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Globalisation: The horns of a trilemma



10 June 2010 14:04

In my previous post I looked at fiscal rules, independent fiscal agencies, and Thomas Friedman's Golden Straitjacket.

The latter is cited in a nice paper by Dani Rodrik for the Journal of Economic Perspectives (JEP). In it, Rodrik is thinking about the future of globalisation, and as a way of plotting out possible scenarios, he identifies a stylised international trilemma for the world economy.* Rodrik argues that countries can choose a maximum of two out of the following three options: democratic politics, national sovereignty and international economic integration: 

Rodrik's proposition is that the kind of deep economic integration implied by globalisation requires the removal of the transaction costs that arise when transactions cross international borders. Nation states are the big driver of these costs – they produce sovereign risk and regulatory discontinuities at the border, and they also make it difficult to agree on global standards and regulations.

One solution to this problem is to do away with nation states – Rodrik’s 'Global federalism' in the above diagram – and align global markets with global politics and global rules and regulations. 

A second option is to forfeit full economic integration to allow space for variation in national policies: in the diagram this is represented by the post-World War II Bretton Woods compromise, which, through the use of capital controls, tried to maintain national markets for capital. 

The third solution seeks to combine the nation state and full economic integration by donning Friedman's Golden Straitjacket at the expense of democratic choice. Here, economic policy-making is taken out of the political sphere, which is one way of thinking about independent central banks and independent fiscal agencies. (In practice, of course, the dividing line need not be so clear: central banks still need to factor political accountability into their decision-making.)

In the initial JEP paper, Rodrik bets that, in the long term, the world economy will be one of global federalism. But en route he thinks two other scenarios are possible: a 'backlash' scenario, under which governments resort to protectionism, or an alternative under which 'an ongoing series of financial crises will leave national electorates sufficiently shell-shocked that they willingly, if unhappily, don the Golden Straitjacket for the long run.' 

Initially, the GFC seemed to raise the prospect of the first of these but, to date anyway, the recourse to protectionism has been muted. Calls for governments to don fiscal straitjackets suggest that we might instead see some version of the second scenario. 

This too would be surprising, however, since one message from the GFC is that the solution of 'leave it to the market and to the technocrats' has also proved deeply problematic: outside of a few cases like Australia, the developed world's independent central banks haven't exactly covered themselves with glory in recent years, while the reputation of large parts of the financial sector has been badly tarnished.

Rodrik has recently applied his model to the Greek crisis. He suggests that the global financial crisis hit Europe when it was part-way through the process of replacing the nation state with federalism (in this case regional federalism, not global). The question for the Europeans is whether they push on with their project, or retreat to one of the other two solutions to the trilemma. 

As I've noted before, in the past the response has been to forge ahead, and there are signs that this might be the response this time. But as I also pointed out, domestic voters may be running out of patience. In particular, the cost of bailing out Greece means that Germans and German politicians seem to be losing some of their enthusiasm for the project.

* This is a variant on the original open economy trilemma (often called the impossible trinity), which states that policymakers can only opt for a maximum of two out of the three following choices: a fixed exchange rate, an independent monetary policy, and free capital mobility. For a quick summary, see this short article by Paul Krugman.

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