Global capital is on the move. As ultra-low interest rates in industrial countries send capital around the world searching for higher yields, a number of emerging-market central banks are intervening heavily, buying the foreign-capital inflows and re-exporting them to keep their currencies from appreciating. Others have been imposing capital controls of one stripe or another. In recent weeks, Japan became the first large industrial economy to intervene directly in currency markets.
Why does no one want capital inflows? Which intervention policies are legitimate, and which are not? And where will all this intervention end if it continues unabated?
The portion of capital inflows that is not re-exported represents net capital inflows. This finances domestic spending on foreign goods. So, one reason countries do not like capital inflows is that it means more domestic demand “leaks” outside. Indeed, because capital inflows often cause the domestic exchange rate to appreciate, they encourage further spending on foreign goods as domestic producers become uncompetitive.
Another reason countries do not like foreign capital inflows is that some of it might be “hot” (or dumb) money, eager to come in when foreign interest rates are low and local asset prices are rising, and quick to leave at the first sign of trouble or when opportunities back home beckon. Volatile flows induce volatility in the recipient economy, making booms and busts more pronounced than they would otherwise be.
But, as the saying goes, it takes two hands to clap. If countries could maintain discipline and limit spending by their households, firms, or governments, foreign capital would not be needed, and could be re-exported easily, without much effect on the recipient economy. Problems arise when countries cannot—or will not—spend sensibly.
Countries can overspend for a variety of reasons. The stereotypical Latin American economies of yesteryear used to get into trouble through populist government spending, while the East Asian economies ran into difficulty because of excessive long-term investment. In the US, in the run-up to the current crisis, easy credit—especially for housing—induced households to spend too much, while in Greece, the government borrowed its way into trouble.
Unfortunately, though, so long as some countries such as China, Germany and the oil exporters pump surplus goods into the world, not all countries can trim their spending to stay within their means. Since the world does not export to Mars, some countries have to absorb these goods, and accept the capital inflows that finance their consumption.
In the medium term, over-spenders should trim their outlays and habitual exporters should increase theirs. In the short run, though, the world is engaged in a gigantic game of passing the parcel, with no country wanting to take the habitual exporters’ goods and their capital surpluses. This is what makes today’s beggar-thy-neighbour policies so destructive: Though some countries will eventually have to absorb the surpluses and capital, each country is trying to avoid them.
So which policy interventions are legitimate? Any policy of intervening in the exchange rate, or imposing import tariffs or capital controls, tends to force other countries to make greater adjustments. China’s exchange-rate intervention probably hurts a number of other emerging-market exporters that do not intervene as much and are less competitive as a result.
But industrial countries, too, intervene substantially in markets. For example, while US monetary-policy intervention (yes, monetary policy is also intervention) has done little to boost domestic demand, it has spurred domestic capital to search for yield around the world. The US dollar would fall substantially—encouraging greater exports—were it not for the fact that foreign central banks are pushing much of that capital right back by buying US government securities.
All this creates distortions that delay adjustment—exchange rates are too low in emerging markets, slowing their move away from exports, while the ease with which the US government is being financed creates little incentive for US politicians to reduce spending over the medium term.
Rather than intervening to obtain a short-term increase in their share of slow-growing global demand, it makes sense for countries to make their economies more balanced and efficient over the medium term. That will allow them to contribute in a sustainable way to increasing global demand. China, for example, must move more income to households and away from its firms, so that private consumption can increase. The US must improve the education and skills of its labour force, so that they can produce more of the high-quality knowledge and service sector exports in which the US specializes. Higher incomes would boost US savings, reducing households’ dependence on debt, even as they maintained consumption levels.
Unfortunately, all this will take time, and citizens impatient for jobs and growth are pressing their politicians. Countries around the world are embracing shortsighted policies that cater to the immediate needs of domestic constituencies. There are exceptions. India, for example, has eschewed currency intervention thus far, even while opening up to long-term rupee debt inflows, in an attempt to finance much-needed infrastructure projects.
India’s willingness to spend when everyone else is attempting to sell and save entails risks that need to be carefully managed. But India’s example also provides a glimpse of what the world could achieve collectively. After all, beggar-thy-neighbour policies will succeed only in making us all beggars.
Raghuram Rajan is professor of finance at the Booth School of Business, University of Chicago, and author of Fault Lines: How Hidden Fractures Still Threaten the World Economy
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