Crises of Financial Openness PDF

Crises of Financial Openness: Financial and Currency Crises Block II 2024 Dr. Toenshoff 1  Review Questions What is NOT among common IMF conditions for loans?  Liberalize Trade and Investment  Democratization  Fiscal Discipline  Privatizat...

Crises of Financial Openness: Financial and Currency Crises Block II 2024 Dr. Toenshoff 1  Review Questions What is NOT among common IMF conditions for loans?  Liberalize Trade and Investment  Democratization  Fiscal Discipline  Privatization of State-Owned Enterprises Which of the following is a condition that makes sovereign borrowing more risky?  Borrowing money in your own currency instead of foreign currencies  Borrowing money when r < g  Spending borrowed money on consumption, rather than growth-promoting investment  Borrowing that is long-term, rather than short-term 2 Game Plan 1929-1939 Great Depression 1997-8 Asian Financial Crisis 2007-2009 Great Recession 2020 Pandemic 3 Great Depression 4 Great Depression Longest and most severe crisis ever experienced by advanced industrialized countries in the West In the US:  Real GDP fell 29% from 1929 to 1933  Unemployment Rate in US peaked at 25% in 1933  Consumer prices fell 25%  7000 banks (nearly 1/3 of banking system) failed In Europe:  In Germany, manufacturing declined by 39 percent, unemployment peaked at 44%  Prices fell by 30% or more in most European countries 5 Great Depression – The Run-Up 1920s: Western Countries are back on the Gold Standard, but persistent imbalances  US CA surplus  Some of Europe CA deficit (lost competitive position in WWI) Huge war debts and reparations payments in Europe – much of it flowed to the US, even more gold entering US system  Instead of letting prices rise in the US as a result, the US lent the money back to Europe in the form of international bonds Boom in credit and international bonds in the US 6  Onset of the Great Depression 1929: US tightens monetary policy to limit stock market speculation -> Stock market crash  Immediate wealth effect  Uncertainty about the economy = less spending on consumer durables  Banks had lent to those invested in the stock market = started failing Smoot-Hawley Tariffs and retaliation – collapse in world trade not helpful Bank failures:  Banking panic (no deposit insurance – money in banks NOT safe) 7  Bank Runs Precondition: “Fractional Reserve Banking” = Banks don’t keep all the money you deposit with them, they lend it back out or invest it to make money 1. Customers start questioning whether a bank will be able to pay out their deposits… 2. More customers withdraw their money from the bank 3. The more customers withdraw money, the more likely the bank will run out of money 4. This is a self-fulfilling prophecy: The more people believe a bank/financial institution will fail, the more likely it will fail 8 Where was the Federal Reserve?  Many local banks were not members of the Federal Reserve system and couldn’t borrow from the Fed as “Lender of Last Resort”  Interest rates were nominally at 0, but DEFLATION meant that borrowing and investment was still costly  Trying to preserve the Gold Standard – limits expansionary monetary policy and bank bailouts 9  Great Depression Spreads to Europe The Gold Standard required monetary contraction in Europe to match the US contraction Loans from the US to Europe used to rebuild came to a halt Rise in protectionism + US consumer market in depression + no more cheap US credit = slump in industrial production in Europe Deflation = European war debt and reparations MUCH harder to pay European banks start failing, too 10  What Led to “Recovery”? In the US: FDR declares bank holiday and institutes a temporary system of deposit insurance = no more need for bank runs Gold inflow from Europe due to economic and political crisis there => inflation => real cost of borrowing decreases FDR’s “New Deal” increases government spending Ultimately (both US and Europe): Breakdown of Gold Standard as countries rescued their banks and expanded monetary policy Outbreak of World War II => Full employment & Huge government spending => good for economic indicators, but of course bad for people 11 The Role of Economic Ideas – Government Stimulus and Bailouts Policy debate: Keynes (Keynesianism) vs. Hayek (Austrian School)  Scholars disagreed (and still disagree) on the causes and remedies to the crisis After experience of Great Depression “we’re all Keynesians now” until 1980s Great Depression: https://www.youtube.com/watch?v=d0nERTFo-Sk Great Recession: https://www.youtube.com/watch?v=GTQnarzmTOc 12 Financial and Currency Crises in Emerging Markets 1990s 13 Volatility in Private Capital Flows Global rise in private capital flows to newly liberalized stock markets  Asia as largest recipient  LA second largest Hot money that can easily be withdrawn Increased volatility of private capital flows to emerging market countries and repeated crises:  1994 crisis in Mexico  1997: Indonesia, Malaysia, South Korea, Thailand  1998 Brazil and Russia  2000 Turkey  2001 Argentina 14  Commonality Across Crises Some form of fixed exchange rate Heavy reliance on short-term capital  Continuous roll-over of foreign liabilities  Depends on government’s ability to maintain confidence in commitment to fixed exchange rate Shock (often) Rapid Government (political, Confidence Government outflow of forced to economic, evaporates toppled due capital devalue contagion) to crisis 15  Asian Financial Crisis: A Risky Banking System Malaysia, Thailand, Indonesia, South Korea Each liberalized financial markets in late 1980s/early 1990s = enable domestic banks and firms to borrow from international markets Domestic banks become intermediaries:  Profitable: Asian banks borrow for cheap internationally, lend for higher interest rates at home  Risky: short-term loans denominated in dollars and other foreign currencies, often then offered long-term loans in domestic currencies to their customers  Exchange-rate risk  Risk that foreign lenders would stop rolling over loans 16  A Risky Banking System (Ctd) Flaws in banking regulation: Moral hazard: Banks believe that governments will bail them out, so they take more risks Why? Financial institutions had close ties to government (often through personal relationships or direct government ownership) Financial regulation underdeveloped & not enforced 17  Shocks to the System Asian countries’ exchange rates start to appreciate against the Japanese yen in mid-1990s Most Asian gvts pegged currencies to the dollar – when dollar appreciated, so did Asian currencies Difficult to export to Japan – debt-service problems for export-oriented firms Real estate prices begin to fall in late 1996 – debt-service problems for real-estate developers By 1997, many of Asian Banks’ largest borrowers struggling to repay their debt -> domestic banks can’t repay their international loans Spring 1997: discovery that Finance One (one of Thailand’s largest financial institutions) was insolvent-> more scrutiny of banks in Asia by foreign banks -> panicked withdrawal of funds from Asian markets in summer of 1997, refusal of foreign banks to roll over loans 18  Contagion Panic started in Thailand in May 1997 – consumed CB forex reserves, Baht floated Next: Philippines – gvt abandons exchange rate after only 10 days Then Indonesia and Malaysia abandon fixed exchange rates in July and August Taiwan forced to devalue Taiwanese dollar South Korean government floats the Won by middle of November Total of $60 bn pulled from region in second-half of 1997, 2/3 of all capital that had flowed in the year before, 1998 another 55$bn flow out 19  The Repercussions IMF lends money to countries in crisis in return for economic reforms:  tighten monetary policy to stem depreciation  tighten fiscal policies to generate financial resources to rebuild financial sector  structural reform (trade liberalization, elimination of domestic monopolies, privatization of SOEs…) Severe economic and political repercussions:  Deep recessions, rise in poverty  Protests and political instability  by late May 1998 Suharto in Indonesia had stepped down from office  Thai government replaced by new coalition that was less corrupt 20  A Lesson Learned Lesson: avoid vulnerability to shifts in market sentiment or subjection to IMF intervention Self-insurance: accumulation of large stocks of foreign exchange reserves 1998-2000 (through persistent current account surpluses) Peg currencies to the dollar at competitive (undervalued (?)) exchange rates Sterilized intervention:  exchanges local currency for forex at fixed XR  then offsets the impact of these purchases on the domestic money supply  use forex reserves (dollars) to purchase US government securities and government-backed securities  “Bretton Woods II” US trade deficit drives growth in East Asia Regional framework for financial cooperation (to avoid reliance on IMF):  Chiang Mai Initiative – pool forex reserves to assist each other in case of market turbulence (ASEAN + Japan , China and South Korea) – gvts can swap their currency for dollars when necessary 21 10 Minute Break Great Recession 2007-2009 23 Global Imbalances 24  Global Imbalances: International Bargaining Failure Governments in surplus countries demand American US blames “Savings Glut” policy changes instead Bush administration tries to push China to Europeans blame US federal gvt’s budget deficit expand consumption and allow RMB to following 2001 tax cut for US CA deficit appreciate against dollar EU argued not their issue, since overall Euro area Tries to shift IMF’s attention to China in CA deficit presses European governments (Germany) China adopts more flexible peg in 2005, but to reduce their Current Account surpluses otherwise also demands US balance its budget instead Result: No action, flow of cheap and plentiful credit from the surplus countries to the US 25 Cheap Credit in US Fuels Real Estate Bubble Real estate prices rose 60% btw 2000 and 2006 Mortgage-backed securities: bundles of different risk in a single security  Ryan Gosling explains MBS tranching: https://www.youtube.com/watch?v=3hG4X5iTK 8M Financial institutions discounted risk of nationwide collapse of real estate prices, worst case scenario planned for: regional collapse 2007: real estate prices fall by almost 25 percent nationwide, mortgage default rates rise sharply Securities suffered large losses, many bought with debt – debt-service problems entire financial system 26 Mortgage defaults rise sharply 27 The Crisis becomes International Great Britain, Ireland and Spain, had their own real estate bubbles that collapsed European financial institutions had purchased mortgage-backed securities in large quantities – suffer same losses Freezing of global credit markets after bankruptcy of Lehman Brothers in fall of 2008 made it difficult for all financial institutions to secure credit for their activities Credit dries up -> interest rates on inter-bank lending grow sharply 28  Policy Reaction: Bank Bailouts Initially US government regulators close some failing banks, arrange sales  E.g. Bear Stearns sold to JP Morgan  failed to find buyer for Lehman Brothers Banks deemed too big to fail got bailouts in both the US and the EU Ireland with the largest bailouts in the EU => creates debt problems in the Eurozone debt crisis 29 Policy Reaction: Monetary Policy Central Banks inject liquidity August 2007: ECB, Bank of England, and Fed inject $200 billion into markets, again in December 2007 Eventually: Unconventional monetary policy – asset purchasing to stimulate the economy = “Quantitative Easing”  What is quantitative easing? - YouTube 30 Central Banks lower Interest Rates to 0 31 Quantitative Easing 32 Policy Reaction: International Cooperation Shift from importance of G-7 to G-20 (with emerging markets) to coordinate response Governments agreed to coordinate fiscal stimulus measures to boost economic activity Expanded IMF lending capacity Financial Stability Board charged with coordinating and monitoring efforts on reform of financial regulation 33 Current Account Balances Today Global imbalances stubbornly large US continues to have CA deficits Trump (largely unsuccessfully) pressured China and Germany to change their policies (sound familiar?) Source: https://www.imf.org/external/data mapper/BCA_NGDPD@WEO/FR A/GBR/DEU/USA/CHN/NLD 34 Lessons: How to prevent banking /financial crises For Banks: Regulation!  Reserve requirements – share of deposits/liabilities a bank has to hold as reserves  Deposit insurance – the government insures bank deposits  Division between risky investment & retail banking  Regulatory Oversight For Governments:  Governments can try (but often fail) to prevent the global imbalances that drive financial crisis For both: Lenders of Last Resort  Institutions that lend money in a crisis to provide emergency liquidity (although beware of moral hazard!)  Central Banks, IMF 35 Coronavirus: A very different kind of crisis 36 Economic Repercussions of the Coronavirus Pandemic 37  Coronavirus = Supply and Demand-Side Shock E.g. in the US: Economic crises discussed until now were crises that occurred primarily because DEMAND declined  Policy implication: Keynes suggests that governments can remedy demand shocks with expansionary monetary and fiscal policy The coronavirus pandemic equally consisted of a severe SUPPLY shock  Factories and services closed down  Supply chains severely disrupted 38 Government Responses to Simultaneous Demand & Supply Shock 39  A Coronavirus-Specific Problem: Inflation Sharp increase in global commodity prices (e.g. lumber, everyone renovates during lockdown) Consumer demand (boosted by tax cuts and stimulus) rapidly shifts from services to goods (coloring books, Peloton bikes, Playstations…) Supply chains severely disrupted = demand for goods cannot be met Once economy reopens: service industry has trouble finding workers who switched to other jobs (Unrelated) spike in energy prices when Russia invades Ukraine 40  A Coronavirus-Specific Problem: Inflation Inflation due to supply shortages poses a big problem for policymakers and Central Banks: Fiscal and monetary policy can boost consumption and rescue businesses from failure, but a low-interest rate will not fix supply chain issues or lockdowns Expanding money supply and boosting demand too much may fuel inflation further 41  The Policy Goal: A “Soft” Landing Bring down inflation without causing an economic recession Seems to be (kind of) working for now: 42  Core Take-Aways Global imbalances contribute to financial and currency crises Countries struggle to coordinate and reduce global imbalances Economic conditions are highly interdependent when capital flows are globalized Fixed exchange rates are hard to maintain when short-term capital is very mobile Crises are harder to address when they include supply-side shocks like the pandemic 43 Next: Trade in Energy, OPEC, and Climate Change Trade in Energy, OPEC and the IPE of Climate Change Block II 2024 Dr. Toenshoff 1 Review Questions Which statement is true about the 2007/2008 Financial Crisis?  It was preceded by global imbalances where the US had a large Current Account deficit  The financial system started collapsing when real estate prices increased sharply  Central Banks reacted to the crisis with unconventional monetary policy  Quantitative easing caused inflation in the 2010s What is NOT a reason why the Federal Reserve could do little to resolve the Great Depression initially?  Deflation meant borrowing costs were high despite interest rates of 0  The US had a stringent debt ceiling, so the Fed could not take out more debt  The Fed was trying to preserve the Gold Standard  Many of the failing banks were outside the Federal Reserve System 2 Two Interrelated Crises 3 Game Plan The Energy Trilemma Oil Institutions: OPEC and the IEA Climate Change:  International Institutions  Domestic Interests and Institutions  3 Common Economic Climate Policies 4 The Energy Trilemma Stable Energy Supply Note: Unlike the Monetary Policy Trilemma, This is not a strict trilemma: It’s hard but not impossible to obtain all three The Energy Trilemma No Energy Poverty Climate Change Mitigation 5  Stable Energy Supply Energy is a good that is more fundamental to our economies and lives than almost any other. We need it to:  Power production  Fuel most forms of transportation  Heat our homes  Supply Electricity to our homes Abundance of reliable, cheap energy fuels economic development Lack of reliable, cheap energy can cause deep economic crises 6 Global Sources of Energy 7 Global Trade in Energy Credit: Koskinen 2016 8 Institutions Governing Energy Policy No ONE institution or agreement governing energy policy Main Institution Oil Exporters: Organization of Petroleum Exporting Countries (OPEC) Main Institution Oil Importers: International Energy Agency (IEA) A lot of others related to energy:  UNFCCC (global climate change framework, more on that later)  IRENA (International Renewable Energy Agency)  IAEA (International Atomic Energy Agency)  World Bank  … 9  OPEC History First half 20th Century: Oil production dominated by the “Seven Sisters”  Now: Exxon, Shell, BP, Chevron 1960: 5 countries (Saudi Arabia, Iraq, Iran, Kuwait, Venezuela) form OPEC to “stabilize prices” and “ensure a fair return on capital for investors”  = trade union to negotiate with oil companies 1970s: OPEC asserts power, oil embargo From 1980s: Mandatory production quotas for members to keep supply steady and prices high  = OPEC becomes a “cartel” 2016: OPEC+ (coordination with Russia and others) 10  OPEC Oil Embargo 1973 By 1973: OPEC’s production of oil at over 50% world share 1973: Yom Kippur War Arab members of OPEC impose an oil embargo on US & Netherlands and cut production Result: Price of imported oil to US quadruples, double-digit inflation 11  Oil Cartel and Oil Prices OPEC negotiates to curb production through quotas, keep prices high for everyone E.g. oil price drop after 2008 financial crash – OPEC countries jointly reduce output BUT: coordinated output cuts hard to maintain – Prisoners’ Dilemma Some argue that Saudi Arabia – OPEC’s biggest producer – tries to uphold discipline through tit- for-tat 12 OPEC Today 13 member countries Still accounts for more than half of world’s crude oil Shale boom in US and Canada has undermined OPEC’s influence in North America 13  The IEA: An Organization for Oil Consumers Created 1974 under OECD framework (= only developed country members) Goal: Reliable energy supply, avoid future oil shocks Measures:  Emergency stocks & collective oil emergency response Promote energy efficiency and diversification  Research into energy markets & consulting  (today) Promote Clean Energy Transition 14 Climate Change 15  Climate Change as Prisoners’ Dilemma Country 2 Cut Emissions Keep Emitting Cut Emissions A B Country 1 Keep Emitting C D Preferences Country 1: C>A>D>B Preferences Country 2: B>A>D>C Climate Change = Collective Action Problem, everyone wants to free-ride on others’ emission cuts 16 17 18 International Climate Negotiations The History of Climate Change Negotiations in 83 seconds - YouTube 1992: countries agree on UNFCCC (United Nations Framework Convention on Climate Change)  Conference of the Parties (COP) held every 2 years  COP 29 held in Baku this November 1997: Kyoto Protocol  Set limits for developed countries to make cuts  US never ratifies, Canada pulls out  Emerging economies (China, India) grow rapidly but have no obligations under Kyoto 19 A New Model: The Paris Agreement The Paris Agreement - in 97 seconds – YouTube More politically palatable:  Everyone has to do “something”  Countries themselves decide how much: Nationally Determined Contributions (NDCs)  Designed to allow US President to circumvent Congress  (Some) Climate Finance Core issues today:  Stock-take last year: How have countries done so far? (result: not enough)  Phasing out of fossil fuels  Climate finance, including “Loss and damage” fund 20 10 Minute Break 21  Domestic Interests Climate action requires that we restrict GHG-intensive activities through higher prices, bans, quotas… In the long run, we all win from policies to mitigate climate change, but in the short-medium run: Winners among Producers Losers among Producers Producers of green energy Fossil Fuel Producers Producers of green transportation Energy-Intensive Producers (Metals, Glass, Paper, Fertilizer, Chemicals….) Producers that use Energy-Intensive Inputs Petrol Car Producers Airlines Cattle Farmers … 22  Domestic Collective Action Problems The costs of effective climate action are acute and concentrated = easy for industry to organize and lobby 23  Domestic Collective Action Problems The benefits of effective climate action are diffuse, they benefit everyone in the world = most (young) citizens benefit, but easy to free-ride off others’ climate protests 24 Domestic Collective Action Problems Two outcomes that can arise from collective action problems: 1. Climate action is stopped/watered down due to forceful lobbying 2. The costs of climate action are born by CONSUMERS, not BUSINESSES 1. E.g. The German Energy Transition largely paid for by energy taxes on households, not businesses 25  A Related Problem: Energy Poverty  When the price of GHG-intensive products rises, not all households can:  Pay to insulate their homes  Pay for an electric car  Install solar panels and heat pumps  Problem: The poorest households spend the biggest income share on energy 26 Vandyck et al. 2023 27 3 Common Policy Approaches 1. Carbon Taxes 2. Emission Trading 3. Green Industrial Policy 28  Carbon Taxes Put a tax on carbon to “price in” the negative effect of climate change (Pigouvian tax) What do you do with the tax revenue?  Pay for energy transition  Pay for adaptation, loss and damage of climate change  Use the money for something else Canada and Switzerland: Rebates (Lump Sum = everyone gets the same back)  still creates incentives, because your behavior does not affect your rebate  only the worst polluters worse off in the end  can be progressive – poorer households get back more  Problem: people tend to underestimate their rebates and overestimate the costs of carbon taxes 29 Carbon Taxes – How are Lump Sum Rebates Progressive? Household A – Lower Middle Class Household B – Upper Class Make $30,000 a year, and spend 10% - Make $200,000 a year, and spend 5% - $3,000 on energy $10,000 Carbon tax increases price of energy by Carbon tax increases price of energy by 10%, additional cost: $300 10%, additional cost: $1000 All citizens get back $500 – household A All citizens get back $500 – household A has $200 more in their pocket than before has $500 less in their pocket than before 30  Emissions Trading: How do carbon markets work? – YouTube (1:42-4.13) The world’s largest carbon market: European Emissions Trading System (ETS) Source: MSCI 31  Globalized Trade = Carbon Leakage (?) High price of carbon => companies shift production to countries with lower carbon prices  Evidence of existence of carbon leakage is mixed: so far, seems limited, but we don’t know what would happen at higher carbon prices 3 possible solutions to carbon leakage: 1. Global price on carbon (very, very hard to negotiate) 2. Tariffs on foreign goods at the border to “level the playing field” 3. Give free permits/tax breaks to companies that export/compete against energy-intensive imports 32 The EU Carbon Border Adjustment Mechanism Initially, EU gave away free ETS permits to companies to “level the playing field” in import- competition and exports Problem: Lots of free permits limit incentives to decarbonize New solution: Instead of free permits for import competition, CBAM: tariff on products from countries that do not have equivalent carbon prices  Companies liked the idea of the CBAM AND free permits  Companies did not like the idea of paying for permits when CBAM introduced Note: This may incentivize countries that are dependent on EU market to also put a price on carbon 33 WTO: What is Allowed? You CAN impose trade measures to prevent climate change – exceptions for environmental protection in GATT Article XX BUT those measures can’t be arbitrary or discriminatory:  You CAN impose a CBAM  You CAN put tariffs only on products from countries without carbon pricing  You CAN’T impose a CBAM and ALSO give your industry free permits Sorry, European Industry, you can’t have it all 34  “Big Green Push”: Green Industrial Policy Some argue that green industries should be treated as “infant industries” Green transition requires large-scale investment in low-carbon technologies Changes to public and private infrastructure:  charging networks for EVs,  pipelines for green hydrogen  smart grids in energy networks  … Green industrial policy has political benefits:  Instead of imposing costs on polluters, you give incentives and subsidies to green industries  Building up your green industries creates jobs  Green industrial policy fosters industries that will lobby in favor of climate action 35 US Inflation Reduction Act 2022 Introduces Tax Incentives, Grants, Loan Guarantees Tax credits (=subsidies) for companies investing in clean energy, transport and manufacturing Tax credits for consumers to make EVs, solar panels, heat pumps etc. more affordable 36 WTO Rules and the US IRA Many of the tax breaks are only applicable to locally produced goods (or goods produced by “trade partners)  E.g. consumers get a tax break for EVs produced in the US, but not in the EU  What WTO rule does that violate? The EU might challenge the IRA at the WTO 37  Limits of State Capacity Definition State Capacity: “ability and effectiveness of a government or state in performing its functions and responsibilities, including policy-making, implementation, and service delivery, to meet the needs of its citizens” (Peters, 2018) Green transitions require money and good governance:  Make and incentivize major investments  Monitor and enforce climate laws  Monitor the effective use of climate subsidies and climate aid  Build resilient infrastructure and disaster response Many developing countries lack the state capacity to effectively implement a green transition 38 International Climate Finance “financing that seeks to support mitigation and adaptation actions that will address climate change” Under UNFCCC, developed countries are supposed to provide and mobilize funds for developing countries’ climate action  In Paris, developed countries reaffirmed commitment to mobilize $100 billion per year until 2020  2022 exceeded $100 bn for first time ($118bn)  In Baku, they just agreed to increase that to $300 billion per year until 2030. Developing countries called this “a joke,” - trillions are needed 39  A New Supply Challenge: Raw Materials Energy transition depends on critical raw materials used in batteries, low-carbon power generation and electricity grids Danger of disruptions – countries (and companies) have started to invest in lowering their dependence:  recycling, at-home processing, substitution Watch out for global fights over raw materials:  https://www.nytimes.com/2022/03/18/podcasts/the- daily/cobalt-climate-change.html 40 Next: Foreign Aid & Immigration