The fundamental determinants of financial integration in the European Union

12

Figure 3 - The intensity of capital controls: The total number of left-wing governments and the total
number of significant government changes

(4) Applying the "second-best" principle of welfare economics

(4a) Capital controls correct distortions in labour and goods markets

Capital controls have also been defended with reference to the "second-best" principle of welfare economics.
Second-best theory suggests that government intervention can enhance welfare in the presence of multiple
distortions. If some unavoidable rigidities exist in goods and labour markets, it has been argued, then some
"optimal" degree of distortions in the operation of financial markets might lead to an overall improvement
of welfare.²⁵ Unavoidable rigidities in goods and labour markets are best matched by some institutionally
created rigidities in foreign exchange and financial markets (Cairncross, 1973). Capital flows exacerbate
economic distortions in the short run and long run. Relevant indicators of economic structure are the
productivity in the business sector (PROD) and the openness of the economy (OPEN). With high openness
capital controls are less effective, so they are less likely imposed. On the other hand, one may argue, with
high openness capital controls may shield the economy from foreign competition, so they are more likely
imposed. Moreover, the productivity in the business sector and the openness of the economy may also control
for omitted variables in the regression specification -- i.e. variables which are strongly correlated with these
control variables.

(4b) Capital controls correct distortions in financial markets and financial systems

We hold that the explanation of European differences in the degree of financial integration cannot abstract
from the analysis of country-specific differences in financial market structure (the financial system inclusive).
The structure and regulation of the domestic financial system is at the heart of the use of capital controls.
With financial markets becoming increasingly integrated, the role of country-specific differences in financial
market structure in explaining closed interest differentials is likely to increase. The OECD (1990a, p. 27)
argues: "The authorities may also wish to regulate capital flows because of concerns with the degree of
foreign exchange exposure of domestic financial institutions and its implications for the soundness of the
financial system as a whole.²⁶ One set of reasons advanced for limiting the size and mobility of capital
flows relates to the associated foreign exchange risks as well as the potential for undermining national
prudential standards by allowing domestic investors to acquire assets that the authorities consider unsound
or by encouraging the emergence of instruments and practices the authorities do not wish to see developed
in local markets." The financial market structure ofEU countries can be seen as the outcome of the behaviour
of the various sectors in the economy (Lemmen and Eijffinger, 1995b). According to Hubbard (1994, p.

²⁵ Or, to keep trade free of tariffs and subsidies, it may be necessary to regulate capital movements.

²⁶ The rationale for capital controls and regulation of domestic financial markets results from the desire to avoid systemic risk.

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