Gregory Thwaites

Monetary Policy Transmission in an Open Economy: New Data and Evidence from the United Kingdom

This paper constructs a new series of monetary policy surprises for the United Kingdom and estimates their effects on macroeconomic and financial variables, employing a high-frequency identification procedure. First, using local projections methods, we find that monetary policy has persistent effects on real interest rates and breakeven inflation. Second, employing our series of surprises as an instrument in a SVAR, we show that monetary policy affects economic activity, prices, the exchange rate, exports and imports. Finally, we implement a test of overidentifying restrictions, which exploits the availability of the narrative series of monetary policy shocks computed by Cloyne and Huertgen (2014), and find no evidence that either set of shocks contains any endogenous response to macroeconomic variables.

The Future of International Capital Flows

The experience of the past decade has demonstrated the challenges that international capital flows can pose for financial stability. The build-up of global imbalances (large net capital flows) was one of the preconditions for the recent financial crisis. Increased interconnectedness between countries’ financial sectors (large gross capital flows) created channels through which the initial shock could spread around the world. In these respects, the scale and volatility of international capital flows were crucial determinants of the depth and breadth of the crisis which followed Lehman Brothers’ demise.These dramatic events demonstrate that it is incumbent upon policymakers to develop strategies to deal with these risks in the future. But however great the challenges policymakers may have faced in the most recent episode, these are set to become even greater in the future as large emerging market economies (EMEs) increasingly integrate into the global financial system.This paper elaborates on the simulations of Haldane (2010), with the aim of constructing some illustrative thought experiments to describe some potential trajectories for G20 countries’ capital flows and external balance sheets over the next 40 years. Some key results from our simulations are as follows:The overall size of external balance sheets relative to GDP across the entire G20 increases from a ratio of around 1.3 to 2.2; The distribution of external assets shifts to emerging markets. By 2050, more than 40% of all external assets are held by the BRICs, up from the current 10%; Non-G7 annual capital outflows are simulated to be more than twice the size of G7 outflows by 2050; Global current account imbalances (the sum of deficits and surpluses) rise from around 4% of world GDP to around 8% at their peak.These simulations focus on two fundamental drivers of capital flows — GDP convergence and demographics. Plainly, other factors which we do not explicitly model — such as financial development, changes in investor preference, exchange rate policies and the development of social safety nets — will also be important in the years to come. Notwithstanding these caveats, it seems reasonable to envisage a future world in which the financial integration of EMEs is accompanied by a substantial rise in international capital flows relative to world GDP.Developments in the size and volatility of global capital flows are linked to UK financial stability both directly and indirectly. Direct links operate via the United Kingdom’s very large gross external balance sheet position, in turn a function of its role as a global financial centre. A more indirect set of channels operate via the International Monetary and Financial System (IMFS), and in particular, through interactions between global capital flows and various frictions that inhibit orderly adjustments to imbalances across countries.The key challenge for policymakers is to mitigate the potential financial stability risks associated with much larger future international capital flows while simultaneously preserving the key benefits that financial globalisation has to offer. The increase in capital flows will have implications for many policy issues, including, but not limited to: the elimination of data gaps; policies which limit the build-up of balance sheet mismatches; the Basel III international capital and liquidity standards; macroprudential policies; the use of capital controls; and reforms to the international monetary and financial system. This is clearly a challenging task, not least because the global nature of the problem will demand a co-ordinated policy response. But while policy co-ordination will be a crucial element of any first-best policy response, individual countries may also be able to introduce unilateral measures to mitigate their vulnerability to large and volatile capital flows — including through macroprudential measures. Although the policy challenge is considerable, the experience of the recent crisis shows that the stakes are already high. But if — as the simulations presented in this paper suggest — global capital flows grow to dwarf those experienced in the lead-up to the 2007–08 crisis, the stakes will become higher still.

Why are Real Interest Rates so Low? Secular Stagnation and the Relative Price of Investment Goods

Over the past four decades, real interest rates have risen then fallen across the industrialised world. Over the same period, nominal investment rates fell, while house prices and household debt ratios rose. I explain these four trends with a fifth — the widespread fall in the relative price of investment goods. I present a simple closed-economy OLG model in which households finance retirement in part by selling claims on the corporate sector accumulated over their working lives. With lower capital goods prices, a given quantity of saving buys more capital goods, but the increase in the real capital-output ratio lowers the marginal product. This has ambiguous effects on interest rates in the long run: if capital and labour are complements, in line with most estimates in the literature, interest rates remain low even if the relative price of capital stabilises. Lower interest rates reduce the user cost of housing, raise house prices and, given that housing is bought early in life, increase household debt. Housing is another vehicle for retirement saving, so omitting housing from the model exacerbates the fall in interest rates. I extend the model to allow for bequests and a heterogeneous bequest motive, and show that wealth inequality rises but consumption inequality falls when capital goods prices fall. Adding a third factor of production can reconcile the recent fall in the investment rate with the fall in the labour share. I test the model on cross-country data and find support for its assumptions and predictions. The analysis in this paper shows recent debates on macroeconomic imbalances and household and government indebtedness in a new light. In particular, low real interest rates may be the new normal. The debt of the young provides an alternative outlet for the retirement savings of the old; preventing the accumulation of debt, for example through macroprudential policy, leads to a bigger fall in interest rates.

The banks that said no: banking relationships, credit supply and productivity in the United Kingdom

This paper uses a large firm-level data set of UK companies and information on their pre-crisis lending relationships to identify the causal links from changes in credit supply to the real economy following the 2008 financial crisis. Controlling for demand in the product market, we find that the contraction in credit supply reduced labour productivity, wages and the capital intensity of production at the firm level. Firms experiencing adverse credit shocks were also more likely to fail, other things equal. We find that these effects are robust, statistically significant and economically large, but only when instruments based on pre-crisis banking relationships are used. We show that banking relationships were conditionally randomly assigned and were strong predictors of credit supply, such that any bias in our estimates is likely to be small.

Efficient frameworks for sovereign borrowing

This paper presents a theoretical model of strategic default to assess how national and international policymakers should seek to influence the cost of default and the distribution of bargaining power in the event of a default. We find that, in the absence of restrictions on the parameter space, deadweight costs of default should be driven to zero. Moreover, if the debtor is risk-averse, there is an optimal division of bargaining power between the debtor and its creditors. Even with restrictions on the parameter space, marginally lower deadweight costs, possibly in some combination with greater creditor bargaining power, can always raise social welfare ex ante. However, once debt has been contracted, the debtors trade-off between creditor bargaining power and deadweight costs changes fundamentally. In equilibrium, the deadweight costs of default may therefore tend to be too high, and the allocation of bargaining power inefficiently skewed towards the debtor. The challenge for policymakers is to find credible, time-consistent combinations of policies that can both reduce deadweight costs and shift bargaining power towards creditors.

Optimal emerging market fiscal policy when trend output growth is unobserved

This paper is concerned with how fiscal policy in emerging markets should respond to economic fluctuations. We model the behaviour of a fiscal authority in an emerging market country who can use external borrowing to smooth the effects of exogenous output shocks on domestic agents’ private consumption. We focus on the policy implications of the facts that (1) the GDP process in emerging markets is characterised by a relatively volatile trend growth rate, and (2) that policymakers cannot directly observe the output gap or the trend GDP growth rate. We have two key findings. First, we find that risk-averse policymakers who face EME-style output processes (ie processes dominated by shocks to the trend growth rate) should run tighter fiscal policies, with lower average debt-GDP ratios, than those in industrialised countries, who face different output processes. Second, our baseline parameterisation suggests that EME policymakers should run countercyclical fiscal policies. This result contrasts with other papers which have used optimising frameworks and the features of EME output processes to rationalise the observed procyclicality of EME fiscal policies or external balances. Simulations suggest that the welfare costs of naively running a fiscal policy that would be appropriate for an industrialised country are around 1% of certainty-equivalent consumption, but this result is sensitive to parameterisation. We find that a simple rule-of-thumb policy that stabilises the debt-GDP ratio in every period entails much smaller welfare losses.