While these trends tell us something about relative patterns of global interconnection, they leave unanswered the question of whether global finance is a truly integrated network. To gauge that, consider an alternative measure of global capital market integration – the correlation between national saving and investment rates. From Feldstein and Horioka (1980), we know that this correlation provides a proxy for capital market integration. For example, a savings/investment correlation of one indicates a closed capital account: all domestic investment needs to be fully financed from domestic saving. At a global level, this  2  BIS central bankers’ speeches  would signify something close to global financial autarky. By contrast, a correlation of zero implies that domestic investment can be fully financed on global capital markets. This would signal something close to perfect capital market integration. So saving/investment correlations of zero and one define the outer limits of global capital market integration. Chart 3 plots this correlation coefficient over the same 140-year period shown in Chart 1. Broadly-speaking, the two series track one another fairly closely. But Chart 3 now allows us to say things about the absolute degree of capital market integration. And what a rollercoaster ride it has been. During the first period, from around 1880 up until the Great Depression, global financial integration sat roughly mid-way between its outer limits. Integration was high-ish, but far from perfect. For around a fifty year period, from the 1930s through to the 1980s, global finance then went into hibernation.
This shows the results of a simulation of a hypothetical financial network of firms. These have differing levels of financial strength, measured on the x-axis. Think of this as a country’s level of official reserves or a bank’s level of liquid assets. On the z-axis is a measure of network interconnectivity – the scale of cross-border assets or interbank exposures. Finally, on the y-axis is a measure of systemic risk – the incidence of default across the network, whether of countries or banks. As the network becomes better integrated, for a given degree of financial strength, systemic risk remains low. We operate in a zone of systemic stability. That is because the network is operating as a shock-absorber, a network insurance device scattering risk to the four corners. So it was pre-crisis. But for a large-enough shock to financial strength, the system fundamentally changes shape. The network flips to a zone of systemic instability. That is because it is now operating as a shock-transmitter, a network incendiary device – and the greater the degree of integration, the sharper this knife-edge. So it was during the crisis. This is the robust-yet-fragile property of connected webs. The global financial crisis provided no better example. The flat earth that was the Great Moderation gave way to the fragile planet that was the Great Recession. Risk-sharing gave way to risk spreading, risk distribution to risk contagion. This was by no means an isolated incident.