Monday, August 17, 2009

Capital Controls, Financial Regulation and the Global Economic Crisis of 2008–2009

In 2008–2009, the world has seen the worst financial crisis since the Great Depression.

In 2002–2004, large amounts of money flowed into the US from East Asia and oil-producing countries at a time when the US Federal Reserve had an easy money policy of low interest rates.

The blogger Cynicus Economicus has argued that
This massive wall of money invested into consumer borrowing created a fundamental problem. In simple terms, the first tranche of money invested ought to find the cream of the investment opportunities. However, as more money enters the system, good opportunities become scarcer – but it must still ‘go’ somewhere. In such circumstances, the capital is allocated to ever riskier investments, which explains the rise in popularity of collateralised debt obligations (CDOs) and other, similar financial instruments. These practices were simply a method of burying bad investments, while creating an illusion of continued low risk … In such a situation, we can see the roots of the house-price boom in the US, UK, Spain and Ireland (among other places) – a classic asset-price bubble in which there was a massive increase in the supply of money and the money simply chased an asset-base that could not expand as fast as the supply of money. A boom in land and property prices was inevitable …
Thus Cynicus Economicus contends that the flood of money from the East to the West with insufficient investment opportunities to “soak up” the money was the underlying and real cause of the crisis. Furthermore, it is claimed that nobody can show how “any regime might have coped with the influx of money from the East” since the “the money coming from the East created a circumstance that was entirely novel in the West.” Thus “the money would have arrived in the economy, and bubbles would [have appeared].” (see note 1 below).

This thesis, I believe, is false. The situation was not novel, and there were clearly ways in which the West could have prevented the asset bubbles.

Was There No Way to Prevent Asset Bubbles in the West?
First, it is simply not true that the flood of money flowing into the West from 2000 to 2006 was unprecedented or novel. There is an obvious historical parallel: the petrodollars that started flooding into London and New York banks in 1973–1974 and 1979 after the “oil shock” price surge. In 1974, the Arab oil-producing countries had a current account surplus of $68 billion US, which they mostly invested in the West (in 2007 inflation-adjusted US dollars that would be the equivalent of $285 billion entering the US economy). In 1975, these countries had a surplus of US $92 billion, an even greater amount.

And yet the Western financial system was not destroyed by large destructive asset bubbles in these years. Why?

The reason is that we had effective financial regulation that still existed before the onslaught of deregulation in the 1980s and 1990s.

Secondly, controls on capital inflows were actually a regular part of capital controls in the Bretton Woods era and in some countries well into the 1980s (Goodman and Pauly 1993: 282).

The dangers of large destabilizing capital inflows into an economy are well known. They can result in:
(1) damaging appreciation of a nation’s exchange rate that harms its exports and trade;

(2) short-term capital or “hot money” that causes financial instability and rapid outflows due to irrational herd behaviour and in turn balance of payments crises, and

(3) asset price bubbles, if there are very large inflows (Magud and Reinhart 2007: 647).
There are effective ways to prevent all these things. For instance, in Europe, which experienced large petrodollar inflows in the 1970s,
“capital controls and domestic bank regulations … separated Eurocurrency markets from the corresponding national markets … [For instance, there were] controls on capital inflows designed to keep a strong currency from becoming stronger … [in the 1970s] the German authorities attempted to discourage capital inflows through a variety of means, including a 60% marginal reserve requirement on bank liabilities to foreigners and a 50% cash deposit ratio on foreign borrowing (Herring and Litan 1995: 33–34).
International financial centres at Paris and Frankfort remained heavily regulated until the 1980s (Jones 1996: 188). As late as the 1970s, both Switzerland and Germany imposed controls on capital inflows to prevent currency appreciation and too rapid an expansion of their domestic money supplies from foreign inflows (Quirk 1995: 9). Germany, in particular, did so during 1971–1975 and from 1977–1981, precisely the time when petrodollars were flooding into Europe through Eurodollar markets. It is no surprise that, despite the massive flood of money in the 1970s, there were no destructive asset bubbles in the West.

Charles Kindleberger in the classic Manias, Panics, and Crashes: A History of Financial Crises (5th edn, John Wiley and Sons, 2005) shows that financial crises are a perennial characteristic of unregulated financial systems: from 1725 to 1929 destructive bubbles have occurred roughly every eight and half years in the West. But they largely disappeared in the Bretton Woods era (1945–1973).

Capital account liberalization and deregulation of financial markets started in the 1970s and intensified in the 1980s and 1990s. The results have been predictable: a massive rise in financial crises and destructive asset price inflation.

Quite simply, an important real cause of the crisis and the asset bubbles was capital account and financial liberalization. It is utterly false to say that real estate and stock market bubbles are inevitable.

Note 1
The views of Cynicus Economicus are presented in these articles:
“Five minutes to midnight,” Trade and Forfaiting Review 12.5 (23 March, 2009)

“Underlying Economic Crisis Caused Financial Crisis,”

Calvo, G. A., Leiderman, L. and C. M. Reinhart, 1994, “The Capital Inflows Problem: Concepts and Issues,” Contemporary Economic Policy 12 (1994), 54–66.

Goodman, J. and L. Pauly, 1993, “The Obsolescence of Capital Controls? Economic Management in an Age of Global Markets,” in J. A. Frieden and D. A. Lake, International Political Economy: Perspectives on Global Power and Wealth, St. Martin's Press, New York, 1991. 280–298.

Herring R. J. and R. E. Litan, 1995, Financial Regulation in the Global Economy, Brookings Institution, Washington, D.C.

Jones, G., 1996, The Evolution of International Business: An Introduction, Routledge, London and New York.

Magud, N. and C. M. Reinhart, 2007, “Capital Controls: An Evaluation,” in S. Edwards (ed.), 2007, Capital Controls and Capital Flows in Emerging Economies: Policies, Practices, and Consequences, University of Chicago Press, Chicago and London. 645–674.

Quirk, P. J., Evans, O., Gajdeczka, P. et al., 1995, Capital Account Convertibility: Review of Experience and Implications for IMF Policies, International Monetary Fund, Washington, DC.

Rajan, R. S., and I. Noy, 2008, “Capital Controls” in K. A. Reinert, R. S. Rajan et al. (eds), The Princeton Encyclopedia of the World Economy, Princeton University Press, Princeton, 2009. 152–156.

Appendix 1: Capital Controls in the West

You can see here when capital controls were abolished in most Western countries. It is clear that throughout the 1970s Western countries were protected from damaging capital inflows.

UK – 1979, capital controls abolished.

Japan – 1980, capital controls abolished.

Germany – 1958, abolition of control on capital outflows; severe restrictions on inflows until 1969, then again from 1971–1975 and 1977–1981; final abolition of remaining controls in 1981.

Australia – 1983.

New Zealand – 1984.

Netherlands – 1986.

France – 1989, remaining controls abolished.

Tuesday, August 4, 2009

Deflation, the Business Cycle and Depression: Is There a Link?

In a recent post on the blog of Cynicus Economicus, there is an interesting discussion on deflation:
Deflation is a decrease in average prices throughout an economy. It is often accompanied by cuts in nominal wages. It is very important to emphasise this definition of deflation: by using the word “deflation” in this article, I am not talking about a decline in the prices of only one or two goods in an economy. Nobody, for instance, denies that specific price deflation in computers (caused by industry producing increasingly cheaper and better computers) is a good thing. But, when average prices across an economy fall in a significant way, you have general deflation, and this is a very different phenomenon from decreases in the prices of a few consumer goods that do not drag down the average price level.

With the exception of Japan in the 1990s, sustained and general price deflation is not something we in the West have seen since the 1930s.

The depressions of 1921–1922 and 1929–1933 were accompanied by severe deflation, and so were depressions in the classical gold standard era.

After World War II, deflationary busts were no longer a feature of the business cycle. The reason this happened was that the business cycles of the post World War II era have been fundamentally different from those before the 1930s. In essence, the gold standard era had its own distinctive business cycle. Before 1931/1933, the West was on gold standards of various types. The UK, for instance, was on the gold standard between 1819–1914 and a gold exchange standard from 1925–1931. The US had a de facto gold standard from 1834.

The age of the classical gold standard, when many other countries adopted the system, was roughly from the 1870s/1880s until 1914.

The gold standard era had its own particular type of business cycle. In that era, contractions in the economy (busts) were usually shortly preceded by the collapse of speculative bubbles and accompanied by general deflation. That is to say, as output collapsed and the economy contracted, deflation was a concomitant feature of the contraction.

I. Does Deflation Cause Depression?
It is certainly the case the price deflation was not in general the cause of gold standard depressions. There are few economists who seriously argue that general price deflation is a single, overarching and actual cause of contractions in the business cycle. Rather, price deflation was a regular characteristic (or symptom) of a contraction in the business cycle. As an economy contracted, at the same time it experienced deflation. The actual causes of recessions and depressions are varied and different from deflation, although deflation could in theory make a depression worse.

Since depressions and recessions in the gold standard era were nearly always deflationary, this is where the link between deflation and depression originates.

But the question whether sustained deflation during a contraction in the business cycle exacerbates depressions (rather than causes them) is, of course, a completely different question, and the volume of evidence suggests that deflation does indeed make depressions or recessions worse.

II. Has Deflation Accompanied a Growth in Output?
Yes, without a doubt. In the 19th century, there was a period of sustained deflation that lasted from 1873 to 1896. The period, however, was not one of continuous economic contraction: there were internal periods of economic growth and contraction (expansions and depressions). The entire period from 1873–1896 was not a “depression” in the accepted sense, but a period where prices showed a general trend towards deflation. The conventional explanation for this prolonged price deflation is that in this period there was an inadequate expansion in the money supply: money demand outstripped supply (money being tied to gold in this era).

To study this period, we can take England as an example. From 1873–1896, England experienced price deflation, but had a number of business cycles you can see here:
1873–1879, depression
1879–1883, expansion
1883–1886, depression
1886–1890, expansion
1890–1894, depression.
Thus there were three economic contractions (genuine downturns in the business cycle, with slumping production, unemployment etc) in this period, but there were two periods of expansion: during these booms output increased despite general deflation, and overall the period saw increased output. So it must be admitted that the idea that deflation only occurs during depressions or recessions is a myth.

Cynicus Economicus argues that
It is worth noting that, if wages were to remain static in monetary unit terms during a period of steady deflation, the recipient of the wages would find the purchasing power of their wage increasing.
This is correct. In the period from 1873–1896, nominal wages did not fall significantly or as fast as prices. This meant that real wages actually rose and living standards rose as well.

However, it should be noted that, apart from the period 1873–1896, expansions in the gold standard era tended to be inflationary. For example, the sustained boom that began in 1898 in most countries and that continued until 1913 was inflationary.

But Cynicus Economicus goes on to argue that
if wages were to remain static in monetary unit terms during a period of steady deflation, … the person would, in real terms, see an increase in their wealth. Even if the person’s wage were to decrease in a period of deflation provided that the decrease is less than the rate of deflation, they would still be seeing an increase in their wealth. Why such an outcome might be viewed as problematic is entirely unclear.
The fatal flaw in this argument is that it fails to take account of the effects of large amounts of debt (or other fixed contracts like leases) during unexpected deflationary periods. If nominal wages remain constant but prices of goods fall (and hence sales earnings), eventually this will cause profits to fall if companies have debt to service or rent to pay.

III. Debt Deflation: It Creates Deeper and Longer Recessions
Cynicus Economicus argues that
That depression might create deflation is not to say that the deflation is itself problematic. When looking at the deflation scare, it is a genuine puzzle that the scare has been allowed to gain so much traction. There is simply no evidence that a deflation would take the economy deeper into depression.
It is correct that deflation is not generally the initial cause of recessions. It could even be said that, under certain circumstances, deflation itself is not problematic.

But under a combination of certain factors, deflation will be catastrophic.

When there is a depression or recession, and deflation occurs, there are reasons why deflation can cause deeper economic contractions. The crucial point is that, if there is a very high level of debt before a recession begins, then deflation can have devastating effects.

Quite simply, Cynicus Economicus does not address the issue of profit and wage deflation, loss of consumer income, and the effects of continuing deflation.

It is the interaction of factors caused by deflation in a recession that can lead to a self-reinforcing downward spiral of prices, profits and wages.

The crucial factor is that the deflation continues. If prices fall, eventually profits fall as well, and employers must cut wages or reduce employment.
Because of wage “stickiness,” businesses will often be forced to reduce employment, rather than reduce wages. Debtors will suffer when they become unemployed and have no income.

Recessions can cause deflationary pressures. When demand falls and consumption falls sharply, first inflation falls through distress selling. If demand and consumption do not recover (or indeed become worse), this cost cutting caused by businesses reducing excess inventory will result in actual deflation. During this process unemployment rises and there will be downward pressure on wages. If there are steep cuts in wages, then incomes are reduced: this is the real cause of debt deflation: unemployment and cuts to wages.

There is both empirical and theoretical evidence that large amounts of debt in an environment of unanticipated wage and price deflation has disastrous effects on economic activity (Zarnowitz 1992: 156; Caskey and Fazzari 1987).

The economist Hyman Minsky (1892; 1986) has studied in detail how such debt deflationary spirals occur in the context of financial crises.

Debt contracts are set in nominal terms. As debtors see their incomes falling (or are laid off), some will eventually be unable to service debt, not only because their nominal wages have fallen, but also because they pay back debt with money of greater value.

Thus debt defaults and bankruptcies increase, money supply contracts, and there are further falls in demand. Debt deflation is a problem for businesses as well. As profits decline, business themselves are subject to much the same problem as individuals. Their debts become a much greater burden. This causes additional falls in output as business go bankrupt. The economy enters a vicious cycle.

The classic example of a deflationary spiral was 1929–1933. Moreover, if a government lowers interest rates in an attempt to stimulate the economy but cannot reduce it any further (because it will approach zero or become negative), then there is also a danger of entering a liquidity trap, if banks do not lend money, and hold excess reserves which they refuse to lend for investment.

This is the recipe for a Great Depression.

IV. Wage Stickiness: An Old Problem
According to Classical economics, downward wage flexibility was supposed to prevent an economy from ever falling into a deflationary spiral and collapse. But nominal wages, like loans or leases, can be fixed by contracts that do not take account of future deflation. As is well known, wage levels in practice tend to respond slowly to economic shocks, and they simply cannot be adjusted instantaneously: wages are “sticky” (Arnold 2008: 167).

But when deflation occurs and nominal wages are not adjusted downward, then profit margins fall (Kumar et al. 2003: 8). Businesses are faced with lower profits. In the face of wage stickiness, the first response tends to be job losses rather than wage cuts. But higher unemployment simply causes further collapses in demand. Once again a vicious circle has developed.

The problem of wage stickiness is a well known one in modern economics. People in general object to having their nominal wages cut. Even managers often dislike across-the-board pay cuts. Recent studies suggest that employers avoid pay cuts because they diminish workers’ morale, and then falling morale reduces productivity (Bewley 1999).

Wage stickiness, then, is a problem that happens even in free market economies. The economic theory that drastic cuts in wages will be able to cure depressions quickly (a feature of neoclassical economics and the Austrian school) is simply a fantasy that takes no account of the empirical evidence from the real world.

One extraordinary example of deflation making a depression worse was the depression of 1873–1879. In this time, in industrial economies like Germany, deflation was accompanied by falls in profits and cuts to nominal wages in industry that reduced real wages and living standards (Kitchen 1978: 159). This was the longest economic depression in recent history: it consisted of 65 months of economic contraction with deflation (Glasner and Cooley 1997: 148, 734).

V. The Solution to Wage Stickiness: Fiat Money!
Since people find it difficult to accept cuts in nominal wages, even if the real wages remain the same or actually rise during deflation, a practical solution is the use of fiat money: the central bank fights deflation with an expansion of the money supply.

If fiscal policy is used to inject the new fiat money into the economy, this will cause inflation and end the vicious circle. Putting people back to work raises output and stimulates demand. Employers find that they no longer have to face the problem of wage cuts as real wages will adjust through the value of money slightly decreasing through later inflation.

Thus fiat money and reflation (and of course fiscal policy) are pragmatic solutions to deflationary spirals and depressions.

VI. Money Does not Rise in Value During Disinflation (High to Low Inflation)
Cynicus Economicus argues that
A good example of this can be seen in private mortgages on housing. If a loan is taken out in a high inflation environment, the interest rate will be relatively high. The targeted central bank interest rate will be high, and the lenders will seek to account for the high inflation by charging a rate of interest that will overcome the devaluation of the money that they are lending, such that they can achieve a positive return. If the interest rate is fixed over a period of, for example, five years and at year four the rate of inflation has fallen by a half, the holder of the debt is effectively seeing the value of their debt inflating. The earlier rate of inflation was eroding the value of their overall debt, and this was accounted for in the interest rate. However, with inflation falling, their debt value is no longer declining at the same high rate, but they are still servicing the debt as if this were the case. Their payments in relation to the actual value of the debt have increased.
The specific effect of debt-deflation Cynicus Economicus is talking about here is when money rises in value through deflation. That is, if you pay back loans in money of higher value later (when it can purchase more), you are experiencing a specific aspect of debt deflation.

But, in the example Cynicus Economicus gives, the real issue is that the debtor is paying a higher real interest rate.

You can calculate the effect of higher real interest rates in this example:
In 2000, a business takes out a loan for five years at a 15% interest rate when inflation is 10% and the bank thinks it will stay at around 10% for some years. The real interest rate in 2000 is 5%. But inflation falls to 5% by 2003. The real interest rate has risen to 10%.

NIR = nominal interest rate
I = inflation rate
RIR = real interest rate.

2000 15% 10% 5%
2001 15% 10% 5%
2002 15% 9% 6%
2003 15% 5% 10%
2004 15% 5% 10%
But this effect is different from paying the money back when it is of greater value through deflation.

We can quote this explanation from Wikipedia:
Deflation is a sustained decrease in the general price level resulting in a sustained increase in the real value of money and other monetary items. Money and other monetary items are worth more all the time during deflation as opposed to being worth less all the time during inflation. Deflation is negative inflation. Disinflation is lower inflation. Prices are still rising during disinflation, but at a lower rate. The general price level still rises, but at a slower rate resulting in a continued, but lower rate of real value destruction in money and other monetary items. A lowering of inflation is not deflation but disinflation. Deflation means the general price level is not increasing at all, but, actually decreasing continuously and the internal functional currency – money - and other monetary items are worth more all the time. Deflation causes an increase in the real value of money and other monetary items. Inflation destroys real value in money. Disinflation destroys real value in money more slowly. Deflation creates real value in money.
The debt deflation effect I have talked about earlier is when you pay back your loan in money of greater value owing to deflation. (But of course paying higher real interest rates is also a part of the problem under deflation and, to this extent, the two situations are similar.)

But, even under disinflation (the move from higher inflation to lower inflation), the value of money is still falling, because it is only the rate of inflation that has changed. You are paying back your loan at a higher real interest rate, and are not subject to the specific debt deflationary effect mentioned earlier. That effect requires that the value of money has fallen through actual deflation.

VII. Does a Move from High Inflation to Low Inflation Cause Debt Deflation and Depression?
Of course not. In a booming economy, when there is a fall in the rate of inflation, this will not have the same effects as long-term, severe deflation in a recession where there is a large amount of debt.

A change in the inflation rate from 3.5% to 2% over one year and then stable inflation at 2% in a booming economy with low debt and high employment will not be a serious problem.

Disinflation is not actual deflation. Average prices are not falling.

The crucial factors that would cause a serious debt deflation and exacerbate a recession would be as follows:
(1) High debt levels before deflation
(2) A recession (for example, caused in part by the collapse of a bubble)
(3) Significant falls in demand and distress selling
(4) Nominal wages at too high a level
(5) Long-term, unexpected and severe deflation in goods produced in an economy
(6) Significant falls in profits, difficulty in servicing debt
(7) High unemployment, business failures, cuts to wages
(8) Further collapses in demand
(9) Then back to (6), (7) etc above.
This is a deflationary spiral. This is similar to what happened in the Great Depression.

A fall from high inflation to low inflation and then stable inflation in an essentially healthy economy does not have the same effect.


Arnold, R. A., 2008. Economics (9th edn), Cengage Learning.

Atkeson, A. and P. J. Kehoe. 2004. “Deflation and Depression: Is There an Empirical Link?” American Economic Review 94.2 (Papers and Proceedings of the One Hundred Sixteenth Annual Meeting of the American Economic Association San Diego, CA, January 3–5, 2004). 99–103.

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