In the article I discuss some possible explanations for two features of financial globalization over recent years; first, the fact that expected returns have fallen significantly in advanced countries, even though economic growth has accelerated; and second, the fact that capital is flowing from poor to rich countries rather than the other way round, a phenomenon known in the literature as the “Lucas Paradox”. The “incomplete” nature of globalization, notably the persistent differences in institutional quality between North and South, might explain both puzzles as well as the emergence of global imbalances. Alternative explanations based on a fall in risk premia and accommodative monetary policy conditions fit the facts less well. I then discuss the implications for monetary policy.
The effects of globalization on the conduct of monetary policy, especially in advanced economies, lie at the heart of many recent academic and policy debates. One difficulty in dealing with this issue is that we do not yet have a general equilibrium model that takes into account all relevant interaction between the various forces unleashed by globalization. As a consequence, the effects of globalization tend to be examined in isolation, from a partial equilibrium perspective, and this may lead to inappropriate conclusions.
I will focus in this article on the question of whether the fall in real long-term interest rates experienced in advanced economies over the last few years reflects a change in the global savings-investment equilibrium, which should in theory be accommodated by monetary policy, or an excess of global liquidity generated by expansionary monetary policies, which should instead induce corrective monetary action. I will try to assess the way in which globalization affects monetary policy, even in a large economy such as the euro area. Since I do not possess a general equilibrium model capable of illustrating all the relevant interactions, I will use the available – yet imperfect – tools of partial equilibrium and try to combine the results of the partial analyses to improve our global understanding of the issue. One should not be disappointed by the fact that the results of such an analysis are not clear-cut. Economists and policy-makers are used to that. What is more important, especially for policy-makers, is to be aware of the risks of taking policy decisions in an uncertain environment, i.e. an environment of which they have only a partial understanding.
This paper is organized as follows. In Section 2, I describe two apparent puzzles in current international financial markets: first, the fact that long-term expected returns have fallen, particularly in advanced countries, while global economic growth has strengthened; and second, the fact that capital tends to flow uphill, i.e. from poor to rich countries, contrary to theoretical predictions (a phenomenon known as the “Lucas Paradox”). In Section 3, I will argue that an explanation centered around the existence of an institutional, legal and financial frictions, which make globalization “incomplete”, can explain both paradoxes. In Section 4, I discuss the evidence on the incomplete nature of globalization, while in Section 5 I deal with some other possible shocks which may have affected global real long-term interest rates in recent years. Of particular relevance is the accumulation of excess liquidity made possible by accommodative monetary policy conditions worldwide. Section 6 discusses some monetary policy implications, and Section 7 concludes.
In this article I have discussed possible factors explaining two relatively striking aspects of financial globalization over recent years: first, the fact that expected returns have tended to decline significantly in advanced countries, even though global growth has accelerated; and second, the fact that capital is flowing uphill rather than downhill (known as the Lucas Paradox). The basic point made by this article is that differences in institutional quality between the North and the South, which persist even in the face of globalization, appear to provide a satisfactory explanation for both puzzles. At the same time, it is quite clear that we are far from having a full understanding of the forces unleashed by globalization. Nor are we able to control for other factors, such as the influence of monetary policy conditions, in a fully satisfactory way. I am therefore forced to conclude that more analytical work is certainly warranted.
