Invested Interests:The Politics of National Economic Policies in a World of Global STOR Finance Jeffry A.Frieden International Organization,Vol.45,No.4.(Autumn,1991),pp.425-451. Stable URL: http://links.istor.org/sici?sici=0020-8183%28199123%2945%3A4%3C425%3AIITPON%3E2.0.CO%3B2-Q International Organization is currently published by The MIT Press. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use,available at http://www.istor org/about/terms.html.JSTOR's Terms and Conditions of Use provides,in part,that unless you have obtained prior permission,you may not download an entire issue of a journal or multiple copies of articles,and you may use content in the JSTOR archive only for your personal,non-commercial use. Please contact the publisher regarding any further use of this work.Publisher contact information may be obtained at http://www.istor org/journals/mitpress.html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. The JSTOR Archive is a trusted digital repository providing for long-term preservation and access to leading academic journals and scholarly literature from around the world.The Archive is supported by libraries,scholarly societies,publishers, and foundations.It is an initiative of JSTOR,a not-for-profit organization with a mission to help the scholarly community take advantage of advances in technology.For more information regarding JSTOR,please contact support@jstor.org. http://www.jstor.org Sun Oct1421:14:502007
Invested Interests: The Politics of National Economic Policies in a World of Global Finance Jeffry A. Frieden International Organization, Vol. 45, No. 4. (Autumn, 1991), pp. 425-451. Stable URL: http://links.jstor.org/sici?sici=0020-8183%28199123%2945%3A4%3C425%3AIITPON%3E2.0.CO%3B2-Q International Organization is currently published by The MIT Press. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/about/terms.html. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/journals/mitpress.html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. The JSTOR Archive is a trusted digital repository providing for long-term preservation and access to leading academic journals and scholarly literature from around the world. The Archive is supported by libraries, scholarly societies, publishers, and foundations. It is an initiative of JSTOR, a not-for-profit organization with a mission to help the scholarly community take advantage of advances in technology. For more information regarding JSTOR, please contact support@jstor.org. http://www.jstor.org Sun Oct 14 21:14:50 2007
Invested interests:the politics of national economic policies in a world of global finance Jeffry A.Frieden A striking characteristic of the contemporary international economy is the great mobility of capital across national borders.Technological innovations, economic trends,and government policies have brought international invest- ment to extremely high levels.Many business executives,politicians,and observers believe that capital now moves so freely that the financial markets of industrialized countries are essentially subsets of one global market.This is widely regarded as a fundamental change in the international economy- something new or at least not seen since the classic gold standard.It is also widely believed to have generated such prominent developments as European Community (EC)movement toward a single currency,harmonization of taxes across national borders,and international convergence of macroeconomic policies. Economists have devoted a great deal of time and energy to analyzing the economic implications of the movement of capital across national borders. Other social scientists have also analyzed the political implications of interna- tional investment.The studies of this latter group have tended to focus on one or another subset of the issue,such as multinational corporations in developed and developing countries,foreign borrowing by developing nations,and the politics of international banking.'Despite the quantity and quality of work on I am grateful to the Social Science Research Council,the German Marshall Fund,the UCLA Academic Senate Committee on Research,and the UCLA International Studies and Overseas Programs for their financial support.I also thank Benjamin J.Cohen,Barry Eichengreen,Judith Goldstein,Joanne Gowa,Robert Keohane,Stephen Krasner,David Lake,Edward Leamer, Timothy McKeown,Louis Pauly,Frances Rosenbluth,John Ruggie,and Michael Wallerstein for their helpful comments and suggestions. 1.For prominent examples from each of these issue-areas,see Helen V.Milner,Resisting Protectionism:Global Industries and the Politics of Interational Trade (Princeton,N.J.:Princeton University Press,1988);Peter Evans,Dependent Development:The Alliance of Multinational,State, and Local Capital in Brazil (Princeton,N.J.:Princeton University Press,1979);David G.Becker et al.,Postimperialism:International Capitalism and Development in the Late Twentieth Century (Boulder,Colo.:Lynne Rienner,1987);Robert Kaufman and Barbara Stallings,eds.,Debt and International Organization 45,4,Autumn 1991 1991 by the World Peace Foundation and the Massachusetts Institute of Technology
Invested interests: the politics of national economic policies in a world of global finance Jeffry A. Frieden A striking characteristic of the contemporary international economy is the great mobility of capital across national borders. Technological innovations, economic trends, and government policies have brought international investment to extremely high levels. Many business executives, politicians, and observers believe that capital now moves so freely that the financial markets of industrialized countries are essentially subsets of one global market. This is widely regarded as a fundamental change in the international economysomething new or at least not seen since the classic gold standard. It is also widely believed to have generated such prominent developments as European Community (EC) movement toward a single currency, harmonization of taxes across national borders, and international convergence of macroeconomic policies. Economists have devoted a great deal of time and energy to analyzing the economic implications of the movement of capital across national borders. Other social scientists have also analyzed the political implications of international investment. The studies of this latter group have tended to focus on one or another subset of the issue, such as multinational corporations in developed and developing countries, foreign borrowing by developing nations, and the politics of international banking.' Despite the quantity and quality of work on I am grateful to the Social Science Research Council, the German Marshall Fund, the UCLA Academic Senate Committee on Research, and the UCLA International Studies and Overseas Programs for their financial support. I also thank Benjamin J. Cohen, Barry Eichengreen, Judith Goldstein, Joanne Gowa, Robert Keohane, Stephen Krasner, David Lake, Edward Leamer, Timothy McKeown, Louis Pauly, Frances Rosenbluth, John Ruggie, and Michael Wallerstein for their helpful comments and suggestions. 1. For prominent examples from each of these issue-areas, see Helen V. Milner, Resisting Protectionism: Global Industries and the Politics of International Trade (Princeton, N.J.: Princeton University Press, 1988); Peter Evans, Dependent Development: The Alliance of Multinational, State, and Local Capital in Brazil (Princeton, N.J.: Princeton University Press, 1979); David G. Becker et al., Postimperialism: International Capitalism and Development in the Late Twentieth Century (Boulder, Colo.: Lynne Rienner, 1987); Robert Kaufman and Barbara Stallings, eds., Debt and International Organization 45,4, Autumn 1991 o 1991 by the World Peace Foundation and the Massachusetts Institute of Technology
426 International Organization specific aspects of the politics of cross-border investment,this literature remains disjointed and short on general analytic principles. This article proposes a framework for analyzing the politics of international capital mobility.It focuses on the distributional implications of cross-border capital movements and on the distributional implications of various economic policies in light of the high degree of international capital mobility. The first section describes just how mobile capital is today and discusses the implications of existing levels of financial integration for national economic policy autonomy.It argues that while financial capital is extremely mobile across borders,other types of investment (especially in equities and sector- specific capital)are far less mobile.In this context,foreseeable levels of international capital mobility restrict but do not eliminate the possibility for national economic policies.Sectoral policies remain feasible,as do policies whose goals directly or indirectly involve the exchange rate. The second section of the article examines the policy preferences of various socioeconomic groups toward financial integration.It emphasizes the differen- tial effects of the increase in capital mobility and focuses on questions concerning which actors are better (or worse)off after financial integration than before and how the various actors can be expected to respond politically to this change in the economic environment.The conclusion here is twofold.Over the long run,international financial integration tends to favor capital over labor,especially in developed countries.But in the shorter run,which is more relevant to politics and policies,the issue is more complex:in the developed world,financial integration favors capitalists with mobile or diversified assets and disfavors those with assets tied to specific locations and activities such as manufacturing or farming. The third section of the article explores what high levels of financial integration imply for the policy preferences of economic interest groups in regard to such other issues as macroeconomic policy and the exchange rate. The section takes a high level of capital mobility as given,to see how various interest groups are expected to behave in this environment.It argues that international capital mobility tends to remake political coalitions by way of its impact on the effects of national policies.The political division between producers of tradable goods and producers of nontradable goods and services is likely to become more important,as are distinctions between internationally diversified and undiversified investors.All of these factors have significant implications for the analysis of politics and economic policy in the advanced industrialized nations. Development in Latin America (Boulder,Colo.:Westview Press,1989);Benjamin J.Cohen,In Whose Interest?Intemnational Banking and American Foreign Policy (New Haven,Conn.:Yale University Press,1987);and Charles Lipson,Standing Guard:Protecting Foreign Capital in the Nineteenth and Twentieth Centuries(Berkeley:University of California Press,1985).The bodies of literature,of course,are far too large to cite or discuss here
426 International Organization specific aspects of the politics of cross-border investment, this literature remains disjointed and short on general analytic principles. This article proposes a framework for analyzing the politics of international capital mobility. It focuses on the distributional implications of cross-border capital movements and on the distributional implications of various economic policies in light of the high degree of international capital mobility. The first section describes just how mobile capital is today and discusses the implications of existing levels of financial integration for national economic policy autonomy. It argues that while financial capital is extremely mobile across borders, other types of investment (especially in equities and sectorspecific capital) are far less mobile. In this context, foreseeable levels of international capital mobility restrict but do not eliminate the possibility for national economic policies. Sectoral policies remain feasible, as do policies whose goals directly or indirectly involve the exchange rate. The second section of the article examines the policy preferences of various socioeconomic groups toward financial integration. It emphasizes the differential effects of the increase in capital mobility and focuses on questions concerning which actors are better (or worse) off after financial integration than before and how the various actors can be expected to respond politically to this change in the economic environment. The conclusion here is twofold. Over the long run, international financial integration tends to favor capital over labor, especially in developed countries. But in the shorter run, which is more relevant to politics and policies, the issue is more complex: in the developed world, financial integration favors capitalists with mobile or diversified assets and disfavors those with assets tied to specific locations and activities such as manufacturing or farming. The third section of the article explores what high levels of financial integration imply for the policy preferences of economic interest groups in regard to such other issues as macroeconomic policy and the exchange rate. The section takes a high level of capital mobility as given, to see how various interest groups are expected to behave in this environment. It argues that international capital mobility tends to remake political coalitions by way of its impact on the effects of national policies. The political division between producers of tradable goods and producers of nontradable goods and services is likely to become more important, as are distinctions between internationally diversified and undiversified investors. All of these factors have significant implications for the analysis of politics and economic policy in the advanced industrialized nations. Development in Latin America (Boulder, Colo.: Westview Press, 1989); Benjamin J. Cohen, In Whose Interest? International Banking and American Foreign Policy (New Haven, Conn.: Yale University Press, 1987); and Charles Lipson, Standing Guard: Protecting Foreign Capital in the Nineteenth and Twentieth Centuries (Berkeley: University of California Press, 1985). The bodies of literature, of course, are far too large to cite or discuss here
Global finance 427 The relationship between international capital mobility and national policies is a prominent example of the much-discussed impact of external conditions on domestic politics.?Elucidating this specific relationship thus also serves the broader purpose of clarifying the domestic effects of international trends.The article,then,both develops an integrated approach to the politics of interna- tional capital movements and addresses more general conceptual issues about the interaction of the domestic and international political economies.In so doing,it presents a summary and empirical illustrations not only of the direct impact of international capital mobility on the effectiveness of national economic policy but also of the distributional effects of capital mobility on the social groups whose demands themselves affect national economic policy. Capital mobility and national economic policies It would be foolish to inquire about the effects of integrated international capital markets on interest group competition over national economic policy if such policy could not be implemiented in a financially integrated world or if contemporary international capital markets were not in fact highly integrated. The initial question therefore concerns the degree to which national economic policy autonomy is compromised by existing levels of international capital mobility. The events of the 1970s and the 1980s have led many to conclude that capital mobility severely limits or contravenes national policy.Between 1978 and 1982, for example,private financial inflows swamped Chile's conservative policies even as private financial outflows thwarted Mexico's free-spending policies.In mid-1981,the economic expansion attempted by the new French Socialist government rapidly confronted a large capital outflow and a run on the franc, leading to a reversal of the policies soon after their adoption.3 Parallel stories about government efforts hampered by capital and currency movements could be told about many other developing and developed countries in the past two decades.Some observers have drawn dire conclusions,such as that of John Freeman,who observed that in the context of the globalization of finance "the nation state has become at best immobilized and at worst obsolete."4 2.The two quintessential works on this subject are Peter Gourevitch's Politics in Hard Times: Comparative Responses to Intemational Economic Crises (Ithaca,N.Y.:Cornell University Press, 1986)and Ronald Rogowski's Commerce and Coalitions:How Trade Affects Domestic Political Alignments(Princeton,N.J.:Princeton University Press,1989). 3.Jeffrey Sachs and Charles Wyplosz,"The Economic Consequences of President Mitterand," Economic Policy 2(April 1986),pp.262-322. 4.See John Freeman,"Banking on Democracy?International Finance and the Possibilities for Popular Sovereignty,"mimeograph,University of Minnesota,1990.From a politically different quarter,former Citibank chief executive officer Walter Wriston has said similar things about the impact of financial internationalization-but approvingly:"It's a new world and the concept of sovereignty is going to change....The idea of fifteenth-century international law is gone.It hasn't laid down yet,but it's dead.It's like the three-mile limit in a world of Inter-Continental Ballistic
Global finance 427 The relationship between international capital mobility and national policies is a prominent example of the much-discussed impact of external conditions on domestic politic^.^ Elucidating this specific relationship thus also serves the broader purpose of clarifying the domestic effects of international trends. The article, then, both develops an integrated approach to the politics of international capital movements and addresses more general conceptual issues about the interaction of the domestic and international political economies. In so doing, it presents a summary and empirical illustrations not only of the direct impact of international capital mobility on the effectiveness of national economic policy but also of the distributional effects of capital mobility on the social groups whose demands themselves affect national economic policy. Capital mobility and national economic policies It would be foolish to inquire about the effects of integrated international capital markets on interest group competition over national economic policy if such policy could not be implem'ented in a financially integrated world or if contemporary international capital markets were not in fact highly integrated. The initial question therefore concerns the degree to which national economic policy autonomy is compromised by existing levels of international capital mobility. The events of the 1970s and the 1980s have led many to conclude that capital mobility severely limits or contravenes national policy. Between 1978 and 1982, for example, private financial inflows swamped Chile's conservative policies even as private financial outflows thwarted Mexico's free-spending policies. In mid-1981, the economic expansion attempted by the new French Socialist government rapidly confronted a large capital outflow and a run on the franc, leading to a reversal of the policies soon after their adoptiom3 Parallel stories about government efforts hampered by capital and currency movements could be told about many other developing and developed countries in the past two decades. Some observers have drawn dire conclusions, such as that of John Freeman, who observed that in the context of the globalization of finance "the nation state has become at best immobilized and at worst ob~olete."~ 2. The two quintessential works on this subject are Peter Gourevitch's Politics in Hard Times: Comparative Responses to International Economic Crises (Ithaca, N.Y.: Cornell University Press, 1986) and Ronald Rogowski's Commerce and Coalitions: How Trade Affects Domestic Political Alignments (Princeton, N.J.: Princeton University Press, 1989). 3. Jeffrey Sachs and Charles Wyplosz, "The Economic Consequences of President Mitterand," Economic Policy 2 (April 1986), pp. 262-322. 4. See John Freeman, "Banking on Democracy? International Finance and the Possibilities for Popular Sovereignty," mimeograph, University of Minnesota, 1990. From a politically different quarter, former Citibank chief executive officer Walter Wriston has said similar things about the impact of financial internationalization-but approvingly: "It's a new world and the concept of sovereignty is going to change. . . . The idea of fifteenth-century international law is gone. It hasn't laid down yet, but it's dead. It's like the three-mile limit in a world of Inter-Continental Ballistic
428 International Organization The first step in evaluating the effects of contemporary levels of international capital mobility is to get a clear picture of where the levels stand in relation to the past.Long-term capital movements across borders were relatively limited for the first twenty-five years after World War II and took place primarily in the form of direct investment.Today,long-term international investment flows are extraordinarily large,and direct investment has been dwarfed by other,more arms-length,forms of cross-border capital movements. According to one source,net international bond and bank lending was $440 billion in 1989,up from $180 billion just five years earlier.Capital outflows from the thirteen leading industrialized countries averaged $444 billion in 1989,with almost two-thirds of the amount consisting of portfolio investment,in contrast to $52 billion in the late 1970s,with two-thirds consisting of foreign direct investment.Capital outflows were equivalent to 15 percent of world merchan- dise trade in 1989,in contrast to 7 percent in the late 1970s.3 According to another source,the outstanding stock of international bank and bond lending was $3.6 trillion in 1989,equivalent to 25 percent of the aggregate gross national product(GNP)of the industrialized countries,in contrast to under $200 billion and 5 percent of aggregate GNP in 1973. Recent changes in regulations and technology have made it possible for money to travel across borders almost instantly,giving rise to massive short-term international financial transactions.In April 1989,foreign exchange trading in the world's financial centers averaged about $650 billion a day, equivalent to nearly $500 million a minute and to forty times the amount of world trade a day.Markets for short-term international financial instruments are comparably large,although exact figures are not available.? Impressive as these numbers are,they do not amount to full international capital mobility.In fact,economic studies have consistently shown that borders and currencies are still substantial barriers to investment flows.3 Although Missiles."Wriston is cited in my Banking on the World:The Politics of American Interational Finance (New York:Harper Row,1987),p.115.See also Walter Wriston,Risk and Other Four-Letter Words (New York:Harper Row,1986). 5.Bank for International Settlements (BIS),Sixtieth Annual Report (BIS:Basle,1990),pp.63, 82,and125. 6.See Morris Goldstein,Donald Mathieson,and Timothy Lane,"Determinants and Systemic Consequences of International Capital Flows,"in Determinants and Systemic Consequences of International Capital Flows (Washington,D.C.:International Monetary Fund,1991),p.5.This assumes a low level of international bond lending in 1973,which is almost certainly the case.Exact figures are not available. 7.See BIS,Sixtieth Annual Report,pp.208-9.See also pp.146-52,which offer data regarding some short-term instruments and indicate that open positions in interest rate futures and options totaled about $1.6 trillion at the end of 1989. 8.The early classic work was M.Feldstein and C.Horioka's"Domestic Savings and Interna- tional Capital Flows,"Economic Joumal 90 (June 1980),pp.314-29.For more on the issue and debates over it,see Ralph Bryant,International Financial Intermediation (Washington,D.C.: Brookings Institution,1987),pp.82-86.For a recent test,see Tamim Bayoumi,"Saving-Investment Correlations:Immobile Capital,Government Policy,or Endogenous Behavior?"IMF Staff Papers 37(June1990),Pp.360-87
428 International Organization The first step in evaluating the effects of contemporary levels of international capital mobility is to get a clear picture of where the levels stand in relation to the past. Long-term capital movements across borders were relatively limited for the first twenty-five years after World War I1 and took place primarily in the form of direct investment. Today, long-term international investment flows are extraordinarily large, and direct investment has been dwarfed by other, more arms-length, forms of cross-border capital movements. According to one source, net international bond and bank lending was $440 billion in 1989, up from $180 billion just five years earlier. Capital outflows from the thirteen leading industrialized countries averaged $444 billion in 1989, with almost two-thirds of the amount consisting of portfolio investment, in contrast to $52 billion in the late 1970s, with two-thirds consisting of foreign direct investment. Capital outflows were equivalent to 15 percent of world merchandise trade in 1989, in contrast to 7 percent in the late 1970~.~ According to another source, the outstanding stock of international bank and bond lending was $3.6 trillion in 1989, equivalent to 25 percent of the aggregate gross national product (GNP) of the industrialized countries, in contrast to under $200 billion and 5 percent of aggregate GNP in 1973.6 Recent changes in regulations and technology have made it possible for money to travel across borders almost instantly, giving rise to massive short-term international financial transactions. In April 1989, foreign exchange trading in the world's financial centers averaged about $650 billion a day, equivalent to nearly $500 million a minute and to forty times the amount of world trade a day. Markets for short-term international financial instruments are comparably large, although exact figures are not available.' Impressive as these numbers are, they do not amount to full international capital mobility. In fact, economic studies have consistently shown that borders and currencies are still substantial barriers to investment flows.' Although Missiles." Wriston is cited in my Banking on the World: The Politics of American International Finance (New York: Harper & Row, 1987), p. 115. See also Walter Wriston, Risk and Other Four-Letter Words (New York: Harper & Row, 1986). 5. Bank for International Settlements (BIS), Sixtieth Annual Report (BIS: Basle, 1990), pp. 63, 82, and 125. 6. See Morris Goldstein, Donald Mathieson, and Timothy Lane, "Determinants and Systemic Consequences of International Capital Flows," in Determinants and Systemic Consequences of International Capital Flows (Washington, D.C.: International Monetary Fund, 1991), p. 5. This assumes a low level of international bond lending in 1973, which is almost certainly the case. Exact figures are not available. 7. See BIS, Sixtieth Annual Report, pp. 208-9. See also pp. 146-52, which offer data regarding some short-term instruments and indicate that open positions in interest rate futures and options A A totaled about $1.6 trillion at the end of 1989. 8. The early classic work was M. Feldstein and C. Horioka's "Domestic Savings and International Capital Flows," Economic Journal 90 (June 1980), pp. 314-29. For more on the issue and debates over it, see Ralph Bryant, International Financial Intermediation (Washington, D.C.: Brookings Institution, 1987), pp. 82-86. For a recent test, see Tamim Bayoumi, "Saving-Investment Correlations: Immobile Capital, Government Policy, or Endogenous Behavior?" IMF Staff Papers 37 (June 1990), pp. 360-87
Global finance 429 these barriers have been and are still being reduced,there are a number of reasons why international investment is by no means yet a seamless web.First, movement of capital across borders still involves country and currency risks. Investors must take into account the possibility that assets in one country may be riskier than those in another country and that movements in exchange rates may affect the return on their investments.Of course,both of these problems are addressed by adjustments to asset prices and returns and by forward markets,but they imply that capital movements among industrialized countries are more difficult than capital movements within them. Second,while some forms of capital do move quite easily across borders, others remain more geographically specific.Most assertions of full interna- tional capital mobility refer to international transfers of financial assets, especially bonds and bank claims.Equity markets appear to be far less integrated,and other forms of capital still less so.In most interpretations,this is because many forms of capital,such as technological and managerial knowledge,skills,and networks,are specific to their current use and cannot easily be transferred from place to place."Although detailed analyses do not exist,most observers would probably agree that financial capital is most mobile across borders,followed by equities and then by firm-or sector-specific capital assets.12 The greater international mobility of financial assets,the more modest international mobility of other assets,and the continued importance of unexpected exchange rate movements must all be taken into account in assessments of national policy autonomy in the contemporary international economy.The appraisal can be divided into policy targeted at well-defined segments of the economy (industries,sectors,and regions)and policy of macroeconomic import.The baseline is the assertion that asset markets are 9.The most careful assessment of the Feldstein-Horioka findings,updated through the late 1980s,emphasizes the great increase in capital mobility and the continued importance of currency premiums.See Jeffrey A.Frankel,"Quantifying International Capital Mobility in the 1980s,"in Douglas Bernheim and John Shoven,eds.,National Saving and Economic Performance(Chicago: University of Chicago Press,1991),pp.227-60. 10.For rough evidence on intranational and international stock price differentials,see Barry Eichengreen,"Is Europe an Optimum Currency Area?"mimeograph,University of California at Berkeley,1990,pp.6-9.The differentials may have to do with nontransferable advantages accruing to national owners,such as greater access to information or to monitoring and enforcement mechanisms 11.The modern theory of foreign direct investment is based on the proposition that multinational firms exist precisely because they facilitate (but do not make costless)the international transmission of such specific assets.The classic statement by Caves is still probably the most appropriate here.See Richard E.Caves,"International Corporations:The Industrial Economics of Foreign Investment,"Economica 38(February 1971),pp.1-27. 12.This is a conclusion made by Frankel in"Quantifying International Capital Mobility in the 1980s."One indication of the high degree to which markets for financial assets are integrated is the virtual disappearance of significant spreads between domestic and offshore interest rates in most currency instruments of members of the Organization for Economic Cooperation and Develop- ment (OECD).Regarding this subject,see Goldstein,Mathieson,and Lane,"Determinants and Systemic Consequences of International Capital Flows,"pp.7-11
Global finance 429 these barriers have been and are still being reduced, there are a number of reasons why international investment is by no means yet a seamless web. First, movement of capital across borders still involves country and currency risks. Investors must take into account the possibility that assets in one country may be riskier than those in another country and that movements in exchange rates may affect the return on their investments. Of course, both of these problems are addressed by adjustments to asset prices and returns and by forward markets, but they imply that capital movements among industrialized countries are more difficult than capital movements within them.' Second, while some firms of capital do move quite easily across borders, others remain more geographically specific. Most assertions of full international capital mobility refer to international transfers of financial assets, especially bonds and bank claims. Equity markets appear to be far less integrated,'' and other forms of capital still less so. In most interpretations, this is because many forms of capital, such as technological and managerial knowledge, skills, and networks, are specific to their current use and cannot easily be transferred from place to place." Although detailed analyses do not exist, most observers would probably agree that financial capital is most mobile across borders, followed by equities and then by firm- or sector-specific capital assets.'' The greater international mobility of financial assets, the more modest international mobility of other assets, and the continued importance of unexpected exchange rate movements must all be taken into account in assessments of national policy autonomy in the contemporary international economy. The appraisal can be divided into policy targeted at well-defined segments of the economy (industries, sectors, and regions) and policy of macroeconomic import. The baseline is the assertion that asset markets are 9. The most careful assessment of the Feldstein-Horioka findings, updated through the late 1980s, emphasizes the great increase in capital mobility and the continued importance of currency premiums. See Jeffrey A. Frankel, "Quantifying International Capital Mobility in the 1980s," in Douglas Bernheim and John Shoven, eds., National Saving and Economic Performance (Chicago: University of Chicago Press, 1991), pp. 227-60. 10. For rough evidence on intranational and international stock price differentials, see Barry Eichengreen, "Is Europe an Optimum Currency Area?" mimeograph, University of California at Berkeley, 1990, pp. 69. The differentials may have to do with nontransferable advantages accruing to national owners, such as greater access to information or to monitoring and enforcement mechanisms. 11. The modern theory of foreign direct investment is based on the proposition that multinational firms exist precisely because they facilitate (but do not make costless) the international transmission of such specific assets. The classic statement by Caves is still probably the most appropriate here. See Richard E. Caves, "International Corporations: The Industrial Economics of Foreign Investment," Economica 38 (February 1971), pp. 1-27. 12. This is a conclusion made by Frankel in "Quantifying International Capital Mobility in the 1980s." One indication of the high degree to which markets for financial assets are integrated is the virtual disappearance of significant spreads between domestic and offshore interest rates in most currency instruments of members of the Organization for Economic Cooperation and Development (OECD). Regarding this subject, see Goldstein, Mathieson, and Lane, "Determinants and Systemic Consequences of International Capital Flows," pp. 7-11
430 International Organization internationally linked to varying degrees:financial markets are closely linked, equity markets are less connected,and markets for firm-and sector-specific capital are quite nationally segmented.In other words,among industrialized countries,financial capital flows freely but other assets flow relatively less freely or very little. Inasmuch as capital is specific to location,increased financial integration has only limited effects on policies targeted at particular industries.Whether or not a sector-specific policy is effective depends greatly on how easily firms can enter the sector.Financial markets can affect the ease of entry by extending funds to new firms.The easier it is for new firms to enter the sector,the more quickly the benefits of the policy to preexisting firms will dissipate and thus the less effective the policy will be.This is a general feature of sector-specific policies and holds as long as financial capital is mobile domestically;it would be true even if capital were not mobile internationally. Where cross-border financial flows reduce entry barriers to a favored sector, they contravene sector-specific policy.International capital mobility may have increased the ability of foreign producers to respond to trade protection by locating in the protected market;inasmuch as the purpose of protection was to support locally owned firms,this objective may be frustrated.The proliferation of Japanese-owned automobile factories in the United States in response to automobile import controls may have been made easier by the integration of financial markets and may have reduced some of the benefits of the controls to shareholders and employees of American-owned automobile manufacturers.3 All in all,however,increased financial capital mobility probably has little effect on most sector-specific policies.Supporters of such policies can generally design them to avoid their frustration by financial flows,domestic or interna- tional.Financial capital mobility,within or across borders,is not likely to affect the impact of cash transfers to farmers on their incomes.Nor can financial flows significantly impede government health and safety standards.Financial integration may make it more difficult to design some sector-specific policies to avoid undesirable side effects (namely,benefits accruing to untargeted firms), but it rarely makes them unsustainable. On the other hand,integration of financial markets has significant effects on the effectiveness and the differential distributional impact of national macro- economic policies.To get a handle on the issue,it is useful to start with what 13.Although I am unaware of any studies of this phenomenon,arguments to this effect are frequently heard among American competitors of the Japanese transplants,often in the context of complaints over the Japanese firms'access to low-cost Japanese funds.There are reasons to doubt the accuracy of the argument,however.First,most foreign direct investment is funded in the host country.Second,if Japanese firms have privileged access to Japanese finance,then financial markets are not fully integrated.The result might be due to preferential ties among Japanese financial and nonfinancial firms,which would constitute a "natural"barrier to financial capital mobility.Further study in this regard is required.A related issue is the effect of foreign-owned branch plants on political lineups in the host country.For anecdotal evidence that Japanese investment in the United States has created or reinforced domestic interest groups that favor freer trade,see "Influx of Foreign Capital Mutes Debate on Trade,"The New York Times,8 February 1987,p.113
430 International Organization internationally linked to varying degrees: financial markets are closely linked, equity markets are less connected, and markets for firm- and sector-specific capital are quite nationally segmented. In other words, among industrialized countries, financial capital flows freely but other assets flow relatively less freely or very little. Inasmuch as capital is specific to location, increased financial integration has only limited effects on policies targeted at particular industries. Whether or not a sector-specific policy is effective depends greatly on how easily firms can enter the sector. Financial markets can affect the ease of entry by extending funds to new firms. The easier it is for new firms to enter the sector, the more quickly the benefits of the policy to preexisting firms will dissipate and thus the less effective the policy will be. This is a general feature of sector-specific policies and holds as long as financial capital is mobile domestically; it would be true even if capital were not mobile internationally. Where cross-border financial flows reduce entry barriers to a favored sector, they contravene sector-specific policy. International capital mobility may have increased the ability of foreign producers to respond to trade protection by locating in the protected market; inasmuch as the purpose of protection was to support locally owned firms, this objective may be frustrated. The proliferation of Japanese-owned automobile factories in the United States in response to automobile import controls may have been made easier by the integration of financial markets and may have reduced some of the benefits of the controls to shareholders and employees of American-owned automobile manufacturers.13 All in all, however, increased financial capital mobility probably has little effect on most sector-specific policies. Supporters of such policies can generally design them to avoid their frustration by financial flows, domestic or international. Financial capital mobility, within or across borders, is not likely to affect the impact of cash transfers to farmers on their incomes. Nor can financial flows significantly impede government health and safety standards. Financial integration may make it more difficult to design some sector-specific policies to avoid undesirable side effects (namely, benefits accruing to untargeted firms), but it rarely makes them unsustainable. On the other hand, integration of financial markets has significant effects on the effectiveness and the differential distributional impact of national macroeconomic policies. To get a handle on the issue, it is useful to start with what 13. Although I am unaware of any studies of this phenomenon, arguments to this effect are frequently heard among American competitors of the Japanese transplants, often in the context of complaints over the Japanese firms' access to low-cost Japanese funds. There are reasons to doubt the accuracy of the argument, however. First, most foreign direct investment is funded in the host country. Second, if Japanese firms have privileged access to Japanese finance, then financial markets are not fully integrated. The result might be due to preferential ties among Japanese financial and nonfinancial firms, which would constitute a "natural" barrier to financial capital mobility. Further study in this regard is required. A related issue is the effect of foreign-owned branch plants on political lineups in the host country. For anecdotal evidence that Japanese investment in the United States has created or reinforced domestic interest groups that favor freer trade, see "Influx of Foreign Capital Mutes Debate on Trade," The New York Times, 8 February 1987, p. 113
Global finance 431 might be called the Mundell-Fleming conditions,taken from the most influential approach to payments balance developed in the early 1960s.4 These conditions include the possibility that financial assets may be fully mobile across borders.(In what follows,I use"capital mobility"to mean the mobility of financial capital,as does the literature in question.) Simply put,the Mundell-Fleming approach indicates that a country can have at most two of the following three conditions:a fixed exchange rate,monetary policy autonomy,and capital mobility.Without capital mobility,national authorities can adopt and sustain a monetary policy that differs from the policies of the rest of the world and can hold their exchange rate constant; however,with mobile capital,the attempt will be contravened by financial flows.Assume the authorities want an expansionary monetary policy.Without capital mobility,a fall in interest rates will lead to a rise in demand,and the economy will be stimulated (we ignore longer-term effects on the payments balance).With capital mobility,reduced domestic interest rates will lead to an outflow of capital in search of higher interest rates abroad,and long before monetary policy has a real effect,interest rates will be bid back up to world levels.is The reason for the result is straightforward:if capital is fully mobile across borders,interest rates are constrained to be the same in all countries and national monetary policy can have no effect on national interest rates. However,to go back to the original conditions,if capital mobility is given (or imposed),monetary policy can be effective if the value of the currency is allowed to vary.Monetary policy operates,in other words,via exchange rates rather than via interest rates as in a typical closed-economy model.With capital mobility,monetary expansion greater than that in the rest of the world causes a financial outflow in which investors sell the currency;the result is currency depreciation.Depreciation in most cases stimulates the economy as prices of foreign goods rise relative to prices of domestically produced goods,thereby increasing local and foreign demand for locally produced goods.6 A parallel story can be told about fiscal policy.If capital is not mobile and the exchange rate is fixed,expansionary fiscal policy raises national interest rates as the government finances increased spending by floating more bonds.The 14.See the following works of Robert A.Mundell:"The Appropriate Use of Monetary and Fiscal Policy Under Fixed Exchange Rates,"IMF Staff Papers 9(March 1962),pp.70-77;"Capital Mobility and Stabilization Policy Under Fixed and Flexible Exchange Rates,"Canadian Journal of Economics and Political Science 29 (November 1963),pp.475-85;and"A Reply:Capital Mobility and Size,"Canadian Journal of Economics and Political Science 30 (August 1964),pp.421-31.The basic model can be found in any good textbook discussion of open-economy macroeconomics;a useful survey is W.M.Corden's Inflation,Exchange Rates,and the World Economy,3d ed.(Chicago: University of Chicago Press,1986). 15.The argument presented here is in simplified form.Variation in monetary autonomy is actually along a continuum,not dichotomous:the choice is not starkly between full monetary independence and none at all;it is instead among different degrees of autonomy. 16.This ignores the potential contravening effects of the depreciation on national income;that is,it assumes that substitution effects dominate income effects or that expenditure switching dominates expenditure reduction
Global finance 431 might be called the Mundell-Fleming conditions, taken from the most influential approach to payments balance developed in the early 1960s.14 These conditions include the possibility that financial assets may be fully mobile across borders. (In what follows, I use "capital mobility" to mean the mobility of financial capital, as does the literature in question.) Simply put, the Mundell-Fleming approach indicates that a country can have at most two of the following three conditions: a fixed exchange rate, monetary policy autonomy, and capital mobility. Without capital mobility, national authorities can adopt and sustain a monetary policy that differs from the policies of the rest of the world and can hold their exchange rate constant; however, with mobile capital, the attempt will be contravened by financial flows. Assume the authorities want an expansionary monetary policy. Without capital mobility, a fall in interest rates will lead to a rise in demand, and the economy will be stimulated (we ignore longer-term effects on the payments balance). With capital mobility, reduced domestic interest rates will lead to an outflow of capital in search of higher interest rates abroad, and long before monetary policy has a real effect, interest rates will be bid back up to world levels.15 The reason for the result is straightforward: if capital is fully mobile across borders, interest rates are constrained to be the same in all countries and national monetary policy can have no effect on national interest rates. However, to go back to the original conditions, if capital mobility is given (or imposed), monetary policy can be effective if the value of the currency is allowed to vary. Monetary policy operates, in other words, via exchange rates rather than via interest rates as in a typical closed-economy model. With capital mobility, monetary expansion greater than that in the rest of the world causes a financial outflow in which investors sell the currency; the result is currency depreciation. Depreciation in most cases stimulates the economy as prices of foreign goods rise relative to prices of domestically produced goods, thereby increasing local and foreign demand for locally produced goods.16 A parallel story can be told about fiscal policy. If capital is not mobile and the exchange rate is fixed, expansionary fiscal policy raises national interest rates as the government finances increased spending by floating more bonds. The 14. See the following works of Robert A. Mundell: "The Appropriate Use of Monetary and Fiscal Policy Under Fixed Exchange Rates," ZMF StaffPapers 9 (March 1962), pp. 70-77; "Capital Mobility and Stabilization Policy Under Fixed and Flexible Exchange Rates," Canadian Journal of Economics and Political Science 29 (November 1963), pp. 475-85; and "A Reply: Capital Mobility and Size," Canadian Journal of Economics and Political Science 30 (August 1964), pp. 421-31. The basic model can be found in any good textbook discussion of open-economy macroeconomics; a useful survey is W. M. Corden's Inflation, Exchange Rates, and the World Economy, 3d ed. (Chicago: University of Chicago Press, 1986). 15. The argument presented here is in simplified form. Variation in monetary autonomy is actually along a continuum, not dichotomous: the choice is not starkly between full monetary independence and none at all; it is instead among different degrees of autonomy. 16. This ignores the potential contravening effects of the depreciation on national income; that is, it assumes that substitution effects dominate income effects or that expenditure switching dominates expenditure reduction
432 International Organization resultant "crowding out"of private investment dampens the expansion. However,if capital moves freely across borders,bonds floated to finance increased government spending are bought by international investors,and there is no effect on interest rates,which are set globally.Relaxing the fixed exchange rate constraint has different effects with fiscal policy than with monetary policy.If the exchange rate varies,as foreigners buy more govern- ment bonds the resultant capital inflow causes a currency appreciation that tends to reduce domestic demand for domestically produced goods and thus to dampen the fiscal expansion.8 The general point is that in a world of fully mobile capital,national policy cannot affect the national interest rate;it can,however,affect the exchange rate.The above discussion of open-economy macroeconomics is meant simply to highlight this result. It may seem unimportant that the world has changed from one in which national macroeconomic policy operated primarily via interest rates to one in which policy operates primarily via exchange rates,but several points to defend the significance of this observation can be made.First,the distributional effects of interest rate changes are different from those of exchange rate changes.If monetary expansion in a stylized world before capital mobility (BCM)meant lower interest rates,then monetary expansion in a stylized world after capital mobility (ACM)means depreciation.To take one distributional example, lower interest rates are good for the residential construction industry,while depreciation is bad for it inasmuch as it tends to switch domestic demand away from nontradable goods and services.By the same token,manufacturers might have been more sympathetic to a tight money stance in the past,when the principal effect of this stance was to raise interest rates,than they are now, when the principal effect is a currency appreciation that tends to increase import penetration.This means that policy preferences of economic interest groups,and therefore political coalitions,are likely to differ between the BCM and ACM worlds.I later return to this point and discuss it in detail. Second,although by definition there is an international component to exchange rate changes,there is not necessarily an international component to 17.The point is not that foreigners buy all the government bonds but,rather,that the increased domestic demand for credit is met by an increased supply of credit as capital flows in,with the result that the price of credit remains unchanged.This of course assumes that the deficit country is not large enough to affect world interest rates,which may not always be the case.It also assumes that the government does not engage in monetary policies that accommodate the fiscal expansion. 18.For a good survey and evaluation,see Michael M.Hutchison and Charles A.Pigott,"Real and Financial Linkages in the Macroeconomic Response to Budget Deficits:An Empirical Investigation,"in Sven Arndt and J.David Richardson,eds.,Real-Financial Linkages Among Open Economies (Cambridge,Mass.:MIT Press,1987),pp.139-66. 19.More accurately,it does not affect the covered interest rate-that is,the interest rate minus (or plus)the market's expectation of currency movements.Obviously,if investors expect a currency to fall,they demand a higher interest rate for securities denominated in it,and vice versa.Covered interest parity appears to have held well from the mid-1970s onward among almost all major currencies
432 International Organization resultant "crowding out" of private investment dampens the expansion. However, if capital moves freely across borders, bonds floated to finance increased government spending are bought by international investors, and there is no effect on interest rates, which are set globally.17 Relaxing the fixed exchange rate constraint has different effects with fiscal policy than with monetary policy. If the exchange rate varies, as foreigners buy more government bonds the resultant capital inflow causes a currency appreciation that tends to reduce domestic demand for domestically produced goods and thus to dampen the fiscal expan~ion.'~ The general point is that in a world of fully mobile capital, national policy cannot affect the national interest rate;19 it can, however, affect the exchange rate. The above discussion of open-economy macroeconomics is meant simply to highlight this result. It may seem unimportant that the world has changed from one in which national macroeconomic policy operated primarily via interest rates to one in which policy operates primarily via exchange rates, but several points to defend the significance of this observation can be made. First, the distributional effects of interest rate changes are different from those of exchange rate changes. If monetary expansion in a stylized world before capital mobility (BCM) meant lower interest rates, then monetary expansion in a stylized world after capital mobility (ACM) means depreciation. To take one distributional example, lower interest rates are good for the residential construction industry, while depreciation is bad for it inasmuch as it tends to switch domestic demand away from nontradable goods and services. By the same token, manufacturers might have been more sympathetic to a tight money stance in the past, when the principal effect of this stance was to raise interest rates, than they are now, when the principal effect is a currency appreciation that tends to increase import penetration. This means that policy preferences of economic interest groups, and therefore political coalitions, are likely to differ between the BCM and ACM worlds. I later return to this point and discuss it in detail. Second, although by definition there is an international component to exchange rate changes, there is not necessarily an international component to 17. The point is not that foreigners buy all the government bonds but, rather, that the increased domestic demand for credit is met by an increased supply of credit as capital flows in, with the result that the price of credit remains unchanged. This of course assumes that the deficit country is not large enough to affect world interest rates, which may not always be the case. It also assumes that the government does not engage in monetary policies that accommodate the fiscal expansion. 18. For a good survey and evaluation, see Michael M. Hutchison and Charles A. Pigott, "Real and Financial Linkages in the Macroeconomic Response to Budget Deficits: An Empirical Investigation," in Sven Arndt and J. David Richardson, eds., Real-Financial Linkages Among Open Economies (Cambridge, Mass.: MIT Press, 1987), pp. 139-66. 19. More accurately, it does not affect the covered interest rate-that is, the interest rate minus (or plus) the market's expectation of currency movements. Obviously, if investors expect a currency to fall, they demand a higher interest rate for securities denominated in it, and vice versa. Covered interest parity appears to have held well from the mid-1970s onward among almost all major currencies
Global finance 433 interest rate changes.If monetary expansion simply reduces national interest rates,chances are that most foreigners will be indifferent.If,however,it leads to currency depreciation in the expansionary country,foreigners are likely to be concerned about their resultant loss of competitiveness.20 Third,the focus on how macroeconomic policy takes effect through the exchange rate helps clarify some observed anomalies of the ACM world.If an American administration in the BCM world had pursued fiscal expansion and monetary stringency,the result might well have been that the policies canceled each other out:tight money would have reinforced the"crowding out"effects of the fiscal expansion.As it was,however,in the ACM world,the Reagan- Volcker fiscal expansion and monetary stringency of the early 1980s had a markedly different impact.Fiscal policy was largely financed by foreign borrowing,which reduced or eliminated the effects of crowding out and contributed to appreciation of the dollar.At the same time,tight money reinforced the rise of the dollar by strengthening the international investment attractiveness of dollar-denominated securities.The result was striking both on macroeconomic grounds,as the dollar soared and the United States became a major net debtor to the rest of the world,and on distributional grounds,as the dollar appreciation devastated U.S.producers of tradable goods(manufactur- ing and agriculture)and favored producers of nontradable goods and services (real estate,health care,leisure activities,and education). To summarize this section,financial capital moves across the borders of developed countries with great ease,while other asset markets are less integrated and some capital remains quite fixed.In this context,while global financial integration may reduce the efficacy of some sector-specific policies,it does not impede most of them.And while international financial integration does not make national macroeconomic policy obsolete,it does shift the effect of macroeconomic policy from the interest rate to the exchange rate.These features of the ACM world are expected to have a significant impact on the interests of various domestic economic interest groups.I return to ACM interest group competition over economic policy after first looking at the expected effects of the shift from BCM to ACM itself. The distributional effects of capital mobility The distinction I draw here is nuanced but important.On the one hand,I am interested in how economic agents are expected to act in a world characterized by capital mobility:What sorts of policies will be pursued by what sorts of groups and coalitions?On the other hand,I am interested in how the shift from 20.For an illuminating discussion of cross-border effects,see Michael Mussa,"Macroeconomic Interdependence and the Exchange Rate Regime,"in Rudiger Dornbusch and Jacob Frenkel, eds.,International Economic Policy:Theory and Evidence (Baltimore,Md.:Johns Hopkins University Press,1979),pp.160-204
Global finance 433 interest rate changes. If monetary expansion simply reduces national interest rates, chances are that most foreigners will be indifferent. If, however, it leads to currency depreciation in the expansionary country, foreigners are likely to be concerned about their resultant loss of competitivene~s.~~ Third, the focus on how macroeconomic policy takes effect through the exchange rate helps clarify some observed anomalies of the ACM world. If an American administration in the BCM world had pursued fiscal expansion and monetary stringency, the result might well have been that the policies canceled each other out: tight money would have reinforced the "crowding out" effects of the fiscal expansion. As it was, however, in the ACM world, the ReaganVolcker fiscal expansion and monetary stringency of the early 1980s had a markedly different impact. Fiscal policy was largely financed by foreign borrowing, which reduced or eliminated the effects of crowding out and contributed to appreciation of the dollar. At the same time, tight money reinforced the rise of the dollar by strengthening the international investment attractiveness of dollar-denominated securities. The result was striking both on macroeconomic grounds, as the dollar soared and the United States became a major net debtor to the rest of the world, and on distributional grounds, as the dollar appreciation devastated U.S. producers of tradable goods (manufacturing and agriculture) and favored producers of nontradable goods and services (real estate, health care, leisure activities, and education). To summarize this section, financial capital moves across the borders of developed countries with great ease, while other asset markets are less integrated and some capital remains quite fixed. In this context, while global financial integration may reduce the efficacy of some sector-specific policies, it does not impede most of them. And while international financial integration does not make national macroeconomic policy obsolete, it does shift the effect of macroeconomic policy from the interest rate to the exchange rate. These features of the ACM world are expected to have a significant impact on the interests of various domestic economic interest groups. I return to ACM interest group competition over economic policy after first looking at the expected effects of the shift from BCM to ACM itself. The distributional effects of capital mobility The distinction I draw here is nuanced but important. On the one hand, I am interested in how economic agents are expected to act in a world characterized by capital mobility: What sorts of policies will be pursued by what sorts of groups and coalitions? On the other hand, I am interested in how the shift from 20. For an illuminating discussion of cross-border effects, see Michael Mussa, "Macroeconomic Interdependence and the Exchange Rate Regime," in Rudiger Dornbusch and Jacob Frenkel, eds., International Economic Policy: Theory and Evidence (Baltimore, Md.: Johns Hopkins University Press, 1979),pp. 160-204
