I'll start off by saying that this will be my first post on financial crises, how they play out, and the international nature of these things. This post will primarily discuss how capital flows in wealthy countries affect less developed countries. The next post (which will be done by the end of this week, it's already ~60% finished as of this publishing) will discuss the specific crisis that began in 2007 and the middling through we're currently ongoing. Now, I'll begin by bashing leftists, socialists, and statists as usual.
Usually when I hear about economic crises, we usually hear people say that financial crises that were caused by factors like "deregulation" or "financialization". Of course, such ideas usually come from those who subscribe to certain political ideologies (usually leftists, socialists, and statists). Not surprisingly, most of the basis for such arguments is nonsense. Almost all financial crises (I can't think of one that wasn't) are international in nature, not domestic or national. So focusing on the domestic or national nature of these crises tells us very little about the development and occurrence of financial crises. Financial crises occur, and are triggered, by expansions and contractions of liquidity in the world's financial centers in combination with international capital flows.
Basically, financial crises aren't caused by "deregulation" or "financialization". New financial instruments will play a role in a financial crisis, but they're not the cause. The cause of any financial crisis lies in international capital flows across borders. Anyways, I'll begin by splitting this post into three separate parts:
1. Liquidity
2. Wealthy Countries Financial Centers as Drivers of Capital Flows
3. Impacts of Capital Flows on Less Developed Countries (LDCs)
NOTE: I'M DEFINING LDC DIFFERENTLY FROM THE DEFINITION USED BY THE WORLD BANK. I'M USING LDC TO MEAN EMERGING ECONOMY!
1. Liquidity:
First, I'll start off with the concept of liquidity. What is liquidity? This is a difficult term to define, but liquidity is basically the amount of "cash" in the financial system. Does liquidity have to be solely defined as the amount of cash? Of course not. Liquidity can not just be cash, but can also be any sort of instrument that is basically like cash. In my post about the basics of banking, I talk about how money has a hierarchy with the short term money market rate of interest being the price of liquidity. In my post about QE and monetary policy, I spoke about how the point of QE was to create a massive pile of cash looking for somewhere to go. Basically, the purpose of QE was to create a massive increase in liquidity by a central bank coming in to swap less liquid assets for more liquid ones. In my most recent post, I discuss how the use of liquid assets in today's financial system has led to a massive decentralization in money. I basically treat these highly liquid assets as another form of money because they're convertible for cash at any point. Anyways, I'm gonna focus on the concept of liquidity for the rest of this post where I'll use liquidity to represent the "money-ness" of an asset.
However, liquid assets can be virtually any money like asset including Asset-Backed Commercial Paper or short term bills (ex. T-bills). In other words, expansions in liquidity can come in a host of ways for a multitude of reasons.
This brings us to the next question: how does a massive increase in liquidity affect asset markets? When you expand liquidity, by definition, we see an increase liquid assets. This can come about for various reasons, but the most common reason usually stems from central bank balance sheet expansion. So how exactly does this work? Recall from my post on the basics of monetary policy and QE that central banks can buy assets by issuing new deposits (or reserves). When central banks expand their balance sheet, it shows up as an asset swap on the private sector balance sheet. So the end result is that the private sector ends up with a bunch of cash looking to go somewhere as short term money market rates fall (assuming you're not at the ZLB). So the cost of financing short term drops while there's a whole bunch of cash looking to go somewhere for a yield. The end result is often times mistaken to be inflation, but the end result often times is asset market dislocation, asset bubbles, massive increases in debt, and the longer term consequences are often deflationary, not necessarily inflationary (although it does depend on the balance sheets and supply-side structure of the different economies in question).
2. Wealthy Country Financial Centers as Drivers of Capital Flows:
So now that we have a basic understanding of liquidity and what drives liquidity, we can see that the largest expansions of international liquidity can only come from the world's largest and most powerful economies because they're the largest and most powerful. Today, that role is played by the Federal Reserve (and has been played by the Fed since either 1914 or 1919 depending on how you look at it).
From September 2008 to December 2014, the balance sheet of the Federal Reserve has increased from $900 billion to $4.5 trillion (it's held flat since). So the net increase in cash for the private sector from the Federal Reserve has been $3.6 trillion. So during this expansionary phase, we've had a $3.6 trillion increase in cash that's looking for a yield. This pile of cash looking for an interest bearing asset goes into both domestic and foreign assets. Due to the sheer size of the American economy, even the smallest capital flows into foreign assets creates huge distortions. For example, a country like Nigeria (with a population of ~150 million people) has NGDP of ~$500 billion. So even a small shift in capital flows by the Federal Reserve can have a HUGE impact on the finances of the country.
When you get a massive expansion of liquidity in the international financial centers, it means there's plenty of cash available for whomever (usually foreign firms/governments) to issue liabilities to get access to international financing. On the other hand, when the wealth country financial centers start to contract liquidity, the amount of cash available for foreign firms/governments becomes very tight. So what we start to see is that the capital that flew into these countries during the expansion phase tends to fly right out in the liquidity contraction.
Simply put: liquidity expansion in the world's financial centers leads to capital inflows and economic expansion in LDCs while liquidity contraction in the world's financial centers leads to capital outflows and economic contraction in LDCs.
3. Impacts of Capital Flows on LDCs:
During the liquidity expansion in the wealthy countries financial centers, financing is available in large amounts for any LDC that cannot finance investment (or consumption) out of current income. So firms and governments can access financing easily for either investment or consumption. If the investment is productive, the future increase in real income is usually well more than enough to pay back the debt and then some. So if an LDC uses foreign financing well to fund productive investment opportunities, they may experience an economic contraction, but they will not be in horrible shape. They may still have a financial crisis (and usually do), but the impacts of the financial crisis will be limited.
Inversely, if the foreign financing is used to finance unproductive investment or unsustainable consumption, the economic activity creating by the unproductive investment or unsustainable consumption stops immediately as financing as dried up which will trigger a financial crisis. Unlike the case where the foreign financing is used well, this time the financing is used poorly while debts still need to be serviced which will usually lead to either private bankruptcies or an increase in government debt which could, and often does, trigger a government debt crisis in LDCs that have poorly managed incoming capital flows.
Note that if the debt taken on by the LDC is denominated in foreign currencies or via a currency peg, the country will usually run out of FX reserves trying to pay off the foreign debt or maintain the peg and eventually, the country will experience a currency crisis along with a sovereign debt crisis and private bankruptcies. Even if the foreign currency debt of the LDC is used productively, there's still a VERY HIGH chance of large private bankruptcies, a banking crisis, a currency crisis and a sovereign debt crisis simultaneously.
Note: If the total financial system of the LDC holds FX reserves larger than their foreign currency obligations, they'll usually be fine, but that's rarely the case. Even when it is the case, things can still get screwy. The only way for a financial system to protect itself against the risks of having foreign currency debt is to not have debts denominated in a currency you can't control.
Usually when I hear about economic crises, we usually hear people say that financial crises that were caused by factors like "deregulation" or "financialization". Of course, such ideas usually come from those who subscribe to certain political ideologies (usually leftists, socialists, and statists). Not surprisingly, most of the basis for such arguments is nonsense. Almost all financial crises (I can't think of one that wasn't) are international in nature, not domestic or national. So focusing on the domestic or national nature of these crises tells us very little about the development and occurrence of financial crises. Financial crises occur, and are triggered, by expansions and contractions of liquidity in the world's financial centers in combination with international capital flows.
Basically, financial crises aren't caused by "deregulation" or "financialization". New financial instruments will play a role in a financial crisis, but they're not the cause. The cause of any financial crisis lies in international capital flows across borders. Anyways, I'll begin by splitting this post into three separate parts:
1. Liquidity
2. Wealthy Countries Financial Centers as Drivers of Capital Flows
3. Impacts of Capital Flows on Less Developed Countries (LDCs)
NOTE: I'M DEFINING LDC DIFFERENTLY FROM THE DEFINITION USED BY THE WORLD BANK. I'M USING LDC TO MEAN EMERGING ECONOMY!
1. Liquidity:
First, I'll start off with the concept of liquidity. What is liquidity? This is a difficult term to define, but liquidity is basically the amount of "cash" in the financial system. Does liquidity have to be solely defined as the amount of cash? Of course not. Liquidity can not just be cash, but can also be any sort of instrument that is basically like cash. In my post about the basics of banking, I talk about how money has a hierarchy with the short term money market rate of interest being the price of liquidity. In my post about QE and monetary policy, I spoke about how the point of QE was to create a massive pile of cash looking for somewhere to go. Basically, the purpose of QE was to create a massive increase in liquidity by a central bank coming in to swap less liquid assets for more liquid ones. In my most recent post, I discuss how the use of liquid assets in today's financial system has led to a massive decentralization in money. I basically treat these highly liquid assets as another form of money because they're convertible for cash at any point. Anyways, I'm gonna focus on the concept of liquidity for the rest of this post where I'll use liquidity to represent the "money-ness" of an asset.
However, liquid assets can be virtually any money like asset including Asset-Backed Commercial Paper or short term bills (ex. T-bills). In other words, expansions in liquidity can come in a host of ways for a multitude of reasons.
This brings us to the next question: how does a massive increase in liquidity affect asset markets? When you expand liquidity, by definition, we see an increase liquid assets. This can come about for various reasons, but the most common reason usually stems from central bank balance sheet expansion. So how exactly does this work? Recall from my post on the basics of monetary policy and QE that central banks can buy assets by issuing new deposits (or reserves). When central banks expand their balance sheet, it shows up as an asset swap on the private sector balance sheet. So the end result is that the private sector ends up with a bunch of cash looking to go somewhere as short term money market rates fall (assuming you're not at the ZLB). So the cost of financing short term drops while there's a whole bunch of cash looking to go somewhere for a yield. The end result is often times mistaken to be inflation, but the end result often times is asset market dislocation, asset bubbles, massive increases in debt, and the longer term consequences are often deflationary, not necessarily inflationary (although it does depend on the balance sheets and supply-side structure of the different economies in question).
2. Wealthy Country Financial Centers as Drivers of Capital Flows:
So now that we have a basic understanding of liquidity and what drives liquidity, we can see that the largest expansions of international liquidity can only come from the world's largest and most powerful economies because they're the largest and most powerful. Today, that role is played by the Federal Reserve (and has been played by the Fed since either 1914 or 1919 depending on how you look at it).
From September 2008 to December 2014, the balance sheet of the Federal Reserve has increased from $900 billion to $4.5 trillion (it's held flat since). So the net increase in cash for the private sector from the Federal Reserve has been $3.6 trillion. So during this expansionary phase, we've had a $3.6 trillion increase in cash that's looking for a yield. This pile of cash looking for an interest bearing asset goes into both domestic and foreign assets. Due to the sheer size of the American economy, even the smallest capital flows into foreign assets creates huge distortions. For example, a country like Nigeria (with a population of ~150 million people) has NGDP of ~$500 billion. So even a small shift in capital flows by the Federal Reserve can have a HUGE impact on the finances of the country.
When you get a massive expansion of liquidity in the international financial centers, it means there's plenty of cash available for whomever (usually foreign firms/governments) to issue liabilities to get access to international financing. On the other hand, when the wealth country financial centers start to contract liquidity, the amount of cash available for foreign firms/governments becomes very tight. So what we start to see is that the capital that flew into these countries during the expansion phase tends to fly right out in the liquidity contraction.
Simply put: liquidity expansion in the world's financial centers leads to capital inflows and economic expansion in LDCs while liquidity contraction in the world's financial centers leads to capital outflows and economic contraction in LDCs.
3. Impacts of Capital Flows on LDCs:
During the liquidity expansion in the wealthy countries financial centers, financing is available in large amounts for any LDC that cannot finance investment (or consumption) out of current income. So firms and governments can access financing easily for either investment or consumption. If the investment is productive, the future increase in real income is usually well more than enough to pay back the debt and then some. So if an LDC uses foreign financing well to fund productive investment opportunities, they may experience an economic contraction, but they will not be in horrible shape. They may still have a financial crisis (and usually do), but the impacts of the financial crisis will be limited.
Inversely, if the foreign financing is used to finance unproductive investment or unsustainable consumption, the economic activity creating by the unproductive investment or unsustainable consumption stops immediately as financing as dried up which will trigger a financial crisis. Unlike the case where the foreign financing is used well, this time the financing is used poorly while debts still need to be serviced which will usually lead to either private bankruptcies or an increase in government debt which could, and often does, trigger a government debt crisis in LDCs that have poorly managed incoming capital flows.
Note that if the debt taken on by the LDC is denominated in foreign currencies or via a currency peg, the country will usually run out of FX reserves trying to pay off the foreign debt or maintain the peg and eventually, the country will experience a currency crisis along with a sovereign debt crisis and private bankruptcies. Even if the foreign currency debt of the LDC is used productively, there's still a VERY HIGH chance of large private bankruptcies, a banking crisis, a currency crisis and a sovereign debt crisis simultaneously.
Note: If the total financial system of the LDC holds FX reserves larger than their foreign currency obligations, they'll usually be fine, but that's rarely the case. Even when it is the case, things can still get screwy. The only way for a financial system to protect itself against the risks of having foreign currency debt is to not have debts denominated in a currency you can't control.
Hey, its cs, uhmmm...just to give yous something on this, not correct to use LDC.....very few LDC's left........LDC, would technically be a country under 1,000 per capita gdp nominal US.
ReplyDeleteOne might prefer to use lower middle income
(1-5k)
middle middle income 5-10k)
upper middle income 10-15k)
advanced (over 15k
This is world bank nomeclature, as is the term LDC, just to let you know.
Thanks, I added in a note. I suck at proofreading (and thoroughly despise it).
Deleteor merely emerging economies
ReplyDeleteor merely emerging economies
ReplyDeleteHey, its cs, uhmmm...just to give yous something on this, not correct to use LDC.....very few LDC's left........LDC, would technically be a country under 1,000 per capita gdp nominal US.
ReplyDeleteOne might prefer to use lower middle income
(1-5k)
middle middle income 5-10k)
upper middle income 10-15k)
advanced (over 15k
This is world bank nomeclature, as is the term LDC, just to let you know.
3rd para under the international aspects of the GFC
ReplyDelete"Since the Federal Reserve took up monetary easing, the current account deficit resolved itself as higher income, higher aggregate demand, higher unemployment,"
you mean higher employment
Thank you very much.
Delete3rd para under the international aspects of the GFC
ReplyDelete"Since the Federal Reserve took up monetary easing, the current account deficit resolved itself as higher income, higher aggregate demand, higher unemployment,"
you mean higher employment