Thomas Oatley is an associate professor of political science at the University of North Carolina, Chapel Hill.
Financial instability once again dominates the news. This time, the so-called “Fragile Five” (Brazil, India, Indonesia, South Africa, and Turkey) are suffering sharp market corrections and currency devaluations. Newspapers are full of articles suggesting that these countries’ problems might precipitate a new global crisis. They are almost certainly wrong.
Most observers think that the current turbulence is a product of the interaction between global forces—the Fed’s tapering—and local considerations—economic and political weaknesses inside the Fragile Five. Yet, both social scientists and pundits tend to emphasize the local factors —domestic financial regulation, macroeconomic policy, and political instability— over the global ones. My current research project, conducted in part with a group of young scholars based at UNC, Indiana University, and Brown University, reverses this emphasis to show how local factors are embedded in a broader global financial structure. This approach explains crises in emerging markets as a function of global dynamics and underscores the need for international policy coordination to make the system work better for emerging markets.
[Investment flows in the world economic system]
We should think of the global financial system as a network of financial relationships, in which some countries are heavily connected to everyone else, while others are only weakly connected. For example, if you look at cross-border portfolio assets, there are enormous differences between the center and the periphery. As the figure above (based on IMF cross-border portfolio investment data for the end of 2012) illustrates, the U.S. is right at the center of the network, attracting investment in large amounts from almost every country in the system. Most countries, including the Fragile Five, sit on the periphery, attracting limited investment from a very small number of countries. The UK occupies an intermediate position in the network—not quite as central as the U.S., but certainly not peripheral either. Large EU countries are in turn less central than the UK, but less peripheral than the remaining countries. Though America’s centrality in the global financial system is widely understood, people have thought little about how this structure affects the system as a whole.
When we think of the global financial system as a network, we see that the causes and consequences of financial crises are very different, depending on whether they happen in the periphery or the center. Since 1970 the global financial system has fluctuated back and forth between two conditions. In one condition, international investment tries to exploit the opportunities available in a small number of emerging market economies—think Latin America in the ’70s, Asia in the ’90s, the Fragile Five more recently. These capital inflows generate bubbles in the favored economies and eventually these bubbles pop to produce financial crises. This means that the current fragility of the five is itself a consequence of global dynamics. Such crises hurt the peripheral countries, but do not tend to spread outside their immediate region, because these countries are so weakly connected. In this condition, the U.S. acts as a system stabilizer – it is connected to peripheral countries, but is diversified, so that it can absorb the shock.
In the second condition, global capital floods into the U.S. and pushes a few key asset prices up sharply—here think of the regional real estate bubbles of the mid-’80s, the tech boom of the late ’90s and the real estate bubble of the 2000s. Eventually these bubbles pop and financial instability results. When the bubble bursts in the U.S., instead of peripheral countries, the whole world suffers, because everyone is connected to the U.S. market and few countries are diversified enough to absorb the shock. The subprime crisis was the most recent occurrence of this process at work.
The scatterplot below illustrates this global dynamic. The horizontal axis captures the U.S. share of net global investment each year; as we move out to the right along this axis, the U.S. attracts a larger share of global investment. The vertical axis measures the number of countries in the world that experience a capital inflow bonanza each year. Both are measured from 1975 – 2008. The negative relationship highlights the two conditions of the global financial system. When the U.S. attracts a large share of cross border investment, the number of periphery countries that attract large foreign capital inflows and experience asset bubbles falls sharply. And as the US demand for capital falls, an increasing number of peripheral countries experience a surge of foreign investment.
The global financial system shifts between these conditions in response to changes in American macroeconomic policy. When American demand for foreign capital is relatively high, global capital floods the U.S. and eventually generates instability at the center. When American demand for global capital falls, as it does in the wake of American financial crises, investment floods the periphery and eventually generates instability in emerging market countries. The American demand for foreign capital, in turn, has been driven by macroeconomic policy: large budget deficits resulting from military spending and the interest rates set by the Federal Reserve. The budget imbalances caused by wars in Afghanistan and Iraq pulled global capital into the U.S. The Great Recession and the Fed’s quantitative easing pushed global investment to the periphery. The Fed’s tapering now pulls these funds back to the center. Peripheral crises thus emerge from global forces—capital market reactions to changes in American policy in the context of an international financial system centered upon the US.
This means that we probably don’t have to worry that the Fragile Five are going to precipitate a new worldwide crisis. Genuinely global crises are caused by instability at the center of the network, not by isolated crises on the periphery. It doesn’t mean that we don’t have to worry at all. Peripheral crises can both disrupt global markets and cause economic devastation for the countries affected.
Local factors are important to peripheral crises but they matter in conjunction with global dynamics. A given set of regulatory arrangements in emerging markets might be sufficient to safeguard a national financial system when investment is focused primarily upon the U.S. market, but inadequate when capital floods the periphery during periods of American retrenchment. On the other hand, cross-national differences in regulatory arrangements and macroeconomic policy may influence which emerging markets attract investment surges and which do not when the U.S. retrenches. Investors may favor markets where regulation is most forgiving and macroeconomic policy most accommodating.
This suggests that systemic forces—the network structure of the global financial system, the centrality of the U.S. in this system, changes in U.S. macroeconomic policy and capital market reactions to these changes—are too important to remain in the background of discussion. This structure merits much greater attention than it currently receives because if global forces drive local instability, then domestic policy reforms are unlikely to stabilize global financial markets in ways that would protect the periphery. Any such measures must be accompanied by changes at the global level. As the Bank of England’s Executive Director of Financial Stability Andrew Haldane has argued, international policy coordination could minimize the global consequence of sudden changes in American policy. A global macro-prudential regulatory regime could support coordination designed to limit the emergence of highly correlated exposures among financial institutions in the center to a small number of economies on the periphery. Though such steps are not panaceas, they may do more to stabilize global markets moving forward than even far-reaching policy reform in the Fragile Five.