A crash-course on the euro crisis
Markus K. Brunnermeier & Ricardo Reis
Capital inflows and their allocation
Section 2
The run-up to the euro crisis
A modern view of capital flows
A model of misallocation
Simple model to illustrate phenomenon of investment booms leading to acute misallocation of capitalWe focus on two types of misallocation: between and within sectorsThe economy has two sectors which each contains several firmsIt has to allocate its scarce capital between the two sectors
Setting up the model
SectorT
Produces goods that are traded in international markets, subject to fierce competitionE.g. manufacturing
SectorN
Produces goods for the domestic market, protected from foreign competition by natural and political barriersE.g. construction and real estate
T
A
Efficient equilibrium
N
Production frontier
Preferences
PoliticsSectorNprotected by local politiciansGiven lack of competition can form local cartelsCoordinate political contributions
FinanceSectorNfavoured by local bankersIn construction collateral is available and is easy to price.Large construction companies often have important shareholder stakes in local banks
Misallocation across sectors
RentsFavouring sectorNcreates rents.Effort and resources are diverted to capture these rentsDirectly lowers the economy’s resources.
Back to model
FavoringN:Illustrated as ataxon sectorTover their output leading to a lower marginal product of capitalThe production frontier is nowflattersince diverting one unit of capital fromNtoTgives a lower returnRentProduction functionshifts inFor simplicity, assume all of the taxes onTis lost this way
T
A
Protecting sector N
N
Effects of misallocation
Equilibrium moves fromAtoBRatio of output inTto output inNfallsEconomyworse off
T
B
A
Misallocation between sectors
N
PoliticsWithout foreign competition, firms can more easily lobby for local regulations to erect barriers to entry and constraints on firms growingPoliticians are receptive to small firms as entrepreneurship is seen as income mobility and small firms employ a large share of the population
FinanceBanks in underdeveloped financial markets lack managerial talent and tools to diversity their credit portfolioSo they are weary of giving large loans to a few firms.
Misallocationwithinsectors
An example of within sector misallocation
Consider a limit on firm size of1unit of capitalThere are many potential firms to produce goodNDemand for goodNis3units in an efficient economyThe most productive firm can produce all3units using3units of capital – thus its productivity is1Yet, facing an upper bound it can only produce1unitThe next best firm needs3units of capital to produce1unitThe third firm needs5units of capital to produce1unitHence,1+3+5=9units of capital is required to produce3units of goodN– productivity is3/9 = 1/3which is lower without barriers to firm size
In model
Implication:Every extra unit produced in sectorNtakes more capitalMoreToutput is sacrificed for an extra unit ofNAnd increasingly so, asNproduction expandsProduction frontierBecomesconcaveStart at same vertical intercept
T
N
B
Effect of firm-size limits
Effects of misallocation
The distribution of firm size is therefore skewed tosmallerfirmsMoving the equilibrium fromBtoCEconomy worse off
T
N
B
C
Misallocation within sectors
Capital inflow
Possible causesFinancial liberalizationCapital market unionEffectsMore capital available for productionProduction functionshifts outClose-to-efficient economy at start (for simplicity): pointAIf efficient economy, move toD
T
N
D
A
Capital inflow boom
With misallocation
The pressure on politicians to make structural reforms is relaxedAbundant credit makes it harder to distinguish productive projectsSome of the funds get diverted to assets which are inelastically supplied, creates capital gains, augments future expectations and fuels asset bubbles that spurs further credit in inefficient sectors
T
N
D
E
Misallocation between andwithin sectors
End result
Economy moves instead toENon-tradable sector booms at expense of tradable sectorTFP falls on aggregateDispersion of TFPacross firms rises as left tail growsAnd debt that funded capital flow must eventually be repaid.
T
N
A
E
Misallocation between and withinsectors after a capital inflow boom
The seeds of the euro crisis: the investment boom in Portugal
Actual TFP in Portugal
The blue line isactualTFPPost 1999 it fallsSeemed puzzling: local firms now had capital from abroad to expand, conquer new marketsSame happened in Ireland, Spain, Italy.Construction and real estate sectors boomed, wages rose.Butproductivity fell.
Actual and counterfactual TFP in Portugal
Orange line fixes the relative size of each economic sector at its 1999 level to build acounterfactual TFPEliminate possible between-sector misallocation.Explains some of the decline.
Actual and counterfactual TFP in Portugal
As well as fixing the relative size, the grey line shows the TFP counterfactual if misallocationwithinsectors also remained at their 1999 levelsEliminate possible between and within-sector misallocation.Explains about half the declinePortugal’s slump in productivity can be partly explained by capital misallocation after the euro in 1999
More euro-area data
Further illustration of this at work ineuroarea2000-07Capital inflows core peripheryCross-sector changes in Portugal and othersDispersion of manufacturing productivity in SpainThe rise in productivity in Spain during the crisis
Capital flowing from core to periphery
Capital flowing from core to periphery
Current account balances as ratio of GDP
Source: Reis, R. (2012) ”Comment” Brookings Papers on Economic Activity
Total Factor Productivity After Inflows
Source: Dias, C, C Marque and C Richmond (2016) ”Misallocation and productivity in the lead up to the Eurozone crisis”, Journal of Macroeconomics
Across-sector reallocation in Portugal
Source: Reis, R (2013) ”The Portuguese Slump and Crash and the Euro Crisis”, Brookings Papers on Economic Activity.
Across-sector productivity and markups
Source: Reis, R (2013) ”The Portuguese Slump and Crash and the Euro Crisis”, Brookings Papers on Economic Activity.
Across-sector reallocation in Spain
Source: Chen, T (2018) ”TFP declines: misallocation or mismeasurement” Columbia University manuscript.
Across-sector reallocation in periphery countries
Source: Chen, T (2018) ”TFP declines: misallocation or mismeasurement” Columbia University manuscript.
Within-sector reallocation, Spain manufacturing
Source: Gopinath, G, SKalemli-Ozcan, LKarabarbounis, C Villegas-Sanchez (2018) ”xxx” Quarterly Journal of Economics
Within-sector reallocation, Spain manufacturing
Source: Gopinath, G, SKalemli-Ozcan, LKarabarbounis, C Villegas-Sanchez (2018) ”xxx” Quarterly Journal of Economics
In crisis, TFP actually rises.
Source: Castillo-Martinez, L. (2018) ”Sudden Stops, Productivity and theExchnageRate” LSE manuscript
Within-sector reallocation, Spain manufacturing
Source: Castillo-Martinez, L. (2018) ”Sudden Stops, Productivity and the Exchange Rate” LSE manuscript
Loss of competitiveness ofTsector
Source: Reis, R. (2012) ”Comment” Brookings Papers on Economic Activity
Trade deficits in Portugal
Source: Reis, R (2013) ”The Portuguese Slump and Crash and the Euro Crisis”, Brookings Papers on Economic Activity.
Summary
A modern view of capital flows shows how investment booms can actually lower productivityThis leads to capital misallocation in poorer countries as their financial markets lack financial depthWe looked at two types of misallocation:betweenandwithinsectorsProductivity slumps accounted for by misallocating capitalThis raised the costs of firms in tradable sectors, reducing their international competitiveness and leading to trade deficits
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