Friday, March 6, 2009

Financial Fragility and the Role of Capital Flows

Via Greg Mankiw, we have this interesting story of Joseph Stiglitz being shunned by the Obama Administration. Here's why this is important:

'In a spate of books, essays and speeches dating from the early '90s, Stiglitz denounced Rubin's support for repeal of the Glass-Steagall Act, which separated commercial from investment banking for precisely the reasons we are now witnessing on Wall Street: new "full-service" banks would seek to hype companies that their stock-market side underwrote and issue loans to them even if they were not credit-worthy. "The ideas behind Glass-Steagall went back even further [than the 1929 crash] to Teddy Roosevelt and his efforts to break up the big trusts," he wrote presciently in "The Roaring Nineties" (2003). "When enterprises become too big, and interconnections too tight, there is a risk that the quality of economic decisions deteriorates, and the 'too big to fail' problem rears its ugly head." Unfortunately, Stiglitz wrote, his worries "were quickly shunted aside"' by the Clinton Treasury team. Earlier, in his book "Globalization and its Discontents" (2002), Stiglitz became the most prominent voice in Washington to say plainly that free-market absolutism, which began with the Reagan revolution and continued under Clinton (who upon being elected declared the era of "big government" was over), was ill-founded theoretically and disastrous practically. "In 1997 the IMF decided to change its charter to push capital market liberalization," he wrote. "And I said, where is the evidence this is going to be good for developing countries? Why haven't you produced some research showing it was going to be good? They said: we don't need research; we know it's true. They didn't say it in precisely those words, but clearly they took it as religion."'

I actually have both the books listed here, but have yet to read them - I'm going to make the time to do that now. What especially struck me was the last point made in the paragraph, which is something I've believed in for some time - that there is no evidence that open capital accounts make sense for developing countries, in fact just the opposite.

In layman's terms, an open capital account means that flows of capital are completely unrestricted. Theoretically, this means capital is free to flow to where returns are highest, which means capital will be allocated efficiently and total welfare increased. In practice, this does not happen. Despite all the hype about China hogging FDI and capital, the number one destination of capital in the world is...the United States. If in fact capital travels to where it will be most effectively used then most of it ought to be going to Africa, where capital accumulation is low and where the marginal productivity of capital ought to be the highest.

At this point I have to distinguish between direct investment and portfolio investment. The former is investment in the classical sense - it is used to produce goods and services. Portfolio investment on the other hand reflects changes in the ownership of productive assets. The difference is crucial - direct investment is illiquid and long term, while portfolio investment is highly liquid and short term.

From the point of view of a developing country, portfolio inflows and outflows can be highly destabilising when the domestic financial system is immature, and become positively dangerous in the presence of pegged exchange rates. The evidence for this is highly persuasive - Mexico, Argentina, Turkey, and of course the whole East Asian Crisis of 1997-98. Here's a short narrative of what typically happens:

1. High growth Developing country is 'noticed' by investors
2. Capital flows in, and placed in the banking system or stock market (which booms). the currency also appreciates, which pulls in more capital.
3. Monetary expansion follows, fully sterilised by the Central Bank until it becomes too expensive, after which the financial system becomes flush with liquidity
4. If bond markets are immature, banks can only respond to expanding balance sheet liabilities by lending aggresively
5. A commodity/real estate/stock market bubble is generated
6. Individuals and companies start borrowing from overseas as the currency has strengthened
7. Investors notice the economy overheating, and become jittery
8. At some point, a tipping point occurs where investors panic and pull out, the currency crashes
9. Net effect: the monetary base contracts sharply and real interest rates rise, banks get saddled with bad debts in speculative activities, companies and individuals with foreign debt finding their debts ballooning, output and employment drop

Sounds awfully familiar, doesn't it. The same general story has occured quite a few times over the last fifteen years in various countries.

Of course, the US capital markets and banking system are far deeper, but let me make conduct this thought experiment. Greenspan cut interest rates to 1% in 2001/2002 in response to 9/11 and the dotcom crash, while the Bush administration increased spending and engaged in the "war on terror". What if the US didn't have an open capital account at the time? Monetary expansion plus fiscal profligacy meant the US financial system would be flushed with funds, and the trade deficit would increase as consumers responded to lower costs. However, in this scenario, the trade deficit can no longer be financed through purchases of US treasuries by surplus nations. That would imply that the excess liquidity would be drained overseas rather than recycled in the domestic system, which further implies a much stronger depreciation in the USD than actually happened and further, causes inflation in imported goods prices. Also, since this source of financing is no longer available, the fiscal deficit has to be financed domestically which drains further funds from the system - we get real crowding out of private investment and consumer borrowing. Interest rates would necessarily have to rise with the increased domestic supply of treasuries, as well as because of excess money demand relative to supply. In short, the US economy would've slowed as would the rest of the global economy, and there would not have been the housing bubble - we might not be in this mess we are now.

Unlikely scenario to be sure, but it makes food for thought.


  1. 97..sounds a bit funny to me ... :)

    Were they asked to save their banks?

  2. Who are you referring to, the other countries I mentioned?