On the Benefits of Capital Account Liberalization forEmerging Economies∗

Pierre-Olivier GourinchasPrinceton University, NBER and CEPR

Olivier JeanneIMF and CEPR

This draft, May 2002

PRELIMINARY AND INCOMPLETE

∗This paper reflects the views of its authors, not necessarily those of the IMF.

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AbstractStandard theoretical arguments tell us that countries with relatively little

capital benefit from financial integration as foreign capital flows in and speedsup the process of convergence. We show in calibrated exercises that conven-tionally measured welfare gains from this type of convergence appear rela-tively limited for the typical emerging country. The traditional theory, then,does not seem to provide a sufficient rationale for capital account liberaliza-tion. Our approach emphasizes instead that poor countries face a number ofmicro-distortions that lower the return to capital, possibly below world inter-est rates. Liberalization of the capital account should then be understood asa means to eliminate or reduce these distortions, unless domestic capital flowsout. It is this disciplining effect of liberalization that creates first order gains,by reducing the wedge between net returns to capital and the world interestrate. Our theory also has implications for the political economy of financialintegration. First, we show that politicians may open the capital account asa way of ”locking-in” domestic reform, even when they cannot commit to ei-ther decision. Second, traditional trade arguments (e.g. Stolper-Samuelson)would argue that domestic capitalists would oppose financial integration asit reduces the return to capital, while workers would typically favor it. Thepolitical economy of financial integration does not seem to reflect these pre-dictions. Often, domestic capitalists favor integration while workers may ormay not oppose it.

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1 Introduction

The recent crises have certainly dampened the hope that capital account lib-eralization provides a smooth road to growth and development for emergingeconomies. Some economists have advocated a policy reversal. The timeseems ripe for a re-examination of the benefits and costs of capital accountopening. This paper attempts to take a broad view of the benefits of capitalaccount liberalization for emerging economies, in an attempt to outline whatcould be a research agenda on these issues. When we look at the range ofbenefits that economists have attributed to capital account opening, whichones seem potentially large and maybe deserve increased attention from theprofession?

We distinguish two classes of benefits of capital account opening. Thefirst category includes the benefits in terms international allocative efficiency.This includes for example consumption smoothing in response to shocks, orthe possibility to accelerate domestic capital accumulation with the help offoreign capital. This category is the one economists understand best, at leastin theory, since it is about the welfare benefits of efficient markets. As notedby Eichengreen (2001) “The case for free capital mobility is thus the same asthe case for free trade but for the subscripts of the model”.The second class of benefits is a bit more difficult to define, but could be

characterized as encompassing the incentives to good policies, or reform, thatare generated by an open capital account. It includes the different ways inwhich capital account openness may improve domestic policies, practices andinstitutions. This includes the market discipline on domestic macroeconomicpolicies induced by the threat of capital flights. More broadly it includesthe incentives to reform the domestic economic system in a way that reducesunproductive activities (diversion, rent-seeking), or secure better guaranteesof property rights–what Hall and Jones (1997) call the “social infrastructureof countries”.

The first part of the paper considers the first class of benefits-those interms of international allocative efficiency. We review the literature andpresent a new piece of evidence, based of the calibration of simple neoclas-sical growth models. We present different variants of a dynamic model of asmall open, capital-scarce economy which converges towards the neo-classical

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steady state. The model is calibrated with data on post WWII emergingeconomies. We find that while financial openness increases domestic welfare,and while this benefit can be significant, it is not very large when compared tothe benefits of alternative policies that reduce domestic distortions or increasedomestic productivity.

This leads us to think that the second category of benefits-in terms ofincentives to reform or good policies-should perhaps receive relatively moreattention than the first. If Hall and Jones (1997) are right that most of theinequality in world income is explained by differences in the “social infrastruc-ture” of countries, then the question of how capital account opening interactswith social infrastructures seems quite relevant. Obviously, this question isas multifaceted as the concept of social structure itself. The balance of costsand benefits of capital account opening must depend on the domestic po-litical economy, institutions, ideological inclinations, and level of economicdevelopment of the country in question. We do not ambition to explore allthe aspects of the problem in this paper, and present instead the following“bits” of analysis.We present a model that focuses on capital account liberalization and the

respect of property rights. We consider a country that can commit not toexpropriate capital at an horizon that is too short for investment to takeplace–the standard time-consistency problem in the taxation of capital. Asa result under financial autarky, all the domestic investment goes to the un-productive, informal sector. However the country can commit to leave thecapital account open (at the same short horizon). We show that an open capi-tal account provides incentives to maintain an investor-friendly environment,because a failure to do so generates a capital outflow. We also show thatif capital becomes illiquid once it is installed in the country, capital accountopenness retain its benefits if investors are given liquidation rights. These liq-uidation rights, however, may make the economy vulnerable to self-fulfillingcapital account crises.

This is work in progress. This is the first draft of the first paper in aresearch program on the benefits and costs of capital account liberalizationfor emerging economies. The goal of this paper is to present the researchprogram, as well as the material that we have at this stage to back it up.

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We think this material is encouraging, but there are a number of holes. Wediscuss the directions that our work could take in the conclusion.

2 International Allocative Efficiency

The literature on the gains from capital account liberalization traditionallyemphasizes two benefits in terms of allocative efficiency. First, through ac-cess to international financial markets, an open economy will be able to sta-bilize consumption more efficiently against output fluctuations. The welfaregains associated with this consumption smoothing are discussed in Obstfeld(1994) and Cole and Obstfeld (XX). Second, financial integration achievesan efficient allocation of world savings as capital scarce countries -with a cor-respondingly high marginal product of capital- can borrow from the rest ofthe world. These capital movements from rich to poor countries acceleratedomestic accumulation and convergence.In this paper, we concentrate on this second class of benefits. First, our

focus is on the factors that eventually lead to convergence in output percapital, less on short term fluctuations and the associated business cyclemovements. Second, our view is that estimates of the gains from internationalrisk sharing are typically low, except perhaps for very poor countries (seePallage and Rob (1999)).While the existing literature has investigated extensively the welfare bene-

fits from consumption insurance, little is known about the size of the welfaregains associated with a faster transition towards the steady state. Whilethere is little conceptual difficulty in this exercise, we will nonetheless reachsome surprising conclusions, that will form the preamble for our subsequentanalysis.We begin this section with the simplest possible model: the textbook Ram-

sey model. In this simple model, calculations of welfare gains from financialopening are straightforward. They are small, very small indeed, for reason-able parameterizations. This is the consequence of an unappealing feature ofthe simplest Ramsey model: the implied theoretical rate of convergence tothe steady state is too rapid. As Mankiw Romer and Weil (1992) noted, thisis the consequence of too low a capital share. To address this problem, weextend the model to accommodate human capital accumulation. While thisensures slower convergence, the implied welfare gains remain small. The rea-

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son is that under financial integration, only physical capital flows instantly.Convergence to the steady state still requires accumulation of human capital,which can only be done domestically.Most of the gains from financial integration result from faster this con-

ditional convergence. We next show that these gains are trivial comparedto the gains obtained from either the removal of domestic distortions thatdistort domestic saving rates, or from the adoption of better technologies.

2.1 The Textbook Ramsey model

We begin by reviewing well known implications of the standard Ramseymodel.

2.1.1 The Model.

Consider then, the problem faced by a small open economy, a la Ramsey-Koopman-Cass. Time is discrete and there is no uncertainty. The represen-tative agent is infinitely lived and has the following preferences, defined oversequences of consumption per effective unit of labor {ct}:

U0 =

∞Xt=0

βt Lt(Atct)

1−γ

1− γ(1)

where 0 < β < 1 represents the discount factor and γ is the coefficient of rel-ative risk aversion. Lt denotes the population size, growing at the exogenousrate n : Lt = L0.n

t, while productivity At increases exogenously at rate g :At = A0.g

t. We make the normalization L0 = 1.The economy produces a single tradable good, using capital and labor,

according to a Cobb Douglas production function, so output per efficientunit of labor, yt, follows:

yt = kαt , 0 < α < 1 (2)

Lastly, the evolution of the capital stock per efficient unit is governed by:

kt+1 =1

ng[(1− δk) kt + yt − ct] (3)

where δk is the rate of depreciation of physical capital.

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Our assumptions imply that k converges towards a steady state valuek∗such that:

k∗ =µ

skδk + n.g − 1

¶1/1−α(4)

where sk = α. (δk + n.g − 1) /¡δk + β−1gγ − 1¢ is the saving rate in the

steady state of the closed economy.We now consider transition path towards this steady state, starting from

an initial capital stock k0 < k∗ at time t = 0, under two scenarios: financial

autarky, and financial integration.

Financial Autarky. Under financial autarky, the small country must accu-mulate capital domestically. Consumption satisfies the usual Euler equation:

c−γt = β.g−γ.c−γt+1£1− δk + α.kα−1t+1

¤(5)

Starting from k0, the economy evolves along the stable arm of the dynamicsystem in c and k defined by equations (3) and (5), and converges towards(c∗, k∗) where c∗ = (1− δk − ng) k∗ + k∗α denotes consumption per efficientunits. Since capital accumulation competes with current consumption, con-vergence towards the steady state occurs gradually over time. Figure 1 depictsthe dynamics in the (c, k) plane.1

Finally, we denote Ua (k0) the welfare of the representative agent withinitial capital k0, defined according to equation (1).

Financial Integration. We consider now the case where this small open econ-omy integrates financially with the rest of the world. We assume that theeconomy is sufficiently small so as not to influence the world interest rateR∗. We further assume that the world real interest rate is consistent withthe steady-state marginal return to capital in the small economy. That is, weimpose that R∗ equals the growth-adjusted discount rate, β−1gγ. This ensuresthat financial integration does not tilt consumption profiles.We also assume that there are no impediments to financial flows. This

maximizes the welfare benefits from integration, since capital flows will fullyand immediately arbitrage away any difference in marginal returns to capital.

1See the next subsection for a description of the relevant parameters.

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In this sense, our model is a model where financial integration results inimmediate and massive capital flows from a capital abundant rest of theworld to a capital scarce domestic economy. The associated neo-classicalwelfare gains should then be understood as upper bounds.Equating domestic and foreign returns to capital, convergence in output

is instantaneous, as is well known:

ki =

µα

R∗ + δk − 1¶1/1−α

= k∗

Since the world interest rate equals the growth-adjusted discount rate, con-sumption also jumps to a constant level, consistent with the intertemporalbudget constraint:

ci = c∗ − (R∗ − gn) (k∗ − k0)Consumption is smaller than the autarky steady state consumption, since

the domestic country must pay interest on initial foreign capital inflows k∗ −k0. we denote U

i (k0) the welfare of the representative agent under financialintegration.To compare welfare under the two scenarios, we define the compensating

variation µi (k0) as the percentage drop in consumption that makes the agentin the integrated economy indifferent between the two convergence paths.That is, µi (k0) satisfies:¡

1− µi (k0)¢1−γ

U i (k0) = Ua (k0)

or equivalently:2

µi (k0) = 1−µUa (k0)

U i (k0)

¶1/1−γ(6)

Similarly, we can define the µa (k0) as the equivalent variation, that is, thepercentage increase in consumption that brings the welfare of the represen-

2With log preferences, the condition becomes:

µi (k0) = 1− e(1−βn)(Ua(k0)−Ui(k0)).

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tative agent under autarky up to its level under integration:3

µa (k0) =

µU i (k0)

Ua (k0)

¶1/1−γ− 1

=µi (k0)

1− µi (k0)

2.1.2 Specification and results

A natural question is whether the welfare gains, as measured by µi (k0) , arelarge or small. To answer this question, we need to make a number of ad-ditional assumptions. First, we assume that the growth rate of productivityg and the depreciation rate for physical capital δk are common across coun-tries. g reflects the advancement of knowledge. Our assumption implies thatthere is a common technological frontier expanding at the same pace in allcountries.4 There is also little reason to assume that depreciation rates dif-fer systematically across countries. Accordingly, we set g = 1.012, in linewith long run multifactor productivity growth in the U.S., and δk = 6%. Wefurther assume that the discount factor β is equal to 0.96, while the capitalshare α is 0.3. We will allow the growth rate of population n to vary acrosscountries.If all countries share the same preferences and technology, they would

all converge towards the same steady state and standards of living. Thisunconditional convergence is strongly at odds with the data (see Barro andSala-i-Martin (1995)). Accordingly, we introduce two elements that allow fordifferent steady states across countries. First, countries may differ in theirlevel of productivity A0. As MRW mention, ‘A0 reflects not just technologybut resource endowments, climate, institutions, and so on’ (MRW pp411).Second, we want to allow for different saving rates, a strong feature of the

data, and correspondingly, for different levels of steady state capital k∗. Todo so, we assume that domestic returns to capital are implicitly distorted ata rate τ that is country specific. We refer to τ as the capital wedge. τ is a

3Similarly, with log preferences:

µa (k0) = e(1−βn)(Ui(k0)−Ua(k0)) − 1

4We will revisit this assumption later in the paper.

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shorthand for all the distortions that potentially affect the return to domesticcapital: credit market imperfections, taxation, expropriation, bureaucracy,bribery and corruption... Different models would have different implicationsfor the implicit rents generated by the distortion, τRk. For simplicity, weassume that these are rebated in a lump-sum fashion to the representativeagent. In this manner, we focus exclusively on the distortive aspects of thecapital wedge. Under this modification, the steady state saving rate is adecreasing function of τ :

sk (τ) = α.δk + n.g − 1

δk +R∗/ (1− τ)− 1. (7)

and the steady state marginal product of capital R∗/ (1− τ) exceeds theworld interest rate when τ > 0, and the capital stock k∗ (τ) decreases in τ .We use data from the Summers-Heston Penn World Tables (PWT), ver-

sion 6.0 to construct the saving rate sk , current capital per capita k0 andthe growth rate of the population n.5 PWT version 6.0 extends data through1998 for most variables in the PWT. As in MRW, we measure n as the aver-age growth rate of the working age population (ages 15 to 64), using data onthe fraction of the population of working age from the World Bank’s WorldDevelopment Indicators. Following MRW, the saving rate sk is defined asthe average share of gross investment in GDP, which implicitly assumes thateconomies are closed. Lastly, PWT version 6.0 does not yet contain esti-mates of the stock of capital. Instead, we follow Bernanke and Gurkaynat(2001)’s methodology and construct capital stocks using a perpetual inven-tory method. We refer the reader to their paper for more details. Our finalsample includes 88 countries.Using equation (4) and data on initial capital and output per capita, we

construct a measure of the initial gap ln k∗/k0 in 1960 and 1995 accordingto:6

ln k∗ − ln k0 = 1

1− α

·ln

µsK

δk + ng − 1¶− ln

µk0y0

¶¸This decomposition follows Klenow and Rodriguez-Clare (1997) and Hall andJones (1999) in writing the capital gap in terms of the capital-output ratiorather than the capital labor ratio. We do this since the capital labor ratio

5Thanks to Refet Gurkaynat for sharing the PWT version 6.0 data.6Note that the capital gap is independent of the country specific capital gap A0.

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Capital Gap OECD non-OECDyear mean min max s.d. Obs. mean min max s.d. Obs.1960 0.59 0.02 0.86 0.20 21 0.60 0.02 0.97 0.26 551995 0.45 0.11 0.73 0.14 20 0.35 0.01 0.93 0.19 47

Table 1: Capital Gap Summary, as a fraction of the Steady State Capital Stock, 1960 and1995

would increase with an exogenous increase in productivity. Instead, along abalanced growth path, the capital output ratio is related to the saving rate.Table 1 reports summary statistics for the capital gap of OECD and non

OECD countries, measured as 1− k0/k∗.7

The table indicates that the average gap has declined somewhat between1960 and 1995. Surprisingly, the decline is more pronounced for non-OECDcountries, indicating that these countries may have moved closer to their con-ditional steady state. We also observe significant heterogeneity, with somecountries exhibiting a capital gap close to 100%.8 For our purpose, the rel-evant number is a capital gap of 35 and 45% for non-OECD and OECDcountries respectively.Our calibrated model requires also an estimate of the capital wedge τ .

We can invert equation (7) to construct an average estimate of the wedgefrom average saving rates sk and labor force growth rates n. We calculatethe capital wedge at the beginning of the sample, using average populationgrowth rates and saving rates from 1960 to 1970. We also calculate the capitalwedge consistent with the saving rate and population growth rate from 1985to 1995. The results are reported in table 2.

The capital wedge is very large for non-OECD countries, with an averageof 19% in 1995. This average masks substantial heterogeneity, as the wedgegoes from -6% for some countries, implying a capital subsidy, to a prohibitive

7We limit the sample to countries with positive capital gaps. For some countries, our measured savingrate is so low that current capital exceeds steady state capital. We do not view these cases as particularlyrelevant. Including them would only decrease average capital gaps.

8Countries with capital gap in excess of 90% include Paraguay in 1995 and 1960, and, Indonesia, Singaporeand Bostwana in 1960.

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Capital Wedge OECD non-OECDyear mean min max s.d. Obs. mean min max s.d. Obs.1960-1970 0.00 -0.06 0.12 0.04 21 0.27 -0.02 0.75 0.19 561985-1995 0.01 -0.04 0.07 0.03 21 0.19 -0.06 0.57 0.14 48

Table 2: Capital Wedge Summary, 1960 and 1995

57%.9 The wedge is strongly correlated with output per capita, reflectingthe correlation between standards of living and saving rates in the standardRamsey and Solow models.We also observe that the wedge has decreased somewhat for non-OECD

countries, from 27% to 19%. In our simulations we use values of τ betwen 0and 0.7.Figure 2 reports the welfare gains, measured by µi, as functions of the

capital gap k0/k∗ (τ) for various values of τ .10 The results indicate that the

welfare gains are minuscule, except for very low initial values of the capitalstock relative to steady state. For the typical non-OECD country, with anaverage capital gap of 35%, and a capital wedge of 20%, the welfare gainsare only 0.96% per year! Table 3 reports several summary statistics relatedto this result. The upper panel shows the minimum, maximum and averagewelfare gain for different values of the capital wedges when the capital gapvaries from 0 to 99 percent. Similarly, the lower panel shows the welfaregain for different levels of the capital gap when the wedge τ is uniformlydistributed between 0 and 70 percent. For example, the table indicates thatfor a capital gap of 35 percent (the average in non-OECD economies in 1995),welfare gains range between 0.4% and 0.8% with an average of 0.77%. ForOECD countries, with an average capital gap of 45%, and no capital wedgeon average, the welfare gains are similar, at 0.72% per year.

Why are the welfare gains so small? One plausible answer lies in thespecification of the model. It is well known that the speed of convergence ofthe Ramsey model around the steady state is equal to (δk + n.g − 1) (1− α) .With α equal to 0.3 and an average population growth rate equal of 2.2%,

9Korea Singapore and Thailand for non OECD countries, and Austria, Finland, France, Japan, Norwayand Switzerland for OECD exhibit negative capital wedges. Madagascar, Mozambique and Uganda havewedges in excess of 50%.10The values for µa are very comparable. Since µi is small, so is µa.

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Welfare Gains (%)τ mean min max s.d.

0 2.18 0 21.7 3.20.1 2.69 0 20.24 3.00.3 2.38 0 18.7 2.60.5 2.11 0 17.4 2.40.7 1.51 0 14.7 1.9

1− k0/k∗99 8.5 6.4 11.5 1.790 4.6 3.3 6.4 1.080 2.4 1.7 3.2 0.560 1.8 1.3 2.4 0.445 1.1 0.7 1.5 0.235 0.77 0.4 1.0 0.1810 0.15 0.02 0.21 0.05

Table 3: Welfare Gains Summary, various capital wedges

the theoretical speed of convergence would be equal to 6.59%. At this speed,a capital gap of 50% would be eliminated in 10.5 years only! It is not sosurprising that financial integration does not provide substantial benefits ifthe convergence speed is so high.11

Presumably, more realistic results would obtain, with possibly larger gainsassociated welfare gains, by increasing the capital share. The next subsectionlooks at the introduction of human capital, alongside physical capital.

2.2 An Extended Ramsey Model with Human Capital

Growth economists have long emphasized the importance of human capital.Here we follow MRW and Mankiw, Barro and Sala-i-Martin (1995) and in-troduce human capital in an otherwise standard Ramsey growth model. Ourobjective here is to derive the implications of the model for the transitionpath under both autarky and financial integration.

11We nonetheless observe that our theoretical speed of convergence of 6.6% is well within existing estimates(see for instance Caselli, Esquivel and Lefort (1996) who find a convergence speed of 10%).

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2.2.1 The Model

We extend the production function as in Hall and Jones (1999), by assumingthat output per capita follows:

yt = kαt .h

1−αt

ht denotes the amount of human-capital augmented labor used in production-measured in efficiency unit (Ht/(At.Lt)) and satisfies:

ht = (1− ut) .eφ.St.ut represents the fraction of time devoted to human capital accumulation, sothat (1− ut) Lt the represents total amount of labor involved in production,while exp (φSt) denotes the efficiency of a unit of labor. We follow Hall andJones (1999) and Bils and Klenow (1996), and interpret St as the educationalattainment, i.e. the average years of schooling of the working age population.With this interpretation, the coefficient φ represents the return to schoolingestimated in a Mincerian wage equation. We assume further that 0 ≤ u <u < 1. In particular, it is not possible to allocate all the time to humancapital accumulation.In addition to the capital accumulation equation, human capital accumu-

lates according to:

St+1 = ut + (1− δh)St (8)

where δh represents the depreciation rate of human capital.Under our assumptions, k and S converge towards steady state values

characterized by:

k∗ =µ

sk (τ )

δk + g.n− 1¶1/1−α

h∗ (9)

h∗ = (1− δhS∗) . exp (φS∗)

S∗ =1− δh + φ− β−1gγ−1n−1

φ δh

where the saving rate for physical capital sk is as before.12

12We assume that the restriction −φ ≤ 1 − δh − β−1gγ−1n−1 < φ (u− 1) is satisfied, so that 0 ≤ u∗ =δhS

∗ < u.

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Under our assumptions, the steady state level of human capital accumula-tion does not depend upon the capital wedge τ . The reason is that the capitalwedge affects identically the return to education and the return on labor.We now consider the transition paths under financial autarky and financial

integration

Financial Autarky. Starting from k0 and S0 the economy evolves along thestable arm of the dynamic system in (c, u, k, S) and converges towards (c∗, u∗, k∗, S∗).Figure 3 reports the optimal consumption and human capital accumulationpolicies as a function of k, for a given S.13 The consumption function is con-cave and monotonously increasing, as typical. The human capital investmentfunction is non monotonous in the capital level: at low levels of physical capi-tal, labour is extremely productive and human capital investment is set to itsminimum, zero. As physical capital increases, holding constant educationalattainment, it becomes optimal to invest in human capital.We denote Ua (k0, S0) the welfare of the representative agent with initial

capital k0 and human capital S0.

Financial Integration. As before, financial integration implies that the returnto physical capital is equalized across countries:

1− δk + α (kt/ht)α−1 = R∗/ (1− τ)

This pins down the ratio of physical to human capital:

kt =

µsk (τ )

δk + g.n− 1¶1/1−α

ht

≡ z∗ (τ) ht

Convergence is not instantaneous, however, since human capital needs tobe accumulated domestically. We show in the appendix that the optimaleducation policy is very simple:

ut = u St < S∗

ut = u∗ if St = S∗

ut = 0 St > S∗

13See the appendix for a discussion of the solution method.

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it is optimal to accumulate human capital at the maximum possible rate,as long as convergence is not achieved, i.e St < S∗. Conversely, if there istoo much human capital to start with, no investment will occur. Conver-gence to the steady state occurs in finite time, at the maximum possiblespeed.[intuition?]Since the worl interest rate equals the growth adjusted discount factor,

consumption is flat and constant, at a level consistent with the intertemporalbudget constraint. Unlike the previous case, in this world, the domesticagent borrows both to increase the capital output ratio, and also to ensurea flat consumption profile. As before, we denote U i (k0, S0) the welfare ofthe representative agent under financial integration, and µi (k0, S0) (resp.µa (k0, S0)) the consumption equivalent from the integrated (resp. autarkic)equilibrium.

2.2.2 Specification and results

To implement the model, we need to construct estimates of the stock of hu-man capital St, and its steady state value S

∗ for the countries in our sample.We describe in details in the appendix our methodology, which follows closelyJones (1997) and Barro and Lee (1993). Briefly, we construct a measure of to-tal educational attainment for people over age 25 using equation (8) and dataon durations of primary, secondary and higher schooling and educational, aswell as data on educational attainment rates for people in the correspondingeducational cells. This provides a stock measure S, every five years from 1960to 1995. To construct a measure of S∗, we use the fact that S∗ = u∗/δh andwe use the investment rates in the last measured year (2000 in most cases) toconstruct steady state educational attainments. As Table 4 reports, the dataindicate that most countries, including OECD countries, are substantiallybelow their steady state human capital stock. The gap decreases from 47%to 28% in OECD countries and from 67% to 28% in non-OECD countries.

Combining equations (9) and data on the capital output ratio and initialcapital stock, we obtain:

ln k∗ − ln k = 1

1− α

·ln

µsk

δ + n+ g

¶− ln

µk

y

¶¸+ [ln h∗ − lnh]

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Human Capital Gap OECD non-OECDyear mean min max s.d. Obs. mean min max s.d. Obs.1960 0.47 0.28 0.82 0.15 22 0.67 0.40 0.98 0.15 441995 0.26 0.10 0.59 0.12 22 0.28 0.05 0.57 0.14 48

Table 4: Human Capital Gap Summary, as a fraction of Steady State Human Capital , 1960and 1995

Capital Gap OECD non-OECDyear mean min max s.d. Obs. mean min max s.d. Obs.1960 0.60 0.04 0.89 0.22 21 0.61 0.03 0.97 0.26 351995 0.50 0.15 0.78 0.15 20 0.42 0.01 0.93 0.19 36

Table 5: Physical Capital Gap Summary, when we include Human Capital, as a fraction ofSteady State Human Capital , 1960 and 1995

The initial capital output gap now depends upon two terms. As before,the first term reflects the gap between the steady state and current capitaloutput ratio. The second term adds the gap between current and steady stateoutput contributions of human capital. Given the definition of h, the only bitmissing is the flow of human capital investment, u, compared to its steadystate value, u∗. Unfortunately, data on u is not directly available. Instead,we approximate u by noting that ut = St+1− (1− δh)St, and construct u1060using data on educational attainment between 1960 and 1965, and u1995 usingdata on educational attainment between 1995 and 2000. The resulting capitaloutput gaps are reported in table 5.

While the average capital gaps are similar as of 1960, the table indicatesalso that the convergence has been slower. On average, 50% of the gapremains in 1995 for OECD countries, and 42% for non-OECD. Lastly, sincethe formula for the saving rate in steady state is unchanged, our estimatesfor the capital wedge are also unchanged.

The results for the equivalent variation are presented in figure 4 and table6. We can see from the figure that the welfare gains drop sharply as physicalcapital increase, just as before, while they remain mostly flat as S0 varies.This suggests that the overall gains are more or less unchanged, as Table

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Welfare Gains (%)τ mean min max s.d.0.00.10.3

1− k0/k∗99 12.0 11.0 13.0 0.8580 4.30 3.49 5.51 0.6160 2.20 1.51 3.27 0.5350 1.62 0.97 2.64 0.5140 1.21 0.59 2.19 0.4910 0.66 0.10 1.57 0.44

1− S0/S∗70 3.17 0.89 22.35 3.2750 2.78 0.57 22.91 3.2025 2.35 0.22 22.23 3.1310 2.17 0.08 21.85 3.09

Table 6: Welfare Gains Summary, including human capital, various capital wedges

6 confirms. For the typical OECD country in 1995, we find a welfare gainto liberalization of 1.14% per year. For the non-OECD country, the gain iseven smaller, at 0.88% per year!! We conclude that the neoclassical gainsfrom financial liberalization do not appear overwhelming. However, to geta comparison that is perhaps more meaningful, we compare these gains tothe gains obtained from the elimination of the capital wedge, the only sourceof distortion in our economy, as well as an increase in A, bringing countriescloser to the world technological frontier.

2.3 Alternative Welfare Experiments

where we consider a decrease in τ and an increase in A0

2.3.1 A reduction in the capital wedge

to be written

2.3.2 An increase in productivity

to be written

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2.4 Final thoughts on the source of changes in relative standardsof living

to be written: Hall Jones decomposition in 1960 and 1995. Compute relativeproductivity, relative k/y and relative h (vis a vis the US). Under the null thatA0 differ across countries but g is common, only relative k/y and relative h canexplain relative y. I show instead that almost all the movements come fromchanges in relative A, i.e. productivity miracles and productivity disasters.

3 Capital Account Liberalization and Economic Devel-

opment: Some Theory

If the inequality between nations resulted from the international allocationof capital, capital account openness would eliminate all differences in outputper capita. However, the evidence suggests that we do not live in such aworld. Most of the inequality between nations seems to be due to differencesin TFPs, not to differences in factor endowments. Hence, capital accountopenness can reduce the international inequality in output per capita only tothe extent it significantly reduces the differences in TFPs.Can capital liberalization, in combination with other policies, induce an

economic take-off (a large increase in TFP) in less developed countries? Ifone views capital account liberalization as a significant component in thepolicy package required for economic development–as some argue–the an-swer must be yes. However, there is no formal model-to our knowledge-ofhow capital account liberalization can contribute to a take-off in TFP. Wepresent such a model below, before discussing other possible approaches inthe conclusion.Our model focuses on the relationship between secure property rights and

capital account openness. The model captures the idea that the freedomto move capital across borders induces countries to secure property rights,because a failure to do so triggers a capital flight. Secure property rights,in turn, are a prerequisite for an efficient use of domestic savings. This isthe traditional “discipline argument” in favor of free capital mobility, appliedto an aspect of domestic policies that is widely acknowledged as crucial foreconomic development, the respect of property rights.

19

3.1 Main assumptions

We consider a small open economy in a world with one homogeneous good.The model has three period t = 0, 1, 2. The country has access to two tech-nologies: an efficient technology and an inefficient technology. Both technolo-gies combine capital and labor to produce the consumption good at periodst = 1, 2. The production functions are Cobb-Douglas:

y = Aekαl1−α (10)

y = Aikαl1−α. (11)

The level of TFP is higher in the efficient technology (Ae > Ai). Thetwo technologies have the same coefficient α, so that the efficient technologydominates the inefficient one irrespective of the factor prices. The reason whythe inefficient technology may nevertheless be used in equilibrium is relatedto taxation. Capital income can be taxed in the efficient sector, not in theinefficient sector. One may think of the inefficient sector as an informal sectorwith small scale projects in which the productive capital is operated by itsowner. This sector is “informal” in the sense that productive capital is noteasily observable–and so cannot easily be taxed–by the government.By contrast, the efficient technology requires capital to be invested in large

scale projects. Capitalists become investors holding financial assets, insteadof small entrepreneurs operating physical assets. The scale of productionmakes capital easier to locate and tax than in the inefficient sector. Themodern sector, as a result, is not only more efficient; it is also more “formal”in the sense that it gives the sovereign more scope in taxing capital income.The country is populated by two classes of agents: capitalists and workers.

Capitalists are endowed with some capital, which they choose to specializeinto the efficient or the inefficient technology at period 0. This choice cannotbe reversed in the following periods. Each unit of capital is productive inperiods 1 and 2 (capital lasts two periods). We assume that the capital usedto produce in period t must be installed in the country in period t− 1.Workers are identical, and each of them is endowed with one unit of labor

in periods 1 and 2, the two periods in which production takes place. Thelabor market is perfectly competitive and labor is perfectly mobile betweenthe formal and informal sectors. The aggregate quantities of domestic capitaland domestic labor are respectively denoted by K and L.

20

We consider two policy areas. The first one is related to domestic redis-tribution. The domestic government taxes capital income in periods 1 and2 and redistributes the proceeds to workers. The other policy area has todo with the capital account. The capital account can be open or closed inperiods t = 0, 1, the periods in which capital is installed for production inthe following period. If the capital account is open, capital can freely flowin and out of the country, and can be rented abroad tax-free, at the worldprice R∗. By contrast, if the capital account is closed, capital cannot crossthe borders. We assume that capital can flow across borders only if it hasbeen specialized in the efficient technology–capital is by nature immobile inthe inefficient sector.We assume that the domestic government determines its policies so as to

maximize the utility of the representative worker–for example, because thecountry is a democracy and workers are the majority. The nature of theequilibrium depends, of course, on the government’s ability to commit to apolicy course, and we compare different assumptions in the following section.The utility of capitalists and workers is equal to their expected undiscountedconsumption in periods 1 and 2

Ut = Et(C1 + C2) (12)

It is Pareto optimal for domestic investment to be in the efficient tech-nology. Whether this is the case in equilibrium, however, depends on thegovernment’s ability to commit, as well as the capital account policy–aswe shall see below. The analysis now proceeds in three steps. First, we ana-lyze the equilibrium under different assumptions on the government’s horizonof commitment, conditional on financial autarky (subsection 3.2). We thenshow how a commitment to capital account mobility at a short horizon canbuttress a commitment to low taxation at a longer horizon (3.3). Third, wepresent an extension of the model in which capital account mobility generatesthe risk of self-fulfilling capital account crises (3.4).

3.2 Financial autarky

We assume in this section that the capital account is closed in periods 0and 1. Hence, the efficiency of the domestic productive sector depends com-pletely on the choice of technology made by domestic capitalists in period 0.

21

Let us denote by Ke and Ki the aggregate quantities of capital respectivelycommitted to the efficient and inefficient sectors (Ke +Ki = K).

In periods t = 1, 2, the real wage w is equal to the marginal productivityof labor in the efficient and inefficient sectors. As a result, labor demandis given by Le = ((1− α)Ae/w)

1/αKe in the efficient sector, and by Li =

((1− α)Ai/w)1/αKi in the inefficient sector. The equation for the equilibrium

in the labor market, Le + Li = L, then implies the following expression forthe real wage

w = (1− α)L−α³A1/αe Ke + A

1/αi Ki

´α. (13)

The return per unit of capital in sector s = e, i is given by

maxl(Ask

αl1−α − wl) = κA1/αs w−1−αα k, s = e, i, (14)

where κ ≡ α(1 − α)(1−α)/α. Hence, in equilibrium the gross rental price ofcapital in sector s must be

Rs = κA1/αs w−1−αα , s = e, i. (15)

Let τ t denote the tax rate on capital income in the efficient sector at timet = 1, 2. By investing one unit of his initial capital into the formal sector acapitalist secures (1−τ 1)Re in period 1 and (1−τ 2)Re in period 2. This mustbe compared with a net return of Ri in both periods if the same unit of capitalis invested in the informal sector. Investment goes to the most efficient sectorif (1− τ 1)Re+(1− τ 2)Re ≥ 2Ri, or, denoting by τ ≡ (τ 1+ τ 2)/2 the averagetax rate over the lifetime of capital,

τ ≤ τ ≡ 1−µAiAe

¶1/α(16)

This is an incentive condition.14 The average tax rate over the lifetimeof capital must be lower than a threshold, above which capitalists prefer to14The inequality is not strict because we assume that capitalists opt for the most efficient technology if

they are indifferent between the two.

22

escape taxation by investing in the inefficient, but tax-free, informal sector.Note that if the productivity gap between the informal and the formal sectorswidens (Ae/Ai increases), it takes a higher tax rate to discourage capitalistsfrom investing in the formal sector.

Let us come to redistributive policies in equilibrium. A key assumption,in this regard, is the horizon at which the domestic government can committo future policy. We compare three assumptions: (i) full-commitment: thegovernment can commit to τ 1 and τ 2 in period 0; (ii) partial-commitment:the government can commit one period ahead, i.e., to τ 1 in period 0 and toτ 2 in period 1; and (iii) zero-commitment: the government sets τ t in periodt.Although we do not wish to specialize the model too much with assump-

tions on the domestic political institutions, our assumptions on commitmentcan easily be interpreted in a simple model of political delegation. For exam-ple, one could assume that the representative worker elects the policymaker,and that policymakers are automata who implement the program on whichthey have been elected. The horizon of commitment, then, is simply thelength of the term for which policymakers are elected.

The extreme cases of full commitment and zero commitment are simple.Let us start with full commitment–the government sets τ 1 and τ 2 at time 0.Then in order to maximize the representative worker’s utility the governmentwill maximize redistribution subject to the constraint of not discouragingcapitalists from investing in the formal sector. That is, it will set the averagetax rate to the threshold τ defined in equation (16). All the surplus generatedby the use of the efficient technology is captured by workers.

At the other extreme, let us assume that the government cannot commitat all. That is, workers effectively decide τ 1 in period 1 and τ 2 in period 2.Then, we obtain the classical time consistency problem in the taxation of cap-ital. The government expropriates capitalists once their capital is irreversiblycommitted to the formal sector by setting τ 1 = 1 and τ 2 = 2. Anticipatingthis, capitalists do not invest in the formal sector.

These results are not new. Where this paper innovates is by focusingon the intermediate case where some degree (but not full) commitment is

23

possible. We do not view the zero commitment assumption as very realis-tic. Countries have institutional and other ways to commit over their futurepolicies at some horizon. To the extent that a time consistency problem re-mains, it is because the political horizon at which the country commits tonon-expropriatory policies is shorter than the economic horizon at which in-vestors have to commit their capital. This idea is captureed, in the model,by the partial commitment assumption that the sovereign can set its policyone period ahead: that is, it can commit to τ t at period t− 1 (t = 1, 2).The equilibrium is then as follows. Like in the no-commitment case, and

for the same reason, the government expropriates capitalists in the formalsector in the last period (τ 2 = 1). The difference with the zero commitmentcase is that now, the government can commit in period 0 not to expropriatein period 1. By increasing τ 1 from zero to 1, the government can achieve anyaverage tax rate τ between 1/2 and 1. The average tax rate has to be largerthan 1/2 because capital is expropriated in the second half of its life. If anaverage tax rate of 50 percent does not discourage capitalists from investingin the formal sector, then the government achieves the same rate of taxationas under full commitment by setting τ 1 = 2τ − 1. On the other hand, if thethreshold τ is lower than 50 percent, the equilibrium is the same as underthe absence of commitment.Our results so far are summarized in the following proposition.

Proposition 1 . Assume that the capital account is closed in periods 0 and1 (financial autarky). Then the equilibrium depends on the horizon of com-mitment of the government in the following way.(i) (Zero commitment) If the government cannot commit, capitalists in-

vest all their capital in the informal sector, and there is no redistribution inequilibrium.(ii) (Full commitment) If the government can commit until period 2, cap-

italists invest all their capital in the formal sector and the government setsthe average tax rate at the maximum level consistent with the existence of the

formal sector, τ ≡ 1−³AiAe

´1/α.

(iii) (Intermediate commitment) If the government can commit one periodahead, the equilibrium is the same as under zero commitment if τ < 1/2 andthe same as under full commitment if τ ≥ 1/2.Under partial commitment, the horizon of political commitment by work-

24

ers is shorter than the horizon of economic commitment by capitalists. As aresult, workers can promise capitalists only a fraction of total returns, andthis fraction may be too small for the efficient, formal sector to develop.The equilibrium in which all the investment goes to the informal sector isPareto-inefficient. Both workers and capitalists are worse off than in the full-commitment equilibrium (the workers strictly so, since they receive a lowerwage and there is no redistribution; the capitalists are indifferent). We showin the following section how this problem can be solved by opening the capitalaccount.

3.3 Capital account mobility and political lock-in

Exactly in the same way as it commits to a low tax rate, the governmentcould commit at period 0 to keep the capital account open in period 1. Forexample, workers can elect in period 0 a policymaker who is ideologicallycommitted to free capital movements. Although workers cannot commit tore-elect this policymaker in period 1, the capital account will be open whenthe first policymaker is replaced. We now analyze how the results derived inthe preceding section under autarky are changed if the capital account is openin period 1. For the sake of the analysis, we keep the capital account closedin period 0. This assumption will be relaxed. Capital account openness playsrather different roles in periods 0 and 1, and it is preferable to analyze themseparately.

Like before, the choice of the second period tax rate, τ 2, is made in period

1. The difference is that now the stock of capital in the formal sector isno longer pre-determined by the domestic capitalists’ period 0 choices. It isdetermined by an arbitrage between domestic and foreign investment thatis made in period 1, the period in which the government sets the tax rate.Because investment decisions are made at the same time as fiscal policy, thestock of domestic capital is now elastic to the tax rate.In equilibrium the net return on capital must be equal to the international

rental price R∗. Using equation (15) this implies

(1− τ 2)R2 = R∗ (17)

where R2 = κA1/αe w

−1−αα2 is the period 2 gross return of capital in the formal

25

sector (see equation (15); we drop the index e to alleviate notations). As-suming that domestic capitalists do not invest in the informal sector (whichis true in equilibrium), the period 2 real wage can be written

w2 = (1− α)Ae

µK2L

¶α

(18)

where K2 denotes the level of capital in the domestic formal sector in period2 (see (13)).The domestic government sets the tax rate τ 2 so as to maximize the last

period consumption of the representative worker, which is equal to the realwage plus the proceed of the tax per capita Cw2 = w2 + τ 2R2

K2L. Simple

manipulations then show

Cw2 =AeK

α2 L

1−α −R∗K2L

(19)

This expression is maximized when there is no distorsion relative to thelaissez-faire (τ 2 = 0). That is, when the capital account is open the rep-resentative worker maximizes his utility by not taxing domestic capital.Opening the capital account in period 1 allows the representative worker

to commit to zero taxation in the last period. Once the capital account isopen, the worker will elect a policymaker that does not tax capital, knowingthat the gain from redistribution will be more than offset by the depressingimpact of the capital outflow on the real wage.

If the capital account is closed in period 0, the domestic worker can nev-ertheless tax capital in period 1, like before. Since the capitalist now receivesa return R∗ per unit of capital in period 2, the incentive condition to investin the formal sector becomes (1− τ 1)Re +R

∗ ≥ 2Ri, which can be written

τ ≤ τ +R∗ −Re2Re

. (20)

If the country is capital scarce (R∗ < Re), the maximum tax rate is lowerthan under financial autarky because opennes reduces the return on capitalbelow the autarkic level.If financial autarky prevents the domestic efficient sector from developing

(τ < 1/2), then opening the capital account in period 1 is Pareto-efficient.

26

Workers strictly benefit since they receive a higher wage plus some transfers.The welfare of capitalists remains at the autarkic level, since the surplusassociated with the use of the efficient technology is captured by workers.

Proposition 2 . Assume the capital account is closed at period 0, but thegovernment commits to open it in period 1, then all domestic capitalists investtheir capital in the efficient, formal sector in period 0. The government taxescapital income at rate τ 1 = 2τ + (R

∗ −Re)/Re in period 1 and at rate τ 2 = 0in period 2. If the domestic formal sector does not develop under financialautarky (τ < 1/2), then opening the capital account in period 1 strictly in-creases the welfare of domestic workers and leaves that of domestic capitalistsunchanged.

Two points are worth making.

• The benefit of capital account liberalization highlighted in the propo-sition is very different from the more traditional benefits in terms ofallocative inefficiency. In particular, it could arise even if there is nocapital flow in equilibrium. Assume that the country is neither capitalscarce nor capital abundant (Re = R∗). Then opening the capital ac-count might seem irrelevant since in equilibrium there is no capital inflowor outflow in period 1. However, that capital can move in and out iscrucial for the development of the formal, efficient sector (the economictake-off).

• Our results are reminiscent of the classical idea that an open capitalaccount reduces the equilibrium level of taxation on capital by makingit more mobile. Furthermore, the point that an open capital account isa way to solve the time consistency problem in the taxation of capitalhas been developed elsewhere (Quadrini, 2000). One issue with thisline of thought, however, is that it assumes that the government cancommit to an open capital account even though it cannot commit tolow taxation. Our model does not have this problem, since it does notassume any asymmetry in the way the country can commit: the horizonof commitment is the same for the redistributive policy and the capitalaccount policy. We show that committing to an open capital accountand low taxation even for a limited horizon has a “lock-in” effect: thesepolicies tend to be maintained once they have been introduced.

27

The assumption that the capital account is closed in period 0 may seemunappealing. Under partial commitment, the capital account regime is in-herited from the past. If the game we are modelling were repeated, thenthe country would start with an open capital account. How are the resultschanged if the capital account is initially open?First, it is easy to see that the government’s problem being the same in

period 0 as in period 1, the tax rate τ 1 is also set at zero. Hence, there is noredistribution in equilibrium once the economy is locked in the regime withan open capital account. As a result, capitalists receive a share of the surplusgenerated by the use of the efficient technology. However, it remains truethat both classes benefit from capital account openness if closure prevents thedomestic efficient sector from developing. Capitalists receive a higher return(if R∗ > Ri) and workers a higher wage. The absence of redistribution doesnot hurt workers since there is no redistribution in the autarkic equilibrium.Note the contrast with the standard Stolper-Samuelson model, in which it isalways the case that one of the two classes (the one with the scarce factor)suffers from financial integration with the rest of the world.

3.4 Capital account crises

So far we have assumed that capital was liquid in period 1. Conditionalon openness, capital was as mobile in period 1 as in period 0. We nowconsider an extension of the model in which physical capital is illiquid. Thisreduces the commitment value of an open capital account, since capital isnot as responsive to the tax rate as before. We show that the benefits ofcapital account openness can be preserved if the capital account policy isaugmented by a financial arrangement that gives capitalists liquidation rights.This arrangement, however, has a negative side effect: it also gives rise toself-fulfilling capital account crises.

Assume that capital invested in the domestic formal sector is virtuallyimmobile in period 1 (it is “bolted down”, to take a metaphore often usedfor FDI). Productive capital can be liquidated in period 1 but (almost) allthe investment is lost in the process. The proceed of liquidation is ² per unitof capital, where ² is assumed to be very small. Then (17) is replaced by

28

(1− τ 2)R2 ≥ ²R∗ (21)

As long as the net return (1−τ 2)R2 is strictly higher than ²R∗, capital doesnot flow out. In period 1, the government will increase τ 2 until (1 − τ 2)R2is equal to ²R∗ since for this range of tax rates domestic capital is inelastic.² being very small, the tax rate τ 2 is very close to 1, and capitalists do notinvest in the formal sector in period 0. Hence it looks like the illiquidity ofcapital destroys the benefit of capital account liberalization: if capital cannotmove out of the country because of its intrinsic illiquidity, then opening thecapital account serves no purpose. Opening the capital account in period1 will not suffice to solve the time consistency problem in the taxation ofcapital.

We modify the model as follows. Assume for simplicity that the formalsector involves one public firm, and that this firm can enter the following typeof contracts with investors: repay ρ1 in period 1 and ρ2 in period 2. Sincethe firm is public, ρ1 and ρ2 are effectively determined by the representativeworker.The condition for capitalists to invest in the formal sector is ρ1 + ρ2 ≥

2Ri, where the first-period payment has to be lower than the first periodoutput per unit of capital (ρ1 ≤ Ae(L/K)1−α). Under partial commitment,the government decides ρ2 at time 1. The second period payment ρ2 is setto (almost) zero once capital is “bolted down” in the country. We assumeAe(L/K)

1−α < 2Ri so that in equilibrium, capitalists do not invest in theformal sector under partial commitment.Let us now assume that the financial contract gives capitalists the right

to ask for an early repayment ρ at the end of period 1, after ρ1 has beenpaid. This payment is made by liquidating capital, and capitalists are servedsequentially, like in the Diamond-Dybvig model. We define an open capitalaccount as a commitment by the domestic government to enforce capitalists’liquidation rights and to allow them to take the proceeds in a tax havenoutside the country.We assume that capitalists are atomistic, so that a small number of them

can receive ρ if they ask for it (because ² > 0). If R∗ρ > ρ2 all capitalistsdemand an early repayment; if others don’t, an individual capitalist is better

29

off receiving ρ and invest it abroad, than waiting until period 2. Hence thereis a run, and the formal sector is liquidated. To avoid liquidation the domesticgovernment minimizes ρ2 under the constraint ρ2 ≥ R∗ρ, and sets

ρ2 = R∗ρ (22)

Hence by choosing ρ appropriately the government can commit itself to anylevel of ρ2. The logic is the same as in Jeanne (2002): the liquidation rightsdiscipline the government to implement the commitment-first-best policy.15

The insight here is that for capital account liberalization to have a commit-ment value, it is not necessary for capital to be liquid; it is sufficient forcapitalists to have liquidation rights.

However, like in Diamond and Dybvig, giving investors liquidation rightson illiquid capital raises the risk of a self-fulfilling crisis. Even if the govern-ment sets ρ2 at the level implied by equation (22), there is an equilibriumin which investors simultaneously ask for repayment. Those that get repaidtake the proceeds out of the country, so that the run can also be described asa capital account crisis. The crisis could be determined by a sunspot event.Let us denote by µ the exogenous probability of a self-fulfilling crisis. Howdoes the decision to open the capital account depend on µ?The aggregate utility of workers is equal to total expected output minus the

level of utility that must be guaranteed to capitalists in order to induce themto invest in the formal sector, 2αAiK

αL1−α. Total expected output is equalto 2AeK

αL1−α−µ(AeKαL1−α−²KR∗), the level of output if there is no crisis

minus the probability of a crisis times the associated output loss. Workersvote in favor of capital account liberalization if the implied aggregate utilityis larger than their utility level under autarky, 2(1 − α)AiK

αL1−α. Takingthe limit ² = 0, we find that the capital account is opened if the probabilityof crisis is not too large

µ ≤ 2− (1 + α)AiAe. (23)

15See also Diamond and Rajan (2001).

30

4 Conclusion

The main contribution of this paper, at the present stage of its development,is that it suggests to look at the question of the benefits of capital accountliberalization for developing economies from a new angle. Capital accountliberalization will not induce a significant catch-up in the development of lessdeveloped economies if its only effect is to re-allocate capital internationally,since the international allocation of capital is not the main factor behindthe inequality across nations. However, capital account liberalization could,in combination with other policies, play a significant role in the economictake-off of less developed economies, and to the extent that it does, it wouldhave large benefits. This suggests to us that the question of the benefits ofcapital account liberalization should be not considered as a simple applicationof the first welfare theorem, but rather as a central question in the field ofdevelopment economics.

We have illustrated the linkage between capital account openness and eco-nomic development in a model that focuses on property rights. Other ap-proaches to this question are possible. For example, one approach could bebased on Parente and Prescott’s view of economic development. Accordingto these authors, the reason for the low TFP in less developed countries hasto be found in the domestic political economy. Some groups benefit from thecontinued use of inefficient technologies, because they own production inputsthat are specific to these technologies and so would become less valuable ifproduction switched to more efficient ones. These groups promote barriersto the adoption of the more efficient technologies, what Parente and Prescottcall “barrier to riches”.How does this analysis relate to capital account opening? First, if the

more efficient technology is foreign and must be imported through FDI, thenthe domestic groups that are opposed to its introduction in the domestic pro-ductive sector–typically, owners of capital and labor that are specific to theless efficient domestic technology–can achieve their objectives by closing theeconomy to FDI. Second, if the more efficient technology can be operated bysome domestic entrepreneurs, then the same groups can impede its develop-ment by domestic financial repression. Capital account restrictions, in thiscase, can be viewed as the external component of financial repression.

31

Finally, the question arises of how these theories can be validated empir-ically. One approach would be based on case studies: looking at the capitalaccount regimes and capital flows in cases of successful economic take-offs.This is unlikely to yield very strong and unambiguous conclusions. We knowthat capital account openness is not always and everywhere a necessary con-dition for an economic take-off, since some countries, such as Korea, grew alot with relatively closed capital accounts. However, such an exercise couldshow that some form of capital account openness can play a key role insome strategies of development that were successful in some countries. Itcould suggest how capital account liberalization and other growth-inducingpolicies complement each other in these cases.

32

References

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Bartolini, Leonardo and Allan Drazen, 1997, Capital Account Liberalizationas a Signal, American Economic Review 87, 138-154.

Bekaert, Geert, Harvey, Campbell R., and Christian Lundblad, 2002, DoesFinancial Liberalization Spur Growth?, mimeo, Columbia University.

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Dornbusch, Rudiger, 1998, Capital Controls: An Idea Whose Time Is Past,in Should the IMF Pursue Capital-Account Convertibility?, Essays in In-ternational Finance No.207, International Finance Section, Departmentof Economics, Princeton University, 20-27.

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33

Matsuyama, Kiminori, 2000, Financial Market Globalization and Endoge-nous Inequality of Nations, mimeo, Dept. of Economics, NorthwesternUniversity.

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Quadrini, Vincenzo, 2001, Policy Commitment and the Welfare Gains FromCapital Liberalization, mimeo, New York University.

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5 Appendix

5.1 Constructing Human capital stocks (in progress)

The methodology here follows Jones (1997) quite closely, building upon Barroand Lee (1993).The concept of human capital measured here is average educational at-

tainment for people over age 25, i.e. the average number of years of schoolingin the population>25. This is a stock measure, as needed for the theory.The stocks are constructed from two different sources. First, using censusesdata for benchmark years, Barro and Lee measure educational attainment forpeople over 25 in three different educational categories: primary, secondaryand higher. Average schooling years is constructed as:

S = dp

·1

2hip + hcp

¸+ (dp + dis) his + (dp + ds)hcs

+

µdp + ds +

1

2dh

¶hih + (dp + ds + dh) hch

where dj is the (country specific) duration in primary (p), incomplete sec-ondary (is), secondary (s) and higher (h); hj are the educational attainmentrates for the corresponding cells, for people over age 25. They complete theirobservations using data on enrollment rates and duration and a perpetualinventory method.The data is coming from the UNESCO. The Barro and Lee (2000) data

provides educational attainment data until 2000 for roughly 100 countries.These correspond to S2000. We need to construct S

∗ to obtain an estimate ofthe long run educational attainment. To do so, we follow Jones (1997) anduse the perpetual inventory method to obtain these long-run estimates.For instance, Barro and Lee formula to update the primary educational

rates use enrollment rates and population growth as follows:

hp,t =

µ1− l25,t

lt

¶hp,t−5 +

l25,tlt(PRIt−15 − SECt−10)

where lt is the population age 25 and over in year t, l25,t is the population ofage 25-29 at age t (i.e. entering the sample over the last 5 years), PRIt−15is the primary enrollment rate at t − 15, and SECt−10 is the secondary en-rollment rate in t − 10. The first term represents the previous stock minus

35

a ‘depreciation’, due to death -assumed to be random across educationalattainments- while the second term reflects accumulation due to the new co-hort who got primary education (and did not go on to secondary education).What interests us is the value of hp,t in steady state. If we assume that theenrollment rates will stay at their current value (measured in 1996 in prac-tice, or the latest available observation when not available), and that theratio of the entering cohorts to the total population over 25 l25/l will remainconstant, then we have:16

h∗p = (PRI − SEC)Similar calculations for secondary and higher education yield:

h∗s = (SEC −HIGH)h∗h = HIGH

The last thing to do is to allocate the educational attainment betweencomplete and incomplete cycles. I do this using data from Barro and Lee onthe percentage of complete versus incomplete schooling in each cell. Denotingπj the ratio of completed to total for cell j, the contribution of primaryeducation to total average schooling is:

dp

·1

2(1− πp) + πp

¸h∗

and we have similar contributions for secondary and higher. Summing givesS∗. An estimate of lnh∗ = ln (H/L)∗ = φS∗.

16This last assumption implies no demographic transition in countries. This is of course an overstatement.As countries age, we can expect smaller younger cohorts relative to the size of the country. This would tendto reduce the estimates of education attainment. Our estimates constitute an upper bound.

36

Figure 1: (c, k) dynamics

37

Figure 2: Equivalent Variation µi (τ ) for various values of the capital wedge (τ) between 0and 0.7.

38

Figure 3: Consumption and human capital investment functions;

39

Figure 4: Equivalent Variation, various values of S0 and k0, for τ = 0.

40