EC 380 - International Economic Issues
2025
The primary role of a bank is to provide intermediation between savers and borrowers
Banks pool deposits and make them available to would-be investors that need loans
A functional banking system is necessary to bolster investment by firms and homeowners
Banking systems are reliant on interbanking lending channels
Why?
No bank has enough money/cash to reedem every $ of deposits it maintains
Some $ of bank’s liabilities returned to depositers every day
In cases where a bank lacks cash, it can engage in interbank lending
A bank is considered insolvent if, even after completely liquidizing its assets, it cannot repay its outstanding liabilities owed to creditors
During a banking crisis, an abnormally large % of borrowers fail to meet debts
Bank assets may suddenly deteriorate
Depositers may trigger a run on banks
If numerous banks struggle meeting obligations to their depositors, there can be a major loss of savings
Remaining savings can be lost, causing households to reduce consumption. This can lead to ripple effects throughout the economy
Note: Most countries offer deposit insurance. But other types of financial products are still vulnerable.
Defined as a sudden collapse of the value of a national currency
This can happen under any form of exchange rate system (fixed or flexible)
Devaluation is similar to a bank run, international currency holders sell their holdings as soon as possible
One possible action a nation can take is to devalue their currency which can stop the “bleeding” of foreign currency reserves
With more reserves, a country can stablize their exchange rate to manageable levels
Defined as a widespread failure to meet debt obligations
If a party fails to honor their debt, these losses can spread throughout the rest of the economy
Spread can end in insolvency, in which other individuals go into bankrupcty because an initial set of individuals do
What usually happens is the debt gets restructured which involves lowering the rate of interest, extending the payback period, partial forgiveness, or a combination of them
Suppose an economy is split into three groups:
Group A is heavily indebeted and holding risky portfolio of assets it invested in
Group B holds relatively correlated assets to Group A but maintains low debt level
Group C holds unrelated assets and maintains low debt level
If Group A experiences a shock in which it cannot service its debts, it may be forced to sell all of its assets to meet as much of their debt as possible
Group B sees assets fall in value as supply in the market suddenly increases
Group B assets fall in value \(\Rightarrow\) Becomes insolvent too. Group C is unaffected
Governments can also fail to obligate their debts. The EU debt crisis saw repeated episodes of Greece nearly defaulting on debt, following a major economic collapse
What happens when an entire country defaults on foreign debts?
Defined as a country having a current account deficit that it cannot finance
Deficit is financed through selling financial assets, which includes currency reserves, as a way to generate capital account net inflow that offsets current account net outflow
If the deficit country capital investments/purchases appear too risky, capital inflows ease
Can put great pressure on domestic reserve, causing them to dwindle
The ability to purchase goods abroad using their denominated currency now faces a limit and may need to stop all together
The ability to convert local currency into foreign debt repayment transfers also kicks in, causing further stress on the deficit country
What are the origins of a given international crisis?
Could be due to:
Macroeconomic imbalances
Capital flow volatility
Long-run underlying issues for the domestic economy may lead to over-reliance of foreign debt and over-leveraged credit status across households
Can be the result of either of these two scenarios
Macro-imablances can be attributed to:
Usually, these issues occur simulataneously, further complicating matters of unravelling macroeconomic imbalances
Poor fiscal policy may lead to major public debt and high domestic inflation
Doubt in government ability may result in government bond yields needing to rise to continue accessing foreign debt. Which limits the ability of the government to service the economy
There is an ebb-and-flow to capital investment
During good times, capital is situated in strong economies and accrue returns based on the economy’s performance
When this economy enters a recession, central banks lower interest rates and domestic economies see a slump in consumption
Capital investors migrate to other economies until resurgence happens
These volatile movements of large sums of capital within these transition periods can carry high costs for the emerging host countries
Particularly strong cases of interbank lending across countries make these spillovers of domestic shocks into foreign countries become amplified
As the world becomes more globalized, financial interlinkages become stronger
Local shocks are increasingly likely to trigger worldwide repercussions due to greater degree of financial interdependence
This aspect of crises determines the scale of how “international” or “cross-country” a given crisis will be
The financial sector has always been a concern for policymakers, due to the too big to fail mindset
Bailouts of banks can protect the economy, but greater risks offer greater returns
Encourages banks to become large enough to force bailouts in between episodes of them over-leveraging themselves
This is known as the Moral Hazard Problem. Where bankers are able to transfer high risks to the government and taxpayer
The solution to fiscal/monetary crises are quite simple:
But the solution may simply not be politically feasible
A budget deficit reduction may stem reserve loses and lower financial exposure
Interest rate appreciation may boost demand for domestic currency, further helping
These are simple but difficult to stomach
In the worst of cases, a policy action may turn a relatively small problem into a full-blown depression
EC380, Lecture 06 | International Crises