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THE CONTEXT OF MODERN CRISES
Major crises have occurred sporadically since the Dutch Tulip Crisis in 1637, but became increasingly global and closer together as the twentieth century approached. Crises moved even closer together at the end of the twentieth century. This is in part due to normal economic expansion and growth, and along with it, rapid changes in production technologies. However, speculative investment sometimes accompanied real expansion, bringing about crises. The major reason for the increase in the occurrence of financial crises at the end of the twentieth century is the immense growth and liberalization of finance, which began with the breakdown of the Bretton Woods system that was constructed in the 1940s, the spread of eurocurrency markets in the 1960s, and the rise of portfolio investment in the 1980s (D’Arista 2002), which are discussed in later chapters.
The US political economy of the 1970s in particular aligned the interests of the banking sector with those of the political arena. This is because the US played a large role in the global economy and led both deregulation and bank standardization. On the one hand, politicians faced the threat of a loss of competition, and on the other, they feared the consequences of a lack of regulation. The relatively recent high-level development of finance has, since then, been a balancing act between the two specters.
The debate over fiscal spending or prudence during crisis, and the beginning of the modern financial architecture, has its roots in the Great Depression. Although banking crises and asset price bubbles were not unique throughout history, the Great Depression was so severe that widely accepted economic policy responses at the time failed to ameliorate the descent into economy-wide failure. New policies, categorized as the “First New Deal,” were tried and failed, until at last government interven?tion in public assistance, labor, and industrial regulation put the economy on the track to recovery (Bordo et al. 1998). The powerful insights of Keynesian theory were also brought to light during the later period of the Great Depression, and underscored an expanded role for government i ntervention. Keynesian perspectives dominated economic thought for some time thereafter, and even after their demise in the 1970s, they have been revived to a large extent today, due to desperate measures undertaken during the Great Recession of 2008.
Of equal importance, the transition from the gold standard, destroyed once and for all during the Great Depression, to pegged exchange rates under the Bretton Woods System created in 1944, established the US dollar (at first tied to gold, later used alone) as the international reserve currency. World leaders set up an adjustable peg system of currencies fixed to the dollar, which was in turn exchangeable for gold (Bordo and Eichengreen 1993). These new global monetary structural changes ushered in years of relative financial stability. After the ravages of the Great Depression and World War II, global financial security was greatly desired. And global financial security was indeed gained, in a period of relative peace, until the 1960s. The lasting element of the Bretton Woods architecture was, and remains, the centrality of the US dollar.
The Bretton Woods meeting was truly singular in that it represented a major global effort to establish monetary and financial rules, for the sake of both stabilizing the world economy and enhancing trade and financial relations. Due to fixed exchange rate regimes, inflation was maintained in most countries at low levels. International monetary cooperation, in conjunction with existing capital controls, brought about a period of calm in the global economy. Pegging currencies to the dollar secured US global economic hegemony through the present day, and has had a lasting impact on the dynamics of international financial power and the anatomy of financial crises down the line. Financial and ideological power was concentrated in the US, has influenced patterns of global trade and investment, and produced directives to developing countries for proper measures for economic development. The historical Bretton Woods meeting also brought into existence international financial and monitoring institutions, namely the International Monetary Fund (IMF) and the World Bank.2
The second half of the Bretton Woods regime, the 1960s, saw the rise of eurocurrencies, which are deposits located in banks outside the home country. The use of eurocurrencies allowed domestic banks to bypass capital controls in international lending. Eurocurrencies also allowed banks to avert domestic reserve requirements, deposit insurance, interest rate ceilings, and quantitative controls on credit growth (D’Arista 2002). Due to an increase in popularity, eurodollars began to affect countries’ domestic balance of payments after a period of only a few years, and by the late 1960s the US Federal Reserve began to loosen requirements of domestic lending in order to compete with eurocurrencies, ushering in a period of financial liberalization in the 1970s.
Although Bretton Woods institutions remain in the form of the World Bank and IMF, an important feature of the Bretton Woods exchange system was shattered unilaterally in 1971 by US President Nixon, who ended the dollar’s convertibility to gold. Nixon closed the “gold window” due to the United States’ perpetual balance-of-payments deficits resulting largely from engagement in the Vietnam War, which had greatly reduced the supply of gold reserves (Bordo 2008). This led to the return of inflation and monetary imbalances and, coupled with capital account liberalization in the early 1970s, signaled the prospective return of financial crises. The dollar became the de facto reserve currency, without a commodity anchor.
A vigorous rise in oil prices in the 1970s caused a global recession, and the recycled petrodollars that had been lent in force to developing nations in Asia, Latin America, and Africa during this period led to a chain of banking and sovereign debt crises years later (Reinhart and Rogoff 2009). Both governments and commercial banks lent exorbitant amounts to developing nations to finance their oil imports, setting the stage for the debt crises of the 1980s. Eurocurrency markets spread through the 1970s, in large part due to petrodollar lending, and came into competition with more restricted commercial bank lending in the 1980s. Financial liberalization continued, particularly with the rapid expansion of portfolio investment in this same period. This greatly increased capital mobility and the quantity of cross-border transactions in bonds and equities (D’Arista 2002).
Due to a global environment of increased financial liberalization, the 1980s saw the emergence of debt default crises in Latin America as banks refused to continue financing developing countries’ interest payments. Crises then came closer together, with the European Exchange Rate Mechanism Crisis and Nordic banking crises of the late 1980s and early 1990s. Policy conditions imposed by the IMF on developing and developed countries alike in exchange for emergency loans required financial austerity and later came under sharp criticism. The “Washington Consensus,” a set of policies so dubbed in 1989 and pushed forward by the IMF for countries enmeshed in crisis, incorporated two of the policy prescriptions that had so emphatically failed in the immediate aftermath of the Great Depression: fiscal policy discipline and expansion of the tax base. The recommendations also included policies that increased the level of risk and exposure to foreign and domestic shocks, such as privatization and trade liberalization.
The prolonged Japanese real estate bust occurred in 1992, followed on its heels by the Mexican peso crisis. Then, just as the 1990s were roaring in the US, the rest of the world went into crisis, hitting the Southeast Asian tigers, Russia, Brazil, and Argentina. Clearly, something was amiss in the global financial architecture. Even the genius mathematical models constructed for long-term credit management under the supervision of Nobel laureates Myron Scholes and Robert Merton failed to decode the complex movements of international finance.
After the Asian financial crisis of 1997, some economists recognized that the collapse of Bretton Woods had led to global financial and monetary instability. The long series of crises after 1971 that came closer together indicated that there may be something fundamentally volatile about the modern financial architecture. The longed-for era of stability under the Bretton Woods system could not be forgotten, and some called for eliminating what has been dubbed the “dollar standard,” in which the dollar gained inherent value with the closing of the gold window, and replacing it with a more globally oriented basis of monetary transactions. Also due to short-t erm capital reversals that occurred during the Asian crisis, the wave of thinking that led to large-scale capital account liberalizations - that is, the Washington Consensus - has become less prominent, if not outmoded in some circles.
The crisis that began in the US in 2007 and 2008 spread quickly across the globe. Because of the centrality of the US economy in terms of both finance and trade, other economies in Europe, Asia, Latin America, and elsewhere were all affected. Those in many strata of income suffered real losses, as individuals directly involved in finance experienced stock market and asset declines, as currencies were devalued, and as export laborers and migrant workers lost jobs.
Although a second radical global change toward economic s tability, another “Bretton Woods,” is unlikely to occur in the near future, it has been recognized that, at least, more sophisticated and coordinated monitoring of the world economy must take place. It behooves us to examine in detail the panoply of crises that have occurred since 1929, in order to better understand the economic and financial context in which these crises arose, and how they were affected by policies designed, for better or worse, to cushion their impact. With international cooperation and greater understanding of historical missteps, we hold the optimistic view that solutions toward stability can be formulated and implemented.