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Free flows of capital do not increase output but do increase inequality

Summary:
There was an IMF paper released in April 2018 – The Aggregate and Distributional Effects of Financial Globalization: Evidence from Macro and Sectoral Data – that had a long title but a fairly succinct message. It indicates that the IMF is still in a sort of schizoid process where the evidential base has built up so against the political voice and practice that the IMF has indulged itself as a front-line neoliberal attack dog that elements in its research division are breaking ranks and revealing interesting information. In part, the Brexit debate in Britain has been characterised by economists supporting the Remain argument claiming that free capital flows within Europe (and Britain) are the vehicle for strong output growth and better living standards. They claim that when Britain leaves

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There was an IMF paper released in April 2018 – The Aggregate and Distributional Effects of Financial Globalization: Evidence from Macro and Sectoral Data – that had a long title but a fairly succinct message. It indicates that the IMF is still in a sort of schizoid process where the evidential base has built up so against the political voice and practice that the IMF has indulged itself as a front-line neoliberal attack dog that elements in its research division are breaking ranks and revealing interesting information. In part, the Brexit debate in Britain has been characterised by economists supporting the Remain argument claiming that free capital flows within Europe (and Britain) are the vehicle for strong output growth and better living standards. They claim that when Britain leaves the EU global capital flows will be more restricted in and out of Britain and that will be damaging. It is really just a rehearsal of the standard mainstream economic claims found in monetary, trade and macroeconomics textbooks. What the IMF paper does is provide what they call a “fresh look at the at the aggregate and distributional effects of policies to liberalize international capital flows” and the researchers find that, “financial globalization … have led on average to limited output gains while contributing to significant increases in inequality”. That is, the pie hasn’t really grown much as a result of all these free trade moves but a growing share is being taken by an increasingly wealthier few. And workers are the losers.

A more accessible version of the paper was published recently by Voxeu (December 2, 2019) – The aggregate and distributional effects of financial globalisation .

The IMF paper is motivated by two factors:

1. That “the efficiency (or output) benefits claimed for capital account liberalization reforms have often proven elusive, that is, difficult to identify in empirical studies”. In other words, often just ideological assertions are made without grounding in facts.

2. “while the fact that trade generates winners and losers is well recognized, the distributional impacts of financial globalization have received less scrutiny.”

The research literature is replete with evidential support for the view that opening up a nation to unfettered financial flows often leads to “financial crisis” and the “pervasiveness of booms and busts”.

In February 1998, Harvard’s Dani Rodrik published a short paper – Who Needs Capital-Account Convertibility? https://drodrik.scholar.harvard.edu/files/dani-rodrik/files/who-needs-capital-account-convertibility.pdf – where he made the point that the ‘boom and bust’ cycles that nations, particularly poorer nations, endure as a result of fluctuations in global capital flows lead to “severe economic crisis the magnitude of which would have seemed inconceivable”.

He was talking at the time about the Asian Financial Crisis of 1997, which devastated the impacted nations.

But he emphasises that while the magnitude of the Asian Crisis was substantial it was “hardly an isolated incident in the history of financial markets”.

He wrote:

Boom-and-bust cycles are hardly a side show or a minor blemish in international capital flows; they are the main story.

The intent of his article was to warn against the “IMFs next major mission the liberalization of capital accounts”. He called an embrace of that mission “sounds genuinely odd”.

He made the case of the introduction and retention of capital controls to prevent unwise short-term borrowing and capital flight.

This is because he considered financial markets to be inherently prone to failure due to “asymmetric information, incompleteness of contingent markets, and bounded rationality (not to mention irrationality)” which means that efficient market theories that abound in the standard New Keynesian framework, and, which led them to ignore the financial sector completely in their analytical frameworks are inapplicable to understanding real world issues.

In that context he concluded that “the benefits of removing capital controls remain to be demonstrated.”

Which ran counter to the IMF mantra and the European elites who had abandoned capital controls under the ‘Single Market’ (Single European Act 1986). the false claims about the effectiveness of the ‘Single Market’ are never far away from the lips of the Remainers in Britain.

Dani Rodrik concluded:

The greatest concern I have about canonizing capital-account convertibility is that it will leave economic policy in the typical “emerging market” hostage to the whims and fancies of two dozen or so thirty-something country analysts in London, Frankfurt, and New York. A finance minister whose top priority is to keep foreign investors happy will be one who pays less attention to developmental goals. We would have to have blind faith in the efficiency and rationality of international capital markets to believe that these two sets of priorities will regularly coincide.

That is a powerful statement and as time has passed, Dani Rodrik has not changed his view much.

In a recent (September 25, 2019) Op Ed – The Puzzling Lure of Financial Globalization – he and Arvind Subramanian state that:

Although most of the intellectual consensus behind neoliberalism has collapsed, the idea that emerging markets should throw their borders open to foreign financial flows is still taken for granted in policymaking circles. Until that changes, the developing world will suffer from unnecessary volatility, periodic crises, and lost dynamism.

They argue that “an important factor in China’s rise was the decision not to open the economy to capital flows”.

The data shows that “(n)early every major emerging-market financial crisis of the past few decades has been preceded or accompanied by surges in capital inflows.”

They note that:

Wealthy elites in several countries – especially in Latin America and South Africa – embraced financial globalization early on because they saw it as offering a useful escape route for their wealth.

And that nations are progressively realising that borrowing in foreign currencies result in “exploding debt burdens whenever the exchange rate weakens by too much”.

The IMF paper (and the Voxeu Op Ed) consider this issue and provide new evidence to support the, now, overwhelming view that free capital flows are not beneficial to nations.

I won’t go into their research design or empirical methodology here. You can access it yourself if interested.

They use “industry-level data” across 149 countries from 1970 to 2010.

They narrow it down to “228 episodes of financial globalisation” (although in the IMF paper they report 224 episodes).

The results (in summary) are:

1. “capital account liberalization episodes … have not had a significant impact on output but have led to a sizeable and statistically significant increase in inequality of about 4 percentage points five years after the liberalization”.

2. To check whether these results reflect the fact that “governments that choose to liberalize the capital account may be more right-wing and less likely to implement redistributive policies”, they add some controls to their statistical framework, and find that their initial results stand (after netting out other possible impacts).

3. They also find that the claim “that inequality (as well as GDP growth) may start to increase before the occurrence of major liberalization episodes” does not hold.

4. “output gains associated with capital account liberalization are small and short-lived, the distributional effects (that is, the effects on the labor share of income) are economically and statistically significant and long-lasting.”

5. “capital account liberalization episodes tend to reduce the labor share in industries with higher external financial dependence” and “in sectors with a higher natural layoff rate.”

6. Where trade unions are strong, the negative impact on the labour share is attenuated.

6. “our findings suggest that countries where a reduction in inequality is an important policy goal may need to design liberalization in a manner that balances the equity impact against the other effects.”

7. “Fiscal redistribution can also help to mitigate the adverse distributional consequences of financial globalization”.

8. “in addition to redistribution, policies could be designed to mitigate some of the anticipated effects in advance—for instance, through increased spending on education and training (so-called pre-distribution policies) to foster greater equality of opportunity.”

Conclusion

While the Voxeu article suggests that the “lure of financial globalisation among policymakers thus remains something of a puzzle”, we should reiterate Subramanian and Rodrik’s statement that the wealthy elites love free capital flows because they can launder money and shunt their wealth around more easily.

There is no puzzle in that.

What all this means is that another plank in the neoliberal consensus that has dominated economic policy making over the last four or so decades is crumbling and in proving to be untenable when confronted with the empirical record.

It is clear that if output growth is not stimulated but inequality rises and the labour share falls, then a few claimants are getting increasingly wealthy at the expense of the rest of us.

That is really what the neoliberal program has been about.

It has aimed to reverse the gains made by the population during the full employment, welfare state era in the post World War 2 era and reclaim a greater share of national income for the elites.

It has been clothed in all sorts of technical justifications that make it seems like we are operating in a TINA world. But the reality is clear – globalisation of financial flows is about power, wealth for a few and criminality rather than advancing the well-being of the vast majority of the population.

The fact that populations have been so benign in the face of all this is a research issue I am currently pursuing.

Why do people support agendas that kick them in the face with such contempt?

That is enough for today!

(c) Copyright 2019 William Mitchell. All Rights Reserved.

Bill Mitchell
Bill Mitchell is a Professor in Economics and Director of the Centre of Full Employment and Equity (CofFEE), at the University of Newcastle, NSW, Australia. He is also a professional musician and plays guitar with the Melbourne Reggae-Dub band – Pressure Drop. The band was popular around the live music scene in Melbourne in the late 1970s and early 1980s. The band reformed in late 2010.

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