Economic Globalization

Sociology 2, Class 7

Copyright © 2011 by Evan Schofer

Do not copy or distribute without permission

Announcements

• Announcements• Midterm is approaching… 2 weeks• I’ll hand out a review sheet on Thursday• We will do some review in section and class next week

• Agenda– Today: More on economic globalization

• Capital flows and currency crises• Thursday: trade & trade agreements

Review: Economic Globalization

• Requirements for a large scale global economy:

• 1. Inexpensive transportation & communication– Example: Containerized shipping

• 2. International financial (money) system– Ex: Gold standard, or system of “floating exchange rates”

• 3. Countries that are willing to participate– Absence of legal or regulatory “barriers”

Review: International Financial System

• In order to conduct trade, there must be an international system to handle currencies– Plan A: The Gold Standard

• For every dollar the government prints, they hold a corresponding amount of gold in the bank

– Plan B: Bretton Woods• The US$ would have value fixed to gold, would serve as

currency for international transactions

– Plan C: The system of “floating” exchange rates• The system we use now…

Floating Exchange Rates

• Plan C: The system of floating exchange rates

• Value of currencies is determined by market• Like the price of commodities: oil, wheat, etc.

• Selling a computer to someone in Europe:– European goes to the currency market (bank)

to buy US dollars – to pay me for the computer• Current exchange rate: .75

– European pays .75 Euros to get each US$

• Therefore, a US$ 1,000 computer costs 750 Euros…

Currency Value ExamplesCountry Currency Number per US$

Europe Euro 0.748

Canada Dollar .987

China Yuan/RMB 6.60

India Rupee 45.04

Japan Yen 82.71

Mexico Peso 12.09

South Korea Won 1112.06

Thailand Baht 30.38

United Kingdom Pound .63

As of Jan 12, 2011

Trade & Exchange Rates

• Currency values affect trade:

• Example: Suppose the Euro becomes more valuable relative to the dollar:

• Euro going up = Dollar drops in value– Euro worth 1.33 US$, goes up to 10 US$ – Dollar drops from .75 Euros to .10 Euros

• How much would a US$ 1,000 computer cost to a European?

• Answer: Only 100 Euros!

• When your currency goes up relative to others, it becomes cheaper to import

• If currency value drops, imports become expensive.

Trade & Exchange Rates

• Who benefits if Euro goes up relative to the US$?

• 1. European consumers – they can buy American products cheaply

• 2. American exporters – they can sell lots more to Europe

• Who Loses?• 1. American consumers – European imports costs

more• 2. European companies – can’t compete with cheap

US imports

Floating Exchange Rates

• Why do currency values “float” (change in value relative to others)?

• Answer: Changes in supply/demand• But: What forces affect supply and demand?

• 1. Asymmetric trade• If a country imports lots more than it exports (“current

accounts deficit”), its currency drops– Ex: If US has a current accounts deficit with Japan

• To purchase Japanese goods, Americans must sell dollars, buy Japanese Yen

– Demand drives up value of Yen relative to the dollar

• Converse is also true… lots of exports cause a currency to float up…

Floating Exchange Rates

• Example: The effects of asymmetric trade on currency values

• Suppose I sell 10,000,000 computers• Europeans will sell 7.5 billion Euros to banks in order

to purchase 10 billion US$…

– If banks (currency markets) are flooded with Euros, supply increases, value drops…

• Currency markets don’t want more Euros

– Changing currency values often result in a trade equilibrium

• Drop in currency limits subsequent imports• But, we’ll discuss exceptions… (ex: China & US)

Floating Exchange Rates

• What forces affect currency values?

• 2. Asymmetric capital flows– If capital moves into a country, 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

• Sometimes countries want to lower interest rates to boost the economy…

– But doing so might cause adverse effects on currency…

Floating Exchange Rates• What causes asymmetric capital flows?• 2. b. Anything else that “scares” investors

– Government instability– Concern that an economy may have problems

• 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.

Floating Exchange Rates

• What forces affect currency values?

• 3. Countries can intervene strategically to alter their currency values

– Sometimes keeping it at a “fixed” value with the dollar or other major currency

• 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

– Of course, this requires lots of money• Mainly, big / wealthy countries do this.

Krugman reading: “Chinese New Year”• Unlike the dollar, the euro or the yen, whose values fluctuate

freely, China’s currency is pegged by official policy at about 6.8 yuan to the dollar. At this exchange rate, Chinese manufacturing has a large cost advantage over its rivals, leading to huge trade surpluses.

• Under normal circumstances, the inflow of dollars from those surpluses would push up the value of China’s currency, unless it was offset by private investors heading the other way. And private investors are trying to get into China, not out of it. But China’s government restricts capital inflows, even as it buys up dollars and parks them abroad, adding to a $2 trillion-plus hoard of foreign exchange reserves.

• This policy is good for China’s export-oriented state-industrial complex, not so good for Chinese consumers.

• My back-of-the-envelope calculations suggest that for the next couple of years Chinese mercantilism may end up reducing U.S. employment by around 1.4 million jobs.

Financial Flows & Exchange Rates

• Issue: Trade & financial flows have a similar 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).

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!

Video

• Commanding Heights, Ep 3, chapter 7• Time: 27:50 – 32:45.

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. Mexican companies had borrowed money from US banks

• US banks must paid in $, not pesos• If pesos are worth less, suddenly you can’t afford to

pay loans• Result: More bankruptcies, economic recession.

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

• 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 prompt a crisis for Asian

economies in the 1990s?– 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…

Asian Financial Crisis• How did globalization prompt a crisis for Asian

economies in the 1990s?– 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

– Lesson: Integrated economies mean that crises tend to spread…

• Example: US financial crisis caused economic disruption around the globe.

More Video: Commanding Heights

• Topic: Asian financial crisis, spillover to other regions…

• Video: 40:48 to 48:10 – Asian economic miracle

• Video: 48:10-1:14:30– Asian financial crisis and contagion

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.

In the News: Article from 2007• 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 … 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 makes the euro a more attractive investment than the dollar.

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