Changes in the Global Financial System

Introduction

World history has witnessed several spells of dynamic and integrated global growth. At the same time, there had been many instances where the growth spells had ended because of financial instability and geopolitical disorders. There are examples of disturbances in British and French economies because of “social, military and monetary chaos” resulting in the French and the American Revolution. Even greater damages to the entire social and economic systems were caused by the aftermath of World War I and the subsequent financial crisis resulting from the Great Depression.

However, the global financial system has undergone a significant transformation with the technological revolution during the mid-1990s. Innumerable innovations in computerized transaction processing, software tools, telecommunication aids, and the proliferation of the Internet have facilitated the creation of an information economy. In this context, this paper discusses the development of the global financial system and the pros and cons of the decision taken by the United Kingdom not to join the unified currency of the European Union.

Changes in Global Financial System

Many scholars have examined the impact of disruptions on the global financial system (e.g. Calomiris & Mason, 1997; Calomiris & Mason,2003 and Carlson & Mitchener, 2009). The great depression was an economic crash that rocked the Americas, which disrupted the economic activities in Europe and other developed nations of the world during the period from 1929 to 1939. The great depression existed for a longer duration and was the strongest economic shock that devastated all the advanced economies of the world.

The nucleus of the issue was identified as the vast discrepancy between the industrial capabilities of the nation and the capacity of the public to utilize the produced goods and services. There were spectacular improvements in the production designs at the time of World War I, which increased the production of goods and services in the United States, well in excess of the boundaries of the ability of the salaried people and growers of the United States to procure and consume them. The investible surplus of a majority of citizens of the country grew to a level where any prudent channelization was not possible, resulting in the savings and investments drawn into speculative activities either in realty assets or in stocks.

The aftermath of World War II on Global Financial System – period 1940-1945

World War II can be considered as instrumental in overcoming the ill effects of the Great Depression. Governments of different nations prepared their responses to improve their economies with sophisticated systems of financial regulations. The key initiative was the Bretton Woods Agreement entered into in the year 1944. The conference held at Bretton Woods (New Hampshire), attended by representatives from 44 nations entered into this agreement, where the values of national currencies were fixed against United States dollars. Under this agreement, the US dollar was equated to one ounce of gold having a value of US Dollars 35. Prior to this agreement, a gold exchange standard was maintained requiring the countries to maintain gold reserves equal to the value of their currencies. The objective of this arrangement was to take guard against the economic volatility affecting the countries since the practice of backing up with gold reserves led to boom-bust models in the economies. In the area of global trading, the objective of the Bretton Woods agreement is to ensure international economic stability, through the mechanism of preventing currencies from jumping national borders. Another objective of the agreement was to prevent speculation in the international currency market.

As an initiative to restore stability in the global marketplace, the agreement restricted the member countries to indulge in any devaluation of their currencies to facilitate their foreign trade. Even though the policies promulgated by the Bretton Woods agreement were short-lived, the agreement made the United States emerge as the global economic power. Post World War II prosperity led to enormous trading volume in the international foreign exchange market and there were massive movements of capital across geographical borders. This prosperity led to the destabilization of the currency conversion factors set in the earlier agreement. Subsequently the need for a new system to meet the demands of this growth and to provide the platform for better global trading arose.

The meeting at Bretton Woods also proposed the establishment of the “International Monetary Fund (IMF)” and the “International Bank for Reconstruction and Development” (the World Bank). The IMF was entrusted with the responsibility to provide short-term lending to countries to manage exchange rate fluctuations and short-term trade imbalances and the World Bank would provide long-term financial assistance to countries for promoting economic development. These institutions were established with the objective of preventing the reoccurrence of another devastating economic event like the Great Depression.

Recovery and Development of Global Financial System – Period 1945-1955

This period marks the start of the global economic recovery and the start of the Cold War between the erstwhile Union of Soviet Socialist Republics (USSR) and the United States. The developments that took place in the attitude and actions of the USSR convinced American leaders that communism posed a permanent threat to the American model of democratic and competitive capitalism. The after-effects of WW II created extremely bad economic and social conditions in Europe with a shortage of energy and reduced production capacity.

In the aftermath of the Great Depression, governments took up the responsibility of managing the economies and this situation prevailed even in developed countries. There were significant changes taking place in the global context. During the late 1960s, the balance of payments deficit of the United State increased and at the same time, the financial position of European countries became stronger with an increasing surplus. However, the European nations were reluctant to revalue their currencies. This situation depicted the intrinsic demerit of a global reserve system in which the national currency of one country plays a major role in the determination of exchange rates of many other currencies. Even though the system of fixed exchange rates and capital controls were abolished, the dollar standard for other currencies was still maintained. The countries were allowed to decide whether to float their currencies or not. Major countries concurred on holding dollar reserves in the United States. The restrictions on cross-border financial transactions were removed largely which led to increased capital flows across countries including developing economies.

“Special Drawing Rights” (SDR) was introduced in 1969, which resulted from the disequilibrium between the “official” and “commercial” price of gold. The period the late 1960s and early 1970s marked the inflexibility of the global financial system and the governments were unable to follow independent economic policies.

Since the flow of foreign capital was influenced by economic cycles, there were significant changes in the borrowing conditions at the end of the 1970s which adversely affected many of the developing countries, which ended up with unserviceable debts. The debt crisis was perceived as another failure in the development effort and was considered the result of unsound fiscal management in failing to create dynamic export sectors to maintain the debt-service to export ratios within manageable limits. These events fuelled the adoption of a diametrically opposite approach with respect to global economic development. This philosophy gained prominence during the 1980s and 1990s. This philosophy called for a radical change in the role of the government in managing economic development, as governments were viewed as poor managers of public finances. This approach called for the development policies to be keen on the macroeconomic stability with the functioning of more deregulated markets and private initiatives. The market-oriented, export-led strategies helped a number of developing countries in Asia to achieve sustained and rapid economic growth during the 1980s. “These development policies involved inter alia, agrarian reforms, investments in human capital, selective trade protection, directed credit and other government support for developing industrial and technological capacity while exposing firms gradually to global competition” (Department of Economic and Social Affairs, 2010).

Status of Global Financial System after Cold War – Period 1985-1995

After the collapse of the Bretton Woods system of fixed exchange rate system, a new global financial environment emerged in different stages. The economic crisis that started at the beginning of the 1980s led to different structures of business organizations and the enterprises merged with each other for greater efficiency and market power. Bankruptcies were also on the rise. These revised structures in the institutions and enterprises in the financial environment resulted in the generation of a new set of financial institutions and agencies in the form of investment banks, stock, and insurance broking firms, and several other financial intermediaries. The emergence of these financial intermediaries made the commercial banking functions combined with the functions of the investment bankers and stockbroking firms.

Recent Changes

There were several factors responsible for the onset of the financial crisis during 2007-2008. In general, the macroeconomic policies implemented in the United States and the rest of the industrially advanced nations were the main contributing factor for the crisis. Economic policies with respect to fiscal adjustments resulted in a reduction of saving volumes in the United States. Even the country allowed a not so stringent monetary policy to be in force for a longer period. “In Japan, the mix of monetary and fiscal policies distorted the global economy and financial system” (Truman, 2009). Easy monetary policies followed by many other countries including the Asian countries contributed their part to the global meltdown. “The impressive accumulation of foreign exchange reserves by many countries also distorted the international adjustment process, including but not limited to taking some of the pressure off of the macroeconomic policies of the United States and other countries” (Truman, 2009). The most recent instance was the “multi-trillion dollar US-centered securitization debacle began to unravel in June 2007” (Engdahl, 2008), resulting in a “Financial Tsunami” towards the mid to end of 2008. “The meltdown has led to shock waves across the world, with the economy after economy gasping for breath to survive this financial tsunami” (Mohanty, 2009).

The United Kingdom and Unification of European Currencies

The question of whether the UK should join the Euro is one of the most significant economic decisions of the decade. On deciding this issue, the UK government’s policy was announced by the Prime Minister in February 1999. In 2003 the Finance Minister after his assessment of the five economic tests announced that Britain was not yet ready to join the Euro (Laboure, 2009). The five economic tests are:

• There should be sustainable convergence between Britain and the economies of a single currency
• There should be sufficient flexibility to cope with the economic change
• There should be a positive effect on investment
• There should be a positive effect of the single currency on the financial services industry
• The single currency should produce a positive effect on growth and employment.

After an application of these tests, the UK decided not to join the euro presently. The UK might suffer from the following possible consequences of not joining the euro:

• The foreign direct investment that should flow into the UK would be affected by the UK not joining the euro. This is so because there is a possibility that not joining the euro would create instability for the sterling currency. This may create a dent in the foreign direct investment in the UK. Moreover not joining the euro may create an impression among the investors that the UK has distanced itself from Europe might affect the perceptions of the prospective investors to reconsider their decision to invest in the UK.
• The UK not joining the euro may create significant damage in the financial sector of the UK. The possibilities are that the position of the city of London may get affected as a financial nerve center of Europe. This may happen due to the fact that at some point in time Frankfurt or Paris might get preferential access to the euro by virtue of regulations imposed by the European Union that favor the banking and investment institutions operating in the Euro-zone.
• Not joining the euro might distance the country from Europe with the result that the UK would have very little political influence within the European Union. The absence of the UK from the membership of significant bodies constituted to take important decisions would adversely affect the power of the UK to protect its interests. It might also be possible that the country may not able to prevent the introduction of new rules and policies that may weaken the position of the country.

The joining of Britain to the euro had been often discussed both as an economic issue having some disadvantages to the country and at times as an economic decision favoring the UK economy. There had been various arguments for and against the country UK joining the euro. The arguments that were offered for joining the euro area:

1. A single currency should be able to avoid currency instability in the United Kingdom. “An end to internal currency instability and a reduction of external currency instability would enable exporters to project future markets with greater certainty. This will unleash a greater potential for growth,” (BBC News, 1997).
2. The UK doesn’t need to have a floating exchange rate the country should be able to adjust itself to the changed economic conditions using the labor costs and labor market. Hence, there is no need to maintain its own currency just for adjusting itself to the changes in the economy. With changing exchange rates, economies cannot achieve stability in their currency value.
3. The economic welfare is facilitated greatly by lower exchange rate transactions costs. In fact, the abolition of exchange rates among European countries by the unified currency had resulted in drastic fluctuations in foreign currency. This would help the United Kingdom in its efforts in stabilizing its exchange value. Businesses can avoid paying hedging costs to insure against the fluctuations of Pound Sterling against the Euro.
4. The adoption of a volatile interest rate by the European Central Bank taking into account the prevailing economic conditions in all the member countries is better and more efficient than the rates adopted by the Bank of England independently.
5. There were arguments put forth against the United Kingdom joining the euro, which cannot be ignored as having any substance. The arguments were:
6. The first argument was that there had been instances where the currency unions have collapsed in the past and the EMU may follow suit.
7. In contrast to the requirements of the UK economy, the deflationary monetary policies followed by the European Central Bank that addresses the economic stagnation and higher structural unemployment will suit only the European economies.
8. Following the example of Ireland in departing from the sterling currency, it is possible, countries might cancel their membership with the EMU and reestablish their own currency and follow an inflationary policy when they find it difficult to continue with the common currency.
9. Countries, which do not have their own mechanism to adjust exchange rates, cannot meet the economic challenges resulting from economic shocks. Thus, the UK may retain the option of devaluation if necessary to help the economy in stabilizing itself.
10. Without an independent currency, the countries would find it difficult to control recessionary trends.
11. The UK joining the unified currency will affect its monetary freedom as it has to adapt to the directions of the European Central Bank. This implies that the economy will lose its currency flexibilities.

Conclusion

The paper discussed the development of the global financial system through the stages of various economic events including the Great Depression and World Wars. The introduction of the Gold Standard under the Bretton Woods Agreement and Special Drawing Rights was part of the discussion. It has been observed through the development of the global financial system that the floating exchange rate mechanism has worked to both the advantages and disadvantages of the economies and the economies with their freedom to decide on the particular mechanisms suitable to ensure the correction to meet different economic challenges. In this context, the discussion also centered around the advantages and disadvantages of the decision of the United Kingdom to stay away from the unified single currency of the European Union.

Recommendations

Based on the discussions, this paper recommends that the governments must follow stricter financial control mechanisms to ensure that the banking system in the respective countries remains strictly regulated to ensure sustained economic growth. In addition, there should be increased transparency in the financial reporting of large corporations so that investor confidence can be boosted. This will ensure the strengthening of the financial system both at the domestic and international levels. Uniform financial reporting is another factor, which will increase the cross-border capital flows, as the investors in different countries will have a better understanding of the financial performance of prospective investible companies.

References

BBC News, 1997, Special Report – Pros and Cons, Available. Web.

Calomiris, C. W., & Mason, J. R., 1997, Contagion and Bank Failures During the Great Depression: The June 1932 Chicago Banking Panic. American Economic Review, 863-883.

Calomiris, C. W., & Mason, J. R., 2003, Fundamentals, Panics and Bank Distress During the Depression. American Economic Review , 93, 1615-1647.

Carlson, M., & Mitchener, K. J., 2009, Branch Banking as a Device for Discipline: Competition and Bank Survivorship during the Great Depression. Journal of Political Economy , 117, 165-210.

Department of Economic and Social Affairs. (2010). World Economic and Social Survey 2010: Retooling Global Development. Web.

Engdahl, F. W. (2008). The Financial Tsunami Part V: The Predators had a Ball. Web.

Laboure, Marion, 2009, UK : Will the weak Sterling rescue the British economy ? Web.

Mohanty, V. (2009). Marketing strategies to refrain India from global recession. Web.

Truman, E. M. 2009, The Global Financial Crisis: Lessons Learned and Challenges for Developing Countries. Web.