Fewer capital flow restrictions foster stronger economic growth

Feb. 2, 2005 -- Shaken by numerous accounting-related scandals in recent years, some investors are clamoring for better legal protection for their investments.

But does investor protection through government regulation foster economic growth? To assess the widely-held view that it does, Washington University economics professor Glenn MacDonald and two colleagues have completed a study concluding that the positive effect of investor protection on economic growth is stronger for countries with fewer restrictions on international capital flows.

Glenn MacDonald

Their paper, "Investor Protection, Optimal Incentives and Economic Growth," was published in August in the Quarterly Journal of Economics. MacDonald, the John M. Olin Distinguished Professor of Economics and Strategy at the Olin School of Business, conducted the study with Rui Castro, an assistant professor at the University of Montreal, and Gian Luca Clementi, an assistant professor of economics at New York's University's Leonard N. Stern School of Business.

The study used an overlapping generations model of capital accumulation, in which young entrepreneurs borrow money from the older generation through optimal contracts whose terms are contingent on public information.

"We assume that it is costly for entrepreneurs to misreport outcomes and conceal resources," the study says. "If hiding is costless, there is no investor protection. If hiding is so difficult that all hidden resources are lost, investor protection is perfect. Our hiding cost is intended to capture all the institutional features that limit the ability of insiders to expropriate outside investors."

A larger cost of hiding resources lowers the risk borne by borrowers, so better investor protection leads to better risk sharing.

The researchers found that the relation between investor protection and growth depends on the opposing supply and demand effects. The demand effect, whereby risk-averse entrepreneurs create a larger demand for capital, supports a positive association between investor protection and growth. The supply effect follows from general equilibrium restrictions that suggest a negative association between protection and growth. Better protection (the demand effect) increases the interest rate and lowers the income of the entrepreneurs, thereby decreasing current savings and the next generation's supply of capital. The supply effect is stronger when restrictions on capital flows are tighter.

MacDonald's team studied the effects protection for investors of entrepreneurial ventures had on economic development in India and South Korea. During the study period, India protected the interests of investors better than did Korea, but Korea grew much faster and had higher saving rates.

The researchers concluded that in countries like India, where outside investors are better protected, equity claims are more prevalent and firm ownership is less concentrated. In addition, the research predicts that the positive effect of investor protection on growth should be larger for countries that impose lower restrictions on capital flows.

As for recent American financial scandals, the researchers suggest that "the firms involved in the scandals are actually the ones that had been performing well," the paper states, "and in which insiders found it profitable to appropriate some of the cash flows, disguising this appropriation by misreporting their accounting numbers."

The effect of those managers' expropriation on their firms' value "was aggravated by the fact that such activity was inefficient," the study states, "in that resources were used up in the hiding process, so that value concealed from investors did not translate one-to-one into higher managerial wealth.