Recently in international economics Category
Kim Jung-il, the ruler of North Korea, died last week, reportedly of a massive stroke. Other than a few deluded souls who might have been sincerely crying their eyes out on North Korean television, he will be missed by no one.
His death does, however, open up the possibility of changes
in that reclusive country's policies, both domestically and
internationally. In terms of politics
and policy, North Korea is probably the hardest country in the world to
reliably understand. We can observe the
final results of whatever process determines policy, but very few people
outside North Korea have any clue how that process actually proceeds. So it is entirely possible that nothing will
change in practical terms as a result of Kim Jung-il's death. Still, if you are a bit of a gambler, the
odds are higher now than they have been in a long time.
The Greek financial system is in big trouble right now. The fundamental problem is that the Greek government has been on a bit of spending bender over the past few years and has borrowed a lot of money to pay for this, all of it denominated in euros. It has become frighteningly clear that this level of debt is unsustainable and the Greek government needs truly radical fiscal reform to avoid defaulting on its outstanding debt. Much of that debt is held in the form of Greek government bonds by Greek banks, but a large amount is also held by various financial institutions outside of Greece.
By itself this is not really a very interesting or important situation. There are a large number of countries in the world and inevitably, some of them get into fiscal trouble. Some sort of financial crisis of this sort happens on a fairly regular basis. Greece is, however, a member of a monetary union. And its financial health could have an effect on the financial health of other members of that union.
The euro is a unique currency because it is issued by a collection of sovereign states, rather than by a single country as is usually the case. The currency was formally introduced into circulation in 2002 and replaced the national currencies of the participating countries. Control of the euro money was given to the European Central Bank (ECB), which was created with the sole purpose of managing the euro. When the euro was created it was very clear that all member countries would be using a single currency and would therefore be unified monetarily. It was not clear, however, how unified these countries would be in fiscal terms, however. There is no governmental equivalent to the ECB. There is a European parliament, but there is no central government with authority to tax and spend for the European Union as a whole. Fiscal matters are, in theory, left entirely to the individual member countries. This means there is no natural central source of funds to "bail out" the Greek government. The two bailout packages worked out so far have been hammered out via complex negotiations between Greece, the ECB, and other European governments.
Suppose Greece decides it is going to default on its government bonds. Does this necessarily mean that the euro as a currency is in trouble? Not necessarily. In fact, if there is no expectation that Europe is a fiscally united, then there should be no issue at all. Greek bonds, though denominated in the same currency as German bond, already pay higher interest rates due to their higher probability of default. If the Greek government decides to default, things could get really bad for Greece, but it need not affect other European countries. The fact that German and other European banks hold Greek government bonds could lead to increased stress on the banking sectors in those countries, but it need not lead to dissolution of the euro as a currency.
However, a problem does arise with one the way that Greece might choose to default on its debt. Rather than default outright, the Greek government could choose to drop out of the euro zone and reintroduce their previous national currency, the drachma. They could do this by initially trading all euro amounts in Greece one-for-one with drachma, for example, and legally rewriting all contracts in euro to contracts in drachma. Then the Greek central bank could drastically increase the number of drachma in circulation and repay its nominal debt with this new money. The result would be a devaluation of the drachma. Greek assets would be worth less on the world market, just like a default, but a formal default would be avoided. In effect, Greece would be solving its fiscal problems by imposing an inflation tax and at least some of the burden of that tax would fall on non-Greek holders of Greek government bonds.
Now suppose you had a time machine and knew for certain that this was going to happen on Dec. 31st 2011. What should you do today? You should sell any Greek assets you hold today to avoid the inevitable loss in their value when the drachma is devalued. If you are a savvy investor you might take profits by short-selling Greek debt. Even if you don't have the time machine and are uncertain what is going to happen, you might still find it prudent to sell. When all or most investors do this, the result is a worsening of the financial crisis.
If investors feel that Greek devaluation is becoming more and more likely, it is only natural that they begin to look at other European countries with similar fiscal problems. These countries include Ireland, Spain, Portugal, and perhaps even Italy & France. If enough countries choose to withdraw and devalue their currencies - particularly if either of the latter two do - then the euro as a multinational currency will effectively be dead.
Greek fiscal problems don't automatically mean the euro is doomed, but it is very easy to see why policy makers in Europe and elsewhere are worried that events are moving in exactly that direction.
Switzerland is having currency problems. This may come as a surprise to many people, since unlike a number of other countries that are in the news these days, the Swiss have been financially responsible. However, as government debt problems have roiled many nations in Europe and the US has struggled with its own government debt ceiling, many investors have turned to Switzerland as a relatively safe investment haven.
The problem with this from the Swiss point of view is what it has done to the exchange rate. Because investors want Swiss financial assets, the demand for Swiss francs on the world market has expanded dramatically. The result has been a surge in the value of the franc over other currencies. A franc is worth 50% more euro today that it was two years ago, and is worth almost 60% more dollars than it was in December of 2008.
For Swiss tourists and importers this is a huge gain; their relative wealth has surged with the exchange rate and foreign goods look much less expensive than the used to. For Swiss firms this is a disaster; for their customers the prices of their goods have risen right along with the value of the franc. As a consequence, sales and orders have dropped off dramatically.
As a result, Swiss policy makers have begun making public statement about a possible pegging of the franc to the euro. This would require a big increase in the Swiss money supply, but it would bring the exchange rate back down.
This is one recent illustration of the importance that exchange rates play in our modern economy. They are particularly important for smaller countries like Switzerland. Countries have a variety of options when it comes to exchange rate policy. All of these, however, are simply variations on two opposites. Countries can choose to fix their exchange rate to another currency or to a commodity (historically, gold) or they can let the value of their currency float on the market.
Since the early 1970s, the Swiss franc has been a floating currency along with the other major "vehicle" world currencies, the US dollar, the euro, the British pound and the Japanese yen. A floating exchange rate gives the central bank issuing the currency complete control over its own money supply. The bank may create more money when it feels the economy needs a stimulus, or create less money if they feel inflation is beginning to become a problem. However, the central bank cannot control the exchange rate in this case. Exchange rates in this case are set in the foreign currency market by the interaction of supply and demand for the domestic currency and the central bank buys and sells in this market only rarely. Indeed, most central banks with floating currencies lack the foreign currency reserves needed to manipulate the exchange rate.
Some countries rigidly peg the value of their currency to another. Hong Kong, for example, pegs the value of the Hong Kong Dollar to the U.S. dollar at a rate of 7.8 HKD per USD. When a country pegs it ends up in the exact opposite position as above. The central bank can choose any value it wants for the exchange rate, but it loses control over its own money supply. It is forced to create an exact amount of new money each year that will keep the exchange rate fixed. If demand for the currency suddenly surges, the bank must create enough money to meet this demand. Central banks that peg the value of their currencies are forced to constantly buy and sell in the foreign exchange market to keep the price constant. When demand for their currency rises, they sell it and buy foreign currencies. When demand falls they buy their own currency and sell foreign reserves.
Most international financial crises over the past several decades have arisen because of central banks attempting to manipulate their money supplies while maintaining a fixed exchange rate. The collapse of the European Exchange Rate Mechanism in 1992, the Mexican peso crisis of 1994 and the Argentina currency board collapse in 2002 are three memorable examples. All were ultimately caused by countries attempting to hold exchange rates fixed, while at the same time engaging in independent monetary policies.
Could we see a similar currency crisis in the near future? Not with the U.S. dollar which freely floats. We could certainly see the value of the dollar drop if supplies expand or demand for the dollar drops, but we are unlikely to see the catastrophic overnight drops associated with a full-blown currency crisis. Europe, on the other hand, does have a fixed exchange rate system in that many different countries all use the same currency. Given the fiscal problems in Greece, Ireland, Portugal, Spain, and other countries in the Euro area, a currency crisis associate with a country dropping out of the euro pact is a real possibility.
Last month the managing director of the International Monetary Fund (IMF), Dominique Strauss-Kahn, was arrested in New York. The extensive coverage of that case has led to increased scrutiny of the IMF as an institution. The IMF is an important institution in international banking and finance, but few people realize what the IMF does and why it matters.
The IMF was created near the end of World War II. In July 1944, delegates from the Allied nations met at the Mount Washington Hotel near Bretton Woods, N.H.. The conference was called to set up an international financial system that would stabilize the world economy once the war was over. The need for stability had been clear as early as World War I, when most major nations abandoned the gold standard. The successive turmoils of the Great Depression and World War II made reestablishment of a gold-based system impossible. The Bretton Woods agreement put the world back on an international gold standard.
Three major international institutions were created as a result of the Bretton Woods Agreement. The World Bank was established to aid in the reconstruction of countries in Europe and Asia that were severely damaged by the war. The General Agreement on Tariffs and Trade (GATT), now known as the World Trade Organization (WTO), was set up to negotiate reductions in high tariff barriers that had been erected during the 1930s. Finally, the IMF was established to help maintain the stability of the fixed exchange rate system.
Most fixed exchange rate systems are subject to speculative instability that is very similar to a bank run. When a run occurs on a bank it is because of widespread beliefs on the part of depositors that the bank lacks sufficient cash on hand to pay out the small number of depositors who would normally withdraw their money in the short-run. As George Bailey explained so well in "It's a Wonderful Life," the deposits in a bank are backed mostly by loans and only a small amount of cash is kept on hand. When depositors fear the cash is going to run out, they all run to the bank and withdraw. This quickly depletes the cash on hand and the bank can become insolvent. Historically, to reduce the likelihood of bank runs, we have instituted deposit insurance and created lenders of last resort, i.e. central banks. They provide cash that the bank does not have on hand during a run and allow depositors to be paid off if they wish. Knowing that the lender of last resort exists and will act if needed is often sufficient to stop a bank run from happening in the first place.
Similarly, when countries fix the value of their currencies they can be subject to speculative attacks. Central banks that fix their exchange rates must constantly buy or sell foreign currency reserves to smooth out fluctuations in the supply and demand for their own currency. Suppose holders of Thai baht believe the Thai central bank will soon run out of U.S. dollars. They also realize the value of the baht will fall. To avoid this loss they attempt to convert their baht to dollars now -- just like a run on bank deposits. The IMF was created to be an international lender of last resort; a sort of central bank for central bankers. When a speculative attack occurred the IMF was supposed to step in and provide needed foreign reserves from its fund (hence the name).
The fixed exchange regime set up at Bretton Woods was abandoned in the early 1970s. And the main purpose for the IMF's existence disappeared at the same time. With floating exchange rates, central banks need never run out of foreign currencies, because they don't really need to buy or sell them.
So what does the IMF do under our current international system? Despite abandoning fixed exchange rates in general, many countries still fix the value of their domestic currencies to others. Sometimes this pegging is formal -- as in the case of Hong Kong -- and sometimes it is informal. The IMF played an important role in supplying needed foreign reserves to Asian countries in 1997, for example. Sometimes countries experience financial turmoil unrelated to exchange rates, and the IMF is increasingly involved in restructuring sovereign debt. The most recent example of this is the crisis in Greece, and looming crises in Spain, Ireland, Portugal and elsewhere.
While these services are useful, they could be provided by other international institutions or governments, even by private parties in some cases. The IMF's main purpose for existing vanished 35 years ago, but the IMF is likely to remain an important international institution for the foreseeable future.