Sunday, February 20, 2011

For Capital Autarky

V Anantha Nageswaran at The Gold Standard makes an excellent connection that may clear up the issue of economic “dark matter.” The basic idea behind the dark matter concept is spelt out in this piece by Ricardo Hausman and Frederico Sturzenegger, and relates to the presence of global imbalances. The United States, for the past decade, has managed to run up a massive current accounts deficit; meaning that the value of American exports has been consistently less than the value of American imports. To pay for this, there has been a corresponding boom in the degree of assets held by foreigners in the US. That is, America has been importing all sorts of goods from other countries, like say cheap toys or oil. To pay for that, instead of producing other forms of goods and services, foreigners have been content to hold American assets denominated in dollars.

This is where the dark matter comes in — it is the value of the financial assets held in the US by foreigners that are otherwise not accounted for. Figuring out what this stuff is was an big question before the financial crisis made other issues more relevant. But (much like the physical dark matter), it’s presence could be assumed from the nature of other statistics — in this case, the value of American goods and services.

Here’s a graph that sort of sums this up:

ie, there is a massive and growing current accounts deficit unless you calculate the value of these domestic asset holdings.

Now, cue Ben Bernake. With a group of co-authors, he has revisited international financial flows, and found some interesting results:
We present evidence that, in the spirit of Caballero and Krishnamurthy (2009), foreign investors during this period tended to prefer U.S. assets perceived to be safe. In particular, foreign investors—especially the GSG countries [“global savings glut” countries, primarily Asia and oil exporters]—acquired a substantial share of the new issues of U.S. Treasuries, Agency debt, and Agency-sponsored mortgage-backed securities. The downward pressure on yields exerted by inflows from the GSG countries was reinforced by the portfolio preferences of other foreign investors. We focus particularly on the case of Europe: Although Europe did not run a large current account surplus as did the GSG countries, we show that it leveraged up its international balance sheet, issuing external liabilities to finance substantial purchases of apparently safe U.S. “private-label” mortgage-backed securities and other fixed-income products. The strong demand for apparently safe assets by both domestic and foreign investors not only served to reduce yields on these assets but also provided additional incentives for the U.S. financial services industry to develop structured investment products that “transformed” risky loans into highly-rated securities.
To spell this out a little more: the argument here is that the United States experienced such massive inflows — roughly a trillion dollars a year for the US at the height of the boom — that they were sufficient to adjust interest rates and borrowing on a massive scale. The “dark matter” people wondered about were held in exactly the mortgage-backed securities (both by the GSEs and private suppliers) that performed horribly in the crash. Most countries that experience such forms of capital inflows have serious problems — think Asian countries before their crisis in 1997. In particular, these countries tend to see massive price appreciation in non-tradable, durable goods (especially real estate, but really all sorts of assets), and a loss of competitiveness in the tradable good sector.

This basically also describes the US, with two important areas of divergence. One, the financial sector had an active supply response as well, doing a great deal to manufacture the sorts of safe assets that were in high demand internationally (greater demand than American manufactures, at least). Many economists were broadly sympathetic to large amounts of foreign capital coming into America on the hypothesis that America’s sophisticated financial markets were best capable of handing these sums. Unfortunately, they were instead sophisticated enough to hide risks and create assets that appeared safe, but were in fact quite dangerous.

And second, there was no currency collapse after the boom. Several Asian countries after 1997, for instance, saw capital flee the country, followed by a major currency collapse. That hasn’t happened with America (though there was a great deal of fear prior to the crisis that exactly this outcome would happen), presumably because America’s crash means systematic failure for the world, and in response to that capital wants to remain in America.

Of course, it is difficult to establish causality here. Why did countries like China, Germany, South Korea, and Saudi Arabia invest their trade surpluses (from cheap goods, electronics, and oil) in America rather than purchasing American goods? For Asian countries, there was the goal of keeping a cheap currency and boosting exports; while the motivation for oil-exporting states is a little murkier. What's going on in Europe is even less clear, as they managed to end up with large amounts of assets in American MBS while having a roughly balanced import/export profile.

This narrative isn’t particularly new; if you’ve been following folks like Nouriel Roubini or Menzie Chinn this should be pretty familiar. So here’s some value added: the reformist goal of globalizing capital has been a catastrophic failure. Virtually every time countries import large amounts of cash, their economy gets trashed. In theory, this FDI could go to productive uses. In reality, it goes into unsustainable patterns of asset booms and crashes. There is the added worse impact of hurting the tradable sector of the economy, which is ultimately responsible for economy-wide productivity; as well as the added worse impact that the domestic financial sector also gets trashed, hurting you for years to come. A few decades ago, there was a big push to get capital to go from rich to poor countries, on the grounds that this could help them grow. Roughly, this failed. In the last few years, the argument instead has been that capital going from poor to rich countries could result in better global financial management. This, too, ended up pretty badly.

Playing financial regulation in an economy getting drowned in cash is like playing whack-a-mole. Even if somehow you prevent asset booms in any one particular area of the economy; the systemic impacts of capital flows ensure that some part of the economy will blow up. Banks will find ways to assume leverage and risk, regardless of what your regulations were before the boom. The political pressures of restraining this debt-fueled boom in consumption and investment are impossible to manage.

Really the only solution here is to return to some sort of Bretton Woods style world of tightly restrained capital flows. This is virtually impossible to re-generate, but the Fed doesn’t need any sort of international agreement to make international capital flow/currency regulation a major priority. This is already the case in many foreign central banks, but it is a mandate completely lacking at the Fed.

Which is why this situation is a little odd. On one hand, Bernanke is the guy arguing that these foreign capital flows are responsible for a large chunk of our problems (and not, say, the low interest rates he was a party to setting). But then he refuses to do anything about them, despite the fact that the Fed is the one actor in the economy with the capacity to do so. If you look around at developing countries, there are plenty of solutions one can come up with — Tobin taxes on capital flows, actual limits on capital flows, active currency interventions, and so forth. I’m all for free trade, free markets, etc.; but there’s no excuse for the Fed not taking these actions more seriously -- especially in light of their own view that this is what blows up crises.

Edit: Just to be clear, "autarky" was a poor wrong wording choice. Capital can and should flow from country to country, but these flows should balance themselves out on net, corresponding to a balance in trade as well.

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