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Investments & Democracy
Democracy & Investments
READING ASSIGNMENT:
Jensen, Nathan M. 2003. Democratic Governance and
Multinational Corporations: Political Regimes and
Inflows of Foreign Direct Investment. International
Organization 57 (3): 587-616
1
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
Time 1
S Promise R
(0,0)
(0,0)
Time 2
Build
S Honor
commit
Rail
ment
(+5,+6)
(+10,–1)
4
• Hostages would like to commit to not pressing charges.
Time 1
H Promise K
(–,1)
Free
(–, 1)
Time 2
H Testify
(T,-10 years)
(0,1)
5
Foreign Direct Investment
and the Commitment Problem
Time 1
Time 2
Invest
G Expropriate
G Offer
F
(0,0)
(-S,S)
(T,0)
(1,1)
Suppose that T>1>S>0
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 3rd 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.
•
http://www.fdi.net/country/sub_index.cfm?countrynum=30
•
http://www.economist.com/node/16486525
10
11
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
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Political federalism
• Veto players generate credible commitments because it is hard to
change policy
• The complex relationship between the central government and subnational 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
“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”
“I must. That minority still controls the police, the army,
and the economy. If we lose them, we cannot address
the other issues.”
19
20
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)
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• 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
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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
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Thank you
WE ARE GLOBAL GEORGETOWN!
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