Bad Samaritans: The Myth of Free Trade and the Secret History of Capitalism

and Argentina, but not most. Above all, agricultural liberalization in the rich world should not be conditional upon further restrictions on the use of the tools of infant industry promotion by developing nations, as is currently being demanded by the rich countries.

The importance of international trade for economic development cannot be overemphasized. But free trade is not the best path to economic development.Trade helps economic development only when the country employs a mixture of protection and open trade, constantly adjusting it according to its changing needs and capabilities. Trade is simply too important for economic development to be left to free trade economists.

CHAPTER 4 The Finn and the elephant

Should we regulate foreign investment?

The Finns like to tell a joke about themselves. What would a German, a Frenchman, an American and a Finn do if they were each asked to write a book on the elephant? The German, with his characteristic thoroughness, would write a thick two-volume, fully annotated study entitled, Everything That There is to Know About the Elephant. The Frenchman, with his penchant for philosophical musings and existential anguish, would write a book entitled The Life and Philosophy of the Elephant. The American, with his famous nose for good business opportunities, would naturally write a book entitled, How to Make Money with an Elephant. The Finn would write a book entitled What Does the Elephant Think of the Finns?

The Finns are laughing at their excessive self-consciousness. Their preoccupation with their own identity is understandable. They speak a language that is more related to Korean and Japanese than to the language of their Swedish or Russian neighbours. Finland was a Swedish colony for around six hundred years and a Russian colony for about a hundred. As a Korean, whose country has been pushed around for thousands of years by every neighbour in sight – the Chinese, the Huns, the Mongolians, the Manchurians, the Japanese, the Americans, the Russians, you name it – I know the feeling.

So, it was unsurprising that, after gaining independence from Russia in 1918, Finland tried its best to keep foreigners out. The country introduced a series of laws in the 1930s that officially classified all the enterprises with more than 20% foreign ownership as – hold your breath – ‘dangerous’. The Finns may not be the subtlest people in the world, but this is heavy stuff even for them. Finland got, as it had wanted, very little foreign investment.[1] When Monty Python sang in 1980, ‘Finland, Finland, Finland … You are so sadly neglected, and often ignored’ (‘The Finland Song’), they did not perhaps guess that the Finns had sought to be neglected and ignored.

The Finnish law was eventually relaxed in 1987, and the foreign ownership ceiling was raised to 40%, but all foreign investments still had to be approved by the Ministry of Trade and Industry. General liberalization of foreign investment did not come until 1993, as part of the preparations for the country’s accession to the EU in 1995.

According to the neo-liberal orthodoxy, this sort of extreme anti-foreign strategy, especially if sustained for over half a century, should have severely damaged Finland’s economic prospects. However, since the mid-1990s, Finland has been touted as the paragon of successful global integration. In particular, Nokia, its mobile phone company, has been, figuratively speaking, inducted into the Globalization Hall of Fame. A country that did not want to be a part of the global economy has suddenly become an icon of globalization. How was this possible? We shall answer that later, but first let us examine the arguments for and against foreign investment.

Is foreign capital essential?

Many developing countries find it difficult to generate enough savings to satisfy their own investment demands. Given this, it seems uncontroversial that any additional money they can get from other countries that have surplus savings should be good. Developing countries should open their capital markets, it is argued by the Bad Samaritans, so that such money can flow in freely.

The benefit of having free international movement of capital, neo-liberal economists argue, does not stop at plugging such a ‘savings gap’. It improves economic efficiency by allowing capital to flow into projects with the highest possible returns on a global scale. Free cross-border capital flows are also seen as spreading ‘best practice’ in government policy and corporate governance. Foreign investors would simply pull out, the reasoning goes, if companies and countries were not well run.[2] Some even, controversially, argue that these ‘collateral benefits’ are even more important than the direct benefits that come from the more efficient allocation of capital.[3]

Foreign capital flows into developing countries consist of three main elements – grants, debts and investments. Grants are money given away (but often with strings attached) by another country and are called foreign aid or official development assistance (ODA). Debts consist of bank loans and bonds (government bonds and corporate bonds).[4] Investments are made up of ‘portfolio equity investment’, which is equity (share) ownership seeking financial returns rather than managerial influence, and foreign direct investment (FDI), which involves the purchase of equity with a view to influence the management of the firm on a regular basis.[5]

There is an increasingly popular view among neo-liberal economists that foreign aid does not work, although others argue that the ‘right’ kind of aid (that is, aid that is not primarily motivated by geo-politics) works.[6] Debts and portfolio equity investment have also come under attack for their volatility.[7] Bank loans are notoriously volatile. For example, in 1998, total net bank loans to developing countries were $50 billion; following a series of financial crises that engulfed the developing world (Asia in 1997, Russia and Brazil in 1998, Argentina in 2002), they turned negative for the next four years (-$6.5 billion per year on average); by 2005, however, they were 30% higher than in 1998 ($67 billion). Although not as volatile as bank loans, capital inflows through bonds fluctuate a lot.[8] Portfolio equity investment is even more volatile than bonds, although not as volatile as bank loans.[9]

These flows are not just volatile, they tend to come in and go out exactly at the wrong time.When economic prospects in a developing country are considered good, too much foreign financial capital may enter. This can temporarily raise asset prices (e.g., prices of stocks, real estate prices) beyond their real value, creating asset bubbles.When things get bad, often because of the bursting of the very same asset bubble, foreign capital tends to leave all at the same time, making the economic downturn even worse. Such ‘herd behaviour’ was most vividly demonstrated in the 1997 Asian crises, when foreign capital flowed out on a massive scale, despite the good long-term prospects of the economies concerned (Korea, Hong Kong, Malaysia, Thailand and Indonesia).[10]

Of course, this kind of behaviour – known as ‘pro-cyclical’ behaviour – also exists among domestic investors. Indeed, when things go bad, these investors, using their insider information, often leave the country before the foreigners do. But the impact of herd behaviour by foreign investors is much greater for the simple reason that developing country financial markets are tiny relative to the amounts of money sloshing around the international financial system. The Indian stock market, the largest stock market in the developing world, is less than one-thirtieth the size of the US stock market. [11] The Nigerian stock market, the second largest in Sub-Saharan Africa, is worth less than one five- thousandth of the US stock market. Ghana’s stock market is worth only 0.006% of the US market.[12] What is a mere drop in the ocean of rich country assets will be a flood that can sweep away financial markets in developing countries.

Given this, it is no coincidence that developing countries have experienced more frequent financial crises since many of them opened their capital markets at the urge of the Bad Samaritans in the 1980s and the 1990s. According to a study by two leading economic historians, between 1945 and 1971, when global finance was not liberalized, developing countries suffered no banking crises, 16 currency crises and one ‘twin crisis’ (simultaneous currency and banking crises). Between 1973 and 1997, however, there were 17 banking crises, 57 currency crises and 21 twin crises in the developing world.[13] This is not even counting