Foreign Capital and Economic Growth in the First Era of Globalization

Abstract

The First Era of Globalization, 1870-1913, was marked by a degree of integration in goods and financial markets comparable to that which prevails today. It also exhibited a large number of financial crises that unfolded in ways very similar to those experienced since the 1970s. In light of skepticism about whether market-based finance is good for development, this paper will reexamine the impact of capital market integration on economic growth during this period. First we will explore whether there are growth benefits from participation in the international capital market. Second we will analyze the side effects of open international capital markets. Between 1880 and 1913 financial crises that accompanied sudden stops meant that any growth advantages to greater inflows of foreign capital were greatly diminished. We then look at several determinants of debt crises and financial crises including the currency composition of debt, debt intolerance and the role of political institutions. We argue that the set of countries that had the worst growth outcomes were those that had currency crises, original sin, poorly developed financial markets and presidential political systems. Those that avoided financial catastrophe generated credible commitments and sound fiscal and financial policies. Such countries succeeded in escaping major financial crises and grew relatively faster despite the potential of facing sudden stops of capital inflows, major current account reversals and currency speculation that accompanied international capital markets free of capital controls.