Introduction

In the 1920’s capital began flowing from Massachusetts to North Carolina, a process that continued until after World War II. This movement of capital was linked to the migration of the textile mills of New England to the South. Beginning in the 1950’s capital moved again as textile manufacturing moved from the US to Mexico, India, and Malaysia. The movement of capital from less productive to more productive uses is a story repeated over and over again throughout history and around the world.

Whether capital moves within a country – say from Massachusetts to North Carolina – or between countries – say from the U.S. to Mexico -- its flow addresses imbalances between local sources of funds (savings) and uses (investment). The period from 1880 to 1913 is often described as the golden era of capital mobility when capital flows between countries was at a peak. Through much of history, the major capital flows have been from rich countries to poorer ones. The UK, for example, financed canals in the US and railroads from Australia to India. The standard theory as articulated by eg. Lucas(1990) is that capital should flow from rich countries to poor countries because the returns to capital should be higher in the latter.[1]

The idea that capital should flow from rich countries to poor countries and that these flows are consistent with the pursuit of higher returns have both been challenged by the facts. Ohanian and Wright (2010) have shown that the direction of capital flows were not always consistent with the pursuit of higher returns as measured by them.[2] Even more damning is the evidence of recent history in which the most notable importer of capital has been the richest country, the United States. Australia, Spain, and the UK have also been importers of capital. Germany, Japan, China, and Switzerland have been significant exporters of capital. Over the last ten years, oil-exporting countries have been massive exporters of capital.

These facts are collectively referred to as "global imbalances." The standard view in policy circles is that they represent not a sensible market reallocation of capital but a serious threat to economic stability. Such "imbalances" are "unsustainable" and the longer they last, the more drastic and painful will be the ultimate "adjustment." There are some important counterarguments to this interpretation of the facts. First, the U.S. current account has been in deficit for twenty years and the size of the deficit has averaged more than 4% of GDP for at least ten years. After 20 years of deficits, you might think positions would change. Instead, the same people are now arguing that these capital flows were one of the root causes of the financial crisis of 2007-2009.

In a widely cited speech in 2005, Ben Bernanke argued that a “savings glut” in Asia, most notably in China, and several European countries with current account surpluses such as Germany, had created severe and persistent global imbalances. The short-hand version of how global imbalances caused the crisis goes something like this: Capital exporting countries flooded the US with savings looking for safe returns. Many of them purchased not equity or textile mills, but US government and agency debt and money market fund shares. These flows (and loose monetary policy) kept interest rates low, making it easy for US individuals and financial institutions to leverage themselves.[3]

Richard Portes (2009), for example wrote “I maintain that global macroeconomic imbalances are the underlying cause of the crisis…. The underlying problem in international finance over the past decade has been global imbalances, not greed, poor incentive structures, or weak financial regulation, however egregious and important these may be.“

It is certainly true that much capital has flowed to the United States. The reasons are many: the U.S. dollar’s status as the reserve currency, the depth, liquidity and relative safety of U.S. financial markets; good institutions.But, it is very difficult to make a causal connection between capital flows and the financial crisis. For one thing the geography of the crisis did not fit this claim. The crisis was severe for some capital importing and some capital exporting countries The financial crisis has everything to do with the decisions financial institutions made about what to invest inand little to do with capital flows.[4]

In this paper we are concerned with what drives international capital flows. We begin by arguing that the very nature of net foreign asset positions gives us valuable clues about what to look for. In the next section of the paper we document some of the striking features of foreign asset positions. These show that net foreign asset positions have very significant low frequency components which means that they are dominated by factors that have slow moving trends. What are they? In this paper we argue that most compelling candidates in order are demographic (occasionally mentioned but largely ignored) trends, movements in productivity, and factors (like tax policy) that influence the capital output ratio.

The natural vehicle to study capital flows is multi-country overlapping generations model where individuals make savings decisions based on their conditional life expectancy and capital flows between countries. In such a world individuals will decide their life cycle savings and consumption based not only on domestic birth rates and mortality but also on the demography of other countries as well. Changes in fertility and mortality are key to understanding and modeling capital flows. As fertility declines populations get older, as mortality declines ( life expectancy increases) the ratio of years of work to years of retirement declines. Global capital flows act to equilibrate the demand and supply of global savings.

We study a calibrated general equilibrium model with a rich set of demographics. We ask to what extent can net foreign asset positions be explained over time (and hence capital flows) by demography, productivity differences and differences in the policy wedges that determine capital output ratios. Differential demographic trends drive savings and investment differences as workers adapt to increased life expectancy and decreased fertility. In such a world capital flows to countries with more favorable demographics and demographics explain well the differences in net foreign asset positions observed in the data. Differences in productivity explain some but not a lot of the movements in net foreign asset positions over time. Differences in wedges due to taxes and other frictions are important in accounting for differences in capital levels but not capital flows.

In the next section of the paper we describe the features of capital flows and net foreign assets that are the subject of controversy. The following section describes the salient characteristics of fertility and mortality that we believe are important drivers of capital flows. We then describe and multi-genration, multi-country overlapping generations model which describes savings decisions in our model economy. We explain the modeling of demographics and the definition of equilibrium. Section 5 describes the results of three major exercise the determine the role of demographics, productivity differences and tax wedges on net foreign assets. We compare the implications of our model with the actual data and find strong support for the view that demographics are an important driving force in global capital flows.

II. The Current Account and Net Foreign Assets

Global capital flows are most often depicted by plotting the current account – aggregate investment minus aggregate savings – as a fraction of GDP. Figure 1 below is a plot of the current account balance for a number of countries.

What is striking about this picture is the persistence of current account positions. Countries that tend to have current account deficits, the U.S., the U.K. and Australia, have them for a long time and likewise for countries that have current account surpluses – e.g. Germany, Japan and China. The net foreign asset positions of these countries are shown in Figure 2 below:

In principal these should represent the same phenomena and the Current Account should simply represent the change in Net Foreign Assets. In practice they don’t line up and the difference is the subject of exploration. Ricardo Hausmann and Federico Sturzenegger (xxxx) have argued that this difference is “dark matter” that is explained by unmeasured flows of intellectual property. McGrattan and Prescott (2009) have argued that it is technology capital and plant specific intangible capital that explains the differences and accounts for much of the measured differences in asset returns. For our purposes these are secondary issues and we will focus primarily on Net Foreign Assets and will treat changes in Net Foreign Asset positions as the capital flows of interest.

Although much attention has been directed at the flows of capital as represented by the current account statistics, not enough has been directed at the question of why these data display the characteristics that they do. The features of the data belie the frequently voiced worry about sudden reversal of capital flows. Figure 3 below is the spectra of current account flows for a group of six countries including both capital exporters and capital importers over the time period 19 60-2008.

The spectra are completely dominated by the low frequencies reinforcing the conclusion that capital flows are driven by long term factors.

III. Demographics

The current account for a country is simply the difference between domestic savings and domestic investment. It is natural to look at life cycle considerations as primary drivers of domestic savings. For a country the key drivers are fertility and mortality. The former determines how many workers there are over time and the latter determines how many years of postemployment they have to save for. As fertility declines as it has in many of the most important economies, there are fewer workers saving over time. As mortality declines the number of years of retirement for each worker is likely to increase relative to the number of years of work.

Figure 4 below shows the fertility rates for Europe, the United States,

Japan, China, and India.[5]

There is a remarkable convergence of fertility rates over time but only the United States and India have fertility above replacement rate. Figure 5 shows how fertility breaks down across the various parts of Europe.

While fertility has been decreasing, life expectancy has been increasing. Indeed their has been a remarkable convergence of poor countries and wealthy countries in terms of life expectancy at birth. Figure 6 shows the life expectancy for Europe, the United States, Japan, China, and India while Figure 7 shows the differences across Europe. There has been very strong convergence across most of Europe but Eastern Europe has lagged far behind.

The convergence across the world is easily seen by plotting the distribution of life expectancy over time for the complete set of countries in the U.N. data set. In the earliest year, 1965, the distribution was bi-modal with a large mass of countries having very low life expectancies. Over time the distribution has not only shifted to the right but more of the mass of the distribution has shifted to the right meaning there are fewer countries that have really low life expectancy. This is at least one indication of development success.

The combination of increasing life expectancy and decreasing fertility means that the median age of the populations increasing, in some cases dramatically. Figure 9 shows the median age for Europe, the United States, Japan, China, and India, Figure 10 shows the breakdown for Europe.

These demographic trends will influence the world demand and supply for capital. Technology and institutions are obviously important drivers of capital flows but to the extent that capital is free to flow between countries lifecycle considerations in these countries will influence capital flows. To quantify the effects demographic dynamics have on savings, investment, the rates of return on the factors of production, and, finally, capital flows, we calibratea two-country general equilibrium model with very detailed demographic dynamics. In the next section of the paper we describe the basic overlapping generations structure and the demographic transitions.

IV.

[1]Lucas, Robert E., Jr. 1990. “Why Doesn’t Capital Flow from Rich to Poor Countries?” AmericanEconomic Review, 80(2): 92–96.

[2]Ohanian, Lee and Mark Wright 2010, “Capital Flows and Macroeconmic Performance: Lessons from the Golden Era of International Finance, American Economic Review: Papers & Proceedings 100 (May 2010): 68–72

[3]Some observers (for example, Caballero and Krishnamurthy, 2009) have argued that the appetite of surplus countries for risk-free assets left the US economy fragile by concentrating the real risks in its financial sector.

[4] Acharya, Cooley, Richardson and Walter, “Manufacturing Tail Risk”, 2010.

[5] All data are taken from the United Nations Population Survey (xxxx) and the World Bank. Projections are ……