By Jonathan Heathcote and Fabrizio Perri
This paper is structured in three parts. The first part outlines the methodological steps, involving both theoretical and empirical work, for assessing whether an observed allocation of resources across countries is efficient. The second part applies the methodology to the long-run allocation of capital and consumption in a large cross section of countries. We find that countries that grow faster in the long run also tend to save more both domestically and internationally. These facts suggest that either the long-run allocation of resources across countries is inefficient, or that there is a systematic relation between fast growth and preference for delayed consumption. The third part applies the methodology to the allocation of resources across developed countries at the business cycle frequency. Here we discuss how evidence on international quantity comovement, exchange rates, asset prices, and international portfolio holdings can be used to assess efficiency. Overall, quantities and portfolios appear consistent with efficiency, while evidence from prices is difficult to interpret using standard models. The welfare costs associated with an inefficient allocation of resources over the business cycle can be significant if shocks to relative country permanent income are large. In those cases partial financial liberalization can lower welfare.
While the allocation (or misallocation) of resources within a country, a sector or a firm are much studies, the international allocation is rarely looked at. This monumental paper, a forthcoming chapter in the Handbook for International Economics surveys the relevant literature, lays out the methodological foundations and takes a quantitative example with business cycle fluctuations among developed economies. The last statement of the abstract is intriguing. Indeed, financial autarky may be preferable in some circumstances, namely when shocks generate large differences in permanent income (very persistent, large innovations). The reasons is that if you only have bonds, they provide poor insurance as they are non-contingent. In addition, introducing bonds changes interest rate responses in a way that amplifies the impact of shocks. The interest rate in the country benefiting from a positive shock declines less than under autarky, leading to a additional wealth effect as it lending. The same would apply if the other country had a negative shock. Now think about it in the context of Germany and the European financial crisis.