Financial Globalization and its Consequences for Productive Government Expenditure

Abstract This paper employs a stochastic growth model to study the impact of international financial liberalization on the share of productive government expenditure in GDP. Financial liberalization is specified to take the form of reducing the costs of both lending to, and borrowing from, abroad. This is shown to impinge on the economy through (i) its interaction with the volatility of returns to domestic capital, and (ii) the impact on agents’ allocation of their portfolio across domestic and foreign assets, and its effect on domestic activity. Reduced foreign lending costs tend to divert resources from the domestic economy, requiring the government to compensate by increasing the share of domestic output allocated to productive activity. Reducing borrowing costs have the opposite effects. Empirical evidence, using a dataset of 97 countries over the period 1970 to 2015 provides convincing support for these findings and the underlying mechanism.