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Where Does Capital Go, In a Capital-Constrained World?

The stock market has stopped falling (for now), and the banking crisis hasn’t generated any major new headlines for several weeks now. Policymakers from Ben Bernanke on down have been talking about “green shoots” appearing in the economy. Meantime, the published statistics and many of the corporate-earnings reports continue to show an economy in a deep funk.

It’s still far too early to say whether the economy is beginning to recover from the body blow delivered to it by the shutdown of new private-credit formation. But even if discretionary consumer spending remains comatose for an extended period (possibly stretching into years), there is still a lot of basic economic activity that must take place.
The private economy will find ways to muddle through and start growing to some extent, even with a non-functioning banking sector.

The nascent reality businesses must deal with today, and that economists and policymakers will recognize tomorrow, is that we now live in a capital-constrained world. Alan Greenspan often said the real benefit of financial innovation is the creation of more usable capital. In that sense, it’s like any other kind of technology.

Whole books will be written on the subject of how best to control the future advance of financial innovation. But many now believe that the last twenty-five years have seen explosive growth in financial engineering, based on the idea that magic happens if you don’t try to control financial instruments. That idea is now in full retreat.

It will be a while before consensus emerges among policymakers about whether Wall Street should be clamped in regulatory irons, even as taxpayer dollars are used to keep the crisis’s culprits in business.

In the meantime, of course, financial innovation is at a standstill because investors and financial institutions have to rebuild from all the losses they’ve suffered. Even without regulatory inhibition keeping financial innovation in check, we’re not experiencing much on that front right now.

And as Greenspan suggested, we’re all feeling the crunch in terms of reduced capital availability. I don’t believe this effect is entirely cyclical, because measures of private credit formation started plummeting in early 2007, long before the economic recession started. We face secular declines in capital availability that will persist even after the current recession ends. Combine today’s uncertainty with tomorrow’s new regulations, and the problem gets worse, not better.

Who benefits the most from that? In an odd twist, the United States does.

Capital always seeks out the highest risk-adjusted rate of return. For over a decade, returns were far better in emerging countries than in developed ones (in non-risk-adjusted terms, the ratio may have been 5 to 1 or higher).

But why would you invest in emerging economies? In order to gain exposure to their development of manufacturing and other productive capacities.

And what’s the point of developing production in places like Vietnam, Thailand, China, and Brazil? To make stuff to export to the United States and the EU.

Everything depends on consumers in the U.S. and the EU — the regions that generate most of the world’s final demand. Consumers may retrench permanently in the face of today’s uncertain economy and tomorrow’s higher budget deficits and taxes, as we struggle to provide healthcare and wind-generated electricity for all. If that happens, then it will make less and less sense to invest scarce capital in emerging countries.

What capital there is will tend to stay in the developed economies, and particularly in the U.S. Rampant financial innovation has been an engine that has lifted hundreds of millions of people out of poverty. As the engine sputters out, the effects in the emerging world will be very serious indeed.



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