Bad Investments and Missed Opportunities? Postwar Capital Flows to Asia and Latin America

Lee E. Ohanian, Consultant

Paulina Restrepo-Echavarria

Mark L. J. Wright, Senior Vice President and Director of Research

May 2018 | Federal Reserve Bank of Minneapolis Staff Report 563

After World War II, international capital flowed into slow-growing Latin America rather than fast-growing Asia. This is surprising as, everything else equal, fast growth should imply high capital returns. This paper develops a capital flow accounting framework to quantify the role of different factor market distortions in producing these patterns. Surprisingly, we find that distortions in labor markets — rather than domestic or international capital markets — account for the bulk of these flows. Labor market distortions that indirectly depress investment incentives by lowering equilibrium labor supply explain two-thirds of observed flows, while improvement in these distortions over time accounts for much of Asia’s rapid growth.