Explaining the Capital Flow Puzzle

I think I have to disagree with Brad DeLong’s assessment of Glenn Hubbard’s WSJ op-ed from the other day. Brad suggests that Hubbard may indeed have identified an important piece of the puzzle – the puzzle being why poor Asian economies are lending so much money to the United States.

Hubbard’s point boils down to this: China and other developing Asian economies are investing large quantities of money in the US because they don’t have good investment opportunities at home. That’s not because the domestic rates of return are no good, but because bad domestic institutions make domestic investment opportunities risky. In other words, the risk-return ratio is better in the US.

But I don’t think this explains today’s pattern of international capital flows. I agree that corrupt and inefficient domestic institutions in many developing countries are major impediments to growth. And there are lots of examples where citizens have sent their savings overseas because they were worried about losing it if they kept it in domestic assets. (Think about many Latin American countries during the 1980s, or most of Africa during the last 50 years, for examples.)

But Asia today does not fit this story.

There are two reasons that I say this. First, the agents that are actually buying the assets in the US are not private individuals in Asian countries, but rather Asian central banks. And we’re reasonably certain that the reason they’re buying US assets is not because they’re seeking the highest or most risk-free return, but rather because they are trying to manage their exchange rate. There’s scant evidence that private individuals in Asian countries are fleeing to foreign assets because they don’t trust their domestic institutions.

Second, the surplus of funds in Asia stems not from an insufficiency of domestic business investment, but rather from an insufficiency of private consumption. Investment spending in countries like China is, if anything, too high – in China it’s currently running at over 40% of GDP, compared to less than 20% in the US. Apparently, individuals and firms see plenty of good investment opportunities in China and other developing Asian economies, and are willing to put money into them.

The problem is that private savings rates are also extraordinarily high in those countries. Furthermore, while such high savings rates are found in countries with questionable institutions, like China, they are also found in countries with impeccable financial credentials, like Singapore. So I don’t believe that weak domestic institutions are what is causing households in a wide variety of Asian countries to decide to save their income rather than spend it.

No, I think that we must look elsewhere to explain the bizarre pattern of poor developing countries (along with many rich countries) lending vast sums of money to the US. Note that the two things that make this pattern possible right now are (1) the fact that the US is living far beyond its means, and borrowing the difference (both at the private and governmental levels); and (2) the fact that households in developing countries like China are saving rather than spending their income. So if you want to explain the pattern of international capital flows today, I think you need to explain facts #1 and #2. I don’t think Hubbard’s story explains either of them.