6.1 crises of financial openness: financial and currency crises Flashcards
Great Depression
1929-1939
Longest and most severe crisis ever experienced by advanced industrialized countries in the West
US:
- real GDP fell 29% 1929-1933
- unemployment rate peaked at 25% in 1933
- consumer prices fell 25% (deflation)
- 7000 banks (nearly 1/3 of banking systems) failed
Europe:
- Germany got hit one of the hardest: manufacturing declined by 39%, unemployment peaked at 44%
- prices fell by 30% or more in European countries (+ many were already in eco problem before crisis, the great depression did not help)
great depression - run up
1920s: Gold Standard + persistent imbalances
- US CA surplus
- some of Europe CA deficit (bc lost competitive position in WW1)
huge war debts and reparation payments in Europe (much of it going to the US)
-> huge inflow gold US
US could let prices rise to maintain its peg to gold, or it could run a financial account surplus to get BoP balanced
-> US lent money back to Europe in the form of international bonds
-> boom in credit and international bonds in the US (also private, not just gov that did this)
onset great depression
1929 US tightens monetary policy to limit stock market speculation (bc boom in credit) -> stock market crash
effects:
- immediate wealth effect: people held stocks, they lose them, they lost part welfare
- uncertainty about econ -> less spending on consumer durables (you’re not gonna buy something expensive if you think you’ll lose your job or smth)
- banks had lent to those invested in the stock market -> weren’t repaid -> started failing
Smooth-Hawley Tariffs and retaliation = collapse in world trade = not helpful
-> bank failures: bank runs bc of panic (no deposit insurance)
where was the Fed?
- many local banks were not member of the Federal Reserve system -> couldn’t borrow from the Fed as lender of last resort
- interest rates were nominally at 0, but deflation meant that borrowing and investment was still costly
- trying to preserve the gold standard limited expansionary monetary policy and bank bailouts
bank runs (great depression)
“fractional reserve banking” = banks don’t keep all the money you deposit, lend it back out or invest it to make money
self-fullfilling prophecy when customers start to doubt if a bank can repay them: they will withdraw their money -> when enough people do so, the bank fails
!since 1929 not really bank runs anymore bc governments and central banks guarantee that you get your money back
great depression spread to Europe
gold standard -> when USD contracts, European currencies also have to contract -> interest rates in Europe were raised
loans from the US came to a halt
rise in protectionism + US consumer market depression + no more cheap US credit -> slump in industrial production in Europe
Deflation = European war debt and reparations much harder to pay (bc the amount of money they had to pay back essentially increased)
-> European banks start failing
Great Depression - recovery
In the US:
- FDR declares bank holiday and institutes a temporary system of deposit insurance = no more need for bank runs -> banks stop failing
- Gold inflow from Europe due to economic and political crisis there => inflation => real cost of borrowing decreases
*crisis Europe becomes bigger than that in the US -> investors start to invest not in Europe but in the US -> stops deflation US - FDR’s “New Deal” increases government spending
Ultimately (both US and Europe):
- Breakdown of Gold Standard as countries rescued their banks and expanded monetary policy
- Outbreak of World War II => Full employment & Huge government spending => good for economic indicators, but of course bad for people
Keynesianism to get out of crisis?
only works when the crisis is on the demand side, not on supply
crisis -> gov needs expansionary monetary policy
but Keynesian view is not uncontested:
- Hayek (Austrian school) disagrees with causes and remedies Great Depression
- 1980s monetarism (Friedman)
financial and currency crises in emerging markets 1990s
1990s global rise in private capital flows to newly liberalized stock markets (Asia and Latin America)
-> increased volatility in capital flows
- stock markets = portfolio investment = hot money: can easily flow in and out of the system
-> repeated crises
commonality across crises:
fixed exchange rate (often pegged to USD) + heavy reliance on short-term capital (continuous roll-over of foreign liabilities, depends on gov ability to maintain confidence in commitment to fixed XR)
- shock (political, economic, contagion)
- confidence in fixed XR evaporates
- rapid outflow of capital
- government forced to devalue
- (often) government toppled due to crisis
underlying factor Asian Financial crisis 1990s
= Risky banking system
liberalization 1980s/90s -> enable domestic banks/firms to borrow from international markets
domestic banks become intermediaries: they borrow internationally in short terms + lend nationally for higher interest rates
- maximally risky: loans got int’l are short term (need to be repaid quickly) + were in foreign currencies (original sin of debt)
- if foreign lenders would stop rolling over loans there would be a problem bc domestic borrowers paid back only on longer term
- exchange rate risk: if the XR changed, the math would look diff and probably not profitable anymore
moral hazard: banks believe that gov will bail them out (they always have) -> take more risk
IN ESSENCE = financial regulation was underdeveloped and not enforced
Asian Financial Crisis - shocks + contagion
XR started to appreciate against the Japanese yen mid-90s
- bc USD appreciated vis-a-vis the yen and bc currencies were tied to the dollar
-> difficult to export to Japan (which was primary export location) -> debt-service problems for real-estate developers
by 1997 many of Asian Banks’ borrowers struggle to repay debt -> domestic banks unable to pay back short-term international debt
spring 1997: one of Thailand’s largest banks becomes insolvent -> other Asian banks under scrutiny by foreign banks -> withdrawal of funds from markets + refusal to roll over loans
contagion (panic started in Thailand): to maintain fixed XR countries started to sell their foreign exchange reserves, but they run out of reserves -> currencies start to float or are depreciated
in period of ~6 months currencies were floated + lot of money left the market
Asian financial crisis 1990s - the repercussions
IMF lends money in return for eco reforms:
*seen as unfair bc the issue was bc failure banks, temporary problem not caused by monetary policy
- tighten monetary policy to stem depreciation
- tighten fiscal policies to generate financial resources to rebuild financial sector
- structural reform: trade liberalization, elimination of domestic monopolies, privatization state owned enterprises
-> severe economic and political repercussions:
- deep recessions, rise in poverty
- protests and political instablity: Suharto (Indonesia) + Thai gov replaced
Asian Financial Crisis - the lesson
= avoid sensitivity to shifts in market sentiment AND subjection to IMF intervention
- self-insurance: accumulation large stocks of foreign exchange reserves (through persistent CA surpluses)
*contributed to 2007-9 great recession - peg currencies to the dollar at competitive (according to US undervalued) exchange rates
sterilized intervention:
- exchange local currency for foreign currency at fixed XR + offset the impact of this purchases on the domestic money supply (decreasing it)
- use forex reserves (USD) to purchase US gov securities and gov-backed securities = allows them to run persistent CA surpluses
- “Bretton Woods 2” bc US trade deficit thrives growth in East Asia
to avoid reliance on IMF:
Chiang Mai Initiative = pool forex reserves to assist each other in case of market turbulence (ASEAN + Japan, China and South Korea) = govs can swap their currency when necessary so that they don’t have to draw on the IMF
Great Recession - imbalances and international bargaining
2007-9
global imbalances: US deficit
US blames “savings glut”: outflow USD bc other countries are saving too much, investing too little
- Bush: tries to push China to expand consumption and allow RMB to appreciate against USD (accusation it is undervalued in comparison to what it would be if it was floating)
- tries to shift IMF attention to China
- presses European govs (Germany) to reduce their CA surpluses
governments in surplus countries demand US policy changes:
- Europeans blame US gov budget deficit following 2001 tax cuts (CA deficit to make up for loss money in taxes?)
- EU argued it is not their issue bc the Euro overall is in balance (bc also deficit countries: Italy, Greece etc.)
- China adopts more flexible peg in 2005, but also demands US to balance its budget
!someone has to adjust domestic policy, but no one wants to be the one to bear the cost -> no action + continued movement cheap credit from surplus countries into the US
Great recession - real estate bubble
US inflow of cheap credit (borrows from the rest of the world) fuels real estate bubble
real estate: easier to get loan: low interest rate, no credit checks, don’t look at history of repaying debts
-> prices rise bc more demand bc more money
mortgage-backed securities: bundles of different risk in a single security
Financial institutions discounted risk of nationwide collapse of real estate prices, worst case scenario planned for: regional collapse
- 2007: real estate prices fall by almost 25 percent nationwide, mortgage default rates rise sharply
- Securities suffered large losses, many bought with debt –debt-service problems entire financial system
great recession becomes international
- Great Britain, Ireland and Spain had their own real estate bubbles that collapsed
- European financial institutions had purchased US mortgage-backed securities in large quantities
- freezing global credit markets after bankruptcy of Lehman Brothers fall 2008 -> makes it diff for all financial institutions to secure credits
- credits drie up -> interest rates on inter-bank lending grow sharply
