Global Economic Policies and Institutions - IRGA - Simona Beretta - 2022/2023, Appunti di Economia Politica

Scarica Global Economic Policies and Institutions - IRGA - Simona Beretta - 2022/2023 e più Appunti in PDF di Economia Politica solo su Docsity! Global Economic Policies and Institutions – Anna Natalia Rodriguez 1 GLOBAL ECONOMIC POLICIES AND INSTITUTIONS – 2022-2023 Global Economic Policies and Institutions – Anna Natalia Rodriguez 2 GLOBAL ECONOMIC POLICIES AND INSTITUTIONS Stylized facts in historical perspective Any transactions has two sides. Money and finance go hand in hand because you can buy something now but you pay later. The two interact in a physical space which is also a time space. We make decisions that govern our future transactions. Trade and finance are interconnected in daily and global level. We need time and space and time includes historical thickness which means that there were periods in which things were in one way and then changed; we need to understand how trade and finance interconnected in a long period and were more or less successful. During the pax Britannica it wasn’t very successful for example. Everybody knew which were the rules of the game even though not everybody played. Money was based on an ongoing and secular debate on whether they should use gold or silver as a basis for money and in this period, UK jumped above the others because of the industrial revolution. This had big macroeconomic consequences. Hence everybody started using gold because they saw a premium in trading with UK. Britain led everybody to use their way because it was a way to relate to them but also because it was a way to mimic the best institutions that were around at the time. However, pax Britannica ended badly with a war that deeply transformed the coming century. People had similar experiences at the beginning of the 90s after the berlin wall was dismantled and there was a new world; people put the seeds of all the income systems of the 20th century with the idea that there was one successful form. Something like the pax Britannica situation happened at the end of the 20s by having institutions that implied that one size of economic policies could fit for all. If we read the details, the institutions both monetary and financial that accompanied pax Britannica were already in crisis before the beginning of the war. The financial crisis of 2007-8 wasn’t taken seriously and this was the sign that something wrong was about to happen. WWI was significant in economic terms because it was the first war that brought people to have financial problems. It was very expensive because of the airplanes but also for other reasons. Countries had to experience some new tricks and they used the old ones like printing money which we know is not very useful. The war had outcomes that depended on the use of economic policies that created consequences like economic instability, nationalism, economic conflicts between countries which led to WWII. After that there was the pax Americana and this period gave an unprecedented boost to growth. Nation states took different steps so to have some structural asymmetries and therefore one size policy can fit all. The industrial revolution led to asymmetry because its nature is technological advances that once built int the productive process deeply transform the material basis of the economy in a way that follows the logic of the economies of scale: once you implement in a small scale, you get so much productivity gain that you make more profits compared to the neighbors that don’t have it. this leads to friendly or unfriendly acquisitions or if the environment is relatively competitive meaning that the tech is new but the products is the same as those that use traditional tech, then the costs are lower and this means that the producer could sell at a cheaper price and then this means more clients and have even more technology in a self-cumulating transformation. This is a sort of deep asymmetry that can be overcome. During the industrial revolution this was experienced in many sectors and created many asymmetries at the time. Pax Britannica was the evidence of the fact that UK during the industrial revolution was growing at a fast pace and was developing institutions that other countries could not reach but at the same time UK was giving the example. The time for the rest of Europe to catch up was long but measurable in decades. The time that is necessary for a gap to be closed has to do with non-material elements and not only resources and things. Countries with incredible land productivity has problems to give all the people food. One of the most important things in non-material elements are knowledge and institutions and one of the most important economic institutions in the UK at the time was money because it was the radical change from barter. There are different forms of money and tokens that show that what was used for paying. the other economic institution that was very important was finance and markets that together with money go hand in hand and are fundamental. Markets allowed to share common understanding of how the society works and about having the possibility to deal with people that you don’t know and in which you can trade. Markets allow to trade under a regime which gives rules to everybody that interacts in it. trade money and finance in that period fit together in a clear way because there was the division of the world in different spheres of interests Global Economic Policies and Institutions – Anna Natalia Rodriguez 5 • Democracy is ruled out (middle row): Hyperglobalization policies can only be implemented by the national government if the citizens’ opposition to them is weakened by a dilution of democratic processes. • National sovereignty is ruled out (bottom row): If hyperglobalization policies are accompanied by supranational institutions that can prevent a race to the bottom in environmental and labor standards, for example, and therefore gain democratic support, this restricts the ability of countries to choose national policies independently. A way of understanding the bottom row is to think of existing arrangements in a federation like the US or Germany. There is free flow of goods, investment, and people across states of the federation. The race to the bottom is prevented by federal legislation and by democratic elections at federal level. This restricts the ability of the states to implement policies that would interfere with the benefits of ‘hyperglobalization’ across the whole country, with the protection of standards and the operation of stabilization policy. A second example is the political integration of Europe over the last few decades. It happened, in part, so that governments could obtain the benefits of free trade, plus the free movement of capital and labor, while retaining some ability at the supranational EU-wide level to regulate profit-making in the interests of fairness and economic stability. The obvious problem is how to make sure that this EU-wide or global governance is democratic as well as technocratic, and to allow voters to change the system if they don’t like it. Other supranational governance initiatives include world agreements on climate change, and efforts by the International Labor Organization to require that all nations meet at least minimal standards for the treatment of labor (eliminating child labor or the physical coercion of employees, for example). The political trilemma of the world economy The trilemma refers to three things that are in relation in a problematic way and each of those things are very valuable and important but cannot occur at the same time: 1. Hyper globalization: a world in which there are virtually no political or cultural barriers to the location of goods and investment. All countries wanted to have the possibility to produce pieces and bits of products in the place where it costs less. 2. Democracy within nation states: This means that the government respects both individual liberty and political equality. 3. National sovereignty: Each national government can pursue policies that it chooses without any significant limits imposed on it by other nations or by global institutions. We still have nation states and sovereignty is important because states want to keep control on how to provide services for their own citizens. Governments wish to pursue policies without limits of other countries or institutions limitations. In 2000 there was the memory of countries that faced financial crises and needed financial helps which came with conditions that were okay in principle but in reality, were very costly. The globalization paradox in the advanced countries Legitimacy and efficacy both require effective regulatory state. Hyper globalization undermines regulations like financial regulations or product safety rules; tax regime like income and capital taxes; domestic norms and institutional practices like employer-employee bargaining. Once again, globalization works best when it is not pushed too far like when domestic policy authorities retain adequate policy space. We can respond by: 1. ignoring the problem and pushing for deeper globalization → at the cost of aggravating the underlying of domestic rules Global Economic Policies and Institutions – Anna Natalia Rodriguez 6 2. harmonizing rules across countries → at the cost of imposing ill- fitting rules on all 3. restricting the scope of globalization → at the cost of giving up on some of the gains from trade These bring us to the trilemma. The history of globalization viewed through the prism of dilemma The gold standard was a hyper globalized world. The national sovereignty produced the golden straitjackets: countries needed to keep a fixed proportion of money and gold amount limiting the possibility of intervening in economic terms and hence narrow domestic policy space in all sectors. This system is very dangerous because it forgets the welfare of people, but it was still long lived because what people thought about the government was not irrelevant to the governments. There was no democracy. This is the meaning of the sentence that the gold standard was dead before WWI because there was already a new world at the beginning of the 20th century. After that there was the communist manifesto and the Russian revolution and the women movements to vote and to have social justice because the world was not the same anymore. Historically the golden straitjackets weren’t compatible with democracy like for example UK in 1931 which is the post great depression; Argentina in 2001 which was the typical country in crisis of the 20th century and then Greece still today which is in crisis. Greece put austerity measures which hit hard the population and worsened the situation. Post covid management was completely different because countries learned from errors. During the Bretton woods period, national sovereignty was one of the options to solve the problem and democratic politics. Trade was seen as beautiful but was not imposed and the creation of GATT was simply a procedure for countries who wished to liberalize trade. The idea was that countries negotiated. The Bretton woods compromise pictured a world that was changing fast because the rate of growth was 5% per year in advanced countries after WWII compared to the growth of 5% in the industrial revolution that happened in a decade. New things were coming, and this was the hyper globalization though financial markets that became more prominent overtime. It started from the euro-dollar market in London. This innovation was very successful, but it created a tension: either hyper globalization with democratic policies giving up sovereignty or the opposite. The first choice leads to global governance and collaboration between countries. From there is the political trilemma of the world economy: Global Economic Policies and Institutions – Anna Natalia Rodriguez 7 Lecture 2: Social interactions and social dilemmas There are two types of social interaction that can help us understand the possible role of public policy and the difference between those is on whether the external effects are present or not. - Tragedy of the commons: a social dilemma Garrett Hardin described this social dilemma considering a situation in which the resources are not owned by anyone (common property) and hence are easily overexploited unless we control access in some way. However, the problem is that if some people decide to reduce consumption they will bear the costs while others will enjoy the benefits today and in the future without doing anything and renouncing to anything. So, there are the people that pay the cost and the others which enjoy the benefits are the free riders. - The invisible hand: when self-interest works Smith identified conditions under which individuals pursuing their own interest, without regard for the interests of others, can be consistent with the common good. He wrote that, under the right laws and economic institutions (private property, and competition among many economic actors), the economy would be guided, as if by an ‘invisible hand’ towards a socially beneficial outcome. When we think about some economic or social or even biological problem, and how it might be resolved, we need to have in mind these two big ideas—the invisible hand and the tragedy of the commons. When we see a social interaction, we must ask whether it is a situation in which individuals, pursuing their own interests could, in principle, result in better outcomes for at least one person. The answer will differ on a case-by-case basis, and so will the remedies. Communities resolve some social dilemmas, and some by government action. Some are avoided or at least moderated because humans have motives other than self-interest. Resolving social dilemmas Social dilemmas can be minimized or avoided if people care sufficiently about their actions and how they affect others: social preferences is caring about others and social institutions are the constraints given by society. People differ in their preferences → the way they compare alternatives as better or worse than each other and use this evaluation as the basis of taking an action. There are two classes of preferences: self-interested preferences and social preferences. A person can simultaneously have both regarding two different issues. Social preferences are not always a good thing because some expel may wish harm to others. They are important in economics because they affect our behavior in economically relevant ways like for example: paying taxes honestly, changing one’s lifestyle to help support a better environment, cooperating with others to achieve a common objective. Social preferences can help to resolve a social dilemma because the others and hence the negative externalities are taken into consideration. Sometimes social dilemmas are solved and kept under control by government policies. A tax requires people to pay for the external costs they impose on others. Therefore, it internalizes the costs, which changes their behavior. In other cases, government can simply prohibit actions that have negative external effects. Local communities also create institutions to regulate behavior but the important thing here is that the power that these local communities have comes from people’s recognition of their power. Social interactions as games To distinguish between the two cases, we will use the tools of game theory to model social interactions. Devising policies to promote people’s wellbeing requires an understanding of the difference between situations in which self-interest can promote general wellbeing, and cases in which it leads to undesirable results. Not all social interactions lead to social dilemmas, even if individuals act in pursuit of their own interests. We will Global Economic Policies and Institutions – Anna Natalia Rodriguez 10 • They decide simultaneously. When a player makes a decision, that player doesn’t know what the other person has decided to do. If Bala produces rice, the dominant strategy for Anil is to produce cassava. If Bala produces cassava, Anil still can choose to produce cassava and have three. For Anil it is better to produce cassava no matter what the other person produces. For Bala, the best choice is always to produce rice based on the dominant strategy and so if they both use this strategy they would end up in the bottom left square. Self-interest works for the good of both agents because there is at the same time economic efficiency and wealth improvement as if an invisible hand had coordinated. Market trades: in goods, services, and financial assets This idea is based on the fact that markets are socially and historically determined as institutions and not simply as mechanisms. Formal (legal) and informal (customary) rules for trade exist and they are not just laws because they are also enforced (rule of law). Formal rules help because they are written, but the substantive quality of social relations makes the difference. If privatization was the old way to keep the oligarchs in charge, now we need the laws to regulate interactions. Laws are important but they are just the beginning of the relations. However, we define trade as the set of voluntary material “do ut des” market transactions. How voluntary are they in reality, especially when there is the state management of key resources (like tourism sector in the Latin American countries is entrusted to the military)? And can money buy anything? 05/10/22 Social interactions and social dilemmas: an example of the tragedy of the commons Externalities: sometimes we do some things, but some people get the outcomes of what we do which can be good or bad. We have again the example of Anil and Bala and the idea is that we have two technologies: terminator (kills everything) and IPC (kills only pests). There is the payoff matrix. In this sort of game, the two players are self-interested and there is no communication and decisions are taken in a non-coordinated environment. They must decide considering that the other player may take decisions regarding of what the other player does. Whatever Bala does, Anil has an interest to use terminator and the same is for Bala. The best situation, by applying a dominant strategy, is that both use terminator. For both there is a dominant strategy and if each of them behaves based on self-interest, they both choose terminator. They would never choose to use IPC because they would be scared that the other chooses terminator. Not all negative consequences apply to those that use terminator→ consider a situation where someone is upstream and someone downstream. While terminator kills everything, if you have integrated pest control, you have to know exactly which one you are using etc. This is the typical prisoner’s dilemma and whenever agents are self-interested and choose based on self-interests there is a robust equilibrium in a dominant strategy. Self interest in this case is not conducive to social good but conduces to equilibrium 2:2 which is a Nash equilibrium which is worse than a equilibrium 3:3 which is not easy to be attained because it takes a sort of social attitude. To get out of this dilemma, there is the need for: repeated interactions (repeated game because in repetitions people learn that if they repeat self-interest, they repeat the 2:2 outcome) leading to informal or formal institutions which allows them self-control and the best outcome for everybody, private negotiations, commonly agreed principles and public intervention like taxes, subsidies and regulations. If people use a strategy which is a rule for applying the decisions over time, this doesn’t provide automatic responses but may affect individual behavior. Global Economic Policies and Institutions – Anna Natalia Rodriguez 11 There is another example of social dilemma which is about public goods. The social dilemma captures the challenges of free riding that many people around the world face. We can consider the example of the irrigation project. For each farmer, the cost of contributing to the project is $10. But when one farmer contributes, all four of them will benefit from an increase in their crop yields made possible by irrigation, so they will each gain $8. Contributing to the irrigation project is called a public good—when one individual bear a cost to provide the good, everyone receives a benefit. As an example, let’s focus on one of the farmers, called Kim. If two of the others contribute, Kim will receive a benefit of $8 from each of their contributions. If she makes no contribution herself, her total payoff is $16. This is shown in the top row of the image and by the red bar with ‘on top in the graph. If she decides to contribute, she will receive an additional benefit of $8 (and so will the other three farmers). But she will incur a cost of $10, so her total payoff is $14, as shown by the blue bar with ‘fourteen’ on top in the graph, and as calculated in the image. Now, when Kim makes her decision, she has the information shown in Figure 2.8. This shows how her decision depends on her total earnings, but also on the number of other farmers who decide to contribute to the irrigation project. Note that the red bars are all higher than the blue ones—when Kim contributes, she earns less than when she free rides. This is a social dilemma. Whatever the other farmers decide to do, Kim makes more money if she doesn’t contribute than if she does. Not contributing is a dominant strategy. She can free ride on the contributions of the others. This public goods game is a prisoner’s dilemma in which there are more than two players. If the farmers just care about their own monetary profits, there is a dominant strategy equilibrium in which no one contributes, and the payoffs are 0. If all contributed, they all would get 22$ which means that everyone would benefit irrespective of what others do. The features of a public goods are that everyone can benefit from it and hence there is no-rivalry which is a common good and the other characteristic is that there is no-excludability. There are degrees of public goods because some are pure ones, and some are hybrid based on the degree of no-rivalry and no-excludability. By producing a public goods, a person pays some money but also gets some sort of benefit. The prisoner dilemma explains also why it is so difficult to produce public goods. Contributing to a common good is costly. Social preferences and social institutions How do we get out of this dilemma? We get out of the bad externalities by cooperating and by following the golden rule of religious traditions: don’t do anything to others that you wouldn’t like to be done to you. There has also been the creation of various institutions like the Elinor Ostrom who got the Nobel prize for her analysis on the common good. It is also very important to understand cooperation considering the role of altruism (being ready to pay for an improvement in other people’s situation and there are different techniques for understanding how much altruism is around), reciprocity and inequality aversion (ability for a person to give up something to solve a problem). The success or failure of communities in addressing the social dilemmas that they face often is determined by the extent and kinds of social preferences in the population. To learn about social preferences, you could use: World Value surveys like interviews or by observing actual behavior which is done by looking at situations, using lab games or lab in the field, randomized control trials or natural experiments. The other way is supporting cooperation by punishing free riders which would lead to improvement in cooperation as well. Free riding today on the contributions of other members of one’s community may have unpleasant consequences tomorrow and this is very relevant to many social and local dilemmas. An experiment demonstrates that people can sustain high levels of cooperation in a public goods game, as long as they have opportunities to punish free riders once it becomes clear who is contributing less than the norm. Altruism could help to solve the free rider problem because for example if Kim cared about the other farmers, she might be willing to contribute to the irrigation problem. However, in the later rounds the reasons why Global Economic Policies and Institutions – Anna Natalia Rodriguez 12 contributions to the public good declined could be connected to reciprocity→ It is likely that contributors decreased their level of cooperation when they saw that others were contributing less, meaning that the others were free riding on them. It seems as if those who contributed more than the average had negative feelings toward the low contributors for their unfairness, or for violating a social norm of contributing. Nash equilibrium In game theory, if everyone is playing their best response to the strategies of everyone else, these strategies are termed a Nash equilibrium (NE). They are also games with no dominant strategies which have the so called: Nash equilibrium. Many economic interactions do not have dominant strategy equilibria, but if we can find a Nash equilibrium, it gives us a prediction of what we should observe. We should expect to see all players doing the best they can, given what others are doing. -Bargaining to resolve problems: People commonly try to do this by doing negotiations to solve their economic and social problems. But negotiation doesn’t always succeed because sometimes conflicts of interest over how the mutual gains of cooperation will be shared, arise. If there is more than one Nash equilibrium, and if people choose their actions independently, then an economy can get ‘stuck’ in a Nash equilibrium in which all players are worse off than they would be in the other equilibrium. If we consider this example, producing the same crop makes the price fall and hence the one who has the benefit is only the one that is specialized in that product. Hence, there are two possible equilibria. Even specializing in the product for which people are not very productive can be an equilibrium. This is a game in which there is no dominant strategy but there are other interactions. They can avoid bringing the same things to the market and hence specialization is the best choice even if you specialize in the one that it isn’t your best. A Nash equilibrium is a situation in which each player wouldn’t change its choice, after the other person has made the choice. It can be socially optimal or not. However, it is a situation from which it is difficult to get out. By considering this example these people both do better if they work in the same language, but Astrid is better with Java and Bettina prefers C++. Their total payoff is higher if they choose C++, but the outcomes are asymmetric. However, it would be important to know which one of the two has more power and who started work on the project first because these things may determine the outcome. Externalities and climate change The environment is one of the most urgent matters to tackle and even though production may present benefits for many countries, it also produces many externalities for others. China and the US are considered in this example, and they are the highest producers with the highest emissions and exploitation of local resources. These two countries have two alternatives: restrict and business as usual and the outcomes are very different based on what the countries use. If everybody restricts, the situation of controlling climate change is reached, if there is BAU then the situation remains the same and the consequences are very bad for the environment. Also, there is an asymmetric possibility in which one reduces and the other doesn’t. If in a big country the reduction of emissions is carried out, this will have a big impact on the whole world. Climate change can be seen as a prisoners dilemma→ if they restrict, it is good for both, if they have both BAU, it is very bad for both; then there are the two intermediate steps because if China restrict and the US is BAU, the situation is better than doing nothing but it is still not as desirable or as “good” for China. From the perspective of a single interested player, the US is better off. The best strategy for China if the US restricts, is BAU and if the US is BAU, then China can choose to restrict but there should be some kind of incentives for the country to choose this option even though Global Economic Policies and Institutions – Anna Natalia Rodriguez 15 form of being unregulated supranational financial markets that undermine the functioning of the system that produce many consequences. The dimension of financial transaction, which is larger than the real transaction within and across countries, and the bank for international settlement come about with empirical research showing on all the payments made in some days in the international system because they are settled by the bank. For each unit of dollar, 65 or little more was used for financial purposes. There was a financial crisis in 2007/8 in which finance was highly regulated after a long period of non-regulation. Money → it also goes in waves and this concerns whether there is fixed or flexile exchange rates. Money is about solving problems of facilitating transactions so that barter is avoided. It can have formal or informal solutions within or between countries. Paper money, which was initially convertible into precious metals (mostly gold), then “fiat” money convertible into goods and services (with inflation as a major problem) this is an example of informal solution. Fiat money is a government-issued currency that is not backed by a physical commodity, such as gold or silver, but by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it. they were like contracts that were about a payment on sight by anyone who was giving it. Then there was the problem of having many nations with different currencies and it was difficult to convert money, and this led to countries to decide which were the fixed and flexible exchange rates. Subsequent international monetary regimes which at the beginning was the gold standard (fixed) then the period between the wars was flexible and then it changed into Bretton woods (fixed) to have then the current prevalence of flexible exchange rate. This means having money going in waves. The nexus between money, trade and finance is taken care of by the BoP identity. This sum must be equal to 0 by definition. The change in reserves is something that the CB knows about. The BoP is an identity, and it is an equilibrium. There is a short run perspective: BoP is okay if there are enough net international financial flows to cover real trade flows (international flows of good). This is called the BoP financing. The long run intertemporal perspective is about not being on average a net borrower or lender. This is because satisfying the intertemporal budget constraint requires a balanced current account which means that the official reserves cannot run out. This is called a BoP adjustment. However it is important to understand how long is the long run. We know that a country is in a good or bad position in the nexus because of the current account and whether it is in surplus or deficit and for how long it has stayed in that situation. Reading by Obstfeld→ Assessing global imbalances: the nuts and bolts Current account imbalances can be healthy or a sign of macroeconomic and financial stress. The IMF conducts annual external assessments for the world’s largest economies with the objective of alerting the global community to potential risks that countries need to address together. A country that has a current account deficit means that it’s importing more than what it is exporting and to finance this deficit, it can incur in liabilities to the rest of the world (borrows from it). Because all borrowing must be matched by lending, the sum of all the world’s current account deficits is equal the sum of its surpluses—a principle known as multilateral consistency. In some cases, CA imbalances can be appropriate or necessary like in those countries whose population is aging rapidly and need to accumulate funds that can be drawn down when the workers retire. If the domestic investment opportunities are few, then these countries may invest abroad instead → CA surplus. In other countries it is true the opposite. Sometimes, the imbalances can point to macroeconomic and financial stress because economies that accumulate external liabilities that are too large, may make then vulnerable to sudden stops in capital flows that force to cut abruptly spending which make financial crisis more likely. Furthermore, persistent imbalances Global Economic Policies and Institutions – Anna Natalia Rodriguez 16 may be symptoms of distortions in the domestic economy that can harm growth and hence removing these distortions may benefit the countries but also the global community because it becomes less vulnerable to contagion from financial crises. History offers many examples of disruptions related to large external imbalances. The most infamous is arguably the Great Depression of the late 1920s and early 1930s. It was preceded by a failure of international cooperation to address persistent imbalances between countries with large surpluses (notably the United States and France) and deficits (including Germany and the United Kingdom). The resulting breakdown of the global economic order inspired the establishment of the IMF after World War II, with its mandate to promote international monetary cooperation and help countries build and maintain strong economies. More recently, the global financial crisis was preceded by record imbalances and a simultaneous but neglected buildup of vulnerabilities. The imbalances unwound only in a once-in-a-generation recession that caused economic distress around the globe. Assessing external imbalances The IMF since 2012, conducts systematic and annual assessments of the 28 largest economies and the euro areas which together account for more than 85% of world GDP. This is done with the objective of identifying risky development early and offer policy advice for countries with potentially disruptive imbalances. The aim is to determine how much an external surplus or deficit is appropriate and how much it is considered to be excessive. To make this external assessment there are 4 steps: 1. Projected current account→ the External Balance Assessment estimates the average CA balance of an economy consistent with fundamentals. 2. EBA norm → the average doesn’t mean optimal or desired. If a country runs an inadequate fiscal policy, the IMF computes the CA balance that would prevail if the fiscal policy were appropriate and hence replacing the actual policies with the desired ones. This gives a CA norm. 3. Staff-assessed norm → the model is usually adjusted for omitted country-specific factors. For instance, a rapidly developing economy may has as a norm a large CA deficit as appropriate; in this case the estimated CA norm is adjusted upward which means toward a lower deficit. 4. CA gap→ it is the difference between the actual CA balance and the staff-assessed norm. this usually captures what drives and economy’s external balance away from the appropriate level. These gaps are then translated into qualitative assessments to form a discussion around policies that are best sited to close them. It must be said that despite the best effort, room for some error remains. The IMF’s assessment are simply analytical tools to determine the difficult question of when external imbalances are appropriate or when they signal risks. Hence, they provide an important public good by alerting the global community of potential balance of payments stresses that countries need to address together. Combating excess global imbalances is a joint responsibility and no single country can do it effectively on its own. This means that countries must act cooperatively in order that all gain because otherwise they will always be at risk of crises. Global Economic Policies and Institutions – Anna Natalia Rodriguez 17 Reading by Grauwe→ The fundamentals of money: national and international The use of money was necessary for the development of modern economy both nationally and internationally. The monetary instrument is used as an acceptable means of payment and as a unit of account and this is a prerequisite for the development of international trade because otherwise it would have reverted to barter. Characteristics of money 1. It is a collective good →the benefit of money to an individual derives exclusively from the fact that others also use it. This is because money has no utility if used by only one person. 2. Users of money can be made to pay quite easily, and this is because whoever uses money will have to hold money balances (cash, demand deposits) which carry no or little interest rate so that the user of money pays by the fact that he forgoes a higher interest rate on other assets. As a result, there is a mechanism in the supply of this collective good that avoids free riding. This implies that it will be profitable for private agents to supply money services because the source of their profits lies in the fact that money holders are willing to pay a price for the service in the form of a low return on the money balances. 3. In order for a particular money to be accepted, the economic agents must be confident that the supplier of this asset will not do things that reduce its value. This poses a problem: how to convince the holder that the supplier can be trusted. There are two ways: -Investing in all kinds of confidence building schemes like sunk capital (large and luxurious buildings which are physical assets that lose much of their values if the business is discontinued). -Guarantee that the money can be converted at a fixed price into another asset over whose value the supplier has no control (this existed in the period of the gold standard when holders of currency could convert it into gold at the central bank). The convertibility of the domestic currency into foreign currencies at a fixed price was the main confidence building device used by countries to have their currency accepted in international transactions. All of these confidence building devices are costly but also necessary. 4. This characteristic has to do with the economies of scale involved in its supply. Suppose that a country has two issuers of different currencies (A and B). As the issuers of these currencies are likely to follow different policies, the changes in the value of these two currencies will not be the same. This means that the price of one currency into the other is likely to fluctuate. The existence of two separate currencies in the same country, reduces the utility of each of them to the residents of that country and some transactions will have to be done with currency A and some with B. Hence, currency A and B will not be universal units of account and media of exchange in this country. If then, currency A were to gain acceptance for all transactions, its usefulness would increases and as a result the residents of the country would be willing to pay a higher price for currency A if it achieves this general acceptance. Hence, there is a scope for the issuer of currency A to increase his profitability by expanding the size of his operations and by supplanting currency B. The same is true for currency B. The supply of money involves a double operation: the supplier issues a liability, which is used as money and purchases an asset. The source of the profit of the issuer of money is the margin between the interest rate earned on the asset and the interest paid on the liability. When the liability of the bank gains increasing acceptance as money, the users are be willing to pay more for the service and as a result, the interest margin between the assets and the liabilities of the bank can increase. In this way the issuer of money profits from increasing returns to scale. The concentration of the money supply process There will be a strong pressure for capturing the benefits of these economies of scale because they can lead either to concentration of the money supply process in the hands of a few or by a cartelization of the market. In the first case, the supplier of money achieves monopoly, which allows him to maximize the interest margin. In the second case several suppliers will make an agreement to tie to each other the currencies they issue like Global Economic Policies and Institutions – Anna Natalia Rodriguez 20 money for domestic transactions and the level of commitment is that the commercial banks guarantee conversion of their outstanding deposits into cash. To guarantee the credibility of this commitment, the government regulates the activities of the banks. At the international level, at one extreme the national authorities control all the financial transactions of the residents with the outside world; at the other extreme, the buying and selling of foreign currencies by residents is free and the authorities commit themselves to convert their currencies into another asset at a fixed price. In between these two extremes there can be systems with few commitments toward convertibility and very little control on international financial transactions. The international gold standard It was in existence during the last part of 19th century until 1914 and it was a monetary arrangement among the major countries of the world. The main feature was that each country committed itself to guaranteeing the free convertibility of its currency into gold at a fixed price. This was a system with commitment and with little coercion. The combination of commitment towards convertibility and absence of controls had important implications. First, the residents of the participating countries had at their disposal a domestic currency which was freely convertible at a fixed price into an asset (gold) acceptance in international payments. The fact that each currency was convertible into gold at a fixed price also made it possible that each currency was convertible into all others also at a fixed price. Professional arbitrage would made sure that when one unit of currency A was worth one gram of gold, and one unit of currency B was worth half a gram of gold. Hence currency A would be worth twice as much as currency B. economic agents could directly convert one unit of currency A into two units of currency B, without the trouble of having to buy gold first. As a result of this international agreement, each participating currency effectively became an international currency. The effect of an arrangement was to provide a collective good, international money to all participants. It also helped to stabilize the monetary system. The economies of scale inherent in the supply of money was made external to individual countries ‘banks and they didn’t have to expand their size to capture the benefits. Furthermore, the participating countries had to accept some rules for the system to be workable. For instance, if one country experienced a faster increase of the supply of the domestic currency, the domestic prices tended to increase faster than foreign ones. This in turn stimulated imports and made exports more difficult and the trade account deteriorated. This had implications for the forex market because there was then excess demand for the foreign currency and the domestic banks who had to supply these foreign currencies to their customers bought them form the central bank by reducing their cash reserves. However, the CB held only gold and it used this to obtain these foreign currencies from the foreign CBs. As a result, the domestic CB had lost gold to the benefit of the foreign CB and the monetary effect of this transaction was that the domestic stock of money had declined. The counterpart was a decline in the gold stock of the country and the rules of the game implied that the country allowed the money stock to decline effectively so that the prices could start declining and the trade account could return in equilibrium. As a result, when the gold stock declines, the CB took actions to ensure that the domestic money stock did not decline. This involved increasing the cash reserves of the commercial banks. As a consequence, the domestic price level was always above the foreign one which meant that the country faced continuous deficit in its trade account and permanent excess demand for the foreign currency. Hence the rules of the game were necessary to ensure credibility even though the system didn’t survive WWI because the monetary authorities arrived at a point where they refused to convert currency into gold. This is also due to the pressure of the war. Domestic money, international money: functional analogies National money is used: - for domestic payments, as a store of value and as a unit of account. We use money and we accumulate it sometimes in 0 interest rate bank accounts or in very low interest rate bank account and people usually have some cash. Global Economic Policies and Institutions – Anna Natalia Rodriguez 21 - If money is not a store of value, then there is no point in exchanging it for a certain solid good. - National money is also a typical unit of account even when we must deal with different currencies because it is important to keep track of what’s happening. Money is what allows to consider everything even though the currencies need to be translated. International money: - has the same function as national money like international payments. - It is also a store of value which is not personal because firms do not keep cash and so they are kept in the international reserves. It doesn’t make sense to have cash in different currencies unless the job that you do is changing money for other people. To keep foreign currency, you usually buy foreign financial assets that are very easy to sell. The reason why international money is useful in terms of reserves is because of international reserves of those players that have a monetary and financial role. Deciding whether or not to hold foreign money either in the form of cash or not, means that there is the need to have the amount of money needed for everyday payments. The reserves that are held, keep the assumption that their value will not change. One of the big problems is that when global imbalances are very high means that some countries are in big deficit and other in big surplus; imbalances are bad for single countries but also for the world system. - The unit of account: the closer the economy, the more trivial the issue of unit of account it is, but if the economy is open then we must choose which unit of account is better. Since we live in a world with many national currencies, we need to know how a currency translates into another and there are experiments of all sorts of convertibility for all currencies. When there was the gold, one ounce of gold was the same everywhere no matter the nationality. Then there is convertibility from one exchange rate to another and then different exchange rates like flexible or fixed or mixed. The good side of fixed ER is good predictability, while with flexible ones there is the need to take a decision because the value of the currency may change with time. The ER allow each country to combine and balance in terms of internal and external equilibrium. The mixed ER seemed to be good, but it closed with global financialization because if you can control the financial market, you can play with the interest rate and hence you can control the external and internal equilibrium. If you live in a globalized world, then the interest rate of small countries is not in their control and hence the middle of the road implies the possibility to keep ER under control. The nature of money: national, international and transnational Money is not a matter of nation states. Money is a tool for communication and speaking economic matter with people that are not known and they may even not speak the same language. A language is useless if it doesn’t convey a message to others because all people need to believe that a piece of paper has a specific value and that is acceptable as a final point of the transaction. Hence, money must be a collective good (not common because it should be non-rival and non-excludable like the judicial system in a country because whether people like it or not, they are protected and punished by it). It is important that money is trusted otherwise it wouldn’t be accepted as a payment. Confidence is also important because it must be credibly convertible to other values that have the same return and hence valuable alternatives. The Weimar republic was a country in a crisis of confidence where its currency was not trusted at all. Money as a collective good means that one currency provides a benefit to the individual who holds it that is proportionate to the number of partners the currency gives access to. The larger is the number of people that can access the currency, the better it is, and this means that money prices economies of scale in its supply. Having one currency is better for the smoothness of the transactions. Since money is a collective good, accessing the form of money that has more partners available means having access to a batter service and this means being ready to pay more for holding that currency. Money also has positive network externalities because people are willing to pay for a good service and those that have a higher quality money has a higher interest rate and this is a way to create a business. This is the idea behind cryptocurrencies and those who are more trusted by people are those that have the highest value and were able to attract a larger network. Since there is a balance of many characteristics of money both at the national and international levels, there can be crisis of confidence due to the concentration Global Economic Policies and Institutions – Anna Natalia Rodriguez 22 which is the consequences of having economies of scale. By having just one central bank in Italy instead of three like in the old times, the banks didn’t check on each other and hence the central bank could do whatever it wanted and hence concentration leads to confidence and credibility issues and hence crisis. Bankers were people in the past which had many people connected to them and they wanted to meet more people because the higher the credibility the richer you would became. There was an incentive for the banker to enlarge the business and this was done by issuing currencies and get interest rates back but the larger the network, the biggest the possibility of clients that don’t repair you. For this reason, it is important to find some ways to encourage commitment and or coercion which can be done by having limitations on how big or risky the banks can get. However, the rules change based on the moment in which they are made based on the needs. The “N-1” issue for the BoP and exchange rates We live in a closed global economy and hence by definition the sum of world exports is the sum of world imports. So what’s the point in wishing to be a surplus country if all want to be a surplus country? Can they all be? No because if there are surplus countries then there have to be deficit countries. Whose fault is it that there are asymmetries and imbalances? Both but there are asymmetries, and everyone would prefer to be in surplus. If there are N countries and we know the position of N-1 then the last country must have the position that is implied by the logical necessity of the sum of world exports being equal to world imports. The same goes for exchange rates because it is the unit of one currency that is required to access one unit of another currency. There is only one independent exchange rate between two currencies A, B: A/B = 1/(B/A). There are only two independent exchange rates among three currencies A, B, C: A/B and A/C which imply B/C. If we live in a world with N currencies, there are only N-1 independent exchange rates. A remarkable implication, if the countries issue national currencies: only N-1 out of N countries can independently pursue a national exchange rate target. The point is: who will remain with what is left? → How do we choose the country that doesn’t get to choose its currency? The problem is: if we want participation, it cannot happen if there isn’t coordination. The international monetary system Because of the N-1 issue, there have to be some forms of practical arrangements for making sovereign targets reciprocally consistent. They can be informal or formal and symmetric or asymmetric. Informal: it just happens. Formal: we sit around a table and agree. Symmetric: we agree and each of us has the same rights and duties. Asymmetric: we sit at a table and some countries will have more rights or duties than others. These decisions can be formal or informal, but they must cover some issues: 1. Payments and accounting → which convertibility practices? (at fixed or flexible exchange rates? Are they credible commitments? Can we be confident that the system will continue working?) 2. Store of value: Reserve instruments (reserves need to be acceptable to partners) 3. Who bears the burden of adjustment, in case of imbalances? How do we deal with them and whose fault is it? All international monetary systems were broken because of adjustment issues. If there are no agreements between flexible and fixed ER, the system is informal and if there are crisis, they will be left to informal systems in which power will matter most and this is something that has to be taken into consideration. Global Economic Policies and Institutions – Anna Natalia Rodriguez 25 transaction protocols that verify, control, and self-execute an agreement, embedded in computerized codes on a blockchain. Differently from centralized finance , where money is held by banks who facilitate money movement between parties with each charging fees for using their services, decentralized finance eliminates intermediaries by allowing people and businesses to conduct financial transactions through emerging technology. Specifically, DeFi uses the blockchain technology that cryptocurrencies use. We can define a blockchain as a distributed and secured database or ledger where transactions are recorded in blocks and then verified by other users. If these verifiers agree on a transaction, the block is closed and encrypted; another block is created that has information about the previous block within it. In addition, we can analyze the features of Defi; first there is accessibility as anyone with an internet connection can access a DeFi platform and transactions occur without any geographic restriction. Then low fees and high-interest rates because DeFi enables any two parties to directly negotiate interest rates and lend money via DeFi networks, however there is a high level of volatility as the value of your tokens can change after you've deposited them into a liquidity pool. Instead, the security and transparency of Defi are debatable as smart contracts published on a blockchain and records of completed transactions are available for anyone to review but do not reveal your identity and blockchains are immutable, but there is a high risk of scams and frauds as Defi is unregulated. Finally, Defi platforms have been described as autonomous because they don't rely on any centralized financial institutions and are not subject to adversity or bankruptcy. However, small groups of stakeholders (or holders of “governance tokens”) could change the rules of the DeFi project, and it might not be in your favor. Another issue of Defi is the Blockchain Trilemma. It’s based on a trade-off between security, decentralization, and scalability that is usually portrayed as a trilemma. In particular, the main goal of scalability is to increase transaction speed (faster finality) and transaction throughput (higher transactions per second). Scalability usually requires sacrificing decentralization, security, or some degree of both. For instance, a scalable and decentralized network will need to incentivize a large number of active participants to achieve high security. A scalable and secure network will generally raise the cost of running a node at the expense of decentralization. Furthermore, decentralized and secure networks keep node requirements low and the cost of attacks high but end up with scalability bottlenecks. So how can we solve the Blockchain Trilemma and achieve decentralization, security, and scalability simultaneously? The answer comes in the form of Layer-1 and Layer-2 solutions. Layer 1 refers to blockchain protocols like Bitcoin, Litecoin, and Ethereum and is the base layer of the blockchain network. The solutions proposed by Layer 1 are two; the first is the Consensus Protocol Improvements using the Proof-of-Stake (PoS) consensus mechanism that is applied in Ethereum 2.0. Using the Proof of Stake means that validators explicitly stake capital in the form of ETH into a smart contract on Ethereum. This staked ETH then acts as collateral that can be destroyed if the validator behaves dishonestly or lazily. At the same time this major consensus mechanism is more energy-efficient because it does not rely on crypto mining but on multiple random validators to agree that a transaction is accurate before it is added to the blockchain. The second solution proposed by Layer 1 is sharding, which is the process of splitting a database horizontally to spread the load. This means that Sharding breaks transactions into smaller datasets called "shards” that are simultaneously processed in parallel by the network. The goal of Layer 1 and 2 is to find an effective balance between network security, decentralization, and scalability. However, alongside the emergence of the Proof-of-Stake systems the paradigm is shifting toward decentralized blockchain networks that are at once distributed, secure, and scalable. Some of the most known Defi platforms nowadays can be Aave, Cardano, Synthetix and Uniswap Ethereum Ethereum is a technology for building apps and organizations, holding assets, transacting and communicating without being controlled by a central authority. Ethereum has its own cryptocurrency, Ether, which is used to pay for certain activities on the Ethereum network. It was launched in 2015, like Bitcoin, but you use digital money without payment providers or banks. But Ethereum is programmable, so you can also build and deploy Global Economic Policies and Institutions – Anna Natalia Rodriguez 26 decentralized applications on its network. Ethereum being programmable means that you can build apps that use the blockchain to store data or control what your app can do. While Bitcoin is only a payment network, Ethereum is more like a marketplace of financial services, games, social networks and other apps that respect your privacy and cannot censor you. Main characteristics of Ethereum: - Banking for everyone → Not everyone has access to financial services. But to access Ethereum and its lending, all you need is an internet connection. - A more private internet → You don't need to provide all your personal details to use an Ethereum app. Ethereum is building an economy based on value, not surveillance. - A peer-to-peer network →Ethereum allows you to move money directly with someone else. No need for intermediaries. - Censorship-resistant → No government or company has control over Ethereum. - Commerce guarantees→ Customers have a secure, built-in guarantee that funds will only change hands if you provide what was agreed. - All products are composable →Since all apps are built on the same blockchain with a shared global state, they can build off each other (like legos). Ethereum is not controlled by any one entity. It exists solely through the decentralized participation and cooperation of the community. Ethereum makes use of nodes (a computer with a copy of the Ethereum blockchain data) run by volunteers to replace individual server and cloud systems owned by major internet providers and services. Ethereum has a native cryptocurrency called ether (ETH). The supply of ETH isn’t controlled by any government or company – it is decentralized and completely transparent. ETH characteristics: - It's really yours → You can control your own funds with your wallet, no third parties necessary. - Secured by cryptography→ it's secured by proven cryptography. Peer-to-peer payments You can send your ETH without any intermediary service like a bank. - No centralized control → ETH is decentralized and global. There's no company or bank that can decide to print more ETH, or change the terms of use. - Open to anyone → You only need an internet connection, you don't need access to a bank account to accept payments. - Available in flexible amounts → ETH is divisible up to 18 decimal places so you don't have to buy 1 whole ETH. You can buy fractions at a time. Ethereum is currently using a proof-of-work mechanism that consumes a large amount of energy. In the coming months Ethereum will undergo its biggest update yet and will switch to proof of stake mechanism which will greatly reduce the environmental impact it has. Layer 2 Layer 2 (L2) is a collective term to describe a specific set of Ethereum scaling solutions. A layer 2 is a separate blockchain that extends Ethereum and inherits the security guarantees of Ethereum. A layer 2 blockchain regularly communicates with Ethereum (by submitting bundles of transactions) in order to ensure it has similar security and decentralization guarantees. All this requires no changes to the layer 1 protocol (Ethereum). This lets layer 1 handle security, data availability, and decentralization, while layer 2s handles scaling. Layer 2s take the transactional burden away from layer 1 and post finalized proofs back to layer 1. By removing this transaction load from layer 1, the base layer becomes less congested, and everything becomes more scalable. Rollups are currently the preferred layer 2 solution for scaling Ethereum. Rollups bundle (or ’roll up’) hundreds of transactions into a single transaction on layer 1. This distributes the L1 transaction fees across everyone in Global Economic Policies and Institutions – Anna Natalia Rodriguez 27 the rollup, making it cheaper for each user. There are two different kinds of rollups: Optimistic rollups and Zero-Knowledge rollups. Legal issues surrounding cryptocurrencies As new uses of cryptocurrencies emerge, so do its potential legal liabilities: CONTRACTUAL ISSUES → One of blockchain technology and cryptocurrencies’ most striking features is their self-executing “smart contracts.” Due to smart contracts’ unique nature and complexity, whether they fit into the legal framework of traditional contract law is difficult to determine. Since smart contracts’ legal validity is unclear, however, they are likely to result in lengthy litigation processes. JURISDICTIONAL ISSUES → The main idea behind blockchain technology that underpins cryptocurrencies is that it involves no way to pinpoint a ledger’s actual location. But this advantage poses a complex jurisdictional challenge. First, since ledgers are located in different jurisdictions, they may be subject to conflicting legal frameworks. Second, the “residence country” for cryptocurrency software is difficult to determine. Third, blockchain’s transnational nature makes determining the correct jurisdiction for blockchain disputes difficult. DATA THEFT AND FINANCIAL FRAUD → Data theft and financial fraud are additional pressing legal concerns surrounding cryptocurrencies. The blockchain’s promise of anonymity can entice many users who are involved in illegal activities to use cryptocurrencies for their financial transactions. PRIVACY CONCERNS → Privacy concerns are closely related to data theft and anonymity in the cryptocurrency space. This anonymity can be threatened by the continuous improvement in blockchain analytic tools. The blockchain analytics firm claimed that it can trace the vast majority of transactions, making “privacy coins” a misnomer. MONEY LAUNDERING → Several commentators suggest that cryptocurrencies provide criminal organizations with a new way to commit fraud, money laundering, and a host of other financial crimes. Various governmental agencies have labeled drug dealers that exchange drugs for cryptocurrency as the “new generation of criminals.” TAX IMPLICATIONS → For US federal income tax purposes, cryptocurrencies are property not a currency. For example, in the US taxpayers are obligated to report transactions involving cryptocurrencies in US dollars on their annual tax returns. As a result, properly reporting cryptocurrencies value is complex for individual taxpayers because they must diligently record the price at which their cryptocurrencies were bought and sold. INTELLECTUAL PROPERTY → Cryptocurrencies are becoming rather popular among intellectual property intensive sectors where goods’ traceability is important, and counterfeit goods are a concern. The use of cryptocurrencies in IP-intensive industries raises concerns about: ownership and authorship, controlling and tracking the distribution of registered or unregistered IPs, and establishing and enforcing IP licenses. LEGAL AND REGULATORY CONCERNS FOR INVESTORS → Since February 2020, cryptocurrencies such as Bitcoin have been legal in the United States and in most other developed countries. However, some concerns still surround crypto's legal validity since they are not backed by any centralized authority and their value totally depends upon the value that other owners and investors ascribe to them. Investors may have limited legal resources if any complications arise from their crypto transactions or ownership. Global Economic Policies and Institutions – Anna Natalia Rodriguez 30 going down and hence domestic money supply goes down. The amount of money in circulation goes down and this can be understood by looking at the balance sheet. Hence also prices go down and this means that the domestic production becomes more competitive, and you need to import less and export more and this would fix the CA. Adjustment is automatic, under the rules of the game. Price specie (what was deemed the store of value) flow mechanism is the one that connects the amount of gold to the level of prices provides a self-adjustment. Another aspect of this mathematical adjustment is the natural distribution of the specie is the idea that gold used as money, tends to move away from the pockets of those who have gold to those who produce goods and services. The idealized international gold standard, in short: Exchange rate regime: fixed rates ( «gold points», corresponding to actual cost of conversion gold-paper money). You didn’t convert money into gold unless you feared that the exchange rate was really in trouble. Reserve regime: Gold (Pound Sterling as a credible substitute) because of the credibility of the British commitment to parity and because pound sterling was the typical cash even in intracontinental Europe trade. Adjustment regime: automatic adjustment (if countries follow the «rules of the game»). The adjustment should have been automatic. Symmetric system: both surplus and deficit countries experience automatic adjustment the idealized version of the gold standard implies symmetry. Countries in surplus would accumulate gold and experience inflation and product becomes less competitive and the deficit countries would experience an outflow of currencies, lower prices and more competitive goods. Whenever a country is losing reserves and seeing its money supply shrink as a consequence, foreign countries are gaining reserves and seeing their money supplies expand → in practice, unhappy holders of pounds can sell these to the Bank of England for gold, sell the gold to other CBs for their currencies and use these currencies to purchase deposits that offer interest rates higher then the interest rate on pounds. UK has a private financial outflow and thee foreign countries have an inflow. This process reestablishes equilibrium in the foreign exchange market. Bank of England is forced to buy pounds and give gold to keep the pound price of gold fixed and its reserves decrease. Because the UK money supply is falling, the UK interests rate goes up again and the foreign money supplies rise pushing down their interest rates and this leads to equilibrium. Britain’s CA surplus and international finance Britain was very rich and could export much more than what it needed to import and the British CA surplus average 5,2% of GDP and this meant accumulating gold. But if you want business to go round then also money had to go round. Hence UK by using these surpluses of gold, they started making massive FDIs and lent to foreign countries and governments. This was a long-term landing because at the time the inflation was not a problem. These FDIs were mostly directed to English speaking countries like US, Australia but not limited. The expanding financial system in London brought consequences because the peripheral countries were very instable in terms of financial investment and of current account position because sticking to the rules of the game can be very costly. Financial instability in peripheral countries also meant that the British financial institutions had ups and down and in fact, it is in this period that the theory of central banking was developed (need for a lender of last resort which is someone outside of the system which helps to face the instability). The international gold standard in practice In practice the international gold standard worked from 1870 to 1914 and it worked on several economic cycles. The benefits of the gold standard other than the desirability of symmetry are: because CB are obliged to fix the money price of gold, they can’t allow their money supplies to grow more rapidly than real money demand and this places automatic limits on the extent to which CB can cause increases in national price levels through monetary policies. These limits make the real values of national monies stable and predictable enhancing the transaction economies arising from the use of money. Global Economic Policies and Institutions – Anna Natalia Rodriguez 31 However the gold standard imposed heavy costs on workers (consider the Rodrick trilemma and the democratic consensus wasn’t an issue at the time). The gold standard places undesirable constraints on the use of monetary policies to fight unemployment. Also, tying currency values to gold ensures a stable overall price level only if the relative price of gold and other goods and services is stable. Furthermore, it is problematic because CB cannot increase their holdings of international reserves as their economies grow unless there are continual new gold discoveries. There were prices instability due to gold discoveries and asymmetric position due to gold producers (Russia and South Africa because they could enter the system with gold and could acquire paper money irrespective of their CA situation). There was competition for attracting existing gold and this meant a deflationary bias in the gold standard countries. The world was practical, but the practice was to use pound sterling as if it was gold. Already at the start of WWI there was the idea that the gold standard was not good. When the gold standard ended, there was a desire to go back, and this was understandable and unrealistic. Before 1870, most countries were largely agricultural and self-sufficient and the trade was local with some luxury goods going around. At the end of the gold standard period, the industrial revolution which was already consolidated had entered almost all Europe and more. The Gold Standard witnessed a great expansion of trade and a flow of private investments at a scale never seen before (and after). At the outset of WWI, nationalist took advantage and the refusal of London financial institutions to extend credit for repaying short term sterling debt interrupted international finance and disrupted foreign exchange markets. In a few days, the Gold Standard came to an end. Hence, it is good to be a country whose currency is also international, but there are also costs if the country wants to keep the position. After WWI After WWI, the practices of selling domestic assets in the face of a deficit and buying domestic assets in the face of a surplus came to be known as the gold standard “rules of the game”. It has been demonstrated that these rules were violated frequently before 1914 because in practice it was the deficit countries that bore the burden of bringing the payments balances of all countries into equilibrium. By not always taking action to reduce gold inflows, the surplus countries worsened a problem of international policy coordination inherent in the system. In fact, countries often reversed the rules and sterilized gold flows, that is, sold domestic assets when foreign reserves were rising and bought domestic assets as foreign reserves fell. Government interference with private gold exports also undermined the system. A fundamental cause of short-term internal instability under the pre-1914 gold standard was the subordination of economic policy to external objectives. The gold standard allowed high degrees of exchange rate stability and international financial capital mobility, but did not allow monetary policy to pursue internal policy goals. How do you pay for an expensive war, if you can’t access credit? You can raise taxes (not reasonable), issue bonds and hoping that citizens will buy them freely (you need people that can afford to buy the bonds, but it was not present), you can print money, and this was done. All countries adopted extra-ordinary monetary policies for financing a very expensive war. How to restore a stable international monetary system? Gustav Cassell came about with the Purchasing Power Parity Theory (“normative” theory) which is one of the key pillars of what we know of the international monetary system. It says that different inflation rates can be accommodated by a change in the exchange rate. If an inflation in a country is double compared to another country, the unit of currency of the inflation country required to buy one unit of the non-inflation country should double and this was the idea that neutrality, meaning the proportion of money creation is mirrored in the proportion of price level growth becomes a 3 elements equations: the percentage change in money is equal to the percentage inflation rate and should be equal to the percentage change in the exchange rate. If I double the money, my price will double, and the exchange rate doubles. This is a normative theory and was a representation of a possible way out. Countries wanted to go back to the gold standard and to do that they would have had to go back with a different exchange rate. Cassell provided the technical support for negotiations that happened in Genoa but they didn’t accomplish anything. Countries also learned that the governments could also have a new economic role: industrial policy. The US returned to gold in 1919. In 1922, at the conference of Genoa: Italy, UK, France and Japan agreed to call for a Global Economic Policies and Institutions – Anna Natalia Rodriguez 32 general return to the gold standard and cooperation among CBs in attaining the internal and external objectives. The conference opted for a partial gold exchange standard in which the smaller countries could hold as reserves the currencies of several large countries whose own international reserves would consist entirely of gold. In 1925, UK returned to the gold standard by pegging the pound to the gold at the prewar price; to do this the CB was forced to follow contractionary monetary policies that contributed to severe unemployment. British stagnation in the 1920s accelerated London’s decline as the world’s leading financial center and many countries held the international reserves in the form of deposits in London. The onset of the crisis of 1929 was also followed by bank failures throughout the world and the UK left the gold in 1931. The idea at the beginning was to rebuild the Gold Standard but this ended with the failure of the Genoa Conference, 1922. This is the Rodrik’s trilemma at work! The “Golden Straitjacket” proved too stringent for indebted countries (Russia and Germany in particular). This meant that there were prewar gold parities, then the countries created new money. There are remarkable legacies of this period like the creation of the international Labor organization in 1919. It is a tripartite structure which includes trade unions, industrial unions and governments. Within the UN, the World Commission on the social dimension of globalization was established by the ILO in 2002 to deal with the hottest issues raised by the no-global movements. The gold standard and the great depression Britain decided to go back to the gold standard at prewar parity and this meant that all countries that had pound sterling could be converted into gold at pre parity exchange rate. This was a very costly policy for the UK even though it consecrated the city of London as the financial center of the world. By returning to the gold standard, the UK was making a strong decision int terms of the Rodrick triangle, it chose the straitjacket sacrificing domestic growth. Many people think that this was the cause of the great depression of 1929. Pros and cons: restoring international financial reputation but facing the deflationary consequences of the necessary contractionary monetary policies. With the Wall Street crash, October 24, 1929: it quickly spread abroad; and Britain ended up being out of the Gold Standard in 1931 because at that point Rodrick’s triangle couldn’t be kept anymore. The contextual events were bank crises, financial instability, bank reforms and nationalizations, hyperinflation, debt repudiations. The graph of disintegration is the representation of the Rodrick’s dilemma. Another enduring legacy of this turbulent period was the BIS- bank for international settlement, which was supposed to die in 1944. It was created to manage reparations payment but in the Bretton woods resolution there was the plan to liquidate it but this could not be done because Germany was a founding member, but it had no power to do it. 8/11/22 We were going through a sketchy version of economic history to understand how interdependence impinges into the national policymaking structure and the international dimensions. In the gold standard there was the spontaneous convergence of different countries towards this way of organizing domestic monetary policy and international monetary policy. Hence, the exchange rate which implies a theoretical way of functioning based on symmetry and self-adjustment, but a practice characterized by the centrality of pound sterling and the need of various countries at different times to go through processes of adjustment because spontaneous adjustment wasn’t practicable not because it is impossible but because it is so costly. Post ww2 was a very confused period with national pressure for nationalistic policies, at the same time a degree of interdependence both desired and in the back of the memories people living in the 30s remembered the Global Economic Policies and Institutions – Anna Natalia Rodriguez 35 The BW accords solved the trilemma because the system was based on the presumption that movements of private financial capital could be restricted, allowing some degree of independence for domestically oriented monetary policies. After the experience of high interwar unemployment, the architects of the BW system hoped to ensure that countries would not be forced to adopt contractionary monetary policies for balance of payments reasons in the face of an economic downturn. Supporting this emphasis on high employment, restrictions on cross-border financial flows would allow “orderly” exchange rate changes in situations of persistent imbalance. In theory, policy makers would be able to change exchange rates in a deliberate fashion, without the pressure of massive speculative attacks. The reserve regime: gold and exchange knowing that among the diff national currencies there was one, the US dollar that at that time could still be converted into gold. It was a hierarchical structure with at the top gold and then the US dollar. All other countries could quote their national currencies either in gold or in dollars because there was a fixed ER between gold and the dollar but it was a stratified system in which the US was the center because all countries tended to keep their fixed ER by trading $ not by trading gold so there is an asymmetry which is stated explicitly in the charter. The US was a special player in the game with costs and benefits. All countries would trade in dollars that was the practical arrangement which provided the US with a very powerful tool, which is to say creating dollars for national purposes would also feed international trade and at the same time the dollar had he commitment of the US who was keeping the parity with gold. Asymmetry was built into the economic structure of the time: the war was world war, but destructions were mostly outside the US. The mechanics of the reserve currency standard: every CB fixed the $ ER of its currency through foreign exchange market trades of domestic currency for dollar assets. The frequent need to intervene meant that CBs held a large portion of their international reserves in US treasury bills and short term dollar deposits, which pay interest and can be turned into cash at relatively low cost. The ER between any two currencies was automatically fixed as well as through arbitrage in the foreign exchange market. The country whose currency is held a reserves occupied a special position because it never has to intervene in the foreign market. If there are N countries with N currencies in the world, there are only N-1 ER against the reserve currency. if the N-1 non-reserve currency countries fix their ER against the reserve currency, there is no ER left for the reserve center to fix→ the center country need never intervene and bears none of the burden of financing its BoP. The reserve issuing currency is in a privileged position because it can use its monetary policy or macroeconomic stabilization even though it has fixed ER. What would be the effect of a purchase of domestic assets by the CB of the reserve currency country? The expansion of the MS would momentarily push its interest rate below those prevailing abroad and cause an excess demand for foreign currencies in the foreign exchange market. All other CBs would be forced to buy reserve assets with their own currencies, expanding their money supplies and pushing their interest rates down to the level established by the reserve center. Adjustment regime: this is the most delicate item that decides of the stability or instability of the international monetary system so for temp disequilibrium you could have IMF temporary financing, for fundamental disequilibrium this is the expression used in the charter. Global Economic Policies and Institutions – Anna Natalia Rodriguez 36 This is the structure three layers: gold, US dollars and all the others. The monetary trilemma: not Rodrik’s but just in the monetary dimension. If you have free financial flows and a single financial market; so an interest rate that moves according to global criteria not domestic criteria, then if you have fixed ER the local int rate will mirror the international int rate and you lose monetary policy as a tool for policy making. Fixed ex rate + international financial integration isn’t compatible with domestic monetary authority so you had three fixed exchange rates, international capital mobility and domestic autonomy of monetary policy, you can’t have three. Mandell Fleming story: if you have fixed ER then you can’t have monetary policy autonomy by going for open financial markets because they would give a level of interest rates I* (star means the global value) and therefore the local monetary policy framework has to deal with the I* and you have to keep it. The other key point both Keynes and White wanted was: fixed ER regime and national autonomy so the Bretton woods articles of agreement let countries be completely free about what to do with international financial flows, open to int fin flows or not, financially protectionist or financially opened. This meant that there were policy options concerning int financial regulation that were up to each country. For example, the UK wanted to be a financial center, they were ready to give up domestic monetary autonomy because in any case the financial sector was so important for British GDP that keeping a financial system open was essential. The alternative is Italy, but all countries except for UK in Europe adopted regulations of int fin flows and also regulation of domestic fin flows. In Italy a large chunk of the banking sector was public so there was a public interest built into the banking strategies and int financial flows were to be administratively approved by the bank of Italy and this was the case of Italy all through the 60s, 70s and 80s only in 90s Italy liberalized int capital flows. Each country could do whatever they wanted so there was no monetary trilemma. So, the BW system was exactly solved and was a perfectly consistent regime. The Rodrick’s trilemma builds on that but doesn’t focus on monetary issues, it focuses on the broader framework in which you have to keep under your eyes not just the econ dimension but also the political dimension of the country. However, you have int finance meaning that capital from country A may wish to flow to country B because there are better investment opportunities, this is international and goes through banking systems and banks are of one nationality or another nationality. And so, you have to stick to Italian regulation or British regulation, that is international. Countries have the possibility to choose international rules for financial transactions. What was not there in 1944 but started being there in the 60s was a completely diff sort of finance→ so there was a financial innovation which was completely diff from int financial flows. Transnational finance that for some features of the system allowed some fin flows not to be under the regulation of the country where money would flow out and the country where money would flow in. So there could be space for financial transactions that were not international but were transnational. If transnational finance is just a detail, then the triangle keeps being stable but if you go into the 60s and you have not international but transnational financial openness, means that the triangle is there and you have to give up something, but what? In the 60s we had this idea that national autonomy and fixed ER became conflicting targets and that was the beginning of the end of BW. Transnational: think about a US multinational that works in Europe. Having a banking account in London implies the possibility of using dollars in London. The national rules in England were the following → the bank of England controls the activities of all banks British, US, Italian whatever all banks that are physically in Britain in their transaction in pounds. So UK is controlling the activity of banks of all nations when they trade in pound. The US have diff rules→ controlling the activities of all banks on the land, on the territory of Global Economic Policies and Institutions – Anna Natalia Rodriguez 37 (it is a FED system so you have 9 fed banks in the US) so each FED bank controls the banks but they don’t control what the subsidiaries that are in London do→ geographical control in the US and a currency control in UK meaning that if an American bank trades in dollars in NY it is under the NY FED bank. If a subsidiary of this bank is in London and trades in pounds it is under the control of the bank of England. If an American bank works in London but uses dollars as a means of exchange this bank for the trades in dollars is neither under the control of US nor under the control of Britain, these dollars travel around and so can be multiplied with the usual money creating process so you make deposits, you make loans, by making loans in a more abundant way you create money so there was a possibility of creating dollars outside the US respecting the rules, there was a void and this allowed transnational financial activities. It creates a space in which you can have business outside the control of CB, so it is not international there is nothing national there, it is transnational which means open to any sort of acceptance of international. How the CB keeps the ER CB intervention is: suppose there is excess demand for dollars so excess supply of local currency, you must provide dollars. Where do you get your dollars? From your assets (-100). But when you give dollars, you receive currency back so the currency in circulation is -100. With sterilization you start by intervening in the forex market (red numbers) -100, - 100. but then you rebalance the amount of domestic money supply by providing new loans +100 loans, +100 currency. So this goes to 0, the monetary supply is what you started with and you achieve this result by reshuffling resources in the assets side. You started with a certain amount of foreign assets, now you have less. You started with an amount of domestic assets, now you have more so you rebalance the asset side away from the international/foreign and towards domestic. Of course if you do it once, two, three, seven at some points your foreign assets are depleted so that is not something you can do on a normal basis, you can do it in the short run because you are trying to maintain equilibrium, it is a risky tool but you can use it. but it is not possible to avoid ER adjustments if you have a structural, fundamental disequilibrium. Under managed floating, monetary policy is influenced by ER changes without being completely subordinate to the requirements of a fixed rate. Instead, the CB faces a trade off between domestic objectives such as employment or the inflation rate and ER stability. When a CB carries out a sterilized foreign exchange intervention, its transactions leave the domestic MS unchanged. To hold the ER constant when fiscal policy becomes more expensive, the CB must buy foreign assets and expand the home MS. The policy raises output but it eventually also causes inflation, which the CB may try to avoid by sterilizing the increase in the MS that its fiscal policy induced. The ineffectiveness of MP under a fixed ER implies that sterilization is a self- defeating policy. The key feature of this model is the assumption that the foreign exchange market is in equilibrium only when the expected returns on domestic and foreign currency bonds are the same, this is called perfect asset substitutability. With this, the R is determined so that the interest parity condition holds; if this is the case, there is nothing a CB can do through foreign exchange intervention that it could not do as well through purely domestic open market operations. The imperfect market substitutability exists when it is possible for assets ‘expected returns to differ in equilibrium and the main factor is risk. (vedi pag. 554) If markets are unsure about the future direction of macroeconomic policies, sterilized intervention may give an indication of where the CB expects the ER to move→ signaling effect of foreign exchange intervention. This intervention signaling can’t be viewed as a policy weapon to be wielded independently of monetary and fiscal policy. Global Economic Policies and Institutions – Anna Natalia Rodriguez 40 Example: fixed exchange rate may be incompatible with full equilibrium (p.605) So this is the case, if you are in position 2 you have neither internal nor external eq. Then you can move either to full domestic or full external, the point is in 2 you have neither eq. but in either 4 or 3 you get much further from one sort of eq if you try to reach the other. You need to go to point 1, but this is exactly the need for adjusting the ER and this was perfectly foreseen in the Bretton woods system. So the system was a fixed ER with a possibility of adjustment, unilateral adjustment just tell in advance to the IMF. The system was fully coherent in principle. Perfectly designed in principle. Internal adjustment: external effects and their financial implications Explanation of what happens in the system: you can have a disequilibrium and it can be a SR or LR disequilibrium so you need financing and adjusting. Suppose you are in recession, income is lower than the desired level of income, the gov increases G, income goes up, interest rates goes up and indeed you get an increase in income which is good, this makes your CA worse. However if you have some financial flows, the rise in int rate can attract foreign funds, foreigners buy domestic assets so you have in the BW system a possible solution for financing domestic disequilibrium through international financial flows. The increase in F can finance the worsening of CA; this is a SR strategy because it means issuing external debt. How much can you increase your debt? For how long can you keep a high debt? And external disequilibrium will build up, you have CA you finance it, meaning next year you have to repay the debt at least to repay the int rates meaning the CA will worsen next year and if you let this spiral feed on itself, you have a CA deficit, you pay, you cover it with debt, higher CA deficit covered with higher debt and this goes on and on until you get to a fundamental disequilibrium and in the LR you need adjustment otherwise external debt becomes unsustainable. And from this we can look at the BW functioning, not the theoretical framework, the theoretical framework was perfect, because you had the monetary trilemma but it was solved, what wasn’t solved was the Rodrik’s trilemma. Since having free international flows could undermine national policies objectives, the BW system established that - countries could choose whether financial flows would be free (in/out/only in or out of the country) or totally controlled, this is a decision taken by the country - adjustment was a problem → Especially in the post war period countries could run deficit and thus there was the need to take care of BOP misalignment. To solve this, IBRD could provide loans to countries in reconstruction, but this did not solve everything because they needed also things like coal and steel for instance, so there was also the idea that temporary disequilibrium and structural one were different. The BW took care of each of these two types, indeed for temporary disequilibrium → IMF lending that was almost automatic: it was for member countries that put an amount of wealth in IMF equal to the quota of the country. Each country could then draw from deposit a multiple of it in an automatic way without conditionality. These drawings were called drawing rights = each country had the right to draw from it. Global Economic Policies and Institutions – Anna Natalia Rodriguez 41 In some cases, financial regulation was the result of BOP equilibrium. For instance, Italy was forbidding movement out and Germany movement in because they had different needs: - Italy wanted to have a lot of investments, a strong investment flow (especially publicly supported ones like infrastructures) and the idea was to have low interest rate to make people invest and it was important that you interest rates were lower than the ones of other countries otherwise the result would have been higher interest rates. - Germany had a much better industrial structure (after some time from the first war) but their problem was that they had terrible experience with hyperinflation and wanted to keep it under control through Bundesbank. If you have a lot of inflows of capital es. if an American firm wants to give money to German subsidiary there is an inflow of capital, that goes on top of a CA surplus. With: fixed exchange rate, surplus in CA and big inflow of capital, what happens? To know that we must understand better: What is the BOP? CA + KA = FA (Current account + capital flow (F) + errors and emissions). If they are all plus, the BOP is in big surplus → it means a lot of foreign currency in the country and then the currency depreciates (they are cheaper). The point is: big surplus = big reserves Reserves are assets and, when CB buys the dollars, it is accumulating assets and CB receives dollars giving in exchange local currency to banks → in the balance sheet of CB it accumulates assets and there is more currency in circulation. The market solution (when dollar abundant and we don’t want to expand quantity of deutschmark) would be to depreciate dollar and appreciate deutschmark; but Germany did not want to change the exchange rate → the solution was related to income inflows: they prohibited outflows. Whenever you put restrictions, people find sideways to do what they want. There were capital flows that were going against the law by moving internationally and so the national macroeconomic autonomy was problematic. Not respecting the law made international financial flows much larger than desirable in the eyes of the national countries and London became the center of euro/dollar market. The euro dollar market is the possibility of making financial exchanges / transaction in dollars that is a foreign currency in a place that was not the US. Basically, it is the market for US dollars (financial activity, es issuing bonds) outside US. This was the first one of many xeno-currencies. There were a lot of markets like this. They were interesting because they were innovation that made domestic control on domestic policymaking less and less effective. The trilemma undermined the viability of the system BW practical solutions for internal and external equilibrium can be summarized in this way: Global Economic Policies and Institutions – Anna Natalia Rodriguez 42 Lecture 7: towards a US$ standard: the rise of the Eurodollar market and the end of the Bretton woods regime. Pragmatic reforms of the international monetary arrangements: the orle of the SDRs. Gold convertibility of US$: the Triffin’s paradox (chapter 19) 1947-71 history Triffin paradox is about the idea that BW was a hierarchical system with centrality of $ that benefitted the US but implied dollar convertibility into gold. Triffin said that there was a contradiction: they needed an international currency because a good currency must be abundant. How can dollars move around the world? The US should send them abroad, implying a BoP deficit for US. As the amount of $ out of US increases, the possibility of converting dollars into gold becomes less and less realistic. The graph that goes from 1950 to 1971 is about the amount of official liabilities (CBs holdings) because CB were tasked with conversion. This happened because over the years some national authorities asked for converting paper dollars into gold and so the amount of gold went down, this undermined the credibility of the gold exchange standard. (There was a point in what Triffin was saying, although someone thought he just wanted to avoid the centrality of US) Practice of BW beyond theory: historical overview - 50s The war ended in ’45 and after there was a clear distribution of spheres of influence between western countries and SU. There were decisions made about boundaries. The international monetary system, to which SU did not participate although it took advantage of it, in 50s was very successful, the BW represented the basis for reconstruction of international integration, there were financial flows also like the Marshall plan which was US $ coming in and also material goods coming in, even though it was not much compared to the rest, but enough to tilt the balance in favor of market solutions. The US played a role including 2 sides: hegemonic power and at the same time - provider of international liquidity $ - market of destination of the newly emerging manufacturing productivity of west and Japan At the time: rapid growth of GDP, no unemployment, reconstruction - 60s In 1958 countries different form US felt ready to declare their parity, that was the same they had informally committed to with declaring it during 50s. In the meantime, things happened: for instance, Europe and Japan were able to accumulate massive reserves in US$. This was clear as a matter of fact in 1960 because BW system was technically unfeasible. Besides this, in 60s there were different political positions and denunciation of the privilege of US that could buy things by printing money (this is De Gaulle’s vision). Apart from political debate, as a matter of fact in 1960s foreign liabilities in US$ to official owners exceeded US golden reserves and thus in 63 it was unfeasible > thus the gold exchanged rate standard lived on the basis of the BW written rules only for a bunch of years. However, the 50s had been truly good and so there was the need to modify the international monetary system keeping on having it based on fixed exchange rate, because it made international trade grow and international investment possible. Global Economic Policies and Institutions – Anna Natalia Rodriguez 45 AA DD graph With devaluation you can affect income levels and bring back external equilibrium and that’s why they can be used as policy tools, however it all depends on how expectations on the future exchange rate works, because if you depreciate and market expects you to depreciate again, new exchange rate will be under attack and this attack will make it more likely that depreciation will occur again (self-fulfilling). So, you don’t have consequently exchange rate adjustment because it is dangerous. Capital flights: if you expect currency to devalue > those who hold that currency don’t want it anymore but want paper. Capital flights reduces reserves, making the country more vulnerable (see chapters in book). 1971 In 1971 things came to an end: diverging domestic policy objectives between the hegemon and other big countries make it impossible to sustain cooperation among them. For instance, France had conflicting political interests with the US → In late 60s, US was engaged in Vietnam war and there were geopolitical implications of it because of historical interest of France in southeast Asia > in this period France highlighted as a problem the ‘exorbitant privilege’ of US dollar. The policy objective of US was to pay for the war + to pay for the so-called great society (= extensive welfare support) and to pay for these things there was the need to collect resources, how? - imposing taxes > but not the solution - issuing bonds (but you need buyers but $ was not so trusted) > but not the solution - print money (if you print dollars, you can use them in other countries, so they pay for your welfare) and this became not acceptable for foreigners! This was a problem for Germany for instance. In Germany: imported inflation due to fixed exchange rate became unacceptable by the end of the 60s. (spiegato: Germany is surplus > attractive for FDI (foreign direct investments) > step in mezzo > inflation) Inflation was not caused by a German policy but was forced to do this because of the commitment of fixed exchange rate. That’s why the system became unacceptable. The core problem was that there was incompatibility between - US domestic policies > needed expansionary monetary policies to finance war and great society - US foreign policies > this implied going against interests of partners and violate expectations that US would provide a correct amount of dollars. There was such a big amount of $ around that the only way to solve was to declare dollar not convertible into gold, this is what Nixon explicitly did. The system as held on the basis of oligopolistic cooperation, and it Global Economic Policies and Institutions – Anna Natalia Rodriguez 46 ended. This is linked to the IR’s hegemonic stability theory. Summary of this theory: after WWI and WWII we wanted to go back to fixed exchange rates and free trade, but we could not do so in both cases. What was the difference? Theory says that a new regime is credible if there is a leader clearly committed to it. In WWI there was a lack of hegemon, after WWII there was a clear hegemon. But after 71 we can say that hegemonic stability theory explains the rise of BW but the demise of BW has to do with a sort of hegemonic instability. This is to say that whenever one plays a massive power role, he inevitably builds contradiction between the different demands on the role of the hegemon (everybody wanted US to be the center and to provide a stable money but it was impossible to combine liquidity and credibility, it is impossible to be an open economy but at the same time to retain all the power, like an empire) After 1971 They met to solve the current disaster: all the members of the BW system needed to redefine system at the Smithsonian institute. This was a formal agreement. In 1973 Italy was the first one declaring that it would have gone for exchange rate. It was meant to be a temporary decision, to take care of centrality and unpredictability of those years. In 73, after going flexible ER, there was the first oil shock that was faced in different ways by countries. Flexibility does not mean leaving everything to markets, there is CB control to avoid excessive fluctuations. (the only country that declared not to care about exchange rate was US). The story of Europe was one of integration > Common budget with flexible exchange rate, can it work? It is difficult to decide which currency is used to express it. They moved to less flexibility, it created a thing named the snake. A sort of snake in the tunnel, made by established boundaries. (Exchange rate vs US and time as axes). If a country depreciates this has an impact on inflation and it requires further depreciation and there is a vicious circle. In 70s we realized that combining high employment and low inflations was complicated and involved expectations (there was stagflation). It was a period of financial independence and capital flights so if for instance there was a change in government in a country and the new government not trusted by markets, capital immediately flew away. There was a gain a sort of Rodrick triangle between - capital flows - national economy - domestic consensus The last 2 had to be chosen and the policy good for stability were very likely to be disliked and so there were events similar to civil conflicts (es. terrorism) in 70s. In this complicated period of 70s, there were efforts to provide European governance (monetary). In 1979 EU able to create European monetary system, that was a step towards the creation of the euro. In those years some seeds were planted at the international monetary level. All countries that signed the treaty to keep fixed exchange rate were against it. At the end of negotiations on how to reform the system they reached Jamaica agreement. They changed the articles of agreement. The charter of IMF required countries to preserve a system of stable exchange rate, and this moved the objective > not a system of stable exchange rate but a stable system of exchange rates. It was a way for them to ignore the problem but was a realistic solution: exchange rate became each member choice, but the fund surveilled the functioning of the system > it meant to collect info and provide tech analysis of situation of different countries and said them what to do. If country was in need of a financial assistance IMF, in this case the surveillance is a tool to influence the policy making in the country asking for IMF support. This is the reform of special drawing rights. The difference between the gold exchange standard and the dollar standard, was that in the second case, the decision to have the dollar as the exchange standard wasn’t the value that backed that currency (which wasn’t gold) but was connected to the authority of the issuer, aka the US. The dollar was between a domestic currency and an international fiat currency which expected the other currencies to convert into dollars at a fixed Global Economic Policies and Institutions – Anna Natalia Rodriguez 47 exchange rate. Countries later went for flexible exchange rate in 1973 and each country had different degrees of involvement of the CBs in the market. The idea was that the US was ready to play as a residual country and all of the other countries were pursuing active exchange rate policies. The US announced this with the idea that they looked at the ER with benign neglect. Between the wars there were many changes in ER but they were policy driven while after 73 the market was so developed that the market decided the given level of the ER and hence they had to cope with the N-1 situation where the US was playing the residual country. Summary chapter 19 Global Economic Policies and Institutions – Anna Natalia Rodriguez 50 consumer-durable expenditure, and home purchases, thus reducing aggregate demand and throwing the economy into a slump. Because the potential consequences of a banking collapse are so harmful, governments attempt to prevent bank failures through extensive regulation of their domestic banking systems. In most countries, an extensive safety net has been set up to reduce the risk of bank failure. The main safeguards are: - deposit insurance → in the US, banks are required to made contributions to the FDIC ( federal deposit insurance corporation) to cover the cost of the insurance. This discourages runs on banks by small depositors who know that their losses will be made good by the government. - Reserve requirements → force the bank to hold a portion of its assets in a liquid form that is easily mobilized to meet sudden deposit outflows. - Capital requirements and asset restrictions - Bank examination from government supervisors - Lender of last resort facilities → Banks can borrow from the central bank’s discount window or from other facilities the central bank may make available (generally after they post assets of comparable or greater value as collateral). Since a central bank has the ability to create currency, it can lend to banks facing massive deposit outflows as much as they need to satisfy their depositors’ claims. When the central bank acts in this way, it is acting as a lender of last resort (LLR) to the bank. - Government organized restructuring and bailouts→ CB LLR role is intended to tide over banks which suffer from temporary liquidity problems. The banking safeguards fall into two categories: facilities for emergency financial support to banks and their customers, and curbs on unwise risk-taking by banks. These two types of safeguards are complements and not substitutes. The possibility that you will take less care to prevent an accident if you are insured against it is called moral hazard. Domestic bank supervision and balance-sheet restrictions are necessary to limit the moral hazard resulting from deposit insurance and access to the lender of last resort, which otherwise would lead banks to make excessively risky loans and inadequate provision for their possible failure. The problem is that some banks have become so big in global markets and so interconnected with other banks and shadow banks that their failure might set off a chain reaction that throws the entire financial system into crisis. When a financial institution is systemically important—that is, “too big to fail” or “too interconnected to fail”—its managers and creditors expect that the government will have no choice but to support it in case it gets into trouble. The resulting moral hazard sets off a vicious circle: Because the institution is perceived to be under the umbrella of government support, it can borrow cheaply and engage in risky strategies that (while times are good) yield high returns. The resulting profits allow the institution to become even bigger and more interconnected, leading to more profits, more growth, and more moral hazard. The entire financial system becomes less stable as a result. For this reason, economists are increasingly in favor of curbs on the size of financial firms, despite the possible sacrifice of scale efficiencies. The credible threat of bank closure is necessary for limiting moral hazard—bank managers need to know they can be put out of business if they misbehave— but devising concrete procedures is not easy, especially in an international context. The challenge of regulating international banking The internationalization of banking weakens purely national safeguards against banking collapse. The global financial interdependence has made the need for effective safeguards more urgent. The result is the second trilemma for international policy makers. → the financial trilemma. Offshore banking involves a high volume of interbank deposits and this implies that problems affecting one bank can be contagious and spread quickly to banks with which it is thought to do business. An international banking system is harder to regulate than a national one: - Deposit insurance is absent in international banking. - The absence of overseas reserve requirements was historically a major factor in the growth of Eurocurrency trading. Nowadays, reserve requirements are less important in many countries. In part this is because governments simply realized the requirements’ futility in a world of globalized banking. Global Economic Policies and Institutions – Anna Natalia Rodriguez 51 - Bank examination to enforce capital requirements and asset restrictions becomes more difficult in an international setting. Banks have often been able to take advantage of this laxity by shifting risky business that home regulators might question to regulatory jurisdictions where fewer questions are asked. This process is known as regulatory arbitrage. Further, it is often unclear which group of regulators would ideally be responsible for monitoring a given bank’s assets. - There is uncertainty over which central bank, if any, is responsible for providing LLR assistance in international banking. There is a similar problem regarding the allocation of responsibility for bank supervision. - When a bank has assets and liabilities in many countries, several governments may have to share operational and financial responsibility for a rescue or reorganization. The resulting uncertainties can slow down or even impede the operation. Big, complex, highly interconnected global banks know how hard it would be for governments to shut them down and reorganize them rather than simply bailing them out, and this can encourage excessive risk taking. The financial trilemma constrains what policy makers in an open economy can achieve; only two goals are achievable at the same time: 1. Financial stability 2. National control over financial safeguard policy 3. Freedom of international capital movements In the early 1970s, the new regime of floating exchange rates presented a new source of disturbance: a large, unexpected exchange rate change that might wipe out the capital of an exposed bank. In response to this threat, central bank heads from 11 industrialized countries in 1974 set up a group called the Basel Committee, whose job is to “strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability,” per the Basel Committee Charter. They reached an agreement called the concordat which allocates responsibility for supervising multinational banking establishments between parent and host countries. In 1988, it suggested a prudent level of bank capital as a system for measuring capital. A major change in international financial relations has been the rapidly growing importance of new emerging markets as sources and destinations for private capital flows. Emerging markets are the capital markets of industrializing countries that have liberalized their financial systems to allow at least some private asset trade with foreigners. Countries such as Brazil, Mexico, Indonesia, and Thailand were all major recipients of private capital inflows from the industrial world after 1990. They were also very weak and contributed to the emerging markets’ severe financial crisis of 97-99. Among the problems there was the one of lack of experience in bank regulation. Thus, the need to extend internationally accepted “best practice” regulatory standards to emerging market countries became a priority for the Basel Committee. In 1997 it issued the Core Principles for Effective Banking Supervision and they were revising it when the 2007 crisis erupted. (vedi global financial crisis case study) The severity of the 2007-2009 crisis have led to reform both national financial systems and the international one: - Basel III → Regarding capital, the new Basel framework makes it harder for banks to get around capital requirements. Basel III still attaches risk weights to different assets, with assets deemed less risky leading to lower required capital. Importantly, Basel III also proposes to phase in a Liquidity Coverage Ratio, under which banks would be required to hold enough cash or highly liquid bonds to cover 30 days of cash outflow in specified crisis conditions. - Financial stability board → its job is to monitor the global financial system and make recommendations for global policy coordination and reform, sometimes in cooperation with other international agencies such as the IMF. - National reforms - The macroprudential perspective → on financial regulation seeks to have the financial system as a whole strong and not just the individual institutions. The Basel Committee has proposed that banks increase their capital ratios during lending booms in order to make the system more resilient during Global Economic Policies and Institutions – Anna Natalia Rodriguez 52 downturns, at which time capital requirements would be loosened. Why is this plan for “countercyclical capital buffers” helpful? If instead all banks simultaneously sell assets to increase their capital buffers in a financial crisis - which is what a micro prudential approach might suggest that they do - the result would be an asset “fire sale” that depresses securities prices and therefore endangers the solvency of the system as a whole. - National sovereignty and the limits of globalization → The Basel multilateral process, like multilateral trade liberalization under the GATT and the WTO, plays an essential rule in allowing governments to overcome domestic political pressures against adequate oversight and control of the financial sector. The process partially addresses the financial trilemma by facilitating some limited delegation of national sovereignty over financial policy. How well have international financial markets allocated capital and risk? The losses caused by financial crises must be evaluated against the gains that international capital markets potentially offer. The international capital market has contributed to an increase in international portfolio diversification since 1970, but the extent of diversification still appears incomplete compared with what economic theory would predict. Feldstein and Horioka pointed out that a smoothly working international capital market allows countries’ domestic investment rates to diverge widely from their saving rates. In such an idealized world, saving seeks out its most productive uses worldwide, regardless of their location; at the same time, domestic investment is not limited by national saving because a global pool of funds is available to finance it. The main problem with the Feldstein-Horioka argument is that it is impossible to gauge if the extent of intertemporal trade is deficient without knowing if there are unexploited trade gains, and knowing this requires more knowledge about actual economies than we generally have. An alternative explanation of high saving-investment correlations is that governments have tried to manage macroeconomic policy to avoid large current account imbalances. A quite different barometer of the international capital market’s performance is the relationship between onshore and offshore interest rates on similar assets denominated in the same currency. If the world capital market is doing its job of communicating information about global investment opportunities, these interest rates should move closely together and not differ too greatly. Large interest rate differences would be strong evidence of unrealized gains from trade. The foreign exchange market is a central component of the international capital market, and the exchange rates it sets help determine the profitability of international transactions of all types. Exchange rates therefore communicate important economic signals to households and firms engaged in international trade and investment. If these signals do not reflect all available information about market opportunities, a misallocation of resources will result. Studies of the foreign exchange market’s use of available information are therefore potentially important in judging whether the international capital market is sending the right signals to markets. There are three kinds of tests to check this and the most important are: 1. tests on interest parity → Recall that interest parity holds when the interest difference between deposits denominated in two different currencies is the market’s forecast of the percentage by which the exchange rate between those currencies will change. Since the interest difference, Rt - Rt*, is the market’s forecast, a comparison of this predicted exchange rate change with the actual exchange rate change that subsequently occurs indicates the market’s skill in forecasting. Statistical studies showed that this difference is a bad predictor (consider the carry trade or the fact that it doesn’t say in which direction the spot ER would change. This test suggest that the market ignores readily available information in setting exchange rates; but because the interest parity theory ignores risk aversion and the resulting risk premiums, the theory may be an oversimplification of reality. Attempts to model risk factors empirically have not, however, been very successful. 2. Test of excessive ER volatility → yield a mixed verdict on the foreign exchange market’s performance. Global Economic Policies and Institutions – Anna Natalia Rodriguez 55 What is rational in a bubble? A bubble may be totally rational. A share price that goes up at time t is rationally motivated by an expected increase for time t+1 We expect price to go up and by buying shares we make prices go up but how far do you get from the fundamentals? Economists disagree on what “efficient” and “rational” means and on whether the bubble was justified rational or exuberant. Beliefs and bubbles Exchange rate determination in the short, medium and long run Exchange rate after 1973 because more and more determined as asset prices and most currency transactions are in short term and become interest bearing assets. For risk neutral agents, the overall returns of holding a given currency, say that $, must be equal to the return of holding the alternative currency, say the €. The currencies cannot be compared and hence one has to hold them and know that equilibrium will imply that holding one or the other will give the same return. The returns on holding a given currency have two components: - The interest rate on that currency - The expected appreciation or depreciation of that currency Exchange rates in the long run and in the short run In the LR, the PPP determines the fundamental value of the ER and the changes of the ER tend to reflect inflation rates differentials. The country with a higher inflation will need to depreciate the currency. The LR provides some idea of what the correct ER should be but in the SR ER are determined by expectations and this means that there is volatility of the nominal ER. In the medium run there is short term volatility and then some long run anchor. Money neutrality implies that the money supply, price levels and ER move in the same proportion over the LR. For instance a 50% increase in money supply means a 50% increase in prices (inflation and a 50% increase in the price of foreign currency (domestic depreciation). In the SR there is the need of expected returns to be equal and the overall returns of the two currencies considered must be equal to : Global Economic Policies and Institutions – Anna Natalia Rodriguez 56 Finance is a game changer especially in those countries that are involved in it. Even rational expectations can be open to surprises and this is why some say that the market is living a period of irrational exuberance and other say that things are rational and things just come by surprise. The model we represented is a short run model and should be able to explain the short run dynamics. The model says that today’s prices reflect our expectations of tomorrow and if they change also the prices will. The volatility shows the difference between the expectations which is usually much higher than the actual change in prices. Prices move very little and exchange rate moves a lot and this casts enormous real implications. This is because when ER changes also the real ER changes and competitiveness changes. The implication of the real ER change implicates that the signals of the market to firms and consumers are volatile as well. Foreign prices expressed in domestic currency fluctuate, affecting consumers ‘choice and firms’ investment decisions. Volatile ER make international trade and investment decisions more uncertain and the systemic risk increases. There are also the nominal ER “waves” which show the depreciation or appreciation of a currency compared to another one. Lecture 10: Real shocks and debt crises. The 1982 emerging countries debt crisis; the Highly indebted low-income countries HIPC initiative; the 2007-08 global financial crisis: causes and consequences. Fundamental crises, self-fulfilling crises (chapter 22) Finance is historically a transnational affair. Crisis are endemic and aren’t caused by an accident coming from outside or due to something absolutely unexpectable coming; but it is a sort of built in mechanism within a business which is all based on the future, on expectations and which allows making money out of big dimension and the bigger the dimension, the riskier the environment, and more likely crisis become. Fact sheet on debt crises The euro dollar system emerged in the 60s and it was mostly interesting for multinational enterprise, individual countries that didn’t want to have political connection with Europe and in general people interested in having a safe. In the 70s, there were flexible exchange rates which gave even more prominent role to the euro dollar market because the reasons for going to the euro dollar market were also related to making speculative decisions. Then a political event with dramatic economic consequences occurred: 1973 quadruple price of oil in a period in which oil exported by oil exporting countries had really no alternative. Oil and gas in the channel, in northern Europe everybody knew it was there but not convenient to extract it so that was a big shock, quantitatively huge. All countries had to react because they were importers of oil, including those who had some oil. And national policymaking was quite different depending on the local circumstances, but all countries went through stagflation: means stagnation so during a stagnation you don’t use financial markets to do fancy things for making money so the financial market lost some of the typical clients which were enterprises that were working in high income countries. These firms had to cope with the lack of demand so they didn’t make a lot of investment and this environment was uncertain so these banks lost clients on the loans side. However, they gained a lot of clients on the depositors side because the countries that gained most out of the oil shock were small rich scarcely populated countries in the middle east. They wanted to keep their money in a safe place, decent rewards, possibly far away from western countries not from the western business. So imagine this bank, a typical euro dollar bank say JPMorgan receiving a lot of dollars, having to provide interest payments and at the same time seeing very little in terms of possibility of lending but if you don’t lend, you don’t get interest rates that allow you to pay interest rates on deposits so the situation was tricky so what did they do? The euro Global Economic Policies and Institutions – Anna Natalia Rodriguez 57 dollar market started finding new clients which were a particular set of lowish medium income countries, we started calling them emerging countries. These emerging countries had a feature usually poor, interested in investing including social infrastructure. These countries had in common one thing: they were usually large significant countries with a level of income which was medium, sometimes medium high with long term project and short run need of cash. Of course you don’t lend money to those who have shortage of cash, so these countries in addition had some feature that allowed banks to think that these countries would pay back; the common features was: being oil exporters. (Mexico, Venezuela, Nigeria). So this was the new thing: the banks were lending to these usually official borrowers so nations and that is why we speak of sovereign debt with a very special contract. In order to make sure they would repay the contract would be short run (3 months), automatically renewed but with an adjustment to interest rates these are called roll-over loans so loans of 3 months. 3 month with a formula determining which will be the interest rate in the next 3 months and the formula was simple. It was a lending in dollars so: interest rate on roll over loans in dollars=interest rates in the US which is changing every 3 months depending on the functioning of the monetary market in the US. In the foreign market international financial system for example, the kind of interest rates that banks would practice among themselves is the LIBOR (London interbank offered rate). This is the interest rate that banks practiced with each other. Depending on the country risk: if you are a well reputed country the spread is small, if you are a risky country the spread is bigger. Rollover=ius (lior)+ spread There was no need to agree, you borrowed money, you kept it for 3 months then you have to give it back with some interest. At the same time the bank is offering you a new loan and you can ask a bigger loan. Countries had long term projects, short term money so they wanted to have short term loans for a long time and in order to access short time loans for a long time you have to repay so you needed to borrow ever larger amount of money because you needed to borrow not just what was necessary to repay the loans but also the interest. And the algebra of this series is an algebra that doubles the amount of money that you owe to your lender so there was a built-in mechanism that made the loans growth very fast. At the beginning countries were lured into this business because there were still rigidities in these countries and they tended to have fixed exchange rates and the exchange rate was kept under control by the CB but there was very little domestic finance, so countries could pursue national interests without worrying about the functioning of world financial markets interfering with local interest. Hence, these countries often had inflation and if you have inflation but you manage to keep fixed exchange rates you repay an amount of dollars which is set outside but an amount of domestic money which is in fact associated to a lower purchasing power because of inflation so these countries believed it was a huge opportunity for them so they heavily borrowed. There were roll over loans and there were syndicated loans. Syndicated loans: there was a leader proposing other banks to be partner of this group lending money so these banks had the idea they were sharing risk. This went on till the 70s. At the end of the 70S, stagflation was understood as a problem in rich countries because they realized they kept inflation high but this didn’t lead to lower unemployment, it led simple to higher inflation. So in some countries this situation was tolerable, in others it wasn’t. Elections were won by two people in US and UK which were the most important financial centers, we had Reagan and Thatcher and they won the election with a program of curing inflation. Volker was appointed chairman of the FED and he immediately started restrictive monetary policy: you decrease the rate of money creation, money becomes scarcer, interest rates go up and that is good because interest rates go up and that is how you keep inflation. Both strategies were successful, inflation was reined in in the US. Domestic objective: reducing inflation, instrument: monetary policy, consequence: interest rates high, which were desirable form the internal point of view but had a terrible consequence at the world level: the interest rate in the US went up and the countries that were accustomed to borrowing with the level of int rates in US + spread, found themselves to keep borrowing with a higher interest rate and that fueled this growing amount of debt so there was the systemic effect, rise in so called world interest rates and all indebted countries were suffering. Then in 1982, Mexico said it wasn’t able to repay the loan. That was a shock because at that time Global Economic Policies and Institutions – Anna Natalia Rodriguez 60 Servicing the external debt At some point you have to serve the external debt, you have to borrow to serve the foreign debt, debt increases and you are at the bifurcation, you have financial inflows that allow financing the deficit and this money that comes in and allows you to finance the deficit alleviates pressure on ex rate. Hence, you do not have to worry about the exchange rate, you have money flowing in. If inflation goes up, you keep the ex rate stable, but the real exchange rate appreciates and you end up with a problem in competitiveness: the local goods cost a lot so it is good to import and it is difficult to export so the financial mechanism brings into micro economic consequences in terms of competitiveness. Lower competitiveness leads you to an unstainable path and the crisis will come. The typical form of an emerging country debt crisis The contrast between SR ex rate strength and LR expectations of an unsustainable foreign debt is such that you find yourself in a fund disequilibrium. The SR is fine but the LR is problematic. You are trapped in a beauty contest story, what are financial markets looking at: at the SR prospects or at the LR fund disequilibrium? Which kind of event can cause this capital flow reversal? Instead of putting money into the country I am pulling money out of this country? All crisis we will discuss including the European crisis follow this pattern. So everything seems fine, SR perfect. What about the fundamental, should I care about it? No. but If somebody starts caring about the fundamental, then you see the path is unsustainable and everybody pulls out of that country. Soros realized that in 1992 the European process of creating the monetary union wasn’t going to work and 1992 the European crisis was huge and it seemed to be the end of the European monetary process but then at the end of the decade 1989 we started with a new plan for the monetary union and we achieved the monetary union but all these steps are never the end of the story. The solution sometimes comes by negotiation but more often comes by crisis. And anything can trigger the capital flow reversal. For example in 1997 we had the south east Asia financial crisis that was triggered by Indonesia. It was caused by foreign capital pulling out of Indonesia and this also affected the nearby countries including countries that apparently had no SR problems at all: south Korea, and all the smaller states were very successful, small emerging economies but the trigger, the pulling out of money from Indonesia was also a problem for all the other countries, you see everything is in the mind of those who make decision as in the beauty contest story. Whenever you have a crisis, you have emergency finance and finance comes with conditions attached and adjustment is required and adjustment can be painful. Some evidence on debt crises Some evidence: it is the most successful emerging countries that face the risk of crisis, because poor countries don’t face sudden reversal, they face constant lack of capital. For example Mexico accessed NAFTA in 1994 and had a huge financial crisis in 1995. Greece accessed eurozone in 2001 but then very suddenly was included in the club but then discarded by the club but the problem was: being focused on the SR or suddenly realizing that there is a LR? Well I think there is some guilt also on taking only the SR view because if you have a debtor, you also have a creditor and the relationship connects two and so if there is excessive credit given the SR expectations that the SR can be repaid, in the LR it will be their business not my business, this SR exaggeration in trusting a country without any LR consideration that is also something we should bear in mind as a problem. Least developed countries have this debt crisis which is due to official loans and in some cases these loans are mis-spent. So we have to look at the two sides and try managing and is not surprising that official development finance is becoming a smaller and smaller part of total financial flows. And as we saw the crisis for low income countries and crisis for emerging countries can be connected. Global Economic Policies and Institutions – Anna Natalia Rodriguez 61 Debt and financial crises in high income countries (imp box ch 19 transf and crisis in world economy + chap 20 global financial crisis 2007-2008) Financialization and the 2007-08 crisis 2007-2008: it came by surprise, maybe the surprise should have been a bit less if we had kept in mind the 1998 Shelton Merton LR asset management disruptor. First of all, an unregulated finance between the BIS did some for regulating financial flows, the so called “Basle rules”. But the idea is to curb those financial flows that increase risk not those that decrease risk so the idea is separating hedging so to control for risk from speculation for risk assuming positions. At the beginning there were some rules but they were disregarded by many countries because they seemed to be reducing also the good kind of finance. What they agreed in Basle was a reform of these regulations on the basis of accurate self-assessment of risk, on the basis of financial institutions. Whether a transaction is hedging or speculation is only in your mind. So there was a logic in this self-regulation. The point is: is it depending on who is making the decision? Because if they are people they can be prudent, if they are machines they simply don’t know, they have no idea, they are instructed to profit of any discrepancy and that is it. Nobody knew what finance was trading. The 2008 financial crisis summary: They had these two institutions that were publicly financed in the US that were giving loans to subprime clients (to clients who were not rich and probably not surely able to repay) but they were to be encouraged in having their own homes so you could lend them money and if they couldn’t repay, the mortgage would imply that the home would go back, would be sold in the market and these two institutions would function. This system seemed to provide a huge opportunity for low income people in the US because they were in the early 2000 the prices of all homes were going up, real estate prices and this implied that these families felt richer so they felt they could borrow more and this led to unsustainability of this because at some point the crash came. And so these families found themselves owing money not being able to repay, but the point was the institutions found themselves with homes that were valued less than the amount of the loan and so these banking institutions went bust, but that is not a global financial crisis, because these firms had repackaged the loans in new tools that were sold with a nice label of being reputable. This new assets that included refined and re-elaborated versions of these bad loans ended up in all the big portfolios in the world and it took time to realize that those were toxic loans because you needed all the steps to go through. So this mortgage houses weren’t repaying their debt, and those to whom they should have repaid their debt weren’t able to repay their debt because there was a huge amount of leverage, the leverage was 9 in 1982 financial crisis: banks had an amount of loans 9 times their capital, this number in 2007/8 was estimated to be 130. So this financialization came in a disturbed environment. Big growth so SR fine. high inequality, very little transfers to developing countries and quite the reverse resources file from developing countries to high income countries in terms of accumulated reserves. Which makes sense, these countries went through fin crisis in the last part of the 20th century, in the 21st century they started piling up their reserves, they knew they couldn’t trust the system, they had to save their own reserves. And the financial market became increasingly opaque, most transactions were made over the counter and many financial transactions weren’t made by bank which were regulated somehow but by other institutions that go under the name of shadow banking, things that aren’t banks but behave like banks. They are unregulated like the euro dollar market, it emerged because of a space of unregulated transactions. So the shadow financial market emerges as a form of shadow banking, the increase in leverage and the serious risk of losing systemic trust as the Minsky hypothesis explains. Exchange rate crises. Fundamental versus self-fulfilling crises? Self-fulfilling crises Imagine one country’s domestic policies are well aligned with external equilibrium. This outcome may be pursued by domestic policy authorities that accept a voluntary sacrifice in terms of internal equilibrium (say, income is lower and unemployment higher than desired, in order to adjust a current account deficit). Is this “virtuous” country exposed to financial crises? Global Economic Policies and Institutions – Anna Natalia Rodriguez 62 Unfortunately, yes, it can be. even virtuous countries can be exposed to financial crisis like south Korea because once the attack start and if money flows out of the country, the country has to cope with this situation and this makes this country more vulnerable and it is the perfect time for a second attack which will make the country even more vulnerable. And at the end of the day you start okay and you end up being very vulnerable. An example → suppose markets expect the country won’t be able to respect some self-imposed restrictive policies. For instance, Italy wants to be virtuous so self imposes a strict government budget, but financial markets say they are Italians they will never make it and they try to sell Italian bonds, what happens to Italian bonds? Their price goes down, the interest rates goes up, the spread between Italian bonds and German bonds (which pay a low interest rates), Italian bonds have to pay a high interest rate. Why is it so? Because people want to sell these bonds unless you give them high interest rate. What happens to public deficit? It goes up because you have to pay interest rates. Why does the government deficit go up? Because the Italian authorities aren’t responsible? No, because financial markets are making the spread go up and so the budget deficit goes up. If you look at the long term performance of public finance in Italy and Germany distinguishing between current expenditure and interest rates you see that Italy has been well behaved but you see that the debt has gone up because of interest rates building upon themselves and they build upon themselves because of negative expectations. That is how self-fulfilling crisis come, by shifting vision in financial markets that for some time feels happy about SR equilibrium and don’t care about fundamental, then the change of vision starts saying what if they you give them a test, but if you put them to a test they will fail almost automatically because of the inner mechanism that if you attack a country, the country becomes more vulnerable, more vulnerable country is the perfect target for an attack, self-fulfilling. Then you have to discern when it is fundamental, when it is self-fulfilling, because the two things both can happen. Economists disagree. Because in some cases you say that it is a pure self- fulfilling, this country had no guilt at all, or mostly self-fulfilling or this is a fundamental equilibrium we have to fix it. Different people are correct to say different things, there is nothing wrong in disagreeing, the point is being opened to the possibility of a different interpretation. Kindleberger elaborates on Minsky’s hypothesis Global Economic Policies and Institutions – Anna Natalia Rodriguez 65 and financial system like Italy, Greece and Spain. The 2010-2013 financial crisis was not due to misbehavior of countries but was due to a long run structural problem which is the macroeconomy asymmetry regarding the presence of one monetary policy and many fiscal policies. How can you have equal fiscal policies if there are very different performances? There is also another structural problem: the countries that need to borrow, are borrowing in a currency which is not their national currency and this is called the original sin. As all countries that cannot borrow abroad by issuing bonds denominated in their own currency. There was a similar story with the covid crisis. The primary fiscal balance is composed by the government revenues minus the expenditure. Primary means the kind of government expenditure and taxation decided by the early budget, not the interest payment on that . this is important information because in 2022 you cannot change the amount of interest rate regarding previous debts, but it is already there and you have to pay it. Primary fiscal balance was measured to understand attitude of governments. There is an ongoing debate on appropriate fiscal rules for the eurozeone countries and the fiscal rules were suspended during the pandemic which is a symptom of big change. In April 2021 there was the creation of the next generation EU→ at the heart of the EU’s response to the covid19 pandemic. This was founded with the EU borrowing on the capital markets. There seems to be an emerging consensus that, in diverse monetary union, managing sovereign spreads is part of the monetary policy; the ECB also sees as its duty to curb the financial risks of climate change. Regarding the spread, if the financial markets feel that the new government of a country is not going to be good, they might drive interest rate of that country up. This is an addition to government expenditure which will make that country perform badly. This is a self fulfilling financial prophecy. This is something that cannot work in a union → we are back to the Rodrik’s triangle. Inflation is back Inflation is not only a European problem and we need to understand how much of the inflation is a macro or microeconomic problem. The macro dimension of inflation is due to expansionary fiscal and monetary policies while the microeconomic nature is connected to temporary shortages due to the pandemic and the increase in energy prices. The trilemma and financial crises: a long run perspective on debt crises management Historical evidence on crisis management: 1st peak was during WWI in which debt was not issued and in fact the war was financed by printing money and there was the period of the disintegration with the nationalistic polices. The 2nd peak was in 1929 in which Global Economic Policies and Institutions – Anna Natalia Rodriguez 66 there was the great depression which of course was better in the emerging countries than in the advanced one. the 3rd peak was 1945 with WWII. There was a moment between 1950 and 1970 in which the debt went down because of the Bretton woods accords where the countries tied to be together and those numbers were low because the GDP after WWI exploded and this is the denominator in the function. This was an unprecedented growth. After 1971 the Bretton woods ended and we moved form a flexible exchange rate to one in which there was a change in perspective and debt of emerging countries exploded because of the oil crisis in 1973 (that led to low GDP growth→ when countries have recession, they don’t borrow a lot form financial markets and in fact in this period the clients of the Eurodollar markets started no longer to be nation states and multinational firms, but oil exporting countries who were not poor and didn’t use that money. So the new clients were merging countries and when they reached the peak in the graph there was a reversal of the debt/GDP ratio for the emerging countries was the 1982 debt crisis from Mexico→ Thatcher and Raegan wanted to control inflation and they managed to do that in these two countries but in the other countries there were high interest rates in 1981 and then there was the debt crisis which started with Mexico and spread in the others especially in the poorest ones. From 2000 to 2010 there was an increase in GDP debt because of the global financial crisis in which countries had to bail out banks. We need to compare the current situation with what is in this graph → we are in a peace time compared than in the past even though wars exist still. The important thing to look at is the level of debt over the GDP and the difference between the private and the public debt. In 2007 advanced economies had a 250 ratio and this made them very vulnerable to any event and in fact the subprime crisis which started as national because a very big issue. Blue line = total public debt/GDP world average (line discussed before). Yellow = percentage of countries I default/restructuring from 1826 to 1900 (gold standard) and1900 2000. Countries defaulting on their debt (who did not pay for the debt) are part of the history of the world since industrial revolution. What is there in 20 century and not in 19th? Countries that have high inflation → by inflating you can create purchasing power of some sort and tax and, if you borrow in your own currency, inflation is a way to reduce the real value of the currency. The problem we have today was faced by countries in history and was solved using the trilemma: you have to decide between integration, national policies (that is not an option) and to develop cooperation. We need cooperation and common management to solve crises.