Book Title
International Economics: Theory and Policy 9th Edition

978-0132146654 Chapter 20 Lecture Notes

December 18, 2019
Chapter 21 Financial Globalization: Opportunity and Crisis     121
Chapter 20
Financial Globalization: Opportunity and Crisis
.1 nChapter Organization
The International Capital Market and the Gains from Trade
  Three Types of Gains from Trade
  Risk Aversion
  Portfolio Diversification as a Motive for International Asset Trade
  The Menu of International Assets: Debt versus Equity
International Banking and the International Capital Market
  The Structure of the International Capital Market
  Offshore Banking and Offshore Currency Trading
  The Growth of Eurocurrency Trading
The Importance of Regulatory Asymmetries
The Shadow Banking System
Regulating International Banking
  The Problem of Bank Failure
Case Study: Moral Hazard
  Difficulties in Regulating International Banking
Box: The Simple Algebra of Moral Hazard
  International Regulatory Cooperation
Case Study: Two Episodes of Market Turmoil: LTCM and the Global Financial Crisis of 2007–2009
Box: Foreign Exchange Instability and Central Bank Swap Lines
How Well Have International Financial Markets Allocated Capital and Risk?
  The Extent of International Portfolio Diversification
  The Extent of Intertemporal Trade
  Onshore-Offshore Interest Differentials
  The Efficiency of the Foreign Exchange Market
nChapter Overview
The international capital market, involving Eurocurrencies, offshore bond and equity trading, and
International Banking Facilities, initially may strike students as one of the more arcane areas covered
in this course. Much of the apparent mystery is dispelled in this chapter. The chapter demonstrates
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122  Krugman/Obstfeld/Melitz •   International Economics: Theory & Policy, Ninth Edition
that issues in this area are directly related to other issues already discussed in the course, including
macroeconomic stability, the role of government intervention, and the gains from trade.
Using the same logic that we applied to show the gains from trade in goods or the gains from
intertemporal trade, we can see how the international exchanges of assets with different risk
characteristics can make both parties to a transaction better off. International portfolio diversification
allows people to reduce the variability of their wealth. When people are risk-averse, this diversification
improves welfare. An important function of the international capital market is to facilitate such
welfare-enhancing exchanges of both debt instruments, such as bonds, and equity instruments, such as
Offshore banking activity is at the center of the international capital market. Central to offshore banking
are Eurocurrencies (not to be confused with euros), which are bank deposits in one country that are
denominated in terms of another country’s currency. Relatively lax regulation of Eurocurrency deposits
compared with onshore deposits allows banks to pay relatively high returns on Eurocurrency deposits.
This has fostered the rapid growth of offshore banking. Growth has also been spurred, however, by
political factors, such as the reluctance of Arab OPEC members to place surplus funds in American
banks after the first oil shock for fear of confiscation by the U.S. government following the confiscation
of Iranian deposits in 1979.
The text also introduces issues of regulating capital markets. Central to this task is the notion of how banks
fail, and what can be done to prevent bank failures. Bank regulation presents a trade-off between
financial stability and moral hazard. You want to promote confidence in the banking system through
financial support, but too much support encourages risk taking by the banks. Deposit insurance,
regulations, and lenders of last resort can all help prevent the lack of confidence in a banking system
that can generate a run on the banking assets. International banking presents additional challenges as
rules are not uniform, responsibility can be unclear and enforcement is difficult.
Industrialized countries are involved in an effort to coordinate their bank supervision practices to
enhance the stability of the global financial system. Common supervisory standards set by the Basel
Committee were developed. Potential problems remain, however, especially regarding the clarification
of the division of lender-of-last-resort responsibilities among countries and the increasingly large role of
nonbank financial firms which makes it harder for regulators to oversee global financial flows. The text
highlights these regulatory difficulties using a case study of the near collapse of the hedge fund LTCM
and the problems in the subprime mortgage market in the United States. This case study is also used to
illustrate the difficult balance regulators face between creating moral hazard and maintaining financial
stability. The financial crisis of 2007–2009 also highlights the increasingly important role played by non
bank financial institutions, the so-called “Shadow Banking System.” Though these institutions operate
much like banks and their profits are intertwined with those of commercial banks, they are not regulated
like commercial banks. Much of the riskiest behavior that contributed to the financial crisis was
by these institutions. In response, the U.S. Congress recently passed the Dodd-Frank Act, which allows
the government to regulate these institutions like banks. This represents another example of the
difficulty in balancing financial support (the bailouts of financial institutions) with moral hazard
(increased supervision and regulation).
The global aspect of the financial crisis is also highlighted with a case study on Central Bank Swap
Lines. European banks heavily invested in mortgage backed securities because they were given good
credit ratings and thus allowed these banks to hold less capital against their purchases of these assets.
However, these banks did not want exposure to currency risk, so they financed their purchases by
borrowing dollars in short-term markets. When mortgage-backed securities plummeted in value, these
European banks were faced with a dilemma. They could not be bailed out by their local central banks
since they needed to pay back their debts in dollars. However, they did not want to sell their
dollar-denominated assets at such a low price. To resolve this dilemma, the Federal Reserve stepped in
and lent central banks around the world dollars, which they could in turn use to bail out their local
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Chapter 21 Financial Globalization: Opportunity and Crisis     123
commercial banks. This demonstrates
an important aspect of increased capital mobility: the importance of policy coordination across
The evidence on the functioning of the international capital market is mixed. International portfolio
diversification appears to be limited in reality. Studies in the mid-1980s cited the lack of intertemporal
trade, as evidenced by small current-account imbalances, as evidence of the failure of the international
capital market. The large external imbalances since then, however, have cast doubt on the initial
conclusions. Studies of the relationship between onshore and offshore interest rates on the same
currency also tend to support the view of well-integrated international capital markets. The developing
country debt crisis represents a dramatic failure of the world capital market to funnel world savings to
potentially productive uses, a topic taken up again in the next chapter.
The recent performance of one component of the international capital market, the foreign exchange
market, has been the focus of public debate. Government intervention might be uncalled for if
exchange-rate volatility reflects market fundamentals, but may be justified if the international capital
market is an inefficient, speculative market, drifting without the anchor of underlying fundamentals. The
performance of the foreign exchange markets has been studied through tests of interest parity, tests
based on forecast errors, attempts to model risk premiums, and tests for excess volatility. Research in
this area presents mixed results that are difficult to interpret, and there is still much to be done.
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley