Financial Liberalization can be defined as a reduction in government intervention in economics, and is seen through a distinct move to incorporate a larger number of private corporations in the market. Economic liberalization allows the market to determine the allocation of goods, and increases the privatization of business enterprise. In the post Bretton Woods era, developing countries were pushed into financial liberalization due to factors such as systemic pressures of globalization and through financial organizations such as the IMF.
There are a number of negative externalities that accompany financial liberalization that can be devastating to a developing economy. Liberalization tends to amplify the weak institutional structure of developing countries, exacerbating large current account deficits, and high debt. Worsening terms of trade, weak macroeconomic policies, hot money flows, and contagion are all effects of too rapid liberalization that lead countries into financial crises (Polak et al, 2018). Lax Supervision, as explained by Noy, focuses on the inability to uphold microeconomic policies of a recently liberalized country, which stems from a countries inadequate supervision of their microeconomic policy while undergoing liberalization, as well as microeconomic policies leading up to a recession (Noy, 2004). These policies encourage risky borrowing and lending, as banks are under the assumption that the government will bail them out should a loan fail. The theory of Monopoly Power examines how the rapid departure from governmental restrictions in the banking sector leads to an increase in competition, opening currency up to speculation and introducing “hot money flows” (Noy, 2004).
“Hot money,” as defined by Polak et. al, can be defined as the “capricious flow of capital from one country to another in order to earn short term profits from interest rates and anticipated exchange rate shifts” (Polak et. al, 2018). The opening of borders that accompanies financial liberalization allows inflows from other countries, leading to an influx of investments from foreign investors. As investors flood banks with foreign capital, interest rates rise along with the demand and supply for a countries currency (Liang et al, 2018). At first, countries will reap the benefits of these monetary decisions through both an increase in lending and asset prices, but quickly becomes problematic when central banks are forced to step in as the lender of last resort due to high risk balance sheets. Hot money flows are dangerous as they lead to financial instability through the distortion of currency through the flooding of banks and quick investor pull outs. Investor pull outs caused interest rates to rise while the real financial growth declined. In extreme cases, countries are excluded from capital markets and forced to default on their loans.
Financial liberalization is not inherently bad as the negative externalities may make it out to be. Issues arise when countries liberalize too quickly, prior to stabilizing and strengthening their financial institutions and their economy as a whole. If a country has stabilized and strengthened its financial institutions, benefits of liberalization include large influxes of currency from foreign investors, and a significant increase in both current and future predictions of GDP. Decreasing taxation on imports while reducing regulation should stymie imports and decrease net capital outflow as demand for state assets increases from outside investors, leading to an appreciation of the currency if all other things are held constant.
Developing market economies began to liberalize in the 1980s largely due to the overwhelming systemic pressures of globalization. The IMF offered overambitious “loan packages” to countries like Turkey, under the pretense that it would aid in the stabilization of Turkey’s economy (Polak et al, 2018), when in reality it only amplified the weaknesses of Turkey’s institutions. The Washington Consensus, which was also proposed in the 80s, was a sort of “reform package,” equipped with ten economic policies that were believed to successfully aid a destabilized country through liberalization. The Washington Consensus focused largely on interest rates, the creation of an independent Central Bank, and the liberalization of Capital Accounts. The IMF and World Bank followed these policies in their treatment of developing countries, without considering the effect their weak financial institutions would have on the outcome of the implementation of such policies (Polak et al, 2018). The pressure to liberalize, and to liberalize quickly, is what caused countries to fall into currency crises and defaults. Countries such as Argentina were encouraged by the IMF to peg their currency to the US dollar, which in turn caused an economic downturn as the peso became severely overvalued and led to a spike in deflation in Argentina. The IMF then withdrew support on Argentina, which was fully reliant on foreign investment, leading to their financial crash. The IMF was expecting developing countries to behave as advanced economies when they did not yet have the financial institutions in place to act as such.
There have been a number of attempts to address the negative externalities that accompany financial liberalization in developing countries. Self imposed regulations are largely applied, but often are not enforced. This is because the regulation of banks falls entirely on said countries shoulders. As aforementioned, developing countries typically do not have the structural integrity to monitor and enforce their supervision over central banks and implemented regulations. Hard or floating pegs were often implemented in liberalizing countries, as economists believed countries with soft pegs had a greater likelihood of currency crises (Polak et al, 2018). Economists speculated that soft pegs rendered higher risks of crises because it leaves currency more susceptible to speculative attacks, currency overvaluation, while stimulating excessive capital inflows (Polak et al, 2018). The Argentine currency crisis is a prime example of the danger of hard pegs. The Argentinians established a currency board in 1991 in reaction to their startlingly high chronic inflation, though their efforts to save their economy from tanking failed (Eichengreen, 180). Initially, when the Argentine peso was pegged to the dollar, the stability aided the economy in regrowth. The chronic inflation due to the inflation crisis that Argentina had been experiencing for years was eased, and they began to engage in more foreign trade and investments. The peso appreciated at a high rate due to being tied to the dollar, however, putting it at a disadvantage as foreign investors no longer wanted to invest, once again creating a severe economic downturn and unrest within Argentina. The main issue with such a currency board is that it allows little access for a “lender of last resort,” meaning there is no effective response to a financial crisis. The banks cannot put money into the domestic financial system, kickstarting the economy, and is therefore forced to simply watch as it banks fail. (Eichengreen 181). The only thing that helped tide over Argentina in the wake of the Mexican financial crisis of 2005 was the IMF’s loan. The high risk associated with hard pegs was simply unavoidable for developing countries should they want to maintain a stable exchange rate with lower risk. The effectiveness of pegged versus floating exchange rates for recently liberalized countries is highly debated.
Although attempts to reduce the negative externalities that accompany liberalization have been somewhat successful, the fundamental problem of liberalization is yet to be addressed. States weak infrastructure is exacerbated by liberalization, but is difficult to strengthen prior to liberalization as there are a number of limiting government restrictions.
The Eurozone Debt Crisis is an ongoing financial crisis that began in Europe in 2009. The crisis involves all the countries in the Eurozone but specifically Ireland, Greece, Portugal, Spain and Cyprus. There are various causes of the Eurozone crisis, and have been a number of attempts to salvage the financial sector and address the fundamental causes of the crisis, though they have not all been successful. The Eurozone financial crisis can be attributed to structural flaws of the Maastricht Treaty regarding financial stability, integration, and supervision (Caporaso and Kim, 2012). Although the European Union had technically “graduated” out of sovereign default, the re-liberalization of the EU through the introduction of a single currency and the opening of state to state barriers.
The cohesive transition of the monetary market in Europe to the Euro was a main factor of the ensuing Eurozone Crisis. The Maastricht Treaty came into effect in November 1993, and was a major step towards total monetary integration. The European Union wanted a singular currency in order to lower transaction costs and manage uncertainty to more effectively reap the benefits of a single market (Caporaso and Kim, 2012). Although a good idea in theory, the Maastricht Treaty had a number of structural flaws that made it less than desirable in practice. The first structural flaw of the Maastricht Treaty was that it appointed no central governing body and outlined no central banking regulations. This necessitated the creation of the SPG in 1997 which would in turn function as the governing body and “police” of the EU countries. The SPG was flawed as well, however, in that its focus lay largely on stabilizing and fighting inflation, leading it to forego growth inducing policies, stifling development within the EU. Although the SPG was meant to be the main governing body, it proved to have weak enforceability as it couldn’t legally impose it’s sanctions (Caporaso and Kim 2012).
Although Portugal, Ireland, Italy, Greece and Spain (PIIGS) are almost always categorized together when discussing the Eurozone Crisis, the causes of their individual crises were far from the same. The crisis in Greece was primarily related to both weak fiscal policy and tax collection as well as lying on their financial books, whereas the Irish and Spanish Crises were more directly correlated to the expansion of credit and the creation of price asset bubbles in construction, tourism and housing (Caporaso and Kim, 2012). Although deep rooted structural flaws fueled the financial meltdown, the debt that fueled the Eurozone Crisis was in fact, with the exception of Greece, largely found in the private sector (Caporaso and Kim, 2012).
Although the European Union had technically “graduated” out of sovereign default, the introduction of the Euro and open borders allowed for the movement of money across borders in a way previously unseen. It was as if the Eurozone was experiencing financial liberalization all over again, and therefore the negative externalities that accompany it. The European Financial Crisis began with a credit boom, predominantly due to the large amount of capital flowing between EU countries through interbank lending. The credit grew largely in the periphery, but the interdependence formed by the Eurozone gave way to market spillover. There was a growing differential between wages between the periphery and central Europe, though production levels were relatively equal. The increase in wages caused an increase in prices, rendering goods less desirable in foreign markets (Caporaso and Kim, 2012). While countries such as Germany and Austria remained relatively stable, Italy, Spain, Portugal and Greece suffered as the prices of their goods skyrocketed and competitiveness decreased.
The two main objectives of attempts to salvage the Eurozone involved saving the periphery countries who were hit the hardest (Portugal, Italy, Ireland, Greece, and Spain), as well as rebooting and restructuring their economies to ensure that such a crisis wouldn’t recur to the same degree (Caporaso and Kim, 783). The IMF first took action with a number of government bailouts. From 2010 to 2011, the IMF along with finance ministers granted 100 billion dollars to bailout Greece, 85 billion to bail out Ireland, and 78 billion to bailout Portugal. In order to be sure the financial crisis wouldn’t fully dissipate to Italy and Spain, the ECB bought Italian and Spanish government bonds to reduce costs of borrowing (Caporaso and Kim, 2012). Although these governments were now bailed out, the markets remained unstable. It was clear that leaders had to create policies that would restructure the fundamental flaws of the fiscal policy of the EU, as well as be able to provide enforcement on sanctions.
One of the most structurally important funds that resulted from the Eurozone debt crisis was the creation of the EFSF, or European Financial Stability Facility. The EFSF allows for a lending ceiling of 440 billion euros to protect and maintain the financial stability of the Eurozone (Caporaso and Kim, 783). The EFSF will undoubtedly be imperative to the continuation of the Eurozone, though it will likely require an increase in the lending ceiling.
In December 2011, an intergovernmental treaty that aimed for the creation of a new European fiscal union was brought to the table. Referred to as the “Six Pack,” and modeled after the SGP, it featured strict and automatic enforcements on government sanctions, national budgets controlled by the EU, focusing primarily on financial stability. The Six Pack included a council that had the ability to use “reverse qualified majority” voting in order to enforce sanctions on states who were not taking action to correct deficits (Caparosa and Kim, 784). This kind of voting rendered the new governance much more credible in their ability to enforce sanctions.
In 2012, the Treaty on Stability, Coordination, and Governance was brought into effect, signed by 25 EU member states with the exclusion of Britain and the Czech Republic. The TSCG established a balanced budget rule which had to be added to the legal system of every member state. The balanced budget rule required state deficits to remain below 0.5% of GDP, and was enforceable by the European Court of Justice (Caporaso and Kim, 784).
The effectiveness of these attempts is hard to measure. Although countries such as Ireland, Italy, and Spain have reaped the benefits of their bailouts and begun to stabilize, Greece remains in severe debt and has proven unable to stabilize. Without an increase in external aid and haircuts in it’s debt, Greece will be entirely incapable of correcting it’s situation.
The focus on austerity measures by European leaders aids in the stabilization of the EU economy but stifles growth, making it more difficult for hard hit countries to meet GDP and budgeting requirements (Caporaso and Kim, 787). This is illustrated by the PIIGS reduction in competitiveness with non-periphery countries (Caporaso and Kim, 787). Although in the long run, stabilizing policies such as the ones implemented will ultimately benefit the EU, in order to help PIIGS out of their individual crises, policy makers must stimulate growth through an increase in job markets, productivity and competitiveness.