demonstrates that a country can have only two of the following three policy options: an independent monetary policy (by which the central bank expands and contracts liquidity with the objective of stable growth and low inflation), a fixed exchange rate (enabling producers of tradables to minimize exchange rate risk), and capital account openness (or freedom for cross-border investment flows of all types).¹ If, for example, the exchange rate is fixed and the capital account open, then the central bank must target the exchange rate by maintaining a tight enough monetary policy (i.e., high enough interest rates) to attract financial deposits, even if the domestic economy is sluggish and arguably in need of a stimulus to growth. If, instead, the exchange rate floats and the capital account is open, then monetary policy may respond to domestic imperatives, although expansionary policy will cause the currency to depreciate commensurately, often provoking inflation as imports become more expensive.

The progressive internationalization of money and credit markets is a second background theme. During the Bretton Woods era, stretching from the end of World War II to the early 1970s, the trilemma was not a problem. Countries had mostly closed capital accounts, and the majority of cross-border financial flows reflected either payments for purchases of goods and services (trade) or long-term foreign direct investment (FDI). Financial globalization began with the Eurodollar markets in the 1960s, expanded slowly after the major industrial democracies floated their currencies in the mid-1970s, then accelerated rapidly from the mid-1980s onward. Although partial capital controls, especially on short-term speculative flows, remain possible and...