Global imbalances or why are the poor financing the rich?

Traditional economic models predict that capital should flow from capital-rich to capital-poor economies. In recent years, capital has been flowing in the opposite direction, although foreign direct investment flows do behave more in line with theory. Do these perverse patterns of flows dampen growth in non-industrial countries by depriving them of financing for investment? On the contrary, the evidence suggests non-industrial countries that have relied more on foreign finance have not grown faster in the long run. At the same time, growth and the extent of foreign financing are positively correlated in industrial countries. I argue that the reason for this difference may lie in the limited ability of non-industrial countries to absorb foreign capital. It gives me great pleasure to deliver the 2007 Tinbergen lecture. It is also a great honor. Jan Tinbergen ( 1903-1994) was a macroeconomist of the highest order. He had a very keen sense of the importance of data and its relevance to policy. Indeed his seminal work on business cycles precipitated important thinking on the subject, which has informed the work of a number of places I have been associated with, including the International Monetary Fund. Jan Tinbergen was not only a great economist, he was also a moral man, a humanist, and a conscientious objector to war in the days when such objection was even considered treasonous. It is with these two aspects of Jan Tinbergen's life in mind that I chose today's topic - " Global imbalances: Or why the poor are financing the rich?" Is the current pattern of global capital flows - from poor countries like China to rich countries like the United States - a travesty? Does it hurt poor countries? This is as much a moral issue as an economic issue. And it can best be addressed by looking at the data, rather than simply by theorizing. That is what I propose to do today. Start first, though, with the theory. Economic theory posits that capital should, on net, flow from richer to poorer countries. Specifically, in the benchmark neoclassical model, capital should flow from countries that have relatively high capital-to-labor ratios and relatively unprofitable investment opportunities to countries that have relatively low ratios. In an influential paper, Lucas ( 1990) noted that flows of capital from the "North" to the "South" are nowhere near the levels predicted by theory. Financial globalization has taken off in the decade and a half since Lucas wrote his paper, with a substantial increase in cross-border capital flows. Figure 1 shows that the quantum of net global cross border financial flows, as measured by the sum of current account surpluses summed over all countries, has been steadily increasing over the last three decades. Non-industrial countries, especially the group of emerging market economies, have become much more integrated into international financial markets. What has become of the empirical paradox that Lucas identified - has increasing financial integration resolved it?