Tuesday, May 25, 2010

The problem with free cross-border capital flows, i.e., hot money

A few days ago, Ian Walsh noted that there is actually a lot of money out there, which has created a really devilish dynamic:

There is a lot of hot money in the world economy, more hot money than there are truly safe investments. The financial bubble and collapse could be summed up as “trying to get AAA security with higher than AAA returns”. The paper was almost all produced in an attempt to get better than Treasury bond returns while claiming to be as secure as Treasury bonds. Obviously, the paper wasn’t, and it all crashed out.

There is still too much hot money which wants AAA security, and better than AAA returns. They demand that governments find a way to give it to them. One way is for the Fed to give them free money, then borrow it back from them (we’ll lend to you at zero, you lend back to us at 3%. Free money!) But there are limits to these sorts of games.

Why? Well, that’s the contradiction. Because the hot money is both scared by the prospects of high deficits (government defaults) and by the economy itself crashing out because, well, there isn’t enough stimulus. If you’re scared of too much stimulus and you’re scared of too high deficits, well, you’re caught between the proverbial rock and a hard place.

Currently the pressure is mostly on the austerity side, with an IMF style crackdown in both Greece and Spain, with a healthcare bill in the US which “saves money” and so on.

The problem is that actual private income in the US, for example, is about 500 billion lower than it was pre-crisis.

The economy breathes fine, as long as we don’t unplug the life support.

And unplug the life support is what everyone except the Chinese seem to want to do.

Those of you who actually have some money to invest may want to read the entire article, entitled Crunch Time: Two Economic Scenarios for the rest of the year.

Yesterday, Walsh discussed the fundamental conundrum any country finds itself in once it accepts economic neo-liberalism's free and unfettered flows of capital (i.e., hot money) across borders:

Here’s the catch-22. Investors are worried about deficits, so they get out of bonds or demand higher rates and attack currencies. The response to that by governments is to slash spending: austerity. But austerity will crash out the economy, which will hurt the stock market and weaken the state’s ability to repay bonds.

As long as governments feel they are at the mercy of the hot money, and as long as the hot money insists that governments both be fiscally austere and have good economies, there is no way out.

Notice, that while China has significant issues, it does not have this issue because it does not rely on hot money. No smart government should. Currency flows are far too fast, not only should there be a tax on all currency flows but every smart country should make it essentially impossible to move large amounts of money in and out of its economy quickly without taking a huge haircut. Flighty money is more trouble than it’s worth. Money that wants to come, and stay, and really invest in the economy should be welcome, but fast money should be heavily discouraged. The harm done by such money is far larger than the good.

Likewise the hot money needs to be taught a lesson. Such “investors” seem to think that they deserve higher than market returns in exchange for lending money. The people lending money are expected to bear all the risk, and expected to get less than market returns (since they’re giving the surplus to the hot money). Would you borrow money under such circumstances? Of course not, which is why no one who doesn’t have a sure thing does, which is why the economy doesn’t grow, because the idle money thinks it deserves most of the returns and none of the risk, and entrepreneurs aren’t interested in that deal.

Once you accept the reality of this relatively simple conundrum, it's not hard to figure out the proper policy responses: a "Tobin" tax on all financial market transactions, especially foreign exchange, and favorable tax treatment for investments in the real economy, especially the building of renewable energy sources. The real problem, of course, is political: overcoming the immense power of the financiers and rentiers, and their chorus of sycophants in the economics profession that continue in their slavish devotion to the discredited ideas of economic neo-liberalism.

No comments:

Post a Comment