Financial Integration, Entrepreneurial Risk and Global Imbalances

How does financial integration impact capital accumulation when countries differ in the efficacyof internal financial markets? We examine this question within a two-country incompletemarketsmodel featuring a specific financial friction: agents face uninsurable idiosyncratic riskin their investment, or entrepreneurial, opportunities. Under financial autarchy, the South (thecountry with the least developed risk-sharing possibilities) features a higher precautionary motivefor saving and a lower risk-free rate, but also a lower capital stock and lower output. Uponfinancial integration,capital flies out of the poor, capital-scarce South, causing a prolonged deepin domestic activity. At the same time, the rich, capital-abundant North runs large currentaccountdeficits and enjoys a prolong boom. However, these effects are more than reversed in thelong run: as time passes, capital starts flowing back into the South, eventually leading to higherdomestic activity than under autarchy. Taken together, these results help explain the emergenceof global imbalances while also providing a distinct policy lesson regarding the intertemporalcosts and benefits of financial integration.