GlobalizationInternational Financial (Chap. 8) and

Monetary (Chap. 9) Relations

The Puzzle of Financen 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 Moneyn 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 Financen 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 Deficitn 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

Total Credit Market Debt as percentage of GDP in US

Great Depression

Pre-Crisis Peak

Tota

l Deb

t as p

erce

ntag

e of

GD

P

The Housing BubbleDelinquency Rates on Mortgage Types

The Crisisn Hedging through “exotics” assumed risks

were uncorrelated. Housing collapse highly correlated.

n Highly leveraged banks exposed; debt-to-reserves ratios rise. Banks halt new lending to consumers, corporations, and each other.

Source: Investment Banker On Life (dot) com; Capital IQ

Jan 11:

buys

Mar 16:

buys

Jul 11:

seized by the FDIC

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 16:

rescued by the federal government

Sep 20: Henry Paulson outlines $700 billion bailout

plan. Bankruptcy judge approves

a

purchase of

core US business

Sep 21:

and

become bank holding companies

Sep 25:

buys

Sep 29: House rejects $700 billion rescue plan; Dow falls by

a record 777 points

Dow

Jon

es I

nd

ust

rial

Ave

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e

The Gathering Storm: Debt Build Up Liquidity Crisis:

Banks in PerilMarket

CollapseGovernmentIntervention

Massive Deleveraging

When the Bubble Burst

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.

1

Marshall PlanLouisiana Purchase

The Bailout In Context

Source: Bianco Research, The Big Picture, BEA, Bloomberg* Indicates committed funding, not actual outlays to date

TARP - $700B Committed

Inflation-Adjusted Costs of Various Programs / Events in US History

Federal Housing Administration

Race to MoonS&L Crisis

Other National Responsesn 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 Mattersn 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 ¥

Appliance in $

Jan. 2005 1¥ = $0.122 ¥7,000 $854

$1 = 8.28¥

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 interestsn 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 policiesn Why don’t the beneficiaries (exporters and import-

competing 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 Regimesn 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 Ratesn 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 Greecen 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.

Conclusionn 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.