Essays on the Causes and Consequences of Financial Globalization

Over the last thirty years cross-border holdings of financial assets have increased dramatically. Historically economists have regarded changes in these positions as being due to cross-border trade in goods and services. Yet, this explanation does not hold in this latest period of financial globalization as financial asset-to-asset trading has become a much larger contributor to changes in cross-border financial asset positions. The literature has also generally subtracted foreign claims on domestic agents from domestic claims on foreign agents before analyzing cross-border positions. However, events during the 2008 financial crisis showed that the evolution of gross positions are critically important to study as well. This dissertation is comprised of three papers that consider causes and consequences of gross cross-border financial asset linkages and their dramatic growth over the last two decades, defined as financial globalization.

Chapter one provides a new explanation for the long-run build-up of total foreign borrowing by the United States from 1970 to 2007. In this chapter I present empirical evidence that suggests that shadow banking in the form of asset backed securities was a meaningful driver of the long-run increase in total external debt. I then develop an open economy model that shows how asset backed securities can cause long-run increases in investment, consumption, total secured borrowing, and total external borrowing. Applying the model to the U.S. data I am able to qualitatively replicate the long-run trends in key macro aggregates. Counterfactual experiments show that while declining and low interest rates did cause long-run increases in external borrowing (consistent with the literature), the effect of financial innovation in the form of asset backed securities had at least as great of an impact.

Chapter two empirically shows that different types of capital inflows have different abilities to predict banking crises in developing and emerging economies, and that the relationship between banking crises and capital inflows has changed over time. In a sample of 29 developing and emerging economies over the period 1976-1991 increases in short-term debt inflows raised the probability of a banking crisis while increases in inflows due to long-term borrowing by the private sector had the opposite effect. Conversely, over the period 1992-2007 increases in inflows due to long-term borrowing by the private sector increased the probability of a banking crisis. The findings suggest distinct optimal capital account liberalization policies between the two periods.

Chapter three empirically shows that central governments in developing and emerging economies meaningfully increase their borrowing in domestic credit markets while they are in default of their debt owed to foreign investors. Typically, the only recourse that international lenders have after a sovereign debt default is exclusion from international credit markets. Access to domestic credit markets reduces this cost of external debt defaults. The findings in this chapter inform the theoretical literature on sovereign debt defaults in that future work should consider the effect of domestic credit markets on sovereign debt default probabilities and the time it takes to resolve such a default.