Is Foreign Capital a Luxury That Poor Countries Can Live Without?

Another pillar of free-market orthodoxy is re-examined in this article from the Economist. Developing countries abandoned the "Washington Consensus" almost a decade ago, in the aftermath of the Asian economic crisis, but its central principles - free trade, open capital markets, privatization and deregulation, have still been the core assumptions guiding U.S. foreign economic policy.

Yet all this time, academic researcheres have not conclusively shown whether or not it "works." The economic theory of liberalization is certainly sound, and still taught as such in universities, but the evidence in the real world is unclear - for instance, serious questions persist on whether free trade lowers wages or makes workers worse off (beyond the effects predicted by theory). The Economist article assess a longer research piece by Professsors Dani Rodrik of Harvard and Arvind Subramanian of the Peterson Institute, which raises similar questions around the assumption of open capital markets.

Their question is a timely one, since the breakdown in U.S. credit markets and the rise of dynamic economies elsewhere may well lead nations to rethink their need for capital market liberalization. Their central point is that, despite the best efforts of researchers, no clear link has been found between freer international capital flows and economic growth. They point out that while open capital markets can provide cheaper capital or discipline policymakers, they can equally lead to overborrowing, capital flight and upward pressure on the local currency.

Advocates of open capital markets assume that countries will simultaneously reform property rights and improve contract enforcement, which are needed to reap openness' full benefits. Yet it is precisely these weaknesses that make investing in developing countries difficult, and in Rodrik and Subramanian's view, it is these constraints on the "supply" of available investments that is the problem, not the "demand" for investments from foreign capital.

In the end, like almost all policy prescriptions for developing countries, adopting economic openness and liberalization works best when domestic systems, regulations and supervision are already sound. It's the classic chicken-and-egg problem - figuring out whether the greater problem is a shortage of investment that foreign sources can fix, or poor investment infrastructure, in which case opening up to foreign capital may do more harm than good. "It depends" is always an unsatisfying answer, but Rodrik and Subramanian conclude that “depending on context and country,” they write, “the appropriate role of policy will be as often to stem the tide of capital flows as to encourage them.”

Economist link: http://www.economist.com/finance/economicsfocus/displaystory.cfm?story_id=11016324
Full article: http://ksghome.harvard.edu/~drodrik/Why_Did_FG_Disappoint_March_24_2008.pdf