Seminar 6: National Trajectories of Liberalization in Europe

The varieties of capitalism (VofC) perspective has been the central framework to explain institutional differences between countries in the study of comparative political economy.

But it’s not viable if it cannot address and explain processes of institutional change. Let’s remind ourselves of the distinctive features of the VOfC approach:

  1. Firm-centric
  2. Rationalist
  3. Complementary institutions
  4. Equilibrium-based
  5. Stability

This leads to a typology of liberal and coordinated market economies (LMEs and CMEs), whereby employers are distinguished by the extent to which they pursue cooperative or competitive forms coordination. The institutions of a political economy are stable only as long as they are supported by certain segments of capital.

Institutional change occurs via the following mechanisms, which force MNCs and government to adapt/change:

  1. Exogenous shocks
  2. Endogenous drift (defection and re-interpretation)

The most cited example of drift and defection is how German employers managed to exit collective bargaining commitments, and their creative reinterpretation of German labour law (favorability principle). Flexibilisation occurred without rewriting the rules.

The form remained ‘stable’ but the ‘function’ changed.

Institutional reform in a market economy is always political because it sparks distributive conflict over who should bear the burden of adjustment.

Institutional arrangements in one sphere of the political economy condition the positions actors take in other spheres.

  1. The origins of pension reform in Sweden compared to the USA
  2. The origins of corporate governance reform in France and Germany

Despite all of this, VOfC is much better placed to explain stability than change. Further, there can be little doubt that all capitalist economies have experienced growing inequality. In the EU, there have been increased pressures for liberalisation.

How does VofC account for these changes? Does it imply all countries are converging toward a single neoliberal growth model? Does it mean that we should give up a comparative research agenda focused on explaining cross-national variation?

Kathleen Thelen suggests no. What we are observing are different trajectories of liberalization built around very different political coalitions.

Her core argument is that to explain institutional change in a political economy we need to analyze the underlying political coalitions upon which those institutions rest.

This requires untangling the difference between coordinated capitalism and egalitarian capitalism. VOfC is primality interested in the coordinated capacities of employers, and the productive capacities of firms. Whilst this may remain stable, over time, it does not imply these structures continue to be egalitarian.

Critics of VOfC are interested less in the efficiency-enhancing effects of economic institutions but their solidarity-enhancing effects. High levels of efficiency and high levels of equality only existed in the post-war golden age of European capitalism.

Over the past twenty years, different European countries have adapted to the pressures of exogenous and endogenous in different ways, and pursued different liberalizing moves. The figure below (figure 4 in Thelens article) illustrates the correlation, or not, between high/low equality and high/low coordination.

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This leads to three ideal-typical trajectories of of economic liberalisation in Europe:

  1. De-regulation (Anglo-Saxon)
  2. Dualisation (Continental Europe)
  3. Embedded flexibility (Scandinavia)

All are based on an expansion of market relations, but occur under the auspices of very different social coalitions, with significant implications for distributive outcomes.

Deregulation occurs through displacement; explicit and direct attempts to impose the market. For example, the assault on the collective bargaining rights of public sector workers in Wisconsin. If employers lack collective coordinating capacities they will do everything to ensure that labour does not either.

Dualisation is based around a differential spread of market forces and occurs through institutional drift (i.e. not updating policies to reflect change). This can often occur through the intensification of cooperation between employers and unions in core sectors of the economy, leading to “insiders and outsiders”.

Flexicurity occurs through conversion whereby labour market and social programs are re-adapted to ensure individuals are reintegrated into the market. This often occurs through active labor market policies, whereby institutions are turned to new goals and built around new social coalitions.

Central to all of these trajectories of change are electoral politics.

Social democratic countries mobilized women and expanded the public sector, thereby turning women into a core constituency of Scandinavian politics. This did not occur in countries with social insurance, or occupation based models, i.e Germany.

screen-shot-2016-10-18-at-12-40-03-p-m

In those countries where manufacturing dominated producer group politics, public policy continued to favour the manufacturing sector, and the trajectory was increased ‘dualism’ between high and low paid workers.

The implication of Thelen’s argument is that to build a new politics of social solidarity does not mean defending labour market institutions and public policies of the past. On the contrary, egalitarian varieties of capitalism remain robust when they are carried forward by new social coalitions and turned to significantly different ends.

Discussion

What type of institutional change does the EU promote? Who are the core actors? How does this interact with domestic politics.

 

 

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Seminar 5: The Politics of Economic Diversity within Europe

Political economists have always been interested in the differences in economic and political institutions that occur across countries. Some regard these differences as deviations from best practice that will dissolve  as nations ‘catch up’ to a technological or organizational leader. Others see them as durable historical choices for a specific kind of society, since institutions conditions levels of social protection and the distribution of income. In each case comparative political economy revolves around conceptual frameworks used to understand institutional variation across nations.

Introduction 

This is the open line to Hall & Soskice’s (2001) seminal book on ‘varieties of capitalism’ (VOfC). It’s core objective is to provide a theoretical framework for understanding the institutional similarities and differences between market economies. It’s a foundational study in the politics of comparative capitalism.

The overarching question guiding the literature on ‘the politics of comparative/advanced capitalism’ is whether we can expect the competitive pressures of globalization to lead to convergence among the advanced industrial societies of the world? Put simply; are all countries converging on a “neoliberal” model of capitalist development?

In this seminar we are going to examine those factors that condition the adjustment path a political economy takes in the face of such challenges. We will ask whether European integration is compatible with different growth models, and whether the EU gives priority to some growth models over others. The Eurozone is an excellent case study to examine this question.

To start, it is worth going back to the classical varieties of capitalism framework (VOfC), to assess it’s merits and limitations.

Debate

VOfC can be considered an attempt to move beyond three different perspectives in the study of comparative capitalism:

  1. Modernization theory (role of the state), classic case studies included France and Japan.
  2. Neo-corporatism (unions-employers), classic case studies included the UK and Germany
  3. Social systems of production (governance), classic case studies included Batten-Württemberg and Third Italy.

VOfC places the firm (or MNC corporation) at the centre of what they call an ‘actor-centred institutional’ framework’. The latter comes from the study of game theory, and rational choice institutionalism.

The corporate firm

VOfC scholars model the behaviour of the corporate firm in game-theoretic terms (strategic interaction). The rationale for this is to provide ‘micro-foundations’ to their ‘macro-economic analysis’. In effect, it is an attempt to replace neoclassical economics with new micro foundations built around the corporate firm and domestic institutions.

The basic elements of the theoretical approach can be summarized as follows:

  • It starts with a relational view of the corporate firm (MNC success depends upon overcoming coordination problems with a wide range of actors).T

Theory 

There are five sub-spheres of the political economy that the corporate firm must engage with, and each throws up a set of coordination problems that need to be resolved if the firms wants to become competitive in a market economy:

  • Industrial/labour relations (managing wage and productivity levels)
  • Vocational training and education (securing a workforce with suitable skills)
  • Corporate finance (secure sufficient levels of finance and investment)
  • Inter-firm relations (securing relationship with suppliers and clients through marketing and sales)
  • Employee relations (developing specialized information/culture within the firm)

Typology

From the VOfC perspective, different countries can be distinguished on the basis of how their MNC firms resolve these coordination problems. Not all firms are the same. Not all domestic institutions are the same. This leads to two ‘ideal types’ along which nations can be arrayed:

  • Liberal market economies (LMEs), of which the USA is an archetype case.
  • Coordinated market economies (CMEs), of which Germany is an archetype case.

In LMEs, firms primarily coordinate their activities via competitive market arrangements: formal contracting based on the price signal and the marginal calculations stressed by neoclassical economics. In CMEs firms depend more heavily on non-market relationships: incomplete contracting and network monitoring based on collaborative relationships and strategic interactions.

Markets (and national models of capitalism) are conceptualized as a set of qualitatively distinct complementary institutions (rules) that support the strategic capacity for:

  • The exchange of information
  • The monitoring of behavior
  • The sanctioning of defection

Deliberation 

One additional factor is emphasized in VOfC that doe snot generally exist in game-theoretic approaches: deliberation.

Deliberation describes the capacity of conflicting actors to reach agreement on the collective and coordination problems they face. Deliberative institutions are forums for communication or problem-solving that provide actors with strategic capacities they would otherwise not enjoy.

In a political economy, where you have multiple actors and multiple iterations (and therefore multiple equillibria), formal institutions are rarely sufficient to guarantee coordination on an agreed equilibrium (for example, how to distribute the burden of fiscal adjustment, austerity).

This requires informal rules, norms and understandings on what is socially appropriate. History and a common culture matter.

Institutional complementarity 

VOfC contends that path dependent differences in the institutional framework (embedded in the five sub-systems mentioned above) of the political economy generate systemic differences in across LMEs and CMEs. They are differences in kind. Each economy operates according to its own distinct logic.

The presence of institutional complementarities reinforce these differences between LMEs and CMEs. VOfC scholars regularly cite the strong correlation between employment protection and stock market capitalisation, which is considered important for long-term and short-term skill investment.

A nation-state (political economy) that has one type of coordination in one sphere of the economy (flexible labour markets) tend to develop complementary practices in other spheres of the economy (de-regulated finance). If this is correct, institutional practices of various types should not be distributed randomly. They should cluster on the LME and CME divide.

Can we say this about a multilevel polity such as EMU?

The LME-CME difference is strongly supported by data on labour market and corporate finance across the OECD. LMEs rely more on markets for both of these, whereas CMEs tend rely on non-market forms of coordination, particularly when it comes to skill formation i.e. human capital regimes.

Old Germany 

The production regime in Germany, in the past, was usually considered the archetype CME. This gives rise to the following set of complementary institutions (see figures 1.3-1.4 in the introduction):

  • Patient capital that enable firms to retain a skilled workforce through economic downturns.
  • Executive managers have structural incentives to engage in consensus-based decision making.
  • Sectoral or industry level pattern wage-setting
  • Industry specific labour skills dependent upon vocational training
  • Inter-firm research, product development and innovation based around strong industry associations

Comparative institutional advantage

On the basis of all this VOfC gives rise to a theory of comparative institutional advantage, which explains why particular types of products are produced in certain types of political economy.

In the export sector this gives rise to a distinction between production regimes with a tendency toward radical or incremental innovation.

How then will these different political economies (and political governmental regimes) adjust to international economic integration?

Politics of adjustment 

The theory of comparative institutional advantage suggests that countries will adjust toward ‘market oriented’ or ‘coordination oriented’ public policies when confronted with a crisis. Corporate firms are not the same, and will adjust very differently, as will governments. This is broadly true when we examine how countries initially adjusted to the Eurozone crisis.

VOfC has been critiqued from five different angles:

  • It presents a too static view of political economies and cannot adequately explain institutional change (divergence within convergence)
  • It underestimated the power of international finance and the importance of monetary regimes (particularly within Europe)
  • It ignores the central role of partisan politics and class conflict in shaping distributional outcomes (power resources)
  • It is an ideal type typology that is not deductively testable (methodologically problematic)
  • It places too much emphasis on the nation-state as the unit of analysis (in a world of supranational governance).

From a VOfC production regime perspective, welfare state development emerges from the strength not the weakness of employers, particularly in CMEs.

It is assumed that business interests will want social insurance, to insure against market risk, which in turn will enable them and their employees to invest in asset-specific skills. Absent this (i.e. in LMEs), there will be no encompassing welfare state development.

Is the VOfC perspective wedded to an understanding of the political economy of manufacturing? How relevant is this today?

New wave of comparative capitalist scholarship 

There have been two dominant responses to the VOfC paradigm, and structural changes in the economy, which have revolutionised the sectoral composition of the labour market, and the politics of money/finance and global capital: an electoral turn, and a macroeconomic turn.

  • The electoral turn focuses on electoral cleavages, and how these increasingly shape economic policymaking, and subsequently the politics of capitalist diversity.
  • The macroeconomic turn focuses on the determinants of aggregate demand (exports and consumption-led), and underlying class-distributional conflicts that shape these.

Both perspectives have dropped the focus on the corporate firm and state elites as political actors in their own right.

  • Another perspective (which I am sympathetic toward) focuses on the set of mutual dependencies that exist between business and the state. The politics of capitalist diversity is an outcome of divergent growth regimes, which are shaped by the quiet elite politics of the business-state relationship.

Discuss these in relation to the Eurozone crisis. Which perspective is better places to explain the origins and response to the Euro crisis?

Seminar 4: Political Institutions and Economic Growth in Europe

Introduction

What made the rapid economic growth in Europe possible after World War II? What explains the slow down from the 1980’s onwards? What public policies can governments pursue to maximise economic and employment performance?

It’s the latter question that every political party in government must consider.

In the post-war era, convergence is defined as the process of transferring the technological and organisational knowledge that had been developed during the war years to European firms and economic development.

The re-building of the capital stock in Europe, and all the labour that was required to do this, spurred the initial period of growth. This was subsequently sustained by commercialising those new technologies that developed during the two world wars.

For Barry Eichengreen (2007), Europe was singularly well suited to take advantage of this period of technological improvement because of a given set of domestic institutions.

Growth was facilitated by encompassing trade unions, cohesive employer associations and growth-minded governments. Together they mobilised savings, financed investment and stabilised wage-income levels consistent with full employment.

  • It required a set of domestic institutions (formal and informal) and a public policy regime aimed at solving a set of problems that de-centralised markets could not.
    • It required coordinated capitalism, made possible by a relatively broad consensus among centre-left/centre-right governments on the role of the state.

Economic institutions 

The origins of post-war industrial production in Western Europe, in effect, required systems of human capital formation (emphasising apprenticeship training and vocational skills) and an active role for the state and social partners.

It was the period of manufacturing-led export growth.

Convergence and catch-up was also attempted by the command economies in the Soviet Union. The institutions of these countries had severe limitations. Extractive political regimes, as argued by Acemoglu and Robinson (2011), don’t last long.

Europe relied on extensive growth in the 30 year post-war period, which meant that a growth in factor inputs (labour and capital) accounted for the increase in productivity and employment outputs.

But from the 1970’s onwards, changes in the international monetary regime, and the opening of the global economy, Europe faced a new set of problems: The challenge of intensive growth.

This is growth that must occur through innovation, technological and productivity improvements (i.e. not just increasing the input of capital and labour).

Intensive growth proved a more difficult task, as the domestic institutions in Europe that enabled extensive growth were now an impediment to reform.

Centrally planned economies were particularly inept at this. All of this facilitated a gradual shift toward more liberalised markets, particularly across the EU.

Europeanisation

European integration was directly related to this process of global economic change, as it required nation-states to liberalise their capital and product markets.

In the 1950’s, six European states put the planning of their iron and steel industries under multinational control. In the 1960’s, they built the first regional customs union (a free trade area with a common external tariff). These countries then went on to construct the single market (1986) and a single currency (1992), as discussed previously.

But what exactly were the domestic institutions, associated with the golden age of European capitalism, which gave rise to post-war growth, high investment, rapid export growth, low inequality and wage moderation? How did these institutions change?

Can we generalize from this experience and say that domestic institutions are the determinants of long-term economic growth? If so, what exactly does this mean?

Four regimes

Peter Hall (2010) suggests that economic performance depends upon success in four institutional fields that differed in the 1950-1970’s ( for the sake of analytic parsimony, we can call this the Keynesian era) and the 1980-2000’s (the neoliberal era):

  1. Production
  2. Labour relations
  3. Socioeconomic policy
  4. International regimes

In Western Europe, the era of mass Fordist production (manufacturing oriented export growth) required long-term capital investment (1 – production regime).

This meant that firms needed certainty about aggregate demand and profits.

Coordinated collective bargaining, among economising social partners, ensured sufficient wage growth to maintain demand but also allowed profits to grow, whilst simultaneously workers invested in specific skills (2 – labour relations regime).

At the same time, national governments took active steps to manage aggregate demand aimed at full employment via the Keynesian welfare state (or think the Rehn-Meidner model in Sweden (3 – socioeconomic policy regime).

Simultaneously international monetary regimes, such as the fixed exchange rate regime in the European Community, accommodated and tolerated an interventionist domestic demand management strategy (4 – international regime).

Keynesian era

All of these economic institutions had deep political roots.

They were not the outcome of an intelligent techno-rational engineer. Rather, they were born out of distributional conflict, constructed by country specific electoral coalitions, which manifested itself in the various forms of the social state.

For Peter Hall, the post-war distributional compromise was shaped by:

  1. Memory of war and recession
  2. Keynesian ideas that appealed to left and right
  3. Partisan electoral competition

In post-war Europe, class-based distributive politics shaped electoral competition and the policy-platforms of mass political parties.

Political parties of the left and right converged around the “mixed market economy” and a “compensating social state”. This class-based electoral competition drove forward the development of wage-led growth regimes. Wage growth sustained demand.

Class discussion: Can we identify an analogous institutional architecture for the subsequent era, from the 1980s to the mid-2000s?

Neoliberal

It is now commonplace to describe the period of socio-structural economic change from the 1980’s onwards, the neoliberal period economic change. Others call it a shift from demand-managed economies, to supply-side managed economies.

In terms of production, the major change was a structural shift away from manufacturing to services, particularly with respect to employment, outsourcing, and the emergence of new information technologies that have fundamentally re-shaped global supply chains (1 – production regime).

These structural economic changes, however, were made possible by shifts in the international monetary regime, which facilitated FDI, capital flows, off-shoring and global financial liberalization aimed at free capital movement (4 – international regime).

In response, there has been a premium placed on high-tech skills, labour market competition, leading to skills-based technological change. Collective bargaining has gradually shifted to the market (firm level) whilst trade union density rates have declined in response to new forms of employment (2 – labour relations regime).

Governments have been less concerned with managing aggregate demand but introducing supply-side reforms aimed at cost reduction (3 – socio-economic regime).

The politics of liberalization

But what were the political conditions that made this shift to post-1980 market liberalism possible? Or more precisely, who were the actors? The electoral coalitions?

Peter Hall identifies the following factors:

  1. Memory of failed state intervention
  2. New classical economic ideas built on monetarist foundations
  3. Fragmented electoral competition

Politically, new electoral cleavages have emerged that cut across the left-right spectrum, and in turn, have restructured political conflict.

Class dealignment, declining voter turnout among low income groups, shifts in occupation structure and rising electoral volatility have meant that centrist parties converged on “supply side policy choices”.

But this consensus has had important consequences: the electoral space is increasingly occupied by populist far-right parties (who have shifted to the left, economically).

In the study of comparative political economy, this has led to debates about whether all countries are converging on a neoliberal model of capitalist development?

As we will see in next weeks seminar, whilst there are certainly commonalities across European countries, but important cross-national differences still remain.

European varieties of capitalism

The policy response to this paradigm shift in the macroeconomy varies between countries, particularly in how they have sought to generate employment growth (i.e. in the absence of state commitment to sustaining aggregate demand).

  • In the liberal market growth model (particularly US and UK) private debt (primarily in mortgage markets and housing finance) during this neoliberal period replaced real wage increases, and consumption sustained aggregate demand.

Housing (funded by cheaper mortgages) became a form of social policy, whilst cheaper imports enabled higher levels of consumption.

The wealth effect, according to recent research, ensured political support for low-tax parties, which generally favour the new right.

In continental European social market economies, two divergent approaches emerged.

  • In the small open Nordic economies the trajectory of liberalization meant an expansion of public services: healthcare, education, childcare, funded by high tax rates. These “flexicurity” regimes often built on the Rehn-Meidner model.
  • In conservative welfare states the new response was built around expanding employment in secondary labour markets (Germany, Italy, Spain) by relaxing restrictions on part-time work and temporary contracts.

Most comparative political economy research suggests that countries with “conservative welfare states” developed “dualised” labour markets, divided into spheres of stable employment in the industrial and/or public sector, and precarious employment in the expanding low-skill private sector services.

Discussion 

If these two different paradigm reflected a generation of socio-structural change, it is worth considering whether we are we now entering a new 30 year period that will shape the architecture of European political economies? What will this trajectory look like?

Class discussion: Is there a new European wide growth regime?

Case study: post-war Germany (that is no more)

Prior to the late 1990’s, Germany was governed by a set of domestic institutions that made for strong international competitiveness that facilitated high-wages and low inequality of incomes and living standards. How was this possible?

For Streeck (1998) the post-war institutional framework can be summarized as follows:

  1. Markets: price competition was mitigated by product specialization. Competitive markets (with strict competition laws) were designed to serve public purposes and to co-exist with an extensive social welfare state.
  2. Firms were considered social institutions and not just networks of private contracts for the property of shareholders. This incentivised long-term relations with banks rather than relying on equity in the stock market.
  3. Labour: human skills in these export firms were considered a fixed productive asset that encouraged employer investment in education and training. Co-determination and employment protection were high.
  4. State: the state was enabling rather than laissez faire. Sovereignty was divided horizontally and vertically, and constitutionally dedicated to competitive markets and a hard currency, whilst public spending on infrastructure and research high. Spending on social protection was high because there is a constitutional obligation to equalize living standards across the Länder.
  5. Associations: economic governance is delegated to centralized and economically sophisticated collective bargaining actors with quasi-public functions: skills, insurance, health and safety, product regulation, quality. Note: union-employer density is now in free-fall, along with bargaining coverage.
  6. Culture: savings rates are high and consumer credit low, which suggests that building long-term orientations are a social norm, and reflected in the qualification-based organization of work.

Beneficial constraints 

In the 1990’s the argument was that these densely regulated institutions imposed a beneficial constraint on employers, forcing them to compete on quality rather than price.

However, three broader conditions to make this strategy successful had to be met:

  1. High global demand for product markets
  2. High investment in product innovation, research and development
  3. Steady supply of high-skilled labour/jobs (and therefore balanced against retirement)

Germany could not sustain the latter (it’s welfare system, and in particular, the cost of pensions). Social institutions that rule out a low wage economy, in order to sustain a high wage economy, will eventually be overrun by market forces.

This is what happened to Germany from the 1990’s onwards.

Germany initially responded to this by reducing retirement (cutting the labour supply of labour). But this became too costly in terms of pensions.

Eventually the government liberalized the labour market (Hartz I and II), leading to a rapidly expansive low-wage sector and an increasingly dualized workforce.

This is an important observation, as it might explain the EU’s response to the Euro crisis in southern Europe, and why the SPD are in such electoral difficulty today.

Three factors can explain the transformation of German capitalism over the past decade.

  • A shift in the bargaining power of actors.
  • The shock of German unification, European integration and globalization.
  • Active management of wage restraint (and growing income inequality), and low-wage employment.

Conclusion 

Discuss. Can the post-war German social market economy (even though it doesn’t really exist anymore) be shifted upwards and exported to the EU as a whole?

This is very difficult for four reasons:

  1. The EU is an international organization constructed through diplomacy not the class politics that gave rise to soziale Markwirtschaft
  2. The German firm is embedded in the broader institutional matrix of the German political economy that is not easily replicable.
  3. There is no EU wide state capacity to equalize living standards
  4. There are no collective bargaining associations with the capacity for high-skill investment

Class discussion 

Screen Shot 2017-10-02 at 22.13.45

Do you agree with the argument by Acemoglu and Robinson that political and economic institutions are the fundamental cause of long-term economic growth?

What’s the causal mechanism in their theory? Does it suggest that economies with higher levels of economic inequality will have lower levels of economic growth?

Seminar 3: The costs and benefits of the single currency.

Introduction

The trilemma associated with governing an open economy in an international market 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 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 trilemma? 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.

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 favouring the liberalisation 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. Societal interest groups push their economic preferences, and governments aggregate these preferences, and use them to formulate bargaining positions.

Economic policymaking is often conceptualised as a form of “organised combat” among competing producer interest groups. This approach has three powerful advantages.

First, it recognises 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. But think about Brexit. The Tory government have pursued a policy, which dominant business interests tend not to want. This would suggest that the Conservative party are responding to something else.

Who are they responding to? Voters? Conservative party elites?

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 often 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 government and party partisanship.

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

More recently, the electoral approach has been conceived systematically in terms of the “supply/demand” of party politics, and best articulated in the constrained partisanship model (Beramendi et al 2015) you read for class this week.

What does the supply and demand of electoral politics mean? How does this relate to preference formation when it comes to understanding European integration?

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, and will pursue policies that represent their core constituencies.

Second, politicians often do stimulate the economy unnecessarily before an election, and there are embedded policy regimes. 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 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? Was it governments who designed the policy response to the euro crisis?

Second, it is analytically attractive to assume a ‘median voter’ and a homogenous electorate with fixed preferences. But politics is far more complicated, as outlined by Beramendi et al. 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, and it’s impossible to ignore the central role of electoral politics in shaping the trajectory of integration.

Institution based 

Institution based approaches generally seek to explain variation in economic and employment policies by examining the causal influence of the organisational structure of the economy on government choices. More often than not, interest based approaches are complemented by institutional based approaches (i.e. constrained partisanship).

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. But more recently, and as outlined above, electorates are bring in as the agent of change.

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

Unlike neoclassical economics the institutional approach emphasises the institutional differences across nations over time. The impact of globalisation 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.

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

Neo-corporatist

  • Neo-corporatist’ research traced differences in macroeconomic performance to whether trade union and employer associations were either centralised or de-centralised.
  • Centralised trade unions and employers were capable of internalising the inflationary pressures associated with full employment, and can pursue wage-restraint in response to European market integration.

This theoretical school of thought was particularly important in the aftermath of the oil crisis shock in the late 1970’s and in 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 emphasised 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? Or why might small open economies have larger public sectors and welfare states?

Varieties of capitalism

  • From the early 1990’s it was gradually recognised that the structure of political economies  were also related to the structure of industrial relations, vocational training, labour markets corporate governance and the financial system.
  • Each sub-sector complemented each other to create distinct “systems” of organising 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 (Hall and Soskice 2001)

Institutional structures interact in complex ways across different sub-policy spheres of the economy to create a matrix that shapes the strategies/policies of both firms and government. The institutional 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 (and financial liberalisation).

Second, it identifies the strategies of firms as central to the 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 

Ideational 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 analysing 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 liberalise 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. It is the ideas that elites have that really matters.

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 ideational explanations is that it is not clear whether it is norms, ideas, discourse, interests, culture or ideology that is the causal factor behind economic policymaking. Trying to disentangle ideas from material interests is not easy.

Material interests are a lot easier to “model”, which is why social scientists tend to focus on interests and preference formation, over the role of ideas and culture.

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 broadly applied to the study of European integration, but clearly need to be made more precise, and specific, in order to develop empirical hypothesis to be tested against real-world cases.

How do ideas, interests and institutions relate to Moracvisk’s original theory of liberal intergovernmental explanations for 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, or in terms of the present trajectory of European monetary integration.

Previously:

  • Interest based scholars focused on coalition building among farmers and industrial workers, particularly in France and the UK.
  • Institutional scholars emphasise the different strategic capacities of the state to engage in public investment.
  • Ideational scholars emphasised 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 conceptualised.

Three institutionalism 

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 organisational structure of the polity or political economy. Paul Pierson, whom you read this week, applies this to explaining EU integration.

It is not easy to change path, once a given set of policies/Treaties are implemented.

HI’s tend to emphasise 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 institutionalist’ 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 liberalisation: 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 depoliticised 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.