The January 26, 1998 issue of Forbes magazine contains an interview with Profess

Question

The January 26, 1998 issue of Forbes magazine contains an interview with Professor Randall Kroszner, a financial historian at the business school of the University of Chicago. He discusses the historical similarities between the collapse of the economies of the Western nations in the

1930s and the collapse of the Eastern nations’ economies in the 1990s. According to Professor Kroszner:

“Countries such as Great Britain had returned to the gold standard [after

WWI] at unrealistic parities and found it difficult to pursue domestic policies consistent with the link to gold. After 1929 there was a dramatic loss of confidence in the central banks’ ability to peg their currencies to gold, and in the banking systems themselves. TheAsian economies are now in turmoil because they had unrealistic exchange rates –except in their case they were pegged to the dollar, not to gold. Their domestic credit policies made their external link to the dollar unsustainable.”

Nigel Holloway points out that both in 1930 and in the mid

-1990s“currency collapses led to a deflationary spiral.” Further discussion centers on the ability of market forces to “sort things out.”

Central banks “do more harm than good in the long run” according

to Professor Kroszner, and the lesson of the depression is to “open –

not close [a country’s] markets in time of crisis.”

Continuing, Professor Kroszner makes a case for the least amount of regulation in the financial markets. Citing as an example the rapid development of 18th century Scotland, Professor

Kroszner suggests, “A virtually unregulated financial system can be the engine of economic development.”

You may remember news about the Asian economic problem.

1. Discuss why financial problems in Asian countries relevant to American firms?

2. Identify if itis reasonable to extrapolate from events of two centuries ago? Does history repeat itself?

3. Explain how you would characterize the level of regulation of U.S. financial markets today? Are they “virtually unregulated?”

4. Describe how financial managers hedge against currency fluctuations like the ones seen in Asia?

Explanation / Answer

1. The financial problems in Asian countries are relevant to American firms for several reasons. Firstly, the financial markets are interlinked and so the Asian financial crisis during the 1990s affected the U.S. markets as well. Secondly, American firms have invested large sums of money in several Asian countries. Any crisis in the Asian market will have a negative impact on the investments made by the American firms. Lastly, the exchange rate fluctuations that occur impacts imports, exports and capital flows for the American firms.

2. Yes it is reasonable to extrapolate from events of two centuries ago. In the 19th century there were several instances of financial crisis. In the year 1819, a financial crisis engulfed USA and the economy collapsed. This happened due to poor regulation of the state banks credit market. In 1825, the stock market in England collapsed on the back of risky loans that created an euphoria. This led to speculative investments. Now, history repeated itself in 2008 when USA was caught in the midst of Lehman crisis. The crisis happened due to laxness in regulation and the risk fuelled euphoria.

3. In the aftermath of the Lehman crisis, regulation of the U.S. financial markets has been tightened. Now the SEC (Securities and Exchange Commission) and the CFTC (Commodity Futures Trading Commission) maintain a tight grip on the financial market. The treasury bond market is regulated by  Treasury Department’s Bureau of the Public Debt and the foreign exchange market is regulated by CFTC and NFA (National Futures Association).

It cannot be said that the financial market in USA is virtually unregulated. There has been laxness at times but after the Lehman crisis the level of regulation and control has been increased.

4. Financial managers hedge against currency fluctuations by using different hedging instruments like currency futures, forwards and options. Financial managers make use of financial engineering to hedge their positions. For instance the financial managers largely use forward contracts to lock a rate of exchange.

References: http://fas.org/man/crs/crs-asia2.htm

http://www.investopedia.com/articles/forex/09/exchange-rate-risk-currency-etf.asp

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