Capital account openness promised developing countries a leap in their economic development. Instead, increased inequality, undermined bargaining power, crisis contagion, and procyclicality dismantled the paradigm as a “bogus claim”. The paper therefore calls for a more careful approach to capital mobility in developing as well as developed countries.
Robert Lucas asked in his 1990 seminar paper why capital doesn’t flow from rich to poor countries even though decreasing marginal rates of return allow for much higher return on investment in capital-scarce than in capital-abundant countries (Lucas, 1990). The “Lucas puzzle” inspired an ample discussion about the benefits and detriments of capital account liberalization, i.e. the openness of developing and developed countries for foreign capital in-/outflow. In the following, this paper describes potentials and pitfalls of capital account openness – theoretically and empirically. It then argues that capital account liberalization was forwarded stressing the merits for “development finance” for developing countries yet could only reap the limited benefits from “diversification finance” for developed countries. Realizing this “bogus claim”, developing (and even developed) countries should consider constraining capital mobility.
Theoretical arguments for capital account openness praise benefits: Less restriction on capital flow allows for more efficient allocation of capital between capital-abundant and capital-scarce countries. As asset pools grow, costs of investments for capital importing countries decrease, return on investments for capital exporters rises, and investment risks shrink due to portfolio diversification. Better allocation is an economic cure-all, as it is supposed to diffuse technology, spur growth, smooth consumption over time, increase employment, prompt the standard of living, and enhance competition in the respective country (Bénassy-Quéré, Coeuré, Jacquet, & Pisani-Ferry, 2019). On the level of state interaction, open countries signal their willingness to adopt “good economic policies” and to comply with trade rules (Kose & Prasad, 2017). Furthermore, high financial integration shows positive externalities, such as reluctance towards military conflicts or a checks-and-balance mechanism for unkept political promises (Gartzke, 2007; Gartzke & Li, 2003).
Empirical assessment of capital account mobility contrasts theoretical advantages: Empirics find promised benefits to be limited and unexpected drawbacks frequent (Bénassy-Quéré et al., 2019; Kose & Prasad, 2017). Instead of an increase in employment, countries with low financial depth have experienced an increase in inequality, especially with regards to labour income. Here, the high mobility of capital undermines bargaining power of workers and distorted wage development (Furceri, Loungani, & Ostry, 2017). With weak financial regulation and supervision, countries are unable to counter contagion, i.e. the spread of foreign economic crisis to the respective country. Likewise, weak institutions and the limited size of economy are unable to cushion so-called “sudden stops”, the abrupt halt of foreign capital inflow (Eichengreen & Gupta, 2017). Both effects have severe consequences for the national economy: Procyclical lending amplifies macroeconomic effects as capital is employed at good times and withdrawn at bad times (Kose & Prasad, 2017).
Neoliberal proponents proclaimed the merits of capital account openness by pointing out the theoretical benefits of “development finance” to raise capital levels and advance all economies. By doing so, they also coerced countries with low financial depth and weak institutions into international competition. Instead of furthering the economy, the capital openness paradigm allowed for limited benefits of “diversification finance” for institutionally-strong economies while raising inequality, reducing workers’ bargaining power, incrementing foreign economic dependency, and increasing risks of macroeconomic contagion for institutionally-weak countries. Lacking reference to country-specific capabilities to balance international turmoil distorted the potential benefits of capital openness to a “bogus claim”, praising international convergence but sustaining existing development patterns.
As complete capital openness is more harmful than beneficial for developing countries, it is no wonder that countries re-introduced capital mobility constraints in the aftermath of the Great Recession and other crisis. Beyond the “New institutional view” – the IMF’s account for the potential threats and unequal competition in the developing-developed capital market by accepting soft constraints (Ahmed & Zlate, 2014; Fritz & Prates, 2014; Taylor, 2018), major detriments of capital openness, such as contagion and procyclicality, are not only problem for developing countries. To mitigate crisis spread, foster anti-cyclicality, and enhance competition on eyesight, the IMF should continue to question its radical capital openness paradigm, also for developed countries.
- Ahmed, S., & Zlate, A. (2014). Capital flows to emerging market economies: A brave new world? Journal of International Money and Finance. https://doi.org/10.1016/j.jimonfin.2014.05.015
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- Kose, M. A., & Prasad, E. (2017). Capital Accounts: Liberalize or Not? - Back to Basics: Finance & Development. Retrieved December 3, 2018, from https://www.imf.org/external/pubs/ft/fandd/basics/capital.htm
- Lucas, R. E. J. (1990). “Why Doesn´t Capital Flow from Rich to Poor Countries?” American Economic Review, 80(2), 92–96. https://doi.org/10.1162/rest.90.2.34
- Taylor, J. B. (2018). Capital Flows, the IMF’s Institutional View, and An Alternative. In Policy Conference “Currencies, Capital, and Central Bank Balances” (pp. 1–12).
This OnePager is part of a six piece series written for the course "Advanced Economics: Economic Theory & Policy" at Hertie School of Governance, lectured by Prof Jean Pisani-Ferry, Chief Economist of the French President and Professor at Hertie School of Governance and SciencePo.