The risks of large capital inflows
The “global savings glut” is a hot topic of conversation again among economists and policymakers courtesy of the recent debate between Ben Bernanke and Larry Summers over the sources of secular stagnation. In their debate, the former Federal Reserve chair and the former Clinton and Obama administration economic policy advisor, respectively, are focused in part on the sources of this world savings glut and in part on the roles those savings play in the lack of robust economic in the United States and other developed economies.
But it’s also important to think about what happens to all these global savings once they flow into other countries. A new working paper released last week highlights the costs and risks of large capital inflows on 69 middle- and high-income countries between 1975 and 2010,. That paper, released by the Board of Governors of the Federal Reserve System, digs into the effects of large inflows of capital on the performance of these economies. The authors of the paper, Gianluca Benigno of the London School of Economics, Nathan Converse of the Federal Reserve Board, and Luca Fornaro of Centre de Recerca en Economia Internacional, examine the high capital flows into these countries and find that their economic performances suffered suboptimal, to say the least.
The authors look at the trends in economic output and employment and find that while capital inflows for the entire country create a boom, the trends in output, employment, and productivity after the end of the inflows are lower than before the boom started. And, when they look just at high-income countries, they find that large capital inflows are often followed by “sudden stops,” when capital actually starts flowing out of the country and a recession is sparked.
Spain in the mid-2000s is emblematic of the effects of capital flows on economic output. Beginning with the creation of the Euro, massive capital inflows appear to have inflated a large housing and construction bubble in the country. When the inflows ended during the most recent financial crisis, the Spanish economy experienced quite a sudden drop.
Furthermore, Benigno, Converse, and Fornaro look at how capital inflows affect the allocation of resources in these economies between sectors. What they find is that capital inflows lead to a change in where capital goes within the economy. Specifically, the reallocation of capital is out of manufacturing and toward services that aren’t tradable, such as the construction industry in the case of Spain. Yet the reallocation of labor away from manufacturing toward services resulting from these capital flows only happens sometimes. When central banks increased capital reserves during periods of high capital inflows, their countries didn’t see labor moved out of manufacturing.
This shift could be responsible in part for the decline in productivity in economies that did not buffer their financial systems from high capital inflows. Manufacturing, especially in middle-income countries, has a higher level of productivity. The tradable sector, whose output is tradable internationally, tends to have higher productivity than the non-tradable sector, or domestic products and services.
Again, Spain is an obvious example. These capital inflows appear to have inflated a large housing and construction bubble in the country, which reduced total productivity growth, especially given the low productivity of the construction industry. This research is particularly relevant and important for policymakers moving forward as many of these episodes have happened over the past decade or so in developed countries in particular. As capital markets have been liberalized, large capital inflows into countries have become more common. Given the damage these large inflows can create, policymakers might want to think about the trade-offs from past liberalizations.