The Cost of Financial Globalization

Opponents of financial globalization see international capital mobility as a destabilizing source in the global economy. There are three main reasons for this: excessive inflows and outflows of capital, worsening income inequality, and international tax competition. As developing countries have liberalized their capital accounts foreign investment has increased. But it has also led to a number of devastating financial crises due to sharp capital flow reversals. When capital inflows quickly turn into capital outflows the domestic financial system may collapse and no longer channel funds from lenders to borrowers, slashing investment and consumption as happened across Asia in the late 1990s. Excessive capital outflows are due to what is known as asymmetric information that exists in financial markets. A lender must assess whether a borrower represents a good or bad credit risk. The borrower knows if she is going to invest the funds in a risky project but the lender does not. Once there are rumours that the debtor is in trouble and may default the lack of information makes creditors worried that this is endemic among all debtors and they begin to withdraw their funds. In a global economy asymmetric information tends to worsen with cultural differences and physical distance.

The Mexican Peso crisis in 1995 is a perfect example of how capital flow reversals, spurred by asymmetric information can be devastating. In the late eighties and early nineties Mexico’s banking system was privatized. At the same time Mexico was also liberalizing its capital account. But, the banking system was incompetent to risk management and the supervision from the central bank was limited. As foreign capital flowed in these funds were channeled into bad investment projects causing an increase in non-performing loans. Bankers like Carlos Cabal were accused of making hundreds of millions worth of bad loans. Cabal was never convicted but as the world interest rate rose and investors realized that Mexico might default on its stand a sharp reversal in capital flow occurred as capital left the country causing a collapse of the financial system and widespread loss in economic activity.

The Asian crisis in 1997 displayed similar features as the Mexican Peso crisis but also illustrated how asymmetric information in the global capital market could cause a financial crisis to spread to other countries. When a country defaults on its stand investors may withdraw their capital from neighbouring countries with similar culture or economic infrastructure because of fear of future default allowing the crisis to spread from country to country.

Financial globalization can also cause problems for developed countries experiencing capital outflows. Capital outflows make workers less productive and therefore cause wages to decline. This may be especially true in industries that employ low skilled labour. So companies such as car producer General Motors have moved some of their production to Mexico where wages are lower, as is electronics producer Thomson RCA. Because the effect is less predominant among high skilled labour wage inequality rises. Financial globalization also poses problems for countries with large welfare programs. These welfare programs are funded by taxing both labour and capital. Without capital restrictions capital tends to flow where taxes on capital are low. So countries may engage in tax competition in order to attract capital. Welfare states cannot afford to reduce capital and must follow suit and lower taxes on capital. In order to maintain the welfare system the lower tax revenues from capital must be compensated with higher taxes on labour. This is a problem for many European countries with large welfare programs and high taxes on labour. Financial globalization may therefore force these countries to reduce the size of the welfare state. Britain’s National Health Service, for example, founded in 1948 is funded exclusively through taxes and provides free healthcare for all. But with patients now suffering long waiting lists and being denied expensive treatments, many say Britain’s welfare state is creaking at the joints.