Full text of Economic Review (Federal Reserve Bank of San Francisco) : 1994, Number 3

View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Economic

Review

e·...... Ba.....
Q.a.&k

~e~~
..,.1 ..n.,.:;
'I:I~S·. .I. y.:;
~
r.
u..:;.1. CLl

of San Francisco
1994

Number 3

Adrian W. Throop

International Fmancial Market Integration
and Linkages of National Interest Rates

Kenneth Kasa

Finite Horizons and the Twin Deficits

Michael P. Dooley and
Kenneth M. Kletzer

Capital Flight, External Debt,
and Domestic Policies

Table of Contents

International Financial Market Integration and Linkages
of National Interest Rates . . . . . . . . . . . . . . . . . . . . . . .
Adrian W. Throop

Finite Horizons and the Twin Deficits ....................................................................... 19
Kenneth Kasa

Capital Flight, External Debt, and Domestic Policies
Michael P. Dooley and Kenneth M. Kletzer

Opinions expressed in the Economic Review do not neces
sarily reflect the views of the management of the Federal
Reserve Bank of San Francisco, or of the Board of Governors
of the Federal Reserve System.
The Federal Reserve Bank of San Francisco’s Economic Review is
published three times a year by the Bank’s Research Department under
the supervision of Jack H. Beebe, Senior Vice President and Director of
Research. The publication is edited by Judith Goff. Design, production,
and distribution are handled by the Public Information Department,
with the assistance of Karen Flamme and William Rosenthal.
For free copies of this and other Federal Reserve publicatons, write or
phone the Public Information Department, Federal Reserve Bank of San
Francisco, P.O. Box 7702, San Francisco, California 94120. Phone
(415) 974-2163.
Printed on recycled paper
with soybean inks.

International Financial Market Integration
and Linkages of National Interest Rates

Adrian W. Throop
Research Officer, Federal Reserve Bank of San Francisco.
The author wishes to acknowledge the able research assistance of Ranjana Gandhi and the helpful comments of the
editorial committee consisting of Timothy Cogley, Ramon
Moreno, and Brian Motley.

The international integration of financial markets has increased dramatically in the last two decades. In the 1970s
government-imposed barriers to the international flow of
capital in the major industrialized countries were gradually
relaxed, and by the 1980s they had been substantially
eliminated.! Moreover, the development and growth of
new financial instruments, such as currency and interest
rate swaps, have further stimulated international financial
integration by giving investors a wider range of choices
than traditionally available in purely domestic financial
markets.
It might be presumed that the international integration
of financial markets would reduce divergences between
interest rates at home and abroad and increase the degree to
which yields in different national markets move together

over time. If so, the ability of central banks to influence

This article finds that even in the 1980s, when barriers to
international capital mobility had been largely eliminated, there was no measurable tendency for real interest
rates between the U.S. and the major industrial countries
to converge. Moreover, the estimated short-run responses
ofboth short-term and long-term real interest rates to one
another have been exceedingly weak. As a consequence, it
appears that U.S. and foreign central banks have been
able to influence their domestic interest rates quite independently from the influence of interest rates abroad,
despite a high degree of international capital mobility.

national interest rates might be importantly constrained by
international flows of capital. This presumption would
appear to be supported historically by the domestic integration of local financial markets. For example, the development of national money and capital markets in the
United States during the latter part of the 19th century
reduced regional disparities among interest rates and made
these rates increasingly responsive to national as opposed
to local conditions. Moreover, after the establishment of
the Federal Reserve System in 1914, it became apparent
that, because of the ease of capital flows between different
regions, monetary policy needed to be made on a national,
rather than a regional, basis.
International financial integration need not always work
to equalize interest rates between different countries, however. If exchange rates between currencies are fixed, then
international financial integration has much the same effect on interest rates as regional financial integration. But
if exchange rates are flexible, exchange rate expectations
and exchange rate risk may prevent a convergence of real
interest rates. As barriers to financial flows across national
borders were reduced in the 1970s, the system of exchange
rates applying to the major currencies changed from one of
fixed to flexible rates. In fact, the flexibility of rates
probably contributed to reductions in barriers to financial
flows by reducing the need for capital controls to manage
payments imbalances. As a result, at the same time that one
1. See, for example, Akhtar and WeiHer (1987).

FRBSF ECONOMIC REVIEW 1994,

NUMBER

source of interest rate divergence was reduced, another
one increased. Earlier empirical studies have provided
mixed evidence on whether real interest rates have tended
to converge in recent years. 2
This article uses cointegration tests and error-correction
modeling to examine the issue. It first reviews the theoretical literature on the short- and long-run connections
between the international mobility of capital and the
equalization of national interest rates. It then explains how
exchange rate expectations and exchange rate risk in a
system of flexible exchange rates can create divergences
between real interest rates even in the absence of institutional or governmental barriers to capital flows across
national borders. Finally, it examines empirically the linkages between U.S. and foreign real interest rates.
It finds that even in the 1980s, when barriers to international capital mobility had been largely eliminated, there
was no measurable tendency for real interest rates between
the U. S. and the major industrial countries to converge.
Moreover, the estimated short-run responses of both shortterm and long-term real interest rates to one another have

investing in a foreign asset due to the risk of changes in the
exchange rate over the period of the investment; DOM is
the portion of the differential that is due to differences
in the characteristics of the assets besides maturity, such as
liquidity, credit risk, or tax treatment, which ca.'1 occur in
purely domestic markets; finally, BAR represents the part
of the differential that is due to government policies and
institutional imperfections that effectively impede financial flows across national jurisdictions. 3
Nominal interest rates are equalized if all the right-handside terms of the identity are equal to zero. If CRISK,
DOM, and BAR are all equal to zero, then U.S. and foreign
assets can be said to be perfect substitutes. In this case,
investors are indifferent between domestic and foreign
assets, and their expected yields in a common currency are
equalized. In addition,· if portfolio adjustments are instantaneous, so that the yields in a common currency are
equalized continuously, then there is said to be perfect
capital mobility. Finally, if %se is zero, then expectations
are static in the sense that the exchange rate expected in the
future is the same as the current exchange rate. Only if all

been exceedingly \Xleak. A.s a consequence, it appears that

these conditions are met, giving perfect capital mobility

U.S. and foreign central banks have been able to influence
their domestic interest rates quite independently from the
influence of interest rates abroad, despite a high degree of
international capital mobility.

and static exchange rate expectations, will nominal interest
rates be equalized continuously at home and abroad under
flexible exchange rates.
The well-known Mundell-Fleming model of an open
economy assumes that the conditions of perfect capital
mobility and static exchange rate expectations hold in the
short run under flexible exchange rates. 4 The implications
of these conditions would be that monetary policy influences aggregate demand entirely through its effect on the
exchange rate, rather than interest rates, and that fiscal
policy "crowds out" other expenditures entirely through
the exchange rate instead of interest rates. These implications are clearly at variance with even the most casual
observation. In the U.S. and other industrialized countries,
actions by monetary authorities clearly can alter interest
rates in the short run, ahd fiscal policy appears to have
influenced interest rates as well. Therefore, to better understand the behavior of interest rates in the short run, the
Mundell-Fleming framework needs to be amended.
The Mundell-Fleming model essentially extends the
widely used IS-LM model of income determination to an
open economy. Both models assume the price level is fixed
in the short run. The Mundell-Fleming model is described
by the following set of equations:

I. INTEREST RATE DIFFERENTIALS
IN THE SHORT AND LoNG RUN

This section reviews the analytics of international interest
rate linkages in the short and the long run under flexible
exchange rates. The sources of differences between nominal interest rates at home and abroad can be summarized by
the following identity:
(1)

i - i* = lin %se + CRISK + DOM

+ BAR

i and i * are, respectively, nominal interest rates in home
and foreign currency denominated assets of a given maturity (n); The variable % se is the expected percentage
depreciation in the value of the home currency over the
maturity of the investment; CRISK constitutes the part of
the differential due to the uncertainty in returns from

2. Pigott (1993-1994) presents evidence to show that the dispersion in
national real interest rates has fluctuated considerably over time but
without any systematic tendency to decline. Despite this evidence, some
observers have argued that integration has increased the synchronization
of interest rate movements over the last decade; see, for example,
Frankel (1989) and Bank. for International Settlements (1988). However,
Kasman and Pigott (1988) find no consistent increase in this tendency
using different but equally plausible measures of synchronization.

3. For further discussion of the various factors underlying this identity,
see Kasman and Pigott (1988).
4. The Mundell-Fleming model was developed in the early 1960s.
Mundell's contributions are collected in Mundell (1968). For Fleming's
contribution, see Fleming (1962).

THROOP / INTERNATIONAL FINANCIAL MARKET INTEGRATION

(2)

+ NX(s)

Y = A(i)

MIP = L(i,Y)

(3)

(4)

The first equation describes equilibrium in the goods
market. It states that real aggregate output (Y) is equal to
real domestic expenditures (A), which vary inversely with
the nominal interest rate i, plus net exports, which vary
inversely with the value of the home currency. The second
equation gives equilibrium in the money market. The
supply of real money balances, M I P, equals the demand for
them, L (i, Y). The last equation describes the conditions of
perfect capital mobility and static expectations for a small
country, which produce an equality between the home (i)
and an exogenously determined foreign (i *) interest rate.
Figure 1 illustrates the behavior of interest rates in the
short run in the Mundell-Fleming model with static expectations and perfect capital mobility, In Figure la, a shift to
the right in the LM schedule because of, say, an action
by the . monetary authority to expand the money supply
initially tends to depress the interest rate at home. But

because the expected return on investing at home then
would be less than that from investing abroad, the value of
the home currency is depressed by capital outflows. Then
as soon as the trade balance adjusts to the lower value of
the home currency, the IS schedule shifts to the right until the home interest rate is pulled back up to the level of
the foreign rate. In this process, there is no net change
in the home interest rate. As a result, monetary policy
influences aggregate demand entirely through its effect on
the exchange rate.
Alternatively, a shift in the IS schedule to the right as in
Figure lb because of, say, an expansionary fiscal policy
initially pushes the home interest rate above the foreign
interest rate. But the resulting capital inflow then moves up
the value of the home currency and reduces net exports until the home interest rate falls back down to the level of the
foreign rate. In the process, the fiscal expansion "crowds
out" other expenditures entirely through its effect on the
exchange rate.
The Mundell-Fleming model assumes a small country.
But relaxing this assumption does not change its conclusions with respect to the differential between interest rates.

FIGURE 1
MUNDELL-FLEMING MODEL
(b)

(a)

LM'

\
I

I
I
I
I
I

t-------~--~/-------I \

)'*

t--------:~--"--------\

\
\

\\ IS' (s')

IS
y

IS' (s')

IS and IS' (s')
y

FRBSF ECONOMIC REVIEW 1994,

NUMBER

This would still tend to zero except for the period during
which the trade balance adjusts. However, in practice, the
period required for the trade balance to adjust lasts for up to
around two years, so that in calendar time the period over
which one can say lhat perfect capital mobility may exist is
not trivial. 5 Because of this, the Mundell-Fleming model
has limited applicability for periods shorter than two years.
A further important limitation of the Mundell-Fleming
model for the short run is its assumption of static expectations. Still retaining the assumption of perfect capital
mobility for the relevant time frame, when expectations are
not static the identity of equation (1) becomes:

(5)

i - i* = 11 n %se

(6)

In s = E(ln s)

n(i - i*)

where E(ln s) is the expected value of the natural log of the
exchange rate. Furthermore, if E(ln s) and i* are fixed, then
the value of the home currency, s, becomes simply a
function of the home interest rate. This situation is shown
in Figure 2, where both i and s are now plotted on the

vertical axes. The IS schedule is flatter than before because
movement along it now includes the effects on aggregate
demand of movements in both the exchange rate and the
interest rate, rather than just the interest rate alone.
Consider now the effects of monetary and fiscal policy
manifested in shifts in the LM and IS schedules. An
expansionary monetary policy that shifts the LM schedule
to the right (as in Figure 2a) now drives down the home
interest rate even after there has been time enough for the
trade balance to adjust to the lower value of the home
currency. The differential that is opened up between the
home and foreign interest rate is proportional to the expected appreciation of the home currency and would not
change as long as the current price level, the expected
exchange rate, and the expanded money supply persist. If
the economy initially had been at full employment, in the
long run the adjustment of the price level and expectations
would eventually drive the system back to its original
equilibrium with the same IS and LM schedules as before.
Even with forward looking rational expectations, however,
a differential between real interest rates would persist
during the gradual adjustment of the price level until the
full employment equilibrium is restored. 6 As a result,
monetary disturbances can create persistent and timevarying differentials in real interest rates even with perfect
capital mobility while this longer-run adjustment takes
place.
5. For evidence on the speed of adjustment of the trade balance, see, for
example, Throop (1989).
6. See Dornbusch (1976).

A fiscal expansion similarly causes persistent effects on
interest rate differentials when expectations are not static.
Lower taxes and/or higher government expenditures shift
the IS schedule to the right (as in Figure 2b). Now, rather
than just the exchange rate changing, as in the pure
Mundell-Fleming model, both the interest rate and the exchange rate are driven up. With the expected value of the
exchange rate fixed, a gap is opened up between the home
and foreign interest rate that is proportional to the expected
depreciation in the value of the home currency. This gap
and both the higher interest rate and increase in real output
will last as long as fiscal policy remains expansive and the
expected exchange rate is unchanged.
As long as the fiscal policy remains expansive, however,
the actual exchange rate will be above that which was
expected. Then, expectations of the exchange rate may be
revised up. If so, the current exchange rate would rise with
any given interest rate differential, breaking the original
linkage between the interest rate and the exchange rate.
The rise in the expected value of the home currency would
then shift the IS schedule back toward its original position.
It is only at this point that the differential between home
and foreign interest rates would be eliminated. This analysis generalizes to any shift in the IS schedule, not just those
caused by fiscal policy. Thus, interest differentials could
exist more or less continuously and vary considerably
under flexible exchange rates due to a variable IS function,
as well as a variable LM function, even with relatively
perfect capital mobility.
Further relaxing the assumptions of the Mundell-Fleming model, consider now the case of imperfect substitutability between home and foreign assets due to currency risk
(CRISK), differences in the characteristics of home and
foreign assets (DOM), or governmental and institutional
barriers to international capital flows (BAR). These put
interest rates in the home country at a premium or discount
compared with foreign rates. For simplicity, suppose initially there is no differential between interest rates at home
and abroad. A rightward shift in the IS schedule to IS'(s),
caused by a fiscal deficit or an investment boom, would put
upward pressure on the home interest rate relative to that
abroad (Figure 3). With imperfect substitutability of assets, however, the resulting inflow of capital from abroad
would tend to raise the required return on U.S. assets
relative to foreign assets. The premium would be required
in order for investors to absorb a larger proportion of home
assets into their portfolios, since the stock of home relative
to foreign assets is increased by both the larger capital
inflow and the appreciation of the home currency. Instead
of being shifted back to IS'(s), the IS schedule would shift
back only to IS'(s') due to the appreciation of the home
currency. At this point the home interest rate would be

THROOP I INTERNATIONAL FINANCIAL MARKET INTEGRATION

FIGURE 2
NONSTATIC EXPECTATIONS
(b)

(a)

LM'

/
I

I
I
I

t--------~,....,,:---__,------

I
I

I
I
I

FIGURE 3

brought down to the level of the foreign interest rate plus a
premium. Here again, the differential between interest
rates would vary over time.
Even with a high degree of international financial market integration so that DOM and BAR are close to zero,
imperfect substitutability can still be created by currency
risk (CRISK). As a result, even with highly integrated
markets under flexible exchange rates, home and foreign
interest rates may be kept apart not only by expected
changes in currency values but also by currency risk.
Finally, and particularly for purposes of empirical implementation, it is necessary to relax the assumption of
constant prices in the Mundell-Fleming model. The identity of equation (1) still holds. But it is convenient to
rewrite it in real terms as 7

IMPERFECT SUBSTITUTES

(7) r - r* = lin %qe + CRISK + DOM + BAR,

\
\
\
\
\

7. The identity of equation (1) can be written as:

\
\
\

IS IS' (s') IS' (s)
y

i, - i; = lin [In s, - E,(ln s,+n)]

+ CRISK, + DOM, + BAR,.

By definition In s, = in q, + In p; - In p" where q is the real exchange
rate and p*and p are foreign and domestic price levels, respectively.
Also by definition,
E, (In s'+n) = E, (In q,+n)

+ In p; + n7r; -

p, -

n7r"

FRBSF ECONOMIC REVIEW 1994, NUMBER 3

where rand r* are real interest rates (nominal interest rates
less expected inflation) at home and abroad, %qe is the expected percent change in the real exchange rate over the maturity ofthe investment, and the other terms are the same as
before. 8 In the case of perfect substitutability and static
expectations (with respect to the real exchange rate),
capital would flow from one country to another until real
interest rates at home and abroad were equalized. In the
case or imperfect substitutability, the real interest at home
would tend to be equated with the foreign one plus a
premium or minus a discount, which itself could vary over
time. But with nonstatic expectations, the real exchange
rate becomes a function of the real interest rate at home
relative to that abroad. Movements ofthe IS and LM schedules create a variable differential in real interest rates (plus
a premium or minus a discount) that is proportional to the
expected change in the real value of the exchange rate as it
moves towards its equilibrium in the long run.

n. REAL INTEREST RATE RELATIONSHIPS
A trend toward the liberalization of capital controls has
been clearly evident since the early 1970s, and in recent
years it has become even more pronounced. 9 In fact, by the
1980s both official and institutional barriers to international capital flows had been largely eliminated in the
major industrialized countries, at least for large borrowers
and lenders. At the short end of the market, this is indicated by a close equality between U.S. and major foreign
interest rates when the latter are covered against exchange
rate risk in the forward market. 10
Forward markets are most developed at the 3-month
maturity and do not exist at maturities greater than two
years, even among well-traded currencies. But in the 1980s
the currency swap market became sufficiently developed to
hedge exchange rate risk for long-term investments as well.
A currency swap is an agreement to exchange a stream of
payments in one currency for a stream of payments in

where 'IT,* and 'lTt are the market's expectations at time t of the inflation
rate over n periods at home and abroad, respectively. Substituting these
two relationships into the identity gives:
(it -

'lT t)

- (i,* - 'IT,*) = lin [In qt - E (In qt+n)]

+ CRISK + DOM + BAR.
8. The real value of the home currency, s, is defined as: q=s(plp*),
where p and p* are the home and foreign price levels, respectively.
9. This trend is documented in International Monetary Fund's annual
report on Exchange Arrangements and Exchange Restrictions.
10. For the evidence on covered returns on short-term assets, see Pigott
(1993-1994), Caramazza et al. (1986), and Frankel (1988).

another. Like a forward contract, a currency swap allows a
domestic investor to hold a foreign currency denominated
asset without currency risk. Deviations from a covered
parity in interest rates appear to be somewhat larger among
long-term assets than among short-term assets, but for the
major currencies the differences are small. Moreover,
current deviations from covered parity of both short- and
long-term interest rates are small compared with periods
when capital controls have been considered important.
Thus, the increase in international financial capital mobility of the last decade has not been limited to the markets for
short-term assets. ll
With official and insitutional barriers to international
capital flows largely eliminated, this leaves only currency
risk and expected changes in currency values as sources of
differences between real interest rates on similar assets.
Figure 4 shows ex ante real U.S. and trade-weighted
foreign 3-month money market rates and the differential
between them, as well as the corresponding rates and
differentials with Canada, Japan, Germany, and the U.K.
for the period 1981 to the present. Figure 5 plots the real
rates and differentials for the same countries with respect
to long-term government bonds. Expected inflation is
measured by the percent change in the CPI over the
previous year for short rates and by a centered 3-year
moving average of CPI inflation for long rates. As other
researchers have shown, a contemporaneous equality of ex
ante real interest rates, whether short-term or long-term, is
easily rejected. 12 Even during the period of relatively high
capital mobility in the 1980s, substantial differentials in
both short and long real rates existed for significant periods
of time. This result is consistent with a Mundell-Fleming
model in which exchange rate expectations are not static,
so that movements in the IS and LM schedules create
variable real interest rate differentials that are proportional
to the expected change in the currency towards its equilibrium real value in the long run. Variable premia for
currency risk also could produce this result.
The more interesting and also more difficult question
to answer is whether shocks to the IS and LM schedules
are infrequent and transitory enough, and variations in
currency risk premiums small enough, that a tendency
towards a convergence of real interest rates can be observed over the longer run. Evidence suggesting that this
may not be the case is that real interest rate differentials
have been shown to be an important force moving real

11. Evidence on the covered returns on long-term assets is provided by
Popper (1990).
12. See, for example, Cumby and Obstfe1d (1984), Mishkin (1984),
Merrick and Saunders (1986), and Gaab, Granzio1, and Homer (1986).

THROOP / INTERNATIONAL FINANCIAL MARKET INTEGRATION

FIGURE 4

u.s. AND FOREIGN SHORT-TERM REAL INTEREST RATES AND THEIR DIFFERENTIALS
u.s. AND FOREIGN TRADE-WEIGHTED
Percent

Foreign
'.'

'/ \

2
/\

\
/

-2

"\
\

u.s, -Foreign

-4

\ """ I

-6

u.s. AND CANADA
Percent

15
\

I \

...

U.S. - Canada
\
\

o I-----...-r----'----.,:---,..~-----'-...;.,.-....,......:>...-.:=o/\ I'

-5

..,,

".: Canada

81
U.S.

.' \

AND GERMANY

Percent
8

...

Germany

4
2

...,

\.
,

..:'

I
I

-2

' -'

-4

U.S. - Germany

FRBSF ECONOMIC REVIEW 1994, NUMBER 3

FIGURE 5

u.s. AND FOREIGN loNG-TERM REAL INTEREST RATES AND THEIR DIFFERENTIALS
u.s. AND FOREIGN TRADE-WEIGHTED

US.

Percent

1~ [
6
4

VJapan

, •

' ..........

...

0
-

.... /

......

.. ,U.S. - Foreign

# .. ' "

.,.....

AND JAPAN

,
"I

...

r /

/ I

U.S. - Japan

-.I

-2

-2
-4

U.S.

-4
US.

AND CANADA

81
AND

Percent

...

I __

... ,

........

U.S.

Percent

8
Germany

6
\

I'
\,

, ...

U.S. - Germany

-4

"
I

...

/
1/

-2

.........

AND GERMANY

-2

-4

UK.

..u.S. - Canada

U.S. - U.K.

THROOP / INTERNATIONAL FINANCIAL MARKET INTEGRATION

exchange rates over extended periods in· the 1970s and
1980s, consistent with an assumption of nonstatic expectations in the Mundell-Fleming model. 13 This has been
especially true for the U.S. dollar in the first half of the
1980s, when a combination of easy fiscal policy and tight
monetary policy in the U.S. pushed up U.S. real interest
rates relative to those abroad. As a result, it may be that
tendencies for the equalization of national real interest

rates are not easily discernible in this period.
This analysis looks at tendencies toward the convergence of real interest rates for both the period of relatively
high capital mobility since the early 1980s as well as the
whole period of floating exchange rates since 1973 since
the former period may be too short to uncover such tendencies. If there were a significant tendency for real interest
rates to converge over the longer period but not the shorter
one, one could say that capital controls in the 1970s were
not sufficient to offset the tendency towards convergence,
but that convergence can take quite a long time under flexible exchange rates. On the other hand, if there were no
significant tendency observable in either period, all that
could be said would be that although a tendency towards
convergence could not be found for the period of high
capital mobility since the early 1980s, such a tendency
might be uncovered if a longer period of high capital
mobility with flexible exchange rates could be observed.
The strongest hypothesis with respect to long-run convergence of national real interest rates would be that there
is a tendency towards equality. Statistically, this would
imply that real interest differentials are stationary, i.e.,
they do not have a tendency to trend either up or down
through time. Stationarity of both short- and long-term real
interest rate differentials for both the short period of full
financial market integration since the early 1980s and the
longer period of floating rates since 1973 was examined
using the augmented Dickey-Fuller test. 14 The null hypothesis of nonstationarity was accepted at the 1 percent level of
significance in all cases.
Thus, only a weaker form of convergence may exist. A
weaker hypothesis would be that real interest rates at home
and abroad are cointegrated in the sense that they do not
tend to drift apart over time. Statistically, this means that a
linear combination of the two interest rates would be

stationary. Thus, if rand r* are cointegrated, then the
cointegrating vector, r - a o- a1r*, would be stationary.
For long-run equality, a o = 0 and a 1 = 1.0. But different
national tax rates could cause a 1 to be different from 1.0,
and currency risk premiums or other factors might cause a o
to differ from zero. So cointegration would appear to be a
better criterion for convergence than equality.
The Engle-Granger two-step procedure could be used to
test fOi the cointegiation of paiis ofreal intciest iates. This
procedure would estimate r = a o + a1r* by ordinary least
squares and test for the stationarity of the residuals by
means of the Dickey-Fuller test. 15 But a more powerful test
is the Johansen procedure, which estimates the cointegrating vector within the context of a complete error-correction
model. 16 Estimation of this type of model also has the advantage of providing estimates of the dynamics of the response of one interest rate to another, and therefore the
time it takes for the system to reach a long-run equilibrium.
This vector error-correction model consists of regressions of changes in each of the two real interest rates on
past changes in its own rate, past changes in the other rate,
and a lagged error-correction term equal to the cointegrating vector. Assuming that the real interest rates are nonstationary, the regressions are in change form (except for the
error-correction term) in order to avoid spurious correlations that otherwise might result from unit roots in the data.
The error-correction term is included in the regressions if it
can be shown that the real interest rates are cointegrated, in
the sense that they tend toward a stable long-run equilibrium relationship. The error-correction term is equal to the
difference between the actual and long-run predicted values of each interest rate. This ensures that the system
moves toward a long-run equilibrium if one exists. Using
this two equation system, impulse-response functions are
derived to examine the estimated short- and long-run
responses of each real interest rate to shocks to either rate.
Formally, this two-equation system is written asP
4

(8)

14. For a discussion of the augmented Dickey-Fuller test, see Charemza
and Deadman (1992), chapter 5.

D.r = i~l BlliD.r:i + i~l B 12 Ar_i

(9)
13. See Throop (1993) and references therein to the extensive literature
on the subject. Besides confirming the importance of real interest rate
differentials in explaining the behavior of real exchange rates since
1973, Throop (1993) also shows that the market's expectation of the
long-run equilibrium of the real value of the dollar tends to be importantly affected by the real price of oil, budget deficits, and the relative
price of traded versus nontraded goods.

D.r* = i~l B2li D.r:i + i~l B22i D.r_i

15. See Engle and Granger (1987), Engle and Yoo (1987), and Charemza
and Deadman (1992), chapter 5.
16. See Johansen and Juselius (1990).
17. Four lags on past changes in rates were used in estimating the
cointegrating vector. Also, constant terms in the vector autoregressions
were restricted to zero, maximizing the chance of finding cointegration.

FRBSF ECONOMIC REVIEW 1994,

NUMBER

Augmented Dickey-Fuller tests indicate that all shortterm and long-term real interest rates are nonstationary in
levels, but stationary in first differences for the period 1981
to the present, as well as for the full period of the float,
consistent with regressions in first difference form. To
determine whether error-correction terms should be included in each of the regression equations, we test for
cointegration between pairs of real interest rates. If a linear
combination of the two (nonstationary) interest rates is
stationary, then they are cointegrated. Tables 1 and 2 compare the maximum eigenvalue and trace statistics of the
Johansen test for cointegration with their critical values.

TABLE

These statistics show that the foreign trade-weighted shortterm real interest rate is the only foreign rate that is
cointegrated with the U.S. real short-term rate for the period of high capital mobility in the 1980s. If the sample
period is extended to the period of the full float, the foreign
trade-weighted short-term real rate ceases to be cointegrated with the U. S. rate, presumably because of increased
barriers to capital mobility, but the Japanese real rate now
becomes cointegrated with the U. S. real rate, despite such
barriers.
These results suggest that on average there was a statistically significant long-run linkage between u.s. and for-

JOHANSEN TEST FOR COINTEGRATION: SHORT REAL RATES

MAXIUMUM EIGENVALUE TEST
Statistic
US. and:
Canada

Germany

Japan

UK.

Trade-weighted

Null

r
r

=
=
=
=

Critical Values

Alternative

1981.Ql-l993.Q3

1974.QI-1993.Q3

10%

0
1

r
r

=
=

1
2

11.3
2.5

7.8
4.8

15.8
9.1

13.8
7.6

0
1

r
r

=
=

1
2

8.2
3.6

8.7
6.8

15.8
9.1

13.8
7.6

0
1

r
r

=
=

1
2

11.2
1.2

15.8
9.1

13.8
7.6

0
1

r
r

=
=

1
2

10.8
2.5

7.2
6.3

15.8
9.1

13.8
7.6

0
1

r
r

=
=

1
2

26.3**
3.4

7.1
3.7

15.8
9.1

13.8
7.6

0
1

r> 1
r = 2

13.7
2.5

12.6
4.8

20.2
9.1

18.0
7.6

0
1

r> 1
r = 2

11.8
3.6

15.5
6.8

20.2
9.1

18.0
7.6

0
1

r> 1
r = 2

12.4
1.2

22.5**
4.9

20.2
9.1

18.0
7.6

0
1

r> 1
r =2

13.3
2.5

13.5
6.3

20.2
9.1

18.0
7.6

0
1

r ;;. 1
r = 2

29.7**
3.4

10.9
3.7

20.2
9.1

18.0
7.6

17.5**
4.9

TRACE TEST
US. and:
Canada

Germany

Japan

UK.

Trade-weighted

=
=
=
=
=

NOTE: ** indicates statistical significance at the 5% level.

THROOP / INTERNATIONAL FINANCIAL MARKET INTEGRATION

eign trade-weighted real short-term interest rates in the
period of high capital mobility. However, examination of
the estimated cointegrating vector, shown in Table 3,
reveals that the US. and foreign trade-weighted short-term
rates are estimated to have moved inversely with one another in the long run. This is not consistent with a tendency
toward convergence of real interest rates. On the other
hand, in the case of the Japanese short rate over the longer
period, the U.S. and Japanese rate are estimated to move
positively with one another in the long run, consistent with
convergence. However, a Chi Square test rejects the restriction that the foreign real interest rate is equal to the home

TABLE

real interest rate in the long run in both cases, and it also
rejects the restriction that the foreign interest rate differs
from the home interest rate by at most a constant. So even
where a tendency towards the long-run convergence of
interest rates is found, as in the case ofJapan, it is relatively
weak.
Turning to long rates, there is no evidence of any significant cointegration between US. and foreign real rates
in the period of high capital mobility since the beginning
of the 1980s (see Table 2). But significant cointegration
between the real long-term US. rate and the corresponding
rates abroad is indicated for Germany and Japan for the full

JOHANSEN TEST FOR COINTEGRATION: LoNG REAL RATES
MAXIUMUM EIGENVALUE TEST
Statistic

Critical Values

Null

Alternative

1981.QI-1992.Q2

1974.QI-1992.Q2

10%

Canada

r = 0
r ~ 1

r = 1
r = 2

8.6
5.4

6.5
4.0

15.8
9.1

13.8
7.6

Germany

r = 0
r ~ 1

r = 1
r = 2

10.1
6.3

14.1 *
4.3

15.8
9.1

13.8
7.6

Japan

r = 0
r ~ 1

r = 1
r = 2

9.9
1.8

17.1 **
7.2

15.8
9.1

13.8
7.6

UK.

r = 0
r ~ 1

r = 1
r = 2

5.4
4.8

11.5
4.0

15.8
9.1

13.8
7.6

Trade-weighted

r=O
r ~ 1

r = 1
r = 2

7.6
5.4

8.1
4.2

15.8
9.1

13.8
7.6

Canada

r = 0
r ~ 1

r> 1
r = 2

14.1
5.4

10.8
4.0

20.2
9.1

18.0
7.6

Germany

r = 0
r ~ 1

r ~ I
r = 2

16.4
6.3

18.4*
4.3

20.2
9.1

18.0
7.6

Japan

r = 0
r ~ 1

r~2

11.7
1.8

24.3**
7.2

20.2
9.1

18.0
7.6

UK.

r = 0
r ~ 1

r ~ 1
r = 2

10.3
4.9

15.5
4.0

20.2
9.1

18.0
7.6

Trade-weighted

r=O
r ~ 1

r ~ 1
r = 2

13.0
5.4

12.3
4.2

20.2
9.1

18.0
7.6

US. and:

TRACE TEST
US. and:

NOTE: ** and * indicate statistical significance at the 5 and 10 percent levels, respectively.

FRBSF ECONOMIC REVIEW 1994,

NUMBER

TABLE 3
JOHANSEN TEST FOR RESTRICTION ON COINTEGRATING VECTOR

PERIOD

RATES

ESTIMATED
COINTEGRATING
VECTOR

Trade-weighted

1981.Ql-1993.Q3

Short

(1.0, -11.3, 2.1)

23.5 (.005)

22.6 (.005)

Japan

1974.Ql-1993.Q3

Short

(1.0,5.6, - 2.4)

10.8 (.005)

8.5 (.005)

Japan

1974.Ql-1992.Q2

Long

(l.0, -76.1, 16.0)

10.8 (.005)

8.5 (.005)

Germany

1974.Ql-1992.Q2

Long

(1.0, 7.8, - 2.6)

5.5 (.050)

9.9 (.005)

COUNTRY

CHI-SQUARE TEST ON
(l.0, 0.0, - 1.0)
RESTRICTION

CHI-SQUARE TEST ON
(1.0, (lQ, -1.0)
RESTRICTION

NOTE: Significance levels are in parentheses.

period of the float. The German and the U.S. long rates are
estimated to be positively related in the long run, consistent
with convergence. But a negative long-run relation is found
between U.S. and Japanese real long-term interest rates.
Moreover, the restriction of either a one-to-one long-run
relationship between u.s. and foreign real long-term rates
or a constant difference between them is rejected by a Chi
Square test in both cases (Table 3).
Impulse-response functions from the estimated vector
error-correction systems are examined next. The response
of the foreign rate to a shock to the U. S. rate is determined
by shocking the error term, el' in equation (8) by one percentage point. It is assumed that any correlation between el
and e2 in equations (8) and (9) is attributable to an effect
of e2 on el' rather than the other way around. This implies
that e2 is not affected by this shock and that the foreign rate
is influenced only through the remaining terms in equation
(9). This procedure avoids a possibly spurious element of
contemporaneous causation in the simulated response, but
it also may underestimate the effect of the U. S. rate on the
foreign rate if there is in fact some contemporaneous causation of e2 by el . Similarly, in the case of the response of the
U.S. rate to the foreign rate, it is assumed that any correlation between el and e2 is attributable to the effect of el on
e2' However, if it is assumed that the causation between the
correlated elements of the error terms runs in opposite
directions, the simulated impulse-response functions are
not changed to any significant extent.
For short rates, estimates are for the period of high
capital mobility since the early 19808, except in the case of
Japan where there was a stronger linkage of interest rates
for the full period of the float. Error-correction terms are
included in the systems for the U. S. and foreign tradeweighted rates and for the U.S. and Japanese rates, although in the former case the signs of the coefficients in the

error-correction term are not consistent with a positive
association between interest rates in the long run. The
impulse-response functions for long-run rates also are from
the period since the beginning of the 1980s, except for
Germany and Japan, which are for the full period of the
float. Error-correction terms are included in the case
of those two countries as well. But only in the case of
Germany do the signs of the coefficients indicate a positive
association between interest rates on U. S. and foreign
assets in the long run.
Figure 6A shows the simulated impact on the foreign
rate over 16 quarters of a permanent 1 percentage point
shock to the U. S. real short-term interest rate, while Figure
6B plots the simulated response ofthe U. S. real short rate
to a permanent 1 percentage point shock to the foreign
rate. The dotted line indicates a 95 percent confidence interval around the estimated impulse-response functions. 18
The response of foreign short rates to a shock to the U. S.
short rate is not significantly different from zero for either
the trade-weighted rate or the four national interest rates.
The response of the U.S. short rate to a shock to the U.K.
short rate is significantly positive but small, after 16 quarters. But the response of the U. S. short rate to the foreign
trade-weighted short rate is significantly negative, and the
response of the U.S. short rate to the three other national
rates is not significantly different from zero.
The impact of a shock to the U. S. rate on the U. S. rate
after 16 quarters is generally not significantly different

18. This confidence interval was established by replicating the impulseresponse 1,000 times according to the observed distribution of errors.
Lags on past changes in rates were reduced to two in the case of short
rates and three for long rates due to a lack of statistical significance of
longer lags. This helped to tighten up the confidence bands around the
impulse-response functions.

THROOP/INTERNATIONAL FINANCIAL MARKET INTEGRATION

FIGURE 6
IMPULSE-REsPONSE FUNCTIONS: SHORT-TERM RATES

FOREIGN TRADE-WEIGHTED RESPONSE; U.S. SHOCK

U.S. RESPONSE; FOREIGN TRADE-WEIGHTED SHOCK

0.50
0.30
0.10

-0.50

-0.10

-1.00

-0.30
-0.50

-1.50

CANADIAN RESPONSE; U.S. SHOCK

U. S. RESPONSE; CANADIAN SHOCK

1.50

0.20

1.00

0.10

0.50

-0.00

0.00

-0.10

-0.50

-0.20

-1.00

-0.30

GERMAN RESPONSE; U.S. SHOCK

U.S. RESPONSE; GERMAN SHOCK

0.60

0.40

0.40
0.20
-0.00
-0.20
-0.40

0.20

-0.60

-0.20
-0.40

-0.60

L-..L...-"""::::~.........
5........-'-7................9 -'--'-1-1-.....1-3..L...-....1-5..........

U.S. RESPONSE; JAPANESE SHOCK

1.25
1.00
0.75

1.50
1.00
0.50

0.50
0.25
0.00

0.00
-0.50

-1.00

U.K. RESPONSE; U.S. SHOCK

U.S. RESPONSE; U.K. SHOCK

0.50

0.48

0.00

0.36

-0.50

0.24

-1.00

0.12

-1.50

0.00

-2.00

-0.00

JAPANESE RESPONSE; U.S. SHOCK

-0.25

-0.12

FRBSF EcONOMIC REVIEW 1994, NUMBER 3

FIGURE 7
IMPULSE-REsPONSE FUNCTIONS: LoNG-TERM RATES

FOREIGN TRADE-WEIGHTED RESPONSE; U.S. SHOCK

U.S. RESPONSE; FOREIGN TRADE-WEIGHTED SHOCK

0.50

2.00

0.30

1.00

0.10
0.00

-0.10
-0.30

-1.00

-0.50

-2.00

CANADIAN RESPONSE; U.S. SHOCK

U.S. RESPONSE; CANADIAN SHOCK

2.50
2.00
1.50
1.00

0.50
0.00
-0.50

1.00

-1.00

0.50
0.00
-0.50

-1.50

-2.00

GERMAN REsPONSE; U.S. SHOCK

U.S. RESPONSE; GERMAN SHOCK

0.80

1.50
1.00

0.60
0.40
0.20

0.50
0.00
-0.50
-1.00

0.00
-0.20
-0.40

-1.50

JAPANESE RESPONSE; U.S. SHOCK

U.S. RESPONSE; JAPANESE SHOCK

0.40

0.75
0.50
0.25
0.00
-0.25
-0.50
-0.75
-1.00

0.20
0.00
-0.20
-0.40

U.K. RESPONSE; U.S. SHOCK

U.S. RESPONSE; U.K. SHOCK

0.40
0.20
-0.00
-0.20

0.90
0.70
0.50
0.30

-0.40
-0.60

0.10
-0.10

-0.80

-0.30

THROOP / INTERNATIONAL FINANCIAL MARKET INTEGRATION

from 1 percentage point, as is the response of the foreign
rates to a 1 percentage point shock to them. As a result,
there is no significant tendency for real short rates to come
back together once they have been pulled apart by a shock.
This appears to be due to the absence of static expectations
and a time-varying currency risk premia in a sample that is
too short to allow one to observe the long-run interestequalizing effects of capital mobility.19

Figure 7 sho\vs the responses of reallong=tenn interest
rates to shocks to real long-term rates in other countries.
As before, the effect of a 1 percentage point shock after 16
quarters on the rate that is shocked is never significantly
different from 1 percentage point. But the effect of that
shock on the other real long-term interest rate is never significantly different from zero. So once a shock drives
national real long-term interest rates apart, there is no
measurable tendency for them to be brought together
again. Again this is not evidence against capital being
highly mobile internationally among the major countries.
However, it does indicate that such mobility tends to make
real interest rates converge only over very long periods
of time.

m. SUMMARY AND CONCLUSION
The impulse-response functions that have been examined
in this study show that there have been virtually no causal
linkages between U. S. and foreign short-term or long-term
real interest rates for periods of up to 16 quarters. Moreover, in instances where longer-run linkages could be identified, the association between U.S. and foreign real rates
was positive only half of the time. Yet, since the early 1980s
differentials between U. S. and foreign interest rates when
covered for exchange rate risk in either the forward market
or by currency swaps have been close to zero. This eliminates government or institutional barriers to capital mobility as sources of disparities between real interest rates on

19. Using multivariate time-series modeling of real interest rate differentials, as opposed to the real rates themselves, Modjtahedi (1988)
reaches quite different conclusions with respect to one-month Eurocurrency rates over fairly short sample periods (1973 through 1979 and
1979 through 1986). First, he finds that national real interest rates are
generally cointegrated, although not always equal in the long run.
Second, he estimates that it takes approximately six months for the
differentials to converge to their long-run values. This estimated speed
of adjustment is difficult to square with the approximately two years that
it takes for the trade balance to adjust to changes in the exchange rate,
and hence also to changes in interest rates. Rapid adjustment also is
inconsistent with extended swings in the real value of the dollar that have
been observed to be associated with similar movements in real interest
rate differentials.

similar assets and leaves only exchange rate expectations
and premia for exchange rate risk as the contributing
factors.
It is difficult to gauge the relative importance of these
two factors with precision. But there is independent evidence that both factors have been important to some extent.
The evidence for the importance of expectations is that real
interest rate differentials have been shown to be an important force driving real exchange rates away from their longrun equilibrium values for extended periods of time. This
has been especially true for the U. S. dollar in the first half
of the 1980s when the combination ofeasy fiscal policy and
tight monetary policy in the U.S. raised U.S. real interest
rates relative to foreign rates. As a result, the real value of
the dollar deviated significantly from its expected long-run
equilibrium value, and the condition of static expectations
required for a short-run equalization of real interest rates
was far from satisfied.
The imp0ftance of premia for exchange rate risk in contributing to divergences in real interest rates is suggested
by evidence from surveys of market expectations of future
exchange rates. If exchange risk premia were small, we
would expect that differences in anticipated returns on
comparable assets calculated using survey data as a measure of expected exchange rate changes would be fairly
small. But in fact this is not the case. 20 Therefore, changing
currency risk premia probably also contribute to variation
in differentials between real national interest rates. Unfortunately, however, empirical studies to date have had little
success in isolating the fundamental economic factors that
tend to cause changes in these currency risk premia. 21

20. See, for example, Pigott (1993-1994).
21. Studies on the existence of exchange risk premia include Frankel
(1982), Hansen and Hodrick (1983), Hsieh (1982), Hodrick and Srivasta
(1984), and Fama·(1984). Attempts to explain exchange risk premia in
terms of the capital asset pricing model include Engle and Rodrigues
(1989) and Lewis (1988).

FRBSF ECONOMIC REVIEW 1994, NUMBER 3

REFERENCES
Akhtar, M.A., and K. WeiHer. 1987. "Developments in International
Capital Mobility: A Perspective on the Underlying Forces and the
Empirical Literature" in Research Papers on International Integration of Financial Markets and U.S. Monetary Policy. Federal
Reserve Bank of New York, pp. 71-188.

Hodrick, Robert 1., and Sanjov Srivastova. 1984. "An Investigation of
Risk and Return in Forward Foreign Exchange." Journal ofInternational Money and Finance 3 (1) pp. 5-29.
Hsieh, David A. 1982. "Tests of Rational Expectations and No Risk
Premium in Forward Exchange." National Bureau of Economic
Research Working Paper No. 843.

Bank for International Settlements. 1989. International Interest Rate
Linkages and Monetary Policy. Spring Economists' Meeting
(March).

Johansen, Soren, and Katrina Juselius. 1990. "Maximum Likelihood
Estimation and Inference on Cointegration-With Applications to
the Demand for Money." Oxford Bulletin of Economics and
Statistics (May) pp. 169-2iO.

Caramazza, Francesco, Kevin Clinton, Agathe Cote, and David Langworth. 1986. International Capital Mobility and Asset Substitutability: Some Theory and Evidence on Recent Structural Changes.
Bank of Canada Technical Report no. 44.

Kasman, Bruce, and Charles Pigott. 1988. "Interest Rate Divergences
among the Major Nations." Federal Reserve Bank of New York
Quarterly Review (Autumn) pp. 28-44.

Charemeza, Wojciech and Derik E Deadman. 1992. New Direction
in Econometric Practice. Aldershot, England: Edward Elgar
Publishing.
Cumby, R.E., and M. Obstfeld. 1984. "International Interest Rate and
Price Level Linkages under Flexible Exchange Rates: A Review of
Recent Evidence." Exchange Rate Theory and Practice, John ED.
Bilson and Richard C. Marston eds. Chicago, Illinois: University
of Chicago Press.
Dornbusch, Rudiger. 1976. "Expectations and Exchange Rate Dynamics." Journal of Political Economy (December) pp. 1161-1176.
Engle, Charles, and Anthony Rodrigues. 1989. "Tests of International
CAPM with Time-varying Covariances." Journal of Applied
Econometrics 4 (2) pp. 119-138.
Engle, Robert E, and Byung-Sam Yoo. 1987. "Forecasting and Testing
inCointegrated Systems." Topics in Applied Regression and Time
Series Analysis, Supplement to Journal of Econometrics, pp.
143-159.
_ _ _~_, and C. W. 1. Granger. 1987. "Cointegration and Error
Correction: Representation, Estimation, and Testing." Econometrica 55 (2) pp. 251-276.
Fama, Eugene E 1984. "Forward and Spot Exchange Rates." Journal of
Monetary Economics 14, pp. 319-338.
Fleming, 1. Marcus. 1962. "Domestic Financial Policies under Fixed
and under Floating Exchange Rates." IMF Staff Papers (November) pp. 369~379.
Frankel, Jeffrey. 1989. "International Financial Integration, Relations
Among Interest Rates, and Exchange Rates and Monetary Indicators" in International Financial Integration and U.S. Monetary
Policy. Proceedings of a Federal Reserve Bank of New York
Colloquium. Ed. by Charles Pigott (October).
_ _ _ _ _ .1988. "International Capital Flows and Domestic Economic Policies" in The United States in the World Economy ed. by
Martin Feldstein. Chicago: University of Chicago Press.
_ _ _ _ . 1982. "In Search of the Exchange Rate Premia: A Six
Currency Test Assuming Mean Variance Optimization." Journal
ofInternational Money and Finance 1 (3) pp. 255-74.
Gaab, w., M. 1. Granziol, and M. Homer. 1986. "On Some International Parity Conditions: An Empirical Investigation." European
Economic Review 30 (3) pp. 683-713.
Hansen, Lars P., and Robert 1. Hodrick. 1983. "Risk Averse Speculation in the Forward Exchange Market: An Economic Analyses of
Linear Models, in Exchange Rates and International Economies
ed. by 1. A. Frankel. Chicago: University of Chicago Press for the
National Bureau of Economic Research.

Lewis, Karen. 1988. "Inflation Risk and Market Disturbances: The
Mean-Variance Model Revisited." Journal ofInternational Money
and Finance (September) pp. 273-288.
Merrick, John 1. and Anthony Saunders. 1986. "International Expected
Real Interest Rates: New Tests of the Parity Hypothesis and U.S.
Fiscal'Policy Effects." Journal of Monetary Economics 18, pp.
313-322.
Mishkin, Frederic S. 1984. "Are Real Interest Rates Equal Across
Countries? An Empirical Investigation of International Parity
Conditions." Journal ofFinance 39, pp. 1345-1357.
Modjtahedi, Baghar. 1988. "Dynamics of Real Interest Rate Differentials: An Empirical Investigation." European Economic Review 32 (6)pp. 1191-1211.
Mundell, Robert A. 1968. International Economics. New York:
Macmillan.
Pigott, Charles. 1993-1994. "International Interest Rate Convergence: A Survey of the Issues and Evidence." Federal Reserve
Bank of New York Quarterly Review (Winter) pp. 24-37.
Popper, Helen. 1990. "International Capital Mobility: Direct Evidence
from Long-term Currency Swaps." Board of Governors of the
Federal Reserve System. International Finance Discussion Paper
no. 382 (June).
Throop, Adrian W. 1993. "A Generalized Uncovered Interest Parity
Model of Exchange Rates." Federal Reserve Bank of San Francisco Economic Review 2, pp. 3-16.
_ _ _ _ _ . 1989. A Macroeconometric Model ofthe u.s. Economy.
Federal Reserve Bank of San Francisco Working Papers in Applied
Economic Theory (89-01).

Finite Horizons and the Twin Deficits

Kenneth Kasa
Economist, Federal Reserve Bank: of San Francisco. I
would like to thank: Barbara Rizzi for excellent research
assistance.

This paper uses Blanchard's (1985) model to study the
relationship between budget deficits and trade deficits.
The model is applied to annual post-war data from the
U.S., Japan, and Germany. lfind that in all three countries
there is a significant link between trade deficits and budget
deficits, holding constant expected changes in GNP and
government expenditure. However, the implied planning
horizons are quite different across countries. Inparticular,
the impliedplanning horizon in the U.S. is only about3 t04
years, whereas in Japan it is 71 years and in Germany it is
31 years.

The United States has run merchandise trade deficits for
eighteen straight years. Including trade in services and net
interest receipts alters the picture only siightiy, for it shows
the current account in deficit for fifteen of the past eighteen
years. Many policymakers and journalists regard this recent experience as symptomatic of some combination of
closed foreign markets and a secular decline in the "competitiveness" of U.S. products. Given this diagnosis, the
remedy then appears obvious-first, pry open foreign
markets where necessary through a process of aggressive
tit-for-tat bargaining, and second, prevent a further erosion
of U.S. technological leadership by providing government
support to those industries that are deemed to be on the
cutting edge of new technology, especially if their foreign
counterparts are being subsidized.
This paper will argue that these policy prescriptions
represent bogus cures for a nonex.istent illness. Rather than
reflecting a nefarious plot on the part of foreign governments to keep out U.S. products, or a gradual waning of
American· hegemony, recent U. S. trade imbalances represent to a large extent the predictable outcome of macroeconomic policies that have as much to do with the actions
of Congress as they do with the actions of foreign governments. In particular, much of the size and persistence of
aggregate trade imbalances can be attributed to shifts in
national fiscal policies that in turn lead to shifts in national
savings rates. If (at a constant interest rate) changes in
fiscal policy do not systematically affect domestic investment rates, then, via a well-known accounting identity,
equating current account deficits to the excess of domestic
investment over national savings, fiscal policy will necessarily affect the current account. In particular, budget
deficits will lead to trade deficits.
The assertion that budget deficits lead to trade deficits is
not new. In fact, it has become the conventional wisdom
within the economics profession. As with other policy
issues, however, the economics profession has not been
entirely successful at getting the message across. This lack
of success can be ascribed to two factors, one theoretical
and one empirical.
First, from a theoretical standpoint, there is no necessary
link: between budget deficits and trade deficits. Specifically, there will be no link: if "Ricardian Equivalence"
holds, that is, if individuals fully capitalize the implied
future taxes associated with budget deficits, either because

FRBSF ECONOMIC REVIEW 1994,

NUMBER

they expect to live long enough to pay the future taxes
themselves, or because at the margin they value the wealth
of their descendants as much as they do their own. If
Ricardian Equivalence holds, then budget deficits that
simply reflect the intertemporal shifting of (lump-sum)
taxes will not affect national savings and the current
account, because changes in private saving will fully offset
changes in government saving (see Barro 1974). Moreover,
we might observe a positive relationship between budget
deficits and trade deficits for reasons unrelated to how the
government finances its expenditures. For example, a budget deficit might not in fact signal higher future taxes if
individuals expect the government to restore a balanced
budget by cutting future government expenditures. In this
case, the anticipated reduction in government expenditures
raises private sector wealth and consumption, and therefore increases the trade deficit. l Alternatively, suppose a
budget deficit occurs because the government reduces
taxes on investment. In this case, even with full tax
discounting we would expect to observe a current account
deficit, not because national saving declines, but because
domestic investment increases. The point is that these
theoretical ambiguities provide ammunition for those who
want to argue that the twin deficits are either an illusion or a
coincidence. For example, conservatives tend to resist the
idea because they fear it will be used as an argument for
raising taxes. With perfectly valid economic arguments on
both sides of the issue, the door is then left wide open for
those who prefer the spurious arguments associated with
foreign trade barriers or declining national "competitiveness." Clearly, the extent to which individuals discount
future taxes is an empirical question, which can be settled
only by empirical work. This brings us to the second factor
behind the economics profession's failure to convince the
public that it is macroeconomic policy that is to blame for
persistent u.s. trade deficits.
On the face of it, existing empirical evidence against
Ricardian Equivalence and thus in favor of the notion that
budget deficits produce trade deficits is surprisingly weak,
despite the apparently strong evidence presented by the
experience of the U.S. during the 1980s. 2 Studies that
examine different time periods or different countries have
failed to produce reliable evidence that budget deficits are

1. Yi (1993) argues that there is some evidence that the U.S. trade deficit
of the 1980s occurred because individuals expected future government
purchases to decline.

2. For surveys of the empirical evidence on Ricardian Equivalence, see
Bernheim (1987) and Seater (1993). Bernheim tends to stress evidence
contradicting Ricardian Equivalence, while Seater tends to focus on
studies that support Ricardian Equivalence.

significantly related to trade deficits. 3 Part of the reason for
this mixed evidence is undoubtedly due to difficulties that
plague all empirical work in economics, e.g. , difficulties in
measuring the relevant theoretical concepts (in this case the
budget deficit), and difficulties in adequately controlling
for the many factors that simultaneously influence the
variables of interest. However, I believe that in the case of
the twin deficits, part of the reason also stems from
a failure to conduct empirical tests within the context of a
clearly specified intertemporal optimization model. 4
An intertemporal approach makes it clear that if we
simply regress current account deficits on contemporaneous values of budget deficits and on control variables like
government spending, investment, and GNP, we should
expect ambiguous results because the coefficients in this
sort of reduced-form relationship are complicated functions of underlying parameters in the economy. Moreover,
this ambiguity arises from the inherently dynamic nature
of the twin deficits issue and in particular does not derive
from the usual sorts of simultaneity bias that clouds
econometric inference. For example, regardless of the
horizon of individuals, or of whether Ricardian Equivalence holds, the coefficients on control variables like
government spending can be either positive or negative,
depending on the relationship between the horizon of
individuals and the perceived persistence of government
spending changes. Similarly, while the model in this paper
predicts that the (partial) correlation between current account deficits and budget deficits is unambiguously positive, the magnitude of this correlation can be arbitrarily
large or small for any finite horizon of individuals, depending on the perceived persistence of budget deficits. In other
words, the size of the coefficient on budget deficits does
not by itself tell us the extent to which individuals discount
future taxes. Instead, a clear picture of the twin deficits
relation requires ajoint estimation ofthe process generating
the current account and the processes generating budget
deficits and the control variables, since economic theory
places cross-equation restrictions on these processes.
The remainder of the paper is organized as follows. The
next section develops a discrete-time version ofBlanchard's
(1985) model. In this model all individuals face the same

3. For example, using a standard reduced-form regression approach,
Bernheim (1988) shows that inferences about the strength of the twin
deficits relationship depend critically on the country and time period, as
well as on the conditioning information set.
4. A notable exception is the work of Leiderman and Razin (1988), who
construct and test a model that is quite similar to the one in this paper.
They apply the model to monthly data from Israel during the early 1980s
and fail to reject the Ricardian Equivalence proposition.

KAsA/FINITE HORIZONS AND THE TWIN DEFICITS

constant probability of death. This probability imparts a
finite horizon to individuals, and serves to parameterize
the extent to which Ricardian Equivalence holds and the
extent to which budget deficits affect the current account.
Estimation of this parameter will be a primary focus of
the paper. Section II discusses the data I use to estimate the
model. Briefly, I apply the model to the U.S., Japan, and
Germany, using as long a time series as I could obtain for
each count..ry. Section III presents the empirical results. Unrestricted estimates reveal a statistically significant (partial) correlation in all three countries between current
account deficits and budget deficits. Restricted estimates,
which allow us to infer the effective planning horizon of individuals, suggest wide disparities in the extent to which
individuals internalize the government's budget constraint.
The estimates range from a 3- to 4-year horizon in the U.S.
to a 71-year horizon in Japan. Perhaps not surprisingly,
however, the horizons are not estimated very precisely. In
particular, their standard errors do not allow us to reject the
hypothesis that the horizons are short and equal across
countries. Section IV discusses some caveats and possible
extensions to the paper.

THE TWIN DEFICITS IN A MODEL
OF "PERPETUAL YOUTH"

This section briefly outlines a discrete-time version of
Blanchard's (1985) model. The analysis and notation borrow heavily from the work of Frenkel and Razin (1987),
and the interested reader is urged to consult their book for
full details.
The model will be developed in four steps. First, I
discuss the model's demographic assumptions. Second,
I solve the intertemporal optimization problem confronting
individual agents in the economy. Third, I aggregate the individual decision rules to arrive at an aggregate consumption function. In the fourth step, I incorporate domestic and
foreign government borrowing, and derive an equilibrium
law of motion for the economy's current account balance.

Demographics

are motivated by analytical convenience rather than by
descriptive realism. 5 In particular, the assumptions that the
survival probability is the same for everyone and that it
remains constant over time greatly facilitate aggregation.
In this world, the only redistributions that matter are
between the currently living and the yet unborn. If allowance were made for more realistic individual life-cycle
dynamics, then we would also need to worry about how
government policy redistributes resources among all those
who are currently living, each of whom will respond to the
policy in a different way because of age differences.
Although the assumption of constant and identical survival rates is important, the particular values chosen for the
birth rate and the death rate are inessential. For example, we
know from Weil (1989) that virtually identical results can be
derived in a framework in which individuals live forever and
new (unrelated) individuals are born each period. In Weil's
model the birth rate rather than the survival rate becomes
the key parameter. In fact, by reinterpreting the parameters, the two models become observationally equivalent.
Specifically, Blanchard and Weil's models will produce
identical results if we set the birth rate in Weil's model
equal to the death rate in Blanchard's, and then increase the
interest rate in Weil's model by Blanchard's d~ath rate. 6
Thus, a finite horizon per se is not the crucial issue here,
although it provides a convenient story for debt nonneutrality. Instead, as noted by Buiter (1988), the crucial
issue is that new individuals enter the economy each
period, and that these individuals are unrelated (in utility
terms) to currently alive individuals. These unborn individuals introduce a wedge between the government's future tax base and the future tax base of those who are
currently living. This wedge then causes social and private
discount rates to diverge, and it is this distortion that is the
fundamental source of debt nonneutrality and the twin
deficits.
Following Frenkel and Razin (1987), let'Y denote an individual's probability of surviving from one period to the
next. Then, from the previous assumptions, 'Y t is the probability that an individual will live for t more years, and
more generally, an individual's expected lifetime is
00

Consider a world in which a new cohort of individuals is
born each period. Without loss of generality, normalize the
size of each new cohort to be one. All members· of this
cohort have the same probability of surviving from one
period to the next, and more importantly, this survival
probability remains constant throughout an individual's
life. In other words, an individual's lifetime is like a
sequence of coin tosses, the probability of living for
another year being completely independent of the individual's current age. Clearly, these demographic assumptions

.! j-yj =

)=1

'Y/(I- 'Y)2.

5. Blanchard cites evidence that survival rates are high and relatively
constant from ages 20 to 40, but start to decline rapidly thereafter,
reaching.99 at age 50, .97 at age 60, .84 at age 80, and .33 at age 100.
To accord with this evidence on individual survival rates, Blanchard
suggests an alternative interpretation of the model in which the basic
unit of analysis is a dynastic household, and the survival rate refers to
the probability that some member of the family continues to live.
6. See Glick and Rogoff (1994) for an application of Weil's model to
issues in international macroeconomics.

FRBSF ECONOMIC

REVIEW

1994, NUMBER 3

Thus, in a very simple and convenient way, -y parameterizes the horizon of individuals. Finally, from our normalization that the size of a new cohort is one, the total
population at any given time is constant and equal to
I.;=o-yj=lJ(1-'Y) (assuming that each cohort is large
enough for the law of large numbers to apply).

Individual Optimization
Individuals are assumed to maximize their expected lifetime utility,
00

(1)

max
{c,}

Eo ,=0
I. flU(c t ),

where denotes the individual's subjective rate of time
preference and ct denotes consumption during period t.
The expectation operator in (1), Eo, reflects uncertainty
over both the duration of the individual's lifetime and his or
her future resources. The previous demographic assumptions allow us to write this as,
00

max Eo I. (-yoYU(c t )

(2)

{c,}

t=O

where now the expectation operator, Eo, only reflects
uncertainty about future resources, and the consumer's
effective discount rate has increased.
Individuals receive an exogenous stochastic labor income stream, {Yt}, which is assumed to be identical across
individuals, and must pay a stochastic lump-sum tax of Tt
to the government during period t. In general, variation
over time in disposable income will cause individuals to
want to borrow and lend. However, no one will be willing
to lend to an individual unless he or she receives a "risk
premium" to cover the probability that the borrower will
die before the debt is paid off. Specifically, let R = (1 + r),
where r denotes the risk-free market interest rate. Then, in
competitive equilibrium, the (gross) rate of interest on
personal loans will be RI-y, since this guarantees an
expected return equal to the risk-free rate. 7 Therefore, the
individual's flow budget constraint is

(3)

= Yt -

bt - R/-y bt_1

where bt denotes period t issues of (one-period) private
sector debt.

7. Following Yaari (1965), an alternative but effectively equivalent
arrangement would have individuals buy life insurance policies in which
insurance companies honor the debts of the deceased or receive their
assets, whatever the case may be. Under this setup, borrowing and
lending takes place at the risk-free rate, but adding in the individual's
insurance premiums leads to an identical expected rate of return on
human capital.

In solving for the individual's optimal consumption/saving plan, I assume the individual's period utility function is
quadratic. Specifically,
(4)

U(C)
t = <Xct -

Y2c t2

Maximizing (2) subject to (3) then gives the following
linear, age-independent consumption function (assuming
oR = 1),8

(5)

ct = [(R--y)/R] [Ht-(RI-y)b t_1]

where Ht denotes the capitalized value of the individual's
expected future disposable income,

(6)

H t = E t j~O
00

(-y)j
R (Yt+j-T t+)·

Aggregation
Since it is assumed that labor, income, and taxes are the
same for everyone, and the demographics imply an age
independent consumption function, the only issue in aggregating concerns private sector indebtedness. Letting B t

denote aggregate per capita private sector debt, we have
00

(7)

= (1- -y) a~o -yaba,f'

where now ba,t denotes the debt at time t ofindividuals who
are a years old. Aggregating both sides of the individual's
budget constraint in (3) yields,

(8)

B t = R . B t_1

+ Ct - (Yt - Tt),

where Ct , Yo and Tt denote aggregate per capita consumption, labor income, and taxes which, from our previous assumptions, are the same as ct ' Yo and T t .
The point to notice is that at the aggregate level, the rate
of return on private debt is just the risk-free market interest
rate. From the law of large numbers, the risk premium is
cancelled by those who die each period.

The Government
For simplicity, I assume the country in question is "small"
in the sense that it takes as given the world interest rate, R.
The main implication of this assumption is that application
of the model to large countries will tend to exaggerate the
effect of fiscal policy on the current account. This is because in large countries part of the effect of fiscal policy is
reflected in the (world) interest rate.
At this point I also remind the reader of a second important assumption implicit in the above setup, namely, the

8. See, e.g., Frenkel and Razin (1987).

KAsA/FINlTE HORIZONS ANDTHE TWIN DEFICITS

assumption that domestic output evolves exogenously, independent of both the current account and the government's fiscal policy. In principle, of course, we should
make output endogenous by introducing a production
function and modeling investment and labor supply decisions. After all, as was noted earlier, the current account
balance is by definition the difference between investment
and national saving. My strategy in this paper, however, is
to see how much of the dynamics in the current account can
be explained solely on the basis of fiscal policy-induced
savings rate dynamics. The danger with this strategy is the
potential of getting a misleading picture of the underlying
reason why fiscal policy affects the current account, if
indeed fiscal policy simultaneously influences both saving
and investment. 9
Having said this, we can now move on and derive an
equation for the current account balance. First, define CAt
to be the economy's current account surplus. Remember
that this is simply the economy's net acquisition offoreign
assets during period t. Therefore, an economy will have a
current account surplus when it spends less than it produces during a given period. That is,
(9)

CAt = Yt - Gt - Ct

+ rFt_1 ,

where Gt denotes government purchases during period t,
and Ft denotes tbe economy's stock of net external assets at
the end of period t.
Now, if we difference both sides of the accounting
identity in (9), and use the fact that, by definition CAt =
F t - F t_ 1 , we get
(10)

CAt = R· CA t_1 +~ Yt - ~Gt - ~Ct.

Next, aggregate the consumption function given in (5) and
substitute it into (10), using the following three facts. First,
note that by definition the sum of aggregate private sector
indebtedness, B t , and government debt, Dr> is equal to net
external debt, -Ft. That is, Bt + Dt=-F(" This allows us to
write the aggregate consumption function in terms of aggregate per capita human capital, Ht , net external assets,
F t , and government debt, Dt . Second, use the government
budget constraint,
(11)

D t = R . Dt- 1 + Gt - Tt

to write Ht in terms of expected future values of Yt, D t' and
G t. Third, note that the change in government debt, ~ t' is

9. Glick and Rogoff (1992) develop an intertemporal optimizing model
of the current account that simultaneously incorporates saving and
investment dynamics. They focus their attention, however, on the
importance of distinguishing global and country-specific productivity
shocks, rather than on the effects of budget deficits.

by definition equal to the government's (interest inclusive)
budget deficit. Specifically, letting BSt denote the government's time tbudget surplus, we haveBSt = - ~t" Doing
all this yields the following expression for the equilibrium
current account balance,
(12) CAt = 'Y CA t_l

+
+

Et_1(~Yt -

( R-'Y~
-~- IE'_1 .I.
"J=l
00

~Gt)

('YV
D 1 (~Gt+j- Yt+)

,H)

(l-'Y)(R~'Y )Et-lj~O

JBSt+j + ut·

This equation is the main result of the model. It explains
the current account balance in terms of five driving forces.
The first component on the right-hand side of (12) represents an autoregressive effect which links persistence in the
current account to the horizon of individuals. Specifically,
the longer is the effective planning horizon, the more persistent are fluctuations in the current account. The second
component on the right-hand side of (12) is a current period
demand effect, which simply says that, all else equal, the
current account surplus increases when available output
increases this period more than does the government's demand for it. The third and fourth terms on the right-hand
side of (12) are more interesting. The third term is a wealth
effect arising from expected changes in government spending and output. If individuals expect government spending
to rise faster than output, then private sector wealth declines. The decline in wealth reduces current consumption, and therefore increases the current account surplus
(i.e., individuals begin to save now for the anticipated decline in their future disposable income). The fourth term on
the right-hand side of (12) is what sets this model apart
from standard applications of the Permanent Income Hypothesis to current account dynamics. 1O Specifically, it
implies that budget deficits produce current account deficits. This, of course, is the "twin deficits" phenomenon.
There are two points to notice about this component. First,
it disappears when individuals have infinite horizons (i.e.,
when'Y = 1). Holding current and future government spending constant, budget deficits just represent the intertemporal shifting of taxes. If individuals fully capitalize these
future taxes then such tax shifting causes no wealth effects,
which in this model is the only way fiscal policy can influence the path of the current account. The second point is
that the effect of budget surpluses on the current account
depends not just on the current realization of the government's budget surplus, but also on the entire expected

10. See, e.g., Sheffrin and Woo (1990).

FRBSF ECONOMIC

REVIEW

1994,

NUMBER

future path of the budget surplus. Finally, the last term in
(12), Up represents revisions between period t-1 and period t of individual's expectations concerning future values
of income, government spending, and the budget deficit. If
expectations are rational, this term will be uncorrelated
with anything in the time t - 1 information set and will also
be serially uncorrelated. Therefore, ut is a valid regression
equation error term.
Because the current account depends on expected future
values of BSt, Yt, and Gt, in order to impiement equation (12) empirically we must take a stand on the nature of
the stochastic processes generating these variables. In
general, there is every reason to believe that these variables
are jointly determined within some larger econo~ic system, and therefore should be forecasted using some sort of ,
VAR. However, in the interests of simplicity, I employ the
following univariate time series specifications for these
variables: 11

(13)
(14)
(15)

+ «BS BSt_1 + E lt
dYt = «2 + TJe fLt + «ydYt_1 + E2t
dG t = «3 + TJe fLt + «GdGt-l + E3t ·
BSt =

«I

Using these to evaluate the forecasting problems in (12)
gives us
(16) CAt = «0

(l--Y)(R--Y) ]

+ -yCA t_1 + «BS [ R _
-Y«BS

BSt_1

+ «y [R'1 - «y(R--y) ]dY
R ~ -Y«y

(XG

[i - i~-y~:)

Also note that the persistence of budget deficits plays an
important role in determining the (contemporaneous) response of the current account to a budget deficit. In
particular, the more persistent a budget deficit is expected
to be, the more likely it is that currently alive individuals
will die before taxes are raised, and therefore the larger is
the wealth effect. However, as pointed out by Poterba and
Summers (1987), even if budget deficits are very persistent, the wealth effect and therefore the (contemporaneous)
response of the current account are small if individuals
have "long" but finite horizons. For example, suppose
-y = .87 and R = 1.02, so that individuals have approximately a 51-year horizon and the real interest rate is 2
percent. Then, even in the limit as (XBSfLO, the coefficient
on BSt is only .13.
Before concluding that the model produces small effects
from budget deficits, however, it should be remembered
that in a dynamic multivariate model, contemporaneous responses may understate the potential of budget deficits to
affect the current account. This is because an initial response may cumulate over time before it begins to die out.
Such amplification occurs in this model if -y + (XBS> 1. For
example, suppose that -y= .87 and «BS= .7. In this case,
the initial response of the current account to a budget
deficit shock will only be about 15 percent the size of the
response after just two periods.

t-I

]dGt_ 1 + ut ·

Equations (13)-(16) clearly illustrate the nature of the
cross-equation restrictions implied by the model. In particular, note that the response coefficients in the current
account equation depend on the autoregressive coefficients
in the equations governing the evolution of BSt , dYt , and
l!t.G t • As noted in the introduction, this makes it difficult to
interpret single-equation regressions of the current account
on other variables. For example, note that the response of
the current account to changes in output and government
spending can go either way, depending on the relative magnitudes of the horizon parameter, -y, and the persistence of
changes in output and government spending, as determined by the parameters «yand (XG'

11. Note, G,and f,are assumed to share a common (deterministic) trend
which, from inspection of (12), cancels out of the current account
equation.

ll.

THE DATA

The model in Section I is applied to annual post-war data
from the U.S., Japan, and Germany. Of course, none of
these countries satisfies the "small" country assumption
of the model, but except for the U.S. during the 1950s and
1960s, the assumption might not be too bad. Due to data
availability problems, the sample varies from country to
country. For the U. S. , the sample extends from 1950-1993,
while for Japan and Germany I was forced to use shorter
samples, 1960-1992 and 1968-1993, respectively. Data are
from NIPA for the U. S., and from the OEeD for Japan and
Germany.
Without a doubt, the variable in the model that is most
difficult to measure is the government budget deficit. In
this paper I make no attempt to correct the standard
reported series for any of the many potential biases to
which these data are subject. Four points about the budget
data should be made, however. First, for all three countries
I measure deficits in reference to the "general" or "consolidated" government. That is, state and local balances are
added to federal or central government balances. Second,
since I define the budget deficit as the change in the government's debt, I use data on the interest inclusive deficit (as
opposed to the primary deficit). Third, the data include

KASA / FINITE HORIZONS AND THE

social security payments and tax revenues. This becomes
important for the U.S. and Japan starting in the late 1970s.
Fourth, rather than express everything in real terms, I
simply divide both sides of equation (16) by nominal GNP,
and express everything as a share of nominal GNP.
Plots of the current account and budget surplus as a
share of GNP are contained in Figures 1-3. These figures
suggest that while there appears to be some sort of relationshin
stren!!th
of the rela----r hetween
- - -- - - -- the
--. - twin
_. _. . deficits.
-- - - - the
'-"
tionship varies over time. In general, the relationship
appears to be closer in all three countries during the 1980s.
The figures also illustrate that the two series are not always
"in phase". These two facts suggest that it is important to
control for other factors that are influencing the current
account balance and to allow for some dynamics.
To get a better sense of the dynamics in the data, Figure
4 presents impulse responses computed from unrestricted
bivariate VAR(2) models consisting of the current account
and the budget surplus (both expressed as a share of
GNP). 12 Note that in all three countries a positive shock to
the budget surplus produces a current account surplus that
peaks after two to three years, and then gradually moves
back toward baiance-a dynamic version of the twin deficits story. The main difference across countries is that
Germany's response appears to be weaker and shorterlived than in the U.S. and Japan, while the U.S. response
appears to be more persistent than in Japan and Germany.
~

m. EMPIRICAL RESULTS
This section presents joint maximum likelihood estimates
ofthe system ofequations (13)-(16). In addition to the usual
assumptions about the error terms, I remind the reader of
two important statistical assumptions that are made when
computing the estimates that impose restrictions on the
nature of the economic equilibrium. First, remember that I
am assuming output is exogenous. Of course, this cannot
literally be true. Imports and exports affect GNP, just as
GNP affects imports and exports. Still, what is important
is that this feedback not be too strong. Otherwise we can
expect to obtain inconsistent parameter estimates. The
second assumption is that there is no feedback from an
economy's external balance to its fiscal policy variables.
Again, I regard this as a reasonable assumption, although
some observers have argued that external balance considerations influence congressional budget deliberations. As
noted in the introduction, however, most members of
Congress seem to see other culprits behind the persistent
12. The equations are ordered so that changes in the budget surplus have
no contemporaneous effect on the current account.

TWIN DEFICITS

FIGURE 1
U.S.: CURRENT ACCOUNT AND BUDGET SURPLUS
AS A SHARE OF

GNP

21 ~

1A. 1\ t""A.. ACurrent Acount
O:Y \/;. :~
:,;' \:: \ :: :':
-1
1

,, ,,"

-2

I·

....

•

"
"

-3

.,
, ,
, ,
,

-4
-5

Budget Surplus

'''"

-6
-7

.,
.

+rrTTTT'"rTTTT'"rTTTT'"rTTTT'"rTTTT'"rTTTT'"rTTTT'"rTT'TT'T'1

1950 1955 1960 1965 1970 1975 1980 1985 1990

FIGURE 2
JAPAN: CURRENT ACCOUNT AND BUDGET SURPLUS
AS A SHARE OF

GNP

5
4
3

0
-1
-2

-3
,
,
,

-4

-5

' : Budget Surplus
'.

-6
60

FRBSF ECONOMIC REvIEW 1994, NUMBER 3

FIGURE

GERMANY: CURRENT ACCOUNT AND BUDGET
SURPLUS AS A SHARE OF GNP

o
-2

-4

..,

,
' ,,

Budget Surplus

-6

+-r-r--.-...,-r-r--.--r-T""'"1-..--r-T""'"1-..--r-.,...,r-r-r-~r-r---r-1

70 72 74 76 78 80 82 84 86

FIGURE

RESPONSES OF CURRENT ACCOUNT
TO A SHOCK IN THE BUDGET SURPLUS
(UNRESTRICTED

0.4

VAR(2))

.... ...... ,
,

0.3
0.2
0.1

o
.., .... "

......

-0.2

GERMANY

-0.1

",.

+--~-...,---r---i---r---r--

U. S. trade imbalance. In any case, ifinstrumental variables
can be found, these exogeneity assumptions can be tested
via a Hausman test, for example. If this test rejects we
should resort to an Instrumental Variables estimator.
Before presenting estimates of the restricted system, let
me briefly describe the results of unrestricted estimation of
the current account equation. (Actually, I estimate the
current account equation jointly with the other equations to
take advantage of potential correlation. among th.e errOi
terms. I refer to the estimates as unrestricted because I do
not impose the cross-equation constraints on the coefficients.) As noted earlier, only in the case of the budget
surplus do we have any expectation concerning the sign of
the coefficient. In particular, if the twin deficits hypothesis
is valid, the coefficient on BSt should be positive. This is
indeed the case. Unrestricted estimates of the budget
surplus coefficient are .266, .064, and .515 for the U.S.,
Japan, and Germany, respectively. The associated t statistics are 5.26, 0.82, and 2.68.
Finally, Table 1 contains estimates of the underlying
parameters, derived by imposing the cross-equation restrictions. In each case I simply fix the value of the interest
rate to be 2 percent, i.e., R = 1.02.13 The first point to
notice is that the fit of the model appears to be reasonably
good, in the sense that the current account equation explains 82 percent of the variation in the U.S. current
account, and about 60 percent of the variation in the
Japanese and German current accounts. On the down side,
however, note that for Germany the cross-equation restrictions are soundly rejected, as the 5 percent critical value for
a X2 (3) random variable is only 7.81. Also note that
for the U.S. and Germany there is borderline evidence
against the hypothesis of no residual (first-order) autocorrelation. This casts doubt, beyond the usual small sample
considerations, on the validity of the standard errors.
Turning to estimates of the horizon parameter, 'Y, note
that while this parameter appears to be relatively precisely
estimated, when we feed these estimates into the formula
for an individual's expected lifetime (i.e., 'Y/(1-'Y)l), we
get far less precise estimates of the effective planning
horizon. For example, the 95 percent confidence intervals
reported below the horizon estimates indicate that we
cannot even reject Ricardian Equivalence (i.e., an infinite
horizon) for Japan and Germany. This is because the

Years

.....- - - r - - ,

13. From (12), what matters is the effective discount rate, 'YIR. RaisingR
should increase our estimate of'Y by the same percentage. For example,
if initially R = 1.02 and we estimate 'Y = .8, then increasing R by 1 percent to 1.0302 should lead to an estimate of 'Y = .808. I tried estimating the model for a 1 percent and 3 percent real interest rate and found
that the results changed little and in the predicted direction.

KASA / FINITE HORIZONS AND THE TWIN DEFICITS

formula starts to become quite sensitive to small variations
in 'Yonce 'Y starts to reach about .80. Of course, this is not
too surprising since, with discounting, it makes very little
difference whether we calculate present values including
50 years or including 100 years. In other words, we will
never be able to tell reliably whether individuals have 50year planning horizons or whether they have 100-year
planning horizons. Fortunately, this sort of distinction is

rarely important in econorrJic policymaking. Of potentially
more importance, however, are differences like that exhibited by the U.S. and Japan, in which the U.S. is estimated to have a horizon of only a few years, while Japan is
estimated to have a horizon of about 70 years. Of course,
differences of this magnitude should manifest themselves
in other data sets. Thus, it would be of interest to crosscheck these results with other studies. One example of a
study yielding results on the implicit planning horizon of
individuals is Hayashi's (1982) paper on the Permanent
Income Hypothesis. Using time-series data on aggregate

U.S. consumption and income, Hayashi's estimates imply
roughly a lO-year planning horizon. One potential explanation of this relatively short horizon, pursued by Hayashi,
is that part of the U.S. population is subject to liquidity or
borrowing constraints, making their behavior appear myopic. For example, his estimates suggest that approximately 17 percent of the U.S. population faces binding
liquidity constraints. However, while liquidity constraints
might explain a lov/=horizon estimate for a particular
country, such constraints seem ill-suited to explain the
cross~sectional difference between the U.S. and Japan.
That is, it seems implausible that capital market imperfections are more severe in the U. S. than in Japan.

IV.

CONCLUSION

NOTES:

This paper developed and estimated a dynamic econometric model of the current account. This model links
persistence in trade imbalances to the effective planning
horizons of individuals. The longer their horizons (as
measured by their "expected lifetimes"), the more persistent will be the economy's aggregate trade imbalances.
The model also illustrates the importance of individuals'
horizons to the notion of the "twin deficits". All else equal,
the longer individuals' horizons are, the weaker will be the
relationship between budget deficits and trade deficits.
This is because budget deficits affect the economy solely by
altering the timing of taxes. Shifting taxes to the future by
running a budget deficit will not create much of a wealth
effect if individuals expect to be around to pay the higher
future taxes. 14 Not surprisingly, it is difficult to estimate
this parameter precisely using relatively short time-series
data. Nonetheless, the point estimates suggest wide disparities in planning horizons among the U.S., Japan, and
Germany. Specifically, the U. S. seems to have a much
shorter effective planning horizon than Japan, with Germany somewhere in the middle. It would be interesting to
cross-check these results using more direct, and probably
more reliable, micro data sets.
Finally, in deriving these results I have made many
simplifying assumptions. Future work along these lines
should attempt to relax some of these to make sure the
inferences hold up. Probably the two most important
extensions would be, first, to "endogenize" output movements by modeling investment, and second, to relax the
"small country" assumption by allowing a country's fiscal
policy to affect the equilibrium world interest rate.

Asymptotic standard errors in parentheses.
Horizon computed as 'Y/ (1- 'Y)2 .
R2 and h stat pertain to the current account equation.
LR(3) is the likelihood ratio statistic for the system's three overidentifying restrictions.

14. Or they expect their children, or other people they care about, to be
around.

TABLE 1
RESTRICTED ESTIMATES OF EQUATIONS

(13)-(16)

USA

JAPAN

GERMANY

1952-1993

1962-1992

1970-1993

.596
(.078)

.888
(.063)

.836
(.131)

aBS

.738
(.077)

.908
(.061)

.553
(.137)

.894
(.082)

.473
(.153)

.395
(.147)

.775
(.109)

.772
(.094)

.208
(.194)

3.66
(1.40, 12.2)

71.3
(13.4,00)

31.1
(3.2,00)

.82

.59

.56

h stat

1.95

1.01

1.82

LR(3)

6.31

3.69

Sample

Horizon

20.7

FRBSF ECONOMIC REVIEW 1994, NUMBER 3

REFERENCES

Barro, Robert 1. 1974. "Are Government Bonds Net Wealth?" Journal
ofPolitical Economy 82, pp. 1095-1117.
Bernheim, B. Douglas. 1987. "Ricardian Equivalence: An Evaluation
of Theory and Evidence." NBER Macroeconomics Annual 2, pp.
263-303.
_ _ _ _ . 1988. "Budget Deficits and the Balance ofTrade" in Tax
Policy and the Economy vol. 2, ed. Lawrence Summers. Cam-

bridge: NBER, MIT Press.
Blanchard, Olivier 1. 1985. "Debt, Deficits, and finite Horizons."
Journal ofPolitical Economy 93, pp. 223-47.
Buiter, William H. 1988. "Death, Birth, Productivity Growth and Debt
Neutrality." Economic Journal 98, pp. 279-93.

Leiderman, Leonardo, and Assaf Razin. 1988. "Testing Ricardian
Neutrality with an Intertemporal Stochastic Model." Journal of
Money, Credit, and Banking 20, pp. 1-21.
Poterba, James M., and Lawrence H. Summers. 1987. "finite Lifetimes
and the Effects of Budget Deficits on National Saving." Journal of
Monetary Economics 20, pp. 369-91.
Seater, John 1. 1993. "Ricardian Equivalence." Journal of Economic
Literature 31, pp. 142-90.
Sheffrin, Steven M., and Wing Thye Woo. 1990. "Testing an Optimizing Model ofthe Current Account via the Consumption Function."
Journal ofInternational Money and Finance 9, pp. 220-33.
Weil, Philippe. 1989. "Overlapping Families of Infinitely-Lived
Agents." Journal ofPublic Economics 38, pp. 183-98.

Frenkel, Jacob, and Assaf Razin. 1987. Fiscal Policies and the World
Economy, 1st edition. Cambridge: MIT Press.

Yaari, Menahem E. 1965. "Uncertain Lifetime, Life Insurance, and the
Theory of the Consumer." Review of Economic Studies 32, pp.
137-50.

Glick, Reuven, and Kenneth Rogoff 1995. "Global vs. CountrySpecific Productivity Shocks and the Current Account." forthcoming Journal ofMonetary Economics.

Yi, Kei-Mu. 1993. "Can Government Purchases Explain the Recent
U.S. Net Export Deficits?" Journal of International Economics
35, pp. 201-25.

_ _ _ _ . 1995. "Budget Deficits and the External Balance."
Unpublished manuscript.
Hayashi, Fumio. 1982. "The Permanent Income Hypothesis: Estimation
and Testing by Instrumental Variables." Journal ofPolitical Economy 90, pp. 895-916.

Capital Flight, External Debt,
and Domestic Policies

In the aftermath of the 1982 international debt crisis,

economists were surprised to lea..rn that a large part of the

Michael P. Dooley
and Kenneth M. Kletzer
Visiting Scholar, Federal Reserve Bank: of San Francisco,
and Professor, Department of Economics, University of
California, Santa Cruz; Professor, Department of Economics, University of California, Santa Cruz.

The international debt crisis of 1982 revealed that unrecorded private capital outflowsfrom developing countries
occurred simultaneously with borrowing from international commercial banks. Current interest in capitalflight
has been generated by the possibility that the resurgence of
private capital inflows to these countries may be limited to
the return of.flight capital. A simple public finance model
shows that simultaneous capital outflows and inflows can
be explained as the result ofprivate international arbitrage
of domestic policies. Tr.e paper discusses tlu! welfare
consequences of gross two-way capital flows that take
advantage of opportunities to avoid taxation or generate
subsidy income.

borrowing of developing countries from international commercial banks was matched not by net imports ofgoods and
services, but instead by unrecorded private capital outflows
from developing countries. A satisfactory explanation for
why residents of a country simultaneously borrow and lend
on international markets clearly calls for a model that
explains patterns of financial intermediation rather than
conventional models for net investment opportunities in
different countries.
This article focuses on a measure of "capital flight"
developed in Dooley (1986) that captures unrecorded private capital outflows and on a number of theoretical
models that might help understand this measure of capital
flight. Interest in capital flight recently has been rekindled
by the resurgence of private capital inflows to developing
countries after nearly a decade of very limited capital
flows. At issue is whether this reflects a "discovery" of
emerging markets by residents of industrial countries or a
return of capital flight by residents of the developing
countries. In either case, it is a private capital inflow. But if
the "home bias" of portfolios of industrial countries really
is being reduced, then the potential for continued inflows
seems very large; in contrast, if the "home bias" of residents of developing countries is being increased by a reduction of capital flight claims on industrial countries, the
scope for continued private inflows is quite limited. The
data seem more consistent with the second interpretation.
We are concerned with the sources of capital flight and
with the welfare consequences of capital flight in the
presence of the policy and institutional environment that
gives rise to it. The next section elaborates on the definition
and estimation of capital flight and reports estimates of
capital flight from 1971-1991 for a sample of 84 developing
countries. Section II presents a simple public finance
model to discuss the effects of different tax treatments for
resident and nonresident holders of claims on domestic
assets. Section III analyzes capital flight using this model
and emphasizes that capital income taxation that varies de
facto by residence and source leads to two-way gross
financial capital flows. The model incorporates a welfareimproving role for capital income taxes. The welfare
consequences of capital flight in this model are due to the

FRBSF ECONOMIC

REVIEW

1994, NUMBER 3

restrictions its possibility imposes on the effectiveness of
these taxes and, therefore, on the fiscal instruments for a
social welfare-maximizing government.
Section IV discusses the welfare effects of capital flight
in the presence of financial market imperfections. In this
case, capital flight can lead to inefficient international
allocations of physical capital stocks. In Section V, subsidies to foreign lenders and their contribution to capital
flight are discussed. Section VI concludes.

I. DEFINITION AND MAGNITUDE
OF CAPITAL FLIGHT
We define "flight capital" as the accumulation ofresidents'
claims on nonresidents that escape control by domestic
governments-that is, that are not subject to taxation,
regulation, or, in extreme circumstances, confiscation.
The method for estimating capital flight (Dooley 1986,
1988) involves calculating the total stock ofexternal claims:
Specifically, sum recorded claims on nonresidents less
direct investments abroad using balance of payments data,
cumulated errors and omissions from the balance of payments accounts, and an estimate of the unrecorded stock of
external claims. The starting value for the cumulated
balance of payments data is estimated by capitalizing
investment income receipts for the initial year; errors and
omissions are included because they often are associated
with accumulations of financial claims on nonresidents
that might include unrecorded capital flows along with
many other forms of assets.
The balance of payments data are known to underestimate seriously the full stock of external debt (using the
World Bank data, among other sources). If these data are
correct, then some sort of balancing transactions also must
be underestimated. These can include any type of foreign
transaction, including imports of goods and services or
purchases of financial claims on nonresidents financed by
the accumulation of unrecorded external debt. Since the
type of transaction cannot be discerned, we assume that all
of the unrecorded debt increases are balanced by increases
in private claims on nonresidents that are not reported in
the balance of payments records.
Next we subtract the stock of claims implied by investment income receipts and market interest rates. Because
this stock of claims represents the portion that earns
income reported in the balance of payments accounts, and
therefore is within the control of domestic authorities, it
can be considered to result from normal portfolio diversification motives rather than from capital flight.
Dooley (1986) compares the yield implied by reported
investment income to the accumulated external claims

from the balance of payments data and to the estimated
total of external claims for several major debtor countries.
These estimates suggest that a significant share of the income earned from claims on nonresidents is not reported in
the balance of payments system and therefore is attributable to the returns to flight capital. The difference between
the estimate of total external claims by nonresidents excluding direct investment abroad and the estimate of assets
on which interest earnings are reported is the estimate of
capital flight intended to measure claims on nonresidents
that are beyond the control of the home government. This
procedure leads to larger estimates of capital flight than of
unrecorded external debt accumulations plus errors and
omissions.
Claessens and Naude (1993) updated estimates of capital flight using this definition ("the Dooley Measure") for
84 developing countries between 1971 and 1991; their
results are summarized in Figure I, which also shows an
estimate of capital flight sometimes used by the World
Bank (the "World Bank Residual Measure"). The comparison of these two measures is interesting because they
are conceptually identical except that the "Dooley Measure" subtracts gross claims for which interest income is
reported in the balance of payments.

FIGUREl
COMPARISON OF MEASURES OF CAPITAL FLIGHT
IN ANNUAL FLOWS

$ u.s. (billions)
200
100

0---,,;:

-100

-200
Dooley

-300

DOOLEY AND KLETZER / CAPITAL FLIGHT

Clearly, this distinction made little difference for the
quantitative measure of capital flight for this group
of countries until 1990 and 1991. The dramatic reversal of
capital flight in 1990 and 1991 according to the "Dooley
Measure" helps explain the large recorded capital inflows
that have dominated recent developments in emerging markets. Indeed, to the best of our knowledge, this finding is
the only direct evidence in support of numerous specula-

tions that what appear to be purchases of emerging market
assets by residents of industrial countries are in fact the
return of flight capital.
As Claessens and Naude point out, the divergence
between the two measures reflects the fact that reported
investment income in 1991 was double that level for 1989,
while interest rates on dollar-denominated instruments fell
by about 30 percent. Our interpretation of these data is that
residents of developing countries have sold off their capital
flight positions in order to purchase assets denominated in
their home countries' domestic currencies. This is incorrectly recorded as an increase in liabilities to nonresidents
in the developing country's balance of payments. The correct entry would be a reduction of private residents' claims
on nonresidents. About half of this inflow has been offset
by official exchange market intervention or by an increase
in official claims on nonresidents. Since the interest income on official reserves is recorded in the balance of
payments, the "Dooley Measure" correctly captures the
decline in the stock of private flight capital. Moreover,
the magnitude of the reversal of capital flight in 1990-1991
is greater than OECD estimates of all private borrowing
by non-OECD countries on international capital markets.
While interesting in themselves, these data tell us nothing
about the motivation behind two-way capital flows that
have dominated international financial markets for the past
20 years. For that, we turn to alternative models of international financial intermediation in the following sections.

n. PUBLIC FINANCE MODEL
The analytical framework for capital flight developed in
this section emphasizes the role of policies adopted by the
domestic government and residents' opportunity to avoid
the impact of those policies on the net income from their
asset holdings. Policies often treat resident and nonresident
holders of claims on domestic assets differently. As a consequence, capital flight and external capital inflows can be
seen as an outcome of international arbitrage of domestic
policies. In practice, the types of policies that can lead
to capital flight vary by residence of the investor, and
can include explicit capital income taxes, restrictions on
the menu of assets available to residents different from
those available to nonresidents, subsidies-including con-

tingent ones-to investment by nonresidents, and outright
confiscation.
The effective taxation of capital income frequently varies both by its source and by the residence ofits recipient.
In many cases, domestic investors' total tax burden on
capital income exceeds that of foreign holders of domestic
claims. When residents hold assets beyond the reach of
their home government, they will tend to realize higher
risk-adjusted post-tax returns for claims on nonresidents
than for claims on domestic assets. Under these circumstances, foreign creditors can have an incentive to
invest in domestic assets when residents do not. Such
differences in effective rates of taxation of asset income
will lead to gross capital outflows and inflows that are
unrecorded in balance of payments data exceeding any net
capital flow.
It is often much more difficult to avoid paying residencebased capital income taxes on income earned from domestic assets than from claims on nonresidents unreported
to domestic fiscal authorities. Such taxes become both
residence-based and source-based, de facto applying only
to domestic capital income earned by residents. The taxes
that can lead to differential burdens for residents and
foreign holders of domestic claims may be anticipated
rather than statutory. For example, in many cases residents
can hold only deposits in the domestic banking system that
are denominated in the domestic currency and are subject
to a reserve requirement, while foreign investors can
acquire claims on domestic intermediaries denominated in
foreign currency that do not require the holding of noninterest-bearing reserves. Resident savers usually receive
below-market interest rates on reserves and face potential
inflation taxes on these deposits, so that nonresidents
receive a higher anticipated post-tax rate of return for
claims on domestic capital.
More generally, when residents do not have access to the
same range of domestic financial instruments as do nonresidents, the contingent taxes imposed by and subsidies
provided by domestic authorities differ for the two types of
creditors. For example, external debt may be denominated
in foreign currency while domestic deposits may only be
available denominated in local currency. Nonresidents can
purchase an asset yielding a different distribution of returns than residents can. As a consequence, the risks and
returns associated with domestic claims differ by the
residence of the investor. This leads to international portfolio diversification, but it does not by itself lead to capital
flight. Capital flight arises when residents avoid anticipated taxation of domestic deposits (for example, through
inflation) and of the gross earnings on reported foreign
assets. Acquisition of assets abroad for both groups then
represents international arbitrage of these tax rules or

FRBSF ECONOMIC REVIEW 1994, NUMBER 3

anticipated levies. The extent to which residents take
advantage of such opportunities is estimated by a measurement of the claims on nonresidents that are unreported in
the balance of payments records.
One concern over capital flight is that private external
debts are socialized, or the payments on these debts are
subsidized by the government. These can lead to the
accumulation of private claims on nonresidents by residents that do not provide foreign exchange earnings avaiiable to the public sector for debt interest payments. Such
subsidies, which often are contingent liabilities for the
government, provide benefits for foreign lenders and,
possibly, private domestic investors.
These ideas can be addressed more formally in a stylized
two-period model of a small open economy with a single
composite good that can be used for private consumption,
public consumption, and investment. In the first period,
the country has an initial endowment of the good, and
households choose a consumption and saving allocation.
Domestic saving can be allocated to investment in home
capital or used to purchase claims on nonresident capital
earnings. External borrowing also is possible, allowing
nonresidents to acquire claims on income produced by
domestic capital. In the second period, output and net
income from investment abroad are allocated to private and
public consumption. The government provides public consumption goods and raises revenue using non-lump-sum
taxes. The instruments available to the fiscal authority
include taxes on labor income, source-based taxes on domestic capital income, and residence-based taxes on investment income. Taxes can be levied at positive or negative
rates (subsidies).
Fiscal authorities face difficulties enforcing compliance
with taxes on foreign source income. We assume that
domestic residents are able to invest in foreign claims
providing income that is beyond the control of national
authorities and therefore untaxable in practice. The model
also allows domestic capital income paid to foreign residents to be taxed at different rates from home source capital
income paid to residents.
Production of output requires inputs of labor and capital using a standard concave technology, given in laborintensive form by j(k). The household sector is represented
by a single household with the utility function
(1)

U = u(c 1, c2 ' 1)

Domestic claims on nonresidents are denoted by B, and
foreign claims on domestic capital are denoted Kf The
share of the domestic capital stock owned by residents is
the difference between K and Kf Note that foreign claims
on residents and residents' claims on foreigners are gross.
This model parallels that of Razin and Sadka (1989), but
they do not allow nonresident claims on residents.
The household budget constraints in each period, respectively, are given by
(2)

+ B + (K - Kf)

= y,

and

(3)

B (l + r*(1 - z tr ))

+ (K - Kf) (l + r(1 - tr )(1 - ts))
+ wl (l - t[).
The tax rate on capital income by residence is given by tr ,
the tax rate on domestic source capital income is given by
ts' and the tax on labor income is given by t[. The rate of
compliance with residence-based capital income taxes for
assets held abroad is measured by z, which takes values
between zero and unity: When z is zero, domestic fiscal
authorities are unable to tax any of the earnings from
claims on nonresidents held by residents; when z is unity,
evasion of investment income taxes is not possible. The
initial endowment of the composite good is y, the wage rate
is w, the domestic (pre-tax) interest rate is r and the foreign
interest rate is r* (net of any foreign source-based taxes).
Suppose that international financial capital mobility is
unrestricted and that this country is small relative to the rest
of the world. Then foreign savings always will flow into the
domestic economy if the post-tax rate of return to foreign
capital is less than the rate of return to domestic capital
after source-based taxes. In equilibrium, the post-tax rate
of return to foreign capital, r*, must be at least as great as
the post-source-based-tax rate of return to domestic capital, (1- ts)r. Therefore, foreign savers will hold claims on
domestic capital only if these two net rates of return are
equal. If r* exceeds (1- ts)r, then domestic residents also
earn a higher return to claims on foreign capital than on
domestic capital after source-based and residence-based
taxes are imposed, so that the domestic capital stock would
be zero. 1 Therefore, assuming that the Inada conditions2

v(g)

where C1 ' C2 ' 1, and g are first-period consumption, secondperiod consumption, leisure consumption, and public
goods consumption, respectively. The initial endowment of
leisure is L. For simplicity, household preferences are
additively separable between public goods and private
goods consumption.

1. This holds for any z between zero and one as long as tr is non-negative.
It also holds for a residence-based subsidy (tr negative) when z is one.

When a subsidy is paid, z should be one, since rational savers would
comply fully.
2. These are thatf'(k) tends to infinity as k tends to zero andf'(k) tends
to zero as ktends to infinity. We also assume thatf(k) is strictly concave.

DOOLEY AND KLETZER / CAPITAL FLIGHT

hold for f(k), we have in equilibrium under perfect financial
capital mobility that
(4)

r* = (l - ts)r.

If z is less than one, then we also have that
(5)

r* (l - z tr )

(1 - ts) (1 - tr ) r.

Equilibrium demand for capital by the firm in the home
count..ry is determined by equality of the marginal product
of capital and the pre-tax rate of interest:
(6)

f'(k) = r.

Household optimization yields consumption demands that
depend upon the tax rates through their effects on the income and the relative price of second-period consumption.

ill.

CAPITAL FLIGHT AND
THE PuBLIC FINANCE PROBLEM

Suppose that domestic savers cannot avoid residence-based
capitalincome taxes by purchasing claims on nonresidents.
In this case, a small country social planner choosing to
maximize the welfare of the representative household
optimizes by financing public goods spending using a
combination of a labor income tax and a residence-based
capital income tax. In the solution, the rate of sourcebased capital income taxation is zero, so that the first-order
condition for an optimum

(7)

f' (k)

= f*' (k*)

is satisfied.
The solution for the optimal tax and public goods supply
problem when there is no issue of tax compliance is wellknown. The rates of tax imposed on labor income and on
interest income of residents are chosen so that the disutility
of the last unit of revenue raised from each is equal when
both taxes are positive. We skip elaborating this rule
analytically. It should be noted that such an equilibrium
plan is not Pareto efficient if labor supply is not perfectly
elastic, since all taxes are distortionary.
Now suppose that both source-based and residencebased taxes are available to domestic fiscal authorities, but
that residents are able to avoid taxes on claims on foreign
capital earnings (z = 0). In this case, any positive rate of
residence-based capital income tax implies that no domestic claims are held by residents and all domestic capital
income is paid to foreign claimants. In the absence of
controls on financial capital outflows, the government
collects no revenue from residence-based capital income
taxes, and all public consumption spending must be financed by taxes on capital earnings that distort the international allocation of production activities and on labor

income that distort consumption-leisure choices and labor supply. Source-based taxes are assumed to be enforceable, but these result in different marginal productivities of
capital at home and abroad. Again, the optimal tax rule is
found by straightforward maximization of representative
household utility subject to the necessary conditions for
private optimization by the household and firm and the
constraint that residence-based taxes raise no revenue.
Social welfare is reduced by the possibility of capital
flight in this model. This is because capital flight is a
consequence of the ability of households to avoid capital
income taxes levied on a residence basis. The effective
marginal tax rate on capital that can be achieved. on a
residence basis is zero. Reducing the residence-based
capital income tax rate to zero can eliminate capital flight in
this model (for arbitrarily small transactions costs associated with the acquisition of foreign assets) and results in no
loss oftax revenue. The restriction in the set ofdistortionary
fiscal instruments available to the government results in
lower maximized social welfare. Capital flight is another
consequence and the channel through which residents
escape the control of national fiscal authorities.
It should be noted that both enforceable residence-based
and source-based capital income taxes affect the net external asset position ofthe country. In general, an increase in a
source-based tax will lead to a net capital outflow, an
increase in a residence-based tax will cause a net capital
inflow, and with enforceable taxes of both types, the net
and gross capital outflow will be equal. However, this is not
the case when residents cannot be effectively taxed on
foreign asset earnings. In the case of this model with no
constraints on external financial capital inflows, all domestic saving goes abroad if tr is positive and all domestic
capital income is owed to foreign residents. The gross
outflow is much larger than the net capital outflow, which
may be positive or negative. This is because domestic
authorities can only effectively tax domestic capital income, although at different rates for nonresident and for
resident claimants.
Given that capital flight is possible, the social welfaremaximizing government would choose to impose controls
on financial capital outflows. Such restrictions can help to
resolve the public finance problem for the government by
reducing the ability of residents to acquire assets earning
income that cannot be taxed. Imposing a complete (assuming enforceability) ban on the acquisition of all claims on
nonresidents leads to a domestic marginal product of
capital that is no greater than the foreign rate of interest:
(8)

(1 - ts)f'(k) = r*, if K!> 0, and
(l - ts)f'(k)

< r*,

if K! = O.

FRBSF ECONOMIC REVIEW

1994,

NUMBER

The equilibrium domestic interest rate can be below the
foreign interest rate when no residence-based and sourcebased capital income taxes are imposed if domestic savings
are adequate to finance all domestic capital. In this case, an
appropriate choice of the residence-based, or equivalently,
source-based, capital income tax can be made so that the
marginal productivity of capital is equal across borders.
However, even if enforceable capital controls are feasible the potential for capital flight still can pose a public
finance problem. The optimal policy for a government that
maximizes the household's utility is to impose capital
controls at some positive level and a residence-based
capital income tax along with a positive rate of labor
income tax in the general case for this model. It will never
be optimal to choose capital income taxes that lead to the
inequality

(9)

j'(k)

< r*.

That is, such a government will not want to impose a
source-based or residence-based tax (with the caveat that
this applies only to residents' holdings of domestic financial assets) and level of capital control that results in a
marginal productivity of capital below the foreign marginal productivity of capital. If it did, it could relax the
quantitative restraint on capital outflows and/or the rate of
taxation of domestic capital income and tax rate on labor
income to reduce the home capital stock and achieve a
more efficient allocation of domestic saving and global
production.
The optimal tax and quantitative restriction on capital
outflows can lead to an equilibrium in which domestic
saving and investment are equal and the marginal productivity of domestic capital is less than the foreign interest
rate. The reason is simply that the optimal level of public
goods spending and distortionary effect of a labor income
tax with no capital outflow imply a higher rate of taxation
on domestic capital than allowed by the restriction that
I' (k) equal r*, when k equals equilibrium domestic saving
per unit of labor. Capital controls are a second-best fiscal
policy instrument to enforceable taxes on capital income
from all sources for residents in such cases. When the
optimum allows the equality
(7)

j' (k) = j'*' (k*)

to be satisfied, then full tax compliance and perfectcapital
controls are substitutes. 3

3. Razin and Sadka derive the optimal restriction on capital outflows for
their model in which domestic capital cannot be purchased by foreign
residents. When residents' foreign capital income cannot be taxed at the
same rate as their income from domestic capital, optimal capital

PREFERENCES OF INTERMEDIARIES
FOR INVESTING AT HOME OR ABROAD

In addition to the problem of efficient revenue collection to
finance public spending programs, other welfare costs can
be associated with capital flight induced by domestic taxes.
One such cost may be due to intermediaries' preferences to
invest in projects in their home country. For example, it is
reasonable to think that intermedia.ries face lower costs of
acquiring information about a borrower's actions and appealing to the power of the state to ensure contractual
compliance when they lend within their home country.
When information is imperfect, so that monitoring is
costly, intermediaries may not invest abroad, even if the
otherwise risk-adjusted expected rate of return is higher.
In the presence of such intermediation bias, claims on
nonresidents will tend to increase foreign capital stocks
and reduce domestic capital stocks, ceteris paribus. A
simple model illustrates the point. Suppose that foreign
intermediaries require a premium for investment returns in
the small country over the interest they are able to earn at
home. In an equilibrium with positive external inflows of
financial capital,
(10)

r*+p=r,

where p is this premium.
Consider a special case in which domestic saving and investment are equal and the rates of interest at home and
abroad are equal in the absence of any capital income taxes
in the home country. Suppose that the domestic government
now imposes a residence-based capital income tax such
that
(11)

r* > (1 - trHr*

+ p),

and (10) holds. This implies that capital flight occurs
according to the definition used in this paper. Imposition of
the tax reduces the domestic capital stock per worker,
raisingj' (k) from r* to r* + p. If a tax rate low enough to
reverse the inequality in (11) is imposed, then we have
(12)

r* = (1 - tr) r,

controls are set so that the equilibrium capital stock exceeds that which
is optimal if all capital income of residents can be taxed. This is due to a
distortion caused by the tax on domestic capital income and the
production distortion (marginal reduction in national income) caused by
capital controls.
This result does not follow in our model since the domestic capital
stock is determined by the marginal conditions for foreign investors. For
a given source-based capital income tax, binding controls on capital
outflows lead to a one-far-one substitution of nonresident for resident
ownership of capital. The optimal source-based tax does not depend on
whether or not foreign capital earnings of domestic residents can be
taxed at the same rate as their domestic capital income.

DOOLEY AND KLETZERI CAPITAL FLIGHT

in equilibrium, and there are no capital inflows, although
there is a net capital outflow as residents acquire claims on
nonresidents.
The presence of financial market imperfections of this
type implies that capital flight-defined as a consequence
of domestic policies and access to opportunities to avoid
their impact 011 private net asset income-has welfare
implications .. It leads to an inefficient allocation of capital
across countries and welfare losses for the home country.
These welfare losses arise because domestic savers are
induced to place their assets abroad to avoid taxation by the
home country. The preferences of intermediaries abroad
over claims in the two countries differ from those of
domestic intermediaries. This means that the supply
of capital abroad rises with capital flight while the stock of
capital. at home declines. This contrasts with the case
of perfect international capital mobility in which foreign
lenders simply took over the task of intermediating between domestic savers and domestic investors.
One policy remedy when capital income taxation is
desirable is to impose capital controls as before. Again, in
contrast with the analysis of the previous section, imposition of a residence-based capital income tax does nofleave
the domestic rate of interest equal to the foreign rate of
interest. Foreign intermediaries will not purchase domestic
claims until the domestic pre-tax rate of interest has risen
sufficiently to overcome the additional costs of monitoring
investments in another country.
An interesting extertsion of this result is the case in
which domestic intermediaries do a very poor job of credit
selection, perhaps because of government controls on
lending decisions. In this case, moving funds offshore
might increase the effective level of domestic investment
assuming foreign intermediaries can overcome· information costs and make better investment decisions.

SUBSIDIZATION OF FOREIGN LENDERS

Capital flight often is linked to the socialization of private
external debt or the subsidization of payments on these
debts. This issue was raised by Diaz Alejandro (1984), who
argued that the foreign. exchange earnings accruing to
private assets placed abroad were unavailable to the government that is obliged to make interest payments to
nonresidents. Private external debt appears to have financed the accumulation of claims on nonresidents that are
placed outside the reach of domestic governments. When
these debts are subsidized, the government bears a burden
while foreign investors and the private domestic claimant
receive the benefits.
Subsidies to foreign capital inflows often take the form
of contingent subsidies, providing insurance to nonresi-

dents that is unavailable to residents. Private intermediaries frequently have been able to borrow from abroad
under explicit or implicit government guarantees of the
debts to the foreign creditors. These guarantees can have
adverse incentive effects for investment choices by the
intermediaries, thus leading to the standard arguments for
public monitoring of investment actions by publicly insured intermediaries. Domestic intermediaries have an
incentive to invest in risky projects since they receive
returns only in the upper tail of the distribution for returns.
In the absence of adequate monitoring of the actions of
domestic investors, domestic savers may anticipate that domestic external borrowing will lead to higher tax rates in
the future because, as domestic intermediaries maximize
their expected returns by selecting risky projects, the value
of the contingent liability of the government rises. Anticipated future capital income taxes will induce capital flight
if it is possible to place assets beyond the reach of domestic
authorities. Eaton (1987) presents a model based on these
notions in which there are multiple equilibria, one of which
involves no capital flight and private debt repayment and
another which involves capital flight and private default.
The role of subsidies to foreign investors for capital
flight can be discussed in the model used to analyze the
effects of taxes on capital income accruing to residents.
Subsidies available to nonresident asset holders but not to
resident investors under perfect international financial capital mobility will lead to an increase in the domestic capital
stock and cause all domestic savings to be placed abroad,
since equilibrium requires that
(13)

r* = (l

+ s)!,(k),

where s is the subsidy rate. By itself, this is not sufficient to
cause capital flight as defined here. Domestic residents
have an incentive only to purchase claims on nonresidents,
but not to place these outside the control of the domestic
government.
Subsidies differ from capital income taxes in that the
limits on the magnitude of the gross flows are different.
The gross capital outflow under perfect international capital mobility when a capital income tax is levied only on residents is given by the total of domestic savings. The opportunity return on domestic assets held by residents is less
than the return to flight capital, but the opportunity interest
cost of borrowing externally is the same as the interest received by relending. If foreign borrowing is subsidized, then the limit on resources that might be available
for investing abroad at a net gain is the extent to which
the subsidy will be offered, that is, the extent to which the
government will subsidize borrowing from abroad to purchase claims on nonresidents that it cannot tax. This might
be called the "extent of the government's stupidity."

FRBSF ECONOMIC REVIEW 1994,

NUMBER

Policies that subsidize nonresident holders of domestic
assets lead to capital flight if the subsidies allow external
debt to finance residents' purchases of claims on nonresidents that generate income untaxable by the government.
Such subsidies may occur through contingent liabilities for
the government. In this case, the social cost ofthe subsidies
is the utility reduction due to a loss of national income
equal to the total subsidy paid to foreign lenders. There
also can be domestic distributional effects that may be of
concern to policymakers in a world with heterogeneous
households (Alesina and Tabellini 1989). It should be noted
that this process also could concern foreign investors. As
the tax base for raising the revenue needed for repayment
erodes and the likelihood that the government will realize
large contingent liabilities rises, foreign holders of domestic claims enjoying public guarantees may anticipate renegotiation by the government. That is, foreign investors
may realize the ability and willingness of the government
to honor these explicit or implicit contingent commitments. Anticipating the possibility of such capital levies,
nonresidents should behave in a time-consistent fashion.
The possibility that subsidies and guarantees generated
lending to developing countries that led up to the 1982 debt
crisis suggests that recent large private capital inflows to
developing countries also might be a cause for concern. It
seems likely to us that once again private capital inflows are
being sustained not only by the more favorable investment
climate, but also by opportunities generated by the governments of developing countries. The form of the incentive is
a little different from the external debt-capital flight pattern that led up to the 1982 debt crisis.
But in one important respect the recent private capital
inflows are similar in that they are sustained by a contingent claim on the government. The distinguishing feature this time is that recent private capital inflows to
developing countries have taken the form of domesticcurrency-denominated instruments including equities, corporate bonds, bank deposits, and government securities
(Gooptu 1993). This is certainly different from the dollardenominated, government-guaranteed, syndicated credits
that comprised the debt buildup before 1982.
In the current pattern of capital flows it is less obvious
that the government ofthe borrowing country has provided a
guarantee. However an implicit guarantee is provided by
the increasingly popular use of the exchange rate as an anchor for inflationary expectations. In basing its credibility
on the maintenance of a fixed or managed exchange rate,
the government, in effect, provides an exchange rate guarantee for the investor in domestic-currency-denominated
instruments.
This, of course, seems to leave the investor with a credit
risk. But in most emerging markets the government is very

likely to provide a credit guarantee as well as the exchange
rate guarantee. In cases where international investors buy
government securities, the guarantee is explicit. Commercial bank deposits also are guaranteed, especially where
the deposit is denominated in domestic currency.
Finally, even the liabilities of domestic nonfinancial
corporations carry a strong government backup. This is
because such firms are heavily indebted to the domestic
banking system. If nonresident creditors want out, these
firms can be expected to ask for and receive credit from the
domestic banks. To refuse would depress the market value
of the banks' existing claims on the domestic firms and call
into question the solvency of the domestic banking system.
What limits this process? As long as the developing
country's central bank maintains domestic nominal interest
rates at levels above those available on similar foreign
assets then, in principle, there is no limit to the private
capital inflows generated. Of course, in reality the government's resources are limited. At some point the market will
begin to doubt the government's ability to maintain the
exchange rate peg and the negative carry resulting from
the low return earned on reserves relative to that paid on the
domestic liabilities issued in sterilized exchange market
intervention. But the scale of private capital inflows necessary to exhaust the central bank's expected net worth can
be very large indeed.

VI.

CONCLUSION

We define flight capital as the accumulation of claims on
nonresidents by residents that escape control of the domestic government. Capital flight by this definition is estimated
by a calculation of gross external claims that generate
income that is not reported in the balance ofpayments data.
Our approach emphasizes the importance of public
policies and anticipated policies for the domestic government in the presence of international capital mobility and
possible evasion of taxation or appropriation by the home
government by domestic savers. Capital flight represents
an arbitrage of the different treatment of resident and
nonresident investors by domestic authorities.
The policies that give rise to capital flight are distortionary in the model presented here, but they are not necessarily
simply undesirable. In the case of optimal public goods
supply without lump-sum taxes, a residence-based capital
income tax is part ofthe efficient policy, iftax compliance is
perfect. The problem of social welfare losses arises because
tax avoidance (or evasion) is possible. The second-best
solution with capital controls includes residence-based
taxes. Without feasible capital controls, the residencebased capital income tax is entirely ineffective for raising
revenue under perfect international capital mobility. In this

DOOLEY AND KLETZER/CAPITAL FLIGHT

case, the social cost of capital flight is the welfare cost of
losing a useful instrument offiscal policy. Capital flight also
can result from the adoption of distortionary policies that
are not welfare-improving. In these instances, it can exacerbate the welfare losses.

REFERENCES
Alesina, Alberto, and Guido Tabellini. 1989. "External Debt, Capital
Flight and Political Risk." Journal ofInternational Economics 27,
pp. 199-220.
Claessens, Stijn, and David Naude. 1993. "Recent Estimates of Capital
Flight." World Bank Working Paper, WPS 1186 (September).
Diaz Alejandro, Carlos F. 1984. "Latin American Debt: I Don't Think
We Are in Kansas Anymore." Brookings Papers on Economic
Activity 2.
Dooley, Michael P. 1988. "Capital Flight: A Response to Differences in
Financial Risks." StaffPapers International Monetary Fund 35 (3)
(September).
_ _ _ _ . 1986. "Country-Specific Risk Premiums, Capital Flight
and Net Investment Income Payments in Selected Developing
Countries." Unpublished paper. International Monetary Fund
(March).
Eaton, Jonathan. 1987. "Public Debt Guarantees and Private Capital
Flight." World Bank Economic Review 1 (May).
Gooptu, Sudarshan. 1993. "Portfolio Investment Flows to Emerging
Markets." World Bank Working Paper, WPS 1117 (March).
Razin, Assaf, and Efraim Sadka. 1989. "Optimal Incentives for Domestic Investment in the Presence of Capital Flight." NBER Working
Paper No. 3080 (August).

Full text of Economic Review (Federal Reserve Bank of San Francisco) : 1994, Number 3

FRASER