"The net transfer of financial resources measures the total receipts of financial and other resource inflows from abroad and foreign investment income minus total resource outflows, including increases in foreign reserves and foreign investment income payments. The net transfer of a country’s financial resources is thus defined as the financial counterpart to the balance of trade in goods and services. "

The role of international capital flows in economic development raises important open questions. In particular, the question asked by Robert Lucas almost twenty years ago—why so little capital flows from rich to poor countries—received renewed interest as capital has been flowing “upstream” from developing countries to the U.S. since 2000. This paper takes a fresh look at the pattern of capital flows to developing countries through the lenses of the neoclassical growth model.
Our contribution is twofold. First, we show that there is a significant discrepancy between the predictions of the textbook neoclassical growth model for the distribution of capital flows across developing countries and the behavior of capital flows in the data. The basic framework predicts that countries that enjoy higher productivity growth should receive more net capital inflows. We look at net capital inflows for a large sample of non-OECD countries over the period 1980-2000 and find that this is not true. In fact the cross-country correlation between productivity growth and net capital inflows is negative. The non-OECD countries that have grown at a higher rate over 1980-2000 have tended to export (not import) more capital. The international capital market, thus, does not allocate capital across developing countries in the way predicted by textbook theory—a fact that we call here the “allocation puzzle”.

Eswar Prasad, Raghuram Rajan, and Arvind Subramanian

Standard economic theory tells us that financial capital should, on net, flow from richer to poorer countries. That is, it should flow from countries that have more physical capital per worker—and hence where the returns to capital are lower—to those that have relatively less capital—and hence greater unexploited investment opportunities. In principle, this movement of capital should make poorer countries better off by giving them access to more financial resources that they can then invest in physical capital, such as equipment, machinery, and infrastructure. Such investment should improve their levels of employment and income.

Global capital flows, including debt, portfolio equity, and direct investment–based financing, topped $6 trillion in 2006. Global imbalances have also risen, with the United States running a current account deficit and some emerging market countries running big surpluses. A chart-based view of where the money goes.

Why does it matter which combination, if any, of the four hypotheses I have advanced is adequate to account for the absence of income equalizing international cap ital flows? The central idea of virtually all postwar development policies is to stimulate transfers of capital goods from rich to poor countries. Insofar as either of the human capital-based hypotheses reviewed in Sections I and I1 of this paper is accurate, such transfers will be fully offset by reductions in private foreign investment in the poor country, by increases in that country's investments abroad, or both. Insofar as returns on capital are not equalized, but where return differentials are maintained so as to secure monopoly rents, capital transfers to poor countries will also be fully offset by reductions in private investments. Giving goods to a monopolist does not reduce his interest in exploiting potential rents.

This essay describes some possible theoretical and empirical reconciliations of the Lucas Paradox. In general, the theoretical explanations for the “Lucas Paradox” fall into two categories. The first category pertains to differences in fundamentals relating to the overall production structure of the economy, including technological differences, lack of productive infrastructure and other elements affecting total factor productivity, missing factors of production, government policies (such as tariffs, taxes, capital controls, and non-trade barriers), and institutional structure. The second category relates to international capital market imperfections, such as information asymmetry (home bias), sovereign risk, and credit failures (financing frictions)