To ensure that European Allies and neutral countries retained access to London markets and had a safe place to deposit assets and the proceeds of their rapidly-increasing wartime borrowing, and pay for supplies, the Bank of England opened ten accounts in the early part of the war (for France, Belgium, Italy, Serbia, Romania, Portugal, Egypt, the Netherlands, Norway and Switzerland). The United States had the opposite problem. The War had led to a huge increase in the demand for US exports from Europe, paid for by foreign assets, typically gold. These massive capital inflows risked driving excessive domestic US credit expansion, threatening inflation and undermining the fixed exchange rate between the dollar and gold, unless the excess could be recycled overseas. But the United States of the time lacked what Strong termed the international ‘banking machinery’ needed to effect this recycling. And the sheer scale of capital movements risked overwhelming the traditional system of physical gold transfers, given the limited global supply of gold, and the significant cost and risk involved with gold shipments in wartime. Strong noted that the desired machinery could take one of three possible forms: the US could lend directly to European banks; it could lend indirectly through private brokers; or it could retain the central banks of Britain and France to act as its agents, purchasing commercial bills, gold and deposits in European markets.
We are therefore faced with a situation where the traditional triangle of the trilemma is shrinking and sometimes seems to collapsing into the straight line of a dilemma. I still think it is a trilemma, but the trade-offs facing SOFIEs can be severe. In principle, there are three ways to mitigate the problem. The first is to adjust macroeconomic policy frameworks and improve execution and policy co-ordination. The second is to use prudential regulation and supervision aimed at reducing potential vulnerabilities and increasing resilience in the face of volatile capital flows. The third is to introduce targeted tools aimed directly at the financial integration part in order to regain greater monetary independence and shift the effects of monetary policy more to the interest rate channel and towards the non-traded goods sector. In Iceland, this issue is very much on the agenda as the country prepares to lift the comprehensive controls on capital outflows that were introduced at the peak of its financial crisis. We have been working through all of the avenues that I have just mentioned. Very recently, we introduced a CFM tool in the form of a special reserve requirement on portfolio inflows excluding equity. It is constructed in such a way that the bite is biggest for short-term flows.