Early View Article - Foreign direct investments and the dynamics of trade and capital flows: Schumpeterian insights for sustained development

Foreign direct investments and the dynamics of trade and capital flows: Schumpeterian insights for sustained development

This article analyses the role of foreign direct investment (FDI) in trade and development theory and outlines the resulting implications for economic policy. We propose an alternative model of international trade and development based on absolute, not comparative advantages of firms, which are nested in countries but compete internationally. Applying a Schumpeterian theory of dynamic development, we consider how firms can either increase their competitiveness through productivity gains at a given wage level, or by combining the existing high level of productivity with lower wages in low-income countries. We argue that the aim of competition policy must be to improve the quality of economic competition in international markets, limit monopoly rents and disincentivise rent-seeking activities through the mere outsourcing of production. To that end, we propose that economic policy must reinstate rigorous wage bargaining regimes and make FDI subject to wage conditionality, obliging foreign companies to increase their wages in the host economy in line with average national productivity growth and the national inflation target.

Policy implications

  • Embedding foreign direct investment (FDI) flows in a wider development strategy: merely a reliance on foreign capital can lead to a middle-income trap and create international market distortions. Embedding FDI in a development strategy necessitates giving developing and emerging economies more industrial and financial policy space.
  • National economies must reinstall post-war wage bargaining systems: this policy is a necessary requirement to set up a competitive regime that incentivizes companies to increase their competitiveness via higher productivity, not lowering wages. Wage policy must hence function again as a productivity whip and high unionization rates ought to limit the firms’ ability to increase their competitiveness through lowering wage bills.
  • Foreign direct investment must be tied to a wage conditionality: the minimum requirement is to force foreign investors to increase their wages in line with the average productivity growth achieved at the national level and the national inflation target in the host economy. As with environment protection or social protection rules, which are part of international trade and investment agreements, the negotiating parties should make the wage rule a mandatory part of the agreement.
  • Integrated economic areas, such as the European Union, should equally apply this wage rule to the free movement of capital, to smooth out development across a diverse range of economies and provide a better institutional framework for productivity-enhancing competition.


Photo by Rachel Claire