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The last decade has witnessed a dramatic change in attitude towards foreign direct investment (FDI) and significantly increased competition between governments to attract FDI as a result. Globalization, and especially the removal of national barriers to capital flows, has lead to a tremendous surge in foreign direct investment which reached a record high of almost US$1.3 trillion in 2000 — representing a growth rate of 18 percent, which is higher than those of any other global economic indicators including world production, trade or capital formation. This development has had a significant impact not only on economic processes but also on government policies aimed at attracting FDI. While still only a few Western countries would acknowledge investment promotion as an economic policy goal , all of them have set up specific policies and institutions that are aimed at attracting and regulating investment flows. The latter is easy to understand given that the overall distribution of FDI remains highly skewed — only 30 host countries in total account for about 95 percent of all FDI inflows, and less than 30 home countries account for 99 percent of all outward investment flows in 2002 — and competition is fierce.

Against this backdrop, it seems of critical importance to address the institutional issues surrounding FDI policy competition in Europe as well as to investigate the political-economic processes that inform them. The dissertation aims to contribute to such a research program by addressing the following questions: (i) To what extent does the current EU institutional framework provide an effective solution for FDI policy competition between governments under the changing conditions for global foreign direct investment as well as current and future rounds of EU enlargement? (ii) What are alternative governance models for FDI competition? and (iii) How can the political challenges to reaching agreement on a globally or regionally-integrated investment framework be overcome?

The objective of the first chapter is to develop a theoretical framework as a “set of general assertions about the world” that informs the process of analysis undertaken in this dissertation. In particular, it introduces the main theories and their subsequent approaches that are being conceptually linked together as theoretical and methodological building blocks useful for the study of foreign direct investment policy competition between governments. In that regard, the chapter aims to approximate what Lakatos (1970) termed a “scientific research program”, that is, a cluster of interconnected theories consisting of a “hardcore” that must be preserved throughout the research as well as a flexible part, a “positive heuristic”, which provides rules and suggestions for further modifications of the program by the scientist.

Theories of foreign direct investment have been reviewed through several theoretical lenses, and any attempt to organize them requires a determination of which structural approach to follow. As the aim of this chapter is to identify theoretical and methodological tools useful for the study of FDI policy competition as a matter of institutional choice, the structure of this section will follow the approach of Agarwal (1980), later refined by Lizondo (1991), which draws a general distinction between FDI theories that assume perfect market conditions and theories that are based on imperfect markets. In the latter category, those theories that explicitly consider market imperfections that affect industry structure, location advantages and transactions costs are particularly emphasized. Following this methodological path will help to accentuate the institutional economics aspect of the analysis of FDI policy competition between governments.

Up to this point, foreign direct investment and the decision to engage in international production have been reviewed exclusively from the firm’s point of view. Even the general considerations of locational factors, which are the domain of the nation-states or — more specifically — their respective governments, have not led to an examination of how government intervention affects both market imperfections as well as FDI flows. Since this issue goes to the heart of the analysis of FDI policy competition, in this intervening part of the chapter a reassessment of the locational dimension is undertaken, which examines the underlying — and potentially conflictual — relationship between firms’ objectives and governments’ interests. In that context, first the neoclassical approach to locational competition is reviewed, followed by an analysis of its implications and shortcomings, which leads to the proposition of an expanded model of FDI policy competition in the final part of this section.

All markets need institutions in order to function properly. From the simplest exchange transaction that is governed by the rules of business, cultural norms or traditions to the most complex decision-making procedure that involves strategic uncertainty and limited information, our behavior is shaped by formal and informal institutions that help to facilitate order in daily social and economic interactions and reduce uncertainty in exchange. While an explicit acknowledgement of this fundamental role of institutions in socio-economic life might seem superfluous and obvious to the reader with a non-economics background, it is a fact that the prevailing neoclassical theory treats institutions as a highly abstract matter as well as exogenously given, and thus inconsequential, in economic processes. The New Institutional Economics (NIE) attempts to address this shortcoming from an economic science’s point of view. The final part of this chapter will, therefore, review some of the main ideas of this theory, along with complementary, yet different, approaches suggested by two NIE scholars — Douglass North and Oliver Williamson — that are relevant to the analysis at hand. This process will serve to highlight the role and importance of institutions in general as well as their significance for FDI government competition in particular.

Europe as a region presents itself as a formidable candidate for the study of FDI competition. First of all, Europe is the most dynamic region in terms of FDI activity, both as a host as well as home destination to global FDI flows. Second, the European FDI competition framework is arguably the most comprehensive and sophisticated in the world, and sufficiently long established to draw preliminary conclusions about its effectiveness. Third, the current and future process of EU enlargement enhances the study by adding a dynamic element due to the ongoing harmonization efforts between old and new member countries. This chapter will examine the first two issues in detail, setting the stage for the discussion of the third issue in Chapter 4.

The main actors engaged in locational competition in Europe are the nation states that drive competition for mobile investment among host locations (more or less active depending upon their respective attitudes toward investment promotion) through a mix of FDI policies aimed at creating a favorable investment climate, reducing costs to investors through tax incentives, grants or other mechanisms, and conducting promotional activities in the areas of information dissemination, image building and investor servicing. The same measures have also been mirrored on a subnational level, in particular in the area of incentives, which have become a major policy instrument for regional and local governments.

A key issue, which emerged in the context of the theoretical framework in Chapter 2, concerns the institutional aspect of FDI competition between governments, and the need to analyze locational competition not just within the neoclassical framework of the “two-dimensional range of price theory, which examines only price and quantity”, but also to consider investment promotion as another area in which governments compete. To follow-up on this point, the underlying institutional governance structure of the competitive process, which involves national or local governments and Investment Promotion Agencies as their agents, will be examined.

The issue of the effectiveness of open competition for foreign direct investment is generally overshadowed by the much larger question about the impact of FDI on economic growth and development. On the positive side, FDI has the potential to bring employment, capital, technology and knowledge to a country. It can also increase income, foreign exchange, and stimulate domestic investment. Moreover, so called spill-over effects can raise productivity of local firms, lower the cost of R&D and innovation, stimulate the establishment of local supplier networks, and generally facilitate an increased integration in global markets. On the negative side, FDI is associated with the risk of lowered domestic savings and investment, the crowding-out of local firms in capital markets, distorted competition, diminished regulatory standards, and the absence of expected spillover effects.