This paper surveys the available empirical evidence on the integration across national capital markets. Various measures of the degree of integration--including deviations from the law of one price, differences between actual and optimally diversified portfolios, correlations between domestic investment and domestic saving, and cross-country links in consumption behavior--are considered. The authors find that capital market integration has been increasing over the past decade--especially for highgrade financial instruments traded actively in the wholesale markets of major financial centers. Capital markets in developing countries, too, are becoming more closely integrated with markets in the rest of the world, although they have progressed less far in that direction than the industrial countries. It is still much too early to speak of a single, global capital market where most of the world’s savings and wealth are auctioned to the highest bidder and where a wide range of assets carries the same risk-adjusted expected return. Some important components of wealth (like human capital) are scarcely traded at all, and currency risk, the threat of government intervention, and the strong preference for consuming home goods and investing in more familiar home and regional markets still serve to restrict the range and size of asset substitutability. But the forces for greater arbitrage of expected returns are already powerful enough to have made a large dent in the autonomy that authorities have over macroeconomic and regulatory policies. When private markets, led by the increasing financial muscle of institutional investors, reach the concerted view (rightly or wrongly) that the risk-return outlook for a particular security or currency has changed, those forces are difficult to resist. Moreover, the authors see little in the factors underlying the evolution of international capital markets to suggest that the increased clout of private markets will reverse itself in the future. Quite the contrary.

The growth and agility of private capital markets have made the conditions more demanding for operating durably and successfully a fixed exchange rate arrangement. There is now less room for divergences of view among participants about the appropriate stance and medium-term orientation of monetary policy, less time to adjust to country-specific shocks, and greater pressure to achieve closer convergence of economic performance.

With benefit of perfect hindsight, it is not hard to identify instances over the past decade when international capital flows (like domestic ones) did not pay enough attention to fundamentals. Nevertheless, the authors see no basis for concluding that private capital markets usually “get it wrong” in deciding which securities and currencies to support and which ones not to. On the whole, most of the policy changes that have been forced by international capital markets -seem to have been in the right direction. The authors therefore see more merit in trying to improve the “discipline” of markets so that it is more consistent and effective rather than in trying to weaken or supplant the clout of markets.