Capital Controls and Competitiveness

When capital flows were liberalized within the European Union in the 1980s capital flowed into Southern Europe. But rather than stimulating investment and labor productivity, these capital flows were associated with rapid growth of the non-tradable sector, rising prices of non-tradable goods, a perceived loss of competitiveness in the tradable sector, and rising unemployment. We develop a model to interpret these trends, and to investigate their welfare consequences. A key departure from standard theory is that output is produced in two sectors: a tradable sector, and a non-tradable sector. Both sectors use two non-reproducible factors, one whose price is fully flexible (land) and another (unionized labor) whose price is downwardly rigid. The tradable sector is relatively intensive in the fixed-price factor. A relaxation of constraints on international borrowing leads to an increase in consumption of tradable goods. As a result, demand for non-traded goods also rises, and factors of production migrate to the non-traded sector. This bids up the price of the flex price factor – there is a real estate boom. Domestic firms cannot raise the price of traded output, and their workers will not accept lower wages. They are therefore forced to shrink in scale, and aggregate unemployment rises.