How far can globalization raise the incomes of poorer countries? How far can foreign aid help? A new NBER paper (pdf) by James Feyrer and Francesco Caselli sheds interesting light on these questions.
Their first contribution is to estimate the marginal product of capital (MPK) in 53 developed and developing countries. They estimate that low income countries - those poorer than Portugal - have an average MPK of 27 per cent, whilst richer countries have an average MPK of 11 per cent.
This is just what you'd expect. Capital is scarce in poorer countries, so its return should be higher.
However, what you'd also expect to happen is that these higher MPKs would attract capital flows from the rich countries to the poor ones, thus enriching the poor countries.
This, of course, doesn't happen. The US's massive current account deficit means it is sucking in capital from poorer countries. And FDI flows much more between rich countries than it does from rich countries to Africa; the data's here (reg. reqd).
This capital immobility is enormously expensive. If capital did flow to equalize MPKs, estimate Caselli and Feyrer, developing countries would see a 25 per cent rise in their incomes.
So why is capital immobile? One view blames capital market imperfections; the (undiversifiable?) risk of investing in poorer countries is too high. This is the origin of Michael Dooley's view that the US current account deficit is sustainable because it's a source of collateral for poorer countries.
However, Caselli and Feyrer have two other explanations.
First,they say, poorer countries lack essential complentarities with physical capital, such as skilled labour (one could add transport links as well).
Second, they say, the price of physical capital is higher in poorer nations, because it attracts taxation, exortioners and rent-seekers.
These explanations, they believe, more than suffice to explain capital immobility. Indeed, they say, credit market frictions, far from impeding capital flows into poorer countries might actually impede outflows - by, for example, limiting the use of offshore accounts.
There's something in this for everyone. The anti-globalizers can take away the message that the orthodox neoclassical case for globalization is too optimistic, at least in one respect.
The anti-foreign aid brigade can take the message that financial aid to poorer countries will not raise incomes much because financial returns on investment aren't as great as MPKs would suggest.
Me? I take the message that our overwhelming moral responsiblity to help the poor should means we should encourage institutional change to reduce the cost of investing.
If it's worth doing in Iraq, it's worth doing elsewhere...