FINANCIAL CRISES,
RESERVE ACCUMULATION
AND CAPITAL FLOWS
Prabhat Patnaik
The Concept of Stock Equilibrium: A Central
Contribution of the Keynesian Revolution
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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 wealthholder”
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 - ρ – c
 where i is yield, ρ 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 country’s 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 < 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 country’s 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.