FINANCIAL CRISES, RESERVE ACCUMULATION AND CAPITAL FLOWS

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FINANCIAL CRISES, RESERVE ACCUMULATION AND
CAPITAL FLOWS

• Prabhat Patnaik

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The Concept of Stock Equilibrium A Central
Contribution of the Keynesian Revolution

• Keynes assumed Corner Solutions for most
  wealth-holders (Bulls or Bears) with only some
  marginal individuals on the borderline. We assume
  dense concentration at the margin, i.e. a
  representative wealth-holder with diversified
  portfolio (Kalecki, Kaldor)
• Stock Equilibrium implies that the perceived
  marginal rate of return is the same from all
  assets for the representative wealth-holder
• This marginal rate of return was expressed by
  Kaldor, following Sraffa and Keynes, as the own
  rate of money interest defined as
• r a i - ? c
• where i is yield, ? is risk premium, c is
  carrying cost, all at the margin and all in terms
  of the asset itself, and a the expected money
  price appreciation of the asset.

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• For stock equilibrium not only must r be equal
  for all assets, but, for each, it must not
  increase with the amount of the asset held.
  Inelastic price expectations ensure this.
• If there exists an asset whose r does not fall as
  the amount held increases, then this r is what
  prevails in stock equilibrium. There always exist
  such assets, e.g. time deposits. Such an asset
  then rules the roost.

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• Let us assume that in a developing economy before
  opening up to capital flows the rate of return
  was r, which was the rate on the asset ruling
  the roost. If this r exceeds the equilibrium
  rate of return (say e) in the advanced economies,
  then the demand for the developing countrys
  assets will increase. A new stock equilibrium
  will be established where e and r become equal,
  typically through r, now interpreted as rate of
  return in foreign exchanger terms, falling below
  r to the level e.

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• The mechanism through which this happens in the
  case of the asset that rules the roost is
  exchange rate appreciation, which, because of
  inelastic exchange rate expectations, generated
  fears of capital loss, and hence establishes
  equilibrium. For other assets it is a combination
  of both fear of exchange rate fall and also fear
  of specific price fall. Fear of exchange rate
  depreciation is therefore an equilibrating
  mechanism.

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• Such increased demand for developing countries
  assets following opening up is what causes
  financial crises. One can explain financial
  crises in a world of stock equilibria in terms of
  external shocks, but not in terms of the inner
  logic of the functioning of the system, unless
  some further theoretical additions are made.
• An obvious addition is to presume that
  expectations get revised at discrete time
  intervals. Then a stock equilibrium prevails on
  the basis of given expectations in any single
  period. But as expectations keep getting revised
  for the next period, based on the experience of
  the current period, we can have wild upsurges
  followed by crises.

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• Given the obvious disastrous consequences of
  financial crises in developing countries,
  governments have been taking steps to prevent
  such crises even while opening up. Holding
  foreign exchange reserves and stabilizing the
  currency is one such step.
• But this negates the very possibility of a stock
  equilibrium, since the fear of exchange rate
  depreciation, as mentioned earlier, is an
  equilibrating mechanism.
• In the example above, since e lt r to start with,
  if the exchange rate remains stable, then e
  continues to remain below r, and no stock
  equilibrium is possible.

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• From a discussion of stock equilibria we cannot
  infer anything directly about capital flows
  (since such equilibria can be established
  theoretically through a tatonement process with
  no actual flows whatsoever). But in practice
  higher demand for developing countries assets
  will be accompanied by larger financial inflows
  from the advanced countries.
• The negation of the possibility of a stock
  equilibrium, in the presence of government
  measures to prevent financial crises through
  exchange rate stabilization, will then mean a
  growing piling up of foreign exchange reserves
  (which will accumulate at an increasing rate
  since the very piling up removes any residual
  fear of exchange rate fall).

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• This is exactly what has been happening in India.
  The government has tried to prevent financial
  crises, not only by stabilizing the currency
  through holding foreign exchange reserves, but
  also by keeping a stock market boom going through
  providing stimuli in various forms. The net
  result is a massive pile up of foreign exchange
  reserves, to the tune of 200 billion in the
  course of just over three years.
• This fact paradoxically is mentioned with pride
  as an achievement of neo-liberalism. But while
  the reserves earn only about 1.5 percent, those
  who are bringing the foreign exchange that goes
  into the reserve earn huge capital gains, not to
  mention the yield on stocks. Even if we take a
  conservative estimate of 20 percent as their rate
  of return, the cost to the country of this
  borrowing dear to lend cheap comes to about 6
  percent of GDP per annum at present.

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• It may be thought that allowing a currency
  appreciation is an obvious solution to this. But
  currency appreciation, quite apart from the
  possibility of financial crises which it entails,
  causes domestic unemployment for workers and
  immiserization for peasants (who cannot adjust
  output and hence take lower prices). The very
  recent experience when some increase has been
  allowed in the value of the rupee bears this out.
• And what is more, this unemployment and
  immiserization occur even as the countrys
  external liabilities increase. The current
  account deficit in other words widens to absorb
  financial inflows at a given level of domestic
  absorption. By allowing an appreciation of the
  currency in the face of financial inflows, the
  country is borrowing to finance its own ruin.

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• This fact strangely is not often appreciated. The
  additions to exchange reserves by countries like
  India and China are often seen as reducing world
  effective demand. This is not true.
• If they did not add to exchange reserves then
  their currencies will appreciate, reducing demand
  for their goods. This will at best increase
  correspondingly the demand for the goods of those
  countries whose currencies depreciate relative to
  theirs. But it will certainly not raise aggregate
  demand for the world as a whole.
• World demand will increase only if countries
  accumulating foreign exchange reserves raised
  their domestic absorption. But this is a truism
  which has nothing to do with their accumulation
  of reserves per se. (For India, which does not
  have a current account surplus it would mean,
  moreover, consuming or making long-term
  investments on the basis of short-term
  borrowings, a singularly unwise move).

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• Countries like India thus get hit both ways. If
  they allow currency appreciation they suffer. If
  they do not, they still suffer.
• Karl Marx had seen crises as temporary and
  forcible resolutions of contradictions of
  capitalism. The same is true of financial crises.
  Preventing them also prevents the temporary
  resolution of contradictions of capitalism, and
  hence accentuates these contradictions, as we
  have seen.

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• This is not to say that crises should be allowed
  to happen it is to go beyond this choice by
  going beyond the existing capitalism that forces
  this choice upon us.
• For counties like India this will mean, to start
  with, capital controls, but that will generate a
  dynamic of its own which will necessarily impinge
  on the balance of class forces and hence engender
  further changes.