austin-murphy-the-triumph-of-evil

238 THE TRIUMPH OF EVIL
higher interest rates in one area can force real income declines there
earlier than otherwise, as in the case without a currency union. Regard­
less, unless a current account deficit is permanently subsidized by other
states in the currency union with surpluses, or unless some other solu­
tion to a BOP problem is employed (such as the one explained in Chap­
ter 5), a current account deficit must eventually be addressed with a
decline in income/consumption (with the decline still being magnified
by postponing it.
It should also be mentioned that, even without any devaluation and
even with approximately the same interest rates throughout a currency
union, use of the same currency does not naturally lead to equal pros­
perity across the union. In particular, once an income differential exists,
it can persist over many decades (or even centuries) even within a
common currency area, as the poorer sections of the USA and Italy
so well illustrate empirically (and as eastern Germany is expected to
further verify with the disastrous unification experiment). One reason
income differentials tend to persist is because income-raising invest­
ment tends to be more attracted to areas nearest to the bigger markets,
which consist of people with higher incomes, as such nearby produc­
tion facilities reduce the transportation/distribution costs of delivering
the products/services to those areas of high demand. Although capacity­
increasing investment might be attracted to the lower income areas,
this income-narrowing process would cease once the wage differentials
declined to the point where they no longer offset transportation cost
differentials. Another reason fo r persistence in income differentials is
that productivity-enhancing investment and mechanization tends to be
especially concentrated in areas with higher incomes, as the benefits
of such investment is higher in the wealthier areas with higher wage
costs. Finally, the most valuable "human capital" (i.e., the most skilled
workers) is attracted to the areas of higher wealth, which can afford
to provide higher wages, more skilled jobs, and better living condi­
tions through more investment in mechanization and infrastructure
(thereby leaving mostly the less skilled and lower-paid workers in the
poorer areas and thereby "naturally" magnifying differences in regional
incomes).9 While some of these problems can be mitigated with central
government subsidy, tax, and other policies, it is important here to point
out that a currency union (or other rigid monetary policy) does not solve
CHAPTER 6 239
BOP problems and, by itself, does not represent an optimal method of
avoiding currency crises.
Capital Controls
A � other solutio � to a �?P problem often proposed is to impose
capttal controls (Gtovanmm, 1992). Capital controls were extensively
e � ployed �y � �ost all countries after World War II to restrict capital
ftt�t ( d mhtbtt �e resul�ing downward pressure on exchange rates
� .
whtch mtght result m inflation or require higher domestic interest rates
� counteract), although these controls have now been removed in many
?ch, de
�
eloped countries that have accumulated sufficient capital to be
mtemattonally competitive (Dooley, 1996). 10
�ita! controls can be used to stop the investment outflows that
Wtll normally occur when investors perceive an increased chance of a
currency depreciation, as so often happens after an initial devaluation
(Age � or and Masson, 1999). In particular, capital controls are useful for
allowmg a country to maintain interest rates below those that would oth­
erwise be required to prevent a currency depreciation beyond the mini­
mum devaluation necessary to create a balanced current account. As a
result, an excessive devaluation (and the resulting inflationary spiral)
can be avoided without incurring the excessive real income losses that
are caused by extremely high interest rates. In addition, if currency con­
�ls are used to restrict capital outflows while at the same time incenti
fl v� (such as tax breaks, contracts guaranteeing investors access to
Oretgn exchange for repatriation purposes, trade barriers that encour­
, ,
�e local production, etc.) are provided for direct foreign investment,
� �may be possible to fund a current account deficit with private capital
:estrn � nt without having to raise interest rates (thus without immedi-
real mcome losses) and without having to allow an immediate cur­
rency decline (thus without increasing future inflation near-te rm).11
�· 7 not directly related to a current account deficit. For instance,
tba Capital controls are also useful for stemming capital flight for factors
whitta .
h controls can be used to prevent an artificial currency devaluation
c ts caused ·
·
tal
mstead by an exogenous shock (such as a random capt-
rni�� ly a temporary effect (as the resulting fall in the exchange rate
outflow).
bav While an artificial devaluation in such a situation might
create a current account surplus which would eventually pressure