ha joon 3 4

CHAPTER 3
My six-year-old son should get a job
Is free trade always the answer?
I have a six-year-old son. His name is Jin-Gyu. He lives off me, yet he is quite capable of making a living. I pay for his lodging, food, education and health care. But millions of children of his age already have jobs. Daniel Defoe, in the 18th century, thought that children could earn a living from the age of four.
Moreover, working might do Jin-Gyu’s character a world of good. Right now he lives in an economic bubble with no sense of the value of money. He has zero appreciation of the efforts his mother and I make on his behalf, subsidizing his idle existence and cocooning him from harsh reality. He is over-protected and needs to be exposed to competition, so that he can become a more productive person. Thinking about it, the more competition he is exposed to and the sooner this is done, the better it will be for his future development. It will whip him into a mentality that is ready for hard work. I should make him quit school and get a job. Perhaps I could move to a country where child labour is still tolerated, if not legal, to give him more choice in employment.
I can hear you say I must be mad. Myopic. Cruel. You tell me that I need to protect and nurture the child. If I drive Jin-Gyu into the labour market at the age of six, he may become a savvy shoeshine boy or even a prosperous street hawker, but he will never become a brain surgeon or a nuclear physicist – that would require at least another dozen years of my protection and investment. You argue that, even from a purely materialistic viewpoint, I would be wiser to invest in my son’s education than gloat over the money I save by not sending him to school. After all, if I were right, Oliver Twist would have been better off pick-pocketing for Fagin, rather than being rescued by the misguided Good Samaritan Mr Brownlow, who deprived the boy of his chance to remain competitive in the labour market.
Yet this absurd line of argument is in essence how free-trade economists justify rapid, large-scale trade liberalization in developing countries. They claim that developing country producers need to be exposed to as much competition as possible right now, so that they have the incentive to raise their productivity in order to survive. Protection, by contrast, only creates complacency and sloth. The earlier the exposure, the argument goes, the better it is for economic development.
Incentives, however, are only half the story. The other is capability. Even if Jin-Gyu were to be offered a £20m reward or, alternatively, threatened with a bullet in his head, he would not be able to rise to the challenge of brain surgery had he quit school at the age of six. Likewise, industries in developing countries will not survive if they are exposed to international competition too early. They need time to improve their capabilities by mastering advanced technologies and building effective organizations. This is the essence of the infant industry argument, first theorized by Alexander Hamilton, first treasury secretary of the US, and used by generations of policy-makers before and after him, as I have just shown in the previous chapter.
Naturally, the protection I provide to Jin-Gyu (as the infant industry argument itself says) should not be used to shelter him from competition forever. Making him work at the age of six is wrong, but so is subsidizing him at the age of 40. Eventually he should go out into the big wide world, get a job and live an independent life. He only needs protection while he is accumulating the capabilities to take on a satisfying and well-paid job.
Of course, as happens with parents bringing up their children, infant industry protection can go wrong. Just as some parents are over-protective, governments can cosset infant industries too much. Some children are unwilling to prepare themselves for adult life, just as infant industry support is wasted on some firms. In the way that some children manipulate their parents into supporting them beyond childhood, there are industries that prolong government protection through clever lobbying. But the existence of dysfunctional families is hardly an argument against parenting itself. Likewise, cases of failures in infant industry protection cannot discredit the strategy per se. The examples of bad protectionism merely tell us that the policy needs to be used wisely.
Free trade isn’t working
Free trade is good – this is the doctrine at the heart of the neo-liberal orthodoxy. To the neo-liberals, there cannot be a more self-evident proposition than this. Professor Willem Buiter, my distinguished former colleague at Cambridge and a former chief economist of the EBRD (European Bank for Reconstruction and Development), once expressed this succinctly:‘Remember: unilateral trade liberalization is not a “concession” or a “sacrifice” that one should be compensated for. It is an act of enlightened self-interest. Reciprocal trade liberalization enhances the gains but is not necessary for gains to be present. The economics is all there’.1 Belief in the virtue of free trade is so central to the neo-liberal orthodoxy that it is effectively what defines a neo-liberal economist. You may question (if not totally reject) any other element of the neo-liberal agenda – open capital markets, strong patents or even privatisation – and still stay in the neo-liberal church. However, once you object to free trade, you are effectively inviting ex-communication.
Based on such convictions, the Bad Samaritans have done their utmost to push developing countries into free trade – or, at least, much freer trade. During the past quarter of a century, most developing countries have liberalized trade to a huge degree. They were first pushed by the IMF and the World Bank in the aftermath of the Third World debt crisis of 1982. There was a further decisive impetus towards trade liberalization following the launch of the WTO in 1995. During the last decade or so, bilateral and regional free trade agreements (FTAs) have also proliferated.Unfortunately, during this period, developing countries have not done well at all, despite (or because of, in my view) massive trade liberalization, as I showed in chapter 1.
The story of Mexico – poster boy of the free-trade camp – is particularly telling. If any developing country can succeed with free trade, it should be Mexico. It borders on the largest market in the world (the US) and has had a free trade agreement with it since 1995 (the North American Free Trade Agreement or NAFTA). It also has a large diaspora living in the US, which can provide important informal business links.2 Unlike many other poorer developing countries, it has a decent pool of skilled workers, competent managers and relatively developed physical infrastructure (roads, ports and so on).
Free trade economists argue that free trade benefited Mexico by accelerating growth. Indeed, following NAFTA, between 1994 and 2002, Mexico’s per capita GDP grew at 1.8% per year, a big improvement over the 0.1% rate recorded between 1985 and 1995.3 But the decade before NAFTA was also a decade of extensive trade liberalisation for Mexico, following its conversion to neo-liberalism in the mid-1980s. So trade liberalization was also responsible for the 0.1% growth rate.
Wide-ranging trade liberalization in the 1980s and the 1990s wiped out whole swathes of Mexican industry that had been painstakingly built up during the period of import substitution industrialization (ISI). The result was, predictably, a slowdown in economic growth, lost jobs and falls in wages (as better-paying manufacturing jobs disappeared). Its agricultural sector was also hard hit by subsidized US products, especially corn, the staple diet of most Mexicans. On top of that, NAFTA’s positive impact (in terms of increasing exports to the US market) has run out of steam in the last few years. During 2001–2005, Mexico’s growth performance has been miserable, with an annual growth rate of per capita income at 0.3% (or a paltry 1. 7% increase in total over five years).4 By contrast, during the ‘bad old days’ of ISI (1955–82), Mexico’s per capita income had grown much faster than during the NAFTA period – at an average of 3.1% per year.5
Mexico is a particularly striking example of the failure of premature wholesale trade liberalization, but there are other examples.6 In Ivory Coast, following tariff cuts of 40% in 1986, the chemical, textile, shoe and automobile industries virtually collapsed. Unemployment soared. In Zimbabwe, following trade liberalization in 1990, the unemployment rate jumped from 10% to 20%. It had been hoped that the capital and labour resources released from the enterprises that went bankrupt due to trade liberalization would be absorbed by new businesses. This simply did not happen on a sufficient scale. It is not surprising that growth evaporated and unemployment soared.
Trade liberalization has created other problems, too. It has increased the pressures on government budgets, as it reduced tariff revenues. This has been a particularly serious problem for the poorer countries. Because they lack tax collection capabilities and because tariffs are the easiest tax to collect, they rely heavily on tariffs (which sometimes account for over 50% of total government revenue).7 As a result, the fiscal adjustment that has had to be made following large-scale trade liberalization has been huge in many developing countries – even a recent IMF study shows that, in low-income countries that have limited abilities to collect other taxes, less than 30% of the revenue lost due to trade liberalization over the last 25 years has been made up by other taxes.8 Moreover, lower levels of business activity and higher unemployment resulting from trade liberalization have also reduced income tax revenue.When countries were already under considerable pressure from the IMF to reduce their budget deficits, falling revenue meant severe cuts in spending, often eating into vital areas like education, health and physical infrastructure, damaging long-term growth.
It is perfectly possible that some degree of gradual trade liberalization may have been beneficial, and even necessary, for certain developing countries in the 1980s – India and China come to mind. But what has happened during the past quarter of a century has been a rapid, unplanned and blanket trade liberalization. Just to remind the reader, during the ‘bad old days’ of protectionist import substitution industrialization (ISI), developing countries used to grow, on average, at double the rate that they are doing today under free trade. Free trade simply isn’t working for developing countries.
Poor theory, poor results
Free trade economists find all this quite mysterious. How can countries do badly when they are using such theoretically well-proven (‘the economics is all there’, as Professor Buiter says) policy as free trade? But they should not be surprised. For their theory has some serious limitations.
Modern free trade argument is based on the so-called Heckscher-Ohlin-Samuelson theory (or the HOS theory).* The HOS theory derives from David Ricardo’s theory, which I outlined in chapter 2, but it differs from Ricardo’s theory in one crucial respect. It assumes that comparative advantage arises from international differences in the relative endowments of ‘factors of production’ (capital and labour), rather than international differences in technology, as in Ricardian theory.9
According to free trade theory, be it Ricardian or the HOS version, every country has a comparative advantage in some products, as it is, by definition, relatively better at producing some things than others.† In the HOS theory, a country has comparative advantage in products that more intensively use the factor of production with which it is relatively more richly endowed. So even if Germany, a country relatively richer in capital than labour, can produce both automobiles and stuffed toys more cheaply than Guatemala, it pays for it to specialize in automobiles, as their production uses capital more intensively. Guatemala, even if it is less efficient in producing both automobiles and stuffed toys than Germany, should still specialize in stuffed toys, whose production uses more labour than capital.
The more closely a country conforms to its underlying pattern of comparative advantage, the more it can consume. This is possible due to the increase in its own production (of the goods for which it has comparative advantage), and, more importantly, due to increased trading with other countries that specialize in different products.How can the country achieve this? By leaving things as they are.When they are free to choose, firms will rationally (like Robinson Crusoe) specialize in things that they are relatively good at and trade with foreigners. From this follows the propositions that free trade is best and that trade liberalization, even when it is unilateral, is beneficial.
But the conclusion of the HOS theory critically depends on the assumption that productive resources can move freely across economic activities. This assumption means that capital and labour released from any one activity can immediately and without cost be absorbed by other activities.With this assumption – known as the assumption of ‘perfect factor mobility’ among economists – adjustments to changing trade patterns pose no problem. If a steel mill shuts down due to an increase in imports because, say, the government reduces tariffs, the resources employed in the industry (the workers, the buildings, the blast furnaces) will be employed (at the same or higher levels of productivity and thus higher returns) by another industry that has become relatively more profitable, say, the computer industry. No one loses from the process.
In reality, this is not the case: factors of production cannot take any form as it becomes necessary. They are usually fixed in their physical qualities and there are few ‘general use’machines or workers with a ‘general skill’ that can be used across industries. Blast furnaces from a bankrupt steel mill cannot be re-moulded into a machine making computers; steel workers do not have the right skills for the computer industry.Unless they are retrained, the steel workers will remain unemployed. At best, they will end up working in low-skill jobs, where their existing skills are totally wasted. This point is poignantly made by the British hit comedy film of 1997, The Full Monty, where six unemployed steel workers from Sheffield struggle to rebuild their lives as male strippers. There are clearly winners and losers involved in changing trade patterns, whether it is due to trade liberalization or to the rise of new, more productive foreign producers.
Most free trade economists would accept that there are winners and losers from trade liberalization but argue that their existence cannot be an argument against trade liberalization. Trade liberalization brings overall gains. As the winners gain more than what is lost by the losers, the winners can make up all the latter’s losses and still have something left for themselves. This is known as the ‘compensation principle’ – if the winners from an economic change can fully compensate the losers and still have something left, the change is worth making.
The first problem with this line of argument is that trade liberalization does not necessarily bring overall gain. Even if there are winners from the process, their gains may not be as large as the losses suffered by the losers – for example, when trade liberalization reduces the growth rate or even make the economy shrink, as has happened in many developing countries in the past two decades.
Moreover, even if the winners gain more than the losers lose, the compensation is not automatically made through the workings of the market, which means that some people will be worse off than before. Trade liberalization will benefit everyone only when the displaced workers can get better (or at least equally good) jobs quickly, and when the discharged machines can be re-shaped into new machines – which is rarely.
This is a more serious problem in developing countries, where the compensation mechanism is weak, if not non-existent. In developed countries, the welfare state works as a mechanism to partially compensate the losers from the trade adjustment process through unemployment benefits, guarantees of health care and education, and even guarantees of a minimum income. In some countries, such as Sweden and other Scandinavian countries, there are also highly effective retraining schemes for unemployed workers so that they can be equipped with new skills. In most developing countries, however, the welfare state is very weak and sometimes virtually non-existent. As a result, the victims of trade adjustment in these countries do not get even partially compensated for the sacrifice that they have made for the rest of society.
As a result, the gains from trade liberalization in poor countries are likely to be more unevenly distributed than in rich countries. Especially when considering that many people in developing countries are already very poor and close to the subsistence level, large-scale trade liberalization carried out in a short period of time will mean that some people have their livelihoods wrecked. In developed countries, unemployment due to trade adjustment may not be a matter of life and death, but in developing countries it often is. This is why we need to be more cautious with trade liberalization in poorer economies.
The short-run trade adjustment problem arising from the immobility of economic resources and the weakness of compensating mechanisms is, although serious, only a secondary problem with free trade theory. The more serious problem – at least for an economist like myself – is that the theory is about efficiency in the short-run use of given resources, and not about increasing available resources through economic development in the long run; contrary to what their proponents would have us believe, free trade theory does not tell us that free trade is good for economic development.
The problem is this – producers in developing countries entering new industries need a period of (partial) insulation from international competition (through protection, subsidies and other measures) before they can build up their capabilities to compete with superior foreign producers. Of course, when the infant producers ‘grow up’ and are able to compete with the more advanced producers, the insulation should go. But this has to be done gradually. If they are exposed to too much international competition too soon, they are bound to disappear. That is the essence of the infant industry argument that I set out at the beginning of the chapter with a little help from my son, Jin-Gyu.
In recommending free trade to developing countries, the Bad Samaritans point out that all the rich countries have free(ish) trade. This is, however, like people advising the parents of a six-year-old boy to make him get a job, arguing that successful adults don’t live off their parents and, therefore, that being independent must be the reason for their successes. They do not realize that those adults are independent because they are successful, and not the other way around. In fact, most successful people are those who have been well supported, financially and emotionally, by their parents when they were children. Likewise, as I discussed in chapter 2, the rich countries liberalized their trade only when their producers were ready, and usually only gradually even then. In other words, historically, trade liberalization has been the outcome rather than the cause of economic development.
Free trade may often – although not always – be the best trade policy in the short run, as it is likely to maximize a country’s current consumption. But it is definitely not the best way to develop an economy. In the long run, free trade is a policy that is likely to condemn developing countries to specialize in sectors that offer low productivity growth and thus low growth in living standards. This is why so few countries have succeeded with free trade, while most successful countries have used infant industry protection to one degree or another. Low income that results from lack of economic development severely restricts the freedom that the poor countries have in deciding their future. Paradoxically, therefore, ‘free’ trade policy reduces the ‘freedom’ of the developing countries that practise it.
The international trading system and its discontents
Never mind that free trade works neither in practice nor in theory. Despite its abysmal record, the Bad Samaritan rich countries have strongly promoted trade liberalization in developing since the 1980s.
As I discussed in the earlier chapters, the rich countries had been quite willing to let poor countries use more protection and subsidies until the late 1970s. However, this began to change in the 1980s. The change was most palpable in the US, whose enlightened approach to international trade with economically lesser nations rapidly gave way to a system similar to 19th-century British ‘free trade imperialism’. This new direction was clearly expressed by the then US president Ronald Reagan in 1986, as the Uruguay Round of GATT talks was starting, when he called for ‘new and more liberal agreements with our trading partners – agreement under which they would fully open their markets and treat American products as they treat their own’.10 Such agreement was realized through the Uruguay Round of GATT trade talks, which started in the Uruguayan city of Punta del Este in 1986 and was concluded in the Moroccan city of Marrakech in 1994. The result was the World Trade Organisation regime – a new international trade regime that was much more biased against the developing countries than the GATT regime.
On the surface, the WTOsimply created a ‘level playing field’among its member countries, requiring that everyone plays by the same rule – how can we argue against that? Critical to the process was the adoption of the principle of a ‘single undertaking’, which meant that all members had to sign up to all agreements. In the GATT regime, countries could pick and choose the agreements that they signed up to and many developing countries could stay out of agreements that they did not want – for example, the agreement restricting the use of subsidies. With the single undertaking, all members had to abide by the same rules. All of them had to reduce their tariffs. They were made to give up import quotas, export subsidies (allowed only for the poorest countries) and most domestic subsidies. But, when we look at the detail, we realize that the field is not level at all.
To begin with, even though the rich countries have low average protection, they tend to disproportionately protect products that poor countries export, especially garments and textiles. This means that, when exporting to a rich country market, poor countries face higher tariffs than other rich countries. An Oxfam report points out that ‘The overall import tax rate for the USA is 1.6 per cent. That rate rises steeply for a large number of developing countries: average import taxes range from around four per cent for India and Peru, to seven per cent for Nicaragua, and as much as 14–15 per cent for Bangladesh, Cambodia and Nepal.’11 As a result, in 2002, India paid more tariffs to the US government than Britain did, despite the fact that the size of its economy was less than one-third that of the UK. Even more strikingly, in the same year, Bangladesh paid almost as much in tariffs to the US government as France, despite the fact that the size of its economy was only 3% that of France.12
There are also structural reasons that make what looks like ‘levelling the playing field’ actually favour developed countries. Tariffs are the best example. The Uruguay Round resulted in all countries, except for the poorest ones, reducing tariffs quite a lot in proportional terms. But the developing countries ended up reducing their tariffs a lot more in absolute terms, for the simple reason that they started with higher tariffs. For example, before the WTO agreement, India had an average tariff rate of 71%. It was cut to 32%. The US average tariff rate fell from 7% to 3%. Both are similar in proportional terms (each representing around a 55% cut), but the absolute impact is very different. In the Indian case, an imported good that formerly cost $171 would now cost only $132 – a significant fall in what the consumer pays (about 23%) that would dramatically alter consumer behaviour. In the American case, the price the consumer pays would have fallen from $107 to $103 – a price difference that most consumers will hardly notice (less than 4%). In other words, the impact of tariff cuts of the same proportion is disproportionately larger for the country whose initial tariff rate is higher.
In addition, there were areas where ‘levelling the playing field’meant a one-sided benefit to rich countries. The most important example is the TRIPS (Trade-related Intellectual Property Rights) agreement, which strengthened the protection of patents and other intellectual property rights (more on this in chapter 6). Unlike trade in goods and services, where everyone has something to sell, this is an area where developed countries are almost always sellers and developing countries buyers. Therefore, increasing the protection for intellectual property rights means that the cost is mainly borne by the developing nations. The same problem applies to the TRIMS (Trade-related Investment Measures) agreement, which restricts the WTO member countries’ ability to regulate foreign investors (more on this in chapter 4). Once again, most poor countries only receive, and do not make, foreign investment. So, while their ability to regulate foreign companies is reduced, they do not get ‘compensated’ by any reduction in the regulations that their national firms operating abroad are subject to, as they simply do not have such firms.
Many of the exceptions to the rules were created in areas where the developed countries needed them. For example, while most domestic subsidies are banned, subsidies are allowed in relation to agriculture, basic (as opposed to commercial) R&D (research and development), and reduction of regional disparities. These are all subsidies that happen to be extensively used by the rich countries. The rich nations give out an estimated $100 billion worth of agricultural subsidies every year; these include the $4 billion given to 25, 000 American peanut farmers and EU subsidies that allow Finland to produce sugar (from beets).13 All rich country governments, especially the US government, heavily subsidize basic R&D, which then increases their competitiveness in related industries. Moreover, this is not a subsidy that developing nations can use, even if they are allowed to – they simply do not do much basic R&D, so there is little for them to subsidize. As for regional subsides, which have been extensively used by the European Union, this is another case of apparent neutrality really serving the interests mainly of rich countries. In the name of redressing regional imbalances, they have subsidized firms to induce them to locate in ‘depressed’ regions. Within the nation, this may be contributing to a reduction in regional inequality. But, when viewed from an international perspective, there is little difference between these subsidies and subsidies given to promote particular industries.
Against these accusations of ‘levelling the playing field’ only where it suits them, the rich countries often argue that they still give the developing countries ‘special and differential treatment’ (SDT). But special and differential treatment is now a pale shadow of what it used to be under the GATT regime. While some exceptions are made for the developing countries, especially the poorest ones (‘the least developed countries’ in WTO jargon), many of these exceptions were in the form of a slightly longer ‘transition period’ (five to ten years) before they reach the same final goal as the rich countries, rather than the offer of permanent asymmetrical arrangements.14
So, in the name of ‘levelling the playing field’, the Bad Samaritan rich nations have created a new international trading system that is rigged in their favour. They are preventing the poorer countries from using the tools of trade and industrial policies that they had themselves so effectively used in the past in order to promote their own economic development – not just tariffs and subsidies, but also regulation of foreign investment and ‘violation’ of foreign intellectual property rights, as I will show in subsequent chapters.
Industry for agriculture?
Not satisfied with the result of the Uruguay Round, the rich countries have been pushing for further liberalization by developing economies. There has been a push to tighten restrictions on controls over foreign investment, over and above what was accepted in the TRIMS agreement. This was attempted first through the OECD (in 1998) and then through the World Trade Organisation (in 2003).15 The move was thwarted both times, so the developed countries have shifted their focus and are now concentrating on a proposal to drastically reduce industrial tariffs in the developing countries.
This proposal, dubbed NAMA (non-agricultural market access), was first launched in the Doha ministerial meeting of the World Trade Organisation in 2001. It got a critical impetus when, in December 2002, the US government dramatically upped the ante by calling for the abolition of all industrial tariffs by 2015.There are various proposals floating around, but, if the rich countries have their way in the NAMA negotiations, the tariff ceiling for developing economies could fall from the current 10–70% to 5–10% – a level that has not been seen since the days of the ‘unequal treaties’ in the 19th and early 20th centuries, when the weaker countries were deprived of tariff autonomy and forced to set a low, uniform tariff rate, typically 3–5%.
In return for developing countries cutting industrial tariffs, the rich countries promise that they will lower their agricultural tariffs and subsidies, so that the poor countries can increase their exports. This was sold as a win-win deal, even though unilateral trade liberalization should be its own reward, according to free trade theory.
The proposal was debated in the December 2005Hong Kong ministerial meeting of the World Trade Organisation. As no agreement could be reached, the negotiation was extended until the following summer, where it was finally put into a state of suspended animation – Mr Kamal Nath, the Indian commerce minister, famously described the negotiation to be ‘between intensive care and crematorium’. The rich countries said that the developing countries were not offering sufficient industrial tariff cuts, while the developing countries argued that the rich countries were demanding excessively steep industrial tariff cuts and not offering enough reduction in agricultural tariffs and subsidies. The negotiation is stalled for the moment, but this ‘industry-agriculture swap’ is basically seen as the way forward by many people, even including some traditional critics of the WTO.
In the short run, greater opening of agricultural markets in the rich countries may benefit developing countries – but only a few of them.Many developing countries are in fact net agricultural importers and thus unlikely to benefit from it. They may even get hurt, if they happen to be importers of those agricultural products that are heavily subsidized by the rich countries. Eliminating those subsidies would increase these developing countries’ import bills.
Overall, the main beneficiaries of the opening up of agricultural markets in the rich world will be those rich countries with strong agriculture – the US, Canada, Australia and New Zealand.16 Developed countries do not protect many agricultural products exported by poor countries (e.g., coffee, tea, cocoa) for the simple reason that they do not have any domestic producer to protect. So, where protection and subsidies are going to come down is mainly in ‘temperate zone’ agricultural products like wheat, beef and dairy. Only two developing countries, Brazil and Argentina, are major exporters of these products. Moreover, some (although obviously not all) of the prospective ‘losers’ from agricultural trade liberalization within rich countries will be the least well-off people by their national standards (e.g., hard-pressed farmers in Norway, Japan or Switzerland), while some of the beneficiaries in developing countries are already rich even by international standards (e.g., agricultural capitalists in Brazil or Argentina). In this sense, the popular image that agricultural liberalization in rich countries is helping poor peasant farmers in developing countries is misleading.*
More importantly, those who see agricultural liberalization in the rich countries as an important way to help poor countries develop often fail to pay enough attention to the fact that it does not come for free. In return, the poor countries will have to make concessions. The problem is that these concessions – reducing industrial tariffs, dismantling foreign investment controls and abandoning ‘permissive’ intellectual property rights – will make their economic development more difficult in the long run. These are policy tools that are crucial for economic development, as I document throughout this book.
Given this, the current debate surrounding the liberalization of agriculture in rich countries is getting its priorities wrong. It may be valuable for some developing countries to get access to agricultural markets in developed economies.* But it is far more important that we allow developing countries to use protection, subsidies and regulation of foreign investment adequately in order to develop their own economies, rather than giving them bigger agricultural markets overseas. Especially if agricultural liberalization by the rich countries can only be ‘bought’ by the developing countries giving up their use of the tools of infant industry promotion, the price is not worth paying. Developing countries should not be forced to sell their future for small immediate gains.
More trade, fewer ideologies
It is hard to believe today, but North Korea used to be richer than South Korea. It was the part of Korea that Japan had developed industrially when it ruled the country from 1910 until 1945. The Japanese colonial rulers saw the northern part of Korea as the ideal base from which to launch their imperialist plan to take over China. It is close to China, and has considerable mineral resources, especially coal. Even after the Japanese left, their industrial legacy enabled North Korea to maintain its economic lead over South Korea well into the 1960s.
Today, South Korea is one of the world’s industrial powerhouses, while North Korea languishes in poverty.Much of this is thanks to the fact that South Korea aggressively traded with the outside world and actively absorbed foreign technologies while North Korea pursued its doctrine of self-sufficiency. Through trade, South Korea learned about the existence of better technologies and earned the foreign currency that it needed in order to buy them. In its own way, North Korea has managed some technological feats. For example, it has figured out a way to mass-produce Vinalon, a synthetic fibre made out of – of all things – limestone, invented by a Korean scientist in 1939.Despite being the second-ever man-made fibre after Nylon, Vinalon did not catch on elsewhere because it did not make a comfortable fabric, but it has allowed North Koreans to be self-sufficient in clothes. But there is a limit to what a single developing country can invent on its own without continuous importation of advanced technologies. Thus, North Korea is technologically stuck in the past, with 1940s Japanese and 1950s Soviet technologies, while South Korea is one of the most technologically dynamic economies in the world. Do we need any better proof that trade is good for economic development?
In the end, economic development is about acquiring and mastering advanced technologies. In theory, a country can develop such technologies on its own, but such a strategy of technological self-sufficiency quickly hits the wall, as seen in the North Korean case. This is why all successful cases of economic development have involved serious attempts to get hold of and master advanced foreign technologies (more on this in chapter 6). But in order to be able to import technologies from developed countries, developing nations need foreign currency to pay for them – whether they want to buy directly (e.g., technology licences, technology consultancy services) or indirectly (e.g., better machines). Some of the necessary foreign currency may be provided through gifts from rich countries (foreign aid), but most has to be earned through exports.Without trade, therefore, there will be little technological progress and thus little economic development.
But there is a huge difference between saying that trade is essential for economic development and saying that free trade is best (or, at least, that freer trade is better) for economic development, as the Bad Samaritans do. It is this sleight of hand that free trade economists have so effectively deployed in cowing their opponents – if you are against free trade, they insinuate, you must be against progress.
As South Korea shows, active participation in international trade does not require free trade. Indeed, had South Korea pursued free trade and not promoted infant industries, it would not have become a major trading nation. It would still be exporting raw materials (e.g., tungsten ore, fish, seaweed) or low-technology, low-price products (e.g., textiles, garments, wigs made with human hair) that used to be its main export items in the 1960s. To go back to the imagery of chapter 1, had they followed free trade policy from the 1960s, Koreans might still be fighting over who owns which tuft of hair, so to speak. The secret of its success lay in a judicious mix of protection and open trade, with the areas of protection constantly changing as new infant industries were developed and old infant industries became internationally competitive. In a way, this is not much of a ‘secret’. As I have shown in the earlier chapters, this is how almost all of today’s rich countries became rich and this is at the root of almost all recent success stories in the developing world. Protection does not guarantee development, but development without it is very difficult.
Therefore, if they are genuinely to help developing countries develop through trade, wealthy countries need to accept asymmetric protectionism, as they used to between the 1950s and the 1970s. They should acknowledge that they need to have much lower protection for themselves than the developing countries have. The global trading system should support the developmental efforts of developing countries by allowing them to use more freely the tools of infant industry promotion – such as tariff protection, subsidies and foreign investment regulation. At the moment, the system allows protection and subsidies much more readily in areas where the developed countries need them. But it should be the other way around – protection and subsidies should be easier to use where the developing countries need them more.
Here, it is particularly important to get our perspective right about agricultural liberalization in the rich countries. Lowering agricultural protection in those countries may help some developing countries, especially Brazil and Argentina, but not most. Above all, agricultural liberalization in the rich world should not be conditional upon further restrictions on the use of the tools of infant industry promotion by developing nations, as is currently being demanded by the rich countries.
The importance of international trade for economic development cannot be overemphasized. But free trade is not the best path to economic development.Trade helps economic development only when the country employs a mixture of protection and open trade, constantly adjusting it according to its changing needs and capabilities. Trade is simply too important for economic development to be left to free trade economists.
* The HOS theory is named after the two Swedish economists, Eli Heckscher and Bertil Ohlin, who pioneered it in the early 20th century, and Paul Saumelson, the American economist who perfected it in the mid-20th century. In this version of free trade theory, for each product there is only one ‘best practice’ (i.e., most efficient) technology, which all countries will use if they are producing it. If each product has one best production technology for its production, a country’s comparative advantage can not be determined by its technologies, as in Ricardo’s theory. It is determined by how suitable the technology used for each product is for the country. In the HOS theory, the suitability of a particular technology for a country depends on how intensively it uses the factor of production (i.e., labour or capital) with which the country is relatively abundantly endowed.
† So, ‘comparative’ in the term ‘comparative advantage’ is not about comparison between countries but about comparison between products. It is because people mix these two up that they sometimes believe that poor countries do not have comparative advantage in anything – which is a logical impossibility.
* The other main beneficiaries of agricultural liberalization in rich countries, that is, their consumers, do not gain very much. As a proportion of income, their spending on agricultural products is already pretty low (around 13% for food and 4% for alcohol and tobacco, of which only a fraction is the cost of the agricultural produce itself). Moreover, the trade in many agricultural products they buy is already liberalized (e.g., coffee, tea, cocoa).
* In the earlier stages of development, most people live on agriculture, so developing agriculture is crucial in reducing poverty. Higher agricultural productivity also creates a pool of healthy and productive workers that can be used later for industrial development. In the early stages of development, agricultural products are also likely to account for a high share of exports, as the country may have little else to sell. Given the importance of export earnings for economic development that I discussed earlier, agricultural exports should be increased as much as possible (although the scope may not be large). And, for this, greater opening of agricultural markets in the rich countries is helpful. But increased agricultural productivity and agricultural exports often require state intervention along the line of ‘infant industry promotion’. Agricultural producers, especially the smaller ones, need government investment and support in infrastructure (especially irrigation for production and roads for exports), international marketing and R&D.

CHAPTER 4
The Finn and the elephant
Should we regulate foreign investment?
The Finns like to tell a joke about themselves.What would a German, a Frenchman, an American and a Finn do if they were each asked to write a book on the elephant? The German, with his characteristic thoroughness, would write a thick two-volume, fully annotated study entitled, Everything That There is to Know About the Elephant. The Frenchman, with his penchant for philosophical musings and existential anguish, would write a book entitled The Life and Philosophy of the Elephant. The American, with his famous nose for good business opportunities, would naturally write a book entitled, How to Make Money with an Elephant. The Finn would write a book entitled What Does the Elephant Think of the Finns?
The Finns are laughing at their excessive self-consciousness. Their preoccupation with their own identity is understandable. They speak a language that is more related to Korean and Japanese than to the language of their Swedish or Russian neighbours. Finland was a Swedish colony for around six hundred years and a Russian colony for about a hundred. As a Korean, whose country has been pushed around for thousands of years by every neighbour in sight – the Chinese, the Huns, the Mongolians, the Manchurians, the Japanese, the Americans, the Russians, you name it – I know the feeling.
So, it was unsurprising that, after gaining independence from Russia in 1918, Finland tried its best to keep foreigners out. The country introduced a series of laws in the 1930s that officially classified all the enterprises with more than 20% foreign ownership as – hold your breath – ‘dangerous’. The Finns may not be the subtlest people in the world, but this is heavy stuff even for them. Finland got, as it had wanted, very little foreign investment.1 When Monty Python sang in 1980, ‘Finland, Finland, Finland … You are so sadly neglected, and often ignored’ (‘The Finland Song’), they did not perhaps guess that the Finns had sought to be neglected and ignored.
The Finnish law was eventually relaxed in 1987, and the foreign ownership ceiling was raised to 40%, but all foreign investments still had to be approved by the Ministry of Trade and Industry. General liberalization of foreign investment did not come until 1993, as part of the preparations for the country’s accession to the EU in 1995.
According to the neo-liberal orthodoxy, this sort of extreme anti-foreign strategy, especially if sustained for over half a century, should have severely damaged Finland’s economic prospects. However, since the mid-1990s, Finland has been touted as the paragon of successful global integration. In particular, Nokia, its mobile phone company, has been, figuratively speaking, inducted into the Globalization Hall of Fame. A country that did not want to be a part of the global economy has suddenly become an icon of globalization. How was this possible? We shall answer that later, but first let us examine the arguments for and against foreign investment.
Is foreign capital essential?
Many developing countries find it difficult to generate enough savings to satisfy their own investment demands. Given this, it seems uncontroversial that any additional money they can get from other countries that have surplus savings should be good. Developing countries should open their capital markets, it is argued by the Bad Samaritans, so that such money can flow in freely.
The benefit of having free international movement of capital, neo-liberal economists argue, does not stop at plugging such a ‘savings gap’. It improves economic efficiency by allowing capital to flow into projects with the highest possible returns on a global scale. Free cross-border capital flows are also seen as spreading ‘best practice’ in government policy and corporate governance. Foreign investors would simply pull out, the reasoning goes, if companies and countries were not well run.2 Some even, controversially, argue that these ‘collateral benefits’ are even more important than the direct benefits that come from the more efficient allocation of capital.3
Foreign capital flows into developing countries consist of three main elements – grants, debts and investments. Grants are money given away (but often with strings attached) by another country and are called foreign aid or official development assistance (ODA). Debts consist of bank loans and bonds (government bonds and corporate bonds).4 Investments are made up of ‘portfolio equity investment’, which is equity (share) ownership seeking financial returns rather than managerial influence, and foreign direct investment (FDI), which involves the purchase of equity with a view to influence the management of the firm on a regular basis.5
There is an increasingly popular view among neo-liberal economists that foreign aid does not work, although others argue that the ‘right’ kind of aid (that is, aid that is not primarily motivated by geo-politics) works.6 Debts and portfolio equity investment have also come under attack for their volatility.7 Bank loans are notoriously volatile. For example, in 1998, total net bank loans to developing countries were $50 billion; following a series of financial crises that engulfed the developing world (Asia in 1997, Russia and Brazil in 1998, Argentina in 2002), they turned negative for the next four years (-$6.5 billion per year on average); by 2005, however, they were 30% higher than in 1998 ($67 billion). Although not as volatile as bank loans, capital inflows through bonds fluctuate a lot.8 Portfolio equity investment is even more volatile than bonds, although not as volatile as bank loans.9
These flows are not just volatile, they tend to come in and go out exactly at the wrong time.When economic prospects in a developing country are considered good, too much foreign financial capital may enter. This can temporarily raise asset prices (e.g., prices of stocks, real estate prices) beyond their real value, creating asset bubbles.When things get bad, often because of the bursting of the very same asset bubble, foreign capital tends to leave all at the same time, making the economic downturn even worse. Such ‘herd behaviour’ was most vividly demonstrated in the 1997 Asian crises, when foreign capital flowed out on a massive scale, despite the good long-term prospects of the economies concerned (Korea, Hong Kong, Malaysia, Thailand and Indonesia).10
Of course, this kind of behaviour – known as ‘pro-cyclical’ behaviour – also exists among domestic investors. Indeed, when things go bad, these investors, using their insider information, often leave the country before the foreigners do. But the impact of herd behaviour by foreign investors is much greater for the simple reason that developing country financial markets are tiny relative to the amounts of money sloshing around the international financial system. The Indian stock market, the largest stock market in the developing world, is less than one-thirtieth the size of the US stock market.11 The Nigerian stock market, the second largest in Sub-Saharan Africa, is worth less than one five-thousandth of the US stock market. Ghana’s stock market is worth only 0.006% of the US market.12 What is a mere drop in the ocean of rich country assets will be a flood that can sweep away financial markets in developing countries.
Given this, it is no coincidence that developing countries have experienced more frequent financial crises since many of them opened their capital markets at the urge of the Bad Samaritans in the 1980s and the 1990s. According to a study by two leading economic historians, between 1945 and 1971, when global finance was not liberalized, developing countries suffered no banking crises, 16 currency crises and one ‘twin crisis’ (simultaneous currency and banking crises). Between 1973 and 1997, however, there were 17 banking crises, 57 currency crises and 21 twin crises in the developing world.13 This is not even counting some of the biggest financial crises that occurred after 1998 (Brazil, Russia and Argentina being the most prominent cases).
The volatility and the pro-cyclicality of international financial flows are what make even some globalization enthusiasts, such as Professor Jagdish Bhagwati, warn against what he calls ‘the perils of gung-ho international financial capitalism’.14 Even the IMF, which used to push strongly for capital market opening during the 1980s and especially the 1990s, has recently changed its stance on this matter, becoming a lot more muted in its support of capital market opening in developing countries.15 Now it accepts that ‘premature opening of the capital account … can hurt a country by making the structure of the inflows unfavourable and by making the country vulnerable to sudden stops or reversals of flows.’16
The Mother Teresa of foreign capital?
The behaviour of international financial flows (debt and portfolio equity investment) is in stark contrast with that of foreign direct investment. Net FDI flows into developing countries were $169 billion in 1997.17 Despite the financial turmoil in the developing world, it was still $172 billion per year on average between 1998 and 2002.18 In addition to its stability, foreign direct investment is thought to bring in not just money but a lot of other things that help economic development. Sir Leon Brittan, a former British commissioner of the European Union, sums it up: foreign direct investment is ‘a source of extra capital, a contribution to a healthy external balance, a basis for increased productivity, additional employment, effective competition, rational production, technology transfer, and a source of managerial knowhow.’19
The case for welcoming foreign direct investment, then, seems overwhelming. FDI is stable, unlike other forms of foreign capital inflows. Moreover, it brings not just money but also enhances the host country’s productive capabilities by bringing in more advanced organization, skills and technology. No wonder that foreign direct investment is fêted as if it were ‘the Mother Teresa of foreign capital’, as Gabriel Palma, the distinguished Chilean economist who is my former teacher and now a colleague at Cambridge, once ironically observed. But foreign direct investment has its limitations and problems.
First, foreign direct investment flows may have been very stable during the financial turmoil in developing countries in the late 1990s and the early 2000s, but it has not always been the case for all countries.20 When a country has an open capital market, FDI can be made ‘liquid’ and shipped out rather quickly. As even an IMF publication points out, the foreign subsidiary can use its assets to borrow from domestic banks, change the money into foreign currency and send the money out; or the parent company may recall the intra-company loan it has lent to the subsidiary (this counts as FDI).21 In the extreme case, most foreign direct investment that came in can go out again through such channels, adding little to the host country’s foreign exchange reserve position.22
Not only is FDI not necessarily a stable source of foreign currency, it may have negative impacts on the foreign exchange position of the host country. FDI may bring in foreign currency, but it can also generate additional demands for it (e.g., importing inputs, contracting foreign loans). Of course, it can (but may not) also generate additional foreign currency through exporting, but whether it will earn more foreign exchange than it uses is not a foregone conclusion. This is why many countries have imposed controls on the foreign exchange earnings and spending by the foreign companies making the investment (e.g., how much they should export, how much inputs they have to buy locally).23
Another drawback with foreign direct investment is that it creates the opportunity for ‘transfer pricing’ by transnational corporations (TNCs) with operations in more than one country. This refers to the practice where the subsidiaries of a TNC are overcharging or undercharging each other so that profits are highest in those subsidiaries operating in countries with the lowest corporate tax rates. And when I say overcharging or undercharging, I really mean it. A Christian Aid report documents cases of underpriced exports like TV antennas from China at $0.40 apiece, rocket launchers from Bolivia at $40 and US bulldozers at $528, and overpriced imports such as German hacksaw blades at $5, 485 each, Japanese tweezers at $4, 896, and French wrenches at $1, 089.24 This is a classic problem with TNCs, but today the problem has become more severe because of the proliferation of tax havens that have no or minimal corporate income taxes.Companies can vastly reduce their tax obligations by shifting most of their profits to a paper company registered in a tax haven.
It may be argued that the host country should not complain about transfer pricing, because, without the foreign direct investment in question, the taxable income would not have been generated in the first place. But this is a disingenuous argument. All firms need to use productive resources provided by government with taxpayers’ money (e.g., roads, the telecommunications network, workers who have received publicly funded education and training). So, if the TNC subsidiary is not paying its ‘fair share’ of tax, it is effectively free-riding on the host country.
Even for the technologies, skills and management know-how that foreign direct investment is supposed to bring with it, the evidence is ambiguous: ‘[d]espite the theoretical presumption that, of the different types of [capital] inflows, FDI has the strongest benefits, it has not proven easy to document these benefits’ – and that’s what an IMF publication is saying.25 Why is this? It is because different types of FDI have different productive impacts.
When we think of foreign direct investment, most of us think about Intel building a new microchip factory in Costa Rica or Volkswagen laying down a new assembly line in China – this is known as ‘greenfield’ investment. But a lot of foreign direct investment is made by foreigners buying into an existing local company – or ‘brownfield’ investment.26 Brownfield investment has accounted for over half of total world FDI since the 1990s, although the share is lower for developing countries, for the obvious reason that they have relatively fewer firms that foreigners want to take over.At its height in 2001, it accounted for as much as 80% of total world FDI.27
Brownfield investment does not add any new production facilities – when General Motors bought up the Korean car maker Daewoo in the wake of the 1997 financial crisis, it just took over the existing factories and produced the same cars, designed by Koreans, under different names. However, brownfield investment can still lead to an increase in productive capabilities. This is because it can bring with it new management techniques or higher quality engineers. The trouble is that there is no guarantee that this will happen.
In some cases, brownfield FDI is made with an explicit intention of not doing much to improve the productive capabilities of the company bought – a foreign direct investor might buy a company that he thinks is undervalued by the market, especially in times of financial crisis, and run it as it used to be until he finds a suitable buyer.28 Sometimes the foreign direct investor may even actively destroy the existing productive capabilities of the company bought by engaging in ‘asset stripping’. For example, when the Spanish airline Iberia bought some Latin American airlines in the 1990s, it swapped its own old planes for the new ones owned by the Latin American airlines, eventually driving some of the latter into bankruptcy due to a poor service record and high maintenance costs.
Of course, the value of foreign direct investment to the host economy is not confined to what it does to the enterprise in which the investment has been made. The enterprise concerned hires local workers (who may learn new skills), buys inputs from local producers (who may pick up new technologies in the process) and has some ‘demonstration effects’ on domestic firms (by showing them new management techniques or providing knowledge about overseas markets). These effects, known as ‘spill-over effects’, are real additions to a nation’s long-run productive capabilities and not to be scoffed at.
Unfortunately, the spill-over effects may not happen. In the extreme case, a TNC can set up an ‘enclave’ facility, where all inputs are imported and all that the locals do is to engage in simple assembly, where they do not even pick up new skills.Moreover, even when they occur, spillover effects tend to be relatively insignificant in magnitude.29 This is why governments have tried to magnify them by imposing performance requirements – regarding, for example, technology transfer, local contents or exports.30
A critical but often ignored impact of FDI is that on the (current and future) domestic competitors. An entry by a TNC through FDI can destroy existing national firms that could have ‘grown up’ into successful operations without this premature exposure to competition, or it can pre-empt the emergence of domestic competitors. In such cases, short-run productive capabilities are enhanced, as the TNC subsidiary replacing the (current and future) national firms is usually more productive than the latter. But the level of productive capability that the country can attain in the long run becomes lower as a result.
This is because TNCs do not, as a rule, transfer the most valuable activities outside their home country, as I will discuss in greater detail later. As a result, there will be a definite ceiling on the level of sophistication that a TNC subsidiary can reach in the long run. To go back to the Toyota example in chapter 1, had Japan liberalized FDI in its automobile industry in the 1960s, Toyota definitely wouldn’t be producing the Lexus today – it would have been wiped out or, more likely, have become a valued subsidiary of an American carmaker.
Given this, a developing country may reasonably decide to forego short-term benefits from FDI in order to increase the chance for its domestic firms to engage in higher-level activities in the long run, by banning FDI in certain sectors or regulating it.31 This is exactly the same logic as that of infant industry protection that I discussed in the earlier chapters – a country gives up the short-run benefits of free trade in order to create higher productive capabilities in the long run. And it is why, historically, most economic success stories have resorted to regulation of FDI, often in a draconian manner, as I shall now show.
‘More dangerous than military power’
‘It will be a happy day for us when not a single good American security is owned abroad and when the United States shall cease to be an exploiting ground for European bankers and money lenders.’ Thus wrote the US Bankers’ Magazine in 1884.32
The reader may find it hard to believe that a bankers’ magazine published in America could be so hostile to foreign investors. But this was in fact true to type at the time. The US had a terrible record in its dealings with foreign investors.33
In 1832, Andrew Jackson, today a folk hero to American free-marketeers, refused to renew the licence for the quasi-central bank, the second Bank of the USA – the successor to Hamilton’s Bank of the USA (see chapter 2).34 This was done on the grounds that the foreign ownership share of the bank was too high – 30% (the pre-EU Finns would have heartily approved!). Declaring his decision, Jackson said: ‘should the stock of the bank principally pass into the hands of the subjects of a foreign country, and we should unfortunately become involved in a war with that country, what would be our condition? …Controlling our currency, receiving our public moneys, and holding thousands of our citizens in dependence, it would be far more formidable and dangerous than the naval and military power of the enemy. If we must have a bank … it should be purely American.’35 If the president of a developing country said something like this today, he would be branded a xenophobic dinosaur and blackballed in the international community.
From the earliest days of its economic development right up to the First World War, the US was the world’s largest importer of foreign capital.36 Given this, there was, naturally, considerable concern over ‘absentee management’ by foreign investors37; ‘We have no horror of FOREIGN CAPITAL – if subjected to American management [italics and capitals original], ’ declared Niles’ Weekly Register, a nationalist magazine in the Hamiltonian tradition, in 1835.38
Reflecting such sentiment, the US federal government strongly regulated foreign investment. Non-resident shareholders could not vote and only American citizens could become directors in a national (as opposed to state-level) bank. This meant that ‘foreign individuals and foreign financial institutions could buy shares in U.S. national banks if they were prepared to have American citizens as their representatives on the board of directors’, thus discouraging foreign investment in the banking sector.39 A navigation monopoly for US ships in coastal shipping was imposed in 1817 by Congress and continued until the First World War.40 There were also strict regulations on foreign investment in natural resource industries. Many state governments barred or restricted investment by non-resident foreigners in land. The 1887 federal Alien Property Act prohibited the ownership of land by aliens – or by companies more than 20% owned by aliens – in the ‘territories’ (as opposed to the fully fledged states), where land speculation was particularly rampant.41 Federal mining laws restricted mining rights to US citizens and companies incorporated in the US. In 1878, a timber law was enacted, permitting only US residents to log on public land.
Some state (as opposed to federal) laws were even more hostile to foreign investment. A number of states taxed foreign companies more heavily than the American ones. There was a notorious Indiana law of 1887 that withdrew court protection from foreign firms altogether.42 In the late 19th century, the New York state government took a particularly hostile attitude towards FDI in the financial sector, an area where it was rapidly developing a world-class position (a clear case of infant industry protection).43 It instituted a law in the 1880s that banned foreign banks from engaging in ‘banking business’ (such as taking deposits and discounting notes or bills). The 1914 banking law banned the establishment of foreign bank branches. For example, the London City and Midland Bank (then the world’s third largest bank, measured by deposits) could not open a New York branch, even though it had 867 branches worldwide and 45 correspondent banks in the US alone.44
Despite its extensive, and often strict, controls on foreign investment, the US was the largest recipient of foreign investment throughout the 19th century and the early 20th century – in the same way strict regulation of TNCs in China has not prevented a large amount of FDI from pouring into that country in recent decades. This flies in the face of the belief by the Bad Samaritans that foreign investment regulation is bound to reduce investment flows, or, conversely, that the liberalization of foreign investment regulation will increase foreign investment flows.Moreover, despite – or, I would argue, partly because of – its strict regulation of foreign investment (as well as having in place manufacturing tariffs that were the highest in the world), the US was the world’s fastest-growing economy throughout the 19th century and up until the 1920s. This undermines the standard argument that foreign investment regulation harms the growth prospects of an economy.
Even more draconian than the US in regulating foreign investment was Japan.45 Especially before 1963, foreign ownership was limited to 49%, while in many ‘vital industries’ FDI was banned altogether. Foreign investment was steadily liberalized, but only in industries where the domestic firms were ready for it. As a result, of all countries outside the communist bloc, Japan has received the lowest level of FDI as a proportion of its total national investment.46 Given this history, the Japanese government saying that ‘[p]lacing constraints on [foreign direct] investment would not seem to be an appropriate decision even from the perspective of development policy’ in a recent submission to the WTO is a classic example of selective historical amnesia, double standards and ‘kicking away the ladder’47
Korea and Taiwan are often seen as pioneers of pro-FDI policy, thanks to their early successes with export-processing zones (EPZs), where the investing foreign firms were little regulated. But, outside these zones, they actually imposed many restrictive policies on foreign investors. These restrictions allowed them to accumulate technological capabilities more rapidly, which, in turn, reduced the need for the ‘anything goes’ approach found in their EPZs in subsequent periods. They restricted the areas where foreign companies could enter and put ceilings on their ownership shares. They also screened the technologies brought in by TNCs and imposed export requirements. Local content requirements were quite strictly imposed, although they were less stringently applied to exported products (so that lower quality domestic inputs would not hurt export competitiveness too much). As a result, Korea was one of the least FDI-dependent countries in the world until the late 1990s, when the country adopted neo-liberal policies.48 Taiwan, where the policies were slightly milder than in Korea, was somewhat more dependent on foreign investment, but its dependence was still well below the developing country average.49
The bigger European countries – the UK, France and Germany – did not go as far as Japan, the USA or Finland in regulating foreign investment. Before the Second World War, they didn’t need to – they were mostly making, rather than receiving, foreign investments. But, after the Second World War, when they started receiving large amounts of American, and then Japanese, investment, they also restricted FDI flows and imposed performance requirements. Until the 1970s, this was done mainly through foreign exchange controls. After these controls were abolished, informal performance requirements were used. Even the ostensibly foreign-investor-friendly UK government used a variety of ‘undertakings’ and ‘voluntary restrictions’ regarding local sourcing of components, production volumes and exporting.50 When Nissan established a UK plant in 1981, it was forced to procure 60% of value added locally, with a time scale over which this would rise to 80%. It is reported that the British government also ‘put pressure on [Ford and GM] to achieve a better balance of trade.’51
Even cases like Singapore and Ireland, countries that have succeeded by extensively relying on FDI, are not proof that host country governments should let TNCs do whatever they want. While welcoming foreign companies, their governments used selective policies to attract foreign investment into areas that they considered strategic for the future development of their economies. Unlike Hong Kong, which did have a liberal FDI policy, Singapore has always had a very targeted approach. Ireland started genuinely prospering only when it shifted from an indiscriminate approach to FDI (‘the more, the merrier’) to a focused strategy that sought to attract foreign investment in sectors like electronics, pharmaceuticals, software quite and financial services. It also used performance requirements quite widely.52
To sum up, history is on the side of the regulators. Most of today’s rich countries regulated foreign investment when they were on the receiving end. Sometimes the regulation was draconian – Finland, Japan, Korea and the USA (in certain sectors) are the best examples. There were countries that succeeded by actively courting FDI, such as Singapore and Ireland, but even they did not adopt the laissez-faire approach towards TNCs that is recommended to the developing countries today by the Bad Samaritans.
Borderless world?
Economic theory, history and contemporary experiences all tell us that, in order truly to benefit from foreign direct investment, the government needs to regulate it well. Despite all this, the Bad Samaritans have been trying their best to outlaw practically all regulation of foreign direct investment over the last decade or so. Through the World Trade Organisation, they have introduced the TRIMS (Trade-related Investment Measures) Agreement, which bans things like local content requirements, export requirements or foreign exchange balancing requirements. They have been pushing for further liberalization through the current GATS (General Agreement on Trade in Services) negotiations and a proposed investment agreement at the World Trade Organisation. Bilateral and regional free trade agreements (FTAs) and bilateral investment treaties (BITs) between rich and poor countries also restrict the ability of developing countries to regulate FDI.53
Forget history, say the Bad Samaritans in defending such actions. Even if it did have some merits in the past, they argue, regulation of foreign investment has become unnecessary and futile, thanks to globalization, which has created a new ‘borderless world’. They argue that the ‘death of distance’ due to developments in communications and transportation technologies has made firms more and more mobile and thus stateless – they are not attached to their home countries any more. If firms do not have nationality any more, it is argued, there are no grounds for discriminating against foreign firms. Moreover, any attempt to regulate foreign firms is futile, as, being ‘footloose’, they would move to another country where there is no such regulation.
There is certainly an element of truth in this argument. But the case is vastly exaggerated. There are, today, firms like Nestlé that produces less than 5% of its output at home (Switzerland), but they are very much the exceptions. Most large internationalized firms produce less than one-third of their output abroad, while the ratio in the case of Japanese companies is well below 10%.54 There has been some relocation of ‘core’ activities (such as research & development) overseas, but it is usually to other developed countries, and with a heavy ‘regional’ bias (the regions here meaning North America, Europe and Japan, which is a region unto itself).55
In most companies, the top decision-makers are still mostly home country nationals. Once again, there are cases like Carlos Ghosn, the Lebanese-Brazilian who runs a French (Renault) and Japanese (Nissan) company. But he is also very much an exception. The most telling example is the merger of Daimler-Benz, the German car maker, and Chrysler, the US car maker, in 1998. This was really a takeover of Chrysler by Benz. But, at the time of the merger, it was depicted as a marriage of two equals. The new company, Daimler-Chrysler, even had equal numbers of Germans and Americans on the management board. But that was only for the first few years. Soon, the Germans vastly outnumbered the Americans – usually 10 or 12 to one or two, depending on the year. When they are taken over, even American firms end up run by foreigners (but then that is what take-over means).
Therefore, the nationality of the firm still matters very much.Who owns the firm determines how far its different subsidiaries will be allowed to move into higher-level activities. It would be very naïve, especially on the part of developing countries, to design economic policies on the assumption that capital does not have national roots anymore.
But then how about the argument that, whether necessary or not, it is no longer possible in practice to regulate foreign investment? Now that TNCs have become more or less ‘footloose’, it is argued, they can punish countries that regulate foreign investment by ‘voting with their feet’.
One immediate question one can ask is: if firms have become so mobile as to make national regulation powerless, why are the Bad Samaritan rich countries so keen on making developing countries sign up to all those international agreements that restrict their ability to regulate foreign investment? Following the market logic so loved by the neo-liberal orthodoxy, why not just leave countries to choose whatever approach they want and then let foreign investors punish or reward them by choosing to invest only in those countries friendly towards foreign investors? The very fact that rich countries want to impose all these restrictions on developing countries by means of international agreements reveals that regulation of FDI is not yet futile after all, contrary to what the Bad Samaritans say.
In any case, not all TNCs are equally mobile. True, there are industries – such as garments, shoes and stuffed toys – for which there are numerous potential investment sites because production equipment is easy to move and, the skills required being low, workers can be easily trained. However, in many other industries, firms cannot move that easily for various reasons – the existence of immobile inputs (e.g., mineral resources, a local labour force with particular skills), the attractiveness of the domestic market (China is a good example), or the supplier network that they have built up over the years (e.g., subcontracting networks for Japanese car makers in Thailand or Malaysia).
Last but not least, it is simply wrong to think that TNCs will necessarily avoid countries that regulate FDI. Contrary to what the orthodoxy suggests, regulation is not very important in determining the level of inflow of foreign investment. If that were the case, countries like China would not be getting much foreign investment. But the country is getting around 10% of world FDI because it offers a large and fast-growing market, a good labour force and good infrastructure (roads, ports). The same argument can be applied to the 19th-century US.
Surveys reveal that corporations are most interested in the market potential of the host country (market size and growth), and then in things like the quality of the labour force and infrastructure, with regulation being only a matter of minor interest. Even the World Bank, a well-known supporter of FDI liberalization, once admitted that ‘[t]he specific incentives and regulations governing direct investment have less effect on how much investment a country receives than has its general economic and political climate, and its financial and exchange rate policies’.56
As in the case of their argument about the relationship between international trade and economic development, the Bad Samaritans have got the casuality all wrong. They think that, if you liberalize foreign investment regulation, more investment will flow in and help economic growth. But foreign investment follows, rather than causes, economic growth. The brutal truth is that, however liberal the regulatory regime, foreign firms won’t come into a country unless its economy offers an attractive market and high-quality productive resources (labour, infrastructure). This is why so many developing countries have failed to attract significant amounts of FDI, despite giving foreign firms maximum degrees of freedom. Countries have to get growth going before TNCs get interested in them. If you are organizing a party, it is not enough to tell people that they can come and do whatever they want. People go to parties where they know there are already interesting things happening. They don’t usually come and make things interesting for you, whatever freedom you give them.
‘The only thing worse than being exploited by capital …’
Like Joan Robinson, a former Cambridge economics professor and arguably the most famous female economist in history, I believe that the only thing that is worse than being exploited by capital is not being exploited by capital. Foreign investment, especially foreign direct investment, can be a very useful tool for economic development. But how useful it is depends on the kinds of investment made and how the host country government regulates it.
Foreign financial investment brings more danger than benefits, as even the neo-liberals acknowledge these days. While foreign direct investment is no Mother Teresa, it often does bring benefits to the host country in the short run. But it is the long run that counts when it comes to economic development. Accepting FDI unconditionally may actually make economic development in the long run more difficult. Despite the hyperbole about a ‘borderless world’, TNCs remain national firms with international operations and, therefore, are unlikely to let their subsidiaries engage in higher-level activities; at the same time their presence can prevent the emergence of national firms that might start them in the long run. This situation is likely to damage the long-run development potential of the host country. Moreover, the long-run benefits of FDI depend partly on the magnitude and the quality of the spill-over effects that TNCs create, whose maximization requires appropriate policy intervention.Unfortunately, many key tools of such intervention have already been outlawed by the Bad Samaritans (e.g., local content requirements).
Therefore, foreign direct investment can be a Faustian bargain. In the short run, it may bring benefits, but, in the long run, it may actually be bad for economic development. Once this is understood, Finland’s success is unsurprising. The country’s strategy was based on the recognition that, if foreign investment is liberalized too early (Finland was one of the poorest European economies in the early-20th century), there will be no space for domestic firms to develop independent technological and managerial capabilities. It took Nokia 17 years to earn any profit from its electronics subsidiary, which is now the biggest mobile phone company in the world.57 If Finland had liberalized foreign investment from early on, Nokia would not be what it is today. Most probably, foreign financial investors who bought into Nokia would have demanded the parent company stop cross-subsidizing the no-hope electronics subsidiary, thus killing off the business. At best, some TNC would have bought up the electronics division and made it into its own subsidiary doing second-division work.
The flip side of this argument is that regulation of foreign direct investment may paradoxically benefit foreign companies in the long run. If a country keeps foreign companies out or heavily regulates their activities, it will not be good for those companies in the short run. However, if a judicious regulation of foreign direct investment allows a country to accumulate productive capabilities more rapidly and at a higher level than possible without it, it will benefit foreign investors in the long run by offering them an investment location that is more prosperous and possesses better productive inputs (e.g., skilled workers, good infrastructure). Finland and Korea are the best examples of this. Partly thanks to their clever foreign investment regulation, these countries have become richer, better educated and technologically far more dynamic and thus have become more attractive investment sites than would have been possible without those regulations.
Foreign direct investment may help economic development, but only when introduced as part of a long-term-oriented development strategy. Policies should be designed so that foreign direct investment does not kill off domestic producers, which may hold out great potential in the long run, while also ensuring that the advanced technologies and managerial skills foreign corporations possess are transferred to domestic business to the maximum possible extent. Like Singapore and Ireland, some countries can succeed, and have succeeded, through actively courting foreign capital, especially FDI. But more countries will succeed, and have succeeded, when they more actively regulate foreign investment, including FDI. The attempt by the Bad Samaritans to make such regulation by developing countries impossible is likely to hinder, rather than help, their economic development.