Relationship Between Financial Globalization And Economic Output Economics Essay

Published: Last Edited:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

Financial globalization has been the main trend of world economy since the collapse of Bretton Woods System. While financial globalization has been associated with high growth rates, increased investment, and a better ability to diversify risk in some countries, a number of other countries have experienced economic volatility because of significant financial crises over the same period. These developments have sparked a hot debate on the benefits of financial globalization.

At the initial stage, literature from such debate mainly focused on the direct

relationship between financial globalization and economic output. The proponents of

financial liberalization, such as Quinn (1997); Fischer (1998); Kraay (1998); Summers

(2000); Donnell (2001); Edison, Klein, and Slok (2004), suggest the way in which

financial globalization can benefit a country: financial globalization offers the

opportunity to augment domestic savings, to relax borrowing constraints, to diversify

away country-specific risk, to increase the investment, and to take the advantage of

technology spillovers. Their opinions are based on the standard neoclassical framework

which opines that it would generate welfare gains for both industrial countries with rich

capital and developing countries with poor capital if capital could flow freely between

them.1 However, with the deepening of financial integration came a spate of currency and

banking crises since 1980s. A number of developed and developing countries have been

hit by several serious financial and economic crises. The merits of international financialintegration are also under forceful attack and doubt. Kaminsky and Reinhart (1998),

Detragiache and Kunt (1998), and Glick and Hutchinson (2001), argue that financial

globalization can increase the propensity to financial crises.2 Bhagwati (1998), Rodrik

(1998), and Stiglitz (2002) argue that increasing capital account liberalization and

unfettered capital flows are the important keys causing global financial stability.

However, literature in this stage has several disadvantages. First, most of the

academic economists analyzed the effects of financial globalization just in a divided

way-either positive or negative-rather than in a unified way, leading to a partial or a

bias account on the effect of financial globalization. More importantly, although vast

empirical literature has shown that GDP of the group of more financially open economies

does grow at a more favorable rate than that of group of less financially open economies,

or that financial liberalization increases the output volatility, it does not provide strong

and robust evidence to establish the causal or direct relationship between globalization

and economic growth and volatility.3

Therefore, at new stage of literature on such subject, academic economists

develop an integrated framework to empirically quantify and contrast the positive and

negative effect of financial globalization on economic growth. They found that the

positive effect of financial globalization on growth by far outweighs the effect on

volatility for the long run. For example, Ranciere, Tornell, and Westermann (2006)

contrast experience of Thailand and India to support this assertion. Their finding is that

"Although Thailand, a country with high financial liberalization, has experienced lending

booms and crises, while India, a country with low financial liberalization, has followed astable and save growth path, Thailand's GDP per capital grew by 148% between 1980

and 2001, while India's GDP per capita grew by only 99%".

By reviewing the existing literature, Kose, Prrasad, Rogoff and Wei (2006)

concluded that there is no strong and robust evidence to establish the causal or direct

relationship between globalization and economic growth and volatility. They propose

"threshold effect", including financial market development, institutional quality,

governance, macroeconomic policies, and trade integration, to argue that globalization

effects on domestic economy through the "threshold effect". In other words, whether one

country could reap benefit from globalization depends on how well its "threshold effect"

is. Especially, more and more economists notice that the financial market development

plays a crucial role in economy growth under the financial globalization. Using crosscountry

data between 1975and 1995, Alfaro, Chanda, Kalemli (2003) show that the direct

relationship between FDI and economic growth is not significant in their model, but once

the financial market development, a interaction factor, is added into the model, the

relationship becomes highly significant. That is, "FDI alone plays an ambiguous role in

contributing to economic growth. However, countries with well-developed financial

markets gain significantly from FDI."4 Levine, Loayza, and Beck (1999) use the

traditional cross-section, instrumental variable procedures and dynamic panel techniques

to argue that "the exogenous components of financial markets development are positively

associated with economic growth." By analyzing the cross-border countries data over

period 1986 to 1995, Klein and Olivei (2006) also show that "countries with open capital

accounts over some part or all of these periods had a significantly greater increase infinancial markets development than countries with continuing capital account restrictions,

and, over the twenty-year period, the developed financial markets make them enjoy

greater economic growth."

I conclude above: firstly, it is arbitrary to say that financial globalization can

directly make countries enjoy the economic growth, or to blame that financial

globalization is a hotbed of the financial crises. The effect of financial globalization on

economy is realized through mechanism of "threshold effect", especially the local

financial markets development. Secondly, lots of existing literature just explored the role

of local financial markets development in contributing to economic growth in a direct

way. That is, it examines how a well-developed financial market helps a country to

realize long-run GDP growth rate increase under the financial globalization.

The goal of my paper is not to perform another test of the direct effect of local

financial market development on GDP growth rate. Instead, its main contribution is to

provide an indirect perspective: If I can certificate that well-developed local financial

markets can decrease the frequency of occurrence of financial crisis and alleviate the

negative impact if financial crises occur, then, it can indirectly reflect that the role of

local financial markets development is important in contributing to the economic growth.