Does Financial Globalization Induce Better Macroeconomic Policies?

Monetary and fiscal policies around the world are in better shape today than two decades ago. This paper studies whether financial globalization has helped induce governments to pursue better macroeconomic policies (the "discipline effect"). The empirical tests have two innovations. First, we recognize potential endogeneity of the observed capital flows in a given country and employ an instrumental variable approach that relies on the autonomous (global) component of the capital flows. Second, we recognize inherent discreteness in defining good versus bad macroeconomic policies and use a transition matrix technique to determine whether capital flows are effective in inducing substantial qualitative policy shifts. Our results suggest that, in spite of the plausibility of the "discipline effect" in theory, it is not easy to find strong and robust causal evidence. There is some evidence that financial globalization may have induced countries to pursue low-inflation monetary policies. However, there is no evidence that it has encouraged low budget deficits.Capital flows;Financial sector;Inflation targeting;inflation, globalization, financial globalization, foreign assets, inflation rates, high inflation, low inflation, international financial, inflation rate, monetary policy, financial integration, inflation equation, international financial integration, international financial statistics, annual inflation, international finance, lower inflation, exchange rates, high inflations, macroeconomic stability, annual inflation rate, international investment, inflation observations, price stability, moderate inflation, capital markets, dollar value, inflation across countries, economic integration, inflation crises, actual inflation, global integration, globalization of securities markets, percent inflation, global capital, reduction in inflation, foreign liabilities, globalization of securities