Speech by Lucas Papademos, Vice President of the ECBat the conference on the “International Dimensions of Monetary Policy” organised by the National Bureau of Economic ResearchS’Agaró, Girona, 11 June 2007
II. Globalisation, price stability and monetary policy
II.1. Impact of globalisation on product and labour markets
Let me start by briefly reviewing both the theoretical arguments and the empirical evidence pertaining to the effects of globalisation on product and labour markets. It would be too easy to dismiss any inflationary effects stemming from globalisation with the argument that its impact will essentially and ultimately result in a change in relative prices and that, ceteris paribus, the overall rate of inflation should not be affected. Firstly, integration is not a one-off event. Steadily rising integration could potentially lead to steadily falling unit labour costs and, ceteris paribus, to protracted periods of lower inflation. Secondly, a higher degree of openness, and thus increased competition could lead to permanently higher productivity growth and, again other things being equal, to lower inflation. Thirdly, globalisation could affect other aspects of the inflation process and the conduct of monetary policy: the slope of the Phillips-curve, the wedge between the “socially optimal” and the “natural” or “potential” output level, the “natural rate of unemployment” or NAIRU and even the relative emphasis placed on preserving price stability by the central bank when formulating monetary policy. Thus, globalisation could eventually affect the inflationary impact of supply shocks and, more generally, inflation dynamics and the size of the ‘inflation bias’ in the economy. [7]
Many economists and policy-makers have examined the effects of globalisation on one or several of these factors and processes, partly in order to better understand or explain the recent period of low inflation. Interestingly, sometimes the theoretical arguments and empirical findings point in opposite directions: Some have argued that increasing global competition will tend to impinge on domestic monopolistic structures and reduce economic distortions. [8] Furthermore, the slope of the short-term Phillips-curve would increase in the short run as national economies would become more flexible. These two propositions and implied parameter changes imply a permanent reduction in the ‘inflation bias’. Others have argued instead that the slope of the Phillips-curve should become flatter. [9]This reasoning is based on a variety of potential channels: an increased degree of openness reduces the responsiveness of inflation to domestic slack, profit margins become more variable under competitive pressure and wage developments that are influenced by the threat of outsourcing jobs and labour immigration. There are other factors, however, which potentially could flatten the slope of the Phillips-curve – the underlying, structural slope or the estimated, effectively observed slope – and which are not necessarily linked to globalisation: for example, inflation expectations that are well-anchored to price stability and less frequent price updates of firms in a low-inflation environment.
Alternative or complementary propositions have also been advanced. It has been argued that the whole debate about the slope of the short-term Phillips-curve is not particularly relevant, if at all. [10] In a highly globalised economic environment, lower inflation could simply be due to a decline in the “natural rate of unemployment” or NAIRU. Importantly, Assaf Razin, among others, has recently shown how the degree of trade and financial integration might both flatten the slope of the short-term Phillips-curve and raise the optimal weight to be placed on the central bank’s inflation objective, when monetary policy maximises consumer preferences. [11] This would lead to the conduct of a more aggressive [optimal] monetary policy in the presence of supply shocks. [12]
Not surprisingly, this debate has triggered a series of empiried studies trying to shed more light on the issue. I will focus on evidence for the euro area. In a recent and often-cited BIS paper, Claudio Borio and Andrew Filardo [13] argue that short-term Phillips-curves have become flatter across countries and that measures of global economic slack have become more important than of domestic slack in explaining domestic inflation. Their own results, however, show that this is not the case in the euro area. Moreover, unpublished research at the ECB does not reveal any statistically significant structural breaks with respect to the slope of the euro area Phillips-curve or any decline in the estimated coefficient over time. Other evidence regarding a possible change in the slope of the short-term Phillips-curve in the euro area is also very mixed, especially with regard to the potential effect of increased openness on the slope. [14] The failure to capture econometrically significant globalisation effects could, of course, be due to the relatively recent nature of certain aspects of this phenomenon and the impact of other factors that might have had relatively greater influence on inflation dynamics during the past ten years. For this reason, the potential effects of globalisation on inflation dynamics, through its influence on behavioural or structural features of the labour and product markets, deserves close monitoring and further analysis.
The policy relevance of this debate is further complicated by the fact that even if future empirical studies would confirm a significant drop in the responsiveness of inflation to domestic slack in Phillips-curve equations, it is not at all clear whether this should be interpreted as a flattening of the aggregate supply curve in the short term. Such “reduced form” evidence can be observationally equivalent to the evidence that could result from an unchanged structural relationship in an economy where the central bank has been successful in reducing inflation and output volatility, which would correspondingly reduce or could even eliminate the empirical correlation between inflation and the output gap. [15] For this reason, economists and policy-makers have to be particularly careful when using simple reduced form estimated Phillips-curve equations to calculate the NAIRU and then employ the estimated value as a benchmark for assessing inflationary pressure.
There are two lessons I derive from this review of theory and evidence. First, there is no consensus at a theoretical level on the relative importance of the various potential effects of globalisation on the inflation process through this channel. Second, the available empirical results provide no clear message either, except that, so far, there is not much evidence to support the view that globalisation has resulted in a flatter Phillips-curve, particularly in the euro area. This situation is, of course, not very comforting for a central banker. The good news is that all studies point toward a lower ‘inflation bias’, although for different reasons.
Another related issue is whether, and to what extent, globalisation has affected prices and wages more directly in the euro area product and labour markets in the short-to-medium term. Estimates obtained at the OECD [16], employing an accounting framework suggest that the more direct effect of globalisation [captured by measures of economic openness] on average annual consumer price inflation is within the range of 0.0 to 0.3 percentage points over the period 2000 - 2005. The average size of the estimated impact is not overwhelming, but at least the upper limit of this range is not negligible either. An internal ECB study finds a comparable effect ranging between 0.1 and 0.2 percentage point over the period 1995 - 2004. The net direct impact of globalisation on HICP inflation is the result of two components: an inflation-dampening effect from non‑commodity import prices and an inflation-augmenting effect from commodity import prices, including oil prices. The two effects are of course linked and may largely offset each other as the economic success of emerging market economies is largely responsible for higher world commodity prices. Moreover, the interpretation of such estimated effects is not straightforward. The domestic economy’s response to the emergence of new international low-cost competitors is not captured by these estimates. Furthermore, it is not clear to what extent and for how long these effects should be expected to persist.
The empirical evidence on the direct impact of globalisation on labour markets is also mixed. Indeed, it seems that the findings are getting less rather than more robust and it may be difficult to disentangle the effects of globalisation from those resulting from technological advances. In theory, it could be expected that the increased openness of the economies may affect the demand for labour by firms in advanced economies directly, as a result of increased international competition and, indirectly, by increasing the real wage elasticity of labour demand. There is some evidence confirming these theoretical propositions. [17] The quadrupling of the effective global labour force over the last twenty years has led to a fall in the labour share of unskilled workers’ sectors in advanced economies and to a – more moderate – rise in the labour share of skilled workers’ sectors. In the euro area, shifts in labour demand are predominantly resulting in changes in employment rather than in wages. The IMF concludes, however, that technological advances had an even bigger impact on the labour share of unskilled workers’ sectors than globalisation as such.
II.2 Impact on monetary aggregates and financial markets
As you are aware, the ECB’s monetary policy strategy attributes a prominent role to the analysis of monetary aggregates and its counterparts in the assessment of risks to price stability over the medium to longer run. Two processes associated with globalisation have made the analysis of monetary aggregates for the purpose of extracting information for assessing future risks to price stability more complex. [18]
The first process is the growing size of international capital flows. The sum of the stocks of foreign assets and foreign liabilities of the total economy as a percentage of GDP – the most frequently used measure of financial globalisation – has increased threefold in advanced economies between the early 1990s and 2004. [19] In the euro area alone, the sum of outstanding foreign assets and liabilities has increased from 190% of GDP in 1999 to 280% in 2005. [20] With larger stocks of foreign assets and liabilities, the probability of occasionally large and volatile net flows has risen. When euro area residents sell securities to non euro area residents or when they borrow abroad, the net external assets of monetary and financial institutions [MFIs] in the euro area rise and the stock of broad money [M3] expands, if the settlement of these transactions involves domestic and foreign banks. Cross-border mergers & acquisitions [M&A] activity of non-financial corporations can also account for a parallel change in net foreign assets and money. Both cross-border portfolio investments and M&A activity are genuine elements of the process of globalisation. Unfortunately, simply accounting for the external sources of money growth and then mechanically correcting for cross-border portfolio flows or M&A activity, on the presumption of their likely remote direct effects on consumer prices, is not an advisable option. Rather, these transactions have to be analysed with respect to their information content concerning their potential wealth effects on residents’ income and on asset prices. [21] Depending on the outcome of this analysis, the policy implications could be far from negligible.
The second process is financial innovation. The increasingly global nature of financial markets and the low level of world interest rates in recent years have fostered financial innovation. These developments, in turn, have contributed to the rapid growth of the activities of Other Financial Intermediaries [OFIs], which include investment funds, financial vehicle corporations as well as dealers in securities and derivative products. While the overall share of OFIs’ money holdings in M3 is only about 10% in the euro area so far – households account for about 50% – OFIs have contributed significantly to the annual growth of euro area M3 since 2005, adding up to 2 percentage points in some months, mainly due to the emergence and expansion of loan securitisation. The motives of OFIs for holding money balances are likely to be of a fundamentally different nature than those of households or non-financial corporations. Moreover, the process of securitisation of loans itself positively affects the capacity of banks [of MFIs, to be precise], to issue new loans and thus it could have an indirect expansionary effect on M3 growth. How can we deal with the influence of these factors on money creation and their potential effects on the medium and long-term inflation outlook? In general, the same answer applies as with respect to changes in net external assets. Given that the OFIs’ money holdings and investment activities could have indirect effects on consumer price developments via asset prices, it would be premature to automatically exclude, without further analysis, the money balances held by OFIs from the monetary aggregates when assessing the risks to price stability. [22]
The general conclusion that emerges from these considerations is that monetary analysis has become more challenging in the global economy as it has to explicitly take account of changes in domestic money and credit markets induced by, or accompanying, financial globalisation. To address this challenge, the Eurosystem is currently stepping up its analytical efforts to deepen its understanding of several aspects of these processes and their implications for the assessment of medium to longer-term risks to price stability.
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