Capital Mobility and Reform

Financial globalization is commonly viewed as a powerful force in constraining or disciplining domestic policies. This paper presents a model that captures various ways in which international capital mo- bility affects domestic policy incentives. Capital mobility supports reform in two ways: 1) capital inflows enhance the benefits of good policies; 2) liberalizing capital outflows may lock in political support for reforms. On the downside, capital mobility makes possible self- fulfilling capital flight that destroys the domestic investor basis and the political support for reform. More generally, individual investment decisions do not internalize their impact on policy incentives, opening some scope for second-best public intervention.