The Capital Matthew Effect

Abstract

This study shows that technological specialization is the primary driver of long-term international capital flows. The underlying mechanism comprises the two faces of capital scarcity: although a shortage of capital currently generates a higher marginal product, it also makes a country incline toward capital-saving technology. Therefore, in equilibrium, the rate of capital returns is jointly determined by a convergence effect from diminishing return and an opposing divergence effect from directed technological change. If the elasticity of substitution between labor and capital is sufficiently high, then initially capital-rich countries will favor a capital-biased technology and continuously import capital from capital-poor countries that develop a labor-biased technology. I name this anti-convergence force on capital allocation as the capital Matthew effect. With this perspective, we can rationalize many related international finance puzzles, such as the Lucas paradox, global imbalance, and the allocation puzzle.

Keywords: directed technological change; international capital flows; Matthew effect

JEL Classification: F20; F30; F63; G15; O33; P16