GLOBAL CAPITAL MARKET INTEGRATION: IMPLICATIONS FOR U.S. ECONOMIC PERFORMANCE

CRS Report for Congress
Global Capital Market Integration: Implications
for U.S. Economic Performance
Updated January 12, 2001
Craig K. Elwell
Specialist in Macroeconomics
Government and Finance Division

Congressional Research Service The Library of Congress

Global Capital Market Integration: Implications for U.S.
Economic Performance
Summary
The post-war period has seen a steady and sizable expansion of international
economic integration. Trade in goods has grown rapidly, but trade in assets (e.g.
bank accounts, stocks, bonds, and real property) has grown far faster. The rapid
growth of international asset markets suggests that they confer important economic
benefits. However, that growth also raises concerns about international capital flows
as initiators or conduits of economic crisis among nations.
Several factors have contributed to the rapid growth of international capital
flows. The collapse of the Bretton Woods System of international monetary
management also initiated a fairly quick abandonment of controls on international
capital flows in most industrial countries. Expanding investment opportunities in both
developed and developing nations raised the incentives for cross border investing.
Innovations in communication and information technology have dramatically reduced
the cost of international communication and expanded access to data for assessing
risk and reward. Also of importance has been the creation of new financial
instruments that improve investment decision making.
The extent of capital market integration is evident in the huge increases in most
financial realms over the last twenty years. These include bank deposits, securities
(stocks and bonds) and foreign exchange. Foreign exchange transactions world-wide
have grown so much that the value of annual foreign exchange trading exceeds the
value of goods transactions by a factor of 50. Despite this growth data indicate that
asset market integration still falls well short of creating one world market in assets.
The economic benefits of international capital flows are significant. The presence
of well functioning international asset markets can extend the benefit of international
trade well beyond the gains associated with the exchange of goods and services.
International capital markets can facilitate a more efficient allocation of saving and
investment across nations, allowing an optimal spreading of consumption spending
over time. International trade in assets can also enable greater diversification of
investment portfolios, leading to reduced investor risk. In conjunction with flexible
exchange rates, high capital mobility also enhances the power of monetary policy as
well as alters how monetary forces are transmitted and distributed through the
economy.
Economists and policy makers have also long recognized that increased
financial integration carries risks. One risk is that more points of economic and
financial contact raise the prospect of the transmission of negative economic shocks,
so called “contagion” effects. In addition, some argue that asset markets themselves
are often destabilizing and can generate periodic crises. For the U.S. the main problem
associated with mobile global capital has been occasional misalignment of the dollar
exchange rate. For the U.S., a large, predominately domestically oriented economy,
with a well developed financial system and a resilient structure of private markets,
large international flows of capital are absorbed to economic advantage, with a
minimum of disruption, even in the face of large currency swings.

Contents
Introduction ...............................................1
Background ................................................ 1
What Caused the Growth of International Capital Flows?..............2
The Reduction of Capital Controls...........................3
The Expansion of Global Investment Opportunities..............3
Innovations in Communication and Market Access...............3
The Extent of Capital Market Integration..........................4
Cross-Border Asset Transactions............................4
Foreign Exchange Transactions.............................5
Evidence of Limited Market Integration.......................5
The Economic Benefits of Capital Market Integration................6
Extending the Gains from Trade.............................6
Economic Concerns with International Capital Flows................10
Asset Price Volatility and Periodic Misalignments...............11
Conclusion ................................................ 13
List of Tables
Table 1. Gross-Border Capital Flows for Major Industrial Countries.........4
Table 2. Foreign Exchange Trading.................................5

Global Capital Market Integration: Implications
for U.S. Economic Performance
Introduction
Economic globalization has been occurring steadily since the end of World War-
II, but that process clearly accelerated over the last two decades. The most dramatic
change has been in the size and influence of international capital markets. These
markets are an ever denser network in which residents of different countries can
exchange assets. The assets traded include stocks, bonds, and bank deposits. Capital
market transactions can be rooted in relatively short term goals associated with
prudent portfolio management or long-term endeavors involving direct investment in
plant and equipment. The rapid growth of these markets suggests that they confer
important economic benefits. However, that growth also raises concerns about
international capital flows as initiators or conduits of economic crisis. Such concerns
are certainly heightened by major economic and financial crises in Europe in 1992-3,
in Mexico in 1994, and East Asia in 1997-8 in which international capital flows
seemed to have played a significant role.
The importance of U.S. international economic transactions with the rest of the
world is well recognized by Congress, which in recent years has closely monitored
many dimensions of U.S. trade performance. Financial market stability, the conduct
of monetary policy, and trade deficits are all issues of congressional concern likely
affected by international capital flows. This report assesses the extent of capital
market integration, outlines and evaluates the economic benefits of greater
integration, and examines the risks that increased capital flows may also carry. The
focus is on how expanding international capital markets affect the U.S. economy.
Background
A high degree of international economic integration, in both goods and asset
markets, is not unique to the current era. The world economy was highly integrated
in the period stretching from the mid-1800's through the beginning of World War I.
There was a dramatic retreat from this achievement in the inter-war period. But, since
the end of World War II, there has been steady movement toward freer trade and
increased interdependence, now reaching a point that rivals the degree of globalization
reached in that earlier era. Nevertheless, there are aspects of the current world
economy that are very different from those of that earlier period of high globalization.
First, there are many more and greatly varied participants (countries) that make up the
world trading system. Second, much improved capacities for communication and
transportation have effectively shrunk the globe and made the process of economic
integration far easier. Third, more so than in earlier times, trade and the mechanisms
of trade have become vehicles that facilitate the transfer of technology and the

profitable absorption of research and development spillovers, making international
trade an important propellent of the difficult process of economic development.
Economic integration of the world economy has increased greatly over the last
fifty years, but the degree of globalization varies by type of market. If one looks at
labor markets it seems very clear that little integration has occurred. These markets
are very segmented and national in scope, with negligible cross border flows and very
little direct competition between countries. Product and asset markets present a very
different picture, however.
The simplest measure of product market integration, goods trade as a percent
of Gross Domestic Product (GDP), has risen steadily over the post-war era. For the
world as a whole the International Monetary Fund (IMF) estimates that this ratio has
doubled since 1950 and continues to rise. The U.S. fits into this general pattern with
merchandise exports as a share of GDP rising from 3.6% in 1950 to about 7.3% in
1999. Yet this ratio very likely underestimates the growth of global integration. The
underestimation is the result of services, which are not widely traded, being the fastest
growing share of total output in advanced economies. If trade is measured as a share
of total “tradeable” goods production, the growth in importance of trade is all the
more impressive. For example, for the U.S. this ratio, using the most recent estimate,
has climbed from 8.9% in 1950 to 35% in 1995.¹
Nevertheless, global integration for trade in goods still falls well short of what
has occurred in the international markets for assets. The sections that follow look
more closely at the phenomenal growth of international capital flows.
What Caused the Growth of International Capital Flows?
The early post-war international financial architecture laid out under the Bretton
Woods Agreement of 1944 did not allow unfettered capital flows.² Capital controls
played an important operational role in that system of fixed but adjustable exchange
rates. Capital controls at that time gave member nations some wiggle room between
external and internal financial conditions. Domestic policy goals could be pursued,
within a limited range, without immediately upsetting the stability of the pegged
exchange rate. If the exchange rate did require adjustment, capital controls helped
ensure that realignments were orderly.
At a more fundamental level, it was thought that capital controls were needed
to facilitate the reconstruction and growth of the international trading system that laid
in ruin in the wake of prolonged depression and world war. Experience in the inter-
war period (1918-1938) led policy makers to believe that uncontrolled capital flows
were volatile and to often caused currency instability. To defend their currencies
countries often resorted to higher tariffs or broader import quotas, actions inimical
to the steady growth of world trade. Therefore, if the first priority of the new world

¹See: The International Monetary Fund (IMF), World Economic Outlook, May 1997.
²For a survey of the evolution of the international monetary system see: Eichengreen,
Barry. Globalizing Capital: A History of the International Monetary System. Princeton, NJ.
Princeton University Press 1996.

financial system was to expand trade, stable currencies would be needed, and that
precluded freely mobile international capital.
The Reduction of Capital Controls.
The very success of the Bretton Woods system in restoring world trade sowed
the seeds of its own demise, including the system international capital controls. As
liberalization of trade and the liberalization of domestic financial institutions
proceeded apace in most industrial economies, regulators found it increasingly
difficult to distinguish between foreign exchange transactions for purposes of trade
and those intended for capital transactions. The volume of “disguised” capital flows
rose dramatically as traders in assets increasingly evaded capital controls .
Over the course of the 1960's and early 1970's the global financial system grew
evermore unstable, with periodic currency crises and large destabilizing capital flows
occurring despite formal capital controls. The U.S. and other industrial nations
formally abandoned the Bretton Woods system in 1973, moving to a system of
floating exchange rates. Capital controls did not instantly vanish at this time, but in
most industrial countries such controls were reduced at an accelerating pace, falling
to extremely low levels of restriction by the mid-1990's.
The removal of capital controls can be seen as a “fait accompli”, but as discussed
more fully below, there was also a growing recognition of the several economic
benefits of capital mobility. In addition, there was more confidence by major
governments that the several risks posed by capital mobility could be managed.
The Expansion of Global Investment Opportunities.
The large increase in international capital flows has not been just a result of
removing barriers, however. The world economy has also seen a significant expansion
of investment opportunities across the globe, raising the incentives for cross border
capital flows. Many developing nations have improved their macroeconomic stability,
greatly extended commitments to the private market as the focus of microeconomic
decision making, and pursued more open trade policies. These are actions that helped
to make a wider spectrum of nations more attractive places to invest, broadening the
global scope for profitable investment.
Innovations in Communication and Market Access.
In addition, innovations in the U.S. and other industrial countries have greatly
improved access to international capital markets by individuals and institutions.
Advances in communications and information technology have led to a particularly
dramatic reduction in the cost of overcoming space and time in financial transactions.
In many countries the cost of telephone communication and high speed computing
has fallen precipitously in recent years. Such innovations help reduce the information
asymmetries that are thought to impair the efficiency of financial markets by quickly
providing investors with a broader array of data with which to evaluate potential
return. Also of importance has been the creation of an array of new financial
instruments such as mutual funds, hedge funds, and credit derivatives that enable

investors to choose with greater ease and precision their desired balance between risk
and reward.
The Extent of Capital Market Integration
There is no one measure of the degree of integration of international capital
markets. Evidence on trends in several types of cross-border asset transactions can
give a picture of the general size and scope of the capital market integration that has
occurred, however.
Cross-Border Asset Transactions.
The two major categories of private cross-border asset flows are direct
investment (i.e., investment in real property such as land, factories, or office buildings)
and portfolio investment (i.e., investment in financial assets such as bank accounts,
stocks, and bonds). The IMF using data through 1997 reports (see Table 1.) that
between 1970 and 1997 gross cross-border flows of direct investment in the³
industrial countries grew by a multiple of 31, rising from $14.5 billion to $448 billion.
Yet this large increase appears tepid compared to the growth of gross flows of
portfolio investment that, over the same time period, saw transactions explode by a
multiple of nearly 200, rising from $5.3 billion to $1040 billion. The growth of both
types of investment are likely evidence of rising capital market integration, but (as
discussed below) are responses to different economic incentives presented by world
capital markets.
Table 1. Cross-Border Capital Flows for Major Industrial Countries
(In billions of dollars)
197019751980 19851990199519961997
Foreign Direct14.534.382.875.9283.2369.0357.5448.3
Investment
Portfolio5.327.160.9233.4329.6764.3 1,162.61040.2
Investment
Source: International Monetary Fund
The rapid growth of portfolio investment is more than just a burgeoning of
international bank deposits. Securities (equities and bonds) transactions have also
grown substantially. For example, in 1975 no major industrial country had cross-
border securities transactions that exceeded 5% of GDP. By 1997, however, the
multiple for these type of transactions ranged from 1 to 7 times GDP. The United
States, for example, saw cross-border transactions in bonds and equities grow from

4% of GDP in 1975 to 213% of GDP in 1997.

³See: The International Monetary Fund, International Capital Markets :Developments,
Prospects, and Key Policy Issues. Washington, DC. September 1998.

Another dimension of asset market integration is the sharp increase in the use
of international markets to raise funds, with new issues of international equity rising
nearly six fold just during the 1990's. Non-resident holding of public debt has also
increased in most industrial countries. For the U.S. the share of total public debt held
by non-residents went from 15% in 1983 to 39% in 1999. We also observe all large
securities markets trade in large numbers of non-resident companies. Capital flows to
and from developing countries are on a smaller scale but have shown similar growth.
Foreign Exchange Transactions.
One more measure that is reflective of the huge increase in cross-border asset
transactions is the scale of foreign exchange transactions. The acquisition of an asset
not denominated in one’s home currency usually requires the acquisition of the
appropriate foreign currency. Therefore, large asset flows must induce large currency
transactions. The Bank of International Settlements (BIS) estimates using data
available through 1995 that daily nominal turnover in foreign exchange markets has
risen six fold between 1986 and 1995, with the value of daily transactions soaring
from $188 billion to about $1.2 trillion (see Table 2.). That latter figure is equal to
over 85% of the foreign exchange reserves held by all countries in that year. On an
annual basis, transactions of that magnitude are also more than 50 times the value of
world wide trade in goods and services in a typical year.
Table 2. Foreign Exchange Trading
1986 1989 1992 1995
Global estimated turnover1885908201,190
(In billions of U.S. dollars)
Sources: Bank of International Settlements and International Monetary Fund.
Evidence of Limited Market Integration.
While there is little doubt that international capital markets have grown in size
and interconnectedness, other evidence suggests integration of the world capital
markets is far from complete. For example, net capital flows (capital outflows minus
capital inflows) have not grown nearly as much. The size of such flows can be
approximated by the absolute value of the advanced countries’ current account
balances. In recent years, this number has averaged near 2.0% of their cumulative
GDPs, not a remarkably large size. Similarly, despite their huge growth, direct
investment flows (i.e., investment in real capital as opposed to portfolio investment)
remain a small percent of total investment, averaging between 5% to 7% for the
advanced economies. Also, several empirical studies have shown a very high
correlation between domestic investment and saving, suggesting that international
capital mobility plays a small role in the finance of domestic investment. Of course,
this high correlation could also reflect the imperfect mobility of trade in goods and

services or the targeting of the current account balance by the government (that is,
using policy instruments to keep the current account balance within a narrow range.)⁴
Another way to assess the extent of capital market integration is by the degree
that asset prices have converged across countries. If one looks at onshore/offshore
yields for identical instruments denominated in the same currency a sharp convergence
has, indeed, occurred. There has also been a high degree of convergence for rates of
return on similar instruments in different currencies.⁵
A better indicator of the extent of capital market integration, however, is the
relative level of real (inflation adjusted) national interest rates across countries. Full
integration of world capital markets would tend to eliminate differences in real interest
rates (for assets of equivalent risk). Because of a lack of accurate data on expected
inflation and forward exchange rates across countries, tests for such convergence are
difficult. However, evidence on nominal interest rates in the United States, Germany,
and Japan does not show a substantial reduction in the dispersion of nominal bond
yields over time.⁶
One is left with the sense that while international capital markets are far more
integrated than was true only twenty years ago, economic integration probably falls
short of forming a single global market. Nevertheless, the substantial degree of
financial integration that has occurred carries a raised potential to strongly influence
the domestic economy and the conduct of economic policy.
The Economic Benefits of Capital Market Integration
That international capital flows have expanded so greatly in recent years is strong
evidence that there are sizable economic incentives propelling these flows. Economic
theory gives us some insight into what these incentives are and how economic
efficiency is increased by international capital market integration.
Extending the Gains from Trade.
The presence of well functioning international asset markets can extend the
benefits of international trade well beyond the gains associated with the exchange of
goods and services. International capital markets can facilitate a more efficient
allocation of saving and investment across nations allowing an optimal spreading of
consumption spending over time. International trade in assets can also enable greater
diversification of investment portfolios, leading to reduced investor risk.

⁴See: Feldstein and Charles Horioka, “Domestic Savings and International Capital
Flows,” Economic Journal, June 1990. Also see: Alan M. Taylor, “International Capital
Markets in History: The Saving-Investment Relationship,” NBER Working Paper 5743,
September 1996.
⁵Bank For International Settlements, 66^th Annual Report, Basle, June 1996.
⁶Marston, Richard. International Financial Integration: A Study of Interest
Differentials Between the Major Industrial Countries. Cambridge University Press, 1995.

Expanding Intertemporal Trade. Gains from trade can arise from intertemporal
exchanges. These are exchanges of current goods and services for claims on future
goods and services, that is, an exchange of goods and services for an asset (i.e. cash
in a bank account, stock, or bond). When the United States (or any trading nation)
borrows from abroad to import materials for a current investment project, it is
undertaking intertemporal trade. In such a transaction, the borrowing nation gains
because it can support a higher rate of investment in capital goods than what current
domestic saving alone could finance. The lending nation gains an asset yielding a
higher rate of return than is available in the home economy. Because of the difference
in their preferences for spending over time, the international asset market allows both
parties to the transaction to raise their economic well-being. The borrower’s
economic well-being is raised by being able to spend more in the current period than
current income allows. The lender’s economic well-being is raised by being able to
spend more in some future period. A country that is a net borrower will also run a
trade deficit, while the country that is a net lender will run a trade surplus. This type
of international asset transaction allows a more global utilization of the world’s
saving, a more efficient allocation of investment spending across nations, and a
preferred distribution of spending over time.
Since the early 1980's the U.S. has incurred trade deficits of moderate to large
size, using international borrowing to push spending beyond current production.
While there is a cost to such borrowing, there is considerable benefit of being able to
pursue desired consumption and productive investment now rather than later.⁷
Similarly, nations like Japan have been able to run trade surpluses, using international
lending opportunities to earn higher returns on their excess national savings and
expanding the prospects for spending in the future. Such net flows have not grown
as fast as gross flows of capital so that external sources of finance still claim only a
small share of the total funding of domestic investment in most industrial countries
(for the U.S. in 1998 the trade deficit represented about 3.5% of GDP and about 15%
domestic investment spending). The trend, nevertheless, has clearly been toward
larger external imbalances (surpluses and deficits).
Enhancing Portfolio Diversification. A look at the record of U.S. capital
transactions in a given recent year shows that the volume of those transactions greatly
exceeds what would be minimally necessary to finance the nation’s trade deficit. For
example, in 1997 the U.S. had a trade deficit of about $331 billion. The U.S. could
have financed this by just selling $331 billion in assets to foreigners. However, what
occurred that year was U.S. residents purchased about $430 billion in foreign assets
(a capital outflow) and foreigners purchased about $753 billion in U.S. assets (a
capital inflow ).⁸ It is clear that with a total turnover (i.e., outflows plus inflows) of
assets of well over a trillion dollars, a large amount of pure asset swapping occurred.
Such asset for asset transactions, like trade in goods, yields important economic
benefits. Investors are most likely risk adverse, weighing an endeavor’s expected yield
and the riskiness of that return, and preferring for a given return projects with lower

⁷See: CRS Report RL30561, The U.S. Trade Deficit in 1999: Recent Trends and
Policy Options, by Craig K. Elwell.
⁸See: Office of the President. Economic Report of the President. February 1999, pp

455.

risk. Risk aversion suggests that investors will prefer to hold a portfolio of assets that
does not offer the highest overall return, but does offer a more certain-less risky-
return.
International trade in assets can make both parties to the trade better off by
allowing them to reduce the riskiness of their investment return. Trade does this by
allowing investors to diversify their portfolios, that is, to spread their holdings across
a wider spectrum of assets than is possible without trade and thereby reduce their
exposure in any individual asset. Diversification is a sound aspect of prudent portfolio
management and thought to be a major benefit of open international capital markets⁹
potentially raising economic return . The overall yield can in fact rise as more high
risk (and high yielding) projects are attempted because the cost of failure can now be
diffused across a broader range of holdings. Similarly, failure will carry less potential
for individual mis-steps having large destabilizing effects that reverberate across
countries.
It is difficult to acquire information on the overall mixture of foreign and
domestic assets in the investment portfolios of a country’s residents. Data for the U.S.
can give a rough notion of changes in diversification over the twenty years from 1977
to 1997.¹⁰ In 1977 the foreign assets held by U.S. residents were equal to about 4.4%
of the U.S. capital stock (i.e. value of the stock of fixed reproducible tangible wealth
taken as a proxy for the total value of the U.S. investment portfolio). U.S. assets held
by foreigners were equal to 2.4% of the capital stock in 1977. By 1999 U.S. holdings
of foreign assets had risen to 21.1% of the capital stock, and foreign holdings of U.S.
assets had increased to 25.0% of the capital stock.
These are certainly substantial increases and do indicate that capital market
diversification has increased greatly. Nevertheless, these percentages still fall well
short of full diversification. Based on the size of the U.S. economy relative to the rest
of the world, portfolio theory suggests a ratio of asset mixing for the U.S. in the
50%-70% range (depending on the measure of assets chosen). Given that there is a
strong presumption among economists that diversification offers large benefits it is
perhaps surprising that greater international diversification has not occurred. It does
seem likely that the process of asset trading will continue to grow, however.
Influence on Domestic Monetary Policy.
Increased integration of the U.S. economy with world capital markets has
influenced the effectiveness and the impact of domestic monetary policy. One of the
main consequences of high international capital mobility has been to make the

⁹See: Levy, Hiam and Marshall Sarnat. “International Portfolio Diversification” in
Richard J. Herring. Managing Foreign Exchange Risk. Cambridge, Eng., Cambridge
University Press, 1983, pp.115-142.
¹⁰Data for foreign asset holding was taken from the International Investment Position
of the U.S. for 1999 and data for the total capital stock are estimates for Private Fixed
Reproducible Wealth. Both series are compiled by the U.S. Department of Commerce, Bureau
of Economic Analysis.

maintenance of fixed exchange rate pegs much more difficult. The U.S. abandoned
fixed exchange rates in 1973, allowing the dollar’s exchange value to float over a very
broad range.
Freed from the need to use monetary policy to strictly maintain the exchange rate
at the pegged value, monetary policy gains greater autonomy to pursue domestic
stabilization goals. Policy induced changes in interest rates can be pursued to affect
domestic inflation and output targets with diminished concern over the effect of that
change on the dollar exchange rate. This is not to say that the monetary authority can
be absolutely indifferent to the effect of its actions on the exchange rate, and
movement of the exchange rate does feedback on domestic policy targets (e.g., a
changing exchange rate has temporary impacts on the price level and inflation). But,
a floating exchange rate is clearly not as binding a constraint on policy action as is a
fixed exchange rate.
The loosening of this restraint has been associated with a dramatic reduction of
the U.S. inflation rate over the last twenty years, as monetary policy focused
persistently on lowering inflation. The dollar exchange rate was not completely
ignored over this period , but much wider bands of fluctuation allowed the monetary
authority to focus more relentlessly on dis-inflation policy.
With a floating exchange rate for the dollar and integrated capital markets, the
mechanism by which monetary policy changes are transmitted to the economy has also
changed. Monetary policy now carries an enhanced influence via changes in the
exchange rate. This means that monetary policy goals can be achieved with less
change in interest rates as some of the needed adjustment can now be achieved with
changes in the exchange rate.
Monetary policy changes are initiated by adjustments in the rate of growth of the
money supply, inducing changes in the level of domestic interest rates and changing
rates of spending in interest sensitive activities such as housing, consumer durables
and business investment. Interest rate changes will, in turn, cause the exchange rate
to change. This occurs because changes in the level of domestic interest rates, relative
to foreign interest rates, will affect the demand for dollar-denominated assets and the
demand for the dollars needed to buy those assets. The exchange rate will
automatically adjust with the change in demand for foreign exchange.
With the added impact of the exchange rate on exporting and import-competing
industries, any given policy induced change of interest rates will have a stronger
ultimate impact on domestic demand. In addition, this leads to a more equitable
distribution of impact as the burden of adjustment is borne more broadly by both
interest sensitive and exchange rate sensitive sectors of the economy. The degree of
equity involved can be disrupted in situations like the early 1980's when a dramatic
run-up of the dollar exchange rate produced disport ionate burdens on the exchange
rate sectors of the economy (i.e. the tradeable goods sectors). This episode
underscores the point that even under a flexible exchange rate regime, movements of
the exchange rate cannot be ignored.

Economic Concerns with International Capital Flows
Increased capital market integration also carries risks. One is that more points
of economic and financial contact raise the prospect of the transmission of negative
economic shocks through so called “contagion” effects. In addition, some argue that
asset markets themselves are often destabilizing and can generate periodic crises. The
unsettling prospect is that in a system of highly mobile international capital the
economy is open to assault by currency speculators who may incite excess volatility
of exchange rates and other assets, and impose economic instability and hardship on
the U.S. economy.
Exposure to External Shocks.
Increased interdependence increases the points of contact among the economies
of the world. Most often these enhanced linkages are a positive construct that help
raise economic efficiency, but from time to time they can play a negative role as
conduits for economic “contagion.” With increased globalization, economic maladies
on the other side of the world will more quickly spread to the U.S., perhaps bringing
undeserved economic misfortune to our citizens.
Expanding trade in goods and assets and the associated increase of global market
integration will increase the risk of economic shocks carrying from one economy to
another. In practice, however, such shocks are seldom carried from the initiating
country to others on the same scale. This attenuation of the transmitted shock is
largely due to differences in economic size and to differences in the degree of
integration. The U.S. is far larger then any single trading partner. Further, trade for
the U.S. is a small share of total economic activity. Taken together, these two factors
most often assure that a foreign economic calamity has small ripple effects on the
United States. Of course, these factors can be expected to exert less and less of an
attenuating effect as trade, interdependence, and the relative size of our trading
partners grows, but there are other forces that will likely work to attenuate the impact
of foreign economic shocks.
Factors That Dampen International Shocks. First, well functioning markets
will provide automatic offsets to external shocks through movement of exchange
rates, interest rates, and prices. Second, quickly responding and prudently applying
economic policy, most often monetary policy, can help to mitigate the effects of
external shocks. A third factor attenuating the impact of external shocks is that
increased global integration also allows shocks to be absorbed by a far larger global
market, thereby reducing the effect on any individual economy. Further, by providing
more rapid and more comprehensive flow of market information about risk and
profitability of investment prospects around the globe integrated asset markets help
facilitate a quicker adjustment to disruption and a more efficient allocation of the
world’s limited saving in both the short-run and the long-run.¹¹

¹¹For further discussion see: International Capital Markets :Developments, Prospects,
and Key Policy Issues. IMF, September 1998.

Impact of the Asian Economic Crisis on the United States. In recent years, we
have seen the American economy prospering despite sharp and prolonged recessions
in Japan, Europe, and Mexico. Nor have troubles in several Asian countries had a
sizable effect on the United States. During this most recent crisis the U.S. has
maintained vigorous economic growth, achieved record low levels of unemployment,
and avoided any re-acceleration of inflation.
The Asian crisis did have an impact, however, in that it contributed to a
substantial widening of the U.S. trade deficit. Sizable inflows of Asian capital, seeking
high and more certain U.S. asset yields, pushed up the dollar exchange rate,
weakening exports and encouraging imports. Several tradeable goods sectors of the
economy were hurt by these changes. On the export side, agriculture and commercial
aircraft experienced damped export sales. While on the import side the steel industry
and the textile and apparel industries came under considerable pressure from low price
competition from the crises affected countries.
On the other hand, there have been economic benefits derived from that crisis.
Lower import prices have elevated real income in the U.S. and dissipated inflation
pressures. In addition, large capital inflows have kept domestic interest rates lower
than they otherwise would be, a boon to U.S. borrowers and interest sensitive sectors
such as housing and consumer durables.
Weighing Risk and Reward. There is no doubt that increased global integration
raises the exposure of to the U.S. economy from external shocks. But, such
integration also boosts the rewards to the economy through improved efficiency. So
far there is no conclusive evidence that the added risk exceeds the added reward.
While individual sectors were hurt, the overall U.S. economy weathered recent
international storms with little difficulty and some benefit. Moreover, we have seen
that the prudent application of domestic macroeconomic policy can do much to
assure that on balance the rewards from this ongoing process continue to exceed the
economic risks.
Asset Price Volatility and Periodic Misalignments.
Beyond their potential for transmitting economic shocks, integrated financial
markets themselves can be the source of problems. Specifically, those markets may
produce excess “volatility” of asset prices, most importantly exchange rates, causing
economic disruption and costly adjustment. Because exchange rates communicate
important economic signals to those involved in international trade and investment,
the argument can be made that any tendency for foreign exchange markets to
“overreact” to events will transmit confusing and error-filled data to international
traders and investors, causing a mis-allocation of global resources.
Has Volatility Been Excessive? Of course, where one perceives volatility and
disruption, another sees global asset markets working quickly and usefully in
response to changes in economic fundamentals that affect risk and profitability.
Whether international asset markets overreact and whether such overreaction carries
more costs than their efficiency benefits warrant is an open question. It is difficult to
determine what constitutes excessive volatility. While exchange rates have in recent
years appeared to be rather volatile, evidence does not point to significant increases

in the variability of other asset prices. And even the increase in exchange rate volatility
has not been conclusively shown to be excessive in the sense that it has gone beyond¹²
what could be attributable to an efficient market function.
The recent currency crisis in several Asian countries highlights these issues. The
international capital market has clearly induced sharp and painful depreciations of the
foreign exchange value of these countries’ currencies. Yet, what is also increasingly
evident is that these countries were pursuing “questionable” macroeconomic policies,
had “suspect” banking and financial practices, and promoted “imprudent” exchange
rate management regimes. International asset markets serve economic efficiency by¹³
reacting quickly and strongly to “bad” fundamentals. Thus, globalization and rapid
capital flows, in this view, have the very positive role of limiting the ability of
countries to pursue incompatible and unsound economic and financial policies. To the
extent that there is still a degree of overreaction by currency and other asset traders
it is possible that these economies will be forced through a measure of “unnecessary”
adjustment. Does the efficiency gain more than offset the “unnecessary” cost? There
is no definitive answer. But we might keep in mind that the economic purpose of IMF
assistance in such circumstances is not to bail-out enterprises generally, rather it is
to offset the unnecessary adjustments forced by the currency markets over-reaction.
It is possible that the global markets in conjunction with well targeted economic
assistance may be a workable and efficient mix, enhancing the operation of the world
economy, and providing indirect benefit to the U.S. as it improves the wealth and
stability of our economic “neighborhood.”
The Problem of Asset Price Misalignment. A more critical issue for the U.S.
and other industrial economies in an international environment of large and rapid
capital flows is the prospect for asset prices becoming misaligned, that is, straying,
and remaining for a time, well beyond a level that is consistent with underlying
economic fundamentals. This was likely true for the dollar in the 1984-85 period, for
the U.S. stock market just prior to the crash in 1987, and for the Japanese Yen in
1995. Such misalignments often impose disproportionate burdens on sectors of the
economy (e.g., exchange rate impacts on tradable goods sectors) and their correction
is potentially disruptive to the wider economy (e.g., inducing financial market
instability).
Misalignments are difficult to identify at the time they are occurring because
there is usually a substantial margin of uncertainty about whether a given level of asset
prices is inconsistent with macroeconomic fundamentals. Those fundamentals will
most often be consistent with asset prices moving in the direction they are moving.
The problem is deciding if they have moved too far.
Once identified, misalignments can be hard to correct because of the huge
volumes of private capital flows that may need to be offset. The corrective actions of
the central bank of one nation may be unable, in some circumstances, to counter the
tide of private capital supporting the misalignment. In these cases coordinated

¹²See: Bank for International Settlements. Financial Market Volatility : Measurement,
Causes, and Consequences, BIS Conference Papers, March 1998.
¹³See CRS Report 97-1021, The Asian Financial Crisis, by Dick K. Nanto.

intervention by several governments may be more effective at correcting the
misalignment. Such coordinated strategy did help to correct the soaring dollar in 1985
and the “overvalued” yen in 1995. Such actions are also thought to carry an important
“signaling” function in the sense that their effectiveness does not stem so much from
the quantity of their financial market actions but from their role as an indicator of the
participating governments’ commitment to more sustainable economic policies. In
general the governments of the industrial economies may not have shown a capacity
to always avoid the periodic policy missteps that induce asset market misalignments,
but, to an extent, they have revealed a capability to effectively deal with the
misalignments in a way that is not overly disruptive to economic activity.
Foreign Finance and Economic Stability. A related concern with globalized
asset markets is that countries with open capital markets will from time to time be
recipients of large net inflows of financial capital, which will just as quickly leave.
These rapidly shifting funds can be a destabilizing force, creating inflationary pressure
and pushing up the real exchange rate. On the other hand, capital inflows can be a
useful and efficient source of financial capital. The desirability and undesirability of
such inflows will hinge critically on the factor or factors that caused them. If the
capital inflow is the consequence of flawed or misguided macroeconomic policies,
then, indeed, such capital flows may quickly desert the economy, and perhaps
precipitate a crisis. If, on the other hand, those inflows are caused by sound economic
policy and good long-term investment prospects, then such inflows can be enduring
and beneficial.
Conclusion
Large, highly mobile international capital flows are an economic fact of life. The
growth of these markets has been phenomenal and the process has not likely ended.
It is very clear that larger more integrated asset markets offer considerable
opportunities to raise economic efficiency and enhance economic well being, but these
flows can also conduct or create economic disruption. The problem for the policy
maker is to ensure that the benefits of asset market integration exceed the costs.
For the United States rising capital market integration appears to have brought
more pluses than minuses. The U.S. has availed itself of the expanding opportunities
for intertemporal trade and financial portfolio diversification that more integrated
markets offer. The disruptive effects caused by these markets seem to have been
modest for the United States. Increased asset price volatility and augmented
channels for “contagion” have been easily absorbed by the U.S. economy. Asset price
misalignment has been a problem for the U.S. on occasion. Of course, this problem
has its roots in the conduct of economic policy as well as the behavior of the
international capital market. When needed, the U.S. has been able to effect
corrections of misalignments with only modest disruption of economic performance.
For a large, predominately domestically oriented economy, with a well developed
and prudently regulated financial system, and with a resilient structure of private
markets such as the U.S., large international flows of capital are absorbed to apparent
economic advantage, with a minimum of disruption, even in the face of large currency
swings.

For smaller, more internationally linked economies, with less developed financial
markets, capital market integration may not be as easy to maintain stable economic
growth. However, the importance of global economic stability suggests the United
States is likely to have an interest in helping to develop and support an international
architecture that extends the benefits of mobile international capital to all economies.