Capital Liberalization and Inequality

by Joseph Joyce (is a Professor of Economics at Wellesley College and the Faculty Director of the Madeleine Korbel Albright Institute for Global Affairs)

Capital Liberalization and Inequality

Inequality, which has drawn a great deal of comment and analysis following the publication of Thomas Piketty’s Capital in the Twenty-First Century, has sometimes been seen as a byproduct to increased international trade. But now other international economic linkages are being investigated. The International Monetary Fund’s Managing Director, Christine Lagarde, has acknowledged the need to take distributional consequences into considerationwhen designing IMF policy programs. Moreover, Fund economists have contributed to the research on the linkages between financial globalization and inequality.

Davide Furceri and Prakash Loungani of the IMF have investigated the effect of capital account liberalization on inequality. They looked at 58 episodes of capital account reform in 17 advanced economies, and found that the Gini coefficient (a measure of inequality) increased by about 1% a year after liberalization and by 2% after five years. One channel of transmission from the capital account to inequality could be the Increased borrowing by domestic firms that allows them to hire skilled workers, who pull ahead of the less-skilled workers.

A similar impact was found by Florence Jaumotte, Subir Lall and Chris Papageorgiou, also of the IMF. They analyzed the effect of financial globalization and trade as well as technology on income inequality in 51 countries over the period of 1981 to 2003. They reported that technology played a larger role in increasing inequality than globalization. But while trade actually reduced inequality through increased exports of agricultural goods from developing countries, foreign direct investment played a different role. Inward FDI (like technology) favored workers with relatively higher skills and education, while outward FDI reduced employment in lower skill sectors. Consequently, the authors concluded, while financial deepening has been associated with higher growth, a disproportionate share of the gains may go to those who already have higher incomes.

Jayati Ghosh of Jawaharlal Nehru University of New Delhi has examined the role of capital inflows in developing countries. She maintains that the inflows appreciate the real exchange rate and encourage investment in non-tradable sectors and domestic asset markets. The resulting rise in asset prices pulls funds away from the financing of agriculture and small firms, hurting farmers and workers in traditional sectors. Eventually, the asset bubbles break, and the poor are usually those most vulnerable to the ensuing crisis.

After the Asian crisis of 2007-08, Barry Eichengreen of UC-Berkeley analyzed some of the other linkages that could tie inequality to capital account liberalization. He dismissed claims that capital mobility hinders the ability of governments to maintain social safety nets or to use macroeconomic policy to stabilize output. He agreed that developing countries were more likely to suffer the negative effects of capital mobility. But the problem lay in the combination of an open capital account and inadequate institutions and regulations.

The global financial crisis demonstrated that weak regulation and volatility in financial flows are not unique to emerging markets and developing countries. Moreover, while the U.S. economy now shows signs of increased growth, the long-term unemployed are not sharing in the recovery.  The U.S. Senate has passed a bill that would extend benefits to this group of workers, but it faces opposition in the House of Representatives. On the other hand, thosehouseholds that own substantial financial assets have benefited greatly from the increase in their value since 2009, which is due in large part to monetary policy. Similar patterns can be found in Europe.

Those most hurt by the outcome of financial instability should be the first to benefit from government policies intended to mitigate its impact. But we know that politicians are much more responsive to their more affluent constituents, who hold financial assets. The uneven recoveries that follow financial crises injure those least capable of dealing with misfortune, thus exacerbating the disparity between those at the top of the income distribution and those at the bottom.