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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).

1999). With this said. From Old Models to Fundamentals-Based Models The focus of the old international finance models is on the current account and monetary reserves. Therefore. inflation and fiscal policies (Blecker. The globalisation and liberalisation of the global economy challenged the validity of old models. This volatility of financial markets can often lead to financial crises which have an impact on the real economy. 1999). the fundamentals based also assumed fixed or predicable exchange rates and financial markets. Therefore. in addition to the assumption of capital mobility. these models take a few assumptions which include: selfequilibrating adjustment mechanism. new models have adequately proven that financial markets have inherent volatility and that exchange rates are unpredictable. money supply. 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. new models have adequately contradicted this assumption. Also.However. . the contemporary international finance environment and changes that followed their time of significance challenged these models. 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. which are determined by macroeconomic fundamentals such as interest rates. For example the assumption about capital mobility ignored international lending and borrowing which have become increasing important in the global economy. Thus fundamentals-based models were devised to deal with these challenges. However. no capital mobility and fixed or predictable exchange rates (Blecker.

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 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). 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. 1999). 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. The latter challenge is most obvious in the market-specific characteristics that determine the equilibrating ability of policy recommendations based on these models (Blecker. However. For instance. Shambaugh & Taylor. fundamentals do not have a decisive role on the exchange rate as fundamentals-based models assert. exchange rates and international . the policy recommendations were a once-off revaluation of currencies or fiscal expenditure reductions (Blecker. 1999). This led to the emergence of new models of speculative behaviour and financial instability. Obstfeld. 1999. Further. aside from instances where elasticities and absorption mechanisms were seen as the self-equilibrating mechanisms of markets. New models assert that exchange rates and international finance are unpredictable.The common ideological foundation in old and fundamentals-based models is that markets are the most efficient economic redistribution mechanism. 2008). Yet. These kinds of policies were the foundation of the Washing Consensus era.

2005). authorities with fixed reserves may be forced to devalue their currency or abandon the peg. If the currency is pegged. that exchange rates are predictable and fundamental-determined. If the actions of a few speculators lead to herding behaviour. Moreover. This occurs when speculators speculate on a currency’s future value and take actions that are followed by other investors due to herding behaviour. speculators could expect a currency to depreciate. Furthermore. these models have the central assertion that exchange rates are unpredictable. fundamentals are not the only decisive influence in financial markets. a panic would ensue causing sudden widespread capital flight (Kindleberger & Aliber. Therefore models such as the random walks and long swings models use empirical evidence to try and . Thus the new models contradict the fundamentals-based model assertions. The result is that the currency appreciates or depreciates depending on the change in demand resulting from the investors’ speculative and herding behaviour. Then they would move their capital out of that specific can be affected by speculative and herding behaviour. The result is that exchange rates and international finance are unpredictable. For example. new models of random-walks and long-swings perform better in predicting the exchange rate. Speculative behaviour can result in self-fulfilling prophecies that force authorities to revalue currencies. 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. This would cause the domestic currency to depreciate due to lower demand for the currency. which is a direct contradiction of the fundamentalbased assumption. However. where other investors follow suit.

The findings are that macroeconomic fundamentals cannot adequately explain exchange rates and their fluctuations.respond to these preoccupations. exchange rates are determined by autonomous currency market factors as opposed to macroeconomic fundamentals (Blecker. Thus. 1999). the new models explain exchange rates and fluctuations and financial instability better than fundamentals models do (Blecker. 1999). exchange rates follow periodic trends of either an appreciation or depreciation of the currency. 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). Moreover. 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. 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. Also. 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. Consequently exchange rates are unpredictable. So we cannot conclusively know what the exchange rate will be tomorrow since there might be a currency appreciation or depreciation. 1999). 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. Moreover. which they speculated about in the first place. This is an actual reality in liberalised markets that allow for easy transfer of . In other words. 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.

The fundamentals-based models assert that interest rates. 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. Blecker. Yet. even if the economy was on a trajectory that would have led to a revaluation (Blecker. Thus. This result is vastly different from the assertions of fundamentals-based models. Most policy-making is informed by. 2000. the volatility of financial markets can often lead to financial crises which have an impact on the real economy (Kindleberger & Aliber. The fundamentalsbased models have no room for considerations about speculating investors. fundamentals are still politically significant. 1999). 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. inflation and macroeconomic indicators determine the exchange rate and international finance. Also. herding behaviour and self-fulfilling prophecies. 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. . 2005. Therefore fundamentals-based models assume predictability which new models have discredited. new models have adequately proven that financial markets have inherent volatility and that exchange rates are unpredictable. Moreover. fundamentals-based models cannot predict the exchange rate and international finance with great success. fundamentals that assume predictability in international financial markets which has been discredited by the new models. Grabel. although the fundamentals are proven as invalid in explaining international finance and exchange rates. Further. 1999). 1999). Thus. and grounded without controls (Palma. 2003).

This leads me conclude that new models are an improvement of the fundamentalsbased models. Thus. interest rate and fiscal policy etc. Moreover. even though fundamentals have been invalidated as economic determinations in international capital. 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. authorities can ensure. In other words. 1999). eventhough new models have discredited the fundamentals-based models due to the empirical invalidity of the fundamentals-based models. Therefore when they speculate they rely on information on fundamentals such as inflation rates. however limited this influence might be. Thus. because speculation and herding behaviour can cause financial instability through speculative bubbles. 1999). they remain informatively and politically significant. Thus it is theoretically difficult to specify whether exchange rate fluctuations are caused by speculative bubbles or fundamentals given this. fundamentals are politically important because they can be utilised in ways that can avoid crisis. that fundamentals are conducive to economic stability thus avoiding speculation. Secondly.This is because speculators and economic authorities are only privy to market information on fundamentals in most cases. the new models do not have the faulty . Firstly. 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. the new models are still theoretically informed by fundamentals (Blecker. 1999). More importantly. which often arises from judgements that the economy is unsustainable (Blecker. these economic agents act upon this information making their actions dependent on fundamentals – at least partially.

e. These findings highlight two constraints that policies face. Conclusion: How far have we gone? At each historic stage of international financial development. the recent economic crises are real-world evidence that the logic and theoretical underpinnings. in resolving the inherent instability of these markets. of fundamentals-based is flawed at best. i. 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. reliance on market mechanisms. . Secondly fundamentals have no direct impact and the current policy tools are incapable of resolving the inherent volatility of these market. given that new models do not conclusively lead to a disregard for or proof of the irrelevance of fundaments. because currency and financial markets are determined by autonomous factors within these markets. 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. Firstly. Also. The fundamentals-based models still had the same theoretical foundations of the old models except that they allowed for capital mobility. if any. policy actions have a limited effect. we have had to adjust our assumptions in order to have models that better explain the economic reality of each. the new models are an improvement of this faulty logic given that their logic is more empirically valid and sound.logic of fundamentals-based models which over-emphasised the primacy of market mechanisms that were assumed to be self-equilibrating. Lastly. Nevertheless. as argued above. This has led the development of fundamentals-based models which sought to correct the deficiencies of old models that excluded capital mobility.

which can partially explain the failure of neoliberal policies of the Washington Consensus era in dealing with developing countries’ foreign exchange crises. Moreover. although fundamentals-based models have been invalidated.However. Thus. even within the paradigm of new models. . These new models have strong and significant implications for policy which highlight the limitations of policy. Nevertheless. fundamentals remain informatively and politically significant. exchange rate and financial market volatilities and policy failures illegitimated the fundamentals-based models. fundamentals still dominate the discourse on international finance. the new models are statistically superior to fundamentals-based models. Therefore new models invalidate the fundamentals-based models’ assumption stability and predictability that is determined by macroeconomic fundamentals.

M. R. Washington DC: Economic Policy Institute. 18. Manias.A. . M.Bibliography Blecker. 2005.Com. I. New York: Palgrave Macmillan. New York: New School for Social Research Centre for Economic Policy Analysis. A. holding a B. (Hon) in Development Theory and Policy student at the University of the Witwatersrand. 1999. Grabel. and International Reserves.. No.. 2008. 2000.Z.. 2003. Chapter 2: International Financial Models and their Policy Implications. 5th ed. R. Palma. Obstfeld.A.P. pp.. the Trilemma. Working Paper No. & Taylor.. Cambridge Journal Of Economics.Sci in Politics.Soc. p. 27(3). G.C. Financial Stability.317–36. J. Shambaugh. The Three Routes to Financial Crises: The Need for Capital Controls . R. In Blecker. * Siyaduma Biniza is currently a B. & Aliber. Panics and Crashes: A History of Financial Crises.39-83. w14217. Philosophy and Economics from the University of Cape Town.. Kindleberger. C. CEPA Working Paper Series III. National Bureau of Economic Research. Averting Crisis? Assessing Measures to Manage Financial Integration in Emerging Economies. Taming Global Finance: A Bettter Architecture for Growth and Equity.