Comment on Ricardo Reis (2013, forthcoming), "Mis-Allocation of Capital Flows: The Portuguese Lost Decade(s) and the Euro-Crisis", Brookings Papers on Economic Activity:
Nineteen years ago I was sitting in this exact same seat, in this exact same room. I don't think David Wessel was sitting behind me--I think he was sitting along the exterior wall. And up on the podium was not Ricardo Reis but the late Rudi Dornbusch, presenting his paper with Alejandro Werner on Mexico: "Mexico: Stabilization, Reform, and No Growth".
Mexico had, Rudi said, "come to be viewed as a showcase of successful stabilization and economic reform, institutional stability, and financial predictability… becoming what Chile already had become and what all of Latin America hoped to be…. The stabilization strategy has led to an overvaluation of the exchange rate, a precarious financial situation, and a lack of growth…."
"An avalanche of capital," Dornbusch and Werner continued, "has strengthened the currency in real terms… financing not only investment but also a high level of consumption and intermediate goods imports, with the large external deficit dampening demand for domestic goods…. To a large extent… real depreciation is needed to improve the long-term economic prospects of Mexico and secure the benefits of economic reform."
Ricardo did not express the thought that I think lay behind Rudi's calls for large real depreciation in Mexico two decades ago. It was, I believe, precisely that real depreciation gives you a set of obvious places to productively direct the inflow of capital--to export agriculture and industry--that is exactly what an economy that has a difficult time productively allocating capital internally needs.
And it is not just Latin America. It is not just southern Europe where this happens. Can any of us think of an economy that had very large capital inflows between 2000 and 2007 and decided to allocate a great deal of them to building 4-bedroom houses with swimming pools and cathedral ceilings in the desert between Los Angeles and Albuquerque?
UPDATE: Paul Krugman has thoughts on these issues:
Hot Money Blues: unrestricted movement of capital is looking more and more like a failed experiment. It’s hard to imagine now, but for more than three decades after World War II financial crises of the kind we’ve lately become so familiar with hardly ever happened. Since 1980, however, the roster has been impressive: Mexico, Brazil, Argentina and Chile in 1982. Sweden and Finland in 1991. Mexico again in 1995. Thailand, Malaysia, Indonesia and Korea in 1998. Argentina again in 2002. And, of course, the more recent run of disasters: Iceland, Ireland, Greece, Portugal, Spain, Italy, Cyprus.
What’s the common theme in these episodes? Conventional wisdom blames fiscal profligacy — but in this whole list, that story fits only one country, Greece. Runaway bankers are a better story; they played a role in a number of these crises, from Chile to Sweden to Cyprus. But the best predictor of crisis is large inflows of foreign money: in all but a couple of the cases I just mentioned, the foundation for crisis was laid by a rush of foreign investors into a country, followed by a sudden rush out.
I am, of course, not the first person to notice the correlation between the freeing up of global capital and the proliferation of financial crises; Harvard’s Dani Rodrik began banging this drum back in the 1990s. Until recently, however, it was possible to argue that the crisis problem was restricted to poorer nations, that wealthy economies were somehow immune to being whipsawed by love-’em-and-leave-’em global investors. That was a comforting thought — but Europe’s travails demonstrate that it was wishful thinking.
And it’s not just Europe. In the last decade America, too, experienced a huge housing bubble fed by foreign money, followed by a nasty hangover after the bubble burst. The damage was mitigated by the fact that we borrowed in our own currency, but it’s still our worst crisis since the 1930s.
Now what? I don’t expect to see a wholesale, sudden rejection of the idea that money should be free to go wherever it wants, whenever it wants. There may well, however, be a process of erosion, as governments intervene to limit both the pace at which money comes in and the rate at which it goes out. Global capitalism is, arguably, on track to become substantially less global.
And that’s O.K. Right now, the bad old days when it wasn’t that easy to move lots of money across borders are looking pretty good.