Capital flows analogy of the day

How do you deal with capital flows when they are so prone to boom-and-bust cycles and generate (roughly once a decade) financial crashes with painful economic consequences?  The mainstream answer is that you do not regulate capital flows directly--through capital controls such as financial transactions taxes or deposit requirements--but you rely instead on prudential regulation of financial intermediaries. The best way to avoid crashes, this argument goes, is not to "throw sand in the wheels of international finance" (as Tobin famously put it), but to make sure that intermediaries do not take excessive risks.

This argument is just about as convincing as the one gun control opponents use when they say "guns do not kill people, people kill people." What we are supposed to conclude from this is that the appropriate way to deal with guns is to regulate the behavior of people who own them--and not to control the circulation of guns directly. But any sane person understands that because we cannot observe and control behavior perfectly, a sensible regulatory framework must use both margins simultaneously.

And it is the same with capital flows.  We bemoan the shortcomings of prudential regulation after each financial crash. That should teach us that policy needs to extend beyond prudential regulation to a wider set of instruments.           

Comments

[Kenji]

Very nice. I just read David Brooks' column, and your post is a nice response to the false dichotomy raised by his column.

[hari]

Dani -

Thanks. It has been my gripe for a long time.

I think you also want someone to look more closely on how the lack of regulatory controls has given a bad image of American capitalism globally.

[Richard Murphy]

The problem is we have little idea how to locate capital flows by place, or by organisation. What we need this time to tackle this issue is 'country-by-country' reporting within multinational corporations. See http://www.taxresearch.org.uk/Blog/2008/01/25/country-by-country-reporting-is-key-to-the-new-economic-order/

[Per Kurowski]

Dany asks “How do you deal with capital flows when they are so prone to boom-and-bust cycles and generate (roughly once a decade) financial crashes with painful economic consequences?”

This question leaves me a bit disappointed especially when coming from a development professor since the answer to me is so obvious…By maximizing the results of the whole cycle!

I do accept “the financial crashes with painful economic consequences” if this is the price to be paid for a previous boom that advanced the country so much that, net, it is much better off.

I do not care an iota for stability that only looks to avoid financial crashes with their painful economic consequences when this could, net, not lead us anywhere.

Risk is the oxygen of development! Stability? Just wait you’ll get enough of it…in due time.

[wjd123]

Let me see if I understand this. We need regulations that control how the market works and we need regulations that control what people can do. It seems to me that neither control will work without a third and a forth requirement. Seeing that regulators do their job by seeing that they have the needed resources to enforce regulations and not allowing those with the power to regulate to do so at their convenience.

[wjd123]

Let me see if I understand this. We need regulations that control how the market works and we need regulations that control what people can do. It seems to me that neither control will work without a third and a forth requirement. Seeing that regulators do their job by seeing that they have the needed resources to enforce regulations and not allowing those with the power to regulate to do so at their convenience.

[Per Kurowski]

Danny says “We bemoan the shortcomings of prudential regulation after each financial crash. That should teach us that policy needs to extend beyond prudential regulation to a wider set of instruments.”

Right, although let us also remember the saying… when in a hole stop digging!

[inthemachine]

I like that the selected analogy is something else that people get irrationally passionate about.

[Per Kurowski]

Well if we pick up on the analogy let me say that currently what is used by the financial regulators is not so much a control over the guns, or a control over the owners of those guns but more, through the credit rating agencies, a control over where those guns can aim…supposedly at safe targets!

[th]

Dani does not refer to the current financial crisis in his post. But it is interesting nonetheless how this financial crisis is different to most of those of the past 30 years or so which originated in emerging markets and which involved massive capital flight away from such countries. The individual banks that have suffered this time have mostly been in OECD countries and so far (and only time will tell for sure) the cyclical risk to developing countries looks limited to the extent of any US recession rather than major capital flight.

[Per Kurowski]

th says “this financial crisis is different to most of those of the past 30 years or so which originated in emerging markets and which involved massive capital flight away from such countries”
Yes and no. Previous capital flights were private but we could also call the recent huge build up of reserves a governmental capital flight.

[happyjuggler0]

Just what regulation would you put in before the previous bubble? Thou shalt not invest in internet stocks that some people think are overvalued but which some think are undervalued?

Discovery is an important facet of markets, and in the long run we are better off for it. The precautionary principle is simply horrible and means zero progress.

"Without deviation from the norm progress is not possible" ---Frank Zappa---

[Per Kurowski]

happyjuggler0 asks “Just what regulation would you put in before the previous bubble?”

I am no Rodrik, but please allow me anyhow to venture an answer.

One way to go would be to follow the time honored tradition of not putting all your eggs in the same basket, and therefore creating a progressive tax on the size of the banks. The larger the bank, the more it will hurt if it fails, so the more it should pay in insurance premiums.

By the way, Marx prophesied “a progressive diminution in the number of the capitalist magnates” and the best way I know of fighting Marxism is to stop this prophecy from becoming a reality.

[Ken Houghton]

Tightened margin requirements are still within the purview of the Fed, and only dampen excessive speculation, for instance.

I wouldn't naturally recommend it, but when the Fed chairman says "irrational exuberance" in 1996 and does jack for the next several years, we must conclude that he approved of the irrationality (though not personally--he was entirely in bonds by 1997, and matched Fed policy to take. Coincidentally.)

[StevenT]

I would say that the best way to control an entity is to let them face the actual risks. Regulations will just lead to more regulations when we still intend to bail our banks and investors out. We should let them absorb the mess they created and so they will learnt and understand the consequences of rapid investments. Be it if our biggest morgage firm went broke or 2-3 of our biggest banks went kaput and tens of thousands of people went around jobless. We could use the 150 billion dollars stimulus for these people instead. The tech companies, which comprises for about half of this nation's assets can self sustain itself during the dotcom bust without having government intervention. I don't see why the financial industry or the many other industries cannot help themselves.

[wjd123]

I have to add to my requirements for regulating financial services. Legal loopholes have to be closed and contagion from other countries has to be controlled. Regulations have to be coordinated toward one ultimate aim and strictly enforced so we don't end up in damned if you do and damned if you don't regulative binds. See here for an example of where the feds duty to keep the economy out of recession forces them to bail out Wall Street by inflating asset prices. http://economistsview.typepad.com/economistsview/2008/01/welfare-for-wal.html Breaches in the regulative regime have to be closed quickly before they can expand.

How will we know when regulating the financial services industries is working. When half the jobs in the industries are eliminated due to regulations. Effective regulations will keep those involved with financial services from finding creative ways to generate fees for themselves without taking risk or adding any value to the economy.

Another sign of effective regulations will be the closing of university departments specializing in finance. Effective regulations will keep high flying financial wizards from hatching schemes to amass personal fortunes by siphoning off wealth created by society into their pockets.

Once these careers are no longer lucrative due to regulations we will know that we have gotten regulations right. Of course, many of those high flying financial wizards who now find their careers to riches blocked by regulations can always find employment with the government working for modest living wages after graduating from the new university departments specializing in financial regulations. Instead of preying on society they can now be its guardians.

[Per Kurowski]

wjd123 says

“How will we know when regulating the financial services industries is working. When half the jobs in the industries are eliminated due to regulations. Effective regulations will keep those involved with financial services from finding creative ways to generate fees for themselves without taking risk or adding any value to the economy.
Another sign of effective regulations will be the closing of university departments specializing in finance. Effective regulations will keep high flying financial wizards from hatching schemes to amass personal fortunes by siphoning off wealth created by society into their pockets.
Once these careers are no longer lucrative due to regulations we will know that we have gotten regulations right.”

This is absolutely not the way of getting the regulations rights these is a just a way of “getting back at those bast...s”

If you worry about bankers making too much money then you should concentrate on the primary reason for that, namely that shareholders do not have enough saying in their own affairs.

Measuring the failure and new entrant rate might instead be a better way to gauge regulatory effectiveness since regulations should be there to incite competition and not protect incumbents.

[StevenT]

Regulations are no regulations without effective enforcements. From Reagan to Bush Sr and Bush, budgets meant enforcements had been cut severely. In fact throughtout this 8 years, not even a single corporation has been investigated for the practice of monopolization. So creating more regulations is obviously not the right method in correcting this issue.