Quality: The Good versus Bad Billionaires

The Good versus Bad Billionaires

Good billionaires emerge outside "rent-seeking industries."  

Common rent-seeking industries are construction, real estate, gambling, mining, steel, aluminum, oil, gas and other commodity sectors that mainly involve digging resources out of the ground.  

In these businesses, major players often spend their time extracting maximum rents from limited national resources by bribing politicians if necessary, not growing national wealth in innovative ways.

New names on the billionaire list can be a favourable sign.  Looking at the scale of billionaire fortunes is not enough to reveal the extent of their political vulnerabilities.

Comparing the share of the wealth generated by "bad billionaires."

To make a qualitative judgement about the sources of great fortunes, compare the total wealth of tycoons in these corruption prone businesses to that of all billionaires in the country.  

This no doubt miscasts many honest mining and oil tycoons, but even in nations where these industries are relatively uncorrupt, they tend to make weak contributions to productivity and to tie the economy to the volatile swings of commodity prices.

Good billionaires

This label is for tycoons in industries that are known to make the largest contributions to growth in productivity or that make popular consumer products, like smartphones or cars.

These "good" industries are the ones least likely to generate backlashes against wealth creation; they include technology, manufacturing, pharmaceutical, and telecoms, as well as retail, e-commerce and entertainment.

How are nations generating their wealth?

Analysing billionaires does offer anecdotally telling, real-time evidence of how nations are generating wealth.  

• Countries with small percentage of bad billionaires

Among the largest developed economies of 2019, bad billionaires controlled the smallest shares of billionaire wealth: in Italy (7%) and France(9%) - a good sign for both countries.

Only 13% of Swedish billionaire wealth originates in rent seeking industries.  Much of the rest is created at globally competitive companies, including H&M in fashion and IKEA in furniture retailing.

• Countries with large percentage of bad billionaires

Few new or good billionaires are to be found in nations like Turkey or Russia, where aging regimes have turned away from reform and promoted favoured tycoons.  The undisputed capital of connected tycoons is Moscow.  Nearly 70% of Russian billionaire wealth comes from bad billionaires.  The Kremlin treats billionaires with contempt, arbitrarily changing rules that govern their businesses knowing the public has little sympathy for a billionaire class widely perceived as corrupt.  

Popular resentment against great wealth is palpable in Mexico as well, where bad billionaires also control close to 70% of billionaire wealth.  Mexican tycoons are known for cornering industries such as telephones and concrete, which earn monopoly profits for their owners while driving up prices for consumers.  

Bad billionaires typically arise in family empires, particularly in the emerging world, where weaker institutions make it easier for old families to cultivate political connections.

China's historical debt binge

September 2008, pre-Lehman Brothers bankruptcy

In September 2008, China's economy was slowing.   The Shanghai stock market had just crashed.  Property prices were weak.  The Chinese officials said China was entering the middle-income rank of nations, so it was time for it to slow down as previous Asian miracle economies, like Japan, South Korea and Taiwan, had.  They talked about cutting back on investment, downsizing large state companies and letting the market allocate credit, which at this point was not growing faster than the economy.  Between 2003 and 2008, credit had held steady at about 10% of GDP.

October 2008, post Lehman Brothers bankruptcy

Lehman Brothers filed for bankruptcy in the US and global markets went into a tail-spin.  Demand collapsed in the US and Europe, crushing export growth in China, where leaders panicked.

By October 2008, the Chinese government had reversed course, redoubling its commitment to the old investment -led growth model, this time by fueling the engine with debt.   From 2008 through 2018, total debts would increase by $80 trillion worldwide, as countries fought off the effects of the financial crisis, but of that total, $35 trillion, or nearly half, was racked up by China alone.

August 2009

By August 2009, the Chinese government had launched an aggressive spending and lending program that kept China's GDP growth above 8%, while the US and Europe were in recession.  That steadily high GDP growth had convinced many Chinese that their government could produce any growth rate it wanted.

Bank regulators were the only officials who expressed alarm and their main concern was increasingly reckless lending in the private sector.  "Shadow banks" had started to appear, selling credit products with yields that were too high to be true.  

2013

By 2013, shadow banks accounted for half of the trillions of dollars in new yearly credit flows in China.  When Beijing began to limit borrowing by local governments, local authorities set up shell companies to borrow from shadow banks.  Soon these "local government funding vehicles" became the biggest debtors in the shadow banking system.

As the flow of debt accelerated, more lending went to wasteful projects.  By some estimates, 10% of the firms on the mainland stock exchange were "zombie companies." kept alive by government loans.  The state doled out loans to incompetent and failing borrowers.

• Lending started to flow into real estate

Much of the lending started to flow into real estate, the worst target for investment binges.  Easy loans spurred the sale of about 800 million square feet of real estate in 2010, more than in all other market so the world combined.  In big cities, prices were rising at 20% to 30% a year.

Caught up in the excitement, banks stopped looking at whether borrowers had income and started lending on collateral - often property.  This "collateralized lending" works only as long as borrowers short on income can keep making loan payments by borrowing against the rising price of their property.  By 2013, a third of the new loans in China were gong to pay off old loans.  In October 2013, Bank of China chairman warned that shadow banking resembled a "Ponzi scheme," with more and more loans based on "empty real estate."

• At the March 2013 party congress, Li Keqiang came in as prime minister.  

He was one of the Chinese leaders who appeared to accept the reality that a maturing economy needed to slow down, which would allow him to restrain the credit boom.  Yet every time the economy showed signs of slowing, the government would reopen the credit spigot to revive it.

• Dubious creditors grew

The cast of dubious creditors grew increasingly flaky, including coal and steel companies with no experience in finance, guaranteeing billions of dollars in IOUs issued by their clients and partners.  

2014: Chinese urged to buy stocks

By 2014, lending entrepreneurs were shifting their sights from property to new markets - including the stock market.

Even the state-controlled media jumped in the game, urging ordinary Chinese to buy stocks for patriotic reasons.  Their hope was to create a steady bull market and provide debt-laden state companies with a new source of funding.  Instead they got one of the biggest stock bubbles in history.

There are 4 basic signs of a stock bubble:  

• high levels of borrowing for stock purchases; 
• prices rising at a pace that can't be justified by the underlying rate of economic growth; 
• overtrading by retail investors and 
• exorbitant valuation.  

June 2015, Shanghai market started to crash

By April 2015, when the state-run People's Daily crowed that the good times were "just beginning,"  The Shanghai market had reached the extreme end of all four bubble metrics, which is rare.

The amount that Chinese investors borrowed to buy stock had set a world record, equal to 9% of the total value of tradable stocks.  Stock prices were up 70% in just 6 months, despite slowing growth in the economy.  On some days, more stock was changing hands in China than in all other stock markets combined.  In June 2015, the market started to crash and it continued to crash despite government orders to investors not to sell.

[Comments:

This credit binge had some characteristics unique to China's state-run system, including the borrowing by local government fronts and the Communist propaganda cheering on a capitalist bubble.  But its fundamental dynamics were typical of debt mania.  It began with private players, who assume the government would not let them fail, and devolved into a game of whack-a-mole.  As the government fitfully tried to contain the mania, more and more dubious lenders and borrowers got in the game, blowing bubbles in stocks and real estate.  The quality of credit deteriorated sharply, into collateralized loans and IOUs.  These are all important mania warning signals.

The most important sign was, as ever, private credit growing much faster than the economy.   After holding steady before 2008, the debt burden exploded over the next 5 years, increasing by 74 % points as a share of GDP.  This was the largest credit boom ever recorded int he emerging world (though Ireland and Spain have outdone it in the developed world).]

By mid 2019

By mid-2019 China had, in fact, seen economic growth slow by nearly half, from double digits to 6%, right in line with previous extreme binges.  To date then, no country has escaped this rule:  a five-year increase in the ratio of private credit to GDP that is more than 40% points has always led to a sharp slowdown in economic growth.

[Comments:

China did however, dodge the less consistent threat of a financial crisis, aided by some unexpected strengths.  One was the dazzling boom in its tech sector, without which the economy would have slowed much more dramatically.  Another was the fact that Chinese borrowers were in debt mainly to Chinese lenders and in many cases the state owned bother parties to the loan.  In short, /China was well positioned to forgive or roll over its own debts.  And with strong export income, vast foreign exchange reserves, strong domestic savings and still ample bank deposits, it has managed to avert the financial crisis that often accompanies large, debt driven economic slowdowns.]

How Paying Off Debt Pays Off

Before 2000

Before 2000, many emerging countries had never seen a period of real financial stability or a healthy credit boom.  

• Inflation was high and volatile, and when prices for big-ticket items are unpredictable, banks won't dare make loans that extend for more than a few months.
• In emerging countries, five-year car loan and the 30 year mortgage, had been unimaginable luxuries.  Yet, these are the many cornerstones of American consumer culture and middle-class existence.

After 2000

The new generation of emerging world leaders began controlling deficits and lowering inflation.  This newly stable environment quickly led to a revolution in lending.  

• Credit cards and corporate bonds were introduced for the first time.
• Mortgages, which barely existed in 2000, became a multibillion-dollar industry, rising from 0% of GDP to 7% in Brazil and Turkey, 4% in Russia and 3% in Indonesia by 2013.

For countries where people cannot buy a car or a house unless they amass enough cash, the introduction of these simple credit products is an important step into the modern world.

Periods of healthy credit growth

Periods of healthy credit growth bear no psychological resemblance to the extreme exuberance of manias or the extreme caution of debt-phobia.  

In place of shady lenders and unqualified borrowers, responsible lenders are widening the choice of solid loan options, creating a more balanced economy.

Global financial crisis in 2008

When the global financial crisis hit in 2008, countries like the US were vulnerable because they had been running up debt too fast.  

In Southeast Asia, however, the opposite story was unfolding.

Indonesia, Thailand, Malaysia and the Philippines had manageable debt burdens and strong banks ready to lend, with total loans less than 80% of deposits.  

Over the next 5 years the health of the credit system would prove crucial:  

• nations such as Spain and Greece, which had seen the sharpest increase in debt before 2008,  would post the slowest growth after the crisis; 
• nations such as the Philippines and Thailand, which had seen the smallest in debt during the boom, would fare the best.

Debt Mania and Debt Phobia

Debts owed by nations

Every new crisis seemed to hatch a new way of thinking about debt, depending on who is lending, who is borrowing, for how long, and many other factors.

• Mexico's "tequila crisis" of the mid-1990s started with short-term bonds.  This led to focus on the dangers of short-term debt.
• The Asian financial crisis started with debt to foreigners, and foreign loans became the new obsession.

The best predictor of these meltdowns:  five straight years of rapid growth in private-sector debt.  

A decade after the global financial crisis, the Bank of International Settlements, the IMF and other international authorities concurred the most consistent precursor of major credit crises going back to the "tulip mania" in 17th century Holland was that private-sector debt - borrowing by corporations and individuals - had been growing faster than the economy for a significant length of time.

The authorities also reached another surprising conclusion:  the clearest signal of coming trouble is the pace of increase in debt, not the size of the debt.  

• Size matters, but pace matters more.  
• Government debt play a role but usually rises later, after trouble starts in the private sector.  
• A sharp increase in private debt is the leading indicator.

The key issue is whether debt is growing faster or slower than the economy.   

• A country in which private credit has been growing much faster than the economy for 5 years should be placed on watch for a sharp slowdown in the economy and possibly for a financial crisis as well.

Thailand in 1997

From the prime minister to farmers gets swept up in the mania for cheap loans. 

A housewife borrows to invest in "four million of anything."  

By 1997, private debt amounted to 165% of GDP in Thailand, but debts of that size would not necessarily have signaled a crisis if the debt had not been growing at an unsustainable pace.

• Over the previous 5 years, private debt had been growing at an annual pace more than twice as fast as the roaring Thai economy and had rise by 67% points as a share of GDP.  

To anticipate coming trouble, the number to watch:  the five-year increase in the ratio of private credit to GDP.

Successful nations avoid debt manias

Successful nations avoid debt manias and are often best positioned for sustained growth after a period of retrenchment.  

• The upside to the rule is that if private credit has been growing much slower than the economy for 5 years, the economy could be headed for recovery, because banks will have rebuilt deposits and will feel comfortable lending again.  
• Borrowers, having reduced their debt burden, will feel comfortable borrowing again.  

That is the normal cycle anyway. 

Debt phobia can be almost as destructive

 After particularly severe credit crises, lenders and borrowers may be paralyzed for years by debt phobia, which can be almost as destructive as debt mania.

Political revolt and Food prices

There is never one cause of a political revolt, but food prices have played a role in many.  

Consumer prices have been intimately connected to the cycle of political crisis, revolt and reform.

1.  The Revolutions of 1848 targeted European monarchies and followed the spread of democratic ideas on the continent.  Spiking food prices was identified as the main catalyst too.

2.  In recent decades, Latin America has been a cauldron of inflation driven unrest.  Between 1946 and 1983, 15 governments fell in Latin America, and in 13 of those cases, from Mexico to Argentina, the regime change followed a sure in the annual rate of consumer price inflation to 20% or more.

3.  Rising prices for wheat and other grains also contributed to the 1989 fall of Communism in the Soviet Union.

Inflation fell in most emerging nations but occasional flare-ups continued to topple leaders.  

There was a strong link between food prices and unrest in many countries between 1990 and 2011.

1.  Inflation helped oust regimes in Brazil, Turkey and Russia (again) in the late 1990s.

2.  In 2008, World Bank warned that at least 33 countries faced a risk of social revolt sparked by food prices, which had risen 80% in the previous 3 years.

3.  Food prices did help spark revolts worldwide in 2011, including the Arab Spring.  

4.  In India before the 2013 election, the voters were complaining about price of onions.  The Congress Party lost to Modi's Hindu nationalist party, and polls showed that inflation had played a major role in the Congress government's downfall.

Conclusion:

High or rapidly rising consumer price inflation threatens economic growth directly and indirectly, because it can provoke destabilising social unrest.  

Watch for leaders who understand this inflation threat, and how to use the weapons that can control it.

High inflation for consumer prices is almost always a threat to growth but deflation is not.

For the eight centuries beginning in 1210, the world's average annual inflation rate was only 1%, according to the Global Financial Database.  For  most of that period, however, the long-term 1% average concealed sharp swings between inflation and deflation.

In early 1930s, deflation disappeared, for reasons that remain mysterious but include the spread of the banking industry and the wider availability of credit, with consequently more money chasing the available goods.

The end of the gold standard in the 1970s made it easier for central banks to print money, which also tends to fuel inflation.

The result was that deflation disappeared completely on the global level, and bouts of deflation - particularly longer ones - became much less common within individual nations as well.  

Though deflation has largely vanished, worldwide, it continues to surface in isolated pockets.  

Japan is the only major country to have suffered a multiyear case of deflation in the postwar era, but many countries have suffered a single-year bout.  

Again, however, these periods did not have a consistent impact on growth, for better or worse.

No clear evidence that consumer price deflation is bad - or good- for economic growth.

In early 2015, the Bank for International Settlements (BIS) looked at the postwar record for 38 countries.  In all, these countries had seen more than 100 years in which prices fell.  

• On average, GDP growth was higher by a statistically insignificant margin during deflationary years, at 3.2%, than during inflationary years, at 2.7%.   
• The cases in which deflation was accompanied by strong growth occurred from Thailand and China to the Netherlands and Japan.  

The BIS concluded there is no clear evidence that consumer price deflation is bad - or good- for economic growth.

High inflation for consumer prices is almost always a threat to growth but deflation is not.

How can you tell when consumer price deflation is the good kind, driven by growing supply, or the bad kind, driven by shrinking demand?  

This task requires parsing conflicting forces of supply and demand, often with unclear results.  

The takeaway is simply that while many analysts now assume that any hint of deflation is worrisome, this assumption is not borne out by the evidence.  

High inflation for consumer prices is almost always a threat to growth but deflation is not.

How to identify potentially threatening asset price bubbles?

In a globalized world, with few barriers to capital flows, investors around the world can bid up prices for stocks, bonds and real estate in local markets from New York to Shanghai.  

Central banks have fueled these purchases with record low interest rates and by entering the bond market as major buyers themselves  

Largely as a result, global financial assets (including only stocks and bonds) are worth $280 trillion and amount to about 330% of global GDP, up from $12 trillion and just 110% in 1980.

Traditionally, economists have looked for trouble in the economy to cause trouble in the markets.  

They see no cause for concern when loose financial policy is inflating prices in the markets, as long as consumer prices remain quiet.  

Even conservatives who worry about easy money "blowing bubbles" still look mainly for economic threats to the financial markets, rather than the threat that overgrown markets pose to the economy.   

But financial markets are now so large, that the tail wags the dog.

A market downturn can easily trigger the next big economic downturn.

Summary:

The general rule is that strong growth is most likely to continue if consumer prices are rising slowly, or even if they are falling as the result of good deflation, driven by strengthening supply network.

In today's globalized economy, in which cross-border competition tends to suppress prices for consumer goods but drive them up for financial assets, watching consumer prices is not enough.  

Increasingly, recessions follow instability in the financial market.  

To understand how inflation is likely to impact economic growth,  keep an eye on stock and house prices too.

Housing bubbles and Stock bubbles fueled by borrowings

Be alert when prices are rising at a pace faster than underlying economic growth for an extended period, particularly for housing.  

• Home prices typically rise by about 5% a year.  
• This pace speeds up to between 10% and 12% in the two years before a period of financial distress.
• Once prices for stocks or housing rise sharply above their long-term trend, a subsequent drop in prices of 15% or more signals that the economy is due to face significant pain.  

In general, housing bubbles were much less common than stock bubbles but were much more likely to be followed by a recession.  The downturn is much more severe if borrowing fuels the bubble.  

• When a recession follows a bubble that is not fueled by debt, 5 years later the economy will be 1% to 1.5% smaller than it would have been if the bubble had never occurred.
• If the investors borrow heavily to buy stock, the economy 5 years later will be 4% smaller.
• If they borrow to purchase housing, the economy will be as much as 9% smaller.

Growing threat of Asset bubbles

Globalization

Rising global competition and the emergence of independent central banks have helped countries contain consumer prices.  But globalization is pushing asset prices in the opposite direction.

In a world with few barriers to the flow of capital, foreigners are often the main buyers of stocks, bonds and real estate in markets from New York to Seoul, making prices for these assets less stable, and an increasingly telling signal of a coming economic crash.

Debt-fueled property booms and recessions

Many postwar economic "miracles," ranging from Italy and Japan in the 1950s to Latin America and Southeast Asia later, first took off because of strong fundamentals (like strong investment and low inflation) but were sustained by rapidly rising debts and ended with a bursting property bubble.

In recent decades, recessions have been more likely to originate in debt-fueled property booms, for the simple reason that there has been an explosion in mortgage finance.  Since the boom in modern finance began in the late nineteenth century, mortgage lending has grown much faster than other lending to households and private companies, which helps explain why economic booms and busts "seem to be increasingly shaped by the dynamics of mortgage credit."

The growing threat posed by asset bubbles

Before World War II, there were 78 recessions - including only 19 that followed a bubble in stocks or housing.  

After the war, there were 88 recessions, the vast majority of which, 62, followed a stock or housing bubble.

For the last 3 decades, every major economic shock has been preceded by a bubble in housing, stocks or both, including 

• Japan's meltdown in 1990, 
• the Asian financial crisis of 1997 - 1998, 
• the dot-com crash of 2000-2001, and, of course, 
• the global financial crisis of 2008.  

Asset price crashes can trigger bad consumer price deflation

Often, a crash in prices of houses or stocks will depress the economy, by making people feel suddenly less wealthy.  Thus shaken, they spend less, resulting in lower demand and a fall in consumer prices.  In other words, asset price crashes can trigger bouts of bad consumer price deflation.  

• This is what happened in Japan, where the real estate and stock crash of 1990 led to the long fall in both asset and consumer prices. 
• It also happened in the US, where the stock crash of 1929 was followed by consumer price deflation in the early years of the Great Depression.

Understanding Real Inflation Threats

When may inflation be too high?

These are still very useful averages as benchmarks for judging when inflation may be too high:

• Any emerging nation with a rate of inflation much above 4%, or 
• any developed nation with a rate much above 2%.

Any country with high inflation has cause for concern.

High consumer price inflation is a growth-killing cancer.  

This still holds true.  

• In the short-term, rapidly rising prices compel central banks to raise interest rates, making it more expensive for businesses and consumers to borrow.  High inflation also tends to be volatile, and its swings make it impossible for businesses to plan and invest for the future.   
• Over the longer term, inflation erodes the value of money sitting in the bank or in bonds, thus discouraging saving and shrinking the pool of money available to invest in future growth.

Actions of central banks post crisis of 2008

In the slow growth-environment that took hold after the crisis of 2008, central banks often worry that inflation may be too low, not too high.

In developed countries, instead of raising rates to make sure inflation doesn't increase to far above a target of 2%, they now cut interest rates when inflation is falling too far below 2%.  

Their big fear is that low inflation will lead to outright deflation - the dreaded but overblow "Japan scenario".

"Bad deflation" and "Good deflation"

History, in fact, shows that neither low inflation nor deflation are necessarily bad for economic growth.   

Japan suffered a rare bout of "bad deflation" after the collapse of its stock and housing bubbles in 1990.  Consumer demand dried up, prices started to fall and shoppers began delaying purchases in the expectation that prices would fall further.  The downward spiral depressed growth for 2 decades.  

However, deflation can also follow a new tech or financial innovation that lowers production costs and boosts economic growth.

If inflation is too high, it is almost always a threat to growth but the same cannot be said of low inflation.  Even if low inflation threatens to devolve into deflation, it could be good for growth if falling prices are driven by new innovation and expanding supply rather than by depressed demand.

Need to control inflation in both consumer markets and financial market

Perhaps, the deepest flaw in traditional thinking, however, is that it still focuses on the kind of inflation that has largely disappeared.   

• After the central banks won the war on high consumer price inflation, they cut interest rates to levels that have fueled a massive run-up in prices for financial assets, including stocks, bonds, and houses.  
• And in recent decades, as we have seen, stock market and housing bubbles have been increasingly common precursors to financial crisis and recessions. 

Traditional thinking fails to recognize the new inflation threat in the financial market

Economists have been very slow to recognize this new inflation threat, and central banks have been very slow to think outside their official mandates, which focus on stabilising the economy by controlling inflation in consumer prices only.  

But successful nations will control both kinds of inflation, in consumer markets and in financial market.

No subject in economics is more paralyzed by traditional thinking than inflation, a term that generally refers only to the pace of increase in consumer prices, a once ubiquitous threat that has largely vanished in recent decades.  

Central bankers and economists still tend to focus on consumer price inflation, even though it has largely disappeared and to ignore prices for assets like stocks, bonds and real estate, even though there is an increasingly clear link between real estate and stock market busts and economic downturns.

Successful Nations Invest Heavily and Wisely

The most basic formula in economics

GDP is the sum of spending by consumers and government plus investment and net exports.

GDP = (C+G) + (I+X)

Investment (I) reveals the most about where the economy is heading.  Without investment, there would be no money for government and consumers to spend.  Investment includes total investment by both the government and private business.    Investment helps create the new businesses and jobs that put money in consumers' pockets.

Consumption is typically by far the largest share of the spending in the economy - more than half.  Investment is usually much smaller, around 20% of GDP in developed economies and 25% in developing economies, give or take.

Investment is the most important indicator of change

Investment is by far the most important indicator of change, because booms or busts in investment typically drive recessions and recoveries.  In the U.S., investment is 6 times more volatile than consumption, and during a typical recession it contracts by more than 10%, while growth in consumer spending merely slows down.

Successful nations versus those facing weak prospects

In successful nations, investment is generally rising as a share of the economy.  When investment is rising , economic growth is much more likely to accelerate.

Any emerging country is generally in a strong position to grow rapidly when investment is high - roughly between 25% and 35% of GDP - and rising.

On the other hand, economies face weak prospects when investment is low, roughly 20% of GDP or less - and falling.   

Much of what makes the emerging world feel chaotic reflects a shortage of investment in the basics.  

In developed economies, investment spending tends to be lower because basic infrastructure is already built.  So pay less attention to the level of spending as a share of GDP and more to whether is is rising or falling.   

Strong growth in investment is almost always a good sign, but the stronger it gets, the more important it is to track where the spending is going.  

Good and bad investment binges.

The best binges unfold when companies funnel money into projects that fuel growth in the future:  new technology, new roads and ports, or especially, new factories.  

Of the 3 main economic sectors - agriculture, services and manufacturing - manufacturing has been the ticket out of poverty for many countries.    

No other sector has the proven ability to play the booster role of job creation and economic growth that manufacturing has in the past.

As a nation develops, investment and manufacturing both account for a shrinking share of the economy, but they continue to play an outsize role in driving growth. 

An investment binge can be judged by what it leaves behind.  

Following a good binge on manufacturing, technology, or infrastructure, the country finds itself with new cement factories, fiber-optic cables, or rail lines, which will help the economy grow as it recovers.  

Bad binges - in commodities or real estate - often leave behind trouble.

• Investment does little to raise productivity when it goes into real estate, which has other risks as well:  it is often financed by heavy debts that can drag down the economy.   
• When money flows into commodities like oil, it tends to chase rising prices and evaporate without a trace as prices collapse.  

So, while investment booms are often a good sign, it matters a great deal where the money is going.

 

Capital flows in a Globalized World

Countries need foreign currency to pay their import bills.   

They can obtain these from:

- foreign bank loans,

- foreign purchases of stocks or bonds of their countries, or,

- direct foreign investment in local factories.

These flows all are recorded in the capital account of the balance of payments.

Analysts and newspaper headlines tend to focus only on foreign purchases of stocks and bonds.  These are often called "hot money" because foreigners looking for a quick profit can dump stocks and bonds like hot potatoes when crises begin.

Bank loans:  the real hot money 

In recent decades, the most volatile capital flows have actually been bank loans, which are now the real hot money.

China and other emerging markets began opening their doors to foreign capital.  Capital flows rose from 2% of global GDP in 1980 to 16% (a whopping $19 trillion) by early 2007.

Then came the 2008 crisis and optimism about emerging nations vanished. 

By 2014, capital flows had fallen back to $1.2 trillion - once again about 2% of current global GDP.  , Bank lending, the largest portion of capital flows, turned negative during the crisis, indicating that banks were liquidating loans to bring money home.

When capital flows slowed

With capital flows slowing, those countries with persistent current account deficits may run into trouble financing these deficits much sooner.

In the pre-2008 era, the tipping point came when the deficit had been increasing by 5% of GDP for five years in a row.  

In the post-crisis era, the tipping point may come faster and at a lower deficit levels; the 5 percent rule may become a 3% rule.

How to read Money Flows: Study the Balance of Payments, especially the Current Account

Money flows

If the currency feels cheap and the economy is healthy, bargain hunters will pour money in it.

If the currency feels cheap but money is still fleeing, something is wrong.#

Study the balance of payments, particularly the current account

All the legal channels for money flows can be found in the balance of payments, particularly the current account.  

Current account = net trade (mainly) + other foreign income.

The current account captures how much a nation is producing compared to how much it is consuming and it reveals how much a nation has to borrow from abroad to finance its consumption habits.  

If a country runs a sizable deficit in the current account for too long, it is going to amass obligations it cannot pay.  The trick is to identify the tipping point.

Persistently high current account deficit leads to economic slowdown

Testing for various sizes of deficits, over various time periods, confirmed that when the current account deficit runs persistently high, the normal outcome is an economic slowdown.  

If the deficit averages between 2% and 4% of GDP each year over a five-year period, the slow-down is relatively mild.  

If the deficit averages 5% or more, the slowdown is sharper, shaving an average of 2.5% points off the GDP growth rate over the following five years.  

The growth slowdown hit countries rich and poor.  

This is the danger zone

If a country runs a current account deficit as high as 5% of GDP each year for five years, it is consuming more than it is producing and more than it can afford.

Running sustained current account deficits of more than 3% or 4% of GDP can also signal coming economic and financial trouble - just less urgently.

In fact, some emerging-world officials have come to believe that when the current account deficit hits 3% of GDP, it is time to restrain consumer spending and prevent the country from living beyond its means.

Below the 3% threshold, a persistent current account deficit may not be a bad thing.  

• If money is flowing out of the country to import luxury goods, which do not fuel future growth, it will be harder for the country to pay the import bills.  
• If it is going to buy imports of factory machinery, the loans financing those purchases are supporting productive investment in future growth.

One quick way to determine whether the rising deficit is a bad sign is to check whether investment is rising as a share of GDP.   Such a rise at least suggests that money is not flowing out for frivolous consumption.

Appendix:

# In late 2014, the Russian ruble collapsed because of the falling price of oil.  Russians were still pulling tens of billions of dollars out of the c0untry every month, fearing that the situation would get worse.  Cheap was not yet a good sign, because the ruble was not yet cheap and stable.

Summary

The article's key points:

To understand money flows, focus on studying the balance of payments, especially the current account.

The current account reflects a nation's production versus consumption and reveals how much it borrows from abroad.

Persistent high current account deficits lead to economic slowdowns.

Deficits between 2% and 4% of GDP cause milder slowdowns; deficits of 5% or more cause sharper slowdowns.

Running deficits above 3% or 4% of GDP can signal economic trouble.

When a country has a 5% GDP deficit for five years, it is living beyond its means.

For deficits below 3%, it depends on whether the money is invested productively or wasted on non-essential imports.

Appendix: In 2014, the Russian ruble collapsed due to falling oil prices, and money continued to leave the country, showing that cheapness of currency wasn't a positive sign until it stabilized.

"In valuing currencies, nothing works." Why "FEEL" is the Best Measure.

Formal measures of valuing currencies are open to manipulation by politicians

The more formal measures are open to manipulation by politicians, who can make their currency, and thus their country, look competitive by cherry-picking data.  

To accurately value currencies, one has to correct for different inflation rates.  

• One common measure, the real effective exchange rate (REER), corrects for consumer price inflation in a country's major trading partners.  
• Competing measures correct for producer prices, labour costs, or per capita income.  
• The results, however, are often contradictory.  

The Economist's Big Mac Index

To improve clarity, experts have attempted to rank how expensive countries are by comparing prices for common items.   

• The granddaddy of these rankings is the Economist's Big Mac Index.  
• Others compare prices for Starbuck coffee, iPhones and other goods.  

All these approaches acknowledge that the only way to value a national currency is by how cheap it feels to buy goods in that country.

Judging a currency by how cheap it "feels" may sound vague, but there is no better way.  

In the absence of an accurate measure, outsiders need to trust that they will know an expensive currency when they feel it.  Of course, the feel of a currency will vary with the traveler. 

• Brazil may feel less expensive to Americans paying in dollars than to Europeans paying in euros.  
• In general, though a rising currency tends to be rising against most major currencies and the currency that matters most is the US dollar.

Is a strong currency a sign of a strong economy? Are we overlooking the risks of a strong currency?

1.   If currency starts appreciating too fast, foreigners will start buying local stocks or bonds not because they believe in the economy, but because they believe the rising currency will increase the US dollar value of those investments.  

2.  For a while this bet is self-fulfilling, as foreign money continues to drive up the value of the local currency.

3.  Eventually, though, an expensive currency makes the country's exports too pricey to compete in global markets.  

4.  The economy stalls, the currency crashes, and the country will be poised to grow only when it stabilizes again, at a competitive value.  

Summary

A cheap currency is good.  A currency that makes local prices feel affordable will draw money into the economy through exports, tourism and other channels.

An overpriced currency will encourage both locals and foreigners to move money out of the country, eventually sapping economic growth.

Successful nations feel cheap, at least to foreign visitors.  (The cars of some developed countries are so cheap relative to those of Malaysia.  The food and personal wears of some developed countries are so cheap relative to their incomes and also for visiting Malaysians too.)