The Global Macro Economy and Finance

In the event of 2007 financial crisis and its prolonged aftermath, it has become increasingly evident that macroeconomic mechanisms and financial institutions, as well as macroeconomic theory and policy relevant to them, are not well tuned to, or in step with, rapidly changing global economic environments. National economies, developed, emerging and developing alike, are ever more closely interconnected through market and financial integration, fast information transmission and human resource mobility, restructuring of the global division of labor, and so on. Macroeconomics, as well as financial economics, appear urged to re-examine, and possibly re-orient, its accepted premises, research foci, analytical method, and even underlying philosophy, in order to understand the nature of problems that the global economy is facing, improve on economic policy and prudent regulations, and reform global and national economic institutions. Understandably, meeting this challenge would be hardly easy because of the complexity of the issues involved.

There is not a single year where our measurement systems are not called into question, and as a consequence it will take more time than we would like to understand what is going on in the world economy.

The national accounts were developed to address the paucity of comprehensive and consistent data confronting decision makers during the Great Depression. Over the intervening years, the accounts have served macroeconomic policy makers well, contributing to the unprecedented period of post-World War II economic growth and prosperity. Despite this success, there have been continuing calls — including those by the founder of US accounts, Simon Kuznets — for an expansion of the accounts to cover household production, environmental externalities, and other near-market and non-market activities that affect households’ wellbeing. One of the most eloquent critiques of the focus on GDP as a measure of society’s progress was made by Robert F. Kennedy:

Too much and too long, we seem to have surrendered community excellence and community values in the mere accumulation of material things. Our gross national product, if we should judge America by that, counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors … Yet the gross national product does not allow for the health of our children, the quality of their education, or the joy of their play … it measures everything, in short, except that which makes life worthwhile. And it tells us everything about America except why we are proud that we are Americans.¹

Robert F. Kennedy, Address, University of Kansas, Lawrence, Kansas, 18 March 1968

Throughout history, various notions of wellbeing have been discussed depending on cultural influences and prevailing political regimes. In the 20th century, wellbeing was often equated with economic welfare. After the Great Depression and World War II, national accounting, and in particular Gross Domestic Product, came to be seen by many as the main way of measuring development. Although several alternative measures of wellbeing and societal progress were developed by researchers during the 1970s and the 1980s (for example, the ones grouped under the so-called ‘social indicators movement’), it is only in the 1990s that initiatives concerned with sustainable development and measuring human development (such as the UNDP Human Development Index, and the UN’s Millennium Development Goals) have captured the attention of media and have played a role in political debates. More recently, thanks to initiatives carried out by (some) national and local political authorities, to the research on the measurement of quality-of-life and happiness, and to initiatives undertaken by the Organization for Economic Co-operation and Development (OECD) on measuring and fostering societal progress, a new movement aiming at measuring wellbeing is emerging.

There has been a widespread presumption that the current economic crisis is a financial crisis, caused by the bursting of a credit bubble. Unjustified optimism about asset prices and associated risks (primarily in housing but also in financial industry equities and even in equities generally), accommodated by lax regulation, careless private lending and loose monetary policies, led to unsustainable levels of household and financial sector leverage. The inevitable collapse of the underlying asset prices then caused widespread bankruptcies, foreclosures, and impaired balance sheets among households, firms, and financial institutions. Combined with consequent large increases in the incremental risks of lending and investing, these balance sheet effects induced large declines in household spending, firm output and investment, and bank lending.¹

Emerging economies frequently experience episodes of large capital inflows. In the mid-2000s for example, global financial markets were flush with liquidity. Many emerging economies had better short-term growth prospects than advanced countries and became an attractive destination for global investors. Large capital inflows, or ‘capital flow bonanzas’ in the terminology of Reinhart and Reinhart (2008), pushed up real exchange rates and inflated asset prices in the countries affected. The ensuing rise in purchasing power and in the value of domestic assets that could serve as collateral fueled a large increase in indebtedness.

Liquidity in the asset market has attracted increasing attention in public debate and academic research, partly because of the recession in 2008 and 2009 in the United States. At the onset of that recession, liquidity suddenly dried up in the asset market. In particular, the market for collateralized debt obligations almost shut down as major financial institutions either had or were perceived to have insufficient funds to meet their contractual obligations. To prevent a complete collapse of the financial market, the US government injected a large amount of liquid assets into the market through various lending facilities which ranged from short-term lending to outright purchases of private equity by the government.

The turmoil that raged in the global financial markets during the 2007–09 crisis left a significant imprint on bank lending over the past several years. The successive waves of turbulence that ripped through the financial system during that period exerted substantial pressure on both the asset and liability sides of banks’ balance sheets, and banks, at the height of the crisis in the latter part of 2008, faced funding markets that were largely illiquid and secondary markets that were essentially closed to sales of certain types of loans and securities. Together with the slowdown in economic activity that emerged at the end of 2007 and accelerated appreciably in latter part of 2008, these financial disruptions led banks to become significantly more cautious in the extension of credit and to take steps to bolster their capital and liquidity positions. Moreover, the persistent tightness of credit conditions faced by many borrowers, in combination with generally weak demand for bank-intermediated credit, have continued to affect lending during the sluggish recovery. Indeed, two years after the official end of the recession, core loans outstanding — the sum of bank loans to households and nonfinancial businesses — remain 13 per cent below the level reached during the cyclical peak in December 2007.¹

In a thought-provoking article ‘Can a “Credit Crunch” Be Efficient?’ Edward Green and Soo Nam Oh use a mechanism design approach to present a model of financial intermediation in which phenomena qualitatively resembling a ‘credit crunch’ occur but are efficient. In this short chapter, we extend and modify the model of Green and Oh in order to examine how different environments of private information and limited commitment generate different financial frictions. Following a tradition of mechanism design, which considers the market structure as an equilibrium outcome of the underlying environment, we ask questions such as: Which markets are open? Which contracts are used? Which institutions arise? We find that the model of Green and Oh is a useful benchmark to explain the recent literature on the mechanism design approach to financial frictions.

During the recent crisis microprudential regulation of the banking system turned out to be unable to maintain financial stability largely because it did not recognize the problem of systemic risk. This chapter discusses in detail the sources of systemic risk, their importance for financial stability and the macroprudential policies that are necessary to address them.

Global financial integration has proceeded ahead of supporting governance arrangements. As a result large gaps have developed in regulation and supervision, and in crisis management and resolution. The incompleteness of the global financial architecture became acutely clear in the financial crisis. Large vulnerabilities had been allowed to develop, and the mechanisms in place for dealing with the crisis, at least its cross-border aspects, proved grossly inadequate.

Financial structure differs greatly across countries. In bank-based financial systems such as in Germany, Japan (until a decade ago), and India, banks offer the main financial services in mobilizing savings, allocating capital, monitoring corporate managers, and providing risk management services.¹ In market-based systems such as in the UK, the US, and Malaysia, both stock markets and banks play important roles in all financial services. What explains financial structure? Does the combination of institutions and markets that constitutes the financial system have any impact on economic development? These questions have fascinated economists for decades. One of the earliest attempts to address these questions was Goldsmith (1969), who 40 years ago tried to document the change of financial structure over time and to assess the impacts of financial development on economic development. He states that ‘one of the most important problems in the field of finance, if not the single most important one, almost everyone would agree, is the effect that financial structure and development have on economic growth’. With data from 35 countries for the pre-1964 period, he finds positive correlation between financial development and economic growth. But he could not go far on financial structure due to data constraints: he could only rely on careful comparisons of Germany and the United Kingdom. Obviously it is hard to extend the conclusions from case studies to the rest of the world.

Stock prices can go down as well as up. Never in financial history has this adage been more apt than on 6 May 2010. Then, the so-called ‘Flash Crash’ sent shock-waves through global equity markets. The Dow Jones experienced its largest ever intraday point fall, losing $1 trillion of market value in the space of half an hour. History is full of such fat-tailed falls in stocks. Was this just another to add to the list, perhaps compressed into a smaller time window?

Private equity funds are typically organized as limited partnerships, with private equity firms serving as general partners (GPs) of the funds and investors providing capital as limited partners (LPs). These partnerships usually last for ten years, and partnership agreements (investor contracts) signed at the funds’ inceptions clearly define the expected GP compensation. Since the payments to GPs can account for a significant portion of the total cash flows of the fund, the fund fee structure is a critical determinant of the expected net fund returns that the LPs receive. Metrick and Yasuda (2010a) estimate the expected present value of the compensation to GPs as a function of the fee structure specified in investor contracts, but do not consider the fair-value test (FVT) scheme, which is a commonly used carried interest scheme in practice.¹ In this chapter, we evaluate the present value of the FVT carried interest scheme by extending the simulation model developed in Metrick and Yasuda (2010a), and compare the relative values of the FVT carry scheme to other benchmark carry schemes.

What do optimal tax models imply about how multinationals should be taxed? How can we best explain the difference between actual policies and the optimal policies implied by existing theories? These questions are becoming increasingly salient, given the growing importance of multinationals in the global economy.

The taxation of foreign-source income has come under increasing attack by academic researchers and policy-makers. According to the traditional view, national welfare maximization requires that a capital-exporting country tax income from capital invested at home and abroad at the same rate, with a deduction for taxes paid to foreign governments. The basic idea is that a lower tax rate on foreign-source income will cause an inefficiently large outflow of investment, as domestic capital owners seek to escape the higher tax rate at home.¹ But Desai and Hines (2003, 2004) have argued that this close relation between investment at home and investment abroad is not observed, and that foreign-source income should not be taxed because the extra tax borne by domestic investors distorts their decisions to buy and sell foreign companies. Their view of the world is described by the following passage:

… modern scholars view FDI as arising from differential capabilities, and consequently differential productivity, among firms, and the extension of intangible assets across borders. This intuition squares well with empirical FDI patterns, which include the fact that most of the world’s FDI represents investment from one high-income country into another, and the fact that a very high fraction of such investment takes the form of acquiring existing businesses. Consequently, most FDI represents transfers of control and ownership, and need not involve transfers of net savings. (2004: 956)

In other words, whereas the focus of the traditional view has been on ‘capital export neutrality’, the new view elevates ‘ownership neutrality’ to center stage, and argues that foreign-source income should be exempt from taxes levied by the home government.