Aftermath: A New Global Economic Order?

Chapter 5. Pierre Elliot Trudeau: A Canadian Scandal?

Growth after the Crisis 77 Whether one thinks this is a big deal depends on one’s views about the growth process in developing nations. If we believe that the binding constraint to growth lies on the saving side, then we would conclude that a reduction in net inflows comes with a significant growth penalty. This would be the conventional inference drawn from the neoclassical growth model and the presumption that private returns to investment are higher in poor nations than in rich nations. But the experience of the past few decades gives us ample reason to take this view with a heavy grain of salt. The presumption that the saving constraint binds in most poor nations is contradicted by one important stylized fact: high growth and net capital inflows are negatively (rather than positively) correlated across developing countries.This was demonstrated in an important paper by Prasad, Rajan, and Subramanian,12 whose central finding is shown in figure 3.4. China, of course, is the best-known case of a high-growth country with a trade surplus, but as the Prasad et al. evidence shows, China’s experience is not an anomaly. Rapidly growing countries are more likely to be net exporters of capital than net importers (and this is true even when aid flows, which tend to go disproportionately to the worse-off countries, are taken out). This should not be surprise in light of the growth story I laid out in the previous section. The binding constraint in that interpretation is not the supply of loanable funds but investment demand in tradables. What limits growth is not access to finance but the low (private) profitability of modern tradables. Accordingly, the key to growth is not more finance but enhanced private profitability in tradables. Moreover, in typical secondbest fashion, more finance can result in lower growth if it exacerbates the more significant constraint. How? Through the effect of capital inflows on the real exchange rate. As shown by Prasad et al. and by me elsewhere ,13 countries with larger net capital inflows and more open capital accounts tend to have more overvalued currencies.This mechanism goes a long way to explain why financial globalization has proved so disappointing for the vast majority of developing nations.14 No doubt there are some countries for which low domestic saving is indeed a binding constraint. This constraint can be relaxed, in principle at least, through access to foreign finance. Brazil, for example, has built a diversified agricultural and industrial base (thanks in large part to industrial policies in earlier decades), but all indications are that investment levels in modern economic activities are currently constrained primarily 78 Rodrik by the high cost of capital driven by low domestic saving.15 Turkey represents a similar case. So growth and investment in Brazil and Turkey go up and down with net capital inflows. However, since capital flows are highly volatile and subject to “sudden stops,” neither Brazil nor Turkey has been able to generate consistently high growth since the end of the 1980s. So even in saving-constrained cases such as these, the appropriate remedy lies not in resuscitating financial globalization but in domestic policies (such as reductions in fiscal deficits and encouragement of private saving). Neither is there much cause for concern regarding a reduction in global risk sharing. In principle, higher levels of gross (two-way) flows allow countries to insure themselves against idiosyncratic risks. But here, too, the evidence cuts the other way. Kose, Prasad, and Terrones find that consumption risk sharing has actually gone down in the developing world since the 1990s (while it has improved in the rich countries).16 One reason of course is the greatest prevalence of financial crises in a financially globalized world. Figure 3.4: Net capital outflows and growth Source: E. Prasad, et al., “Foreign Capital and Economic Growth,” Brookings Paper on Economic Activity 1 (2007). 6 4 2 0 -15 -10 -5 0 5 -2 GUY TZA MWI CYP MUS CHN KOR SGP THA MYS TUR IRN ZAF VEN NGA KEN KEN ARG ZWE GMX GMX COL GAA RSD GRY PRY DZA COL ECS MAR NGA BRAEGY DOM DOM HTI HTI TUN TTO IND IND GHL LTG ISR PAK ZMB CIV MDG SLE SEN CRI HND BOL RAM RAM MLI MOZ Average current account as percent of GDP Average per capita GDP growth Growth after the Crisis 79 The bottom line...