Global Capital Flows : The Roles of Demography, Productivity and Taxes

In this paper we are concerned with what drives international capital flows. The estimated spectra of net foreign asset positions show that they are driven almost entirely by low frequency components which argues against many of the dire warnings that are issued about short term adjustments in capitals flows and âglobal imbalancesâ. Capital flows are dominated by factors that have slow moving trends. The most compelling candidates are demographic trends, productivity, and policies (like tax policy) that change slowly over time. We study capital flows in a multi-country overlapping generations model where individuals make savings decisions based on their conditional life expectancy. In such a world individuals will decide their life cycle savings and consumption based not only on domestic birth rates and mortality but also on the demography of other countries as well. Changes in fertility and mortality are key to understanding and modeling capital flows. As fertility declines populations get older, as mortality declines the ratio of years of work to years of retirement declines. Global capital flows act to equilibrate the demand and supply of global savings. We study a calibrated general equilibrium model with a rich set of demographics. We ask to what extent can net foreign asset positions be explained over time by demography, productivity differences and policy wedges. Differential demographic trends drive savings and investment differences as workers adapt to increased life expectancy and decreased fertility. In such a world capital flows to countries with more favorable demographics and demographics explain well the differences in net foreign asset positions observed in the data. Differences in productivity explain some but not a lot of the movements in net foreign asset positions over time. Differences in wedges due to taxes and other frictions are important in accounting for differences in capital levels but not capital flows.