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Perils of Plenty:
Can Foreign Reserves Grow Forever?
Paul McCulley and Ramin Toloui November 2007

Seminal research showed how central banks can be tempted to exploit the short-run Phillips curve tradeoff by permitting a higher rate of inflation today in order to push down unemployment temporarily.

But such behaviour has the consequence of generating higher, self-fulfilling inflation expectations in the future.
Robert Barro and David Gordon (1983), "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, vol. 91, pp. 589-610.

Central banks are now well aware of the "time inconsistency" trap, which is one reason why the predominant focus of central banks today is on keeping inflation under control.

The lessons of the Asian financial crisis could fill several books, and indeed they have.
For a scholarly example, see Morris Goldstein (1998), The Asian Financial Crisis: Causes, Cures, and Systemic Implications, Institute for International Economics. For a general audience example, see Paul Blustein (2001), The Chastening, Public Affairs.

To assess the concept of reserve adequacy, it is useful to start with why countries hold foreign reserves in the first place. The principal reason is to provide a ready source of liquidity in the event of unforeseen disruptions in the funding of a country’s international balance of payments activities.

Under the original Bretton Woods system and for a number of years that followed, capital controls remained widespread and capital mobility across borders was limited. Under Bretton Woods, therefore, shocks to the balance of payments came primarily from the trade account

The shortcomings of this concept of reserve adequacy became painfully apparent in the 1990s. With the liberalisation of capital controls beginning in the 1980s, cross-border financial flows accelerated dramatically.

Japan’s experience in the late 1980s and early 1990s has become a fascinating empirical counterpoint to this discussion. Ronald McKinnon and others have argued that Japan’s mistake was to submit to pressure from the United States and other countries to allow yen appreciation, which was followed by more than a decade of deflation in Japan. Larry Summers and others have responded that Japan’s mistake was to pursue an easy monetary stance in the late 1980s aimed at limiting yen appreciation, which produced enormous real estate and equity bubbles. The size of these bubbles meant that when they popped, the depth and velocity of the decline created a discontinuous change that made successful stabilisation much more difficult.

For an introduction to this debate, see Ronald McKinnon (2005), "China’s New Exchange Rate Policy: Will China Follow Japan into a Liquidity Trap," Wall Street Journal, October, and Larry Summers (2007), "History Holds Lessons for China and its Partners," Financial Times, February 25. An online debate about the topic can be found at

Full text

McCulley, whose remarks were quoted on the cover of the Wall Street Journal,
should know about a Minsky moment:
he coined the term during the 1998 Russian debt crisis (Lahart 2007).

John Mauldin 2007-11-12

Paul McCulley

There is no such thing as Rational expectations
Rolf Englund

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