0.1 Economic development is about all of economics  (Page 12/14)

Another closely related lesson from the past half-century concerns the tax policy implications of the international mobility of capital. Capital is now very mobile internationally. In the first decades after World War II, the design of tax policies in both rich and poor countries was based on the assumption that capital would not migrate in response to policies such as very high tax rates that reduce its return. Total world financial assets exceeded $150 trillion by 2007 before the meltdown of 2007-2010. By 2012 global financial assets grew to $225 million. This capital is sufficiently mobile everywhere so that attempts to apply high corporate income or other capital taxes have had very disappointing results: capital tends to flee when the taxes drive down its net-of-tax return much below what it can earn elsewhere.

6) The Role of Foreign Trade Regimes, Flexible Exchange Rates and Real Exchange Rates

The Clinton Administration (1993-2001) was convinced that International Trade was the surest, and usually the shortest, path to improved living standards. This is why President Clinton stressed the need for the creation of NAFTA (The North American Free Trade Area) in 1996. While NAFTA has had relatively small benefit for U.S. and Canada, big benefits for Mexico. U.S. Trade with Mexico increased by 506% from 1993 to 2012, whereas U.S. trade with the rest of the world grew by only 279% over the same period. Countries that have consistently relied on strongly protectionist policies have experienced relatively limited economic growth (North Korea, Tanzania before 1998, Burma, India before 1932, and China before 1980).

Trade is greatly affected by a key macro price: the exchange rate . The nominal exchange rate is the one quoted daily in the press – say 1 Euro = $1.33 dollars. The real exchange rate, rather than the nominal rate, turns out to be one of the most consequential of all magnitudes in economic development. The real exchange rate reflects not only the nominal exchange rate, but changes in relative inflation rates across nations as well. The real rate of exchange exerts strong effects on import or export of traded goods. A realistic exchange rate regime is one in which a country’s nominal exchange rate adjusts to differential movements in the rate of domestic inflation so as to maintain appropriate real exchange rates. World experience has shown that policies using flexible exchange rates are far more successful in achieving this objective than are the type of fixed-exchange rate regimes requires so commonly applied from 1945-1990. We will see in China that with flexible exchange rates, movements in real exchange rates are small and gradual, affected mainly by changes in domestic prosperity. Conversely, under a fixed exchange rate regime, economic damages from inappropriate macroeconomic policies can be concealed for a time, but corrections follow, and always involve large devaluations usually with disastrous effects. However, that is not to say that a flexible exchange rate system is free of problems. For example, sudden, unforeseen capital flight can occur.