What’s the price of free-flowing capital?

Photo of construction crane by jgroupstudios, veer.com

Jagdish Bhagwati, a professor of economics at Columbia University, is a well-known defender of free trade and globalization. He literally wrote the book on the topic. But while he’s a staunch defender of free trade, he’s not so sure about the unencumbered flow of capital.

Bhagwati has quipped that being for free trade doesn’t necessarily mean being for “free capital flows, free immigration, free love, free whatever.” His hesitance, along with that of other economists, to fully embrace free capital was sparked by the experiences of East Asian countries who went through large financial crises in 1998 after capital streamed out of their economies. But new research points to additional long-run costs associated with large influxes of capital into countries as well.

Economists have long warned about the so-called “resource curse,” wherein the discovery of a natural resource in an economy can actually hurt that economy in the long run. Finding a new natural resource means that many more people will want to buy the resource in the currency of the country. The result is a higher demand for that currency, in turn making the currency stronger. This stronger currency, however, puts other industries in the economy at a disadvantage compared to the newly discovered natural resource.

New research, highlighted by Noah Smith at Bloomberg View, argues that this natural resource curse is actually just a specific case of the general problem of foreign capital flowing into the country. According to a paper by economists Gianluca Benigno of the London School of Economics, Nathan Converse of the Federal Reserve Board, and Luca Fornaro of CREI, when foreign capital enters into an economy, it affects the distribution of labor and resources among industries. Increased capital flows tend to shift resources toward the finance and construction industries, and these industries tend to be less productive than tradable sectors like manufacturing.

But capital inflows might not only affect long-run productivity—there is also some evidence that increased liberalization of capital flows can actually increase economic inequality as well. A paper by economist Mauricio Larrain of Columbia Business School looks at what happened to wage inequality after several countries loosened capital restrictions. The result:  Overall wage inequality went up, as did wage inequality between sectors.

At the same time, inequality itself might be at the root of the flows of capital between countries. A group of economists at the International Monetary Fund wrote a working paper in 2012 that suggests increased income inequality results in higher demand for capital, and that demand gets satiated by foreign supply. For example, the rise in U.S. inequality might have increased demand for credit, which was supplied by foreign funds. And that seems to have played a big role in inflating the U.S. housing bubble.

This isn’t to say that increased investment from other countries is always and everywhere a problem. But we should be increasingly aware of the problems that can arise when lots of capital flows in, and we should also be aware of where capital is going.