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THE GLOBAL CAPITAL MARKET: The Integration of Global Capital Markets 3

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Figure 1 offers another indicator of capital mobility, the standard deviations of the difference between one-year interest rates on sterling-denominated assets sold in New York and those sold in London. (See Obstfeld and Taylor, 1998, for data on levels of mean annual interest differentials.) The interest differential, as well as is variability, should equal zero if capital mobility between the two centers is perfect, but these measures can deviate from zero in the presence of transaction costs, political risks, and other barriers to the free flow of money. In practice, differences in the American and British financial instruments chosen for comparison also can lead to interest differences. By focusing on return standard deviations, I downplay such discrepancies, which are not necessarily evidence of financial-market segmentation.

Under the pre-1914 gold standard, New York-London differentials show relatively small fluctuations (and they do so around a declining trend average differential). Differentials start to open up during World War I, become quite large by the early 1920s, and decline briefly in the late 1920s before widening sharply in the early 1930s through the early 1950s. Some arbitrage gaps remain in the mid-1950s, but the variability of return differentials is generally quite small after the early 1950s, and through the late 1960s. This degree of financial market cohesion in the 1950s and 1960s reflects New York’s and London’s positions as world financial centers, and is not typical of most other industrial country pairs (Marston 1995). Interest gaps open up sharply again in the late 1960s, but have become progressively steadier and smaller since the early 1970s, once again reaching levels close to those of the later classical gold standard years, 1890-1914.

What explains the long stretch of high capital mobility that prevailed before 1914, the subsequent breakdown in the interwar period, and the very slow postwar reconstruction of the world financial system? The answer is tied up with one of the central and visible areas in which openness to the world capital market constrains government power: the choice of an exchange rate regime.