'Cause let's face it, it didn't. It didn't boost investment and growth in emerging market economies; it led to increased volatility; and it played an important supporting role in the current subprime mortgage mess.
I have a new paper with Arvind Subramanian which scrutinizes the reasons. From the introduction:
What these findings reveal are the shortcomings of the mental model that dominated thinking about capital flows a decade ago. This model had two key premises. First, it presumed that low savings and weak financial markets at home were first-order constraints on economic growth and development. Thus greater access to investible funds from abroad and improved financial intermediation would provide a powerful boost to domestic investment and growth along with better consumption smoothing. Second, while it recognized the potential of adverse interactions between lenders’ incentives abroad and borrowers’ incentives at home, it assumed that sufficiently vigilant prudential regulation and supervision could ameliorate the attendant risks sufficiently. Indeed, given the presumed importance of access to international finance, this model required that policy makers give very high priority to the implementation of appropriate regulatory structures.
In brief, the argument was this: (1) Developing nations need foreign capital to grow. (2) But foreign capital can be risky if they do not pursue prudent macroeconomic policies and appropriate prudential regulation. (3) So developing countries must become ever more vigilant on those fronts as they open themselves up to capital flows. This syllogism remains at the core of the case for financial globalization (e.g. Mishkin 2006), even though, as we shall see, some newer arguments have begun to take a different tack (e.g. Kose, Prasad, Rogoff, and Wei). But the syllogism relies heavily on a premise that is by no means self-evident. Certainly the results of Prasad, Rajan, and Subramanian (2007) and Gourinchas and Jeanne (2007) are at variance with the presupposition that poor nations need foreign finance in order to develop.
To make sense of what is going on, we need a different mental model. We must begin by taking note of the fact that developing countries live in a second-best world, which means that they suffer from multiple distortions and constraints. While some nations may be severely constrained by inadequate access to finance, others—and perhaps a majority—are constrained primarily by inadequate investment demand, due either to low social returns or to low private appropriability. As we shall argue below, targeting the external finance problem when the “binding constraint” lies with investment demand can be not only ineffective, it can actually backfire. In particular, capital inflows exacerbate the investment constraint through the real exchange rate channel: the increase in the real exchange rate which accompanies capital inflows reduces the real profitability of investment in tradables and lowers the private sector’s willingness to invest. The result is that while capital inflows definitely boost consumption, their effect on investment and growth is indeterminate, and could even be negative. The flat investment profile that most emerging market economies have seen since the early 1990s—compared to their experience prior to financial globalization—can be understood in these terms. The exceptions are countries such as China, India, or Chile that have managed to prevent real exchange rate appreciation for a sustained period of time thanks in part to their reliance on capital controls.
Furthermore, government capacities are limited. Priorities have to be selected carefully since not all distortions can be removed simultaneously. The emphasis on strengthening financial regulation and governance, demanding as it is even in advanced countries, is particularly challenging in countries that are struggling with problems of underdevelopment. Confronting this challenge, and paying up the implied opportunity costs, makes a lot of sense if what one gets in exchange is a big boost in growth, as would be the case when the binding constraint on growth is access to external finance. But otherwise, exhortations on prudential regulation serve little purpose other than reveal the professional limitation of every specialist: insistence that the government undertake all the complementary reforms that would ensure the success of the specialist’s policy recommendation, and indifference to the trade-offs that might arise from the needs of more urgent reforms elsewhere. (Footnotes omitted)
The paper does two things. First, it evaluates and critiques the latest generation of work in favor of financial globalization--mainly the writings of Rick Mishkin, Peter Henry, and Kose, Prasad. Rogoff, and Wei. Second, it argues that we need to understand the difference between saving- and investment-constrained economies in order to make sense of financial globalization. In investment-constrained economies--where investment is low not because of poor access to credit but because of low perceived return--capital inflows are at best ineffective, at worst harmful.
The paper will be eventually published in the IMF Staff Papers, the house organ of that hotbed of radical economists...