General 13/06 Flashcards
What are the main problems for advanced countries in order to restore growth?
Non-economic factors:
- ageing populations;
- falling long-term rates of economic growth;
- inability to engage in substantive and lasting reforms.
Macroeconomic problems:
- the poor state of finances;
- institutions entering a spiral of decline from which it is difficult to escape.
The steady downward trend is due to:
1) the exhaustion of the supply of educational improvements;
2) the exhaustion of the gains from past innovation.
The Rule of 70
To double the income, a country needs 70/g years, in which g is the constant growth rate.
Chinese Growth
The People’s Republic of China was born in 1949, and it started its industrialisation process [investments in heavy industries: steel, concrete, machinery] immediately.
In 1978 Deng Xiaoping started a series of reforms and a general opening up of the Chinese Economy.
❶ Gradual reforms started in rural areas with township and village enterprises (TVEs).
❷ Then first steps followed to open up the economy to foreign trade and investment [which only started to play a significant role in the 1990s].
❸ More generally, China’s economic reforms model became “Crossing the river by feeling the stones”.
❹ Gradualism was a means to:
- circumvent political resistance to reform;
- adopt a pragmatic approach in a heavily distorted environment where the ‘first best’ solutions were unlikely to apply.
❶ Decentralisation and incentives became a powerful tool for progress within the confines of central political guidance.
❷ The distributed benefits of reforms to a large part of the population, to local government and party officials generated strong incentives to pursue growth and promote the market economy.
❸ A dual-track system allowed the survival of the planning system [avoiding a collapse in production] and an unplanned economy to emerge.
The 3 phases of China’s reform
The first phase revolved around the search for the right economical institutions for China.
The second phase started in 1993 with the national congress laying out a comprehensive plan to build the institutions for a market-driven economy. During this phase, there was the entrance of China into the WTO (2001). There was also an explosion in the foreign investment
The third stage happened from 2004 onwards. We have 2 main ingredients. The first is the gradual expansion of the social safety net -> China started to think about national welfare policy. They had a vast working-class and needed to start thinking about pensions, housing and other forms of welfare execution. The other factor was a return to industrial policy -> they started 16 megaprojects and the five-year strategy from 2015 had a great focus on industry policy.
Recent return to industrial policy to the government’s forefront since 2015.
China’s Demographic Transition
Pre-divident: pre-industrial society, high birth rate but also mortality.
Early-divident: with an increase in food supply and sanitation, the death rate falls rapidly as life expectancy increases and the population overall increases. This is a classic case for developing countries, the position of many African countries nowadays.
Late-divident: death rate continues to fall, reaching a floor level and remaining stable from there on as no more significant health and food improvements can be made. The birth rate starts falling and so the total increase in population keeps increasing but at a smaller rate.
Post-divident: birth rate keeps decreasing and the overall population is stable or slowly increasing
No-more-divident: the birth rate is very low and the population starts to decrease slowly or keeps stable. Current situation.
Economic implications of the demographic trends
For a country to grow it needs investment (infrastructure investment, then human capital investment, research, etc).
Impeeding factors to investment:
Too low incomes do not allow suitable levels of savings
Too low incomes do not allow to support high birth rates, which are expected to counterbalance a low life expectancy
In countries late-divident countries, the global dependency rate is very low and frees up resources for saving and, therefore, investment
Dependency ratios: children/adults, elderly/adults, (children+elderly)/adults.
During the 35 years between 1975 and 2010, China enjoyed a period with a very relevant positive gap between the working population vs dependent population, allowing for a window of opportunity during which investment was high.
From now on the old-age dependency ratio comes back to grow (China has entered its fourth phase of DT).
This rise some problems in terms of the welfare state: pension problems firstly, which may slow down future growth.
Middle-income threat: you are stuck in a situation where you are not rich enough to pay for the old population.
History of China’s Economic Growth
❶ Pre-1978 period, growth comes from increases in both physical and human capital. TFP declines by 1.07% a year in this period.
❷ After 1978, capital accumulation and TFP growth reversed their roles [The physical capital/output ratio remained constant and the growth rate of hc was lower]. In contrast, TFP grew rapidly at 3.16% a year, equal to 78% of the growth of GDP per capita.
Ak Mod
The total final output per capita Y depends on:
A: Total Factor Productivity, Knowledge and Technical efficiency
K: Capital (financial c., buildings, technical plants, etc.)
L: Labour (number of employees, worked hours, Skills)
Why do we need sustainable growth?
Demography, growing demand for better life quality and well-being. With growth, it is easier to manage many of the problems we face. In order to have growth, we need to ensure a good quality of fundamentals: human capital, institutions’ quality, tax burden, public and private debt, rules and trust.
Understanding Total Factor Productivity Differences
- Human Capital: worker’s skills -> this comes from education and training (more education and training usually means better wages)
- Technology: more efficient technologies increase the productivity parameters.
- Institutions: foster human capital and technology growth by securing basic rights such as A) Property Rights B) The Rule of Law C) Government Systems D) Contract Enforcement
The Middle Income Trap
Several developing countries experienced rapid economic development. At some point in their development they began to experience economic stagnation [or slower growth compared to previous levels] over a sustained period of time: a phenomenon labelled as the ‘middle income’ trap.
Middle-income countries find themselves in a trap because they can no longer compete in standardised, labour-intensive commodities, as wages are relatively too high (can’t be simply a place of cheap labour anymore), but they have not achieved the ability to compete in higher value-added activities on a broad scale, as productivity is relatively too low.
The migration of people from the unproductive sides of the country to the productive parts slows down or the population just gets older.
It is very difficult to keep moving up the value chain (you can only go so far with production of let’s say tomatoes like Mexico and to move to a technological hub is impossible).
How to get out of the middle income trap?
Education, Specialization, Democratization, Strong middle class Large scale institutions at a world-class level
Factors that indicate that China might be stuck in the middle income trap
- China is losing its advantage in low-cost labour. A decline in China’s workforce could drive up wages faster than productivity gains.
- China has already experienced a slowdown in TFP growth in recent years
- Potential slowdown in the near future: The IFM (2017) warned that for China: “A sharp slowdown in the future remains a risk”.
Evolution of Employment in China
- Underemployment in rural areas allowed the industrial sector to expand and increase its labour force with no pressure to raise wages.
- However, since 2005, the “labour shortage” phenomenon has begun to turn up in coastal cities
- This finding has important policy implications both for the general global economy as well as for China’s future development.
Policy Themes for Getting ou of the Middle Income Trap
Policymakers in middle-income countries must focus on the transition from productivity growth stemming from inter-sectoral resource reallocations to intra-sectoral catch-up technological growth (moving up the value chain). Also develop more mature institutions. Focus on:
- Innovation: Competition and new capital investments and R&D can create an environment for innovation
- Cities: ‘Smart cities’ have become a dominant theme in recent economic development literature
- Demography: The danger for all middle-income countries is that of growing old before they get rich
China: Growth Sources, Trends and future Challenges
Capital Accumulation
Low dependency ratio conducive to high savings; unlimited supply of labour preventing diminishing return on capital
Challenge: Unsustainable. It is difficult always to find new productive investments, especially when there are shortages in the labour market for high-skilled positions
Quantity of Labour
Population structure guarantees labour supply, which turns into a comparative advantage in labour-intensive manufacturing.
Challenge: Unsustainable. Demographic dividend disappears as economy passes Lewis turning point (situation in economic development where surplus rural labour is fully absorbed into the manufacturing sector)
Human Capital
Education expansion and mass labour entry improves the quality of stock of workers
Challenge: Education expansion eventually slows, calling for enhancing its quality and equality
Total Productivity Factor (TPF)
An increase from the improvement of incentives and resource allocation system
Challenge: Increasingly challenging and important to sustain growth; requires new sources of increase
TPF (Resource Allocation)
Reallocating efficiency of resources through labour mobility from agriculture to industrial sectors
Challenge: Dominant in the early stage of development; diminishes after Lewis turning point
TPF (Technology)
The utilisation of advantages of backwardness through absorbing foreign technology and management
Challenges: A gap narrows; technological progress increasingly rely on independent innovation
Population Factor
A widely defined demographic dividend is manifested in all factors driving rapid growth
Challenge: Diminishes as China ages; the second dividend available from removing remaining barriers to movement
Romer Model: Increase in the share of research
If we increase the share of the working population doing research, initially the output will go down (as fewer people are working on producing output) but in the long run, the output per person will be higher because we’ve increased our growth rate.
Change in China’s Economic Model
- Old model based on statal intervention and strong exports is no longer sustainable:
The Chinese economy was characterised by high levels of investment, infrastructure building. China has been investing half of its GDP.
But now a lot is lost, most things needed were already built -> they need to shift toward more complex mechanisms.
Another problem is that with such a steep growth the government has more margin for error and people get sloppy, too optimistic, less competent.
A turning point to the Chinese economy came in 2009. Predictions were that a big recession would come, but government policies acted as to not permit that. Boosted investment and spending. This accomplished the goal but was well over what was sustainable. It is sustainable for a big growth rate, but if it falls it isn’t anymore. - More emphasis on private consumption and innovation.
- Challenging implementation of a new sustainable growth model unless China can effectively implement economic reforms.
Signs of an Expected Regression in China’s Economy
- Real state bubble: Chinese property is too expensive and there was an overbuild -> many infrastructures for not enough people
- Stock market bubble
- Municipal debt: Chinese municipal governments shouldn’t be borrowing money, but they were doing it and incentivised by the central government to keep up with the desired investment levels.
- Excess capacity: too much stimulation of investment and confidence, many enterprises and not sustainable that are being kept afloat by cheap credit or political privileges.
- Capital flight: capital leaving the country with fear of the economic collapse, which only further speeds up the process.
However, there are reasons to be optimistic. China has a lot of human capital (they have been investing in this area).
Major long-term challenges facing China’s Economy
- Incomplete transaction to a market economy (still a huge number of state-owned enterprises).
SOEs in the banking sector: creation of the Big Four to support companies through funding in specific sectors - State-dominated banking sector, with excess credit (“cheap money”) and high debt
- Large internal imbalances (of savings, fixed investment and consumption)
Xi Jinping’s new 5-year plan: Dual Circulation (Domestic + External)
Domestic:
- increase domestic demand
- upgrade supply chains
- seek more independence in key technology (more investment in Research and Development)
External:
- welcome Foreign Direct Investment (FDI) in China
- strengthen the BRI strategies
- take advantage of regional trade integration
Key factor for China’s sustainable development: Human and Social Capital
- China is at the forefront of a global transformation and aims to establish itself as a major hub for both the generation of knowledge and the production of innovation.
- The initiative intends to “transform China from a manufacturing giant into a world manufacturing power” by 2049.
- The enhancement of innovation requires building a learning economy, the basis of which is social capital.
Social capital: the networks of relationships among people who live and work in a particular society, enabling that society to function effectively”. It involves the effective functioning of social groups through interpersonal relationships, a shared sense of identity, a shared understanding, shared norms, shared values, trust, cooperation, and reciprocity.
“Made in China 2025” Initiative
- The initiative intends to “transform China from a manufacturing giant into a world manufacturing power” by 2049.
- China is quickly gaining ground on advanced economies in high tech value chains.
- China’s share in manufacturing global value chains has risen sharply from 6% to 19% in the past 15 years at the expense of the EU.
Digital Silk Road (DSR)
China aims to use the Digital Silk Road (DSR) to advance global
technological integration.
1. The DSR draws on three core state-driven strategies: (a) Made in China 2025, (b) the BRI, and (c) China Standard 2035.
2. The defining feature of DSR has been its core focus on connectivity infrastructure, both in telecommunitation/5G, hardware, and smart cities.
3. Chinese companies have signed more than 116 smart-city of safe-city partnerships exporting China’s ‘sharp eyes’ approach to high-tech urban policy.
China needs to Rebalance sources of Growth
Previous drivers of growth are losing traction and others are growing:
- Strong decrease in the contribution of TFP
- Sharp decline in Labour Contribution
- Oversize/Overreliance on infrastructures
- Improvements in the added value of exports
- Expansion in high technology exports
New Reforms: the 3 Ds
- Removing Distortions: resources should be allocated to the most productive sectors of the economy
- Accelerating Diffusion: extend current production frontier to global frontier
- Fostering Discovery: focus on R&D
New Growth Model for Chinese Cities
- Talent Attraction and Retention
- Innovation Capacity
- World-Beating Private Firms
- High Market Transparency
- High Quality of Life
- New Regional Clusters of Cities
- Environmental Quality
The Case of Shenzen
The early 1990s saw the start of the second season of major reforms based on six policy lines.
❶ Structural reform of government and administration systems
❷ Promotion of high-tech companies
❸ Great efforts to keep local bellwether companies
❹ Opening of the ChiNext subsidiary of the Shenzhen Stock Ex.
❺ Allowing international acquisition
❻ Attraction of talents with a study-abroad background.
Shenzhen successfully transformed the foundation of its
economic growth from a cheap labour-intensive industry to a
more innovative and more innovative and technology technology-oriented oriented one.
❶ S. keeps investing in R&D building high-quality tertiary
education Institutions [13 Universitites].
❷ S. encouraged big firms to stay local so contributing to high fiscal revenue.
❸ S. created a positive circulation among talents, entrepreneurs, governments and economic growth.
❹ In 2000 S’s population reached 7 million, almost doubling the 4.2 million line of the master plan [S. is facing a critical shortage of land resources].
Challenges for Chinese Mega Cities
- Sufficient Resources
- Energy Supply
- Security
- Traffic and Mobility
- Waste Management
Social and Institutional gaps China
Rapid growth has been accompanied by social inequality and severe environmental degradation and pollution. Major development challenges are foreseen in pursuing high-quality green development, specifically:
❶ Social Challenges
Closing the inequality gap.
Strengthening health security.
Ageing before affluence.
❷ Institutional Gaps
Strengthening institutions and capacity to support reforms.
Removing constraints on the private sector.
Investing in innovation and human capital.
Belt and Road Initiative: Motivations and Goals
Connecting the vibrant economic East-Asian circle to the rest of the world.
❶ Looking for new export markets: Infrastructure development in countries along the Belt and Road routes will increase growth in their economies and thus contribute to a growing demand for China’s goods and services goods and services.
❷ Vent for surplus to export overcapacity: In order to alleviate the problems created by excess capacity in the construction and associated sectors, Chinese construction companies are encouraged to look elsewhere for opportunities.
❸ Improving digital connectivity: Part of the BRI is improving connectivity among the countries involved by means of soft infrastructure to create the so-called “digital Silk Road digital Silk Road”.
❹ International stature of the renminbi: China has set the goal of making the renminbi a global reserve
currency.
❺ Securing energy supply: A strategic rationale of the BRI is to secure China’s energy supply through new pipelines in Central Asia and Russia.
❻ Support China’s economic rebalancing: Giving greater impetus to the longstanding go west policies
aimed at rebalancing economic development aimed at rebalancing economic development.
❼ Reducing trade costs: As the world’s biggest trading nation, China’s main interest is to reduce the transport costs.
Implications of the BRI to the Global Economy
- Revising the existing international economic order: Technical knowledge intensive are mainly dominated by highly developed countries. The BRI runs mostly through developing countries, consisting a relevant opportunity.
- Rebalancing the global economy: BRI agregate of nations covers 1/3 of the total world GDP.
- Actively promoting globalization: alleviate the imbalance in economic development between developing and developed countries.
Foreign Criticisms to the BRI
- Executing projects in foreign countries that those countries will have severe difficulties in paying back.
- Using the infrastructures for military purposes
- The overarching objective of the initiative is helping China to achieve geopolitical goals by economically binding China’s neighbouring countries more closely to Beijing.
- Beijing is showing ability to finance projects and to leverage over recipients of these loans selling them high-end industrial goods.
- More questionable is whether China’s neighbours will be willing to absorb its excess industrial capacity.
- The lack of political trust between China and some BRI countries is a considerable obstacle. And what about Europe?
The Investment Equation
It’s made up of two parts. The first is the a_i parameter, reflecting the long-run fraction of potential output that goes to investment. If this was the only term, the investment equation would look like the others. The last part is what’s new, and it indicates how the interest rate enters the model. In particular, the amount of investment depends on the gap between the real interest rate Rt and the marginal product of capital r.
The real interest rate Rt is the rate at which firms can save or borrow. For example, Rt might equal 10 per cent, implying that firms can borrow $100 today if they are willing to pay back $110 next year (assuming there is no inflation).
The marginal product of capital (MPK) r is familiar from the long-run model: it reflects the amount of additional output the firm can produce by investing in one more unit of capital. Our short-run model takes r to be an exogenous parameter determined by the long-run model. Since the marginal product of capital is constant along a balanced growth path, we don’t include a time subscript on r.
The Investment Equation in the Long-Run
In the long run, we have that the output gap is 0 and therefore R_t = r and investments become a fixed percentage of the potential output a_i.
Consider the case where the economy has settled down at its long-run values, so the output is at potential and Yt tilde = 0. In the long run, as we’ve seen, the real interest rate prevailing in financial markets is equal to the marginal product of capital, so that Rt = r. In this case, the IS equation reduces to a simple statement that 0 = a bar. The reason is straightforward: when output is equal to potential, the sum C + I + G + EX - IM is equal to Y bar, and therefore the share a bar parameters ac ai ag aex aim must add up to 1. In the long run, then, a bar = 0. In fact, our baseline IS curve will respect this long-run value. We will think of a bar = 0 as the default case. However, shocks to the economy can push a bar away from 0 in the short run.
What makes the short-run output fluctuate is the difference between the R_t and r, if they are equal then we have Y tilde = 0.
Shocks to aggregate demand (shift in the IS curve)
- Changes in consumption relative to potential output
- Technological improvements that stimulate investment demand given the current interest rate
- Changes in government purchases relative to potential output
- Interactions between the domestic and foreign economies that affect exports and imports
Positives of Public Expenditure
It contributes to current effective demand
It expresses a coordinated impulse on the economy
It increases the public endowment of goods for everybody
It gives rise to positive externalities to economy and society
The Government Budget Constraint
Government Purchases + Transfer Payments (Social Security, Welfare payments, etc) + Interest Payment on Debts = Taxes + New Borrowings + Change in Money Stock (Printing more money)
Uses = Sources
We’ll assume that Tr and delta_M are zero.
The Government Budget Constraint
Government Purchases + Transfer Payments (Social Security, Welfare payments, etc) + Interest Payment on Debts = Taxes + New Borrowings + Change in Money Stock (Printing more money)
Uses = Sources
We’ll assume that Tr and delta_M are zero.
Government Borrowings
A government can increase its debt if the GDP is growing even faster -> same or less Debt/GDP ratio.
If a country’s debt-GDP ratio gets to be too high, lenders may become worried about the government’s ability to repay its debt, and may stop lending. This will itself prevent government borrowing from growing too large, but it may also force the government to turn to the printing press in order to satisfy its budget constraint. At high and growing debt-GDP ratios, the possibility of high or even hyper inflation becomes a concern. As soon as investors doubt the ability of the government to finance its spending, they may demand higher interest rates on new borrowing. These higher interest rates will compensate them for the possibility that the debt will be repaid with dollars that are worth less because of future inflation. The higher interest payments in turn make it more difficult for the government to satisfy its budget constraint and may precipitate a crisis.
Evolution of Debt
deltaB/Y = (r-g)(B/Y) + (G - T)/Y -> evolution of debt. (G-T) is called the primary balance. Debt is sustainable when at least change in debt per GDP is constant, cioè doesn’t increase.
In terms of the derivative: d_1 + (r - b)*b_0
To account for the inflation factor:
i = r + pi
n = g + pi
Main Functions of a Central Bank
Oversight on the creation of money via specific monetary policy’s instruments (see later)
Acting as the banks’ bank, granting loans to the banks and acting as lender of last resort.
Supervising and monitoring the banking system to ensure compliance of financial conditions and safeguard its good and healthy status.
Monetary Policy - Central Banks
In case of an increase in the money stock via an open market operation, the central bank buys bonds and pays them on the market with newly printed money, so the price of bonds increases and the interest rate decreases with the increase in Ms.
In case of a contractionary monetary policy, the central bank sells bonds and withdraws money from the market: the price of bonds decreases, and the interest rate they pay increases, together with the decrease of money supply.
Pb = 100/(1+i), Pb = price of a bond, i = interest rate. Their relation is negative
Lending Rates
Interbank rates (EURIBOR, LIBOR, etc) are flexible and determined by the supply and demand relantions.
CB process of adapting MS to fit the inflation goals
The central bank can peg the nominal interest rate at a particular level by being willing to supply whatever amount of money is demanded at that level. That is, it makes the money supply schedule horizontal.
Stickiness of Prices
Prices need time to adjust to changes in interest rates, meaning that CB can cause a rapid boom or recession, as output changes are going to occur faster than changes in the prices that will counterbalance this factor.
Short-Run Model
IS curve + MS curve + Phillips curve
Classical Gold Standard
international monetrary system was in practice during the first wave of globalization (1870-1914). It then ceased to exist due to the outbreak of the WWI in 1914 that lead central banks to suspend gold payments.
The system worked well independently to the fact that it was not born in an international conference; countries simply started adhering to this standard over time. At a certain time - after 1907 - the global gold supply stopped to increase, causing major issues to the growth of the global economy that started to be sustained by sterling pound holdings that could be converted to gold at any time in any amount - they were considered as safe as gold. Another big plus is that contrary to gold holdings, central banks could invest sterling holdings to earn interest.
Requirements to qualify as a gold standard country
- Set a fixed ratio (parity) of national currency to gold
- Maintain convertibility of notes at par value on demand
- Maintain a free market for gold (money supply determined by gold reserves)
Liquidity 1870-1914
Liquidity at the global level in 1870-1914 depended on newly mined gold.
In practice, Britain’s dominance of world markets made sterling a major source of supplementary liquidity (foreign governments and central banks hold deposits in London as alternative to gold reserves)
England’s adjustment mechanism of its amount of Sterling
When the Bank of England moves the discount rate (Bank rate), the interest rates adapt and moves up:
- the rate paid on deposits at commercial banks
- the rate applied in the money market
- the prime rate on short term loans
Eventually, this leads to:
- a substancial amount of short-term sterling flow to London
- British long-term investment abroad is postponed
- sterling flow from world periphery to Europe
- Quick adjustment scheme
Gold Standard natural self-equilibrating features - price-specie flow (Hume 1757)
- Country runs trade deficit
- Gold outflows
- Gold reserves reduce
- Money supply contracts
- Prices decline
- Exports start to increase
- Gold inflows
- Trade balance brought back to equilibrium
- Gold reserves are restored
Impact of the Boer War on the Sterling Credibility
This means that the sterling exhanges played a very important role as a supplement to gold reserves, but after 1902 this role dimminished, because central banks increasingly changed their supplies from sterling to gold. Why did this happen after the Boer War (period of tensions in international politics)? The war led to a financial crisis that pushed the US to adopt a central bank, set up in 1913.
Even though gold was interest free, central banks took this path of going back to gold due to the lack of confidence. The Boer War was fought by England and caused big spendings in the military, leading to distrust over the convertibility of the sterling.
The eminent fall of the gold standard facing global growth
Gold was doomed to fail sooner or later, because the gold supply couldn’t keep pace with the economic growth. If gold stocks didn’t increase sufficiently, it would’ve suffocated this growth. The use of sterling as an alternative would also eventually fail, because it depends on its convertibility to gold.
Everyone was starting to accumulate sterling pounds to a point where its convertibility wouldn’t be possible.
Impact of WWI on the gold standard
Governments needed resources to pay for the war, so during that period central banks printed a lot of money. This was a major problem, because going back to gold after the war required additional measures. This also led to a period of great inflation in the participating countries.
With the war, gold supplies diminished and money supply increased because of the printing of money. The restoring of the parity was a hard challenge.
Problems in restoring the pre-war gold parity
The general consensus after WWI was to restore the previous gold standard.
But restoring the pre-war gold parities would have required a larger stock of gold than was currently available due to the printing of money during the war.
The second issue was that newly mined gold was not enough to sustain the growth rates.
Possible solutions to restoring the gold parity
One of the problems was reducing this money supply at the national level. The way to do this was to reduce prices at the national level, and to do that the easiest route was to cut labour costs, to cut jobs, increasing the level of unemployment and reducing wages. But as jobs and wages costs go down, demand shrinks, output contracts, and this leads to deflation and unemployment, measures that are highly politically costly. All the electorate held accountable the governments taking this policies. It was not easy to bring down inflation.
Depreciating the national currency was another alternative that was more feasible and not so politically costly. It affected the more rich and powerful, but was overall more feasible.
Another alternative was to use alternative reserve assets to gold such as the dollar or sterling, reducing the gold requirements.
Genoa Conference (1922) - context and basics
Provide coordination as to the restoration of the gold standard - laid down the rules of the game of the new gold standard.
If there had been an uncoordinated attempt to restore the gold standard, there would have likely been a generalised scramble for gold and deflation.
At the Genoa Conference, the US was invited but did not participate. The main intervenient was, therefore, Great Britain, that wanted to avoid at all costs a scramble for gold. Because the position of the pound was a bit precarious and if all the countries had started scrambling for gold it would have been much more difficult for Great Britain to restore its pre-war parity. This desire to avoid a rush for gold was very much in line with the interests of the Bank of England.
Genoa Conference (1922) steps to restore gold parity
Fix the parity between each national currency and gold, not necessarily at the former gold power - this was the invitation to depreciate the parity, a means of economising the use of gold.
They didn’t want any control on the exchange rates. They envisaged the existence of another reserve asset other than gold.
Conclusion: Depreciate and use alternative reserve assets, mainly the dollar and the pound.
From gold standard to gold exchange standard 1925-1932 (Genoa Conference 1922)
- In addition to gold, also the dollar and pound sterling were defined as reserve assets
- central banks would issue bank notes against holdings of gold, dollars, and pounds
- gold was withdrawn from circulation and concentrated at central banks
- use of gold was limited to the settlement of international accounts
Modifications in central banks statutes
- Set a minimum proportion of gold in total reserves
2. Set a requirement for backing of notes in circulation (cover ratio) - backing could be as low as 35-40%
The behaviour of banks 1925-1932
Banks behaved in a rather discretionary way:
- rarely applied minimum gold cover
- clung to gold
- generally, central banks held reserves in excess of legal requirements in order to face temporary fluctuation in export earnings
Liquidity problem 1925-1932
The liquidity problems of the interwar fold standards were not caused by gold scarcity:
- measures to economize gold were effective
Rather, troubles arose from mismanagement of gold and foreign-exchange reserves:
- maldistribution (France + USA = 63%)
- shift out of foreign exchange: central bankers opted for gold in face of currency floating, thus global reserves contracted
Maldistribution of gold 1925-1931
Countries that accumulated gold didn’t release it. They wanted to cling to gold and didn’t comply with the readjustment mechanism. They prevented gold from flowing and this put other countries in a deflationary cycle because they couldn’t expand their money supply.
For an international monetary mechanism it is important that countries with a surplus comply with it.
Surplus countries were simply accumulating gold and not inflating their domestic economy and releasing it due to:
- legal impediments on central bank operations
- deliberate policy
Cycles of depreciation 1925-1931
First Cycle (1929): contraction of US outward capital floes accelerated the decline of commodity prices and developing countries no longer could keep the parity
Second Cycle (1933): Developed countries also started to depreciate their currencies
European Repayment of debt after WWI 1925-1931
Countries that received capital from the United States had to make payments back to US: Germany used the American short run capital to repay Western Europe for the war reparation, and western European countries repaid it back to the US because they needed to pay for the war debt.
So the capital was not being used for development or resources as suggested by Keynes, it was money that simply flooded from one country to another to end up in the US again.
Problems with the short-term capital flow to adjust the gold distribution 1925-1932
If a country, especially whose economy and currency was weakened, started to increase its discount rate, it appeared as a sign of peril instead of a reassuring move. Actually, it signalled fear and made capital migrate to safer destinations.
Since short run capital movement were basically private capital, it didn’t help in the equilibrating mechanism. In fact, it acted against it. The burden of keeping the equilibrium fell on the shoulders of the central banks, that needed to use a lot of reserves.
Problems with adjustment mechanism 1925-1932
- Money coming back to the US to pay back European debt
- Short-term private capital flows not helping with the adjustments
Market pessimism (Keynes and White)
Markets at the microeconomical level was the most effective mean of allocating resources and keeping the economy working. Markets at the macroeconomical level, he believed, were not able to keep a full level of working capacity. This was worn out by the great recession when the markets showed a great deal of resilience.
Plans for the Post WWII era
Started as soon as 1941 and had White (USA) and Keynes (UK) as main protagonists.
They envisioned:
- system of rules and understandings to guide national policies
- binding international agreements open to subscription by other countries
- international organisations tasked with enforcing the rules
Keynes plan: International Clearing Union
A clearing union simply takes records of all debits and credits of all participating countries and clears them (debits vs credits) so to reduce the number of payments that countries need to do -> reducing the overall volume of payments.
Instead of countries settling their payments bilaterally, they do it through the central union. All debits and credits are cleared by the central unit and only the remaining ones that really need to paid are done. They simplify the process and reduce the overall volume of payments to be made.
Keynes Plan: The Bancor
The ICU idea encompassed the creation of an international currency that would gradually replace the gold in a process of one-way convertibility: the bancor. The ICU would, thus, gradually concentrate all gold reserves.
At equilibrium, member’s balances would be zero. The burden of disequilibrium would be shares symmetrically between debtors and creditors to avoid hoarding.
The exchange rates would work in a system of adjustable pegs.
Keynes Plan: Equilibrating mechanisms
If a country insisted in accumulating credit balances, they had to pay interest on their accumulations or even this balance could be expropriated by the clearing union and distributed to the rest of the countries -> bancor depreciation with time.
Credits and debits are denominated in bancors, avoiding key-currency previleges.
White’s Plan
Initially not incompatible with Keynes (later they became). White plan didn’t differ that much from Keyne’s plan in the sense that both searched for an international currency (called Unitas in this case), not attached to any national currency. More or less less like the international clearing union, White had envisaged the setting up of an international estabilisation fund which would later become the IMF.
This idea differed from an international clearing union in terms of its operation: this fund was to be obtained by the pulling of national currency or gold of each participating country that would be used to extend credit facility to countries in deficit. Basically, it worked more like an international bank. This reflected the American view: less generous in terms of the amount of funds that should be made available to participating countries through the IMF. Keynes had initially envisaged 26M, but White, fearing that most of the burden would fall under the shoulder of the US, considerably reduced this amount. What the Americans expected was that a country would remain as the richest most advanced country in the world
Basis of Bretton Woods
As time went by, Keyne’s and White’s plans were altered and an international currency was no longer envisaged.
Creation of the IMF that was supposed to extend short term credit facilities to countries that found themselves in a deficit situation, working as follows:
- IMF member countries would pool funds according to pre-assigned quotas (national currency and gold)
- supplies deficit countries with the foreign exchange needed to settle their deficit
- countries that draw on the Fund’s facilities will repurchase their currency with gold or other convertible currency
The outcome of Bretton Woods negotiations
Creation of the IMF that give rise to a dollar exchange standard:
- the dollar was declared the key currency; against it other currencies would maintain a fixed parity; the dollar alone would be pegged to gold
- he parity (fixed exchange rate to dollar) could be revalued or devalued with permission of the IMF under what was called “fundamental disequilibrium”. This gave a lot of freedom to the IMF in what concerned exchange rates.
- the responsibility for the adjustment was left on the shoulders of deficit countries
- capital controls were weakened
Differences to Keyne’s initial plan
- No bancor: dollar as key currency
- The responsibility for the adjustment was left on the shoulders of deficit countries. The symmetry that Keynes hoped to impose on the behaviour of all the countries in the system was not accepted, mostly due to the US that wanted to maintain its privileged position and didn’t want to comply with the re-equilibrium of the system
- way lower contribution from the US than Keyne’s proposed
The US were very powerful and the last decision was ultimatly in their hands.
American concessions in Bretton Woods for the reduced contribution to the Fund
- flexible exchange rates instead of fixed
- capital controls
- scarce currency (discriminatory trade controls agains surplus countries to allow rebalance)
American concessions in Bretton Woods for the reduced contribution to the Fund
- flexible exchange rates instead of fixed
- capital controls
- scarce currency (discriminatory trade controls agains surplus countries to allow rebalance)
UK vs USA priorities during BW
For the UK, the most important thing it was to maintain full employment at the national level.
In the US, this was not a big preoccupation - the US economy had totally absorbed the unemployment of the 30s and was enjoying a period of full employment.
The UK also wanted to be able to impose trade restrictions and flexible exchanges.
They also had concerns over the role of the pound sterling. Still a lot of pounds were being held outside the UK in the empire, and they feared that the convertibility of the pound to dollar or gold would have caused a flight from the currency and its demise as a reserve currency.
The US instead wanted to have a multilateral trading system with no descriminition whatsoever or control over exchange rates - free market and fixed exchange rates.
US interests in BW
New York Bankers pressure group pressured policy makers to make a system based on free market principles that would make them take over from London the role of leading international lenders.
US congress was not interested in the UK preferences.
The US held 60% of the global gold reserves, so they didn’t see why they would comply to a set of regulations as the ones envisaged at BW. They expected to get benefits from the use of the dollar as the key currency in publicity and trade.
US underestimation of European conditions during BW and later adjustments
Why would the richest country in the world renounce its power status? The US didn’t do that and as such didn’t accept the system of full symetry in sharing the burden of the adjustment of the payment system.
It should be said, however, that there was a serious mistake from the US in assessing and underestimating the dire situation of Europe. The US were, thus, forced to revise their position. Through the Marshall Plan, the US redistributed gold reserves (3B per year going from the US to Europe). Nonetheless, this was not sufficient and there was still a need for a devaluation of European currencies.
The american dollars that Europe received from the Marshall plan were intended to reconstruct the continent after the second WW.
Devaluation of european currency: big competitive advantage with respect to the dollars. Growth process based on exports.
Exports from Europe to the US + Marshall Plan with flow of gold and hence dollars -> great flow of dollars to Europe
Pound weakness and Marshal Plan
In 1946 the US conceeded a loan to the UK with the condition of in a one year period the UK restoring the convertibility of the pound (by July 1947). With this posibility of converting pounds to dollars, pound owners imediatly converted their currency to a point where the UK had to cancel the conversion - the pound was very weak, as all european currencies, when compared to the dollar, reflecting the disparity between US economy and European economies.
The US realized their misperception and implemented the already seen set of measures including the Marshall Plan.
The European Payments Union 1950-1958
Example of an effective clearing system.
At the end of WWII countries’ currencies were not convertible into one another, so trade was only possible bilaterally.
The system allowed for the re-start of European trade:
- countries were given 15% of their total trades in credit
- cleared all debit and credit positions from members’ trade
- pressed creditor countries to eliminate trade restrictions
Positive impacts of the EPU
Under bilateral clearing, both the number of transactions and their volume is reduced. There is an impressive reduction in the number of foreign reserves to be used to settle these transactions.
Under the system of EPU, there is a further reduction. This system allowed for the increase of international trade among European countries, also allowing for an accumulation of enough foreign exchange reserves to resume convertibility in 1958 (however, there was still capital controls)
The EPU: symmetry at work
The system was symmetrical because the countries running deficit positions would be charged an interest if exceeding the 15% quota - thus pressuring them to close the gap - and at the same time, countries in surplus would be pressured to do the same by liberalizing trade and reduce their positive surplus. By liberalizing trade and reducing restrictions to imports, these would increase and the surplus of the trade balance would go down.
The 1960s: from dollar scarcity to dollar glut with the European rebuilt
In general, the amount of money flowing out of the US was higher than the amount flowing in - started in 1950s and worsened in the 1960s.
This obviously implies a deficit, which the US would need to reduce via its reserves. This situation was particularly problematic with the Western European countries. This caused a sharp decline in US gold reserves, leading to a deficit situation.
So, European CBs started accumulating dollars, due to European exports and imports of dollars.
Why did the dollar glut happen?
- 1949: devaluation of European currencies in 1949
- 1948-1951: Marshal (Europe) and Dodge (Japan) plans
- building of US military bases overseas & large defense budget
- decline in US industry & exports competitiveness (related to some degree to European currencies devaluation
The Triffin dilemma
Triffin’s dilemma exposed a major design flaw in the BW arrangements - the system was doomed by using a national currency as key currency.
Because the dollar would have to expand to accomodate growth and international trade. And its supply was freely available.
However, the underlying asset - gold - could not expand at the same pace of the dollar.
> Keynes was right in thinking about an international currency.
1960: first time US monetary liabilities to foreigners exceeded US gold reserves -> full convertibility was no longer possible
Tiffin suggestions
- Reduction of the deficit
- enhancing US competitiveness through R&D investment
- elimination of trade restrictions against US
- increased European contribution to development aid - Creation of a new international reserve asset similar to Keynes’ bancor
Uneven impact of the US deficit
US benefited from the “exorbitant privilege” - using the dollar as key currency meant they could get foreign goods in return for issuing them.
The inflow of dollars in Western Europe led to an expansion in money supply and to inflation.
The US kept using this privilege to pursue their goals regardless of the deterioration of its external accounts.
This caused anxiety in the rest of the world with liquidity and confidence issues.
The Exorbitant privilege and European Critics
Conference press by president Charles de Gaulle - the president complained about the americans enjoying the previllege of running a huge balance of payment deficits, that after a while they weren’t able to make for just paying gold (otherwise gold reserves would deplete very fast). So the US ‘forced’ Europe to accept dollars as payment. This created a glut - europeans were flooded by dollars: they exported a lot to the US (due to the undervalue exchange rate of European currency) and the US payed for its deficit using dollars instead of gold.
At a certain point, Europeans were fed up with all these dollars, as this was detrimental for their economy. They didn’t know what to do with all those dollars. But, at the same time, there was no clear solution: if they tried to redeem gold for dollars from the fed, this would have priven the US from the gold standard, which was unfeasible.
International cooperation to save BW
To deal with this situation of excessive dollars held outsside the US, 2 main roads were pursued in order to keep the system going:
- International cooperation to avoid the redemption of dollars into gold, including the gold pool (1961)-> avoid the devaluation of the dollar against gold;
- However, this scheme didn’t last that long and other similar schemes were designed, like currency swaps among central banks to defend the price of the dollar in foreign exchange markets.
The system, however, had become very fragile, because of the pilying up of US dollars at European central banks.
A very important factor was also the devaluation of the sterling, the second most important reserve currency, in 1967 as a result of a speculative attack. This was seen as a sign that the dollar could also be under attack soon.
Liquidity issue - the impact of growing US deficit
One might think that liquidity was not a problem as there was plenty of available dollars. But liquidity was indeed an issue, because of a matter of confidence:
- dollars outside of the US were widely available; but precisely for this reason, confidence over time diminished regarding the the convertibility of dollars. Instead of signalling the liquidity of the system, it gave the idea that the system was in a very fragile situation.
Even the US at a certain point realized it was necessary to come up with an alternative reserve currency other than the dollar, because the US government couldn’t keep printing dollars and letting them pile up around the world.
As a matter of fact, liquidity was very needed in the 60s to allow:
- expansion of international trade - continuous growth around the world, especially in Europe and Japan
There was also an increase in quotas (amount of money that the IMF would lend to member countries to help them keep their accounts in equilibrium), but this also didn’t keep pace with international growth.
Attempt to respond to the Liquidity crisis: SDRs
So there was the idea of introducing a new reserve asset: SDR (special drawing rights). This was an unit of account to be used exclusively by central banks and governments to settle their international account. It was an international reserve asset, initially with the value of 1 dollar. Later, their price was relative to a basket of international currencies, including the dollar, sterling, francs, etc.
This was to supplement the provision of reserve assets without over-pressuring the dollar.
However, negotiations were very lengthy and when they were first issued it was already too late and there was already too much pressure on dollars.
US goes off gold (August 1971)
As a result, the dollar started to weaken, and to combat this trend was too politically costly (higher interest rates, wage restraint, import reduction, spending cuts), especially with elections due soon at the time.
So instead, Nixon decided to close the “gold window”, i.e., suspend gold payments and thus the convertibility of dollars.
US went back to a self centered approach and protecting their own interests after helping Europe with the Marshal plan for example in the aftermath of WWII.
Origins of the Eurodollar Market
Midland Bank (1955): attracts $, sells them and buys them back after 1 month - arbitrage Bank of England worries but turns a blind eye because of benefits for the British BOP US banks can draw funds if they have higher interest rates
Money Multiplication
Occurs when borrowers in the Eurodollar market change $ to local currency and $ are lent back into the market by national central banks
Immediate factors behind the rise of the Eurodollar market
- British banks seeking profit opportunities
- Tight monetary conditions in the UK
- Forbidden use of sterling to finance third parties
Fundamental Factors behind the rise of the Eurodollar
- Growing volume of international trade and investment finance
- Tight regulation in the US vs barely any regulation in the Eurodollar market
- Deficit in the US BOP
State as a key facilitator for the Eurodollar market
UK:
- eased UK BOP problems
- revived London as an international financial center
US:
- measures limiting capital outflows from the US
- US banks moving their international business to London
Oil Shocks 1970s and External Debt Frenzy
The oil shocks had a dramatic impact on the international financial flows:
- redistributed international reserves with arab countries accumulating large surplus and industrial and non-oil developing countries accumulating large deficits
Arab countries unable to spend their new wealth deposited it in large banks in Europe and US that lended it to LDC
International Debt Crisis 1982
The crisis occured in August 1982 becuase of Mexico: this caused panic, and 25 biggest debtors declared their bad situation. By October 1983, many countries have rescheduled their external debt (about maturity, etc = renegotiation). The biggest borrowers were 4 Latin American countries. Majority of banks involved were US banks: their exposure (280%) was massive and threatening.
Causes of the International Debt Crisis 1982
- Debtor countries bad economic management:
- expansionary monetary policy
- unproductive investment - Exogenous shocks:
- oil price
- Volcker shock - Systemic crisis of capitalism
- Overlending by banks
Volcker shock
Real interest rates were in some periods negative, but then they increase all of a sudden. This was called the “Volcker shock” from the FED action in an attempt to lower inflation by increasing interest rates.
Overlending from banks to LDCs
The idea was that States couldn’t bankrupt: this is a sign of the confidence of that period, especially from banks. This may be true, but States can default.
These banks were overconfident on the possibility of being repaid, so they wasn’t used to check the creditoworthiness of these developing countries.
All was triggered by the higher profitability of lending to those developing countries with respect to internal market.
Risk of debts wasn’t entirely taken by commercial banks, but it was a little bit spread among intermediaries banks.
Responsibility was left on the shoulders of only private sector
Reforming the international monetary system in the 1970s
The european remained staucnhly in favour of pegged fixed exchange rates:
After the floating of the dollar, there was pressure from the part of France, other European countries and Japan to go back to a system of pegged exchange rates - towards fixed parities - because this eliminates the foreign exchange rate risks in international transactions (highly welcomed by all the major economies in the world at the time). As a matter of fact, this was the path that european countries followed during the 70s.
Apart from Europe, there were attempts from the US to set up new rules, although it was very difficult to come to an agreement. The IMF appointed the creation of a comittee in 1972 - the so called C-20 - with the objective of discussing a reform of the IMF. This comittee was not able to reach an agreement and discussions to this end were taken over by the American and French presidents in the Rambouillet meeting of 1975. In this meeting, they reached an agreement on a new formula for exchange rates.
2nd IMF Amendment on Currencies
There was a move from what used to be a system of stable exchange rates - articles of agreement of the IMF - to a stable system of exchange rates. This apparently very subtle modification meant the possibility for members of the IMF to adopt the exchange mechanism of their preference with a relatively wide spectrum of possibilities.
The types of exchange arrangements included:
- Free floating: value of the exchange rates is set by free operations of foreign exchange markets - Managed floating: Degree of intervention from central bnks to achieve some target levels - Soft peg: when the value of a currency is related to a basket of other currencies, meaning its exchange rate moves together with the value of the basket of other currencies. - Hard peg: when either you have the fixed exchange rate or even when a country adopts the legal currency of another country (dollarization in Central and South America that adopted the dollar as the legal tender).
2nd IMF Amendment on new roles
Surveillance: monitoring of the evolution of policies related to exchange rates. Bilateral between the IMF and the countries. Started with the second amendment.
Lending: became a defining factor of the operations of the iMF. Grew gradually in the 70s and 80s without influence of the amendments.
Dealing with the debt crisis of 1982
The crisis was a global event that threatened to stop growth and the stability of the financial system of the largest and most advanced economies.
The crisis was perceived as temporary and as a liquidity crisis, not a solvency crisis. The intervention - or rather no intervention - of the creditors and of the IMF followed this interpretation of the crisis.
The interpretation was that the debtor countries had the responsability for the crisis, not of the lender countries.
Focus on the debtor countries was not fair, because as we’ve seen last class the lending by banks was not prudent.
Western governments adopted a self-interested approach:
- Avoid failure of large domestic lenders - Avoid going at the roots of the crisis
Dealing with the debt crisis: pressure on LDCs
The financial flows of money that had inundated the debtor countries after the second oil shock came to an end in a matter of months, as banks stopped to lend realizing the difficulties in many countries repaying the debt.
There was an inversion in the direction of the capital flows:
- During the 70s capital was flowing from rich countries to less developed countries - With the crisis in August 1982, these flows dried up and these LDC still had to pay back their debt. So money started to flow again from LDC to rich countries, inverting the direction of funds.
This inversion of the financial flows led to severe economic and social costs:
- Decline in income per capita - Increase in unemployement
Consequences of dealing with the debt crisis for LDCs
Countries were left to act on their own (little intervention from the IMF) and to rebalance their accounts these countries had to implement policies that acted fast - forced to implement policies with the priority to restore external equilibrium.
One of those measures was currency devaluation in an attempt to increase exports and reduce imports. But this also reduced citizens’ consumption possibilities.
To add to this we have an unfriendly external environment.
These countries emerged with a big fiscal deficit in spite of the government spending cuts implemented. This happened because the income from taxes was also significantly decreasing as a resullt of the slow-down of the economy.
In the 70s, many latin american countries had used foreign finanncing to fund their fiscal deficit, but this was no longer possible. They had now to relie on their central banks and this meant printing more money in order to finance their fiscal deficit, which gave rise fo inflation.
Role of the IMF in solving the debt crisis
Attempt to push banks to keep lending to debtor countries, in spite of their concerns on the creditworthiness of these debtors.
If banks stoped lending to debt-distressed countries, they would go bankrupt and this could lead to even greater losses to those banks as they would not get their loans paid back. So it was also of their interest to keep these countrie afloat.
- The IMF had this role of trying to explain this longer-view to private actors - The IMF also had the role of coordinating in order to keep as many banks as possible
Big banks were happy to see the IMF taking this role because they felt more protected.
IMF financing to debtor countries in the 19802
- Macroeconomic: restore the equilibrium between aggregate demand and supply
- Structural adjustment: increase efficiency, raise investment and output
Structural adjustment loan (SAL)
Instrument available by the Wold Bank to help less developed countries to deal with the oil shock and the growing current account imbalance. Its main objectives were:
- Reduce imbalances in current accounts - Foster growth
There were also conditions attached to these loans.
The Washington Consensus (1989)
The Washington consensus evolved form this practice of conditional lending to developing countries from the late 70s to initial 80s.
The Washington Consensus is a set of ten economic policy prescriptions considered to constitute the “standard” reform package promoted for crisis-wracked developing countries.
Ideas of neoliberal character.
Some problems with the policies of the Washington consensus
These IMF and WB policies were not always well received by the recipient countries because their implementation was not the well planed and studied (questions such for how long to apply them, all at once or not, etc)
- Not to blame the policies but the way in which they were applied
Mixed or neutral effects on growth.
Pros and Cons of capital account liberalization
Countries having short capital supply benefit from supplementary amounts coming from abroad.
Increased availability of capital is supposed to reduce financing costs.
The presence of foreign banks also lead the domestic financial sectors to be more competitive, dynamic and responsive.
Obv, at the international level, informational asymmetries will be much higher.
The greater capital volatility is very destabilising for those countries receiving a lot of capital from abroad.
Consequences of capital account liberalization
KPRW indicate that there are no signs in support of a clear link btw growing capital integration and economic growth. Benefits most often relate to improvements in the environment.
RS highlighted how often least-developed countries do not lack capital to invest, rather, opportunities to invest in. Suggestion for capital investment is not to proceed single-minded, each situation will have specific capital requirements.
EM underline how before capital liberalization, you should make sure financial actors are able to hedge themselves against the risks coming with it. It is thus advisable that each risk management mechanism are evolved before opening up to foreign investors.
Towards greater financial openness 70s - present
During a currency crisis in 1976, UK had the option of tightening capital control, but they eventually gave up bc of the too high costs this would have entailed - failure of strengthening capital controls
This left the door open to the liberalisation of financial flows
US lifting of capital controls in 1974
capital controls had been introduced to reduce the flight of dollars: why did they chose to reverse such decision so radically?
the idea was that liberal international financial systems would extend the role of the dollar, bringing benefits to the US economy. in the 70s, the dramatic increase in the price of oil increased demand of dollars - bc all oil transaction were settled in dollars.
