Download “The exorbitant priviledge” (Giscard d`Estaing)

The modern financial system
Eurodad AGM 2008
Sargon Nissan
nef (the new economics foundation)
Traditional function of the
Financial System
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To transfer money from surplus to where
there is a demand/need for it
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Banks are crucial to this process
– Take in savings (Deposits)
– Loan the deposits to firms & individuals at a
higher rate of interest
Government Intervention
Government control of the financial system, via:
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Interest rates
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Reflect time value of money
Reflect risk of default (non-repayment)
Fractional reserve banking
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How much bank must held as proportion of deposits
$100 deposited in a bank with 20% fractional reserve
requirement increases money supply by $400
The birth of the modern financial system
Features of the post-BW system
Gradual end on the constraints of money creation
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Evolved from using a gold standard to $ pegs
with a gold guarantee
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1971 Nixon Shock
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Gold link broken by Nixon due to domestic spending
and costs of Vietnam war
Fiat money system
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Money could be created without underlying asset
backing it
Features of the post-BW system
Bretton Woods-era gave way to freer flows of capital and
floating exchange rates
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Volatility drastically increased
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Volatility created need to hedge against fluctuating prices
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Contradicting expectations and orthodox economic
predictions
New markets in volatility-management tools: derivatives
Created marketplace for speculative profits and amplified the
use of these tools
Assault on transparency
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Vast majority of derivatives ‘OTC’ – over the counter and not
traded on exchanges
Created mechanism to avoid supervision or regulatory
oversight
Features of the post-BW system
New markets in derivatives allowed huge
profit opportunities via speculation on
price movements that were disconnected
from real economic activity
The era of financialisation
Financialisation
Developed countries’ financial systems exploded
relative to other parts of economy, particularly
the role of banks
Climate of greater general indebtedness and
increased gearing (debt to equity ratios)
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Financial assets and debts become larger
proportion of GDP
Banks strategically became focused upon
commissions business and speculative operation
Boom in mortgage lending, speculative
price bubbles & Financial ‘innovation’
Bubbles
• Debt being used to inflate value of assets against
which more debt is raised to re-start the cycle
Financial innovation/Derivatives
• Also used to evade legislative oversight
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e.g. 1999 Amendment to US Community Reinvestment
Act which excluded banks’ mortgage investment in
securities from scrutiny – then sub-prime lending
doubled from 2001 to 2006
Policy Blame
• Ignored bubbles and stoked consumer spending
via indebtedness
Financialisation
Real income levels did not follow growth
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Finance met gap in income levels
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Created climate for bubbles with loose
monetary policy
– US mortgages grew $2.1 to $3 trillion from
2001 to 2006
– The proportion of that which was sub-prime
jumped from 8.6% to 20%
Financialisation
Key features of international financialisation
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Liberalisation of capital account
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Capital flows increasingly taking form of
FDI and portfolio investment
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Inflation targeting priority over growth,
jobs, health or other social outcomes to
protect value of investment capital
Implications for Developing Countries
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Costlier Short Term borrowing
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Domestic financialisation
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Exposure of Short Term obligations (debts
that have to be repaid in short term) as
borrowing has dried-up
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Export and trade demand
GROUP EXERCISE
The flow of money and the reserve currency
“The exorbitant priviledge” (Giscard d’Estaing)
How does the money system reveal the challenges of
reform?
An international reserve currency
A Currency used as a reserve or store of wealth,
as if it were an asset itself - the US Dollar
Source of wealth for whoever has the priviledge
to issue that currency
• Un-cashed cheque at everyone else’s
expense
• Permits deficit financing
– Vietnam and Iraq wars
– Current US bank bailout
Historic role of international currencies
No reserve currency has ever been permanent
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Drachma from 500 BC replaced by Roman
aureus and denarius
Reserve currency reflects political power and
authority
•
Gold coins in Genoa and Florence from 13th
Century, then usurped by Venetian ducato by
15th Century
Modern Era
Britain’s challenge to Dutch
• guilder overtaken by sterling by 18th Century
• Bank of England and Stock Exchange established
included vibrant foreign currency exchange
Stability of Britain’s economic strength
• sterling retained position for 100+ years
• By this point tokens (e.g. symbols of metallic value)
and receipts (bank notes) had become symbols of
money and value, not actually holding value
Gold Standard
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Limited gold restrained creation
of money ‘tokens’
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Where gold was unavailable
poorer countries began to hold
financial assts convertible into
gold
Start of process of countries’ central banks
holding foreign exchange reserves as part of
normal practice
End of Bretton Woods
Nixon shock
• Tension of the consequences of exploiting
reserve currency
– When world demanded gold for dollars, France,
UK, Nixon ended Bretton Woods system Valerie
Giscard d’Estaing “The exorbitant priviledge”
“Our currency but your problem”
End of Bretton Woods
Nixon shock
• Tension of the consequences of exploiting
reserve currency
– When world demanded gold for dollars, France,
UK, Nixon ended Bretton Woods system Valerie
Giscard d’Estaing “The exorbitant priviledge”
“Our currency but your problem”
Who said this?
“The exorbitant priviledge”
(Valerie Giscard d’Estaing)
Operating a reserve currency brings costs
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Euro area lacks political will for unity and
avoids promoting Euro as reserve
Euro area not de-coupled, but connected, to
US crisis
Flight to quality is thus benefiting dollar –
where else is there to go? For the moment
A globalised system – no winners
China’s Dollar dependence
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Reserve accumulation over $1tn
Power to destabilise US financial system but
only at huge cost to itself
Not just China, but Brazil, India, Russia and
oil-exporting Gulf states all similarly attached
to US situation
No winners – for now
What will change this? Maybe the current crisis
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US domestic economy transformed, like 19th C UK,
to financial services while neglecting exports,
manufacture and jobs
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Weaker dollar needed to stimulate US economy but
counter-balanced against damage it does to its
‘Faustian’ partners
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US lacks surpluses given its economic weakness to
sustain strong dollar as reserve
Assessing the impact on Developing
Countries
Eurodad AGM 2008, section II
Sargon Nissan
nef (the new economics foundation)
Emerging Markets - 2008
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Severe losses in equity and bond markets
Corporate defaults in specific sectors, e.g.
construction and real estate
Local cost of funding much higher and
likely to remain so – limiting investment
Investment funds investing in EM debt
have suffered outflows
Economic expectations are for easing
inflation, growing current account deficits
Capital flows – still going uphill
Net capital flows have been negative due to reserve
accumulation
2007
China $1.5 trillion
Russia $455 billion
Mid East $638 billion
Africa $145 billion
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Sterilisation of exchange pegs by purchase of US
Treasuries
Provides Insurance
Liberalisation’s Logic
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Increased investment
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Stability
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Better targeted
investment (efficiency)
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Growth
Emerging Markets fuelling the crisis
Reserves from Current Account surpluses
transferred into property bubble
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Exchange rate pegs are a crucial driver of
reserve accumulation
– Accounting for 75% of reserves accumulated
by DCs since 2002
– Export expansion and import suppression, via
exchange rates
Emerging Markets fuelling the crisis
Countries also accumulate as self-insurance
– Of reserves accumulated since 2002, 1/3
borrowed
– India’s reserves 100% borrowed
Why?
• Expensive but driven by desire to prevent
currency appreciation and deficits, plus
provides a cushion against shocks
Vulnerability to the crisis
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Consider factors which impact sovereign
financial autonomy
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Foreign banks’ involvement in Developing Countries
(grown)
FDI restrictions in banking sector
Asset share of bank assets by foreign banks
Reserve accumulation
‘Fluidity’ of flows
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Net private inflows vs gross outflows
FDI outflows, including from ‘non-official’ sources
Vulnerability to the crisis - Risks
Financial contagion
– Dropping stock markets, currency
pressure
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Trade
Remittances
FDI and portfolio investment
Lending
Aid
Vulnerability to the crisis
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Exporters to most affected countries (e.g. Mexico)
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Countries with exports tied closely to global
demand levels, or high income elasticity
(commodities or tourism)
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Countries with significant remittance flows
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Very open economies where investment biased to
FDI or portfolio investment (e.g. South Africa)
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High current account deficit countries –
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increasing pressure for devaluation and inflation, also
exacerbated by high government deficits (India)
Analysing Crisis Impact
Reliance on exports
Reliance on international finance
– Some forms of reliance are inherently more
precarious, e.g. extent of FDI accounted for by
portfolio flows, bank lending…
External penetration of the financial system
– Home bias, lack of local knowledge, regulatory
power of domestic authority, capital flight risks
Analysing Crisis Impact - Trade
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Trade openness
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Current account balance
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Export focus (to whom?)
– South-south links
– Extent of presumed ‘decoupling’ – looks like
we’re all in it together
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Export vulnerability (Elasticity of demand for key
exports)
Analysing Crisis Impact
Reliance on international finance
Openness of capital account
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Capital inflows, Bank flows, Portfolio flows as % of GDP
Domestic banking sector’s relative importance
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% of domestic assets and liabilities in domestic banks’
portfolios, % of foreign currency denominated debt
Reserves
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Reserves to GDP - Ability to offset foreign shortfalls
Currency denomination of foreign exchange reserves
Implications
Implications of Crisis Impact
Regulation and Governance
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Potential for renewed emphasis on bilateral
forms of influence versus multilateral structures
of negotiation, such as collective trade or finance
rules
– Altered regulatory regimes
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de jure (e.g. Basle II)
de facto (ratings agencies and other private actors)
– Risk of a technocratic approach being taken
Implications of Crisis Impact
Solidarity
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Different countries will be impacted
differently, challenging in novel ways the
capacity to develop a collective response
from the South
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Vulnerability and agency (or lack of)
reveal new cracks in collective bargaining
positions
Implications of Crisis Impact
Institutional power
Potentially reinvigorating consequences for
IMF and other BW institutions as political
and economic actors.
Governance issue had waned as their
significance and centrality contracted but
could once again be a crucial component
of any new settlement
Implications of Crisis Impact
Changing of the guard, not the
system?
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New centres of financial power
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Too soon to proclaim the death of the old
centres of finance?
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Will the name-plates change and nothing
else?