Macro finance has long told itself a comforting story. Governments and central banks set the terms; markets then respond, rates move, capital flows and exchange rates adjust. That story had the virtue of simplicity, and for a long time it was good enough to teach and to build policy on. But that comfort is no longer earned. Hélène Rey’s account of the global financial cycle, which argues that open economies face a ‘dilemma, not trilemma,‘ and the Bank for International Settlements writing on a second phase of global liquidity – to name just two strands of a much larger literature – have already said so.
Macro finance needs a framework built around the fact that global capital matters. The protagonists of the fuller story are global investors such as hedge funds, sovereign wealth funds, pension and insurance funds, shadow-banking vehicles and high-frequency traders. They act in the markets as marginal buyers and sellers, and continuously decide which government’s money and debt are worth holding, and at what speed and price capital moves in and out of them.
In an earlier essay, I called them ‘the devils’– borrowing the term from Guido Maria Brera’s novel and the TV series it inspired. Not because they are villains – they do what allocators do: move capital in search of maximum returns at a speed and scale no government can match – but because they weigh a country’s prospects only insofar as these bear on repayment, and on that narrow basis alone, they set prices that matter more than the decisions of the governments whose fortunes those prices determine.
The most direct effect of global investor choices is on sovereign bond prices, which reset every time global portfolios shift towards or away from their debt. From there, the effect travels along two further paths. Exchange rates move as portfolios rebalance across currencies in search of yield or safety, repricing a country’s currency and forcing its own central bank to react. And the general price level moves too, as wealth-holders reallocate across money, bonds, equities, and other assets, changing the relative scarcity of goods, assets and money itself. The same portfolio-clearing mechanism thus surfaces in different markets, on different timelines, which is why a bond-market repricing today can show up as a currency move next week and an inflation print months later.
From prices to policy space
As the portfolio theory of inflation predicts, inflation in open and internationally financially integrated economies is triggered less by money-supply growth than by shifts in those portfolios’ composition. When global investors decide, at the margin, to hold less of a government’s debt and more of something else, that debt has to reprice to find buyers. If the government issues more debt to cover the gap, or the central bank absorbs it, the consequence follows later as currency depreciation, higher import prices, or added liquidity chasing a fixed supply of goods. Inflation becomes the visible symptom of portfolio rebalancing: the share of wealth investors are willing to hold in a government’s obligations determines the price level those obligations can sustain, not the other way around.
But the mechanism doesn’t stop at the price level. If investors’ portfolio decisions determine how much of a government’s debt the market will absorb, and at what price, those decisions also determine how much room that government has to run deficits, finance public spending or ease policy without triggering a repricing. Policy space is thus not a fixed endowment a country draws down at its own discretion; it is set jointly, in real time, by the government’s choices and by investors who were never at the table. A central implication of the PTI is that a country’s policy space is endogenous to global investor behaviour, not a domestic given that global capital merely constrains from the outside.
Why patching won’t do
The usual policy response to the relevance of global capital has been incremental: add a risk-premium term, treat capital flows as an exogenous shock to hedge against, refine the demand-side model at the margins. Each treats global investors as noise to be absorbed into an existing structure, not as a reason to rebuild it.
The harder alternative is to make investor portfolio behaviour central to the same models that determine growth, inflation and policy space. Fiscal space, specifically, is not merely a debt-to-gross domestic product ratio calculated in isolation; it reflects the extent of financial accommodation that global investors are prepared to grant, based on how credible they judge the government to be and how solid its policy framework.
Methodologically, this calls for a critical revision of existing macroeconomic models of economies that today are highly financially integrated. Standard models typically build on three types of agents: households, firms and government. Global investors have no equivalent standing; they appear, when they appear at all, as part of an external constraint rather than as agents whose choices help set prices. They should instead be integrated explicitly as primary decision-makers, whose portfolio decisions affect markets alongside – and often ahead of – the decisions conventional models already account for. With this revision in place, inflation, debt sustainability, exchange-rate dynamics and the width of a country’s policy space stop being separate puzzles and become outputs of the same portfolio-clearing logic.
What is at stake
Nearly every live debate in central banking today – from, say, debt sustainability in the eurozone, to the credibility of monetary frameworks, or the search for new fiscal-monetary architecture – is being argued partly with tools built for a world in which global capital was a footnote. That world has not existed for quite some time. A central bank that sets policy without asking how global portfolios will reprice its country’s debt is negotiating with one eye closed, and a finance ministry that plans a deficit without asking what price global allocators will demand for it is doing much the same.
The UK’s 2022 mini-budget was not some emerging-market afterthought. It took place in the world’s sixth-largest economy and the issuer of one of its most-traded currencies. A fiscal announcement that domestic institutions judged unremarkable in isolation was repriced within days by global bond and pension fund managers who simply declined to hold the debt on the terms offered. The government’s fiscal space had not changed on paper; what changed was the portfolio decision of investors who had never been part of the policy conversation. Treasuries that treat episodes like this as one-off dysfunction, rather than as the mechanism’s ordinary operation, will keep being surprised by the next one.
The institutions that manage the next decade well will be the ones that stop treating investor behaviour as a risk to hedge after the fact and start building it into the model from the first line, not the appendix.
Macro finance needs foundations built around actors who move the prices and delimit the space within which governments set policies. Until that refoundation happens, central banks and finance ministries will keep rediscovering, one surprise at a time, that the devils are real.
Biagio Bossone is an adviser to international financial institutions and national central banks.
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