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Motivation
Cross-border capital flow reached nearly $6 trillion in 2004. Less than 10% goes to developing countries. The paradox of too little capital flow: in a one-sector model, marginal product of capital is lower in rich country, but the amount of capital from rich to poor countries is too small (the Lucas Paradox) Example: India vs the U.S. (5800% difference in MPK) The paradox of too much capital flow: in a 2-sector, 2-factor model, factor prices are equalized in a free trade world (FPE due to Samuelson). So there is no incentive for any capital to flow.
Existing explanations of the Lucas paradox do not survive in a generalization to a 2X2 model To build a micro-founded non-neo-classical theory to solve the two paradoxes To highlight (possibly different) roles of financial development and property rights institutions in international capital flows
Difference in effective labor Missing factor (e.g. human capital) Sovereign risk (Reinhart and Rogoff) Trade cost (Obstfeld and Rogoff) Difference in TFP (of which institution is a special case)
Common problem: They do not survive in a generalization to a neoclassical two sector, two factor model
If existing explanations of the Lucas paradox dont work, what about textbook reasons that break the FPE in the 2X2X2 model?
Difference in technology
We are NOT saying that FPE is realistic, but that it is much more difficult to escape from the tyranny of FPE that the existing literature may have realized.
We work with a two-sector model but with two twists To resolve the Lucas paradox, we introduce a financial contract between entrepreneurs and investors: Each only gets a slice of the marginal product of physical capital. To move away from FPE, we introduce heterogeneous entrepreneurs, which result in sector- level DRS (despite firm-level CRS).
Indias K/L ratio is only 1/15 of the U.S. Its financial system is also much less efficient In the absence of capital flow, the return to financial investment is lower in India than in the U.S. India experiences an outflow of financial capital At the same time, because Indians return to physical capital is higher -> Inflow of FDI
Inflow of FDI is bigger than it would have been if its financial system had been more efficient
Return differential is smaller than Lucas calculation Much smaller friction can stop the capital flows
Roadmap
The Model
Two key parameters
Comparative Statics
Free trade in goods Financial capital flow FDI World capital market equilibrium
Model Description
The Model
Financial Contract:
Solution
Lemma 2: The more productive entrepreneurs enter the heterogeneous sector, while the less productive ones enter the homogeneous sector. In the heterogeneous sector, relatively more productive entrepreneurs manage more capital.
A Stolper-Samuelson Plus theorem holds: (Prop 1) When p r but w When r but w When r but no change in w When N1 r but w But FPE does not hold!
Proposition 1: An increase in N1 will decrease r but increase w. An improvement in the level of financial development will increase r but has no effect on w. Lower expropriation risk increases r but decrease w.
Equilibrium Conditions
N1 , y1 more than y2 , and p y1 and y2 proportionately, but no change in p (or N1) N1&N2 , y1& y2 proportionately, but no change in p
Comparative Statics
Proposition 2: The increase in K will increase N1, and decrease the relative price of good 1. The improvement in the level of financial development, however, has no effect on outputs and the commodity price. Lower risk expropriation decreases N1 and N2, but has no effect on p.
When K/L
N1 r but w
(prop 2) (prop 1)
The intuition from a one-sector model is restored in this two-sector, two-factor model! Question: Is the Lucas Paradox also restored? No! The differential in returns to capital depends on c1f/(1+f), which can be very small Evidence: Caselli and Feyrer (2005)
Free trade in goods Just financial capital flow (+ free trade) Just FDI (+ free trade) Both types of capital flows (free trade)
Two countries differ in factor endowments and levels of financial development and property rights protection.
Prop 3: The Heckscher-Ohlin theorem still holds: Each country exports the good that uses its more abundant factor intensively.
Proposition 4: If the two countries have the same level of property rights protection and financial development, financial capital will flow out of the capital abundant country, and into the capital scarce one. If the two countries have the same capital-labor ratio, financial capital will flow out of the country with lower financial development or poorer property rights protection and into the other one.
Proposition 5: Suppose trade in goods is free and expropriation risk in the two countries are the same, FDI will flow out of the capital abundant country to the labor abundant country. If the two countries have the same K/L ratio, then FDI will go from the country with poor property rights protection to the other.
Free capital mobility + free goods trade If a country has low K/L and low , then it experiences two way gross flows (outflow of financial capital but inflow of FDI), and a small net flow
e.g. China
If a country has a low K/L and low , then outflow of financial capital + outflow of FDI
e.g. Zimbabwe
Contrasting effects of poor financial development vs. poor property rights protection
A lower level of financial development results in a lower r, which generates an outflow of financial capital. As a result, w becomes lower, which attracts more FDI than otherwise. Worse property rights protection results in both a lower profit, leading to less FDI, and a lower r, leading to outflow of financial capital
Empirical evidence: Wei 2006
Property rights protection, financial development, and composition of capital flow (Wei, 2006, connecting two views on financial globalization )
FDI/total foreign liability IV Regression Portolio equity Portolio debt /total foreign /total foreign liability liability Loan/total foreign liability
Institutional Quality
Observations R-squared
FCF
FDI
H E A
C A*
Y2 B L L+L*
In equilibrium, wage is always higher in the country with better financial institution or lower expropriation risk.
Prop 5:
Suppose the two countries are diversified in the equilibrium with free trade and free capital mobility, then the wage rate is always (at least weakly) higher in the country with better property rights protection or with better financial development
Conclusions
Existing explanations of the Lucas paradox dont survive in a model with two sectors and two factors. It is difficult to simultaneously resolve Lucas paradox and FPE in a neo-classical framework We build a micro-founded non-neoclassical model Key twists: Financial contracts Heterogeneous firms The model highlights (potentially different) roles of financial development and property rights protection It generates predictions about gross as well as net capital flows. It avoids both the Lucas paradox and FPE.
Legal origins: La Porta, Lopez-de-silanes, Shleifer, and Vishny (JPE 1998) Settler mortality
Corruption is mostly affected by settler mortality but not by legal origin Financial development is affected by both legal origins and settler mortality.
(1)
Corruption(GCR/WDR)
34 0.40
34 0.53
33 0.57
Corruption(GCR/WDR)
-0.10** (0.04)
Observations R-squared
40 0.15
34 0.09
34 0.28
34 0.36
(1) Log(settler mortality) 0.46** (0.08) Log(Population density in 1500) Legal origin (French) Legal origin (German) Legal origin (Scandivanian) Legal origin (Socialist) Observations R-squared 44 0.44
Corruption(GCR/WDR) (2) (3) (4) 0.31** (0.08) 0.27** (0.07) 0.37 (0.23) 0.00 (0.00) 0.00 (0.00) 0.71 (0.66) 48 0.24 40 0.36 0.10 (0.08) 0.62** (0.22) 0.00 (0.00) 0.00 (0.00) 0.79 (0.72) 44 0.20
Financial development (5) (6) (7) -0.21** (0.03) -0.07** (0.03) -0.18** (0.08) 0.74* (0.38) 0.70* (0.38) -0.25** (0.10) 120 0.14 -0.14* (0.08) 0.00 (0.00) 0.00 (0.00) -0.29 (0.21) 60 0.47 -0.18** (0.08) 0.00 (0.00) 0.00 (0.00) -0.14 (0.25) 73 0.14
-0.06 (0.17) 0.00 (0.00) 0.00 (0.00) -0.98** (0.45) 70 0.33 61 0.29
The welfare effect of financial capital outflow is determined by the trade off between investors' gain and entrepreneurs' loss. If the later dominates the former, welfare is reduced at home due to financial capital outflow.