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 consideration when 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, those households 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.
There seem to be a wide variety of ways capital liberalization can ultimately hurt a developing nation or region and the possible negative effects ripple deeply into the lower socioeconomic classes of society. The study by Furceri & Loungani, I think, is the most clear about the overall effects of free capital flow on inequality (Gini increasing 1% after one year & 2% after 5 years); however, it probably has the omitted bias of politics- mentioned toward the end. It is also interesting to see the effects different types of FDI can have on a population; it would be even more insightful to see the distinct effect of limiting the types of capital flow and their effects on inequality. The conclusion seems to remain, though, that only nations with a strong institutional foundation and regulation ultimately benefits the most from the liberalization of capital flows as pointed out in the study by Barry Eichengreen.
The conclusion states that uneven recoveries exacerbate the income disparity between top earners and those at the bottom. However, it would interesting to see if there is another lag in the recovery process that we haven’t discovered yet. Perhaps the policies that were put into place helped the top income earners in the short run, but in the long run, these benefits will be spread to the lower income earners. If this were to hold true, it would probably close the gap by a minimal amount.
It’s interesting to think about what policy tools could be utilized to make the recovery more even. As mentioned in this blog entry, the U.S. Senate just passed a bill to extend more benefits from the long-term unemployed; however, it leads me to question, what more could be done?
I think the story of how financial liberalization would help the traded goods sector more so than non-traded goods makes total sense. Though this increases inequality, would the Balassa-Samuelson theory suggest that over time, the wages in the non-traded goods sector would increase as well?
I think it is very interesting that IMF is focusing more on income distribution now, and justified this effort under the assumption that income equality helps economic stability and growth. While I think that is certainly true, all else equal, IMF should be careful when walking on the fine line of how much and how to control cross-border capital flows. While too little control might dramatize inequality, too much would hinder economic growth. I wonder since market supply and demand seem to force that traded goods sector will be the hot sectors of tomorrow, we probably cannot change the direction of future economic growth (i.e. sectors that already pay well vs. not). All we can do is try to balance overall economic growth by following the sectors trends as well as some limited relief of sectors not doing so well, and hope that time will make the adjustment of shifting workers around and equalize wages across sectors.
Another way we can explore the deepening inequality from capital mobility is by applying the Heckscher-Ohlin trade theory model to winners and losers of the global labor market. Assuming perfect competition, countries that are abundant in a certain labor sector (high vs low skilled workers) will increase production of goods and services that require the use of the labor sector which it is abundant in. This is to gain comparative advantage in maximizing returns from the use of available resources. For example, the USA is abundant in highly skilled workers, so it will increase the production of goods/services that use highly skilled workers and decrease the production of goods/services that use low-skilled workers. The income inequality aspect of this analysis is dependent on the Stolper–Samuelson theorem, which says (in a simplified nutshell) that trade between an advanced economy and an emerging one would lower the wages of the unskilled in the advanced economy since the developing country has so many of the unskilled. Naturally, production of goods that require low-skilled workers would be increased in emerging economies that are low-skilled worker abundant.
Where does capital mobility come into this? I believe investors are smart and would invest in the industry that maximizes on the labor sector abundance in a country — that would speed up or exacerbate the phenomenon I mentioned above. Therefore, with the globalization of economies, capital liberalization would allow more capital backing of industries that require highly-skilled workers in advanced economies and of industries that require low-skilled workers in emerging economies. The winners of this phenomenon would be those who are part of the labor sector that is abundant in their country — their wages would rise. The losers are the latter — their wages would drop with the lack of demand for their labor services. Hence the deepening inequality and the increase in the Gini coefficient.