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THE GLOBAL CAPITAL MARKET: Market Failures and the Policy Response

I have argued that the international capital market has the potential to yield great benefits, but that it also constrains national choices over monetary and fiscal policies, and may facilitate excessive borrowing. To what extent is the positive potential of the international capital market outweighed by a potentially disruptive role? Are there policy reforms or institutional changes that might improve the balance of benefits and costs? Here, I discuss three facets of the debate: the very low degree of international diversification of equity portfolios; the problem of international capital-market crises, much in the news recently; and the role of the IMF as an international emergency lender.

The International Diversification Puzzle

The opportunities for global risk sharing that the international capital market offers should lead investors to diversify their portfolios over investments in many countries. In practice, however, little of the sort seems to have happened. The majority of investors seem to remain parochial in outlook, choosing to retain most of their wealth at home.

In an article that drew attention to the extent of the international diversification puzzle, French and Poterba (1991) pointed out that at the end of the 1980s, U.S. investors held 94 percent of their equity wealth in U.S. equities and Japanese investors held 98 percent of theirs in Japanese equities, while French, German, and even Canadian investors held only around 1 percent of their equity wealth in U.S. or Japanese equities. Such wildly unbalanced allocations are hard to reconcile with any intuitive notion of a well-diversified portfolio. As a first pass, one might expect people to diversify by “holding the market,” that is, by demanding a country’s stocks in rough proportion to its share in global market capitalization. International diversification has occurred in the 1990s, but even the much publicized growth of U.S.-based global equity mutual funds has not nearly erased the basic puzzle raised by the French-Poterba data.