EMU Monitor: Some thoughts on the Lucas Paradox

By: Alan Ahearne, Bruegel and NUI Galway

Economic theory predicts that capital should flow from rich countries to poor countries. Poor countries have lower levels of capital per worker—in part, that explains why they are poor. In poor countries, the scarcity of capital relative to labour should mean that the returns to capital are high. In response, savers in rich countries should look at poor countries as profitable places in which to invest.

In reality, things just don’t seem to work that way. Surprisingly little capital flows from rich countries to poor countries. This puzzle, famously discussed in a paper by Nobel Laureate Robert Lucas in 1990, is often referred to as the “Lucas Paradox.”  Lucas himself put forward several candidate explanations, including differences in human capital between rich and poor countries as well as failures in international capital markets that might account for the lack of flows. But none of these candidates can come near to explaining quantitatively the observed shortage of capital flows relative to what economic theory, specifically the neoclassical growth model, would predict. 

Flows of capital from rich to poor countries are important because they can serve to augment the stock of capital and boost incomes in poorer countries. When these inflows take the form of foreign direct investment, the effect on incomes can be substantial, since FDI often brings with it technological know-how. As a result, large flows of capital from rich to poor countries could potentially contribute to convergence in per capita incomes. These flows don’t happen on a large scale, however, and partly as a result we don’t see widespread convergence of living standards between rich and poor countries. Africa is not catching up with the United States. 

One place where the evidence does point to convergence over the past few decades is in western Europe.  The lower income economies in western Europe have generally grown faster than the high income countries since World War II. Since the mid-1990s, countries such as Ireland and Spain have outperformed Germany and France. This raises the question of how capital has moved within the EU-15. Does capital flow from the European countries with the highest income to those at the bottom the EU-15 income table?

The answer appears to be yes. In a new paper by Jürgen von Hagen and me, we find that intra-European trade surpluses are positively correlated with per-capita GDP in the EU-15. To be sure, trade balances are not exactly the same as current account balances, but they should be fairly good proxies. And of course current account balances tell us what’s happening to capital flows.  In other words, the results of our research suggest that capital does indeed flow from the rich EU-15 countries to the poorer ones. The stark difference between Germany’s intra-European trade surplus and Spain’s trade deficit (see Chart) is illustrative.

Interestingly, the positive relationship between trade surpluses and per-capita GDP becomes a lot stronger after the beginning of EMU, and only for EMU countries. One interpretation of these results is that the elimination of exchange rate risk made other euro area countries much more attractive destinations for investment for wealthy euro area countries. A euro bond is a euro bond no matter in which euro area country it is issued. And a euro bond is not the same thing in the eyes of euro area investors as a sterling bond. It may well be that economists have underestimated the extent to which people prefer to keep their savings in their own currency. Perhaps that explains why Japanese citizens have been content to park much of their savings in ultra-low yielding Japanese Government Bonds for over a decade, when markedly higher returns have been available abroad.  

Of course the creation of a single currency was meant to increase financial integration within Europe, amongst other things. It seems to be working in that direction. The more cranky observers might point to increased German purchases of Spanish real estate and wonder whether the pick-up in capital flows within the euro area is really in everyone’s interest. But I think a more sober assessment might be that the creation of the euro has lead to an improvement in the allocation of capital across Europe. And that has got to be a welcome development.     

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