Kieran Healy

Elusive Gains

We all know what the benefits of open international capital markets are. Just like free trade in other goods, capital account liberalization means money flows where it’s needed, which makes for economic growth and development. We know this not just because of some verbal arguments, but because economists can write down a model of this process, and we can see it happening in the data. Right?

Wrong. A fascinating paper [pdf] by Pierre-Olivier Gourinchas and Olivier Jeanne shows that this isn’t the case at all. (This blog isn’t the New York Times, but in the spirit of full disclosure I should say that Pierre is a friend of mine.) They find that, for most countries, the average welfare gain from financial integration is only 1.24% of current consumption. This is tiny compared to the potential gains from increased productivity growth or a reorganization of the domestic market. Rather than helping them converge with developed economies, the best that capital mobility can do is to accelerate developing countries towards some steady-state (good, bad or very bad) largely determined by other factors.

What makes the paper particularly interesting and (I think) important, though, is that the authors don’t just do a bunch of cross-national time-series regressions to estimate the relative effect of some capital liberalization variable. That’s a worthwhile approach, but a significant result would not unduly upset most economists. This paper, by contrast, takes the standard model used to explain why financial liberalization is a good thing, calibrates it with the data, and shows that it fails on its own terms. That’s a much more serious challenge to the prevailing wisdom. The authors conclude that, based on this calibrated neoclassical growth model,

less developed countries do not benefit greatly from international financial integration. Less developed countries have far more to gain from improving their own domestic allocative efficiency than from an improvement in the allocative efficiency of the international financial system.

Pierre and Olivier are of course well-aware of ways in which financial liberalization might benefit developing countries, over and above the elusive gains from increased allocative efficiency at the international level. For instance, it might help developing countries if foreign banks (who know what they are doing) were allowed in; or liberalization might matter because it signals that the country is serious about protecting property rights, and so on. But these are not empirically settled questions and, as the authors say themselves, these “channels are not captured by the basic neoclassical framework.” And it’s that framework that’s supposed to give the original argument its real force.

Fascinating stuff. Read the paper yourself.

The study seems to be saying that no matter how much you eat, it won’t do you much good if your metabolism can’t do much with the nutrients.

A very quick review of the paper suggests that its conclusions are what anyone who’s lived in a developing (more precisely, an underdeveloped) country would say: the drag of an inefficient political economy is a much greater factor than is the benefit of increased access to foreign capital.

Further research needs to focus on questions such as the following:

How productive is the population? (e.g., poor health, low levels of education, a culture that is not oriented toward modern operations)

How much does the government detract from efficiency? (e.g., red tape, corruption, misallocations due to statist investment decisions, insecure contract and property rights, and tax disincentives)

Although the report’s main conclusion was not particularly surprising, a rather startling statement appears on page 24: “On the basis of our sample, we can identify eight countries that closed more [than?] 30 percent of their productivity gap with the U.S. between 1960 and 1995…. The list includes Korea, Botswana, Barbados, Isreal, Cyprus, Mauritius, Hong Kong and Singapore.”

Botswana Even allowing that it probably started from a very low base, making a productivity catch-up easier, how often do we hear of an economic success story in sub-Saharan Africa. Good for them!

Well done Botswana indeed, although its development model (“discover diamonds”) may not be replicable elsewhere.

This is not new. THe IMF had a report saying the same thing back in March. Click here:

http://www.imf.org/external/np/res/docs/2003/031703.htm

Botswana aside, Barbados, Cyprus, Mauritius, Hong Kong and Singapore are all small or tiny countries seemingly reliant mostly on entrepot trade and offshore banking. Singapore and Hong Kong are trade cities whose hinterlands are in different political jusrisdictions.

Korea, like some of the other success stories of the last half century (Japan, Taiwan) developed under a protectionist regime and had a very favorable relationaship with the US based on a miltary alliance.

I don’t know anything about Cyprus.

Damien,

the second author on the paper is an economist in the IMF’s research department. The report you’re talking about was co-authord by the head of that department (Ken Rogoff) and cites the Gourinchas and Jeanne paper.

Capital Mobility

Daniel’s post on the Cancun trade talks explains that their failure was rooted in disagreement about restrictions on foreign investment and capital controls. This reminds me that it’s time you all re-read Pierre-Olivier Gourinchas and Olivi…

Capital Mobility

Daniel’s post on the Cancun trade talks explains that their failure was rooted in disagreement about restrictions on foreign investment and capital controls. This reminds me that it’s time you all re-read Pierre-Olivier Gourinchas and Olivi…