International Financial System Essay

There are some assumptions that the United States faces different economic â€Å"reality† than the rest of the world. The speech given by Governor R. S. Kroszner given on September 1, 2008 is about the United States in the International Financial System. He argued â€Å"against the decoupling hypothesis† and talked about the â€Å"two puzzles in the international financial accounts† of the United States. The situation with the housing slowdown in the United States in the summer of 2007 affected also European money markets. It became harder to sell the houses for their original prices. â€Å"Then turmoil emerged in financial systems around the world in the late summer of 2007. † The mortgages taken in the United States were backed with another loans like car loans or student loans and then reinvested again. A lot of foreign investors bought those securities that created difficulties in money markets in Europe. At the beginning of 2008, the financial system in the United States weakened the growth of gross domestic product and affected many emerging markets economies, reducing their growth and prospects for growth. Stock market declined sharply. The food and energy prices increased, and it created a concern of inflation. In other words, Governor wants to show that there is a connection between economies of different countries. It appears that a shock of one country is affecting the economy of many others. According to him, â€Å"the global economy remains closely connected by both trade and financial linkages. † He summed up in short that â€Å"one country’s imports are another’s exports. † The weakness in one economy affects the demand for the imported products that are the stimulus for the economy of the other country which exports these products. Financial account which consists of purchases and sales of assets is a major account. â€Å"Global Financial linkages include not only the net international investment positions but also the sizes of gross cross-border claims and liabilities positions. † There are enormous investments made by US residents and by foreigners. According to Kroszner, â€Å"US liabilities to foreigners totaled more than $20 trillion, exceeding $140 percent of US GDP. US claims on foreigners totaled $17. 5 trillion, roughly 130 percent of US GDP. † This statistics reveled by the FED stuff, indicates that there is a financial linkage between the countries around the world. As a result, â€Å"more than two-third of U. S. liabilities are in the form of debt instruments, while half of U. S. claims are in equity securities and direct investment. † In other words, foreign investors find attractive U. S. markets because of many factors like the Rule of Law, social and political stability, the respect for private property, the uniform commercial code with the court system that can help to resolve disputes, the reliable open market, the safety and soundness of banking system, and finally the transparency in pricing of securities. The next point of the Governor’s speech is about two puzzles. There is an assumption that the United States has the unknown ways to have the higher returns on its investments. The U. S. residents have income of $90 billions more than the foreign investors on their investments in the United States. According to the governor, â€Å"the answer lies in the returns, composition, and size of U. S. claims and liabilities. The return received on U. S. direct investment claims on the rest of the world is much larger than paid by U. S. on its direct investment liabilities to the rest of the world or any other assets. † In short, direct investment appears to be a greater share of U. S. claims than it is of U. S. liabilities. Moreover, the United States is not the only country that has a positive net investment income. United Kingdom has also a larger difference in the rate of return on direct investment claims and liabilities comparing to other countries. This fact proves that the U. S. residents allocate their investments with a greater risk premium and make more physical investments in other countries. Kroszner suggested that difference of $90 billion can be partially explained also by favorable tax laws that â€Å"reduce their overall tax burden† on their direct investments in other countries. Another puzzle was about the U. S. ability to borrow on better terms than the other countries do in order to finance their ‘external deficit. † The United States has huge account deficits over $3. 8 trillion. To finance the deficit U. S. needs to borrow abroad. According to the governor, â€Å"U. S. net liabilities increased by only $600 billion, which is $3. 2 trillion less than the cumulated current account deficits. About $2. 4 trillion of this amount is because of valuation adjustments (capital gains) favoring us claims. † The adjustments constantly occur because of the changes in asset prices and the U. S. currency which is considered to be the major medium of exchange on the market, about 66%. Besides the fact that the United States has the deficit since 1980s, the foreigners are still willing to invest in U. S. market. They can find it more attractive if the United States has the higher real interest. They observe such relative facts like the real sustainable economic growth, the relative inflation rates, and Purchasing Power Parity in the long-run exchange rates. They might also choose to invest in certain securities because of personal preferences and tastes. All these facts influence their decision making to invest in the U. S. market, but the key to resolve the second puzzle lies in differences in portfolio returns, composition, and size. â€Å"Most U. S. liabilities are debt securities, which realize small capital gains, while a large fraction of U. S. claims on the rest of the world are equity securities, which realize much larger capital gains. † In other words, the U. S. residents are taking more risk when invest in the new emerged markets while the foreign investors make safe decisions to invest in the U. S. securities with lower risk and lower return like U. S. bond and bills. Because of global trading and financial linkages, all the countries are bounded together.