Approaches to Economic Development in EMCs: A polarized debate Country Risk- February 2008

1. MH BOUCHET/CERAM (c)  Approaches to Economic Development in EMCs:A polarized debateCountry Risk- February 2008

2. MH BOUCHET/CERAM (c) Country risk and development policy strategy Behind economic policy measures, there is often a « model » of economic development that policymakers try to implement, to adopt or to enforce! Ex.: Chavez in Venezuela, Putin in Russia, Morales in Bolivia, George Bush in the US, Thaksin in Thailand, Ben Ali in Tunisia, Hamas in Palestine, Castro in Cuba…

3. MH BOUCHET/CERAM (c) Economic Development Theories

4. MH BOUCHET/CERAM (c) The global economy: A polarized debate

5. MH BOUCHET/CERAM (c) Summing up the key stances… Economic development is rooted in market-driven economic policies, in cautious monetary management, and in trade liberalization Free trade is mutually beneficial = positive sum game Development catch-up takes place as capital flows from rich to poor countries with technology transfers The State should limit its intervention to the strict minimum to avoid any market distortion Competition for profits leads to ever extending the capitalist system into developing economies where labor is cheaper, hence higher profits Keen competition between multinationals erodes the dynamic stimulus of competition and leads to monopolies for the sharing of markets worldwide. The State must intervene to foster a steady expansion of aggregate demand to fight unemployment

6. MH BOUCHET/CERAM (c) A polarized debate Neo-classical and monetarist economists The lesser the state the better: the state’s intervention is dangerous and useless The free market is the best tool to allocate and distribute resources Rational behavior of the economic agent Self-regulatory role of the market-based economy Unemployment cannot drop below its natural rate or at the cost of rising inflation Monetary policy is too important to be left in the hands of politicians! Keynesian economists Necessary regulatory role of the state to smooth the consequences of economic cycles and to stimulate demand Risk of long-term stubborn unemployment due to protracted demand weakness Key role of multiplier Temporary budget deficit should be accepted

7. MH BOUCHET/CERAM (c) I- Liberal & neo-classical school of thought Market-based economic policy Minimum state intervention Key role of competition

8. MH BOUCHET/CERAM (c) The neoclassical liberal school Economic development is rooted in market-driven economic policies, in cautious monetary management, and in trade liberalization: Low taxes and minimum public sector budget deficit!

9. MH BOUCHET/CERAM (c) From classical to neo-classical scholars

10. MH BOUCHET/CERAM (c) Founding fathers of economic liberalism: Convergence between trade, economic growth, peace and collective well-being

11. MH BOUCHET/CERAM (c) The founding fathers of the Liberal school Gournay (1750): “Laissez-faire, laissez passer” Adam Smith: 1776: The Wealth of Nations: Natural order stems from individual choices with minimal state involvement: “natural harmony” David Ricardo (1817): Principles of Political Economy and Taxation: the law of comparative advantage: a positive sum game for all countries! James Mill (1821): Elements of Political Economy: trade liberalization = exporting for importing (against the mercantilists)

12. MH BOUCHET/CERAM (c) Adam Smith (1723 –1790) Adam Smith, Scottish philosopher and economist: "The Wealth of Nations", on free trade and market economics (1776) "Little else is required to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice."ADAM SMITH, 1755

13. MH BOUCHET/CERAM (c) Adam Smith Adam Smith heavily influenced economic thought throughout the Victorian Era. Generally considered the "father of modern economics”. Competition, the market's invisible hand, leads to proper pricing to balance supply & demand forces Opposed to any government intervention into business affairs. Trade restrictions, minimum wage laws, and product regulation are detrimental to a nation's economic health. Smith was not an apologist for the capitalist class.

14. MH BOUCHET/CERAM (c) Theory of Absolute Advantage „Wealth of the Nations“ (1776): nations = households „Every prudent master of a family will never attempt to make at home what it will cost ... more to make than to buy. The tailor does not attempt to make his own shoes, but buys them from the shoemaker ... What is prudence in the conduct of every private family, cannot be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the product of our own industry employed in a way in which we have some advantage.“

15. MH BOUCHET/CERAM (c) Absolute Advantage A country has an absolute advantage over another in the production of good X when an equal quantity of resources can produce > X in the first country than in the second = higher productivity!

16. MH BOUCHET/CERAM (c) David Ricardo (1772 – 1823) David Ricardo, working in the early part of the 19th century, realised that absolute advantage was a limited case of a more general theory: Theory of Comparative advantage Major work: „On the Principles of Political Economy and Taxation“ (1817)

17. MH BOUCHET/CERAM (c) David Ricardo In the aftermath of Napoléon’s defeat, in 1815, British peasants consider that maintaining agricultural protectionism is a key to national security. Meanwhile, British industrialists want to achieve a decline in the price of wheat and of wages through import liberalization. Rising food prices and rising wages will squeeze industrial profits and only trade can lower costs! Each and every nation gets interest in specializing its production in those goods where it has « comparative advantage » depending on each nation’s endowments (labor, capital, land…). Free trade will then increase global welfare

18. MH BOUCHET/CERAM (c) Comparative Advantage Question David Ricardo tackled in 1817 (industrial revolution): what if one country can produce all commodities more efficiently than other countries? Ricardo‘s answer underlies the theory of comparative advantage: potential gains from trade with >0 sum game for all players! The gains from specialization and trade depend on the pattern of comparative, not absolute, advantage

19. MH BOUCHET/CERAM (c) Comparative Advantage A difference in comparative costs of production – the necessary condition for international exchange to occur – reflects a difference in the techniques of production, the capital and labor inputs, and productivity Trade is beneficial to all participating countries: win/win!

20. MH BOUCHET/CERAM (c) Productivity competition: Thailand vs Brazil

21. MH BOUCHET/CERAM (c) Productivity competition Thailand has an ABSOLUTE comparative advantage over Brazil. One Thai worker produces both more shoes and more stereo headphones than a worker in Brazil. But …Thailand has also a larger relative advantage over Brazil in producing stereo (6/2) than shoes (12/10)

22. MH BOUCHET/CERAM (c) No Trade: each country divides its own production capacity between shoes and stereo 1000 workers= 300 work on shoes and 700 work on stereo

23. MH BOUCHET/CERAM (c) Complete specialization:

24. MH BOUCHET/CERAM (c) Trade at the ratio of 2 shoes/1stereo (i.e. Thailand’s internal trade ratio = Thailand’s domestic price.) All gains go to Brazil that consumes more shoes and more stereo while Thailand is not better off

25. MH BOUCHET/CERAM (c) Trade at the ratio of 5 shoes/1stereo (i.e. Brazil’s internal trade ratio = Brazil’s domestic price.) All gains go to Thailand that consumes more shoes and more stereo while Brazil is not better off

26. MH BOUCHET/CERAM (c) Trade negotiations produce a mid-range price of 4 shoes for 1 stereo with mutually fruitful exchange:Both Thailand and Brazil are better off!

27. MH BOUCHET/CERAM (c) The Liberal economics school Samuelson (2004) : Ricardo is right but… They are both winners and losers Productivity gains in China’s export sector raise total wealth in each country: China and the US. But technical progress in China can also improve productivity in export goods competing with the US = China’s advances in semiconductors or India’s in financial services. Then, trade can turn entirely to the emerging country’s advantage.

28. MH BOUCHET/CERAM (c) Samuelson on the limits of trade benefits (2004) The aggregate economic gains to a nation from trade may decline in the future if other nations become more productive in those sectors in which the « rich » country holds a comparative advantage. The benefits of trade that derive from specialization are diminishing. Protectionism is NOT a solution: monopoly, crony capitalism and recession: pursuing open trade and competition is the better option for promoting overall growth and prosperity! Endless productivity growth race!

29. MH BOUCHET/CERAM (c) Modern liberal scientists: Walter Rostow : “take-off” paradigm Huntington: the Institutional development school The approach to development of the IFIs (FMI) Arthur Laffer (Chicago, South Carolina) Milton Friedman (Chicago): Monetarism Gary Becker (Chicago, Nobel Prize 1992) James Buchanan (Nobel Prize, 1986) Robert Lucas Paul Samuelson Jagdish Bhagwati Martin Wolf (FT)

30. MH BOUCHET/CERAM (c) The liberal “think-tanks” Mount Pelerin Society of liberal supply-side economists created in 1947 by Friedrich von Hayek Hoover institution (Standford University) Cato Institute (www.cato.org) American Enterprise Institute Washington -based Heritage Foundation

31. MH BOUCHET/CERAM (c) The neoclassical liberal school Robert J. Lucas, Robert Barro, and Thomas J. Sargent’s central assumption of "rational expectations", which assumes that actors in the economy are smart and forward looking and therefore attempt to predict the policies that government is going to implement. Excessive state intervention creates “moral hazard” (bail out of US Savings & Loans in 1990, Japan’s financial system in 1999, France’s Crédit Lyonnais, central banks interventions in 2008?...)

32. MH BOUCHET/CERAM (c) The Liberal economics school James Buchanan & Gordon Tullock (“The Calculus of Consent”), against the distortion of majority rule in parliamentarian democracy (the dictatorships of organized minorities) influenced by Friedrich Hayek’s “The Constitution of Liberty”: liberal interpretation of democracy ? rule of law and principle of generality ? simple majority rule can be applied only to general laws without any embodied discrimination.

33. MH BOUCHET/CERAM (c) Milton Friedman’s approach to economic growth and development Economic development’s roots? ? free-market economy + minimum state intervention + cautious monetary management = non-inflationary economic growth Consumers warrant more importance than citizens: “Capitalism and Freedom“-1962

34. MH BOUCHET/CERAM (c) Friedman’s approach to economic growth Diagnosis: from 1865 to 1965, average US economic growth (excepted 1930 crisis) has been 4.0%; since 1965, however = 2.5% due to excessive state intervention and over-regulation. “Money matters”: Policy-makers cannot have long-term influence on interest rates, on employment rate, and on growth rate. The only justified policy mission is avoiding both inflation and depression. The only variable under the control of decision-makers is price stability through prudent monetary management: regular and moderate expansion of domestic money supply. Keynesian anticyclical monetary policy is pointless and doomed to failure due to complex and uncertain lags between money supply, prices and growth.

35. MH BOUCHET/CERAM (c) Friedman’s approach to economic growth Liberal revolution could close the gap between potential output of 6% yearly and current average growth of 2-3%. Recommendation: limiting public spending as a proportion of GDP as much as possible. Hong-Kong as a target: 15/20% of GDP (vs. 50% in France) with GDP per capita equal to the US level. “The lesser the state intervention, the better!”

36. MH BOUCHET/CERAM (c) Milton Friedman: The Social Responsibility of Business is to Increase its Profits (NYTM, 09/1970) “I share Adam Smith's scepticism about the benefits that can be expected from "those who affected to trade for the public good” Promoting desirable "social" ends, a "social conscience" and responsibilities for providing employment, eliminating discrimination, avoiding pollution… boils down to pure and unadulterated socialism. The doctrine of "social responsibility" involves the acceptance of the socialist view that political mechanisms, not market mechanisms, are the appropriate way to determine the allocation of scarce resources to alternative uses. The manager is the agent of the individuals who own the corporation, and his primary responsibility is to them.

37. MH BOUCHET/CERAM (c) Milton Friedman: The Social Responsibility of Business is to Increase its Profits (NYTM, 09/1970) The political mechanism is based on conformity. The individual must serve a more general social interest–whether that be determined by a church or a dictator or a majority. The individual may have a vote and say in what is to be done, but if he is overruled, he must conform. Unfortunately, unanimity is not always feasible. There are some respects in which conformity appears unavoidable. The doctrine of "social responsibility" taken seriously would extend the scope of the political mechanism to every human activity. It does not differ in philosophy from the most explicitly collectivist doctrine. It differs only by professing to believe that collectivist ends can be attained without collectivist means. In Capitalism and Freedom, I have called it a "fundamentally subversive doctrine" in a free society, and have said that in such a society, "there is one and only one social responsibility of business–to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud."

38. MH BOUCHET/CERAM (c) Theoretical bases of monetarism Monetary policy must be totally free from state intervention = independence of the Central Bank and currency boards in EMCs Conclusion: 1. Economic crises have nothing to do with capitalism vulnerability but with bad economic policies; 2. The market remains the best coordination instrument with minimum state intervention; 3. The cause of most economic crises is the intervention of the welfare state; 4. The role of lender of last resort of the IMF and the resulting moral hazard increase the probability and the severity of financial crises.

39. MH BOUCHET/CERAM (c) II- The stages of growth Where does development come from? How can EMCs take off?

40. MH BOUCHET/CERAM (c) The Stages of Growth Expressing the growth process as a sequence of stages instead of a simple chronological story Aim is to design a model by specifying and isolating a limited number of factors in different stages to help predict change Karl Marx: feudalism gave way to bourgeois capitalism to be followed by socialism and then communism Karl Bücher and German historiography: « household economy » in the antiquity, then the « town economy » of the late Middle Ages, and thereafter the « national economy » of modern times Walter ROSTOW: the « take off »

41. MH BOUCHET/CERAM (c) Walter ROSTOW’s “take-off” approach to economic development An historical approach to the underlying economic conditions of self-sustaining economic growth

42. MH BOUCHET/CERAM (c)

43. MH BOUCHET/CERAM (c) “Take-off” approach to economic development During economic development societies pass through 5 stages: The traditional society, the pre-conditions for take-off, the take-off, the drive to maturity, and maturity (mass consumption)

44. MH BOUCHET/CERAM (c) Take-off approach to economic development 3 requirements for the take-off: Rise in the rate of productive investment from 5% to >10% of national income Development of manufacturing sectors Existence of a political, social and institutional framework which supports the expansion of the modern sector

45. MH BOUCHET/CERAM (c) A linear process of economic development... W. Rostow ’s Stages of Economic Growth: the « take-off approach » 5 étapes de la croissance Sociétés traditionnelles (pas de science moderne) Pré-conditions du décollage (période de transition entre sociétés traditionnelles et société moderne technologique) Décollage (apparition des premières industries, forte augmentation de la productivité agricole) Marche vers la maturité (dvpt au delà des secteurs qui ont initié le décollage) Consommation de masse (économie de service)5 étapes de la croissance Sociétés traditionnelles (pas de science moderne) Pré-conditions du décollage (période de transition entre sociétés traditionnelles et société moderne technologique) Décollage (apparition des premières industries, forte augmentation de la productivité agricole) Marche vers la maturité (dvpt au delà des secteurs qui ont initié le décollage) Consommation de masse (économie de service)

46. MH BOUCHET/CERAM (c) Economic growth in emerging market countries Annual Growth in GDP (real PIB/h base 100 en 1970)

47. MH BOUCHET/CERAM (c) Economic growth in emerging market countries Annual growth in GDP (real per capita GDP/ base 100 in 1970)

48. MH BOUCHET/CERAM (c) Take-off trigger: Net private capital flows to EMCs

49. MH BOUCHET/CERAM (c) Overall net external capital flows to EMCs

50. MH BOUCHET/CERAM (c) Development and the neoclassical liberal school Robert Lucas While income inequalities rose in the 20th century, the 21st century will see a convergence trend: Today, all countries have access to the same technology and institutions and adopt market-friendly economic policies, with fully mobile capital, then the process of catch-up will take place as capital flows from rich to poor countries.

51. MH BOUCHET/CERAM (c) Samuel HUNTINGTON

52. MH BOUCHET/CERAM (c) From Economic growth to Sustainable development « Political order in changing societies » Probing the conditions under which societies undergo rapid and disruptive social and political change: The primary problem of politics is the lag in the development of political institutions behind social and economic change Growth extends political consciousness, broadens political participation, and increases political demands Instability stems from rapid social change and rapid mobilization of new groups into politics coupled with slow development of political institutions

53. MH BOUCHET/CERAM (c) Political order (and disorder) in rapidly changing societies

54. MH BOUCHET/CERAM (c) Simon Kuznets (Nobel Prize 1971) Growth = long-term rise in capacity to supply increasingly diverse economic goods, based on advancing technology, and the institutional and ideological adjustments that it demands.

55. MH BOUCHET/CERAM (c) Simon Kuznets Characteristics of modern growth High rates of growth of per capita product Rise in the rate of productivity High rate of structural transformation Change in social and ideological structures Globalization of technological and capital flows Large income gap between developed and emerging countries= ? RISK

56. MH BOUCHET/CERAM (c) The emphasis on market-based economic policies “It is safe to say that we are witnessing this decade, in the United States, history’s most compelling demonstration of the productive capacity of free people operating in free markets”. Alan Greenspan, December 1999 Globalization is an endeavor that can spread worldwide the values of freedom and civil contact – the antithesis of terrorism!”. Alan Greenspan (2003)

57. MH BOUCHET/CERAM (c) The IMF Approach to Economic Growth and Development Development is economic growth + those conditions that make it sustainable, i.e. social mobilization, good governance, macro-economic stabilization; institutional development... A country cannot have a sustained economic adjustment unless the government gets its budget in order Setting the prices right: interest rates, exchange rates, domestic prices, agricultural and commodity prices Institutional changes: staffing, training, education, procedures, laws, regulations...

58. MH BOUCHET/CERAM (c) The IMF and World Bank Approach to Economic Growth and Development Sustainable development stems from a combination of sound economic policies, growth, and institutionalization with timely structural reforms: Stabilizing the macroeconomic situation Reducing the size of the public sector as the private sector is the main engine for growth Reform of the regulatory framework Good governance

59. MH BOUCHET/CERAM (c) IMF’s Monetary Approach to the Balance of Payments J. Polak (IMF/1957); Harry Johnson (1975) Robert Mundell (1975) Easy to apply in LDCs as monetary statistics are readily available Easy to modelize for IMF staff missions with macroeconomic projections Easy to impose IMF’s domestic credit ceilings as major policy instrument of demand management: domestic credit is the appropriate policy instrument for the control of the balance of payments.

60. MH BOUCHET/CERAM (c) The IMF Approach to Economic Growth and Development

61. MH BOUCHET/CERAM (c) The IMF Approach to Economic Growth and Development: Policy implications To boost domestic economic activity, the government resorts to high public spending, laxist domestic credit policy, and low taxes. This results in sharp rise in PSBR that is financed by the government selling debt to the central bank: ? increase in the monetary base and money supply ? increase in domestic spending ? increase in imports and financial assets ? wider balance of payments deficit and downward pressure on the exchange rate ? offsetting central bank intervention on the exchange market ? reduction in monetary base and money supply to avoid a rise in import prices and inflation. Monetary base MB = commercial bank reserves plus currency in circulation

62. MH BOUCHET/CERAM (c) The IMF Approach to Economic Growth and Development: Policy implications In terms of country risk assessment, central bank’s balance sheet information will convey timely signals about the direction of fiscal and monetary policies and about the foreign exchange operations of the central bank. In particular, official foreign assets and domestic assets (loans to government and loans to banks) will be interpreted as signals of stabilization or run-away domestic policy.

64. MH BOUCHET/CERAM (c) The « Washington Consensus »John Williamson, 1989: « lowest common denominator of policy advice for EMCs” Fiscal discipline A redirection of public expenditure priorities toward social fields (primary health care, primary education, and infrastructure) Tax reform (to lower marginal rates and broaden the tax base) Interest rate liberalization A competitive exchange rate 6. Trade liberalization 7. Liberalization of inflows of foreign direct investment 8. Privatization 9. Deregulation (to abolish barriers to entry and exit) 10. Secure property rights

65. MH BOUCHET/CERAM (c) III- The roots of underdevelopment Marx and his sons & grandsons The dependency school The dissidents

66. MH BOUCHET/CERAM (c) The « anti-liberal » school of thought Marx and his grandsons Dependency School: Paul Baran/Sweezie, Samir Amin, Immanuel Wallerstein, A. Gunder Frank… The “dissidents”: Krugman, Sachs, Stiglitz

67. MH BOUCHET/CERAM (c) Marxist approach to economic development Development’s ingredients? ? Capital accumulation + labor exploitation to generate surplus value and profits! ? Overall revenue is based on the economic value stemming from C, V and PL. Over the long term, there is a declining trend in V vs C, due to technology progress and on-going capital investment.

68. MH BOUCHET/CERAM (c)

69. MH BOUCHET/CERAM (c) Capitalism: a contradiction-driven engine of growth and crisis After years of scholarly research (in the British Museum Reading Room), Das Kapital was published in 1867. Engels edited the further two volumes which were issued posthumously in 1885 and 1894. Marx offers his economic interpretation of history and the theory of class struggle. Capitalism is a form of social order that contains its own inherent contradictions. Labor theory of value + Exploitation and alienation of the worker + Falling rate of profit = inevitable crisis, leading to revolution and eventually to the socialist state.

70. MH BOUCHET/CERAM (c) Marxist approach to economic development World capitalism is doomed to systemic crises due to several internal contradictions: 1. The contradiction between labor exploitation and the need for stimulating consumption leads to overproduction crisis 2. Competition for profits leads to ever extending the capitalist system into developing economies where labor is cheaper, hence long-term diminishing trend in profits 3. Keen competition between multinational companies gradually erode the dynamic stimulus of competition and leads to monopolies for the sharing of markets worldwide

71. MH BOUCHET/CERAM (c) Overall revenue Y is based on the overall economic value stemming from C (constant capital), V (variable capital) and PL (surplus value or profit). C= constant capital = machinery, equipment… V= variable capital = salaries and wages Over the long term, there is a declining trend in V vs C, due to technology progress, competitive pressure for higher productivity, and on-going capital investment.

72. MH BOUCHET/CERAM (c) Marxist approach to economic development Overall Revenue Y = C + W + PL Profit rate= PL/Y= PL + 1

73. MH BOUCHET/CERAM (c) The gloom approach Rosa Luxembourg (1871-1919) German revolutionary leader, journalist, and socialist theorist, who was killed in Berlin in 1919 during the German revolution. Only socialism could bring true freedom and social justice. Luxemburg was the advocate of mass action, spontaneity, and workers democracy. In 1912 appeared her major theoretical work, The Accumulation of Capital, in which she tried to prove that capitalism was doomed and would inevitably collapse on economic grounds.

74. MH BOUCHET/CERAM (c) Marx’s comeback Joan Robinson (1903-1983), "one of the leading unorthodox economists of the 20th century ». Robinson incarnated the "Cambridge School ». She traveled extensively, especially to India and China. « The Accumulation of Capital » (1956) extends Keynes's theory to account for long-run issues of growth and capital accumulation. Strong sense of the historical context of social change and concern with the challenge of stable and shared economic development .  Robinson's 1942 Essay on Marxian Economics proved insightful, critical and among the first studies to take Marx seriously as an economist.

75. MH BOUCHET/CERAM (c) Marx ‘s grandsons: Dependency Approach Economic development’s roots of industrialized countries? ? Center-periphery interactions with massive exploitation of cheap labor and abundant raw materials in under-developed countries. WHO?: Wallerstein, Baran, Sweezie, Samir Amin, Palloix, Gunder Franck... (The Capitalist World-Economy)

76. MH BOUCHET/CERAM (c) Dependency Approach The only kind of social system is a world system, defined as a unit with a single division of labor and multiple cultural systems. The capitalist world-economy emerged in the mid-XVI° century and spread over the entire world. It is characterized by a situation of structural dependence of developing countries under the domination of “center-country economies”. The capitalist world-economy’s objective is production for sale in a market in which the aim is to realize the maximum profit. In such a system, production is constantly expanded as long as further production is profitable.

77. MH BOUCHET/CERAM (c) Dependency Approach Engine of growth: capitalism is the only mode of production in which the maximization of profit creation is rewarded per se. The “rewards” and “penalties” are mediated through a structure called “the market”, that is the principal arena of economic power struggle. Thus the pressure is for constant expansion. The world capitalist system involves not only appropriation of the surplus value by an owner from a worker, but an appropriation of surplus of the whole world-economy by core areas (Britain in the XIX° century, USA and industrialized countries in the XX° and XXI° centuries).

78. MH BOUCHET/CERAM (c) Dependency Approach Engine of growth and crisis? The ability of the system as a whole to expand and create more profit regularly runs into the bottleneck of inadequate world demand: crisis of overproduction, stock market crisis, deflation… The role of the state as an institution in the world-economy is to regulate the market, i.e., to monitor the freedom of the market to minimize the risk of crisis. The world economy does not tolerate any “socialist systems” because it is rooted in a single world system, capitalist in form.

79. MH BOUCHET/CERAM (c) The « DISSIDENTS » Krugman Stiglitz Sachs Bourdieu Foucault

80. MH BOUCHET/CERAM (c) Paul Krugman’s view on economic crisis

81. MH BOUCHET/CERAM (c) Paul Krugman’s view on globalization In the 1980s, openness to trade was widely believed to reduce the likelihood of financial crises. Today, growing global integration does predispose the world economy toward more crises because it creates pressures on governments to relax restrictions. Economies are doing better in good times but are far more vulnerable to sudden crises due to rapid capital flight. The ride will continue to be very bumpy for many years to come!

82. MH BOUCHET/CERAM (c)

83. MH BOUCHET/CERAM (c)

84. MH BOUCHET/CERAM (c) Joseph Stiglitz’s views

85. MH BOUCHET/CERAM (c) Core ideas Poverty is an « affront to human dignity » G7 governments urge liberalization on developing countries while maintaining trade restrictions and pushing intellectual property protection into the WTO. The IMF's policies, in part based on the outworn presumption that markets, by themselves, lead to efficient outcomes, failed to allow for desirable government interventions in the market. Asymmetries of information prevent markets from full efficiency. Government and market are complementary and there is an important role, if limited, for government to play.

86. MH BOUCHET/CERAM (c) What is asymmetry of information? It is the difference in information between two economic agents within an economic relation (e.g.: « the worker and his employer, the lender and the borrower, the insurance company and the insured ») According to Stiglitz, financial markets cannot regulate themselves because anyone do not have the same information at the same moment. Therefore the aim is to find the best structure to regulate markets (and not to let them work by themselves).

87. MH BOUCHET/CERAM (c) Consequences Deregulation will not promote financial development when information is asymmetric and competition inadequate. The economic efficiency is not secured. It will spur corruption and create an oligarchic elite that opposes the emergence of competitive markets. The partisans of the « Washington consensus » overlook the importance of economic and corporate governance, underestimate the difficulty of building institutions, and forget that many countries lack the sophisticated public administrations needed to ensure adequate competition.

88. MH BOUCHET/CERAM (c) The challenge of the IMF Increased transparency at the IMF is essential. Decisions there are made on the basis of ideology and bad economics (sic!) When crises hit, the IMF prescribes outmoded, inappropriate, if standard solutions, without considering the effects they would have on the people in the countries told to follow these policies. No discussions of the consequences of alternative policies. Ideology guides policy prescription…

89. MH BOUCHET/CERAM (c) Jeffrey Sachs’ views

90. MH BOUCHET/CERAM (c) Sachs: The situation in Asia There vas no  « fundamental » reason for Asia ‘s financial calamity Budgets were in balance or surplus Low inflation High private savings rates Economies were poised for export growth The IMF’s tough macro-economic conditionality for approving financial support led to recessionary monetary policy and increased panic

91. MH BOUCHET/CERAM (c) The Asian crisis: an unpredictable crisis In Thailand: currency overvalued + overcapacity in real estate Bath devaluation required in 1997 Overstated financial panic of the investors in Asian countries + domino effect Flight of capital Asian countries needed significant financial sector reform But not sufficient cause for panic and for harsh macroeconomic policy adjustments

92. MH BOUCHET/CERAM (c) IMF declarations Before the Asian crisis (April 1997): « Directors welcomed Korea’s continued impressive macroeconomic performance [and] praised the authorities for their enviable fiscal record » « Directors strongly praised Thailand’s remarkable economic performance and the authorities’ consistent record of sound macroeconomic policies » IMF, 1997 annual report

93. MH BOUCHET/CERAM (c) Modelling Financial Crisis: The Generations Approach

94. MH BOUCHET/CERAM (c) „Even though we have seen much research on that topic, it is somewhat a disheartening fact that each wave of crises seems to elicit a new style of model, one that makes sense of the crisis after the fact!“ Paul Krugman

95. MH BOUCHET/CERAM (c) Definition of „Financial Crisis“ Currency crisis: situation in which an attack on the currency leads to substantial reserve losses, or to a sharp depreciation of the currency – if the speculative attack is ultimately successful – or to both. Banking crisis: Non-performing loans Bank runs ? closure, mergers or takeover by public sector Twin crisis: Kaminsky/Reinhart (1999)

96. MH BOUCHET/CERAM (c) First Generation (I) Exemplified by Krugman (1979) and Flood and Garber (1984) Classical Balance-of-Payment crisis Currency crisis stems from a government‘s decision to peg an exchange rate using reserves in the face of a long-term upward trend in relative prices Budget deficits financed by money creation with increasing domestic credits and crowding out First generation crisis are „home-made“

97. MH BOUCHET/CERAM (c) First Generation (II) Assumptions: Small open economy, perfect capital mobility, fixed exchange rates, „perfect foresight“ Crisis are predictable and deterministic ? result of bad policy Technique of backward-induction First speculative attack as soon as possible Currency crisis will occur as soon as a speculative attack can succeed

98. MH BOUCHET/CERAM (c) Second Generation (I) Pioneered by Maurice Obstfeld Series of speculative attacks on EMS currencies 1992/93 and Mexico‘s Tequila crisis of 1994/95 Financial crises can arise even in the presence of sound fundamentals! No deterioration in classical macroeconomic parameters Official exchange-market intervention ? fruitless effort Self-fulfilling crises

99. MH BOUCHET/CERAM (c) Second Generation (II) Changes in macroeconomic figures and policy more crucial than seignorage Continuous comparison of the goverment‘s net benefits from changing the exchange rate versus defending it Goal: Minimizing a loss function Fundamentals are far from „irrelevant“ ? define range of possible equilibria Diamond and Dybvig (1983): Bank runs can exhaust the reserves of solvent banks

100. MH BOUCHET/CERAM (c) Second Generation (III) Stylized model: Three players: The government defending the exchange rate peg Two holders of domestic currency (neither has sufficient resources to exhaust the government‘s reserves) The peg will collapse if each believes that the other attacks High/low level of reserves Intermediate level opens the way for expectations to play a crucial role Many small traders tendentiously lead to a unique equilibrium („classical theory“)

101. MH BOUCHET/CERAM (c) Brazilian Crisis „I see little reason to doubt that Brazil is in the intermediate situation [one of multiple equilibria] so far as its internal debt dynamics are concerned.“ Williamson (2002) Bad equilibrium vs. good equilibrium: If the markets believe the debt will be serviced, then it will be possible [for the country] to service it Bond spreads signal risk perception Matter of market psychology rather than the laws of economics IMF can play a useful role in breaking a panic

102. MH BOUCHET/CERAM (c) Third Generation (I) „I can‘t imagine that 20 or 25 years ago my predecessors would have been worried about an economic crisis in Thailand or Indonesia, or even Korea“ Robert Rubin, Former Secretary of the Treasury, in: Thomas Friedman (1999) Much more heterogeneous than first two generations Asian Crisis 1997/98

103. MH BOUCHET/CERAM (c) Third Generation (II) Three main variants: Moral-hazard-driven lending Currency crises as byproduct of bank run Balance-sheet implications of currency depreciation Short-term debt Other key inputs: Maturity mismatch, currency mismatch, contagion, crony capitalism, corruption and bad governance

104. MH BOUCHET/CERAM (c) Outlook – Early Warning Systems Financial crisis literature as a reference point for the identification of „Early Warning Indicators“ Try to predict crises using various techniques Signals approach, econometric models, logit and probit models, etc.

105. MH BOUCHET/CERAM (c) New generation of financial crisis? 2007-2008 US subrime crisis and global contamination Roots in lack of transparence and governance Risk is not priced adequately Liquidity crisis Contagion from fiancial sphere to real economic sphere Cut in global growth

106. MH BOUCHET/CERAM (c) Sources (I) Flood, Robert and Peter, Garber (1984, „Collapsing Exchane-Rate Regimes: Some Linear Examples“, Journal of International Economics 17, 1-13. Friedman, Thomas (1999), „The Lexus and the Olive Tree“, New York. Goldstein/Kaminsky and Reinhart (2000), „Assessing Financial Vulnerability“, Institute for International Economics. Krugman, Paul (1979), „A Model of Balance-of-Payments Crises“, Journal of Money, Credit, and Banking 11, 3, pp. 311-25. Krugman, Paul (1996), „Are Currency Crises Self-fulfilling?“, NBER Annual Macroeconomics Conference.

107. MH BOUCHET/CERAM (c) Sources (II) Obstfeld, Maurice (1986), „Rational and Self-fulfilling Balance-of-Payments Crises“, American Economic Review 76, pp. 72-81. Obstfeld, Maurice (1994), „The Logic of Currency Crises“, Working Paper 4640 NBER, Cambridge. Williamson, John (2002), „Is Brazil Next?“, International Economics Policy Briefs, PB 02-7, IIE.