Lecture 11: Globalization & financial crises 1 The global financial crisis (GFC) of 2007/8 is the signal event of the past 20—if not 40—years. And if the past is any guide, the repercussions will be long-lived and widely felt. When future history is written, 2007 will likely be seen as a point of departure leading to: 1.) the rise and fall of nations? Introduction 2 Irrespective of history, working out a resolution as well as preventing future crises requires a consideration of the role of globalization. Namely, can we assign a causal role for financial globalization in the GFC? And what can we say about the prospects of Introduction 3 Somewhat surprisingly, financial crises have a very long history. Less surprisingly, financial crises can also generally be traced back to the interaction of two sets of actors: money-lenders and governments. Thus, the first recorded financial crisis occurred Financial crises: the first 2500 years 4 For the next 2300 years or so, modern debt institutions evolved gradually. Primary role of government, but relationship between debt, taxes, and power all blurred. Pattern of warfare, forced loans from moneylenders, and default common across Eurasia. Financial crises: the first 2500 years 5 However, these repeated incidences of default and subsequent financial fall-out were generally domestic in nature. From 1800, we see the development of international markets for government debt as capital relentlessly pursues higher returns. Financial crises: the first 2500 years 6 Financial crises: the first 2500 years 7 One fact that jumps out from the figure are the long periods where a high percentage of all countries are in a state of default or restructuring. Indeed, there are four pronounced peaks or default cycles in the figure: the 1830s, 1880s, 1930s, and 1980s. Financial crises: the first 2500 years 8 Whereas multi-decade lulls in defaults are not at all uncommon, each lull has invariably been followed by a new wave of default. Curiously, past 15 years seem awfully quiet… Prime generators of waves of default: 1.) global conflict; 2.) global economic factors Financial crises: the first 2500 years 9 Emphasis on sovereign external debt, however, ignores the long history of domestic default. Domestic debt constituted an important—and now growing—share (≈85%) of government debt in most countries, including LDCs. Financial crises: the first 2500 years 10 The large share and long duration of domestic debt gives governments a further means of defaulting on their obligations, namely inflation. Inflationary monetary policy conveys two “benefits” to governments: 1.) seignorage gains (incurring debt in old money but paying off in new) Financial crises: the first 2500 years 11 Financial crises: the first 2500 years 12 In combination, domestic and external default generally spell bad news for banks. Not surprising given their holdings of both domestic and external debt on balance sheets. Reflects the primary role of banks: maturity transformation (borrow short run, lend long run). Financial crises: the first 2500 years 13 Financial crises: the first 2500 years 14 The common element underlying all financial crises is “excessive” debt accumulation. Can be on part of governments, corporations, or individuals alike, but all reliant upon a narrative in which “this time is different”. Crises of confidence 15 The catalyst for change often comes in the revelation of information running counter to the prevailing narrative. A crisis of confidence ensues and lending, particularly in the short run, ceases. Crises of confidence 16 This precariousness of confidence can even emerge in situations where a boom is not obviously about to go bust. Best seen in the example of a bank run, the primary form of financial crisis in the late 19th & early 20th centuries. Waves of bank runs rocked North America in 1866, 1872, 1873, 1884, 1890, 1893, 1907, 1923, 1929… Crises of confidence 17 First, let’s consider why banks actually exist… The most important function of banks is to create and provide liquidity. Investors who have a demand for liquidity will prefer to invest via a bank, rather than hold assets directly. Crises of confidence 18 Leading us to consider what banks actually do: 1.) Banks issue demand deposits that allow depositors to withdraw funds at any time. 2.) Banks make loans that cannot be sold quickly at a high price. This mismatch in maturities causes problems Crises of confidence 19 Deposits that are more liquid than a bank’s assets are a form of insurance/pooling by which depositors share risk of liquidating assets too early. Requires two things: 1.) banks must profit from the difference between short and long rates of return; and Crises of confidence 20 Consider the perspective of a depositor with $1: Crises of confidence 21 Thus, any whiff of problems is enough to push us from the good equilibrium “No bank run/wait” to the bad equilibrium “Bank run/withdraw”. But there are two means of resolving this indeterminacy: 1.) providing depositors with the assurance that there is no need to “get in line”; and Crises of confidence 22 Over time, institutions developed in North America to resolve exactly these problems in banking. The incentive to make a run on a bank diminished with federally-administered deposit insurance in 1933 (FDIC) and 1967 (CDIC). Crises of confidence 23 Thus, the phenomena of the bank run would seem to be a thing of the past. However, the experience of the past six years suggests this is not the case. In particular, the rise of the shadow banking system has meant that the actors in the drama have changed and so perhaps has the stage. Crises of confidence 24 Just like traditional banks, shadow banks are also financial intermediaries that conduct maturity, credit, and liquidity transformation. Examples of shadow banks include asset-backed commercial paper (ABCP) conduits, structured investment vehicles (SIVs), money-market mutual funds (MMFs)… Crises of confidence 25 Up to 2007, the shadow banking system provided sources of funding for credit by converting illiquid, long-term assets into money-like, short-term liabilities. Much of the demand for these liabilities were generated by global imbalances—large and persistent current account surpluses. Crises of confidence 26 Crises of confidence 27 Crises of confidence 28 Crises of confidence 29 Credit creation through maturity and liquidity transformation can significantly reduce the cost of credit relative to direct lending. However, shadow banks’ reliance on short-term liabilities to fund illiquid long-term assets was an inherently fragile and prone to runs. Crises of confidence 30 But why? Prior to the onset of the GFC, the shadow banking system was presumed to be safe due to insurance provided by the private sector. Once private sector insurance providers’ solvency was questioned Crises of confidence 31 The run on the shadow banking system began in the summer of 2007 and peaked following the failure of Lehman Brothers in October 2008. System was stabilized only after a series of official liquidity facilities and credit guarantees that replaced private sector guarantees entirely. Crises of confidence 32 The GFC of 2007/08 also generated a tremendous global policy response, a tenuous recovery, and two dangerous prospects. Monetary policy became highly accommodative through traditional and non-traditional means… a liquidity-led wave of inflation? Not likely. Future prospects 33 For large parts of the global economy, deleveraging is now the name of the game. Potential work-outs: 1.) let denominator do the work, but growth in DCs markedly slower since at least 2000. 2.) more defaults/write-downs, but limits exist. Future prospects 34 Periodic crises of confidence underlie the longrun history of the global economy. And their most clear manifestation—banking/ financial crises—are strongly correlated with globalized capital markets. Conclusion 35