Capital market intervention: How can we make it sound like a good idea?
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?
You’re too generous Matt, I really don’t think that this policy ever makes sense. I accept that a government might think consumption is too high, but there are much better policies to combat this (consumption tax, savings subsidies). But you should mention that the adjustment to restricted capital inflows would also come through lower investment (which seems to be Rodrik’s concern, investment bubbles). Does the government think we’re investing too much?
Rodrik’s argument is mainly ass IMHO. It’s another version of “markets lead to bubbles, bubbles are bad, hence markets are bad”. I’m not convinced by either of the first two premises.
The benefits of financial diversification are important. Owning foreigners’ assets, and having them own ours, is positive sum. From that starting point, I’d need a lot of convincing that this policy internvention is beneficial.
“You’re too generous Matt, I really don’t think that this policy ever makes sense.”
Indeed, I’m not in any way pro-capital controls, however I think it is important to sometime try to make your best argument for a policy you don’t like – just to see if you learn anything. So I’ll try to argue the points you’ve raised, even though I agree with them 😉
“I accept that a government might think consumption is too high, but there are much better policies to combat this (consumption tax, savings subsidies)”
A consumption tax does not necessarily imply that the value of private consumption will fall if borrowing can be increased. If our agents are the headless chickens that Dr Cullen believes (or if agents believe that it is a temporary tax) – it is possible that these schemes could just lead to more borrowing. As a result, it might be more effective to just directly limit borrowing by limiting capital inflows.
“adjustment to restricted capital inflows would also come through lower investment”
It would, as we have higher domestic interest rates. However, this policy would just take away the ‘worst investments’ as the cost to capital would be higher – making more rubbish investments not-economical. Doesn’t this imply that we are making more productive use of our limited capital?
“Rodrik’s argument is mainly ass IMHO.”
I’m not going to defend his argument as I don’t really agree with him either – and I’m having enough trouble trying to make my own one 😉
See, now I think that that quality economic thinking is an all-too-scarce resource that could be more efficiently allocated to not constructing a rational explanation for the poll-driven machinations of dimwits 🙂 But nonetheless, I admire your quixotic quest…
“A consumption tax does not necessarily imply that the value of private consumption will fall if borrowing can be increased.”
Ricardian equivalence? Now you’re getting desperate. But remind me to quote you back at you next time we’re talking about whether externality taxes are a good idea. 😉
“Doesn’t this imply that we are making more productive use of our limited capital?”
Yes I agree. If we blew up half our capital with dynamite, capital productivity would probably increase. is that Labour party policy yet?
Now if I was trying to defend the idea I might head down the “undermines national sovereignty” route… luckily I’m not that masochistic.
“Ricardian equivalence? Now you’re getting desperate.”
Ricardian equivalence – or possibly habit formation. If we felt that people solely followed rules of thumb, and formed habits with their consumption, then a consumption tax may not be the least cost way to reduce the level of consumption.
“Yes I agree. If we blew up half our capital with dynamite, capital productivity would probably increase. is that Labour party policy yet?”
But this policy actual leads to the removal of the least efficient types of capital investment.
Don’t forget that the higher interest rates, and limit on borrowing, will actual lead to greater private savings in order to fund this investment – which will in turn ensure greater domestic ownership of these higher quality assets (especially since New Zealanders are still able to buy overseas assets). In the lower interest rate case, domestic savings was lower – implying that asset accumulation would also be lower.
“Now if I was trying to defend the idea I might head down the “undermines national sovereignty” route… luckily I’m not that masochistic.”
I don’t think I could attempt that route without dieing a little inside 😉