CPE Globalization Briefs Center for Popular Economics PO Box 785 Amherst MA 01004 413 545 0743 www PopularEconomics org Hot Money E conomists call the short term investments that zip rapidly into and out of an economy portfolio investment and contrast them with more longterm flows called foreign direct investment Most others call this footloose finance hot money Movements of portfolio investment can destabilize entire regions of the world A sudden outflow of portfolio investment can trigger a financial meltdown requiring bailouts of billions of dollars to clean up the mess Portfolio investments reflect changes in how investors see their short term prospects When expectations begin to sour an initial withdrawal of capital can cause the currency of a country to fall reducing the value of other portfolio investments As investments lose value more investors will pull out resulting in a cascading outflow of finance and rapidly falling exchange rates Investors are not the only ones to lose during a currency crisis Falling currency values directly affect the lives of ordinary people As the currency loses value imports of basic goods become much more expensive In addition economic activity slows down because of increasing costs of imported materials and equipment The result is stagflation higher prices and slower growth that can reduce the living standards of a sizable portion of the population In the face of financial pressure many countries raise their domestic interest rates in order to bribe investors to stay Higher interest rates often mean higher rates of return However they also mean a slower economy and higher debt payments for many people living standards suffer again In recent years the expansion of portfolio investment and the reduction in regulatory controls have left countries around the world more susceptible to financial crises Although vulnerability varies from economy to economy today any given country faces on average an estimated 10 percent chance of a financial crisis every year Changing institutions also contribute to higher risks For example the expansion of stock markets in many developing countries can encourage a higher volume of portfolio flows and increase uncertainty on domestic financial markets What can be done about the dangers associated with rapid inflows and outflows of short term investment One solution would be to implement a low level tax often called a Tobin tax on every Total Portfolio Investment Flows to Developing Countries by Region billions U S 25 1990 20 1998 15 10 5 0 5 Europe Central Asia Latin America East Asia South Asia Sub Saharan Middle East the Pacific Africa N Africa Source World Development Indicators 2000 Table 6 7 cross border foreign exchange transaction The tax would penalize investors for playing speculative games in which finance is rapidly moved from one investment to another However for long term investors the total level of taxation would be negligible A second strategy would be to implement capital controls policies that restrict the movement of short term portfolio flows For example a country could require foreign investors to keep a fraction of capital inflows in a reserve account for a minimum length of time for example a year The reserve account would act as a speed bump slowing down short term financial flows and lessening the risk of a financial crisis Sources Dean Baker Gerald Epstein and Rober Pollin 1998 Introduction in D Baker G Epstein and R Pollin eds Globalization and Progressive Economic Policy Cambridge UK Cambridge University Press World Bank 2000 Safeguarding against crisis the near term agenda Global Development Finance Washighton DC The World Bank Graciela Kaminsky and Carmen Reinhart 1999 The twin crises The causes of banking and balance of payments problems American Economic Review 89 3 473 500 The Center for Popular Economics is a non profit collective of political economists that teaches economic literacy to activists for progressive social change CPE creates and communicates economic theories that challenge systems of oppression based on class race gender and nation Our programs and publications demystify economics and provide alternative to mainstream analyses 2
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