Risk and Global Economic Architecture: Why Full Financial Integration May Be Undesirable

Abstract

Integration of global financial markets was supposed to lead to greater financial stability, as risks were spread around the world. The finan cial crisis has thrown doubt on this conclusion. A failure in one part of the global economic system caused a global “meltdown.” The recent crisis has shown that in the absence of appro priate government intervention, privately profit able transactions may lead to systemic risk. This paper provides a general analytic framework within which we can analyze the optimal degree (and form) of financial integration. Within this general framework, full integration is not in general optimal. Indeed, faced with a choice between two polar regimes, full integration or autarky, in the simplified model autarky may be superior.