Central banks in a fragmented world

ECB President Christine Lagarde speaking at the Council on Foreign Relations’ C. Peter McCullough’s International Economics Series

New York, April 17, 2023

It’s great to be here in New York.

The global economy has been in a process of transformation. Following the pandemic, Russia’s unjust war on Ukraine, its use of force weapons, the sudden acceleration of inflation, and the growing rivalry between the United States and China, the technical plates of geopolitics are turning rapidly.

We are witnessing the fragmentation of the world economy as each alliance tries to attract the rest of the world to its own strategic interests and shared values. And this division may well bring together two blocs led by the two largest economies in the world.

All of this could have far-reaching implications for many areas of policy making. And in my opinion today, I want to examine what implications it may have for central banks.

In short, we can see two major implications for the policy environment for central banks: First, we will see more volatility as global supply elasticity declines. And second, we can see more diversification as geopolitical tensions rise.

A changing global economy

In the post-Cold War era, the world benefited from a remarkably favorable geopolitical environment. Under the leadership of the United States, rules-based international institutions have grown and international trade has expanded. This has led to the development of global value chains and as China joins the global economy, the global labor supply has increased significantly.

As a result, global supply is more elastic to changes in domestic demand, which has led to relatively low and stable inflation for a long time.[1] This underpins a policy framework in which independent central banks focus on stabilizing inflation without paying much attention to supply-side disruptions.[2]

But that period of relative stability may now be giving way to a period of lasting instability that will result in lower growth, higher costs and uncertain trade partnerships. Instead of fluctuating global supply, we may face the risk of recurring supply shocks. Recent events have made it clear how much critical supplies depend on stable global conditions.

That is most visible in Europe’s energy crisis, but also extends to other critical supplies. Today, the United States is dependent on imports for at least 14 essential minerals.[3] And Europe depends on China for 98% of its rare earth supply.[4] Supply disruptions on these fronts could impact critical sectors of the economy, such as the automobile industry and the transition to electric vehicle production.

In response, governments are enacting legislation to increase security of supply, notably the US deflationary act and the strategic autonomy agenda in Europe. But this, in turn, can accelerate fragmentation as organizations eagerly adjust. In fact, following the Russian invasion of Ukraine, the share of global companies planning to localize their supply chain has doubled from a year ago to around 45%.[5]

This “new global map” – as I called these changes elsewhere[6] – May have primary implications for central banks.

In the year A recent study based on data from 1900 shows that geopolitical risks have led to high inflation, low economic activity, and a decline in international trade.[7] And the ECB’s analysis suggests that similar results can be expected in the future. If global value chains are divided along geopolitical lines, global consumer price inflation could be around 5% in the short run and roughly 1% in the long run.[8]

These changes signal a second shift in the central banking landscape: we see the world becoming more multipolar.

Season Pax Americana In the year After 1945, the US dollar was firmly established as the global reserve and transaction currency, and more recently the euro was promoted to second place.[9] This had many – mostly important – implications for central banks. For example, the ability of central banks to act as “conductors of the international orchestra” as described by Keynes, or for firms to make claims on their domestic currencies, which made import prices more stable.[10]

In parallel, Western payment infrastructures have taken on an increasingly global role. For example, the number of countries using the payment messaging network SWIFT has more than doubled in the decade since the fall of the Berlin Wall.[11] In the year By 2020, more than 90% of cross-border transfers were being signaled via SWIFT.[12]

But new business models may improve payments and international currency reserves.

In recent decades, China has increased its bilateral trade with emerging markets and emerging economies 130-fold, and the country has become the world’s leading exporter.[13] And recent studies show that there is a strong correlation between a country’s trade with China and its renminbi reserves.[14] New business models can lead to new alliances. One study suggests that alliances can increase a currency’s share of a partner’s reserve holdings by 30 percentage points.[15]

All this may create an opportunity for some countries that want to reduce their dependence on Western payment systems and currency frameworks – due to political choice, financial dependence, or financial sanctions in the last decade.[16]

Anecdotal evidence, including official statements, suggests that some countries are considering adding alternatives to major traditional currencies to demand international trade, such as the Chinese renminbi or the Indian rupee.[17] We are also seeing gold reserves led by countries with geopolitical ties to China and Russia as an alternative reserve asset.[18]

There are attempts to create alternatives to SWIFT. In the year Since 2014, Russia has developed such a system for domestic and cross-border use, more than 50 banks in dozens of countries have used it in the past year.[19] And since 2015, China has established its own system for clearing payments in renminbi.

These developments do not signal a loss of dominance for the US dollar or the euro. So far, the data does not show any real changes in the use of international currency. But they suggest that the global currency situation should no longer be taken for granted.

Policy frameworks for a fragmented world

How should central banks respond to these twin challenges?

We have clear examples of what it is is not Do when there is a sudden increase in volatility. In the year In the 1970s, as OPEC became more assertive and the decades-stable energy price bubble deflated, central banks faced uncertainty in the geopolitical environment. Hopes of monetary stability and inflation failed to hold up – a mistake that cannot be repeated as long as central banks are free and there are clear price stability obligations.

Thus, in the face of persistent supply shocks, independent central banks can move forward by ensuring price stability. But this can be achieved at a lower cost if other policies cooperate and help to fill supply capacity.

For example, if fiscal and structural policies focus on removing supply constraints created by the new geopolitics – such as ensuring stronger supply chains or increasing energy production – then we can see a virtuous circle of lower volatility, lower inflation, higher investment and higher growth. . But if fiscal policy focuses primarily on supporting revenue to offset spending pressures (rather than temporary and temporary responses to large shocks), this will increase inflation, raise borrowing costs, and lower investment in new supply.

In this sense, to the extent that geopolitics fragment the global economy into competing groups, this calls for greater policy coherence. Not to violate freedom, but to recognize it Support each other between policies, and how best to achieve their objectives if each is aligned behind a strategic goal.

We can see the benefits of this especially in Europe, where joint action is more common than what member states can do alone, such as industrial policy, defense and investing in green and digital technologies.

There is another benefit: Achieving the right policy framework will determine not only how our economy is viewed at home, but also how it is viewed globally in the context of greater “systemic competition.” And while the international institutions established in the aftermath of Bretton Woods remain instrumental in fostering a rules-based multilateral system, the prospect of multilateralism raises the possibility of such domestic policy coordination.

First, an economic policy mix that leads to less volatile growth and inflation will be key to attracting international investment. Although 50-60 percent of US short-term assets held abroad are in the hands of governments with strong ties to the United States – meaning they cannot be excluded for geopolitical reasons.[20] The single most important factor influencing global currency usage remains the strength of fundamentals.[21]

Similarly, for Europe, long-standing projects such as deepening and integrating our capital markets can no longer be viewed solely through the lens of domestic financial policy. To be clear, we need to complete the European Capital Markets Union. This will be crucial in determining whether the euro remains among the leading world currencies or whether others will take its place.

Central banks have a big role to play here too – even as major players.

For example, the way swap lines are used can affect the volatility of major international currencies.[22] Both the Federal Reserve and the ECB, in their respective directions, have been active in providing offshore liquidity during recent crises. But others are moving in, increasing the role of their funds. We have seen the People’s Bank of China set up more than 30 bilateral swap lines with other central banks to compensate for the lack of liquid financial markets in the renminbi.[23]

How central banks navigate the digital age — such as revamping their payment systems and issuing digital currencies — will also be crucial for which currencies ultimately rise and fall. This is a critical reason why the ECB is deeply examining how the digital euro can best function once it is launched.

Therefore, we must be prepared for the new reality that may await us in the future. The time to think about how to respond to changing geopolitics is when the divide is upon us, not before. Because, if I may quote Ernest Hemingway, interruption can happen in two ways: gradually and then suddenly.[24]

Central banks should provide stability in a time of uncertainty. And I have no doubt that central banks will rise to the challenge.

Thank you.


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