Saturday, December 3, 2011

Why doesn't capital go where the greatest returns are

This post developed from thoughts from comments here. I think China's ace, which could also be considered its curse, is that it has a glut of people it has to provide employment for, or its society may break down. Hence its policies. I think US's ace, which could also be considered its curse, is that it has a glut of capital it has to provide a return for, or its society may break down. Hence its policies.

Capital tends to congregate in the US because of its perceived safe haven. China population is stuck in China because of the constraints of its nation-state borders. We know why they are stuck, but why does all the world capital necessarily have to congregate in the US? Capital is supposed to be free to go almost anywhere in the world nowadays.

This is something that the proponents of market liberalization had not counted on. Capital mobility was promoted as one of the hallmarks of globalization because its natural inclination was supposed to be to go where the returns are, and hence, it was supposed to go to all corners of the world in search of profit, until all the world's frontiers were finally ushered into the same first world standard of living.

It did not happen that way. In its stead, each unit of capital tended to go lemming-like to anywhere in the world the rest of capital tended to go. Where all other capital-holders were going was where returns were being harvested. And because investment return was self-reinforcing, more capital going to one area tended to increase the asset values of its targets there. Hence, it would induce others to pile on and further magnify the positive returns of those who were coming into that area.

It all goes well until people start to believe pie in the sky visions of ever increasing returns. Then the first few capitalists start getting out, stopping the upward trajectory, and thus encourages further others to also cash out. This then now leads to a downward cascade of asset values, leaving those who are slower to move to panic, and finally to leave the area, sometimes, worse off than before the capital ever came.

We see this happening again and again, everywhere. When the barriers to capital mobility first came down, capital did go to the farthest frontiers of the earth, in search for its pot of gold. But once this reflexivity process has driven a local area into manic booms and panicked busts, capital once again leaves that area, and because capital mobility goes both ways, it now brings back with it previously indigenous capital and takes it along for the next wild ride. Example, when barriers to Eastern Europe and to China investment first fell, first world capital came to Eastern Europe/China. Then when capital jacks up the rate of return to the zenith there, capital will once again leave, taking along some home-grown capital, which should have stayed there and built a more sustainable growth, because local capitalists now realize that the piling up of foreign capital to domestic assets has now led to asset values ripe for a crash. Where they want to be is in a safe haven.

Because of the great losses that a crash unleashes on the local populace, especially those who who were the last ones into the headiest assets that crashed, it would likely be years before local capital will once again brave the market again. The aftershocks of the locust-like rampage of capital has probably left an economy over-invested in sectors that now stand devoid of demand, and under prepared in others where a flicker of demand can lead back to a more sustained growth across all sectors.

The irony of it all is that with the liberalization of capital also came the dismantling of laws and institutions of government that would have enabled it to be the investor of last resort in the face of such manic capital merry-go-round. Not only did liberalized markets leave the gates open for some capitalists who turned out to be mere short-term speculators (barbarians), they also threw away the tools that they would need to rebuild once the barbarians have come and gone. All that's left is finger-pointing as to who's at fault. Such is the behaviour of people who have no other choice but to sit, close their eyes, and wait for either a miracle or for it all to end. Moral of story is, when you liberalize the market, you also need to strengthen government to act as cleanup crew in case things get out of hand.


ArmchairAnalyst said...

I think liquidity is an under-rated factor in looking at capital flows, in this case, where "liquidity" is broadly defined as the ease at which one can enter/exit a trade, i.e. change their mind on a decision.

For example, with US treasuries, it's reasonably easy to "stop out" on say a bad decision made to hypothetically buy 10 year bonds expecting the yield to fall say 50 bp when in fact it rises by 50 bp.
You just sell to any number of investors who trade what are the world's most liquid securities.

But say a "developing country" bond, although the return/yield is much higher, if it all goes pear shaped then it's much more costly to exit the postiion. Partly because there are less investors in the market with differing views to yours. In other words, you have to be totally committed because it's difficult to turn back.

So basically capital is attracted to the US because US treasuries allow you to change your view more easily.

Mario said...

great stuff. more interesting paradoxical and circular "ties" we find ourselves wrapped up in with our economies. You have a knack for bringing these ties out to the forefront.

Moral of story is, when you liberalize the market, you also need to strengthen government to act as cleanup crew in case things get out of hand.

right...the irony of course being that those who seek to "liberalize the markets" are also the same people who absolutely abhor "regulation." That's one of the main reasons why they fought so hard to "liberalize" at all (note the sub-text of such diction). One more spinning wheel all alone in the universe....

Rogue Economist said...

AA, I see what you're saying about liquidity in US securities, although it doesn't relate to the more general point of the post, which was that the previously closed markets of the world were liberalized with the intent of attracting capital to them.

But global capital, at least as we see right now, still converged even further in the US, a market that was long ago fairly open and ready to take the rest of the world's capital, without need for liberalization elsewhere.

Thanks Mario. I think we find too many paradoxes right now because of the prevalence of ideological beliefs rather than complete understanding of the economy. Example, today most economists are either on the side of free market enthusiasts who hate all forms of government, or they're on the side of progressives that espouse the virtues of all-consuming government, and believe that the free market only leads to evil.

The right mix of course is somewhere between the two, and the optimal mix varies over time. Right now, we need to swing the pendulum slightly back because we over-reached on free market.

miltonf said...

Capital is free to move about and it doesn't always go to the highest return because risk is also built into the Equation. That's why capital prefers US Treasuries rather than Italian bonds.

Mario said...

it's true miltonf however why not AU and Canadian bonds too? The risk is just as low there as with fact if we were basing our investments on the corrupt crooks at S&P then both AU and CA are LESS risky than UST. So there are other things going on here than just true "risk" analysis. Ironically it appears with with MORE freedom there actually becomes LESS variance.

Rogue Economist said...

miltonf, you're focusing too much on the rhetorical question, why capital doesn't go to the the highest return destination. The point of the post is to call attention to capital being freed to go to in search of return as justification for complete liberalization.

The expectation of liberalization was that capital will disperse everywhere. What we saw is that capital did go everywhere, but as a horde. It came as a horde, it left as a horde.

Return wasn't the whole picture, and you're right, risk is the other half of the equation. That's why complete capital mobility is very unstable, and likely to break an economy as it is to make it. It needs a filler when it suddenly decides to leave a place, so those who never meant to leave do not leave along with the 'hot' members of the horde.

Mario said...

It needs a filler when it suddenly decides to leave a place, so those who never meant to leave do not leave along with the 'hot' members of the horde.

that's an interesting point as well. I think it's more of an expectations or confidence issue than any "real" or quantitative least for monetary sovereign nations like the US, AU, GB, JP, etc.

For countries in the EU this presents very real issues as we see today.

Personally it would be great when our leaders realized that for most nations, bonds are just savings accounts and have the same effect for both sides of the transaction. When people realized this, the only real default risk is insane fools holding the purse strings.

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draftnik said...

The biggest problems are very volatile and unstable global markets. The investors build its activity on the markets moods and fair that capital which will place in right place will be return with profit. Actually not only with profit but just only return is something will go wrong.

Mario said...

Rogue...and how about this today:

Mike focuses, rightly so, on the debt crises, however in this case the focus could be the ZERO % INTEREST RATE!! wow

Rogue Economist said...

Mario, you've got my point right, and I want to reiterate that the confidence fairy as I mean it here is one who tells everyone he will be the investor of last resort in initiatives that create jobs that sustain aggregate demand, not necessarily in overbid up securities that need to correct.

Re: Mike Norman's post. It could not get any clearer than that, and in the face of the facts, it's hard to believe anyone still believes the problem in the US right now is too much sovereign debt. There's another agenda there for those who want to cap the debt, and it has nothing to do with the debt.

Mario said...

+1 ;)