From Chapter 1 of the IMF’s recent World Economic Outlook (Box 1.2), a set of findings by Jörg Decressin and Marco Terrones:
The econometric results confirm that net capital inflows, financial sector reform, and total factor productivity are good predictors of a credit boom. Net capital inflows appear to have an important predictive edge over the other two factors.
The Econometric Results
These results are reported in a table of estimates obtained from logit regressions over a sample up to 2010:
Statistical significance is one issue. Another question is how much improvement in getting right signals does one obtain by adding financial reform and productivity to a basic specification using only net capital inflows? That is addressed in this depiction of the ROC curves for each model (although only for sample up to 2007):
Receiver operating characteristics (ROC) curves were discussed in this post.
There is a slight increase in predictive power, but the graph validates the conclusions made by the authors — most of the predictive power is in net capital flows.
How much do international factors matter? The authors include additional variables to account for foreign effects.
To explore the possibility that net capital inflows are capturing the effects of easy international financial conditions on domestic credit booms, we include in the regression analysis proxies for return (the real interest rate) and volatility (Chicago Board Options Exchange Market Volatility Index) in the United States. Although these variables have the expected signs, they are not statistically significant (Table 1.2.1, columns 7 and 8). Moreover, when included with net capital inflows, the predictive power of the volatility variable remains broadly unchanged (Table 1.2.1, columns 9 and 10).
I think this is a particularly interesting set of findings. As an international finance economist, my view had been that net capital inflows were particularly dangerous for the United States in that they resulted in increasing net indebtedness to foreigners that would eventually lead to foreigners dumping dollar denominated assets (see Chinn (Council on Foreign Relations, 2005)). A competing view was that the net capital inflows signaled financial excess (of course, the two are not mutually exclusive — both forces could be in effect, but with different strength). The findings reported here are more consistent with the second view. (There is of course yet another view, that all that borrowing was justified by the high productivity and entrepreneurial energies unleashed by the tax cuts of 2001 and 2003); ’nuff said of that.)
While net capital flows show up, it’s important in my view not to interpret the inflow as necessarily being “pushed” in from abroad (China, oil exporters in the years up to 2008), but also “pulled in” by policies, perhaps involving loosening of constraints on the financial sector. So, I don’t adhere to the Bush Administration’s “Blame it on Beijing” view as propounded in the 2009 Economic Report of the President.
Several policy implications flow from these findings:
… Given the high costs of credit boom-bust cycles, policymakers should closely monitor the joint behaviour of capital inflows and domestic lending. 6 There is also evidence that financial sector reforms are predictors of credit boom-busts. Policymakers must ensure that financial liberalization programs are designed to strengthen financial stability frameworks. Last, there is evidence that large productivity gains increase the risk of a credit boom, particularly in advanced economies, driven perhaps by exuberant optimism in new sectors. Thus, even during particularly good periods for the economy, policymakers must be on the lookout for emerging threats to financial stability stemming from credit booms.
I think this warning should be kept in mind when three years after the largest financial crisis in history, we see attempts to gut effective regulation of the U.S. financial system. From Moneyline.com:
Republicans will are likely to up attacks on the Dodd-Frank legislation that increases regulation on the financial sector as campaign season heats up, the New York Times reports.
Dodd-Frank aims to curb abusive lending practices, stop high-risk bets on complex derivative securities and protect consumers from financial fraud, among other goals.
Many of the bill’s provisions haven’t gone into effect, which will give Republicans new material to point out how President Barack Obama’s efforts to increase regulation will continue to hamper economic recovery.
“It created such uncertainty that the bankers, instead of making loans, pulled back,” says Republican presidential hopeful Mitt Romney, speaking at a South Carolina rally over labour Day weekend where he again called for the law’s repeal, the New York Times reports.
The bill does have its supporters, some of whom in turn admit the law may hamper job demand.
“Dodd-Frank is adding safety margins to the banking system,” says Douglas J. Elliott, an economic studies fellow at the Brookings Institution.
“That may mean somewhat fewer jobs in normal years, in exchange for the benefit of avoiding something like what we just went through in the financial crisis, which was an immense job killer.”
A replay of financial boom and crash is what we risk if we let the agents the financiers have bought off to sabotage regulating the financial system (as discussed here).
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