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Is ‘Hot Money’ Responsible for the Financial Crises?

Image of $5 bill on fire by flickr user Mike Poresky.
Photo by flickr user Mike Poresky and used under a Creative Commons / Attribution 2.0 Generic license.

Paul Solman answers questions from the NewsHour audience on business and economic news here on his Making Sen$e page. Here is Tuesdays query:

Rob Griffith asks: Is there any consensus about whether large rapid inflow and efflux of capital into various countries has played a significant role in the financial crises of the last 30 years, like those in Latin America, East Asia, the U.S. and Europe? If so, what actions are considered to be more helpful than harmful?

Paul Solman: Consensus? In economics? Hardly ever. That’s why any economist worth her salt will qualify almost all assertions with the phrase “ceteris paribus,” meaning “all things equal,” as in, “If more money is printed, there will be inflation, ceteris paribus.” One of the safest statements in economics is that printing money causes inflation. But if people refuse to spend the new money and bury it instead, no inflation. “All things” have not remained the same.

As to the financial crises of the last 30 years, yes, rapid capital flows have often been fingered as a key culprit. “Hot money,” it’s called, and it generally comes from foreign investors in the form of short-term loans that drive down interest rates when they flood the country, spurring spending and investment. When the investors get nervous, however, and suddenly pull their money out by selling their loans (or simply not refinancing them with new lending), interest rates shoot up, the domestic currency drops in value, and spending and investment swoon. This is how China explains its strict controls over foreign investment and its refusal to let its currency trade openly: it says it’s worried about the role of “hot money” in causing bubbles and busts.

This entry is cross-posted on the Rundown– NewsHour’s blog of news and insight. Follow Paul on Twitter.

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