Bad Investments and Missed Opportunities? Postwar Capital Flows to Asia and Latin America

Lee Ohanian, Paulina Restrepo-Echavarría and Mark L. J. Wright, American Economic Review 2018. Read in the authors’ final (May 2018) draft. No seminar recording exists; the included stand-in video is Restrepo-Echavarría’s April 2019 St. Louis Fed “Dialogue with the Fed” public talk, “Go with the Flows” (whisper-transcribed, with a separate Q&A transcript) — a general-audience lecture on the balance of payments and capital-flow sustainability that motivates the paper’s themes rather than presenting its results. There is no discussant.

The allocation puzzle from the previous entry — capital flowing toward slow growers — is here given its longest-running and most consequential instance, and then an autopsy. After World War II, East Asia (Japan, Korea, Taiwan, Hong Kong, Singapore) grew like nothing in recorded history while Latin America stagnated; and the capital went to Latin America, whose net exports ran persistently negative while Asia’s hovered near zero. Every explanation on offer before this paper reached for capital-market imperfections, domestic or international — the whole apparatus of blocks three and four of this reading list. Ohanian, Restrepo-Echavarría and Wright’s finding is that the main culprit was hiding in a different market altogether: the one for labor.

Wedge accounting goes abroad

The method is the paper’s first contribution: capital flow accounting, the open-economy, low-frequency descendant of Cole–Ohanian and Chari–Kehoe–McGrattan business cycle accounting. Build a three-region world model — Latin America, East Asia, Rest of the World — with common preferences and technology, complete markets in state-contingent bonds, and three time-varying “taxes” per region: a labor wedge τʰ (driving a gap between the wage and the marginal rate of substitution), a domestic capital wedge τᵏ, and an international wedge τᴮ taxing returns on foreign asset positions. Estimated on a newly assembled 1950–2007 dataset of output, consumption, investment, hours and capital flows, the wedges make the model replicate the world data exactly; the counterfactuals then re-run history with each wedge frozen, allocating observed flows to their proximate causes. It is Gourinchas–Jeanne’s exercise (the authors are explicit about the kinship) but dynamic, general-equilibrium, three decades longer — and, decisively, with an endogenous labor margin, the one thing G–J’s framework couldn’t price.

The labor wedge ate the story

The measured wedges hand down a clean verdict. The labor wedge moves more than everything else — by as much as 50 percent within regions — and its geography is the postwar economic history of the world in one panel: Asia’s labor wedge starts high in 1950 (hours per capita low), collapses through the 1960s toward zero by 1990; Latin America’s starts high and rises into the 1970s; and hours worked mirror the wedges throughout.

 and per-capita hours (right) for Asia, Latin America and the rest of the world. Asia’’s wedge falls from ~0.35 to ~0 by 1990 while its hours climb; Latin America’’s wedge stays high into the 1980s.’)

The mechanism connecting this to capital flows is elementary once said aloud: labor-market distortions — taxes, regulation, union power — depress equilibrium labor supply, which depresses the marginal product of capital, which kills the incentive to invest and to import capital. Asia in 1950 was fast-growing but heavily labor-distorted, so its capital returns were unremarkable and the world (correctly, privately) declined to send it money; as the distortions unwound, Asia financed its own boom. In the counterfactuals, the regions’ own labor wedges account for roughly 30 percent of the variation in capital flows to Asia and Latin America in the 1950s–60s, and general-equilibrium effects of other regions’ labor wedges contribute another 30–40 — some 60–70 percent of observed flows all told, with the unwinding of Asia’s labor distortions simultaneously explaining much of its growth miracle. The same object CKM’s business-cycle accounting had flagged as the dominant closed-economy distortion turns out to run the open-economy show too — at the frequency of decades.

The capital-market findings are the deliberately provocative remainder. Domestic capital wedges: quantitatively minor throughout. International wedges: important not in the 1950s–60s heyday of capital controls, but in recent decades — operating mainly through the slow legacy of accumulated net foreign asset positions — and, most counterintuitively, from the 1960s on they reduced Asian capital outflows: without them, Asia’s surpluses would have been even larger. The exception where the international wedge dominates on its own is exactly where the narrative history says it should: Latin America’s 1980s debt crisis, the same episode Restrepo-Echavarría’s limited-commitment paper in the previous block modeled from the inside.

What the talk adds, and the ledger

The Dialogue with the Fed lecture is the paper’s worldview served to a lay audience, and two of its moments are worth keeping. One is a memorably honest data point about the whole enterprise of measuring flows: summing every country’s current account — which should give zero by construction — instead yields a world deficit of about 5 percent of world GDP; “the world is running a deficit with itself,” a measurement gap larger than most of the effects economists argue about. The other is her structural-transformation framing of why a mature service economy like the U.S. naturally imports goods and exports services — the benign reading of persistent imbalances that the paper’s normative punchline sharpens: since flows are governed by distortions, there is “no presumption that rapidly growing countries should receive disproportionately high capital flows,” and the welfare payoff to domestic institutional reform — especially labor-market reform — is far larger than capital-account liberalization debates assume.

As the closer of block four, the paper completes a clean progression: Lucas posed the level question and auditioned suspects; Gourinchas–Jeanne showed the allocation is backwards and indicted the saving side; ORW put the whole system on the table and returned a name — the labor wedge — while demoting the capital-market frictions that two blocks of this syllabus had painstakingly built. That the demotion comes partly from an author of BKK’s successor papers and an author of the sovereign-debt empirics gives it the flavor of an internal audit. And it tees up the final block precisely: if labor-market distortions and their reform drive the medium-run, what drives emerging-market fluctuations — interest rates, trend shocks, or the informal margin of the labor market itself? Those are papers 20, 21 and 22.