Countercyclical Policy in the Center and its Impact on the Periphery: A minskyan view Esteban Pérez Caldentey

Hyman Minsky (1982, 1986a) argued that counter cyclical policies (lender-of-last resort interventions to expand the overall financing capacity of an economy, and deficit spending to sustain profits) to confront a financial crisis and a recession make the occurrence of an event like the Great Depression unlikely. Paradoxically, he also sustained that these policies add to the instability of the economic system. Counter cyclical actions “validate the existing fragile financial structure as financial market risk is socialized” (Pollin, 1997).

In the case of the larger developed economies, particularly that of the United States, the instability potential of countercyclical policies not only affects the domestic economy but spills rapidly outside the national borders with major impacts on the periphery (developing economies).

Minsky (1986b, p. 10) explained the extension of the financial fragility hypothesis to international financial relations as follows:

The same consideration (that applies to the domestic economy)* that cash flows must support asset values holds for international indebtedness. The only special difference is that the supporting cash flows may be derived from income denominated in one currency while payments are denominated in another. The peso denominated income of a Mexican entity may need to be exchanged into dollars for a commitment to be validated. The terms upon which dollars are available for pesos then determines whether commitments can be fulfilled.

* The parentheses were inserted by the author of this blog.

The Federal Reserve sets these terms at the global level. Minsky’s observation that “the Federal Reserve is the essential operator in a system characterized by a vast structure of indebtedness denominated in dollars” (Minsky 1983, p. 2) is spot on. “The dollar is the premier international currency across all uses — trade invoicing, trade financing, cross border payments and funding in global capital markets” (Hofmann et al., 2022).

Record low international interest rates and quantitative easing (QE) policies during and after the Global Financial Crisis (2008–2009) contributed largely to boost the rise in external debt and debt service payments affecting all developing regions, reaching record levels in some cases, and leading to an unprecedented rise in their external financing needs (US$ 2 to 5 trillion dollars between 2010 and 2020).

Developing countries took advantage of the cheaper cost of issuing external (for the most part dollar denominated debt) relative to domestic debt notwithstanding the fact that an increased demand for dollars propped up its value thus increasing the dominance and power of the Federal Reserve as the global central bank. This process was facilitated by the increasing importance of the international bond market as a major source of finance for emerging and developing economies (35% and 50% of global liquidity in 2007 and 2022) for most economic sectors outpacing bank-intermediated cross-border finance. For their part, foreign investors were willing to take on more risk by investing in emerging market economies in exchange for higher returns. The international bond market was also used in some cases to pay for existing debt obligations denominated in local currency indicating the build-up of a Ponzi financing structure.

During the Pandemic the increase in the availability of speculative finance in the form of short- term capital gave a false sense of security to peripheral countries. Some mainstream economists mistakenly celebrated the positive response of private financial markets to the Pandemic in light, of the weak actions undertaken by international financial institutions to counteract its social and economic impact.

This process of indebtedness increased the degree of exposure of peripheral countries to changes in international interest rates and nominal exchange rate variations which have mainly financial impacts. In the short run, the trade of developing countries is invoiced in foreign currency and their exporters are generally unhedged against currency fluctuations. In the long run, the balance- of-payments literature has amply shown that price elasticities of exports and imports are statistically insignificant.

Exchange rate variations are accompanied by changes in risk indices, so that an exchange rate depreciation (appreciation) translates into an increase (a decline) in developing country risk perceptions. In combination with the increase in the stock of external debt and its servicing, this placed limits for the management of fiscal policy while increasing the cost of external borrowing.

These perceptions of risk are transferred to the production sphere since the sovereign risk index tends to determine the evolution of the corporate risk index. To this transmission channel must be added the impact that exchange rate variations have on the balance sheets of the non-financial corporate sector and the financial sector as their financial position is characterized by the fact that foreign currency liabilities are often not fully hedged by foreign currency assets. An exchange rate depreciation worsens the balance sheet of those firms that are externally indebted. If companies in a mismatch decide to purchase foreign currency to meet their foreign exchange obligations, the increased demand for foreign exchange may aggravate exchange rate depreciation. This in turn may intensify capital outflows while increasing the debt burden underscoring the transition toward financial fragility.

These vulnerabilities were exposed with the tightening of international financial conditions as a response to the increase in inflation in 2021 following the Pandemic.

The contractionary stance of monetary policy affected not only international financing conditions in emerging markets but also domestic financing conditions. Empirical evidence for emerging and developing economies shows that the dollar index is not only associated with a higher spread of foreign currency yields but also with that of local currency yields.

This stylized fact is explained by the important role that foreign investors have acquired in local debt markets. Global liquidity conditions reflected in nominal exchange rate changes affect the profitability of foreign investors holding securities in local currency. A depreciation, current or expected, of the local currency relative to the dollar implies current and expected capital losses, which increases risk of foreign investors exposed to holdings of securities in local currency. In this way a depreciation of the nominal exchange rate has amplifying effect on the risk conditions of the securities markets in local currency. Most central banks of the periphery have limited firing power and are market followers. The extent to which they can intervene in the domestic bond market is limited by the degree to which the local currency is expected to depreciate and by the floor set by the international interest rate. The extent to which they can intervene in the foreign exchange market is limited by the stock of international reserves.

Market based economic systems with complex intertemporal and financial linkages at the domestic and international levels are inherently unstable, even more so, when the subordinate position of peripheral countries within the international currency hierarchy is considered in the analysis. Minsky believed that ‘the proper functioning of a globally integrated financial structure’ required cooperation in counter cyclical policies (1986b, p. 33). Financial cooperation beyond lender of last resort interventions should also be on the agenda. His skepticism that the required international cooperation in monetary and fiscal policies would be forthcoming (Minsky, 1979, p. 29) was visionary. The deficit in international cooperation is manifest in the strengthened asymmetry in policy autonomy between developed and developing economies. The contractionary bias built into debtor (peripheral) countries’ typical short-term adjustment policy stance has remained a pervasive weakness of the global financial architecture and a stumbling block to global growth and full employment, as well as to their social and economic development.

(This article was originally published in the Monetary Policy Institute Blog #86 on June 27, 2023)