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Why Did Financial Globalization Disappoint?

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The stylized fact that there is no correlation between long-run economic growth and financial globalization has spawned a recent literature that purports to provide newer evidence and arguments in favor of financial globalization. We review this literature and find it unconvincing. The underlying assumptions in this literature are that developing countries are savings-constrained; that access to foreign finance alleviates this to boost investment and long-run growth; and that insofar as there are problems with financial globalization, these can be remedied through deep institutional reforms. In contrast, we argue that developing economies are as or more likely to be investment- than savings-constrained and that the effect of foreign finance is often to aggravate this investment constraint by appreciating the real exchange rate and reducing profitability and investment opportunities in the traded goods sector, which have adverse long-run growth consequences. It is time for a new paradigm on financial globalization, and one that recognizes that more is not necessarily better. Depending on context and country, the appropriate role of policy will be as often to stem the tide of capital inflows as to encourage them. Policymakers who view their challenges exclusively from the latter perspective risk getting it badly wrong.

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  1. Of course, the Asian financial crisis forced the IMF to abandon efforts to amend its Articles of Agreement to promote capital-account liberalization. But in some of its recent bilateral trade agreements, the United States did succeed in getting its trading partners (for example, Chile and Singapore) to commit irrevocably to it.

  2. We do not evaluate here the impact of financial globalization on financial crises, except to note the recent assessment by Reinhart and Rogoff (2008, p. 7): “Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically.”

  3. See Bresser-Pereira and Gala (2007) for a similar argument.

  4. This point brings to mind the complaint that Larry Summers voiced while discussing a paper on China's banking problems: “Like experts in many fields who give policy advice, the authors show a preference for first-best, textbook approaches to the problems in their field, while leaving other messy objectives acknowledged but assigned to others. In this way, they are much like those public finance economists who oppose tax expenditures on principle, because they prefer direct expenditure programs, but do not really analyze the various difficulties with such programs; or like trade economists who know that the losers from trade surges need to be protected but regard this as not a problem for trade policy” (Summers, 2006).

  5. Before we review these new arguments, it should be noted that at least two additional papers that have appeared since PBH's survey—Gourinchas and Jeanne (2007) and PRS (2007)—come closer to the conclusion that foreign capital has a negative effect on long-run growth. So, if anything, the weight of at least the macroeconomic evidence has shifted toward a less favorable view of financial globalization.

  6. Gourinchas and Jeanne (2007) focus only on developing countries, but PRS (2007) distinguish between developed and developing countries.

  7. This point is obscured in Henry's (2007) account because Henry focuses on the growth rate of the capital stock (I/K, assuming no depreciation), which is of course different from the investment rate (I/Y). In the neoclassical growth model, capital-account liberalization has long-run effects on the latter, but not the former. This can be seen by writing I/Y=(I/K)(K/Y) and noting that in the post-liberalization steady state I/K is constant while K/Y is higher.

  8. Schularick and Steger (2007) find a positive relationship between financial integration and investment rates during the earlier era of globalization (1880–1913), but no such relationship in the data for 1980–2002. They interpret this as being the result of much larger net capital flows under the classical gold standard.

  9. One of the more persuasive papers in this literature is by Rajan and Zingales (1998). But this paper establishes an effect on relative growth (finance-intensive sectors grow more rapidly than other sectors in countries where there is greater financial depth) and not on the average level of growth.

  10. See for example Calvo, Lederman, and Reinhart (1996) on the role of U.S. interest rates as a determinant of capital flows to developing countries.

  11. These results do not seem to be due to changes in relative prices: the pattern of correlation we get is quite similar when we compute the investment effort by taking the ratio of investment to GDP at constant local currency units. Nor can we explain it easily through other channels by which U.S. real interest rates affect economic activity in emerging markets. When U.S. interest rates are high, the demand effect is negative, and that should exert a depressing effect on investment in developing countries.

  12. In principle, the fact of being more closed to capital means that interest rate changes in the United States should have little impact on the availability of savings in these countries, leading to a weak or no correlation. One interpretation of the strong negative correlation would then be that it reflects the more traditional demand channel of higher interest rates in the United States reducing the demand for exports and hence leading to lower investment.

  13. The investment demand schedule here is strictly speaking that for tradables because that is key for long-run growth.

  14. Johnson, Ostry, and Subramanian (2007) show that not only is the average level of overvaluation significantly greater for slow-growing sub-Saharan African countries relative to the sustained growth performers but that consecutive spells of overvaluation are longer in duration and the degree of overvaluation during these spells significantly greater.

  15. The recent paper by Prasad and Rajan (2008) outlines a “pragmatic” approach to capital-account liberalization which recognizes that most countries are unlikely to be savings-constrained, but also that capital controls are ineffective in many settings. An imbalance in much of the commentary on these issues is the tendency to take the difficulties of administering capital controls as an immutable fact while evincing great enthusiasm for the complementary institutional reforms that will render capital flows safe.


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*Dani Rodrik is a Professor of International Political Economy at Harvard University, and Arvind Subramanian is a Senior Fellow, Peterson Institute for International Economics and Center for Global Development. The authors thank Olivier Jeanne, Ayhan Kose, Peter Henry, and John Williamson for comments on an earlier draft.

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Rodrik, D., Subramanian, A. Why Did Financial Globalization Disappoint?. IMF Econ Rev 56, 112–138 (2009).

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