Posted by: Dirk | September 29, 2010

Revisiting (Reflections on) Bhagwati’s ‘Capital Myth’

In an article published in Foreign Affairs in 1998, Jagdish Bhagwati confronts what he calls The Capital Myth. In his own words:

This is a seductive idea: freeing up trade is good, why not also let capital move freely across borders? But the claims of enormous benefits from free capital mobility are not persuasive. Substantial gains have been asserted, not demonstrated, and most of the payoff can be obtained by direct equity investment. And even a richer IMF with attendant changes in its methods of operation will probably not rule out crises or reduce their costs significantly. The myth to the contrary has been created by what one might christen the Wall Street-Treasury complex, following in the footsteps of President Eisenhower, who had warned of the military-industrial complex.

Well, with hindsight there seems to be more than a grain of truth in this. Economists justified free trade together with free capital flows as the right set of policies. Here is Gregory Mankiw, quoted by the NY Times in 2004 as saying:

”I think outsourcing is a growing phenomenon, but it’s something that we should realize is probably a plus for the economy in the long run,” Mr. Mankiw told reporters on Monday.

”We’re very used to goods being produced abroad and being shipped here on ships or planes,” Mr. Mankiw continued. ”What we are not used to is services being produced abroad and being sent here over the Internet or telephone wires. But does it matter from an economic standpoint whether values of items produced abroad come on planes and ships or over fiber-optic cables? Well, no, the economics is basically the same.”

What had changed, in my opinion, was not the transport mode of items but the terms of payment: the US ran a huge current account deficit. The US had to borrow abroad in order to finance its net imports, or, from the other point of view, it had to spend the net capital inflows on something. It doesn’t matter here whether the current account drives the capital account or otherwise. What is important is to understand the financial implications. Current account imbalances have to be financed by international capital flows. Or, capital flows can cause current account imbalances. This is what was going on in the background, as many papers on the sustainability of the US current account deficit prove.

A year on from Gregory Mankiw’s remarks, to honor Jagdish Bhagwati’s 70th birthday, Maurice Obstfeld prepared some Reflections upon Rereading the Capital Myth from 2005. Apart from the fact that once again one of the most interesting academic discussions happens outside academic journals, the article gives you a good idea what kind of arguments were used to justify the liberalization of capital markets. Following are some extracts, which should give you an idea. I highlight some arguments that seem dubious at least in 2010, years 3 A.S-P (after sub-prime), and others, which were quite prescient.

The basic differences relate to the intertemporal nature of financial trades and to the potential for asymmetric information to eliminate trade gains. Asset trade inherently involves commitment – the commitment to pay on a later date. Payment in reality is therefore always contingent, and the circumstances of contingency can depend on information known to only one party to the deal. Thus, financial transactions inherently must allow for the asymmetric-information distortions that we call moral hazard and adverse selection. These distortions reduce the gains from asset trade that would otherwise be available – even with an efficient and impartial judicial enforcement system. As is well appreciated, government guarantees aimed at mitigating the redistributive effects of financial crises can, in fact, worsen moral hazard and raise the probability of eventual crises.

A tentative conclusion is that among richer countries that have addressed the most domestic serious financial-sector problems and have flexible exchange rates, private financial flows have not entailed significant additional financial instability in recent years. Thus, there is at least the potential for creating an environment within which trade in financial assets can yield net welfare gains. Outside of a few exceptional cases, these generalizations do not yet apply, however, to most developing countries, which have suffered quite harshly in financial crises. Mishkin (1996) provides an early analytical discussion of the particular financial vulnerabilities of developing countries.

The rapid expansion of gross asset positions, far beyond the minimum asset trade that would be needed to settle current account imbalances, is certainly driven in part by enhanced risk sharing between countries. But it certainly also reflects transactions that, while they do not create additional trade in underlying economic risks, do raise the risk of counterparty failure. Since leveraged international portfolios generally are not balanced in currency terms – for example, the U.S. borrows overwhelmingly in dollars, but balances its assets more evenly among dollars, euro, yen, and other currencies – exchange rate changes have the potential to redistribute large sums internationally in minutes.


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