2. Why does capital flow from poor to rich countries? – the real puzzle

This paper was first published in  Real-World Economics Review, issue 81, 2017 http://www.paecon.net/PAEReview/issue81/Joffe81.pdf

Michael Joffe

Imperial College London



Lucas’ classic paper (1990) highlighted the paucity of capital flows from rich to poor countries, in contrast with predictions of standard theory – the Lucas puzzle (or paradox). Subsequently, abundant capital has flowed from certain low-income countries to rich ones, notably China to the USA. More generally, empirical research has shown that fast-growing developing countries rely less on foreign capital; and, international capital flows towards countries with lower productivity growth and lower investment – the “allocation puzzle”. This paper considers post-reform China, finding that massive outflows are a consequence of growth that is readily understandable, and widely understood (except by some economists). Similar experiences also occurred in previous dynamic Asian economies. The causal direction is different from what Lucas assumed.

The academic literature seeks to explain the discrepancy from standard theory – not the phenomenon itself – by invoking financial-sector weakness or under-development and its impact on borrowing or saving, or accumulation of foreign reserves that affects the exchange rate. Mainstream economic accounts rely on what they see as “typical” behavior, which accords with standard theory. However, the empirical analyses strongly suggest that East Asia has a different dynamic, with different causal processes. This is not a minor exception, given these countries’ population size, contribution to world economic growth in the past half-century, and influence over global capital imbalances. Their strong growth performance suggests that invoking financial “weakness” is misplaced. Rather, a better analysis is needed of the impact of these countries’ channeling of capital for strategic purposes, and how this brings about a distinct pattern of causal processes.

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