As readers of this blog already know, markets are far less integrated internationally than popular views of globalization presume. So many of you are probably wondering why a game of chicken initiated in the U.S. Congress could wreak havoc as far away as Asia, or how problems in the Eurozone might cloud U.S. prospects. And of course, you want to know what is to be done.
Our current problems stem, in part, from the special characteristics of finance, which as Keynes noted, is highly dependent on sentiment and, as Hyman Minsky emphasized, therefore particularly susceptible to crises. Their conclusions are corroborated not just by empirical experience but by experimental research on asset markets by Nobel Laureate Vernon Smith, among others.
Such problems are amplified in a cross-border context by decay of trust across borders and with distance described in my previous post, and exemplified by the data on Western Europeans trusting their own fellow citizens more than twice as much as citizens of other Western European countries and nearly four times as much as citizens of countries outside Western Europe. Also recall that sympathy and, one would presume, solidarity in matters such as bailouts are much more distance-sensitive. Furthermore, fear leaps borders faster than confidence. All this suggests a particular fragility of confidence in and commitment to foreign financial assets when the times get tough.
Smarter Financial Integration
The importance of dispelling the globaloney that capital respects no boundaries is the obvious first implication of the contrast between real flows and irrational fears. If investors recognize the limited real connections between economies, they should be less prone to panic at distant signs of distress.
It is also clear, or at least clearer than just a few years ago, that policymakers should favor FDI and, more generally, equity investment over other types of capital flows, because FDI is less prone to be withdrawn when an economy is in trouble, and investment in building or upgrading real productive capacity is particularly suited to spurring much-needed growth. Conversely, short-term international borrowing, especially in foreign currencies, should be treated with caution.
More controversially, international capital imbalances such as persistent current account surpluses and deficits need to be curbed as well. Before the crisis, many authors advanced frameworks in which international capital imbalances were supposed to be a "win-win" phenomenon. And indeed, it is hard to see how capital imbalances could be a problem in a world with perfect international integration of capital markets. One would simply expect ebbs and flows, whether balanced or not, to lead to the outcome mistakenly asserted 150 years ago by David Livingstone: "capital, like water, tends to a common level." Incomplete international integration of capital markets — the reality of what I call World 3.0 — is what opens up the possibility of problematic international capital imbalances.
This problem is worth stressing because imbalances may be moving back into a danger zone. For capital flows, the historical data suggest that policymakers should start paying attention when the absolute values of capital accounts add up to 3% of GDP and start getting worried when they exceed 4%. For the twelve countries with historical data reaching back to 1870, this quantity decreased from a very worryingly high 5% of GDP in 2008 to 3% in 2009, but then edged back into the danger zone by rising to 3.5% in 2010. And for a broader sample of more than 180 countries, it dropped from 5.5% in 2008 to 3.9% in 2009, before rising to 4.2% in 2010 with further increases forecast.
The need to manage international capital imbalances doesn't imply, however, that all one can or should do is blame foreigners for our present predicament. Rather, domestic problems are often at the root of international imbalances. As Lorenzo Bini Smaghi put it back when the global financial crisis first erupted three years ago, "[E]xternal imbalances are often a reflection...of internal imbalances." This does not seem to be a bad characterization of the current problems in the United States and in the Eurozone.
To summarize, the good news associated with taking World 3.0's limited levels of integration seriously is twofold. First, fear is more contagious than actual links justify. And second, contrary to common assertions, many of the problems that we face can be dealt with nationally or regionally instead of requiring global solutions. (Nothing wrong with the latter — it's just that they are very hard to achieve). The bad news is related to the recent record of politicians in the U.S. and in the Eurozone in dealing with their respective "debtacle," which does not inspire much confidence that they will manage to handle problems that still are, in principle, manageable.