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Financial History of Sub-Saharan Africa  

Leigh Gardner

African financial history is often neglected in research on the history of global financial systems, and in its turn research on African financial systems in the past often fails to explore links with the rest of the world. However, African economies and financial systems have been linked to the rest of the world since ancient times. Sub-Saharan Africa was a key supplier of gold used to underpin the monetary systems of Europe and the North from the medieval period through the 19th century. It was West African gold rather than slaves that first brought Europeans to the Atlantic coast of Africa during the early modern period. Within sub-Saharan Africa, currency and credit systems reflected both internal economic and political structures as well as international links. Before the colonial period, indigenous currencies were often tied to particular trades or trade routes. These systems did not immediately cease to exist with the introduction of territorial currencies by colonial governments. Rather, both systems coexisted, often leading to shocks and localized crises during periods of global financial uncertainty. At independence, African governments had to contend with a legacy of financial underdevelopment left from the colonial period. Their efforts to address this have, however, been shaped by global economic trends. Despite recent expansion and innovation, limited financial development remains a hindrance to economic growth.


The State of DSGE Modeling  

Paul Levine

Dynamic stochastic general equilibrium (DSGE) modeling can be structured around six key criticisms leveled at the approach. The first is fundamental and common to macroeconomics and microeconomics alike—namely, problems with rationality and expected utility maximization (EUM). The second is that DSGE models examine fluctuations about an exogenous balanced growth path and there is no role for endogenous growth. The third consists of a number of concerns associated with estimation. The fourth is another fundamental problem with any micro-founded macro-model—that of heterogeneity and aggregation. The fifth and sixth concern focus on the rudimentary nature of earlier models that lacked unemployment and a banking sector. A widely used and referenced example of DSGE modeling is the Smets-Wouters (SW) medium-sized NK model. The model features rational expectations and, in an environment of uncertainty, EUM by households and firms. Preferences are consistent with a nonstochastic exogenous balanced growth path about which the model is solved. The model can be estimated by a Bayesian systems estimation method that involves four types of representative agents (households, final goods producers, trade unions, and intermediate good producers). The latter two produce differentiated labor and goods, respectively, and, in each period of time, consist of a proportion locked into existing contracts and the rest that can reoptimize. There is underemployment but no unemployment. Finally, an arbitrage condition imposed on the return on capital and bonds rules out financial frictions. Thus the model, which has become the gold standard for DSGE macro-modeling, features all six areas of concern. The model can be used as a platform to examine how the current generation of DSGE models has developed in these six dimensions. This modeling framework has also used for macro-economic policy design.


Economic History of the Middle East, 622–1914  

Timur Kuran

In the Middle Ages, the Middle East was an economically advanced region. Driving its successes were an essentially uniform legal system that supported intra- and interregional commerce, partnership rules that supported commerce among nonrelatives, and a form of trust known as waqf, which served as both a wealth shelter and a vehicle for endowing social services with protections against state predation. These same institutions disincentivized the institutional advances needed to generate the modern economy’s infrastructure indigenously. Home-grown innovations, such as the tradable equity known as gedik and a form of waqf used for moneylending (cash waqf), were ill-suited to large-scale and perpetual enterprises. Partnerships used to form small and ephemeral enterprises did not spawn organizational forms conducive to pooling resources on a large scale and perpetually. The waqf’s rigidities led to increasingly serious capital misallocation and misuse with changes in relative prices and the emergence of new technologies. Thus, the Middle East reached the Industrial Era institutionally unprepared. Sensing an existential threat from the West, its ruling elites launched massive economic reforms in the 1800s. These reforms involved transplanting Western economic institutions to the West in a hurry. Although the Middle East’s economic performance improved greatly in absolute terms, it remained underdeveloped in 1914, and the catch-up process has continued. Until the 1700s, the economic fortunes of the Middle East’s religious minorities generally tracked those of its Muslims. Thereafter, non-Muslims pulled ahead. As the global economy modernized, they benefited from a right that, from the early years of Islam, was denied to Muslims: choice of law. With the development of modern economic institutions by Europeans, choice of law enabled non-Muslims to increase the efficiency of their business operations. In the century preceding the Industrial Revolution, non-Muslims benefited also from international treaties that strengthened their property rights vis-à-vis those of Muslims.


The History of Central Banks  

Eric Monnet

The historical evolution of the role of central banks has been shaped by two major characteristics of these institutions: they are banks and they are linked—in various legal, administrative, and political ways—to the state. The history of central banking is thus an analysis of how central banks have ensured or failed to ensure the stability of the value of money and the credit system while maintaining supportive or conflicting relationships with governments and private banks. Opening the black box of central banks is necessary to understanding the political economy issues that emerge from the implementation of monetary and credit policy and why, in addition to macroeconomic effects, these policies have major consequences on the structure of financial systems and the financing of public debt. It is also important to read the history of the evolution of central banks since the end of the 19th century as a game of countries wanting to adopt a dominant institutional model. Each historical period was characterized by a dominant model that other countries imitated - or pretended to imitate while retaining substantial national characteristics - with a view to greater international political and financial integration. Recent academic research has explored several issues that underline the importance of central banks to the development of the state, the financial system and on macroeconomic fluctuations: (a) the origin of central banks; (b) their role as a lender of last resort and banking supervisor; (c) the justifications and consequences of domestic macroeconomic policy objectives - inflation, output, etc. -of central banks (monetary policy); (d) the special loans of central banks and their role in the allocation of credit (credit policy); (e) the legal and political links between the central bank and the government (independence); (f) the role of central banks concerning exchange rates and the international monetary system; (g) production of economic research and statistics.


International Reserves, Exchange Rates, and Monetary Policy: From the Trilemma to the Quadrilemma  

Joshua Aizenman

The links of international reserves, exchange rates, and monetary policy can be understood through the lens of a modern incarnation of the “impossible trinity” (aka the “trilemma”), based on Mundell and Fleming’s hypothesis that a country may simultaneously choose any two, but not all, of the following three policy goals: monetary independence, exchange rate stability, and financial integration. The original economic trilemma was framed in the 1960s, during the Bretton Woods regime, as a binary choice of two out of the possible three policy goals. However, in the 1990s and 2000s, emerging markets and developing countries found that deeper financial integration comes with growing exposure to financial instability and the increased risk of “sudden stop” of capital inflows and capital flight crises. These crises have been characterized by exchange rate instability triggered by countries’ balance sheet exposure to external hard currency debt—exposures that have propagated banking instabilities and crises. Such events have frequently morphed into deep internal and external debt crises, ending with bailouts of systemic banks and powerful macro players. The resultant domestic debt overhang led to fiscal dominance and a reduction of the scope of monetary policy. With varying lags, these crises induced economic and political changes, in which a growing share of emerging markets and developing countries converged to “in-between” regimes in the trilemma middle range—that is, managed exchange rate flexibility, controlled financial integration, and limited but viable monetary autonomy. Emerging research has validated a modern version of the trilemma: that is, countries face a continuous trilemma trade-off in which a higher trilemma policy goal is “traded off” with a drop in the weighted average of the other two trilemma policy goals. The concerns associated with exposure to financial instability have been addressed by varying configurations of managing public buffers (international reserves, sovereign wealth funds), as well as growing application of macro-prudential measures aimed at inducing systemic players to internalize the impact of their balance sheet exposure on a country’s financial stability. Consequently, the original trilemma has morphed into a quadrilemma, wherein financial stability has been added to the trilemma’s original policy goals. Size does matter, and there is no way for smaller countries to insulate themselves fully from exposure to global cycles and shocks. Yet successful navigation of the open-economy quadrilemma helps in reducing the transmission of external shock to the domestic economy, as well as the costs of domestic shocks. These observations explain the relative resilience of emerging markets—especially in countries with more mature institutions—as they have been buffered by deeper precautionary management of reserves, and greater fiscal and monetary space. We close the discussion noting that the global financial crisis, and the subsequent Eurozone crisis, have shown that no country is immune from exposure to financial instability and from the modern quadrilemma. However, countries with mature institutions, deeper fiscal capabilities, and more fiscal space may substitute the reliance on costly precautionary buffers with bilateral swap lines coordinated among their central banks. While the benefits of such arrangements are clear, they may hinge on the presence and credibility of their fiscal backstop mechanisms, and on curbing the resultant moral hazard. Time will test this credibility, and the degree to which risk-pooling arrangements can be extended to cover the growing share of emerging markets and developing countries.