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:
- A fixed exchange rate,
- A sovereign monetary policy
- 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:
- Restrict the democratic state in the interest of minimizing the international transactions costs of globalization (i.e. reduce taxes and public services).
- 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).
- 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.
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 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.
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.