Globalization

Unit 6: Financial Crisis, the IMF, and the World Bank

Part 1: 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

”If you owe your bank a billion pounds everybody has a problem.”
—The Economist

Throughout history, and for numerous reasons, most nations have experienced a financial crisis of one sort or another. For instance, following WWI, Germany was forced into crisis by the allies’ insistence on war reparation payments which—because the debt was primarily financed through printing money—(1) collapsed the value of the Reich mark, (2) eroded the savings of the of the middle class, and (3) empowered Hitler’s Nazi party. As another example, America’s heyday of the 1920s came to a devastating end with the sudden and unexpected collapse of the U.S. stock market in late 1929. In a matter of weeks the New York Times index of industrial stocks fell nearly 50%—from a high of 452 to a low of 224. And by the mid 1930s roughly 25% of America’s banks had failed. Similarly, a financial crisis struck Thailand in June of 1997 and quickly spread throughout Southeast Asia. Foreign investors sought to “cash out” of the region before the pegged exchange rates—which secured their investments—unraveled under intense speculative attacks. Over ensuing months, the value of Thailand’s baht and South Korea’s won, to name but two, depreciated by nearly 50%.

By definition a financial crisis is the result of:

a banking crisis
an exchange rate crisis
some combination of the two

The following paragraphs will explore these factors in more detail.

A banking crisis. A banking crisis occurs when the banking system becomes unable to perform its normal functions and is threatened with disintermediation—that is, when it becomes unable to serve as an intermediary between savers, investors, and borrowers. A classic example of a banking crisis occurred during America’s Great Depression. The banks—which functioned by lending depositors’ funds out to borrowers—became unable to service the depositors because borrowers defaulted. When the banks failed, everyone who lost their money was forced to cut back on consumption. Business had no choice but to respond by laying off workers, thus spreading the recessionary effects. In fact, even governments themselves are susceptible to crises brought on by disintermediation. For example, imagine a government that issues bonds or takes on loans in order stimulate growth through deficit-financed spending. If the spending is unsuccessful, no new income will be created, and the government will face a crisis. The financial crisis in 2008 and the government’s response is just such a circumstance, and only time will tell if their stimulus creates the necessary new income to successfully recover.

Exchange rate crisis. An exchange rate crisis occurs when a nation cannot maintain the international value of its currency. Under a fixed exchange rate system, crisis entails the loss of international reserves, which forces either devaluation or an abandonment of the system altogether. Under a flexible exchange rate system, crisis means an uncontrolled, rapid depreciation of the currency. Generally speaking, countries that attempt to peg the value of their currency to another without adequate reserves are most vulnerable to such a crisis. Exchange rate crises become financial crises because they are typically followed by bankruptcies and recession. For example, following the currency depreciations in Southeast Asia, many local banks that had borrowed U.S. dollars in order to finance the loans they made to local businesses failed. The dollars these banks now owed to the international investors increased in value by nearly 50% relative to what they were owed from loans they’d made in their national currencies.