Lucas Paradox Research Articles

Growth in a time of external imbalances

Globalization and financial integration have increased in the last three decades giving rise to cumulated large external imbalances. The question we address in this paper is whether economic growth can be affected by these external imbalances. We estimate an augmented growth equation with the external stock position of the countries measured by the net foreign asset position. Unlike previous literature, we use non-parametric methods that capture non-linearities and heterogeneity, and apply them to a sample that includes 106 developed and developing countries for the period 1983-2011. Contrary to the neoclassical theory, we find that improvements in the external position foster growth. Our results are in line with current theoretical contributions explaining the Lucas Paradox where financial frictions are present. Within this framework, the general outcome should be a positive sign and the “neoclassical” negative relationship between net foreign assets and growth would be just a particular case, with no universal explanatory mechanism. Accordingly, we find that the effect of the net foreign asset position on growth is heterogeneous, the impact depending on the characteristics of the countries such as institutional quality, openness and financial development.

The Public and Private Marginal Product of Capital

Why does capital not flow to developing countries as predicted by the neoclassical model? What are the direction and degree of capital misallocation across nations? We revisit these questions by removing public capital from total capital to achieve a more accurate estimate of the marginal productivity of private capital. We calculate marginal product of capital schedules in a large sample of advanced and developing countries. Our main result is that, in terms of the Lucas Paradox, private capital is allocated remarkably efficiently across nations. Tentative estimates of the marginal productivity of public capital suggest that the deadweight loss from public capital misallocation across countries can be much larger than that from private capital.

The Effects of International Financial Integration in a Model with Heterogeneous Firms and Credit Frictions

This paper examines the consequences of international financial integration in a two-sector heterogeneous-agent dynamic general equilibrium model of occupational choice with financial constraints and idiosyncratic risks. We discuss the macroeconomic and distributional effects of financial market integration for small economies which differ only with respect to the tightness of constraints on the domestic credit market. The results contribute to an explanation of the ‘Lucas paradox’, i.e. the empirical observation of capital flowing from poor to rich countries, where lending countries are characterized by tighter domestic constraints and lower capital returns. Capital market liberalization goes along with adjustments towards the world return. Capital-exporting countries experience an increase in GNP, whereas the GDP effect is of ambiguous sign and driven by the tightness of the domestic credit market. Countries with less tight constraints or unlimited access to external business financing loose throughout integration due to a decline in aggregate output and a very unequal distribution of welfare gains and losses in the underlying heterogeneous-agent economy. We find that international integration is only beneficial for economies where financial constraints on entrepreneurial activity are very tight. Here, we observe an accumulation-driven rise in the entrepreneurship rate, overall positive output effects and welfare gains for all members of society.

THE POLITICS OF FDI EXPROPRIATION

AbstractI examine the role of political instability and fractionalization as potential explanations for the lack of capital flows from rich countries to poor countries (i.e., the Lucas Paradox). Using panel data from 1984 to 2014, I document that (i) developed countries exhibit larger inflows of foreign direct investment (FDI), (ii) countries subject to high investment risk (IR) receive low FDI inflows, and (iii) IR is higher in fractionalized and politically unstable economies. These findings suggest a negative relationship between political instability and FDI through the IR channel. I inspect the theoretical mechanism using a dynamic political economy model of redistribution, wherein policymakers can expropriate resources from foreign investors. The proceeds are used to finance group‐specific transfers to domestic workers but hinder economic growth by discouraging FDI. I show that the political equilibrium exhibits overexpropriation and underinvestment.

Institutions and information flows, and their effect on capital flows

We examine the empirical role of information flows and institutional quality in explaining the capital flows per capita across countries, and their role in explaining the so-called Lucas paradox -low levels of capital flows to poor countries. The findings of this paper suggest that countries with better institutions and high information flows receive high capital flows, and information flows also provides a partial explanation to the Lucas Paradox. The latter result is significant even after controlling for institutional quality, financial openness and human capital differences across countries, and using instrumental variable for information flows. This paper also examines the indirect effects of institutional quality on capital flows per capita through its impact on information flows and finds that countries with better institutional quality have higher levels of information flow. Accounting this indirect effect is economically important and papers that do not account for this indirect effect of institutions on capital flows per capita would underestimate the effect of institutions on capital flows per capita. Findings of this paper suggest that relatively poorer countries should improve their institutional quality and increase their access to worldwide information and promote investments in communications infrastructure to attract long-term capital flows.

Medium and Long Run Implications of Financial Integration Without Financial Development

We show that, in a two-country model where the two economies differ in their level of financial market development and initial capital endowment, financial integration has sizeable transitory as well as permanent effects. We confirm that, consistent with the Lucas paradox, financial integration in the medium term can reduce capital accumulation and increase savings in the financially less developed country, characterized by domestic capital market distortions, due to a higher risk premium in production activities. In the long run, however, integration produces higher levels of capital than in the autarky steady state. The opposite happens to the financially advanced economy, where integration initially boosts consumption and leads to a lower saving rate, and in the long run causes a reduction in capital compared with the autarky steady state. 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; assuming a constant relative risk aversion (CRRA) utility function, these forces are both decreasing in wealth.

Lucas Paradox in the Short-Run

This paper is concerned with whether the persistence of the Lucas paradox (that unlike what the classical economic theory would predict, capital flows to richer economies rather than poorer ones where marginal returns to capital are expected to be higher) within developing countries is because of the unobservable county-specific effects. Perhaps capital has been flowing to where it has already flowed and not necessarily where it had already been. Using five-year (rolling-averaged) panel data for up to 47 developing countries over the period 1980-2006, it examines if including the institutional quality index removes the Lucas paradox intertemporally (i.e. in the short-run). The ‘short-run’ relationships are captured by employing linear static (principally within-group fixed effects) and dynamic (system GMM) panel data methods. I demonstrate that the persistence in the Lucas paradox within developing countries is so entrenched that allowing for unobserved country-specific effects, within-group (time series) variation and autoregressive dynamics do not resolve the paradox.

Lucas Paradox in the Long-Run

This paper investigates international capital flows to developing countries for the period 1970-2006. The study focuses on the empirical puzzle that although one would expect international capital to flow to capital scarce countries where returns are higher, observation shows that capital flows to richer rather than to poorer countries (the Lucas paradox). To explore this, total capital is measured as the sum of foreign direct investment and portfolio equity flows. The paper addresses the argument, based on cross-section evidence (Alfaro et al., 2008, Rev. Econ. Stats), that including the quality of institutions accounts for the paradox (because richer countries have better institutions they attract more capital) and finds that this only holds if developed countries are included; within developing countries, institutions do not account for the paradox. Hence, for a consistent sample of 47 developing countries the positive wealth bias in international capital flows or the Lucas paradox is shown to be a persistent phenomenon in the long run.

Does institutional quality resolve the Lucas Paradox?

ABSTRACTThe Lucas Paradox observes that capital flows predominantly to relatively rich countries, contradicting the neoclassical prediction that it should flow to poorer capital-scarce countries. In an influential study, Alfaro, Kalemli-Ozcan, and Volosovych (AKV) argue that cross-country variation in institutional quality can fully explain the Paradox, contending that if institutional quality is included in regression models explaining international capital inflows, a country’s level of economic development is no longer statistically significant. We replicate AKV’s results using their cross-sectional IFS capital flow data. Motivated by the importance of conducting inference in statistically adequate models, we focus on misspecification testing of alternative functional forms of their empirical model of capital flows. We show that their resolution of the Paradox relies on inference in a misspecified model. In models that do not fail basic misspecification tests, even though institutional quality is a significant determinant of capital inflows, a country’s level of economic development also remains a significant predictor. The same conclusions are reached using an extended dataset covering more recent IFS international capital flow data, first-differenced capital stock data and additional controls.

What Form did Global Financial Integration Take from 1960 to 2015? A Topological Analysis

We propose an original analysis of the second globalization era, using an alternative range of equity prices integration indicators based on the topological structure of world equity markets. The sample includes 32 countries over the period 1960-2015. Particular importance is given to the study of the major stylized fact in the literature, the Lucas paradox, in its different forms including the “allocation” puzzle within emerging economies. This original methodological approach highlights that the second globalization era is characterized by an increasing unpredictability of the structure and dynamics of the system. First, at the end of the study period the most integrated countries are split between advanced economies and emerging economies while some advanced economies are among the least integrated. Secondly, the structure of the network changes from a linear network to a star network, implying a shortening of transmission chains and thus a facilitated diffusion of international price shocks.

Medium and Long Term Implications of Financial Integration Without Financial Development

We show that, in a two-country model where the two economies differ in their level of financial market development and initial capital endowment, financial integration has sizeable transitory as well as permanent effects. We confirm that, consistent with the Lucas paradox, financial integration in the medium term can reduce capital accumulation and increase savings in the financially less developed country, characterized by domestic capital market distortions, due to a higher risk premium in production activities. In the long run, however, integration produces higher levels of capital than in the autarky steady state. The opposite happens to the financially advanced economy, where integration initially boosts consumption and leads to a lower saving rate, and in the long run causes a reduction in capital compared with the autarky steady state. 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; assuming a constant relative risk aversion (CRRA) utility function, these forces are both decreasing in wealth.

Transboundary capital and pollution flows and the emergence of regional inequalities

We seek to explain the emergence of spatial heterogeneity regarding development and pollution on the basis of interactions associated with the movement of capital and polluting activities from one economy to another. We use a simple dynamical model describing capital accumulation along the lines of a fixed-savings-ratio Solow-type model capable of producing endogenous growth and convergence behavior, and pollution accumulation in each country with pollution diffusion between countries or regions. The basic mechanism underlying the movements of capital across space is the quest for locations where the marginal productivity of capital is relatively higher than the productivity at the location of origin. The notion that capital moves to locations of relatively higher productivity but not necessarily from locations of high concentration to locations of low concentration, does not face difficulties associated with the Lucas paradox. We show that, for a wide range of capital and pollution rates of flow, spatial heterogeneity emerges even between two economies with identical fundamental structures. These results can be interpreted as suggesting that the neoclassical convergence hypothesis might not hold under differential rates of flow of capital and polluting activities among countries of the same fundamental structure.

Patterns of International Capital Flows and Their Implications for Developing Countries

According to a standard economic theory, capital should flow from rich capitalabundant countries to poor capital-scarce countries. However, a reverse pattern has prevailed in the world economy. This is the so-called Lucas paradox. In addition, it has been shown that counterintuitively there is negative correlation between capital inflow and productivity growth across developing countries. This is the so-called allocation puzzle. This survey attempts to shed light on the following questions: 1) What are the patterns of international capital flows in the world economy? 2) What are the most plausible explanations for these patterns? 3) What are the possible implications of these developments for developing countries?

A Bit Goes a Long Way: Bilateral Investment Treaties and Cross-Border Mergers

We examine whether Bilateral Investment Treaties (BITs) remove impediments to foreign investment by helping enforce contracts and property rights. We find that BITs have a large, positive effect on cross-border mergers: the probability and dollar volume of mergers between two given countries more than doubles after the signing of a BIT. Most of this increase is driven by capital flowing from developed economies to developing economies, answering the long-standing Lucas Paradox as to why most cross-border capital still flows to developed countries. Additionally, most of our results are driven by target countries with “medium” levels of political risk, consistent with popular views that BITs are ineffective for countries with very high risk and not necessary for countries with low political risk.

The causes and consequences of delayed/abandoned cross-border merger & acquisition transactions

PurposeDrawing attention to the significant number of unsuccessful (abandoned) cross-border merger and acquisition (M&A) transactions in recent years, the purpose of this paper is to analyze three litigated cross-border inbound acquisitions that associated with an emerging economy – India, such as Vodafone-Hutchison and Bharti Airtel-MTN deals in the telecommunications industry, and Vedanta-Cairn India deal in the oil and gas exploration industry. The study intends to explore how do institutional and political environments in the host country affect the completion likelihood of cross-border acquisition negotiations.Design/methodology/approachNested within the interdisciplinary framework, the study adopts a legitimate method in qualitative research, that is, case study method, and performs a unit of analysis and cross-case analysis of sample cases.FindingsThe critical analysis suggests that government officials’ erratic nature and ruling political party intervention have detrimental effects on the success of Indian-hosted cross-border deals with higher bid value, listed target firm, cash payment, and stronger government control in the target industry. The findings emerge from the cross-case analysis of sample cases contribute to the Lucas paradox – why does not capital flow from rich to poor countries and interdisciplinary M&A literature on the completion likelihood of international takeovers.Practical implicationsThe findings have several implications for multinational managers who typically involve in cross-border negotiations. The causes and consequences of sample cases would help develop economy firms who intend to invest in emerging economies. The study also offers some implications of M&A for telecommunications and extractive industries.Originality/valueAlthough a huge amount of extant research investigates why M&A fail to create value to the shareholders during the public announcement and post-merger stages, there is a significant dearth of research on the causes and consequences of delayed or abandoned national and international deals. The paper fills this knowledge gap by discussing an in-depth cross-case analysis of Indian-hosted cross-border acquisitions.

On the explanation of the Lucas Paradox

This paper demonstrates that institutional quality provides a full explanation to the Lucas Paradox when country heterogeneity is controlled. Furthermore, in terms of the explanation of the paradox, quantile regression estimates reveal that foreign flows are driven by theoretical explanations at the lower tail, despite that they are significantly affected by growth prospects towards the higher tail.

Transboundary Capital and Pollution Flows and the Emergence of Regional Inequalities

We seek to explain the emergence of spatial heterogeneity regarding development and pollution on the basis of interactions associated with the movement of capital and polluting activities from one economy to another. We use a simple dynamical model describing capital accumulation along the lines of a fixed-savings-ratio Solow-type model capable of producing endogenous growth and convergence behavior, and pollution accumulation in each country with pollution diffusion between countries or regions. The basic mechanism underlying the movements of capital across space is the quest for locations where the marginal productivity of capital is relatively higher than the productivity at the location of origin. The notion that capital moves to locations of relatively higher productivity but not necessarily from locations of high concentration to locations of low concentration, does not face difficulties associated with the Lucas paradox. We show that, for a wide range of capital and pollution rates of flow, spatial heterogeneity emerges even between two economies with identical fundamental structures. These results can be interpreted as suggesting that the neoclassical convergence hypothesis might not hold under differential rates of flow of capital and polluting activities among countries of the same fundamental structure.

Capital Inflows and Economic Growth: Does the Role of Institutions Matter?

AbstractRecent evidence shows that institutions figure prominently in explaining the ‘Lucas paradox’. Using a threshold regression model, we extend this evidence to a situation where institutions index the relationship between foreign capital inflows and economic growth. We find strong and robust evidence that portfolio equity (including foreign direct investment) and debt inflows have positive effects on growth only in countries with high‐quality institutions. Countries that fall below the threshold level of institutional quality record either insignificant or negative effects. This paper provides a possible explanation on the so‐called Lucas paradox. Copyright © 2015 John Wiley & Sons, Ltd.

Stranger Times: The Impact of Relativistic Time Concepts on the Time Value of Money

The notion that time is relative has been widely accepted by physicists since Albert Einstein formulated his theory of relativity in 1905. However, many other scientific disciplines, like finance and economics, have thus far disregarded relativistic time concepts. In this paper, I show how a relativistic approach towards time influences the core principle of finance theory, the time value of money concept. I show that, to avoid arbitrage, relativistic time concepts call for an adjustment to time value of money calculations – the concept of proper interest. Adjusting time value of money functions leads to a market-wide changes in financing costs for firms. Furthermore, I propose that variation in life expectancy is a proxy for time dilation. Therefore, I use a relativistic time concept to amend the Lucas Paradox and show that current methods of explaining the paradox might gravely underestimate its magnitude.

International specialization and the return to capital

AbstractHow does factor accumulation affect an open economy’s pattern of international specialization and returns to capital? We provide a new integrated treatment to this question using a panel of 44 developing and developed countries over the period 1976–2000. The data confirm the Heckscher-Ohlin prediction that, with sufficient differences in country endowments, there is no factor price equalization and countries specialize in different subsets of goods. Innovatively, we obtain the returns to capital implied by this model: these are consistent with the Lucas paradox, which we explain after accounting for cross-country differences in the cost of capital goods. Our findings are also consistent with Ventura’s hypothesis that the growth of small open economies can be promoted by “beating the curse of diminishing returns” – indeed we find no decrease in the return to capital at any given capital-labor ratio despite capital accumulation by most countries within a cone of diversification.