The dramatic increase in flows of foreign direct investment (FDI) during the last two decades of the twentieth century has been accompanied by an extensive literature dealing with the impact of multinational corporations (MNCs) on issues such as economic growth, poverty and inequality, the environment, and cultural diversity. As many of the concerns about these impacts, positive as well as negative, revolve around the question of markedly increased competition among states for MNCs, it is surprising how little attention has been paid to the political and economic factors that attract FDI.
Nathan Jensen has written an interesting, empirically grounded, and provocative book dealing with that topic. He focuses on political institutions, arguing that to attract MNCs, the institutions that underlie policy must provide credible commitments to favorable policies and be sufficiently flexible to adapt to changing economic conditions.
Jensen is concerned with three sets of institutions: democratic polities, veto players who have policy preferences supportive of multinationals, and the International Monetary Fund's conditionality agreements. He also looks at the impact of fiscal policy on MNCs' investment decisions, arguing that there is no evidence of a “race to the bottom.” I find the first three arguments convincing (with some caveats) but the last—that dealing with the relationship between FDI inflows and fiscal policy autonomy—problematic.
One of the strengths of this book is that the theoretical arguments are subject to extensive and generally rigorous empirical tests—typically cross-sectional time-series regression analyses. That said, I would have preferred more concern about the problems of FDI inflows (FDI/GDP) as a dependent variable.
Measurement questions aside, three issues are relevant. First, net inflows are reported; one never knows the balance between new inflows of direct investment and divestment or outflows. As Jensen is concerned with the impact of politics on FDI, divestment could be nontrivial. Second, a breakdown of FDI by sector is not available; if one is concerned about political reactions to FDI, it makes a difference whether you are talking about an oil concession or a manufacturing plant. Third, there is increasing evidence that it may not be appropriate to pool advanced and developing countries in the same regression equation. (A frustration of this book is that country lists are not provided for most of the regressions.)
That said, FDI inflows are the best available measure of MNCs' activity abroad and are widely used in empirical research. Furthermore, Jensen makes a very reasonable effort to fully specify his equations controlling for all of the “usual suspects.” However, I am concerned that by not taking the limitations of his dependent variable seriously enough, he may have overgeneralized the applicability of the results. Let me turn to some of his specific arguments.
The chapter dealing with democracy and FDI is the strongest in the book: Both the theoretical arguments and empirical analyses are convincing. Jensen refutes arguments that MNCs prefer autocrats and demonstrates a significant and positive relationship between democratic political institutions and FDI inflows. The results are robust to a number of specifications, including an attempt to control for selection effects resulting from the fact that democracy is less prevalent in poor countries.
Three mechanisms link democratic institutions and FDI inflows: information or transparency in economic and political affairs; representation that provides the means for foreign firms to exert influence on government policy; and “audience” or electoral costs of reneging on agreements with foreign investors. While the arguments about transparency and representation are reasonable and convincing, audience costs ignore the reality of the political process in many mineral-rich poor countries. Neither Hugo Chavez nor Evo Morales appears overly concerned about being thrown out of office for tightening the screws on MNC activity.
Jensen also appears on solid ground arguing that veto players whose interests correspond with those of the foreign investor are likely to increase the perception and probability of credible commitments. The argument rides on an assertion that an arrangement is most likely in a politically federal (as opposed to fiscally federal or politically decentralized) system. While I was not entirely convinced by the logic of the argument, it is certainly an interesting possibility. His empirical work supports the hypothesis.
I do have a number of concerns about Jensen's attempts to refute the “race to the bottom” argument. With some minor exceptions, he fails to find a negative impact of government consumption, social security spending, capital taxation, labor taxation, or a left-leaning government on inflows of FDI. He concludes that MNCs' investment decisions do not challenge fiscal policy autonomy, that “pessimism about the role of government fiscal policy in attracting foreign direct investment suffers from over-exaggeration” (p. 54).
That conclusion rests on a very slender theoretical and empirical foundation. Jensen uses the notion that capital is footloose and mobile as a straw man, and that straw man is easy to blow over. The extensive literature on the impact of incentives on FDI decisions makes it clear that subsidies or tax rebates are rarely more than a marginal factor; my reading of studies on the impact of incentives on FDI is that they are inconclusive. Jensen does not deal sufficiently with this literature, which has to inform any discussion of the impact of fiscal policy on flows of FDI.
Perhaps more important, it is not clear that impacts on FDI inflows are a reasonable test of the race-to-the-bottom argument. The threat of a reduction in inflows or even the possibility of outflows may well be enough to constrain fiscal policy.
Furthermore, empirical tests of this proposition are limited to 15 countries of the Organization for Economic Cooperation and Development. While a country list is not available, the panel's starting point of 1963 makes it likely that the sample is restricted to a small number of relatively advanced countries. Given the complexity of this area of research, one simply cannot declare an argument false on the basis of a lack of statistical significance in a regression equation; at a minimum, one would want a positive and significant result for its inverse. Any conclusion here has to be limited to the old Scottish verdict of “not proven.”
My quibbles aside, this is an interesting and provocative book. It is a serious effort to think about and test the impact of political institutions on multinational firms and flows of foreign direct investment. With the exception of the work on the race to the bottom (in many ways tangential to the book's main argument), the empirical tests are well specified and robust. This is worthwhile reading for anyone interested in the political economy of FDI.
