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A system under strain
Political economy takes front seat
Developments in the global monetary system are suddenly coming quickly. Last week’s 75 basis point increase in US interest rates prompted a matching hike from the Swiss central bank, as well as 50 bp hikes in the UK and Norway. Japan’s central bank launched an exchange-rate intervention, though this has not yet included raising rates.
Then, fiscal plans released by the UK’s new government prompted a sharp decline in the US dollar price of British pounds. By Wednesday, this had led the Bank of England to announce a plan to buy long-dated UK sovereign debt to the tune of £65 billion, a pointed reversal from the BoE’s tightening stance.
Punditry is suddenly in excess supply, and full of noise. Briefly, two small points worth keeping in mind as we enter this new, likely more tumultuous period.
Political economy at the fore
The political economy of the monetary system is suddenly front and center. The crisis of the pound is focused on the relationship between the Treasury, which is pursuing debt-financed tax cuts, and the Bank of England, which is charged with stability of prices and financial markets. For the Bank of Japan, meanwhile, global inflation is providing a welcome relief from years of disinflation and deflation. But even there, the dollar’s strength creates losers, and the central bank cannot avoiding entering into politics. One can hear echoes of the East Asian financial crisis.
Political economy surfaces when private market-making breaks down. Market prices always rise and fall, creating winners and losers, fortunes and failures. Such fluctuations don’t necessarily challenge the rules of the game. When losses get big, or when they come fast, private market-making fails. The integrity and legitimacy of the system as a whole come into question. Governments step in—they don’t have much choice. Political-economic negotiations are the way that new boundaries can be drawn, new rules to the game, eventually allowing private market-making to be restored.
The financial system is fragile—small causes have big effects. One symptom of fragility is that distress is flaring up in many different places at once: the UK, Japan and Korea, for example, are all rushing to respond this week. In each case there are local narratives that determine the details of how the distress manifests, and exactly which financial relations break down: government finance in the UK, importers in Japan, and so on. These details are important—they will determine who ends up bearing the losses, and what will be the path to recognizing those losses. But the details only make sense in the context of a single, globalized, dollar-based financial system, in which dollar interest rates are being pushed upward very quickly.
Though it is not how central banks describe their own actions, the point of raising interest rates is to increase the cost of overnight funds, to make it more costly for borrowers to delay final settlement. This rising cost leads those who are able to settle to do so. Those who can’t settle will instead have to pay more to borrow, hoping for better days to come.
For some, those better days will come. Others will push back the day of reckoning as long as possible, against increasingly difficult odds, until they finally have to throw in the towel. Such capitulation will take the form of default, of one kind or another. And despite what central bankers might say, this is not really a side-effect, but is in fact the main effect of raising dollar interest rates.
Cash reserves everywhere are being stretched—that’s what tighter monetary policy is doing. The result is fragility, big responses to modest disturbances. More or less by definition, this will continue to be the case until the Fed sees a reason to stop tightening—inflation comes down, or crisis becomes systemic. Private capital will always pare down reserves, so that fragile financial conditions are hard to absorb. That in turn means that discontinuities are likely, and so political institutions will be called on to set and hold boundaries on fluctuating prices.
The system is under strain, and relief is not yet in the cards: more fireworks to come.
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