We examine the empirical role of different explanations for the lack of flows of capital from rich to poor countries–the "Lucas Paradox." The theoretical explanations include differences in fundamentals across countries and capital market imperfections. We show that during 1970–2000 low institutional quality is the leading explanation for the lack of capital flows. For example, improving Peru?s institutional quality to Australia?s level, implies a quadrupling of foreign investment. Recent studies emphasize the role of institutions for achieving higher levels of income but remain silent on the specific mechanisms. Our results indicate that foreign investment might be a channel through which institutions affect long–run development.
Working Paper 06–04, Weatherhead Center for International Affairs, Harvard University, 2006.