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

Course Number 1135

Associate Professor Laura Alfaro
Early Winter, 14 session half-course
1.5 credits
Exam

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. International capital flows can significantly affect countries' development efforts and provide clear investment opportunities for businesses. 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.

During the 1990s and early 2000s, the world witnessed an explosion in capital flows at the global level. Gross foreign assets and liabilities stood at two or three times GDP for many countries, as compared to just two decades ago. 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 2009, the global economy remained mired in a deep crisis following the subprime meltdown in the U.S. The World Bank, in one of its bleakest assessments yet of the ongoing crisis, estimated that the global economy would contract in 2009 for the first time since World War II. The World Bank's sister organization, the International Monetary Fund (IMF) released a similar outlook. More than $50 trillion in wealth had been wiped out across borders over the last 18 months. Policymakers across the world found themselves trying to tackle a dizzying array of problems, from rising unemployment to frightened investors to plunging exports. 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 situation was also a true testimony of how intertwined individual economies had become over the years. With the explosion of international capital flows, financial institutions in various corners of the world had inadvertently participated in the United States' debt-financing boom. The effect of policies to deal with the ongoing global crisis and new policy choices remained to be seen.

Career Focus

The course is intended for students with who expect to have careers influenced by international trends; careers in global financial management.

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 several fundamental characteristics of the international financial system: why cycles in international capital flows recur; and how does 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

HC: 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 the 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, Challenges and Policies of Large Economies, studies the cases of the three 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 module. The module ends with a discussion of the "global imbalances," the U.S. subprime crisis and the global financial crisis of 2008-2009.