Mobile capital and governance, v.2

(Author’s note:   This is a revised version of a post I wrote in July 2009, one of the earliest posts for this blog.  I revised it in the light of current market volatility and related concerns re governance and economic stability under President Noynoy Aquino.) 

The notion that mobile capital is a powerful corrective to bad governance has a noble lineage from Adam Smith, David Hume, and Charles de Montesquieu. In recent years, the idea was resurrected by globalists and like-minded entities such as ratings agencies, like Moody’s, and multilateral financial institutions such as the World Bank.

Adam Smith of “The Wealth of Nations” fame

To Smith’s mind, bad governance is excessive taxation of capital and property. Not taxation per se, as he recognized the need for public goods and the role of the state in the provision of such goods. Bad governance discourages investment and owners of transportable assets can readily change domiciles to jurisdictions with acceptable tax burdens. Smith argued that a tax burden is acceptable to businessmen if the state can provide an acceptable bundle of public goods. To businessmen, therefore, tax payments are like capital outlays for durable goods. The key public goods include internal order and political stability, a reliable system of property rights protection, contract enforcement, and dispute settlement, and public infrastructure.

Neoclassical economics assert that rational businessmen will pay taxes to the extent that the monetary value of the marginal public good, or MPG (reckoned as a valuable collective product), is equal to the marginal tax cost MTC).

Given the distinct possibility of free riding, taxes are paid starting from the point where MPG > MTC and stops when MPG = MTC. Free-riding requires that tax collection is best done through an entity imbued with legitimacy and a monopoly of means of violence–that is, the state. The payment of taxes is never voluntary and it takes a

Ratings agencies

coercive agency to collect taxes. This is not to say that non-state actors cannot collect taxes or provide public goods. States and non-states must have arms to collect taxes. However, only states can collect taxes legitimately. When non-state actors, such as insurgent armies do so, this activity is rightfully called extortion (albeit revolutionary).

New People’s Army (NPA) fighters

By default, states are considered legitimate both by its constituents and the international community. However, like all political goods, legitimacy is exhaustible. A state’s legitimacy is directly related to the magnitude and the sign of the difference between MPG and MTC, a quantity we designate as net public good (NPG). The greater the value of NPG, the greater the amount of legitimacy a state enjoys. As NPG decreases, state legitimacy similarly goes down. Should NPG take on a negative value, then the collecting state is considered illegitimate and engaged in plunder. If L was the state’s legitimacy, then L is a function of net public goods (NPG) or the difference between marginal public good (MPG) and marginal tax cost (MTC). The L function could be written as L = f(NPG) = f(MPG-MTC) or L = k NPG = k (MPG-MTC), where k is some constant between 1 and zero.

These points are crucial since the time gap between tax payment and provision of public goods is quite substantial. Notwithstanding the innate legitimacy of the state, rulers and bureaucrats may choose to use public tax revenues to provide private goods for themselves and their supporters. When they do, the state loses legitimacy and anti-state actors (that could provide the equivalent of public goods) gain traction and could eventually replace the illegitimate state in power. When economic agents pay taxes, there’s no guarantee they will get anything in return. They cannot use the tax receipt to demand a refund should the public goods they expect fail to materialize. This lack of certainty of getting something in return is another reason why economic agents do not readily pay taxes.

David Hume

Montesquieu

Among the classical political economists like Smith, Hume and Montesquieu, there was no discussion about state succession.  That will come later with John Locke and Jean Jacques Rousseau.  Smith and company believed that capital mobility can check excessive taxation, aka bad governance.   If a capitalist faces onerous taxes, he has just to transfer to another place with lighter taxes.  Of course, his assets must be fluid so he can move easily.

In recent years, a country’s ability to attract mobile capital is considered a sign that it is well governed.  How then shall we interpret the massive flight of capital from the same country?  Did it change to being poorly governed overnight?  Or, was it a matter of governance at all?

How potent is capital mobility against bad governance? In my opinion, its potency is limited since bad governance seems to be the norm instead of the exception in the contemporary world. Why is this the case?

For one, capital mobility is not perfect. The state is not helpless and has ways to reduce capital’s mobility.

Secondly, not all capital is fluid; some capital are tied down in fixed and other assets and capital owners must sustain prohibitive transactions costs before they could be transported. This explains the popularity of stock market placements–portable capital, in short.

Philippine Stock Exchange (PSE) trading floor during a lull

Lastly and most importantly, there may be substantial interests (domestic and foreign) who are rather impervious to capital’s mobility. Some of them welcome the outflow of capital if it results in a less-competitive situation where they will have greater control over market prices. Others may not need to interact with mobile foreign capital and will therefore remain unaffected by their exit. Still some others may be satisfied with a feckless state that allows their illicit businesses to operate and prosper. In truth, there exists a politico-economic constituency that profits from state weakness and is impervious to the disciplinary strictures of mobile capital.

There is a fourth reason for mobile capital’s relative impotence. Differences in time horizons require decomposition of mobile capital.

Ford Motor Corporation Philippines (and its fixed assets)

Direct investors have greater concerns about governance since they have longer time horizons compared to owners and managers of ‘hot money’. Of greater concern to the latter is a country’s capital account regime.  That is, if the host state has a liberal regime that allows for the unimpeded movement of foreign exchange. Provided comparatively better margins could be made in the short run,  and provided earnings can be repatriated, portfolio capital may still be attracted to jurisdictions with poor governance. To some extent, the institutional weakness of the host state can offer windfall profit opportunities for extremely mobile capital. Occasional crises may lower asset prices and offer portfolio managers more attractive buys.

Board of Investments (BOI)

In addition, bureaucracies in weak states will offer all sorts of incentives to offset institutional infirmities and enhance returns on investments. To be sure, better governance may bring higher returns to portfolio investments. But ‘hot money’ managers may not have the patience or the inclination to wait for better institutions to evolve. They may in fact be penalized by their bosses if they did not respond to better profit opportunities elsewhere.

Notwithstanding the points above, it does not readily follow that direct investors have a natural predisposition for good governance. When and where rents are offered by corrupt bureaucrats, these will not be refused. Thus, direct investors will differ with each other regarding their political connections and acumen. To the extent that rent-seekers have captured the state or a substantial amount of the economic space, the disciplinary power of mobile capital is consequently reduced.

Crime and punishment

Crime was initially the province of biologists, sociologists and psychologists.  Biocriminologists believe that criminals are genetically predetermined. They maintain that the human body needs a stable amount of minerals and chemicals for normal brain functioning and growth.  Chemical and mineral imbalances lead to cognitive and learning deficits and these factors in turn are associated with antisocial behavior.

The application of psychology in the criminal and civil justice system is known as forensic psychology. Hugo Munsterberg (1863 – 1916), a German-American psychologist was the first to pioneer the application of criminal psychology in research and theories. His research extended to witness memory, false confessions, and the role of hypnosis in court.

Hans Eysenck

The late Hans J. Eysenck, a British psychologist, is known for his theory on personality and crime.  He proposed that crime is the result of interaction between environmental conditions and features of the nervous system.  Eysenck’s emphasis is on the genetic predisposition toward antisocial and criminal behavior. His followers believe that each criminal has a unique neurophysiological makeup that when mixed with a certain environment cannot  but result to crime.

If biology could explain criminality, then why is the majority of crime and violence in poor, underdeveloped neighborhoods? To ignore environmental and social aspects contributing to crime would be a mistake, according to sociologists.

William Glasser

The medical doctor and psychiatrist William Glasser contributed choice theory, which suggested among others, that the criminal is rational  when he decides to commit a crime. The variety of reasons in which one offends can be based on a variety of personal needs, including: greed, revenge, need, anger, lust, jealousy, thrills, and vanity.

Gary Backer

A political economy perspective was pioneered by Nobel laureate Gary Becker (1968), the maverick economist who first argued that an economic approach can be brought to bear on (at the time) non-traditional (usually thought to be sociological or psychological topics) such as racial discrimination, family life, and crime and punishment. Crime and punishment are by definition and practice opposing aspects of a dyad.  They define each other—a crime is that which must be punished and punishment is the appropriate sanction or remedy to crime.

The fundamental premise of a political economy perspective on crime and punishment is that crime is a rational human activity.  Sociologists, psychologists and criminologists have usually considered criminals as sociopaths and maladjusted individuals.  This may be true but not entirely true.  Using a political economy approach, criminals are regarded as rational actors.  As rational actors, they are guided by a rewards vs. costs calculus.  Criminals do crime because they obtain material and non-material (such as enhanced prestige or status within certain social circles) gains.   When somebody commits a crime, he believes that rewards are greater than costs.

The costs of committing a crime (from the viewpoint of the criminal as well as society) include the following:

• Cost of being detected
• Cost of being arrested
• Cost of being indicted
• Cost of being found guilty
• Cost of being punished

The costs of crime are qualified by legal due process, particularly by constitutional provisions that a person is presumed innocent until proven guilty beyond reasonable doubt, as well as the infirmities of the state’s authorities.  The detection of a crime (or a criminal) does not automatically lead to the arrest of the suspect.  In the same manner, the arrest of a suspect does not lead an indictment.  In the peculiar legalese of Filipino lawyers, for instance, there must be a finding of probable cause against a suspect so an information could be filed against her/him in court.  Even if indicted, a suspect is not automatically found guilty unless proven beyond reasonable during the court’s processes.  And a suspect pronounced guilty may not necessarily be punished.  Sentences could be suspended for a number of reasons including pleas for insanity or for health reasons.

Philippine police in training

The economic analysis of crime is also mindful of the costs of crime prevention and punishment as well as the costly impact of crime on society.  Becker believes that making a distinction between two tasks—crime prevention and apprehension of criminals (or police work) and punishment of criminals (through courts and penal systems)—is useful for analytical purposes.  The incidence of crime, crime prevention, apprehension and punishment of criminals imposes costs (or entails expenses) on society.  While it is desirable to cut the incidence of crime or increase the rate of punishment, society must spend more on law enforcement (for police, courts, and prisons).  If society does not have such other resources, it may have to accept a crime rate which may rise as population grows.

Filipino prisoners

Building on these earlier ideas, Becker notes that if (costly) apprehension does not automatically lead to (costly) punishment such as jailing, then cheaper punishment alternatives should be considered.  The payment of fines is the least costly mode of punishment and incarceration can be seen as a ‘fine’ since the criminal incurs foregone income.  Furthermore, fines as punishment for heinous crimes such as murder and rape are not morally and ethically acceptable.  Generally, that is.  In certain societies, however, a convicted killer may be set free provided a fine (called ‘blood money’) is paid to the victim’s relatives.  Nonetheless with these type of crimes, society must still decide on the resources to use for law enforcement and for punishment of criminals.

In a playfully inquisitive mode, Becker poses this question: Suppose you reduce the resources expended for crime prevention and apprehension of criminals and increase the severity of penalties, will the incidence of crime be reduced?  The reasoning behind the question is as follows.  Society may not have enough resources for both crime prevention and punishment of criminals.  It is must therefore make a decision where resources are to be concentrated.  However, it does not make sense to reduce resources for punishment of criminals and concentrate resources to prevent crime and capture criminals.  It leads to an absurd situation where society is saddled with a great number of criminals in police precincts but with inadequate courts and prisons.  However, increasing the severity of punishment may not ultimately redound to society’s good.  It will simply increase the incentive of the police (specially in weak states) to set suspects free in exchange for bribes or to actively arrest fall guys again for monetary gain.