Post-Bretton Woods Financial Crises: Euro & Argentina PDF

11/4/24 Post- Bretton Woods Financial crises: Euro and Argentina ​ Bretton Woods put the US in the middle ​ Getting rid of Bretton Woods DID NOT get rid of American Centrality ○​ US $ still head of global currency Anatomy of a “Typical” Crisis ​ Good ○​ Open capital ac...

11/4/24 Post- Bretton Woods Financial crises: Euro and Argentina ​ Bretton Woods put the US in the middle ​ Getting rid of Bretton Woods DID NOT get rid of American Centrality ○​ US $ still head of global currency Anatomy of a “Typical” Crisis ​ Good ○​ Open capital account (capital mobility is high) ​ Money can moves across borders in great volume ○​ Pegged exchange rate (fixed exchange rate) ​ Maybe to attract more trade, maybe more investment etc ○​ Lots of borrowing, often for good stuff ​ Bad ○​ Something happens, the exchange rate no longer makes sense (economy suffering) ○​ Growing current account deficit, budget deficits ○​ Growing foreign debt, esp. Short term debt ○​ Climbing interest rates on foreign debts ​ The Crisis: ○​ Default on debt payments ○​ Financial panics ​ Currency sell-off, depreciation & abandonment of peg ​ Failure of banks and “real” economy: a “sudden stop” Europe: Not a fan of Post Bretton Woods Chaos ​ Look at all those little countries ○​ Adorable ​ But that is a lot of exchange rate risk! ​ Even the Smithsonian agreement was too volatile ​ Imagine being a German manufacturer selling all over Europe, You have to worry about a lot of exchange rate movements ○​ That sucks! ○​ Makes it hard to compete with the US (or China) 3 Reasons for the Euro ​ 1) Trade ○​ Europe countries very reliant on each other for trade ​ 2) Inflation ○​ a) Italy, Spain, etc had real inflation problems ○​ b) Nobody trusted them to manage their currency, which is a problem and creates more inflation ○​ c) abandoning the idea of their own currency “fixes” the problem ​ 3) Too much democracy ○​ Too much policy space and euro was a way to constrain space Robert Mundell and the Euro ​ ex; why can't Mundell install a new toilet in his Italian Villa? ○​ Because the Italians don't have to be competitive ○​ They just inflate their way out of non-competitiveness ○​ Too much monetary autonomy, not enough discipline ​ “It [the Euro] puts monetary policy out of the reach of politicians,” he said. “[And] without fiscal policy, the only way nations can keep jobs is by the competitive reduction of rules on business.” ➔​ Pointed blame at Italian currency  ◆​ When Italians had the Lira (old currency) uncompetitiveness not a problem ◆​ Currency was constantly depreciating What was Supposed to Happen? ​ Southern Europe to become more like Northern Europe ○​ Stability and Growth Pact takes away Southern Europe’s ability to deflate currency, borrow recklessly, or spend a lot of money ○​ Countries in the Southern periphery would “have” to become more efficient and competitive like Northern Europe ○​ The Eurozone would be forced to be more like Germany, Netherlands etc  ​ Countries paying a lot of interest besides Germany and the Dutch ​ When the Euro starts to come on board, capital accounts are open and all countries on board ○​ Working very well, if you are Greek business you can borrow more money than ever before Not much actually changed in the south -​ Southern europea countries never reformed the way they were supposed to -​ The overvalues ( for theme, undervalued for germany, netherlands etc) currency was weakening exports -​ But.. they could borrow a lot bc they SGP was not properly enforced and lenders didn’t believen the no bail out clause -​ Greek balance and Spanish Blanave over time -​ Was supposed to get Greece more competitive -​ If you took away fiscal and monetary policy nothing less besides work hard and be more efficient -​ NOT getting more efficient, Mundell plan does not work at all -​ Can just borrow as much money as wanted Who Lent Southern Europe Money? ​ The same giant pool of money the loaned money to the American mortgage market ○​ Another classic post-Bretton woods financial crisis ○​ Aging population in Europe ,Asia, North America ○​ Low consumption in Germany and Asia  ○​ Low interest rates in US, GER, JAP, UK ​ A perception of lower risk ○​ Slightly higher return in Southern Europe ○​ Belief in the European seal of approval ○​ Beleifs that there would be a Euro bailout ○​ Fudged national macroeconomic numbers Airport Ciudada real (don quixote airport) - ciudad valdeluz -​ A lot of money got misspent ​ Open capital accounts, can borrow as much as you want ​ Realizing we shouldn't have lent that much money ​ Lehman Brother collapse and if American Mortgage ​ TERRIBLE for Greece ○​ Devastated Greece economy Argentina Background ​ Mid-sized country: 32 million in 1991 (46 million today) ​ Highly educated ○​ 100% literacy rate (historically among the highest in Latin America) ​ One of the world’s richest developing countries ○​ Outside of oil countries and East Asian Tigers ○​ 1991 GDP per capita= $6300 ○​ ​ Very low trade openness  ○​ 14% of GDP in 1991 ○​ Top trade partner = Brazil (30% of Arg’s exp’s) ​ Not always the best politically coherent country ○​ Not very globally integrated economy, didn’t get a ton of FDI, didn’t trade a ton compared to global standards -​ Tough place to govern because a weird country demographically ​ GIANT city in Buenos Aires and other than that basically empty But a HUGE Inflation Problem ​ Argentina did fixed exchange rate because had an out of control inflation rate ​ Argentina was never as good as America The “Convertibility Plan” of 1991 ​ A new policy to stabilize the economy ​ “Currency board” ○​ Pegged Arg Peso at 1 per US$ ○​ 2/3rd of money supply backed by US$ reserves ○​ Board to be independent of political officials ○​ 40% reserve requirements for private banks ○​ A monetary “straitjacket”, most extreme fixed XR regime” (Gurtner) ​ Total inability to run monetary policy, forcing Argentina to become more American  ○​ Like what Mundell wanted for Southern Europe -​ Gdp growth -​ Fdi went way up once you don't have to worry abt the peso 1990s Performance of the Convertibility Plan ​ Dramatically cut inflation, increase new investment ​ BUT… ○​ The 1:1 peg stopped making sense (US economy and Argentina ​ The US had the internet boom, Argentina did not ​ Peso too strong for Argentine economy ​ Made MUCH worse after Brazil devalued in 1999 ○​ Recession and Unemployment ​ Corollary: increased poverty and lots of automatic spending ​ Budget deficits continued ​ External debt to finance current account deficit ○​ Up to $145 billion as of Dec 2000, from $57b in 1991 The 2001 Crisis ​ Perceptions… ○​ High unemployment, not politically sustainable ○​ Cutting the budget deficit would only get harder ○​ Especially because of the growing debt and interest payments ○​ And because Argentine politics is not great ​ State governments issue billions of Patacones to make up for lack of spending ​ So… interest rate premia increase in late 2001 ​ Accelerating bank runs, freeze on withdrawal  ​ End of Dec 2001, Gov’t floats the peso ​ Buenos aries started issuing their own currency when there wasn’t enough pesos around How Bad was the 2001-2002 Crisis? ​ As bad as it gets!!! ​ Deep impoverishment ​ Unemployment rose to 18% ​ A 16% per capita GDP decline 2000-2002 ○​ US decline 1929-31, or 1931-33, was “just: 14% ​ Peso dropped from 1 US Dollar to.33 US $ EXAM!!!!!!!!!! Why did the crisis happen? Gurtner vs. rodrik -​ Gurtner -​ Brazils 1999 devaluation catalyzed the crisis -​ But core problem: failure to control budget deficits -​ High external debt was a result of that -​ Domestic political institutions that made budget control impossible also doomed the external commitment device -​ We need a stronger strait-jacket -​ Had the right idea but argentinian politics were too screwed up, need a better straitjacket, stricter set of rules -​ Rodrik -​ The currency board was the problem, not domestic politics -​ Solution is not a stronger “straight jacket made of platinum”  -​ rather the right approach would have been to encourage monetary autonomy over stable XR’s from the start -​ Whole game is terrible, don’t exchange rates for this reasons, don’t use global financial economy to pay off deficiencies in own government 11/7/24 Global capital flow cycle -​ Raghuran Rajan: heard of RBI, professor at booth (chicago) -​ “If the policy hurts the rest of the world more than it helps the United states, should this policy be pursed?” Major Crisis’ Since the End of Bretton Woods ​ 1980s Latin American Debt Crisis ​ 1992 European Monetary System Crisis ​ 1994 Mexican “tequila” crisis ​ 1997 East Asian Financial Crisis ​ 1998-1999 Russia and Brazil Crisis’ ​ 2000-2001 Turkey crisis ​ 2001 Argentina crisis ​ 2008 Iceland ​ 2010-PIIGS ​ More recently: Sri Lanka, Turkey (again), Argentina (again), Pakistan… ➔​ Crisi in one place creates conditions for next crisis A lot of money is traded, globally. Mostly dollars. -​ Massive scale of foreign exchange market -​ Trillions of dollars a day -​ Massive pile of financial transactions The impossible trinity: an analogy -​ Giant pool of money (the trillions of $$) The global capital flow cycle: two central components -​ 1) lots of money goes into emerging markets (flows out of big, US markets into emerging markets of poorer countries) -​ Strengthens currencies and inflated asset prices (bc of more money in these markets) -​ Hot money that can be withdrawn at the first hint of trouble (effects countries ability to export etc) -​ 2) Lots of money goes out of emerging markets -​ Depresses asset prices, raises interest rates and creates banking and currency prices -​ 3) american monetary policy moves the cycle from one phase to the other -​ Failing US interest rates push money to emerging markets for higher returns  -​ Rising US interest rates pull capital out of emerging markets and back into dollar-denominated assets Latin american debt crisis -​ In the 1950s and 1960s latin american govts began pursing foreign loans for investments in infrastructure, power plants, schools, etc -​ Mostly from the US and mostly in US $ -​ Everybody was using fixed exchange rates -​ Time of really ambitious govts in latin america -​ Brazil took in large amounts of global capital and used it for growth Latin American Debt Crisis ​ This was great for US banks, too (US wants to pile money into places like Latin America during this time) ​ US economy cooling down from competition in Japan and Europe ​ They needed somewhere to put their money ​ Latin American Governments (and government owned companies) were perfect Petro-dollar recycling -​ October 1973: Yom kippur war -​ Egypt, syria lead pan-arab forces in fighting in golan heights sinai -​ Does Not work (almost works) -​ 1973-1974: OAPEC oil embargo to US others -​ Oil prices shoot up -​ Huge windfall for oil producers -​ Huge problem for oil importers -​ Collary problem, what are the OPECC countries going to do with this money? -​ 1974-1982: petrodollar recycling -​ OPEC countries earn dollars from global oil sales -​ Dollar sent to american banks -​ American banks invest the globally -​ Global capital flow cycle pushing money into emerging markets -​ 1974 to 1982 -​ Huge growth in “third world” debt -​ Countries borrow pertodollars to buy oil -​ Capital inflows choking off exports -​ Through 1970s, the amount of money grew exponentially because of Petro-dollar recycling -​ Arabs Won't sell US oil anymore which has negative effects of the US economy -​ Saudi Arabia has more money than it can handle, don’t have the banks that can handle the money -​ Sent money to NY Banks and sent money directly to Latin America -​ US wanted to invest the money in Latin America US inflation, federal reserve chair heights on the rise -​ Non-obvious role of the united states -​ Paull volker (federal reserve chair) inherited problem of experiencing high inflation Us interest rates on the rise -​ Volker fixed inflation using monetary policy -​ Volker jacked up interest rates to almost 20% (very high) The Volcker Shock Was Bad For Borrowers ​ High US Interest Rate means it is expensive to borrow money ○​ Really bad for US borrowers ○​ Really bad for US Home builders ​ But Latin American governments were also borrowers ​ Volcker put the global capital flow cycle in reverse Latin American Debt Crisis ​ In 1982 (August), Mexico announced that it could not pay the interest and principal on its $100 billion debt to foreign banks ○​ Investors stopped their lending to Latin America ○​ New debt collapsed ○​ Currencies collapse ○​ Huge economic pain ​ Huge unemployment ​ Huge stop in spending ○​ Governments across Latin America Collapse Argentina has a HUGE inflation problem (partially from the latin american debt crisis) Asian Financial Crisis: Background ​ Capital accounts open in 1980s and early 1990s ​ It became easier for private individuals to move capital into and out of emerging markets ○​ Increased the volatility of capital flows to “emerging market” countries East Asian Financial Crisis: Partial Liberalization ​ Financial liberalization was partial (and cynical) ○​ Open to foreign money, but not foreign banks ○​ Asian Banks intermediated flow of funds from foreign lenders to local borrowers  ​ Interest rates in international markets were lower than interest rates inside Asian economies ​ Asian banks could thus borrow money at a low rate of interest, and then lend it to domestic borrowers at a higher rate of interest. They keep the differences as profit ​ Financial institutions had close ties with government ○​ In Indonesia, seven state-owned banks controlled half of the assets in the banking system and relatives and friends of Suharto controlled others ○​ Similar situation in Thailand, elsewhere Asian Financial Crisis: Moral Hazard ​ Politically connected banks thought government would bail them out if they lost money ○​ They were correct ○​ Little incentive to evaluate the risks associated with their loans ​ International investors loaned too much to Asian Banks, and Asian Banks loaned too much to Asian Businesses ​ Good banking regulation could have avoided this ○​ Hard for any country they were way to corrupt ○​ In Indonesia, any regulator who enforced prudential rules was removed from his position This Crisis Begins ​ The crisis itself was extremely standard ​ SE Asian currencies tied to the US dollar ​ US dollar appreciates as foreign investment pours into the stock market in the 1990s ​ Japan relaxes Foreign investment rules for its pension system, and otherwise took steps to weaken the yen ○​ Increases the amount of money flowing into SE Asia ​ SE Asian currencies appreciate too much, choking off exports, especially to Japan This Crisis Begins II ​ 1997: SE Asian firms start to fail, then their banks start to fail ​ One of Thailand’s largest financial institutions, finance One, went insolvent ​ The discovery caused foreign banks to look much more closely at banks throughout Thailand, Asia ​ Panic, Global Capital cycle flows into reverse  ​ Capital fees from Thailand ​ The exchange rates no longer makes sense and it can’t hold up Thailand in 1997: Extremely Screwed ​ They could float the exchange rate ○​ Thai baht will crash, but “order” will be restored ○​ However: lots of banks, firms have borrowed money in dollars ○​ If the Baht crashes they will all go bankrupt ​ They could defend the fixed exchange rate ○​ If you raise interest rates high enough, the Baht will be worth more abd the exchange rate will make sense ○​ But lots of Thai borrowers borrowed in Bahts. High interest rates would crash the economy, and bankrupt many ​ Screwed either way, they chose the worst possible option ○​ They had too many veto players; couldn’t act decisively ○​ Waited, hoped it went away ○​ Run out of dollars, crashed the economy The crises spreads -​ Other countries look like thailand -​ Weak banks, corrupt govts -​ Bad exchange rate pegs to the US dollar -​ Insufficiant dollar reserves -​ Markets turn first to the philippines -​ Force the govt to abandon its fixed exchange rate after only 10 days -​ Crises moves to: indonesia, malaysia, kore, taiwan, hong kong -​ Then russia, turkey, brazil -​ *remeber that the brazilian collapse is what triggers the argentine collapse -​ Global Financial Markets -​ “What happened to Thailand will happen here in Philippines” -​ Domino effect -​ Giant pile of money leaves, goes to US, and leaves wreck behind it Consequences: ​ Economic: ○​ Deep recessions through Asia ○​ Malaysian Stock Exchange down 75% ○​ Massive, Intrusive, largely ineffective, massively unpopular input from the IMF ​ More on that later ​ Political:  ○​ Regime opponents demanded fundamental political reform ○​ Suharto steps down following protests in Indonesia ○​ Massive political reform in Thailand Systemic: bretton woods II -​ East asian govt learn one big lessons: never run out of $$ -​ Over the next decade accumulate more than $4 trillion in $ -​ Mainly through trade surpluses -​ US now even more the center of the global financial system -​ Works as long as the asian countries are comfortable holding that many dollars It's Still Happening: Currency Wars and Temper Tantrums ​ The early 2000s were a period for financial stability in Asia ○​ Sort of ○​ Asian countries who now held huge dollar reserves were not happy with low US interest rates ○​ They invested in the American property market/Southern Europe, helped fuel crisis there ​ After 2008 Financial crisis: The Federal Reserve sought to induce economic recovery by lowering rates using quantitative easing ​ Low rates encourage private investment that boosts economic output and employment ○​ Monetary autonomy Summary: ​ Capital FlowCycle ○​ When at top: money flowing in ○​ When at bottom: money flowing out 11/11/24 Debt Crises and the IMF International repercussions -​ contagion : uncertainty about one country can feed uncertainties about others -​ Countries are connected through trade so a crises is one country affects another -​ Traders start to fear their investments in countries that are similar and start existing all such countries -​ Latin american debt crises spread to Somebody needs to help!!  -​ Countries in financial crises need to be able to pay their bills -​ Societies in financial crises need to be able to avoid political meltdown -​ Make sure that the crises does not spread -​ Convince creditors they don't need to immediately stop lending to everyone else -​ Convince creditors that if a government needs help it will be able to access it The international Monetary fund (IMF) -​ A bretton woods institution -​ A giant international credit union -​ Everyone joins in and contributes -​ Draws on IMF resources when in crises -​ Purposes: -​ To promote international monetary stability -​ “Lender of last resort” -​ Provides bailout loans during crises -​ Demands conditionality in exchange -​ “We’ll give you a check if you do x y z” The international Monetary Fund (IMF) -​ serves the world -​ Global institution -​ Primarily serves the developing world -​ Not an american institution but also basically an american institution -​ Votes are dependent on how much funding a country has invested in the IMF, USA has 15% investment (a lot of $) this does not include all of its allies like canada etc so we have veto power -​ Headquarters in DC -​ Americas have an effective veto over decision making power (more on that below) -​ Staffed overwhelmingly with american trained (or american style) economists -​ A conduit of american ideas and possibly american intrests -​ But: traditionally headed by europeans -​ Kristalina Geogieva -​ (we get the world bank) IMF conditionality -​ The IMF will give you money often very cheaply if you adopt their preferred policies -​ Not free money but cheap money (low interest rates) -​ They tell you what to do to avoid crises, its not suggestions they are orders, the more u listen the more money you get, easily -​ Mostly they tell you to raise interest rates and cut out big spending, lower wages for civil servants, not building unnecessary things like airports not needed -​ They are there to get you out of your debt crises -​ Money in exchange for following there policies; you have to do what they want  -​ These places are the policies that you need to fix in order to avoid another crises -​ The IMF is there to get other countries to invest in your country again, like put trust in you again -​ Generally speaking: -​ Crises happen because nobody wants your currency -​ IMF policy conditions are meant to make people want your currency again -​ Spend, borrow less; raise interest rates -​ IMF policy condition not there to solve other problems (inequality, poverty, etc) and might make those things worse -​ If you do these things, other lenders will lend you money -​ Catalytic lending What do IMF conditionality terms require? -​ The “washington consensus” -​ Macro: the big picture problem is nobody wants to lend you money. So you need to make people want to lend you money. -​ Raise interest rates, cut the budget deficit -​ Stop spending money on bailouts to failing enterprises/banks -​ Great for credit worthiness but can be miserable for people in a country -​ Micro: reduce size of the govt (a special case of “stop spending money”) -​ Privatization -​ privatize , education, healthcare etc pretty much everything -​ Trade liberalization -​ Open yourself up to free trade; stop producing things that are not globally competitive, its a waste of money -​ Investment deregulation, liberalize banking/insurance -​ Allow the market to do its thing, the govt should get out of the economy as much as possible -​ Intervention on specific line items in the budget IMF conditionality -​ Imagine you defaulted on your student loan and the bank said -​ “Ill lend you money to cover your debt, but you must stop going out to eat and buying unnecessary books” -​ If other banks see you stick to this plan, they will lend you money again too -​ Is this good advice? -​ Not going out to eat is not fun, but is probably a good idea in the long run -​ Buying fewer books probably good idea in the short run especially if you were not reading those books -​ But in the long run you need to learn stuff and buying books is a part of that -​ Stop spending money on stupid stuff like going out to eat shopping etc -​ Applied to a govt: -​ Govts need to make long term investments in growth  -​ Govts need to help provide a minimal quality of life to maintain stability -​ 100% possible the crisis occurred because the govt spent too much doing those things -​ But: IMF condition scan easily get too punitive and become self defeating -​ Stop spending money on the stupid stuff like rebuilding railroads, highways, taking loans out to improve healthcare if they can’t afford it. Need to figure out what is wasteful and whats not wasteful Why don't people trust the IMF? -​ The US is powerful at the IMF -​ Many believe that the IMF serves (mainly) US foreign policy interests -​ Or reflects american ideas in a more indirect wat -​ IMF staff based in DC and most attend US universities -​ Under any interpretation the IMF is there to bailout (often american) western investors -​ A lot of people don't like that -​ Its not clear that the IMF “works” -​ Pretty good at re-establishing debt sustainability -​ Not obviously good at helping growth -​ Usually generates more inequality -​ A lot of the cut spending is meant to decrease inequality -​ The worst of the worst countries end up with the biggest loans Criticism of the IMF policy prescriptions -​ Sachs -​ The IMF especially in asia caused more panic than necessary and made the crises worse, people were freaking out a lot more than they needed to -​ Tight monetary policy deepes the crisis -​ Slows growth -​ Causes banks failuers and panics -​ Profoundly counter productive actors -​ Too intrusive, not good at what it does, too much -​ Counter productive -​ Plus the IMF tends to mismanage acts too late and without considering unique circumstances -​ Plus the IMF is arrogant -​ Why should the iMF need to impose mirco conditions -​ To serve the interests of the US and the other major powers -​ Not necessary for crises recover -​ A critique for the left A critique from the right -​ IMF decisions are driven by the leading shareholder states -​ Makes the IMF less legitimate  -​ Makes the IMF enforcement less credible -​ Undermines the ‘stamp of approval’ signal IMF lending may send -​ We need the IMF to be more IMF-y not less Politics and the IMF conditionality axel dreher -​ What is the UN security council? -​ Makes alot of important decisions on global imports and exports. 2 types of members: permanent and temporary members. Permanent is P5, the big militaries in the world, US UK france china soviet union russia etc, rotate 10 other temporary countries like bolivia etc -​ What is the argument? -​ The veto power that the P5 have is very similar to the veto power the US has in the IMF for having 15% of shares. Bigger picture -​ We’ve had exorbitant privilege for a while - since WW2 -​ For better or for worse -​ Other countries–mainly china–are coming for it -​ Next time: the US dollar 11/13/24 China: BRI, AIIB, and Financial Diplomacy Background -​ Lots of capital mobility, financial crises post Bretton Woods -​ Countries like to build fun things like airports that nobody needs, but then eventually they go broke -​ Sometimes the things they build are actually very useful, but they can overspend and go broke anyway -​ Those crises undermine national currencies and threaten global order -​ The IMF then comes in to help -​ They trade loans for policy concessions, usually according to the “washington consensus” -​ Privitize, cut spending, raise interest rates, etc -​ A consensus among the US bank, treasury, etc -​ Nobody* enjoys this (* every so often a govt in a country will want to privitize and hire the IMF to be the bad guy) -​ Intrusive, demanding, not fun at all -​ Maybe not even effective (Sachs) -​ Think of IMF as your doctor telling you to get on a diet The international monetary fund (IMF)  -​ Not an “american” institution, but also basically an american institution -​ Americans have 15% of funding to the IMF -​ Americans have and effective veto power, lots of decision making power TEST -​ When countries are becoming strategically important to the US, strategic reasons to channel more money to the countries important to the US World (development) bank -​ Comes in when you are poor -​ If the project has a lot of developmental merit and you cannot afford commercial loans the world bank comes in and gives money -​ To poor countries -​ Finances new dams, modernizing the grid, -​ Also a Bretton woods institution -​ A development bank -​ Lends money for development related projects/budget support -​ Also in the conditionality game -​ “Structural adjustment plans” -​ Also “american” The world bank: also a controversial institution -​ Like the IMF, they also give sweetheart deals to american (and western) allies or countries of strategic importance -​ Their conditions have historically been really overbearing  -​ Less so recently -​ But it really left a bad reputation -​ They have a lot of environmental and social stipulations -​ Maybe good ideas maybe not -​ Very demanding -​ Definitely slows things down -​ A rich country like france and china don’t really care about getting a project like a dam done quickly they rather take their time (quality control) -​ Disconnect between the people lending vs receiving the money -​ Reflects the priorities of the lending counties much more than the borrowing countries We’ve (USA) been in charge since WWII/Bretton Woods -​ We control the global currency (US dollar) -​ We (sort of) control the IMF -​ We (sort of) control the world bank -​ Since the end of the USSR there really has not been an alternative -​ There are benefits to that -​ There are downsides to that -​ The US being in charge is Philosophically mismatched to the times What if someone else could take our place? -​ China wants in -​ They know that global leadership comes through global finance -​ Maybe by displacing the dollar -​ Maybe by displacing IMF/world bank -​ They are coming for our exorbitant privilege Belt and road initiative -​ A Lot of ports, roads, seaways -​ Builds a lot of physical infrastructure, a way of -​ Financial endeavor, coordinating a lot of branches of chinese banks, not just about financing  -​ Chinese banks loaning money Belt and road initiative: not entirely new -​ First wave of globilization linked china to india and central asia, and eventually europe -​ The “silk road” -​ Very important to chinese centrality -​ 100 BC to 1400s -​ Then as now china was the world manufacturing powerhouse serving consumers in the west -​ China used to be the center of the world But its been a couple hundred years -​ The 1400s-1600s were bad, -​ The fall of the mongol empire -​ Ottomans closing black sea trade with the west -​ The europeans discovery of the new world -​ The 1800s not great either -​ Opium wars (forced to cede control to UK/France) -​ Taiping rebellion (30 million dead) 5-10% population -​ 1900s could have been better -​ Got routed by the japanese in WWII -​ Maoist disasters with an inward chinese orientation -​ Going from extremely economically dominant in the “silk road” era to completely falling apart, poor and isolated from the rest of the world But not anymore -​ In the late 1980s under Deng Xiaoping china started to liberalize and open up -​ In 2001 china gets in the WTO -​ Controversial -​ Very impactful -​ successive chinese administrations have figured out how to grow via capitalism -​ a huge a totally unprecedented turn around -​ a controversial model to much of the developing world -​ Has the capacity to challenge in the US  -​ -​ Chinas rise is potentially displacing the US -​ -​ Some cities in china are now larger that NYC -​ This is a spectacular change since the 90s BRI (belt and road initiative) background -​ The 2008 financial crisis was bad for china -​ They lost money on the US mortgage market -​ trade , FDI collapsed -​ Korean and taiwanese firms pulled out -​ American firms and banks pulling out -​ Unemployed college graduated, which is a disaster for the ruling party -​ Tade shut down, foreign direct investment shut down -​ A Lot of corporations that helped rebuild china are pulling out -​ So what did they do? -​ They printed money, loaned it out and spent it -​ Often state directed -​ They would not allow themselves to experience a downturn -​ What did they build -​ Hospitals, bridges, trains, infrastructure -​ This is where the idea of an ultra modern china comes from -​ Steel capacity, cement -​ Did this to keep there markets high Totally unsustainable -​ Warped chinese economy by creating over capacity -​ Steel production increased by 300 millions tons -​ More than the combined production of the US and EU -​ They cant keep building bridges -​ 40 of the 100 tallest bridges in the world all in the same poor chinese provenance -​ Not great -​ “Cant” stop producing steel, or slow things down for major infrastructure providers including banks Belt and road initiative -​ Very ambitious financial and infrastructure project -​ Cina lends money to developing countries and middle income countries to pay for chinese built infrastructure -​ This is a financial project -​ The doers are the big cinese banks -​ The loans are really the BRI -​ A couple hundred billion so far, could be several trillion -​ Really hard to say exactly BRI goals -​ What does china hope to achieve -​ 1. Market for chinese over production capacity -​ 2. Geopolitical motives -​ 3. Anchor western china in chinese economic model -​ 4. Establish energy routes outside of US influence -​ 5. Entrench itself in global affairs -​ What do other countries get? -​ Loans -​ Infrastructure -​ No US, no IMF and no world bank -​ No more scolding, just money -​ Treating the world like america treats its allies -​ Lots of money to build things, not a lot of demands that it serves any larger chorerent vision of economic sustainability Asian infrastructure investment bank - AIIB -​ A chinese alternative to the world bank -​ Founded in beijing in 2015 -​ Why would people want a world bank alternative? -​ Too long, too picky, too american -​ Too many intrusive conditions -​ It was controverisal -​ US did not want the competition  -​ Chinese values vs american values -​ China as 26% voting rights -​ India 8% -​ Canada pulled out due to there skepticism about china having so much power in this -​ We tried to stop others from joining, failed\ Fall of the BRI? -​ Many projects haven’t panned out -​ Uncompetative bidding, overlooking local suppliers -​ Low quality builds -​ Not a lot of planning, environmental concern -​ The kind of thing the WB insists on -​ Can lead to disconnected pieced of infrastructure that dont serve local interests -​ That planning is annoying but may be useful Coco coda sinclair dam, ecuador -​ Constructed by chinese engineering from sinohydra for $2.25 billion -​ Chinas export-import bank loaned $1.7 billion for coco codo with an interest rate of 7% -​ In 2018, 7,648 large and small cracks identified in the generator hall -​ Causes substantial erosion, likely led to two oil spills, destroying nearby towns Fall of the BRI -​ Increasingly bad press around debt traps -​ Countries borrow a lot of money (at commercial rates!) and then cannot pay it back -​ Find themselves dependent on china -​ No better than western, IMF; maybe worse! Sri lanka -​ Borrowed a lot of BRI money -​ They have a corrupt govt that likes spending a lot of money -​ Chinese lenders hold almost a 5th of sri lankas external debts -​ Mattala rajapaksa airport (worlds emptiest airport) -​ This family came into power and built a giant airport that nobody needed -​ Giant 7 lane highway always empty, elephants are always moved off the runway -​ Hambantota port -​ Also built by the same family -​ Could not pay china back at all -​ Huge global meltdown and now concern is that china will store naval boats there since they took over -​ Constructed by china Huanqiu contracting and engineering corporation, opened in 2010  -​ Same provinces as the airport, same rationale -​ Unable to repay its debt, sri lanka gave china a controlling equity stake a 99 year lease -​ Without an economic rationale concerns that it could become a chinese naval facility Sri lanka is not doing great -​ Had a total economic meltdown -​ Much of unnecessary borrowing much from china not all but a lot -​ The international monetary fund is lending sri lanka $3bn to help it deal with its worst economic crises in history as an independent nation -​ So the IMF comes back to bail out at the end of the day with the US money Bigger picture -​ We’ve had exorbitant privilege for awhile -​ For better or for worse -​ Other countries–mainly china– are coming for it 11/18/24 Exorbitant Privilege/Global currency, Pt I of II Background: Central Banks -​ Institution that manages (run) a country’s monetary policy and currency -​ Enact a bunch of policies with the end goal of managing floating money -​ You can have monetary policies without a central bank (central banks are modern) -​ The federal reserve (est. 1913), bank of england (est. 1694) etc -​ Often adjacent to govt. Not exactly part of the govt but fully separate from it either -​ Central banks oversee banking systems and the currency -​ Central banks create “base money” -​ Physical currency floating around. Do you have a dollar in your wallet not -​ Bank accounts are another form of money -​ Commercial banks create money through fractional reserve lending -​ If i deposit $100 in the bank, the bank lends some of that out -​ That person spends the loaned money on pizza, and now I have money in the bank and the pizza restaurant has money in the bank -​ We created money! -​ Banks set the terms by which that happens -​ Modern central banks do that by: -​ Help set interest rates -​ High interest rates mean banks will not loan a lot of money. Low interest rates mean money demand is higher and lend out more money. If they want to slow that down theyll make intrest rates high  -​ Oversee bank safety via “prudential regulations” -​ Lender of last resort -​ They do all this in the context of any exchange rate arrangements that they need to uphold -​ While making sure that there is enough foreign currency to handle the country’s external economic needs -​ Not really true for US bc we have floating exchange rates Background: reserve currency -​ Currency that central banks hold -​ Special currencies that are highly valued and respected for international trade, finance etc -​ “Global” currencies are “reserve currencies” -​ I.e., central banks around the world own it as part of their foreign exchange reserves -​ Countries use their own currency in their borders but international transactions are often cleared in a reserve currency -​ The US dollar is one of the very few currencies that is hard, if you want to import things to peru you cant use the peruvian sol because they are no valuable outside of its countries boarders -​ The difference between dollars and chuck e cheese tokens -​ Has its own internal currency but the actual corporation that needs to pay tax, rent etc -​ Hard currency -​ Very few of them, highly respected, ex: US dollar -​ Why do you need a foreign reserves? -​ Pay for imports (that are not bought and sold in your currency) -​ Service your debt (if you have borrowed in a currency other than your own) -​ Manage your exchange rate -​ To raise value of your currency you need to sell something and buy your own currency -​ Chuck e cheese has its own currency that it can print, but its external commitments are in dollars -​ Rent, energy, taxes, payroll -​ Chuck e cheese needs to make sure it has enough dollars to service those needs -​ Largest foreign exchange reserves, by country (Million USD) -​ 1. China $3.38 Mn -​ 2. Japan $1.25 Mn -​ 3. Switzerland $898,588 Mn -​ US does not have this because this is there currency Background: central banks and reserve currencies -​ A reserve currency has to be trusted -​ Competent central banks are not inevitable  -​ If you want others to use your currency it has to be useful, but also people need to believe that: -​ You will not print too much money when you shouldn’t -​ You will print money when you should -​ I.e you will be a prudent (careful) lender of last resort if there is a financial crisis Major reserve currencies since 1250 -​ Florentine florin - italy -​ Venetian ducat -​ Portuguese real -​ Spanish real -​ Dutch guilder -​ French livre -​ UK pound sterling -​ US dollar When did the dollar become the global currency? -​ 1944 -​ But it reallt started in the 1920s -​ The united states was a growing power -​ With a newly competent central bank -​ The federal reserve was created in 1913 What does it mean for the dollar to be the global reserve currency? -​ Generally international transaction happen in dollars, over half -​ About half of all international trade is invoiced in dollars -​ Almost all commodities are invoiced in dollars -​ Energy, metals, agricultural products -​ Half of international debt is denominated in dollars -​ 85% of all foreign exchange transactions are in dollars This no londer makes a lot of sense -​ germany and china both export more -​ US stopped being #1 in 2012 -​ USA accounts for 20% of FDI, down from 85% in 1980 -​ 80% in south korean trade is dollar-denomination, even though only 20% goes to the US Why is the dollar still king? -​ Inertia -​ Lack of alternatives -​ We are a really big economy -​ We have the worlds most developed and open financial system -​ We political coherence at least relative to the alternatives  -​ Many of the benefits also benefit others -​ We dont take (too much) advantage of it Its good to be the king: exorbitant privilege -​ Everyone needs dollars -​ Seinorage -​ The difference between what it costs to create money, and what people will trade for it -​ We create money out of thin air, and people in other countries really value it -​ Sort of like a natural resource -​ Other countries want/need dollar denominated assets -​ The US govt can borrow a lot of money cheaply -​ We get a big military and low taxes (and other stuff) and everyone else has to help finance it -​ Great for canada/japan/germany/ukraine/etc bad for russia/iran/etc -​ That makes our interest rates lower, which is great -​ You get to go to college/buy a house -​ We “get” to build a system where all of that is bought on credit -​ We can use control over dollar to sanction countries -​ Russia, iran, venezuela Its not good to be the king: exorbitant privilage -​ Everyone else gets: -​ The inconvenience of travel and money exchange -​ Non US firms have to convert into native currency -​ Those firms (and banks) need to worry about exchange rate risk -​ Relatively higher borrowing costs -​ Other countries compete with the US economically and militarily -​ We have a pretty big advantage -​ The problems of dollar invoicing -​ For many, the problems of original sin Dollar invoicing -​ If trade is prices in dollars, exchange rate movements against the dollar should have negligible effects on exports -​ Essentially all commodities are priced in dollars, so commodity exporters cannot really control that aspect of their economy with monetary policy Original sin: why are poor countries poor? -​ Some countries commitment to fiscal sustainability is less credible -​ Markets will be quicker to anticipate defaults and inflation -​ Hence such countries will face higher interest rates and more jittery investors -​ Fear of floating  -​ Some countries do not allow their exchange rates to fluctuate and thereby absorb shocks -​ Exposes them to currency misalignments that result in exchange rate crises rather than smooth adjustment -​ Currency mismatches on national balance sheets -​ Countries with net foreign currency exposure, are more vulnerable to a crises -​ Bad times will cause a currency depreciation that raises the cost of debt service -​ That higher cost of debt service can result in further currency depreciation, in a vicious cycle Original sin: the root cause of all this -​ Most govts can’t borrow in their own money -​ Imagine bolivia wants to borrow a lot of money from abroad -​ Someone gives bolivia money today in exchange for more money in the future -​ It needs to find someone to take that deal -​ Somebody wants a steady stream of payments from bolivia -​ But who needs a steady stream of boliviano payments? Basically nobody -​ And if anyone is willing to take that they will charge a lot of money for it -​ So if bolivia wants to borrow a lot of money from abroad they will have to do it in dollars -​ Bolivia exports commodities -​ Commodities are priced in dollars -​ You really do not need bolivian currency to buy what bolivia has to sell This is bad (original “sin”) currency mismatch -​ Currency mismatches -​ Entities in countries with original sin borrow in dollars, but dollar earn in local currency -​ Dollar appreciations increase value of liabilities relative to assets -​ Example: -​ A thai bank borrow money in dollars, and then the dollar appreciates against the thai bhat -​ All of the banks liabilities (in dollars) go up, all of their assets (in baht) go down  -​ That put the bank in a tough position -​ It will have to take less risk in its lending portfolio -​ That hits the marginal thai borrower and thus the thai economy -​ It might go under entirely That is bad (origianl “sin”): fear of floating -​ Fear of floating -​ Countries with original sin cant really have floating exchange rates -​ To much risk of not servicin debt, wont be loaned to as a result -​ Prevents govts from having autonomous monetary policy -​ It makes countries prone to crises That is bad (original “sin”): excess reserves -​ Excess reserves -​ Countries with original sin must hold additional international reserved -​ If a country owes dollars, its central banks needs a lot of dollars -​ To service debt -​ To communicate to others potential loenders that it can servie its debt -​ That is a waste -​ You could buy stuff with that money -​ You could invest in other things with that money -​ But not you have to be happy with a pile of dollars -​ Which often lose value due to inflation -​ Which do not earn a lot of interest What could end exorbitant privilege? -​ BRI/AIIB (not going to happen, hut it was part of the idea) -​ If enough countries are doing enough of the borrowing and trading with china, it might make more sense to hold chinese yuan than US dollars -​ Bad economic management -​ If the dollar is no longer reliable -​ If the US does not support other countries using the dollars -​ geopolitics/ overuse of sanctions -​ More on this next week -​ If enough countries would rather live under chinese dicatate that american -​ But: you can replace something with nothing -​ Issue is not is the US perfect (it is not) but if it is the best (it probably is) 11/20/24 Financial diplomacy The dollar is the global reserve currency  -​ About half of all international trade is invoiced in dollars -​ Almost all commodities are invoiced in dollars -​ Energy, metals, agricultural products -​ Half of international debt is denominated in dollars -​ Everybody needs dollars so everybody is willing to invest in dollar denominated investments -​ Us govt bonds -​ Corporate bonds -​ Us stock market -​ That gives us an exorbitant privilege -​ Cheap loans -​ Strong dollar -​ Lack of XR risk Why is the dollar still king? 3 options There are no threats -​ Inertia - the world runs on dollars, easier to keep using dollars, we are used to it -​ Lack of alternatives- alternatives would be japan but its too small, europe is too fractured, china is extremely bad option There are only economic threats -​ We are a big economy -​ We have the worlds most developed and open financial system -​ US dollar is well managed There are political threats -​ We have political coherence, at least relative to the alternatives -​ Many of the benefits also benefit others -​ We don’t take (too much) advantage of it -​ Other countries do not perceive a political risk to using the US dollar Broz background: 2008 financial crisis -​ Everyone wants dollar-denominated debt -​ That sucks if US interest rates are low -​ Interest rates were low in the 1900s and getting lower -​ Global demand for dollar denominated debt that pays more than gov’t bonds -​ The answer to this was — Mortgages! -​ They are sade! And predictable! And they pay a little more! -​ You can make “mortgage backed securities” - bonds tied to mortgages - by bundling mortgages together -​ It was perfect 2008 financial crises — MBSs (mortgage backed securities) -​ Banks ramped up mortgage lending to meet demand -​ To make mortgage- backed bonds, we need mortgages -​ We ran out of good borrowers  -​ Lenders started giving mortgages to marginal borrowers -​ Banks would sell to MBSs to investors but kept a lot of them -​ Often the riskiest ones that they couldn’t sell - “toxic waste” -​ Kept the riskiest ones for themselves which was a bad idea -​ People stopped paying mortgages -​ Foreign banks, particularly european banks, began accumulating MBSs -​ Interest rates rose in 2004 -​ Marginal mortgage borrowers could not pay their mortgages -​ Bonds tied to those mortgages became worthless -​ Many banks had a lot of worthless assets -​ A lot of those assets are “off balance sheet” -​ We don't know who is about to go bankrupt -​ Everyone starts to panic but actually nuts - absolutely harrowing -​ The fed begins acting as a lender of last resort to american banks -​ But this is a global crises that could get ugly fast -​ European and asian central banks are in a pinch -​ Their banks need dollars, but they only have so many dollars -​ They can only print euros, yen, etc -​ The fed became the world's de facto lender of last resort -​ This is always the subtext of the dollar being the global currency -​ Ultimately the US is in charge -​ It only works if you trust the US in that role Swap lines -​ Currency swap to facilitate other countries foreign exchange needs -​ Super important -​ CBs agree to “swap” currency with at a pre determined price, up to a determined price, up to a pre determined amount (or unlimited -​ An agreement between 2 central banks to swap currencies -​ Ie., canada and US, we have an open agreement. If canada needs US dollars we will give them some dollars and they will lend us there dollars and eventually we will trade back. Essentially foreign central banks have access -​ A way to avoid crises and keep the economy stable Swap lines  -​ Keeps world financially stable in a crises -​ Annouce the swap before a crises might help avoid a crises -​ Shows the anchor currency is responsible -​ But an unlimted swap line is, essentially a licneces for other countries to print your currency -​ Not a trivial thing to do -​ We have those with the ECB, BOJ, BOE, swiss national bank, bank of canada How did the federal reserve determine which central banks to select for swap lines? -​ Approval of swap line requests based on -​ Economic and financial mass of the country’s economy -​ A record of sound economic management -​ The probability that the swap line would make an economic difference -​ Favored foreign central banks of important US trading partner -​ Emphasized because this sort of foreign assistance is controversial -​ Congressional backlash against the fed’s political independence -​ Some countries tired but were denied -​ Chile, peru, iceland, indonesia, india, others..,. -​ The strongest correlate of a swap agreement is the exposure of US commercial banks to a foreign market -​ So if bank of america loaned money to banks/firms in country X, and country X was likelier to get a swap line, a lot likelier -​ Is that bad? -​ There should be a balance, we need to take care of ourselves and also take care of our allies -​ The fed must protect the stability of the US financial system -​ Favors swap arrangements that were important to US banks Sanctions -​ Use financial/commercial power to force countries to change their policies -​ A middle ground between diplomacy and welfare -​ Sometimes effective, sometimes not -​ A way to “do something” without going to war -​ 6,000 sanctions in first two years of biden administration -​ Everyone agrees its too much, but all of them justifiable on their own terms -​ Hard to walk away from Sanctions south africa -​ Comprehensive anti-apartheird act of 1986 -​ Fully enforced under Bush I -​ Prohibition of loans to SA -​ prohibition of computer exports to SA -​ Prohibition of air transport to SA -​ Etc..  -​ Very successful, coupled with a lot of civil society Sanctions: Venezuela -​ Made it impossible for the venezuelan oil sector to function by the use of sanctions -​ Meant to force maduro out -​ Venezuela dependent on oil sector -​ Strangled their ability export oil -​ 71% economic collapse -​ 3x great depression -​ Did not get rid of maduro, relaxed after Ukraine/russia war -​ Totally wrecked venezuela and got very little out of it New sanctions coming -​ Secondary sanctions on Iran -​ Will make life really hard Dollar-based sanctions -​ The world runs on dollars, but the dollar is a national currency, not a global one -​ The US is in a weird position to use its financial power to punish others -​ The US must balance its desire to use this tool but not so much that it becomes a reason countries want to stop using the dollar How do sanctions work -​ Small banks dont hold mutual accounts -​ My bank cant take a 100 from me and credit it to a company in mozambique -​ But all banks that deal in dollars hold accounts with correspondent banks -​ My bank tells correspondent bank to debit its account and credit the mozambique account Primary sanctions -​ Ban banks from doing bussiness with specially designated nationals (SDNs) -​ Done by office of foreign assets control  -​ No correspondent banking services makes it harder to move dollars internationally -​ So every major US bank (or foreign bank that does business in the US) is also a part of executing US foreign policy -​ Primary sanctions make life hard but not impossible -​ There are non-US banks that clear in dollars -​ Or you could bank in euros in pounds Secondary sanction -​ A nuclear bomb -analogy -​ Sanctions anyone who banks with an SDN -​ Foreign banks won’t bank with an SDN if they will be cutoff from the correspondent banking system -​ Total ex-communication from the dollar banking system -​ A sanction on our allies potentially How does the US manage this? Who do we go after and why? -​ We go after Iran, venezuela, russia, north korea, syria the most -​ Mostly for foreign policy, human rights, democracy -​ So if you are against american conceptions of those concepts you prefer a non-dollar system -​ Or if you want to be able to do business with people who are against american conceptions of those concepts you prefer a non dollar system -​ Thats a lot of people Sanction on iran -​ Sanctions on iran for developling nuclear weapons -​ Obama signed the JCPOA with iran - limit nuclear developement in exchange for sanctions easings -​ European companies begin investing in iran -​ Trump wanted to go back to the sanctions regime -​ Pulled out of JCPOA and put in secondary sanctions -​ This led to europeans questioning their reliance on the USD