foreign economic policies -...

The domestic sources offoreign economic policiesMichael J. Hiscox

� Introduction 51

� Policy preferences 52

� Institutions 65

� Conclusions, extensions, and complications 72

READER’S GUIDE

How should a nation manage its economic ties with the rest of the world? How should thegovernment regulate the flow of goods, people, and investment to and from foreignnations? Debates over foreign economic policies are a recurring, often volatile feature ofnational politics in all countries. Indeed, how governments should now be dealing with themultiple facets of ‘globalization’ is perhaps the single most pressing political issue of ourtime. It is an issue that has been debated in international institutions, national legislatures,and lecture halls across the world; it has mobilized nationalist populist movements at oneend of the political spectrum, and transnational environmental and human rights organiza-tions at the other; and it has led to violent protests and demonstrations in the streets ofSeattle, Melbourne, Washington, Genoa, and New York. What are the battle lines in thesepolitical debates? How are policies decided in different countries? How do differences inpolitical institutions shape these policy decisions? And how do new ideas and informationabout policy options filter into politics? This chapter examines each of these questions,focusing on the domestic politics of trade, immigration, investment, and exchange rates.

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Each government must make choices about how bestto manage the way its own economy is linked to theglobal economy. It must choose whether to open thenational market to international trade, whether toliberalize trade with some nations more than withothers, and whether to allow more trade in somesectors of the economy than in other sectors. Eachgovernment must also decide whether to restrictinternational flows of investment in different sectorsand whether to regulate immigration and emigrationby different types of workers. And it must either fixthe exchange rate for the national currency or allowthe rate to fluctuate to some degree in response to sup-ply and demand in international financial markets.

Of course, if every government always made thesame choices in all these areas of policy, things wouldbe very simple for us as scholars (and much morepredictable for us as citizens of the world). Butgovernments in different countries, and at differentmoments in history, have often chosen radically dif-ferent foreign economic policies. Some have closedoff their national economies almost completely fromthe rest of the world, imposing strict limits on trade,immigration, and investment—an example is Chinain the 1960s, which kept itself almost entirelyisolated from the rest of the world’s economies. Inother instances, governments have adopted the veryopposite approach, allowing virtually unfettered eco-nomic exchange between their citizens and foreign-ers—ironically, Hong Kong in the 1960s may be thebest example of this type of extreme openness. Mostgovernments today adopt a mixture of policies thatfall somewhere in the middle, imposing selective con-trols on activities that affect some sectors of theireconomy and restricting exchange with some foreigncountries more than with others. Understanding whygovernments make the particular choices they dorequires careful attention to the political pressuresthey face from different domestic groups and thepolitical institutions that regulate the way collectivedecisions are made and implemented.

Politics, we know, is all about who gets what, when,and how. Different individuals and groups in everysociety typically have very different views about what

their government should do when it comes to settingthe policies that regulate international trade, immi-gration, investment, and exchange rates. These com-peting demands must be reconciled in some way bythe political institutions that govern policy making.To really understand the domestic origins of foreigneconomic policies we thus need to perform two criti-cal tasks:

1 Identify or map the policy preferences of differentgroups in the domestic economy.

2 Specify how political institutions determine theway these preferences are aggregated or convertedinto actual government decisions.

The first step will require some economic analysis.How people are affected by their nation’s ties with theglobal economy, and thus what types of policies theyprefer to manage those ties, depends primarily onhow they make their living. Steelworkers typicallyhave very different views about most foreign eco-nomic policies from wheat farmers, for instance,because such policies rarely affect the steel and wheatindustries in similar fashion. Of critical importancehere are the types of assets that individuals own andhow the income earned from those assets is affectedby different policy choices. The second step calls forpolitical analysis. How political representatives areelected, how groups organize to lobby or otherwiseinfluence politicians, and how policies are proposed,debated, amended, and passed in legislatures, andthen implemented by government agencies, alldepend on the structure of political institutions.Democratically elected leaders face very differentinstitutional constraints from military dictators, ofcourse, and even among our democracies there isquite a wide range of institutional variation that canhave a large impact on the behaviour of policy makers.

These two analytical steps put together like this,combining both economic and political analysisin tandem, are generally referred to as the political

economy approach to the study of policy outcomes.In the next two sections we will consider each of thetwo analytical steps in some detail, examining thedomestic sources of policies in the areas of trade,

THE DOMESTIC SOURCES OF ECONOMIC POLICIES 51

Introduction

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immigration, investment, and exchange rates. Thenwe will shift gears a little, and consider the ways inwhich ideas and information might affect policymaking. We will also discuss linkages between the dif-ferent policy dimensions and non-economic issues,focusing on environmental and human rights con-

The guiding assumption here is that, when it comes totaking positions on how to regulate ties with theglobal economy, individuals and groups are funda-mentally concerned with how different policychoices affect their incomes. Of course people mayalso have important non-material concerns thataffect their attitudes toward foreign economic poli-cies. Many people are concerned about the culturalimplications of globalization, for instance, and itsimpact on the world’s environment and on humanrights, and these concerns may have an impact ontheir views about the regulation of internationaltrade, immigration, and investment. We will discusssome of these important considerations in moredetail later in the chapter. But we begin here with thesimplest possible framework in which economic poli-cies are evaluated only in terms of their economiceffects. Given that organized producer groups havealmost always been the most vocal participants indomestic debates about foreign economic policies,and the debates themselves have been couchedmainly in economic terms, this seems like an appro-priate way to begin.

Trade

The dramatic growth in international trade over thelast few decades has intensified political debate overthe costs and benefits of trade openness. In theUnited States, the controversy surrounding the crea-tion of the North American Free Trade Agreement(NAFTA) in 1993 was especially intense, and similararguments have arisen in Europe over the issue ofenlargement of the European Union and overattempts to reform the Common Agricultural Policy.

Rapid trade policy reforms have also generated asignificant political backlash in many developingnations. And recent years have witnessed violentprotests and demonstrations by groups from a varietyof countries that hope to disrupt meetings of theWorld Trade Organization (WTO). Political leadersaround the world frequently voice concerns about thenegative effects of trade and the need to protect theirfirms and workers from foreign competition.

What is behind all of this political fuss and bother?At first glance it may seem puzzling that there is somuch conflict over trade. After all, the most famousinsight from all of international economics is theproof that trade provides mutual gains: that is, whencountries exchange goods and services they are allgenerally better off. Trade allows each country to spe-cialize in producing those goods and services inwhich it has a comparative advantage, and in doingso world welfare is improved (see Chapter 1, Box 1.8).

While there are gains from trade for all countries inthe aggregate, what makes trade so controversial isthat, among individuals within each country, tradecreates winners and losers. How trade affects differentindividuals depends upon how they earn their living.To flesh out this story, economists have traditionallyrelied upon a very simple theory of trade devised bytwo Swedish economists, Eli Heckscher and BertilOhlin. In the Heckscher–Ohlin model of trade, eachnation’s comparative advantage is traced to its particu-lar endowments of different factors of production:that is, basic inputs such as land, labour, and capitalthat are used in different proportions in the produc-tion of different goods and services. Since the costs ofthese inputs in each country will depend on theiravailability, differences in factor endowments acrosscountries will create differences in comparative

cerns and how they feature in debates over foreigneconomic policies. Finally, to link all this to the chap-ter that follows, in the conclusion we will briefly con-sider the impact of domestic politics on bargainingover economic issues between governments at theinternational level.

52 MICHAEL J. HISCOX

Policy preferences

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advantage. Each country will tend to export itemswhose production requires intensive use of the factorswith which it is abundantly endowed relative to othernations; conversely, each country will import goodswhose production requires intensive use of factorsthat are relatively scarce. Countries well endowedwith land, like Australia and Canada, are expected toexport agricultural products (for example, wheat andwool), while importing products that require theintensive use of labour (for example, textiles andfootwear) from more labour-abundant economies likeChina and India. The advanced economies of Europe,Japan, and the United States, well endowed with cap-ital relative to the rest of the world, should exportcapital-intensive products (for example, automo-biles and pharmaceuticals), while importing labour-intensive goods from less developed trading partnerswhere supplies of capital are scarce compared to supplies of labour.

Building on this simple model of trade, WolfgangStolper and Paul Samuelson derived a famous theo-rem in 1941 that outlined the likely effects of trade onthe real incomes of different sets of individuals withinany economy. According to the Stolper–Samuelsontheorem, trade benefits those who own the factors ofproduction with which the economy is relatively wellendowed and trade hurts owners of scarce factors. Thereasoning is straightforward: by encouraging speciali-zation in each economy in export-oriented types ofproduction, trade increases the demand for locallyabundant factors (and bids up the earnings of thosewho own those factors), while reducing demand forlocally scarce factors (and lowering the earnings ofowners of such factors). In Australia and Canada, thetheorem tells us that landowners should benefit mostfrom trade, while workers can expect lower real wagesas a consequence of increased imports of labour-intensive goods. In Europe, Japan, and the UnitedStates, the theorem predicts a fairly simple class divi-sion over trade: the trade issue should benefit ownersof capital at the expense of workers. The converseshould hold in relatively labour-abundant (and capi-tal-scarce) developing economies like China andIndia, where trade will raise the wages of workers rela-tive to the profits earned by local owners of capital.

By revealing how trade benefits some people whilemaking others worse off, the Stolper–Samuelson the-orem thus accounts for why trade is such a divisive

political issue. The theorem also provides a neat wayto map the policy preferences of individuals in eacheconomy. In each nation, owners of locally abundantfactors should support greater trade openness, whileowners of locally scarce factors should be protection-ist. There is a good deal of evidence in the histories ofpolitical conflict over trade in a variety of nations thatfits with this simple prediction (see Rogowski 1989).In Australia, for instance, the first national electionsin 1901 were actually fought between a Free Tradeparty, representing predominantly rural voters, anda Protectionist party that was supported overwhelm-ingly by urban owners of capital and labour. A verysimilar kind of political division characterized mostdebates over trade policy in Canada in the late nine-teenth century, with support for trade openness em-anating mostly from farmers in the vast westernprovinces. In Europe and Japan, in contrast, much ofthe opposition to trade over the last century or so hascome from agricultural interests, anxious to blockcheap imports of farm products from abroad. In theUnited States and Europe, at least since the 1960s,labour unions have voiced some of the loudest oppo-sition to trade openness and have called for importrestrictions aimed at protecting jobs in labour-inten-sive industries threatened by foreign competition.

On the other hand, political divisions and coali-tions in trade politics often appear to contradict thissimple model of preferences. It is quite common to seeworkers and owners in the same industry bandingtogether to lobby for protective import barriers, forinstance, in contemporary debates about policy inEurope and the United States, even though theStolper–Samuelson theorem tells us that capital andlabour are supposed to have directly opposing views.So what is going on here? The critical problem seemsto be that the theorem is derived by assuming thatfactors of production are highly mobile between dif-ferent industries in each economy. An alternativeapproach to mapping the effects of trade on incomes,often referred to as the ‘specific factors’ model, allowsinstead that it can be quite costly to move some fac-tors of production between different sectors in theeconomy. That is, different types of land, labour skills,and capital equipment often have a very limited orspecific use (or range of uses) to which they can be putwhen it comes to making products. The plant andmachinery used in modern manufacturing industries


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is very specialized: the presses used to stamp outautomobile bodies are only designed for that purpose,for instance, and cannot be adapted easily or quicklyto perform other tasks. Steel factories cannot easily beconverted into pharmaceutical factories or softwaredesign houses. Nor can steelworkers quickly adapttheir skills and become chemical engineers or com-puter programmers.

In the specific factors model, the real incomes ofdifferent individuals are tied very closely to the for-tunes of the particular industries in which they maketheir living. Individuals employed or invested inexport industries benefit from trade according to thismodel, while those who are attached to import-com-peting industries are harmed (see Jones 1971; Mussa1974). In the advanced economies of Europe and theUnited States, the implication is that owners andemployees in export-oriented industries like aero-space, pharmaceuticals, computer software, con-struction equipment, and financial services, should

be much more supportive of trade than their coun-terparts in, say, the steel, textiles, and footwearindustries, which face intense pressure from importcompetition. There is much evidence supportingthese predictions in the real world of trade politics,especially in the debates over trade in the mostadvanced economies where technologies (and theskills that complement them) have become increas-ingly specialized in many different manufacturingand service industries, and even in various areas ofagriculture and mining production (see Hiscox 2002;Magee 1980). In the recent debates over regional andmultilateral trade agreements in the United States, forinstance, some of the most vociferous opposition toremoving barriers to trade has come from owners andworkers aligned together in the steel and textileindustries.

The leading research on the political economy oftrade now routinely assumes that the specific factorsapproach is the most appropriate way to think about


Box 3.1 The repeal of the Corn Laws

The story of the repeal of Britain’s protectionist Corn Lawsin 1846 is perhaps still the best-known example of a politi-cal clash over trade policy that fits nicely with theStolper–Samuelson theorem. With the revival of foreigntrade after the Napoleonic Wars, policy debates in Britainbegan to focus on the protectionist Corn Laws thatrestricted importation of various grains (wheat, rye, bar-ley, and oats, as well as peas and beans), defended res-olutely by the landowning elite. Pressure for reform camemost strongly from manufacturers, and especially textileproducers in Leicester and Manchester, anxious to reducelabour costs (see McCord 1958). It was these manufac-turers who formed the leadership of the Anti-Corn LawLeague in 1838, and a cotton manufacturer, RichardCobden, became the League’s most famous advocate.The push for reform soon drew a larger following amongboth the urban middle and working classes, and attractedsupport from the working-class Chartist reform move-ment, which organized the ‘bigger loaf’ campaign in the1840s (Magnus 1964: 65–6). The effects were soon felt inParliament, transformed by the Great Reform Act of 1832and the enfranchisement of voters in the large industrialcentres of the West Riding. Cobden himself enteredParliament in 1841, campaigning with the cry ‘You must

untax the people’s bread!’ and the League stepped up itscampaign with a storm of pamphlets, petition drives,public meetings, and addresses to labour unions. Thewidespread economic distress of the early 1840s had agreat impact on the Tory prime minister, Robert Peel. Heintroduced a sliding scale for grain duties in 1841and then reduced those rates slightly in 1842 and 1844,in an attempt to ease the food crisis, but this arousedfierce opposition from landed interests and from withinConservative ranks. The failure of the potato crop in1845, and the ensuing crisis, gave Peel the pretext to act.Amid reports of widespread starvation, the prime ministerpushed through a bill to repeal the Corn Laws alto-gether, with support from Liberals and Radicals. The con-flict over repeal split the Conservatives irrevocably. Once‘purified’ of their Peelite faction, the Tories (known foryears as the Protectionists) were increasingly isolated onthe trade issue in Parliament. Peel’s supporters, includingGladstone, gravitated to the Liberals, and their free-tradeplatform drew on an immense base of support amongurban industrialists, the middles classes, and workers.Gladstone’s first budget as prime minister in 1860 effec-tively eliminated all remaining protectionist duties inBritain.

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trade policy preferences, at least in the contemporarycontext in the advanced economies (see Grossmanand Helpman 1994; Rodrik 1995), so we will rely uponit for the most part in the discussions below. Thismodel, it is worth noting, is still nested withinthe broader Heckscher–Ohlin theory that explainstrade according to differences in factor endowments.Newer theories of trade, motivated by some clear evi-dence that not all trade seems to fit well with this sim-ple endowments-based theory (for example, Europe,Japan, and the United States all importing automo-biles from each other), have made some significantdepartures from the standard Heckscher–Ohlinframework. One innovation is to allow that technolo-gies of production and tastes among consumers mayvary substantially across countries. Such differencesmight affect the types of products an economy will belikely to export and import, but the predictions abouttrade policy preferences derived from the specific fac-tors approach are not otherwise affected: individualsengaged in export industries favour trade, while thosein import-competing industries oppose trade. A morecomplicated innovation in trade theory allows for thepossibility of economies of scale. In some industriesrequiring large investments of capital, the largestfirms may enjoy such a dramatic cost advantage oversmaller firms that those markets tend to be domi-nated by only a few, very large corporations. In suchcases, in which firms compete with one another andwith foreign rivals for different market niches, trademay have different effects for firms in the same indus-try. These types of complexities are difficult to incor-porate into a broadly applicable model of trade,however, so we will not pursue them here. Althoughit might be pointed out that large firms that enjoyeconomies of scale in production also tend to engagein foreign investment, locating parts of their enter-prise in different nations. Below we will discuss thepolitical implications of this type of multinationalinvestment in more detail.

Immigration

Of course globalization is not simply a matter of theamount of trade in goods and services, it also involvesinternational flows of the factors of production them-selves—the migration of workers between nations

and international investment and lending that trans-fers capital across borders. There is not a radical differ-ence between how we analyse these phenomena andhow we examined trade, but neither is the analysisidentical in terms of the economic effects and the pol-icy preferences that we anticipate for different sets ofindividuals within each nation.

Political debates about immigration policy havebeen rising in volume and intensity in recent years inalmost all Western economies. On the one hand,immigration is seen by many as an economic and cul-tural lifeline that can supply firms in key industrieswith skilled workers while also injecting new artisticand intellectual life into the nation. On the otherhand, many people are concerned that immigrantstake jobs away from local workers and create ethnicenclaves that can balkanize a nation and lead to morecrime and other social ills. These latter concerns haveencouraged the recent imposition of much tighterimmigration controls in many countries, while alsonurturing the growth of extremist anti-immigrantpolitical movements in several European countriesand increasing the incidence of hate crimes directedtoward immigrants. The debate seems certain to con-tinue in the years ahead, and grow fiercer.

Historically, immigration has almost always been amore politically controversial topic than trade orinvestment. The issue is so sensitive that tight restric-tions on immigration are nearly universal. Again, thismakes little sense if we look only at the aggregate wel-fare effects of international labour flows. It is easy todemonstrate that when labour is free to migrate tocountries where it can be more productive (and earncorrespondingly higher wages), there will be anincrease in total world output of goods and services.And total output must also increase in any economythat allows more immigrants to enter. This expansionin production makes it possible, in principle, foreveryone to enjoy higher standards of living.Migration flows can actually serve the same economicpurpose as trade flows. Indeed, in the standardHeckscher–Ohlin model of trade described above,trade is simply a function of country differences inendowments of labour and other factors, and so inter-national movements of goods and internationalmovements of factors are actually substitutes for oneanother. Countries that are abundantly endowedwith labour, like China and India, and in which wages


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are thus quite low compared to wages paid elsewhere,are not only natural suppliers of labour-intensiveexports for the world market, they are also naturalsuppliers of emigrants.

As we already know, however, what matters mostfor politics is not that aggregate welfare gains are pos-sible from exchanges (of goods or factors) betweeneconomies; what matters most is that some peoplegain and other people lose. Which individuals aremost likely to oppose immigration? Again, the stan-dard economic analysis emphasizes the importanceof the different types of productive factors—includ-ing land and capital, as above, with an additionaldistinction made between high-skilled labour (or‘human capital’) and low-skilled or blue-collar labour.What is critical, as you will have already guessed, isthe impact that immigration can have on relative sup-plies of factors of production in the local economy.If immigrants have low skill levels, as is typicallyassumed when discussing the effects of immigrationin the advanced economies of Europe and NorthAmerica, allowing more immigration will increasethe local supply of low-skilled labour relative to otherfactors. The effect is to lower the real wages of all low-skilled workers, as the new arrivals price themselvesinto employment by accepting lower pay, while rais-ing the real earnings for local owners of land, capital,and skills, as demand for these other factors increases.Of course, if a nation only allows high-skilled workersto immigrate, the effect will be lower real wages forhigh-skilled workers, but higher real earnings for low-skilled workers and owners of land and capital.

The basic results from this simple model of theimpact of immigration—often referred to as ‘factor-proportions’ analysis (see Borjas, Freeman, and Katz 1996; Borjas 1999)—are widely applicable.Immigration always harms local workers with similarskill levels to those of the arriving workers, while bene-fiting local owners of other factors. Even if we allowfor high levels of trade, which can partially offset theimpact of immigration as economies adjust to thechange in factor supplies by importing less of somegoods that can now be produced locally at a lowercost, the effects are always in the same direction—although they may become very small in size, andeven disappear altogether, if the local economy is verysmall relative to other economies and if the inflow ofimmigrants is very small in magnitude (Leamer and

Levinsohn 1995). The effects are even generally thesame if we allow that the skills of workers can behighly ‘specific’ to particular industries, though theimpact of immigration on earnings will be larger forhigh-skilled (specific) workers in some industriesthan in others. Any inflow of unskilled labour will beespecially valuable for high-skilled workers in sectorsthat use unskilled labour more intensively, for exam-ple, but it will still benefit all high-skilled workerssince output (and demand for their skills) will rise ineach industry. On the flip side, an inflow of any typeof high-skilled labour will generate the largest declinein earnings for high-skilled workers in the sameindustry (those who own the very same specific skillsas the immigrants). But it will also hurt high-skilledworkers in other industries in the local economywhose earnings will suffer, albeit in a relatively minorway, as demand for their types of specific skills falls inresponse to the expansion taking place in the indus-try into which the skilled immigrants have moved.

So again, we have a very simple and generally appli-cable way of identifying the policy preferences ofindividuals. Individuals can be expected to opposeany policy that would permit immigration of foreignworkers with similar skill levels, but they will supportother types of immigration. Individuals who maketheir living from ownership of land and capital arelikely to be the strongest supporters of more openimmigration laws. If we look at the actual politicaldebates over immigration laws in particular coun-tries, the general alignment of interests seems to fitrather well with these expectations. Typically, themost vocal opposition to changes in immigrationlaws that would permit more low-skilled immigrationcomes from labour unions representing blue-collarworkers. In the United States, for instance, the AFL-CIO has traditionally taken a very tough stancein favour of restrictive immigration laws and bordercontrol measures aimed at stemming illegal immigra-tion into the country from Mexico (Tichenor 2002:209). American business and farm associations havetaken a very different position, often lobbying formore lenient treatment of illegal immigrants and forlarger quotas in various non-immigrant working visacategories. In similar fashion, trade union federationsin Britain, France, and Germany have raised protestsabout enlargement of the European Union and thepossible influx of low-skilled workers into their


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economies from new member countries in Southernand Eastern Europe. High-skilled workers have notshied away from immigration politics either, oftenlobbying to restrict inflows of immigrants with skillsthat match their own and would thus pose a competi-tive threat in the local labour market—the AmericanMedical Association, for instance, the organizationwhich represents doctors in the United States, haspushed hard in recent years to limit the number of for-eign doctors granted visa status while also making itmore difficult for them to obtain licences to practice.

This simple approach to the political economy ofimmigration restrictions is very useful, at least asa first step toward understanding the politicalforces that are likely to shape policy outcomes. It isextremely difficult, however, to analyse the politics ofimmigration without examining non-economic con-cerns among individuals having to do with questionsof culture and identity. Immigration policy, afterall, has a profound impact on who makes up thenation itself. In this way it is quite different from tradepolicy. A great deal of recent research suggests thatdivisions among individuals over immigration policyare most strongly related to fundamental differencesin cultural values associated with ethnic and racialtolerance and cosmopolitanism (for example,Espenshade and Calhoun 1993; Citrin et al. 1997;McLaren 2001). This question of whether preferences

related to non-economic issues have a profound effecton attitudes toward foreign economic policies is onethat we will return to below.

Foreign investment

Capital can also move from one country to another.These movements usually do not take the form of aphysical relocation of some existing buildings andmachinery from a site in one nation to another siteabroad (the equivalent to worker migration). Instead,they take the form of financial transactions betweencitizens of different nations that transfer ownershiprights over assets: a firm in one country buys facilitiesabroad that it can operate as a subsidiary, for instance,or individuals in one country buy shares of foreigncompanies, or a bank in one country lends money toforeign firms. All such transactions increase the stockof capital available for productive use in one country,and decrease the stock of capital in another country.

The dramatic increase in the volume of inter-national capital flows over the past forty years, out-stripping the increase in trade, has had a profoundimpact on the international economy. Short-termflows of capital in the form of ‘portfolio’ investment(purchases of company shares and other forms ofsecurities including government bonds), which can


Box 3.2 The ‘new world’ closes its door to immigrants

Beginning in the 1840s and 1850s, there was a huge surgein emigration from England, Ireland, and other parts ofEurope and Asia to the ‘New World’ economies in Northand South America and Australasia where labour was rela-tively scarce and wage rates were comparatively high. Therudimentary border controls and open policy towardimmigrants in these frontier economies meant that labourflows responded quite quickly to economic events—andin particular, to gold rushes and other ‘booms’ associatedwith the construction of railways and the birth of newindustries. Over time, however, as labour unions becamemore organized and politically influential in the NewWorld economies, greater restrictions on immigrationwere imposed. The political pressure for limits onimmigration became especially strong during economic

recessions, when local rates of unemployment often roseswiftly and labour groups blamed new immigrants for tak-ing jobs away from ‘native’ workers (see Goldin 1994).Between the 1880s and the 1920s, all the new worldeconomies gradually closed themselves off to immigration(see O’Rourke and Williamson 2000). In the United States,the first bans were imposed on Chinese immigrants in1882 and then immigrants from all Asia in 1917, when atough literacy test was also introduced as a way of limitinginflows of low-skilled workers. In 1921 the EmergencyQuota Act placed severe restrictions on all new arrivals.The strongest political support for these measures camefrom north-eastern states with highly urbanized popula-tions working in manufacturing industries, where labourunions were particularly well organized and vocal.

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change direction quite rapidly in response to news andspeculation about changing macro-economic condi-tions and possible adjustments in exchange rates,have had a major impact on the choices governmentscan make when it comes to monetary and exchange-rate policies. Longer-term capital flows in the form of‘direct foreign investment’ (where the purchase offoreign assets by a firm based in one country gives itownership control of a firm located on foreign soil),have perhaps been even more politically controversialsince the activities of these multinational firms canhave a major impact on economic conditions in thehost nations in which they manage affiliates. Manycritics of multinational corporations fear that the eco-nomic leverage enjoyed by these firms, especially insmall developing nations, can undermine nationalpolicies aimed at improving environment standardsand human rights. The political debate over directforeign investment is thus highly charged.

Tight restrictions on both short- and long-terminvestment by foreigners have been quite commonhistorically, although the controls have been muchless strict than those typically imposed on immigra-tion. Clearly these controls cannot be motivated by adesire for economic efficiency. If such controls areremoved and capital is allowed to move freely to thoselocations in which it is used most productively (andwhere it will be rewarded, as a result, with higher earn-ings), it is easy to show that the total output of goodsand services will be increased in both the country towhich the capital is flowing and in the world eco-nomy as a whole. Again, this expansion in aggregateproduction makes it possible, in principle, to raise the standard of living for people everywhere.International investment, just like the migration ofworkers examined above, can serve the same eco-nomic purpose that is otherwise served by trade.International flows of capital substitute for theexports of capital-intensive goods and services in thebenchmark Heckscher–Ohlin model. In general,then, we can expect that the advanced industrialeconomies of Europe and the United States, whichhave abundant local supplies of capital for invest-ment and in which rates of return on capital are thusquite low compared with earnings elsewhere, are thenatural suppliers of capital (as well as capital-inten-sive goods) to poorer nations in which capital is in rel-atively scarce supply.

One point worth making here about the likelydirection of capital flows concerns the distinctionbetween lending and portfolio flows of capital anddirect foreign investment (see Ravenhill, Chapter 1 inthis volume). It is reasonable to imagine that the for-mer types of international investment are drivenpurely by the quest to maximize (risk-adjusted) ratesof return on capital, in line with the Heckscher–Ohlinmodel. With the small caveat that capital-poor devel-oping countries are often politically unstable, andhigh levels of risk can deter investors, we should nev-ertheless expect large flows of capital from the indus-trial nations to the developing world. It is much lessclear that economy-wide differences in rates of returnare critical for explaining patterns in direct foreigninvestment. There is certainly a considerable amountof direct investment by European, American, andJapanese firms in developing nations, with manyfirms setting up a ‘vertical’ multinational structure ofenterprises that locates land or labour-intensive partsof the production process in developing nations. Butthe vast bulk of direct foreign investment in the mod-ern world economy actually takes the form of capitalflows between the industrial economies themselves,with firms creating ‘horizontal’ structures in whichsimilar functions are performed in facilities in dif-ferent locations (see Graham and Krugman 1995: 36).This type of investment does not fit well with thestandard Heckscher–Ohlin predictions based uponfactor endowments, and is best explained instead bythe special advantages that firms in some industriesgain by jumping borders (and trade barriers) and byinternalizing transactions within the firm itself.Firms that rely heavily upon specialized technologiesand management and marketing expertise may havea hard time selling these kinds of intangible assets toforeign companies it would like to contract with assuppliers or distributors; instead, it may make farmore sense to keep all these relationships within thefirm (see Hymer 1976; Caves 1982). Many of thesetypes of horizontal multinational firms also appear tohave been established to secure access to foreign mar-kets into which they might not otherwise be able tosell because they faced trade barriers. This ‘tariff-jumping’ motive was a big factor in motivatingJapanese auto firms to set up manufacturing facilitiesin both Europe and North America beginning in the1980s. The implication is that there is often a strong


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connection between the effects of trade policies andinvestment (and investment restrictions), a topic wewill return to in the final section of the chapter.

Now, putting aside the aggregate welfare gains thatinternational movements of capital make possible,which individuals are likely to benefit from such cap-ital flows and which individuals will lose out? Here wecan simply apply the logic of the same ‘factor propor-tions’ approach we used above to outline the effects ofimmigration. We might distinguish between differ-ent types of capital, in the same way we distinguishedbetween low- and high-skilled labour above, and setapart lending and short-term or portfolio investmentflows from direct foreign investment. But to keepthings simple here we will just consider them all as asingle form of capital. What is critical here, of course,is the impact that inflows of any foreign capital haveon relative supplies of factors of production in thelocal economy. Allowing more inflows of capital fromabroad will increase the local supply of capital relativeto other factors and thus lower real returns for localowners of capital. At the same time, inflows of invest-ment will raise the real earnings of local owners ofland and labour by increasing demand for these otherfactors of production.

Again, even allowing for the fact that trade flowscan partially offset the impact of international move-ments of factors of production—economies that getinflows of capital from abroad may adjust by import-ing fewer capital-intensive goods and producing moreof them at home, since they are now less costly tomake locally—the direction of the effects on theincomes of different groups is always the same. Localowners of capital are disadvantaged by inflows of for-eign capital; local landowners and workers (in all cat-egories) are better off. These effects may diminish insize in cases in which the local economy is very smallrelative to others and the inflow of capital is verysmall in magnitude, as we noted above when dis-cussing the income effects of immigration, but theyare always working in the same direction. And again,parallel with the analysis of immigration flows, theseincome effects are not drastically affected by allowingthat capital can take forms that are highly ‘specific’ touse in particular industries, though the effects may belarger for owners of some types of capital than others.This is especially relevant when we think about directforeign investment, which typically involves the

relocation of a particular set of manufacturing or mar-keting activities that require very specific types oftechnologies in one particular industry. An inflow ofany type of specific capital will of course result in adecline in earnings for local owners of capital in thesame industry; it will also hurt all others who ownspecific types of capital used in different industries, ina more marginal way of course, as demand for theirassets will fall in response to the expansion takingplace in the industry favoured by foreign investment.

We can thus expect that policies allowing greaterinflows of foreign capital will be strongly opposed byindividuals who own capital in the local economy,but such policies will be supported by local landown-ers and workers. There is some evidence that does fitwell with these basic predictions. Perhaps the bestexample involves the way European and Americanauto companies have supported restrictions on theoperations of local affiliates of their Japanese rivalssince the 1980s. In Europe, auto firms pushed hard foran agreement with Japan that included in the limitsset on the total Japanese market share of the Europeanauto market, cars produced in Japanese affiliates. Inthe United States, after some initial hesitation (per-haps reflecting the fact that they had themselves setup numerous foreign transplant firms around theworld) the US auto firms supported a variety of pro-posals for ‘domestic content’ laws that would haveplaced local affiliates of Japanese auto makers at aconsiderable disadvantage by disrupting their rela-tionships with parts suppliers at home (Crystal 2003).The ‘big three’ American firms (Ford, General Motors,and Chrysler) also seized the opportunity to demandhigh local content requirements in the ‘rules of ori-gin’ for autos in the negotiations over the 1993 NorthAmerican Free Trade Agreement, ensuring that theywould have a major advantage over Japanese trans-plants producing cars in Mexico for the NorthAmerican market. Interestingly, the workers that wewould expect to be strongly supportive of incomingJapanese investment in the auto industry, representedby the United Auto Workers union, were actually quitelukewarm—perhaps because they had long advocatedthat tough domestic content rules be applied toAmerican firms, to prevent them from transplantingtheir parts manufacturing facilities to Canadaand Mexico, and perhaps also in response to concernsthat the foreign transplants setting up in southern


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American states like Tennessee (Nissan) and Kentucky(Toyota) were not employing union members.

Foreign investment tends to be even more politic-ally controversial in developing nations, where thebehaviour of large foreign corporations can haveprofound effects on the local economy and on localpolitics. One particular concern among critics ofmultinational firms has been the role that severallarge corporations have apparently played in support-ing authoritarian governments that have restrictedpolitical organization among labour groups, limitedgrowth in wage rates, and permitted firms to mistreatworkers and pollute the environment (see Evans 1979;Klein 2002). While the evidence is not very clear, localowners of capital may well have muted their opposi-tion to investments by foreign firms in order to sup-port authoritarian policies adopted by militaryregimes in some cases: in Nigeria, for instance, whereShell (the European oil company) has long been themajor foreign investor, or more recently in Myanmar,where Unocal (an American oil and gas firm) is thekey foreign player. But the basic competitive tensionbetween local capitalists and foreign firms (whoseentry into the economy bids down local profits) istypically very obvious even in these unstable andnon-democratic environments, as local firms haveoften encouraged their governments to impose severerestrictions on foreign investments, including oner-ous regulations stipulating that foreign firms use localrather than imported inputs, exclusion from keysectors of the economy, and even nationalization(seizure) of firms’ assets (Jenkins 1987: 172). Newerevidence suggests that, as we might expect giventhe preferences of labour in capital-poor developingnations, left-wing governments backed by organizedlabour have made the strongest efforts to lure foreignfirms to make investments (Pinto 2003).

So far we have considered only the issue of whethergovernments relax restrictions on inflows of foreigncapital. Of course, governments can and often do takeactions that influence how much investment flowsout of their economies. And the same holds for labourflows, as governments often try to affect emigration aswell as immigration—many governments, in coun-tries as diverse as Australia, Canada, and India, areworried about a ‘brain drain’ of skilled workers andprofessionals, for instance, and have adopted a rangeof policies to discourage or tax such labour flows. But

the issue of outward direct investment, often involv-ing the ‘outsourcing’ of jobs by multinational firmsto their affiliates in labour-abundant (low-wage)nations, has become an especially salient politicalissue recently in Europe and the United States. Thepolitical divisions over the issue are largely what weexpect from the factor proportions theory: those whoown capital are strongly opposed to any restrictionson their ability to invest it abroad in order to earnhigher profits, but restrictions on outward invest-ment are strongly supported by local workers whounderstand that capital outflows will reduce their realearnings. In the United States, for instance, the mostardent advocates of legislation that would raise thetax burden on profits earned abroad by American cor-porations has been the AFL-CIO and those workersamong its membership that have been hit hardest byoutsourcing (for example, labour unions in the textileand auto industries). Interestingly, these labourunions have often had support from environmentaland human rights groups concerned that competi-tion among developing countries to attract newinvestments from multinational firms may produce a‘race to the bottom’ in environmental and labourstandards. Coalitions of labour unions and humanrights groups have waged campaigns to try to force UScorporations to adhere to strict codes of conductabroad. We will discuss these types of multi-issuepolitical coalitions below.

Exchange rates

Of course a critical difference between transactionsthat take place between individuals living in the samecountry and transactions between people in differentcountries is that the latter require that people canconvert one national currency into another. If a firmin Australia wants to import DVDs from a film studioin the United States, for example, it will need toexchange its Australian dollars for US dollars to paythe American company. The rate at which this con-version takes place will obviously affect the transac-tion: the more Australian dollars it takes to buythe number of US dollars required (the price of theDVDs), the more costly are the imports for movie-loving Australian buyers. All the trade and investmenttransactions taking place every day in the world


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economy are affected by the rates at which currenciesare exchanged.

Prior to the First World War, almost all governmentsfixed the value of their currency in terms of gold,thereby creating an international monetary system inwhich all rates of conversion between individual cur-rencies were held constant (for further discussion ofthis international gold standard, see Chapter 1, Box1.3). Between the Second World War and 1973, mostcurrencies were fixed in value to the US dollar, themost important currency in the post-war world eco-nomy. In this system, often referred to as the ‘BrettonWoods’ system (see Chapter 1, Box 1.4), the UnitedStates agreed to guarantee the value of the dollar bycommitting to exchange dollars for gold at a set price of$35 per ounce. Since 1973, when the Nixon adminis-tration officially abandoned the fixed rate between thedollar and gold, all the major currencies have essen-tially been allowed to fluctuate freely in value in worldfinancial markets. Among developing nations, how-ever, many governments continue to fix the value oftheir currency in terms of dollars or another of themajor currencies (see Frieden, Ghezzi, and Stein 2001).And groups of nations in different regions of the world,including the members of the European Union, havemade separate efforts to stabilize exchange rates at theregional level, even progressing to the adoption of acommon regional currency.

The fundamental choice each government mustmake involves whether to allow the value of thenational currency to fluctuate freely in response tomarket demand and supply, or instead fix the value ofthe currency in terms of some other currency or exter-nal standard—typically, the currency of a major trad-ing partner or, as was common in the past, gold(a precious metal valued highly in most societiesthroughout history). When a government chooses tofix the value of the national currency, it sets the offi-cial rate of exchange and commits itself to buy thecurrency at that fixed rate when requested to by pri-vate actors or foreign governments. Between a ‘purefloat’ and a fixed exchange rate there are intermediateoptions: a government can choose a target value forthe exchange rate and only allow the currency to fluc-tuate in value within some range around the targetrate. The wider this range, of course, the more policyapproximates floating the currency.

When it comes to trade, immigration, and invest-ment, economists agree almost universally on thepolicy choice that is best for maximizing national(and world) output and, hence, general standards ofliving: removing barriers to all types of internationalexchange is optimal because it allows resources to beallocated in the most productive way. There is nosimilar consensus, however, on the best approach tocurrency policy. Fixing the exchange rate has pros and


Box 3.3 Investment, imperialism, and the ‘race for Africa’

Beginning in the 1870s, vast quantities of investmentcapital flowed from the centres of finance in WesternEurope to the rest of the world, providing the capital ne-cessary to develop railroads and telegraph networks, ports,and new mining industries in eastern and central Europe,the Americas, and much of Asia. Beginning in the 1880s,the political context in which these foreign investmentswere made began to change drastically as an intense racedeveloped among the major powers for political control ofterritories in Africa and Eastern Asia. Governments inBritain, France, Germany, and Belgium made imperialexpansion in these regions their most urgent foreign policypriority. Seizing political control of territories in whichthere was often no clear or stable governing authority, orat least not one capable of defending the area fromconquest by outside force, was a way to safeguard the

investments that were being made in these territories(mostly in the production of raw materials, such ascotton, silk, rubber, vegetable oils, and other products of tropical climates, as well as railways and ports, thatwere all very vulnerable to seizure). These imperial poli-cies were supported most strongly by financial interestsand conservative parties, typically backed by commercialand shipping industries as well, and by military leadersanxious about the security implications of falling behindrivals in the control of strategic territories and ports.Indeed, British economist, J. A. Hobson (1902), and fol-lowing him, Lenin (1916), famously interpreted the impe-rial expansion of this time as the natural consequence ofowners of capital needing access to new investmentopportunities overseas; imperialism was, in Hobson’sterms, ‘excessive capital in search of investment’.

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cons, and it is not always clear which are larger. Byeliminating fluctuations in the exchange rate, fixingmakes international trade and investment less costlyfor firms and individuals, since they will not need toworry that the benefits from these international trans-actions will be adversely affected by some sudden,unexpected shift in exchange rates. By doing awaywith exchange-rate risk, fixing allows the economy tobenefit more fully from international trade and invest-ment. But what is the downside? What does the gov-ernment give up by pledging to buy or sell its owncurrency on request at the official rate of exchange?The answer, in short, is control over monetary policy.

A nation’s monetary policy regulates the supply ofmoney (and the associated cost of credit) in orderto manage aggregate levels of economic activityand hence levels of inflation and unemployment.Governments typically use monetary policy tocounter economic cycles: they expand the supply ofmoney and lower the cost of credit during recessionsto increase economic activity and promote job cre-ation, and they restrict the supply of money and raisethe cost of borrowing during ‘booms’ to sloweconomic activity and control inflation. When a gov-ernment commits to fixing the exchange rate, it effec-tively gives up the ability to tailor monetary policy tomanage domestic economic conditions. To see why,just imagine what happens to money supply if, at thegiven exchange rate, the nation’s residents spendmore on foreign goods and services and assets in anygiven period than foreigners buy from firms and indi-viduals in that nation: the country’s ‘balance of pay-ments’, which registers the value of all transactionswith the rest of the world, will be in deficit. Thismeans that that there is less overall demand for thecountry’s currency than for the currencies of othercountries (needed for residents to buy foreign pro-ducts and assets). To satisfy this excess demand for for-eign currencies and maintain the exchange rate at thefixed level, the government will be a net buyer of itsown currency, selling off its reserves of foreign curren-cies (or gold). The automatic effect of maintaining thefixed exchange rate in these conditions then, is toreduce the total supply of the nation’s money in cir-culation and slow domestic economic activity. Justthe opposite should occur when the nation runs a bal-ance of payments surplus: excess demand for its cur-rency compared to other currencies will require that

the government increase the supply of its money incirculation, stimulating economic activity.

In effect, then, fixing the value of the currencymakes monetary policy a hostage to exchange-ratepolicy. Even if a government sets the exchange rate ata level that it hopes will generate no balance ofpayments deficits or surpluses, since the balance ofinternational transactions in any period will dependheavily upon external economic conditions andevents in foreign countries, it has very little control.A recession abroad, for instance, will reduce pur-chases of a nation’s products by foreigners and lead toa deficit on the balance of payments and so, if cur-rency values are firmly fixed, this recession will be‘transmitted’ to the home nation by the subsequentreduction in its money supply.

The crux of the choice between fixed and floatingexchange rates is the choice between stability andpolicy control: a stable exchange rate will increase theeconomic benefits attainable from internationaltrade and investment, but this requires giving up theability to adjust monetary policy to suit domesticeconomic conditions. Governments in the mostadvanced economies have generally decided thatpolicy control is more important to them thanexchange-rate stability, at least since the early 1970s.Governments in smaller, developing nations havemostly chosen exchange-rate stability over policycontrol. In part this is because these countries tend torely more heavily upon trade and foreign investmentas sources of economic growth. This choice is alsomore attractive for governments in smaller countriestrying to defeat chronic inflation. Government pro-mises to deal with runaway inflation in these coun-tries may not be regarded as credible by private actors ifgovernments in the past have shown a tendency to actirresponsibly (for example, by printing and spendinglarge amounts of money) when facing electoral chal-lenges. Since the expectations that private actors haveabout government policy feed directly into the prices(and wages) set, inflationary expectations can havedevastating effects. In such circumstances, fixing thenation’s currency in terms of the currency of a majortrading partner which has a comparatively low rate ofinflation can serve an important function, providinga way for the government to commit itself more cre-dibly to a low-inflation monetary policy. In essence,by committing to keep the exchange rate fixed, the


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government is ceding control of monetary policy in avery clear and visible way, and anchoring inflation athome to the inflation rate in the partner country (seeBroz and Frieden 2001; Giavazzi and Pagano 1988).

In terms of the effects on aggregate welfare, the wis-dom of fixing exchange rates is thus not always crystalclear. The best or most preferred policy for differentsets of individuals within each country can be simi-larly difficult to identify. Consider first the case inwhich we assume that factors of production aremobile between sectors in the domestic economy(they are not ‘specific’ to particular sectors) and so wecan apply the logic of the Stolper–Samuelson theo-rem and the factor-proportions analysis. Sinceexchange-rate volatility serves, in effect, as an addedbarrier or cost to international trade and investmentflows, we have a place to begin when trying to mapthe policy preferences of individuals: in each eco-nomy, owners of locally abundant factors are morelikely to support a fixed exchange rate, while ownersof locally scarce factors are more likely to prefer afloating rate. In the capital-abundant, labour-scarceadvanced economies of Europe and the United States,we might thus expect a simple class division overexchange-rate policy: fixed rates benefit owners ofcapital at the expense of workers. We could expect thereverse alignment of class interests in the labour-abundant, capital-scarce economies of, say, Chinaand India. In such countries, greater exchange-ratecertainty should encourage more trade and greaterinflows of foreign investment, and both types of inter-national flows will benefit workers at the expense oflocal owners of capital.

But here we cannot think about exchange-ratestability without thinking also about monetary policycontrol. In general, workers might be expected tooppose fixed exchange rates in most circumstances,since they are likely to bear greater costs than otherswhen monetary policy can no longer be used to averteconomic downturns that result in higher levels ofunemployment. Owners of capital, on the other hand,care less about unemployment rates than they doabout keeping inflation in check, which is typicallymuch easier for the government to achieve (as notedabove) when monetary policy is committed to keep-ing the exchange rate fixed. Just as in the case for thenation as whole then, owners of labour and owners ofcapital may have to make a difficult choice about

where they stand in terms of the trade-off betweenthe effects of greater currency stability and less mone-tary policy control. In contemporary, labour-scarceEurope, for instance, workers would seem to be betteroff along both dimensions if exchange rates were moreflexible, while owners of capital should prefer fixedrates. There is some evidence that fits with this inter-pretation. Labour unions in Western European coun-tries generally provided the most vocal opposition togovernment policies aimed at fixing or stabilizingexchange rates in the 1970s and 1980s, particularly inFrance and Italy. But the record is mixed. Whilethe labour-backed Socialist government that cameto power in France in 1981 initially abandonedexchange-rate stability as a goal, by 1983 it was com-mitted to a fixed currency peg (see Oatley 1997). Infact, during the inter-war period in Europe, left-winggovernments tended to keep their currencies fixed tothe gold standard longer than other governments(Simmons 1994). And looking across a broader rangeof countries, in which labour is the locally abundantfactor and capital is scarce, the preferences of thesebroad classes of individuals when it comes toexchange rates becomes even more difficult to predict.

Perhaps one major reason why it is difficult to findcompelling evidence to support simple class-basedinterpretations of exchange-rate politics is that indi-viduals tend to see things very differently dependingon the industries in which they are employed andinvested. If we allow, as in previous discussions above,that factors of production are typically very specific toparticular industries, we get a very different picture ofthe alignment of individual preferences on theexchange-rate issue. And the picture is also muchclearer. Individuals employed or invested in sectorsthat invest or sell in foreign markets are likely to favourexchange-rate stability, since fluctuations in ratesimpose costs on their international transactions andbecause they have a relatively small economic stake indomestic (versus foreign) macro-economic condi-tions. Those individuals associated with firms andbanks that invest heavily in foreign markets, forinstance, and export-oriented sectors that sell a largeproportion of their output abroad, should thus tend tosupport fixed exchange rates. On the other hand,owners and employees in import-competing indus-tries and those producing non-traded services(for example, building, transportation, sales) whose


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incomes depend overwhelmingly on domestic eco-nomic conditions, are likely to favour flexibleexchange rates that allow the government more con-trol over monetary policy. There is some compellingevidence supporting these predictions, especially inthe debates over exchange-rate policy in the mostadvanced economies. In Europe in recent decades, forinstance, the strongest support for fixing exchangerates (and ultimately, for creating a commonEuropean currency) has come from the internationalbanks, multinational firms in a diverse range ofindustries (including auto firms such as BMW andMercedes), and from export-oriented sectors. Thestrongest opposition to fixed rates has tended to comefrom owners and labour unions associated withimport-competing industries such as coal, steel, andtextiles, especially in nations like France and Italy thathave battled relatively high rates of inflation (seeFrieden 1994). In developing nations, recent studieshave indicated that governments are more likely tofloat their currency when the import-competingmanufacturing sector accounts for a large proportionof the local economy (Frieden, Ghezzi, and Stein 2001).

Finally, when a government does decide to fix orstabilize its currency it must also decide the level atwhich to set the exchange rate. Whether the currencyshould be ‘stronger’ (that is, take a higher value versusother currencies) or ‘weaker’ (a lower value) is a sec-ond, important dimension of exchange-rate policy.Even when the currency is floating, in fact, if it hap-pens to move strongly in one direction or another, theissue can become a salient one, since the governmentmay be called upon to intervene in an effort to raise orlower the exchange rate toward some new target.What is interesting in this regard is that the align-ment of the various groups in terms of preferences forfixing versus floating the currency are not quite thesame as the way they are positioned on the issue ofthe actual rate that should be set or targeted. Astronger currency will harm those in both export-oriented and import-competing industries, since itwill make their products less attractive to consumersrelative to the foreign alternatives. Individuals inthese sectors should prefer a weaker currency. But aweaker currency will harm all others in the local econ-omy by eroding their purchasing power when itcomes to buying foreign goods and services. Ownersand employees in non-traded sectors should prefer a

stronger currency, as should any multinational firmsor international banks that are investing abroad andpurchasing foreign assets (Frieden 1994). In the realworld of politics, in instances in which the level of anation’s exchange rate has in fact become a salientpolitical issue, these types of coalitions do appear toemerge. Devaluation of the US dollar became a majorelection issue in the 1890s, for instance, with the riseof the Populist movement, supported predominantlyby export-oriented farmers who demanded a breakfrom the gold standard in order to reset the dollarexchange rate at a lower level. The Populists wereopposed most strongly by banking and commercialinterests in the north-eastern states who favoured astrong dollar (see Frieden 1997).

Key points

� According to the Stolper–Samuelson theorem, tradebenefits those who own the factors of productionwith which the economy is relatively well endowedand trade hurts owners of scarce factors.

� In the alternative ‘specific factors’ model, individualsemployed or invested in export industries are the oneswho benefit from trade while those who are attachedto import-competing industries are disadvantaged.

� The leading research assumes that the specific fac-tors approach is the most appropriate way to thinkabout the effects of trade in the contemporaryadvanced economies.

� Immigration harms the real earnings of local workerswith similar skill levels to those of the arriving work-ers, while benefiting everyone else in the host country.

� Inflows of foreign capital will hurt individuals whoown capital in the local economy, while benefitingall local landowners and workers.

� Individuals attached to firms and banks that investabroad or export a large proportion of their outputare likely to favour a fixed exchange rate. On theother hand, owners and employees in import-com-peting industries and those producing non-tradedservices are likely to favour a flexible exchange rate.

� A stronger currency will harm those in both export-oriented and import-competing industries, whilebenefiting all others in the local economy.


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Once we have specified the preferences of differentindividuals and groups on any particular issue weneed to think about how much influence they willhave over policy outcomes. This is where politicalinstitutions come in. Political institutions establishthe rules by which policy is made, and thus how thepolicy preferences of different groups are weighed inthe process that determines the policy outcome. It isappropriate here to start with the broadest types ofrules first, and consider the formal mechanisms bywhich governments and representatives in legislativebodies are elected (or otherwise come to power).These broad features of the institutional environmenthave large effects on all types of policies. But then wecan move on to discuss more specific aspects of the

legislative process and administrative agencies thathave implications for the formulation and imple-mentation of trade, immigration, investment, andexchange-rate policies.

Elections and representation

Perhaps it is best to start with the observation that thegeneral relationship between democratization andforeign economic policy making is a matter that is stillopen to considerable theoretical and empirical doubt.Part of the puzzle is that there is a great deal of varia-tion in the levels of economic openness we haveobserved among autocratic nations. In autocratic


Box 3.4 The politics of the rising dollar

Between 1980 and 1985 the US dollar rose by approxi-mately 50 per cent in value against the Japanese yen andby roughly similar amounts against the Germandeutschmark and the British pound. The rapid dollarappreciation placed immense strain on US producers oftraded goods and services and by 1985 the Reagan gov-ernment was being lobbied strenuously by a large varietyof groups asking for some kind of action to halt the rise(see Destler and Henning 1989). The strongest pressurecame from groups in a broad collection of export-oriented sectors, including grain farmers, firms like IBMand Motorola in the computer industry, and Caterpillar, alarge exporter of construction equipment and machinery.The voices of these exporters were swelled by protestscoming from firms in import-competing industries,including the major auto companies and the steel makers.The initial reaction from the Reagan administration was tosit tight, and characterize the rise of the dollar as a signthat the rest of the world held the United States and itseconomy in high esteem. The government had set acourse to restrain inflation when entering office in 1981,and had raised US interest rates considerably. Takingaction to devalue the dollar would have thrown into sub-stantial doubt this commitment to defeat inflation. After

their initial pleas were rebuffed by the White House, how-ever, many groups from the steel, autos, and textile indus-tries began demanding new forms of trade protectioninstead, bombarding Congress with calls for trade barriersthat would make up for the competitive effects of the dol-lar appreciation. It was this threat of runaway protection-ism in Congress that finally prompted the government totake action on the dollar. In 1985, the White Housereached an agreement with the governments of Japan,Germany, Britain, and France, which became known asthe Plaza Accord (a reference to the lavish New York hotelin which it was negotiated). This deal provided for acooperative effort to manage a gradual depreciation ofthe dollar against the other currencies, with each govern-ment agreeing to alter its macro-economic policies insuch a way as to ease demand for the dollar comparedwith other currencies (for example, the Reagan govern-ment agreed to lower interest rates and to make anew effort to reduce the size of the US budget deficit). Bygiving up some control over macro-economic policy,in coordination with other governments, the WhiteHouse was able to reverse the rise in the dollar and easethe strain imposed on US producers of traded goods andservices.

Institutions

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regimes, the orientation of policy will depend uponthe particular desires and motivations of the (non-elected) leadership, and there are different theoreticalapproaches to this issue. Non-elected governmentscould pursue trade and investment liberalization inan effort to maximize tax returns over the long termby increasing aggregate economic output. Such poli-cies may be easier to adopt because autocratic leadersare more insulated than democratic counterpartsfrom the political demands made by any organizeddomestic groups that favour trade protection and lim-its on foreign investment (Haggard 1990). Perhapsthis is an apt description of the state of affairs inChina as it has been gradually opening its economy totrade and investment over the past two decades, andnon-democratic governments in Taiwan and SouthKorea pursued trade liberalization even more rapidlyin the 1960s. On the other hand, autocratic govern-ments may draw political support from small, power-ful groups in the system that favour protection. Manysuch governments appear to have used trade andinvestment barriers in ways aimed at consolidatingtheir rule (Wintrobe 1998). The experience in Sub-Saharan African nations since the 1960s, and inPakistan and Myanmar, seems to fit this mould.Without a detailed assessment of the particulargroups upon which a particular authoritarian regimedepends for political backing, it is quite difficult tomake predictions about likely policy outcomes undernon-democratic rule.

In formal democracies that hold real elections, themost fundamental set of political rules is the set thatdefines which individuals get to vote. If the franchiselaw gives more weight to one side in a policy contestcompared to others, it can obviously have a largeimpact on policy outcomes. Where only those whoown land can vote, for instance, agricultural interestswill be privileged in the policy-making process. If thislandowning elite favours trade protection, as it did inBritain in the years before the Great Reform Act of1832, then such a policy is almost sure to be heldfirmly in place. By shifting political power away fromlandowners and towards urban owners of capital andlabour, extensions of the franchise had a majorimpact on all forms of economic policy during thelate nineteenth and early twentieth centuries inEurope, America, and elsewhere. In England, theextension of voting power to the middle and working

classes, achieved in the reforms of 1832 and 1867, hadthe effect of making free trade politically invincible—with a huge block of workers along with the urbanbusiness class supporting trade openness, and only atiny fraction of the electorate (the traditional ruralelites) against it, a government that endorsed tariffs orrestrictions on investment would have been commit-ting electoral suicide. In the United States andAustralia, on the other hand, where labour and cap-ital were in relatively scarce supply, the elimination ofproperty qualifications for voting and the extensionof suffrage had exactly the opposite effect, empower-ing a larger block of urban voters who favoured hightariffs. In general, extensions of the franchise tourban classes tend to produce more open policiestoward trade, immigration, and investment in labourand capital-abundant countries, and more closed orprotectionist policies in labour and capital-scarceeconomies.

The precise rules by which representatives areelected to national legislatures are the next criticalfeature of the institutional environment. Scholarshave suggested that in parliamentary systems inwhich legislative seats are apportioned among partiesaccording to the proportion of votes they receive(‘proportional representation’), narrowly organizedgroups have far less impact on policy making in gen-eral than they do in electoral systems in which indi-vidual seats are decided by plurality rule (seeRogowski 1987). Parliamentary systems with propor-tional representation tend to encourage the forma-tion of strong, cohesive political parties, whichappeal to a national constituency and have less togain in electoral terms by responding to localized andparticularistic demands (McGillivray 1997). Othertypes of systems, in contrast, tend to encourage intra-party competition among individual politicians andthe development of a ‘personal vote’ in particularelectoral districts and thus are more conducive tointerest group lobbying. The implications for foreigneconomic policies are usually spelled out in very clearterms: we expect that proportional representationsystems with strong political parties (e.g. Sweden) willtypically produce lower levels of trade protection andother restrictions than alternative types of electoralsystems (e.g. Britain, the United States) in which par-ticular local and regional interests have a greaterinfluence.


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These conclusions about the impact of particularis-tic groups in different types of electoral systems restupon a critical insight derived from theoretical workon collective action in trade politics: that there is afundamental asymmetry between the lobbying pres-sure generated from groups seeking protectionist poli-cies and the lobbying pressure that comes from groupswho oppose such restrictions. The main reason for thisis that restrictions on imports and other types ofexchange, when imposed one at a time, tend to havevery lopsided effects. As we know from the analysis ofthe specific factors model above, the benefits of a tariffon a particular good are concentrated on the owners ofcapital and labour engaged in that particular industry.If the tariff is substantial, these benefits are likely to bequite large as a share of the incomes of those individu-als, and thus they will typically be willing to spend agood deal of their time and energy (and savings) lob-bying to ensure they get the tariff they want. Thestakes are very high for them. By contrast, the costs of

the tariff are shared among all the owners of othertypes of specific factors in the economy; they are dis-persed so broadly, in fact, that they tend to be quitesmall as fraction of the incomes of these individuals.Thus it is unlikely that those hurt by the new tariff willbe prepared to devote resources to lobbying againstthe policy proposal. Collective political action willalways be much easier to organize in the relativelysmall groups that benefit from a particular traderestriction than in the much larger groups (the rest ofthe economy) that are hurt by the restriction (seeOlson 1965). Perhaps the best example of this logic isthe extraordinary political power that has beendemonstrated by the small, highly organized agricul-tural groups in Europe, the United States, and Japanover the past fifty years. These groups, which togetherrepresent a tiny fraction of the population in eachpolitical system, have been able to win extremely high(if not prohibitive) rates of protection from importsand lavish subsidies (see Tyers and Anderson 1992).


Box 3.5 The institutional foundations of the gold standard

Why was the gold standard, the system of fixed exchangerates that appeared to work so well in bringing order andstability to the global economy between the 1880s and1914, so difficult to re-establish in the 1920s? One veryimportant reason has to do with the major changes inpolitical institutions that took place in Western nationsaround the time of the First World War. The gold standardrequired that governments give up control of monetarypolicy in order to keep the value of their currencies fixedin terms of gold (and one another). In essence, macro-economic policy was held hostage to exchange-rate pol-icy, so that currency values were stable. This wasespecially difficult for small economies that happened torun large balance of payments deficits at the set rates ofexchange. To maintain their exchange rates they wereforced to reduce the supply of their money in circulationand raise interest rates, thereby reducing economic activ-ity at home and increasing unemployment. If they werealready in the midst of an economic recession, this meantmaking the downturn even worse. Governments couldonly follow through with this type of commitment to afixed exchange rate if the economic costs of recession—which fell predominantly upon workers who lost jobs and

income and small businesses and farmers driven intodebt—did not have direct political consequences in termsof their ability to remain in office. This changed in manynations around the turn of the century when electorallaws were reformed, extending the franchise to largerproportions of the population (including workers whohad previously been denied the right to vote in manyplaces). Around this same time labour organizations,including both trade unions and labour parties, grew inpolitical strength in almost all the Western economies,using strikes to push for political reforms while gainingsignificant electoral representation for the first time.Given these profound changes in the lie of the politicalland, the attempts to recreate the gold standard in theinter-war period appear to have been doomed from theoutset. Governments elected by much broader segmentsof the population were increasingly unwilling give uptheir ability to manage domestic economic conditions,especially during recessions, just in order to maintain thegold parity. Eventually, after weathering several smallercrises, the system collapsed when governments beganabandoning the gold standard altogether after 1929 inresponse to the onset of the Great Depression.

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Other aspects of electoral institutions may alsoplay a role in shaping policy outcomes. In general,smaller electoral districts in plurality systems may beexpected to increase the influence of sectoral or par-ticularistic groups over elected representatives andthus lead to higher levels of protection (Rogoswki1987; Alt and Gilligan 1994). In larger districts, politi-cal representatives will be forced to balance the inter-ests of a greater variety of industry groups whenmaking decisions about policies and will be lessaffected by the demands of any one industry lobby,and a larger share of the costs of any tariff or restric-tion will be ‘internalized’ among voters within thedistrict. From this perspective, upper chambers of par-liaments, which typically allocate seats among repre-sentatives of much larger electoral districts than thosein lower chambers, tend to be less inclined towardtrade protection and other types of restrictive foreigneconomic policies. Meanwhile, in legislative cham-bers in which seats are defined along political-geographic lines without regard for population (forexample, in the United States Senate, where each statereceives two seats), agricultural, forestry, and mininginterests in underpopulated areas typically gaina great deal more influence over policy making thanthey can wield in chambers (e.g. the United StatesHouse of Representatives) where legislative seatsare defined based upon the number of voters in eachdistrict.

We have generally been focusing on trade policies,since most of the past research on the effects of insti-tutions has tended to concentrate on tariff levels. Butrecent studies also suggest that differences in elec-toral institutions can have a significant impact onexchange-rate policies. In particular, in plurality sys-tems in which elections are all-or-nothing contestsbetween the major parties, governments appear to befar less likely to fix exchange rates and give up controlover monetary policy than governments in propor-tional representation systems (see Clark and Hallerberg2000). It appears that the costs of having ceded con-trol over monetary policy in plurality systems, shouldthe government face an election contest during aneconomic slump, are much higher than elsewhere.This difference also appears to be more pronouncedfor governments in plurality systems in which thetiming of elections is predetermined by law (Bernhardand Leblang 1999).

Legislatures and policy-making rules

The rules that govern the way national legislatures goabout making laws can have profound effects on theway the preferences of individuals and groups areaggregated into different types of foreign economicpolicies. These rules determine the way new policiesare proposed, considered, amended, and voted upon.They structure the interactions among different leg-islative and executive bodies and they establish whichbranches have what types of agenda setting and vetopower over policy.

Most of the recent research on the impact of legis-lative institutions on foreign economic policies hasbeen focused on American trade policy, but the impli-cations from this work are quite general and so it isworth close scrutiny. The point of departure for manystudies is the infamous Smoot–Hawley Tariff Act of1930, which was such a disaster that it helped inspire afairly radical change in the rules by which theCongress has dealt with trade policy ever since. Thecore of the legislative problem, as many see it, is thepossibility for ‘log rolling’ or vote trading betweenprotectionist interests. The benefits of a tariff ortrade restriction can often go to an import-competingindustry located almost entirely in one electoraldistrict, with the costs born generally by individualsin the rest of the economy. In such cases, lobbyingpressure by these industries can generate a protec-tionist log roll when tariffs are being set by votingamong members of a legislature: each member of thelegislature will propose generous protective measuresfor industries in his or her own district withoutaccounting for the costs they impose on individualselsewhere. To gain support for these measures,each member will vote in favour of similar measuresproposed by other legislators. If members canvote indefinitely on a sequence of such proposals, apolicy that includes every new tariff can be the equi-librium outcome (supported by each legislator’sbelief that a vote against another’s proposalwould induce others to retaliate by offering anamendment to withdraw protection from the defec-tor’s district). The result of such unchecked log rollingis a vast array of protective measures, such that allindividuals are far worse off than they were beforethe bill was passed (see Weingast, Shepsle, andJohnsen 1981).


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According to conventional wisdom, the Smoot–Hawley tariff was just such a log-rolling disaster, andCongress reacted to it in a remarkably sensible way byredesigning the rules governing the way trade policywas made. Specifically, Congress delegated to theexecutive branch the authority to alter US trade pol-icy by negotiating reciprocal trade agreements withother countries. This practice of delegating negotiat-ing authority to the president has been continuedsince 1934. By delegating authority over policy to thepresident, who would presumably set trade policy tobenefit all individuals within the one, national elec-toral district, this innovation eliminated the spectreof protectionist log rolling altogether and ensuredthat all the costs of trade protection were fully ‘inter-nalized’ by a decision maker accountable to all voters.In addition, by empowering the president to negoti-ate trade agreements that elicited reciprocal tariffreductions from other countries, the change helped

to mobilize support for trade liberalization amongexport interests who could now expect improved salesabroad as a result of tariff reductions at home.

The lessons drawn from this case are almostcertainly overdrawn, and the conventional accounthas some gaping inconsistencies. In particular, thereappears to have been no learning at all on the part ofmembers of Congress between 1930 and 1934: thecongressional voting records indicate that, amongstthe members voting on both bills, almost all thosewho voted for Smoot–Hawley in 1930 voted againstthe RTAA in 1934 (see Schnietz 1994). Moreover, it isnot at all clear that protectionist log rolls have been anotherwise unsolvable problem for tariff legislation inthe US Congress (or elsewhere)—what of all the casesin which liberalizing bills were passed by legislaturesin the absence of delegation? In the US Congressitself, the major acts passed by the Democrats when incontrol of government before the 1930s (the Wilson


Box 3.6 The Reciprocal Trade Agreements Act of 1934

In 1930 the US Congress passed the infamousSmoot–Hawley Tariff Act, which raised import duties on avast array of manufactured and agricultural goods (someto over 200 per cent), and was quickly dubbed the ‘worsttariff bill in the nation’s history’ even before it was passed.Retaliation from other countries, in the form of higher tar-iffs, was swift and substantial, and the subsequent sharpdecline in world trade and the collapse of the fragileinternational monetary system increased the depth andscope of the Great Depression. The 1930 tariff bill waswidely regarded as a case of protectionist log rolling runwild. The Senate alone made 1,253 amendments to theoriginal House bill, and duties on over 20,000 items werealtered (Pastor 1980: 77–8). When the Democrats woncontrol of the White House, and majorities in Congress, in1932, they looked for a way to make a change. Ruralinterests still made up a large part of the Democrats’ elec-toral base, especially in the south, and still stronglyfavoured trade and the party’s traditional anti-tariff plat-form. Unilateral tariff reductions were politically sensitivein the midst of a recession, however, and were not popu-lar at all among workers, who had thrown their support tothe Democrats in the 1932 campaign. Roosevelt’s secre-tary of state, Cordell Hull, a long-time advocate of freetrade, instead designed new legislation that would permit

the president to negotiate bilateral treaties with tradingpartners to restart trade by making reciprocal reductionsin import duties. Passed as the Reciprocal TradeAgreements Act in 1934, the legislation granted the pres-ident authority (for three years) to negotiate alterations ofup to 50 per cent in the existing import duties. When thatinitial authority expired in 1937, Congress renewed it and continued to do so in the decades that followed.Beginning in 1974, the president’s authority wasexpanded to cover negotiations over a range of non-tariffbarriers to trade, although various procedural and moni-toring provisions were also introduced to constrain exec-utive behaviour, and the Congress maintained the powerto approve or reject any trade agreement by vote (underthe so-called ‘fast-track’ provision that prohibited amend-ments and set a firm time limit for a ratifying vote). Thedelegation of policy-making power to the executivebranch, which can aggregate the costs and benefits ofprotection across the entire nation and bargain for recip-rocal changes in the policies of other governments toopen foreign markets to American exports, is creditedwith reorienting US trade policy away from protectionismin the decades since 1934 (see Destler 1995; Gilligan1997; Lohman and O’Halloran 1994; Bailey, Goldstein,and Weingast 1997).

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Tariff of 1894 and the Underwood Tariff of 1913) standout in this regard. Examples also abound in the leg-islative histories of other Western democracies. Itshould not be a mystery as to why. In parliamentarysystems, political parties play critical roles in control-ling the legislative agenda. In proportional represen-tation systems these parties compete for a share of thenational vote, and so legislation designed to appeasedistrict-specific interests holds little appeal. Even inplurality rule systems, however, the majority partythat forms a government typically imposes strict con-trol over the policy agenda in a way that prevents suchself-defeating log rolls. Finally, the notion that presi-dents, simply by dint of having a large (national) con-stituency, must be champions of freer trade, ishopelessly ahistorical. Here again, we cannot ignorethe critical role played by political parties. In the UScase, the Republican base of support between the1840s and 1940s was concentrated among manufac-turing interests in the north-east and midwest statesand was staunchly protectionist, and a long list ofRepublican presidents championed high tariffs inelection campaigns and backed the most protection-ist of Republican tariff bills in Congress (see Hiscox1999). More generally, in all the Western democra-cies, political parties typically have very distinct coreconstituencies among the electorate, defined inregional or class terms, to whom they are principallyaccountable when designing policies. Whether a gov-ernment allows protectionist amendments duringlegislative deliberations of policy, and whether a pres-ident supports trade liberalization, will depend ontheir partisan affiliation and the preferences of theirparty’s core electoral base.

Despite the distortions, the story of the RTAA doesstill hold some valuable lessons for thinking aboutways in which legislative rules can affect foreign eco-nomic policies. The explicit institutional connectionthat the RTAA forged between tariff reductions athome and reciprocal reductions in tariffs abroad,surely played a role in generating increased supportfor trade policy reform among export-oriented indus-tries and thus made it easier for all policy makers tosupport trade liberalization. This same link is nowmore or less routine, of course, for policy making inmost Western governments as a consequence of theirmembership commitments in the WTO. For nationsoutside the WTO, however, most of them developing

countries, where attempts to liberalize trade policyhave a poor political track record, this does suggestthat governments are more likely to succeed withtrade reform if they can do so as part of a bilateral orregional free trade agreement with major tradingpartners.

The RTAA also offers a lesson about group access tolawmakers that is often overlooked. Up until 1934,congressional committee hearings were pivotal inshaping the trade legislation voted upon in the USHouse and Senate. The hearings format, whichassigned particular days for receiving testimony onthe duties to be levied on different commodities, wasespecially convenient for industry group lobbying.This system was changed completely in 1934. Afterthe RTAA, hearings were typically limited to generaldiscussions about whether to extend the president’snegotiating authority and, after 1974, whether toimplement previously negotiated agreements (under‘fast-track’ provisions that prohibited amendment).Closing off this very direct channel by which groupshad been able for years to lobby for changes in dutieson particular items, may have had the most profoundeffect on trade policy-making in the United States. Ingeneral, any type of policy-making rules whichprovide routine access for organized groups to exertlobbying pressure to change particular features of leg-islation will make trade protection and other forms ofrestriction more likely—including open legislativehearings and ‘commissions’ or industry advisory pan-els set up within government agencies to gather opin-ions from producer and labour groups (see Alt andGilligan 1994; Verdier 1994).

Legislative institutions can influence other types offoreign economic policies too. One line of work byscholars has been focusing on the general differencesbetween multi-party coalition governments and sin-gle-party majority governments. Coalition govern-ments appear to have less incentive than majoritygovernments to alter their monetary policy prior toelections to try to boost economic activity in an‘opportunistic’ fashion, since voters find it difficult toassign blame or credit to any single party within thecoalition. An implication seems to be that coalitiongovernments are also much more likely than othertypes of government to adopt fixed exchange ratesand give up control over monetary policy (seeBernhard and Leblang 1999).


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Bureaucratic agencies

Lastly, there is the issue of how foreign economic poli-cies are implemented or administered by the bureau-cratic agencies of each government. The rules that areestablished to regulate these agencies and the waythey make decisions can play a powerful role in shap-ing policy outcomes. Legislatures delegate theresponsibility for implementing their laws to theseagencies, establishing the rules by which they areto operate, the ways in which their performanceis monitored and evaluated, and so on. Built intothese relationships between the legislature and thebureaucracy, however, there is always some measureof ‘slack’—that is, some room for bureaucrats tomanoeuvre free from legislative interference. Thisbureaucratic independence can have importanteffects in terms of foreign economic policies.

When it comes to the implementation of trade poli-cies, for example, there is often a real fear that thebureaucratic agencies that administer various aspectsof trade laws may develop a far too cozy relationshipwith the sectors of the home economy that they aresupposed to be regulating. This danger of bureau-cratic ‘capture’ appears to be very real. In the US case,the Departments of Commerce and Agriculture areboth regarded as unapologetic advocates of protec-tion for their ‘clients’—American business firmsand farmers. Indeed, the International TradeAdministration, located within the Department ofCommerce, is renowned for having ‘gone native’.Charged with making rulings on petitions from UScompanies claiming that foreign firms are dumpingproducts below cost in the American market, the ITAfinds in favour of local firms in approximately 99 percent of cases (see Bovard 1991).

This problem is by no means unique to theAmerican system. In Japan, the Ministry forInternational Trade and Industry (MITI), and theMinistry for Agriculture, Forestry, and Fisheries(MAFF), have long been known for their extremelyclose ties with Japanese industry and the farming andfishing communities (see Okimoto 1988: 310). WhileMITI was for many years heralded by Westernobservers as the model for a new kind of autonomousstate bureaucracy, capable of expertly targeting subsi-dies to particular manufacturing industries thatwould excel in competition with foreign producers

(Johnson 1982), comprehensive evidence from recentstudies indicates that MITI actually allocated supportto favoured industries in a highly political andineffective way, much like captured bureaucracieselsewhere (see Beason and Weinstein 1993).

In general, extreme cases aside, the interplaybetween bureaucratic independence and account-ability is a complex thing. In some issue areas, greaterindependence is generally regarded as desirable.Central banking is perhaps the most important case.The general problem, which we have discussed brieflyabove, is often referred to as the time inconsistency ofmonetary policy. Governments have an incentive toallow an unexpected rise in inflation that boosts eco-nomic activity, especially when facing an upcomingelection. But since private actors know this, anypromises a government may make to keep inflation incheck may not be considered credible. Even if the gov-ernment has all the best intentions, private actorsmight nevertheless keep inflation expectations high.By delegating control over monetary policy to anindependent central bank that is insulated from anypolitical temptations to alter monetary policy, thegovernment can beat the problem. Moreover, inde-pendent central banks also appear to play an impor-tant role in shaping currency policies. Recent studieshave indicated that governments in countries withindependent central banks are less likely to engage inelectorally motivated manipulations of exchangerates (Clark and Reichert 1998). And a related claim isthat governments that can commit credibly to lowinflation by establishing an independent centralbank are less likely to need to fix their exchange rate inorder to gain anti-inflationary credibility. Centralbank independence and fixed exchange rates, inother words, can function as policy substitutes (seeClark and Hallerberg 2000).

Key points

� Restrictions on the franchise can give more weight toone side relative to others in contests over foreigneconomic policies. Extensions of the franchise tourban classes tend to produce more open policiestoward trade and investment in labour and capital-abundant countries, and more closed or protectionistpolicies in labour and capital-scarce economies.


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� Collective action is easier to organize in the relat-ively small groups that benefit from a particulartrade restriction than in the much larger groups thatare hurt by the restriction, so the strongest lobbyingpressure tends to come from protectionist groups.

� Proportional representation systems with strongpolitical parties typically generate lower levels oftrade protection and other restrictions than plural-ity rule systems in which particular local andregional interests have a greater influence.

� Small electoral districts in plurality rule systemstend to increase the influence of sectoral or particu-laristic groups over elected representatives whencompared to larger districts, and thus lead to higherlevels of protection.

� In plurality rule systems in which elections are all-or-nothing contests between the major parties, gov-ernments are less likely to fix exchange rates thangovernments in proportional representation systems.

� Whether a government allows protectionist logrolling in a legislature, and whether a president

There is really no such thing as the ‘national interest’when it comes to foreign economic policy—or, ratherthere is no one national interest, there are many.Different individuals have very different conceptionsof what is best for the nation and, not coincidentally,best for themselves, when it comes to setting foreigneconomic policies. This chapter has attempted to out-line the principal divisions that usually characterizedomestic political battles over trade, immigration,investment, and exchange rates. These divisions, as wehave seen, tend to fall along either class or industrylines. Owners of capital and workers are typically pittedagainst one another when it comes to restrictions oninflows of labour or capital, for example, but they tendto take the same position in each industry on trade andexchange-rate issues since the effects of policy can bevery different for different sectors of the economy.

Once we know who wants what, the next taskinvolves figuring out who gets what they want from

the political process. This second step involvesunderstanding how policies are decided in differentcountries and thus how differences in political insti-tutions affect economic policy choices. Our ultimategoal is to figure out why governments in differentcountries often choose very different types of trade,immigration, investment, and exchange-rate policies.We might also hope to form some reasonably accuratepredictions about what our governments are likely todo in the future. Understanding why governmentsmake the choices they make, and predicting whatthey will do next, requires careful attention to thepolitical pressures they face from domestic groupsand to the ways in which the preferences of thesegroups are aggregated into collective decisions bypolitical institutions. But there are at least three addi-tional complications to this simple analytical picturethat we should discuss briefly here: the first hasto do with the knowledge or information that

supports trade liberalization, will depend on theirpartisan affiliation and the policy preferences oftheir party’s core electoral constituency.

� An explicit institutional connection that links tariffreductions at home with reciprocal reductions intariffs abroad (e.g. a free trade agreement), can gen-erate much stronger support for trade policy reformamong export-oriented industries.

� Rules that provide access for organized groups toexert lobbying pressure to change particular fea-tures of legislation make trade protection and otherforms of restriction more likely.

� The delegation of policy-making authority tobureaucratic agencies or bodies independent fromnational legislatures may not produce policies lessaffected by lobbying from protectionist interests,since groups may gain privileged access to decisionmakers in such agencies.

� The existence of an independent central bankmakes it less likely that a government will choose tofix the exchange rate.


Conclusions, extensions, and complications

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individuals have about the effects of different policiesand about the preferences of others; the secondextension involves allowing for linkages betweenthe various policy issues and between these issuesand other non-economic policy concerns; and thethird complication involves international bargainingand the ways in which we might think about theconnection between domestic politics and inter-national politics.

Information and the role of ideas

Who gains and who loses? And who wins the politicalcontest between those who gain and lose? Answeringthose questions in each issue area is the heart of thestandard political economy approach that we haveoutlined above. In keeping with traditional assump-tions, we have been taking it for granted that indi-viduals know what they want, know what others wanttoo, and know what types of policies will have whatkinds of effects. These are heroic assumptions. A greatdeal of the most recent research in both economicsand political science, in fact, has tried to depart fromthis notion that people have full or complete inform-ation about their world, examining the effects ofuncertainty, asymmetry in information amongactors, and changes in knowledge that might beattributable to learning and the impact of new ideas.It is useful in this respect to distinguish between twobasic types of information that individuals may bemissing: people may be lacking knowledge about theeffects of different policies on economic outcomes, orthey may not have full knowledge about other people(including government leaders) and their prefer-ences. We can discuss each of these informationalproblems separately.

What if we allow that individuals are not sureabout the effects of different types of policies? It tookus quite a while to disentangle the various effects oftrade, immigration, investment, and exchange-ratepolicies above, with the help of several simplifyingassumptions, so this does seem an important ques-tion to pose. It clearly provides a large windowthrough which new ideas, in the form of new beliefsabout cause-and-effect relationships betweenpolicies and outcomes, might have a large impact on

policy making. Indeed, this is the view espoused byJohn Maynard Keynes (1936: 383) in his famous con-tention that ‘the ideas of economists and politicalphilosophers, both when they are right and whenthey are wrong, are more powerful than is com-monly understood. Indeed the world is ruled bylittle else.’

Several prominent scholars have indeed argued thatforeign economic policies have changed markedly inresponse to new ideas about policies and their effects.The abandonment of mercantilist restrictions ontrade and investment by most European governmentsin the nineteenth century has been attributed, insome large measure, to the ideas of Adam Smith andDavid Ricardo and the development of classical tradetheory (Kindleberger 1975; Bhagwati 1988). The multi-lateral liberalization of trade and investment amongWestern economies in the post-Second World War era,allowing governments considerable scope for manag-ing their domestic economies to avoid recessions, hassimilarly been traced to the refinement of classical andneoclassical economic theories and the ideas ofKeynes himself (Ruggie 1982; Goldstein 1993). Morerecently, the rush to liberalize trade by governments indeveloping nations has been attributed to a learningprocess and the discrediting of the idea that rapiddevelopment could be achieved by import-substitu-tion policies (see Krueger 1995). Competing ideasabout cause-and-effect relationships often appear inpolicy debates, and dominant ideas are frequentlyembedded within policy-making institutions as thefoundations for rules followed by bureaucratic agen-cies (Goldstein 1993). Yet there remains much debateabout the degree to which these types of ideas areindependent of the interests that might be served bythem. Weber’s famous analogy compared ideas to‘switchmen’ who determine the tracks along whichhuman behaviour, pushed by interests, travel (Weber1913). From a more sceptical perspective, one mightsuggest that the individuals who gain and lose themost from any economic policy, such as tariffs ontrade, have all the knowledge they need about itseffects and need no new ideas from economists to helpthem out; the policies just reflect the wishes of thoseinterested actors who have the most political clout,and the ideas that attract our attention are just theones sprinkled like holy water over the new legislation


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(to borrow an equally memorable metaphor fromKindleberger). The relationship between ideas andinterests is still very murky, and will remain so until wehave a better understanding of where new ideas aboutpolicy come from, and what explains which ideascatch on and spread.

But by focusing just on the role of new ideas andhow they might change knowledge about policies, wemay actually be missing the bulk of the iceberg herewhen it comes to the impact of incomplete informa-tion. We noted in the discussions above that whileforeign economic policies such as tariffs on importedgoods generate real costs for a large set of owners andworkers in all the other (non-protected) sectors of theeconomy, these costs are dispersed across such a largenumber of individuals that the per-person losses canbe extremely small. Not only will it not pay for thoseaffected to take political action to oppose the tariff inthese cases, it may not even pay for them to spend anytime or resources acquiring accurate informationabout the policy and its effects. Public opinionexperts typically regard foreign economic policies as aparticularly complex set of issues about which surveyrespondents have very low levels of information

(see Bauer, Pool, and Dexter 1972: 81–4). Surveyresponses to questions about these issues tend to varydrastically with simple changes in question wording,making it very difficult to pinpoint where the publicstands on any policy question at any particular pointin time (see Destler 1995: 180). One implication is thatvoters may be very susceptible to issue framing ormanipulation by political leaders and organizedlobby groups whenever these issues become moreprominent. Recent research on political communica-tion and public opinion has highlighted this possibil-ity (for example, Manheim 1991; Zaller 1992: 95). Tothe extent that this type of influence can be exercised,the politics of globalization may be regarded, at leastto some degree, as a competition in issue framingamong organized interests on different sides of thedebate trying to sway public opinion to their side.This did appear to be an important dimension of theintense debate over NAFTA in the United States in1993 (Holsti 1996: 52).

Another interesting implication of incompleteinformation among voters is that it may providean explanation for why governments so often seem todo very inefficient things when setting foreign


Box 3.7 The rise of free trade in Europe

The publication of The Wealth of Nations by Adam Smith in1776 stands out as an intellectual landmark in the history ofthinking about international trade, pointing out the criticalrole that trade plays in encouraging specialization and theresulting gains in efficiency and wealth. Smith adroitlypunctured the old doctrine of mercantilism, whichfavoured expanding exports while restricting imports andhoarding gold, making it clear that national wealth isdefined not by stocks of gold but by how much citizenscan consume with the resources they have at their dis-posal. But the modern theory of international trade reallybegan with the arrival of David Ricardo’s Principles ofPolitical Economy and Taxation in 1817. Ricardo demon-strated that trade is mutually beneficial for all countries,even a country that cannot produce anything more effi-ciently than other nations in terms of the costs of its inputs.As long as the costs of production are different in differentnations, Ricardo’s analysis showed that it must be truethat, in terms of the opportunity costs of production (the

value of other things that might have been produced withthe inputs used to make a given item), each nation will bebetter at producing some things than others and thusthere is a basis for specialization and exchange that willleave both countries better off. This ‘law of comparativeadvantage’, which Paul Samuelson has called the mostbeautiful law in economics, has had a profound impact onall scholarly and political debates about trade ever since.That the cause of free trade was taken up enthusiasticallyby the leading English political economists, including JohnStuart Mill, all inspired by Ricardian theory, and that theseideas also spread rapidly throughout Europe during thenineteenth century, has led many scholars to suggest thatthe broad shift away from trade protectionism in Europe(which began in 1846 with the repeal of the Corn Lawsthat Ricardo himself had attacked) was due in large meas-ure to a profound change in the way leaders understoodthe economic effects of trade (see Kindleberger 1975;Bhagwati 1988).

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economic policies. Economists are fond of pointingout that if a government really wanted to redistributeincome to particular groups of owners and employ-ees, using restrictions on trade is a very inefficient wayto go about it. It would be far better just to make adirect, lump sum payment to these groups that standto benefit from protection, and thus avoid the ineffi-ciencies generated by the allocation of resources tosuch uncompetitive industries. But if the costs of suchdirect payments to taxpayers are more visible(because they must appear, say, in the government’sannual budget), they are more likely to generate abacklash among the voters on whom the burden falls.If this is true, it may make sense for a government touse trade policies to redistribute income to favouredgroups because these policies provide an effective dis-guise in a low-information environment (see Tullock1983). From this perspective, the use of trade protec-tion can be characterized as ‘optimal obfuscation’(Magee, Brock, and Young 1989).

Finally, what happens if we allow that individuals,even if they are fully informed about the effects offoreign economic policies, may nevertheless beuncertain about the motivations or intentions of thegovernment managing them. One circumstance inwhich this type of incomplete information canbecome important is when setting exchange-rate pol-icy, as we have discussed above. Since governmentshave an incentive to print money and allow a burst ofinflation when facing an election, any promises theymake to keep inflation in check may not be consider-ed credible by private actors who understand that thegovernment has an incentive to bluff and portrayitself as ‘tougher’ on inflation than it really is. Theproblem is that no one can be sure that the govern-ment values its low-inflation reputation enough (rel-ative to how much it wants to win re-election) to keepits pledge; even if the government would have fol-lowed through with its promises, private actors mightnevertheless keep inflation expectations high. Ifthere is no independent central bank to which con-trol of monetary policy can be ceded, governments inthese circumstances are likely to be drawn more to fix-ing the exchange rate, especially in countries thathave a history of chronic inflation. Fixing the value ofthe currency is a way for the government to signal toprivate actors that it is committed to keeping inflation

under control by raising the potential costs to itselfshould it fail.

Another important context in which incompleteinformation about the government may play a keyrole in shaping policies is the case in which a govern-ment is attempting to reform trade policy in the faceof stiff opposition from groups in import-competingindustries. In such cases, since the government mayindeed have an incentive to back down if it encoun-ters a major political revolt, any promises it makes inadvance to hold fast to the reforms may not be con-sidered credible by the groups (who know full wellthat the government could just be trying to bluff itsway through the painful reforms). Thus, even if thegovernment does fully intend to stick with thereforms, it may have to weather a long and costly (andperhaps even violent) political protest. Again, tyingits own hands in some clear and visible way can be anespecially attractive policy option for a government inthis situation, and by signing an international tradetreaty with a major regional partner, it might be ableto do the trick. This desire to make a credible commit-ment to trade reform is widely held to have been alarge reason why the Mexican government initiatedthe negotiations that produced the NAFTA agreementin 1993, after two decades of failed efforts to lowertrade barriers unilaterally (see Whalley 1999b).

Combinations of policies andissue linkages

Up to this point we have been examining one type offoreign economic policy at a time. It is clear, however,that the effects of different policy instruments oftendepend upon how other policies are set. In the basicHeckscher–Ohlin model, trade and factor move-ments are substitutes for one another—more of onetype of international flow will generally mean less ofanother and vice versa. If exports of labour-intensiveproducts can move easily across a border between alabour-abundant economy (where wages are low) anda labour-scarce economy (where wages are high), thiswill tend to equalize labour costs over time, reducingthe incentives for workers themselves to try tomigrate between countries. If exports between the


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countries are blocked or impeded, more workers arelikely to try to cross the border into the country thatpays higher wages. When a dam is placed in front offlows in one channel it tends to divert flows into otherchannels.

This interaction among policies can become veryinteresting because we know that while trade and fac-tor flows are substitutable in general terms, they actu-ally have different types of effects on individuals.Individuals may thus have preferences over differentcombinations of policies. Perhaps the best exampleconcerns the relationship between trade flows (andtrade barriers) and direct investment. There is a greatdeal of evidence that firms engage in direct invest-ment in markets as a way of ‘jumping’ trade barriersthat would inhibit exports, and they even seem toreduce exports and invest more to stave off anti-cipated pressure for tariffs among local firms—aphenomenon known as ‘quid pro quo foreign invest-ment’ (Bhagwati et al. 1987; Blonigen and Feenstra1996). Local firms may be able to raise trade barriers,since they should have the lobbying support of theirworkers whose jobs are endangered by high levels ofimports, but they are less likely to win restrictions oninward direct investment by foreign firms since work-ers in the industry will benefit from any new inflowsof capital. Indeed, the best policy combination for localworkers in an industry facing competition from a(relocatable) foreign producer is a high tariff and norestrictions on inward foreign investment. Local firmswould prefer restrictions of both types of exchange,but would accept any restrictions rather than none atall if those are the politically feasible options. Thispolitical logic helps explain the common pattern inpolicies toward the automobile industry in Europeand North America, where restrictions on importswere negotiated with Japanese auto firms but norestrictions were imposed to block the same firmsfrom investing heavily in production facilities withinboth markets.

Exchange-rate policy can also be ‘in play’ at thesame time as trade policy. Trade policy and exchange-rate policy are partially substitutable: a 1 per centdepreciation of the currency is equivalent to a 1 percent across-the-board tariff on imports and a 1 percent subsidy for all exports. But clearly the coalitionthat supports depreciation—those invested andemployed in both import-competing and exporting

industries—is different from the coalition that wouldsupport higher tariffs (import-competing interests).Exchange-rate policies tend to be more rigid thantrade policies, in general, mainly because the credibil-ity of monetary policy commitments is underminedby frequent shifts in policy. But when there is anopportunity for the government to alter the exchangerate, intense lobbying for protection by import-com-peting groups (or even just the threat of it), mayinduce export interests to help persuade the govern-ment to weaken the currency—an outcome thatwould ease the competitive pressure on producersthreatened by imports, while not harming (benefit-ing, in fact) those engaged in export industries. Thisseems to have been the case in the United States in theearly 1980s, as the value of the US dollar rose dramatic-ally. While the White House appeared to prefer toleave both its currency and trade policies unchanged,fearing a spate of protectionist legislation fromCongress in response to lobbying by firms and unionsin import sensitive sectors, and hearing support fordepreciation from export interests as well, it moved in1985 to weaken the value of the dollar. Similarly, inmany Latin American nations in the 1980s and 1990s,governments attempting reforms aimed at loweringbarriers to trade were able to render these changesmore politically palatable to threatened sectors bydevaluing exchange rates at the same time (see DeGregorio 2001).

Perhaps even more important, in some ways, thanthese connections between different foreign eco-nomic policies are the linkages that have been madewith increasing frequency in recent policy debatesbetween these policies and a variety of non-economic

issues. Some of these linkages are not new. Trade andinvestment policies have always been connected invarious ways to the issue of national security. Mostgovernments place tight controls on trade in weaponsand dangerous chemicals, for instance, and restric-tions on foreign investment in strategically importantindustries (for example, energy, airlines, and broad-casting) are also common. And governments havestrong incentives to lower barriers to trade and invest-ment more rapidly among alliance partners thanwith other nations in the international system, as thepost-Second World War experience in Europe, andamong the industrialized democracies more gener-ally, makes clear (see Gowa 1994). All individuals


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within an economy tend to share similar concernsabout national security, so this form of issue linkagetends to affect policy making in a fairly straightfor-ward way, generating more support among all citizensfor policy options that contribute most clearly tonational security. But foreign economic policies arenow linked more regularly with a range of othernon-economic issues about which individuals tend tohave more varied opinions. Most importantly, tradeand investment are now frequently linked to discus-sions of environmental policy and to human rightsissues in the political debates about globalization inWestern democracies.

How do these issue linkages affect the analysis ofthe politics of trade and investment? The clearestimpact is the involvement of a variety of organizedenvironmental and human rights groups in recentdebates over regional trade agreements and the WTO(see Destler and Balint 1999). The members of thesegroups care deeply about addressing environmentaland human rights problems in their own countriesand in other countries around the world, and theyeither believe that globalization is making these prob-lems worse and thus should be restrained in someway, or they argue that trade and investment provideeconomic leverage which can and should be used topersuade governments in developing nations toimprove environmental and labour standards anddemocratic institutions. The position taken by manyof these groups is that all trade agreements, includingthe WTO itself, should include provisions for mini-mum environmental and labour standards thatwould be enforced (if necessary) by the imposition oftrade sanctions. Many environmental groups havealso lobbied for changing the existing rules of theWTO, so that laws that discriminated against foreignproducts on environmental grounds (for example,import bans on tuna caught using nets that alsoendanger dolphins) would be permissible. But envi-ronmentalists and human rights activists have alsoexpressed grave concerns about the behaviour ofmultinational firms in developing nations, withmuch of the focus being on whether these large cor-porations are moving production to areas in whichthey can pollute and otherwise damage the environ-ment, or run ‘sweatshop’ factories in which they mis-treat and underpay workers, avoiding the regulatorysupervision that would prevent such behaviour in

their home countries. The policies recommended bythese groups, and especially by human rights organi-zations worried by the lack of democratic institutionsin countries such as China, typically involve amore proactive use of economic sanctions—that is,Western governments cutting off trade with, andinvestment to, such ‘problem’ nations until theirleaders make significant political reforms. Consumerboycotts aimed at particular corporations that areinvesting in such nations are usually warmly recom-mended too (although these types of consumeractions represent private, market behaviour and arethus not a question of public policy).

One important general development has been theformation of what might be called ‘Baptist and boot-legger’ coalitions between some of these issue groupsand the business and labour organizations that havean economic stake in restricting international tradeand/or investment. This type of coalition gets itsname from American politics in the era ofProhibition, when strong support for the ban on alco-hol sales came from Baptists, on moral grounds, andfrom bootleggers, who made large fortunes sellingalcohol on the black market (see Yandle 1984). Inrecent debates over the NAFTA in the United States,for instance, environmental groups such as the SierraClub, joined with labour unions in lobbying againstthe agreement on the grounds that it did notcontain provisions that would ensure a substantialimprovement in environmental and labour standardsin Mexico (see Destler and Balint 1999: 42–5). Andrecent ‘anti-sweatshop’ campaigns, organized byhuman rights groups and student activists, and tar-geting foreign investment and outsourcing by USapparel manufacturers to nations such as Vietnamand China, have been backed financially and sup-ported enthusiastically by American textile unionsand firms producing locally.

The concern among many analysts, especiallyamong those who generally support internationaleconomic integration for its ability to raise livingstandards in all countries, is that these types ofpolitical coalitions may be hijacked by their protec-tionist members who support restrictions on interna-tional trade and investment regardless of whetherthey have any positive (or negative) long-term effectson environmental conditions or human rights stan-dards. It would be far better, many argue, to pursue


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improvements in environmental and human rightsstandards by working towards separate internationaltreaties dealing with those precise issues in a moredirect way, perhaps by compensating developingnations for making costly improvements to theirenvironmental and labour laws. Sanctions couldseverely limit economic growth in the very poorestdeveloping countries where governments are likelyto resist making political concessions (especiallydemocratic reforms that increase the risk thatthey will be toppled from power). The issues are com-plex, however, and the political problems are diffi-cult. The ‘Baptists’ are drawn to supporting economicsanctions rather than other policy instruments (forexample, new international treaties, or foreign aidgrants to nations that improve their environmentalstandards) because they have calculated that thesealternatives are politically infeasible. With the sup-port of the ‘bootleggers’ for restrictions on trade andinvestment, however, they might stand a greaterchance of getting something done that will havebeneficial effects.

The general point here is that our simple, one-issue-at-a-time approach to the analysis of foreign eco-nomic policies becomes much more complicatedwhen we allow that different policy instruments areoften up for grabs at the same time and have partiallysubstitutable effects, and if we account for the factthat a variety of groups are often interested in usingthe tools of foreign economic policy to advance non-economic types of goals. Often it is the institutionalcontext in which government decisions are made(many of the features of which we have discussedabove) that determines which types of policy instru-ments are more adjustable than others and whichtypes of political coalitions are more viable than oth-ers. The most comprehensive and persuasive accountsof economic policy making will take all these com-plexities into account.

International bargaining anddomestic politics

Finally, in anticipation of the chapter that follows, itis worth pausing here briefly to consider the ways in

which the domestic politics of foreign economicpolicies may be translated into international-levelbargaining over these same issues. What we reallyrequire here is a theoretical model of the policy-making process that takes into account all of theincentives and constraints operating among actors atboth the domestic and international levels. This isthe type of model Putnam (1988) famously envi-sioned using the metaphor of the ‘two-level game’. Agovernment engaged in international economicnegotiations actually plays two different political‘games’ at the same time, he suggested, with itsactions constituting ‘moves’ that must be seen notonly in the context of the demands made by indi-viduals and groups in domestic politics, but in view ofthe bargaining power that it has when negotiatinginternational agreements with other governments.Government leaders negotiate with other leaders atthe international level over the terms of economicagreements, and in those negotiations the relativesize and strength of the economy can make a tremend-ous difference to the terms that can be demanded.But the leaders must be attuned to the preferences ofthe domestic groups whose support they need toremain in office and the set of international dealsthat would actually be ratified or supported by thesegroups at home.

To date, theoretical work along these lines hasfocused mainly on differences between the prefer-ences of legislative and executive branches of govern-ment, and their different agenda-setting and vetoingpowers, and how these features of domestic politicsaffect the outcomes of international negotiationsand agreements (see Evans, Jacobson, and Putnam1993; Milner 1997a). Much of the attention has beendirected to the so-called ‘Schelling conjecture’,which holds that a hawkish domestic constituency—represented in the simplest models as a legislaturethat prefers very little international cooperation—can actually improve the bargaining power of theexecutive branch in its dealings with foreign counter-parts (Schelling 1960: 28–9). Recent work has alsofocused on how executive-legislative divisions affectthe credibility of governments during internationalnegotiations (for example, Martin 2000) andwhether international agreements are negotiatedto allow for greater flexibility in cases when


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future changes in domestic political coalitionsmight lead to substantial shifts in the types ofpolicies a government can implement (Downs andRocke 1995).

While full of insights about the effects of domesticpolitical institutions on the prospects for inter-national cooperation, this line of work has so far paidvery little attention to the roles played by organizedinterests and voters in shaping legislative and execu-tive preferences on particular policy issues. In fact, todate, standard political economy models of trade pol-itics, emphasizing the role played by organized lobbygroups in the formulation of policy, have not beenlinked at all to two-level game models of negotia-tions over trade and other economic agreements.Moreover, the existing work on two-level games tendsto concentrate overwhelmingly on parameters thatoperate only on one level—domestic politics in thehome nation. Features of the strategic relationshipbetween nations, such as the economic and militaryasymmetries that might affect relative bargainingpower, or common ties to alliances or internationalinstitutions that might affect incentives to cooperate,are largely ignored. We clearly need a better two-levelmouse trap: a model that incorporates a fuller repre-sentation of organized interests and lobbying at thedomestic level, while also allowing for the ways inwhich incentives and constraints are generated at theinternational level.

In practice, most international political economistswork with partial theories that focus on one set ofcausal variables operating at one level. Some arguethat the features of the international system, such asthe distribution of economic power, and any specificnation’s position within it, impose broad but impor-tant constraints upon what governments can andcannot do when setting policies. Others, in keepingwith the orientation of this chapter, argue that theprime focus of our attention should be placed onwhat is going on within nations—their particular setsof political institutions and the preferences and lob-bying activities of different group of individuals—since it is these things that primarily determine thepolicies chosen by governments. But in principal,almost all scholars recognize that politics at both thedomestic and international levels should be a featureof any complete analysis of foreign economic policy.

Integrating theoretical insights about politics at thesetwo levels is an extremely complex and challengingtask that still remains, to a very large extent, undone.

Key points

� To understand the domestic origins of foreign eco-nomic policies we need to perform two main tasks:first, map the policy preferences of different groupsin the domestic economy, and then specify howpolitical institutions affect the way these preferencesare aggregated into actual government decisions.

� Policy preferences depend mainly on the types ofassets people own, and how the income earnedfrom those assets is affected by different policies.

� Political institutions affect policy outcomes bydefining who gets to vote, how political representa-tives are elected, and how policy making takes placein legislatures and is delegated to presidents andgovernment agencies.

� New ideas about cause-and-effect relationshipsappear to have had a large impact on foreign eco-nomic policies in different eras. The relationshipbetween ideas and interests is far from clear, how-ever, and we need a better understanding of wherenew ideas about policy come from and whatexplains which ideas catch on and spread.

� Foreign economic policies involve a complex set ofissues about which most voters have very low levelsof information. As a result, the politics of globaliza-tion may be regarded to some degree as a competi-tion in issue framing among organized interests.

� If private actors have incomplete information aboutthe degree to which the government is committedto policy reforms, the government may have anincentive to tie its own hands in some visible way(e.g. by fixing the exchange rate, or signing a tradetreaty) to signal its intentions in a credible way.

� Since the effects of a change in one type of foreigneconomic policy may depend upon choices madeabout other types of policy, individuals may havepreferences over different combinations of policiesthat are closely related (e.g. tariffs and restrictionson inward investment induced by tariffs).


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� Trade and investment policies are also linked to dis-cussions of non-economic issues. One importantdevelopment has been the formation of ‘Baptist andbootlegger’ coalitions between environmental andhuman rights groups concerned about globaliza-tion and business and labour organizations thathave an economic stake in restricting internationaltrade and investment.

� Governments may be thought of as playing politicalgames at two levels, their actions constituting

moves that are both responses to demands made bygroups in domestic politics and responses to offersmade by other governments in international negotia-tions.

� We need a better theory of two-level games thatincorporates fuller representations of both domes-tic and international politics. In practice, mostinternational political economists employ partialtheories that focus only on variables operating atone level.


QUESTIONS

1 If the economic case for trade liberalization is so strong, why is it that governmentscontinue to impose barriers to trade and are so frequently engaged in trade disputes?

2 Trade theory does not imply that every individual within each nation will benefit fromthe lowering of trade barriers, just that aggregate benefits will exceed aggregatelosses. Who stands to benefit most from trade liberalization in the advancedeconomies of Europe, Japan, and the United States and who is most likely to bedisadvantaged? What about in developing nations with different types of factorendowments?

3 Can these different groups of individuals reach some kind of agreement so that tradeliberalization can benefit everyone? What are the political obstacles to this type ofagreement?

4 Is it inappropriate to think only, or primarily, in terms of economic gains and losseswhen evaluating the effects of increased international trade? How important are othertypes of concerns (for example, national security, income inequality, environmentalhazards, human rights abuses) in the political debates that determine policyoutcomes?

5 What types of electoral and policy-making institutions tend to mitigate the effects oflobbying by protectionist groups when it comes to the determination of trade policy?Are electoral systems based upon proportional representation likely to generate lessprotection than plurality systems?

6 Do the economic effects of immigration shape the political struggles over changes inimmigration law? Or do the politics of immigration reflect other types of cultural andsocial divisions within host countries?

7 What are the economic effects of foreign investment for the source country and for thehost country? Does foreign investment generate a ‘race to the bottom’ in labour andenvironmental standards in developing countries? Does it inhibit democratic reform?

8 What economic and political changes during the twentieth century led to theabandonment of fixed exchange rates among the advanced economies? Why domany developing countries continue to fix their exchange rates?

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FURTHER READING

Trade

Destler, I. M. (1995), American Trade Politics, 3rd edn. (Washington DC: Institute forInternational Economics). This is required reading for anyone interested in how US tradepolicy is made. It provides a comprehensive analysis of American political institutions andpolicy making

Hayes, J. P. (1993), Making Trade Policy in the European Community (London: Macmillan). Thisbook provides a thorough discussion of the processes of trade policy making in theEuropean Community.

Hiscox, M. J. (2002), International Trade and Political Conflict (Princeton: Princeton UniversityPress). An analysis of historical changes in levels of factor specificity in several Westernnations, relating these changes to shifts in political alignments in trade politics.

Krueger, A. O. (1995), Trade Policies and Developing Nations (Washington DC: BrookingsInstitution). An engaging discussion of trade liberalization in developing nations in recentyears.

Rogowski, R. (1989), Commerce and Coalitions (Princeton: Princeton University Press).A sweeping analysis of coalitions in trade politics in a variety of historical contexts, basedupon an application of the Stolper–Samuelson theorem.

Immigration

Borjas, G. J. (1999), Heaven’s Door: Immigration Policy and the American Economy (Princeton:Princeton University Press). A provocative analysis of the effects of immigration in theUnited States in recent decades.

Fetzer, J. S. (2000), Public Attitudes toward Immigration in the United States, France, and Germany

(Cambridge: Cambridge University Press). This book uses available survey data to comparepublic attitudes toward immigration in the United States, France, and Germany and thedeterminants of anti-immigrant sentiments.

Tichenor, D. J. (2002), Dividing Lines: The Politics of Immigration Control in America (Princeton:Princeton University Press). A very impressive history of immigration politics in the UnitedStates.

Investment

Crystal, J. (2003), Unwanted Company: Foreign Investment in American Industries (Ithaca, NY:Cornell University Press). An excellent study of political debates about inward direct foreigninvestment in the United States

Graham, E., and Krugman, P. R. (1995), Foreign Direct Investment in the United States (WashingtonDC: Institute for International Economics). This book provides a comprehensive analysis ofthe economic and political effects of inward foreign investment.

Moran, T. (1998), Foreign Direct Investment and Development (Washington DC: Institute forInternational Economics). An excellent study of the effects of direct foreign investment indeveloping nations.

Exchange Rates

Frieden, J., Ghezzi, P., and Stein, E. (eds.) (2001), The Currency Game: Exchange Rate Politics in

Latin America (New York: Inter-American Development Bank). A very interesting collectionof research on the politics of exchange rate policies in Latin America.

Henning, R. C. (1994), Currencies and Politics in the United States, Germany, and Japan

(Washington DC: Institute for International Economics). This book provides a clear and


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detailed discussion of exchange-rate policy making in the United States, Germany, andJapan.

Simmons, B. A. (1994), Who Adjusts? Domestic Sources of Foreign Economic Policy During the

Interwar Years (Princeton: Princeton University Press). An impressive analysis of the politicaldeterminants of exchange-rate policies adopted by Western nations in the inter-war period.

Institutions

Gilligan, M. (1997), Empowering Exporters: Reciprocity and Collective Action in Twentieth Century

American Trade Policy (Ann Arbor: University of Michigan Press). A fine study of theimportance of institutionalizing reciprocity in trade policy making.

Hiscox, M. J. (1999), ‘The Magic Bullet? The RTAA, Institutional Reform, and TradeLiberalization’, International Organization, 53/4: 669–98. A critical review of research on theRTAA that emphasizes the role of political parties and their core constituencies in thepolitics institutional change.

Rogowski, R. (1987), ‘Trade and the Variety of Democratic Institutions’, International

Organization, 41/2: 203–23. A classic analysis of the ways in which different types of electoralinstitutions affect trade policy outcomes in democracies.

Wintrobe, R. (1998), The Political Economy of Dictatorship (Cambridge: Cambridge UniversityPress). An excellent analysis of policy making in non-democratic regimes.

Extensions and complications

Elliott, K. Ann, and Freeman, R. (2003), Can Labor Standards Improve under Globalization?

(Washington DC: Institute for International Economics). This book provides acomprehensive review of the debates about whether trade and investment policies shouldbe linked to agreements about improving labour standards in developing nations.

Goldstein, J., and Keohane, R. O. (eds.) (1993), Ideas and Foreign Policy: Beliefs, Institutions, and

Political Change (Ithaca, NY: Cornell University Press). An important collection of essaysdiscussing the impact of new ideas on foreign policy outcomes.

Graham, E. (2000), Fighting the Wrong Enemy: Anti-Global Activists and Multinational Enterprises

(Washington DC: Institute for International Economics). A compelling analysis of theeffects of direct foreign investment in developing nations that argues that criticisms madeby environmental and human rights groups are misguided.

Irwin, D. (1996), Against the Tide: An Intellectual History of Free Trade (Princeton: PrincetonUniversity Press). A sweeping account of theoretical developments in economics thatsupport the case for trade liberalization.

WEB LINKS

For regular research reports and briefs on policy issues:

www.iie.com/ Institute for International Economics.

For theoretical background on international economics and helpful beginner guides:

www.internationalecon.com/ International Economics Study Center.

www.amosweb.com/gls/ Amos World Economics Glossary.

For data and analysis of public opinion on international economic issues:

http://people-press.org/pgap/ The PEW Global Attitudes Project.


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www.pipa.org/ The Program on International Policy Attitudes (PIPA).

For data on world trade, migration, and investment:

www.wto.org/english/res_e/statis_e/its2003_e/its03_toc_e.htm WTO’s International TradeStatistics.

www.migrationinformation.org/Profiles/ ILO’s International Labour Migration Database.

http://r0.unctad.org/en/subsites/dite/fdistats_files/WID3.htm UNCTAD’s WorldInvestment Directory.

For information and statistics on trade, immigration, investment, and exchange-rate policies:

http://cs.usm.my/untrains/trains.html UNCTAD’s TRAINS Database of Trade ControlMeasures.

www.wto.org/english/tratop_e/dda_e/tnc_e.htm WTO’s Negotiations Committee.

www.ustr.gov United States Trade Representative (USTR).

http://europa.eu.int/comm/trade/ European Union Trade Policy.

www.meti/go.jp/english/index.html Japanese Trade Policy.

www.migrationpolicy.org/ The Migration Policy Institute.

www.imf.org/external/np/tre/tad/exfin1.cfm IMF’s Country Finances and Exchange Rates.

www.federalreserve.gov/ Federal Reserve Board.

www.bankofengland.co.uk/ Bank of England.

www.ecb.int/ European Union Central Bank.

www.boj.or.jp/en/ Bank of Japan.


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