Crises of Financial Openness: Financial and Currency Crises Flashcards
What was the great depression?
The longest and most severe crisis ever experienced by advanced industrialized countries in the West
Run-up to the Great Depression
- 1920s: Western countries are back on the gold standard, but persistent imbalances
– US current account surplus
– Some of Europe current account deficit (lost competitive position in WW1) - Huge war debts and reparation payments in Europe - much of it flowed to the US, even more gold entering US system
– Instead of letting prices rise in the US as a result, the US lent the money back to Europe in the form of international bonds - Boom in credit and international bonds in the US
Onset of the Great Depression
- 1929: US tightens monetary policy to limit stock market speculation -> stock market crash
– Immediate wealth effect
– Uncertainty about the economy = less spending on consumer durables
– Banks had lent to those invested in the stock market = started failing - Smoot-Hawley tariffs and retaliations - collapse in world trade not helpful
-
Bank failures:
– Banking panic (no deposit insurance - money in banks NOT safe)
What is the precondition to bank runs?
“Fractional Reserve Banking”
- Banks don’t keep all the money you deposit with them, they lend it back out or invest it to make money
Banks runs order of events
- Customers start questioning whether a bank will be able to pay out their deposits
- More customers withdraw their money from the bank
- The more customers withdraw money, the more likely the bank will run out of money
- This is a self-fulfilling prophecy: the more people believe a bank/financial institution will fail, the more likely it will fail
Where was the federal reserve during the Great Depression?
- Many local banks were not members of the federal reserve system and couldn’t borrow from the federal reserve as “lender of last resort”
- Interest rates were nominally 0, but deflation meant that borrowing and investment was still costly
- Trying to preserve the gold standard - limits expansionary monetary policy and bank bailouts
Great Depression spread to Europe
- The gold standard required monetary contraction in Europe to match the US contraction
- Loans from the US to Europe used to rebuild came to a halt
- Rise in protectionism + US consumer market in depression + no more cheap US credit = slump in industrial production in Europe
- Deflation = European war debt and reparations much harder to pay
- European banks start failing too
What led to recovery from the Great Depression?
In the US:
- FDR declares bank holiday and institutes a temporary system of deposit insurance = no more need for bank runs
- Gold inflow from Europe due to economic and political crisis there -> inflation -> real cost of borrowing decreases
- 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 WW2 -> full employment and huge government spending -> good for economic indicators, but of course bad for people
Volatility in private capital flows (financial and currency crises in emerging markets 1990s)
- Global rise in private capital flows to newly liberalized stock markets
– Asia as largest recipient
– Latin America as second largest - Hot money that can easily be withdrawn
- Increased volatility of private capital flows to emerging market countries and repeated crises
Commonality across crises (financial and currency crises in emerging markets 1990s)
- Some form of fixed exchange rate
- Heavy reliance on short-term capital
– Continuous roll-over of foreign liabilities
– Depends on government’s ability to maintain confidence in commitment to fixed exchange rate
Shock -> Confidence evaporates -> Rapid outflow of capital -> Government force to devalue -> Government topped due to crisis (often)
Asian financial crisis: A risky banking system
Malaysia, Thailand, Indonesia, South Korea
- Each liberalized financial markets in later 1980s/1990s = enable domestic banks and firms to borrow from international markets
- Domestic banks become intermediaries:
– Profitable: Asian banks borrow for cheap internationally, lend for higher interest rates at home
– Risky: Short-term loans denominated in dollars and other foreign currencies, often then offered long-term loans in domestic currencies to their customers
—> Exchange rate risk
—> Risk that foreign lenders would stop rolling over loans
- Flaws in banking regulation
– Moral hazard: banks believe that government will bail them out, so they take more risks
– Financial institutions had close ties to government
- Financial regulation underdeveloped and not enforced
Shocks to the system, Asia (financial and currency crises in emerging markets 1990s)
- Asian countries’ exchange rates start to appreciate against the Japanese yen in mid-1990s
- Most Asian governments pegged currencies to the dollar - when dollar appreciated, so did Asian currencies
- Difficult to export to Japan - debt-service problems for export-oriented firms
- Real estate begins to fall in late 1996 - debt-service problems for real-estate developers
- By 1997, many Asian Banks’ largest borrowers struggling to repay their debts -> domestic banks can’t repay their international loans
- Spring 1997: discovery that Finance One was insolvent -> more scrutiny of banks in Asia by foreign banks -> panicked withdrawal of funds from Asian markets in summer 1997, refusal of foreign banks to roll over loans
Contagion, Asia (financial and currency crises in emerging markets 1990s)
- Panic started in Thailand in may 1997 - consumed CB forex reserves, Baht floated
- Next: Philippines government abandons exchange rate after only 10 days
- Then Indonesia and Malaysia abandon fixed exchange rates in July and August
- Taiwan forced to devalue Taiwanese dollar
- South Korean government floats the Won by middle of November
- Total of $60 billion pulled from region in second-half of 1997, 2/3 of all capital that had flowed in the year before, 1998 another $55 billion flows out
The repercussions, Asia (financial and currency crises in emerging markets 1990s)
- IMF lends money to countries in crisis in return for economic reforms
– Tighten monetary policy to stem depreciation
– Tighten fiscal policy to generate financial resources to rebuild financial sector
– Structural reform (trade liberalization, elimination of domestic monopolies, privatization of SOEs) - Severe economic and political repurcussions
– Deep recessions, rise in poverty
– Protests and political instability
—> By late May 1998 Suharto in Indonesia had stepped down from office
—> Thai government replaced by new coalition that was less corrupt
What did Asian countries learn and what did they do? (financial and currency crises in emerging markets 1990s)
Avoid vulnerability to shifts in market sentiment or subjection to IMF intervention
- Self-insurance: accumulation of large stocks of foreign exchange reserves 1998-2000 (through persistent current account surpluses)
- Peg currencies to the dollar at competitive (undervalued?) exchange rates
- Sterilized intervention
- Regional framework for financial cooperation (to avoid reliance on IMF)
