Opening Up to Inequity Finance & Development, March 2016, Vol. 53, No. 1
Davide Furceri and Prakash Loungani
Low Skills Low Wages
After countries remove restrictions on capital flows, inequality often gets worse
In June 1979, shortly after winning a landmark election, Margaret Thatcher eliminated restrictions on “the ability to move money in and out” of the United Kingdom, which some of her supporters regard as “one of her best and most revolutionary acts” (Heath, 2015). The Telegraph wrote that “in the economic dark ages that were the 1970s” U.K. citizens could “forget about buying a property abroad, purchasing foreign equities or financing a holiday . . . The economic impact was devastating: companies were reluctant to invest in the U.K. as it was tough even for them to move money back to their home countries.” Thatcher abolished “all of these nonsensical rules and liberalized the U.K.’s capital account.”
But Thatcher’s critics had a different view. They regarded this same liberalization as starting a global trend whose “downside . . . proved to be painful” (Schiffrin, 2016). In their view, while the free mobility of capital across national borders confers many benefits in theory, in practice liberalization has often led to economic volatility and financial crisis. This in turn has adverse consequences for many in the economy, particularly for those who are not well off. Liberalization also affects the relative bargaining power of companies and workers (that is, of capital and labor, respectively, in the jargon of economists) because capital is generally able to move across national boundaries with greater ease than labor. The threat of being able to move production abroad reduces labor’s bargaining power and the share of the income pie that goes to workers.
In studying such distributional effects of capital account liberalization we found that after countries take steps to open their capital account, an increase in inequality in incomes within countries follows (Furceri and Loungani, 2015). The impact is greater when liberalization is followed by a financial crisis and in countries where there is low financial development—that is, where financial institutions are small and access to these institutions is limited. We also find that the share of income going to labor declines in the aftermath of liberalization. Thus, like trade liberalization, capital account liberalization can lead to winners and losers. But while the distributional effects of trade have long been studied by economists, the distributional impacts of opening the capital account are just starting to be analyzed.
The push toward liberalizationAt its annual meeting in October 1997 in Hong Kong SAR, the IMF put forward its arguments why countries should keep moving toward full capital account liberalization—that is, the elimination of restrictions on the movement of funds in and out of a country. The IMF’s then-first deputy managing director, Stanley Fischer, called liberalization “an inevitable step on the path of development which cannot be avoided and should be embraced.” Fischer, now vice chairman of the U.S. Federal Reserve Board, noted that liberalization ensures that “residents and governments can borrow and lend on favorable terms, and domestic financial markets become more efficient as a result of the introduction of...