1. Lecture Topic The Global Financial System May 13, 2008
POLS/ECON 426 International Political Economy
Lecture Topic The Global Financial System
May 13, 2008
Professor Timothy C. Lim Cal State Los Angeles

2. Dynamics of the World Economy The Global Financial system
Global Financial System: Introduction
“When America sneezes, the world catches a cold”
What does this statement suggest?

3. So, what is interdependence?
Dynamics of the World Economy The Global Financial system
Global Financial System: Introduction
The statement, “When America sneezes, the world catches a cold”, reflects a basic feature of international and global political economy: interdependence
International trade, transnational production, the growth of TNCs, etc. all relate to increasing interdependence
But, nowhere do we see the significance of interdependence more clearly than in the development of the global financial system or GFS
So, what is interdependence?

4. Dynamics of the World Economy The Global Financial system
Interdependence in the Global Economy
There are several ways to define interdependence
Here’s one of the most common: interdependence means “dependent on others for some needs,” which suggest that no one is able to produce everything one needs
The foregoing definition is useful and important, but interdependence has another aspect as well, one based on interconnectedness
In the global economy, the fate of one national system (or unit) is increasingly dependent on and influenced by the activities of others national units and of the system as a whole: a “sneeze” anywhere in the system may lead to serious “disease” for everyone

5. Dynamics of the World Economy The Global Financial system
Interdependence in the Global Economy
The concept of interdependence or interconnectedness serves as an essential backdrop for our discussion of the GFS
To repeat a key point: More so than in other aspects of the global economy, developments in the GFS expand and deepen global interdependence and interconnectedness:
We are all profoundly affected by the GFS
The GFS is “making the world smaller,” much smaller than it has ever been
But, “small” is not always beautiful: a smaller world also means that the ugliness and pain of globalization is felt more intensely and more quickly than ever before

6. Dynamics of the World Economy The Global Financial system
GFS: Definitions and Background
The origins of the contemporary global financial system can be found in the creation of the post-war international monetary system (IMS), which was negotiated at Bretton Woods in 1944
The conference produced a number of major agreements:
A return to the gold standard based on the US dollar (the US$ was fixed to gold at $35 ounce, while other currencies were fixed to the US$)
Establishment of the IMF and the IBRD (International Bank for Reconstruction and Development)
The IRBD was originally designed to aid in the reconstruction of western Europe
The IBRD later became the World Bank
Bretton Woods conference, 1944

7. Dynamics of the World Economy The Global Financial system
GFS: Some Questions
What was the logic of returning to a gold standard fixed to the U.S. dollar (also known as the gold exchange system)?
Why were the IMF and IBRD established?
The purpose of the IMF was to further ensure international financial stability through the creation of a lender of “last resort.” Recall that one of the problems of the interwar period was precisely because there was no lender of last resorts that countries could turn to when they experience financial difficulties. The result was a retreat to protectionism, which exacerbated, rather than ameliorated problems. The IBRD was created to deal with the longer term reconstruction issues faced by Western Europe: it was a mechanism to provide a minimal degree of liquidity in capital-poor economies.
The logic of the gold exchange system (GES) was to create more stability and flexibility in the IMS. The basic idea was that, by having a generally fixed standard, all countries would have greater faith in the underlying value of their currencies. At the time, the GES allowed for occasional adjustments in situations where the underlying productivity of a country’s economy changed. For example, if a country experienced a natural or even man-made disaster that wiped out its industrial base, it would be allowed to lower the value of its currency to encourage exports and help rebuild the economy.
More on the IMF and IBRD on following slides

8. Dynamics of the World Economy The Global Financial system
Definitions and Background: IMF
A key purpose of the IMF was to monitor the implementation of the Bretton Woods agreement
To fulfill this goal, one of the IMF’s function was to hold gold and currency reserves that were contributed by the member countries and then lend this money out to other nations that had difficulty meeting their obligations under the agreement
Note: in 2004, the IMF had the third largest reserves of gold in the world at 3,217 tons
Over time, the core mission of the IMF has remained basically the same, but its approach and focus have changed: today, the IMF lends primarily to developing countries and focuses on promoting liberalization
Dominique Strauss-Kahn, current Managing Director of the IMF

9. Dynamics of the World Economy The Global Financial system
Definitions and Background: IBRD
The purpose of the IBRD was to provide long-term credit
Remember from our earlier discussions, that credit is vital for economic growth and development: the problem in the early postwar years was that most countries had very little access to credit and this was why the IBRD was created, namely, to funnel credit to rebuilding countries in Europe
The IBRD did not initially have sufficient funds, but ultimately, the US increased credit by creating the Marshall Plan, which funneled $13 billion to Europe (equivalent to about $100 billion today), most of which was in the form of grants
The original focus of the IBRD was western Europe and Japan; today, however, the World Bank/IBRD loans primarily to middle income and “credit-worthy” poor countries

10. Dynamics of the World Economy The Global Financial system
GFS: More Questions
What happened to the GES? Why
Related question: What is the Triffin Dilemma?
The failure of the GES was due to a variety of factors, but one of the most important was simply that, as the world began to catch up with U.S. economically, America’s ability to maintain sufficient gold reserves relative to the amount of paper dollars in circulation invariably declined. At the same time, it was in the interests of the U.S. to help its major allies rebuild competitive economies: the U.S. needed a healthy international economy. This is an aspect of the Triffin Dilemma.
The GES was formally abandoned by Richard Nixon in 1971, when he declared that the United States would “close the gold window,” no longer making it possible to convert the dollar directly to gold. This was dubbed the “Nixon Shock,” in part because he did not consult with members of the international monetary community before announcing the decision. Importantly, this occurred at a time when the U.S. economy was faltering. To pay for the cost of the Vietnam war, the U.S. was printing excessive amounts of paper dollars, much of which was sent overseas. Many countries became worried about the ability of the U.S. to actually convert dollars to gold.

11. Dynamics of the World Economy The Global Financial system
GFS: Triffin Dilemma
In 1960, economist Robert Triffin exposed a fundamental problem in the international monetary system. If the United States stopped running balance of payments deficits, the international community would lose its largest source of additions to reserves. The resulting shortage of liquidity could pull the world economy into a contractionary spiral, leading to instability. On the other hand, if U.S. deficits continued, a steady stream of dollars would continue to fuel world economic growth and stability.
However, excessive U.S. deficits (dollar glut) would erode confidence in the value of the U.S. dollar. Without confidence in the dollar, it would no longer be accepted as the world's reserve currency. The fixed exchange rate system could break down, leading to instability.

12. Dynamics of the World Economy The Global Financial system
GFS: Triffin Dilemma
Triffin was essentially correct: The United States was between the proverbial “rock and hard place”
Nixon’s decision to close the “gold window,” therefore, was basically inevitable, but it also ushered in a new era of instability in the global financial system, which continues to play out today (we’ll discuss this point shortly, but first …)

13. Dynamics of the World Economy The Global Financial system
GFS: Summing Up Thus Far
The U.S. decision to rebuild the IMS in the post-war period reflected America’s new position as the dominant economic power in the world
U.S. power and interests were manifested in the Bretton Woods conference: the decision to establish a GES rather than the British model
U.S. decision to unilaterally abandon the GES was both a reflection of U.S. power and interests and also a reflection of the limits of American power
Marshall Plan: A fundamentally geopolitical and geo-economic decision
The Triffin Dilemma represented, on a smaller scale, the dilemma of hegemonic power: a hegemon benefits from system stability and growth, but must also expend valuable resources to keep system together

14. Dynamics of the World Economy The Global Financial system
End of the GES: Implications
The U.S. decision to abandon the GES rate had profound reverberations around the world
Initial repercussions were limited: the IMS went through a period of flux, with some countries trying to maintain a fixed exchange rate, while other turned to a “floating rate system”
Medium and longer term consequences were more important and can be connected to …
The Oil Shock of the mid-1970s
A global recession beginning in the late s
The debt crisis of the 1980s and beyond
All three issues had cascading effects throughout the world: America’s “sneeze” did indeed cause a global “cold”

15. Dynamics of the World Economy The Global Financial system
GFS and the Oil Shock
How did the decision to abandon the gold exchange system contribute to the Oil Shock of the mid-1970s?
Transactions for oil in international markets took place in US dollars. With the shift to a floating rate system, however, the dollar was devalued, which meant that--without an adjustment--oil producing countries would earn less on the sale of each gallon of oil.* The solution was obvious: raise the price of oil.
* Note: The recent increase in world oil prices is also due, in part, to a devaluation of the US $

16. Dynamics of the World Economy The Global Financial system
GFS and the Oil Shock
In October 1973, another more serious shock occurred: the outbreak of the Yom Kipper War, during which the oil- producing Arab states imposed an oil embargo on the U.S. and other allies of Israel
One result was dramatic spike in oil prices: 300% in three months
The surge in world oil prices had a cascading effect throughout the world. Some of the effects were obvious (such as?), some less so …
Image: Yom Kippur War 1973 on the Golan heights

17. Dynamics of the World Economy The Global Financial system
GFS and the Oil Shock
A less obvious impact: Over time, the large increase in oil prices created huge cash (US$) surpluses among the oil-producing economies: the money in these surpluses is referred to as petrodollars
The oil-producing countries literally found themselves with so much money they could not spend it fast enough. Given their relatively small populations, they could not import enough from countries that bought their oil to keep from piling up enormous dollar surpluses
So, what’s the problem?

18. Dynamics of the World Economy The Global Financial system
GFS, the Oil Shock, and Interdependence
Here’s the basic problem: The world economy would contract if the huge among of petrodollars was taken out of circulation (i.e., not spent or loaned to someone else to spend)
The solution, therefore, was a no-brainer: Recycle excess petrodollars through the international banking system
This is exactly what happened, but this helped to create another, perhaps even more serious problems …
In a global system of increasing interdependence and interconnectedness, the recycling of petrodollars increased competition among poor countries, making it harder for them to sell their goods, which made it harder for them to pay their debts, which made them poorer …

19. Dynamics of the World Economy The Global Financial system
GFS, the Oil Shock, and Interdependence
The 1973 Oil Crisis (and subsequent “oil shocks”), in short, helped to create the basis for one of the most intractable problems of the post- war GFS: the ongoing international debt “crisis”
The debt crisis, however, is not solely a product of the first Oil Shock: it is also tied to seemingly mundane policy choices--such as interest rate policy-- made in the developed world, especially within the United States
Consider the connection between international debt and U.S. interest rate policy: How are the two issues related?

20. Dynamics of the World Economy The Global Financial system
GFS: Interdependence and Interest Rates
“Whereas interest rates on international loans were about 2 per cent in the the early 1970s they rose to over 18 per cent in the early 1980s. This greatly increased interest charges to developing states on their international loans. At the same time that developing states were facing higher interest charges it became more difficult for them to sell their products to developed states …. The consequence for many developing countries was disastrous.” Some results …
The “Lost Decade” in Latin America
The “triumph of neoclassical economics” in the developing world
The AIDS crisis in Africa

21. Dynamics of the World Economy The Global Financial system
The “Lost Decade”
The 1980s have been called the “lost decade” for Latin America:
Regional economic output per capita declined by an average of 1.3% annually and by a total of 12%
Among the worst-performing economies were Argentina, where real GDP per capita declined by an average of 3.2% annually, Bolivia (- 2.6%), and Venezuela (-2.3%)
Gross domestic investment in the region fell by a total of 30% over the decade ending in 1990
Inflation escalated during the 1980s as the region's central banks monetized huge government deficits; hyper-inflation reached more than 8,000% per annum in Bolivia in 1985, and more than 3,000% in Argentina and 1,200% in Brazil in 1989

22. Dynamics of the World Economy The Global Financial system
The “Lost Decade”
While there are clearly multiple, interlocking reasons for Latin America’s economic decline during the 1980s, it is even clearer that U.S. interest rate policy played a key role
The decision by the U.S. Federal Reserve to fight inflationary pressures (precipitated by the second oil shock in 1979) by raising interest rates in the U.S. effectively raised interest rates throughout the world
Significantly, even oil-producing economies in Latin America (Mexico and Venezuela) were adversely affected
Ironically, US efforts to defeat inflation domestically led to hyperinflation in Latin America, most notably in Bolivia

23. Dynamics of the World Economy The Global Financial system
The “Lost Decade” and the Washington Consensus
Latin America’s economic difficulties in the s also led directly to the subsequent liberalization of most of Latin America’s economies along the lines of the “Washington Consensus”
Key Points
A profoundly political process imposed on Latin America
Led to economic resurgence in region
But, did not eliminate instability and turmoil, e.g., Mexican debt crisis of 1994
Washington Consensus
Low government spending
Competitive exchange rates
Free trade
Privatization
Undistorted market prices, limited state intervention
Deregulation, reduced capital controls
“Labor market restructuring”
Export-led development

24. Dynamics of the World Economy The Global Financial system
GFS: Theoretical Issues
When we look at the contemporary GFS, interdependence and interconnectedness are all but impossible to ignore; still, there are very different perspectives on how the GFS should be analyzed and understood
To simplify, there are two main theoretical divisions …
Unit-level
System-level
Some questions: How do these two “levels-of-analysis” differ? What are the implications, both practical and theoretical, of unit- as opposed to system-level analysis? Which approach is dominant?

25. Dynamics of the World Economy The Global Financial system
Unit-Level Explanations: An Example
What were the causes of the Mexico’s debt crisis in 1994?
Liberal analysts pinpoint a number of key factors …
A spending splurge and a high deficit by the outgoing administration in 1994
Lax banking or corrupt practices, including enormous illicit payoffs to the Salinas family
The rebellion in Chiapas, which worried investors
Hasty privatization of banks without respect to “fit and proper” criteria (in other words, not all banks got into the hands of people who knew how to manage them)
No capitalization rules based on market risk and ill-conceived issuance of short- term, dollar-indexed, peso-demoniated Mexican government securities, called Tesobonos
Key Point: All of the factors are the product of decisions made at the domestic, or unit-level; the implication is clearly that, with better decisions, Mexico would have avoided a second debt crisis

26. Dynamics of the World Economy The Global Financial system
GFS: Theoretical Issues
The unit-level liberal perspective has clearly dominated policy and mainstream academic discourse for many decades
This dominance is reflected in the so-called “Washington Consensus,” which is premised on basic liberal assumptions and policy prescriptions
One difficulty with the unit-level liberal view is that it fails to deal adequately (at least according to critics) with the increasing significance of interdependence and global interconnectedness

27. Dynamics of the World Economy The Global Financial system
Theoretical Issues: Casino Capitalism
In the unit-level liberal view, market decisions should be left in the hands of market actors: for the most part, this has been the case in the development of the GFS
As Susan Strange argued, though, this has turned global financial markets into giant casinos, where investors and speculators place bets on the future of company profits, commodity prices, exchange rates, interest rates and many other economic indicators
The problem?
Millions of people are involuntary players
Whole economies may suffer serious economic turmoil even when their governments “do the right thing” (e.g., Mexico in the mid-1990s)
The investors themselves have found ways to minimize or avoid risk (especially through derivatives): this encourages even more speculation

28. Dynamics of the World Economy The Global Financial system
Autonomy, Convergence and Democracy
The foregoing discussion raises critical questions …
Given the increasing influence of the GFS on states, societies and peoples throughout the world, what should be done? What can be done?
Do increasingly “free” global financial markets threaten state autonomy? Does it matter?
Is the “structural power of capital” increasing? Is this a problem?
Are markets an appropriate substitute for states? Do freer more powerful markets threaten democracy? Or do they help to strengthen democracy?