KEY POINTS

1. Countries can use their external wealth as a buffer to smooth consumption in the face of fluctuations in output or investment. However, this process is not without its limits. The country must service its debts and must not allow debts to roll over and grow without limit at the real rate of interest.
2. The condition that guarantees that debts are serviced is the long-run budget constraint, or LRBC: the present value of future trade deficits must equal minus the present value of initial wealth.
3. The long-run budget constraint can be put another way: the present value of GDP plus the present value of initial wealth (the country’s resources) must equal the present value of GNE (the country’s spending).
4. In a closed economy, the country must satisfy TB = 0 in every period as there is no external trade in goods or assets. In an open economy, the economy has to satisfy only the long-run budget constraint, which states that TB equals minus the present value of initial wealth. The former is a tighter constraint than the latter—implying that there can be gains from financial globalization.
5. The current account may be lower than normal in any period when there is unusually high private or public consumption (such as during a war), unusually low output (such as occurs after a natural disaster), or unusually high investment (such as that following a natural resource discovery).
6. If poor countries had the same productivity as rich countries, there would be substantial gains from investing in poor countries where the marginal product of capital, or MPK, would be much higher. However, this is not the case, and there is little evidence of investment inefficiency at the global level as measured by MPK gaps between countries. What gaps there are may be due to risk premiums. Consequently, large-scale investment (and foreign aid) in poor countries may not accelerate economic growth.
7. In addition to lending and borrowing, a country can reduce its risk by the international diversification of income claims. In practice, only capital income claims (capital assets) are tradable. Labor is not a tradable asset.
8. When assets are traded internationally, two countries can eliminate the income risk arising from country-specific or idiosyncratic shocks; such risk is called diversifiable risk. However, they can do nothing to eliminate the global risk, the shock common to both countries, called undiversifiable risk.
9. In practice, the use of the current account as a buffer and the extent of diversification fall far short of theory’s prediction even in advanced countries. Consumption volatility persists, domestic investment is mostly financed from domestic saving, and portfolios display pronounced home bias.
10. In emerging markets and developing countries, financial openness has progressed more slowly and access to global capital markets is more limited and often on worse terms. The gains from financial openness appear weaker, and there is the downside risk of sudden stops and other crises. For gains to be realized, countries may require deeper institutional changes and further liberalization.