Difference between trade in goods and trade in finance

The best ideas on any topic in economics come when we have criticisms/critiques of an academic paper/ thought/article etc.

I just came across this piece written by Jagdish Bhagwati and critique by Maurice Obstfeld. And let me tell you it is super-stuff. This is what makes the field of economics so interesting.

I have often wondered what is the difference between trading in goods and trading in finance (assets)?  The latter has been distinguished from the former in wake of number of financial crisis. The initial idea was that trading in finance would also have similar benefits as trade in goods does (developing countries would need to fiannce their investments they would need additional finance apart from domestic savings) , hence it was advocated by a number of economists. Then came number of crisis in 1994 where finance (mainly short-term capital flows) was held largely responsible for the crisis. So now, we have 2 seperate topics and financial globalisation is a different topic altogether.

JB says in this famous and often cited piece that trade in widgets isn’t the same as trade in dollars. He says:

Each time a crisis related to capital inflows hits a country, it  typically goes through the wringer. The debt crisis of the 1980s cost South America a decade of growth. The Mexicans, who were vastly overexposed through short-term inflows, were devastated in 1994. The Asian economies of Thailand, Indonesia, and South Korea, all heavily burdened with short-term debt, went into a tailspin nearly a year ago, drastically lowering their growth rates.

The difficult part is the policies followed after the financial crisis. It basically leads to further opening of the capital markets which caused the crisis in the first place:

When a crisis hits, the downside of free capital mobility arises. To ensure that capital returns, the country must do everything it can to restore the confidence of those who have taken their money out. This typically means raising interest rates, as the IMF has required of Indonesia. Across Asia this has decimated firms with large amounts of debt. It also means having to sell domestic assets, which are greatly undervalued because of the credit crunch, in a fire sale to foreign buyers with better access to funds……. Thus, Thailand and South Korea have been forced to further open their capital markets, even though the short-term capital inflow played a principal role in their troubles in the first place.

He in the article then goes onto point out the Wall Street -Treasury Complex where both combine to always promote capital openness:

Wall Street’s financial firms have obvious selfinterest in a world of free capital mobility since it only enlarges the arena in which to make money. It is not surprising, therefore, that Wall Street has put its powerful oar into the turbulent waters of Washington political lobbying to steer in this direction……Wall Street has exceptional clout with Washington for the simple reason that there is, in the sense of a power elite a la C. Wright Mills, a definite networking of like-minded luminaries among the powerful institutions-Wall Street, the Treasury Department, the State Department, the IMF, and the World Bank most prominent among them……

So he provides a basic framework on which Obstfeld builds his thoughts. He says the difference between trade in goods and dollars is:

The basic differences relate to the intertemporal nature of financial trades and to the potential for asymmetric information to eliminate trade gains. Asset trade inherently involves commitment – the commitment to pay on a later date. Payment in reality is therefore always contingent, and the circumstances of contingency can depend on information known to only one party to the deal. Thus, financial transactions inherently must allow for the asymmetric-information distortions that we call moral hazard and adverse selection. These distortions reduce the gains from asset trade that would otherwise be available – even with an efficient and impartial judicial enforcement system.

As is well appreciated, government guarantees aimed at mitigating the redistributive effects of financial crises can, in fact, worsen moral hazard and raise the probaility of eventual crises.

Again, the difference compared to goods markets is a matter of degree. A consumer durable yields returns over time, it may be known to the seller to be a “lemon,” yet an unconditional service contract may leave the owner with insufficient incentives to operate the durable good appropriately. But there is no doubt that commitment and informational problems are by far most severe, and have the widest systemic ramifications, in the financial market setting.

Obstfeld then says domestic financial markets also pose problems as the above i.e. intertemporal nature and assymetric information are a problem in domestic markets as well. What makes international capital flows a bigger problem is addition of 3 more risks:

1.  Sovereignty: The potential involvement of two (or more) governments as implicit parties to international contracts.
2. Regulatory end-run:  International transactions can sometimes be used to evade domestic supervision.
3. Currency mismatch: The potential for unbalanced positions creates a significant additional systemic risk.

This is basic stuff and very well said. For a survey on whether financial globalization (or trade in finance) is helpful or not, I have put findings of the most exhaustive paper on the subject here and here. And in nut-shell the evidence so far has been mixed.