The Benefits and Risks of Financial Globalization

It is by now almost impossible to conceive of a world without a global financial system. To be sure, large numbers of low-income developing countries have little access to that system. But most middle-income developing countries, even some that still have capital controls of one sort or another, are increasingly integrated into that system, and all of the major developed countries are fully integrated. Types of Global Financial Integration When assessing the benefits and risks of participation, it is useful to identify four types of financial integration: 1. Integration of the public sector by way of sovereign borrowing, which can take two forms: the issuance of foreign-currency debt, whether under foreign or domestic law, and the issuance of local-currency debt which foreigners can purchase on the issuer's home market. 2. Integration of the corporate sector by way of foreign direct investment, as well as cross-border borrowing and equity issues in other countries' markets. 3. The further integration of the corporate sector that occurs when institutional and individual investors buy and sell the stocks and bonds of other countries' firms in those countries' asset markets. 4. The integration of the banking sector by way of the worldwide interbank market in which they can borrow or lend temporarily--the option exercised with dire consequences by some of the East Asian countries' banks a few years ago. Foreign direct investments, as well as long-term contractual arrangements between domestic and foreign firms, have made today's globalization different from yesterday's globalization. In earlier periods, countries specialized in products. Some produced raw materials; others produced manufactured goods. Today, by contrast, countries specialize increasingly in processes. A large part of international trade involves intermediate goods--parts and components that will be assembled and sold thousands of miles away. This could not have happened, of course, without the revolutions in communications and transportation that we now take for granted. But the specialization in processes, rather than whole products, is in part responsible for those two revolutions--the use of aircraft, for example, to carry high-value parts from continent to continent. I think it fair to say, moreover, that the integration of the corporate sector, by way of foreign direct investment, is not likely to threaten the stability of the international financial system, let alone the U.S. financial system. It is unfortunate, of course, that too much of the world's oil and gas production, present and future, takes place in volatile parts of the world and that the transmission of oil and gas is also vulnerable to political instability in many parts of the world. And we have seen how that instability can pose hard problems for the Fed. It is widely agreed that a big supply shock, such as a run-up in the oil price, poses an intractable problem for any central bank that seeks to maintain price stability without depressing real growth, and that is precisely the problem the Fed may face quite soon. Gains from Financial Integration It is also worth noting that the gains from financial integration have not been as large or widespread as many economists expected when they confronted the data. A remarkable paper by four economists, Kenneth Rogoff and three of his former colleagues at the International Monetary Fund (Kose et al. 2006), has surveyed the very large body of research on the gains from integration--whether and to which extent it has fostered economic growth in the developing countries. To some significant extent that large body of research is flawed analytically. Much of it, for example, relies on overly simplistic measures of the degree to which countries restrict international capital flows, and much of it also fails to distinguish between the effects of capital controls and of other institutional features of the countries under study. …