Institutions, Volatility and Investment

Countries with strong executive constraints have lower growth volatility but similar average growth to those with weak constraints. This paper argues that this may explain a strong reduced-form correlation between executive constraints and in‡ows of foreign investment. It uses a a novel dataset of Dutch sectorlevel investments between 1983 and 2012 to explore this issue. It formulates an economic model of investment and uses data on the mean and variance of productivity growth to explain the relationship between investment in‡ows and executive constraints. The model can account for the aggregate change in in‡ows when strong executive constraints are adopted in terms of the reduction in the volatility in productivity growth. The data and model together suggest a natural way of thinking about countryspeci…c heterogeneity in investment in‡ows following the adoption of strong executive constraints. Keywords: foreign investment, volatility, political risk, executive constraints, democracy We thank Stephan Litschig, Silvana Tenreyro and seminar participants at CIFAR, University of Sussex and UPF for their comments. We thank Pablo Augustin, Diogo Baptista, Paola Ganum and Heather Sarsons for excellent research assistance. Special thanks goes to De Nederlandsche Bank, in particular, Rini Hillebrand and Henk Prins for the preparation and explanation of the FDI data. Both authors thank the IGC for …nancial support. Mueller acknowledges …nancial support from the Ramon y Cajal programme and Spanish Ministry of Economy and Competitiveness, through the Severo Ochoa Programme for Centres of Excellence in R&D (SEV-2011-0075). All errors are unfortunately ours.