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The Global Capital
Hill, Chapter 11
Review: Basic Economics
 Economists teach that the most efficient use of
resources can be achieved by free competition
 “Every individual seeks the most advantageous
employment for his capital….
 “Study of his own advantage necessarily leads
him to prefer that employment most
advantageous to society”
- Adam Smith, 1776
 Commercial banks – take deposits from savers,
pay interest, and lend money to borrowers
at slightly higher interest
 Can grow very large
 Most employees make <$150,000/year
 Investment banks – create securities (stocks, bonds,
derivatives) for companies and sell them
 Also arrange mergers
 Many employees make $1 million or more a year
How do you know when
you’ve made money…
 at a commercial bank?
 There are many businesses where it takes a long time
to know if you’ve made money
 Real estate
 Cattle breeding
 But banking is probably the biggest and most
Does this create any
What to do about the dangers
of banking?
 For centuries there has been disagreement
 Free enterprise banking – let people create and run
banks freely
 Advocates believe most problems of banking are caused by
government mistakes
 They fear regulation will reduce efficiency
 Government-regulated banking – government sets
rules about who can start a bank and how they can run it
 Advocates believe government can reduce the dangers
without greatly reducing efficiency
A brief history of banking
 Traditionally, governments regulated banking tightly
 In 19th century in US and UK, much freedom of banking
was introduced
 Helped cause rapid economic growth
 Also contributed to many ‘panics’
 Banking scandals were believed to have contributed to
Great Depression of 1930s
 When free trade was promoted in 1940s, 50s, banking
was tightly regulated
 In 1970s, tight regulations in many industries
(banking, trucking, airlines) were believed to be
preventing economic innovation and growth
 Much deregulation in late 70s, 80s, 90s, 2000s
Functions Of A Generic
Capital Market
Figure 11.1: The Main Players in a Generic Capital Market
Attractions Of The Global Capital Market
Borrowers benefit from:
 the additional supply of funds global capital markets provide
 the associated lower cost of capital (the price of borrowing
money or the rate of return that borrowers pay investors)
 The cost of capital is lower in international markets because
the pool of investors is much larger than in the domestic
capital market
Attractions Of The Global Capital Market
Figure 11.3: Risk Reduction
through Portfolio
Growth Of The Global Capital
 Global capital markets have been growing at a rapid pace
 In 1990, the stock of cross-border bank loans was just
$3,600 billion
 By 2006, the stock of cross border bank loans was $17,875
 The international bond market shows a similar pattern with
$3,515 billion in outstanding international bonds in 1997,
and $17, 561 billion in 2006
 International equity offerings were $18 billion in 1997 and
$377 billion in 2006
Manias and Crashes
 Unfortunately, the world economy since the time of the
Holy Roman Empire (800 years ago!!!) has been
plagued by
 Manias – periods when everyone believes they can make
money doing something that turns out not to be so great
after all
 Example – the dotcom boom of the early 2000s.
 Crashes – periods when the economy has huge
problems as the problems of the mania period unravel
Kindelberger, Manias, Panics, and Crashes,
Mid 2000s: The world had a
lending & investing mania
 Deregulation
 Excess savings in developing countries (China, Taiwan)
and Japan
 It’s hard to spend money in a fast-growing economy
 “Easy money” in the developed countries
 U.S. government allowed money supply to grow
 Banks, most of all in U.S., issued ‘sub-prime’
 Banks did not want to own them, but packaged pieces
of many mortgages into bonds
 Banks said the mortgages underlying the bonds wouldn’t
all default at once
 Rating agencies (firms resembling Consumer Reports) agreed
 Developing country & Japan investors bought
 Eventually the pile got so bad people saw the problems
The Crash of 2008
 Many banks have so many hard-to-evaluate
investments that no one knows if their assets are
worth more than their liabilities
 Would you invest in your bank if your deposits weren’t
government guaranteed?
 Lent huge amounts of money to banks
 Took over dying banks
 Launched huge stimulus packages (deficit spending)
So what do we do?
 Do we increase regulation?
 If so, how?
 What do we do about dying banks?