What's the Matter With Capital Flows?
For a couple of years, I've been toying with some disquieting questions for a basically libertarian economics writer: what if the free movement of capital is inherently unstable? Cyprus is a perfect example of why I worry. The country's banks have accumulated, by one report, deposits from Russian nationals that actually exceed its GDP. This is exceedingly dangerous, because as we saw in both the Great Depression and in this crisis, during a global financial meltdown the distinction between bank debt and public debt becomes somewhat irrelevant. Countries with bad banking crisis usually end up with a pretty hefty national debt from dealing with the fallout, and banks whose sovereigns become insolvent tend to follow suit pretty quickly.
Paul Krugman thinks that international capital deregulation, combined with a race to the bottom by governments like Cyprus, are what destabilized the world's banking system:
Let me make a broader point: we’ve now seen three island nations around Europe become huge international banking hubs relative to their GDPs, then get into crisis because their domestic economies don’t have the resources to bail out those metastasized banking systems if something goes wrong. This strongly suggests, to me at least, that we have a fundamental problem with the whole architecture (to use the preferred fancy word) of international finance.
As long as you haven’t bought into the Barney-Frank-did-it school of thought, you realize that the global crisis of 2008 was in a fundamental sense made possible by the erosion of effective bank regulation. As Gary Gorton (pdf) has documented, we had a 70-year “quiet period” after the Great Depression in which advanced countries had very few major financial flare-ups; Gorton argues, and most of us agree, that the key to this quietness was a constrained, regulated financial system that also limited the opportunities for excessive non-bank leverage.
But this regulation in turn depended, to an important extent, on limited international capital flows; otherwise regulations made in Washington or elsewhere would have been bypassed via havens like, well, Cyprus. And once capital controls began to be lifted in the 1970s we entered an era of ever-bigger financial crises, starting in Latin America, then moving to Asia, and finally striking the whole world.
So what are we going to do about this? Cyprus, as a euro-zone country, should really be part of a euro-wide safety net buttressed by appropriate regulation; it’s insane to imagine that the euro can be run indefinitely with merely national deposit insurance. But euro-area deposit insurance doesn’t seem to be in the cards — and anyway, there are plenty of other potential Cypruses out there.
All of which raises the question, is the era of free capital movement just a bubble, fated to end one of these years, maybe soon?
I don't entirely disagree. Clearly, massive capital flows are undermining deposit insurance, one of the most powerful weapons we have for fighting bank panics. Moreover, some of the worst ideas our bank regulators had during the run-up to the crisis were almost certainly motivated by the fear that stodgy American banks would lose out to to the racier European financial capitals. (I know this will come as quite a shock to people who think that the Republican Party has all the bad ideas, but if you sit down quietly with a cup of tea, or perhaps a small restorative brandy, the faintness will pass.)
And yet, it doesn't seem quite adequate. America's financial markets weren't awash with foreign capital because we offered an attractive tax haven; quite the reverse, in fact. And the foreigners weren't here because lax regulators would let them buy all manner of dodgy securities that weren't available back home; they were here buying Treasury bills. The massive imbalances that built up during the Dotcom Bubble and the Naughty Aughties don't seem obviously related to our banking regualtion. Neither does all the capital that sloshed into Spain and drove their housing market into a bubble worse than ours--despite rules for mortgage securitization* that were praised as models for what the US should have done to prevent our banking crisis during the early days of the Great Recession.
I could name a half a dozen other countries that clearly had too much capital washing in, not seeking a tax haven or even lax financial regulation, but investing in boring, prosaic stuff like houses. Yes, the financial instruments got pretty exotic at the end, but this went on for years--by 2000, my old employer, The Economist, was warning of a global housing bubble.
There's something else disquieting about these massive capital flows; they seem to be unusually stupid money. Nor is that entirely surprising; it's very, very hard for someone thousands of miles away to really understand what's going on inside another country's capital markets. Yes, they can read all the research reports, and distance may give them some valuable perspective. But the fact remains that they are making decisions based on substantially less information than, say, someone who is sitting in a Denny's listening to the busboy talk about his plan to make a fortune flipping houses with no money down.
Of course, foreign capital flows have also done enormous good--they played a substantial role in building America's economy, for starters. But foreign money is more likely to flee at the first sign of danger--which may be a welcome check on Argentina-style expropriations, but can also create vicious self-fulfilling prophecies. The 1920s boom, and the Great Depression that followed, both seem to have been driven by massive rivers of gold that flowed into America's markets chasing yield, and then out fleeing the banking crisis.
The problem is, as Tyler Cowen points out, that there's no obvious alternative.
The way I put this point is to suggest that the era of reliable deposit insurance may be coming to a close (and not for the better). What kind of international capital regulations would or could limit this problem is a topic deserving of much more attention. We can’t go back to Bretton Woods, numerous companies and developing economies already rely on international capital flows, and so what is actually on the table here?
Capital controls create their own problems, many of them arguably worse than financial crisis. And the Bretton Woods regime did not come undone in the 1970s because of the ideological fervor of free-marketeers; it was torn apart by its own internal tensions. Which is to say, the capital controls may have kept the banking system (and the economy) stable, but they were not stable themselves.
I am increasingly concerned that international capital flows may be dangerously destabilizing for the host countries--and also concerned that I see no possible alternative. One by one, the certainties of the 20th century are falling away.
* Banks had to keep 10% of the securities they underwrote on their books, which in theory eliminates the incentive to write fraudulent mortgages and foist them off on unwitting investors.