PLAN OF THE BOOK AND FINDINGS

The following chapter opens with a brief intellectual history of the ILLR concept. In large part due to the work of the US economist Charles P. Kindleberger, scholars initially attributed the role of global financial stabilizer to the world’s leading economy, generally referred to as the "hegemon.” For years, the concept was largely subsumed by theories of hegemonic stability. However, the analytical focus of scholars shifted in the 1980s and 1990s as the IMF took on a more prominent role in international financial crisis management. As economists and political economists alike became increasingly focused on the IMF as the ILLR, analysis of direct lending between states outside of that institution fell by the wayside even though such actions continued. Meanwhile, the Fund’s efforts were not without critics. Several scholars highlighted the institution’s shortcomings as international financial stabilizer. After further considering the IMF’s weaknesses as an ILLR, the chapter ends with a brief overview of the key US ILLR mechanism employed by the Federal Reserve and Treasury: emergency loans via reciprocal currency swaps with foreign central banks. In addition to discussing how this works in practice, I consider why the provision of liquidity via these channels more closely approximates Bagehot’s ideal-type LLR for the global economy. First, I point to the independence of the Fed’s swap lines and the Treasury’s ESF from Congress. This autonomy enables swift action. Second, I draw attention to the ability of the Fed to create dollars—the closest thing the world economy has to truly global currency. Thus, it has the capability to provide virtually unlimited global liquidity.

The remainder of the book comprises empirical chapters structured around the history of change in the global financial system. Although the system’s need for an ILLR is a constant, the specific challenges facing the world economy vary across time. Thus, in order to uncover the particular motivations behind US efforts to provide international liquidity, I focus on four distinct historical periods. Table 1.1 lists these periods and summarizes the basic findings of my analysis including (1) the changes in the international financial system that generated an opening for a new kind of crisis, (2) the problems that an ILLR was needed to address, (3) the shortcoming(s) that inhibited the IMF from effectively managing the crisis on its own, and (4) the specific US interests that US policymakers sought to protect via the provision of international liquidity. The arguments and findings of each chapter are summarized below.

Chapter 3: By the early 1960s the Bretton Woods monetary order, still only in its teens, was showing premature signs of age in the face of easing restrictions on international capital flows. As newly freed private capital was flowing out of the United States to new offshore financial markets in Europe, the stability of the system’s linchpin currency—the dollar— became jointly threatened by the "gold drain” and the threat ofa speculative

Table 1.1 OUTLINE OF THE BOOK

Chapter 3

Chapters 4, 5, and 6

Chapter 7

1960s

1980s

1990s

2008

System

change

relaxation of capital controls; shift from dollar shortage to dollar glut

globalization of commercial bank lending

globalization of portfolio investing

foreign banks build up massive dollar- denominated assets/liabilities

ILLR needed to

stabilize Bretton Woods monetary regime

prevent sovereign defaults

stabilize

emerging market currencies

stabilize global financial system

IMF

weakness

resource insufficiency and unresponsiveness

unresponsiveness

resource

insufficiency

resource

insufficiency

US

interests

prevent gold drain; protect dollar from potential speculative attack

protect US banking system from foreign shocks

protect US financial system from foreign shocks

protect US financial system from foreign shocks; prevent interest rates from rising for US homeowners

attack against its fixed exchange rate. It was in this context that the Federal Reserve, led by Chairman William McChesney Martin, pushed for the construction of a central bank currency swap system through which shortterm liquidity could be provided directly between the United States and the Paris Club countries. Although these arrangements ultimately resulted in the United States’ first foray into the provision of international liquidity following World War II, the impetus for the creation of this system was quite self-interested. US economic policymakers were motivated to create these alternative financing arrangements due to emergent US preferences for a more effective ILLR mechanism. In particular, for the first time since the IMF was created, policymakers were fearful that the United States itself might need to draw on the Fund’s resources.

A growing glut of dollars in the global economy was draining the country’s gold stock as countries increasingly looked to convert their expanding dollar reserves into bullion before the greenback was devalued. These conversions, in turn, increased the odds of a speculative attack against the dollar, which would have forced just such a devaluation. The United States needed access to foreign exchange if it was to protect itself from both threats. However, at the time, the Fund was chiefly a lender of dollars and could not provide the United States with the sufficient foreign exchange it would need in the event of a serious crisis. A new international agreement would soon be reached—the General Arrangements to Borrow (GAB)— that increased the Fund’s access to foreign exchange and hence its ability to provide credit to the United States. Yet it also added a lengthy, cumbersome, and risky negotiation process. The problem of resource insufficiency was replaced with the problem of unresponsiveness. Because US officials viewed the IMF as too unresponsive to effectively react to a crisis, they responded by developing a program to provide the United States access to substantial, flexible, on-demand emergency financing directly between central banks. Paradoxically, the initial impetus for the swap deals was the United States' need for an ILLR. However, the Fed soon emerged as the primary lender in the swap system. Foreign central banks quickly made use of the reciprocal nature of the swap lines for their own short-term liquidity needs. This chapter explains why the motivation behind the Fed’s ILLR activities was not an interest in meeting its partners’ needs, but rather in meeting its own.

Chapters 4,5, and 6: Chapter 4 documents how the international financial system began to change during the 1970s. The end of the Bretton Woods regime in 1971 and the continued removal of barriers to international capital flows paved the way for the globalization of finance. Leading the globalization charge were US banks, which dramatically expanded their foreign balance sheets during the 1970s and early 1980s. Billions of dollars in lending went to developing countries. For the first time in decades, the US financial system was no longer confined within national borders. Banks were now directly exposed to foreign financial shocks. When a wave of developing-country debt crises hit in the early 1980s, the IMF adopted a crisis-management strategy known as "concerted lending” that further inhibited the institution’s ability to provide speedy loans. By refusing to release funds until commercial banks increased their exposures, the IMF was trying to keep the banks "in the game.” However, for many countries in dire need of credit, this meant historically long waits for emergency financing as negotiations with the banks dragged on. Within this context Treasury stepped in to provide "bridge loans” to a select group of economies in crisis by tapping the ESF—a 50-year-old fund that provided Treasury with resources, independent of congressional appropriation, which it could deploy to bail out foreign governments.

By the late 1980s, the IMF moved away from the concerted lending strategy. In the 1990s, it implemented several reforms designed to increase the institution’s ability to respond swiftly to rapidly developing crises. Yet, even as the Fund was working to become a more responsive ILLR, continued changes in the global financial system undermined these efforts. After retrenching throughout the 1980s, US banks again began to rapidly expand their foreign portfolios during the following decade. Additionally, portfolio capital flows from the United States to select emerging markets expanded significantly. The result was that the financial exposures and spillover channels into the US economy from foreign crises grew even more complex. By the time a slew of currency crises spread across developing countries in the mid- to late 1990s, the IMF’s effectiveness as an ILLR remained limited. The complexity and herdlike behavior of financial markets required immense rescue packages that the Fund could not provide on its own. Again, Treasury stepped in and provided funds via the ESF on several occasions—this time supplementing IMF credits.

Between 1982 and 1999, the ESF provided emergency loans to more than 20 different countries on more than 50 separate occasions. Chapters 5 and 6 aim to answer the following question: What motivated the United States to act as the ILLR during these years? More precisely, why did some countries in crisis receive US assistance while others facing similar circumstances were passed over? Treasury repeatedly defended its actions as being necessary to preserve the stability and integrity of the US financial system. Because the US financial system now expanded beyond US borders, LLR actions had to follow suit. Yet, many members of Congress disagreed, charging that Treasury was "bailing out” irresponsible countries and, even worse, the big Wall Street banks. Theoretically, defensive financial considerations could motivate the United States to provide bailouts through either causal pathway: special interests or the national interest. Because commercial banks are clear beneficiaries of international bailouts, they have incentives to lobby their government for such policies. Thus, Treasury’s actions might represent the influence of powerful financial interests on the United States’ foreign economic policy. Without ignoring the impact of private interests on policy outcomes, I contend that it is too simplistic to view economic policymakers as mere agents of the private financial sector. They are also individuals operating inside state institutions with their own interests in policy. Although Treasury and the Fed have missions encompassing a number of roles, each is charged with providing a key public good for the US economy: protecting and providing for the stability of the US financial system, broadly construed. I expect that policymakers prefer policy choices that increase the likelihood their institution will live up to this mandate. Thus, via the national interest pathway, ESF credits may also represent economic policymakers’ efforts to defend the stability of the US financial system, broadly defined, which extends beyond Wall Street banks to "Main Street” as well.

In order to assess the validity of these two competing views, I develop and test an empirical model of ESF bailout selection in chapter 5. Central to my analysis is newly collected data from decades of Federal Reserve reports on the foreign lending activities of major US banks that allow me to model (1) where the institutions were exposed as well as (2) how their stock of capital has varied over time. This is important because financial system exposure to foreign crises is not simply a function of outstanding foreign loans but also of the capital that financial institutions hold in reserve. Ultimately, my statistical analysis finds that as the exposure of major US banks to a foreign country in financial distress increases, the United States was far more likely to intervene on the foreign country’s behalf and provide a bailout. However, this effect is strongest when systemic risk facing the US financial system is elevated. In other words, my analysis shows that the context within which specific financial crises occur influences the likelihood that Treasury will provide an emergency rescue to a country in distress. The results support the assertion that US economic policymakers intervene where major banks are exposed in order to protect the national financial and economic interest rather than just the private financial interests of banks. Chapter 6 builds on this argument by presenting data from carefully selected case studies from the 1980s and 1990s. These include cases where Treasury provided bailouts as well as cases where it did not. The cases further support the argument that policymakers decided to act as an ILLR because they believed that

IMF actions alone would not protect the US financial system from grave harm due to spillovers from foreign financial shocks.

Chapter 7: The final empirical chapter puts the spotlight on the most recent example of US ILLR actions during the global financial crisis of 2008. No other moment in history so laid bare the inability of the IMF to act effectively to stabilize the global financial system in the face of a systemic crisis. Beginning in the summer of 2007 and culminating in the fall of 2008, the freezing of global credit markets on fears of exposure to toxic subprime mortgages in the United States led to an acute shortage of dollars in international financial markets. This development was a consequence of yet another change in the global financial system that began at the end of the twentieth century: the massive growth in foreign (primarily European) banks’ dollar- denominated assets, which were concentrated in US mortgage-backed securities. The inability to access the short-term dollar financing they needed to roll over debts in 2008 meant that many foreign institutions could be forced to default on their obligations to predominantly US financial institutions. After nearly a decade of remarkable global financial stability, the IMF had not significantly increased its lend- able resources since 1999—despite the dramatic growth of the global financial system. Consequently, when the crisis hit, the Fund was not prepared to respond and, thus, was an incapable ILLR. Once again, the United States filled the vacuum.

This time, the Federal Reserve provided nearly $600 billion in credit to a group of 14 advanced and emerging economies starved for dollars. Why did the Fed act in such an unprecedented way? I argue that the international dimensions of the crisis threatened US financial interests in two key ways. First, systemically important US banks and money market funds were directly exposed to foreign financial institutions that were blocked from frozen dollar-funding markets. Thus, without an ILLR, the US financial system was facing an existential threat from a wave of potential foreign defaults. Moreover, the IMF was incapable of providing the amount of liquidity that the global financial system needed as its financial resources were seriously constrained. Second, the seizure of global credit markets severely impaired the transmission of the Fed’s interest-rate cuts to the real economy. Only by providing dollars to a global economy desperate for liquidity could the Fed ensure that the US economy got the stimulus it needed by cutting rates to historically low levels. In support of my argument, this chapter presents a variety of evidence including case-study analysis of the financial risks facing the US economy from foreign sources, statistical analysis of the Fed’s swap line selection, and chronological process tracing drawing from a review of FOMC transcripts during the crisis. Collectively, the data I present in the chapter support these points.

This book concludes by discussing its contributions to the field of international political economy and to the literature on financial crisis governance. First, it presents a far more complete picture of how international financial crises have been managed following World War II. Until very recently, scholarly interest in the ILLR role has focused almost exclusively on the IMF. Yet, as I show here, the IMF’s provision of international liquidity is only part of the story. For decades, ad hoc, unilateral state action has complemented (and sometimes even substituted for) the IMF’s multilateral bailouts. Second, the book highlights how the IMF has been consistently dogged by two chronic weaknesses as an ILLR: the problems of resource insufficiency and unresponsiveness. The regularity with which these shortcomings of the Fund have limited its ability to effectively respond to international financial crises provides useful insights into how the institution should be reformed if it is to become a more effective crisis manager. Third, this book reveals how the globalization of finance has resulted in the globalization of national lender of last resort mechanisms. Over a 50-year period, the United States has repeatedly adapted to the changing nature of the international financial system by using existing institutions to meet new, unexpected, and sometimes unprecedented financial needs.

 
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