We study the effect of international financial integration on economic development when the quality of governance may be compromised by corruption. Our analysis is based on a dynamic general equilibrium model of a small economy in which growth is driven by capital accumulation and public policy is administered by government-appointed bureaucrats. Corruption may arise due to the opportunity for bureaucrats to embezzle public funds, an opportunity that is made more attractive by financial liberalization which, at the same time, raises efficiency in capital production. Our main results may be summarized as follows: (1) corruption is always bad for economic development, but its effect is worse if the economy is open than if it is closed; (2) the incidence of corruption may, itself, be affected by both the development and openness of the economy; (3) financial liberalization is good for development when governance is good, but may be bad for development when governance is bad; and (4) corruption and poverty may coexist as permanent, rather than just transitory, fixtures of an economy.
- Financial liberalization