New international money game-7th edition summary
New international money game-7th edition summary
1 A System Is How the Pieces Fit
The years since the early 1970s have been the most tumultuous in monetary history. The world price level in 2008 was more than five times higher than in 1970; never before have price levels increased so rapidly in so many countries. The US dollar price of gold at the end of 2008 was more than 25 times higher than the US$35 parity in 1970 – and this price had been 25 percent higher in the summer of 2008 than at the end of the year. A barrel of oil nearly reached $150 in June 2008, more than 50 times higher than at the end of 1970; the oil price had quintupled between 2003 and 2008 and then declined to below $50 toward the end of the year. The US financial system had shattered. The two large government-sponsored lenders, Fannie Mae and Freddie Mac, that together carried the credit risk associated with more than 50 percent of US home mortgages, were placed in a US ‘conservatorship’ because they were effectively bankrupt; the individuals and firms that owned both the common stock and the preferred stock in these firms lost all their money. AIG, the largest insurance company in the world, required a massive loan from the US Government. The US investment banking industry collapsed; two of the five largest firms disappeared, one by bankruptcy and the other by a forced merger, while two of the other large investment banking firms sold themselves to large commercial banks. Many of the 20 largest US commercial banks were forced to take capital from the US Treasury. The British banking system also was in turmoil. Northern Rock, the largest mortgage lender in the country, was taken over by the government. The British Treasury became a two-thirds owner of the Royal Bank of Scotland and a large owner of Lloyds. Similarly, banks in Ireland, Iceland, and even Switzerland received large capital investments from their governments. This global financial crisis led to a recession in most of the large industrial countries. Japan imported a recession because of a decline in the foreign demand for its autos and electronics and other manufactures. Similarly, Taiwan, South Korea, and Singapore experienced sharp declines in their exports. The growth rate in China declined sharply, and 20 million migrant workers became unemployed. The global financial crisis that began in the summer of 2007 is the fourth since the early 1980s. The first involved the inability of Mexico, Brazil, Argentina, and ten or so other developing countries to make the payments on their US dollar-denominated debt in a timely way. Their currencies depreciated sharply and many of the borrowers and banks in these countries became bankrupt; some large US banks that had made extensive loans to these borrowers would have failed if the regulatory authorities had not connived in the fiction that these loans were performing. The second financial crisis was in Japan in the 1990s, when most of the commercial banks and investment banks and insurance companies failed. At about the same time, many of the banks in Finland, Norway, and Sweden failed. The third crisis began in the second half of 1997 when the Thai baht depreciated sharply, which triggered the depreciation of the Malaysian ringgit, the Indonesian rupiah, the Philippine peso, the South Korean won and eventually the Russian ruble in the summer of the 1998, the Brazilian real in January 1999, and the Argentinean peso 2 years later. Once again many of the domestic banks in these countries failed when the currencies depreciated. Each of these financial crises followed the implosion of a credit bubble, which had involved the rapid growth in the indebtedness of a particular group of borrowers, often at annual rates of 20-30 percent for 3 or 4 or more years. During the 1970s the major international banks increased their loans to the governments and government-owned firms in Mexico and other developing countries at the annual rate of 30 percent; the external indebtedness of these countries increased from $120 billion at the end of 1972 to $800 billion 10 years later. During the 1980s and especially during the second half of that decade the real estate loans of the banks headquartered in Tokyo and Osaka increased at the rate of 30 percent a year. Industrial firms invested in real estate because the rates of return from ownership of property were so much higher than the rates of return on investment in manufacturing. The prelude to the Asian financial crisis of the second half of the 1990s was a large inflow of money from mutual funds and pension funds, which led to increases in stock prices and real estate prices. The global financial crisis that began in 2007 followed the sharp increase in real estate prices in the previous 4 or 5 years. These financial crises have occurred in waves, which generally have involved four or five or more countries usually at about the same time, although the debacles in some of the non-Asian countries in the late 1990s followed the collapse of the Thai baht by more than a year. Similarly, the credit bubbles that preceded these crises also occurred in waves that involved four or five or more countries at the same time. That so many countries were involved in these bubbles and crisis at about the same time suggests that they have had a common origin. The changes in the values of national currencies in the foreign exchange market since the early 1970s have been much larger than ever before, even after adjusting for differences in national inflation rates. The US dollar price of the euro varied within a range of 80 percent between 1999 and 2008 even though the annual inflation rates in the United States and Europe usually differed by less than 1 percentage point. At the end of June 2008, the US dollar price of the euro approached $1.58, higher than at any previous time – but by September the US dollar price declined to less than $1.30. The US dollar price of the British pound was above $2.00 in June 2008; by the end of the year the price had declined below $1.50.
Despite the turmoil in the currency markets and the security markets, national income and wealth surged at least until the second half of 2008. Tens of million of people have moved from poverty to the middle class in China, Brazil, South Korea, Mexico, and other emerging market countries as their economies have become more fully integrated with global markets. In 1980 the United States was the world’s largest international creditor country; its net foreign assets were larger than the combined net foreign assets of all other creditor countries. By 2000, the United States had evolved into the world’s largest debtor country, and its net foreign liabilities were larger than the combined net foreign liabilities of all other debtor countries. This dramatic change is the US international investment position has no precedent in the experience of any other country. Moreover, this change did not occur because US goods and services were too expensive; the paradox is the combination of a US trade deficit that has reached 6 percent of US GDP and yet a value for the US dollar that is so low that Europeans and Latin Americans have traveled to New York and other US cities for their Christmas shopping. Tourists find Disneyland in California and Disneyworld in Florida significantly less expensive than their counterparts in Europe and Asia. US net international indebtedness has been increasing twice as rapidly as US GDP. Mexico and Thailand and numerous other countries also experienced rapid increases in their indebtedness relative to their GDPs in the 1990s; when the inflow of foreign money declined abruptly, their currencies depreciated sharply and most experienced financial crises. The sharp increase in US stock prices in the late 1990s was a bubble; the market value of US stocks doubled in the 3 years after December 1996 when the Chairman of the Federal Reserve commented on ‘irrational exuberance.’ Stock prices in Europe increased almost as rapidly as in the United States. The implosion of this bubble in stock prices was followed by a recession but not by a financial crisis. The likelihood that the surges in national price levels, the large changes in currency values, the waves of asset bubbles, and the massive failures in banking systems are independent and unrelated events is low. A model is needed to link the large variations in the values of national currencies and the episodic surges in the prices of real estate and of stocks in different countries. Scientists in every field search for models that describe how the basic components of their universe fit together. The pervasive view in astronomy until the fourteenth century was that Venus and Mars rotated around the Earth. Galileo and Copernicus used the data obtained from new and more powerful telescopes to propose a revolutionary model that had the Earth, Venus, Mars, and the other planets rotate in a more or less flat plane around the Sun. Their model integrated the Sun, the planets and their moons, comets and asteroids and also placed the solar system within the constellation of stars. Einstein integrated the speed of light, matter, and energy. Biologists seek to relate the understanding of the most minute and basic components of life, including genes and chromosomes. Climatologists view patterns of wind, rainfall, temperature, and ocean currents in a comprehensive model.
Those who seek to become the Copernicus of the international financial arrangements must integrate the relationships among the monetary systems of the United States, Britain, Japan, Germany, and France and their neighbors that use the euro, Switzerland and more than 150 other countries each with its own money. The models must highlight the relationships among the changes in the values of the US dollar, the British pound, the Japanese yen, the euro, the Swiss franc, and other currencies with the changes in the rates of growth of money in each country and with the changes in the prices of domestic goods and of real assets and of securities denominated in each currency. The relationships among the planets in the models developed by Copernicus and Galileo have not changed in the last five centuries; Mars will never replace Venus as the planet closest to the Earth. In contrast, those who deal with international monetary issues recognize that the financial arrangements are in flux; the British pound was the dominant international currency during the nineteenth century before it was displaced by the US dollar at the outset of the First World War. While the US dollar has remained the dominant currency, the supremacy of the US dollar has been challenged by the shift in the US international financial position to the largest international debtor. Gold was at the center of international monetary arrangements in 1900, but at the periphery of these arrangements in 2000. Similarly, the relationships among both the levels and rates of growth of the GDPs of individual countries change; Japan was at the top of the GDP growth rate hit parade in the 1950s and the 1960s while China was in number one position on this hit parade in the 1980s and the 1990s. Countries often experience relatively high rates of growth during the first two or three decades after they begin to industrialize; subsequently their growth rates slow. Britain was the first country to industrialize during the middle decades of the nineteenth century; Germany and the United States then followed in the last several decades of that century
Fitting the pieces: central bank monetary policies
From time to time, the descriptive title for international financial arrangements has changed. The ‘gold standard’ was the applicable name during much of the nineteenth century and until the First World War; its dominant feature was that the central bank in each of the participating countries had a fixed price for gold in terms of its own currency. In the 1920s there was a modest change in the name to the ‘gold exchange standard’; its distinguishing feature was that some central banks acquired securities denominated in the British pound and in the US dollar as part of their international reserve assets. From the end of the Second World War to the early 1970s ‘the Bretton Woods system’ was the descriptor (derived from the village in New Hampshire where the treaty that established the International Monetary Fund (IMF) was signed); one of its key attributes – that currency values would be fixed or at least not allowed to vary significantly – was derived from the gold standard. Its innovative feature was that changes in currency values would be discrete and in accord with the provisions of the IMF Treaty. This system of adjustable parities became obsolete in the early 1970s; the thrust of the successor arrangement of floating exchange rates was that currency values would change in response to market forces, much like the prices in the markets for stocks, bonds, and commodities. One initial name for the new arrangements was the ‘Post-Bretton Woods system.’ Many central banks have intervened extensively to limit changes – and especially increases – in the price of their currencies and the term ‘Bretton Woods II’ has been applied to these arrangements. Virtually every country except the relatively small ones has its own national money, produced by its national central bank. Iceland, with a population of 300,000, has an independent central bank and its own currency. Panama and Luxembourg have much larger populations than Iceland but do not have a national currency; Panama has used the US dollar as its money for more than 100 years and Luxembourg used the Belgian franc as its money before the adoption of the euro. Central banks – the Bank of England, the Bank of France, the Federal Reserve, the Bank of Japan, and the Swiss National Bank – were established to enhance financial stability by providing an ‘elastic supply of currency.’ Each central bank initially had a fixed price for its currency in terms of gold, which was part of a ‘marketing plan’ to induce individuals to acquire its currency notes. During the last several decades of the nineteenth century the British, French, German, and American monetary systems were linked by flows of gold from one country to others. The theory was that the money supply and the price level in a country would increase in response to the inflow of gold; conversely, the money supply and the price level would decline in response to an outflow of gold. When a national currency was pegged to gold, it was also pegged to every other currency that was also pegged to gold. Each central bank was supposed to insulate its national economy from the financial problems of individual banks by reducing the likelihood that depositors might rush to get their money from one or several banks at the same time, because of their concern that if the bank closed, they would lose part or all of their money. Since the banks would not have enough money to meet the demands of many depositors at the same time, these rushes for money sometimes caused the result they anticipated. During the First World War governments borrowed from their banks to get much of the money needed to finance military expenditures. After the war governments imposed additional objectives on their central banks; one was to achieve a low inflation rate and another, at least in some countries, was to achieve a high level of employment. Since the early 1970s central banks have not been committed to maintain a fixed price for their currencies; instead, many have given greater priority to domestic objectives in managing the growth of their money supplies. One consequence – at least for a while – was greater divergence in national inflation rates. The unique development at the end of the twentieth century was that 11 of the then 15 member countries of the European Union (EU) adopted the euro – essentially a supranational currency – as the successor to the German mark, the French franc, the Italian lira, and the currencies of eight other countries. The European Central Bank (ECB) is owned by the national central banks and develops a common monetary policy for its members. Britain and several other members of the EU have retained their national currencies, although Greece subsequently adopted the euro. Most of the countries that are scheduled to join the EU appear likely to adopt the euro, eventually if not immediately.
Fitting the pieces: the market in national currencies
International transactions for the purchase of goods, services, and securities differ from domestic transactions in one unique way – either the buyers or the sellers must transact in a foreign money. When Americans buy new Mercedes and new Volkswagens, they pay US dollars to the dealers, who in turn pay the US subsidiaries of Mercedes and of Volkswagen. These subsidiaries then take most of these dollars to the currency market to buy the euro so they can pay their head offices in Germany. One of the two basic approaches toward organizing the currency market is that each central bank buys and sells its currency to limit the changes in its price, usually within a narrow or modest range; this practice follows from the gold standard arrangements. The other basic approach is that the price of each national currency increases and decreases in response to changes in demand and supply, much like the prices of pork bellies and of government bonds and of copper and of stocks. The intermediate approach is that central banks buy and sell their currencies to limit changes in their prices – and to achieve some other national objectives. For most of the 200 years from the advent of the United States as a newly independent country until the early 1970s, the US dollar price of the British pound was pegged because the British pound had a parity for gold of 87 shillings 6 pence per ounce while US dollar had a parity of $20.67 per ounce. The ratio of the two gold parities was $4.86 = 1 British pound after an adjustment for the small difference in the gold content of British coins and of US coins. The US dollar price of the British pound was not pegged between 1797 and 1821, during and immediately after the Napoleonic Wars. Nor was the US dollar price of the British pound pegged during and after the US Civil War – from 1861 until 1879. The move away from pegged values for currencies reflects the fact that wars have been associated with higher inflation rates and larger differences in national inflation rates. A system of pegged currency values requires that central banks buy and sell their own currencies to limit the changes in their prices. The securities that central banks acquire after they have sold their currencies in the foreign exchange market are grouped as international reserve assets. Some central banks began to acquire securities denominated in the British pound and securities denominated in the US dollar at the end of the nineteenth century because they wanted the interest income on these securities. Nevertheless, central bank holdings of gold were the largest component of international reserve assets until the 1960s. Then securities denominated in the US dollar became the largest component. In the 1960s and the 1970s central banks acquired securities denominated in the German mark and in the Japanese yen as international reserve assets, although securities denominated in the US dollar still account for two-thirds of international reserve assets; securities denominated in the euro are the second largest component.
During the nineteenth century, the stability of international financial arrangements resulted from the self-interest of individual countries. In contrast, during the twentieth century national governments signed treaties, agreements, accords, and communiqués that contained commitments about how they would manage their currencies. One pattern about changes in currency values since the early 1970s is evident from the comparison of changes in the Japanese yen price of the US dollar with the changes in the Swiss franc price of the US dollar. At the end of 1970, the Japanese yen had a parity of 360 while the Swiss franc had a parity of 4.30; the ‘cross rate’ was 84 Japanese yen for each Swiss franc. At the end of 2008 the Japanese yen price of the US dollar was 111 while the Swiss franc price of the US dollar was 1.11; the Japanese yen price of the Swiss franc was 100. The declines in the price of the US dollar in terms of both the Swiss franc and the Japanese yen have been much larger than the changes in the Japanese yen price of the Swiss franc. The inference is that many of the shocks that have led to changes in the value of the US dollar have centered on the United States. Inflation rates in the twentieth century were much higher than in the nineteenth century. The American and British price levels at the end of the nineteenth century were not significantly different from those at the end of the eighteenth century, although there had been extended episodes of sharp increases and then decreases of price levels within the century. In contrast, the US price level at the end of the twentieth century was nearly 20 times higher than at the beginning, and the British price level was more than 25 times higher. Increases in national price levels in the twentieth century occurred in three major episodes; the first was during and immediately after the First World War and the second was during and after the Second World War. The third surge in national price levels occurred in the 1970s and differed from the earlier episodes both because the price increases were larger and because they occurred during peacetime. During the nineteenth century governments accepted changes in their domestic price levels as a way to maintain parities for their currencies in terms of gold. In contrast, during most of the twentieth century governments – especially the governments of large countries – were reluctant to accept a significant external constraint on the choice of their domestic economic policies. Financial crises were more severe in the last several decades of the twentieth century than in the earlier period, although the period between the First World War and the Second was also marked by major crises.
The waxing and waning of financial hegemony
Copernicus believed that the orbits of the planets were determined by gravitational pulls and would not change; similarly, he was not concerned that the relative size of the various planets might change. In contrast, one of the dominant features of international financial arrangements is that the economic standing of individual countries and of their currencies changes. Britain was the dominant economic power during the nineteenth century and London was the primary international banking and financial center; Britain also was the largest international creditor country. The British pound was the dominant currency; import prices and export prices were quoted in terms of the pound and world trade was financed by credits denominated in the pound. US railroad firms went to London to borrow money to finance their expansion. The United States supplanted Britain as the dominant economic power during the First World War; US GDP was three times larger than the British GDP. For the next 30 or 40 years – until the 1960s – the United States became an even more ascendant economic power, in part because of the dislocations to production and trade in both Europe and Asia associated with the Second World War. US industrial capacity surged, while wartime damage reduced productive capacity in Britain, Germany, France, and Japan. At the end of the 1940s it seemed as if the United States would remain the dominant economic power ‘until the end of time.’ US industrial supremacy seemed unchallenged and unchallengeable. The US dollar was the dominant currency, in part because of US industrial leadership and in part because the US commitment to a low inflation rate seemed stronger than that of any other large country. During the 1950s and the 1960s the United States developed a persistent payments deficit; US holdings of gold declined by more than half and foreign holdings of US dollar securities surged. Despite the decline in US gold holdings, the US international financial position seemed impregnable, in part because the United States was the world’s largest net international creditor country. In 1971, an event that seemed unthinkable 10 years earlier occurred: the US Treasury stopped selling gold at $35, and the price of gold began to increase; by the end of the decade the price had nearly reached $1000. The US dollar depreciated extensively relative to the German mark and the Swiss franc and the Japanese yen through most of the 1970s. In 1980 the United States began to develop a persistent annual trade deficit and the US net international creditor position began to decline and by the late 1980s the United States had evolved into an international debtor; the United States became the world’s largest international debtor in 2000. The transformation of the US net international investment position from the world’s largest creditor to the world’s largest debtor occurred because foreign investors and central banks wanted to increase their holdings of US dollar securities. The invisible hand was at work, and the United States developed the trade deficit that was the mirror of the trade surpluses of Japan, China, and many other developing countries.
The plan of the book
The chapters in this book are arranged in two major groups. The first group – Chapters 2 through 13 – focus on macro international topics, including changes in the monetary roles of gold, the costs and benefits of floating exchange rates and of pegged exchange rates, the waves of credit and asset bubbles since the 1970s, and the evolution of the United States from the world’s largest creditor country to the world’s largest debtor. The second group – Chapters 14 through 24 – has a micro focus and centers on specific topics, including the nature and impacts and causes of globalization, the impacts of differences in national tax rates on the competitive position of firms producing in different countries, and the changes in the structure of the international banking industry. The impacts of the Organization of Petroleum Exporting Countries (OPEC), the cartel of the oil-producing countries, on the supply of petroleum in the long run are analyzed. The first chapter in Part I (Chapter 3) summarizes the changes in the monetary role of gold in the last 300 years. The changes in international financial arrangements are summarized in Chapter 4. The changes in organization of the foreign exchange market are described in Chapter 5, and the attention is given to why the range of movement in the price of national currencies in the foreign exchange market has been so large relative to the difference in national inflation rates. The unique international roles of the US dollar are reviewed in Chapter 6. The thrust of Chapter 7 is the growth of the offshore banking market, identified by the mismatch between the currency in which a transaction is denominated and the currency of the country where the transaction occurs. The causes of the several inflations of the twentieth century are examined in Chapter 8. The relationships among the various asset price bubbles since the 1980s are reviewed in Chapter 9. The causes of the financial crises are analyzed in Chapter 10. The explanations for the change in the US international investment position from the world’s largest creditor to the world’s largest debtor are evaluated in Chapter 11. The thrust of Chapter 12 is the factors that determine the rate of growth of national money supplies. One of the major concerns since the breakdown of the Bretton Woods system of adjustable parities has been monetary reform; a major question is how to maintain an open trading system in an increasingly fractious world. The first chapter in Part II (Chapter 14) analyzes the globalization of markets over the centuries and then provides an overview of subsequent chapters. The thrust of Chapter 15 is on the impacts of national taxation and regulatory regimes on the international competitiveness of firms that produce in different countries. The question addressed in Chapter 16 centers on the impact of the financial crisis on the competitiveness of US banks relative to banks headquartered in various foreign countries. The impact of the production-limiting arrangements by OPEC on the Malthusian specter that the world petroleum supplies will be exhausted is analyzed in Chapter 17. Whether national markets for bonds and stocks are segmented or integrated is evaluated in Chapter 18. The focus of Chapter 19 is the revolution in finance and the surge in the number of new financial instruments – futures and options and swaps and credit default swaps. Whether there is a pattern in the ownership of multinational firms is discussed in Chapter 20. The economic success of Japan in the 1960s, 1970s, and 1980s is summarized in Chapter 21. The transformation of China from a command economy to a market economy is reviewed in Chapter 22. Russia’s evolution from a Marxist command economy to a market economy is reviewed in Chapter 23. The final chapter considers the likelihood these international monetary and financial problems will become less severe.
2 The Name of the Game Is Money – But the Disputes Are about Where the Jobs Are
International finance is a game with two sets of players: one set includes the politicians and bureaucrats and the central bankers in different countries and the other set includes the chief financial officers and treasurers of giant, large, medium-large, medium, medium-small, and small firms and banks and hedge funds, and other financial institutions. The government officials want to win elections and secure a niche in the histories of their countries for enhancing economic well-being and financial stability. The cliché is ‘good jobs at good wages.’ A few aspire to get their portraits on the national currency. And to do so, they want to manage their economies to provide more and better-paying jobs and greater financial security for their voters. These officials want to avoid sharp increases in inflation rates and sharp declines in the prices of their currencies. The chief financial officers and corporate treasurers want to profit from – or at least avoid losses from – changes in currency values, changes that are inevitable in a world with more than 150 national monies. The traders in the large international banks and in the hedge funds want a lot of variability in the prices of individual currencies; the larger the variability, the greater the scope for trading profits.
Changes in the price of the US dollar
Consider the changes in the Japanese yen price of the US dollar in the last 50 years. Throughout the 1950s and the 1960s the Japanese currency had a ‘fixed price’ of 360 yen per US dollar, which had been set in the late 1940s when Japan was still occupied by US military forces. The productive power of the Japanese economy then was far below that of the early 1940s as a result of destruction of factories and business relationships during the war and the loss of what had been several colonies. In the early 1970s, the Bank of Japan stopped pegging the yen – largely at the insistence of the US Government – and the currency appreciated to 175 yen per dollar by the end of the decade. In contrast, in the early 1980s the yen declined sharply; in the second half of the 1980s the yen again appreciated, and by 1997 had reached 80 yen per dollar – briefly. For much of the period between 1995 and 2008 the yen traded in the range of 110-150 yen per dollar, although at the end of 2008 the yen had again appreciated to 90 yen per dollar. As the yen appreciated the managers of most Japanese firms and many Japanese politicians were concerned that exports from Japan would be less profitable and decline, while imports would increase because they would be less expensive and they would pose more of a competitive threat to Japanese firms. The Bank of Japan often bought US dollars to limit the appreciation of the yen in the effort to support the competitive position of Japanese firms in global