There is a global financial cycle in capital flows,  asset prices and in credit growth. This cycle co‐moves with the VIX,  a measure of uncertainty and risk aversion of the markets. Asset markets in countries with more credit inflows are more sensitive to the global cycle. The global financial cycle is not aligned with countries ’  specific macroeconomic conditions. Symptoms can go from benign to large asset price bubbles and excess credit creation,  which are among the best predictors of financial crises. A VAR analysis suggests that one of the determinants of the global financial cycle is monetary policy in the centre country,  which affects leverage of global banks,  capital flows and credit growth in the international financial system. Whenever capital is freely mobile,  the global financial cycle constrains national monetary policies regardless of the exchange rate regime. For the past few decades,  international macroeconomics has postulated the “trilemma”:  with free capital mobility,  independent monetary policies are feasible if and only if exchange rates are floating. The global financial cycle transforms the trilemma into a “dilemma ”  or an “irreconcilable duo”:  independent monetary policies are possible if and only if the capital account is managed. So should policy restrict capital mobility?  Gains to international capital flows have proved elusive whether in calibrated models or in the data. Large gross flows disrupt asset markets and financial intermediation,  so the costs may be very large. To deal with the global financial cycle and the “dilemma”,  we have the following policy options:  (  a)  targeted capital controls;  (b)  acting on one of the sources of the financial cycle itself,  the monetary policy of the Fed and other main central banks; (c)  acting on the transmission channel cyclically by limiting credit growth and leverage during the upturn of the cycle,  using national macroprudential policies;  (d)  acting on the transmission channel structurally by imposing stricter limits on leverage for all financial intermediaries. We argue for a convex combination of (a),  (c)  and (d).

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Financial deregulation can help rationalize the negative correlation between house prices and current account balance observed in the United States and in several other countries that have experienced the highest degree of turmoil during the recent financial crisis. Lower collateral requirements facilitate access to external funding and increase the demand for consumption and housing. As a consequence, house prices increase and the current account turns negative because households borrow on net from the rest of the world. At the same time, however, the world real interest rate counterfactually raises. Expansionary monetary policy shocks in the United States, amplified by exchange rate pegs to the dollar in emerging economies, keep the world real interest rate low but play virtually no role for house prices and the current account.

This paper was prepared for the NBER-Sloan Project on the Global Financial Crisis. The authors are economists in the International Finance Division of the Federal Reserve Board. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views

Abstract not found

Do global current account imbalances still matter in a world of deep international financial markets where gross two-way financial flows often dwarf the net flows measured in the current account? Contrary to a complete markets or “consenting adults” view of the world, large current account imbalances, while very possibly warranted by fundamentals and welcome, can also signal elevated macroeconomic and financial stresses, as was arguably the case in the mid-2000s. Furthermore, the increasingly big valuation changes in countries ’ net international investment positions, while potentially important in risk allocation, cannot be relied upon systematically to offset the changes in national wealth implied by the current account. The same factors that dictate careful attention to global imbalances also imply, however, that data on gross international financial flows and positions are central to any assessment of financial stability risks. The balance sheet mismatches of leveraged entities provide the most direct indicators of potential instability, much more so than do global imbalances, though the imbalances may well be a symptom that deeper financial threats are gathering.

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Abstract Deleveraging from high debt can provoke deep recession with significant international side effects. The exchange rate of the deleveraging country will depreciate in the short run and appreciate in the long run. The real interest rate will fall by more than in the rest of the world. Bounds and policies that constrain the adjustment can prolong and deepen the recession. Early exit strategies from accommodating monetary policy can be quite harmful, as can such other policies as keeping interest rates too high during the deleveraging period. The analysis also applies to a monetary union facing internal adjustment of current account imbalances.

Global imbalances are defined. Several explanations for the development of large current account deficits and surpluses in key economies during the period after 1997 are discussed, including the saving-investment approach, the intertemporal approach, mercantilism and the Bretton Woods II hypothesis, and the global saving glut view. A discussion of the literature linking the financial crisis of 2008-09 to the development of global imbalances concludes.

Abstract Emerging markets have cast off their original sin--their external liabilities are no longer dominated by foreign-currency debt and have shifted sharply towards direct investment and portfolio equity. Their external assets are increasingly concentrated in foreign exchange reserves. Given the deteriorating public debt trajectories of reserve currency economic areas, the long-term risk on emerging markets' external balance sheets is shifting to the asset side. Still, emerging markets are looking for more insurance against balance of payments crises even as adverse debt dynamics in advanced economies increase the potential costs of self-insurance through reserve accumulation. I propose a mechanism for global liquidity insurance that would meet this need with fewer domestic policy distortions and force a quicker adjustment of global imbalances. I also argue that the big risks most emerging markets face from rising financial openness are no longer related to dependence on foreign finance but arise because capital flows heighten home-grown vulnerabilities and exacerbate the costs of weak domestic policies and institutions. 1 I am grateful to Ayhan Kose for extensive comments on an earlier draft and to numerous colleagues at Cornell and Brookings for helpful comments and discussions. I thank Mengjie Ding, Karim Foda, Parul Sharma and especially Lei (Sandy) Ye for excellent research assistance.