DP4855 | World Finance and the US 'New Economy': Risk Sharing and Risk Exposure

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The promising prospect of a ?New Economy? in the US attracted substantial equity inflows in the late 1990s, helping to finance the country?s burgeoning current account deficit. After peaking in 2000, however, US stocks fell by some 8 trillion dollars in value. To assess the welfare effects of international financial markets in this context, we use an analytically tractable (two-country, two-period, two-state) model of the global economy which allows the country experiencing the favourable supply side ?shock? to consume more against expected future output and to spread risk by selling shares. Since irrational exuberance and distorted corporate incentives can cause serious asset overvaluation, however, an asset price ?bubble? is also included, where market participants assign unwarranted likelihood to high pay offs. Relative to autarky, internationalizing financial markets does offer welfare gains. But these are small relative to the international wealth transfer that can arise from selling shares globally at inflated prices. Parameter variations suggest that this conclusion is quite robust. A calibrated exercise shows how capital inflows to finance the ?New Economy? can be twice the consumption-smoothing deficit on current account; and how market losses ? due to ?misfortune? or ?excess upside probability? ? can have global effects on consumption when the bubble bursts. The analysis complements recent econometric studies of the transmission mechanism which find that financial factors are needed to explain why the European economy was so strongly affected by the US downturn starting in 2002.