Question

Groningen Valley Bank (GVB) invests in hydrogen production in Eemshaven. To finance this, it found a Dutch investor in December 2022. This is Mr Heiko Sprik, a wealthy individual residing in Veendam who buys 100mln of unlisted shares. Mr Sprik borrows 20mln of this from ING bank. The GVB is successful and in January 2023 the Australian Retirement Trust (ART) borrows Dollars in New York to buy more unlisted GVB shares, at a higher price than Mr Sprik bought them in December. The bank of ART converts its member's pension payment into US Dollars so that ART can buy the shares, and the Rabobank of GVB converts the dollars received from ART into Euros for GVB. Rabobank then invests the Dollars in US Treasury Bills. As the value of participation in GVB rose, Mr Sprik sold some of his shares to build a second home and to buy a ship in Hamburg, fine wines in France and three Maserati's in Genoa, as well as living the good life more generally. Many of his local investor friends do the same, and the Groningen economy registers high economic growth. c) In this story, in which transactions does excess financial elasticity change the Dutch NIIP positions more than would be the case without excess financial elasticity? d) Why are changes in the NIIP that are caused by excess financial elasticity ultimately contractionary? e) What feedback mechanism is at work in the expansionary phase? Is it also at work in the contractionary phase? Explain why or why not.

Answer 1

Excess financial elasticity affects the NIIP when investments from entities like ART inflate local asset values. These inflations are contractionary as they may lead to rapid investment inflows and subsequent outflows, causing economic downturns. The feedback mechanism that fuels growth during expansion can similarly exacerbate contraction during economic downturns.

Step-by-step explanation:

In the described scenario, excess financial elasticity changes the Dutch NIIP (Net International Investment Position) when foreign investors, such as the Australian Retirement Trust (ART), borrow to invest in unlisted shares of GVB. This occurs because the foreign investment inflates the value of domestic assets beyond what they might otherwise be, leading to a substantial shift in the NIIP.

Changes in the NIIP caused by excess financial elasticity are ultimately contractionary because they may lead to unsustainable economic expansions. These expansions often end in sudden corrections when investors' sentiment shifts and they consequently pull out their investments rapidly, which can disrupt financial markets and cause economic contractions.

During the expansionary phase, a feedback mechanism is at work, whereby the increasing investment and consumption (i.e., through Mr. Sprik's expenditures and the local economic boom) fuel further economic growth, attracting more investment. However, this mechanism can reverse during the contractionary phase, as declining values and panic can lead to rapid capital outflows and economic downturns.