The recent turbulence in the European Monetary System has added fresh impetus to the study of international capital flows. In recent years, the industrialized countries have increased the volume of capital movements among themselves while many developing countries have also embarked on extensive programmes of capital market liberalization. These developments have major implications for exchange rate targeting, control of the macroeconomic aggregates, central bank independence, international taxation conventions, fiscal policy coordination and the convergence of national growth rates. A CEPR joint conference with the Pinhas Sapir Center for Development (Tel Aviv University) and the Bank of Israel on `Capital Mobility: New Perspectives', held in Tel Aviv on 20/21 December 1992, provided a forum for the discussion of recent research in these areas. The conference was organized by Research Fellows Leonardo Leiderman and Assaf Razin (Tel Aviv University), with the collaboration of Marco Pagano (Università Bocconi, Milano).

In his paper, `Are Industrial-Country Consumption Risks Globally Diversified?', Maurice Obstfeld (University of California at Berkeley and CEPR) used various consumption-based tests to assess the efficiency and openness of international asset markets, and in particular their ability to smooth consumption by diversifying the risk of country-specific shocks. Obstfeld analysed the differentials between domestic and world consumption growth rates for G7 countries to assess the extent of their integration with world financial markets. In several variants of this framework, he found a general tendency for such integration to increase but strong evidence applied only to Germany. There was also weak evidence that consumption growth volatility fell in the other countries except Canada. These results generally support the hypothesis of increased diversification.

In their paper, `Convergence in Growth Rates: The Role of Capital Mobility and International Taxation', Assaf Razin (Tel Aviv University and CEPR) and Chi-Wa Yuen (Hong Kong University of Science and Technology) developed a two-country endogenous growth model. It was driven by human and physical capital accumulation and endogenous population growth, which was determined by an explicit trade-off between quality and quantity of children. Capital mobility and taxation policies generated the observed long-run variations in rates of growth and levels of per capita income. Cross-country variations in tax policy did not affect total GDP growth, but their effects on after-tax rates of return cause a country with a lower tax rate to exhibit higher growth of physical capital and lower population growth, which raises its per capita income level and growth rate. This will apply if the `residence principle' dominates, i.e. if each country taxes its own residents, regardless of the source of their income, and does not tax non-residents on income earned within its borders. If this is adopted universally, optimal tax policies will lead to the equalization of growth rates across countries.

Recent growth literature has seen several attempts to explain the observed failure of national growth rates to converge by extending the traditional Solow growth model. By adding human capital accumulation as a determinant of growth, Mankiw, Romer and Weil found evidence of conditional convergence. In, `Economic Growth and the Solow Model', Daniel Cohen (Université de Paris I, Ecole Normale Supérieure, Paris, and CEPR) challenged this framework, which restricts human and physical capital accumulation to the same `law-of-motion': a fixed proportion of income is invested in each, so growth is a one-dimensional dynamic process, which suppresses critical differences between human and physical capital. By estimating the two accumulation equations separately he showed that human capital accumulation is also augmented by a `knowledge function' and can exhibit constant returns to scale. these results indicate the need to include a `knowledge/GDP ratio' as a second term in the growth process.

In `A Note on the Idiosyncratic Determinants of Economic Growth', Cohen examined the appropriateness of MRW's use of secondary school enrolment as a proxy for human capital investment. Estimating their growth equation with an additional, idiosyncratic term to control for cross-country differences, he found that the coefficient on school enrolment became wrongly signed, which casts doubt on the causality assumption. By dropping the school enrolment term and estimating the traditional Solow model with the idiosyncratic term alone, he found a speed of convergence towards the steady state of 6% per year.

Lars E O Svensson (Institute for International Economic Studies, Stockholm, and CEPR) presented `An Interpretation of Recent Research on Exchange Rate Target Zones'. He noted that Krugman's model of an S-curve generated by the assumptions of perfect credibility and interventions only at the margins pointed to testable hypotheses that had been rejected by the data. In particular, the theory suggests that exchange rates should usually lie near the edges of their bands in a U-shaped density function, but the data generate a hump-shaped distribution in which exchange rates most often lie near the central parity. This indicates which suggests that intramarginal intervention is the rule. Perfect credibility in Krugman's model also implies a strong negative correlation between the exchange rate and uncovered interest differentials, since an actual exchange rate near the weaker edge of its band can only appreciate, which should reduce the differential between domestic and foreign interest rates. The observed relationship between exchange rates and the uncovered interest differential is diffuse, however, with no apparent correlation of any sort. Svensson attributed this to imperfect credibility, since realignment expectations are high when the exchange rate is near the edge of its band. More recent models have incorporated imperfect credibility and intramarginal interventions in order better to describe exchange rate behaviour in a target zone regime.
The experience with exchange rate bands has included band widths ranging from 1% under Bretton Woods up to 10% in Chile today. In their joint paper, `The Choice of Exchange Rate Bands: Balancing Credibility and Flexibility', Alex Cukierman (Tel Aviv University), Miguel A Kiguel (World Bank), and Leonardo Leiderman (Tel Aviv University and CEPR) investigated the optimal width of exchange rate bands, which are understood as a limited commitment device in a world in which realignment may entail a political cost. In their model, band width is determined endogenously by real economic objectives and the parameters relevant to expectations. These include the strength of policy-makers' reputation, the cost to them of reneging and the variance of shocks. The credibility of the band falls as the exchange rate moves towards its weaker edge; a wider band allows a greater range of flexibility, while choosing a narrow band enhances policy-makers' credibility. The trade-off between these objectives determines the optimal band width for a given set of parameters.

In `Exchange Rate Volatility, Relative Price Uncertainty and Investment: An Empirical Investigation', John Huizinga (University of Chicago) examined the effects of the increased nominal exchange rate volatility, and thus uncertainty, that accompanied the transition from Bretton Woods to flexible exchange rates. He compared volatility and uncertainty in exchange rate levels to that of a variety of price and quantity measures from data on four-digit US manufacturing industries, in order to test whether the increased exchange rate uncertainty was correlated with uncertainty about real economic variables or dampened investment. He found that the regime switch had led to an increase in uncertainty in all variables, which was much more pronounced for industries that were highly exposed to international trade. Regarding investment, high uncertainty about real output prices was negatively correlated with investment and productivity growth rates and positively correlated with the share of equipment in the capital stock.

Attempts to explain the volatility of capital flows into Latin America have often focused on factors outside the region, such as fluctuations in US interest rates. In `Capital-Flow Volatility and Expected Government Policy', Giuseppe Bertola (Princeton University and CEPR) and Allan Drazen (University of Maryland) developed a model in which factors within the region account for investment behaviour. Productivity grows exogenously but is subject to technological shocks; investment is irreversible; the dividends process responds one-for-one to the rate of productivity and is a decreasing function of the existing capital stock. With productivity shocks, procyclical policy may magnify the variability of returns to investment and magnify the volatility of capital flows. Bertola and Drazen discussed a `dynamic Laffer curve' that shrinks the tax base during the low-productivity state, when higher taxation is required to maintain government expenditure. Increased tax rates imply a lower after-tax return on investment and hence a reduced capital inflow. In bad times the government may also want to reduce the burden on domestic residents through transfers, which further increase taxation on (foreign) investment. They concluded that the volatility of capital flows into Latin America primarily reflects the effects of government policies in magnifying developments within the region.

In deterministic, static neoclassical models of a small, open economy, savings and investment are independent if capital mobility is free, but empirical studies have usually found positive savings-investment correlations. Experience with other indicators consumption smoothing, asset return differentials and investment variability has been controversial, and direct measures have found a bias towards domestic investment. In his paper, `Robustness of Macroeconomic Indicators of Capital Mobility', Enrique G Mendoza (IMF) argued that these results need not indicate the failure of international financial deregulation, since positive savings-investments correlations do not provide full information on the extent of capital mobility, and savings and investment may be expected to move together even under perfect capital mobility for certain types of shocks. Mendoza conducted simulations for an artificial economy subject to persistent productivity and terms-of-trade shocks, which created business cycles similar to those realized in Canada and Mexico. He then tested the various `indicators' of capital mobility under several sets of parameters and assumptions about the degree of capital mobility and found that the indicators were more sensitive to parameters describing the stochastic process and the preference structure than to the degree of capital mobility.
In their joint paper, `Business Cycle Volatility and Openness: An Exploratory Cross-Sectional Analysis', Assaf Razin (Tel Aviv University and CEPR) and Andrew K Rose (University of California at Berkeley) examined the relationship between barriers to international trade and capital mobility and business cycle volatility. The domestic effects of country-specific shocks should be sensitive to the openness to international goods and financial markets, since increased openness in the capital market should smooth consumption dynamics for shocks that are transitory and increase the volatility of investment for those that are persistent. Increased openness to trade should increase output volatility through industrial diversification if shocks are idiosyncratic. The authors' preliminary international cross-sectional investigation based on institutional indicators of barriers to flows of capital and goods found no strong evidence of such correlations, however, which they tentatively attributed to the persistent and common nature of some shocks, which should weaken the theoretical predictions.

In their joint paper, `Liberalization of the Capital Account: Experiences and Issues', Donald J Mathieson and Liliana Rojas-Suarez (IMF) noted that the use of capital controls has been motivated by various factors: to reduce the volatility of capital flows, to ensure that domestic savings lead to domestic investment, to limit foreign ownership of domestic assets, and to prevent capital inflows from inducing currency appreciations during periods of stabilization and reform. While these controls were never fully effective, governments' ability to restrict cross-border capital flows deteriorated significantly in the 1980s, and it is now extremely costly to maintain effective barriers. The authors attributed this change to several factors, including technological advances and learning-by-doing, and then examined its policy implications. They concluded that the sequencing and speed of liberalization matters less than its `fundamentals' for policy and that fiscal adjustment is critical to any stabilization programme

In `The Political Economy of Capital Controls', Alberto Alesina (Harvard University and CEPR), Vittorio Grilli (Birkbeck College, London, and CEPR) and Gian Maria Milesi-Ferretti (LSE) investigated the determinants and effects of capital controls in OECD countries. They found that the choice of exchange rate regime proved important, since managed systems tended to have stronger capital controls, while central bank independence was negatively correlated with indicators of restrictions to capital flows, which reflect governments' differing abilities to apply an inflation tax. Neither the political leaning of the ruling party nor a measure of social conflict proved significant. In countries with capital controls in place, both the inflation tax and seigniorage tended to be high, while real interest rates and debt accumulation were lower, which may be attributed to the effect of capital controls in inducing `financial repression'.


In addition to the above papers, the conference featured a panel discussion on `Economic Policies and Market Responses in a Changing Europe: What Next?'. Jacob A Frenkel (Bank of Israel, Tel Aviv University and CEPR) provided a historical perspective within which current events may be better understood. Daniel Cohen discussed the idea of currency union in the context of the development of the single market. Lars Svensson drew conclusions about the establishment of monetary and exchange rate credibility from the failure of Nordic countries to defend their parities against speculative attacks in late 1992. Richard Portes (CEPR and Birkbeck College, London) expressed pessimism concerning various proposals to restore the European Monetary System.



The papers presented at this conference will be published by Cambridge University Press later this year, in a volume edited by Leonardo Leiderman and Assaf Razin.