Refers to exchange rate crises, banking crises or some combination of the two. These are often the variables through which the contagion effects are spread

• Refers to exchange rate crises, banking crises or some combination of the two.

• These are often the variables through which the contagion effects are spread from one country to another

International Financial Crises

• Economic integration = opportunities for growth and development but also =

• Easier for crises to spread from one country to another

• e.g. 1992 currency speculation against British pound and other European currencies = near collapse of monetary arrangements in Europe

• A banking crisis occurs when

• The banking system becomes unable to perform its normal lending functions and some or all of a nation’s banks are threatened with insolvency. (net worth is negative = assets are less than liabilities)

• If banks cannot pay its creditors (depositors) because its debtors (businesses, loans) have gone under or defaulted = Disintermediation

• When depositors lose their money (unless they have deposit insurance), Consumption drops, new investments slows down, economy falls into deep vicious circle of recession.

Sudden and unexpected collapse in the value of a nation’s currency.

May occur in either fixed or flexible regimes but research shows that countries with fixed regime are more vulnerable to this type of crisis

Result is steep recessione.g. A country borrows large amounts in international

capital markets.Country’s currency collapses value of debt increasesMany banks fail capital outflow and no new I economy

goes into deep recession

5

Exchange rate crisis

• Banking system is the channel for transmitting recessionary effects

• Prior to the Asian crisis, banks borrowed dollars in capital markets.

• When home country currency collapsed, dollar value of debt increased.

• Many banks failed. Disintermediation took place and economies slid into deep recession

1994, speculation against the Mexican peso = its collapse and spread of “Tequila effect” through out South America.

1997 several East Asian economies were thrown into recession by a wave of sudden capital outflows

Contagion effect = not a single pattern = different rules of behavior

7

1. Macroeconomic imbalances

2. Volatile flows of financial capital that quickly move in and out a country (sudden changes in investor expectations may be the triggering factor)

8

2 Origins of Financial Crisis

Macroeconomic Imbalances-Best example is Third World Debt crisis (1980)-Overly expansionary fiscal policies creating

large government deficits financed by high growth of money supply

-potential problems of government spending are compounded by inefficient and unreliable tax systems

Tax revenue may be insufficient for government expenditure

9

-Governments resort to selling bonds to finance expenditures but capital markets are underdeveloped

-So governments require central banks to buy the bonds

-Money supply increase-Inflationary pressure -currency becomes overvalued-everyone tries to sell domestic assets

and convert them to foreign exchange-Government begins to run out of

international reserves-pressure on currency to depreciate

10

• If exchange rates are fixed serious repercussions on real value of the exchange rate

• Capital flight if people begin to think exchange rate is overvalued and correction is likely in future

• In addition to large budget deficits and inflationary pressures is a large and growing current account deficit.

• People try to sell their domestic assets and acquire foreign ones run on a country’s international reserves

• Portfolio managers look at actions of each other for information about the direction of the market

• Herd mentality

• A small trickle of funds can be fueled by speculations which can lead to a huge capital flight.

12

Crisis caused by volatile capital flows

• When this happens, international reserves disappear, exchange rates tumble and weakens the financial sector

• A weak financial sector intensifies the problems

13

Steps Countries can take to minimize likelihood of crises and damage they cause when they happen

-maintain credible and sustainable fiscal and monetary policies

-engage in active supervision and regulation of the financial system

-provide timely information about key economic variables such as central bank holding of international reserves

14

Domestic Issues in Crisis Avoidance

• Elements of macro imbalances, volatile capital flows and financial sector weakness.

• Overvalued real exchange rates, current account deficits because domestic savings could not support investments

• In 1990 – 1993 capital inflows of $91B made up of private investment, direct investment and bank loans

15

The Mexican Peso Crisis (94/95)

• In 1994, interest rate movements led to large losses for banks and investors

• Investors called for reducing level of exposure to Mexico

• Dec. 1994, newly elected president, Zedillo, announced a 15% devaluation

16

Currency speculators had expected a 20 – 30% devaluation Zedillo’s announcement sent financial markets into turmoil

More capital fled the country

Dollar reserves shrank.

Though 2 days after the announcement, Mexico said it would move to a flexible exchange rate, the damage had already been done

17

Both domestic and foreign capital continue to leave the country

By March 1995, peso had lost more than 50% of its value

NAFTA and IMF helped in the form of line of credit and loans with conditions of decreasing G and increasing T

18

Began in Thailand in July 1997 and spread to Malaysia, Philippines, Indonesia and South Korea

Symptoms of crisis were fairly similar across countries

-currency speculation and steep depreciation

-capital flight

-financial and industrial sector bankruptcies

19

1997/1998 Asian Crisis

Countries had large trade deficits (on average 5.2% of GDP, Thailand had a deficit of 8% of GDP) the year before the crisis

Large current account deficits = large capital inflows

Because for last 30 years these countries averaged 5% growth in GDP and foreign investors had no reasons to believe otherwise

Also, Japan and Europe were losing grounds in growth and investors were looking elsewhere

20

• Exchange rates in the region were pegged to the dollar dollar appreciating in the 90s meant many exchange rates appreciating as well.

• Exchange rates were harder to sustain because it became more difficult to export. CA deficits increased

• Financial sector problems because of family ties

21

• Investors lost confidence in Thailand to keep its exchange rate pegged

• People began to suspect devaluation and refused to hold Thai baht

22

Many loans to the Thai financial sector were in dollars so this raised the cost of devaluation

Thailand served as a wake-up call to investors in the region

Others think the devaluation in Thailand made exports from other countries less competitive which led them to devalue as well.

Whatever the case, the Thailand experience had a contagion effect

23

Effect spread to countries as far as Brazil and Russia

With the exception of Singapore and Taiwan, every country affected by the crisis experienced a recession in 1998

Singapore and Taiwan had had large surpluses so they concentrated on domestic economies rather than defending their currencies

IMF helped with loans and conditions of interest rate hikes. Capital controls were implemented in some countries

24

• In the 1980s, high interest rates and an appreciation of the US dollar caused the burden of dollar denominated debts in Argentina, Mexico, Brazil and Chile to increase drastically.

• A worldwide recession and a fall in many commodity prices also hurt export sectors in these countries.

• In August 1982, Mexico announced that it could not repay its debts, mostly to private banks.

Latin American Financial Crises

• After liberalization in 1991, Russia’s economic laws were weakly enforced or nonexistent.

There was weak enforcement of banking regulations, tax laws, property rights, loan contracts, and bankruptcy laws.

Financial markets were not well established.

Corruption and crime became growing problems.

Because of a lack of tax revenue, the government financed spending by seignoirage.

Interest rates rose on government debt to reflect high inflation from seignoirage and the risk of default.

Russia’s Financial Crisis

The IMF offered loans of official international reserves to try to support the fixed exchange rate conditional on reforms.

But in 1998, Russia devalued the ruble and defaulted on its debt and froze financial asset flows.

Without international financial assets for investment, output fell in 1998 but recovered thereafter, partially due to the expanding petroleum industry.

Inflation rose in 1998 and 1999 but fell thereafter.

Russia’s Financial Crisis (cont.)

Chapter 18

International Monetary System, 1870–1973

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 18-28


Preview

• Goals of macroeconomic policies

• Gold standard

• International monetary system during 1918-1939

• Bretton Woods system: 1944-1973

• Collapse of the Bretton Woods system

• International effects of U.S. macroeconomic policies


Macroeconomic Goals

• “Internal balance” describes the macroeconomic goals of producing at potential output (or at “full employment” or with sustainable and effective use of resources) and of price stability (or low inflation). An unsustainable use of resources (over-employment) tends

to increase prices and an ineffective use of resources (underemployment) tends to decrease prices.

Volatile aggregate demand and output tend to create volatile prices.

• And volatile prices makes planning for the future more difficult, imposes a cost of adjusting prices, and arbitrarily redistributes income between lenders and borrowers.


Macroeconomic Goals (cont.)

• “External balance” describes a current account that is not “too” negative or “too” positive. A large current account deficit can make foreigners

think that an economy can not repay its debts and therefore make them stop lending, causing a financial crisis.

A large current account surplus can cause protectionist or other political pressure by foreign governments (ex., pressure on Japan in the 1980s and China in the 2000s).



• “External balance” can also mean a balance of payments equilibrium: a current account (plus capital account) that

matches the non-reserve financial account in a given period, so that official international reserves do not change.


Gold Standard, Revisited

• The gold standard from 1870–1914 and after 1918 had mechanisms that prevented flows of gold reserves (the balance of payments) from becoming too positive or too negative. Prices tended to adjust according the amount of

gold circulating in an economy, which had effects on the flows of goods and services: the current account.

Central banks influenced financial asset flows, so that the non-reserve part of the financial account matched the current account in order to reduce gold outflows or inflows.


Gold Standard, Revisited (cont.)

• Price specie flow mechanism is the adjustment of prices as gold (“specie”) flows into or out of a country, causing an adjustment in the flow of goods. An inflow of gold tends to inflate prices.

An outflow of gold tends to deflate prices.

If a domestic country has a current account surplus in excess of the non-reserve financial account, gold earned from exports flows into the country—raising prices in that country and lowering prices in foreign countries.

Goods from the domestic country become expensive and goods from foreign countries become cheap, reducing the current account surplus of the domestic country and the deficits of the foreign countries.



• Thus, price specie flow mechanism of the gold standard could automatically reduce current account surpluses and deficits, achieving a measure of external balance for all countries.



• The “Rules of the Game” under the gold standard refer to another adjustment process that was theoretically carried out by central banks: The selling of domestic assets to acquire money when gold

exited the country as payments for imports. This decreased the money supply and increased interest rates, attracting financial inflows to match a current account deficit.

• This reversed or reduced gold outflows.

The buying of domestic assets when gold enters the country as income from exports. This increased the money supply and decreased interest rates, reducing financial inflows to match the current account.

• This revered or reduced gold inflows.



• Banks with decreasing gold reserves had a strong incentive to practice the rules of the game: they could not redeem currency without sufficient gold.

• Banks with increasing gold reserves had a weak incentive to practice the rules of the game: gold did not earn interest, but domestic assets did.

• In practice, central banks with increasing gold reserves seldom followed the rules.

• And central banks often sterilized gold flows, trying to prevent any effect on money supplies and prices.



• The gold standard’s record for internal balance was mixed. The U.S. suffered from deflation,

recessions and financial instability during the 1870s, 1880s, and 1890s while trying to adhere to a gold standard.

The U.S. unemployment rate 6.8% on average from 1890–1913, but it was less than 5.7% on average from 1946–1992.


Interwar Years: 1918–1939

• The gold standard was stopped in 1914 due to war, but after 1918 was attempted again.

The U.S. reinstated the gold standard from 1919–1933 at $20.67 per ounce and from 1934–1944 at $35.00 ounce, (a devaluation the dollar).

The UK reinstated the gold standard from 1925–1931.

• But countries that adhered to the gold standard for the longest time, without devaluing their currencies, suffered most from reduced output and employment during the 1930s.


Bretton Woods System: 1944–1973

• In July 1944, 44 countries met in Bretton Woods, NH, to design the Bretton Woods system: a fixed exchange rates against the U.S. dollar and a fixed

dollar price of gold ($35 per ounce).

• They also established other institutions:1. The International Monetary Fund

2. The World Bank

3. General Agreement on Trade and Tariffs (GATT), the predecessor to the World Trade Organization (WTO).


International Monetary Fund

• The IMF was constructed to lend to countries with persistent balance of payments deficits (or current account deficits), and to approve of devaluations.

Loans were made from a fund paid for by members in gold and currencies.

Each country had a quota, which determined its contribution to the fund and the maximum amount it could borrow.

Large loans were made conditional on the supervision of domestic policies by the IMF: IMF conditionality.

Devaluations could occur if the IMF determined that the economy was experiencing a “fundamental disequilibrium”.


International Monetary Fund (cont.)

• Due to borrowing and occasional devaluations, the IMF was believed to give countries enough flexibility to attain an external balance, yet allow them to maintain an internal balance and stable exchange rates.

The volatility of exchange rates during 1918–1939, caused by devaluations and the vagaries of the gold standard, was viewed as a source of economic instability.


Bretton Woods System: 1944–1973

• In order to avoid sudden changes in the financial account (possibly causing a balance of payments crisis), countries in the Bretton Woods system often prevented flows of financial assets across countries.

• Yet, they encouraged flows of goods and services because of the view that trade benefits all economies.

Currencies were gradually made convertible (exchangeable) between member countries to encourage trade in goods and services valued in different currencies.


Bretton Woods System: 1944–1973 (cont.)

• Under a system of fixed exchange rates, all countries but the U.S. had ineffective monetary policies for internal balance.

• The principal tool for internal balance was fiscal policy (government purchases or taxes).

• The principal tools for external balance were borrowing from the IMF, restrictions on financial asset flows and infrequent changes in exchange rates.


Macroeconomic Goals

• Suppose internal balance in the short run occurs when production at potential output or “full employment” equals aggregate demand:

Yf = C(Yf – T) + I + G + CA(EP*/P, Yf – T) (18-1)

• An increase in government purchases (or a decrease in taxes) increases aggregate demand and output above its full employment level.

• To restore internal balance in the short run, a revaluation (a fall in E) must occur.



• Suppose external balance in the short run occurs when the current account achieves some value X:

CA(EP*/P, Y – T) = X (18-2)

• An increase in government purchases (or a decrease in taxes) increases aggregate demand, output and income, decreasing the current account.

• To restore external balance in the short run, a devaluation (a rise in E) must occur.



Fiscal expansion(G or T)

Exchangerate, E

XX

II

1Internal balanceachieved: outputis at its full employment level

External balance achieved: the currentaccount is at its desired level



• But under the fixed exchange rates of the Bretton Woods system, devaluations were supposed to be infrequent, and fiscal policy was supposed to be the main policy tool to achieve both internal and external balance.

• But in general, fiscal policy can not attain both internal balance and external balance at the same time.

• A devaluation, however, can attain both internal balance and external balance at the same time.



Fiscal expansion(G or T)

Exchangerate, E

XX

II

1

3

Devaluation that results in internal and external balance: by making domestic goods cheaper, aggregate demand, output and the current account increase.

2

4

Fiscal policy that results in internal or external balance: by reducing demand for imports and output or increasing demand for imports and output.

At point 2, the economy is below II and XX: itexperiences low outputand a low current account



• Under the Bretton Woods system, policy makers generally used fiscal policy to try to achieve internal balance for political reasons.

• Thus, an inability to adjust exchange rates left countries facing external imbalances over time. Infrequent devaluations or revaluations helped

restore external and internal balance, but speculators also tried to anticipate them, which could cause greater internal or external imbalances.


External and Internal Balances of the U.S.

• The collapse of the Bretton Woods system was caused primarily by imbalances of the U.S. during the 1960s and 1970s. The U.S. current account surplus became a deficit

in 1971.

Rapidly increasing government purchases increased aggregate demand and output, as well as prices.

Rising prices and a growing money supply caused the U.S. dollar to become overvalued in terms of gold and in terms of foreign currencies.


Fig. 18-3: U.S. Macroeconomic Data, 1964–1972

Source: Economic Report of the President, 1985. Money supply growth rate is the December to December percentage increase in M1. Inflation rate is the percentage increase in each year’s average consumer price index over the average consumer price index for the previous year.


Fig. 18-3: U.S. Macroeconomic Data, 1964–1972

Source: Economic Report of the President, 1985. Money supply growth rate is the December to December percentage increase in M1. Inflation rate is the percentage increase in each year’s average consumer price index over the average consumer price index for the previous year.


Problems of a Fixed Exchange Rate, Revisited

• Another problem was that as foreign economies grew, their need for official international reserves grew to maintain fixed exchange rates.

• But this rate of growth was faster than the growth rate of the gold reserves that central banks held. Supply of gold from new discoveries was growing slowly. Holding dollar denominated assets was the alternative.

• At some point, dollar denominated assets held by foreign central banks would be greater than the amount of gold held by the Federal Reserve.


Problems of a Fixed Exchange Rate, Revisited (cont.)

• The Federal Reserve would eventually not have enough gold: foreigners would lose confidence in the ability of the Federal Reserve to maintain the fixed price of gold at $35/ounce, and therefore would rush to redeem their dollar assets before the gold ran out.

This problem is similar to what any central bank may face when it tries to maintain a fixed exchange rate.

If markets perceive that the central bank does not have enough official international reserve assets to maintain a fixed rate, a balance of payments crisis is inevitable.


Collapse of the Bretton Woods System

• The U.S. was not willing to reduce government purchases or increase taxes significantly, nor reduce money supply growth.

• These policies would have reduced aggregate demand, output and inflation, and increased unemployment. The U.S. could have attained some semblance of external

balance at a cost of a slower economy.

• A devaluation, however, could have avoided the costs of low output and high unemployment and still have attained external balance (an increased current account and official international reserves).


Collapse of the Bretton Woods System (cont.)

• The imbalances of the U.S., in turn, caused speculation about the value of the U.S. dollar, which caused imbalances for other countries and made the system of fixed exchange rates harder to maintain.

Financial markets had the perception that the U.S. economy was experiencing a “fundamental equilibrium” and that a devaluation would be necessary.



• First, speculation about a devaluation of the dollar caused investors to buy large quantities of gold. The Federal Reserve sold large quantities of gold in March

1968, but closed markets afterwards.

Thereafter, individuals and private institutions were no longer allowed to redeem gold from the Federal Reserve or other central banks.

The Federal Reserve would sell only to other central banks at $35/ounce.

But even this arrangement did not hold: the U.S. devalued its dollar in terms of gold in December 1971 to $38/ounce.



• Second, speculation about a devaluation of the dollar in terms of other currencies caused investors to buy large quantities of foreign currency assets. A coordinated devaluation of the dollar against foreign

currencies of about 8% occurred in December 1971.

Speculation about another devaluation occurred: European central banks sold huge quantities of European currencies in early February 1973, but closed markets afterwards.

Central banks in Japan and Europe stopped selling their currencies and stopped purchasing of dollars in March 1973, and allowed demand and supply of currencies to push the value of the dollar downward.


International Effects of U.S. Macroeconomic Policies

• Recall from chapter 17, that the monetary policy of the country which owns the reserve currency is able to influence other economies in a reserve currency system.

• In fact, the acceleration of inflation that occurred in the U.S. in the late 1960s also occurred internationally during that period.


International Effects of U.S. Macroeconomic Policies (cont.)

Source: Organization for Economic Cooperation and Development. Figures are annual percentage increases in consumer price indexes.

Inflation rates in European economies relative to that in the US

0

1

2

3

4

5

6

7

8

9

10

1966 1967 1968 1969 1970 1971 1972

year

perc

ent

US

France

Germany

Italy

Britain


International Effects of U.S. Macroeconomic Policies (cont.)

• Evidence shows that money supply growth rates in other countries even exceeded the rate in the U.S.

• This could be due to the effect of speculation in the foreign exchange markets.

Central banks were forced to buy large quantities of dollars to maintain fixed exchange rates, which increased their money supplies at a more rapid rate than occurred in the U.S.


Table 18-2: Changes in Germany’s Money Supply and International Reserves, 1968–1972 (percent per year)


Summary

1. Internal balance means that an economy enjoys normal output and employment and price stability.

2. External balance roughly means a stable level of official international reserves or a current account that is not too positive or too negative.

3. The gold standard had two mechanisms that helped to prevent external imbalances

Price specie flow mechanism: the automatic adjustment of prices as gold flows into or out of a country.

Rules of the game: buying or selling of domestic assets by central banks to influence flows of financial assets.


Summary (cont.)

4. The Bretton Woods agreement in 1944 established fixed exchange rates, using the U.S. dollar as the reserve currency.

5. The IMF was also established to provide countries with financing for balance of payments deficits and to judge if changes in fixed rates were necessary.

6. Under the Bretton Woods system, fiscal policies were used to achieve internal and external balance, but they could not do both simultaneously, so external imbalances often resulted.


Summary (cont.)

7. Internal and external imbalances of the U.S.—caused by rapid growth in government purchases and the money supply—and speculation about the value of the U.S. dollar in terms of gold and other currencies ultimately broke the Bretton Woods system.

8. High inflation from U.S. macroeconomic policies was transferred to other countries late in the Bretton Woods system.


Fig. 18-1: Internal Balance (II), External Balance (XX), and the “Four Zones of Economic Discomfort”

Documents

Refers to exchange rate crises, banking crises or some combination of the two. These are often the variables through which the contagion effects are spread