URC paper

Research methods – 3301

Abstract The European sovereign debt crisis has left the confederation that makes up the European Monetary Union (EMU) in shambles. Portugal, Ireland, Italy, Greece, and Spain in particular have experienced recessions to a degree that no other EMU country has experienced, due largely to each of these countries tremendous amounts of government debt. Fiscal instability in the region forced the governments of these countries’ to implement harsh austerity measures. However, the austerity has caused political unrest that has led to riots and anti-government protests. I posit that the financial and political unrest in the EMU has caused a decrease in foreign direct investment (FDI) to these five countries. Not knowing whether a country will be solvent in the future adds quite a bit of clout when Multinational Companies (MNCs) are looking to invest in a particular country. The lack of policy stability in the region will also cause a decline in FDI. When the EMU started to falter in 2009, Greece was on course to have a debt-to-GDP ratio of 198%. This was clearly unsustainable and something had to be done, so the International Monetary Fund (IMF), the European Central Bank (ECB), and other members of the EMU stepped in and attempted to aid the Greek government in turning their economy around. Action was taken to save Greece from bankruptcy, but more importantly this was an attempt to stabilize the value of the Euro. By not stabilizing the value of the Euro the entire currency was at risk of severe devaluation. However, the citizens of Greece were opposed to the “bailout” because it imposed austerity in order to get them on a path to solvency. Riots quickly ensued that shook the political class in Greece causing them to rethink the harsh measures imposed by the IMF, ECB, and other EMU members. Other countries in the region adopted the Greek model of success and have found themselves in similar economic circumstances. Greece was the tipping point for the European sovereign debt crisis and has had a domino effect on other confederation members, but not to the same extent. With Portugal, Ireland, Italy, Greece, and Spain on a decline economically, foreign investors will seek out emerging markets for their entrepreneurial endeavors as opposed to those on the decline.
Intro
Financial and economic crises have occurred throughout history the first known documented crisis happened in 1830. The European Monetary Union is not the first region with financial woes. During the mid 1990’s East Asian countries experienced a similar situation that the Euro-Zone is currently facing. Much like the European financial crisis the Asian financial crisis began in one country and spread like a wildfire. In Asia the country that sparked the downturn was Thailand, while in Europe it was Greece. These two regions have countries that are economically tied together. This is important to note because crises of this sort can typically be contagious throughout a region, as we see in the case of the EMU as was observed in the East Asian crisis. “…Evidence indicates that a stronger trade linkage is associated with higher incidence of a currency crisis”(Salaheen 2005). This implies that countries that rely on import and export economies will be disproportionally vulnerable to currency crises, because of their economic interdependence. However propinquity is not the only commonality. These regions also suffered from an unsound banking system (Cabalu, 1999). The banks were practicing excessively risky lending practices, which created a bubble that was bound to burst. This coupled with the Yen being pegged to the dollar made it difficult to float their currency, further complicating monetary policy. This caused strife for the East Asian countries, because as the US dollar goes down in value with respect to the Yen; they gained competitiveness in trade-weighted terms. When the US dollar appreciates with respect to the Yen the effects are adverse on net exports and growth. The Euro has put these same constraints on EMU countries. The single currency doesn’t allow for monetary policy, much like the Yen being pegged to the US dollar. The lack of monetary policy can exacerbate these crises, as exhibited by the Dark Ages. Upon its creation, The European Monetary Union (EMU) aided, economically, most of the countries that belong to it. This is due to the fact that economic and monetary unions cause a reduction in transaction costs that affect the rewards of internationalization, such as exchange rates, trade barriers, and liquidity-related costs (de Sousa, 2011). This economic benefit led to “… cheap borrowing and consumption…” (Pitelis, 2012) this was one benefit of entering this union. However these countries abused these low interest rates and transaction costs by borrowing and spending money on consumption as opposed to investing in their countries future. The ability for countries to attain such low barrowing costs could have lead to vast amounts of economic growth. This, however, did not occur; most of the nations Governments undertook initiatives that were irresponsible and harmful to their country’s economy. In Greece, for example the government over promised benefits to its baby boomer generation and stuck the younger, smaller, generations with the costs of those benefits. This is one contributing factor to the fiscal crisis that Greece currently faces. Greece also has to deal with corruption. Corruption is not isolated to authoritarian regimes, the democracy in Greece was found to be fudging numbers in the lead up to their fiscal collapse (Pitelis, 2012). When a government is cooking the books, they come across as untrustworthy. This is a major factor MNCs look at when deciding whether to invest in a country. Greece is not the only country in the European Monetary Union with financial woes. Other countries like Portugal, Spain, Ireland, and Italy are all heading down the same path as Greece. These countries have also received loans from the IMF, ECB, and other EMU members to stay solvent. These loans were made with stipulations for cutting back government spending as well. Austerity measures were not accepted in any of these five Organization for Economic Development (OECD) countries, for political reasons. This problem has been on display in some of these countries with massive crowds of people protesting such cut backs and hints of fiscal discipline. The workers that have been promised pensions and jobs from the governments in these countries are going to have a hard time letting those clientelistic benefits go. This, in turn, makes it exponentially more difficult to keep these countries from going the way of the Weimar Republic. These countries are also suffering from extremely high unemployment, in Spain’s case 25.8%. Chronic unemployment is also placing a strain on these economies. Unemployment affects GDP, economic growth, and the tax base. As this occurs, it becomes difficult for the economies to grow their way out of this recession with considerably high unemployment numbers. Another issue these countries are facing is a structural problem with their banks. These banks provided loans to the public, neglected to do their due diligence, and much like the American banks, had balance sheets that were in fact not balanced. This has led to unstable banking systems in these OECD countries, which will also prove to stifle FDI because of the astronomical interest rates.
Literature Review “Foreign Direct Investment is the purchase of physical assets or a significant amount of the ownership (stock) of a company in another country to gain a measure of management control” (Li, 2009). “As with other aspects of finance, foreign direct investment has become a more important component of almost all economies” (Keohane, 1996). FDI initially started in the early 1950’s (Leitao, 2010). Since then there have been very different schools of thought on the subject. The first and most obvious factors that affect FDI are the macroeconomic conditions of the host country. The macroeconomic variables that businesses look at when deciding whether to invest or not consist of “openness [of a country], GDP growth, average inflation over the previous three years, the logs of GDP per capita, and the real effective exchange rate, and (to estimate clustering effects) the stock of FDI” (Walsh, 2010). However, it is important to note that FDI concerning natural resource extraction is affected very little by macroeconomic conditions. This is because a natural resource provides comparative advantage for the host country, and the fact that natural resources are finite makes them even more valuable. Once the multinational corporation (MNC) makes it into the host country FDI influences many economic factors. These factors consist of “…production, employment, income, prices, exports, imports, economic growth, balance of payments, and general welfare…” (Tatoglu, 2002). “Prices matter because they are the basic signal by which economic information is transmitted and therefore the proximate (if not the underlying) determinant of wages, rents, and profits” (Keohane, 1996). When factors such as employment, income, and growth are on the rise, the host country, as a whole, will be made better off. This can be seen when “countries which reduce international barriers to either goods or capital sacrifice domestic autonomy in the hope of a higher standard of living” (Keohane, 1996). Businesses should also be concerned about the capital they bring into the host country because it may lead to expropriation. Expropriation is unlikely to happen in democracies due to the number of veto players with various preferences (Li, 2009). MNCs who invest in foreign countries must be concerned about the risk of expropriation. This occurs when the host country confiscates capital from a company, whom has invested in said county, and nationalizes that capital for the advancement of country wide welfare. “Governments may openly expropriate assets” (Jensen, 2008). However, in order for expropriation to occur governments in the host countries “… must possess both the incentive and the political capacity to expropriate” (Li, 2009). In order to avoid expropriation MNCs will invest in capital that is mobile. This is because “internationally mobile capital will gain political power, relative to labor and political officials, as internationalization proceeds” (Keohane, 1996). When governments realize that companies are aware of the threat of expropriation, they must “…pursue policies that will increase rates of return on domestic investment” (Keohane, 1996).
Another effect FDI has on an economy is the spillover effects into the domestic economy. The literature on spillover effects calls it a “new economic geography” more commonly known as industrial districts, which allows firms to cluster together and share knowledge of production, specialized labor, and forward and backward linkages among suppliers and customers (Barry, 2003). The spillover effect created by FDI allows for innovations in technology which “…makes capital substantially more productive…” (Globerman, 2002). FDI also provides “demonstration effects” this occurs when firms send signals to potential investors as to the reliability and attractiveness of the host country (Barry, 2003). Another effect of FDI on a host country is the infrastructure that the company brings to the host country. Companies may need to build roads, communication systems, and other essential infrastructure that will aid the MNC in conducting business in the host country. Despite all of the economic evidence “… capital flows cannot be predicted by looking exclusively at labor and capital scarcity” (Globerman, 2002). We must evaluate the political factors involved in the decision making of MNCs as well.
The other side to FDI literature concerns regime type and institutions. Both of these topics effect whether or not a company will choose to invest in a certain country. Much research has been done on the type of regime that is optimal for FDI inflows. However, most of this research has been done in developing countries, which tend to be overwhelmingly authoritarian and dictatorial. MNCs are more likely to invest in personalist authoritarian regimes due to the lack of veto players within the regime (Tsebelis, 1995). With only one veto player, the MNCs only need to adhere to one set of preference structures (Biglaiser, 2012). On the other end of the spectrum, FDI becomes more difficult to achieve in military juntas because of the various Generals in positions of power that MNCs have to please in order to attain the ability to invest in the host country (Biglaiser, 2012). This regime type allows for various veto players and sets of preferences, which makes it very difficult for an MNC to invest in a country with this form of government (Biglaiser, 2012). However, the consensus is that democratic regimes are the optimal form of government to attract FDI because they are the most free and most liberalized, which tend to have positive effects on the markets.
A democracy is optimal for FDI inflows because “…democracy is thought to spur a desire for immediate consumption and reducing the pool of resources from which investments are made” (Tatoglu, 2002). A democracy also benefits foreign investors because of their high tendencies to liberalize. “On average, democratic regimes will liberalize more readily then nondemocratic ones” (Keohane, 1996). A liberalized economy serves businesses quite well because in democracies there are avenues that companies can use to become part of the political process and possibly lobby for their own interest (Jensen, 2008). Democracy also “… reduces political risks… and provides stability of policy, the ability of firms to influence policy outcomes, the transparency of policy and politics, and how reputation costs affect leaders incentives to expropriate multinational assets” (Jensen, 2008). These institutions put in place by these governments also aid companies in achieving FDI.
When it comes to institutions there are many aspects that MNCs look at such as “… an effective, impartial, and transparent legal system that protects property and individual rights; public institutions that are stable, credible, and honest; and government policies that favor free and open markets” (Globerman, 2002). These institutions are important when MNCs are considering FDI because it ensures that the regime duration will be long enough to receive returns on investment without risk of expropriation among other things. An independent judiciary is a must for county’s credibility. Politician should not have a say in the judicial process because their preferences may interfere with the rulings. When rulings are handed down from legal scholars their judgments tend to be more impartial than those guided by politicians. Policies that encourage free and open markets also entice MNCs to invest because these countries are usually more liberalized, which is a factor that these companies look at. Institutions may not always be governmental institutions; they can be social and economic as well. These groups also have an input when it comes to FDI. “Internationalization affects the opportunities and constraints facing social and economic actors, and therefore their policy preferences” (Keohane, 1996). This stems from the liberalization movement, the social and economic agents see the opportunity cost of not allowing MNCs in their country, thus provoking them to organize and lobby in favor of these MNCs, so that they may reap the benefits of economic growth they bring.
Although factors of production and macroeconomic conditions are the leading factors MNCs consider when deciding to put FDI in a country, they also must weigh the opportunity cost of regime types and institutional barriers. Regime type plays an important role when MNCs consider FDI because these firms are looking for long term stability in the markets they enter. The type of regime can also indicate how easy it is to receive FDI inflows into the host country. Institutions of the host country are also important factors because it can lead to better communication with the regime and allow for a better deal making process, so that the host country is attractive to foreign firms. Social institutions, or social capital, are an important determinant of FDI as well. When these groups come together they can lobby their governments for investment from abroad. These social actors see the opportunity for economic growth and an increased standard of living by bringing these firms into their country. So, not only do economic factors matter, but political and institutional factors play an instrumental role in attracting FDI.
Hypothesis
Political unrest and a financial crisis will have a negative correlation with FDI. Political unrest is bad for FDI because MNCs see what is happening in potential host countries. When this occurs firms are concerned with violence that may come out of the tensions between citizens and government. This tension may lead to looting, burning down of buildings, and possibly civil war. This unrest also puts on display the ineffectiveness of the government, which may lead to deterrence from investing. Political unrest when coupled with a financial crisis can cause some extremists to take advantage of the situation and call for economic nationalism, as Rahm Emanuel said, “You never let a serious crisis go to waste. And what I mean by that it’s an opportunity to do things you think you could never do before (Emanuel, 2008).” In turn, this economic nationalism would cripple the country’s economy even further. The financial crisis led to skyrocketing interest rate. Based on basic macroeconomic principles as interest rates go up investment goes down this is because borrowing money becomes more expensive when interest rates rise. Financial crises like these call for government to decrease their irresponsible spending. While necessary, a decrease in government spending will have a negative effect in the short run because government spending is an essential part of the GDP equation.
Conclusion
This paper should be used as a starting point in order to find out how FDI is affected by economic decline and political unrest. Further research will need to be done at a later date because various pieces of data are lagging indicators. With only a few years being accounted for in this study it behooves researches to further investigate this topic.

Works Cited
Barry, Frank, Holger Gorg, and Eric Strobl. "Foreign Direct Investment, Agglomerations, and Demonstration Effects: An Empirical Investigation." Review of World Economics 139.4 (2003): 583-600. Print.
Biglaiser, Glen, and Taylor McMichael. "Direct Investment and Authoritarianism in the Developing World." n/a n/a (2012): 1-32. Print.
Emanuel, Rahm . "Rahm Emanuel on the Opportunities of Crisis." Wall Street Journal CEO Council. Wall Street Journal. Wall Street Journal CEO Council, Washington, D.C. . 19 Nov. 2008. Address
Globerman, Steven, and Daniel Shapiro. "Global Foreign Direct Investment Flows: The Role of Governance Infrastructure." World Development 30.11 (2002): 1899-1919. Print.
Jensen, Nathan. "Political Risk, Democratic Institutions, and Foreign Direct Investment1." Southern Political Science Association 70.4 (2008): 1040-1052. Print.
Keohane, Robert O., and Helen V. Milner. Internationalization and domestic politics. Cambridge [England: Cambridge University Press, 1996. Print.
Leitao, Carlos. "Localization Factors and Inward Foreign Direct Investment in Greece." Theoretical and Applied Economics 17.6 (2010): 17-26. Print.
Li, Quan. "Democracy, Autocracy, and Expropriation of Foreign Direct Investment." Comparative Political Studies 42.8 (2009): 1098-1127. Print.
Pitelis, Christos. "On PIIGS, GAFFS, and BRICS: An Insider-Outsider 's Perspective on Structural and Institutional Foundations of the Greek Crisis." Contributions to Political Economy 31.1 (2012): 1-13. Print.
Tatoglu, Ekrem . "Locational Determinants of Foreign Direct Investment in an Emerging Market Economy: Evidence From Turkey." Multinational Business Review 10.1 (2002): 1-7. Print.
Tsebelis, George. "Decision Making in Political Systems: Veto Players in Presidentialism, Parliamentarism, Multicameralism and Multipatyism." British Journal of Political Science 25.3 (1995): 289-325. Print.
Walsh, James, and Jiangyan Yu. "Determinants of Foreign Direct Investment: A Sectoral and Institutional Approach." IMF report 187 (2010): 1-28. Print. de Sousa, Jose, and Julie Lochard. "Does the Single Currency Affect Foreign Direct Investment?" Journal of Economics 113.3 (2011): 553-578. Print.

Cited: Barry, Frank, Holger Gorg, and Eric Strobl. "Foreign Direct Investment, Agglomerations, and Demonstration Effects: An Empirical Investigation." Review of World Economics 139.4 (2003): 583-600. Print. Biglaiser, Glen, and Taylor McMichael. "Direct Investment and Authoritarianism in the Developing World." n/a n/a (2012): 1-32. Print. Emanuel, Rahm . "Rahm Emanuel on the Opportunities of Crisis." Wall Street Journal CEO Council. Wall Street Journal. Wall Street Journal CEO Council, Washington, D.C. . 19 Nov. 2008. Address Globerman, Steven, and Daniel Shapiro Jensen, Nathan. "Political Risk, Democratic Institutions, and Foreign Direct Investment1." Southern Political Science Association 70.4 (2008): 1040-1052. Print. Keohane, Robert O., and Helen V. Milner. Internationalization and domestic politics. Cambridge [England: Cambridge University Press, 1996. Print. Leitao, Carlos. "Localization Factors and Inward Foreign Direct Investment in Greece." Theoretical and Applied Economics 17.6 (2010): 17-26. Print. Li, Quan. "Democracy, Autocracy, and Expropriation of Foreign Direct Investment." Comparative Political Studies 42.8 (2009): 1098-1127. Print. Pitelis, Christos. "On PIIGS, GAFFS, and BRICS: An Insider-Outsider 's Perspective on Structural and Institutional Foundations of the Greek Crisis." Contributions to Political Economy 31.1 (2012): 1-13. Print. Tatoglu, Ekrem . "Locational Determinants of Foreign Direct Investment in an Emerging Market Economy: Evidence From Turkey." Multinational Business Review 10.1 (2002): 1-7. Print. Tsebelis, George. "Decision Making in Political Systems: Veto Players in Presidentialism, Parliamentarism, Multicameralism and Multipatyism." British Journal of Political Science 25.3 (1995): 289-325. Print. Walsh, James, and Jiangyan Yu. "Determinants of Foreign Direct Investment: A Sectoral and Institutional Approach." IMF report 187 (2010): 1-28. Print. de Sousa, Jose, and Julie Lochard. "Does the Single Currency Affect Foreign Direct Investment?" Journal of Economics 113.3 (2011): 553-578. Print.