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Financial openness, democracy, and redistributive policy

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  • Dailami, Monsoor

Abstract

The debate about the relationship between democratic forms of government and the free movement of capital across borders dates to the 18th century. It has regained prominence as capital on a massive scale has become increasingly mobile and as free economies experience continuous pressure from rapidly changing technology, market integration, changing consumer preferences, and intensified competition. These changes imply greater uncertainty about citizens'future income positions, which could prompt them to seek insurance through the marketplace or through constitutionally arranged income redistribution. As more countries move toward democracy, the availability of such insurance mechanisms to citizens is key if political pressure for capital controls is to be averted and if public support for an open, liberal international financial order is to be maintained. The author briefly reviews how today's international financial system evolved from one of mostly closed capital accounts immediately after World War II to today's enormous, largely free-flowing market. Drawing on insights from the literature on public choice and constitutional political economy, the author develops an analytical framework for a welfare cost-benefit analysis of financial openness to international capital flows. The main welfare benefits of financial openness derive from greater economic efficiency and increased opportunities for risk diversification. The welfare costs relate to the cost of insurance used as a mechanism for coping with the risks of financial volatility. These insurance costs are the economic losses associated with redistribution, including moral hazard, rent-seeking, and rent-avoidance. A cross-sectional analysis of a large sample of developed and developing countries shows the positive correlation between democracy (as defined by political and civil liberty) and financial openness. More rigorous econometric investigation using logit analysis and controlling for level of income also shows that redistributive social policies are key in determining the likelihood that countries can successfully combine an openness to international capital mobility with democratic forms of government.

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 2372.

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Date of creation: 30 Jun 2000
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Handle: RePEc:wbk:wbrwps:2372

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Keywords: Economic Theory&Research; Environmental Economics&Policies; Fiscal&Monetary Policy; Banks&Banking Reform; Payment Systems&Infrastructure; Economic Theory&Research; Banks&Banking Reform; Environmental Economics&Policies; Macroeconomic Management; Financial Intermediation;

References

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  1. Dani Rodrik, 1998. "Democracies Pay Higher Wages," NBER Working Papers 6364, National Bureau of Economic Research, Inc.
  2. Aymo Brunetti & Beatrice Weder, 1994. "Political credibility and economic growth in less developed countries," Constitutional Political Economy, Springer, vol. 5(1), pages 23-43, December.
  3. Dailami, Mansoor, 1999. "Managing risks of capital mobility," Policy Research Working Paper Series 2199, The World Bank.
  4. Haggard, Stephan & Maxfield, Sylvia, 1996. "The political economy of financial internationalization in the developing world," International Organization, Cambridge University Press, vol. 50(01), pages 35-68, December.
  5. Dailami, Mansoor & Klein, Michael, 1998. "Government support to private infrastructure projects in emerging markets," Policy Research Working Paper Series 1868, The World Bank.
  6. Dennis Mueller, 1998. "Constitutional Constraints on Governments in a Global Economy," Constitutional Political Economy, Springer, vol. 9(3), pages 171-186, September.
  7. Devarajan, Shantayanan & Hammer, Jeffrey S., 1998. "Risk reduction and public spending," Policy Research Working Paper Series 1869, The World Bank.
  8. E. Pasour, 1994. "Redistribution and constitutional political economy," Constitutional Political Economy, Springer, vol. 5(1), pages 81-98, December.
  9. Alberto Alesina & Vittorio Grilli & Gian Maria Milesi-Ferrett, 1993. "The Political Economy of Capital Controls," NBER Working Papers 4353, National Bureau of Economic Research, Inc.
  10. Steven Radelet & Jeffrey D. Sachs, 1998. "The East Asian Financial Crisis: Diagnosis, Remedies, Prospects," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(1), pages 1-90.
  11. Razeen Sally, 1998. "Classical Liberalism and International Economic Order: An Advance Sketch," Constitutional Political Economy, Springer, vol. 9(1), pages 19-44, March.
  12. John F. Helliwell, 1992. "Empirical Linkages Between Democracy and Economic Growth," NBER Working Papers 4066, National Bureau of Economic Research, Inc.
  13. Kapstein, Ethan B., 1989. "Resolving the regulator's dilemma: international coordination of banking regulations," International Organization, Cambridge University Press, vol. 43(02), pages 323-347, March.
  14. Calvo, Guillermo A & Mendoza, Enrique G, 1996. "Petty Crime and Cruel Punishment: Lessons from the Mexican Debacle," American Economic Review, American Economic Association, vol. 86(2), pages 170-75, May.
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Citations

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Cited by:
  1. Mattoo, Aaditya & Rathindran, Randeep, 2006. "Measuring Services Trade Liberalization and Its Impact on Economic Growth: An Illustration," Journal of Economic Integration, Center for Economic Integration, Sejong University, vol. 21, pages 64-98.
  2. Barry Eichengreen & David Leblang, 2008. "Democracy And Globalization," Economics and Politics, Wiley Blackwell, vol. 20(3), pages 289-334, November.
  3. Yung-hsiang Ying & Koyin Chang & Ginny ju-ann Yang & Chen-hsun Lee, 2014. "Measuring co-movement of globalization and democratization in the time–frequency space," Economics Bulletin, AccessEcon, vol. 34(1), pages 206-219.
  4. Kozo Kiyota & Barbara Peitsch & Robert M. Stern, 2007. "The Case for Financial Sector Liberalization in Ethiopia," Working Papers 565, Research Seminar in International Economics, University of Michigan.
  5. Dilli Raj Khanal, 2007. "Banking and Insurance Services Liberalization and Development in Bangladesh, Nepal, and Malaysia: A Comparative Analysis," Working Papers 4107, Asia-Pacific Research and Training Network on Trade (ARTNeT), an initiative of UNESCAP and IDRC, Canada..
  6. El Khoury, Antoine C. & Savvides, Andreas, 2006. "Openness in services trade and economic growth," Economics Letters, Elsevier, vol. 92(2), pages 277-283, August.
  7. Geoffrey R D Underhill & Xiaoke Zhang, 2006. "Norms, Legitimacy, and Global Financial Governance," WEF Working Papers 0013, ESRC World Economy and Finance Research Programme, Birkbeck, University of London.

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