Footloose Capital Drives Up Income Inequality

A bit of history for background: In June 1979, shortly after winning a landmark election, Margaret Thatcher eliminated restrictions on the ability of companies to move money in and out of the United Kingdom.

Two very different views

To this day, Thatcher’s admirers consider this “one of her best and most revolutionary acts.” The Telegraph writes, “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.”

Likewise, foreign capital had difficulty moving into the United Kingdom. Thatcher abolished “all of these nonsensical rules and liberalized the U.K.’s capital account.”

Thatcher’s critics regard this same liberalization as starting a global trend whose “downside … proved to be painful.”

In their view, while the free movement of capital across national borders confers many benefits in theory, in practice it is a source of crisis and any benefits from it accrue to only a few.

My recent work with Davide Furceri finds that the push to eliminate restrictions on the ability of capital to cross national boundaries has been followed by increased inequality in incomes within countries.

We study 80 episodes over the past four decades in which countries made significant steps to open up their economies to foreign capital flows.

These episodes were followed by an increase in inequality (as measured by the Gini coefficient, the most commonly-used measure of inequality) and a decline in labor’s share of the income pie.

Tracing the channels

Why is opening up the economy to foreign capital flows followed by inequality? We discuss three channels through which the effect occurs:

1. Giving capital the ability to move abroad freely lowers the bargaining power of workers and hence their share of income.

2. Foreign capital flows are a source of volatility and crisis, which disproportionately hurt those who are less well off.

3. In countries where there is poor lack access to financial markets, the benefits from foreign capital flows accrue largely to those who are well off.

Each of these channels receives support from our evidence.

Shift in bargaining power

In the textbook model of perfect competition, each factor of production — capital and labor — gets its just rewards based on its contribution to the company’s profits.

But in the real world, the division of the economic pie is based not just on the relative contributions of capital and labor to the bottom line, but on their relative bargaining power.

In his 1997 book, “Has Globalization Gone Too Far?,” Harvard University economist Dani Rodrik argued that making capital footloose tilts the playing field in favor of capital, the more mobile of the factors of production.

The threat by capital that it will relocate abroad causes workers to lose bargaining power and some share of their income.

The impact of the loss of bargaining power may be more severe for labor in advanced economies than in emerging economies. There are two reasons for this:

1. Companies in advanced economies may be in a better position to make a credible threat to relocate abroad.

2. In many emerging economies, capital is scarce relative to labor. The arrival of foreign capital can raise the demand for labor, mitigating some of the effects of the relative change in bargaining power due to the opening of the capital account.

Our evidence points to a clear decline in labor’s share of income following capital account liberalization.

Focusing on the medium-term impacts, labor’s share falls by about 1 percentage point in advanced economies and by about 0.6 percentage points in emerging economies.

Volatility and crisis

Dani Rodrik noted that in 1996, five Asian economies received nearly $100 billion in inflows, but experienced an outflow of over $10 billion the following year. “Consequently,” Rodrik wrote, three of those economies “were mired in a severe economic crisis.”

Rodrik argues that this is not an “isolated incident” and that “boom-and-bust cycles are hardly a sideshow or a minor blemish in international capital flows; they are the main story.”

If volatility and crises disproportionately affect those who are less well off, then opening up the capital account would lead to increased inequality.

Indeed, we find that the impact of openness on inequality differs markedly, depending on whether or not opening up the capital account was followed by a crisis.

In cases where there was a crisis, there was a medium-run increase in inequality of 3.5%, compared with a 1% increase in cases where no crisis ensued.

Lack of financial inclusion

In theory, liberalization should expand the access of domestic borrowers to sources of capital.

In practice, the strength of domestic financial institutions may play a crucial role in determining the extent to which this takes place.

Where financial institutions are weak and access to credit is not inclusive, liberalization may bias financial access in favor of those well-off and therefore increase inequality.

The impact of liberalization on inequality also differs by financial depth and inclusiveness.

We separate out countries where financial markets are not very deep from others using a composite indicator from the Fraser Institute.

In the medium run, inequality increases by over 2% in countries with low financial depth, four times the increase in countries with high financial depth.

Proceed with caution

Opening up the capital account allows domestic companies to access pools of foreign capital, and often — through foreign direct investment in particular — access to the technology that comes with it.

It also allows domestic savers to invest in assets outside their home country. If properly managed, this expansion of opportunities can be beneficial.

However, at a time when rising inequality is a source of concern to many governments, weighing these benefits against the distributional effects is also important.