Clive Crook | A Cruel Sea of Capital
A Cruel Sea of Capital
Thursday 01 May 2003
THOSE who believe that globalisation throttles democracy, gouges the poor and fouls the environment are bound to regard today's mostly open markets for international capital as evil. However, this does not prove that unimpeded flows of capital are a good thing. The capital market has vindicated its critics and embarrassed its would-be defenders too often of late. It has been responsible for, or at least deeply implicated in, some very costly economic breakdowns. Perhaps the anti-globalists are on to something.
Rapid globalisation has done nothing to undermine the confidence liberals have always placed in trade. No serious economist questions the case for international integration through flows of goods and services, though there is a lively argument over how integration through trade can best be brought about. Trade is good. But even the most enthusiastic advocate of economic integration may be starting to wonder whether unimpeded flows of capital are quite such a blessing.
Economic principles suggest that they should be. Economics relies heavily on the idea that wider opportunities make people better off or at least that they do not make them worse off. Whatever else trade does, it widens opportunities. When trade barriers come down, people on each side have an opportunity lacking in a closed economy. They can decide to consume goods that they have not produced, and pay for them by producing goods they do not wish to consume. If they believe they are better off as a result, that is what they will do. Otherwise, they will carry on as before.
Essentially the same logic applies to international finance. Just as a closed economy can consume only what it produces, it can invest only what it saves no more, no less. Trade in capital makes it possible for countries to separate their saving and investment choices. They can invest more than they save by borrowing the difference from abroad; or they can invest less than they save by lending out the surplus. Changes in the price of capital will ensure that global supply and demand match up, just as changes in the prices of goods bring exports and imports into global balance.
Just as nothing forces a country to trade when the economy opens up, nothing forces a country to become a net importer or exporter of capital if its firms and individuals prefer to lend and borrow as they did before. International capital widens choices in just the same way as international trade.
So how can you be worse off if you are given choices you did not have before, without being obliged to take them up? The answer is that you may make choices you come to regret. Experience suggests that even within the borders of a single economy, trade in capital is far more prone to mistakes than trade in goods or services though why this should be so is not immediately obvious. And if domestic trade in capital is more error-prone than domestic trade in goods, then international trade in capital is even worse. This perhaps is easier to understand: take the mistakes that get made in a domestic context, then multiply them by ignorance due to distance and exchange-rate risk.
The result is plain enough: recurring financial calamity; sovereign debt default; capital flight; currency crisis; bank failure; stockmarket crash. And the harm is by no means confined to the people who made the mistakes, or to the finance industry at large. Financial collapses have an unmatched capacity for projecting their effects right across the domestic economy, and in the worst cases far beyond that, across the region and even across the world.
Even if there were no doubt that the gains from trade in capital are large on a par with the gains from trade in goods and services the costs incurred in recent financial emergencies would still give one pause. Financial crises of the sort that hit Latin America in the 1980s, Mexico in 1994 or East Asia in 1997-98 cause recessions equivalent to years of growth forgone. The 1980s were aptly called Latin America's lost decade . Argentina and Brazil, to name but two, are even now struggling, respectively, with an exceptionally severe recession and the threat of a new financial collapse. Financial distress is a salient ingredient in Japan's endless economic difficulties, in Europe's current slowdown, in the fragility of America's economic recovery. And if things grow suddenly worse in any of these places, finance will spread the damage far and wide.
So trade in capital is different from trade in goods and services in two main ways: in the scope for getting things wrong, and in the punishment that follows. The first is great and the second is fearsome. It is enough to make a good liberal stop and think.
We all make mistakes
What makes finance so prone to error? Financial markets are asset markets: that is, they are markets for streams of payments spread out over time. (Many goods and some services have an extended time dimension too. By definition, the more this is true, the more such goods and services behave like assets. That is why the market for houses behaves a lot like the market for corporate bonds and not much like the market for biscuits.) When you buy an asset you are gambling on the future. Small changes in beliefs about the future can have a surprisingly large effect on the value of the assets concerned.
The numbers can seem outlandish, but it is only a matter of the arithmetical relationship between present value, compound interest and future value. Pricing a company share, for instance, involves several variables, but on plausible assumptions an improvement of just one percentage point in the expected growth of a company's earnings could easily justify a rise of 25% in its share price.
In other words, because asset prices are bets on a distant and uncertain future, they are inherently volatile. Moreover, investors tend to deal with uncertainty in ways that aggravate the problem. If information about underlying value is absent or obscure, they are likely to become preoccupied with the views of other investors. Sometimes, maybe usually, this is a process that uncovers new information and disperses it. Now and then, however, it degenerates into crowd hysteria.
In extreme cases, the views of other investors are taken seriously even when flatly contradicted by such facts as may be available. That was certainly true during the later stages of the dotcom bubble of the 1990s, and there are countless other examples. From time to time, such mental aberrations are even dignified by being presented as schools of thought : from momentum investing and greater fool theory to the new economy .
Now add to this the possibility of leverage. Thanks to capital markets, investors can place their bets on this distant and uncertain future using borrowed money. Without debt, the most you can lose is everything you have. If you can borrow, on the other hand, there is really no limit to what you can lose, because leverage allows you to punt other people's money as well as your own. Financial markets attract talented and ingenious people. A great deal of effort, it is said, goes into finding ways of pooling and reducing risk. Evidently, however, a good deal also goes into finding ever more complicated ways of building leverage on leverage, and then leveraging some more.
It has been widely noticed that going bankrupt for a few million dollars is no more painful than going bankrupt for a few thousand. This is apt to discourage prudence, and the imprudent, however talented and ingenious, make mistakes.
Debts are also a main reason why mistakes in financial markets, when they happen, can have bigger consequences than errors in an economy's less excitable parts. Losses may cascade across a series of lenders, many of which may not even have realised that they were exposed to the risk. A surprise that is big enough and bad enough may perturb the mood of self-justifying expectations that had up to then been propping valuations across an entire class of investments, and at worst across the economy as a whole.
A particular risk is that a bank may be threatened with failure as a result of its losses. Banks are intrinsically fragile entities, which is why, historically, they have invested so much in the pretence of security and solidity. They promise to give depositors all their money back on demand. As soon as depositors ask a bank to make good on that pledge, the bank (which retains only a fraction of its deposits in ready cash) goes bust. Depositors at other banks may then want their money back too. And because banks provide the infrastructure of payments services in a modern economy, that comes under threat as well.
Financial volatility need not in itself be such a bad thing. Even if it causes volatility in GDP, and hence in incomes, that is not necessarily disastrous either. People have ways of protecting themselves against ups and down in their incomes. Financial markets, of course, can help them in this. Governments can help as well, with safety-nets of one sort or another and with policies that mitigate the highs and lows of the economic cycle. Unfortunately, the evidence suggests that financial volatility not only causes bigger ups and downs in output and incomes, it also leads to lower average incomes over time. Latin America's lost decade really was lost.
All this, to be sure, could perfectly well be true of a closed economy. But an economy with financial links to the outside world may, according to circumstances, face much bigger risks. The problems of uncertainty are worse, for the reason already mentioned: distance, measured not just in miles but also in differences in language, business culture and legal environment. This increases the tendency to rely on other investors' judgments rather than one's own. It also increases the scope for risk that is disguised, accidentally or otherwise, and hence the danger that investors will be taken by surprise.
And trading capital across borders usually involves an additional financial market that is especially susceptible to all of the above: the market for foreign exchange. Most if not all of the big financial crises of recent decades have involved banking crises, currency crises or both. In these ways, the global capital market appears to take a big problem the economic instability that would anyway be caused by purely domestic finance and make it worse.
If the scope for error in capital markets is so great and the subsequent punishment so brutal, do the benefits of unimpeded global finance, substantial as they may be, justify the risk? The answer, as this survey will argue, is yes but for many economies it is a close thing. Much depends, as well, on exactly what is meant by unimpeded .
A close-run thing
Trade in goods and services is simple: what governments need to do, through the World Trade Organisation, through this or that regional trade agreement, or best of all unilaterally, is abolish their barriers. When it comes to finance, there is no such straightforward advice. Let capital flow where it may is bad policy. Finance must be intelligently regulated, at home as well as internationally, in ways that ordinary commerce does not require. When capital flows are liberalised, it needs to be done cautiously and within prudent limits. To that extent, global finance must indeed be impeded.
Governments and their advisers are a long way from understanding how this should ideally be done, let alone from putting any such understanding into practice. There is no detailed consensus on the right approach to international financial regulation, any more than there is on the domestic sort: there is plenty of activity, but for the most part it is co-operation without conviction.
The risks of international finance need to be frankly acknowledged, and then reduced so far as possible. That means weighing the costs and benefits of different kinds of capital mobility, and setting policies accordingly. It means abandoning certain orthodoxies of international economic policy. The danger cannot be eliminated altogether, but the remaining risk is worth taking because the potential gains from international capital flows are large, especially for the world's poor countries.
To ignore that potential would be an even greater mistake than to liberalise recklessly. The global capital market is a treacherous aid to economic growth, but in the end, above all for the poor, an indispensable one.
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