Medjo Ndille

Olivier Medjo
15 February 2011

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International macro-finance is a new area of open economy macroeconomics that brings portfolio choice and asset pricing considerations into models of international macroeconomics. This column argues that the recent global crisis illustrates just how important these considerations are. It surveys recent developments in international macro-finance and suggests several promising directions for future research.

Financial markets and their role in international risk sharing have inspired a vast body of theoretical literature. Over the past 40 years, international finance and economics has evolved into a vibrant field spreading from the basic international version of the capital asset pricing model to some of the most sophisticated dynamic stochastic general equilibrium models.

Curiously, however, the research effort in economics has evolved almost in parallel with that in finance. In economics, the main focus has been on real quantities and international relative prices such as consumption, investment, current account, terms of trade and exchange rates. Meanwhile, international portfolio choice and international equity markets have been largely overlooked. Indeed, the asset structure of these models has been mostly of two types: either the only asset is an international bond and markets are incomplete, or there is a full set of Arrow-Debreu securities and markets are complete.

Both approaches have been very useful, but they cannot address many questions pertaining to portfolio problems and to the international equity markets. Finance, on the other hand, has focused more on cross-country portfolio allocations and asset prices. Terms of trade and hence exchange rates have been largely overlooked because the majority of the models featured a single-good framework, in which forces of arbitrage equate terms of trade to unity. Models with endogenous portfolio selection, equity prices and time-varying terms of trade and exchange rates in a single framework have been quite rare.

Although we have learned a tremendous amount from this research, in recent years two main phenomena have required a redefinition of the agenda behind the theories of financial markets in the international context:

• Contagion among developed and relatively unconnected countries.

Contagion refers to the transmission of crises from one country to another. Prominent examples of this phenomenon include the 1997 Asian crisis, the 1998 Russian crisis, and the subprime mortgage crisis of 2007-2008. Policymakers are now worried about contagion that could be sparked by possible Greek default. It is difficult to address this phenomenon within standard macro models. Indeed, the turmoil is thought to be transmitted, most likely, through the financial sector, which is missing from these models.

• The role that asset prices and exchange rates play in the global imbalances
• The second significant development that has influenced the literature has been the unprecedented rise in external deficits in many developed nations, which has sparked a discussion about sustainability and the possible dramatic unravelling of global imbalances (with Nouriel Roubini making particularly striking predictions).

The rise in external deficits, however, came hand-in-hand with the explosion in cross-border risky asset holdings. Before 1985, the US held virtually no foreign equities; nowadays, foreign equities account for a large and growing part of the country's assets. Following influential work of Lane and Milesi-Ferretti (2001) and Gourinchas and Rey (2007), it has become clear that (unrealised) capital gains on these equity positions are missing from national accounts. The alarming current-account deficits worldwide may then be simply due to this misreported income from equity positions. Today an extremely active literature, both empirical and theoretical, is trying to better understand how the capital gains on foreign equity positions, or the so-called valuation effects, affect our thinking about the current account and the external adjustment process.

Unfortunately, most of the existing international macro models are not well-suited for dealing with these issues because they are missing equity markets and portfolio choice. A new and rapidly growing strand of literature, commonly known as international macro-finance, is trying to fill this gap. This new generation of macro models provides a redefinition of the current account (adjusted for capital gains on equity holdings) and modifies the standard theories of the current account. More generally, this research programme focuses on the interaction between the financial sector and the real economy, and as such can address a wide spectrum of issues such as contagion, composition of international portfolios, valuation effects, and others.

The modelling framework

The framework that has become the core of international macro-finance consists primarily of general equilibrium asset-pricing models with multiple goods. The richness of this framework comes at a cost: most of the macro-finance models are quite complex. Problems involving portfolio choice are particularly difficult to analyse because for these problems standard first-order approximation methods cannot deliver desired results. Engel and Matsumoto (2006), Devereux and Sutherland (2010), and Tille and van Wincoop (2010) have developed an approach based on higher-order approximations around a deterministic steady state. It is a powerful technique. However, its disadvantage is that to this day little is known about the behaviour of these economies away from the deterministic steady state, where the underlying volatilities are not small.

Another strand of the macro-finance literature simplifies the models and seeks to find exact solutions. The main advantage of this approach is that the economy can be analysed away from the steady state, but the disadvantage is that solutions only exist in few special cases. An early work that presents one of such special cases is Helpman and Razin (1978). Their setup has been developed further by a number of authors, including Cole and Obstfeld (1991) and Pavlova and Rigobon (2007). These papers consider pure-exchange economies in which a representative agent in each country has log-linear preferences. In recent years the literature has made progress extending the setup beyond log-linear preferences. The solution is especially simple in complete markets, but the models remain tractable even in the presence of market frictions (for an elaboration and references).

In January 2010, the Journal of International Economics ran a special issue on international macro-finance. This collection of works gives an excellent overview of the latest contributions to this field and provides further references.

Next steps: Areas for further research

Although we have learned a great deal from this strand of research, many questions remain open. In order to tackle more ambitious questions raised by the data and current events, the existing models certainly require improvements along several dimensions.

• First, the discussion of global imbalances, current account sustainability, and, more generally, of international portfolios and risk sharing requires the introduction of market incompleteness into the story. This direction is important not only because markets are generally believed to be incomplete, but also because there is no role for policy under complete markets (an allocation is already Pareto efficient). Having incomplete markets adds a layer of methodological complexity (we provide details in Pavlova and Rigobon 2010). In his Ohlin lecture, Maurice Obstfeld remarks that “portfolio choice under incomplete markets is largely terra incognita.” Developing such models and understanding their workings constitutes frontier research in international macroeconomics these days.
• Second, many models that have been developed in international macro-finance so far feature pure-exchange economies. This view of production is too simplistic. The natural next step is to include factors of production into these asset pricing models. Labour market considerations such as effort and unemployment, as well as investment, are important elements through which the real economy and financial markets interact with each other.
• Third, our models are missing a full-fledged financial sector, the importance of which has been underscored by a series of recent contagious crises. The first step could be to model the financial inefficiencies stemming from the organisational structure of the financial sector in reduced-form – for example, in the form of financial constraints on certain market participants (e.g., margin constraints), which may prevent them from supplying liquidity at times when it is needed the most. The next step would then be to introduce agency problems and endogenise these constraints. The fact that constraints on traders that we observe in the real world tend to bind at the same time, normally in bad times, can emerge as one of the leading explanations of contagion and as a channel of propagation of systemic risk.
• Finally, as our models get progressively more complicated, we will need to rely on numerical methods. The literature is now testing the appropriateness of higher order approximation methods, with the approximations taken around a deterministic steady state. Perhaps even more complex methods (finite-element methods or projection methods) are required.

The field of international macro-finance is a new and active area of research. There are many ways in which one can push its frontier. Here we have highlighted just several possible promising directions. We are sure that there are many more.

Olivier Medjo
13 April 2011

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The meeting of the European Council on 24-25 March focused on shoring up the battered Eurozone infrastructure through the European Stability Mechanism. This column argues that the mechanism is seriously flawed. It says it is unlikely to withstand the shock of a severe financial crisis and may even spread the damage to high-debt countries, while leaving the Eurozone in the grip of paralysing vetoes.

The war in Libya and the terrible disasters in Japan have diverted the public attention from the conclusions of the most recent European Council (24 and 25 March 2011). Most commentators have noted the limited scope of the decisions (such as Euro Intelligence (2011) and Münchau 2011 in the Financial Times). One might almost say it is as Shakespeare, "Much Ado About Nothing". Unfortunately, the decisions concerning the new European Stability Mechanism, the ESM, are about much more than nothing, and could prove detrimental to the stability of the Eurozone. Here's why.

Stability pact and the macro imbalances

Most comments focused on the measures aimed at strengthening the “corrective arm” of the Growth and Stability Pact (countries should reduce their public debt in proportion to the distance from the target of 60% of GDP), its “preventive arm” (countries should adopt national budgetary rules consistent with the objectives of the pact); and the proposals aimed at reducing macroeconomic imbalances, such as monitoring competitiveness and productivity growth issues are hardly mentioned in the summit conclusions. And for a good reason – the European legislative process on these matters is still ongoing, requiring the approval, possibly after important changes, of the European Parliament. The summit, however, decided about the ESM.

The European Stability Mechanism

Since June 2013 the new fund will succeed to the European Financial Stability Facility and to the European Financial Stabilisation Mechanism with the task of providing financial assistance to Eurozone members. This will be done through loans (conditional on adjustment measures) and, in exceptional cases, through the direct purchase of government bonds in the primary market. The ESM architecture has at least four major problems.

• The first problem is that the endowment is too little too late.

The endowment amounts to €700 billion, which gives a loan capacity of €500 billion. Member countries will actually disburse only €80 billion, in five annual instalments starting in 2013. The rest will take the form of guarantees and "callable capital" (see also Buiter 2011).

"Too little, too late", one may say, considering that during the 2011 (and not in 2013!) the debt coming to maturity of Greece, Ireland, Italy, Portugal, and Spain, will top €502 billion, and that financial requirements of Spain central and local governments up to 2013 are estimated around €470 billion. The agreement provides for the possibility of accelerating payments should a crisis unfold before 2013. Yet delays may be uncertain and long, leaving the Eurozone’s sovereigns exposed to speculative attacks.

• The second weakness lies in the funding system.

Because the new fund is financed by guarantees that will be called in case of need, rather than by an endowment of its own, the activation of the guarantees is likely to produce multiplier effects and contagion (see again Münchau 2011). 

Take Italy. For every €100 billion that may be necessary to "save" other countries of the euro, the Italian budget will be burdened by almost €18 billion (equal to the percentage in the budget of the European Central Bank), about one percentage point of Italian GDP, and this would occur at the worst possible time, when the markets would likely require high and rising interest rates.

• The ESM’s third and very serious defect concerns the voting mechanism.

Unlike the IMF, whose decisions require a simple majority (of the shares), the ESM decisions of approving a loan, determining the interest rates and the terms of conditionality, require the unanimity of Eurozone finance ministers. Each country is effectively given a veto power on the Board. It is not difficult to imagine scenarios like the following: country G, which is in good financial health, trades his consent to lend to country I, in exchange for the latter consenting to adopt the very policy measure that mostly benefits country G (e.g. the increase in the corporate tax rate).

• Finally, the statute requires that the European Commission should carry out an assessment of sustainability of public debt of the country, presenting difficulties in accessing financial markets.

If the European Commission were to conclude that a country is technically insolvent, then the ESM will provide a loan only to the extent that private sector will be involved. First note that, on economic grounds, if a country has difficulties in tapping the financial markets, it must be exactly because investors perceive it as insolvent, so it not difficult to imagine that the Commission will also come to this conclusion for most aspirant borrowers. While it is understandable to try and prevent moral hazard and not reward excessive risk taking, this norm may prove very damaging. Imagine what would happen if Europe were to declare today that all the countries (still) tapping European money after 2013 will default with absolute certainty in 2013 (albeit partially). This is exactly what this norm states. As of today, the markets will require higher yields on the new issues of actual and perspective ESM clients, precipitating the insolvency crisis. Just as is now happening in Portugal.

In short the design of the ESM presents serious flaws. The fund is unlikely to withstand the shock of a severe financial crisis (involving Portugal and Spain), it may accelerate and even spread the crisis to high debt countries, while leaving the Eurozone in the grip of paralysing vetoes.

Olivier Medjo