Global finance

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The global financial system is the worldwide framework of legal agreements, institutions, and both formal and informal economic actors that together facilitate international flows of financial capital for purposes of investment and trade financing. The system has evolved substantially since its emergence in the late 19th century during the first modern wave of economic globalization, marked by the establishment of central banks, multilateral treaties, and intergovernmental organizations aimed at improving the transparency, regulation, and effectiveness of international markets.[1]:74[2]:1

Definition

A financial system consists of systemically important financial institutions, their customers and other stakeholders, and financial regulators. Contemporary globalization and economic integration have increased the interdependence of financial systems around the world and the importance of financial institutions that operate by design at an international or multinational level.

The World Health Organization (WHO) defines "global financial system" as "...various official and legal arrangements that govern international financial flows in the form of loan investment, payments for goods and services, interest and profit remittances. The main elements are the surveillance and monitoring of economic and financial stability, and provision of multilateral finance to countries with balance of payments difficulties. The organization at the centre of the system is the International Monetary Fund (IMF), which has the mandate to ensure its effective running."[3]

The Financial Times lexicon defines it as an "..interplay of financial companies, regulators and institutions operating on a supranational level. The global financial system can be divided into regulated entities (international banks and insurance companies), regulators, supervisors and institutions like the European Central Bank or the International Monetary Fund. The system also includes the lightly regulated or non-regulated bodies - this is known as the 'shadow banking system'. Mainly, this covers hedge funds, private equity and bank sponsored entities such as off-balance-sheet vehicles that banks use to invest in the financial markets."[4]

History of international financial architecture

Emergence of financial globalization: 1870-1914

Main article: Economic globalization
Map showing the route of the first transatlantic cable laid to connect North America and Europe.
The SS Great Eastern, a steamship which laid the transatlantic cable beneath the ocean.

The world experienced substantial changes prior to 1914 which created an environment favorable to an increase in and development of international financial centers. Principal among such changes were unprecedented growth in capital flows, rapid financial center integration resulting from these capital flows, and faster communication. Before 1870, London and Paris existed as the world's only prominent financial centers. Berlin and New York soon rose to eminence on par with London and Paris. An array of smaller financial centers became important as they found market niches, such as Amsterdam, Brussels, Zurich, and Geneva. London remained the leading international financial center in the four decades leading up to World War I.[1]:74–75[5]:3

The first modern wave of economic globalization began during the period of 1870-1914, marked by phenomena such as expansion of transportation, record levels of migration, enhanced communications, trade expansion, and growth in capital transfers.[1]:75 During the mid-nineteenth century, the passport system in Europe dissolved as rail transport expanded rapidly. Most countries issuing passports did not require their carry, thus people could travel freely without them.[6] The standardization of international passports would not arise until 1980 under the guidance of the United Nations' International Civil Aviation Organization.[7] From 1870 to 1915, a total of 36 million Europeans migrated away from Europe. Approximately 25 million (or 70%) of these travelers migrated to the United States while most of the rest reached Canada, Australia, Argentina, and Brazil. Europe itself also experienced an influx of foreigners from 1860 to 1910, growing from 0.7% of the population to 1.8%. While the absence of meaningful passport requirements allowed for free travel, migration on such an enormous scale would have been prohibitively difficult if not for technological advances in transportation, particularly the expansion of railway travel and the dominance of steam-powered boats over traditional sailing ships. World railway mileage grew from 205,000 kilometers in 1870 to 925,000 kilometers in 1906, while steamboat cargo tonnage surpassed that of sailboats in the 1890s. Advancements such as the telephone and wireless telegraphy (the precursor to radio) revolutionized telecommunication by providing instantaneous communication. In 1866, the first transatlantic cable was laid beneath the ocean to connect London and New York, while Europe and Asia became connected through new landlines.[1]:75–76[8]:5

Economic globalization grew under free trade, starting in 1860 when the United Kingdom entered into a free trade agreement with France known as the Cobden–Chevalier Treaty. However, the golden age of this wave of globalization endured a return to protectionism between 1880 and 1914. In 1879, German Chancellor Otto von Bismarck introduced protective tariffs on agricultural and manufacturing goods, making Germany the first nation to institute new protective trade policies. In 1892, France introduced the Méline tariff, greatly raising customs duties on both agricultural and manufacturing goods. The United States maintained strong protectionism during most of the nineteenth century, imposing customs duties between 40 and 50% on imported goods. Despite these protective measures, international trade continued to grow without slowing. Paradoxically, foreign trade grew at a much faster rate during the protectionist phase of the first wave of globalization than during the free trade phase sparked by the United Kingdom.[1]:76–77

Unprecedented growth in foreign investment from the 1880s to the 1900s served as the core driver of financial globalization. The worldwide total of capital invested abroad amounted to US$44 billion in 1913 ($1.02 trillion in 2012 dollars[9]), with the greatest share of foreign assets held by the United Kingdom (42%), France (20%), Germany (13%), and the United States (8%). The Netherlands, Belgium, and Switzerland together held foreign investments on par with Germany at around 12%.[1]:77–78

Panic of 1907

Main article: Panic of 1907

In October 1907, the United States experienced a bank run on the Knickerbocker Trust Company, forcing the trust to close on October 23, 1907, which provoked further reactions. However, the panic was averted due to U.S. Secretary of the Treasury George B. Cortelyou and John Pierpont "J.P." Morgan depositing $25 million and $35 million, respectively, into the reserve banks of New York City, enabling withdrawals to be fully covered. The bank run in New York led to a crunch in the money market which occurred simultaneously as demands for credit heightened from cereal and grain exporters. Since these demands could only be serviced through the purchase of substantial quantities of gold in London, the international markets became exposed to the crisis. The Bank of England had to sustain an artificially high discount lending rate until 1908. To service the flow of gold to the United States, the Bank of England organized a pool from among twenty-four different nations, for which the Banque de France temporarily lent £3 million (GBP, 305.6 million in 2012 GBP[10]) in gold.[1]:123–124

Birth of the U.S. Federal Reserve System

The United States Congress passed the Federal Reserve Act in 1913, giving rise to the Federal Reserve System. The inception of the system drew influence from the Panic of 1907, underpinning legislators' hesitance in trusting individual investors such as John Pierpont Morgan to serve again as a lender of last resort. The system's design also considered the findings of the Pujo Committee's investigation of the possibility of a money trust in which Wall Street's concentration of influence over national financial matters was questioned and in which investment bankers were suspected of unusually deep involvement in the directorates of manufacturing corporations. Although the committee's findings were inconclusive, the potential for such a concentration was enough to motivate support for the long-resisted notion of establishing a central bank. The Federal Reserve System's overarching aim was to become the sole lender of last resort and to resolve the inelasticity of the United States' money supply during significant shifts in money demand. In addition to addressing the underlying issues that precipitated the international ramifications of the 1907 money market crunch, New York's banks were liberated from the need to maintain their own reserves and began undertaking greater risks. New access to rediscount facilities enabled these banks to launch foreign branches, bolstering New York's rivalry with London's competitive discount market.[1]:123–124[5]:53[11]:18[12]

Interwar period: 1915-1944


Economists have referred to the onset of World War I as the end of an age of innocence for foreign exchange markets, as it was the first geopolitical conflict to have a destabilizing and paralyzing impact. The United Kingdom declared war on Germany on August 4, 1914 following Germany's invasion of France and Belgium. In the weeks leading up to the UK's declaration of war, the foreign exchange market in London was the first to exhibit signs of distress. European tensions and increasing political uncertainty motivated investors to chase liquidity, prompting commercial banks to begin borrowing heavily from London's discount market. As the money market tightened, discount lenders began rediscounting their reserves at the Bank of England rather than discounting new pound sterling bills. In response to this stress, the Bank of England was forced to raise discount rates daily for three days from 3% on July 30 to 10% by August 1. As foreign investors resorted to buying pounds for remittance to London just to pay off their newly maturing securities, the sudden demand for pounds led to further distress in the international markets as the pound appreciated beyond its gold value against most major currencies, yet sharply depreciated against the French franc after French banks began liquidating their London accounts. Remittance to London became increasingly difficult and culminated in a record exchange rate of $6.50 USD/GBP. Some early emergency measures were introduced in the form of moratoria and extended bank holidays, but to no effect as financial contracts became informally unable to be negotiated and as export embargoes thwarted gold shipments. A week later, the Bank of England began to address the international deadlock in the foreign exchange markets by establishing a new channel for transatlantic payments whereby participants could make remittance payments to the UK by depositing gold designated for a Bank of England account with Canada's Minister of Finance, and in exchange receive pounds sterling at an exchange rate of $4.90. Approximately $104 million in remittances to the UK flowed through this channel in the next two months. However, pound sterling liquidity ultimately did not improve due to inadequate relief for merchant banks receiving sterling bills. As the pound sterling was the world's reserve currency and leading vehicle currency, market illiquidity and merchant banks' hesitance to accept sterling bills left foreign currency markets paralyzed.[11]:23–24

In 1930, the Allied Powers established the Bank for International Settlements (BIS). The principal purposes of the BIS were to manage the scheduled payment of Germany's reparations imposed by the Treaty of Versailles in 1919, and to function as a bank for central banks around the world. Nations are able to hold a portion of their reserves as deposits with the institution. The BIS additionally serves as a forum for central bank cooperation and research on international monetary and financial matters. In line with managing Germany's war reparations, the BIS also operates as a trustee and facilitator of financial settlements between nations.[1]:182[13]:531–532[14]:56–57[15]:269

Smoot–Hawley tariff of 1930

U.S. President Herbert Hoover signed the Smoot–Hawley Tariff Act into law on June 17, 1930. The tariff's original aim was to protect agriculture in the United States, but congressional representatives ultimately raised tariffs on a host of manufactured goods resulting in average duties as high as 53% on over a thousand different imported goods. Twenty-five trading partners of the United States responded in kind by introducing new tariffs on a wide range of U.S. goods. Hoover had been pressured and compelled to adhere to the Republican Party's 1928 platform, which sought protective tariffs to alleviate market pressures on the United States' struggling agribusinesses and reduce the domestic unemployment rate. The culmination of the Stock Market Crash of 1929 and the onset of the Great Depression heightened fears, further pressuring Hoover to act on protective policies against the advice of Henry Ford and over 1,000 economists who protested by calling for a veto of the act.[8]:175–176[16]:43–44[15]:186–187 Exports from the United States plummeted 60% from 1930 to 1933.[8]:118 Worldwide international trade virtually ground to a halt.[17]:125–126 The international ramifications of the Smoot-Hawley tariff, comprising protectionist and discriminatory trade policies and bouts of economic nationalism, are credited by economists with prolongment and worldwide propagation of the Great Depression.[2]:2[17]:108[18]:33

Formal abandonment of the Gold Standard

Main article: Gold standard

The classical gold standard had first been established in 1821 by the United Kingdom as the Bank of England enabled redemption of its banknotes for gold bullion. France, Germany, the United States, Russia, and Japan each embraced the standard one by one over the course of 1878 to 1897, marking its international acceptance. The first departure from the gold standard occurred in August 1914 when these nations erected trade embargoes on gold exports and suspended redemption of gold for banknotes. Following the end of World War I on November 11, 1918, Austria, Hungary, Germany, Russia, and Poland began experiencing hyperinflation during the early 1920s. Having informally departed from the gold standard, most currencies were freed from exchange rate fixing and allowed to float. Most countries throughout this period of fluctuation sought to gain national advantages and bolster exports by depreciating their currency values to predatory levels. A number of countries, including the United States, made unenthusiastic and uncoordinated attempts to restore the former gold standard. The early years of the Great Depression brought about bank runs in the United States, Austria, and Germany, which placed pressures on gold reserves in the United Kingdom to such a degree that the gold standard became unsustainable. Germany became the first nation to formally abandon the post-World War I gold standard when the Dresdner Bank implemented foreign exchange controls and announced bankruptcy on July 15 of 1931. In September 1931, the United Kingdom allowed the pound sterling to float freely. By the end of 1931, a host of countries including Austria, Canada, Japan, and Sweden abandoned gold. Following widespread bank failures and a hemorrhaging of gold reserves, the United States broke free of the gold standard in April 1933. France would not follow suit until 1936 as investors fled from the franc due to political concerns over Prime Minister Léon Blum's government.[11]:58[17]:414[18]:32–33

Trade liberalization in the U.S.

The disastrous effects of the Smoot–Hawley tariff proved difficult for Herbert Hoover's 1932 re-election campaign. Franklin D. Roosevelt became the 32nd U.S. president and the Democratic Party worked to reverse trade protectionism in favor of trade liberalization. As an alternative to cutting tariffs across all imports, Democrats advocated for trade reciprocity. The U.S. Congress passed the Reciprocal Trade Agreements Act in 1934, aimed at restoring global trade and reducing unemployment. The legislation expressly authorized President Roosevelt to negotiate bilateral trade agreements and reduce tariffs considerably. If a country agreed to cut tariffs on certain commodities, the U.S. would institute corresponding cuts to promote trade between the two nations. Between 1934 and 1947, the U.S. negotiated 29 bilateral trade agreements and the average tariff rate decreased by approximately one third during this same period. The legislation contained an important most-favored-nation clause, through which tariffs were equalized to all countries, such that bilateral agreements would not result in preferential or discriminatory tariff rates with certain countries on any particular import, due to the difficulties and inefficiencies associated with differential tariff rates. The clause effectively generalized tariff reductions from bilateral trade agreements, ultimately reducing worldwide tariff rates.[8]:176–177[15]:186–187[17]:108

Rise of the Bretton Woods financial order: 1945

Main article: Bretton Woods system

As the inception of the United Nations as an intergovernmental entity slowly began formalizing in 1944, delegates from 44 of its early member states met at a hotel in Bretton Woods, New Hampshire for the United Nations Monetary and Financial Conference, now commonly referred to as the Bretton Woods conference. The delegates remained cognizant of the effects of the Great Depression, the struggles to sustain the international gold standard during the 1930s, and the resulting market instabilities. Whereas previous discourse on the international monetary system focused on fixed versus floating exchange rates, the delegates at Bretton Woods favored pegged exchange rates for their flexibility. Under this system, nations would peg their exchange rates to the U.S. dollar and the U.S. dollar would be convertible to gold at $35 USD per ounce.[8]:448[19]:34[20]:3[21]:6 This arrangement is commonly referred to as the Bretton Woods system. Rather than maintaining fixed exchange rates, nations would peg their currencies to the U.S. dollar and allow their exchange rates to fluctuate within a 1% band of the agreed-upon parity. To meet this requirement, the nations' central banks would intervene by conducting sales or purchases of their currencies against the U.S. dollars.[13]:491–493[22]:21[15]:296 Member states could adjust their pegs in response to long-run fundamental disequillibria in their balance of payments, but were responsible for attempting to correct such imbalances by employing fiscal and monetary policy tools before resorting to repegging strategies.[8]:448[23]:22 The adjustable pegging enabled greater exchange rate stability for commercial and financial transactions which in turn fostered unprecedented growth in international trade and foreign investment. This feature grew from delegates' experiences in the 1930s when excessively volatile exchange rates and the reactive protectionist exchange controls that followed proved destructive to international trade and prolonged the deflationary effects of the Great Depression. Capital mobility faced de facto limits under the Bretton Woods system as governments instituted restrictions on capital flows and aligned their monetary policy to support their exchange rate pegs.[8]:448[24]:38[25]:91[26]:30

An important component of the Bretton Woods agreements was the creation of two new international financial institutions, the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD). Collectively referred to as the Bretton Woods institutions, they became operational in 1947 and 1946 respectively. The IMF was established to support the Bretton Woods monetary system with the mission of facilitating multilateral cooperation on international monetary issues, providing advisory and technical assistance to member states, and offering emergency lending to nations experiencing repeated difficulties restoring their balance of payments equilibrium. Members would contribute funds to a pool according to their share of gross world product, from which emergency loans could be issued by the IMF.[22]:21[27]:9–10[28]:20–22 Under the agreement which established the IMF, members were authorized and encouraged to employ capital controls as necessary to help manage payments imbalances and meet pegging targets, but were prohibited from relying on IMF financing to cover particularly short-term capital hemorrhages.[24]:38 While the IMF was instituted to guide members and provide a short-term financing window for recurrent balance of payments deficits, the IBRD was established to serve as a type of financial intermediary for channeling global capital toward long-term investment opportunities and postwar reconstruction projects.[29]:22 The creation of these two organizations was a crucial milestone in the evolution of the international financial architecture, and some economists consider it the most significant achievement of multilateral cooperation following World War II.[24]:39[30]:1–3 Following the later establishment of the International Development Association (IDA) in 1960, the IBRD and IDA became collectively known as the World Bank. While the IBRD lends to middle-income developing countries, the IDA extended the Bank's lending program by offering concessional loans and grants to the world's poorest nations.[31]

General Agreement on Tariffs and Trade: 1947

In 1947, 23 countries concluded the General Agreement on Tariffs and Trade (GATT) at a UN conference in Geneva. Delegates intended for the agreement to suffice in the interim while member states would negotiate and ratify the creation of a UN body to be known as the International Trade Organization (ITO). As the ITO never became ratified, GATT became the de facto framework for later multilateral trade negotiations that followed. Participating countries emphasized trade reprocity as an approach to lowering barriers in pursuit of mutual gains.[16]:46 The agreement's structure enabled its contracting signatories to codify and enforce a set of regulations for trading of both goods and services.[32]:11 GATT was centered on two precepts: trade relations needed to be equitable and nondiscriminatory and subsidizing non-agricultural exports needed to be prohibited. As such, the agreement's most favored nation clause prohibited members from offering preferential tariff rates to any nation that it would not otherwise offer to fellow GATT members. In the event of any discovery of non-agricultural subsidies, members were authorized to offset such policies by enacting countervailing tariffs.[13]:460 The agreement provided participating governments with a transparent structure for managing trade relations and avoiding protectionist pressures.[17]:108 However, GATT's principles did not extend to investments or financial activity, consistent with the era's rigid discouragement of capital movements.[33]:70–71 The agreement's initial round achieved only limited success in reducing tariffs. While the U.S. reduced its tariffs by one third, other signatories offered much smaller trade concessions.[25]:99

Resurgence of financial globalization

Flexible exchange rate regimes: 1973-present

Although the exchange rate stability sustained by the Bretton Woods system helped facilitate expanding international trade, this early success masked its most fundamental underlying design flaw, wherein there existed no mechanism for increasing the supply of international reserves to support continued growth in trade.[22]:22 The system began experiencing insurmountable market pressures and deteriorating cohesion among its key participants in the late 1950s and early 1960s. Central banks worldwide needed more U.S. dollars to hold as reserves, but were unable to expand their money supplies if doing so meant exceeding their dollar reserves and threatening their exchange rate pegs. To successfully accommodate these needs, the Bretton Woods system depended on the United States to run dollar deficits. As a consequence, the value of U.S. dollars began exceeding their gold backing. During the early 1960s, investors could sell gold for a greater dollar exchange rate in London than in the United States, signaling to market participants that the dollar was overvalued. In 1960, Belgian-American economist Robert Triffin defined this problem now known as the Triffin dilemma, in which a country's national economic interests conflict with its international objectives as the custodian of the world's reserve currency.[19]:34–35

France voiced concerns over the artificially low price of gold in 1968 and even called for returns to the former gold standard. Around this same time, excess dollars flowed into international markets as the United States expanded its money supply to accommodate the costs of its military campaign in the Vietnam War. The United States' gold reserves were assaulted by speculative investors following its first current account deficit since the 19th century. In August 1971, President Richard Nixon suspended the exchange of dollars for gold as part of the Nixon Shock. The closure of the gold window via the suspension of convertibility effectively shifted the adjustment burdens of a devalued dollar to other nations. Speculative traders chased other currencies and began selling dollars in anticipation of these currencies being revalued against the dollar. These influxes of capital flows presented difficulties to foreign central banks, which then faced choosing among inflationary money supplies, largely ineffective capital controls, or floating exchange rates.[19]:34–35[34]:14–15 Following these woes surrounding the U.S. dollar, the dollar price of gold was raised to $38 USD per ounce and the Bretton Woods system was modified to allow fluctuations within an augmented band of 2.25% as part of the Smithsonian Agreement signed by the G-10 members in December 1971. The agreement ultimately delayed the system's demise for a further two years.[21]:6–7 The system's erosion was expedited not only by the dollar devaluations that occurred, but also by the oil crises of the 1970s which emphasized the importance of international financial markets in petrodollar recycling and balance of payments financing. Once the world's reserve currency began to float, other nations began adopting floating exchange rate regimes.[14]:5–7

The post-Bretton Woods financial order: 1976

As part of the first amendment to the IMF's articles of agreement in 1969, the IMF developed a new type of reserve instrument, called special drawing rights (SDRs), that could be held by central banks and exchanged among themselves and the Fund as an alternative to gold. SDRs entered service in 1970 originally as units of a market basket of then-sixteen major vehicle currencies of countries whose share of total world exports exceeded 1%. The basket's currencies have changed over time and presently consists of the U.S. dollar, euro, Japanese yen, and British pound. In addition to holding SDRs as reserves, nations are able to denominate transactions among themselves and the Fund in SDRs, although the instrument was not a vehicle currency for trade. In international transactions, the currency basket's portfolio characteristic affords greater stability against the foreign exchange uncertainties inherent with free floating exchange rates.[25]:117[24]:50–51[27]:10[18]:34–35 Special drawing rights were originally defined as equivalent to a specified amount of gold, but were not directly redeemable for gold and instead served as a surrogate in obtaining other currencies that could be exchanged for gold. The Fund created an initial allocation of 9.5 billion XDR from 1970 to 1972.[29]:182–183

IMF members convened in January 1976 and signed the Jamaica Agreement, which ratified the end of the Bretton Woods system and fundamentally reoriented the Fund's role in supporting the international monetary system. The agreement officially embraced the flexible exchange rate regimes that had emerged after the failure of the Smithsonian Agreement measures. In tandem with accepting floating exchange rates, the agreement endorsed central bank interventions aimed at clearing excessive volatility. The agreement retroactively formalized the abandonment of gold as a reserve instrument and the Fund subsequently demonetized its gold reserves, returning it to member states or selling it to provide poorer nations with relief funding. Developing countries and countries not endowed with oil export resources enjoyed greater access to IMF lending programs as a result of the agreement. The Fund continued to assist nations experiencing balance of payments deficits and currency crises, but later began imposing conditionality on its relief funding that required countries to adopt macroeconomic policies aimed at reducing deficits through spending cuts and tax increases, reducing protective trade barriers, and implementing contractionary monetary policy.[18]:36[35]:12–13[28]:47–48

The second amendment to the IMF's articles of agreement was signed in 1978. This amendment legally formalized the free-floating acceptance and gold demonetization achieved by the Jamaica Agreement, and required members to support stable exchange rates through orderly macroeconomic policies. The post-Bretton Woods system was decentralized in that member states retained their autonomy in selecting an exchange rate regime. The amendment also expanded the institution's capacity for oversight and charged members with supporting international monetary sustainability by cooperating with the Fund on regime implementation.[25]:138[24]:62–63 This role is called IMF surveillance and is recognized as a pivotal point in the evolution of the Fund's mandate, which was extended beyond payments imbalances management to broader concern with internal and external stresses on countries' overall economic policies.[30]:10–11[25]:148

Under the dominance of flexible exchange rate regimes, the foreign exchange markets became significantly more volatile. In 1980, U.S. President Ronald Reagan was elected to office, and his administration brought about increasing balance of payments deficits and budget deficits. To finance these deficits, the United States offered artificially high real interest rates to attract large inflows of foreign investment capital. As foreign investors' demand for dollars to invest in the U.S. grew heavily, the dollar's value appreciated substantially, until reaching its peak in February 1985. The U.S. trade deficit grew to $160 billion in 1985 ($341 billion in 2012 dollars[9]) as a result of the dollar's strong appreciation. The G5 met in September 1985 at the Plaza Hotel in New York City and agreed that the dollar should depreciate against the major currencies to resolve the United States' trade deficit and pledged to support this goal with concerted foreign exchange market interventions, in what became known as the Plaza Accord. The U.S. dollar continued to depreciate, but industrialized nations became increasingly concerned that it would decline too heavily and that exchange rate volatility would increase. To address these concerns, the G7 (now G8) held a summit in Paris in 1987, where they agreed to cooperatively pursue improved exchange rate stability and to better coordinate their macroeconomic policies, in what became known as the Louvre Accord. This accord became the provenance of the managed float regime by which central banks jointly intervene to resolve under- and overvaluations in the foreign exchange market to stabilize otherwise freely floating currencies. Exchange rates stabilized following the embrace of managed floating until the United States enjoyed a period of strong economic performance from 1997 to 2000 due to the Dot-com bubble. The U.S. attracted heavy foreign investment until the dollar began depreciating in 2001 following the 2000 stock market correction of the Dot-com bubble, a growing trade deficit, and political uncertainties in the wake of the September 11 attacks.[18]:36–37[25]:147[36]:16–17[19]:37[14]:175

European Monetary System: 1979

Following the Smithsonian Agreement, member states of the European Economic Community adopted a narrower currency band of 1.125% for exchange rates among their own currencies, creating a smaller scale fixed exchange rate system known as the snake in the tunnel. The snake proved unsustainable as it did not compel EEC countries to coordinate macroeconomic policies. In 1979, the establishment of the European Monetary System (EMS) phased out the currency snake. The EMS featured two key components: the European Currency Unit (ECU), an artificial weighted average market basket of European Union members' currencies, and the Exchange Rate Mechanism (ERM), a procedure for managing exchange rate fluctuations in keeping with a calculated parity grid of currencies' par values.[18]:42–44[11]:130[37]:185 The parity grid was derived from the parities each participating country established for its currency with all other currencies in the system, denominated in terms of ECUs. The weights within the ECU changed in response to variances in the values of each currency in its basket. Under the ERM, in the event that an exchange rate reached either its upper or lower limit (within a 2.25% band), both nations in that currency pair were obligated to intervene collectively in the foreign exchange market and buy or sell the under- or overvalued currency as necessary to return the exchange rate to its par value according to the parity matrix. The requirement of cooperative market intervention marked a key difference from the Bretton Woods system. Similarly to Bretton Woods however, EMS members were able to impose capital controls and other monetary policy shifts on countries responsible for exchange rates approaching their bounds, as identified by a divergence indicator which measured deviations from the ECU's value.[13]:496–497[22]:29–30 The central exchange rates of the parity grid could be adjusted in exceptional circumstances, and were modified every eight months on average during the systems' initial four years of operation.[25]:160 During the twenty year lifespan of the EMS, these central rates underwent more than 50 adjustments.[21]:7

Birth of the World Trade Organization

The Uruguay Round of GATT multilateral trade negotiations took place from 1986 to 1994, with 123 nations becoming party to the series of agreements achieved throughout the negotiations. Among the achievements were trade liberalization in agricultural goods and textiles, the General Agreement on Trade in Services, and agreements on intellectual property rights issues. One of the key manifestations of this round of negotiations was the Marrakech Agreement signed in April 1994, which established the World Trade Organization (WTO). The WTO is a chartered multilateral trade organization, charged with continuing the GATT mandate to promote trade, govern trade relations, and limit or prevent damaging trade practices and policies. The WTO became operational in January 1995. Compared with its GATT secretariat predecessor, the WTO features an improved mechanism for the settlement of trade disputes since the organization is membership-based and not dependent on the achievement of consensus as in a traditional trade negotiation. This function was designed to address prior weaknesses, whereby parties in dispute would invoke delays, attempt to obstruct negotiations, or fall back on weak enforcement.[16]:47[8]:181[13]:459–460 In 1997, WTO members reached a financial services agreement and made commitments to soften restrictions on foreign commercial financial services providers, including banking services, securities trading, and insurance services. These financial services commitments entered into force in March 1999, and at that time consisted of at least 70 governments accounting for approximately 95% of worldwide financial services.[39]

Financial integration and systemic crises: 1980-present

Main article: Financial integration

International financial integration among industrialized nations grew substantially during the 1980s and 1990s, as did liberalization of their capital accounts.[24]:15 Accompanying the increase in financial integration in recent decades was a succession of deregulation, in which countries increasingly abandoned regulations geared to monitor the behavior of financial intermediaries and simplified administrative requirements governing disclosure to the public and to regulatory authorities.[14]:36–37 As economies became more open, nations became increasingly exposed to external shocks. Economists have argued that greater worldwide financial integration has resulted in more volatile international capital flows, thereby increasing the potential for turbulence in financial markets. Given greater financial integration among nations, a systemic crisis in one can easily become contageous and spread to others.[32]:136–137 The 1980s and 1990s saw a wave of financial and currency crises and sovereign defaults, including the 1987 Black Monday stock market crashes, 1992 European Monetary System crisis, 1994 Mexican peso crisis, 1997 Asian currency crisis, 1998 Russian financial crisis, and the 1999-2002 Argentine peso crisis.[1]:254[41]:6–7[42]:26–28[13]:498[18]:50–58 These crises differed in terms of their breadth, causes, and aggravations, among which were capital flight brought about by speculative attacks on fixed exchange rate currencies perceived to be mispriced given a nation's fiscal policy,[14]:83 self-fulfilling speculative attacks by investors expecting other investors to follow suit given doubts about a nation's sustainment of its currency peg,[41]:7 lack of access to well developed and properly functioning domestic capital markets in emerging market countries,[30]:87 and current account reversals during conditions of limited capital mobility and dysfunctional banking systems.[33]:99

Following research on the systemic crises that plagued developing countries throughout the 1990s, economists have reached a consensus that liberalization of capital flows carries important prerequisites if these countries are to observe the benefits offered by financial globalization. Such conditions include stable macroeconomic policies, healthy fiscal policy, robust bank regulations, and strong legal protection of property rights. Economists largely favor adherence to an organized sequence of encouraging foreign direct investment, liberalizing domestic equity capital, and embracing capital outflows and short-term capital mobility only once the country has achieved functioning domestic capital markets and established a sound regulatory framework.[24]:113 An emerging market economy must develop a credible currency in the eyes of both domestic and international investors in order to realize benefits from financial globalization such as greater liquidity, greater savings at higher interest rates, and accelerated economic growth. If a country embraces unrestrained access to foreign capital markets without itself maintaining a credible currency, it becomes vulnerable to speculative capital flights and sudden stops, which carry serious economic and social costs.[34]:xii

Countries have sought to improve the sustainability and transparency of the global financial system in response to the crises of the 1980s and 1990s. The Basel Committee on Banking Supervision was formed in 1974 by the G-10 members' central bank governors to facilitate cooperation on the supervision and regulation of banking practices. It is headquartered at the Bank for International Settlements in Basel, Switzerland. The committee has held several rounds of deliberation known collectively as the Basel Accords. The first of these accords, known as Basel I, took place in 1988 and emphasized credit risk and the risk assessment of different asset classes. Basel I was motivated by increasing concerns over whether large multinational banks were appropriately regulated, stemming in part from observations during the 1980s Latin American debt crisis. Following Basel I, the committee published recommendations on new capital requirements for banks. The G-10 nations implemented these recommendations four years later. In 1999, the G-10 established the Financial Stability Forum (reconstituted by the G-20 in 2009 as the Financial Stability Board) to facilitate international cooperation among regulatory agencies and promote stability in the global financial system. The Forum was charged with developing and codifying twelve international standards and implementation thereof.[24]:222–223[30]:12 The Basel II accord was set in 2004 and again emphasized capital requirements as a safeguard against systemic risk as well as the need for consistency across worldwide banking regulations so as not to competitively disadvantage banks operating internationally. It was motivated by what were seen as inadequacies of the first accord such as insufficient public disclosure of banks' risk profiles and insufficient oversight by regulatory bodies. Members were slow to implement it, with major efforts by the European Union and United States taking place as late as 2007 and 2008.[15]:486–488[24]:160–162[14]:153 In 2010, the Basel Committee revised the capital requirements in a set of enhancements to Basel II known as Basel III, which centered on the implementation of a leverage ratio requirement aimed at restricting excessive leveraging by banks. In addition to strengthening the ratio of capital to leverage, Basel III modified the formulas used to weight risk and compute the capital thresholds necessary to mitigate the risks of bank holdings, concluding that the capital threshold should be set at 7% of the value of a bank's risk-weighted assets.[18]:274[43]

Birth of the European Monetary Union

In February 1992, the European Union countries signed the Maastricht Treaty which outlined a three-stage plan to accelerate progress toward an Economic and Monetary Union (EMU). The first stage centered on liberalizing capital mobility and aligning macroeconomic policies between countries. The second stage established the European Monetary Institute which was ultimately be dissolved in tandem with the establishment in 1998 of the European Central Bank (ECB) and European System of Central Banks. Key to the Maastricht Treaty was the outlining of convergence criteria that EU members would need to satisfy before being permitted to enter the third and final stage of the monetary union. The final stage introduced a common currency for circulation known as the euro, which was adopted by eleven members of the fifteen-member European Union in January 1999. In doing so, they disaggregated their sovereignty in matters of monetary policy. These countries continued to circulate their national legal tenders, exchangable for euros at fixed rates, until 2002 when the ECB began issuing official coinage and notes. As of 2011, the EMU comprises seventeen nations which have embraced the euro, and Denmark, Latvia, and Lithuania which are members of the ERM II established in 1999, and the United Kingdom which has opted out of both in favor of monetary policy autonomy.[15]:473–474[18]:45-4[37]:185–186[21]:7

Global financial crisis

Main articles: Financial crisis of 2007–08 and Great Recession

Following the market turbulence of the 1990s financial crises and September 11 attacks on the U.S. in 2001, financial integration intensified among the developed nations and emerging markets, with substantial growth in capital flows among banks and in the trading of financial derivatives and structured finance products. Worldwide international capital flows grew from $3 trillion to $11 trillion U.S. dollars from 2002 to 2007, primarily in the form of short-term money market instruments with maturities of less than one year. The United States experienced growth in the size and complexity of financial institutions engaged in a broad range of financial services across borders in the wake of the Gramm–Leach–Bliley Act of 1999 which repealed the Glass–Stegall Act of 1933, ending limitations on commercial banks' investment banking activity. Industrialized nations increasingly began relying on foreign capital to finance domestic investment opportunities, resulting in unprecedented capital flows to advanced economies from developing countries, as reflected by global imbalances which grew to 6% of gross world product in 2007 from 3% in 2001.[24]:129–130[18]:19

The global financial crisis that precipitated in 2007 and 2008 shared some of the key features exhibited by the wave of international financial crises in the 1990s, including accelerated capital influxes, weak regulatory frameworks, relaxed monetary policies, herd behavior during investment bubbles, collapsing asset prices, and massive deleveraging. The systemic problems originated from within the United States and other advanced nations.[24]:133–134 Similarly to the 1997 Asian crisis, the global financial crisis entailed broad lending by banks undertaking unproductive real estate investments as well as poor standards of corporate governance within financial intermediaries. Particularly in the United States, the crisis was characterized by growing securitization of non-performing assets, large fiscal deficits, and excessive financing in the housing sector.[33]:21–22[18]:18–20 While the real estate bubble in the U.S. triggered the financial crisis, the bubble was financed by foreign capital flowing from many different countries across the world. As its contageous effects began to infect other nations, the crisis became a precursor for the global economic downturn now referred to as the Great Recession. In the wake of the crisis, the total volume of world trade in goods and services fell 10% from 2008 to 2009 and did not recover until 2011, with an increased concentration in emerging market countries. The global financial crisis demonstrated the negative effects of worldwide financial integration, sparking discourse on how and whether some countries should decouple themselves from the global financial system altogether.[44][45]:3

Eurozone crisis

In 2009, a newly elected government in Greece revealed that the previous government had been falsifying its national budget data, and that its fiscal deficit for the year was 12.7% of its GDP as opposed to the 3.7% espoused by the former government. This news alerted financial markets to the fact that Greece's deficit exceeded the eurozone's maximum of 3% as outlined in the Economic and Monetary Union's Stability and Growth Pact (SGP). Investors concerned by the possibility of a sovereign default began rapidly selling Greek bonds. Given Greece's prior decision to embrace the euro as its currency, it no longer held monetary policy autonomy and could not intervene to depreciate a national currency for the purposes of absorbing this shock and boosting competitiveness, as was the traditional solution to sudden capital flights. The crisis proved contagious when it spread to Portugal, Italy, and Spain (together with Greece these are collectively referred to as the PIGS). Ratings agencies downgraded these countries' government debt instruments in 2010 which further increased the costliness of refinancing or repaying their national debts. The contagion continued to spread and soon grew into a European sovereign debt crisis which threatened economic recovery in the wake of the Great Recession. In tandem with the IMF, the European Union members assembled a €750 billion bailout for Greece and other afflicted nations. Additionally, the ECB pledged to purchase bonds from troubled eurozone nations in an effort to mitigate the risk of a banking system panic. The crisis is recognized by economists as highlighting the depth of financial integration in Europe, contrasted with the lack of fiscal integration and political unification necessary to prevent or decisively respond to financial and economic crises. During the initial waves of the crisis, there was public speculation that the turmoil could result in a disintegration of the eurozone and an abandonment of the euro. German Federal Minister of Finance Wolfgang Schäuble called for the expulsion of offending countries from the eurozone. Now commonly referred to as the Eurozone crisis, it has been ongoing since 2009 and most recently began encompassing the 2012–13 Cypriot financial crisis.[18]:12–14[46]:579–581

Implications of globalized capital

Balance of payments

Main article: Balance of payments

The balance of payments accounts summarize payments made to or received from foreign countries. Receipts from foreign countries are considered credit transactions while payments to foreign countries are considered debit transactions. The balance of payments comprises three components defined by their transaction types: transactions involving the export or import of goods and services form the current account, transactions involving the purchase or sale of financial assets form the financial account, and certain transactions involving unconventional transfers of wealth among countries form the capital account.[46]:306–307 The current account summarizes three variables: the trade balance, net factor income from abroad, and net unilateral transfers. The financial account summarizes the value of exports versus imports of assets, while the capital account summarizes the value of asset transfers received net of transfers given. The capital account also includes the official reserve account, which summarizes central banks' purchases and sales of domestic currency, foreign exchange, gold, and SDRs for purposes of maintaining or utilizing bank reserves.[47]:169–172[48]:32–35[18]:66–71

Because the balance of payments indeed sums to zero, a current account surplus is indicative of a deficit in the asset accounts and vis versa. A current account surplus or deficit serves as an indicator of the extent to which a country is relying on foreign capital to finance its consumption and investments, and whether the country is living beyond its own means. For example, assuming a capital account balance of zero (thus no asset transfers available for financing), a current account deficit of $1 billion implies a financial account surplus (or net asset exports) of $1 billion. A net exporter of financial assets is known as a borrower, exchanging future payments for current goods and services. Further, a net export of financial assets indicates growth in a country's debt. From this perspective, the balance of payments links a nation's income to its spending by indicating the degree to which current account imbalances are financed with domestic or foreign financial capital, which in turn sheds light on how a nation's wealth is shaped over time.[47]:203[18]:73[46]:308–313 A healthy balance of payments position is important for sustaining economic growth. If countries experiencing a growth in demand have trouble sustaining a healthy balance of payments, demand can slow, leading to unused or excess supply, discouraged foreign investment, and less attractive exports which can further reinforce a negative cycle that intensifies payments imbalances.[49]:21–22

A country's external wealth is measured by the value of its foreign assets net of its foreign liabilities. When the current account does not balance, a current account surplus (and corresponding financial account deficit) indicates an increase in external wealth while a deficit indicates a decrease. Aside from current account indications of whether a country is a net buyer or net seller of assets, shifts in a nation's external wealth are influenced by capital gains and capital losses on foreign investments. Having positive external wealth means that a country serves as a net lender (or creditor) in the world economy, while having a negative external wealth indicates that a country is a net borrower (or debtor).[47]:13,210

Unique financial risks

Main article: Systemic risk

Both nations and businesses operating internationally face an array of financial risks that are unique to foreign investment activity. Political risk entails the potential for losses originating from a foreign country's political instability or otherwise unfavorable political or regulatory developments. Political risks manifest in different forms. Transfer risk emphasizes uncertainties surrounding a country's capital controls and balance of payments. Operational risk characterizes concerns over a country's regulatory policies and their impact on the normal operations of multinational businesses. Control risk is born from uncertainties surrounding property and decision rights in the local operation of foreign direct investments.[18]:422 Credit risk in an international context implies that lenders such as banks and other financial institutions may face an absent or unfavorable regulatory framework that affords little or no legal protection of their investments in foreign countries. For example, foreign governments may commit to a sovereign default or otherwise repudiate their debt obligations to international investors without any legal consequences or recourse for the investor. Governments may also choose to expropriate or nationalize foreign-held assets or enact contrived policy changes following a foreign investor's decision to acquire assets or make a foreign direct investment in the host country.[47]:14–17 Country risk encompasses both political risk and credit risk, and represents the potential for unanticipated developments in a host country to threaten its capacity for debt repayment and repatriation of gains from interest and dividends.[18]:425,526

System components

As per the Financial Times lexicon referenced above, the global financial system can be divided into regulated entities, regulators, supervisors and their institutions. Since, by their nature, multinational entities are networked, their multiple functions often overlap in numerous organizations.

Main economic actors

  1. Local and national financial institutions (depository, contractual, and investment institutions), multilateral development banks, regional development banks, bilateral development banks and agencies, the World Bank and other supranational banks, the International Monetary Fund and the Bank for International Settlements (see International financial institutions).
  2. Customers of the global financial system, which include multinational corporations, nations, their economies and government entities, e.g., the central banks of the G20 major economies, finance ministries EU, NAFTA, OPEC, and others.
  3. Regulators of the global financial system, many of which play dual roles, in that they are financial organizations at the same time. These include the above mentioned International Monetary Fund and Bank for International Settlements, particularly its “Global Economy Meeting (GEM), in which all systemic emerging economies’ Central Bank governors are fully participating, has become the prime group for global governance among central banks” per Jean-Claude Trichet, President of the European Central Bank.,[50] as well as the national financial regulators of the major economies.

Financial institutions

The global financial institutions are investment banks, Insurance companies, commercial banks and non-bank financial institutions active in the stock, bond, foreign exchange, derivatives and commodities markets, investing private equity including mortgages in hedge funds and pension funds, mutual funds, sovereign wealth funds, etc. In addition to the individual commercial organisations that operate at an international level there are a number of public and semi-public international institutions.

Systemically important "public" financial institutions operating internationally include:

Systemically important "private" financial institutions operating internationally include:

  • The Institute of International Finance (IIF), a trade organization of the world's largest commercial banks and investment banks.
  • The World Federation of Exchanges (WFE) which publishes global stock capitalization information in annual reports.[52]
  • The Global Financial Markets Association (GFMA), which consists of European, Asian and North American financial market associations: The Association for Financial Markets in Europe (AFME) in London and Brussels, the Asia Securities Industry & Financial Markets Association (ASIFMA) in Hong Kong, and the Securities Industry and Financial Markets Association (SIFMA) in New York and Washington DC.

International lobbying firms play a role in international financial systems, as they increasingly develop cross-border lobbying arms to influence international negotiations. For example, Podesta Group, a Washington lobbying firm, founded "Global Solutions" to influence multilateral free trade agreements, such as the Trans-Pacific Strategic Economic Partnership Agreement (TPP) and the Transatlantic Trade and Investment Partnership (TTIP), and other issues "at the intersection of trade, economics, politics and diplomacy".[53]

Regulators and supervisors

Governments act as regulators in various capacities within financial systems, traditionally primarily through their finance ministries and their financial regulatory agencies. They pass the laws to regulate financial markets, set the tax burden for private sector, e.g., banks, funds and exchanges. At the same time governments also participate in global financial markets through discretionary spending and borrowing. They are closely tied to, though in most countries independent of central banks that issue government debt, set interest rates and deposit requirements, and intervene in the foreign exchange market.

A number of international bodies exist to coordinate global financial regulation, such as the Basel Committee on Banking Supervision (BCBS), the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) as well as organizations that focus on encouraging specific global standardisation such Financial Action Task Force on Money Laundering (FAFT). However these organisations cannot themselves make regulation and it is up each country's government to implement recommendations. Some countries deliberatly create a light regulator environment within their jurisdiction as a way to attract financial business into offshore financial centres and tax havens.

Regional regulators

In addition to national regulators there are a number of supranational financial regulators generally based around trade blocs. For example these include agencies belonging to Commonwealth of Independent States, Mercosur, North American Free Trade Agreement (NAFTA) and the Eurozone. Within the Eurozone the agencies include the European Central Bank,[54] EU Department of Internal Market and Services,[55] European Banking Authority,[56] and the European Shadow Financial Regulatory Committee (ESFRC).[57]

Academic institutions

Academic institutions play a special role, as they educate the professionals working in the global financial system: economists, executive officers and financial analysts, and drive the research. The Harvard Business School, for example advertises that its "Executive Education prepares executives from all over the world for new levels of leadership".[58]

Many central bank chiefs are Harvard educated, such as Mario Draghi of the European Central Bank, Mervyn King and Charlie Bean Deputy Governor at the Bank of England, Stanley Fischer Governor of the Bank of Israel, John de Gregorio in Chile, Athanasios Orphanides in Cyprus, Phillip Lowe, Deputy Governor of the Reserve Bank of Australia and Olivier Blanchard of the IMF, and meet every two months in the 18-men group of the Economic Consultative Committee of the Bank for International Settlements in Basel.

At the same time, academic institutions are both investors of their revenues, including incomes from international patents or other international business operations, and creditors in the global financial financial system.

Criticism, discussions and reform

Among the many critics of the global financial system are:

See also

References

Notes

Further reading

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