How does international capital flow?

Summary

Focus

Gross capital flows play a central role in today's policy debates. Yet current theory largely relies on net flow models of saving and current accounts. This limits the scope of policy advice.

Contribution

We extend the standard open economy macroeconomic model to include credit creation, thus allowing us to study gross capital flows. The model clarifies that it is shifts in cross-border gross financial positions, rather than changes in real saving, that finance economic activity. Financial shocks become a key source of real vulnerability. We shed new light on four classic policy debates around capital flows.

Findings

Gross capital flows depend critically on financial factors, such as banks' willingness to lend and household portfolio preferences. Real saving shocks have little and only indirect effects on gross positions. This has far-reaching implications. First, persistent US current account deficits are better explained by a domestic credit glut than the global saving glut. Second, gross flows are an important indicator of financial vulnerability, more so than real saving or current accounts. Third, there is no Triffin's current account dilemma (the assertion that US current account deficits are necessary to meet global demand for reserve currency) because dollars are created by banks rather than current account deficits. Fourth, the high correlations between gross capital inflows and outflows are overwhelmingly the result of double-entry bookkeeping.

Abstract

Understanding gross capital flows is increasingly viewed as crucial for both macroeconomic and financial stability policies, but theory is lagging behind many key policy debates. We fill this gap by developing a two-country DSGE model that tracks domestic and cross-border gross positions between banks and households, with explicit settlement of all transactions through banks. We formalise the conceptual distinction between cross-border saving and financing, which often move in opposite directions in response to shocks. This matters for at least four policy debates. First, current accounts are poor indicators of financial vulnerability, because in a crisis, creditors stop financing debt rather than current accounts, and because following a crisis, current accounts are not the primary channel through which balance sheets adjust. Second, we reinterpret the global saving glut hypothesis by arguing that US households do not finance current account deficits with foreigners' physical saving, but with digital purchasing power, created by banks that are more likely to be domestic than foreign. Third, Triffin's current account dilemma is not in fact a dilemma, because the creation of additional US dollars requires dollar credit creation by US and non-US banks rather than US current account deficits. Finally, we demonstrate that the observed high correlation of gross capital inflows and outflows is overwhelmingly an automatic consequence of double entry bookkeeping, rather than the result of two separate sets of economic decisions.

JEL classification: E44, E51, F41, F44

Keywords: Bank lending, money creation, money demand, uncovered interest parity, exchange rate determination, international capital flows, gross capital flows.