Rethinking capital flows

Brad DeLong has a good paper detailing how the reality of international capital flows has been different from what economists expected in 1990. In particular, economists expected rich countries (such as the US) to be net capital exporters to poor countries (such as Mexico and China) where low wages made the marginal return to capital favorable.

In practice this has not been the case. While the US has invested in factories in Mexico and China, those countries have found reason to send even more capital back to the US. Net net, money flows from poor countries to the US. Part of the reason for this is that the people with money in poor countries do not trust those countries, and so would prefer to bank their pesos in US$. While Mexico has a central bank, dollar/peso convertibility has rendered it dependent on the Fed. Another part of the reason is a "vendor financing" strategy by low wage manufacturers (China) to boost exports and support employment by giving money to Americans.

Brad is not sure what to do about this turn of event, and ends the paper tentatively suggesting that the US should boost aggregate demand by higher government spending, higher deficits, lower taxes, lower interest rates, and encouraging businesses to bear more risk.

Given that the US is in its current position because of low interest rates and excessive business risk, suggesting that the government tries to turn that handle again simply points to the damaging boom-bust cycle that's been instituted by the Treasury and the Fed. His other recommendations are flat out inflationary. Since the US has been able to manage it's enviable position by being the world's reserve currency, it seems risky to inflate it further. There are other reserve currencies waiting in the wings.

There is an excellent discussion of this dynamic on Naked Capitalism.