Theory behind financial flows not going to the most developing nations even though they have the highest growth rates

Question

I remember reading a bunch of articles on this a few years ago, but I can't find any of the references any more.

It has been a while since I looked at this, so here is a rough paraphrase of the theory and I was trying to find some good references for it. Basically there is a theory in development economics or economic growth where financial flows should go to the areas with the most potential economic returns, which usually means developing nations. But if I remember correctly, this result is not visible in the actual financial flows data, where most financial flows remain within developed nations. So the argument was that there is more to be gained from money flowing or concentrating in some higher returns industries within developed nations, rather than flowing to places which in principle might have higher returns.

Like I said, this is a very rough paraphrase to the point of being inaccurate. But if anyone know what this theory is called or the latest work in this area, that would really be appreciated.

Answer 1

Its called Lucas paradox and its actually specifically about flows of capital not financial flows per se. Also it is not an idea from developmental economics or growth theory but international macroeconomics (or at least that’s where it originated I am sure the idea could get home in other subfields as well).

The paradox arises because classical international macro theory would predict that capital should flow from capital rich countries to capital poor countries as in those the rate of return on capital should be higher. Hence rational investors should flock to those.

The paradox is actually relatively recent as it was proposed just 30 years ago in this paper:

Lucas, Robert (1990). "Why doesn't Capital Flow from Rich to Poor Countries?". American Economic Review. 80 (2): 92–96.

The interesting thing is that this paradox emerged only during 20th century as there is an evidence for large capital flows during the first wave of globalization (i.e. pre WWI) between capital rich an poor countries.

Some possible explanations offered in literature are that this is either due to market imperfections, sovereign risk, difference in institutions (or better said lack of good institutions in poor countries), or missing technology, infrastructure, or some other important factors of production such as human capital in developing countries.

Some of the recent work on this area includes:

Montiel, P. J. (2006, February). Obstacles to investment in Africa: Explaining the Lucas paradox. In high-level seminar Realizing The Potential for Profitable Investment in Africa.

Schularick, M., & Steger, T. M. (2008). The Lucas Paradox and the quality of institutions: then and now. Available at SSRN 1656282.

Azémar, C., & Desbordes, R. (2013). Has the Lucas Paradox been fully explained?. Economics Letters, 121(2), 183-187.

Akhtaruzzaman, M., Hajzler, C., & Owen, P. D. (2018). Does institutional quality resolve the Lucas Paradox?. Applied Economics, 50(5), 455-474.

You will also find other good sources cited inside the articles listed above, especially the first one has a good literature review.