Capital Flight Essay

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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 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.

Other Factors

Monetarists point to other related factors critical to investor confidence and prevention of capital flight. First, the degree of market integration through trade or stock markets will determine the level of development of the domestic economy. Development itself creates confidence in that it creates prospects for growth that draws in capital. Second, the strength of the regulatory environment or the degree of transparency of rules creates confidence. For example, political independence of central banks ensures that monetary policies are geared toward austerity to ensure low inflation as a pre-condition for economic growth and exchange rate stability. Third, the degree of asset specificity will determine the cost of collecting information about prospects of the economy and create the degree of risk averseness.

For example, foreign direct investment (FDI) is least liquid, and being locally situated, can have more access to information, and hence, is less risk averse. In contrast, bond capital that lends to governments is highly liquid, has difficulty collecting information given the collective action problem of scattered investors, and hence, is highly risk averse. To prevent the flight of risk-averse capital, nonpolitical institutions are critical. Institutional strength increases transparency, reduces transaction costs, enables cost-benefit analyses, and ensures rational behavior.


The politically normative post-Keynesians offer strong counterarguments to the monetarist claims. They point out that the monetarists’ argument is internally inconsistent. If money is neutral in the long run, it cannot also be a source of growth. Why should governments care for “sound money” if there is going to be no fundamental change in the real economy? They indicate that while governments pursue low-inflation orthodoxy there are serious distributive effects in terms of creating inequality by hampering policies designed to rectify unemployment and create growth.

More critically, post-Keynesians point out that the rational expectations assumptions of the monetarists are based on unrealistic expectations of perfectly functioning markets, perfect information, and perfectly rational actors that result in indeterminate predictions about capital flight. They point out that there are market imperfections like concentration of institutional investors that lead to inefficient allocation of capital. Moreover, investors with short time horizons and performance pressures for furthering their own careers are likely to pursue irrational herd-like market behavior rather than individual rational cost-benefit calculus through careful evaluation of available information. This irrationality leads to speculative flows that impact real-time economic decision making within an economy. The sudden expansion of credit leads to asset price bubbles and consumption booms. This leads to currency appreciation “overshoot” as market expectations undergo irrational exuberance about growth expectations.

As consumers start relying on paper wealth in terms of rising asset prices, they engage in risky behavior of borrowing more, consuming more, and saving less. As domestic savings fall and open capital accounts provide the lure of cheap money, investors of local origin undertake unstable, short-term borrowing in hard currency to finance long-term projects. With the economy expanding on the basis of these reflexive asset bubbles—where expectations shape the reality—the outcome is unstable macroeconomic fundamentals. When the economy collapses under negative external shocks, like oil price shocks, currency devaluates drastically. This leads to devalued assets, high debts, and inflation. This causes capital flight as both international investors and domestic savers shift their assets abroad.

The credit crunch impacts further investment and affects local production and exports leading to a contraction of the economy. There is then increasing political demand for protection. With these kinds of market imperfections, growth is hampered, forcing governments to take protective measures to safeguard populations against the harshness of the vagaries of the market through expansionary policies geared to create safety nets. This creates loss of market confidence and results in cumulative capital flight.

Overall, capital flows in disequilibrating ways. “Hot money” flows for quick turnovers and quick profits and there is less productive capital-asset formation in the form of long-term FDI and fixed local capital. However, such market distortions can be corrected through strong political institutional structures—primarily the state undertaking growth measures.

Post-Keynesians point out that capital flight also depends on the capability of states to coordinate and create international regimes and institutions to regulate capital. This regulation would constrain herd-like behavior of investors that spreads contagion of financial crises and weakens economic fundamentals. However, in the current context of an international regime of neoliberalism that delegitimizes capital controls, governments have been forced to open up their economies to generate credibility even if they do not have the necessary domestic institutional strength.

Government Control

International institutions like the International Monetary Fund and the World Bank by advocating capital account liberalization as part of their development package conditionalities have further created an unstable financial system. The system is prone to crises of capital glut or crunch depending upon unstable and irrational market sentiments that lead to capital inflows and capital flight. While the Bank for International Settlements regime has sought to monitor capital behavior through increasing regulations, the regulations lag behind the rapid pace of technological growth that allow capital to evade and exit. Hence, government control of markets is critical.

Mixed economies like China and India that exercise significant government control over their economies have not lost out in terms of growth or ability to attract capital and prevent capital flight (e.g., the Asian financial crisis). Hence, a balance between growth and equity, free market and political intervention is critical.


  1. Philip Arestis, “Post-Keynesian Economics: Towards Coherence,” Cambridge Journal of Economics (January 20, 1996);
  2. Victor A. B. Davies, “Postwar Capital Flight and Inflation,” Journal of Peace Research (v.45/4, 2008);
  3. European Network on Debt and Development, “Addressing Development’s Black Hole: Regulating Capital Flight,” (cited March 2009);
  4. Ilene Grabel and Ha-Joon Chang, “Reclaiming Development from the Washington Consensus,” Symposium on “The 15th Anniversary of the Washington Consensus: What Happened? What’s Next?” Journal of Post Keynesian Economics (v.27/2, 2004–05);
  5. Adam Harmes, “Institutional Investor’s and Polyani’s Double Movement: A Model of Contemporary Currency Crises,” Review of International Political Economy (v.8/3, 2001);
  6. John Harvey, “A Post Keynesian View of Exchange Rate Determination,” Journal of Post Keynesian Economics (v.14/1, 1991);
  7. Andrew Van Hulten, “Capital Flight and Capital Controls in Developing Countries,” Progress in Development Studies (v.7/4, 2007);
  8. Ian Katz, “Capital Flight to South Florida,” BusinessWeek (June 25 2007);
  9. Jonathan Kirshner, “The Political Economy of Low Inflation,” Journal of Economic Surveys (v.15/1, 2001).

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