By Martin Wolf
Published: Last updated: June 1 2010 23:26
Fables seek to illuminate reality. The goal of the one I told last week – concerning “the grasshoppers and the ants” – was to provide a simplified account of the world economy. Today I wish to address two questions: who benefits from the trade flows between import-surplus grasshoppers and export-surplus ants? Can the two co-exist fruitfully?First, who benefits? My colleague, Robin Harding, raised this question in response to my advice to ants: “If you want to accumulate enduring wealth, do not lend to grasshoppers.” He asked: what about the gains for the grasshoppers?
The traditional answer is that both sides should gain from any voluntary exchange. That includes these “inter-temporal exchanges” – in which ants offer goods to grasshoppers now in return for future repayment.
Yet this assumes that the decisions are well informed, markets are flexible and contracts are enforced. None of these assumptions seems all that plausible. A reason people may not make informed decisions is, readers argue, that what some call “locusts” (financial capitalists) fool both grasshoppers and ants. At best, agency and information problems in financial markets make it hard for ants or grasshoppers to understand what is going on. At worst, locusts use their wealth and knowledge to rig the game to their advantage.
Financial markets are certainly subject to cycles of euphoria and panic. A big role is played by the property market. In good times, rising land prices provide collateral for leverage and an incentive for risk-taking. In bad times, a collapse in land prices may lead to mass bankruptcy and threaten to destroy leveraged financial institutions.
Some economists question whether the benefits of trade in goods and services apply to trade in finance at all. Jagdish Bhagwati of Columbia University wrote a famous article on these lines in the wake of the Asian financial crisis of 1997-98. In this he decried what he called the “Wall Street-Treasury complex”.*
In sum, we cannot assume that cross-border finance allows ants and grasshoppers to make wise decisions about the timing of lending and spending. Ants are likely to find that their funds have been consumed or invested in production of non-tradeable assets, such as housing. They are also likely to find it hard indeed to extract repayment from grasshopper colonies. True, inside the eurozone, powerful ant nations may be able to put the countries in trouble under central control, though even that would only be possible with smaller countries. But the equivalent will be impossible vis-a-vis the US – the biggest net debtor.
The implication seems to be that grasshoppers should at least benefit from an inflow of often unrequited resources. But that assumption is unwarranted if the outcome is unsustainable levels of consumption and underinvestment in capacity to produce tradeable goods and services. The economic collapse, when inflows of capital halt, can be very painful – even more so if a fixed exchange rate (or currency union) demands a period of falling nominal wages and prices. That, in turn, tends to raise the real value of debt, worsening the plight of the grossly overindebted grasshoppers.
In all, large-scale net flows of debt finance from ants to grasshoppers seem unlikely to do either side much good. Ants, it is true, do build up their productive capacity. But they also accumulate poor-quality assets and become dependent on what may well be unsustainable grasshopper demand. The economies of grasshopper colonies, in turn, come to depend on unsustainable capital inflows and excessive consumption. When the glorious party ends, both sides end up with big headaches.
This leads to the next question: is there a way to ensure ants and grasshoppers coexist harmoniously?
A part of the answer must be to reduce the instability of financial markets. This is the focus of the debate on regulation – a topic I have discussed previously. I would add two points here: first, seek to reduce the extremes of the property cycle by taxing the rental value of land; second, remove incentives for leverage from the tax code.
Yet the biggest single problem of the global system, in my view, is the attempt by ants to provide so much “vendor finance” to grasshoppers. In the end, both ants and grasshoppers have ended up disappointed. A more productive use of the surplus savings and productive capacity of ageing ant nests would be to lend to younger ones. So finance should flow to emerging countries, in general, and fixed investment in emerging countries, in particular. It is in the latter that the best opportunities for new investment should exist. It is the latter that are also most likely to generate the ability to service and repay the loans they have received.
This seemingly sensible proposition runs up against two huge difficulties: the first is that almost every attempt to generate large net flows of capital to emerging countries over the past three decades has ended up in a crisis; the second is that, as a result, the emerging world has decided to run current account surpluses and recycle those surpluses into ever larger foreign exchange reserves: in 2010, for example, according to the International Monetary Fund, the current account surplus of emerging countries will be $420bn, with an accumulation of reserves of $630bn.
Thus, in aggregate, emerging countries are recycling current account surpluses, plus the net private capital inflow, into reserves. Nearly all of these surpluses are generated by emerging Asia, in general, and China, in particular, though these countries have the best investment opportunities.
So long as this remains true, the grasshopper colonies of the developed world are likely to remain net recipients of capital, which they will surely continue to waste. Yet, under the pressure of the crisis itself, many erstwhile grasshopper colonies are being forced to become more “ant-like”. If today’s rich ant nests do not change their behaviour, potential surpluses will be huge. Either the emerging world as a whole starts to absorb these surpluses into potentially productive younger nests, or the world will be stuck in a demand trap, with everybody seeking export surpluses.
Flows of finance from export-driven ant nests to advanced grasshopper colonies end in tears. Flows of finance from old ant nests to young ones have not worked out either. If a way is not found to fix these failures, the open global economy itself may disappear.
* The Capital Myth, Foreign Affairs, May/June 1998, www.foreignaffairs.com
Copyright The Financial Times Limited 2010.
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