^*Dani Rodrik is a Professor of International Political Economy at Harvard University, and Arvind Subramanian is a Senior Fellow, Peterson Institute for International Economics and Center for Global Development. The authors thank Olivier Jeanne, Ayhan Kose, Peter Henry, and John Williamson for comments on an earlier draft.

Abstract

The stylized fact that there is no correlation between long-run economic growth and financial globalization has spawned a recent literature that purports to provide newer evidence and arguments in favor of financial globalization. We review this literature and find it unconvincing. The underlying assumptions in this literature are that developing countries are savings-constrained; that access to foreign finance alleviates this to boost investment and long-run growth; and that insofar as there are problems with financial globalization, these can be remedied through deep institutional reforms. In contrast, we argue that developing economies are as or more likely to be investment- than savings-constrained and that the effect of foreign finance is often to aggravate this investment constraint by appreciating the real exchange rate and reducing profitability and investment opportunities in the traded goods sector, which have adverse long-run growth consequences. It is time for a new paradigm on financial globalization, and one that recognizes that more is not necessarily better. Depending on context and country, the appropriate role of policy will be as often to stem the tide of capital inflows as to encourage them. Policymakers who view their challenges exclusively from the latter perspective risk getting it badly wrong.