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 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 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.
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.