Watching as the Spanish government announced drastic new austerity measures, you could have been forgiven for thinking that neoliberal orthodoxy holds sway almost as decisively as when Alan Greenspan was the maestro of the Federal Reserve.
But away from Brussels, one element at least of the neoliberal canon – the idea that capital must be allowed to flow unchecked around the world – is coming under sustained attack.
The theory says that free capital flows allow savings to be directed – by the invisible hand of the financial markets – to wherever they will be most profitably employed. In this way, savers get a better return on their nest egg, while underdeveloped economies receive the financial leg-up they need. And as firms from one country take over those of another, they bring much-needed expertise as well as help new ideas to be adopted rapidly worldwide.
Except that isn't what's been happening: instead, for the past decade and more, savings have been pouring uphill from poor countries to rich. Whether you call it a savings glut or a borrowing binge (two sides of the same coin), it has led to a flood of money sluicing through financial markets, looking for a home. And far from nurturing development and improving the standard of living of the poorest, these vast flows of money have created a repeated pattern of boom, bust and financial crisis.
When the climate is "risk on", as they say in Wall Street and Canary Wharf, capital rains down on the fashionable economies of the moment. But a change in mood – or an increase in interest rates in Washington, say – can, like the proverbial flap of a distant butterfly wing, unleash an economic storm as capital floods back out again.
A recent paper by thinktank the Bretton Woods Project, Time for a New Consensus, enumerates five major threats of unregulated capital flows. There is currency risk, because large inflows can push up a country's exchange rate (you need to buy Turkish lira if you want to buy a firm in Istanbul). An overvalued currency undermines domestic exporters and leaves them unable to compete. There is flight risk, because funds often leave as rapidly as they arrive, pulling the rug out from under local businesses and stunting economic growth.
Contagion risk is the threat that close financial links between economies means a shock in one can drag everyone down – as shown by the devastating knock-on effects of the US sub-prime crisis over the past four years.
Fragility risk occurs when an economy becomes heavily dependent on borrowing from overseas, often in foreign currencies. Hungarian households took out mortgages in euros in the runup to the credit crisis, for example, as their country prepared to join the single currency. That meant the sharp decline in the forint took a severe economic and social toll when the crisis hit, as the loans spiralled in value relative to homeowners' wages.
Finally, sovereignty risk, chillingly familiar to a string of crisis-hit countries across the world in the past two decades, is the threat that instead of overseas investment giving governments the resources they need to improve the livelihoods of their population, politicians are left with little or no control over their own economies. Increasing domestic interest rates to control an unsustainable boom has little impact if cut-price capital keeps flooding in.
Not surprisingly, large developing countries have long been suspicious of the west's insistence that its banks and corporations must be allowed to bestride the world, unrestrained by government interference.
The World Trade Organisation summit in Cancún in 2003, part of the now dormant Doha round, collapsed because the rich world insisted that the so-called Singapore issues, which included removing restrictions on foreign investment, must be part of any bargain. Developing countries objected so vehemently they walked out.
Since the onset of the credit crunch in 2007, those countries – including China and India – that have kept tight control over financial inflows have fared better than those that have thrown open their borders.
And in recent years, several countries have quietly begun erecting breakwaters against the latest tidal wave of capital, driven by low interest rates in the west. Brazil, Argentina and Costa Rica have used various measures, including taxes on purchases of shares and bonds and insisting that short-term investors deposit funds with the central bank for a year, to dampen the stop-go cycle.
It doesn't mean no investment; just trying to discriminate between long-term capital that will help to deliver jobs and sustainable growth and the short-term whims of the herd.
The International Monetary Fund responded to growing pressure for a rethink last year and issued two papers acknowledging that regulations on capital flows could be useful. But it suggested their use should be restricted to crises and governed by a strict code of conduct. That idea was rejected by emerging economies, which are wielding growing influence at the Washington-based lender. The G20, a forum in which China, India and Brazil have a strong voice, issued its own far more radical study in October. The tide is turning.
One unlikely recent champion of the reintroduction of regulations on capital flows is the Bank of England. The shock of being caught unawares by the vulnerability of the UK's financial system in 2007 and 2008 caused soul-searching in Threadneedle Street, and recent papers and speeches have helped build the case for new thinking.
Two research studies in particular, released last month, suggested cross-border flows of capital will increase radically in the coming years as developing countries grow in size; that the UK will be particularly vulnerable to future sudden reversals in these flows, because of its vast external balance sheet; and that the international community should consider drawing up a set of rules governing how and when countries can act to protect themselves.
If there's one thing policymakers should have learned over the past four years, it's that financial markets can't be left to run the world themselves.
Comments
8 January 2012 1:41AM
This is interesting stuff...especially the new rising intellectual confidence of other G20 countries. Meanwhile what is going to happen to all the debt still weighing down the western economies. It seems to me we need a global New Deal. The West has messed up big style through financialisation of their economies, to get through this we need to offer huge concessions to the BRICs etc. on voting rights at the IMF, on the future of the world's reserve currency, on the structure of the UN permanent council and so on in order to get the debt re-set the world economy needs. As things stand we are still heading for the mother of all crises...and father (don't want to be sexist...)
8 January 2012 2:52AM
It is a very interesting debate, surely we should treat the IMF as commercial bank with voting rights dependent on the countries contribution. There would obviously need to be a ceiling on contributions.
With regard to a world reserve currency, I see no contenders prepared to on this role from the dollar. It was thought that the Euro might offer an alternative but it can't manage it's own zone.
8 January 2012 4:44AM
....cross-border flows of capital will increase radically in the coming years as developing countries grow in size....
Oh, no, they won't.
In the coming years the only 'development' (i.e. industrial development) is going to be de-development.
I write from the Middle Mekong region (Isaan and Laos) which is attached to (or semi-detached from, according to viewpoint) the industrialising area of Thailand which has been 'developing' this past forty years.
In recent years, it has become clear that the 'Western' customers for the manufacture-for-export portion of that 'development' were getting themselves into an industrialism/capitalism/ consumerism cul-de-sac, closed off by the dwindling of the supplies of cheap energy that it depended on.
The first crunch came in mid-2008 when oil supplies could not match demand, the oil price shot up and so destroyed enough demand to bring it down----but too late for those who had lost their jobs during that 'demand destruction'. That was bad news in the 'West', but the agrarian sector here absorbed redundant industrial workers who returned to their home villages and settled in easily (helped of course by the rising prices received for the rice and sugar that the sector produces).
Over-indebtedness caused the 'Western' financial sector to lurch-----and historians in the future will look back and see the collapse of Lehmann Brothers as having been the first manifestation of de-development.
Like many Western economists and other commentators, such as Larry Elliot and Will Hutton, Heather Stewart is writing in blissful ignorance of the shifting of the economic tectonic plates that underly.
Next time they shift (later this year beneath the Eurozone?) they'll set off a tsunami of protectionism (as exhibited by Cameron trying to protect London's finance industry at the 'Euro Summit).
We will not see this predicted cross-border flows of capital chasing yield on that capital simply because there'll be far too much fear of loss of that capital.
8 January 2012 6:50AM
Money flows are certainly crucial and will be crucial but they have sadly been used by the parasitics to do damage rather than to energise and synergies markets. I see the rational of putting up obstructions, maybe that is the start point, if you place a barrage across the flow you can at least have control of the flow you require and stem or meter the damaging effects?
8 January 2012 7:55AM
....if you place a barrage across the flow you can at least have control of the flow....
Yes----and that is what Mahathir of Malaysia did in the 1997 Asian financial crisis.
The IMF, and Uncle Tom Cobley and all, screamed that it was "against the rules" but he told them to "sod off!" and they had to.
Some ten years later, Thailand did the same when the speculators were massing against its currency.
Clearly, the lesson had been learnt and the plan was in place.
The Bank of Thailand simply said that currency purchases above a small limit were subject to 10% being withheld and returned after one year, provided that the currency (baht) purchase had been held for the year.
The mass of speculators dispersed within 24 hours!
Noticeably, the IMF et al kept stumm!!
Of course, simple people like me and my small-farmer neighbours are not sophisticatedly knowledgeable about manipulating capital like Heather Stewart et al.
So we keep ours in the form of productive land (and in gold, whilst we wait for suitable neighbouring land to come on the market).
There's such a thing as being well ahead by being sufficiently far behind!
8 January 2012 9:39AM
This article seems to link austerity in Spain to free capital flows without spelling out what this link is. Given that Spain's problem right now is lack of access to sufficiently cheap capital, it seems to me that anything that constrains this would simply increase Spain's borrowing costs, resulting in further austerity.
Furthermore, while the author seems to agree that excessive cheap credit from China has been the issue (and, of course, Western governments were only too happy to borrow from China), she doesn't take into account that extremely tight capital controls in China have facilitated this - if China allowed free capital flows, then the yuan would have risen against other currencies over the years as China's prosperity grew, and the imbalances would have eventually corrected as Chinese imports became more expensive. However, by allowing anything but free movement of capital, the Chinese government can artificially peg the yuan to the dollar.
8 January 2012 10:45AM
Indeed the IMF has changed its attitude to the free-flow of capital and Brazil, amongst other developing markets, do have capital controls on inflows. Most of this arises from the Asia crisis of the 1990s when hot money flowed out as easy as it rolled in. But.
We have been told by Dave that the UK national interset and that of the City of London are one and the same thing. Both the US and UK are adamant in their opposition to a financial transaction tax. Sterling doesn't plummet like a stone due to the City being able to re-cycle savings from exporting nations. All of this depends on the free flow of capital. A UBS document from 2011 reckons only 5% of forex transactions are due to trade, 95% due to 'investment'.
Brazil imposing capital controls on inflows is one thing, the G20 behaving in the sane vein over inflows and outflows is one idea that will never be saluted.
8 January 2012 10:51AM
Spain's major problem is employment laws that protect those in jobs from the outsiders (mostly the young). It's lack of comparative advantage would exist no matter its currency and borrowing costs.
France, similarly, has this problem and adresses it with auromation. The Metro now has two lines fully automated due to the public sector train workers and their demands. So jobs are simply lost to both insiders and outsiders.
I know this doesn't sit well with the 'we must be nice to each other' approach but life is like that.
8 January 2012 11:31AM
Large inward flows produced in Spain - as in Ireland - an unsustainable property boom.
No sovereign government should allow capital inflows without guarantees as to thier destination. Brazil's recent decision to tax inwards flows in order to manage their volume is perfectly reasonable as is China's reluctance to allow speculative inflows.
8 January 2012 11:38AM
This is a good piece Heather. Another subject I have been writing about ever since Thatcher removed exchange controls. She was wrong to do so, it has been a major part of our economic decline, and must be reversed.
Why are economists and politicians 20 years behind the rest of us on such obviusly disasterous policies? I suspect dodgy lobbyists with too easy access to Ministers.
At the moment, if you look at the exchange rate, you will see that the Euro is now at 1.20 because, all the "hot money" has lurched out of the Euro from Greece, Italy and Spain into Sterling.
This rate is the critical point, and any increase in Sterlings value. above this rate, will undo all the exporters work over the last two years and cost yet more British jobs.
Heather discusses this problem very well. Government I hope will act swiftly to prevent an over appreciation of Sterling to protect our economic recovery.
8 January 2012 12:08PM
See Professor Steve Keen's Debt Manifesto campaign:-
http://www.debtdeflation.com/blogs/2012/01/03/the-debtwatch-manifesto/
8 January 2012 12:18PM
The moral being for Libertarians and Neo-Liberals that the flow of capital is anything but free but in fact manipulated by governments for national advantage.
8 January 2012 2:22PM
Velocity.
8 January 2012 3:05PM
But surely all those in "the know" have been saying that inteventionism (such as capital flow controls) will result in a rerun of the 1930s mess??
Are we really coming to the conclusion that they those in the know simply don't have a bloody clue?
8 January 2012 3:09PM
I take your point but this global race to the bottom for currency values does keep inflation clocking up.
Do you say we should have more QE and would this result in a faster decrease in the value of Sterling?
8 January 2012 3:17PM
... Not with a big bang but a whimper.
8 January 2012 3:59PM
(G-T) = (S-I) – NX
8 January 2012 10:21PM
Globalisation is the process by which the capitalist class multiplies its wealth whilst producing absolutely nothing of tangible value. To the contrary, "financial innovation" is a byword for carefully crafted jeopardization of the means to finance the real economy. It is crime against society, and the weapon is bankers' biggoted belief in a system they are striving to destroy.
9 January 2012 8:00AM
interesting column. I'd add one extra country that's done quite well out of financial controls. Iceland. Of course, they're completely against EEA rules, but seemingly both the EU and IMF have kept quiet on the matter.
9 January 2012 9:30AM
The banks want everything to stay as they were pre-2008. Now, we have seen what happens when the banks get there way, free un-regulated financial markets are a disaster. It is still hard to believe that the Glass-Steagall legislation was only repealed in 1999. It took the financial institutions nine years to engineer another disastrous boom of 1920’s proportions.
Things need to change drastically, if you like global depressions listen to the banks and keep things the way they are, if you don’t ignore them.
9 January 2012 1:42PM
Heather,
Why don't you look at papers published by Claudio Borio at the Bank for International Settlements and his opposition to the Federal Reserve view that it was an inbalance in savings that led/resulted in the "Great Financial Crisis.'
Indeed, and for other readers, why not check our the large volume of work by both Borio and William White you may be surprised.
As for Capital controls/Restrictions, the IMF paper you cite came after both South Korea and Indonesia introduced limit cash flow capital restrictions in early 2011 if memory serves me correct - hence, if both an emerging economy and one of the World's largest economies can fallback on capital controls, a new 'Bretton Woods' agreement would be possible if we abandon the farce that is/was Doha - only the 1% Kleptocracy has benefited from so called 'World Free Trade', most of it written by neo-liberals and neo-conservatives, that these policies failed spectacularly in 2007/8 and have been proved as abject failures in countries as diverse as the UK, Chile and Argentina I suggest a new Bretton Woods would be a good start to turn back 30 years of unfettered neo-liberal greed and consensus among our global ruling elite.
9 January 2012 3:32PM
My views on this are far from main stream.
I am oppossed to QE because it is not tackling the main cause of our near depression and simply causes inflation. Money only has a value if you think it does (since the gold standard was dropped) otherwise it is merely a nice piece of printed paper with no intrinsic value.
If you look back at the world prior to the first world war, the world economy revolved around the British empire and several smaller empires (forget the moral arguments about empire for this debate) and everything was pretty much in balance.
America became hugley wealthy simply trading internally. However after the 1914/18 war it realised there was a whole world outside of the US and moved out into the international arena bringing an immense manufacturing base and colossal amounts of money, which destablised everything and eventually led to the stock market crash and the great depression.
Move forward to today and substitute China for America and you have history repeating itself, with 1 very important exception. America's industries wete home grown and built mostly to seve America's internal market.
China on the other hand exploited the so called "comparative advantage" and the greed of the West to simply transplant jobs from Western economies tio China.
So economies like the UK went from wealth creating exporters, say of shoes, to wealth destroying importers of their own shoes. Losing not just wealth creation but skills learned over many years, in the making of those shoes.
The amnswer is simple. We must make it illegal to switch production of UK firms overseas. We can set up new ventures overseas, that is different altogether.
We must also make it illegal to sell UK firms to overseas firms unless that UK firm is in distress.
The List of UK firms being taken over whilst successful (funded entirely by borrowing) and then being put in distress by the foreign owners struggle to repay thsat debt is endless.