Teoria International Economics

The way we produce wealth

"The way we produce wealth is at the basis of everything in life." To do so, we are favorable to the free movement of goods, people, and capital (where capital is not money, but machines or everything that is used to produce and increase productivity) because all things must be placed where they are more productive (better allocation of goods).

The role of policy makers

Does the world go forward if the markets do the same? NO! The world is moved by policy makers (institutions, people) whom we follow the rules after they have done us an environment.

The credit crunch and the great recession

On 9 August 2007, BNP Paribas called a conference in which it said that they were not able to reimburse the owners of shares in three of its mutual funds (no liquidity). Banks collect money from people (in exchange for shares) and form funds in order to "invest" in other projects (for example, buy a part of shares from another company).

Interbank market and liquidity issues

Other banks already knew that problem! How?

Interbank market: Banks borrow and lend from and to each other (trade of liquidity), especially in case of short liquidity to finance projects. An entrepreneur calls BNP that has no liquidity; BNP calls Deutsche; Deutsche transfers money on BNP’s books; BNP gives checks to the entrepreneur, pays interests (in terms of basis points) to Deutsche and deposits a part of the money it has received (by Deutsche) to the Central Bank (that controls the amount of credit issued by banks).

NB: 1 basis point = 1% of 1% 75 basis points = 0.75%

• When BNP deposits $1 to the Central Bank, BNP gains the right to lend $40 (40 times the sum it has deposited).

So, what is a credit crunch? A situation in which mutual credit flows of banks are blocked due to lack of liquidity (that we consider a mean of payment).

Impact on the real economy

The crisis started in the banking system, while other sectors of the real economy were still good!

Real economy: Import + Export + Sell + Purchase + Spend NB: Exports are the savings of a country.

Production: 10 Consumption: 7 Savings: 3 I export them.

In reality, what happened in the other sectors was the growth of unemployment (defined as a loss of output and an increase in costs).

Role of Central Banks

What can Central Banks do about it? Manage the credit situation! How and why?

If a company fails, a bank that had invested in it may fail. It is a problem of all citizens and not only for a Central Bank. When banks stop flowing liquidity from and to each other, there are consequences on the real economy (firms cannot get loans for more investments, the workplaces decrease, and the economy freezes). So, what is the task of a Central Bank?

During the crisis, Central Banks were willing to lend money to commercial banks at low interests (when the interests are low, commercial banks are encouraged to borrow). The Central Banks are also called "Banks of banks" and "lender of last resort" because they are the lenders to whom commercial banks go when they do not find liquidity elsewhere (to gain trust commercial banks have to show their books).

• Discount rate: Interest rate that commercial banks have to pay to Central Banks in order to get a loan.

On the other hand, commercial banks do not want other commercial banks to know it has gone to the Central Bank to ask for liquidity in order not to lose reputation. So, what happens? Commercial banks concede loans to each other with an inflated rate (even +20% over the discount rate).

In 2007, even with a discount rate of 0%, no banks showed up to the Central Banks to maintain their reputation (liquidity trap).

Effects on GDP

Which were the main effects of the Credit Crunch in terms of GDP (Gross Domestic Product: value of the total amount of goods and services produced in a certain period, usually 1 year)?

China, India, Brazil, Russia, Germany, Mexico, USA... England, Spain, Italy, Greece, France... Δ=0 Sweden Variation from 2007 to 2014.

Post-WWII economic division

In 1944, considering the possible results of WWII, the future winning state divided the world into three main areas:

• Market economies (US, "noi")
• Soviet Union, Poland (OTHERS, "comunisti")
• India, South Africa...

They also founded two big agencies:

• World Bank: Guarantees credit to great operas (After collecting money, bonds...) such as reconstructions and improvement of infrastructure.
• International Monetary Fund: Nations pay a fee in exchange for Special Drawing Rights in case of difficulties such as the Germany-Greece situation.

Bond: Promise/Obligation to pay a specified sum at a future time; the minister of the treasury of a country pays whoever brings the piece of paper after 1 year (for example) from the emission. At the emission, the State receives money thanks to the sale while, at the future time, pays interests to the purchaser.

• Price: 50 Paid by banks to the State
• Value after 1 year: 100 Paid by the State to the banks
• 100-50 → 100 of interests = 150

The bond is not very risky so it does not guarantee a huge return (due to the low interest rate).

Origin of the crisis

Main cause: Credit Crunch

Deeper causes

• Chinese current account surplus
• Expansionary monetary policy in USA (2000-2006)
• De-regulation of financial markets (From 1999)
• Increasing sophistication of financial intermediation (From 1980s)

Summary of 2007 events

Banks conceded mortgages to people with scarce financial credibility; to get rid of a part of the risks, banks used to sell their credits to "special purpose vehicles". These particular societies paid banks after the emissions of bonds in the market. Sometimes these bonds were not easy to sell and remained blocked in the market OR sometimes there were some bonds with a very high risk that were issued in order to get liquidity immediately (but the possibility of the issuer to "fall headlong" were so high that the bond had no chance to be repaid by the issuer itself to the buyer Junk Bonds). If the emission went bad, the SPV did not have the liquidity to pay banks. Moreover, the owner of the mortgages started to become insolvent, so the lack of liquidity became the main problem of banks.

NB: A toxic asset is an asset that can ruin an entire portfolio, because it makes you lose reputation. It has 0 market value (0 demand) so no one wants to buy it.

Especially for high-risk bonds, the custom was to make a profit and then to get rid of them distributing the bonds in the market itself, until someone did not want to take the risk of buying. A "NO" is enough to stop this flow and destroy the reputation of the issuer of the bond itself.

Imports and currency issues

Imports from China to the USA were more than exports:

• Importer (USA) YEN
• Producer (USA) $
• Commercial Bank Importer Commercial Bank Producer

The dollar has left the USA, while the YEN has not left China so the balance is not respected. The Chinese Central Bank will sell dollars to America in exchange for government bonds. The demand for bonds increases, the price of bonds increases, and the rate of interests in the US will decrease!

The American traders are unsatisfied. Where does he get the money if the interest rate is falling? They need a lot of bonds to get profits.

Expansionary monetary policy

What is expansionary monetary policy? The expansionary monetary policy consists of an introduction of a lot of liquidity by the Central Bank in order to revive the economy.

NB: The federal funds rate is the discount rate! If the discount rate decreases, the cost of liquidity for banks decreases, the cost of credit for clients decreases, investments increase, and the economy revives.

Historical context of monetary policy

2000: DOT.COM crisis; many investors decided to move capital to internet-based companies (that economy was growing too fast). When some of these companies failed, everybody wanted to sell shares. The Central Bank decided to decrease the FFR in order to avoid panic selling. After 2008, the discount rate was flat to 0; 2001: Twin Towers attack; Wall Street was closed for 3 days to avoid economy collapse. This should have been stimulated to avoid economy collapse.

Commercial banks to borrow money but this did not happen. Therefore, the monetary transmission mechanism (increasing/decreasing the interest rate) was dead. So, Central Banks started to use an unconventional tool, called "Quantitative Easing".

De-regulation and financial innovation

De-regulation:

1933, banks were divided into two categories:

• Investment banks
• Commercial banks

Investment banks have the right to invest (any expenditure by a firm to increase its production capacity is considered an investment; any other expense is not). They cannot open checking accounts.

Commercial banks collect liquidity through checking accounts (even if a big portion goes to Central Banks). They cannot invest or buy financial assets; they can only buy treasury bills or lend money. The Central Bank is not "lender of the last resort"; Lehman Brothers got shut down because it could not get liquidity anywhere and could not ask the CB.

During years, commercial banks asked the legislator (US Congress) for the possibility to invest; investment banks asked instead for the possibility to open checking accounts. NO AND NO! After 60 years of struggle, the legislator gave up on the born of Universal Banks. Everyone started to act risky, especially when the interest rates were low ("unprofessional behavior of the banking system").

Financial innovation:

A few years ago, a new profession was invented: the FED WATCHER; they control the FED, read every document the FED writes, and study its behavior. If the FED is going to (or if I think that) increase the interest rate on bonds, I will sell European ones taking €, I will change them in $ and then I will buy US Treasury Bills because they have a high interest rate. EVERYTHING HAS TO DO WITH EXPECTATIONS!

If we have an excess demand for US Treasury Bills, the $ is appreciating (I need more foreign currency to have 1$).

The world economy after the renminbi devaluation

What is a devaluation?

Monetary policy tool of countries. It is a deliberate adjustment of the value of a country's currency, relative to another currency, group of currencies, or standard.

In 2015, the Central Bank of China surprised markets with three consecutive devaluations of the Renminbi, decreasing its value by over 3%. The PBOC claimed they wanted to make the exchange system more market-oriented. The Renminbi has a heavy influence from the USD, which has been appreciating. Meanwhile, currencies of other developing countries are falling (South China Morning Post), making China’s exports more expensive and thus less competitive. Devaluation implies a lower exchange of Renminbi per unit of foreign currency, making China’s exports cheaper. Other developing countries’ exports in turn become less competitive.

Impact of the crisis on GDP

What happens when a crisis like this shows up? Mainly, the GDP decreases! In 2007, high per capita income countries were damaged by the crisis; low per capita income countries "took advantage" of the crisis itself.

Role of policy makers during a crisis

What can Policy Makers (Governments and Central Banks) do about that? It depends on the economic theory they believe in; in any case, policy makers can do something to revive an economy that is in recession. To understand what, let us introduce the concept of NATION STATE.

A place will be called like this, if the authority on that place can manage 4 things:

• Commercial policy: All legislative measures a government can take to regulate the flow of goods and services with the rest of the world (international trade). Ex: Tax on import to stimulate Made in Italy NB: 28 European countries have no commercial policy anymore.
• Exchange rate NB: 19 of 28 countries do not have their own currency or Central Bank.
• Monetary policy: Setting interest rates, stimulate credit… NB: 19 of 28 countries do not have these privileges.
• Fiscal policy (Government): Spend-Tax- These are the two tasks of a government.

So, what may Central Banks and Governments do to face a crisis?

• Central Banks: Injecting liquidity into the system at a low price- Decreasing interest rates
• Governments: Expansionary Monetary Issue more bonds, Collect more taxes or Spend-Tax

If a government spends more than what it has: Deficit spending (portion of expenses in excess related to taxes incomes). During the last crisis, China and USA kept spending over years and managed to re-