blecker’s critique of fundamentals-based international financial models by siya biniza.pdf
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Blecker’s Critique of Fundamentals-Based International Financial Models
Written by Siyaduma Biniza*
The importance of international finance is undoubtedly a central issue in contemporary
economics. The globalisation of finance and the severe impact of financial crises, such
as the most recent global recession of 2008 and the more recent Eurozone crisis, have
led to a revival of the debate about ideology, scholarship and policy work on
international finance. This essay discusses Blecker’s criticism of fundamentals-based
international finance models and their continued relevance in the policy discourse. The
discussion begins with a theoretical analysis that contrasts fundamentals-based models
with new models. Then I consider a few of the fundamentals-based models before
taking a look at the new models on financial and exchange rate volatility. Lastly I
examine whether the new models are an improvement of the fundamental-based
models.
Fundamentals-based models of international finance can be understood as a special
case of the old models allowing for capital mobility. The old models assume automatic
adjustment mechanisms such as flexible prices or exchange rates; which are asserted as
equilibrating mechanisms whenever an economy has a current account imbalance. But
the old models lack an explanation of financial markets since they neglect the capital
account; which the fundamentals-based models have incorporated. This is why
fundamentals-based models can be seen as a special case of the old model. In addition
to correcting the short-coming of the classical models, which ignored the capital
account and capital mobility, the fundamentals-based models have the central
assumptions that exchange rates are predictable and that international finance is
fundamentals-determined (Blecker, 1999).
However, new models have adequately contradicted this assumption. Also, new
models have adequately proven that financial markets have inherent volatility and that
exchange rates are unpredictable. This volatility of financial markets can often lead to
financial crises which have an impact on the real economy. With this said, it is
important to understand that international finance models are largely influenced and
informed by cataclysmic global events and economic environment at specific times in
history.
From Old Models to Fundamentals-Based Models
The focus of the old international finance models is on the current account and
monetary reserves. These models conceived the domestic economy as being closed
because of the capital controls that largely restrained capital mobility at the time of
their significance. Therefore, these models take a few assumptions which include: self-
equilibrating adjustment mechanism, no capital mobility and fixed or predictable
exchange rates (Blecker, 1999).
However, the contemporary international finance environment and changes that
followed their time of significance challenged these models. For example the
assumption about capital mobility ignored international lending and borrowing which
have become increasing important in the global economy. The globalisation and
liberalisation of the global economy challenged the validity of old models. Thus
fundamentals-based models were devised to deal with these challenges. Therefore, in
addition to the assumption of capital mobility, the fundamentals based also assumed
fixed or predicable exchange rates and financial markets; which are determined by
macroeconomic fundamentals such as interest rates, money supply, inflation and fiscal
policies (Blecker, 1999).
The common ideological foundation in old and fundamentals-based models is that
markets are the most efficient economic redistribution mechanism. The policy
recommendations that arise from these models are that governments should do
nothing because the markets have self-equilibrating mechanisms that would result in
optimal outcomes on themselves (Blecker, 1999). However, aside from instances where
elasticities and absorption mechanisms were seen as the self-equilibrating mechanisms
of markets, the policy recommendations were a once-off revaluation of currencies or
fiscal expenditure reductions (Blecker, 1999).
These kinds of policies were the foundation of the Washing Consensus era. They were
also the sworn financial planning policies of institutions such as the International
Monetary Fund and the World Bank who enforced them as main remedies to many
developing country foreign exchange reserve crises in the form of Structural
Adjustment Programmes (Blecker, 1999). Yet, these policies hardly achieved their
intended consequences because the challenges of the old models were still present
because of the old models formed the theoretical foundations of these models. One
such spurious assumption is the self-equilibrating adjustment mechanisms that ignore
the market-specific sensitivity to these automatic adjustment mechanisms which
means that not all markets are always self-equilibrating. The latter challenge is most
obvious in the market-specific characteristics that determine the equilibrating ability of
policy recommendations based on these models (Blecker, 1999; Obstfeld, Shambaugh
& Taylor, 2008). This led to the emergence of new models of speculative behaviour and
financial instability.
New models assert that exchange rates and international finance are unpredictable.
Further, fundamentals do not have a decisive role on the exchange rate as
fundamentals-based models assert. For instance, exchange rates and international
capital can be affected by speculative and herding behaviour. Speculative behaviour
can result in self-fulfilling prophecies that force authorities to revalue currencies. This
occurs when speculators speculate on a currency’s future value and take actions that
are followed by other investors due to herding behaviour. The result is that the
currency appreciates or depreciates depending on the change in demand resulting
from the investors’ speculative and herding behaviour.
For example, speculators could expect a currency to depreciate. Then they would move
their capital out of that specific economy. If the actions of a few speculators lead to
herding behaviour, where other investors follow suit, a panic would ensue causing
sudden widespread capital flight (Kindleberger & Aliber, 2005). This would cause the
domestic currency to depreciate due to lower demand for the currency. If the currency
is pegged, authorities with fixed reserves may be forced to devalue their currency or
abandon the peg. The result is that exchange rates and international finance are
unpredictable. Moreover, fundamentals are not the only decisive influence in financial
markets.
Furthermore, new models of random-walks and long-swings perform better in
predicting the exchange rate. However, these models have the central assertion that
exchange rates are unpredictable, which is a direct contradiction of the fundamental-
based assumption, that exchange rates are predictable and fundamental-determined.
Thus the new models contradict the fundamentals-based model assertions.
New Models: Unpredictable Exchange Rates and Financial Instability
The preoccupation of the contemporary models has thus been to understand what
causes exchange rate volatility and financial market instability. Therefore models such
as the random walks and long swings models use empirical evidence to try and
respond to these preoccupations. The findings are that macroeconomic fundamentals
cannot adequately explain exchange rates and their fluctuations. Moreover, the new
models explain exchange rates and fluctuations and financial instability better than
fundamentals models do (Blecker, 1999).
The random walks and long swings argue that exchange rates depend on the
exchange rate value in the previous period and that over time exchange rate exhibit
periods of appreciation and depreciation (Blecker, 1999). In other words the exchange
rate today depends on yesterday’s exchange rate value which might be higher or lower
than today’s exchange rate value. So we cannot conclusively know what the exchange
rate will be tomorrow since there might be a currency appreciation or depreciation.
Also, exchange rates follow periodic trends of either an appreciation or depreciation of
the currency. Consequently exchange rates are unpredictable. Moreover, these models
are able to predict the exchange rate with greater precision than the fundamentals
models which assume that exchange rate are determined by macroeconomic
fundamentals (Blecker, 1999). Thus, exchange rates are determined by autonomous
currency market factors as opposed to macroeconomic fundamentals (Blecker, 1999).
So how and why do exchange rates fluctuate?
One of the answers to this question is currency speculation and herding behaviour set
off a self-fulfilling prophecy through herding behaviour of other speculators who
follow others’ actions (Blecker, 1999). In other words, when people share a certain belief
about the direction of a specific exchange rate which leads them to speculate in
currency markets in order to make a quick earning, the change in demand for the
currency they are speculating on directly affects the exchange rate for that currency
either leading to an appreciation or depreciation; which they speculated about in the
first place. This is an actual reality in liberalised markets that allow for easy transfer of
capital without controls (Palma, 2000; Grabel, 2003). Therefore the collective action of
speculators leads to a self-fulfilling prophecy through the demand effect on exchange
rates in currency markets which causes exchange rate fluctuates. Thus, faced with
sufficient changes in currency demand authorities are forced to revalue currencies
which may occur earlier than would have been the case without speculation and
herding behaviour; even if the economy was on a trajectory that would have led to a
revaluation (Blecker, 1999).
This result is vastly different from the assertions of fundamentals-based models. The
fundamentals-based models assert that interest rates, inflation and macroeconomic
indicators determine the exchange rate and international finance. The fundamentals-
based models have no room for considerations about speculating investors, herding
behaviour and self-fulfilling prophecies. Also, fundamentals-based models cannot
predict the exchange rate and international finance with great success. Moreover, new
models have adequately proven that financial markets have inherent volatility and that
exchange rates are unpredictable. Further, the volatility of financial markets can often
lead to financial crises which have an impact on the real economy (Kindleberger &
Aliber, 2005; Blecker, 1999). Therefore fundamentals-based models assume
predictability which new models have discredited.
Yet, fundamentals are still politically significant. Most policy-making is informed by, and
grounded in, fundamentals that assume predictability in international financial markets
which has been discredited by the new models. Thus, although the fundamentals are
proven as invalid in explaining international finance and exchange rates; we cannot
completely ignore the fundamentals-based models since they are still explanatively
and politically significant in the current macroeconomics and international finance
discourse (Blecker, 1999).
This is because speculators and economic authorities are only privy to market
information on fundamentals in most cases. More importantly, these economic agents
act upon this information making their actions dependent on fundamentals – at least
partially. Therefore when they speculate they rely on information on fundamentals
such as inflation rates, interest rate and fiscal policy etc. Thus it is theoretically difficult
to specify whether exchange rate fluctuations are caused by speculative bubbles or
fundamentals given this. Thus, even though fundamentals have been invalidated as
economic determinations in international capital, they remain informatively and
politically significant. Thus, eventhough new models have discredited the
fundamentals-based models due to the empirical invalidity of the fundamentals-based
models; the new models are still theoretically informed by fundamentals (Blecker,
1999).
Are the New Models an Improvement on the Fundamentals-Based Models?
Fundamentals are still informatively significant because speculation and herding
behaviour results from judgements based on fundamentals (Blecker, 1999). Moreover,
because speculation and herding behaviour can cause financial instability through
speculative bubbles, fundamentals are politically important because they can be
utilised in ways that can avoid crisis. In other words, authorities can ensure, however
limited this influence might be, that fundamentals are conducive to economic stability
thus avoiding speculation; which often arises from judgements that the economy is
unsustainable (Blecker, 1999).
This leads me conclude that new models are an improvement of the fundamentals-
based models. Firstly, the new models are more empirically valid and they are sound
explanations of exchange rate fluctuations and financial instability – which is a reality in
the contemporary global economy. Secondly, the new models do not have the faulty
logic of fundamentals-based models which over-emphasised the primacy of market
mechanisms that were assumed to be self-equilibrating. Also, the recent economic
crises are real-world evidence that the logic and theoretical underpinnings, i.e. reliance
on market mechanisms, of fundamentals-based is flawed at best. Lastly, given that new
models do not conclusively lead to a disregard for or proof of the irrelevance of
fundaments; the new models are an improvement of this faulty logic given that their
logic is more empirically valid and sound.
These findings highlight two constraints that policies face. Firstly, because currency
and financial markets are determined by autonomous factors within these markets,
policy actions have a limited effect, if any, in resolving the inherent instability of these
markets. Secondly fundamentals have no direct impact and the current policy tools are
incapable of resolving the inherent volatility of these market. These are challenging
and significant implications because the findings invalidate the fundamentals-based
policies which suggest that automatic market adjustments and fundamentals-based
policy recommendations to deal with problems related to international finance.
Nevertheless, as argued above, fundamentals are still informatively and politically
important even through the models based on them are invalidated by contemporary
models on speculative behaviour and financial instability.
Conclusion: How far have we gone?
At each historic stage of international financial development, we have had to adjust our
assumptions in order to have models that better explain the economic reality of each.
This has led the development of fundamentals-based models which sought to correct
the deficiencies of old models that excluded capital mobility. The fundamentals-based
models still had the same theoretical foundations of the old models except that they
allowed for capital mobility.
However, exchange rate and financial market volatilities and policy failures
illegitimated the fundamentals-based models. Therefore new models invalidate the
fundamentals-based models’ assumption stability and predictability that is determined
by macroeconomic fundamentals. Moreover, the new models are statistically superior
to fundamentals-based models. These new models have strong and significant
implications for policy which highlight the limitations of policy; which can partially
explain the failure of neoliberal policies of the Washington Consensus era in dealing
with developing countries’ foreign exchange crises. Nevertheless, even within the
paradigm of new models, fundamentals remain informatively and politically significant.
Thus, although fundamentals-based models have been invalidated, fundamentals still
dominate the discourse on international finance.
Bibliography
Blecker, R.A., 1999. Chapter 2: International Financial Models and their Policy
Implications. In Blecker, R.A. Taming Global Finance: A Bettter Architecture for Growth and
Equity. Washington DC: Economic Policy Institute. pp.39-83.
Grabel, I., 2003. Averting Crisis? Assessing Measures to Manage Financial Integration in
Emerging Economies. Cambridge Journal Of Economics, 27(3), p.317–36.
Kindleberger, C.P. & Aliber, R.Z., 2005. Manias, Panics and Crashes: A History of Financial
Crises. 5th ed. New York: Palgrave Macmillan.
Obstfeld, M., Shambaugh, J.C. & Taylor, A.M., 2008. Financial Stability, the Trilemma, and
International Reserves. No. w14217. National Bureau of Economic Research.
Palma, G., 2000. The Three Routes to Financial Crises: The Need for Capital Controls. CEPA
Working Paper Series III, Working Paper No. 18. New York: New School for Social
Research Centre for Economic Policy Analysis.
* Siyaduma Biniza is currently a B.Com. (Hon) in Development Theory and Policy student at the University of the Witwatersrand, holding a B.Soc.Sci in Politics, Philosophy and Economics from the University of Cape Town.
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