Question

Is financial globalization beneficial? Discuss the DD-AA Model and the II/XX model

Answer 1

The current Age of Globalization in the last 50 years is actually the second great wave of globalization of international trade and capital flows. The first occurred from 1870 to 1914, when international trade grew at a 4% rate annually, rising from 10% of GDP in 1870 to over 20% in 1914, while international flows of capital grew annually at 4.8% and increased from 7% of GDP in 1870 to close to 20% in 1914.1 With the coming of World War I, the first Age of Globalization came to an end, leading to what Rajan and Zingales (2003a) have referred to as the “Great Reversal.” Given the economic and political nightmares that followed the Great Reversal, in the fading days of World War II, the victorious allies decided to create a new international system to promote world trade and prosperity, which resulted in the establishment of two new international financial institutions, the International Monetary Fund (IMF) and the World Bank, and also the General Agreement on Tariffs and Trade (GATT) whose successor organization is the World Trade Organization (WTO).

These new institutions were created to promote globalization and in this they were extremely successful. Once the world economy returned to normal by the end of the 1950s, globalization advanced at a rapid pace. From 1973 until today, world trade grew at a pace of 11% annually, rising from just over 22% of world GDP to 42% today (Estevadeordal and Taylor 2002). Since 1973, the flows of capital between countries have also exploded, rising from 5% of world GDP to 21% today (World Bank 2004). We are clearly in the second wave of globalization.

Although economic globalization has come a long way, in one particular dimension it is very far from complete. As is documented in Obstfeld and Taylor (2004), financial globalization is primarily confined to rich countries. Despite the huge increase in international capital flows in recent years, they primarily flow from North to North, that is from rich to other rich countries which are mostly in the northern hemisphere, rather than from North to South, from rich to poor countries. There are two complementary reasons why capital flows occur: they can move funds from countries where the marginal productivity of capital is relatively low to countries where it is high, or they can facilitate diversification. Most international capital flows are just exchanges of assets between rich countries and because these countries are likely to have similar marginal productivity of capital, these capital flows primarily reflect diversification. At the same time, we see much less international capital flowing to poor countries to enhance their economic development, which would likely be driven by the other motive for capital flows.