South-Western College Publishing - Economics  
Rethinking Capital Ideas
Subject Recession, Fiscal Policy
Topic International Finance
Key Words Economic Growth, Capital Flows, Capital Controls
News Story

The 1990s were a period of world-wide economic growth. The prevailing doctrine seemed to be that the optimal world is one where capital can freely flow from one country to another. The Clinton Administration led a global push to free the flow of capital throughout the world. Recent events have caused many to question that doctrine and a growing number of economists are calling for an overhaul of the economic system which has governed the global economy for almost 50 years. This debate is expected to continue at next month's special meeting of finance ministers and bankers from the Group of Seven industrialized countries.

Capital flows are simply the result of people and financial institutions searching for higher rates of return on their capital. This may occur simply as the result of an individual placing a deposit in his or her local bank. That deposit may wind up in Brazil if the bank lends money to a Brazilian company. Vast sums of capital flowed into many developing countries as a result of just such a process, creating a speculative bubble that burst when the capital was withdrawn.

The question of whether capital should be globalized is not a new one. In the 13th century England borrowed funds from Florentine merchants to finance its wars. England defaulted on its payments causing the collapse of two Florentine banks. In 1842, a developing country defaulted on the bonds it had issued. The country was subsequently denounced for its default and labeled "a nation with whom no contracts can be made." That country was the United States. Capital, at least from the 13th century on, has sought out higher returns by crossing geographic and political boundaries. One of the risks associated with this movement has always been default.

But many people argue that today's problems are different. The scale of capital flows is enormous and consequently, so is the ability of abrupt changes in these flows to cause a nation's financial system to collapse. Many countries imposed capital controls early in this century but lifted them during the 1970s and 1980s. Countries that resisted relaxing controls, such as China and India, have weathered the current crisis better than most of the ones that adopted liberalization policies. Malaysia, believing that free capital flow is responsible for its financial crisis, has imposed rigid currency controls.

How the industrialized countries might deal with this problem is uncertain. Federal Reserve chairman, Alan Greenspan, has denounced rigid capital controls but has proposed tightening supervision over banks that engage international finance. Other advocates of free capital flows also seek methods of reducing market volatility. (Updated October 15, 1998)
Questions

1. Describe the 'managed float' system of exchange rate management. How does the system differ from freely floating exchange rates?

2. Using demand and supply curves of a foreign currency, show the impact of an increase in supply of the currency on a country's exchange rate.

3. Suppose that the supply of the foreign currency now decreases. Show the impact of this decrease on the exchange rate.
Source Nicholas D. Kristof, "As Free-Flowing Capital Sinks Nations, Experts Prepare to 'Rethink' System," The New York Times, September 20, 1998

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