Finally, emerging/developing economies have been subject to wide swings in financing from abrupt withdrawal of funds in 2008 to significant inflows recently, and as a result they are starting to implement capital controls. The risk is that these may spread unless financial flows become less erratic and more long-term and stable. 7. Concern about commodity bubble and high-yielding products  Over the past several decades, the world financial system has produced a seemingly endless series of bubbles (e.g. the dotcom bubble, the housing bubble and the Yen carry trade). Each bubble had its apologists before it burst, who argued that it was rational and that “this time is different.” Historically, commodities (apart from oil) were in a downward trend for over 100 years until 2002. Since then the entire decline has been reversed and commentators are talking about a “Paradigm Shift.” Compared to historical trends, commodities are as over-priced as the US stock market during the “tech bubble” of 2000. The parabolic rise in commodity prices has serious consequences and it is open to question whether the world economy is strong enough to support their continued gains. It is particularly damaging to inflation and growth in emerging market economies which are relatively heavy users of commodities. With interest rates at current low levels, investors are looking for high-yield products; but high yield brings high risks as well.
The tendencies that I have described can be problematic in their own right but in no way fatal, as the experience of New Zealand and others attests to. It is when they interact badly with other economic and financial risks that can face small, open and financially integrated economies – such as the global credit cycle, domestic financial vulnerabilities, policy conflicts, and asymmetric shocks – that we can have a lethal cocktail. This was the case in Iceland. To demonstrate this, let me take a stylised example which is, I admit, heavily influenced by the experience of my own country. A small, open, and financially integrated economy develops a positive output gap that is larger than in the rest of the world. The economy is booming and is seen as a good investment by outside investors. This occurs in a situation where the global credit cycle is in a strong upswing. The result is capital inflows and upward pressures on the exchange rate. The country has a floating exchange rate and has adopted a flexible inflation targeting regime. Monetary policy therefore reacts by raising interest rates due to the risks that the booming economy poses for future inflation. This, however, widens the interest rate differential vis-à-vis the rest of the world and sucks in even more capital through carry trade and other channels. The currency therefore appreciates further. This helps to limit inflation, both directly, through lower imported inflation in terms of domestic currency, and indirectly, by directing demand abroad.