Thursday, April 17, 2014

Hooray for International Capital Flows

Antonio Fatas presents these charts (HT: Mark Thoma) comparing global growth rates  and investment rates among advanced and emerging economies.

It seems to me that this relates to a topic I have touched on here:

And here (with probably a little too much sarcasm):

It looks to me like we have a set of growing emerging markets, who are accumulating their own capital.  But, their own economies are still characterized by high risk premiums.  So, emerging market capital is hungry for a source of low risk income.  Western sovereign debt, low-yield bonds, and real estate fill that need.  So, emerging market capital is moving to the developed world.

And, in return, developed world capital is filling the gap.  American capital, especially, is lured by profitable risk, so our corporations are investing very profitably in emerging markets.  As the Western baby boomer bulge enters their twilight years, we are confronted with a time mismatch between boomer production abilities today and boomer consumption needs in 20 or 30 years.  Part of that mismatch is being bridged through investment in durable property like homes.  Part of that mismatch is being bridged through the investment of boomer savings into emerging economies, where growth of labor output is not as constrained by demographics.  Here is a graph of labor force growth in the US.  This looks like it tracks pretty closely with Antonio Fatas' graph of GDP growth.  Maybe in the US, investment is constrained by the availability of labor.

So, there is this huge, mutually beneficial transfer happening between emerging market capital and developed market capital.  This causes all sorts of problems for politically charged statistics, because, for starters, it makes it look like developed nation capital is capturing a larger portion of production, God forbid.  And, it creates a sustained trade deficit in the US.

But the actual result here is basically what we should have hoped for from global finance.  Risks are being traded off to where they are more appropriate.  And the end result is that huge populations of the world's laborers are being exposed to more opportunities for prosperity.

The increasing wages in these economies, the high growth rates, and the high returns to capital, are all products of improving market-securing institutions.  This is why I hate the subtly incorrect notion that production moves to places with low wages.  Production moves to places with rising wages, not low wages.  From a previous post:
This is basically the problem with developing economies, where institutional improvements make capital investments safer, and foreign investment is lured into the growing economy.  But, since reversals are possible, and trust requires the passage of time, firms require a higher rate of return.  Nations that reverse to poorer institutions will lead to losses for those firms.  In nations that continue to improve, the realized returns of the investing firms will appear to be high.  Over time, as trust is gained, realized returns will settle to a long term reasonable equilibrium.

This is why it appears that production moves to places with low wages, when production really only moves to places with rising wages.  The necessary development of trust creates a lag effect where the higher required returns cause wages to rise more slowly than they would without this long tail risk.  So, there is a period of time where firms earn seemingly oversized profits at the expense of lower wages for the laborers in the developing economy.  Of course, the profits aren't oversized, they are just the payment received for taking on long tail risk with a binary and unpredictable payoff.  This generally calls for a high return, and also tends to produce survivorship bias in hindsight.
 In a way, the ability of US corporations to earn excess profits by moving production to developing economies is very similar to the well-documented momentum effect on individual US stocks.  Markets have a trust-but-verify mentality.  Efficiency means that prices fairly quickly react to new information, but not all the way, because the veracity of new information has its own risk distribution, with its own long tail of failure risk.

CEO's don't necessarily even need to model their investment decisions this way.  These factors will be built into their assumptions about wage growth and other costs, and their heuristics for how risky each location is.  So, they could account for all this and still misunderstand their investment decisions as being the result of moving to places with low wages.

But, it's not the low wages that attract capital.  Improving institutions lead to capital investment and increasing wages.  That's why most capital flows to high wage countries and why Korea and Taiwan are now among them.  That's why low wages aren't drawing capital to Congo, Zimbabwe, and Niger.  And, it's why American inner cities lack retail.

We are living in much better times, globally, than is sometimes acknowledged.

Follow up post.

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