Financial openness makes it easier for countries to invest and take advantage of new production opportunities.
1. The Basic Model
Introduce I, so that the LRBC is PV of Q = PV of C + PV of I. Again compare the closed economy with an open economy where the LRBC is satisfied.

2. Efficient Investment: A Numerical Example and Generalization
Suppose an investment opportunity occurs today. It requires a sacrifice of current Q and yields a permanent increase in Q thereafter. The closed economy would have to give up C today to undertake the investment. The open economy borrows today to finance the investment, running a trade deficit. It also enjoys a permanent increase in consumption, but to repay the debt it runs trade surpluses in perpetuity.
1. Generalizing
The model is similar to that in our discussion of consumption smoothing. The investment requires ΔK units of output today, and generates ΔQ units of output every period thereafter. Consumers want to maintain a constant consumption stream, constrained only by the LRBC. Given the PV of C, therefore, the economy wants to maximize PV of Q – PV of I. The investment costs ΔK today, and yields a perpetual increase in output with PV of ΔQ /r^*. Therefore investment occurs up to the point where ΔQ = r^* ΔK. Equivalently, optimal investment requires MPK = r^* .

3.Summary: Make Hay While the Sun Shines
In a closed economy, investment requires the sacrifice of current consumption. In an open economy, however, the economy can borrow to finance investment, without sacrificing consumption. It will invest up to the point where the world interest rate equals the MPK.

You can probably just assert this, since it is such an obvious extension of the previous intertemporal budget constraint. Write the two period version.

The example of Chile’s sovereign wealth fund

Copper-Bottomed Insurance

Many developing countries experience output volatility. Sovereign wealth funds can buffer these shocks, as recent experience in Chile has shown.

Thousands of government workers marched on downtown Santiago [in November 2008], burning an effigy of Chilean Finance Minister Andres Velasco and calling him “disgusting” as a strike for higher wages paralyzed public services.

Five months later, polls show that Velasco is President Michelle Bachelet’s most popular minister. During a three-year copper boom he and central bank President Jose De Gregorio set aside $48.6 billion, more than 30 percent of the country’s gross domestic product, that he is now using for tax cuts, subsidies and cash handouts to poor families.

The Chilean peso has risen almost 10 percent against the dollar this year to become the best-performing currency among emerging markets. The country’s economy is expected to grow 0.1 percent in 2009, as the region contracts 1.5 percent, according to the International Monetary Fund….

Velasco, 48, applied the lessons learned from decades of economic failure in Latin America—ones he said could also help the U.S. The current crisis followed “a massive regulatory failure in many advanced financial markets over the last decade or so,” Velasco said in an interview April 21 [2009] in his office overlooking the presidential palace in downtown Santiago.

“This is a movie that may be novel to some Americans, but this is a movie that people in other places of the world, Chile included, know we have seen,” said Velasco, who is scheduled to meet April 25 with Federal Reserve Chairman Ben S. Bernanke in Washington. “We know how it begins, how it unfolds and how it ends.”…

Commodity-driven swings of boom and bust have defined Latin America’s economic history for the past 100 years.

“That is a cycle that needs to be ended,” Velasco said. “We have been out to show that a Latin American country can manage properly, and not mismanage, a commodity cycle. You save in times of abundance, and you invest in lean times.”

When Velasco joined Bachelet’s new cabinet in March 2006, the price of copper had risen by more than half in 12 months to $2.25 a pound. Taxes and profits from state-owned Codelco, the world’s largest copper producer, provide about 15 percent of government revenue. Bachelet, 57, Chile’s second consecutive socialist president, came under almost immediate pressure to start spending the revenue.

Students went on strike in May of that year, demanding more money for education. More than 800,000 people protested at high schools and universities, and police with water cannons and tear gas arrested more than 1,000. Velasco reiterated his commitment to “prudent fiscal policies” as politicians from the governing coalition demanded he resign….

In his first three years in office, Velasco posted the biggest budget surpluses since the country returned to democracy in 1990. In 2007, Chile became a net creditor for the first time since independence from Spain in 1810.

Last July [2008], copper reached a record of $4.08 a pound. By year-end, the central bank had built $23.2 billion of reserves. The government had $22.7 billion in offshore funds and about $2.8 billion in its own holdings.

After Lehman Brothers Holdings Inc.’s September 15 bankruptcy sparked a global credit freeze, Velasco and De Gregorio had the equivalent of more than 30 percent of GDP available if needed to shore up Chile’s banks and defend the peso.

The price of copper plummeted 52 percent from September 30 to year-end, and Velasco dusted off his checkbook. In the first week of January, he and Bachelet unveiled a $4 billion package of tax cuts and subsidies.

“He has been vindicated,” said Luis Oganes, head of Latin American research at JPMorgan Chase & Co. in New York, who studied under Velasco….

Velasco’s stimulus spending, including 40,000-peso ($68.41) handouts to 1.7 million poor families, has paid off politically. His approval rating almost doubled to 57 percent in March from a low of 31 percent in August…. He is now the most well-liked member of the government, second only to the president at 62 percent.

“People finally understood what was behind his ‘stinginess’ of early years,” said Sebastian Edwards, a Chilean economist at the University of California, Los Angeles. “That explains the rise in his popularity.”

Source: Excerpted from Sebastian Boyd, “Harvard Peso Doctor Vindicated as Chile Evades Slump,” bloomberg.com, April 23, 2009. Used with permission of Bloomberg L.P. © 2013. All rights reserved.

Here too, it may be cleaner just to write down a two-period, neoclassical investment problem, where th firm wants to maximize the PV of production - Investment (the left-hand side of 17-5). Derive the result that you should invest as long as MPK > r^* .

This is the Fisher separation theorem, separating the investment and saving decisions. It may be hard for students to see what this is actually saying without the benefit of the two-period model--but developing the full two-period model with a concave intertemporal PPF may be asking too much.

On the other hand, developing such a model would have the merit of showing that the gains from international intertemporal trade are isomorphic to the gains from trade in goods and services in a single time period.

Again, a simple phrase to use that captures the gist of the argument.

Consider the example of the Norwegian oil boom, where I was financed entirely by borrowing from abroad, rather than by domestic savings. Does access to international capital decouple S and I in general? The evidence here suggests that the decoupling is greatest in economies where international financial integration has advanced the most.

1. Can Poor Countries Gain from Financial Globalization?
If a country’s MPK exceeds it should run TB deficits to finance I. Why then doesn’t more capital flow to poor countries?
a. Production Function Approach
Use a Cobb-Douglas production function with capital share of 1/3.
b. A Benchmark Model: Countries Have Identical Productivity Levels
Set total factor productivity A = 1. Poorer countries must have higher MPKs than rich countries. Example: Mexican MPK in the 1980s was 5.4 times larger than the U.S. MPK. Then capital should flow from rich to poor countries until MPKs equalize. Output per worker should converge.
c. The Lucas Paradox: Why Doesn’t Capital Flow from Rich to Poor Countries?
Lucas’s question: Capital is not flowing from rich to poor countries?
d. An Augmented Model: Countries Have Different Productivity Levels
Answer: As are lower in poorer countries than in rich. Example: Mexican TFP must be 63 percent of the U.S.’s. This also implies that output per worker need not converge.

Delinking Saving from Investment

The story of the Norwegian oil boom provides a good illustration of our theory about investment and financial openness. North Sea oil was discovered in the 1960s, but the mass exploitation of this resource was unprofitable because cheap and plentiful supplies of oil were being produced elsewhere, primarily in the Persian Gulf. Then came the first “oil shock” in the early 1970s, when the cartel of Oil Producing and Exporting Countries (OPEC) colluded to raise world oil prices dramatically, a shock that was (correctly) viewed as permanent. At these higher oil prices, it suddenly made sense to exploit North Sea oil. Starting in the early 1970s, oil platforms, pipelines, refineries, and terminals were sprouting offshore and along the coast of Norway, causing its capital stock to permanently increase in response to a new productive investment opportunity.

Figure 6-6 shows the path of saving (S) and investment (I) measured as ratios of GDP in Norway from 1965 to 1990. The oil boom is clearly visible in the investment share of GDP, which in the 1970s rose about 10 percentage points above its typical level. Had Norway been a closed economy, this additional investment would have been financed by a decrease in the share of output devoted to public and private consumption. As you can see, no such sacrifice was necessary. Norway’s saving rate was flat in this period or even fell slightly. In Norway’s open economy, saving and investment were delinked and the difference was made up by the current account, CA = S − I, which moved sharply into deficit, approaching minus 15% of GDP at one point. Thus, all of the short-run increase in investment was financed by foreign investment in Norway, much of it by multinational oil companies.

Is Norway a special case? Economists have examined large international datasets to see whether there is general evidence that countries can delink investment decisions from saving decisions as the Norwegians did. One approach follows the pioneering work of Martin Feldstein and Charles Horioka.12 They estimated what fraction β of each additional dollar saved tended to be invested in the same country. In other words, in their model, if saving rose by an amount ΔS, they estimated that investment would rise by an amount ΔI = βΔS. In a closed economy, the “savings retention” measure β would equal 1, but they argued that increasing financial openness would tend to push β below 1.

For example, suppose one were to estimate β for the period 1980 to 2000 for three groups of countries with differing degrees of financial integration within the group: in a sample of countries in the European Union, where international financial integration had advanced furthest, the estimated value of β is 0.26, meaning that 26% of each additional dollar saved tended to be invested in the same country; in a sample of all developed countries with a somewhat lower level of financial integration, the estimate of β is 0.39; and in a sample of emerging markets, where financial integration was lower still, the estimate of β is 0.67.13 These data thus indicate that financially open countries seem to have a greater ability to delink saving and investment, in that they have a much lower “savings retention” measure β.

Discuss this: The original F-H paradox-- that beta was large--was interpreted as evidence against integration. But breaking it down by country types in this way suggests that in fact delinking of S and I is greater for financially open economies.

They will be familiar with production function and diminishing marginal productivity, but may need to walk through the Cobb-Douglas example.

In fact, you may not need to get involved in the details of Cobb-Douglas at all. Just write q = Af(k) and draw Figure 6-7 (a). Depict the interest rates in the two countries as the slopes of the production at those two points and argue the profitability of capital flow to the poor country.

Compare this to the argument in Chapter 3 that in the long run real interest rates should equalize.

Say that is one of the great issues in growth economics.

Here too you may not need Cobb-Douglas; just let there be different A's.

A striking result.

Profound conclusion: Productivity differences should cause divergence. Access to capital markets will not be sufficient for poor countries to catch up. But what is A, exactly? Not just technical efficiency. It may also reflect institutions, public policies, cultural conditions, and human capital.

e. More Bad News?
Other reasons to think convergence may not occur: (1) Poor countries face risk premia that (2) may be large enough to make capital flow to rich countries; (3) the cost of capital may be higher in poor countries; (4) capital’s share may be smaller in poor countries; (5) foreign aid shouldn’t be any more effective than private capital flows in promoting growth (unless they finance public goods that confer externalities sufficiently large to allow the economy to escape a “poverty trap”).

But there still might be conditional convergence.

Elicit discussion about the implications of rich countries converging to a nice steady state, and poor countries converging to another.

Students will have been posing that question before this point.

Discuss these two interpretations of A.

Also discuss these confounding factors. What if capital is flowing uphill?

[em]A[em] Versus [em]k[em]

In our previous calculations, we found that Mexico did not have a high level of MPK relative to the United States. Hence, we would not expect large flows of capital into Mexico but would expect Mexico to remain relatively poor even with access to global financial markets.

Is this conclusion true in general? What about other developing countries? Table 6-5 repeats the same exercise we just did for many developing countries, including Mexico. In all cases, predicted GDP gains due to financial globalization are large with the benchmark model, but disappointingly small once we augment the model to correct for productivity differences. Moreover, if we were to allow for the fact that gross national income (GNI) gains are less than GDP gains as a result of factor payments to foreign capital that would be due on foreign investment, then the net GNI gains would be smaller still.

This is a profound result. Once we allow for productivity differences, investment will not cause poor countries to reach the same level of capital per worker or output per worker as rich countries. Economists describe this outcome as one of long-run divergence between rich and poor countries. Unless poor countries can lift their levels of productivity (raise A), access to international financial markets is of limited use. They may be able to usefully borrow capital, thereby increasing output per worker by some amount, but there are not enough opportunities for productive investment for complete convergence to occur.

In the developing world, global capital markets typically are not failing. Rather, low levels of productivity A make investment unprofitable, leading to low output levels that do not produce convergence. But what exactly does A represent?

An older school of thought focused on A as reflecting a country’s technical efficiency, construed narrowly as a function of its technology and management capabilities. Today, many economists believe there is very little blocking the flow of such knowledge between countries, and that the problem must instead be one of implementation. These economists believe that the level of A may primarily reflect a country’s social efficiency, construed broadly to include institutions, public policies, and even cultural conditions such as the level of trust. Low productivity might then follow from low levels of human capital (poor education policies) or poor-quality institutions (bad governance, corruption, red tape, and poor provision of public goods including infrastructure). And indeed there is some evidence that, among poorer countries, more capital does tend to flow to the countries with better institutions.19

More Bad News? The augmented model shows that as long as productivity gaps remain, investment will be discouraged, and, regrettably, poor countries will not see their incomes converge to rich levels. If we now take some other factors into account, the predictions of the model about convergence are even less optimistic.

• The model makes no allowance for risk premiums. Suppose the MPK is 10% in the United States and 13% in Mexico. The differential may be a risk premium Mexico must pay to foreign lenders that compensates them for the risk of investing in an emerging market (e.g., risks of regulatory changes, tax changes, expropriation, and other political risks). In this case, no additional capital flows into Mexico. In Figure 6-7, panel (b), Mexico stays at point C and its income does not increase at all.
• Risk premiums may be large enough to cause capital to flow “uphill” from poor to rich. If world capital markets impose a risk premium higher than 3%, say, 7%, then capital would actually leave Mexico for the United States, moving from the higher to the lower MPK region, in search of a “safe haven” that provides higher risk-adjusted returns. In Figure 6-7, panel (b), Mexico would move left of point C as capital flowed out, and per capita output would fall. Is this a relevant case? Yes. Figure 6-8 shows that risk premiums can be substantial in emerging markets, including Mexico. And U.S. Treasury securities data indicate that from 1994 to 2006, U.S. holdings of Mexican assets rose from $50 billion to $65 billion, but Mexican holdings of U.S. assets rose from $5 billion to $95 billion; on net, capital moved north.
• The model assumes that investment goods can be acquired at the same relative price in output terms everywhere. In fact, the model treats one unit of investment as the same as one unit of output. But in developing countries, it often costs much more than one unit of output to purchase one unit of capital goods. Poor countries often are ill-equipped to efficiently supply nontraded capital goods (such as buildings or bridges), and their imported capital goods (such as machinery and equipment) are often quite expensive because of trade costs (such as tariffs and transport costs).20
• The model assumes that the contribution of capital to production is equal across countries. In our estimates, we used 1/3 as the elasticity of output with respect to capital. But recent research suggests that capital’s share may be much lower in many developing countries, where a large part of GDP is derived from natural resources with little use of physical capital. This lowers the MPK even more.21
• The model suggests that foreign aid may do no better than foreign investors in promoting growth. The model doesn’t care where additional capital comes from. Investments paid for by transfers (aid or debt relief) rather than private investments face the same low MPK and the same divergence result holds. Economists dispute whether foreign aid can make a difference to long-term development and growth, or if it is only an act of charity to prop up the poor (or even a total waste of money). The argument also extends to nonmarket and preferential lending offered to poor countries by international financial institutions such as the World Bank (see Side Bar: What Does the World Bank Do?). In support of the case that aid can make a difference, aid proponents argue that aid can finance public goods that can provide externalities sufficient to jolt a poor country out of a bad equilibrium or “poverty trap”—goods that private markets cannot provide (such as infrastructure, public health, and education). Aid skeptics reply that the evidence for such effects is weak, either because the links are not there or because in practice aid is so bureaucratized and subject to so many diversions and misappropriations that very little of it actually gets spent wisely (see Headlines: A Brief History of Foreign Aid).

Also entertain the possibility that human capital may be much greater in developed economies (up to 60 percent of the total capital stock in the U.S., by some estimates).

A primer on the World Bank

What Does the World Bank Do?

The World Bank (worldbank.org), based in Washington, D.C., is one of the Bretton Woods “twins” established in 1944 (the other is the International Monetary Fund). Its main arm, the International Bank for Reconstruction and Development, has 188 member countries. Its principal purpose is to provide financing and technical assistance to reduce poverty and promote sustained economic development in poor countries. A country’s voting weight in the governance of the World Bank is based on the size of its capital contributions. The World Bank can raise funds at low interest rates and issue AAA-rated debt as good as that of any sovereign nation. It then lends to poor borrowers at low rates. Because the borrower nations could not obtain loans on these terms (or even any terms) elsewhere, the loans are a form of aid or transfer. In return for the preferential rate, the bank may approve a loan for a particular development purpose (building infrastructure, for example) or to support a policy reform package. Controversially, conditions may also be imposed on the borrowing nation, such as changes in trade or fiscal policy. As a result of sovereignty, the implementation of the conditions and the use of the loans have in some cases not turned out as intended, although outright default on these preferential loans is almost unheard of.

The debate about the effectiveness of foreign aid and how it should be implemented

A Brief History of Foreign Aid

Foreign aid is frequently on the political agenda. But can it make any difference?

In 1985, when Bob Geldof organized the rock spectacular Live Aid to fight poverty in Africa, he kept things simple. “Give us your fucking money” was his famous (if apocryphal) command to an affluent Western audience—words that embodied Geldof’s conviction that charity alone could save Africa. He had no patience for complexity: we were rich, they were poor, let’s fix it. As he once said to a luckless official in the Sudan, after seeing a starving person, “I’m not interested in the bloody system! Why has he no food?”

Whatever Live Aid accomplished, it did not save Africa. Twenty years later, most of the continent is still mired in poverty. So when, earlier this month, Geldof put together Live 8, another rock spectacular, the utopian rhetoric was ditched. In its place was talk about the sort of stuff that Geldof once despised—debt-cancellation schemes and the need for “accountability and transparency” on the part of African governments—and, instead of fund-raising, a call for the leaders of the G-8 economies to step up their commitment to Africa. (In other words, don’t give us your fucking money; get interested in the bloody system.) Even after the G-8 leaders agreed to double aid to Africa, the prevailing mood was one of cautious optimism rather than euphoria.

That did not matter to the many critics of foreign aid, who mounted a lively backlash against both Live 8 and the G-8 summit. For them, continuing to give money to Africa is simply “pouring billions more down the same old rat-holes,” as the columnist Max Boot put it. At best, these critics say, it’s money wasted; at worst, it turns countries into aid junkies, clinging to the World Bank for their next fix. Instead of looking for help, African countries need to follow the so-called Asian Tigers (countries like South Korea and Taiwan), which overcame poverty by pursuing what Boot called “superior economic policies.”

Skepticism about the usefulness of alms to the Third World is certainly in order. Billions of dollars have ended up in the pockets of kleptocratic rulers—in Zaire alone, Mobutu Sese Soko stole at least four billion—and still more has been misspent on massive infrastructure boondoggles, like the twelve-billion-dollar Yacyreta Dam, between Argentina and Paraguay, which Argentina’s former President called “a monument to corruption.” And historically there has been little correlation between aid and economic growth.

This checkered record notwithstanding, it’s a myth that aid is doomed to failure. Foreign aid funded the campaign to eradicate smallpox, and in the sixties it brought the Green Revolution in agriculture to countries like India and Pakistan, lifting living standards and life expectancies for hundreds of millions of people. As for the Asian nations that Africa is being told to emulate, they may have pulled themselves up by their bootstraps, but at least they were provided with boots. In the postwar years, South Korea and Taiwan had the good fortune to become, effectively, client states of the U.S. Between 1946 and 1978, in fact, South Korea received nearly as much U.S. aid as the whole of Africa. Meanwhile, the billions that Taiwan got allowed it to fund a vast land-reform program and to eradicate malaria. And the U.S. gave the Asian Tigers more than money; it provided technical assistance and some military defense, and it offered preferential access to American markets.

Coincidence? Perhaps. But the two Middle Eastern countries that have shown relatively steady and substantial economic growth—Israel and Turkey—have also received tens of billions of dollars in U.S. aid. The few sub-Saharan African countries that have enjoyed any economic success at all of late—including Botswana, Mozambique, and Uganda—have been major aid recipients, as has Costa Rica, which has the best economy in Central America. Ireland (which is often called the Celtic Tiger) has enjoyed sizable subsidies from the European Union. China was the World Bank’s largest borrower for much of the past decade.

Nobody doubts that vast amounts of aid have been squandered, but there are reasons to think that we can improve on that record. In the first place, during the Cold War aid was more often a geopolitical tool than a well-considered economic strategy, so it’s not surprising that much of the money was wasted. And we now understand that the kind of aid you give, and the policies of the countries you give it to, makes a real difference. A recent study by three scholars at the Center for Global Development found that, on average, foreign aid that was targeted at stimulating immediate economic growth (as opposed to, say, dealing with imminent crises) has had a significantly beneficial effect, even in Africa.

There’s still a lot wrong with the way that foreign aid is administered. Too little attention is paid to figuring out which programs work and which don’t, and aid still takes too little advantage of market mechanisms, which are essential to making improvements last. There’s plenty we don’t know about what makes one country succeed and another fail, and, as the former World Bank economist William Easterly points out, the foreign-aid establishment has often promised in the past that things would be different. So we should approach the problem of aid with humility. Yet humility is no excuse for paralysis. In 2002, President Bush created the Millennium Challenge Account, which is designed to target assistance to countries that adopt smart policies, and said that the U.S. would give five billion dollars in aid by 2006. Three years later, a grand total of $117,500 has been handed out. By all means, let’s be tough-minded about aid. But let’s not be hardheaded about it.

Source: James Surowiecki, “A Farewell to Alms?” New Yorker, July 25, 2005.

This is a devastating and discouraging indictment.