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Mundell Financial Crises And The Intl Monetary System

This document provides an overview of the evolution of international monetary systems and financial crises. It discusses the Bretton Woods system, the move to floating exchange rates in the 1970s, and crises under fluctuating rates. It then covers the creation of the euro and the 2007-2009 financial crisis. The crisis originated from securitization of mortgages and financial innovations, and came to a head in September 2008 with the collapse of Lehman Brothers, drying up credit markets.

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Financial Crises and the International Monetary System Robert Mundell Columbia University New York, NY 10027 March 3, 2009
Outline Financial Crises and the IMS The Evolution of the IMS The Bretton Woods System Fluctuating Exchange Rates Crises Under Fluctuating Rates The Euro The 2007 9 Financial Crisis 2007-9 Five Goats of the Crisis What is to be Done? Policies for Rest of the World Toward a Global Currency
International Crises and the IMF
Exchange Rates and Crises Financial Crises national or international. Frequency depends on the type of international monetary system. Large fluctuations in exchange rates a major cause of financial crises. j
Sequences Seq ences of International Monetary Monetar Systems Bimetallisms 600 BC –47 BC Gold Standard 46 BC- 1203 Bimetallisms 1204 – 1789 Flexible Rates 1789 – 1814 Free-Coinage Bimetallism 1815 – 1873 The Gold Standard 1873 – 1914 Anchored Dollar Standard 1915 – 1924 Gold Exchange Standard 1925 – 1933 Anchored Dollar Standard 1934 – 1971 Dollar Standard 1971 – 1973 Flexible Exchange Rates 1973 – 1998 Currency Areas 1999 – ? 3/5/2009 Robert A. Mundell 5
Recent Phases of the International Monetary System Date System Reserve Asset(s) Leader(s) 1803-1873 1803 1873 Bimetallism Gold & Silver France 1873-1914 Gold Standard Gold and £ Britain 1915 1924 1915-1924 Anchored $ St St. Gold and $ U.S. US 1924-1933 Gold Standard Gold,$ and £ US, UK, France 1934-1971 Anchored $ St. Gold and $ U.S., G-10 , 1971-1973 Dollar Standard $ U.S. 1973-1985 Flex. Ex. Rates $, DM, £, U.S., FRG 1985-1999 Man. Ex. Rates $, DM, ¥ U.S. 1999-2009 Dollar and Euro $, €, ¥, £ U.S. EMU 2009-? Currency Areas $. €, ¥, C¥, £ US, EMU
2. Evolution of the International Monetary System
The Victorian Age In the nineteenth century, the British Empire was the first-among-equals great power, the pound sterling was the most important currency in the world, and London was the financial center of the world. There were no major banking crises that affected the stability of the system. y y
The Gold Standard and Economic Powers, c.1890 , (Inner circles represent gold stocks) France Japan K Cuba British Empire Spain Puerto Rico Russian Empire U.S. Ottoman Empire German German Empire Italy y Empire Austria-Hungarian Empire
U.S. on the Brink By the outbreak of World War I, the United States was on the verge of superpower f status. The Federal Reserve System (1913) gave the U.S. a central bank and concentrated its monetary power. The US economy was alreadybigger than the next three biggest economies put together.
The Gold Standard and Economic Powers, c.1913 France British Empire United States Russia Ottoman Empire Germany Austria-Hungary Italy
The Late 1920s The U.S. had half the world’s monetary gold. ld Europe and the rest of the world had p gone back to the gold standard, creating deflation. g France enacted its monetary law. The world economy was just a year away from economic doom!
The Gold Standard and Economic Powers, c.1928 (Inner circles represent gold stocks) (I i l t ld t k ) BritishEmpire e British Empire s p Soviet Union Soviet Union France Gold UnitedStates United States Japan J Germany Italy It l
3. 3 The Bretton Woods System
1934-71 Deflation led to the breakup of the gold standard and the U.S. went off gold in 1933. ff In 1934, however, FDR devalued the dollar and put the U.S. back on a weak form of the gold standard. This made the U.S. explicitly the center of the international monetary system for four decades.
Dollar Standard 1934-1971. y A.K.A. the Bretton Woods “System” Gold Soviet Union U.K. U.S. Japan China France Italy Germany
Bretton Woods and the IMF At the meeting of 44 nations in Bretton Woods, New Hampshire, U.S.A., in 1944, the IMF was set up to supervise the fixed exchange rate system. The i i l B iti h d A Th original British and American plans i l included a world currency, but 1944 was a presidential election year and it was not good politics. g p
Defects of the Bretton Woods System There was no world currency. There was no mechanism for keeping the world price level in line with the fixed price of gold (US sterilization). IMF assets included junk currencies that had no use internationally, so it couldn’t y, be a revolving credit system.
Flexible Exchange Rates the g Result of Failure to Negotiate The BW System broke down because the world price level tripled while the price of f gold was kept at $35, the price set in 1934. When President Nixon took the dollar off gold on August 15, 1971, the other countries took their currencies off the dollar. None of the major countries wanted to scrap the system but a reformed system could not be negotiated.
Fluctuating Exchange Fl ct ating E change Rates
Monetary Nationalism Fluctuating exchange rates meant that each country was responsible for its own monetary stability. It inaugurated an era of monetary nationalism.
A Chaotic System y There are 185 members of the IMF today. today Scores of countries on flexible rates would have meant chaos. ld h h E.G. if there are N = 200 countries in the world with separate currencies, there are ½ x N x (N-l) = 19,900 ( ) , exchange rates!
Fluctuating Rates the Worst g Idea Fluctuating rates a system of monetary nationalism. The smallest countries lose the most, the biggest countries might gain. The idea was invented by the superpowers, Britain in 19th C and U.S. in 20th C. Idea never subjected to careful scrutiny scrutiny.
National Monetarism Under the fixed exchange rate system, the smaller countries could benefit from being part of the huge dollar area. The breakup of the fixed exchange rate system by the monetary nationalists shifted power and seigniorage to the United States. What DeGaulle called “an exorbitant h ll ll d “ b privilege.” The U S did not want to share the gains of U.S. its large currency area with the rest of the world.
Flexible Rates 1973-99 ¥ Soviet Union Canada Sweden Korea ₤ RMB $ France DM Hong Kong India Gulf CFA Italy Mexico Countries Latin American & Caribbean
Unofficial Dollar Standard In practice flexible exchange rates did less harm because countries could use the dollar as a unit of account and keep currency reserves in dollars dollars. For most countries “the exchange rate” meant the rate on the dollar. dollar The Federal Reserve became an unofficial world central bank, providing global reserves, bank reserves supplying the unit of account, and sometimes acting as lender of last resort.
Crises under Fluctuating Rates
Financial Crises Under Fluctuating Rates There were no banking crises under the Bretton Woods System System. By contrast there were four banking crises under fluctuating rates. rates They were all associated with large swings in major exchange rates. rates The two major exchange rates involved were the dollar rate against European currencies currencies, and the dollar-yen rate.
The Four Crises Under Fluctuating Rates The S&L Crisis – early 1980s The International Debt Crisis – 1982 The IMF Asian Crisis – 1997-8 IMF-Asian 1997 8 Lehman Shock and World Crisis - 2008
Dollar-Euro Cycle in Red 1.4 14 Ascent of the Yen in Blue 1.2 1.0 0.8 0.6 Dollar per ECU/Euro Dollar per 100 Yen 0.4 1975 1980 1985 1990 1995 2000 2005
6. Th E 6 The Euro
European Currency Europe most of all disliked flexible rates and the power it gave the dollar. d h i h d ll Europe embarked on its project for a p p j common currency even before the system broke up. y p My plan for a European currency (called europa) was presented and published in 1969.
Currency Areas Before the Euro: 1990 ¥ Canada Soviet Union Sweden Korea $ ₤ RMB France DM Hong Kong India Gulf Italy Mexico Countries Brazil ARG CFA Latin American & Caribbean
Currency Areas after the Euro ¥ Canada Russia Korea ₤ Sweden $ RMB Taiwan € India Hong Kong Indonesia Mexico M i Australia Brazil Gulf Latin American & Caribbean Countries CFA
Creation of the Euro The creation of the euro in 1999 concentrated the monetary power of Europe. f Upon its creation, the euro overtook the yen as the #2 currency in the world. Had Britain joined it, the euro area would be as large or larger than the dollar area (depending on the exchange rate)
The 2007-9 Financial Crisis
The Origins The early origins go back to the Federal y g g Reserve policies used to cope with the global slowdown of 2001-2. With very low interest rates and a low dollar l i t t t d l d ll in the recovery, a housing boom developed. As long as house prices were rising there was a cushion of safety between mortgages and house values.
End of the Boom When th h Wh the house prices stopped rising and i t d i i d began to fall, the boom ended. When house prices fell below mortgage values, values homeowners walked away from their mortgages. Sub-prime mortgage assets became toxic, creating a devastating hole in balance sheets.
Five Trouble-Makers Securitization of mortgages Derivatives Credit-Default-Swaps Credit Default Swaps Mark-to-Market Accounting Rules g Variable Rate Mortgages
Financial Innovations Securitization of mortgages cut li k S iti ti f t t link between issuers and holders. Derivatives created new systemic risks risks. Credit default swaps enabled insurance without ownership ownership. Mark-to-market accounting in investment accounts created intertemporal instability p y in balance sheets.
Massive Liquidity Crisis Sudden awareness of the problem in the summer of 2007 created a massive balance sheet problem for banks amounting to hundreds of billions of dollars. Mark-to-market accounting forced them to cover the holes. The scramble for liquidity was completely h bl f l d l l unprecedented in the annals of finance. A financial panic was about to occur. occur
The Liquidity Crisis: Aug 9-10, 2007 The panic was averted by prompt action by the ECB. It offered unlimited credit at 4% on ff August 9. 95 billion in euros were lent at that rate More came from the Fed and other central banks when their markets opened later and the next day the lending continued.
Injections by ECB and FRB in Billions of Dollars in August 2007 Thursday Friday August 9 August 10 130 54 ECB 24 38 FRB
Solvency Problem The prompt actions of the ECB and FED and others in August 2007 solved the liquidity problem at the time. What remained was the solvency p problem of those institutions with big g holdings of these defaulting assets.
Slowdown and then Recovery After the resolution of the liquidity crisis there was relative quiet for 13 Months Months. The great expansion of 2002-2007 came to an end in the U.S. with the great slowdown in 2007 (4) and 2008 (1) and a near recession. But then expansion came in 2008 (2) with growth of 2.8%. h f 8 A recovery seemed to be coming.
The Spring Recovery In the spring of 2008 it looked as if the U.S. economy was recovering There was 2 8% recovering. 2.8% growth in the second quarter of 2008. Bear Stearns was a problem – the biggest bailout since LTCM in Sept 1998 - but it seemed to be settled with its absorption into d b l d h b J.P. Morgan in May 2008.
Financial Blowout and Recession in 2008-II But instead of recovery in the last half of 2008 we got the greatest financial disasters in American history and a an unambiguous recession with two consecutive quarters of negative growth in 2008 (3) and 2008(4).
Lehman’s Collapse L h ’ C ll Lehman’s demise was the biggest failure in world history. Previously, Previously Enron in 2002 had been the biggest. But the Lehman failure was six times bigger than Enron. gg
Credit Dried Up The most serious cost of the failure of Lehman was a colossal increase in the demand for money on the part of both banks and the public. d h bl Money became even tighter. Credit became unavailable except for super-solvent firms. Credit for ordinary enterprises dried up.
Two Questions Two questions arise: 1. 1 What put Lehman Bros in danger? 2. Why did the Fed and Treasury let Lehman fail?
Lehman’s Collapse Lehman was too big to fail BUT THE FED AND TREASURY LET IT FAIL. It was a mind-boggling mistake mistake. It put other institutions at risk and made the take-over of AIG, at a cost of $ $78 billion+++ inevitable.
The Big Question Why did the financial crisis occur and why did it happen to come about in y pp August and September 2008? What caused the debacle that September?
Currency Appreciation and y pp Tight Money The dollar soared in July-September and the price of gold f f fell. These are two symbols of tight money. True, interest rates were low and monetary expansion was enormous, but not enough to offset the increase in the demand for money.
The Dollar in Euros and the Price of Gold in Dollars in July and November 2008 Euros per Dollar Dollars per Euro Gold ounce per Dollar July 15 0.63 1.60 980 Oct 27 0.80 1.25 720
The price of gold plummeted. p g p Tue Feb 10 16:21:09 2009 Advertise Ad ti o
Low Gold, Strong Dollar The soaring dollar and falling gold price were symptoms of a shortage of dollar liquidity liquidity. Had the FED recognized this shortage and bought foreign exchange to prevent the appreciation, there would probably have been no financial crisis in the fall. Instead, the dollar appreciation overvalued d h d ll l d US dollar assets including all fixed income securities and mortgages, tipping Lehman mortgages Bros and other banks over the edge.
The Fed Screwed Up! The Federal Reserve cut off the economic recovery in 2008(2) and tipped the economy into recession and financial crisis. crisis
Joint Fed-Treasury Mistake This does not exonerate the Secretary of the Treasury for the joint Fed- Treasury mistake in letting Lehman Brothers failed. The f il Th failure greatly increased the tl i d th demand for money further, creating the casualties that followed.
Five Goats of the Crisis
Five G t Who C t ib t d Fi Goats Wh Contributed to the Financial Crisis Ranieri Clinton Greenspan Bernanke Paulsen
Lewis Ranieri Julia Finch Guardian.co.uk (26/01/09) The bond trader who turned home loans into tradable securities The father of securitized mortgages Pioneered mortgage-backed bonds in 1980s “Mortgages are math” Created collateralized pools of mortgages Lost connection between original borrowers and lenders But ranked by Business Week with Bill Gates and Steve Jobs as one of the greatest innovators of the past 75 years. i f h
Bill Clinton Julia Finch Guardian.co.uk (26/01/09) Strengthened the 1977 Community Reinvestment Act to force mortgage lenders to relax their rules to allow more socially disadvantaged borrowers to qualify for home loans In 1999 repealed Glass-Steagal Act, which ensured complete separation between commercial banks, which accept deposits and investment banks which deposits, banks, invest and take risks, prompting the era of the superbank and primed the sub-prime pump. In 1998, sub-prime loans were just 5% or all mortgage lending; by 2008 it was approaching 30%
Alan Greenspan Julia Finch Guardian.co.uk (26/01/09) Kept interest rates too low, dollar too week, for too long led the housing bubble to long, develop Supported sub prime lending sub-prime Advocated variable rate mortgages Defended derivatives: “Derivatives have been f d dd “ h b an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so.” Senate Banking Committee, 2003 so Committee
Maurice “Hank” Hank Greenberg The founder of AIG, the biggest insurance company in the world. world Conducted a vast business in credit default swaps (CDS). Insured mortgage assets for a regular premium for people/institutions that didn’t own them. h Similar to insurance, but different because the buyer of a CDS does not need to own the mortgage asset or even suffer a loss from a default event. Allowed mass multiples of derivatives.
Ben Bernanke Allowed dollar to soar as the euro fell from above $ $1.60 in June to below $1.30 in $ October 08. Failed to realize this appreciation surge freezing of credit markets and extreme shortage of dollar liquidity. Dollar surge brought on the recession in last half of 2008 and the financial crisis with Fanny Mae, Freddy Mac and Lehman and AIG etc.
Hank Paulsen Bailed out Bear-Stearns but allowed Bear Stearns Lehman Bros. to fail. Failure of Lehman Bros. made it necessary to save AIG AIG. Failed to notice significance of dollar appreciation in third quarter of 2008 i ti i thi d t f
What Should be Done?
Summary of 6 Proposals: 1, 2, y p , , 3 1. Issue Dates Spending Vouchers to increase effective demand demand. 2. 2 Cut corporation tax rates from 35% to 15% to allow recapitalization of corporations and increase competitiveness. 3. Government Takeover and Restructuring of Insolvent Banks for subsequent privatization l k f b to rehabilitate the banking system.
Proposals 4, 5, 6 4. Stabilize dollar euro rate with the euro fixed at limits dollar-euro between $1.20 and $1.40 to avoid beggar-thy-neighbor exchange rate opportunism. 5. Establish an International Macroeconomic Advisory Council as a global version of the Volcker-Chaired Obama Advisory Council to deal with the coordination of international macroeconomic policies. i li i Issue 1 Trillion SDRS to IMF members in proportion to quotas or according o acco ding to a ne fo m la int od ced to dist ib te the new formula introduced distribute seigniorage more equitably.
1. Dated Spending Vouchers Dated Spending Vouchers (DSVs) of $500 billion (divided up among individuals) that expire after three months. Retailers would use the executed vouchers as tax credits. This would amount to stimulus in one quarter that would represent a potential 12.5% increase in spending in the quarter's income. income It is superior to a tax change because it is temporary and flexible: it doesn't change the doesn t tax structure and it can be repeated as needed.
Proposal 1, Cont’d Given the fact that there is great uncertainty about the needed amount that is necessary, a tool that targets spending per quarter is flexible fl bl is superior to a one-shot guess. h It would involve a once-for-all redistribution that benefits lower income groups and maximizes the proportion of it that will be spent.
2. Slash Corporate Profits p Taxes Cut the C t th corporate tax rate f t t t from 35% t 15% t to to recapitalize banks and corporations and spur investment. This measure takes account of the fact that the government is already a non-voting shareholder in non voting corporations with 35% of the stock – without adding any capital to the corporation or share in any losses. Instead of the government buying stock in corporations to recapitalize them, the tax cut would let the corporations recapitalize themselves. ( (Note that Germany recently cut its corporation tax from y y p 25% to 15%, and its overall taxes on corporations from 38.7% to about 30%.)
Corporation Tax Cut, cont’d Economists have been behind the curve on the impact of the corporate profits tax on investment and growth and employment. It is usually looked upon as an instrument for redistribution from the rich to the poor, ignoring the negative effects on the allocation of resources. Elimination of the corporation tax has long ben a project of tax experts like the late William Vickrey, Nobel-prize-winning tax expert who, although a left-leaning liberal, regarded the corporation income tax as an "abomination" because of its harmful effects on output, growth and efficiency. efficiency A large cut in the corporate tax rate would make the stock market soar and restore the health of ailing corporations and banks and together with the DSVs jump-start i i h h DSV j investment and recovery. d
3. Restructure and Privatize Insolvent Banks Government should take over and restructure large insolvent banks f subsequent for privatization. Several key banks are at present technically insolvent if their assets were written down to their market value, and the purpose of this measure is to avoid the unproductive trauma of new bank failures.
3, cont’d Government takeover of prominent insolvent banks. Selection and removal of taxic assets assets. Reconstitution followed by privatization.
4. Dollar-Euro Anchor 3. Stabilize the dollar-euro rate and let the dollar-euro be the new anchor for the international monetary system around which an international currency can be based. The t bili ti Th stabilization can be done gradually by creating a b d d ll b ti band of fluctuation at the margins of which the banks intervene and then narrow the band as the FRB and ECB get more comfortable at coordinating monetary policies policies. The Treasury/FRB can start by putting a floor to the euro (and a ceiling for the dollar) at $1.20 and the ECB put a floor to the dollar (and a ceiling for the euro) at $1.40. ( g ) $
$-€ Anchor, cont’d The Federal Reserve should modify its policy of sterilizing automatically all foreign exchange intervention. Japan and China could also be invited to take t t k part i th stabilization program t in the t bili ti as could the United Kingdom
5. International Macroeconomic Advisory Council Work t W k to establish for the world as a whole an t bli h f th ld h l International Macroeconomic Advisory Council as a counterpart to the Volcker-chaired Obama p Advisory Council. Form a committee of 10-15 wise people from around the world to advise and evaluate d th ld t d i d l t economic strategy and make recommendations. These could raw materials for an International Economic Advisory Council for policy at the Global Level.
6. Trillion SDR issue It is imperative to provide public money to especially the smaller countries who do not have a lender of last resort. The SDR is the best mechanism for dealing ith thi d li with this.
6. The Trillion SDR Issue SDRs were initially issued with a gold value guarantee. guarantee The amount 9.5 billion SDRs issued in 1970- 72 would now be worth $270 billion. The world has changed greatly since then and the requirements for international money are correspondingly greater. d l Such an issue would prevent the collapse of the banking systems in the rest of the world world.
Policies for U.S. Dated Spending Vouchers (DSVs) Corporate tax cut from 35% to 15% Stabilization of Dollar Euro Exchange Rate Dollar-Euro and Plan a World Currency Reform of Banking System with Reconstitution of assets and Privatization. Initiate Trillion SDR allocation to save the global banking systems.
Policies f R t f W ld P li i for Rest of World
Policies for Rest of World Establish an international counterpart to the Volcker-Chaired Advisory Committee Stabilize exchange rates were feasible Support Trillion SDR allocation. allocation Initiate change of name of SDR. Support and Contribute to Formation of Global Currency Bretton Woods Type Conference in Shanghai in 2010 to restructure the International Monetary System.
Toward a Global Currency y
Regionalism If the major countries do not support a multilateral approach toward a restoration of the international monetary system, Asia and the other continents should act for itself by creating an Asian currency.
World Currency The Long Run Goal is a Global Currency. As Paul Volcker puts it, the global it economy needs a global currency. The problem is to devise a way to achieve it.
Several Competing p g Approaches Regionalization Approach Dominant Currency Approach Precious Metals Approach Intor Approach pp
An Asian Currency by 2015? India Russia $ Baht¥ RINGITT € YEN P-Peso PP WON 15 EURO RMB Africa Rupiah HK$ ₤ Australia-NZ Latin Dollar Arab Bloc
APEC Solution? Simple if Japan fixed yen to dollar, p y , C$ like China. Rupee Pakistan Lat$ Latin Dollar $ $ C¥ ¥ Ruble R bl € YEN EURO RMB ¥ RINGITT Africa ₤ Arab Bloc
Alternative Scenario: APEC + Europe? u op Euro Area $ ₤ India ¥ € Russia DEY RMB Africa Latin Dollar Dinar Area Indonesia
Three Stages of Monetary Reform Stage I. Convergence of DEY (Dollar-Euro- Yen) Exchange Rates and G-3 Monetary y Policy Use of DEY as platform, possibly with gold, for world currency the INTOR currency, Creation of INTOR and Ratification by the y Board of Governors of IMF.
The INTOR: What could we expect? A single unit for quoting prices. A common unit for denominating debts. A common rate of inflation for participating countries. A common interest rate on risk-free assets. A global business cycle.
The SDR Basket SDR = dollar + euro + yen + pound pound 11% yen 15% dol l ar 45% eur o 29% dol l ar eur o y yen p pound 3/5/2009 Robert A. Mundell 93
Quotas in IMF Belgium 2% United State s Canada 17% 3% China, P.R. Mainland 3% United Kingdom France 5% 5% Switz e rland Germany 2% 6% India Saudi Arabia 2% 3% Russia Italy 3% 3% Japan Ne the rlands 6% 2%
Intor Sandwich Yen(SDR), Yen(SDR) 7.5% Euro(SDR), Pound(SDR), 14.5% 5.5% Dollor(SDR), 22.5% Gold , 50% 3/5/2009 Robert A. Mundell 95
World Map with the INTOR ¥ $ India RMB € ₤ Latin Dollar L ti D ll Russia Arab Bloc Africa
Thank Y Th k You

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Mundell Financial Crises And The Intl Monetary System

  • 1.
    Financial Crises andthe International Monetary System Robert Mundell Columbia University New York, NY 10027 March 3, 2009
  • 2.
    Outline Financial Crises andthe IMS The Evolution of the IMS The Bretton Woods System Fluctuating Exchange Rates Crises Under Fluctuating Rates The Euro The 2007 9 Financial Crisis 2007-9 Five Goats of the Crisis What is to be Done? Policies for Rest of the World Toward a Global Currency
  • 3.
  • 4.
    Exchange Rates andCrises Financial Crises national or international. Frequency depends on the type of international monetary system. Large fluctuations in exchange rates a major cause of financial crises. j
  • 5.
    Sequences Seq ences of International Monetary Monetar Systems Bimetallisms 600 BC –47 BC Gold Standard 46 BC- 1203 Bimetallisms 1204 – 1789 Flexible Rates 1789 – 1814 Free-Coinage Bimetallism 1815 – 1873 The Gold Standard 1873 – 1914 Anchored Dollar Standard 1915 – 1924 Gold Exchange Standard 1925 – 1933 Anchored Dollar Standard 1934 – 1971 Dollar Standard 1971 – 1973 Flexible Exchange Rates 1973 – 1998 Currency Areas 1999 – ? 3/5/2009 Robert A. Mundell 5
  • 6.
    Recent Phases ofthe International Monetary System Date System Reserve Asset(s) Leader(s) 1803-1873 1803 1873 Bimetallism Gold & Silver France 1873-1914 Gold Standard Gold and £ Britain 1915 1924 1915-1924 Anchored $ St St. Gold and $ U.S. US 1924-1933 Gold Standard Gold,$ and £ US, UK, France 1934-1971 Anchored $ St. Gold and $ U.S., G-10 , 1971-1973 Dollar Standard $ U.S. 1973-1985 Flex. Ex. Rates $, DM, £, U.S., FRG 1985-1999 Man. Ex. Rates $, DM, ¥ U.S. 1999-2009 Dollar and Euro $, €, ¥, £ U.S. EMU 2009-? Currency Areas $. €, ¥, C¥, £ US, EMU
  • 7.
    2. Evolution ofthe International Monetary System
  • 8.
    The Victorian Age Inthe nineteenth century, the British Empire was the first-among-equals great power, the pound sterling was the most important currency in the world, and London was the financial center of the world. There were no major banking crises that affected the stability of the system. y y
  • 9.
    The Gold Standardand Economic Powers, c.1890 , (Inner circles represent gold stocks) France Japan K Cuba British Empire Spain Puerto Rico Russian Empire U.S. Ottoman Empire German German Empire Italy y Empire Austria-Hungarian Empire
  • 10.
    U.S. on theBrink By the outbreak of World War I, the United States was on the verge of superpower f status. The Federal Reserve System (1913) gave the U.S. a central bank and concentrated its monetary power. The US economy was alreadybigger than the next three biggest economies put together.
  • 11.
    The Gold Standardand Economic Powers, c.1913 France British Empire United States Russia Ottoman Empire Germany Austria-Hungary Italy
  • 12.
    The Late 1920s TheU.S. had half the world’s monetary gold. ld Europe and the rest of the world had p gone back to the gold standard, creating deflation. g France enacted its monetary law. The world economy was just a year away from economic doom!
  • 13.
    The Gold Standardand Economic Powers, c.1928 (Inner circles represent gold stocks) (I i l t ld t k ) BritishEmpire e British Empire s p Soviet Union Soviet Union France Gold UnitedStates United States Japan J Germany Italy It l
  • 14.
    3. 3 The BrettonWoods System
  • 15.
    1934-71 Deflation led tothe breakup of the gold standard and the U.S. went off gold in 1933. ff In 1934, however, FDR devalued the dollar and put the U.S. back on a weak form of the gold standard. This made the U.S. explicitly the center of the international monetary system for four decades.
  • 16.
    Dollar Standard 1934-1971. y A.K.A. the Bretton Woods “System” Gold Soviet Union U.K. U.S. Japan China France Italy Germany
  • 17.
    Bretton Woods andthe IMF At the meeting of 44 nations in Bretton Woods, New Hampshire, U.S.A., in 1944, the IMF was set up to supervise the fixed exchange rate system. The i i l B iti h d A Th original British and American plans i l included a world currency, but 1944 was a presidential election year and it was not good politics. g p
  • 18.
    Defects of theBretton Woods System There was no world currency. There was no mechanism for keeping the world price level in line with the fixed price of gold (US sterilization). IMF assets included junk currencies that had no use internationally, so it couldn’t y, be a revolving credit system.
  • 19.
    Flexible Exchange Ratesthe g Result of Failure to Negotiate The BW System broke down because the world price level tripled while the price of f gold was kept at $35, the price set in 1934. When President Nixon took the dollar off gold on August 15, 1971, the other countries took their currencies off the dollar. None of the major countries wanted to scrap the system but a reformed system could not be negotiated.
  • 20.
    Fluctuating Exchange Fl ctating E change Rates
  • 21.
    Monetary Nationalism Fluctuating exchangerates meant that each country was responsible for its own monetary stability. It inaugurated an era of monetary nationalism.
  • 22.
    A Chaotic System y There are 185 members of the IMF today. today Scores of countries on flexible rates would have meant chaos. ld h h E.G. if there are N = 200 countries in the world with separate currencies, there are ½ x N x (N-l) = 19,900 ( ) , exchange rates!
  • 23.
    Fluctuating Rates theWorst g Idea Fluctuating rates a system of monetary nationalism. The smallest countries lose the most, the biggest countries might gain. The idea was invented by the superpowers, Britain in 19th C and U.S. in 20th C. Idea never subjected to careful scrutiny scrutiny.
  • 24.
    National Monetarism Under thefixed exchange rate system, the smaller countries could benefit from being part of the huge dollar area. The breakup of the fixed exchange rate system by the monetary nationalists shifted power and seigniorage to the United States. What DeGaulle called “an exorbitant h ll ll d “ b privilege.” The U S did not want to share the gains of U.S. its large currency area with the rest of the world.
  • 25.
    Flexible Rates 1973-99 ¥ Soviet Union Canada Sweden Korea ₤ RMB $ France DM Hong Kong India Gulf CFA Italy Mexico Countries Latin American & Caribbean
  • 26.
    Unofficial Dollar Standard Inpractice flexible exchange rates did less harm because countries could use the dollar as a unit of account and keep currency reserves in dollars dollars. For most countries “the exchange rate” meant the rate on the dollar. dollar The Federal Reserve became an unofficial world central bank, providing global reserves, bank reserves supplying the unit of account, and sometimes acting as lender of last resort.
  • 27.
  • 28.
    Financial Crises Under Fluctuating Rates There were no banking crises under the Bretton Woods System System. By contrast there were four banking crises under fluctuating rates. rates They were all associated with large swings in major exchange rates. rates The two major exchange rates involved were the dollar rate against European currencies currencies, and the dollar-yen rate.
  • 29.
    The Four CrisesUnder Fluctuating Rates The S&L Crisis – early 1980s The International Debt Crisis – 1982 The IMF Asian Crisis – 1997-8 IMF-Asian 1997 8 Lehman Shock and World Crisis - 2008
  • 30.
    Dollar-Euro Cycle inRed 1.4 14 Ascent of the Yen in Blue 1.2 1.0 0.8 0.6 Dollar per ECU/Euro Dollar per 100 Yen 0.4 1975 1980 1985 1990 1995 2000 2005
  • 31.
    6. Th E 6The Euro
  • 32.
    European Currency Europe mostof all disliked flexible rates and the power it gave the dollar. d h i h d ll Europe embarked on its project for a p p j common currency even before the system broke up. y p My plan for a European currency (called europa) was presented and published in 1969.
  • 33.
    Currency Areas Beforethe Euro: 1990 ¥ Canada Soviet Union Sweden Korea $ ₤ RMB France DM Hong Kong India Gulf Italy Mexico Countries Brazil ARG CFA Latin American & Caribbean
  • 34.
    Currency Areas afterthe Euro ¥ Canada Russia Korea ₤ Sweden $ RMB Taiwan € India Hong Kong Indonesia Mexico M i Australia Brazil Gulf Latin American & Caribbean Countries CFA
  • 35.
    Creation of theEuro The creation of the euro in 1999 concentrated the monetary power of Europe. f Upon its creation, the euro overtook the yen as the #2 currency in the world. Had Britain joined it, the euro area would be as large or larger than the dollar area (depending on the exchange rate)
  • 36.
  • 37.
    The Origins Theearly origins go back to the Federal y g g Reserve policies used to cope with the global slowdown of 2001-2. With very low interest rates and a low dollar l i t t t d l d ll in the recovery, a housing boom developed. As long as house prices were rising there was a cushion of safety between mortgages and house values.
  • 38.
    End of theBoom When th h Wh the house prices stopped rising and i t d i i d began to fall, the boom ended. When house prices fell below mortgage values, values homeowners walked away from their mortgages. Sub-prime mortgage assets became toxic, creating a devastating hole in balance sheets.
  • 39.
    Five Trouble-Makers Securitization of mortgages Derivatives Credit-Default-Swaps Credit Default Swaps Mark-to-Market Accounting Rules g Variable Rate Mortgages
  • 40.
    Financial Innovations Securitization of mortgages cut li k S iti ti f t t link between issuers and holders. Derivatives created new systemic risks risks. Credit default swaps enabled insurance without ownership ownership. Mark-to-market accounting in investment accounts created intertemporal instability p y in balance sheets.
  • 41.
    Massive Liquidity Crisis Sudden awareness of the problem in the summer of 2007 created a massive balance sheet problem for banks amounting to hundreds of billions of dollars. Mark-to-market accounting forced them to cover the holes. The scramble for liquidity was completely h bl f l d l l unprecedented in the annals of finance. A financial panic was about to occur. occur
  • 42.
    The Liquidity Crisis: Aug9-10, 2007 The panic was averted by prompt action by the ECB. It offered unlimited credit at 4% on ff August 9. 95 billion in euros were lent at that rate More came from the Fed and other central banks when their markets opened later and the next day the lending continued.
  • 43.
    Injections by ECBand FRB in Billions of Dollars in August 2007 Thursday Friday August 9 August 10 130 54 ECB 24 38 FRB
  • 44.
    Solvency Problem Theprompt actions of the ECB and FED and others in August 2007 solved the liquidity problem at the time. What remained was the solvency p problem of those institutions with big g holdings of these defaulting assets.
  • 45.
    Slowdown and thenRecovery After the resolution of the liquidity crisis there was relative quiet for 13 Months Months. The great expansion of 2002-2007 came to an end in the U.S. with the great slowdown in 2007 (4) and 2008 (1) and a near recession. But then expansion came in 2008 (2) with growth of 2.8%. h f 8 A recovery seemed to be coming.
  • 46.
    The Spring Recovery In the spring of 2008 it looked as if the U.S. economy was recovering There was 2 8% recovering. 2.8% growth in the second quarter of 2008. Bear Stearns was a problem – the biggest bailout since LTCM in Sept 1998 - but it seemed to be settled with its absorption into d b l d h b J.P. Morgan in May 2008.
  • 47.
    Financial Blowout and Recessionin 2008-II But instead of recovery in the last half of 2008 we got the greatest financial disasters in American history and a an unambiguous recession with two consecutive quarters of negative growth in 2008 (3) and 2008(4).
  • 48.
    Lehman’s Collapse L h ’ C ll Lehman’s demise was the biggest failure in world history. Previously, Previously Enron in 2002 had been the biggest. But the Lehman failure was six times bigger than Enron. gg
  • 49.
    Credit Dried Up The most serious cost of the failure of Lehman was a colossal increase in the demand for money on the part of both banks and the public. d h bl Money became even tighter. Credit became unavailable except for super-solvent firms. Credit for ordinary enterprises dried up.
  • 50.
    Two Questions Two questionsarise: 1. 1 What put Lehman Bros in danger? 2. Why did the Fed and Treasury let Lehman fail?
  • 51.
    Lehman’s Collapse Lehmanwas too big to fail BUT THE FED AND TREASURY LET IT FAIL. It was a mind-boggling mistake mistake. It put other institutions at risk and made the take-over of AIG, at a cost of $ $78 billion+++ inevitable.
  • 52.
    The Big Question Why did the financial crisis occur and why did it happen to come about in y pp August and September 2008? What caused the debacle that September?
  • 53.
    Currency Appreciation and y pp Tight Money The dollar soared in July-September and the price of gold f f fell. These are two symbols of tight money. True, interest rates were low and monetary expansion was enormous, but not enough to offset the increase in the demand for money.
  • 54.
    The Dollar inEuros and the Price of Gold in Dollars in July and November 2008 Euros per Dollar Dollars per Euro Gold ounce per Dollar July 15 0.63 1.60 980 Oct 27 0.80 1.25 720
  • 55.
    The price ofgold plummeted. p g p Tue Feb 10 16:21:09 2009 Advertise Ad ti o
  • 56.
    Low Gold, StrongDollar The soaring dollar and falling gold price were symptoms of a shortage of dollar liquidity liquidity. Had the FED recognized this shortage and bought foreign exchange to prevent the appreciation, there would probably have been no financial crisis in the fall. Instead, the dollar appreciation overvalued d h d ll l d US dollar assets including all fixed income securities and mortgages, tipping Lehman mortgages Bros and other banks over the edge.
  • 57.
    The Fed ScrewedUp! The Federal Reserve cut off the economic recovery in 2008(2) and tipped the economy into recession and financial crisis. crisis
  • 58.
    Joint Fed-Treasury Mistake This does not exonerate the Secretary of the Treasury for the joint Fed- Treasury mistake in letting Lehman Brothers failed. The f il Th failure greatly increased the tl i d th demand for money further, creating the casualties that followed.
  • 59.
    Five Goats ofthe Crisis
  • 60.
    Five G tWho C t ib t d Fi Goats Wh Contributed to the Financial Crisis Ranieri Clinton Greenspan Bernanke Paulsen
  • 61.
    Lewis Ranieri Julia FinchGuardian.co.uk (26/01/09) The bond trader who turned home loans into tradable securities The father of securitized mortgages Pioneered mortgage-backed bonds in 1980s “Mortgages are math” Created collateralized pools of mortgages Lost connection between original borrowers and lenders But ranked by Business Week with Bill Gates and Steve Jobs as one of the greatest innovators of the past 75 years. i f h
  • 62.
    Bill Clinton Julia FinchGuardian.co.uk (26/01/09) Strengthened the 1977 Community Reinvestment Act to force mortgage lenders to relax their rules to allow more socially disadvantaged borrowers to qualify for home loans In 1999 repealed Glass-Steagal Act, which ensured complete separation between commercial banks, which accept deposits and investment banks which deposits, banks, invest and take risks, prompting the era of the superbank and primed the sub-prime pump. In 1998, sub-prime loans were just 5% or all mortgage lending; by 2008 it was approaching 30%
  • 63.
    Alan Greenspan Julia FinchGuardian.co.uk (26/01/09) Kept interest rates too low, dollar too week, for too long led the housing bubble to long, develop Supported sub prime lending sub-prime Advocated variable rate mortgages Defended derivatives: “Derivatives have been f d dd “ h b an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so.” Senate Banking Committee, 2003 so Committee
  • 64.
    Maurice “Hank” Hank Greenberg The founder of AIG, the biggest insurance company in the world. world Conducted a vast business in credit default swaps (CDS). Insured mortgage assets for a regular premium for people/institutions that didn’t own them. h Similar to insurance, but different because the buyer of a CDS does not need to own the mortgage asset or even suffer a loss from a default event. Allowed mass multiples of derivatives.
  • 65.
    Ben Bernanke Alloweddollar to soar as the euro fell from above $ $1.60 in June to below $1.30 in $ October 08. Failed to realize this appreciation surge freezing of credit markets and extreme shortage of dollar liquidity. Dollar surge brought on the recession in last half of 2008 and the financial crisis with Fanny Mae, Freddy Mac and Lehman and AIG etc.
  • 66.
    Hank Paulsen Bailed outBear-Stearns but allowed Bear Stearns Lehman Bros. to fail. Failure of Lehman Bros. made it necessary to save AIG AIG. Failed to notice significance of dollar appreciation in third quarter of 2008 i ti i thi d t f
  • 67.
  • 68.
    Summary of 6Proposals: 1, 2, y p , , 3 1. Issue Dates Spending Vouchers to increase effective demand demand. 2. 2 Cut corporation tax rates from 35% to 15% to allow recapitalization of corporations and increase competitiveness. 3. Government Takeover and Restructuring of Insolvent Banks for subsequent privatization l k f b to rehabilitate the banking system.
  • 69.
    Proposals 4, 5,6 4. Stabilize dollar euro rate with the euro fixed at limits dollar-euro between $1.20 and $1.40 to avoid beggar-thy-neighbor exchange rate opportunism. 5. Establish an International Macroeconomic Advisory Council as a global version of the Volcker-Chaired Obama Advisory Council to deal with the coordination of international macroeconomic policies. i li i Issue 1 Trillion SDRS to IMF members in proportion to quotas or according o acco ding to a ne fo m la int od ced to dist ib te the new formula introduced distribute seigniorage more equitably.
  • 70.
    1. Dated SpendingVouchers Dated Spending Vouchers (DSVs) of $500 billion (divided up among individuals) that expire after three months. Retailers would use the executed vouchers as tax credits. This would amount to stimulus in one quarter that would represent a potential 12.5% increase in spending in the quarter's income. income It is superior to a tax change because it is temporary and flexible: it doesn't change the doesn t tax structure and it can be repeated as needed.
  • 71.
    Proposal 1, Cont’d Given the fact that there is great uncertainty about the needed amount that is necessary, a tool that targets spending per quarter is flexible fl bl is superior to a one-shot guess. h It would involve a once-for-all redistribution that benefits lower income groups and maximizes the proportion of it that will be spent.
  • 72.
    2. Slash CorporateProfits p Taxes Cut the C t th corporate tax rate f t t t from 35% t 15% t to to recapitalize banks and corporations and spur investment. This measure takes account of the fact that the government is already a non-voting shareholder in non voting corporations with 35% of the stock – without adding any capital to the corporation or share in any losses. Instead of the government buying stock in corporations to recapitalize them, the tax cut would let the corporations recapitalize themselves. ( (Note that Germany recently cut its corporation tax from y y p 25% to 15%, and its overall taxes on corporations from 38.7% to about 30%.)
  • 73.
    Corporation Tax Cut,cont’d Economists have been behind the curve on the impact of the corporate profits tax on investment and growth and employment. It is usually looked upon as an instrument for redistribution from the rich to the poor, ignoring the negative effects on the allocation of resources. Elimination of the corporation tax has long ben a project of tax experts like the late William Vickrey, Nobel-prize-winning tax expert who, although a left-leaning liberal, regarded the corporation income tax as an "abomination" because of its harmful effects on output, growth and efficiency. efficiency A large cut in the corporate tax rate would make the stock market soar and restore the health of ailing corporations and banks and together with the DSVs jump-start i i h h DSV j investment and recovery. d
  • 74.
    3. Restructure andPrivatize Insolvent Banks Government should take over and restructure large insolvent banks f subsequent for privatization. Several key banks are at present technically insolvent if their assets were written down to their market value, and the purpose of this measure is to avoid the unproductive trauma of new bank failures.
  • 75.
    3, cont’d Governmenttakeover of prominent insolvent banks. Selection and removal of taxic assets assets. Reconstitution followed by privatization.
  • 76.
    4. Dollar-Euro Anchor 3. Stabilize the dollar-euro rate and let the dollar-euro be the new anchor for the international monetary system around which an international currency can be based. The t bili ti Th stabilization can be done gradually by creating a b d d ll b ti band of fluctuation at the margins of which the banks intervene and then narrow the band as the FRB and ECB get more comfortable at coordinating monetary policies policies. The Treasury/FRB can start by putting a floor to the euro (and a ceiling for the dollar) at $1.20 and the ECB put a floor to the dollar (and a ceiling for the euro) at $1.40. ( g ) $
  • 77.
    $-€ Anchor, cont’d The Federal Reserve should modify its policy of sterilizing automatically all foreign exchange intervention. Japan and China could also be invited to take t t k part i th stabilization program t in the t bili ti as could the United Kingdom
  • 78.
    5. International Macroeconomic AdvisoryCouncil Work t W k to establish for the world as a whole an t bli h f th ld h l International Macroeconomic Advisory Council as a counterpart to the Volcker-chaired Obama p Advisory Council. Form a committee of 10-15 wise people from around the world to advise and evaluate d th ld t d i d l t economic strategy and make recommendations. These could raw materials for an International Economic Advisory Council for policy at the Global Level.
  • 79.
    6. Trillion SDRissue It is imperative to provide public money to especially the smaller countries who do not have a lender of last resort. The SDR is the best mechanism for dealing ith thi d li with this.
  • 80.
    6. The TrillionSDR Issue SDRs were initially issued with a gold value guarantee. guarantee The amount 9.5 billion SDRs issued in 1970- 72 would now be worth $270 billion. The world has changed greatly since then and the requirements for international money are correspondingly greater. d l Such an issue would prevent the collapse of the banking systems in the rest of the world world.
  • 81.
    Policies for U.S. Dated Spending Vouchers (DSVs) Corporate tax cut from 35% to 15% Stabilization of Dollar Euro Exchange Rate Dollar-Euro and Plan a World Currency Reform of Banking System with Reconstitution of assets and Privatization. Initiate Trillion SDR allocation to save the global banking systems.
  • 82.
    Policies f Rt f W ld P li i for Rest of World
  • 83.
    Policies for Restof World Establish an international counterpart to the Volcker-Chaired Advisory Committee Stabilize exchange rates were feasible Support Trillion SDR allocation. allocation Initiate change of name of SDR. Support and Contribute to Formation of Global Currency Bretton Woods Type Conference in Shanghai in 2010 to restructure the International Monetary System.
  • 84.
    Toward a GlobalCurrency y
  • 85.
    Regionalism If themajor countries do not support a multilateral approach toward a restoration of the international monetary system, Asia and the other continents should act for itself by creating an Asian currency.
  • 86.
    World Currency TheLong Run Goal is a Global Currency. As Paul Volcker puts it, the global it economy needs a global currency. The problem is to devise a way to achieve it.
  • 87.
    Several Competing p g Approaches Regionalization Approach Dominant Currency Approach Precious Metals Approach Intor Approach pp
  • 88.
    An Asian Currencyby 2015? India Russia $ Baht¥ RINGITT € YEN P-Peso PP WON 15 EURO RMB Africa Rupiah HK$ ₤ Australia-NZ Latin Dollar Arab Bloc
  • 89.
    APEC Solution? Simple if Japan fixed yen to dollar, p y , C$ like China. Rupee Pakistan Lat$ Latin Dollar $ $ C¥ ¥ Ruble R bl € YEN EURO RMB ¥ RINGITT Africa ₤ Arab Bloc
  • 90.
    Alternative Scenario: APEC+ Europe? u op Euro Area $ ₤ India ¥ € Russia DEY RMB Africa Latin Dollar Dinar Area Indonesia
  • 91.
    Three Stages ofMonetary Reform Stage I. Convergence of DEY (Dollar-Euro- Yen) Exchange Rates and G-3 Monetary y Policy Use of DEY as platform, possibly with gold, for world currency the INTOR currency, Creation of INTOR and Ratification by the y Board of Governors of IMF.
  • 92.
    The INTOR: Whatcould we expect? A single unit for quoting prices. A common unit for denominating debts. A common rate of inflation for participating countries. A common interest rate on risk-free assets. A global business cycle.
  • 93.
    The SDR Basket SDR= dollar + euro + yen + pound pound 11% yen 15% dol l ar 45% eur o 29% dol l ar eur o y yen p pound 3/5/2009 Robert A. Mundell 93
  • 94.
    Quotas in IMF Belgium 2% United State s Canada 17% 3% China, P.R. Mainland 3% United Kingdom France 5% 5% Switz e rland Germany 2% 6% India Saudi Arabia 2% 3% Russia Italy 3% 3% Japan Ne the rlands 6% 2%
  • 95.
    Intor Sandwich Yen(SDR), Yen(SDR) 7.5% Euro(SDR), Pound(SDR), 14.5% 5.5% Dollor(SDR), 22.5% Gold , 50% 3/5/2009 Robert A. Mundell 95
  • 96.
    World Map withthe INTOR ¥ $ India RMB € ₤ Latin Dollar L ti D ll Russia Arab Bloc Africa
  • 97.