In a speech delivered at the Council on Foreign Relations’ C. Peter McColough Series on International Economics in New York on April 17, 2023, Christine Lagarde, President of the European Central Bank, analyzed the potential implications of a fragmenting global economy on central banks. Lagarde explained that the world is undergoing a period of transformative change, marked by Russia’s unjustified war against Ukraine, the weaponization of energy, the sudden acceleration of inflation, and the growing rivalry between the United States and China. These geopolitical shifts are leading to a fragmentation of the global economy into competing blocs, with each bloc attempting to pull as much of the rest of the world closer to its respective strategic interests and shared values.
Lagarde explained that this fragmentation may have far-reaching implications across many domains of policymaking, including central banking. Two profound effects on the policy environment for central banks could result: first, we may see more instability as global supply elasticity wanes, and second, we could see more multipolarity as geopolitical tensions continue to mount.
The period after the Cold War saw the world benefiting from a remarkably favorable geopolitical environment, under the hegemonic leadership of the United States, rules-based international institutions flourished, and global trade expanded. This led to a deepening of global value chains, and as China joined the world economy, a massive increase in the global labor supply. Global supply became more elastic to changes in domestic demand, leading to a long period of relatively low and stable inflation. This period of relative stability may now be giving way to one of lasting instability resulting in lower growth, higher costs, and more uncertain trade partnerships. Instead of more elastic global supply, we could face the risk of repeated supply shocks. Recent events have laid bare the extent to which critical supplies depend on stable global conditions.
According to Lagarde, this “new global map” is likely to have first-order implications for central banks. One recent study based on data since 1900 finds that geopolitical risks led to high inflation, lower economic activity, and a fall in international trade. And ECB analysis suggests similar outcomes may be expected for the future. If global value chains fragment along geopolitical lines, the increase in the global level of consumer prices could range between around 5% in the short run and roughly 1% in the long run.
Lagarde further explained that the new trade patterns may have ramifications for payments and international currency reserves. In recent decades, China has increased over 130-fold its bilateral trade in goods with emerging markets and developing economies, with the country also becoming the world’s top exporter. And recent research indicates there is a significant correlation between a country’s trade with China and its holdings of renminbi as reserves. New trade patterns may also lead to new alliances. One study finds that alliances can increase the share of a currency in the partner’s reserve holdings by roughly 30 percentage points.
In conclusion, Lagarde argued that central banks must be prepared to navigate a rapidly changing global landscape marked by geopolitical tensions and increasing fragmentation. The role of central banks in stabilizing inflation and promoting financial stability will remain crucial, but new challenges will arise as the world becomes more multipolar and global supply becomes less elastic. It is essential that central banks maintain an open dialogue with policymakers and stakeholders to address these challenges and ensure that the global financial system remains robust and resilient.
