Chapter 14 Appendix: Free Trade, Financial Globalization, and Growth

Chapter 14
Appendix
Free Trade, Financial Globalization,
and Growth
Although we have seen in the chapter that financial development spurs economic
growth, implementing financial development is by no means easy. In this appendix, we
show how free trade and financial globalization help promote financial development
and hence economic growth.
Free Trade and Financial Development
In your principles of economics course, you probably discussed the concept of comparative
advantage, which provided a strong argument for why free trade, the opening up
of domestic markets to goods and services from abroad, raises the standard of living in
an economy. Free trade, however, can also lead to institutional reforms that raise the
rate of economic growth. To see why, we need to ask an important question: why do
countries not adopt institutional frameworks that promote financial development and
economic growth? After all, it is in the best interest of a country to promote high economic
growth.
Special Interests and Financial Repression
The benefits of financial development are enjoyed by numerous sectors of the population,
while the costs are borne by narrower special-interest groups. The benefits of an
efficient financial system are spread widely: to the young couple who can now buy a
house with the help of a mortgage, to the new car owner who is able to finance its purchase
with an auto loan, to the entrepreneur who can get capital to start her new business,
and to the corporation that can finance its investment in a new manufacturing
1

2 CHAPTER 14 APPENDIX
plant. On the other side, there are relatively few, powerful, concentrated special-interest
groups who lose from financial development and so try to slow its progress with
financial repression. 1
GOVERNMENT. Government is often the primary source of financial repression.
Although strong property rights are a crucial element in financial development, they
severely constrain a government’s ability to expropriate property and ideas whenever it
wants to profit from them. Governments also have strong incentives to establish and
support state-owned banks through which politicians and government officials can
channel funds to themselves, their families, their cronies, and businesses that support
their political campaigns.
REPRESSIVE INCUMBENTS. Incumbents, entrenched, rich elites who own businesses
that are threatened by competitive, free markets, also often support financial
repression. 2 Large, established business firms often finance new investment projects
out of their previous earnings and so do not need funds from external sources in the
financial markets. Incumbent financial institutions also have incentives to repress the
financial system because they have little to gain from financial development, and frequently
have much to lose. A better-developed financial system will allow new businesses
to access funds that will increase competition and thus lower the incumbents’
profits. They are therefore likely to oppose institutional reform that promotes financial
development.
How Free Trade Fosters Financial Development and
Economic Growth
Allowing entry of foreign goods and services into an economy produces a more competitive
environment that will drive down the revenue of incumbent firms and reduce
their profits, requiring them to seek out external sources of finance. These sources of
finance will be available only if the financial system has the wherewithal to solve asymmetric
information problems. As a result, incumbent firms and their rich, elite owners
will now have incentives to support the necessary institutional reforms to make the
financial system work better. In turn, the resulting reforms will increase the size of the
financial sector and will foster economic growth. Free trade can therefore be an important
force that stimulates economic growth.
The Evidence: Free Trade and Economic Growth
A well-known study by Andrew Warner of the Millennium Challenge Corporation and
Jeffrey Sachs of Columbia University found that developed economies that were open to
trade grew at a 1.6% higher rate than ones that were closed to trade. 3 For developing countries,
the difference was even larger, 3.8%. However, there is a possibility that causation
1For further discussion of why financial repression occurs, see Frederic S. Mishkin, The Next Great
Globalization: How Disadvantaged Nations Can Harness Their Financial Systems to Get Rich (Princeton, NJ:
Princeton University, 2006).
2Raghuram Rajan and Luigi Zingales, Saving Capitalism from the Capitalists: Unleashing the Power of Financial
Markets to Create Wealth and Spread Opportunity (New York: Crown Business, 2003).
3Jeffrey D. Sachs and Andrew Warner, “Economic Reform and the Process of Global Integration,” Brookings
Papers on Economic Activity (1995): 1–95.

FREE TRADE, FINANCIAL GLOBALIZATION, AND GROWTH 3
might run from faster growth to trade openness, rather than the other way around.
Alternatively, opening up to trade might occur at the same time as other institutional
reforms, and these other reforms are what might have stimulated economic growth.
In a later study, Jeffrey Frankel and David Romer of the University of California at
Berkeley used geography to help evaluate whether causality actually runs from trade to
higher growth, and they found that it does. 4 The location of a country affects the
amount of trade because countries that are isolated geographically (like New Zealand)
or are landlocked and have very few natural seaports (like Bolivia) have less trade
because transportation costs for goods are higher. These countries have less trade and
also grow slower than other countries. Because the location of a country is surely
exogenous—where a country is located is not a choice—this evidence suggests that
causality indeed runs from trade to growth. Their study concludes that a rise of one percentage
point in the ratio of trade to GDP raises income per person by one-half of a percentage
point.
In addition, research has linked greater openness to trade to a larger financial sector
and the increased competition from foreigners that stimulates domestic firms to become
more productive in order to survive. 5 The evidence is strongly supportive of free trade
being good for economic growth.
Financial Globalization and Economic Growth
The benefits of globalization of trade in goods and services are not a controversial subject
among economists (although they are among the general public). One of the few things
economists agree on is that the globalization of international trade, in which markets are
opened to flows of foreign goods and services, is desirable. Financial globalization,
the opening of markets to flows of foreign capital (also referred to as capital account
liberalization) is, however, highly controversial even among economists.
Financial globalization can encourage financial development and economic growth
by directly improving the way financial markets work. Indirectly, as occurs with free
trade, financial globalization changes the distribution of economic power and increases
incentives for financial development.
Direct Benefits
When foreign financial institutions enter a country, domestic financial institutions have
to become more efficient in order to survive, which typically happens. 6 Foreign financial
institutions bring “best practices” to domestic financial markets based on expertise
4Jeffrey A. Frankel and David Romer, “Does Trade Cause Growth?” American Economic Review 89 (June 1999):
379–399.
5Raghuram Rajan and Luigi Zingales, “The Great Reversals: The Politics of Financial Development in the
20th Century,” Journal of Financial Economics 69 (2003): 5–50; and H. Svalaeryd and J. Vlachos, “Market for Risk
and Openness to Trade: How Are They Related?” Journal of Public Economics 57 (2002): 364–95.
6For example, see Ross Levine, “Foreign Banks, Financial Development and Economic Growth,” in International
Financial Markets: Harmonization versus Competition, ed. Claude E. Barfield (Washington, D.C.: AEI Press, 1996); Stijn
Claessens et al., “The Role of Foreign Banks in Domestic Banking Systems,” in The Internationalization of Financial
Services: Issues and Lessons for Developing Countries, eds. Stijn Claessens and Marion Jansen (Boston: Kluwer
Academic, 2000); and Stijn Claessens, Asli Demirguc-Kunt and Harry Huizinga., “How Does Foreign Bank Entry
Affect Domestic Banking Markets,” Journal of Banking and Finance 25 (2001): 891–911.

4 CHAPTER 14 APPENDIX
they have gained from their past experience, and they are also likely to promote technology
transfer to domestic financial institutions. Entry of foreign financial institutions helps
improve domestic prudential regulation and supervision. Government supervisors are
now able to see the risk management practices that have been successfully used in foreign
institutions and to insist that they be adopted by domestic institutions.
Financial globalization has additional direct benefits for domestic financial markets.
Allowing foreign capital to freely enter domestic financial markets increases the availability
of funds, which in turn increases liquidity and lowers the cost of borrowing, stimulating
investment and economic growth. This cycle has happened as countries have opened up
their stock markets to foreign capital, as documented in a study by Peter Blair Henry, now
of New York University. On average, dividend yields (the amount of dividends relative to
the price of shares of stock) fall by 2.4 percentage points, the growth rate of investment
increases by 1.1 percentage points, and the growth rate of output per worker increases by
2.3 percentage points. These results prompted Henry to state that “the increasingly popular
view that capital account liberalization brings no real benefits seems untenable.” 7
Indirect Benefits
Opening up to foreign capital and foreign financial institutions is a strong force for institutional
reforms that promotes financial development. When domestic businesses can
borrow from abroad or from foreign financial institutions that establish affiliates in the
less-developed country, domestic financial institutions will start to lose many of their old
customers. To stay in business, they will have to seek out new customers and lend to them
profitably. They will need the information to screen out the good credit risks from the bad
and to monitor borrowers to make sure they do not take on excessive risk. Domestic
financial institutions will thus have incentives to encourage politicians to adopt institutional
reforms, such as better accounting standards and disclosure requirements, that will
make it easier for them to acquire the information that they need to make profitable loans.
The institutions will also see the need to improve the legal system so they can enforce
restrictive covenants or be able to take title to collateral if a borrower defaults. With globalization,
domestic financial institutions will support legal reform that will help them
make profits and also strengthen the property rights that directly encourage investment.
Will Financial Globalization Always Work?
Given the benefits of financial globalization, it seems as though opening up domestic
financial markets to international capital should have an unambiguously positive
impact on economic growth and the reduction of poverty. However, evidence from
aggregate data on the benefits of financial globalization is mixed: there is no clear-cut
relationship between international financial openness and economic growth. 8
7Peter Blair Henry, “Capital Account Liberalization, the Cost of Capital and Economic Growth,” American
Economic Review 93 (2003): 91–96.
8For example, see the surveys in Ross Levine, “Financial Development and Economic Growth: Views and
Agenda,” Journal of Economic Literature 35 (1997): 688–672; Barry Eichengreen, “Capital Account
Liberalization: What Do Cross-Country Studies Tell Us?” World Bank Economic Review 15 (2001): 341–365;
Stanley Fischer, “Globalization and Its Challenges,” American Economic Review 93 (2003): 1–30; Hali J. Edison,
Michael W. Klein, Luca Antonio Ricci, and Torsten Slok, “Capital Account Liberalization and Economic
Performance: Survey and Synthesis,” IMF Staff Papers 51, no. 2 (2004): 26–62; and Eswar Prasad, Kenneth
Rogoff, Shang-Jin Wei, and M. Ayhan Kose, “Effects of Financial Globalization on Developing Countries:
Some Empirical Evidence.” International Monetary Fund mimeo. (March 2003).

SUMMARY
FREE TRADE, FINANCIAL GLOBALIZATION, AND GROWTH 5
Why doesn’t opening up financial markets always work? Opening up an economy
to international capital flows, particularly if the transition is not managed to prevent
excessive risk taking, can damage the financial system and in turn the economy.
Although financial globalization can be a strong force for good, it can also go very
wrong if a country doesn’t manage the process properly. This riskiness makes financial
globalization very controversial.
1. Free trade helps promote financial development and
economic growth by increasing competition and
driving down the profits of incumbent firms, requiring
them to seek out external sources of finance.
Incumbent firms will now have incentives to support
the necessary institutional reforms to make the
financial system work better, thereby fostering economic
growth.
KEY TERMS
capital account liberalization,
p. 3
financial globalization, p. 3
financial repression, p. 2
REVIEW QUESTIONS AND PROBLEMS
1. What is financial repression? Why does it occur?
2. Who supports financial repression and why?
2. Financial globalization can encourage financial development
and economic growth by directly improving
the way financial markets work and also by changing
the distribution of economic power, thereby increasing
incentives for financial development. Financial
globalization may not be beneficial if it is not managed
to prevent excessive risk taking, which can damage
the financial system and in turn the economy.
free trade, p. 1
3. How does free trade promote financial
development?
4. What are the benefits of financial globalization?