Global Capital Markets PDF

- -
SE\II'\ \RIOS
" ~FUNDAÇÃO DF PF~( >l J~ \
"
" GETULIO VARGAS rCU,\()\lJC \
EPGE
Escola de Pós-Graduação em
Economia
"Global Capital Markets: Integration,

Crisis and Growth"
Prof. Alan Taylor (Northwestem University/NBER)

(co-autoria com Maurice Obstfeld)
LOCAL
Fundação Getulio Vargas
Praia de Botafogo, 190 - 10° andar - Auditório
DATA
12/11/98 (53 feira)
HORÁRIO
16:00h
Coordenação: Prof. Pedro Cavalcanti Gomes Ferreira

•
Email: ferreira@fgv.br- • (021) 536-9250
fH3c1Jd C'it){2-- 5
BIBLIOTECA
'. MARIO HENR'QlJE SIMONSEN
FUNJAÇAO G::OU; VARGAS
J
'( <;.': ;
( __
\ \
r- _ I ) .
U ')
•
Global Capital Markets
Integration, Crisis, and Growth
This book presents an economic history of intemational capital

mobility since the late nineteenth century. The book begins with a
preamble that introduces the major issues and examines developments
in the eighteeneth century and before, important historical
preconditions that set the stage for a global market in the nineteenth
century. We then discuss the theory and empirical evidence
surrounding the falI and rise of integration in the global market. A
discussion of institutional developments focuses on the use of capital
controls and the pursuit of macroeconomic policy objectives in the
context of changing monetary regimes. A fundamental macroeconomic
policy trilemma has forced policymakers to trade off beteween
conflicting goals, with natural implications for capital mobility.
Understood this way, the present era of globalization can be seen, in
part, as merely the resumption of a liberal world order that had
previously been established in the years from 1880 to 1914. Marking a
reaction against that order, the Great Depression emerges as the key
tuming point in the recent history of intemational capital markets, and
offers important insights for contemporary policy debates.
MAURICE OBSTFELD is Class of 1958 Professor of Economics at the

University of Califomia at Berkeley and a Research Associate of the
National Bureau of Economic Research.
ALAN M. TAYLOR is Assistant Professor ofEconomics at

Northwestem University and a Faculty Research Fellow of the
National Bureau of Economic Research .
NWOTECA IlARIO HENRIQUE _ _

qlNDAclO GETOUD 'AlUI
Global Capital Markets
Integration, Crisis, and Growth
MAURICE OBSTFELD
ALA'; ;"1. TAYLOR
6C~BRIDGE
>, UI'<IVERSITY PRESS
Contents
Foreword page Xl
Acknowledgements X111
Part one: Preamble
Global Capital Markets: Overview and Origins 4
1.1 Theoretical Benefits 5

1.1.1 Intemational Risk Sharing 5
1.1.2 Intertemporal Trade 8
1.1.3 Discipline 9
1.2 Problems of Supranational Capital Markets in Practice 10
1.2.1 Enforcement of Contracts and Informational Problems 10
1.2.2 Loss of Policy Autonomy II
1.2.3 Intemational Aspects of Capital-Market Crises 12
1.3 The Emergence of World Capital Markets 14
1.3.1 Early Modem FinanciaI Development 15
1.3.2 Technological and Institutional Changes 17
1.3.3 The Rise of Global Finance 21
IA Stylized Facts for the Twentieth Century 23
1.5 Trilemma: Capital Mobility, the Exchange Rate, and
Monetary Policy 26
1.6 Summary 28
Vil
Vll1 Contents
Part two: Global Capital in Modero HistoricaI Perspective 31
2 Globalization in Capital Markets: The Long-Run Evidence 34
2.1 Introduction 34
.., .., Overview 36
2.3 Quantity Cri teria 41
2.3.1 The Stocks of Foreign Capital 41
2.3.2 The Size ofFlows 52
2.3.3 The Saving-Investment Relationship 59
2.3.4 Caveats: Quantity Cri teria 68
2.4 Price Criteria 71
2.4.1 Covered Interest Parity 72
2.4.2 Real Interest Parity 76
2.4.3 Purchasing Power Parity 79
2.4.4 Caveats: Price Cri teria 85
2.5 Summary 86
3 Globalization in Capital Markets: A Long-Run Narrative 88
3.1 Capital Without Constraints: The Gold Standard, 1870-1931 88

3.1.1 The Classical Gold Standard Era 88
3.1.2 Rebuilding the Gold Standard 91
3.2 Crisis and Compromise: Depression and War, 1931-46 97
3.2.1 Capital Markets and the Great Depression 97
3.2.2 Policy Response: A Consensus on Capital Mobility 103
3.2.3 World War II and its Aftermath 107
3.3 Containment Then Collapse: Bretton Woods, 1946-71 113
3.3.1 Stability Without Integration? 113
3.3.2 Leakage, then Deluge 119
3.4 Crisis and Compromise II: The Floating Era, 1971-99 121
3 A.1 Integration Without Stability? 121
3A.2 The New Global Capital Market 123
Contents IX
Part three: Lessons for Today 125
4 Open Capital Markets: Worth the Risk? 127

4.1 Introduction 127
4.1.1 Open Capital Markets in Historical Perspective 127
4.1.2 Open Capital Markets Today 127
4.2 Evidence on Benefits versus Costs 127
4.2.1 Convergence 127
4.2.2 Growth 128
4.2.3 Portfolio diversification 128
4.2.4 Consumption smoothing 128
4.2.5 Output volatility 128
4.2.6 Corrleation versus Causation 128
4.3 Implications for Today's Global Economy 128
4.3.1 The Menu of Policy Choices 128
4.3.2 The Perpetuai Choice: Intervention versus Markets 128
Appendix:
An InternatÍona{ Macroeconomic Database 129
References 130
lndex 140
•
2
Globalization in Capital Markets:
The Long-Run Evidence
2.1 Introduction
In theory and practice, the extent of intemational capital mobility can have
profound implications for the operation of individual and global economies.
With respect to theory, the applicability of various classes of macroeconomic
models rests on many assumptions, and not the least important of these are
axioms linked to the closure of the model in the capital market. The predictions
of a theory and its usefulness for policy debates can revolve critically on this
part of the structure.
The importance of these issues for policy is not surprising at <lll' a moment's
refteclion on practical aspects of macroeconomic policy choice underscores the
impact lhat capital mobility can have on the efficacy of various interventions:
trivially, if capital is perfectly mobile, this dooms to failure any attempts to
manipulate local asset prices to make them deviate from global prices, includ-
ing the most criticai macroeconomic asset price, the interest rate. Thus, the
feasibility and relevance of key policy actions cannot be judged absent some
informed position on the extent to which local economic conditions are in any
way separable from global conditions. This means an empirical measure of
market integration is implicitly, though rarely explicitly, a necessary adjunct
to any policy discussion. Although recent globalization trends bave brought
this issue to the fore, we show in this chapter how the experience of longer-run
rnacro-:conomic history can clarify and inform these debates.
In attacking the problem of measuring market integration, economists have
no universally recognized criterion to tum to. For example, imagine the simple
expedient of examining price differentials: prices would be identical in two
identical neighboring economies. being determined in each by the identical
structures of tastes. technologies, and endowments; but if the two markets were
physically separated by an infinitely high transaction-cost barrier one could
3.+
2.1 /ntroduction 35
hardly describe them as being integrated in a single market, as the equality of

prices was merely a chance event. Or consider looking at the size of ftows
between two markets as a gauge of mobility; this is an equally ftawed criterion,
for suppose we now destroyed the barrier between the two economies just
mentioned. and reduced transaction costs to zero; we would then truly have
a single integrated market, but, since on either side of the barrier prices were
identical in autarky, there would be no incentive for any good or factor to move
after the barrier disappeared. Thus, convergence of prices and movements of
goods are not unambiguous indicators of market integration. One could run
through any number of other putative criteria for market integration. examining
perhaps the leveIs or correlations of prices or quantities, and discover essentially
the same kind of weakness: alI such tests may be able to evaluate market
integration. but only as a joint hypothesis test where some other maintained
assumptions are needed to make the test meaningful.
Given this impasse, an historical study such as the present chapter is poten-
tially valuable in two respects. First, we can use a very large array of data
sources covering different aspects of international capital mobility over the last
one hundred years or more. Without being wedded to a single criterion, we can
attempt to make inferences about the path of global capital mobility with a bat-
tery of tests. using both quantity and price cri teria of various kinds. As long as
important caveats are kept in mind about each method, especially the auxiliary
assumptions required for meaningful inference, we can essay a broad-based
approach to the evidence. Should the different methods all lead to a similar
conclusion we would be in a stronger position than if we simply relied on a
single test.
Historical work offers a second benefit in that it provides a natural set of
benchmarks for our understanding of today's situation. In addition to the many
competing tests for capital mobility, we also face the problem that almost every
test is usually a matter of degree. of interpreting a parameter or a measure of
dispersion or some other variable or coefficient. We face the typical empirical
conundrums (how big is big:' or how fast is fast?) in placing an absolute
meamng on these measures. An historical perspective allows a more nuanced
view, and places all such inferences in a relative context: when we say that a
parameter for capital mobility is big, this is easier to interpret if we can say that
by this we mean bigger than a decade or a century ago. The historical focus
of this chapter will be directed at addressing just such concerns. I We examine
BUI nOle lha!. agJ..ln. auxiliary assumprions will be necessary. and lhe caveals will be considered
along lhe", ay: for example. whal if neighboring eco no mies became exogenously more or less
Idenllcal o\er time. but no more or less integrated in terms of transactlon costs O
36 Globalization in Capital Markets: The Long-Run Evidenee
the broadest range of data over the last one-hundred-plus years to see what has
happened to the degree of capital mobility in a cross section of countries. 2
The empirical work begins by looking at the extent of international capital
movements over a century or more, employing data on both stocks and fiows
of foreign capital. We then develop more refined quantity criteria by looking
at the correlations of saving and investment in individual economies over the
long run. In principie, more open economies should be better able to de-link
saving and investment decisions via externai finance. An important discussion
of caveats ends this section.
The next empirical section focuses on price-based criteria for capital market
integration, and looks at three parity relations: covered interest parity (CIP), real
interest parity (RIP), and purchasing power parity (PPP). In principie, ali three
relations should come c10ser to equality the more integrated markets are. An
examination of long-run price and interest rate series since the late nineteenth
century affords a test ofthese relations. Once again, an important section details
the caveats with this approach.
The conclusion conjectures some reasons why international capital mobility
might have varied from time to time in the international economy over the last
century or so. Important constraints on policy makers included a fundamental
tradeoff between monetary policy choice, policies as regards capital mobility,
and the desire for activist domestic monetary policy. We have termed this the
maeroeeanomie palie)' trilemma 3 Consideratio!'! ofthe trilemma illustrates the
tensions facing policymakers during the interwar period, a major turning point
in the evolution of markets in the twentieth century, and helps us understand
the changing commitments of governments to monetary regimes, their attempts
at sterilization, and their confiict over adherence to the previously sacrosanct
"rules of the game" under the orthodoxy of the gold standard. In this political
economy context, the empirical evidence appears consistent with the stylized
facts of twentieth-century social, political, and economic history.
2.2 Overview
The broad trends and cycles in the world capital market that we will document
refiect changing responses to the fundamental trilemma. Before 1914, each of
~ Given the limitations of the data. we will frequently be restricted to looking at between a
dozen and twenty countries for which long-run macroeconomic statistics are available. and
this sample will be dominated by today's developed countries. including most of the OECD
countries. However, we a1so have long data series for some developing countries such as
Argentina. Brazil. and Mexico: and in some criteria. such as our opening look at the evolution
of the stock of foreign investments, we can examine a much broader sample.
3. See section 1.5.
2.2 Overview 37
the world's major economies pegged its currency's price in terrns of gold, and
thus. implicitly, maintained a fixed rate of exchange against every other major
country's currency. Financiai interests ruled the world of the classical gold
standard and financiai orthodoxy saw no alternative mode of sound finance. 4
Latin American interludes of floating exchange rates were viewed from the
main financiai centers with "fascinated disgust," to use the words of Bacha and
Dlaz Alejandro (1982). Thus the gold standard system met the trilemma by
opting for fixed exchange rates and capital mobility, sometimes at the expense
of domestic macroeconomic health. Between 1891 and 1897, for example, the
United States Treasury put the country through a harsh deflation in the face
of persistent speculation on the dollar's departure from gold. These policies
were hotly debated; the Populist movement agitated forcefully against gold, but
lost. The balance of political power began to change only with the First World
War, which brought a sea-change in the social contract underlying the industrial
democracies. Organized labor emerged as a political power, a counterweight
to the interests of capital 5
Although Britain's return to gold in 1925 led the way to a restored interna-
tional gold standard and a limited resurgence of international finance, the system
helped propagate a worldwide depression after the 1929 New York stock mar-
ket crash. Following (and in some cases anticipating) Britain's example, many
countnes abandoned the gold standard in the early 1930s and depreciated their
currencies: many also resorted to trade and capital controls in order to manage
independently their exchange rates and domestic policies. Those countries in
the "gold bloc," which stubbornly clung to gold through the mid-1930s, showed
the steepest output and price-Ievel declines. But eventually in the 1930s, ali
countries jettisoned rigid exchange-rate targets and or open capital markets in
favor of domes ti c macroeconomic goals. 6
Thcse decisions reflected the shift in political power solidified by the First
World \Var. They also signaled the beginnings of a new consensus on the role of
economic policy that would endure through the inflationary 1970s. As an im-
mediate consequence. howevcr. the Great Depression discredited gold-standard
orthodoxy and brought Keynesian ideas about macroeconomic management to
the fore. It also made financiai markets and financiai practitioners unpopular.
Their supposcd ex cesses and attachment to gold became identified in the public
mind as causes of the economic calamity. In the United States. the New Deal
brought a Jacksonian hostility toward eastern (read: New York) high finance
back to Washington. Financiai products and markets were banned or more
.1See Bordo and Schwartz (198.1): Eichengreen (1996).

~.See Temm ( 1989)
6 See Temm ( 1989): Eichengreen (1992)
38 Globalization in Capital Markets: The Long-Run Evidence
closely regulated, and the Federal Reserve was brought under heavier Treasury
influence. Similar reactions occurred in other countries.
Changed attitudes toward financiai activities and economic management un-
derlay the new postwar economic order negotiated at Bretton Woods, New
Hampshire, in July 1944. Forty-four allied countries set up a system based
on fixed, but adjustable, exchange parities, in the belief that floating exchange
rates would exhibit instability and damage international trade. At the center
of the system was the International Monetary Fund (IMF). The IMF's prime
function was as a source of hard-currency loans to governments that might oth-
erwise have to put their economies into recession to maintain a fixed exchange
rate. Countries experiencing pennanent balance-of-payments problems had the
option of realigning their currencies, subject to IMF approval. 7
Importantly, the IMF's founders viewed its lending capability as primarily a
substitute for, not a complement to, private capital inflows. Interwar experience
had given the latter a reputation as unreliable at best and, at worst, a dangerous
source of disturbances. Encompassing controls over private capital movement,
perfected in wartime, were expected to continue. The IMF's Articles of Agree-
ment explicitly empowered countries to impose new capital controls. Article
VIII of the IMF agreement did demand that countries' currencies eventually be
made convertible - in effect. freely saleable to the issuing central bank, at the of-
ncial exchange parity, for dollars or gold. But this privilege was to be extended
only to ;;:nresidents (not a country's own citizens), and only if the country's
currency had been earned either through merchandise sales or as à return on
past lending. Convertibility on capital account, as opposed to current-account
convertibility, was not viewed as mandatory or desirable.
Unfortunately, a wide extent even of current-account convertibility took many
years to achieve. In the interim, countries resorted to bilateral trade deals
that required balanced or nearly balanced trade between every pair of trading
partners. IfFrance had an export surplus with Britain, and Britain a surplus with
Germany, Britain could not use its excess marks to obtain dollars with which
to pay France. Germany had very few dollars and guarded them jealously for
criticai imports from the Americas. Instead, each country would try to divert
import demand toward countries with high demand for its goods, and to direct
its exports toward countries whose goods were favored domestically.
Convertibility gridlock in Europe and its dependencies was ended through
a regional multilateral clearing scheme, the European Payments Union (EPU).
The clearing scheme was set up in 1950 and some countries reached de facto
7. On lhe Brelton Woods syslem. see Bordo and Eichengreen (1993).

2.2 Overv/ew 39
convertibility by mid-decade. But it was not until December 27, 1958 that
Europe officially embraced convertibility and ended the EPU.
Although most European countries still chose to retain extensive capital con-
trols (Germany being the main exception), the retum to convertibility, important
as it was in promoting multilateral trade growth, also increased the opportuni-
ties for disguised capital movements. These might take the form, for example,
of misinvoicing and accelerated or delayed merchandise payments. Buoyant
growth encouraged some countries in further financialliberalization, although
the U.s.. worried about its gold losses, raised progressively higher barriers
to capital outftow over the 1960s. Eventually, the Bretton Woods system 's
very successes hastened its collapse by resurrecting the "inconsistent trinity"
or tr/lemma.
Key countries in the system, notably the U.S. (fearful of slower growth) and
Germany (fearful of higher inftation), proved unwilling to accept the domestic
policy implications of maintaining fixed rates. Even the limited capital mobility
of the early 1970s proved sufficient to allow furious speculative attacks on the
major currencies, and after vain attempts to restore fixed dollar exchange rates,
the industrial countries retreated to ftoating rates early in 1973. Although
viewed at the time as a temporary emergency measure, the ftoating-dollar-rate
regime is still with us a quarter-century on.
Floating exchange rates have allowed the explosion in intemational financiai
markets experienced over that same quarter-century. Freed from one element
of the trilemma - fixed exchange rates - countries have been able to open their
capital markets while still retaining the ftexibility to deploy monetary policy in
pursuit of national objectives. 8
There are several valid reasons for countries to fix their exchange rates -
for example. to keep a better lid on inflation or to counter exchange-rate insta-
bility due to financial-market shocks. However, few countries that have tried
have succeeded for long; eventually, exchange-rate stability tends to come into
conflict with other policy objectives. the capital markets catch on to the gov-
ernment's predicament. and a crisis adds enough economic pain to make the
authorities give in. In recent years only a very few major countries have ob-
served the discipline of fixed exchange rates for at least five years, and most
of those were rather special cases. 9 One puzzling case, Thailand, has dropped
off the list - with a resounding crash. Even Hong Kong, which operates as a
8. Aksma. Grilli. and ~ilesi-Ferreni (1994) and Grilli and Milesi-Ferreni (1995) report on panel
studles of the incidence of capital controls (for 20 industrial countries over the years 1950 to
1989. and for 61 industrial and developing countries over the years 1966 to 1989). They find that
more tlexible exchange rate regimes and greater central bank independence lower the probability
of capnal controls.
9 See Obstfeld and Rogoff (1995).
40 Globalization in Capital Markets: The Long-Run Evidenee
currency board supposedly subordinated to maintaining the Hong Kong-U.S.

dollar peg, suffered repeated speculative attacks in 1997. Another currency-
board country, Argentina, has now held to its 1: 1 dollar exchange rate since
April 1991, and so joins the exclusive five-year club. To accomplish this feat,
the country has relied on IMF credit and has suffered unemployment higher
than many countries could tolerate. The European Union members that have
, maintained mutually fixed rates have been aided by market confidence in their
own planned solution to the trilemma, a full currency merger due to be con-
summated in J anuary 1999. The trend toward greater financiai openness has
been accompanied - inevitably, we would argue - by a declining reliance on
pegged exchange rates in favor of greater exchange rate flexibility.
In short, the limitations that open capital markets place on exchange rates
and monetary policy are summed up by the idea of the "inconsistent trinity" or,
as we term it, the maeroeeonomie poliey trilemma: a country cannot simultane-
ously maintain fixed exchange rates and an open capital market while pursuing
a monetary policy oriented toward domestic goals. Governments may choose
only two of the above. If, monetary policy is geared toward domestic consid-
erations, capital mobility or the exchange-rate target must go. If instead, fixed
exchange rates and integration into the global capital market are the primary
desiderata, monetary policy must be entirely subjugated to those ends.
The details of this argument form the core of this book, based on empirical
evidence and the historical r~cord, but we can already pinpoint lhe ke:' turning
points (see Table 2.1). The Great Depression stands as the watershed here,
in that it was caused by an ill-advised subordination of monetary policy to an
exchange-rate constraint (the gold standard), which led to a chaotic time of
troubles in which countries experimented, typically noncooperatively, with al-
ternative modes of addressing the fundamental trilemma. Interwar experience,
in turn, discredited the gold standard and led to a new and fairly universal policy
consensus. The new consensus shaped the more cooperative postwar interna-
tional economic order fashioned by Harry Dexter White and John Maynard
Keynes. but also implanted within that order the seeds of its own eventual de-
struction a quarter-century bter. The global financiai nexus that evolved since
is based on a solution to the basic open-economy trilemma quite different than
that envisioned by Keynes or White - one that allows considerable freedom
for capital movements, gives the major currency areas freedom to pursue in-
ternai goals, but largely leaves their mutual exchange rates as the equilibrating
residual.
2.3 QlIantiry Criteria 41
Table 2.1. The Trilemma and Major Phases of Capital Mobility

Resolutlon of tnlemma -
Countries choose to sacrifice:
Activist Capital Fixed
Era Eolicies mobilitv exchange rate Notes
Gold standard Most Rare Rare Broad consensus.

(crises) •
lnterv.·ar Rare Several Most Capital controls esp. in
(when off goldl C. Europe. La!. America.
Bretton Woods None(O) Most Rare Broad consensus.

(crisies)
Float Rare Gening Gening Some consensus; except

to be rare to be common currency boards. others.
2.3 Quantity Criteria
This section employs data on the stocks and ftows of capital between coun-
tries. that is. quantity data. to examine how the extent of capital mobility has
changcd o\'cr the last hundred or so years. We begin by looking at long-term
capital mobility. and we first discuss the size of foreign investment stocks and
flows. Ceteris pariblls. a greater degree of capital mobility should lead to larger
tlows ando with cumulation over time, larger stocks of foreign investment. We
then relate the size of ftows to saving and investment pattems, to see to what
extent the externaI ftows mattered in terms of the overalI composition of saving
and in\cstment. \Ve next consider the saving-investment correlation. an oft-
employed test that asks whether saving and investment activities lean toward
being dc-Ilnked. as in a theoretically open economy, or tend in the direction of
equallty. as in a closed economy.
2.3.1 The Stocks of Foreign Capital

In this section we examine the extant data on foreign capital stocks to get some
sense of the evolution of the global market. AIthough the concept is simple, the
measurement is not. Perhaps the simplest measure of the activity in the global
capital market is obtained by looking at the total stock of overseas investment at
a point In time. Suppose that the total asset stock in country or region i, owned
by country or region j, at time tis Aij/' lncluded in here is the domestically-
, '.
42 Globali:.atioll in Capital Markets: The Long-Rull Evidence
owned capital stock Aiit. Of interest are two concepts: what share of lhe total
assets of country j are held overseas? and what share ofthe Iiabilities of country
i are held overseas? Essentially, we are interested in the measures
ForeignAssetsShareit = LAjir!LAjit; (2.1 )

j#1 j
Foreign Liabilities Shareit LAijr!LAijt. (2.2)
j#i j
Note that here we are concerned with net wealth and asset measures, since
we want to identify the extent to which the net wealth of a country is held in its
own versus others' portfolios. There is, then, a complication to our measures,
since, over the long-run timescales we are dealing with, there has been a vast
multiplication in the ratio oftotal assets to net weath and total assets to GDP. This
is because financiai development, and the increasing sophistication of national
capital markets, has allowed the capital stock of each economy to be packaged
and repackaged in various asset bundles, which may be held by a chain of
assets and Iiabilities in various financiai intennediaries between the physical
asset itself and the ultimate net wealth owner. At the international levei, we
also need to keep the net wealth question in perspective, but the problem is
somewhat simpler in the sense that ali net foreign claims are true net c1aims on
a natIonal economy: should ali creditors show up demanding paymenl, lhen,
even after a country Iiquidates its own foreign holdings, it will still need to hand
over an amount of its own net wealth equal to the net c1aim. In that sense, net
foreign Iiabilities represent a claim on an economy's net wealth. Thus, in ali
that follows we must be careful to keep this distinction in mind. 10
A relatively easy hurdle to surmount concerns nonnalization of the data;
foreign investment stocks are commonly measured at a point in time in current
nominal terms, in most cases U.S. dollars. Obviously, both the growth of the
national and international economies might be associated with an increase in
such a nominal quantity, as would any long run inflation. These trends would
have nothing to do with market integration per se. To overcome this problem,
we elected to normalize foreign capital at each point in time by some measure
of the size of the world economy, dividing through by a nominal size indexo
The ideal denominator. given that the numerator is the stock of foreign-
owned capital, would probably be the total stock of capital. However, construct-
ing long-run time-series for national capital stocks is fraught with difficulty. 11
10. For cross-country evidence on the evolution of financia! assets as a fraction of output see Gold-
smith (1985).
II Only a few countries have reliable data from which to estimate capita! stocks. Most of these
2.3 Quantity Criteria 43
Given these problems we chose a simpler and more readily available measure
of the size of an economy, namely the levei of output Y measured in current
prices in a common currency unit. 12 Over short horizons, unless the capital-
output ratio were to move dramatically, the ratio of foreign capital to output
should be adequate as a proxy measure of the penetration of foreign capital in
any economy. Over the long run, difficulties might arise if the capital-output
ratio has changed significantly over time - but we have little firm evidence to
suggest that it has. 13 Thus. our analysis focuses on capital-to-GDP ratios of
the form
Foreign Assets-to-GDP Rati0 it L Ajir/Yit ; (2.3)

Ui
Foreign Liabilities-to-GDP Rati0 it L Aijr/Yi!. (2.4)
Ui
A still irksome empirical problem, however, arises for the numerator. It is

in fact very difficult to discover the extent of foreign capital in an economy
using both contemporary and historical data. For example, the IMF has always
reported balance-of-payments ftow transactions in its lnternationai Financiai
Statistics. It is straightforward for most of the recent postwar period to discover
the annual flows of equity, debt, or other forms of capital account transactions
fram these accounts. Conversely, it was only in 1997 that the IMF began
reporting the corresponding stock data, namely, the international investment
position of each country. This data is also more sparse, beginning in 1980 for
less than a dozen countries. and expanding to about 30 countries by the mid-
estlmates are accurate only at benchmark censuses. and in between census dates they rely on
comblnations of interpolation and estimation based on investment fiow data and depreciation
assumpttons. Most ofthese esttmares are calculared in real (constanr price) rather than nominal
(current pnce) rerrns. which makes them incommensurate with the nominally measured foreign
caflital data. At the end of the day. we would be unlikely to find more than a handful of countries
for whlch thls technique would be feasible for the entire twentierh century. and certainly nothing
lik.: global coverage would be posslble even for recent years.
12 For the GDP data we rely on Maddison's (1995) constant price 1990 U.S. dollar estimares of
output for the period from 1820. These figures are then "reflared" using a U.S. price deflator to
obtaln estimates of nominal USo dollar "World" GDP at each benchmark date. This approach is
crude. stnce. in particular. it relies on a PPP assumption. Ideally we would want historical series
on nominal GDP and exchange rates. to estimate a common (U.Sdollar) GDP figure at various
hlstoncal dates. This is possible for a small sample of countries. notably the main creditor
nattons In the disrant pasr; it is also possible for the last few decades for almost alI countries.
\Ve follow this route when applying our method to a smaller sample group of countries.
13 But for exactly the reasons just mentioned. since we have no capital stock data for many countries.
it is hard to forrn a sample of capital-output ratios to see how these differ across time and space.
What IS typlcally the case. and the working assumptton for most studies. is that the capital-
output ranges from 3 to 4 for most countries. both developed and developing. [Literature on
capltal-output ratios.]
1990s. The paucity of data is understandable, since the collection burden for
this data is much more significant: knowing the size of a bond issue in a single
year reveals the tlow transaction size; knowing the implications for future stocks
requires, for example, tracking each debt and equity item, and its tluctuating
market value over time, and maintaining an aggregate of these data. The stock
data is not simply a temporal aggregate of fiows: the stock value depends on
past tlows, capital gains and losses, and any retirements ofprincipal or buybacks
of equity, and a host of other factors. Not surprisingly this kind of data is hard
to collect and rarely seen. Just as the IMF has had difficulty assembling this
data, so toa have economic historians. Looking back over the nineteenth and
twentieth centuries an exhaustive search across many different sources yields
only a handful of benchmark years in which estimates have been made, an
effort that draws on the work of dozens of scholars in official institutions and
numerous other individual efforts. 14 It is based on these efforts that we can put
together a fragmentary, but still potentially illuminating, historical description
in Table 2.2 and Figure 2. I. Displayed here are nominal foreign investment
and output data for major countries and regions, grouped according to assets
and Iiabilities. Many cells are empty because data is unavailable, but where
possible summary data have been derived to illustrate the ratio of foreign capital
to output, and the share of various countries in foreign investment activity.
What do the data show? On the asset side it is immediately apparent that
for alI of the nineteenth century, and until the intcrwar period, the British werc
rightly terrned the'bankers to the worId"; at its peak, the British share of total
glob::d foreign investment was almost 80 perccnt. This is far above the current
U.S. share of global foreign assets, a mere 24 percent in 1995, and still higher
than the maximum U.S. share of 50 percent circa 1960. The only rivais to the
British in the early nineteenth century were the Dutch, who according to these
figures held perhaps 30 percent of global assets in 1825. This comes as no
surprise given what we know of Amsterdam's early preeminence as the first
global financiai center before London 's rise to dominance in the eighteenth and
nineteenth centuries. IS By the late nineteenth century both Paris and Berlin had
also emerged as major financiaI centers, and, as their own economies grew and
industrialized. French and German holdings offoreign capital rose significantly,
each ecIipsing the Dutch position. In this era the United States was a debtor
rather than a creditor nation, and was only starting to emerge as a major lender
and foreign asset holder after 1900. European borrowing from the United States
in WorId War One then suddenly made the United States a big creditor. This
14. See. for example. Paish (19xx), Staley (19xx), Woodruff (19xx), and Twomey (19xx).
15. Indeed, the Amsterdam market was an important source of externai finance for Britain during
the Industrial Revolution. See chapter I.
Table 2.2. Foreign Capital Stocks

1825 1855 1870 1900 1914 1930 1938 1945
Assers
Umted Kingdom 0.5a 0.7a 4.9a 12.la 19.5a 18.23 22.ge 14.23
Franee O.la 2.5a 5.2a 8.6a 3.5a 3.ge
Germany 4.8a 6.7a l.la 0.7e
Netherlands 0.3a 0.2a O.3a l.la l.2a 2.3a 4.8e 3.7a
United States O.Oa O.Oa O.Oa O.5a 2.5a 14.7a 11.5e 15.3a
Canada O.la 0.2a 1.3 a l.ge
Japan l.2e
Other Europe 4.6c
Other 6.0c 2.0a
Ali 0.9a 0.9a 7.7a 23.8a 38.7a 4 1.1 a 52.8e 35.13
World GDP Illb 128b 221b 491b 491b 722b

Sample GDP 43f 76f 149f 182f 273f
Sample slze 7f 7f 7f 7f 7f
Assets/Sample GDP 0.55 0.51 0.28 0.26 0.12

Assets/World GDP 0.07 0.19 0.18 0.08 0.11 0.05
UKJAII 0.56 0.78 0.64 0.51 0.50 0.44 0.43 0.40

CS/AII 0.00 000 0.00 0.02 0.06 0.36 0.22 0.43
Lwbilules
Europe 5.4a 12.0a 10.3a
North Amenca 2.6a I !.la 13.7a
Oceanla l.6a 2.3a 4.5a
LatIn Amen~a 2.9g 8.9g l1.3g
ASla lexd. Japan) 2.4g 6.8g 10.6g
Afn.:a 3.0g 4.lg 4.0g
Developlng Countries 6.0g 13.0g 25.9g
Ali 17.9a 45.5a 55.0a
World GDP Illb 128b 221b 491b 491b 722b
Sampk GDP
Sampk slze
LiabIlIlles/Sample GDP
LiabIlltIes/World GDP 0.14 0.21 0.11
Developlng Counuies/AII 0.34 0.29 0.47
--.-':"--:~.-, ...--
Table 2.2. (Continued)
1960 1971 1980 1985 1990 1995
AsseIS
United Kingdom 26.4a 551d 857d l.757d 2 ..~89d
Franee 736d 1.105d
Germany 1.2a 257d 342d 1.I00d 1.672d
Netherlands 27.6a 178d 418d
United States 63.6a 775d 1.296d 2.178d 3,353d
, Canada 129d 227d 302d
Japan 160d 437d 1.858d 2.725d
Other Europe
Other 5.9a
All 124.7a 1.963d 4.025d 10.321d 14.25ld
World GDP 1.942b 4.733b 11.118e 12.455e 21.141e 25.llOe

SampleGDP 67lf 5.922d 8.873d 17.584d 21.479d
Sample size 7f 10d 19d 28d 29d
AssetslSample GDP 0.18 0.29 0.37 0.47 0.54

Assets!World GDP 0.06 0.18 0.32 0.49 0.57
UKlAIl 0.21 0.28 0.21 0.17 0.17

US/AIl 0.51 0.39 0.32 0.21 0.24
Liabilitles
Europe 7.6a
N orth Ameriea 12.5a
Oeeania 2.2a
Latin Ameriea 9.2a 5~G 250g 505g 768g
'",
Asia lexel. Japan) 2.7a 29g 129g 524g 960g

Afriea 2.23 199 124g 306g 353g
Developing Countries 14.la 107g 506g 1.338g 2.086g
All 39.9a 1.569d 3.685d 10.311d 1".735d
World GDP 1.942b 4.733b 11.118e 12.455e 21.141e 25.11Oe

Sample GDP 5.922d 8.873d 17.584d 21.479d
Sample size 10d 19d 28d 29d
Liabilities/Sample GDP 0.26 0.42 0.59 0.69

Liabilities/World GDP 0.02 0.14 0.30 0.49 0.59
Developing Countries/All 0.35 0.32 013 0.14

Notes and Sources:
VOlts for foreign investment and GDP are billions of eurrent U.S. dollars.
a =from Woodruff(1967. 150-159).
b =from t\laddlson (1995): sample of 199 eountries: 1990 US dollars converted to
eurrent dollars using US GDP deflator: some interpolation.
e =from Lewis (1945. 292-97).
d =from lFS (9/97). Maximum 40 eountry sample 1980-1997. Sample size varies.
e =from World Bank (1994).
f =excludes "Other Europe" and "Other": GDP data from appendix.
g =from Twomey (1998: unEublished worksheets).
.,-,
".
1.0
-<>-- AsselS/Sample GDP
0.9 • AsselS/World GDP
- - - - UK share of ali asseIS
0.8 ~
'" , ,
- - - - - - US share of ali assets
/
0.7 ~
/
/
0.6 - /
/
0.5 ~
0.4 ~
0.3 -
0.2 -
0.1
0.0 -------~~=--=--:=-----------------
1820 1840 1860 1880 1900 1920 1940 1960 1980 2000
1.0
-<>-- Liabilities/Sample GDP
0.9 ~ • Liabilities/World GDP
- - - - LDC share of allliabilities
0.8
0./
06
0.5
"'-
OA / "-
/ "-
...... / '-
0:1 ...... /
02
\....-
0.1
00
IS20 18.\0 1860 1880 1900 1920 1940 1960 1980 2000
Fig. 2.1. Foreign capital stocks
:;
, ." -,.,'
48 Globa/ization in Capital Markets: The Long-Run Evidence
carne at a time when she was ready, if not altogether willing, to assume the
mantle of "banker to the world," following Britain 's abdication of this position
under the burden of war and recovery in the 1910s and 1920s.1 6 But the
dislocations of the interwar years were to postpone the United States' nse
as a foreign creditor, and New York's pivotal role as a financiai center. After
1945, however, the United States decisively surpassed Britain as the major
international asset holder, a position that has never been challenged. 17
How big were nineteenth century holdings of foreign assets? In 1870 we
estimate that foreign assets were just 7 percent of World GDP; but this figure
rose quickly, to just under 20 percent in the years 1900-14 at the zenith of the
classical gold standard. During the interwar penod, the collapse was swift,
and foreign assets were only 8 percent of world output by 1930, 11 percent in
1938, and just 5 percent in 1945. Since this low point, the ratio has climbed,
to 6 percent in 1960, 18 percent in 1980, and then climbing drarnatically to
57 percent in 1995. Thus, the 1900-14 ratio of foreign investment to output
in the world economy was not equaled again until 1980, but has now been
approximately doubled. 18
An alternative measure recognizes the incompleteness of the data sources:
for many countries we have no information on foreign investments at ali, so
a zero has been placed in the numerator, although that country 's output has
been included in the denominator as part of the World GDP estimate. This
is an unfortunate aspect of our estirr.:!t;:::;) procedure, and makcs ~he above
ratio a likely an underestimate, or lower bound, for the true ratio of foreign
assets to output. One way to correct this is to only include in the denominator
the countries for which we actually have data on foreign investment in the
numerator. 19 This procedure yields an estimate we term the ratio of foreign
16. This Anglo-American transfer of hegemonic power is discussed by Kindleberger (1986).

17. or course. lhis is lhe gross foreign inveslmenl position. nOllhe nel position. The Uniled Slales
is also now lhe world's number one debtor nalion. in bOI h gross and net lerms. She holds more
liabililies lhan any olher country. ando since the early 19805, has been. on neto a debtor country.
18. However. even lhen we cannOl necessarily infer lhallhere has been an increase in foreign asseI
ownership relalive 10 10lal asseIS. since lhe asseI 10 GDP ralio has risen across lhe twentielh
century wilh financial developmenl (see Goldsmilh 1985). This is nOl a problem if we view ali
foreign asseIs as "outside" - bUl allhough lhat mighl be reasonable for lhe nineleenth century. il
mighl nOl be 50 reasonable now. In lhe pasl. mOSl assel-liabilily posilions were one way aI lhe
national levei (examp!e: Brilain circa 1900). bUlloday lhe nel ftows are much less lhan lhe gross
ftows (example: mOSl OECD countries loday). Hence. nOl ali foreign asseIs may be "outside"
and 50 the multiplicalion of asseIs can be an issue lhal introduces biases even aI lhis levei - as
when. say, a domeslic asseI is held overseas by an instilution lhal is in lum held by domestic
investors. Given lhe macroeconomic aggregale dala we are dealing with here. however. lhe
resolulion of lhis kind of dala problem seems impractical.
19. Thal sample of countries is much less lhan lhe entire world. as we have nOled. Unlil 1960. il
inc1udes only lhe seven major credilor countries nOled in Table 2.2; after 1980. we rely on lhe
IMF sample from which we can identify 10. rising to 30. countries wilh foreign investment and
GDP dala.
assets to sample GDP. This is likely an overestimate, or upper bound, for the
true ratio, largely because in historical data, if not in contemporary sources,
attention in the collection of foreign investment data has usually focused on
the principal players, that is, the countries which have significant foreign asset
holdings. 20 Given ali these concerns, does the ratio to sample GDP evolve in a
very different way? No. It is, as expected, higher at most points, except 1985.
The two ratios are very dose after 1980. But before 1945 they are quite far apart:
from 1870 to 1914, the sample of seven countries has a foreign asset to GDP
ratio of over 50 percent, far above the world figure of7 to 20 percent. Clearly,
these seven major creditors were exceptionally internationally diversified in
the late nineteenth century in a way that no group of countries is today. By
this reckoning, in countries like today's United States, we still have yet to see
a return to the extremely high degree of international portfolio diversification
seen in, sal'. Britain in the 1900-14 period, a historical finding that sheds light
on the ongoing international diversification puzzle. 21
Is the picture similar for liabilities as well as assets? Essentially, yes. The
data is much more fragmentary here, with none in the nineteenth century, when
the inforrnation for the key creditor nations was simpler to collect than data
for a multitude of debtors, perhaps. Even so, we have some estimates running
from 1900 to the present at a few key dates. The ratio of liabilities to World
GDP follows a path very much like that of the asset ratio, which is reassuring:
thel' are each approximations built from different data sources at certain time
points. though, in principie, they should be equal. Again, the ratio reaches a
local maximum in 1914 of 21 percent, collapsing in the interwar period to 11
percent in 1938, andjust 2 percent in 1960. By 1980 the ratio had risen to 14
percent. and by 1985 it had exceeded the 1914 levei and stood at 30 percent.
By 1995, the ratio was 59 percent.
Finally, what about the distinction between net and gross stocks? A cursory
glancc at the data reveals that this problem is very serious in recent decades,
but relatively unimportant in the pre-1914 era of globalization. The reason is
simple: in the late nineteenth century the principal ftows were long-terrn in-
vestment capital, and virtually unidirectional at that. The key creditor nations,
20 Th~t 15. we are probably restricted in these samples to eountries with individually high ratios of
forelgn assets to GOP. For example. in the rest ofEurope eirea 1914. we would be unlikely to
find countries with portfolios as diversified intemationally as the British. French. Germans. and
Outch. If we included those other eountries it would probably bring our estimated ratio down.
Howc'er. In the 19805 and 1990s IMF data the problem is much less severe sinee we observe
m~ny more countries. and both large and small asset holders. Sample selection might not be as
biased in thls data set: for example. one of the biggest foreign investors in 1990 is France. but
French data IS unavailable for most of lhe 1980s. This is interesting because it is only at the
1985 benchmark that this ratio to sample GOP is below the ratio to "World GOP."
21 On the intemational dlversification puzzle see K. K. Lewis (1996)
50 Globali:ation in Capital Markets: The Long-Run Evidence
principally Britain, but also France and Gennany, engaged in the financing of
other countries' capital accumulation, and in doing so, developed enonnous
one-way positions in their portfolios. For example, circa 1914 the scale of Ar-
gentine assets in Britain 's portfolio was very large, but the converse holding of
British assets by Argentine 's was trivial by comparsion. Thus, the nineteenth
century was an era of one-way asset shifts, leading to great portfolio diversifi-
cation by the principal creditor/outftow nations like Britain, but relatively little
diversification by the debtor/inftow nations. To a first approximation, the gross
asset and liability positions were very c10se to net in that distant era. The 1980s
and 1990s are obviously very different: for example, the United States became
in this period the world's largest net debtor nation. But whilst accounting for
the biggest national stock of gross foreign liabilities, the United States also held
the largest stock of gross foreign assets.
Thus, our discussion of the stock data, and our inferences conceming the
recovery of foreign asset and liabilities in the world economy after 1980 needs
considerable modification to take into account this problem. And, indeed, it is
a significant problem for ali of the countries concemed: the rank of countries
by foreign assets in the IMF sample, is very highly correlated with the rank by
foreign liabilites. Countries such as Britain, Japan, Canada, Germany, and the
Netherlands are ali big holders of both foreign assets and liabilities. Strikingly,
when we net out the data. the result is that, since 1980, there has been virtually
/lO change in the net foreign asset position (or liability) position in the wcdd
economy, as inàicatcd by Figure 2.2. Thus, for ali the suggestion that we have
retumed to the pre-1914 type of global capital market, here is one major qualita-
tive difference between then and now. Today's foreign asset distribution is much
more about asset swapping by countries, than about the accumulation of large
one-way positions. It is therefore more about hedging, portfolio diversifcation,
and risk sharing than it is about long-term finance and the mediation of saving
supply and investment demand between countries. In the latter sense, we have
never come c10se to recapturing the heady times of the pre-1914 era, when a
creditor like Britain could persist for years in satisfying half of its accumulation
of assets with foreign capital, or a debtor like Argentina could simlarly go on
for years generating liabilities of which one half were taken up by foreigners.
Instead. still to a very great extent today, a country's net wealth will depend, for
accumulation, on the pravision of financing from domestic rather than foreign
sources. and issue we will shortly take up again in the discussion of long-run
trends in capital ftows.
An interesting, and c10sely related, insight also follows fram looking at the
share of less-developed countries (LDCs) in global liabilities. This is now at
an ali time low. In 1900. LDCs in Asia. Latin America, and Africa accounted
08~-------------------------------------------------------
~ Assets/Sample GDP
07; ---o- LiabilitieslSample GDP
I _ Assets/World GDP
___ LiabilitiesIWorld GDP
_ Net Assets/World GDP
06; _ _ _ Net Liabilities/World GDP
05 .
o' .
o:. '
02 j
OI •
.... .. -- • • • • •
00-------------------------------------------------------
IQ!l5 1900
• • • • ~
109\
I
Fig. 2.2. Foreign capital stocks
for 34 percent of global Iiabilities. The global capital market of the nineteenth
century centered on Europe, especially London, extended relatively more credit
to LDCs than does today's global capital market. Is this surprising? There are
various interpretations for this observation. One is that capital markets are
biased now, or were biased in the past; for example, did Britain, as an imperial
power. favor LDCs within her orbit with finance? or, today, does the global
capital market fail in the sense that there are insufficient capital flows to LDCs,
and an excess of flows among developed countries (DCs)? These are hard
c1aims to prove, as market failure could be a cause, as could a host of other
factors including institutions and policies affecting the marginal product of
capital in different 10cations. 22 Of course, this resultjust follows from the fact
that many of the top asset holders also figure in the top Iiability holders, and
most of them are developed OECD countries. A rival explanation for the recent
fali in the LDC share of liabilities, and the rise of DC Iiabilities, could be just
a move toward greater - c10ser to optima!? - global portfolio diversification,
22. See Lucas ( 1990).

and we might see this as an efficient rebalancing given the large weight that DC
capital has in the global capital stock.
Figuring whether toa much or toa little diversification existed at any point
must remain conjecturai, and conclusions would hinge on a calibrated and
estimated portfolio model applied historically. This is certainly an object for
future research. However, unless the global economy has dramatically changed
in terms of the risk-return profile of assets and their global distribution, we have
no prior reason to expect the efficient degree of diversification to have changed.
For the present we can just say that, unless a massive such change did occur in
the 1914-45 period, and unless ir was then promptly reversed in the 1945-90
period, we cannot explain the time path of foreign capital stocks seen in Table
2.2 and Figures 2.1 and 2.2 except as a result of a dramatic decline in capital
mobility in the interwar period, and a very slow recovery of capital mobility
thereafter.
2.3.2 The Size of Flows

In contrast to the previous discussion of stocks, this section now attempts an
analogous historical survey of global foreign investment ftows since the late
nineteenth century. 23 The stock data suggested a amrked diminution of foreign
investment activity in the middle of the twentieth century, with recovery to the
1900--14 leveis only seen as recently as the 1980s and 1980s. Can the fiow data
detect a similar historical evolution?
Some basic definitions and notation will now prove useful. To simplify, we
may define gross domestic product Q as the sum of goods produced, which, with
imports M, may be allocated to private consumption C, public consumption G,
investment 1, or export X, so that Q + M = C + 1 + G + X. Rearranging,
GDP is given by
GDP == Q = C + I + G + NX, (2.5)
\vhere N X = X - M is net exports. If the country's net credit (debt) position

vis-a-vis the rest of the world is B (-B), and these claims (debts) earn (pay)
interest at a world interest rate r, then gross national product is GDP plus
(minus) this net factor income from (to) the rest of the world,
GNP == Y = Q + rB = C + I + G + NX + rB. (2.6)

It is then simple to show that the net balance on the current account is
CA == N X + r B = (Y - C - G) - 1 = S - 1, (2.7)
23. The next!Wo sections draw heavily on A. M. Taylor (1998).
where 5 == Y - C - G is gross national saving. Finally, the dynamic structure

of the current account and the credit position is given by the equality of the
current account surplus (C A) and the capital account deficit (- K A), so that
t::,.B I = BI - BI_I == CAI = -K AI' (2.8)
This section, and some that follow, will focus on the patterns of saving (5),
investment (I), and the current account (C A) as defined above. The basic
identity (2.7), C A = 5 - I, is central to the analysis. In terrns of historical
data collection, it proves essential to utilize the identity to measure saving
residually, as 5 = 1 + C A. because no national accounts before the 1940s
supply independent saving estimates; rather, we have access only to investrnent
and current-account data.
A sense of the changing patterns of international financiai ftows can be
gleaned by examining their trends and cycles. However, a norrnalization is
again needed. Measurement traditionally focuses on the size of the current
account balance C A, equal to net foreign investment, as a fraction of national
income Y. Thus (C A / n/I becomes the variable of interest, for country i in
period t. a convention we follow here. Table 2.3 and Figure 2.3 present some
basic trends in foreign capital ftows. We measures the extent of capital ftows
with the mean absolute value I'lICA/Yi.I' The average size of capital ftows in
this sample was often as high as 4 to 5 percent of national income before World
\Var I. At its first peak it reached 5.1 percent in the overseas investment boom
of the late 1880s. This fell to around 3 percent in the depression of the 1890s.
The figure approached 4 percent again in 1905-14, and wartime lending pushed
the figure over 6 percent in 1915-19. Flows diminished in size in the 1920s,
however. and international capital ftows were less than 2 percent of national
in come in the late 1930s. Again. wartime loans raised the figure in the 1940s,
but in the 19505 and 1960s, the sizc of international capital ftows in this sample
declincd to an ali time low. around 1.3 percent of national income. Only in the
late 19705 and 1980s have ftows increased. though not to leveis comparable to
those of a century ag0 24
Indl\idual country data supply some detail to fill in this general picture. Some
countries were clearly very dependent on foreign capital inftows before 1914,
including the well-known cases of the settler economies, Argentina, Australia,
and Canada. ~lany of these countries had typical capital inftows in excess of
5 percent of GDP, and in some years in excess of 10 percent. The Argentine
figure beforc 1890 is inaccurate and surely an overstatement, as it derives from
24 The open c"eles in Figure 2.3 (and later figures) denote gaps in data coverage due to the two
world wars. The cireles' positlons are determined by the incomplete sample of countJies for
whlch data are available.
Table 2.3. Si::.e of Capital Flows: Average Absolute Value of CA/Y, By

Country, Selected Periods, Annual Data
ARe AOS i:AN IJ1'lK t:11'l t:RA IJEO IrA
1870-1889 .187 .097 .072 .018 .062 .029 .019 .012
1890-1913 .062 .063 .076 .027 .059 .023 .014 .019
1914-1918 .027 .076 .035 .054 .142 .031 .117
1919-1926 .049 .088 .023 .012 .039 .117 .022 .043
1927-1931 .037 .128 .036 .007 .029 .037 .018 .015
1932-1939 .016 .037 .016 .008 .029 .025 .004 .007
1940-1946 .048 .071 .065 .024 .069 .018 .034
1947-1959 .031 .034 .023 .014 .014 .015 .020 .014
1960-1973 .010 .023 .012 .019 .017 .006 .010 .021
1974-1989 .019 .036 .017 .032 .024 .008 .021 .013
1989-1996 .020 .045 .040 .018 .051 .007 .027 .016
lPN NLD NOR ESP SWE GBR USA AlI
1870-1889 .005 .060 .016 .010 .031 .045 .015 .040
1890-1913 .022 .053 .041 .014 .023 .045 .008 .037
1914-1918 .066 .043 .033 .063 .029 .035 .058
1919-1926 .021 .069 .027 .020 .029 .017 .039
1927-1931 .006 .004 .019 .018 .016 .020 .008 .027
1932-1939 .011 .018 .013 .012 .015 .011 .006 .015
1940-1946 .010 .049 .013 .019 .073 .010 .039
1947-1959 .013 .038 .031 .023 .011 .012 .006 .020
1960-1973 .010 .013 .024 .012 .007 .008 .005 .013
1974-1989 .018 .026 .052 .020 .015 .015 .014 .022
1989-1996 .021 .030 .029 .032 .020 .026 .012 .026
the rather poor quality data from this era. Even so it reveals the extent to which
foreign finance was willing to fuel an investment boom before the Baring crash
in 1890. AIso. note that. unlike the settler economies, the U.S. economy had
matured by the tum of the century, and was on the verge of becoming a capital
exporter. with saving and investment almost in balance.
The major capital exporter was obviously Britain. with between 5 percent and
10 percent of GDP devoted to overseas investment in a typical year before 1914.
This coincided with the years of so-called "Edwardian failure" at home, and
the increasingly promising ventures for capital within and beyond the empire. 25
This extraordinary net ftow of capital as a share of output has never been matched
since by any overseas investing country. AlI countries shared in the collapse of
capital ftows in the interwar period, and few have recovered the pre-1914 leveI
of ftows as a share of output. 26
25. See Edelstein (1982) and HaIl (1968) for more on this phenomenon ofBritish capital outlfow.
26. That is. excepting brief upsurges during and after the wanime periods when credits. especiaIly
2.3 QlIarztity Criteria 55
.07 -
o
06 -
"
I I
I
I ',
I
05 -
.Oo! .
9,
I
.02 -
.0 I -
00
1860 1880 1900 1920 19o!O 1960 1980 2000
Fig. 2.3. Slze af capital ftaws: average absolute value of CNY, 15 cauntries.
quinquennia. annual data
Gi\en that the size of flows is still smaller then a century ago, we would
have to take this data as indicative of an incomplete recovery of global capital
markets relative to their levei of integration in 1914. There still cou1d be other
explanations for this path of capital flows over time, but. as in the caveats for
the stock data, we would have to posit some large shock that made countries
more alike. reducing the incipient flows after 1914. This is potentially plau-
sibk \\ithin the group of most developed OECD countries where productivity
convergence has taken place: but it stillleaves out the potential flows betweerz
core to periphery that. given the still large development gap between rich and
poor countries today.
In order to confront that questiono Figure 2.4 examines the same kind of flow
data on the time series of C A / Y for the postwar period, but expanding the
samplc to encompass developed and developing countries. 27 We here divide
the world into two samples. and look at the size of flows in each as a share of
from the l:nited States to Europe. inftated the size of intemational transactions. For clarity .
.... anlme qumquennia (1914-18 and 19o!~6) are shown as open circles in the chart: note that
in these penods the averages are based on incomplete samp1es.
2~ We dra .... on data from the lr"vrFs InrernarlOIlQ1 Financiai Srarisrics here and in Figure 2.6. Note
that because of errors and omissions it seems tha! planet earth is usually running a current
account Imbalance.
"
" ....... , . ~
.w'I-------------------------------------------
-{)-- Industrialized Countries CNGDP
.03 1I - Developing Countries CNGDP
.02 ~
-.02 ~
I
I
-.03 J
i
-.04 - ' - - - - - - - - - - - - - - - - - - - - - - - - - - - '
1940 1950 1960 1970 1980 1990 2000
Fig. 2.4. Size of capital ftows, postwar: CA/Y, developed and developing country
samples. annual data
each region 's output. It is apparent that there has been a surge in capital flows to
devclopir.g countries in the 1930s and 1990s, far exceeding any previous flows
in the preceding fifty years. At peak times this flow has amounted to about 3
to -+ percent of dcvloping country GDP. and a very much smaller fraction of
developed country GDP. However,judged next to the size offlows see in the late
nineteenth century, one is struck by two features of this postwar data: first. how
small even the large flows in the 1990s are as a fraction of the receiving region 's
output. as compared to similar receiving region in the 1890s and 19OOs; second,
one is struck by the fact that this surge in inflows was not witnessed sooner
in the postwar period. taking about thirty to forty years to overcome whatever
impediments to capital movement there were between core and periphery. Thus,
even expanding to a global sample, we argue that, most likely, the U-shape in
the long-run flow data reflect the considerable shifts in the transactions costs
for capital arising from policy environments which became more inimical to
capital movements after 1914, and especially so after 1929. This phase of
relative capital immobility has perhaps only just disappeared in the last decade
or so.
In order to further contrast the situation now and a hundred years ago it is
worth spending a few moments examining how important capital flows are now,
and were then. relative not just to GDP, but relative to total capital formation.
2.3 Quantity Cri te ria 57
(a) Ratio of capital inflows to investment for periphery economies

.60 1 78
01870-1889
.50 -
1111890-1913
40 ~
.30 ~
:0 .
10 ~
00
- 10
ARG FIN AUS CAN NOR SWE DNK ESP
(b) Ratio of capital outflows to saving for core economies

40 - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
01870-1889
.30 ~
1111890-1913
10 -
00
- 10 -
-20------------------------------
GBR NLD FRA DEU USA lPN
Fig.2.5. CapItal flows in relation to saving and investment, 1870--1913: 15 countries,

quinquennia, annual data
Some natural questions to ask are: how important are the inftows as a fraction of
total capital forrnation in recipient countries? and how important were outftows
as a fraction of total saving for source countries?
Let us look first at the data for the late nineteenth century. Figure 2.5 displays
the ratio of average capital inftows to average investment for periphery countries
in our l5-country sample, and the ratio of capital outftows to saving for core
countries. looking at subperiods 1870-89 and 1890-1913. Once again, the
Argenune figure pre-1890 must be taken with a pinch of salt, but in several cases,
especially the settler economies, we see the remarkable importance of capital
inftows for capital formation. In several economies foreign capital supplied
up to half of investment demando This squares with well-known data on the
stocks of foreign capital in some of the settler economies: by 1914 about 50
percent of the Argentine capital stock was in the hands offoreigners: for Canada
, .
- '
58 Globa/i;:ation in Capital Markets: The Long-Run Evidence
.15 - , - - - - - - - - - - - - - - - - - - - - , - - - - - - - - - -
--o-- Industrialized Countries CNS
_ Developing Countries -CM
.10
.05
-.05
-.10 ,
-.15 -'-I----------------------~
1940 1950 1960 1970 1980 1990 2000
Fig. 2.6. Capital flows in relation to saving and investment, postwar: developed and
developing country samples, annual data
and Australia the figure was in the range 20 percent to 30 percent. 28 Clearly
these large ftows cumulated over time into a vcry strong foreign (read, mostly
British) interest in the total capital stock of many nations before 1914. On the
sending side. the British dominance is readily apparent in the figure: about one
third of total British saving was devoted to overseas investment in the 1870-
1914 period; moreover, it is acknowledged that in some periods, for example
1900-13, this fraction crept as high as one half. 29 In contrast, few other capital
exporters in the core could register anything like so high a fraction of foreign
investment relative to total savings, with France, Germany, and the Netherlands
each registering less than 10 percent of domestic savings as destined for foreign
countries in the 1890-1913 era.
Next. we again make a comparison to the contemporary era with this type
of measure. Using our long run database we would find postwar ftows much
lower relative to saving and investment as compared to the pre-1914 era, just as
we did relative to output. But clearly we cannot satisfactorily use our existing
long-run database for this question, or we open ourselves to the criticism that in
focusing on our long-run fifteen-country sample we are missing the heart of the
action in today's global capital market. Instead we should tum our attention to
28. See A. M. Taylor (1992) for more discussion of these comparative data and sources.
29 On British foreign investment in this era see Edelstein (1982).
2.3 Qlwfltiry Criteria 59
the importance of capital ftows in relation to saving and investment in today's

core and periphery. We can use the postwar data to look at how important
developed countries outftows were as a share of their total saving, and how
important developing country inftows were as a share of their total investment.
These measures would then accord with the pre-1914 data in Figure 2.5.
For the postwar period Figure 2.6 supplies the details. As with the discussion
of ftows as a share of output in Figure 2.4, one is forced to note the relatively
small impact offtows until the 1980s and 1990s: inftows have never amounted to
more than about lOto 15 percent of developing country investment, and outftows
neve r more than about 5 percent of developed country saving. This contrasts
with nineteenth century experience, where a country like Britain exported as
much as half her annual savings. and where countries such as Australia, Canada,
and Argentina, imported up to half their savings supply. And even now, the
ftows for the core group are still small compared to the total size of the core
capital market as measured by aggregate saving. lndeed, in many years, both
periphery and core countries appear to have sizeable inftows, due to the usual
data problems. But corrections to the data could probably not affect the two key
qualitative messages of this chart. 30 First, ftows have grown large in the last
ten years, for the first time in the postwar era, but they have not yet surpassed
their importance in the pre-1914 era relative to receiving and sending region
capital markets. Second. and as in the pre-1914 era, because the capital market
in the core is so much bigger than the periphery, these ftows weigh as a much
larger share of periphery investment than they do as a share of core saving.
ar course, mere ftow data, as a quantity criterion, serve only as weak evi-
dence of changing market integration. However, these basic descriptive tables
and f1gures do illustrate the record of capital ftows, and offer prima facie ev-
idence that the globalization of the capital market has been subject to major
dislocations. most notably in the inter-war period, with a dramatic contraction
of tlows seen in the Depression of the 1930s. Moreover, this low levei in the
volume of ftows persisted long into the postwar era, and possibly even to to-
day. We now turn to more formal tests to see whether this description, and the
conventional historography of world markets that points to the Depression as
an era of dlsintegration, has broader support.
2.3.3 The Saving-Investment Relationslzip

Feldstein and Horioka (1980) proposed cross-country saving-investment corre-
lations as a measure of international capital mobility. They reasoned that, in a
10 The concluslon holds éVen if we were to shift the focus to the key capital importers and exporters.
we suspcct
world of perfectly mobile capital, domestic savings would seek out the highest
retums in the world capital market independent of local investment demand,
and by the same token the world capital market would cater to domestic invest-
ment needs independent of domestic savings supply. Thus, they expected to
find low correlations of domestic saving and investment rates among developed
countries given the conventional wisdom that intemational capital markets were
well integrated by the 1960s and 1970s. In a surprising and provocative result,
they discovered a high and significant investment rate-saving rate correlation
with coefficients typically close to unity for a cross section of OECD countries
with five-year period averaging. It appeared that changes in domestic saving
passed through almost fully into domestic investment, suggesting imperfect
intemational capital mobility.31
A substantialliterature has evolved following Feldstein and Horioka (FH) to
assess whether incrementai savings were retained in the home country or else
entered the global capital market seeking out the highest retum. But as is well
known, the same literature has criticized the FH methodology on both theoret-
ical and empirical grounds. This section develops and extends the historical
application of saving-investment analysis, and seeks to extend its theoretical
and empirical scope in several ways.32 Methodologically, we apply not only
the traditional FH tests, but offer an altemative time-series approach based on
a more explicit mode!. A major criticism of the FH method is that one might
expect saving and investment te be ~~ghly corre!ated once time-~""ragirg is
performed in CI oss-section, simply because ali countries must abide by a long-
run version of current account balance in order to satisfy their intertemporal
budget constraint. This idea leads to a very different modelling approach, and
to a hypothesis that saving and investment may have trends or unit roots, but
that the current account will be stationary - that is, investment and saving will
be cointegrated - and an error-correction model (ECM) emerges as a natural
theoretical framework.
The standard technique employed for estimating long-run capital mobility is
the generic FH regression of average invcstment rates on a constant and average
31 Their finding of a large and significant coefticient has been replicated many times for various
cross-section and time-series samples using post-World War Two and historical data. so much
so as to be now considered a robust result - a stylized fac!. as it were (Dombusch 1991; Feldstein
and Bacchetta 1991; Frankel 1991; Obstfeld 1991; Tesar 1991; Sinn 1992).
32. Our statistical tests have enhanced power compared to other historical studies. since we have
increased the sample size: we use annual data for the full period 1850 to the present, and
we increase the cross-section size from the usual nine or ten up to fifteen, by adding various
countires missing from earlier studies. Some applications of the Feldstein-Horioka approach
in economic history, the natural antecedents of this chapter, include Bayoumi (1989), Zevin
(1992), and Eichengreen (1990)
2.3 Quantiry Criteria 61
saving rates. The regression is perfonned on a cross section of countries indexed

by i. where we use a "short" averaging penod T (say, five or ten years):
-- FH FH--
(l/n,=a +b (S/ni+Ui, (2.9)
-- IT --- IT
where (l/n i = T LI (f/nit, (s/n i = T LI (S/nit. The cross-section
slope coefficient b FH has the conventional interpretation of a long-run savings-
retention coefficient for the sample of countries. 33 The results are shown in
Figure 2.7. The figure displays the coefficient b FH for both 5-year and ten-year
averaging patterns with two-standard-error intervals above and below indicated
by vertical bars. Before FH-type coefficients can be interpreted we require a
benchmark for what constitutes a "high" or a "Iow" b FH . Put another way,
b FH comes equipped with no intrinsic absolute yardstick: we need to find
a period we consider one of undisputed capital mobility and then compare
other b FH observations to this benchmark. 34 Alternatively, we might search for
movements in b FH as indicators of whether saving-investment interdependence
was relatively high or low for a given penod. There is certainly variance in
the coefficient. The estimated coefficient is significant in most periods, and
usually positive. It occasionally exceeds unity. The results reveal considerable
tluctuation in the magnitude of b FH over the long run.
What do the results show? First. international capital market integration, as
measured by b FH for this admittedly small sample, has shown no marked trend
over the last hundred or so years: we can say that, in this narrow sense, saving-
investment association has been no weaker in the last decade for these countries
than it was circa 1900. Second, the coefficient b FH has not evolved unifonnly
or monotonically over time: saving-investment association was relatively low
during the 1880s, when financiaI markets were engaged in a frenzy of foreign
investment. The crash of the early 1890s brought this phase to a halt (higher
!JFH). Gradually. closer to \Vorld War One, saving-investment association again
decreased (falling b FH ) in the last great foreign investment boom during the
age 01' high imperialismo The Great Depression ushered in a time of increased
corre lations ior several decades (rising b FH ). The saving-investment association
began to decline in the late 1970s and 1980s. albeit to a limited degree. 35 We
:n In 3 s~n\~. b FH is measuring the extent to which the sample of countries deviates. on average over
the sample penod. from the closed-economy property whereby saving rates equal investment
r3tes by identitl'. Smce period averaging is employed the procedure anempts to abstract from
buslness cl'cle fluctuations that simultaneously affect both saving and investment. The averaging
:Dsa Implies that this procedure has nothing to sal' abou! l'ear-to-year (short-run) capital mobility:
the ability of countries to temporanly run current-account surpluses or deficits in response to
shocks a! hlgh frequencies (meaning approximately annual frequencies. or higher) .
.'4 See Obstfeld (1986: 1994)
,5 For comparslOns on the size of the recent postwar coefficient see Feldstein and Bacchetta 1991:
Obstfeld 1994: and A. M. Taylor 1994a.
62 Globali-:.ation in Capital Markets: The Long-Run Evidence
2.0 ~----------------------
i
1.5 1
I
1.0 , .0
...0,
I'.
~.OC.O
ce . 1
• U-' , Cit'
0.5 l ~~ cJP cJk)~ 00 ° ° I
° °
00 +-' -----------------------+
,
- ,
-)
0 T
I
-1.0~'- - - - - - - - - - - - - - - - - - - - - - - ' -
1860 1880 1900 1920 1940 1960 1980 2000
2.0~i~~~1
1.5~
~~i~
i
1.0 -
O~O ~Rg8aO j 'b i······ ~<§'

O
, ~~~<" t
05 +
'6 '~~(R.o
Cí~ ... O \J ~O "O
" .. j
0.0 ---.---------------------+
!
-0.5 - 1
-1.0 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _----L
1860 1880 1900 1920 1940 1960 1980 2000
Fig. 2.7. Feldstein-Horioka coefficient: 15 countries. quinquennia and decades.

annual data. with plus or minus 2 s.e. bars
CII.UQTECA IIA~niJ H~ftIQUE . . . .

-"IlIf'I"rln f:;FTfIlIO VI"-
;" t.. .' .

I· ./" . .. ' I ,':
........... .., ~- "
may note the remarkable relationship between the results of the FH test and
the stylized facts concerning institutional change, monetary experiments, and
policy regimes.
Still, we might ask, what does the FH coefficient mean and how do we
measure it accurately? The criterion. despite the attention it has commanded
and ItS widespread use, is handicapped by two distinct sets of problems: First,
do the regressions of investment on saving measure true and unbiased "savings
retention"'l Second. even if estimated accurately. what does the coefficient say
about international capital mobility?36
An alternative to the Feldstein-Horioka approach of estimating the savings-
retention coefficient is to employ time-series analysis for an individual country.
However. for technical reasons. there is no reason to expect cross-section and
time-series coefficients to bear any relation to each other since the time-series
and cross-section properties of the estimators differ dramatically.37 The time-
series estimation ofthe coefficient also raises additional concems, as it embodies
an assumption of stationarity in the series (1/ Y)it and (S/ Y)it. Such an as-
sumption may indeed be valido especially for short time frames. However,over
longer horizons, several studies have cast doubt on the assumption that saving
and investment rates are truly stationary.38
Ali the same. the above ideas would be entirely familiar to anyone applying
the standard small-open-economy macroeconomic model, or an open-economy
growth model, to the problem at hand: for a poor (capital scarce) country.
accumulation-Ied growth would begin at low income leveis using borrowed
funds for investment; at the same time, permanent consumption leveis would
be attained by borrowing against future output. Saving would start low and
end high. to repay these debts; investment would start high and end low, as
36 Th~s~ concems hinge of the samc typ~s of caveats already mentioned: what auxiliary assump-
tlons we thlnk are relevant for the structural modeling of saving and investment in the long run.
and how we think the structure may have changes so as to possibly account for the parameters
secn. Sce Obstfeld (1986: 1994)
3 7 :-'lor~o\~r. the natural interpretation ofthe two coeffjcients differs substantially - typically b CS is
consld~red an Indlcator of long-run Intemational capital mobility in a sample group of countries.
w hereas b T 5 is seen as a measure of short-run. year-to-year intemational capital mobility in a
slnglé country (Obstfcld 1986: 1994).
38 Thls problem will come as no surprise to economic historians: the notion of saving and in-
vestment shlfts as important features of growth and structural transformation in the long run is
embodled in many national histories. includlng the famous "grand traverse" described by the
Lnlted States economy in the nineteenth century (Abramovitz and David 1973: David 1977). A
similar upward shift In the investment rate has been documented in nineteenth century Britain
(Crafts 1985. chapter 4. for examplel. The stationarity of some settler-economy saving and
Investment rate series could also be called into question based upon an examlnation of long-run
trends in the Australian and Canadian data since 1870 (McLean 1994 illustrates the pattems).
W A Lewis (1954.155) considered such shifts in saving and investment the essential problem
of economic developmenL
steady-state leveIs were reached. The long-run intertemporal budget constraint

would be met, and the current account would tend toward a stable, steady-state
leveI, implying stationarity.
We used routine stationarity tests to check on the stationarity of the series
(5/nit, (Ilnit, and (CA/nit in our long-run sample of annual data for
15 countries. The current-account ratio is stationary in ali cases, encouraging
the view that it may be subject to equilibrium tendencies as theory suggests.
However, the saving and investment series were not stationary. 39 Thus, the new
strand of cointegration research into the properties of saving and investrnent cor-
relations may have a particular resonance in long-run historical applications. 40
An important implication is that there exists an error-correction representation
of the relationship. The simplest such representation, commonly adopted in
the Iiterature, is the first-order error-correction model (ECM), which may be
written
ECM
= a + bECM .6.(51 nt +
ECM
c ((5 I nt-I - (I I nt-I) +
ECM
d (51 nt-I + Ut· (2.10)
This equation states that instantaneous changes in investrnent may be driven by

a pass-thorugh from instantaneous changes in saving, as in a c10sed economy,
or through an error-correction term, which tends to drive investment and saving
back towards some long-run equilibrium relationship in levels. 41
In the ECM equation, each of the terms has implications not only for the
dynamics. but for our interpretation of the system as decribing capital mobility.
The coefficient b ECM has the natural interpretation: even given a long-run
equilibrium relationship between saving and investment, b ECM measures to
what extent a temporary annual shock to domestic saving .6. (5 I nt passes
through (ful1y? partially? not at ali?) into domestic investment .6.(1 I nt.
39. Standard Dickey-Fuller test were used. On these econometric maners see A. M. Taylor (1997).
40. The cOlntegration approach 10 the saving-investment relationship has been much discussed in
th~ Inerature. and the details need not be repeated at length here (see Miller 1988; Leachman
1991; Vikoren 1991; Jansen and Schulze 1996; A. M. Taylor 1997).
41 This approach follows Jansen and Schulze (1996). A. M. Taylor (1997) applied (2.10) as a con-
venient estimating equation for implementing a well-specified test of the saving-investment
correlation. It is immediately obvious that (2.10) embodies a long-run equilibrium rela-
tionship between saving and investment prescribed by theory. In the steady-state equilib-
rium 1':,.( I / Y)/ = /':;(5/ Y)/ = O. The implied equilibrium relationship in leveis is given
by (JECM + ~CM«5/Y) - (l/n) + d ECM (5/Y) = O. Parameter restrictions may be
used 10 test various natural hypotheses conceming the nature of this long-run equilibrium. If
d ECM = O then the relevant error-correction terrn is just the current account (C A/ n/; here.
«(l/n/. (5/ nrl have a cointegrating veClOr that is (1. -I); and the long-run equilibrium cur-
rent account is equal 10 a constant. C A' = (5/ Y)' - (l/ n' = _a ECM / ~CM; moreover.
if a ECM = d ECM = O, then this constant is zero.
2.3 QI/antit)" Criteria 65
.70 -
• Pass Through (b)
O Adjustment Speed (c)
.60 .
.50 "
40 "
f
I
.30 " ! í
.20 "
f
.10 "
00
1880--1913 191+-1945 1946-1971 1972-1992
Fig. 2.8. The Saving"Investment Error"Correction Model: Pooled Coefficients with

plus or minus 2 s.e. bars
It is thus a "short-run" adjustment parameter, with a meaning not unlike that

of a conventional FH coefficient. The coefficient c ECM also has a natural
mterpretation: it measures the speed of convergence of the system toward
equilibrium Converted into a "half-life" measure, this provides an indication
of the sustainability of saving-investment inequality for each country in the
sample period under study. It is thus a kind of "long-run" measure of capital
mobilay
Summary results of this modeling approach are shown in Table 2.4 and
Figurc2.8 for our long-run data for 15 countries since 1880. Consider the
average and pooled estimates of the pass-through coefficients b ECM and the
aJjustment-speed coefficients cEo,l for the full sample. The pooled estimates
would be appropriate ifthe same dynamic model applied to ali countries, and the
average estimates would be representative of the mean coefficient were individ-
ual countries' coefficients considercd to be random draws, as in a heterogeneous
pane!.
What general picture do the results present') Let us first look at the pass-
through coefficients hEo,I Under the classical gold standard this coefficient
, ,
Table 2.4. The Saving-Investment Error-Correction Model

Pass-tlirougli (6)
1880-1913 1914-1945 1946-1971 1972-1992
Argentina -0.01 0.11 OA5 0.88
Australia OA8 0.03 -0.14 0.59
Canada 0.87 0.50 OA2 0.87
Denmark 0.22 0.22 0.60 0.67
Fin1and 0.02 0.08 0.89 0.87
France 0.65 0.90 0.79 0.67
Gerrnany 0.94 1.26 1.24 0.33
Italy 0.96 0.67 0.71 0.83
Japan 0.23 0.56 1.03 0.92
Nether1ands 0.20 0.56 0.01 OA1
Norway 0.26 1.10 0.75 -0.25
Spain OA2 OAO 0.79 0.08
Sweden 0.34 0.03 0.26 0.33
UX 0.05 0.20 0.04 0.86
U.S.A. 1.06 0.82 0.93 0.91
Average b OA5 0.50 0.58 0.60
std. deviation 0.35 0.38 0.39 0.34
Pooled b 0.34 OA3 0.58 0.52
std. error 0.02 0.03 0.04 0.04
Adjustment speed (c)
1880-1913 1914-1945 1946-1971 1972-1992
ArgentIna 0.1 S 0.31 OA2 0.78
Australia 0.23 0.33 0.76 0.54
Canada 0.14 0.26 0.52 0.30
Denmark 0.36 0.89 0.S5 0.19
Fin1and 0.32 0.52 0.87 0.44
France 0.37 0.58 0.71 1.07
Gerrnany 0.64 1.15 0.54 0.32
1taly 0.20 0.56 0.69 0.75
Japan 0.57 0.21 0.55 0.28
Netherlands 0.46 1.10 0.18 0.49
Norv.·ay 0.11 0.52 0.60 0.07
Spain OA9 0.19 OAO OA6
Sweden 0.28 0.24 0.65 0.89
UX 0.11 0.20 -0.11 0.30
U.S.A. 0.16 0.28 0.50 0.26
A \,'era~e 0.31 0.49 0.54 0.48
std. deviation 0.16 0.31 0.24 0.27
Pooled c 0.22 OA7 0.56 0.30
std. error 0.03 0.04 0.04 0.03
.,". , . . . <> ' .... '
',,',":.. ,"
2.3 QlIantiry Criteria 67
was relatively low, around 0.45 on average (0.34 in the pooled sample) meaning
that the pass-through of saving shocks to investment is less than 50 percent. But
in the interwar period this coefficient rises to 0.50 on average (0.43 pooled), and
then rises still more in the Bretton Woods era to 0.58 average (0.58 pooled). In
the recent fioat the evidence is mixed. with the average coefficient rising a little
to 0.60, but the pooled estimate falling slightly to 0.52. By this measure of the
short-run independence of saving and investment, no era after 1914 exhibited as
much short-horizon capital mobility as the classical gold standard era, though
recent trends suggest a halt to the disintegration trends since 1914, and perhaps
even a modest reintegration of markets.
Similar findings follow fram an analysis of lhe overall adjustrnent-speed
coefficients c ECM . For simplicity, let us just focus on the average estimates
(the pooled estimates tell much the same qualitative story). Before 1914, the
adjustment speed was only 0.31, which corresponds to a half-life of about 2
years. Thereafter the coefficient rose to 0.49 in the inter-war period (a half life
of about I year), and stayed at about the same levei lhereafter (rising to 0.54
in the Bretton Woods era, then falling to 0.48 again in the recent fioat). Thus,
under both cri teria, the classical gold standard emerges as perhaps the modern
era with the greatest degree of capital mobility since 1850. The Bretton Woods
era appears to be the nadir of capital mobility, after a major setback in the inter-
war years. Little evidence of a return to high capital mobility was evident in
data fram the 1970s and 1980s. though it is as yet toa soon to tell if the 1990s
might overturn the trend.
Of eourse, looking at averages masks individual country variations in the
eoefticients. and sue h variation is considerable. Argentina is a striking example,
where the trend toward immobility is much more marked than in the overall
sample. The pass-through coefficient rises from about zera (smallest in the
pre-191-'+ period) to almost 0.9 (one of the largest in the post 1973 period); and
the ad justment speed climbs fram 0.18 (again one of the smallest pre-1914) to
almost 0.8 in the last period (one of the biggest again). This finding comes as
no surprise. of course. to students of Argentina's eheckered economic history
and polie)' reeord. By dint of IOward-Iooking policies in both trade and capital
markets. which ereated a mass of distortions and obstacles to accumulation,
Argentine growth after 191-.+ sputtered to a halt. These results give explicit
form to the eontention that iso!ation from world markets, especially here in the
capital market. was one feature of that decline, and perhaps a causal feature, as
has been argued elsewhere ..J2
In general. the long run capital mobility measure c ECM seems to conform
-12 On thé Argéntlna case see A. ~1. Taylor (1992; 1994b; 1998)
more closely to the stylized facts for capital mobility in the long run. Most
countries do exhibit the sty lized inverted- U pattem of c ECM coefficients, but
note that these are exclusively an Anglo-Saxon group of countries: the United
Kingdom, and its New World offshoots (the United States, Canada and Aus-
tralia), Netherlands, Germany, and the Scandinavians. 43 One cannot read toa
much into these individual-country findings, but they mesh at the broad levei
with the perception of relatively limited barriers to financiai market operations
in the traditions of this Anglo-Saxon group of countries.
Conversely, another group of countries appears to show no downtum in c ECM
coefficients after 1971, and very high leveis for these coefficients overall. This is
the Latin group, of which Argentina is just the extreme case. But similar trends
of ever-rising coefficients, suggesting ever more rigid associations of saving and
investment in the long and short run can be seen for ali these countries: France,
Italy, and Spain (though Spain 's coefficients show more restraint and does not
climb even higher after 1971). To repeat, inference is loose, but here again these
findings also seem to mesh with historical account of capital market rigidities
and a greater fondness for capital controls in this Latin group of countries.
Thus, although the pattem of short-run capital mobility (measured by b ECM )
appears unclear given the present results, and subject to much volatility across
time and space, the historical patterns of long-run capital mobility (measured
by c ECM ) appear more systematic and interpretable in the light of the extant
historiography. Overall, thcse rcsdts comp!:;nent the p:ev:c)l!!: result~ \!sir.g
q uanti ty-criteria.
2.3.4 Caveats: Quantity Criteria

We have spent many pages reviewing the quantity evidence from the nineteenth
and twentieth centuries for the macrohistorical recordo Was this a useful exer-
cise? Are the interpretations valid? An obvious objection to quantity criteria
is that they may be poor indicators of market integration. Flows may happen
despi te high barriers to mobility, at least with sufficient inducement; conversely,
flows may not happen even in a fully-integrated world, at least if there are no
price diffcrentials to be arbitraged away. That is, changes in economic structure
In the markets under consideration could induce quantity changes without any
shift in the underlying costs of arbitrage, and hence with no change in the true
degree of integration.
43. Interestingly. with respect to ~CM The famously outward-Iooking Norway exhibits very smalI
c ECM coefficients. especially after 197 I. when huge current account deficits were sustained by
a promised long-run retum from a positive endowment shock (oil discovenes), in full agreement
with the precepts of the small-open-economy mode!.
For this reason, some argue, one should really work with price data, and
eschew quantity criteria. However, we make three response to this critique.
First. we will work with price data, and examine what the historical record has
to say there, in the very next section. Second, a moment's thought will convince
the reader that price evidence is no easier to interpret: structural shifts in markets
could just as easily lead to price convergence as to quantity movements, making
inferences about underlying shifts in mobility just as difficult to discern. Third,
given these concerns, we must of necessity take some kind of stand concerning
the underlying structure of markets and how that changed over time. Without
such a prior, interpretation can't proceed.
Our prior is that changes in mobility do dominate the picture for the twentieth
century. so that out interpretation is admissible as a good approximation. We
base this prior on a conjecture, and on the consistent weight of evidence in
various tests. The conjecture is that a rival explanation based on structural
changes would have to propose some implausible changes in the world economy
to generate the patterns seen, keeping capital mobility constant. We would have
to posit some technological or endowment changes in the interwar period that
rendered economies more similar (with less incentive for capital movements)
and then a prompt reversal of these shocks in the postwar period. It is not easy
to think what these shocks would be. Demographically, very large gaps opened
up between rich and poor countries this century, as demographic transitions
drew to a cIose in the core and were only just begun at the periphery; at the
same time. capital accumulation raced ahead in the core, and stagnated at the
periphery. Both these shocks had predictable implications for living standards.
Ali of which would lead one to expect even larger movement of capital. Thus,
it would be hard to reconcile these shocks with the empirical growth record,
as the)' would imply some kind of global convergence in the interwar period
followed by a divergence in the postwar period. with reversion to more or less
the 1913 position. Such was not obviously the case as we can see from the
long-run income per capita figures shown in Figure 2.9: by this yardstick the
global economy reached its point of maximum divergence, not convergence, in
the mid-twentieth century.44
44 The lncome per caplta data are fram Maddison (1989) Similar conclusions follow fram the
real wage data of Williamson (1993). A final possibility might be to use human capital as an
explanatory vanable. since if it were complementary to physical capital. its scarcity in poorer
countnes lnlght discourage capital lnfiows: this has been praposed in growth theory for the
recent postwar penod (Lucas 1990) However. the historical data before 1945 is so poor on
schooling and literacy. that we have linle idea how much divergence or convergence in human
capital endowment could have accounted for the capital fiows seen here. But note again that
such an explanation would require some implausible reversals: a convergence in human capital
le\ eis before 1913. then a divergence. then a convergence once again in the recent decades. No
stud, \\e know has made such a claim for global schooling and literacy panerns in lhe twentieth
100,000 - , - - - - - - - - - - - - - - - - - - - - - - -
GDP per capila in intemalÍonaJ dollars (1980 prices), log scale
--+-OECD average (16 counllies)
--o-- Asian Average (9 counlries)
--o-- Latin Arnerican average (6 counlliesl
10,000
1,000
100
1880 1900 1920 1940 1960 1980 2000
.75
--+- Coefficient af varialion (31
countries)
.70 J
I
.65 ~
.60
1880 1900 1920 1940 1960 1980 2000
Fig.1.9. The Divergence and Convergence of Incomes in the Twentieth Century

Absent these kind of convergence patterns, then, we can gain further con-
fidence from what is a fairly consistent picture delivered by a great variety of
quantity cri teria. Ali told, almost every measure we have proposed has illus-
trated the kind of stylized U-shape postulated by conventional wisdom. Had
this not been the case, our interpretation would have to be more shaded, but the
fact that many signs point in the same direction is surely an important result: ali
the more so since, unlike the stylized fact, there is in reality no single measure
of capital mobility. It ali depends on the kind of mobility you want to mea-
sure. Short-run or long-run? For consumption or investment? For two-way
diversification or for taking out a one-way position? It is reassuring for our
interpretative schema that, in most of these dimensions, the evidence appears
to be leading the same way.
Given these caveats, what do the quantity data say about capital mobility?
As in so many other dimensions, the answer depends on the question being
asked. However. in no dimension is it obvious that the contemporary era vastly
dominates the pre-19l3 era in terms of having a well-functioning market. The
stocks and ftows of foreign capital today are, relative to the size oftoday's global
economy, no larger than during the golden age at the eve of World War One.
The ability of countries today to delink their saving and investment leveIs, and
their freedom to sustain current account imbalances. appear to be no greater
than a century ago. The only place where we seem to be ahead today is in
risk sharing. but this has still remained very low as compared to a theoretical
optimum.
2.4 Price Criteria
The next stage of our empirical discussion moves from quantity to price crite-
ria. Here we will encounter some venerable parity tests from the international
finance lnerature: covered interest parity, real interest parity, and purchasing
power parity. Compared to quantity criteria. such tests offer a seemingly a more
direct test for market integration: but for reasons already given, the relationship
of prices. or the distribution of prices, in two locations cannot test market inte-
gration without auxiliary assumptions. These problems will be faced when we
sum up our findings and face another set of caveats.
cen!ury. ThlS does no! !O deny that schooling was important as a growth determinants in the more
dlstant eras: on late nineteenth century schooling and catch up see O'Rourke and Williamson
(1995) Nor do we deny that for some countries. at some criticai junctures. human capital and
Investment In research might have made a very big difference: on how the United States kept
IIS technological lead at mid-century see Nelson and Wright (1992).
2.4.1 Covered lnterest Parity

Perhaps the most unambiguous indicator of capital mobility is the relationship
between interest rates on identical assets located in different financiai cen-
ters ..~5.46 Thus, for example, interest rates on Euromark deposits in London
in recent years have been quite close to those on comparable Deutsche mark
deposits in Bonn. The great advantage of comparing onshore and offshore
interest rates such as these is that relative rates of retum are not affected by
pure currency risk. 47 For much of the period we study in this chapter, a direct
onshore-offshore comparison is impossible. However, the existence of forward
exchange instruments allows us to construct raughly equivalent measures of
the retum to currency-risk-free intemational arbitrage operations.
Forward exchange trading - in which two parties contract to exchange cur-
rencies at a predetermined rate on an agreed date - is one way to conduct
intemational interest-rate arbitrage free of currency risk. Using monthly data
on forward exchange rates, spot rates, and nominal interest rates for 1921 to
1996, we assess the degree of intemational financial-market integration by cal-
culating the retum to covered interest arbitrage between financiai centers. For
example, a London resident could earn the gross sterling interest rate I + i; on
a London loan of one pound sterling. Altematively, he could invest the same
currency unit in New York, simultaneously covering his exchange risk by sell-
ing dollars forward. He would do this in three steps: Buy er dollars in the spot
exchange markel (wÍ1ere er IS the SpOl plü;e of sterling in dollar terms); next.
invest the proceeds for a total of er (I + ir) (where ir is the nominal dollar interest
rale; and, finally, sell that sum of dollars forwa:-d at for er (1 + ir) / fr in sterling
(where Ir. the forward exchange rate, is the price of forward sterling in terms
of forward dollars). The net gain fram borrowing in London and investing in
New York,
~(l + ir) - (I + i;), (2.11 )

fr
is zero when capital mobility is perfect and the interest rates and forward rate
are free of default risk.
We can pursue a similar arbitrage calculation before 1920, but with minor
45 See the discussion in Obstfeld (1995). for example.
46. This section draws heavily on Obstfeld and Taylor (1998).
47. Eichengreen (1991) presents similar data for the interwar period, as does Marston (1995) for the
postwar period. Under a fixed exchange rate regime such as the gold standard, another arbitrage-
like test of financial-market integration asks whether nominal interest differentials in different
currencies are consistent with the maximal allowable exchange-rate Huctuation band (Goschen
1861: Weill 1903; Morgenstem 1959; Officer 1996). Such a test relies on the maintained
hypothesis that the exchange-rate band is credible (though not on uncovered interest parity).
and more recently has been interpreted as a test of exchange-rate credibility (Svensson 1991;
Giovannini 1993; Marston 1995, chap. 5; Hallwood, MacDonald, and Marsh 1996) .
•
2.4 Price Cri te ria 73
modifications to correspond to historical practice and the prevailing financiai

instruments and institutions of that earlier time. Forward exchange markets
functioned before World War 1. 48 Yet they were comparatively thin before the
period of ftoating exchange rates that followed the war. For the period 1870
through 1920, we consider a different type of sterling interest-rate arbitrage
operation between London and New York, the dominant market of its kind,
involving the New York market for sixty-day sterling bills. 49 Sixty-day sterling
bills were promises to pay the bearer one pound sterling, usually in London,
after sixty days. Thus, the dollar price of a sterling bill is the New York price
of forward sterling in terms of current dollars. Rather than lending a pound in
London at the gross interest rate prevailing there, one could instead buy el sight
dollars and use these to purchase el / b l pounds payable in sixty days (where b l
is the New York dollar price of a sterling bill). The net gain from borrowing in
London to buy sterling bills in New York would be
e{ •
b: - (1 + i l ), (2.12)
which again is zero under perfect integration of the New York and London
financiai markets. 50
Table 2.5 and Figure 2.10 present some evidence on covered interest arbitrage
on the dollar-sterling exchange since 1870, showing the above differentials for
the years from 1870 to the present. Differential returns are calculated as annual
rates of accrual. Some concerns about the data warrant mention. 51 First, as
.1S S~e Einzig r 1937. chap. 7.)
-19. For a dlScussion of this market, see Perkins (1978).
50 ThlS arbltrage argument underlies the calculation in the textbook by Spalding (1915, chaps.
5-6 I. for example. although he assumes perfect intemational financial integration. Notice that,
unlike in the case of covered interest arbitrage. differential default risk belween the New York
anJ London markets is not imponant here. An implicit forward exchange rale based on the
so-calkd "Iong·· exchange rate b{ lS given by fimphcit = b{ (I + ir).
51 The data were collecled from vanous sources. Exchange rates: Before 1921 spot and 60-day
sterling bill exchange rates (in U.S. dollars) are from the Financiai Review or Commercial and
FillllllCtill Chronicle: 1921-1936 spot and 90-day forward rates are from Einzig (1937). 1937-
:\0\ ember 19-16 spot and 90-day for"'ard rates are from the Ecollomist. December 1946-May
19.1 7 spot and thmy-day forward rales are from the Wall Street Journal. June 1947-1965 spot
anJ 90-dav for",ard rates are from the New York Times. and thereafter from OECD Historical
S{llItSItCS and (staning in January 1976) from Reuters (as reponed by Datastream). The Einzig
for~lgn exchange data are monthly averages whereas ali other exchange rates are taken at or near
the end of lhe month. Interest rates: From 1870-1920. three month rates on London bank bills
from Caple and Webber (1985). data taken at or near end of month. From 1921-1936, month
awrage data on London and New York three-month market discount rates from Einzig (1937)
Lmted Kingdom interest rate data for 1937-April 1971 are three-month London bank bill rates
fram Caple and Webber (1985): from May 1971-April 1991. three-month London bank bill
rales from Dataslream; and from May 1991-April 1996 five-month London bank bill rates from
Dataslream (ali aI or near end of month). From 1937-April 1940. rates on banker's acceplances
In :\ew York from lhe ECUllOmÍ.<t. aI or near end of month. From May 1940- May 1947. the
same rales are monthly averages as reported by lhe Federal Reserve. From June 1947-1965.
74 Globali':.ation in Capital Markets: The Long-Run Evidence
Table 2.5. Covered Interest Parit)' Since 1870:

US.-UK Covered Domestic Interest Differentials,
Selected Periods, Percent per Annum
mean sld. devo
1870-1889 1.02 0.66
1890-1913 0.60 0.39
1914-1918 0.05 0.70
1919-1924 1.05 2.06
1925-1930 -0.58 0.95
1931-1939 0.12 2.05
1940-1946 -0.44 0.31
1947-1956 1.29 3.50
1957-1967 0.02 0.54
1968-1979 0.10 2.01
1980-1989 -0.64 1.28
1990-1996 0.25 0.47
NOles: Month1y data. Various maturities. Sixty-day bills before
1920. forward exchange after 1920.
Sources: Various. See tex!.
10 ,---------------------------------------------~
___ mean
--O--sld. de\'.
8 J
II
6
-4 ~------------------------------------------~----_4
1860 1880 1900 1920 1940 1960 1980 2000
Fig. 2.10. Covered interest parity since 1870: U.S.-U.K. covered domestic interest
differentials. annual, percent per annum
,'.!, .. '
2.4 Price Crireria 75
described above. the two measures of market integration that we calculate refer
to different arbitrage possibilities before and after 1920, and thus comparability
across this break cannot be assured. Second. the forward and sterling bill
transactions appear at different maturities in our data set: through 1920 we
deal with two-month rates, afterward with three-month rates. Third, most data
are observed at or near end-of-month, but ali data for the years from 1921 to
1936 are averages of weekly numbers. Averaging has the effect of dampening
measured volatility for part ofthe interwar period. Fourth, data from World War
II reftect rigidly administered prices and have no capital-mobility implications.
Fifth. the data used are not c10sely aligned for time of day (and even differ as
to day in some cases), so that some of the monthly deviations from nominal
interest parity that we calculate may be spurious. Sixth and finally, this exercise
is being performed here only for a single country-pair, the United States and
United Kingdom. In future work we hope to compile similar data for more
countries. inc1uding France and Germany, to permit an evaluation of covered
interest arbitrage between other markets.
Despite these many caveats, the figures are revealing and supportive of the
con\"entional wisdom. Differentials are relatively small and steady under the
pre-191"+ gold standard. but start to open up during World War L They stay quite
1arge in the earll' 1920s. 52 Differentials diminish briefty in the late 1920s, but
widen sharply in the early 1930s. There are some big arbitrage gaps in the late
19"+(j~ through the mid-1950s. but these shrink starting in the late 1950s and
earll' 1960s. only to open up again in the late 1960s as sterling is devalued and
as the Bretton \Voods system unra\"els in the early 1970s. Interest differentials
have become small once again only in the most recent years offtoating exchange
rates. Thus. the Great Depression, perhaps as part of a much broader interwar
phasc of dismtegration. stands out as an event that transformed the world capital
market and Icft interest arbitrage differentials higher and more volatile than
ever before. Disintegration lasted for several decades, and large nominal retum
differenuals persisted into the 1980s.
30-to-YO dJV banker"s acceptance Interest rJtes in New York come from the New York Times.
observcd at or near month's end. Data for January-Apríl 1966 are month averages of 90-day
banker"s acceptance rates reported by the Federal Reserve. Starting in May 1966 the Fed reports
rnonth-end dJta. whlch we have used in the calculations.
52 The rather stable prernium on New York loans before World War I (which appears to fali in the
carly menlleth century) probably reflects a less liquid market. (The London reference rate is a
hl~h-quality bank bill rate.) For a comparative discussion ofthe New York and London capital
markets before 1914, see Davls and Cull ( 1994, chap. 4).
2.4.2 Real Interest Parity

A basic standard for market integration remains the law of one price; this is
usually interpreted for capital markets as implying some test for the equaliza-
tion of real costs of capital, typically real interest rates. 53 It is well known,
however, that real interest rate convergence is a very strong criterion for market
integration, resting as it does not only on perfect capital mobility but also on
two supplementary parity relationships, either of which may fail to hold and
which are not directly relevant to capital mobility: uncovered interest parity
(UIP) and purchasing power parity (ppp).54
Clearly, risk premia can modify UIP even in a world of free trade and fric-
tionless asset markets, so UIP cannot be a relevant precondition for free capital
mobility. As is well known, however, it is hard to devi se reasonable models in
which currency risk premia are large. 55 As for PPP it may fail even over the
long run because nontraded goods enter consumption price indexes. If capital
is mobile and technologies ultimately converge intemationally, however, there
will be a tendency for countries' relative prices of nontradables in terms of
tradables to be equalized as time passes. The mechanism bringing about this
equality is akin to that und-~rlying the factor-price equalization proposition in
trade theory. 56 It can work even without capital mobility, of course, but is likely
to be speeded by the technology transfer that international capital mobility may
)J Thls '~étion draws heavily on ObSlfeld and Taylor \! 998).

54. L.;ncovered (or "open") inleresl parily requires lh::ll the expecled rale of rtbrive currency de-
preciation over the relevant horizon equal the corresponding nominal interest rate difference
between the two currencies,
Erer"'l - er = ir - ir"·
Here er is the log spolexchange rate (defined as lhe domeslic-currency price offoreign currency)
and ir and ir" are lhe home and foreign currency interesl rates. Purchasing power parily (striclly,
the Strong Relative version of PPP) implies lhal expecled exchange rate changes equal expecled
inflal10n differentials.
"here ;rr+1 = Pr+1 - pr and rrr"+1 = P;+I - Pro are the inflation rates in the IWO currencies
based on log price leveis pr and Pr·' UIP and PPP together imply lhe equalization of ex ante
real interest rates,
Since UIP compares asseIS with the same country/political risk characteristics, and which may
be freely traded againsl each other, capital mobility comes in by ensuring lhat interest rates on
a given currency are the same lhe world over. as discussed in the previous section. See Isard
(1995 ).
55. See K. K. Lewis (1996).
56. See Obslfeld and Rogoff (1996, chap. 4) .
•
2 ../ Price Criteria 77
facilitate 57 Thus, even though PPP is some times asserted to be a proposition

about goods-market integration, capital mobility can indeed be relevant to the
issue. hence to the international equality of expected real interest rates. Studies
of long-run pattems of PPP may be very suggestive of the likely periods in
which real interest parity holds or fails.
The real-interest parity relationship between prices in two physically sepa-
rate. but economically integrated, markets could be tested in a number of ways.
Prices may be equalized save for some transaction-cost gap; or they may equal-
ize in the long-run, but exhibit short-run deviations. Such concems make the
test of strict and perrnanent equality only the most extreme or pure criterion
for integration. If integration is not viewed as a zera-one variable, the degree
of integration becomes a valid object of research. Exploring both the equili-
brating forces of adjustment (promoting convergence in prices) and the nature
of disequilibrating shocks to the system (promoting divergence), we may ask:
how did the system perforrn in terrns of the overall deviations fram real interest
rate equality which were actually recorded across time?
The pattems of real interest rate dispersion offer preliminary evidence as to
the working efficiency and stability of the world capital market, and the basic
record for our sample of countries is indicated by Table 2.6 and Figure 2.11.
Shown there is the standard deviation of real ex post interest rates for a sample
of ten countries from 1880 to 1989. Quinquennially averaged data are used in
the figure. and in the table we present data for selected periods. 58
The dispersion measure (the standard deviation) of real rates shows a pattern
definHe pattern. There was slight convergence in real interest rates after 1880
and before 1914, though nothing as dramatic as the convergence seen prior to
1870 (cf. Lothian 1995). But after 1914, the dispersion of real rates rose sharply.
It fell slightly from the late 1920s to the early 1930s, but then increased again.
Dispersion hit a peak in the late 1940s, and then convergence in real interest
rates was again seen during the early phase of Bretton Woods, such that, after
1960. dispersion leveIs had returned to their pre-1914 leveIs. Dispersion has
been /lal almost ever since, with some divergence apparent upon the collapse
oI' the Bretton \Voods system in the early 1970s.
The dispersion data thus confirm again the textbook characterization of the
evolutIon oI' International capital market integration. Integration was re1atively
high in lhe late nineteenth and late twentieth centuries - though arguably no
)7 Tr:ll1spon com ar regulations impedmg the intemational shipment of tradables will. however.
weaken :ll1, tendency for countnes' price leveis to converge.
58 The method echoes the recent study of Lothi:ll1 (1995). :ll1d we find similar panems here.
Elchengreen (1991) compares :ll1d :ll1alyzes real interest dlfferentials ave r subperiods of the
Intef"',\,ar penod.
78 Globali::.ation in Capital Markets: The Long-Run Evidence
Table 2.6. Real lnterest Parir)' Since 1870: Dispersion of Real lnterest
Rate, 10 Countries, Selected Periods, Percent per Annum
Avg. absolute differentíal relative to USA
AUS BEL CAN FRA DEU IT A NLD SWE GBR Std. deviation
1870-1889 4.5 3.8 4.3 4.8 1.6 1.8 3.3 3.2 3.3 4.2
1890-1913 2.8 4.1 2.1 4.2 2.4 1.8 2.8 2.6 1.8 3.4
• 1914-1918 7.9 1.3 0.7 11.0 5.8 8.3 6.2 (91)
1919-1926 3.5 lU 2.2 13.5 6.1 9.4 4.2 5.8 4.6 20.2
1927-1931 2.9 7.6 l.l 6.6 2.9 4.8 1.7 1.8 1.3 6.0
1932-1939 3.3 3.3 1.2 10.7 2.6 4.7 3.8 3.4 3.0 6.5
1940-1946 3.3 10.7 3.2 38.5 5.5 5.2 3.9 (22.3)
1947-1959 4.4 3.3 1.8 4.5 4.5 4.4 4.2 3.0 2.1 6.0
1960-1973 1.3 1.3 1.0 0.9 1.8 2.0 1.7 1.4 1.3 1.6
1974-1989 1.9 2.4 1.2 1.5 2.4 2.2 2.3 1.8 3.2 3.7
1990-1996 3.6 2.7 2.2 2.6 1.5 3.2 1.6 1.9 l.l 1.8
Notes: Annual data. Parentheses denote average with some countries missing.
Sources: See Appendix.
30
<?
25 "
"
,"
"
"
20 ," ,
,
15
,
10
5
\j
O
1860 1880 1900 1920 1940 1960 1980 2000
Fig. 2. I I. Real interest parily since 1870: dispersion of real interest rate, 10 countries,
quinquennia, percenl per annum
, . ., . , \' ,"\.
2.4 Price Cri te ria 79
better now than under the gold standard - and it was subject to a massive
dislocation in the interwar period. Thus. together with the evidence on the
extent of capital flows. this subsection again offers support for the view that the
Depression marked a low point in the modem history of international capital
mobility.
2.4.3 Purchasing Power Parity

As we have just noted. PPP remains a problematic concept for studies of cap-
ital market integration. since it may appear. at first sight. essential1y a test of
goods-market arbitrage. 59 Though critics have worried about this problem. the
concern may be misplaced. especial1y in the longer run. The important dis-
tinction here is between the general absolute price levei and the structure of
relative prices: aggregate PPP is an absolute price driven phenomenon. PPP is
therefore somewhat distinct from lhe pure LOOP concept applied to individual
commodities. ando more properly in the domain of monetary economics and
the macroeconomic theory of inflation.
On historical grounds. we would rapidly arrive the same conc1usion. Con-
ceiving of PPP in 1922. Cassei was motivated by a desire to understand the dy-
namics and behavior of exchange rates and prices following lhe vast dispersion
in national price leveis driven by wartime inflations in the various belligerent
countries. Adjusting exchange rates to be consistent with PPP. so as to reinstate
the gold standard credibly. was seen as a macroeconomic problem requiring
monetary adjustments. notably stringenl deflations in the countries that had in-
stigated a great deal of monetization of fiscal gaps to finance the war. In lhe
interim. convertibility and disequilibrium exchange rates were sustainable only
with strict exchange and capital controls which appeared in the war. These
controls subsequently subsided through the 1920s. but rose to unprecedented
heights in the 1930s and persisted into the 1960s. 1970s. and 1980s under the
Bretton Woods system. Viewed in such terms. the historical success or failure
of PPP can be seen as intimately tied to the mobility of global financiai capital
in the course of the twentieth century.60
Such an identification of PPP with capital market integration is. of course.
easily defensible on theoretical grounds. as is well known. PPP is a neces-
sary condition for the most stringent of capital market integration tests. the
international equalization of real interest rates. Indeed. PPP in its Strong formo
59 This section draws heavily on A. M. Taylor (1998).

60 Far the onglna! work see Cassei (1922). On adjustments in the 1920s see Kindleberger (1986)
ano Eichengreen (1992) We discussed the 1ang run evo1ution of capital contrais in Obstfeld
and Taylor ( 1998), and we cover this subject in the next chapter.
combined with speculative efficiency - uncovered interest parity (UIP) and cov-
ered interest parity (CIP) - is a sufficient condition for the equalization across
countries of ex ante real interest rates, as we have already seen in the preceding
section.
From an historical standpoint, there have been numerous studies of PPP for
various countries over the period in question, some covering a particular era or
monetary regime. 61 Recent empirical research, mostly based on the time-series
analysis of short spans of data for the ftoating-rate (post-Bretton-Woods) era
had led many to conclude that PPP failed to hold, and that the real exchange
rate followed a random walk, with no mean-reversion property. However, more
recent studies have challenged this conventional wisdom, seeing it as a ftawed
result arising from lack of statistical power and small-sample problems. A
newly emerging literature exploits more data and higher-powered techniques,
and claims that, in the long run, PPP does indeed hold: it appears from these
studies that real exchange rates exhibit mean reversion with a half-life of tive
years or so.62
An early, standard test of PPP took the form of testing for the restriction
f3 = 1 in the equation el = ex + f3(PI - p7) + tI where PI is the log domestic-
currency consumption-price leveI, p; is the log foreign-currency consumption-
price leveI, and el is the log of the exchange rate (domestic-currency price of
foreign exchange).63 Simple as this equation might be, the PPP literature has
6 I. McCloskey and Zecher (1984) argued lhal PPP worked very weIl under lhe Anglo-American gold
slandard before 19 I 4. using lhis as a basis for a monelary lheory of gold-standard adjustmenl.
Diebold. Husted. and Rush (199 I) explored a very long run of nineleenth century data for six
countries. and found suppon for PPP based on the low-frequency infonnatíon lack.ing in shon-
sample studies. Abauf and Jorion (1990) studied a century of doIlar-franc-sterling exchange
rate data and veritied PPP; Lothian and Taylor (1996) found the same for rwo centuries of doIlar-
franc-slerling dala. LOlhian (1990) also found evidence that real exchange rales were slationary
for Japan. the U.S .. lhe U.K .. and France forthe period 1875- I986. allhough yen exchange rales
exhibiled only lrend-slalionarity - an oft-repeated tinding lhal the real yen exchange rale has
appreciated over lhe long run againsl ali currencies. In full length monographs. both Lee (1978)
and Officer (1982) found strong evidence in favor of PPP based on analysis of long lÍme-series
runmng from lhe pre-1914 gold slandard lO lhe managed float of lhe I 970s. Obviously. this
paper builds on a very strong foundalion of hislOrical work by a number of scholars. covering
vanous countries in differenllime periods. Olher studies of long run dala are numerous (Frankel
1986; Edison 1987; Johnson 1990; Glen 1992; Kim 1990).
62. See M. P. Taylor (1995); Frool and Rogoff (1995). The newer findings use various sleps to
expand lhe size of samples used to test PPP. As nllted. il has been possible to USf> much !ClTJgpr-
run lime series for cenain individual countries. spanning a century or more; typically such
exercises have concentraled on more-developed countries wilh good hisloriCal data availabilily
(e.g .. U.S .. Brilain. France). AIlematively. researchers have expanded lhe data for lhe recent
floal or poslwar periods cross-seclionally lO exploillhe additional infonnation in panel data (Wei
and Parsley 1995; Frankel and Rose 1995; Pedroni 1995). II is slilllOO early lO say whelher
lhe revisionisl PPP tindings will prove robuSl. and already challenges lo lhis inlerpretation have
emerged (O'ConneIl 1996; PapeIl 1995; Pape 11 1995; Wei and Parsley 1995; Edison. Gagnon.
and Melick 1995; Engel 1996).
63. See. for example. Frenkel (198 I).
grown to encompass seemingly innumerbale problems with the nai've test. For
example, there are reasons to expect that, even if markets are well-integrated,
it may not be the case that f3 = 1. For example, non-traded goods circumvent
the exact pass-through of price shocks from one market to another. This might
plausibly lead to a long-run relationship as above, but with a sIope not equal to
unity. The tenn Weak PPP is used to describe the case f3 1-=1, as opposed to
Strong PPP, the case f3 = 1.
An alternative methodology imposes the restriction that f3 = 1 (Strong PPP),
in which case the residuais can be constructed, rather than estimated. The
residuaIs are then tenned the real e.xchange rate, the Iog of which is written
qr = er - Pr + p;. In this methodology attention focuses on whether this
variable is stationary, or else obeys the null of a random walk.
Other problems arise for the simplest PPP tests. In theory the choice of
benchmark country (for p*) should be immateriaI, but this matters in practice
(e.g .. it is easier to reject the unit-root nulJ during the recent ftoat when Gennany
is the benchmark rather than the U.S., a finding possibly related to the unusual
swings in the dollar in the 1980s). A solution to this problem in the paneI
context is, instead, to set the benchmark relative to a world-average basket of
currencies. Thus O'ConnelJ suggested using a "dolJarized" price index as the
variable to be studied in country i, defined as rir = pir - eir, which is supposed
to be following a mean-reverting process with respect to an unobserved "world
nominal anchor" ar.6-1
A comprehensive examination of the PPP property for our sample of twenty
countries over more than one hundred years, one of longest and broadest panels
of data studied to date, can be found elsewhere. 65 The key finding is that sta-
64. See O'Connell (1996). In this approach. we posit
O(,/! - (l,) = y, + 0('1.1_1 - a,_I) + E/!.

Wl: C:ll1 set the benchmark relative to the U.S. by subtracting the U.S. equation from the equation
for country /. eliminating a, to obtain
O(,/! - 'CS.r) = (y, - yuS) + ó(',.,_1 - 'US.,-I) -"- E" - EUS./·
The benchmark·related problems are clear. First. the term EU S., introduces cross-sectional
dependenct In the panel estimation. Second. if ó is not constant across countries then the
benchm;:u-ktng Introduces serial correlation in the error terms. O'Connell (1996) therefore
ad\ ocates subtracttng a world average of the first equation from itself. implying
OI'" - '\\',) = (y, - YW) + 0('1.1_1 - 'W.I-)) + E,I - EWI.
wherc a subscnpt IV denotes a world average. Here we are testing the relationship between
country i '5 "dollanzed" price index and that of the world. This may make it easier to maintain
an assumptlon of cross-sectional independence since the term EW.r only has an impact on the
dlsturbance covanance matrix that is O( 1I../N) for a pane I of cross-sectional width N.
65. See A. ~1. Taylor (1997)
82 Globali::.ation in Capital Markets: The Long-Run Evidence
Table 2.7. Purchasing Power Parir;: Panel Tests

Estimares o(rhe sloe.e 0Lrhe coinreí!.ratiní!. reíI.'ession 7? - a + b 7?W. ree.niní!. b a1ü1 (t)t
Gold Inter Br. Float Ali Gold Inter Br. Float Ali
Std. war Wds. ~rs. Std. war Wds. yrs.
OLS FMOLS
ARG 1.68 1.53 1.85 1.00 0.82 1.42 -3.03 1.83 4.87 0.84
(0.8) (0.6) (07) (00) (0.6) (2.5)- (16.2)- ( 1.9)- (9.8)- (3.\)-
AUS 0.82 1.63 1.05 0.72 0.86 0.97 1.52 0.99 0.78 0.88
(OA) (1.3) (0.2) (0.8) (1.1 ) (0.3) (5.3)- (0.1) (2.2)- (5.7)-
BEL 1.28 0.06 0.78 0.92 1.20 1.26 0.20 0.81 0.78 l.l8
(0.5) (1.1 ) ( 1.8)- (0.2) (1.0) (2.1)- (4A)- (7A)- ( 1.8)- (4.2)-
BRZ 0.52 1.78 -0.62 OA6 0.50 0.36 -IA3 -0.61 3.00 OA8
(06) (10) (IA) (1.5) (1.7)- (4.9)- (13.3)- (3.9)- (14.2)- (8.8)-
CAN 0.93 0.83 0.61 0.79 0.89 1.0 I 0.90 0.57 0.80 0.89
(0.2) (OA) (1.5) (0.7) (0.8) (0.1) (1.4) (4.6)- (1.6) (37)-
DEN 0.80 0.64 1.68 0.87 1.09 0.86 0.48 1.77 0.50 1.08
(0.4) (0.3) (1.4 ) (OI) (0.4) (1.5)- (1.6)- (5.6)- (1.2) (1.9)-
FIN 0.80 1.50 0.61 l.l6 1.04 0.83 1.80 0.58 1.04 1.05
(06) (0.9) ( 1.2) (1.0) (0.4) (2.3)- (9.2)- (4.0)- (09) (2.2)-
FRA 0.47 0.96 0.58 0.96 0.86 0.50 0.99 0.56 0.86 0.86
(10) (OI) ( 1.2) (0.2) (1.7)- (3.5)- (OI) (4.2)- (2.5)- (10.1)-
GER 0.82 0.09 0.94 0.92 1.02 0.79 0.05 0.99 1.06 1.0 I
(l.l ) (08) (03) (0.4) (02) (60)- (3.5)- (0.1) (1.1 ) (0.3)
ITA 0.64 -0.05 1.16 1.03 0.97 0.64 1.07 l.l7 0.29 0.96
(1.5) ( 1.0) (07) (O I) (03) (5.6)- (03) (2.2)- (8. 1)- (1.4 )
lPN 2.64 2.14 1.34 1.46 1.50 2.28 2.94 1.34 1.07 1.49
(15) (08) (18)- (I A) (2.9)- (6.2)- (5.7)- (67)- (0.6) (15.0)-
,\~"cv 1 71'. 1 9" 0.79 C.5::: 0.79 2.10 2.35 0.76 0.31 O~ 1
(0.5) (0.5) (07) (09) (l.l ) (4.0)- (3.8)- (37)" (5.3)- (5.7)-
NLD 0.43 0.09 1.32 0.99 l.l2 0.52 -0.17 1.33 l.l9 1.11
(15) lO.9) (2.4 l· (00) (09) (9.3 \- (5.0)· (110)' (2.3)" (U)'
NOR 0.83 1.31 1.09 1.05 105 0.81 1.71 l.l0 0.88 1.05
(05) lO.7) (06) (O A) (06) (2.1)· (9.0)- (4.8)' (3.8)- (2.9)-
PRT 115 119 0.96 0.84 0.65 l.l4 1.37 1.06 0.80 0.65
(02) (05) (0.1) (0.8) (0.9) (0.5) (83)- (0.6) (3.5)- (4.2)-
ÉSP 1.39 143 1.60 1.17 1.08 1.36 1.98 1.52 0.69 1.08
(06) lO.7) (13) (0.9) (0.5) (31 )- (9.6)- (4.7)- (5.0)- (3.1 )-
SWE 0.81 1.00 1.32 0.83 1.08 0.76 1.25 1.32 0.75 1.08
lO 7) (00) (2.1). lO8) (07) (U)· (60)' (6.2)' (3.5)- (3.3)·
CHE 122 0.08 1.35 2.09 163 122 -0.07 1.35 2.31 1.63
(06) (10) (24)' (31 )' (35)- (2.5)' (5.0)· (78)' (10.1)- (17.0)'
GBR 0.52 106 0.98 l.l6 0.93 0.53 0.97 0.95 1.38 0.95
(2.9)' (0.4) (OI) (06) (07) (12.9)' (1.2) (0.6) (4.7)- (2.9)-
," .... fi 4-1 fi IíR fi 1í9 fi 98 fi 94 0.52 O 7J 0.71 1.02 0.95
(2.1 )- lO 6) (2.4)· (00) (0.4) (9.3)' (2.7)' (7.7)- lOl) (1.5 )
.'.
1.' •
.' . , .'.'
Table 2.7. (Continued)
Pane1 coertlctents a!üi comleRral/on test stal/Stlcs
Gold Inter Br. Float Ali Gold Inter Br. Float Ali
Std. war Wds. yrs. Std. war Wds. yrs.
CJLS F'MCJ[S
0.57 0.66 0.76 0.86 0.75 101 105 100 101 100
(Q I) (OI) (OI) (O I) (0.1) (0.5) (1.2) (0.4) (0.2) (0.1)
Feasible FMOLS GroU!; Mean FMOLS
0.86 1.15 102 0.99 100 0.99 0.78 100 122 100
(9.3)- (32)- (1.7)- (0.4) (12) (9.2)- (0.6) 0.3)- (1.2) (15)
ADF statistic PP statistic
-15.1- -22.4" -10.3- -9.0- -12.9' -14.7- -12.4' -11.2' -9.1 -12.2-
Rho statistic V statistic
-51.3" -44.8" -44.2' -312 -62.2' 37.0 3.4 30.1 14.1 97.4"
7 The t statistic is for the null hypothesis HO: b - I.
, significant at the 5% leveI.

Notes and sources: See text and A!;~ndix. Tests are due to Pedroni (1995: 1996).
tionarity of the real exchange rate is very hard to uphold in ali circumstances. If
cross-country heterogeneity must be admitted to the analysis of panel dynamics,
then a cointegration analysis with heterogeneous slopes is needed. 66 Suppose
we estimate an equation ofthe form rit = (ti +f3irROW.t +Eit. This is the analog
of the nalve PPP model using a "dollarized" rest-of-world (ROW) price index
as the relevant nominal anchor for each country. Table 2.7 reports the results for
our balanced pane! of twenty countries, showing estimated coefficients, using
OLS and F1vl0LS methods and panel cointegration test statistics.
What the mass of results in this table shows is that for this panel, in most
cases. given a null of (i) a unit coefficient and (ii) nonstationarity, we can
almost accept (i) and, as shown above, reject (ii). The lesson of these results
is clear: we probably do have real exchange rate processes that revert to an
equilibrium for most countries, and that equilibrium usually shows an almost
unit proportionality between domestic and world dollar prices. But in a few
cases it is far from unity, and in virtually every case it is most likely flOt exactly
unit).
Thus. only a slight weakening of the Strong PPP hypothesis is needed:
enough ftexibility in the coefficients to admit a non-unit pass through from
world to domestic prices. and, in most cases, that pass through seems like a
not implausible number that is close to, but not exactly equal to one. Qualita-
tive I)". this seems like a reasonable step to take, and it has enormous benefits
in terms of our capacity to reject nonstationarity. With just a little ftexibility in
the speciflcation. cointegration tests support the notion of an equilibrium PPP
relationship.
66 For thls technique we rely on Pedroni (1995: 1996)
~) \
" \'
.,'1., •
.10 ~------------------------
r
.09 ~
08 1i
07 ~
I
.06 j
i
.05 J
.04 1i ..
.03 i I
~
02
.01 ~
~:
.oo~'
I ______________________---J
1880 1900 1920 1940 1960 1980 2000
Fig.2.12. Purchasing powcr parity: dcviations from equilibrium
j-;-uw w,- might ask, givcn the coint.:,b.ating .cgression as a best-fit estimate of
the (Weak PPP) equilibrium rela,ionship, how far from this relationship did the
internation3.1 system deviate at ccrt3.in times? That is, what do the residuaIs of
the regression tell us about the size and persistence of PPP deviations? Figure
2.12 offers a basis for evaluating deviations from Weak PPP. The residuaIs Eit
estimated in the regression provide a measure ofthe deviation oflog "dollarized"
price leveIs from their equilibrium value. Hence, we may usefully study the
dispersion of these residuaIs over time to get some sense of the extent to which
deviations from Weak PPP equilbrium waxed and waned in different eras.
Figure 2.12 shows a measure of the dispersion of the residuaIs U E2 (t), defined
as U E2 (1) = Var(Eis Is = I). This measure of deviations from parity produces
reasonable insights. We find that PPP deviations were relatively small in the
pre-1914 era, as is well appreciated fronl our h.nowltdge of the golJ standar~.
Dispersion grew dramatically after 1914 with the collapse of the classical gold
standard and the disparate inflationary experiences of the several economies,
as Casell observed. Dispersion fell in the late 1920s, as a new gold standard
was rebuilt, but when this experiment failed dispersion grew again in the 1930s
following widespread deflations and various devaluations and depreciations.
Dispersion was again high immediately after 1945, but fell steadily during the
postwar era. Convergence toward equilibrium was tentative during the early
years of Bretton Woods before 1960, when pervasive capital controls were the
norm. Thereafter, in the (brief) heyday of the postwar fixed-exchange rate
system, deviations from equilibrium dipped to historically low leveIs. Even a
modest increase in dispersion in the floating-rate era cannot undo the conclusion
that from the 1960s to the present we have seen a degree ofintegration (measured
by PPP) not known since the end of the classical gold standard in 1914.
The interwar period emerges as an important watershed, marking an era of
increased deviations fram parities. The Depression emerges as the era when
deviations from parity reached historie maxima prior to a sustained decline after
1945 under Bretton Woods and the float. These findings further strengthen the
case that the Great Depression stands as the nadir of intemational capital market
integration in the modem era.
2.4.4 Caveats: Price Criteria

This section has reviewed several kinds of price cri teria that might be used to
evaluate the integration of global capital markets over the long run. The data is
scarce. and we cannot cover alI countries at alI times. However, we have found
that tests of the law of one price for assets, based on various parity relationships,
do suggest changes in the degree of integration consistent with the stylized facts
V.:e described earlier. An examination of covered interest parity, real interest
parit;.. and purchasing power parity all indicate an increase in deviations fram
parity in the interwar period, and a gradual decrease in those deviations in
more recent decades. This would support the view that global capital markets
have witnessed two great phases of integration, one before 1914, and one in
the contemporary period, with both separated by a long phase of disintegration
during the two wars and the Great Depression.
AI though price cri teria sue h as these may appear more persuasive than the
quantity cnteria. we must again caution that their interpretation still rests on
aux il iary assumptions about structural change in the world economy at different
times. It is in theory possible that all the price movements we have described
were caused by structural shifts at the levei of national economies having noth-
lng to do with capital mobility and obstacles to market integration. These would
be the same kinds of shocks outlined in the earlier section on caveats regarding
quantity cnteria. Essentially we have to worry that certain kinds of shocks
might have caused price divergence in the interwar and mid-century epochs,
absent an) change in arbitrage opportunities. Yet, exploiting what we already
know from the quantity criteria. we sue h an explanation implausible.
For suppllse that arbitrage possibilities were unchanged over time. Then his-
86 Globa/ization in Capital Markets: The Long-Run Evidence
toricalIy, the maximal deviations from price parity would have to be considered
the eras of maximal profit opportunities. In that case, the very greatest arbi-
trage activity, and the movement of stocks and the increase in flows, ought to
have been seen at those times. Such was precisely not the case. The maximal
flows and changes in stocks took place in the initial and final phases of our time
frame, before 1914 and in the recent decades. These were also times of minimal
deviations from price parity relations. At the same time, the period of maximal
price deviations at mid-century, was also the era of minimal quantity activity.
This pattem contradicts the idea that structural changes in nonarbitrage aspects
of the global economy could simultaneously explain both the evolution of price
and quantity behavior. Rather, this empirical evidence is entirely consistent
instead with the idea that there have been large shifts in the extent of arbitrage
possibilities over time: forging a global market before 1914, virtually c10sing
that market for many decades thereafter, and reforging the market even now.
2.5 Summary
Many studies of market integration have focused on a single kind of criterion.

This approach seems unreasonably restrictive to us, since the interpretation of
such narrow criteria must necessarily rest upon untested auxiliary assumptions.
b) ,-umrast, Wt: ~tt nu Itasun lU úi~l1li~~ (111)' u~eful information, in either
price or quantity forrn, especialIy given the paucity of historical data in certain
quarters. Thus. we have opted for a broad battery of tests to try to cut down
the possible set of explanations that could account for the empirical record, and
so. by a process of elimination. work towards a set on controlled conjectures
conceming the evolution of the global capital market.
The preceding section succinctly conveys the benefits we think this kind of
approach can deliver. Our quantity-based tests delivered a certain set of styl-
ized facts. and the price-based tests another set of facts. Combining the two.
and introducing evidence on convergence and divergence in other economic
phenomena such as Iiving standards and demography, we c1aim there is over-
whelming support for the notion that the major long-run changes in the degree
af global capital mobIiity have taKen the torrn of changes in the impedlments
to capital flows themselves, rather than any encouragement or discouragement
to flows arising from structural shifts within the economies themselves. That
is not to discount the fact that such changes have occurred, and are no doubt
important at the margin; but it is an assertion that the virtual disappearance of
foreign capital flows and stocks in mid-century. and the explosion in price differ-
entials. can only be explained by an appeal to changes in arbitrage possibilities
..
2.5 Summary 87
as permitted by two major constraining factors in capital market operations:
technology and national economic policies.
From this point, it is a short step to the conclusion that a full accounting ofthe
phenomena at hand must rest on a detailed political and institutional history.
Clearly. technology is a poor candidate for the explanation of the twentieth
century collapse of capital mobility. In the 1920s and 1930s the prevailing
financiaI technologies were not suddenly forgotten by market participants: in-
deed some technologies, such as futures markets for foreign exchange carne to
fruition in those decades. Technological evolution was not smooth and linear,
but, as we have already noted. was at least unidirectional, and, absent any other
impediments. would have implied an uninterrupted progress toward an ever
more tightly connected global marketplace. Such was not allowed to happen,
of course. Rather. the shifting forces of national economic policies. as inftu-
enced by the prevailing economic theories of the day, loomed large during and
after the watershed event of the twentieth century, the economic and political
crisis of the Great Depression. Understanding the macroeconomic and interna-
tional economic history of our present century in these terms, and the changes
it wrought for the operation of the global capital market, is a long and complex
story. a narrative that properly accompanies the empirical record presented in
this chapter. and that we now take up in the chapter that follows.
000088986
" 11111111111111111111111111111111111

Global Capital Markets PDF

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Global Capital Markets PDF

Uploaded by

Copyright:

Available Formats

- -

"Global Capital Markets: Integration,

Prof. Alan Taylor (Northwestem University/NBER)

Coordenação: Prof. Pedro Cavalcanti Gomes Ferreira

This book presents an economic history of intemational capital

MAURICE OBSTFELD is Class of 1958 Professor of Economics at the

ALAN M. TAYLOR is Assistant Professor ofEconomics at

NWOTECA IlARIO HENRIQUE _ _

ALA'; ;"1. TAYLOR

Part one: Preamble

Global Capital Markets: Overview and Origins 4

1.1 Theoretical Benefits 5

Part two: Global Capital in Modero HistoricaI Perspective 31

2 Globalization in Capital Markets: The Long-Run Evidence 34

3 Globalization in Capital Markets: A Long-Run Narrative 88

3.1 Capital Without Constraints: The Gold Standard, 1870-1931 88

Part three: Lessons for Today 125

4 Open Capital Markets: Worth the Risk? 127

hardly describe them as being integrated in a single market, as the equality of

.1See Bordo and Schwartz (198.1): Eichengreen (1996).

7. On lhe Brelton Woods syslem. see Bordo and Eichengreen (1993).

currency board supposedly subordinated to maintaining the Hong Kong-U.S.

Table 2.1. The Trilemma and Major Phases of Capital Mobility

Gold standard Most Rare Rare Broad consensus.

Bretton Woods None(O) Most Rare Broad consensus.

Float Rare Gening Gening Some consensus; except

2.3 Quantity Criteria

2.3.1 The Stocks of Foreign Capital

ForeignAssetsShareit = LAjir!LAjit; (2.1 )

Foreign Assets-to-GDP Rati0 it L Ajir/Yit ; (2.3)

A still irksome empirical problem, however, arises for the numerator. It is

Table 2.2. Foreign Capital Stocks

World GDP Illb 128b 221b 491b 491b 722b

Assets/Sample GDP 0.55 0.51 0.28 0.26 0.12

UKJAII 0.56 0.78 0.64 0.51 0.50 0.44 0.43 0.40

World GDP 1.942b 4.733b 11.118e 12.455e 21.141e 25.llOe

AssetslSample GDP 0.18 0.29 0.37 0.47 0.54

UKlAIl 0.21 0.28 0.21 0.17 0.17

Asia lexel. Japan) 2.7a 29g 129g 524g 960g

World GDP 1.942b 4.733b 11.118e 12.455e 21.141e 25.11Oe

Liabilities/Sample GDP 0.26 0.42 0.59 0.69

Developing Countries/All 0.35 0.32 013 0.14

Fig. 2.1. Foreign capital stocks

16. This Anglo-American transfer of hegemonic power is discussed by Kindleberger (1986).

Fig. 2.2. Foreign capital stocks

22. See Lucas ( 1990).

2.3.2 The Size of Flows

GDP == Q = C + I + G + NX, (2.5)

\vhere N X = X - M is net exports. If the country's net credit (debt) position

GNP == Y = Q + rB = C + I + G + NX + rB. (2.6)

where 5 == Y - C - G is gross national saving. Finally, the dynamic structure

t::,.B I = BI - BI_I == CAI = -K AI' (2.8)

Table 2.3. Si::.e of Capital Flows: Average Absolute Value of CA/Y, By

(a) Ratio of capital inflows to investment for periphery economies

(b) Ratio of capital outflows to saving for core economies

Fig.2.5. CapItal flows in relation to saving and investment, 1870--1913: 15 countries,

the importance of capital ftows in relation to saving and investment in today's

2.3.3 The Saving-Investment Relationslzip

saving rates. The regression is perfonned on a cross section of countries indexed

O~O ~Rg8aO j 'b i······ ~<§'

1860 1880 1900 1920 1940 1960 1980 2000

Fig. 2.7. Feldstein-Horioka coefficient: 15 countries. quinquennia and decades.

CII.UQTECA IIA~niJ H~ftIQUE . . . .