Monetary policy in a world of mobile capital.

• Author: Bernanke, Ben

The free movement of capital across borders has created, and will certainly continue to create, enormous economic benefits. Capital flows afford developing countries and other regions the means to exploit promising investment opportunities while providing savers around the globe the means both to earn higher returns and to reduce risk through international portfolio diversification. Access to international capital markets also permits nations to accumulate foreign assets in good times and to deplete those assets or to borrow in bad times, mitigating the effects on living standards of shocks to domestic income and production. In recent years, global capital flows have attained record highs relative to global income, reflecting both the powerful tendency of capital to seek the highest return and a concerted international effort to dismantle political and regulatory barriers to capital mobility.

In this article, I address the role of monetary policy, particularly the choice of the exchange rate regime, in enabling economies to take maximum advantage of the increasing openness and depth of international capital markets.

The Trilemma

The discussion of monetary policy and capital flows almost inevitably begins with the well-known trilemma, the observation that a country can choose no more than two of the following three features of its policy regime: (1) free capital mobility across borders, (2) a fixed exchange rate, and (3) an independent monetary policy. (1) Various combinations of these features have dominated world monetary arrangements in different eras. Under the classical gold standard of the 19th century, the major trading countries chose the benefits of free capital flows and the perceived stability of a fixed relation of their currency to gold; of necessity, then, they largely abjured independent monetary policies. Under the Bretton Woods system created at the end of World War II, many countries renounced capital mobility in an attempt to maintain both fixed exchange rates and monetary independence. Currently, among the major industrial regions at least, we have collectively chosen a regime that gives up fixed exchange rates in favor of the other two elements.

The Case for Floating Exchange Rates

Is the international monetary regime that is in place today the best one for the world? For the economically advanced nations that use the world's three key currencies--the euro, the yen, and the dollar--I believe that the benefits of independent monetary policies and capital mobility greatly exceed whatever costs may result from a regime of floating exchange rates. My view is widely, though not universally, shared among economists and policymakers. In particular, what was once viewed as the principal objection to floating exchange rates, that their adoption would leave the system bereft of a nominal anchor, has proven to be unfounded. Most countries today, including many emerging market and developing nations as well as the advanced industrial countries, have succeeded in establishing a commitment to keeping domestic inflation low and stable, a commitment that has served effectively as a nominal anchor.

A newer critique of floating exchange rates contends that exchange rates are more volatile than can be explained by the macroeconomic fundamentals and, moreover, that this excess volatility has in some cases inhibited international trade (Flood and Rose 1995, Rose 2000, Klein and Shambaugh 2004). Like other asset prices, floating exchange rates do indeed exhibit a great deal of volatility in the very short term, responding to many types of economic news and, sometimes it seems, to no news at all. Whether this very short-term volatility is excessive relative to fundamentals (which are inherently difficult to observe and measure) is debatable. In any ease, this short-term volatility seems unlikely to have substantial effects on trade or capital flows, because short-term fluctuations in exchange rates are easily hedged.

Exchange rates also exhibit long-horizon volatility, of course; but, although the swings in the exchange value of the dollar over the past 30 years have been large, so have been the changes in the global macroeconomic environment. As key components of the international adjustment mechanism, fluctuations in exchange rates and the associated financial flows have often played an important stabilizing role. For example, the sharp rise in the dollar in the late 1990s reflected to an important degree a surge in U.S. productivity growth, which raised perceived rates of return and attracted significant inflows of capital. The capital inflows, the stronger dollar, and the associated rise in imports worked together to permit increased capital investment in the United States during that period, enabling production and incomes to grow without overheating the economy or requiring a sustained rise in interest rates. The value of floating exchange rates as shock absorbers might make their adoption worthwhile even if their volatility did have a chilling effect on trade. However, the sharp rise in trade volumes relative to world gross domestic product in recent decades suggests to me that, at least for the world as a whole, any such chilling effect has likely been minor.

The presumption in favor of allowing the market to determine the exchange rates among the major currencies is strengthened by the fact that a consensus about the appropriate levels at which to peg these currencies would be difficult to obtain. A poor choice of the rates at which currencies would trade could condemn one or more regions to unwanted inflation and the other regions to economic stagnation for a transition period that could easily last several years. The United Kingdom suffered the consequences of a poor choice of peg when it returned to the gold standard after World War I, because an overvalued pound reduced British exports and significantly worsened the country's unemployment problem. The United Kingdom faced analogous problems 65 years later, when it entered the European exchange rate mechanism (ERM) in 1990 at a parity that again disadvantaged British exports and contributed to Great Britain's worst recession in the past 20 years. Nor were these macroeconomic costs compensated for by greater external stability; in both episodes, doubts about the sustainability of the peg generated speculative attacks that ultimately forced the pound off its fixed rate.

Overall, the case for floating exchange rates among the United States, Japan, and the euro zone seems to me to be compelling. For smaller industrial countries, the case for floating rates may in some instances be less clear-cut, for example, when the...