On a macro level, one of the most outstanding characteristics of the current crisis is the way capital has been exported from China, Japan and the Middle East to the US. The transfer of Asian capital has permitted the US to consume Asian exports and, as a result, the US has been able to live well beyond its means. Unregulated capital flows have created a situation where different countries are acting like one country: part of the economy manufactures (Asia) and the other part of the economy consumes (the US).
Unfortunately, capital has got ahead of itself. Asia and the US are different countries, with their own loyalties and social agendas. The current arrangement is leading to all kinds of resentment as the US replaces rising real wages with its simulacrum û cheap debt; while in Asia, the manufacturing emphasis does not involve the poorest segments of the population in the economy. (Manufacturing is also much less labour intensive than service industries, meaning Chinese cities benefit far more than the countryside.)
Before capital flows were deregulated in the 1980s, they followed trade. This created some stabilising mechanisms. Thus, a country which exported a lot would gradually see its currency rise. A country which imported a lot saw its currency depreciate. Eventually, these shifts would lead to an adjustment in the terms of trade.
But as Nomura Research Institute economist Richard Koo points out in his brilliant book The Holy Grail of Macro-economics: Lessons from JapanÆs Great Recession when capital is freed, it doesnÆt just follow trade, it follows interest rates. So when Japan cut its interest rates to close to zero, and when Swiss and Taiwanese interest rates were low, investors borrowed in those currencies and invested them in countries with higher interest rates, like the US, barely glancing at their balance of trade. In other words, exchange rates are no longer stabilising international trade flows û on the contrary, they are exacerbating trade imbalances, enabling the US to maintain a strong currency to fund its imports, and the exporting countries to benefit from a weak currency stimulating exports. ThatÆs the opposite of what happened in the past. Essentially, the dollar is being propped up in the face of economic logic.
Interest rates also make a mockery of the policies of many central banks. Japan initially lowered its interest rates to stimulate its economy after the trauma of the bursting of the bubble in 1989. Instead, Japanese capital has been exported to stimulate the US û which with a current account deficit equivalent of 6% of GDP is clearly already stimulated quite enough. ItÆs not clear how the US could react if it wanted to change this scenario: lower rates would make the US less desirable to international capital but could over-stimulate the domestic financial system. In other words, itÆs not just countries with pegged currencies, as often claimed, which have lost the power to influence events. The US is just as hampered.
Koo gives an interesting illustration of the problem. Last year, the central bank of New Zealand had to simultaneously raise interest rates and intervene to weaken its currency, in order to slow its economy. This is bizarre by traditional standards, but the bank knew that raising rates would attract an avalanche of foreign capital seeking higher interest rates, which would overheat the economy all over again. ThatÆs why it had to push the currency down.
The current situation û with the world holding its breath for the dollar to crash on the back of the US financial crisis û could never have happened before the deregulation of capital flows. The dollar would have sunk gradually lower under the weight of its inability to export until it reached a tipping point û and then US companies would have started exporting again, thus keeping the US manufacturing sector afloat, and helping the dollar to strengthen. Perversely, the current situation of continuously funneling capital to the US has harmed US exports (and by extension many manufacturers) in favour of its consumers. In Asia, countries are accumulating increasingly worthless FX reserves ($4.3 trillion at last count), while many of their own populations are forced on a consumption diet. And the longer it continues, the more that is the case.
If capital does become more regulated, investment banks will be hit harder than being accused of greed and other unpleasant things. Regulating and slowing capital flows would deprive bankers of the fees that accompany such enormous flows. But bankers need to learn that they are the tail, not the dog, and that itÆs time the dog took control over its hind end again. However, given the power of the financial lobby in the political establishment, itÆs unlikely capital flows will be regulated any time soon.