Dienstag, Februar 26, 2008

A Really, Really Bad Idea...

This is in today's FT.

It's a really, really bad idea. Time for some fisking...

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.

And large inflows of capital also made it possible for these countries to actually finance projects and businesses, allowing their economies to expand. The debt crises that developed, however, aren't a function of capital flows, but a lack of due diligence and proper credit risk analysis. Here the authors are confusing cause and effect, or at least they are muddling them. Again: the problem is a failure of capital management, and not inflows as such.

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.

Again: confusion as to the problem. The real problem is that the lending banks and investors are failing to perform due diligence and to properly manage their credit portfolios, and has nothing to do with the volume of capital flows. Again, muddled thinking about what the problem is.

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.

Now this is indeed accurate. The financial sector has lost, basically, the ability to do good risk analysis, as lawyers and accountants make the decisions, not economists.

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.

Well, first of all the term "pathologies" is completely inaccurate. The US has not gone on a "borrowing binge" unless you refer solely to the volume of deals: measured as a percentage of GDP, other countries should be so lucky. But the next sentence is critical: current account surpluses are posited as the cause of a savings glut, when in reality the two positions are reversed: because local consumers do not have adequate consumption choices - and live in unstable countries where continuity is a problem - they save involuntarily, resulting in a savings glut that, due to the lack of investment choices domestically, leads to a current account surplus. Capital always seeks its rent: it is also uniquely fungible and goes to where the rents are. This can drive asset prices up, but not necessarily so: the problem arises when you do not have enough good bankers out there who can balance, properly, risks and returns.

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.

Now this is where their analysis starts to turn silly. They are correct in saying regulation failed, abysmally, in preventing stupid people from being separated, permanently, from their money (aka they lost it all). But is that the job of bank regulations? Simply put, no: bank regulations exist to ensure that financial transactions are transparent and that risks are clearly stated: they do not exist to "protect" people from making stupid investment decisions. And that regulation always lags innovation: duh.

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.

And this is where the idea goes really, really bad. Basically: if we can't stop people from making bad decisions, then they shouldn't be allowed to invest. The "fallacy" that the authors bring up is a straw man: the error is that you cannot regulate everything. The British experience now with the basic ban of firearms has led to a major upswing in criminal behavior, as criminals no longer need fear that their victims will defend themselves: if you do so in the UK right now, you may well end up being prosecuted for having defended one's self, rather than waiting for the police to do so.

This is throwing the baby out with the bath water: they are basically saying that if people can't be prevented from making bad investment decisions, that they should not be allowed to invest. What comes next, prove that you are a good parent before you can become a parent? Do the writers fail to see the absurdity of that position?

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.

Ah, the long, cold, dead hand of Johann Gottlieb Fichte and his Closed Trade State (Der geschlossne Handelsstaat. Ein philosophischer Entwurf als Anhang zur Rechtslehre und Probe einer künftig zu liefernden Politik, 1800), which should be a part of everyone's education to show how not to do things. Put simply, Fichte called for state control of each and every external transaction, and the role of the state is to a) beggar thy neighbor and b) ensure that the guilds and closed economic systems never see any change. Historically a really, really bad idea: mercantilism and the guild system, dedicated to maintaining local monopolies on the means of production and coupled with the allocation of resources on the basis of power politics, invariably lead to economic crises as the misallocation of capital bears its bitter and indigestible fruit and local monopolies become repressive and prices become punitive, as they invariably do within monopolies.

The greatest achievement of the last millennium has been the liberalization of trade and market-based allocation of capital: that these do not work perfectly and have negative side effects is vastly outweighed by the very real positive benefits of both.

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.

The source of the large current account surpluses is that the countries they list have comparative advantages and it is in the interest of the consumer, the ultimate beneficiary of the world economy, to have them make goods and sell oil: reducing these comparative advantages is hidden mercantilism, plus the absurd Utopian idea that each and every country should be an island unto itself. Reducing consumer utility should be the LAST priority for the international community, not the highest: this is a fundamental misunderstanding of what economics is all about (hint: the best possible allocation of scarce resources is identical with the smallest ecological impact of such allocation, per definition).

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.

Translation: Tax the consumer to make him poor, making also those who supply the goods to the consumer poor as well. Raise exchange rates to make imports more expensive and further reduce consumer choices.

Further, and here is the real problem: current accounts, given comparative trade advantages, are never balanced, but always show imbalances. It's the way the world economy works, and the authors apparently really don't want the world economy to work, preferring, instead, poverty for billions, rather than using trade to improve their lives.

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

Again: a really, really bad idea. What makes this idea even worse is that the authors believe, apparently that the WTO, the World Bank, etc., can actually manage the world economy: they can't, just like NÖSPL failed to manage the economies of the former Warsaw Pact. People, it doesn't work, it makes things worse.

What the WTO can do is to help policy makers make policy that alleviates negative impacts of changes in the world economy that lead to runs on currencies, banking failures and the like. It can't run the world economy, deciding what interest rates should be, what exchange rates should be, what tariffs should be. That was the world of back when, which led to Smoot-Hawley and the Great Depression. The road there is paved with the best intentions, but please, learn from history.

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.

Again, throwing the baby out with the bathwater. Their approach is to stop change, rather than to ride it to greater prosperity for the greatest number: they want to stop markets from functioning, and we should know by now how well that works.

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.

Uh, it's really a credit to the IMF that they don't get near the topic with a ten-foot pole.

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.

Tell that to the hundreds of millions in China and India who have moved into what passes for the middle class there.

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.

Sigh. Since when has financial globalization had anything to do with "consumption smoothing" or reduced volatility? There is so much wrong with these two sentences...

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.

Translated: as long as the world doesn't have a right and proper government, trade should be forbidden, unless it's done the way we want it to be done.

These ideas are really, really bad. They lead to greater poverty and reduce standards of living, all in the name of preventing the destruction of capital.

Got news for you: the destruction of capital is part and parcel of how the world economy works.

Capital is destroyed when bad investment decisions are made and as a result, capital is poorly allocated. This has everything to do with risk analysis and risk control: the authors seem to advocate the elimination of risk from financial transactions. This is so far removed from the realities of the world economy as is possible.

The problem that the authors try to address is that international financial transactions are fraught with risks and that probably the vast majority of these risks are not identifiable or even knowable when the transaction is made. The abysmal failure of national and international finance to do due diligence and proper risk analysis is a very serious problem, one that needs to be worked on (but which costs time, money, and denying the BSDs of the industry their playgrounds).

But these ideas? Really, really bad.

PS: NÖSPL is the German acronym for the closed feedback loop system for planning and direction (Neues Ökonomisches System der Plannung und Leitung) that was implemented in the COMECON in the 1960s. The man who was in charge of implementing it in Eastern Germany committed suicide instead. Literally.

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