Global Finance The Political Economy of States, Firms, and Markets · 2019-11-10 · Currency Traders •Currency traders, also called currency speculators,buy and sell international

Global Finance The Political Economy of

States, Firms, and Markets

Today’s Agenda

• Brief Review

• Breakdown of Bretton

Woods System

• Debt and Financial Crises

Breakdown of Bretton Woods

System

U.S. Fiscal and Trade Deficits• In the United States,

spending on Vietnam, along

side new domestic social

programs, increased under

President Johnson,

contributing to rising fiscal deficits and growing inflation.

• U.S. trade deficits also grew

as consumers bought more

goods from rebounding

foreign economies.

The End of Bretton Woods4.9 U.S. Exports and Imports, 1960-1972

Billions of dollars

The End of Bretton Woods4.11 U.S. Fiscal Deficits, 1965-1972

Billions of dollars

Nixon and the End of the Gold Standard • On August 15th 1971,

President Nixon declared that the United States would bring an end to the convertibility of the dollar to gold, effectively ending of the gold standard used for Bretton Woods-era.

Financialization & the Globalization of Finance

• The end of the Bretton

Woods era contributed to

the growth of financial markets, which was

accelerated by the financial

deregulation of the 1970s

and 1980s.

• Deregulation of banking relaxed Depression-era

price controls over credit

and savings, allowing banks

to operate in a wider array

of investment areas around

the world.

Eliminating Capital Controls

From the 1970s to the 1990s,

governments lifted controls on

capital, for example:

•1981 U.S. removes

restrictions on international

banking

•1984 ¥/$ agreement

liberalizes Japanese

investment

•1986 London Stock Exchange

accepts foreign securities

deals

• Rise of institutional capital investment

• Greater mobility of capital for efficient production

• Greater currency speculation & market volatility

http://data.worldbank.org

http://data.worldbank.org

Foreign Direct Investment FlowsLiberalized capital flows brought a major shift in the volume and distribution of foreign direct investment (FDI) around the world.

1970 2015

• Capital investment flowed to new areas of opportunity in the developing world.

• By the year 2000, FDI in Chinareached over $40 billion.

http://data.worldbank.org

• In recent years, FDI in China has exceeded $200 billion.

• In part, this dramatic increase in FDI reflects China’s economic opening to market forces starting in 1978.

http://data.worldbank.org

Remember when

$40 billion seemed

like a big deal back

in 2000?

The Future of Capital: Asia

Understanding Financial Markets

The Rise of Financial Markets• While trade involves the use of

capital to purchase goods and

services, the world of finance

and investment involves the use of capital to obtain other forms of capital.

• Financial markets include a

variety of different types of

capital exchange and investment.

1. Equity markets

(public/private)

2. Bond markets

3. Derivative

markets

4. Currency markets

1. Equity Markets• Stocks are ownership shares in

companies, also called “equities.” • Equities may be reserved for private

ownership (e.g., a family business), also known as “private equity.”

• Publicly traded equities (or stocks) can be purchased on major stock exchanges (e.g., NYSE) or traded “off-exchange” between parties.

Stockholders need to monitor their investments, both in publicly and privately traded companies.

Major U.S. Stock Exchanges

Chicago Board Options Exchange (CBOE) is the largest U.S. options exchange.

NY Stock Exchange, founded 1792; world’s largest stock exchange (by market cap).

National Association of Securities Dealers Automated Quotations, dealer-based exchange.

The Investors Exchange was founded as an alternative exchange in 2012 and received SEC approval to list companies in 2017.

The Chicago Exchange was founded in 1882 and was purchased by NYSE’s parent company (Intercontinental Exchange) in 2019, ending its 136-year run.

There are several stock market exchanges in the United States, though only the NYSE and NASDAQ exchanges have a market capitalization of greater than $1 trillion.

Sto

ck

p

erfo

rm

an

ce

o

n U

.S

. e

xch

an

ge

s

(O

cto

be

r 2

01

8-O

cto

be

r 2

01

9)

Dow Jones Industrial Average,

1900-2019Housing Market Crash

Nasdaq Composit

Index, 1978-2019

Dot Com Crash

World Stock Markets

• Bonds and other notes of debt are a commitment to pay an established rate of return or interest within a specified period of time.

• Governments, companies, and other entities can borrow capital by issuing bonds to finance their activities.

2. Bond Markets

Securities are effectively tradable loans to governments and private firms.

3. Derivative Markets•Derivatives are a type of security whose value is established by the underlying value of something else

•Common types of derivatives include options, futures, and swaps.

•Derivatives can be simple or complex collateralized debt obligations (e.g., structured investment vehicles, or SIVs)

Options: The right to

buy/sell (e.g. stock) at a

specified price.

Futures: Contract to buy

an asset today at a

specified price.

Swaps: Contract to

exchange cash flows in

the future.

4. Currency Markets• Foreign currency trading, also

known as foreign exchange, Forex,

or FX, is the global market for buying and selling currencies, with daily trading volume exceeding $5 trillion (world’s largest market).

• Foreign exchange (forex) market trading has such a large impact on the supply and demand for currencies that it can undermine central bank policies.

Foreign Reserves by Country• The United

States had foreign currency reserves of $123.5 billion as of August 2018.

• The United Kingdom had $187.4 billion in foreign reserves as of August 2018.

Currency Traders• Currency traders, also called

currency speculators, buy and sell international currencies to profit from fluctuations in currency values.

• George Soros, a Greek holocaust survivor, made billions by trading international currencies. In 2018, Soros had a net worth of $8 billion, after donating $18 billion to his philanthropic agency, Open Society Foundations.

Implications of Liberalized Finance • In a world where capital moves

freely, quickly, and in many forms and directions across

national borders, there are

greater rewards for investors,

but also greater risks.

• When a large number of

borrowers cannot repay their

lenders or investors, this

creates the potential for major financial crisis.

"If you owe your bank a hundred pounds, you have a problem. But if you owe your bank a million pounds, it has."- John Maynard Keynes

Debt and Financial Crises

The Good Old Days• During the Bretton Woods era,

capital controls contributed to

a relatively high degree of stability in currency values

and financial markets.

• These arrangements became

untenable due to the limits of

U.S. macro-economic policy, as

well as the growth of financial

markets.

Major Debt & Financial Crises

• Since the 1970s, the rapid movement of short-term capital, or “hot money,” has caused a series of devastating debt and financial crises.

• Some of these crises have been interrelated, as worried investor have rapidly withdrawn capital from entire regions, contributing to a “contagion” effect.

• 1980s Debt Crisis

• 1990s Devaluations

• 2000s Financial Crisis

1980s Debt Crisis

Explanation for the Crisis• In the 1970s, ”petrodollars” from

oil rich countries provided a

source of newfound investment in

developing countries, causing

third world debt to increase from

$100 to $600 billion.

• When world interest rates more

than doubled from 1979-82, a

stronger dollar made this debt

more expensive (imposing $22

billion in interest payments) amid

a global recession that slowed

domestic economies.

1990s Currency Devaluations

• 1994 Tequila Crisis

• 1997 Asian Flu

• 1998 Ruble Devaluation

Case Study: 1994 Mexican Peso Crisis• Political instability

(Chiapas, Colosio)• Foreign direct

investment flows reverse

• Imbalance of payments

• Depleted foreign reserves

• December Devaluation

Despite jubilation over Mexico�s entry to NAFTA in 1994, a series of domestic political crises spooked international investors, leading to capital flight, and a severe devaluation of the national currency.

Tequila Crisis

Ganapolsky & Schmukler, 1998

Thailand spent billions of dollars of its foreign reserves to defend the Thai baht against speculative attacks, but ultimately had to devaluate its currency, causing a 20% drop in value.

Case Study: 1997 Thai Baht CrisisFrom mid-1980s to 1997, a massive injection of FDI and loans fuels

5-15% growth and speculative real estate bubble.

From Thai Crisis to Global Contagion

Despite IMF intervention to help support the Thai baht,

there was a region wide panic in SE Asian financial markets,

leading to massive capital flight with impacts around the

world.

Russian Ruble DevaluationIn the 1990s, Russia struggled with the economic challenges of maintaining a fixed rate of exchange for the ruble (for political stability) amid negative growth and deficit spending, partly due to the costs of the war in Chechnya.

2008 Global Financial CrisisU.S. Housing, Debt, and Deliverance

Since 1929, real (inflation-adjusted) home prices have grown at a rate of about 2% annually.

HOUSING MARKET

BUBBLE

Lending to high-risk

(subprime)

borrowers,

contributed to

growing home-

ownership, but an

unprecedented

inflationary bubble.

When �interest only,�adjustable rate

mortgages reset many

borrowers found

themselves in over

their heads.

HOUSING MARKET BUBBLE

Generous lending conditions, including to high-risk (subprime) borrowers,

contributed to growing home-ownership, but an unprecedented

inflationary bubble. When �interest only� adjustable rate mortgages reset,

many borrowers found themselves in over their heads.

Deriv

ativ

es a

nd C

olla

tera

lizat

ion

Some Other Contributing Factors:

Supportive Monetary Policy: Made ample capital available to borrowers.

New forms of investment expanded the market.

Optimistic Analysts: Many investors got pumped up by exuberant forecasts and strategies.

Fanny & Freddy

expanded lending

to subprime

borrowers, and

owned or

guaranteed about

half of all U.S.

mortgages.

—FIN—