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Understanding Deflation

Deflation means a prolonged period of falling prices. Deflation has the following negative consequences:

  1. Businesses and consumers are aware that prices are falling and thus delay purchases of goods and services as much as possible. This reduces demand in the economy and leads to less production, less jobs, less cash flow for businesses and individuals.
  2. Real interest rates are equal to => nominal rate – inflation rate. If the inflation rate is negative, real rates of interest can actual get higher as deflation continues. Since nominal interest rates cannot got below zero it means the central bank cannot stimulate the economy through lower interest rates. If deflation persists, higher real interest rates make it credit less affordable which reduces economic activity and demand in the economy.
  3. Debt is services out of nominal cash flows. If prices are falling, so are sales and from the government’s perspective, tax receipts. Debt payments are however fixed. That means that debt servicing as % of cash flow rises. This combined with less demands leads to more bankruptcies which in turn lead to layoffs and reduced demand.
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Consequences of a Globalized World

“In this new world of global finance, it is popular to argue that governments ought to play a smaller role in the economic system, to be less intrusive. But an interesing byproduct of the crises of the recent period is that world governments have been doing more, not less, in this vital area. In fact, recent banking crises have been managed only through extensive and continuing government intervention.” – Paul Volcker

Globalization has made the world today an increasingly interconnected system and is a result of the “development of global financial markets, the growth of transnational corporations, and their increasing domination over national economies” (Soros, p. 1). For all the good that has come about from globalization, including increased productivity and improvements in living standards, the global financial system has broken down occasionally and caused collapses with consequences extending far beyond financial markets. The inherit instability of the system has raised backlash against globalization and questions about its sustainability. While free market apostles say that markets are self-regulating mechanisms which should be left to their own devices, I wish to argue that the global financial markets are prone to collapse and only increased regulation and strengthening of international financial institutions can provide stability and sustainability to the system.

Globalization, the free movement of capital between countries and continents, is a system outgrown from World War II that has emerged as a trend in the last 40 years, gaining momentum after the collapse of the Soviet system. In the years of the Cold War, the affairs of the world were dominated by “Great Powers” and the movement of private capital was greatly limited by the institutions of the Bretton Woods system established after WWII, the World Bank and the International Monetary Fund (IMF). With time, the controls of the movement of capital were gradually lifted as the 1973 oil crisis increased the need for offshore financial markets. The oil shocks created a trade surplus among the OPEC member countries, leading them to invest oil money internationally, a phenomenon known as “petrodollar recycling”. The development of international markets was further helped in the 1980s by the economic policies of Margaret Thatcher and Ronald Reagan, who both relinquished control over national economies, giving more power to the marketplace. With the end of the Cold War, the world quickly moved to be dominated by financial markets and the powers of globalization, as free market capitalism triumphed over socialism. Increases in efficiency and standards of living followed, as the fear of nuclear war dissipated and economic sacrifices in the name of national security would no longer be tolerated.

While the rise of modern international finance is mostly a product of the 1990s, it is important to understand that globalization is not a new phenomenon. Though lacking modern communication technology, the 19th century was very much a globalized world, with investors allocating capital freely between countries and often pursuing profits in remote parts of the world. Gunboat “diplomacy” was often a way of protecting the interests of United States investors in foreign regions. This world of freely moving capital was brutally halted, first by World War I and then the Great Depression of the 1930s. What emerged from WWII were the modern welfare states of the United States and Europe. It is clear that the current state of interconnectivity of global markets is not new. Globalization is a process that can be reversed – it would be foolhardy to believe otherwise.

Globalization exerts pressures on governments of countries seeking access to capital. In a globalized world, capital is free to move as it wishes while the movement of people between countries is highly regulated. As capital is an essential means of production today, the need to attract foreign investment has become a dominant part of the policy of many foreign countries. Financial journalist Anthony Rowley writes, “in Asia especially, the dependence upon bond issues is likely to reach major proportions as the region seeks to fund a huge burden of financial private infrastructures, government debt and housing finance.” Capital tends to go to places where it is least taxed and least regulated. Today’s global state of affairs, where capital can move swiftly and freely, inhibits the ability of governments to tax and regulate capital, undermining national sovereignty. The undermining of the government’s ability to control the economy and reduced ability to tax capital is leading to the disappearance of safety nets and social programs. Globalization also has other negative effects that most hurt the poorest and the least developed nations in the global capital system. As Roger Cohen from the New York Times puts it, “it is the erosion of national sovereignty. It is footloose corporations taking investments where labor is most productive. It is the growing premium on technical skills — and the growing plight of unskilled laborers.” The unrestrained pursuit of profit destroys the environment and leads to a marginalization of developing countries, as workers rights and social benefits are cut in the name of prosperity and attracting capital. In Argentina, a country hit hard by globalization gone wrong, the backlash against globalization is particularly severe. Economic woes are met by dissatisfaction and resentment from the local population, best expressed by Bishop Marcelo Palentini: “In Argentina workers have lost in a few years rights they fought for over a century. We’re a colony here. All that is missing is to have Clinton come here and plant the American flag.” (Cohen). Global financial markets do not and cannot by themselves bring the rule of law, the protection of human rights or provide social justice. Social values and public goods can only be provided through the political process.

The global financial markets today have become more powerful than the most powerful of countries. The sterling crisis of 1992 illustrates this point clearly, as it was a defining battle between the British government and the financial markets. Britain was, at the time, a member of the European Exchange Rate Mechanism (ERM), a set of guidelines for regulating the exchange rates between major European currencies. After the collapse of the Berlin Wall, Germany’s central bank raised interest rates, causing the British pound to fall against the deutschmark. As the sterling declined, it got close to the agreed ERM exchange rate limits, which if breached would face Britain to devalue the sterling. Financial market speculators sold billions of pounds, betting that they would be able to force the British government to devalue the sterling. The British government tried various methods to prevent this from happening, including interest rate increases and open market operations. These attempts failed and Britain devalued the pound on September 16, 1992 and left the ERM. George Soros, who reportedly made over $1 billion during the collapse of the pound, had this to say about the actions of the British government: “It indicated to us that we were in the end game, this was an act of desperation, so instead of restraining ourselves, it was really an invitation to try to sell as much as possible. […] A single government, like the British government, has practically no power in resisting these global powers.” (Curtis). Up until that time, the sense that the markets could take on a central bank and actually win was unbelievable. Since the collapse of the British pound, many countries have seen their economies wrecked by powers of the global markets. Countries like Mexico have had their currencies devalued by the global markets and had no control over what happened, as illustrated by the words of Mexico’s finance minister during the 1994 peso crisis: “Everybody feels their life is determined by someone outside, and everyone wants to know, who is this person? Who is this force? We thought we were on the path to the First World and suddenly something went wrong. We are losing control.” (Friedman, p. 271)

The issues of financial instability are rarely heard of by the American public as the United States remains the largest and most powerful nation in the world, never having to devalue its currency to please the global financial markets. However, should a crisis arise, it is doubtful that the United States would be able to withstand the power of the markets and it would most likely have to cede to the demands of the global financial community. The unsuccessful defense of the pound sterling in 1992 cost the British treasury about 27 billion pounds, which is a meager sum compared to the volume of the daily transactions in the foreign exchange (FX) market today. The average daily FX transaction volume is over $3 trillion today (Bank of International Settlements). Given the size and power of the financial markets, it is doubtful that the United States Treasury with its reserves totaling less than $100 billion could withstand even one day of fighting the market. The United States still is a global superpower, but it no longer gets to set the rules of the marketplace, and today it must play by the rules just like any other country in the global financial system. The United States is vulnerable, as are all countries.

Given the power of global markets, it is shocking to discover how instable the system really is. Market fundamentalists preach that markets tend towards equilibrium and provide for the best allocation of resources. This is a good description of the markets for physical goods and services but is often not an accurate description of how financial markets function. Financial markets often form trends which are at first self-reinforcing and then self-destructive, leading to a pattern of boom and bust. For example, a country that has an appreciating currency and high interest rates will attract capital from countries with lower interest rates. The inflow of speculative capital into that country will then led to an appreciation of the currency, which in turn leads to more inflows of capital. This trend is self-reinforcing, until the overvalued exchange rate creates serious trade and budget deficits, which can then led to a destructive flight of capital from a country. This is evident in the wild gyrations of currency, debt and equity markets around the world as well as the many economies hurt by the global financial system. Examples include Mexico in 1982, and then in 1994, the Asian crisis in 1997, and the Russian debt crisis in 1998, amongst many others.

With more local companies being acquired by American and European multination corporations, globalization is beginning to be seen as a new form of colonialism and can be expected to be met with similar distaste. Argentina has liberalized its economy and conceded to the demands of global markets and economic reformers, all in the name of progress. While Argentina has enjoyed rising living standards, the country was not spared from economic disaster, and since the Asian crisis hit, “plants have been idled, growth forecasts have been slashed and the Argentine stock market has plunged more than 25 percent” (Cohen). The plight of Mexico is yet another example of a country that was heading in the direction of the First World, or as Thomas Friedman puts it, has “put on the Golden Straitjacket,” but was hit by chaos on the way. In fact, “Mexico has been through two financial collapses — the debt crisis of the 1980s and the Mexican meltdown of late 1994. These battered the banking system and left sobered banks, now often in foreign hands.” (Cohen). Furthermore, the instability of the global financial system can devastate economies, leaving thousands without jobs and without a future. In the aftermath of the financial crisis in Argentina, Bishop Marcelo Palentini estimates that “in the province of Jujuy, 42 percent of the population is unemployed or doing menial work.” (Cohen). The loss of jobs in Argentina is crippling and has left the country with political instability as strikes and riots across the country have threatened to overthrow the government. Though the change in power in Argentina ended up being a peaceful one, this is has not always been the case. For example, “in Indonesia political crisis has followed the economic collapse” (Pfaff), suggesting that political unrest and strong grassroots backlash against globalization can eventually led to the downfall of the entire system. As long as the failures of globalization are isolated to small and poor countries, the system can remain stable; however, growing evidence that even larger countries, with more sophisticated financial systems, like the United States, can be affected.

Under globalization, distress in financial markets is no longer isolated to local economies, and often affects the entire world. As Anthony Rowley writes, “World Bank chief economist Michael Bruno noted that ‘there are no reasons for Mexico’s problems to become a generalized problem for the region, or for developing countries as a whole’. Yet this is precisely what is happening and the spread of the contagion cannot be blamed solely upon what Bruno condemned as the ‘herd instinct’ among international investors.” It is clear that not even the United States is immune to problems as the financial crisis in Asia in 1997 eventually led to a stock market panic in 1998, quelled only by the intervention of Alan Greenspan and the Federal Reserve, decreasing interest rates to calm the markets. However, the intervention by the Fed caused other problems, as the decreased interest rates helped create the bubble in Internet stocks and then the dot-com collapse in March of 2000. The large financial losses amongst American investors during 2000-2001 can be traced back to the collapse in Asia in 1997. Globalization has led to the integration of financial markets, allowing investors to efficiently allocate capital and seek the greatest return. Greater market efficiency has come at the cost of greater instability, as problems in one part of the system can spread to other members of the global financial community. For example “Mexico’s monetary unrest extended well beyond its borders — to other Latin American countries, Spain, Italy and Asia, particularly Thailand and Hong Kong. Monetary unrest no longer stays local; increasingly, it requires coordinated responses by international monetary authorities” (Mainichi Daily News). In addition, a 1995 IMF study concluded that “a banking crisis in one country is no longer an isolated incident. It can have far-reaching spill-over effects in other countries” (Crutsinger). The increased interconnectivity of financial markets means that even countries allowing the best possible economic policies are at risk of crisis if a major collapse should happen in any part of the system. The investors and institutions controlling the vast majority of the worlds capital often do not distinguish between emerging economies treating “Seoul, Sao Paulo, Bangkok and Buenos Aires as one interchangeable funny world, developing nations that threaten the annual bonus” (Cohen). This degree of interdependence today is not yet widely recognized even among the world best economists given how far and fast the recent crises have spread. As financial journalist Adam Entous writes, “the extent of the financial shock to hit Asia took the international lending agency by surprise. Neither economic forecasts nor asset prices in the financial markets foretold the depth and breadth of the crisis to come.” Having given away power to the markets, governments have made their countries, economies and citizens susceptible to economic problems they did not cause and are not responsible for. As Paul Krugman from Princeton notes, “the financial risks of globalization are a lot bigger than optimists imagined. We are back to a volatile, pre-depression world economy of financial booms and busts quite different from the Cold War years” (Cohen). These increases of vulnerability and inability for countries to control their own economic and social destinies have led to a backlash against the system, and threatened the sustainability of globalization at large.

Immediately following the Asian crisis, the international community has recognized the problems of globalization and made them a topic at the 1999 Davos Economic Forum. Reporting on the forum in Davos, William Pfaff notes that, “globalization orthodoxy no longer dominates the international debate, which it did before the Asian crisis,” and “the globalization model of the future simply is no longer as interesting as it was. It was presented as a kind of panacea for the world economy. Now its limitations, and the destructive consequences it can have, are clear.” It is now recognized that the stability of the globalized world matters, but it is uncertain if this recognition lasts long enough for real reforms to be made as crises affecting poor people in poor countries tend to quickly leave the headlines as investors all look for the next big opportunity. For those left without jobs and whose businesses have been bankrupted, there is little hope for change in the future as one of the problems of modern financial markets is that there is truly no one in control. There is, therefore, a need for a set of global institutions that would act together with political and monetary authorities to avert and limit the impact of financial crashes. As Anthony Rowley writes, “the IMF has realized the need for a massive increase in its resources in order to cope with what appear likely to be further financial crises as developed-country savings are invested increasingly in the developing world and as the number of countries with access to private capital markets expands.” This reaction, while encouraging, has quickly been forgotten and never implemented as in 2000-2001 the United States entered a recession and the loss of jobs and savings in the stock market took center stage in political debates.

As the world has never been more open than today, the United States, due to losses on sub-prime mortgages, stands at the brink of a credit crisis of unknown proportions, but one that has already affected investors in America, Europe and Asia. While all are hopeful that the effects of this crisis remain limited and contained to the banking sector in developed nations, it is hard to forget that the Asian crisis did not cause global repercussion until over 18 months after it started, suggesting that credit problems in the United States can still affect the rest of the world. In all previous crises, developing nations ended up being hurt the most and it is those nations that require the most international assistance to cope with the problems. Unfortunately, as we wait for the financial troubles to unfold, “some people have simplistically asserted that the World Bank is no longer needed in an age when the private sector can handle the job of development. Others claim the IMF is redundant because the capital markets have in effect taken over its function. In fact, the reverse is true and the IMF has moved to centre stage in global finance” (Rowley). The market fundamentalists that have come to dominate the political stage in most industrial countries are attempting to limit and marginalize the power of the IMF and the World Bank at a time when they may be needed the most. In fact after an “economic crisis that shook Asia to the core, international financial regulators doubt they have the systems in place yet to prevent another such meltdown” (Wheatley). Additionally, Adam Entous writes that “many countries are vulnerable to reversals of market sentiment. It is therefore critical that countries take the necessary steps to reduce their vulnerability,” suggesting that while the current bull market in emerging markets continues, many countries are ill prepared for a downturn should foreign capital be withdrawn.

Steps must be taken to stabilize globalization and strengthen international monetary institutions. The sustainability of the current system is based on in its acceptance to the populations whose lives it dominates: people of the developing world. Governments must be able to minimize the impact of international financial crises on their economies, and while many developing countries are too weak to do so, collectively this can be achieved through international monetary institutions, such as the World Bank and IMF. This means strengthening these institutions to deal with the “worrying trends in the 10-trillion-dollar-a-day global capital market” (Wheatley). Moreover, better standards for international reporting of loans and stricter deposit requirements may be necessary, as the former can help prevent the emergence of speculative bubbles while the latter will make the system more resilient to shocks. Alan Wheatley notes that, “Hubert Neiss, the IMF’s director for Asia and the Pacific, identified a need to restrain short-term capital flows to help to prevent future crises, for example by setting higher reserve requirements or raising prudential borrowing limits.” Stabilizing globalization does not mean bailing out imprudent investors, but the diminishing of speculative frenzies and speculative panics which led to abrupt and devastating economical, social and political consequences. Stabilizing globalization in the short run will be most beneficial to poor and developing countries, but in the long run may prevent the reoccurrence of a Great Depression, something in which the United States and other developed countries have the greatest vested interest. The United States is the primary beneficiary of globalization today and has the most to lose, should the system break down. It is the United States that must act along with other countries to strengthen the international financial system and create a world in which not only competition but also cooperation is a way of solving problems.


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