Lecture notes: International financial system

This topic

International finance as a somewhat technical topic

• Gilpin on the reading list — he is one of us!
• explain in a less complicated way

The problem of payments

You always have to pay for what you buy

• within a country you do this with a certain currency — Turkish lira, for example

The reason you can do this

• it is an official currency — backed by the government
• or by gold for a long time — eg. France — if you don’t trust the govt at least you should trust gold

But this doesn’t work between countries

• you can’t use TL when you buy things abroad — it is just a piece of paper
• you need something else which they will accept

An aspect of the division of the world into states — a political division

• if we had a world government we could have a world currency

Also,

• money making — magical money trees — don’t work
• that is, creation of money by means of debt — bank accounts
• foreigners will not be impressed
• you need “hard money” — money that foreigners can accept — wide, universal, acceptance

Cf. trade with East Asia in the early modern period:

• Europeans wanted everything but there was nothing Chinese or Indians wanted from Europe

first solution

• silver — remember Potosi!

later opium

• East India Company growing opium in India — force it on the Chinese — two wars about this
• sell opium to them — get local currency
• use the local currency to buy whatever they wanted

Or compare the gold standard of the 19th century

• all major currency were convertible into gold
• a local currency is like a receipt for gold — people are prepared to accept the receipt as long as they can convert it into gold
• makes possible “the first era of globalization”

but problems

• world trade dependent on gold production
• cf. “gold rushes” in Australia and Alaska
• if trade expands quickly, gold production cannot keep up

deflationary

• you can’t buy things if there is no money — demand for something goes up, but prices can’t go up since there is no money
• required British power to back it up — more difficult as British power declines

no independent monetary policy

• could not make yourself more competitive by devaluation — stimulate your own economy

Bretton Woods — two solutions (we already discussed this … ):

Dollars backed up by gold

• everyone was prepared to accept them
• US had great gold reserves — Fort Knox

Fixed exchange rates

• everyone knows what one currency is worth in terms of another
• important for trade and for investments
• you must know what things cost and what the returns on capital might be

From 1971 onwards:

• this system breaks down — no longer convertible into gold
• currencies float freely — a market in currencies — prices go up and down depending on demand
• just like any other market — supply and demand
• a lot of supply — a lot of money is created — prices go down
• a lot of demand — money is scares — prices go up

Optimal currency areas

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Krugman – 2001 – Lessons of Massachusetts for EMU'

Another way to discuss this — which areas should have which currencies?

• we assume that this area is the same as the state — we have national currencies

But this does not make economic sense

• we need a currency that fits with our particular level of economic activity
• economic activities might vary a lot between different regions inside a country

For example:

• economy very depressed in Anadolu
• unemployment, lack of investment — little economic growth — deflationary pressure
• they are under-performing compared to their potential

At the same time:

• the economy is booming in Istanbul
• high demand for workers, lots of investment, ways to make money, economic growth
• they are over-performing — inflationary pressure

Specialization within a market

• the bigger the market, the more specialization
• but this also opens you up to shocks — there is a crisis for a particular sector
• the tourism industry collapses during a pandemic …
• you need some way to help this sector

What does this mean in terms of monetary policy?

Anadolu

• should have low interest rates
• money should be cheap and there should be a lot of it
• encourage investments — encourage higher prices — wages etc.

Istanbul

• should have higher interest rates
• push down prices — cool off the economy

But if you have the same currency, you cannot do both at the same time

• you cannot simultaneous increase and reduce interest rates
• the monetary policy is geared towards Istanbul

There is a monetary union, if you like

• the exchange rates are as fixed as they can be

“Optimal currency areas”

regional currencies

• regions with the same kind of economic conditions should share a currency

those with different conditions should have different currencies

• this applies across borders — as well as within countries
• you can talk about “optimal currency areas”

With separate currencies their prices can vary in relation to each other

Little demand for one currency

• nothing to buy from that area — no one wants to invest there —  the price of that currency will go down
• as a result, goods will become cheaper and investments more profitable
• more demand — push the currency up

A lot of demand for a currency

• many people want to buy products from there — many people want to make investments
• the price of the currency goes up

goods become more expensive, investments less profitable

• less demand for the currency
• push the currency down

But impossible is the currency is the same!

Cf. the fallacy of bullionism

We talked about this — David Hume and the fallacy of bullionism (mercantilism)

• a country tries to hoard gold
• there is more and more money
• the prices go up
• its goods become more expensive — while foreign goods become cheaper
• gold flows out

Ergo: the policy is self-defeating

• money, like water, always finds its level
• its price comes to correspond to the demand and supply of it

Exchange rate adjustments

better …

• Istanbul should join the euro-zone
• Anadolu have another currency!

With the same currency

• Anadolu can only compete by reducing its TL prices — reducing wages — becoming poorer
• or by people moving west — cf. the enormous growth of Istanbul

General factor mobility

• money is moving west too and factories … no point in staying out east
• but this only depresses Anadolu even more — only old people left — companies leave since there is no way to make money

With different currencies …

• domestic prices would stay the same — wages and prices don’t have to go down
• only the price of things in terms of another currency would change

cf. drop in TL exchange rate

• we are still the same in Turkey, but only poor abroad
• in Turkey I’m still a well-paid professor — but if  I go to Sweden I’m more like a badly paid garbage collector
• this isn’t great, but it’s better than actually have a declining TL salary

But there are consequences …

• a cheaper currency makes people poorer — we can buy less abroad with our money
• contributes to inflation — prices go up since the prices of imported goods go up — like oil and gas — which in turn influences everything else
• but of course it’s very good for export companies — Turkish goods are now cheaper abroad

In practice the problems are avoided by means of govt transfers

• money moves from the rich to the poor
• they are being subsidized — all kinds of Robin Hood taxes

I don’t have data for Turkey, but it works the same way in the United States

• there are enormous differences between rich and poor areas in the US

nice overview

Example: the euro

• the idea behind the euro …

Small countries with high international dependence

• a high proportion of all economic activities take place with other countries
• not true for large economies — the US, China, India etc
• it is proportionately more important to have stable prices

You need to know what things cost

• important for buying and selling — you need to protect yourself
• important for investments — you need to be able to calculate your returns

Also high integration between regions

• western Germany is a lot like eastern France, etc
• the economy functions in the same way — it is easy to share the same currency

A common currency is OK as long as the economies work in the same way

• and gov’ts pursue the same policies
• we just learned that from the Turkish example

Short history of the euro

• 1980s — everyone wanted low inflation and accepted high interest rates
• no need for independent decision-making

Privileged position for the Germans, and the German Bundesbank

• it is the largest economy — very successful export industry
• Germany is Istanbul, so to speak

German fears

• to be saddled with too many Anadolu
• traditional German fear of inflation — the hyperinflation during the 1920s (is always cited)
• inflation moves money from savers to spenders

That is,

• if exchange-rates are fixed, the Germans were afraid that they had to bail out weaker currencies —
• use their reserves to buy foreign currency — sell the mark — thereby creating more of it
• this would produce inflation at home — increase the money supply
• Germans agree to help out only if they are allowed to maintain low inflation at home

Consequences of this …

• they are not going to defend weaker currencies to the same extent
• instead these countries have to adjust their prices — they have to shoulder the cost, make themselves poorer
• pegging their currencies to the German mark

The euro as a more widely shared version of this system

• no obvious German control — a way to reduce German privileged position
• although ECB is in Frankfurt

European Central Bank

Monetary union and the euro

• early 199s — Mitterand supports German unification in return for German support for the euro
• better for France to have an official role than no role at all
• the Germans get safeguards to allow inflation in Germany to remain low

The euro crisis

There were sovereign debt problems in a number of Mediterranean countries

• the states were running deficits in Portugal, Ireland, Italy, Greece and Spain

Capital inflow

• the money had to come from somewhere
• the Germans are lending money which allows Mediterranean countries to balance their budget
• and also to buy German goods …

Greece a particular problem

• borrowed heavily from foreign lenders to fund budget and current account deficits
• investors started worrying about the ability of the Greek gov’t to repay — increased rates on govt bon
• people who lent money to the government ask for higher interests on their bonds to compensate for the higher risk

Ways to deal with the Greek debt …

Default — and leave the lenders with the bill

• this is not a way to make friends
• not a good idea if you want to borrow again
• very expensive to borrow money

Austerity program to eliminate the gov’t deficits

• cf. IMF conditionality
• generate the funds needed to pay the debt
• but obviously painful for the government and for the economy
• social programs are reduced, state officials are fired
• everyone suffers because of the cutbacks — not least people on fixed income

Other EU gov’ts lend more money to Greece so that they could repay

• “restructuring loans”
• but also increases the debt burden

As long as Greece is on the euro, the options are limited

• a weaker euro would be great for Greece since it would make it more competitive, but this would overheat the economy in northern Europe and create inflation

In the end, a combination of all three solutions

• conditionality and austerity measures — they can borrow more money provided that they undertake cuts and reforms
• Greek GDP falls 45% between 2008 and 2011
• but they consider exiting the euro as an even bigger problem

Countries outside the euro don’t have this problem

• Britain
• Sweden
• Turkey

They can just devalue their currency if they need to

• they would become poorer in another currency, but just as before in their own

Another solution — cf. Turkey/Anadolu/Istanbul — labor mobility

• make migration possible
• people would leave Greece and go elsewhere for jobs
• but there are limits to this in Europe — language and culture —
• not as easy as in the US

Or alternatively — “fiscal stabilizers”

• actually transfer funds from richer parts of Europe to poorer
• cf. what the US gov’t does — or the Turkish — in fact all gov’t do it

this would push towards European unity

• but there are obvious problems with this of course …
• the Germans don’t want transfers to “feckless Mediterranean types”
• (they forget how much they benefited from the loans they took up — first German banks benefited, then German industry)

US-China relations

 

 

some more recent data here.

Two countries are buying things in unequal proportions from each other

Fixed exchange rates

But if the goal is to maintain fixed exchange rates …

• the gov’t intervene in exchange markets to prevent this from happening
• the US sells RMB and buys dollars — the price of the RMB goes down and the price of the dollar goes up

That is,

The change in money supply alters prices

This changes consumer demand

That is,

Variable exchange rates

but the mechanism is different:

Some additional points:

US has traditionally run large current account deficits

Chinese investment in US gov’t bonds

This generates conflict

• US trade with China
• US trade with Germany

If the US has a persistent trade deficit with China, the RMB should appreciate and the imbalance should close

Advantages to the US

Advantages to China