Where does international capital flow?

Why are some states rich and others poor? This is a question that has concerned many scholars. The socio-economic theory provides plenty of explanations about that growth gap. Some of them are contradictory.

According to Feenstra and Taylor (2008), some decades ago there was a common opinion among economists about the development process of the third world. It was widely believed that all countries, rich or not, could have access to the same technology and if the political choices were extroverted, the capital will flow from rich to poor countries. This was based on the neoclassical economic theory according to which the returns on capital are higher where the capital is relatively scarce. So, poor states with rare capital and high interest rates are expected to draw capital flows from rich ones. However, in the real world, what we see is that nations with scarcity of capital are not able to attract capital which mainly flows from them to the affluent ones. The professor and Nobelist of economics Robert Emerson Lucas, first described this phenomenon, now known as the Lucas paradox, in his book “Why Doesn’t Capital Flow from Rich to Poor Countries” (1990).

Possible explanations for this paradox can be summarized into two categories. The first focuses on international market imperfections such as sovereign risk and asymmetric information, between those ‘in’ and ‘out’ of the country. However, according to Robert Lucas (1990), these imperfections were not able to explain the scarcity of capital flows to the developing countries before 1945, where a lot of countries were under the supervision of the developed world as colonies. Why would someone invest money in England, rather than India as a British colony? If they preferred the colony, they would be able to achieve better returns due to the scarce capital, according to the neoclassical economic theory. However, this is far from reality. Colonies, such as India and African Nations suffered from underinvestment long before the 20th century, exempted from the choice of multinational companies searching to find new markets for their products.

According to Acemoglou, Johnson and Robinson (2001, 2002), the gap between developed and developing countries is affected by more than that. The second category of explanation has to do with the fundamentals that affect the production structure of the economy, such as technologies, infrastructures, government policies and institutional structures. The quality of these dramatically oscillates the uncertainty of the state. In the case of India, institutions, quality of infrastructure, human development level and governmentality were weaker than England.  For instance, legislation on property rights, corruption and political instability which directly affect the flow of direct foreign investment, especially greenfield ones, seemed to be significantly weaker in colonies, rather than in colonialists.

The Lucas paradox is a symptom of the development failure in developing countries. The flow of the capital seems to follow an opposite direction which can interpret, ceteris paribus, and impoverish states.

By Dorothy Vaitsi