The Role of the U.S. in the Global Financial System

Leave a reply

The mandate of the Federal Reserve is clear: “…promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” How to achieve those goals, of course, has been the subject of great debate: should the central bank use interest rates or monetary aggregates? should it rely on rules or discretion? The ongoing controversy within the U.S. over the benefits and costs of globalization opens up the issue of the geographic scope of the Fed’s responsibilities: does the Fed (and for that matter the U.S. Treasury) need to worry about the rest of the world?

Stanley Fischer, Federal Reserve Vice Chair (and former first deputy managing director of the IMF) sees a role for limited intervention. Fischer acknowledges the feedback effects between the U.S. and the rest of the world. The U.S. economy represents nearly one quarter of the global economy, and this preponderance means that U.S. developments have global spillovers. Changes in U.S. interest rates, for example, are transmitted to the rest of the world, and the “taper tantrum” showed how severe the responses could be. Therefore, Fischer argues, our first responsibility is “to keep our own house in order.” It also entails acknowledging that efforts to restore financial stability can not be limited by national borders. During the global financial crisis, the Fed established swap lines with foreign central banks so that they could provide liquidity to their own banks that had borrowed in dollars to hold U.S. mortgage-backed securities. Fischer cautions, however, that the Fed’s global responsibilities are not unbounded. He acknowledges Charles Kindleberger’s assertion that international stability can only be ensured by a financial hegemon or global central bank, but Fischer states, “…the U.S. Federal Reserve System is not that bank.”

The U.S. did hold that hegemonic position, however, during the Bretton Woods era when we ensured the convertibility of dollars held by central banks to gold. We abandoned the role when President Richard Nixon ended gold convertibility in 1971 and the Bretton Woods system subsequently ended. Governments have subsequently experimented with all sorts of exchange rate regimes, from fixed to floating and virtually everything in between.

While many countries do not intervene in the currency markets, others do, so there is a case for a reserve currency. But perhaps more importantly, we live in an era of global finance, and much of these financial flows are denominated in dollars. The offshore dollar banking system, which began in the 1960s with the Eurodollar market, now encompasses emerging markets as well as upper-income countries. This financial structure is vulnerable to systemic risk. Patrick Foulis of The Economist believes that “The lesson of 2007-08 was that a run in the offshore dollar archipelago can bring down the entire financial system, including Wall Street, and that the system needs a lender of last resort.”

Are there alternatives to the U.S. as a linchpin? The IMF is the international agency assigned the task of ensuring the provision of the international public good of international economic and financial stability. Its track record during the 2008-09 crisis showed that it could respond quickly and with enough financial firepower to deal with global volatility (see Chapter 10). But it can only move when its principals, the 189 member nations, allow it to do so. The Fund’s subsequent dealings with the European nations in the Greek financial crisis demonstrate that it can be tripped up by politics.

Is China ready to take on the responsibilities of an international financial hegemon? Its economy rivals, if not surpasses, that of the U.S. in size, and it is a dominant international global trader. China’s financial footprint is growing as well, and the central bank has established its own series of swap lines. This past year the renminbi was included in the basket of currencies that are used to value the IMF’s Special Drawing Rights. But the government has moved cautiously in removing capital account regulations in order to avoid massive flows in either direction, so there is limited liquidity. Chinese debt problems do not encourage confidence in its ability to deal with financial stress.

The Federal Reserve is well aware that international linkages work both ways. Fed Chair Janet Yellen cited concerns about the Chinese economy last fall when the Fed held back its first increase in the Federal Funds rate. And Fed Governor Lael Brainard believes that the global role of the dollar and the proximity to a zero lower bound may amplify spillovers from foreign conditions onto the U.S.

Whether or not the U.S. has a special responsibility to promote international financial stability may depend in part on one’s views of the stability of global capital markets. If they are basically stable and only occasionally pushed into episodes of excess volatility, then coordinated national policies may be sufficient to return them to normalcy. But if the structure of the global financial system is inherently shaky, then the U.S. needs to be ready to step in when the next crisis occurs. Andrés Velasco of Columbia University believes that “Recent financial history suggests that the next liquidity crisis is just around the corner, and that such crises can impose enormous economic and social costs. And in a largely dollarized world economy, the only certain tool for avoiding such crises is a lender of last resort in dollars.”

Unfortunately, if a crisis does occur it will take place during a period when the U.S. is reassessing its international ties. Donald Trump, the presumptive Republican candidate, achieved that position in part because of his argument that past U.S. trade and finance deals were against our national interests. He shows little interest in maintaining multilateral arrangements such as the United Nations. Trump has announced that he would most likely replace Janet Yellen because of her political affiliation. It is doubtful that the criteria for a new Chair would include a sensitivity to the international ramifications of U.S. policies.

The interest of the U.S. public in international dealings has always waxed and waned, and Trump’s nomination is a sign that we are in a period when many believe we should minimize our engagement with the rest of the world. But this will be difficult to do as long as the dollar remains the predominant world currency for private as well as official use. Regardless of domestic politics, we will not escape the fallout of another crisis, regardless of where it starts. It would be better to accept our international role and seeks ways to minimize risk than to undertake a futile attempt to make the world go away.

The People’s Verdict on Globalization

1 Reply

The similarities in the electoral appeals of businessman Donald Trump and Senator Bernie Sanders have been widely noted (see, for example, here, here and here). Both men attract voters who feel trapped in their economic status, unable to make progress either for themselves or their children. Moreover, both men have assigned the blame for the loss of manufacturing jobs in the U.S. on international trade agreements. Regardless of who wins the election, globalization, which was seen as a irresistible force in the 1990s after the collapse of the Soviet Union and the entry of China into the world economy, is now being reexamined and found to be detrimental in the eyes of many.

Trump and Sanders have been particularly vociferous about the North American Trade Agreement, which they hold responsible for the migration of U.S. jobs to Mexico. But those who blame the foreign sector for a loss of jobs should also finger capital flows. The investment of U.S. firms in overseas facilities that then ship their products back to the U.S. represents outward foreign direct investment (FDI), and thus in this story is also responsible for the disappearance of manufacturing jobs. Moreover, Lawrence Summers of Harvard has pointed out that firms that have the option to relocate will be less inclined to invest in new capital in their home country, which leads to lower productivity and wages for their workers.

Whether technology or trade is more responsible for the shrinkage in manufacturing jobs has been the subject of much study (see, for example, here). In the past, most studies assigned the primary role for labor force disruption to technology. David Autor of MIT, Lawrence F. Katz of Harvard and Melissa S. Kearney of the University of Maryland, for example, drew attention to technology that accomplishes routine tasks without human intervention and leads to a polarization of the labor force, as middle-skill level jobs are eliminated, leaving only low-skill and high-skill jobs. In addition, information technology that allows firms to coordinate their facilities in different countries allows more outsourcing and reallocation of plants.

Those who seek to defend global trade flows cite rises in employment due to exports and also gains due to increases in efficiency and economics of scale that accompany specialization. In addition, lower prices due to imports raise real incomes. No one denies that increased imports can disrupt labor markets, but this has viewed as a transitional cost that could be absorbed.

But recent economic studies by widely respected economists (including MIT’s Autor) have found that imports—and in particular, imports from China—are responsible for some of the loss of U.S. manufacturing jobs. Autor, David Dorn at the University of Zurich and Gordon Hanson at the University of California—San Diego view China’s entry into world markets as an epochal shock. Standard economic analysis would have predicted a shift within U.S. industries as workers in firms that lost their markets to Chinese imports migrated to other sectors, with no change in aggregate employment. But in reality the shift to new jobs by those workers exposed to import competition has not taken place and employment has fallen in those labor markets. In another study with MIT’s Daron Acemoglu and Brendan Price, these authors estimate U.S. job losses from Chinese import competition in the range of 2 – 2.4 million.

The relative effects of technology and international trade/finance on employment will undoubtedly be investigated, analyzed and debated for many years to come. But Steven R. Weisman of the Peterson Institute for International Economics makes an important point in his new book on globalization, The Great Tradeoff: Confronting Moral Conflicts in the Era of Globalization:

Facts, by themselves, will never definitely resolve the arguments over the effects of trade and investment on inequality or economic justice in general. Globalization, and indeed the full array of political conflicts in the modern era, must be resolved by men and women, not idealized concepts and truths.

A honest debate over the benefits and costs of globalization is overdue. To date, the U.S. has managed to avoid hard choices, but that will not continue, Dani Rodrik of Harvard’s Kennedy School of Government has examined the policy challenge In his book, The Globalization Paradox: Democracy and the Future of the World Economy. He makes the case for the existence of a policy “trilemma,” by which he means that a nation can not simultaneously have democracy, national sovereignty and “hyperglobalization,” i.e., the removal of all domestic barriers to trade and finance.

Rodrik examines the three possible national positions under his trilemma. If a nation totally embraces the global economy, then it can not allow domestic politics to enact rules and regulations that are not in alignment with international standards. He cites the era of the Gold Standard as a period when nations could not exercise discretionary policies. On the other hand, democratically elected global institutions could devise global regulations for the global markets. This would require a sort of global federalism, i.e., the U.S. model on a wider scale. Rodrik cites the European Union as a possible move in this direction, but was skeptical when he wrote his book of the feasibility of the EU expanding its scope. Recent events have certainly diminished any confidence in that model.

That leaves the “Bretton Woods compromise,” which is the use of national regulations by nations to choose their degree of integration with international markets. The restrictions on capital flows under the Bretton Woods international monetary system allowed governments to use macroeconomic policies to attain full employment (see Ch. 2 here). Similarly, Japan, Korea, China and other East Asian economies implemented measures to promote exports to accelerate growth. The global economy benefitted those who engaged in it, but each nation chose the scale of its involvement.

Rodrik raised a concern that the embrace of the global economy has engendered democratic oversight. In the case of the U.S., this may have been mitigated by the role of the U.S. as a global hegemon that set the pace for hyperglobalization. The U.S. was an active proponent of the World Trade Organization (WTO), which replaced the General Agreement on Tariffs and Trade (GATT) in 1995 and has sought to further trade integration. Financial deregulation began in the U.S. in the 1980s with the removal of regulations on thrifts, and continued in the 1990s with the elimination of restrictions on interstate banking and the repeal of the Glass-Steagall Act that had separated commercial banking from other financial activities such as underwriting.

Both U.S. political parties embraced global economic integration. In the Republican party, the pro-business wing was allied with social conservatives and a group thaty advocated a strong military presence. The Democrats joined together unions with pro-business groups. But this year’s primaries are demonstrating that these coalitions are breaking down. Both Trump and Sanders are giving voice to those who feel that their support has been taken for granted and their concerns and interests ignored. There are projections of fundamental realignments on both sides of the political duopoly (see here and here), which may bring about a change in the U.S. position on globalization.

It is not clear what options are available. Despite the promises of Trump and other politicians, the jobs that have either been outmoded by technology or moved away will not be recreated. But it may be possible to devise stronger safety nets for those who do not share directly in the gains of more international trade and investment. President Obama went a long way in that direction through his achievement of expanded health care coverage. Rodrik believes that upper-income countries “…must address domestic concerns over inequality and distributive justice. This requires placing some sand in the wheels of globalization.” Summers has called for a shift in focus in negotiations from trade agreements to international harmonization agreements, that would include labor rights and environmental protection.

All this should be addressed, and quickly, since China’s impact on the global economy has not yet been fully felt. Arvind Subramanian and Martin Kessler of the Peterson Institute for International Economics claim that China’s effect on global trade makes it a “mega-trader.” A similar phenomenon may take place in the financial markets as China continues its relaxation of capital controls. The IMF has found that growth “surprises” in China already have a significant impact on equity markets in other economies. But the IMF expects that financial spillovers will become more significant in the future, particularly if Chinese residents are allowed to hold foreign equity and bonds. Martin Wolf points out that capital account liberalization may lead to a “large net capital outflow from China, a weaker exchange rate and a bigger current account surplus.” The international financial system is not robust enough to withstand another shock, which would only encourage more calls for nationalist measures. The costs of globalization must be explicitly addressed if we expect the public to ignore the siren song of politicians who would use protectionist measures to protect voters from the consequences of further globalization.

The Repercussions of Financial Booms and Crises

Leave a reply

Financial booms have become a chronic feature of the global financial system. When these booms end in crises, the impact on economic conditions can be severe. Carmen M. Reinhart and Kenneth S. Rogoff of Harvard pointed out that banking crises have been associated with deep downturns in output and employment, which is certainly consistent with the experience of the advanced economies in the aftermath of the global crisis. But the aftereffects of the booms may be even deeper and more long-lasting than thought.

Gary Gorton of Yale and Guillermo Ordoñez of the University of Pennsylvania have released a study of “good booms” and “bad booms,” where the latter end in a crisis and the former do not. In their model, all credit booms start with an increase in productivity that allows firms to finance projects using collateralized debt. During this initial period, lenders can assess the quality of the collateral, but are not likely to do so as the projects are productive. Over time, however, as more and more projects are financed, productivity falls as does the quality of the investment projects. Once the incentive to acquire information about the projects rises, lenders begin to examine the collateral that has been posted. Firms with inadequate collateral can no longer obtain financing, and the result is a crisis. But if new technology continues to improve, then there need not be a cutoff of credit, and the boom will end without a crisis. Their empirical analysis shows that credit booms are not uncommon, last ten years on average, and are less likely to end in a crisis when there is larger productivity growth during the boom.

Claudio Borio, Enisse Kharroubi, Christian Upper and Fabrizio Zampolli of the Bank for International Settlements also look at the dynamics of credit booms and productivity, with data from advanced economies over the period of 1979-2009. They find that credit booms induce a reallocation of labor towards sectors with lower productivity growth, particularly the construction sector. A financial crisis amplifies the negative impact of the previous misallocation on productivity. They conclude that the slow recovery from the global crisis may be due to the misallocation of resources that occurred before the crisis.

How do international capital flows fit into these accounts? Gianluca Benigno of the London School of Economics, Nathan Converse of the Federal Reserve Board and Luca Forno of Universitat Pompeu Fabra write about capital inflows and economic performance. They identify 155 episodes of exceptionally large capital inflows in middle- and high-income countries over the last 35 years. They report that larger inflows are associated with economic booms. The expansions are accompanied by rises in total factor productivity (TFP) and an increase in employment, which end when the inflows cease.

Moreover, during the boom there is also a reallocation of resources. The sectoral share of tradable goods in advanced economies, particularly manufacturing, falls during the periods of capital inflows. A reallocation of investment out of manufacturing occurs, including a reallocation of employment if a government refrains from accumulating foreign assets during the episodes of large capital inflows, as well as during periods of abundant international liquidity. The capital inflows also raise the probability of a sudden stop. Economic performance after the crisis is adversely affected by the pre-crisis capital inflows, as well as the reallocation of employment away from manufacturing that took place in the earlier period.

Alessandra Bonfiglioli of Universitat Pompeu Fabra looked at the issue of financial integration and productivity (working paper here). In a sample of 70 countries between 1975 and 1999, she found that de jure measures of financial integration, such as that provided by the IMF, have a positive relationship with total factor productivity (TFP). This occurred despite the post-financial liberalization increase in the probability of banking crises in developed countries that adversely affects productivity. De facto liberalization, as measured by the sum of external assets and liabilities scaled by GDP, was productivity enhancing in developed countries but not in developing countries.

Ayhan Kose of the World Bank, Eswar S. Prasad of Cornell and Marco E. Terrones of the IMF also investigated this issue (working paper here) using data from the period of 1966-2005 for 67industrial and developing countries. Like Bonfiglioli, they reported that de jure capital openness has a positive effect on growth in total factor productivity (TFP). But when they looked at the composition of the actual flows and stocks, they found that while equity liabilities (foreign direct investment and portfolio equity) boost TFP growth, debt liabilities have the opposite impact.

The relationship of capital flows on economic activity, therefore, is complex. Capital inflows contribute to economic booms and may increase TFP, but can end in crises that include “sudden stops” and banking failures. They can also distort the allocation of resources, which affects performance after the crisis. These effects can depend on the types of external liabilities that countries incur. Debt, which exacerbates a crisis, may also adversely divert resources away from sectors with high productivity. Policymakers in emerging markets who think about the long-term consequences of current activities need to look carefully at the debt that private firms in their countries have been incurring.

The IMF and the Next Crisis

Leave a reply

The IMF has issued a warning that “increasing financial market turbulence and falling asset prices” are weakening the global economy, which already faces headwinds due to the “…modest recovery in advanced economies, China’s rebalancing, the weaker-than-expected growth impact from lower oil prices, and generally diminished growth prospects in emerging and low-income economies.” In its report to the finance ministers and central bank governors of the Group of 20 nations before their meeting in Shangahi, the IMF called on the G20 policymakers to undertake “…bold multilateral actions to boost growth and contain risk.” But will the IMF itself be prepared for the next crisis?

The question is particularly appropriate in view of the negative response of the G20 officials to the IMF’s warning. U.S. Treasury Secretary Jacob J. Law sought to dampen expectations of any government actions, warning “Don’t expect a crisis response in a non-crisis environment.” Similarly, Germany’s Minister of Finance Wolfgang Schaeuble stated that “Fiscal as well as monetary policies have reached their limits…Talking about further stimulus just distracts from the real tasks at hand.”

The IMF, then, may be the “first responder” in the event of more volatility and weakening. The approval of the long-delayed 14th General Quota Review has allowed the IMF to implement increases in the quota subscriptions of its members that augment its financial resources. Managing Director Christine Lagarde, who has just been reappointed to a second term, has claimed the institution of new Fund lending programs, such as the Flexible Credit Line (FCL) and the Precautionary and Liquidity Line (PLL), has strengthened the global safety net. These programs allow the IMF to lend quickly to countries with sound policies. But outside the IMF, Lagarde claims, the safety net has become “fragmented and asymmetric.” Therefore, she proposes, “Rather than relying on a fragmented and incomplete system of regional and bilateral arrangements, we need a functioning international network of precautionary instruments that works for everyone.” The IMF is ready to provide more such a network.

But is a lack of liquidity provision the main problem that emerging market nations face? The Financial Times quotes Lagarde as stating that any assistance to oil exporters like Azerbaijan and Nigeria should come without any stigma, as “They are clearly the victims of outside shocks…” in the form of collapses in oil prices. But outside shocks are not always transitory, and may continue over long periods of time.

There are many reasons to expect that lower commodity prices may persist. If so, the governments of commodity exporters that became used to higher revenues may be forced to scale down their spending plans. Debt levels that appeared reasonable at one set of export prices may become unsustainable at another. In these circumstances, the countries involved may face questions about their solvency.

But is the IMF the appropriate body to deal with insolvency? IMF lending in such circumstances has become more common. Carmen M. Reinhart of Harvard’s Kennedy School of Government and Christoph Trebesch of the University of Munich write that about 40% of IMF programs in the 1990s and 2000s went to countries in some stage of default or restructuring of official debt, despite the IMF’s official policy of not lending to countries in arrears. Reinhart and Trebesch attribute the prevalence of continued lending (which has been called “recidivist lending”) in part to the Fund’s tolerance of continued non-payment of government debt.

More recently, the IMF’s credibility suffered a blow due to its involvement with Greece and the European governments that lent to it in 2010. (See Paul Blustein for an account of that period.) The IMF ‘s guidelines for granting “exceptional access” to a member stipulate that such lending could only be undertaken if the member’s debt was sustainable in the medium-term. The Greek debt clearly was not, so the Fund justified its lending on the grounds that there was a risk of “international systemic spillovers.” But the IMF’s willingness to participate in the bailout loan of 2010 only delayed the eventual restructuring of Greek debt in 2012. The IMF now insists that the European governments grant Greece more debt relief before it will provide any more financial government.

Reinhart and Trebesch write that the IMF’s “…involvement in chronic debt crises and in development finance may make it harder to focus on its original mission…” of providing credit in the event of a balance of payments crisis. Moreover, its association with cases of long-run insolvency may “taint all of its lending.” This may explain the limited response to the IMF’s programs of liquidity provision. Only Colombia, Mexico and Poland have shown an interest in the FCL, and the Former Yugoslav Republic of Macedonia and Morocco in the PLL.

Even if the IMF receives the power to implement new programs, therefore, its past record of lending may deter potential borrowers. This problem will be worsened if the IMF treats countries that need to adapt to a new global economy as temporary borrowers that only need assistance until commodity prices rise and they are back on their feet. The day when the emerging market economies routinely recorded high growth rates may have come to an end. If so, debt restructuring may become a more common event that needs to be addressed directly.

China’s Vulnerable External Balance Sheet

Leave a reply

China’s capital outflow last year is estimated to have totaled $1 trillion. Money has been channeled out of China in various ways, including individuals carrying cash, the purchase of foreign assets, the alteration of trade invoices and other more indirect ways. The monetary exodus has pushed the exchange rate down despite a trade surplus, and raised questions about public confidence in the government’s ability to manage the economy. Moreover, the changes in the composition of China’s external assets and liabilities in recent years will further weaken its economy.

Before the global financial crisis, China had an external balance sheet that, like many other emerging market economies, consisted largely of assets held in the form of foreign debt—including U.S. Treasury bonds—and liabilities issued in the form of equity, primarily foreign direct investment, and denominated in the domestic currency. This composition, known as “long debt, short equity,” was costly, as the payout on the equity liabilities exceeded the return on the foreign debt. But there was an offsetting factor: in the event of an external crisis, the decline in the market value of the equity liabilities strengthened the balance sheet. Moreover, if there were an accompanying depreciation of the domestic currency, then the rise in the value of the foreign assets would further increase the value of the external balance sheet. and help stabilize the economy.

After the crisis, however, there was a change in the nature of China’s assets and liabilities. Chinese firms acquired stakes in foreign firms, while also investing in natural resources. The former were often in upper-income countries, and were undertaken to establish a position in those markets as much as earn profits. Many of these acquisitions now look much less attractive as the world economy shows little sign of a robust recovery, particularly in Europe.

Moreover, many of these acquisitions were financed with debt, including funds from foreign lenders denominated in dollars. Robert N McCauley, Patrick McGuire and Vladyslav Sushko of the Bank for International Settlements estimated that Chinese borrowing in dollars, mostly in the form of bank loans, reached $1.1 trillion by 2014. The fall in the value of the renminbi raises the cost of this borrowing. Menzie Chinn points out that if the corporate sector’s foreign exchange assets are taken into account, then the net foreign exchange debt is a more manageable $793 billion. But not all the firms with dollar-denominated debt possess sufficient foreign assets to offset their liabilities.

Declines in the values of the foreign assets purchased through Chinese outward FDI combined with an increase in the currency value of foreign-held debt pushes down the value of the Chinese external balance sheet. This comes at a time when the Chinese central bank is using its foreign exchange assets to slow the decline of the renminbi. The fall in reserves last year has been estimated to have reached $500 billion. Moreover, foreign firms and investors are cutting back on their acquisition of Chinese assets while repatriating money from their existing investments. China’s external position, therefore, is deteriorating, albeit from a strong base position.

Policymakers have a limited range of responses. They are tightening controls on the ability of households and companies to send money abroad, as the head of the central bank of Japan has urged. But controls on capital outflows are often seen as a sign of weakness, and do not inspire confidence. Raising interest rates to deter capital outflows would only further weaken the domestic economy, and may not work. Such moves would be particularly awkward to defend in the wake of the IMF’s inclusion of the Chinese currency in the basket of currencies that the IMF’s Special Drawing Rights are based on.

China’s remaining foreign exchange reserves and trade surplus allow policymakers some breathing room, as Menzie Chinn points out. The Chinese authorities retain a great deal of administrative control over financial transactions.  As policy officials are shuffled around, those still in office seek to reassure investors that the economy remains in good shape. But injecting more credit into the economy does not alleviate concerns about mounting debt. The economic measures promised by the leadership are being judged in the financial markets, and the verdict to date seems to be one of little or no confidence.

Monetary Policy in an Open Economy

Leave a reply

The recent research related to the trilemma (see here) confirms that policymakers who are willing to sacrifice control of the exchange rate or capital flows can implement monetary policy. For most central banks, this means using a short-term interest rate, such as the Federal Funds rate in the case of the Federal Reserve in the U.S. or the Bank of England’s Bank Rate. But the record raises doubts about whether this is sufficient to achieve the policymakers’ ultimate economic goals.

The short-term interest rate does not directly affect investment and other expenditures. But it can lead to a rise in long-term rates, which will have an effect on spending by firms and households. The relationship of short-term and long-term rates appears in the yield curve. This usually has a positive slope to reflect expectations of future short-term real rates, future inflation and a term premium. Changes in short-term rates can lead to movements in long-term rates, but in recent years the long-term rates have not always responded as central bankers have wished. Former Federal Reserve Chair Alan Greenspan referred to the decline in U.S. long-term rates in 2005 as a “conundrum.” This problem is exacerbated in other countries’ financial markets, where long-term interest rates are affected by U.S. rates (see, for example, here and here) and global factors.

Central banks that sought to increase spending during the global financial crisis by lowering interest rates faced a new obstacle: the zero lower bound on interest rates. Policymakers who could not lower their nominal policy rates any further have sought to increase inflation in order to bring down real rates. To accomplish this, they devised a new policy tool, quantitative easing. Under these programs, central bankers purchased large amounts of bonds with longer maturities than they use for open market transactions and from a variety of issuers in order to bring down long-term rates. The U.S. engaged in such purchases between 2008 and 2014, while the European Central Bank and the Bank of Japan are still engaged in similar transactions. As a consequence of these purchases, the balance sheets of central banks swelled enormously.

In an open economy, there is another channel of transmission to the economy for monetary policy: the exchange rate. If a central bank can engineer a currency depreciation, an expansion in net exports could supplement or take the place of the desired change in domestic spending. A series of currency depreciations last summer led to concerns that some central banks were moving in that direction.

But there are many reasons why using exchange rate movements are not a solution to less effective domestic monetary policies. First, if a central bank wanted to use the exchange rate as a tool, it would have to fix it. But it then would have to surrender control of domestic money or block capital flows to satisfy the constraint of the trilemma. Second, there is no simple relationship between a central bank’s policy interest rate and the foreign exchange value of its currency. Exchange rates, like any asset price, exhibit a great deal of volatility. Third, the impact on an economy of a currency depreciation does not always work the way we might expect. Former Federal Reserve Chair Ben Bernanke has pointed out that the impact of a cheaper currency on relative prices is balanced by the stimulative effect of the easing of monetary policy on domestic income and imports.

Of course, this does not imply that central banks need not take notice of exchange rate movements. There are other channels of transmission besides trade flows. The Asian crisis showed that a depreciation raises the value of debt liabilities denominated in foreign currencies, which can lead to bankruptcies and banking crises. We may see this phenomenon again in emerging markets as those firms that borrowed in dollars when U.S. rates were cheap have difficulty in meeting their obligations as both interest rates and the value of the dollar rise (see here).

Georgios Georgiadis and Arnaud Mehl of the European Central Bank have investigated the impact of financial globalization on monetary policy effectiveness. They find that economies that are more susceptible to global financial cycles show a weaker response of output to monetary policy. But they also find that economies with larger net foreign currency exposures exhibit a stronger response of output to monetary policy shocks. They conclude: “Overall, we find that the net effect of financial globalization since the 1990s has been to amplify monetary policy effectiveness in the typical advanced and emerging markets economy.”

While their results demonstrate the importance of exchange rate in economic fluctuations, that need not mean that monetary policy is “effective” as a policy tool. As explained above, flexible (or loosely managed) exchange rates are unpredictable. They can change in response to capital flows that react to foreign variables as well as domestic factors. The trilemma may hold in the narrow sense that central banks maintain control of their own policy rates if exchange rates are flexible. But what the policymakers can achieve with this power is circumscribed in an open economy.

Can Systemic Financial Risk Be Contained?

1 Reply

Risk aversion is a basic human characteristic, and in response to it we seek to safeguard the world live in. We mandate airbags and safety belts for automobile driving, set standards for the handling and shipment of food, build levees and dams to control floods, and regulate financial transactions and institutions to avoid financial collapses. But Greg Ip in Foolproof shows that our best attempts at avoiding catastrophes can fail, and even bring about worse disasters than those that motivate our attempts to avoid them. Drivers who feel safer with antilock brakes drive more quickly and leave less space between cars, while government flood insurance encourages building houses on plains that are regularly flooded.

Is the financial sector different? The traditional measures implemented to avoid financial failures are based on attaining macroeconomic stability. Monetary policy was used to control inflation, and when necessary, respond to shocks that destabilized the economy. When a crisis did emerge, the primary responsibility of a central bank was to act as a lender of last resort, providing funds to institutions that were solvent but illiquid. There was a vigorous debate before the global crisis of 2008-09 over whether central banks should attempt to deflate asset bubbles, but most central bankers did not believe that this was an appropriate task.

Fiscal policy was seen as more limited in its ability to combat business downturns because of lags in its design, implementation and effect. A policy that established a balanced budget over the business cycle, thus limiting the buildup of public debt, was often considered the best that could be expected. Automatic stabilizers, therefore, were set up to respond to cyclical fluctuations.

In open economies, flexible exchange rates provided some insulation against foreign shocks, and avoided the dangers that a commitment to a fixed rate entailed. Countries that did fix, or at least manage, their exchange rates stockpiled foreign exchange reserves to forestall speculative attacks. IMF surveillance provided an external perspective on domestic policies, while IMF lending could supplement foreign exchange reserves.

The global financial crisis demonstrated that these measures were inadequate to provide financial stability. The Federal Reserve led the way in implementing new monetary policies—quantitative easing—to supplement lower policy rates that faced a zero lower bound. But policymakers also responded with a broad range of innovative financial regulations. A new type of regulation—macroprudential—was introduced to minimize systemic financial risk, i.e., the risk associated with the collapse of a financial system (as opposed to the microprudential risk of the failure of an individual institution). These measures seek to prevent speculative rises in asset prices and credit creation, and the establishment of risky balance sheet positions. They include limits on interest rate and foreign exchange mismatches on balance sheets, caps on bank loan to value ratios, and countercyclical capital requirements (see here for an overview of these measures).

In the international sector, the Basel Committee on Banking Supervision produced “Basel III,” a new set of regulations designed to strengthen the resilience of its members’  banking systems. Capital control measures, once viewed as hindrances to the efficient allocation of savings, are now seen as useful in limiting inflows of foreign funds that contribute to asset bubbles. Swap lines allow central banks to draw upon each other for foreign exchange to meet the demand from domestic institutions, while the IMF has sought to make borrowing more user-friendly. Meetings of the member governments of the newly-formed Group of 20 allow them to coordinate their policies, while the IMF’s surveillance purview has expanded to include regional and global developments.

Are these measures sufficient? The lack of another global crisis to date is too easy a criterion, given that the recovery is still underway. But there may be inherent problems in the behavior of financial market participants that could frustrate policies that seek to prevent or at least contain financial crises. Moral hazard is often blamed for shoddy decision-making by those who think they can dodge the consequences of their actions. Many who were involved in the creation and sale of collaterized securities may have thought that the government would step in if there were a danger of a breakdown in these markets. But many banks held onto these securities, indicating that they thought that the reward of owning the securities outweighed the risks. Bank officials who oversaw the expansion of mortgage lending generally lost their jobs (and reputations). It is difficult to believe after the crisis that anyone thought that they could manipulate the government into absorbing all the consequences of their actions.

But if moral hazard is not always at fault, there is ample evidence that asymmetric information and behavioral anomalies result in hazardous behavior. Will the regulatory provisions listed above minimize the incidence of risky financial practices? There is some evidence that the provisions of the Dodd-Frank Act are working. But the regulatory framework continues to be implemented, and bankers and other financial market participants will always seek to find loopholes that they can exploit.

Regulatory practices on the international level are also subject to manipulation. Roman Goldbach, a political economist at Deutsche Bundesbank, in his book Global Governance and Regulatory Failure: The Political Economy of Banking points out that the overlap of national and global standards in what he calls the “transnational regulatory regime” results in layering “gaps.” The resulting loopholes in the policymaking process allow private interest coalitions to have a disproportionate influence on policy formulation. Moreover, policy officials consider the competitiveness of domestic financial structures as a goal (at least) equal to financial stability in international negotiations over regulatory standards. While there have been substantial changes since the global crisis, including the formation of the Financial Stability Board, the incentives in the governance structure of global finance have not changed.

Even regulations that work as intended may have unintended and unwanted consequences due to externalities. Kristin Forbes of MIT and Marcel Fratzscher, Thomas Kostka and Roland Straub of the European Central Bank examined Brazil’s tax on capital inflows from 2006 to 2011. They found that the tax did cause investors to decrease their portfolio allocation to Brazilian securities, as planned. But other countries also felt the impact of the tax. Foreign investors increased their allocation to economies that had some similarities to Brazil, while cutting back on those countries that were likely to impose their own control measures. Capital control measures that are imposed unilaterally, therefore, may only divert risky funds elsewhere, and are not a tool for controlling global financial risk.

The flow of money looking for higher yields outside the U.S. may diminish in the wake of the rise in the Federal Funds rate in the U.S. But Lukasz Rachel and Thomas D. Smith of the Bank of England claim that long-term factors account for a decline in the global real interest rate that will not be soon reversed. This poses a challenge for policymakers, as measures implemented in one country to contain a domestic credit boom may be undermined by foreign inflows. Domestic actions, therefore, ideally would be matched by similar measures in other countries, which would require macroprudential policy coordination.

Barry Eichengreen of UC-Berkeley has studied the record of international policy coordination, and finds that it works best under four sets of circumstances: when the coordination is centered on technical issues, such as central bank swaps; when the process is institutionalized; when it is aimed at preserving an existing set of policies, i.e., regime preserving, rather than devising new procedures; and when there exists a sense of mutual interests on a broad set of issues among the participants. Are such conditions present today? At the time of the crisis, central bankers cooperated in setting up the currency swap agreements while discussing their monetary policies. The formation of the Group of 20 provided a new forum for regular consultation, and there was widespread agreement in preserving a regime that encouraged international trade while preventing competitive currency devaluations. But the passage of time has weakened many of the commitments made when the crisis threatened, and the uneven recovery has caused national interests to diverge.

Perhaps a more basic issue is whether it is possible to design a financial system free of volatility. A government that is willing to replace markets in directing financial flows and allocating financial returns can maintain stability, but at a price. Such a system is characterized as “financial repression,” and includes limits on interest rates received by savers, control of banks and their lending, and the use of regulations to prevent capital flows. These regulations penalize household savers, and allow the government and state-sponsored enterprises to receive credit at relatively low rates while blocking credit to firms that do not enjoy government backing.

China used these types of measures during the 1980s and 1990s to finance its investment- and export-led growth, and its self-imposed financial isolation allowed it to escape the effects of the Asian financial crisis. But more recently China has engaged in financial liberalization, removing controls on interest rates and bank activities while deregulating its capital account and allowing more exchange rate flexibility. The responses have included the emergence of a shadow banking system and a boom in private credit, which will require government actions to avoid a crisis.

Several years ago Romain Rancière of the Paris School of Economics, Aaron Tornell of the University of California-Los Angeles and Frank Westermann of Osnabrueck University coauthored a paper (here; working paper here) on the tradeoff between systemic financial crises and economic growth. They showed that financial liberalization leads to more growth and a higher incidence of crises. But their empirical estimates indicated that the direct effect on growth outweighed the negative impact of the crises. They contrasted the examples of Thailand, which had a history of lending booms and crises with that of India, which had a more controlled financial sector, and showed that Thailand had enjoyed higher growth in per capita GDP. In a subsequent paper (here; working paper here), they explored the relationship between crises that produced a negative skewness in the growth of real credit, which in turn had a negative link with growth.

If there is a tradeoff between the volatility associated with financial liberalization and economic growth, then each society must choose the optimal combination of the two. Financial innovations will change the terms of the tradeoff, and lead to movements back and forth as we learn more about the risks of new financial tools. The advantages of novel instruments at the time when they seem most productive must be weighed against the possible (but unknown) dangers they pose. Perhaps the greatest threat is that the decisions over how much control and regulation is needed will be made not by those public officials entrusted with preserving financial stability, but by those who will profit most from the changes.

The Enduring Relevance of “Manias, Panics, and Crashes”

1 Reply

The seventh edition of Manias, Panics, and Crashes has recently been published by Palgrave Macmillan. Charles Kindleberger of MIT wrote the first edition, which appeared in 1978, and followed it with three more editions. Robert Aliber of the Booth School of Business at the University of Chicago took over the editing and rewriting of the fifth edition, which came out in 2005. (Aliber is also the author of another well-known book on international finance, The New International Money Game.) The continuing popularity of Manias, Panics and Crashes shows that financial crises continue to be a matter of widespread concern.

Kindleberger built upon the work of Hyman Minsky, a faculty member at Washington University in St. Louis. Minsky was a proponent of what he called the “financial instability hypothesis,” which posited that financial markets are inherently unstable. Periods of financial booms are followed by busts, and governmental intervention can delay but not eliminate crises. Minsky’s work received a great deal of attention during the global financial crisis (see here and here; for a summary of Minksy’s work, see Why Minsky Matters by L. Randall Wray of the University of Missouri-Kansas City and the Levy Economics Institute).

Kindleberger provided a more detailed description of the stages of a financial crisis. The period preceding a crisis begins with a “displacement,” a shock to the system. When a displacement improves the profitability of at least one sector of an economy, firms and individuals will seek to take advantage of this opportunity. The resulting demand for financial assets leads to an increase in their prices. Positive feedback in asset markets lead to more investments and financial speculation, and a period of “euphoria,” or mania develops.

At some point, however, insiders begin to take profits and withdraw from the markets. Once market participants realize that prices have peaked, flight from the markets becomes widespread. As prices plummet, a period of “revulsion” or panic ensues. Those who had financed their positions in the market by borrowing on the promise of profits on the purchased assets become insolvent. The panic ends when prices fall so far that some traders are tempted to come back into the market, or trading is limited by the authorities, or a lender of last resort intervenes to halt the decline.

In addition to elaborating on the stages of a financial crisis, Kindleberger also placed them in an international context. He wrote about the propagation of crises through the arbitrage of divergences in the prices of assets across markets or their substitutes. Capital flows and the spread of euphoria also contribute to the simultaneous rises in asset prices in different countries. (Piero Pasotti and Alessandro Vercelli of the University of Siena provide an analysis of Kindleberger’s contributions.)

Aliber has continued to update the book, and the new edition has a chapter on the European sovereign debt crisis. (The prior edition covered the events of 2008-09.) But he has also made his own contributions to the Minsky-Kindleberger (and now –Aliber) framework. Aliber characterizes the decades since the early 1980s as “…the most tumultuous in monetary history in terms of the number, scope and severity of banking crises.” To date, there have been four waves of such crises, which are almost always accompanied by currency crises. The first wave was the debt crisis of developing nations during the 1980s, and it was followed by a second wave of crises in Japan and the Nordic countries in the early 1990s. The third wave was the Asian financial crisis of 1997-98, and the fourth is the global financial crisis.

Aliber emphasizes the role of cross-border investment flows in precipitating the crises. Their volatility has risen under flexible exchange rates, which allow central banks more freedom in formulating monetary policies that influence capital allocation. He also draws attention to the increases in household wealth due to rising asset prices and currency appreciation that contribute to consumption expenditures and amplify the boom periods. The reversal in wealth once investors revise their expectations and capital begins to flow out makes the resulting downturn more acute.

These views are consistent in many ways with those of Claudio Borio of the Bank for International Settlements (see also here). He has written that the international monetary and financial system amplifies the “excess financial elasticity,” i.e., the buildup of financial imbalances that characterizes domestic financial markets. He identifies two channels of transmission. First, capital inflows contribute to the rise in domestic credit during a financial boom. The impact of global conditions on domestic financial markets exacerbates this development (see here). Second, monetary regimes may facilitate the expansion of  monetary conditions from one country to others. Central bankers concerned about currency appreciation and a loss of competitiveness keep interest rates lower than they would otherwise, which furthers a domestic boom. In addition, the actions of central banks with international currencies such as the dollar has international ramifications, as the current widespread concern about the impending rise in the Federal Funds rate shows.

Aliber ends the current edition of Manias, Panics and Crashes with an appendix on China’s financial situation. He compares the surge in China’s housing markets with the Japanese boom of the 1980s and subsequent bust that initiated decades of slow economic growth. An oversupply of new housing in China has resulted in a decline in prices that threatens the solvency of property developers and the banks and shadow banks that financed them. Aliber is dubious of the claim that the Chinese government will support the banks, pointing out that such support will only worsen China’s indebtedness. The need for an eighth edition of Manias, Panics and Crashes may soon be apparent.

Dilemmas, Trilemmas and Difficult Choices

Leave a reply

In 2013 Hélène Rey of the London Business School presented a paper at the Federal Reserve Bank of Kansas City’s annual policy symposium. Her address dealt with the policy choices available to a central bank in an open economy, which she claimed are more limited than most economists believe. The subsequent debate reveals the shifting landscape of national policymaking when global capital markets become more synchronized.

The classic monetary trilemma (or “impossible trinity”) is based on the work of Robert Mundell and Marcus Fleming. The model demonstrates that in an open economy, central bankers can have two and only two of the following: a fixed foreign exchange rate, an independent monetary policy, and unregulated capital flows. A central bank that tries to achieve all three will be frustrated by the capital flows that respond to interest rate differentials, which in turn trigger a response in the foreign exchange markets.  Different countries make different choices. The U.S. allows capital to cross its borders and uses the Federal Funds Rate as its monetary policy target, but refrains from intervening in the currency markets. Hong Kong, on the other hand, permits capital flows while pegging the value of its currency (the Hong Kong dollar) to the U.S. dollar, but forgoes implementing its own monetary policy. Finally, China until recently maintained control of both its exchange rate and monetary conditions by regulating capital flows.

Rey showed that capital flows, domestic credit and asset prices respond to changes in the VIX, a measure of U.S. stock market volatility. The VIX, in turn, is driven in part by U.S. monetary policies. Consequently, she argued, there is a global financial cycle that domestic policymakers can not resist. A central bank has one, and only one, fundamental choice to make (the “dilemma”): does it regulate the capital account to control the amount and composition of capital flows? If it does, then it has latitude to exercise an independent monetary policy; otherwise, it does not possess monetary autonomy.

Is Rey’s conclusion correct? Michael Klein of the Fletcher School at Tufts and Jay Shambaugh of George Washington University have provided a thorough analysis of the trilemma (working paper here; see also here). Their paper focuses on whether the use of partial capital controls is sufficient to provide monetary policy autonomy with a pegged exchange rate. They find that temporary, narrowly-targeted controls–“gates”– are not sufficient to allow a central bank to both fix its exchange rate and conduct an independent policy. A central bank that wants to control the exchange rate and monetary conditions must impose wide and continuous capital controls–“walls.” But they also find that a central bank that forgoes fixed exchange rates can conduct its own policy while allowing capital flows to cross its borders, a confirmation of the trilemma tradeoff.

Helen Popper of Santa Clara University, Alex Mandilaras of the University of Surrey and Graham Bird of the University of Surrey, Claremont McKenna College and Claremont Graduate University (working paper here; see also here) provide a new empirical measure of the trilemma that allows them to distinguish among the choices that governments make over time. Their results confirm, for example, that Hong Kong has surrendered monetary sovereignty in exchange for its exchange rate peg and open capital markets. Canada’s flexible rate, on the other hand, allows it to retain a large degree of monetary sovereignty despite the presence of an unregulated capital market with the U.S.

The choices of the canonical trilemma, therefore, seem to hold. What, then, of Rey’s challenge? Her evidence points to another phenomenon: the globalization of financial markets. This congruence has been documented in many studies and reports (see, for example, here). The IMF’s Financial Stability Report last October noted that asset prices have become more correlated since the global financial crisis. Jhuvesh Sobrun and Philip Turner of the Bank for International Settlements found that financial conditions in the emerging markets have become more dependent on the “world” long-term interest rate, which has been driven by monetary policies in the advanced economies.

Can flexible exchange rate provide any protection against these comovements? Joshua Aizenman of the University of Southern California, Menzie D. Chinn of the University of Wisconsin and Hiro Ito of Portland State University (see also here) looked at the impact of “center economies,” i.e., the U.S., Japan, the Eurozone and China, on financial variables in emerging and developing market economies. They find that for most financial variables linkages with the center economies have been dominant over the last two decades. However, they also found that the degree of sensitivity to changes emanating from the center economies are affected by the nature of the exchange rate regime. Countries with more exchange rate stability are more sensitive to changes in the center economies’ monetary policies. Consequently, a country could lower its vulnerability by relaxing exchange rate stability.

Rey’s dismissal of the trilemma, therefore, may be overstated. Flexible exchange rates allow central banks to retain control of policy interest rates, and provide some buffer to domestic financial markets. But her wider point about the linkages of asset prices driven by capital flows and their impact on domestic credit is surely correct. The relevant trilemma may not be the international monetary one but the financial trilemma proposed by Dirk Schoenmaker of VU University Amsterdam. In this model, financial policy makers must choose two of the following aspects of a financial system: national policies, financial stability and international banking. National policies over international bankers will not be compatible with financial stability when capital can flow in and out of countries.

But abandonment of national regulations by itself is not sufficient: International banking is only compatible with stability if international financial governance is enacted. Is the administration of regulatory authority on an international basis feasible? The Basel Committee on Banking Supervision seeks to coordinate the efforts of national supervisory authorities and propose common regulations. Its Basel III standards set net capital and liquidity requirements, but whether these are sufficient to deter risky behavior is unclear. Those who deal in cross-border financial flows are quite adept in running rings around rules and regulations.

The international monetary trilemma, therefore, still offers policymakers scope for implementing monetary policies. The financial trilemma, however, shows that the challenges of global financial integration are daunting. Macro prudential policies with flexible exchange rates provide some protection, but can not insulate an economy from the global cycle. In 1776, Benjamin Franklin urged the members of the Second Continental Congress to join together to sign the Declaration of Independence by pointing out: “We must, indeed, all hang together, or most assuredly we shall all hang separately.” Perhaps that is the dilemma that national policymakers face today.

Growth in the Emerging Market Economies

1 Reply

In recent decades the global economy has been transformed by the rise of the emerging market economies. Their growth lifted millions out of poverty and gave their governments the right to call for a larger voice in discussions of international economic governance. Therefore it is of no small importance to understand whether recent declines in the growth rates of these countries is a cyclical phenomenon or a longer-lasting transition to a new, slower state. That such a slowdown has wide ramifications became clear when Federal Reserve Chair Janet Yellen cited concerns about growth in emerging markets for the delay in raising the Fed’s interest rate target in September.

The data show the gap between the record of the advanced economies and that of the emerging markets. I used the IMF’s World Economic Outlook database to calculate averages of annual growth rates of constant GDP for the two groups.

2001-07 2008-09 2010-15
Advanced 2.46% -1.62% 1.82%
Emerging and Developing 6.62%  4.48% 5.47%
Difference: (Emerging + Developing)               – Advanced 4.16%  6.1% 3.65%

The difference in the average growth rates was notable before the global financial crisis, and rose during the crisis. Since then their growth rates have fallen a bit but continue to exceed those of the sclerotic advanced economies. Since the IMF pools emerging market economies with developing economies, the differences would be higher if we looked only at the record of emerging markets such as China, India and Indonesia.

And yet: behind the averages are disquieting declines in growth rates, if not actual contractions, for some members of the BRICS as well as other emerging markets. The IMF forecasts a fall in economic activity for Brazil of -3.03% for 2015 and for Russia of -3.83%, which makes South Africa ’s projected rise of 1.4% look vigorous. Even China’s anticipated 6.81% rise is lower than its extraordinary growth rates of previous years, and exceeded by India’s projected growth of 7.26%. The IMF sees economic growth for the current year for the emerging markets and developing economies of 4% , a decline from last year’s 4.6%.

What accounts for the falloff, and can it be reversed? The change in China’s economic orientation from an economy driven by investment and export expenditures to one based on consumption spending has slowed that country down. The decline in that country’s demand for raw materials to transform into finished goods for export is rippling through the economies of the major commodity exporters, such as Australia and Brazil. The Economist has claimed that the resulting fall in commodity prices constitutes a “great bear market.”

This downturn may be aggravated by a failure in institutions. Bill Emmott writes that emerging markets need political institutions that “…mediate smoothly between competing interest groups and power blocs in order to permit a broader public interest to prevail.” He specifically cites the leaderships of Brazil, Indonesia, Turkey and South Africa as examples of governments that have not been able to achieve that task.

The basic model of economic growth, the Solow-Swan model, predicts that income in the poorer countries should catch up with those of the advanced economies as the former countries adopt the advanced technology of the latter. This basic result is modified if there are higher population growth rates or lower savings levels, which can lead to lower per capita income levels. On the other hand, the Asian countries used high savings rates to speed up their economic growth while their birth rates fell.

But convergence has not been achieved for most economies despite periods of rapid growth. Some economists have postulated the existence of “middle-income traps.” Maria A. Arias and Yi Wen of the St. Louis Federal Reserve Bank describe this phenomenon in a recent issue of the institution’s publication, The Regional Economist. They explain that while income rose close to U.S. levels in the “Asian Tigers” (Hong Kong, Singapore, South Korea and Taiwan) as well as Ireland and Spain, per-capita income shows no sign of rising in Latin American economies such as Brazil and Mexico. There may also be a “low-income” trap for developing economies that never break out of their much lower per-capita income.

Why the inability to raise living standards? Arias and Wen, after discussing several proposed reasons such as poor institutions, compare the cases of Ireland and Mexico. They claim that the Irish government opened the economy up to global markets slowly in earlier decades, and encouraged foreign direct investment to grow its manufacturing sector. This allowed the country to benefit from the technology embedded in capital goods. Mexico, on the other hand, turned to foreign capital markets to finance government debt, which left the economy vulnerable to currency crises and capital flight. Arias and Wen conclude that governments should manage the composition of capital inflows and control capital flows that seek short-term gain rather development of the manufacturing sector.

But there may be a more basic phenomenon taking place. In 2013 Lant Pritchett and Lawrence Summers of Harvard presented a paper with the intriguing title, “Asiaphoria Meets Regression to the Mean.” They examined growth rates for a large number of countries for10 and 20 year periods, extending back to the 1950s. They showed that there is ”…very little persistence in country growth rate differences over time, and consequently, current growth has very little predictive power for future growth.” While acknowledging China and India’s achievements, they cautioned that “…the typical degree of regression to the mean imply substantial slowdowns in China and India relative even to the currently more cautious and less bullish forecasts.” They drew particular attention to the lack of strong institutions in the two countries.

If growth does slow for most emerging market economies, then the recent buildup of corporate debt in those countries may be a troubling legacy of the recent, more robust period. Debt loads that looked manageable when borrowing costs were low and future prospects unlimited are less controllable when that scenario changes. While there may not be a widespread crisis that afflicts all the emerging markets, those countries with extended financial sectors are vulnerable to international volatility.