TCS Daily


Against Sedentary Lifestyles

By Daniel Drezner - October 8, 2003 12:00 AM

In the wake of the reversal in momentum that the Doha round of trade talks suffered last month in Cancun, it is easy for those who value open markets to despair. Many policy analysts employ a bicycle metaphor to understand economic liberalization. If the pace of trade openness slows down, then like a bicycle, then the current era of economic globalization will totter and eventually collapse. Such a reversal would surely trigger a global economic slowdown.

 

It's therefore important to remember that reducing barriers to international trade is only one of several ways through which economies can become more integrated and dynamic. Just as important is an arena that is almost entirely outside the WTO's purview -- the elimination of capital controls.

 

This flies in the face of much of the conventional wisdom about the merits of globalization. Many mainstream commentators have now come to accept the wisdom of free trade, but draw the line at the free movement of capital. They will point to the effects of the Asian financial crisis, which wreaked havoc across the Pacific Rim and led to instability in Russia, Brazil, Argentina, and Turkey. They will cite Globalization and Its Discontents, a jeremiad against the International Monetary Fund's policies of capital openness during said crisis, written by Nobel prize-winning economist Joseph Stiglitz. They will point to articles indicating that the removal of capital controls lead to more banking crises. When economists like Paul Krugman and Joseph Stiglitz say that Malaysia had the right idea in imposing capital controls, it gives people pause. Even Stanley Fischer, formerly the number two man at the Fund, said this year: "the relationship between capital account liberalization and growth is likely inherently weaker than that between current account liberalization and growth." How could the liberalization of capital markets possibly facilitate global economic growth?

 

To answer that question, you need to read a book that blows this line of thinking out of the water -- Raghuram Rajan and Luigi Zingales' Saving Capitalism from the Capitalists. Rajan and Zingales -- both economists at the University of Chicago's Graduate School of Business -- are not dogmatic libertarians. They express more than a passing concern for income distribution. But on the issue of capital openness, they advocate complete liberalization. In response to critics, "complaining about the risks associated with the process of liberalizing the financial sector," they speak truth to power:

 

Financial crises are indeed more likely when a country liberalizes. This should not be surprising. In the same way as a man who never stirs out of bed cannot be hit by a speeding car, an economy that does not liberalize will not suffer a crisis but will slowly die from a sedentary lifestyle.

 

The argument for why capital account liberalization spurs greater economic growth is simple. Robust economic growth is strongly correlated with a high degree of "financial development," which means the size, sophistication and innovation of a country's equity markets, bond markets, and banking sectors. Critics suggest that economic growth leads to sophisticated capital markets, not vice versa. However, empirical studies reveal that financial development is robustly correlated with future rates of economic growth, increased productivity, and high rates of investment. Another study demonstrates that countries that liberalize their equity markets experience a one percent increase in their annual real economic growth. The more developed the financial markets, the better for society -- but not necessarily the state.

 

In the developing world, governments can exploit repressed capital markets and privileged access to scarce foreign exchange to reward favored interests and political supporters. Leaders who want to stay in power will try to direct government benefits towards key backers. One of the most potent patronage levers in the developing world is access to government-owned or government-influenced financial institutions. The result is massive inefficiencies in the allocation of capital, and high barriers to entry for potential entrepreneurs.

 

The liberalization of capital markets changes this dynamic. Access to foreign markets reduces the scarcity of capital in emerging markets. The ability to borrow from foreign sources dilutes political influence over their financial sectors and injects much-needed competition into a country's financial sector. This lowers the barriers to entry for new businesses -- domestic and foreign -- and increases economic growth.

 

Much in this argument is not new. As far back as 1776, Adam Smith understood the political and economic dangers of reducing competition in The Wealth of Nations, writing:

 

"People of the same trade seldom meet together even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices....

 

"In a free trade an effectual combination cannot be established but by the unanimous consent of every single trader, and it cannot last longer than every single trader continues of the same mind."

 

The value added of Rajan and Zingales is to stress the crucial role of free capital flows to this logic. To support this argument, Rajan and Zingales provide a plethora of interesting cases, anecdotes, and useful thought experiments. An example: sophisticated and open capital markets should benefit firms that rely heavily on external financing -- i.e., those with significant fixed costs for research and development, such as pharmaceutical companies. Sure enough, when the authors looked at three developing countries at roughly similar levels of GDP per capita, they found a clear correlation between the sophistication of national capital markets and the growth of that country's drug research sector.

 

It would be nice to see the Doha round liberalize markets even further. However, it would be even nicer to see the development of robust capital markets in the developing world. A key step for this to occur is to break down the barriers to cross-border capital flows. It would serve everyone's interests if the international financial institutions adopted the recommendations of Rajan and Zingales. Fortunately, there is an excellent likelihood of that happening: Raghuram Rajan has recently been appointed the International Monetary Fund's Chief Economist.

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