Polisci110G Week 8 Notes
Polisci110G Week 8 Notes Polisci110G
Popular in Governing the Global Economy
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This 6 page Class Notes was uploaded by Erica Evans on Monday February 29, 2016. The Class Notes belongs to Polisci110G at Stanford University taught by Kenneth Scheve in Fall 2016. Since its upload, it has received 9 views. For similar materials see Governing the Global Economy in Political Science at Stanford University.
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Date Created: 02/29/16
Polisci110G 2/25/2016 Current Events • 1) Britain is considering leaving the EU • Why is being out of the EU bad for the British pound? • There is perfect free trade in the EU • Outside countries’ corporations see it as a single unit • The attractiveness of Britain as a site for foreign investment is decreased if they are not in the EU, because investment there would just be for Britain instead of the rest of the continent • 2) China’s trilemma makes it vulnerable to more shocks • China has a fixed exchange rate and relatively free capital movements • Over the last 6 months when there has been various economic shocks, there have been a lot of out-‐flows of reserve currencies • China has a huge amount of foreign currency, so they are not in danger of financial crisis • But they are trying to keep the exchange rate fixed while money flows out of their country, so in order to do this, they have have to sell more foreign currency • People think they will start implementing more capital controls • 3) South Africa outlines tax rises to stave off downgrade threat • different organizations like S&P decide the credit risk of various financial instruments – how likely it is that the gov/company does/does not pay back. • South Africa is in danger of its foreign debt becoming junk Financial Crisis: • Currency Crisis: (exchange rate crisis) is a significant depreciation in the exchange rate – common thresholds 15% to 25% over a year • Banking Crisis: a financial distress resulting in erosion of banking system capital – common rule is the closure, merger, or government takeover of one or more financial institutions • Twin Crisis: a combination of currency and bank crises • Debt Crisis: • Inflation crisis: inflation above 20-‐25% (really rapid rate) • Asset Crisis: Stock market decreases by a significant amount First Generation Crisis: • THIS IS IMPORTANT! • First generation crisis model: intuitive. Countries adopt unsustainable economic policies. This is not a surprise why the crisis took place. One of the most common ways that this happens is when countries try to ignore the trilemma. Maybe they have an expansionary monetary policy with a fixed exchange rate, or persistent fiscal deficit with a fixed exchange rate, or a persistent current account deficit with fixed exchange rate. A model: • As soon as investors think you will go off fixed exchange rate… they liquidate their domestic holdings 1986 Peruvian Crisis • KNOW THESE GRAPHS! Key theme: • Exogenous policy inconsistency (violating the trilemma) drives crisis. Perhaps easiest way to think of credit expansions is as the result of fiscal deficit monetization by the central bank. • But since anticipation of future depreciation can rive crisis, it can be expected future policy inconsistencies that cause a crisis. Second Generation Crisis: • Second Generation crisis: models focus on how the interaction between investors’ expectations and actual policy outcomes can lead to self-‐fulfilling financial crises. • Expectation à action of risk premium hike à raise cost of defending fixed ER à fixed ER abandoned and expectation fulfilled • Key idea is that crises can occur in countries who are not obviously implementing inconsistent policies What causes loss in confidence? • How do investors all coordinate their expectations? • An example: George Soros and 1992 ERM crisis. • One way to solve the coordination problem is one large trader who changes everyone’s expectations. • Soros made sure everyone knew he was making this big one-‐way bet which changed what everyone else thought. • The Bank of England was forced to sell marks in response – losing reserves in billions all morning long • By the afternoon, they had to abandon the exchange rate Why do crises spread? • A common shock might affect all countries similarly – like if the price of oil changes • Trade might spread a crisis because currency depreciation weakens fundamentals in other countries by reducing the competitiveness of their exports – international spillover • Financial interdependence can spread crisis because turmoil on one country can force creditors to recall their loans in another country causing a credit crunch in other debtor countries – international spillover • Crisis in one country can change expectations about other countries, especially if country-‐specific information costly and imperfect. Wallstreet bankers just have general ideas about a region and don’t really know that much about individual countries. U.S. Financial Crisis: • Credit expansion of early 2000s, U.S. financial sector allocated lots of resources to real estate and financed these investments through the issuance of new financial instruments • Significant portion of these instruments found their way into commercial and investment bank balance sheets • These investments largely finances with short0term debt • Real estate prices start to fall, defaults increase • Less credit available à banking crisis • Housing bubble: people thought housing prices will keep going up • Bank lending standards fell because they weren’t worried about people losing money on houses • Risk to lenders was low • Securitization: Key feature of the credit expansion à people who couldn’t qualify for a loan before can now get one • Selling securities to investors à diversifies risk. • These mortgage-‐backed securities à CDO Polisci110G 2/23/2016 Trilemma in History: • Experts thought the Gold Standard was the only way to organize the macro-‐ economic system • Everyone thought they’d go back to the gold standard after WWII • But they didn’t.. • There were high macro-‐economic costs of a fixed exchange rate because of instability during the depression • The patterns of previous devaluations undermined confidence in the gold peg • As soon as you think you might go off the gold system, everyone will want to exchange their money for gold because the longer you wait the less your money will be worth Terms: • Balance of payments = current account + capital account = always equal to zero • Current account: balance of payments on goods and services + net international transfer payments + net factor income from abroad • Capital account: sales of assets to foreigners – purchases of assets from foreigners • Current account = -‐capital account • Adjustment to imbalances takes place differently under fixed and floating exchange rates – helps us understand what a country is going to choose Balance of payments: • If a fixed exchange rate, solve through interest rates (monetary policy) • If a floating exchange rate, solve through the exchange rate directly • Balance is restored as deficit countries see imports go down and exports go up while surplus countries see the opposite Bretton Woods System • After WWII – mass mobilized wars affected everyone. • Allies decided the post-‐war world would follow fixed exchange rates and independent monetary policy • We needed trade to recover the economies and prevent future wars • The system was designed to provide exchange rate stability • But they had to give up capital mobility • In the 19 century, you didn’t have capital controls • This was similar to the gold standard. All the other countries pegged their exchange rates to the dollar, and the U.S. was pegged to gold. • The difference was that it was more flexible. • Allowed for changes if there were persistent balance of payments problems • The IMF – coordinates this • The US functions as a stabilizing force, had a huge advantage and trade surplus • The U.S. was giving a lot of money – Marshall plan and spending money overseas in various conflicts (Korean war) which balanced these payments accounts Problems in the 1960’s • Bretton Woods period: until 1971 • Bretton Woods System came under strain • It became difficult to have effective capital controls -‐-‐ Rising capital mobility • There was domestic financial deregulation • Lack of monetary discipline in the U.S. because of Vietnam War and Great Society programs lead to budget deficit which caused inflation and pressure on the dollar • Investors and governments cashed out $7 billion taking 40% of America’s gold reserve 1970’s • Struggle to figure out what the new international monetary policy will be • 1973: after Bretton Woods we have to revisit the trilemma • But now we have to accept that capital will be mobile because no one is able to control it • All countries are choosing along the financial integration line • What did countries do during this period? • Most countries are not choosing monetary independence – but the big countries are like the U.S. and Australia Democracy: • ***Expansion of the franchise and democratization around the world led policymakers to value monetary independence more in adopting monetary and financial policies • Voters like growth and dislike inflation and unemployment and they vote retrospectively through weighing the present more than the past. • Democracy effect: politicians adopt floating ER and capital mobility or fixed ER And capital controls Options: • 1) Central bank independence • 2) Fixed exchange rate with low-‐inflation anchor • Right wing parties care more about inflation and less about unemployment • Left wing parties care more about employment and less about inflation Four sets of domestic interest groups: • Export-‐oriented producers • Import-‐competing producers • Non-‐traded-‐goods producers • Financial services
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