This paper analyzes international borrowing and lending in an optimal growth model with adjustment costs for investment. We study the relation between optimal savings and investment, and the current account, in the transition towards the balanced growth path, and derive the implications of financial openness for both the transition path and the balanced growth path. A comparison with financial autarky reveals that, to the extent that countries start from different initial conditions, and there is pre-commitment to debt repayment, financial openness is beneficial for both “poor” and “rich” countries, as it allows them to engage in mutually beneficial inter-temporal trade. During the adjustment process, relatively “poor” countries experience higher consumption and investment compared to autarky, and thus cumulate current account deficits. There is an inter-temporal tradeoff, in that they experience lower steady state consumption, due to the need to service their accumulated foreign debt. The opposite happens in relatively “rich” countries. The inter-temporal tradeoffs implied by financial openness result in a time inconsistency problem. “Poor” countries reach a point in the adjustment process at which it is welfare improving to renege on their commitment to repay their foreign debt. In the absence of sufficient pre-commitment mechanisms, international lenders anticipate these incentives, and international borrowing and lending are driven to zero. This time inconsistency problem can thus explain both the Feldstein-Horioka puzzle and the Lucas paradox that capital does not flow from “rich” to “poor” countries. Credible sanctions in the case of default and ceilings on international borrowing are analyzed as partial solutions to the time inconsistency problem of international borrowing.

Keywords: time inconsistency, international borrowing, optimal growth, financial openness, debt default
JEL Classification: F43 F34 O11 D91 D92

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