Economic Globalization 3 Sociology 2, Class 8 Copyright © 2008 by Evan Schofer Do not copy or distribute without permission

Announcements Agenda –Midterm review sheet handed out Plus info on midterm format –Today: More on on Economic Globalization Floating exchange rates, currency values, and financial crises More video –If time allows; otherwise it will be next Tuesday.

Midterm Info Topic coverage: –All class lecture material Lecture notes on course website –All readings up through Week 5 –Commanding Heights video, Episodes 1 & 3 Available via course web page… –Exam Format: Closed book / closed notes Mix of short answer/multiple choice, medium length, and one short essay question.

Review: Economic Globalization Question: What are some basic things that are absolutely required in order to have a global economy? –1. Inexpensive transportation & communication –2. International financial (money) system –3. Countries that are willing to participate Removal of legal or regulatory “barriers”

Review: International Financial System International transactions require a system to: Convert from one currency to another Determine appropriate exchange rate –Examples: The Gold Standard Bretton Woods Floating Exchange rates

Review: Floating Exchange Rates The current international monetary system: floating exchange rates Values of currency change with supply and demand Changes in currency value affect trade –If the US$ goes up compared to the Chinese Yuan: US consumers can buy Chinese goods more cheaply –US consumers win –Chinese exporters “win” It is more expensive for Chinese consumers to buy US goods –Chinese consumers lose –US Exporters “Lose”.

Floating Exchange Rates Why do currency values “float” (change)? What forces affect supply and demand? 1. Asymmetric trade If a country imports more than it exports, its currency drops Ex: US has a current accounts deficit with Japan (imports more than it exports) To purchase Japanese goods, Americans must sell dollars, buy Japanese Yen –Demand drives up value of Yen relative to the dollar.

Floating Exchange Rates What forces affect currency values? 2. Asymmetric capital flows If capital moves into a country, its currency goes up –Ex: In early 1990s, global investors moved money into Thailand, Mexico… raising the value of currency If capital moves out of a country, its currency goes down –Investors feared problems in Mexico, Thailand… pulled money out –Thai Baht and Mexican Peso dropped in value

Floating Exchange Rates What causes asymmetric capital flows? 2. a. Interest rates –If a country raises interest rates, its currency goes up Reason: Foreign investors prefer high rates –The “electronic herd” is attracted to high rates… –If a country cuts interest rates, its currency drops Investors would prefer moving money into countries where banks pay higher interest… –Important issue: Globalization limits the ability of governments to control their own monetary policy Ex: The US wants to lower interest rates to boost the economy… but can’t because it will hurt the US $.

In the News: US Dollar & Interest Rates LONDON (AFP) - The dollar plunged to a record low Tuesday against the euro, which broke through the 1.60-dollar barrier, as the unit was hit by dismal US housing news and fresh fears over the health of the US economy. Also weighing on the dollar was a comment from the head of the French central bank, Christian Noyer, highlighting the interest rate differential between the United States and the eurozone. The European Central Bank's benchmark rate, 4.00 percent, is already substantially higher than that of the US Federal Reserve, which stands at 2.25 percent. Higher interest rates in the eurozone -- and the likelihood that they will not change -- makes the euro a more attractive investment than the dollar. While the Fed is scrambling to galvanize economic momentum and head of recession by lowering rates, the ECB is focused on curbing inflation -- currently at 3.6 percent in the eurozone -- and has shown no inclination to make credit cheaper. Issue: Fed can’t lower interest rates without hurting the dollar!

Floating Exchange Rates What causes asymmetric capital flows? 2. b. Anything else that “scares” investors Government instability Concern that an economy isn’t going to do well –Ex: Fears that Thailand was going “bust” Policy changes that investors don’t like –Ex: big increase in taxes –Shift away from free-market policies (“golden straightjacket”) All of these things can cause investors to pull their money out of a country quickly, harming currency values.

Review: Floating Exchange Rates What forces affect currency values? 4. Countries can intervene strategically to alter their currency values Governments can sell their currency to lower its value –They buy other currencies on global markets Governments can buy their own currency to raise its value –They spend “reserves” of gold or other currencies on global markets This requires lots of money, so rich countries can do it more.

Trade & Exchange Rates Recent news article: WASHINGTON (AP) -- America's beleaguered manufacturing companies, chafing over the loss of 2.7 million jobs over the last three years, vowed Wednesday to press ahead harder to get China to stop manipulating its currency to gain trade advantages. (Associated Press) Issue: China keeps value of currency low Aids exporters, at expense of US companies

Trade & Exchange Rates Issue: Countries can strategically alter their currency values to gain an advantage in trade Asymmetric trade with China should cause Chinese Yuan to rise relative to the US$ The US imports much more than it exports (trade deficit) –But: China floods market with Yuan, buys US$ Yuan value stays low compared to US$ Result: Chinese exports remain cheap for Americans Result: American manufacturing companies = Angry! Note: US did a similar thing in the 1970s But, it requires lots of $ to do this. Thailand was doing it, but ran out of money… it’s currency suddenly plummeted.

Financial Flows & Exchange Rates Issue: Trade & financial flows have same impact on currencies Asymmetrical flows cause currency values to change –But remember: Investment flows are larger than trade flows, and they can happen much faster Elwood: “pinball capital” Result: global investors can cause currency values to change rapidly Called: market volatility (rapid change in value) If a currency value falls too low, serious economic problems arise.

Exchange Rates & Volatility Capital flows and resulting currency volatility can produce severe crises Example: Mexico in 1994 –Global investors bought lots of stock, investments in Mexico over several years… This caused a slow rise in the peso. Not a problem. –A minor political crisis led to panic selling in 1994 The stock market began to plummet –Global investors rushed to sell stocks, converted pesos to dollars –Result: Selling of pesos made the value of pesos plummet!

Exchange Rates & Volatility Why was it bad for the value of pesos to drop severely, rapidly? –1. Suddenly, imports were very expensive Price of gas shot up Businesses dependent on imports couldn’t afford costs; potential for bankruptcies –2. Many Mexican companies had borrowed money from US banks US banks must paid in $, not pesos If pesos are worth little, suddenly can’t afford to pay loans Result: More bankruptcies, economic recession/depression.

Exchange Rates & Volatility In the case of the 1994 peso crisis, the US government stepped in Provided emergency loans, etc., to prevent massive bankruptcy But, that was just a small crisis… It is clear that crises could occur that are too large to stop so easily.

Asian Financial Crisis Recall Commanding Heights Video: In the 1990s, foreign investors moved capital into Asia And, foreign banks lent money to Asian companies at very low interest rates –Consequence: Rapid economic growth Economies “heated up” But, capitalism is prone to boom-bust cycles… Companies built more factories and housing than needed –The “boom” ended But – global dynamics made the “bust” much worse!

Asian Financial Crisis How did globalization harm Asian economies? –1. Investors pulled out quickly – affecting currencies Asian currency valued dropped… Imports became expensive Companies could no longer pay off loans to foreign banks –Bankruptcies, unemployment… –2. Contagion Worries about Thailand spread to other Asian countries –Self-fulfilling prophecy: fear of problems caused investors to pull out, creating real problems Also, many US companies were invested in Asia (or had made loans)… Now they were losing money –Integrated economies mean that crises tend to spread…

Capital Flows & the United States Krugman article: “Don’t Cry for Me America” Explains how investors are starting to pull out of the US Results won’t be as dire for us… –Isn’t happening too quickly –American companies have loans payable in US$ (if it were Euros, we’d be in bigger trouble) But, still… a serious issue for the US econoomy.

More Video: Commanding Heights Topic: Asian financial crisis, spillover to other regions…