How Global Capital Flows

Capital flows across borders in several forms: foreign direct investment in factories and firms, portfolio investment in stocks and bonds, and bank loans. In principle, capital should flow from rich countries, where it is plentiful, to poorer ones, where returns should be higher, financing investment and growth. In practice, economist Robert Lucas noted in 1990 that far less flows to poor countries than theory predicts, partly because of weaker institutions, risks and skills.

Since the 1980s many countries have removed capital controls, and cross-border flows have grown enormously. Long-term investment such as FDI tends to be stable, but short-term portfolio and bank flows, sometimes called 'hot money', can rush in during booms and flee at the first sign of trouble, a 'sudden stop' that can trigger currency and banking crises. Some countries, such as Chile in the 1990s, used taxes or reserve requirements on short-term inflows to slow them, and James Tobin proposed a small tax on currency transactions.