Are High International Capital Flows a Bad Thing?

In “We must curb international flows of capital,” Dani Rodrik and Arvind Subramanian make what many might consider to be a radical argument: too much money sloshing around internationally leads to trouble. It’s not quite a hot money argument (unstable and rapidly moving investments were the proximate cause of the 1997 emerging markets crisis). Instead, Rodrik and Subramanian characterize overly high money flows, which they note are often seen as positive, as a pathology.

While intuitively, this makes some sense (large flows tend to be one-way for a while, and when they abate, considerable disruption results), the authors assert their case rather than prove it. Yet recent events do seem to bear them out. Our current global imbalances (are they Chinas’ fault for saving so much, or the US’s for saving so little) illustrate that very large international flows of capital tend to be deployed badly. Crappy investments are not only bad for the investor, who makes a sub-par return, but they can be bad for the recipient as well, as our subprime mess attests. Domestic resources (talent as well as incremental capital) follow the dumb money. Super-cheap capital fuels speculation. There often aren’t enough decent potential projects to provide solid rates of return, but the availability of funding leads entrepreneurs to cook up ways to put it to work. The venture may fail, but hey, they got a decent living out of it, and in many cases, a good bit more than that.

Now of course, I am arguing for an insufficiency of good projects, that if you have a negative real interest rate, as we had in the US for a few years, bad outcomes are probable. But independent of that, another factor which no one wants to admit is that foreign investors are far less likely to find good opportunities (save cases like FDI where they are building factories and have correctly diagnosed that there is a niche open to them).

The best projects can be readily funded locally. Natives know who has good reputations, which products will appeal to local tastes. Outsiders not only have trouble assessing the investment opportunity, but they also have difficulty judging how good their advisors are. Working with foreigners, I am amazed how mixed in quality their teams are, and how little sense they often have of who is knowledgeable and who is a lightweight.

The article (perhaps due to space limitiations) surprisingly fails to acknowledge an argument of Thomas Palley’s, namely, that international development priorities are all wrong. The powers that be have encouraged emerging markets to focus on export-led growth. Palley instead makes a case that they would do better to devote more resources to building a domestic consumer market, which in turn means taking more aggressive measures to reduce income disparity.. That would lower their trade surpluses and would go a considerable way to reducing the international financial slosh that troubles Rodrik and Subramanian.

From the Financial Times:

First large downhill flows of capital – from rich countries to poor countries – led to the Latin American debt crisis of the early 1980s. In the 1990s similar flows begat the Asian financial crisis.

Since 2002 the flows have been uphill, from emerging markets and oil-exporting countries to the developed world, especially the US. But the outcome has not been very different. So, it does not seem to matter how capital flows. That it flows in sufficiently large quantities across borders – the celebrated phenomenon of financial globalisation – seems to spell trouble.

Causes and consequences vary, depending on which way capital flows. Developing country borrowing was associated with unsustainable fiscal policies (Latin America) and inappropriate exchange rate policies (Asia). But the financial sector was not blameless: for every overborrower there was an overlender.

The pathologies were different when the US went on a borrowing binge. Large current account surpluses and the associated savings glut in the rest of the world fed a global liquidity boom, which stoked asset prices. Even though the roots of the subprime crisis lie in domestic finance, international capital flows magnified its scale.

Some would claim that the problem in all these instances was not liquidity but lax regulation, which turned what should have been prudent borrowing into a destructive binge. But this argument is too optimistic about the potential of prudential regulation to stem excessive risk-taking. In the US the entire policy apparatus avoided any regulatory action against lax lending. Even when the will is there, prudential regulation is bound to remain one step behind financial innovation.

If the risk-taking behaviour of financial intermediaries cannot be regulated perfectly, we need to find ways of reducing the volume of transactions. Otherwise we commit the same fallacy as gun control opponents who argue that “guns do not kill people, people do”. As we are unable to regulate fully the behaviour of gun owners, we have no choice but to restrict the circulation of guns more directly.

What this means is that financial capital should be flowing across borders in smaller quantities, so that finance is “primarily national”, as John Maynard Keynes advised. If downhill and uphill flows are both problematic, capital flows should be more level.

But how is such a levelling-off of flows to be achieved? In the current context, the source of liquidity is large current account surpluses in the oil-exporting countries and east Asia, especially China. Reducing these should be a high policy priority for the international community. Two concrete actions – one for each source of liquidity – suggest themselves.

First, some variant of petrol tax in the main oil-importing countries (including the US, China and India) is essential to cut demand and reduce oil prices and hence the current account surpluses of oil exporters. That such measures should be taken for environmental reasons or that they would reduce the size of sovereign wealth funds only adds to their attractiveness. Second, some appreciation of east Asian currencies is necessary to reduce their surpluses. Even though undervaluation is a potent instrument for promoting growth in low-income countries in general, at this juncture self-interest on both sides calls for an orderly unwinding of current account imbalances.

This appreciation can be achieved either unilaterally or, if necessary, multilaterally through the World Trade Organisation, as a recent Peterson Institute paper has proposed.

Measures needed for when capital flows downhill are likely to take a different form. When appetite for emerging market debt is strong, neither prudential regulation nor macroeconomic policies does much to stem capital inflows. Developing nations need to rely on a broader set of instruments, targeting the capital account directly. Deposit requirements on capital inflows and financial transaction taxes are some of the tools available.

We need an enlarged menu of such options. Unfortunately, capital controls are such a bugaboo that the International Monetary Fund, to its discredit, has done little work on capital-account management techniques.

But will not such interference with capital flows reduce the benefits of financial globalisation? Even leaving financial crises aside, those benefits are hard to find.

Financial globalisation has not generated increased investment or higher growth in emerging markets. Countries that have grown most rapidly have been those that rely least on capital inflows. Nor has financial globalisation led to better smoothing of consumption or reduced volatility. If you want to make an evidence-based case for financial globalisation today, you are forced to resort to indirect and speculative arguments.

It is time for a new model of financial globalisation, one that recognises that more is not necessarily better. As long as the world economy remains politically divided among different sovereign and regulatory authorities, global finance is condemned to suffer deformations far worse than those of domestic finance. Depending on context, the appropriate role of policy will be as often to stem the tide of capital flows as to encourage them. Policymakers who view their challenges exclusively from the latter perspective will get it badly wrong.