Manufacturing-Finance Comparative Advantage and Global Imbalances

Treating finance as a tradable service, this paper examines how global current account imbalances can emerge as a result of the Ricardian comparative advantage in manufacturing and finance. The financial sector screens borrowers to limit its risk exposure when it provides finance to manufacturing firms that are born with heterogeneous risks. In a dynamic model of two countries whose heterogeneous rates of productivity growth maintain their positions of comparative advantage, the country with comparative advantage in finance specializes in creating financial assets so it is able to carry over the current savings to the next period. As a result, the other country is willing to save and lend its savings to this country. The amount of lending increases over time because of productivity growth in both countries, so persistent global imbalances emerge in the steady state and its scale increases as the manufacturing-finance comparative advantage gets stronger between the two countries. Our empirical tests of bilateral trade and current accounts with panel data of OECD countries provide consistent and robust supports to these theoretical claims.