Why Does Standard Economic Theory Promote Financial Liberali

Why Does Standard Economic Theory Promote Financial Liberalization That Enables Capital Mobility?

Standard economic theory advocates for financial liberalization and capital mobility primarily because it is believed to enhance economic efficiency and growth. The liberalization of financial markets allows for better allocation of resources, promoting investment where it is most productive. Additionally, free capital flows enable countries to access global savings, reducing the cost of financing investments and fostering international economic integration. These factors, in theory, lead to increased productivity, higher income levels, and accelerated economic development.

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Financial liberalization, as promoted by standard economic theory, is rooted in the belief that open capital markets foster a more efficient allocation of resources across borders. This belief stems from classic economic principles suggesting that free movement of capital allows countries to tap into global savings and investment pools, thereby reducing domestic borrowing costs and increasing investment opportunities. The first rationale for promoting financial liberalization is the enhancement of economic efficiency. When capital can move freely, investors can seek the highest returns regardless of geographic location, leading to the reallocation of resources toward the most productive sectors and regions. This process reduces distortions inherent in protected markets and promotes competitiveness in international markets (Mishkin, 2007).

The second reason relates to promoting economic growth through increased access to external financing. Countries with liberalized financial markets can attract foreign direct investment (FDI) and portfolio investment, providing essential capital inflows that finance infrastructure, technology, and innovation. These inflows can help bridge savings-investment gaps, especially in developing economies, and accelerate development processes (Edwards, 2017). The availability of foreign capital also diversifies domestic financial markets and introduces best practices, further strengthening the financial system.

Despite these theoretical benefits, empirical evidence presents a more nuanced picture. It is observed that liberalized capital markets can lead to destabilizing capital flows, such as sudden stops and reversals, which undermine economic stability. For example, during the Asian financial crisis of 1997, rapid and massive capital outflows contributed significantly to economic turmoil (Radelet & Sachs, 1998). Similarly, Latin American countries experienced volatile capital inflows and outflows during the 1980s and 1990s, often leading to economic crises (Calvo, Leiderman, & Reinhart, 1993). These patterns support the empirical reality that capital mobility can be associated with increased financial instability, contrary to the idealized view of smooth and beneficial flows.

Financial markets are inherently prone to instability due to herding behavior and volatility. Herding occurs when investors follow the actions of others rather than relying on fundamental analysis, amplifying market swings during boom and bust cycles (Bikhchandani, Hirshleifer, & Welch, 1992). Such herding behaviors can lead to asset bubbles and crashes, causing significant economic disruptions. Additionally, financial markets are volatile because of the speculative component of trading, risk perceptions, and changes in investor sentiment. Market participants often react to news and geopolitical events impulsively, leading to rapid shifts in asset prices and capital flows (Shiller, 2003). These factors make financial markets susceptible to instability, making it difficult for policymakers to maintain equilibrium.

Developing countries began stockpiling foreign reserves after 2000 as a strategy to mitigate external vulnerabilities. Amid increasing global financial integration, these nations faced rising risks of sudden capital outflows, currency crises, and balance of payments problems. Holding large reserves acts as a buffer, providing countries with the capacity to defend their currencies and maintain economic stability during periods of global financial turmoil (Aizenman & Jinjarak, 2014). This shift was also motivated by lessons learned from the 1997 Asian financial crisis, which underscored the importance of self-insurance against volatile capital flows and external shocks.

The concept of 'Original Sin' in international finance refers to the inability of developing countries to borrow in their local currency in international markets. Instead, they have to borrow in foreign currencies, exposing them to exchange rate risk and debt sustainability challenges (Eichengreen & Hausmann, 1999). This situation limits their monetary policy autonomy and makes them vulnerable to external shocks, as depreciation of their currencies increases debt burdens in local currency terms.

Advocates of capital controls argue that they can help manage volatile capital flows, protect domestic financial markets, and maintain macroeconomic stability. First, capital controls can reduce the likelihood of sudden stops and reversals, providing policymakers with more control over monetary and exchange rate policies. Second, controls can prevent excessive short-term inflows driven by speculative activities, which often destabilize economies (Reinhart, Reinhart, & Rogoff, 2015). Thus, in certain contexts, capital controls serve as a necessary policy tool to safeguard economic stability.

Under the gold standard, the theory considered the system to be automatically self-adjusting because balance of payments deficits would lead to a decline in domestic price levels and gold reserves, restoring equilibrium. Conversely, surpluses would lead to price level increases and gold inflows, balancing external accounts over time. This dynamic was believed to function via the price-specie-flow mechanism, ensuring that external imbalances corrected themselves without government intervention (Cassel, 1918).

A credible commitment to the “rules of the game” under the gold standard implies that countries adhere strictly to the discipline of maintaining gold convertibility and avoiding devaluation. Such commitment fosters trust among countries and investors, leading to stable exchange rates and reduced uncertainty. Credibility is crucial because it signals that a country is committed to maintaining its fixed rate, discouraging speculative attacks and facilitating international economic cooperation (Eichengreen, 1996).

The colonies and peripheral countries played a vital role in maintaining stability under the gold standard by acting as providers and absorbers of gold. Their monetary policies were often synchronized with the central countries, ensuring gold flows remained consistent with the system’s stability. Colonial economies, especially those producing gold or linked to the gold-producing countries, helped sustain the gold reserves necessary for fixed exchange rates. Their participation in global gold flows reinforced the stability of the international monetary system, although often at the expense of their own economic sovereignty (Temin, 1989).

The Bretton Woods system was characterized by three main features: fixed exchange rates tied to the US dollar, which was convertible to gold; the establishment of the International Monetary Fund (IMF) to oversee exchange rates and provide financial assistance; and the creation of the World Bank to support reconstruction and development. One significant way in which the Bretton Woods system diverged from Keynes's original plan was the U.S. dollar's convertibility to gold, which eventually led to the system’s collapse when the U.S. could no longer sustain gold reserves amidst persistent balance of payments deficits (Friedman, 1951).

The international monetary system needs a lender of last resort to provide liquidity during times of financial crises when private markets are unable or unwilling to lend. This role is crucial to prevent crises from escalating into broader economic downturns. The International Monetary Fund (IMF) has historically fulfilled this role by offering financial assistance to countries facing balance of payments crises, helping restore stability and confidence (Isard & Turnovsky, 2012). Under the gold standard, the Bank of England played this role, acting as the ultimate lender of last resort. During Bretton Woods, the Federal Reserve in the U.S. provided similar functions, underpinning the stability of the dollar-based system (Mishkin, 2007).

Currency crises of the 1980s and 1990s shared several features, including abrupt reversals of capital flows and sharp devaluations or depreciations of national currencies. A common characteristic was the buildup of high short-term foreign debt, often financed by international financial markets, leaving countries vulnerable to sudden shocks. Additionally, both crises were triggered by speculative attacks or the loss of investor confidence, leading to rapid withdrawals of capital and forcing authorities to abandon fixed or semi-fixed exchange rate regimes (Calvo, Leiderman, & Reinhart, 1993; Goldstein & Loayza, 2000).

References

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