International coordination and precautionary policies

Joshua Aizenman 03 January 2016



“It takes a heap of Harberger triangles to fill an Okun Gap.”  Tobin (1977)        

The Global Crisis has renewed the debate on the benefits and limitations of international coordination of macro policies. The history of international cooperation during the Crisis resembles a glass that is half full according to some, or mostly empty to others. Remarkably, the US Federal Reserve Bank (Fed) fostered international cooperation by an unprecedented expansion of swap lines from December 2007.[1] Yet, on 30 January 2014, Raghuram Rajan, Governor of the Reserve Bank of India noted that “international monetary cooperation has broken down… The US should worry about the effects of its policies on the rest of the world.”

The complex history of limited global cooperation was evaluated by Eichengreen (2014). Frankel (2015) provides a synopsis of the history of international economic cooperation from the Great Depression, analysing episodes in which countries behaved cooperatively or non-cooperatively in international fiscal and monetary games.[2] A central policy lesson of these insightful papers is that international cooperation is rare, and occurs mostly in exceptional circumstances. Hence, countries may invest more in precautionary strategies and putting their house in order in anticipation of trouble. In a recent paper, I highlight the rare conditions leading to international cooperation (Aizenman 2015). The precautionary policies of emerging market economies may be viewed as the second-best outcome of limited cooperation.

Circumstances leading to greater international cooperation

The rarity of international cooperation suggest that in ‘normal times,’ in the absence of bad tail events, the costs of deeper international cooperation fall short of the benefits. This concept is in line with the presumption that the gains from cooperation have the size of Harberger’s triangle, about 0.5% - 1% GDP points.[3] Such gains may not be worth the possible income redistribution effects, which may be of an even larger magnitude than efficiency gains from cooperation. In contrast, clearly adverse tail events that may induce the immanent collapse of financial markets would bring massive losses. Collapsing financial markets may terminate the entire Marshalian surpluses associated with normal operations, triggering global financial contagion in domestic and global networks, and generating costs of double-digit GDP points. In circumstances of bad tail events inducing imminent and correlated threats of destabilisation in most countries, the perceived losses have a first-order magnitude of terminating the total Marshalian suplus. This imminent threat may promote international cooperation.

The first year of the Global Crisis illustrates that exceptional circumstances may lead to beneficial cooperation. The Fed swap lines that were activated during the quarters leading to the Crisis is a prime example of bad tail events inducing global cooperation. The pre-Crisis dynamics led to a huge dollar funding gap with the potential to lead to the collapse of a large share of the global banking system, and thus wipe the surpluses associated with the liquidity and credit services of financial intermediation. The magnitude of the dollar funding gap in 2007 and 2008 was unprecedented.[4]

The benefits of swap lines may be modelled using a version of Diamond and Digivid’s (1983) paper in which the lender of last resort may prevent the first-order costs of a financial panic on the order of magnitude of those observed during the Great Depression.[5] A key benefit of ex ante international cooperation may be reducing the probability of bad tail events, as well as the balance-sheet exposure to such events.[6] This mission may be a top priority for international financial institutions and central banks. Achieving this cooperation cannot be taken for granted – ex ante cooperation must deal with complex moral hazard and agency problems. Furthermore, the benefits of such cooperation are easily overlooked as the counter-factual; that is, identifying all the tail events that were prevented is hard to measure.

Obstacles preventing cooperation

The obstacles preventing cooperation may be hard to overcome. Status quo bias may reduce macro-economic cooperation, both domestically and internationally. This is the case if policymakers and agencies take the view that “if it ain’t clearly broken from my perspective, don’t fix it”.  This may reflect the concern that changing the status quo might trigger political costs, inducing the decision-maker to delay action and thus gamble on resurrection. New policies may raise income distribution concerns, triggering a war of attrition among key stakeholders aimed at shifting the costs to others and delaying cooperation.[7] One expects that greater income inequality and polarisation may intensify the incidence of wars of attrition that delay adjustment.[8] The delay in achieving this cooperative outcome may reflect the resistance of powerful domestic groups (e.g. ‘rentiers’), engaging in a war of attrition against interest rate cuts and monetary expansions.  Status quo bias may also explain central banks’ unwillingness to increase inflation-targeting from 2% to 4% in times of global peril, as was advocated by Blanchard et al (2010).

Precautionary policies

Developing countries and emerging markets are more vulnerable to adverse tail events. Limited financial depth, inability to borrow in their own currency, less developed institutions, and possible history of defaults imply greater vulnerability. The scarcity of global cooperation at times of peril suggests that emerging markets would benefit from building precautionary buffers during tranquil times, such as international reserves and sovereign wealth funds.[9] However, relying mainly on international reserves may miss the benefits associated with policies aimed at controlling a country’s balance-sheet exposures – for example, reducing its short-term external borrowing (Rodrik 2006).[10] Greater exchange rate flexibility is another margin of safety, mitigating the moral hazard game between the private sector (ignoring exchange rate risk) and the central bank (which is expected to bail out systemic balance sheet exposure).  Indeed, emerging markets took these lessons to heart after the financial crises of the 1990s. These precautionary policies were tested by the Global Crisis, with mixed outcomes, leading Rey (2013) to doubt the usefulness of exchange rate flexibility.[11]

Chances are, however, that claims of the Trilemma’s death and the futility of flexible exchange rate regimes are exaggerated (see Aizenman et al 2015 and Blachard et al 2015a, 2015b).[12] Latin American countries may provide useful lessons. The Global Crisis increased these countries’ exposure to larger and more volatile financial flows, and to adverse shocks that followed the Crisis. Starting in 2014, these shocks include Latin American countries’ collapsing terms of trade due to the drop in commodity prices. However, most of these countries have so far retained their resilience, wherein managed exchange rate flexibility and greater coordination between domestic institutions has helped.  Chances are that the flexibility of the exchange rate of Mexico and other countries in Latin America has so far prevented a balance-of-payment cum banking crisis, akin to the one observed during the 1990s. Exchange rate flexibility has also contributed to increasing financial stability in countries that have managed their balance-sheet exposure efficiently.

Exchange rate flexibility has other side benefits such as reducing the exposure of countries to destabilising dynamics of the type experienced by Spain and other exposed Eurozone countries in 2010-2012.[13] The gains from exchange rate flexibility may be illustrated the contrast between Poland (flexible exchange rate country, EU member), Germany and Spain (Eurozone countries). Figure 1 shows the remarkable resilience of Poland, managing overall a steady and positive real GDP growth rate under flexible exchange rate during the 2000s, experiencing a much milder exposure to the Global Crisis and the Eurozone Crisis than did Germany and Spain.[14]  

Figure 1. Real GDP growth rate, 1998-2014

Notes: Poland [solid curve], Germany [dashed curve], Spain [dotted curve]. Data source: FRED

However, a flexible exchange rate is not a magic remedy – among n flexible exchange rate currencies, only n–1 are independent at most. Size matters even under flexible exchange rate regimes. The weakening gains from exchange rate flexibility highlighted by Rey (2013) may be the outcome of the events leading to the Global Crisis; in which financial instability in the US was transmitted globally due to global balance-sheet exposure, as the US global share in finance vastly exceeded its global GDP share.[15] These factors, however, do not negate the usefulness of managed exchange rate flexibility in dealing with terms of trade shocks, domestic disturbances, and other shocks. Indeed, the lesson of the 1990s has been that emerging markets converged to the middle ground of Mundell’s trilemma – controlled exchange rage flexibility and limited financial integration, retaining monetary independence.


The scarcity of global cooperation validates the need for countries to put their house in order. This recommendation does not negate the key importance of global cooperation in the aftermath of bad tail events — that is, shocks that may induce a global depression. A key role of international financial institutions and central banks remains facilitating deeper ex ante international cooperation aimed at reducing the probability of such tail events. Time will continue to test the viability of such cooperation.

The evolution of emerging markets in past decades may reflect the learning process induced by the sudden stop crises that have followed their financial openings of the 1990s. Emerging market economies have moved over time from fixed exchange rate and closed financial systems during the Bretton Woods system to controlled exchange rage flexibility and limited financial integration, retaining monetary independence. This configuration, properly buffered by precautionary policies (hoarding international reserves and controlling external borrowing) may be emerging markets’ second-best response to the limited efficacy of international coordination.


Aizenman, J (2015) “International coordination and precautionary policies,” NBER Working Paper No. 21793.

Aizenman, J and J Lee (2007) "International reserves: Precautionary versus mercantilist views, theory and evidence", Open Economies Review, 18.2: 191-214.

Aizenman, J and G Pasricha (2010) "Selective swap arrangements and the global financial crisis: Analysis and interpretation," International Review of Economics & Finance,  19(3): 353-365.

Aizenman, J, M Chinn and H Ito (2015) " Monetary policy spillovers and the Trilemma in the new normal: Periphery country sensitivity to core country conditions,” Journal of International Money and Finance, forthcoming.

Alesina, A and A Drazen (1991) "Why are stabilizations delayed?", American Economic Review, 81(5): 1170-1188.

Blanchard, O, G Dell’Ariccia and P Mauro (2010) "Rethinking macroeconomic policy", Journal of Money, Credit and Banking, 42(s1): 199-215.

Blanchard, O, G Dell’Ariccia and P Mauro (2013) Rethinking macro policy II: Getting granular, International Monetary Fund.

Blanchard, O, J Ostry, A R Ghosh and M Chamon (2015a) “Are capital inflows expansionary or contractionary? Theory, policy implications, and some evidence”, CEPR, Discussion Paper 10909.

Blanchard, O, G Adler and I de Carvalho Filho (2015b) “Can foreign exchange intervention stem exchange rate pressures from global capital flow shocks?”, NBER Working Paper 21427.

Borio, C (2003) "Towards a macroprudential framework for financial supervision and regulation?", CESifo Economic Studies, 49(2): 181-215.

Bruno, V and H Song Shin (2014) "Assessing macroprudential policies: Case of South Korea", The Scandinavian Journal of Economics, 116(1): 128-157.

Calvo, G A (1998) "Capital flows and capital-market crises: The simple economics of sudden stops", Journal of Applied Economics, 1(1): 35-54.

Diamond, D W and P H Dybvig (1983) “Bank runs, liquidity and deposit insurance”, Journal of Political Economy, 91: 401−419.

De Grauwe, P and Y Ji (2013) "Self-fulfilling crises in the Eurozone: An empirical test", Journal of International Money and Finance, 34: 15-36.

Eichengreen, B (2014) “International policy coordination: The long view," in R Feenstra and A Taylor (eds), Globalization in an Age of Crisis, University of Chicago Press.

Frankel, J A (2015) “International coordination”, Asia Economic Policy Conference, Policy Challenges in a Diverging Global Economy, Federal Reserve Bank of San Francisco, 19-20 November.

Harberger, A C (1954) "Monopoly and resource allocation", American Economic Review, 44 (May):  77-87.

Harberger, A C (1959) "Using the resources at hand more effectively", American Economic Review, 49(2): 134-146.

McGuire and von Peter (2009) “The US dollar shortage in global banking and the international policy response”, BIS, WP 291.

Obstfeld, M and K Rogoff (2002) “Global implications of self-oriented national rules”, Quarterly Journal of Economics, 117: 503–35.

Rajan, R G (2005) “Has financial development made the world riskier?” NBER, Working paper No. w11728, presented at Jackson Hole Economic Symposium 2005, Federal Reserve Bank of Kansas City.

Rey, H (2013) “Dilemma not trilemma: The global financial cycle and monetary policy independence”, NBER, Working paper No. 21162, presented at Jackson Hole Economic Symposium 2013, Federal Reserve Bank of Kansas City.

Rodrik, D (1999) “Where did all the growth go? External shocks, social conflict, and growth collapses”, Journal of Economic Growth, 4(December): 358-412.

Rodrik, D (2006) "The social cost of foreign exchange reserves", International Economic Journal, 20(3): 253-266.

Tobin, J (1977 "How dead is Keynes?", Economic Inquiry, 15(4):  459-68.


[1] “In response to mounting pressures in bank funding markets, the FOMC announced in December 2007 that it had authorized dollar liquidity swap lines with the European Central Bank and the Swiss National Bank to provide liquidity in US dollars to overseas markets, and subsequently authorised dollar liquidity swap lines with each of the following central banks: the Reserve Bank of Australia, the Banco Central do Brasil, the Bank of Canada, Danmarks Nationalbank, the Bank of England, the European Central Bank, the Bank of Japan, the Bank of Korea, the Banco de Mexico, the Reserve Bank of New Zealand, Norges Bank, the Monetary Authority of Singapore, Sveriges Riksbank, and the Swiss National Bank…In May 2010, the FOMC announced that in response to the re-emergence of strains in short-term US dollar funding markets it had authorised dollar liquidity swap lines with the Bank of Canada, the Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank. In October 2013, the Federal Reserve and these central banks announced that their existing temporary liquidity swap arrangements – including the dollar liquidity swap lines – would be converted to standing arrangements that will remain in place until further notice.” From The Boards of Governors Policy Overview, Dollar Liquidity Swap Lines (accessed 25 November 2015).

[2] Frankel concluded that perceptions of the signs of spillovers and directions of coordination vary widely and inhibit cooperation. Furthermore, the existence of different models and domestic interest groups is as important as the difference between cooperative and non-cooperative equilibria.  Complaints about foreigners’ actions and calls for cooperation may obscure the need to settle disagreements domestically.

[3] See Harberger (1954, 1959) for discussions on the second order costs of distortions. See Obstfeld and Rogoff (2002) for a model where the benefits from monetary policy coordination that might arise in a two-country world are small and may be swamped by the gains from pursuing stabilisation policies within the individual countries.

[4] “If we assume that these banks’ liabilities to money market funds (roughly $1 trillion, Baba et al 2009) are also short-term liabilities, then the estimate of their US dollar funding gap in mid-2007 would be $2.0–2.2 trillion. Were all liabilities to non-banks treated as short-term funding, the upper-bound estimate would be $6.5 trillion…

In providing US dollars on a global scale, the Federal Reserve effectively engaged in international lending of last resort…  Once the swap lines became unlimited, the share provided through the Eurosystem, the Bank of England and the Swiss National Bank combined was 81% (15 October 2008), and it has remained in the range of 50–60% since December 2008.” (McGuire and von Peter 2009).

[5] The Appendix of Aizenman and Pasricha (2010) outlined such a model, where in circumstances of unanticipated deleveraging, swap-lines may prevent or mitigate costly liquidation, allowing investment projects to reach maturity and providing positive option value to both the source and the recipient countries.

[6] See Rajan (2005), a seminal paper for concerns about the growing exposure to tail risks.

[7] See Alesina and Drazen (1991) for a model of delayed stabilisation.

[8] This notion is in line with Rodrik (1999), who found that countries that experienced the sharpest drops in growth after 1975 were divided societies (as measured by indicators of inequality, ethnic fragmentation, and the like) with weak institutions of conflict management (measured by indicators of the quality of governmental institutions, rule of law, democratic rights, and social safety nets).

[9] The precautionary logic of hoarding international reserves can be outlined in models inspired by Diamond and Digvid (1983) and Calvo (1998), in which international reserves may reduce the costs associated with sudden stops and capital flight crises (see Aizenman and Lee 2007).

[10] A possible lesson articulated by Professor Hyun-Song Shin (serving in 2009-2010 as the chief economic advisor to President Lee Myung-bak) are policies inducing the private sector to internalise the social costs of external hard-currency borrowing, possibly by relying on Pigovian taxes. These considerations are reflected in the proliferation of Marcoprudential policies after the Global Crisi (See Borio 2003 and Blanchard et al 2013), and exemplified by the policies adopted by South Korea in 2010 (Bruno and Shin 2014).

[11] Specially, Rey concluded that a potent global financial cycle exists in gross capital flows, credit creation and asset prices, all of which have tight connections with fluctuations in uncertainty and risk aversion. The global financial cycle is closely related to the VIX, and particularly related to the role of monetary policy in the centre country.  Accordingly, this potent cycle invalidates Mundell’s trilemma and leads to a new ‘irreconcilable duo’ dilemma, in which independent monetary policies are possible if and only if the capital account is managed, directly or indirectly via macroprudential policies.

[12] An alternative take is that Mundell’s trilemma morphed into a quadrilemma, wherein financial stability is a fourth dimension of a desirable macro outcome.  For most financial variables, the strength of the links with the centre economies have been the dominant factor over the last two decades, while the movements of the policy interest rate have also appeared sensitive to global financial shocks around the emerging market crises of the late 1990s and since the Global Crisis of 2008. While certain macroeconomic and institutional variables are important, the arrangement of open macro policies such as the exchange rate regime and financial openness are also found to have a direct influence on sensitivity to the centre economies.  In this context, the quality of institutions matters; that is, countries that constrain their balance-sheet exposure keep benefiting from exchange rate flexibility.  Countries with better institutions may use marcoprudential policies and capital controls more effectively with exchange rate flexibility.

[13] Specifically, the fixed exchange rate associated with being a euro member restrains Spain’s ability to quickly improve its competitiveness by means of a nominal exchange rate adjustment, thus exposing the country to destabilising rises in its sovereign spreads, as was highlighted by the contrast between Spain and the UK analysed by de Grauwe and Ji (2013).  They pointed out that bond markets in a monetary union are more fragile and susceptible to self-fulfilling liquidity crises, as countries in a monetary union like the Eurozone are unable to rely on monetary policy to stabilise the economy, and to provide an effective lender of last resort support for the domestic banking system.

[14] The GDP/capital growth rate decline during the Global Crisis (2006 to 2008) was about 4% in Poland, half of the decline experienced by Germany and Spain.  Remarkably, the public debt/GDP of Poland increased mildly from 45% in 2007 to 57% in 2013, while that of Spain almost tripled during that period, rising from 37% to 94%.  The zloty/euro rate depreciated by 44% during the Crisis (rising from 3.21 zloty/euro on 30 June 2008 to 4.64 zloty/euro on 1 February 2009), mitigating the recessionary impact of the Crisis.

[15] Approximately two thirds of global corporate bonds outstanding are issued in US dollars.  Similarly, the global share of US government bonds in international reserves has hovered around 60% in recent decades, more than twice the global GDP share of the US.



Topics:  Global crisis Global economy

Tags:  macroeconomy, macroeconomics, financial crisis, global crisis, cooperation, macro cooperation, financial markets, international cooperation, Central Banks, central banking

Dockson Chair in Economics and International Relations, USC, and Research Associate, NBER

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