domestic financial systems

Crises Then and Now

To understand the capital imbalances that occurred during the Great Recession, it is helpful to compare the period that led up to the crisis to earlier cycles of globalization. In the first era of globalization (from approximately 1870 to 1914) both trade and financial flows expanded dramatically. Capital came mainly from Europe, especially from the United Kingdom, which largely channeled its investments into its colonies. British investors directed their money to rich settler countries, such as Australia and Canada, where it was used to develop natural resources. Many of the poorer emerging markets of the day were part of some European state’s empire, meaning that they presented few sovereign risks and investors could expect to find virtually identical legal and institutional support there as what they knew from home. Although in the one region where investment was risky, the independent states of Latin America, investors often experienced recurrent defaults, banking crises, and currency crashes, capital basically flowed from the rich core to the poor periphery in the lead-up to World War I.

But then, the first era of globalization fell victim to all-out war, the Great Depression, and war again. By 1945, most countries had retreated behind trade barriers and capital controls. The 1944 Bretton Woods conference, convened to rebuild the international economic system, established a global financial order that led to the creation of the IMF and, eventually, the World Bank. Under the Bretton Woods system, a sense of calm settled on global markets, with no financial crises occurring throughout the 1950s and 1960s. Although the cause of this tranquility is still debated, two features of the Bretton Woods regime undoubtedly contributed. Under the Bretton Woods fixed-exchange-rate system, governments could tightly control external flows of capital to prevent the flight of money and avert speculative attacks on their currencies. And strict, even draconian, restrictions on domestic financial systems kept banks constrained, forbidding them from taking large risks and moderating their ability to leverage. Yet the Bretton Woods system withered away in the 1970s and 1980s, undercut by financial innovations designed to evade capital controls, a lack of commitment to fixed exchange rates, and a willingness of governments, especially in the developed economies, to tolerate greater financial freedom at home and abroad. As a result, a more freewheeling system of finance arose, similar to that of the first era of globalization. This occurred first, in the 1980s, among developed markets and then, in the 1990s, among emerging markets as they opened up their economies and began to embrace financial globalization. Financial crises then began reemerging. They did not immediately impact the seemingly resilient developed economies. Various crises in developed countries, from the widespread U.S. savings and loan failure in the 1980s to the collapse of Scandinavian banks in the early 1990s, were costly but not crippling. But the arrival in the emerging world of financial globalization, with its demands of political and institutional stability, financial supervision, and monetary and fiscal probity, proved far more damaging. Emerging countries often experienced a double or triple crisis.