Capital Inflows , Liquidity and Bubbles Guillermo

Policymakers in Emerging Market economies (EMs) are facing a serious dilemma: while their economies are currently benefiting from a surge of capital inflows, they fear a replay of the 1990s and early 2000s when their economies underwent costly Sudden Stops (of capital inflows). A serious concern is that a capital‐inflow episode could give rise to "bubbles," i.e., an artificial or transitory increase in some asset prices (typically in the real estate sector) that could go bust as a result of unpredictable external contagion or liquidity shocks, and trigger major credit disruption. This note will provide some support for the conjecture that there is a connection between capital inflows and bubbles. In a nutshell, the argument will be that a capital‐inflow episode enhances the liquidity of some of the receiving‐economy's assets, which in turn fosters larger flows and higher asset prices: liquidity creates wealth. However, liquidity may suffer a major setback as capital flows collapse (a Sudden Stop), potentially causing a severe impact on output and employment. These effects can occur even in the case in which Sudden Stop does not give rise to net capital outflows. The BLOCKINLogic BLOCKINbehind BLOCKINthe BLOCKINConjecture Firstly, a few words about liquidity. A liquid asset's salient property is being easily salable (see Menger (1892)). A prime example of salability is cash. Cash (particularly in the form of fiat money) is a good example to drive home the fact that intrinsic value is not a necessary condition for a liquid asset to fetch a positive price in terms of other intrinsically valuable commodities – illustrating the fact that liquidity creates wealth. Salability is not a property that per se enhances utility or production. To take advantage of salability individuals and firms have to sell the asset. Therefore, liquidity is a property that can only exist in a social environment, it is an eminently social good, i.e., a good that enhances utility or production because it improves social interaction or, in the usual jargon, facilitates market transactions. Salability itself is facilitated by the existence of a market in which there is 1 I wish to thank Sara Calvo and Pablo Ottonello for very valuable comments.