Lucas paradox redux

By bne IntelliNews July 16, 2012

Ben Aris in Moscow -

Markets are supposed to be rational - both classical economics and common sense say capital should flow to wherever the returns are highest. The trouble is the real world doesn't work like that, especially in difficult times like today.

With massive debts on national balance sheets and several rounds of currency-debasing quantitative easing the best solution western governments can come up to solve their woes, the risks are rising fast. Investors have flocked to traditional "safe havens" of the US dollar and US Treasury bills, which Goldman Sachs recently lampooned in a paper as "the assets formerly known as safe."

"The number of 'AAA'-rated sovereigns is declining and in the advanced economies, the number of countries with an 'AAA' debt rating fell from 68% before the 2007-2009 financial crisis to 52% currently. In emerging markets, there are no 'AAA'-rated countries, but an 'AA' rating is held by 15% of countries (up from 10% pre-crisis)," Neil MacKinnon, economist with VTB Capital wrote in a note in July. "International Monetary Fund projections envisage gross general government debt of the advanced economies will reach $59 trillion by 2016 compared to $47 trillion at the end of 2011."

Indeed, things have got so crazy that bond investors are willing to buy German bunds that earn negative real interest and lock in losses rather than snap up the rock solid Russian quasi-sovereign bonds from the likes of Sberbank and VEB that pay at least a 6% yield. Russia has just over a dollar of cash to back every dollar of external debt (both sovereign and commercial), so the chances of default are small, especially when you set Western Europe's macroeconomic problems against Russia's.

Accepting losses when there are relatively safe high returns on offer makes no sense. This surprising situation where capital does not flow from developed countries to developing countries despite the fact developing countries have lower levels of capital per worker and so the returns related to the infusion of capital are higher is known as the "Lucas paradox", after the Nobel Laureate Robert Lucas of the University of Chicago, who came up with the idea in a paper in 1990.

Uphill struggle

What is responsible for this "uphill" flow of capital? The paradox doesn't apply to the flow of labour, as the hordes of immigrants arriving in Russia from the 'Stans last year showed (resulting in growth of the Russian population for the first time in two decades, from 142m to 143m). The US experiences much the same thing with Mexicans sneaking over the border to look for work.

In a conversation with bne, Lucas says he doesn't know the answer, but highlights two areas that he believes could be responsible. The first is simply due to the rudimentary nature of developing economies: the lack of infrastructure and modern equipment, missing factors of production, and poor regulation and low-quality institutions.

His original paper was inspired by Africa's plight in the 1980s: mineral rich in oil, minerals and diamonds, the continent subsisted on international aid and received almost no investment. "In Africa, there were almost no institutions, as the continent was ruled by warlords and those institutions left by the French didn't function. The experience in India that inherited British institutions was mixed, but somewhere like Singapore, which threw itself into institution-building following independence, has been a remarkable success," says Lucas.

In Russia's case, Lucas points to President Vladimir Putin as a problem for investors: "There is real political risk in Russia and Russia under Putin doesn't inspire confidence. It is not an easy place to do business, as the government plays its favourites," says Lucas. "And this is true, not just in Russia, but in dozens of emerging markets. Of course, this raises the question of why companies are so comfortable investing into China, which is no different. Is it irrational? There is no obvious answer."

Subsequent research found that the one place where the Lucas paradox didn't work was post-colonial America, where the British institutions were taken over by the founding fathers and improved upon: British capital continued to flow after American independence and financed much of the new country's early growth. (To a lesser extent, British colonialism in the 17th and 18th century, the golden era of the British Empire, also facilitated capital flows: colonists take their money with them.)

Where's the story?

The second group of problems has to do with the imperfections in the international capital markets, the risk of expropriation by the host government and the asymmetrical nature of information.

The golden rule of investing is "invest in what you know." According to the US Bureau of Labour Statistics, the US press corps numbers about 60,000 journalists - or one hack per 5,300 citizens. By contrast, the entire English-speaking press corps in Russia (which actually covers the 15 republics of the former Soviet Union) numbers about 300 hacks, according to bne's estimates - or one journalist per 834,000 people.

And that is before you take into consideration the space the Russia story gets in the international media: in 2011, the Wall Street Journal published a total of 2,608 stories with the word "Russia" in them on its website (and only 876 in the print issue), against the 64,336 articles with the word "America" in them (20,384 in print). Yet this is despite the fact that the four BRIC countries already account for 25% of global GDP, 40% of the global population and 50% of global growth.

Another big problem is the flaws in the way capital markets are run. A crisis in, say, Mexico will typically impact a market like Russia, despite the two economies having virtually no direct links with one another. "Emerging markets tend to move together even when there is no economic connection," says Lucas, speaking from his home in Chicago. "Russian bonds and Mexican bonds move together because there is some trader in New York that is trading both of them. The money is not so much moving around the world as around a room."

The Lucas paradox will eventually undo itself as these distortions disappear over time. Since Lucas wrote his paper, Africa has become a lot more democratic and investment has finally started to flow to exploit its enormous natural resources - with much of it coming from Russia, India and China, which are a lot more comfortable working with poor institutions and patchy information.

Likewise, as more and more investors travel to the emerging markets (and young Russians in search of a job go the other way), information is becoming more readily available in London and New York, even if it isn't in the mainstream media.

Finally, as emerging markets develop, institutions are being built. Russia has clearly entered a new phase where the government needs to nurture rather than push the economy forward. And the effort to set up supra-regional bodies like the Customs Union, which came into being in January 2010, as well as membership of the WTO will force Russia to improve the quality of its institutions at home as well.

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