Journal of Democracy

Journal of Democracy 11.4 (2000) 95-106

Comparing East Asia and Latin America

Capital Mobility and Democratic Stability

Sylvia Maxfield

Although the democratic governments of Latin America and Asia have managed to survive the financial crises of the 1990s, there remains widespread concern that the volatility of capital flows can suddenly, even unexpectedly, force abrupt changes in economic policy and compromise political stability, especially in fledgling democracies. Over the longer term, it is feared, governments may find themselves perennially caught between socially beneficial policies preferred by voters and capital-friendly measures demanded by footloose global investors.

Doomsaying about the political consequences of capital mobility follows a venerable intellectual tradition. ¹ Dependency theorists writing in the 1960s and 1970s linked international economic transactions of all kinds to democratic failures, and particularly to the rise of "bureaucratic-authoritarianism" in Latin America's Southern Cone. ² Even earlier, John Maynard Keynes interpreted World War II as the consequence of untrammeled international capital flows under the gold standard, which forced governments to adjust their domestic policies, wreaking social havoc that led to the emergence of fascist governments. The doomsayers, however, miss important nuances in financial-market behavior and fail to appreciate the ways in which financial flows can help strengthen young democracies.

Capital flows and financial crisis are undeniably linked in developing countries. Yet it is unclear whether these crises pose a serious threat to fledgling democracies. The relationship among financial reform, capital mobility, and democracy is very complex, and the concerns about foot-loose capital and volatility are probably overblown. Moreover, after [End Page 95] financial crises the resumption of flows can have varying effects; some types of flows may actually have a salutary impact on democratic institution-building.

The doomsday view is wrong on several counts. First, investors do not all have the same policy interests. There is no single recipe specifying which policies investors demand of the fledgling democracies where they invest. Second, international bond investors impose what Layna Mosley calls a "strong and narrow" constraint on policy. ³ In other words, bond-market investors react strongly to government policy in some areas, but do not react at all to policy change in many other areas. The literature on the determinants of aggregate financial flows to and from emerging markets supports this hypothesis. ⁴ For these reasons, international investors do not constrain government policy as much as the doomsayers imply.

Furthermore, international capital mobility and the related growth of the international securities market should help strengthen democracy in at least two ways. First, securities-market growth could help prevent the concentrations of economic power so typical of emerging-market countries today. Second, capital-market development will likely bring with it a greater demand for transparency in both the private and public sectors. Not only should this limit the scope for cronyism in emerging market countries; it should also help strengthen democratic institutions. Above all, investors seek predictability. It is easier to anticipate future economic policy in a well-functioning democracy than in a system where policies are made behind closed doors.

Financial Reform and Economic Crisis

The empirical record suggests that financial-market deregulation and financial crises are closely linked in emerging-market countries. ⁵ Recession often follows on the heels of financial and balance-of-payments crises. By financial-market deregulation, I mean measures that allow market-based individual or corporate borrowing from domestic and international financial institutions, that free domestic actors to purchase and sell shares of stock or bonds issued in local or international financial exchanges, that allow foreigners to purchase and sell securities freely on local exchanges, and that permit foreign corporations to purchase or establish domestic financial institutions.

But do these policies necessarily lead to financial crisis? The conventional wisdom is that the sequencing and pace of financial reform can raise or lower the likelihood of a problem, as can the type of exchange-rate regime in place and international liquidity cycles. This argument holds that increased access to international capital amplifies inefficiencies in recently liberalized local financial markets in what is known as the "trampoline effect." In the...