A post at Kiwiblog reminded me of an issue I have wanted to discuss for a while – the optimality of capital market intervention. In this post I aim to discuss some of the basic issues surrounding capital market intervention from a selfish-country perspective. Furthermore, I want to paint a picture where capital market intervention is actually optimal.
As DPF mentions it is fundamentally unfair that we want other countries to allow us fair access to their capital, but we are unwilling to give access to our own capital. Although this is true, the government of New Zealand is elected to maximise the welfare of New Zealander’s – not the welfare of people around the world. As a result, we have to ask if such controls are in the interest of New Zealand itself. Note: I would like it if other countries in the world cared about other people – sadly governments are really just local institutions that have been created to increase the bargaining power of a select group, so this isn’t the reality of it.
Fundamentally, the type of capital inflows that the government is looking at restricting are inflows of ‘financial capital‘. This capital funds our current account deficit, and is provided at the ‘world interest rate’. Limiting the inflow of ‘capital’ implies that we can only fund our current account deficit by reducing our outflow of capital (when we purchase assets overseas), or else we have to reduce our current account deficit, which pretty much implies we need to improve our ‘balance of trade‘ (exports – imports). In the first case nothing really happens – growth in our foreign assets fall in line with growth in foreign claims in our economy.
In the second case, the export price is determined exogenously (as we are a tiny country) and the underlying cost factors are unchanged this implies that we would have to reduce our imports – which would be the result of lower levels of consumption. How do we lower consumption – increase the domestic interest rate (note interest rates rises because the ‘supply’ of funds at every interest rate has fallen).
Think of it this way. Currently, the private economy wants to borrow and spend $X. However, the government wants to constrain the private economy from borrowing this – by limiting the amount the private economy can borrow. If the government believes that private borrowing is too high (which requires some sort of market failure among consumers – say a massive goods based prisoners dilemma), then this policy could make sense – as it liquidity constrains the economy.
Right, I have attempted an argument for why capital inflow restriction might be a good idea. Dr Rodrik also has some arguments why it may be a good idea. Can you guys suggest any other reasons why capital market intervention makes sense – or conversely why it might be silly?