The Welfare Implications of Global Financial Flows

Any discussion of whether the global financial system has served the world well requires us to think about what it is that capital flows could achieve in the best of circumstances. The basic neoclassical model suggests that, with rising financial globalization, capital should flow from rich to poor countries, making people in both sets of countries better off by enabling a more efficient international allocation of capital from countries where capital is less productive to those where it ought to be more productive. In addition, financial flows should allow for more efficient sharing of risk across countries, thereby facilitating the smoothing of national consumption against country-specific shocks to national output. These benefits are likely to be greater for developing countries as they have less capital and more volatile growth, implying that both the growth and risk sharing benefits would be larger for them. Have international capital flows delivered these benefits? The macroeconomic evidence that financial integration has accounted for systematically higher growth rates in developing economies is not robust, especially when one controls for other determinants of growth (Kose et al. 2006). And there is certainly no evidence that developing economies, or even the smaller group of emerging market economies, have been able to better share their income risk and achieve improved consumption smoothing during the recent period of financial globalization. Indeed, some observers have argued that financial globalization is the proximate determinant of the financial crises experienced by many developing economies over the last two decades. And yet, financial globalization has continued apace, with rising cross-border financial flows and with developing countries actively seeking to open up their capital accounts. So what have these flows wrought? And do the patterns of these flows imply that the international financial system is working well or not? Patterns of Flows One of the remarkable features of recent capital flows, especially since the beginning of this decade, is that total capital flows (private plus official) have been from relatively poor non-industrial countries (emerging market economies and other developing countries) to advanced industrial countries, exactly the opposite of the direction predicted by theory (see Figure 1; Figure 2 shows similar calculations excluding the United States). This is despite the fact that there have been no sudden stops, drastic capital flow reversals or other types of financial crises that have hit developing economies during this decade. Furthermore, among non-industrial countries, more capital seems to go to slower-growing economies rather than faster-growing economies, a phenomenon that has been dubbed the allocation puzzle by Gourinchas and Jeanne (2006). Indeed, as a group, the faster-growing developing economies have been exporting capital during this decade (see Prasad, Rajan, and Subramanian 2007). [FIGURES 1-2 OMITTED] A large portion of the flows of capital from developing to industrial economies is of course in the form of official accumulation of international reserves. But, from a financing perspective, the net effect is still the same--that of reducing the quantum of capital available for investment in developing countries. In short, the flow of capital from developing countries would seem to be starving these already capital-scarce economies of capital and sending it to richer industrial countries where, given the relative abundance of capital, its productivity should be lower. Does this seemingly perverse flow of capital from developing to industrial countries adversely affect growth in the former group? The recent strong growth performance of emerging market economies suggests that this is not the ease. Remarkably, the historical evidence also suggests that such uphill flows of capital do not adversely affect growth in developing economies, at least in one very basic sense. …