Globalization International Financial (Chap. 8) and Monetary (Chap. 9) Relations
The Puzzle of Finance n Every year, approximately $5 trillion is invested abroad. Why is so much money invested in foreign countries? n And why do relations between foreign investors and the countries in which they invest often become hostile and politically controversial? n Why did the U.S. economy crash in 2008?
The Puzzle of Money n In the absence of global government, how are international currencies supplied and international monetary relations regulated? n What s the Eurozone and why does it matter? n What s wrong with Greece?
Balance of Payments (BoP) n BoP = Current Account + Capital Account n Current Account (Net Income flows) = n Balance of Trade (X-M) n Factor Income (earnings on investments - payments to investors) n Cash Transfers n Capital Account (Net Change in Assets) = n Change in foreign ownership of domestic assets - change in domestic ownership of foreign assets
US Current Account Balance
Current Account Imbalances
How does a country correct a current account deficit? n Given that the balance of payments must sum to zero, a structural deficit in the current account must entail: n Change the exchange rate to correct imbalance. n Deflate the domestic economy (reduce growth) to correct imbalance; austerity in Europe. n Borrow abroad (or sell foreign assets).
Types of International Finance n Portfolio Investment: bonds, equities without controlling interest, or other financial instruments. n Sovereign Lending: private lending to foreign governments. n Foreign Direct Investment: investments in which the investor maintains managerial control.
Why Borrow? Why Lend? n Borrowing for long term development often good for economy. n Borrowing for short term fluctuations can be efficient. n Borrowing to fund current consumption is dangerous. n Lenders seek highest return given political risk.
U.S. Finances its Current Account Deficit n Faced with a current account deficit: n US borrows from countries with surpluses. n Sells assets held abroad. n Faced with a current account surplus: n China and other surplus countries lend to the U.S. and other deficit countries. n Purchase assets in the U.S. n Problem is one of credibility: as debt increases, will or can the borrowing country repay? n US is uniquely able to borrow because of reserve asset status of the dollar and the security of Treasury bonds.
Creation of the Bubble n U.S. savings rate close to zero, federal budget deficit expanding, and current account deficit increasing. n Federal Reserve Bank lowers interest rates after tech bubble burst in 2000 and keeps them low. Borrowing expands, with much of the new lending going into the housing market. n Rather than boost savings and reduce consumption, U.S. borrows abroad to keep economy growing. n Banks also increase leverage. Newly deregulated financial sector takes on more risk to increase returns, hedging through exotic financial instruments.
The Financial Crisis Pre-Crisis Peak Total Debt as percentage of GDP Great Depression Total Credit Market Debt as percentage of GDP in US
The Housing Bubble Delinquency Rates on Mortgage Types
The Crisis n Hedging through exotics assumed risks were uncorrelated. Housing collapse highly correlated. n Highly leveraged banks exposed; debt-toreserves ratios rise. Banks halt new lending to consumers, corporations, and each other.
When the Bubble Burst Jul 13: nationalized by the federal government Sep 15: files for bankruptcy; agrees to be taken over by Dow falls 504 points, most since 9/11 Sep 20: Henry Paulson outlines $700 billion bailout plan. Bankruptcy judge approves a purchase of core US business Dow Jones Industrial Average Jan 11: buys Mar 16: buys Jul 11: seized by the FDIC Sep 16: rescued by the federal government Sep 25: buys Sep 21: and become bank holding companies Sep 29: House rejects $700 billion rescue plan; Dow falls by a record 777 points The Gathering Storm: Debt Build Up Liquidity Crisis: Banks in Peril Market Collapse Government Intervention Massive Deleveraging Source: Investment Banker On Life (dot) com; Capital IQ
Crisis Spreads Without lending, economy moves into recession, exacerbating the underlying problems. Stock market collapse reduces wealth and consumption further. Highly interdependent global financial markets and banks collapse, first in U.S., then in Europe.
U.S. Response U.S. loans massive amounts of capital to banks in (largely failed) effort to restart lending. Federal Reserve Bank prints money. Congress passes Troubled Asset Relief Program (TARP). U.S. engages in additional stimulus spending, enlarging federal deficit.
The Bailout In Context Inflation-Adjusted Costs of Various Programs / Events in US History Federal Housing Administration TARP - $700B Committed Marshall Plan Louisiana Purchase Race to Moon S&L Crisis Source: Bianco Research, The Big Picture, BEA, Bloomberg * Indicates committed funding, not actual outlays to date 1
Other National Responses n China engages in new stimulus spending. n Bank of England responds aggressively in supporting financial sector. n All of Europe insures depositors after Ireland does so. n Iceland and other off-shore banking centers fail. n Europe relies on built in stabilizers of social welfare spending and deflation for highly indebted Mediterranean countries. n Eurozone crisis begins in Greece in Spring 2010.
How does a normal country correct a current account deficit? n Given that the balance of payments must sum to zero, a structural deficit in the current account must entail: n Change the exchange rate to correct imbalance. n Deflate the domestic economy (reduce growth) to correct imbalance; austerity in Europe. n Borrow abroad (or sell foreign assets); U.S. solution until 2008.
Why the Exchange Rate Matters n To exchange goods with others in a foreign country, need to convert one currency into the other. n Foreigners want to be paid in their own currency. n To buy assets in another country, foreigners need to covert their currency into the home currency. n When balance of trade is negative, a country should depreciate its exchange rate, lowering the price of its goods. This stimulates exports and lowers imports. n When BoT positive, should appreciate.
Depreciation of the Dollar (relative to the Chinese Reminbi) Exchange Rate Appliance in Jan. 2005 1 = $0.122 7,000 $854 $1 = 8.28 Appliance in $ Feb. 2013 1 = $0.159 7,000 $1,117 $1 = 6.65
Appreciation of the Reminbi (relative to the Dollar) Exchange Rate Machine tool in $ Machine tool in Jan. 2005 1 = $0.122 $25,000 207,000 $1 = 8.28 Feb. 2013 1 = $0.159 $25,000 156,637 $1 = 6.65
Exchange rates affect interests n A depreciation in the exchange rate: n Benefits exporters, as the price of their products is now lower. n Benefits import-competing industries, as the price of foreign products is now higher (implicit protectionism). n Harms consumers, who pay higher prices for imported products (and domestic substitutes). n Inverse for an appreciation in the exchange rate. n Yet, all tradables sectors also want exchange rate stability (predictability) and, thus, prefer (low but) fixed exchange rates.
Beggar-thy-neighbor policies n Why don t the beneficiaries (exporters and importcompeting industries) always lobby for depreciated exchange rates? n Free rider problem. Effects of depreciation spread across all tradable sectors. n If all countries did so, none would reap an advantage, and each would only lower its purchasing power against countries that did not depreciate. Approximates a Prisoners Dilemma. n Beggar-thy-neighbor monetary policies in the 1930s worsened the Great Depression. n Given incentives to defect, need exchange rate regime (institution) to facilitate cooperation and exchange.
Exchange Rate Regimes n Gold standard (1870-1929): all major currencies convertible into gold at fixed rate. n Bretton Woods regime (1950-1973): major currencies fixed to the dollar; dollar fixed to gold. n Present (1973-): major currencies float against each another, minor currencies fixed to different major currencies. n Eurozone is a fixed currency regime.
The Problem of Fixed Exchange Rates n Under fixed exchange rate regimes, to correct current account deficits, countries must boost savings and reduce investment by raising interest rates, raise taxes, or reduce government spending. n All reduce the rate of economic growth. n This was the primary mode of adjustment under Bretton Woods regime and is required for eurozone members.
Current Account Imbalance within Europe
Austerity in Greece n Eurozone within the EU is a fixed change rate regime. n Only option for deficit states the so-called PIGS is to deflate their economies by reducing government spending, raising taxes, or both. n Austerity policies producing extremely high unemployment in Europe and continuing recession.
Austerity Improves the Current Account
At the Expense of Employment and per capita Income
Greece s Great Depression
What Can Greece Do? n Endure austerity. n Leave Euro and return to national currency, which can then be allowed to depreciate. n Convince Germany and European Central Bank to increase monetary growth to offset Greek austerity. n Convince banks to forgive Greek debt. n On-going negotiations.
Conclusion n Distributional implications (interests) of exchange rates require some regime to manage. n Fixed exchange rates impose rigid economic constraints on government policy. n This implies austerity in eurozone countries in light of Germany s emphasis on price stability. n U.S. exempt from economic constraints, but freedom to borrow can also be dangerous by creating economic bubbles that then burst.