Harmful credit cycles

Developing countries with fully opened capital account are overexposed to boom and bust cycles in international credit flows. During boom, they borrow too much enjoying the capital inflow disregarding the risk; during busts, the flow turns around (sudden stop) triggering the financial crises. The flood of capital into Latin America in 80s, or in East Asia in 90s were no exceptions, those episodes just repeated that destabilizing pattern. Recent empirical literature has established a strong relationship between capital market liberalization and financial instability.

Unrestricted capital mobility pose huge welfare costs for developing economies, the acknowledgement of this fact led some countries to start imposing prudential control on international capital flows. The global financial crisis invigorated experiments with capital control. Taiwan, Korea, Indonesia, Thailand and Brazil introduced curbs on capital inflows in 2009 and 2010.

The proposed study has the objective of developing a dynamic stochastic general equilibrium (DSGE) model to quantify the parameters of welfare maximizing ex-ante macroeconomics policy. The research focus is on microfoundation of “overborrowing” in developing countries. (this is actually my research proposal for PhD in Economics)

Welfare-based analysis of the gains and costs of capital flow management for individual countries and the rest of the world is a very recent area in macroeconomics. Until recently, theoretical literature could not explain a wide variety of capital account policies that we observe in both developing and developed countries. Meanwhile, welfare benefits for trade international cooperation have been widely studied, however welfare benefits for international cooperation of capital account policies (Costinot et al, 2011, an exception) is completely a new ground. Yet, those topics are highly connected, since real exchange rate can be distorted by managing capital account. Issue of opennes of capital account needs futher research.[1]

Modern capital controls were developed by the belligerents in World War I to preserve a tax base to finance wartime spending. Controls began to disappear after the war, only to return during the Great Depression. At that time, their purpose was to permit countries greater ability to reflate their economies without the danger of capital flight. In fact, the International Monetary Fund (IMF) Articles of Agreement (Article VI, section 3) signed at the Bretton-Woods conference in 1944 explicitly permitted capital controls. One of the architects of those articles, John Maynard Keynes, was a strong advocate of capital controls and the IMF often was seen as such during its early years. During the Bretton-Woods era of fixed-exchange rates, many countries constrained asset transactions to cope with balance-of-payments difficulties. However, recognition of the costs and distortions created by these restrictions led to gradual removal of all limitations on buying and selling of both stocks and bonds internationally during the 70s and 80s. The United States, for example, removed its most prominent capital controls in 1974. During the 1990s, mostly under the pressure of developed economies, developing countries began to liberalize trade in assets as well. (Neely 1999). Before 1999 contrary to many topics in macroeconomics, capital controls have received cursory treatment in textbooks and scant attention from researchers. In the early 2000s, the established consensus that capital controls – like tariffs on goods – obviously detrimental to economic efficiency begun to break down. Large capital flows to developing countries in 80s and 90s posed a new problem to policymakers. Then a series of exchange rate/financial crises in both developed and developing countries in 90th. Today the global financial crisis has been followed by experiments with capital control. Taiwan, Korea, Indonesia, and Thailand introduced curbs on capital inflows in 2009 and 2010. Brazil in October 2009 introduced a pro-cyclical tax in all capital inflows except FDI; these measures are consistent with the last academic advancement in this area of macroeconomics. Today IMF again endorses capital controls as useful policy responses to certain circumstances (Blanchard 2012).

Recent crisis drew attention to credit booms. Schularick and Taylor (2009) after analyzing the dataset for the years 1870-2008 covering 12 developed countries, where they decoupled money and credit aggregates, showed that leverage in financial sector has strongly increased since the second half of the 20th century. At the same time, there has been a fall in safe assets on banks’ balance sheets. From 1870 until 1939, money and credit were volatile but maintained approximately steady relationship to each other and to the size of the economy (the Great Depression is an exception). After WW II, the huge growth in the use of credit and increasingly complex forms of leverage, along with a steady decline in bank-held safe assets such as government securities, led to an unprecedented level of risk throughout the credit system up to 2008. They assumed that the belief that central bank would prevent the collapse of a nation’s currency (moral hazard) led to this unprecedented risk tolerance by private sector. The main observation, however, is that behavior of credit aggregates is the single best predictor for the likelihood of future financial instability. The long-run record shows that recurrent episodes of financial instability have more often than not been the result of credit booms gone wrong. The policy implications are straightforward; credit cycles need supervision and moderation.

Situation in credit cycles for developing countries is much more perilous. Developing countries exhibit financial amplifications.[2]  When a country experience shocks that lead to a decline in aggregate demand, their exchange rates depreciate and asset prices fall. This results in a declining value of collateral (balance sheet effects). In the presence of financial market imperfections, such balance sheet effects constrain the access of economic agents to external finance, which in turn forces them to cut back on their spending and contract aggregate demand further. In other words, a financial amplification is a mechanism that amplifies economics shocks.[3] Noteworthy is that exactly this amplification is happening right now in Russia, where I am writing this proposal. Russian economy is having too much debt with short maturity nominated in foreign currency. The fall in oil prices and sanctions led to a devaluation of local currency that, in turn, devalued assets, including collateral and this further contract the aggregate demand. Russian monetary authorities made a mistake that led to a “twin” crisis that was first noticed back in 1999. The idea originates from the paper by Kaminsky and Reinhart (1999). In this empirical paper researcher found that problems in the banking sector typically precede a currency crisis and that a currency crisis deepens the banking crisis, activating a vicious spiral. Importantly, they also found that financial liberalization often precedes banking crises. Similar results were repeated in different papers using other methods (e.g. Glick and Hutchison, 1999). The punch line that that openness of emerging markets to international capital flows, combined with a liberalized financial structure, makes them particularly vulnerable to, first, currency crisis and, second, banking crisis.

Carlos Diaz-Alejandro (1985) gave an insightful explanation of how reforms for freeing domestic capital market and financial innovation leads to financial crises. The boom-bust credits patter he described primarily in context of Latin America is universal (Reinhart 2014). Overborrowing of private sector is the outcome of moral hazard, which arises when investors believe they will be bailed out of bad investment by the taxpayer. This bailing out may be carried out by the treasury, the central bank, or by international agencies. In this sense, the taxpayers subsidized the investments. Current empirical literature validates the assertions of Diaz-Alejandro. Recent empirical work, Magud, Reinhart, and Rogoff (2011) merged 30 empirical studies and concluded, among other things, that limiting private external borrowing in the “good times” plays an important prudential role, because more often than not countries are “debt intolerant”, in other words banks cannot withhold a sudden stop. In general terms there is a consensus that international financial integration and openness to capital flow provide little if anything by way of boosting long-run growth (Jeanne 2012). In a way, two economists Kenneth Rogoff and Carmen Reinhart in 2008 drew a line in empirical evidence. Most empirical works had been focused on two or three decades of data, but Rogoff and Reinhart analyzed eight centuries of data and found that capital mobility has a direct relationship with incidences of financial crises (Reinhart and Rogoff 2008). Interesting that in early 2000s, as demonstrated in a voluminous literature review by Joshua Aizenman (2004), financial opening was seen as a complicated trade-off. Some researcher was able to associate a financial opening with a higher rate of growth, meanwhile opening and liberalization is risky, so it should be done but with proper prudence.

The fact is established – the world failed to live up to the purity of classical models. Unrestricted capital mobility pose welfare costs for economies, especially for developing, where welfare costs of macroeconomic volatility are particularly large (Loayza et al. 2007) and where markets often fail or/and instistutionas are weak.[4] For a developing country, instruments such as dollar debt are comparatively cheaper, but they impose risk on borrowers in case the exchange rate depreciates. These debts also do not involve risk sharing, like local currency debt or, even more so, equity and FDI. Borrowers do not internalize the exchange rate risk that these actions pose on balance sheet. As a result, they unintentionally contribute to financial amplification. In a way, financial fragility is an uninternalized side-product of external financing, just as air pollution is an uninternalized side-product of driving. It is optimal for drivers to enjoy the benefits of their mobility while disregarding the pollution that they impose on the rest of society, since each driver knows that her individual contribution to air pollution is minuscule. In aggregate, however, there will be excessive pollution if all drivers act this way. In other words, clean air is a public good and will be subject to a “tragedy of the commons” in the free market equilibrium (Korinek, 2012). The described outlook shapes a natural role for ex-ante policy intervention, or prudential capital control.  The best example of this policy today is a Brazilian pro-cyclical tax mentioned earlier. In a way, it is a Tobin (1978) tax that “throw some sand in the wheels of our excessively efficient international money markets” because real factors such as capital and labor cannot keep up leading to painful episodes of adjustment in the real economy. Again something that I observe today in the ongoing situation in Russian economy. Rapid devaluation of ruble caused a cost-push inflation that, in turn, created an inflation expectation, so that prices on all products, with different time lags, are getting high. That, in turn, would cause nominal wages to go up. The period of constantly changing relative prices along will stumble growth.[5]

Excessively volatile credit cycles with over-borrowing problem and financial fragility (exchange rate risk and balance sheet effect) cost a lot in term of welfare for developing countries. First reason for that is deviation from a smooth path consumption. Second reason is a negative impact on output growth and thus on future consumption. Ramey and Ramey’s seminal paper first empirically documented the effect of volatility on growth back in 1995. Most literature on the empiric of financial liberalization relies on cross-country methodology; posing a serious pitfall on evaluating the net-welfare effects. There is no conclusive data to understand if Korea would have been better off by refraining from financial opening in the early 1990s, or if Chile would have benefited by retaining financial repression in the 1980s and 1990s. Some economists (e.g. Haggard 2000) argue that Korean crisis of 1997 could have prevented much deeper and longer calamity, like the one in Japan. The beginning of both crises had common nature – domestic banks accumulated nonperforming loans over time. Meanwhile, Chile’s GDP tripled since the beginning of 2000s and country has a sound banking system, and one could say that it was the result of the painful earlier reforms that were triggered by the crises of the early 1980s.

That is why a formal welfare-based analysis is required. It is quite possible that the private sector fully recognize the risk of a potential aggregate shock and include it in their decision. The fact that agents borrow at a very large extend could be because gains from increased investment today fully compensate for the costs of financial troubles in the future. Therefore, the task is to show overborrowing in equilibrium to warrant ex-ante intervention. It has been archived (financial amplification is exactly this fact relabeled) by capturing exchange rate, price or interest rate externalities (Korinek, 2012). The new area is quantification of optimal tax and welfare costs, the best method for that would be a DSGE model. There are examples of this approach. Bianchi (2011) quantified welfare gains and optimal tax rate for Argentinian data. As in Lorenzoni (2008), he analyzed constrained efficiency by considering a social planner that faces the same financial constraints as the private economy, but internalizes the price effects of its borrowing decisions and then calibrated the model to get the numbers. In order to specify meaningful DSGE model I would need to study overborrowing problem on micro-level first, however as a hypothetical research direction the work by Bianchi (2011) can be extended by including explicit role for financial intermediation, as in for example Gertler and Karadi (2010).


Aizenman, Joshua. 2004. “Financial Opening: Evidence and Policy Options.” Challenges to Globalization: Analyzing the Economics (University of Chicago Press) 473-94. http://www.nber.org/chapters/c9547.pdf.

Bianchi, Javier. 2011. “Overborrowing and Systemic Externalities in the Business Cycle.” American Economic Review 101 (7): 3400–26. http://econ.as.nyu.edu/docs/IO/18565/Bianchi_20110113.pdf.

Blanchard, Olivier, and Jonathan Ostry. 2012. “The Multilateral Approach to Capital Controls.” December 11. http://www.voxeu.org/article/multilateral-approach-capital-controls.

Costinot, Arnaud, Guido Lorenzoni, and Iván Wening. 2011. “A Theory of Capital Controls as Dynamic Terms of Trade Manipulation.” Unpublished. http://economics.yale.edu/sites/default/files/files/Workshops-Seminars/International-Trade/costinot-111116.pdf.

Diaz-Alejandro, Carlos. 1985. “Goodbye Financial Repression, Hello Financial Repression.” Journal of Development Economics 19 (1-2): 1–24.

Gertler, Mark, and Peter Karadi. 2010. “A model of unconventional monetary policy.” Journal of Monetary Economics. http://www.econ.nyu.edu/user/gertlerm/GertlerKaradijournal.pdf.

Glick, Reuven, and Michael Hutchison. 1999. “Banking and Currency Crises: How Common Are Twins?” (Federal Reserve Bank of San Francisco). http://www.frbsf.org/economic-research/files/glick_hutchison.pdf.

Haggard, Stephan. 2000. The Political Economy of the Asian Financial Crisis. Washington,: D.C.: Institute for International Economics.

Jeanne, Olivier. 2012. “Capital Flow Management.” American Economic Review 203-206. http://www.econ2.jhu.edu/People/Jeanne/OJeanne_AERPP_2012.pdf.

Jeanne, Olivier, Arvind Subramanian, and John Williamson. 2012. Who Needs to Open the Capital Account. Washington: DC: Peterson Institute for International Economics. http://www.piie.com/publications/chapters_preview/5119/05iie5119.pdf.

Korinek, Anton. 2011. “The New Economics of Prudential Capital Controls: A Research Agenda.” IMF Economic Review 59 (3). https://www.imf.org/external/pubs/ft/wp/2011/wp11298.pdf.

Krugman, Paul. 1999. “Balance sheets, the transfer problem, and financial crises.” International Tax and Public Finance (6): 459-472. http://www.ide.go.jp/English/Publish/Download/Report/2006/pdf/2006_04_18_02.pdf.

Loayza, Norman, Romain Ranciere, Luis Serven, and Jaume Ventura. 2007. “Macroeconomic Volatility and Welfare in Developing Countries: an Introduction.” The World Bank Economic Review 21 (3): 343–357. http://www.romainranciere.com/research/WBER.pdf.

Magud, Nicolas, Carmen Reinhart, and Kenneth Rogoff. 2011. “Capital Controls: Myth and Reality – a Portfolio Balance Approach.” National Bureau Of Economic Research Working Paper 16805. http://www.nber.org/papers/w16805.pdf.

Mendoza, Enrique. 2002. “Credit, Prices, and Crashes: Business Cycles with a Sudden Stop.” Preventing Currency Crises in Emerging Markets (University of Chicago Press). http://www.nber.org/papers/w8338.pdf.

Neely, Christopher. 1999. “An Introduction to Capital Controls.” Federal Reserve Bank of St. Louis Review 13–30. http://research.stlouisfed.org/publications/review/99/11/9911cn.pdf.

Ramey, Garey, and Valerie Ramey. 1995. “Cross-Country Evidence on the Link Between Lovatility and Growth.” American Economic Association 85 (5): 1138-1151. http://econweb.ucsd.edu/~vramey/research/Ramey_Ramey_Volatility.pdf.

Reinhart, Carmen. 2010. “Eight Hundred Years of Financial Folly.” May 05. http://www.voxeu.org/article/eight-hundred-years-financial-folly#f7.

—. 2014. “Why Reading Diaz -Alejandro is Essential for Understanding Financial Crises.” São Paulo: LACEA. http://www.carmenreinhart.com/user_uploads/data/47_data.pdf.

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[1] See Korinek (2011), Jeanne (2012) for explicitly stating numerous research agendas in this area

[2] A financial crisis in developing country can be modeled as an episode of financial amplification (e.g. Krugman, 1999; Mendoza 2002)

[3] This “amplification” mechanism is also known in literature as debt deflation, Fisherian deflation, or financial accelerator. A simple model of financial amplification that analytically demonstrates this mechanism can be found in Korinek (2011)

[4] As in Leo Tolstoy’s famous quote, perfect markets are all the same; every imperfect market is imperfect in its own way.

[5] There is a huge shortage in both ruble (short-term panic of selling ruble assets and increased official interest rate) and dollar (a drop in oil prices decreased dollar incomes, while sanction forced agents to amass dollars to payoff external debts, because latters could not be rolled over any more) liquidity in Russia, yet central bank can’t satisfy demand even for ruble liquidity, because that will justify inflation expectation and surge long-term interest rate making investment in ruble even more expensive. It is a shame that Russian central bank abandoned dollar interventions too soon (since 2009 a policy of inflation targeting was announced, because in 2008 central bank prevented ruble from devaluation after the drop in oil prices, exactly to save dollarized bank sector, that prevention caused a monstrous capital outflow and contracted Russian economy by 8%. However, Australian and New Zealand experience of 1997 is already a textbook example why Russian central bank should not have done it). This was exactly the time when interventions would save economy from panic.