Lecture 8: Globalization & international capital
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Already seen the brief outline of developments in global capital flows in earlier lectures.
Prior to 1850, whole lotta nuthin’…international capital flows limited in the main to two cities.
1850 to 1913: 30/30/40, the “developing world”, the UK, and NA/Australasia.
Development of global capital markets
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Yet again, 1914 as a turning point…WWI & explosion of US-owned debt leads to loss of
UK’s role as global financial hegemon & the
GBP’s role as global reserve/trade currency.
Also brings about declining prominence of international financial flows generated by:
1.) reluctance by US to assume role of hegemon;
2.) disorder of interwar commercial relations;
Development of global capital markets
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Long-run financial flows, thus, grind to a halt; but we see the rise of “hot money” after GD.
Speculators rush to capitalize on currency fluctuations generated by non-credible commitments to GS and market momentum.
Consequently, international capital flows seen as
Development of global capital markets
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Implemented to reconcile conflicting policy objectives (fixed ERs and monetary policy autonomy) by keeping capital account closed.
Gives rise to “trilemma” of international macro.
Came in the form of:
1.) direct prohibitions on capital transactions and associated transfer of funds
Development of global capital markets
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But from 1960s, a slow dismantling of capital controls which really takes off from 1980.
Total stock of cross-border capital: in 1950, <$100 billion (or 5% of world GDP); in 2014, >$100 trillion (or 160% of world GDP).
We also see rise of multi-national corporations
(MNCs) and their role in global capital flows:
Development of global capital markets
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Two further developments over this period which we need to highlight:
1.) Change in sources and destinations of global capital flows.
This is not a UK or even US-led story anymore, but still dominated by “North-North” flows.
Development of global capital markets
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Development of global capital markets
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2.) Change in composition of the flows related to removal of capital controls: a.) the rise and fall and rise of private-sector capital flows; b.) the rise and fall and rise of FDI; c.) the explosion of short—and ultra-short— international capital flows
Development of global capital markets
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Development of global capital markets
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Beyond documenting these trends, we need to push deeper and ask about the sources of this sea-change in global capital markets:
1.) What are some of the perceived benefits of liberalizing the capital account?
2.) What are some of the perceived costs of liberalizing the capital account?
Development of global capital markets
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Capital account is part of balance of payments which measures all international transactions involving a change in ownership of an asset.
When a country liberalizes its capital account it is simply moving from a closed to an open capital account where financial capital may move (more) freely in and out of the country.
Benefits of capital account liberalization
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Liberalizing one’s capital account is thought to have a number of benefits:
1.) it allows countries to smooth aggregate consumption in times of need like war.
2.) it allows countries to diversify risk in face of random (uncorrelated) shocks to output.
Benefits of capital account liberalization
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4.) it potentially allows for higher levels of investment and hence growth as capital flows in from other countries.
Taking first two as given and ignoring the third, we will focus on the fourth as the “big one”.
Allocative efficiency: differentials in return to capital (MPK) drives investors; capital flows from developed to less developed countries.
Benefits of capital account liberalization
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For better or worse, a fairly large literature has developed which runs counter to this logic.
Rodrik: no correlation between capital account openness and growth rate.
Eichengreen: meta-analysis of other studies
…same finding.
Benefits of capital account liberalization
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But should one expect that the transition from a closed capital account to an open one will result in a higher, permanent rate of growth?
Maybe not…in a neoclassical growth model, capital account liberalization should result in a higher, temporary rate of growth.
Benefits of capital account liberalization
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As you might have seen before, the Solow model of economic growth focuses on four variables:
1.) output (Y)
2.) capital (K)
3.) labor (L)
4.) efficiency (A)
The last element can loosely be thought of as
Benefits of capital account liberalization
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Production function of the economy given by:
( )

( ( ), ( ) ( ))
Its two critical features:
1.) Output from given quantities of K and L rises over time only if the amount of knowledge increases.
2.) A and L enter multiplicatively
Benefits of capital account liberalization
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Two further assumptions about the production function:
1.) It is characterized by CRS:
( , )

( , )
That is, we consider a large economy case where gains from specialization have been exhausted.
2.) Inputs other than K, L, A are unimportant
Benefits of capital account liberalization
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CRS also allows us to work with the production function in so-called “intensive form”:
( , )

( , )

Y
F 


K
AL
,1


  1
AL
( , )
/
 k
/
 y y
 f

0
Benefits of capital account liberalization
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Evolution of effective labor is exogenous:
 dL dt

A
Output is divided between consumption and investment (an increase in K stock):
Benefits of capital account liberalization
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Because:
1.) the evolution of labor and knowledge is exogenous and
2.) we are concerned with the effects of capital account liberalization, we need to concentrate on the behavior and
Benefits of capital account liberalization
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The important thing to recognize is that the dynamics of k (=K/AL) will determined by the growth of not only K but also A and L.
Taking the total derivative of k : k

 k

K
K

 k

L
L

 k

A
A
Benefits of capital account liberalization
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k k
 k


K
AL
 k
L
L
 n
A
A
 g
K
 sY
 
K
This tells us that change in capital per effective laborer is given by the difference between actual investment and break-even investment.
Benefits of capital account liberalization
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Here, k s
is the steady-state level of k with a closed capital account.
Benefits of capital account liberalization

Here, k* is the level of k once the capital account opens as r home
>r row
.
Benefits of capital account liberalization

Implications for variables of interest:
Interest rate Growth rate of K
Growth rate of Y/L t o time ln(Y/L) t o time t o time t o
Benefits of capital account liberalization time

As we have seen, the benefits of capital account liberalization must be carefully measured and may be somewhat limited.
Even in the best case scenario, there is an inherent trade-off: higher growth rates can be achieved but these come with a higher variance.
Costs of capital account liberalization
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Liberalizing one’s capital account is thought to have a number of potential costs:
1.) through market discipline, it can constrain policymakers seeking to maintain output and employment.
2.) opening the capital account increases a country’s exposure
Costs of capital account liberalization
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Global capital flows can be characterized by not only their size but also their character.
Most of the benefits listed have been implicitly about long-term capital flows, e.g., risk sharing, consumption smoothing, & allocative efficiency.
A big distinction arises when we start thinking
Costs of capital account liberalization
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Same as the “hot flows” of speculative money which arose in the interwar period.
Driven by the goal of short-run profits, these capital flows not only engage in arbitrage but also are marked by momentum trading.
Now as then, they can indeed be destabilizing.
Costs of capital account liberalization
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In many instances, these start with a currency crisis (collapse of a fixed exchange rate regime accompanied by a loss of official reserves).
Circular logic? Investors dump a currency because devaluation expected; but pressure on currency comes from this lack of confidence.
Does not necessarily have to stem from a fixed
ER either; in any case, easier seen than described or defined.
Costs of capital account liberalization
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Costs of capital account liberalization
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But why should we care about such crises?
Country in crisis suffers a loss of international reserves, but the crisis itself is just a depreciation of what was probably an over-valued currency.
At the same time, a depreciation should give rise to the process of expenditure switching.
Costs of capital account liberalization
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In advanced countries, this is borne out in the data; growth increases relative to trend after currency crises.
At the same time, currency crises can have very damaging effects, especially for developing countries where growth suffers for many years.
Why the differential response?
Costs of capital account liberalization
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Thus, financial disruption caused by crises is likely to lead to the insolvency of local banks.
This is due to lax regulation, currency mismatch, and/or the absence of a lender of last resort.
Banking and currency crises highly correlated; so much so known as the “twin crises”.
Costs of capital account liberalization
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Last 35 years especially have seen tremendous growth in capital flows across national borders.
An outcome of abandoning capital controls and, thus, liberalizing capital accounts.
Although there is some encouraging evidence, should also take into account the nature of flows and the maturity of domestic financial markets.
Conclusion
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