The Capital Matthew Effect: Directed Technical Change and International Capital Flows

Abstract

This study shows that technological specialization is one plausible driver of long-term international capital flows. The underlying mechanism comprises the two sides of capital scarcity: although a shortage of capital currently generates a higher marginal product, it also makes a country inclined toward capital-saving technology. Therefore, in equilibrium, the rate of capital returns is jointly determined by a convergence effect from the law of diminishing return and an opposing divergence effect from directed technological change. Initially capital-rich countries favor capital-complements-biased technology and continuously import capital from capital-poor countries that develop capital-substitutes-biased technology. We name this anti-convergence force on capital allocation the capital Matthew effect. This new perspective is consistent with many related international finance puzzles, including the Lucas paradox, global imbalance, and allocation puzzle. Finally, we provide both country-level and firm-level evidence supporting this new model mechanism.

Keywords: directed technical change, international capital flow, Lucas puzzle, global imbalance, allocation puzzle, Matthew effect