A Guide to the (Financial) Universe: Part I

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A Guide to the (Financial) Universe: Part 1

  1.     Introduction

A decade after the global financial crisis, the contours of the financial system that has emerged from the wreckage are becoming clearer. While the capital flows that preceded the crisis have diminished in size, most of the assets and liabilities they created remain. But there are significant differences between advanced economies and emerging markets in their size and composition, and those nations that are financial centers hold large amounts of international investments. Moreover, the predominance of the U.S. dollar for official and private use seems undiminished, if not strengthened, despite the widespread predictions of its decline. A guide to this new financial universe reveals a number of features that were not anticipated ten years ago.

2.       External Assets and Liabilities

Financial globalization is the result of the flow of capital across borders and the integration of domestic financial markets. Financial flows like trade flows increased during the first wave of globalization during the 19th century, which ended with the outbreak of World War I. After World War II, trade and capital flows started up again and grew rapidly. In the mid-1990s financial flows accelerated more rapidly than trade, particularly in the advanced economies, and peaked on the eve of the global financial crisis.

Philp R. Lane of the Central Bank of Ireland and Gian Milesi-Ferretti of the IMF in their latest survey of international financial integration (see also here) provide an update of their data on the size and composition of the external balance sheets. Financial openness, as measured by the sum of gross assets and liabilities, for most countries has remained approximately the same since the crisis. But its magnitude differs greatly amongst countries.  Financial openness in the advanced economies excluding the financial centers, as measured by the sum of external assets and liabilities scaled by GDP, is over 300%, which is approximately three times as large as the corresponding figure in the emerging and developing economies. This is consistent with the large gross flows among the advanced economies that preceded the crisis. However, the same measure in the financial centers is over 2,000%. These centers include small countries with large financial sectors, such as Ireland, Luxembourg, and the Netherlands, as well as those with larger economies, such as Switzerland and the United Kingdom.

Some advanced economies, such as Germany and Japan, are net creditors, while others including the U.S. and France are net debtors. The emerging market nations excluding China are usually debtors, while major oil exporters are creditors. These net positions reflect not only the acquisition/issuance of assets and liabilities, but also changes in their values through price movements and exchange rate fluctuations. Changes in these net positions can influence domestic expenditures through wealth effects. They affect net investment income investment flows, although these are also determined by the composition of the assets and liabilities (see below). In many countries, such as Japan and the United Kingdom, international investment income flows have come to play a large role in the determination of the current account, and can lead to a divergence of Gross Domestic Product and Gross National Income.

The external balance sheets of the advanced economies are often characterized by holdings of equity and debt liabilities—“long equity, short debt’’—while the emerging market economies hold large amounts of debt and foreign exchange reserves and are net issuers of equity, particularly FDI—“long debt and foreign reserves, short equity.” The acquisition of foreign reserve holdings by emerging Asian economies is responsible for much of the “Lucas paradox,” i.e., the “uphill” flow of capital from emerging markets to advanced economies. However, there has also been a rise in recent years n the issuance of bonds by non-financial corporations in emerging markets, in some cases through offshore foreign affiliates.

As FDI has increased, the amount of investment income accounted for by FDI-related payments has risen. In the case of the emerging markets, these payments now are responsible for most of their investment income deficit, while the amounts due to banks and other lenders have diminished. FDI payments for the advanced economies, on the other hand, show a surplus, reflecting in part their holdings of the emerging market economies’ FDI.

The balance sheets of the international financial centers also include large amounts of FDI assets and liabilities. These holdings reflect these countries’ status as financial intermediaries, and funds are often channeled through them for tax purposes. The double-counting of investment that this entails overstates the actual value of foreign investment. The McKinsey Global Institute in its latest report on financial globalization has estimated that if such double-counting was excluded, the value of global foreign investment would fall from 185 percent of GDP to 140 percent.

The composition of assets and liabilities has consequences for economic performance. First, equity and debt have different effects on recipient economies. Portfolio equity inflows lower the cost of capital in domestic markets, and can enhance the liquidity of domestic stock markets and the transparency of firms that issue stock. In addition, M. Ayhan Kose of the World Bank, Eswar Prasad of Cornell University and Marco E. Terrones of the IMF have shown that equity, and in particular FDI, increases total factor productivity growth. Philip R. Lane of the Central Bank of Ireland and Peter McQuade of the European Central Bank, on the other hand, reported that debt inflows are associated with the growth of domestic credit, which can lead to asset bubbles and financial crises. Second, the differences in the returns on equity and debt affect the investment income flows that correspond to the assets and liabilities. Equity usually carries a premium as an incentive for the risk it carries. The U.S. registers a surplus on its investment income despite its status as a net debtor because of its net positive holdings of equity.

Third, the mix of assets and liabilities influences a country’s response to external shocks. FDI is relatively stable, but its return is state-contingent. Debt, on the other hand, is more volatile and in many cases can be withdrawn, but its return represents a contractual commitment. As a result, the mix of equity and debt on a country’s external balance sheet affects its net position during a crisis as well as its net investment income balance.

The change in the value of equity, for example, can depress or raise a country’s balance sheet during a crisis. Pierre Gourinchas of UC-Berkeley, Hélène Rey of the London Business School and Govillot of Ecole des Mines (see also here) have characterized the U.S. with its extensive holdings of foreign equity as the world’s “venture capitalist.”  Gourinchas, Rey and Kai Truempler of the London Business School showed that the loss of value in its equity holdings during the global crisis provided a transfer of wealth to those countries that had issued the equity.  Those nations that had issued equity, on the other hand, avoided some of the worst consequences of the crisis.

This analysis of external balance sheets, however, assumes that the assets and liabilities are pooled. Stefan Avdjiev, Robert N. McCauley and Hyun Song Shin of the Bank for International Settlements (see also here)  have pointed out that public assets, such as the foreign exchange reserves of the central bank, may not be available to the private sector. South Korea, for example, had a positive net international investment position that included foreign currency assets, which appreciated in value when the global crisis struck. Nonetheless, corporations and banks had issued dollar-denominated liabilities, and their value also rose. The country was one of those that entered into a currency swap arrangement with the Federal Reserve.

Eduardo A. Cavallo and Eduardo Fernández-Arias of the Inter-American Development Bank and and Matías Marzani of Washington University in St. Louis also investigate whether foreign assets provide protection in the case of a shock. They report that portfolio equity assets as well as reserves lower the probability of a banking crisis. Portfolio equity, like reserves, are relatively liquid and therefore residents can draw upon them during periods of volatility.

The difference between private and public assets liabilities has been investigated by Andreas Steiner of Grongien University and Torsten Saadma of the University of Mannheim. They calculate a measure of private financial openness that excludes the reserve assets of central banks as well as loans based on development aid. In the case of emerging markets and developing economies, their measure differs significantly from the standard measure, and results in different findings for the linkage of financial openness and growth.

Avdjiev, McCauley and Shin of the BIS also point out that balance sheets are measured on a national basis. But assets and liabilities may be held through foreign affiliates. International banks, for example, have foreign units with claims and liabilities. If these are consolidated on their parents’ balance sheet, then a very different assessment of the banks’ international creditworthiness may emerge. Similarly, non-financial firms may obtain credit through their foreign branches that borrow in the offshore debt markets. The credit inflow could hamper the ability of domestic authorities to stabilize the financial system. External balance sheets measured on a national basis may give a misleading picture of domestic institutions’ foreign linkages.

(to be continued)

Recent Research

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My recent research has dealt with issues related to financial globalization, and the accumulation of foreign assets and liabilities on external balance sheets. These include equity (foreign direct investment and stock) and debt (bonds and bank loans). Their amounts and composition differ between the emerging market economies and the advanced economies. The former generally hold assets in the form of foreign reserves, and issue equity to finance domestic investment. The latter nations hold the equity of the emerging economies and sell debt. In my work I have investigated the impact of the composition of the external balance sheets on economic performance as well as the determinants of the equity/debt liabilities mix, and this work has now been published.

In “External Liabilities, Domestic Institutions and Banking Crises in Developing Economies” (working paper here), my coauthors, Nabila Boukef Jlassi of the Paris School of Business and Helmi Hamdi of CERGAM EA 4225 Aix-Marseille University, and I examined the impact of foreign equity and debt liabilities on the occurrence of bank crises in 61 lower- and middle-income counties during the period of 1986-2010. We found that FDI liabilities lowered the probability of such crises while debt liabilities increased it. However, we also found that domestic institutions that decreased financial or political risk partially offset the impact of the debt liabilities on the probability of bank crises. A decrease in investment risk directly reduces the incidence of crises.

In “External Balance Sheets as Countercyclical Crisis Buffers” (working paper here), I investigated the claim that the composition of the external balance sheets of many emerging markets—“long debt and foreign exchange, short equity”—affected the performance of these countries during the global financial crisis of 2008-09. Using data from 67 emerging market economies, I showed that those economies that had issued FDI liabilities had higher growth rates during the crisis, fewer bank crises and were less likely to borrow from the IMF. Countries with debt liabilities, on the other hand, had more bank crises and were more likely to use IMF credit.

Why do equity—and FDI in particular—and debt have such different impacts? First, equity represents a sharing of risk, whereas debt is a contractual commitment by the borrower. The equity premium is a compensation for the lower return incurred during a downturn. Second, debt is more likely to be reversed during a crisis than FDI, contributing to a “sudden stop.”. Third, FDI investors may be willing to provide more finance to keep their investment viable during a period of financial stress.

What determines the equity/debt mix of liabilities? In “Partners, Not Debtors: The External Liabilities of Emerging Market Economies” (working paper here), I studied the determinants of equity and debt liabilities on the balance sheets of 21 emerging market economies and 20 advanced economies over the period of 1981-2013. In the analysis I used a measure of domestic financial development that distinguished between financial institutions and financial markets. The results showed that the development of domestic financial markets is linked to an increase in equity liabilities, and in particular, portfolio equity. FDI liabilities, on the other hand, are more common when financial institutions are not well developed. Moreover, countries with higher growth rates are more likely to issue equity. Larger foreign exchange reserves are also associated with more portfolio equity.

The composition of assets and liabilities has other effects. Changes in the their values will impact a country’s net international investment position, which influences domestic spending and international solvency. In addition, they yield different income streams that determine net investment income, a component of the current account. In my current work I am looking at the income investment flows of advanced and emerging market countries. The flows in the advanced economies grew rapidly during the period of financial globalization leading up to the global crisis of 2008-09. In some cases, such as Japan and the United Kingdom, the net flows have become substantial and are a major determinant of the current account. The income flows of the emerging market economies did not have the same rapid growth, but their composition changed from payments to banks to payments on FDI and portfolio equity. I plan to write about these changes in future research papers.

 

Not All Global Currencies Are The Same

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The dollar may be the world’s main global currency, but it does not serve in that capacity alone. The euro has served as an alternative since its introduction in 1999, when it took the place of the Deutschemark and the other European currencies that had also been used for that purpose. Will the renminbi become the next viable alternative?

A new volume, How Global Currencies Work: Past, Present and Future by Barry Eichengreen of the University of California-Berkeley and Arnaud Mehl and Livia Chiţu of the European Central Bank examines the record of the use of national currencies outside their borders. The authors point out that regimes of multiple global currencies have been the norm rather than an exception. Central banks held reserves in German marks and French francs as well as British sterling during the period of British hegemony, while the dollar became an alternative to sterling in the 1920s. The authors foresee an increased use of China’s renminbi and “..a future in which several national currencies will serve as units of account, means of payments, and stores of value for transactions across borders.”

Camilo E. Tovar and Tania Mohd Nor of the IMF examine the use of the reminbi as a global currency in a IMF working paper, “Reserve Currency Blocs: A Changing International Monetary System.” They claim that the international monetary system has transitioned for a bi-polar one based on the dollar and the euro to a tri-polar system that also includes the renminbi. They provide estimates of a dollar bloc equal in value to 40% of global GDP that is complemented by a renminbi bloc valued at 30% of global GDP and a euro bloc worth 20% of world output. The renminbi bloc, however, is not primarily Asian, but rather dominated by the BRICS countries (Brazil, Russia, India, China, South Africa). This suggests that its increased use may be due to geopolitical reasons rather than widespread regional use.

If relative size is a driving factor in the adoption of a currency for international transactions, then an increasing role for the renminbi is inevitable. But the dollar will continue to be the principal currency for many years to come. Ethan Ilzetzki of the London School of Economics, Carmen Reinhart of Harvard’s Kennedy School and Kenneth Rogoff of Harvard examine the predominance of the dollar in a NBER working paper, “Exchange Arrangements Entering the 21st Century: Which Anchor Will Hold?” They show that the dollar is far ahead of other currencies in terms of trade invoicing , foreign exchange trading, and most other measures.

The U.S. also holds a dominant role in international financial flows. Sarah Bauerle Danzman and W. Kindred Winecoff of Indiana University Bloomington have written about the reasons for what they call U.S. “financial hegemony” (see also their paper with Thomas Oatley of the University of North Carolina-Chapel Hill and Andrew Penncok of the University of Virginia). They point to the central role of the U.S. financial system in the network of international financial relationships. They claim that the financial crisis of 2008-09 actually reinforced the pivotal position of the U.S., in part due to the policies undertaken by U.S. policymakers at that time to stabilize financial markets and institutions. This included the provision by the Federal Reserve of swap lines to foreign central banks in countries where domestic banks had borrowed dollars to invest in U.S. mortgage-backed securities. (Andrew Tooze provides an account of the Federal Reserve’s activities during the crisis.)

The central position of the U.S., moreover, evolved over time, and reflects a number of attributes of the U.S. economy and its governance. Andrew Sobel of Washington University examined the features that support economic hegemony in Birth of Hegemony. He cites Charles Kindleberger’s claim of the need for national leadership in order to forestall or at least offset international downturns, such as occurred during the depression (see The World in Depression 1929-1939). Kindleberger specifically referred to the need for international liquidity and the coordination of macroeconomic policies by a nation exercising economic leadership.

Sobel, drawing upon the history of the Netherlands, Great Britain and the U.S., maintains that the countries that have provided these collective goods have possessed public and private arrangements that allowed them to provide such leadership. The former include adherence to the rule of law, a fair tax system and effective public debt markets. Among the private attributes are large and liquid capital markets and openness to foreign capital flows. Sobel shows that these features evolved in the historical cases he examines in response to national developments that did not occur in other countries that might have been alternative financial hegemons (such as France).

Will a new dominant financial hegemon appear to take the place of the U.S.? It is difficult to see the European Union or China assuming that role in the short- or medium-term. European leaders are dealing with disagreements over the nature of their union and the discontent of their voters, while China is establishing its own path. (See Milanovic on this topic.) U.S. financial institutions are dedicated to preserving their interests, and not likely to surrender their predominance. It would take a major shock, therefore, to current arrangements to upend the existing network of financial relationships. But we now live in a world where such things could happen.

Conferences in 2018

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It may be January but the deadlines for spring conferences are fast approaching. Here is a list of those suitable for research in international macroeconomics:

Conference                                               Dates                     Location                         Submission Date

Global Macro Workshop                      4/17-4/18         Marrakech, Morocco                   1/31

Current Acc Balances, Cap Flows,

and Int’l Reserves                                   5/4-5/5             Hong Kong                                    2/1

Int’l Trade and Finance Association    5/23-5/26          Beijing, China                               1/31

Int’l Symposium on Money, Banking

and Finance                                              6/7-6/8           Aix-en-Provence, France             2/18

INFINITI                                                    6/11-6/12       Poznań, Poland                             1/31

Danish Intl Econ Workshop                  6/14-6/15       Aarhus, Denmark                         3/1

Barcelona GSE Int’l Capital Flows         6/18-6/19       Barcelona, Spain                         2/28

European Economics and Finance      6/21-6/24       London, United Kingdom          4/4

Hen U/INFER Workshop on 

Applied Macro                                        6/23-6/24       Kaifeng, China                            1/31

NBER: Int’l Finance and Macro             7/11-7/13        Cambridge, U.S.                        3/19

Central Bank Research Association     8/20-8/21       Frankfurt, Germany                  2/15

After the Global Financial Crisis: Are We Safe Now?

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A decade after the global financial crisis the global economy seems (finally) to be enjoying a robust recovery. Economic growth is widespread and includes increased expenditures on investment, a sign that business firms expect continuing demand for their products. With the crisis finally behind us, we can revisit it to reassess its causes and the response. We can also ask whether our ability to respond to another crisis is adequate.

Reappraisals of the roots of the crisis have focused on the fragility of the financial sector, and the consequences of inadequate capital and liquidity shortfalls. Low interest rates due in part to foreign savings contributed to a rise in housing prices in the U.S., and the extension of mortgage loans to borrowers who sought to profit from further price increases. Bankers were willing to extend credit in part because they could pass along any risk through the sale of mortgage-backed securities, in some cases to financial firms in Europe. Credit booms in the housing sector also occurred in other countries, most notably Ireland and Spain.

But by 2007 as interest rates and the price of servicing the debt rose, housing prices stalled and mortgage borrowers who expected capital gains began to exit the market. The mortgage-backed securities lost their value, which led to a chain of liquidations of positions that pushed their prices further down. In the summer of 2008 the federal government was forced to take over the government-sponsored agencies, the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), that were active in the secondary market for mortgage securities. The failure of Lehman Brothers in September 2008 signaled a financial collapse that quickly spread to Europe.

In the aftermath of the crisis there was a wave of new rules in the financial sector. National bank regulators acting together at the Basel Committee on Banking Supervision revised capital adequacy ratios. In the U.S. the Dodd–Frank Wall Street Reform and Consumer Protection Act was enacted to overhaul and update our regulatory rules and institutions. The bill consolidated government supervisory agencies, extended their reach and introduced new tools, including a mechanism to allow the orderly closure of financial companies that have failed. The Consumer Financial Protection Bureau (CFPB) was established to prevent the predatory mortgage and other lending practices that had contributed to the crisis.

While national leaders were criticized at the time for an initially fumbling response, Daniel Drezner of the Fletcher School at Tufts University appraised the macroeconomic and financial policies undertaken at the time of the crisis and concluded that the system “worked,” i.e., the policy measures undertaken adverted a much worse outcome. The leaders of the Group of 20 nations (the successor to the Group of 7) agreed to increase government spending and to expand the resources of the International Monetary Fund to allow it to lend to a range of countries. Just as importantly, they also agreed to refrain from implementing trade barriers or engaging in competitive exchange rate depreciations. The Federal Reserve, aware of the central role of the dollar, instituted swap agreements with foreign central banks that enabled them to assist their banks with dollar obligations.

Ten years later, is the global economy safe from another financial meltdown? If one did occur, could we respond as aggressively? Because of the slow recovery, credit growth does not seem excessive—with the significant exception of China. Global stock markets, on the other hand, continue to set new records. The U.S. cyclically adjusted price earnings ratio has reached a level only seen in 1929 and during the “tech bubble,” leading inevitably to explanations of why this time the valuation is justified. Bitcoin, supposedly a new form of currency, continues to draw investors with a scarce understanding of what they are purchasing, and many are doing so by borrowing on their credit cards. A collapse in prices could lead to an unraveling of positions and a new round of liquidations that could extend into other financial markets.

Unfortunately, central banks will have limited room to respond. While the Federal Reserve is increasing the Federal Funds rate, it currently stands at only 1.50%. But even this is higher than the Bank of England’s target rate of 0.5% or the European Central Bank’s 0.0%. Central banks could return to quantitative easing operations but they would be beginning with much larger balance sheets than they had in 2008. A fiscal stimulus would be effective in the event of an economic contraction, but the U.S. has just enacted tax cuts that are expected to add $1.5 trillion to the federal debt. How would financial markets respond if a new downturn lowered tax revenues further as the government sought to increase spending?

Moreover, the financial sector in advanced economies is just as large as it was before the crisis. The size of financial sectors has been cited as a cause of concern by economists at the Bank for International Settlements and also a team at the IMF. The latter paper finds: “The effects of financial development on growth and stability show that there are tradeoffs, since at some point the costs outweigh the benefits.” There seems little doubt that we reached that point years ago.

There also seems to be no recognition of the fragility of the financial sector, and the threat it can pose. The success of governments in preventing a recurrence of the Great Depression precluded a public accounting of the causes of the crisis and the dangers of financial excess. A recent column in The Economist concluded:

“The success of the response to the downturn helped avoid some of the disasters of the 1930s. But it also left the fundamentals of the system that produced the crisis unchanged. Ten years on, the hopes of radical reform are all but dashed. The sad upshot is that the global economy may have the opportunity to relearn the lessons of the past rather sooner than hoped.”

If such a disaster occurs, it is difficult to imagine how the current administration in the U.S. would respond. There is no sense of common purpose or even an acknowledgement of the global interdependence of economies. Economic nationalism during a period of volatility will surely set off a round of tit-for-tat responses that in the end would leave no country better off.

In the meantime the financial sector enjoys continuing growth in earnings and the U.S. Congress is preparing to loosen some of the Dodd-Frank banking restrictions. But, as Martin Wolf of the Financial Times has warned, “The world at the beginning of 2018 presents a contrast between its depressing politics and its improving economics.” Markets can and do change rapidly,and there are many potential sources of disruption. And the greatest danger is always the one you do not see coming.

Venezuela and the Next Debt Crisis

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The markets for the bonds of emerging markets have been rattled by developments in Venezuela. On November 13,Standard & Poor’s declared Venezuela to be in default after that country missed interest payments of $200 million on two government bonds. Venezuelan President Nicolás Maduro had pledged to restructure and refinance his country’s $60 billion debt, but there were no concrete proposals offered at a meeting with bondholders. By the end of the week, however, support from Russia and China had allowed the country to make the late payments.

Whether or not Venezuela’s situation can be resolved, the outlook for the sovereign debt of emerging markets and developing economies is worrisome. The incentive to purchase the debt is clear: their recent yields of about 5% and total returns of over 10% have surpassed the returns on similar debt in the advanced economies. The security of those returns seem to be based on strong fundamental condtions: the IMF in its most recent World Economic Outlook has forecast growth rates for emerging market and developing economies of 4.6% in 2017, 4.9% next year and 5% over the medium term.

The Quarterly Review of the Bank for International Settlements last September reviewed the government debt of 23 emerging markets, worth $11.7 trillion. The BIS economists found that much of this debt was denominated in the domestic currency, had maturities comparable to those of the advanced economies, and carried fixed rates. These trends, the BIS economists reported, “..should help strengthen public finance sustainability by reducing currency mismatches and rollover risks.”

It was not surprising, then when earlier this year the Institute for International Finance announced that total debt in developing countries had risen by $3 trillion in the first quarter. But surging markets invariably attract borrowers with less promising prospects. A FT article reported more recent data from Dealogic, which tracks developments in these markets, that shows that governments with junk-bond ratings raised $75 billion in syndicated bonds this calendar year. These bonds represented 40% of the new debt issued in emerging markets. Examples of such debt include the $3 billion bond issue of Bahrain, Tajikistan’s $500 million issue and the $3 billion raised by Ukraine. These bonds offer even higher yields, in part to compensate bondholders for their relative illiquidity.

The prospects for many of these economies are not as promising as the IMF’s aggregate forecast indicates. The IMF’s analysis also pointed out that there is considerable variation in performance across the emerging market and developing economies. The projected high growth forecast for the next several years is based in large part on anticipated growth in India and China, which account for more than 40% of the collective GDP of these nations. Weaker growth is anticipated in Latin America and the Caribbean, sub-Saharan Africa, North Africa and the Middle East.

The IMF also raised concerns about the sustainability of the sovereign debt of these countries in October’s Global Financial Stability Report. In the case of low-income countries, the report’s authors warned: “…this borrowing has been accompanied by an underlying deterioration in debt burdens… Indeed, annual principal and interest repayments (as a percent of GDP or international reserves) have risen above levels observed in regular emerging market economy borrowers.” Similarly, Patrick Njoroge, head of Kenya’s central bank, has warned that some African nations have reached a debt-servicing threshold beyond which they should not borrow.

None of these developments will surprise anyone familiar with the Minsky-Kindleberger model of financial crises. This account of the dynamics of such crises begins with an initial change in the economic environment—called a “displacement”—that changes the outlook for some sector (or nation). The prospect of profitable returns attracts investors. Credit is channelled by banks to the new sector, and the increase in funds may be reinforced by capital inflows.The demand for financial assets increases their prices. There is a search for new investments as the original investors take profits from their initial positions while new investors, regretful at missing earlier opportunities, join the speculative surge. The pursuit of yield is met by the issuance of new, increasingly risky assets. The “speculative chase” further feeds a price bubble, which is always justified by claims of strong fundamentals.

At some point there is a reassessment of market conditions. This may be precipitated by a specific event, such as a leveling off of asset prices or a rise in the cost of funding. An initial wave of bankruptcies or defaults leads to the exit of some investors and price declines. Further selling and the revelation of the flimsy undergirding of the speculative bubble results in what Kindleberger calls “revulsion.” In a world of global financial flows there are “sudden stops” as foreign investors pull out their funds, putting pressure on fixed exchange rates. Contagion may carry the revulsion across national boundaries. The end, Kindleberger wrote, comes either when prices fall so low that investors are drawn back; or transactions are shut down; or when a lender of last resort convinces the market that sufficient liquidity will be provided.

The market for the bonds of developing economies has followed this script. The initial displacement was the improvement in the growth prospects of many emerging market countries at a time when the returns on fixed investments in the advanced economies were relatively low. A credible case could be made that emerging market economies had learned the lessons of the past and had structured their debt appropriately. But the subsequent increase in bond offerings by governments with below investment grade ratings shows that foreign investors in their eagerness to enter these markets were willing to overlook more risky circumstances. This leaves them and the governments that issued the bonds vulnerable to shocks in the global financial system. A rise in risk aversion or U.S. interest rates would lead to rapid reassessments of the safety and sustainability of much of this debt.

This potential crisis has caught the attention of those who would be responsible for dealing with its painful termination. The IMF’s Managing Director Christine Lagarde at the Fund’s recent annual fall meeting warned of the risk of “a tightening of the financial markets and the potential capital outflows from emerging market economies or from low‑income countries where there has been such a search for yield in the last few years.” The IMF has dealt with this type of calamity before, and it never ends well.

Economic Consequences of Populism

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Who is the true populist: Bernie Sanders, who promises single-payer health care and college without tuition, or Donald Trump, who campaigned on a promise to “drain the swamp”?  Jeremy Corbyn of the UK’s Labour Party, who wants to nationalize public-sector firms, or Marine Le Pen of France’s National Front, who wants to take France out of the Eurozone? And what would be the consequences of their policies?

To answer these questions requires first an understanding of populism. One definition of populism, such as the one found here, refers to it as policies for the “common people.” Populism, therefore, divides the world into two groups: the good “common people” and the evil “them.” “They” deprive the “people” of the rewards of their hard work and exclude them from the political process. But just who are these “common people”? And who are not?

Dani Rodrik of Harvard’s Kennedy School in one recent paper and a second coauthored with Sharun Mukand of the University of Warwick proposes an analytical framework for understanding the different strands of nationalism. Rodrik and Mukand suggest that populist politicians obtain support by exploiting divisions within a society, and envisage two kinds of separation. The first is an ethno-national split, such as occurred in Europe in the 1930s and again in modern-day Europe, and is usually associated with right-wing movements. The second is a partition by economic class, as seen in the U.S. in the 1890s, Peron’s Argentina and contemporary Venezuela, and is often found in left-wing organizations.

Under this classification, Trump and Le Pen are nationalist populists while Sanders and Corbyn have a class-based agenda. Once we understand this demarcation, we can see they will advocate different policies. The nationalist populists are suspicious of all foreign contact. They regard trade pacts as zero-sum transactions: one side to an agreement wins, and the other loses. Similarly, immigrants hurt native workers and impose fiscal costs on society. These populists are in favor of government expenditures for the “people,” but not anyone else. They favor domestic firms and will support measures to benefit them.

Class-based populists, on the other hand, are concerned about the “workers,” who includeindustrial laborers and farmers. They are suspicious of property owners and the financial sector. They seek to use taxes and other measures to redistribute property. They may also advocate government control of the economy through public ownership or the use of licenses and other means to guide production. They can grant subsidies for the purchase of basic needs, such as food or fuel. They will oppose foreigners if they are seen as allied with domestic financiers.

Initially, populist measures of either type may lead to prosperity, as more domestic and/or government spending leads to more jobs. But less efficient firms are subsidized, which increases costs. Over time these costs must be paid, as well as those made directly to households. If the bond markets are reluctant to finance government budget deficits (except at very high interest rates), the government may turn to the central bank to finance its expenditures. But the resulting inflation leads to more spending and monetary creation. A country with a fixed exchange rate, like several in Latin America, eventually runs out of foreign exchange. The resulting crises are blamed on “foreigners” or “capitalists,” and eventually may lead to a collapse.

Rudiger Dornbusch and Sebastian Edwards (currently at UCLA’s Andersen School of Management) wrote an analysis of the populist policies of Latin American governments that appeared in the Journal of Development Economics in 1990 (see working paper here). In their view:

“We mean by “populism” an approach to economics that emphasizes growth and income redistribution and deemphasizes the risks of inflation and deficit finance, external constraints and the reaction of economic agents to aggressive non-market policies.…populist policies do ultimately fail; and when they fail it is always at a frightening cost to the very groups who were supposed to be favored.”

The most prominent manifestations of President Trump’s nationalist populism have come in the negotiations over NAFTA  and the administration’s refusal to abide by the decisions of the World Trade Organization. In addition, there are its policies that affect illegal immigrants and its support of measures to cut legal migration. None of these will lead to an immediate crisis in the U.S.  economy, but they will have long-run consequences for the growth of the economy. Moreover, the law of unintended consequences has a wide reach, The Trump administration may find that retaliation can sting.

 

2017 Globie: “Grave New World”

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Once a year I choose a book that deals with an aspect of globalization in an interesting and illuminating way, and bestow on it the “prize” of the Globalization Book of the Year (known as the “Globie”). The prize is strictly honorific—no check is attached! But I enjoy drawing attention to an author who has an insight on the process of globalization.  Previous winners are listed below.

This year’s Globie goes to Stephen D. King for Grave New World: The End of Globalization, The Return of History. King is senior economic adviser at HSBC Holdings, where he was chief economist from 1998 to 2015. He is the author of Losing Control: The Emerging Threats to Western Prosperity, which won the Globie in 2010, and therefore is the first two-time winner.

In the new book King addresses the current status of globalization, and how it may evolve in the future. In the book he makes six claims:

  • Globalization is not irreversible;
  • Technology can both enable globalization and destroy it;
  • Economic development that reduces inequality between states but reinforces domestic inequality creates a tension between a desire for gains in global living standards and social stability at home;
  • Migration in the 21st century will affect domestic stability;
  • The international institutions that have helped govern globalization have lost their credibility;
  • There is more than one version of globalization.

King is particularly perceptive in pointing out alternative viewpoints to those usually espoused in Western media. In Chapter 7, for example, he gives six different perspectives on how globalization has affected economic welfare. He begins with the Western version, and follows it with the Chinese, Ottoman, Russian, Persian and African versions. Each region sees history filtered through its own experiences and comes to very different conclusions on the benefits and costs of globalization.

Differences over globalization also exist within Western nations, as recent elections have shown. King points out that supporters of Donald Trump in the U.S. were concerned about immigration and terrorism, while Hilary Clinton’s supporters were worried about inequality. Nor are these concerns confined to the U.S., as the Brexit vote revealed. Part of these divisions are responses to the hardships and dislocations caused by the global financial crisis. But whatever the source, this upheaval hastens a retreat by Western countries from global engagement.

While the Western economies are withdrawing from international commitments, others are actively pursuing their own global agendas. China’s Silk Road initiative, for example, extends its trade ties with central Asia and Europe. The Asian Infrastructure Investment Bank bolsters China’s neighbors’ capacity to engage in more transactions. At some point India will undoubtedly respond with its version of an Asian initiative.

King readily admits that his view of the future is “unsettling.” Our faith in technology and markets has not led to the widespread adoption of Western values or shared prosperity. The challenge is to formulate international mechanisms that mitigate market failures, including inequality. A vision based on every nation following its own interests is not likely to achieve that goal.

Previous Globie Winners

2014    Martin Wolf : The Shifts and the Shocks: What We’ve Learned–and Have Still to                                                    Learn–from the Financial Crisis

2015    Benjamin J. Cohen: Currency Power: Understanding Monetary Rivalry

2016    Branko Milanovic: Global Inequality

 

Trump and International Finance

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International trade and immigration were flashpoints of Donald Trump’s presidential campaign, and in his first year he has shown that he intends to fulfill his promises to slow down the movements of goods and people. Last month negotiations over NAFTA began with Canada and Mexico, with the U.S. trade representative Robert Lighthizer announcing that current bilateral deficits “can’t continue.” The President threatened to shut down the government if Congress does not approve the funding for a wall with Mexico—a threat that seems to have been retracted in view of the need to approve funding for relief funds to Texas. But another aspect of globalization—international financial flows—seems to have escaped the President’s wrath. The reason for this divergence tells us much about the reasons for the President’s opposition to economic globalization.

President Trump has complained about exchange rates, particularly those of China and Germany, insisting that their governments lower the value of their currencies to increase exports to the U.S. But the U.S. Treasury did not label either country a currency manipulator in its latest report, although they made the “watch list.” (How Germany manipulates the euro has yet to be demonstrated.) Similarly, Trump received considerable press coverage during his campaign when he attacked U.S. firms that allegedly transferred U.S. jobs abroad. Recently his indignation seems to have trailed off, and has been replaced by the assertion that lower corporate tax rates will serve as an incentive for U.S. firms to repatriate funds held abroad that they will spend on domestic investments—a claim with little evidence to back it up. The President has rarely voiced any concern about the impact of financial globalization.

While Senator Bernie Sanders did not make international finance a focus of his campaign for the Democratic nomination for the presidency, he sharply criticized the financial sector. He called for the breakup of the largest financial institutions, and proposed a tax on financial transactions to finance public colleges and universities. Any of these actions would certainly affect capital flows. And Sanders expressed strong disapproval of the IMF’s programs with Greece.

The reason for the different stances on finance by Trump and Sanders can be explained using a framework recently proposed by Professor Dani Rodrik of Harvard’s Kennedy School of Government. He distinguishes between the sorts of cleavages that can divide societies. One of these is an ethno-national/cultural cleavage, which differentiates people by nationality and/or race. The other is an income/social class cleavage, which distinguishes people by income class. The former results in right-wing populism that targets foreigners as the source of the hardships that domestic citizens experience. The second form of division leads to left-wing populism, which criticizes the wealthy, banks and corporations.

Trump’s appeal has been to a base that is largely white, and who often live in economically distressed areas. They are receptive to the argument that foreigners are the cause of their economic distress, and that the country needs a strong leader who can stand up to the external threat. Research by Diana Mutz and Edward D. Mansfield of the University of Pennsylvania has shown that opposition to globalization is often based on attitudes and views outside the economic realm. They cite as sources of opposition to globalization: first, a belief that the U.S. is superior to other nations; second, a desire to avoid engagement with the rest of the world; and third, negative feelings towards those who are racially and ethnically different.

Trump’s opposition to trade and immigration allows him to show these voters that he will support them against the foreign menance. International finance, on the other hand, lacks a clear foreign villain. It is difficult to attack foreign central banks for helping to finance our fiscal deficits, and the financial crisis of 2008-09 originated in this country.

But Rodrik points out that there are countries where international capital movements have been much more controversial. Latin American countries have often faced financial shocks, which led to a left-wing populism that opposed foreign banks. More recently, Greece has been receptive to populists who oppose the austerity measures imposed by other European governments and the IMF.

In the case of the U.S., Sanders’ campaign showed that a leftist form of populism would include opposition to the financial sector. This form of activism can, of course, be found in U.S. history. The populist movement of the 1890s called for the abandonment of the Gold Standard and an increase in the provision of credit to farmers. More recently, opponents of the Federal Reserve have included members of Congress from both parties.

While Trump was willing to criticize Wall Street during his campaign, he has adopted a very different stance since his election. He has called for repeal of most of the Dodd-Frank Wall Street Reform Act. Steve Mnuchin, the Secretary of the Treasury and Gary Cohn, Director of the National Economic Council, both worked at Goldman Sachs. But Trump’s opposition to trade and migration allows him to maintain his base of support among Republican voters.

International bankers know that they have nothing to fear from a Trump administration—except perhaps his incompetence. Any threats to the stability of financial markets will come from self-inflicted wounds, such as a government shutdown over the debt ceiling. The low market volatility foreseen by the VIX index may soon be upended.