Financial Globalization and the Decline of Public Policy: A Political Economy Approach

This paper analyzes how international financial liberalization may affect the determination of domestic public policies, taking into account the political reality of developing countries. In developing countries, rich individuals who are the owners of capital often monopolize the power of political decision. It is shown that, under this non-democratic political regime, financial liberalization may lead to the decline of domestic public investment. This occurs because financial liberalization makes the domestic return on capital linked to the world interest rate and lessens the rich individuals' incentive' to promote the productivity of domestic production. If poor individuals have only labor as an internationally immobile production factor, the decreased domestic productivity caused by the decline of public investment depresses their income and welfare. Specifically, it is shown that in the financially closed economy the desired levels of public investment could coincide between the rich and the poor, but in the open economy they may radically diverge. This result implies that, under financial liberalization, there may emerge a class conflict over the determination of public investment. Further, in our model, the decreased domestic productivity may trigger off capital outflows from developing countries. Thus, this paper may also provide a possible explanation to the capital flow paradox that capital moves from capital-scarce developing countries to capital-abundant developed countries.