December 1, 2012
International Crisis in Lending
Lessons to be learned
Group V Samantha Jeffrey
The debt crisis played a huge role in international lending. This report will discuss how economic crisis can result from many different factors such as changes in government policies which result in failure, and the cost of bank bailouts. Least developing countries also learned a lesson about how interest rates and low exports and imports played a major role in the financial crisis. These countries also tried to stabile their country's currency by fixing its exchange ...view middle of the document...
International flows of financial claims are conventionally divided into four different categories one type would be by lender or investor (private versus official) (Pugel 513). When lending is stable countries lenders with net savings will receive larger returns and the borrowers will pay lower cost, which is considered well-behaved. However, when the opposite occurs there is a financial crisis and the lending and borrowing are considered not well-behaved. The financial crisis begins when the country that borrows defaults on their debt and the lenders recognize the risk and stop new lending. One major cause that leads to a financial crisis is the effect of overlending and overborrowing. Overlending and overborrowing takes place when the borrowing country is aggressive with developing policies to encourage economic growth. Basically the government unknowingly borrows too much to cover budget deficits and is unable to pay back the loans. It is said that lenders only lend (and that borrowers only borrow) for investment projects that generate the returns in the future that can be used to service the debt (Pugel 529).
The optimum currency area, discussed in the article by Paul Krugman, is a prime example of countries implementing new policies to improve economic growth thus causing a budget deficit and default in repayment. The government created the Euro dollar, which would be a common currency utilized by many European countries, in hopes of promoting political integration and harmony. The theory was thought upon to reduce transaction costs, elimination of currency risk, greater transparency and possibly greater competition because prices are easier to compare (Krugman). It also was suppose to influence a boom in trade within the European countries. However, the theories weren’t fully thought through and cause a financial crisis among European countries.
After the creation of the Euro there were massive capital movements from Europe’s core leading to an economic boom and significantly higher inflation rates in certain European countries (Krugman). This led to an unbalanced shock to the European central bank thus causing their ability to repay the debt to be reassessed. The private capital flows were then stopped and ended in a debt overhang between the prices and unit labor cost among the periphery and its core. There also wasn’t much thought given the banking issues such as federal bank backing. Due to its absence the banks had to be bailout and contributed to the public debt to GDP by an additional 40 points (Kraugman). In contrast, other countries such as the U.S. practice well-behaved lending by backing the deposits of national banks at federal level to ensure bailouts have no hardship on state governments. The fact that there was sovereign debt also played a part in private banks fear of receiving payment because sovereign borrowers do not have to pay if they choose not to. This is why the lender last resort benefit would have come in...