Financial Globalization

Stephen DeAngelis

May 7, 2008

Globalization rests on three principal flows: people, resources, and capital. The Economist, however, published an article questioning whether the free flow of capital is really a good thing for developing countries [“Policing the frontiers of finance,” 12 April 2008 print edition].

“When Hank Paulson, America’s treasury secretary, urged China to liberalise its capital markets earlier this month, he sensed a hardened reluctance in his hosts. ‘There’s no doubt that what is happening in the US markets is clearly giving the Chinese pause,’ he said. America’s subprime meltdown is not, it seems, the best advertisement for unfettered finance elsewhere.”

The article has a point, it was the lack of regulation of the mortgage industry that created the crisis (along with the anti-savings, credit spending U.S. culture). The article goes on to note that the theory behind financial globalization and the reality of capital flows seem to be different. At least, the article notes, its hard to prove the theory either right or wrong.

“Against this backdrop, Dani Rodrik of Harvard University and Arvind Subramanian of the Peterson Institute, in Washington, DC, have published a timely reappraisal of financial globalisation. They conclude that it is far from obvious that developing countries benefit much from opening up to global capital. In principle, the free flow of capital across borders makes funds available more cheaply to poor countries and, by lifting investment, boosts GDP and raises living standards. The trouble is, economists have struggled to establish a strong link between freer capital flows and speedier economic development. That has not stopped researchers from looking, and many believe a tangible connection will soon be found. Perhaps the effect is not picked up in studies because capital flows are hard to measure accurately, argue the optimists. Messrs Rodrik and Subramanian are not convinced: measurement error bedevils many studies, but that has not barred researchers from establishing that policies to improve education or trade are good for growth.”

In other words, if good policies can improve education and trade, good financial policies ought also to be good for growth. The question remains, what is good financial policy? The article continues in its search.

“Perhaps foreign capital helps indirectly—by disciplining policymakers or by promoting reforms that improve the financial system. The authors say it is possible to make the opposite argument and find indirect costs. Plausibly, lifting restrictions on capital flows could undermine the domestic financial system because spendthrift governments can tap a larger pool of funds abroad. Also, the well-off have less incentive to lobby for reforms at home if they are free to store their wealth overseas. Perhaps, then, the gains from globalised finance are latent and will be unleashed once catalysing reforms are in place? Maybe they will. But the wish list of complementary measures is difficult to tick off. Economies might reap the benefits of foreign capital more fully if property rights were stronger, contracts were more enforceable, and if there were less corruption and financial cronyism. But the authors point out that if poor countries could carry out such ambitious reforms ‘they would no longer be poor’ and financial globalisation would be ‘a clearly dispensable sideshow’. With so much else to do first, liberalising capital flows would not be an obvious policy priority.”

Reforms must be made and claiming that legal reforms can’t be put in place by poor countries sounds patronizing. There is clearly more than one theory, financial or otherwise, at play here. If global capital is simply a credit line for poor countries, then perhaps Rodrik and Subramanian are justified in their pessimism. A certain amount of credit is needed by poor countries — if they wisely invest it in physical and human capital (roads, education, etc. and on better governance). That’s important because some infrastructure needs to be in place to attract the more important capital — foreign direct investment. FDI is not just a measure of investment it means real jobs for real people. That’s how you get a better quality of life. As American’s are learning, the “good life” can only be bought on credit until the bills come due. The article continues.

“Foreign capital ought to be good for countries that have profitable ventures that lack funding because of low savings at home. But Messrs Rodrik and Subramanian argue that for many countries, it is not low savings but a shortage of good investments that is the binding constraint. Weak property rights, poorly enforced contracts and the fear that profits will be siphoned away make it hard to conceive of ventures that might generate a reliable return. When investment opportunities are scarce, capital inflows simply displace domestic savings and encourage consumption.”

I harbor no disagreements with Rodrik and Subramanian on these points. The work that Enterra Solutions® is doing in Iraq is focused on helping find good investments — companies that can produce goods for sale domestically and internationally. Part of our efforts is aimed at strengthening the financial sector of the country. Rodrik and Subramanian agree that strengthening that sector is important for development.

“Whatever their misgivings about cosmopolitan capital, the authors do not deny that deeper financial markets in general help to foster prosperity. Even in economies short of good investment projects, a sturdier channel connecting domestic savers and borrowers will help growth. The more domestic savings can be put to work, the less need is there for foreign capital, and using local funds helps keep the exchange rate down and promotes export growth. By contrast, encouraging foreign capital to flood in can put upward pressure on the exchange rate, making exports less competitive. In some circumstances, capital controls may be justified if they keep the currency cheap and promote growth.”

The key to prosperity argue Rodrik and Subramanian are exports.

“Why do the authors make such a strong case for export-led growth as a means to development in poor countries, even if it is at the expense of more open capital markets? First, they believe, exports are a force for institutional reform. A firm making clothes to sell abroad demands consistent state regulation, reliable transport links and enforceable contracts with suppliers to a degree that a barbershop serving the domestic market does not. Second, exporters foster skills, technology and expertise that can fruitfully spill over to other enterprises.”

Bingo! Rodrik and Subramanian have identified many of the puzzle pieces Enterra Solutions is helping put together in Iraq. This effort has to work hand-in-hand with the government. The Chinese are certainly learning a hard lesson about regulation and enforcement. There is no reason that each developing country has to learn that lesson anew. By implementing proven, internationally recognized policies, procedures, and regulations, developing countries can start to worry more about enforcement than enactment. That will help them gain the trust of the international marketplace must faster and make their goods more attractive to a larger audience.