Global Financial Crises and Institutions Cheat Sheet

I recently completed a class called Global Financial Crises and Institutions with Dr. Nils Bjorksten. A great class by the way. We were permitted the use of a single page so-called “Cheat Sheet” during the final exam. The text below was my cheat sheet. It fit on one page using the front and back with extra wide margins in size 10 Calibri font.

  • Financial Crisis Cheat Sheet
  • Global governance v. national government: Instead of a global legislature and court system, policymakers meet and make nonbinding statements. A network of multilateral institutions follows up with technical support work.
  • Bretton Woods: Governments directly controlled capital movements (that is, exchange rates). In 1960s many thought dollar overvalued. Nixon closed gold window in 1971. Flexible, more floating-based, exchange rates flourished.
  • Mundell’s Impossible Trinity. Cannot have independent monetary policy, stable exchange rate, and open capital markets simultaneously. Rodrick’s Political Trilemma: cannot have deep economic integration, a nation state, and democratic politics all at once. Bretton woods allowed nation states with democratic politics while ignoring deep economic integration, which is liberalized tread and capital. Dirty float is in the middle of Mundell’s impossible trinity. ie loose float like china was at one time, although at other times china hard a strict float and very recently they are arguably market priced.
  • Hedgehogs only have one trick but it’s a good one (liberalization). Foxes always say it depends and use complex plans. Truth in the middle: There is a usually good solution but needs to be put in context which usually makes optimal implementation relatively complex.
  • LDC Debt Crisis: “less-developed-country” or Latin American Debt Crisis occurred in 1980s. In 70s several less developed countries, notably Brazil, Argentina, and Mexico, borrowed large amounts. In 70s and 80s the world economy went into recession due in large part to oil prices. A liquidity problem for certain countries arose. In 1982 Mexico declared it would not be able to service its debt and lending to Latin America abruptly halted. 1980s known as La Década Perdida or the lost decade bc it took about the whole decade for the damaged economies to recover. But is a country ever really insolvent, or does it just fail in terms of willingness to pay because political election is not tenable for people who would pay (bc it would cost voters)
  • LDC crisis solutions: Initially U.S. forbearance. LDCs engaged in austerity and structural adjustments (privatization, deregulation, trade liberalization, tax reform). Baker plan had no debt forgiveness. World Bank, IADB to help with debt rescheduling and associated structural adjustment. Paris Club utilized, use of paris club requires having a program with IMF. Brady plan 1989 Negotiations for debt reduction (haircuts). A haircut marks down the value of an asset by sale or balance sheet, not forgiveness, loss relative to first price but not to current fair price. LDC made debt forgiveness look good.
  • Shadow banking is non-traditional banking. Traditional banking hard2define but many say: Reserve-based deposit lending. Much of Shadow Banking is securities markets including derivatives. Dodd-Frank addresses some of Shadow Banking by including securities regulation. Housing/Financial Crisis/Great Recession
  • Bail out vs bail in: Bail-out means someone external to the problem inserts money, usually a government (LDC interesting case). Bail-in means creditors put in money to fix the problem (or grant forbearance, debt forgiveness, haircuts, etc). LDC was a combination bail out and bail in. In LDC the creditors left ‘holding the bag,’ but some creditors were govt’s and govt orgs (IMF).
  • Central planning collapses in 1989. Now need to secure stability, estabilsh banking system w/ central bank, fix taxes, privates firms, permit new firms, cut subsidies, liberalize prices, start social safety net. Areas affected are big and close.
  • Problems of liberalization: Revenue problems, expenditure (subsidy) problems, hyperinflation, unemployment, social unrest, no social safety net, price instability, political instability, and reform fatigue. Crises sprung up from rapid liberalization, but many bounced back quickly (Russia, Bulgaria, Czec Republic, and Baltics). Sometimes new economic elites captured thrown out governments.
  • Washington Consensus: Main message: Large government approach discredited; liberalize markets, privatize where possible, let incentives drive development. Includes tax reform, competitive (float or at least fundamentally based price) exchange rate, Trade liberalization, deregulation, and more. Crises in 80s and 90s led to rethinking through 90s. Market orientation retained, but tempered by country-specific non-market interventions (notably restricting capital flows and exchange rate arrangements)
  • ERM crisis (exchange rate mechanism). Showed fixed exchange rates and free capital flows can be a dangerous combination. European integration project started with exchange rates stable (’87). Bretton Woods collapse a problem, Resolved by “snake” (pegging each other) 1972-77, replaced by ERM in 1979. Key points: July 1987: The Single European Act. Completion of the frontier-free market by end of 1992, July 1990: Phase 1 of EMU removes restrictions on capital movements. December 1991: Maastricht agreement on draft Treaty on European Union: completion of EMU and introduction of a single European currency, June 1992: Maastricht treaty fails Danish referendum vote, which sparks unwinding of convergence plays
  • Treaty of the European Union 1992 (Maastricht Treaty): Replaced EEC with European Union: Agreed on Economic and Monetary Union to proceed in three stages, 1990-93: Completely free circulation of capital, 1994-98: Countries achieve convergence criteria, 1999-2001: Introduction of common currency and European Central Bank
  • ERM unfolding: Finland first country to abandon peg, Sept ‘92, Soros bet against Bank of England and won, Successful speculative attacks on Italy, Spain, Sweden futilely set overnight rates at 500%, France successfully defended its peg, Portugal, Ireland, Spain devalued in May 1993, Currency bands widened to 15%, effectively floating all exchange rates; crisis ended
  • ERM Crisis to Washington Consensus: Questioning whether exchange rate crises can be blamed on poor fiscal and monetary discipline, Awareness that financial sector can be source of shocks, crises now believed to be bad policies and shifts in investor sentiment. Surprises: Failure to grow, public revenue problems, and price/exchange rate stability problems. eg, ERM case, the market didn’t act like policymakers thought investors are supposed to act. Speculative attacks and market emotion weren’t supposed to happen, they were supposed to use specific metrics of market fundamental health.
  • Crises: LDC, ERM, Mexican 94 with tequila contagion, transition, Asian 97, Dot-Com, Housing.
  • How do you fix a run on a bank? Deposit insurance, lender of last resort (IMF), orderly entry and exit, regulate to prevent. How do you fix a ‘run on a country?’ or country debt issues (size matters)
  • Transition crisis: (from Soviet Russia to democratic states) Much more difficult and drawn out than expected, Politics could overwhelm technocratic programs (e.g., Russia)
  • Asian crisis: capital account crisis with new features: Inside of managed capitalism, healthy fundamentals and deep financial integration of private markets, but banks had close, nontransparent relationships with industrial conglomerates, Foreigners happy to invest, but only in foreign currency and only short term, little oversight led to corporate overinvestment
  • Features of Capital Account Crises: Presence of large balance sheet effects, Private sector is part of the problem and the solution. Capital crises implied new role for IMF: From crisis lender to crisis manager. Arrange additional financing, encourage private sector involvement (bail in), Help negotiate debt forgiveness if necessary. Is the IMF up to the task? Problems: Technical competence, impartiality, political legitimacy, and has no role in U.S. crisis. Perceived poor performance led to- backlash against the IMF through 90s. How has IMF responded or adapted? 1999 external evaluation of what went wrong (Crow report), Establish Independent Evaluation Office (IEO), New International Capital Markets department, Financial Sector Assessment Program (FSAP) exercises, Greater transparency, reweight voting power on Executive Board
  • We should have expected housing crisis according to Reinhart and Rogoff. “Periods of high international capital mobility have repeatedly produced international banking crises, not only famously, as they did in the 1990s, but historically.” R&R book – debt build up is a warning sign, but debt to GDP ratio more important than level of debt, another warning sign was immense rise in housing prices, rising consumer debt, and huge leveraged positions by traders.
  • Financial regulation is constructed piecemeal over time, on what existed in the past. Is it sound? “In policy work you never start with a clean slate.” Unintended consequences happen. We are always in one of three crisis phases: prevention, containment, recovery
  • Financial crisis: (housing, great recession) Financial sector recovered way before real economy. Recovery: interest rates, stimulus, bail out
  • Paradox of policy response: “Actions that seem reasonable – letting banks fail, forcing their creditors to absorb losses, balancing government budgets, avoiding moral hazard – make the crisis worse. Actions necessary to ease the crisis seem inexplicable and unfair.” Tim Geithner
  • Dodd-Frank aims to: Reduce systemic risk, End too big to fail, Shadow banking oversight, Derivatives oversight, Improve bank safety and soundness, Higher mortgage standards, Curb Fed emergency authority for bailouts, Do something about credit rating agencies, Consumer financial protection, Investor protection, Corporate governance, Federal insurance office
  • Expected questions: 1) Crises reshape view of Washington Consensus, 2) Can you bail out a country? 3) Is a country ever really insolvent? 4) Is hyperglobalization still the future? (Hyperglobalization means free flow like Rodrik’s deep economic integration, liberalization, Washington Consensus.) 5) Bail out vs bail in? Who actually gets bailed out? 6) Is IMF up to task of crisis manager instead of crisis lender? 7) Problems and solutions to piecemeal regulation? 8) paradox of policy response
  • 2

1 thought on “Global Financial Crises and Institutions Cheat Sheet”

Leave a Comment