Financial Globalization, Fragmentation, and Crises: Over a Century-long Journey

According to theory, capital market integration enhances welfare by facilitating international consumption risk sharing. However, it also amplifies the risk of contagion in bad times. The relationship between capital market integration and the probability of facing a financial crisis is less well understood, with both positive and negative effects theoretically plausible. We make two contributions with respect to the previous literature: 1) We provide a comprehensive empirical examination of financial globalization in the long run among stocks, government bonds, and real estate markets, from a comparative perspective. We employ 150 years of data to show that aggregate stock integration exhibits a swoosh-shaped pattern, while bond integration follows a J-shaped trajectory. Housing integration remains consistently low and stable throughout the period. 2) We propose novel country specific indicators of integration that distinguish between the shocks a country transmits to the rest of the world and those it receives, and empirically assess whether capital market integration predicts future episodes of financial crises over the long-term using duration analysis. We estimate that, over the long run, financial integration decreases the likelihood of financial crises.