This paper examines the welfare consequences of liberalizing capital markets in the presence of increasing returns driven by externalities in knowledge and capital accumulation. Using a revealed preference argument in a continuous-time infinite horizon model, this paper shows that the opening of capital markets can result in welfare deterioration if foreign interest rates are high and capital outflows are likely. Does opening capital markets improve welfare? A simple reinterpretation of the static theory of gains-from-trade in an intertemporal framework leads us to answer in the affirmative. Opening up capital markets should result in welfare gains by exploiting the possibility of international borrowing and lending at world interest rates different from autarky rates. Despite the theoretical prediction, most countries have been imposing various restrictions on international capital transactions. Besides difficulties in managing exchange regimes arising from massive short-term capital movements with free capital mobility, growth oriented economies are also concerned about possible adverse effects of capital flight on domestic capital accumulation. When the outside world offers higher returns to capital than domestic markets, domestic savings may go abroad to finance foreign capital accumulation instead of domestic accumulation. However, if no distortion exists in the market mechanism, the cost of decreased domestic capital accumulation and slower growth must be more than offset by the benefit of increased capital income from abroad. The defense of capital controls on the grounds of loss in domestic production when capital outflows are likely after liberalization can be justified only when there is a substantial amount of external economies associated with containing knowledge and capital within the border. External economies from scale of operation, knowledge creation, and physical or human capital accumulation have received renewed attention, and have become one of the building blocks in endogenous growth models. (See, for example, Romer 1986 and 1987, Lucas 1988, and Grossman and Helpman 1990.) In these models, an individual production unit has the standard neoclassical technology but spillovers of external exonomies from the aggregate stock of knowledge and capital make the economy as a whole exhibit scale economies and prevent the marginal product of capital from falling below the subjective discount rate, sustaining unbounded