Capital Flight is Good
Some people (Yves Smith and Tim Duy, to name two, but I’m sure there are many others that I haven’t gotten around to reading yet) are worried that concern about capital flight is going to have to be a constraint on the Fed’s ability to deal with this crisis. I disagree. I don’t think the Fed will or should be concerned about capital flight. In fact, I think capital flight is part of the solution, not part of the problem.
In general, capital flight is a problem if you care about quantities that are not denominated in your own currency. If all the quantities you care about are (or can be) denominated in your own currency, then you can just print as much currency as you need to replace the foreign capital. There are basically 4 situations where capital flight is a problem, which I will call the 4 Fs:
As long as inflation was a major issue, there were limits to what the Fed could do to stabilize the domestic financial system. It could only take on mortgage securities, for example, up to the point where it used up all its assets. In that situation, an absence of foreign demand for US securities might be a big problem.
If, as now appears to be the case, the risk of deflation is a bigger issue than the risk of inflation, then there is no limit to what the Fed can do. If it runs out of assets, it just prints more money to buy assets with. If foreigners refuse to buy US assets, the Fed prints money for Americans to buy them. If Americans refuse to buy risky assets, then the Fed can trade its own assets for risky assets through programs like the TSLF. Or lend money directly against risky assets. If foreigners withdraw capital, the Fed can replace it with newly created money. (Actually, it won’t need to, because when the proceeds from the withdrawn capital are converted out of dollars, the counterparty to that conversion will have dollars to invest.)
If the dollar weakens, so much the better. $2/Euro. $3/Euro. In the words of Chico Marx, “I got plenty higher numbers.” It might be a problem for Europe, but not for the US (and for Europe it would be a self-inflicted wound, since there is plenty of room to expand the supply of euros if there were a will to do so).
There is no limit to the potential magnitude of the Fed’s actions, but there could conceivably be limits to the effectiveness of those actions even as the magnitude becomes infinitely large. That situation is exactly one where capital flight would be a good thing. If the Fed can’t manage to stimulate the economy sufficiently by printing money, the stimulus has to come from somewhere else. Increased demand for US exports, due to a weak dollar, due to capital flight, is one of the chief candidates.
In general, capital flight is a problem if you care about quantities that are not denominated in your own currency. If all the quantities you care about are (or can be) denominated in your own currency, then you can just print as much currency as you need to replace the foreign capital. There are basically 4 situations where capital flight is a problem, which I will call the 4 Fs:
- Full employment. If all your real domestic resources are being used, then the withdrawal of foreign capital will mean the withdrawal of real resources, which will reduce your growth potential. This was an issue for the US in the late 90s. But today the US is not at full employment. And if you still think it is, just wait a few months.
- Fixed exchange rate. If you need to defend an exchange rate, the government will effectively have to supply exiting capital out of limited official reserves. This was a large part of the problem in the early 30s. But today the US does not have an obligation to defend its currency, nor does it have (about which see the rest of this post) and interest in maintaining its currency’s value.
- Foreign currency-denominated debts. If you have to pay back foreign currency, you’ll be in trouble if capital flight weakens your own currency and thereby makes foreign currency harder for you to get. This has been a problem in various places, particularly Latin America, in the past, but it’s not an issue for the US today: almost all our debts are denominated in dollars.
- (in)Flation. If your country is experiencing, or on the verge of experiencing, an unwelcome inflation, capital flight will exacerbate the problem by weakening your currency and thereby raising import prices. As of 8:29 AM on Friday, I still thought this was an issue for the US today. I no longer do.
As long as inflation was a major issue, there were limits to what the Fed could do to stabilize the domestic financial system. It could only take on mortgage securities, for example, up to the point where it used up all its assets. In that situation, an absence of foreign demand for US securities might be a big problem.
If, as now appears to be the case, the risk of deflation is a bigger issue than the risk of inflation, then there is no limit to what the Fed can do. If it runs out of assets, it just prints more money to buy assets with. If foreigners refuse to buy US assets, the Fed prints money for Americans to buy them. If Americans refuse to buy risky assets, then the Fed can trade its own assets for risky assets through programs like the TSLF. Or lend money directly against risky assets. If foreigners withdraw capital, the Fed can replace it with newly created money. (Actually, it won’t need to, because when the proceeds from the withdrawn capital are converted out of dollars, the counterparty to that conversion will have dollars to invest.)
If the dollar weakens, so much the better. $2/Euro. $3/Euro. In the words of Chico Marx, “I got plenty higher numbers.” It might be a problem for Europe, but not for the US (and for Europe it would be a self-inflicted wound, since there is plenty of room to expand the supply of euros if there were a will to do so).
There is no limit to the potential magnitude of the Fed’s actions, but there could conceivably be limits to the effectiveness of those actions even as the magnitude becomes infinitely large. That situation is exactly one where capital flight would be a good thing. If the Fed can’t manage to stimulate the economy sufficiently by printing money, the stimulus has to come from somewhere else. Increased demand for US exports, due to a weak dollar, due to capital flight, is one of the chief candidates.
Labels: Bernanke, capital, deflation, economics, exchange rates, finance, inflation, macroeconomics, monetary policy, US economic outlook
posted by knzn at 3/17/2008 07:15:00 PM
7 Comments:
increased demand for US exports? are you f'ing kidding me?!?!
"Sell the United States...sell its money...sell its stocks...sell its debt."
Ummmm.... WHAT?!?!
This is complete and utter nonsense. If you really believe this, then I've got my own Four Fs for you and they are all the same.
Oh... and if my word have offended you, just write a piece about how "Insults Are Good."
If people are truly this dense, maybe my Gold raft will keep me afloat after all.
"If the dollar weakens, so much the better. "
The purchasing power of people's money being stolen is a good thing? People who are paid and saved in dollars don't think a depreciating currency is good thing. Who it is good for though is some hack who went $100,000 in debt for an economics degree who can now pay it back in a weakened currency.
A weaker dollar in the foreign exchange market doesn't necessarily have a large effect on the overall purchasing power of the dollar; it just makes it more expensive to buy imports. And this is where I should get all patriotic and say "Those 'people who are paid and saved in dollars' ought to be better Americans and stop buying a bunch of foreign stuff! If they insist on buying foreign stuff, it serves 'em right that they have to pay more!"
Moreover, if they "saved in dollars" exclusively, they were being imprudent. It's not good investment strategy to have all your assets in the same currency. (The fact that they are paid in dollars is pretty much irrelevant; they can do whatever they want with the money as soon as the paycheck clears.)
Buy less foreign goods? You mean BMW's & Toshiba's...How about underwear wee don't make that here anymore. Get real...been to the deaprtment store lately. There is no Americsan stuff...hardly.
Imports are only 17% of GDP to begin with. Many of them have domestic substitutes. Many of them will have domestic substitutes in a few years if the weak dollar makes it profitable to produce those substitutes. Many of them come from countries that effectively peg to the dollar. Many of them are made by producers that will aggressively defend their market share by keeping dollar prices unchanged. Many of them are things people can do without anyhow.
I have a lot more sympathy for the people that will lose their jobs, or not be able to get jobs, because the dollar isn't weak enough to compensate for weak business conditions, than I do for people whose savings will be worth a fraction of a percentage point less in real terms because of the weak dollar.
I am in 100% agreement with you, KNZN, on the content of this post. The same logic leads me to believe that when EURUSD finally does head lower, it will be because the ECB prints more euros, not because we print fewer dollars. The dollar, and eventually the euro, price of "stuff" is going to go up. Ergo, I am turning bullish risky assets, and feel we have another major leg up in the commodity cycle ahead of us. The boom will continue until Asian undervaluations are completely eliminated through inflation, at which point we may have to worry about a serious contraction but that seems years in the future.
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