There are some books that were important to forming the way I think about economic problems, but if I write about it, I feel that I can’t do justice to the quality of the book. The Volatility Machine, by Michael Pettis, is one of those books. Michael Pettis was a managing director at Bear Stearns, and an adjunct professor at Columbia University when he wrote it.

The book was written in 1999-2000, and published in 2001. It explains how economic activity in the developed world travels into the smaller markets of the developing world, amplifying booms and busts. Coming off the Asian/Russian crises of 1997-1998, it was a timely book. During boom periods, capital flows from the developed countries to the developing countries; during bust periods, capital gets withdrawn. There is a kind of “crack the whip” effect, where the tail feels the change in direction the most.

Borrowing short is a weak position to be in, as the Mexican crisis in 1994 showed us, as the Fed raised rates and the tightening spilled into Mexico, which was financing with short-term debt, cetes. The same is true of corporations that finance with short debt; they are ordinarily less stable than firms that finance long. The Volatility Machine explains why the same forces apply to both situations.

Buffett has said, “It’s only when the tide goes out that you learn who’s been swimming naked.” Rising volatility is that tide going out, and it reveals weak funding structures and bad business/government plans. Booms set up the overconfidence that leads some economic parties to presume on future prosperity, and choose financing terms that are less than secure if the market turns.

Countries that are small and reliant on continued capital inflows are vulnerable to volatility. In the 1970s-1990s, that was the developing countries. Today, the developing countries vary considerably. Some have funded themselves conservatively, some have not, and a number are net capital providers. The US is the one reliant on capital inflows. So what would Michael Pettis have to say in this situation?

You don’t have to look far. Today, Michael Pettis is a professor at Peking University’s Guanghua School of Management. He is studying China from the inside, and writes about it at his blog (I read it every day, and will add it to my blogroll the next time I update it), China financial markets. Among his most interesting recent posts:

China’s latest batch of numbers aren’t good

Chinese pro-cyclicality makes predictions so difficult

More on why high share prices don’t mean Chinese banks are in good shape

The new China-Europe-US world order

Things have gotten grimmer in China

His views are complex and nuanced, and reflect the sometimes asymmetric incentives that politicians and policymakers face.  When I read his writings on China, I am simultaneously impressed with the rapid growth, and with the potential fragility of the situation.

So, enjoy his blog if that is your cup of tea.  If you want to learn how international finance affects developing economies, buy his book.

Full disclosure: if you buy the book through the link above, I will receive a pittance.

This entry was posted on Friday, February 1st, 2008 at 1:50 am and is filed under Book reviews, Currencies, Macroeconomics, Speculation. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.