23 min read

B. Eichengreen (2019), Globalizing Capital

B. Eichengreen (2019), Globalizing Capital
Book notes.

Comment: To me this book is the most comprehensive record of the history of the global monetary system. It is short and consice, yet full of facts and insights. If you're looking for one book that could explain you the development of the last 200 years of the monetary system, I'd recommend to reading "Globalizing Capital", (or at least to skimming through my notes).

Amazon Link.


The global monetary system in the last 200 years went from bimetallism to gold to exchange-gold to adjusted-floating to floating. These are the currency regimes that the West went through. Changes in the system were very often caused by a chain of individual country decisions. Consequently, these decisions would affect the future course of the local currency, and also monetary economics of other countries. These two characteristics are called path dependence and network externalities.

Path dependence and network externalities: Monetary arragements established by international nefotiation are the exception, no the rule. More commonly, such arragements have arisen spontaneously out of the individual choices of countries constrained by the prior decisions of their neighbors and, more generally, by the inheritance of history.

Historically, exchange rates were pegged to the value of gold or/and silver.  In the new era after the two world wars, pegged exchange rates became hard to maintain and had to be controlled. What caused difficulties to maintain pegged rates in 20th century as it was in the 19th century was a shift in social objectives of central banks and governments. Defending exchange rate stability often comes with social costs that hit regular citizens (e.g. higher interest rates). Universal male suffrage and labor unions changed the environment in which, all of a sudden, central banks had to take into consideration not only exchange rate stability but also other things like the level of employment. Capital controls and monetary unions were also a mean to manage a variety of new economic goals. Capital controls loosened the link between domestic and foreign economic policies, and monetary unions eliminated the problem of exchange rates at all. Nevertheless, in the end, capital controls didn't really work, and monetary unions couldn't be established everywhere. Thus, the floating was inevitable.

All these events of the past are important because "international monetary system is fundamentally a historical process".

The options available to aspiring reformers at any point in time are not independent of international monetary arrangements in the past. And the arrangements of the recent past themselves reflect the influence of earlier events.

Gold Standard

The gold standard came by an accident, and not by a planned action.

  • In 1717, Issac Newton set a too low gold price for silver --> silver disappeared from circulation in the Great Britain.
  • Britain soon became a powerful industrial, financial and commercial economy and foreigners would start to trade and borrow more from them.
  • Gold standard as a international monetary system started around 1870s.
  • Before the gold standard, many countries were on the bimetallic standard or silver standard. Only Great Britain was fully on gold.

Gold became the primary metal-based money in Europe because of:

  • Silver discoveries in Nevada in the 1850s (global inflation of silver money)
  • British commercial and financial dominance
  • Germany assimilating more gold and selling silver as a consequence of French indemnity paid in gold (Franco-Prussian War) and finally liquidation of silver by Germany
  • Industrial revolution increased trade connections, and so Great Britain and Germany incentivized, through network externalities, other countries to also adopt the gold

Switching to the gold standard in the second half of the 19th century may not be the best decision because

  • it is likely that France and other bimetallic countries would absorb the surplus of silver and sell their gold to remain the metal balance in the global market
  • As Milton Friedman noted, the Great Britain in the 1870s and 1880s experienced a significant deflation as less money chased more goods. Deflation could probably have been avoided if free silver coinage was to stay in Europe and the US.
  • A lot of countries had a big portion of their international reserves in the form of financial claims on other countries whose currencies were convertible into gold (e.g. British Treasury bills or bank deposits in London). Exchange reserves were attractive because they bore interest.
  • Britain, Norway, Finland, Russia and Japan operated fiduciary systems in which the central bank was permitted to issue a limited amount of currency not backed by gold reserves (but usually collateralized by government bonds).
  • Some countries operated proportional systems, in which foreign exchange reserves couldn't fall below a certain proportion (usually 40%). Some countries had hybrid systems of these two forms.
  • There was elasticity in the relationship between money supply of gold and foreign-exchange reserves.

Price-specie flow model is a simple model of the gold standard developed by David Hume. A country with trade deficit was a net imported, so the gold was flowing out of the country. Less gold means less money, and so prices fell locally. Though, prices rose aboard in the surplus countries, which exported more than imported. Then, it was more attractive (cheap) for foreigners to import goods from the first country that experienced fall in prices. Consequently, the first country exports more and gets gold inflow that increases prices.
Essentially, that was the balance-of-payments adjustment mechanism of the mid-18th century.
Cons: the model lacks international capital flows, international gold shipments and central banks

  • In reality, when faced with external gold drain, a central bank could raise its discount rate to lower the volume of domestic credit. Higher discounting rate would lower the domestic demand and cause fall in prices, and at the same time it would attract more money from abroad. This means that the central banks to some extent could restore the external balance without gold outflows.
The cornerstone of the prewar gold standard was the priority attached by governments to maintaining convertibility
  • Central bank Control the discount rate was highly harmonized with BoE leading the market. If BoE raised its interest rate, other central banks were expected to follow. Only then the system was able to work. It was prevalent in the times of the gold standard
  • When one country experienced a domestic financial crisis, other countries would often borrow its gold to that country in crisis (e.g. 1890 Baring crisis). International solidarity in times of crisis made the gold standard work.
  • Periphery areas couldn't enjoy the monetary stability of their north-central European peers because they often didn't have a central bank to control the discount rate or significant links with the Great Britain. Another reason, prevalent in Latin countries, is that some countries deliberately followed policies that favored depreciation and inflation often because of political influences, and so they often had to suspend gold convertibility.

The Interwar Period

  • During the war, governments issued fiat currency to finance their military operations, so the post-war reconstructions were also monetary.
  • After the war, only USD remained convertible to gold (European currencies were overvalued, so they would lose gold otherwise).
  • First half of 1920s -- free float regime.
  • Austria, Germany, Hungary and Poland experienced hyperinflation (1923-1925), then they stabilized with gold.
  • Other high-inflation European counties also eventually stabilized, but without drastic currency-reforms, like in Germany.
  • The new adjustment mechanism didn't work. Some countries (Britain) were in constant BoP deficit, and some (France) in constant and persistent
If France's stabilization in 1926 is taken to mark the establishment of the gold standard and Britain's devaluation of sterling in 1931 its demise, then the interwar gold standard functioned as a global system for less than five years.
  • Many countries established their central banks, including the Fed in 1913, but, the mere existence of a central bank was no guarantee of stability. Central banks couldn't stop the great depression.
  • The depression started in the periphery, where primary-producing countries were hit by declines in capital imports and revenues from commodity exports. Then politics got the upper hand and these countries devalued / introduced capital controls.
By 1932 the international monetary system has splintered into three blocks: the residual gold-standard countries (US), the sterling area (Britain); and the Central and Eastern European countries (Germany), where exchange control prevailed.

That tripolar system was not stable either.

Britain devalued while the continent didn't, so the latter had to hike rates and depress their economies, so the pressure to devalue was even bigger, which caused capital flight. Eventually everyone devalued.

When FDR won the election, he started raising the dollar price of gold, which devalued the USD and helped the US to kick-start the recovery domestically, but caused chaos everywhere else, and pushed overseas countries to also devalue.

Floating came back in the 1930s, but because the experience with 1920s floating wasn't satisfactory, this time governments "managed" floating.

Restructuring the Gold Standard

By 1926 the gold standard was operating in 39 countries. By 1927 it was essentially complete. Though, some countries never restored convertibility: Spain, China, Soviet Union.

After the war, governments didn't allow gold to circulate much, and to increase reserves supply, central banks would augment gold with foreign exchange. The postwar standard was the gold-exchange standard. This was caused by worries of a global gold shortage.

Conference in Genoa, 1922:

  • Negotiating convention of holding unlimited foreign-exchange reserves
  • International cooperation - harmonizing the level of interest rates (preventing individual scramble for gold that would only depress the global economy)

US didn't take part in the conference, neither did they take part in other meetings that would discuss the old-new monetary system. The monetary system was thus never fully reconstructed.

Nurkse: "The piecemeal and haphazard manner of international monetary reconstruction sowed the seeds of subsequent disintegration."

Problems of the New Gold Standard

  • The gold supply growth couldn't keep up with the growth of the economy
  • Germany and France absorbed almost all the increase in global monetary reserves
  • The adjusting mechanism didn't work properly because of officials intervention in the gold market
  • Perceptions of the appropriate structure and operations of the interwar system were conditioned too much by the prewar experience.
  • "They [France] viewed the Genoa proposals to institutionalize the gold-exchange standard as a British ploy to fortify London's position as a financial center, at the expense of Paris"
  • Emelie Moreau (head of BoF) almost broke the sterling when he wanted to sell all foreign reserves in the gold market.
  • As gold flowed to France and Germany, other central banks were forced to raise interest rates and tighten credit to defend their reserves.
  • US (the largest holder of monetary gold) didn't want to help with the global gold shortage. They could reduce the discount rate to encourage gold outflows to redistribute the gold to the rest of the world. Instead, the Fed was worrying about stock market speculation and, in 1928, they raised the rate from 3.5% to 5%...
Its actions were felt both at home and abroad. Tighter money slowed the expansion of the U.S. economy. Higher interest rates kept American capital from flowing abroad. The Fed's failure to release gold heightened the stains on ther countries, which were forced to respond with discount-rate increases of their own.

Great Depression

  • Developing economies were faced with capital and commodity market shocks and had to suspend convertibility. It happened many times before, but at no time before 1913 nearly all peripheral countries abandoned convertibility.
  • Harvest failures, military conflicts and economic mismanagement in individual countries caused exports to fall and capital flows to dry up
  • The gold standard's disintegration at the periphery undermined its stability at the center
  • Industrial production collapsed.

Triffin: "The most significant development of the period, was the growing importance of domestic factors as the final determinant of monetary policies".

Coordinationg domestic and foreign economic policies would have made it possible to neutralize the balance-of-payments concesequences. The worldwide shortage of liquidity produced by the collapse of financeial intermediation would have been averted.
  • The reflationary measures that were undertaken in the 1930s were initiated unilaterally.
  • US France and Britain were unable to agree on concerted action (London Economic Conference 1933).
  • Domestic stimulation were a "beggar-thy-neighbor" policies.

The development of the interwar monetary system can be understood in terms of 3 interrelated political and economic changes:

  • Growing tensions between competing economic policy objectives (e.g. currency stability vs unemployment).
  • International capital flows were not stabilizing anymore in times of crisis because of new internal objectives of central banks, and so their credibility was diminished, which caused capital flows to be destabilizing.
  • Changing center of gravity of the international system (Britain → US).

Bretton Woods

  • Keynes denies the existence of "a smoothly functioning mechanism of adjustment which preserves equilibrium if we only trust to the methods of laissez-faire". For him, laissez-faire never existed because central banks controlled the policy rate.
  • Main arrangements of the Bretton Woods
  1. Pegged exchange rates can be adjusted when there exists a "fundamental disequilibrium" (the phrase was never defined).
  2. Countries can limit international international capital flows by imposing controls.
    • Alternative to deflationary bank rate increases, goal: to avoid disruptive capital flows that created instability
  3. IMF monitors national economic policies and extends balance-of-payments financing to countries at risk
    • IMF additionally had a provision, scarce-currency-clause, that allowed to sanction governments responsible for policies that destabilized the international system
    • IMF was also created to restore the free world trade
    • In practice only capital controls functioned as planned
    • Exchange controls substituted for the missing adjustment mechanism

Bretton Woods conference

Keynes' plan:

  • Each government can adjust their exchange rate and impose controls to reach full employment.
  • Clearing Union - countries with payments surplus finance drawing rights of other deficit countries.

Harry Dexter White's plan:

  • No controls and no pegged currencies, reached by a superintended international institution.
  • Americans opposed the clearing union because it "involved unlimited liability for potential creditors" (Harrod 1952).


  • Postwar Europe had a massive demand for dollar (and goods generally), notwithstanding the Marshall Aid. That was the central monetary problem of the postwar period.
  • Addressing the sources of both internal and external imbalance was the key to stabilization. Import controls alone don't restore equilibrium, monetary and fiscal action has to be also put into action.
  • "By attempting a compromise between the gold standard and fixed rates on the one hand and flexible rates on the other, the Breton Woods planners arrived at a condition which ... [was] not a true adjustment system" — Scammell (1975) p. 81-82
  • "Trade restrictions might be dismantled without creating unsustainable deficits requiring substantial currency depreciation if government spending were cut and demand were reduced" — Conclusion of Milward (1984)
  • If the Bretton Woods system had ever operated it ended in 1947 — Milward (1984)
  • In the 60s, capital controls were much more difficult to impose. The emergence of multinational corporations and the eurodollar market made controls on capital movement basically impossible to fully enforce.
In retrospect, the belief that this system could work was extraordinarily naive. The modest quotas and drawing rights of the Articles of Agreement were dwarfed by the dollar shortage that emerged before the IMF opened for business in 1947. Postwar Europe had immense unsatisfied demands for food stuffs, capital foods, and other merchandise produced in the United States and only limited capacity to produce goods for exports.

USD as the main reserve currency

  • de Gaulle problem — IMF quotas were supposed to satisfy the world's demand for liquidity. Instead, the system grew less symmetric as the dollar solidified its status as the leading reserve currency.
    • Consistent with the French position in the interwar period - Genoa conference in 1922 i.e. French opposed any scheme that would give a special status to any currency.
    • An example of the US "exorbitant privilege".
  • Triffin dilemma — demand for reserve that is satisfied by only one currency (USD) makes the system dynamically unstable.
    • US payments deficit and maturity mismatch of assets and liabilities made a "bank-run" -like problem. The US acted like a banker to the world, borrowing short and lending long.
    • Triffin feared that this kind of bank run, liquidating USD reserves for gold when US deficit liabilities are much more than US gold reserves, would prompted US government to revert to deflationary policies, which would then starve the world of liquidity.
  • de Gaulle problem and Triffin dilemma induced a need for an additional source of liquidity - the solution was a pool of Special Drawing Rights (SDRs), but by the time SDR came into being, the world was full of dollars and inflation.


Sterling crisis in 1947

  • Americans proposed a $3.75 billion loan to Britain on the condition that they agree to restore current-account convertibility (5 years ahead BW deadline).
  • Sterling became convertible into dollars. Convertibility was suspended after 6 weeks.
  • The decision was disastrous and caused massive reserve losses.

1953 "Stop-Go" policy — return to bank rate policy, lowering discount rate before elections i.e. increasing income, and then lifting the rate up (often to late to avert a crisis)

The Battle for Sterling

  • Around 1961, Britain went from modest surplus to substantial deficit. The situation was bad and devaluation seemed inevitable, but the British government (Labor Party) resisted. They used everything they could to avoid devaluation: interest rate hikes, import tariffs, spending cuts, multiple IMF loans, and it worked for a few years until 1967 when the British, despite all those measures, were forced to devalue 17%

United States

  • US goal: restoration of an open multilateral trading system (Cordell Hull).
  • In the beginning of the postwar period the American sentiment, for some reason, was that the US will be in perennial surplus and Europe in perpetual crisis.
  • Americans underestimated the level of need for dollar in the postwar period.
  • Marshall Plan was not approved by the Congress before the sterling crisis, after the crisis the plan was put into place (1948).
  • The recession caused a reduced US demands for European goods.
  • It created a big problem for European reserves. Devaluations followed in September.
  • Magnitude: American imports from the sterling area fell by 50% (Q1-Q3 1949).
  • The demand for dollar got even bigger.

Recession of 1949

Triffin: Controls only "slowed down, or postponed, the exchange-rate readjustment which had characterized the 1920s, and bunched up many of them in September 1949"

European Payments Union (EPU)

  • Established to solve Europe's trade and payments problems. Active in years 1950-1958. EPU was a departure from Bretton Woods.
  • Goal: restoration of current-account convertibility.
  • Participating countries were rapidly reducing barriers of trade among themselves and applied all restrictions equally.
  • Countries running deficits had access to internal credit, similar to IMF quotas that were available through the Bretton Woods framework.
  • Less trade restrictions inside the EPU meant a discrimination towards external countries, especially the US.


  • Labor a communist movements were very strong after the war and demanded wage increases, higher taxes and more social welfare, so European governments had to compromise with these parties. The Deal made the government commit to full employment and growth for more moderated demands coming from the populists...
  • ... Because of this, officials couldn't use the central bank discount rate to adjust BoP as it was done before the war, so they had to resort to exchange controls.
  • Reaction: $120m loan from EPU (European Payments Union), temporary currency and import controls, increase in tax and interest rate to restrict consumption; success in 1951 - BoP surplus and lifting off restrictions.

German BoP crisis in 1950


  • France had a discrimination deal with the US, FX rate at 264 francs when free market rate was 300, but then the franc devalued.
  • Many payment crisis' throughout the 1950s.
  • Deficit spending (military and social) problem / socialists in parliament and political instability / 1955-56 Algeria and Suez crisis. Parallel to "the battle of the franc" in 1924.
  • Charles de Gaulle forms a government in 1958 and imposes austerity measures (parallel to Poincare stabilization 1926), after that came stabilization and economic liberalization.

The crisis of the dollar

  • Rapid growth of Western European countries and Japan made those countries an attractive region to invest in, despite high levels of inflation.
  • Capital outflows in 60s made gold to trade at $40 an ounce, whereas US pegged gold at $35. This made an arbitrage opportunity to foreign central banks, but the officials oversees decided to support the dollar by creating the London Gold Pool.
  • There were limits to that kind of support, though. For instance, Germans feared that large-scale dollar purchases may cause a surge in domestic inflation.
  • The dollar devalued once in 1971, when Germany, fearing inflation, allowed the mark to float upward. Other European countries followed by converting dollars to gold.
  • 13 August 1971 - Nixon closes the gold window and puts tariffs on imports to resist further devaluation.
  • An attack on Sterling in 1972 forced Britain to float the currency. This caused flight from the dollar. In 1973, other countries also decided to float their currencies and the Bretton Woods officially ended.


  • Floating exchange rates were a consequence of the rise of international capital mobility.
  • Current account convertibility made distinction of current and capital accounts purchases/sales difficult to determine. Market participants found new ways of circumventing barriers to international capital flows.
  • Europeans and Japanese hoped for restoration of par values, the US wanted to continue floating (because of past attacks on the dollar).

Leaving currency pegs

Jacques Rueff predicted that the collapse of par values would provoke liquidation of foreign exchange reserves and a deflationary scramble for gold, like that which had aggravated the Great Depression. In the end he was wrong, because when floating really happened officials started doing monetary financing and the problem of the 70s was not deflation but inflation.

  • There was no consensus forecast on floating.
  • Two conficting views:
    • Floating will remove misalignments, and then settle down to equilibrium levels
    • Floating will cause financial turmoil and instability
  • Today we know that both positions were oversold.
  • Nominal and real Exchange rates were volatile, even more than predicted by the proponents of floating, but there was no financial chaos that the critics anticipated.
  • Overvalued dollar depreciated 30% against deutsche mark in the first 6 months, but then it setlted down.

70s didn't experience misalignment of 80s because of following reasons:

  • Governments intervened in the currency markets,
  • Willingness to adjust monetary and fiscal policies with the exchange rate in mind.

The dollar had dramatic misalignment in the 1980s.

Three significant transformation in late 70s:

  • Stance of US policies
  • Stance of Japanese policies
  • European Monetary System

Few nations had been more committed to than Japan to exchange market intervention, however later in the 70s they gravitated towards greater exchange rate flexibility, so did the US.

Volcker after his appointment was prepared to increase interest rates to any level, in order to reduce inflation. High interest rates attracted foreign capital and caused the dollar to up.

Europeans and Japanese continued to attach more importance to exchange rate stability. To them, budget deficits and high interest rates were the source of misalignment. They wanted cooperation, but the US was reluctant.

Plaza Accord

  • By the mid-80s, USD was thought to be overvalued and in a bubble. USD FX rates were trading at levels that couldn't be explained by macro fundamentals, so in September 1985, G-5 officials held a secret meeting where they agreed to push the dollar down.
  • The official rationale for this was stopping the coming protectionist legislation going through the US Congress that was aimed at protecting domestic producers. It threatened the Reagan's agenda of deregulation and economic liberalization, and jeopardized European and Japanese access to the US market.
  • No monetary or fiscal policies were discussed at Plaza, yet dollar fell 4%.
  • Some think that Plaza was irrelevant, USD had already begun to decline 6 months before Plaza and its subsequent fall was just the unwinding of unsustainable appreciation.
  • Others think that Plaza signaled an impending policy shift - willingness to stabilize the exchange rate.
  • These two positions can be reconciled, because a few months earlier there was a change in leadership and policy of US Treasury, that focused more on intervention (James Baker).

After a few years of USD decline, the US settled into a policy of benign neglect of the exchange rate. Bush and Clinton administrations displayed little readiness to adjust policies to stop the currency's fall. There were higher costs to overvalued currency, than to undervalued currency. USD depreciation was driven mostly by domestic considerations, especially cutting rates and recession responses.

By 1992, an undervalued dollar became a big problem for Japan and Europe.

The Snake and the European Monetary System

  • The Werner Report (1970) recommended creating a European monetary union by making a central authority to harmonize fiscal policies and accelerate integration of commodity markets. No ECB, no single currency.
  • The Snake - When Bretton Woods collapsed, Europeans agreed to limit the fluctuations of bilateral rates to 4.5%. (Smithsonian Agreement in 1971 allowed for 9% fluctuations).
  • After few years the snake encountered problems: oil shock, monetary aggregate targeting by the Bundesbank, divergence in unemployment rates and responses to recession.
  • At the beginning, the snake was a response to American exorbitant privilege. After a few years, though, the Deutsche Mark emerged as the European reference currency and an anti-inflationary anchor.

French support for pegged rates and the negative effects of declining USD on Deutsche Mark motivated Schmidt and Giscard to create the European Monetary System in 1979.

  • Exchange rate mechanism - currency exchange rate within 2.5% bands, capital controls were permitted. Rates were modified once every ~8 months.
  • After a few years the exchange rate problem was solved, but there were other problems, most notably high unemployment producer competitiveness with the US and Japan. These led to a radical acceleration of European integration.
  • The Delors Committee (1988): removing capital controls all at once, complete centralization of monetary authority, creation of single European currency, ceilings on budget deficits.
  • The Maastricht Treaty described transitions to be completed in three stages with ultimate deadline 1/1/1999, and also introduced convergence criteria that had to be fulfilled to join the union.
  • Negotiations were very optimistic, but then the (currency) crisis hit.
  • There are three explanations for the crisis: inadequate harmonization of past policies, inadequate harmonization of future policies, and speculative pressures.
  • Eichengreen is convinced that the third explanation is correct (Self-fulfilling crises) and there is no evidence to support the first two.

Some small open economies established currency boards that pegged currency to the one of a trading partners. They succeeded in small countries like Hong Kong or Cayman Islands but failed in other countries like Argentina. The system was similar to the gold standard, it had an advantage of stable prices but lacked flexibility and an ability of a lender-of-last-resort intervention.

Regions of the past French colonies in Africa, collectively pegged their currencies to French franc - CFA zone. The project was successful, since these countries enjoyed a long period of low inflation compared to their neighboring countries. CFA could exist for such a long time (fell in 1994) because of the support of the French government.

One Common lesson of post BW projects (Plaza, Snake, EMS): limited measures could not succeed in a world of unlimited capital mobility.

A Brave New Monetary World

  • As time went by, more and more countries switched to pure floating.
  • Monetary authorities around the world were slowly going from exchange rate targeting to inflation targeting.
  • Yet, floating was not free: Countries with large foreign debt were scared of depreciation, and strong export countries were scared of appreciation, so intervention in the FX market was common.
  • Many developing countries in Asia worried about appreciation of their currency against Chinese RMB
  • China did not feed a pressure to devalue, because at that time (90s) they still had tight capital controls, which allowed them to pursue an independent monetary policy.
  • At the beginning of 2000s, China got huge surplus that they had to get rid of, in order to avoid inflation, so they parked newly acquired dollars into UST bonds. China exported manufacturing goods, US exported liquid financial assets. Win-win. For the Chinese, it was also a way to bullet-proof their economy.

The Asian Crisis

  • In the mid-90s, Asian economies grew at +7%, which attracted foreign investors, especially because of low interest rates in major financial centers. Seeing yields depressing, many of them engaged in carry trade of Asian securities. Capital flowed even to troubled countries like the Philippines.
  • Some countries were pressured to relax capital-account restrictions (like South Korea in 1996) and made a mistake of doing that before relaxing their currency exchange pegs.
  • Problems began when exports slowed down. That was caused by intensifying Chinese competition, appreciation of USD/JPY, and higher yields in Japan. (Asian currencies were then pegged to USD.) First to fall was the Bangkok Bank of Commerce in mid 1996. Thai bat was the most overvalued currency.
  • The thai government refused to restrain investment for fear of slowing growth and alter the exchange rate, so domestic banks borrowed offshore. Finally, the inevitable devaluation came in summer of 1997.
While Thailand's crisis was widely foreseen, what was not anticipated was its spread to other countries.
  • Next were Philippines, Indonesia, Malaysia, Taiwan and Korea.
  • Indonesia experienced a bank run, then the entire banking system shut down. Korea merely escaped that scenario with the help of G-7 banks' short-term loans

Foreign Exchange Instability

  • Argentina, Brazil and Turkey all experienced high inflation rooted in large budget deficits. In the early 90s, all these countries stabilized, for a while, by pegging to USD. However, exchange-rate-based stabilization addressed only symptoms and not the real causes of inflation (budget deficit).

History showed that governments that held onto pegs for deal life, not so much because of any intrinsic merits but because they saw no alternative, were setting themselves up for a nasty fall.

Brazil's stabilization with the new currency pegged to USD, "real", reduced traded-goods inflation, but didn't slow down nontraded-goods inflation. The result was loss of competitiveness and rising unemployment in the medium run. In the short-run, the stabilization was mostly positive.

Lax fiscal discipline, instability spillovers from other regions, and inability to stabilize when it was needed (rising interest rates) caused a crisis and massive capital outflows. The surprise was that the exchange rate stabilized much more quickly than in other regions (e.g. Asia). Switching central bank priorities to inflation targeting helped. Sound conditions of the banking system also helped.

Turkey's crisis was similar, but worse, because of weak financial system. Argentina's problems were very comparable, though more extreme.

Global Imbalances

Late 90s: China had been unscathed by the Asian crisis and grew fast with 40% investments/GDP and high household savings. The US, on the other hand, run large current account deficits. Investments rose but savings didn't, so most of that investment was financed by foreigners. Personal savings even turned negative.

Some were saying that more spending was cased by strong fundamentals, but a more plausible reason was a series of rate cuts in response to the 2001 recession. Then, low interest rates fueled an unprecedented housing boom.

The US could spend so much and run deficits because other countries were willing to run large surpluses. The situation was similar to Bretton Woods, that's why some academics described late 90s/ early 2000s as Bretton Woods II. One county was supplying the rest of the world with international liquidity, as emerging market economies were exporting their way to higher incomes by running surpluses.

As Chinese population started aging, there was a need for slowing down investments and reducing reserves. In July 2005, China revalued RMB by 2.1%. This was still too low to eliminate imbalances, but it was something.

A Decade of Crisis

Global Financial Crisis

GFC roots lay in the credit boom inflicted by Fed's rate cuts and bank's competition in speculative investments followed by elimination of Glass-Steagall Act.

The US dollar has a tendency to strengthen when the global economy experiences a crisis. Capital flows come to stabilize exactly when the markets come under strain. That's another example of the US exorbitant privilege.

The crisis quickly spread to Europe and Asia (most notably - South Korea). Fed organized dollar swap lines to provide liquidity to foreign banks. That led to another debate on international reserves. Chinese were calling for diversification of global liquidity, for a move from USD to SDRs, but there was no interest of exporters, importers and investors in doing business with SDRs.

European Debt Crisis

Euro crisis: investors were confusing devaluation risk with the risk that a government or mortgage borrower might default.

In Europe, The GFC problem was in denial. The ECB actually hiked rates instead of lowering them, in response to increases in food and energy prices. Additionally, EU countries entered GFC with high public debts. In November 2009 a semi-sovereign debt crisis started in Dubai.

Then it came out that the Greek government had cooked the books, the country's budget deficit was much higher than previously reported. A default of Greek government would have jeopardized the stability of French and German banks that had lent generously to Greek financial institutions and bought Greek government bonds. IMF gave Greece a €30 billion loan, 3200% of the country's IMF quota.

As a consequence, Greece would have to embrace austerity - rise taxes and cut spending, however, that kind of response doesn't go without causing a deep recession.

The only countries undertaking significant fiscal consolidations that escaped this fate had done so by devaluing their currencies and substituting external demand for the domestic demand that was lost.

Things got even worst when ECB raised interest rates twice in mid-2011…

Eventually, the situation resolved with debt restructuring and change in leadership of the ECB. Mario Draghi came in and started closing spreads. Greek bonds got a cushion landing on the ECB's balance sheet.

Meanwhile, there was a debate of whether Greece should leave the Euro zone. Leaving the EU is possible and also envisioned by the regulations, leaving the European monetary union is not. A "Grexit" would have triggered a financial chaos. The process takes time, switching to euros took EU countries over 2 years. During that time, people would want to locate their money in German banks, fearing devaluation, and the government would then have to impose capital controls (something that has happened to Russia after their invasion of Ukraine). Financial markets would have had to close, the economy would collapse.

Abandoning the euro was more complicated than leaving the gold standard. There the gold standard was essentially a monetary arrangement, the euro was part of a larger diplomatic construct.

Then the crises of Ireland, Portugal and Spain followed. Ireland had a banking sector and real estate market problem, Spain also had a real estate problem and Portugal had a growth problem.

The euro crisis was backstopped by Mario Draghi and the ECB that committed to "do whatever it takes" to preserve the euro area.

Currency Wars and China

After the GFC, western economies waged a war against deflation and cut interest rates to historical lows. Emerging economies weren't so happy with that, as their currencies were appreciation and threatening manufacturing competitiveness. Inflation came, too. So, they started devaluing their currencies, similar to 1930s when countries started leaving the gold standard.

Barry argues that the response was inappropriate. The times were different. Emerging economies still experienced solid growth, and now the problem was inflation, not deflation. Blaming western countries was wrong. Chronic deflation in the West would hurt the demand, and so the global economy. Instead of devaluing their currencies, EMs should raise taxes and cut spending. However, slowing the growth in times of prosperity is politically difficult.

China, again, wasn't affect by overvaluations overseas because of capital controls. A few years later, China wanted to get RMB a serious reserve currency status by making it into the SDR basket, but IMF first required the currency to be "freely usable" in international transactions. So, China relaxed their capital controls in 2015. Capital flowed in, and Chinese share prices doubled in 6 months. Then, PBoC, to reduce bubbles in equities and property markets, started tightening credit conditions. Prices fell down, more than anticipated. Next, Chinese devalued 2% because of some technicalities, but didn't communicate clearly with the markets. Investors took fright. As a consequence, PBoC had to intervene in the FX market and tighten capital controls. Ironically, by that time (Nov 2015) IMP added RMB to the SDR basket.

Chinese policy moved too fast in the direction of capital-account liberalization.

The legitimacy of the governing regime rested fundamentally on its success at delivering prosperity, stability, and economic growth [so] domestic imperatives trumped external objectives.

Having learned the hard way, they now tightened controls and refocused on what mattered the most: the maintenance of financial stability and a high rate of GDP growth.