Does Competition for Capital Discipline Governments? Decentralization, Globalization and Corruption

Many political economists believe that competition among countries—or regions within them—to attract mobile capital should discipline their governments, rendering them less corrupt and more friendly toward business. This argument surfaces repeatedly in debates over both political decentralization and globalization. We argue that it is based on an assumption— countries or regions start out identical—that is quite unrealistic. We reexamine the standard model that predicts a disciplining effect of capital mobility, and show that if units are sufficiently heterogeneous exactly the opposite prediction often follows. If some units are exogenously much more attractive to investors than others (and competition for capital is intense), the only equilibrium under capital mobility will involve polarization. Initially disadvantaged units will actually be more corrupt, more starved of capital, and slower to grow if capital is mobile than if it is not. By contrast, exogenously attractive units will do more to woo investors, suck capital out of their lower productivity counterparts, and grow faster. We suggest this may help explain the disappointing results of liberalizing capital flows within the Russian federation and in sub-Saharan Africa.