5.1 Money Society EMU PDF

Societal Interests in the Monetary System European Monetary Union Block II 2024 Dr. Toenshoff Review Questions Matching exercise period – side of trilemma (see pictures from last set of slides) What was NOT a reason why the Gold Standard ended? Painful deflationary periods...

Societal Interests in the Monetary System European Monetary Union Block II 2024 Dr. Toenshoff Review Questions Matching exercise period – side of trilemma (see pictures from last set of slides) What was NOT a reason why the Gold Standard ended? Painful deflationary periods became politically infeasible Keynesian ideas made monetary policy autonomy more attractive The Bank of England had too much gold, leading to imbalances The Great Depression made a peg to gold hard to maintain 2 Recap: Pros and Cons of Pegging Your Currency to the US$ Pros Cons Much easier trade and No monetary policy investment with the US, autonomy – e.g. if US including US tourism raises interest rates, you raise interest rates Monetary policy discipline: Peg requires monetary policy that mirrors US  Good if your institutions (CB) not very trustworthy 3 Recap: Upward spiral of inflation Long-run Short-run Read: Oatley, Chapter 13, pp.280-288 4 The Plan Society Centered Approach European Monetary Integration The Eurozone Crisis and its Aftermath 5 “Society Centered” Approach to Monetary Politics 6  Policy Choices Along Two Axes Strong currency Domestic XR stability economic autonomy Weak currency 7 What are your monetary preferences? Should the Netherlands have… A fixed or floating exchange rate? A strong or weak currency (relative to major trading partners)? 8  Why do governments choose different paths? Society Centered Approach: Domestic politics, shapes monetary policy Interests and Institutions… 1. Electoral Models 2. Partisan Models 3. Sectoral Models 9 Electoral Models Help explain choice between fixed and floating exchange rate Politicians have two major ways to influence the state of the economy Fiscal policy (taxes & spending) Monetary policy (adjust interest rates, if available) Assumption: Policymakers who are sensitive to the (short- term) welfare of citizens want monetary policy autonomy, only maintain fixed XR if compatible with MP they want to implement 10 Electoral Models Regime Type: Democracies are more sensitive to the state of the domestic economy… Therefore, monetary policy autonomy is more important (but not irrelevant in non-democracies). Institutional heterogeneity: Electoral rules in different democracies (or non-democracies) might alter these incentives. Veto players The more fiscal constraints, the more monetary policy autonomy is valued Ex. Obama and the Republican Congress. 11  Electoral models Institutions and Credibility:  Fixed XR requires a commitment to uphold the peg…  Democracies might not be the best at upholding commitments…  Why? Elections…  Politicians often have incentives to focus on the next election, not long-term commitments. 12  Partisan Models XR policy is determined by the ruling party’s ideology/interests Remember the Phillips Curve: There is a trade-off between inflation and employment Left-wing parties are “pro-employment” Tend to represent labor organizations, poor folks Right-wing parties are “anti-inflation” Tend to represent business interests, rich folks 13 Partisan Models Prediction of partisan model: Right-wing governments are more likely than left-wing governments to establish & maintain a fixed XR Right-wing governments are more likely than left-wing governments to promote a “strong currency” (because it requires taming inflation) Connection with Electoral Model: Voters choose left-wing parties during recessions & right wing parties under inflation 14 Sector Models Interest groups have different preferences towards the trade-off: Some prefer XR stability Others like monetary policy autonomy The “sector” of employment determines preferences. 15 4 interest groups 1. Export-oriented producers 2. Import-competing producers 3. Nontraded-goods producers 4. Financial services industry. 16 4 interest groups 1. Export-oriented producers  Fixed XR: stability for int’l transactions  Weak XR: lowers price of products abroad 2. Import-competing producers 3. Nontraded-goods producers 4. Financial services industry. 17  Strong currency Domestic XR stability economic autonomy Export Oriented Weak currency 18 4 interest groups 1. Export-oriented producers 2. Import-competing producers  Floating XR: prefer monetary policy to address recessions/inflation  Weak XR: keeps price of imports high 3. Nontraded-goods producers 4. Financial services industry. 19  Strong currency Domestic XR stability economic autonomy Import Export Oriented Competing Weak currency 20 4 interest groups 1. Export-oriented producers 2. Import-competing producers 3. Nontraded-goods producers  Floating XR: prefer monetary policy to address recession/inflation  Strong XR: consume more traded goods, travel more, pay for tuition…. 4. Financial services industry. 21  Strong currency Non-Traded Goods Domestic XR stability economic autonomy Import Export Oriented Competing Weak currency 22  4 interest groups 1. Export-oriented producers 2. Import-competing producers 3. Nontraded-goods producers 4. Financial services industry.  XR stability for int’l transactions  But XR volatility can be profitable  Currency trade  Monetary policy autonomy maintains stable domestic banking system  WEAK preferences for floating XR  No preference for strength of currency  Buy foreign assets when XR is strong, repatriate investments when XR is weak.  Win/win 23  Non-Traded Strong currency Goods Financial Services Domestic XR stability economic autonomy Export Oriented Import Competing Weak currency 24 Allies and Adversaries XR stability: Non-tradeable and import competing want flexibility Export oriented wants stability XR strength: Export oriented and import-competing want a weak currency Non-tradeables want strong currency 25  Non-Traded Strong currency Goods Financial Services Domestic XR stability economic autonomy Import Export Oriented Competing Weak currency 26 Criticisms of Each Model? Electoral Model: Limited in explanation. Tells us only why a government might abandon a fixed XR. Some governments don’t abandon fixed XRs according to its predictions Partisan Model Sector Model 27 Criticisms of Each Model? Electoral Model Partisan Model Monetary policy preferences aren’t always neatly distributed across parties. Other issues matter. Leftists sometimes pursue contradictory measures, rightists are sometimes expansionary. Can’t explain situations where monetary policy is separated from politics (Independent Central Banks) Sector Model 28 Criticisms of Each Model? Electoral Model Partisan Model Sector Model Overestimates importance of fixed XR to export interests They have ability to purchase insurance Weak currency also increases production costs, eliminating some gains to traded-goods sector (remember supply chains…) They also use imported imports, which rise in cost as a currency weakens Can’t tell us much about which sectors will prevail in political competition. 29 The European Monetary Union 30  Road to Economic and Monetary Union ▪ 1979 – 1999: European Monetary System with the European Exchange Rate Mechanism (ERM) ▪ 1992: Maastricht Treaty: convergence criteria or Maastricht criteria ▪ 1997: Stability and Growth Pact Two rules on fiscal discipline: - annual budgetary deficits should not exceed 3% of national GDP; - government debt should be no more than 60% of GDP. ▪ 1st January 1998: European Central Bank (ECB) ▪ 1st January 1999: adoption of the euro and of a single monetary policy under the ECB  Economic and Monetary Union: Why? Why give up control of monetary policy? Trade: Most EU countries are highly dependent on trade and investment flows within the EU  Economic and Monetary Union: Why? The role of ideas: the triumph of monetarism over Keynesianism. Monetarism believes that Keynesian stimulus is ineffective at solving crises Enter: Milton Friedman Central Bank should just focus on keeping inflation at a steady, low level Lesson: no need for expansionary policy in crises -> giving up sovereignty over MP is less costly  Pre-EURO: The EMS By late 1970s, all European countries wanted to restrict inflation  Common policy objective = fixed exchange rate less costly From 1979: System of fixed but adjustable exchange rates in Europe 100 Trillion Mark Note from 1923 In practice: Germany set monetary policy for everyone  Bundesbank worried about having to use inflation to support weaker currencies  Solution: Let Bundesbank set monetary policy that controls inflation, everyone else has to converge to maintain peg to Mark  Economic and Monetary Union: EURO replaces EMS Other European countries wanted a say in monetary policy once inflation down Germany & Bundesbank opposed (inflation worries, again…) France makes EMU condition of supporting German reunification – Germany acquiesces BUT: Bundesbank writes most of the rules for ECB  The European Central Bank Key characteristics Governance The ECB’s primary objective is to The Governing Council is the main maintain price stability decision-making body of the ECB. It is formed by: Inflation target: 2% over the medium  6 members of the Executive Board; term;  the 20 governors of the national central banks of the euro area The ECB is an independent institution countries. (EU institutions and member states have no influence). ECB not allowed to buy government debt 36  The EMU before the eurozone crisis: A monetary union without fiscal and banking union EMU Monetary Banking Fiscal union union union 37 10 Minute Break 38 The Eurozone Crisis 39  From the Great Recession to the Eurozone crisis: Private debt or public debt crisis? ▪ 2007: housing bubble burst in the US; ▪ Banking crisis and sudden reduction of availability of credit; ▪ Governments’ bailout (financial assistance) of financial institutions in the US and Europe => private debt became public debt; ▪ Increasing sovereign spreads as trust in the solvency of government decreased. 40 General government debt (as % of GDP) Source: OECD 41  The Eurozone crisis: causes Trigger Structural causes Balance of payment (BOP) 2009: The newly elected Greek imbalances; government revealed a much higher budget deficit than previously declared. The architecture of the Eurozone itself: ▪ No lender of last resort; ▪ Monetary union without a fiscal or banking union; 42 Structural causes: the Eurozone crisis as a BOP crisis After Euro introduced, macroeconomic conditions diverge: Northern Europe experiences much slower growth than Southern Europe With the adoption of the single currency, countries in the periphery were able to borrow at very low rates (see next slide): Banks in Europe’s core invested in faster- growing countries in the periphery. Northern Europe Southern Europe Slow Growth Faster Growth Very Low Inflation and Higher Inflation and Wage Wage Growth Growth Exports More Competitive Exports Less Competitive Capital Flows Core Periphery = Increasing debt-financed consumption Big Current Account Surpluses/Deficits (and no XR adjustments possible) 43 Decreasing costs of borrowing: 10-year government bond yields Source: Baldwin et al. (2015) 44 Current Account Deficits/Surpluses Core: France, Germany, Benelux Periphery: Ireland, Southern Europe Source: Frieden & Walter (2017). 45  Structural causes: the Eurozone’s architecture 1/2 The fragility of the Eurozone (De Grauwe, 2011) ▪ Eurozone countries issue debt in a currency over which they have no control; ▪ It means that countries cannot force their national central bank to provide liquidity (no lender of last resort); ▪ As a result, countries are more exposed to market panics 46 General government debt (as % of GDP) in 2011 Source: OECD 47 Structural causes: the Eurozone’s architecture 2/2 ▪ The Eurozone is a monetary union without a fiscal union, no coordination that could have counteracted the imbalances ▪ Northern Europe could have used fiscal expansion, southern Europe contraction ▪ Stability and Growth Pact rules regularly ignored (by all) ▪ The Eurozone is a monetary union without a banking union, necessary to prevent the “doom loop” between national governments and banks ▪ Governments increase public debt to save national banks ▪ Government debt becomes unsustainable ▪ Domestic banks hold government debt now at risk of default 48  Possible Solutions to the Eurozone Crisis External Adjustment Internal Adjustment Financing Deficit Countries Exchange-rate devaluation Austerity (public spending cuts Cover funding gap through (Periphery) and/or tax increases) and external funding structural reforms to restore the competitiveness of exports (typically associated with increased unemployment, lower wages, recession, …) Surplus Countries Exchange-rate appreciation Reforms aimed at boosting Providing financing for deficit (Core) domestic demand, letting countries w/ BOP problems inflation increase and competitiveness of exports decrease Implication for the Eurozone breakup Convergence of deficits and Permanent financing Eurozone surplus countries (burden structures sharing among creditors and (e.g. fiscal federalism, debtors) automatic stabilizers) Source: Frieden & Walter (2017) 49 The Northern Countries Don’t Adjust by Boosting Demand 50  Crisis resolution: the chosen option Internal adjustment in debtor states, temporary financing and expansionary monetary policy 51  Internal adjustment & temporary financing To avoid default, Greece was granted loans by the Troika (IMF, European Commission and the ECB) in exchange for austerity measures  = tax increases, reforms to enhance competitiveness and public spending cuts in categories such as pensions, unemployment benefits, health and education Ireland and Portugal’s bailout followed soon; Problem: Austerity led to economic contractions, so debt/GDP ratio WORSENED Confidence among creditors was not restored and sovereign spreads kept increasing, with Italy looking like a mortal threat to the euro. 52  Monetary policy In July 2012, ECB’s President Mario Draghi announced to be ready to buy governments’ bond in the secondary market; Financial markets believed in Draghi’s “Whatever it takes” and borrowing costs returned to pre-crisis level; The ECB implemented several other unconventional measures to keep interest rates down. 53 Austerity measures continued in all of the debtor countries: at what cost? 54  Painful Adjustment Despite some limited debt restructuring, the burden of adjustment has almost exclusively fallen on debtor countries, especially on the youth; In Ireland, Italy, Spain, Portugal and Greece unemployment has soared, gross domestic product (GDP) has fallen and the debt-to-GDP ratio has increased; Inequality has risen, together with poverty and homelessness, while mental illnesses and suicides have increased; Last but not least, economic hardship has fueled populism and anti-EU feelings. 55 Changes To Avoid Future Crises More fiscal discipline  European Semester (ex-ante coordination of fiscal policy);  Fiscal Compact (2012) to foster budget discipline in the EU;  Creation of a permanent fund, the European Stability Mechanism (ESM).  Banking Union  Created in 2014  Single Supervisory Mechanism  Single Resolution Mechanism (SRM) with a Single Resolution Fund for effective and efficient resolution of non- viable credit institutions. 56 Next: Sovereign Borrowing & The IMF 57 Sovereign Debt Crises Block II 2024 Dr. Toenshoff Review Questions According to the Sector Model of Monetary Policy, what preferences best describe the non-traded goods sector?  Weak currency and monetary policy autonomy  Strong currency and monetary policy autonomy  Weak currency and exchange rate stability  Strong currency and exchange rate stability What was NOT a potential solution to the Eurozone crisis?  Internal adjustment through austerity in deficit countries  Internal adjustment through economic expansion in surplus countries  External adjustment through exchange rates while keeping the Euro  Permanent financing of deficit countries by surplus countries 2 The Plan What is Sovereign Debt & What is it good for? Debt Crises in general The IMF and World Bank The Latin American Debt Crisis A New Global Debt Crisis? 3 What is Sovereign Debt & When is it Good? 4 What is sovereign debt? When expenditure exceeds income, difference is made up with borrowing Govt Budget Deficits Public/National Debt Citizens’ Saving Deficits Private/Personal Debt 5 Which Governments Borrow? Netherlands 2022: public debt = 45.1% GDP What stands out about the top 20 debtors? Many low income, emerging markets (Sudan, Venezuela, Argentina) Also high income, market leaders (Japan, Singapore, US) Europe-heavy: Greece, Italy, France, Spain, Belgium Who borrows? Everyone 6  Who Lends to Governments? Multilateral institutions (International Monetary Fund, World Bank, etc) Bilateral governments (China, United States, etc) Private market (=“International Sovereign Bonds (ISB)”: Commercial banks issue loans (less popular since 1980s) Asset managers (pension funds, other private investors) & citizens buy sovereign bonds Central banks (like ECB during COVID)  Since 1970s: private foreign capital > foreign aid, FDI 7  Debt is Unproblematic When… Interest rate (r): cost of borrowing; percentage of principal loan that is due per period Economic growth (g): percentage change in value of goods & services produced within period Debt “works” when r < g (interest rate – growth differential) When interest rates increase or growth slows, debt becomes unsustainable (more on that later) 8  Why Borrow? Investment in Growth Consumption Smoothing (to Manage Crises) Short-Term boost in Domestic Economy Note for all three: Debt is inter-temporal: future generation responsible for paying it back in taxes 9  Why Borrow? Investment in Growth  Especially in poor countries: low domestic savings = low investment  Debt fills this savings gap  “Works” if truly spent on growth-enhancing projects (not consumption or “white elephants”)  By the time you have to pay it back, your economy is larger and can bear the cost of repayment Consumption Smoothing (to Manage Crises) Short-Term boost in Domestic Economy 10  Why Borrow? Investment in Growth Consumption Smoothing (to Manage Crises)  Crisis (ex. pandemic) with huge, sudden costs: borrow to smooth costs out over the future. Also called tax smoothing  One crisis this can help with: Climate crisis… Short-Term boost in Domestic Economy 11  Debt and the Climate Crisis What do sovereign debt and climate change have in common? Both intertemporal problems: future generation faces the costs Govt can borrow $$ to invest in climate change mitigation Instead of experiencing environmental disaster, next gen will pay higher taxes Debt-for-nature swaps: creditors forgive part of debt, in exchange govt expands conservation Blue & green bonds: govts borrow and use funds for Climate mitigation & environmental investments (very large chunk of today’s climate finance) Is this the answer to all of our climate woes? Probably not. Meaningful climate mitigation would likely need to come through grants, massive debt relief for low-income states, or massive low-cost lending 12  Why Borrow? Investment in Growth Consumption Smoothing (to Manage Crises) Short-Term boost in Domestic Economy  Tax smoothing is not only attractive in times of crisis…  Debt provides short-term benefits to politicians:  Purchase more public and private goods to reward supporters  Increase popularity by borrowing to fund a war  Use debt for a short-term economic stimulus before an election  In the long-run, such debt is problematic if it doesn’t boost economic growth  In the short-run, it helps win elections  Yet another time-inconsistency problem for short-sighted elected officials 13 Sovereign Borrowing ≠ Private Borrowing Many of us think public debt = private debt. What does the Dutch word “schuld” mean? Debt, blame, fault, guilt I always live within my means. The government should, *Borrows billions every year* too! Why can the government be in constant debt, when this would be a disaster for a household? The government lives forever Central Bank can influence r to reduce debt service (ex. Japan, US, UK) The multiplier effect: govt spending (& other fiscal policy) can influence g The govt can force a household to repay its debt (via the courts). Who forces the govt to repay? But Too Much Borrowing Has Risks Why not borrow all the time, then? If debt servicing becomes too expensive, it can crowd out other spending  World Bank: 3.3 billion people live in countries that spend more on interest payments than on either education or health High debt may cause inflation, or make it hard to lower inflation  Higher interest rates problematic if some of your debt is paid at those interest rates  Tempting to print money to repay debt Debt service capacity: the ability of the government to make payments on interest and principal as required by loan terms Function of foreign reserves: govt needs dollars (or euros, or yuan) to repay debt What happens if exports collapse? Russia 2022: US sanctions froze Russian assets Creditors demanded to be paid in dollars, not rubles Russia ran out of dollars, defaulted in April Debt Crises in General 16 Capital Flow Cycle There is an excess of currency in the world seeking a home (Supply) Banks don’t like to sit on capital, they want to invest, make money! Foreign capital floods a country w/ a Demand for capital Examples: 1980s Latin American Debt crisis 1997 Asian crisis Stimulates economic boom Mexican 1994 crisis More borrowing = more jobs, more consumption Russian, Brazilian, Capital account surplus Turkish and Argentinian crises (late 90s) Germany 1930’s Encourages financial leveraging and risk taking Great recession of More money and fewer safe assets 2008/2009 Investors have FOMO, even more lending Culminates in a crash as banks realize they’ve made too many bad bets and restrict credit to most borrowers (credit crunch) 17  How does a debt crisis happen? Creditors worry: what if govt doesn’t pay us back? Maybe govt borrowed too much, external shock, Government borrows etc Needs to pay interest, When creditors worry, principal credit ratings go down & interest rates go up Credit crunch, Borrowing gets more expensive Govt may borrow even more to pay off some creditors in short-term Punishment Creditors don’t trust govt No access to credit for a while, or only very expensive credit Govt misses a Restructure debt Negotiation between govt payment: default & creditors for debt Capital flight, domestic relief, “haircut”, more economic crisis time to repay 18  What happens when there’s a debt crisis on the horizon? Gunboat diplomacy: foreign policy goals achieved by the threat of military force 1902: Germany, Britain, & Italy imposed a naval blockade on Venezuela, “pay us back or else” Not much militarized debt collection since the 19 th century Why don’t we see borrowers & creditors fighting wars over sovereign debt? Instead, less costly options: Repay debt Default 19 Solution 1a: Print Money to Repay debt Print money: govt needs money to repay creditors, so it just prints more! Citizens hate it: inflation is painful, especially for poor Creditors hate it: their investment is worth less Not a popular strategy to cause inflation. However, this could be a side benefit of inflationary periods: debt is worth less Original sin (Eichengreen, Panizza, & Hausmann): governments can’t borrow domestically or internationally in their own currency Creditors worry govt might print more money to “inflate away” their debt, so they only lend in other “safe” currencies Govt needs access to dollars, euros, yuan to repay debt 20 Solution 1b: Austerity to Repay debt Austerity: govt cuts spending and/or increases taxes to raise the money it needs to repay creditors Creditors love it. We’ll come back to this and the IMF Citizens…sometimes hate it (think Greece 2013 from last lecture). Sometimes they don’t mind, austerity can be popular (Barnes & Hicks, 2018) Ongoing debate about the effects of austerity: Leaders may be punished at the next election, or maybe voters don’t really care Sometimes helps economic growth by reducing wasteful spending, sometimes harms growth by cutting investment 21 Solution 2: Default Default: Government misses a payment to one or more of its creditors But, think back to the household fallacy: government default =/= personal default. No “super-government” to force a government to repay So…why not default? Consequences of default: Economic crisis: capital flight, unemployment, recession Damage supporters: right-wing voters may be both investors & citizens Reputation: credit rating drops, more expensive to borrow in future Institutions: some countries have rules/norms that punish a leader for default Since 2020: Belarus, Ghana, Zambia, Sri Lanka, Lebanon, Argentina, Ecuador, Suriname, Ukraine 22 Solution 3: Get creative E.g. debt-land swaps Sri Lanka sold land to China 2016: Sri Lanka had massive debts, needed dollars urgently to repay China stepped in, bought a 99-year lease to Hambantota Port Sri Lanka used dollars from sale to repay bondolders “Debt-trap diplomacy”? China is Sri Lanka’s largest single creditor Media & political concern that China has strategic influence over its debtors. Political scientists are less concerned (Brautigam & Rithmire, 2021) Port was leased, not technically sold. But, could Sri Lanka actually change the terms of the lease agreement if it wanted to? (Probably not) 23 Solution 3: Get creative E.g. debt-land swaps Sri Lanka sold land to China 2016: Sri Lanka had massive debts, needed dollars urgently to repay China stepped in, bought a 99-year lease to Hambantota Port Sri Lanka used dollars from sale to repay bondolders “Debt-trap diplomacy”? China is Sri Lanka’s largest single creditor Media & political concern that China has strategic influence over its debtors. Political scientists are less concerned (Brautigam & Rithmire, 2021) Port was leased, not technically sold. But, could Sri Lanka actually change the terms of the lease agreement if it wanted to? (Probably not) 24 10 Minute Break 25 The IMF & World Bank 26  The firefighters: IMF and World Bank World Bank Group Ajay Banga, President WBG International Monetary Fund (IMF) World (as always…a US citizen) Bank Loans to Loans to fund prevent/resolve development projects economic crisis International organizations funded by contributions from member states (quotas)  If your quota is higher = you get more votes in decision-making Global financial safety net: when govt runs out of funds or can’t get loans from other creditors, turn to the IMF/World Bank 27  The IMF 3 missions: monitor, assist, develop Monitor: track state of the economy during annual Article IV visits Assist: provide financial assistance to govts in crisis (loans) Develop: technical assistance & training so govt can monitor itself, implement “sound” policies International Lender of Last Resort (ILLR): The IMF as a “bailout” system to rescue governments in a balance-of-payments crisis & help them repay their debts Liquidity crisis: govt ran out of cash (South Korea, 1998) Structural crisis: structure of economy causes/intensifies crisis (Argentina, 1983) IMF lends to govts that have run out of cash & credit: Govt’s creditors get repaid, avoid default Govt has to implement policy conditions to prevent future crises & make sure IMF gets repaid 28 29 The IMF’s problem: moral hazard IMF as ILLR provides an implicit bailout guarantee for countries that have high debt burdens and balance of payment problems. A prospective bailout incentivizes irresponsible behavior (on both sides) Borrowers: “Why change policies if the IMF will just keep bailing me out?”  Remember, our survival-motivated politician: extra incentive to borrow a lot right before an election, if they know they can rely on the IMF to deal with the debt later Creditors: “Why not lend to very risky governments if an IMF bailout will make sure I get repaid?” How can the IMF prevent this behavior and make sure problems that lead to unsustainability do not continue?  Policy conditions on loans help borrower moral hazard: these act like collateral  Selective lending helps creditor moral hazard: IMF doesn’t bail every govt out! 30 Policy conditions: structural adjustment General idea: governments need to take a smaller role in policy areas where markets work reasonably well Stabilize macroeconomic environment, often includes:  Fiscal discipline: cut spending, raise taxes  Competitive exchange rate (often means devaluation)  Secure property rights and deregulate  Fight inflation with high domestic interest rates Liberalize trade and FDI Privatize state-owned enterprises Neocolonialism (dependency theory?)  Some argue that this was a way for the West to impose policies that favored its industries over the development of the country 31 IMF backlash Sovereignty: external, Western intervention Kenya 2023: public protests against IMF loan as “undemocratic” Which govts get the best deals with the IMF? Often, US allies (Dreher & Jensen, 2007) Can help keep incumbent government in power (Vreeland, 2003). Should the IMF lend to dictators? Strong, fiscally conservative conditions Pakistan 2022: devastating floods triggered economic crisis, IMF refused to lend unless fuel subsidies were cut & taxes increased Limit social spending, development of welfare state in Global South, death by “a thousand cuts” (Kentikelenis & Stubbs, 2022) Creditor bias Conditions often help creditors regain investments: IMF helps coordinate creditors, may give them more power 32 Why do governments still borrow from the IMF? No (or little) choice: IMF isn’t called the international lender of last resort for nothing Govt can’t get funds anywhere else, all other creditors refuse to lend Shift in IMF policy: less stringent structural adjustment Increased attention to climate investment Ex: during COVID-19, IMF advocated for stimulus! Incorporating social conditions, like expansion of health & edu spending in Pakistan The scapegoat hypothesis Leader wants to consolidate debt, raise taxes, cut spending, etc But, citizens are opposed – leader is worried about getting kicked out of office Solution! Bring in the IMF: “I have no choice but to raise taxes, the IMF is making me do it!” 33 The Latin American Debt Crisis 34  Stage 1: Mounting Debt Before the 1970s most developing countries couldn’t attract private capital flows. They depended on the World Bank and Foreign Aid for capital 1973 Oil Shock increases the “pool of money” in commercial banks Oil Producers made lots of $$$ and put their money in Western banks Oil Producers had large current account surpluses Seeking to make a return, banks were now willing to lend to “risky” countries by lending them “petrodollars” LA govts were engaged in Import Substitution Industrialization (ISI) strategy: Remember, this required a lot of cash!  Exacerbated by high oil prices –> larger current account deficits –> more need for debt-finance Supply of Petrodollars meets demand for funds in Latin America – Latin American countries became world’s largest borrowers by early 1980s 35 Stage 2: Debt Crises Long-term structural cause: consistent debt-financed government deficits to fund ISI Shocks: Rising US interest rates Most debt was borrowed in dollars (original sin) Debt interest rates pegged to US rates (variable) When US interest rates rise, interest rates rise for LA debt & as US interest rates rise, capital flowed out to the safer asset (US treasury bonds) Value of debts also grew as US currency appreciated Recession in developed world Reduced appetite for LA exports, less money coming in to pay debts Oil prices rose again in 1979 Less money coming in and higher bills to pay, incentive to borrow even more Eventually, banks stop lending… First to Mexico (August 1982), then others 36 Resolution Without foreign $$, budget deficits couldn’t be sustained and economic growth went in reverse LA states turned to the Lenders of Last Resort: IMF and WB offer some loans, implement policy conditions First: creditors try macroeconomic stabilization (they thought this would be a quick fix)  Doesn’t work, govts still can’t raise enough $$ to repay debts Second: creditors band together and push for deeper structural adjustment, reduce govt role in economy Creditors got most of their money back, LA countries faced significant economic losses public opposed structural adjustment, domestic war of attrition on who needs to bear the costs wasn’t until late 1980s that govts succeeded in cutting expenditure and reducing public debt Inflation stayed high for a decade, higher unemployment, lower wages Why weren’t creditors punished for their “risky” loans? Why did govts pay the cost of the crisis? 37  Resolution The IMF & WB helped negotiate on behalf of the creditors, not on behalf of the govts Without the IMF, creditors faced a collective action problem States needed new loans to restart growth and to payback old loans Each creditor didn’t want to be the ones to make the loans alone, they relied on the IMF to provide loans with conditions IMF got creditors on board by coordinating and making new loans conditional on new loans from creditors (& on adoption of new policies) 38  Resolution Why didn’t LA states default or threaten default en masse? 1. Crisis reduced power of key interest groups that had supported ISI, they were no longer strong enough to oppose reforms 2. US government intervened with Brady Plan: forced creditors to negotiate 3. Realization that maybe East Asian model was better after all… The collective action problem again: Default was only optimal if debtors did so together If they collectively defaulted they could’ve bankrupted many western banks & thus had leverage Yet some could get a better deal if they defected unilaterally (more capital from IMF & Banks) Banks negotiated new loans and payment schedules independently Creditors engaged in a divide & conquer strategy Outcome was to the advantage of creditors. They got most of their money back AND economic policies across LA changed to be a lot more creditor-friendly 39 A New Global Debt Crisis? 40  Cheap Credit flowing Into Developing World (AGAIN) After Great Recession, extremely low interest rates in the West Money is cheap, returns are low => Financial institutions seek higher returns from riskier investments in developing and emerging economies 41 Are we in a new global debt crisis? Triple-crisis threatens debt 1. Pandemic: high budget deficits to support economy & expand healthcare 2. War in Ukraine: contributed to inflation, especially grain. Many poor countries heavily subsidize food & oil imports, & now govts need to borrow more to pay for them (see Egypt) 3. US interest rates rise and dollar appreciates: more expensive to pay back existing debts For states that can borrow this is easy. For states that can’t it will make it more difficult to pay back existing debts  Why invest in Ghana when the US Fed will give you 4.5%?  Look out for Ghana, Egypt, Kenya, El Salvador, Pakistan There is a movement to offer debt relief to developing countries from official lenders to avoid a widespread crisis  IMF and WB are working to coordinate creditors, but little progress. Private bondholders & China are reluctant to cooperate 42 Example: Sri Lanka “We borrowed too much money at very high interest rates in dollar terms in short maturity and invested in non-revenue generating infrastructure projects.” Causes of the 2022 debt crisis? years of “imprudent” fiscal policy and risky borrowing global shocks (COVID-19, war in Ukraine, high interest rates, inflation etc) changing supply of credit (China stopped most of its official external lending after 2019) Sri Lanka has been in IMF programme since 2023 Come back in a few years for a full post-mortem: it’s hard to identify causes while you’re still in crisis! 43 Discussion: Would the world be a better place without the IMF and World Bank? 44 Takeaways Capital Flow Cycle – Supply & Demand of capital is important Foreign capital is essential to economic growth and management of crises: funds investment & smooths consumption in crises Debt can help politicians stay in office – can lead to time inconsistency problems Creditors and Borrowers have collective action problems in times of crisis IMF is often the lender of last resort for governments in crisis IMF structural adjustment helps push through reforms to resolve crises, but with growth/social/democratic costs 45 Next: Financial and Currency Crises