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.