International Political Economy-- International Debt and Financial Crises Professor Yu Xunda 2013. 05 Suggested Readings Clive Dilnot. “The Triumph of Greed,” New Statesman, December4, 2008. Barry Eichengreen. Globalizing Capital: A History of the International Monetary System. Princeton, NI: Princeton University Press,1996. Dani Rodrik. “Goodbye Washington Consensus, Hello Washington Confusion?” Journal of Economic Literature, XLIV(December 2006), pp.973-987 Jeffery Sachs. The End of Poverty: Economic Possibilities for Our Time. New York: Penguin,2006. Robert Wade. “The First-World Debt Crisis of 2007-2010 in Global Perspective,” Challenge, July-August 2008,pp.23-54. Page 2 Content 8-1 The Debt Crisis of The 1980s 8-2 The Asian Financial Crisis 8-3 The Global Financial Crisis of 2007 Page 3 1. The Debt Crisis of The 1980s The first LDC debt “crisis” began in 1982, when Mexico announced that it would default on its bank debt, generating fear that other countries with substantial debt, such as Brazil, would follow Mexico’s lead. Huge financial flowed from the North to the South, especially those LDCs. Page 4 1.1 The Reasons ----(1) Why? ----totally, the globalization of financial flow which powered by market deregulation and technological change ----for the North: financial centers in the industrial North increasingly sought new investments possibilities and higher returns. While those scare resources, low-cost labor, favorable economic development policies in LDCs all favored new investment opportunities.. ----for the South(LDCs): they were receiving less financial assistance from ODA sources. inflation rates were running ahead of interest rates on loans—creating negative real rates, which traditionally favor borrowers. Page 5 1.1 The Reasons ----(2) However, the uncoordinated actions of the market generated a “debt trap” for both debtor states and their creditors. In retrospect, too much was loaned to too many. International banks continued to make additional loans to states with growing debt both to provide more resources for economic development and to sustain interest payments on earlier loans. With so much debt outstanding, the banks were in as much trouble as the debtor nations. Debtor nations owed more than they could reasonably reply, yet they continued to borrow more in order to meet their short-run obligations. In essence, debtor states only refinanced their loans and stretched out the time period for repayment of the loans. Most states restrained imports and promoted exports to generate income. But at last, only Korea and Turkey recovered, other went deeper into the red. Page 6 1.2 Measures: ------- (1) US’s Baker Plan US’s Baker Plan -------------to implement market-oriented structural changes to debtor economies combined with $20 billion in new loans, provided by commercial banks over three years. However, it did not work. As countries tried to expand their exports all at once, commodity and oil prices collapsed, leaving many nations (especially African countries) worse off than before the loans. By the late 1980s, many debtor states faces “donor fatigue,” whereby social and political tensions related to policies adopted to relieve the debt grew and dissatisfaction with international debt management festered. The U.S. Treasury secretary James Baker Page 7 1.2 Measures: ------- (2) debt swaps were employed in some cases. Then debt swaps were employed in some cases. -------some amount of debt could be swapped with a bank in exchange for land or valuable properties in debtor countries. However, the banks found themselves unable to grant debt relief in this manner, since they were caught in a situation referred to as the “prisoners’ dilemma”. Finally, given the high stakes and the intensely competitive nature of international finance, no one state or bank was willing to forgive LDC debts, and the vicious cycle of debt for these nations continued. Page 8 1.2 Measures: ------- (3) The Brady Plan As cooperation can be encourages by a hegemon, whose share of the resulting gains is so great that it is willing to bear the costs of organizing a cooperative effort--------the U.S. In 1989, President George H.W. Bush initiated the Brady Plan-----whereby old debt was exchanged for bonds that could be exchanged for new bank loans. Under this scheme, Mexico benefited from some debt relief, the banks reduced the risk of default, and the U.S. government avoided increasing international financial instability. While to honor such huge debt and interest burdens would have required harsh mercantilist policies restricting imports and expanding exports, generating problems in the industrialized nations that rely on LDCs to import some of their manufactured goods. The discipline and sacrifice necessary for LDCs to service their debt often generated much social and political unrest, including strikes and riots. Page 9 1.3 Debt Crisis and a New Role for the IMF During the mid-1980s, the U.S.pushed the IMF to work closely with the World Bank on solving LDC debt problems. Washington Consensus emerged as the best strategy for developing nations. According to the neoliberal ideas of the Reaganism, debt would be overcome as economies opened up and integrated into the growing global economy. The role of IMF then shifted away form “helping member states deal with balance-of-payments problems” into the “lender of last resort” in the international economy an institution that could help nations pvercome their debt burden. Page 10 1.4 The logic of the IMF’s policies The logic of the IMF’s policies was to reduce the current account deficit by increasing exports and reducing imports and simultaneously help finance the capital account by stemming capital fight and limiting new borrowing needs. In the long run, these policies were also intended to encourage economic growth, creating a situation in which the nation can repay its old debts and be less dependent on credit in the future, In the short run, the debtor-nation government was expected to enact policies that at first lowered living standards and imposed hardships, especially on the poor, in some cases leading to violence and civil unrest. In practice, the relationship between the IMF and those debtor nations was often conflictual. Page 11 1.5 A Balance-of-Payments Financial Crisis Definition: states borrowed too much money to use for development projects or pay for imports. This type of debt stems from many of the transactions states conduct every day. Capital fight: when investors transfer their bank accounts out of the country to “safe harbor” nations. In turn, it creates an extreme shortage of funds in the debtor nation’s banks, which sends national interest shooting up. Debt problems related to a balance-ofpayments crisis brought on by speculation and capital fight can disrupt and distort trade and international financial relationships. Page 12 2. The Asian Financial Crisis The crisis started on July 2, 1997, when Thailand’s currency , the baht, suddenly collapsed in value. It started a chain reaction of economic, political, and social effects, together referred to as the Asian financial crisis because it spread to Indonesia, Malaysia, Taiwan, Hong Kong, South Korea, and elsewhere in the region. It raises questions abut the trade-offs surrounding speculative attacks in a more integrated global monetary and finance structure. Page 13 2.1 Whole Process of the Asian Financial Crisis Whole process 1. The government’s exchange-rate pledge -2. A business bubble ---- 3. Bad loans -----4. Disinvestment -5. A hedge fund ----- Eventually, on July2, 1997, the Thai government was forced to abandon its pledge. And at last, the new exchange rate was about 50 baht per dollar, with similar collapses in other Asian countries. For many, the Asian crisis was an economic collapse similar to the Great Depression. Page 14 3. The Global Financial Crisis of 2007 By September 2008, the U.S.real estate-mortgage problem had resulted in a full-blown crisis that quickly became a global financial debate, essentially freezing the circulation of credit within and between states. financial turmoil: Some of the world’s largest financial institutions had either gone bankrupt, been nationalized, or been rescued by the government. a deep global economic recession with dizzying job losses, record home foreclosures, and a substantial increase in poverty. Public confidence in governments’ handling of economic affairs faltered. Page 15 3.1 Why did this happen? Some often-mentioned causes include: A global economic imbalance rooted in a U.S.balance-of-payments problems. A U.S.regulatory regime that led to excessive debt and imprudent lending practices of banks, mortgage companies, and other financial institutions. A myopic ideology that promoted globalization and the “magic of the market” without accounting for market failure and the impact of deregulation on financial institutions. The irrational, unethical, and even illegal behavior of some individuals and companies. Weak global governance Page 16 3.2 the Run-up to the U.S. Financial Crisis The shift of ideology: From 1930s to the 1960s, Keynesianism. In late 1960s, in pursuit of economic growth, the orthodox economic liberal ideas (OEL) gradually replaced the Keynesianism. In 1973, the U.S.adopted a more economic liberal outlook and replaced the fixed-exchange-rate system with a flexible-exchange-rate system, which lead to increased speculation on currencies and more money circulating in the international economy. In 1980s, Reaganism and Thatcherism In the late 1990s, stock prices skyrocketed and the development of new technologies and communication systems enhanced market activity. By the end of 1990s, many nations were competing to attract huge amounts of unregulated “hot money”. In 1999, the U.S repealed the Glass-Steagall Act. Even the dot-com investment bubble burst in 2000 and 2001 did not change the liberal ideas. Page 17 3.3 Structural problems’ role in 2007 The U.S.was running a huge trade deficit with China, Japan, and other exporters who had been financing this deficit by buying enormous amounts of U.S.stocks, Treasury bills, etc. The U.S gradually built up an unsustainable level of personal and public debt. Structural problems’ role in the onset of the financial crisis in 2007 The Federal Reserve lowered interest rates following the dot-com bubble burst, making it easier to buy a house on credit. Subprime mortgage loans are believed to allowed to have caused many buyers to make irrational decisions often based on incomplete (hidden) information. Deregulation allowed making the “bid deal” to overshadow careful risk assessment. Page 18 3.4 the Bubble Bursts By early 2007, a slew of large mortgage companies with significant portfolios of subprime loans—worth $13billion or 20%of U.S.home lending—failed for bankruptcy. Home mortgage markets in other countries, including the UK and Japan, began reflecting the same trend occurring in the U.S. By August 2007, a worldwide credit crunch grew amongst banks and hedge funds that held a vast amount of mortgage-backed securities. Troubles at many financial companies around the world unfolded and mounted through the end of the year. The real estate bubble -began to tear in July 2008 after panicky investors started unloading their stocks in the state-created Fannie Mae and Freddie Mac loan agencies, which together owned or guaranteed $6 billion of the $12 trillion mortgage market in the U.S. Page 19 3.5 Congress ----”rescue plan” But investors were rapidly losing confidence and began disinvesting the U.S.real estate and stock markets. Impacts: Ripple effect:speculators left real estate and focused on hot commodities like oil, gold, rice, and wheat, etc, causing the ripple effect of high energy costs on consumers and business. Herd effect: when big banks began to fall. The herd effect took over and investors scrambled to disinvest in U.S.mortgages and other securities. Contagion effect: a border global financial crisis spread all over the world. Page 20 3.6 We Are All Keynesians Now As the fear of not only a recession but a second Great Depression mounted, more and more people began to sound like Keynesian HILs than Milton Friedman OELs. Although many OELs preferred to let the market run its course, culling a number of big banks and letting the strongest ones survive. But most HIL and mercantilist-oriented officials supported a quick injection of new national bank monies in the hope that this would unfreeze the U.S.and global monetary and financial systems. Page 21 3.7 Contagion Takes Over By October, the crisis was spreading through Europe. By December 2008 the global economy was clearly in a recession as reverberation from the financial crisis continued to rock both Wall Street and Main Street. Most countries agreed to further cut interest rates to stimulate the world economy. Many states, especially those emerging economies, more and more involved in negotiations to solve the crisis. Many officials focused on encouraging emerging economies like China and Saudi Arabia to invest in real estate and home mortgages in the U.S.and other industrialized nations. In effect, globalization would work in reverse, helping rescue the developed nations while making them more dependent on the developing nations. Page 22 3.8 Riding Out the Storm Since late 2008 almost every member of the G20, including the U.S., implemented a large government-spending program. In April the U.S and other G20 countries pledged $1.1 trillion to deal with the financial crisis, including $750 billion in additional funding for the IMF. ---------By the end of summer 2009 it seemed that the worst of the crisis was over. However, many structural problems remained and new ones loomed ahead. Many poorer countries in the world are likely to struggle with the effects of the financial crisis longer than the wealthier countries Bring large numbers of people living in poverty to over one billion; Many countries are adopting more protectionist policies that threaten the growth of global trade and incomes of Southern exporters. Page 23 Discussion Questions Compare and contrast the three different types of debt problems that were discussed in this chapter in terms of (a) the source of the debt, (b) the major actors in each situation and their interests, and (c) how the situation was resolved, if it was. Why so much fuss over speculation? Why do you suppose Keynes would be concerned about it today? Explain the connection between debt that results from borrowing money and the debt associated with a deficit in the balance of payments. Use examples from the readings. Which of the main causes of the financial crisis offered in this chapter do you think best explain it? Justify your answer. Explain the role of the IMF in helping to solve these balance-of-payments crises. Do you feel the IMF could do more? Why? Why not? Page 24 Thank You !