Asymmetries of financial openness in an optimal growth model

Abstract

This paper analyzes international borrowing and lending in an optimal growth model with adjustment costs for investment, under both pre-commitment and lack of pre-commitment to debt repayment. We study the dynamics of the current account in the transition towards the balanced growth path, and derive the implications of financial openness for both the transition path and the balanced growth path. A comparison with financial autarky reveals that, under pre-commitment, and to the extent that countries start from different initial conditions, financial openness is beneficial for both poor and rich countries, as it allows them to engage in mutually beneficial inter-temporal trade. During the adjustment process, relatively poor countries experience higher consumption and investment compared to autarky, and thus experience current account deficits and accumulate net foreign debt. The inter-temporal tradeoff is asymmetric between poor and rich countries, in that poor countries experience lower steady state consumption, due to the need to service their accumulated foreign debt while the opposite happens in relatively rich countries. Under non pre-commitment, this asymmetric inter-temporal tradeoff results in a time inconsistency problem. Poor countries reach a point in the adjustment process after which it is welfare improving for them to default on their foreign debt. In the absence of pre-commitment mechanisms, international lenders anticipate these incentives, and international lending and borrowing breaks down. This time inconsistency problem can thus explain both the Feldstein-Horioka puzzle and the Lucas paradox that capital does not flow from rich to poor countries. Credible sanctions in the case of default and ceilings on international borrowing are analyzed as partial solutions to the time-inconsistency problem caused by this asymmetry between poor and ‘rich’ countries.