In my earlier blog post, I had referred to the work by Blanchard and his co-authors on whether capital inflows were contractionary. The full paper is here. Have not read the full paper yet. Here are some expanded thoughts:
The policy implications drawn are convenient in theory and they are hard to execute in practice. They had conveniently ignored the political economy dynamics and the power of international portfolio investors to keep markets open, especially now that their opportunities and avenues to make returns have shrunk dramatically.
Further, non-bond flows (FDI) are dwarfed by the size and speed of bond flows. Hence, they are a problem for developing countries. For developed countries, currency appreciation should matter relatively less than for small, open and developing economies. They should be happier with bond inflows because it depresses interest rates across the yield curve, something that their policymakers aim for and hence, should welcome! This is particularly true for the United States.
The situation, hence, is this: capital inflows are not contractionary for the developed world. The authors say that they found bond inflows to have slightly negative effect on output. We need to see how big the effect was, what the lag was and for what countries. The devil may be in the details.
In general and, on balance, capital inflows are expansionary for them through the asset market effect. They stoke bubbles in bond and stocks. The currency effect is not important, by and large, for developed countries.
Capital inflows are expansionary for the developing world too, through credit and capital misallocation.
Mundell-Fleming might have been right and appropriate for periods when capital flows had not grown to such Frankenstein proportions. The problem is to deal with the excess stimulus and undesirable side effects of capital inflows and not the other way around.
Global financial integration – especially of the portfolio variety – has to be rethought and urgently too.