Capital flows uphill

The market continues to rise gently. Today the S&P is pulling back after making a new all time high . I continue to sit on the sidelines, but I admit to a little nervousness.

I have just started reading The Dollar Trap by Edwar S Prasad. I have barely started reading and already I have the idea that it will turn what I think and know about the markets on its head. I will fill you in fully when I have finished but already I have a sinking feeling. What I was taught no longer works.

The book makes a claim to explain why, when the US Government is pursuing a raft of policies that should be digging a grave for the Dollar, the currency goes from strength to strength. The answer is that there is nowhere else for nervous money to go. The worse things get, the more nervous investors get and the more

Dollars they want. Americans and their financial institutions are sitting on a gold mine. They're digging a hole and the deeper they dig the stronger their currency gets. Now they're in their hole their best strategy is to keep digging because the rest of the world will shore up the tunnels as they make them.

I've read a little deeper now. The argument in the book looks in depth at what it describes as "uphill capital flows".

Economic theory predicts that capital should flow from developed to developing countries. The data suggest that exactly the opposite is happening as shown in these two pie charts from the book .

According to theory capital should flow from better developed countries who lack the opportunity to increase productivity and to generate a better return on capital. Less developed countries have it in their nature to develop faster. They have large underemployed workforces ready to work and generate profits.

The equations that make these capital flows work  are simple. Savings >Investment equals capital outflow. Savings < Investment equals capital inflows.

Net result is that the high levels of savings generated in the poorer parts of he world are exported to richer countries. In the US , at any rate, these capital inflows do not go into investment but find their way into consumption. And when they do find "investment" destinations they fund asset bubbles such as the the sub prime housing market.

The paradox is explained in a variety of ways. They boil down to the argument that developing countries lack the capital and market infrastructures that provide a safe home for savings generated. Prasad summarises them as follows: "These problems include ramshackle infrastructure, unstable governments that could turn around and confiscate foreign-owned companies, high levels of corruption , and so on."

More of this later and in the mean time I will continue to sit nervously on the sidelines  as I watch the stock market inflate.