In one of his most memorable and widely quoted passages, John Maynard Keynes extolled the virtues not only of trade integration but also of financial integration when he wrote, in 1920, of the fabled Englishman who could "adventure his wealth in . . . new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages."1 Consistency was, of course, not a Keynesian virtue, and in 1933, in one of his less quoted passages, Keynes's musings on globalization turned more melancholy, even skeptical: "I sympathize with those who would minimize, rather than with those who would maximize, economic entanglement among nations. Ideas, knowledge, science, hospitality, travel—these are the things which should of their nature be international. But let goods be homespun whenever it is reasonably and conveniently possible. . . ." He reserved his deepest skepticism for financial globalization, warning, "and, above all, let finance be primarily national."2
Which Keynes was right? the Keynes of 1920 or the Keynes of 1933? And why? Or, to put it more mundanely, does foreign capital play a helpful, benign, or malign role in economic growth? The question has fueled passionate debates among economists, policymakers, and members of civil society. It has gained importance in recent years because of the curious, even seemingly perverse, phenomenon of global capital flowing [End Page 153] "uphill" from poorer to richer countries. But it has economic relevance beyond the current conjuncture because it goes to the heart of the process of development and the role of foreign capital in it. It also has enduring policy relevance as developing countries try to decide whether to open themselves up more to financial globalization, and if so, in what form and to what degree.
We undertake an empirical exploration of this question, beginning with some stylized facts that motivate our analysis. The current account balance, which is equivalent to a country's saving less its investment, provides a summary measure of the net amount of capital, including private and official capital, flowing in or out of a country.3 Figure 1 shows that net [End Page 154] global cross-border financial flows, measured as the sum, relative to world GDP, of national current account surpluses of countries that have surpluses, has been more or less steadily increasing over the last three and a half decades. Although financial globalization was also well advanced in the era leading up to World War I,4 there appear to be some important
[End Page 155]
differences in the current episode: today's globalization involves a greater number of countries; not only are net flows sizable, but there are large flows in each direction as well; and these flows encompass a wider range of more sophisticated financial instruments. But it is the apparent perversity in the direction of flows that is most characteristic, and most puzzling, about the globalization of today.5
In the benchmark neoclassical model, capital should flow from rich countries with relatively high capital-labor ratios to poor countries with relatively low ratios. Yet, as the top panel of figure 2 suggests, the average income per capita of countries running current account surpluses (with income measured relative to that of the richest country in that year, and with countries weighted by their surpluses in calculating the average) has been trending downward. Correspondingly, the average relative income per capita of deficit countries, weighted in the analogous way, has trended upward. Indeed, in this century the relative income per capita of the surplus countries has fallen below that of the deficit countries. Not only is capital not flowing from rich to poor countries in the quantities the neoclassical model would predict—the famous paradox pointed out by Robert Lucas6—but in the last few years it has been flowing from poor to rich countries. However, this is not a new phenomenon. In the late...