[International Markets] The New Hegemon?

Hamurabi

So I've noticed a recurring theme in the international economic news of the past few months -- the U.S. debt (and international borrowing) issue, the debt ceiling debacle over the summer, and now I hear tell that Europe is literally sinking into the ocean under the weight of all its debt. Lurking in the background of all these economic calamities seems to be the specter of upsetting global finance markets. We need to reduce our debt and deficits here in the U.S. because otherwise international capital markets will raise our borrowing costs; Greece needs to implement radical reforms or international investors will stop lending to it and bankrupt the state; developing countries in the third world need to liberalize their economies in order to attract foreign direct investment.

I guess what I'm trying to express here is the degree to which we take the impact of global markets for granted.

Now, I understand that worrying about the confidence of some pension fund in Germany or hedge fund in Manhattan is just part and parcel of living in a globalized world, and that it isn't necessarily an easily classifiable "good" or "bad" thing. After all, we Westerners (as the dominant global political hegemon of the moment) want to see economic and societal values that we view as universal (protection of private property, a reliable system of law, stable governance, etc.) spread as far and wide as possible; it's not that we're imperialistic, necessarily, but that we'd like the developing world to adopt reforms that we view as being crucial to achieving the levels of wealth we enjoy here in North America or in Europe.

The downside, of course, is that international pressures can sometimes overrule traditional notions of sovereignty. It's an established consensus view in economics, for instance, that stimulative deficit spending during a time of deep recession is the most efficient way to get back on track to growth. Well, what if international markets feel you can't be trusted to spend your way out of a recession, because it is the opinion of the market that your reckless spending is what got you into a recession in the first place (whether or not that's accurate). If you try to employ stimulative measures, you're viewed as being oblivious to the problem, or unwilling to make the "tough decisions" it takes to get your economic house in order; your borrowing costs go through the roof, and you become a self-fulfilling prophecy. Even if you try to appease the markets, drastic austerity doesn't exactly have a great track record globally, and you plunge into a cycle of stagnation.

Are we really comfortable with the amount of control over domestic policy that we give to the international markets? If not, what, if anything, can be done to keep from being at the mercy of these markets? Is this just something we'll have to deal with as a consequence of a modern international economic system (one that the West largely created)?

ronya

This manner of idea is not new; Dani Rodrik and Thomas Friedman have pushed similar ideas before, and Rodrik's formulation of it has become relatively well-known:

e.g.,: (warning: PDF)

The three nodes of the extended trilemma are international economic integration, the nation-state, and mass politics. I use the term “nation-state” to refer to territorial-jurisdictional
entities with independent powers of making and administering the law. I use the term “mass politics” to refer to political systems where: a) the franchise is unrestricted; b) there is a high degree of political mobilization; and c) political institutions are responsive to mobilized groups.

The implied claim, as in the standard trilemma, is that we can have at most two of these three things. If we want true international economic integration, we have to go either with the nation-state, in which case the domain of national politics will have to be significantly restricted, or else with mass politics, in which case we will have to give up the nation-state in favor of global federalism. If we want highly participatory political regimes, we have to choose between the nation-state and international economic integration. If we want to keep the nation-state, we have to choose between mass politics and international economic integration. None of this is immediately obvious. But to see that there may be some logicin it, consider our hypothetical perfectly integrated world economy.

This would be a world economy in which national jurisdictions do not interfere with arbitrage in markets for goods, services or capital. Transaction costs and tax differentials would be minor; convergence in commodity prices and factor returns would be almost complete. The most obvious way we can reach such a world is by instituting federalism on a global scale. Global federalism would align jurisdictions with the market, and remove the “border” effects. In the United States, for example, despite the continuing existence of differences in regulatory and taxation practices among states, the presence of a national constitution, national government, and a federal judiciary ensures that markets are truly national. The European Union, while very far from a federal system at present, seems to be headed in the same direction. Under a model of global federalism, the entire world — or at least the parts that matter economically — would be organized along the lines of the U.S. system. National governments would not necessarily disappear, but their powers would be severely circumscribed by supranational legislative, executive, and judicial authorities. A world government would take care of a world market.

But global federalism is not the only way to achieve complete international economic integration. An alternative is to maintain the nation-state system largely as is, but to ensure that national jurisdictions—and the differences among them—do not get in the way of economic transactions. The overarching goal of nation-states in this world would be to appear attractive to international markets. National jurisdictions, far from acting as an obstacle, would be geared towards facilitating international commerce and capital mobility. Domestic regulations and tax policies would be either harmonized according to international standards, or structured such that they pose the least amount of hindrance to international economic integration. The only local public goods provided would be those that are compatible with integrated markets.

It is possible to envisage a world of this sort; in fact, many commentators seem to believe we are already there. Governments today actively compete with each other by pursuing policies that they believe will earn them market confidence and attract trade and capital inflows: tight money, small government, low taxes, flexible labor legislation, deregulation, privatization, and openness all around. These are the policies that comprise what Thomas Friedman (1999) has aptly termed the Golden Straitjacket.

The price of maintaining national jurisdictional sovereignty while markets become international is that politics have to be exercised over a much narrower domain. [...] In such a world, the shrinkage of politics would get reflected in the insulation of economic policy-making bodies (central banks, fiscal4 authorities, and so on) from political participation and debate, the disappearance (or privatization) of social insurance, and the replacement of developmental goals with the need to maintain market confidence. The essential point is this: once the rules of the game are set by the requirements of the global economy, the ability of mobilized popular groups to access and influence national economic policy-making has to be restricted. The experience with the gold standard, and its eventual demise, provides an apt illustration of the incompatibility: by the interwar period, as the franchise was fully extended and labor became organized, national governments found that they could no longer pursue gold standard economic orthodoxy.

Note the contrast with global federalism. Under global federalism, politics need not, and would not, shrink: it would relocate to the global level. The United States provides a useful way of thinking about this: the most contentious political battles in the United States are fought not at the state level, but at the federal level.

Figure 2 shows a third option, which becomes available if we sacrifice the objective of complete international economic integration. I have termed this the Bretton Woods compromise. The essence of the Bretton Woods-GATT regime was that countries were free to dance to their own tune as long as they removed a number of border restrictions on trade and generally did not discriminate among their trade partners. In the area of international finance, countries were allowed (indeed encouraged) to maintain restrictions on capital flows. In the area of trade, the rules frowned upon quantitative restrictions but not import tariffs. Even though an impressive amount of trade liberalization was undertaken during successive rounds of GATT negotiations, there were also gaping exceptions. Agriculture and textiles were effectively left out of the negotiations. Various clauses in the GATT (on anti-dumping and safeguards, in particular) permitted countries to erect trade barriers when their industries came under severe competition from imports. Developing country trade policies were effectively left outside the scope of international discipline.

The most dicey projection is that we shall see an alliance of convenience in favor of global governance between those who perceive themselves to be the “losers” from economic integration, like labor groups and environmentalists, and those who perceive themselves as the “winners,” like exporters, multinational enterprises, and financial interests. The alliance will be underpinned by the mutual realization that both sets of interests are best served by the supranational promulgation of rules, regulations, and standards. Labor advocates and environmentalists will get a shot at international labor and environmental rules. Multinational enterprises will be able to operate under global accounting standards. Investors will benefit from common disclosure, bankruptcy, and financial regulations. A global fiscal authority will provide public goods and a global lender-of-last resort will stabilize the financial system. Part of the bargain will be to make international policymakers accountable through democratic elections, with due regard to the preeminence of the economically more powerful countries. National bureaucrats and politicians, the only remaining beneficiaries of the nation-state, will either refashion themselves as global officials or they will be shouldered aside.

Global federalism does not mean that the United Nations will turn itself into a world government. What we are likely to get is a combination of traditional forms of governance (an elected global legislative body) with regulatory institutions spanning multiple jurisdictions and accountable to perhaps multiple types of representative bodies. In an age of rapid technological change, the form of governance itself can be expected to be subject to considerable innovation.

Many things can go wrong with this scenario. One alternative possibility is that an ongoing series of financial crises will leave national electorates sufficiently shell-shocked that they willingly, if unhappily, don the Golden Straitjacket for the long run. This scenario amounts to the Argentinization of national politics on a global scale. Another possibility is that governments will resort to protectionism to deal with the distributive and governance difficulties posed by economic integration. That would be the backlash scenario. If I were making a prediction for the next 20 years rather than 100, I would regard either one of these scenarios as more likely than global federalism. But a longer time horizon leaves room for greater optimism.

Rodrik is, as you might guess, presently an advocate of the third option "free trade with capital controls" sort of philosophy. But regardless of the point on the trilemma favored, the trilemma itself is, I think, consistent.

The Ender

Global federalism is a pipe dream, imho. The scale of governance required is too large to centralize, even if we could envision a world with much more equal resource distribution & demographics.

Are we really comfortable with the amount of control over domestic policy that we give to the international markets? If not, what, if anything, can be done to keep from being at the mercy of these markets? Is this just something we'll have to deal with as a consequence of a modern international economic system (one that the West largely created)?

I'm critical of markets in general, but the economist arguments for 'fixing' them (making them a little less volatile / cannibalistic) that I've heard are:

a) Enforcing rigid restrictions on how large an individual business can get.

b) Enforcing rigid restrictions on how far an individual can be leveraged.

c) Enforcing rigid restrictions on how many countries an individual business can operate in.


Some variation on all of these ideas have been tried before, of course, but arguably the enforcement has been lacking, which proponents of the ideas tend to argue is why they haven't produced the desired result.

ronya

Capital controls are a thing which exist; they work plausibly for countries with extensive trade but conducted through a relatively small number of channels (e.g., Malaysia during the 1997 crisis - the fundamentals were thought to be, and indeed turned out to be, strong and so resisting the speculative attack via those channels was 'enough').

Perhaps that philosophically falls under Ender's (b) though.

The Ender

Capital controls are a thing which exist; they work plausibly for countries with extensive trade but conducted through a relatively small number of channels (e.g., Malaysia during the 1997 crisis - the fundamentals were thought to be, and indeed turned out to be, strong and so resisting the speculative attack via those channels was 'enough').

Perhaps that philosophically falls under Ender's (b) though.

I would say so (though, in fairness, I believe the Malaysian situation did not involve really 'rigid' controls per se? Just some incentive / disincentive programs?)

ronya

The Ender wrote:

Capital controls are a thing which exist; they work plausibly for countries with extensive trade but conducted through a relatively small number of channels (e.g., Malaysia during the 1997 crisis - the fundamentals were thought to be, and indeed turned out to be, strong and so resisting the speculative attack via those channels was 'enough').

Perhaps that philosophically falls under Ender's (b) though.

I would say so (though, in fairness, I believe the Malaysian situation did not involve really 'rigid' controls per se? Just some incentive / disincentive programs?)

The controls were quite rigid and extensive (warning: PDF):

The policies Nor Mohamed designed were extraordinary in their complexity and sophistication. A perusal of Bank Negara’s press release of September 1, 1998, which details existing and new regulations, can give one the sense that Malaysian authorities went through the balance of payments line by line analyzing ways to prevent the outflow of short-term capital and eliminate speculation on the ringgit. Malaysian authorities clearly sought to separate rigidly their restrictions on short-term capital outflows from the long-term capital inflows—foreign direct investment—on which the economy, or at least the government’s plan for the economy, had become so dependent.

The most direct, and perhaps most notorious, of Malaysia’s unorthodox policies were the controls on capital outflows. Nonresidents were required to wait for one year to convert ringgit proceeds from the sale of Malaysian securities—that is, foreigners who sold shares on the KLSE could not take the money out for a year. Business Week likened the policies to “a financial Roach Motel: Money can get in, but it can’t get out.” In February 1999, the government replaced this regulation with a sliding scale of exit taxes on capital gains, ranging from 10 to 30 percent. Then, in September 1999, Bank Negara replaced the two-tier tax with a flat 10 percent exit tax, which it subsequently abolished in February 2001. Additionally, Malaysians themselves were prohibited from investing abroad without prior approval from Bank Negara.

A more subtle policy was the elimination of the offshore ringgit market, which was viewed as a source of speculative funds and upward pressure on domestic interest rates. Toward this end the government required that all ringgit held offshore be repatriated within a month, after which only the ringgit already in Malaysia would be legal tender. Furthermore, ringgit lending by Malaysians to foreigners was prohibited. With these two simple regulations, the offshore market for ringgit was eliminated. As Nor Mohamed recognized, “It’s easier to stop the guy who has the ringgit from lending to currency speculators” than it is to prevent speculators from borrowing ringgit.

Two related measures were the fixing of the exchange rate at 3.8 ringgit per U.S. dollar and the closure of the Central Limit Order Book (CLOB), an over-the-counter market for shares on the KLSE based in Singapore, which was seen as a loophole to the regulation of foreigners’ repatriating the proceeds of their securities sales.

With this complexity and sophistication came, inevitably, enormous confusion about what the policies prohibited and allowed. Bank Negara undertook a massive information campaign, complete with scores of clarifications and a twenty-four-hour hotline to answer questions. Of course, this was an administrative burden for the bank as well as for anyone who had to operate within the new set of regulations. The complexity of the policies, combined with the prime minister’s colorful rhetoric, also led to the widespread perception that the Malaysian policies were not only unorthodox, but downright radical.

shryke

ronya wrote:

The Ender wrote:

Capital controls are a thing which exist; they work plausibly for countries with extensive trade but conducted through a relatively small number of channels (e.g., Malaysia during the 1997 crisis - the fundamentals were thought to be, and indeed turned out to be, strong and so resisting the speculative attack via those channels was 'enough').

Perhaps that philosophically falls under Ender's (b) though.

I would say so (though, in fairness, I believe the Malaysian situation did not involve really 'rigid' controls per se? Just some incentive / disincentive programs?)

The controls were quite rigid and extensive

Bowchickawowow?

Calixtus

Which part of the current crisis is caused by a lack of international economic integration, exactly?

And how does free trade and/or global federalism deal with commerical interests who take short-term actions for profit now in favour of long-term stability?

Why would an elected official get any better at managing an economy than Greece or Italy, just because he gets more constitutients?