Tuesday, October 16, 2012

This Time is Different

I read Reinhart and Rogoff's book some time ago.   It is mostly a warning about making short term investments in other countries.   "This Time it is Different."   Unlike all the other times when investors have been burned by lending short to foreign governments and banks, this time the rapid flow of hot money is sustainable.    We will be able to get our money back.  Not likely, say Reinhart and Rogoff.

Of course, foreigners have been investing in the U.S. for some time now.    The U.S. government has been funding a large and growing national debt with T-bills sold to foreign investors.     And there has been substantial foreign borrowing by U.S. banks, including shadow banks.

Reinhart and Rogoff also show that a country receiving substantial foreign investment ends up in very bad shape when the investment flows are reversed.   When the foreigners stop rolling over their short term government bonds and bank deposits, then the net capital outflow is going to result in a reduction in real income.

Unfortunately, they and others have been misusing their work to provide excuses for the Federal Reserve's poor performance over the last 4 years.   Rather than the true message that financial crises caused by a large sudden withdrawal of foreign investment is bad for both the foreign investors and the country losing the capital, they have turned this into a claim that a financial crisis necessarily results in a deep and persistent recession.

In reality, the U.S. recession and slow recovery was and is due to incompetent Fed policy--the use of an interest rate instrument to target the inflation rate.   The solution is nominal GDP level targeting, and a seamless transition to the use of base money as an instrument any time interest rate targeting becomes ineffective.

Now, if foreigners lose confidence in the willingness of the U.S. government to repay its debts, or they decide that private investment in the U.S. is a bad idea, and a large net capital outflow develops, then real income in the U.S. will suffer.   In my view, the least bad policy would remain keeping nominal GDP on a stable growth path.   Trying to maintain the dollar exchange rate or prevent inflation--immediately due to rising prices for imported goods--would exacerbate the problem.

On the other hand, shifting to a more rapid growth path for nominal GDP would not prevent the inevitable loss in real income.    Reinhart and Rogoff have plenty of examples (it is almost the norm) where nations suffering the net capital outflow have massive growth in nominal GDP and massive inflation as well.   My view is that contracting nominal GDP to defend the exchange rate or the consumer price level is as bad, if not worse, than expanding nominal GDP beyond its existing trajectory in a futile effort to maintain real income.

But the U.S. has not suffered a net capital outflow at all.  Instead, the "crisis" here has been associated with a net capital inflow.

How many of Reinhart and Rogoff's episodes were about a financial crisis "caused" by increased foreign investment?    The U.S. in the Great Depression?    Was that inevitable?    Or was it a Federal Reserve disaster?

Anyway, it is still possible that the U.S. could suffer from a large net capital outflow.   This was the crisis that many economists were expecting.   Surely, it was the crisis that Reinhart and Rogoff were expecting--the one they wrote their book about!  

Running huge budget deficits and building up a massive government debt does not help avoid that problem--it makes it more likely.    The answer is, and has always been, a new monetary regime--a nominal GDP level target.


  1. Bill
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