Financial Integration, Investment, and Economic Growth

by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation,

Monday, July 20, 2009 at 10:08 AM EDT

(Editor’s Note: This post comes to us from Moritz Schularick of the Free University of Berlin and Thomas M. Steger of ETH Zurich and CESifo.)

In our forthcoming The Review of Economics and Statistics paper: Financial Integration, Investment, and Economic Growth. Evidence from Two Eras of Financial Globalization, we turn to the economic history of the first era of financial globalization (1880-1914) for new insights into whether international financial integration boosts economic growth. We rely on models and techniques employed before in order to ensure the comparability of our results with those of previous studies, since our primary aim is to benchmark the present to the past. Economic historians have often underscored the contribution that international capital flows made to economic growth in developing countries during the “first era of globalization” – the years of the classical gold standard from 1870-1914. Yet it has not been tested econometrically for a broad cross-section of countries whether the first era of financial globalization does provide evidence that financial globalization can indeed spur growth.

We assembled the largest possible dataset for the years 1880-1914 covering 24 countries from all world regions that accounted for more than 80 percent of world output at the time. We use capital flows from the United Kingdom – the world’s leading financial centre at the time – as a proxy for the degree of financial openness of individual countries. Such detailed capital flow data are available from a recently published analysis of the geographical patterns of stock and bond issues at the London Stock Exchange (Stone, 1999). We also employ older data for foreign investment stocks (Woodruff, 1966) and net capital movements as implied by current account balances (Jones and Obstfeld, 1997) to corroborate our findings.

The new dataset allows us to show that international financial integration had a statistically significant effect on growth in the first era of global finance. We ensure the robustness of our model specification by first estimating our regressions on a dataset for 1980-2002. Using these models on our data, we find the first era of financial globalization saw a positive relationship between international financial integration and economic growth. Importantly, our study also suggests that a comparable effect cannot be found today. If financial integration contributes to economic growth today, the effect would need to be conditional on certain types of capital flows or on third factors such as the institutional framework.

We can show that before 1914 opening up to the international capital market went hand in hand with higher domestic investment. Today, changes in identical measures for financial integration are essentially uncorrelated with changes in domestic investment. Our explanation for this phenomenon focuses on the different patterns of financial globalization. The first era was marked by massive net capital flows from rich to poor economies (“development finance”). In contrast, today’s globalization is marked by high gross flows (“diversification finance”) and limited net capital transfers. In other words, in the historical period financial globalization led to long term net flows of capital from rich to poor economies. It is these net flows of capital that we suggest lead to growth.

The full paper is available for download here.

This article originally appeared on The Harvard Law School Forum on Corporate Governance and Financial Regulation.