Investments & Democracy Democracy & Investments READING ASSIGNMENT: Jensen, Nathan M Democratic Governance and Multinational Corporations: Political Regimes and Inflows of Foreign Direct Investment. International Organization 57 (3):

Plan 1.Democracy  Foreign Direct Investment 1.Audience Costs 2.Veto players 2.Investment  Democracy ? 1.Credible commitment and asset specificity 2.Portfolio vs. Fixed investment 2

Part 1: Democracy  FDI It’s all about commitment. 3

Ship owner & Railroad builder S Promise Not R Build Rail Not S Honor commit ment Reneg otiate (0,0) (+10,–1) (+5,+6) Time 1Time 2 4

Hostages would like to commit to not pressing charges. H Promise Not K Free Kill H Testify Not (–,1) (0,1) (T,-10 years) Time 1Time 2 5

G Offer Not F Invest Not G Expropriate Not (0,0)(-S,S)(1,1) (T,0) Time 1Time 2 Suppose that T>1>S>0 Foreign Direct Investment and the Commitment Problem 6

What do we call this problem? Commitment problem Credible commitment problem Time-inconsistent preference problem Time-consistency problem Obsolescing bargain 7

Other examples? (and solution) Ulysses & the Sirens (solution?) –Tying hands to the mast Love –Marriage Learning in a class –Exam! Specific assets (solution?) –Vertical integration –Interesting example – all of the others involve delegation to a credible 3 rd party. This one involves eliminating the middle-man FDI –Democracy! 8

Why might democracies be more credible? 2 alternative answers: 1.Audience costs 2.Veto players 9

Audience costs Example: Left-wing Luiz Inácio “Lula” da Silva –Many people feared that he would “be another Chavez [Venezuela],” pursuing socialist policies and expropriating investments. During 2002 Brazilian presidential elections: –Lula signed a pre-agreement with the IMF pledging market-friendly policies (commitment) Brazil also has many “checks and balances” in its political system. In fact, policies did not radically change under Lula, and the economy continued to grow

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Veto Players 12

What determines FDI? Political institutions are central to explaining why some countries are more successful in attracting international capital Democratic institutions lower political risks for multinational corporations POLITICALLY FEDERAL INSTITUTIONS lower political risks for multinationals and allow host countries to attract higher levels of FDI inflows –Political federalism provides credibility that investments will not be taxed at increasing rates –This credibility is more important than fleeting promises of low taxes 13

Jensen considers alternative hypotheses… Chapter 4: The Race to the Bottom Thesis and FDI –FDI goes wherever taxes are lowest –This causes countries (jurisdictions) to compete for FDI by lowering taxes competitively until no one taxes! –Theoretical flaw: Firms may want public goods for their work force –Empirical flaw: We simply do not observe a lot of evidence that FDI simply goes to countries with low taxes Chapter 5: Democracy and FDI –We do observe FDI going to democracies –Argument: democracies are richer? The effect remains when we control for per capita GDP –Argument: democracies are more credible? Theoretical flaw: not all democracies provide a policy-stable environment Chapter 6: Veto Players and FDI –Political federalism makes it more difficult for tax rates to be changed –Credible commitment –Democracy finding disappears – really driven by political federalism 14

Political federalism Veto players generate credible commitments because it is hard to change policy The complex relationship between the central government and sub- national governments provides assurances of future economic policies that multinationals will prefer Although FDI benefits national economies in the aggregate, many of the specific goods are local, such as employment creation and spillovers on the local economy. These localized benefits depend on the productive operation of the multinational firm. Thus, subnational units possess both the incentive and the ability to veto legislation that would hamper the operations of the multinational, leading these corporations to prefer to invest in these types of systems. 15

Part 2: Investment  Democracy ? It’s all about commitment… to leave! 16

Why is oil important? Dutch disease Oil exports drive up currency value Suffocates other export entrepreneurial activity Economy does not develop 17

Alternative - Game theoretic story for oil Democracy  redistribution Rich vs. Poor Dictatorship: Rich pay “repression” cost Democracy: Rich suffer redistribution Unless the rich have a credible threat to exit  the poor have a credible promise to temper redistribution Democracy works 18

19 “I must. That minority still controls the police, the army, and the economy. If we lose them, we cannot address the other issues.” “Sorry, Mandela, but we've got problems everywhere we look. Housing, food, jobs, crime, our currency. You can't keep interrupting affairs of state to placate a minority”

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Credible threat & income distribution (Ross 2001, Rosendorff 2001, Boix 2003, Jensen and Wantchekon 2004, Freeman and Quinn 2012) Democracy an elite-question: –Costs of repression (autocracy) –vs. Costs of income redistribution (democracy) Income distribution obviously matters (higher income inequality makes repression more attract) Asset specificity: –oil can’t come with you (Middle East, Nigeria) –education, FINANCIAL ASSETS can! (India, South Africa) With low asset specificity –The elites have a credible exit threat –The poor then have a credible commitment to keep redistribution low  democracy With high asset specificity –The elites cannot take their income with them – no exit threat –So the poor cannot credibly commit to low redistribution –And the elites prefer costs of repression (autocracy) 21

Asset specificity  regime  FDI Mobile assets  democratic institutions Fixed assets  dictatorship Alternative way to generate commitment ***not*** to expropriate under democracy? Checks and balances! Federalism Veto players US Constitution 22

Freeman & Quinn Capital account liberalization  Democratization If capital can flee, the poor are credibly constrained  credible commitment to low levels of expropriation  Allow for democratization 23

Summary Commitment problem, Time-inconsistent preference problem Governments attract FDI… –When they have a credible commitment to fixed policies –Audience costs? –Veto players Political Federalism Rich support democracy… –When they have a credible exit threat –Leads to a credible commitment of the poor NOT to expropriate –Oil and other fixed assets  bad for democracy –Portfolio and other mobile assets  good for democracy So, mobile investments lead to democracy Democracy leads to fixed investments 24

Thank you WE ARE GLOBAL GEORGETOWN! 25