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
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 Shadow Banking System
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
The Financial Trilemma
International Regulatory Cooperation through 2007
Case Study: The Global Financial Crisis of 2007–2009
Box: Foreign Exchange Instability and Central Bank Swap Lines
International Regulatory Initiatives after the Global Financial Crisis
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
Summary
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.
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 stocks.
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. This tension is highlighted by the “financial
trilemma,” the observation that you can only ever have two of the following three policy goals: financial
stability, national control over financial safeguard policy (e.g., FDIC insurance), and free capital mobility.
If for example, one country was perceived to be more likely to bail out their national banking system, then
this would trigger a flow of capital to that country as well as increase the risk-taking behavior of that
nation’s banks, reducing financial stability.
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
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 nonbank 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 initiated 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).
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 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.
◼ Answers to Textbook Problems
1. The better diversified portfolio is the one that contains stock in the dental company and the dairy
company. Good years for the candy company may be correlated with good years for the dental
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
(and earnings of companies in the two countries) will tend to be negatively correlated under a floating
3. The main reason is political risk—as discussed in the Appendix to Chapter 14 (3).
4. If I put $2000 in China the rate of return is 10 % means = Total money = 2000 + 10%*2000 = 2200
If I put $2000 in India the rate of return is 5 % means = Total money = 2000 + 5%*2000 = 2100
If I put 50 percent of money both the countries, then the expected return will be = (1000 +
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
130 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
reserves only to the extent that the interest it paid was less than the rate it would have paid were
the dollar not a reserve currency. The high liquidity of the dollar makes this plausible, but it is
impossible to say whether the amount of seigniorage the United States extracted was economically
significant.
6. Tighter regulation of U.S. banks increased their costs of operation and made them less competitive
7. Under moral hazards, the party takes a risk, knowing that the potential burden of such a risk will be
taken and borne by the other party, in part or whole. Similarly in the banking system, the individual
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.
Where r is the home real interest rate, r* is the foreign, and %eq is the expected percentage change
10. There is direct link between the domestic currency depreciation and the National debt. If a domestic
currency depreciates in the international market, then the real debt level arises. When the foreign
11. U.S. gross foreign liabilities rise as the Brazilian has a claim on the fund, and U.S. assets rise as the
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
13. A bank fails when it is unable to meet its obligation to its depositors. When the depositors demand
their money back and the bank is unable to return the amount in time, then the consumers lose their
Chapter 20 (9) Financial Globalization: Opportunity and Crisis 131
confidence in the bank; in such a situation the bank is said to have failed. Yes, increased reserve
requirements can meet the demand of its depositors at the time of an impending bank failure.
14. Eurodollar interest rates exceed those on U.S. bank deposits after the global financial crisis because
investors perceive greater risk in Eurodollar deposits than in U.S. deposits. The perception of greater