When the US Federal Reserve increases the money supply, in the short run that puts downward pressure on the nominal rate of interest. The lower rate of interest induces investors to shift out of US Treasury bills and bonds into something else, seeking more preferable risk-return combinations. Some of that money will eventually find its way into investment spending, but in the meantime many investors look around for some other financial investment that will offer better risk-adjusted returns.
That is what happened, in part, with the financial crisis as people snapped up those inappropriately rated AAA mortgage-backed securities via the shadow banks.
Nowadays, this short term money (sometimes called "hot money" because it is moved quickly in response to changes in interest rates, exchange rates, and expectations) is flowing into and out of the financial markets in other countries. It is, after all, a global market.
Catherine Mann (Brandeis University) presented numerous charts showing some tendencies in the market for this to happen. Unfortunately I'm not able to find a link to the charts; I'm hoping they will become available soon here.
Her emphasis was on the problems faced in emerging markets that result from quick and sudden short-term cash flows into and out of their economies. I wasn't entirely convinced by her graphs and data, but I'd like to have a closer look at them at some point. All the same, her point is one I hadn't considered before: short-term movements of very large amounts of financial capital into and out of a country can play havoc with that country's attempts to control its own monetary positions.
A priori, this position makes some sense. One of the reasons for the phenomenal growth in the MSBs was the massive inflow of financial capital to the US pre-2007. At the same time, though, emerging markets face different problems. Massive inflows of financial capital can distort the local economy, putting considerable downward pressure on short-term interest rates. When that financial capital moves elsewhere, there is then pressure that causes the short-term interest rates to rise.
I viewed this phenomenon with less of an "ain't it awful" perspective than was hinted at both by Catherine Mann and in this piece by Patrice Hill, a media bench partner at the Rocky Mountain Economic Summit. Instead, I see it as a healthy flow of capital. It is this ebb and flow of capital throughout the world markets that tends to equalize the risk-adjusted interest rates and which sends signals to investors about the global cost of capital.
If the large-scale movement of short-term funds can wreak havoc on a local economy, the players in that economy are not adequately accounting for these potential movements in their decision-making. If you get a bunch of short-term money injected into your economy, there is no guarantee it will stay there for long. Counting on those funds as being anything other than short-term funds can lead to bad decisions.
My attendance at the summit was supported by several sponsors, including the Department of Economics at The University of Regina.