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Programme Summary- Objectives - Rationale/Profile - Research Needs

Objectives

The main objective of this £5 million programme is to promote and support world-class theoretical, empirical and policy-oriented research focusing on the interrelationship between finance and the world economy under the following two related areas:

1. To advance our understanding of ways financial markets and financial policies influence major global issues, such as poverty, development, growth and transition. Questions to be addressed, or topics to be examined under this area, include the following:

The relationship between finance and growth, through time and at different stages of development and the relative importance of different types of finance (e.g. banks, stock markets). The role of institutions in promoting financial development, investment (private and public), human capital, R&D, export performance and growth; political economy aspects of this relationship at different stages of development.

Capital mobility and its relationship to institutional and economic development. Ways of increasing the level and stability of capital flows to developing countries and the role of different types of flows. For example, is Foreign Direct Investment (FDI) the only viable modality or can equity flows reach significant levels without exposing the recipient countries to high levels of risk?

The political economy aspects of cross-country variation in institutional quality, such as governance, regulation and supervision of financial institutions and legal systems; How are market rules and regulations set within and across countries? What is the impact of foreign institutions on local corporate governance? What is the role of cultural factors in explaining the workings of political institutions?

Microlevel (informational) aspects of finance and implications for policies. What are the determinants of the cost of capital in developing countries, and to what extent does it reflect increased risk taking due to asymmetric information? What is the role of credit and financial intermediaries in this context? What is the role of social structures, culture and behaviour in the decision making process? How and why do these vary around the world?

The design of financial instruments, such as risk mitigation tools, specifically aimed at alleviating poverty. The socio-economic, cultural and political obstacles to accessing financial services, including credit and insurance, by the poor.

The role of decision making in international institutions and their elationship to domestic politics and the (re-)design of an appropriate international financial architecture to deliver global financial stability and growth. Is the current structure appropriate when it was set up for a different purpose? Are there appropriate controls? More specifically, what kinds of reform are required to improve the governance and policies of the Bretton Wood Institutions to ensure global financial stability without adverse effects on world poverty and political stability? What are the disruptive consequences of IMF and World Bank policies?

Alternative e.g. psychological and behavioural approaches to finance and their implications for financial markets and the world economy. What are the current psychological developments in the area of risk in decision making and the role played by psychological biases, heuristics and computational mechanisms that support reasoning and the decision making process? What policy implications emerge from this type of approach?

Security issues and their linkages to finance and the world economy, e.g. financial crime and its links to terrorism or the relationship between financial crises and poverty and the extent to which it breeds terrorism or political instability, in a global context.

Spatial aspects of economic relationships and their implications for economic growth around the world. Where will different economic activities take place in the 21st century? To what extent will IT enable activities to relocate, and will it undermine the future development of cities? How will improvements in logistics reshape world economic geography? Will East and South Asia continue to supply an ever-increasing share of world manufacturing? Will Africa continue to be marginalised?

2. To analyse policy issues in a variety of institutional and cultural settings in an era of low inflation, increasingly integrated financial markets, changing demographics and trade patterns. Questions to be addressed, or topics to be examined under this area, include the following:

The interaction between policy and financial stability, in both developed and developing economies, including the appropriate response by government, businesses and individual to volatility in asset prices such as tocks, shares and house prices.

The political economy aspects of public debt in the Euro-zone and Japanese-style persistent depression, following falls in asset values and appropriate policy responses, and the role of the political process, interest groups and cultural factors.

The degree of wage and price rigidity at low inflation and its implications for inflation and unemployment; the prospects of reinstating fiscal policy for stabalisation purposes; the benefits and costs of 'de-politicising' fiscal policy.

What are the most feasible exchange rate regimes for for emerging countries, following difficulties with currency boards and pegged exchange rates, in the presence of thin financial markets and inadequately developed institutions; Are there any historical lessons to be learned, for example from the Gold Standard period?

What are the implications of changing demographics such as ageing populations in rich countries and Aids in Africa for government policies? What are the implications of changing trade patterns for rich and poor countries?

The suitability of inflation targeting for developing and transition economies under financial fragility, underdeveloped financial markets and weak institutions; the benefits and costs of price level targeting vis-a-vis inflation targeting.

 

Rationale/Profile for the Programme

Given the recent world events, the subject matter provides an opportune moment for a broadly based yet focused programme of research on Finance and World Economy, to address a number of key issues faced by academics, policy makers and practioners.

The questions or topics, set out above, have been formulated following an extensive consultation exercise with senior academics and policy makers both in the UK and overseas. They should, therefore, provide a very useful framework for researchers, and help them to propose projects based on ideas that are likely to be 'winners' in terms of high quality academic research and policy relevance.



Scientific, Practical and Policy Context:

The context in which the research will be carried out is one in which the transition economies and developing countries are challenged both by their own needs for appropriate policy and the knock-on implications of the policies adopted in the developed world. Many of these countries are additionally handicapped by an inadequately developed institutional infrastructure that prevents them from benefiting fully from increased integration of financial markets. For example, inadequate enforcement of contracts, protection of (physical and intellectual) property rights, and corruption are widely recognised as substantial obstacles to investments, FDI, trade, financial developements in political economy, which highlight the influence of interest groups.

Financial instability has had enormous consequences on the world economy, affecting even relatively successful economies, and a major adjunct of attacking world poverty under the UN vision for 2015 has to be achieving a more stable financial environment. Financial crises in East Asia, Russia and more recently Argentina, have rekindled the debate on the choice of an exchange rate regime and the desirability of free capital flows. They have also raised important questions concerning the policies of the IMF in resolving financial crises, and, more broadly its governance and accountability. There are also related questions regarding the transmission mechanisms of financial instability across borders and the influence of psychological factors. Episodes of financial instability have also served to highlight the link between poverty and poorly designed policies, as well as the political economy aspects of financial crises. Demographic developments, such as the rise of Aids in Africa are likely to become increasingly important in the design of appropriate policies, providing additional challenges for policy makers. Some of the epidemiological projections regarding Aids, for example, are quite worrying. Yet, there is very little, if any analysis, of these new challenges and their implications for policies.

In contrast, the developed world is characterised by downward spiralling financial markets, widespread low inflation, with monetary policy based on inflation targeting and floating exchange rates. There are also concerns about private savings in these countries (too little in some countries, too much in others) as well as over investment and public debt.

The dominant framework for monetary policy in the developed world, and increasingly also in emerging countries, is one in which independent commitees of experts or independent central banks set interest rates. It seems for the moment that the question of how to conduct monetary policy has been 'solved'. But how long will this regime last? On past experience, one would not expect any monetary policy regime - however seemingly stable - to last long. In theoretical terms the current (Kydland-Prescott-Lucas) paradigm, on which this policy framework is based, does not recognise financial market imperfections or incompleteness, and ignores the importance of stock market volatility and the existence of distortionary fiscal policy. Thus, many of the theoretical solutions break down under plausible scenarios, for example when there are asset price bubbles, multiple equilibria or bounded rationality. In practical terms, one danger associated with low inflation is Japanese-style persistent depression following over investment and deflation of asset values. An interesting feature of Japan and other countries is the prolonged failure of policymakers to tackle these problems effectively, which may indicate the relevance of political economy considerations, such as active interest groups and political pressures to maintain the status quo.

A further feature of low inflation is the question of whether it is associated with more wage and price rigidity, which may indicate the existence of a long-run inflation/employment trade-off. A related development concerns public debt and its interation with changing demographics - ageing populations and changing patterns of work and leisure - and their wider socio-economic effects.

The appropriate (re-)design of the international financial architecture, together with appropriate ,echanisms for crisis avoidance and resolution remains a high priority for policy makers. Progress has been quite slow in this area and there still remain many issues to be worked through before such a mechanism is likely to come into being.

Last but by no means least, the broader context in which the research will be carried out is one in which global security issues are of paramount importance, following on from the events of 9/11 in the U.S. and subsequent developments in Asia and the Middle East. These vents have exposed a new and so far little understood source of vulnerability for the world economy, which a programme of research on 'finance and world economy' cannot ignore. The social and political aspects of these events, as well as their causes and effects together with the role played by finance, need to be better understood by researchers and policy makers alike. This undoubtedly dictates innovative inter-disciplinary approaches and international perspectives.


Research needs / implications (data, methods etc):

In the absence of a suitable established model of financial markets and their interrelationship with the world economy, research methods will include developing theoretical approaches as well as empirical testing of data, new models and ideas. Empirical methods to address the research questions and topics will include time series studies using long-run historical data, mostly available for developed economies, and cross section or, perhaps more profitably panel data, which exploit both cross-country and time-series variation using state of the art computational, econometric and statistical techniques.

There is also scope for greater diversity in the data and models that can be used to examine institutional, political economy, and psychological or geographical factors. Scope for new theoretical and analytical interdisciplinary work also provides ample opportunities for methodological advances across the different social science disciplines and to provide a greater evidence base for policy making. Besides the empirical testing of theories, some research questions would also lend themselves to financial and economic experiments, across countries and cultures, thereby moving the field of experimental economics more into the grounds of finance and psychology and thus widening the scopes for comparison. For example, it would be worthwhile using experiments to test whether rational choice and efficient markets receive more support in experiments conducted in Anglo-Saxon countries, than in transition economies, with their post-communist legacy, or in Muslim countries. Similarly, the Programme would bring anthropological insights into advancing our understanding of apparently intractable economic problems such as the failure of repeated fiscal and monetary interventions in Japan.

Data resources to support the programme are also available through the Economic and Social Data Service (ESDS) International via the following web link: http://www.esds.ac.uk/international

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Last updated July 2006
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