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Are free capital movements a good idea?
The standard line is that Chile and China have avoided crack-ups -- of the sort that plagued Thailand, Indonesia, and Argentina -- by restricting the free flow of capital in and out of their country. Kenneth Rogoff and co-authors now offer a very serious 92-page look at whether such views are true. Their conclusions include:
The majority of empirical studies are unable to find robust evidence in support of the growth benefits of capital account liberalization. However, studies that use measures of de facto integration or finer measures of de jure integration tend to find more positive results. More importantly, studies using micro data are better able to detect the growth and productivity gains stemming from financial integration.
There is little formal empirical evidence to support the oft-cited claims that financial globalization in and of itself is responsible for the spate of financial crises that the world has seen over the last three decades.
The conceptual framework we present suggests that in addition to the traditional channels (e.g., capital accumulation), the growth and stability benefits of financial globalization are also realized through a broad set of “collateral benefits”...These collateral benefits affect growth and stability dynamics indirectly, implying that the associated macroeconomic gains may not be fully evident in the short run and may be difficult to uncover in cross-country regressions.
How does the argument here work? First, liberalization tends to bring growth, which offers long-term protection against crises. Banking crises tend to be more disruptive than currency crises and also tend to precede them; free capital markets are not usually at fault in those cases. Plenty of countries with capital controls have gotten into big messes. Macro-volatility has been declining as the world has become more integrated in terms of capital flows.
I wish this piece had looked at the (supposedly?) negative instance of free capital movements more closely, but still it shifted my priors [correction: posteriors] on the issue.
Posted by Tyler Cowen on August 31, 2006 at 06:34 AM in Economics | Permalink
Comments
Surely this is pretty egregious model-mining? If one considers the universe of possible models, then some will show an effect and some won't (also, the availability of data for micro models is likely to be highly related to whether the recent growth experience has been positive or not, since bankrupt entities don't file accounts.
"Little formal evidence" for a link between financial liberalisation of currency crises is a perfect crystalline example of what is wrong with econometrics. What Rogoff means is that there isn't a study which puts together a big sample and passes a 5% significance test. IMO, Rogoff is one of the most overrated economists around.
Posted by: dsquared at Aug 31, 2006 8:41:43 AM
Er, you should shift your posterior, not your prior, in response to evidence. You should only shift your prior when you change your mind about what you should believe in the *absense* of evidence.
Posted by: Robin Hanson at Aug 31, 2006 9:25:53 AM
My intuitive sense has been that capital controls at some level ought to be appealing to international investors -- the idea being that as an investor, I'm willing to accept some restrictions on my ability to pull my money out quickly in exchange for assurances that everybody else also cannot pull out at once (in a speculation induced panic).
What are the flaws in this reasoning?
Posted by: Slocum at Aug 31, 2006 10:33:26 AM
Generally, I try to shift my posterior as little as possible, unless the evidence in question involves heavy objects about to fall through the space currently occupied by my posterior, etc. Remember, all progress is due to the lazy man!
Slocum, I think your idea runs afoul of the practical realities of portfolio investment, which require enough flexibility to at least allow the _appearance_ that you're nimbly moving money out of poorly performing vehicles and into better ones. (Generally this happens _after_ the bath has been taken, and is called "window dressing", but there you go.)
dsquared, while not a slavish fan of the arbitrary p<=0.05 school, myself, I'd have to say that I'd prefer a large study that has better statistical significance than a small one with p=0.4. I don't think this is a Ziliak and McCloskey moment.
Posted by: Bernard Guerrero at Aug 31, 2006 11:27:16 AM
I think the reason why Thailand, Argentina etc. "cracked up" is because they tied their currencies to an outside peg, and while this bought them short term stability, it came at the cost of an inevitable crash due to unsustainability. A better comparison would be to check out comparable countries that had currencies that were set by market forces instead.
Posted by: happyjuggler0 at Aug 31, 2006 11:43:42 AM
I think Slocum's question is a good one -- Hedge, VC, and private equity funds typically have very strong capital controls, and mutual funds are adding them (taxing freq. trading to prevent market timing). So there _is_ evidence that investors sometimes prefer or will accept lockups.
Applied to countries, IMHO the problem with Slocum's idea is that lockups magnify both political and financial risk. The political risk is simple: a country with capital controls is free to raise investment taxes or even have an election or coup during your lockup period, but no one locks up money in a hedge fund without a contract specifying the fees and giving you an out if the management leaves.
The financial risk problem is that you can't have stop-loss policies on your investments if you can't trade them easily. If you want to buy U.S. equities but protect yourself from a market crash, you can easily buy stocks + protective puts, or if you prefer, you can buy stocks and set up stop-loss orders to create a "synthetic option" i.e. with the same delta and payoff structure as a purchased option. Such synthetic options may not be possible for investments in countries with excessive capital controls.
Liquidity may also be a problem. Many people hate short-term speculators, but they do provide liquidity and thus lower transaction costs for everybody.
Posted by: DK at Aug 31, 2006 12:35:34 PM
I quite like the notion of Slocum, as far as I am aware it is shared by the bank-run literature, but not readily accepted in the portfolio investment literature.
I would assume that whether or not investors would take Slocum's view will depend very much on how (perceived) Investment Opportunity Sets vary over time and how much people disagree with one another.
If I am quite certain about the IOS but am worried that other "herding" people may cause markets to crash due to following some negative (and in my opinion wrong) signal, I should approve of such a constraint.
If the variance of my prior on the IOS is large enough (and updating processes are not too positively correlated across people), I will value the ability to move out of the investment more highly than I value others being stuck with me.
Beliefs about returns change much less for checking accounts (I have been getting <1% and a sloppy handshake with irritating continuity...), perhaps this is why it is more dominant for the bank-run theories.
Posted by: A at Aug 31, 2006 12:48:47 PM
Slocum,
Obviously, some people in high places share your view otherwise stock markets would not have automatic shutdowns when prices dropped too fast. But last I remember reading, studies have shown that those automatic shut downs don't really save any pain overall.
Markets are not perfectly rational, but they usually have a reason for acting the way they do. Sometimes everyone rushes for the exits because so jerk screamed fire when there was none. But most of the time, people run for the exits because there truly is a fire.
Would you want to go into some place where they restricted your ability leave because they where worried that some one would give a false alarm? Myself I would rather take a risk with suffering bad effects from a false alarm than be forced to sit around while the fire burns.
Liquidity is fundamentally a good thing, and if someone wants to take it away from me they had better compensate me.
Posted by: The Chieftain of Seir at Aug 31, 2006 1:34:14 PM
"I think the reason why Thailand, Argentina etc. "cracked up" is because they tied their currencies to an outside peg, and while this bought them short term stability, it came at the cost of an inevitable crash due to unsustainability"
Thailand had a sort of unofficial crawling peg. The government never made any formal commitments, but everyone assumed that changes would be gradual. I can remember how brilliant Thai companies considered themselves back in 1993 when they began issuing debt in US dollars rather than borrowing from Thai banks at high interest rates. The companies could have hedged the currency, but it was even more profitable to just ignore the risk, and they thought that they had an implicit deal with the government on the currency. Always get it in writing! (and even then it may not hold, as in Argentina).
I can also remmeber how proud the Philippines was for not catching the Asian Flu. The rest of us couldn't help noticing that they avoided the Flu by also skipping the Asian Miracle. North Korea and Vietnam weren't hit by capital outflows, either.
Last, China's immunity was helped by the fact that the government controlled the data and was able to adjust it appropriately, to reflect a broader reality. The business community in Asia noticed a slowdown in the Chinese economy in 1998, even though it wasn't reflected in the key official figures (although it certainly wasn't as bad as Thailand or Indonesia). Analysts focused on indicators such as power usage - why would power usage drop if the economy was growing at the reported rate?
Over time, China has improved its data management, to guarantee that more and more statistics are fully consistent and suitably patriotic. I don't know what figures analysts are using today to measure the true pace of the economy, but the good analysts certainly don't take China's reported numbers at face value.
Posted by: Ann at Aug 31, 2006 1:35:21 PM
Just what I needed to imagine, a bunch of economists shifting their posteriors.
Posted by: Constant at Aug 31, 2006 8:48:44 PM
I believe what needs to be precisely investigated is the ratio of
direct investments to portfolio capital inflow. It would be wise for economic
government of any country to maintain certain justified ratio, which prevents
from "flu-like" financial effects caused by disproportionally high presence
of portfolio investments.
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