Capital Flight

Capital flight is a phenomenon that occurs when market investors withdraw money from an economy because they have lost confidence in its prospects of growth. International and domestic causes of capital flight are debatable. The monetarist position and the post-Keynesian position mark the boundaries of this debate. The chicken-versus-the-egg problem is preeminent: To garner investor credibility, what should be given priority—growth or equity? Theoretically, growth can create equity in the long run. But, empirically, huge social inequalities (initial or developing) within or between states tend to create social conflict that can decimate growth. Hence, the two camps differ over whether financial globalization and integration of markets is productive for growth and equity. To assess this, they look at macroeconomic fundamentals, i.e., money, output, and consumption that determine supply and demand.

Monetarists tend to emphasize theoretical claims that supply of capital/“sound money” will universally create growth through rational investor actions based on cost-benefit calculations. On the other hand, post-Keynesians tend to emphasize the empirically contingent impact of capital allocation on distributive justice for labor. Hence, they point to irrational market sentiments that misalign capital allocation and [Page 226]productive output and reduce income and consumption demand. Consequently, policy prescriptions differ. Monetarists argue for universal policies of political neutrality of states, auto-regulated/free markets and capital account liberalization. Post-Keynesians prefer historically contingent political intervention in the domestic and global market for purposes of growth and welfare.

Monetarists argue that competitive markets create efficient/rational capital allocation. They claim that equity will occur automatically through trickle down effects of economic growth. Post-Keynesians advocate for politically proactive policies of safety nets to ensure that winners compensate losers. Given that labor engaged in productive output of trade and services is mostly internationally immobile, due to immigration barriers, social insurance would reassure them. It would give them confidence to build capabilities and compromise with capital about wages/income to ensure conflict-free growth. Creating investor credibility is then critical to prevent capital flight, but the difference lies in the focus—capital or labor.

The monetarists posit that it is the lack of long-run macroeconomic fundamentals of growth that generates loss of credibility for international capital and results in capital flight as a form of market discipline. The post-Keynesians point out that it is the lack of market-friendly capital controls that forces governments to take protectionist measures against the short-run excesses of capital mobility that destroy the macroeconomic fundamentals and result in capital flight. The cause and effect, in essence, are reversed in the two arguments.

For monetarists, a stable macroeconomic environment is ensured through low inflation and currency stability to ensure that output and consumption are not affected. Hence, imprudent fiscal and monetary policies of expansion need to be avoided. This can be achieved through political neutrality. For monetarists, governments act expediently to stay in power, and hence, they can never be committed to consistent low inflation. Populist policies of market intervention then result in workers rationally adjusting their wage demands based on future inflationary expectations. Hence, long-term trade-off between inflation and unemployment is impossible. All attempts by government to boost employment, to manage demand and consumption through expansion only result in inflation without real growth. Policies of expansion result in rent-seeking from entrenched interest groups like labor unions. Labor unions demand high wages and, being unrelated to productivity, this leads to increased costs of output. This leads to labor market rigidities and inflationary price spirals. High inflation leads to currency instability. As currency value depreciates in the face of inflation, purchasing power parity falls. This leads to export-import imbalances and balance of payment crisis. As trade deficits and debts increase, loss of confidence by market investors and capital flight occurs.

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