NBER WORKING PAPER SERIES INTERNATIONAL CREDIT FLOWS AND PECUNIARY EXTERNALITIES

This paper develops a dynamic two-country neoclassical stochastic growth model with incomplete markets. Short-term credit flows can be excessive and reverse suddenly. The equilibrium outcome is constrained inefficient due to pecuniary externalities. First, an undercapitalized country borrows too much since each firm does not internalize that an increase in production capacity undermines their output price, worsening their terms of trade. From an ex-ante perspective each firm undermines the natural “terms of trade hedge. ” Second, sudden stops and fire sales lead to sharp price drops of illiquid capital. Capital controls or domestic macro-prudential measures that limit short-term borrowing can improve welfare. Markus K. Brunnermeier Princeton University Department of Economics Bendheim Center for Finance Princeton, NJ 08540 and NBER markus@princeton.edu Yuliy Sannikov Department of Economics 208 Fisher Hall Princeton University Princeton, NJ 08544 sannikov@gmail.com For a long time the “Washington Consensus” held the view that free trade and full capital account liberalization are conducive to higher economic growth and welfare. A world in which goods and capital can flow freely was considered as the guiding “north star” and any incremental liberalization towards this ideal was considered as a step in the right direction. Recently, the IMF took on a more nuanced view, see Ostry et al. (2010). 1 This more balanced view acknowledges that in a second best world, liberalizing only some markets might be harmful. Especially, the buildup of persistent capital flow imbalances in form of short-term debt, referred to as “hot money,” increases the risk of financial instability. To avoid sudden reversals it might be desirable to “manage” capital flows. Capital controls should be part of the macroprudential tool kit. We set up a quantifiable model that allows one to analyze capital account liberalization and capital controls. We identify circumstances under which short-term debt capital flows are excessive and can lead to inefficiencies and instabilities. To this end we develop a dynamic two-country, two-good stochastic growth model in continuous time with endogenous capital formation. International financial markets are imperfect but there are no international trade frictions. The two consumption goods and the single physical capital good can be traded freely. Like in the classic Ricardian trade model, each country has some (comparative) advantage in producing one good and hence should ideally specialize in producing that good. Our model shows that in a world with less than perfect risk sharing, (which can be justified by information problems and moral hazard considerations) although opening the capital account can boost overall economic growth, the resulting debt imbalances can lead to more volatility and therefore threaten financial stability. The key trade-off is between better allocation of physical capital and better risk sharing. With an open international bond market the inflow of short-term hot money allows the poorer country to boost its production capacity, buying additional physical capital financed with debt from abroad. While this improves output levels, increased leverage makes the country vulnerable to additional shocks. Short-term debt acts as a palliative after a sequence of negative shocks, but the initial calm can be treacherous. With a bit of luck positive shocks follow and the strains on the global economy may never be noticed. However, if another bad shock arrives the country experiences a sudden stop of funding and conditions deteriorate quickly. Fear of future deterioration leads to fire sales, depressing the price of physical capital if it is technologically illiquid due to 1See also the policy recommendations in the report of the Committee on International Economic Policy and Reform (2012).