Office of Science & Technology - International Capital Flows and Financial Crises
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International Capital Flows and Financial Crises Print E-mail
bridges vol. 16, December 2007 / OpEds & Commentaries

by Anton Korinek


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Anton Korinek
The following article is based on a presentation given by the author at the Embassy of Austria in Washington, DC, on the occasion of a joint event between the Office of Science & Technology (OST) and the DC Chapter of the Association of Austrian Scientists and Scholars in North America (ASciNA) on November 13, 2007.




Over the past decade the world has witnessed a series of spectacular financial crises in emerging markets, which has led to sharp increases in unemployment and poverty in the affected countries. Since international capital flows played an essential role in these crises, there is renewed interest in the question of whether they should be regulated so as to "put sand in the wheels" of the international financial system.

The promise of free capital flows

Three main arguments suggest that free capital flows to emerging markets would increase economic welfare worldwide:

First, poor countries are generally short of capital, and due to its scarcity capital earns high returns there. On the other hand, rich countries have an abundance of capital and earn lower returns. By letting capital flow from rich to poor countries, poor countries would have more capital to invest and rich countries could earn higher returns.  

Secondly, international borrowing would allow countries to smooth out bad economic shocks, i.e., to borrow in bad times so as to cover the shortfall in income and repay in good times.  

Third, free capital flows allow countries to better diversify risk, since investors have more investment opportunities over which to spread their capital.

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Adam Smith: Economist and author of An Inquiry into the Nature and Causes of the Wealth of Nations
Underlying these premises is one of the fundamental tenets in economics, the so-called First Fundamental Theorem of Welfare Economics, which states that the free market equilibrium allocates resources the most efficient way possible and thereby maximizes public welfare (this is the formal version of Adam Smith's "invisible hand"). By implication, government restrictions on the free flow of capital supposedly reduce public welfare. The idea behind the theorem is that whenever two market participants agree on a transaction, it must be advantageous to both of them - otherwise they would not find agreement - and hence welfare is increased. If the government places restrictions on a market transaction, then a mutually beneficial exchange cannot take place and hence welfare is reduced.

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