What Do We Know About Global Financial Crises? Putting IPE and Economics in Conversation
Summary and Keywords
Since the 1970s, financial crises have been a consistent feature of the international economy, warranting study by economists and political scientists alike. Economists have made great strides in their understanding of the dynamics of crises, with two potentially overlapping stories rising to the fore. Global crises appear to occur highly amid global imbalances—when some countries run large current account deficits and others, large surpluses. A second story emphasizes credit booms—financial institutions greatly extend access to credit, potentially leading to bubbles and subsequent crashes.
Global imbalances are, in part, the product of politically contested processes. Imbalances would be impossible if states did not choose to liberalize (or not to liberalize) their capital accounts. Global political structures—whether international institutions seeking to govern financial flows, or hierarchies reflecting an economic power structure among states—also influence the ability of the global system to resolve global imbalances. Indeed, economists themselves are increasingly finding evidence that the international economy is not a flat system, but a network where some states play larger roles than others.
Credit booms, too, and the regulatory structures that produce them, result from active choices by states. The expansion of the financial sector since the 1970s, however, took place amid a crucible of fire. Financial deregulation was the product of interest group knife-fights, states’ vying for position or adapting to technological change, and policy entrepreneurs’ seeking to enact their ideas.
The IPE (international political economy) literature, too, must pay attention to post-2008 developments in economic thought. As financial integration pushes countries to adopt the monetary policies of the money center, the much-discussed monetary trilemma increasingly resembles a dilemma. Whereas economists once thought of expanded access to credit as “financial development,” they increasingly lament the preponderance of “financialized” economies. While the experimentalist turn in political science heralded a great search for cute natural experiments, economists are increasingly turning to the distant past to understand phenomena that have not been seen for some time. Political scientists might benefit from returning to the same grand theory questions, this time armed with more rigorous empirical techniques, and extensive data collected by economic historians.
Among economists and international political economy (IPE) scholars, financial crises are the blockbuster event. Banking collapses, stock market crashes, hyperinflation, currency crises, and debt crises immiserate and eviscerate those affected by them. For instance, Reinhart and Rogoff’s (2009, p. 165) “big five” banking crises caused an average of 3 years of negative GDP growth. Ordinary recessions create conditions for their own recovery—businesses can take advantage of depressed asset prices and wages to find new opportunities for profitable investment. However, because financial crises disrupt critical elements of the payments system, recoveries are slow, and crashes can take on a self-sustaining character. Understandably, economists and IPE scholars would like to know why financial crises occur.
The specialization of labor between economics and IPE may prevent due consideration of some important ideas. Economists may discount the role of political constraints in shaping how theories are translated into policy. For instance, Atif and Sufi (2014) wrote a book criticizing the response to the 2008 financial crisis for insufficient attention to homeowners with underwater1 mortgages, and excessive focus on shoring up the banks. The authors soon faced a review of their book written by none other than Larry Summers (2014)—former director of President Barack Obama’s National Economic Council, and one of the most widely cited economists of all time. Summers denied “a blinkered attachment to an at best incomplete, and at worst harmful, banking-based view,” and explained the lack of aid to underwater homeowners more simply: “The judgment of the president and his advisers was that there was essentially no chance of it getting the requisite 60 votes in the Senate.” It is very easy to find workable solutions to economic problems if one ignores political constraints.
This article aims to serve as a matchmaker between economic explanations of global financial crises and political science theories that can explain why governments sometimes fail to prevent crises. Many economists argue that global imbalances between countries with current account surpluses and deficits create situations prone to generate financial crises. Other economists focus on the role of credit booms and financialization in generating unsustainable bubbles. There is a vast wealth of political science literature exploring how hegemony, institutions, and domestic politics influence the dynamics of global imbalances. In contrast, there is a dearth of political science work on the politics of credit booms. Although some works explore phenomena that may contribute to credit booms (e.g., the political economy of deregulation), more work needs to be done in order to understand the global rise of financialization.
The article first presents background information on what financial crises are, distinguishing between different types of crises, and exploring some seminal economic works on the causes of crises. Next, two of the leading explanations of global financial crises are summarized: global imbalances and credit booms. Then, the political science literature is explored, highlighting relevant political science works that can explain the presence or absence of global imbalances and credit booms, respectively. The article closes with a synthesis of the collective knowledge of economists and political scientists on global financial crises, suggesting areas where further attention might expand this knowledge.
What is a Financial Crisis?
In order to understand what a financial crisis is, it is necessary to examine what financial systems are. Finance is fundamentally about intermediation—turning savings into investment. In practice, intermediation may be achieved through many channels within an economy. Firms may raise capital through equities markets, and firms and governments may raise funds from banks or other lenders. Intermediation can take place domestically or internationally. Through these channels, otherwise idle capital can be harnessed to new and innovative enterprises. However, the process of financing is vulnerable to different types of disruption, particularly if lenders overextend themselves or if borrowers fail.
Types of Financial Crises
Reinhart and Rogoff highlighted five different types of financial crisis, including: banking crises, stock market crashes, currency crises, debt crises, and hyperinflation (Reinhart & Rogoff, 2009, pp. 3–20). Banks typically lend out and invest far more than the amount of money they have in reserve (or in relatively liquid assets). During times of duress, depositors may hear that “there’s something funny going on down at the bank,” and rush to withdraw funds. When everybody withdraws their money at once, assuming there is no system of deposit insurance, banks may be unable to compensate all of their depositors, prompting a collapse. When many important financial institutions collapse in tandem, there is a banking crisis.
Stock markets are prone to similar risks to those threatening banking systems. Stocks are valuable because they entitle the holder to a share of a company’s profits. However, some investors may also purchase stocks speculatively, believing others will want to buy the stock in the future, pushing up its price. As speculative dynamics intensify, stock prices may exceed their fundamental value. For instance, during the height of the dot-com boom, the online pet supply store Pets.com had a market capitalization of over $200 million, despite barely having any sales in a low-margin industry (Tam & Mangalindan, 2000). Sometimes, instead of markets’ “correcting” to a company’s fundamental value, investors sell in a panic. When panics occur across many firms simultaneously, investors can come to resemble individuals in a stampede. One may not want to move in the same direction as the crowd, but when 10,000 people are moving in one direction, the relevant choice is to follow or to be trampled.
Since at least the 1600s, cross-border processes of intermediation have existed (Neal, 1990). In a world of global commerce and investment, but national currencies, another channel for disruption emerges. The exchange rate of a currency is driven by a market, in which some buy a currency (common reasons include a desire to purchase a reserve asset, invest in the country, visit the country, or purchase goods in the country), and others sell the currency. When countries allow their currency to float, exchange rates tend to reflect market assessments of the value of their currency. Although large shocks (e.g., the success of the “Leave” side in Britain’s 2016 Brexit referendum) can cause shifts in currency value, such outcomes are rare. Other countries, however, peg their currencies to other currencies (or to some asset, like gold)—committing to maintain a particular exchange rate. When gaps between the market rate and the peg emerge, investors may become suspicious of the ability of the government to maintain the status quo, prompting them to short the currency. For instance, investors might borrow money in a currency they believe will collapse, convert the borrowed money into a more stable currency, and then, after the currency collapses, repay the debt for a fraction of the cost of borrowing. When many investors short a currency at once, governments may prove unable to defend their currency, triggering a panic. Other investors, too, may worsen the situation by pulling funds out of the country. For instance, the Thai Baht fell by more than 80% in the 1997 East Asian crisis, despite an IMF rescue (Kaminsky & Reinhart, 1999).
Sovereign debt crises occur when countries default on the debts that they owe, refusing to pay some or all borrowed funds. Often, a debt crisis follows a previous financial crisis of a different type. Debt crises cause immense damage to the financial institutions and other actors that were owed money. Moreover, after countries default, it becomes difficult for them to borrow money from international capital markets—a costly prospect, since most countries run fiscal deficits habitually (Tomz, 2007). States are not the only actors that can be in default, however—subnational, municipal, or private actors can also trigger debt crises.
A final type of financial crisis is hyperinflation—a state of affairs where inflation spirals out of control. Perhaps the most important driver of increased prices over time is monetary policy. While historically governments influenced prices through currency debasement or printing money, contemporarily, other mechanisms prevail. Central banks can alter the reserve ratio, lower short-term interest rates, use open market operations, or engage in quantitative easing (the purchase of assets to release money into the economy) to influence the economy. Expectations of future inflation, too, may also play a big role in price setting, as unions bargain for wages and as firms set prices. At times, governments may lose control of the process, as prices climb ever higher. In 2009, Zimbabwe’s currency had been rendered so worthless that most transactions were carried out using foreign currencies—1 U.S. dollar was worth 35 quadrillion Zimbabwean dollars (Marawanyika & Wallace, 2015).
Explanations of Financial Crises
Different types of financial crises may overlap. For instance, many countries experience double crises (a simultaneous banking and currency crisis), posing a particularly difficult dilemma for policymakers. The measures likely to ward off the currency crisis (e.g., increased interest rates to attract more portfolio investment) are also likely to worsen the banking crisis. Many works on financial crises aim to explain one particular financial crisis. Such works are able to explore the idiosyncratic features of a particular financial crisis, but lack in generality.
A number of classic economics works posit general theories of financial crises. One view understands crises as the result of fluctuations in the supply of money. Friedman and Schwartz (1963), for instance, argued that the Great Depression of the 1930s was exacerbated by Federal Reserve policies that allowed the money supply to decline by a third (although the authors argued that had Governor of the New York Federal Reserve Benjamin Strong not died in 1928 he might have done more). Consistent with the broader views of the authors that government intervention tends to make things worse, they contrasted the response to the Depression with that to the Panic of 1907, where a voluntary clearinghouse and the creation of scrip by private banks averted a worse crisis.
Other works suggested that focusing on money alone is too limited. Kindleberger (1978) and Minsky (1992) synthesized a common dynamic to explain the pattern of mania and panic characterizing most financial crises. In their schema, prices of assets may climb due to a real, exogenous shock. Expansions of credit amplify the surge in asset prices. These increases may be the result of central bank policy, but could also stem from other sources (e.g., margin trading in the 1920s expanded access to capital for many investors). Surging asset prices may stoke a mania among investors in which expectations of returns become unrealistic. However, when fundamentals and market prices are misaligned, the stage is set for a panic. In the Kindleberger-Minsky formulation, panics can have a self-sustaining momentum. Minsky imagined three different types of investors, financing their operations through borrowing: hedge investors, who can make interest payments and pay down principal from their present returns; speculative investors, who can make interest payments from current returns, but who cannot pay down principal; and Ponzi investors, who can neither make interest payments nor pay down principal. The problem with panics is that they tighten credit markets overall, shifting some hedge investors into being speculative investors, and some speculative investors into being Ponzi investors. Further collapse tightens markets even further. Kindleberger and Minsky both concluded that it is of the utmost necessity to employ a lender of last resort in order to stop financial crises.
Additional works examined the particular role of the banking system in times of great financial duress. Bernanke (1983) agreed with monetarist views that the financial system could have non-neutral effects on the economy, but disputed the particular emphasis on the money supply. Instead, Bernanke argued that the Great Depression (and conceivably other such events) resulted from a disruption in the effectiveness of banks as intermediaries. Because of the role of banks in creating money, widespread banking collapses may also limit the effectiveness of central banking tools in hard times. Later, as an employee of the Federal Reserve, Bernanke (2002) gave a speech on the occasion of Milton Friedman’s 90th birthday, declaring “Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” True to his word, as Chairman of the Federal Reserve during the 2008 financial crisis, Bernanke took aggressive steps to shore up the American banking system.
Some explanations of crises emphasize psychological or ideational dynamics as driving crises, while others defend the rationality of investors and markets. Keynes (1936) and Shiller (2000), for instance, emphasized the potential for “animal spirits” or “irrational exuberance” to drive markets to dizzying heights. The recurrence of major crashes is not necessarily a sure sign of investor irrationality, however. Investment decisions entail tradeoffs between risk and reward—they do not always pan out. Knight (1921) posed the idea that it may not always be possible to distinguish between risk and uncertainty. Risks of some event may be predicted from some probability distribution with a fixed mean and variance. However, under some circumstances, parameters may be too unstable to support reliable predictions—probability distributions may be unknown. Nelson and Katzenstein (2014) contended that, faced with uncertainty, markets may develop conventions enabling coordinated behavior. However, since conventional understandings may diverge from reality (e.g., “house prices always go up”), they may also produce disastrous results. Examining the behavior of investors in the lead-up to the 2008 financial crisis, Nelson and Katzenstein find much to support their view. The role of credit ratings agencies in blessing dubious securities, the widespread contention that house prices could only go up, and risk models that envisioned that certain mortgage-backed securities would never lose more than 2% of their value all stood in stark contrast to the idea that investors were simply rational utility-maximizers.
Dispute rages among economists about the best way to regulate financial systems in order to stop financial crises from occurring. Some economists are skeptical of the merits of regulating, preferring to let markets operate. Some works advocate for scope restrictions (e.g., like the Glass-Steagall-era U.S. system where commercial and investment banks were separated), arguing that a decentralized banking system may encourage lower risk taking and less interbank lending (Dewatripont & Tirole, 1994; Mishkin 1999). Others, drawing from American historical experience (Calomiris, 2000) or a comparison with centralized banking systems like that of Canada (Bordo et al., 1994) suggested that scope restrictions may not increase stability. There is wider agreement on the need for prudential regulations, such as company reporting rules and leverage ratios (Financial Crisis Inquiry Commission, 2011).
Economic Theory and Global Financial Crises
As devastating as individual financial crises can be, the spread of crises from one country to another represents an even more frightening development. Particular periods have been characterized by frequent, intense financial crises occurring in many countries at the same time. The Panic of 1873, the Baring Crisis in 1890, the Panic of 1914, the Great Depression of 1929–1939, the Latin American debt crisis of 1982, the East Asian crisis of 1997, and the Great Recession of 2008 represent some of the most salient examples. Recent scholarship has tended to emphasize two different (and potentially overlapping) explanations for global financial crises.
Global Imbalances and Financial Crises
In the 1980s and 1990s, observers tended to view financial crises as resulting from bad fundamentals. Observers might declare that “Of course Mexico had problems in 1995 and Indonesia had problems in 1997—they had borrowed heavily, while maintaining crony capitalism.” Yet, as the number of financial crises intensified, some economists began to worry that there was something larger going on. Assembling a large amount of long-term historical data, Bordo et al. (2001) concluded that, indeed, the financial crisis problem was growing worse. The long-term historical pattern of financial crises, too, seemed to fit well with increased capital mobility. Just as the rush of capital into developing economies lifts up an economy, the rapid exodus of funds can be calamitous. Why couldn’t lenders simply renegotiate the terms of their loans, accepting haircuts or longer schedules, to avoid default and collapse? Some of the countries facing capital flight, after all, were illiquid, not insolvent. Radelet and Sachs (1998) pointed to the collective action problem faced by financial markets amid a crisis. As international finance markets grew larger and more diverse, it became more difficult to get firms to cooperate to avoid disaster.
By the 2000s, observers became increasingly concerned that the patterns seen in developing countries might also imperil developed economies. Just before his installation as chair of the Federal Reserve, Bernanke (2005) delivered a speech on global imbalances. Bernanke argued that countries like China and Japan faced a dearth of investment opportunities. Instead, savers there were funneling money into deficit countries, most notably the United States, with serious consequences for U.S. credit markets. After drawing a comparison between America’s current account deficit in the 2000s and previous developing world debt crises, Bernanke buried the lede, saying only that “the risk of a disorderly adjustment in financial markets always exists.” Subsequent events seem to have vindicated Bernanke’s view, as a bubble in the American housing market burst, taking the global financial system down with it.
A number of works seeking to understand financial crises have found evidence supporting the idea that Bernanke’s observation was part of a more general phenomenon (Claessens et al., 2012; Del’Ariccia et al., 2012; Kaminsky & Reinhart, 1999; Reinhart & Rogoff, 2009). Kaminsky and Reinhart explored the incidence of twin crises—simultaneous banking and currency crises. They argued that such crises tend to follow the crash of a boom fueled by capital inflows and an overvalued currency. Following the 2008 financial crisis, Reinhart and Rogoff (2009) conducted a sweeping history of eight centuries of financial crises. Examining data from the last two centuries, they constructed an early warning system highlighting different variables that were strong predictors of financial crises. Capital inflow bonanzas, of a sort that are highly possible amidst global imbalances, were among the best warning signs.
Credit Booms and Financial Crises
Yet, not all economists agree with the proposition that rising global imbalances are the primary cause of increasing financial crises. Schularick and Taylor (2012) argued that credit booms, too, are a large part of the problem. Analyzing the data from 17 advanced economies from 1870 to 2012, they found evidence that credit booms (measured by examining bank loans as a percent of GDP), too, correlate well with the pattern of global financial crises observed over the past 150 years. Total bank loans as a share of GDP surged from the late 19th century until the 1920s (with a large dip during World War I), crashing and then declining to very low levels until the 1950s. Subsequently, bank loans rose relative to GDP, passing the 1929 peak sometime in the 1980s, and peaking just before the 2008 financial crisis. Mortgage debt, in particular, appeared to be a large part of the increase in borrowing. In subsequent work, Jorda et al. (2016) found that crises precipitated by credit booms tend to result in particularly severe downturns, and, venturing into political science, Funke et al. proposed that such crises tended to produce far-right extremist political parties (Funke et al., 2016).
In some respects, the “credit boom” explanation of financial crises stands in opposition to the way financial economists once understood the role of finance in the economy. Rajan and Zingales (2003) described the rise of finance as “financial development,” with increased financialization sparking increased growth and innovation. Many restrictions on financial intermediation were termed “financial repression”—superstitious relics employed by rent-seeking states. Since the 2008 financial crisis, however, many of the same financial economists have begun to see things differently. In a conference in 2005, Rajan prophetically warned of excess risk-taking and leverage by the financial sector, while Zingales’ (2015) presidential address to the American Finance Association argued that academics overestimated the benefits of finance to society. Along those lines, a recent IMF paper found that when credit to the private sector exceeds 100% of GDP, growth levels tend to deteriorate (Arcand et al., 2016).
The Politics of Current Account Imbalances
If global imbalances are a potential cause of global financial crises, it is useful to understand why political actors may fail to rein them in. Some works argue that the presence of a strong hegemon is necessary to curtail global imbalances. Others are more skeptical, and even point out ways in which hegemony can be destabilizing. A second set of works emphasize the importance of interstate cooperation, while a third examines how domestic preferences constrain possible adjustments to global imbalances.
Perhaps the best-known “grand theory” of IPE is hegemonic stability theory. Kindleberger (1973) adapted an idea developed by Olson (1965) about when collective action is most likely to succeed. Olson contended that a general problem in political systems is the under-provision of public goods—those that are nonrival in consumption and nonexcludable. Because individuals can gain the benefits of public goods without contributing to their production, ordinarily, free-riding is rampant. Olson’s solution to this problem lay in the creation of a privileged group. When a small set of actors are able to gain the bulk of the benefits from the public good, they may also be willing to pay the costs of its production.
To Kindleberger, the maintenance of economic stability is yet another public goods problem: stability benefits all countries, whether or not they contribute to its upkeep. In particular, Kindleberger identified the maintenance of freedom of the seas, a market for distress goods, a stable medium of exchange, macroeconomic coordination, and lender-of -last-resort operations as critical public goods. He then argued that their provision would be greatest when a single country dominated the global economy. In effect, hegemony was an example of a single state’s occupying the “privileged group” role sketched out by Olson. If large global imbalances were a potential problem for global stability, it would certainly help if a single actor were able to get the major economies to adjust policies so as to limit their current account surplus or deficit. Empirically, the theory offered an explanation for the economic calamities of the interwar period: no state was willing or able to provide the public goods necessary for the maintenance of the system.
By the 1980s, however, the phenomenon most political scientists were interested in was trade, not financial stability. Krasner (1976) formulated a somewhat different discussion of hegemonic stability that hinged on the question of whether hegemony led to increased trade flows. Some criticisms were broadly theoretical, challenging the Olsonian logic behind hegemonic stability. For instance, Snidal (1985) pointed out that theoretically one could still have public good provision with multiple actors. Other works criticized the empirical veracity of hegemonic stability theory, challenging whether hegemony corresponded well with tariff levels (McKeown, 1983). And, indeed, even as political scientists were contemplating a world after hegemony, the bottom did not appear to be falling out of the global economy in the 1980s.2
There were also more direct challenges to the whether the mechanisms underlying hegemonic stability theory, and in particular, its ability to explain global financial crises. Eichengreen (1987) argued that the empirical pattern of financial stability in the 19th century was not, in fact, an example of hegemonic stability. Typically, French and German central banks would act as a lender of last resort, bailing out Britain, rather than the reverse, a finding supported by other economic historians as well (Flandreau, 1997). Rather, Eichengreen saw the absence of interwar cooperation as the central reason states were unable to avoid crisis during that period.
One of Kindleberger’s public goods is the presence of a global medium of exchange. Some scholars, exploring the role of monetary or financial hegemony, argue for formulations that cast leadership as potentially destabilizing to the system. Triffin (1960) and Strange (1971) explored one of the defining features of financial hegemony: possession of the reserve currency. Both argued that possession of the reserve currency is something of a curse, because it forces leading countries to make trade-offs between domestic political objectives and international responsibilities. Indeed, the United States spent the 1960s struggling to avoid devaluation, while also maintaining current account deficits that were necessary to provide liquidity to the global economy.
Many recent works have built a different argument about the role of dominant countries over the economy, focusing on the concept of “exorbitant privilege”. Eichengreen (2011) argued that the country holding the reserve currency gains advantages by doing so. Since other countries desire to hold their currency (or bonds) in reserve, the hegemon can effectively borrow cheaply from the rest of the world. Reinvestment of this global largesse can earn the reserve currency country a much higher return than the cost of borrowing. Gourinchas and Rey (2007) estimated that the United States earns excess returns of 3% through such a process, leading them to characterize the United States as a global “venture capitalist”. Cohen (2004) argues that states see possession of reserve currency status as desirable, to the point that states compete for the privilege.
By some accounts, granting the holder of the global reserve currency the ability to borrow in unlimited amounts may be a bit like giving out credit cards at a frat party. Global hegemons can find plenty of frivolous ways to spend money. Schwartz (2009) and Chinn and Frieden (2011) argued that the United States effectively recycled China’s trade surplus in order to finance a boom in American housing markets. Eventually, cheap Chinese credit stoked a bubble, and then a collapse. Schwartz saw this process as structural—multiple actors acting in their own interest jointly produced a system that was prone to collapse. Chinn and Frieden, on the other hand, pointed the finger at the fiscal policy of the Bush administration. They argued that the Bush (and Reagan) administrations, cut taxes in order to “starve the beast”, constraining future Democratic governments from increasing spending. Large budget deficits increased the current account deficit of the United States, effectively producing a capital bonanza and a housing bubble.
Oatley (2015) wove the story of current account deficits and crises into a broader historical context. In Oatley’s account, military build-ups by the reserve currency country have produced recurrent global consequences. He recounted how the United States expanded military spending during the Vietnam War, in the early 1980s, and following the 9/11 terrorist attacks—each time financing arms expenditures with deficits. As budget deficits led to current account deficits, saver countries effectively financed a boom in the United States, driving up the value of the U.S. dollar (sparking trade-bashing and protectionist sentiment) and stimulating overinvestment. In all three cases, boom led to bust. Thus, Oatley could predict the 1968 currency crisis, the S&L crisis of the 1980s, and the 2007 subprime mortgage crisis.
Of course, it may not make sense to separate the political implications of hegemony from the economic processes that put one country or another on top. Reuveny and Thompson (2004) drew on extensive data on southern debt crisis cycles from Suter (1992) to argue that cycles of growth in the global north drive debt crises. Radical innovation in the global north stimulates rapid economic growth and increased demand for commodities from the global south. During this period, southern states take advantage of high commodity demand and borrow heavily. When growth decays in the north, demand for commodities stalls, triggering serious economic problems for indebted countries. Further, increased weakness and division at the top of the international system may prevent the kind of coordinated assistance that might otherwise blunt the effects of southern debt crises.
Interstate Cooperation and Global Imbalances
The role of interstate cooperation to reduce structural imbalances has also been explored by IPE scholars. At the most basic level, some works focus on the role of different regimes. According to Krasner (1983), regimes are “institutions possessing norms, decision rules, and procedures which facilitate a convergence of expectations.” The gold standard, the Bretton-Woods system, and the post-Bretton Woods system might all be considered examples of regimes structuring monetary relationships among states. Regimes may be restricted in what they can accomplish in part by material realities. For instance, Mundell (1963) posited the presence of a trilemma—it is possible to have two of the following three things at the same time: fixed exchange rates, free-floating capital flows, and the ability to use monetary policy counter-cyclically. For instance, if governments with fixed exchange rates and open capital accounts cut interest rates to combat a recession, portfolio investors will seek higher returns elsewhere, placing downward pressure on the currency and undercutting the fixed exchange rate.
The maintenance of a monetary regime (e.g. by limiting dangerous imbalances) is often undermined by the divergent interests of state actors. According to the foundational works from the neoliberal institutionalist school, however, these constraints can be overcome with good institutional design: information sharing among actors, ongoing communication, a long shadow of the future, and clear expectations for actors (Axelrod, 1984; Keohane, 1984).
Along this line of thinking, some works examined cooperation to reduce global imbalances through the lens of great power conferences. Gallarotti (1995) examined monetary conferences in the 19th century, wherein states sought to bring order to the international monetary system. The more recent negotiation of the Plaza (1985) and Louvre (1987) accords, whereby G-5 countries eased imbalances through coordinated fiscal policy, have also received attention in the literature. Putnam and Bayne (1987) and Funabashi (1989) provided a detail-oriented accounts of international cooperation, stressing the influence of substate actors. Putnam and Bayne described the influence of “Sherpas” (emissaries preparing the summit for attendees) over the course of affairs. Funabashi described the interactions of bureaucrats and politicians, juggling re-election concerns, departmental mandates, and national interests. Putnam (1988) subsequently argued famously that summits could be employed as part of a two-level game wherein governments could expand their ability to enact unpopular domestic legislation by pointing to international commitments. Funabashi described how the divergent interests of national governments and bureaucrats shaped the outcome at Plaza and Louvre, noting that some of the most important contestation occurred within a country (e.g., Funabashi described a “palace coup” against Federal Reserve chairman Paul Volcker). More recent work examined the implications of a shift from a G-5/7 to a G-20 world, and the rising power of the BRICs bloc within international institutions (Stuenkel, 2013). However, absent a modern Plaza accord, discussions have tended away from issues of macroeconomic coordination to address global imbalances.
Network Structure and Global Crises
More recent work challenged the bedrock assumption that international monetary relations pose a trilemma. Rey (2015) argued that, in an era of intense financial integration, countries import the monetary policy of the money center. Instead of a “trilemma,” policymakers face a dilemma—free flows of capital entail the loss of monetary sovereignty. If this is true, then dreams of solving global imbalances with grand bargains like the Plaza Accord may prove to be a mirage. Skeptical of the prospects for international monetary coordination, Rey argued that, if states want to maintain independent monetary policies, they need to consider tough leverage rules, or even the use of capital controls.
IPE scholars have been increasingly attentive to the idea that structure influences global imbalances and the pattern of crises generally. For instance, one recent project measures the hierarchy of states by centrality within a network of cross-border financial flows (Oatley et al., 2013). Some states, such as the United States and Britain, are highly central, while even some large economies remain more peripheral (e.g., China). Once upon a time, IPE theorists and policymakers would speak breathlessly about the prospects that crisis contagion could decimate the international financial system (Strange, 1998, pp. 106–112). The network view suggested that the global economy may be fairly robust to crises in the periphery of the global financial system, though not to crises in the center. In contrast, financial crises in highly central economies like the United States may have ripple effects through the global economy. Danzman et al. (2017) contended that during periods of heavy borrowing by the United States capital becomes scarce abroad, reducing the number of capital bonanzas abroad.
Domestic Politics and Macroeconomic Adjustments
There is a vast literature exploring how domestic politics influence state preferences for exchange-rate adjustments that might raise or lower global imbalances. Both the internal adjustments (e.g., higher interest rates) and external adjustments (e.g., exchange-rate devaluation) necessary to respond to current account deficits are likely to be politically contentious. Frieden (1991, 2002, 2015) divided exchange-rate policy into a two-by-two axis—states may maintain either a weak or a strong exchange rate, and a fixed or a floating exchange rate. Frieden argued that exposure to the international economy, and relative preferences on international-domestic trade-offs play a large role in determining where domestic interest groups stand on exchange rates. Along these lines, Henning (1994) sought to explain the global adjustments of the 1980s as the product of lobbying by industries adversely affected by a strong dollar. One can also find evidence of interest-group politics inside authoritarian regimes. For instance, Shih (2008) explored the relationship between Chinese factional politics and monetary policy and concluded that both the economic interests of different factions and the role of technocratic actors within the system are important.
Industry-level analyses are not the only lens by which the literature has explored exchange-rate politics, however. Simmons (1994) explored how partisan politics played a large role in how different countries operated during the interwar gold standard era. In her account, parties of the left were more willing to devalue or drop off the gold standard (consistent with the interests of labor), whereas right-wing parties tended to implement tariffs and internal adjustments in order to stay on the gold standard. Additional works discussed the role of the political business cycle in influencing exchange-rate politics. For instance, Abrams and Butkiewicz (2012), examine the Nixon tapes, where they find strong evidence that President Richard Nixon’s 1971 decision to shift the United States to a floating exchange rate was driven by a desire push Federal Reserve Chairman Arthur Burns into enacting expansionary monetary policies and help Nixon win the 1972 election. Similarly, Stein and Streb (2004) argued that governments seeking re-election often take actions to defend their exchange rate, to preserve the purchasing power of consumers prior to elections. They tend to devalue after the election, perhaps hoping that voters will have forgotten about the adverse effects of devaluation by the time they are up for re-election again. Some more recent work, however, has stressed the limitations of these perspectives in understanding important developments. Walter (2013), for instance, argued that the increasingly complex financial interests of voters may defy the broad categorizations informing the politics of internal and external adjustments.
Many other political science works have sought to explain the rapid liberalization of capital accounts since the 1970s. Not only is capital account liberalization a necessary condition for the emergence of global imbalances, its spread is puzzling in many regards. The economic evidence for benefits to financial liberalization (at least of portfolio investment) is not as strong as that for foreign direct investment or free trade (Bhagwati, 1998). Simmons and Elkins (2004) examined the diffusion of capital account liberalization among states. They emphasized the importance of competition for capital among states. States liberalize in response to competitors for the same pool of capital. Chwieroth (2010), on the other hand, emphasized the role of ideas and institutions. In his account, the IMF became increasingly enamored with neoliberal ideas in the 1980s, which posited that liberalized capital accounts should help developing countries. Thus, just when many developing countries faced currency crises in the 1980s and 1990s, the IMF conditionality pushed many to liberalize.
Other works examined the dynamics of capital flight itself, bringing the interests of investors into the story. In some respects, Frieden’s (1991) expectation of strongly contested politics over liberalization is at odds with two stylized facts: the widespread adoption of liberalization by the 1990s, and the tendency for states to retain liberal capital accounts even after currency crises. Partially explaining this discrepancy, Haggard and Maxfield (1996) offered a twist to the intuitive notion that balance of payments crises are likely to provoke capital controls or protectionism. They argued that crises put a premium on foreign exchange reserves, enhancing the influence of actors capable of generating reserves, such as the export sector and investors desiring access to overseas markets. In other words, currency crises enhance the leverage of the actors least likely to support capital controls or protectionism. Other works looked at what factors attract or repel investors. Much earlier work suggested that investors had strong preferences related to political institutions, with some arguing that investors favor authoritarian regimes able to provide opportunities for monopolies and politically unpopular incentives (Li & Resnick, 2003), whereas others argued that investors favor democratic countries with transparent political processes (Jensen, 2008). However, these works tended to measure investment flows at the country-year level—a poor way to capture portfolio investors, who are able to rapidly shift funds between countries. Pepinsky (2014) got around this limitation by examining portfolio flows in the aftermath of the collapse of Lehman Brothers in 2008. He found little evidence that portfolio investors cared about the specific institutional features of states, and instead that capital tends to flee to states with records of good governance—strong rule of law and lower political risks.
Others emphasized how domestic political complementarity across the world’s major economies can enable or undermine interstate cooperation. For instance, Broz (1997) sought to understand why the classical gold standard of the 19th century functioned well, while that of the interwar period failed. Broz argued that Britain’s commitment to the gold standard was deemed highly credible by international markets due to the position of moneyed interests within parliament. As a result, Britain could run small current account deficits without triggering speculation against the pound. In contrast, Germany and France possessed powerful domestic interests that favored monetary expansion and other policies at odds with the maintenance of the gold standard. The only way they could reassure global markets was by operating a limping gold standard and holding large reserves of gold. In times of duress, the gold reserves could be lent to Britain, shoring up the international financial system. In effect, Broz provided the political underpinnings for Eichengreen’s (1995) and Flandreau’s (1997) contention that central bank cooperation, rather than hegemony, allowed the gold standard to work.
The theme of complementarity provides an apt segue to an assessment of the relationship between the economic and IPE literature on global imbalances. Many economists point to global imbalances as a potential cause of financial crises. The IPE literature, in turn, has explored how hegemony (or its absence), institutional structures, and domestic politics each may explain why global imbalances persist despite their disastrous consequences. Capital account liberalization has proliferated internationally, and is unlikely to reverse despite persistent crises. In a tightly integrated world, the policies of the global money center tend to have ripple effects around the globe. And unfortunately, leaders in the money center rarely have strong political incentives to prioritize good global stewardship over their domestic policy goals. Sometimes, by happenstance, domestic interests among the world’s major economies might facilitate cooperation to limit imbalances. At other times, grand bargains might be crafted by the world’s major economies. Frequently, however, imbalances may be able to persist, despite their consequences.
The Politics of Credit Booms
In contrast to IPE explorations of global imbalances, there is no grand political science theory of the kind of financialization that might spark unsustainable credit booms. Conventional political science works have tended not to explore financialization as a distinct phenomenon in its own right. Like most economists prior to the 2008 financial crisis, the increased intensity of intermediation was often depicted as “financial development,” even if there might remain some need for prudential regulations. However, there are different publications exploring themes that might provide political rationales for why credit booms accelerated in some eras and not in others. Many of these research projects do not ordinarily speak to one another—they are divided by epistemology or by heterodox-orthodox affiliations.
Structural Views of Financialization
Some works explored how the purview of the leading economies in the system might trigger global shifts toward something like financialization. For instance, Seabrooke (2007) focused on the domestic challenges of hegemonies in decline. Examining Britain in the late 19th century, he argued that Britain encouraged access to credit for the working classes as a way to uphold the legitimacy of the city-treasury vision of Britain as the world’s banker. In many respects, Seabrooke’s argument is similar to Rajan’s (2010) explanation of the subprime mortgage crisis as the product of government efforts to mask rising inequality with greater access to credit.
Arrighi’s (1994) sweeping history of the global economy incorporated elements of both material and ideational competition. He argued that hegemonic leaders (Holland, Britain, and the United States) held power not only because of their material advantages, but also because their legitimacy served the interest of the system. Over time, however, as other states emulate their institutions, the power of the hegemon wanes and competition intensifies between states and firms. In response, the hegemonic state launches a “financial expansion.” Financial expansions entail a shift toward greater mobility for capital, and the delinking of investment from production and trade. Instead, “purely financial deals” predominate, maintaining profitability either by expanding the market or through the redistribution of additional capital toward the capitalist class. While this process can stave off challenges for a time, it is unsustainable and tends to result in “crises of over-accumulation,” especially as rising powers come to replace incumbent leading states (Hung, 2008).
The Sussex school, on the other hand, focused on the role of techno-industrial change in reshaping economic forces. Perez (2002, 2009) argued that since the Industrial Revolution, history has been characterized by a series of paradigm-shifting technological revolutions. At first, radical innovations emerge in a world that is unable to comprehend their potential—banks and other established financial institutions have no way of evaluating the potential profitability of new enterprises. However, once new industry firms begin to earn high profits, capital develops a love affair with the new enterprises, pouring capital into high-tech enterprises. For Perez, the canal mania of the late 18th century, the railroad mania of the 1840s, the myriad bubbles of the late 19th century, the roaring twenties, and the dot-com boom of the 1990s are part of the same historical process of irruption and mania. While manias bring crises and great economic destruction with them, they also force governments and firms to establish institutions that incorporate new industries into the broader economic paradigm. Pets.com may have turned out to be a bust, but today a similar company—Amazon—is a corporate powerhouse.
Some IPE scholars have also sought to explain the recent wave of financialization through the lens of hegemonic leadership. For instance, Helleiner (1996) argued that in the 1970s, the declining United States may have benefited from a return to globalization. Shifting from a Bretton-Woods world of embedded liberalism to a world of floating exchange rates and intense capital flows meant that other countries would have to hold the U.S. dollar in reserve (although Helleiner also stressed the importance of neoliberal ideas in driving this outcome). Oatley and Petrova (2017) offered a great deal of support for the idea of a nexus between financial leadership and financialization. In an error-correction model, they found that the reserve use of a country’s currency is a strong predictor of its financialization. Financial deregulation, however, is much less important in their model.
Domestic Politics and Financialization
Financialization may also stem from policy decisions of governments. In theory, governments could enact any manner of restrictions on the financial sector, preventing its expansion. Historically, for instance, usury laws prevented lending behavior from taking place outside of the fringes of the economy. While the growth of financial markets might be assisted by some forms of state intervention like the protection of property rights and the presence of a lender of last resort, financial markets are most likely to expand in an environment that does not restrict intermediation and financial innovation. Certainly, Witko (2016) finds evidence that deregulation accelerated financialization in the postwar United States. The median voter may have distinct preferences on these matters, preferring more regulation than financial firms. If financial risk taking produces a financial crisis, it is taxpayers who will foot the bill. Further, Piketty’s (2013) argument that inequality is likely to increase because returns to investment exceed wage growth implies adverse consequences for many in environments where investment returns surge.
If voters are unlikely to favor the kind of financialization experienced since the 1970s,3 what can explain the spread of policies that reduce the taxation of capital and the regulation of financial firms? Some works emphasized the idea that powerful interest groups—most notably financial firms themselves—have been able to organize collectively and enact their own preferred policies (Hacker & Pierson, 2010; Johnson & Kwak, 2011). Politicians, in turn, may be more influenced by business groups and wealthy elites who are able to furnish the costs of collective action than they are by diffuse voters. There are parallels to this in literature that sought to explain developing country crises following liberalization. In countries where democratization is partial, or where a developmentalist ethos fosters strong government-business ties, cronyism may drive public policy (Haggard, 2000). Once freed from regulation and assured of rescue by their allies in government, firms may take undue risks.
At the same time, the detailed history of episodes of deregulation depicts a more complicated story. For instance, in the United States, while it is true that financial firms lobbied extensively on questions of deregulation, they were often internally divided. The abolition of the Glass-Steagall rules, which separated commercial and investment banks, had support from commercial banks but opposition from investment banks and insurance companies (Suarez & Kolodny, 2011). The elimination of bank branching laws, in turn, faced intense opposition from smaller savings and loans (Kroszner & Strahan, 1998). Turning to the question of international regulation, Young (2012) found evidence that transnational financial lobbying occurs. However, access by firms did not always manifest as influence, and the influence of lobbying actually tended to increase regulatory scrutiny.
Others examined the drivers of international financial regulation. The most important instance of international financial regulation is the Basel Capital Accord, which imposes global capital requirements on signatories. Financial institutions in countries that sign on to the Basel accord agree to limit the riskiness of their assets relative to their capital holdings. Yet the emphasis of the Basel accord on leverage may reflect the prerogatives of power politics rather than prudential concerns. By numerous accounts, the Basel accord may have been crafted in part to force Japan—whose banks tended to have high leverage ratios compared to those in the United States and Britain—to enact policies that would reduce its competitiveness (Oatley & Nabors, 1998; Singer, 2007). Alternatively, Walter (2008) examined the implementation of standards following the East Asian crisis, and similarly argued that the economic structures there, such as the prevalence of family-owned businesses and a tendency toward relationship capitalism, are a poor fit for global regulatory standards. Yet it is not clear that extant global regulatory standards—even if they were strongly enforced—would be sufficient to prevent serious credit booms. Certainly, the presence of the Basel Capital Accord did not preclude over-leveraging in the run-up to the 2008 financial crisis.
Unlike the literature on global imbalances, there is no unified theory of the politics of credit booms—although recent work is making important strides in that direction. There are some grand theories that explore processes (technological change and hegemonic competition) that might explain the overall global pattern. There are also many well-considered political science works that examine phenomena that could be part of an explanation of financialization and credit booms. However, the two have evolved with comparably little communication between them.
Economists stress both global current account imbalances and credit booms as non-exclusive drivers of global financial crises. Political scientists know a great deal about how politics and global imbalances might interact. The presence of a single dominant global power is probably not a necessary cause for global cooperation to reduce current account imbalances. Nonetheless, some degree of global concentration of economic power probably simplifies global collective action. Whereas there was considerable cooperation to reduce imbalances during the G-5 era (e.g., the Smithsonian Agreement, the Plaza Accord, and the Louvre Accord), there has been far less collaboration since. Indeed, monetary coordination may be far less viable an option than it was in the 1980s, due to the increased tendency for other countries to follow the monetary policies of the center of the system. The hierarchical structure of the system poses many challenges. Some of the special privileges afforded to the leading power can be abused (and, indeed, the leading global economy may often have strong incentives to abuse their powers). On the other hand, the system may require some degree of profligacy by the United States; otherwise, the system will be starved for reserves.
Management of global imbalances can be difficult to coordinate because the internal and external adjustments they require are politically contentious. Whether politicians are constrained by the interests of powerful industries within their political coalition, the interests of the social classes they rely upon for support, or short-term political motivations, politics is likely to limit the ability of leaders to cooperate. At the same time, well-crafted global regimes and international summits may offer leaders the ability to overcome these limitations by playing two-level games.
Although the literature on the politics of credit booms is far less developed, there is great potential for a synthesis. Credit booms also correlate with the global structure of power. Great powers tend to dominate the international system in part by excelling at the production of leading technologies (Modelski & Thompson, 1996). As a result, technological paradigm shifts are likely to draw together many factors that are adverse to global economic stability. Technological transitions require financial innovations in order to finance new industries. Simultaneously, paradigm shifts make the distribution of global power more diffuse, as it becomes uncertain which state will best capitalize on the emerging techno-industrial paradigm. Heightened interstate competition for economic leadership, in turn, may prompt more and more states to deregulate their financial systems as they seek to create an environment conducive to innovation. Even absent financial deregulation, the excess returns earned by investors in reserve currency countries might help encourage the growth of a sprawling financial center. Seeking to do more with less, states may also substitute credit for social welfare spending, as they attempt to craft legitimate social orders. Policies crafted by states involved in apex competition for financial and technological leadership may, in turn, diffuse abroad to developing countries through imitative and coercive processes. However, such policies will often prove a poor fit for the needs of developing countries, further weakening global stability.
In many important ways, the research projects of economists and IPE scholars are converging. Both are beginning to pay attention to the central challenges to global stability posed by recurrent global imbalances and financialization. Similarly, economists are becoming increasingly aware of the importance of both political constraints and hierarchical structures in conditioning political outcomes. This is an important development for the understanding of financial crises, and we should make sure it continues.
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(1.) Mortgages are considered “underwater” if a borrower owes more than the market value of the home.
(2.) Rumors of the demise of American hegemony in the 1980s may have been greatly exaggerated.
(3.) Financialization in late 19th century Britain poses less of a mystery. It is more conceivable that, at the heart of a vast empire with a restricted franchise, the average British voters saw themselves on the winning side of finance.