Chapter 20 (9)
Financial Globalization: Opportunity and Crisis
◼ Chapter 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
Banking and Financial Fragility
The Problem of Bank Failure
Government Safeguards against Financial Instability
Moral Hazard and the Problem of “Too Big to Fail”
Box: The Simple Algebra of Moral Hazard
The Challenge of Regulating International Banking
128 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
◼ Chapter 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
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.
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.
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 subprime mortgage market in the United States. This
Chapter 20 (9) Financial Globalization: Opportunity and Crisis 129
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 because 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 commercial banks. This demonstrates an
important aspect of increased capital mobility: the importance of policy coordination across countries.
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-
◼ Answers to Textbook Problems
1. The better diversified portfolio is the one that contains stock in the dental company and the dairy
2. Our two-country model (Chapter 19 [8]) showed that under a floating exchange rate, monetary
expansion at home causes home output to rise but foreign output to fall. Thus, national outputs
3. The main reason is political risk—as discussed in the Appendix to Chapter 14 (3).
4. Reserve requirements are important for bank solvency. Maintaining adequate reserves enables a bank
to remain solvent, even in periods in which it faces a relatively high amount of withdrawals relative
130 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
5. This is again an open-ended question. The main criticism of Swoboda’s thesis is that foreign central
banks held dollars in interest-bearing form, so the United States extracted seigniorage from issuing
6. Tighter regulation of U.S. banks increased their costs of operation and made them less competitive
7. Banks are more highly regulated and have more stringent reporting requirements than other financial
institutions. Securitization increases the role played by nonbank financial institutions over which
8. The extent of international diversification should go down because some consumption now depends
exclusively on local conditions. In that case, agents want assets correlated with the price of that
9. No, real interest rate equality is not an accurate barometer of international financial integration.
As we saw in Chapter 16 (5), there is a real interest parity condition, which is that r = r* + %eq.
10. Canada’s current account to GDP ratio ranged from −4 percent to 3 percent over the period, and
on net was marginally positive but close to zero. The moderate CA surplus in the last few years
11. U.S. gross foreign liabilities rise as the Brazilian has a claim on the fund, and U.S. assets rise as the
fund buys more Brazilian equity. Likewise, Brazil’s foreign assets and liabilities rise. But no U.S.
12. This problem presents a trade-off between a bank’s desire to put as much of its operating capital to
work earning a return and its desire to signal strong financial solvency. There are higher potential
Chapter 20 (9) Financial Globalization: Opportunity and Crisis 131
13. The scenario in the previous problem changes if the bank’s creditors expect the government to bail
out the bank if it becomes insolvent. In this case, the bank would in fact be better off financing its
14. Eurodollar interest rates exceed those on U.S. bank deposits after the global financial crisis because