This is the summary of a paper issued as Working Paper no. 12-2021, Department of Economics, Athens University of Economics and Business. An earlier version of this paper was presented in seminars at the Athens University of Economics and Business (2014), Boston College (2017) and the ASSET Conference in September 2019.
The paper is forthcoming in the June 2021 issue of the Journal of Economic Asymmetries, https://doi.org/10.1016/j.jeca.2021.e00201
This paper analyzes international borrowing and lending in an optimal growth model with adjustment costs for investment, under both pre-commitment and non pre-commitment to debt repayment.
We study the dynamics of 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, under pre-commitment, and to the extent that countries start from different initial conditions, financial openness is beneficial for both poor and rich countries, as it allows them to engage in mutually beneficial inter-temporal trade.
During the initial period of the adjustment process, relatively poor countries experience higher consumption and investment compared to autarky, and thus experience current account deficits and accumulate net foreign debt. However, the inter-temporal tradeoff is asymmetric between poor and ‘rich’ countries, in that poor countries end up with lower steady state consumption relative to autarky, due to the need to service their accumulated foreign debts. The opposite happens in relatively rich countries, which end up with higher steady state consumption relative to autarky, as they become international lenders during the transition. The dynamic paths of consumption for relatively poor and rich countries under financial autarky and financial openness are depicted in the following graph.
Under non pre- commitment, this asymmetric inter-temporal tradeoff results in a time inconsistency problem. “Poor” countries reach a point in the adjustment process after which it is welfare improving for them to ‘default’ on their foreign debt and use the debt servicing payments to increase domestic consumption and investment. In the absence of effective pre-commitment mechanisms, international lenders anticipate these incentives, and international lending and borrowing completely breaks down. Thus, in the absence of effective pre-commitment mechanisms, the only time-consistent solution is financial autarky. 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 can function as partial solutions to the time-inconsistency problem caused by this asymmetry between poor and ‘rich’ countries.