Michael J.

Hiscox / The Domestic Sources of Foreign Economic Policies 241

The Domestic Sources of Foreign

Economic Policies Michael J. Hiscox

E
ach government must make choices about how best to manage the way its own econ-
omy is linked to the global economy. It must choose whether to open the national
market to international trade, whether to liberalize trade with some nations more
than with others, and whether to allow more trade in some sectors of the economy than
in other sectors. Each government must also decide whether to restrict international flows
of investment in different sectors and whether to regulate immigration and emigration by
different types of workers. And it must either fix the exchange rate for the national cur-
rency or allow the rate to fluctuate to some degree in response to supply and demand in
international financial markets.
Of course, if every government always made the same choices in all these areas of
policy, things would be very simple for us as scholars (and much more predictable for us
as citizens of the world). But governments in different countries, and at different moments
in history, have often chosen radically different foreign economic policies. . . .
Politics, we know, is all about who gets what, when, and how. Different individuals
and groups in every society typically have very different views about what their govern-
ment should do when it comes to setting the policies that regulate international trade,
immigration, investment, and exchange rates. These competing demands must be rec-
onciled in some way by the political institutions that govern policy making. To really
understand the domestic origins of foreign economic policies we thus need to perform
two critical tasks:
1. Identify or map the policy preferences of different groups in the domestic economy.
2. Specify how political institutions determine the way these preferences are aggregated
or converted into actual government decisions.
The first step will require some economic analysis. How people are affected by their
nation’s ties with the global economy, and thus what types of policies they prefer to man-
age those ties, depends primarily on how they make their living. Steelworkers typically
have very different views about most foreign economic policies from wheat farmers, for
instance, because such policies rarely affect the steel and wheat industries in similar fash-
ion. Of critical importance here are the types of assets that individuals own and how the
income earned from those assets is affected by different policy choices. The second step
calls for political analysis. How political representatives are elected, how groups organ-
ize to lobby or otherwise influence politicians, and how policies are ­proposed, debated,
amended, and passed in legislatures, and then implemented by government agencies, all
depend on the structure of political institutions. Democratically elected leaders face very
different institutional constraints from military dictators, of course, and even among our

Michael J. Hiscox, “Foreign Economic Policies,” in Global Political Economy, ed. John Ravenhill. pp. 51–54,
57–62, 65–68. By permission of Oxford University Press. Portions of the text and all footnotes have been
omitted.

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 242 Politics in the International Economy

democracies there is quite a wide range of institutional variation that can have a large
impact on the behaviour of policy makers. . . .

Policy Preferences
The guiding assumption here is that, when it comes to taking positions on how to regulate
ties with the global economy, individuals and groups are fundamentally concerned with
how different policy choices affect their incomes. Of course people may also have impor-
tant non-material concerns that affect their attitudes toward foreign economic policies.
Many people are concerned about the cultural implications of globalization, for instance,
and its impact on the world’s environment and on human rights, and these concerns may
have an impact on their views about the regulation of international trade, immigration,
and investment. We will discuss some of these important considerations in more detail
later in the chapter. But we begin here with the simplest possible framework in which
economic policies are evaluated only in terms of their economic effects. . . .

Trade
The dramatic growth in international trade over the last few decades has intensified polit-
ical debate over the costs and benefits of trade openness. In the United States, the contro-
versy surrounding the creation of the North American Free Trade Agreement (NAFTA)
in 1993 was especially intense, and similar arguments have arisen in Europe over the
issue of enlargement of the European Union and over attempts to reform the Common
Agricultural Policy. Rapid trade policy reforms have also generated a significant political
backlash in many developing nations. And recent years have witnessed violent protests
and demonstrations by groups from a variety of countries that hope to disrupt meetings
of the World Trade Organization (WTO). Political leaders around the world frequently
voice concerns about the negative effects of trade and the need to protect their firms and
workers from foreign competition.
What is behind all of this political fuss and bother? At first glance it may seem puz-
zling that there is so much conflict over trade. After all, the most famous insight from all
of international economics is the proof that trade provides mutual gains: that is, when
countries exchange goods and services they are all generally better off. Trade allows each
country to specialize in producing those goods and services in which it has a comparative
advantage, and in doing so world welfare is improved.
While there are gains from trade for all countries in the aggregate, what makes trade
so controversial is that, among individuals within each country, trade creates winners
and losers. How trade affects different individuals depends upon how they earn their
living. To flesh out this story, economists have traditionally relied upon a very simple
theory of trade devised by two Swedish economists, Eli Heckscher and Bertil Ohlin. In
the Heckscher-Ohlin model of trade, each nation’s comparative advantage is traced to
its particular endowments of different factors of production: that is, basic inputs such
as land, labour, and capital that are used in different proportions in the production of
different goods and services. Since the costs of these inputs in each country will depend
on their availability, differences in factor endowments across countries will create differ-
ences in comparative advantage. Each country will tend to export items whose production
requires intensive use of the factors with which it is abundantly endowed relative to other

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 Michael J. Hiscox / The Domestic Sources of Foreign Economic Policies 243

nations; conversely, each country will import goods whose production requires intensive
use of factors that are relatively scarce. Countries well endowed with land, like Australia
and Canada, are expected to export agricultural products (for example, wheat and wool),
while importing products that require the intensive use of labour (for example, textiles
and footwear) from more labour-­abundant economies like China and India. The advanced
economies of Europe, Japan, and the United States, well endowed with capital relative to
the rest of the world, should export capital-intensive products (for example, automobiles
and pharmaceuticals), while importing labour-intensive goods from less developed trad-
ing partners where supplies of capital are scarce compared to supplies of labour.
Building on this simple model of trade, Wolfgang Stolper and Paul ­Samuelson derived
a famous theorem in 1941 that outlined the likely effects of trade on the real incomes of
different sets of individuals within any economy. According to the Stolper-Samuelson theo-
rem, trade benefits those who own the factors of production with which the economy is
relatively well endowed and trade hurts owners of scarce factors. The reasoning is straight-
forward: by encouraging specialization in each economy in export-oriented types of pro-
duction, trade increases the demand for locally abundant factors (and bids up the earnings
of those who own those factors), while reducing demand for locally scarce factors (and
lowering the earnings of owners of such factors). In A ­ ustralia and Canada, the theorem
tells us that landowners should benefit most from trade, while workers can expect lower
real wages as a consequence of increased imports of labour-intensive goods. In Europe,
Japan, and the United States, the theorem predicts a fairly simple class division over trade:
the trade issue should benefit owners of capital at the expense of workers. The converse
should hold in relatively labour-abundant (and capital-scarce) developing economies like
China and India, where trade will raise the wages of workers relative to the profits earned
by local owners of capital.
By revealing how trade benefits some people while making others worse off, the
Stolper-Samuelson theorem thus accounts for why trade is such a divisive political issue.
The theorem also provides a neat way to map the policy preferences of individuals in each
economy. In each nation, owners of locally abundant factors should support greater trade
openness, while owners of locally scarce factors should be protectionist. There is a good
deal of evidence in the histories of political conflict over trade in a variety of nations that
fits with this simple prediction. In Australia, for instance, the first national elections in
1901 were actually fought between a Free Trade party, representing predominantly rural
voters, and a Protectionist party that was supported overwhelmingly by urban owners of
capital and labour. A very similar kind of political division characterized most debates
over trade policy in Canada in the late nineteenth century, with support for trade open-
ness emanating mostly from farmers in the vast western provinces. In Europe and Japan,
in contrast, much of the opposition to trade over the last century or so has come from
agricultural interests, anxious to block cheap imports of farm products from abroad. In
the United States and Europe, at least since the 1960s, labour unions have voiced some of
the loudest opposition to trade openness and have called for import restrictions aimed at
protecting jobs in labour-intensive industries threatened by foreign competition.
On the other hand, political divisions and coalitions in trade politics often appear
to contradict this simple model of preferences. It is quite common to see workers and
owners in the same industry banding together to lobby for protective import barriers,
for instance, in contemporary debates about policy in Europe and the United States, even
though the Stolper-Samuelson theorem tells us that capital and labour are supposed to

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 244 Politics in the International Economy

have directly opposing views. So what is going on here? The critical problem seems to
be that the theorem is derived by assuming that factors of production are highly mobile
between different industries in each economy. An alternative approach to mapping the
effects of trade on incomes, often referred to as the ‘specific factors’ model, allows instead
that it can be quite costly to move some factors of production between different sec-
tors in the economy. That is, different types of land, labour skills, and capital equipment
often have a very limited or specific use (or range of uses) to which they can be put when
it comes to making products. The plant and machinery used in modern manufacturing
industries is very specialized: the presses used to stamp out automobile bodies are only
designed for that purpose, for instance, and cannot be adapted easily or quickly to per-
form other tasks. Steel factories cannot easily be converted into pharmaceutical factories
or software design houses. Nor can steelworkers quickly adapt their skills and become
chemical engineers or computer programmers.
In the specific factors model, the real incomes of different individuals are tied very
closely to the fortunes of the particular industries in which they make their living. Indi-
viduals employed or invested in export industries benefit from trade according to this
model, while those who are attached to import-competing industries are harmed. In the
advanced economies of Europe and the United States, the implication is that owners and
employees in export-oriented industries like aerospace, pharmaceuticals, computer soft-
ware, construction equipment, and financial services, should be much more supportive
of trade than their counterparts in, say, the steel, textiles, and footwear industries, which
face intense pressure from import competition. There is much evidence supporting these
predictions in the real world of trade politics especially in the debates over trade in the
most advanced economies where technologies (and the skills that complement them) have
become increasingly specialized in many different manufacturing and service industries,
and even in various areas of agriculture and mining production. In the recent debates
over regional and multilateral trade agreements in the United States, for instance, some of
the most vociferous opposition to removing barriers to trade has come from owners and
workers aligned together in the steel and textile industries. . . .

Foreign Investment
Capital can also move from one country to another. These movements usually do not take
the form of a physical relocation of some existing buildings and machinery from a site in
one nation to another site abroad (the equivalent to worker migration). Instead, they take
the form of financial transactions between citizens of different nations that transfer own-
ership rights over assets: a firm in one country buys facilities abroad that it can operate as
a subsidiary, for instance, or individuals in one country buy shares of foreign companies,
or a bank in one country lends money to foreign firms. All such transactions increase the
stock of capital available for productive use in one country, and decrease the stock of
capital in another country.
The dramatic increase in the volume of international capital flows over the past forty
years, out-stripping the increase in trade, has had a profound impact on the international
economy. Short-term flows of capital in the form of ‘portfolio’ investment (purchases
of company shares and other forms of securities including government bonds), which
can change direction quite rapidly in response to news and speculation about changing

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 Michael J. Hiscox / The Domestic Sources of Foreign Economic Policies 245

macroeconomic conditions and possible adjustments in exchange rates, have had a major
impact on the choices governments can make when it comes to monetary and exchange-
rate policies. Longer-term capital flows in the form of ‘direct foreign investment’ (where
the purchase of foreign assets by a firm based in one country gives it ownership control
of a firm located on foreign soil), have perhaps been even more politically controversial
since the activities of these multinational firms can have a major impact on economic
conditions in the host nations in which they manage affiliates. Many critics of multina-
tional corporations fear that the economic leverage enjoyed by these firms, especially in
small developing nations, can undermine national policies aimed at improving environ-
ment standards and human rights. The political debate over direct foreign investment is
thus highly charged.
Tight restrictions on both short- and long-term investment by foreigners have been
quite common historically, although the controls have been much less strict than those
typically imposed on immigration. Clearly these controls cannot be motivated by a desire
for economic efficiency. If such controls are removed and capital is allowed to move freely
to those locations in which it is used most productively (and where it will be rewarded,
as a result, with higher earnings), it is easy to show that the total output of goods and
services will be increased in both the country to which the capital is flowing and in the
world economy as a whole. Again, this expansion in aggregate production makes it pos-
sible, in principle, to raise the standard of living for people everywhere. International
investment, just like the migration of workers, can serve the same economic purpose that
is otherwise served by trade. International flows of capital substitute for the exports of
capital-intensive goods and services in the benchmark Heckscher-Ohlin model. In general,
then, we can expect that the advanced industrial economies of Europe and the United
States, which have abundant local supplies of capital for investment and in which rates
of return on capital are thus quite low compared with earnings elsewhere, are the natural
suppliers of capital (as well as capital-intensive goods) to poorer nations in which capital
is in relatively scarce supply. . . .
Now, putting aside the aggregate welfare gains that international movements of capi-
tal make possible, which individuals are likely to benefit from such capital flows and
which individuals will lose out? Here we can simply apply the logic of the same ‘factor
proportions’ approach we used above to outline the effects of immigration. We might
distinguish between different types of capital, in the same way we distinguished between
low- and high-skilled labour above, and set apart lending and short-term or portfolio
investment flows from direct foreign investment. But to keep things simple here we will
just consider them all as a single form of capital. What is critical here, of course, is the
impact that inflows of any foreign capital have on relative supplies of factors of produc-
tion in the local economy. Allowing more inflows of capital from abroad will increase
the local supply of capital relative to other factors and thus lower real returns for local
owners of capital. At the same time, inflows of investment will raise the real earnings of
local owners of land and labour by increasing demand for these other factors of produc-
tion. . . . We can thus expect that policies allowing greater inflows of foreign capital will
be strongly opposed by individuals who own capital in the local economy, but such poli-
cies will be supported by local landowners and workers. . . .
Foreign investment tends to be even more politically controversial in developing
nations, where the behaviour of large foreign corporations can have profound effects
on the local economy and on local politics. One particular concern among critics of

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 246 Politics in the International Economy

multinational firms has been the role that several large corporations have apparently
played in supporting authoritarian governments that have restricted political organiza-
tion among labour groups, limited growth in wage rates, and permitted firms to mistreat
workers and pollute the environment. While the evidence is not very clear, local owners
of capital may well have muted their opposition to investments by foreign firms in order
to support authoritarian policies adopted by military regimes in some cases: in Nigeria,
for instance, where Shell (the European oil company) has long been the major foreign
investor, or more recently in Myanmar, where Unocal (an American oil and gas firm)
is the key foreign player. But the basic competitive tension between local capitalists and
foreign firms (whose entry into the economy bids down local profits) is typically very
obvious even in these unstable and non-democratic environments, as local firms have
often encouraged their governments to impose severe restrictions on foreign investments,
including onerous regulations stipulating that foreign firms use local rather than imported
inputs, exclusion from key sectors of the economy, and even nationalization (seizure) of
firms’ assets. Newer evidence suggests that, as we might expect given the preferences of
labour in capital-poor developing nations, left-wing governments backed by organized
labour have made the strongest efforts to lure foreign firms to make investments. . . .

Exchange Rates
Of course a critical difference between transactions that take place between individuals
living in the same country and transactions between people in different countries is that
the latter require that people can convert one national currency into another. If a firm in
Australia wants to import DVDs from a film studio in the United States, for example, it
will need to exchange its Australian dollars for US dollars to pay the American company.
The rate at which this conversion takes place will obviously affect the transaction: the
more Australian dollars it takes to buy the number of US dollars required (the price of the
DVDs), the more costly are the imports for movie loving Australian buyers. All the trade
and investment transactions taking place every day in the world economy are affected by
the rates at which currencies are exchanged.
Prior to the First World War, almost all governments fixed the value of their currency
in terms of gold, thereby creating an international monetary system in which all rates of
conversion between individual currencies were held constant. . . . Between the Second
World War and 1973, most currencies were fixed in value to the US dollar, the most
important currency in the post-war world economy. In this system, often referred to as
the ‘Bretton Woods’ system, the United States agreed to guarantee the value of the dollar
by committing to exchange dollars for gold at a set price of $35 per ounce. Since 1973,
when the Nixon administration officially abandoned the fixed rate between the dollar and
gold, all the major currencies have essentially been allowed to fluctuate freely in value in
world financial markets. Among developing nations, however, many governments con-
tinue to fix the value of their currency in terms of dollars or another of the major curren-
cies. And groups of nations in different regions of the world, including the members of
the European Union, have made separate efforts to stabilize exchange rates at the regional
level, even progressing to the adoption of a common regional currency.
The fundamental choice each government must make involves whether to allow the
value of the national currency to fluctuate freely in response to market demand and sup-
ply, or instead fix the value of the currency in terms of some other currency or external

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 Michael J. Hiscox / The Domestic Sources of Foreign Economic Policies 247

standard—typically, the currency of a major trading partner or, as was common in the
past, gold (a precious metal valued highly in most societies throughout history). When a
government chooses to fix the value of the national currency, it sets the official rate of
exchange and commits itself to buy the currency at that fixed rate when requested to by
private actors or foreign governments. Between a ‘pure float’ and a fixed exchange rate
there are intermediate options: a government can choose a target value for the exchange
rate and only allow the currency to fluctuate in value within some range around the
target rate. The wider this range, of course, the more policy approximates floating the
currency. . . .
The crux of the choice between fixed and floating exchange rates is the choice between
stability and policy control: a stable exchange rate will increase the economic benefits
attainable from international trade and investment, but this requires giving up the abil-
ity to adjust monetary policy to suit domestic economic conditions. Governments in the
most advanced economies have generally decided that policy control is more important to
them than exchange-rate stability, at least since the early 1970s. Governments in smaller,
developing nations have mostly chosen exchange-rate stability over policy control. In part
this is because these countries tend to rely more heavily upon trade and foreign invest-
ment as sources of economic growth. This choice is also more attractive for governments
in smaller countries trying to defeat chronic inflation. . . .

Institutions
Once we have specified the preferences of different individuals and groups on any particu-
lar issue we need to think about how much influence they will have over policy outcomes.
This is where political institutions come in. Political institutions establish the rules by
which policy is made, and thus how the policy preferences of different groups are weighed
in the process that determines the policy outcome. It is appropriate here to start with the
broadest types of rules first, and consider the formal mechanisms by which governments
and representatives in legislative bodies are elected (or otherwise come to power). These
broad features of the institutional environment have large effects on all types of policies.
But then we can move on to discuss more specific aspects of the legislative process and
administrative agencies that have implications for the formulation and implementation of
trade, immigration, investment, and exchange-rate policies.

Elections and Representation

Perhaps it is best to start with the observation that the general relationship between
democratization and foreign economic policy making is a matter that is still open to con-
siderable theoretical and empirical doubt. Part of the puzzle is that there is a great deal of
variation in the levels of economic openness we have observed among autocratic nations.
In autocratic regimes, the orientation of policy will depend upon the particular desires and
motivations of the (non-elected) leadership, and there are different theoretical approaches
to this issue. Non-elected governments could pursue trade and investment liberalization
in an effort to maximize tax returns over the long term by increasing aggregate economic
output. Such policies may be easier to adopt because autocratic leaders are more insu-
lated than democratic counterparts from the political demands made by any organized
domestic groups that favour trade protection and limits on foreign investment. Perhaps

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 248 Politics in the International Economy

this is an apt description of the state of affairs in China as it has been gradually opening
its economy to trade and investment over the past two decades, and non-democratic gov-
ernments in Taiwan and South Korea pursued trade liberalization even more rapidly in
the 1960s. On the other hand, autocratic governments may draw political support from
small, powerful groups in the system that favour protection. Many such governments
appear to have used trade and investment barriers in ways aimed at consolidating their
rule. The experience in Sub-Saharan African nations since the 1960s, and in Pakistan and
Myanmar, seems to fit this mould. Without a detailed assessment of the particular groups
upon which a particular authoritarian regime depends for political backing, it is quite dif-
ficult to make predictions about likely policy outcomes under non-democratic rule.
In formal democracies that hold real elections, the most fundamental set of political
rules is the set that defines which individuals get to vote. If the franchise law gives more
weight to one side in a policy contest compared to others, it can obviously have a large
impact on policy outcomes. Where only those who own land can vote, for instance, agri-
cultural interests will be privileged in the policy-making process. If this landowning elite
favours trade protection, as it did in Britain in the years before the Great Reform Act of
1832, then such a policy is almost sure to be held firmly in place. By shifting political
power away from landowners and towards urban owners of capital and labour, exten-
sions of the franchise had a major impact on all forms of economic policy during the late
nineteenth and early twentieth centuries in Europe, America, and elsewhere. In England,
the extension of voting power to the middle and working classes, achieved in the reforms
of 1832 and 1867, had the effect of making free trade politically invincible—with a huge
block of workers along with the urban business class supporting trade openness, and only
a tiny fraction of the electorate (the traditional rural elites) against it, a government that
endorsed tariffs or restrictions on investment would have been committing electoral sui-
cide. In the United States and Australia, on the other hand, where labour and capital were
in relatively scarce supply, the elimination of property qualifications for voting and the
extension of suffrage had exactly the opposite effect, empowering a larger block of urban
voters who favoured high tariffs. In general, extensions of the franchise to urban classes
tend to produce more open policies toward trade, immigration, and investment in labour
and capital-abundant countries, and more closed or protectionist policies in labour and
capital-scarce economies.
The precise rules by which representatives are elected to national legislatures are the
next critical feature of the institutional environment. Scholars have suggested that in par-
liamentary systems in which legislative seats are apportioned among parties according to
the proportion of votes they receive (‘proportional representation’), narrowly organized
groups have far less impact on policy making in general than they do in electoral systems
in which individual seats are decided by plurality rule. Parliamentary systems with pro-
portional representation tend to encourage the formation of strong, cohesive political
parties, which appeal to a national constituency and have less to gain in electoral terms by
responding to localized and particularistic demands. Other types of systems, in contrast,
tend to encourage intra-party ­competition among individual politicians and the develop-
ment of a ‘personal vote’ in particular electoral districts and thus are more conducive
to interest group lobbying. The implications for foreign economic policies are usually
spelled out in very clear terms: we expect that proportional representation systems with
strong political parties (e.g. Sweden) will typically produce lower levels of trade protec-
tion and other restrictions than alternative types of electoral systems (e.g. Britain, the
United States) in which particular local and regional interests have a greater influence.

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 Dani Rodrik / Why Doesn’t Everyone Get the Case for Free Trade? 249

These conclusions about the impact of particularistic groups in different types of elec-
toral systems rest upon a critical insight derived from theoretical work on collective action
in trade politics: that there is a fundamental asymmetry between the lobbying pressure
generated from groups seeking protectionist policies and the lobbying pressure that comes
from groups who oppose such restrictions. The main reason for this is that restrictions
on imports and other types of exchange, when imposed one at a time, tend to have very
lopsided effects. . . . Thus it is unlikely that those hurt by the new tariff will be prepared
to devote resources to lobbying against the policy proposal. Collective political action will
always be much easier to organize in the relatively small groups that benefit from a par-
ticular trade restriction than in the much larger groups (the rest of the economy) that are
hurt by the restriction. Perhaps the best example of this logic is the extraordinary political
power that has been demonstrated by the small, highly organized agricultural groups in
Europe, the United States, and Japan over the past fifty years. These groups, which together
represent a tiny fraction of the population in each political system, have been able to win
extremely high (if not prohibitive) rates of protection from imports and lavish subsidies.
Other aspects of electoral institutions may also play a role in shaping policy outcomes.
In general, smaller electoral districts in plurality systems may be expected to increase the
influence of sectoral or particularistic groups over elected representatives and thus lead
to higher levels of protection. In larger districts, political representatives will be forced to
balance the interests of a greater variety of industry groups when making decisions about
policies and will be less affected by the demands of any one industry lobby, and a larger
share of the costs of any tariff or restriction will be ‘internalized’ among voters within the
district. From this perspective, upper chambers of parliaments, which typically allocate
seats among representatives of much larger electoral districts than those in lower cham-
bers, tend to be less inclined toward trade protection and other types of restrictive foreign
economic policies. Meanwhile, in legislative chambers in which seats are defined along
political-geographic lines without regard for population (for example, in the United States
Senate, where each state receives two seats), agricultural, forestry, and mining interests in
underpopulated areas typically gain a great deal more influence over policy making than
they can wield in chambers (e.g. the United States House of Representatives) where legis-
lative seats are defined based upon the number of voters in each district.

Why Doesn’t Everyone Get the Case

for Free Trade? Dani Rodrik

F
ree trade is not the natural order of things. We get free trade—or something approximat-
ing it—only when the stars are lined up just right and the interests behind free trade have
the upper hand both politically and intellectually. But why should this be so? Doesn’t
free trade make us all better off—over the long run? If free trade is so difficult to achieve, is
that because of narrow self-interest, obscurantism, political failure, or all of these combined?
It would be easy to associate free trade always with economic and political progress
and protectionism with backwardness and decline. It would also be misleading. . . . The

Dani Rodrik, The Globalization Paradox, Why Global Markets, States, and Democracy Can’t Coexist, 2012,
Oxford University Press pp. 54–66. Reprinted by permission. Portions of the text have been omitted.

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