The conventional wisdom is that economic policy affects capital
markets, either directly through interest rates or indirectly
through its impact on economic growth and corporate earnings,
which in turn affect equity markets. Another way of saying this is
that economic fundamentals influence financial markets.
This is still true. But I would like to offer another view that I
shall exaggerate a little in order to be provocative. In the Transatlantic
relationship, and also to a lesser degree in other regional relationships,
it seems that the direction of influence is being turned
on its head. Capital markets increasingly affect the real economy,
rather than the other way around, even across the Atlantic.
What we are seeing is an increasing
correlation of market interest rates between
the United States and Europe,
even though economic cycles still diverge.
Not only do European stock exchanges
take their cue from the New
York Stock Exchange, but bond yields on
either side of the Atlantic have moved
much closer together over the past ten
years or so.
The reason is that as capital markets
become more integrated, international
investors react quickly to price signals
emanating from the United States, the
world's largest economy and capital
market. Higher U.S. bond yields usually
reflect stronger U.S. growth. And when
the United States is expecting higher
growth, European yields also tend to
rise, because investors think that a
stronger U.S. economy will stimulate
growth in Europe. There is an instantaneous
arbitrage opportunity between
U.S. and European bond yields.
Most fundamentally, however, capital
markets are undergoing a profound
structural change. Increasingly, financial
markets draw on one global pool of capital,
and any market participant can tap
into it directly, without having to go
through banks any more. Banks, insurance
companies, mutual funds, governments and households can access capital
markets either directly or indirectly,
through pension funds, or trade risk
exposure directly with other market
participants.
The dominant role of banks as intermediaries
in capital transactions has diminished,
meaning that bond yields are
becoming more relevant pricing instruments
than bank loan interest rates.
Bond rates also have stronger linkages
than bank rates across national borders
and across the Atlantic. Bank rates are
still more reliant on rates set by the national
monetary authorities, whereas
bond yields tend to react more readily to
other influences as well.
Transatlantic capital flows are increasingly
driven by portfolio considerations.
The closer we move to a single
pool of capital, as we are continuing to
do, at least in the very advanced world,
the more such capital will carry a single
price tag.What is the implication of all
this for policy coordination across the
Atlantic, and more broadly among the
G-7 countries?
The evolution toward a global capital
market is creating a natural center of
gravity for interest rate determination in
Washington, the modern Rome. International
interest rates are increasingly
driven by the U.S. Federal Reserve, which
is today playing a global role similar to
that played on a regional basis by the
German Bundesbank in Europe in the
late 1980s and early 1990s. Central
banks, however, have a national mandate,
with domestic objectives enshrined
in their legal statutes. The Federal Reserve
pursues primarily domestic aims in
setting U.S. monetary policy, just as the
Bundesbank did 15 years ago.
Just as it did in Europe, this may
pose problems for countries that are at a
different stage in the business cycle or,
more fundamentally, have a significantly
different growth potential from the leading
country, in this case the United
States. Today, such problems face a number
of European countries, which have
failed to reform their economic structures.
As a result, countries outside the
United States see a greater need for policy
coordination, given that the repercussions
of U.S. monetary policy spread
far beyond America's borders. And this
applies not only to Europe, but perhaps
even more so in emerging markets.
In the early 1990s, the Bundesbank's
interest rate policy was particularly untenable
for the rest of Europe because of
the European Union's fixed exchange
rate regime, which did not allow other
countries any room for maneuver. In
today's Transatlantic relationship, the restrictions
are not that stringent, given
the flexibility of the dollar/euro exchange
rate. Nevertheless, the correlation
of high Transatlantic interest rates restricts
Europe's room for pursuing an independent
monetary policy, especially at
times when rates are rising.
The European Central Bank, of
course, can set the interest rates it deems
appropriate, but market rates do not
necessarily follow. At least outside the
United States, market rates are much less
swayed by national monetary policies,
than in the past, but obey the laws of a
global capital pool. Although prospects
for economic recovery in Europe remain
uncertain, the growth differential between
the United States and Europe
seems to be widening again, as the
United States moves into another upswing.
If the strong U.S. growth scenario
drives up U.S. bond yields, and European
bond yields follow, Europe may
come under pressure to use other policy
methods to stimulate growth.
Fiscal policy, however, has clearly
been largely exhausted, which leaves
structural policy as the only option. For
some European governments it will be
politically difficult to press for serious
structural reforms meaning that Europeans
are going to have a hard time
catching up with the United States. Nevertheless,
the Europeans will have to find
a way to implement needed structural
reforms both as a means of stimulating
their economies and to raise their
growth potential in the medium term,
given that monetary policy is now such a
weak lever.
There is, of course, one way to limit
the consequences of these Transatlantic
interest rate correlations. Europe may be
able to gain some protection from U.S.
interest rate contagion if it continues to
create its own highly efficient capital market,
similar to the market the United
States has established over the past few
decades. I hope that the Europeans have
clearly understood this message, and that
they will press forward with the necessary
actions as soon as reasonably possible.
Gerd Häusler is Counselor and Director of the International Capital Markets
Department of the
IMF. He was previously Senior Advisor to the Deutsche Börse in Frankfurt, and before that Chairman
of Dresdner Kleinwort Benson in London. He was also a member of the Board of Managing
Directors at Dresdner. He spent twelve years at the Bundesbank, where he held a number of positions
including Member of the Board of Managing Directors and of the Central Bank Council.
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