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Three essays on democracy and economic policy

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Three essays on democracy and economic policy

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Content TH REE ESSAYS ON DEMOCRACY AND ECONOM IC POLICY Copyright 2005 by John A. Doces A Dissertation Presented to the FACULTY OF TH E GRADUATE SCHOOL UNIVERSITY OF SOUTHERN CALIFORNIA In Partial Fulfillment of the Requirements for the Degree DOCTOR OF PHILOSOPHY (POLITICAL ECONOM Y AND PUBLIC POLICY) December 2005 John A. Doces Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. UMI Number: 3220100 INFORMATION TO USERS The quality of this reproduction is dependent upon the quality of the copy submitted. Broken or indistinct print, colored or poor quality illustrations and photographs, print bleed-through, substandard margins, and improper alignment can adversely affect reproduction. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if unauthorized copyright material had to be removed, a note will indicate the deletion. ® UMI UMI Microform 3220100 Copyright 2006 by ProQuest Information and Learning Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor, Ml 48106-1346 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table of Contents List of Tables............................................................................................................................... iii List of Figures..............................................................................................................................iv Abstract..........................................................................................................................................v Chapter 1........................................................................................................................................1 Chapter 2..................................................................................................................................... 26 Chapter 3......................................................................................................................................60 Chapter 4.................................................................................................................................... 106 Chapter 5.................................................................................................................................... 132 Bibliography................................................... 136 ii Reproduced with permission of the copyright owner. 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List of Tables Table 1.1............................................................................................................................. 11 Table 2.1.......................................................................................................................................49 Table 2.2....................................................................................................................................... 50 Table 2.3....................................................................................................................................... 57 Table 3.1....................................................................................................................................... 72 Table 3.2....................................................................................................................................... 79 Table 3.3....................................................................................................................................... 80 Table 3.4....................................................................................................................................... 83 Table 3.5....................................................................................................................................... 85 Table 3.6....................................................................................................................................... 87 Table 3.7....................................................................................................................................... 94 Table 3.8....................................................................................................................................... 95 Table 3.9....................................................................................................................................... 96 Table 3.10................................................................................................................................... 103 Table 4.1.....................................................................................................................................119 Table 4.2.....................................................................................................................................120 Table 4.3.....................................................................................................................................121 Table 4.4.......................................................................................................................... .......1 2 5 Table 4.5.................................................................................................. 128 Table 4.6.....................................................................................................................................129 iii Reproduced with permission of the copyright owner. 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List of Figures Figure 2.1.....................................................................................................................................26 Figure 2.2......................................................................................................................................27 Figure 2.3.....................................................................................................................................28 Figure 4.1....................................................................................................................................107 Figure 4.2....................................................................................................................................110 Figure 4.3....................................................................................................................................I l l Figure 4.4....................................................................................................................................116 iv Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Abstract This dissertation is composed of three chapters. Chapter 2 studies the relationship between parliamentary versus presidential democracies and international trade. It analyzes whether parliamentary or presidential democratic political systems are more amenable to special interest groups seeking to alter trade policy. The question asked here is if bilateral exports are higher when the trading partners are both parliamentary systems. A theoretical model is developed that derives the trade-offs the government faces when deciding on international trade policy. The model highlights that a government’s willingness to trade-off sector specific interests versus aggregate welfare varies amongst parliamentarism and presidentialism and is thus a key reason why we see variations in trade policy. Using the gravity model as a baseline specification the dyadic results indicate that parliamentarism has statistically significant more trade than dyads composed of two presidential regimes. The results show that parliamentary systems have higher levels of bilateral exports. Chapter 3 studies democracy and capital flows paying specific attention to foreign direct investment. D o developing countries that consolidate their power in the form of more autocracy generate increased inflows of FDI? Section 3.1 analyzes the change in the level of democracy in developing countries and the effect this has on inward foreign direct investment. Section 3.2 considers the impact o f the consolidation of autocracy on inward flows of FDI. The extension, Section 3.3, looks at bilateral portfolio flows. All the results indicate that democracy has a positive effect on FDI inflows for developing countries. Finally, Chapter 4 considers price stability in the context of parliamentary and V Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. presidential democracies. The theory in Section 4.1 argues that in parliamentary systems the tradeoff between output and inflation is more severe than in presidential regimes and develops the hypothesis that parliamentary regimes have more price stability compared to presidential democracies. This is due to the fact that the policymaking process is more collegial in parliamentary systems and thus politicians cannot afford to neglect the popular will in favor of low levels of unemployment. I argue, it is likely that parliamentary systems will delegate control over monetary policy to independent institutions such as central banks. This delegation results in more price stability compared to presidential regimes. The econometric results are supportive indicating that parliamentary regimes have more price stability measured by the change in the inflation rate. Finally, section 4.2 offers an empirical analysis of this effect on economic integration. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1 Introduction Today it is common to hear vigorous debate on international economic issues. From international trade, to foreign investment, to aid for developing countries it seems just about everyone has an opinion on these important economic issues, and these issues are often at the heart of political debates across the world. But, what are the factors that connect our global economy? Specifically, what determines levels of bilateral trade between countries? Why does capital flow unevenly amongst the world’s countries? Why do some countries live with persistent price instability? Each of these questions is important in their own right and I will argue in this dissertation that each is influenced by political institutions. If political institutions and the resulting politics play a role in determining equilibrium outcomes to these questions, what is the role, and how do the outcomes vary amongst alternative political institutions? In this dissertation I will be tackling the question of how political institutions influences economic outcomes. Drazen (2000) sums the essence of this question nicely. He states: “This question has been asked probably as long as people have been interested in economics itself. From Adam Smith’s Wealth ofNations in 1776 (or perhaps the Physiocrats even earlier) until at least John Stuart Mill’s Principles of Political Economy in 1848, what we now call ‘economics’ was in fact generally referred to as ‘ political economy’. This terminology in large part reflected the belief that economics was not really separable from politics. This was more than an administrative classification of disciplines; it arose from the widespread view that political factors are crucial in determining economic outcomes” (p.3). 1 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Drazen clarifies a central theme of this dissertation: political institutions such as political regimes defined by a constitution, electoral systems, and the level of democracy are crucial to consider when trying to study and analyze many economic outcomes. As an example of the importance of domestic political institutions, consider Eichengreen’s (2003) prediction that “the spread of democratization in the Third World creates popular resistance to strict regulations that limit citizens’ freedom of financial action” (p-10). Institutional change created by democratization allows citizens to better resist limits to their financial actions in ways that prior to democratization were not possible. The important part of his prediction rests with the idea of democratization because without this shift in the political structure the ability of groups to show their displeasure with financial regulations is limited. In a more formal sense, democratization acts as a primary independent variable influencing financial freedom. Eichengreen’s prediction fundamentally involves the idea put forth in this dissertation since a large part of democratization involves the development, or re-development, of institutions. This is the main idea here: political institutions matter when it comes to determining economic policy. Exploring and testing these types of questions is what this dissertation does. The central argument here is that institutional variation amongst democracies will produce varying policy outcomes. The logic is simple: different political institutions create different opportunities for different groups to capture the policy process so that these differences I argue impacts the ability of these groups to alter economic policy outcomes. I consider, for example, the effect of presidential versus parliamentary democracies and levels of bilateral trade. I also consider the impact that a change in the 2 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. level of democracy has on inward flows of capital such as foreign direct investment. Many analyses can be developed from this simple argument, and the point of this dissertation is to explore some of these in depth. The basic position of my dissertation is that if we overlook domestic political institutions we will likely miss much of what influences our economic world. Perhaps, Franzese (2002) sums up this position best when he states, “ .. .the broad claim that differing political-economic institutions induce different policy and outcome responses to similar stimuli is a core tenet of comparative and international political econom y.. (p.xviii). In light of his work and a huge body of other work, my position is not a new position in political economy as prior research in comparative political economy has found that domestic politics influences economic outcomes. Events associated with democracy such as elections, cabinet dissolutions, and interest group formation have been shown to influence exchange rate movements and exchange rate types (Leblang and Bernhard, 2002; Freeman, Flays, and Stix, 2000; Broz and Frieden, 2001). Also, democratic institutions, like transparent central banks, are believed to more easily acquire reputations that are credible (Stasavage, 2003), and the degree of central bank independence has been shown to influence pre-electoral monetary expansions (Clark and Hallerberg, 2000). Grossman and Helpman (2002) nicely illustrate this position. They note that: “In representative democracies, governments shape trade policy in response not only to the concerns of the general electorate, but also to the pressures applied by special interests. Interest groups participate in the political process in order to influence policy outcomes. Politicians respond to the incentives they face, 3 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. trading off the financial and other support that comes from heeding the interest groups’ demands against the alienation of voters that may result from the implementation of socially costly policies” (p. 111). The point that the formation of trade policy is shaped by multiple domestic interests is important and illuminating. It is this exchange between domestic politicians and domestic special interests mediated by domestic institutions that is often at the heart of studies in political economy. As a simple example of the importance of domestic interests and international trade consider the importation of Mosquito nets into Nigeria to help control the spread of malaria. An article from The Economist (7/02/05) notes that, “Nigeria, for example, has on various occasions imposed tariffs of up to 40% on imported nets to protect its own netmakers” (p-26). The nets, paid for by donors from wealthy western countries, compete with the domestic production of mosquito nets which makes an apparently good idea difficult to actually implement. Domestic producers of mosquito nets are not in favor of the free nets from abroad because to them this gift acts effectively to increase the number of suppliers and is seen by them as increased competition primarily in the form of lower prices. Given issues of group organization, and collective action, the domestic mosquito owners will be the group to organize since their benefits from protection are concentrated and thus, the tariffs should be unsurprising. The donors overlook the role of domestic politics and how the domestic political institutions in Nigeria funnel the special interests’ demands into actual policy outcomes. Incorporating domestic politics and institutions into the analytical framework I believe 4 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. proves to yield theory and empirical results that ihuminate many puzzling economic outcomes. In addition to not being a new position in political-economy, it should also be mentioned that the position of this dissertation is not necessarily a new one in international relations. Domestic politics, both the institutions and outcomes, has seen a resurgence in international relations scholarship especially since the end of the Cold War. Part of the reason for this resurgence is that it has become increasingly unrealistic to take nation-states as individual actors in which the only conflict they face is from other nation-states. Notable work on topics such as the democratic peace theory, bilateral trade (Mansfield, Milner, and Rosendorff, 2000), and central bank independence (Broz, 2002) have all considered the significance of domestic political institutions as an important factor in international relations. Entire works, such as Milner (1997), have been devoted to establishing that “cooperation among nations is affected less by fears of other countries’ relative gains or cheating than it is by the domestic distributional consequences of cooperative endeavors. Cooperative agreements create winners and losers domestically; therefore they generate supporters and opponents” (p.9). The idea, of course, is that domestic politics, especially politics resulting from distributional consequences, matters for international relations and the outcomes that prevail. So the position of this dissertation is not necessarily new, but this work does make important contributions to this body of research. Chapter 3, for example, makes an important theoretical contribution to the literature on capital flows to developing countries. Since relative factor endowments in developing countries are such that labor 5 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. is abundant and capital is scarce, I argue capital inflows thus favor domestic labor at the expense of the domestic competing capital owners who are often the political authorities. This creates an incentive for the policy controlling elite to hold capital inflows down. Answers to questions such as why capital does not flow from rich to poor countries are vital to our understanding of how the global economy operates and, more importantly, to present and future international relations. 1.1 The Empirical Puzzle The general empirical puzzle is why international economic policy outcomes vary amongst different types of democracies. I focus on this general puzzle and its many manifestations. Specifically, I analyze bilateral international trade, capital flows in the form of foreign direct investment, and price stability all in the context of some domestic political institution. Answers to these puzzles are not readily apparent. They are, however, important and hold implications for future economic trends such as globalization. The empirical puzzles presented in this dissertation remain mysterious and without our full understanding. I believe that part of the reason these puzzles persist is because we have been using frameworks that have not been able to uncover the essential mechanisms necessary to understand them. Think about the case of global capital flows in the form o f foreign direct investment. For years dependency theory, and its many variants such as world systems theory, held a somewhat unified perspective that according to Woods (1996) highlighted “the negative impact of world capitalism on developing countries” (p. 16). The process of capital expansion was typically theorized as exploitative. The problem with this 6 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. position, however, implicit in Lucas’s (2002) famous question, is that typically capital does not transfer from rich to poor countries. If it is not there then how can it be exploitative? The fact is that capital basically flows amongst the world’s rich developed countries despite less than optimal returns. Capital flows, a form of economic globalization, unfortunately often bypass the world’s poor countries. As the United Nations reports in their 2003 Human Development Report: “But just as globalization has systematically benefited some of the world’s regions, it has bypassed others as well as many groups within countries. In the 1990s most of East and South Asia saw living standards improve dramatically. But large parts of Sub-Saharan Africa, parts of Eastern Europe and the Commonwealth of Independent States (CIS) and many countries in Latin America and the Middle East did not” (p. 17). And this puzzle persists. The problem it seems is not necessarily one of capital expansion and exploitation but rather the lack of capital expansion into the world’s developing countries. The puzzle remains: why does capital flows unevenly amongst the world’s countries? Answers to the empirical puzzles presented in this dissertation are important. Most have implications for economic growth, human development and international relations. Again, consider the case of foreign investment into LDCs. The World Bank makes the following point in their 2005 World Development Report: “A good investment climate provides opportunities and incentives for firms— from microenterprises to multinationals— to invest productively, create jobs, and expand. It thus plays a central role in growth and poverty reduction” (p.l). As the report states: investment increases economic growth and can help to reduce poverty in the world 7 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. LDCs which makes understanding how investment augmenting capital flows vary a significant concern for us to understand. These are important issues to pursue and their ultimate answers hold implications for many of the world’s people. The rest of this introduction defines the primary concepts that will be utilized throughout the body o f this dissertation, and offers a plan o f the dissertation. 1.2 Primary Concepts The most general political concept considered in this work is the idea of democracy. Democracy is often thought of as a compromise between majorities and minorities, and is seen as both a constitutional and social process (Dahl, 1956; Macpherson, 1977). Diamond (1999) defines three types of democracies. An electoral democracy in which “government offices are filled as a consequence of contested elections” has been the standard definition in much empirical work (see also Przeworski et. al. (2000)). The electoral definition is useful in empirical work but has been critiqued as a limited conception of democracy. It does, however, have the empirical virtue in that it is easy to measure accurately and is assumed by those who employ it to be the essence of what a democracy is. A more encompassing idea of democracy, typically defined as a liberal democracy, includes other contingencies. Some of these contingencies (Lijphart, 1999) are that the m ilitary is held in check by elected officials, electoral processes are uncertain and there is true party alternation, citizens (minorities included) can exercise multiple means for political expression, and, finally, the elected representatives play some role in the governing process. The liberal idea thus extends the electoral definition so that it includes guarantees of civil rights and liberties so that if people are to sincerely engage 8 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the electoral process then they must be able to engage in activities beyond voting. These include, to name a few, organizational rights and freedom of speech especially those allowing criticism of the existing regime. I believe the electoral-liberal distinction is important, and the liberal idea of democracy will be favored in this work. The standard model of a liberal democracy that has guided academic and non- academic work is Dahl’s polyarchy model. According to Dahl (1998, p.38), democracy provides opportunities for effective participation (see also Schattschneider, 1983, p. 138), equality in voting, gaining enlightened understanding, exercising final control over the agenda, and the inclusion of all adults in the political process. Dahl (1998) notes that democracy is a system of rights and that large-scale democracy requires the following elements: officials that are fairly elected; elections that are open, impartial, and common; abundant sources of information; “associational autonomy”; and “inclusive citizenship” (p.48). His model thus combines the elements of both the electoral idea of what a democracy is and also extensions based on the liberal idea of democracy. For this dissertation, both electoral elements and liberal notions of genuine political participation should be present as criteria for defining democracy. Three specific ideas guide this dissertation’s conception of democracy. First, some institutional separation among the governing bodies should exist (e.g. an independent judiciary). Why is institutional separation, commonly referred to as checks-and- balances, important to include when defining democracy? The reason is because when governing bodies are collapsed into one entity it leaves the governed with little options to challenge policy outcomes. Like a monopoly, citizens living in societies with no separation-of-power cannot pursue other options that require the government to at least 9 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. consider their demands. With effective institutional separation there is thus an increased likelihood that opportunities for effective participation, equality in voting, the ability to gain enlightened understanding. Political options, represented by institutional separation, for the governed allows for many of the components of the polyarchy model to flourish. The second idea guiding this dissertation’s conception of democracy is that political participation is effective and that the ruled can effectively voice their concerns and desires. If political participation is effective then many of Dahl’s representative characteristics of a democracy such as alternative sources of information and associational autonomy should naturally follow. The third idea of democracy in this dissertation is that the executive should face real constraints in the governing process. This is important because it means the governing agenda is not controlled by one person or an elite. Authentic democracies to a certain extent should not be governed by a single individual or small ruling clique since their will is generally not the product of the people’s will. If the executive faces constraints then the policy process is more likely to be open with higher levels of transparency in the governing process. O f course, this is not to claim that special interests do not capture the policy process. This is one of the central points of this dissertation. The distinction here is that in a democratic system there are trade-offs when politicians favor special interests. In non-democracies there are no trade-offs, at least electorally. To operationalize democracy, I use the Polity variable, and its component parts, from the Polity I V data set. The Polity measure is calculated as follows: 10 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Polityt = Democracyt — Autocracyt where t represents the year. If a country scores a 10 they are deemed “strongly democractic” and if they score a -10 they are deemed “strongly autocratic”. Marshall et. al. (2002) note that, “The Polity index expands the conceptual boundary separating democratic from autocratic practices so that one may more accurately place borderline or transitional polities along the supposed continuum from tightly closed autocracies to highly open democracies” (p-45). This measure will help to cover the three aspects of democracy that I consider to be important. Table 1.1 highlights the Polity measure and its component parts democracy and autocracy. Depending on the empirical question being asked, various measures Table 1.1. Summary Coding Rules for Polity Democracy and Autocracy Indicators See Marshall et. al. p.42__________________________________________________________ Z Democracy Z Autocracy Points Points 1. Competitiveness of Political Participation Competitive 3 0 Transitional 2 0 Factional 1 0 Restricted 0 1 Suppressed 0 2 Not Applicable 0 0 2. Regulation of Political Participation Regulated 0 0 Factional I Transitional 0 0 Factional) Restricted 0 1 Restricted 0 2 0 0 3. Competitiveness of Executive Recruitment Flection 2 0 Transitional 1 0 Selection 0 2 4. Openness of Executive Recruitment Flection 1 0 Dual: Hereditary and Flection 1 0 Dual: Hereditary and Designation 0 1 Closed 0 1 5. Constraints on Chief Executive Rarity or Subordination 4 0 Intermediate 1 3 0 Substantial 2 0 11 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 1.1 continued Intermediate 2 1 0 0 0 0 1 2 3 Slight Moderation Intermediate 3 Unlimited Tower such as democracy itself or the Polity measured are utilized in this work. For example, Chapter 3 considers the impact of the change in the level of democracy and autocratic consolidation on inward foreign direct investment. The measure of democracy is used in the first case and the measure of autocracy in the second case. In the Polity measure, democracy is a measure of how well citizens can express their views, if the executive is constrained, and to the extent there exists a guarantee to citizens of fundamental civil liberties. As seen in Table 1.1 it is an additive measure that takes values from 0 to 10 with higher values indicating higher levels of democracy. It is measured based on four categories: the competitiveness of political participation; the competitiveness of executive recruitment; the openness of executive recruitment; constraints on the chief executive (Source: Polity IV ). The index is computed as follows: (1) Competitiveness of political participation: +3 if competitive, +2 if transitional, +1 if factional.; (2) Competitiveness of executive recruitment: +2 if there is an election, +1 if it is transitional; (3) Openness of executive recruitment: +1 if it is a dual/election or an election; (4) Constraints on chief executive: +4 if executive parity or subordination, +3 is an intermediate category, +2 if there is substantial limitations, +1 is an intermediate category. While not a perfect match to Dahl’s polyarchy model, there is a connection to this measure and the idea of democracy presented here. Categories (1), (2), and (3) of the democracy measure help to pick up the idea that a democracy should have some 12 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. institutional separation. Category (3) which measures the constraints on the chief executive is especially important in this regard. If a chief executive has unlimited power indicating no institutional separation then the score is awarded no points. Conversely, in this case the autocracy score is awarded three points. The second idea of democracy that political participation is effective is an explicit category in the Polity measure. Finally, the last idea that in a democracy the executive should face constraints in the governing process is measured by category (5) in Table 1.1. Here if there are enough constraints on the chief executive to the extent that he or she is an equal then the democracy score is awarded four points. The second part of the Polity measure, autocracy, captures how much of the political process is controlled by elites. It is also an additive measure that uses the following categories: the competitiveness of political participation; regulation of political participation; competitiveness of executive recruitment; openness o f executive recruitment; constraints on the chief executive (Source: Polity IV ). The index is computed as follows: (1) Competitiveness of political participation: +2 if suppressed, + 1 if restricted. (2) Regulation of Political Participation: +2 if restricted; +1 if factional/restricted (3) Competitiveness of executive recruitment: +2 if there is a selection; (4) Openness of executive recruitment: +1 if it is dual: hereditary and designation or closed; (5) Constraint on chief executive: +3 if unlimited power; +2 Intermediate 3; +1 slight moderation. High levels of autocracy indicate low levels of polyarchy: the competitiveness of political participation is suppressed and subject to restricted regulation with little constraints on the chief executive indicating littie or no checks and balances. 13 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. It is important to note that there are criticisms of the Polity IV data set. Mainwaring, Brinks, and Perez-Linan (2001), for example, argue there are several disadvantages of the Polity (specifically Polity III) data. First, they argue there is a disconnection between the definition and operationalization of democracy. Second, they feel the coding and operationalization rules of the Polity measure are unclear. Finally, they believe there is no rationale for the aggregation rules used by the Polity measure. I believe the first criticism is the most important to address. It is especially important to maintain as close of a connection between our theoretical concepts and how we measure and operationalize them empirically. This makes their criticism important to consider. However, any measure of democracy is vulnerable on this point1 . The important point is that the operationalization of a variable match as closely as possible to its conceptualization. As laid out, the Polity measure adequately captures my conception of democracy based on Dahl’s model of polyarchy and thus serves as an essentially accurate measure of democracy. Additionally, the correlations between existing measures of democracy show the high degree of similarity between these measures. The correlation, for example, between the Polity III data set2 and Mainwaring et. al.’s (p.53) measure of democracy is .86. This suggests that the differences between the measures are basically insignificant. 1 For instance, in their own measure o f democracy Mainwaring et. al. include the extent to which “elected officials really govern”(38) as part of their definition of democracy. However, diey measure this by checking if eidier die “military as an institution” (47) dominates major policy areas (other than military policy), or if the elected head of government is powerless so that die “electoral process does not determine who really governs”. A frequent and vocal criticism, however, o f m odern representative democracy is that elected politicians are controlled by special interest money, especially corporate interests, and thus they effectively do not enjoy “real governing capacity”. N o considerations o f special interests like these are considered in their measure making it vulnerable to the same critique. This is the predecessor to the Polity IV data set with the difference being the time period covered. 14 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Another check of this measure is to consider the degree of correlation amongst these measures for developing countries. If we see high correlations then it is likely the measures are to a certain degree interchangeable. Using some data from Chapter 3 (see Table 3.5), a sample of developing countries, the correlation between the Polity measure and the Freedom House measure of political rights is .88 and the civil liberties measure is .77. For the democracy score the correlations are .84 and .72, respectively. The indication is that generally these measures are all measuring democracy. 1.2.1 Democracy versus democratization A major premise of this dissertation, especially in Chapter 3, is that democracy and democratization are different concepts. This idea comes from Rustow whose model highlights that democratic development does not occur instantaneously and “one generation is probably the minimum period of transition” (Anderson, 1999, p.22). For the development of democracy to occur Rustow’s model highlights that a sense of national unity, “entrenched and serious” conflict, and a “conscious adoption of democratic rules” are necessary parts of the process. Rustow’s work clearly spells out that the level of democracy and democratization are different ideas. Given this idea it is important that research, including empirical work incorporate his, and other, ideas into the work. Much empirical work, however, does not necessarily make this distinction and measures democratic consolidation using measures of democracy. I find this to be an unacceptable way of measuring democratization as it lacks conceptual precision. Associated with but conceptually distinct to the level of democracy, democratic consolidation, or the move to a higher level of democracy, is concerned with keeping 15 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. democracy alive where it is weakly or not fully established (Dominguez, 1998)3 . The distinction is important to keep in empirical work, and dates at least back to Rustow who proposed that democracy does not develop instantaneously and “one generation is probably the minimum period of transition”4 . Much of the qualitative, or case study, literature on democratic consolidation suggests the process is an up-and-down, wave- like motion5 . Many factors such as economic development, elite interests, prior statehood, a strong sense of nationalism, and rule of law (Bunce, 2000) have been attributed to sustaining democratic consolidation. Democratic consolidation thus involves the deepening of democratic institutions, and increasing political equality and civil liberties6 . I argue we need to be concerned about this distinction. Democratization is about the development and deepening of democratic institutions, and increasing political equality. Schedler (2001, p.68), considers democratization to include both the deepening and completing of democracy while also avoiding breakdowns and the erosion of existing democracy. Munck (2001) argues that, “Originally the concept of 3 Schedler (2001, p.67) argues a democratic regime is consolidated “when it is ‘ likely to endure’” or “when we may expect it ‘to last well into the future”’. 4 See Anderson 1999, p. 22. Rustow argues that the task of democratization is “devising a manageable sequence o f tasks”. Huntington (1984), however, argues that Rustow’s model helps to point out the complexities o f democratization but that it is “a mistake to swing entirely to another extreme and ignore the environmental factors that may affect democratic development.” 5 According to Haggard and Kaufman (Anderson, 1999) the latest wave o f democratization in Latin America is a process o f “redemocratization” (p.84) suggesting that there was a movement away from developing m ore democratic institutions but now a gradual return to this process. O ’ Donnell and Schmitter (1986) state that in the process o f democratization “recuperation is often as im portant a goal as extension and expansion” (p.8). 6 O ’Donnell and Schmitter (1986) define democratization as the “processes whereby the rules and procedures o f citizenship are either applied to political institutions previously governed by other principles, or expanded to include persons not previously enjoying such rights and obligations, or extended to cover issues and institutions not previously subject to citizen participation” (p.8). Rueschemeyer et. al. (1992): “Democratization represents first and foremost an increase in political equality” (p.5). Diam ond (1999): “continued democratic development is a challenge for all countries, including the United States; all democracies, new and established, can become m ore democratic” (p-18). Tilly (2000): “movem ent toward broad citizenship...” (p.l). 16 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. democratic consolidation had a quite clear and distinct meaning, captured best in the literature on Latin America. In that context the process of democratic transition actually involved a process of redemocratization” (p.126). Following this literature, democratic development is here considered to be a consolidating political system, or one moving closer to a consolidated democracy. Ultimately it is about the development of a democratic system. Conversely, many countries experience movements away from democracy. Here this process is considered to be just the opposite of what has been explained as democratization. This process includes the consolidation of power around a narrow elite and generally involves the loss of civil rights and liberties7 , and here will be referred to as autocratic consolidation. Just as measuring democracy is tricky, so to is measuring democratization. In then study of democratization and war, Mansfield and Snyder (1995) consider “states to be democratizing if, during a given period of time, they change from autocracy to either anocracy or democracy, or if they change from anocracy to democracy” (p.9). These three typologies are based on Russett’s (1993) index where democracies have an index score between 30 and 100, anocracies from -24 to 29, and autocracies from -100 to -25. The index is calculated based on the following formula: PCON (DEM-AUT) 7 D iam ond (1999) states: “Viewed in this way, continued democratic development is a challenge for all countries, including the United States; all democracies, new and established, can become more democratic” (p-18). 17 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. This index subtracts a state’s democracy score (DEM) from its autocracy score (AUT) and multiplies it by the extent to which power is monopolized (PCON) by state authorities. The possible range is from -100 to 100. I propose two alternative measures that I feel are more accurate than this last measure. The reason for this adjustment is simple: I have argued that democratization is essentially about the growth in the level of democracy so I feel it is most accurate if we simply measure democratization as either the change in the level of democracy or the growth in democracy. To do this we can measure the former as just the first difference in the level of democracy. The latter we can measure as follows Thus g will give us the growth rate in democracy, and will thus be referred to as democratization. Note that if we substitute autocracy for democracy then it will be a measure of the degree of autocratic consolidation. 1.2.2 Parliamentarism and Presidentialism democracy matters for economic policy. Chapter 2, for example, argues that trade policy out-comes vary depending on if the constitution provides for a parliamentary [Democracy t + 1 ^ = [Democracy t )[ 1 + g)" If we solve for g then we get the growth rate of democracy which is as follows (1.1 ) Democracy Democracy f (1.2) In addition to the depth of democracy, part of this dissertation argues that the type of system or a presidential system. A large part of Chapter 2 thus considers how the effect of special interest politics varies in these two political systems, and finds that for trade 18 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. policy the ability of special interests to capture the political process determines different policy outcomes for parliamentarism versus presidentialism. Some basic features of parliamentary systems should be highlighted (Verney in Lijphart, 1992, p.32): the executive is divided into the head o f government and head of state; the government is a collective body where the prime minister is generally first among equals; the government is responsible to the assembly; neither the assembly nor the government can dominate the other, (i.e., the government depends on the support of the assembly but the government can dissolve the parliament); the government is indirecdy responsible to the electorate, (i.e., voters elect assembly representatives who appoint the government). The important point is that in parliamentary systems the executive depends to some degree on the support of the legislature; if they cannot maintain this support then they possibly risk their power. Lijphart (Linz and Valenzuela, 1994) sees that the prime minister’s strength varies amongst different cabinets but that there is a high degree of collegiality in decision-making. Typically decision-making has to be collegial in parliamentary systems since the alternative is a possible dissolution of the government. The impact of collegial decision-making on policy outcomes is a significant factor I believe as to why we see variations in policy between parliamentary and presidential regimes. In contrast, presidentialism has several prominent characteristics (Verney in Lijphart, 1991, p.40): the president is elected by the people for a fixed term; the president is the only executive so that presidential government is individualistic; the president depends on a popular vote and is elected by the entire body of electors. Presidentialism is a system in which an individual assumes the role of the executive and 19 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. is generally directly responsible to the electorate. Linz and Valenzuela (1994) describe it as a system of “dual democratic legitimacy” (p.2). Haggard and McCubbins (2001) state that, “A separation of powers is the defining feature of presidential systems...” (p-3). A separation of power they argue is the ability to exert influence over public policy through the exercise o f a veto. Likewise, I believe this separation common to presidential regimes also hold implications for economic policy. To help clarify the differences between these two systems, Cheibub et. al. (2004) note three key institutional differences. First, “Under parliamentarism, every government must enjoy the support of a parliamentary majority: the legislature can dismiss the government if it so wishes. Under presidentialism it cannot. A prime minister can change at any time, with or without elections” (p.567). This means that elections are to some degree endogenous in parliamentary systems. Second they note that, “Under presidentialism, only the president can be the formateur and the president’s party, unless he or she is independent, must be included in every portfolio coalition, regardless of the number of seats it controls” (p.567). Third, when there is a governing crisis (i.e., no single party controls a legislative majority and all coalition attempts fail) under presidentialism the president’s party governs alone but under parliamentarism there are early elections. These differences I believe shape incentives and constrain behavior in particular ways such that economic policy is certain to be influenced by these institutional differences. To measure parliamentary regimes I use a discrete variable that captures each country’s type of political system. This variable comes from The Database of Political Institutions (TDP1) (Beck et. al., 2001). Those political systems with unelected executives 20 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. or with presidents who are directly elected, or by an electoral college (whose only function is to elect the president), in cases where there is no prime minister, are coded as a 0. In systems with both a prime minister and a president, TDPI considers the following factors to categorize the system: (i) Can the president veto legislation and does the parliament needs a supermajority to override the veto? (ii) Can the president appoint and dismiss prime minister and/or other ministers? (iii) Can the president dissolve parliament and call for new elections? Finally, (iv) if the sources mention the president more often than the PM then this serves as an additional indicator to call the system presidential (as in Romania, Kyrgyzstan, Estonia, Yugoslavia). The system is presidential if (i) is true, or if (ii) and (hi) are true. If no information or ambiguous information on (i), (ii), (hi) is available, then (iv) is determinant. Countries in which the legislature elects the chief executive are parliamentary, with the following exception: if that assembly or group cannot easily recall him (if they need a 2/3 vote to impeach, or must dissolve themselves while forcing him out) then the system gets a 1 which is considered to be semi-presidential (p-5). For this measure then if the political system is parliamentary the variable receives a scores of 2, if it is semi-presidential then a score of 1, and a presidential system receives a score of 0. 1.3 Estimation Methods In this dissertation I rely on cases to help illuminate my points, but I test my hypotheses using econometric analyses. In each case I detail the estimation methods utilized. Typically, I use some from of ordinary least squares (OLS) varying the standard errors as necessary for common complications such as heteroskedasticity and serial correlation. In Chapter 3 I run into endogeneity issues that are worked out explicitly in the 21 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. corresponding section. I feel that good econometrics comes from good theory that guides specification. As much as possible, I adhere to this belief. There are, however, practical limitations to this philosophy but through the use of different estimation techniques I believe that many of these issues can be overcome. 1.4 The Plan of the Dissertation The rest of this dissertation is composed of three chapters. Each chapter is put together in a similar manner with multiple sections in each chapter. The primary sections include the following components: background, theory, and empirical results, and finally in each chapter I consider an extension which is designed to show work that serves as a supplement to the main text of each chapter. This work is not necessarily complete but serves to indicate possible avenues of future research that are related to the topic of that specific chapter. Chapter 2. This chapter studies the relationship between parliamentary versus presidential democracies and international trade. International trade can change income distributions (Hiscox, 2001; 2002), and, some argue, increase the elasticity o f labor demand (Krishna, Mitra, and Chinoy, 2001; Rodrik, 1997; Slaughter, 2000). Given these effects it is easy to see why international trade is a political issue. W hat is less understood about this process is how special interests are mapped into actual trade policy. To help understand this process, Chapter 2 analyzes whether parliamentary or presidential democratic political systems are more amenable to special interest groups seeking to alter trade policy. The question asked here is if bilateral exports higher when the trading partners are both parliamentary systems. 22 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A theoretical model is developed that derives the trade-offs the government faces when deciding on international trade policy. The model highlights that a government’s willingness to trade-off sector specific interests versus aggregate welfare varies amongst parliamentarism and presidentialism and is thus a key reason why we see variations in trade policy. Using the gravity model as a baseline specification the dyadic results indicate that parliamentarism has statistically significant more trade than dyads composed of two presidential regimes. The results show that parliamentary systems have higher levels of bilateral exports. Chapter 3. This chapter studies democracy and capital flows paying specific attention to foreign direct investment (FDI). FDI involves the control8 of the factors of production which differentiates it from short-term portfolio flows and makes domestic political institutions critical to its success. Including political institutions such as the change in democracy within the standard framework for analyzing FDI is relatively novel. As will be explained in Chapter 3 there is a wide range of arguments on the political economy of FDI. I believe this topic needs further exploration. The reason for this addition is simple: FDI flows between countries with well developed laws and legal institutions9 , both characteristics of democratic countries, and thus we should expect that increasing the level of democracy will increase FD I1 0 for developing countries. Moreover, there is 8 See Krugman and Obstfeld (2003, p.171). 9 See Carr, Markusen, and Maskus (2003). 1 0 F or example, die Slovakian finance minister states tiiat FD I flowing into Slovakia will be increasing because “investors will have the added economic and legal certainty o f being part o f the E U ’s internal m arket” (see The TLconomist 4/17/2004, p.52). In other words, Slovakia’s political and legal system will now be m ore similar to diose in western Europe where much o f the FD I flows from, and investors there can face less risk. 23 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. a suggestion in much of this work that for developing countries it is beneficial to consolidate power as this can help attract foreign capital. Certainly there are examples of heavy-handed regimes, like China and many other oil producing countries, which receive high levels of FDI. But is it true? That is, do developing countries that consolidate their power in the form of more autocracy generate increased inflows of FDI? The point of Chapter 3 is to test these two claims. Section 3.1 analyzes the change in the level of democracy in developing countries and the effect this has on inward foreign direct investment. Section 3.2 considers the impact of the consolidation of autocracy on inward flows of FDI. The extension, Section 3.3, looks at bilateral portfolio flows. All the results indicate that democracy has a positive effect on FDI inflows for developing countries. Chapter 4. Finally, Chapter 4 considers price stability in the context of parliamentary and presidential democracies. This is an important research topic given the movement for monetary integration amongst many of the world’s countries. The theory in Section 4.1 argues that in parliamentary systems the tradeoff between output and inflation is more severe than in presidential regimes and develops the hypothesis that parliamentary regimes have more price stability compared to presidential democracies. This is due to the fact that the policymaking process is more collegial in parliamentary systems and thus politicians cannot afford to neglect the popular will in favor of low levels of unemployment. Thus, I argue, it is likely that parliamentary systems will delegate control over monetary policy to independent institutions such as central banks. This delegation results in more price stability compared to presidential regimes. The econometric results are supportive indicating that parliamentary regimes have more 24 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. price stability measured by the change in the inflation rate. Finally, section 4.2 offers an empirical analysis of this effect on economic integration 25 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2 International Trade Consider the following figure, Figure 2.1, which shows varying levels of trade openness for Canada and Mexico. This figure indicates that from 1980 to 2000 Canada has Figure 2.1. Trade openness: Canada versus Mexico o Q 9 - C l, < N 1980 1985 1990 1995 2000 Year -•----- Canada ♦ -----Mexico consistently maintained higher levels of trade openness than Mexico, with an increased level of separation starting around 1995. Canada and Mexico share much in common: both countries border the United States, are member of NAFTA, share similar sized G D P’s (see Figure 2), and both have relatively large land areas. However, Canada has a parliamentary political system while Mexico a presidential system. Does this contribute to their different levels of trade openness? And, more importantly, does this varying trade dependence manifest itself in different levels of trade openness? 26 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Is the difference in their varying levels of trade openness just a fact of their differing relative economic size? Figure 2.2 shows that Mexico and Canada do have varying GD P’s, but the disparity in GDP between the two countries is Figure 2.2 Econom ic size: Canada versus Mexico < N C l C l < N 1980 1985 1990 1995 2000 Year Canada Mexico not that great. Notice that around 1990 the differences in levels of trade openness were roughly constant but as Figure 2.2 shows Mexico’s GDP was rapidly catching Canada’s. Furthermore, consider the period since 1995 in which Canada and Mexico have seen a strong convergence in GDP. If GDP were driving this process then we should expect Mexico’s level of trade openness to approach Canada’s. But, as Figure 2.1 shows, over this period the level of trade openness has diverged so that there is more separation of trade openness between the two countries. Now consider bilateral exports from Canada and Mexico to the United Kingdom. Again, we can control for many important variables such as distance by 27 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. focusing on Canada and Mexico. Figure 2.3 shows this scatterplot. The results indicate that Canada has consistently had higher levels of exports to the U.K. than has Mexico. Figure 2.3. Exports to the United Kingdom: Canada versus M exico i i i i 1980 1985 1990 1995 2000 Year Exports from Canada ----- *-----Exports from Mexico Based on this descriptive data, the question asked in this chapter is as follows: Are bilateral exports higher between trading partners composed of two parliamentary countries compared to a mixed dyad composed of a parliamentary and presidential dyad? Determining why levels of bilateral exports vary amongst different country-dyads has important domestic and international political implications. International trade creates over-all gains but domestically there are winners and losers; internationally international trade is believed to influence the degree of peaceful relations between countries. The political effects of increased bilateral trade, commonly called globalization, cannot be understated. Understanding why certain countries trade more with each other is important for our knowledge of processes like globalization and more 28 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. broadly how the global economy operates. The primary section in this chapter does exactly this as it focuses on parliamentarism, presidentialism, and bilateral exports and trade openness. The extension, Section 2.2, adds to the analysis a consideration o f the effects of the electoral system on international trade. Together both sections highlight the role domestic political institutions play in the formation of trade openness. 2.1 Parliamentarism, Presidentialism, and Bilateral Exports 2.1.1 B ackground When countries have trade imbalances there are often calls from domestic politicians, and their constituents, for more fair trade. Presently the imbalance in bilateral trade between the U.S. and China is a point of contention and has spurred calls by some U.S. politicians for the Chinese to revalue their currency. Bilateral exports between countries is a touchy political issue generating all sorts of extended political batdes. In part this is true because it is easy for the general voting public to grasp the idea that we take in more of their goods than they take in of our goods. This is an easy issue to get voters excited about, especially compared to more abstract concepts in international economics such as exchange rates. In this section I ask how bilateral exports are affected by the type of democratic political system that each country trading partner has. This section thus considers the relationship between the executive and legislature and the role their separation, or lack of, plays in determining trade policy. As explained in the introduction, typically in parliamentary regimes there is little if any institutional separation between the executive and the legislature while in presidential type democracies there is usually a high degree of institutional separation. The question here is does this matter for bilateral exports? 29 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. To help answer this question I model the process so as to uncover the mechanisms I believe are driving variations in bilateral exports. 2.1.2 T heory Following Grossman and Helpman (2002), the theory here develops a “political support function” in which the government is considered to be weighing the competing interests of the industry specific factors of production with that of the consuming public. The point of the theory is to illustrate how importing countries are influenced by the political regime type of the exporting country. The Set Up In democracies let’s assume that the trade policy-making process is controlled by elected representatives and that their constituency, the public, is imperfectly informed about the trade policy process so that the elected representatives do not have to converge to the preferences of the median voter. The government’s political support depends directly on the policies it implements and indirectly on any benefits that accrue to special interests as a result of their policies. To derive the government’s political support function I consider the equilibrium actions of lobby groups. The lobby groups, representing the factor owners, have stakes in certain industries and their specific factors. The lobbies’ power comes from their ability to direct campaign contributions that are tied to the actions of the government. Assume the lobby’s contribution schedules are set to maximize the aggregate welfare of the lobby members. Lobbies hold much persuasive power, especially over incumbents who want to attract lobby funds to use for future campaign expenditures. To attract these funds the 30 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. incumbent chooses a policy vector of trade taxes on imports and trade subsidies for exports. Lobbies form “contribution schedules” and based on these various schedules the incumbents choose a vector of trade taxes and subsidies on various imports and exports. The contributions enter the government’s utility function because campaign funds can be used for political advertising or other useful political activities. More formally, assume a situation with just two countries, home and foreign, in which both countries have similar political and economic systems although their tastes, endowments, and political conditions are not necessarily identical. So both countries might be democracies but in this case one might have a parliamentary system and the other a presidential system. All individuals have the same “additively separable preferences” in which each maximizes individual utility of the following form U = Cz + Y U <{< : ,) (2.1) In this utility function Cz is consumption of good z , the numeraire good, and has the same price domestically as it does internationally. Cx, is consumption of good X ,., i = 1,2,.. .n . The functions U,{*) are differentiable, increasing, and strictly concave. The domestic price of good Xi in the home country is denoted by P, and 7 n is its world price. Given each resident’s preferences, the home country demands di(P,.) units of good Xi which is the inverse of «,',(•). The consumer uses the remainder of their expenditures E on the numeraire good as represented in the following indirect utility function v(p,E ) = E + s(p) (2.2) 31 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. where p = (pi, p 2 , • • • P„) is the vector of home prices of the non-numeraire good and s(p) = 1 1 . .(I (P:), ~ PidiiPi) is their surplus from consumption of these goods. The numeraire good z is produced using only labor with constant returns to scale. Assume that the aggregate labor supply I guarantees positive output o f this good. Each of the other goods is manufactured from labor and some sector specific input, also with constant returns to scale. Various specific inputs are available in inelastic supply. Denote ll,;(lb) as the aggregate rent accruing to the specific factor used in producing goods X , and note that the slope of this function gives the industry supply curve, that is Xi(P,) — H,(Pi) ■ In order to gain lobby contributions, the government uses a limited set of policy instruments such as trade taxes or subsidies. These policy instruments can be used with any of the non-numeraire goods. The government uses trade policy in order to influence income redistributions amongst different interest groups in the economy. Trade taxes or subsidies drive a wedge between domestic and world prices and in the process create gains for some groups— but these gains come at the expense of other interest groups. We can represent the government’s policies by parameters r s u c h that Pi = t illi,. Then r , ; > 1 represents one plus the tariff rate on an import good or one plus the rate of an export subsidy on an export good. Note that r < 1 represents an import subsidy or an export tax. The vector of trade policies t = „ ) generates per capita government revenue of 32 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. (2.3) where n = (7n,7T2,...,7t„) T V measures the population, normalized to 1, and the government redistributes any resulting revenue. Individuals generate their own revenue from wages, government transfers, and other sources. Those who own some of the specific factor used in industry i will see their income tied to the price of X , , so that they have a direct stake in the trade policy r . Assume those who benefit from policy r , organize exogenously. Their ability to organize confers a political advantage relative to individual factor owners since these interest groups control greater resources than the average individual does. With these significant resources the lobbyists can gain access to politicians so that they can deliver their political demands. Assume lobbies deliver their demands to the politicians in a simple manner in which it is understood by the politician that the funds depend on specific policy positions. The lobby representing industry i submits its contribution schedule c,;(r,») which in this case has all arguments but the tariff policy omitted. The organized input owners maximize the following indirect utility function and an is the fraction of the population that owns the specific input used in sector i , the consumer surplus. Equation (2.5) gives the total welfare, not including deductions v ‘ = w l T^ ) ~ ci T?) (2.4) where W i(T^ ) = li + 11,(7 + a{r(r,Tv) + s(ttt)] (2.5) and is the joint labor endowment of these factor owners. Note that s (t t t ) = s(p) is 33 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. for their contributors, of the ft. members of lobby group i which they derive from wages, quasi rents, transfers from the government, and surplus from consuming the non-numeraire good. The incumbents facing these different contribution schedules then set trade policy either unilaterally, or through a process of bargaining, so as to maximize their political welfare. Assume politicians care about accumulation of campaign contributions and possibly also about the welfare of the average voter; concern for the average voter will only arise if upcoming elections depend on their welfare. The government’s objective function is linear of the following form G = E i e i + aW(T,7r),a>0 (2.6) where L is the set of organized industries and W (t, 7t) = / + 11,('' ,) + r(r, 7r) + s(rn) (2.7) measures the average gross welfare. Net imports of good i in the home country are Mi(P,) — di(P,;) — XiiPi) and those in the foreign country are M*{P*) = d* ~ X ‘ , (Pt) ■ The world product markets will thus clear when M ,{ r ,:7 r,;) + = 0, i = 1 ,2 ,..., n . (2.8) This equation allows us to solve for the market clearing price of good x t as a fraction of the industry trade taxes or subsidies imposed by the two countries. Define this function as 7r,;(r , ; . r *). Using equation (2.8) we can express the welfare levels of the organized industry groups and of the average voter in each country as a function of trade policy vectors r and r * . For example the expression in (2.7) for the gross 34 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. welfare of owners of the specific factor used in home industry i becomes W i ( t , t * ) = [r, 7t(r, r*)] and the average welfare of home voters can be written as W [r, 7t(r, r*)]. Inserting these functions into (2.4) and (2.6) gives the objectives of the lobbies and politicians as functions of the trade policy vectors in each country. The Trading Equilibrium To find the equilibrium suppose the sequence of actions is as follows: The lobbies in each country move first setting country schedules that link gifts to various policy outcomes (the lobbies act simultaneously and non-cooperatively) and then the government sets trade policy. To see the equilibrium outcome assume governments behave unilaterally ignoring the impacts of their actions on agents in the other country. Typically states interact continuously but making the assumption that they behave unilaterally proves useful to show the departures from cooperative actions. Define the equilibrium response by each country as a response to an arbitrary policy choice of the other. The definition is as follows (see p.148): 35 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. D efinition 1. "Let t * be an arb itrary policy vector of th e foreign country. T hen a set of feasible contribution functions {c"}i6i an d a tra d e policy vector t ° are an equilibrium repsonse to r * if (a) r° = a r g m a x ^ .e icj(r;r*) + c l W ( t , t * ) an d (b) for every organized r interest group i E L there does not exist a feasible contribution function c , ( t , t * ) and a trad e policy vector such th a t (i) 7-' = a rg m a x c,;(t;t*) + ,eLc%r ]r *) + aW (r]T*) T and (ii) W i ( t \ t *) - Ci(r\ r*) > W f r 0 , r*) - c?(r°, r* )" The equilibrium response comprises a set of feasible contribution schedules and a policy vector. This definition does not allow lobbies to cooperate, and the lobbies also take the other country’s policies as given. Note that I assume a lobbies’ offers to its own government cannot be observed by the other government. It is natural to assume that contribution schedules cannot be observed abroad because it is likely problematic for special interest groups to be open and explicit about their willingness to pay the government for favorable treatment, and, even if they did, the promises are not binding so the full details of the agreement cannot be known. Also, if interests were to announce their intention to vary support according to policy positions taken by politicians these promises would be legally binding. To find the equilibrium, in this context we have a situation in which the home government acts simultaneously as the agent for several different principals. The equilibrium policy response to r* according to Grossman and Helpman (2002) satisfies the following requirement that is implied by condition (2.5) 36 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. t° = a rg m a x W t( t , r *) - c ° ( t- ,t* ) + E , ei cj(r ;r *) + a W ( r ,r *), Vi e L (2.9) r This condition has the following interpretation: The equilibrium trade policy vector must maximize the joint welfare of each lobby i and the government when the contribution schedules of all lobbies other than i are taken as given. In equilibrium there can exist no such possibilities for a lobby to improve its position. The same holds for the foreign lobby. Now let’s assume the lobbies set their contribution schedules, which are differentiable around the equilibrium point. With differentiability a trade policy vector that satisfies (2.9) the first-order condition is as follows: t * ) - t*) + E 7 S i t * ) + = 0,V ie L (2.10) The home politicians’ utility maximization ensures, by part (a) of definition 1, that E.,eL + aVrW (r°,T*) = 0 (2.11) Taken together (10) and (11) imply V tC?(t 0 ;t *) = V T W ,.(r0 ,r* ),V i e L (2.12) That is, the contribution schedules are set so that the marginal change in the donation for a small change in home policy (foreign policy taken as given) matches the effect of the policy change on the lobby’s gross welfare. Now if we sum (2.12) for all i and substitute into (2.10) we get the following EjeL V rW ,(r°, t ) + a\7T W(T°, r*) = 0. (2.13) This allows us to compute the equilibrium home policy response to an arbitrary foreign policy vector r * . Similarly we have 37 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. E,;gl* Vr*VF*(r *°;r ) + a*Vr*IK*(T*0 , r ) = 0 (2.14) which gives the foreign equilibrium response to an arbitrary home policy vector. Finally let’s define the full equilibrium under a trade war. W hen policies are set each government makes an equilibrium response to what it expects the other’s country policy to be. This is important because we want to analyze how exports vary within a dyad when political systems vary. To characterize the equilibrium policy vectors by substituting r*° for T* in (2.14) and then treating these equations as a system of simultaneous equations. After some manipulations (see p. 152) the home country’s equilibrium policy is as follows: 1 X i , + — (2.15) a + a L 7riM i e* Note that e* = r *7riM* jM * ■ And for the foreign country T* Y * 1 t * ° — i = — — ------ — — H (2.16) a* + a*L 71 iM i e,: Equations (2.15) and (2.16) show the ad valorem trade tax and subsidy rates in each country as the sum of two components. These components represent the political support and the terms-of-trades motives for trade intervention. The Tolitical Effects Key to this analysis is the parameter a in (2.15) and (2.16) which represents the government’s weighing of a dollar of social welfare compared to a dollar of campaign contributions. Here I expect a to vary between parliamentary and presidential systems. Work by Plasser and Plasser (2002) on global political campaigning provides information on funding practices in 72 countries (see p. 174-179). In their work they classify the countries “according to the importance of fundraising activities and 38 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. contributions of special interest groups.” Their conclusion is as follows: “Countries where extensive fundraising is a prerequisite of successful campaigning and the influx of private interest money is regarded as decisive are first and foremost the United States, the majority of Latin American countries, Russia, Belarus, the Ukraine, and, in East Asia, South Korea and Taiwan.” Most of these countries are presidential regime types. Their research suggests money plays a larger role in presidential systems, a manifestation of powerful special interests. Additionally, in their Table 6.41 (p.176) they classify the role of special interest influence in four ways: low, medium, high, and extremely high. I code each category as follows: low =l, medium=2, high=3, and extremely high=4. This allows a simple bi- variate regression of the effect of each country’s political regime type (i.e. parliamentary=l, or presidential0) on the level of special interest money. I expect that the coefficient on regime type should be negative suggesting that parliamentary systems have a negative impact on special interest money. The estimated equation using an ordinary least squares estimator with robust standard errors (in parentheses) is as follows: A Special Interest = 3.6 — 1.25 P arliam en tary S y ste m . (.123) (.196) For this simple regression the F-statistics is 41.27 (significant below the 1% level of significance), the R-squared is .37, and the number of observations is 68. 1 Countries include: Argentina, Australia, Austria, The Bahamas, Barbados, Belarus, Belgium, Bolivia, Botswana, Brazil, Cameroon, Canada, Chile, Colombia, Czech. Republic, Denmark, Ecuador, Finland, France, Gabon, Georgia, Germany, Ghana, Greece, Guatemala, Flungary, India, Ireland, Israel, Italy, Ivory Coast, Jamaica, Japan, Lesotho, Malawi, Malaysia, Mali, Malta, Mauritius, Mexico, Mozambique, Namibia, Netherlands, New Zealand, Norway, Panama, Paraguay, Peru, Poland, Portugal, Romania, Russia, Singapore, Slovakia, South Korea, Spain, Sweden, Switzerland, Taiwan, Tanzania, Trinidad and Tobago, Turkey, Ukraine, United Kingdom, United States, Venezuela, Zambia, Zimbabwe. 39 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Consider an interpretation of this estimated equation. If the system is presidential then the variable parliamentary system is scored 0 and the predicted special interest score is 3.6. Now consider if the regime type is parliamentary so that the score for the covariate is a 1. Here the predicted value of the dependent variable is 3.6 — 1.25 = 2.35 which means that for parliamentary systems the predicted value of the importance of special interest money is less extreme than compared to presidential regimes2 . These basic statistical results help illustrate the idea that presidential systems are more prone to being controlled by special interest influences. In addition to the importance of money in presidential compared to parliamentary systems, there are two other basic reasons to expect that a varies amongst presidential and parliamentary systems. The first is that a parliamentary government risks collapse if it cannot maintain legislative cohesion. The risk of collapse is important because it makes the bargaining power of coalition members more evenly distributed. As Persson and Tabellini (2000) note: “Disagreement within the majority in the legislature is a serious business that can lead to a government crisis. As a result, bargaining power is more evenly shared within the majority coalition, making the parliamentary regime less competitive for voters than the presidential congressional regime” (p.263). When bargaining power is more evenly distributed it becomes more difficult to promote special interests resulting in a higher value in a , unless those special interests are tied to the general social welfare. 2 Alternative estimators (Tobit and ordered logit) yield similar results except the ordered logit indicates a more significant negative effect from the parliamentary system variable. 40 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The second, and related, reason a varies is because parliamentary systems favor the party rather than the politician’s special interests. Persson and Tabellini (2000, p.7), for example, contend that parties are often strong in parliamentary systems, and a stable majority of legislators tends to pursue the joint interests of the votes. As a result they find that: “spending in parliamentary regimes thus optimally becomes directed towards broad programs that benefit a majority of voters such as social security and welfare spending. In presidential regimes, instead, the (relative) lack of such a majority tends to pit the interests of different minorities against each other for different issues on the legislative agenda. As a result, the allocation of spending targets powerful minorities, typically the constituency of the powerful officeholders such as the heads of committees in Congress” This point, that parliamentary regimes tend to target their spending toward majority interests compared to presidential regimes, is important because it results in policies that typically favor the party and is another reason why parliamentary systems generally spend more on social programs and run larger budget deficits than presidential systems. Politicians in parliamentary regimes will be less willing to trade-off special interests in favor of majority interests. The institutional structure dictates that this practice be followed because if they favor special interests then parliamentary politicians risk less legislative cohesion and an increased probability of government collapse. This raises the opportunity cost of favoring special interests and thus increases the value of a in parliamentary systems compared to presidential systems. 41 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. These two points illuminate implications for this theory. The indication is that a will be greater in parliamentarism versus presidentialism. This leads to the following assumption: A ssum ption 1: aP R E S < aPARL. Now let’s consider how the policy outcome changes when the political situation does. Suppose that home politicians were to become less sensitive to public interest, a drop in a , characteristic of a presidential system. For the case of a home im port good with active lobbies there is an increase in the tariff since lobbying groups sense that the marginal cost of gaining protection has decreased since the government is now more partial to special interests. But, due to the drop in a , the foreign lobbies and foreign governments expect a more protectionist stance from the home government which changes their political moves. The foreign country knows that a higher domestic tariff means a lower world price for the good being protected since the supply on the world market has effectively increased due to the larger home barrier. Consider the importing (home) country’s move to increase its tariff from the foreign country’s perspective. In equation (2.16) what is important for the foreign country is e,: which in this case measures the home country’s im port demand. The home country’s tariff lowers e,; and in response the foreign country increases its tariff, as indicated by equation (2.16). This example illustrates the idea that the type of political system from which exports originate is important for bilateral exports. In this case if the home country happens to be a presidential regime then the expectation is that special interests will be better able to capture the policy-making process resulting in higher tariffs. In a situation of bilateral trade if the importing 42 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. country happens to be a parliamentary system then the expectation is that the amount of imports will be less than had the exporting country been parliamentary. Based on this discussion I offer the following proposition: Proposition 1: P arliam en tary dyads com pared to presidential dyads will have m ore b ilateral trade. 2.1.3 E m pirical R esults The purpose of this section is to test the hypothesis that dyads made up of two parliamentary countries will have more bilateral trade compared to dyads composed of a parliamentary regime and a presidential regime. To test this hypothesis a gravity based specification using Anderson and VanWincoop (2003) is utilized. The baseline empirical specification I use in the empirical analysis is as follows: In Xij = a + In y t + In y.j + (1 - a)p In da + (1 — cr) In bn — (1 — <r) In P, - (1 — a) In P , (2) Correspondingly my specification is as follows log E x p o rts^ = a + /^ P arliam en tary l( + /^ P arliam en tary ^ + /^P arliam entary., * P arliam en tary jt + f3A log G D P ( + /Tlog G D P + 0 6 logC PIa + /?7 logC P P t + log D istance ^ + p g log PO P,, + /?1 ( ) logPO P + /31 1 Contiguous + /31 2 Comm on Language + /3r,Form er Colony + /?1 4 logE xportsiy t _ x + Pijt Note in this specification that the parameters /94 through p H represent the baseline specification which corresponds to Anderson and van W incoop’s specification. The rest of the covariates are additional controls and will be considered in the empirical analysis as necessary. 43 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. To measure the dependent variable the logarithm of the value of exports from state i to state j in year t. This is drawn from the IMF’s Direction of Trade database, and in its original form exports is measured in millions of dollars. To test the hypothesis I use three sets of independent variables that are necessary for a causal understanding of the relationship between the political variables and the dependent variable. The first three covariates represents the test variables for hypothesis 1. Parliamentary System. This is a discrete variable that captures if country i or country j in each dyad has a parliamentary system’. I include each term separately in the regressions. This variable is taken from The Database of Political Institutions (TDP1) (Beck et. al., 2001) and is measured such that if the political system is parliamentary then the variable receives a scores of 2, if it is semi-presidential it receives a score of 1, and if it is a presidential system it receives a score of 0. Based on the theory of this chapter, I am most interested in the following partial derivative <91ogexports„, ^ ^ , ; ----------- -— = (3 .2 + P arliam en tary , dP arliam ent ary ■ 3 Those political systems with unelected executives or with presidents who are directly elected, or by an electoral college (whose only function is to elect the president), in cases where there is no prime minister, are coded as 0. In systems with both a prime minister and a president, T D P I considers the following factors to categorize the system: (i) Can the president veto legislation and does die parliament needs a supermajority to override the veto? (ii) Can the president appoint and dismiss prime minister an d /o r other ministers? (iii) Can the president dissolve parliament and call for new elections? Finally, (iv) if the sources mention the president more often than the PM then this serves as an additional indicator to call die system presidential (as in Romania, Kyrgyzstan, Estonia, Yugoslavia). The system is presidential if (i) is true, or if (ii) and (iii) are true. If no information or ambiguous inform ation on (i), (ii), (iii) is available, then (iv) is determinant. Countries in which the legislature elects die chief executive are parliamentary, with the following exception: if that assembly or group cannot easily recall him (if they need a 2 /3 vote to impeach, or m ust dissolve diemselves while forcing him out) then the system gets a 1 which is considered to be semi-presidential (Beck et. al. 2001). 44 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. This partial derivative helps to test the hypothesis since it indicates the change in bilateral exports due to a change in the importing country’s political regime type. The key to the interactive effect is /3; i * P arliam entary, which indicates the impact of the amount of imports if the exporting country is parliamentary. That is, this partial derivatives help to estimate how the exporting country’s regime type impacts the amount that the other partner in the dyad will import. Based on the theory I expect this to be increasing as the parliamentary variable for country i increases in value from 0 to 2 . Given the use of an interaction term I feel it is important to take a mom ent to be clear as to how the results will be interpreted. There are three points I want to emphasize here. First, the inferences regarding the test variables will be tested for statistical significance using a joint hypothesis for all three terms (31 = (3 .2 = /33 = 0 . This is done because the standard errors for each individual term increase due to multicollinearity between the individual test variables and the interaction term thus increasing the likelihood of not rejecting the null hypothesis that there is no effect due to the test variables individual effect. The second point is that for each regression I calculate the conditional effect of the partial derivative, fj.t * P arliam en tary , , as P * 2 since the score of 2 indicates a parliamentary regime. The important point regarding the interpretation of the estimated effect is the calculation of the appropriate standard error to test if the estimated effect of the partial derivative is statistically significant. To do this, I follow Wooldridge (2003, p. 196) and substitute into each regression either (P arliam en tary .-2)*P arliam entary?. This substitution 45 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. accomplishes two necessary calculations that enable us to make valid inferences: first, it calculates an approximate percentage change in exports at the value of the conditioning variable we are interested in, and, second, it also provides a robust standard error and t- statistic for a statistical test of the estimated effect. Finally, my third point I want to emphasize is that the predicted percentage change in exports is an approximation that is increasingly accurate at small changes. To accompany this I include in brackets the exact percentage change that is calculated as follows4 : [exp(/32 + /T? * P arliam entary,) — 1] * 100 [exp(/32 + /33* 2 ) - l ] * 1 0 0 [exp (predicted value) — 1] * 100 Now to test the hypothesis under the most rigorous conditions I include several important control variables. These include the common covariates derived using the gravity model of international trade (Anderson, 1979; Bergstrand, 1985; Sanso et. al., 1993; Mansfield, Milner, and Rosendorff, 2000). The baseline specification includes several independent variables based on Anderson and van Wincoop (2003). GDP. I take the logarithm of each country’s real gross domestic product in year t. This is expected to have a positive impact on international trade and it is measured from The World Bank World Development Indicators 2004. Bilateral Distance. This measure captures the geographical distance between members of a dyad (measured in kilometers), and it is measured as the bilateral distance between the primary city based on population and its effect should be negative as countries further apart incur increased transportation costs to international trade. This is taken 4 N ote the same process applies to the second specification expect we multiply by 1 rather than 2. 46 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. from the Centre D ’Etudes Prospectives E t D ’Informations Internationales database (http: / / www. cepii. fr /). Consumer Price Index. This is a measure of the growth in the consumer price index for each country in year t. The log of this measure is taken and it is taken from The World Bank World Development Indicators 2004. In addition to these gravity based controls it is often common to include a measure for population effects. I add this measure for each member of the dyad to the specification. Population. This captures the logarithm of each country’s population for year t. The effect is less clear because population represents both a factor of production and a consumption effect. Each effect can exert both negative and positive influences on trade. The expectation is for the effect to be negative. It is measured using The World Bank World Development Indicators 2004. Additional controls to capture cultural effects that might impact bilateral trade are included. Contiguity. This location control captures if the pair in the dyad share a common border. It should have a positive impact assuming the neighbors have friendly relations. Common Language. This helps to capture the effect of an officially shared common language and should increase the amount of bilateral trade as it acts to lower trading costs. Former Colony. To control for colonial relations I include if either dyad partner is a former colony of the other country. This should have a positive impact on dyadic trade. 47 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The cultural and location controls are all drawn from the Centre D ’Etudes Prospectives E t D ’Informations Internationales database (http://ww w .cepii.fr/). The sample of fifty-three countries5 includes as many o f the world’s parliamentary and presidential countries for which data is available. The period covered is from 1980-2000 and is collected annually. I do not analyze dates prior to 1980 because many of the countries were less than full democracies prior to this date. It is also true that some of the sample countries in the 1980’s were not full democracies but by 1990 most of the countries in our sample had achieved a reasonable level of democracy6 . To control for the problem of including non-democracies I drop all observations with a Polity score of less than 6 which is the rule Mansfield, Milner, and Rosendorff (2000) follow. This means many observations in the 1980s are not included for some of the Latin American countries like Mexico and others. Nevertheless the time period covered in this analysis is important in the development of the world economy as it captures the period leading up to the collapse of the Cold War world order, and it also covers the period of increased globalization that started in the early 1990’s. In estimating these equations I make several assumptions about the data. First, I assume that the variance of the error term is non-constant and thus robust standard errors are utilized. Second, I assume there is no serial correlation because serial 5 Countries include: Argentina, Australia, Austria, The Bahamas, Barbados, Belarus, Belgium, Belize, Bolivia, Brazil, Canada, Chile, Colombia, Costa Rica, Denmark, Dominican Republic, Ecuador, El Salvador, Finland, France, Germany, Greece, Guatemala, Honduras, Iceland, India, Ireland, Israel, Italy, Jamaica, Japan, S. Korea, Luxembourg, Mexico, Netherlands, New Zealand, Nicaragua, Norway, Panama, Paraguay, Peru, Philippines, Poland, Portugal, Spain, Sweden, Switzerland, Thailand, Turkey, United Kingdom, United States, Uruguay, Venezuela. 6 N ote that we do include Belarus, a former Soviet state, in our sample. There are no observations here prior to 1992 since it was not an independent state. 48 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. correlation results from model misspecification. The baseline specification here is correctly specified and thus I assume there is no serial correlation. Finally, I pool the data because in the fully specified model I believe I capture the unobserved time- constant factors that affect bilateral exports7 . Thus there is no concern of heterogeneity bias due to correlation between any unobserved fixed effects and the covariates since I explicidy include these fixed effects in the specification8 . As a result of these assumptions, our primary estimator utilized here is pooled ordinary least squares with robust standard errors. The summary statistics are reported in Table 2.19 . The statistics for the trade Table 2.1. Descriptive Statistics Variable Observations Mean St. Dev Min M ax Parliamentary i 36,593 1.27 .95 0 2 Parliamentary j 36,593 1.23 .96 0 2 Parliamentary i * 36,593 1.56 1.93 0 4 Parliamentary j Majoritarian i 36,118 .54 .50 0 1 Majoritarian j 36,161 .56 .50 0 1 Majoritarian i * 35,690 .30 .46 0 1 Majoritarian j Log Exports 36,593 3.45 3.27 -4.60 12.39 Log Exports t-1 33,026 3.60 3.22 -4.60 12.24 Log GDP i 36,593 25.16 2.00 19.00 29.90 Log GDP j 36,593 25.03 2.10 19.00 29.90 Log CPI i 36,067 1.98 1.55 -4.07 9.37 Log CPI j 36,022 1.97 1.54 -4.07 9.37 Log POP i 36,593 16.39 1.71 11.94 20.74 Log POP j 36,593 16.32 1.73 11.94 20.74 Log Distance 36,593 8.59 .96 4.00 9.88 7 For a debate on the appropriateness o f fixed effects in iinternational political economy see Beck and Katz (2001); Green, Kim, and Yoon (2001); King (2001) . All of these articles appear in a special issue c International Organisation Spring 2001. 8 Again as a check I do account for any other time invariant factors by using a fixed effects (within estimator) that sweeps out all the constants influencing bilateral exports. 9 Notice that the statistics for G D P and population are the same for each dyad member. This is not a mistake but just a result o f having so many observations. As a check, note that the correlations between the dyad members’ GDPs and populations are low. 49 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 2.1 continued Contiguous 36,593 .04 .19 0 1 Common 36,593 .18 .39 0 1 Language Former Colony 36,593 .037 .19 0 1 variable reveals that the mean value of the log of exports is 3.45 which means that the average value of exports from country i to country j in this sample is approximately $24 million. The maximum amount of bilateral trade was in 2000 from Canada to the U.S. at a value of about $240 billion. There are several dyads that trade at the minimum amount of only about $10,000. Exports from Belize to Guatemala, for example, in 1991 satisfy this amount which is interesting since they are neighbors. But, for the same year exports from Guatemala to Belize were about $3.5 million. Also, note that the average distance between dyad pairs is about 5,500 kilometers which is approximately die distance between El Salvador and Paraguay, with a maximum dyadic distance of 19,711 kilometers which is the distance between Peru and Thailand. The results testing the first hypothesis are presented in Table 2.2. The first specification in column 1 of Table 2.2 indicates that each test variable is positive and most importantly that the interaction effect is positive. The F-statistic indicates that the Table 2.2. Regression Estim ates for Parliamentary System in country i, Parliamentary System in country j, and other covariates on Exports (log) from country i to country j. Sample period 1980-2000.______________________________________________________________ 1 2 3 4 5 6 TEST VARIABLES Parliamentary Systemi .085“ -.170“ -.269“ -.151“ -.02“ -.126“ (.027) (.016) (.016) (.017) (.009) (.032) Parliamentary System] -.026 -.264“ -.279“ -.166“ -.042“ -.142“ (.028) (.017) (.017) (.018) (.009) (.035) Parliamentary Systemi* .416“ .205“ .211“ .141“ .026“ .110“ Parliamentary Systemi CO NTRO L (.017) (.009) (.009) (.01) (.005) (.009) VARIABLES 50 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 2.2 continued Tog of GDPi 1.07” 1.23” 1.26” .181” .552” (.004) (.009) (.009) (.007) (.044) Log of GDPj .838” .852” .886” .136” .782” (.004) (.009) (.009) (.006) (.041) Log of CPU .029” .079” .091” .013” .042” (.006) (.007) (.007) (.004) (.009) Log ofCPlj -.049” -.044” -.034” -.008b .005 (.006) (.007) (.007) (.004) (.009) Log of Distance -1.06” -1.04” -.962” -.151” I o " f e “ (.009) (.009) (.01) (.006) (.012) Log of Populationi -.202” -.231” -.015” -.157 (.009) (.009) (.005) (.172) Log of Populationj .021b -.047” -.007 .473” (.011) (.01) (.005) (.155) Table 2.2 Continued Contiguous .453” .073” .301” (.037) (.014) (.04) Common Language .647” .093” .721” (.026) (.014) (.027) Former C olony .426” .052” .435” (.038) (.016) (.038) Lagged Log Exports .842” (.005) Constant 2.72” -35.12” -35.95” -37.79” -5.69” -24.65” (.044) (.195) (.207) (.207) (.198) (4.47) Observations 36,593 35,513 35,513 35,513 31,998 35,513 F Statistics (All 835” 16,384” 13,216” 10,327” 30,667” 1,386” covariates equal to 0) F Statistic JTest variables 164” 155” 72” 9.10” 53.50” equal to 0) L-squared .07 .78 .78 .79 .94 .84 NO TES: Regressions 1 through 5 use OLS with robust standard errors in parentheses. Regression 6 uses fixed effects (within) estimator. a=p<.01 b — p<.05 c=p<.10_______ test variables are jointly significant below the 1% level of statistical significance. The partial derivative shows, as expected, that a change in exports due to a change in country j’s political regime type will be approximately 81% [124%] greater if the exporting country is a parliamentary regime. That is, the importing country takes in more imports if they originate from a country with a parliamentary regime which is 51 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. consistent with the theory of this chapter. This estimated effect is statistically significant below the 1 % level of significance, and together the test variables explain about 7% of the variation in the dependent variable. This estimated effect shows support for the model’s first proposition that parliamentary regimes have more bilateral trade compared to presidential regimes. The next specification in column 2 reports the results of the baseline model corresponding to Anderson and van Wincoop (2003). Here the coefficients on each individual test variable are now negative but the interpretation yields an estimated effect of approximately 14.6% [15.7%] more exports from country i to country j when country j, the importing country, is a parliamentary regime. This estimated effect is statistically significant and the F-statistic is significant below the 1% level of significance indicating that jointly the test variables are statistically significant. The other covariates in this specification have the anticipated signs. For both the exporting and importing country national income measured by GDP has a statistically significant positive impact on trade. Distance has an expected negative effect indicating that a 1% increase in distance between two countries has a decrease in exports from country i to country j by about 1.1%. This specification explains 76% of the variation in the dependent variable. In the third specification of Table 2.2, I extend the specification and add controls for each dyad member’s population. As for the key partial derivative, in this case exports from country i to country j will be about 14% [15.3%] higher if the importing country is parliamentary where again this is statistically significant below the 1% level of significance. The test variables are jointly significant and the specification explains also about 78% of the variation in the dependent variable. Population is often 52 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. found in gravity models of trade so I feel this is an important addition to the baseline specification. The estimates for the test variables and controls remain similar to those in the second specification. The signs of the estimated coefficient for the variable capturing the effects of population are plausible: If the exporting country’s population increases by 1% then their exports decrease by about two tenths of a percent while if the importing country’s population increases by 1% then their imports increase by about five one-hundredths of a percent. The fourth specification in Table 2.2 adds the cultural controls for dyad contiguity, the sharing of a common language, and if either member of the dyad is a former colony. The cultural controls have the expected interpretations. If countries in the dyad, for example, are contiguous then they will trade about 45% [56%] more than if they are not contiguous. Likewise, if they share a common language then they will trade around 65% [91%] more than if they do not share a common language. Finally, if they have a colonial relationship then trade will be approximately 43% [54%] higher than if they have no prior colonial relations. More importantiy the test variables remain statistically significant below the 1 % level but do drop somewhat in the magnitude of their effect. In this regression, the estimated effect for our partial derivative drops modesdy so that exports are now 13.6% [14.6%] higher if the importing country of the dyad is parliamentary. This effect is still statistically significant below the 1 % significance level. The baseline specification’s estimates remain virtually identical in both statistical significance and magnitude to those in the second and third specifications. 53 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The last two specifications in Table 2 add two extensions to show the robustness of the results. The fifth column adds a lagged dependent variable to the specification. The results for the test variables indicate a depressed effect such that the estimated effect is now only near 1.0% [1.6%] higher if the importing country is a parliamentary regime. This estimate is still significant at or below the 1 % level of significance. The lagged dependent variable depresses the effects of all the other covariates (see Achen 2000) and is likely an unnecessary addition. To see the depressive effects, consider the effect of the exporter’s GDP which is now .180 down from around 1.10. The latter estimate is consistent with other researches’ estimates of this variable and the first estimate surely seems to be depressed by the lagged dependent variable. Finally, the last column in Table 2.2 provides the results which include dummy controls for time and each member of the dyad. The results for the test variables are still significant below the 1% level of significance. The effect here shows that if the exporting country has a parliamentary regime then trade between the countries making up the dyad will be about 8.0% [8.3%] higher than if the exporting country had a presidential regime. This estimated effect is statistically significant, and the three test variables are jointly significant. The results in Table 2.2 provide strong support for the first hypothesis. It is clear that exports from one country in a dyad pair will be higher if the receiving country in the dyad has a parliamentary regime. This shows that the importing country will trade more with a partner country if that partner country is a parliamentary regime suggesting that parliamentary regimes are more open to trade. 54 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2.3 Extension Let’s extend the theory and consider the effect of the electoral system. We know that parliamentary democracies have higher levels of bilateral exports than presidential democracies. The question here is if this result extends into other types of democratic institutions? I thus ask if majoritarian electoral systems compared to proportional electoral systems have more bilateral exports. Why should we expect that the type of electoral system will have an effect on bilateral trade? Rogowski and Kayser (2002) remark that “every electoral system may be conveniently be regarded as a method for translating parties or candidates shares of the popular vote into shares of offices, typically seats in parliament” (p. 529). They find that majoritarian electoral systems favor broad based constituents. In the context of their study they take this group to be consumers. Accordingly they believe this should cause politicians to favor lower prices in majoritarian compared to proportional electoral systems. If this is true then we should expect majoritarian electoral systems to be less amenable to capture by special interest groups compared to proportional electoral systems. A ssum ption 2: C L M A J < C L PRO P. In the context o f the model of this chapter this leads to the following proposition: Proposition: M ajo ritarian electoral system s com pared to propo rtio n al electoral system s will have m ore open trade. The empirical specification is similar and is follows: 55 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. log Exports,,,. = a + /^M ajoritarian,,. + /?2 M ajoritarian + /?3 M ajoritarian jf * M ajoritarian,, + log G D P , + /?5 log G D P , + /36 logC PI( , + /?7 logCPI,, + /?8 log Distance^., + /?9 log PO P,, + /?1 0 logPO P„ + /^ C o n ti g u o u s + /?1 2 Common Language , + /3)3 Form er Colonyijt + /^logE xports.^ _ , + Vijt Now the following partial derivative is of special interest <91ogexports„, „ „ , ------------------- — = P 2 + * M a jo rita ria n .. ^ M ajo ritarian , For the second proposition * M ajoritarian, is calculated as ft * 1 since the variable majoritarian takes a value of 1 if the electoral system is majoritarian. I construct another set of test variables to address hypothesis 2. This is the exact same set-up as the regime type test variables except, as noted in the second specification, I include the variables for the electoral systems. These variables are also drawn from the TD PI (Beck et al 2001). Some details on this measure are helpful. In majoritarian or plurality systems, legislators are elected using a winner-take-all or first past the post rule. The variable scores 1 if this system is used, 0 if it is not; 1 if there is competition for the seats in a one-party state, “blank” if it is ambiguous whether there is competition for seats in a one-party state, and “NA” if there is no competition for seats in a one-party state or if legislators are appointed. The expectation is for the majoritarian dyad to have a positive effect on measures of trade openness. The basic specification with only the test variables for the electoral system is reported in the first column of Table 2.3. Like the results in Table 2.2, this specification 56 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 2.3. Regression Estimates for Majoritarian Electoral System in country i, Majoritarian Electoral System in country j, and other covariates on Exports (log) from country I to country j. Sample period 1980-2000.________________________________________ 1 2 3 4 5 6 TEST VARIABLES Majoritarian Systemi .058 -.464“ -.373“ -.422“ -.057“ -.046 (.048) (.025) (.026) (.026) (.015) (.079) Majoritarian Systemj .190“ .066“ .092“ .043b .026b -.195“ (.045) (.023) (.024) (.023) (.013) (.069) Majoritarian Systemi* .298“ .397“ .394“ .331“ .029“ .335“ Majoritarian Systemj (.068) (.032) (.033) (.032) (.017) (.027) CONTROL VARIABLES Log of GDPi 1.08“ 1.20“ 1.25“ .182“ .562“ (.005) (.009) (.009) (.007) (.045) Log o/GDPj .828“ .871“ .916“ .139“ .789“ (.004) (.008) (.008) (.006) (.042) Log of CPU .001“ .061“ .064“ .006 .038“ (.006) (.007) (.007) (.004) (.009) L°& °f CPIj -.021“ -.003“ -.001“ -.0004 .006“ (.006) (.007) (.007) (.004) (.009) Log of Distance -1.14“ -1.12“ -1.01“ -.161“ -1.08“ (.009) (.009) (.009) (.006) (.011) Log ofPopulationi -.160“ -.196“ -,011b -.130 (.009) (.009) (.005) (.173) Log of Population] -.058“ -.092“ -,011b .481“ (.01) (.01) (.005) (.157) Contiguous .454“ .075“ .312“ (.038) (.014) (.041) Common Language .721“ (.025) .109“ (.014) .793“ (.027) Dormer Colony .337“ (.037) .033b (.016) .344“ (.038) Lagged Log Exports .842“ (.005) Constant 3.25“ -34.68“ -35.46“ -37.75“ -5.73“ -29.98“ (.031) (.199) (.207) (.207) (.201) (5.31) Observations 35,690 34,624 34,624 34,624 31,577 34,624 F Statistics (All covariates equal to 0) 50.52“ 16,447“ 13,274“ 10,284“ 31,339“ 1,346“ F Statistic JTest variables 188“ 148“ 132“ 11“ 52“ equal to 0) .85 PCsquared .005 .78 .79 .79 .94 N O TES: Regressions 1 through 5 use OLS with robust standard errors in parentheses. Regression 6 uses fixed effects (within) estimator. a=p<.01 b — p<.05 c-=p<.10 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. shows positive signs for all the test variables and a positive sign for the interaction term. The joint test of these covariates is statistically significant below the 1% level of significance, and the estimated effect indicates that if the exporting country has a majoritarian electoral system then trade will be 10.8% [11.4%] higher. This estimated effect is statistically significant below the 1% level of significance. The second specification presents the results of the baseline specification. The sign for the exporting partner’s electoral system is positive and the sign for the importing partner’s electoral system is positive. The combined effect highlights that if the exporting country has a majoritarian electoral system then trade will be close to 46.3% [58.8%] higher when the exporting country has a majoritarian electoral system. This latter estimated effect is statistically significant below the 1 % level of significance. The other covariates in this specification have the same signs as the results in the same specification in Table 2 except that population for country j is negative in all cases but those in column 6. Adding the controls for population in the third specification show that the estimated effect that if the exporter has a majoritarian electoral system will be about 48.6% [62.5%] more bilateral trade. This estimated result is also statistically significant below the 1% level of significance. The fourth specification adds the cultural controls with the appropriate signs and comparable effects to those in Table 2.2. The results for the test variables in this case show that if the exporting country has a majoritarian electoral system then trade will be roughly 37% [44%] between the dyad members. This result is still statistically significant below the 1% level of significance. The last two columns in Table 2.3 provide the two robustness checks for the second hypothesis. In the fifth column I include a lagged dependent variable. Like the 58 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. results in Table 2.3, the outcome of the inclusion of this variable is to depress the magnitude of the rest of covariates including the test variables. Now if the exporting country has a majoritarian electoral system trade will only be approximately 5.5% [5.6% ] higher. This result, however, is still statistically significant below the 1 % level of significance. The last column in Table 3 provides the estimates including year and country fixed effects. These results show slightly different results as the sign on the estimated coefficient for the country j test variable has reversed. The sign on the interaction term is still positive but the estimated effect indicates that if the exporting country a majoritarian electoral system then bilateral exports will be about 14% [15%] less. 2.3.1 General Discussion Several important results have been found in this chapter. Two I believe are especially important. Countries that share parliamentary governments trade more. Also, countries that have majoritarian electoral systems trade more. These results are specific to the measurement of the dependent variable, bilateral exports, but hold implications for broader processes such as globalization. They also hold implications for other work in this dissertation. In Chapter 4 I will come back to these results when I consider bilateral inflation rates. In this chapter I will partially rely on the results from this chapter that parliamentary regimes have higher levels of bilateral exports. 59 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3 Foreign Investment This chapter studies investment inflows into developing countries. This is an important topic as foreign investment is a source of funds that can encourage development and growth and, in the right situation, help to raise living standards. Development due to foreign direct investment (FDI) can occur through linkages as input suppliers can achieve larger output levels leading to economies-of-scale. Additionally, FD I through acquisitions leads to higher levels of firm productivity and workers gain additional human capital as the typical foreign firm is more technologically sophisticated relative to the host country’s competing firms. There are also negative effects as FDI can displace competing firms in the host country but the net development effect is thought to be positive which is why many countries expend valuable scarce resources to attract FDI. The topic this chapter tackles is how a change in the level of democracy, and the growth of autocracy (i.e. autocratic consolidation) influence foreign investment. Section 3.1 analyzes inward FD I into developing countries with a focus on the change in the level of democracy as a means of attracting FDI. This analysis serves as the backbone of this chapter arguing that a change in the level of democracy attracts FD I for developing countries. The empirical evidence is supportive indicating that from 1990 to 1999 if developing countries increased their level of democracy by one point then the change in FDI increases by approximately $200 million. The magnitude of this result is more significant if the change in the level of democracy is treated as an endogenous regressor. In this latter case the change in FDI inflows due to a one point change in democracy is approximately $975 million. Section 3.2 studies a different operationalization of political change on FD I 60 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. inflows into developing countries. Here the impact of autocratic consolidation on FDI inflows is studied. This is a topic of great concern for foreign investors that continually finds its way into the popular press. I find no evidence, however, that autocratic consolidation increases FDI for developing countries. Finally, the extension of this chapter, Section 3.3, considers inward bilateral portfolio investment (IBPI). In this part both the level of democracy in the receiving country and also the difference in the democracy scores between the sender and recipient are considered as determinants of IBPI. The results indicate that the level of democracy and the difference in democracy matters for IBPI. All together the theory and results in this chapter challenges existing research in international political economy on the flows of FDI to developing countries. These challenges are an important addition to this body of work. The points are im portant to highlight, however. First, the empirical results, over longer periods of time, are yielding data that I believe does not support the contention that autocratic regimes are better suited to bring about economic modernization especially by attracting more foreign investment. The second reason to challenge this research is because I find that the supposed negative connection between the level of democracy and FD I inflows is theoretically underdeveloped. This second point is held for two reasons. First, the literature seeing a positive connection between autocracy and investment inflows sees that the autocrat’s ability to lower wages is a benefit for foreign firms and is a primary reason why foreign investors will choose autocratic regimes. 61 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. However, this argument mistakenly conflates wages and labor costs1 . Foreign firms, like any firm, care about decreasing labor costs and wage suppressing policies diminish labor productivity since they cut out the labor with the highest opportunity cost so that the decline in labor’s marginal product is likely to be greater than the reduction in wages. These policies will thus serve to increase labor costs resulting in lower firm profits. Moran (2002) articulates this point well stating that, “ ... a firm’s attempt to increase profits by keeping wages below the amount by which the employees’ labor increases the firm’s profit, and by imposing unappealing and intolerable working conditions, should damage its ability to attract the kinds of workers that the firm needs. To the extent that the firm persists in using labor suppression, it is likely to be less productive and less competitive, and to suffer declines in both outputs and profits” (p.25). Rather, to entice foreign FDI domestic governments, autocrats included, should increase labor productivity by improving the existence and quality of public goods.2 Developing human capital as a strategy to attract FDI is consistent with the empirical evidence as indicated by the almost lack of FD I to the poorest parts of the world such as Africa where the stock of human capital is low. 1 Given the facts on FD I inflows this also seems problematic. Developed countries send and receive m ost FD I, it is primarily “horizontal” as m ost o f the production is sold hr the host countries (see Markusen, 1995; Oneal and Oneal, 1988; Slaughter (Unpublished manuscript)), it involves multinational corporations (MNCs) that have high levels o f research and development relative to sales, and it employs a high proportion o f sophisticated labor and produce products that are new or technically complex (see Markusen, 1995). Ultimately, most FD I is found to be horizontal which is why it generally flows between rich, developed economies. In 1990, for example, approximately 88% o f FD I flowed to “High Incom e” countries, and in 2002 76% o f FDI flowed to the “High Incom e” countries as defined by The World Bank (Source: W orld Bank World Development Indicators 2004, p.328). Also see Root et. al. 1979. 2O n this point, N oorbakhsh et. al. (2001, p.1603) find empirical support noting that human capital is an im portant determinant o f IFD I for developing countries. 62 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The second problem with this literature is that it argues that autocrats offer foreign firms the benefit of restricted market competition (e.g. monopolistic conditions) but generally dismiss the theoretical point that the autocrat has to accept the resulting inefficiency (or must be compensated for accepting it). The autocrat will likely require some compensation for accepting this inefficiency which adds a contractual element that the foreign firm will find inefficient since the autocrat has an incentive to renegotiate in the case of increased firm profits. There is empirical evidence that this is the way autocrats act. Consider the following quote regarding foreign investors (The W all Street Journal Guy Chazan, 6/02/05, p. A ll) which states that, “With the price of crude nearly doubling since 2001, countries sitting on big reserves are demanding a bigger cut of windfall profits.” Firms that do get present day restricted market access must weigh these benefits against the likely future costs of expropriation if their investments are profitable. In addition, there are other reasons to question the causal link between autocracy and inflows of FDI which makes alternative interpretations important to consider3 . 3.1 Change in the Level of Democracy, Developing Countries and Foreign Direct Investment 3.1.1 Background In the global economy there has been a conspicuous lack of capital flows to the world’s less developed countries (LDCs). This is puzzling since capital is relatively scarce in 3 The autocrat assumes a further cost as the people know about the monopoly, since there is only one producer, and they will blame the autocrat for fewer jobs and higher prices due to less production which will necessitate an increased use o f protective resources as the autocrat’s policies whll anger the people. O n a m inor point, the literature assumes that the firm granted the monopoly is profiting. M onopoly is not a guarantee of profit. Profits depend on the difference between price and average costs and since labor is a large part of the composition of the factors employed the firm will also see increased costs from disgruntled labor. 63 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. these countries. Graham (1996) illustrates this point stating that, “the substantial two- way flows of FD I between the United States and Europe cannot readily be explained on the basis of different rates of return. Indeed, given the dismal returns on FD I in the United States... one might well wonder why this investment came at the rates and magnitudes that it did during the late 1980s” (p-23). So why has FDI continually flowed between the U.S. and Europe? Or, to put it another way, why has capital not flowed to where the return is higher— in the LDCs? The lack of capital flows to LDCs is a puzzle in need of further attention. Capital inflows are a source of economic development for many of the world’s less developed countries (LDCs) which makes understanding their determinants important for scholars in political economy. In this section I thus ask the following question: How does a change in the level of democracy influence capital inflows into developing countries? Specifically, I seek to understand if democratic consolidation influences foreign direct investment (FDI) into developing countries? By addressing the issue of capital inflows to LDCs this section helps to answer long-standing puzzles such as Lucas’s (1990) question of why capital does not flow from rich to poor countries. The argument presented here is logically founded on the idea that domestic political institutions and the incentive structure they create force FDI to flow in this unexpected way. Przeworski (2003) makes this point nicely stating that, “If citizens can control the elected representatives, if the elected representatives have proper incentives to want to and proper instruments to be able to control appointed officials, if the regulators have incentives and instruments to regulate in the public interest, then the state will do all it should and will not do what it should not” (p.215). The critical idea 64 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. captured by Przeworski is that if the regulators have incentives. This point, in the case of FDI, I argue is valuable in explaining FDI inflows into developing countries. This section’s argument is that the typical autocrat in a developing country faces an incentive structure which makes limiting capital inflows in his best interest. Developing countries’ factor endowments are such that on average capital is scarce and labor is abundant which is important because increasing FDI enhances the marginal product of labor while simultaneously depressing the return to the autocrat’s capital. This thus gives the autocrat an incentive to limit FDI inflows as these capital flows compete with the returns to capital owners from which the autocrat draws political support. But, democratic consolidation allows those who stand to gain from increased FD I inflows, the labor force, to more effectively voice their approval for larger FDI inflows. Missing capital flows to LDCs have thus been a typical pattern in the global economy because prior to the end of the Cold War many developed countries supported autocratic regimes so they would not fall to communism thus allowing the autocrats to suppress the flow of competitive foreign capital since they could safely ignore the demand of the abundant factor, labor4 . 3.1.2 Theory Here I explain why foreign firms find democratic consolidation to be beneficial for their FDI commitments. Chapter 1 discussed the critical concepts of democracy and democratization. Let’s review these concepts in the context of foreign investment. As stated, democracy includes the right to vote and participate in the political 4 Epstein et. al. (2004), for example, find diat the num ber o f memberships in international organizations increases democratic transitions from autocracy to partial democracy. 65 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. process5 , and more extensive definitions include civil liberties6 7 . Associated with but conceptually distinct to the level of democracy, democratic consolidation, or what I take as the move to a higher level of democracy, is concerned with keeping democracy alive where it is weakly or not fully established8 . For developing countries democratic consolidation often involves restructuring power away from a small ehte to a larger political body. The distinction between democracy and democratic consolidation dates back at least to Rustow who proposed that democracy does not develop instantaneously and “one generation is probably the minimum period of transition”9 . Much of the qualitative, or case study, literature on democratic consolidation suggests the process is an up-and-down, wave-like motion1 0 . Recent work in economics is also now profitably making this distinction (Acemoglu and Robinson, 2001). For this section, democratic consolidation is taken to be an increase in political competition and most importantly it is an increase in the separation of powers away from the executive, in this case the 5 See Dahl (1956); Macpherson (1972, 1977); D iam ond (1999). 6 According to Dahl (1998) democracy is a system o f rights, and that large-scale democracy, which he defines as “polyarchy”, requires: elected officials; free, fair, and frequent elections; alternative sources o f information; associational autonomy; inclusive citizenship. Schattschneider (1983) defines democracy as a “competitive political system in which competing leaders and organizations define the alternatives o f public policy in such a way that the public can participate in the decision-making process” (p.138). Lijphart (1999) defines democracy as literally “governm ent by the people or, in representative democracy, government by die representatives o f the people” (p.l). 7 See Collier and Levitsky (1997). 8 See Dominguez (1998). Schedler (2001) argues a democratic regime is consolidated “when it is ‘ likely to endure’” or “when we may expect it ‘to last well into the future’” (p.67). 9 See Anderson (1999). Rustow argues that the task o f democratization is “devising a manageable sequence o f tasks” (p-22). 1 0 According to Haggard and Kaufman (Anderson, 1999) the latest wave o f democratization in Latin America is a process o f “redemocratization” (p.84) suggesting that there was a m ovem ent away from developing more democratic institutions but now a gradual return to this process. O ’D onnell and Schmitter (1986) state that in the process o f democratization “recuperation is often as im portant a goal as extension and expansion” (p.8). 66 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. autocrat” . Some positive change in the level of democracy is thus assumed to be the empirical counterpart of democratic consolidation. To help answer why firms considering FDI would be attracted by democratic consolidation in developing countries assume that developing countries are autocratic. Przeworski et. al. (2000) argue that “the relationship between the level of economic development and the incidence of democratic regimes is strong and tight. Indeed, one can correctly predict 77.5 percent of the 4,126 annual observations of regimes just by looking at per capita income” (p.79). Furthermore, assume most LDCs are governed by a narrow elite, and that this elite draws power from the owners of land and capital, and also through control of the military. The autocrat specifically draws political support from local owners of capital as they control the economies’ productive resources and thus the autocrat’s economic surplus. In some cases the autocrat may actually own the capital or, following Maguire and Olsen (1996), may be the direct beneficiary of the capital owners’ successes in which case he wants to maximize their profits since he draws revenue from this fund. It is easy to see that the autocrat will politically favor the capital owners over the other primary productive factor labor, the abundant factor. Branstetter and Feenstra (2002), for example, test the thesis for China that “the continuing presence of inefficient 1 1 O ’Donnell and Schmitter (1986) define democratization as guided by the idea o f citizenship and argue that it refers to the “processes whereby the rules and procedures o f citizenship are either applied to political institutions previously governed by other principles, or expanded to include persons not previously enjoying such rights and obligations, or extended to cover issues and institutions not previously subject to citizen participation” (p.8). Rueschemeyer et. al. (1992) state that “Democratization represents first and foremost an increase in political equality” (p.5). As Diam ond (1999) states that “continued democratic development is a challenge for all countries, including the United States; all democracies, new and established, can become more democratic” (p-18). Tilly (2000) defines democratization as the “m ovem ent toward broad citizenship, equal citizenship, binding consultation of citizens from arbitrary state action” (p.l). 67 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. state-owned industries creates a local political force that may resist the entry of competing, foreign firms” (p.341). Their conclusion: “we find that the weight applied to the output of state-owned enterprises is much larger (four to seven times in our point estimates) than the weight applied to consumer welfare. The evidence of a political premium on state-owned production diminishes over time, but the point estimates still indicate these firms are favored” (p.356). Their research supports the idea that autocrats favor their capital stock over other factors such as labor. Labor has little to offer the autocrat, at least in terms of political capital, because in most LDCs labor is the relatively abundant factor and is poor in per capita terms due to low levels of productivity and high population growth rates. Most laborers barely have enough resources to fulfill their basic needs and beyond their labor effort have little to offer the autocrat. The autocrat does, however, want to encourage development and needs foreign capital to do so since the existing domestic capital stock is incapable of promoting serious development. It is inferior compared to the capital of the foreign providers. The autocrat’s policy options include inward looking policy programs such as those espoused by programs like import-substitution industrialization (ISI) (which called for over-valued exchange rates amongst other policies prescriptions) or outward oriented policies which call for turning to the international economy for both shot-term and long-term capital. Development is important for the autocrat because it offers him increased regime stability and a larger surplus to tax thus potentially increasing his security and wealth. With the increased wealth the autocrat can develop, or appear to be developing, new defense programs that enhance his ability to more easily negotiate 68 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. concessions from foreign countries, and this newfound wealth can also be used to subdue subversive groups or other political opposition. The benefits from development are important for the vitality of the regime but must be controlled so that the autocrat maintains political control. The problem for the autocrat in his quest to attract FDI is that foreign investors know the autocrat favors the elite, specifically domestic capital owners, and consequently he has an incentive to expropriate existing foreign capital to the benefit of the elite. That is, domestic capital owners in competing industries stand to lose from increased FDI since the foreign firm is more technologically advanced, efficient, and over-all more competitive compared to the domestic firms. The foreign firm has a competitive organizational advantage that will be exploited in the host country to the detriment of any competing firms. It is true that FDI can, if inputs are not imported from the home country, create backward linkages allowing input supphers to achieve scale effects, a gain to up-stream domestic capital owners. But these gains are diffuse relative to the concentrated losses that the competing capital owners will face from foreign firms. Those domestic capital owners that compete with the foreign investors will thus have a strong incentive to limit the inflow of FDI into the host country. The autocrat in need of foreign capital flows faces a dilemma: O n the one hand he wants to attract foreign capital but on the other hand he needs to insure the foreign owners that he will not expropriate their capital at the behest of domestic capital owners. To solve this problem the autocrat can offer the foreign firm some guaranteed policy such as a specified tax rate. The problem, however, with this solution is that his policy commitment to foreign investors is dynamically inconsistent. To see this 69 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. problem more clearly define the dynamic inconsistency as the autocrat’s promised tax policy on the foreign firm’s profits. In this case suppose there are two periods, t — 1,2, and that the autocrat in period 1 promises a binding profit tax policy to the foreign investor toward any period 2 profits. If nothing changes between periods, a key aspect of a time inconsistency problem, the autocrat’s announced tax policy is dynamically inconsistent as he has an incentive to arbitrarily increase the profit tax in period 2 if the firm generates profit. Arbitrary taxation of a firm’s profit decreases FDI in two specific ways. First, it changes the future (but not necessarily the present) production decisions of existing foreign firms. Profit taxes do not affect marginal costs, nor average total costs, but rather they cut into the difference between price and average total costs. This alters the FD I decisions of existing firms by decreasing the reinvestment of residual profits, and it more importandy will also signal to firms considering FDI that the foreign political environment is not safe for their investment to profit. A recent article in The Wall Street Journal (Guy Chazan, 6/02/05) provides anecdotal evidence supporting this dynamic inconsistency. The article notes that, “In Venezuela, President Hugo Chavez retroactively raised the country’s take from existing contracts with Western operators” (p.A ll). Since the bargaining advantage shifts to the autocrat once the foreign investor takes control of the capital, this dynamic inconsistency is a distinct possibility. W hat is interesting about this inconsistency is that the autocrat changes the policy ostensibly for the benefit of the foreign investor. Why? Remember the autocrat’s constituent base is comprised of members of the elite composed of a mix of the military, capital, and land owners. The foreign firm’s profits directly offend existing 70 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. domestic firms in the host country and the autocrat’s change in tax policy is designed to appease these supporters and to benefit the foreign firm by decreasing the alienation they face domestically. To put it most simply: In period 1 the autocrat decrees there will be no profit taxes in period 2 for the foreign investor but then in period 2 the autocrat triggers a profit tax and is himself better off and tells the foreign investor they too are better off because they do not face the ire of the domestic firms. But, the autocrat’s move is unappealing from the foreign investor’s perspective. The reason to invest abroad is to increase firm profits and if these profits cannot be realized then the whole reason for pursuing FDI is no longer necessary. The autocrat also realizes this and understands that what the foreign firm needs is some type of credible commitment preventing the dynamic inconsistency. What the foreign firm needs is some commitment mechanism from the autocrat. The autocrat can pursue democratic reforms as a means of building commitment since democratic reforms involve increasing the transparency of the policy making process and work to reassure investors that their capital is safe from arbitrary expropriation. Along these lines Broz (2002) argues that democracies compared to autocracies are more transparent which means they are more equipped to credibly develop less transparent institutions like independent central banks. Autocracies, on the other hand, being less transparent, must buy credibility by providing more transparent institutions. This is the position the autocrat is in here. To overcome this problem the autocrat can relax his political control which signals that the policy-making process is changing so that it is less arbitrary. Wittman (1989) notes that democratic institutions 71 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. increase political accountability as they enhance monitoring of political agents through competitive elections that can result in a takeover. This gains the autocrat the ability to assure foreign investors the security they need to invest and also diversifies his constituent base since part of increasing democracy means enfranchising those who have typically been left out of the political process which, in the case of LDCs, is the labor force. They will support the inflow of foreign capital as it offers better job opportunities in period 2 than what existed in period 1. Labor will likely vote for increased openness of capital inflows since this will increase their marginal product. Increased FDI acts as a gain for labor in two ways. First, their marginal productivities increase due to the increased capital flows, and, second their relative wage increases due to lower prices from increased production1 2 . As democratic consolidation takes place so that the voice of labor is included in the political process more labor demands will make it politically advantageous to allow increased flows of FDI. The effect will be especially great at first since the capital stock is likely small to begin with1 3 . Graham (2000, p.94) provides evidence presented in Table 3.1 indicating that labor should vote in favor of the foreign capital. Table 3.1. Average com pensation paid by foreign affiliates and average dom estic manufacturing wage, by host-country incom e, 1994_________________________________ Income category of host country All High Middle Low Countries Average compensation paid by 15.1 32.4 9.5 3.4 affiliates (thousands of dollars) Average domestic manufac- 9.9 22.6 5.4 1.7 1 2 A third related gain for labor is the possible increase in jobs due to a higher level o f output with less entry restrictions. This, o f course, depends on the composition o f the factors hired as production expands. 13 . . . . Diminishing returns to the capital will occur but in the context o f this model this is negligible since it is likely not an immediate concern due to the low levels o f pre-existing capital. 72 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 3.1 continued turing w age (thousands o f dollars) R atio 1.5 1.4 1.8 2.0 Table 3.1 marks that for low income countries foreign affiliates pay on average twice the wages compared to the domestic manufacturing wage which suggests that as long as labor knows of these benefits then they will vote in favor of the foreign capital. Moreover, Feenstra and Hanson (1997) find that inflows of FD I into Mexico increased wages for the relatively skilled labor in Mexico. This discussion leads to the following proposition: Proposition: F or developing countries dem ocratic consolidation will cause increased changes in FDI. 3.1.3 Empirical Results Based on the propositions, the hypothesis being tested is that democratic consolidation increases the change in inward FDI for developing countries. The null hypothesis is thus that democratic consolidation should have no effect on the change in FD I inflows. Based on the theory I expect to reject this in favor of a one-sided alternative that democratic consolidation increases the change in FDI inflows for developing countries. To help test this hypothesis a combination of two empirical specifications is utilized. First, a political specification: A FDI = / (ADemocracy, APolitical R isk). And, second, an economic specification AFDI = /(A G D P, AGDP per capita, APopulation, ATrade Openness, Alnfrastructure, AHuman Capital) 73 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Together these specifications will help to test the hypothesis ceteris paribus. The period from 1990 to 1999 is chosen as the sample to test this hypothesis. This sample captures the period just after the unraveling of the Cold War system and also the next six to seven years when the international system experienced major changes away from the Cold War model. This period has seen increased pressure for developing countries to develop democracy which according to this paper’s theory should increase FD I flows into these countries. To be included in this sample a country must be classified by The World Rank for 2004 as either low income, lower middle income, or upper middle income. This is a common classification of developing countries (see Todaro and Smith, 2002, p.34). The sample consists of a large group of countries which includes all regions of the world1 4 . Final inclusion is ultimately dependent on the data availability especially in term s o f the political test variables. Typically small countries with populations below five hundred thousand have no data from the political sources which means that not all countries classified by The World Rank as developing can be included in the sample. Ultimately, this sample does represent a diverse set of the world’s developing countries including all regions of the world. To measure the change in inward flows of FDI, I take the change in the World Bank’s measure of the net inflows of investment required to acquire a lasting 1 4 Included countries are as follows: Argentina, Bangladesh, Bolivia, Brazil, Cameroon, Chile, China, Colombia, Congo (Republic), Costa Rica, Dominican Republic, Ecuador, Egypt, El Salvador, Gabon, Ghana, Guatemala, Honduras, Hungary, India, Indonesia, Ivory Coast, Jamaica, Jordan, Kenya, Malaysia, Mexico, Morocco, Mozambique, Myanmar, Nicarauga, Nigeria, Pakistan, Panama, Paraguay, Peru, Philippines, Poland, Romania, Senegal, Slovakia, South Africa, Sri Lanka, Syria, Tanzania, Thailand, Togo, Trinidad and Tobago, Tunisia, Turkey, Uruguay, Venezuela, Vietnam, Zambia, Zimbabwe. 74 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. management interest (10 percent or more of voting stock) in an enterprise operating in an economy (other than that of the investor). This represents a transfer of savings across national boundaries that is designed to take control of foreign factors, and is the standard definition of FDI used by private research firms such as AT Kearney (see 2004 report, p.l) and also the U.S Bureau of Economic Analysis. In addition, it is in keeping with recent work in political economy such as Li and Resnick (2003) and Jensen (2003) which allows for comparison across studies. The important point is that this measure indicates control of the firm and thus the existing capital stock. It is measured in millions of dollars (Source: World Bank, World Development Indicators). To test the effect of democratic consolidation on inflows of FDI, the change in the level of democracy from the Polity I V data collection is included in the specification. This section asks how changes in authority patterns influence capital flows into developing countries which makes the Polity data a credible source of measurement of the primary test variables as set out by the theory1 5 . This measure is closely connected with the theory of this paper as it measures the concentration of political power in the polity’s executive branch and also captures the level of political competition such that it serves as a good measure of the process described in the theory. To capture the effect of democratic consolidation on the change in FD I inflows several controls common to research on FDI inflows are utilized. 1 5 Nevertheless there are criticisms o f this project. For example, Mainwaring, Brinks and Perez-Linan (2001, p.56) argue that “[djespite its merits” there are “disadvantages” to the Polity III data, the predecessor to Polity IV . They cite several criticisms, the most im portant that there is a disconnection between the definition and operationalization o f democracy. This is a com m on problem for any measure o f democracy. But, the correlation between the Polity III data and their measure o f democracy is .86 (see p.53) which is high and suggests that the measures are capturing the same idea. Also, tire correlation between the Polity III data and another com m on measure o f dre level o f democracy, the Freedom House data, is also .86. See M unck 2001, p.126 and Collier and Levitsky 1997 for other criticisms. 75 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. FDI t-1. Research on FDI flows finds a dynamic effect to FD I inflows so a lagged dependent variable is used to capture what is referred to as an “agglomeration effect”1 6 common to FDI inflows. A lagged dependent variable is valuable in this case because it allows us to ask what happens to FDI inflows if two countries with the same FDI in year t-11 7 change their level of democracy by different amounts. GDP. Studies of inward FDI commonly include measures for the over-all economic size of the receiving country since this should attract FD I as larger market size signals greater potential for the success of the firm’s investment. The change in the log of GDP is included to capture this effect (Source: World Bank World Development Indicators 2004). GDP per capita. Similarly, the change in GDP per capita (log) is included as a proxy for worker productivity and is expected to increase FDI as multinational firms seek to minimize labor costs (Source: World Bank World Development Indicators 2004). Population. The population size of the domestic market as this should attract higher levels of FDI as larger populations signal greater amounts of labor as a key factor in the production process. Here, the change in the log of population is included as a control for a country’s population (Source: World Bank World Development Indicators 2004). Infrastructure. Poor infrastructure, especially for developing countries, can depress FDI inflows as it signals higher costs particularly in the case of vertical FDI. To control for this factor a measure of the change in the total road network1 8 , which proxies for 1 6 See Cheng and Kwan, 2000. 1 7 See Wooldridge, 2003, p.300. 1 8 See Cheng and Kwan, 2000. 76 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. physical infrastructure, is included in the specification. This should have a positive effect on FDI inflows as it helps to reduce production costs. Trade Openness. In the case of horizontal FDI, trade openness and FDI are believed to be substitutes as each represents a means to gain market access. But for developing countries if FDI is vertically motivated then trade openness is likely going to have a positive impact on the inflows of capital (Source: World Bank World Development Indicators 2004). There are likely competing effects so that the effect may be positive or negative but should be controlled for anyways (Source: World Bank World Development Indicators 2004). Risk. Other studies in political economy include measures of investment risk to hold constant any general economic, political, and social risk factors that might dissuade FDI inflows. This study follows this consideration and takes the change in investment risk from the Composite International Country Risk Guide (ICRG) which is an overall index, ranging from 0 to 100 (highest risk to lowest) that is calculated from twenty-two components of investor risk and should have a positive influence on FDI inflows (Source: World Bank World Development Indicators 2004). School Enrollment. Finally, Noorbakhsh et. al. (2001) find human capital to be an important determinant of FD I inflows for developing countries. To capture this effect the change in the gross ratio of the total students enrolled relative to the population of the age group that corresponds to this level of education is taken from the United Nations Educational, Scientific, and Cultural Organization (UNESCO) Institute for Statistics. To be counted in tertiary education generally requires that some secondary level of education has been completed which means higher levels of this measure 77 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. suggest more of a commitment to the development of human capital (Source: World Bank World Development Indicators 2004). The estimation model is of the following general form: A F D Ijt - 0F D Ih j + a(ADem ocracy)ti + 0(AX')( , + ju.t where AX„ is a vector of the covariates and fJj is a linear additive term1 9 . To estimate this model a dynamic panel generalized method of moments (GMM) estimator suggested by Arellano and Bond (AB) is utilized. This estimator naturally allows the inclusion of a lagged dependent variable to capture the agglomeration effect without causing estimator bias. To do this, it treats the lagged dependent variable as endogenous and instruments for it using its own lagged values. The AB estimator also takes the first difference of the covariates so that it naturally fits the theory of this paper that democratic consolidation (i.e. changes in the level of democracy) increase FDI inflows. In addition, the AB estimator sweeps out any fixed effects, such as natural resource endowments, that might cause foreign firms to use FDI. When using this technique several diagnostic checks should be completed. First, a Sargan test of over-identifying restrictions should be done in which rejection of the null hypothesis suggests model misspecification2 0 . Second, a test of first order serial correlation of the first differenced residuals according to Arrelano and Bond should be negative and statistically significant. Third, a test of the first differenced residuals wRecent work on bilateral FD I has used tire gravity model which has typically been the specification in analyses o f bilateral trade. This will serve as the baseline specification including the lagged value o f IFD I substituting for distance since this is not bilateral data. The baseline specification thus includes log o f GD P, log of population, and the lagged value o f FDI. See di Giovanni 2004; Blomberg and Mody 2005 20 Wawro (2002, p.39) cites that rejection o f this test should lead one to consider model respecification. 78 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. should be negative and show no second ordet serial correlation. Finally, the parameter estimate of the lagged regressand should be less than .8. If it is not then the estimator has been shown to exhibit downward biases (see Blundell and Bond (1998); Wawro (2002, p.35))2 1 . Each of these diagnostic tests will be discussed as necessary. The descriptive statistics, reported in Table 3.2, indicate that the mean change in democracy is about .086 which is consistent with the expectation that from 1990 to 1999 democratic reforms increased in developing countries. The average Table 3.2. Descriptive Statistics for the General Sample Variable O b s M ea n St. D ev. M in M a x AIFDI (millions $) 497 277.02 1,598 -5,033 16,697 ALevel of Democracy 487 .086 1.00 -7 8 AChange in Polity 487 .143 1.73 -13 15 AGDP (log) 495 .049 .132 -.815 .395 AGDP per capita (log) 495 .014 .043 -.186 .121 Alnvestment Risk 499 1.13 4.25 -19.75 18 ATrade Openness 503 1.13 7.69 -33.24 48.97 ARoads (log) 484 .013 .178 -2.19 2.15 ASchool 443 .545 1.69 -14.46 11.66 change in FD I inflows is $277 million dollars over this period. Argentina from 1998 to 1999 had the maximum inflow of $16.6 billion and, interestingly, their change in democracy over this period increased by one point. The largest loss in FDI was for Indonesia between 1997 and 1998 in which they lost over $5 billion in FDI inflows. Peru is an interesting case because from 1992 to 1993 in which democracy increased by one point and they received about $800 million more in FDI inflows. Likewise, Mexico from 1996 to 1997 increased their level of democracy by two points and pulled in approximately $3.6 billion more in FDI. Other notable descriptive statistics indicate 2 1 Arrelano and Bond (1991) suggest that inferences should be made on the one step procedure while regression diagnostics should be done using the two step procedure. This suggestion is followed here. 79 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. that trade openness was increasing on average by about seven percent and investment risk was decreasing on average by about one point. The change in investment risk and the change in democracy are correlated at .18 which means they are capturing different effects. Table 3.3 presents the first set of regression results in which the covariates are all assumed to be exogenous. The first parameter estimate of the change in democracy (at its mean plus one standard deviation) increases FDI by about $236 million and is Table 3.3. Panel Analysis o f change in FDI due to change in democracy. All variables assum ed to be exogenous. D ependent variable is the change in FD I inflows. 1 2 3 4 Test Variables ALevel of Democracy 219.31“ 197.83b 202.54b 270.46b (87.02) (87.25) (88.78) (112.50) Control Variables IFD I(t-l) .762“ .727“ .726“ .689“ (.022) (.040) (.041) (.045) AGDP (log) 795.22 692.15 1,215 (767.53) (877.01) (1,044) AGDP per capita (log) 770.95 887.12 -235.93 (2,354) (2,483) (2,859) APopulation (log) -4,724 -4,793“ -2,015 (4,224) (4,368) (5,601) Alnfrastructure [log(roads)] -14.22 -47.02 (452.20) (591.09) ATrade Openness -1.36 -2.43 (12.05) (14.06) ARisk -45.99b (23.38) ASchool 68.01 (47.44) Constant 87.90“ 134.66 144.97 135.99 (31.85) (100.38) (110.76) (150.71) Diagnostics Sargan Test a n .£ • + > . v £ 5 X L = 47-3 X L = 46-9 X L = 48-3 p=.12 p=.09 p=.09 p=.06 Ho: N o AR(1) Z=-2.32 Z=-2.30 Z=-2.27 Z=-2.11 p=.02 p=.02 p=.02 p=.06 80 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 3.3 continued Ho: No AR(2) Z=-.89 Z=-.90 Z=-.91 Z=-.86 I I p=.37 p=.36 p=.39 Wald 59T 601a 578a 501a Observations 434 426 414 367 Notes: Arellano-Bond estimator is used. Coefficient estimates are based on one step method. Diagnostics based on two step mediod. All covariates are treated as if they are exogenous. a— p<.01 b— p.05c— p<.10________________________________ statistically significant at the one percent level of significance indicating that the null hypothesis of no AR(1) is negative and rejected while the null hypothesis of no AR(2) is negative but cannot be rejected. This indicates the estimator is consistent. Regression 2 adds the controls for GDP, GDP per capita and population. The magnitude of the change in democracy decreases slightly but is still statistically significant at the five percent level. All diagnostics are in order. As further controls for infrastructure, trade openness, investment risk, and human capital are added the magnitude of the effect from the change in democracy changes so that at its mean plus one standard deviation FD I inflows change by about $290 million. Approximately 6.5% of the countries in the sample have changed their democracy scores by one point or more and the average change in democracy for this proportion of the sample is about two and a half points indicating that for those countries undertaking the most serious democratic reforms FD I flows will increase by about $675 million. The other extreme in which countries develop less democracy shows that each half point decrease in the change in democracy will drop FDI inflows by about $135 million. The Sargan test, however, in every regression to some degree indicates potential model misspecification. The likely persistence of this condition is the potential endogeneity of the change in democracy. 81 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The model specification poses potential endogeneity problems for the change in democracy due to simultaneity2 2 issues. Inflows of FDI likely influence the development of democracy. Rosendorff (2001), for example, argues that a slow growing capital stock leads to an increased likelihood of democratic transition. Flis argument sees that labor benefits from additional capital so that a slowing capital stock pushes labor to demand for political reform. In the context here, this raises the possibility that the change in democracy is endogenous. To address this issue I endogenize the change in the democracy measure using the AB estimator. Table 3.4 presents the results of the Arellano-Bond estimator considering the change in democracy as an endogenous covariate. Regression 1 shows an increase in the magnitude of the change in democracy so that a one point change increases FDI inflows by about $400 million. Note that all diagnostic tests are met and the Sargan test’s null hypothesis cannot be rejected (pointing to the likely endogeneity of the change in democracy) indicating that the model is likely not misspecified. Regressions 2 and 3 reveal that a one point change in democracy increases FDI inflows by about $380 million. In both cases the Sargan test cannot be rejected suggesting that the change in democracy is endogenous. In addition, the test for no AR(1) is negative and rejected in both cases while the test for no AR(2) cannot be rejected in both cases. This suggests the diagnostics are in order. Finally the inclusion of the measures for investment risk and human capital in regression 4 raise the magnitude of the change in democracy so 2 2 See Buonaccorsi 1996; Chesher 1991; Geraci 1977; Lewbel 1997; Nagar 1959; Sawa 1969; Stefanski 1985. 82 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 3.4. Panel Analysis of change in FDI due to change in democracy. Democracy assumed to be endogenous in all regressions. Log of GDP assumed to be endogenous in regressions 5 and 6. Log of GDPpc assum ed 1 2 3 4 5 6 Test Variables ALevel of 403.76* 386.51b 376.01b 977.02* 470.33* 303.37* Democracy (158.01) (158.27) (160.54) (242.14) (177.29) (162.19) Control Variables IFD I(t-l) .754* .725* .723* .654* .687* .707* (.031) (.039) (.039) (.046) (.041) (.039) AGDP (log) 877.87 868.21 1,822* 2,104* 1,071 (726.79) (804.55) (1,061) (1,251) (1,174) AGDP per 897.85* 1,230* -600.01 -889.62 -2,177 capita (log) (2,302) (2,406) (2,957) (2,808) (4,057) APopulatio -4,569 -4,373 -2,474 -7,043 -7,036 n (log) (4,144) (4,326) (5,828) (4,964) (4,799) Alnfrastruct 6.058 -91.02 81.91 185.31 ure (447.53) (605.75) (561.24) (532.01) (log(roads)] ATrade -.259 -6.32* -2.52 -13.72 Openness (11.56) (14.16) (13.35) (12.91) ARisk -79.48b (24.48) -64.35* (22.68) -35.62* (22.26) ASchool 51.66 (49.77) 40.37 (43.12) 23.33 (40.89) Constant 135.99 125.02 114.56 143.80 203.25 274.44b (150.71) (95.66) (107.45) (154.89) (137.99) (130.83) Diagnostics Sargan Test 'A /2 X cfl= 54- X L =49. X L = 5 0 . X L =49- X m = “ X L =69 6 57 3 2 9 7 p=.89 p=.96 p=.96 p=.96 p=.0003 p=.000 Ho: N o Z=-2.41 Z —2.41 Z=-2.38 Z=-2.05 Z —2.16 Z=2.26 AR(1) p=.01 p=.01 (p=.02) P=.04 p=.03 p=.02 Ho: N o Z — .74 Z=-.76 Z — .78 Z=-.67 Z=-84 Z=-.87 AR(2) P=.46 p=.45 (p=.43) P=.51 p=.40 p=.38 Wald 616* 624* 602* 476* 586* 638* Obs 430 422 410 364 364 364 Notes: Arellano-Bond estimator is used. Democracy is assumed to be endogenous in regressions 1 to 4. Democracy and Log GDP are assumed to be endogenous in regression 5. Democracy, log GDP, and log GDPpc are assumed to be endogenous in regression 6. Coefficient estimates are based on one step method. Diagnostics based on two step method. All covariates are treated as if they are exogenous. Standard errors in parentheses. a— p<.01 b— p.05 c— p<. 10____________ Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. that a one point change in democracy increases FDI inflows by about $977 million. Note here that all diagnostic tests are in order and in this case the Sargan test cannot be rejected as opposed to regression 4 in Table 3.3. Endogenizing the change in democracy has been a good idea. In addition to the change in democracy being endogenous it also might be the case that the change in GDP and the change in GDP per capita are also endogenous. Regression 5 and 6 account for this possibility. Regression 5 endogenizes GDP and regression 6 endogenizes both GDP and GDP per capita. The effect of the change in democracy in both regressions drops somewhat but is still statistically significant at the ten percent level or lower. Notice, however, the Sargan test statistics reveal that in both cases the null hypothesis is rejected suggesting that including the extra endogenous variables creates model misspecification. Regression 4 thus stands as the best specification and, as stated, in this case the impact of the change of democracy on FDI increases is both statistically and practically significant. To check the robustness of these results, consider an alternative measure of democratic consolidation, the change in the Polity score. This is a slightly different measure of the domestic country’s authority structure because it includes both the democratic and autocratic elements present in the political system. The Polity measure is calculated as follows: Polityt = Level of Democracyt — Level of Autocracyt. If a country scores a 10 they are deemed “strongly democractic” and if they score a -10 they are deemed “strongly autocratic” (see Marshall et. al. 2000)2 3 . Two regression results are reported in Table 3.5 which maintain consistency with the results presented in Table 3.3 2 3 Level of autocracy measures how much o f the political process is controlled by elites. See Table 2 for die precise details on how these categories are measured. 84 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. and Table 3.4. As an exogenous regressor the change in the Polity score increases FD I inflows by about $137 million per point change in this score. Table 3.5. Alternative test variables: Panel Analysis of change in FDI due to change in Polity Score.________ 1 2 Test Variables APolity 137.08b 648.95a (70.51) (181.55) Control Variables IFDI(t-l) .689a ,657a (.045) (.048) AGDP (log) 1,190 1,743 (1,045) (1,111) AGDP per capita (log) -7.24 -1,282 (2,859) (3,036) APopulation (log) -2,435 -4,985 (5,603) (6,087) Alnfrastructure [log(roads)] -14.44 -2.44 (591.16) (635.57) ATrade Openness -2.50 -2.74 (14.08) (14.94) ARisk -45.44b -81.26a (23.49) (26.76) ASchool 70.36 53.47 (47.45) (51.89) Constant 142.51 240.21 (150.79) (161.96) Diagnostics Sargan Test xL= 4 7 - 7 xL= 4 7 '4 T ? I I o p=.97 Ho: N o AR(1) Z=-2.13 Z=-2.43 p=.03 p=.015 Ho: N o AR(2) Z=-.87 Z=-.51 p=.39 p=.61 Wald 498a 424a Observations 367 364 Notes: Arellano-Bond estimator is used. Coefficient estimates are based on one step method. Diagnostics based on two step method. All covariates are treated as if they are exogenous in regression 1. Polity is assumed endogenous in regression 2. a— p<. 01 b— p. 05 c— p<. 10_____________________________________ 85 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Endogenizing the change in the Polity score indicates about $648 million more in FDI inflows per point Polity change. In both regressions 1 and 2 the change in Polity is statistically significant at the five percent level or less and all serial correlation diagnostic tests are in order. Comparing Sargan tests, however, suggests the second regression is preferred since the first is likely misspecified due to endogeneity. This evidence provides additional information indicating that democratic reforms attract additional foreign capital in the form of FDI. In total the results in Tables 3.3, 3.4, and 3.5 call into question prior research, such as Li and Resnick (2003), that developing democracy will deter inward flows of FDI for developing countries. A reconsideration of their research is appropriate to learn more about the robustness of these results. Applying the measure of democratic consolidation utilized in this paper to the data Li and Resnick use, reveals different results. Their dependent variable is net FDI inflows measured in billions of dollars (Source: World Bank World Development Indicator.r), and the sample is a similar group of developing countries2 4 . They use eleven control variables2 5 . 2 4 Sample includes: Albania, Algeria, Argentina, Bahrain, Bangladesh, Bolivia, Botswana, Brazil, Bulgaria, Chile, China, Colombia, Costa Rica, Cote d’Ivoire, Czech Republic, Dominican Republic, Ecuador, Egypt, El Salvador, Ghana, Guatemala, Guinea, Honduras, Hungary, India, Indonesia, Jamaica, Jordan, Kenya, Korea Republic, Malawi, Malaysia, Mexico, Nicaragua, Pakistan, Panama, Paraguay, Peru, Philippines, Poland, Romania, Russia, Singapore, Slovak Republic South Africa, Sri Lanka, Thailand, Trinidad and Tobago, Turkey, Uganda, Uruguay, Venezuela, Zimbabwe. 2 5 Democratic property rights measures die property rights protection associated with democracy (Source: Knack and Keefer, IRIS). Regime durability captures the number o f years since the last regime change (Source: Polity IV ). Political instability is a composite measure used to capture the effect o f political instability (Source: Banks). Labor cost measures labor cost changes through die annual percentage change in the real manufacturing wage for each country (Source: International Labor Organization’s 1999 Key Indicators of the Labor Market). G D P, G D P per capita, and G D P growth measure the gross domestic product, G D P per capita, and the percentage growth in G D P respectively (Source: W orld Bank World Development Indicators). Exchange rate volatility captures the mean absolute deviation from the mean o f the official exchange rate o f local currency per U.S. dollar (Source: W orld Bank World Development Indicators). Capital controls measures the barriers to entry or exit for capital (International Monetary Fund, A n n u al 86 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The replication of the results of the model used by Li and Resnick (2003) (see Model 3 p.195) are presented in regression 1 of Table 3.6 and are confirmed. Applying Table 3.6. Regression Results for Reanalysis o f Li and R esnick (2003) 1 2 3 4 Test Variables Level of Democracy (L.R.) ADemocracy AAutocracy APolity -,09c (.02) .115 (.076) -.052 (.101) .106= (.061) Control Variables IFD I (t-1) .969“ (.032) .947“ (.029) .959“ (.033) ADemocratic Property .07“ .045 .041 .044 Rights (.04) (.031) (.030) (.031) AOther Property Rights .04c -.014 -.014 -.006 (.014) (.025) (.024) (.026) ARegime Durability .02° .015 .013 .033 (.008) (.020) (.024) (.026) APolitical Instability -.01 -.016 -.005 -.013 (.01) (.014) (.016) (.016) ALabor Costs -.002 -.003 .0007 -.001 (.002) (.004) (.004) (.004) AGDP (log) l.L -8.08b -7.03b -7.40= (.29) (3.44) (2.98) (3.35) AGDP per capita (log) -.004 8.82“ 7.30“ 8.23 (.30) (3.46) (3.01) (3.43) AGDP Growth .018 .006 .003 .004 AExchange rate volatility (.012) -.0001b (.00005) (.014) (.014) (.015) ACapital Controls -.08“ -.065 -.062 -.061 (.05) (.077) (.074) (.081) AGlobal IFDI .003c -.001 -.001 -.001 (.001) (.002) (.002) (.001) Constant -27.4C .185c .231b .172= Diagnostics O (5.6) (.102) (.095) (.103) Reports on Exchange Arrangements and Exchange Controls). Global IFD I measures the total am ount o f FD I available to all countries (Source: Li and Resnick, 2003). 87 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 3.6 continued Sargan Test X L =30-3 x L =40-4 X L = 3 2 -6 P=1.00 p=1.00 II o o Ho: N o AR(1) Z — 1.78 Z=-2.29 Z=-1.66 P = 075 p=.02 p=.09 Ho: N o AR(2) Z — 1.63 Z — 1.40 Z —1.60 p=.10 P=. 16 P=. 11 Wald 114° 1,169“ 1,452“ 1,123“ Observations 458 354 391 349 Notes. Regression 1 replicates Li and Resnick (2003) using O LS with panel corrected standard errors correcting for AR(1). Regressions 2 to 4 use the Arellano B ond estimators. Each test variables is assumed to be endogenous in these regressions. a — p < .0 1 b= p.Q5 c— p < .1 0 __________________________________________ the estimation method used in this paper (assuming endogeneity) and using the change in democracy as an endogenous regressor reveals in regression 2 that a one point change in democracy will increase FD I inflows by about $115 million. All the diagnostic tests are in order and the Sargan test suggests no model misspecification. However, the parameter estimate on the lagged regressor of .969 is likely causing the estimator to be biased downward. This problem, however, suggests evidence against Li and Resnick (2003) since the impact of the change in democracy is likely larger than the one estimated. As an alternative, consider the change in the autocracy score as a test of the theory that more autocratic regimes increase flows of FDI for developing countries. The results show a negative coefficient which is not as hypothesized but it is statistically insignificant. According to the Sargan test it does appear that assuming the endogeneity of the autocracy measure is appropriate. But, again, the parameter estimate on the lagged dependent variable is .947 which suggests the estimates are biased downward which is thus not strong support for the position that developing countries face a trade off in the form of less FDI due to developing democracy. 88 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Finally, consider regression 4 using the change in the Polity measure. Here the results per point increase in the Polity score is about $100 million in more FDI. The sample here has about thirteen percent of the observations increasing their Polity score by one or more points. Together these results present evidence that developing democracy attracts more capital in the form of FDI inflows. Why do the results change? One reason might be due to the framework Li and Resnick employ to analyze FDI inflows into developing countries. In their work they argue the following: “MNEs are typically more competitive than indigenous firms in the developing host country. While inward investment raises competition in the host country and may improve the allocation of resources, foreign firms typically displace local businesses and even compete for loans in the host country. Just as with trade, the growing presence of more-competitive foreign firms often turns less- competitive local firms into losers. Local business owners and the unemployed, suffering concentrated losses, are likely to get organized and lobby for protective industrial policy from the government” (p. 183). But, who are the “local business owners” in the host country? They are the autocrat himself. Given the theory in this section the results in Table 6 should not be surprising. Since autocratic countries are primarily LDCs in which capital is scarce and are countries where the autocrat has a stake in the domestic capital it is no surprise that increasing democracy and allowing the factor that will benefit, labor, to engage the political process with more sincerity will result in more FDI inflows in these countries. 89 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3.2 Autocratic Consolidation and Foreign Direct Investment in D eveloping Countries Section 3.1 argues and establishes that higher levels of democracy will increase FDI inflows for developing countries. A related concern in the literature and a practical issue for foreign investors is if the consolidation of power by autocrats creates favorable investment conditions which thus serve to increase FDI inflows. In this section I test this related idea. I find that consolidating autocracy does not increase FDI for developing countries and that there is no serious empirical evidence to support the argument that autocratic power is favored by foreign investors. The Yukos trial in Russia illustrates this situation well. The following quote from The Wall Street Journal (Gregory L. White, 6/01/05) regarding this trial shows how the consolidation of power impacts the decisions of foreign investors: “But the price the Kremlin has paid for that break with the past has been high. Concerns that the case is politically motivated have led Western courts to reject appeals from Russian counterparts for legal assistance. Western governments have begun to openly question Mr. Putin's commitment to the rule of law and other fundamental democratic principles. The government's methodical dismantling of Yukos has deeply shaken investors, spurring a surge in capital flight, stunting economic growth and roiling oil markets” (p. A3) The costs in lost foreign investment due to consolidation of power are predictable. The same article goes on to note that: “Capital flight, which had steadily declined during Mr. Putin's first term, jumped to $12 billion last year; government officials have said falling investment led to a slowdown in economic growth to just over 5%, about half the rates seen among 90 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Russia's neighbors. The Organization for Economic Cooperation and Development cited last week ‘considerable damage to the business climate’ from the Yukos affair and other Kremlin policy shifts.” The idea here being that increasing authoritarian control has been costly for firms doing business in Russia and has led to less foreign investment. This pattern of increasing political authority aimed at foreign investors is not contained just to Russia, however. Consider another recent article in The Wall Street Journal (Guy Chazan, 6/02/05) which states that the arbitrary control of foreign investments “is a pattern evident elsewhere” (p. All). This article goes on to detail other situations such as, “In Venezuela, President Hugo Chavez retroactively raised the country's take from existing contracts with Western operators. In Nigeria, lawmakers are discussing tough new conditions for the development of its oil-rich offshore waters. Russia, once seen as a new Klondike, has plans to reserve its biggest new oil fields for locally controlled companies” (p. All). What is clear from these articles is that foreign investors should look upon regimes that are consolidating their power with serious skepticism— even in the face of large oil reserves. However, this is not necessarily the position in the academic literature with a large body of work arguing that autocratic regimes are better equipped to mobilize resources to promote growth and specifically to attract foreign investment. 3.2.1 Background The literature considering the benefits of autocracy cites several factors as to why increasing the power of the autocrat might increase FD I inflows. These reasons, as mentioned, range from the ability to control labor by suppressing their wages to being 91 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. able to offer firms non-competitive market structures. Additionally, power consolidation may also bring order to societies where very little exists. This can help to promote growth and stability which will attract inward flows of FDI. Each o f these reasons appears to be a valid point as to how consolidating autocracy might benefit developing countries in the form of more capital inflows. But is it true? To test this idea I consider the growth of autocracy as a measure for the consolidation of autocracy in the sample of developing countries presented in this chapter. This is a similar idea to the one in Section 3.1 but nevertheless different. In Section 3.1 the question was asked at the level of democracy which captures the state of the regime at a moment in time. There it was found that a change in the level of democracy increases FDI into developing countries. Here, I am considering the growth rate of autocracy over a period of time (e.g. 2 years) and the effect that growth has on FD I inflows today. So, this section considers the inflow of FDI at a moment in time as a function of the growth of autocracy over some period prior to this moment in time. 3.2.2 Theory In this section I rely on the theory and propositions from the preceding section. Based on this theory I propose that autocratic consolidation will decrease inward flows of foreign direct investment. 3.2.3 Empirical Results The point of this section is to test the hypothesis that autocratic consolidation decreases FD I inflows for developing countries. Based on the theory presented here, I expect that we will not be able to reject the null hypothesis that growth in autocracy does not attract inward flows of FDI. 92 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The Data Sample. Same as Section 3.1 Dependent Variable. Same as Section 3.1 Test Variables. Autocratic consolidation. This captures the growth in autocracy. I use a one year and a two year measure of the growth in autocracy as defined in the Introduction. Control Variables. All are the same as in Sectin 3.1 except I add one additional control, the degree of political competition which measures the “degree of ‘democraticness’ within the polity (Source: Polity IV. See Marshall and Jaggers, 2002, p.68). This is a concept variable that combines the regulation of political participation and the competitiveness of political participation. The reason it is added is to try and capture the supposed competing effects of becoming more autocratic. That is, some might argue that if we control for the negative impact of increasing autocracy, say the lack of political competition, then what is left over, increased order and stability, should serve to increase FDI inflows. So I control for the negative impact of autocratic consolidation by including political competition in the specification. Since I have computed the growth rate it would be inappropriate to use an estimator such as the one in Section 3.1. I am not interested in the change in the growth rate but rather the effect of the growth in autocracy over a period of time on a 93 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. specific level of FDI today. Therefore, the primary estimation method is least squares with panel corrected standard errors correcting for first order serial correlation. Table 3.7 reports the summary statistics. For the one year growth in autocracy the mean score is about .019. This indicates that on average the countries in this sample increased their autocracy score by about 2%. Flowever, the two year growth in autocracy indicates that autocracies declined marginally by about .3% while democracy grew by about 4.5%. This means that over the two year time frame this sample’s Polity scores were likely increasing. The question is how this growth impacted FDI inflows into these countries. Table 3.7. Descriptive Statistics Variable Obs Mean St. Dev. M ax Min IFDI (millions $) Fable 3.7 continued 553 1,665 5,038 44,237 -2,745 IFDI lag (millions $) 497 1,531 A,121 44,237 -489 Autocracy growth (oneyear) 487 .019 .402 6 -.9 Autocracy growth (twoyear) 433 -.0035 .172 1.65 -.684 Democracy growth (twoyear) 433 .046 .248 2 -.646 Folitical Competition 548 6.47 2.97 1 10 GDP (log) 550 23.80 1.51 27.62 20.71 GDP per capita (log) 550 7.14 .99 9.07 4.86 Investment Risk 555 62.92 9.2 82 36 Trade Openness 559 64.4 31.2 217.6 1.5 Toads (log) 547 11 1.4 15 8.5 Sige of Fabor Force 560 33,000,000 10,700,000 750,100,000 463,634 The main interpretation in this section is on the sign of the estimated coefficient. According to the theory of this section, we should not be able to reject the null hypothesis that the growth in autocracy attracts inward FDI. Table 3.8 presents the one year growth rate in autocracy regression results. 94 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 3.8. Panel Analysis of FDI due to one year growth in autocracy. Dependent variable is the change in FDI inflows. 1 2 3 4 Test Variables Growth in Autocracy -115.54 -224.1 l b -256.29c -162.61 (one year) (108.59) (111.86) (148.46) (186.87) Control Variables Political Competition -65.21 -159.35b -138.03b -40.09 (77.46) (65.96) (72.24) (41.30) GDP (log) l,728b l,893c 583.44 (831.26) (1,041) (573.67) GDP per capita (log) 321.53 112.85 -299.72 (957.21) (1,166) (491.29) Population (log) 143.03 147.55 -417.63 (972.74) (1,119) (569.46) Infrastructure [log(roads)] -104.36 (231.39) 129.21 (103.95) Trade Openness 9.07 -4.43b (8.03) (2.08) Risk -4.58 (28.21) 14.58 (13.59) School 4.76 (36.25) IFDI(t-l) .975“ (.069) Constant 2,198“ -42,994“ -44,770“ -6,212b (831.22) (10,725) (10,293) (2,487) R-squared .11 .12 .87 Wald Chi-Squared 1.15 25.66“ 48.80“ 2,239“ Observations 486 477 430 430 Notes-. OLS with panel corrected standard errors corrected for first order serial correlation. Growth in autocracy is measured as: Autocracy (t+1)- Autocracy(t)/Autocracy(t). All covariates are treated as if they are exogenous. a— p<.01 b=p.Q5 c— p<.10______________________________________________________ In every specification the results indicate a negative impact from the growth in autocracy which is consistent evidence against the hypothesis that autocratic consolidation of power increases FDI inflows. Additionally, regressions 2 and 3 show 95 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. that it is statistically significant at or below the 10% level of significance. Consider, for instance, regression 3 where the change in FDI inflows due to the growth in autocracy at its mean of .019 actually decreases FDI by almost $5 million. This means we reject an alternative hypothesis that autocratic consolidation increased FD I inflows. Moreover, the two year growth rates in autocracy in Table 3.9 show the same type of results. The regression in column 1 shows that controlling for political competition, the two year growth in autocracy has a negative effect on FDI inflows and is marginally statistically significant at the 10% significance level. Additionally regression 3 using a fuller specification indicates that at its mean plus one standard deviation (approximately .17) FDI inflows will fall by about $236 million dollars. The last regression in column 4 including the lagged dependent variable shows a negative effect on the two year growth of autocracy but it is statistically insignificant. N ote that statistical insignificance is evidence in favor of the theory presented in this section as it shows that in this case the two year growth of autocracy pushes away FDI inflows. Table 3.9. Panel Analysis o f FDI due to two year growth in autocracy. Dependent variable is the change in FDI inflows.___________________ 1 2 3 4 Test Variables Growth in Autocracy -607c -971.45b -1,392“ -441.89 (two year) (353.94) (386.75) (496.52) (509.78) Control Variables Political Competition -102.67 -208.37“ -173.30b -46.93 (93.15) (74.61) (83.04) (47.39) GDP (log) l,846b 2,296b 627.40 (959.92) (1,152) (676.10) GDP per capita (log) 289.62 -16.24 -327.84 (1,074) (1,279) (597.78) Population (log) 123.86 -90.65 -444.72 (1,061) (1,213) (667.95) 96 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 3.9 continued Infrastructure |log(roads)] -104.36 145.40 (231.39) (112.95) Trade Openness 10.04 -5.10a (8.74) (1.69) Risk -35.28 12.33 (36.35) (18.16) School 1.07 -.186 (38.43) (18.13) IFDI(t-l) ,976a (.073) Constant 2,498a -44,858a -47,238a -6,556b (861.69) (10,928) (9,795) (2,774) R-squared .14 .14 .88 Wald Chi-Squared 2.94 30.54a 66.70a 3,189a Observations______________________ 433_______ 425________378________378 Noter. OLS with panel corrected standard errors corrected for first order serial correlation. Growth in autocracy is measured as: (Autocracy(t+2)/Autocracy(t))/s.5- 1. All covariates are treated as if they are exogenous. a— p<.01 b=p.Q5 c— p<. 10____ The results in Section 3.2 continue to support the robustness of the results in Section 3.1 that FD I responds favorably to increases in the level of democracy and does not respond well to autocratic power consolidation. To this point the main capital flow that has been discussed if FDI. To wrap this chapter up I extend the ideas of this chapter to shorter term capital flows commonly referred to as portfolio investment. 3.3 Extension: Democracy and Portfolio Investment 3.3.1 Background As an extension to the primary work in this chapter, I consider an alternative capital flow, portfolio investment to see if there are possible political factors that might also influence these capital flows. The specific question asked is if there is a risk premium 97 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. due to differences in bilateral levels in the level of democracy that impacts the inflow of portfolio capital. A common model (see Hubbard p.95) used to model risk premiums is the capital asset pricing model (CAPM). Typically the CAPM applies to a stock within a portfolio of stocks. The magnitude of a single stock contributed risk to the overall portfolio is measured by beta. The larger beta the larger the systematic risk and thus the higher is the expected return on assets that the investors will require. In the CAPM the expected return on asset j, R '-, depends on the default-risk-free interest rate, R f , and the expected return on the market portfolio, R e m . We have the following Risk prem ium on th e m arket portfolio m R f + f3: i * ( R ^ R f ) (3-1) E xpected R etu rn Risk-free ra te Risk prem ium on asset j on asset j So the expected return on asset j has two components: the default risk-free-rate and the risk premium. The latter compensates the investor for the risk that the equity will not generate the expected return. In the context of this dissertation I am asking if democracy is a possible risk factor? Imagine answering this question from the perspective of a large mutual fund deciding between two countries A and B. Is there a risk premium on democracy? That is does beta matter when we consider differences in democracy between two countries? Here I am concerned with a portfolio of stocks based on a source country and the question is does adding country A to the portfolio versus country B matter if they have different levels of democracy? 98 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Based on the logic of Section 3.1 the argument here is that investors will gravitate to countries with higher levels of democracy. The logic is simple: Higher levels of democracy offer more assurances that investments are safe from arbitrary expropriations. This makes investors and investment funds feel more secure in their acquisitions and thus more likely to buy the assets in those countries where the level of democracy is higher ceteris paribus. 3.3.2 E m pirical R esults The full model specification is as follows portfolio . . t = a + P1 log (Distit) + P2 log(GDP„) + P3 log {GDP ] t ) + P ro cess jt +P jGorruptionCosts jf + Pf.JudicialIndp + P7 Democracy + PH Language (3-2) PP ^Contiguous iit + P W T elecom : j t + Pijt The dependent variable measures portfolio flows from country i to country j in year 2002. It is measured in million of dollars and is taken from the IMF. The covariates are grouped according to the gravity model. The first group (represented by parameters P1 to /!.,) are the standard variables in the gravity model applied to international portfolio movements (see Faruqee et. al.., p-8). Distance. The log of distance captures information costs and is expected to have a negative effect on bilateral portfolio movements. However, considering the state of technology this effect could easily be statistically significant. Here the logarithm of GDP in country i and country j is included as two separate covariates. The expectation is that each should increase bilateral portfolio flows. Capital Market Openness. A measure of the access to capital markets in country j is included and should have a negative impact on portfolio flows. This is measured on a 99 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. seven point scale where a score of 1 indicates that foreign investors are prohibited from investing in stocks and bonds and a score of 7 indicates investors are free to invest. Given its scale it is expected that this will have a positive sign on investment into country j (Source: The Global Competitiveness Report 2001-2002). Next, parameters /3r ,to //, represent the test variables. Corruption control. This measures the costs to firms from the unfair or corrupt practices of other firms. It thus represents market based corruption. It takes a score of 1 if these practices impose large costs and a score of 7 if these behaviors impose no costs or are irrelevant (Source: The Global Competitiveness Report 2001-2002). It should have a positive impact on the dependent variable. Judicial independence. This captures the independence of the courts and should reassure investors that they have recourse to any arbitrary state action. A score of 1 indicates that the judiciary is not independent and subject to interference by the government and/or parties to disputes while a score of 7 indicates the judiciary is independent and not subject to interference. The expected sign given its scale is positive (Source: The Global Competitiveness Report 2001-2002). The level of democracy. As previously defined in the Introduction, this is a 10 point scale with higher scores indicating higher levels of democracy and is taken from the Polity I V data set. This is measured in two ways. First, D em ocracy j is the score for country j in 2002. It is expected this will have a positive impact on the inflows of portfolio investments. In addition, another version of this test variable controls for the difference in democracy: (D em ocracy %)-{Democracy j) . Here the expectation is 100 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. that the sign should be negative. If country j has less democracy than country i then the score is positive and investors should show reluctance with their investments in countries that have lower levels of democracy then the home country. If country j has more democracy then the score is negative which multiplied by a negative coefficient means more portfolio investments. Finally, (3H to f3w represent other controls. Language. This captures if both countries officially share a common language. It is expected to have a positive impact on bilateral portfolio flows. Contiguous. This captures if both countries share a border and should also proxy for distance costs or other special relations shared by countries with a border. While these are less given the modern state of technology, the expectation is for this to have a positive impact on the dependent variable. Both language and contiguous are the same as those in Chapter 2. Telecom . This measures the quality of competition in the telecommunications sector. The more competition in the receiving country’s telecommunication sector then the more portfolio investments since foreign investors will feel they have measures to pull their money out if necessary. The question asked the Global Competitiveness Report is as follows: Is competition in your country’s telecommunications sector sufficient to ensure high quality, infrequent interruptions, and low prices. A score of 1 means no and a score of 7 means yes it is equal to the world’s best. The sign here should be positive. The data here is a cross-section of a number of countries for the year 2002. 101 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. There are twenty-four source countries2 6 and seventy-two host countries2 7 . The estimation method here is OLS with robust standard errors. Included are country dummies for the country where the portfolio capital comes from. The U.S. is the reference category. The regression results are presented in Table 3.10. The standard gravity specification is shown in column 1. Distance, as expected, has a negative impact on bilateral portfolio flows. The GDP for the source country surprisingly has a negative effect but it is statistically insignificant. GDP for the host country has a positive and statistically significant impact on bilateral portfolio flows. Likewise, open capital markets attracts FDI but this measure is statistically insignificant. The test variables are presented in column 2. Each covariate has a positive sign. The host country, for example, receives about $3.5 million more in FPI for each point increase in the level of democracy. For a democracy score of 5 a country can expect almost $18 million more in FPI. Is this significant? The mean FPI for the sample is about $80 million so an increase of this size appears to be significant. Consider also that the mean democracy score for the host country’s in 2002 is about 8. A score of 8 pulls in about $145 million in FPI. This is about twice the mean and clearly a 2 6 Argentina, Austria, Belgium, Canada, Chile, Cyprus, Denmark, Estonia, France, Germnay, Hungary, Ireland, Italy, Japan, Netherlands, Norway, Poland, Portugal, Spain, Sweden, Switzerland, Thailand, United States, Uruguay. 2 7 Argentina, Australia, Austria, Bangladesh, Belgium, Bolivia, Brazil, Bulgaria, Canada, Chile, China, Colombia, Costa Rica, Czech Republic, Denmark, Dominican Republic, Ecuador, Egypt, El Salvador, Estonia, Finland, France, Germany, Greece, Guatemala, Honduras, Hungary, India, Indonesia, Ireland, Israel, Italy, Jamaica, Japan, Jordan, South Korea, Latvia, Lidiuania, Malaysia, Mauritius, Mexico, Netherlands, New Zealand, Nicaragua, Nigeria, Norway, Panama, Paraguay, Peru, Philippines, Poland, Romania, Russia, Singapore, Slovakia, Slovenia, South Africa, Spain, Sri Lanka, Sweden, Thailand, Trinidad, Turkey, Ukraine, United Kingdom, United States, Uruguay, Venezuela, Vietnam, Zimbabwe. 102 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 3.10. Regression Results for bilateral pottfolio investments. 1 2 3 4 5 6 7 Gravity Controls Distance (log) -11.19b -7.58 -3.62 -6.72 -2.39 (5.10) (5.17) (5.63) (5.15) (5.63) GDPi (log) -3.12 -3.02 3.81 -5.07 2.17 (4.95) (5.41) (5.76) (5.29) (5.66) GDPj (log) 38.06c 35.07c 35.02c 33.02° 33.07° (2.93) (3.05) (3.21) (3.01) (3.16) Test Variables Capital Market 8.23 -7.58 -8.85 -8.59 -9.74 Access (7.19) (7.38) (7.58) (7.37) (7.54) Corruption Control 20.83b 9.72 9.57 19.5 l b 9.03 9.09 (8.94) (9.16) (9.11) (8.87) (9.15) (9.06) Judicial 12.85b 4.85 5.81 13.80b 6.20 7.34 Independence (5.36) (5.24) (5.22) (5.36) (5.24) (5.21) Democracy) 3.45b 5.18C 4.82° (1.59) (1.65) (1.64) Democracyi- -2.91* -4.71° -4.32° Democracyj (1.58) (1.65) (1.64) Other Controls Language 63.73c 65.93° (16.18) (16.18) Contiguous 52.24a 54.99b (27.70) (27.84) Telecom 3.93 3.52 (3.99) (4.00) Constant -821.5C -172.6C -791.2C -1011° -138.6° -791.2° -1011° (149.9) (23.96) (159.6) (174.9) (28.79) (159.6) (174.9) Ho:/3s = (3( . = j37 = o 24.5C 10.5C 9.65c 23.2° 9.7° 9.65° N 1340 936 1340 1340 1300 1300 1300 R-Squared .24 .24 .26 .27 .24 .25 .25 F 11° l l c 10c 10c 11° 9.5° 9.1° Notes. Estimation method is OLS with robust standard errors in parentheses. Dummy variables for each country i are included. United States is the reference category. a=p<.10 b — p<.05 c— p<.01.____________________________________________________ 103 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. significant amount. Some descriptive statistics help further illustrate this story. For the 90 countries in the sample with a democracy score of 0 the average amount of FPI is about $35 million. Conversely, for the 249 countries in the sample with democracy scores o f 8 the FPI is about $88 million. And for the 414 countries with a perfect democracy score of 10 the average FPI is about $102 million. It seems that democracy matters for FPI. Consider the other test variables in regression 2. Each point increase in corruption control and judicial independence yield about $20 million and $13 million more in FPI respectively. These three covariates explain about 24% of the variation in FPI. Combining the two specifications in regression 3 shows similar results except now open capital markets has a negative sign but it can safely be ignored as it is statistically insignificant. All other signs remain consistent. Notice that the effect of both corruption control and judicial independence decreased while the effect of source country democracy increased. Each point increase in democracy here yields about $5 million in FPI. Finally, regression 4 adds additional controls. Here dyad partners sharing a common language and border are expected to send or receive about $110 million more in FPI. In this specification the source country’s GDP has a positive but statistically insignificant effect. The rest of the covariates all have the same signs. Again each point increase in host country democracy will yield about $4.8 million more in FPI. Now let’s consider the difference in democracy scores between the source and host countries. Specification 5 presents just the test variables. The results are similar to those in regression 2. However, in this case if the source country has a higher level of democracy so the difference is positive then FPI decreases by about $3 million per point 104 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. difference. Column 6 adds the gravity variables to the specification and indicates that each point difference in democracy costs the source country about $5 million in FPI. Similar results hold for the full specification in column 7. Robustness check using the least absolute value (LAV) regression procedure to control for the influence of any outliers indicates that in regression 4 the effect of the host country democracy is to increase FPI by about $1 million for each point of democracy. It is statistically significant and the rest of the covariates generally remain the same. The sign on judicial independence does change but it is statistically insignificant. The same procedure is applied to column 7 and the results estimate that the coefficient on the difference in democracy is -.595 indicating that if the difference in the democracy scores is positive then each point difference reduces FPI by about $600,000. 3.4 General D iscussion The results in this chapter have indicated two key results on foreign investment. First, for developing countries increasing the level of democracy will increase levels of FD I as it signals to potential investors that the political conditions will support large-scale investment. Second, autocratic consolidation does not increase inward flows of FDI. Both these results point to the idea that for developing countries in the long-run at least the benefits of democratic governance are likely going to result in higher levels of FD I and die extension suggests more inflows of portfolio capital due to higher levels of democracy in the receiving country 105 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4 Democracy and Price Stability Price stability is a policy concern for all governments. Large changes in the inflation rate can cause economic and social problems, and in extreme circumstances can lead to major political upheavals. Unexpected changes in inflation can also cause social tensions since they arbitrarily redistribute wealth from creditors to debtors. The case of long-term debt like mortgages illustrates this problem. If inflation turns out ex- ante to be different than expected then ex-post there is a winner and thus a loser from the unexpected change in inflation. The losers obviously will be frustrated by this outcome and can attempt to gain political action in order to rectify the problem. In this way prices become a political issue and thus are an important policy concern for all governments. When the result of extreme movements in the inflation rate is a change in leadership the stretch of price instability extends into international relations. This was the case in Germany just prior to World War II and makes understanding the implications of price stability an important concern for scholars in both economics and international relations. It is reasonable then that most governments would consider stable prices to be a public good that if generated will enhance their political success. The question I thus ask in this last section is if certain types of governments are more capable of maintaining price stability. Specifically, I ask if parliamentary regimes compared to presidential regimes are better able to control price stability? This question is similar to those in Chapter 2 as it involves comparing parliamentary versus presidential regimes but here it focuses on changes in the inflation rate as the dependent variable. 106 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. As a first cut at this question, consider some descriptive data concerning the cases of Belize and Costa Rica. Both of these countries are relatively small Central American countries that are essentially equidistant from the United States. However, Belize and Costa Rica differ in that Belize employs a parliamentary system while Costa Rica has a presidential system. Does this make a difference in terms of their price stability? Figure 4.1 shows that the two countries have varying rates of inflation with Belize having a lower level of inflation but also a consistently more stable inflation rate. The point of this chapter is to explain why this is the case. Here I want to understand what role the political structure plays in the varying levels of price stability. Figure 4.1. Inflation rates: Belize versus Costa Rica O O C M O n ------------------------------------ 1 ------------------------------------ 1 ------------------------------------ 1 r~ 1980 1985 1990 1995 2000 Year •----- B e l i z e — Costa Rica There are several ways we can begin to answer this question. A glance at some prior research can help us to further understand this puzzle. In their research on government spending Persson and Tabellini (2001) establish that: “The size of 107 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. government is strongly influenced by the political constitution. Proportional and parliamentary systems spend the most, while presidential regimes and countries electing their legislatures by plurality rule spend the least1 ” (p-21). If we assume larger governments are more likely to run deficits then there is the possibility that larger governments will crowd out private investment due to higher interest rates. In the short-run this can lead to a drop in aggregate demand which puts downward pressure on prices thus creating a natural mechanism by which parliamentary regimes generate price stability and thus lower rates of inflation. However, if parliamentary governments print money in order to finance their spending then we might expect price instability from parliamentary regimes. Thus it seems that relying on the size o f government as an explanation leads us to competing stories that ultimately do not help to distill the logic of what is occurring here. A different analysis is in order so we can understand the mechanism at work here. Section 4.1 does exacfiy this as it analyzes how price stability varies amongst parliamentary and presidential regimes. The extension of this chapter, Section 4.2, considers the related idea of relative inflation rates. It asks if parliamentary regimes are better able to match inflation rates. Answers to questions like this one hold important implications for currency unions such as the European Union. If country’s that are part of a currency union cannot match inflation rates then the likelihood of long-term monetary agreement is limited. 1 N ote that the effect o f regime type is a larger and more robust effect than the electoral rule. 108 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4.1 Parliamentary Regimes and Price Stability 4.1.1 Background The question being asked in this section is if parliamentary systems can maintain more price stability compared to presidential regimes. Answers to this and related questions are somewhat limited in the political economy literature. Much o f the work that does exist compares democracies versus non-democracies all in the context of inflation and monetary policy. Desai et. al. (2003) consider if democracies suffer from higher inflation than non-democracies. They model two competing perspectives that each explain how democracy increases price instability. The first model, a “populist” mechanism, argues that democratically elected officials generate revenues in response to public demands for redistribution. To accommodate increased demands politicians print money which leads to inflation. The second model, an “elitist” mechanism, sees that elites gain from inflation due to lower real interest rates which reduces the value of their liabilities. So as the elite captures the policy process they lobby and receive policies that generate inflation2 . Desai et. al. hypothesize that income inequality bridges these two competing explanations so that the redistributive effect of the inflation tax increases with high income inequality. That is, in democracies with high levels of income inequality we should expect higher levels of inflation. Relatedly, Keefer and Stasavage (2002) test and find support for the idea that countries with higher levels of CBI and more veto players have less inflation. In the same vein, Rogowski and Kayser (2002) argue and find that majoritarian electoral 2 This, o f course, assumes the elites are debtors and not creditors. 109 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. systems have a greater “scat-vote elasticity” which biases policy in favor of the majority which they take to be consumers. They find that majoritarian systems are associated with a 10% drop in consumption prices for the average O ECD country. The question is if parliamentary systems have more CBI? And furthermore if they have more veto players? If they do have more CBI we should ask why this is the case. Consider Figure 4.2 where price stability is measured as the log of a country’s inflation rate, measured as the growth in the consumer price index (CPI) (Source: World Bank: World Development Indicators). Figure 4.2 indicates that the spread of the inflation rate has a wider spread around a higher level for presidential compared to parliamentary regimes. For the parliamentary systems the scatter is slightly tighter and centered at Figure 4.2. Price Stability and Regime Typi • - D n------------------------ 1 -------------------------1 ----------------------- 1 ------------------------ r 0 .5 1 1.5 2 Regime type (2=parliamentary 1— mixed 0— presidential) 110 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. a lower level of the log of the CPI. The basic indication is that parliamentary systems have more price stability compared to presidential regimes. In addition, Figure 4.3 shows the standard deviation of inflation over the period from 1980 to 2000. Notice that the same story is indicated by Figure 4.2. The scatter for regimes that were presidential over the entire period is again spread around higher levels. Again, the spread around those countries that were parliamentary shows a lower standard deviation thus indicating more price stability. The suggestion from these basic data plots is that parliamentary regimes maintain more price stability. But, why would this be true? Moreover, is it robust to a multivariate regression. The rest o f this section answers these questions. Figure 4.3. Standard deviation of inflation: Presidential versus Parliamentary systems_______________________________________________ & a o a o •£J '■ d o -8 o a .5 1 1.5 Regime type (2=parliamentary l=mixed 0=presidential) i n Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4.1.2 Theory To examine the impact of parliamentary regimes on price stability I proceed in two steps. First, I show that the creation of monetary policy suffers from a tradeoff between output and inflation. This tradeoff is the part of the model where I capture the political pressure which I will argue results in varying price stability between parliamentary and presidential regimes. The model developed in this section follows the work of Barro and Gordon (1983) and recent work by Keefer and Stasavage (2003). Second, I show how the tradeoff between output and inflation causes presidential governments to decrease price stability and for parliamentary governments to increase price stability. To begin assume that the aggregate demand disturbances have real effects and that inflation expectations influence short-run aggregate supply. Both of these effects can be captured in the following equation y = y + b(rr — irK ),b > 0 (4.1) This is the Lucas supply equation which tells us that output equals average output if expected inflation, 7 re, is equal to inflation 7 T .3 But if expected inflation exceeds actual inflation then we get a shift in the short-run aggregate supply since the costs borne by producers will be expected to increase and actual output is below full employment output. Now, in this state the policymaker minimi2 es the following quadratic loss function 3 N ote that y is the log o f output and y is the log o f its flexible price level. 112 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. L = ^ (y - y *)2 + ^ a (7r - ^*)2 ,2/* > y ,a > 0 (4.2) The parameter a reflects the relative importance of output and inflation in social welfare. The lower the value of CL the less weight is given to inflation concerns relative to output. In other words, lower values of CL indicate that low levels of unemployment are a supportable policy position. We can thus think of CL as measuring political pressure for more output or lower unemployment. If CL is low then this means that in (4.2) this policymaker has responded to the pressure to provide low levels of unemployment. Typically the parties or groups that apply pressure for low values of CL are left leaning such as the Democratic party in the United States. Likewise, I argue (see Chapter 2) that parliamentary systems naturally favor policies that touch a large part of the electorate. This is because parliamentary systems typically govern by coalition and do not have a separation of power between the executive and the legislature which creates a situation in which it is favorable to generate policy that favors a broad base of the electorate. As a result, I expect the value of CL to be lower in parliamentary systems compared to presidential systems. Stated explicitly this assumption is as follows: A ssum ption: a Parl < (2p res • Now assume the policymaker controls money growth and thus controls the behavior of society’s aggregate demand. The policymaker’s choice variable is the level o f inflation, subject to the constraint in equation (4.2). Suppose the policymaker chooses 7 r taking 7te as given. The policymaker’s problem is as follows: 113 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. m m 7 T (4.3) The first order condition yields the following result b2 7te + an* + b(y* - y ) a + b2 (4.4) Since there is no uncertainty, n = n e ^ we get the following equilibrium (4.5) a Equation (4.5) is revealing in the regard that as CL approaches zero, or society prefers less unemployment, the expected inflation grows in an explosive manner. This is a serious problem and has major implications for the ability of governments to effectively govern. If not controlled run away inflation expectations can cause governments to lose their power. In a coalition government, typical in parliamentary regimes, the necessity of controlling CL is of utmost importance. If the government loses the ability to keep C l at a reasonably high level then they risk their power as a new election can be called. But, in a system where the coalition has broad based policy concerns favoring a low value of CL what can be done? That is, the tradeoff between inflation and unemployment is especially severe in parliamentary governments because of the tension between appeasing the coalition with low unemployment but also maintaining low and consistent expected inflation. This leads to a problem that is especially serious in a parliamentary government. In terms of equation (4.5) supporting a low value of CL means it is likely that the policymaker pushes V * > y and thus raises inflation as the policy effect is to 114 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. increase aggregate demand pushing output beyond full employment and thus raising prices. Unless aggregate demand is subsequendy reduced, then the long-run effect is only nominal in effect as only prices will rise since aggregate supply will shift back to the full employment level of output. To solve this problem the government can delegate control of C L to an independent institution that can place a higher value on CL without facing the political pressure to increase inflation in the favor of less unemployment. A common means to do this is to create an independent central bank. Reducing aggregate demand is politically costly so the policymaker will let the economy run its natural course which will only yield higher prices. So the policymaker chooses to delegate control of policy to an independent central bank. This changes the objective function as follows L ' = - (y - y * f + - a'(7r — 7T*f, y* > y , a' > 0 (4.6) 2 2 where the importance society places on inflation a! may differ compared to a . The choice of inflation this new policymaker pursues is as follows b b^ 7 r = n* + —----- -(y*-y) + —------- ( n e - n * ) (4.7) a + b a + b It is common to assume that independent central banks maintain a fundamental policy goal of low inflation. As Cukierman (1998) notes, “By delegating some of their authority to a relatively apolitical institution, politicians accept certain restrictions on their future freedom of action. The main motive for such delegation is usually the preservation of price stability” (p.350). Given this it is safe to assume in this case that a' > a . This leads to the following proposition 115 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Proposition 1. Political regim es th a t delegate m onetary policy to an independent central bank will achieve m ore price stab ility com pared to regim es th a t do not delegate to an independent central bank. The next question is whether central banks vary in independence amongst parliamentary and presidential regimes. Using data from Cukierman (1998, p.434) that averages CBI4 over the period 1980 to 1989 combined with average regimes scores over the same period yields a simple correlation coefficient of -.50 indicating that higher regime scores (i.e. parliamentary regimes) have lower CBI scores which means they have higher levels of CBI. Consider a simple scatter plot o f this data in Figure 4.4. Figure 4.4. Average central bank independence________________________________ U rO . H <N _ “ i - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -r .5 1 1.5 Average regime type (2=parliamentary l=mixed (^presidential) Here the data shows a negative slope indicating that parliamentary regimes have more CBI. Moreover, a bivariate regression yields the following estimation equation: 4 N ote, that a score o f 0 indicates perfect CBI independence. 116 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. cbi = .231 — .05parliam entary (n=46, R-squared=.25, and the F-statistic =14). These results support the idea that parliamentary regimes have central banks that are more independent compared to presidential regimes. Based on this data I offer a second proposition Proposition 2. P arliam en tary regim es com pared to presidential regim es have more independent central banks. Taken together the two propositions presented here support a third proposition (assuming that governors of central banks prefer price stability): Proposition: P arliam en tary regim es will have m ore price stab ility com pared to presidential regimes because presidential system s have less central b an k independence. 4.1.3 Empirical Results The hypothesis being tested is that parliamentary systems have more price stability compared to presidential systems. To test this hypothesis I employ a panel data set over the years 1980 to 2000 that includes a large sample of the world’s countries5 . There are two dependent variables that are used to test this hypothesis. Variance of the change in CPI. The first dependent variable is the yearly variance of a country’s CPI. To measure this I take the average CPI for each country over the total sample period (per country) and then I subtract each year’s inflation rate from the average inflation rate and then square the resulting value. Finally, I take the log o f this 5 Sample includes: Argentina, Australia, Austria, Bahamas, Barbados, Belarus, Belgium, Beli2e, Bolivia, Brazil, Canada, Chile, Colombia, Costa Rica, Denmark, Dominican Republic, Ecuador, El Salvador, Finland, France, Germany, Greece, Guatemala, Honduras, Iceland, India, Ireland, Israel, Italy, Jamaica, Japan, South Korea, Luxembourg, Mexico, Netherlands, New Zealand, Nicaragua, Norway, Panama, Paraguay, Pem, Philippines, Poland, Portugal, Spain, Sweden, Switzerland, Thailand, Turkey, United Kingdom, United States, Uruguay, Venezuela. 117 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. value so that the measure is an approximate percentage change in the variance of the inflation rate. The larger the values here the more price instability a country is experiencing (Source: World Bank: World Development Indicators). Note that coefficients estimated to have a negative effect indicate they increase price stability. Log of the change in CPI. The second dependent variable is the logarithm of the inflation rate. Thus this measures price instability as it measures the approximate percentage change in the inflation rate when the partial derivative is taken. Similarly, estimated effects that are negative indicate more price stability. Several standard controls are included. These will help to identify a ceteris paribus effect from the regime measure on the measures of price stability. (All except veto players are taken from the World Bank World Development Indicator?). GDP. Economic size measured by the log of G D P is included and should increase the level of price instability. Countries with low levels of GDP need more control over monetary policy for stimulative reasons and should thus generate more price instability as they maintain control over monetary policy. Size of Labor Force. A measure for the size of the labor force (measured in millions) is included. On the one hand, country’s with larger labor forces should have more price stability since this acts as a natural check on inflation. The standard Phillips curve demonstrates this as it argues there is a fundamental trade-off between inflation and unemployment and more reserve labor then the easier it is to increase output without increasing inflation. But there are likely competing effects if the labor force overcomes collective action issues and lobbies for policies supporting lower unemployment. Overall, I expect that countries with larger labor forces should thus find it easier to 118 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. control inflation. This means the slope of their line of a graph of inflation and unemployment is less steep indicating less of a trade-off between inflation and unemployment. Trade Openness. Likewise, trade openness, here measured as exports plus imports as a percentage of GDP, acts as another natural control o f price stability. Countries with more openness to international trade should have less inflation and thus more price stability. Veto Players. The more veto players in a political system the higher the possibility that government spending will be higher as a veto player can prevent policy change such as reductions in spending. Since it is generally politically more viable to support increased spending I expect the sign to be positive. (Source: Keefer and Stasavage (2003)). CPI lagged. Finally, a one period lag for inflation is included to control for any past inflation that might cause future price instability. This should have a positive sign. The descriptive statistics are reported in Table 4.1. The mean of the log of the variance of inflation is approximately 3.5. The maximum is 18.62 which is Bolivia in 1985 while the minimum is -15.32 for the United States in 1991. The mean of the CPI mean is about 2.2 indicating the inflation rate on average for this sample is about 2.2 percent. The high is a rate of approximately 7 percent for Nicaragua and Japan has the lowest change in the inflation rate at .56. Table 4.1. Descriptive Statistics__________________________________________ Variable Obs Mean St. Dev. Min M ax Variance CPI (log) 1099 3.46 4.29 -15.32 18.63 CPI (log) 1083 2.17 1.58 -4.07 9.37 System 1099 1.16 .968 0 2 Veto Players 1035 .836 .943 0 2 (polarization) 119 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 4.1 continued GDP(log)t-l 1040 24.67 2.09 19.00 29.85 Labor Force t-1 1060 19.59 52.54 .043 441 (millions) Trade Openness 1028 4.02 .554 2.44 5.54 (log)t-l CPI t-1 1046 90.00 647.47 -1.26 11,749 The results for the amount of inflation measured by the log of the variance in inflation are presented in Table 4.2. The bivariate regression in the first column reveals Table 4.2. Regression Estimates for Parliamentary System on Price Stability. Sample period 1980-2000.______________________________________________________ 1 2 3 4 5 6 T est Variables Parliamentary System -1.84“ -1.91“ -1.39“ -1.39“ -.452c -1.22“ (.175) (.287) (.283) (.272) (.278) (.221) Control Variables Veto Players .092 .284c .309b .148 .225c (.153) (.156) (.153) (.119) (.119) Tog of GDP t-1 -.538“ -.545“ -.174 -.272b (1.43) (.133) (.172) (.125) Tabor Force t-1 -,0007c -.0008° -.0007 -.0002 (.00047) (.0004) (.001) (.0005) Trade Openness t-1 -2.06“ -2.12“ .404 -.267 (.530) (.509) (.443) (.370) CPI t-1 .00002 .0001 .0001 (.002) (.0001) (.0001) Constant 5.74“ 5.81“ 26.66“ 27.03“ 6.28 12.45“ (.242) (.401) (4.91) (4.61) (4.55) (3.60) Observations 1,098 1,034 966 964 964 964 Wald Chi-Squared 110“ 44“ 81“ 92“ 45“ F Statistic 1.17 T-squared .12 .13 .16 .18 .11 .28 NOTES: Price stability is measured as the variance in each country’s inflation rate measured by the growth o f the CPI. Regressions 1 through 4 use OLS with panel corrected standard errors. Regressions 5 and 6 use a fixed effects within estimator and a random effects estimator respectively. Standard errors in parentheses. a=p<.01 b=p<.05 c=p<.10__________________________________________________________ that as expected parliamentary regimes have about 360% less variance in their inflation than presidential regimes. Adding veto players indicates the same effect for the 120 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. parliamentary variable and the measure for veto players has a positive but statistically insignificant effect. Regression 3 includes all covariates except the lag of CPI. The indication is that parliamentary regimes have about 280% less variance in their CPIs. This is a sizeable amount and it is statistically significant at the 1 % level. Here the measure of veto players is now statistically significant. The rest of the covariates except for GDP have the expected signs. Interestingly G D P has a negative sign indicating more price stability due to higher levels of GDP. The coefficient on GDP is the elasticity so that a 1 percent increase in the lagged GDP causes about a half percent increase in price stability. Adding the lagged value of CPI does not significantly change the results. To check the robustness of the results two alternative estimators are presented in columns 5 and 6 of Table 4.2. In regression 5 a fixed effects within estimator indicates that parliamentary regimes have about 90% less variance in their inflation rates. This coefficient estimate is marginally significant at the 10% level of significance. Likewise, the random effects estimator shows that parliamentary regimes have 240% less variance in their inflation rates. This estimate is statistically significant at the 1% level of significance. The results using the average log of inflation are presented in Table 4.3. The Table 4.3. Regression Estimates for Parliamentary System on Average Price Stability. Sample period 1980-2000._________ 1 2 3 4 T est Variables Parliamentary System -,435a -.471* -.385a -.383a Control Variables (.110) (.108) (.089) (.087) Veto P'layers -.015 (.021) -.011 (.023) -.013 (.023) 121 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 4.3 continued Tog of GDP t-1 -.239" -.239" (.029) (.049) Tabor Force t-1 -.0003 -.0005 (.001) (.001) Trade Oppeness t-1 -.729" -.779" (.255) (.235) CPI t-1 .0001 (.00007) Constant 2.57“ 2.69" 11.41" 11.61" (.273) (.265) (2.11) (1.91) Observations 1,082 1,071 999 997 Wald Chi-Squared 16" 19b 50" 61" F Statistic P-squared .13 .14 .20 .21 NOTES: Price stability is measured as the log of the change in each country’s CPI. Regressions 1 through 4 use OLS with panel corrected standard errors. Standard errors in parentheses. a— p<.01 b=p<.05 c=p<.10________________________________ simple bivariate regression in column 1 shows that parliamentary regimes have about 88 percent change in their inflation rate. This simple specification explains 13 percent of the variation in the dependent variable which is a sizeable portion. As covariates are added to the specification the impact of the parliamentary effect remains roughly the same. For specification 2 the effect of the parliamentary measure controlling for the effect o f veto players causes the change in inflation to be 94 percent less compared to presidential regimes. The full specification in column 4 indicates a similar effect from the parliamentary measure. What kind of effect is say an 80 percent less change in inflation as regressions 3 and 4 approximately indicate? Suppose a presidential regime has an inflation rate of 3 percent than compared to a parliamentary regime they might experience a change of 80 122 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. percent more in their inflation rate than the parliamentary regime. So the presidential regime could see a new inflation rate of about 5.4 percent. Is this significant? Consider its effect on real interest rates. The 2.4 percent change in inflation causes real interest rates to drop by the change in inflation and this changes the incentives borrowers and lenders face resulting in changes in behavior. The results in Tables 4.2 and 4.3 indicate support for the theory of this section. In what follows I extend the empirical analysis in two important ways. First, it might be argued that some o f the countries in the sample were not full democracies over the entire sample period. This is a fair point. For example, according to Przeworski et. al.’s (2000) conception of democracy there are some discrepancies especially during the 1980s for some of the countries in this sample. According to their measure Argentina (1980-82), Belize (1980), Bolivia (1980-81), El Salvador (1980-84), Guatemala (1980- 1985), Honduras (1980-81), South Korea (1980-87), Mexico, Nicaragua (1980-83), Panama, Peru (early 1990s), Philippines (1980-85), Poland (1980-88), Thailand(l 980-82) were not full democracies during the year in parentheses. While these years are generally minimal and random, a robustness check should be performed. Many of these countries are Latin American and have presidential systems. If non-democracies have higher levels of inflation then it may be possibly that another effect is at work here. To check this I replicate regressions 4 for both dependent variables constraining the sample to the period from 1990 to 2000. The results show no significant deviations. For the first dependent variable (the log of the variance in the inflation rate) the coefficient estimate for the parliamentary system measure is -1.53 and it is statistically significant at or below the 1 % level of significance. All other covariates have the same 123 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. signs. For the dependent variable measured as the mean level of CPI the coefficient estimate on parliamentary system is -.52 and it too is statistically significant at or below the 1 % level of significance. All other covariates retain their signs except for the labor force measure but it is statistically insignificant. Finally, in Figure 4.2 there is a noticeable amount of variation in the log of the inflation rate amongst just presidential systems. Why is this the case? In presidential systems by definition there is a separation-of-power between the executive and the legislature. This endows the president with veto power over legislation. However, the executive’s veto power varies amongst presidential systems. Haggard and McCubbins (2001, p.80) detail how his veto power varies amongst some of the world’s major presidential systems. An important veto power the president can have is the package veto. The ability to exercise a package veto means the executive either accepts or vetoes an entire bill from the legislature. Package veto power varies amongst presidential systems and is I believe a key reason why we see the variation in Figure 4.2. If a president has a high level of ability to exercise a package veto then they can easily dismiss bills that will increase spending and lead to higher inflation. I would expect that in presidential systems with more package veto power that there would be more price stability. To test this I add a measure for package veto based on the work of Haggard and McCubbins (see Table 3.3). They measure a package veto based on three scores: 0 indicates no veto, or an override by a majority; 1 indicates no veto on spending, but veto with extraordinary majority override on other bills; 2 indicates veto with extraordinary majority override on all bills. Since scores of both 0 and 1 have no veto 124 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. power over spending I code all countries with either score of 0 or 1 as a 0 and all countries with a score of 2 I code as a 1. Table 4.4 presents the results o f a bivariate specification and a full specification for each dependent variable. The results in Table 4.4 show that if the president can veto spending bills with Table 4.4. Regression Estimates for Parliamentary System on Average Price Stability. Sample period 1980-2000._________ Log of inflation Log of inflation rate variance Test Variables Package veto -1.95“ -1.56a -,958a 0 0 0 0 r (.622) (.523) (.296) (.233) Control Variables Veto Players .359b .008 (.160) (.061) Log of GDP t-1 -.803a -.344“ (.291) (.116) Labor Force t-1 .01 .004 (.02) (.005) Trade Openness t-1 -3.2 l a -1.03a (log) (.841) (.349) CPI t-1 -.00006 .0001 (.0002) (.00007) Constant 6.81* 37.24“ 3.39a 15.39a (.521) (8.96) (.282) (3.53) Observations 419 393 416 390 Wald Chi-Squared 10“ 31b 10a 67“ F Statistic K-squared .06 .13 .14 .21 NOTES: Regressions 1 through 4 use OLS with panel corrected standard errors. Regressions 5 and 6 use a fixed effects within estimator and a random effects estimator respectively. Standard errors in parentheses. a=p<.01 b=p<.05 c=p<.10_______________ that package veto then they will have about 150 to 200 percent less variance in their inflation rates. Similarly, they will between 85 and 95 percent less changes in their inflation rates due to the ability to completely override bills including spending bills. 125 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. This is an important result and shows that if policy is insulated from popular pressure through either CBI or a package veto then price stability is more likely to be a reality. 4.2 Extension: Price Integration The main section of this chapter has established that parliamentary regimes have more price stability compared to presidential regimes. Let’s extend this analysis to the dyadic framework of chapter 2. If parliamentary regimes do have more price stability then it could be the case that they achieve more bilateral economic integration. Why? When inflation rates are consistent it is easier to unify monetary policy which is a crucial part of developing economic integration. I thus propose to test the hypothesis that dyads composed of parliamentary regimes achieve more economic integration than presidential regimes. To see this idea more clearly consider a situation with just two countries. Assume that nominal interest rates are equal. Now suppose that in one country there is an exogenous supply side shock that leads to a marked increase in inflation and thus a significant change in the inflation rate. So now the country where inflation is suddenly higher, say the foreign country, real interest rates are suddenly lower there relative to the other country where there was no change in inflation. The reaction to this situation by the foreign country investors is to buy the home country’s currency to invest with since real interest rates are suddenly higher relative to the foreign country’s. This increases capital inflows into the home country which also decreases the supply of their currency in the market for foreign exchange. This causes the real exchange rate to appreciate. 126 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. This means home country goods are relatively more expensive so that net exports decline. The question is, where is it more likely that as the real exchange rate is pushed up imports will increase? Chapter 2 established that parliamentary dyads trade more and specifically that they import more. Given this results, it should be the case that governments employing parliamentary governments will achieve higher levels of financial integration since they are more open to trade. Dependent Variable To capture the idea of integration the ratio of inflation rates is computed. If they are equal then this ratio should be 1. I next subtract 1 from the ratio and then square the deviation since I am concerned with positive or negative deviations from equal rates of inflation. Then I take the square root so the dependent variable has less extreme values. The idea of this measure is that larger positive values indicate economies that are less integrated. If they were more integrated than any price differences would be arbitraged away and the ratio of their inflation rates would be close to 1. The main test variable measures if the dyad is composed of two parliamentary regimes. This takes a 1 if they are and 0 otherwise. In addition, I use a measure to capture if the dyad is composed of a parliamentary and presidential regime. This is coded as 1 if the dyad is mixed and 0 otherwise. Given this set-up I use the presidential dyad as the reference category so the interpretations are relative to the presidential dyad. The control variables are those found in the gravity specification. GDP. Economic size measured by GDP for each country is included and it is expected that larger economies will be more highly integrated. The signs should thus be negative. 127 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Population. A measure for each dyad’s population is included. Its effect on economic integration is uncertain. On the one hand more population represents a larger demand effect which should increase integration but it also acts as an increased factor of production which can depress levels of economic integration. Distance. Countries further apart should have less economic integration. The sign should thus be positive. Bilateral Exports. Finally, bilateral exports should increase integration and should have a negative sign. The descriptive statistics are presented in Table 4.5. All covariates are the same Table 4.5. Descriptive Statistics Variable Obs Mean St. Dev. M in M ax Integration 54,802 3.10 29.93 .00006 1,903 Parliamentary Dyad 55,388 .305 .461 0 1 Mixed Dyad 55,388 .533 .499 0 1 GDPi (log) t-1 54,120 24.67 2.09 19.00 29.85 GDPj (log) t-1 54,120 24.67 2.09 19.00 29.85 POPi (log) t-1 55,160 16.19 1.75 11.89 20.72 POPj (log) t-1 55,160 16.19 1.75 11.89 20.72 Distance (log) t-1 55,160 8.61 .97 3.67 9.88 Exports (log) 46,678 3.17 3.22 -4.61 12.39 as those in Chapter 2 except for the measure of economic integration. This construction gives 54,802 observations, a mean score of 3.10 with a standard deviation o f 29.93. According to this measure Panama and Nicaragua have the least integration as in 1987 they have the maximum score of 1,903. Interestingly both are presidential regimes. The regression results are presented in Table 4.5. Negative values on 128 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the coefficients indicate depressing effects on the dependent variable which means their effect is to increase economic integration. Conversely, positive coefficients indicate less economic integration. Column 1 shows that parliamentary dyads have about 2.3 less points of economic integration compared to presidential dyads. The full set of controls presented in regression 2 have the anticipated effects except for the GDP in country i which is negative. Here the parliamentary dyad compared to the presidential dyad scores about 4.1 points lower which indicates more integration. Additionally, the mixed dyad also scores lower than the presidential variable suggesting that mixed dyads have more integration than presidential dyads. Regression 3 and 4 present a fixed effects within estimator and a random effects estimator which show consistent results for the measure of the parliamentary dyad. The Hausman test rejects the null hypothesis in favor of the fixed effects estimator. Finally, a robust regression to control for outliers is presented in regression 5. The results are consistent statistically except the effect on the parliamentary and mixed dyad measures is less severe. Table 4.6. Regression results for parliamentary dyad on Integration 1 2 3 4 5 TEST VARIABLES Parliamentary Dyad -2.31” -4.10” -11.64” -6.68” -.051” (.593) (.689) (1.61) (.928) (.009) M ixed Dyad -1.07c -1.52c -6.38c -3.19c .121” (.605) (.636) (1.10) (.737) (.008) CONTROL VARIABLES Log of GDPit-1 -1.06” -.951 -.61 l b .012” Log of GDPjt-1 (.182) .798” (.658) 1.71” (.272) 1.80” (.002) .094” (.150) (.643) (.254) (.025) 129 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 4.6 continued Tog of POPit-1 .478" 5.68b .441 -.013" (.127) (2.78) (.300) (.003) T°g ofPOPjt-1 -2.82" -6.53" -3.38" -.083" (.159) (2.74) (.305) (.003) Tog ofDistancet-1 ,445b -.059 .024" (.195) (.391) (.003) Tog Exports ,504b .020 .171 -.00007 (.115) (.175) (.137) (.001) Constant 4.43" 36.05" 5.02" 26.03" -.693" (.584) (6.71) (42.49) (7.29) (.074) Observations 53,639 41,624 41,624 41,624 41,624 Wald Chi-Squared 155" F Statistic 27" 36" 10" 361" K-squared .0007 .007 .003 .007 .16 Notes. Regression 1 and 2 use OLS with robust standard errors in parentheses. Regression 3 uses a fixed effects within estimator. Regression 4 uses a GLS random effects estimator. Regression 5 uses a robust regression a— p<.01 b:z:p<.05 c=p<.10___________________________________________ 4.3 D iscussion The primary result in this chapter establishes that parliamentary systems have more price stability than presidential regimes. I argue this is because parliamentary regimes cannot naturally avoid the tradeoff between inflation and unemployment and thus delegate control of monetary policy to an independent institution. In this case empirical data support that this delegation is to an independent central bank. I argue that this since there is more delegation in parliamentary regimes then there is consequently more price stability in parliamentary regimes. This is an important conclusion and has implications for international financial integration especially for currency unions in which monetary policy is tied amongst a number of countries. The second extension in this chapter indicates that dyads composed of parliamentary regimes have more financial integrations as measured by the ratio o f their 130 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. inflation rates. This is an expected result considering the research presented in Chapter 2 which found that parliamentary dyads trade more than presidential dyads. 131 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 5 Conclusion This dissertation examines the connection between domestic political institutions and international economic policy arguing that these institutions significantly shape economic outcomes such as bilateral exports, foreign direct investment (FDI), and price stability. A large part of this dissertation assumes then that we cannot takes states as homogenous units. We have to relax this assumption and peer into the black box of the state. Accounting for what is in the black box has increased my understanding of international economic outcomes. Relaxing this assumption has lead to some interesting results and several recurring themes. These themes deserve comment. The first theme running throughout this dissertation is that political institutions shape incentives. By shaping incentives these institutions help shape economic policy. This was borne out in both chapters 2 and 4 where it was shown that parliamentary regimes tend to favor broad based policy due to the collegial nature of power sharing and the lack of a separation-of-power between the executive and the legislature. In the case of chapter 2 this resulted in more bilateral trade between parliamentary regimes compared to pairs of countries composed of presidential systems. Likewise, in chapter 4 the favoritism for broad based policy was argued to be a factor as to why central banks are more independent in parliamentary regimes and thus prices more stable in these systems. Similarly, chapter 3 explained how increasing the level of democracy in developing countries changed the incentive structure so that once resistant actors begin to allow increasing inflows of foreign capital into the domestic economy. 132 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The implication of this theme carries over into a number of important areas in political economy. For example, the present push for increasing foreign aid into some of the world’s poorest countries as a development strategy is highly popular at the moment. But considering the research presented here is it likely to succeed? Tough question must be asked about processes such as foreign aid. For example, what effect does foreign aid have on the incentive for the receiving country to save? If it diminishes the incentive to save then this could pose a serious problem for the long-run ability to create and maintain economic growth and development. A second important theme prevalent in this dissertation is that power matters. Specifically, those that wield power can hold a tremendous amount of influence over economic policy. This was a large part of the logic behind the differences between parliamentary and presidential regimes. If in parliamentary regimes cabinet power depends on the approval of the legislature then it is more likely that small players, or parties, can wield an enormous amount of influence, especially if the cabinet depends on a coalition for their power. Coalition governing makes compromise more likely and is a reason I argued in chapter 4 that parliamentary regimes delegate more authority to an independent central bank. Moreover, in chapter 4 it was also shown that presidents with a package veto over spending bills can increase price stability. Power matters for economic policy. Likewise, in chapter 3 part of the logic as to why autocrats in developing countries limit capital inflows is because they have the power to limit these inflows. But, as explained, the process of democratic development changes power configurations which thus makes the prospect of the capital inflows into developing countries more likely. 133 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. This second theme also has implications beyond this dissertation. Since power relations within states and amongst states are constantly in flux it is important to imagine how these changes may come to affect future economic outcomes. The Middle East with its conspicuous yet seemingly tenuous power structures and its grip on oil seems to be a natural case where changes in power could have major economic effects especially globally. China is another example in which a change in the domestic power structure could potentially have dramatic domestic and international economic effects. Indeed, there is an abundance of current countries, such as Colombia and Mexico, where power relations could change rapidly and impact international economic matters. The economic impact is a guarantee but the economic outcome is uncertain. Finally, the last theme in this dissertation is that the nation-state is not a unitary actor. Countries are complex entities and their internal processes matter for international economic matters. This was an especially prominent theme in chapter 3 in which the fact that developing countries generally do not receive much in the way of capital inflows was confronted and explained by considering that the nation-state is a complex bundle of multiple actors expressing their preferences. As a result, if the global community wants to promote foreign investment in these countries then the research in this dissertation suggests that it would be a wise policy to negotiate guarantees from autocrats that they will not expropriate the foreign capital arbitrarily. Incorporating multilateral institutions such as the United Nations might be a first step toward promoting foreign investment in the world’s LDCs. Appeals for foreign investors to just invest in these countries are likely to fail. The international community 134 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. must somehow extract guarantees that autocrats will credibly commit to not expropriating the foreign capital. In the end, I believe that in order to understand our international economy we must consider the domestic politics and political institutions that shape many of these outcomes. Possibly, this might help to overcome some of the more serious problems we face today. 135 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 6. Bibliography A.T.KEARNEY FD I Confidence Index: Global business Policy Council. 2002 and 2004. Achen, Christopher. 2000. “Why Lagged Dependent Variables Can Suppress the Explanatory Power of Other Independent Variables.” Paper Presented at the Annual Meeting o f the Political Methodology Section of the American Political Science Association, UCLA, July 20-22. Alexander, Gerard. 2002. “Institutionalized Uncertainty, the Rule of Law, and the Sources of Democratic Stability” Comparative Political Studies 35(10): 1145-1170. Allison, Graham T. Jr. and Robert P. Beschel Jr. 1992. “Can the United States Promote Democracy?” Political Science Quarterly 107(l):81-98. Anderson, Lisa. 1999. Transitions to Democracy. New York: Columbia University Press. 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