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

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Presentation on theme: "Lecture Topic The Global Financial System May 13, 2008 Professor Timothy C. Lim Cal State Los Angeles POLS/ECON."— Presentation transcript:

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

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

3 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? Dynamics of the World Economy The Global Financial system

4 Interdependence in the Global Economy There are several ways to define interdependence Heres 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 Dynamics of the World Economy The Global Financial system

5 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 Dynamics of the World Economy The Global Financial system

6 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: 1.A return to the gold standard based on the US dollar (the US$ was fixed to gold at $35 ounce, while other currencies were fixed to the US$) 2.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 Dynamics of the World Economy The Global Financial system Bretton Woods conference, 1944

7 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? Dynamics of the World Economy The Global Financial system 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 countrys 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. 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. More on the IMF and IBRD on following slides

8 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 IMFs 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 Dynamics of the World Economy The Global Financial system Dominique Strauss-Kahn, current Managing Director of the IMF

9 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 Dynamics of the World Economy The Global Financial system

10 GFS: More Questions What happened to the GES? Why Related question: What is the Triffin Dilemma? Dynamics of the World Economy The Global Financial system 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. 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, Americas 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.

11 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. Dynamics of the World Economy The Global Financial system

12 GFS: Triffin Dilemma Triffin was essentially correct: The United States was between the proverbial rock and hard place Nixons 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 (well discuss this point shortly, but first …) Dynamics of the World Economy The Global Financial system

13 GFS: Summing Up Thus Far The U.S. decision to rebuild the IMS in the post-war period reflected Americas 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 Dynamics of the World Economy The Global Financial system

14 All three issues had cascading effects throughout the world: Americas sneeze did indeed cause a global cold 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 1970s The debt crisis of the 1980s and beyond

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 $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 Image: Yom Kippur War 1973 on the Golan heights The surge in world oil prices had a cascading effect throughout the world. Some of the effects were obvious (such as?), some less so …

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, whats the problem?

18 Dynamics of the World Economy The Global Financial system GFS, the Oil Shock, and Interdependence Heres 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 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 Americas 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 Americas economic difficulties in the 1980s also led directly to the subsequent liberalization of most of Latin Americas 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 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 Mexicos 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?


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