Lucas Paradox Research Articles

How does interregional capital misallocation affect technological innovation in China? Theoretical mechanism and empirical evidence

ABSTRACT Capital allocation plays a pivotal role in production factor inputs and technology selection within the production process, exerting a profound influence on technological innovation. Leveraging panel data encompassing 284 prefecture-level cities in China from 2001 to 2019, this paper delves into the impact and underlying mechanisms of interregional capital misallocation on technological innovation. The findings are as follows: (1) The astern coastal regions are experiencing capital overallocation, whereas inland developing areas are prone to undercapitalised. This uneven distribution uncovers a notable ‘Lucas Paradox’ within China's regional capital allocation. (2) Interregional capital misallocation hampers technological innovation. This discernible inhibitory effect persists even after a series of robustness checks. From 2001 to 2019, interregional capital misallocation resulted in an average loss of 2.35 patents per 10,000 people in China. (3) In cities with excessive capital allocation, lower administrative level, insufficient financial development, and non-innovative pilots, this inhibitory effect is more pronounced. (4) Institutional environment destruction, fiscal expenditure bias and enterprise innovation inertia are the main channels through which interregional capital misallocation hindering technological innovation.

CAPITAL FLOWS AND INSTITUTIONAL QUALITY: A SYSTEMATIC LITERATURE REVIEW

The understanding of what drives capital flows is continually evolving. Earlier theories provided support for the role of macroeconomic factors, however, the drivers expanded to include non-macroeconomic factors following the Lucas (1990) paradox, which spurred interest towards examining the role of institutional quality and, in more recent years, capital market frictions. While other reviews of capital flow literature have concentrated on macroeconomic drivers, this review focuses on institutional factors and frictions and delves into three types of flows, as drivers can vary by type of flow. The literature is vast on drivers of foreign direct investment (FDI) while drivers of other types of capital flows have been less studied, and evidence remains scant. There is evidence of institutional quality helping to explain the Lucas paradox. Based on the literature reviewed in this paper, many institutional factors are important for FDI. Law and order and military in politics are notably important for both FDI and portfolio debt. Findings for portfolio equity are limited. On capital market frictions, the empirical evidence shows that distance; economic ties; and having a common language, border, and colonial past help explain capital flows; with distance driving all three types of capital flows. This review will help inform further research and policies aimed at attracting and retaining foreign capital, especially in developing economies that need such flows for economic development and poverty alleviation.

Credit market imperfection, lack of entrepreneurship and capital outflow from a developing economy

AbstractThis paper explores the impact of credit market imperfection on lack of demand for capital, trade, and capital flows in an economy with wealth heterogeneity. In particular, we look at the implications of wealth heterogeneity. We show that the low return of capital and lower output of credit‐intensive output in autarky may reflect lack of entrepreneurship and demand for credit due to wealth heterogeneity and eventually may lead to capital outflow from a capital‐scarce country. This is a different way of echoing the sentiment of the well–known Lucas paradox, which suggests that capital might flow from the poor to the rich countries. We also show the possibility of trade and capital flow being complements and not substitutes, as is usual in standard trade models driven by factor abundance.

Schumpeter’s insights for monetary macroeconomics and the theory of financial crises

Abstract The purpose of this paper is to show that Schumpeter can offer important insights for macroeconomic theory today. This applies especially to his distinction between a “real analysis” and a “monetary analysis,” as he calls it, and its implications for monetary macroeconomics, especially the theories of financial crises at the national and the global levels. The main problem of the “real analysis” is the identity of the financial sphere with the real sphere. The consequence of this narrow view is the inability to understand the dynamics of a monetary economy, which is the main cause for financial crises. The flaws of the real analysis manifest themselves also at the global level. The Feldstein–Horioka puzzle and the Lucas paradox are obvious “anomalies” of this paradigm. Models based on the real analysis are unable to explain the extent and even direction of international capital flows. Thus, the economics profession was unable to see the risks that were accumulating in the international financial system before the outbreak of the Great Financial Crisis.

Japan and the allocation puzzle in an aging world

Capital that flows from rich to poor countries can be important in equalizing living standards across countries. Various factors, however, contribute to the Lucas Paradox and the mixed empirical evidence on the direction of capital flows. Differences in fundamentals, or simply TFPs, international financial market imperfections, differential demographic aging across regions of the world, or fiscal institutions affect the dynamics of capital flows. This paper builds a general equilibrium model of the world economy under imperfect capital mobility, populated by overlapping generations of individuals in three regions: the High-income (HI), Middle-income (MI) regions and Japan. We show that both TFP and aging are important factors to explain capital flows from the MI region to the HI region in the future and that Japan will turn a net borrower in mid-century in a process where the MI region further accumulates its external wealth. An alternative transition path in which the MI region exhibits catch-up in the expansion of the pension system and the TFP growth throughout the century shows significant effects on the predicted external wealth position of Japan.

ANALYZING INTERNATIONAL CAPITAL FLOWS TO DEVELOPING AND EMERGING MARKET COUNTRIES USING A TWO-COUNTRY DYNAMIC STOCHASTIC GENERAL EQUILIBRIUM (DSGE) MODEL UNDER ASYMMETRIC INFORMATION STRUCTURE

In this study, in order to investigate the different forms of capital flow between developing and developed countries in the steady state, a two-country dynamic stochastic general equilibrium (DSGE) model, under asymmetric information, is developed. For simulating countries, the parameters of previous studies are used. The results showed that international risk-sharing can explain the Lucas paradox. In both symmetric and asymmetric information structures, net foreign assets in the forms of stocks in steady state are negative for developing countries. In other words, in the steady state, capital exits from the developing country in the form of bonds and enters these countries in the form of stocks. Besides, net capital inflows in the form of stocks and net outflows of capital in the form of bonds in the present model under asymmetric information are larger than that under symmetric information structure. Furthermore, impulse function results show that the two countries are highly correlated. So, the occurrence of a shock in one country changes the production and consumption of another country. But the impact of the shock on macro variables in the country itself is greater than in another.

Can Blended Finance Be a Game Changer in Sustainable Development? An Empirical Investigation of the “Lucas Paradox”

In recent years, the global development community has been emphasizing blended finance approaches for economic development without taking into consideration practical implications of the Lucas Paradox, or the observation that capital does not flow from rich to poor countries. To prevent misuse of official development funds as catalysts for private flows, it is crucial to consider the direction of blended finance approaches in light of the Lucas Paradox. To fill this important gap in the literature, this paper investigates determinants of capital flows in recipient countries where a blended finance strategy is applied in light of the Lucas Paradox, with a focus on foreign direct investment and portfolio equity investment. For the analysis, this paper utilizes a cross-sectional sample of 157 countries between 2002 and 2018, including ODA recipients and OECD DAC members, by conducting a regression analysis based on the ordinary least squares (OLS). Our findings suggest that the Lucas Paradox strongly exists in all recipient countries that can utilize ODA as a catalyst, which is the core of the blended finance strategy. Institutional quality, human capital and asymmetric information improvement appear to mitigate the Lucas Paradox, although the paradox does not disappear entirely. In addition, total ODA, institutional and human capital appear to be determinants of the paradox in the multiple regression model.

Institutional Quality and International Capital Flows to the Emerging Economies

The international capital flows and the factors influencing them are imperative in this era of globalization and financial liberalization. This paper empirically examines the role of institutional quality in enticing foreign capital flows in emerging market economies (EMEs). A panel data set for the period 1995-2018 is used for the 24 major EMEs including Argentina, Bangladesh, Brazil, Chile, China, Czech Republic, Greece, Hungary, India, Indonesia, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Romania, Russia, South Africa, Thailand, Turkey, Ukraine, and Venezuela. The system GMM estimation technique of dynamic panel data handling developed by Arellano-Bover (1995) and Blundell-Bond (1998) is employed for the estimation. The empirical results reveal that the FDI inflows are positively and significantly affected by the institutional quality, but the portfolio equity capital inflows are not influenced by any indicator of institutional performance. In other words, the Lucas paradox is explained by the institutional quality only in the case of FDI inflows. The study accomplishes that the policy aiming at attracting FDI flows by improving institutional infrastructure is expedient for the emerging economies.

Financial Integration Without Financial Development.

This paper shows that, in a two-country model, where the two economies differ in their level of financial market development, financial integration has sizable short- and medium-term effects, even in the absence of aggregate risks. Consistent with the Lucas paradox, the present work establishes that financial integration can reduce the speed of capital accumulation and increase savings in a developing country still in the process of convergence toward the steady state and with domestic capital market distortions. The level of capital accumulation at the time of integration crucially affects agents’ welfare. The closer the economy is to its steady state, the lower are agents’ welfare gains in the financially less advanced economy, while they are always negative in the more developed country. Two forces drive these results: precautionary saving and the propensity to move resources from risky capital to safe assets until the risk-adjusted return on capital equalizes the risk-free interest rate. Under the assumption of the constant relative-risk-aversion utility function, those forces are both decreasing in wealth.

Asymmetries of financial openness in an optimal growth model

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.

Empirical Verification of the Occurrence of Lucas Paradox in the Region of Central – Eastern Europe

The purpose of this article is to study the occurrence of the Lucas paradox in the region of Central-Eastern Europe. According to the research conducted by Robert Lucas (1990), the direction of the international capital flows is different than the neoclassical theory suggests. The capital does not flow from the richer, high-income economies to the poorer, but rather stays in those with the higher capital resources or flows to the other ones with similar level of GDP. The paper verifies whether the paradox appears in the region, in the way that it examines the impact of the GDP on the FDI inflows. Additionally, the study implements few basic models with factors that may potentially resolve the puzzle of the capital flows. The study method is based on panel data estimations, initially using pooled OLS, and subsequently using fixed or random effects models as appropriate. The examined economies are the member states of the European Union, from the region of Central-Eastern Europe, and the examined years are 2000-2018. Based on the literature, and the widely emphasized need for differentiating between the types of international capital flows, the article focus is on the foreign direct investment only, as they constitute large part of the whole global capital flows. Results of the research confirm the presence of the paradox in the region in the examined period. Even though the estimation of the additional models helps to remove the effects of the paradox for the region, it does not fully explain under which circumstances the neoclassical theory would be applicable. None of the applied models reverses the sign of the GDP variable to negative, keeping it statistically significant at the same time.

Global governance and gross capital flows dynamics

One of the famous puzzles in macroeconomics, the Lucas (Am Econ Rev 80:92–96, 1990) paradox on “why doesn’t capital flow from rich to poor countries”, continues to exist and shapes capital flows in the modern world. This paper provides cross-country evidence on the role of politico-institutional and financial determinants in gross capital flows dynamics over the period 2000–2016. Using panel regressions incorporating country fixed effects, the study argues that institutional quality rather than the effect of diminishing returns of capital is a key explanation for the “Lucas Paradox”. It corroborates previous empirical evidence that government effectiveness, regulatory quality, rule of law, and political stability remain the most important institutional indicators in determining gross capital flows dynamics, highlighting the symmetric effect. In contrast, voice and accountability, and corruption are not significant determinants of gross capital outflows dynamics. The main contribution of the paper comes in identifying the link between the multidimensional nature of financial development and gross capital flows. The empirical results highlight the significance of the differences in gross capital inflows/outflows depending on the country’s level of financial development. The study shows the significance and predominance of financial institutions versus financial markets in the dissemination of gross capital flows.

Currency Risk and Capital Accumulation

The Lucas Paradox states that there are large and persistent differences in capital-output ratios across countries, suggesting capital is not flowing to countries where it is relatively scarce. In the data, capital-output ratios vary a lot cross-sectionally even within developed countries, and they are negatively correlated with currency risk premia and risk-free rates. To rationalize these patterns, I build a quantitative multi-country model of capital accumulation with external habit and heterogeneous exposures to a global productivity shock. I show that currency risk in this model generates cross-country variations in risk-free rates and capital-output ratios that are consistent with the data. I estimate the model using GDP data from countries issuing the G10 currencies and find two main results: (1) The heterogenous loadings that I extract from GDP data alone are highly correlated with capital-output ratios; and (2) when I feed the estimated loadings to the model, model-generated capital-output ratios account for roughly 55% of the cross-country variation in the data. I conclude that variation in currency risk and therefore currency risk premia have significant effects on the real economy.

The Lucas Paradox and Institutional Quality: Evidence from Emerging Markets

The neoclassical theory illustrates that the capital will flow from the capital-rich economies towards the capital-poor states. However, it is generally observed that the capital does not move from high-income to low-income economies. This contradictory behavior of global capital flows is called the Lucas paradox. According to Alfaro, Kalemli-Ozcan, & Volosovych (AKV) model, the Lucas paradox can be entirely explained by the institutional quality. In the light of AKV notion, this paper examines the role of institutional quality in explaining the Lucas paradox. The empirical analysis involves 17 major emerging economies of the world by using panel data for the period 1999-2018. The GMM estimation reveals that the Lucas paradox is explained by the institutional quality in case of FDI flows only. However, institutional quality indicators generally remain unable to explain the paradox in case of portfolio equity capital flows. Moreover, financial development is found to be a significant determinant of portfolio equity flows in the emerging markets. Finally, we suggest that the financial flows to the emerging markets are sensitive to the nature of the capital flows.

Credit Market Imperfection, Lack of Entrepreneurs and Capital Outflow from a Developing Economy

This paper explores the impact of credit market on the entrepreneurs and demand for credit in a credit constrained economy and the resultant impact on the capital flows. In standard trade models the capital flows across countries are explained as a result of the rate of return differentials due to presence/absence of capital among the countries whereby capital flows from the capital rich countries to capital poor countries. We show that the rate of return differentials could arise due to presence/absence of entrepreneurs, i.e., low price of capital in autarky may reflect lack of demand for credit due to scarcity of entrepreneurs and not capital abundance and eventually may lead to capital outflow from a capital scarce country. This is a different way of echoing the sentiment of the well-known “Lucas Paradox” which suggests that capital might flow from the poor to the rich countries. We also show the possibility of trade and capital flow being complements and not substitutes, as is usual in standard models.

REEXAMINATION OF LUCAS PARADOX: GRAVITY MODEL APPROACH FOR BRICS COUNTRIES

Although the neo-classical theory argues that capital should flow from developed countries to the developing countries until the marginal return of investment among countries is equalized, Lucas (1990) reached the conclusion that such capital flows have not occurred from US to India even though the marginal return of capital in India is about 58 times that of US. Lucas explained this paradoxical finding as of stemming from primarily human capital differences, external benefits of human capital and capital market imperfections. Lucas’s paradoxical findings brought intense debates with it on the subject and led to researches on other determinants of capital flows. In accordance with these discussions, our study questioned the existence of Lucas Paradox for BRICS countries (Brazil, Russia, India, China, South Africa) using panel data for 2002-2014 period. Findings obtained from the Augmented-Gravity model confirm the existence of Lucas Paradox in BRICS countries. In other words, marginal return of capital is not an important determinant of capital inflows towards BRICS countries. The general conclusions of the study show that capital inflows depend on institutional quality, agglomeration effect, trade openness degree, exchange rate and volatility of inflation.

The Capital Matthew Effect

This study shows that technological specialization is the primary driver of long-term international capital flows. The underlying mechanism comprises the two faces of capital scarcity: although a shortage of capital currently generates a higher marginal product, it also makes a country incline toward capital-saving technology. Therefore, in equilibrium, the rate of capital returns is jointly determined by a convergence effect from diminishing return and an opposing divergence effect from directed technological change. If the elasticity of substitution between labor and capital is sufficiently high, then initially capital-rich countries will favor a capital-biased technology and continuously import capital from capital-poor countries that develop a labor-biased technology. I name this anti-convergence force on capital allocation as the capital Matthew effect. With this perspective, we can rationalize many related international finance puzzles, such as the Lucas paradox, global imbalance, and the allocation puzzle.

International Capital Allocations and the Lucas Paradox Redux

This paper studies the marginal product of private capital (MPK) with new data and a new framework to obtain a better understanding of international capital allocations and the Lucas Paradox (LP). Our point of departure is three influential studies of MPK’s and, based on the most recently available data, the LP is either sustained, inverted, or rejected. We then introduce three improvements in measuring spot MPK’s, and the LP clearly reemerges. While these results are provocative, they may be misleading because they do not recognize the dynamics of the capital accumulation process toward steady-states. We develop and estimate a model that allows us to map spot MPK’s into steady-state MPK’s. The LP remains; the steady-state MPK’s for poor countries is 48% to 77% higher than for rich countries. Four policy implications follow from these estimates. First, there is a great deal of misallocated capital globally: 14% to 21% of the global capital stock. Second, this misallocation is primary due to the difference between country-specific steady-state MPK’s and the global MPK that would maximize world output. Third, the benefits of optimally reallocating capital and eliminating the LP are modest: 1.0% to 1.5% of global output or $873 to $1,309 billions of 2019 US dollars. Fourth, the estimates for both misallocation and reallocation depend crucially on the elasticity of substitution between capital and labor. Our empirical work uncovered three new puzzles that have emerged beginning in 1990, 1) the MPK’s for both poor and rich countries have been rising sharply, 2) the gap has been widening, and 3) the steady-state MPK’s exceed the average spot-MPK’s. The later result is inconsistent with the Dynamic Inefficiency, Saving Glut, or Secular Stagnation hypotheses.

The Role of Productive Structures in the Attractiveness of African Economies: A “Lucas Paradox” Approach

The purpose of this article is to analyze the paradox of atrophy of capital flows to African countries, while economic theories predict that such flows of investment should be large enough because of higher returns on capital in countries where its presence is relatively low in production factors. The GMM estimate of a system of two equations for a sample of 25 African countries over the period 2004-2014 gives the following results: the low investment flows are due to the production structures of African economies, which lack efficiency and attractiveness. Also, by improving the structural elements of the economy that render production ineffective, African countries can thus increase their potential to raise larger flows of foreign direct investment.

Should Capital Flow from Rich to Poor Countries?

Are human and physical capital stocks allocated efficiently across countries? To answer this question, we need to differentiate misallocation from factor intensity differences. We use newly available estimates on factor shares from Monge-Naranjo, Santaeullia-Llopis, and Snchez (2019) to correctly measure the factor shares of physical and human capital for a large number of countries and periods. We find that the global efficiency losses of the misallocation of human capital are much more substantial than those of physical capital, amounting to 40 percent of the world?s output. Moreover, contrary to the findings of Monge-Naranjo, Santaeullia-Llopis, and Snchez (2019) for physical capital, the global misallocation of human capital does not seem to be subsiding. We argue that the proper measure of global misallocation requires considering the potential gains of reallocating both physical and human capital. In this case, the implied efficiency loses from misallocation are up to 60 percent of global output. Attaining those gains, contrary to the prominent Lucas paradox (Lucas, 1990), would often require physical capital to flow from poor to rich countries.