What Is International Economics About?
International economics uses the same fundamental methods of analysis as other branches
of economics, because the motives and behavior of individuals are the same in international
trade as they are in domestic transactions. Gourmet food shops in Florida sell coffee
beans from both Mexico and Hawaii; the sequence of events that brought those beans to
the shop is not very different, and the imported beans traveled a much shorter distance
than the beans shipped within the United States! Yet international economics involves new
and different concerns, because international trade and investment occur between independent
nations. The United States and Mexico are sovereign states; Florida and Hawaii
are not. Mexico’s coffee shipments to Florida could be disrupted if the U.S. government
imposed a quota that limits imports; Mexican coffee could suddenly become cheaper to
U.S. buyers if the peso were to fall in value against the dollar. By contrast, neither of those
events can happen in commerce within the United States because the Constitution forbids
restraints on interstate trade and all U.S. states use the same currency.
The subject matter of international economics, then, consists of issues raised by the
special problems of economic interaction between sovereign states. Seven themes recur
throughout the study of international economics: (1) the gains from trade, (2) the pattern
of trade, (3) protectionism, (4) the balance of payments, (5) exchange rate determination,
(6) international policy coordination, and (7) the international capital market.
The Gains from Trade
Everybody knows that some international trade is beneficial—for example, nobody thinks
that Norway should grow its own oranges. Many people are skeptical, however, about the
benefits of trading for goods that a country could produce for itself. Shouldn’t Americans
buy American goods whenever possible, to help create jobs in the United States?
Probably the most important single insight in all of international economics is that
there are gains from trade—that is, when countries sell goods and services to each other,
this exchange is almost always to their mutual benefit. The range of circumstances under
which international trade is beneficial is much wider than most people imagine. It is a
common misconception that trade is harmful if there are large disparities between countries
in productivity or wages. On one side, businesspeople in less technologically
advanced countries, such as India, often worry that opening their economies to international
trade will lead to disaster because their industries won’t be able to compete. On the
other side, people in technologically advanced nations where workers earn high wages
often fear that trading with less advanced, lower-wage countries will drag their standard of
living down—one presidential candidate memorably warned of a “giant sucking sound” if
the United States were to conclude a free trade agreement with Mexico.
Yet the first model this book presents of the causes of trade (Chapter 3) demonstrates
that two countries can trade to their mutual benefit even when one of them is more
efficient than the other at producing everything, and when producers in the less efficient
country can compete only by paying lower wages. We’ll also see that trade provides benefits
by allowing countries to export goods whose production makes relatively heavy use of
resources that are locally abundant while importing goods whose production makes heavy
use of resources that are locally scarce (Chapter 5). International trade also allows countries
to specialize in producing narrower ranges of goods, giving them greater efficiencies
of large-scale production.
Nor are the benefits of international trade limited to trade in tangible goods. International
migration and international borrowing and lending are also forms of mutually beneficial
trade—the first a trade of labor for goods and services (Chapter 4), the second a trade of
current goods for the promise of future goods (Chapter 6). Finally, international exchanges
of risky assets such as stocks and bonds can benefit all countries by allowing each country to
diversify its wealth and reduce the variability of its income (Chapter 21). These invisible
forms of trade yield gains as real as the trade that puts fresh fruit from Latin America in
Toronto markets in February.
Although nations generally gain from international trade, it is quite possible that international
trade may hurt particular groups within nations—in other words, that international
trade will have strong effects on the distribution of income. The effects of trade on
income distribution have long been a concern of international trade theorists, who have
pointed out that:
International trade can adversely affect the owners of resources that are “specific” to
industries that compete with imports, that is, cannot find alternative employment in other
industries. Examples would include specialized machinery, such as power looms made
less valuable by textile imports, and workers with specialized skills, like fishermen who
find the value of their catch reduced by imported seafood.
Trade can also alter the distribution of income between broad groups, such as workers
and the owners of capital.
These concerns have moved from the classroom into the center of real-world policy
debate, as it has become increasingly clear that the real wages of less-skilled workers in
CHAPTER 1 Introduction 5
the United States have been declining even though the country as a whole is continuing to
grow richer. Many commentators attribute this development to growing international
trade, especially the rapidly growing exports of manufactured goods from low-wage countries.
Assessing this claim has become an important task for international economists and
is a major theme of Chapters 4 through 6.
The Pattern of Trade
Economists cannot discuss the effects of international trade or recommend changes in government
policies toward trade with any confidence unless they know their theory is good
enough to explain the international trade that is actually observed. As a result, attempts to
explain the pattern of international trade—who sells what to whom—have been a major
preoccupation of international economists.
Some aspects of the pattern of trade are easy to understand. Climate and resources
clearly explain why Brazil exports coffee and Saudi Arabia exports oil. Much of the
pattern of trade is more subtle, however. Why does Japan export automobiles, while the
United States exports aircraft? In the early 19th century, English economist David Ricardo
offered an explanation of trade in terms of international differences in labor productivity,
an explanation that remains a powerful insight (Chapter 3). In the 20th century, however,
alternative explanations also were proposed. One of the most influential, but still controversial,
explanations links trade patterns to an interaction between the relative supplies
of national resources such as capital, labor, and land on one side and the relative use of
these factors in the production of different goods on the other. We present this theory in
Chapter 5. Recent efforts to test the implications of this theory, however, appear to show
that it is less valid than many had previously thought. More recently still, some international
economists have proposed theories that suggest a substantial random component in
the pattern of international trade, theories that are developed in Chapters 7 and 8.
How Much Trade?
If the idea of gains from trade is the most important theoretical concept in international
economics, the seemingly eternal debate over how much trade to allow is its most important
policy theme. Since the emergence of modern nation-states in the 16th century,
governments have worried about the effect of international competition on the prosperity
of domestic industries and have tried either to shield industries from foreign competition
by placing limits on imports or to help them in world competition by subsidizing exports.
The single most consistent mission of international economics has been to analyze the
effects of these so-called protectionist policies—and usually, though not always, to criticize
protectionism and show the advantages of freer international trade.
The debate over how much trade to allow took a new direction in the 1990s. After
World War II the advanced democracies, led by the United States, pursued a broad policy
of removing barriers to international trade; this policy reflected the view that free trade
was a force not only for prosperity but also for promoting world peace. In the first half of
the 1990s, several major free trade agreements were negotiated. The most notable were the
North American Free Trade Agreement (NAFTA) between the United States, Canada, and
Mexico, approved in 1993, and the so-called Uruguay Round agreement, which established
the World Trade Organization in 1994.
Since that time, however, an international political movement opposing “globalization”
has gained many adherents. The movement achieved notoriety in 1999, when demonstrators
representing a mix of traditional protectionists and new ideologies disrupted a major
international trade meeting in Seattle. If nothing else, the anti-globalization movement has
forced advocates of free trade to seek new ways to explain their views.
6 CHAPTER 1 Introduction
As befits both the historical importance and the current relevance of the protectionist
issue, roughly a quarter of this book is devoted to this subject. Over the years, international
economists have developed a simple yet powerful analytical framework for determining
the effects of government policies that affect international trade. This framework helps
predict the effects of trade policies, while also allowing for cost-benefit analysis and defining
criteria for determining when government intervention is good for the economy. We
present this framework in Chapters 9 and 10 and use it to discuss a number of policy issues
in those chapters and in the two that follow.
In the real world, however, governments do not necessarily do what the cost-benefit
analysis of economists tells them they should. This does not mean that analysis is useless.
Economic analysis can help make sense of the politics of international trade policy, by
showing who benefits and who loses from such government actions as quotas on imports
and subsidies to exports. The key insight of this analysis is that conflicts of interest within
nations are usually more important in determining trade policy than conflicts of interest
between nations. Chapters 4 and 5 show that trade usually has very strong effects on
income distribution within countries, while Chapters 10 through 12 reveal that the relative
power of different interest groups within countries, rather than some measure of overall
national interest, is often the main determining factor in government policies toward international
trade.
Balance of Payments
In 1998 both China and South Korea ran large trade surpluses of about $40 billion each. In
China’s case the trade surplus was not out of the ordinary—the country had been running
large surpluses for several years, prompting complaints from other countries, including the
United States, that China was not playing by the rules. So is it good to run a trade surplus
and bad to run a trade deficit? Not according to the South Koreans: Their trade surplus was
forced on them by an economic and financial crisis, and they bitterly resented the necessity
of running that surplus.
This comparison highlights the fact that a country’s balance of payments must be
placed in the context of an economic analysis to understand what it means. It emerges in a
variety of specific contexts: in discussing foreign direct investment by multinational corporations
(Chapter 8), in relating international transactions to national income accounting
(Chapter 13), and in discussing virtually every aspect of international monetary policy
(Chapters 17 through 22). Like the problem of protectionism, the balance of payments has
become a central issue for the United States because the nation has run huge trade deficits
in every year since 1982.
Exchange Rate Determination
The euro, a common currency for most of the nations of Western Europe, was introduced on
January 1, 1999. On that day the euro was worth about $1.17. By early 2002, the euro was
worth only about $0.85, denting Europe’s pride (although helping its exporters). By late
2007, the euro was worth more than $1.40; by the middle of 2010, it had slid back to $1.29.
A key difference between international economics and other areas of economics is that
countries usually have their own currencies—the euro being the exception that proves the
rule. And as the example of the euro/dollar exchange rate illustrates, the relative values of
currencies can change over time, sometimes drastically.
For historical reasons, the study of exchange rate determination is a relatively new part
of international economics. For much of modern economic history, exchange rates were
fixed by government action rather than determined in the marketplace. Before World War
I the values of the world’s major currencies were fixed in terms of gold; for a generation
CHAPTER 1 Introduction 7
after World War II, the values of most currencies were fixed in terms of the U.S. dollar.
The analysis of international monetary systems that fix exchange rates remains an important
subject. Chapter 18 is devoted to the working of fixed-rate systems, Chapter 19 to the
historical performance of alternative exchange-rate systems, and Chapter 20 to the
economics of currency areas such as the European monetary union. For the time being,
however, some of the world’s most important exchange rates fluctuate minute by minute
and the role of changing exchange rates remains at the center of the international economics
story. Chapters 14 through 17 focus on the modern theory of floating exchange rates.
International Policy Coordination
The international economy comprises sovereign nations, each free to choose its own economic
policies. Unfortunately, in an integrated world economy, one country’s economic
policies usually affect other countries as well. For example, when Germany’s Bundesbank
raised interest rates in 1990—a step it took to control the possible inflationary impact of
the reunification of West and East Germany—it helped precipitate a recession in the rest of
Western Europe. Differences in goals among countries often lead to conflicts of interest.
Even when countries have similar goals, they may suffer losses if they fail to coordinate
their policies. A fundamental problem in international economics is determining how to
produce an acceptable degree of harmony among the international trade and monetary
policies of different countries in the absence of a world government that tells countries
what to do.
For almost 70 years, international trade policies have been governed by an international
treaty known as the General Agreement on Tariffs and Trade (GATT). Since 1994, trade
rules have been enforced by an international organization, the World Trade Organization,
that can tell countries, including the United States, that their policies violate prior agreements.
We discuss the rationale for this system in Chapter 9 and look at whether the current
rules of the game for international trade in the world economy can or should survive.
While cooperation on international trade policies is a well-established tradition, coordination
of international macroeconomic policies is a newer and more uncertain topic.
Only in the past few years have economists formulated at all precisely the case for
macroeconomic policy coordination. Nonetheless, attempts at international macroeconomic
coordination are occurring with growing frequency in the real world. Both the
theory of international macroeconomic coordination and the developing experience are
reviewed in Chapter 19.
The International Capital Market
During the 1970s, banks in advanced countries lent large sums to firms and governments
in poorer nations, especially in Latin America. In 1982, however, first Mexico, then a
number of other countries, found themselves unable to pay back the money they owed.
The resulting “debt crisis” persisted until 1990. In the 1990s, investors once again
became willing to put hundreds of billions of dollars into “emerging markets,” both in
Latin America and in the rapidly growing economies of Asia. All too soon, however, this
investment boom came to grief as well; Mexico experienced another financial crisis at the
end of 1994, much of Asia was caught up in a massive crisis beginning in the summer of
1997, and Argentina had a severe crisis in 2002. This roller coaster history contains
many lessons, the most undisputed of which is the growing importance of the international
capital market.
In any sophisticated economy there is an extensive capital market: a set of arrangements
by which individuals and firms exchange money now for promises to pay in the future.
The growing importance of international trade since the 1960s has been accompanied by a
8 CHAPTER 1 Introduction
growth in the international capital market, which links the capital markets of individual
countries. Thus in the 1970s, oil-rich Middle Eastern nations placed their oil revenues in
banks in London or New York, and these banks in turn lent money to governments and
corporations in Asia and Latin America. During the 1980s, Japan converted much of the
money it earned from its booming exports into investments in the United States, including
the establishment of a growing number of U.S. subsidiaries of Japanese corporations.
Nowadays China is funneling its own export earnings into a range of foreign assets, including
dollars that its government holds as international reserves.
International capital markets differ in important ways from domestic capital markets.
They must cope with special regulations that many countries impose on foreign investment;
they also sometimes offer opportunities to evade regulations placed on domestic
markets. Since the 1960s, huge international capital markets have arisen, most notably the
remarkable London Eurodollar market, in which billions of dollars are exchanged each
day without ever touching the United States.
Some special risks are associated with international capital markets. One risk is that of
currency fluctuations: If the euro falls against the dollar, U.S. investors who bought euro
bonds suffer a capital loss—as the many investors who had assumed that Europe’s new
currency would be strong discovered to their horror. Another risk is that of national
default: A nation may simply refuse to pay its debts (perhaps because it cannot), and there
may be no effective way for its creditors to bring it to court. International financial linkages
helped turn the downturn in the U.S. housing market that had begun in 2006 into a
global economic crisis.
The growing importance of international capital markets and their new problems
demand greater attention than ever before. This book devotes two chapters to issues arising
from international capital markets: one on the functioning of global asset markets
(Chapter 21) and one on foreign borrowing by developing countries (Chapter 22).
International economics uses the same fundamental methods of analysis as other branches
of economics, because the motives and behavior of individuals are the same in international
trade as they are in domestic transactions. Gourmet food shops in Florida sell coffee
beans from both Mexico and Hawaii; the sequence of events that brought those beans to
the shop is not very different, and the imported beans traveled a much shorter distance
than the beans shipped within the United States! Yet international economics involves new
and different concerns, because international trade and investment occur between independent
nations. The United States and Mexico are sovereign states; Florida and Hawaii
are not. Mexico’s coffee shipments to Florida could be disrupted if the U.S. government
imposed a quota that limits imports; Mexican coffee could suddenly become cheaper to
U.S. buyers if the peso were to fall in value against the dollar. By contrast, neither of those
events can happen in commerce within the United States because the Constitution forbids
restraints on interstate trade and all U.S. states use the same currency.
The subject matter of international economics, then, consists of issues raised by the
special problems of economic interaction between sovereign states. Seven themes recur
throughout the study of international economics: (1) the gains from trade, (2) the pattern
of trade, (3) protectionism, (4) the balance of payments, (5) exchange rate determination,
(6) international policy coordination, and (7) the international capital market.
The Gains from Trade
Everybody knows that some international trade is beneficial—for example, nobody thinks
that Norway should grow its own oranges. Many people are skeptical, however, about the
benefits of trading for goods that a country could produce for itself. Shouldn’t Americans
buy American goods whenever possible, to help create jobs in the United States?
Probably the most important single insight in all of international economics is that
there are gains from trade—that is, when countries sell goods and services to each other,
this exchange is almost always to their mutual benefit. The range of circumstances under
which international trade is beneficial is much wider than most people imagine. It is a
common misconception that trade is harmful if there are large disparities between countries
in productivity or wages. On one side, businesspeople in less technologically
advanced countries, such as India, often worry that opening their economies to international
trade will lead to disaster because their industries won’t be able to compete. On the
other side, people in technologically advanced nations where workers earn high wages
often fear that trading with less advanced, lower-wage countries will drag their standard of
living down—one presidential candidate memorably warned of a “giant sucking sound” if
the United States were to conclude a free trade agreement with Mexico.
Yet the first model this book presents of the causes of trade (Chapter 3) demonstrates
that two countries can trade to their mutual benefit even when one of them is more
efficient than the other at producing everything, and when producers in the less efficient
country can compete only by paying lower wages. We’ll also see that trade provides benefits
by allowing countries to export goods whose production makes relatively heavy use of
resources that are locally abundant while importing goods whose production makes heavy
use of resources that are locally scarce (Chapter 5). International trade also allows countries
to specialize in producing narrower ranges of goods, giving them greater efficiencies
of large-scale production.
Nor are the benefits of international trade limited to trade in tangible goods. International
migration and international borrowing and lending are also forms of mutually beneficial
trade—the first a trade of labor for goods and services (Chapter 4), the second a trade of
current goods for the promise of future goods (Chapter 6). Finally, international exchanges
of risky assets such as stocks and bonds can benefit all countries by allowing each country to
diversify its wealth and reduce the variability of its income (Chapter 21). These invisible
forms of trade yield gains as real as the trade that puts fresh fruit from Latin America in
Toronto markets in February.
Although nations generally gain from international trade, it is quite possible that international
trade may hurt particular groups within nations—in other words, that international
trade will have strong effects on the distribution of income. The effects of trade on
income distribution have long been a concern of international trade theorists, who have
pointed out that:
International trade can adversely affect the owners of resources that are “specific” to
industries that compete with imports, that is, cannot find alternative employment in other
industries. Examples would include specialized machinery, such as power looms made
less valuable by textile imports, and workers with specialized skills, like fishermen who
find the value of their catch reduced by imported seafood.
Trade can also alter the distribution of income between broad groups, such as workers
and the owners of capital.
These concerns have moved from the classroom into the center of real-world policy
debate, as it has become increasingly clear that the real wages of less-skilled workers in
CHAPTER 1 Introduction 5
the United States have been declining even though the country as a whole is continuing to
grow richer. Many commentators attribute this development to growing international
trade, especially the rapidly growing exports of manufactured goods from low-wage countries.
Assessing this claim has become an important task for international economists and
is a major theme of Chapters 4 through 6.
The Pattern of Trade
Economists cannot discuss the effects of international trade or recommend changes in government
policies toward trade with any confidence unless they know their theory is good
enough to explain the international trade that is actually observed. As a result, attempts to
explain the pattern of international trade—who sells what to whom—have been a major
preoccupation of international economists.
Some aspects of the pattern of trade are easy to understand. Climate and resources
clearly explain why Brazil exports coffee and Saudi Arabia exports oil. Much of the
pattern of trade is more subtle, however. Why does Japan export automobiles, while the
United States exports aircraft? In the early 19th century, English economist David Ricardo
offered an explanation of trade in terms of international differences in labor productivity,
an explanation that remains a powerful insight (Chapter 3). In the 20th century, however,
alternative explanations also were proposed. One of the most influential, but still controversial,
explanations links trade patterns to an interaction between the relative supplies
of national resources such as capital, labor, and land on one side and the relative use of
these factors in the production of different goods on the other. We present this theory in
Chapter 5. Recent efforts to test the implications of this theory, however, appear to show
that it is less valid than many had previously thought. More recently still, some international
economists have proposed theories that suggest a substantial random component in
the pattern of international trade, theories that are developed in Chapters 7 and 8.
How Much Trade?
If the idea of gains from trade is the most important theoretical concept in international
economics, the seemingly eternal debate over how much trade to allow is its most important
policy theme. Since the emergence of modern nation-states in the 16th century,
governments have worried about the effect of international competition on the prosperity
of domestic industries and have tried either to shield industries from foreign competition
by placing limits on imports or to help them in world competition by subsidizing exports.
The single most consistent mission of international economics has been to analyze the
effects of these so-called protectionist policies—and usually, though not always, to criticize
protectionism and show the advantages of freer international trade.
The debate over how much trade to allow took a new direction in the 1990s. After
World War II the advanced democracies, led by the United States, pursued a broad policy
of removing barriers to international trade; this policy reflected the view that free trade
was a force not only for prosperity but also for promoting world peace. In the first half of
the 1990s, several major free trade agreements were negotiated. The most notable were the
North American Free Trade Agreement (NAFTA) between the United States, Canada, and
Mexico, approved in 1993, and the so-called Uruguay Round agreement, which established
the World Trade Organization in 1994.
Since that time, however, an international political movement opposing “globalization”
has gained many adherents. The movement achieved notoriety in 1999, when demonstrators
representing a mix of traditional protectionists and new ideologies disrupted a major
international trade meeting in Seattle. If nothing else, the anti-globalization movement has
forced advocates of free trade to seek new ways to explain their views.
6 CHAPTER 1 Introduction
As befits both the historical importance and the current relevance of the protectionist
issue, roughly a quarter of this book is devoted to this subject. Over the years, international
economists have developed a simple yet powerful analytical framework for determining
the effects of government policies that affect international trade. This framework helps
predict the effects of trade policies, while also allowing for cost-benefit analysis and defining
criteria for determining when government intervention is good for the economy. We
present this framework in Chapters 9 and 10 and use it to discuss a number of policy issues
in those chapters and in the two that follow.
In the real world, however, governments do not necessarily do what the cost-benefit
analysis of economists tells them they should. This does not mean that analysis is useless.
Economic analysis can help make sense of the politics of international trade policy, by
showing who benefits and who loses from such government actions as quotas on imports
and subsidies to exports. The key insight of this analysis is that conflicts of interest within
nations are usually more important in determining trade policy than conflicts of interest
between nations. Chapters 4 and 5 show that trade usually has very strong effects on
income distribution within countries, while Chapters 10 through 12 reveal that the relative
power of different interest groups within countries, rather than some measure of overall
national interest, is often the main determining factor in government policies toward international
trade.
Balance of Payments
In 1998 both China and South Korea ran large trade surpluses of about $40 billion each. In
China’s case the trade surplus was not out of the ordinary—the country had been running
large surpluses for several years, prompting complaints from other countries, including the
United States, that China was not playing by the rules. So is it good to run a trade surplus
and bad to run a trade deficit? Not according to the South Koreans: Their trade surplus was
forced on them by an economic and financial crisis, and they bitterly resented the necessity
of running that surplus.
This comparison highlights the fact that a country’s balance of payments must be
placed in the context of an economic analysis to understand what it means. It emerges in a
variety of specific contexts: in discussing foreign direct investment by multinational corporations
(Chapter 8), in relating international transactions to national income accounting
(Chapter 13), and in discussing virtually every aspect of international monetary policy
(Chapters 17 through 22). Like the problem of protectionism, the balance of payments has
become a central issue for the United States because the nation has run huge trade deficits
in every year since 1982.
Exchange Rate Determination
The euro, a common currency for most of the nations of Western Europe, was introduced on
January 1, 1999. On that day the euro was worth about $1.17. By early 2002, the euro was
worth only about $0.85, denting Europe’s pride (although helping its exporters). By late
2007, the euro was worth more than $1.40; by the middle of 2010, it had slid back to $1.29.
A key difference between international economics and other areas of economics is that
countries usually have their own currencies—the euro being the exception that proves the
rule. And as the example of the euro/dollar exchange rate illustrates, the relative values of
currencies can change over time, sometimes drastically.
For historical reasons, the study of exchange rate determination is a relatively new part
of international economics. For much of modern economic history, exchange rates were
fixed by government action rather than determined in the marketplace. Before World War
I the values of the world’s major currencies were fixed in terms of gold; for a generation
CHAPTER 1 Introduction 7
after World War II, the values of most currencies were fixed in terms of the U.S. dollar.
The analysis of international monetary systems that fix exchange rates remains an important
subject. Chapter 18 is devoted to the working of fixed-rate systems, Chapter 19 to the
historical performance of alternative exchange-rate systems, and Chapter 20 to the
economics of currency areas such as the European monetary union. For the time being,
however, some of the world’s most important exchange rates fluctuate minute by minute
and the role of changing exchange rates remains at the center of the international economics
story. Chapters 14 through 17 focus on the modern theory of floating exchange rates.
International Policy Coordination
The international economy comprises sovereign nations, each free to choose its own economic
policies. Unfortunately, in an integrated world economy, one country’s economic
policies usually affect other countries as well. For example, when Germany’s Bundesbank
raised interest rates in 1990—a step it took to control the possible inflationary impact of
the reunification of West and East Germany—it helped precipitate a recession in the rest of
Western Europe. Differences in goals among countries often lead to conflicts of interest.
Even when countries have similar goals, they may suffer losses if they fail to coordinate
their policies. A fundamental problem in international economics is determining how to
produce an acceptable degree of harmony among the international trade and monetary
policies of different countries in the absence of a world government that tells countries
what to do.
For almost 70 years, international trade policies have been governed by an international
treaty known as the General Agreement on Tariffs and Trade (GATT). Since 1994, trade
rules have been enforced by an international organization, the World Trade Organization,
that can tell countries, including the United States, that their policies violate prior agreements.
We discuss the rationale for this system in Chapter 9 and look at whether the current
rules of the game for international trade in the world economy can or should survive.
While cooperation on international trade policies is a well-established tradition, coordination
of international macroeconomic policies is a newer and more uncertain topic.
Only in the past few years have economists formulated at all precisely the case for
macroeconomic policy coordination. Nonetheless, attempts at international macroeconomic
coordination are occurring with growing frequency in the real world. Both the
theory of international macroeconomic coordination and the developing experience are
reviewed in Chapter 19.
The International Capital Market
During the 1970s, banks in advanced countries lent large sums to firms and governments
in poorer nations, especially in Latin America. In 1982, however, first Mexico, then a
number of other countries, found themselves unable to pay back the money they owed.
The resulting “debt crisis” persisted until 1990. In the 1990s, investors once again
became willing to put hundreds of billions of dollars into “emerging markets,” both in
Latin America and in the rapidly growing economies of Asia. All too soon, however, this
investment boom came to grief as well; Mexico experienced another financial crisis at the
end of 1994, much of Asia was caught up in a massive crisis beginning in the summer of
1997, and Argentina had a severe crisis in 2002. This roller coaster history contains
many lessons, the most undisputed of which is the growing importance of the international
capital market.
In any sophisticated economy there is an extensive capital market: a set of arrangements
by which individuals and firms exchange money now for promises to pay in the future.
The growing importance of international trade since the 1960s has been accompanied by a
8 CHAPTER 1 Introduction
growth in the international capital market, which links the capital markets of individual
countries. Thus in the 1970s, oil-rich Middle Eastern nations placed their oil revenues in
banks in London or New York, and these banks in turn lent money to governments and
corporations in Asia and Latin America. During the 1980s, Japan converted much of the
money it earned from its booming exports into investments in the United States, including
the establishment of a growing number of U.S. subsidiaries of Japanese corporations.
Nowadays China is funneling its own export earnings into a range of foreign assets, including
dollars that its government holds as international reserves.
International capital markets differ in important ways from domestic capital markets.
They must cope with special regulations that many countries impose on foreign investment;
they also sometimes offer opportunities to evade regulations placed on domestic
markets. Since the 1960s, huge international capital markets have arisen, most notably the
remarkable London Eurodollar market, in which billions of dollars are exchanged each
day without ever touching the United States.
Some special risks are associated with international capital markets. One risk is that of
currency fluctuations: If the euro falls against the dollar, U.S. investors who bought euro
bonds suffer a capital loss—as the many investors who had assumed that Europe’s new
currency would be strong discovered to their horror. Another risk is that of national
default: A nation may simply refuse to pay its debts (perhaps because it cannot), and there
may be no effective way for its creditors to bring it to court. International financial linkages
helped turn the downturn in the U.S. housing market that had begun in 2006 into a
global economic crisis.
The growing importance of international capital markets and their new problems
demand greater attention than ever before. This book devotes two chapters to issues arising
from international capital markets: one on the functioning of global asset markets
(Chapter 21) and one on foreign borrowing by developing countries (Chapter 22).
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