Rare Institutional Disruptions and Uphill Capital Flows

Abstract

Standard international macroeconomic models overpredict capital flows into countries with relatively lower capital stocks and faster-growing TFP. Asymmetric invest- ment risk has been shown in similar models to be a significant driver of capital flows between otherwise symmetric countries. But can risk drive capital “uphill?” This paper builds a model with two large open economies to assess the ability of asymmetric aggregate risk to partially counteract the neoclassical convergence forces. The two economies are calibrated to the average 1980 capital stocks, TFP levels, and trend TFP growth rates of a group of 21 developed markets and a group of 21 emerging markets, respectively. In addition, the two economies’ TFP processes are subject to both transitory Gaussian shocks and rare disasters, both calibrated to evidence that emerging markets are not just more volatile, but are addi- tionally subject to rare disasters that are both more common and more severe than those in developed markets. At the baseline calibration, risk is able to prevent 82% of the flows that would have occurred due to the convergence forces, and if the initial gap in capital per worker and TFP in the average emerging market were 61% that which was observed in the data, the risk motive would exactly offset the convergence forces. This paper concludes that the literature’s insights on the first-order importance of risk remain relevant even in a setting where powerful countervailing forces would drive capital “downhill.”