If you would like.
Welcome back to the Stanford initiative.
We're going to kick off a new section that
is going to focus on firms, investors, and
global capital locations.
And this is where my
quarters brand name and
Jesse Schrader,
also the organizers of the initiative.
I'll pick the first module of the session
to give you an overview of why do we care
about capital allocation.
And in some sense it will be more general
then the specific research papers that we
will cover in the rest of the session.
And it should be really treated as an
introduction to the field more generally
or to a topic more generally.
The basic question that we care about
is who gets capital from whom around
the world.
Why do we care?
We care because this affects risks.
For example,
a shared is the US exposed to China or
is France exposed to Germany.
But it's not just about a descriptive
version of the risk that we share.
There's also an element these
positions at this capital
allocations endogenously
generating new risks, for
example through externalities
to financial amplifications.
So wide topic that economists
have cared about for a long time.
And typically we think of the benefits
as being transferring capital
from savers to productive users
that might have productive ideas,
but not enough capital to pursue them.
We also think of the benefits
as sharing risk more globally.
So diversifying portfolios.
It's one way to reduce the prevalence
of idiosyncratic risks globally.
We also think of these flows of capital.
So the changes in allocation
of capital over time,
as forces that might
equilibrate exchange rates.
This goes back to the Friedman
stabilizing speculation.
It might, for example, equalize or
stabilize seeping interest rates and
government rates around the country or
even the private cost of borrowing.
It might be that firms in particular
country are facing high cost of
capital because there isn't
enough capital domestically.
And if capital comes in from abroad,
that lowers the cost of capital.
Of course over the years, we've come to
understand that there are a number of
problems that also come with
the global allocation of capital.
For example, capital flights, we just went
through a major episode during the early
part of the COVID crisis, where capital
flew out very fast on emerging markets.
We also came to understand that there is
endogenous amplification of these risks.
For example,
if we lend a lot to an emerging market,
in that foreign currency, and
the exchange rate deeper shades,
this has a negative wealth
effect on that country.
The negative wealth effect itself
mind you is more depreciation
as the foreign investors try
to pull out even farther.
And more recently we'll start with
thinking about unequal access to capital.
If you take a look at who dominates
capital markets globally, you will
quickly realize the large governments,
the large firms play a very big role.
And in particular for the firms,
these might not be a level playing field,
that if you're a small firm you're you
might not have as easier time as accessing
the global capital market as
your larger counter parties.
Similarly, if you focus on the very,
very large firms,
there are all sorts of
reasons why they might
use this international margins to
actually gain the system a little bit.
For example, evade regulation or try to
reduce their tax burden or try to seek
out particularly investors in a way
that might not be optimally socially.
These are all issues that
fundamentally rely on the knowledge of
who owns what around the world.
And how do these genius players behave?
And that's really where the data work
has come in is trying to provide detail
answers to these questions.
But if I step away before
we even talk about data and
think about a very simple example again,
Michael one on one.
You want to think about two countries or
two firms there is i and j.
They have a very standard production
function with some productivity and
some capital.
And I struck from labor for a second just
for the sake of simplicity and you can
think of our firm or country j having
a much lower capital stock than country i.
And the basic question is
always been should capital
flow from country i to country j?
And does it in practice, or
you could do it within two
firms within the same country?
And under various mild conditions on
the production function the classic
neoclassical explanation or
prediction is yes,
it should flow until the marginal
product of capital is equalized.
Now this very simple frictionless
benchmark was put forward and
most prominently international by Lucas.
He look, we should be expecting capital to
flow from very rich countries with high
capital stocks for example emerging
markets and might have capital stock and
high marginal product of capital.
And the fact that it doesn't in practice,
that stimulated all sorts
of research over time.
So this very simple benchmark has been
such an interesting place to start
asking questions.
We will start with thinking about risk.
What if these two firms have different
risks, you wouldn't think you want to
always put all your money into
the firm with the highest return.
You want to sort of risk adjust.
What if there is wasteful default or
expropriation,
maybe the returns to the investment
depend on the identity of the investor?
Maybe foreign investors get a much
different rate of return than domestic
investors because we selectively
expropriate the foreigners.
But then you can think of like
more deeper down the frictions.
A lot of the capital is allocated by
institutional investors, mutual funds,
banks, and insurance companies, or by
firms themselves to t direct investment,
or governments through official flows.
And these various players might
have different objectives
from the simple abstract
arguably neoclassical model.
And similarly for the firms it's one thing
to say we have one cost of capital we all
borrow at the same rate, and the supply of
capital is infinite elastic at that rate.
Versus the reality as soon as you start
looking at the micro data, you figured out
that there are valuable costs in raising
capital, but there's also fixed costs.
I need to have accounting systems,
I need to reach out to the investors and
make them aware of who I am as a firm.
I need lawyers, I need bankers all of
these things can have a very large fixed
costs that might prevent a smaller firm
from actually accessing the capital.
And I'm going to start by taking
the perspective of the investors.
In particular, you can think of
a very simple benchmark, and
at some level it's a crazy benchmark.
But benchmarks are useful precisely in
their craziness because they sharpen what
it is that we need to think about
the generation of realistic deviations.
If you think of the world CAPM, everybody
should be holding some form of risks,
asset, and the same exact world
portfolio of all risky investments.
When I'm only differing the extent to
which we own the proportion, which we own
the safe asset and the risky portfolio,
we're going to hold these students.
Now of course, immediately you might
think that that's not the right idea.
Many assets are not traded.
My future labor income cannot be traded.
And for example, if my future liberal
income is particularly correlated
with some risks, I might want to
tilt my portfolio towards assets
that are negative related to those risks.
As we'll see the data is extremely
far from this very simple
benchmark to very well known
phenomenon,our home country bias.
And here the country's disproportionally
invest in securities or
assets that are domestic and
currency bias.
The idea that investors disproportionally
hold a securities that are denominated in
their own currency and
the currency that is domestic.
Why are the deviations there?
So as soon as you have benchmark, you
start thinking about how could I deviate?
And fundamentally,
I'm not going to go deep into theory.
But you can think of the forces that
drive portfolio decisions globally as
being the covariance between an object and
that I'm going to call M,
a stochastic discount factor.
You want to think of it as a proxy for
the risks that I care about and
the return on the assets, okay?
And the other two terms that
are in that equation are tau,
which I'm going to take to be frictions.
I perceive a different rate of return from
the true rate of return R because there
are some frictions that
dissipate some of the returns.
You can think of tau as a number between,
for example, zero and
one, one being no frictions at all.
But also there might
be an information set.
So let me start from
the information frictions.
One very simple story is, well,
I might have much better information
on the firms that are closest to me.
They're the things that
I am familiar with,
I know their managers, I know their
history, or maybe I know their products.
So that's why I shop
everyday at the supermarket.
And that might lead me to overweight
these firms because I have a much better
information.
The second one is the tau
is a transaction cost.
I really mean transaction cost in a very
broad sense, not just the fees that you
pay to take on the investment, but
also, for example, expropriation risk.
Maybe as a foreigner,
I don't perceive the true rate of return
R that the domestic investors perceive.
I perceive that one minus some percentage
that gets expropriated for me.
It might be sovereign default.
It might be that it's very difficult in
the private market to recover the assets
if the firm tries to
walk away with some cash.
It might be other sort of costs,
like capital controls.
But also it could be that there
are no frictions whatsoever, but
our simple benchmark is just too crazy.
The actual real proxies for
M, the sources of risk,
are very different from the World Cup M.
Maybe the domestic assets in domestic
currency are a very good hedge for
the risks that I care about.
If I now switch from
the investors into the firms,
if I start thinking about the duality
between the investor problem and
the firm problem,
the stock of assets is not constant.
A single investor might take the world
stock of assets as being constant.
But a firm, for example,
our government can choose what to issue.
And, for example, if investors had
biases and markets are segmented,
the firms of the government might decide
to cater to these biases to reduce their
own cost of capital.
Think of a world where US investors
only want to buy assets in dollars.
Well, maybe European firms want to issue
in dollars to tap in this supply of
capital in the US.
They're going to be a bit of
a jerk is going around and
trying to tap all sorts of
margins around the world.
But of course,
this might lead to unequal access.
Because only large firms in Europe might
have the economic ability to scale
necessary to issue, for example, bonds or
receive loans in multiple currencies.
You might think I need to hedge them.
I need to be smart enough to deal
with foreign currency payments.
There might be other requirements like
having a treasury that can deal with
all this.
All of these are,
in some sense, fixed costs.
There might be also some costs.
And these might lead, for example,
to the global market being dominated by
large firms, something that Jesse Schrader
will show you much more later.
If that's the world you live in,
now there are interesting questions.
When you open up the capital account
of a country, when you liberalize and
you say, well, I'm going to make it very
easy to get capital from foreigners.
These might have
distributional consequences.
Small and
large firms might not benefit equally.
And these are things that we just
started studying as a field,
at least at the micro level.
The second thing that I think we come to
more prominently realize in recent years
is the importance of governments.
And this is a very active research agenda.
Governments are big in global capital
flows, not only in the private market,
where, for example,
they are sovereign debt borrowers.
But more recently,
they're also very large investors.
Their enormous sovereign wealth funds
like the Norwegian pension fund,
there are very meaningful holders
of assets around the world.
And that might have a very
different value function,
a very different incentives to invest
than private, smaller investors.
But also there is the official market.
This is sort of government to government.
There's always been development aid, but
they're also very large
strategic investments.
Think like the Marshall plan from the US,
but also the China Belt and
Road Initiative right now.
These might have very different motives
from the traditional risk taking that
we put in our models.
But in the data, they're very meaningful
parts of global capital flows.
And there's a lot of interesting
work going on right now trying to
understand that thing.
Another aspect of the government
is the provision of safe assets.
So I want you to think of
the International Monetary System as
fundamentally an agreement
about producing safe assets.
There is a short supply, there's lots
of risky stuff around the world,
but there is not enough safe things.
And the governments have
a key role in producing it.
Now for living memory, given that these
audience is all young people like us,
the US has been the hegemon in this
system, has been the main provider,
a dollar has been center.
But I want you to sort of
think that this isn't static.
This is a research question.
The world did not always look like this.
And I'm not going to go into
the details of this picture, but
if you take a very brief look at the last,
say, 200 years of monetary history,
you find very often big changes.
Where the UK in the 1970s was the
cornerstone of world financial markets.
Between the two war,
you find the US and the UK,
both playing a very meaningful role.
And then ultimately,
you see the US taking over after 1940s and
having this very long run as
the global provider of safe assets.
But recently, we're thinking about China,
we're thinking about other issues.
So you don't want to take
these things as static.
Now why do we care about
the role of the dollar?
Well, we care because the dollar is used
to allocate capital between lenders and
borrowers that might never involve the US.
That's the international
role of the currency.
What does that really mean?
Why do we care?
Well, one is it might give an outsized
role to US monetary policy.
US changes rates.
And all of a sudden,
the lending rate between Europe and
Brazil is changing as a response
because it's dollar denominated.
It might have very large
distributional effects.
Think of an emerging market firm
that has borrowed in dollars.
If he hasn't hedged and
the dollar depreciates,
that can have a very large negative
wealth effect on this emerging market.
That's what economists refer
to originally as original sin,
particularly in the context of sovereigns.
There might be complementarities between
the decisions to borrow in dollars and
the decisions to price in dollars in
good markets, whether your export or
imports are denominated in dollars.
Which itself might have interesting
consequences when the dollar moves if
these prices are sticky.
From the perspective of the US, this might
give it advantages or disadvantages.
One that Jesse will highlight in his
session is the ability of US firms to get
a lot of foreign capital even when
they're small, because they're
borrowing in dollars and everybody
sort of is willing to lend in dollars.
The last two slides,
I'm going to focus on policies.
If you want to understand why there's
been so much policy about capital flows,
you need to think about
what happens during crisis.
And we've really gone through
four generations of models.
The first generation was sort of Krugman.
And it was a very simple, beautiful model
where the foreign capital attacks currency
peg, when the country doesn't have
sufficient reserves to defend the peg.
The second model was a refinement and
it was really motivated empirically by
the European Exchange Rate Mechanism
crisis of the 90s.
It's a model by Maurice Obstfeld,
Who showed us that these attacks
may also come out of the blue.
Why?
Because the foreign capital so
vastly exceeds the domestic resources
to defend a speculative attack.
That it all really depends on
the coordination of the foreigners,
whether they attack or not and so
they might come completely unannounced.
The third model,
it's very used these days.
It's the models of endogenous mismatches,
that were really created based
on the Asian financial crisis,
where Asian economies had borrowed
very heavily in foreign currency, and
is the idea that I put forward at the very
beginning where my currency depreciates,
because the foreigners
are pulling out of my country.
Because I borrow in foreign currency that
induces a negative wealth effect on me,
I lose networth, the banking system
lends less, the economy goes even worse,
the foreigners try to pull out even
farther and depreciate the currency.
And there is a spiral that brings me
deeper and deeper into the crisis.
In the more recent years, there is what
I'm going to call the fourth model.
Which is just a generalization of all this
just simply thinks of the foreigners,
as being more flighty, foreign capital
pulls out the first sign of trouble and
domestic investors are not
a perfect substitutes.
They cannot come in very quickly and
take care of this.
And therefore this creates
some externalities.
And from a theory perspective, there's
been a tremendous amount of work in
the last few years, giving us rationales
for policies like capital controls,
foreign exchange intervention,
financial regulation,
macro prudential regulation that are based
on addressing these externalities,
the fact that investors do not
capture all these margins.
My preculiar externalities where
I don't internalize the actions,
the effect of my actions on market prices
that might have to do with demand.
I don't internalize the effect of my
spending on aggregate demand or network.
I don't internalize the transactions I
make because everybody else is making
similar transactions have
an effect on financial stability.
The really common element of all this
is you need to know who owns what.
And while the theory literature I think
has done important advances, very little
has been done empirically, the evaluation
of these policies is still in its infancy.
And this matters, I mean emerging
markets have been long ahead of theory.
In the practice of these policies, the IMF
has only really recently changed its
stance on capital controls and
effects intervention,
agreeing that there are things that under
certain conditions we might want to do.
But as economists,
we don't have clean answers, yet.
We don't know exactly how they work,
how well they work,
what are the costs,
that's an open question.
And I think we're starting to have
the data to answer these very important
questions.
Similarly, and then I'm going to stop,
the central banks are collecting
incredible data sets for microdata.
But it is not an obvious
question on how to use it.
Should they use all this
richness to drive policy?
Right now that's not happening.
Why?
Because we don't have a framework that
tells us exactly which summary statistics
we should extract from all this data to
figure out what's relevant for policy.
So this is a big opportunity for people
like you that are entering the research
field, because it's likely
to have academic impact and
real world impact through policy.
And these are questions
that we care a lot about.
I'm going to stop here.
And take 30 seconds of
questions if you have any.
I know that this was sort of,
extremely high level.
We're going to dig deeper in a second.
