Global Capital and National Institutions: Crisis and Choice in the International Financial Architecture

Course Number 1137

Professor Laura Alfaro
Winter; Q3; Q4; 3 credits
20 sessions
Paper

Course Overview

The course addresses the opportunities created by the emergence of a global economy and proposes strategies for managing the risks associated with globalization. The course focuses on the opportunities and threats created by the flow of international capital across countries. International capital flows can significantly affect countries' development efforts and provide clear investment opportunities for businesses.

During the 1990s and early 2000s, the world witnessed an explosion in capital flows at the global level. This explosive growth, especially in emerging markets, has been fueled both by changes in world politics (e.g., the end of the Cold War, collapse of the Soviet Union, shifting political climate in China, and political changes in Latin America and Asia) and advances in technology. Private capital flows-debt finance, equity capital, and foreign direct investment (FDI)-became larger than current and past official capital flows. FDI has become the dominant source of foreign private capital for emerging markets, promising additional productivity gains for recipient countries. Beyond merely adding to the stock of capital, FDI may translate into the promise of better technology, modern management, and greater access to global markets. Portfolio equity liberalization might help in a different way by exposing local companies to the scrutiny of the international capital market (and potentially requiring greater accounting transparency and more effective corporate governance). This new era of foreign capital mobility has also been characterized by low interest rates in industrial countries, growing external imbalances in the U.S. economy, and the rise of China, all of which posed new challenges to policy management.

In 2012, the global economy remains mired in the aftershock of the U.S. subprime meltdown. The 2008-2009 Global Financial Crisis has been notable for its speed, severity, and international span. Almost all industrial countries and a large number of developing and emerging economies were inflicted in 2008, witnessing substantial declines in total output and employment. The severity of the crisis, regarded as the worst financial crisis since the Great Depression of the 1930s, led many economists to explore the economic patterns and causes of the recent crisis. According to one view, shared by many academics and policy makers, the financial sector debacle had its origins in the "global imbalance" - the phenomenon of large current account surpluses in China and a few other countries co-existing with large U.S. deficits. The effect of policies to deal the global crisis and new policy choices remained to be seen.

The course emphasizes both the economic consequences of policies and the political and institutional context in which they are established and implemented. The material thus bridges a gap between firm- and household-level behavior, which is typically well understood by a managerial audience, and aggregate phenomena, which are often less understood by this audience.

Career Focus

The course is intended for students with who expect to have careers influenced by international trends.

Educational Objectives

The course has been designed to give students an appreciation of the critical role of institutions and policies in affecting patterns of international capital flows and the abilities of government to manage them effectively. The course is tied together by two broad themes: (1) the determinants and effects of international capital, and (2) policy-makers' management of these flows. The cases approach these themes by exploring institutional detail in deep local context, exposing students to key recent events that have shaped the way economists think about these subjects. The events covered have a clear global perspective as the cases are set in Africa, Asia, Europe and Latin America, as well as the United States. The course also covers events from the last three decades, as not only do they affect today's business environment, but they also reveal the cyclical nature of international capital flows.

The course encourages students to consider fundamental characteristics of the international financial system: why cycles in international capital flows recur; and how sovereign debt and domestic debt differ from each other in their contracts, explicit and implicit, and their enforcement. The course also teaches students three key insights from the field of international economics. First, trade in goods is different from trade in financial assets: a financial transaction inherently involves a commitment to pay at a later date. Financial transactions are therefore fundamentally affected by problems of asymmetric information and the risk that the contract will not be enforced, and both problems are exacerbated at the international level. Second, international financial flows are affected by two additional macroeconomic risks that are absent within countries: sovereign risk and the use of different currencies. Third, international capital flows imply additional policy challenges for countries as policy-makers face a difficult trade-off among three objectives: monetary policy autonomy, a stable fixed exchange rate, and free capital mobility. Research has demonstrated that local conditions-political objectives, financial markets, firms, and institutions-decisively influence the operation of these basic macroeconomic logics in actual practice. As a whole, the course emphasizes the importance of domestic institutions for effective macroeconomic policy-making, capacious regulations, credible policy commitment, and attracting and using foreign direct investment efficiently.

Course Content and Organization

Global Capital and National Institutions: Crisis and Choice in the International Financial Architecture, focuses on the costs and benefits of international capital and the policies utilized to make it work. The course is composed of three intellectual segments.

• The module Determinants and Effects of International Capital Flows studies both potential positive and negative effects in host economies of opening up to international capital flows. In particular the cases analyze the effects of capital flows in the development efforts of countries, with an emphasis on FDI (which has become the main source of private flows to emerging markets) and the policies to attract and maximize FDI's benefits. In addition, the cases in this first segment explore the effects of international capital flows in the context of financial crises.
• The second segment of the course, Policies and Strategies for Harnessing the Benefits of Financial Globalization, focuses on strategies to harness the benefits of financial globalization and minimize potential risks. The cases cover policies regarding the management of capital inflows using capital controls, the choice of exchange rate regime, and policies associated with the management of sovereign defaults. The module ends with a discussion of the effects of transfers of capital and debt relief between rich and poor countries.
• The last segment of the course, Global Challenges Ahead, studies the cases of the largest economies in the world. Because of their economic importance and political power, the policy options available to these countries, and their effects, are in many ways different from the standard "small open economy" cases analyzed previously in the course. The module ends with a discussion of the "global imbalances," the Global Financial Crisis, its lingering and differential effects across regions and in particular industrialized and emerging countries.

Administration

Grading is based on class participation and written report. Class participation will receive a weighting of 60%. Questions regarding the course should be addressed initially to our assistant, Mary Heanue (office: Morgan 270; telephone: 495-9102; e-mail: mheanue@hbs.edu).

Written report

Reports can (and are encouraged to) be conducted by groups of students (maximum of four per group). The report should use the framework and tools developed in class to evaluate a specific policy or business issue. The emphasis should be on analysis of the problem identified and development of an appropriate policy or business prescription. However, business plans will not be acceptable as written reports in this course.

Early in the course you will be required to e-mail a one-paragraph proposal for the report to me. I will comment, suggest possible sources of information and potential scope for collaboration with other members of the section. Towards the end of the in-class portion of the course, each group will need to provide me with a one-page outline of their report. I will of course be available in the ensuing weeks during office hours for refinement of the ideas and further discussion. The final report is due at the end of the term. This should consist of 10-15 pages of text (normal font size, margins and spacing) with exhibits, charts and tables as required.

Textbook

A recommended textbook is Macroeconomics 6th edition by N. Gregory Mankiw. We will not work through this book in detail during class time. Rather the book is intended as a background reference, in part to aid recall of material introduced during BGIE in the required curriculum. Reference to relevant sections of the textbook will be made on the online course platform.