Financial imbalances, the IMF and fiscal tea leaves
It has been argued that low interest rates in the US were perhaps the most important root cause for the ensuing financial frenzy. This IMF paper does not deny this theory, but allows for the possibility that the causal relationship needs to be addressed from a different angle: capital inflows have contributed in some countries towards depressing the long term interest rate, leading to a reduction in the spread between long and short term bank lending rates. This is something first year undergraduates learn: capital inflows lead to lower interest rates, because the supply of money increases drives down the price of money.
But how did this translate into financial crisis? On page 9 we read:
“A compression of the spread between long and short rates that is brought on by capital inflows at the individual country level affects the incentives of financial institutions to lever up.”
In other words: if a bank cannot make enough bucks from the difference between what it receives as interest on lending operations minus the interest it pays depositors on their bank accounts, there would be incentives to scale up its operations, or leverage. How do they do this? They borrow money on their own account from other banks and investors and start gambling with this money on the financial markets. Remember, CDOs, CDS, etc.?
Now the IMF confirms this is precisely what has happened (OK, it is more complex than this, weak supervision and regulation amplified the mess):
“[…] differences across countries in current account balances and the net capital flows associated with these differences had a statistically strong effect on financial sector imbalances. […] a current account deficit and the corresponding net capital inflow increases banking sector leverage. These effects are also economically sizable." (page 17).
To spell it out more clearly, the IMF adds:
“We find that a lower spread is associated with greater leverage. Since a compression of spreads at the local level is driven in part by capital inflows (Appendix I), the empirical evidence on the effect of the spread between long term and short term rates on banking sector leverage confirms and complements the evidence on the effect of capital flows on banking sector leverage. In particular, it documents an important mechanism through which capital inflows will have led to an increase in leverage." (ibid.).
Observers of financial crises in recent decades will hardly be surprised to learn that portfolio flows were particularly associated with financial turmoil. Mexico 1995, Argentina 2001/2002, and the Asian financial crises 1997/1998 all bear witness to the devastating role of volatile portfolio inflows. Sometimes, it seems we need to learn the hard way. The IMF writes:
“We find that, controlling for the net flow, both the size of other investments and of portfolio investments have a statistically significant effect on the build-up of financial imbalances, while the size of foreign direct investment does not. These results are plausible since some share of both other investments and portfolio investments would be expected to contribute to the funding of the domestic banking system, through foreign interbank loans and debt securities respectively. We find, finally, that controlling for the composition of gross flows does not alter the baseline result of a negative effect on the net flow, as measured by the current account. This is not surprising since, as we document in Appendix I, the net flow is a key determinant of long-term interest rates, which in turn can have an independent effect on banking system leverage."
So far, so good. But now the tea leaves start to get interesting. The balance-of-payment related question about a chicken or egg has to be addressed: is the current account deficit driving capital inflows, or are capital inflows driving a current account deficit? Unfortunately, the IMF does not address this question in the paper. Is this omission because it would have led inevitably to the insight that huge fiscal incentives for capital inflows may have actually been the key reason for the persistent current account deficits of the US, if not the UK?
As we argue in our AIE-briefing paper, the exemption of foreign bank deposits from taxation is a key determinant of global portfolio investment flows. Now, as readers of this blog will know, the US is the world’s pre-eminent tax haven, not least through its qualified intermediary programme that guarantees non-residents anonymity and tax exemption for their investments in US-government debt. It is the biggest capital-sucking machine ever devised. This policy, copied by much of Europe, wreaks havoc on countries in the global South. But now we know it also wreaks havoc on western/northern economies.
There is hope: some brave folks in the US are currently seeking to end this abuse by calling for routine reporting of non-resident deposits. From the point of view of rectifying harmful capital flows, this would be an important step in the right direction.