Why doesn’t Luxembourg send all its capital to India?

Abstract

In the standard neoclassical model, when two countries with disparate capital levels open to trade, the capital-rich country exports capital to the capital-poor country. This hastens growth in the poor country and generates income for the rich country, to the benefit of both. Real countries do not engage in this capital trade to the extent that theory predicts. It is widely understood that the weak property rights that afflict poor countries play a major role in this failure. Weak property rights make rich countries reticent about investment out of fear of expropriation. In this paper we also ascribe the insufficiency of international capital flows to weak property rights. But we model property rights as arising naturally during the process of economic growth. The impairment of trade is again the consequence of the reticence of rich countries: they want to avoid the erosion of their own property rights when trade occurs.