The modern financial system

Eurodad AGM 2008

Sargon Nissannef (the new economics foundation)

Traditional function of the Financial System

• To transfer money from surplus to where there is a demand/need for it

• Banks are crucial to this process– Take in savings (Deposits)– Loan the deposits to firms & individuals at a

higher rate of interest

Government Intervention

Government control of the financial system, via:

• Interest rates– Reflect time value of money– Reflect risk of default (non-repayment)

• Fractional reserve banking – How much bank must held as proportion of deposits– $100 deposited in a bank with 20% fractional reserve

requirement increases money supply by $400

The birth of the modern financial system

Features of the post-BW system

Gradual end on the constraints of money creation

• Evolved from using a gold standard to $ pegs with a gold guarantee

• 1971 Nixon Shock– Gold link broken by Nixon due to domestic spending

and costs of Vietnam war

• Fiat money system– Money could be created without underlying asset

backing it

Bretton Woods-era gave way to freer flows of capital and floating exchange rates

• Volatility drastically increased– Contradicting expectations and orthodox economic

predictions

• Volatility created need to hedge against fluctuating prices– New markets in volatility-management tools: derivatives– Created marketplace for speculative profits and amplified the

use of these tools

• Assault on transparency– Vast majority of derivatives ‘OTC’ – over the counter and not

traded on exchanges– Created mechanism to avoid supervision or regulatory

oversight

Features of the post-BW system

New markets in derivatives allowed huge profit opportunities via speculation on price movements that were disconnected from real economic activity

Features of the post-BW system

The era of financialisation

Developed countries’ financial systems exploded relative to other parts of economy, particularly the role of banks

Climate of greater general indebtedness and increased gearing (debt to equity ratios)

• Financial assets and debts become larger proportion of GDP

• Banks strategically became focused upon commissions business and speculative operation

Financialisation

Bubbles• Debt being used to inflate value of assets against

which more debt is raised to re-start the cycle

Financial innovation/Derivatives• Also used to evade legislative oversight

– e.g. 1999 Amendment to US Community Reinvestment Act which excluded banks’ mortgage investment in securities from scrutiny – then sub-prime lending doubled from 2001 to 2006

Policy Blame• Ignored bubbles and stoked consumer spending

via indebtedness

Boom in mortgage lending, speculative price bubbles & Financial ‘innovation’

Real income levels did not follow growth

• Finance met gap in income levels

• Created climate for bubbles with loose monetary policy– US mortgages grew $2.1 to $3 trillion from

2001 to 2006– The proportion of that which was sub-prime

jumped from 8.6% to 20%

Financialisation

Key features of international financialisation

• Liberalisation of capital account

• Capital flows increasingly taking form of FDI and portfolio investment

• Inflation targeting priority over growth, jobs, health or other social outcomes to protect value of investment capital

Financialisation

• Costlier Short Term borrowing

• Domestic financialisation

• Exposure of Short Term obligations (debts that have to be repaid in short term) as borrowing has dried-up

• Export and trade demand

Implications for Developing Countries

The flow of money and the reserve currency“The exorbitant priviledge” (Giscard d’Estaing)

How does the money system reveal the challenges of reform?

GROUP EXERCISE

A Currency used as a reserve or store of wealth, as if it were an asset itself - the US Dollar

Source of wealth for whoever has the priviledge to issue that currency

• Un-cashed cheque at everyone else’s expense

• Permits deficit financing– Vietnam and Iraq wars– Current US bank bailout

An international reserve currency

No reserve currency has ever been permanent

• Drachma from 500 BC replaced by Roman aureus and denarius

Reserve currency reflects political power and authority

• Gold coins in Genoa and Florence from 13th Century, then usurped by Venetian ducato by 15th Century

Historic role of international currencies

Britain’s challenge to Dutch • guilder overtaken by sterling by 18th Century• Bank of England and Stock Exchange established

included vibrant foreign currency exchange

Stability of Britain’s economic strength • sterling retained position for 100+ years• By this point tokens (e.g. symbols of metallic value)

and receipts (bank notes) had become symbols of money and value, not actually holding value

Modern Era

• Limited gold restrained creation of money ‘tokens’

• Where gold was unavailable poorer countries began to hold financial assts convertible into gold

Gold Standard

Start of process of countries’ central banks holding foreign exchange reserves as part of normal practice

Nixon shock • Tension of the consequences of exploiting

reserve currency

– When world demanded gold for dollars, France, UK, Nixon ended Bretton Woods system Valerie Giscard d’Estaing “The exorbitant priviledge”

“Our currency but your problem”

End of Bretton Woods

Nixon shock • Tension of the consequences of exploiting

reserve currency

– When world demanded gold for dollars, France, UK, Nixon ended Bretton Woods system Valerie Giscard d’Estaing “The exorbitant priviledge”

“Our currency but your problem”

Who said this?

End of Bretton Woods

Operating a reserve currency brings costs

• Euro area lacks political will for unity and avoids promoting Euro as reserve

• Euro area not de-coupled, but connected, to US crisis

• Flight to quality is thus benefiting dollar – where else is there to go? For the moment

“The exorbitant priviledge” (Valerie Giscard d’Estaing)

China’s Dollar dependence

• Reserve accumulation over $1tn • Power to destabilise US financial system but

only at huge cost to itself• Not just China, but Brazil, India, Russia and

oil-exporting Gulf states all similarly attached to US situation

A globalised system – no winners

What will change this? Maybe the current crisis

• US domestic economy transformed, like 19th C UK, to financial services while neglecting exports, manufacture and jobs

• Weaker dollar needed to stimulate US economy but counter-balanced against damage it does to its ‘Faustian’ partners

• US lacks surpluses given its economic weakness to sustain strong dollar as reserve

No winners – for now

Assessing the impact on Developing Countries

Eurodad AGM 2008, section II

Sargon Nissannef (the new economics foundation)

Emerging Markets - 2008

• Severe losses in equity and bond markets• Corporate defaults in specific sectors, e.g.

construction and real estate• Local cost of funding much higher and

likely to remain so – limiting investment• Investment funds investing in EM debt

have suffered outflows• Economic expectations are for easing

inflation, growing current account deficits

Capital flows – still going uphill

Net capital flows have been negative due to reserve accumulation

2007China $1.5 trillionRussia $455 billionMid East $638 billionAfrica $145 billion

• Sterilisation of exchange pegs by purchase of US Treasuries

• Provides Insurance

Liberalisation’s Logic

• Increased investment

• Stability

• Better targeted investment (efficiency)

• Growth

Emerging Markets fuelling the crisis

Reserves from Current Account surpluses transferred into property bubble

• Exchange rate pegs are a crucial driver of reserve accumulation– Accounting for 75% of reserves accumulated

by DCs since 2002– Export expansion and import suppression, via

exchange rates

Emerging Markets fuelling the crisis

Countries also accumulate as self-insurance– Of reserves accumulated since 2002, 1/3

borrowed– India’s reserves 100% borrowed

Why?• Expensive but driven by desire to prevent

currency appreciation and deficits, plus provides a cushion against shocks

Vulnerability to the crisis

• Consider factors which impact sovereign financial autonomy

– Foreign banks’ involvement in Developing Countries (grown)

– FDI restrictions in banking sector– Asset share of bank assets by foreign banks– Reserve accumulation

• ‘Fluidity’ of flows– Net private inflows vs gross outflows– FDI outflows, including from ‘non-official’ sources

Vulnerability to the crisis - Risks

Financial contagion – Dropping stock markets, currency

pressure

• Trade

• Remittances

• FDI and portfolio investment

• Lending

• Aid

Vulnerability to the crisis

• Exporters to most affected countries (e.g. Mexico)

• Countries with exports tied closely to global demand levels, or high income elasticity (commodities or tourism)

• Countries with significant remittance flows

• Very open economies where investment biased to FDI or portfolio investment (e.g. South Africa)

• High current account deficit countries – – increasing pressure for devaluation and inflation, also

exacerbated by high government deficits (India)

Analysing Crisis Impact

Reliance on exports

Reliance on international finance– Some forms of reliance are inherently more

precarious, e.g. extent of FDI accounted for by portfolio flows, bank lending…

External penetration of the financial system– Home bias, lack of local knowledge, regulatory

power of domestic authority, capital flight risks

Analysing Crisis Impact - Trade

• Trade openness

• Current account balance

• Export focus (to whom?)– South-south links – Extent of presumed ‘decoupling’ – looks like

we’re all in it together

• Export vulnerability (Elasticity of demand for key exports)

Analysing Crisis ImpactReliance on international finance

Openness of capital account– Capital inflows, Bank flows, Portfolio flows as % of GDP

Domestic banking sector’s relative importance– % of domestic assets and liabilities in domestic banks’

portfolios, % of foreign currency denominated debt

Reserves – Reserves to GDP - Ability to offset foreign shortfalls

Currency denomination of foreign exchange reserves

Implications

Implications of Crisis Impact

Regulation and Governance

• Potential for renewed emphasis on bilateral forms of influence versus multilateral structures of negotiation, such as collective trade or finance rules– Altered regulatory regimes

• de jure (e.g. Basle II) • de facto (ratings agencies and other private actors)

– Risk of a technocratic approach being taken

Implications of Crisis Impact

Solidarity

• Different countries will be impacted differently, challenging in novel ways the capacity to develop a collective response from the South

• Vulnerability and agency (or lack of) reveal new cracks in collective bargaining positions

Implications of Crisis Impact

Institutional power

Potentially reinvigorating consequences for IMF and other BW institutions as political and economic actors.

Governance issue had waned as their significance and centrality contracted but could once again be a crucial component of any new settlement

Implications of Crisis Impact

Changing of the guard, not the system?

• New centres of financial power

• Too soon to proclaim the death of the old centres of finance?

• Will the name-plates change and nothing else?