Lecture 11: Globalization & financial crises
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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
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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
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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
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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
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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
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Financial crises: the first 2500 years
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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
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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
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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
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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
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Financial crises: the first 2500 years
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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
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Financial crises: the first 2500 years
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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
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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
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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
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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
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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
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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
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Consider the perspective of a depositor with $1:
Crises of confidence
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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
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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
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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
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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
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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
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Crises of confidence
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Crises of confidence
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Crises of confidence
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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
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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
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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
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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
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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
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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
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