Departement SAEMQ, University of Bergamo

February-March 2015

International Monetary Economics course

(taught by Riccardo Bellofiore, Stefano Lucarelli and Jan Toporowski)

JAN TOPOROWSKI LECTURES

transcript by

Lecture 1: Michela Locatelli, Silvia Maggi, Diana Brambilla, Chiara Carissimi.

Lecture 2: Ilaria Brivio, Sophie Ciacciarelli, Marco Fassina, Federica Tarantino, Sara TinelliLecture 3: Brando Viganò, Claudio Iacopino, Simone Perego, Michael RavelliLecture4: Sara Brevi, Roberto Moroni, Federica Rota, Niccolo’ Suardi, Rudy Zanoli Lecture 5: Invernici Elena and Vailati ValeriaLecture 6: Antonella Cordaro, Laura Birbes, Mattia Ferrarin, Silvia Bacis, Souad El Khadir Lecture 7: Polina Vasileva, Salam Aslam and Alina Giachin

revised by Patrizio Lainà,

Ph.D. University of Helsinki, Visiting Scholar at Department SAEMQ, University of Bergamo

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1. TOPOROWSKI LECTURE TRANSCRIPTION

1st LECTURE – University of Bergamo, Friday 20th February 2015

Performed by Michela Locatelli, Silvia Maggi, Diana Brambilla, Chiara Carissimi.

Introduction:These lectures have been a great stimulus to my own thinking and to my own research because theyhave challenged me to think what is international money really about, what is the connection betweeninternational money and macro economy. In particular, how it is connected to the problems of theEurozone. Money credit conceptI’ll give you an Outline of the rest of the course at the end of this lecture.These lectures are new, there is not a textbook about this, I refer to some literature, but there is not onebook or one paper where you can find all of this. It’s a synthetic discussion of money and the macroeconomy and how macroeconomic imbalances fit into international money.

- Introduction of Theories of International Money

- Credit and Finance: usually in the text books credit and finance are treated as savings and very

usually divided, I want to treat them more specifically from an historical perspective.

- Varieties of International monetary circulation: how money circulates in the modern globalised

economy

- Overview of the whole course in one table which shows the whole course. That’s what you

have to remember to fit the other lectures in.

1.Introduction of Theories of International MoneyEssentially, what I’m looking at is a macro economic theory of money, in other words, an explanationof what money does in any economy, and its role in economic crisis. This has to be understood,without it, it is not possible to understand the role of money. As we will see later on, there are theoriesof explanations of money which talk about how useful it is in exchange; these kinds of explanationsthat’s not all the money does in the modern economy. We need to know the traditional ones.Let’s consider the theories that explain the functions of essential properties of money. If you look at astandard textbook of money, it would tell you that money has to be scarce, divisible, quotable, essentialfeatures. The functions of money: mean of exchange, unit of account, store of value. These are allfeatures of money, but they don’t tell you what money does in a modern international economy. Thosekind of definitions we had had since the XIX century, money has changed very much since the XIXcentury.Theory of money has an explanation of what money does in an economy and its role in economiccrisis, this requires an explanation of the economy in which money functions. This is why you can’tunderstand money by looking at its functions or its properties. Nor we understand money by knowingthat once it was gold, or that money is what the government says it’s money or money is what we useto pay taxes. We need to understand how money functions in an economy, so we need to understandthe economy in which it works. This was done by Joseph Schumpeter who distinguished between, first of all, commodity theories ofmoney in which money is related to some commodity (ex. gold) and therefore to obtain it throughexchange. Because a commodity is what you exchange. That’s a relatively simple first type of money.Money which comes from trade or money which is used to trade. Schumpeter distinguished that this is one money but nowadays we use credit. What is credit? Well, youhave monetary theories of credit where money that is obtained through exchange is deposited into a

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bank which lends the money out. So here we have this idea that there is credit, but credit operates aspurely as intermediation. Banking and finance it is pure intermediation: it’s taking the money that Idon’t want to use today and lending it to someone else who wants to use it today. Commodity or fiatmoney, just simply put into a bank and then lend it out today. What I want to argue is that this explainshow money operates in an exchange economy or in a merchant capitalist economy. I buy goods, I haveto pay money for them, I take them to the market, I sell them for more money and in exchange formoney. I may finance this by borrowing money from a bank; that is a relatively simple economy andeven if you do have a credit it’s a relatively simple credit.What we need to distinguish here is a different type of money which is a pure credit money or Credittheories of money. These are the theories that you can find in Keynes, Wicksell and Schumpeter. I willdiscuss this more in the coming lectures because they actually changed the way in which the economyworks and I’ll explain this later on. Let me just say what Schumpeter had to say about these theories. Ifyou read a text book, they would tell you: yes, money was notes and coins, then there were bank notesand now we use bank deposits, but it’s the same thing. It is not the same thing, although the text bookstell you it is, it isn’t. Schumpeter when considering these views, he explained the situation as follows, and this is one of hismost important quotations: “…logically it is by no means clear that the most useful method (in the analysis of money) is to startfrom the coin (i.e. metallic money) – even if, making a concession to realism, we add inconvertiblegovernment paper (i.e. paper money or government bonds) – in order to proceed to the credittransactions of reality. It may be more useful to start from these (credit transactions) in the first place,to look upon capitalist finance as a clearing system that cancels claims and debts and carriesforward the differences … In other words, practically and analytically, a credit theory of money ispossibly preferable to a monetary theory of credit.’(Schumpeter 1954 p. 717) The monetary theory of credit was the stereo credit in which money is put into a bank end the banklends the money out. The other system, which Schumpeter was referring, is capitalist finance as aclearing system that cancels claims and debts and carries forward the differences. Here Schumpeter waslooking at the practice how banks operate when clearing payments. When payments are cleared, if youpay with a debit card in a shop, what the shop gets it’s a record of your payment and it gives that to itsbanker and the shop’s banker takes it to your banker and says: please, pay this from this person’saccount. In average, yesterday they would have made each payment like this. What they do today is thatthe shop’s banker will take the instructions to pay to your bank, your bank will show the shop’s bank allthe payment instructions that it has from the shop’s bank, they will add all these up and they will makea payment for just a difference. Ex. If my bank owes to your bank 200€ and your bank owes my bank150€, then they will simply cancel all the payments through my bank paying 50€ to your bank. This iscalled clearer, system of clearing. Banks do this every day. Years ago, when everything was based onpaper, they did this every two weeks, but nowadays they just do it every day. Schumpeter was pointingout that you can go even further of this; my bank says to your bank: I owe you 50€, I won’t pay todaybut I will add the 50€ to what I will owe you tomorrow. So in a fact you have clearing, but nopayments. In a pure credit economy this what happens, payments cancel out over time. It means youdon’t need to have reserves for making credit transactions, you have a pure credit economy betweenbanks.In the international context this does affect the theory of exchange rates and the macro economicadjustments. The traditional theory of exchange rate is that when two countries trade, they havepayments, currency going one way and currency going other way with export and imports. Actuallywhat happens is that those payments cancel out. It’s just a transfer. I’m introducing to you a firstcomplication in the theory of money, which is the idea that, in pure credit, credit transactions don’trequire any payments, they cancel out over time. The second complication that I want to introducewhen credit and finance come into the analysis.2.Credit and finance.

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Coming to the analysis, in the second half of the XIX century with the Companies acts at the age of70s, this allowed companies with limited liabilities to be established. Why is this important? It meantthat companies could be financed with long term debt and equity=share capital of the company. The1870s acts started in North America and in Great Britain and developed in Europe in a different way.They changed finance with 2 very important effects:

2.1- This new system of financing enterprises changed the nature of capitalistic crisis.

If you consider the traditional economic analysis, this analysis envisages a capitalist or classic

capitalist who financed its business out of its own pocket/money or with short term bank loans or

with bills. Bills are like a commitment to pay in 3 months’ time and you use this time to buy goods,

especially those guaranteed. The consequence of financing in this way was that the classic

capitalists were permanently and chronically short of money. Because if you finance your business

enterprise with short term money, let’s say with 3 months loans and every 3 moths you have to

renew the loan, if you have equipment like machinery which lasts 30/40/50 years, over those

30/40/50 years, if it’s financed this way, you have to keep renewing loans.

They were permanently short of money and that lead to a classic 19th century capitalist crisis which

was essentially a bank crisis.

An economic boom usually means that bank notes and coins would circulate out of the bank andwould be circulating in the economy. The bank would be running short of notes and coins and withtherefore stop lending; if a bank is running short of reserves it stops lending and arises interestrates. When banks did this in the 19th century this would cause a credit squeeze and all theseclassic capitalists who had long term assets which they were financing with short term loans, theywould find themselves obliged to repay their debts, but unable borrow more. So they had to repaytheir debts out of their own money, but they didn’t have much of this. So they would stopproducing materials, stop paying their workers in order to repay the debts. It was, in classic words, acommercial crisis and trade crisis, it took Hawtrey saying that was the kind of crisis that wouldaffect capitalism. With long term finance this changes.After the 1870s, what capitalism could do it was matching financing to the duration of the capitalistequipment, this is what used to be called funding. It is the standard way, that Keynes describes intohis Treaties of money, in which a firm even today finances its long term assets; instead of using itsown money, it borrows money from a bank, it buys the assets and then it issues a long term bondof approximately the length of the life time of the assets. Ex. Airlines: an airline which is buying aircraft, a long term asset which will last 20 or 30 years. Anairline, when it is buying an aircraft will use its own money or borrow money to buy that aircraft,and then, as soon as it can, it will replace that money by issuing a long term bond, put money intoreserves and use that money for the bond to put money back into its savings and reserves and repayback the bank loan. Why? Because the finance it’s cheaper, it’s long term, the financing is fixed andfinancing costs are fixed. The airline does not have to worry about this anymore, unlike theprevious case when it had to keep refinancing with short term loans.

The other thing that happened was the internationalisation of crisis. Old bank crisis with localcrisis. What happened with in new kind of crisis is that the new crisis would be a stock market crisis,and stock market when it crash it would affect shareholders and other markets elsewhere.

- One of the earliest and most important ones was the Vienna stock market crisis of 1873 which

affected the whole of Europe, in particular central Europe.

- A second big important crisis was in 1893, Bearings Crisis (Bearings was a bank in London).

That was interesting because the reason why the bank went into trouble was the bank had been

issuing bonds for the Argentine government and the Argentine government run out of gold to

make the payments of the bonds. And Bearings had guaranteed the bonds, so Bearings started

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to run out of gold. The Bearings crisis caused such a collapse in London and such a shortage of

gold that the Bank of England nearly survived. Payments had to be made in gold, they had to

obtain gold from somewhere else. So London was draining gold, taking gold from Paris, and

eventually advocate the crisis.

- The biggest one of the period of the Gold Standard was the Knickerbocker Trust Crisis in

New York in 1907. Knickerbocker Trust was a major bank in New York, it suspended

payments to other banks in New York, but also in Chicago, because it didn’t have enough gold.

Those banks didn’t receive gold from Knickerbocker Trust, so they couldn’t make their own

payments and in this way the crisis spread internationally. All the way through to affecting Italy

as well. The core feature of the crisis was that Knickerbocker was operating in the capital and

stock market, that was why it brought into difficulties other banks. So you have a changed

nature of capitalist crisis. It changed the structure and possibly even the nature of capitalism.

2.2 Change of structure or nature of capitalismIf a company was financed with long term capital, it then becomes possible, by issuing long termbonds or long term capital, to take over another company; you can do much as an acquisition.In the previous system where companies where operating with short term loans, they barely hadenough money to finance production and their business investment; there wasn’t finance formergers and takeovers, you didn’t have mergers and takeovers. You had occasionally companiesjoining together, but they didn’t buy each other out. With the purchase or the refinancing ofcompany stock what you get is the rise of monopoly corporations or monopoly finance capital.All I want to emphasise is that it’s at this point that academic economics started to go wrong andstarted to lose touch on with was actually happening. If you look on text books under monopoly,what they are really talking about is the idea of Monopoly. Alfred Marshall, a 19th century economist,talked about monopoly in terms of unnatural monopoly. Ex. If I control a natural spring I can sellwater and decide the price. State Monopoly: if a government gives a company a monopoly for tradeor a monopoly over a road infrastructure or railway. For Marshall if there were increasing returns forscale, especially in manufacturing industry, large companies could have lower average costs andtherefore they could get to dominate in position and eliminate competition because their costs werelower. What the monopoly and finance capital, it’s nothing to do with competition. It is notcorporations which are good at competition, they became big through operations like mergers andacquisitions. Ex. Back to the Case of airlines: Ryanair makes a great pretence that it’s very bigbecause it competes with other airlines, but it’s a minor part of the story; it’s big because it took overother smaller airlines through mergers and acquisitions. General Motors is a very large corporationcar producer, not because it is so competitive, but because it took over other companies.

One of the consequences of this, is that you have a corporate structure which is divided between largecorporations, which use the capital market, and small medium sized enterprises, on the other hand, thatoperate through competition and survive through competition. The business cycle is in a fact acomplex interaction between corporations and small and medium sized enterprises. Because whenthere is an economic boom the small and medium size enterprises grow, but because the largecorporations have market power, they get the profits. It is a fact.I really want to highlight two aspects of having corporations financed with long term securities. Twoconsequences:

1- Corporations prefer to overcapitalise, they prefer to issue more capital not less. Why? Because it

means they can hold liquid assets in their balance sheet to hedge against their financial liabilities.

So any large corporation (like Ford, Siemens, FIAT), if possible, likes to hold more capital than

it needs, so that it has liquid assets and, the liquid assets it holds, so that it always has money to

be able to make payments on its long term debts. It doesn’t just have to rely only on

production. If it relies on production, then it is vulnerable to the business cycle. Any business if

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it has a fluctuating market, it tries to keep some savings aside to pay their bills when sales are

produced. This is important because if you don’t pay the bills, that’s the end of the company.

Illiquidity means the end of the company. The company will be taken to court, it will have its

assets taken away. So all the capitalisation becomes important.

2- Liquidity: if a capitalist firm is financed with long term liabilities (bonds or shares), it has to

persuade both the individuals or institutions to hold long term bonds/shares. The condition for

this is that the markets for those bonds or shares are liquid. If they are not liquid markets,

supposing the airline which wants to fund its purchase of an aircraft with a 30 year bond, if

there are not liquid markets, the airline needs to find someone who is willing to hold the bond

for 30 years. Certainly it won’t be an older person, even if most of rich people are actually older,

because he is not going to be alive when the bond has been repaid. On the other hand, an older

person will hold the bond if they knows that they can sell the bond at a good price. To be able

to sell it at a good price you need to have liquid capital markets.

Today this is done through private equity, hedge funds. These institutions which borrow money

short term and use it to buy long term bonds. They operate along the yield curve and borrow

short term to buy long term securities. The important thing about this is that they provide

liquidity with bonds. If I hold a bond or a share, I can go to a bank and I can borrow money

using that as a security, so that I can get cash. If everyone had to wait for 30 years or forever to

get their money back, no one would hold it. For many radical economists, this kind of re-

intermediation, borrowing short term money to buy financial assets, is considered

financialisation or something else like this. It is the liquidity needs of long term assets. Once

you have capitalism operating with long term finance, then it creates additional kinds of credit

in order to make that long term finance liquid.

Rise of multinational corporations:The other fact is that it changes the nature or the type of multinational corporations. Multinationalcorporations are very important, we find them at the heart of the international monetary transactions.How and why they are involved? They’re involved through successive generations.

1st generation of Multinational companies were effectively domestically financed companiestrading companies. They were established in a particular country in order to tradeinternationally. That’s the basis of prosperity of Northern Italy from the Dark Ages over the lastthousand years, in the sense that cities like Venice, Bergamo as well, had international tradingbusinesses financed domestically in their own cities. In modern times, one of the largest is TheBritish East India Company which traded with India, it was established very long time ago. Thenthey gave rise to the second generation2nd generation of multinationals. Domestically financed companies producing abroad. Theoriginal one was the British East India Company which established tea implants in India in the 19th

century to produce tea because English liked to drink tea and tea was very light to carry in ships, sothe value added transport costs were low. But by the end of the 19th century is an industrialcorporation. Producing abroad meant effectively that these companies were exporting capitalequipment. This is what you find in the analysis of the empirics by ? and ?.Ex. General motors: theywere establishing plants which were producing the whole finished goods abroad.3rd generation of multinationals really is what we nowadays associate with multinationals, they aredomestically financed but they are engaged in international production. So you had differentstages of production placed in different countries. Ex. Mexican maquiladora production where thecomponents are produced in Asia, they are assembled in Mexico and exported to Europe. Fordistinternational production: how the car industry is now organised, different components produced in

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different parts of the world. They produce engines in Germany, body parts elsewhere, theyassemble in a third country and then export.4th generation multinational since the 1980s. This is a multinational corporation that isinternationally financed and operating in different countries. What makes it different to theprevious multinationals is that it doesn’t necessarily come from an advanced industrial country orfrom a trading corporation of an established capitalist country, but in many cases it comes fromother countries, very often third world countries. Ex. Cemex, which is a Mexican corporation. TheMexican stock market is tiny, is not significant; the Cemex became a multinational not throughissuing long term bonds and shares in Mexico, but through borrowing money and then issuing longterm securities in New York, London and other financial centres. So it used the capital markets ofthe main capitalist countries to become an international corporation. Ex. Arcelor-Mittal, the owneris an Indian citizen. The Bombay stock market is a very interesting speculative market, but it’s not amarket from which you could create a multinational corporation. They created Arcelor-Mittalthrough issuing shares in London, New York, Paris, Frankfurt and buying up steel companies; inthis way becoming a multinational corporation. Ex. Tata motors; it was an Indian corporation, butin last 15 years it became a multinational corporation, again, through issuing shares in London. Itnow owns a part of the British car industry. This is a new generation of multinationals because it’susing capital markets in international financial centres to create a large corporation. It’s differentfrom the 3rd generation because with these corporations you now have a cross border structure ofassets and liabilities. That becomes very important for exchange rate theory. It’s a major change inthe way in which capitalised enterprise is organised. This leads on to my third section:

3.Varieties of International monetary circulationIf we want to understand what international money is, we have to understand how money circulates ininternational economy. I’m facing this on the work of a very obscure German monetary theorist HansNeissan and of an Italian monetary theorist Augusto Graziani. You can identify different types ofmonetary circulations.

- Income money. It is money in a circular flow of income between firms and households. Firms

buy facts and services from households, pay them money. Households use their incomes to pay

firms for goods and services they buy from them. Circular flow which takes place through

production. Production creating income, income being used for expenditure, expenditure

creating sales revenue for firms. In monetary economics it is usually where the function of

money finishes, people buy goods and services from each other, households buy goods or

services from firms, firms using money to pay their suppliers through markets for facts and

services.

- Investment money. When firms invest they buy fixed capital equipment and they pay for it

using money. Firms use money to buy facts and services for the production of investment

goods, but the income that workers receive is not spent on buying investment goods because

they don’t use investment goods. So this is a different type of monetary circulation, in

particular, for Kalecki this is the foundation of how money is monetised.

- Portfolio money. Money that financial investors pay each other for financial assets and for

foreign currencies including re-intermediation by banks, hedge funds, private equity in order to

make long term securities bonds and shares more liquid. Once firms started to finance

themselves using long term liabilities (bonds and shares), you have to have a monetary

circulation which will make those long term liabilities/financial obligations liquid. That liquidity

determines the value of those bonds. This 3rd type of monetary circulation is very much

concerned with the liquidity of the capital market. And, because it includes foreign currencies, it

affects the liquidity of markets in other countries. Portfolio money is a very important form of

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international monetary circulation; it’s not just capital exports or imports and not just countries

which have savings placed abroad, it’s making those financial instruments liquid or less liquid.

- Internal corporate money. These are book keeping transfers between subsidiaries of firms,

especially international firms. 40% of the turnover of foreign trade takes place between

subsidiaries of multinational companies. These are not transactions which take place through

markets, they are administrative payments within the same corporation. Because they don’t go

through a foreign exchange market, the don’t have an effect on exchange rate. But they may

affect the exchange rate. It’s important for transfer pricing within the private sector, this is an

important aspect of corporate financial activity.

International monetary circulation ideas. The important thing to remember is that: it is much morecomplex than just production and the needs of trade. If someone tells you that the foreign exchangemarket is determined by exports and imports, he’s wrong; it’s all the other complex factors which enterall of which have international aspects. Shareholders of large corporations are often international sopayments on bonds are made cross border. Portfolio transactions, again, take place cross border today.Production may be more or less international. Ex. Car industry or steel industry are veryinternationalised with different stages of production in different countries. That’s a part of the analysis,the other part that must be taken into account is that there are cross boarder assets and liabilities, that iswhat we have to take into account when looking at international money and internationalmacroeconomics.

4.Overview of the whole courseCommodity Money Basic theory of money exchange rate macro adjustments. Money as a medium of exchange, obtainingits value from exchange; commodity money is not necessarily an actual commodity like gold, it may bepaper money, but it obtains its value from exchange with commodities. From this you get a purchasingpower parity theories of exchange rate, in other words, the notion that over time prices adjust indifferent countries to equalise purchasing power. The mechanism of the macro-adjustment is donethrough the Gold standard or movements of gold between countries. Monetary theories of creditTheories of credit in which credit exists, so you have interest rates, but the credit system is a system inwhich money is put into the bank and then lent out today. What you get from this portfolio theory ofthe exchange rate, the exchange rate is no longer just determined by the exchange of commodities, butit’s also determined by the exchange of capital assets/financial obligations. From this, you get notionsof interest rate parity, the exchange rate must somehow gravitate towards an equalisation of the rate ofinterest, so that the return on financial assets in different countries should somehow equalise, orcovered interest parity where changes in the exchange rate should not set differences in interest rates.Theory of monetary hierarchy: notion that different currencies in the world exist within a hierarchywith the ones at the top being the reserve currencies against which all the other currencies areexchanged.Macroeconomic adjustment through Chinese savings glut and shifts of savings around.Credit theories of money They arise out of long term obligations, giving rise to liquidity preference theories of interest of money,as you find in Keynes, but on international scale. Ex. dollar bonds are the most liquid, low rate ofinterest, lower than the interest rate on Greek bonds because they are less liquid. The notion here isthat international credit is backed by debt. There is a problem here, in that, the macroeconomicadjustment that takes place with international credit is not clear. We will try to look at some of theinternational adjustments that take place, but they are much more complex than the other ones. This is

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one of the reasons why when you’re talked international monetary theories, you are taught either thehistory of the intern monetary arrangements or names and simple versions.

Table of the course:

Table which includes: “Theory of money”, the “exchange rate theory” that is associated with thattheory and, thirdly, how “macroeconomic adjustments” occur within that theory.Commodity or Ricardian money. The exchange theory is the purchasing power parity. The macroeconomic adjustment takes placethrough gold reflux. This is the simplest kind of international monetary analysis and the link withmacroeconomic adjustment.Monetary theory of creditNotion that credit is money put into a bank and then lent out. Notion of portfolio or interest rate paritygiving you an equilibrium exchange rate. The macroeconomic adjustment process is understood as theMundell-Flaming.Credit theory of moneyThe system works differently, the exchange rate is not just affected by production and trade, but it’salso affected by cross currencies credit and debit operations. In other words, a company may haveassets in one currency and liabilities in another currency, making it vulnerable to exchange ratefluctuations. These credits and debts operations affect the exchange rates, it’s more than justspeculation. The way in which macroeconomic adjustment occurs is through investment and tradeimbalances. Although we know it happens in practice, in the other theories they were all worked out byfluctuations in the exchange rate. You also have debt structures. An international economy does notjust have production, exchange, trade, investment, international money to pay for all of this, it also gotdebt structure which needs to be serviced. Long-term credit or equity Long term financial or monetary instruments, bonds or shares, they are also exchanged. They have aneffect on the exchange rate. They are also affected by liquidity operations. Ex. Greek government is dueto repay a large loan, they have no money, they need to refinance and borrow money. These kinds ofoperations affect the exchange rate. The ECB won’t buy Greek government bonds because Germany

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doesn’t want to. To avoid catastrophic issues. So, the ECB lends money to Greek banks, Greek bankstake the money, then they buy Greek government bonds. Money given indirectly. The exchange ratetheory, at the level of credit money with long term credit and debt, becomes very complex. Themacroeconomic adjustment that occurs is through a process of capital market inflation and deflation.Questions:Over time the Greek governments bonds have been more and more bought by ECB and otherEuropean countries. A common system of collateral requirements was needed when the ECB was setup.In a fiscal position of a country: Primary surplus is the one before paying financial obligations. Greeceuntil recently was getting close to a primary surplus. If you are heavily into debt, if you get a primarybalance or surplus, than the debtors and creditors risk switches dramatically. If you have a primary deficit it means you have to borrow more money from a bank. If you get a primary balance or surplus you don’t need to borrow any more money. The risk switches tothe person who owns the debt because he needs to make the repayment, but he could add the amountthat owes without actually paying it. There isn’t a mechanism in Europe for this. You have to have a short financing of your currentposition. The worst thing you can do is default when you still need to borrow money. You shouldborrow money and pay everything.

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TOPOROWSKI LECTURE TRANSCRIPTION

2nd LECTURE – University of Bergamo, Thursday 18th February 2015

Performed by Brivio Ilaria, Ciacciarelli Sophie, Fassina Marco, Tarantino Federica,Tinelli Sara

1. THE BERNANKE THEORY OF FINANCIAL CRISIS

I am going to talk today about the theory of financial crisis that partially we have already discussedlast week: the “savings glut” theory of financial crisis.This theory was performed by Ben Bernanke as an explanation for the American financial crisis.A couple of words on Ben Bernanke. He was a distinguished American monetary theorist and heworked on monetary theories before becoming a chairman at the general Federal Reserve.He was a provident proponent of what was known as the credit view of money. The prevalent viewat that time was that the most important monetary aggregate was notes and coins, and bank’sreserves in the Federal Reserve.The view of monetarist is the basic money supply determining the price level. Bernanke shouldn’tjust look at what was the monetary base. But, he also had to look on how private commercial bankswere developing credit. This is the background.When he became chairman of the Federal Reserve in 2005, he had to engage with much moreinternational monetary theory .The other background feature of Bernanke was that he spent somestudies about the depression in the 1930s and he had come on the conclusion that the depression hadbeen caused by the fact that so many banks collapsed and he saw banks as the place whereinformation of creditworthiness was concentrated. This information owned by the banks was themost important asset and the destruction of American banks in the 1930s, according to Bernanke,had caused the crisis. Now, I would talk about Ben Bernanke’s pronouncements about the financial crisis. Which is theinternational monetary explanation?It’s the Monetary theory and this of credit leads to a “loanable funds” theory of financial instability.It is associated with the particular view which Keynes had about the Neoclassics.Let me put on the diagram showing where we locate the different monetary theories. Today we aregoing to speak about Monetary theory of credit and Portfolio/interest rate parity. The reason why Idivided these theories into this scheme is due to the fact that each of these theories of credit has itsown logical operations.I will explain the Theory of financial Crisis with a couple of quotations from Ben Bernanke, whenhe was already chairman of the Federal Reserve. This theory became the official view of the federalreserve and due to the fact that federal reserve is the most important central bank in the world itcame to be regarded as the official view of all the central banks. First quotation: global “savingglut” and the US current account deficit.This is Bernanke before the crisis, but he is explaining how international money works and howinternational money is connected with macroeconomic imbalances.He said in 2005 that :“…over the past decade a combination of diverse forces has created asignificant increase in the global supply of saving”.This is a pre-emptive idea that saving is independent of investment.This is what is called “a global saving slut, which helps to explain both the increase in the UScurrent account deficit (we’ll come back on this later on)and the relatively low level of long-termreal interest rates in the world today”.For long-term real interest rate Bernanke was referring to US interest rate.11

The federal US government which was running a very large fiscal deficit (the US government wasin the middle of the war in Iraq, intervention in Iraq and activity to support that).He was saving government bonds but finding that there was a huge demand for US governmentbonds, they could sell US government bonds around 3/4% interest rate at this time, which isextraordinary for a country which had a bigger government debt which was, in relation to GDP, onthe scale of the Greek government debt today. In 2011 he came back to the financial crisis and he pointed out that “In 2007, more than 75% ofinvestment from ‘saving glut’ countries was in AAA rated US assets. An asset class that constitutedonly 36% of total US securities”. There was a reason for this and the main reason was that most ofthe foreign countries reserves were held by central banks and central banks typically were notinvested, they don’t find bonds that are less than AAA rated.“The preference by so many investors for perceived safety created strong incentives for USfinancial engineers to develop investment products that ‘transformed’ risky loans into highly ratedsecurities”This was a reference to the subprime mortgages that were converted into AAA rated mortgagebacked securities. Bernanke said that this, rather than low Fed interest rate, created the crisis.Bernanke was saying this because a number of economists stated that the cause of the crisis was thelow interest rate, determined by Central Banks. Bernanke was saying that crisis really was fault of the countries with the saving gluts, principallyChina.“In analogy to the Asian Crisis, the primary cause of the breakdown was the poor performance ofthe financial system, not the inflows themselves”. It is the fault of a financial system when therewas a demand for AAA rated securities , it manufactures AAA rate securities out off poor qualityloans.Three conclusions we can draw from this:1)first of all the primary cause of the crisis and the macroeconomic imbalances was the excessivethrift of Chinese, too much savings by Chinese. The US financial system was passivelyaccommodating, it was mainly putting the customer first (the customer wanted AAA ratedsecurities, the US financial system gave it).2)Financial globalization is good, or mainly is a passive vehicle for “investors” choices. 3)His final conclusion is a common one at that time which is that “better quality control is needed infinancial services”.

2 – THEORY OF MONEY: COMMODITY OR FIAT MONEY

If you take the standard saving identity from the national income accounts, in an open economysaving is equal to:S = I + (G – T) + (X – M)S = saving I = investments G = government expended sharesT = taxes X = exportsM = importsS – I is equal to the Net Private Sector Acquisition of Financial Assets. (G – T) is equal to the Net Supply of Domestic Financial Assets, the exogenous supply in effect ofgovernment securities. S – I – (G – T) = X – M which is equal to the Net Private Sector Accumulation of Foreign Assets.In effect, what Bernanke said is that in the case of the Chinese (G – T) is very small, while S – I and(X – M) are very big.

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Now, if your currency or your money is Commodity of Fiat Money, the Foreign Assets are ForeignCurrency. There are not supposed to be more sophisticated flows. So, trade surplus is matched byan inflow currency.Really, the first explanation of macroeconomic adjustment in accordance to this kind of monetaryimbalance was David Hume’s “specie flow” adjustment. David Hume was one of the firstcomponents of the quantity theory of money and this is a commodity theory of money. The idea isthat if you have a trade surplus, these results in money inflows. The money inflow expands themoney supply. In David Hume’s time, this could be in form of crashes methods. As the quantity ofmoney increased, the higher prices will make imports more competitive and it will make exportsless competitive. So, those exports will be reduced and imports will be increased until the tradesurplus will disappear. We have the primitive notion of international money inflows creating anequilibrium in trade balance. This is still the idea at the back of many people’s minds and this iswhy the monetary equilibrium is associated with trade balance. For example, the Greeks could havethe economy and the money supply in equilibrium if they have a trade balance. The way he shiftthis into the monetary theory of credit is evaluated simply a credit based on monetary deposits. Youmake it a little more sophisticated by save the money inflow goes into the credit system and is lentout. So, the credit system acts more or less as pure intermediary. Bernanke had in mind the idea thatthe Chinese banking system accumulates U.S. dollar credits and these are used to buy U.S.securities: the securities prices rise, lowering long – term yields. Bernanke in principle, when hewas in the Federal Reserve, talked about long – term yields. Are you familiar with what long – termyields refer to? The rate of interest obtained on long – term securities. So, this is the Bernanketheory and it is essentially a monetary theory of credit.

3 – “LOANABLE FUNDS” THEORY

He needs also to take in consideration what happens to this money and what is the circulation of thismoney. The standard explanation is the “loanable funds” theory. Standard because some times agothere was different approaches to the balance of payments. This is very similar to David Hume’sapproach with Fiat currency, but again trade balance is determined by primitive inflation. Thinkingabout the monetary theory of credit, you have that it allows to have a monetary rate of interest. So,you have that it is a standard “real” theory of finance and interest rates. It’s “real” because the rateof interest is supposed to represent not money, but savings. The term that keeps values in thediscussion, Chinese is saving too much. The money earning to American bonds is savings. In theclassical theory, interest is as reward for “abstinence”, or a “postponement of consumption” or“waiting” (Nassau Senior, Mill, Marshall). In the first half of 19th century, the English monetarytheorists Nassau Senior, Mill and Marshall said that the rate of interest is what you get not spendingyour money in assumption. Again, a general discussion of the role of China in the internationalfinancial system notice that Chinese are related to be dealer and postponements of consumption.Chinese living standards lower than Americans. This is a hard documentary because most people indeveloping world have low standards than Americans. In the 30s end of the 19th century, Marxperformed the idea that interest is a claim on “surplus” value produced by labour employed bycapitalists using borrowed money. For Marshall, the interest is payable only on “liquid” capital.“Liquid” capital are the securities that can easy convert into money. Interest is not payable normallyon machinery and so on. As well as now, there is supposed to be a relationship through investmentsand the rate of interest is supposed to be a cost of financing investment. Traditionally, if the rate ofinterest goes up, more would be saved. If the rate of interest goes down, there is a great incentive toborrow money for fixed investment. This leads to the notion of “loanable funds” theory of theeconomics at the beginning at the 20th century (D.H. Robertson; McKinnon & Shaw). This is thenotion that rate of interest equalizes current saving with current investment. AAA savings arerepresenting the capital stock, the accumulated savings in the economy. So, in theory savings are

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supposed to be brought into the equilibrium of investment, but AAA savings are representing theAAA capital stock in the economy. Investment is a change in the capital stock. So, the rate ofinterest is simply equalizing current saving with current investment. Now, what happens to the restof savings that are not affected by the rate of interest? In this theory, just the new saving that isbought on funds market where it meets business investors with profitable projects and the count ofequilibrium of the rate of interest. This rate of interest really becomes a real rate of interest, whichreally is a concept of commodity money. At the back of it, there is the notion of the commoditymoney. The rate of interest is the word for “postponement of consumption” and it represents theextra consume of goods that you can’t obtain. So, the real rate of interest (RRI) is a concept ofcommodity money. This is different from the Fisher idea of the “real” rate of interest, where RRI isthe inflation – compensated rate of interest. It is closed to the concept of the rate of interest that youfind in the Neoclassical theory, where the rate of interest is simply the rate of discount of futureconsumption or income for current consumption. You have this concept that “Real” Rate of Interestrepresents the commodities from surplus produced in the future. So, the “Real” Rate of Interest isunrelated to money or capital flows. That is what you find in the “loanable funds” theory. Bernanke was unconsciously putting forward the “loanable funds” theory, savings were determinedby the rate of interest, but he also taking on the important notion of the English economist JohnAtkinson Hobson. Hobson was one of the idealist of the international finance and his theory is verysimilar to the Bernanke’s theory of the global savings glut. In the case of Hobson, imperialism iscaused by global savings glut. The global savings glut is not because the Chinese have saving toomuch, but is because of the unequal distribution of income in the capitalist countries, which meansthere are too many rich people that do not spend their own money. So, the savings are settledaround the globe and financing imperialistic advents. In this way, we can see the connection withthe past. In the case of Hobson, there is a much greater emphasis with the principles of economiesand he was arguing that the distribution of income is too unequal, while Bernanke was arguing thatChinese are not consuming there are saving too much. Both Hobson and Bernanke believe that thefundamental course of capitalistic nations is that people do not consume enough.

4. MR KEYNES AND THE “NEO-CLASSICS”

They are not the classics, but the neo-classics.The previous part of the lecture I did talking about the great English physical-economist Hobson,look at his theory of all the savings Hobson was and you could see at his some aspects, Keynes reliable, in one aspect in particular. Hobson and Keynes represented, and always represented, the ideas of the politician of interests, thepolitician at keeping get financial revival Hobson was the opponent of this and argued that the impair was in fact the drain on the finances ofthe British straight. And in the late 1914 and after the Second World War, just at the point it has thateveryone believed that it was with triumph of Keynesianism, he was in fact triumph Hobson. For the rest of this lecture I’m going to talk about some ideas of Keynes, and in particular hiscriticism of neo-classics. All of you I hope are familiar with the criticism that Keynes put forwardthis generally theory of what Keynes called “neo-classics”, the people who believed in free trades,the quantitative theory of money and the tendency of the economy to follow employmentequilibrium; all of which has been denied.Very few people know is that Keynes also used the term neoclassical, and used it in a very veryspecific sense. If you get any edition of Keynes’ general theory and you look in the index you’llfind the nature of neoclassical and you probably find this quotation “Unlike the neo-classicalschool, who believes that saving and investment can actually be unequal, the classical school properhas accepted the view that they are equal”

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What did Keynes mean by the “neo-classics”? Keynes meant by the neo-classics, people likeWicksell, Hayek, Hawtrey, Robertson and until recently himself. What was the main idea behind the neo-classic theory? The neo-classic theory was that saving wasnot input to investments, but, and this is the important thing for macroeconomics and for thedynamics of the economy, the difference between saving and investment is what createsdisturbances in the economy, cause the economy can have a boom or a recession. At this time theneo-classics like , Robertson, Hayek, Hawtrey and Wicksell, argued that the difference betweensaving and investment is in effect credit creation or credit repayment. They did have this idea thatyou take your saving and you just keep it on deposit; if you did then you will be lent out again forinvestment. Hayek actually had an intermediary position of it, because he argued that this credit creation wouldactually give rise to force saving. If investment was greater than saving, the difference betweenthem would be made up by bank loans and the bank loans would create inflation and the inflationwould cause prices to rise because real wages to fall. So the falling real wages was what Hayekrefers to as forced saving because in effect the economy saves, makes up the difference betweenvoluntary saving and actually investments by the reduction of the living standards or the reductionin consumption of workers. This is Hayek force savings. The origin of this idea really comes from Wicksell. Wicksell, in 1890, argued that credit creation isreally determined by the difference between the money rate of interest and the natural rate ofinterest. The natural rate of interest was a kind of real rate of interest; it’s a marginal return onproductive capital.Wicksell was a neo-classic who believed that capital has a marginal return, that is profits marginalreturn on capital not that profit is the surplus of labor.This natural rate of interest was a money rate of interest . Then entrepreneurs will borrow money toinvest, and this would create an investment, and it will cause the cumulative process of economicexpansion that would gained up boosting the economy and eventually link to inflation. What wouldhappened maybe is that banks in the process of this boom start to losing their reserves, they start tolosing gold, they start to losing coins; the way banks would react it would be by raising interestrates. So eventually this difference will disappear. Similarly and conversely natural rate of interestfell then the natural if fell below the money rate of interest then entrepreneurs will not invest andthe economy will contract. So this was a theory of credit cycles and it could use if it makes up atheory of business cycle. The issue that comes out for this lecture is “why did this low rate ofinterest in the US not simulate an investment boom in America?” It should do that, but it didn’t.There are also several explanations. One of the reasons is that investment is not driven by the rate of interest. If you look at the data ofthe rate of interest and investments you find that both of them are procyclical, variables, they bothrise in a boom and fall in a recession. Wicksell knew this, and that was why he said it was not the rate of interest, that itself determinesthe business cycle, that determines the boom of all the sample and determines the rate ofinvestments, but it’s the difference between the marginal return of capital, the real rate of interest,and the money market rate of interest. And this is, in effect, what happened in Wicksell was thatsaving was catching up with the level of investments, but saving just not equals to investments. Inpractice we know that saving, actually, if you take a closed economy with no government, savingalways equals investments. It’s not just by definition and not because this is a national income,accounting identity, but because there is something else which is disappeared out of the economy,out of economic analysis and that is the circular flows of income. The incomes generated in aconsumption sector represent the consumptions in the economy and the incomes generated in theinvestments sector represent saving.More generally, if you take this, if you accept this national income identity and circular flow ofincome or if you start looking to the schemes of the production in Marx’s Capital, Volume two, you

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find that saving is equal to total investments + fiscal deficit + trade surplus , what I showed youbefore. We can use this to examine, to understand the great Chinese saving glut. In China there is a veryvery high level of investments even today, but let’s say in the 1990s and the first decade of thiscentury, it was something like 40% - 45% of GDP put into fixed capital investments?In practice China has a very small fiscal deficit and it has a very small trades surplus (possibly nowa deficit). It’s more or less balanced. In effect it’s this free high level of investment which means that total saving in the Chineseeconomy is extremely high, it gives you very very high saving rate. In the US the situation is much reversed. In US total saving, as a proportion of GDP, is around15%, that is remarkably low. There’s a very large fiscal deficit and there’s similarly large tradedeficit both of 5-6 % of GDP. So the trade deficit offsets the fiscal deficit and this is a negativeeffect for US. Likely China it is at first investment that determine saving, and precisely becauseinvestment is so low, it appears that the US is saving very little. Instead in the case of China itappears as if china is saving a huge amount. But Chinese saving is not the postponed consumptionof Chinese population, it’s not the fact that living’s standards in china is so lower compared to US.In fact most saving in China appears as saving, not of households, but of firms. And you can findthat the big accumulation of savings in china is in Chinese firms and in particular private sectorfirms. So at this point the theory starts to fall apart: it’s not Chinese consumers that are postponingconsumption and investing and buying American government bonds until the moment when theywill be consuming in the future; it’s, on the contrary, Chinese firms that are investing massively(particularly the state corporation) and the result is an accumulation of savings in firms and inparticular in private sector firms. One other thing that comes out, what Keynes call neoclassicalposition, is that in confusing savings with credit, it assumes that all banks do is take saving andpass it onto someone else, and let’s say the case of Chinese saving are passed as loans to USgovernment. It not only confuses saving with credit but it also confuses saving with savings. Thiswas something which Keynes pointing out in his treaty on money and there is an important differentbetween them. Saving, as are saved before, is current income that is not consumed; it’s a flow ofincome over a particular period of time, and this flow is an addition to financial assets. Instead,savings themselves are another flow that are the total stock of financial asset, which if you like ismade up of the cumulating saving of the past. What Keynes is pointing out on his treaty of money isthat the relationship between them is very important, and very unlike what the loanable funds theorysuggests, because if you look at the financial market, the market for security is divided up in two:the primary market (new sec issued) and the secondary market (already issued securitysubsequently bought and sold). Now, why is this distinction important? Because the secondarymarket, according to Keynes, was the market in which the rate of interest is set. So it is not set inthe market of new securities, and the buying and selling assets and liabilities traded in secondarymarket they don’t just cancel out. If we go back, I said that savings minus investments is the netaccumulation of financial assets, and it was the addition to savings of the private sector, but thisdoesn’t mean that the rest of the savings are totally inactive; they’re not inactive, because peoplemove their portfolio around and change them, and it’s in changing their portfolio around that, asKeynes argued, that is where the rate of interest is determined. So, in terms of the financial system, but also the international financial system, this intermediatesnot only current savings, but also provides liquidity against total savings. The reason why you havea secondary market is in order to provide liquidity for existing savings: so I can take a long-termbond and sell it. It also accommodates shifts between assets and liabilities, and these shifts typicallyoccur as quite frequently in balance sheets. In particular in private sector corporations you havefirms borrowing short-terms to pay long-term debts, or they re-issue shares to repay short-termdebts; they may sell long-term assets to build up liquid or short-term assets. It’s common forexample for corporations to sell, let’s say an office building in which they have headquarters, it’scommon to sell the office building and then lease back the office building, so they stay in the office

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building; the money that they get for selling the office building, they put into a bank deposit, so thebalance sheet becomes much much more liquid.In private sector finance, everyone understands this; unfortunately, the people who owe Greece’sgovernment debt don’t understand this. I think that they have their debts, they must pay them ontime, but no one pays them on time. In the private sector, no one pays, free rate debts are paid ontime. Typically they’re refinanced earlier, they get an opportunity to refinance earlier.It’s the shifts that arise in the markets and become very very important indicators for economicactivity; and use money, as I said in the last week’s lecture, there is a surplus of money going on,and it’s what, if I go back to my diagram, it’s why in the end this monetary theory of credit isunsatisfactory, it doesn’t explain what happens in the financial market, it’s an oversimplificationthat secondary market, if we start looking at it, start on act in it, to see what’s happening there,that’s what takes you down to long-term credit and the operations of credit markets.When Keynes was writing his “Treatise on money”, he was looking at it purely, or largely, assomething that’s domestic at the internal financial markets. I think we have to go beyond this, now,and say that there is an international financial system which is in many respects integrated andwhich allows this kind of shift in assets and liabilities to occur not just between short and long term,but also between currencies. That’s what we will be doing ready in the later lectures.But I now really come to my conclusion. The essence of the Bernanke “Savings glut” theory is thatis essentially a monetary theory of credit, based on a distinction between saving and investment thatreally takes us back to the theories of Hobson and early Keynes. In the case of Hobson, the notionthat these excessive savings are the foundation, are founded on an unequal distribution of incomeand on the foundation of imperialism, which today we consider, you know, it’s not a diplomaticterm. Bernanke would not accuse the Chinese of being imperialistic, but he’s happy, or theAmericans are happy for the Chinese to hold the American government debt, possibly for the samereason that the Greeks are also happy for the Germans and everyone else to hold Greek governmentdebt, because it means that everyone else has an interest in the survival and the financial viability ofthe Greek government. I think in the case of Hobson was a particularly…you know…political-economic interpretation,distinction between saving and investment: in case if Keynes and Wicksell, Hawtrey and all theother economists at the early part of the twentieth century, for them this was the distinction betweensaving and investment with the foundation of the business cycle, and created instability.From a more modern perspective, we can say that what’s wrong with these theories is that theyconfuse “saving” with “savings”. There is a constant shift between saving and savings, there’s alack of understanding that where the saving come from; it’s not due to under-consumption, orpostponed consumption in the case of Chinese, but it is due to their high level of investment.It confuses saving with credit, because credit is supposed to be the same as saving. The financialsystem is reduced to being just a pure intermediary with people who have savings, or who aresaving, putting their money into this intermediary, and the intermediary lending it to someone else.And that actually is the standard feature of the American finance theory, and either the Diamondand Dybvig model of banking, even the Diamond and Dybvig model of maturity transformation it’ssupposed to explain financial instability, but it essentially just presupposes that there’s an agent whoacts as a pure intermediary.So this confusion between saving and credit, I think my fundamental objection to this kind ofanalysis is that it doesn’t explain debt structures. Debt structures are washed out into just simplyborrowing or lending, and differences between short-term and long-term disappear in all of these.What I’m going to do in the remaining lectures is that I will look, I think I will first of all examinesome more of the macroeconomic adjustment, that arises from this kind of theory, which isMundell-Fleming interest rate equalization theory. But I will then, what I will do afterwards, I willstart to fill up what I believe that is blank spaces around here ready that haven’t been developed, butyou won’t find on textbooks, because no one talks about a pure credit of theory of internationalfinance and its macroeconomic implications, all of this is supposed to be, all of this is reduced to a

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very simple case of pure intermediation of savings, and this is not thoroughly inaccurate, but itgives strong explanation of where credit flows come from, and the relationship to stocks andsavings, the relationship between different rates of interest, and in particular their relationship to theexchange rate which we haven’t dealt with today.So this concludes my first lecture, I hope you have questions on this.

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TOPOROWSKI LECTURE TRANSCRIPTION

3rd LECTURE – University of Bergamo, Friday 19th February 2015

Performed by Brando Viganò, Claudio Iacopino, Simone Perego, Michael Ravelli

Today I’m going to talk about the global macroeconomic imbalances and neomercantilism.

This what I’m doing is continuing what I did yesterday which was related to talk about thegold influx today I will say something about Mundell-Fleming really looking more at thismonetary theory of credit.

The logic that all the working out monetary have using is a monetary theory credit tounderstand the international monetary system.

Now the monetary theory of credit as I keep seeing it in the last two lectures is really routedin the idea that foreign currencies are accumulated through trade imbalances so we will talkabout macroeconomic imbalances which really mean as trade imbalances and in this a keyrole is played by a so called neomercantilism.

So I will explain today some more about neomercantilism and in specific domestic saving andthen what the connections between them then look at even comprise that and examine wherefirms’ saving comes into analysis and then this leads beyond to the limits to neomercantilism.

And we will get on to the more interesting topic which looks forward to credit approach thatis international monetary integration.

Before we can finish with monetary theory of credit or monetary approach to credit we needto conclude with the Ricardian approach to international money related to which this is thefoundation of the optimal currency area theory of Mundell-Fleming which postulates aparticular type of macroeconomic adjustment with commodity money then I will give myexplanation of critique of international commodity money and end up with internationalmonetary endogeneity .

So in this lecture like in the other lectures we are looking at the standard textbook approacheswithin a resolution in monetary theory of credit and then trying to move beyond those intocredit approaches to international money.

“Neo-mercantilism”

Neomercantilism is well known concept nowadays it’s a trade and industrial policy ofmaintaining trade surpluses as part of export led growth, it’s a school of thought based on theidea you can obtain growth through having a trade surplus which is necessary to have growth.

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The other traditional reason for having an export surplus was to accumulate foreign exchangeand the gold reflux principles of I talked about yesterday of debit due this was in fact acritique of mercantilism debit due was an effect arguing that you cannot accumulate moregold without affecting your price level in the idea would if affect your price level it cannotaffect your level of output in such a way of getting growth.

The mercantilist theory is based on the principle that money accumulation stimulates growthas I said, Hume has criticized this because He argued that eventually it leads you to loseinternational competitiveness.

Export led growth experienced a renewed of interest in the work of Nicholas Kaldor in a lot ofhis development economics hicks where he explicated export led growth a particular becauseof the post war experience and Japan since the 1980s Germany since 2000 and some peoplesay that it’s true also for China.

I mentioned this examples because it is forgotten nowadays that the japan traditionally in thepast was not an exponent of export led growth, in post war period in 1950s 1960s and in themost of 1970s Japan periodically hit an export sealing and it’s development was frustrated bybalance of payments deficits

Most countries as their economy expand their imports rise their exports rise at the same time,so typically the foreign trade balance is a bottom neck for growing economies and this indeedwas the case in Japan and also the case in the post war Germany and I think we will see is alsothe case in China.

Nevertheless the economists like Kaldor believe that you could get an export surplus as asustainable position, similarly the IMF and the world banks base their policies on the idea thatcountries can obtain export surpluses.

Neo-mercantilism and domestic saving

So now let’s go to neomercantilism and domestic saving so let’s go back on the nationalincome identity account that incoming be equal to consumption plus investment plus thefiscal deficit plus the trade surplus, this is what I did yesterday so I didn’t go into it today.

Y = C + I + (G – T) + (X – M)

S – I = (G – T) + (X – M)

You get from this I can rearrange this so you can end up with three balances:

The private sector balance (S – I)

The government sector balance (G – T)

The foreign trade surplus (X – M)

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So that you have from this private sector balance a net financial accumulation so they say NETfinancial accumulation it means the financial accumulation net taking away financial assets orclaims against other sections of the private sector.

Net in this sense because in actual fact private sector accumulation of financial assets will nobe really much much bigger than this but this is taking out or cancelling all the borrowing andlending in the private sector.

So the private sector net financial accumulation is equal to the fiscal deficit plus the tradesurplus.

This leads to what has been advanced by the Levy Institute as it’s sometimes referred to thethree balances approach of Wynne Godley and Randall Wray.

In other words the idea that is necessary to have a fiscal deficit plus some kind of tradesurplus neomercantilism in order to maintain financial accumulation and to give you aneconomic boom.

Godley himself attended to be a little bit sceptical of when you could get this kind of privatesector financial accumulation in particular because he believed that if you expanded the fiscaldeficit too much you tend to reduce the trade surplus and in fact the one offset the other onewhich in the time he was writing actively during the 1980s, it was the case of UK and US, ifyou look at the size of their fiscal deficit it’s more or less equivalent to the trade surplus so theone cancel the other.

So Godley was a little bit sceptical on neomercantilism but on the whole he was close toKaldor and very much abdicated this idea that a trade surplus is a desirable thing because itleads to an economic boom.

Why I think this is need to be unpacked, because it’s only one part of the picture in fact theprivate sector it’s not just one sector, there are number of interesting things about thisapproach, it’s good we have now figured the flow of funds accounts which support this kind ofthree balances analysis, but it misses out some fundamental complexity in the model, inparticular it misses out the fact that the private sector is not one homogeneous agent but itconsists of different classes and even as economic agents it consists of two particular classesof agents, households and firms so that strictly speaking in the flow of funds this will bedistinguished.

Now If you do this you can divide up saving in to saving of households and saving of firms sothat can be total saving equal to saving of households and saving of firms which is equal toinvestment plus the fiscal deficit plus the trade surplus.

S = SH

+ SF

= I + (G – T) + (X – M)

If you move this (Sh) around you get really the most interesting equation which is that thesaving of firm is equal to investment of firms minus households saving plus the fiscal deficitplus the trade surplus and this is the most important distinction.

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SF

= I - SH

+ (G – T) + (X – M)

The significance of firms’ saving

This is why the distinction is to be made in this kind of analysis, because what you have now isa relationship between saving of firms which is net financial accumulation and the saving ofhouseholds and it’s not the case that the saving of households actually improves and helps theeconomy because it gives money to firm and we know that more savings means moreinvestment, in actual fact if households save more than it means that firms will save less.

The original idea of this goes back belonging to Karl Marx, who argued that holding of moneycould have two effects in the economy. Holding of money can be that on one hand it givesfirms the money to invest or the finance or the liquidity to invest and to expand the economicactivity, but in the same time holding of money can also congest the economy meaning it canstop circulation in the economy, because if households save money than it means that theyhave received income from their employers which employers do not receive back again assales revenue. If a car worker is paid wages and saves some of those wages it means that hisemployer and all the other employers in the economy don’t receive back all the money theypaid to workers as wages and they don’t receive back as sales revenue.

So this is a very very important distinction.

Let me expand on this even further and look at what is the significance of saving of firms.

The saving of firms is the net financial accumulation or the net cash flow of all non-financialfirms or businesses after payment of interest and dividends.

The saving of firms is the way in which firms accumulate money and that saving is thefoundation for the future growth and this financial accumulation may be added to thereserves of firms in order to finance investment or to repay their debts. It’s the source offirms’ liquidity; it gives them bank credit without indebtedness.

Nowadays we are in a credit economy in monetary theory of credit, the financial accumulationof firms’ saving is money that is added to their bank account without them having to borrowenough money. They can use it to finance investment and to repay debt as well. It facilitatesinvestment, investment being the process of circulating liquidity around other firms. If a firminvests using its own reserves, it’s taking those reserves and circulates them around otherfirms. The reserves leave the account, leave the balance sheet of that firm and spread aroundthe balance sheets of other firms.

This is in contrast to households saving where households’ saving is as I said a deduction fromfirms’ cash flow.

The relationship between them is fairly straightforward.

You can put a 45 degree line that suppose that the level of households’ saving is this amountS0, it has negative sign because it’s a deduction from households’ saving.

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If firms’ investment where 0, then firms would have a cash flow deficit of the amount ofhouseholds’ saving. So at 0 investment, firms’ businesses lose in every period.

Limits to “neo-mercantilism”

What firms need to do is to invest at least as much as household saving if they want theiroverall balance to be balanced. The more firms invest the more money they will receive. Whyis this important? Because this is a domestic business consideration. It’s important because inmost countries this relationship between investments minus households saving is moreimportant and significant than the fiscal deficit and the trade surplus. So this is why theincouragment to save is not desirable. And this is why the encouragment to run a tradesurplus is maybe necessary for exchange rate reasons, and is something like Bretton-Woods,but otherwise it is not essential for a country.

Secondly, this is even more important, a country is not one firm that requires balance for itscurrent account, this is one of the fundamental errors in a lot of the discussions about theeuropean monetary union, too much emphasis is placed on the trade balance ignoring the factthat within a monetary union it doesn't really matter. So this is one reason why the tradebalance is less important. A third reason is that there aren’t just firms in the economy, when Italked about the significance of firms saving (the net financial accumulation of firm) I said thatit affects the firm’s sector as a whole, but the firm’s sector as a whole consist of different typeof businesses, in particular small and medium size enterprises, a crucial component of theinternational financial system, a multinational cooperation operating each of which operatesan internal financial system using transfer pricing.

Transfer pricing occurs when trade happens between subsidiaries of the same company. Forexample Ford, which makes his engines in Germany but also assembles cars in Italy, while theassemble line in Italy buys the engines in Germany and buy them at a price which isdetermined by Ford, it’s not something that goes to the market, because the subsidiary in Italydoesn't have a free choice of where to buy its engines. What this means is that the transferprices traditionally they have been used to make profit disappear in one place and reappearsomewhere else. If Italy has a higher tax rate than Germany, than it make sense for the

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engines exported from Germany to Italy to be exported at a high price so the profit appear inGermany, and Ford pays less taxes there.

If they want the profit to appear in Italy they lower the price of the engine from Germany. Sothis is transfer pricing, it doesn't need to happen internationally, it can happen just within twosubsidiaries of the same company. Lets say the company wants to book a loss, maybe becauseof the tax reason, so this is one way in which the transfer price is used. Is even easier for amultinational to operate internal debt system. For example there are many multinationalwhich have their headquarters in Ireland, because Ireland offers a very low corporate tax rate.In many case they don’t have any business operation in Ireland, but they have headquarters inIreland and thay want to make their profits in Ireland, how do you do this? Well you run intothe books of the company’s subsidiaries in Italy or in England a loan from the headquarter, aloan that is used to buy management services, and of course interests have to be paid on theloan, interests are deductible, repayments of the loan have to be maid, so an internal systemlike this is a way in which make out a balance sheet, but you have to have a company withsubsidiaries.

So in this sense when we talk about firms benefiting from cash flow from a trade surplus,actually that cash flow is very elastic, multinationals can benefit even without a surplus. Theother limitation is that near mercantilism can be reinforced or weakened by a veryconcentrated export sector. One of the reasons why Japan and Germany have a very strongexport sector is because their export sectors are highly concentrated. In Germany for examplethere are maybe 5 corporations which accounts for something like 80% of Germanmanufactoring exports. There is a similar situation in Japan, also in South Korea. So on the onehand this concentrated corporate sector has power and exercise influence on the governmentto facilitate exports, so it becomes a kind of lobby group, near mercantilism become a politicalphenomenon, for these reasons you find countries be able to follow near mercantiliststrategies.

On the other hand there are countries such as Italy, Italy has a strong export sector but isfragmented in a lot of small and medium size enterprises, it doesn't have a powerful orpolitical voice. So a lot of near mercantilism comes from this, from such peculiarities ofcorporate structure and finally from this near mercantilism analysis overlooks is that firmsthemself engage in financial operations (multinational companies internal debt structure) butit also means that firms can obtain liquidity from those operations, and that, maybe even moreimportant, having a trade surplus. Near mercantilism is not just an economic phenomenonand it’s not just trade surplus, it’s much more complex.

International monetary integration

Let me introduce at this point another limitations on near mercantilism and the monetarytheory of credit that we are looking at. This is the issue of international monetary integration,this is something that was common before the first World War and the gold’s standard, themechanisms broke down, and Bretton Woods international monetary integration was highlylimited, but we now have since the 1980s a new face of international monetary integration,which is about capital movements between national currencies that affected the exchangerate adjustments. What it means is that, you also get cross-border capital movements withincurrency areas, as the European Monetary Union, but also other currency areas around the USdollar, there the capital movements may not affect the exchange rate (can not affect the

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exchange rate), but very often the banks balance sheet are not integrated. In integrated bankbalance sheet is a balance sheet that has foreign assets and liabilities.

The key liabilities for a bank are deposits in local currency, which its counterpart is loans inlocal currency, bonds in local currency. And then foreign currency deposits, and thecounterpart of this should be foreign currency loans and bonds. So what very often happenswhen bank balance sheet are not integrated is that they don’t have the element of foreigncurrency deposits, foreign currency assets and liabilities. Even Deutsche Bank, which operatesin most countries in the European monetary union, it operates with subsidiaries. In otherwords there is an Italian bank called Deutsche Bank, registered in Italy which has an Italianbalance sheet with local assets and local liabilities. The capital movements in a currency areawon’t affect the exchange rate, the bank balance sheet may not necessary be integrated.

The cross border bookkeeping transfers are important, but ones you start gettinginternational monetary integration, there is more than just money being transfer, there arecredit operations, and those credit operations they not just sum up to zero, they do haveimportant effects. So I really mentioned the international monetary integration as a way ofhighlighting that with near mercantilism, they still do not take into account the properinternational credit operations.

The Ricardian approach to international money

Let me just conclude on the question of commodity adjustment, in the end, commodity moneyor regarding money treat money solely as a medium of exchange, this is the essence ofcommodity money and I could this Ricardian fairy because this is unfactual moloch call it andMarx give the definition of it; he said the Ricardian fairy of money is the money that princeabout the efficient parthian an efficient exchange of commodities.

What does it mean seems that if u have efficient part then you are left with know money incirculation you are left every one through get money and they have the commodities theywant, what this imply?

It’s a very important thing if there is money accumulation it means the barter has beenincomplete, because someone has sold some commodities and custom board othercommodities.

This is why in the end the commodities approach is not satisfactory, and the commodityapproach to international macroeconomic adjustment the go reflag method is not appropriateand suddenly it means that new mercantilism is signed of incomplete disequilibrium ininternational monetary economic system.

“Optimal currency area” theory

Let me move on to optimal currency area theory because it brings much more to the kind offerried which inform monetary theory.

Optimal currency area theory and which is the fundamental theory which underlinesinternational economic decision making, the approach to the not just only European economic

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union, but international monetary arrangements those arrangements in Europe which areknow in such crisis.

The theory is originated to Robert Mundell economist (Canadian) and John Flemming(English) to put out similar theory more less at the same time. Both came to the conclusion atthat is specific true the mood of Flemming approach arguing that under floating exchangerates monetary policy is affected with three capital movements, I think it could besummarized in the formally of IS-LM analysis with international interest rate adjustment tothe global average interest rate.

But it’s not necessary to much simple to say that what happen on the floating exchange rate isa lose of monetary policy, I give low interest rate and this lead to a capital outflow becausecapital moves to countries whether interest rate are higher. The capital outflow gives straightto an exchange rate depreciation which gives right to an export lead boom.

So in the Mundell-Fleming analysis if you have 3 capital movements a monetary policy iseffective because through the exchange rate channel a fiscal policy by constraints it’ ssupposed not to be effective because you follow lose fiscal policy you end up with higherinterest rates and higher interest rate will result in a capital inflow and the capital inflow willappreciate interest rate make your exports uncompetitive and make your imports morecompetitive and the economy shift to the origin you unaffected the fiscal similes is offset bythe white mink trade deficit.

This is the Mundell-Fleming in a sense it’s a counterpart to godless ideas that the exchangerate affect trade balance is offset any fiscal imbalance. By constraints if you have tightmonetary policy than you end up with higher interest rate discourses a capital inflow whichintern causes an exchange rate appreciation and it leads to an exports contraction.

Mundell-Fleming say that monetary policy is the way to regulate the economy and it workthrough the exchange rate channel.

He then introduces asymmetric shocks by 1960s economists called shocks to explaineverything what they couldn’t explain: an asymmetric shock change under the fact that thereis equilibrium in a country and not in the others.

Probably a more sensible way tearing is to have no currency business cycles, if we have arecession in Italy while not affect another countries the Mundell-Fleming view requiredifferentiated monetary policy in particular because fiscal policy in nationality assistant work.If you have, for example, country full employment and there are other countries which haveunemployment you need to huff differentiate monetary policy; or if you have a country whichhave a trade surplus which should have a lower rate interest and countries with trade deficitand higher interest rate to attract capital inflow and the exchange rate give by balance trade,country with deficit may have lower rate interest to make currency depreciate and thereforegive them the hope for export.

In Mundell-Fleming puts forward the system for international adjustment, the alternative wayjust think it’s through the labour market by changing weight rate, for example, if u have an oldprice shock, the example (took from Mundell) was the old price shock in 1970 s whencountries import like is native Canada had large trade deficit, the Mundell argued that the

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exchange rate evaluation is an alternative to cutting wages in order to expand export, the ideais that the alternative way of making your export competitive.

Macroeconomic adjustment with commodity money

This really is a peculiar idea in Mundell-Fleming cause it’s an idea comes from commoditymarket theory and really goes back to the original macroeconomic adjustment that we hadwith commodity money in the theory that was put forward by Marshall-Keynes, so theintellectual inspiration of Mundell-Fleming is that the adjustment happening through labourmarket or through the exchange rate.

It have origin in the critic of Marshall and Keynes critic at the gold standard this is knownfrom Keynes book; Keynes put forward through his books he was attract on monetary worldin 1923, and in up book and subsequently after Marshall died Keynes put forward someMarshall’s monetary theory and he argued that monetary policy it’s not just affect exchangerate but also affect rate on domestic investment. In particular you have the problem if u aremaintaining a fixed exchange rate as happened at the gold standard then you need to race alower interest rate in order to regulate the level of reserves in the economy. If you raiseinterest rate then you got capital inflow with the gold deposit to derive in your financialcentre if u lower interest rate the gold deposit will leave your financial centre.

So to regulate you have to race interest rate on gold deposit, both Marshall and Keynes believethis may completely distort the domestic economy because if u have a country in recessionfacing at the same time a trade deficit it would be necessary for this country to raise interestrates to attract reserves, gold reserves in this case, because if you didn’t raise interest ratesyour banking system could rapidly befogs into a crisis. And crisis would happen because ofwhat know is drain at that time in 1970s two gold drains or two councy drains; first of all ifyou had an economic boom then the gold reserves come up to the bank going to thecirculation, they would go to someone else bank circulating around the economy; the secondlydrain is if u had a country imported more during boom them more gold abroad to pay forimport, if this happened simultaneously will happen a banking crisis and as I said in my firstlesson, this is still a banking crisis view of what goes wrong in the economy in a financial crisisis not a sophisticated credit view of the crisis, long term view of crisis.

Keynes regarded the gold standards as a baric relic; he said that as result of this inflexibilitywhat country need is a fixed exchange rate assert to assimilate international trade and certaininternational trade, but you should have the exchange rate should be flexible in that if therewas a claire case structure if you have deficit in your trade balance it should be adjust yourexchange rate.

Fixed but adjustable exchange rate can stay with this position all the way through to right outto break moves even if he was wrong, why he was wrong you need to come here next week toknow!

In particular I think I miss innovation that Mundell-Fleming make practiced in upon economyis couple flows and not trade that determine exchange rate and in term Mundell-Flemingargument in Keynes time: the capital flow depends in interest rate choose understanding onenowadays it was century circulate the US Brazil carry trade, in the past there was Japan,Brazil-US carry trade if you can get a high interest rate in Brasil it is worth wild borrowing

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money in dollars, for the dollars in NY converting them to Brazilian Real and place in the Realon deposit for 3 /6 month; if you put lot of money you get a lot of interest then when ininterest much great then the interest that you paid on borrowing the dollar in NY.

That’s the goal of carry trade, it’s a standard system/techniques in international speculation.

Can you tell me what can go wrong with it? Student: they can convert the exchange rate. Yeahthe exchange rate risk. That’s why these people don’t sleep at night. You have to do a lot ofmoney to make a profit on the margin. So this means that you have a lot of money at risk.Capital flows also depend on expectations. Expectations on future interest rate, exchangerates and asset prices. And this is in a senses one of the reasons why currency boards tend toend up in the financial crisis. Because if a currency board if a fixed exchange ratearrangements lasts a long time there is a tendency to believe that it will last forever. And youare more likely to move money into an unsuitable currency. Infact Mundell in his originalpaper (1961 paper) in the american economic rewiew assumes stationary expectations. In1973 infact Mundell pubblished another little book (uncommon arguments for commoncurrencies) which actually he starded to see the floor in his arguments that the exchange ratecould be a substitute for wage flexibility. Could be a costless substitute for exchange rateflexibility. Because if you have an exchange rate devaluation this is in a smaller country with alower real incomes and this will offset the export trade benefit of a devaluation. Let me giveyou an example, a present example, the case of Greece. 40% of all goods and services whichare consumed in Greece are imported. It’s not possible for Greece to have its own currencyand depriciate it without this affecting greek real incomes. If Greece want to introduce its newcurrency then Greece wouldn’t have the same amount of import. If we are talking about alabor market adjustment in effect any increase in employment in exports would be offset by adecrease in employment for the domestic market. And this is why devaluation for smallcountries doesn’t work. Even without excluding the cost of the debt. So what we find withMundell 1973 is a shift in his thinking, more towards recognising benefits of pulling foreignexchange reserves, if a number of small countries get together and pull for an exchangereserve it is easier to manage their exchange rate. This is the possibility of sharing the burdenof adjustment of a foreign trade shock. In other words in case of a foreign trade shock,reserves can help to hold the situation stable while the economy adjust through fiscal policiesand then by spreading the costs of adjustment over time. What is the conclusion that comesfrom this? It is the idea that a large currency area is superior to a small area. A large currencyarea should give you more flexibility. In implication a large european monetary union is betterthan a smaller one. What i think is wrong I feel uncomfortable about these theory postulatedrelationship between abstracted countries or agents in markets.

Critique of international commodity money theory

We are moving towards the end of this lecture. Now we discuss what i think is wrong of thisinternational commodity money theory. Firstable there is no uncertainty and speculation.This is a standard keynesian view. Reinforced by the fact we start having the possibility ofexchange rate adjustements then this adds to the uncertainty the future uncertainty, and addsto the possibility of speculation. There are a lot of people, a lot of economist that argue thatspeculation is really the problem. And many politicians as well. Secondly there is the creditnature of international reserves. International reserves are in effect claims on or deposit ininternational commercial banks rather than central banks. In this sense we had been inBretton Woods system for over 44. Secondly there is the International integration of bank

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balance sheet which reinforces the credit nature of international money. But we come on thisnext week.

International monetary endogeneity

One element of this is intenational monetary endogeneity. Now in effect floating exchange ratea privatisation of international money. What happens is that goverment and corporationsborrow increasingly from syndicates of international banks principaly american ones andinternational credit flows don’t go through central banks anymore. we have lending ondemand until the third world debt crisis broke out in 1982, this was eventually refinanced bythe IMF and the world bank written off for poorest countries or rifinanced into rising in thebond market. With the bond markets you have the rise of credit rating agencies, theelimination of reserve requirements in favour of capital requirements with the Basel accord in1988. In effect moving towards the Wicksellian pure credit banking. This means that theinternational monetary system is time to behave in a more more dysfunctional way. Yuo havemany developing countries for example Brazil eliminated change controls in order torefinance government debt into domestic debt. This is an operation which is important tounderstand. If a government has foreign debt the foreign debt is unmanageable depends onthe import for currency reserves and on money coming from exports. So if you can getportfolio capital inflow then what this does it would generally boost the local stock marketand the government can afford sell bonds or privatisation share issues into the domesticmarket use the proceeds to buy the dollars coming in and repays foreign debt. A good exampleof this is Mexico in 1989. Mexico was a heavily indebted country and the government wasunable to make its payments on its dolllar debt and this precipitated in 1992 crisis. In 1989the american government which was uncomfortable about this infact if mexico had forced intothe financial crisis 120 milion mexican could pass the border. It could be a serious problem forthe US plus the US have so many interests in mexico so they offered a way to guarantee themexico foreign debt but with higher interest rate, and so mexico obtained the capital inflow indollar. The dollars were exchanged for pesos the government issued new bonds took thepesos back and used the pesos to buy dollars from the central bank and so It convertedforeign currency debt into domestic currency debt.

In effect what we have is that official financial institutions after 1989 or after 1992 came backto guarantee the international credit system via government borrowing. That what happens inall cases from IMF refinancings in 1980 to troika today. What the official agencies do, Theydon’t guarantee the international financial system directly but they guarantee through thegovernment borrowing. In the case of IMF and world bank they do not create money throughopen market operations but they lend money to governments so the balance sheet consists ofclaims on governments. So in effect IMF and world bank have no liabilities. In modern timethey do exactly the same with Iceland and Greece. The situation now becomes morecomplicated because with the independent central banks, governments don’t have centralbank to manage bond markets and this is a particular problem because what we have seen inthe last crisis governments take over the liabilities of banks in crisis. Iceland being an exampleof this. In the bond markets you have the rise of rating agencies. But we still have unstableforeign capital flows giving rise in exchange rate instability.

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TOPOROWSKI LECTURE TRANSCRIPTION

4th LECTURE – University of Bergamo, Thursday 26th February 2015

Performed by Sara Brevi, Roberto Moroni, Federica Rota, Niccolo’ Suardi, Rudy Zanoli

MACROECONOMIC ADJUSTMENT IN A RICARDIAN INTERNATIONAL

MONETARY SYSTEM

I am now looking at the macroeconomic adjustment for the commodity and monetary theory of credit

so we talk about fixed exchange rates and the neo-classical theory of international money and finance

then floating exchange rates and the classical theory of macroeconomic adjustments and then I am

going to say a discuss the factor that make this different approach, a credit approach to international

money.

The first reason is the fact that among this transactions taking place the role of the Central Bank is

important and I will give you a very short history of international money as sterilization which I’ll

explain is the operation of the Central Bank which will lead me to the limits this kinds of operations,

the limits of central bank control of balance sheet and then I’ll go on to monetary and financial

innovation and finish with speculation and refinancing because these also appear.

Let me start off with the notion of fixed exchange rates and neo-classical theory of international money

and finance. If you have commodity money or a monetary theory of credit in which the banking system

transfers savings between different agents or internationally between different countries then you have

something like the gold standard and the usual neo-classical view is that there are decreasing returns to

productive capital. This is well known here in neo-classical economics, in other words the more capital

that is used in production, the lower is his marginal product and this is certainly true in mining, in

agriculture and extractive industries but in actual fact in other sector such as manufacture is not true

but the neo-classical theory is that it has to be like this. Really taking this view from the old classical

theorist David Ricardo who argued this point except for David Ricardo was looking at an agriculture

economy and that’s one of the cases where it’s true.

A second prevailing view in commodity money, this was allied with a notion of sterility of money and

finance. This is traditional view that money cannot produce a surplus if it goes into production. This

you find in Marx, it goes back to Francois Caney. All of who argued what happens with money trading

or trading a financial instrument is really just simply allocating savings around, but in itself it is sterile

because its productive activity generates surplus. The result is that in international system you have a

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global investment and disinvestment, which is supposed to equalize the rate of interest. Now by the

rate of interest was made here is the natural rate of interest, so if you have the marginal product of

capital and the capital in country A and in country B and let’s suppose that country A is advanced

capitalist country, so it’s capital rich and country is a developing country or an emerging market and it

is capital poor.

The return to capital will be a decreasing return in both countries and in a capital rich country you’d

have a low return to capital (RA), in country B you would have a high return (RB). The neo-classical

view has a traditionally mean that this represents a misallocation of capital or not an optimal allocation

of it because it’s possible to shift capital between countries to increase capital in B and decrease capital

in country A to get a higher return for country A and a lower return for country B. The international

financing system exists to facilitate the transfer of capital from country A to country B and in theory

what should happen is they’ll be eventually in equilibrium (RE) and have same rates of return on capital.

It would supposed to explain the global movements of capital, in accordance with the different rates of

interest or the marginal product of capital in different countries.

This is under fixed exchange rate regime like the gold standard and in the second half of the nineteen

century, before the WWI, in the period of the gold standard this actually appeared happening because

capital was moving from Europe, which was a develop/advanced capitalist country to U.S. and then

from U.S. down to Latin America. Since the breakdown of the gold standard this give arise to a

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puzzlement, this is not how capital moves around the globe, the most recent term for this is the “Lucas

Paradox” (2002). The paradox comes about because most movements in money capital go between

Europe and North America and also go from North America from East Asia. Very little capital flows

from the advanced capitalist countries to poorest countries where capital is most lacking, very few

capital flow who goes for example from Europe to Africa, where Africa is most capitalist scarse

country. The paradox in actual fact in world known and the part of the reason why it’s not a paradox,

it’s a paradox if you believe this theory, but part of this theory is accosted to the neo-classical notion

that profit or surplus is determined by the scarsing capital and it’s not what determines the rate of

profit.

This theory held from the early part of last century through the rise of Mundell-Fleming and this leads

me now onto the second part which is the Mundell-Fleming and this classical theory of

macroeconomic adjustment.

Mundell-Fleming is more classical because it relies on labor market adjustment as I mention last week

and I’ll explain further today. If you have fixed exchange rates then this ones move to monetary

autonomy from countries or from governments and governments cannot set their own rate of interest

because for domestic circumstances the rate of interest, as an instrument, has to be used to manage

reserves and the government cannot reduce the rate of interest if that is what’s needed in domestic

economy. However Mundell-Fleming in effect shows that monetary policy is effective under floating

exchange rates and if you have floating exchange rates then a monetary policy will expand or reduce the

money supply.

If you have floating exchange rates then a monetary policy works in the form of expanding the money

supply, or reducing the money supply. Then what you have are differences (showed last week) between

the money rate of interest, the domestic rate of interest, and the international rate of interest.

The IS-LM system is the system between the real rate of interest and output, or employment. You have

an IS curve which shows the different real rates of interest at which saving is a good investment, and

you have the LM curve which shows the different points at which the money market is in equilibrium.

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So this shows the points of the domestic equilibrium where the money market and the real goods

market are in equilibrium.

Lets’ suppose that the global rate of interest is the lower one (g), the adjustment is suppose to take

place through the discrepancies of the rate of interest and through capital flows. And the way it would

happen is that if you had a lower global rate of interest and the domestic rate of interest is higher than

the global one and this would cause a capital inflow. The way the capital inflow happens is that a capital

comes into the economy and it comes as foreign currency or gold, which is converted into domestic

currency, the increasing of the demand for money causes, against the foreign currencies, the exchange

rate to appreciate. So the exchange rate appreciates and if the exchange rate appreciates in this theory

exports become less competitive and the IS curve is supposed to shift inwards (blue line).

So the effective capital inflows causes the exchange rate to appreciate and exports to fall, imports may

rise and this would cause the IS curve to shift inwards.

To list the principal ideas:

- Capital inflow

- Exchange rate appreciates

- Exports become less competitive

- The IS curve shifts inwards

- Imports may rise.

So this can give you the point that the global rate of interest and the domestic rate of interest are the

same.

Under a system of fixed exchange rate what Mandel Flaming argued is that the monetary policy is now

effective.

If the central bank expands the money supply, causing the LM curve to shift up, you have this

increasing in the money supply that leads to lower interest rates and leads to capital outflows, leads to

exchange rate devaluation, leads to increased exports and the IS curve shifts to the right.

So having expanded the money supply with effects on the real rate of interest this would cause the IS

curve to shift.

The point of Mandel Flaming is that the real rate of interest goes back to the global rate of interest, but

it does this in the process and the economy expands.

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In other words you can have macroeconomic adjustment in this way: IS curve shifts to the right,

employment plus output.

I can do exactly the same in reverse: if the central bank reduces the money supply and the IS-LM

system causes the LM curve to shift upwards, this would result in a higher real rate of interest and the

higher real rate of interest will evoke a capital inflow. Because it’s the capital flows that make the real

rate of interest go to the global rate of interest.

If the central bank reduce the real rate of interest this would be higher than the global rate of interest,

there would be a capital inflow and the currency will appreciate and as the currency appreciates exports

shrink and the IS curve shift to the left as well.

This is under floating interest rates and you could show also that under this system the fiscal policy

wouldn’t be effective. Under floating exchange rates if you try to manage the domestic equilibrium

using fiscal policy it doesn’t work. And the reason why it doesn’t work is that the change in the real rate

of interest goes against the fiscal policy: it causes a capital inflow or a capital outflow and the change in

the exchange rate will contradict the fiscal policy.

If you expand the fiscal policy the IS curve shifts to the right, the real rate of interest in the economy

rises, a capital inflow causes the currency to appreciate, exports fall. So on one hand the government is

spending more money, on the other hand exports fall. The finale effect is that the IS curve shifts back.

Mandell Flaming is important to understand it, it still frames the way in which the central banks or the

policy makers think of a macroeconomic adjustment in an open economy with fixed or floating

exchange rate.

Under fixed exchange rates, in actual fact, the outcome is very different. The central bank doesn’t have

monetary autonomy, monetary policy doesn’t work but fiscal policy works.

It is worth looking to this different cases, between fixed and floating exchange rates, a fiscal and a

monetary policy.

In this case (mentioned last week), the exchange rate devaluation is supposed to be a substitute to wage

flexibility and in the optimum currency area theory Mandell argued that if you have a flexible labor

market and the economy is subject to a shock of some kind (f.e. unemployment), you don’t need the

exchange rate instruments. If there is sudden increase in unemployment the labor market is supposed

to adjust, the wage rate would fall and the exports would increase and also output and employment.

What Mandell had argued is that if you don’t have a flexible labor market the exchange rate devaluation

is an alternative to this.

This only works for countries with vertically integrated production: the only input is labor. In vertically

integrated production the very stages of production occur only in one country (from raw materials to

final output.

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Nowadays the only countries where this happens are very large industrial countries, lie United States

and to some extent also Japan, where all the stages of production are combined in one country.

Elsewhere it happens among commodities producers, such as Argentina, or many of the African

countries. These are countries which have a very short production cycle, they are essentially extracting

minerals or agricultural producing. The only input is labor.

The exchange rate devaluation will work as Mandell had argued (it would make exports increase).

Otherwise there is very little competitive benefit from devaluation. Even if devaluation makes the

exports more competitive, importing input for production makes prices to rise.

If you have a manufacturing company, like in Italy, it doesn’t have a big benefit, because Italy must

import energy and raw material.

The benefits would be offsets from the costs of import.

The macroeconomic benefit is reduced because as exports may rise, actually the increase cost of

income would reduce the benefits and would cause the IS curve to go back to its origin.

So, your devaluation cannot work in this way. Nor the devaluation nor the change in wages can

increase competitiveness, and therefore the analysis is questionable.

It’s also questionable because the hole IS-LM system is suspect: particularly the LM curve, because the

supply demand for money is brought to equilibrium by the real rate of interest and this cannot be true

because is the money rate of interest that brings the supply demand of money in equilibrium.

A Short history about international money sterilization, for example if the central bank increases the

real rate of the real money supply, this is a peculiarity of this, the real money supply is the rate of

interest in real terms commodity money based, in actual if you have a commodity money we have a

fundamental problem: there’s a tendency to believe that commodity is exchanged for commodities but

you cannot make payments with anything else but money.

There’s monetary innovation, which affects all of this, one of the reasons why this analysis very specific

and rigorous as it maybe in its mathematical form, is wrong. Money of course started of metallic

money, with metallic money you have much more frequent payments crisis precisely because this gold

reflex mechanism, that if you have trade deficit you may have gold in your economy but it leaves your

economy at a less price adjust , the economy runs out of money and secondly it happened in countries

with serious problems in the early years of capitalism and in order to solve this problem paper money

was introduced, originally in China in 12th century and the use of paper money spread widely for

international transactions, Chinese paper money was found in India, it was used in Chinese trade with

India in the 13th century. In Europe it really emerged in 17th century and paper money was not a very

command in the kind we know, what was more used was trade bills to exchange for each other. There

was an exchange market in Amsterdam in 18th century where trade bills in different currencies were

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exchange for each others. Unfortunately it is still an inflexible system, this is an introduction of credits

if there wasn’t paper around credits would be used, a typically what happen to merchant ‘would give

each others credits really going back to the period of the roman empire when government started to

give issued credits even in the 13th century and in the 19th century we have the emergence of something

very specific to capitalist production what Marx called “interest bearing capital”, the capital was used to

finance production using machines, merchant’s capital and merchant’s credit is used to finance stocks

of goods which merchants buy and then sell and they need credit in between buying stocks of goods

and then selling them; they sometimes make circulating capital, solvency credits start off with world

expansion of dynastic arrangement, they claim against the future wealth of the king by conquering rich

countries and taking the treasure all by marriage and the treasure could be used to repay the debts. This

is the origin of government debt, it is not the origin of modern debt, this was born in 17th and 18th

century to finance long wars and originally starts with the French innovation which was a rentes that is

an income for your life, and in 17th century a wealthy man who want to look after his wife in case she

died would buy a rentes from French crown that it would oblige them to pay an income to his wife: it’s

a kind of life insurance; or if you may be obligate to a cheaper one, they start to pay when the merchant

died it is associated with life insurance. It really works in different way, so the development of credit

and the loss of connection by the middle of the 20th century and the loss of connection with metallic

money in the international context.

Externalization: the central bank controls reserves or high power money (HPM) which gives the rights

to the ruling doctrine until yesterday because in these days the central bank was heard saying the

consensus was dead, the new consensus was the idea that the central bank change the interest rate and

supposed to change the business cycle and is supposed to change it in line with inflation target and the

view is that the policy is endogenous to the business cycle and it mean that during the boom the central

bank raises the interest rates, during the recession is lower in them because during recession the interest

rate are not working

In one sense sterilizations operations are crucial , but in practise they are very limited; they are central

banks’ and used to regulate the money supply and the whole idea comes from a time when central

banks were obsessed by supply of money and sterilization operations occurred through open market

operations buying and selling securities being bonds; secondly foreign currency operations buying and

selling foreign currency. This is another way of sterilization; if a central bank buys bonds or foreign

currency it pays for those by crediting and commercial bank with reserves; if a central bank sells foreign

currency or sells bonds it deducts the value of those bonds or currency from reserve accounts of

commercial bank, so these are the really true key ways, the central bank tries to regulate money supply

or the amount of money in financial market. The two other ways, first of all a central bank raises a

lower commercial banks reserve ratio, the reserve ratio is the ratio of assets that the commercial bank

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has, the ratio of assets to reserves the proportional asset that have to be kept. In the euro area this is

10%, if you watch to the past, if you raise a reserve ratio it would cause banks to reduce their lending.

In anyway they try to conserve the reserve they had at the central bank, but the principle way in which

they would respond to being forced to increase the reserves they don’t take anymore loans, why these

will give them more reserves? because if you don’t give loans what happen is that the bank receives

reserves when loans are repaid, but doesn’t give the reserve, it doesn’t give the money out and when

you repay a loan, you take the bank deposits and give it to the bank and the bank cancels the loan, the

balance sheet of the bank shrinks, so if a bank is conservative and doesn’t give the money out but they

just receive repayments and they increase the reserve ratio, the amount of assets goes down. This is an

important way in which the central bank control the amount of reserves , it is not used very much

anymore, for very rich foreign countries.

The other more unusual way of affecting the reserves of the commercial banks is for the government to

move deposits between a commercial bank and the central bank , if the government has deposit in

commercial bank and move to the central bank , the way in which this is start is by taking the amount

of deposit reserves from commercial bank back to central bank. So if the Italian government has bank

deposit of a hundred million euros and decides to transfer its account Banca d’Italia, a hundred million

euros get transferred but a hundred million euros in reserves is taken away from a commercial bank to

central bank. Under the gold standard this kind of regulation reserves was done with interest rate and

gold points was the price of gold bullion in terms of gold coins.

What happened with the system of international credit bond is that when WWII broke out all,

governments of the countries that were participating, and also most of the other countries, took control

over foreign financial assets, bonds, stocks and shares, giving in exchange domestic government bonds,

so to have financial assets with which they could borrow foreign currency and in this way assist with

the expenditure of the war. This was combined with foreign exchange controls who has a band on the

holding of foreign currency and also has a way of concentrating all the foreign currency in the central

bank. If you were forbidden to hold foreign currency, you were given a certain period of time in which

you had to hand over foreign currency to the bank, with the bank paying you local currency; the bank

would then hand over the dollars to the central bank. This was a way of concentrating all the foreign

currency, to assist with the expenditure of the war.

A third element was credit and interest rate controls.

This was important for two reasons. One was because during the war there was full employment.

Everyone was being paid, but there was a fear of inflation; so to prevent further inflation, any credit

that was lent out was lent out to priority sector (food supply, arms, necessities for the population and

37

for war production). The interest rate controls were also there because all governments issued bonds

and they want to keep financing costs as low as possible, so keeping interest rates down.

It’s out of this that the Bretton Woods system came along with fixed exchange rates and foreign

exchange controls and it’s often believed that on the Bretton Woods capital controls were introduced,

but they were already there. The Bretton Wood system would not have been possible before WWII.

Fixed exchange rate meant that in each country the central bank operated and sterilized the foreign

exchange market. If there were an inflow of foreign currency because a country had a trade surplus, the

central bank would buy all the excess of foreign currency to prevent the price of domestic currency

going up. What happened was that the foreign exchange market was taken into the central bank balance

sheet. In a central bank balance sheet it’s visible the up and down with foreign currency inflows. So the

central banks would expand its balance sheet when buying foreign currency paying for it with reserves.

Those reserves are the liabilities of the central bank. Liabilities in the sense that the central banks has to

pay them to whoever the commercial bank instructs. If they were capital controls they wouldn’t be paid

to a foreign owner but within the economy they could circulate. When buying foreign currency the

central bank, liabilities would increase and on the other side of the balance sheet the foreign currency

assets would increase.

If the central bank decides to sell foreign currency, then its balance sheet would contract because it sells

foreign currency and takes in payment for them the reserves, so just with book keeping entry that can

be cancelled out, it belongs to the central bank. When selling foreign currency the central bank liability

decrease while central assets in foreign assets also decrease. Following the Bretton Wood system credit

controls and interest rates controls remained principally because governments in Europe and North

America were heavily indebted after the war, with the exception of the Germans (their debt was

forgiven).

To keep the cost of borrowing down interest rates controls were maintained also for the Keynesian

belief that if you kept interest rates low this would encourage business investments, fixed capital

investments. There were credit controls to direct credit towards real activity, away from financial

activity; the Euro markets undermined all of this.

The Euro markets were unregulated markets in foreign currency held outside the country of issue. Euro

markets started in London, in October 1957, when the British banks made an official request to the

Bank of England to be allowed to open US $ accounts in London for account holders who were not

resident in the UK. The Bank of England sensing a possibility of attracting international business to

London said yes to the opening of dollar bank accounts but to non-residents in the UK. Switzerland

was also a fairly free dollar market; then Singapore, Hong Kong markets flourished. But for people

residents in other particular country (Italians in Italy, Germans in Germany) you cannot hold foreign

currency. To buy foreign currency you had to go to the bank, buy a certain amount of currency up to

38

50 pounds, 60 euros, and you were allowed to have it; this would be written in the back of your

passport and stamped by the bank to show that this was what you were taking out of country. This was

the way in which foreign exchange controls worked.

The Euro market attracted business to London but at the end it undermined the system of fixed

exchange rates; you could not have fixed exchange rates if you had a parallel system where currencies

were bought and sold against each other at free exchange rates. This gave rise to the breakdown of the

system of fixed exchange rates.

In the 1960 there were a series of foreign exchange crisis; the US was running out of gold (under

Bretton Woods the US had an obligation to convert $ into gold); in 1971 they devalued against gold

and in 1972 they went off the Gold Standard. This was replaced in 1970’s by monetarism (to the mid

1980). The idea of monetarism is that you regulate the domestic money supply and this regulates the

price level. In an open economy it gives rise to the monetary approach to the balance of payments. The

belief was that if there is an expansion of the money supply, inflation would make your exports less

competitive and imports more competitive and you will have a trade deficit. Monetarism emphasized

how much the money supply determines the price level and also the balance of payments in the same

way of the mechanism of the Gold Reflux. It was referred to as the “reserve position doctrine” because

in any economy it was then realized that most payments are made by credit between commercial banks,

credit that the central bank doesn’t control unless it’s within the foreign exchange market that the

central bank operates. If it’s commercial credit, than Friedman believed there was a fix relationship

between the amount of reserves and the amount of credit. This was through the credit multiplier.

After Bretton Woods, foreign exchange sterilization was abandoned. Central banks did not buy or sell

foreign currency. The foreign exchange market went off of the balance sheet of the central bank and

into the balance sheet of the commercial banks. So there was floating exchange rates, sometimes

referred to as dirty floating; dirty floating meant central banks would allow the exchange rate to float

but with possibility to intervention (to stop a rapid rise or fall). Foreign exchange sterilization was

abandoned and replaced by bond sterilization (buying and selling of bonds as a way of regulating the

reserves of a commercial banks). These open market operations were focused on the domestic base

money and note, which is banks reserves and notes and coins, in the belief that there is a stable credit

multiplier. There are various definitions of the money supply and the most narrow is notes and coins

plus reserves of the central bank. The broader definition includes commercial bank credit. In the

monetarist view this relationship was supposed to be fixed by the credit multiplier, which was

determined by the reserve ratio. Determining the amount of reserves in the monetarist view determined

how much credit there was in the economy.

In many developing countries, what happened is the central banks were managing either trade surpluses

or foreign debt. Once the Euro market had developed, governments were preferred to borrow from

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Euro markets because there were no conditionality like if they would have borrowed from the IMF or

the World Bank.

During the 1970 the central banks were managing foreign debt and surpluses; in 1982 there were

international debt crisis, but monetarism itself was undermined because in the end the credit multiplier

was unstable and the central banks couldn’t make it work. The relationship of credit to base money

proved to be unstable.

Why? Because credit was endogenous; I will if I have time today or tomorrow explain some more about

this.

More importantly, what happened was that fixing the amount of reserves was very inconvenient for a

banking system where the demand for reserves was unstable. When in 1979 Paul Volcker fixed the

money supply and refused to supply extra reserves when the banking system needed it, that caused the

interest rates to shoot up. In effect it was one of the causes of the international debt crisis because all

the governments in Mexico, Argentina, Venezuela and so on, which had borrowed in dollars at floating

rates of interest, suddenly found that they had to pay very high rates of interests.

What was then discovered was the endogeneity of these reserves: banks found themselves in the

position that they could actually force central banks to provide reserves.

How could they do this? Well, there were two mechanisms: first of all through the lender of last resort.

If commercial banks run out of reserves, under the lender of last resort the central bank was obliged to

lend to banks in difficulty. More importantly, the other way of making a fussy accommodation was that

commercial banks could force the central bank to provide reserves simply by refusing to rollover

government bills (short-term government borrowing). If they refuse to roll over what that would mean

is that when a government bill is repaid the commercial bank has credited to its reserve account the

reserves equal to the repayment. If the commercial banks want the reserves all that they needed to do is

to wait for the bills to be repaid and then refuse to lend money back to the governments and that could

cause financing difficulties for the government. (You can read in today’s financial times the modern day

version of this: the Greek government is hoping to finance its expenditure or to cover its financial

position by issuing short term bills to Greek banks which will be covered by European central banks

lending to the Greek banks. This would allow the Greek government to carry on, but it would mean

that, in three months’ time, they would have to rollover those bills: if they can roll them over the Greek

government is in trouble).

This meant that effectively the reserves of commercial banks become endogenous. They could be

whatever the commercial banks want them to be.

This leads to the exchange rates targeting. In 1986 Monetarism was abandoned also because the Us

dollar was appreciating, making life very difficult because of high interest rates for the American

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exporters, undermining the international banking system with the high interest rates. The Americans

demanded to the Japanese and the Europeans (the British, the Germans and the Italians) to make their

currencies appreciate against the dollar, imposed the dollar devaluation. How could this happened?

Through the central banks. The central banks effectively selling their dollars reserves and this goes back

to the previous system of trying to target the exchange rates. On the mainland of Europe, fixed

exchange rates were considered always desirable and they tried to maintain them (in large part because

in Europe there are many small countries for whom the exchange rate is the main determinant of the

rate of inflation).

However, what was by now happening was that the international capital movements were very large

and effectively, by 1991-92, the capital control system had to be removed; Britain eliminated its capital

controls in 1979, mainland Europe did so around between 1989 and 1991. The result was that within a

few months the system of fixed exchange rates was in crisis and broke down. Its crisis of 1991 is really

the main reason why we have a common currency in Europe: because it became very clear that was not

possible to maintain fixed exchange rates in Europe.

In the 90’s a new consensus monetary policy emerged: the idea was to target the rate of inflation using

interest rates. No longer the money supply (moving the money supply around was considered out of

date: you couldn’t control the money supply). The fixed exchange rates system had broken down, again.

Interest rates were then used. Initially what happened was that central banks would use open market

operations to manage interbank interest rates, but even then, it was realized that the central bank

doesn’t need to use open market operations. All they need to do is to announce central bank deposit

and borrowing interest rate. If the central banks announce the rate of interest of which it would take

deposits and reserves and a rate of interests of which it would lend reserves, that would form a corridor

and in a commercial banks the interest rate would settle within that rates of interest. In actually the

announcement of the CBE deposit and borrowing rates affectively minimized sterilization and allowed

central banks to control interest rates, but that is all they did.

Exchange rates were allowed to float and when the Euro was been set up the European central bank

and the Federal Reserve entered into a SWAP agreement (2001). This was very important for

maintaining the stability of the system: in effect, it means that the Us Fed will exchange dollars or buy

Euros from the ECB at a fixed exchange rate. It would swap them and obviously would then go back

into dollars in the future but also at the same rate of interest, this was the way of insuring that the ECB

didn’t run out of dollars and the Federal reserve would not run out of Euros. The Federal Reserve

doesn’t need Euros, but the ECB does need dollars. Why? Because still a very large amount of dollars

transactions takes place in Europe and, in particular, the dollar swaps market is a very important market

in Europe between European commercial banks. In effect, what happened was that we ended up at

that time with a small central bank, with a balance sheet in domestic assets and liabilities but very small

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and not much happening with it. (By the beginning of this century the bank of England, e.g., which had

been a very large bank/employer was simply reduced to a monetary policy committee and nothing else

the people to supply and nothing else because they didn’t record, they didn’t reregulate the banks:

regulations were taken away). You have small central banks except in the developing countries where

you have foreign assets and this is due to exchange rate targeting. In a country like Ghana, the

Ghanaian central bank has a very large balance sheet related to the GDP, on its liability side the

reserves of Ghanaian bank has a huge amount of notes and coins in Ghanaian currency (domestic), on

the assets’ side 80% of it is in dollars (foreign currency). That is a distinction among many central banks

(the same thing with Kuwait, Brazil).

In Europe it didn’t happened until the crisis. In the crisis, of course all the central banks have expanded

their balance sheets because of quantitative open market operations. The bank of England for example

increased its balance sheet 6 times by buying bonds from the banking sector; the bank of Japan has a

balance sheet, which is something like 150% of GDP.

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TOPOROWSKI LECTURE TRANSCRIPTION

5th LECTURE – University of Bergamo, Friday 27th February 2015

Performed by Invernici Elena and Vailati Valeria

CROSS-BORDER CREDIT OPERATIONS

1. The Balance sheet of an International Bank 2. Insolvency and Illiquidity 3. Hedging of Assets and Liabilities 4. Reserve Currency and Credit operations 5. Monetary & Financial Innovation 6. Speculation and Refinancing

In international monetary theory, as in economics in general as in history, there are essentially 2different positions:

- On the one hand, there is the view that everything that happens is because there exist a small group of

people who plan and rigorously carry out every disaster that happens to us, and they are usually made up

of a combination of Jews, Communists and Freemasons. The purpose of investigating international

monetary theory is to identify the links who take us back to the small group of Jews, Communists and

Freemasons, who have been working on this since the beginning of time.

- The alternative view, which is very prevalent now in Europe among the political establishment, is that

everything goes wrong because people will not do things in accordance to the rules. If only people did

everything in accordance to the rules than we would come to a general equilibrium in which everyone is

optimized and we would live in the best of all possible worlds.

Just to conclude what a was saying, there is a Zen Buddhist approach to success which postulates thatonly when you have embraced failure and accepted it, you can be truly successful.

Today and next week we are moving on to the position of credit theory of money, and I will startexamining the cross currency credit operations and next week we will do the rest (because the rest stillremains largely unknown and it’s up to you to work out). Today I will talk about the cross currencycredit and debt operations, by starting from what are the core intermediary for this, which is theinternational bank. We look at the balance sheet of an international bank and then we will go into anumber of banking issues, which are of different importance for international banks.

First of all insolvency and illiquidity: this has to be understood.

Secondly, the hedging of assets and liabilities: this is an important aspect of international bankingoperations. In particular, with international banking operations they have all these operations that arevery specific to international banking.

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Then I’ll go back to the general features of international money: the question of reserve currency andhow this is affected by credit operations. Reserve currency is an issue but it is well known ininternational monetary theory.

Then I’ll move on to how those structures change through monetary and financial innovations and Iwill conclude by saying something about speculation and refinancing.

1. The Balance Sheet of an International Bank

I showed it last week, here it is in a more rigorous form:LIABILITIESASSETSDeposits of publicCash in tills

Deposits at the central bankLocal Deposits of other banksDeposits with/loans to other banks

Local currency loans Foreigncurrency depositsForeigncurrency loansLocal CapitalBonds & bills (negotiable) Capital of Parent BankPremises Off-balance sheet reserves.

In all international banks you will find something like this: a liability side and an asset side. Theprinciple liabilities of any bank are the deposits held by the public (by the public it is usually meanthouseholds and firms) and the second element, which is of increasing importance in banking but also ininternational banking as well, is the local deposits of other banks.

That’s common to domestic banking and other banks in general. On the assets side banks keep someof those deposits as cash in the tills and secondly in the form of deposits of the Central Bank.

Those deposits at the Central Bank are the reserves of commercial banks and it’s those reserves that thecentral bank looks after. The Federal Reserve, for example, is a reserve bank that exists to look after thedeposits of its member banks. The Federal Reserve Bank was set up specifically to look after thereserves of commercial banks. Before the Federal Reserve had been established in the U.S.,commercial banks used to keep their reserves with another commercial bank: JP Morgan, which actedas a reserve bank to the other banks. It was when JP Morgan in the Knickerbocker trust crises run out

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of reserves that it was realized that commercial banks really need to have a more systematic previsionof reserves. This section is common to domestic banks as well as international banks.

What makes international bank specific and unusual different from holy domestic banks is that theyhave foreign currency deposits and they will also lend money in foreign currency. That’s thedistinguishing feature. International banks, like domestic banks, are financed with local capital (in other words: shares andbonds issued by the bank within a given country).The bank also hold bonds and bills that are negotiable (in the sense that they can be sold). Thedifference between the bonds and the bills and local currency loans (or foreign currency loans) is thatloans normally can not be sold unless they are securitized (it means unless you make up a bond and sellit on). Bills stay on the books of the bank until they are repaid. Bonds and bills can be sold (this iscalled negotiable) and that’s the advantage, because they are liquid and they can be sold at any moment.In the balance sheet, there is usually some capital of the parent bank and there are also some premisesand very liquid assets like these, and then the bank will have also off-balance sheet reserves, and I willexplain further how these off-balance sheet reserves expose to the deposits of the central bank.Assets and liabilities are supposed to equal and in general foreign currency deposit amount must beequal to foreign currency loans. The interesting way to looking at this, at a balance sheet like this, inthat it can be viewed as a set of dated payment commitments. I mean that all the liabilities arecommitments to make some payments in the future, so the capital of the parent bank represents acommitment to make the payments on that capital (the dividends or the interest). Foreign currencydeposits, or any deposits, represents a commitment in the future to pay back that deposit. Given theterms of the deposit, you cannot refuse to pay that back. Some banks sometimes prefer to organize it insuch a way that they give a high rate of interest for one-year deposits and they do this because it meansthey can fix when the deposit has to be repaid.On the asset side, this can be viewed as a set of dated payment to claim. In other words: claims in thefuture, claims to a cash flow, some kind of income or some kind of repayment. So in the loanagreement, for example, it is specified when those payments have to be made, what the rate of interestwould be, when it would be paid and when the loan would actually be repaid. Similarly with the bondsand the bills. The bond and the bills have the advantage that you can actually get a payment for themimmediately if you sell it. So the liabilities are a set of dated commitments. Income or assets are datedpayments claims, and you could do what kind of calendar for the future, showing how these cash flowswill match.Some of these are contingent or discretionary liabilities. Contingent or discretionary liabilities arepayment commitments whose dates and amount are uncertain. So if you have a current account, this isa discretionary liability and you can take this out at any moment. If you can sell a bond or a bill on theassets side, and you can sell it straightaway, you can get a good price. This is something that the bankcan do at its own discretion. You can contrast this with liabilities that are certain. If a bank is refinancedwith fixed interest bond, then the dates of the payments and the amount of the payments are fixed.That’s how a balance sheet appears at any time. Banks usually draw up balance sheets on a quarterlybasis. Possibly on a monthly basis. The question is what causes balance sheet to change? Because that’sthe critical factor in determining whether the bank is going to do well and make a good business or it isgoing to do badly. The monetarist view is that banks really depend on deposits: in the first place thebank has to receive the deposit and than the deposit creates a loan. In other words the bank decideswhether to lend the money out, but the key decision is the decision of the public to put money into thebank. About hundred years ago an English journalist (Hartley Withers: he was the editor of “TheEconomist”, he knew a lot about banks) was reflecting on this and came to the conclusion that actuallyit’s not the deposit that creates the loans, is the loan that creates deposits. This was a pure credit view,because it starts of with a bank creating a loan. When you have a loan from a bank, the bank makes acertain amount of money available to keep in use as a bank deposit. So you use the loan as a payment

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for goods and services and that payment appears as a bank deposit in the account of the person fromwho you bought the goods and services.If I borrow some money to buy a house, the bank gives me a loan, I transfer the loan to the personselling the house. The person has a deposit on their account. The balance sheet now has a loan and ifyou take the balance sheet of the banking system as a whole, local currency loans become bigger andthe deposits of the public have also got bigger by the same amount. So the conclusion was that thedecision to lend money leads to the creation of credit. It is in opposition to the monetarist view thatsays always that the deposits create the loans.In general, we can say that if you have drawn up a balance sheet, assets equal liabilities. Under theregulation of bank and companies, you have to draw them up in a way that assets equal liabilities. If youadd up all the assets and all the liabilities, and the assets are greater than the liabilities, there is a profitof the company that is transferred to reserves. It is true that the balance sheet of the bank is integratedwith the income and expenses account. If at the end of the year, the bank’s assets are bigger thanliabilities than that excess assets are transferred to reserves. It’s a profit, and it should match the profitin the income statement. If the assets are less than liabilities it means that the bank has a loss, and thatloss has to be covered from reserves.If the bank runs out of reserves (the off-balance sheet reserves), the bank has to ask the shareholders tocover the loss. So when there was the discussion over the last 4 or 5 years in Europe about banksdealing serious troubles, and they needed to raise the capital, because their reserves were insufficient tocover the liabilities and government had to intervene very often to put more capital into the bank. Thisleads me on to the thing that can start to go wrong in the company or in a bank.

2. Insolvency and Illiquidity

If the value of liabilities is greater than the value of assets than the bank is technically insolvent.Technically insolvent means that selling all the assets would not raise enough money to pay theliabilities. This possibility may never happen providing the bank is still paying its obligations. Let’sremember that liabilities are a set of dated obligations in the future. The bank usually doesn’t have topay them all at once.So insolvency is an extreme situation, it will happen for a bank when it cannot pay all the liabilities, andthen the owner of the liabilities takes the bank to court and at that point the bank is in seriousdifficulty, because the court can judge that it should start selling its assets to pay for the liabilities. Thesituation where a bank cannot pay its liabilities is called illiquidity. If a bank is illiquid, it means that theassets may cover the liabilities but the liabilities have to be paid out before the assets can be realized orsold.That’s one of the important reasons why banks hold in the balance sheets negotiable bonds and bills,because they allow the bank to raise money quickly. In the past, what happened was that banks heldlots of treasury bills and government bonds, because you could sell them very quickly and at a verygood price. Why U.S. government bonds? Why the bonds of a highly indebted government areconsidered so liquid? Because you can sell them in the markets at a high price. This is why is it good asreserves, you have interest on them and they can be converted in a bank deposit very quickly.Insolvency doesn’t mean illiquidity. A bank or a business may be illiquid but it can still be solvent.However, it always has to be remembered that a bank (or a business) obliged to sell all its liquid assetsin a fire sale can become insolvent. If you own a factory and you are told that you have to sell thisfactory in 6 months, than it is unlikely that you get a good price for it, because every buyer will knowthat you have to sell it within 6 months, and they will insist on getting a lower price. So if a bank or abusiness is illiquid it can become insolvent because the value of its assets will fall. This can happen evenif it wasn’t insolvent at the beginning because the sale of assets on a large scale would bring down thevalue of its assets.In most banking jurisdictions, bank insolvency usually requires what the Americans call “promptcorrective actions”: the owners (old or new owners) have to put in more capital to increase the assets orthe bank is wound up. This practice is very common in United States because in the U.S. - although it

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has a very important banking system (American banking system is the core of international monetarysystem) - the domestic banking system is highly fragmented, it contains a huge number of very smallbanks. Sometimes we find it difficult to match it in Europe. In Europe, we have small banks in theform of cooperative banks or regional banks, but in the U.S, until quite recently, there were still one-man banks in small towns: one man who would hold the bank deposits for the other people and theother businesses in the town, and make loans to them. This is something that we find difficult toimagine in Europe. Because of these problems of solvency and the possibility of insolvency, in particular in a financialsystem that is unstable (and international financial system is very unstable) it is very very important forbanks to hedge their assets and liabilities, to assure the value of their assets and to make sure that theyhave the liquidity to pay the liabilities.

3. Hedging of assets and liabilities

Under Bretton Woods, when international financial transactions went through the balance sheets of theCentral Bank, that was a form of insurance. The Central Bank operated as a kind guarantor ofinternational payments, this doesn’t happen anymore. The hedging of assets and liabilities has to bedone privately and has to be done by the managers of the banks. The business of banks is to managerisks. Apart from making payments and acting as places where you put savings and so on…banks aresupposed to manage risks. The way they do it specifically is through hedging of assets and liabilities. What is hedging? Hedging means matching a commitment to pay with some kind of income or a claimor an asset. So if you are an Italian bank and you have Italian bank deposits, you could hedge them byholding a U.S. government bond that can be sold at a good price at any moment. So the owner of thedollar deposits wants to take them out or wants to use them to make a payment to another bank, youcan immediately cover that position. Another way of hedging is, for example, making floating rate loans against floating rate deposits. In thatway, the interest payments era hedged. If the bank has dollar deposits on which it pays dollar interestrates, it needs to generate that cash flow from somewhere. The U.S. Government bond would do this.The interest on a dollar deposit nowadays is very very small, it’s next to nothing. The interest on adollar U.S. government bond would be 2.5% or 3%. Or the bank can do something more complicated by holding a call option in US dollars. For example, ifthe bank has a call option in US dollars, the commitment to sell the US dollars in the future at a certainexchange rate can be hedged in the options market with a put option of the same dollar amount. In thisway the positions are covered, or that same option can be covered maybe by hedging in the cashmarket with a dollar deposit. Or you can even do this with credit insurance. That will give you a hedgeand, if you have a hedge like this you build a certain margin to cover the cost of the bank and that’smaybe a small amount for profit, but it’s then fixed.If you don’t have a hedge, this is an unhedged commitment and it refers to an exposure. There arevarious ways of hedging exposures or commitments and they work in different ways. The oldest andperhaps the standard hedge was usually cash, which today would be bank deposits or a deposit with theCentral Bank. Why is this the most common hedging device? Because it is for all purposes, you can useit for everything. For example, if an Italian bank holds some other assets, like Greek governmentbonds. As there isn’t a liquid market for Greek government bonds, you may have difficulties to sellthem at a good price, so it’s a less efficient hedging device.It is less efficient if you are an international bank and your liabilities are in dollars. So this is vulnerableto exchange rate risks. At the moment, the euro is going down and the dollar is going up, so it’s notuseful. The general purpose of a bank deposit is as hedging device because the bank can spend it as itwants. It’s a little bit like if you have health insurance. Health insurance is useful if you think you aregoing to get ill, it will pay out if you get ill and it won’t pay out otherwise. A bank deposit is a muchmore useful hedging devise because you can use it for any eventuality, while an insurance policy is veryspecific.

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This is one of the reasons why, for Keynes, this is the foundation of liquidity preference. The fact thatcash (or a bank deposit) is a universal hedging device. It means that if investors start getting worriedthey start holding bank deposits. The problem is that it doesn’t work universally in internationalbanking, because you may have liabilities in different currencies and you have to decide in whichcurrency you hold your bank deposits. Let’s consider an unhedged carry trade: this is a standardspeculative operation. You borrow US dollars to convert into Brazilian Real to get profit from theinterest rate differentials. If you are a bank you can borrow in US dollars at 1% - 1.5%, something likethis. The Brazilian Real rate of interest is 8% - 10%. If you borrow in dollars (for 6 months or 1 year)and convert these dollars into Real on deposits at 8% or 10%, you are going to make a profit on themargin between the two rates of interests, but you have an unhedged exposure. You have an unhedgedexposure because you have US liabilities, but Brazilian Real assets. The obvious thing that could gowrong is if the exchange value of Brazilian Real depreciate, and you will need more Brazilian Real torepay your dollar liabilities. You could get a similar situation if a Brazilian corporation finances itsbusiness with US dollar loans. Why should a Brazilian corporation finance its business with US dollarloans? The obvious reason is that the rates of interest is much lower. If a Brazilian corporation borrowsin New York, it pays 2%, while in Brazil it has to pay 10% - 12%. However, it is an unhedged exposure.What could go wrong? the Brazilian Real may depreciate. If the Brazilian corporation is doing itsbusiness in Brazilian Real, it has cash flows in Brazilian reals but outgoings in dollars. It has what iscalled a currency mismatch and it has an exposure, but they still might do this, because Fixed ExchangeRates encourage ‘unhedged’ foreign exchange exposures. If the Brazilian government can says that itwants to maintain monetary stability by paying the exchange rate of Brazilian Real against the US dollar,that’s what would happen if you have interest rate differentials. This is one of the reasons why if you have fixed exchange rates. What the Brazilian government shoulddo is to bring interests rates down to US levels. By contrast if you have floating exchange, rates thanthis really can work if foreign currency exposures are perfectly hedged, or if the balance sheets can becostlessly reconstructed as exchange rates float and this is the problem because you can’t do itcostlessly.As an example of this, I give you the case of the Greek crisis. One of its features was that at the highpoint of the crises - when it was feared that Greece would exit from the Euro and obviously all assetsin Greece would then depreciate in price - multinational companies and multinational banks, which hadassets in Greece (and having assets in Greece doesn’t mean to hold real assets, but it means to holdgovernment bonds or company bonds) would lose some of the value of those assets and couldbecome insolvent. What did banks and companies do? They suddenly reconstructed their balancesheets to match liabilities against assets. And if you have a position where the foreign currency liabilitiesare equal to the foreign currency assets, than the issue of exchange rates will not matter. What they didwas that they held bonds against deposits of the Greek Central Bank or of other banks, so that in theevent that all these foreign currency loans in Greece were converted into Drachma (which thendepreciated), the value of assets and liabilities stayed the same.

4. Reserve Currency and Credit operations

In the first half of this lecture I explained to you how international banks manage their balance sheetsto some extent. Management of their balance sheet and maintaining their solvency and liquidity issupposed to be the reserve currency. The monetary approach to international money plays great emphasis on the role of the reservecurrency, the reserve currency is the currency held in reserves by central banks and used by commercialbanks as a means of international settlement. There is a sort of circularity of the argument here, becauseif they are accepted as reserves, they can be used as a means of payment in international transactions, ifthey can be used as a means of payment in international transactions then they would be held inreserves and the argument is chicken and egg argument.Initially international reserves were held in the form of gold, as a commodity money and that has a veryinteresting property and that is that if you hold gold than you hold an asset but that asset it’s not a

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liability for anyone, it’s a commodity and this is what for many people who believe that gold reallyshould be a true source of value, a true reserve currency and there are still economists that believe this.Then, it’s this quality that they find makes gold special, that gold has value without being a liability. There are certain disadvantages, however, to holding gold or cash as reserves, gold is expensive tomove around internationally, or it did used to be moved around internationally. Later on 20th century,what happened with gold reserves is that the reserve would stay in the same place in the central bankbut they would have next to the reserve, there would be a ledger and instructions that ownership istransferred from one person, from one country to another so the gold couldn’t move but ownershipmoved around. This is fine if you have a legal system which allows transfer of ownership and enforcement ofownership. Cash reserves, of course, have the disadvantage that they are less secure, they are less securebecause of these ownership difficulties.Nowadays, effectively since the Second World War, the US$ has been the main reserve currency and upto 1972 you could convert US dollars for gold but in 1972 the gold window was closed. Now, for thosewho believe that there is something very special about gold, the closure of gold window should havemeant that the international monetary system would collapse. In fact it didn’t. What happened in the1970s and the 1980s was that there were serious crisis but they were crisis in the credit system and notnecessarily crisis of the US$. Quite the reverse by the 1980s the dollar was increasing in value, they soldout the currencies even though it was not backed by gold, so all those Austrian economists who lovegold found this really deeply problematical but then they don’t really understand credit anyway.With reserve currencies, when it’s not gold there is an issue that arises of seigniorage. If you have goldas a reserve currency then there is a certain cost in acquiring gold. Gold must be either mined, gold outof the ground, and then converted into gold bars or if a country doesn’t have gold mines it has toexport to acquire gold.If a fiat currency becomes gold, so becomes a reserve currency, then fiat currencies usually are costlessto produce. The cost of producing a bank note is very much less than the value of the bank note,similarly with coins. The result is that is believed that this allows spending without income or debt. Now, if the government has the possibility of just issuing money then it doesn’t need to raise taxes, itcan just spend, and this is known as the privilege of seigniorage. In literature, there is a lot of talk about the privilege of the US government to pay for its imports just bypaying in dollars. This, as I will explain later on, is not just an issue of seigniorage. Really arises becausein a pure credit economy, the counterpart of international credit is international debt, and the first stepto understanding international money in a pure credit approach is to understand international moneynot just as credit but also as debt. So, behind the system of international money, is a whole system ofinternational and cross border debt. This International credit system depends enormously on the liquidity of international markets of privatecredit, as I will explain. That liquidity depends on first of all commercial banks holdings of reservescurrencies; the reserve currency is what is needed to make the international payment. If the reservecurrency is dollars, then dollars have to be held not in the form of dollar notes but in the form of dollarcredit, so dollar deposits and preferably dollar deposits in New York or Brussels, where you can makeclear payments with dollars. Secondly, this liquidity of international markets for private credit depends on commercial bankswillingness to innovate against the reserve currency, in other words to convert other assets or bondsand other currencies into the reserve currency. That’s quite important that in the past, I mean, you cansee the difference again of it comparing US government bonds which are universally accepted as goodas dollars bank deposits. That’s a form of innovation that took place which allowed at the end of the19th century US government bonds to be viewed as the same as US currency and in theory, if you want,strong international financial markets in need to have this conversion and, as I will come back to lateron, one of the reasons why we don’t have this in Europe is because not all government bonds areconvertible into euros immediately.Specifically what is needed is a willingness of commercial banks in the country of the reserve currency,say the US$, to extent credit. That’s quite important. What does this mean? This means that if an

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American bank offers dollar credits, those dollar credits, that are dollar loans, can be converted into adeposit.The more commercial banks in the US lend money abroad, the more liquid are international financialmarkets, the more reserve currency is around. So this doesn’t just depend on the FED, the FederalReserve has the function of standing behind its commercial banks.The fourth element in determining the liquidity of the international monetary system is the trade deficitin the reserve currency area to supply free or unborrowed reserves to the rest of the world.If you want a currency to be treated as reserve currency, you have to be able to supply it to the rest ofthe world. It’s not just sufficient to be willing to buy back your own bonds in that currency, you have tobe able to give a good supply of this and I would say that they specifically talk a little be more about theproblems that may arise if you don’t do this.Therefore, what we have in the world is a two-tier monetary system; first of all countries whosecurrency is based on some other reserve currency, so the US$ is the reserve of currency; currenciessuch as the Indian rupee are obtaining value because of their convertibility into US$. Curiously, theAustralian dollar as early as the soon after the Second World War realized that convertibility meanssterling, the formal colonial country, was irrelevant, is convertibility against the dollar that counted sothey linked their currency to the dollar. So, you have countries that very often are based on the US$, and then often have the US$ as a reservecurrency but their currencies may be used as a reserve currency in their region. So the Indian rupee isbased on the US$ but the Indian rupee is used as a reserve currency by Bangladesh, by the Maldives, bySri Lanka, countries in the region that to some extent depend on India.Similarly, with China, China famously keeps its reserves in US$. It’s now diversifying but most of itsreserves are in the US$.Beyond this are certain countries with a reserve currency, the US$, that’s backed by sophisticatedmarkets in financial assets. Why is it good to hold reserves in the US$? Because if you hold reserves in the US$ you can buy a verywide range of financial assets in US$.Why will the Chinese currency not be a reserve currency? Amongst other reasons, there’s that with theChinese currency you cannot buy a wide range of sophisticated financial assets with it. Question of the student: What about Europe in this issue?Answer of Professor Toporowski: The euro is a good currency, you can make payments with it but it’sthe only thing you can do with it. The problem is that the financial asset markets are weak and notstable. Fifteen years of building up strong capital markets has left Europe with weak capital marketsbecause they forgot one thing, that strong capital markets are based on government bonds and not onjust having a good currency and payments system.The monetarist view providing that the money is divisible, portable and scarce and that it functions as ameans of payment, store of value and a medium of exchange, that’s all you need but you need morethan this

5. Monetary & Financial Innovation

Let me now move on to monetary and financial innovation. In all of this, a monetary and financialinnovation is key, it’s a key process happening and it changes international money.Monetary innovation is really developing new means of payment, let’s say paper money in an economyusing metallic money or credit cards, it can even be dramatic and catastrophic dollarization, localcurrencies replaced by dollars in common exchange. Dollarization may be actually using actual dollarnotes or a currency which is packaged to some kind of unofficial dollar exchange rate.For example in Argentina, Argentina had its currency packed to the US$, this eventually left Argentinain crisis so they moved to floating exchange rates. What did the floating exchange rate do? They led tothe dollarization of the Argentinian economy. If you want to buy a real estate for example, is valued indollars, financial assets are valued in dollars. That doesn’t mean that you pay for them in dollar but youagree a price in dollars and you may pay the price in local currency at an unofficial exchange rate.

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So prices and money contracts are fixed in dollar terms that payments are in dollars or in local currency.This is common situations of hyperinflation. In the past in Latin America, it happened in EasternEurope, one of the most famous recent examples was in Barbuay, there was a loss of confidence inlocal currency and people wanted to maintain the value of their liquid savings so they would holdmoney in foreign currencies.That’s a kind of monetary innovation, financial or credit innovation is somewhat different.Dollarization occurs with inflation in the goods market, as I said, in particular with hyperinflation.Financial or credit innovation is associated with inflation in the asset market. To understand how thisworks, you need to understand the difference between secured and unsecured lending.Security lending is lending with security in the form of collateral in case of default or non-payment.Most financial transactions are done with collateral, you borrow from a bank and you leave them yourgovernment bond for an insurance policy and if you don’t make the payments, then the bank takes thatbond. It’s well known with real estates and mortgage lending. Unsecured lending is something different. Unsecured lending is lending where you don’t have securityand correspondingly it’s more risky. Unsecured lending is actually marginal, an example of this is creditcard debt, this is unsecured debt and that’s why if you have a credit card you’re given a fairly strictcredit card limit, you go over it they refuse payment. Traditional security was lend of real estate. In the 19th century what happened in Europe was thedevelopment of land banks to lend money against the security of land and what then happened wasthat it actually helped to develop markets in land or real estate. There’s a very nice example of this fromdeveloping countries. Why does it develop markets in real estate? Because if I own land and I canborrow money against a security of the land, it also means that if I don’t own land I can borrow moneyin order to buy land. What that does is to allow markets in land to flourish and in many developingcountries where land is traditionally been owned by communities for centuries back, very often withcommunal ownership, you didn’t even know who was the owner because it was owned by the wholefamily. The starting point of the market in land is the establishment of land banks.Question of the student: Is this what they call land grabbing?Answer of Professor Toporowski: Land grabbing? Yes. In the colonies it was land grabbing.Kenya is a very nice example because if you have read the stories by Karen Blixen after Africa, abouthow she lived on a plantation in Africa and everything was going wrong but it was such a beautiful lifethey lived that affected rising their standards of living, better than the natives. If you understand theeconomic history, you will understand that they had a serious problem. The white settlers in Kenya hada serious problem in the 1930s because they were producing agricultural commodities, tea, coffee,cocoa and the price of these fell. They couldn’t get the value from the land and the colonialgovernment established land banks to help the settlers but you could only borrow from them againstthe value of your plantation but you could only borrow if you were wide so the European settlers hadfinanced not the people who had originally owned the land and probably still owned it.From the end of the 19th century, you get a very interesting innovation that financial assets, stock,shares, insurance policies start being used as security for loans and what happens with this? Whathappens with this is that it means that they inflow of credit into financial asset markets becomesunstable, you get asset inflation and deflation of what I call capital market inflation or deflation. Thevalue of financial assets becomes unstable. If there is credit coming into the market, asset prices willrise, would tend to rise; if there’s credit going out of them, asset prices would tend to fall.What does this lead to? A very interesting development of financial derivatives markets to fix the futureprice of an asset. So let’s say, if we just take the case of the exchange rate, if an exporter receives in US$in six months’ time, you could fix that, you could fix the rate of interest of US dollars into euros with afuture or a forward contract. That’s the starting point of the process of innovation. The next stage of innovation is that you have this contract, that contract would have a value, it wouldcertainly have a higher value if the dollar appreciates. What can you do with that contract? You couldborrow money against it, you can use that contract to security for loan.

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Now the inflow of credit into market for financial securities or derivatives makes those markets moreliquid, and hence the prices of securities become more volatile. As they become more volatile, newderivatives to fix future prices of unstable securities.So what you find is that the derivatives market which started off with the exchange rate derivatives inthe 1970s, in the 1970s financial derivatives were essentially of two kinds: one options for the prices ofstocks and shares because stocks and shares were the unstable financial assets and then, with thecollapse of Bretton Woods, you have exchange rate futures coming. As monetarism developed, you had interest rate derivatives. Why? Because under monetarism when thecentral bank was holding the amount of reserves constant, the rate of interest was moving around in avery volatile way so to fix that interest rate you could check out interest rate derivatives. In the 1990s you had credit and security based derivatives, and even more extremely now you have anew phenomenon in international money, the use of dollar swaps as a money market instrument. InEurope, as money markets have become more and more affected by crisis in Europe, increasinglybanks use dollar swaps instead of money market instruments, borrowing and lending from each otherin euros.

6. Speculation and Refinancing

I’m going through a number of different processes, different transactions which are taking place in thecredit economy, pure credit international economy.Speculation is buying an asset in order to obtain an increase in its value. It’s common selling it and thenbuying it back at a cheaper price.In 19th century, merchants’ speculation was used as a critique of paper money or credit. You know, themonetarists believed that, or the currency school believed that you have to restrict money circulationbecause if you made the money supply elastic, then merchants would borrow huge amounts of money,buy all the stocks, in particular, commodity, and hold on to them until the price went up and they madespeculative profits. So you find in the monetary literature of the 19th century people like John Stuart Mill arguing that this iswhy paper money issued needs to be restricted. Actually, in the financial markets you couldn’t do thisfor reasons which I will explain in any case. In particular, if you had a financial asset, you could getcredit against it. The more the price went up, the more credit you could obtain against it.In a credit economy, this business of restricting paper money didn’t really work.What happened is that since 20th century speculation in financial assets becomes normal, it’s a commonevery day occurrence.Floating exchange rate allows speculation on exchange rates. So in a carry trade, carry trade isspeculation on interest rates. You borrow in a currency which has a low rate of interest to place adeposit in a country where the rate of interest is much higher. Once exchange rates are stable then youborrow in the currency that’s believed to depreciate in favour of putting a deposit in a currency thatyou expect to appreciate. Some of you will have noticed that a couple of weeks ago the Swiss unpacked their currency from theeuro. Anyone that had borrowed in euros and put money on deposit in Swiss francs, made quite a lotof money (something like 40%). This actually is one of the reasons why Mario Draghi’s quantitativeeasing is dangerous because there is another currency which is packed in this way and that’s the Danishkrone. If you have quantitative easing it’s perfectly easy to borrow money in euros and put it ondeposits in Denmark which is why the Danish Central Bank has reduced its interest rates and makethem negative.Speculation usually involves an initial unhedged exposure. Particularly if you are going to use futuresmarkets to hedge your exposure, let’s say we’ve borrowed in euros, we bought a Danish krone, we’vepacked that somewhere on deposit in a Danish bank. What we need to hedge that position? What youreally need is to find another bank which would convert the Danish krone into euros at a higher rate, atthe moment you would probably have to pay a lot of money to a bank to do this but it depends onexpectations, the fee you would have to pay would be quite high.

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This kind of speculation and hedging operation has to be distinguished from refinancing existingfinancial liabilities. Refinancing is really borrowing money to pay off existent obligations convertingexistent liabilities into liabilities in another currency or with a longer term or at cheaper financing costsin another part of the yield curve.If you for example issue short-term interest rates in Europe, are much lower than long-term interestrates so if you borrow short term and repay your long-term obligations you can save financing cost inthis way. This kind of refinancing is important because it can reduce the cost of finance and make a balancesheet more liquid. So let me finish off this lecture with the story of the refinancing of the Mexican government debt.You may read in your textbook, it’s now financial history, that in 1982 the Mexican Governmentprecipitated the international debt crisis because it was the Mexican government that first announcedthat they were unable to make the payments on their foreign debt and it was rapidly followed byVenezuela, Argentina and a number of other countries.Now, what happened after that was a very interesting financial operation, it was a crisis for a number ofyears, there were attempts made to resolve the crisis. In the end, the American government viewed thatif they didn’t do something about this it would drag down American banks.What eventually happened was that the US treasury more or less guaranteed the Mexican bonds,Mexican debt, but in exchange the Mexican Government liberalized its capital account to allow capitalinflows and outflows and they managed to secure a capital inflow, in other words, from the US dollarcame into Mexico by Mexican financial assets. The effect of this liberalization was that the capitalinflow was converted into Mexican pesos, the dollars went into the Mexican Central Bank, thegovernment of Mexico took the dollars, repaid its foreign currency debt and financed it by issuingMexican bonds in Mexican currency. So affectively it repatriated its foreign debt refinancing US$ debtinto domestic currency debt. Mexican corporations did something different; they refinanced their domestic currency debt into dollarliabilities to reduce the cost of finance.In a brief period, in about 5 years, the Mexican foreign debt crisis resolved and at the same time thenext Mexican crisis was prepared because in 1994-1995 the Mexican currency went into crisis and wasdevalued by 20%. All of those Mexican corporations which had borrowed in dollars found the dollarliabilities increased and came into the problem that I started with that they had foreign currencyliabilities against local currency assets and when liabilities increased by 20% the assets against them didnot increase by 20%. So let me conclude with this, that not all international credit operations are speculation and not allrefinancing is without crisis. What you have to understand is the complexity of credit operations andsee how they interact with debt structures and next week I will explain some more about this and I willactually show you some examples of this.

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TOPOROWSKI LECTURE TRANSCRIPTION

6th LECTURE – University of BergamoThursday 5th March 2015

Performed by Antonella Cordaro, Laura Birbes, Mattia Ferrarin, Silvia Bacis, Souad El Khadir

1. Credit-counterparts monetary theory

What I will do, first of all, is to discuss a little bit about the credit-counterparts monetary theory. Thiswas a theory which emerged between the 1960s and 1970s, and it is the most important work of HarryJohnson. Harry Johnson was a monetarist, and what he tried to do is, like Milton Friedman, he tried togive corporate elements of credit into his monetary thinking. Harry Johnson performed a theoryexplaining why credit is issued and the effects of credit in the economy. As we will see, this is a step inthe way to have credit theory. But now I want to discuss about macroeconomic adjustment, in other words, what kind ofmacroeconomic adjustments does a credit international money requires. And finally, I will talk todayabout the management of international money, and how international money need to be managed. Let me start with the first part of this lecture, the Credit-counterparts monetary theory. At themonetarist version and then the Keynesian’s criticism of this. The monetarist version starts from thesaving identity; the saving is equal to investment, is equal to the government expending trade minustaxes. In other words, this is the fiscal deficit plus x minus m which is the current account surplus. Ifyou take investment on the other side, you will find that you get an equation for the private sector netacquisition of financial assets, saving minus investment and this could be positive or negative; and thisequals the fiscal deficit plus the foreign trade surplus. In the monetarist version, financial assets are equal to money, which consists in banknotes or whatbanks have, net credit or reserves, plus securities, stocks shares, bills, securities which can be boughtand sold, plus unsecuritised claims on economic units, something like loans that appears in bankbalance sheet and are not tradable; economic units are governments, firms or households. Now, in amonetarist analysis, a banknotes plus net credit reserves were high powered money or base money.Now, from equation one, change in high powered money, plus or minus, plus change in governmentsecurities, plus the change in foreign financial assets is equal to a fiscal deficit, plus a net inflow offoreign currency, plus or minus, plus a net acquisition of foreign securities. Now, the monetarist version has a basic problem, a fiscal deficit, which will appear as a change in highpowered money if the deficit is monetized or a change in government securities and what themonetarists argued is this fiscal deficit. The Keynesian’ version of this is that the fiscal deficit plus the trade surplus provide financial assets forthe private sector, referring to the equation one as a trade balance model and essentially arguing that,and this is the net wealth of the private sector to gain the fiscal deficit plus the trade surplus andtherefore the fiscal deficit is necessary all the time to keep supply the private sector. The monetaristversion of this credit counterparts story was essentially failed because the monetarist view wascontrolled the high powered money and if you take this effectively and you had a monetary approach toa balance of payments and you control the money supply, control the price level affectively, you willdetermine your international competiveness, in the long run you will have a balance foreign trade ,youwill have monetary inflow on foreign currency. So, this is the monetarist view starting from controlling monetary policy, controlling fiscal policy thatwill eliminate the fiscal deficit that will give you an appropriate price level, to give you a trade balance.So these elements would eliminate, would reduce to zero a unit effectively, get down through the zerobalance and the credit counterparts; and the zero balance will show the equilibrium.

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The reason why this system failed was because of the endogeneity of high powered money, thecommercial bank reserves at the central bank. As I said before, the Central Bank does not control thebank reserves, the central bank has to provide sufficient reserves if it is to avoid interest rate instabilityor banking crisis, this was the argument in the 1980s. And the third way in which the central bankprovides reserves is in market for government bills or tradable bills. If a bank does not have reserves, itcan be obtain reserves with short term bills, which is simply a weighted repayment. In a credit economy, the net acquisition of financial assets is the increase or decrease in net outstandingdebt. This means an increase in financial assets of private sector minus the increase in debt liabilities ofprivate sector. The net acquisition of financial assets of the private sector are on level assets whichrequired the private sector excluding the assets which are claims. What is missed out specifically are liquidity operations in long term securities, if you remember I talkedto you about long term credits. Or the case that I have put here, which is that a hedge fund borrowsmoney from a bank, the bank creates a loan to buy government bonds from an insurance company. Soyou have an increase in private sector debt, it is matched by an increase in private sector deposits. Thehedge fund borrowed the bank deposit, that bank deposit now belongs to the insurance company. Youhave what was initially a less liquid portfolio, it is now more liquid, because there are more bankdeposits. In the overall portfolio of the financial system, specifically where is it? It is in the portfolio ofthe insurance company. Typically what the insurance company would do is then to buy some othersecurities, so it would get spread around. Because the increase in private sector debt is matched by an increase in private sector deposits, this, as Isay, gets cancelled out and therefore in the credit counterpart story you only find net increases. Thedifference between them is essentially the difference between gross debt and net debt in the privatesector. The gross debt is the total debt, the total balance sheet, of the private sector. The net debt, orthe net acquisition of financial assets, is the assets minus private sector liabilities. This is important tounderstand, because in many critical analyses, particularly those under the title of financialization, willtypically emphasize the size of the gross balance sheet and they will say that this is the total debt in theeconomy, omitting the other side of this, which is the assets side. And you even have someone - it is a particularly obvious barrier in the reasoning of Thomas Piketty,who adds financial assets to real assets, which is wrong. His empirical conclusion is absolutely correct,but you cannot add gross financial assets to real assets, because you are double counting, you arecounting both the real assets and the way in which those assets are financed. And in particular, becausethen if you have refinancing or liquidity operations, it changes the way in which it appears to add debtto the system, but actually they are just claims on financial claims, and then claims on claims onfinancial claims, like this. I have wondered for a very long time when I started thinking about all of this,very long ago, about thirty-five years ago - much more than that, why is it that you have a system inwhich there are financial claims built on financial claims? It is surely inefficient. Surely you should have a system having simply one intermediary between the borrower and the lender.Why do we have two, three, four, five different intermediaries? And the reason why we have two, three,four, five different intermediaries is precisely because in order to move interest in a system of long-termfinance, you need to make those long-term finance instruments liquid.

2. Macroeconomic adjustmentLet me now move to part number 3 – actually it should be number 2, as they say there are two types ofeconomists, those who can count, and those who cannot count. Let me move on to macroeconomicsadjustments, how these occur in conditions of international debt. There have essentially been two series episodes of international debt deflation. The first one was theinterwar period between the First and Second World War, and the second one was in the 1980s. And ifyou like, you could think of the current euro zone crisis as being a crisis of debt deflation. But it is avery peculiar one, because it is debt deflation within one currency zone. So, and I will be discussing ittomorrow.

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What became very clear from the debt deflation of the interwar period and the one of the 1980s, theone of the 1980s affecting the indebted developing countries, was specifically the need for tradeimbalances to facilitate international debt payments, interest and repayments. If we look at thoseperiods in turn, in the first case of the interwar period what happened was that only the countries thathad been active in the First World War ended the First World War with very large debts. At the treatyof their sides they tried to hedge those debts by making the Germans pay, but, as Keynes pointed out,post-war Germany had been stripped of a lot of its export capacity, and therefore it was not in aposition to pay those debts. In 1982 the second international debt crisis arouse because many developing countries had borrowed indollars at floating rates of interest and because of the monetary policies and the Volcker shock, theirinterest rates suddenly went up. This coincided with two developments in the international economy.First of all, a decline in commodity prices - in 1980-81 the oil price peaked and then it started falling,and a number of other commodity prices also started falling. At the same time because of the monetarypolicies being carried out in North America and Europe, those countries went into recession and werebuying fewer imports, specifically from the developing countries, which then affected the exports ofthe developing countries. This is how in the context of international debt, debt deflation transmits itselffrom one country to another. You probably may be familiar with the efficient debt deflation theory of depressions, where whenprices fall, the real value of debt rises. In the international economy, if we are looking at the globaleconomy, deflation transmits itself essentially when countries moving into the recession buy fewerimports, and this impacts on the exports of other countries. So the essential problem in the 1980s, onefundamental problem, was that the developing countries were heavily indebted in dollars, but theirexports were falling. What should have happened at that time is that the US should actually have expanded its trade deficit,and had they done so, it might have eased the crisis. And this is an interesting point because if you lookat international financial crises, excluding the current one, but first of all the one of 1982 and theemerging markets’ crisis of the 1980s, so the 1990s, both of these coincided with periods, when the USwent into recession and reduced its imports. So this leads me to a new concept, in the main horizon of financial system or in policy: a credit neo-mercantilism. A credit neo-mercantilism is: not running a trade deficit to supply foreign currency tocountries needing it to service their foreign debt. The question is, does it matter which country? Theanswer is, yes, it does, because if you have a foreign debt in a particular currency, if your income in thatcurrency is insufficient, then that currency will tend to appreciate as people who are exporting indifferent countries sell their revenue in other currencies to buy the currency of the debt. Let me give you an example of this, something like 60 to 70% of international debt is in US dollars. Asfor Latin American countries virtually all their foreign debt is in US dollars. Let’s suppose they exportto Europe - they have an export surplus towards Europe, so they have trade surplus revenue in euros, isthis as good as dollars? Well, the currency is convertible but what the Latin American countries wouldneed to do is to convert the euros to the dollars, and this would then cause the dollar to appreciate.You find that in times of crises, the dollar has tended to appreciate, in particular after the 2008-2010crisis. This is a very strange phenomenon because everyone thought that the 2008 crisis is Americanbased and the dollar should collapse. It did not, actually the dollar appreciated. Why? Because peoplewere selling other currencies to buy dollars to repay their dollar debts. So, this is not a new idea, the first who put forward this idea of running a trade deficit in the currencyof the debt was Minsky in the 1980s. What it implies is that in actual fact what we need in a system ofinternational debt are macroeconomic imbalances as international credit and debt expand, as opposedto the elimination of imbalances. And that is why the United States in many aspects has done such agood job in the postwar period in supplying the rest of the world with dollars, with free dollars,through its trade deficit. Although as I said at Khrushchev’s times when the American economy wentinto recession, it did not supply enough dollars and that is when those countries went into recession. Inactual fact, the situation is more complex than this, because you find that the US trade deficit is not

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with countries that have dollar debt, it is with countries that have trade surplus and do not have dollardebts, we will see that tomorrow. So, the whole situation starts to become much more complex. So, we need macroeconomic imbalances, we need trade imbalances. What we need in the internationaleconomy is an INVESTMENT BOOM, which involves expanding credit through debt-financedinvestment and it will be redistributed internationally by trade imbalances. That’s the way aninternational system is based on debt in a traded global economy. The investment boom is based on thetheory of Minsky and Konesky (but also in some Keynes theories) and it is the way in which profits andsurpluses are generated. Investment are debt finance, credit are mixed and in an international context you have to create asystem of trade balances. The surpluses are important for debt structure, which requires a properinvestment to create sufficient surpluses to make a defense against future debts. If your investment istoo low you may face (in a macroeconomic way) less employment and (in a credit system) firms andother economic unit are not be able to service adequately. In Europe there are insufficient investments when the problems appears in the government sector. Inan international economy this investment boom and the surpluses must be redistributed through thecountries. At the present international economy the main foreign debts are in the developmentcountries and the most developed countries are financing these debts, excluding the European area.What it needs to happen is that current debts are in dollars and U.S.A. is trading deficits, which are notrunning natural, because the country is doing investments above all in East Asia countries, but thesecountries are not running deficits but surpluses (also China is running like that). So, the geographic distribution of trade balances don’t match the geographic distribution of debt andthis could be explained by the MYTH OF ‘AUTOMATIC’ MACROECONOMIC ADJUSTMENT. Ifall the countries move to balance trade, the private sector will be balanced and an equilibrium will becreated. Unfortunately, this is not the reality, because the equilibrium position is not taken into account in thedistribution of the international debt. If you look on the debates in Europe, WAGE FLEXIBILITY islargely inducted on the purpose that it can bring about metro acquired balances. There is the belief thatwage flexibility is alternative to exchange rate flexibility and there are theories in the optimum currencyarea building this belief (also Keynes himself made theories about that). This works if you don’t have aninternational credit money system, because in this case wage flexibility has purpose effects, in particularearning wages, which increase the real value of debt. In this way you may obtain some competitive situations in the export trade and this is offset by ashrinking consumer market for falling wages. So when you get an export, it doesn’t improve yoursituation, but in addition to this the falling wages is associated with falling prices, deflation and realvalue of debt prices. So it is important to reduce the falling wages to reduce the possibility of a fall ofprices. This discussion can be associated in what is happening in Europe. In many realities there is a fall ofwages that create a worse situation and politicians and economists are arguing to find a solution to thisproblem and raising wages. For example, Germany is a country with little debt in economy, both inpublic and in private industries. On the contrary, in Greece the debt is much larger. If German wagesrise, the real value of their debt will be reduced, but if the Greek wages stay low there will be a fall oftheir prices. In conclusion, flexible wages are not a proper macroeconomic solution to the problem of internationaldebt, neither is the exchange rate. In the Bretton Woods conference, fixed-but-adjustable exchangerates were intended to manage trade deficits, not international debt, because they are connected to thebalance sheet of the Central Bank and they are subject to Government negotiation rather than themacroeconomic adjustment in the private sector.

3. Management of international moneyIt is important to underlying that there is a FUNDAMENTAL DILEMMA, a contradiction ofinternational finance to manage external debt. It requires overvalued exchange rate, but trade deficit

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requires undervalued exchange rate. With an overvalued exchange rate is possible to buy your foreigndebt and to convert it into domestic debt. Concerning the government debt, given a certain amount oftax revenue, it can buy more of its foreign debt with an higher exchange rate. At the same time, if youwant to encourage exports, the best way is to buy undervalued exchange rate. So, international debtrequires a more active management of trade, because there is not a spontaneous and automatic way tomanage it. Ok, so let me explain two techniques of managing international debt. First of all managing trade, it usestrade ad a way of generate bank claims in currency of the debt, this is like the standard firms thatoperate in production with using credit, savage; firms take out the loan and they received a price, aboutproduction cost, a sort of price which create sufficient surplus to pay the debt. So Accenture doesn’tpay your debt through your income, or if you like your debt, an edge with your income; however this isone way. The second way is Refinancing, to vary term and currency of the debt. So you take out your euro loanin order to pay by dollar, and specifically what is really important in international finance isinternational credit operations which is to extend the term of the loan, so you have a nice long termthat fix your finance cost and stabilize your position. A kind or refinancing is domesticating or externalizing the debt, if you domesticating or externalizingthe debt is a more complex arrangement. Domesticating means converting the debt into a domesticcurrency. One advantage is that you obtain your revenue in a domestic currency, this is a more efficientway of managing your debt, in particular you avoid exchange rate risk. Externalizing the debt wouldmeans convert your domestic debt in foreign debt. The disadvantage is that your income is convert in foreign currency. If you want to do this it requiresvery sophisticated financial market and ‘open’ capital accounts. In other words you need to be able tomake capital transfers, a system of capital controls where capital transfers are restricted. I think that International debt/credit, not “Neo-liberalism”, is a cause of international financialliberalization. From 1980 many developing countries refinanced debts, a sort of refinancing operations,to do this you have to open capital accounts. Now at that time maybe critics argued this, neoliberalistgovernment do this, do capital restrictions, because they believe that neoliberalism in three marketssystem go out. What was in 1980 a practical necessity of refinancing debt and that was why capitalaccount liberalized. I finish off with the story of Mexican government debt refinanced in 1990, I mentioned before.Mexican government precipitated in international debt crisis in 1982, October, when they announcedthey were in default on payment of foreign debt. This left international banks, predominant Americanbanks with a very large losses in balance sheet. In some cases, every city bank was in excess ofshareholders. The response were two initiatives: The first was the bankruptcy which was pay an attempt to combinethe World Bank and IMF and commercial lenders to lend it more money to Mexical and othersdeveloping countries and still works. It didn’t work for refinancing long maturity. So what was next, a couple of years later, was the branding initiative, that was something different. Thebranding initiative combined seven governments and American government didn’t want to collapsefinancing. The Mexican , south Korea, the Mexican case was very structural because Mexicangovernment managed the debt refinancing in a very interesting way. Under the branding initiative theMexican government debts were converted into bonds, into a guarantee for US treasury. So this madebonds so much stronger and more liquid and then Mexican government had to pay an higher price.Next thing Mexican government did was it abolished capital control, and obtain capital inflow from USinto Mexico, US managers transfer dollars into Mexico to invest in Mexican assets. When you transfer dollars in this way, it where exchange in Mexican city, dollars enters into a bankingsystem and by Mexican central bank. The Mexican central bank issued domestic bonds, use money tobuy dollars from central bank and use dollar to pay the US debt. In effect, Mexican government at 1993had refinanced all the form that entry in the Mexican Pesos, with all benefits in the kind with thatbecause bonds that they hedge with a Mexican tax revenue are the bonds by some interest but alsosubject of evaluation, depreciation and inflation rules.

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How this works for Mexican government? Mexican government had refinanced the level of rate tomaintain strong and stable the exchange rate in the US dollar. When assets is attracted the CapitalInflow the privatization in Mexican Companies. The Mexican companies refinanced by the percentagein the dollar. So you have in the private sector something different because the Government had domesticated theprivate sector, that have externalized with all the consequences than happens when the exchange ratedevaluate a Mexican corporations and their liabilities increased by 20%. In essence, this is a prototypefor that management and the exchange rate can allow a property in the Private sector and in the publicsector. The operations of Mexican government had depreciated Mexican corporations, also should findhow the kind of credit operations can be done but they need an open capital account. The other point that I make about is the particular incident of interest rate because, in order tomaintain the exchange rate stable, the Mexican government run up to the Exchange Crisis, that hadkept high interest rate and the high interest rates were with incentive for Mexican corporations torefinanced the dollar; because by then dollar interest rate much lower and also the Governmentinsurance need to keep interest rate stable.

Student questions:1. You mentioned that wage flexibility has perverse effects in a credit money system. But is theresome difference between commodity money system and credit money system? Also in a commoditymoney system the real value of debt increases if wages decrease (although it is possible that there is lessdebt as money is not backed with equivalent amount of debt). ANSWER: If you have commodity money you have know that. Usually the amount of that is very veryslight. You possibly have something like a credit and if the interest rate go up than of you stocks and[… ] if interest rate go down. The financial production is financed by borrowers. If you had commoditymoney export, the evaluation of a lower value of production you have a problem in the domesticmarket. Because level of production depends on level of profits, that also depends on level of interestrate and therefore prices changing have substitutions events and have always effects in income. 2. Bellofiore: What is exactly the special situation of crisis of prices in the centralized capital in theUnion System after the important meeting with Merkel and Sarkozy 2010? ANSWER: I think that mercantilists thinking that the way you drive export is the lower weights and itis possibly a mix. To make Germany a successful exporter it Is not the exchange rate in euro but, Ithink there is not damage between the Germany produces and the other countries and it’s competitiveby other factors. 3. Student: Is there some correlation between inflation, instability on the demand, unemploymentetc …?ANSWER: UK the effect of privatization affecting investment has been very very poor record ofinvestment. […]I think that doesn’t affect shareholders value because a company has limited liquidityand can increase it by issuing bonds, borrowing money. In effect business corporations are really morepercecive of liquidity of money.Student: This increases the instability?Toporowski: Yes, absolutely. It increased the instability in a particular weakness of the banking system.Bellofiore: Isn’t it better to say level of autonomy expenditures?ANSWER : Yes, of course. The other thing you need is the price system, the system of supply anddemand even the variation system that generate resolution.

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TOPOROWSKI LECTURE TRANSCRIPTION

7th LECTURE – University of Bergamo, Friday 6th March 2015

Performed by Polina Vasileva, Salam Aslam and Alina Giachin

Problems of International Credit: International Debt and the European MonetaryUnion

1. Introduction2. The International Distribution of Credit and Debt3. International Distribution of Credit and Debt: The complications of currency & sector4. International Credit and Debt by Type of country5. The European Monetary Union6. Revision

Introduction by Riccardo Bellofiore:

In the Previous Lectures Toporowski explained why the International Monetary Theory is wrong andhow it goes wrong.

In this Lecture, he will look on the empirical aspects and on specific problems of international moneyand macroeconomic adjustment. So that you can see that it is not only theoretical discussion and acritique of International Monetary Theory, but you can use it to understand specific problems.

This lecture gives a general introduction and conclusion from the analysis that where put forward in thelast weeks and will explain the International Distribution of Credit and Debt, which is crucial forunderstanding the International Monetary Theory. Breaking down, it will give a further look on thecurrency and sector (private and public sector) of International Distribution and its complication. (Itwould need to get brake down even further, to the individual firm that is operating, but this is toocomplex to describe it in this lecture).

Furthermore, the lecture will continue with suggesting the international credit and debt by the type ofdifferent country. You can examine in different countries and can buy certain characteristics of foreigncredit and debt positions. After that will look on the great exception, the situation of the EuropeanMonetary Union.

In that part a lot of Toporowkis reflection on international money and credit will arise, because of hisof own thinking and research of European Monetary Union. If you look on the way in which EuropeanMonetary Union focus on international money and finance, you will understand that it explainstheories, which don not have any relevance for the European Monetary Union. Furthermore, thislecture should show also another way to approaching the problems of the European Monetary Union,other than the monetarist. 1. Introduction by Jan Toporowski:

The essential Idea that comes out of the analysis is, that trade does not drive Credit & Debt. This is astandard approach in the Internationally Monetary theory, that the countries supposedly borrow,

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because they have a trade deficit. They lend because they have a trade surplus and there is a notion, thatthere is international mediation of surpluses to deficits. But it is essentially that it is trade, that isdriving.

However, since the 1980th we have a different situation in which credit and debt are driving trade. Allthe interest in exports lead growth since the 1980th. This is based on the idea, that a country orgovernment is in debt needs to generate a trade surplus.

How do you do this? It is the debt and credit, which is driving trade, the exchange rates, and the macroadjustment. So International capital flows are not ‘pure intermediation’ of ‘saving’ surpluses from richcountries to finance ‘saving’ deficits of poor countries + speculation (idea of: à la Thirlwall, Cheneryetc.). You can get savings from rich countries.

International capital flows are in fact the financing & refinancing of international debt +speculative margin. What we call international credit really has behind it is international debt and thatis the underlining factor that determines how good that credit/ money is.

It is rather like with the bank balance sheet: We have the money in the bank. But the determining if thebank is good or not, is the asset side.

Origin of this research: There is a database which the World Bank shares and it has the distribution of debt by countries. But itshows only the currency of the US $. You will not find a breaking down in other currencies.

Another new concept was the Net International Investment position of different countries. It is akind of balance sheets of the foreign assets and liabilities of different countries. You can only find thesecountries of the world, where you have good data.

2. The International Distribution of Credit and Debt

The Net International Investment Position (NIIP) shows foreign assets and liabilities of countries,but assets do not equal liabilities.

- The Deficits (if Liabilities > Assets) must be (4 different ways):

1st: financed from current account or trade balance(surpluses)

2nd: increase in foreign liabilities, borrowing more from abroad or decrease foreignassets (sell assets)

3rd: interest differentials: i.e., there is an item in the current account, which is interest, profits& dividends (ipd) on foreign assets. Ipd has to be paid on foreign liabilities.

If ipd on foreign assets is > ipd expenditure foreign liabilities, than you can use it to manageyour deficit. In affect if you look on the Balance of Payments the Balance of ipd = Balance onTrade + Net increase in foreign liabilities (increase in ext. liabilities + decrease in ext. assets). Sothis comes from the Balance of Payments which all has to sum up to zero = 0.

- If you have Surpluses (Assets > Liabilities) this may be due to external trade surpluses that have built up these external trade accounts; or due to External income account (ipd fromext. assets > ipd on foreign assets) (trade surplus + balance on ipd = external current accountbalance); or Net increase in foreign assets/decrease in foreign liabilities (can be due to Anexchange rate shift or a change in the value of assets)

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BUT

Capital flows include not just these changes, in the assets and liabilities. Capital flows alsoinclude refinancing + speculative portfolio transfers, that this Net international investmentposition changes.

The simplest way to understand this is to have a look on this graphic:

3. International Distribution of Credit and Debt: The complications of currency & sector

The blue line of the top shows the U.S. external liabilities. The country is in debt. You can see a moreand more American borrowing from abroad.

The second (purple) line are the U.S. external assets abroad. It starts in the 1980 where the U.S. assetsabroad were slightly greater than the U.S. liabilities abroad. Then the U.S. started to borrow more andmore from abroad and its deficits got wider, right up to now.

The green line on the bottom is the Imbalance, whichis very large in 2011 and probably getting bigger.

But countries do not borrow and lend abroad. In the financial markets people who operating are thegovernment, firms (or housholds/ corporate institutions):

We will break this down into the private and public sector (looking to the bottom part of the graphic)

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U.S. Public sector: The red line is the U.S. government assets abroad, their embassies, their military bases…(not verysubstantial)

The purple line are the U.S. government foreign liabilities and shows the shift towards increasingborrowing from abroad, in effect of the saving of U.S. government bonds. Probably the counter part ofthis is in effect that build up in us government bonds in central bank reserves in china and in thedeveloping world (Which is why there are not bonds for Chinas investors to buy).

U.S. Private Sector:Blue line is the U.S. assets abroad.

You already have one small break down. The Corporate sector has small surplus, while public sector is in debt. If you look on the currency theforeign liabilities are in US$ (US government and corporate stocks and shares held abroad) and thoseare the reserves of international monetary system. Another important factor is that the US assets heldabroad in foreign currencies (For example: The assets of Texico, which is held in Italy are valued inEuros means you have a different debt dynamics). First of all, if the US$ depreciates (devaluation),then it improves the Net International Investor Position (NIIP) as well as, possibly, the balance oftrade.

Because all those externalized abilities stay the same and still have the same value in dollars or at least inthe Cash flow in U.S. Corporation. (These liabilities stay the same) But the assets in dollar terms go upin value. So a devaluation improves the NIIP of the U.S. Deterioration in rest of the world’s NIIP asUS$ depreciates.

If you look at the first graph, the dollar depreciated in 1986 and in the 1995. When the dollar depreciates, it is desaturation in the rest of the world, in the NIIP. If the rest of theworld holding all the U.S. dollars assets and the dollar devalues, they are also reduced in value.

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In a sense, if you think about the China’s government and their dollars reserves it might be a reason forlinking their currency to the dollar, stabilizing there value of reserves.

Something else, which is important is the huge increase in the NIIP is due to American corporationsgoing offshore for their borrowing. So increasingly, the borrowing in dollars affects the balance.

4. International Credit and Debt by Type of country International Financial Centres (e.g., USA& UK):

UK & US :If you look at other countries, you can break this down in different types of countries. The mostimportant ones are the U.S. and the UK.

In general, both of them have very similar profiles, a large private sector and NIIP surplus, publicsector deficit and more assets (credits) abroad than liabilities (foreign liabilities (debts) in domesticcurrency) The British sector borrows largely from British financial market, because it does not need toborrow abroad. If they have liabilities than it is British government bonds (UK corporate shocks andshare held by people abroad and offshore centers). If you have a public sector deficit, British bonds areheld abroad in portfolios or in reserves. The foreign assets in credits are usually in the foreign currency.

Example: large multinational based in London, financing themselves with issuing stocks and shares inLondon but holding assets in Europe and in the rest of the world.

If Currency appreciation (for example the dollars) it causes deterioration in NIIP (the opposite of thedevaluation, because the foreign assets in terms of the value go down). This causes depreciation, whichimproves NIIP. The Balance is sensitive.

China:It is hard to get Information of China because they do not publish official data about their balancesheets. They have the largest foreign credit reserves (foreign assets) in the world, (bigger than all theother developing countries together) and that is most of all the Net International Investment Position,because they have negligible liabilities (there have been some small issues of Chinese corporate bondsin London)

Capital controls mean no significant private sector foreign liabilities (but Hong Kong?). The bonds thathave been issued in London have been a very small scale in Chinese currency. There is no public sectorforeign liabilities, because Chinese government does not borrow abroad. But there is a common withHong Kong, because Hon Kong has a free capital market (free capital flows) whit a currency linked tothe US $. If the Chinese corporations will not have access to the free credit market they trying to getinto Hong Kong, because the financial system of China very much controlled by the government. Theissue of Hong Kong add complexity, but there had been a capital controls between China and HonKong. It is unclear what the liabilities are, because of undisclosed mature between Hong Kong andChina.

A Currency appreciation causes a deterioration in NIIP, because the dollar reserves liabilities decreasein value and a depreciation will improve the NIIP (same Outcome as the US but for different reasons).The reason is that it is negligible and no effective external financing/refinancing is needed (there is noexposure). They simply have a large amount of foreign assets. Also because China is moving to becomemore and more an international finical intermediary. They have trade circles with the US, but most ofthese trade circles is matched deficits, which supply China with oil, raw materials, food and so one. So

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what they try to do for those countries: to pay them in Chinese currency, to keep their dollar surplusand dollar assets.

Resource-rich commodity exportersFor example, Norway and Kuwait have a large external NIIP surpluses for private & public sectors(usually holds Sovereign Wealth funds, tax exports and uses them money from those taxes to build uplarge portfolios on foreign assets). They have small negligible foreign liabilities.

Why is this done? Because these oil exports in countries have very small domestic bond or capitalmarkets. They have a low absorption capacity for foreign capital. They cannot do much with theirforeign revenue so they hold it as foreign currency assets. (Different from China, because it has a largeabortion capacity). Large foreign assets/credit due to small domestic bond/capital markets (due tomodest real assets).

Again a currency appreciation will cause a deteriorates of the NIIP and the depreciation will improvesNIIP (but for different reasons to US & China – you got no capital controls and really small domesticcredit markets). In the Middle East these credit markets are even smaller because they have Islamicbanking. But countries like Iran or Venezuela have a great absorption capacity.

For Emerging Markets e.g., Brazil, Mexico, S. Africa: Here you have external Liabilities > ExternalAssets depending on capital controls (in order to limit private sector borrowing abroad, or capitalinflow). Most of these externalist liabilities and assets are in US dollars. Sometimes difficult to tell,because countries like South Africa has a large mining sector. The mining companies have migrate inLondon (like FIAT in Italy) and these in terms of the NIIP those mining corporation have large foreignliabilities, which controlled by South African private sector. But, S.A. has also large foreign assets. Herewhat happens is that the reverse of these other countries, in general a currencydepreciation/devaluation causes deterioration of NIIP (because there it is a Net Foreign Liability andthe depreciation increase the value of those liabilities). A Currency appreciation/revaluation improvesthe NIIP.

In the 1980, when the international monetary fund was laundering around in the developing countriesthe tried to devalue the currencies to improve their trade position, but it made the debt position evenworse.

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These is government debt of Mexico, the currency composition and the few cases break done bycurrency. Here these is the foreign debt. The top line is the dollar debt and you can see how the declinehere was the refinancing of the Mexican debt. These were currency operations and it certainly brokedown for amount of these foreign debt and build up again up to its 90% and now its declining again.Interesting, because if you want to put the US $ exchange rate against this you will find that, when thecrises started, the dollar has appreciated and despite this the Mexican have managed to refinance theirdebt into domestic currency. This other one (green line), which is rising is the Euro. The effect this andthe smaller ones, the Japanese here. Here is largely trade credits (is not long term debt). The reason whyit becomes significant and takes of is that in affect that you have the Deutsche Mark or other individualEuropean currencies, they all disappear and became all one large currency the Euro

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This is growth external debt by sector. The blue line (2-2,5%) this is the debt of central bank borrowing(in dollars mostly)

In 2010/2011 these section in the Mexican government is 40-45%. So, the Mexican government isborrowing more. The part in the middle (the green line) is 8%, are the deposit takers (Mexican banks,borrowing abroad by foreign currency operations or to hedge dollar deposits). The largest section onthe top (on the left 50%, on the right 46%) these are other sectors (private sectors, principally Mexicanbusinesses?)

This unfortunately is the last part of the second part of the lectures by young Toporowski forinternational monetary economics, you have exactly one hour to wrap up and tell us everything as youknow.

Ok in terms of this last table is useful because it shows some of these currency difficulties that I havebeen speaking about in relation to foreign debt and it shows the proportion of external debt that it is indomestic of foreign currency. So if we take, let’s say, the poorest in the first three counties such as therea in measure specs the poorest and the most marginal countries Bolivia, Costa Rica, Moldova. All ofthese have no foreign debt in their own currency. Those have to get someone to hold their bonds andtheir external debt is wholly are in foreign currency. Principally, dollars i get Moldova could be rubles,could also be Euros. If we move further down we see the Ukarine 2% manages to borrow 2% managesto borrow abroad in its own currency, 2% to its total foreign debt. possibly this is privatization or somekind of sale assets to foreigners. and then for Bulgaria, this goes upto 3%. Argentina it goes upto 6%and with Romania this is 10%, India 21%. In case of India, where now in the world of a country wheresome of ex-business people, the Tata's, now operate from London. So they hold assets based inLondon in India and those assets of Tata's in London or foreign liabilities in Indian currency.

Hungary 23% debts, yes again i think its possibly a privatization effect. Switzerland 45%, privatecitizens in Switzerland borrowing in Swiss Franks from abroad effectively foreigners, this case could bethe liabilities the Swiss banking system to foreigners. In case of South Africa, it goes upto 59%, theseare the large mining companies I mentioned before holding assets in South African currency. And then

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at the bottom we have Germany which borrows in it's own currency, the Euro, come out Germany in aminute. The Slovak Republic which is also the Europe essentially that this is possibly the liabilities ofthe Slovak banking system to foreigners located in Slovakia is the special banking center. The role ofthese could be investigate further and finally the United States 91% of it's borrowing abroad is in USdollars for obvious reasons and perfectly hedged position because they borrow dollars and may haverevenues in dollars.

let me know move on to the problems of the European Monetary Union. The peculiarity of theEuropean Monetary Union is that the external assets and liabilities of the country's in the EuropeanMonetary Union are overwhelmingly in Euros. this is essentially the domestic currency. And. thereforethey unaffected by the ,exchange rate. However, they nevertheless have met international investorpositions. They have assets and liabilities abroad.

Let's look at first of all Germany. We gonna start again from the bottom. The brown line at the bottomof the external assets of the Germany Government, public sector. Obviously money which Germangovernment may be has lead to foreign governments still have claims of foreign governments. InGerman embassies abroad. the next line are the foreign liabilities of the German public sector. Nowthese are overwhelmingly German government bonds which are held in portfolios in elsewhere i meanparticular course and the offshore banking center of Germany which is Lexemberg. A lot of Germanshave bank accounts in Lexumberg or Switzerland through which they buy German government bonds.

The next line, this one, of the external liabilities of the private sector, money that has been borrowedabroad by German corporations, German banks, and higher up of the assets of principally Germancorporations, insurance companies, financial institutions and banks. So this is quite substantial. Infact,the privagte sector has a surplus and the public sector has a small deficit, well it seem its not effected byexchange rate risk. Yes indeed the Germans are money to foreigners.

If we look at the other extreme, Greece, at the international investment position, by sector, and here itgoes in the same order at the bottom of the foreign assets of the Greek public sector I set amount ofGreek embassy's property held abroad. The next one is the liabilities of the public sector. This isessentially a debts of the greek government. The third one are the liabilities of the private sector, it ismore or less stable. In other words, borrowing against bonds borrowing from other countries of Greekcorporations / Greek businesses. The item at the very top of the foreign assets of the Greek privatesector, have quite a lot of i mean something shipping and so on, its one of the major sectors in Greekeconomy. So you have a sizable public sector deficit Greek Government debts held abroad and a largeprivate sector surplus.

Now actually this external assets and liabilities don't just depend on borrowing from foreigners, no onedecides to borrow from foreigners, a very few people decide to borrow it from foreigners or borrowingabroad instead of borrowing at home. What this really reflects is the debts of domestic market, i meandomestic financial market, which is well developed and large in the case of Germany and isundeveloped in the case of Greece. Essentially, if Greek government wants to sell its bonds, youcannot really sell through the banks. There are not large institutions that will hold large quantities ofgovernment bonds in a way that there exist in Germany.

Now what's interesting would be that if you let suppose you had a brey cup of the Euro. Let say re-introduction national currencies, would have much the same effect on both countries. It would makeexternal assets, claims on foreign residents and external liabilities, foreign residents' claims on residentsin the country, into foreign currency assets and liabilities. I am sure if a good friend has got into powerwhat he was doing if you look at this and say that's fine usually private sector assets, nationalize themand use them to pay off the Greek Government's foreign debts.

What it will then do however is to reintroduce this fundamental dilemma that I referred to before thecontradiction of international finance but if you have a net external debt situation, as this governmenthas, ideally should have available value of exchange rate. But your trade deficit would requireundervalued exchange rates.

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The surplus increase of the private sector is constructive. It's the private sector assets abroad which isthat top line and the next one is private sector liabilities abroad. Private sector assets abroad roller in abank accounts held abroad shipping outside Greece, hotels, property. If they are abroad I am sure thatthey can easily be nationalize. Exactly, it is the problem. You could pass the law than here to criminallyoffense to hold assets abroad and what will you then to and well this is what happening from 1939-1940 in Brit. You can do this in more time. You say that you have to compensate people and the wayyou do it is you say I give you a domestic bond. If someone has a Swiss bank account with 10,000euros in it, you have to make you worth their wall to declare this and surrender it and in particular whatthey could always do in European Union is to say well no thanks I'll go away my bank account is, I amgoing to live in Switzerland or I am somewhere else. I want to be where I can get access to this.

In all these cases we have these figures and the interesting thing is to breakdown and no at done thebreakdown by sector but really you have to go right down further down to the individual once youunderstand what the position of the individuals is then you can see the social and political impact ofdoing the change like this. But there are some economist, I don't know if class would be interested insuch complications. Do you know what is cost of, don't you and do you have any idea because it' thebank's referred to people you may not know. Do you know Greece where it is, no I am giving noprobably that the Greece is a kind of turmoil. The government is by series and finance ministry isYanis Varoufakis but in the deal with the SNB if other state sitter if got something but other people,outside Greece & also in Greece and also within the partier , critical because they say they did not getanything substantial and it was a failure. Lapavisis is the most important economist among the critics,where in Varoufakis is willing to strengthen Greece position in the bargaining within euro, very muchreducing reversing those territory. The position by Lapavitsas, it's debt is just a dillusion. The only wayout is extent in the Europe and default on the debts.

Varoufakis more or less is a provocation or not or neitherly at proposed to default within Europe. Youhave to understand that no country in Europe at the present legal system could be put out of theEurope. For sure what Varoufakis want is a renegotiation of the debt. This may be interpretive also inanother way which I think is nearer to your opposition, you repeatedly said that you don't need to paythe past debt, you can just refinance and you can do that from strong position if you are in the situationof Greece in the last couple of years may be three in which Greece as a positive primary public budgetto do the state expenditure less taxes. Cancelling from the expenditure the interest payments, this ispositive. So in this position if you don't pay debts back, so to speak, you have not user program of thepeople doing these things, which you will need to refinance also the intersects expenditure and so youneed to stay out of condition because you are in the weaker position as a debtor. In this case they havedebtors but they don't need to go to the market to finance the state expenditures. The problem has notbeen this in the last month as being the liquidity position of the bank. Lapavitsas is for going out of theEurope, exit of the Europe and default.

Yes, but interesting thing about it's position, he was arguing for default when Greek government so hada primary deficit. This is very stupid thing to do. If I have a primary deficit which means that I need toborrow from them and I tell to my bankers that they can go to hang themselves with my debt, but theni need to borrow from them tomorrow. That weakens my position. You cannot even do this if youneed to borrow from them tomorrow. If you are in a position of primary balance where your currentexpenditures covered then it's not you who is in trouble, it's your creditors because they need to havetheir money back. I don't have the money. You have to talk to me about how you're gonna get yourmoney back. But you have to talk to me. This is the position that the Greeks are in the moment. Butwhatever happens, my point about Costas Lapavitsas he said colleague of mine from SOAS andwhatever happens he will say that the working class was betrayed.

So what I want to argue if you have breakup of the euro what you would do is that at the Germancurrency would appreciate. It would reduce the net international investor position of both the Germanprivate and the public sector and it's important to understand that the German private sector is highlyconcentrated. There is small number of corporations and banks that really do the cross border debt

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operations. It would make the trade surplus position for exporting from Germany from more difficultthan it is now. But it would increase real wages because in effect German citizens with a new currencywould depreciate to buy more imports.

In the case of Greece, the situation a new Greek currency which depreciated. This would marginallyimprove the net international investor position of the private sector. but it would greatly worsen the netinternational investor position of the public sector, because they hold a foreign debt which would be ineuros. It might improve the trade position, although bearing in mind that Greece is not a commoditysupporter. Greece exports also tend to have low value added. They have a high import content. And todepreciation of the currency would produce real wages which is already the problem at I think the outerleft have not really appreciated very much.

My conclusion from this is very simple that in the euro the exchange rate changes would cost conflictsshifts in the structure of the economy and in the debts structures of the economy. From marginalimprovements in welfare, there would certainly be a set amount of redistribution if your thinking aboutwages certainly German workers would benefit from the breakup of the euro. Greek workers I don'tthink would Greek workers would not benefit from the breakup of the euro.

Can you say some more about the net changes in the next international investment position ofGermany and Greece, what derives the changes you said. You thought of an appreciation of the euroand devaluation of the recommend. Yes, that's next. Both of them are characterized by private sectorsurpluses and public sector deficits in foreign borrowing. It's likely that if the successive currency innew Deutsche mark should call it appreciates. Then foreign holders of German government bondswould be happy to hold German government bonds. They will hold on to this. For the Germangovernment it would be easier to finance it's foreign debts.

For Greece: the Greek public sector there would have a serious problem because domestic debt can beconverted by law into the new currency and can depreciate. But most of Greece's foreign debt is nowheld abroad and you cannot pass a law in Greece converting Greek foreign debt into domestic assets.So would stay in some kind of, it has to be renegotiated with those holders of the debt. In some marginthey would want to maintain that debt in a foreign currency which would remain strong. They wouldnot want the value of their assets reduced. That would be the problem from the public sector.

For the private sector: The German private sector would find their foreign assets at sheer reduced mypriorities and value in relation to their current activities. But it would depend on individual businessesand how that position is hatched. For the foreign liabilities of the private sector, well those foreignliabilities would now be easier to manage if the new German currency appreciated. So actually it wouldbe probably even new currency might improve the situation for the German private sector as well asthe main public sector. For the Greek private & public sector, they would be seriously effected by thisdepreciation. There is a question, well how would this effect wages? Certainly the real wages inGermany would rise and real wages in Greece would fall. This would effectively widenthe disparity between Greek and German wages. It's not true that as they sometime said that the realwages of the Greek workers have gone up and this is the small made Greece noncompetitive. Greekwages are still below German wages. This is something which against some of the people on the lefterconfused about. So real wages would be reduced in Greece by a depreciation of the Greek currency.

I would continue as say as revision. Just put this table up again and to show really how we've gonethrough in these lectures a number of different theories of money, different effects the exchange ratehas on them. Today we were talking about effects of exchange rate on foreign long term credit andequity. This we haven't spoken about because this is getting complex. Certainly the UK and US assetsabroad are effected by differential rates of couple of market inflation in foreign financial centers assupposed to New York or London. But a lot of this worth down changes this is really just thebeginning of my research and hope it will give you some idea of how credit really does change once youstart thinking about credits and debts in the international contents it really does change the way whichwe view the problems in Europe and the problems of the world globally.

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I am finished, does anyone have questions on this.

I have two questions relating to the possible exit of the Costas Lapavitsas. First of all what wouldhappen to the primary balance if the Greece decided west. I understood that you would assume thatthis would stay three months unchanged. It could be that after it would exit the primary balance wouldbe primary financial surplus would become of property of foreign investors. Then again does it notmatter if you have a primary deficit, if you have your own currency in your own central bank, couldn'tthey risk around just finance and budget deficits targetted from the central bank and then the pastorsby them see any problems.

Yes, infact there is no problem with this. Infact it already happening because as we were talking overcoffee. The ECP has said that it's not going to buy the Greek government bonds as part of the councildevising but it's lending money to Greek commercial banks who will buy Greek government bonds. Sowhether you finance your deficit or your any borrowing through the commercial banking system orthrough central banking, really does it make very much difference. I accept I guess further if it is truethe central bank then the interest gets paid. It reduces the net borrowing of the Greek government. Iwould have thought that the fiscal position of the Greek government would then be effected by thisdepreciation of the new currency and scale of that depreciation and what that real incomes. Because ifreal incomes reduced substantially then this reduces the tax paying capacity they reduces the tax base.So I doubt it the Greek government could maintain it's primary balance of surplus if they set it fromthe Europe. or they could because as you know domestically when you sue the taxation then becomesoppressive and people would start getting annoyed in that situation, the political problems.

I think you know this is a kind of analysis which is to be done because what's happening in themeantime is that people are looking to commodity money of monetary theory of credit for happysolutions if Greece lose. Because something tells them that bank in the 19th century this marginworked. But I don't think they will do, this is more like a situation about Argentina in that whathappened after Argentina overcame it's crises in 2001 & 2002 you had a slow systematic dollarization ofthe Argentina economy. I think in the same way what would happen in Greece is they don't be aeuroization. Let's say Greece just left the euro area asset functioning without Greece. Then effectivelythe private sector moves into operation in euros informally. and what that then does with narrows, itnarrows the tax space, more or more wealth goes offshore and you lose control over your markets andstart getting hyper inflation because the prices become linked. that's exaggerated real estate and so onbecome linked to the euro. So even if you pay for them in Neudrachma you pay at the unofficialexchange rate and the unofficial exchange rate would be bad.

So this is how if you gain a distributional effects would mean there will be a big squeeze on publicsector accounts. If you operate in private sector you find some with the in paid in euros. You makeyour contract in euros and effectively you lose monetary control.

But I am sure I can't be more specific. It's a too technical question. it was a joke. A British televisionused to say, yes it's a very good question absolute fundamental.

I am telling you that if something is too technical question, you have to understand the whole structureof the economy, the debt structures and then factors like dollarization, how dollarization effects theeconomy, would you assume it would leave I think Greece's 3% of the euros and GDP, Greece willbecome totally marginalize and it would just revert to be in the kind of marginal, if anything was goingto would save Greece at that point would be if the Greek banks got permission to operate in offshorefinancial center of the Europe outside the Europe that might help.

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