Financial globalization and real regionalization

Over the period 1972-1986, the correlations of GDP, employment and investment between the United States and an aggregate of Europe, Canada and Japan were respectively 0.76, 0.66, and 0.63. For the period 1986 to 2000 the same correlations were much lower: 0.26, 0.03, and -0.07 (real regionalization). At the same time, U.S. international asset trade has significantly increased. For example, between 1972 and 1999, United States gross FDI and equity assets in the same group of countries rose from 4 to 23 percent of the U.S. capital stock (financial globalization). We argue that these two trends are intimately related. We document that the correlation of real shocks between the U.S. and the rest of the world has declined. We then present a model in which international financial market integration occurs endogenously in response to less correlated shocks. Financial integration further reduces the international correlations in GDP and factor supplies. We find that both less correlated shocks and endogenous financial market development are needed to account for all the changes in the international business cycle. keywords: International business cycles, international diversification JEL Classification Codes : F36, F41 Preliminary. We thank Robert Engle, Alessandra Fogli, Philippe Martin, Andy Neumeyer and seminar participants at the CEPR ESSIM 2001, the Econometric Society Summer Meetings 2001, the Duke International Economics Group Meetings in Venice, and the SIEPR Meetings in Stanford for helpful comments. Heathcote thanks the NSF Economics Program for financial support. Remaining errors are our own.