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International Politics, GOV 207 Global Economic Architecture The International Economy is made up of two interlocking components: International Finance and International Trade. Trade involves the exchange of goods and services. It refers to what is sometimes called “the real economy.” It includes the organizational systems responsible for the production and distribution of goods like of cars, food, and clothing. Goods and services must be paid for, unless one relies on a barter system of exchange. Money or some other medium of exchange are essential for the efficient flow of trade. “Money makes the world go round,” may be a cliché but is nonetheless a truism. Money is at the heart of the financial system. Money We will not give a history of money. It is beyond the purpose of this page to go into a full history of money, but the earliest forms of money were gold and silver coins. King Croesus of Lydia is often reputed to be the first to have minted coins. Paper money was developed much later. But as late as 1971, the American dollar was still linked to gold. Foreigners could exchange $32 for an ounce of gold. That was the official exchange rate for the dollar. Letters of credit, stock certificates, bonds, and mortgages are other examples of monetary instruments. Markets for trade and finance The term “market” has many distinct, though interrelated, meanings. It can refer local markets, stock markets, or large geographic areas that form a common trading area. Local Market The County Fair or the local farmers market is a place were many agricultural producers sell their products directly to each other and visiting consumers. These kinds of markets are concerned with goods. Financial Markets and Stock Exchanges But in addition to the traditional marketplace, where you shop, there are also more specialized markets where the goods bought and sold can be stocks, bonds, commodities, currencies, futures, and derivatives. These are financial markets. These markets are called organized market exchanges (http://en.wikipedia.org/wiki/Exchange_(organized_market) or stock exchanges (http://en.wikipedia.org/wiki/Stock_exchange). “Financial markets facilitate the exchange of liquid assets. Most investors prefer investing in two markets, the stock markets and the bond markets. NYSE, AMEX, and the NASDAQ are the most common stock markets in the US. Futures markets, where contracts future delivery of goods are exchanged, these are often and outgrowth of general commodity markets. “Currency markets are used to trade one currency for another, and are often used for speculation on currency exchange rates. “The money market is the name for the global market for lending and borrowing. “Prediction markets are a type of speculative market in which the goods exchanged are futures on the occurrence of certain events. They apply the market dynamics to facilitate information aggregation.”( See Wikipedia s.v. “Markets” Available online at http://en.wikipedia.org/wiki/Market . Accessed on November 28, 2008). The following articles in Wickipedia the Free Encyclopedia provide additional information on prediction markets (http://en.wikipedia.org/wiki/Prediction_markets), financial derivatives (http://en.wikipedia.org/wiki/Derivative_(finance)), the global financial crisis of 2008 (http://en.wikipedia.org/wiki/2008_financial_crisis), and leveraging and deleveraging (http://en.wikipedia.org/wiki/Leverage_(finance)) . National Markets The term market can also apply to a geographic territory within which there are frequent economic transactions. These territories can be a city, region, country, or the entire world. Since trade is facilitated through the use of money, the market can describe an are within which a given currency predominates. The development of the modern state after 1648 and the state’s more recent transformation into the nation-state after 1871 has resulted in national markets and national economies. Each state has its own economy and monetary system. The state, that is the central government of the state, creates its own currency, banking system, and national economy. Mercantilism is the earliest economic theory associated with the modern state. Under mercantilism, the state actively promotes trade and commerce to strengthen the king’s power and wealth. A wealthy king can afford a large military, which in turn promotes security and expansion. Mercantilism tended to give way to the economic ideas of the Physiocrats in France and Adam Smith in England. “Laissez faire, laissez nous passer,” which means “let us do or make, let us pass” became the new motto. Free trade was championed by the new ideology of laissez faire capitalism. But even in an age of markets largely unregulated by governments, there remained a strong undercurrent of economic nationalism or mercantilism. The Global Market Just as the state remains the most important actor within the global political system, national economies remain the key building block of the international economy. But a global economy has been building for a long time. The global economy has been building since the days of the Voyages of Discovery and Christopher Columbus. European expansion led to colonialism (settling one’s own people in foreign lands) and imperialism (ruling foreign lands and people with one’s own administrators). Imperialism fostered the growth of an international economy in a number of ways from extracting raw materials to investing in the building of infrastructure (harbors and railroads), to dumping one’s own surplus production on the “natives” in foreign lands. The end of European imperialism by 1991 and the rise of the Third World or Global South or Underdeveloped World has not diminished world trade and finance. It has stimulated it. It is hotly debated whether the end of European imperialism and the formation of almost 150 new sovereign, independent states has produced economic independence as well as political independence. Many argue hat the Global South continues to be economically dependent on the Global North. Modernization theory and Dependency theory are two contending approaches to this question. They are discussed elsewhere in these Web pages. What is a fact is that the global economy has grown by leaps and bounds since World War II. Growing interdependence and globalization seem to have produced an irreversible change in the global system, even given the economic crisis of 2008.
The Globalization of Finance. Charles W. Kegley, Jr. describes the globalization of finance. (Kegley, World Politics, 12th Ed., p. 260 – 261). “The globalization of finance refers to the increasing trans-nationalization or centralization of financial markets through the worldwide integration of capital flows.” “Global finance encompasses ‘all types of cross-border portfolio-type transactions—borrowing and lending, trading of currencies or other monetary claims, and the provision of commercial banking or other financial services. It also includes capital flows associated with foreign direct investment –transactions involving significant control of producing enterprises’ (B. Cohen 1996; 2005).” The starting point for understanding the global economy remains an understanding of the national economies of the different countries of the world and their respective currencies. The Major Currencies of the World Since World War II, the dominant currency in the world has been the US dollar. Other important currencies are the Euro, Pound Sterling of the United Kingdom, Japanese Yen, and Chinese Yuan. But the dollar has played an important role outside its function as the currency of the world’s largest national economy, the United States of America. It has functioned as the medium of exchange for the international economy. In recent years, these two functions of the dollar—as currency used within the United States and linked to the economic condition of the US, and as a global medium of exchange—have come into conflict. As the relative position of dominance of the American economy has declined and as our balance of payments deficit has grown, which should result in a devaluation of the dollar so that our trade balance will be regained, this weakening of the dollar has made its global function—as the primary medium of exchange—problematic. The weakening of the dollar at home within our national economy has resulted in a decline of dollar assets throughout the world. All foreigners holding US dollars have seen their assets decline as the dollar has declined vis-à-vis other currencies. The dollar is no longer a stable measure of global wealth. But there is as yet no alternative. The global financial system is in trouble in part because there no longer is a single medium of exchange whose value remains relatively stable over extended periods of time. Bretton Woods: 1944 - 1971 The current financial system was created at the end of World War II at Bretton Woods, New Hampshire. The Western wartime allies met to plan for the future political economy of the world. The planners wanted to avoid a return to protectionism (each country going it alone), which had plagued the world after World War I and may have contributed to the outbreak of the second world war. A system of relatively free trade and economic liberalism was to prevail. Pound sterling and the dollar were the dominant currencies at the time. A system of fixed exchange rates between major currencies was created. When national economies got into trouble because of imbalances in their international trade and finance balances, the International Monetary Fund (IMF) was created to lend them money until their currencies and trade patterns stabilized or were readjusted. Since much of Europe was damaged during WWII, an International Bank for Reconstruction and Development was created to lend money to Europe for rebuilding its infrastructures and economies. These loans were intended to “prime the pump” of economic recovery. The United States, which funded most of these loans, expected to profit by a) selling most of the goods the Europeans would buy with the funds received and b) the overall increase in trade that revived European economies would generate. European recovery would also diminish the threat of communist revolution that prolonged economic turmoil might engender. It was a win-win situation for all. This system worked well until 1971 when the global burden became intolerable for the domestic U.S. economy. The U.S. economy was growing in absolute terms, but its relative position of dominance was declining. Especially our military commitments throughout the world were eating into our balance of payments. Floating Exchange Rates In 1971, President Richard Nixon delinked the dollar from gold. He would no longer exchange $32 for an ounce of gold. The stable value of the dollar to gold was broken and with it the fixed system of exchange rates. The dollar would float in value depending on market forces. The underlying domestic economy of the United States and the faith that foreign exchange traders put into the value of the dollar would henceforth be delinked. It may be difficult for students to accept but money is a commodity just like copper or pork belly futures. Money can be bought and sold. One can exchange one currency into another not only when you are a tourist and need to convert dollars into euros to buy a meal at a small bistro in Bordeaux, but also as a speculator who wants to make a profit our of currency fluctuations from one day to another. This kind of trading in currencies is called arbitrage. In late 2007, “the volume of arbitrage traders routinely exceeds $2 trillion daily,” according to Kegley (12th ed., p. 261). “As a result of increasing cross-over capital flows, the global financial market has become increasingly interconnected. This has made imperative the need for a reliable system of money exchange across borders to cope with the broad array of fluctuating national currencies. The daily turnover on the global currency markets often is greater now than the global stock of official foreign exchange reserves, and this has practically eliminated the capacity of government central banks to influence exchange rates by buying and selling currency in those markets.” (Kegley, World Politics, 12th Ed, p. 261). The central governments of so-called sovereign states and their central banks have lost control over the value of their own currency on the global currency markets. Think about the implications of that statement. Global Stock Markets or Equity Trading We have all heard of the New York Stock Exchange. But there are many other equity traders besides the one in New York and other countries have their own stock exchanges. Between 1980 and 2008, “the market value of stock transactions increased five-fold .” The various equity trading exchanges are increasing interdependent. Trading takes place somewhere in the world twenty-four hours a day. What happens in Asia impacts on the US and European exchanges. To hedge against the ups and downs of the market and of particular stocks, various hedge funds have been developed. “Derivatives combine speculation in options and futures to hedge against volatility in financial markets, but they require no actual purchase of stocks or bonds. Derivatives account for trillions of dollars in cross-border transactions and are now estimated to be the most globalized financial market.” Derivatives are a new kind of stock market that is almost totally unregulated by central governments. These derivative markets and their hedge funds seem to be at the real root of our current financial crisis of 2008. The Internet has helped to produce the digital world economy. A great deal of equity trading is done over the Internet. Small investors are charged small fees for trading in markets worldwide. The entry of small, speculative investors is a relatively new developmet. Bubbles and the Growth of World Wide Debt. One way to buy a product is to buy it on credit. When expenditures are greater than income, one can always borrow the money—at least for a while until one runs out of credit. Governments have long spent more money than their tax revenues produced. For most of World War II, the United States government has been engaged in deficit financing. But multinational corporations and national businesses borrow money to finance their expansion and to lend to their consumers so that they can afford to buy their products. The car industry routinely helps to finance the cars that their consumers buy—with an interest charge, of course. Corporate indebtedness has grown even faster than government debt. And then, there is the rising tide of consumer debt. Installment buying or buying on credit was pioneered in the United States. How could we buy our refrigerators, cars, or houses if credit were not made available to us. Selling potential home buyers mortgages without down payments and at low start-up interest rates that will later balloon—what has been called the subprime housing mortgage market—is generally blamed as triggering the world-wide financial crisis of 2008. Third World Debt The overall problems of the Third World are discussed on other pages, but economic underdevelopment is clearly a main problem. Whether underdevelopment is due to domestic factors (modernization theory) or international factors (dependency theory) remains debatable. Probably both factors play a role. Most Third World countries depend largely on the sale of primary products (natural resources and agricultural products) for their export earnings. Their need to buy imports generally exceeds their earnings from exports. While direct foreign investment by multinational corporations and other investors may help to pay for infrastructure development (harbor improvements, railroads, highways, etc) and modernization of existing plants (improvement in mining technology, fertilizer plants, light manufacturing, etc.), most development depends on foreign aid from Global North countries (often with strings attached), loans from the World Bank and Transnational Banks. Most Third World countries are heavily indebted and often close to default on their annual repayment obligations. The larger the national debt to foreigners the greater percentage of small budgets must go to repayments. Meanwhile domestic expenditure needs continue to grow. Declining economic conditions lead to political instability and even the threat of revolution. Debt forgiveness and more foreign aid is often suggested as a remedy. Growing Indebtedness of the United States and 2008 Financial Crisis From being a creditor country at the end of World War II, the United States has become the world’s largest debtor nation. Our almost perpetual trade deficit and balance of payments deficit is resulting in an ever greater U.S. indebtedness to foreigners. Our largest trade deficit is with China, which is becoming our largest creditor. To a large extent American consumer demand for Chinese products is stimulating Chinese economic growth. They need to export to us to keep their economy going (at least for now) and are willing to take our IOUs as payment (at least for now). It is a condition of mutual dependence. It might be called a symbiotic relationship. But it is a very unstable relationship and dangerous for the future prosperity of both countries. Devaluing the American dollar or increasing the value of the Chinese yuan might result in restoring the trade balance. The Chinese have been unwilling to increase the value of their currency. It would make their products more expensive on the world market and they would sell less. That would impact negatively on their domestic manufacturing economy and might raise unemployment. The U.S. Treasury’s and Federal Reserve Bank’s decisions to allow the value of the dollar to fall, making US products cheaper to buy for foreigners, allowing us to sell more of our products, and maybe restoring our balance of payments, is causing all sorts of repercussions throughout the world. American consumer demand has become the engine for world economic growth. Piling on more debt has been the panacea for world and US growth (on paper) since 1982. The US may be losing its economic hegemony in the world. But our economy is still the world’s largest and the world’s engine for growth. Efforts to put our own economic house in order, by doing something about our balance of payments deficit, by allowing the value of the US dollar to depreciate, is having world-wide repercussions as the global economy is forced to readjust itself. But these efforts are also negatively impacting on the US economy. The financial crisis in the US is impacting on our real economy. Unemployment is going up, consumer demand is down, and that has world-wide impact. The US financial crisis is also a global financial crisis. Wall Street is not only the financial center of the United States, it is the world financial center. Major American banks and investment houses not only dominate the US, but the world. Their liabilities are not only to their American investors but to world-wide investors. Since the Reagan era of a revival of unbridled and unregulated American finance capitalism, the distinction between commercial banking and investment banking has been eliminated. Commercial banking used to be restricted local markets handling checking and saving accounts; providing home mortgages to credit worthy clients in the local community; and loans to established businesses. The investment banks handled the big bucks: raising money for big business and state government, through the floating of stock and bond offerings. Stock brokers were the intermediaries to the stock exchanges in buying and selling. Now everybody does everything. New exotic financial instruments have been created over the last twenty years. Hedge funds sit on top of ordinary stocks and bonds. Stocks and bonds are supposed to have a relationship to the underlying value of the land, house, plant, or enterprise. Businesses fail. Markets go up and down. Hedge funds are insurance policies if the market falls. These insurance policies are themselves being bought and sold as if they were backed by real assets. They are not. They are simply Ponzi schemes, pure speculation, gambling. But for a considerable time, these hedge funds have made huge profits for their investors so that more and more people have bought into them and driving up their market price even further. As long as the underlying economy was sound, hedge funds did not have to pay out. They simply collected their insurance premiums and made profits. Derivatives, future’s trading, arbitrage are other questionable financial practices. Subprime mortgages were bundled into bonds, given good ratings (triple or double A) by the ratings agencies, and sold to investors world wide. As long as housing values in the US rose, even these subprime mortgages could still make money after foreclosure. The value of the house was still higher than the mortgage. But with house values declining, this entire bubble bust and it is still bursting. Most banks not only had huge portfolios of mortgages to borrowers who should never have been lent money (sub-prime loans), they also had huge hedge fund commitments. The banks had to cover the bets (insurance policies for the downside of funds and currencies). They simply lacked the money to pay off. And since the commercial banking and the investment speculation have become intertwined, they are bringing down commercial banking. The US government bailout of the American financial system is being sold as help for the local credit market. What used to be your local commercial bank, where you keep your checking account and savings account and where you go to borrow money is failing, because its central headquarters in New York has been gambling on the global financial markets. But many of your retirement funds also sought to profit from these new global financial Ponzi schemes because they produced (for a while) higher returns. So your 401K plan may be in trouble. The US Congress under the outgoing Bush administration has authorized $700 on a bailout of the U.S. financial system. But shoring up major American banks has meant the assumption of outstanding debt totally between 7 and 8 trillion dollars according to Mark Shields and David Brooks of PBS News House of November 28, 2008. Let us hope that the U.S. Secretary of the Treasury, Henry Paulson, and Chairman of the Board of Governors of the Federal Reserve System, Ben Bernanke, know what they are doing and will be successful. There is real doubt that this huge assumption of debt by the American government (and the American people) will actually work even when nearly all economists agree that we have no choice but to try. The new economic team of President-elect Barak Obama seems experienced and extremely able. But so far, they seem to agree with the current direction of the bailout. There does seem to be a greater emphasis on fiscal policy (spending on actual projects) in addition to the current monetary policies. Frankly, I doubt that the current financial bailout will succeed. Disentangling the sound part of banking from the speculative part will be very difficult, expensive, and wrenching to all of us not entirely innocent naïve victims. We were all greedy and invested in the highest yield funds. How do you think they made their money? By speculation. They didn’t earn it the hard way. And those who knew the risks, looked the other way. The government regulators following a conservative ideology against regulation didn’t step in and regulate. The Global Energy Crisis The energy needs of the world depend on fossil fuels. Modern industrial economies, and even post-industrial ones if there is such a thing, depend on oil and gas. Most petroleum reserves are located in the Middle East and a few other countries. Many believe that half of all the oil in the world that will ever be located has already been consumed. Supply is limited by known reserves and potentially undiscovered resources. But all fossil fuels are limited in quantity and non-renewable. The industrialization of the world, which is ongoing and irreversible, will increase demand. When demand is larger than supply, prices go up. While the global economy was humming (and it will again) demand for oil went up. Not only did the US, Europe, and Japan compete for oil, but the growing economies of China and India made new demands. In 2008, the price of a barrel of oil went from about $90 in January to $145 in August only to plunge to $50 by November. These fluctuations within one year are unprecedented. They mark fundamental problems within the international economy. The precipitous drop in prices may mark the looming world financial crisis and coming world depression. As the world economy collapses, the demand for oil is dropping. While American automobile drivers may heave a sigh of relief that the price for a gallon of regular, unleaded gasoline has dropped below $2 (from its 2008 high of over $4) their faltering paychecks may even make those prices too high to afford. But when the economy recovers, as it will eventually, and world wide demand for oil picks up, so will the prices when maximum supply has been pumped out of the ground. There is a need for alternate energy sources that do not depend on fossil fuels and especially petroleum and natural gas. No such alternate energy source is in sight yet. Windmills and solar panels will not do and are not ready for prime time. Nuclear power poses fundamental problems. There is a limited supply of uranium and what are we to do with nuclear waste? The huge costs of buying foreign oil for all oil importing countries is a strain on their balance of payments. The rise in oil prices may cause inflation and redirect wealth towards OPEC and the other oil producing countries. These shifts undermine American hegemony and are signs of the ongoing financial realignments of the world economy. Conclusion The global economy hit a major snag during 2008. The world financial system is in crisis, world debt is at record levels, and credit is drying up. Without credit, trade declines, demand for production goes down, unemployment goes up. Countries are tempted to save themselves by becoming more protectionist. Even before this crisis, globalization was under attack by labor leaders and environmentalists. While free trade may increase world GDP, within the world there are winners and losers. The rich within countries get richer at the expense of the majority and poor countries fall further behind. Both labor environmental concerns have been neglected on the altar of unregulated finance and trade. The global economic system requires a major restructuring. The further globalization of the world has stalled.
World Finance and Trade Finance and Trade are separate but interrelated aspects of the global economy. Finance Money makes the world go round. After World War II, the world’s financial and trading system needed to be redesigned.
A new international economic structure
was created at Bretton Woods, N.H., in 1944. Globalization has been a result of this approach. Bretton Woods created the International Monetary Fund and the International Bank for Reconstruction and Development became the World Bank Each country has its own currency. Governments print money. Borrow money. Give credit and make loans. For effective international trade, there must be a medium of exchange (money). Currencies must be convertible. Exchange rate between currencies. It can be fixed as it was from 1944 – 1971 or floating as it has been since 1971.
Ultimately, exchange rates depend on
the underlying trade patterns.
Despite the dominance of the Liberal
International Economic Order, there is a strong undercurrent of mercantilism and
neo-mercantilism in the public policies of many countries. Autarchy is the effort by a state to be entirely self-sufficient. No international trade. Hegemony is the overwhelming dominance by one state and national economy. Collective goods like air, water but also fish in the ocean. Goods that anyone can have for free. Overuse of collective goods can spoil them. Air pollution, water pollution, overfishing. This leads to the Destruction of the Commons. Free riders take advantage of the commons by overusing “free” but finite resources. Global Capital Markets have grown at twice the rate of global GDP Borrowing and Lending Trading in Currencies or other monetary claims There is a difference between providing Commercial Banking services and Investment Banking services. Foreign Aid by Global North countries to Global South countries to foster economic development and to gain political influence. Direct Foreign Investment by multinational corporations (MNCs) means building plants and developing resources in a country for the ultimate profit and gain of that corporation. The country where the investments are made will also profit from employment, technology transfers, infrastructure development, and general development. New global financial instruments include Hedge Funds (Trading reached $69.8 trillion in 2007 (Economist, May 26, 2007, p. 75).) Global Monetary System International Monetary Fund (IMF) seeks to stabilize exchange rates World Bank makes loans to Global South countries Central Banks of States manage financial systems of states. Currencies is the medium of exchange within a country. Exchange Rates allow one currency to be converted into another. Arbitrage is trading and profiting in currencies. (Trading dollars for yen or euros.) International Loans and International Debt is growing. Finance Capitalism is the general term for the world financial system based on private ownership. Direct Foreign Investment is money invested by multinational corporations in a foreign country. Foreign Aid is usually money granted or loaned by one country’s central government to another country. Global Fiscal System Since there is no global government with taxing and spending power, there is no global fiscal policy. Each state handles its own fiscal policies. By aggregating national economies, one can develop a picture of Global GWP, Per capita income, total public (by governments and other public authorities) expenditures, and total global tax revenues. Global Trade With the creation of an international finance system at Bretton Woods in 1944, there emerged a need to regulate and stimulate trade on a global level. This trade regime was based on free trade and liberal economics. The protectionism of the post World War I world was to be replaced by trade liberalization. High tariffs and quotas whereby individual countries protected their economies from foreign competition were to be replaced with free trade. Tariffs and quotas were to be lowered or eliminated. General Agreement on Tariffs and Trade (GATT) is a multilateral treaty designed to lower trade barriers. On January 1st, 1948, the General Agreement of Tariffs and Trade (GATT) “was signed by 23 countries: Australia, Belgium, Brazil, Burma, Canada, Ceylon, Chile, China, Cuba, the Czechoslovak Republic, France, India, Lebanon, Luxembourg, Netherlands, New Zealand, Norway, Pakistan, Southern Rhodesia, Syria, South Africa, the United Kingdom, and the United States. According to GATT's own estimates, the negotiations created 123 agreements that covered 45,000 tariff items that related to approximately one-half of world trade or $10 billion in trade.” “The GATT, as an international agreement, is a treaty. Under United States law it is classified as a congressional-executive agreement. Based on the Reciprocal Trade Agreements Act it allowed the executive branch negotiating power over trade agreements with temporary authority from Congress. At the time it functioned as a provisional, but promising trade system. The agreement is based on the "unconditional most favored nation principle" This means that the conditions applied to the most favored trading nation (i.e. the one with the least restrictions) apply to all trading nations. In the US, there was large opposition against the International Trade Organization (which had been ratified in several countries), and thus President Truman never even submitted it to the Congress.” (http://en.wikipedia.org/wiki/General_Agreement_on_Tariffs_and_Trade) World Trade Organization. “The World Trade Organization (WTO) is an international organization designed to supervise and liberalize international trade. The WTO came into being on 1 January 1995, and is the successor to the General Agreement on Tariffs and Trade (GATT), which was created in 1947, and continued to operate for almost five decades as a de facto international organization. "The World Trade Organization deals with the rules of trade between nations at a near-global level; it is responsible for negotiating and implementing new trade agreements, and is in charge of policing member countries' adherence to all the WTO agreements, signed by the majority of the world's trading nations and ratified in their parliaments.[4][5" (http://en.wikipedia.org/wiki/World_Trade_Organization). Oil. The role of fossil fuels in the global economy. http://www.wtrg.com/prices.htm
The Underground Economy In addition to the official, governmentally-sanctioned world economy there is an underground economy made up of: Illegal Trade Drug Trade Trade in Endangered Species Illegal Arms Trade White Slavery International Criminal Cartels The Finances of Terrorist Networks Black Market Economy
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