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Why Do International Financial Crises Happen?

Jomo Kwame Sundaram, a former economics professor and United Nations Assistant Secretary-General for Economic Development, received the Wassily Leontief Prize for Advancing the Frontiers of Economic Thought in 2007.

Am underlying cause of international financial crises has been the ascendance, transformation and hegemony of the financial sector over the past three to four decades. Credit: IPS

KUALA LUMPUR, Malaysia, May 31 2017 (IPS) - International currency and financial crises have become more frequent since the 1990s, and with good reason. But the contributory factors are neither simple nor straightforward. Such financial crises have, in turn, contributed to more frequent economic difficulties for the economies affected, as evident following the 2008-2009 financial crisis and the ensuing Great Recession still evident almost a decade later.

Why international coordination?
Why is global co-ordination so necessary? There are two main reasons. One big problem before the Second World War was the contractionary macroeconomic consequences of the ‘gold standard’.

In 1944, before the end of the Second World War, President Franklin Delano Roosevelt convened the United Nations Conference on Monetary and Financial Affairs – better known as the Bretton Woods Conference – even before the UN itself was set up the following year in San Francisco. After almost a month, the conference established the framework for the post-war international monetary and financial system, including the creation of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), or World Bank.

To be sure, the Bretton Woods system reflected sometimes poor compromises made among the negotiating government representatives. Nevertheless, it served post-war reconstruction and early post-colonial development reasonably well until 1971.

In September of that year, the Nixon Administration in the US – burdened with mounting inflation and unsustainable budget deficits, partly due to the costly Vietnam War – unilaterally withdrew from its core commitment to ensure full US dollar convertibility to gold at the agreed rate. Thus, the unilateral US action did not involve a transition from the Bretton Woods system to any coherent, internationally agreed alternative.

Birth of a ‘non-system’
The pre-1971 post-Second World War period has often been referred to as a Golden Age, a period of rapid reconstruction, growth and employment expansion after the devastation of the Second World War. It was also a period of development and structural transformation in many developing countries.

All this came to an end when coordination and multilateralism collapsed following President Nixon’s decision to renege on 1944 US commitments at Bretton Woods which became the basis for the post-war international monetary system.

The leading international monetary economist of the post-war period, Robert Triffin, described the post-1971 arrangements as amounting to a ‘non-system’. Now, with the international monetary system essentially the cumulative outcome of various, sometimes contradictory and ad hoc responses to new challenges, the need for coordination is all the more urgent.

A strong case for co-ordination has long been made by the United Nations. For example, soon after the global financial crisis exploded in late 2008, the 2009 mid-year update of the UN’s World Economic Situation and Prospects showed how better coordinated and more equitable fiscal stimuli would have benefited all parties – developed countries, developing countries, transition economies and, most of all, the least developed countries.

Anarchy and fragility

Since the collapse of the Bretton Woods system in 1971, a small handful of currencies – especially the US dollar, the international favourite by far – have been held by others as reserve currencies. This has allowed the issuers of these currencies – especially the US – to run massive trade deficits, contributing to unsustainable global imbalances in savings and consumption.

A second underlying cause of international financial crises has been the ascendance, transformation and hegemony of the financial sector – termed ‘financialization’ – over the past three to four decades. Partly as a consequence, many decision-makers are now often more concerned with short-term financial indicators than other key economic indicators, often presuming that the former reflect the latter despite the lack of such evidence.

A third factor has been growing ‘financial fragility’, partly due to the global financial ‘non-system’ in place since the collapse of the Bretton Woods system. Referring to this ‘non-system’ as an international financial ‘architecture’ is really insulting to architects. The lack of coherence and coordination has been exacerbated by financial deregulation, liberalization and globalization over the past three decades.

Finance calling the shots

The growing and spreading subordination of the real economy to finance in recent decades is a fundamental part of the problem. While finance is indeed a very important, if not an essential hand-maiden for the functioning of the real economy, the subordination of the real economy to finance has transformed macro-financial dynamics, with unproductive, contractionary, even dangerous consequences.

So, to address the root causes of crises, much better, including more appropriate regulation of the financial system is needed to ensure consistently counter-cyclical macro-financial institutions, instruments and policies, and to subordinate the financial sector to the real economy.

The 2008 financial crisis has catalyzed many debates on these issues – some old, some new – for instance, between Keynesian/Minskyian economists and their opponents; between Anglo-American and continental European worldviews; and between the global North and South. Any sustainable solution will clearly require much better international cooperation and co-ordination.

Hence, almost a decade since the 2008 global financial crisis began, there is no shared political commitment to much needed international financial reforms. It took fifteen years from the beginning of the Great Depression, a world war and Roosevelt’s extraordinary leadership before the world was able to reform the international financial system in 1944. But sadly, there is no Roosevelt for our times.

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  • Adil Khan

    This is a very thought provoking article. Author’s main line of argument that world needs a regulatory arrangement to regulate international financial system that US systematically dismantled and consistently resists every effort to do so resonates well with similar US veto of a UN in 1970s that proposed a mandatory code of conduct for multinationals operating in developing countries. Perhaps the emerging distancing between US and the rest of the World on US guided old international order – both in the ream of geopolitics and economics – will help to bring greater sanity and equity in a new international order.

  • Siddique Ahmed

    United Nations & its affiliates such as International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), or World Bank has not been effective in regulate International Financial crisis. Through war and Credit crumps, US trade deficit. For almost three decades financial misuse in nuclear power race has also made financial regulatory means difficult. US guided world order is the root of the crisis.

  • Walter Garcia

    This comes from the author: As it was not clear to your commentator, the main intent of my article and my other writings, especially for IPS, has been to develop a multilateral system fairer to developing countries. In this regard, the article sought to understand recent international financial crises affecting these economies. In the recent past, we have tried to understand the origins of the current malaise, particularly since 2008. In the coming weeks, I will try to demystify some myths about the so-called East Asian economic miracle and the 1997-1998 Asian financial debacle.

    While I appreciate the intent of your commentator’s remarks, it is not clear what one is to make of them as ostensible historical corrections.

    First, as the author well knows, Bretton Woods did not explicitly provide for Special Drawing Rights, and Keynes’ ‘bankcor’ proposal was rejected by his colleagues back in 1944. The SDRs proposal is usually dated back to the 1960s.

    Second, while there are many aspects of Marshall Plan which many of us find objectionable, most of those who invoke it today seek to transfer significant resources on concessional terms to finance and catalyze world economic recovery, beginning with global priorities in the interest of developing countries, especially the poorest ones. Hence, for example, we have called for such resources to be made available to subsidize the massive expansion of renewable energy in such economies to enable them to not only ‘leapfrog’ a ‘fossil fuel stage’, but also to overcome mass ‘energy poverty’ and to accelerate industrialization and human progress.

    Third, Triffin’s emphasis on the ‘non-system’ anticipates the anarchic financial liberalization and globalization which followed.

    I am sure there are many who know this historical subject much better than I do and perhaps they may wish to contribute to a better understanding of our past in order to forge a brighter future for all.

  • oni_baba1979

    Thank you for you response. I fully agree that we need a more equitable multilateral system, and myself have been involved at an advisory capacity favoring the Belt and Road Initiative.

    In terms of Marshall Plan Economic Cooperation, I thought it would be good to readjust the narrative somewhat, and I also think that the points that I bring up, coalesce with why the BRI is a better system, stepping in front of the neoliberal institutions. If I may, I want to suggest that you turn to the primary text, the 1948 Economic Cooperation Act. In the Act you will find a “missing” section… it is “115K,” which are the agreements signed between the US and the participating countries outlining the financial terms and processes through which Marshall Aid takes place. You should be able to find 115K online, but if you can’t I have them and you can contact me again.

    The main reason why Keynes’s Bancor Plan failed, was not because of poor planning or faulty analysis, but because it was an international-based monetary union, and it needed the cooperation of all the countries including the US to stabilize, lest the UN go the way of League of Nations. White’s Stabilzation Fund won because the US used it’s clout to essentially co-opt the Bretton Woods Agreement in its favor. It was well understood that the US would be principle in reconstruction, but at that time- in 1944-5, under FDR, I don’t think Europe understood what the terms of reconstruction were going to be. I’m confident asserting that the conditions for economic assistance under Truman was a bitter pill for Europe to swallow, as most of the 115K counterpart fund terms weren’t signed until after 1951 when the 1948 ECA expired and rolled into the Mutual Securities Act.

    Thanks again

  • Kiers

    do you have a link to this “mandatory code of conduct for multinationals operating in developing countries”?

    Interesting parallel in this day and age is OECD’s “BEPS” initiative (must be annoying them like crazy)

  • Adil Khan
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