This week's cover-story in The Economist warns of an impending debt crisis in the emerging economies. This is seen as the third stage in the ongoing debt saga: first came the 2008 'global' crisis; then the 2010 crisis in Greece and the European periphery; now the emerging economies.
These crises are caused by total debt (both domestic and foreign), but the foreign component is always the most problematic, as it involves exchange rates, scarce foreign currency and flighty foreigners.
This latest round of hand-wringing is a reminder of the divergent opinions about capital flows. The traditional conventional view among policy and academic economists was that capital flows were unambiguously a Good Thing, a beneficial element of globalisation. The policy prescription which followed was that emerging economies should open the capital markets to foreign flows. The promise was that, provided they let their exchange rates float, things would work out well.
The experience of the past two decades has been less benign. The sloshing backwards and forwards of foreign capital has typically been driven by the abnormal circumstances in advanced economies, rather than by macro-policy mistakes in the emerging economies. A policy framework that presumes these flows to be beneficial is irrelevant to the policy challenge the emerging economies face.
Over the past decade, the policy debate has been inching forward to incorporate the inconvenient reality that the flows may be disruptive. Olivier Blanchard, recently retired as the IMF chief economist, has co-authored two papers from his new base in the Peterson Institute. As he did at the IMF, Blanchard continues to strive to bring the consensus policy framework closer to the real world.
One paper argues that capital inflows can push up asset prices in the recipient country, over-stimulating domestic demand in the process. This might seem like an obvious-enough insight, but is the opposite of the conventional academic model on which much policy prescription had been based.
The second paper argues that foreign exchange intervention can be effective in stabilising the exchange rate in the face of excessive capital flows. Again, this contradicts most academic models, which see intervention as futile or distortionary.
It is (just) possible that these two papers may shift the policy advice of the IMF in the right direction, and it would become more ready to see capital flow management and foreign exchange intervention as first-rank policy tools for emerging economies rather than last-resort measures of desperation.
Such a shift would not, however, go unchallenged. [fold]
Coinciding with the publication of these papers, the 6000-page Trans-Pacific Partnership (TPP) draft agreement includes a Joint Declaration on macroeconomic policy that fully embodies the Old View which holds that intervention in the exchange rate will be seen as a prime facie case of 'manipulation'.
'Each Authority confirms that its country is bound under the Articles of Agreement of the International Monetary Fund (IMF) to avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage.'
This Declaration, included at the insistence of some members of the US Congress, may not have much force in constraining policy-making in practice. In putting a link to the Declaration on the Australian Reserve Bank website, the RBA noted this Declaration was 'not legally binding'.
But it is a demonstration of the pathetic standard of the international economic debate, where half-learned textbook economics become the basis of strongly held policy doctrine. The Declaration requires an annual examination of member countries' macro-policies, with the detailed requirements for disclosure of foreign-exchange levels and intervention making it clear where the focus will be.
The next phase of sensible policy debate on capital flows should be to explore the practical application of Blanchard's insights. What measures of capital flow management will be effective, and in what circumstances? When is foreign exchange intervention effective? What does this say about the optimal size of foreign reserve-holdings? Can effective methods of reserve pooling (such as the Chiang Mai Initiative) be developed? Can the US Fed's swap facilities be more widely accessed? How can the Fund's role as global lender-of-last-resort be made more relevant?
These important debates are constrained because the TPP countries have now signed up to a declaration that genuflects to an old policy mindset, overtaken by reality.
They say that the challenge for academic economists is to prove that what happens in the real world could also happen in theory. Blanchard and his colleagues have taken a useful step in this direction, reconciling theory with inconvenient reality. This might be seen as progress, if only the political-economy of international economics were not still in the hands of Keynes' 'madmen in authority … distilling their frenzy from some academic scribbler of a few years back'.
Photo courtesy of IMF