1. Countries can benefit from international financial markets because they can help them to smooth their consumption streams, invest more efficiently, and diversify their risks.
2. However, the extent to which countries exploit these benefits is limited. There are still consumption shocks, investment is often financed by domestic saving, and investors have a bias from home assets.
3. Are global capital markets failing? There are still many barriers to financial liberalization, so perhaps financial markets are still not sufficiently integrated. Yet institutional weaknesses in developing countries may be exacerbated by financial liberalization. The gains to them of embracing financial globalization may be smaller, when weighed against the costs of potential financial crises.
If a firm or household were to retreat from the national financial markets by keeping its money in a bag in a closet and paying cash for all its purchases (house, cars, appliances, toothpaste, gum, etc.), we would regard it as a strange and potentially costly move. By allowing households to save and borrow, financial markets help households smooth consumption in the face of shocks to their income (such as a debilitating illness, the loss of a job, destruction of property by floods or other acts of nature). Likewise, financial markets allow firms to borrow to invest efficiently in productive projects and permit investors to diversify their portfolios across a wide range of assets.
On the global scale, the same principles apply in theory to countries, subject to the long-run budget constraint. They, too, face income shocks, new investment opportunities, and country-specific risks. We have seen how they can similarly benefit from access to an external capital market—the global capital market.
Theory proves to be far from reality, however: the extent to which countries make use of global financial markets is still limited. Even in the most financially open advanced countries, consumption shocks remain, investment is often financed out of domestic saving, and a home bias persists in investors’ portfolios. In poorer countries, we see no consumption smoothing gains realized, and there is little scope for development based on external finance until current low productivity levels are improved.
Are global capital markets failing? To the criticism that financial globalization doesn’t work, one could respond that it hasn’t really been fully tried yet. Many emerging markets and most developing countries are still on the road to full financial liberalization, and large barriers remain. Even so, deeper institutional weaknesses in these countries may hinder the efficient operation of the mechanisms we have studied. One could argue that such weaknesses may be corrected or diminished by the stimulus to competition, transparency, accountability, and stability that financial openness may provide.25 But without further institutional improvements, the benefits of financial globalization are likely to be much smaller for these countries, and any benefits must be weighed against potential offsetting costs, such as the risk of crises, which we discuss in later chapters.
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