Does Foreign Capital Harm Poor Nations? New Estimates Based on Dixon and Boswell's Measures of Capital Penetration

by Glenn Firebaugh
Does Foreign Capital Harm Poor Nations? New Estimates Based on Dixon and Boswell's Measures of Capital Penetration
Glenn Firebaugh
The American Journal of Sociology
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Does Foreign Capital Harm Poor Nations? New Estimates Based on Dixon and Boswell's Measures of Capital Penetration1

Glenn Firebaugh

Pennsylvania State University

Capital penetration is the core concept of capital dependency theory. Be- cause capital penetration is so important to the theory, Dixon and Boswell in "Dependency, Disarticulation, and Denominator Effects: Another Look at Foreign Capital Penetration" measure it two ways. Their preferred measure is the ratio of foreign stock to total stock. I will call this measure PEN2 to distinguish it from the PEN measure used in earlier studies (see Firebaugh [I9921 for review). Dixon and Boswell's second measure is the ratio of stock to total GDP, or PENS. Note that the two measures differ only in the denominator: PEN2 uses total stock and PEN3 uses total GDP. We expect the two measures to yield similar results because total GDP is a linear function of total stock; in fact, total stock and total GDP are correlated .99 across the 76 nations in the Dixon and Boswell study. Like Dixon and Boswell, I rely primarily on PEN2 and use PEN3 as a check on the PEN2 results.

Because capital penetration is the ratio of foreign capital stock to total capital stock (domestic stock + foreign stock), the effects of penetration reflect the relative effects of foreign and domestic capital. For example, a negative penetration coefficient in an economic growth model implies that domestic capital yields greater economic returns than does foreign capital. However, capital dependency researchers routinely interpret a

The intense debate over the effects of multinationals in the Third World (Vernon 1977; Barnet and Muller 1974; see Jenkins [I9871 for an overview) has generated a prodigious literature on foreign investment effects that has spilled over into sociology. The Dixon and Boswell article contributes to that sociological literature. Though I continue to disagree with William Dixon and Terry Boswell on key points (as this response will make clear), we all seek a better understanding of how the world system works. My hope is that this exchange will lead to more rigor in both theory and re- search in development sociology. My comment is based on research supported in part by National Science Foundation grant SBR-9308505. I thank Ken Bollen for com- ments. Direct correspondence to Glenn Firebaugh, Department of Sociology, 206 0s- wald Tower, Pennsylvania State University, University Park, Pennsylvania 16802. E-mail: 

O 1996 by The University of Chicago. All rights reserved.


AJS Volume 102 Number 2 (September 1996): 563-575 563 negative penetration coefficient as indicating a negative absolute effect of

foreign capital (e.g., penetration promotes "immiseration [sic]in the non-

core" [Wimberley and Bello 1992, p. 9151).

Here, I use the Dixon and Boswell data and measures to show that their PEN ratio slope is negative only because domestic capital is better than foreign capital. The absolute effect of foreign capital is positive, not negative. Dixon and Boswell are not the first to misinterpret PEN effects, of course. Sociologists in the 1970s and 1980s created a large but unsound research literature based not only on the confusion of relative and absolute effects but also on the interpretation of denominator effects as dependency effects. The Dixon and Boswell article is a significant advance over that earlier literature, and my critical remarks should not detract from the article's achievement in placing dependency research on surer footing.



The PEN ratio measures a nation's mix of foreign and domestic ~apital.~ Hence the slope for the PEN ratio in the Dixon and Boswell growth model reflects the relative effects of foreign and domestic capital, with a negative slope implying that foreign investment stock is less beneficial than domes- tic stock. Observe that there are three possibilities when the PEN ratio effect is negative:

  1. domestic stock > foreign stock > 0,
  2. domestic stock > 0 > foreign stock,
  3. 0 > domestic stock > foreign stock,

where ">"denotes "better than." Note that 1-3 differ only in the place- ment of the zero. In possibility 1,both types of investment yield positive returns for the host nation, with greater returns for domestic stock. In possibility 2, domestic stock yields positive returns and foreign stock yields negative returns. In possibility 3, both yield negative returns, with domes- tic stock having less negative returns.

Possibility 3 can be ruled out from the outset since no one believes that poverty in the Third World is caused by too much domestic investment. However, capital dependency theorists argue that poverty in the Third World stems in large part from the presence of foreign investment stock in those nations. To be consistent with capital dependency theory, one has to assume negative foreign stock effects-possibility 2-because the

'A nation with a high PEN ratio can be said to have too much foreign capital or too little domestic capital.

Investment Domestic Stock:
Mix (PEN2)* Foreign Stock
Twenty-fifth percentile ...............................  
Median ..........................................................  
Seventy-fifth percentile ............................  
Mean ..........................................................  
Five most dependent nations:  
Panama ....................................................  
Jamaica .....................................................  
Liberia .....................................................  
Trinidad and Tobago ..............................  
Guinea ......................................................  

* Ratio of foreign stock to total stock X 100,i.e., foreign stock expressed as % of total stock in 1967.

theory's central thesis is that foreign capital on balance hams less devel- oped countries (LDCs; see Chase-Dunn 1975).

Yet Dixon and Boswell's own data and measures suggest otherwise. In this response, I report a reanalysis of the PEN data designed to choose between possibilities 1 and 2 above. To proceed systematically, I organize my response as follows. First, I verify the "differential productivity" claim that domestic investment tends to benefit LDCs more than foreign invest- ment does. Second, I test possibility 1 against possibility 2: Does foreign capital have a beneficial or adverse effect on economic growth in LDCs? That is the telling question for capital dependency theory, and here I provide two tests, including a test of the Dixon and Boswell claim of unmea- sured externality effects associated with foreign investment stock in LDCs. Third, I examine the claim that foreign stock crowds out domestic stock. Finally, I contrast my conclusions with those of Dixon and Boswell. No matter how the data are tortured, they fail to confess the capital depen- dency creed.


One simple fact bedevils theories based on the premise that the ills of LDCs are due to the presence of foreign capital: foreign stock constitutes a relatively small fraction of total investment stock in the majority of LDCs. The Dixon and Boswell PEN2 measure itself tells us that (table 1). Foreign stock constitutes less than 8% of total investment stock in the majority of the 76 LDCs they studied; in fact, for one-fourth of the nations,

foreign stock constitutes less than 5% of the total, and, for three-fourths

of the nations, foreign stock constitutes less than 12% of the total. In no

instance is the majority of investment foreign owned. In the most extreme

case (Panama), foreign stock constitutes about 40% of the total.

Based on these figures, no one should be surprised that the returns to a 1% foreign investment rate are less than the returns to a 1% domestic investment rate, since a 1% increase in foreign capital represents less in- vestment than does a 1% increase in domestic capital. The ratio of domes- tic capital to foreign capital is about 10 to 1 in the average LDC (table 1). Thus if it takes $1K to boost the foreign investment rate by 1%, it takes $10K to boost the domestic investment rate by 1%. Naturally, $10K in investment stimulates more economic growth than does $1K in invest- ment.

Because $10K in investment stimulates more economic growth than does $1K in investment, a domestic investment rate of 1% stimulates more economic growth than does a foreign investment rate of 1%-just as the data show (Firebaugh 1992; Dixon and Boswell above). Hence the steeper slope for the domestic investment rate does not necessarily mean that a dollar of domestic investment tends to boost the economy more than does a dollar of foreign investment. Although I do not wish to belabor the obvi- ous, investment rate is the rate of growth of capital stock. The rate of growth of foreign stock might have less effect than the rate of growth of domestic stock simply because there is less foreign stock.

Upon further reflection, then, we need to revisit the Firebaugh-Dixon- Boswell conclusion that domestic capital is better, this time employing models that avoid the different-base problem. To facilitate comparison with earlier research, I use a model that parallels the Dixon and Boswell model (based on the model used by Firebaugh [1992], which is based on the model of Bornschier and Chase-Dunn [1985]). To avoid the different- base problem, I use total investment rate in place of separate terms for domestic and foreign rates and add an interaction term-total investment rate weighted by investment mix-to capture the difference (if any) in the returns to foreign and domestic investment. This interaction term models the effect of investment rate as a function of the investment mix: the greater the ratio of foreign stock to total stock, the smaller the impact of investment rate on economic growth rate if foreign investment is less benejicial than domestic investment is. Thus the interaction term directly tests the hypothesis that foreign investment is not as good as domestic investment. A negative coefficient for the interaction term indicates that foreign investment is less beneficial, whereas a positive coefficient indi- cates that foreign investment is more beneficial.

Table 2 reports the results. The key finding is the negative effect of the interaction term. Though that finding is consistent with the differential-


Model 1 Model 2 Investment rate: 1967-73 ................................................................................. Adjustment (interaction) term: Investment rate X investment mixa ............................. Control variables: Market size, as measured by 1967 energy consumption (logged) .............................................................................. Export ratio (exports as % of GDP) .................................... Log(GNP per capita), 1965 .............................................

Constant ..............................



Adjusted RZ...............................................................................

NOTE.-Unstandardized OLS regression coefficients (t-ratios are in parentheses); N = 76 LDCs.

" The interaction term reflects different dollar-for-dollar rates of return for foreign and domestic invest- ment. The investment mix is measured as PEN2, i.e., as the ratio of foreign stock to total stock (X 100).

* P < .05, two-tailed test.
** P < .01, two-tailed test.

productivity claim of Dixon and Boswell, it undermines their interpreta- tion of the PEN ratio effect, as we see subsequently.

The results in table 2 underscore the centrality of investment to eco- nomic growth. Just three variables-investment rate, market size, and the different-returns interaction term-explain more than half of the vari- ance in economic growth rates among the 76 nations (model 1). To be true to the original Bornschier and Chase-Dunn (1985) model, I also estimated a model with export activity (ratio of exports to GDP) and initial income level (per capita GNP in 1965, logged) as control variables. I report those results as model 2 (table 2). In exploratory analysis, however, those control variables were statistically significant scarcely more often than expected by chance, and in any case I reached the same key substantive conclusions about investment effects whether or not I included the nonsignificant con- trols. I save space by emphasizing results for the trimmed model in subse- quent tables.


The results for the interaction term confirm that domestic capital benefits LDCs more than foreign capital does. In the absence of an adjustment

term, then, we expect the slope for the PEN ratio to capture that differen-

tial productivity effect: the greater the proportion of (less productive) for-

eign investment in the investment mix, the slower the economic growth

for given foreign and domestic investment rates, just as Dixon and Bos-

well found. So, as we see in the next section (second test), the negative

PEN slope in the Dixon and Boswell analysis is an apparent artifact of

the failure to control adequately for the differential productivity of foreign

and domestic capital.

But Dixon and Boswell interpret the negative PEN slope as a reflection of actual adverse effects stemming from capital penetration. As they say, "These results show that, even while holding investment rates constant as foreign capital increasingly penetrates Third World economies, the countries in our sample experience slower rates of growth" (p. 553), where Dixon and Boswell are referring to the results for the PEN ratios in their table 1 above.

The problem is that the PEN ratio slopes tell us only part of what happens when "foreign capital increasingly penetrates Third World econ- omies," since by dejinition foreign capital "increasingly penetrates" only when the foreign investment rate exceeds the domestic investment rate. So to get the actual net efSect of an increase in penetration, we must also include the positive rate effect implied by the increase in foreign stock.

Consider instances where a nation's PEN ratio increases due to gains in foreign capital as opposed to reductions in domestic capital. (Though an increase in the PEN ratio could result from gains in foreign capital or from declines in domestic capital, dependency theorists use the term capi- tal penetration, which clearly implies the former.) In such instances Dixon and Boswell's own estimates (their table 1 above) imply that gains in pene- tration spur economic growth. Consider Panama, the most penetrated na- tion in the analysis. To isolate the net effect of gains in foreign stock, we assume constant domestic stock. For Panama, the Dixon and Boswell estimate of growth for a 1% gain in PEN2 is .07(Foreign Investment Rate) -.07(PEN2) = .07(4.2) -.07(1) = 0.224%, since a 1% increase in PEN2 requires a 4.2% increase in Panama's foreign stock with domestic stock constant. In fact, the Dixon and Boswell estimates imply a net positive effect of increasing penetration for all LDCs: the slopes for PEN2 and foreign investment rate are both .07 in absolute value, but the positive investment rate effect is always larger, since (domestic stock constant) a 1% increase in PEN2 requires a foreign investment rate of 4% or more at all levels of PEN2.3

These results give the benefit of the doubt to dependency theory, since the coefficient for the PEN2 term fails to attain statistical significance when nonsignificant control variables are trimmed from the model. Either way-whether we include the PEN2

These findings have important implications for capital dependency the- ory since foreign capital obviously cannot be responsible for low incomes unless it adversely affects in~ome.~

In the PEN data, however, the positive

rate effect of increasing penetration outpaces the negative ratio effect.

And, as Dixon and Boswell point out, economic growth tends to stimulate

domestic savings and investment, spurring growth in the next period-

so the indirect effect of foreign stock through domestic savings is likely

positive as well. At the least, faster growth now implies an elevation of

the economic base, so, even if later growth rate is the same, the absolute

gain is larger since it begins on a higher base.

If foreign stock's net effect is positive in the PEN data, why have depen- dency researchers missed it? One reason is the denominator effects prob- lem described by Firebaugh (1992), Firebaugh and Beck (1994), and Dixon and Boswell. A second reason-now clarified by the Dixon and Boswell rateslratio model-is the confusion caused by the use of the term "capital penetration" to refer to a ratio that is definitionally linked to other vari- ables included as regressors in the PEN modeLs


Based on the negative slope they found for the PEN ratio, Dixon and Boswell speculate that there are unmeasured externalities associated with foreign stock and that these externalities harm LDCs independent of the effect of differential productivity. As noted above, however, the negative PEN ratio effect (if it exists: see n. 3) might in fact reflect the effect of differential productivity, since their model does not adequately control for that effect.

To differentiate the two explanations for the negative PEN ratio coeffi- cient, I added the PEN ratio to the investment rate model of my table 2.

term or drop it-the Dixon and Boswell estimates imply that gains in capital penetra- tion will spur economic growth.

Note that the total investment rate model of tables 2 and 3 collapses the foreign and domestic investment rates into a single rate, so it is not suited for estimating the net effect of foreign capital. I used the total investment rate model to test directly the differential productivity argument (taking into account the different-base problem). To determine the direction of the net effects of foreign and domestic capital, however, the Dixon and Boswell model is superior since it does not conflate the two rates.

For these reasons, it will not do to draw a sharp distinction between foreign invest- ment and capital penetration, and then to claim that, when capital dependency re- searchers speak of harmful effects, they are referring only to the effects of penetration and not to the effects of foreign investment. The critical question is whether LDCs tend to be better off with foreign capital than without it. Lest there be any doubt that leading dependency theorists really mean to say that foreign capital is a serious prob- lem in the Third World, consider the fact that Bornschier and Chase-Dunn (1985, chap. 10) call for the creation of a world government to solve the problem.




Model 1 Model 2 Model 3 Model 4
Investment rate:  
1967-73 ..................................................  

Adjustment (interaction) term: Investment rate X investment mixa ......

Measures of 1967 capital penetration: PEN2-(foreignltotal stock) X 100 ......

PENS-ratio of foreign stock to GDP ....

Control Variable: Market size, measured by 1967 energy consumption (logged) ..........................

Constant ...............................................

Adjusted R ............................................

NOTE.-Unstandardized OLS regression coefficients (t-ratios are in parentheses); N = 76 LDCs.

"The interaction term reflects different dollar-for-dollar rates of return for foreign and domestic investment. The investment mix is measured as PEN2, i.e., as the ratio of foreign stock to total stock (X 100).

* P < .05, two-tailed test. ** P < .01. two-tailed test.

Recall that the model in table 2 uses total investment rate to avoid the different-base problem and includes an interaction term to capture the differential productivity of foreign and domestic capital.

The logic of the test is as follows. If the negative PEN coefficient stems from greater returns to domestic capital, then the "effect" should disappear when we adjust for different rates of return. On the other hand, if the effect arises from some other source-such as negative externalities asso- ciated with foreign capital-then the PEN ratio effect should remain even after the adjustment term is added.

The results (table 3) indicate that Dixon and Boswell's PEN ratio effect is due to differential productivity, not negative externalities. When the ad- justment term is omitted (models 1and 2), the PEN slope is negative. When the adjustment term is included (models 3 and 4), the penetration effect disappears (the coefficient reverses sign but is not significant). This result holds whether PEN2 or PEN3 is used to measure capital penetration.




Adjusted R2 ...............................................

Model 1 Model 2 Model 3 Model 4
Measures of investment rate: Foreign, 1967-73 .....................................  
Domestic, 1967-73 ...............................  
Adjustment (interaction) term: Investment rate X investment mix .......  
Measures of 1967 capital penetration: PEN2-(foreignltotal stock) X 100 ......  
PENS-ratio of foreign stock to GDP ....  

Constant ...................



NOTE.-Unstandardized OLS regression coefficients (t-ratios are in parentheses); N = 76 LDCs. Results for control variables are excluded to save space. Control variables are market size (log of energy consumption, 1967), exportsIGDP, and initial income (log of GNP per capita, 1965)-see Dixon and Boswell's table 1, above.

* P < .05, two-tailed test.
** P < .01, two-tailed test.

The results in table 3 undermine confidence in Dixon and Boswell's claim that the penetration effect they observed constitutes "empirical evi- dence that penetrated countries suffer negative externalities independent of differential productivity" (p. 56 1).To check their claim yet another way, I reestimated their actual models (table 4). The results are the same as before. Whether we use PEN2 or PENS, Dixon and Boswell's penetration effect disappears when the adjustment term is added.


The reanalysis of the PEN data using the Dixon and Boswell rateslratio model has failed to uncover evidence of a harmful foreign capital effect. The reanalysis has suggested, however, that domestic capital is better than foreign capital. That finding suggests a final line of defense for capital dependency theory: foreign capital on balance harms LDCs because it crowds out domestic capital.

The argument that foreign capital harms LDCs by reducing domestic capital has vexed empirical research in more than one discipline. Even if it can be shown that foreign investment tends to reduce domestic invest- ment in the Third World, the net effect of foreign capital need not be adverse since, in a crowding-out situation, the net effect of foreign cap- ital would depend on (1) the severity of the crowding-out effect (Does $10 in foreign investment reduce domestic investment by $10, or by $5, or by SO$?) and (2) the relative returns on foreign and domestic invest- ment.

The massive data collection effort required to get careful estimates of crowding-out effects might not be necessary, however, since the PEN data offer no hint of a crowding-out situation. The association between foreign stock and domestic stock is positive for the 76 nations in the study (r =

3.57 for domestic and foreign stock in 1967 and .354 in 1973). Similarly, Dixon and Boswell (table 2, p. 555) find no evidence that foreign invest- ment crowds out domestic investment; in their models the effect of foreign stock on domestic stock is either zero or po~itive.~


We are now in a position to evaluate Dixon and Boswell's five conclusions

(p. 561):

We have shown the following five points. First, foreign capital penetration reduces economic growth even when controlling for investment rates to eliminate any artifactual denominator effects. Second, by using multiple in- dicators of penetration, we have isolated the first empirical evidence that penetrated countries suffer negative externalities independent of differential productivity. Third, our results demonstrated that domestic capital forma- tion is not higher in more penetrated countries once past accumulations are taken into account, and preliminary evidence suggests penetration may actually lower domestic capital formation indirectly through diminished growth. Fourth, we reconfirmed prior findings linking penetration to income inequality with controls to eliminate any possibility of denominator effects. And fifth, all of these results were obtained using new measures of foreign penetration that are both simpler and more intuitive than the indicator in current use.

Though the fifth conclusion is correct, the first four are problematic.

Conclusion 1 is based on a negative PEN slope in an analysis that fails to appreciate the implications of the definitional link between investment rates and investment ratios. It is not true that the PEN data indicate that foreign capital has harmful effects over the long or short run (as read-

Because Dixon and Boswell find that the effect of foreign stock on domestic stock is at worst zero, their results imply that a dollar of foreign stock adds a dollar (or more) to total stock.

ers might infer from Dixon and Boswell's first conclusion). In fact, the

PEN data indicate that the net effect of an increase in foreign capital

penetration, domestic stock constant, is to increase growth rates in


Conclusion 2 is unsupported by the data. Whether we use PEN2 or

PENS, there is no trace of negative externalities associated with foreign


In conclusion 3, the first half undercuts capital dependency theory. Un- less foreign investment actually reduces domestic investment, then a dol- lar of foreign investment increases total investment by a dollar (or more, if foreign investment spurs domestic investment). If this conclusion is cor- rect, foreign stock does not crowd out domestic stock. The second half of conclusion 3 (preliminary evidence) is based on results from two-stage least squares estimates of a model of reciprocal effects between economic growth and domestic investment rate. Even if we assume that the reported coefficients are reliable, this conclusion is not, since it is based on the mistaken premise that a negative slope for the PEN ratio indicates adverse foreign capital effects.

Similar problems plague conclusion 4, which addresses investment and inequality. There is evidence that LDCs with higher PEN ratios tend to have higher levels of inequality, as Dixon and Boswell find. The positive coefficient indicates that foreign investment has a positive effect on in- equality relative to domestic investment's effect. Note the possibilities: both types of investment boost inequality, with foreign investment boost- ing it more; foreign investment boosts inequality whereas domestic invest- ment reduces it; and both reduce inequality, with foreign investment re- ducing it less. In short, a positive sign for the PEN ratio is consis- tent with the statements that (a) foreign capital boosts inequality and

(b) foreign capital reduces inequality. Further research is needed to ad- judicate.'

In an otherwise careful summary of my article (Firebaugh 1992), several of Dixon and Boswell's interpretations are somewhat misleading. First, the claim that I "ignored dependency theory's fundamental distinction between foreign investment (rates or flows) and the long-run penetration of foreign capital" (p. 554) is curious in light of extended discussions in the article (e.g., the section "Capital Stock versus Capital Flow," pp. 117-18 in Firebaugh [1992]). Second, my phrase "foreign capital. . .lowers output" (quoted by Dixon and Boswell, p. 547) would imply a negative growth rate only if foreign capital were the sole determinant of economic growth. To say that foreign capital lowers output is to say that the output is lower than it would have been without the foreign capital. Contrary to the claims of Dixon and Boswell, foreign capital could lower output in the context of either positive or negative growth rates. Finally, my objection to one-component models was not "sweeping" (p. 559) but was restricted to models where the dependent variable is a growth rate.



Capital dependency theory in sociology from the outset has been posed as an alternative to the conventional view that capital-poor nations should generally try to import capital (Chase-Dunn 1975). Capital dependency theorists turned the conventional view on its head, arguing that capital- poor nations are poor in large part because they have imported capi- tal (Chase-Dunn 1975; Bornschier 1980; Bornschier and Chase-Dunn 1985).

According to the PEN data, foreign capital plays a decidedly secondary role to domestic capital in economic development in the Third World, and the net effect of foreign capital is positive, not negative. So if the PEN data are reliable, we must conclude that the central tenets of capital de- pendency theory do not apply in the real world. If the central tenets of capital dependency theory do not apply, some vestige of the theory might be salvageable in the form of warnings to poor countries against importing capital indiscriminately. Dixon and Boswell (p. 562) appear to take that tack in their final sentence, stating that "dependent countries should aim toward a balanced and linked mix of foreign and domestic investment and strive to eliminate the negative externalities produced by penetration." Though the concern about negative externalities appears to be misplaced, the advice about seeking a balanced investment mix is right on target. Yet some might question whether such advice is necessary since it is com- monplace in development literature already (e.g., Morley 1975; Gillis et al. 1983, chap. 14). Indeed, if capital dependency theory reduces to the advice that LDCs seek "a balanced and linked mix of foreign and domestic investment," then what was all the fuss about?


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