The Domestic Sources of Foreign Economic Policies Week 5-6 The Domestic Sources of Foreign Economic Policies

Foreign economic policies(FEP) encompass: International trade International flows of investment and capital Immigration and emigration Exchange rate for national currency

2 Key domestic explanations of different choices/decisions in FEPs 1) The policy preferences (Trade, Immigration, Foreign Investment, Exchange Rates) of different groups in the domestic economy Requires economic analysis Basic assumption: individuals and groups are concerned about how different policy choices affect their incomes 2) How domestic political institutions (Types of Political Systems, Legislatures and Policy-making Rules, Bureaucratic Agencies) determine the way these preferences are aggregated or converted into actual government decisions Requires political analysis

1) Policy Preferences: Trade (1) Heckscher-Ohlin model Differences in factor endowments (land, labour or capital) create differences in comparative advantage Each country tends to export those items whose production requires intensive use of domestically abundant factors Each country tends to import those items whose production requires intensive use of domestically scarce factors

Absolute Advantage vs. Comparative Advantage – Specialization Absolute Advantage: One nation can produce more output with the same resources as the others. Comparative Advantage: One nation produces a good of a lower opportunity cost than the other.

Heckscher-Ohlin model – Simplest form

1) Policy Preferences: Trade (2) Stolper-Samuelson theorem Outlining the likely effect of trade on the real incomes of different sets of individuals within an economy. Assumption: factors of production are highly mobile between different industries (shifting industry is easy) Trade benefits those who own the factors of production that are relatively abundant Trade hurts those who own the factors of production that are relatively scarce Trade creates winners and losers within each country: Winners would support greater trade openness Losers would be against greater trade openness

1) Policy Preferences: Trade (3) Specific factors model (now the most commonly accepted) Accounts for coalitions between labour and capital in the same industry (interests assumed to be opposed in Stolper-Samuelson) Relaxes the Stolper-Samuelson assumption that factors of production are highly mobile between different industries Different types of factors of production have very limited or specific use Trade benefits the factors of production that are employed in export-oriented industries Trade hurts the factors of production that are employed in import-competing industries

1) Policy Preferences: Immigration (1) In principle, and at the aggregate level: Freedom of movement for labour will lead to increases of total output of goods and services (at global and national levels) Labour movement should respond to price signals to improve economic efficiency International movement of labour (and other factors of production) is a substitute for movement of goods (within Heckshcer-Ohlin model)

1) Policy Preferences: Immigration (2) Who will oppose immigration? Why? “Factor-proportions” analysis Similar form of analysis to Heckscher-Ohlin endowments-based theory Additional distinction is made between types of labour: e.g. high-skilled vs. low-skilled Immigration harms local workers with similar skill levels to those of the arriving workers Owners of land and capital are likely to be the strongest supporters of more immigration Non-economic factors (culture, identity) are also very important

1) Policy Preferences: Investment (1) Portfolio investment: purchases of company shares and other forms of securities, including government bonds Foreign Direct Investment (FDI): purchase of assets by foreigners that lead to ownership control of a firm In general, it is reasonable to expect large flows of capital from industrial nations to the developing world (in line with Heckscher-Ohlin model)

1) Policy Preferences: Investment (2) Who will oppose inward investment? Why? “Factor-proportions” analysis Inflows of foreign capital will lower real returns for local owners of capital NOTE: bulk of FDI in modern world economy occur between industrial economies alone Firms gain advantages in “jumping borders” and trade barriers (e.g. access to foreign markets) FDI allows firms to internalize transactions

1) Policy Preferences: Exchange Rates (1) Policy choices: Allow the value of the currency to fluctuate freely Fix the value of the currency There is no consensus among economists on exchange rate policy There is a trade-off between monetary policy and exchange rate policy EITHER stable exchange rates but no control of monetary policy OR fluctuating exchange rates and independent monetary policy

1) Policy Preferences: Exchange Rates (2) Difficult to form simple class- or industry-based analysis of policy preferences Individual interests vary according to a range of considerations such as: Ownership of factor of production (labour or capital) Specificity of factors of production (fixed or mobile) Destination of the output of production (export or domestic market) Reliance on foreign markets (net purchases or net investments)

2)Institutions: Political Systems Autocratic regimes may support either trade liberalization or trade protection In democracies, the balance of policy preferences can be affected by: The extension of the electoral franchise The voting system adopted The cost of political action and lobbying The design of electoral districts

2) Institutions: Legislatures & Rules Legislative rules determine the way policies are proposed, considered, amended and voted upon Lobby groups’ ability to access lawmakers increases chances of protectionism An institutional ability to link domestic tariff reductions with reciprocal reductions abroad can facilitate trade liberalization

2) Institutions: Bureaucratic Agencies How bureaucratic agencies implement or administer foreign economic policies can have important effects The danger of “bureaucratic capture” by partisan groups

Complications: Information (1) Standard political economy approach assumes that individuals know what they want what others want what types of policies will have what effects More recent research has emphasized Uncertainty Asymmetry of information among actors Changes in knowledge due to learning and the impact of new ideas

Complications: Information (2) New ideas and knowledge can have a large impact on policy-making Many individuals have incomplete information about foreign economic policies and are susceptible to issue-framing or manipulation Governments may choose to “tie their hands” in order to demonstrate credible commitment to certain policies

Complications: Issue Linkages The effects of different policy instruments depend on how other policies are set Linkages can be made with both economic and non-economic policies (e.g. national security, environmental policies, human rights issues) Interesting coalitions may emerge Issues may be “hijacked” by powerful groups Non-economic goals may trump economic goals or outcomes

Complications: Int’l Bargaining Putnam’s (1988) “two-level game” Governments engaged in international economic negotiations are involved in two different political games simultaneously International level: relative size and strength can be important Domestic level: preferences of domestic groups and legislative processes are important