European Affairs

Several reasons have been advanced for why this might be happening. The first is the increased integration of the global economy, meaning that industries are now functioning on a much more worldwide basis.

Certainly within the high tech sector activities are not concentrated within countries but rather are concentrated within industries and spread across countries. We also have multinational corporations that span both sectors and countries.

Secondly, there are large investment entities, such as hedge funds and investment banks, which are also taking on a global perspective as they operate in many countries’ markets every day.  In doing so, they transmit a kind of investor psychology from one region to another.

Thirdly, people often point to what we might term common shocks as linking markets in different areas more closely. Examples would be oil price increases or other developments that are commonly and simultaneously experienced by the different markets.

(Many financial firms are consolidating )

Two trends might help to explain this phenomenon. One is simply the vastly increased volume of capital flows; the other is the consolidation among financial firms. Both are happening around the world and particularly across the Atlantic, further linking the U.S. and European economies.

If we look at the volume of international capital flows throughout the 1990s, we see that investments in emerging markets were dealt a serious blow by the financial crisis that began in Asia in1997. These flows have made some recovery, but are not back to their earlier peaks.

What we are seeing instead are huge flows from the United States to Europe, and even more from Europe to the United States. One can see this particularly in the buying of stocks and bonds.  Flows out of the United States doubled between the first and second halves of the 1990s, while those into the United States quadrupled. U.S.-European transactions grew at a similar rate.

Foreign Direct Investment, or the purchase of at least a controlling interest in another company, has increased even faster, particularly between the United States and Europe.  This is where we see the mergers and acquisitions that attract so much attention.  Foreign direct investment flows from Europe to the United States were seven times higher in the late 1990s than in the early years of the decade.

One reason was clearly a European desire to participate in the U.S. technology investment boom.  European investors purchased, or at least joined with, firms operating in the United States.

An additional impetus came from the creation of the euro. The introduction of the European common currency in January 1999 meant that a European portfolio investor was no longer achieving much currency diversification by owning other European investments.

This was not something that occurred suddenly on the day the euro was introduced. In fact, during the last years of the European Exchange Rate Mechanism, which preceded the euro, there was very little movement of exchange rates. The gradual move toward this stability probably led to an increase in dollar investments to offset the lack of distinction between investments in the different euro countries.

(Huge increase in flows into U.S.)

There is also a broader diversification effect arising from the move to a single monetary policy.  If the euro area begins to function as a single economy, then quite apart from the currency, European investors will need to move out of Europe to achieve variety in their portfolios. I think both of these were factors in the very sizeable increase in capital flows between Europe and the United States.

Another element is the increased tendency of U.S. corporations to finance themselves internationally. Foreign placement of equity has been important, but the data are most striking for the issuance of corporate debt. U.S. companies are choosing European markets to float corporate debt, and this has become the vehicle for much of the transatlantic capital flow.

This, too, I believe is an indirect result of the coming of the euro.  Simply put, the infrastructure of Europe’s bond markets has developed very rapidly in recent years, making it a more attractive place for U.S. companies to raise finance.

There have also been increases in the other direction as more foreign companies list on U.S. stock exchanges. The non-U.S. share of listings on the New York Stock Exchange has risen markedly. We should remember that these are two-way flows, even if the largest increases are in the flows from Europe to the United States. And while securities flows get all the attention, inter-bank flows have increased as well.

On the whole, the increase in flows has been driven by general economic globalization, but the changes to the European financial markets arising from the introduction of the euro have supported and encouraged these increases.  Substantial increases in the flows in turn support the development of the infrastructure, creating a self-reinforcing trend.

The second issue is consolidation throughout financial sectors in the major industrialized countries. A group sponsored by the Group of 10 has just completed a  sizable work on this, which is known as the Ferguson study, after the Fed’s Vice Chairman Roger Ferguson. We see consolidation within specific sectors - banking, insurance and the securities industry - as well as among firms that span these three sectors.

(U.S. monetary policy has more effect on Europe)

Much of the consolidation has been within countries, but some has been cross-border. The result is larger, more interdependent, firms and this too is changing the character of international, and in particular transatlantic, financial trends.

What might this mean for monetary policy? There is a risk of exaggeration here. I don’t mean to suggest that monetary policy either in the United States or in Europe needs to change in any abrupt way. But one implication of these trends is that over time more companies are financing themselves in global markets as opposed to national markets.

Logic suggests that the monetary policy actions of any one central bank will come to be a bit less of an issue for a given company if it is looking at global markets, rather than national markets, in making its business decisions. The flipside of this is that there will be more spillovers and more interconnections among the countries.

A monetary policy action by the United States will have more implications for Europe if European companies are heavily involved in the United States through mergers and acquisitions, or only through financing.

Similarly, monetary policy in Europe might have more implications for the United States given that U.S. companies are financing themselves in European markets, and U.S. corporations are more tied to European companies.

Over a long horizon, I think, these factors suggest more commonality in the problems faced by the central banks generally.  I don’t think this raises the need for an explicit coordination of policy, but it does argue for a growing awareness of the policies and the macroeconomic events of both areas and a growing degree of cooperation in the monetary policy sphere.  

(Some say markets can be wrong)

There are, of course, problems. There is a sense at the official level, as well as at the private level, that global capital flows have become overwhelming.  Daily turnover in foreign exchange markets is bigger than the Gross Domestic Product of any number of countries. And there are certainly occasions when the outcome of market events has been unwelcome.

Governments have tried somehow to say markets are wrong and to interfere or change behavior. They have organized international studies of the markets, and of particular players on the markets.  Hedge funds come to mind as people who sometimes have been pointed to as the villains, but not always.

I also think the growing integration within Europe of its financial markets, and between European markets and others, puts these markets out of reach of any one country or any one regulator. The size gets beyond the scope of any one central bank. People feel that somehow we have let loose an uncontrollable tornado.

On good days, people say “this is great, this is liquidity, this is risk management, this is an opportunity that I didn’t have before;” on bad days, they say ”somebody is out there doing something to my country or my currency or my industry.”

We need to learn to come to terms with that, and we need to develop trust in the fundamentals that underlie the markets. We need to develop trust in each other in the official sector that in the event something actually does go wrong, we will know how to proceed.

(Terrorists challenged the global system)

The events of September 11 posed a challenge to U.S. and to global financial markets.  The problems that were experienced were very serious, but through the efforts of many in both the private and the official sectors, the functioning of global markets was restored promptly.

The measures that had been put in place earlier to provide backup records and facilities proved their value.  No doubt many lessons were learned, however, and further improvements in the system of backup facilities and procedures will surely be made. One very positive feature of the response to the disruption was the constructive  consultation among the major central banks. They worked together to assure the functioning of their respective domestic markets at a time of extreme stress.  And they have continued to address the problems of the global economy in the aftermath of the attacks.  

These totally unexpected attacks have provided additional evidence of the extent of global integration of capital markets, particularly those across the Atlantic. The attack was not just on New York and its financial sector.  It was on the world’s financial system.  And that system has rebounded from the attack, demonstrating its fundamental strength and vitality.

Dr. Karen Johnson is the Director of the International Finance Division, Federal Reserve System. A graduate of the Massachusetts Institute of Technology, her main fields of interest include international finance, monetary theory and policy, and macroeconomics. She has held numerous positions within the FED’s International Finance Division including Economist, Senior Economist, Section Chief, and Assistant Director.


This article was published in European Affairs: Volume number II, Issue number IV in the Fall of 2001.