Monday, January 30, 2006

Capital Flows from the Poor to the Rich

From Reuters, via USA Today, some hand wringing from bureaucrats:
DAVOS, Switzerland (Reuters) — Massive flows of capital from the emerging to the developed world are unsustainable and risk damaging both poor and rich countries, some of the world’s top finance officials said on Saturday.

Speaking at the World Economic Forum in Davos, European Central Bank President Jean-Claude Trichet said that the current global investment pattern was “profoundly abnormal” and in no country’s interest.

“It is not sustainable in the long run that the emerging world would finance the industrial world. It doesn’t correspond to the interest of the emerging world, neither to the interest of the industrialised world,” he said.

In a similar vein, Indian Finance Minister Palaniappan Chidambaram said countries like his, one of the emerging stars on the global economic scene, were under threat.

“Global imbalances are deepening and that has serious consequences for developing countries like India,” he said.

The United States is currently seeing huge inflows of capital from the developing world, notably China, that are financing its current account deficit, bolstering the dollar and keeping long-term interest rates low though bond purchases.
Finding that capital flows from less developed to more developed nations would seem to violate basic laws of economics.

With capital, like everything else, diminishing marginal returns should apply. Where capital is scarce, modest investments should generate large returns.

(In the Third World, this usually involves exploiting cheap labor. For the economist, “exploitation” is not a bad word.)

As capital becomes more plentiful, the returns should decrease, as all the opportunities to invest for a large return have been exhausted.

So why doesn’t this economic logic seem to apply? Because politics intrudes.

While underdeveloped nations have opportunities for large returns on capital, investment there also involves large risk premiums. There may be chronic instability (many parts of Africa and the Middle East). Or current stability may seem tenuous, as it is obvious that the society must undergo a wrenching transformation (China or Saudi Arabia). Or a government that doesn’t respect property rights may be in power (Russia or Venezuela).

In all of these cases, investors are going to expect a larger return on capital than they would get in the United States. After all, if the expected return is equal, you are going to go with the safe investment.

So one way to interpret these capital flows is that “they” are “getting what the deserve” given their inability to create a proper climate for investment.

Unfortunately, the truth is often that the common people are getting hurt because of the irresponsible actions of elites. So we’ve got to be clear on who “they” are.

But in some cases, ordinary citizens are complicit, as when they elected Venezuelan president Hugo Chavez.

Either way, the free market will do what it usually does: punish economic folly, and reward economic prudence.

And the fussing and fuming from the “social justice” crowd at places like Marquette won’t change it.

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