Why Has US Finance Grown? Because The World Is Not a Monad

Guesting at Noah Smith's place, Dan Murphy seeks to explain why the financial sector grew to be such a large component of the US's economy during the 2000s. He offers three possibly explanations: finance became better at "making markets" by matching buyers and sellers, the need to manage risk became more important, and that people became convinced that employing financiars would help them boost their investment portfolios. Murphy suggests that the first two are not good explanations because they are static variables unable to explain change. He doesn't seem to think the third is as well, although it seems that way to me.

I don't think this is the right way to think about this. Instead, I'd rather embed finance into the broader US economy and then embed the broader US economy into the broader global economy. What changes have been taking place in the global economy over the past decade-plus that could help explain this? Two prominent things immediately come to mind:

1. The opening of capital accounts around the world, which began in the 1990s but accelerated dramatically during the 2000s.

2. Changes in the global trading system, particularly the expansion of the GATT -- which added many new members following the end of the Cold War -- and the transition from the GATT to the WTO.

The cumulative effect of these two factors both forced encouraged the US to pursue its comparative advantage in high-skilled service labor (e.g. finance) and increased the market into which the US could sell its comparative advantage. The result is thus entirely predictable: finance becomes a bigger size of the US's economy, while comparatively disadvantaged sectors shrank. Factor in positive feedback dynamics in global financial markets and this isn't much of a mystery at all.

On Blanchard on Capital Flows and the IMF

Oliver Blanchard went to a IMF conference on capital flows, and wrote up some thoughts. It's well worth reading the whole (short) post, if only to see where the IMF's thinking on this is right now, but I want to highlight a few bits.

First, while the issue of capital controls is fraught with ideological overtones, it is fundamentally a technical one, indeed a highly technical one. Put simply, governments have five tools to adjust to capital flows: monetary policy, fiscal policy, foreign exchange intervention, prudential tools, and capital controls. The challenge is to find, for each case, the right combination.

Regular readers will guess that I disagree with this completely. The issue of capital controls is not just "fraught with ideological overtones", it is also fraught with distributionary consequences. If governments choose to restrict capital flows using one of the five tools Blanchard lists, then they will be benefitting some groups over others. Which of the five they employ will also involve winners and losers. From this perspective there is no "right" combination, only choices that advantage some members of (domestic and global) society and disadvantage others. The challenge for political leaders is to find the combination that will allow them to remain in office. The challenge for interest groups is to push for the combinations that will benefit them. But this is not a technocratic problem, or at least not just one.

Blanchard gets close to understanding this a bit later, when he writes:

The nature of specific investors must inform the policy choices. We often think of inflows and outflows as coming from primarily from decisions by foreign investors. The reality is that many of these inflows and outflows often come from decisions by domestic investors. When this is the case, targeting nonresidents is largely misguided.

Layna Mosley, one of my professors, has done a lot of very good work examining how, when, and to what extent international investors place pressures on domestic governments*. There is less work (that I know of) that seeks to explain how, when, and to what extent domestic political actors (including investors) pressure their governments for certain types of policies related to capital flows. But surely this is a political question that requires a political answer. To the extent that the IMF isn't thinking about those issues they are probably missing the boat.

It is not clear that the diversity of approaches we observe in practice comes from different circumstances, or from suboptimal responses. It was interesting to observe for example that Chile relies on foreign exchange intervention, not on capital controls, but India, instead, relies on capital controls, not on foreign exchange intervention. Are these corner solutions really optimal?

Again... what is meant by optimal? Different policies will benefit different actors. In many of the cases under discussion there is no reason to think that we're on the Pareto frontier, but even if we are the actual policy choices reflect distributional concerns. Instead of trying to figure out whether these policy choices are optimal, we should be thinking of them in terms of bargaining theory. And because these policies involve international as well as domestic actors, we need to complicate the model to include multiple levels of analysis. Blanchard seems to realize this towards his conclusion.

There were some issues that I would like to have seen explored more fully.

One was the multilateral angle. As my IMF colleague Min Zhu said in his opening remarks, “ensuring that countries reap the full benefits of capital flows is a shared responsibility between advanced and emerging market economies, between surplus and deficit countries, between capital-exporters and capital-importers.” The challenge is to translate this into practice. What is the actual responsibility of source countries? Should they take it into account in conducting monetary policy, and if so, how? Should we worry about the “beggar thy neighbor” effect of controls? Some of the evidence presented at the conference suggested that these spillovers across recipient countries were not very large. Theoretical and further empirical work is badly needed here.

These are good questions, and they do need more work. But they are political questions, so economists are not very well suited to answer them. I understand that Blanchard's position within the IMF means that he has to focus on the technocratic rather than the political, but if he wishes the IMF to be an effective institutions in the future he should at least be thinking of the political implications of capital flows. This has been the IMF's weakness for decades; it's high time for them to get better on this score.

*I discussed this work briefly here, but interested folks are encouraged to read the actual research (linked in that post).

From Iceland to...

Dave Hart at IPE Journal has a nice historical discussion of "hot money" flows, and their relevance today.

In fact, many emerging markets are toying with capital controls as a way to limit volatility. Brazil has done so, and there is speculation (so far un-founded) that Malaysia will follow suit. Brazil was even somewhat successful in getting pro-capital control language in the G20 communique from Korea ("practical tools to overcome sudden reversals of flows," anyone?). The large exporters will also continue to keep large foreign exchange reserves as a buffer - a policy that turned out to be rather justified in recent years, despite the distorting effects it has on global imbalances and the huge opportunity cost.

He concludes that this is likely to be a growing issue over the next few years, and adds "We do not know who will be blowing up their Land Rovers next."

The Effect of the Unholy Trilemma on the International System

McMegan can't find anything wrong with Drezner's post about international politics and the unholy trilemma. Let me try to help her. Drezner's is a decent post, but it reads like he might have been a bit short of time because it's a bit under-developed. First, his claim:

The unholy trinity in open economy macroeconomics is pretty simple. It's impossible for a country to do the following three things at the same time:

1) Maintain a fixed exchange rate

2) Maintain an open capital market

3) Run an independent monetary policy

One of the issues with macroeconomic policy coordination right now is that different countries have chosen different options to sacrifice. China, for example, has never opened its capital account. The United States, in pursuing quantitative easing, has basically chucked fixed exchange rates under the bus, no matter how many times Tim Geithner utters he "strong dollar" mantra in his sleep to reporters.

So far so good -- although I'd emphasize more than him that it is possible to do any two of those three, so the choice is which one to neglect, not which one to pursue -- and he's honing in on an important dimension of IPE right now: what happens when the major economies disagree about which two to prioritize? Bretton Woods I emphasized #s 1 and 3; Bretton Woods II emphasized #s 2 and 3 (see graph above). Right now there doesn't appear to be a consensus.

As Drezner notes, right now the U.S. is letting the exchange rate float (which is nothing new; it has been official policy since the early 1970s), China maintains a closed capital account, Brazil is trending towards that direction, the E.U. has sacrificed independent monetary policy within its borders and fixed exchange rates beyond them, the U.K. is allowing sterling to float, Japan is also eschewing a fixed exchange rate, while open exporting economies like S. Korea and Switzerland have worked to protect their exchange rates. Right now nobody is stressing too much about maintaining capital account openness, but this is a relatively new development.

The interesting part of this, to me, is that divergent policies could put states, especially major trading partners, at cross-purposes. This could under-cut the effectiveness of states' domestic policy goals, which could lead to confrontation and instability. Unfortunately Drezner ultimately neglects the question of why different countries will prioritize different policies, and what the implications of those choices are for the macro system. Instead, he argues that we'll see "a lot more capital controls". That's true, but we'll also probably see a lot more central bank activity and a lot more exchange rate manipulation, depending on the domestic political incentives of states. We've already seen increased management along all of these dimensions recently. In other words, I think we should expect a more active role overall for states in managing their economies in the coming decade that in the past one, but different states will prioritize different goals.

What intrigues me is how the financial sector responds to a situation in which their freedom of action in emerging markets becomes more and more constrained. It's possible that they could pressure the Fed to change its position in the future. It's also possible, however, that big firms could see these controls as a useful barrier to entry for new firms.

My money is on the former response, however.

Or they could revert to their default position: the Washington Consensus. The major criticism from the advanced economies of emerging economies prior to the Asian financial crisis was the persistence of capital controls. The major IPE controversy from 1973-2000 or so was the use of the IMF to break those controls down. It's definitely possible that that debate flares up again in the coming years, precisely because capital owners in emerging countries benefit from a more-closed financial system while capital owners in developed countries benefit from a more-open financial system.

We'll have to wait and see, but the longer it takes the global economy to rebound, the stronger these pressures will become.

Policy Preferences over Capital Controls

Sebastian Mallaby has a new op-ed in the Financial Times about the difficulty of reversing financial globalization. While that may be true, Mallaby makes some pretty crazy claims on the path to this conclusion.

First, Mallaby suggests that a growing preference for increased capital restrictions among policy makers in US and Europe signals an end to consensus among the richest economies that capital mobility creates growth. By comparing the policy response (and rhetoric) of today to the response to the Asian and Latin American crises of previous decades, Mallaby points out that while the IMF, the US, and the EU pushed capital account openness before, they are now more willing to entertain the idea that capital account openness might be too risky. But, in the past the US and Europe weren't the states having difficultly financing their current account deficits. It makes sense that the US and Europe will now be more open to some measures of capital account restraints since they may want to keep investment from going abroad. And, this policy preference may well be temporary - when macro imbalances are corrected, the US and Europe may be perfectly willing to support unfettered capital account openness once more.

Second, in talking about US animosity towards China, Mallaby offers this policy advice:

Equally, proposals to prevent Chinese capital from flowing into the western economies have a clear appeal. China's peg, and the associated capital exports, distort the world economy; and years of patient diplomacy have failed to resolve the problem. Retaliating against China via trade sanctions would be reckless, since doing so would spread the existing currency war into the trade realm. So why not apply a more proportionate sanction? China already prevents foreigners from buying its bonds, so what is wrong with preventing China from buying US Treasuries? (emphasis added)

Wait, what? The last thing the US wants to do is to cut off a major buyer of its debt!

Rather than characterizing the return of capital controls as an indication that policymakers are moving towards a new consensus on the perils of globalized finance, it may be far more helpful to think about the conditions under which governments will advocate barriers to financial flows.

Finally, while the incentives for making it difficult for domestic capital to exit are pretty straightforward, it is less clear what drives governments to erect barriers to foreign sources of investment. Mallaby mentions Brazil's new tax on foreigners holding domestic securities. What drives these policy choices? Might it be that emerging economies may want to limit the rate of capital inflows since inward investment can easily overwhelm a small economy? If so, would that preclude advanced industrial economies from enacting such barriers?

A Tobin Tax Isn't the Answer

Dani Rodrik (again) advocates the adoption of a Tobin tax:

The beauty of a Tobin tax is that it would discourage short-term speculation without having much adverse effect on long-term international investment decisions. Consider, for example, a tax of 0.25% applied to all cross-border financial transactions. Such a tax would instantaneously kill the intra-day trading that takes place in pursuit of profit margins much smaller than this, as well as the longer-term trades designed to exploit minute differentials across markets.

Economic activity of this kind is of doubtful social value, yet it eats up real resources in terms of human talent, computing power, and debt. So we should not mourn the demise of such trading practices.

He says that the tax will raise much-needed revenue for all kinds of socially-beneficial programs. But if the tax is successful in limiting cross-national transactions ("throwing some sand in the wheels of international finance"), then the revenue from the tax will be less significant. Only if large, frequent, cross-national flows persist will the revenue come in, and if that happens then the other goal of the Tobin tax (protection from "hot money" flows) will be betrayed. It's like raising cigarette taxes to pay for education: if people do what you want them to do -- stop smoking -- then you don't have any money to fund the new education program.

But even if that weren't true, Rodrik is in effect arguing that markets should be less efficient. The "intra-day trading that takes place in pursuit of profit margins" is done by arbitrageurs, and arbitrageurs serve a very valuable function: they bring financial markets into equilibrium in quick and relatively painless ways. Without them inefficiencies will persist for longer, potentially leading to harsher corrections down the road. Moreover, financial instability is not caused by arbitrageurs trading for tenths or hundredths of a percent; it comes from quick reversals of the "long-term international investment decisions" that Rodrik hopes to keep, and argues that the Tobin tax won't affect. It may be possible to argue that some short-term efficiency should be sacrificed for long-term stability, but that isn't what Rodrik is really saying. In fact, he acknowledges a Tobin tax will have no effect on stability:

What the Tobin tax does not do is help with longer-term misalignments in financial markets. Such a tax would not have prevented the US-China trade imbalance. Neither would it have stopped the global saving glut from turning into a ticking time bomb for the world economy. It would not have protected European and other nations from becoming awash in toxic mortgage assets exported from the US. And it would not dissuade governments intent on pursuing unsustainable monetary and fiscal policies financed by external borrowing.

So what we're left with is the new revenue. Rodrik says that a small Tobin tax would raise "hundreds of billions" worldwide. Presumably these will used on all sorts of really great projects that everyone loves (he lists "foreign aid, vaccines, green technologies, you name it"). But the vast majority of these taxes will be recouped by the countries with the biggest financial sectors (who receive the most inflows): the U.S., U.K., Germany, Japan. In essence, then, we would be taxing investors from poorer countries in order to redistribute to citizens of richer countries. How is this a net global benefit? Does it make sense for the Chinese to fund the health care system in the U.K. or retirement pensions in the U.S.? Should Indians have to pay for the privilege of investing in the U.S. or Japan?

I don't see how a Tobin tax would improve the system.