Published by EH.NET (December 2004)
Maurice Obstfeld and Alan M. Taylor, Global Capital Markets: Integration, Crisis and Growth. New York: Cambridge University Press, 2004. xviii + 354 pp. $65/?45 (hardback), ISBN: 0-521-63317-6.
Reviewed for EH.NET by Marc D. Weidenmier, Department of Economics, Claremont McKenna College.
Obstfeld and Taylor survey the history of international capital markets from the classical gold standard to today using modern economic theory in their monograph, Global Capital Markets: Integration, Crisis and Growth. The authors synthesize history and modern economic theory to produce an illuminating discussion of the forces that drive international financial market integration. The book is divided into four parts. Part One reviews the theoretical foundations of open economy macroeconomics and outlines the basic argument of the book. Obstfeld and Taylor discuss how international capital markets allow residents of different countries to pool risks, impose discipline upon governments, and allow countries with very little domestic savings to borrow abroad so that they can pursue growth policies. The authors also introduce the open economy macroeconomic policy trilemma to provide a theoretical framework for their subsequent historical and economic analyses. The open economy macroeconomic trilemma states that a country can pursue at most two elements of the “inconsistent trinity”: (1) open capital markets, (2) independent monetary policy, and (3) a fixed exchange rate.
Obstfeld and Taylor analyze the historical development of global capital markets in Part 2. They employ quantity and price evidence to measure capital mobility during the classical gold standard, inter-war gold standard, Bretton Woods period, and the recent float (1973-present). Using a new macro database assembled from primary and secondary sources, they examine purchasing power parity, the correlation of saving and investment, covered interest parity, and real interest rate convergence. They find that global capital market integration has followed a U-shaped pattern since the outbreak of World War I. Integration peaked during the classical gold standard period, declined during the inter-war period, only to recover during Bretton Woods. They note that market integration has increased dramatically in the last twenty years. Obstfeld and Taylor conclude that net flows of foreign capital are no larger today than they were during the classical gold standard period.
In Part 3, the authors discuss the role of institutions in shaping the evolution of international capital markets. They review the history of international monetary arrangements and measure the degree of monetary independence under fixed and floating exchange rates. In accordance with the policy trilemma, they find that countries with fixed exchange rates have had very little ability to conduct independent monetary policy with open capital markets. Then they test the effect of political and economic institutions on sovereign risk during the classical and inter-war gold standards. They find that being a member of the gold standard reduced the cost of capital during the classical gold standard but not during the inter-war period. Membership in the British Empire lowered sovereign risk in the inter-war period, but not during the classical gold standard period. Obstfeld and Taylor also find that countries with high public debts were charged higher interest rates after World War I, suggesting that policymakers lost the ability to conduct independent policy. Their findings indicate that the inter-war gold standard was less credible than the classical gold standard.
The authors conclude with a discussion of the policy lessons from their historical examination of international capital markets. They note that there are winners and losers from globalization and it is very difficult to quantify the costs and benefits of open capital markets. Financial liberalization, for example, is not (p. 299) “a universal panacea” or “a risk never worth taking.” Their main lesson is that policymakers must take into account country-specific institutions and economic conditions before giving policy advice, especially to developing countries.
Although Obstfeld and Taylor provide a thorough empirical analysis of international capital markets, some of their findings warrant additional research. In their chapter comparing sovereign risk in the classical and inter-war gold standards, they find that being a member of the British Empire reduced the cost of capital in the interwar, but not the classical gold standard. It is unclear why this would be the case. Their results may simply be driven by a very small number of British colonies in their sample. It would be interesting to expand the coverage of their sample to further test for the existence of an empire effect in both periods. Second, Obstfeld and Taylor often use time averaged rather than point-in-time data to estimate financial market integration in their analysis of deviations from covered interest parity. A number of studies have shown that a point-in-time analysis of covered interest arbitrage can yield very different results (M.P. Taylor, 1987). Third, the authors discuss at length the theoretical proposition that financial markets allow investors to pool risks and smooth consumption. A long-run empirical analysis of historical consumption data across countries and monetary regimes might be a useful exercise to shed some additional insight into this question. This type of study would probably be limited, however, given the availability of historical data on aggregate consumption.
Overall, Global Capital Markets is an excellent study of the evolution of international capital markets since the classical gold standard period. This book is a must read for economists and economic historians with an interest in international economics.
Marc D. Weidenmier is an Assistant Professor of Economics at Claremont McKenna College and a Faculty Research Fellow at the NBER. He has recently published the following papers: “Gunboats, Reputation, and Sovereign Repayment: Lessons from the Southern Confederacy,” Journal of International Economics (forthcoming), “Real Shock, Monetary Aftershock: The San Francisco Earthquake and the Panic of 1907” (co-authored with Kerry Odell), Journal of Economic History (forthcoming), and “Empire, Public Goods, and the Roosevelt Corollary” (co-authored with Kris Mitchener), Journal of Economic History (forthcoming).