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Polisci110G Week 8 Notes

by: Erica Evans

Polisci110G Week 8 Notes Polisci110G

Erica Evans
GPA 3.9

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Notes from 2/25 and 2/23
Governing the Global Economy
Kenneth Scheve
Class Notes
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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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