What Is the Global Financial System?
The global financial system is a complex network of financial institutions, markets, and instruments that enables the flow of capital and resources within a country as well as across international borders.
This web of economic interactions facilitates trade, investment, and wealth distribution among nations.
By connecting markets and economies, the global financial system plays a vital role in fostering economic growth and development, while also being a source of potential financial instability and contagion when risks aren’t managed well.
We provide a short overview of the global financial system since the 1870s and then explain the global financial system in the following section.
A Brief History of the Global Financial System since the 1870s
The dawn of financial globalization can be traced back to the late 19th century when the world experienced a surge in international capital flows.
The period between the 1870s and the outbreak of World War I in 1914 marked a new era of interconnectedness and rapid expansion in the global financial system.
The Gold Standard Era (1870s-1914)
This period saw the widespread adoption of the gold standard, a monetary system where a country’s currency was directly convertible to gold.
The gold standard fostered international trade and investment by providing a stable exchange rate system, which facilitated the integration of financial markets and capital flows.
The Interwar Years (1918-1939)
The aftermath of World War I led to significant economic dislocation, and the gold standard was temporarily suspended.
Countries attempted to revive the gold standard in the 1920s, but the Great Depression in the 1930s led to widespread economic growth problems (due to overspending and the resultant debt in the preceding years), protectionism, and competitive currency devaluations.
An easy way to get out of debt problems is to create money, which a “hard” monetary system interferes with.
This period saw a retreat from financial globalization as nations focused on domestic economic policies.
The Bretton Woods System (1944-1971)
In an effort to establish a stable post-war international monetary system, the Bretton Woods Conference in 1944 led to the creation of the International Monetary Fund (IMF) and the World Bank.
Under the Bretton Woods system, countries pegged their currencies to the US dollar, which in turn was convertible to gold.
This system facilitated international trade and investment, fostering the gradual resurgence of financial globalization.
The Floating Exchange Rate Era (1971-Present)
The collapse of the Bretton Woods system in 1971 (due to the US’ indebtedness as a result of spending on wars and domestic social programs, which was referred to as “guns and butter” policies) led to a shift toward floating exchange rates, where currency values were determined by market forces.
This period saw the emergence of new financial centers, such as New York (which had already eclipsed London earlier in the 20th century) and Tokyo, and the rapid expansion of international capital flows, driven by technological advancements and financial liberalization.
The globalization of financial markets during this era also gave rise to financial crises, such as the Latin American debt crisis in the 1980s and the Asian financial crisis in the late 1990s.
Today we remain in the floating exchange rate era. However, the cycle between “hard” systems and fiat systems is still a reality even if these inflection points occur infrequently.
Institutions With the Global Financial System
Creating a comprehensive list of the global financial system is a complex task due to the vastness and intricacy of the system.
However, we can narrow it down to roughly 12 broad categories or elements. There is some overlap among them.
- Central Banks: These are national banks that provide financial and banking services for their country’s government and commercial banking system. They also implement monetary policy.
- Commercial Banks: These are profit-seeking institutions that accept deposits from individuals and corporations and use those funds to extend loans.
- Investment Banks: These institutions assist individuals, corporations, and governments in raising financial capital by underwriting or acting as the client’s agent in the issuance of securities.
- Insurance Companies: These are companies that provide coverage, in the form of compensation resulting from loss, damages, injury, treatment, or hardship in exchange for premium payments.
- Pension Funds: These are investment pools that pay for employee retirement commitments. They are funded by the employer and the employees via funds that are pooled to eventually give them a benefit plan.
- Hedge Funds: These are alternative investments using pooled funds that employ different strategies to earn active returns for their investors.
- Stock Exchanges: These are marketplaces where stock buyers connect with sellers. Stocks, bonds, and other securities are traded on a stock exchange.
- Regulatory Bodies: These are government or non-government organizations that oversee and regulate the financial markets and companies to protect investors.
- International Financial Institutions: These include the International Monetary Fund (IMF), the World Bank, and the Bank for International Settlements (BIS). These institutions facilitate international cooperation in financial matters.
- Financial Markets: These are markets where people trade financial securities and derivatives at low transaction costs. They include the stock market, bond market, commodities market, and foreign exchange market.
- Non-Banking Financial Companies: These are institutions that provide banking services without meeting the legal definition of a bank. They exist outside the standard regulations.
- Fintech Companies: These are businesses that leverage new technology to create new and better financial services for both consumers and businesses. It includes companies working in personal finance, payments, insurance, wealth management, and more.
Each of these elements interacts with the others in various ways, forming a web of relationships that constitute the global financial system.
The evolution of the global financial system since the 1870s has been marked by periods of rapid expansion and retrenchment, as well as ongoing efforts to establish stability and promote economic growth.
Today, the global financial system remains a very important component of the world economy, enabling the flow of capital and resources that underpin international trade, investment, and development.