Money and finance in the global
economy
• The international monetary system is the body
of rules and procedures by which different
national currencies are exchanged for each other
in world trade.
• The global financial system (GFS) refers to those
financial institutions and regulations that act on
the international level.
• The main players are private (banks, hedge funds
etc) and public (central banks and government
departments) and international organizations
(the IMF, Bank for International Settlements etc).
Money and finance in the global
economy
• The international monetary system is
closely tied to the international finance
system.
• Flows of international capital and FDI are
conducted in money. If there is a change in
exchange rates they inevitably impact on
the value of investment.
The role of the international
monetary system
• It requires a nation, or a group of nations, to
maintain and manage it; leading nations might
agree to entrust an international organization to
achieve this, see IMF and World Bank.
• It has to determine the way to solve imbalances of
national economies, by some agreed form of
adjustment.
• It has to provide sufficient international liquidity.
Countries need to rely on sufficient financial
reserves to meet sudden shocks.
The post-Bretton Wood
international monetary system
• Fixed exchange rates broke down in 1971. What
followed were fluctuating exchange rates with no
general rule on exchange rate adjustments.
The dollar remains the key reserve currency,
although the system is based on some cooperation
among the FED, the European Central Bank (the
Bundesbank before 1999) and the Bank of Japan.
• The IMF act as regulator of the world international
monetary system.
The post-Bretton Wood
international monetary system
• Many countries have chosen either to create monetary
unions (the euro), or to peg their currencies to the dollar
(dollar peg as in many South East Asian countries
before 1997).
• Some countries manage their currencies with currency
reserve boards, which means relinquishing control to
the IMF, which will cover their money supply with
dollars (for example Hong Kong in the 1990s, and
Argentina in early 2000s).
The International Monetary Fund
• The International Monetary Fund (IMF)
oversees exchange rates and balance of
payments. It offers financial and technical
assistance when requested.
• Its headquarters are located in Washington D.C.
and offices around the world. It has currently 185
members.
• It came into existence in December 1945, when
the first 29 countries signed its Articles of
Agreement.
The International Monetary Fund
• An unwritten rule establishes that the IMF's
managing director must be European and that
the president of the World Bank must be from
the US.
• The IMF is for the most part controlled by the
major Western Powers, especially the US, with
voting rights on the Executive board based on a
quota which reflects its monetary stake in the
institution.
The post-Bretton Wood
international monetary system
• The desirable objectives of the international monetary
system are.
• 1) exchange rate stability.
• 2) being able to run an independent monetary (and more
broadly economic) national policy, for example a fiscal
deficit when needed to boost economic growth.
• 3) enjoy freedom of capital flows, in order to have a
more efficient financial system, international investment
etc. As we shall see this third point is now being
challenged.
The post-Bretton Wood
international monetary system
Desirable objectives of IMS:
• 1) exchange rate stability;
• 2) independent monetary policy;
• 3) free capital flows.
• The three objectives however are incompatible,
only two are achievable at the same time.
• Under Bretton Woods there was 1 and 2, but not 3.
• Currently most countries, have 2 and 3, but not 1.
• The Euro means that each UE member state
enjoys 1 and 3, but not 2.
Flexible, fluctuating exchange rates
• Pros
• They prevent currency
misalignments
• Allow countries to
conduct independent
monetary policies
• Cons.
• They produce too
much fluctuations on a
day-to day basis:
volatility.
• They produce long
periods of currency
under or overevaluation, distorting
trade.
International monetary system: alternative
solutions
Possible alternatives:
•Return to gold. Advocated by extreme neo-liberals.
•Managed currencies. Imply limitations to the free flow of
capital. see Tobin tax.
•Regional monetary Unions.
•Currency pegs.
Financial markets are central
• Well functioning financial markets are a central
feature of a modern market economy. They allow
resources to be taken from people who do not
need them or can not use them to people who need
them and can use them.
• 1) they mobilize savings, 2) they allocate capital,
to finance investment; 3) they pool risk and
distribute risks to those who can bear them; 4)
they monitor managers.
Financial markets are risky and fragile
• Financial markets are fragile and vulnerable.
• They suffer from inadequate information.
• Banks have short term liabilities in domestic or
foreign currency, which are payable on demand,
while most of their assets are long-term, and
subject to fluctuations.
• Financial markets are liable to wild swings in
prices. They tend towards herd behaviour.
Capital flows in the global economy
Under Bretton Woods countries controlled their capital
market. Free capital flows started to materialize
• with the Eurodollar market in the 1960s. After the end of
Bretton Woods the situation gradually evolved with:
A) Liberalisation of financial markets. Scrapping of capital
controls.
B) Innovation in financial instruments (Derivates etc.)
Today huge amounts of capital is exchanged every day on
the foreign exchange market: in 2007 the daily volume of
foreign currency transactions was $ 3.2 trillion.
Liberalization of capital markets in the 1980s
and 1990s
• Since the late 1980s the IMF became a
strong supporter of free capital markets: it
advised countries that came under its
influence to dismantle controls over crossborder lending and borrowing.
• The removal of capital controls would
increase the demand for services from the
City and Wall Street. The US and Britain
pushed for capital liberalization.
Liberalization of capital markets in
the 1980s and 1990s
• The EU during the 1980s turned towards capital
liberalization. During the late 1980s capital
controls had been removed in all the major
European countries. Free capital movements were
enshrined in the Maastricht Treaty.
• The OECD adopted free capital flows as part of it
Code of Liberalization of capital controls. New
member countries, such as Mexico and S.Korea,
adopted the Code.
Global finance: new developments,
opportunities and risks
• Today’s global financial movements are different from
those of the past, since they have no relation with
international trade.
• Financial globalisation has made all national economies
closely interdependent. It has also made available vast
financial resources for developing countries.
• A large share of global finance consists of short term
capital flows, which by definition are highly volatile and
speculative. Speculators can attack currencies whose
exchange rate is deemed to be non-credible.
Free capital flows
• Pros
• They improve the global
allocation of resources
• They provide an incentive
to governments to pursue
sound fiscal monetary
policy
• Cons
• International capital
markets do not allocate
resources efficiently.
Speculators and investors
tend to be irrational and
short-term.
• Global finance is
unregulated and lacks
institutional support
(standards, supervision,
lenders of last resort.
Tobin tax
• Already in 1978 James Tobin (a keynesian
economist from Yale) criticized “excessive”
financial capital mobility. These flows constrained
the ability of governments to pursue adequate
domestic economic policies.
• He recommended a tax on international currency
transactions: consisting in a small levy on each
transaction.
• Tobin met with considerable opposition but his
suggestion is being reconsidered in the light of the
recent massive global financial crises.
Financial crises: general outline
How do they break out?
•Speculation fuelled by euphoria over the performance
of a single sector or of a particular country’s economy
(herd psychology)
•Rise in profits and in investment.
•Prices rise and the velocity of exchanges accelerates,
generating a boom.
Financial crises: general outline
• Ad one point the bubble bursts. This can be the
result of a single event such as a bank failure or a
corporate bankruptcy.
The large increase in prices and profits suddenly
goes into reverse gear.
Overreaction generates a “run on the countries”.
Banks stop extending credit, and in fact demand
payment for the credits they earlier had granted,
i.e. there is a credit squeeze. Foreign capital moves
out. Currencies are forced to devalue.
Financial crises
1970s- early 1980s: Crisis in developing
countries, especially Latin America.
Build-up of high debt levels with Western banks, which had
used their lines of credit to recycle Petrodollars.
Starting in 1979, Paul Volcker, the Fed Chairman, raised
interests drastically to fight US inflation.
International banks followed suit, raised interest rates and
the unsustainable debt of many countries position was
exposed.
Japan: crisis of the 1990s
• At the end of the 1980s real estate prices rose by three times,
producing a real estate bubble. This uncovered one of the unspoken
factors of the Japanese economic miracle, i.e. the power of big
speculators, with ties to the criminal world as well as top politicians.
• Japan’s Central Bank responded first by raising interest rates and this
determined a steep fall of house prices in 1991. This was not,
however, accompanied by economic recovery, rather it was followed
by a creeping recession.
• In the next stage, interest rates were lowered, down to zero, in order to
jump start the economy. The State launched big public expenditure
programs, borrowing large quantities of money.
• The economy did not react as hoped. Japan’s economy was based on a
low rate of private consumption. GDP growth rates remained low,
below the economy’s growth potential. In other workds Japan had
fallen into a deflationary trap.
Japan’s growth rate.
Japan’s economic crisis
• Japan’s economic problems were compounded by the fact
that its banking sector became heavily indebted.
• Stagnation also meant a rise in unemployment, which
reached 5% of the work force. Investment and
consumption both were flat or negative.
• Reflationary policies proved too weak.
• Reforming the economy proved difficult, because of over
regulation and structural rigidities.
• Japanese society resisted steps towards liberalization. The
Japanese social model was called into question, but
reforming it was slow and painful.
Japan’s economic crisis in the 1990s
• Two mistakes in economic policy (Krugman):
• A) Government did not act consistently. In 1997 after a few
years of slow recovery, fears were raised about the rise in public
debt due to government deficits and projected pension costs. As a
result taxes were raised, growth was throttled and the country
plunged again in recession.
• B) Politicians failed to address the real weakness which lay in the
banking system. Banks had suffered from the fall in real estate
stock and, following that, they had exposed themselves by lending
to the State. Protracted recession compounded the problem.
• Recapitalization of the banks was carried out in 1998, with a State
injection of $ 500 bn.
Japan recovers?
• First signs of recovery of the Japanes economy
had to wait until 2003. In that year GDP grew by
more than 2% and the deflationary spiral began to
loosen.
• Japanese exports benefited from the rise in US
trade deficit and from the strong performance of
China. Big flows of Japanese FDI to China.
Interest rates remained very low, leaving Japanese
monetary policy almost defenceless against the
new economic crisis of 2008.
Financial crises – 1990s
• 1992-3 Crisis in the European Exchange Rate
Mechanism. (ERM). The Italian Lira and the
pound sterling devalue.
• 1994-5, a boom in Mexico attracts short term
capital flows from the US.
In December 1994 the Mexican peso devalues,
following an abrupt crisis of confidence in the
Mexican economy. President Clinton leads a
recovery effort, sustained by US Treasury funds as
well as by the IMF. In 1995 Mexico’s GDP fell by
6%.
Financial crises –East Asia
• 1997-2000 – Crisis in South and South-east
Asia. Possible background causes: growing
Chinese competition with the exports of the
Asian Tigers casts doubts on the durability
of the boom. Overvaluation of Asian
currencies.
The origins of the Asian crisis
• Asian economies had liberalized their capital markets
since the early 1990s. This factor is seen by some as the
origins of the subsequent financial crisis.
• Rapid capital liberalization was deeply unsettling to the
paradigms of the Asian model, which was based on
government “soft control” of the economy.
• Liberalization was not accompanied by regulation, i.e. by
new rules and standards to govern capital markets (for
example transparency, reserve requirements for banks
etc).
• The combination of semi-fixed exchange rates (dollar
peg) and capital liberalization was also potentially deeply
unsettling.
The origins of the crisis
• The Asian capitalist model is different from the American
or European models. Although each country had its own
specific features, there were some common trends. The
Asian model can be described as a developmental State,
based on close links between the government, banks and
other businesses in the industrial and service sectors. Often
loans were granted on a personal basis, on the basis of
close connections  hence the term “crony capitalism”. A
more benign interpretation speaks of “alliance capitalism”.
• Bad loans of Asian banks had reached astronomic
proportions.
The origins of the crisis
• There was a strong resistance to liberalization of
inward flows of FDI, which possibly aggravated the
crisis. South Korea for example, even after the crisis
has broken out, ruled out allowing its banks to
borrow long-term, rather than short term. Although
short term debts were one of the keys to the current
crisis, long term borrowing meant leaving the door
open for FDI to penetrate the S. Korean economy.
• Many bad or dubious debts were concealed to
everybody until the end.
Asia’s financial crisis: 1997-8
• Japan had already incurred into financial and
economic difficulties since the early 1990s.
Japan’s crisis had originated from bad loans of
its banking system and had developed into a full
scale recession, with a protracted fall in the
economy’s demand.
• Speculation on shares is hit by a crisis of
confidence. In the preceding decade, high
growth rates had been customary for South East
Asian countries. This record of success prevents
a stronger reaction to the crisis.
Asia’s financial crisis: 1997-8
• Throughout the 1990s East Asia was booming. Large
inflows of foreign capital, about $90 bn. a year of short
term capital fuel the boom, plus FDI inflows as well.
• By 1997 prosperity brought its own problems, there was
rising prices and exports from East Asia faltered.
• Banks were becoming highly indebted. There was a real
estate bubble. At this point investors got nervous and
started moving out their capital from these countries.
• This generated a sell-off. Currencies devalued. Stock
markets collapse and the real estate market crumbled.
• The outflow of foreign capital from Indonesia, Maleysia,
the Philippines, S. Korea and Thailand in 1997 was $12
bn. From net creditors they turned net debtors (-$100bn
,io.e 10% of their combined GDP).
Chronology of the Asian financial crisis
Thailand had benefited from dollar and yen loans, converted into
baht to speculate in local real estate and other assets.
International banks and hedge funds poured money into
Thailand. By 1996 doubt began to creep in: were these loans
secure? Selling of baht assets into dollars commenced. To
counter the impending crisis and maintain the value of the baht,
the Thai central bank raised interest rates. However higher
interest rates reduced the demand for real estate and brought
prices down. Selling of the baht increased and the Bank ran out
of dollars to support the baht.
July 1997- Thailand dropped the baht-dollar peg, leaving the
bath free to float
August 1997- The IMF grants a 17 billion dollar
loan to Thailand. Indonesia prime minister blames
foreign speculators for the crisis
October 1997. The Hong Kong stock market falls
by 25% over just 4 days and a few days later falls
by another 5%. Shares fall all over the world,
including on Wall Street. The IMF approves a
rescue package of 42 billion dollars for Indonesia.
November 1997: The crisis spreads to Brasil. The
South Korean currency, the won, crashes. In
Japan Yamaichi Securities collapse, revealing
how the acute problems of the Japanese
economy have not been solved.
December 1997 . Fears for the South Korean
economy dramatize the crisis. The IMF grants a
huge bailout loan of 58 billion $ to South Korea.
January 1998. The IMF and the Indonesian
government agree on a package of economic
reforms while Indonesia sinks deeper.
April 1998. Signs of crisis in Japan. New
agreement between the IMF and Indonesia. The
US Congress criticizes the IMF’s role in the Asian
crisis.
May 1998. Student revolts in Indonesia. Amidst
further economic trouble, the Indonesian
president, Suharto, resigns.
January 1998. One of the most important
investment banks in Hong Kong, Peregrine
Investments Holding folds. However despite
renewed heavy losses on the stock markets in
the entire region, the Hong Kong dollar resists.
Monetary policy in H.K is managed through a
Currency Board, which backs the money supply
with of US dollars. Also China is prepared to
support the Hong Kong dollar with its own vast
monetary reserves. Speculators retreat.
May 1998: devaluation of the ruble. Bad news from
Russia sparks a wave of panic on world markets,
with a sharp fall in Wall Street. Brazil’s currency,
the real, comes under attack
October 1998. The IMF, strongly backed by the US
Treasury, grants Brazil a huge, 40 bn. $ loan,
demanding a change in Brazil’s economic policy
and further market reform.
January 1999: failure by Brazil to carry out
economic reform leads to a 35% devaluation of the
real and the flight of investors.
China and India escaped the crisis. Their capital
markets had remained closed
Asian financial crisis: 1997-8
•Exchange rates in Asia were semi-fixed and pegged to the dollar.
Countries did not have the credibility however to maintain their dollar
peg, and this encouraged speculators.
• Governments acted to defend their overvalued exchange rates by
raising interest rates. This hurt domestic businesses, while
international investors were facilitated.
•There was a flight of capital away from local currencies to the dollar,
pushing them to devalue.
•Domestic banks were exposed, having taken out large dollar loans; a
weaker domestic currency meant paying a higher dollar rate.
• Moreover they had borrowed short and loaned long-term to domestic
businesses.
Asian crisis: the IMF steps in.
• The IMF followed a bailout strategy. It granted
substantial loans to the countries hit by the crisis and at
the same time it imposed upon them a strict medicine of
structural reforms. Ailing banks and firms were shut
down.
• The economies were supposed to eliminate any
remaining barrier to foreign capital. Budget discipline
meant drastic cuts in expenditure. Cuts in subsidies hurt
the poor and caused social unrest.
Asian crisis: the IMF steps in
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The IMF prescription included the following elements:
Cuts in public expenditure
Higher interest rates
Currency revaluation and stabilization
Structural reform, especially bank mergers.
Improvement in accounting standards
Opening the market to foreign acquisitions.
Cuts in subsidies.
The IMF package caused deep resentment in many South
Asian countries. Many countries resisted to what they saw
as US-inspired measures to destroy the Asian model.
Debates and recriminations
Was the IMF prescription correct?
According to Stiglitz the Asian crisis was different from the financial
crises in Latin America during the 1980s. Whereas in Latin
America the problem had been inflation and debts in the public
sector, in Asia public finances were in good shape, whereas the
corporate sector was badly in debt.
The solution therefore should have been different, and should not
have included budget cuts and austerity measures. It should have,
instead, concentrated on macro-economic stability, and in
corporate restructuring.
Rather than imposing austerity, the IMF should have let corporations
pay the price of their profligacy, by allowing exchange rate
devaluation. Interest rates should not have been raised.
Financial crisis in Asia: debate
Left wing critics: They blame the IMF for its arrogance
and insensitivity and for its neo-liberal ideological
approach. The IMF proved to be the tool of international
finance, and its prescriptions followed the wishes of the
US government and Wall Street.
Right wing, free market critics, the IMF should not have
spent so much money bailing out speculators.
Financial crisis in Asia: debate
The IMF defence. Only a strong IMF package stopped
the crisis from damaging the entire world economy.
According to Martin Wolf the IMF was made the
scapegoat, while responsibility for bad economic
management rests with governments.
It is reasonable and consistent that the IMF should
follow to a certain degree the will of its paymasters,
i.e. the lending nations. If it were to act otherwise
creditors would stop funding it and would seek to
manage their relations with debtor countries
bilaterally.
Proposals and remedies.
Gilpin believes that short term capital flows should be regulated.
A tax could be levied to discourage speculation. Other observers
think this solution – called the Tobin tax -both impractical and
unreasonable.
The Asian crisis highlighted the need for better international
rules. Prescription on bank reserves were introduced through the
Basel convention. Proposals were floated for an international
bankruptcy procedure.
It remains true that the international financial system is the
weakest link in the global economy and that its governance is
very weak and contested.
Outcome of the crisis
• Of the five most affected countries, Malaysia, the
Philippines, S. Korea, Thailand, Indonesia, in 2001 only
Indonesia had failed to recover previous GDP levels.
• South Korea, on the other hand, had experienced GDP
growth of over 20% on its pre-crisis level. The aggregate
GDP level of the five was 13% higher than in 1996.
• The quick recovery suggests that the crisis was mainly
financial. Economic fundamentals were not to blame.
Global finance is a factor of instability (Roderick)
Argentina 2001
• Argentina had pegged its currency to the dollar,
but the peso weakened and to sustain the peg it
was necessary to raise interest rates, causing an
economic recession.
• An aggravating factor was the fact that the
Brazilian currency depreciated against the dollar,
as did the euro, causing all kinds of problems for
Argentinean exports.
• The peg could not be sustained, and the currency
was devalued and following from that there the
country defaulted on its debts.
The 2007-2010 crisis. The origins.
• Long term. Structural imbalances in the world
economy, with USA and China.
• Greenspan’s two bubbles:
• A) The new economy bubble (dot.com) burst in 2000
determining a sharp fall in the stock market and a domestic and
international recession. The Fed reacts with aggressive cuts
interest rate cuts.
• B) The real estate bubble was a consequence of very low real
interest rates after 2001. There was a boom in risky mortgage
lending. Dubious loans were securitized as widely traded
instruments. Speculative activity was fuelled by the rise in
prices.
The 2007-2010 crisis. The origins.
• The financial crisis in the US was centered, at least
initially, not on the big commercial banks, but on the
informal or shadow unregulated financial sector, (hedge
funds, futures, money markets and corporate bond
markets), where a huge amount of transactions was carried
out. The size of the informal market in 2007 amounted to
various trillion dollars, much larger than the formal
banking sector. Also the big investment banks Goldman
Sachs, JP Morgan, Lehman) were heavily involved in it.
• After the Great Depression, up until the 1980s, the
majority of financial transactions were carried out by
institutions supervised by the FED.
• After the 1980s, a parallel market without formal rules and
no supervision, highly leveraged, had grown in size and
importance.
The financial crisis spreads.
• The growth in short term capital movements
has encouraged the spread of the crisis in
many countries, with serious effects in some
emerging economies. Iceland, the Ukraine,
the Baltic States all requested IMF help.
Other countries followed
The crisis and the lessons of the past.
• The current crisis includes a number of features of
the previous financial crises.
• A) the real estate bubble (Japan, end of the 1980s)
• B) collapse of the financial system (Great
Depression 1929-31)
• C) deflationary trap in the USA and in Western
Europe (Japan 1990s)
• D) waves of international speculative hot money
and competitive devaluations. (South East Asia,
1997-1999)
• What was the ERM (Exchange Rate
Mechanism) and how did it work?
• What is the 1987 Single European Act ?
• How did the process of German unification
affect the progress towards EMU?
• Why were convergence criteria established
by the Maastricht Treaty ?
• How important has the enlargement of the
EU from 15 to 25 members been for the
global economy?
• Was the creation of the Euro in 2002
beneficial both for the member states and
for the global economy or was the Euro a
flawed project from the start?