Empires, Past and Present

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Economists rarely write about “empires,” unless they are referring to historical examples such as the Roman empire. But Thomas Hauner of the Federal Reserve Bank of Minneapolis,  Branko Milanovic of the Graduate Center of City University of New York and Suresh Naidu of Columbia University have presented a study of empires using criteria drawn from an economics classic, John Hobson’s Imperialism (1902). The same criteria can be used to examine whether any empires exist today.

Hobson was not a Marxist, but his work greatly influenced later Marxist writers who wrote about imperialism, including Vladimir Lenin, Rudolf Hilferding and Rosa Luxemburg. Hobson believed that there was chronic underconsumption in advanced capitalist countries due to unequal distributions of income. This lowered the return on domestic investment, and as a result the owners of financial capital turned to foreign markets where returns would be higher. These investors relied on their governments to guarantee the safety of their foreign holdings from seizure.

Hauner, Milanvic and Naidu demonstrate that there was a high degree of inequality within the advanced capitalist countries in the late 19th century. The foreign assets held by wealthy investors in Britain and France expanded greatly during this period, and these assets generated rates of return higher than those available from domestic investments. They also present evidence of a linkage between the accumulation of foreign assets and militarization that led to World War I. These results are consistent with Hobson’s work.

Hobson’s empires established positive net international investment positions (NIIP) and received income from these foreign investments. The payments appear in the current account of the balance of payments as “net primary income.” This component of the current account records the difference between payments received by domestic residents for providing productive resources, such as their labor, financial resources or land, to foreigners minus the payments made to foreigners for their productive resources made available to the domestic economy. For most countries, receipts and payments on financial assets are the largest component of their net primary income.

Great Britain was a financial center and the preeminent creditor nation during the zenith of its empire, and a net recipient of foreign income. It earned net income worth 5.4% of GDP in the period 1874-1890, and 6.8% from 1891 to 1913 (Matthews, Feinstein and Odling-Smee 1982). The surpluses were large enough to offset a trade deficit and allow the country to continue to invest abroad and expand their foreign holdings.

What are the largest creditor nations today? Are they also Hobsonian empires? Japan is the leading creditor nation, with a net international investment position of $2.8 trillion in 2015, which represented 67% of its GDP. It earned $165.88 billion in net primary income, worth 3.8% of its GDP. Germany is also a creditor nation, with a NIIP of about $1.5 trillion (45% of GDP) in 2015 and net income of $74.6 billion (2.2% of its GDP).

But Japan and Germany nations do not fulfill the other criteria to be called empires. They do not have the disparities in wealth that the U.S. and many developing countries possess. Their Gini coefficients are almost identical: 32.1 for Japan and 31.4 for Germany. These are similar in magnitude to those of other European countries, higher than those of the Scandinavian nations but below those of Portugal and Spain.

Moreover, the two nations are not militaristic powers. Japan’s constitution forbids the use of force, although the country does have Self-Defense Forces. Prime Minister Shinzo Abe is seeking to amend the country’s constitution in order to clarify the rules governing the disposition of these troops. Germany is part of NATO, but the foreign deployment of German forces is strictly supervised by Parliament.

The situation of other large countries is more anomalous. China is a leading creditor nation, with a NIIP in 2015 only slightly lower than Germany’s and equal to 194% of its GDP. But that country registered a deficit of net primary income of $41.8 billion. On the other hand, the country with the largest inflow of income in absolute terms was the U.S., a debtor nation with a NIIP of -$7.8 trillion in 2015, worth about 45% of GDP. Its net income inflow of $204.5 billion represented 1.1% of its GDP.

The explanation for these seemingly inconsistent results lies with the composition of the external assets and liabilities. The U.S. is “long equity, short debt,” with assets largely composed of foreign direct investments (FDI) and portfolio equity, and liabilities primarily in the form of debt (bonds, such as U.S. Treasury securities, or bank loans). In 2015, for example, 60% of its assets were held in the form of FDI or portfolio equity, which earn an equity premium because of their riskier nature. China, on the other hand, is “long debt and short equity,” where the debt includes the central bank’s foreign reserves held in the form of U.S. Treasury bonds. Debt assets and foreign reserves constituted 79% of China’s foreign assets in 2015, and the returns on these have been quite low in recent years. FDI and portfolio equity liabilities, on the other hand, accounted for 74% of the external liabilities.

The unusual nature of these income flows have attracted great attention. Yu Yongding of China’s Academy of Social Sciences, for example, has written about his country’s “irrational IIP structure.” He attributes this to an undervalued exchange rate that has allowed the country to have surpluses in both the current and capital accounts that were balanced by increases in foreign reserves, as well as government policies that favored FDI from abroad.

The positive return that the U.S. receives has been called an “exorbitant privilege” that is due to the status of the dollar as a reserve currency. In 1966 Emile Despres of Stanford University, Charles P. Kindleberger of MIT and Walter S. Salant of the Brookings Institution wrote that the configuration of the U.S. balance of payments was due to its status as the “world’s banker”, issuing short-term liabilities in exchange for long-term assets. More recently, Pierre-Olivier Gourinchas of UC-Berkeley and Hélène Rey of the London Business School updated this description of the U.S. to the “world venture capitalist.”

The global financial crisis might have ended this status of the U.S., but the influence of the U.S. economy and its monetary policies has not diminished. Changes in U.S. interest rates have widespread effects on capital flows and credit creation. Several recent studies, including one by Òscar Jordàof UC-Davis, Moritz Schularick of the University of Bonn and Alan Taylor of UC-Davis, have referred to the existence of a global financial cycle that is very responsive to U.S. monetary policy. Similarly, Matteo Iacoviello and Gaston Navarro  of the Federal Reserve Board have written about the spillover effects of U.S. interest rates on foreign economeis.

It may be time for a new definition of imperialism. If the U.S. possesses an empire, it is based on its ownership of foreign capital that it accumulates in return for the issuance of “safe assets.” It takes advantage of this position to invest in more lucrative equity. In addition, it hosts the largest and most liquid financial markets and networks. Moreover, the U.S. government has shown its willingness to use financial sanctions as a policy tool.

With respect to the other attributes of 19thcentury empires, we no longer send Marines to Central America to safeguard our foreign holdings. But our military spending greatly exceeds that of other nations. Wealth is heavily concentrated; the richest U.S. families—those in the top 1% of the distribution of wealth—own 40% of the wealth in this country. Those assets undoubtedly include direct and indirect ownership in foreign enterprises, which contribute to the returns they receive.

What could end this arrangement? The renminbi and the euro are rival currencies, but it is doubtful that they will attain the global status of the dollar. Under ordinary circumstances, one might expect the U.S. position to continue for the foreseeable future. But these are not ordinary times. The Trump administration seems ready to shred a wide range of international agreements, such as those that established the World Trade Organization and the North American Free Trade Association. Moreover, the tax legislation passed last year that lowered personal and corporate tax rates is pushing up the government’s budget deficit. The Congressional Budget Office’s projection for this fiscal year’s deficit has risen from $563 billion to $804 billion and is projected to reach $1 trillion by 2020. Will U.S. Treasury securities continue to be viewed as safe?

The record of transitions in international monetary regimes does not bode well for the future. The gold standard collapsed in the 1930s as governments sought to escape the world-wide contraction in global economic activity. The Bretton Woods regime began to disintegrate when the Nixon administration ended the conversion of the dollar reserves of foreign central banks into gold in 1971. None of these regime ends were planned and they led to further instability. The end of America’s hegemonic financial position has long been forecasted–and avoided. But the shockwaves of the global financial crisis are still taking place, and eventually may be even more disruptive than we ever imagined.

West Coast Workshop in International Finance

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7th Annual West Coast Workshop in International Finance
November 9, 2018

Call for papers and workshop announcement
Submission Deadline: August 17th, 2018

The 7th annual West Coast Workshop in International Finance will be held at the University of California, Santa Cruz on Friday, November 9th. (Past workshop agendas can be seen here.)

We encourage submissions in all areas of open-economy macroeconomics and international finance. Policy-relevant theoretical work, empirical research, computational work, and historical approaches are all welcome.

Please submit full papers via email to: WCWIF@scu.edu. The deadline for paper submissions is Friday, August 17, 2018.

The WCWIF organizing committee will select the papers to be presented at the conference and will notify presenters the first week in September. Paper presenters will be responsible for their own travel expenses.

The WCWIF 2018 organizing committee includes:

Yu-chin Chen, University of Washington
Grace Weishi Gu, UC Santa Cruz
Chenyue Hu, UC Santa Cruz
Mark Spiegel, Federal Reserve Bank of San Francisco
Romain Rancière, USC
Andrew Rose, UC Berkeley
Katheryn Russ, UC Davis
Kenneth Kletzer, UC Santa Cruz (Co-Chair)
Helen Popper, Santa Clara University (Co-Chair)

The workshop is sponsored by the Department of Economics at UC Santa Cruz, by the Department of Economics at Santa Clara University, and by the Federal Reserve Bank of San Francisco.

Please share this call with colleagues who may be interested.

Can Globalization Be Reversed?

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The wide-scale imposition of tariffs by the Trump administration is part of a larger effort to undo the expansion of markets around the globe and ensure that the goods consumed in the U.S. will be produced here. Will it be successful? And what would a world that represented a retreat from the globalization of the 1990s and early 2000s look like?

Martin Sandbu of the Financial Times believes that the open world economy “can withstand the assault.” He points out that the emerging market economies that have benefitted from the increase in international trade have an interest in maintaining the current regime. Moreover, it will be difficult to replace global supply chains with production facilities in each economy where a firm sells its products. Finally, limiting overseas expansion of markets will do nothing to address the problem it is supposed to correct: the stagnant wages of relatively low-skilled people. There are policies to help those whose jobs have been eliminated by technology, but these include better educational opportunities and health care, not limitations on trade.

While globalization will not be replaced by national autarchies, it is possible to imagine more narrow organizations of production and finance. The increase in the number of regional trade pacts will accelerate If the World Trade Organization is undermined by the Trump administration. Whether or not regional trade agreements are the source of trade creation or diversion is an empirical issue. Research by Caroline Freund of the Peterson Institute for International Economics and Emanuel Ornelas of Sao Paulo School of Economics-FGV indicates that such pacts in the past were beneficial for trade. But there is no guarantee that this outcome will continue in the future, particularly if the regional pacts replace wider agreements.

The world could divide into competing spheres of influence. China is taking advantage of the withdrawal of the U.S. from international pacts to advance its Belt and Road Initiative that will link it to resource-rich developing economies in Asia and Africa as well as markets in Europe. Advocates of British withdrawal from the European Union claim that there are better opportunities in the “Anglosphere” of English-speaking countries such as the U.S. and Australia.

But the Trump administration has exhibited animus to even regional pacts such as NAFTA, and seemingly favors bilateral pacts guided by mercantilist goals. Such an approach would be a serious problem for U.S. based multinationals that have integrated production lines across the borders with Mexico and Canada. Nor will the governments of those agree to mercantilist arrangements that are designed to ensure bilateral trade surpluses for the U.S.

A world of tariffs and quotas, moreover, would also be a step towards increased government controls on the private sector. Anne Krueger of Johns Hopkins points out that quotas, such as those on steel that South Korea has agreed to, must be administered by either the Korean or U.S. government. Similarly, exemptions from tariffs must be granted by a bureaucracy that reviews applications from private firms. These grants of authority open up opportunities for corruption. They also act as barriers to entry for new firms, and lessen incentives to innovate. All this adds to the higher costs that consumers and those who rely on imported intermediate goods will pay.

Perhaps the most self-defeating counter-globalization measure would be to lower immigration. While most of the benefits of immigration flow to the migrants themselves, there is also a “migration surplus” for the economy that hosts them. The tax payments of migrants can be used to pay rising Social Security payments at a time when the native U.S. population is aging.  Moreover, immigrants have a strong record of establishing new businesses. The Center for American Entrepreneurship reports that 43% of firms listed in the 2017 Fortune 500 were founded or co-founded by first- or second-generation migrants.

Not all movements towards globalization were beneficial for those countries that opened up their borders. In the area of finance, financial flows led to the Asian crisis of 1997-98 and the global financial crisis of 2008-09, while their impact on growth is slim at best. The IMF has renounced its previous advocacy of capital account deregulation and now views capital controls as part of a government’s toolkit of macroprudential measures to stabilize the financial sector.

Moreover, Dani Rodrik of the Kennedy School has pointed out that the hyperglobalization drive of the 1980s and 1990s pushed trade agreements beyond their “traditional focus on import restrictions and impinged on domestic policies…” Rodrik argues that some of the recent trade pacts are designed to increase the revenues of multinational firms, and their redistributive effects will overwhelm any increases in efficiency.

But attempting to impose a system of nationalistic managed trade that limits the movements of people is inherently difficult, and will lead to widespread government intervention. Workers and firms who benefit from such measures will be outnumbered by those who lose export opportunities and those who must pay higher domestic prices. Over time, firms will cut back on investments if they feel the need to secure government approval. All this will lower productivity in economies where productivity growth is already depressed. There is a need for a better-designed globalization, but what we are seeing is a movement to a world of national barriers that will only fuel xenophobia and hamper long-term growth.

The Spillover Effects of Rising U.S. Interest Rates

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U.S. interest rates have been rising, and most likely will continue to do so. The target level of the Federal Funds rate, currently at 1.75%, is expected to be raised at the June meeting of the Federal Open Market Committee. The yield on 10-year U.S. Treasury bonds rose above 3%, then fell as fears of Italy breaking out the Eurozone flared. That decline is likely to be reversed while the new government enjoys a (very brief) honeymoon period. What are the effects on foreign economies of the higher rates in the U.S.?

One channel of transmission will be through higher interest rates abroad. Several papers from economists at the Bank for International Settlements have documented this phenomenon. For example, Előd Takáts and Abraham Vela of the Bank for International Settlements in a 2014 BIS Paper investigated the effect of a rise in the Federal Funds rate on foreign policy rates in 20 emerging market countries, and found evidence of a significant impact on the foreign rates. They did a similar analysis for 5-year rates and found comparable results. Boris Hofmann and Takáts also undertook an analysis of interest rate linkages with U.S. rates in 30 emerging market and small advanced economies, and again found that the U.S. rates affected the corresponding rates in the foreign economies. Finally, Peter Hördahl, Jhuvesh Sobrun and Philip Turner attribute the declines in long-term rates after the global financial crisis to the fall in the term premium in the ten-year U.S. Treasury rate.

The spillover effects of higher interest rates in the U.S., however, extend beyond higher foreign rates. In a new paper, Matteo Iacoviello and Gaston Navarro of the Federal Reserve Board investigate the impact of higher U.S. interest rates on the economies of 50 advanced and emerging market economies. They report that monetary tightening in the U.S. leads to a decline in foreign GDP, with a larger decline found in the emerging market economies in the sample. When they investigate the channels of transmission, they differentiate among an exchange rate channel, where the impact depends on whether or not a country pegs to the dollar; a trade channel, based on the U.S. demand for foreign goods; and a financial channel that reflects the linkage of U.S. rates with the prices of foreign assets and liabilities. They find that the exchange rate and trade channels are very important for the advanced economies, whereas the financial channel is significant for the emerging market countries.

Robin Koepke, formerly of the Institute of International Finance and now at the IMF, has examined the role of U.S. monetary policy tightening in precipitating financial crises in the emerging market countries. His results indicated that there are three factors that raise the probability of a crisis: first, the Federal Funds rate is above its natural level; second, the rate increase takes place during a policy tightening cycle; and third, the tightening is faster than expected by market participants. The strongest effects were found for currency crises, followed by banking crises.

According to the trilemma, policymakers should have options that allow them to regain monetary control. Flexible exchange rates can act as a buffer against external shocks. But foreign policymakers may resist the depreciation of the domestic currency that follows a rise in U.S. interest rates. The resulting increase in import prices can trigger higher inflation, particularly if wages are indexed. This is not a concern in the current environment. But the depreciation also raises the domestic value of debt denominated in foreign currencies, and many firms in emerging markets took advantage of the previous low interest rate regime to issue such debt. Now the combination of higher refinancing costs and exchange rate depreciation is making that debt much less attractive, and some central banks are raising their own rates to slow the deprecation (see, for example, here and here and here).

Dani Rodrik of the Kennedy School and Arvin Subramanian, currently Chief Economic Advisor to the Government of India, however, have little sympathy for policymakers who complain about the actions of the Federal Reserve. As they point out, “Many large emerging-market countries have consciously and enthusiastically embraced financial globalization…there were no domestic compulsions forcing these countries to so ardently woo foreign capital.” They go on to cite the example of China, which “…has chosen to insulate itself from foreign capital and has correspondingly been less affected by the vagaries of Fed actions…”

It may be difficult for a small economy to wall itself off from capital flows. Growing businesses will seek new sources of finance, and domestic residents will want to diversify their portfolios with foreign assets. The dollar has a predominant role in the global financial system, and it would be difficult to escape the spillover effects of its policies. But those who lend or borrow in foreign markets should realize, as one famed former student of the London School of Economics warned, that they play with fire.

A Guide to the (Financial) Universe: Part III

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Parts I and II of this Guide appear here and here.

4.      Stability and Growth

Is the global financial system safer a decade after the last crisis? The response to the crisis by central banks, regulatory agencies and international financial institutions has increased the resiliency of the system and lowered the chances of a repetition. Banks have deleveraged and possess larger capital bases. The replacement of debt by equity financing should provide a more stable source of finance.

Indicators of financial volatility, such as the St. Louis Fed Financial Stress Index, currently show no signs of sudden shifts in market conditions. The credit-to-GDP gap, developed by the Bank of International Settlements (BIS) as an early warning indicator of systemic banking crises, exhibits little evidence of excessive credit booms. One exception is China, although its gap has come down.

But increases in U.S. interest rates combined with an appreciating dollar could change these conditions. Since the financial crisis, financial flows have appeared to be driven in part by a global financial cycle that is governed by U.S. interest rates as well as asset market volatility. This has led Hélène Rey of the London Business School to claim that the Mundell-Fleming trilemma has been replaced by a dilemma, where the only choice policymakers face is whether or not they should use capital controls to preserve monetary control. Eugenio Cerutti of the IMF, Stijn Claessens of the BIS and Andrew Rose of UC-Berkeley, on the other hand ,have offered evidence that the empirical importance of any such cycle is limited. Moreover, Michael W. Klein of Tufts University and Jay C. Shambaugh of George Washington University in one study and Joshua Aizenman of the University of Southern California, Menzie Chinn of the University of Wisconsin and Hiro Ito of Portland State University in another have found that flexible exchange rates can affect the sensitivity of an economy to foreign policy changes and afford some degree of policy autonomy.

A rise in U.S. rates, however, will increase the cost of borrowing in dollars. The volume of credit flows denominated in dollars reflects the continuing predominance of the dollar in international financial markets. Dollar-denominated credit to emerging market economies, for example, rose by 10% in 2017, driven primarily by a rise in the issuance of debt securities. Higher interest rates, a depreciating currency and a deteriorating international trade environment can quickly downgrade the creditworthiness of emerging market borrowers.

Other potential sources of stress remain. One of these is the lack of adequate “safe assets,” which serve as collateral for lending. U.S. Treasury bonds are utilized for this purpose, but in the run-up to the global crisis mortgage-based securities (MBS) with the highest ratings also served that function. Their disappearance leaves a need for other privately-provided safe assets, or alternatives issued by the international public agencies. Moreover, doubts about U.S. fiscal solvency could lead to doubts about the creditworthiness of the U.S. government securities.

Claudio Borio of the BIS perceives another flaw in the international monetary system: “excess financial elasticity” that contributes to financial imbalances. The procyclicality of finance is heightened during boom periods by capital inflows, and the spread of easy monetary conditions in core countries to the rest of the world is facilitated through monetary regimes. The impact of the regimes includes the decision of policymakers to resist currency appreciation which affects their interest rates, and the role of dominant currencies such as the dollar. Borio calls for greater international cooperation to mitigate the volatility of the financial cycle.

Dirk Schoenmaker of the Duisenberg School of Finance and VU University Amsterdam has drawn attention to a fundamental tension within the international system. He suggests that there is a financial trilemma, with only two of these three characteristics of a financial system as feasible: International financial integration, national financial policies and financial stability. A nation that wants to enjoy the benefits of cross-border capital flows needs to coordinate its regulatory activities with those of other countries. Otherwise, banks and other institutions will take advantage of discrepancies across borders in the rules governing their activities to find the least onerous regulations and greatest room for expansion.

These concerns about stability could be accepted if financial development had a positive impact on economic growth. But Boris Cournède, Oliver Denk and Peter Hoeller of the OECD,  in a review of the literature on the relationship of the financial sector and economic growth, report that above a threshold of financial development the linkage with growth is negative (see also here). Their results indicate that this reversal occurs when the financial expansion is based on credit rather than equity markets. Similarly, Stephen G. Cecchetti and Enisse Kharroubi of the BIS (see also here) report that financial development can lower productivity growth.

In addition, it has long been acknowledged that there is little evidence linking international financial flows to growth (see, for example, the summary of this work by Maurice Obstfeld of the IMF (and formerly of UC-Berkeley)).  More recently, Joshua Aizenman of the University of Southern California, Yothin Jinjarik of the University of Wellington and Donghyun Park of the Asian Development Bank have shown that the relationship of capital flows and growth depends on the form of capital. FDI flows possess a robust relationship with growth, while the linkage with other equity is smaller and less stable. The impact of FDI may depend on the development of the domestic financial sector. Debt flows in normal times do not reinforce growth, but can contribute to the probability of a financial crisis.

The impact of international financial flows on income inequality is also a subject of concern. Davide Furceri and Prakash Loungani of the IMF found that capital account liberalization reforms increase inequality and reduce the labor share of income. Furceri, Loungani and Jonathan Ostry also report that policies to promote financial globalization have led on average to limited output gains while contributing to significant increases in inequality. Distributional effects are more pronounced in those countries with low financial depth and inclusion, and where liberalization is followed by a crisis. A similar result was reported by Silke Bumann of the Max Planck Institute for Evolutionary Biology and Robert Lensink of the University of Groningen.

The change in the international financial system that may be the least understood is the evolution of FDI, which has grown in recent decades while the use of bank credit has fallen. FDI flows are increasingly routed thought countries such as Luxembourg and Ireland for the purpose of tax minimization. Moreover, the profits generated by foreign subsidiaries can be reinvested and form the basis of further FDI. Quyen T. K. Nguyen of the University of Reading asserts that such financing may be particularly important for operations in emerging market economies where domestic finance is limited. FDI flows also include intra-firm financing, a form of debt, and therefore FDI may be more risky than commonly understood.

5.     Conclusions

As a result of the substantial capital flows of the 1990s and early 2000s, the scope of financial markets and institutions now transcends national borders, and this expansion is likely to continue. While financial openness as measured by external assets and liabilities has not risen since the global crisis, this measurement is misleading. Emerging market economies with growing GDPs but less financial openness are becoming a larger component of the global aggregate. But financial openness and GDP per capita are correlated, and the populations of those countries will engage in more financial activity as their incomes increase.

A stable international financial system that promotes inclusive growth is a global public good. Global public goods face the same challenge as domestic public goods, i.e., a failure of markets to provide them. In the case of a global public good, the failure is compounded by the lack of an incentive for any one government to supply it.

The central banks of the advanced economies did coordinate their activities during the crisis, and since then international financial regulation has responded to the growth of global systematically important banks. But the growth of multinational firms that manage global supply chains and international financial institutions that move funds across borders poses a continuing challenge to stability. In addition, while the United Kingdom and the U.S. served as a financial hegemons in the past, today we have nations with small economies but extremely large financial sectors that reroute financial flows across border, and their activities are often opaque.

The global financial crisis demonstrates how little was understood of the fragility of the financial system that had built up around mortgage-backed securities. Regulators need to understand and monitor the assets and liabilities that have replaced them if they are not to be caught by surprise by the outcome of the next round of financial engineering. If “eternal vigilance is the price of liberty,” it is also a necessary condition for a stable financial universe.

A Guide to the (Financial) Universe: Part II

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(Part I of this Guide appears here.)

3. Crisis and Response

The global crisis revealed that the pre-crisis financial universe was more fragile than realized at the time. Before the crisis, this fragility was masked by low interest rates, which were due in part to the buildup of foreign reserves in the form of U.S. securities by emerging market economies. The high ratings that mortgage backed securities (MBS) in the U.S. received from the rating agencies depended on these low interest rates and rising housing prices. Once interest rates increased, however, and housing values declined, mortgage borrowers—particularly those considered “subprime”—abandoned their properties. The value of the MBS fell, and financial institutions in the U.S. and Europe sought to remove them from their balance sheets, which reinforced the downward spiral in their values.

The global crisis was followed by a debt crisis in Europe. The governments of Ireland and Spain bolstered their financial institutions which had also lent extensively to the domestic housing sectors, but their support led to a deterioration in their own finances. Similarly, the safety of Greek government bonds was called into question as the scope of Greek deficit expenditures became clear, and there were concerns about Portugal’s finances.

Different systems of response and support emerged during the crises. In the case of the advanced economies, their central banks coordinated their domestic policy responses. In addition, the Federal Reserve organized currency swap networks with its counterparts in countries where domestic banks had participated in the MBS markets, as well as several emerging market economies (Brazil, Mexico, South Korea and Singapore) where dollars were also in demand. The central banks were then able to provide dollar liquidity to their banks. The European Central Bank provided similar currency arrangements for countries in that region, as did the Swiss National Bank and the corresponding Scandinavian institutions.

The emerging market countries that were not included in such arrangements had to rely on their own foreign exchange reserves to meet the demand for dollars as well as respond to exchange rate pressures. Subsequently, fourteen Asian economies formed the Chiang Mai Initiative Multilateralization, which allows them to draw upon swap arrangements. China has also signed currency swap agreements with fourteen other countries.

In addition, emerging market economies and developing economies received assistance from the International Monetary Fund, which organized arrangements with 17 countries from the outbreak of the crisis through the following summer. The Fund had been severely criticized for its policies during the Asian crisis of 1997-98, but its response to this crisis was very different. Credit was disbursed more quickly and in larger amounts than had occurred in past crises, and there were fewer conditions attached to the programs. Countries in Asia and Latin America with credible records of macroeconomic policies were able to boost domestic spending while drawing upon their reserve holdings to stabilize their exchange rates. The IMF’s actions contributed to the recovery of these countries from the external shock.

The IMF played a very different role in the European debt crisis. It joined the European Commission, which represented European governments, and the European Central Bank to form the “Troika.” These institutions made loans to Ireland in 2010 and Portugal in 2011 in return for deficit-reduction policies, while Spain received assistance in 2012 from the other Eurozone governments. In 2013 a banking crisis in Cyprus also required assistance from the Troika.These countries eventually recovered and exited the lending programs.

Greece’s crisis, however, has been more protracted and the provisions of its program are controversial. The IMF and the European governments have been criticized for delaying debt reduction while insisting on harsh budget austerity measures. The IMF also came under attack for suborning its independence by joining the Troika, and its own Independent Evaluation Office subsequently published a report that raised questions about its institutional autonomy and accountability.

In the aftermath of the crisis, new regulations—called “macroprudential policies”—have been implemented to reduce systemic risk within the financial system. The Basel Committee on Banking Supervision, for example, has instituted higher bank capital and liquidity requirements. Other rules include restrictions on loan-to-value ratios. These measures are designed both to prevent the occurrence of credit bubbles and to make financial institutions more resilient. A European Banking Authority has been established to set uniform regulations on European banks and to assess risks. In the U.S., a Financial Stability Oversight Council was given the task of identifying threats to financial stability.

The crisis also caused a reassessment of capital account restrictions. The IMF, which had urged the deregulation of capital accounts before the Asian crisis of 1997-98, published in 2012 a new set of guidelines, named the “institutional view.” The Fund acknowledged that rapid capital flows surges or outflows could be disruptive, and that under some circumstances capital flow management measures could be useful. Capital account liberalization is appropriate only when countries reach threshold levels of institutional and financial development.

One legacy of the response to the crisis is the expansion of central bank balance sheets. The assets of the Bank of England, the Bank of Japan, the European Central Bank (ECB) and the Federal Reserve rose to $15 trillion as the central banks engaged in large-scale purchases of assets, called “quantitative easing”. The Federal Reserve ceased purchasing securities in 2014, and the ECB is expected to cut back its purchases later this year.  But the unwinding of these holdings is expected to take place gradually over many years, and monetary policymakers have signaled that their balance sheets are unlikely to return to their pre-crisis sizes.

(to be continued)