Seminar 1: What is the New Political Trilemma in Europe?

Introduction 

The Argentine response to the economic crisis and inflation of the 1990s was led by the finance minister Domingo Cavallo. He instituted the ‘convertibility law’ that anchored the peso to the US dollar. This was coupled with trade and financial liberalization, liberal tax reform and privatization. All of these policies (market liberalization) were aimed at reducing transaction costs for the in-flow of capital. His liberalization policies, and the hard currency regime associated with the convertibility law, appeared to work. It eliminated hyperinflation. Capital inflows increased. Everything looked stable.

Then the Asian financial crisis hit the world, which reduced the appetite of international investors to invest in emerging markets. In 1999 Brazil devalued it’s currency by 40 percent against the dollar. The Argentine peso was now hugely overvalued, and the economy uncompetitive. Investor confidence collapsed. Argentina responded with severe austerity policies. Government salaries and pensions were cut by almost 15 percent. Fearing devaluation, domestic savers pulled their money out of bank accounts. The government responded by limiting cash withdrawals. Mass protests ensued. Looting and strikes spread. Everything suddenly looked unstable.

This story reflects the global trilemma of international economics, brilliantly outlined by Dani Rodrik in his book ‘the Globalization Paradox’. It’s ultimately a story about constrained policy choices (democracy), in a world of free flowing capital (markets).

The economic trilemma  

The original trilemma in the study of international economics suggests that you cannot simultaneously have:

  1. A fixed exchange rate,
  2. A sovereign monetary policy
  3. Global capital integration.

As Paul Krugman explains:

“The point is that you can’t have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain, the USA – or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (as Argentina did)”.

Argentina removed the risk of financial instability but ran into another dilemma: an uncompetitive currency. They choose to not have a sovereign monetary policy, much like the countries of the Eurozone today. This meant that when confronted with an economic crisis, the cost of adjustment fell on government expenditure; pensions, public sector workers, social services. The policy objective was to ensure that the government would pay their debt obligations to foreign creditors. Eventually the Argentine people were unwilling to accept the level of austerity imposed. The state defaulted on their debt in 2001, and continue to be stuck in a legal battle with the US in 2017.

From the perspective of the euro crisis, it is worth noting that the Asian financial crisis, and the Argentinian debt crisis, all occurred in the late 1990’s, just as governments in Europe agreed to create a single currency, via the Maastricht treaty. This is an important global political observation for understanding why governments chose to do this.

The golden straitjacket 

Tom Friedman describes the constraint facing  governments in a world of free capital mobility as the golden straightjacket of globalization. Friedman argues that “when you put this jacket on, your economy grows (goes global) but your politics shrinks. Governments have to follow the rules set by financial markets, which means that domestic politics is reduced to a choice between Coke and Pepsi”.

The extent to which global markets constrain domestic policy choices, and the extent to which they undermine democratic responsiveness, were summed up by John Bruton a few years ago (John Bruton is a former Irish Prime Minister), when he argued that the interests of banks not social protection should be the priority of the Irish government.

This caused a storm on social media, but was he not simply pointing out an empirical reality facing governments today? He was basically arguing that in order for Ireland to secure the confidence of market investors, it had to priortise it’s debt obligations (which, of course, originated in the private banking sector that collapsed in 2008).

The implication is that the cost was largely borne by the public sector.

Global markets, democratic politics 

This tension between globalized markets and national democratic politics is real. It can be observed in the growing competition between nation-states over corporate tax rates, and how policymakers should respond to tax avoidance, an issue that has grown in importance in European politics today (think Apple Tax).

The main factor driving international tax competition is the removal of capital controls. Ireland and Spain are free to compete for FDI though their national tax codes.

The argument by Dani Rodrik is that once a government accepts free capital mobility, they must then choose whether they want monetary sovereignty or fixed-exchange rates. If they choose a shared currency (a radical form of a fixed exchange rate) then they must give up national central banks. This is the situation of the eurozone today.

It must be emphasised that this does not mean governments, and electorates, have no choice. Governments are free to set their national tax codes – as long as it does not undermine the competition law, and the single market.

In terms of international monetary politics, what this means is that when governments give up monetary sovereignty they give up the capacity to set interests rates, adjust the price of their currency and the shape of the money supply.  Put simply; they give up a very important tool of macroeconomic politics.

The distributional and political effects of adjusting an economy via the price of the currency, is very different than adjusting it via wages, salaries, and government expenditure. Think about the electoral consequences of imposing austerity.

The political trilemma 

All of this frames Dani Rodrik’s argument that democratic states face, not only an economi trilemma, but a “political trilemma” when deciding how to integrate their national economies into the global markets, as outlined in this classic article.

He argues that we can either:

  1. Restrict the democratic state in the interest of minimizing the international transactions costs of globalization (i.e. reduce taxes and public services).
  2. Limit the globalization of international capital and strengthen the role of the state within national borders (i.e. expand the role of the state in the economy).
  3. Globalize the democratic state as a complement to global capital markets (i.e. have a global government capable of providing social rights, and market freedoms).
    • The EU could be conceptualised as a variant of this.

This thought experiment provokes the following observation: if we want to embrace globalized markets and democratic politics, then we have to give up the nation-state. The European Union (EU) is perhaps the most successful case of attempting to govern beyond the nation-state. But at what cost? Is it a case of embracing the market, and giving up democratic politics, in favour of technocracy, or something in-between?

What do electorates want? Do they want to transfer more sovereignty to the EU, or less? To answer this question we need to study the demand-side of politics.

International monetary politics

Both (1) and (2) above have been instituted via different international monetary regimes. In the eurozone we live in a variant of (1), whereas (2) was reflected in the Bretton Woods compromise. The global governance option, whereby there is a global federal constitution built around mechanisms of responsibility is a hypothetical ideal.

There are obviously no political conditions in place that would enable (3) to happen. The only thing that comes close are the various attempts at facilitating international coordination to the constraints of global markets through regional cooperation, such as the EU.

 Is the monetary union in Europe a radical response to the global trilemma?

This is the question I want you to consider this week. The Euro area is a currency union, but not a political, federal or fiscal union. It’s not the USA. In this regard, it is a pretty radical experiment on how to manage diverse democracies within a stateless currency.

Positive and negative integration 

The EU has moved from a customs union to a free trade area in the attempt to build a truly single market (for capital, goods and services), with hugely positive effects.

Member-states guided by the Commission and monitored by the European Court of Justice (ECJ) have successfully liberalized restrictions on trade (often described as negative integration i.e. removing trading borders). But what they have not achieved is constructing those supra national institutions aimed at providing the public services, or social, functions of the nation-state (often described as positive integration). Why?

Later in the course we will call this the asymmetry of European integration.

To reach agreement on politically contentious issues and to harmonize policies at the EU level (such as a common consolidated corporate tax base, a common Euro bond or a shared basic income scheme) requires consensus in the European Council (and increasingly ,in the Euro Summit). But each member-state has a veto in the Council, with the implication that reaching shared agreement is politically difficult.

National interests (particularly of larger member-states) tend to prevail in the intergovernmental  bargaining process, and it’s easier for member-states to agree market liberalization policies (negative integration) than policies requiring governments to increase their contributions to the EU budget.

Regional integration  

Before we examine this asymmetry of integration, which I will suggest is the core problem in the EU, it is worth reminding ourselves that the global economy is not nearly as integrated as some people think. Capital inflows/outflows have a remarkably strong regional bias. Rich countries continue to invest in other rich countries.

The Eurozone is a very good example of this, as will see over the coming weeks. For example, see world exports as a percent of GDP in this data.

This home-bias in trade can predominately be explained by the fact that political and legal systems are organized at the national or regional level, and therefore the transaction costs associated with trade and investment are reduced only at this level. The EU has significantly removed trading barriers via the single market.

 

Regulatory competition 

Regulatory competition in a global market inevitably puts pressure on European welfare states. The three biggest areas of public expenditure in all advanced capitalist democracies are health, education and social security, particularly pensions. This basically means payment for education. healthcare and eldercare. Electorates rarely, if ever, want to see this areas cut, rather they want more investment.

This begs the question, why pays? Expenditure has to be funded by taxes or debt.

Until quite recently this was not really a problem within the European Union. The EU did not interfere in national social/labour markets, or redistributive policies. It was a regulator of markets. Member-states were free to respond to the political preference of their citizens and pursue high or low social compensation regimes. Technical expertise in a given set of policy areas (usually associated with the market, trade and competition) rather than democratic legitimacy (usually associated with politics) is what mattered.

With the launch of the euro, this balancing act between allowing member-states to pursue their own domestic distributive choices, whilst allowing the EU to regulate, came to an end. At present, it’s not quite clear what will come next.

Non-optimal currency area

The single currency constrains and shapes the capacity of governments to respond to the political preference of their citizens. Member-states must follow rules that ensure governments act “responsibly” when dealing with market forces. This is not to suggest domestic politics does not matter, but it does mean that the politics of adjustment is made more difficult; just think about the austerity programs across Europe.

In joining EMU, member-states gave up monetary sovereignty, which meant that when confronted with a crisis, the tools of adjustment were limited. We will discuss the consequences of this in the coming weeks. Fiscal, welfare and labour market regimes differ hugely among the 19 member-states of the single currency. Can all these countries continue to co-exist, without creating imbalances between each other?

We know that the EMU is not an optimal currency are,  and we know that national governments were perfectly aware of this when they entered the single currency. Why then did they construct a monetary union? To answer this question we need to understand the importance of ideas, interests and institutions in shaping the politics and economics of European integration.

Conclusion

National governments have two political constituents to satisfy: markets and voters. This is the fundamental dilemma of democratic capitalism. Next week we will discuss different theories of comparative political economy and how these relate to European integration. Be sure to read this classic article by Peter Hall.

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Seminar 3: The Costs and Benefits of the European Monetary Union.

Introduction

In week one, we discussed the trillemma associated with governing an open economy in an international market. This suggests that nation-states can only have two of the following:

  • Full freedom of full capital movements (let’s call it globalisation).
  • Fixed exchange rate (think of it as the price of your currency).
  • Independent monetary policy (think of it as democracy, or central banking).

A country with full capital mobility and fixed exchange rates loses the capacity to conduct a national monetary policy. This means countries lose an important tool of economic adjustment when confronted with an economic crisis, such as a recession.

This week we are asking whether the Economic and Monetary Union in Europe (EMU) is a radical response to this trillemma? If so, what are the costs and benefits?

In the EMU, nation-states have given up their monetary policy in return for a shared currency, between 19 different nation-states, and the free movement of capital between these countries (but they have not created a banking, capital market or fiscal union), governed by the European Central Bank (ECB) in Frankfurt.

The Costs of EMU

(Summary: loss of currency adjustment, loss of lender of last resort, being compelled into a pro-cyclical fiscal policy).

What are the costs of the European monetary union?

The cost derives from the fact that when a country relinquishes its national currency it loses an instrument of economic policy i.e. it loses the ability to conduct a national monetary policy. In effect, it no longer has a national central bank.

This graph on divergent bond yields sets the scene for the series of crises that afflicted the Euro area since 2008, and an important reminder of what happens when a country loses the ability to conduct it’s own monetary policy in response to a crisis.

The important thing to note is that the increase in the interest rate charged to governments (to borrow money) meant some countries got priced out of international markets, and had to resort to a non-market loan from the IMF/EC/ECB (the Troika).

When national central banks cease to exist, countries cannot use exchange rate adjustments as a policy instrument (devaluations and revaluations are ruled out, and interest rate risks are priced in). They also cannot change the short term interest rate.

Any adjustment must now take place via internal devaluation. What this means is that when confronted with a shock, internal prices (think wages, rents, healthcare, education) must be adjusted downwards, rather than the price of currency.

Let’s assume a monetary union and take two countries, Spain and Germany.

If output (economic growth) declines in Spain and unemployment rises, whilst the opposite occurs in Germany (output increases and unemployment declines), how is it possible to bring both countries back into equilibrium?

  • This decline in output can be caused by either an external shock to aggregate demand, such as a financial crisis, or something as simple as a change in consumer preferences, or a reversal of capital flows from German to Spanish banks.

There are two possibilities in the classical theory of optimal currency areas (OCA): wage/price flexibility and mobility of labour.

First, if wages decline in Spain the aggregate supply curve shifts downwards whereas it shifts upwards in Germany (wage rises). This makes Spanish products more competitive (exports improve) whilst in Germany imports increase (domestic demand improves).

This generates a balanced relationship.

Second, an additional mechanism that will lead to a new equilibrium between these countries involves the mobility of labour. Unemployed workers in Spain will move to Germany where there is excess demand for labour. This leads to a decline in unemployment in Spain, and avoids wage-inflationary pressure in Germany.

In OCA theory, absent these two mechanisms in a monetary union, Spain and Germany will be stuck in a bad equilibrium. It generates a long-term aggregate demand problem.

What would happen in a hard-peg and soft-peg currency regime?

Spain would either devalue the currency or adjust domestic interest rates, whilst directly targeting the real exchange rate to improve cost competitiveness.

The consequence of losing this tool of adjustment can be viewed here.

If wages are rigid, (what economists call “sticky”), and labour mobility is absent, different countries in a monetary union will find it extremely difficult to adjust (and improve price competitiveness) when confronted with an asymmetric shock.

Unemployment will remain high in Spain, and it will be faced with years of deflation, whereas Germany is unlikely to push for a policy that undermines its competitiveness.

Divergence between the two countries grows. Does all of this sound familiar? It should.

The loss of monetary independence leads to the second cost. Member-states, in effect, issue debt in a foreign currency over which they have no control. Financial markets now have the power to force a default on these countries when faced with crisis. Think back to the divergence in bond yields, which started the sovereign debt crisis.

For example, let’s take the case of the UK and Spain.

If UK investors fear a default they will sell their UK government bonds. Interest rates (bond yield) will rise and the price of the pound will drop. Pounds will be sold in the foreign exchange market. Capital will be forced to stay local.

Further, the British government can get the Bank of England to buy bonds. The debt market would stay liquid. British society has a lender of last resort. This acts as a bulwark against financial attack.

The UK can effectively finance debt through money creation. The tradeoff is higher inflation. They can do this because they have a lender of last resort.

In Spain the opposite occurs. If a default risk arises investors will sell their bonds and re-invest them in a safer Euro region, say Germany. Money floods out of the Spanish banking system. The money supply shrinks.

Spain now faces a liquidity crisis. There is no lender of last resort. The Spanish government has no influence over the ECB. Spain is effectively borrowing in a foreign currency. A liquidity problem turns into a solvency problem.

In a monetary union, short-term interest rates converge (i..e cheap credit, the good times of the Euro) but when faced with an asymmetric shock, long-term interest rates on government bonds diverge (bad times of the Euro).

This is what happened from 2008-2011 until Mario Draghi (governor of the ECB) signalled that he would intervene in bond markets if necessary. And he did, the ECB are indirectly buying government debt through the private banking sector.

During the asymmetric shock, GDP and employment declines rapidly in one region (southern Eurozone) whilst it recovers more rapidly elsewhere (northern Eurozone). This reinforces pressure on fiscal policy. Budgets are cut. Taxes are increased.

Being forced into an internal devaluation is the third cost of monetary union. Pro-cyclical fiscal policy deepens the monetary asymmetry.

In a monetary union this asymmetry in fiscal responses to an asymmetric shock could be avoided with a budgetary union and the issuance of a common Euro bond (much like the fiscal equalization among the German Länder, or the US Federal States).

This provides an insurance and a protection mechanism for its members. The EU budget amounts to only 1.1% of EU GDP whereas national budgets typically absorb 40-50% of GDP. Social welfare and public services remain at the national level.

Finally, the cost of monetary union is also related to differences in labour market and legal institutions.

Some countries market-oriented labour markets (Ireland), other countries have collective bargaining oriented labour markets (Italy).

These legal-institutional differences also apply to mortgage markets, banking, taxation and corporate finance, to name but a few. We will discuss these differences in more detail in our seminar on European varieties of capitalism.

So, the costs of EMU are primarily related to how countries respond to an economic recession: a) the loss of currency adjustment to deal with competitiveness problems, b) the loss of a lender of last resort, which acts as a bulwark against financial markets, c) being forced into an internal devaluation, which leads to pro-cyclical fiscal policy, d) being stuck in a monetary union with divergent legal-institutions to deal with markets.

Note, the EU and the troika are fully aware of these. Hence, their preference for, a) a supranational capital markets union, b) empowering the ECB to stabilise financial markets, c) liberalisation of labour and product markets. In short, EU policymakers want to “complete the monetary union”. Why is this not happening?

What are the benefits of a monetary union?

While the costs of monetary union are usually associated with macroeconomic outcomes, the benefits are usually associated with microeconomic outcomes.

These benefits are primarily associated with the direct and indirect effects of eliminating transactions costs (for free trade in capital) and ensuring price transparency.

Removing exchange rate risk facilities economic growth. It provides stable money.

According to the neoclassical model of technological change, a monetary union will expand and improve free trade. A single currency complements economies of scale.

Monetary union also spurs financial and capital market integration. This generates welfare gains. Markets are less uncertain about the future revenue of firms.

All of these benefits are reflected in a famous EC Commission report on ‘One Market, One Money‘ (1990), which provided the ideational basis for the EMU.

The role of economic ideas: Keynesians versus Monetarists 

Comparing the costs and benefits of monetary union is not just a technical exercise. When comparing costs and benefits it makes a huge difference as to what “model’ we use, and what assumptions we make. These are related to ideas.

Monetarists and Keynesians look at the political and economic world in very different ways. This is fundamentally related to different ideas about how economies operate.

For monetarists, national monetary tools are ineffective instruments to correct asymmetric shocks. Losing monetary sovereignty makes no difference.

Monetarists operate from the micro-foundations of classical political economy, which assumes price and wage flexibility (and if these are not flexible then policymakers ought to make them so i.e. liberalisation of markets, including collective bargaining).

Keynesians on the other hand see the world as full of rigidities (wages and prices are not flexible). National monetary policies and the exchange rate are powerful instruments in absorbing shocks. Losing sovereignty makes a big difference.

In trying to assess the cost-benefits of a monetary union what matters most is the extent of wage and price rigidities.

This leads to a division between economists operating from abstract-theoretical models (i.e. that assume by definition lower wages = more employment) and political economists operating from case-based empirical studies (i.e. that show there is no relationship between wage cuts and employment).

In the Euro area all labour market policies are focused on supply-side reforms. The monetarist argument dominates.

The monetary union has also exposed governability problems associated with democratic legitimacy. Governments have less capacity to shape the course of their domestic economies yet are accountable for it’s performance.

In world of free capital flows successful economic management has become much harder. Nation-states are weaker.

Unlike monetary policy (Europeanized)  fiscal and incomes policies (nationalized) are politicized policy instruments. The EU now affects all three.

For Fritz Scharpf in trying to maintain output legitimacy governments may undermine input legitimacy.

In conclusion, monetary union benefits some and imposes a cost on others. There are winners and losers.

In the absence of a federal union some countries such as the Benelux, Germany, and other export-oriented economies benefit. But can this be said for countries such as Italy, Greece, Portugal and possibly Spain?

To get a sense of these differences, lets examine the divergence in macroeconomic policies post-EMU.

Fritz Scharpf suggests that monetary union created the conditions for a sequence of three crises from 2008-2010. Banking crisis – credit squeeze – sovereign debt crisis.

Some consider the design of EMU to blame for the problems afflicting the Euro. Others blame the inability of southern European governments to impose tough structural reforms. Discuss.

What next for an incomplete monetary union?

Assuming that countries are not likely to leave a monetary union (even if they suffer years of one-sided deflation and austerity), is it possible to imagine a political-fiscal union emerging as a complement to monetary union?

This is a political question that requires giving up more national sovereignty and brings us back to the initial trilemma.

The European Monetary Union was a radical political response to the global economic trilemma: capital mobility combined with complete abandonment of national monetary sovereignty.

Member-states of the EMU have accepted deep economic integration. The choice is then between national politics (less integration) and shared policies (more integration).

If member-states accept more integration (which seems to be the case, for example, on banking union) then the choice is more democratic or technocratic decision-making (ECB, EU Commission).

Public opinion favors accountability so the choice is what type of policymaking governments should institute.

To complete the monetary union governments need to go down either the intergovernmental or federal route. EMU is stuck somewhere in the middle.

German voters don’t want a budgetary union, or a common Eurobond, and Irish voters don’t want tax harmonization.

Europe is stuck in a bad equilibrium.

Seminar 2: The Political Economy of European Integration

Introduction

The state and the market represent two different ways of organizing human endeavor, and the relationship between them has always been a central preoccupation of comparative and international political economy.

When economics became its own specialist discipline with the marginal utility revolution it fell to political scientists to inquire more deeply into the relationship between politics and economics in shaping public policy outcomes.

For Peter A. Hall, the study of political economy is a specific social scientific inquiry into three particular types of issues: power, institutions, distribution (PID).

In terms of explaining the political economy of European integration, what might this mean? Or, what type of research questions does it lead to?

What explains the decision by nation-states to increasingly transfer policymaking sovereignty to the European Union?

The PID in political economy

Let’s unpack the meaning of power, institutions and distribution.

First, when political economists systematically inquire into the politics of power they are inclined to ask: whose interests are being served by any given set of economic arrangements? For example, who benefits from the single market?

Whereas marginal economists tend to analyze the market and price formation in terms of Pareto-optimality, political economists tend to analyze markets in terms of whose interests are being served by a given set of public policy choices.

They are interested in the extent to which bargaining  power is distributed across different social groups, and political and economic actors.

Second, political economists tend to analyze the market as a set of variegated institutions that adapt and mutate across time and space. Institutions are conceptualised as the “rules of the game“, which shape actor behaviour.

This mean that political economists tend to be more interested in concrete phenomena (the impact of EMU on member-states) rather than abstract theories.

Competitive markets are one way to allocate scarce resources in a society (and a very effective one) but their institutional formation differs, depending on the firm, sector and country, such that there can never be a “one size fits all” market explanation.

Third, political economists analyze the market as a human construct, whose conception is based on the primacy of politics. This means they are often interested in the distributive effects of capitalist markets and the power relations underpinning them.

Think about these questions in terms of the financial crisis.

What would be the implication of analysing financial markets as efficient systems setting optimal asset prices (such that risk is widely dispersed), as opposed to a set of unstable markets that serve certain interests over others?

In this module we are interested in the intersection between comparative and international political economy, as it pertains to European integration.

To explain this we are going to examine the relative role of interests, ideas and institutions. Think about this in terms of the following question (next weeks topic):

Why would nation-states give up monetary sovereignty?

Interest-based

Interest-based approaches to European political economy give specific priority to the material interests of the core actors being studied. These interest-based approaches can be divided into two schools of thought: producer groups and electoral politics.

Producer group

  • Producer group theories attempt to explain variation in economic policymaking preferences among governments. The unit of analysis is usually the nation-state (or the EU) whilst the central actors under study are producer group interests.

What is a producer group? How is it related to the factors of production?

To explain changes in economic policymaking (such as favoring the liberalization of internationally traded services) researchers in this tradition tend to focus on the material interests of producer groups, and their relationship to the government of the state (such as the role of export employers in lobbying government).

  • Producer group coalitions can be broken down in functional terms (workers, capitalists, farmers) or by specific sector (traded versus the non-traded sectors), or asset specificity (mobile versus fixed).

Pioneers of this type of research include Barrington Moore (1966) and Peter Gourevitch (1977, 1986).

Research in this tradition has attempted to explain European integration by tracing government policy to the different producer group coalitions within a country (whether employers are predominately export led or focused on domestic demand).

More recently, a similar approach has been adopted to explain why countries and sectors adopt different position on international exchange rate regimes.

For example, why did Ireland and the Netherlands join the EMU whereas Sweden and Denmark did not?

All of these countries are small open European economies but with very different producer group coalitions.

Broadly speaking, the producer group perspective tends to explain domestic policy choices as a response by governments (and employers) to international economic change.

Economic policymaking is conceptualized as a form of “organized combat” among competing producer interest groups.

This approach has three powerful advantages.

First, it recognizes that change in domestic economic policy must win the support of broad segments of society. Think about Italy in this regard. Governments are heavily dependent upon winning the support of different producer group coalitions (taxi-drivers, chemists, trade unions, small businesses) and economic reform is unlikely to be successful if the government does not win the support of these producer group interests.

Second, it highlights that politics is always a struggle over economic resources.

Third, it combines the study of comparative politics with international relations and therefore provides a causal mechanism often lacking in the latter when trying to explain the ‘domestic’ mechanism of change (i.e. why countries push for European integration).

But this perspective also has serious shortcomings.

It tends to not take electoral politics very seriously. Political parties are considered the agent of producer groups, and therefore lacking autonomy. Think about Brexit. The Tory government have pursued a policy, which business interests tend not to want. This would suggest that the Conservative party are responding to something else.

Electoral

  • The second school of thought in interest-based approaches to explaining patterns of economy policymaking is the ‘electoral approach’. Individuals in the electoral arena, rather than producer groups, are seen as the central actors. Change can be explained by politicians reacting to the electorate in seeking re-election.

Economic policy in this regard is explained by the ‘political business cycle‘.

Politicians, it is assumed, think only in the short-term and therefore economic performance will always be sub-optimal. They will pump-prime the economy prior to an election. But this will vary by party partisanship.

Left-wing and right-wing governments, it is argued, behave differently.  Left wing governments should lead to higher inflation and lower unemployment. Right wing governments will cut welfare expenditure and taxes.

The electoral approach has two significant strengths.

First, it is reasonable and obvious to assume that the first priority of politicians is to seek re-election.

Second, politicians often do stimulate the economy unnecessarily before an election. One only has to think about successive FF governments in Ireland and the regular patterns of pro-cyclical fiscal policy governance.

But there are three significant limitations to this approach when it comes to European integration.

First, governments regularly pursue medium to long-term objectives, despite short-term electoral incentives, such as delegating monetary sovereignty to central banks.

Think about the policy response to the crisis in the Eurozone. Did governments put their own re-election interests first?

Second, it is analytically attractive to assume a ‘median voter’ and a homogenous electorate with fixed preferences. But politics is far more complicated. Voters do not often voter in their own material interests (think about this in terms of income distribution i.e. why don’t the poor soak the rich?).

Similar to a lot of rational expectations economic models, what the electoral approach makes up for in methodological parsimony/clarity it often lacks in empirical validity.

However, as discussed last week, the European Union is becoming increasingly important in shaping electoral preferences. It is becoming politicised.

Institution-based 

Institution-based approaches generally seek to explain variation in economic and employment policies by examining the causal influence of the organizational structure of the economy on government choices.

The unit of analysis is the nation-state and the principal actors are important organised interest groups such as trade unions, employer associations, and the corporate firm.

Institutions, it is argued, shape, enable and constrain the behavior of actors.

Unlike neoclassical economics the institutional approach emphasizes the institutional differences across nations over time. The impact of globalization will be mediated differently depending on the domestic structure of the economy.

These differences, it is argued, give rise to qualitatively distinct varieties of capitalism, which, in turn, result in distinctive patterns of economic policymaking.

There have been two broad schools of thought in the institutional approach in trying to explaining European political economy: neo-corporatist and varieties of capitalism.

Neo-corporatist

  • Neo-corporatist’ research traced differences in labour market performance to whether trade union and employer associations were either centralized or de-centralized. Centralized trade unions capable of internalizing the inflationary pressures associated with full employment can pursue wage-restraint in response to globalization.

This was particularly important in the aftermath of the oil crisis shock in the late 1970’s and the period of high inflation.

Over time the emphasis was placed on the extent to which employers and trade unions could engaged in long term coordinated wage-setting, which is particularly important in the context of adapting to the European monetary union.

Some scholars emphasized that it was predominately small states operating in a global market who constructed corporatist institutions; whether trade unions were export-led or not; and the extent to which left-leaning parties were in government.

Why might small states have a preference for social partnership?

Varieties of capitalism

  • From the early 1990’s it was gradually recognized that the structure of labour markets were also related to the structure of industrial relations, vocational training, corporate governance and the financial system.
  • Each sub-sector complemented each other to create distinct “systems” of organizing the economy, giving rise to different European models of capitalism.

For example, countries such as Germany had banks oriented toward the long-term financing of industry, with the implication that corporate strategies and patterns of economic policymaking were quite different from those countries with short-term finance and heavy reliance on stock market valuations (UK/USA).

All of this led to the varieties of capitalism school of thought.

Institutional structures interact in complex ways across different sub-policy spheres of the economy to create a matrix that shapes the strategies/policies of government.

The institutional complementarity approach has three powerful advantages.

First, it moves far beyond those conventional economic analyses that assume a one-size fits all strategy of adjustment to European integration (financial liberalization).

Second, it brings the strategies of business firm (corporation) back into the central analysis of political economy.

Third, it highlights the importance of strategic interaction (game theory) in shaping patterns of economic policymaking.

However, there are three serious limitations to the institutional approach.

First, it tends to underplay the importance of conflict in capitalist market economies.

Second, it has a tendency to downplay the importance of the state.

Third, methodological, it risks becoming tautological in the sense that we can end up with just as many varieties of capitalism as nation-states.

It is generally better equipped to explain stability than change.

How might a VoC approach explain the different preferences member-states have to more or less European integration? For example, the difference between France and Germany when it comes to issuing a single euro-bond?

Ideas-based 

Ideas based approaches generally seek to explain change by examining the causal influence of economic ideas. There are three different approaches to this.

  • First, some scholars incorporate ideas into interest based approaches by analyzing the importance of ‘focal points’.

Ideas act as focal points around which collective action problems can be resolved. Garrett & Weingast (1993) employ this approach to explain why nation-states converged on a particular kind of approach to European integration, by examining what enabled different governments agree to the shape of the single market (1986).

In this approach, material interests are the primary causal factor to explain why member-states choose to liberalize trade but ideas act as focal points that enabled conflicting political actors to reach shared agreement on a similar course of action.

  • Second, some scholars, such as Mark Blyth, give ultimate causal priority to the role of ideas and elites in explaining why government choose a given set of economic policies.

This approach tends to give priority to the importance of professional economic communities. Think about the role of economists in the Ministries of Finance (or think about the shift toward monetarism in the Bank of England).

Would Ireland have gotten rid of protectionism if TK Whitaker was not the secretary general of the Dept of Finance?

Ideas are assumed to be formed or influenced by elites and epistemic communities.

These elites hold a certain worldview, which they implement when they are in positions of state power, where they can effectively translate their ideas into policy.

  • Third, other scholars go behind the specific importance of ideas to give causal priority to cultural variables.

Different economic ideas are cultural world-views and deeply intwined in national histories and language. In a sense, one can think about this approach in terms of the strong anti-inflation stance in Germany, or their strong moral dislike of debt (schuld), which directly translates into ‘guilt’ or ‘responsible’.

Cultural based political economy gives priority to the way different kinds of knowledge and information are distributed in particular sectors of the economy.

The problem with ideas-based explanations is that it is not clear whether it is norms, ideas, discourse, interests, culture or ideology that is the causal factor behind economic policy.

Trying to disentangle ideas from material interests is not easy. Material interests are a lot easier to “model”.

But ideas clearly matter in shaping economic decision making, and this is reflected in the policy preference for a particular kind of adjustment package in Europe today, or is it?

Is the European path of adjustment (austerity) the outcome of ideas, structural institutional constraints or the interests of larger member-states, such as Germany?

Discussion  

These three approaches to studying political economy can be applied to the study of European integration.

But in terms of assigning relative priority to different socioeconomic variables these different approaches also lend themselves to different causal propositions.

Think about this in terms of the the broad paradigm shift toward, and subsequently away from, aggregate demand policies associated with the Keynesian welfare state.

Why were active aggregate demand policies adopted in some countries but not others? Why did they come to an end?

  • Interest based scholars focus on coalition building among farmers and industrial workers, particularly in France and the UK.
  • Institutional scholars emphasize the different strategic capacities of the state to engage in public investment.
  • Ideational scholars emphasize the role of epistemic communities among economic professionals in the state.

In many ways these different approaches reflect a difference between positivistic and cultural oriented approaches to causal inference in the social sciences.

This can be reflected in how certain variables such as ‘institution’ are conceptualized.

Three institutionalisms 

There are three school institutionalist analyses: historical, rational-choice and cultural.

For historical institutionalists (HI’s), institutions are a path dependent set of rules and procedures embedded in the organizational structure of the polity or political economy.

It is not easy to change path.

HI’s tend to emphasize the asymmetries of power associated with the origins (critical junctures) and development of institutions. Institutions are a calculus that shape and constrain the actions of governments and firms.

What policies governments can or cannot pursue is dependent upon the broader institutional structure of the economy.

In Ireland, this means that government economic policy is shaped by the path dependent effect of its heavy reliance on foreign direct investment (FDI).

  • Think about it this way: is any government likely to increase corporate tax rates in Ireland? Why not? One can hypothesise that no government is likely to risk undermining a core comparative advantage of its export sector.

Institutions are the functional rules of the game that reduce transaction costs. This tradition draws upon a Williamson approach to ‘new economics of organization’.

Douglas North developed these arguments and applied them to political institutions.

More recently, many EU scholars use this approach to model decision-making in game theoretic terms, particularly in trying to explain why nation-states delegate sovereignty and decision-making to international organizations.

This approach has four relevant features.

  • First, actors are generally assumed to have fixed preferences and always attempt to maximize these.
  • Second, they see all politics as a collective action dilemma.
  • Third, all behavior is driven by a strategic calculus.
  • Finally, institutions are formed to facilitate co-operation.

Norm based, or sociological institutionalism, also has four distinctive characteristics.

  • First, institutions are more than just the rules of the game with an instrumental purpose. They are symbols, values, scripts, procedures and norms of appropriateness that give meaning to human action. Think about why we wait at a red light when the road is quiet (well, at least they do in Germany).
  •  Second, institutions matter because they prescribe norms of behavior. In the EU Council member-states adopt a norm of consensus rather than strategic calculation.
  • Third, they highlight the interactive and mutually constitutive character of decision-making.
  • Finally, institutions emerge less because of a means-ends calculation but because they give legitimacy to human endeavour.

Which of these ‘new insitutionalist’ approaches are better placed to explain the trajectory of European integration?

The obvious functional answer as to why nation-states would transfer sovereignty to the EU is that are the large material gains to be made from exchange and liberalization: time inconsistency, incomplete contracting, productivity and employment gains.

But this is only part of the story.

History and ideas played an important role, particularly the importance of new classical economics, which effectively ruled out any beneficial role for governments in the macro economy, and depoliticized demand management.

We will discuss this in more detail next week when we analyze the costs and benefits of establishing the single currency in Europe.

For the remainder of our course, I want you to think about the interaction between interests, ideas and institutions in explaining the trajectory of European integration.

 

Blog post assignment

Your blog post assignment is due on Friday November 11th, before 5pm (end of week 9). You must drop in a hard copy, and submit a copy on safe assign (via blackboard).

Here are some tips for writing a good blog post:

  1. Be clear about what you want to say before you start.
  2. Map out the paragraph structure in your rough work.
  3. Start with a clear puzzle and a specific question (questions lead to answers).
  4. Write a direct imaginative title.
  5. Write a captivating introduction.
  6. Specify your core claim/argument.
  7. Marshall empirical evidence to back up this claim.
  8. Discuss this evidence in relation to the wider literature.
  9. Graphically present your data where possible.
  10. Conclude by specifying why it is relevant.
  11. Write for a public audience.
  12. Use in-text citations (a rich bibliography signals that you’ve researched the topic).
  13. Enjoy the writing process.
The length is between 1200-1400 words. For a blog post this implies 10-13 concise paragraphs. The referencing style is Harvard.
Use online links in the text to direct the reader to the references. There is a blog option on Microsoft word, which is useful.
Make sure to write your name/student number on the cover page. Print on one side only, use font size 12, space 1.5, and staple the pages together. Use a standardized font.
You need to submit a hard copy into my assignment box in the SPIRe corridor + submit a copy via safe assign on blackboard.

Feel free to email me with your ideas, or to discuss further. For examples of excellent academic-style blogs, see this website: http://blogs.lse.ac.uk/europpblog/