Globalization

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

Part 2: Causes of Nation-State Level Crises

Financial crises at the nation state level occur, fundamentally, for two reasons: (1) macroeconomic imbalances, such as large budget deficits caused by overly expansionary fiscal policies; and (2) volatile international financial capital flows out of the economy.

Macroeconomic imbalances. The “lost decade” of the 1980s was, for many Latin American nations, a period wrought with financial crisis of the macroeconomic imbalance sort. Following WWII many of these nations sought isolationist policies that relied on government expenditure for industrial development—government monopolies operated the airlines, the energy, the mills, the telecommunication, and so on. These policies often resulted in spending that far outpaced the tax revenues collected. In order to finance this spending, the governments resorted to issuing bonds—typically to foreign investors—with the “guarantee” of a pegged exchange rate. As a last resort, bonds were even issued to their own central banks.

These policies, coupled with the inherent inefficiency of state-run industry, were a recipe for disaster. By requiring the central banks to purchase their bonds, the governments were essentially printing money. This led to massive inflation—often over 1000% per year—and (as you will recall from Unit 5) put tremendous pressure on their currencies to depreciate. Knowing these governments could not pay their debts, and fearing total financial ruin, foreign investors and financial capital quickly headed for the door. In the end, the inefficiencies of these state-run economies and their resulting macroeconomic imbalances led to nearly a decade of negative economic growth and declining living standards in Latin America.

For an audio clip on the need for debt relief in developing nations, listen to this NRP interview below. John Ydstie talks with Nancy Birdsall, head of the Center for Global Development in Washington D.C., about the progress that has been made in relieving the debts of the world’s poorest countries. (4:30) Birdsall is co-author of Delivering on Debt Relief: From IMF Gold to a New Aid Architecture. The book is published by Institute for International Economics, April, 2002.

AUDIO CLIP: NPR Audio: Debt Relief (4/18/2002).
http://discover.npr.org/features/feature.jhtml?wfId=1141922

Crises caused by macroeconomic policies can be cured, and on paper the solution is quite simple, but the consequences can be painful and are often politically difficult. These steps include:

Deficit financing. Although macroeconomic imbalances can lead to crisis, one should not take the above example to imply deficit financing is always bad. For example, during the Great Depression, the U.S. deficit-financed spending put people back to work through “New Deal” projects—leading to increased consumption, private sector hiring, economic recovery, and new tax receipts that could pay back the initial debt. Thus, deficit financing is not inherently bad or good, but ultimately depends on whether enough new growth is created so that the old debt can be comfortably absorbed—a debate often raised when contemplating the current state of the U.S. economy.

VIDEO: Is Borrowing and Debt Owed to Foreigners a Good Thing or a Bad Thing?

Volatile international financial flows. Volatile international financial flows, as described above in the case of South East Asia, are another common cause of crises that have been the subject of much debate in recent years. These crises are due in large part to recent advances in technology coupled with increased openness in financial markets, which now make it possible to shift enormous amounts of money from one market to another almost instantaneously. While many argue in favour of the efficiencies of such technology, others claim that the gains are far outweighed by the volatility caused by these freedoms.

Today, investors move billions of dollars in and out of markets across the globe on a daily basis in response to the slightest change in information about interest rates, exchange rates, and other macroeconomic conditions. A problem created by this free flow of money and information is a kind of “herd” mentality, where small adjustments in economic conditions can result in massive destabilizing financial flows. The example of the crisis in Southeast Asia is a perfect case in point. The crisis began in a few nations that investors feared had growing macroeconomic imbalances—caused by growing trade deficits and politically corrupt “crony” capitalism—and quickly spread throughout the region, adversely affecting many nations without the same fundamental weaknesses.

VIDEO: The IMF and the Asian Crisis

http://web.singnet.com.sg/~mielbox/welcome13.html

Regulatory control. The destabilizing potential of large-scale capital that flows out of nations has called into question the need for some sort of regulatory control. Proponents of such legislation argue that placing restrictions—such as a transaction tax—on the cross-border flow of capital would cause investors to more carefully consider information, helping to minimize destabilizing “knee-jerk” reactions. On the other hand, economic theory clearly holds information and unfettered access as key to market efficiency.