One overlooked implication of the sell-off in emerging markets is that the global financial system is more dysfunctional than generally thought.
I say this for a simple reason - that one contributor to the sell-offs has been concern about some countries' current account deficits. Such deficits, says Russell Jones at Llewellyn Consulting, leaves countries "vulnerable to capital flight in periods of global risk aversion". Sure enough, countries such as South Africa, Brazil and Chile, all of which have deficits, have been hard hit.
But here's the thing. In one context, these deficits are small. South Africa's is larger than most; the IMF expects it to be just over 6 per cent of GDP. But even 6 per cent is not much. If a man with good prospects on £30,000 a year could not borrow £2,000, we'd consider the domestic financial system to be grievously flawed. Why, then, should we not think the same of the global financial system?
The fundamental purpose of a financial system is to move finance from savers to borrowers. But countries can't easily borrow a few per cent of their income without talk of a crisis; this is the so-called Feldstein-Horioka puzzle, named after the economists who pointed it out back in 1980. Something, then, is wrong. But what?
Part of the answer lies in the old cliché that investors hate uncertainty - that is, risk that can't be quantified. And emerging economies are unfamiliar and uncertain to western investors. Most British investors, for example, feel more comfortable investing in the US - thanks to its cultural hegemony - than we do in Turkey or even South Africa. What's more, we can't diversify these uncertainties away because - as we've seen - falls in one emerging market tend to be accompanied by falls in shares around the world.
All this means we invest in unfamiliar nations only when we are unusually tolerant of danger - when money is cheap and economic activity high. This means that such countries can't borrow much in normal times and when they do are vulnerable to "sudden stops" - big outflows. The fear of this also prevents them from borrowing much in the first place.
But there's something else, pointed out by Ken Rogoff and Maurice Obstfeld. They say that the costs of cross-border trade in goods and services stop countries borrowing a lot from overseas.
Such trading costs mean that most of what we spend goes upon domestic goods and services. This means that when a country's spending exceeds its income - that is, when it runs a current account deficit - there'll be high demand for domestic goods. This in turn means their prices will be expected to fall - because countries can't run deficits forever and so there will have to come a time when its income exceeds its spending, which can only mean that there'll be less demand for domestic goods and therefore lower prices. And if people expect prices of domestic goods to fall, it follows that the expected real interest rate will be high. But if real interest rates are high, people won't want to borrow much. This prevents current account deficits from being big in the first place.
Whichever of these explanations is correct, the implication is much the same. For all the talk of globalisation, we don’t live in a fully globalised world. Finance, goods and services don’t flow as freely between London and Istanbul as they do between London and Manchester, which means that the global economy is not the domestic economy writ large: countries can’t borrow as freely as individuals.
All that excited talk about a "flat world" and hyper-globalisation a few years ago was bunkum. Worse still, so too is the idea that the global financial system serves the textbook function of efficiently matching savers to borrowers.
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Chris blogs at http://stumblingandmumbling.typepad.com