Financial integration

Financial integration consists of the (increasing) interconnection of banking systems and financial markets, and of the strengthening of debit/credit relationships among economic units (firms, banks, households and governments) located in different geographical areas. Such a cross-border interconnection of economic units, markets and institutions mainly operates through three different, though linked, channels:

(1) the removal of national barriers to capital movements;

(2) the practice of States ceding full control over monetary policy to independent and politically insulated central banks that are mostly focused on inflation targeting (see Major, 2012); and

(3) the change in economic policy, in favour of "scientific" monetary policy rules as opposed to discretional (that is, "politically biased") fiscal measures (see Gabor, 2014).

Focusing on the second channel, inflation targeting is commonly pursued through the steering of the targeted short-term nominal rate of interest (in the unsecured money market) and/or the pegging of the national currency to a stronger one. As a result, finan- cial integration is often associated with a certain degree of loss of monetary and fiscal sovereignty (of weakest or "peripheral" countries at least).

The standard indicator employed by economists in order to test the degree of financial integration of a given country (with either the rest of the world or another economic area) is the sum of amounts of cross-border assets and liabilities as a percentage of Gross Domestic Product (GDP). Other indicators are the amount of foreign investment to GDP, the degree of synchronization (that is, statistical correlation) in the movement of asset prices and stock-exchange indexes, the convergence in inflation and interest rates, and the trend in cross-border activities undertaken by banks and other financial operators.

The process of financial integration is not an exclusive feature of today's financially sophisticated capitalist economies. It appeared in the late seventeenth century and gained momentum in the period from the mid 1870s to the First World War (the so-called "gold standard era"). The inter-war years interrupted the process of financial integration, which restarted in the 1950s, accelerated in the 1970s-1980s, and achieved its peak at the end of the 1990s after the end of the Cold War. It was promoted by Anglo-Saxon economies and then increasingly involved other economies. Since the 1970s, policies aiming to liberalize capital movements have been imposed by the International Monetary Fund and the US government (as the necessary condition to access international finan- cial aids) to a number of developing countries, in the wake of the so-called "Washington consensus". In continental Europe, the removal of national barriers in financial activities and other services was mainly promoted by the "Single Market Act" of the European Union passed in 1986 and enacted in 1992. The recent financial crises that affected advanced economies, and the emancipation of a number of Asiatic and South-American countries from the "Washington consensus", could represent a new turning point in the process of worldwide economic and financial integration.

The enhancing of financial integration through the removal of capital controls and through other institutional changes is traditionally considered as a positive phenom- enon by both mainstream economists and supranational institutions, because it would support the efficient allocation of capital and labour-force. More precisely, integration measures - it is usually argued - allow capital to move from "core" economies (char- acterized by a larger stock of capital and hence lower return rates) to "peripheral" economies (with a lower stock of capital and hence higher return rates), therefore trig- gering a catching-up process in the latter economies. In the absence of capital controls, each country has no longer to solely rely on its own domestic saving to finance invest- ment (see, among others, Feldstein and Horioka, 1980; Blanchard and Giavazzi, 2001). Further, free access to the international capital market expands the opportunities for portfolio diversification, therefore reducing the investors' risk. However, other econo- mists (many of whom draw on Minsky, 1986) have pointed out the potential destabiliz- ing effects linked to the process of financial integration. The risk of abrupt reversals of capital flows, financial contagion, misallocation of resources (leading to domestic asset bubbles and debt-based consumption), bankruptcy chain-reactions, cross-border transmission of instability, and permanent imbalances in current accounts - all entailed by the process of financial integration - have been recently stressed by the same supra- national institutions that promoted that process (see, among others, European Central Bank, 2010; Forster et al., 2011). The point is that, in spite of globalization tendencies, the separation between distinct country-based capitals remains a central feature of today's capitalist economies. Large transnational corporations and banking groups are still strongly linked to a single country with respect to ownership and management (see Duménil and Lévy, 2004). Consequently, in the presence of asymmetrical shocks, finan- cial integration is suddenly replaced by "home-bias" tendencies and "flight-to-safety" forms of behaviour of investors. Finally, the available empirical evidence suggests "that there might be a point beyond which a country becomes 'over-integrated', in the sense that further integration is associated with movement away from rather than towards optimal diversification" (European Central Bank, 2010, p. 70).

See also:

Asymmetric information; Bubble; Capital controls; Central bank independence; Contagion; International Monetary Fund; Rules versus discretion; Sudden stops.