Do finite horizons matter? The welfare consequences of capital account liberalization

Cross-sectional regressions have repeatedly failed to find robust effects of capital account liberalization on investment or GDP per capita, and Gourinchas and Jeanne (2006) found that the welfare gain from integration, measured over an infinite consumption stream, is small. This paper argues both findings are what the neo-classical model should predict and that neither settles whether liberalization is worth doing, because the theory predicts a temporary growth effect with a permanent level effect, and because the standard welfare measure spreads a gain concentrated in the first years over an infinite horizon on which the two consumption paths eventually coincide. Working in a calibrated infinite-horizon Ramsey model with Cobb-Douglas production (beta = 0.96, capital share 0.3, depreciation 0.06, output growth 1.012, population growth 1.022, log utility), the authors assume the liberalizing economy faces the world interest rate immediately and so jumps to the integrated steady state at once – an assumption made explicitly “to abstract from speed of convergence issues” – while the autarkic economy climbs there gradually from the same starting point, the population-weighted capital stock of 1995 (1.96, against a steady state of 3.97). They then compute the Hicksian consumption-equivalent gain over horizons from five years to infinity for 81 non-OECD countries. The timing result is the paper’s core empirical claim: “95% of the increase in annual consumption from capital account liberalization accrues in the first 10-15 years after the opening.” Consequently the same welfare difference reads very differently depending on the normalising horizon. In the baseline, where the economy pays interest on the inflow in perpetuity and never repays principal, the average infinite-horizon gain is minus 3.46 percent of annual consumption – financing costs outweigh the gain – while the five-year figure is 19.02 percent, and the numbers decline monotonically with the horizon, crossing zero around 35 to 40 years. The gain scales with initial capital scarcity: 51.47 percent at five years for the most capital-scarce quartile of countries, against minus 0.90 percent for the most capital-abundant quartile. The robustness exercises mostly preserve the horizon result while showing how sensitive the level is to the debt contract: allowing conditional convergence with country-specific earnings-price ratios gives 9.89 percent at five years and minus 8.35 percent at infinity; imposing the Obstfeld-Rogoff transversality condition, so principal and interest are settled only at infinity, gives 29.32 percent at five years and a positive 4.97 percent at infinity; a 50-year amortising contract gives 18.22 percent and minus 4.12 percent; starting from 1960 rather than 1995 capital stocks, when gaps were wider, gives 32.03 percent at five years. Adding a normally distributed technology shock (mean 1, standard deviation 0.03, described by the authors as “not a realistic shock … used for illustrative purposes”) makes the contract form decisive: with a non-contingent debt contract the computed gains turn sharply negative at every horizon, whereas an equity-like contract that suspends payments in bad states “comes close to the case of an economy that liberalizes and does not need to make repayment.” The authors’ conclusion is methodological and carefully bounded: they “do not claim that policies that lead to permanent effects on TFP and growth are not important,” only that finite-horizon evaluation “may be more appropriate and policy-relevant” for policies with temporary growth and permanent level effects.

Economic Modelling | Macro Paper Warehouse

Do finite horizons matter? The welfare consequences of capital account liberalization