Dani Rodrik on financial innovation and financial crises

Dani Rodrik writes:

Carmen Reinhart and Ken Rogoff’s new paper (summary here) makes the obvious but important point that financial globalization and financial crises are related. In their words, “Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically.” Here is the picture that is words a thousand words.

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Now what is important about this conclusion is that it runs counter to a growing piece of conventional wisdom in the academic literature, namely that there is no relationship between propensity to financial crisis and openness to foreign capital flows. Rogoff himself (with co-authors) wrote in an earlier survey: “In sum, there is little formal empirical evidence to support the oft-cited claims that financial globalization in and of itself is responsible for the spate of financial crises that the world has seen over the last three decades.”

I think the difference may be between cross-sectional and historical evidence: the latter shows a close correlation, but this does not mean (perhaps) that the countries that experience the most crises during periods of high capital mobility are necessarily those that are financially the most open.

There is also a possibility that we are observing what essentially amounts to learning by trial and error; in newly liberalized nations, both market participants and regulators are new to the game they are playing, so they make the same mistakes over and over again and for a while get away with them, simply because the environment is forgiving, until something changes abruptly and the forgiving environment is no longer there.

In mid-1990s Russia, for example, both the banking sector and the central government carried a lot of dollar-denominated liabilities, but their assets were largely ruble-denominated. When oil prices fell, the government lost a substantial part of its revenue and had to both default on its bonds and devalue the ruble, with the latter instantly rendering the banking sector insolvent.

In retrospect, maintaining currency neutrality should have been one of the goals of banking regulation, but there was a competing agenda: Russian regulators actively sought to prevent capital flight, so requiring banks to carry foreign assets to offset their exposure to foreign liabilities would require wholesale abandonment of not only a large body of law, but also of institutions created to enforce it.

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