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J. Bradford DeLong (1998), "Helping Countries Prepare for International Capital Flows," USIA Economic Perspectives (August 5, 1998).
Back in the 1890s and 1900s international capital flows were of great benefit to the world. Flows of money and investment from the center to the periphery of the world economy allowed investors in the capital-rich core to earn higher rates of return than they would have otherwise, and allowed workers in the resource-rich periphery access to the fixed and working capital they needed to multiply their productivity--and hence their wages.
In the 1920s and 1930s international capital flows--interacting with attempts to restore the pre-World War I monetary order--did great harm to the world economy. Rational and less-than-rational fears of heightened taxation, of devaluation, and of depression caused country after country to suffer large-scale capital flight. Central bank and finance ministry beliefs that long-run growth required holding on to the gold standard led them to induce recessions in order to defend the gold standard. In the end defense of the gold standard proved incredible: the political will to continue the defense drained away as unemployment deepened in the Great Depression, and all that the combination of international capital flows and government commitment to the gold standard did was to make the Great Depression much greater than it would otherwise have been.
The architects of the Bretton Woods system that governed international monetary arrangements in the 1950s and 1960s had lived through the 1920s and 1930s. They were eager to embrace controls on international capital flows, which they saw as bringing little more than trouble: destabilizing speculation, irrational capital flight, and the potential for chains of contagious panic like that that had brought on the Great Depression. Stable exchange rates (so that world trade could develop and expand) and governments committed to preventing serious depressions at home seemed much more important than encouraging the free flow of international capital.
But with the breakdown of the Bretton Woods fixed exchange-rate system in the 1970s, the political retreat from social democracy in the 1980s, and the fading of the memory of the Great Depression, the pendulum swung back once again. The first generation of post-World War II economists would have said "yes." The second and third generations of post-World War II economists regretted the fact that capital controls kept people with money to lend in industrial countries away from people who could make good use of the money to expand economic growth in developing economies, and noted that capital controls were not working effectively anyway as ingenious investors found more and more ways around them. The balance of opinion shifted to the view that the world economy was sacrificing too much in the way of economic growth to be worth whatever reduction in instability capital controls produced.
So now we have all the benefits of free flows of international capital. These benefits are mammoth: the ability to borrow abroad kept the Reagan deficits from crushing U.S. economic growth like an egg, and the ability to borrow from abroad has enabled successful emerging market economies to double or triple the speed at which their productivity levels and living standards converge to the industrial core.
But the free flow of financial capital is also giving us one major international financial crisis every two years.
The root cause of the crises is a sudden change of state in international investors' opinions. Like a herd of not-very-smart cattle, they all were going one way in 1993 or 1996, and then they turned around and are all going the opposite way today. Economists will dispute which movement was less rational: Was the stampede of capital into emerging markets an irrational mania disconnected from fundamentals of profit and business, or is the stampede of captal out of emerging markets today an irrational panic? The correct answer is probably "yes"--the market was manic, it is now panicked, and the sudden change in opinion reflects not a cool judgment of changing fundamentals but instead a sudden psychological victory of fear over greed.
So what is to be done?
Countries that seek to take advantage of the large benefits (and they are large benefits) of global capital flows need to make sure that they do not destroy their own ability to handle crises. In the current international monetary system it is assumed that one reaction to a crisis will be a devaluation: since the world economy has signalled that it is no longer willing to pay as much for a country's capital or goods as before, a devaluation is a way of reducing the price of a whole nation's goods, the analogue to a firm cutting its prices in response to falling demand. But devaluation does little good if the value of the debts owed by a country in crisis rise as the currency falls in value: if the banks and firms in a country in crisis have borrowed not in their local currency, but in dollars, pounds, yen, or marks.
Thus the first thing that a country seeking to take advantage of international capital flows must do is establish a system to detect and penalize home-country institutions and firms that borrow in money-center currencies, for a large amount of such borrowing is what turns a shift in animal spirits by foriegn investors from an annoyance to a catastrophe.
The second thing that must be done is the creation of a good system of domestic banking regulation: a system that will detect--and close down--financial institutions that are insolvent or nearly-insolvent, and that thus have strong incentives to make risky but uneconomic investments. After all, if a firm is already insolvent any further investments it makes are "heads, we win; tails, our creditors lose" propositions. Only if the financial system can be kept well-capitalized and solvent will the inflow of foreign capital generate productive and profitable investments.
But most of all there needs to be sufficient international liquidity to handle the kind of large-scale financial crisis that springs from a shift in animal spirits on the part of investors in the industrial core. There needs to be a well-capitalized IMF to make structural adjustment loans to countries willing to adopt policies that will generate future export surpluses. There needs to be a willingness on the part of creditor countries to accept flows of imports from developing countries that are the real-side counterparts of financial flows.
And it is from this perspective that recent political developments are very troubling. It is not that there is anything wrong with the conclusions of the Birmingham G-7 summit: they are all good ideas. But in our current international financial system, sudden changes in investors sentiment will generate large shifts in hot money around the globe--and there must be sufficient reserves in the G-7 and the IMF to neutralize the effects of such shifts, and there must be the willingness on the part of the G-7 and the IMF to use their reserves when necessary.
Yet we live in a world in which the leader of one branch of the U.S. legislature--Newt Gingrich--announces that the U.S. will not increase its IMF quota because President Clinton has been insufficiently cooperative in investigations of the President's sex life. We live in a world in which the leader of the other branch of the U.S. legislature--Trent Lott--calls for the replacement of Michel Camdessus on the grounds that the IMF should not have "a socialist from France" at its head.
The internationalist consensus that dominated the U.S. government since the end of World War II appears to be gone. Only by the skin of its teeth--and by a very "creative" reading of the legislative mandate governing use of the Exchange Stabilization Fund--did the U.S. government contribute to the successful resolution of Mexico's peso crisis in 1995. There is no guarantee that there will be more congressional realization of America's national interest in a prosperous world economy in any future crisis. There is no guarantee that there will be equivalent opportunities for creative definition of executive powers.
Thus from the perspective of any developing country preparing for international capital flows, the most important thing that needs to be done is completely outside its power: the creation of an IMF and a G-7 that can provide support to deal with international financial crises in the absence of U.S. leadership.
Charles Kindleberger thought that, at the deepest level, the cause of the Great Depression was that Britain could not longer and the U.S. would not take responsibility for dealing with international financial crises. Listening to Newt Gingrich and Trent Lott, it is hard to escape the conclusion that we are about to enter an era in which once again the U.S. will not take responsibility.
If so, then the future is bleak unless we can quickly construct other instrumentalities that can and will take its place in handling international financial crises.
approximately 1600 words.
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